I. Introduction

There is widespread evidence that firms’ incentives to operate informally are shaped by the possibility of reducing or eliminating tax payments, and avoiding burdensome and often complex administrative procedures associated with tax and regulatory compliance and bureaucratic corruption (see Dabla-Norris et. al, 2008 and references therein). However, by operating informally, firms may limit their access to bank financing. This is because banks tend to be unwilling to grant credit to enterprises that lack proper documentation (such as government registration and licensing, tax compliance certificates, and audited financial statements); hidden assets generally cannot be used as collateral for bank loans; and inaccurate representation of firms’ financial soundness and economic prospects in their financial statements could scare off prospective lenders (World Bank, 2007a).

At the same time, deficiencies in the legal and institutional environment can discourage firms to seek bank financing (Demirgüç-Kunt and Maksimovich, 1998; Beck et. al, 2005,Savafian and Wimpey (2007)). In addition, these deficiencies can make it difficult for banks to enforce contracts as well as to sort and monitor borrowers, resulting in credit rationing by lenders. Recent research shows that access to bank finance has a significant and positive effect on firm performance, by encouraging new firm entry, growth, and innovation (see Klapper et. al, 2006; Claessans and Leavan, 2003; and Aiyagari et. al, 2007).

Understanding the link between informality and firms’ access to bank credit is, therefore, important, given its implications for productivity and firm growth.² The goal of this paper is to examine the relationship between informality and bank credit and the role of tax and legal institutions in determining this. To this end, we develop a simple model in which firms can choose to operate informally, and both the extent of informality and a firm’s reliance on bank credit are related to policy and institutional constraints. In the model, firms trade off a high tax and regulatory burden against the possibility of retaining more profits at the risk of being caught and fined. However, this makes it more difficult to obtain bank credit because doing so requires official financial documentation, and the process of hiding economic activity involves concealing the true level of profits or sales. This framework also shows that a higher tax and regulatory burden reduces the use of bank finance by encouraging informality and discouraging investment demand. By contrast, a stronger legal environment reduces informality, and encourages bank borrowing.

We test these predictions using a firm-level data set for 26 countries in Eastern Europe and Central Asia. Financial sectors in transition countries have achieved rapid credit growth and diversified in recent years (EBRD, 2006). However, there is evidence that, despite some regional variation, bank loans still play a limited role in enterprise financing. At the same time, high costs of business regulation, weak tax administration, a poor institutional framework, and weak property rights are viewed as major obstacles to doing business in transition countries (World Bank, 2007b). Moreover, there is considerable variation in the extent of informal activity across transition countries that is influenced by differences in tax, legal, and regulatory obstacles faced by firms. These are important concerns for policymakers, because creating incentives for formalization and encouraging financial-sector intermediation are viewed as important steps to increase aggregate productivity and sustain growth.³

Our paper provides empirical evidence of a strong negative association between informality and bank credit.⁴ In line with our model, we find that a firm’s reliance on bank credit is positively associated with the quality of the legal environment and is negatively associated with weaknesses in tax administration, as proxied by bribes to tax collectors and the severity of tax administration constraints. By contrast, weaknesses in tax administration are positively associated with the use of informal credit and with the probability that firms self-report the availability of financing as a major obstacle to their operations. Moreover, we find a differential impact of the legal environment and tax administration contraints on access to bank and informal credit by formal and informal firms. In particular, we find that an efficient and well-functioning legal system increases access to bank credit even for financially opaque informal firms while lowering reliance on informal credit by formal firms. Finally, we find that weaknesses in tax administration increase reliance on informal credit by informal firms more significantly than for formal firms.

When we look at countrywide institutions, we find that firms tend to use less bank credit in countries with underdeveloped financial systems, and in countries where tax compliance costs are high. An interaction term between tax compliance costs and the level of informal activity is negative and significant, suggesting that the negative association between informality and credit is stronger in countries with a weak tax administration.

The significant negative association between informality and bank credit is robust to the inclusion of other variables that capture the role of firm transparency and performance in obtaining bank credit. Thus, while the correlation between informality and bank credit could still reflect the presence of unobserved firm traits linked to both informality and access to credit, it is also consistent with informality reducing access to formal sector loans. We also find that these results do not appear to be driven by reverse causality. Using instrumental variable techniques to deal with the potential endogeneity between informality and bank credit leaves the results unchanged.

The remainder of the paper proceeds as follows. The next section lays out the analytical framework and derives its main predictions. Section 3 then describes the data and the empirical model. The results are presented in Section 4, and Section 5 concludes.

II. Analytical Framework

The model is kept as simple as possible to generate empirically testable predictions. Consider a representative firm operating for two periods in a competitive environment. In each period i=1,2, a firm produces output Y_i using capital k_i, according to a general production function y_i = f(k_i,), with f’(.) > 0 and f’’(.)< 0. In the first period, the firm’s initial capital is given by k_L In the second period, the firm can self-finance part of its physical capital using its first period profits (retained earnings). The firm can also borrow some capital from a financial intermediary with access to perfect outside capital markets, where a one-period risk-free security earns a net return r > 0.⁵ The firm’s capital stock in the second period is given by

where k₂ is the firms’ capital in period 2, π₁ is its first-period profit, and L is the firm’s external borrowing. For simplicity, the rate of capital depreciation is assumed to be 1. The firm gets dissolved in period 2, paying out all of its dividends; the dividend for period 1 is assumed to be zero.

In each period i’=1,2 the firm can operate fully in the formal sector or hide a fraction α_i of its activity by operating informally, where α = 0 denotes full formality or compliance with existing taxes and regulations, and α =1 denotes complete evasion of taxes. If the firm operates formally, its reported revenue is subject to a financial burden at a rate T. This can be interpreted as the cost of complying with taxes, bribes, and burdensome regulations as a result of weaknesses in the tax and regulatory environment. For instance, Dabla-Norris et al. (2008), Dabla-Norris and Inchauste (2008), and Freidman et al. (2000) find that higher tax and regulatory constraints and corruption are all significant determinants of informality. Similarly, Johnson et al. (2000) using firm-level data for five Eastern European countries find that bureaucratic corruption and burdensome regulations, rather than high tax rates, create incentives for firms to operate informally.

To avoid the tax and regulatory burden, the firm can hide a fraction of its activities or assets by operating informally. However, it faces the prospect of a fine with some probability. For simplicity, we do not distinguish between the role of the probability of being caught from the size of the fine. We assume that the expected penalty of being caught, P, is increasing in α and the firm’s output y, such that P = C(α)y, where C(.) is assumed to be a convex function. The underlying idea is that tax penalties usually depend on the size of tax evasion, and it is easy to divert a smaller amount of resources, but as the level of informality increases it becomes more difficult for a registered firm to operate without being observed by the government and courts (see, for example, Loayza, 1996).

The firm derives profits from its formal and informal operations in both periods. The income of a firm after incurring the tax and regulatory burden is given by (1 − α_i)(1 − T)y_i while the income generated informally is α_iy_i. The firm’s profits in period 1 and 2 can then be written as:

We assume that the firm faces a credit ceiling $\overline{L}$, where the credit ceiling constraint given by

is a function of firm’s reported sales, the level of its fixed assets, k₁, and the quality of legal and financial institutions, q. Specifically, we assume that the credit ceiling is decreasing in the firm’s level of informality α₁. This assumption captures the idea that a bank loan typically requires official documentation or accounting data, so that a firm’s revenue is at least partially verifiable, and it can engage in legal contractual relationships. This enables it access to bank credit. ⁶ Hiding profits or sales from tax authorities, and the associated lack of transparency, increases information asymmetries in the borrower-lending relationship, reducing incentives for banks to lend.

In reality, a firm may still be able to finance its investment needs by borrowing from informal sources. Informal creditors can screen and monitor borrowers and enforce contracts without having to rely on evidence of cash flow and profitability, and without recourse to the legal system. This is because these relationships are largely based on personal interaction between the borrower and lender based on an understanding of the borrower’s business, and not just on collateral or credit scoring systems (McMillan and Woodruff, 1999). Firms in transition economies may have another reason to prefer informal financing in addition to borrower/lender information asymmetries. Bank financing may make it difficult for firms to hide their activities from tax collectors. While we do not model this explicitly, in the empirical section we examine the relationship between firm informality and use of informal credit sources.⁶

The credit ceiling is also assumed to increase with the initial level of capital (k₁), which captures the size of the firm’s assets that could be used as collateral. Boot and Thakor (1994) and others have shown that collateral can be an instrument to overcome the asymmetric information problem between lender and borrowers. In their framework, collateral serves as a signaling device that offers the lender a signal about the true riskiness of the borrower. Finally, we assume that the credit ceiling is increasing in the quality of the legal and financial system (q). This is in line with La Porta et. al (1997) and Djankov et. al (2007) who find that deficiencies in the legal and institutional environment make it difficult for banks to enforce contracts. Similarly, Demirguc-Kunt and Maksimovic (1998) find that a higher proportion of firms use long-term external financing in countries with a better legal system.

