Institutional Quality and Development: On the Role of Informality

While some view the informal economy as parasitic, others view it in a more positive light. We argue that the effect of the informal economy on development depends on both the size of the locale and the institutional environment. Good institutions facilitate productive activity and voluntary exchange when informal networks are insufficient. Using data from 5,505 Brazilian municipalities, we analyze the relationship between (formal) institutions, informality, and development. We find that formal institutions and informal production tend to be substitutable in areas with large populations, and complementary in small municipalities. Our results highlight the importance of informal networks to economic development, especially in small locales.