Estimating the Effects of Formality on Mexican Informal Microfirms A Joint Multivariate Approach

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1 Etimating the Effect of Formality on Mexican Informal Microfirm A Joint Multivariate Approach Sonia Di Giannatale, Gibrán Ramírez-Abarca and Ricardo Smith* Fecha de recepción: 2 de febrero de 2012; fecha de aceptación: 20 de mayo de Abtract: In thi article we ue a multivariate framework to etimate net profit and level of capital and labor for informal Mexican microfirm had they been formal. We etimate a Roy model to imultaneouly model three different microfirm repone conditional on the ector (formal or informal) choice. Repone include profit and level of labor and capital to be ued in each ector. Our reult indicate that the formal counterfactual of currently informal microfirm employ higher level of labor and phyical capital; yet, they do not earn higher profit. Keyword: microfirm behavior, informal ector, Roy model, developing economie. Etimación de lo efecto de la formalidad obre microemprea informale mexicana: Un enfoque multivariado conjunto Reumen: En ete artículo uamo un análii multivariado para etimar lo beneficio neto y lo nivele de capital y trabajo de microemprea informale mexicana de haber ido éta formale. Etimamo un modelo de Roy para modelar imultáneamente la repueta de la microemprea condicionale a la elección del ector de operación, formal e informal. La variable de repueta incluyen lo beneficio neto y lo nivele de capital y trabajo uado en cada ector. Nuetro reultado indican que lo contrafactuale formale de microemprea informale uan mayore nivele de capital y trabajo, pero no obtienen mayore beneficio neto. Palabra clave: comportamiento de microemprea, ector informal, modelo de Roy, economía en dearrollo. jel Claification: C3, D2, O12, O17. *Sonia Di Giannatale, onia.digiannatale@cide.edu, aociate profeor of Economic, Department of Economic, cide. Gibrán Ramírez-Abarca, gibran_ramirez@hacienda.gob.mx, director, Department of Public Policie for Productivity, Secretaría de Hacienda y Crédito Público. Ricardo Smith, rmithramirez@gmail.com, adjunct profeor of Economic, Department of Economic, cide. Mexico City. The author have benefited from comment and uggetion by Robert Duval and participant at the cide Economic Seminar. The author thank three anonymou referee for enriching comment. The author alo thank Rodolfo Cermeño, Itza Curiel-Cabral and Alejandro López-Feldman for technical upport. Remaining error are the author reponibility. economía mexicana nueva época, vol. Cierre de Época (II) pp

2 442 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm Introduction According to Fajnzylber et al. (2009), microfirm owner and their worker accounted for approximately 50 per cent of the Latin American labor force during the lat decade. In all Latin American countrie, and epecially in Mexico, 1 a ignificant proportion of thee microfirm operate in the informal ector of the economy; that i, they neither pay taxe nor fulfill their legal obligation toward their worker. Yet, they make ue of many public good, uch a the public health ytem, the idewalk, treet and park where they conduct buine, and, in many cae, do not pay for the electricity or water they ue a production input. However, the quality of thoe public good might be compromied becaue of the reulting lo of tax revenue. The dicuion over the determinant of informality i till ongoing. A country regulatory burden and it capacity to enforce the law have both been identified a determinant of informality, but there i empirical evidence that ugget that a the latter grow tronger the former become le important (Dabla-Norri et al., 2008). At the individual microfirm level, the owner choice of operating in the formal or the informal ector of the economy hould be part of a profit maximization deciion, a Levenon and Maloney (1998) dicu. Under thi perpective, Fajnzylber et al. (2009) analyze whether formalization ha an impact on the performance of Mexican microfirm and which treatment (credit upply, entrepreneurial training, and acce to government ervice) i more effective on buine performance. They find that formalization ha potential poitive effect in profit and the urvival rate of microfirm. In thi article we concur with the idea that formality i an input of the productive proce, where it marginal value increae a the ize of the firm increae. For larger firm, meeting intitutional requirement become more important becaue a larger operation i more likely to draw the attention of governmental agencie. For ome firm, however, either becaue of pecific characteritic of their type of activity and capital retriction, or their owner entrepreneurial ability, the optimal deciion i to remain in the informal ector and to maintain a mall cale of production. For intance, Dabla-Norri et al. (2008) empirically etablih a poitive aociation between mall firm and informality. On the other hand, Cunningham and Maloney (2001) how that, ince the informal ector in 1 According to Levy (2008), 58 per cent of the Mexican labor force and 60 per cent of the employed population worked in the informal ector in 2006.

