Informal Sector and Economic Growth:

The Supply of Credit Channel∗

Baptiste Massenot† Stéphane Straub‡
September 2011

Abstract

A standard view holds that removing barriers to entry and improving judicial
enforcement would reduce informality and boost investment and growth. We show,
however, that this conclusion may not hold in countries with a concentrated bank-
ing sector or with low financial openness. When the formal sector becomes larger
in those countries, more entrepreneurs become creditworthy and the higher pres-
sure in the credit market increases the interest rate. This reduces future capital
accumulation. We show some empirical evidence consistent with these predictions.
Keywords: Informal sector; Barriers to entry; Credit market; Enforcement; Fi-
nancial openness
JEL Classification Numbers: O17

1 Introduction

A popular idea in policy circles holds that granting access to formal credit markets to
potential entrepreneurs, by improving public institutions and specific regulations, is an
important condition for economic development. In particular, reforms allowing economic
agents to formalize and therefore better collateralize their assets should naturally lead
them to invest more, increase their productivity, and ultimately the benefit of higher
overall growth would ensue. Such reforms typically include strengthening property rights
on land and housing, and reducing burdensome registration procedures.1
∗
We are grateful to Catherine Casamatta, Tiago Cavalcanti, Florencio López de Silanes, Gilles Saint-
Paul, David Thesmar and seminar participants at the SSES annual meeting in Lucerne for very helpful
comments.
†
University of Lausanne, [email protected]
‡
Toulouse School of Economics, ARQADE, and IDEI, [email protected]
1
This was famously suggested by ? and ?.

1
 This paper examines in a general equilibrium framework the chain of causality behind
that line of thinking. It does so by modeling explicitly individual agents’ decisions to
become formal in relation with their access to a credit market plagued by moral hazard,
and the effect of these decisions on the size of the formal sector and on the level of output.
The main insight is that while better property rights and less burdensome regulations may
under certain conditions facilitate agents’ access to formal loans, such reforms interact
with the characteristics of the credit market and its environment in ways that crucially
shape the ultimate magnitude of the effect on formality and output.
In a nutshell, the modeling strategy relies on an overlapping-generations model where
economic agents, when young, undertake productive projects, deciding whether to work in
the formal or informal sector. These decisions depend on the trade-off between the costs
of entry and the benefit from accessing the formal credit market, itself a function of the
quality of enforcement and property rights, which allow for the efficient collateralization of
assets. Entrepreneurs save part of their profits for future consumption and these savings
constitute next period’s supply of credit in the economy.
In this context, the equilibrium interest rate that results from the interaction between
the supply of loanable funds and the demand for credit is a key variable in determining the
equilibrium level of formality. Indeed, lower entry costs and better contract enforcement
unambiguously imply a larger formal sector, a higher demand for credit and higher output
as long as there is an infinitely elastic supply of funds at the prevailing interest rate, for
example in the case of an open economy with no barriers to international capital flows and
a competitive banking sector. However, absent these conditions, an increase in demand
resulting from a higher rate of formality increases the interest rate, weakening the link
between reforms, formality and output.
Finally, we show some empirical evidence related to the implications of our model. We
find that countries with lower entry costs or a higher quality of enforcement tend to have
a larger credit market and a smaller informal sector, the more so the more competitive
their banking sector and the more open to international capital flows their economy.

2
Related Literature The argument above is composed of two parts. First is the link
between better regulations and access to credit at the individual level, resulting in in-
creased incentives to enter formality, and second is the link between these individual
decisions and output or growth.
As for the first part of the story, it is relatively well understood how light registration
procedures and strong property rights interact in providing the necessary conditions to
access the credit market. As first shown by ? in the case of Peru, and further documented
by ? for 85 countries, firms first face significant “entry costs”, in the form of registration
and license fees, to be able to operate formally.2
As discussed in ?, formal lenders commonly impose an array of requirements on
prospective borrowers before entering in legal contractual relationships. These include
making operations observable through accounting books, providing credible proof of lo-
cation, and being able to attach valuable assets as collateral. Complying with the entry
regulations described above can be considered as a way to satisfy these requirements.3
Moreover, smoothly functioning credit markets also rely on effective property rights, in
at least two ways. First, the existence of property titles is a necessary condition for
collateralized credit.4 Second, good enforcement of such rights allows lenders to recoup
their money in case of failure or conflict. Thus, slow and costly judicial processes may
significantly affect access to credit for small borrowers, even in the presence of formal
property titles.5
Most microeconometric empirical studies, however, find a weak or insignificant effect
of improved property rights on credit market access for the poor. For example, ?, find
no evidence that a nationwide titling program in Peru (the biggest of its kind worldwide)
increased access to private credit among the poor. The discussion alludes to the fact that

2
According to ?, they range from a low of 2 procedures, taking two days and generating a cost
equivalent to 2.3% of per capita GDP in Canada, to a high of 21 procedures, 80 days and 463% of per
capita GDP in the Dominican Republic. ? and ? provide microeconomic evidence from a program in
Mexico that reducing these costs spurs entry from new entrepreneurs.
3
Of course, this is not to say that such regulations and their costs are efficient. Indeed, in developing
countries they often respond to extractive motivations (see ?; ?).
4
Collateralized loans are the most common formal credit contracts in developing countries. See ? for
stylized facts and discussion.
5
See for example the studies in ? for microeconomic evidence, and ?, ? for regional and cross-country
evidence.

