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Keywords:

  • informality;
  • entrepreneurship;
  • emerging market;
  • institutional environments

Abstract

  1. Top of page
  2. Abstract
  3. Introduction
  4. Methodology
  5. Findings
  6. Discussion and Contributions
  7. Conclusion
  8. Acknowledgements
  9. References

Our qualitative research shows that when making decisions about informality, entrepreneurs in emerging economies purposefully navigate between the enabling and constraining rules of the macro institutional environment and the norms of the meso institutional environment. We show that: (1) informality is a multidimensional continuum along which path to formalization unfolds; (2) as entrepreneurs grow more successful they become simultaneously more attuned to the countervailing constraints of both the macro and meso institutional environments; and (3) informal firms and formal firms weave together an exchange system that legitimizes the persistence of informality. In the context of informality, meso institutions serve as the connective tissue which cross-link levels of the environment and shape the context in which entrepreneurs make decisions. Copyright © 2014 Strategic Management Society.


Introduction

  1. Top of page
  2. Abstract
  3. Introduction
  4. Methodology
  5. Findings
  6. Discussion and Contributions
  7. Conclusion
  8. Acknowledgements
  9. References

Firms that fail to legally register and pay taxes represent one common form of firm activity that falls within the boundaries of the informal economy. Such firms make up the informal economy and represent 40 to 60 percent of the GDP in emerging economies (Schneider, 2005; Portes and Schauffler, 1993; de Soto, 1989). A prominent view of informality suggests that firms start and remain informal because the economic costs, in both money and time, to formally register with the government are too high (de Soto, 2000; Webb et al., 2013). By implication, if governments lower costs or reduce the time and complexity required to complete registration, then entrepreneurs would react by converting their informal ventures into formal ones (de Soto, 2000). Proponents of this ground their argument in the nexus of behavioral responses of individuals to changes in macro institutional regimes. An alternative argument suggests that by staying informal, entrepreneurs are making rational decisions based on cost-benefit analysis (de Mel, McKenzie, and Woodruff, 2013; Perry et al., 2007). That is, the cost of being formal is too high relative to the benefit. Whether initial registration costs or ongoing costs impede formalization remains a hotly contested academic question that also confounds policy makers as they design interventions to stem the tide of informality.

In this article, we argue that informality is a nuanced phenomenon best examined at the intersection of institutional environments that entrepreneurs face. Using qualitative field data, we show that in making decisions about informality, entrepreneurs in emerging economies purposefully navigate between the enabling and constraining powers of the macro and meso institutional environments they face. At their core, institutions consist of rules and norms, both formal and informal, which structure social interaction by constraining and enabling actors' behaviors (Helmke and Levitsky, 2004). Institutions exist at the macro, meso, and micro levels that, in the context of our work, broadly correspond to the national (federal or common union), local (including communities of practice), and individual levels, respectively. Prior research has focused on the top-down effects of macro regulatory environment on informality. We believe it is time to drill deeper (Bruton, Ireland, and Ketchen, 2012) and unpack how informal entrepreneurs navigate among levels of institutional environments. To motivate our research we ask three questions:

  • Research Question 1: How do the macro and meso institutional environments affect entrepreneurs' decisions to formalize their businesses?
  • Research Question 2: As their firms become more successful, how do the countervailing demands of the macro and meso institutional environments influence the informal entrepreneurs' cost-benefit considerations related to formalizing?
  • Research Question 3: How does the interaction between informal firms and formal organizations affect the cost-benefit decisions that informal entrepreneurs make with respect to formalization?

We examine these research questions in the Dominican Republic, where informality is central to the local economy (42% of GDP, Vuletin, 2008) and a key source of economic growth. Despite its significant role in countries such as the Dominican Republic, informality remains understudied, especially from an entrepreneurship perspective (Bruton, Khavul, and Chavez, 2011; Khavul, 2010; Bruton, Ahlstrom, and Obloj, 2008; de Soto, 1989).

Our study makes several contributions to the literature. First, we show that entrepreneurs see formalization of their firms in terms of multiple strategic choices that unfold over time and are not simply excluded from formalization by the cost or complexity of registration. We suggest that the binary classification of formal versus informal firms, into which the management literature has tended to pigeonhole this decision, needs to evolve into a multidimensional continuum that is responsive to institutional differences and cross-country variation. Second, we demonstrate that when successful entrepreneurs face the challenges of institutional pluralism, they become simultaneously more attuned to the countervailing constraints of both the macro and meso institutional environments. Finally, we show that informal and formal firms weave together an exchange system that legitimizes the persistence of informality.

Informal firms and institutional environments

Informal firms

Informal firms are organizations that conduct market-based activities with legal goods produced and distributed without regard for taxation or regulation (Portes and Castells, 1989; de Soto, 1989; Portes and Haller, 2005; Schneider, 2005; Webb et al., 2009). The distinction between legal and illegal activity is important because many informal businesses supply illegal goods (i.e., pirated media and software) and do not register with their governments. By contrast, our research focuses on the vast majority of unregistered businesses that provide legal goods and services (de Soto, 1989), and we leave aside questions of illegal goods that notionally fall within the boundaries of the informal economy. Albeit at different rates, informal firms are prevalent in both mature and emerging economies. As a defining characteristic of entrepreneurial life in emerging economies (Khavul, Bruton, and Wood, 2009; Khavul, 2010; Kodithuwakku and Rosa, 2002), the effect of informality on firm productivity and growth is much debated (LaPorta and Shleifer, 2008). Scholars have long accepted that institutional context influences entrepreneurial activity (Estrin, Korosteleva, and Mickiewicz, 2013), so the face of entrepreneurship differs between emerging and mature economies (Peng, 2000; Bruton et al., 2008). Similarly, the causes and consequences of informality in emerging and mature economies likely differ. Indeed, research that distinguishes the contours of informality in emerging and mature economies is gaining momentum (Estrin and Mickiewicz, 2012). The spotlight on the role of institutions in firm entry and growth is particularly intense (Estrin et al., 2013).