3 economía mexicana nueva época, vol. Cierre de Época (II) Mexico i highly heterogeneou, a reaonable explanation for microfirm owner deciion to remain in the informal ector can be found in difference in their entrepreneurial abilitie and heterogeneou preference, and not in ditortion in the labor or credit market, a it i uually aumed. In thi paper, we focu on the deciion-making proce of informal Mexican microfirm trying to anwer two quetion: a) are, ceteri paribu, formal firm more profitable than informal one?, and b) i, a uggeted by the model of Rauch (1991), the informal ector the optimal choice for mall firm and the formal ector the preferred choice for larger firm? To anwer thee quetion, we perform quantitative comparion on three meaure of firm ize: net profit, invetment in phyical capital, and number of worker. Our tudy explicitly aume the endogeneity of the firm deciion. That i, we aume that the deciion of whether or not to participate in formal intitution i part of the entrepreneur profit maximization deciion problem (Levenon and Maloney, 1998). Accordingly, auming profit-maximizing owner, a microfirm operate in the formal ector only if the net profit (monetary or not) obtained from operating in thi ector exceed thoe obtained in the informal ector. We perform a joint imultaneou analyi of a vector of interrelated microfirm repone reulting from the ector choice by uing a Roy model with multiple repone variable (Heckman and Vytlacil, 2007). We etimate all the parameter in the model uing full information maximum likelihood by mean of a Montecarlo em algorithm. Thi methodology allow u to control for the endogeneity of the repone, account for the correlation among the different repone, and, therefore, obtain more efficient etimate of the treatment effect. Additionally, we include a heterokedatic error covariance matrix in the etimation. Thi multivariate approach ditinguihe our analyi from other related empirical paper that analize microfirm repone eparately uing either tandard election model or matching method. Differently from mot of the related literature on treatment effect, in which the effect of treatment (formality in thi cae) on the treated (formal) ub-population i the focu of the etimation, we etimate the effect that treatment would have on the untreated (informal) firm. We tudy informal microfirm for three reaon. Firt, previou tudie have focued either on the formal ub-population or on the whole population. The proportion of the informal ector in the economy ha increaed teadily in the lat decade in Mexico (Duval and Orraca, 2011). Thi fact ugget that in Mexico there are incentive for operating

4 444 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm in the informal ector, contradicting the reult of Fajnzylber et al. (2009), who, by uing both matching and tandard control function technique, found poitive effect of formality on the profit and urvival rate of formal Mexican microfirm. McKenzie and Sakho (2010), on the other hand, by uing intrumental variable and matching technique on Bolivian data, found that effect of formality on profit depend on firm ize. In particular, they found that, for mall firm, lower profit are aociated with regitering for taxe; while middle-ize firm might benefit from formalization. Second, Latin American government have hown an increaing interet in reducing the ize of the informal ector by providing incentive to informal microfirm to move into formality; therefore, it i intereting to explore how well informal firm, a they are, would perform under the rule of the formal ector. Our third reaon i methodological. Although we ue data from more recent wave of the urvey ued by Fajnzylber et al. (2009), the data till have the ame problem that thoe author encountered, which i the difficulty to atify the common upport aumption for the treated ub-population; an iue that i le problematic for the untreated ub-population. In imple word, for each informal entrepreneur it i poible to find a imilar (in obervable) formal counterpart; the oppoite, however, i not alway true a there are type of formal entrepreneur (e.g. very highly trained or educated one) that cannot be found in the informal ector. Our empirical reult indicate that the main determinant of ector choice are the microfirm owner level of formal education and acce to credit, and the microfirm type of economic activity. Even though the nature of our etimation i tatic, our reult how that the right incentive for a microfirm growth are only found in the formal ector of the economy, and that thi growth occur if the entrepreneur education level and ability to obtain outide fund are adequate, a well a if the microfirm operate in the ector of commerce and ervice. Moreover, when comparing the behavior of currently informal microfirm and their expected behavior were they to operate in the formal ector, we find that thee microfirm would obtain an annual net profit in the formal ector that i lower than what they currently obtain in the informal ector, even after adjuting their capital and labor level. Hence, thoe entrepreneur would optimally chooe to tay in the informal ector. Thi article i organized a follow: in ection I we decribe the data we ue and preent ome decriptive tatitic. In ection II, we preent the econometric model and the methodology we ue to quantify the im-