3
banks probably face complex changes in the composition of demand for credit and may
alter the way they price loans in response to the evolution of foreclosing rules.
? provide a complementary rationale for why informality is so prevalent. They build
a model of a de Soto effect and show that if the degree of credit market competition is
low, borrowers may lose from improving property rights and thus they may oppose any
such reform.
The second part of the story links the level of formality to output. Such a link has
been put forward among others by ? and ?. More recently, ? analyze how much of the
variation in the size of the informal sector and in the level of per capita income across
countries can be explained by regulation costs and enforcement of financial contracts.
Calibrating their model to US data, they conclude that it is regulation (a fixed cost of
formality) that accounts for most of the differences in the size of informal sectors between
the United States and Mediterranean Europe, while for a developing country like Peru,
contract enforcement appears to be equally important. However, these factors fail to
account for most of the income differences among countries. Importantly, Antunes and
Cavalcanti assume that the local lenders have access to world capital markets and borrow
or lend any amount at a constant interest rate.
Closer to our paper are ? and ? who present general equilibrium models with financial
frictions and an endogenous interest rate. These references find two effects of smaller
financial frictions on the economy. First, a standard positive demand effect because
individuals obtain more credit. This results in a higher interest rate which leads to a
second negative effect on the future supply of credit. ? compare the effect of a higher
investor protection on the economy in a closed and in an open economy. In the open
economy, there is only the demand effect because the interest rate is taken as given. In
the closed economy, the same demand effect implies a higher interest rate which reduces
the profits and the savings of entrepreneurs, leading to the second negative effect on the
supply of credit. Similarly, ? show that lower intermediation costs or better enforcement
have the same two counteracting effects on the economy and find the supply effect to be
quantitatively significant.

4
 Our paper focuses on the impact of the quality of enforcement and of entry costs on the
size of the informal sector and on output. Its main insight is to point out the importance
of the second general equilibrium negative effect that has generally been ignored in policy
discussions about the merits of reducing the size of the informal sector. We show that this
negative supply effect arises when there is low financial openness or weak competition
in the banking sector. This has implications for the timing of development policies,
suggesting that reforms aimed at reducing informality by removing barriers to entry or
improving enforcement can be more effective in financially liberalized countries.
The paper is organized as follows. Section 2 presents the model. Section 3 discusses
the related empirical evidence. Section 4 concludes.

2 The Model

This section presents an overlapping generations model with (i) a financial friction
arising from a moral hazard problem between investors and entrepreneurs and (ii) an
informal and a formal sector.

2.1 The Environment

The economy consists of an infinite sequence of two-period lived overlapping gen-

erations, with time indexed by t = 0, 1, .... There is no population growth and each
generation is normalized to a continuum of size 1. There are three goods in the economy:
capital k, final good y and a collateral good X, for example a house or a piece of land.
Capital is used for the production of the final good and can be stored. The final good
is used as a numeraire and for consumption. The collateral good is used to secure loans.
Following ?, young agents are endowed with an amount X of collateral good, which is
uniformly distributed between 0 and 1 and the cumulative distribution function of which
is denoted by D(X). At t = 0 there is an initial old generation endowed with a level of
capital k0 .
Individuals born at t have preferences defined over their level of consumption of final

5
good both at t and t + 1:

u(ct , ct+1 ) = ln(ct ) + β ln(ct+1 ), (1)

where β is the discount factor.

Young agents can use a technology that transforms capital into the final good:

yt = ãkt , (2)

where ã is a productivity parameter that can be high (ã = A) or low (ã = 0). The
probability of success depends on the level of effort of the entrepreneur: he can either
work, in which case the probability of success is pH , or shirk, in which case it is only
pL < pH , but he enjoys a non-monetary private benefit Bkt (or equivalently saves on the
cost of effort).
Young entrepreneurs do not have any capital but they can borrow from banks. We
follow ? by assuming that banks can observe the outcome of the project but not the effort
of the entrepreneur. These contracts specify the amount of capital kt to be lent and a
repayment rt to the lender if the project is successful. Banks can seize the collateral X
of entrepreneurs if the project fails.
This setting is summarized in Figure ??. Each period t is divided in two sub-periods
t− and t+ in the following way (considering agents born at t): At t− , agents are born and
endowed with a an amount of collateral X. Given this endowment, they borrow from
the olds of the previous generation a certain amount of capital that they use to carry out
their productive project. At t+ , they use the proceed from the project to consume and
save. At t + 1− , they lend part or the totality of their savings from the previous period
t+ to the young agents born at t + 1− . Finally, at t + 1+ , they consume the rest of their
saving and the return on their loan.