Institutions

Institutions and their governance play an important role in the rise and fall of nations (Acemoglu and Robinson, 2012), the evolution of organizational forms (Khavul, Chavez, and Bruton, 2013), and policies to promote economic inclusion (Banerjee and Duflo, 2011. Formal and informal institutions shape entrepreneurial behaviors in subtle but pervasive ways (Scott, 1995; Bruton, Ahlstrom, and Li, 2010; Estrin et al., 2013). To date, almost all of the analysis of how institutions affect informality has looked at the macro (national or regulatory) level, yet institutions also help direct actions of individuals and communities at the meso level (Roelants, 2000; Elsner, 2010).1 The meso level institutions are a bridge built on community values that accrete over time into a coherent and predictable set of well-known rules and taken-for-granted norms. Institutions at this level come closest to ‘more-or-less taken-for-granted social behavior that is underpinned by normative systems and cognitive understandings that give meaning to social exchange and thus enable self-reproducing social order’ (Greenwood et al., 2008: 4). Meso institutions could be identified in local geographically defined communities, but they can also refer to communities of practice and communities bound together by ethnic, economic, and political ties. Meso institutions can be formal, with codified rules, or informal, with rules that members know and follow but that no one explicitly states (Helmke and Levitsky, 2004).

The boundaries of meso institutional environments are porous and responsive to the reach and influence of macro institutions. Porous boundaries allow meso institutional environments to capture information about changes in the macro institutional environment as they diffuse across the institutional landscape. As it crosses meso institutional boundaries, such new information can trigger communities to engage in sensemaking processes that may require the augmentation of existing taken-for-granted norms. The responsiveness of meso institutional environments can be seen when the taken-for-granted norms or values coalesce over time and either complement or substitute the formal rules in the macro environment. Thus, complementary meso institutions bridge the gap between the demands of the macro environment and the needs of the individual. However, in emerging economies, we often observe that meso institutions can also be substitutes for weak macro institutions, the symptoms of which are limited enforcement of legal requirements and tacit complicity at multiple levels of government to circumvent legal institutional frameworks. In this setting, meso institutions provide the locus for an entrepreneur's identity and solidarity with a community, but they also reinforce business informality. Hence, meso institutional environments are the anchor around which informality develops despite the codified rules to the contrary.

Methodology

  1. Top of page
  2. Abstract
  3. Introduction
  4. Methodology
  5. Findings
  6. Discussion and Contributions
  7. Conclusion
  8. Acknowledgements
  9. References

Case studies and empirical setting

We used qualitative grounded theory methodology organized around a series of case studies (Eisenhardt, 1989; Eisenhardt and Graebner, 2007; Glaser and Strauss, 1967; Strauss and Corbin, 1990; Yin, 2003). A qualitative approach is appropriate for building theory (Lee, 1999). Grounded methods allow us to develop a highly textured view of informality in emerging economies (Bruton et al., 2011). Informal firms are complex and remain largely unexamined from an entrepreneurial perspective.

Empirical setting

Our research is set in Santo Domingo, the capital of the Dominican Republic, a country with a large, economically significant informal economy (42% of GDP, Vuletin, 2008) and high rates of poverty (50% of the population living on less than $2.50 a day). We restricted our focus to informal vendors who principally sold prepared food and fruit from stands along streets and in local markets. Vendors either had fixed retail locations or delivered goods as they rolled through the community on bicycles or in other vehicles. In the Dominican Republic, as in many other countries around the world, entry into street vending is easy and levels of informality are high. Although countries in the Latin American and Caribbean region are heterogeneous, they share a culture of business informality. Looking in-depth at one nation and at a typical industry allowed us to explore broad questions but within a focused setting. Our goal is to provide insights that would spur future research across multiple countries and with the use of multiple methods.

Cases

We used a purposive research, case selection process where, to be selected, specific cases had to meet desired underlying firm characteristics. We worked with individuals who had deep knowledge of entrepreneurs in these communities and could direct us to a broad cross-section of firms with variable outcomes. We conducted 40 interviews of which 31 were with informal vendors (14 fruit sellers and 17 food sellers) and nine with experts and key industry informants. Both groups of vendors included sellers who had permanent locations and those who moved their locations. We captured differences of type and size across vendors. Out of 31 firms, two firms had over $1 million a year in sales, two firms were in the $100,000 to $450,000 range, six firms had from $30,000 to $100,000 a year in sales, while six others sold $10,000 to $30,000 per year. The remaining firms sold less than $10,000 per year. In a country where minimum salary is $150 USD a month, the majority of the firms we interviewed are far larger than would be expected of informal firms that are only self-employment vehicles. Indeed, half the firms had more than two employees and nine out of 31 also hired individuals from outside the family. Our cases represent a cross-section of informal vendors in the capital of the Dominican Republic and make for an appropriate empirical setting to understand informality. Table 1 summarizes key information about our cases.

Table 1. Case studies
  1. ***Confirmatory interview conducted also with an entrepreneur who moved from informal to formal with more than $2.5 million in revenue and multiple employees. Eight other interviews also conducted with experts on informal firms. All amounts in U.S. dollars.

  2. ‘Family’ refers to the number of family members working in the business.