5 economía mexicana nueva época, vol. Cierre de Época (II) pact of formality on net profit and the level of phyical capital and labor. In ection III, we dicu our reult. Finally, in the lat ection, we offer our concluding remark. I. Data We employ data from the Mexican Microfirm National Survey (Encueta Nacional de Micronegocio, Enamin) for the year 1998 and Thi urvey i part of an additional quetionnaire that come with the National Survey of Urban Employment (Encueta Nacional de Empleo Urbano, eneu), where people who ay they are owner of a firm with ten or fewer employee mut anwer the Enamin quetionnaire, which gather pecific information about the characteritic of the microfirm. The number of regitered quetionnaire in Enamin-1998 and Enamin-2002 were and , repectively. We ue data from both urvey in our etimation and, becaue our tet of the exitence of tructural change between 1998 and 2002 were tatitically rejected, in thi article we preent and dicu only the reult of the joint ample, which comprie a total of microfirm. Many informal microfirm owner, however, ue the informal market a a ource of ubitence while eeking a wage-earning job. Mexican informal firm are heterogeneou in the ene that a fraction of their owner are true entrepreneur, while ome owner are trying to earn a living while earching for a job with a paid alary and benefit, (Bruhn, 2012). Thi mean that many microfirm have a very hort life pan, a ituation that i not repreentative of microfirm owned by individual who have actively decided to be their own boe. In order to avoid thi bia, in the final etimation we ue only microfirm whoe owner are 20 year old or more, who invet more than US $100 in capital, and who have been operating for at leat 4 year. We decided to ditinguih the true entrepreneur from the other by impoing the above requirement, that are baed on the owner behavior, a oppoed to directly uing the anwer to quetion, included in the quetionnaire, that explicitly ak the microfirm owner about their motivation to open their buinee and their plan for the future. Our intention i to avoid the poibility that while anwering thoe quetion, the owner could be mireporting their real motivation and buine plan. Becaue we ue individual dummie to control for heterogeneity among different municipalitie, in order to correctly identify municipal effect, we conider only thoe municipalitie with 15 obervation or more.

6 446 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm Table 1. Decriptive tatitic Variable Average Std. Dev. Median Minimum Maximum Sub-ample informal ector Monthly net profit* Capital tock* Labor Gender Marital tatu Age Primary eh High chool Univerity Time (year) Formal credit Informal credit Manufacture Commerce Service Sub-ample formal ector Monthly net profit* Capital tock* Labor Gender Marital tatu Age Primary eh High chool Univerity Time (year)

7 economía mexicana nueva época, vol. Cierre de Época (II) Table 1. Decriptive tatitic (Cont.) Variable Average Std. Dev. Median Minimum Maximum Formal credit Informal credit Manufacture Commerce Service Source: Author own elaboration uing data from Enamin 1998 and Note: *Monthly net profit and capital tock are expreed in 2002 Mexican peo. 1US$=10.2MX$ in eh: Elementary High School. Sample ize: N = Obervation informal ector: (weighed). Obervation formal ector: (weighed). All thee retriction reduce the final ample to obervation. Finally, we aume a microfirm to be formal if it i regitered with the Minitry of Finance and Public Credit (Secretaría de Hacienda y Crédito Público, hcp). According to table 1, 49.8 per cent (weighted) of the microfirm in our ample are formal. About 26 per cent of all microfirm in the ample are run by women. The microfirm owner average age i 44 year, and around 70 per cent of them are married. It i oberved that mot of the microfirm owner have only finihed primary or elementary high chool education, 71 per cent in the ub-ample of informal microfirm owner, and 54 per cent in the ubample of formal microfirm owner. Only 8 per cent of informal microfirm owner have completed a college education, while 26 per cent of formal microfirm owner have done o. Regarding the characteritic of the microfirm, the average time of operation of the microfirm in the ample i 11.9 year. On the other hand, the average monthly net profit of informal microfirm i Mexican peo with a tandard deviation of Mexican peo, thee monetary amount (and all monetary amount from now on) are expreed in 2002 Mexican peo and the average exchange rate in 2002 wa 1 US dollar per 10.2 Mexican peo. Alo, the average monthly net profit of formal microfirm i Mexican peo with a tandard deviation of Mexican peo. The average value of the capital tock of informal microfirm, expreed in 2002 Mexican peo, i Mexican peo with a tandard deviation of Mexican peo, while that of formal microfirm i Mexican peo with a tandard deviation of Mexican peo. The average number of worker in informal microfirm, including the owner, i 1.32 while that of formal microfirm i No microfirm in the ample employ more than 7 worker.

8 448 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm Finally, 3 per cent of the informal microfirm in the ample ued a formal credit ource to tart the buine, while 15 per cent of them ued an informal credit ource. Interetingly, 6 per cent of the formal microfirm in the ample ued a formal credit ource to tart the buine, while 19 per cent of them ued an informal credit ource. The ret of the microfirm, formal and informal, financed their buinee by uing peronal aving or benefit obtained from the owner previou job. II. Econometric Model To motivate our empirical approach let u conider N profit-maximizing microfirm that ue capital (K) and labor (L) a input. Each microfirm i (i = 1,, N ) mut chooe whether to operate in the formal ector ( = 1) or the informal ector ( = 0). Simultaneouly, and conditional on the choen ector, the microfirm mut determine the optimal amount of capital and labor, a well a the optimal production level (Y). Thu, the problem microfirm i olve i: ~ ~ ~ ~ (S i, Y i, K i, L i ) = ar gmax { i π 1 (Y i, K i, L i ) + (1 i ) π 0 (Y i, K i, L i )}. t. i = 0, 1 Y i g (K i, L i ; a i ) K i 0 L i 1 where, g (K i, L i ) i a production function that atifie g 1 > 0, g 2 > 0, g 11 < 0, g 22 < 0, and a i i an indicator of the owner productivity depending on hi/her characteritic uch a education and entrepreneurial capacity. The profit function π are given by π, (Y i, K i, L i ) = p Y i r K i w L i C (b i, Y i, K i, L i ), where p, r and w are the price of the product, capital, and labor, repectively, in ector. The function C repreent other operating cot in ector. Thee cot depend on the characteritic and regulatory environment, b i, of the municipality in which the microfirm i located. The microfirm that operate in the formal ector mut pay municipal legal fee, taxe (ome of which are proportional to the firm ize, Y i and K i ), and the ocial ecurity payment of it worker in proportion to the amount of labor employed, L i. The component of the cot C 0 for microfirm in the informal ector include fine for failure to pay permit, taxe, and/or ocial-ecurity payment to it worker. The probability of being fined will