6
 Figure 1: Timing

2.2 The Choice Between Formal and Informal Sectors

Entrepreneurs can decide to enter either the formal or the informal sector.6 The
benefit of entering the formal sector is that they can pledge their collateral to banks, which
allows them to borrow more. The downside is that entering the formal sector is costly.
This section compares these costs and benefits and infers which sector entrepreneurs
decide to enter as a function of their collateral endowment.
We assume that it is less profitable for banks to lend to shirking entrepreneurs than
to store and that high effort is more profitable than storing, by setting pL A + B < pH A.
As a result, banks only offer contracts that induce entrepreneurs to work. This gives the
following incentive compatibility constraint:

pH (Akt − rt ) ≥ pL (Akt − rt ) + Bkt . (3)

Banks cannot seize the collateral of informal entrepreneurs whose project failed and
6
The difference with ? is that here income is verifiable both by formal and informal lenders. This
assumption is in line with the literature on financial markets in developing countries, which generally
holds that the formal financial sector has a comparative advantage in fund intermediation over space
and in creating scale economies, as well as the technical possibility to attach assets as collateral, while
the informal credit market enjoys superiority in solving enforcement and information problems (See ?).

7
they only get paid by successful entrepreneurs. The break-even constraint of banks tells
us that their expected benefit should at least cover the interests paid to depositors:

pH rt ≥ it kt . (4)

Assuming a competitive banking sector, equations (??) and (??) are binding. Then,
combining these two constraints and using the assumption above (pL A + B < pH A) gives
the solutions kt = 0 and rt = 0. No lending and thus no production occurs in the informal
sector.7
If entrepreneurs decide to operate formally, they have to pay a fixed cost C, that
represents the direct costs of registration or the time wasted in procedures. We assume
that this cost reduces the amount of the available collateral to X −C. Formal registration
allows banks to seize a proportion θ of this available collateral. The parameter θ can be
interpreted as the quality of enforcement: seizing collateral in court can be slow and
imperfect, the laws protecting creditor rights can be inefficient, etc. The remaining share
1 − θ is assumed to disappear.
The break-even constraint of a bank contracting with a formal entrepreneur becomes:

pH rt + (1 − pH ) θ (X − C) ≥ kt it . (5)

Combining equations (??) and (??) gives the following financial contract:

kt = φ(it )∆pθ (X − C) , (6)

and
rt = φ(it )(∆pA − B)θ (X − C) , (7)

(1−pH )
where φ(it ) = ∆p(it −pH A)+pH B
, with Φ0 (it ) < 0. Entrepreneurs can now borrow from banks
if they operate in the formal sector.8 A lower interest rate it , lower entry costs C, better

7
Other specifications of the model could induce banks to lend a positive amount but what is important
for our purpose is that informal entrepreneurs are less able to borrow than formal ones, as shown below.
8
Another interpretation is that entry to the formal sector leads entrepreneurs to choose more pro-

8
enforcement θ, or higher collateral X all increase the size of the loan kt .
Young agents trade-off the costs and benefits of entering the formal and informal
sectors. In the informal sector, entrepreneurs can enjoy the full value of their collateral
but are not able to finance their projects. The surplus of an informal entrepreneur is thus
simply equal to his collateral X. In the formal sector, entrepreneurs have to pay the entry
costs C, which allow them to borrow from banks. The surplus of a formal entrepreneur
becomes pH (Akt − rt + X − C). Comparing these two surpluses shows that there exists
a cutoff quantity of collateral Xt∗ below which entrepreneurs prefer to enter the informal
sector and above which they prefer to enter the formal sector:

pH φ(it )θB + pH
Xt∗ (it ) = C. (8)
pH φ(it )θB + pH − 1

This quantity of collateral determines the size of the informal sector. By definition, it is
bounded between 0 and 1. Zero entry costs lead to a totally formal economy. There also
exists a cutoff level of C above which and a cutoff level of θ below which the economy is
completely informal. We can show the following result (proof omitted):

Proposition 1 A lower interest rate it , lower entry costs C, or a better quality of en-
forcement θ reduce the size of the informal sector Xt∗ .