Case 1

6 family members in business

14 other people cooperate in business

Strong connections to suppliers (4) and strong connections to police

Annual sales $1.2 million

Case 2

2 family members in business—no others

Strong relationships with customers (wholesales to suppliers to hotels and other higher-end clients) and suppliers

Annual sales $1 million

Case 3

1 family member in business

3 other employees

Strong connections to suppliers (6) and customers (wholesales to suppliers of resorts and high-end hotels)

Annual sales $450,000

Case 4

4 family members in business

9 other employees

Works with those in market to grow business (was critical of one woman in market who does not network with others)

Annual sales $172,000

Case 5

No family members in business

2 employees

No connections to suppliers: buys strictly on price each day and has no connections to other stalls in market

Annual sales $80,000

Case 6

No family members in business

6 employees

Stress no connections to community and weak connection to suppliers (Haitian immigrant)

Annual sales $51,000

Case 7

No employees (although girlfriend seemed to be working consistently)

Supplier brought him the chickens and offered credit to him

Worked at night so did not have to register but knew police in area and offered them free food periodically

Annual sales $50,000+

Case 8

2 employees, all family

Loans and credit cards

Started the business with a friend, then bought him out

2 suppliers and they provide credit

Annual sales $30,000

Case 9

2 family members in business—no others

No relationships with community, customers, or suppliers

Annual sales $30,000

Case 10

3 family members in business—no others

All financial instruments, credit cards, loans, savings accounts; multiple suppliers who provide credit

Annual sales NA but estimated to be in top one-third of interviews

Case 11

2 employees, all family

No banking instruments

Help from church pastor

Multiple suppliers who provide credit

Annual sales $30,000

Case 12

2 family members in business—no others

Savings accounts

Multiple suppliers who provide credit

Annual sales $20,000

Case 13

No family members in business

2 other employees

Participates in a coop, which provides loans

Help from church pastor

Multiple suppliers who provide credit

Annual sales $25,000

Case 14

1 employee, an assistant, no family members

Loans from loan sharks

Started the business with a friend, then bought him out

Changes suppliers based on prices; pays cash

Annual sales $15,000

Case 15

Husband and wife team

Loans from bank; savings account

Help from church pastor

Multiple suppliers who provide credit

Annual sales $20,000

Case 16

4 family members in business

4 others part-time employees

Loans with those in market and credit with suppliers

Annual sales $12,000

Case 17

3 employees, all family

Loans from bank; savings account

Help from church pastor

Multiple suppliers who provide credit

Annual sales $10,000

Case 18

No employees; self-financed stand

No credit from suppliers

No relationship at all with other food stands in area around bus station; does not even know their names

Annual sales $9,500

Case 19

2 employees, all family

Loans from banks, saving accounts, and credit cards

The idea from the business came from the daughter who works with her

5 suppliers and some provide credit

Annual sales $8,000

Case 20

3 family members in business—no others

Relationship with supplier strong and relationship with stadium owner is the reason he can sell at cock fights

Annual sales $7,000

Case 21

4 employees, all family

Owns another business, a butcher shop

Loans from banks,

Business was ‘my’ idea but the family helped a lot

3 suppliers and some provide credit

Annual sales $6,000

Case 22

No employees

Loans from loan sharks

Sister help start the business

2 suppliers, no credit

Annual sales $6,000

Case 23

1 family member in business

No other employees

Loans only from loan sharks

No suppliers, buys at the market and supermarket

Annual sales $5,000

Case 24

2 employees, all family

All financial instruments, credit cards, loans, savings accounts

One supplier who does not provide credit

Annual sales $3,200

Case 25

1 family member in business

No other employees

Loans only from loan sharks

No suppliers, buys at the market and supermarket

Annual sales $2,400

Case 26

Self only

No relationships with community, customers, or suppliers (buys damaged fruit and resells it cheap)

Annual sales less than $1,000

Case 27

2 family in business—no others

Strong relationship to community; lends money to even potential competitors

Annual sales less than $1,000

Case 28

Self only

No relationships with community, customers, or suppliers (Haitian illegal immigrant); reported harassment by police

Annual sales less than $1,000

Case 29

No family in business

1 employee

No connections to suppliers; buys strictly on price each day and no connections to other stalls in market area; new business, the entrepreneur owns successful clothing store

Annual sales less than $1000

Case 30

1 family member in business

No other employees

Bank loans

No suppliers, buys at the market and supermarket

Annual sales does not know, has no sales data. Buys daily and does not know how much is left over. Estimated to be in the lower one-third of interviews.

Case 31

No family members in business

No other employees

Loans only from loan sharks

Multiple suppliers who do not provide credit

Annual sales does not know, has no sales data. Buys daily and does not know how much is left over. Estimated to be in the lower one-third of interviews

 

Summary of qualitative steps

We analyzed the data in seven steps, employing well-established methods for grounded field research (Strauss and Corbin, 1990; Auerbach and Silverstein, 2003) that had previously been used to provide insights into new domains (i.e., Bruton et al., 2011).

Step 1

In the initial step, we defined research questions and broad categories a priori to guide the field research (Strauss and Corbin, 1990). We established these research questions from the literature in entrepreneurship and on informal firms. To supplement the literature and confirm that the research questions were salient, we conducted preliminary conversations with field and content experts. We then established the parameters of the purposive sampling, which involves selecting participants with specific characteristics (Lincoln and Guba, 1985).

Step 2

Next, we generated an interview protocol. The protocol provided a framework that guided our discussions with participants at the informal firms. In developing the protocol, we discussed expected categories of outcomes based on the theoretical and empirical literature from economics, sociology, and economic development.

