How does competition from informal firms impact research and development by formal manufacturing small and medium enterprises in the developing and emerging economies?

Abstract The impact of competition from informal or unregistered firms on the likelihood of research and development (R&D) activity by formal manufacturing small and medium enterprises (SMEs) in 90 developing and emerging countries is estimated. A positive impact is found with a one standard deviation increase in informal competition resulting in a 3.1–3.6 percentage point increase in the probability of R&D activity. Given that only 15.7% of SMEs are engaged in R&D activity, this is a large effect. Consistent with the “legalist” view of informality, the positive impact of informal competition on the likelihood of R&D activity is bigger in countries where the business environment is less favorable to formal versus informal firms due to factors such as weaker rule of law, a higher tax rate on commercial profits, and a greater regulatory burden on the formal firms. We provide several layers of defense against omitted variable bias, reverse causality, and measurement errors. As expected, informal competition has no statistically significant impact on the likelihood of large firms engaging in R&D activity.