A larger interest rate makes entrepreneurs less creditworthy and thus increases the size
of the informal sector. A better quality of enforcement increases the amount of collateral
that banks can seize and thus increases the size of loans. The effect of lower entry costs
is obvious. These results are consistent with the empirical evidence documented, for
example, in ? and ?.

2.3 Equilibrium in an Open Economy

In this section, we present a version of the model that is consistent with the standard
view on informality and economic growth. The main insight is that a larger formal sector

ductive technologies, consistently with ?.

9
 it
6

i∗

Ktd (it )
-
Kt∗ Kt

Figure 2: Equilibrium in an open economy

is beneficial for the economy because the ability of entrepreneurs to collateralize their
assets increases investment.
We consider a small open economy with free capital flows and that cannot influence
the world interest rate. As a result, agents take the interest rate i∗ as exogenous. The
supply curve of capital is thus represented in Figure ?? by a horizontal line.
Equations (??) and (??) give the aggregate demand for capital, which is equal to the
sum of the credits granted by banks:

Z 1
Ktd (it ) = kt dD(X). (9)
Xt∗

When the interest rate it increases, banks respond by lending less to satisfy their break-
even constraint. An indirect effect is that less entrepreneurs are willing to enter the
formal sector. Overall, we have a standard demand function decreasing in the price. It
is represented in Figure ??.
The equilibrium stock of capital K op in an open economy is simply given by the
intersection of the supply and demand of capital:

op
Kt+1 = Ktd (i∗ ). (10)

Let Yt = pH AKt∗ be the level of output in the economy. Then, the following result
holds:

10
Proposition 2 In an open economy, lower entry costs C or a better quality of enforce-
ment θ at date t have a positive impact on output Yt .

Proof. From Equation (??), the function Ktd is increasing in kt and decreasing in Xt∗ ;
From Equation (??), kt is increasing in θ and decreasing in C; From Proposition 1, Xt∗
is increasing in C and decreasing in θ. This proves Proposition 2.
Intuitively, a higher quality of enforcement θ or lower entry costs C have two effects
on the aggregate demand for capital. First, it increases the amount banks are willing
to lend to entrepreneurs. Second, more entrepreneurs enter the formal sector and this
allows them to borrow more. Such changes shift the demand for capital to the right. The
equilibrium stock of capital and production increase.

2.4 Equilibrium in a Closed Economy

We now show how the mechanism of the previous section is affected by the introduc-
tion of restrictions on international capital flows. Closing the economy affects the supply
of credit as banks are now limited in their capacity to lend by the size of national savings.
As a consequence, the equilibrium interest rate ict of the economy is endogenously deter-
mined by capital supply and demand. We show that, in contrast to the previous section,
the effect of larger entry costs or of a better quality of enforcement on the economy now
vanishes.

The consumption/saving decision We start by characterizing the supply of credit,

which is equal to the sum of individual savings. We show how individuals decide to
allocate their income between present and future consumption. Informal entrepreneurs
and unsuccessful formal entrepreneurs make zero profit and thus do not consume or save.9
The profit πt of successful formal entrepreneurs is given by:

πt = Akt − rt (11)

9
Informal entrepreneurs only consume their endowment. This is a normalization and does not affect
our results.

11
This profit is allocated between consumption ct and savings st :

ct + s t = πt (12)

When old, individuals are constrained by the proceeds from their savings:

ct+1 = it+1 st (13)

The problem of young individuals is to choose the allocation of income between present
and future consumption that maximizes (??) under the constraints (??), (??), and (??).
The straightforward solution to this problem is:

β
st = πt . (14)
1+β

Thus the savings of entrepreneurs are a fixed fraction of their profit.

The capital market The supply of capital Kts is given by the sum of individual savings
st−1 :
Z 1
Kts = pH st−1 dD(X). (15)
∗
Xt−1

Because Kts is independent of the contemporary interest rate it , Figure 3 represents this
equation as a vertical line. The closed economy (indexed by c) equilibrium interest rate
ict and capital Ktc are such that the demand for capital equals the supply:

Ktc = Kts (ict ) = Ktd (ict ) (16)

We get the following result:

Proposition 3 In a closed economy, the effect of permanent lower entry costs C or of

a better quality of enforcement θ at date t on output Yt is nil.