Step 3

We then conducted 31 semi-structured, face-to-face, in-depth interviews with informal firms (Weiss, 1994). Initial prescreening questions ensured that all those interviewed self-identified as informal entrepreneurs. The face-to-face interviews lasted from 45 to 90 minutes. We used a local interpreter experienced in assisting social studies research conducted for international organizations (The World Bank, Inter-American Development Bank, etc.). To ensure consistency, we had all interviews taped and transcribed in Spanish and then translated into English. To ensure accuracy, a team member fluent in Spanish and English sampled and translated the interviews independently and compared the translations to those of the expert. These experts had few disagreements on the translations. Most queries dealt with local idioms and word usage. We asked each entrepreneur similar questions; however, as the respondents raised issues that provided rich insights, we would discuss those particular issues in greater depth with each interviewee. As of the end of the interviews, no new concepts emerged (though new stories still emerged).

Step 4

We compared patterns observed in the cases and focused on the similarities and differences identified across them. This interaction among the authors required extensive discussion of the details of the interviews we observed and the implications for those observations. We built and modified the categories generated by Step 1 as we discovered information that either supported or countered our expectations. In addition, we created new categories to reflect insights that did not fit into existing categories. In those few instances in which the authors disagreed on the impact of the case on the research question, we discussed the discrepancies until we reached a consensus.

Step 5

We made extensive use of secondary data, including the nature of the business registration process in Santo Domingo and the Dominican Republic. Table 2 summarizes those registration requirements. In addition, we examined all major newspapers in Santo Domingo, January 1, 2012 through June 1, 2013, looking specifically for illustrations of where the practice of macro and meso institutions conflicted. Table 3 summarizes our findings from the newspapers.

Table 2. Requirements for business registration in the Dominican Republic and the City of Santo DomingoThumbnail image of
Table 3. A selection of commentaries on the popular press of the Dominican Republic regarding street sellers in Santo DomingoThumbnail image of
Step 6

To increase the validity of the findings, we interviewed eight experts on informal firms. These experts included academics, government researchers, a supplier to the firms, and NGO managers. In addition, we interviewed a respondent at one informal business that had moved from informal to partially formal. Our analysis was consistent with that of outside experts, yet this step is particularly important in reconciling any differences or explaining disparities.

Step 7

Finally, we used the field evidence to generate a set of testable propositions that lay the groundwork for future research. Each of these propositions in turn generated a corollary insight that flows from the proposition and expands the understanding of informal firms. Earlier, we posed three research questions that we will now examine in detail. We offer illustrative quotes and stories for each proposition in Table 4.

Table 4. Illustrative and supporting quotes for propositionsThumbnail image of

Findings

  1. Top of page
  2. Abstract
  3. Introduction
  4. Methodology
  5. Findings
  6. Discussion and Contributions
  7. Conclusion
  8. Acknowledgements
  9. References

Research question 1: how do the macro and meso institutional environments affect entrepreneurs' decisions to formalize their businesses?

Registration

In the Dominican Republic, as in most countries around the globe, business formality is the law of the land. However, few of our entrepreneurs registered their firms in the way that national rules and regulations require. Indeed, the informal entrepreneurs we interviewed were surprised and occasionally astonished when we asked them about registration. ‘Why register?’ they replied.

Dominican informal entrepreneurs generally regard the central government as ineffectual and compliance with it as not worth the effort. For a case in point, consider just one recent effort to regulate street vendors. In response to numerous complaints to the press about the health and nuisance risk vendors pose (see Table 3 for archival data), the central government produced new regulations requiring vendors to wear clean uniforms. Although visions of starched and uniformed street vendors may appeal to policy makers, such requirements are utterly unrealistic in this emerging economy. Indeed, most street sellers quickly realized that the government had neither the means nor the will to enforce the requirement. What the government did do was make considerable noise on the issue, but everyone knew full well that these requirements could never be, and never were, acted on. Such scenarios are ongoing and condition Dominican entrepreneurs to make decisions in an environment that predictably fails to provide signals of consistent and strong institutions.

Over time, observations of inconsistent and toothless government policy lead to self-reinforcing patterns of behavior based on accepted norms in the meso institutional environment. The informal entrepreneurs we interviewed knew of no one in their community who had registered with the central government and believed that they would be an exception if they openly chose to do so. In fact, there was a profound sense that if the entrepreneurs pursued registration, they would be outliers bucking the informal rules of the meso environment that others followed. Entrepreneurs made passionate arguments that the cost and complexity of registration prevented them from becoming formal. Yet, most entrepreneurs we interviewed had no firsthand experience with registration and relied on limited information that circulated in their environment and supported accepted meso institutional practices. Thus, the choices entrepreneurs make are consistent with the narratives developed within communities of practice found in their meso institutional environments. This suggests that:

  • Proposition 1: The weaker the formal macro environmental institutions, the more likely informal entrepreneurs are to rely on norms in the meso institutional environment.
  • Corollary 1: Meso institutional narratives and beliefs influence the decisions of entrepreneurs with respect to formalization of their firms.
Shades of grey

Entrepreneurs we interviewed self-identified as running informal firms when they did not pay taxes, duties, fees, or register in any way with the central government. Indeed, much of the management literature would identify such firms as informal. However, informal firms often paid duties, fees, and taxes that registered them with other levels of government including local zones, city government, and county municipalities. Although the total amount paid to the local government was significantly lower than firms would need to pay to the central government, entrepreneurs selectively paid when they regarded the services provided as relevant to the welfare of their business. For example, entrepreneurs paid fees to register with the local authorities in order to have space in local markets, be able to put up signs to their businesses, and have health inspections. Such fees and taxes secure basic property rights and legitimize the firms in the eyes of their peers, customers, and suppliers. Although they complained about the quality of the services they received from the city or municipality, the entrepreneurs we interviewed (as well as an important number of their peers) did register at the local level. They were unwilling to pay fees or taxes to higher levels of government from whom they saw no benefit. For most firms that self-identified as informal, the meso environment (the informal, unwritten community standards) set an expectation that registering with the local authorities, to some degree, was acceptable and even desirable. However, we certainly did observe that the very poorest and worst-performing firms (often itinerant mobile vendors) did not register with anyone and disengaged from government at all levels. Such firms fly under the radar and perceive themselves as invisible. These completely informal firms were often migrants from Haiti who operate in ethnic enclaves and are poorly integrated into Dominican society. Their marginalized status in society, the transience of their businesses, and the subsistence nature of their businesses mean they feel little pressure to register. However, Haitian entrepreneurs, though informal, are not invisible; in fact, their presence attracts public scrutiny and debate.

