In developing countries, informal firms account for up to half of economic activity. They provide livelihood for billions of people. Yet their role in economic development remains controversial. Some, like Hernando De Soto (1989, 2000), see informal firms as an untapped reservoir of entrepreneurial energy, held back by government regulations. In this view, unleashing this energy by reducing entry regulations or improving property rights would fuel growth and development. Others, like Levy (2008), take a more cynical view, stressing the advantages enjoyed by informal firms and workers from avoiding taxes and regulations. A report from the McKinsey Global Institute describes informal firms as parasites competing unfairly with law-abiding formal firms (Farrell 2004). In this view, informality should be suppressed, not unleashed. Still others follow the development tradition of Lewis (1954), Harris and Todaro (1970), and more recently Rauch (1991) and see informality as a byproduct of poverty. From this dual perspective, formal and informal firms are fundamentally different. Productive formal entrepreneurs pay taxes and bear the cost of government regulation to reach new customers, raise capital, and access public goods. These entrepreneurs are often educated and find it more profitable to run bigger formal firms rather than the smaller informal ones. In contrast, informal entrepreneurs are typically uneducated and unproductive, and they run small businesses producing low-quality products for low-income customers using little capital and

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Informality and Development

The United States has long been viewed as having among the world’s most entrepreneurial, dynamic, and flexible economies. It is often argued that this dynamism and flexibility has enabled the US economy to adapt to changing economic circumstances and recover from recessions in a robust manner. While the evidence provides broad support for this view, the outcomes of entrepreneurship are more heterogeneous than commonly appreciated and appear to be evolving in ways that could raise concern. Evidence along a number of dimensions and a variety of sources points to a US economy that is becoming less dynamic. Of particular interest are declining business startup rates and the resulting diminished role for dynamic young businesses in the economy. We begin by describing how the concept of entrepreneurship is reflected in existing data on firm age and size. The recent addition of firm age to official statistics represents a dramatic improvement in the information available to entrepreneurship researchers. We then turn to a discussion of the role of startup firms in job creation. Business startups account for about 20 percent of US gross (total) job creation while high-growth businesses (which are disproportionately young)

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The Role of Entrepreneurship in US Job Creation and Economic Dynamism

Over the past quarter century, labor’s share of income in the United States has trended downward, reaching its lowest level in the postwar period after the Great Recession. A detailed examination of the magnitude, determinants, and implications of this decline delivers five conclusions. First, about a third of the decline in the published labor share appears to be an artifact of statistical procedures used to impute the labor income of the self-employed that underlies the headline measure. Second, movements in labor’s share are not solely a feature of recent U.S. history: The relative stability of the aggregate labor share prior to the 1980s in fact veiled substantial, though offsetting, movements in labor shares within industries. By contrast, the recent decline has been dominated by the trade and manufacturing sectors. Third, U.S. data provide limited support for neoclassical explanations based on the substitution of capital for (unskilled) labor to exploit technical change embodied in new capital goods. Fourth, prima facie evidence for institutional explanations based on the decline in unionization is inconclusive. Finally, our analysis identifies offshoring of the labor-intensive component of the U.S. supply chain as a leading potential explanation of the decline in the U.S. labor share over the past 25 years.

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The Decline of the U.S. Labor Share

From the perspective of a wide range of labor market outcomes, the recession that began in 2007 represents the deepest downturn in the postwar era. Early on, the nature of labor market adjustment displayed a notable resemblance to that observed in past severe downturns. During the latter half of 2009, however, the path of adjustment exhibited important departures from that seen during and after prior deep recessions. Recent data point to two warning signs going forward. First, the record rise in long-term unemployment may yield a persistent residue of long-term unemployed workers with weak search effectiveness. Second, conventional estimates suggest that the extension of Emergency Unemployment Compensation may have led to a modest increase in unemployment. Despite these forces, we conclude that the problems facing the U.S. labor market are unlikely to be as severe as the European unemployment problem of the 1980s.

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The Labor Market in the Great Recession

This paper describes a real-time, quarterly growth-accounting database for the U.S. business sector. The data on inputs, including capital, are used to produce a quarterly series on total factor productivity (TFP). In addition, the dataset implements an adjustment for variations in factor utilization—labor effort and the workweek of capital. The utilization adjustment follows Basu, Fernald, and Kimball (BFK, 2006) as updated in Basu, Fernald, Fisher, and Kimball (BFFK, 2013). Using relative prices and input-output information, the series are also decomposed into separate TFP and utilization-adjusted TFP series for equipment investment (including consumer durables) and "consumption" (defined as business output less equipment and consumer durables).

