Peter Neis (Toulouse School of Economics)

Courts, Firms and Informality

Abstract

This paper studies the impact of judicial efficiency on informality. In many developing countries most firms and workers operate and work informally outside the legal and regulatory systems. A better judicial system can lead to a higher share of formal firms, since it changes the marginal benefit of being formal. Similarly, the impact on the workforce can go either way as formal firms can be incentivized to hire fewer formal workers. This can lead to the paradoxical effect that a more efficient judicial environment results in a larger share of formal firms albeit with fewer formal workers. The paper introduces judicial efficiency in an equilibrium model. Judicial efficiency can affect firms’ decisions through two channels. First, it can have a direct impact on a firm’s productivity, this captures a general, better economic environment. Second, it can have an impact on the relative cost to hire formal workers compared to informal workers. The paper uses data from India to test the impact of the judiciary on the two margins of informality. In India, most firms and workers are operating informally while the judicial system is hampered by its large and increasing backlog. Results show a negative effect of court efficiency on the share of informal firms among small firms and a negative but not statistically significant effect on the share of informal workers. Consolidating these findings with the proposed model implies that the observed effects can be explained solely by a relative cost on formal workers in formal firms and one does not need to include a general TFP shock.