Proof. On the one hand, using equations (??) and (??), Equation (??) can be
rewritten as πt = φ(ict )Bθ(X − C). Then, Equation (??) can be rewritten as Kts =

12
 it
6

ict

Ktd (it )
-
Kts Kt

Figure 3: Equilibrium in a Closed Economy

β c
R1
β+1
p H Bφ(i t−1 )θ − C)dD(X). On the other hand, using Equation (??), Equa-
X ∗ (ict−1 )
(X
R1
tion (??) becomes Ktd = φ(ict )∆pθ X ∗ (ic ) (X − C)dD(X). Finally, combining these ex-
t

pressions gives the law of accumulation of capital:

βpH B
K1c = Ktc . (17)
(β + 1)∆p

The growth rate of the economy is thus independent of C and θ. This proves Proposition
3.
Intuitively, lower entry costs C or better enforcement θ at t have two effects on the
economy at date t + 1. First, because more entrepreneurs are formal and because each
formal entrepreneur makes more profit, the aggregate savings are also higher and this
shifts the supply curve of capital to the right. Second, such policies increase the interest
rate ict because of the demand effect described in the previous section. As a consequence,
the profit and the savings of entrepreneurs are lower. We showed that these two effects
always cancel out.
Comparing Propositions 2 and 3, lower entry costs or better enforcement have a
positive impact on the size of the formal sector and on output in an open economy but
no impact in a closed one. Of course, the knife-edge nature of this result hinges strongly
on the logarithmic utility assumption, which ensures that savings are independent of the
interest rate. With a more general utility function, for example CRRA, there would
be a third effect on savings as the interest rate would then depend on the elasticity of

13
intertemporal substitution. However, for reasonable values of this elasticity, this effect is
likely to remain small and thus the impact of lowering C or increasing θ would still be
lower in a closed economy.

2.5 Large Banks

We now relax the assumption of a competitive banking sector. If financial interme-

diaries have some market power, they ask for a higher repayment, which further reduces
the savings of young entrepreneurs and thus the supply of credit.
We follow ? in assuming that the marginal cost of lending is equal to the interest rate
it plus a parameter τ . There are two banks in the economy competing à la Bertrand. One
has a marginal cost equal to zero (τ = 0) and the other has a strictly positive marginal
cost (τ > 0). The efficient bank offers loan contracts such that entrepreneurs do not
prefer to contract with the inefficient bank. The parameter τ can thus be thought of as
a measure of competition between the two banks. The lower this parameter, the more
competitive the banking sector.
We now show how the parameter τ modifies the previous analysis. The break-even
constraint of the lender becomes:

pH rt + (1 − pH ) θ (X − C) ≥ kt (it + τ ), (18)

In an open economy where the interest rate it is given, a higher τ increases the repay-
ment that can be asked to entrepreneurs and reduces the size of the loan. Entrepreneurs
thus end up with a lower profit and save less. In this setting, a more concentrated banking
sector thus reduces the accumulation of capital.
Let us now solve for the equilibrium interest rate in a closed economy. This is done in
a simple way with the change of variables I = it +τ . This gives the same results as before,
that is I = ict . This implies that the interest rate in an economy with a concentrated
banking sector is equal to ict − τ . In the extreme case of a perfectly closed economy, it and
τ are thus perfect substitutes. Finally, Proposition 3 is unchanged in the case of large

14
banks in a closed economy.
To summarize, in an open economy, a more concentrated banking sector makes the
impact of lower entry costs or better enforcement less positive. In a closed economy, by
contrast, the size of banks does not change this impact.

3 Empirical Evidence

In this section, we present some empirical illustration of the key predictions of our
model. We are interested in the impact of a better quality of enforcement or of lower entry
costs on both the size of the credit market and of the informal sector depending on, first,
financial openness and, second, the degree of concentration of the banking sector. We
expect such policies to have a greater impact in economies with a more competitive and
open credit market. The channel emphasized in our model, linking the policy variables
C and θ to both output and formality, goes through the size of the credit market. For
this reason, we study the determinants of both access to credit and informality. To do
so, we use the following cross-country data.
STEPS refers to the number of steps necessary to open a business and is provided
by ?. The number of steps to register a business varies from 2 in Australia and Canada
to 20 in Bolivia, with an average of 9.5.
FORMALISM is a measure of the quality of contract enforcement from ?. They
computed the number of legal procedures to collect a bounced check in court. The
variable varies from 0 to 7, with a mean of 3.5 and where a higher value means a lower
quality of contract enforcement.
OPENNESS refers to the measure of regulatory restrictions on international capital
flows from ? averaged over 1996-2000. This index ranges from -1.83 to 2.5, where a higher
value means more financial openness.
SPREAD is the interest rate spread from the World Bank and we use it to proxy
for the competitiveness of the banking sector. Indeed, in our model, the measure of
concentration τ can also be interpreted as a spread. It is the difference between the