9 economía mexicana nueva época, vol. Cierre de Época (II) depend on local characteritic, b i, uch a the efficiency of local government in curbing the informal economy, and alo on the firm ize, Y i, K i, L i, (larger firm are eaier to detect). An informal microfirm face the rik of having it capital and merchandie conficated and having to pay bribe to inpector to avoid legal conflict ~ ~ with ~ the local authority. Thu, there i an optimal repone triplet (Y i, K i, L i ) for each ector, in which production level and optimal input level will depend on characteritic of the microfirm and owner, a i, and thoe of the market, b i, p, r, w. A profit-maximizing microfirm will operate in the formal ector if π 1 π 0 T i > 0, where, T i denote the tranaction cot of moving from one ector to the other. Becaue the regime to which a microfirm may belong (informal or formal) are mutually excluive, our econometric model mut allow u to contruct a counterfactual againt which we can compare each repone variable (net profit or firm ize), and, thu, to quantify the expected impact of moving from one regime to the other. The mot frequently ued method for contructing a counterfactual are the matching method (Roenbaum and Rubin, 1983) and the Roy model (Roy, 1951; Heckman and Vytlacil, 2007). Intead of impoing the aumption of conditional independence required by matching method, here we ue a generalized Roy model with a dichotomou election equation and multiple repone. Econometrically, the microfirm problem i equivalent to the following reduced model: * S i = X 1i β 1 + ε 1i π i = X i β 2 + ε 2i K i = X i β 3 + ε 3i L i = X i β 4 + ε 4i π i = X i β 2 + ε 2i K i = X i β 3 + ε 3i L i = X i β 4 + ε 4i } } election equation repone equation, informal ector S i repone equation, formal ector S i 1 0 (1) * In our analyi, S i i a latent variable repreenting the net benefit of moving from the informal to the formal ector of the economy. The obervable * 0 counterpart of S i i the dichotomou optimal repone S i, which take the * value 0 if S i i nonpoitive and it take the value 1 otherwie. The repone variable π i i the net profit of the microfirm i when operating 0 in

10 450 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm ector S i. We decided to ue thi variable intead of the production level becaue we are intereted in comparing the level of net profit between 0 ~ ~ ~ the two ector (Note that π i i a function of Y i, K i and L i ). The other variable that we ue to contruct the ~ vector of dependent variable are the invetment in phyical capital, K i, and the number of worker (including ~ the owner) 2, L i, repectively. All thee variable are ued in their logarithmic form. The obervable variable for number of worker i cenored at 1 ince no microfirm can operate with le than one worker (in it logarithmic form, the cenorhip occur at zero). Thu, the equation ytem in (1) include three latent variable, which are denoted by the ymbol (*). The vector X i contain exogenou variable aociated with characteritic of the microfirm, it owner and the local market where it operate. The vector X 1i i alo exogenou and contain the determinant of the choice of ector of operation, but ome of the component of X 1i do not influence the optimal repone vector (π ~ ~ ~ i, K i, L i ). In order to control for difference in behavior among microfirm operating in different ector, the model allow that β j β j (j = 2, 3, 4). The dif- 0 1 ference between the lope vector can be evaluated tatitically. The diturbance ε 1i and ε ji are aumed to be heterokedatic and normally ditributed with zero average and covariance matrice Ω,i. In order to control for nonoberved heterogeneity, we aume multiplicative heterokedaticity. Thu, the element in Ω,i are var[ε 1i ] = σ 11 exp(h i δ 1 ) = exp(h i δ 1 ) H i δ 1 + H i δ cov[ε j 1i, ε ji ] = σ 1j exp ( ) 2 var[ε ji ] = σ jj exp(h i δ j ) H i δ u + H i δ cov[ε v ui, ε vi ] = σ uv exp u,v = 2, 3, 4 ( 2 ) 2 A better variable to repreent labor would have been total wage paid by the microfirm. Many microfirm, however, ue houehold labor (e.g. the owner poue and children comprie all or part of the microfirm labor), which receive neither paid market wage nor monetary payment at all. Therefore, we were unable to contruct that variable. However, plitting the labor variable in two component: houehold and non-houehold labor, our model can be extended to partially tackle thi iue. Thi implie replacing the labor equation in each regime of the empirical model by two new equation modelling the two type of labor. Such a model would allow u to tudy the relationhip between the two type of labor and determine, for intance, whether it i true that informal microfirm make more inteive ue of houehold labor than formal one. (2)

