Doing it under the table

In developing economies, managers often choose to hide their firms' activities in the informal sector, beyond the reach of government officials. In this dissertation, I examine the factors that drive one widespread form of participation in the informal sector: the hiding or underreporting of sales. In the first study, I present a novel empirical strategy to estimate the extent of sales underreporting using readily available firm financial data. Applying this model to a sample of Indian manufacturing firms over the period from 1999 to 2007, I examine how sales underreporting is influenced by macroeconomic conditions and by the firm's institutional environment, including the regulatory burden and corruption. For robustness, I benchmark my estimates against the World Bank Enterprise Survey dataset for India, which includes data on managers' self-reported hidden sales. Comparison with the survey results provides broad support for the model. In the second essay, I explore the links between participation in the informal economy and corporate governance. In particular, I argue that unreported sales can be viewed simultaneously as expropriation of shareholders and as participation in the informal economy. Building on the corporate governance literature, I examine the relationship between informality and two corporate governance mechanisms: the concentration of ownership, and legal protection of minority investors. Using a dataset of 643 publicly listed firms in 14 countries, drawn from the World Bank Enterprise Surveys (WBES), I find that both ownership concentration and the quality of investor protection are important drivers of informality. In the third essay, I build on the previous two chapters, using the empirical model introduced in the first study to examine the relationship between corporate governance and unreported sales among Indian manufacturing firms. In particular, I examine how underreporting of sales is influenced by ownership concentration, cross-listing on US and European exchanges, and by business group affiliation. As in the cross-country study, I find that ownership concentration significantly influences unreported sales. I also find that cross-listed firms report a larger portion of their sales, consistent with the argument that cross-listing limits the ability of insiders to expropriate value from external investors. Finally, I find that business group affiliated firms engage in more extensive under-reporting of sales. Furthermore, ownership concentration and cross-listing have no influence on the behavior of group firms, suggesting that these governance mechanisms are insufficient to constrain the behavior of insiders of Indian business groups.