15
lending rate and the deposit rate. This measure is averaged over 1996-2000. It varies
between 1 and 82 with a mean of 10. More direct measures of concentration exist but
cover fewer countries.
GDP refers to the measure of real GDP per capita from ?. We take the logarithm
of its average over 1996-2000.
CREDIT refers to the ratio of private credit over GDP averaged over 2001-2005
from ?. It varies from 7 to 195 percent, with an average of 66 percent.
INFORMALITY refers to the size of the informal sector as measured by an indicator
of unofficial or unregistered business activity from the World Economic Forum’s Global
Competitiveness Report 2006-2007 that we take from ?.
We divide our sample between countries that have low and high OPENNESS, and
between countries that have a high and a low SPREAD, high meaning above the me-
dian and low below. Consistently with the predictions of our model, Figures ?? and ??
show that the relationship between CREDIT and STEPS (our proxy for entry costs) or
FORMALISM (our proxy for enforcement) is more negative in countries with a low value
of SPREAD, i.e., those with a more competitive banking sector and Figures ?? and ??
show a slightly more negative relationship in countries with a high value of OPENNESS.
A similar pattern emerges from Figures ??-?? that use the size of the informal sector as a
dependent variable. In particular, Figures ?? and ?? show a striking difference between
low and high spread countries in terms of the impact of both STEPS and FORMALISM.
We then run OLS regressions of CREDIT and INFORMALITY on STEPS or FOR-
MALISM, interacted with OPENNESS and SPREAD. In all regressions we control for
GDP as richer countries are likely to provide more developed credit markets. Tables ??
and ?? show the results.
Column 1 of Table ?? shows that the coefficient of the interaction between OPEN-
NESS and STEPS is significantly negative, which means that higher entry costs have a
more negative impact on credit in countries that are more open to international capital
flows. Take France which belongs to the group of the most open countries and where it
takes 14 steps to open a new business. Reducing the number of steps to 10 in France

16
(equivalent to a one standard deviation reduction) would increase the size of the credit
market by 23 percentage points. On the other hand, for Chile, which is the least open
country in our sample with a score of -1.55 for openness, the overall effect of STEPS
on CREDIT becomes positive and equal to .5. A one standard deviation reduction in
STEPS in Chile (from 10 to 6) would decrease the size of the credit market there by 2
percentage points. The coefficient on STEPS also becomes positive for 24 other countries
out of the 80 observations available.
In column 3, the coefficient of the interaction between SPREAD and STEPS is sig-
nificantly positive, suggesting that higher entry costs have a more negative impact on
lending in countries with a higher spread. In a country with a relatively low spread like
South Korea with 1.2 percent, 4 fewer steps would increase credit by 21 percentage points.
By contrast, in Peru, which has a relatively high spread of 21 percent, the overall effect
of STEPS on CREDIT becomes positive and equal to .7. A reduction of the number of
steps to open a business in Peru would thus decrease credit by 2.8 percentage points.
In columns 2 and 4, we look at the impact of the policy variables on informality and
find consistent results. Reducing the number of steps would have a bigger impact in
countries that are more open and that have a lower spread.
The results of Table ?? also mostly support our results. In particular, in column
3, the coefficient of the interaction between SPREAD and FORMALISM is significantly
positive, which means that a higher quality of enforcement has a more positive impact
on lending in countries with a more competitive banking sector. Take again Peru, which
has a spread of 21 percent. A one standard deviation improvement in our measure of
enforcement would have no effect on credit. By contrast, the same policy in South Korea,
which has a spread 1.3 percent, would increase credit by 20 percentage points. Similarly,
column 4 shows that improving the quality of enforcement would stimulate formality
more in countries with a lower spread.
Overall, the results suggest that reducing the cost of entering the formal sector or
improving the quality of enforcement can have a sizable positive impact on credit and
formality in countries that are open to international capital flows or with a low spread,

17
i.e., with a competitive banking sector. The same policy in closed or high spread countries
would have lower or even negative impacts on credit and formality.

4 Conclusion

In this paper, we presented a general equilibrium model with an informal and a

formal sector. We have analyzed how reforms to entry costs and judicial enforcement can
affect formality and output. The conventional wisdom states that such policies should be
associated with positive outcomes along these dimensions. We have shown, however, that
in the context of our model, this prediction becomes less obvious if we take into account
characteristics of the credit market like its degree of concentration or its openness to
international capital flows. We also have presented some empirical evidence consistent
with these predictions.
Our work is consistent with a number of results in the literature pointing to an
ambiguous impact of the type of reforms discussed here. It also suggests the importance of
taking into account general equilibrium effects when implementing such policies. Indeed,
incentives to enter formality and access credit may require a more competitive and open
credit market to be effective.