If full registration and complete compliance define business formality, then such formal firms are in the minority in the Dominican Republic and other developing economies. The vast majority of firm in the Dominican Republic are, to some degree, informal. Our findings suggest that what is commonly referred to in a binary way as informality versus formality should be viewed along a multidimensional continuum with multiple points in between complete informality and total formalization and variation in the level of compliance across institutional dimensions. In this conceptualization, entrepreneurs make strategic decisions about where to position their firms along the continuum. Our evidence suggests that there are clear cost-benefit calculations that entrepreneurs make when it comes to the decision to formalize. In addition, they adopt a portfolio approach to compliance along multiple institutional dimensions such as health laws, labor laws, tax laws, and others (Perry et al., 2007). However, the decisions about whether to register or not are conditioned on the unwritten but well-understood and taken-for-granted rules found in the entrepreneur's meso institutional environment. This strategic approach to informality suggests that firms might choose compliance levels to meet some of the expectations of their macro institutional environment without violating its overall norms and practices of their meso institutional environments (Godfrey, 2011). This suggests that:

  • Proposition 2: At each stage, entrepreneurial firms will choose, within each institutional dimension, a level of compliance where the benefits of formalization outweigh its cost.
  • Corollary 2: Informality is a multidimensional continuum that ranges from no formal registration with any government agency to degrees of partial registration with intermediate authorities and across multiple institutional dimensions.

Research Question 2: as their firms become more successful, how do the countervailing demands of the macro and meso institutional environments influence the informal entrepreneurs' cost-benefit considerations related to formalizing?

The last two propositions and their attending corollaries suggest that informality is not an all-or-nothing decision for most informal firms. We showed that informal entrepreneurs make calculated decisions based on the perceived costs and benefits of formalization along multiple institutional dimensions. Moreover, the norms and taken-for-granted rules of the meso institutional environment serve to reinforce this approach. In this section, we focus on what happens to successful entrepreneurs and show how macro and meso institutional environments, especially when in conflict, influence the cost-benefit decisions that entrepreneurs make.

Trade-offs with rules in the macro environment

Informality presents successful entrepreneurs with the countervailing demands of rules in the macro environment and norms in the meso environment. Consider the practical dilemma of a successful entrepreneur. As profits grow, the entrepreneur has to decide what to do with the accumulated cash. The most common investments involve real property: building homes for the immediate and extended family and the purchase of rural land. At some stage, too much cash accumulates and the entrepreneur is forced to turn to a bank. In the Dominican Republic, as in many Latin American countries, banks are subject to strong currency controls. Such controls, although intended to prevent the laundering of drug money, are useful for identifying successful informal firms that should be paying taxes. As bank assets increase, the entrepreneur becomes more visible and at risk of being called to pay income tax. This visibility initiates the process of formalization that goes beyond the local authorities, but even as the process of formalization unfolds, entrepreneurs continue to strategically manage the formal and informal boundaries of the firm.

One of our respondents who had a multilocation business initiated the process of formalization on the advice of his attorney who recommended that he register one of his three business locations because the amounts of money he was depositing in the banks were becoming suspicious and the authorities might believe that he was laundering money or participating in other illegal activities. Thus, as the entrepreneur and his business became more successful, he became more attuned to the demands of the formal rules in the macro institutional environment. At a certain level, the risks of playing the ‘see if you can get me game’ became too great. Nevertheless, the entrepreneur continued to straddle both the formal and the informal worlds even as his business had more than $1 million in sales. Partial registration provides protection of the firm's assets, but still offers ways around employment, retirement, and health care costs. A strategy of partial business registration provided him with strategic flexibility at the same time as registration provided a legitimizing cover. This suggests:

  • Proposition 3: As the wealth of informal entrepreneurs increases, they become more attuned to formal rules in the macro institutional environment and launch their firms on the path to formalization.
  • Corollary 3: Financially successful informal entrepreneurs adopt staged formalization when the level of their commercial activity threatens to expose them to formal scrutiny.
Trade-offs with norms in the meso environment

As firms grow and become more successful, we find that the informal hold of the meso institutional environment on the entrepreneurs becomes more, rather than less, intense. The successful entrepreneurs in our study initially lived in severe poverty, yet some of their informal firms grew relatively large in terms of revenue (see Table 1). However, financial success did not translate into outward manifestations of wealth as one would find among successful managers, doctors, and other professionals with relatively high incomes. These people have desirable houses, maids, drivers, and guards to protect their assets; none of the successful entrepreneurs we interviewed pursued such public displays of wealth. They continued to live in the communities in which they made their income and without the trappings that accompanies financial success. Certainly, they improved their homes, bought hard assets for family members (e.g., homes for mothers or mothers-in-laws), and paid for better educations for their children. Yet, for the most part, they were quite humble in their appearance and demeanor.