The firm’s problem is formally given by (see Appendix 1 for details):

We can distinguish between two cases: (i) when the credit ceiling constraint is not binding, i.e. $L<\overline{L}({\alpha }_1;k_1,q)$, and (ii) when the credit ceiling constraint is binding, i.e. $L<\overline{L}({\alpha }_1;k_1,q)$.

When the credit ceiling is not binding, the firm’s share of informal operations is decreasing in the tax and regulatory burden; that is, dα_i/dT = 1/C”(α_i)> 0, where i = 1,2. This is because firms weigh the benefits of being formal against the costs; thus, when the tax and regulatory burden increases, more firms choose to operate informally. Furthermore, a larger tax and regulatory burden discourages bank financing.

The intuition behind this is as follows. Suppose firm’s investment demand (k₂) remains unchanged with a higher tax burden. Then the firm would need to increase not only its hidden profits but also bank financing in order to achieve a desired level of investment. The magnitude of this increase would depend upon the extent to which the firm would want to increase its hidden profits instead of relying on bank financing. However, a higher tax burden would discourage investment. We assume that weaknesses in tax policy and administration and a poor business environment reduce the net profitability of investments, creating sufficient disincentive for investment. As a result, a firm’s investment demand is negatively related to the tax burden faced, thereby, reducing its demand for bank financing. This result is consistent with Johnson et al. (2002), who find that entrepreneurs are unwilling to invest when returns are insecure due to corruption or expropriation.

When the credit ceiling constraint is binding, the model reduces to the following two equations:

where $\overline{L}\prime ({\alpha }_1;.)<0$. Differentiating equation (6) with respect to the quality of legal environment, q, while applying the envelope theorem, reveals that ∂α1/∂q<0, implying that a better quality of the legal and financial environment reduces the propensity for a firm to operate informally. Moreover, since by assumption, the credit ceiling $\overline{L}$ is decreasing in α1, and $\partial \overline{L}({\alpha }_1;k_1,q)/\partial q>0$, we can show that the amount of bank financing, L, is increasing in the quality of legal and financial institutions. This gives us

In the empirical section of the paper we examine the relationship between informality and bank financing, arguing that higher informality is likely associated with lower reliance on bank financing. This is particularly likely to be the case when evading taxes and hiding sales or profits makes it difficult for banks’ to accurately assess a firm’s credit worthiness, and effectively restricts firms’ access to credit and to external finance (the case where $L=\overline{L}({\alpha }_1;k_1,q)$). The issue of reverse causality is addressed in the robustness section.

III. Empirical Strategy and Results

B. Data and Summary Statistics

We use the 2005 Business Environment and Enterprise Performance Survey (BEEPS) conducted by the World Bank and the EBRD. The data set consists of firm-level survey responses for firms in 26 transition countries in Eastern Europe and Central Asia.⁸ The survey reports detailed information on firm size, employment, age, industry, ownership, legal status, governance, and financing, as well as questions on firm financing from different sources. We only consider firms that have external financing sources.⁹ Table 1 contains sample statistics of the variables we consider.

Table 1.

Summary Statistics

Table 1.

Summary Statistics

Variable		Obs	Mean	Sth. Dev.	Min	Max
General Characteristics of Firms
	Bank Credit	4226	0.56	0.50	0	1
	Informal Credit	4226	0.29	0.45	0	1
	Financing Obstacle	4085	0.22	0.41	0	1
	Informality	4226	11.20	19.24	0	98
	Government ownership	4226	0.10	0.30	0	1
	Exporter	4226	0.28	0.45	0	1
	Corporation	4226	0.27	0.45	0	1
	Small	4226	0.66	0.47	0	1
	Large	4226	0.12	0.32	0	1
	Age	4226	16.36	18.50	4	180
	Mining	4226	0.01	0.11	0	1
	Construction	4226	0.13	0.34	0	1
	Manufacturing	4226	0.45	0.50	0	1
	Transport	4226	0.10	0.29	0	1
	Retail	4226	0.36	0.48	0	1
	Real Estate	4226	0.11	0.31	0	1
	Hotel	4226	0.06	0.23	0	1
	Other industries	4226	0.10	0.30	0	1
Quality of Business Environment
	Bribes - tax collection	4226	0.16	0.36	0	1
	Tax administration constraint	4136	0.26	0.44	0	1
	Index of legal quality	3626	0.91	0.63	0	2
Institutional Variables
	GDP per capita (log)	4226	7.82	0.86	5.47	9.34
	Inflation (annual percent)	4226	5.84	4.31	0.5	17.30
	Real GDP growth (percent)	4226	4.99	2.81	0.1	14.55
	Rule of law	4226	-0.17	0.71	-1.32	1
	Private Credit (percent of GDP)	4226	29.64	15.39	6.19	59
	Time to pay taxes (hours per year)	4226	486.82	547.82	96	2185

View Table

Table 1.

Summary Statistics

Variable		Obs	Mean	Sth. Dev.	Min	Max
General Characteristics of Firms
	Bank Credit	4226	0.56	0.50	0	1
	Informal Credit	4226	0.29	0.45	0	1
	Financing Obstacle	4085	0.22	0.41	0	1
	Informality	4226	11.20	19.24	0	98
	Government ownership	4226	0.10	0.30	0	1
	Exporter	4226	0.28	0.45	0	1
	Corporation	4226	0.27	0.45	0	1
	Small	4226	0.66	0.47	0	1
	Large	4226	0.12	0.32	0	1
	Age	4226	16.36	18.50	4	180
	Mining	4226	0.01	0.11	0	1
	Construction	4226	0.13	0.34	0	1
	Manufacturing	4226	0.45	0.50	0	1
	Transport	4226	0.10	0.29	0	1
	Retail	4226	0.36	0.48	0	1
	Real Estate	4226	0.11	0.31	0	1
	Hotel	4226	0.06	0.23	0	1
	Other industries	4226	0.10	0.30	0	1
Quality of Business Environment
	Bribes - tax collection	4226	0.16	0.36	0	1
	Tax administration constraint	4136	0.26	0.44	0	1
	Index of legal quality	3626	0.91	0.63	0	2
Institutional Variables
	GDP per capita (log)	4226	7.82	0.86	5.47	9.34
	Inflation (annual percent)	4226	5.84	4.31	0.5	17.30
	Real GDP growth (percent)	4226	4.99	2.81	0.1	14.55
	Rule of law	4226	-0.17	0.71	-1.32	1
	Private Credit (percent of GDP)	4226	29.64	15.39	6.19	59
	Time to pay taxes (hours per year)	4226	486.82	547.82	96	2185

We construct three dependent variables that capture the extent to which firms rely on bank credit for their external financing needs. The first variable, Bank Credit, is a binary variable that takes the value of 1 if a firm relies on bank credit (commercial banks, development and foreign banks) for its external financing of either working capital or new investment, and zero otherwise. We construct this variable based on the survey responses about the proportion of firms’ working capital and new investment over the past year that was financed through internal and external funds.

The second dependent variable, Informal Credit, is a binary variable which takes the value of 1 if the firm relies on money-lenders or family and friends to finance either working capital or new investment, and zero otherwise. Over 56 percent of firms in our sample use bank credit to meet their external financing needs, while 29 percent of firms use informal credit sources to finance working capital or new investment.

The third dependent variable, Financing Obstacle, is a dummy which equals one if firms report the availability of financing as a “major constraint”, and zero otherwise. Simply looking at financing patterns of firms does not allow us to distinguish between credit demand and supply effects. Unfortunately, the survey does not contain detailed information on the loan amount requested and received. In the survey, enterprise managers were asked to rate the extent to which access to financing (as determined by collateral requirements and credit availability) constrained the operation of their business. The ratings are quantified from 1 to 4, with 1 denoting no obstacle and 4 a major obstacle.¹⁰ Overall 22 percent of all firms in our sample report availability of financing as a major obstacle.

The key variables of interest, informality (Inf), is retrieved from the answer to the following question in the survey:

• “Recognizing the difficulties many firms face in fully complying with taxes and regulations, what percentage of total annual sales would you estimate the typical firm in your area of business reports for tax purposes?”

Firms are considered to be more informal the lower the percentage of sales reported for tax purposes. This variable is only a rough proxy for informality for two reasons. First, the question is phrased in terms of typical behavior by firms in that sector, rather than the behavior of the firm in question, which may introduce a bias towards the average behavior of other firms in that environment. Although firms are understandably reluctant to reveal the extent of their reporting to government, managers presumably most often respond based on their own experiences. Therefore, with caution, the responses can be interpreted as indicating the firms’ own behavior (Johnson and others, 2000). Second, all the firms in the survey are registered firms, which implies they all have at least some operations in the formal economy. Hence, we are ignoring firms that are completely unregistered, particularly very small enterprises. In this respect, our results can be seen as capturing the degree of tax evasion or of tax noncompliance. Sales to tax authorities are not fully reported by 39 percent of firms in our sample, with an average level of informality of 11 percent.