18
 Figure 4: CREDIT and STEPS: Low versus high SPREAD
200 High SPREAD Low SPREAD

JPN
CAN

DNK
NLD
CHE
IRL GBR
150

HKG PRT
ESP
ZAF

MYS

NZL AUT CHN

CREDIT

AUS
SWE
THA
100

SGP
KOR
FRA
ITA ISR
PAN JOR

CHL
GRC
FIN BEL
LVA LBN
VNM

SVN EGY
HRV MAR
HUN
50

BGR
LTU
CZE
SVK
BRA UKR LKA
MNG DOM PHL
POL
ZWE KEN IDN
COL
ECU
JAM URY
PER ROM
MEX
NGA GEO
VEN MOZ ARG
TZA
UGA MDG
ZMB KGZ ARM MWI
0

0 5 10 15 20 0 5 10 15 20
STEPS

Figure 5: CREDIT and FORMALISM: Low versus high SPREAD

High SPREAD Low SPREAD
200

JPN
CAN

DNK
NLD
CHE
GBR
IRL
150

HKG PRT ESP

ZAF

LUX

MYS

NZL CHN
AUT
CREDIT

AUS
SWE
MLT THA
100

SGP
BRB KOR
FRA
ISR
JOR PAN

GRD CHL
GRC
BEL FIN
EST LBN
LVA
VNM
BLZ BHR
ARE
KWT
VCT SVN EGY
HRV MAR
NAM HUN
50

BGR SLV
LTU HND
TTO CRI CZE
BGD LKA
BRA UKR
DOM
POL GTM PHL
ZWE
KEN IDN
COL ECU
JAM SWZ URY
ROM PER BWA
MEX PRY
GEO
NGA MOZ VEN ARG
UGA MWI TZA
ZMB
0

0 2 4 6 0 2 4 6
FORMALISM

19
 Figure 6: CREDIT and STEPS: Low versus high OPENNESS
200 High OPENNESS Low OPENNESS
USA

JPN
CAN

DNK
NLD
CHE
IRL GBR
150

HKG PRT
ESP
ZAF

MYS

NZL AUT CHN

CREDIT

AUS
SWE
THA
100

SGP
KOR
FRA
ITA JOR ISR
PAN

CHL
FIN BEL
LVA LBN
TUN VNM

EGY SVN
HRV MAR
HUN
50

BGR
LTU IND
CZE
SVK KAZ
LKA BRA UKR
MNG PHL DOM
PAK POL
KEN IDN ZWE
COL
ECU
URY TUR SEN
JAM ROMMLI
PER
MEX GHA BFA
ARG VEN NGA MOZ
UGA TZA MDG
ZMB KGZ ARM MWI
0

0 5 10 15 20 0 5 10 15 20
STEPS

Figure 7: CREDIT and FORMALISM: Low versus high OPENNESS

High OPENNESS Low OPENNESS
200

USA

JPN
CAN

DNK
NLD
CHE
GBR
IRL
150

HKG PRT ESP

ZAF

MYS

NZL AUT CHN

CREDIT

AUS
SWE
MLT THA
100

SGP
BRB KOR
FRA
ITA ISR
JOR PAN

GRD CHL
GRC
BEL FIN
EST LBN
LVA
VNM TUN
BHR BLZ
ARE
KWT
EGY VCT SVN
HRV MAR
HUN NAM
50

SLV BGR
LTU IND HND
TTO CRI CZE KAZ
BGD LKA
BRA UKR
GTM DOM PHL
PAK POL
KEN IDN ZWE
COL
JAM URY TUR SWZ SENECU
PER BWA ROM
MEX GHA
GEO NGA CIV
ARG VEN MOZ
UGA TZA
ZMB MWI
0

