Informality and Productivity Productivity Differentials between Formal and Informal Firms in Turkey

The informal sector constitutes a large share of employment and output in all developing countries. Although the informal sector is regarded by many researchers and policy makers as a source of employment developing countries desperately need, there is ample evidence that documents that informal firms are less productive, employ unskilled labor, and pay lower wages. This study analyzes the sources of productivity difference between informal and formal firms in Turkey. Since the data on the informal sector is likely to be noisy, we use two different approaches to analyze productivity differentials: firm-level analysis and individual-level analysis. In the case of firm-level analysis, we estimate and compare productivity levels of informal and formal firms by using matching propensity score and switching regression methods. In the case of individual-level data, we compare wage differentials between informal and formal wage workers by estimating a multinomial selection model. Our findings indicate that there is a significant productivity gap between informal and formal firms, and a wage gap between informal and formal workers. Moreover, the hypothesis that more educated entrepreneurs and workers move to the formal sector is supported by the data. This process of self-selection contributes to widen the productivity gap between informal and formal firms. The theories of life-cycle and learning are also supported by our findings. Older (i.e., more experienced) firms tend to operate in the formal sector. However, the relationship between informality and age is U-shaped for entrepreneurs and workers. Even after controlling for all these factors (self-selection, differences in endowments, and learning), the productivity gap does not disappear. The findings suggest that there is a substantial but untapped potential to increase productivity in Turkey. The productivity effect of operating formally is higher for services, but we may expect that a large number of informal service firms could not survive if they operate formally.