The survey also includes a large number of questions on the firm’s perception of the tax and regulatory burden faced by firms and the quality of the legal environment in which they operate. We use two measures to proxy for the tax and regulatory burden faced by firms. Enterprise managers were asked to rate the extent to which weaknesses in tax administration constrained the operation of their business, quantified from 1 to 4, with 1 denoting no obstacle and 4 a major obstacle. We construct a binary variable which takes the value of 1 if the firm reports weaknesses in tax administration as a “major” obstacle, and zero otherwise. Businesses were also asked how common it was to give bribes to deal with taxes and tax collection, regulations, and customs, rated from from 1 (never) to 6 (always). We construct a binary variable which takes the value of 1 if firms report that it is common to give bribes “usually” or “always” (responses 5-6), and zero otherwise. In our sample, 26 percent of firms that report tax administration to be a major constraint to their business use bank credit, while 33 percent use informal credit. Similarly, 15 percent of firms that report that giving bribes to tax collectors is common use bank credit, while 18 percent use informal credit.

To capture the quality of the legal and contractual environment within which firm’s operate, we construct an additive index which combines three main questions about the efficiency of the legal system. Businesses were asked to evaluate whether the country’s courts enforced decisions, whether the courts were honest, and whether courts were viewed as being fair and impartial. The answers were rated from 1 (never) to 6 (always). The legal effectiveness index we construct ranges from 0 to 2, with 2 indicating that the entrepreneurs said all three dimensions of the legal system were frequently or always true, and 0 indicating an affirmative response to none. A higher value of this index therefore represents a better legal environment.

The survey also contains information on firm size, age, and industry, structure, and legal ownership, all of which are used to control for differences in financing requirements and firms’ propensity to be informal. Empirical studies have found that smaller firms are more credit constrained than larger firms, in part due to market imperfections and greater information asymmetries associated with lending to such firms (Beck et al., 2005). At the same time, Dabla-Norris et al. (2008ab) find that small firms tend to have a higher incidence of informality relative to large firms. There may also be an ownership effect of the firm (private or state) in influencing its access to credit. Heterogeneity of firms in terms of access to credit may also arise due to other characteristics, such as firm age, exporting status, and legal structure. Being an older firm should lower informational opacity (Frazer, 2004) and increase their propensity to be formal. Firms that are incorporated are usually subject to more stringent reporting mechanisms (Demirguc-Kunt et al., 2006), which might make getting credit easier and evading taxes harder.

The survey defines firms of different sizes, small, medium, and large, based on the number of full time workers (small = 5-50, medium sized = 51 -500, and large firms > 500) We construct two dummy variables for large and small firms. Over 66 percent of the sample is made up of small firms, while only 12 percent of firms are large. We control for industry effects by including dummy variables for mining, construction, manufacturing, transport, retail, real estate, hotel, and other sectors. State-owned firm is a dummy variable that equals one if the government holds a majority stake in the firm, and zero otherwise. Corporation is a legal status dummy that takes the value of one if the firm is organized as a corporation, and zero otherwise. Exporter is a dummy variable that takes the value of one if some percentage of the firm’s sales are exported directly, and zero otherwise. In our sample, 10 percent of firms are state-owned companies and 28 percent are corporations. Over 28 percent of them are exporters, and they are mostly concentrated in the manufacturing (45 percent) and retail (36 percent) sectors. Firms are on average 16 years old, but there are some in the sample that are 180 years old.

In order to address the question of whether the impact of informality on firms’ reliance on bank credit varies based on the country’s level of institutional development, we complement the firm level data with cross-country level indicators from various sources. We would expect that a better legal environment and lower regulatory costs not only reduce incentives for informality by making market interactions more efficient, but making participation in formal credit markets more attractive.¹¹ We use the index of Rule of Law from Kaufmann, Kraay, and Mastruzzi (2006) as a proxy for the quality of legal institutions and level of legal enforcement in a country.¹² The index includes perceptions of both violent and non-violent crime, the effectiveness and predictability of the judiciary, and the enforceability of contracts, with higher values denoting a better quality of rule of law. Higher costs of tax compliance resulting from a weak tax system and poor administration can create incentives for informality, reducing firm’s reliance on bank credit. We use the hours per year it takes for businesses to pay taxes (corporate, value added, and labor tax) from the World Bank’s Doing Business survey.¹³ Finally, we use the ratio of private credit to GDP, which is widely used as an indicator of financial intermediary development (Beck et al., 2000).

We also use country-level controls in some specifications, including real GDP per capita to control for the country’s general economic development, and the average growth rate of GDP per capita in the previous three years, since firms in faster growing countries are expected to grow faster and have a higher demand for external financing. We also include the inflation rate to proxy for monetary instability, conjecturing that firms in more stable monetary environments face fewer obstacles to obtaining credit.

Table 2 presents correlations between our measures of access to credit, informality, firm level constraints, and the level of institutional development in the sample countries. As can be seen from the simple correlations of the firm-level variables in Panel A, informality is negatively correlated to the use of bank credit and positively correlated with the use of informal credit and self-reported financing constraints. Bank credit is negatively correlated with tax administration constraints and positively correlated with the index of legal quality. As expected, informality and the use of informal credit is positively correlated with tax constraints and negatively correlated with the index of legal quality. Moreover, the simple correlations indicate that larger firms, exporters, and firms that are incorporated are less likely to be informal and more likely to use bank credit. Panel B shows that firms in poorer countries with higher inflation, lower bank development, and higher tax compliance costs are less likely to use bank credit and more likely to use informal credit or report lack of availability of financing as a major obstacle to the growth of their business.

Table 2

Correlation Matrix

Table 2

Correlation Matrix

Panel A: Firm Level variables
	Bank Credit	Informal Credit	Financing Obstacle	Informality	Government ownership	Exporter	Corporation	Small	Large	Age	Bribes – tax collection	Tax administration constraint	Index of legal quality
Informal Credit	-0.33	1
Financing Obstacle	-0.04	0.10	1
Informality	-0.07	0.13	0.08	1
Government ownership	-0.06	-0.10	0.01	-0.09	1
Exporter	0.13	-0.13	-0.01	-0.07	0.05	1
Corporation	0.03	-0.07	-0.07	-0.05	-0.10	0.12	1
Small	-0.17	0.20	0.07	0.13	-0.28	-0.29	-0.15	1
Large	0.11	-0.13	-0.06	-0.09	0.32	0.23	0.09	-0.52	1
Age	0.06	-0.13	0.02	-0.09	0.41	0.18	0.04	-0.35	0.35	1
Bribes - tax collection	-0.02	0.04	0.04	0.03	0.01	-0.01	-0.03	-0.02	0.00	0.02	1
Tax administration constraint	-0.01	0.10	0.16	0.07	-0.07	-0.02	-0.02	0.04	-0.05	-0.05	0.12	1
Index of legal quality	0.07	-0.07	-0.09	-0.12	0.08	0.06	0.03	-0.12	0.08	0.06	-0.10	-0.12	1
Panel B: Country Level variables
	Bank Credit	Informal Credit	Financing Obstacle	Informality	GDP per capita	Inflation	GDP growth	Rule of Law	Private Credit	Time to pay taxes
Informal Credit	-0.33	1
Financing Obstacle	-0.04	0.10	1
Informality	-0.08	0.15	0.09	1
GDP per capita	0.02	-0.08	0.00	-0.03	1
Inflation	0.04	0.00	-0.07	0.06	-0.52	1
GDP growth	-0.06	0.10	0.00	-0.03	-0.36	-0.16	1
Rule of Law	0.03	-0.05	0.05	-0.05	0.88	-0.58	-0.31	1
Private Credit	0.02	-0.10	-0.06	-0.03	0.63	-0.19	-0.49	0.59	1
Time to pay taxes	-0.08	0.06	0.00	0.01	-0.27	0.28	-0.02	-0.27	-0.12	1

View Table

Table 2

Correlation Matrix

Panel A: Firm Level variables
	Bank Credit	Informal Credit	Financing Obstacle	Informality	Government ownership	Exporter	Corporation	Small	Large	Age	Bribes – tax collection	Tax administration constraint	Index of legal quality
Informal Credit	-0.33	1
Financing Obstacle	-0.04	0.10	1
Informality	-0.07	0.13	0.08	1
Government ownership	-0.06	-0.10	0.01	-0.09	1
Exporter	0.13	-0.13	-0.01	-0.07	0.05	1
Corporation	0.03	-0.07	-0.07	-0.05	-0.10	0.12	1
Small	-0.17	0.20	0.07	0.13	-0.28	-0.29	-0.15	1
Large	0.11	-0.13	-0.06	-0.09	0.32	0.23	0.09	-0.52	1
Age	0.06	-0.13	0.02	-0.09	0.41	0.18	0.04	-0.35	0.35	1
Bribes - tax collection	-0.02	0.04	0.04	0.03	0.01	-0.01	-0.03	-0.02	0.00	0.02	1
Tax administration constraint	-0.01	0.10	0.16	0.07	-0.07	-0.02	-0.02	0.04	-0.05	-0.05	0.12	1
Index of legal quality	0.07	-0.07	-0.09	-0.12	0.08	0.06	0.03	-0.12	0.08	0.06	-0.10	-0.12	1
Panel B: Country Level variables
	Bank Credit	Informal Credit	Financing Obstacle	Informality	GDP per capita	Inflation	GDP growth	Rule of Law	Private Credit	Time to pay taxes
Informal Credit	-0.33	1
Financing Obstacle	-0.04	0.10	1
Informality	-0.08	0.15	0.09	1
GDP per capita	0.02	-0.08	0.00	-0.03	1
Inflation	0.04	0.00	-0.07	0.06	-0.52	1
GDP growth	-0.06	0.10	0.00	-0.03	-0.36	-0.16	1
Rule of Law	0.03	-0.05	0.05	-0.05	0.88	-0.58	-0.31	1
Private Credit	0.02	-0.10	-0.06	-0.03	0.63	-0.19	-0.49	0.59	1
Time to pay taxes	-0.08	0.06	0.00	0.01	-0.27	0.28	-0.02	-0.27	-0.12	1

