Institutional Quality and Development: On the Role of Informality

It is well understood that developing countries have large informal sectors. The informal sector, however, has a theoretically ambiguous effect on development. Some view informality as one aspect that comes from lacking full development, while others see informal activity as a restraint to growth. We argue that this ambiguity is because its impact is conditional on both the size of the locale and the existing institutional environment. Good institutions facilitate productive activity and voluntary exchange when informal networks are insufficient. Informal activity facilitates economic growth most effectively in smaller communities. We explore how the conditional effects vary across different population sizes. This diverges with the view that informality and formal activity are substitutes. We hypothesize that instead they can be complimentary in certain aspects. Using data from 5,505 Brazilian municipalities, we analyze the relationship between (formal) institutions, informality, and development. We use three separate measures for institutional quality: governance quality, de facto law provisions, and distribution of political power. In a previous study, these indicators were found to be positively associated with economic performance. Following the previous literature, we define the informal sector as those that do not contribute to the country's social security. In our baseline results, we find inconsistent results between the conditionality of institutional quality and informality. Only once we include the conditionality of population size do we find that formal institutions and informal production tend to be substitutable in areas with large populations, and complementary in small municipalities. We emphasize our differential effects, which have less potential endogeneity concerns. However, we stress that our results should not be interpreted as causal. Our results do highlight the importance of informal networks to economic development, especially in small locales. Future research may be warranted to address causality, as well as exploring the cultural aspect associated with informal networks and population size.