There are clear reasons for such behavior. Overt displays of wealth would attract attention to their business, increase the risk of resentment, and open them to criminal extortion. Moreover, the entrepreneurs we studied lived, worked, and traded within the communities from which they originated. Moving out of the community in which one has established a firm is not a simple task, even with increasing wealth. Consequently, to avoid a backlash from those on whom their success depended, entrepreneurs took measures to minimize visible symbols of success. Thus, as their wealth increased, entrepreneurs had to negotiate trade-offs within meso institutional environments that engender conformity and reinforce the maintenance of community norms. This suggests:

  • Proposition 4: As the wealth of informal entrepreneurs increases, they become more attuned to the constraints of the meso institutional environment.
  • Corollary 4: Financially successful informal entrepreneurs avoid strong displays of their success to prevent a backlash from their meso institutional environment.

Research Question 3: how does the interaction between informal firms and formal organizations affect the cost-benefit decisions that informal entrepreneurs make with respect to formalization?

Twenty years ago, Portes and Schauffler (1993: 46) noted ‘the dynamism of informal enterprises and its manifold connections with larger firms are central issues entirely missed by an analyst that defines the sector as consisting in survival activities.’ Our interviews show that informal entrepreneurs can and do interact with formal organizations and are an integral part of the network of formal organizations and informal firms in the local business ecosystem (Roberts, 1994; Portes and Benton, 1984). Moreover, our data strongly suggest that interactions between formal organizations and informal firms influence the cost-benefit considerations of entrepreneurs as they contemplate formalization.

In the Dominican Republic, city and district authorities allow firms to register locally and operate in their communities without reporting them to central authorities. As long as the informal businesses are up-to-date and registered with the local authorities, they operate in the same manner and with the same rights as formally registered firms. Specifically, they exercise property rights over their locations and business names. Moreover, local authorities assist informal firms in the resolution of disputes and enforcement of agreements. Notably, administrative bodies at different levels of government in the Dominican Republic appear to have no coordinated effort to ensure that their records aligned. Thus, a firm could pay local fees and registration taxes but still completely avoid registering with the central government or other government levels in which income taxes are much more extensive or severe. However, at the local level, officials had the power to collect fees on-site, pressure those who did not comply, and—in the extreme—extort what was due. For those firms registered with the local authorities, the regulatory rules of the macro environment seemed far removed and a cost not worth considering.

When we then looked at which parts of the private formal sector engaged with informal firms, we found that banks were key support structures for informal firms. We found that although informal businesses in our study were mostly cash operations, banks were willing to lend them relatively large amounts of money. For example, at least two entrepreneurs stated that they had rejected loans for significant amounts of money (more than $25,000) because they did not need the money for the business. Banks were always offering significant sums to them as personal loans on generous terms. In addition, we noted that informal entrepreneurs had access to various financial instruments, including credit cards. Likewise, we found, on the basis of their operating history, suppliers—often multiple suppliers—provided credit (in some cases significant amounts of credit plus generous repayment terms) to firms both small and large. Clearly, excluded from the banking and supplier relationships were the smallest and the most mobile of the vendors who bought and sold goods daily on a cash basis. However, for informal firms, the lack of formalization did not appear to be a significant barrier to working with formal organizations. In fact, in choosing to work with informal firms, formal organizations adopt the implicit norms of the meso institutional environment and, in the process, lend legitimacy to it. Banks are a clear example of this behavior. Banks want local informal firms as customers and structure the relationships in ways to serve them effectively. Generally, they ignore the letter of the law regarding registration. By supplying financial services, banks enable informal firms to continue to operate and grow. Since the boundaries between the formal and the informal economies can be crossed so easily, even in the heavily regulated financial sector, informal entrepreneurs see no specific urgency to become formal. In sum, we observed that the interactions between the formal and informal sectors reduce the cost of informality. If a business can operate in the informal economy and have largely unrestricted access to the formal economy, then why pursue formalization given its obvious cost and uncertain benefit?

  • Proposition 5: The more developed the channels of interaction between informal firms and formal organizations in local environment, the lower the incentive for informal firms to formalize.
  • Corollary 5: Informal firms interact with a variety of formal organizations in their environment to weave together an exchange system that legitimizes the persistence of informality.

Discussion and Contributions

  1. Top of page
  2. Abstract
  3. Introduction
  4. Methodology
  5. Findings
  6. Discussion and Contributions
  7. Conclusion
  8. Acknowledgements
  9. References

In this article, we argued that understanding how informal firms in emerging economies navigate between the enabling and constraining forces in the macro and meso institutional environments yields core insights into why business informality persists. Building on prior literature that had focused on the regulatory aspects of the macro institutional environment, we consider the persistence of informality through the added lens of meso institutional environments where taken-for-granted social behaviors toward informality become institutionalized. In this section, we set our findings in the context of prior studies, and we offer future research directions.

Why informality?

In asking why informal firms do not register, scholars principally advance two hypotheses (Perry et al., 2007). The first suggests that the cost and complexity of registration prevents entrepreneurs from pursing formalization and excludes them from the formal economy. Thus, in order to change entrepreneurial behavior, it has been argued that laws need to be changed and costs need to be reduced (de Soto, 1989). The competing hypothesis advances that entrepreneurs make rational cost-benefit calculations and when they find that the benefits of formalization are lacking, they exit (or more likely never enter) the formal economy (Maloney, 2004). Our findings align with the rational decision-making side of the debate. Although entrepreneurs in our study invoked the high initial costs and complexity of registration as a reason for not registering, they rapidly broadened this narrative and argued more passionately that benefits from acquiescing to the demands of the macro institutional environment were limited and the penalties for failing to do so were remote. They perceived the macro institutions as weak and relied on the meso institutional norms in their local environment as support for remaining informal.

