Financial structure, informality and development

The impact of capital market imperfections and costs of creating and operating formal sector firms on total factor productivity is studied. We propose a firm dynamics model with endogenous formal and informal sectors where firms face a technology adoption opportunity. The model predicts that countries with a low degree of debt enforcement and high costs of formality are characterized by low allocative efficiency and large output shares produced by low productivity, informal sector firms. For frictions parametrized using the Doing Business database, the model generates a drop in total factor productivity of up to 25% relative to the US. ► This is a theory of TFP based on measured institutional differences across countries. ► We develop a firm dynamics model with endogenous formal and informal sectors. ► Countries with high formality costs are characterized by low allocative efficiency. ► They also display a large share output produced by low productivity informal firms. ► The model explains between 40% and 70% of TFP differences across countries.