11 economía mexicana nueva época, vol. Cierre de Época (II) where σ 11 = 1, according to the uual reparametrization in model with dichotomou variable. All the parameter in the model are etimated imultaneouly uing full information maximum likelihood by mean of a Monte Carlo EM algorithm (Wei and Tanner, 1990). Thi algorithm allow u to efficiently handle the preence of multiple latent variable without reorting to the calculation of multiple integral (ee, for intance, Natarajan et al., 2000). II.1. The Effect of Formality on Microfirm net Profit and Size The expected effect of operating in the formal ector, conditional on currently operating informally, i.e. the treatment effect on the untreated (teut), i etimated according to: 1 0 teut i = E[y ji i = 0] E[y ji i = 0] j = 2, 3, = x i (β j β j ) { ( 1 H i δ σ j ) 1j exp 2 ( 2 ) } ( 2 ) H i δ j H i δ 0 1 σ1j exp exp 0 ( ( ( exp ( x i β 1 Φ H i δ 1 exp ) 2 ) x i β 1 H i δ 1 where Φ ( ) and Φ ( ) are the cumulative function and the denity function of the tandard normal ditribution, repectively. Variable y ji (j = 2, 3, 4) correpond to ~ π i, K ~ i, and L ~ i, repectively. The ample average of thi effect for each of the three repone variable wa obtained by calculating teut i for each obervation in the informal ubample and then calculating the correponding ample average. The tandard error for the average effect wa etimated by mean of the delta method (Greene, 2007). According to Roy hypothei that comparative advantage drive microfirm behavior, we expect the average etimated value of teut i for the microfirm net benefit to be tatitically non-poitive. Φ ) 2 ) (3)

12 452 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm II.2. Specification of the Model Next, we dicu the regreor (in mall capital) ued in our etimate. We conider ocioeconomic characteritic like gender and chooling a determinant of the ector of operation. The variable gender i dichotomic, and the motivation for including it a a determinant of the ector of operation i the evidence that in Mexico there exit an important proportion of women who decide to work a entrepreneur in the informal ector, ince they conider that in thi way they could have a better work-family balance, (Maloney, 2004). On the other hand, educated microfirm owner are expected to extract greater benefit from operating in the formal ector. In the model, we conider five dummie for chooling: illiterate, primary (between 1 and 6 year of chooling, not including prechool year of education), elementary high chool (between 7 and 10 year of chooling, including the previou chooling level), high chool (between 11 and 13 year of chooling, including the previou level), and univerity (more than 13 year of chooling). The firt dummy i excluded from the model for the uual reaon of identification. The motivation for including chooling a a determinant of the ector of operation i to ue it a a proxy of entrepreneurial ability. There are theoretical model that obtain that the ize of a firm i determined by it owner entrepreneurial ability, (Luca, 1978; Jovanovic, 1982; Rauch, 1991; and De Paula and Scheinkman, 2011). The econd variable we conider i the time the microfirm ha been operating. We expect that firm with more time in the market would tend to be in the formal ector (Jovanovic, 1982). In order to capture nonlinearitie in the effect of thi variable, it i included in linear and quadratic form. The third variable i the microfirm owner acce to credit. Becaue formal microfirm owner tend to have broader acce to credit from the formal market, we ue the type of credit the individual ued to tart the microfirm. 3 The variable include three dummie: own capital; formal credit, if the credit wa provided by the upplier of the microfirm or by a formal credit intitution; and informal credit, if the credit came from a 3 Certainly, it i poible that hitory of credit acceibility i correlated with unoberved component of entrepreneurial ability, which may generate inconitency of ome pecific coefficient in our model. Our main interet, however, i to fit the expected difference between repone of informal microfirm and their counterfactual, not to identify pecific coefficient. Regreor can fail to be exogeneou, but the treatment effect can till be identified a dicued in Heckman et al. (1998).