0 2 4 6 0 2 4 6
FORMALISM

20
 Figure 8: INFORMALITY and STEPS: Low versus high SPREAD
50 High SPREAD Low SPREAD

ZMB

KGZ
ZWE VEN
40

MDG
PER
JAM UGA MOZ IDN
MEX
NGA MWI
TZA UKR ECU
INFORMALITY

MNG BRA DOM ARG

KEN MAR
BGR ARM GEO PHL
ITA LKA EGY
30

HRV COL
ZAF KOR
GRC HUN PAN CHN
URY VNM
POL

LVA ROM BEL THA JOR

ESP
20

SWE
SVK PRT
CAN CZE
GBR
SVN LTU DNK ISR
IRL MYS AUT JPN
AUS NLD CHL FRA
NZL HKG

FIN CHE
10

SGP

0 5 10 15 20 0 5 10 15 20
STEPS

Figure 9: INFORMALITY and FORMALISM: Low versus high SPREAD

High SPREAD Low SPREAD
50

ZMB

ZWE PRY
VEN
40

PER
GTM
JAMUGA MOZ HND IDN
MEX
MWINGA
UKR
TZA ECU
INFORMALITY

BRA
BGD DOM ARG
KEN MAR
GEO BGR SLV PHL
LKA
EGY
30

TTO HRV COL

NAM ZAF KOR
GRC CHN
HUN PAN
VNM URY CRI
POL

LVA ROM BRB

MLT BEL THA JOR
ESP
BWA
20

SWE
PRT
BHR CAN KWT
CZE
GBR
SVN
EST
LTU DNK ISR
MYSIRL JPN AUT
AUS NLD
FRA ARE CHL
HKG NZL LUX

CHE
FIN
10

SGP

0 2 4 6 0 2 4 6
FORMALISM

21
 Figure 10: INFORMALITY and STEPS: Low versus high OPENNESS
50 High OPENNESS Low OPENNESS

ZMB

KGZ
VEN ZWE
40

MDG
PER
JAM IDN
UGA MLI MOZ
MEX
NGA MWI BFA
TZA TUR
KAZ UKR ECU
INFORMALITY

MNG ARG BRA DOM

KEN MAR
ARM PHL BGR
ITA
EGY LKA
30

PAK HRV COL

ZAF KOR
PAN HUN CHN
URY IND VNM
POL

BEL
LVA JOR THA ROM
ESP
20

SWE TUN
PRT SVK
CAN USA CZE
GBR
DNK LTU ISR SVN
IRL AUT JPN MYS
AUS NLD FRA CHL
NZL HKG

FIN CHE
10

SGP

0 5 10 15 20 0 5 10 15 20
STEPS

Figure 11: INFORMALITY and FORMALISM: Low versus high OPENNESS

High OPENNESS Low OPENNESS
50

ZMB

VEN ZWE
40

PER
GTM
JAMUGA IDN MOZ HND
MEX
MWINGA
TUR UKR
TZA KAZ
ECU
INFORMALITY

ARG BRA
BGD DOM
KEN MAR
GEO SLV BGR PHL
EGYITA LKA
30

TTO HRV
PAK COL
ZAF KOR NAM
GRC PAN CHN
HUN
URY CRI VNM
IND
POL

BEL JOR LVA BRB

MLT THA ROM
ESP
BWA
20

SWE TUN
PRT
CAN USA KWT BHR CZE
GBR
DNK EST
LTU ISR SVN
IRL JPN AUT MYS
AUS NLD
FRA ARE CHL
HKG NZL

CHE
FIN
10

SGP

0 2 4 6 0 2 4 6
FORMALISM

22
 Table 1: The impact of entry costs on credit and informality
(1) (2) (3) (4)
dependent variable CREDIT INFORMALITY CREDIT INFORMALITY
GDP 28.539∗∗∗ -6.177∗∗∗ 25.611∗∗∗ -5.334∗∗∗
(3.475) (0.778) (4.104) (0.762)
STEPS -1.876∗∗ 0.416∗ -5.621∗∗∗ 1.046∗∗∗
(0.933) (0.217) (1.937) (0.354)
OPENNESS 16.737∗∗∗ -0.614
(6.278) (1.195)
STEPS*OPENNESS -1.533∗∗ 0.122
(0.610) (0.120)

23
SPREAD -3.937∗∗ 0.905∗∗∗
(1.676) (0.330)
STEPS*SPREAD 0.300∗∗ -0.076∗∗
(0.149) (0.031)
constant -177.525∗∗∗ 78.189∗∗∗ -101.484∗∗ 63.357∗∗∗
(32.568) (7.878) (48.850) (9.184)
N 80 78 70 70
adj. R2 0.595 0.616 0.586 0.666
Robust standard errors in parentheses
∗
p < 0.10, ∗∗ p < 0.05, ∗∗∗ p < 0.01
 Table 2: The impact of enforcement on credit and informality
(1) (2) (3) (4)
dependent variable CREDIT INFORMALITY CREDIT INFORMALITY
GDP 27.621∗∗∗ -6.213∗∗∗ 25.165∗∗∗ -5.962∗∗∗
(3.372) (0.763) (3.577) (0.560)
FORMALISM -13.841∗∗∗ 1.038 -21.564∗∗∗ 2.561∗∗∗
(3.536) (0.775) (5.494) (0.731)
OPENNESS 4.579 -2.206
(9.121) (1.474)
FORMALISM*OPENNESS -0.129 0.571
(2.373) (0.413)

24
SPREAD -4.795∗∗∗ 0.529∗∗
(1.755) (0.216)
FORMALISM*SPREAD 0.990∗∗ -0.101∗
(0.411) (0.054)
constant -136.340∗∗∗ 79.016∗∗∗ -74.000 69.669∗∗∗
(33.585) (8.135) (45.205) (6.641)
N 93 86 85 81
adj. R2 0.560 0.595 0.594 0.645
Robust standard errors in parentheses
∗
p < 0.10, ∗∗ p < 0.05, ∗∗∗ p < 0.01