C. Empirical Results

To study the impact of a firm’s propensity for informality on its reliance on formal and informal credit, we proceed in several steps. We first examine this relationship controlling for broad firm characteristics, such as size, age, legal status, ownership, and industry, as well as country dummies. In line with the predictions of our model, we then examine the role of the business environment and country-wide institutions in determining the impact of informality on bank credit. As robustness tests, we introduce variables that enable us to examine this relationship controlling for other features of firm transparency and performance. Finally, we report results of instrumental variables regressions to address concerns of reverse causality.

Baseline regressions

We first examine the relationship between informality and firm’s reliance on bank credit. Table 3 presents our baseline specification for both dependent variables of interest. Columns 1 and 2 report regressions with the dependent variables Bank Credit and Informal Credit, measuring a firm’s reliance on bank and informal sources of external financing, respectively. Column 3 provides the results with the dummy dependent variable Financing Obstacle measuring perceived financing constraints. All columns report coefficient estimates with country dummies to control for unobserved heterogeneity across countries.

Table 3

Baseline Regression

$\mathit{Credit}{}_{ij}=f(\mathit{In}{f}_{ij},Z_{ij})={\beta }_0+{\gamma }_j+{\beta }_1\mathit{In}{f}_{ij}+{\beta }_2{X}_{ij}+{\epsilon }_i$

Credit is either Bank Credit, Informal Credit, or Financing Obstacle. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Financing obstacle is a dummy variable that that takes the value of 1 if the firm reports the availability of financing as a “major constraint”, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. γ are country dummies, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Table 3

Baseline Regression

$\mathit{Credit}{}_{ij}=f(\mathit{In}{f}_{ij},Z_{ij})={\beta }_0+{\gamma }_j+{\beta }_1\mathit{In}{f}_{ij}+{\beta }_2{X}_{ij}+{\epsilon }_i$

Credit is either Bank Credit, Informal Credit, or Financing Obstacle. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Financing obstacle is a dummy variable that that takes the value of 1 if the firm reports the availability of financing as a “major constraint”, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. γ are country dummies, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Dependent variable	Bank credit (1)	Informal Credit (2)	Financing Obstacle (3)
Government ownership	-0.545 (0.081)***	-0.215 (0.088)**	0.137 (0.086)
Exporter	0.203 (0.050)***	-0.179 (0.054)***	-0.059 (0.057)
Small	-0.436 (0.054)***	0.394 (0.058)***	0.212 (0.061)***
Large	0.236 (0.080)***	-0.044 (0.089)	-0.202 (0.090)**
Age	0.001 (0.001)	-0.005 (0.002)***	0.002 (0.001)
Corporation	0.066 (0.055)	-0.133 (0.059)**	-0.146 (0.064)**
Informality	-0.004 (0.001)***	0.008 (0.001)***	0.006 (0.001)***
Constant	0.100 (0.113)	-0.789 (0.119)***	-1.237 (0.132)***
Industry dummies	YES	YES	YES
Country dummies	YES	YES	YES
Observations	4226	4226	4085
Pseudo R2	0.100	0.080	0.090

View Table

Table 3

Baseline Regression

$\mathit{Credit}{}_{ij}=f(\mathit{In}{f}_{ij},Z_{ij})={\beta }_0+{\gamma }_j+{\beta }_1\mathit{In}{f}_{ij}+{\beta }_2{X}_{ij}+{\epsilon }_i$

Credit is either Bank Credit, Informal Credit, or Financing Obstacle. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Financing obstacle is a dummy variable that that takes the value of 1 if the firm reports the availability of financing as a “major constraint”, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. γ are country dummies, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Dependent variable	Bank credit (1)	Informal Credit (2)	Financing Obstacle (3)
Government ownership	-0.545 (0.081)***	-0.215 (0.088)**	0.137 (0.086)
Exporter	0.203 (0.050)***	-0.179 (0.054)***	-0.059 (0.057)
Small	-0.436 (0.054)***	0.394 (0.058)***	0.212 (0.061)***
Large	0.236 (0.080)***	-0.044 (0.089)	-0.202 (0.090)**
Age	0.001 (0.001)	-0.005 (0.002)***	0.002 (0.001)
Corporation	0.066 (0.055)	-0.133 (0.059)**	-0.146 (0.064)**
Informality	-0.004 (0.001)***	0.008 (0.001)***	0.006 (0.001)***
Constant	0.100 (0.113)	-0.789 (0.119)***	-1.237 (0.132)***
Industry dummies	YES	YES	YES
Country dummies	YES	YES	YES
Observations	4226	4226	4085
Pseudo R2	0.100	0.080	0.090

Column (1) shows that there is a statistically significant negative relationship between a firm’s propensity to be informal and its reliance on bank financing. This holds even after controlling for firm, industry, and country characteristics. The relationship is also economically significant. The marginal effects (not shown in the table) show that the probability of the firm relying on bank credit increases by 2 percentage points for every 10 percent reduction in informality at the sample average of 11 percent. The results also indicate that firms reporting fewer sales for tax purposes are also the one that use more informal sources of external financing. Column (2) shows that informality is positively and significantly associated with higher reliance on informal credit. This suggests that bank and informal credit are substitutes to some degree. We also find that informality is associated with a higher incidence of severe financing constraints (i.e. a higher probability of firms rating the availability of finance as a major obstacle). This tentatively indicates that informal firms are more likely to face greater financing constraints rather than simply having a lower demand for bank credit.

In line with previous studies, the results suggest that individual firm characteristics are an important determinant of a firm’s reliance on bank financing. As expected, the probability of the firm relying on bank credit increases with firm size. We also find that smaller firms are more likely to be financially constrained and to rely to a lesser extent on the banking system for credit than large firms. The marginal effects show that the probability of relying on bank credit decreases by 27 percent for small firms compared to large firms. At the same time, the probability of relying on informal sources of financing increases by 13 percent for small firms. This result suggests that reliance on informal external finance decreases with size. Moreover, it suggests that formal and informal credit are only imperfect substitutes since informal sources might fulfill completely the financing needs of smaller firms, but might not satisfy credit demand as scale increases.

With respect to other controls, we find that exporters and foreign-owned firms use significantly greater bank finance and report to be less financially constrained. State-owned firms, on the other hand, rely to lesser extent on bank financing as compared to private firms. Presumably, these firms receive public funding, which reduces their reliance on both bank and informal credit. Firms organized as corporations are also less likely to be financially constrained and to rely less on informal credit as compared to other forms of legal organization.

Informality, access to credit, and the business environment

We extend the baseline regressions by including survey-based indicators of the tax and regulatory system and the quality of legal institutions in Table 4. The survey-based measures of insitutional quality are introduced one at a time for each of the three dependent variables, and simultaneously in columns 4, 8, and 12.¹⁴ Consistent with the predictions of our model, weaknesses in tax administration have a negative and significant effect on a firm’s reliance on bank credit (columns 1 and 4). In particular, the marginal effects (for column 4) show that a firm that reports having to frequently give bribes to deal with taxes and regulations has a 5 percent lower probability of using bank credit than firms that report bribes to be less common. Moreover, a firm’s reliance on bank credit is increasing in the quality of the legal environment as expected. For example, the estimates imply that an improvement in the legal quality index from the sample average of 0.91 is associated with a 4-percent increase in the probability of using bank credit.