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A Quarterly, Utilization-Adjusted Series on Total Factor Productivity

We show that most small business owners are very different from the entrepreneurs that economic models and policymakers often have in mind. Using new data that sample entrepreneurs just before they start their businesses, we show that few small businesses intend to bring a new idea to market or to enter an unserved market. Instead, most intend to provide an existing service to an existing market. Further, we find that most small businesses have little desire to grow big or to innovate in any observable way. We show that such behavior is consistent with the industry characteristics of the majority of small businesses, which are concentrated among skilled craftspeople, lawyers, real estate agents, health care providers, small shopkeepers, and restaurateurs. Lastly, we show that nonpecuniary benefits (being one's own boss, having flexibility of hours, and the like) play a first-order role in the business formation decision. Our findings suggest that the importance of entrepreneurial talent, entrepreneurial luck, and financial frictions in explaining the firm size distribution may be overstated. We conclude by discussing the potential policy implications of our findings.

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What Do Small Businesses Do

A large literature shows that the self-employed underreport their income to tax authorities. In this paper, we quantify the extent to which the self-employed also systematically underreport their income in U.S. household surveys. We use the Engel curve describing the relationship between income and expenditures of wage and salary workers to infer the actual income, and thus the reporting gap, of the self-employed based on their reported expenditures. On average, the self-employed underreport their income by about 25%. We show that failing to account for such income underreporting leads to biased conclusions in a variety of settings.

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Are Household Surveys Like Tax Forms: Evidence from Income Underreporting of the Self-Employed

In this paper, we show that most small business owners are very different from the entrepreneurs that economic models and policy makers often have in mind. Using new data that samples early stage entrepreneurs just prior to business start up, we show that few small businesses intend to bring a new idea to market. Instead, most intend to provide an existing service to an existing market. Further, we find that most small businesses have little desire to grow big or to innovate in any observable way. We show that such behavior is consistent with the industry characteristics of the majority of small businesses, which are concentrated among skilled craftsmen, lawyers, real estate agents, doctors, small shopkeepers, and restaurateurs. Lastly, we show non pecuniary benefits (being one's own boss, having flexibility of hours, etc.) play a first-order role in the business formation decision. We then discuss how our findings suggest that the importance of entrepreneurial talent, entrepreneurial luck, and financial frictions in explaining the firm size distribution may be overstated. We conclude by discussing the potential policy implications of our findings.

Only half of all startups survive past the age of ve and surviving businesses grow at vastly di erent speeds. Using micro data on employment in the population of U.S. businesses, we estimate that the lion's share of these differences is driven by ex-ante heterogeneity across fi rms, rather than by ex-post shocks. We embed such heterogeneity in a fi rm dynamics model and study how ex-ante differences shape the distribution of fi rm size, "up-or-out" dynamics, and the associated gains in aggregate output. "Gazelles" - a small subset of startups with particularly high growth potential - emerge as key drivers of these outcomes. Analyzing changes in the distribution of ex-ante fi rm heterogeneity over time reveals that gazelles are driven towards extinction, creating substantial aggregate losses.

The Nature of Firm Growth

This paper studies a dynamic general equilibrium model with sticky prices and rational expectations in an environment of low interest rates and deflationary pressures. We show that small changes in the public’s beliefs about the future inflation target of the government can lead to large swings in both inflation and output. This effect is much larger at low interest rates than under regular circumstances. This highlights the importance of effective communication policy at zero interest rates. We argue that confusing communications by the US Federal Reserve, the President of the United States, and key administration officials about future price objectives were responsible for the sharp recession in the US in 1937-38, one of the sharpest recessions in US economic history. Poor communication policy is the mistake of 1937. Before committing the mistake of 1937 the US policy makers faced economic conditions that are similar in some respect to those confronted by Japanese policy makers in the first half of 2006.

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Benjamin Pugsley

Papers

What Do Small Businesses Do

Are Household Surveys Like Tax Forms: Evidence from Income Underreporting of the Self-Employed

What Do Small Businesses Do

The Nature of Firm Growth

The Mistake of 1937: A General Equilibrium Analysis