13 economía mexicana nueva época, vol. Cierre de Época (II) ource uch a family, friend, or another informal lender. The dummy own capital i excluded from the regreion. Given the poibility that acce to credit might be endogenou to the ector deciion, we etimated two additional pecification a robutne check: one in which we exclude all the credit dummie, and another in which we only ue one dummy variable that take the value one if the entrepreneur tarted the microfirm with a credit from any ource (formal or informal) and zero if he/ he ued fund of hi/her own. The fifth variable i the productive ector to which the microfirm belong. We conider four dummie: agriculture, manufacturing, commerce, and ervice. The contruction ector i excluded from the analyi becaue thi ector i under-repreented in the ample. The dummy agriculture i excluded from the regreion to avoid the problem of multicollinearity. In our core pecification, we include age and marital tatu a regreor in the election equation only. In the repone equation we exclude thee regreor for econometrical reaon, a we explain below. Our intention i to take into account evidence that upport the idea that younger individual tend to be le rik avere (Jovanovic, 1979), while individual who have family reponibilitie tend to be more rik avere (Carraco, 1999). Becaue operating in the informal ector entail higher rik for the microfirm owner of being dicovered and punihed by governmental official, we expect that older and married microfirm owner would prefer to operate in the formal ector. Therefore, by including thee variable in the election equation, we intend to model the effect of the entrepreneur rik averion on the deciion of ector of operation. Regarding to the repone equation, the variable age i highly correlated with the entrepreneur experience, which i already captured in thi model by the linear and quadratic effect of time. So, having age in the repone equation entail the rik of multicollinearity. 4 Alo, we do not expect any ignificant effect of marital tatu on the microfirm ize, conditional on the ector in which the entrepreneur ha decided to operate. Nonethele, we teted an additional pecification in wich we added marital tatu while excluding age in the repone equation. The variable age i meaured in year, while the variable marital tatu i a dichotomic taking the value one for married individual. 4 We performed the experiment of adding age while excluding marital tatu in the repone equation. The model, however, did not converge, an outcome that upport our hypothei of multicollinearity when adding age to the repone equation.

14 454 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm In order to control for the characteritic of local market, pecific dummie for municipalitie are conidered in each equation. Alo, to control for heterokedaticity, we conider time of operation (in it log form) a the variable H i. We expect that younger microfirm (i.e. in the early tage of adaptation to the market condition) would diplay greater variability in the repone variable than thoe that have been operating for a longer time. Finally, the dependent variable monthly net profit, capital tock and labor are ued in their log form in the etimation. III. Reult In thi ection we tet our model and dicu the effect that formality may have on informal microfirm. Since direct dicuion of lope etimate can lead to erroneou concluion in nonlinear model, in addition to the coefficient etimate, table 2 report the marginal effect for the election equation, which are uitable etimator for quantifying the impact of each regreor on the expected value of a dichotomou dependent variable (Greene, 2007). We evaluate three hypothee regarding our model pecification. In each cae, we ue a Wald (Chi-2) tet, baed on the likelihood of the unretricted model. The firt tet imultaneouly evaluate the hypothee 0 1 H 0 : β j = β j j = 2, 3, 4; that i, it evaluate whether net monetary profit, the degree of invetment in capital, and labor level are determined in the ame way in both the formal and informal ector. The tet rejected the null hypothei (p< 0,0001), indicating that microfirm react differently depending on the ector in which they operate. The econd tet evaluate the exitence of heterokedaticity; that i, it 0 1 imultaneouly evaluate the hypothee H 0 : δ 1 = δ j = δ j = 0 j = 2, 3, 4. In thi cae, the null hypothei wa rejected (p=0.179), although according 0 to table 2, δ 3 i ignificant individually. The third tet evaluate whether there are efficiency gain when etimating a unique Roy model with three repone, intead of etimating three eparate Roy model with only one repone. If the covariance between the error term of the different repone for each regime are zero, then a joint etimation will not be more efficient than etimating equation for the three repone eparately. The correponding null hypothei i H 0 : σ uv = 0 u, v = 2, 3, 4 = 0, 1. The Wald tet rejected H 0 (p< 0,001), an outcome that upport our joint pecification.

15 economía mexicana nueva época, vol. Cierre de Época (II) Table 2. Etimate and marginal effect for the election equation Informal ector Formal ector Equation Variable Etimate Std. error Marg. effect Std. error Sector Contant a (election) Gender Marital tatu a a Age a a Primary eh* a a High chool a a Univerity a a Time E-4 9.7E-4 Time 2-1.9E-4 1.5E-3 Formal credit a a Informal cred a a Manufacture b b Commerce a a Service b b Monthly net profit Capital tock Contant a a Gender a a Primary a eh* a High chool a a Univerity a a Time b Time 2-1.9E-4 b 1.5E-4-3.1E-4 c 1.6E-4 Formal credit a c Informal credit a a Manufacture a Commerce a b Service b b Contant a a Gender a a Primary a 0.077