Table 4

Access to Credit and Informality: Impact of Business Environment

$\mathit{Credit}{}_{ij}=f(\mathit{Inf}{}_{ij},Z{}_{ij})={\beta }_0+\gamma {}_j+{\beta }_1\mathit{Inf}{}_{ij}+{\beta }_2{T}_{ij}+{\beta }_3{q}_{ij}+{\beta }_{4}X{}_{ij}+{\epsilon }_i$

Credit is either Bank Credit, Informal Credit, or Financing Obstacle. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Financing obstacle is a dummy variable that that takes the value of 1 if the firm reports the availability of financing as a “major constraint”, and zero otherwise. Inf is the percentage of sales mat are not reported for tax purposes. T is the tax burden measured by the severity of tax administration constraints faced by individual firms and the frequency with which firms have to give bribes to deal with taxes and tax collection. The quality and efficiency of the legal system, q, is proxied by the index of legal effectiveness, y are country dummies, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Table 4

Access to Credit and Informality: Impact of Business Environment

$\mathit{Credit}{}_{ij}=f(\mathit{Inf}{}_{ij},Z{}_{ij})={\beta }_0+\gamma {}_j+{\beta }_1\mathit{Inf}{}_{ij}+{\beta }_2{T}_{ij}+{\beta }_3{q}_{ij}+{\beta }_{4}X{}_{ij}+{\epsilon }_i$

Credit is either Bank Credit, Informal Credit, or Financing Obstacle. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Financing obstacle is a dummy variable that that takes the value of 1 if the firm reports the availability of financing as a “major constraint”, and zero otherwise. Inf is the percentage of sales mat are not reported for tax purposes. T is the tax burden measured by the severity of tax administration constraints faced by individual firms and the frequency with which firms have to give bribes to deal with taxes and tax collection. The quality and efficiency of the legal system, q, is proxied by the index of legal effectiveness, y are country dummies, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Dependent variable	Bank Credit				Informal Credit				Financing Obstacle
	(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)	(10)	(11)	(12)
Government ownership	-0.550 (0.081)***	-0.550 (0.082)***	-0.574 (0.087)***	-0.576 (0.088)***	-0.213 (0.089)**	-0.179 (0.089)**	-0.271 (0.096)***	-0.245 (0.097)**	0.141 (0.086)	0.171 (0.087)*	0.185 (0.092)**	0.207 (0.094)**
Exporter	0.201 (0.050)***	0.207 (0.051)***	0.206 (0.054)***	0.198 (0.055)***	-0.178 (0.054)***	-0.165 (0.054)***	-0.193 (0.058)***	-0.177 (0.058)***	-0.057 (0.057)	-0.067 (0.057)	-0.042 (0.061)	-0.049 (0.061)
Small	-0.437 (0.054)***	-0.427 (0.054)***	-0.437 (0.058)***	-0.437 (0.058)***	0.397 (0.058)***	0.389 (0.058)***	0.393 (0.062)***	0.392 (0.063)***	0.213 (0.061)***	0.211 (0.062)***	0.141 (0.065)**	0.149 (0.066)**
Large	0.236 (0.080)***	0.246 (0.081)***	0.194 (0.085)**	0.204 (0.086)**	-0.042 (0.089)	-0.062 (0.090)	-0.029 (0.095)	-0.051 (0.096)	-0.201 (0.090)**	-0.198 (0.092)**	-0.216 (0.096)**	-0.210 (0.097)**
Age	0.001 (0.001)	0.001 (0.001)	0.001 (0.001)	0.001 (0.001)	-0.005 (0.002)***	-0.005 (0.002)***	-0.005 (0.002)***	-0.005 (0.002)***	0.002 (0.001)	0.002 (0.001)	0.002 (0.002)	0.002 (0.002)
Corporation	0.064 (0.055)	0.072 (0.056)	0.040 (0.060)	0.050 (0.060)	-0.132 (0.059)**	-0.132 (0.059)**	-0.160 (0.064)**	-0.164 (0.065)**	-0.144 (0.064)**	-0.126 (0.065)*	-0.139 (0.069)**	-0.111 (0.070)
Informality	-0.004 (0.001)***	-0.004 (0.001)***	-0.004 (0.001)***	-0.003 (0.001)***	0.008 (0.001)***	0.007 (0.001)***	0.007 (0.001)***	0.006 (0.001)***	0.006 (0.001)***	0.005 (0.001)***	0.005 (0.001)***	0.004 (0.001)***
Bribes - tax collection	-0.127 (0.057)**			-0.115 (0.064)*	0.110 (0.059)*			0.086 (0.067)	0.135 (0.063)**			0.071 (0.071)
Tax administration constraint		-0.045 (0.049)		-0.026 (0.052)		0.166 (0.049)***		0.158 (0.053)***		0.428 (0.053)***		0.423 (0.057)***
Legal quality index			0.091 (0.036)**	0.089 (0.037)**			-0.077 (0.038)**	-0.066 (0.038)*			-0.227 (0.040)***	-0.196 (0.041)***
Constant	0.111 (0.113)	0.153 (0.115)	0.077 (0.126)	0.127 (0.118)	-0.798 (0.119)***	-0.837 (0.122)***	-0.766 (0.134)***	-0.819 (0.136)***	-1.246 (0.132)***	-1.299 (0.135)***	-0.953 (0.144)***	-1.045 (0.148)***
Industry dummies	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES
Country dummies	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES
Observations	4226	4136	3626	3565	4226	4136	3626	3565	4226	4136	3626	3565
Pseudo R2	0.104	0.102	0.100	0.100	0.081	0.081	0.085	0.086	0.088	0.101	0.093	0.109

View Table

Table 4

Access to Credit and Informality: Impact of Business Environment

$\mathit{Credit}{}_{ij}=f(\mathit{Inf}{}_{ij},Z{}_{ij})={\beta }_0+\gamma {}_j+{\beta }_1\mathit{Inf}{}_{ij}+{\beta }_2{T}_{ij}+{\beta }_3{q}_{ij}+{\beta }_{4}X{}_{ij}+{\epsilon }_i$

Credit is either Bank Credit, Informal Credit, or Financing Obstacle. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Financing obstacle is a dummy variable that that takes the value of 1 if the firm reports the availability of financing as a “major constraint”, and zero otherwise. Inf is the percentage of sales mat are not reported for tax purposes. T is the tax burden measured by the severity of tax administration constraints faced by individual firms and the frequency with which firms have to give bribes to deal with taxes and tax collection. The quality and efficiency of the legal system, q, is proxied by the index of legal effectiveness, y are country dummies, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Dependent variable	Bank Credit				Informal Credit				Financing Obstacle
	(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)	(10)	(11)	(12)
Government ownership	-0.550 (0.081)***	-0.550 (0.082)***	-0.574 (0.087)***	-0.576 (0.088)***	-0.213 (0.089)**	-0.179 (0.089)**	-0.271 (0.096)***	-0.245 (0.097)**	0.141 (0.086)	0.171 (0.087)*	0.185 (0.092)**	0.207 (0.094)**
Exporter	0.201 (0.050)***	0.207 (0.051)***	0.206 (0.054)***	0.198 (0.055)***	-0.178 (0.054)***	-0.165 (0.054)***	-0.193 (0.058)***	-0.177 (0.058)***	-0.057 (0.057)	-0.067 (0.057)	-0.042 (0.061)	-0.049 (0.061)
Small	-0.437 (0.054)***	-0.427 (0.054)***	-0.437 (0.058)***	-0.437 (0.058)***	0.397 (0.058)***	0.389 (0.058)***	0.393 (0.062)***	0.392 (0.063)***	0.213 (0.061)***	0.211 (0.062)***	0.141 (0.065)**	0.149 (0.066)**
Large	0.236 (0.080)***	0.246 (0.081)***	0.194 (0.085)**	0.204 (0.086)**	-0.042 (0.089)	-0.062 (0.090)	-0.029 (0.095)	-0.051 (0.096)	-0.201 (0.090)**	-0.198 (0.092)**	-0.216 (0.096)**	-0.210 (0.097)**
Age	0.001 (0.001)	0.001 (0.001)	0.001 (0.001)	0.001 (0.001)	-0.005 (0.002)***	-0.005 (0.002)***	-0.005 (0.002)***	-0.005 (0.002)***	0.002 (0.001)	0.002 (0.001)	0.002 (0.002)	0.002 (0.002)
Corporation	0.064 (0.055)	0.072 (0.056)	0.040 (0.060)	0.050 (0.060)	-0.132 (0.059)**	-0.132 (0.059)**	-0.160 (0.064)**	-0.164 (0.065)**	-0.144 (0.064)**	-0.126 (0.065)*	-0.139 (0.069)**	-0.111 (0.070)
Informality	-0.004 (0.001)***	-0.004 (0.001)***	-0.004 (0.001)***	-0.003 (0.001)***	0.008 (0.001)***	0.007 (0.001)***	0.007 (0.001)***	0.006 (0.001)***	0.006 (0.001)***	0.005 (0.001)***	0.005 (0.001)***	0.004 (0.001)***
Bribes - tax collection	-0.127 (0.057)**			-0.115 (0.064)*	0.110 (0.059)*			0.086 (0.067)	0.135 (0.063)**			0.071 (0.071)
Tax administration constraint		-0.045 (0.049)		-0.026 (0.052)		0.166 (0.049)***		0.158 (0.053)***		0.428 (0.053)***		0.423 (0.057)***
Legal quality index			0.091 (0.036)**	0.089 (0.037)**			-0.077 (0.038)**	-0.066 (0.038)*			-0.227 (0.040)***	-0.196 (0.041)***
Constant	0.111 (0.113)	0.153 (0.115)	0.077 (0.126)	0.127 (0.118)	-0.798 (0.119)***	-0.837 (0.122)***	-0.766 (0.134)***	-0.819 (0.136)***	-1.246 (0.132)***	-1.299 (0.135)***	-0.953 (0.144)***	-1.045 (0.148)***
Industry dummies	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES
Country dummies	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES
Observations	4226	4136	3626	3565	4226	4136	3626	3565	4226	4136	3626	3565
Pseudo R2	0.104	0.102	0.100	0.100	0.081	0.081	0.085	0.086	0.088	0.101	0.093	0.109

By contrast, weaknesses in tax administration—as proxied by the frequency of bribes to tax collectors as well as the extent to which tax administration is viewed as a major constraint— are positively and significantly associated with the use of informal credit and with the probability that firms self-report the availability of financing as a major obstacle to their operations. For example, from the estimates in columns 8 and 12, we find that a firm that sees tax administration as a major obstacle has a 6 percent higher probability of using informal credit and a 12 percent higher probability of reporting being financially constrained. We also find that a better legal environment is negatively and significantly associated with both the use of informal credit as well as access to credit as measured by the financing obstacle. The significant association between informality and different measures of access to credit continues to hold in all regressions.