As we look in the broad literature on informality, there are contemporaneous field experiments in economics that strongly support our qualitative findings. For example, de Mel et al. (2013: 123) recently ran a controlled experiment in Sri Lanka to test whether ‘the exclusion or exit view of informality better reflects reality.’ With a set of firms similar to ours, they created multiple treatment groups. For some groups, de Mel et al. (2013) reduced the costs of gathering firsthand information about the registration process and, for others, they offered different levels of financial incentives (reimbursement of costs and direct payments) to induce registration. The results were startling and revealed much about the demand for formality and the persistence of informality. Neither reducing the cost of information nor incentivizing registration by reimbursing the (relatively small) financial costs of registering had any effect on the rates of registration. However, direct payments, proportional to the monthly profit of the average firm, did induce firms to formalize initially at an increasing rate but then at a diminishing one. This experiment ruled out the idea that information search costs and the direct costs of registration are the principal barriers to formalization. Sri Lankan entrepreneurs, in a weak macro institutional environment, were making rational cost-benefit calculations similar to the Dominican entrepreneurs we interviewed. Thus, they remained informal not because of entry barriers to formalization, but because formalization did not make economic sense in terms of what they received in exchange for their tax contributions. Moreover, in an environment where they also did not believe in the enforcement powers of the central government, the decision to formalize could be made only when the balance of economic consequences changed.

Informality as a multidimensional continuum

The relentless focus by scholars on economics of formalization, we believe, has narrowed the conceptualization of informality. That is, most management studies classify firms as either formal or informal, but as we show in this article, this does not capture the nuanced empirical realities of what it means to be an informal business in an emerging economy. At first pass, we find that entrepreneurs do, indeed, self-identify as informal: they do not pay taxes and are not fully registered with all levels of government. On this basis alone, much macro (national) level empirical data classifies firms as informal. In fact, empirical evidence suggests that informal firms do register and do pay fees at multiple levels and for multiple reasons. Much as we had, de Mel et al. (2013) also showed that Sri Lankan entrepreneurs may have self-identified as informal but were often registered at the district and other levels. This insight forced de Mel et al., (2013) to revise the assignment of firms in their large-scale experiment. Hence, reliance on macro data often will result in misclassification, and it amalgamates informal firms in a way that will obscure important underlying effects. In our view, creating an additional category called semiformal obscures the issue. We propose that the concept of informality should be treated along a continuum that reflects the multiple levels of engagement of the firm with its environment.

Understanding the shades of grey that typify the informal economy requires more precision in data collection as well as an embrace of cross-country differences in the levels of formalization that firms can achieve within the norms of their meso institutional environments. Although ours is a single-country study, taken in conjunction with evidence provided by de Mel et al. (2013) and earlier observations of this in Perry et al. (2007), we would hypothesize that context matters as does the appropriate placement of informal firms along a finer-grained multidimensional continuum. For future studies, mapping multiple dimensions along which firms can and do choose to comply with regulations across the jurisdictions (local, regional, and national levels) would serve to unpack the extent of formalization. In addition, such maps can be combined into firm-level portfolios of compliance and help us understand the heterogeneous choices firms make with respect to formalization and the impact such choices have on firm survival and performance.

In further support of the rational cost-benefit hypothesis, we find clear evidence that informal firms approach formalization strategically. Firms comply with registration at levels where the perceived benefit of formalization is clear and within the bounds of communal norms in the meso environment. Our contention is that in the future, researchers need to move beyond seeing firms in binary terms and embrace the shades of grey. Scholars should be asking more complex and revealing questions that can explain the persistence of informality and the often frustrating policies to eradicate it. Our evidence suggests that no reduction in the time or cost of registration would move our informal firms to formality. If their peers are not registered and government services are not in line with expectations, the entrepreneurs we interviewed would not register.

Institutional pluralism

In the Dominican Republic, as in many emerging countries around the world, there are successful informal entrepreneurs who eventually chose to begin the formalization process. One of the goals of our research was to understand how such successful informal entrepreneurs managed the countervailing forces of the macro and meso institutional environments. Although the literature often categorizes firms as formal or informal, our research suggests that for those who elect to do it, formalization is a process that exposes entrepreneurs and their firms to the challenges of institutional pluralism. That is, they begin to operate in multiple institutions spheres. Thus, the question of how informal entrepreneurs in the process of formalizing manage the countervailing forces of multiple institutional environments is particularly intriguing and relevant to answering why and how informality persists.

We found that as entrepreneurs became more successful, they had to become more attune to both the macro and meso institutional environments. Where the macro environment is concerned, success pushes the entrepreneurs to launch their firms on the path to formalization. We contend that successful entrepreneurs adopt staged formalization when their level of commercial activity threatens to expose them to formal scrutiny. Thus, the benefits of formalization begin to outweigh its costs. Success brings entrepreneurs into the open, but they strategically reveal their financial hand one card at a time. As this process unfolds, we found successful informal entrepreneurs have to become more, rather than less, attuned to the often constraining norms of the meso institutional environment.

The challenge for successful informal firms and the entrepreneurs who run them is to operate within institutional spheres that are potentially at odds with one another. Commitment and conformity with institutional environments confer recognizable identities and legitimacy to the organization and its leadership. In the context of informality, we argued that in the absence of strong macro institutions, the norms of the meso institutional environment serve as effective substitutes. In our data, it was clear that entrepreneurs are attuned to the norms in the meso environment as they reject or skirt the rules of the macro environment. Successful informal entrepreneurs who begin the process of formalization are forced to play more than one game at a time (Kraatz and Block, 2008). That is, they make a strategic choice to engage with the rules in the macro environment, which may be at odds with meso norms. The competing demands of the macro and meso institutional environments force the entrepreneur to continuously resolve tensions that arise from, ‘multiple regulatory regimes, embedded within multiple normative orders, and/or constituted by more than one cultural logic’ (Kraatz and Block, 2008: 243). Successful informal entrepreneurs must meet the expectations of multiple audiences, often while juggling identities that are growing at odds with each other.