16 456 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm Table 2. Etimate and marginal effect for the election equation (Cont.) Informal ector Formal ector Equation Variable Etimate Std. error Marg. effect Std. error eh* a High chool a Univerity a a Time b Time 2-4.2E-4 b 1.8E-4-1.9E-4 1.9E-4 Formal credit a c Informal credit c a Manufacture a a Commerce a a Service a a Labor Contant a b Gender a a Primary a b eh High chool a Univerity Time Time 2-5.9E-4 b 3.0E-4-7.0E-5 1.7E-4 Formal credit b a Informal credit b c Manufacture a a Commerce a a Service a a Covariance matrix a a c a a a a a a a a a a 0.027

17 economía mexicana nueva época, vol. Cierre de Época (II) Table 2. Etimate and marginal effect for the election equation (Cont.) Informal ector Formal ector Equation Variable Etimate Std. error Marg. effect Std. error a a d d d b E d Source: Author Own elaboration uing data from Enamin, 1998 and Note: *eh: elementary high chool. a Significant at 0.01; b Significant at 0.05; c Significant at III.1. Determinant of Sector Choice According to table 2, the main determinant of ector choice (formal or informal) are: the owner chooling, the owner acce to credit to tart the microfirm, and the microfirm type of economic activity. The probability that an individual with univerity tudie will operate in the formal ector i 34 percentage point higher than one without formal tudie and 20 point higher than one who ha achieved a high chool education. An individual with a high chool education ha 9 more probability point than an individual who achieved an elementary high chool education to operate in the formal ector. Moreover, a microfirm owner with an elementary high chool education ha 5 more probability point than an individual with primary education to be a formal entrepreneur. Finally, our analyi indicate that the probability of operating in the formal ector for an individual that ha obtained only a primary chool education i not greater than that of an individual with no formal education, and that the probability of operating in the formal ector i increaing with repect to the achievement of higher education level. A microfirm owner that had acce to either a formal or informal credit ource to open hi buine ha 18 and 6, repectively, more probability point to chooe to operate in the formal ector than an individual who ued hi own money to do o. Thi indicate that an individual who wa able to obtain eed capital from a formal or informal credit ource ha more probability point of chooing the formal ector than an individual who ued hi own money. Moreover, an entrepreneur that ha obtained outide financing to tart hi microfirm, either formal or informal, tend to how higher monthly net profit, capital invetment and labor than an

18 458 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm entrepreneur that ued hi own money to do o. Thi lat reult i tatitically ignificant both for informal and formal entrepreneur. However, thi tendency eem to be tronger for informal entrepreneur that have obtained outide fund from a formal ource to tart hi buine (3 per cent of the informal entrepreneur ub-ample). Alo, an entrepreneur who work in the ector of commerce or ervice ha 15 and 4, repectively, more probability point to work in the formal ector than an individual who work in agriculture. On the other hand, a married individual ha 5 probability point more than an unmarried individual to work in the formal ector, and thi reult i tatitically ignificant. The owner age, albeit tatitically ignificant, eem to explain little of the owner choice of ector of operation. The owner gender ha not tatitically ignificant effect on entrepreneur choice of ector of operation. Some tudie, like Jovanovic (1982), conclude that larger and older firm are more efficient. Thi concluion lead u to expect that older firm would be more inclined to move from the informal ector to the formal ector after attaining a certain ize and level of abilitie. However, our etimate indicate that the time a company ha been operating i not in itelf a factor in the ector choice (the marginal effect of time i not ignificant, ee table 2). On the other hand, a longer operation time implie greater ize (in term of a more intenive ue of capital and labor), which ugget a more elaborated relation between the age of the microfirm and it likelihood to remain in the informal ector. A table 2 how, microfirm that have been in the market longer tend to how greater net profit and invetment in capital than thoe of younger microfirm. Note that thi tendency i tatitically ignificant only among formal microfirm, indicating that only the formal ector provide the neceary incentive for the growth of a microfirm. Our empirical etimation i tatic; but our reult ugget that a microfirm born in the informal ector may eventually face the deciion to remain at a certain ize or move to the formal ector to extend it cale of production. III.2. Effect of the Sector Choice on net Profit and Microfirm Size In order to compare each microfirm againt it counterfactual, we ue expreion (3) for microfirm currently operating in the informal ector. Table 3 provide a mean of comparing the behavior of microfirm currently in the informal ector and their expected behavior had they been operating in the formal ector.