To test whether tax and regulatory constraints and the quality of the legal environment have a differential impact on access to credit by formal and informal firms, we separate the sample and define formal firms as those that report 100 percent of their sales; as before, informal firms are those that report less than 100 percent of their sales. Columns (1–3) and (7-9) in Table 5 present the results for the bank credit variable, while columns (4–6) and (10–12) report results for informal credit. Comparing columns (1–3) and (7–9), we see that informal firms benefit more from an efficient and well-functioning legal systems as compared to formal firms. In particular, an improvement in the legal quality index results in a 7 percent increase in the probability of informal firms using bank credit. This finding suggests that lenders find that a stronger legal environment is more valuable for firms where accounting information is poorer, and therefore adverse selection and incentive problems would otherwise be more severe. Moreover, a higher frequency of bribes to deal with taxes and regulations reduces the use of bank credit by formal firms, while more severe tax administration constraints reduce the use of bank credit by informal firms.

Table 5

Access to Credit, and Business Environment: Formal vs. Informal Firms

$\mathit{Credit}{}_{ij}=\beta {}_0+\gamma {}_j+{\beta }_{1}T{}_{ij}+{\beta }_{2}q{}_{ij}+{\beta }_{3}X{}_{ij}+\epsilon {}_i$

Formal firms report 100 percent of sales for tax purposes. Informal firms report less than 100 percent of sales for tax purposes. Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable mat takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. T is the tax burden measured by the severity of tax administration constraints faced by individual firms and the frequency with which firms have to give bribes to deal with taxes and tax collection. The quality and efficiency of the legal system, q, is proxied by the index of legal effectiveness, y are country fixed effects, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Table 5

Access to Credit, and Business Environment: Formal vs. Informal Firms

$\mathit{Credit}{}_{ij}=\beta {}_0+\gamma {}_j+{\beta }_{1}T{}_{ij}+{\beta }_{2}q{}_{ij}+{\beta }_{3}X{}_{ij}+\epsilon {}_i$

Formal firms report 100 percent of sales for tax purposes. Informal firms report less than 100 percent of sales for tax purposes. Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable mat takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. T is the tax burden measured by the severity of tax administration constraints faced by individual firms and the frequency with which firms have to give bribes to deal with taxes and tax collection. The quality and efficiency of the legal system, q, is proxied by the index of legal effectiveness, y are country fixed effects, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

	Formal Firms						Informal Firms
Dependent variable	Bank Credit			Informal Credit			Bank Credit			Informal Credit
	(1)	(2)	(3)	(4)	(5)	(6)	(V)	(8)	(9)	(10)	(11)	(12)
State	-0.531 (0.092)***	-0.521 (0.093)***	-0.553 (0.099)***	-0.165 (0.102)	-0.127 (0.103)	-0.244 (0.111)**	-0.531 (0.179)***	-0.59 (0.179)***	-0.551 (0.185)***	-0.353 (0.185)*	-0.32 (0.183)*	-0.351 (0.197)*
Exporter	0.195 (0.064)***	0.203 (0.064)***	0.219 (0.069)***	-0.155 (0.069)**	-0.137 (0.070)**	-0.183 (0.076)**	0.231 (0.084)***	0.232 (0.084)***	0.214 (0.089)**	-0.231 (0.087)***	-0.215 (0.087)**	-0.24 (0.093)***
Small	-0.435 (0.067)***	-0.426 (0.067)***	-0.415 (0.072)***	0.412 (0.073)***	0.412 (0.074)***	0.405 (0.079)***	-0.49 (0.094)***	-0.478 (0.095)***	-0.514 (0.101)***	0.442 (0.096)***	0.417 (0.096)***	0.436 (0.102)***
Large	0.302 (0.096)***	0.315 (0.097)***	0.266 (0.103)***	-0.031 (0.108)	-0.058 (0.109)	0.013 (0.117)	0.119 (0.150)	0.126 (0.151)	0.093 (0.157)	-0.105 (0.160)	-0.117 (0.160)	-0.162 (0.170)
Age	0.001 (0.002)	0.001 (0.002)	0.001 (0.002)	-0.004 (0.002)**	-0.004 (0.002)**	-0.004 (0.002)*	0.000 (0.003)	0.000 (0.003)	0.000 (0.003)	-0.008 (0.003)**	-0.007 (0.003)**	-0.009 (0.004)**
Corporation	0.091 (0.069)	0.097 (0.070)	0.088 (0.076)	-0.144 (0.076)*	-0.146 (0.077)*	-0.188 (0.085)**	0.012 (0.092)	0.015 (0.094)	-0.039 (0.098)	-0.123 (0.093)	-0.111 (0.095)	-0.143 (0.100)
Bribes - tax collection	-0.14 (0.073)*			0.043 (0.077)			-0.115 (0.095)			0.218 (0.094)**
Tax administration constraint		-0.004 (0.065)			0.129 (0.068)*			-0.126 (0.075)*			0.209 (0.074)***
Legal quality index			0.034 (0.045)			-0.101 (0.048)**			0.187 (0.061)***			-0.062 (0.061)
Constant	0.044 (0.150)	0.025 (0.153)	-0.014 (0.166)	-0.947 (0.167)***	-0.984 (0.169)***	-0.9 (0.182)***	0.071 (0.172)	0.212 (0.177)	0.056 (0.197)	-0.362 (0.174)**	-0.427 (0.180)**	-0.331 (0.199)*
Industry dummies	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES
Country dummies	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES
Observations	2586	2531	2183	2586	2531	2183	1640	1605	1443	1640	1605	1443
Pseudo R2	0.10	0.10	0.10	0.07	0.07	0.08	0.12	0.12	0.12	0.12	0.12	0.12

View Table

Table 5

Access to Credit, and Business Environment: Formal vs. Informal Firms

$\mathit{Credit}{}_{ij}=\beta {}_0+\gamma {}_j+{\beta }_{1}T{}_{ij}+{\beta }_{2}q{}_{ij}+{\beta }_{3}X{}_{ij}+\epsilon {}_i$

Formal firms report 100 percent of sales for tax purposes. Informal firms report less than 100 percent of sales for tax purposes. Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable mat takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. T is the tax burden measured by the severity of tax administration constraints faced by individual firms and the frequency with which firms have to give bribes to deal with taxes and tax collection. The quality and efficiency of the legal system, q, is proxied by the index of legal effectiveness, y are country fixed effects, X are firm-level controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