Theorizing about formalization in terms of an entrepreneurial journey into institutional pluralism opens a series of opportunities that we think are ripe for research. Take, for instance, identity conflicts that may arise when successful informal entrepreneurs begin to respond to the demands of the macro environment. What types of symbolic exchanges would they engage in to help validate their new identities and maintain their old ones? We argued that successful entrepreneurs become more attuned to the demands of their meso environment in order not to face delegitimization in the process. If the path to formalization entails a risk of losing a core identity (a cost), then it might be a plausible deterrent to formalization. If successful informal entrepreneurs do manage their countervailing forces in identity-enhancing and legitimizing ways, what could be the effect on the community-level adoption of the formalization process? Finally, is formalization a stable, time invariant process or does it ebb and flow as strategic priorities change and entrepreneurial opportunities emerge? Thus, unfolding the process of formalization should give us greater insights into the multiple levels at which entrepreneurs and their firms manage the transition.

Crossing boundaries

Given the size of the informal sector in many emerging economies, it is likely that the formal and the informal sector, rather than being sealed off from one another, are, in fact, tightly bound. Our research showed that the informal firms we interviewed were part of well-developed local ecosystems that, at worst, tolerated their presence (e.g., itinerant mobile refugees), but more often deeply engaged with them. As a result of this research, we offer several insights about the mutual dependence between the formal and informal economy that underscore the embedded nature of the informal sector.

Informal firms receive support from private, formal, and often regulated organizations. For example, suppliers extend credit and banks give informal firms loans. These are private economic decisions that operate in the large grey zone of commercial activity in the Dominican Republic. The entrepreneurs we interviewed regarded exchange with formal organizations as affirming of the meso institutional norms under which they operate. The existing close relationship between formal and informal firms reduces the perceived benefit of formalization. Other studies (Bruton et al., 2011; Khavul et al., 2013) also documented how banks cross over between the formal and informal economies in the provision of loans to growing firms. In contrast, de Mel et al. (2013) found that formalization did not help Sri Lankan informal businesses access loans from banks. Here we emphasize again the importance of properly capturing the different institutional contexts in which informal firms carve out their existence. Countries differ in how tight the formal and informal sectors are bound and in the opportunities that informal firms have absent of registration.

In the Dominican context, one of the most intriguing observations we report is the role local authorities play in perpetuating informality and creating barriers to formal registration at the central government level. As we showed, business owners, especially those with fixed retail locations, want to protect their space, put up signs, pass health inspections, and generally avoid excessive local pressure. Many register at this level and see no reason to go any further. Such a strategy is accepted practice within the norms of the meso environment. It is more than a symbolic gesture. Electing to comply with the local authorities reduces the inefficiencies associated with informality. The local authorities, however, have no obligation (or for that matter, tools) to report the registrations to the central authorities. Moreover, they also lack any incentive to do so. The administrative layers of government operate largely in isolation. The central government collects income and profit taxes and they send little of that down to the local authorities. As such, the only viable sources of revenue for local authorities are the fees and licenses they issue to businesses. Thus, while the central government has limited means of tracking informal businesses and meager means of enforcing their tax obligations, the local authorities are in a different position and have every incentive—and often the means—to capture formalization-related revenue. In effect, we see a partitioning of the public revenue resource environment between the central government and the local authorities. Such partitioning effectively creates a barrier to the sort of full formal registration that reflects the letter of the law. If local authorities are charging fees from which entrepreneurs see at least some benefit, entrepreneurs regard this as sufficient contribution to the public finances. Payments at the local level (even if coerced) fulfill the rational cost-benefit calculation. Given the administrative structures in the Dominican Republic, formalization at the central level seems a remote possibility, even if the costs were reduced and processes reformed.

Conclusion

  1. Top of page
  2. Abstract
  3. Introduction
  4. Methodology
  5. Findings
  6. Discussion and Contributions
  7. Conclusion
  8. Acknowledgements
  9. References

Entrepreneurship and management research often makes passionate pleas for increasing cross-level theorizing and empirical work. In this article, we explicitly conceptualize as meso the space in which taken-for-granted local norms toward informality emerge and are reinforced. We show that meso institutions serve as the connective tissue that cross-links levels of the environment and shapes the context in which entrepreneurs make decisions. Specifically, meso institutions influence the decisions of entrepreneurs with respect to formalization of their firms and the trade-offs they make as they become successful. Likewise, we suggest that meso institutional norms are legitimated by the intertwined formal and informal economy. Our insights into the meso institutional environment and the role it plays in the context of informality should stimulate a renewed interest in cross-level research. In a variety of contexts and across different communities, meso level institutions can both attenuate and amplify the effects of macro institutions on societal outcomes. Our goal is to ignite more meso level research.

Acknowledgements

  1. Top of page
  2. Abstract
  3. Introduction
  4. Methodology
  5. Findings
  6. Discussion and Contributions
  7. Conclusion
  8. Acknowledgements
  9. References

We want to thank the editors of the special issue and the reviewers for their developmental help with the article. Thanks also to Jeff McMullen, Ramon H. Mejia, Harold Rueda Alvarez, and Guillermo E. Vanderlinde for their assistance with this research and their thoughtful comments on earlier versions of this article. Research Reported in this paper was partially funded by the Spanish Ministry of Economy and Competitiveness. Grant No. ECO2012-30932.

Footnotes
  1. 1

    One should note that this view of meso institutions is not universal. Droege and Johnson (2007) and Potts (2007) view meso institutions not as reflective of levels but as a process through which institutions pass in their development. If they are in the process of developing, they are referred to as meso institutions. We adopted the more dominant view of institutions as occurring at different levels.

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  5. Findings
  6. Discussion and Contributions
  7. Conclusion
  8. Acknowledgements
  9. References
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