What induces firms to subcontract to the informal sector? Evidence from a developing country

ABSTRACT

Adding specific firm-level insights into the factors driving firms to subcontract operations to the informal sector, this article uses data from garment exporters in Pakistan. Nesting the analysis in the larger literature on the drivers of the shadow economy, we find that sole proprietorship ownership structure was more likely to subcontract underground, as were older entrepreneurs. On the other hand, older firms were less likely to subcontract underground. The effects of the entrepreneur’s education, firm size, input costs and overall economic prosperity, economic freedom and government stability were largely insignificant.

KEYWORDS:

• Informal economy
• subcontracting
• sole proprietorship
• firm age
• firm size
• Pakistan

JEL CLASSIFICATION:

• L24
• L67
• H26
• O53

Acknowledgments

We thank a referee for comments and Jim Saunoris for help with the data.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Conversely, not all informal work is necessarily exploitative, and when it is cooperative or facilitative, policymakers could view informal activity more favourably – see Williams and Windebank (2001).

² Given the clandestine and illegal nature of underground operations, contracts in the informal sector are likely to be verbal or incomplete (see Goel 2001).

³ Mezzadri (2010), focusing on the Indian garment industry, notes the possibility that in some cases the government might promote the informal sector.

⁴ Note that larger values of AGEfirm imply newer or younger firms.

⁵ Using the ‘estat classification’ command in STATA. Additional details are available upon request.

⁶ For instance, informal sector workers in Pakistan have complained about harassment (https://www.thenews.com.pk/print/404174-women-workers-demand-same-wages-end-to-harassment).

⁷ Electricity use might also be seen by proxying for technological change – some manual production might be done without much electricity use in the garments industry.

⁸ With the positive linkage between economic prosperity and economic freedom, GDP was dropped as a regressor.

⁹ Additional details are available upon request.

¹⁰ The significance of entrepreneur and firm characteristics in driving the degree of informality (and not strictly the tendency to subcontract to the underground sector) was also found in an alternate dataset for Pakistan by Williams, Shahid, and Martinez (2016).

¹¹ Barrientos (2013) notes that globalization might affect contracts in the informal sector via the role of intermediaries.