Trade liberalization in Latin America has substantially altered business opportunities andeconomic development in the region. As barriers to competing inputs have come down andforeign investment in the region has gone up, small, domestic firms have struggled to stayafloat. Many small businesses have survived by skirting the legal requirements to operate abusiness, including registration and taxation, thereby bringing their operating costs just lowenough to earn a profit. As trade liberalization continues to reduce barriers to foreigncompetition, and domestic firms face increasing pressure to compete, these “informal” firmshave come under increasing pressure to legitimize or cease operations. With strong pressurefrom the tax‐paying business community, international organizations, and foreign industry,many countries have increasingly begun formalization programs that target informality as areason for slow growth in the face of open trade.In this thesis, I pose a straightforward question—is formalization good for economicdevelopment? This question opens the door to an evaluation of the underlying cause ofinformality, the basis for the push for formalization, and an assessment of the likely result ofsuch a process.Formalization attempts to remedy the problems of low productivity and aversion tocompliance with the law through economic incentives, such as tax discounts and streamlinedbusiness procedures that are intended to help firms make their way into the formalmarketplace. However, in many developing countries, the informal economy is an economicconsequence of trade pressures, and a legal consequence of a failed social contract between thestate and its small business community.In its current iteration, the formalization process is coupling the tools used to improvebusiness practices and procedures with the legalization process for millions of existing informalfirms. By doing so, the state is ignoring the dual legal and economic framework within whichinformal firms operate. Improvements in business processes are good for business and can helpexisting and intending formal firms succeed. But these are much less likely to overcome thedeep‐rooted failure of the state to address the needs of the bulk of the citizenry.I argue that an effective formalization process must 1) address the terms of the socialcontract between the state and its informal economy, and; 2) make improvements in socialprograms to protect the health, safety and prosperity of existing informal firm operators. It ismy contention that informal firms have largely rejected the state’s rule of law contract becausethe firms are unwilling to cede their freedom to operate an informal business in exchange forstate protection of property or rights that they rarely possess. As such, in order to not onlyreduce the growth of the informal economy, but also to improve the rule of law, the state musttake aggressive steps to reform their arrangement with the informal economy by buildingdynamic linkages between formal and informal legal and economic frameworks. An immediatestep that states should take, I argue, is to implement programs that remove some hazards ofoperating an informal business by enforcing restrictions on the use of certain public space,providing safety equipment to street‐based firms, and investing in improvements in the designof public space.This modified formalization approach is not intended to rapidly eliminate the informaleconomy. Rather, it is aimed at improving the economic development of the state through anenabling, rather than a punitive approach. This modified approach will increase the value of thesocial contract and rule of law to informal firms; illuminate a pathway to voluntary legalization;protect individuals operating informal firms, and; improve access to education, training, andsocial services for all small firms. Capitalizing on the contributions made by the informaleconomy to a state’s economic development may help to turn a destructive process into agrowth opportunity.
