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Informality , Firm Size and Economic Growth : Testing the de Soto Hypothesis

Formalizing a concept developed by de Soto (1989), I construct a simple general equilibrium model of the informal sector. Agents in the economy can choose to be entrepreneurs in the formal or informal sector, or work in the labor market. Government rent-seeking and bureaucracy leads to a bifurcation in the size of firms: small informal firms and large formal firms. The empirical implications of the model are tested using cross-country data. The data do not conform to the model’s predictions, indicating that this popular conception of the nature of informal sectors should be re-examined.