19 economía mexicana nueva época, vol. Cierre de Época (II) Table 3. Effect of formality on the net profit and ize of Mexican microfirm Expected log difference between operating formally minu operating informally, conditional on operating informally * Repone Effect Standard error Net annual profit Capital tock a Labor b Adding marital tatu Net annual profit c Capital tock a Labor b Excluding all credit dummie Net annual profit b Capital tock a Labor c Including a ingle credit dummy Net annual profit c Capital tock a Labor c Source: Author own elaboration uing data from Enamin, 1998 and *Etimation carried out on the ubample of informal microfirm. a Significant at 0.01; b ignificant at 0.05; c ignificant at The etimation indicate that in the formal ector, thee ame microfirm would obtain an annual net profit that i 6 per cent lower than what they currently make in the informal ector. 5 The difference i not tatitically ignificant, however. Thi i true regardle of their cale of operation, ince, according to the value in the ame table, when operating in the formal ector thee microfirm would have to raie their invetment in capital in 250 per cent and increae the number of worker in 80 per cent. 5 Note that the dependent variable in the model are in log form; thu, figure diplayed in table 3 are the difference between the expected value of two logarithm. The percentage preented in the text for the potential tranition from the informal to the formal ector were obtained from the ratio E [e y1 ji i = 0] E [e y0 ji i = 0], j = 2, 3, 4. E [e y0 ji i = 0]

20 460 Di Giannatale, Ramírez-Abarca and Smith: Effect of Formality on Mexican Informal Microfirm On the other hand, a we mentioned before, we performed everal robutne check in order to tet the uitability of everal of the deciion we made in our econometric pecification; that i: a) Adding marital tatu while excluding age in the repone equation, b) Excluding credit dummie, and c) Including only one credit dummy. In all the aforementioned pecification, ee table 3, we obtained reult that how that currently informal microfirm would obtain (were they in the formal ector) a profit that i at leat 20 per cent lower (tatitically ignificant only in one pecification) than what they currently obtain, after increaing their capital invetment in at leat 155 per cent and the number of worker in at leat 13 per cent. Even though we oberve numerical difference, thee additional reult are of the ame nature a our core reult, mentioned in the previou paragraph. In ummary, our reult indicate that in order to compete in the formal ector, a microfirm mut increae it ize. Depite thee adjutment, microfirm that are currently informal would not perform better in the formal ector in term of profit than they currently do operating informally. An explanation to thi reult i that, probably, thoe microfirm owner do not have the ability of exploiting the advantage that the formal ector offer. Therefore, thoe owner optimal deciion i to remain working in the informal ector. Our reult are along the line of Levenon and Maloney (1998), who conider formalization to be part of the microfirm growth proce in developing countrie. Thu, above a certain ize, a microfirm i better off in the formal ector, becaue it can continue growing, pay more qualified worker, and earn enough profit to compenate for the additional cot of formalization. Concluion In thi article, we ue a multivariate framework to tudy the effect of formality on three repone variable of informal microfirm, including net profit and level of capital tock and labor. We are able to control for the correlation between microfirm repone and heterokedaticity. Uing a Montecarlo EM algorithm allow the etimation of a even-equation model uing full information maximum likelihood. Our reult indicate that the main determinant of ector choice are the microfirm owner level of formal education, acce to credit and type of economic activity. In addition, microfirm with more time in the market

21 economía mexicana nueva época, vol. Cierre de Época (II) tend to have higher net profit and capital than younger companie; but thi tendency i tatitically ignificant only for formal microfirm. All of thi allow u to ugget, even taking into account the tatic nature of our etimation, that the neceary incentive for the growth of a microfirm exit only in the formal ector, and that thi growth take place only if the microfirm owner education level and ability to obtain outide fund are adequate, a well a if the microfirm work in commerce and ervice. Regarding the effect of formality on microfirm net profit and ize, our reult indicate that, when comparing the behavior of currently informal microfirm and their expected behavior were they to operate in the formal ector, the microfirm would not obtain a higher annual net profit in the formal ector than what they currently obtain in the informal ector. In addition, if operating in the formal ector, the currently informal microfirm would need to coniderably increae their invetment in capital and their number of worker. It i intereting to note that, depite thee adjutment in capital and labor, informal microfirm would not do better in the formal ector in term of profit than they currently do operating informally. Thi reult ugget that the level of formal education, ability to obtain outide fund and type of activity of thoe individual that chooe to operate in the informal ector limit the profit they can obtain in the formal ector. Therefore, the optimal deciion of uch entrepreneur i to remain informal. Given our empirical reult, a direction for further reearch could be tudying the effect of increaing the level of formal and financial education of the informal microfirm owner by mean of an effective qualification of middle-aged entrepreneur and incentive for young entrepreneur to reume their formal education. Fajnzylber et al. (2009) find empirical evidence of the poitive impact of training on the profit of microfirm. Even though formal education doe not eem to be relevant in ome international meaure of entrepreneurial ability baed on peronal characteritic ee, for intance, Ardagna and Luardi (2010) our empirical reult eem to ugget that, given the low level of education and lack of outide funding oberved in the ample of entrepreneur of our tudy, invetment in formal and financial education might improve the entrepreneurial ability of thoe individual. Finally, thi analyi provide a framework that might lead to further dicuion of whether a more educated informal entrepreneur would be able to adjut hi microfirm tructure were it to operate in the formal ector and to exploit the advantage of the formal ector of the economy, conidering different policy cenario.

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