Does Competition from Informal Firms Impact R&D by Formal SMEs? Evidence Using Firm-Level Survey Data

The informal sector is an important source of livelihoods and jobs for a vast majority of people in developing countries. However, there is concern that it may undermine growth and development of the formal sector. For instance, the growth literature indicates that research and development activity and innovation are a key driver of long-term growth. How does the competition that formal sector firms face from informal sector firms affect research and development activity by the formal firms The present paper attempts to answer this question using firm-level survey data for small and medium-size enterprises in a large cross-section of mostly developing countries. The results show that higher informal competition leads to greater a likelihood of spending on research and development by formal firms. For the most conservative baseline specification, a one standard deviation increase in informal competition leads to an increase of 5.2 percentage points in the likelihood of spending on research and development by formal firms. This is a large increase given that less than 18 percent of the firms in the sample engage in research and development activity. Further, consistent with the "parasite” view of informality, the positive impact of informal competition on research and development activity is magnified when the business environment is less conducive to operating in the formal sector compared with informal sector due to factors such as higher corruption, weaker rule of law, more burdensome business regulations, and a higher tax rate on profits. As expected, there is no impact of informal competition on research and development activity among large firms. The main findings are robust to several controls, alternative specifications, and endogeneity checks