	Formal Firms						Informal Firms
Dependent variable	Bank Credit			Informal Credit			Bank Credit			Informal Credit
	(1)	(2)	(3)	(4)	(5)	(6)	(V)	(8)	(9)	(10)	(11)	(12)
State	-0.531 (0.092)***	-0.521 (0.093)***	-0.553 (0.099)***	-0.165 (0.102)	-0.127 (0.103)	-0.244 (0.111)**	-0.531 (0.179)***	-0.59 (0.179)***	-0.551 (0.185)***	-0.353 (0.185)*	-0.32 (0.183)*	-0.351 (0.197)*
Exporter	0.195 (0.064)***	0.203 (0.064)***	0.219 (0.069)***	-0.155 (0.069)**	-0.137 (0.070)**	-0.183 (0.076)**	0.231 (0.084)***	0.232 (0.084)***	0.214 (0.089)**	-0.231 (0.087)***	-0.215 (0.087)**	-0.24 (0.093)***
Small	-0.435 (0.067)***	-0.426 (0.067)***	-0.415 (0.072)***	0.412 (0.073)***	0.412 (0.074)***	0.405 (0.079)***	-0.49 (0.094)***	-0.478 (0.095)***	-0.514 (0.101)***	0.442 (0.096)***	0.417 (0.096)***	0.436 (0.102)***
Large	0.302 (0.096)***	0.315 (0.097)***	0.266 (0.103)***	-0.031 (0.108)	-0.058 (0.109)	0.013 (0.117)	0.119 (0.150)	0.126 (0.151)	0.093 (0.157)	-0.105 (0.160)	-0.117 (0.160)	-0.162 (0.170)
Age	0.001 (0.002)	0.001 (0.002)	0.001 (0.002)	-0.004 (0.002)**	-0.004 (0.002)**	-0.004 (0.002)*	0.000 (0.003)	0.000 (0.003)	0.000 (0.003)	-0.008 (0.003)**	-0.007 (0.003)**	-0.009 (0.004)**
Corporation	0.091 (0.069)	0.097 (0.070)	0.088 (0.076)	-0.144 (0.076)*	-0.146 (0.077)*	-0.188 (0.085)**	0.012 (0.092)	0.015 (0.094)	-0.039 (0.098)	-0.123 (0.093)	-0.111 (0.095)	-0.143 (0.100)
Bribes - tax collection	-0.14 (0.073)*			0.043 (0.077)			-0.115 (0.095)			0.218 (0.094)**
Tax administration constraint		-0.004 (0.065)			0.129 (0.068)*			-0.126 (0.075)*			0.209 (0.074)***
Legal quality index			0.034 (0.045)			-0.101 (0.048)**			0.187 (0.061)***			-0.062 (0.061)
Constant	0.044 (0.150)	0.025 (0.153)	-0.014 (0.166)	-0.947 (0.167)***	-0.984 (0.169)***	-0.9 (0.182)***	0.071 (0.172)	0.212 (0.177)	0.056 (0.197)	-0.362 (0.174)**	-0.427 (0.180)**	-0.331 (0.199)*
Industry dummies	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES
Country dummies	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES	YES
Observations	2586	2531	2183	2586	2531	2183	1640	1605	1443	1640	1605	1443
Pseudo R2	0.10	0.10	0.10	0.07	0.07	0.08	0.12	0.12	0.12	0.12	0.12	0.12

With respect to the use of informal credit, we find that a better legal environment lowers reliance on informal credit by formal firms. By contrast, a stronger legal environment is not significantly associated with reliance on informal credit by informal firms. However, tax and regulatory constraints increase the use of informal credit sources by informal firms more significantly. In particular, weaknesses in tax administration result in an 8 percent increase in the probability that informal firms rely on informal financing and a 4 percent increase in the probability that formal firms rely on informal credit.

Informality, access to credit, and institutional development

Next, we examine the effect of country-specific institutions on access to credit in Table 6 by replacing the survey-based measures of the business environment with country-wide variables. We include three country-wide institutional variables, namely financial sector development, an index of the rule of law, and a measure of the efficiency of the tax system (the number of hours it takes per year to comply with taxes) to the baseline regressions reported in Table 4. Given the high degree of correlation between the country dummies and country-specific institutional variables, we control for country characteristics by including real per capita GDP, GDP growth, and consumer price inflation.

Table 6.

Access to Credit and Informality: Impact of Institutional Development

$\mathit{Credit}{}_{ij}=f(\mathit{Inf}{}_{ij},Z{}_{ij})={\beta }_0+\gamma {}_j+{\beta }_1\mathit{Inf}{}_{ij}+{\beta }_{2}T{}_j+{\beta }_3{q}_j+{\beta }_{4}X{}_{ij}+\epsilon {}_i$

Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. T is a country-wide measure of tax burden proxied by the time taken to pay taxes per year. The quality and efficiency of the legal system, q, is proxied by a countrywide measure of the rule of law and the ratio of private credit to GDP. X are firm level and country-wide controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter, the log of GDP per capita, average GDP growth, and CPI inflation. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Table 6.

Access to Credit and Informality: Impact of Institutional Development

$\mathit{Credit}{}_{ij}=f(\mathit{Inf}{}_{ij},Z{}_{ij})={\beta }_0+\gamma {}_j+{\beta }_1\mathit{Inf}{}_{ij}+{\beta }_{2}T{}_j+{\beta }_3{q}_j+{\beta }_{4}X{}_{ij}+\epsilon {}_i$

Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. T is a country-wide measure of tax burden proxied by the time taken to pay taxes per year. The quality and efficiency of the legal system, q, is proxied by a countrywide measure of the rule of law and the ratio of private credit to GDP. X are firm level and country-wide controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter, the log of GDP per capita, average GDP growth, and CPI inflation. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Dependent variable	Bank Credit				Informal Credit
	(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)
State	-0.570 (0.079)***	-0.568 (0.079)***	-0.586 (0.080)***	-0.574 (0.080)***	-0.210 (0.088)**	-0.202 (0.088)**	-0.201 (0.088)**	-0.202 (0.089)**
Exporter	0.186 (0.049)***	0.199 (0.049)***	0.196 (0.049)***	0.188 (0.050)***	-0.186 (0.053)***	-0.200 (0.053)***	-0.200 (0.053)***	-0.181 (0.053)***
Small	-0.440 (0.053)***	-0.444 (0.053)***	-0.424 (0.053)***	-0.427 (0.053)***	0.400 (0.057)***	0.400 (0.057)***	0.393 (0.057)***	0.389 (0.057)***
Large	0.237 (0.079)***	0.238 (0.079)***	0.245 (0.079)***	0.244 (0.079)***	-0.047 (0.089)	-0.048 (0.088)	-0.051 (0.088)	-0.053 (0.088)
Age	0.001 (0.001)	0.001 (0.001)	0.001 (0.001)	0.001 (0.001)	-0.005 (0.002)***	-0.005 (0.002)***	-0.005 (0.002)***	-0.005 (0.002)***
Corporation	-0.055 (0.049)	-0.086 (0.048)*	-0.088 (0.048)*	-0.074 (0.049)	-0.120 (0.052)**	-0.091 (0.051)*	-0.084 (0.051)*	-0.127 (0.053)**
GDP per capita	0.086 (0.047)*	0.089 (0.047)*	0.109 (0.046)**	0.051 (0.049)	-0.093 (0.049)*	-0.140 (0.049)***	-0.126 (0.048)***	-0.102 (0.050)**
Inflation	-0.034 (0.007)***	-0.030 (0.007)***	-0.034 (0.007)***	-0.036 (0.007)***	-0.005 (0.008)	-0.007 (0.008)	-0.006 (0.008)	-0.002 (0.008)
Growth	0.004 (0.010)	-0.004 (0.010)	-0.015 (0.010)	-0.016 (0.011)	0.024 (0.011)**	0.029 (0.011)***	0.037 (0.011)***	0.028 (0.011)**
Informality	-0.004 (0.001)***	-0.004 (0.001)***	-0.004 (0.001)***	-0.004 (0.001)***	0.008 (0.001)***	0.008 (0.001)***	0.008 (0.001)***	0.008 (0.001)***
Private Credit	0.005 (0.002)**			0.004 (0.002)**	-0.006 (0.002)***			-0.007 (0.002)***
Rule of Law		0.162 (0.082)**		0.208 (0.085)**		0.083 (0.084)		0.112 (0.089)
Time to Pay Taxes			-0.0002 (0.000)***	-0.0002 (0.000)***			.00009 (0.000)**	0.00009 (0.000)**
Industry dummies	YES	YES	YES	YES	YES	YES	YES	YES
Observations	4226	4226	4226	4226	4226	4226	4226	4226
Pseudo R2	0.079	0.078	0.081	0.084	0.068	0.067	0.068	0.070

View Table

Table 6.

Access to Credit and Informality: Impact of Institutional Development

$\mathit{Credit}{}_{ij}=f(\mathit{Inf}{}_{ij},Z{}_{ij})={\beta }_0+\gamma {}_j+{\beta }_1\mathit{Inf}{}_{ij}+{\beta }_{2}T{}_j+{\beta }_3{q}_j+{\beta }_{4}X{}_{ij}+\epsilon {}_i$

Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. T is a country-wide measure of tax burden proxied by the time taken to pay taxes per year. The quality and efficiency of the legal system, q, is proxied by a countrywide measure of the rule of law and the ratio of private credit to GDP. X are firm level and country-wide controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter, the log of GDP per capita, average GDP growth, and CPI inflation. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Dependent variable	Bank Credit				Informal Credit
	(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)
State	-0.570 (0.079)***	-0.568 (0.079)***	-0.586 (0.080)***	-0.574 (0.080)***	-0.210 (0.088)**	-0.202 (0.088)**	-0.201 (0.088)**	-0.202 (0.089)**
Exporter	0.186 (0.049)***	0.199 (0.049)***	0.196 (0.049)***	0.188 (0.050)***	-0.186 (0.053)***	-0.200 (0.053)***	-0.200 (0.053)***	-0.181 (0.053)***
Small	-0.440 (0.053)***	-0.444 (0.053)***	-0.424 (0.053)***	-0.427 (0.053)***	0.400 (0.057)***	0.400 (0.057)***	0.393 (0.057)***	0.389 (0.057)***
Large	0.237 (0.079)***	0.238 (0.079)***	0.245 (0.079)***	0.244 (0.079)***	-0.047 (0.089)	-0.048 (0.088)	-0.051 (0.088)	-0.053 (0.088)
Age	0.001 (0.001)	0.001 (0.001)	0.001 (0.001)	0.001 (0.001)	-0.005 (0.002)***	-0.005 (0.002)***	-0.005 (0.002)***	-0.005 (0.002)***
Corporation	-0.055 (0.049)	-0.086 (0.048)*	-0.088 (0.048)*	-0.074 (0.049)	-0.120 (0.052)**	-0.091 (0.051)*	-0.084 (0.051)*	-0.127 (0.053)**
GDP per capita	0.086 (0.047)*	0.089 (0.047)*	0.109 (0.046)**	0.051 (0.049)	-0.093 (0.049)*	-0.140 (0.049)***	-0.126 (0.048)***	-0.102 (0.050)**
Inflation	-0.034 (0.007)***	-0.030 (0.007)***	-0.034 (0.007)***	-0.036 (0.007)***	-0.005 (0.008)	-0.007 (0.008)	-0.006 (0.008)	-0.002 (0.008)
Growth	0.004 (0.010)	-0.004 (0.010)	-0.015 (0.010)	-0.016 (0.011)	0.024 (0.011)**	0.029 (0.011)***	0.037 (0.011)***	0.028 (0.011)**
Informality	-0.004 (0.001)***	-0.004 (0.001)***	-0.004 (0.001)***	-0.004 (0.001)***	0.008 (0.001)***	0.008 (0.001)***	0.008 (0.001)***	0.008 (0.001)***
Private Credit	0.005 (0.002)**			0.004 (0.002)**	-0.006 (0.002)***			-0.007 (0.002)***
Rule of Law		0.162 (0.082)**		0.208 (0.085)**		0.083 (0.084)		0.112 (0.089)
Time to Pay Taxes			-0.0002 (0.000)***	-0.0002 (0.000)***			.00009 (0.000)**	0.00009 (0.000)**
Industry dummies	YES	YES	YES	YES	YES	YES	YES	YES
Observations	4226	4226	4226	4226	4226	4226	4226	4226
Pseudo R2	0.079	0.078	0.081	0.084	0.068	0.067	0.068	0.070

Our model predicts that a more efficient legal system and greater financial-sector development increases the use of bank credit, while higher compliance costs associated with taxes discourage the use of bank credit. Columns (1–4) report results for bank credit as the relevant dependent variable, while columns (4–8) report regressions for the informal credit variable. ¹⁵ The results confirm that more developed financial systems and better quality legal institutions are associated with higher use of bank credit even controlling for other country-specific and firm-level characteristics. In contrast, weaknesses in tax administration—as proxied by high costs of tax compliance—are negatively and significantly associated with reliance on bank credit. However, we find that firms tend to use more informal credit in countries with less developed financial systems, and in countries where tax compliance costs are high. The significant association between informality and access to credit continues to hold in all regressions.

In particular, the effect of tax institutions on a firm’s reliance on bank credit are not only statistically significant, but also economically relevant. In order to assess the economic effects, we use the column 4 results to quantify the effect that weaknesses in the tax system have on the probability that a firm uses bank credit. As an example, consider Ukraine and Estonia. Our results indicate that if took the same number of hours per year to comply with taxes in Ukraine as in Estonia (104) instead of its own level (2185), there would be a 4-percentage point increase in the probability that Ukranian firms rely on bank credit.

In terms of the impact of countrywide controls, we find that firms in richer countries with lower inflation tend to rely on bank credit relative to firms in lower levels of GDP per capita and higher inflation rates. GDP growth is insignificant in all bank credit regressions. In contrast, poorer and faster growing countries tend to rely more on informal sources of financing.

Next, we address the issue whether the impact of informality on the use of bank versus other informal sources of credit depends on the country’s level of financial and legal development and the quality of its tax institutions. To examine this issue, in Table 7 we interact the informality variable with a variable proxying for institutional development. The coefficient on the interaction term then measures whether, for instance, the financial development of the economy has an effect on the relation between reported informality and reliance on bank and other sources of credit. The results indicate that informal firms’ reliance on bank credit is most severely affected by weaknesses in the tax system. While we continue to find that a more developed financial sector and legal system are positively and significantly associated with the use of bank credit, the coefficients of the interaction terms of informality with financial sector development and rule of law are insignificant. These results support the prediction of the model that in countries where the effective tax burden faced by firms is high, in the form of high compliance costs and weak administration, informal firms have an even greater incentive to forego bank credit.

Table 7.

Informality, Access to Credit, and Business Environment: Interaction Effects

$\mathit{Credit}{}_{ij}={\beta }_0+{\gamma }_j+{\beta }_1\mathit{In}{f}_{ij}+{\beta }_2{T}_j+{\beta }_3{q}_j+{\beta }_4{X}_{ij}+{\beta }_5\mathit{In}{f}_j*T_j+{\beta }_6\mathit{In}{f}_{ij}*q_j+{\epsilon }_i$

Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. T is a country-wide measure of tax burden proxied by the time taken to pay taxes per year. The quality and efficiency of the legal system, q, is proxied by a country-wide measure of the Rule of law and the ratio of private credit to GDP. X are firm level and country-wide controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter, the log of GDP per capita, average GDP growth, and CPI inflation. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Table 7.

Informality, Access to Credit, and Business Environment: Interaction Effects

$\mathit{Credit}{}_{ij}={\beta }_0+{\gamma }_j+{\beta }_1\mathit{In}{f}_{ij}+{\beta }_2{T}_j+{\beta }_3{q}_j+{\beta }_4{X}_{ij}+{\beta }_5\mathit{In}{f}_j*T_j+{\beta }_6\mathit{In}{f}_{ij}*q_j+{\epsilon }_i$

Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. T is a country-wide measure of tax burden proxied by the time taken to pay taxes per year. The quality and efficiency of the legal system, q, is proxied by a country-wide measure of the Rule of law and the ratio of private credit to GDP. X are firm level and country-wide controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter, the log of GDP per capita, average GDP growth, and CPI inflation. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Dependent variable	Bank Credit			Informal Credit
	(1)	(2)	(3)	(4)	(5)	(6)
Informality	-0.002 (0.002)	-0.004 (0.001)***	-0.002 (0.001)	0.007 (0.002)***	0.007 (0.001)***	0.007 (0.001)***
Private Credit	0.005 (0.002)**			-0.006 (0.002)***
Informality*Private credit	-0.000 (0.000)			0.000 (0.000)
Rule of Law		0.150 (0.085)*			0.115 (0.088)
Informality*Rule of Law		0.001 (0.001)			-0.002 (0.001)
Time to pay taxes			-0.0002 (0.000)***			0.000 (0.000)
Informality*Time to pay taxes			-0.000 (0.000)**			0.000 (0.000)
Industry dummies	YES	YES	YES	YES	YES	YES
Observations	4226	4226	4226	4226	4226	4226
Pseudo R2	0.079	0.078	0.082	0.069	0.067	0.068

View Table

Table 7.

Informality, Access to Credit, and Business Environment: Interaction Effects

$\mathit{Credit}{}_{ij}={\beta }_0+{\gamma }_j+{\beta }_1\mathit{In}{f}_{ij}+{\beta }_2{T}_j+{\beta }_3{q}_j+{\beta }_4{X}_{ij}+{\beta }_5\mathit{In}{f}_j*T_j+{\beta }_6\mathit{In}{f}_{ij}*q_j+{\epsilon }_i$

Credit is either Bank Credit or Informal Credit. Bank Credit is a dummy variable that takes the value of 1 if the firm uses bank credit to finance either working capital or new investment, and zero otherwise. Informal Credit is a dummy variable that takes the value of 1 if the firm uses credit from money-lenders or family and friends to finance either its working capital or new investment, and zero otherwise. Inf is the percentage of sales that are not reported for tax purposes. T is a country-wide measure of tax burden proxied by the time taken to pay taxes per year. The quality and efficiency of the legal system, q, is proxied by a country-wide measure of the Rule of law and the ratio of private credit to GDP. X are firm level and country-wide controls including firm age, size and industry dummies, as well as dummies equal to 1 if the firm is owned by the government, if it is a corporation, and if it is an exporter, the log of GDP per capita, average GDP growth, and CPI inflation. Robust standard errors are in parentheses; significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

Dependent variable	Bank Credit			Informal Credit
	(1)	(2)	(3)	(4)	(5)	(6)
Informality	-0.002 (0.002)	-0.004 (0.001)***	-0.002 (0.001)	0.007 (0.002)***	0.007 (0.001)***	0.007 (0.001)***
Private Credit	0.005 (0.002)**			-0.006 (0.002)***
Informality*Private credit	-0.000 (0.000)			0.000 (0.000)
Rule of Law		0.150 (0.085)*			0.115 (0.088)
Informality*Rule of Law		0.001 (0.001)			-0.002 (0.001)
Time to pay taxes			-0.0002 (0.000)***			0.000 (0.000)
Informality*Time to pay taxes			-0.000 (0.000)**			0.000 (0.000)
Industry dummies	YES	YES	YES	YES	YES	YES
Observations	4226	4226	4226	4226	4226	4226
Pseudo R2	0.079	0.078	0.082	0.069	0.067	0.068