A Behavioral Theory of Firm Formalization

Firm formalization refers to the process by which unregistered firms register with the relevant authorities and comply with the applicable rules and regulations associated with business and tax. Informal firms – unregistered firms or firms hidden from taxation and regulation - contribute substantial portions to the GDP and employment, especially so in emerging and developing markets. However, they are also responsible for disproportionate shortfalls in tax revenues, precarious working conditions, and environmental pollution. Efforts to formalize these firms have met with limited success because, this thesis posits, the focus on the costs and benefits of formalization has led to an elusive understanding of firms’ formalization decisions. Guided by the question - how does the bounded rationality of the decision-makers shape firm formalization decisions?, this thesis seeks to improve our understanding of when and why informal firms formalize.
To this end, the thesis consists of three research papers that employ different methodologies and data. The first paper draws on prospect theory to propose a behavioral framework of firm formalization decisions. The second paper uses the behavioral theory of the firm and institutional theory to investigate how financial performance and legitimacy aspirations jointly influence formalization decisions in times of economic disruption. The third paper draws on the behavioral theory of the firm and social embeddedness theory to examine the influence of social embeddedness on the relationship between firm financial aspirations and formalization.
The thesis argues that the formalization decision includes multiple, interrelated variables that create interdependencies between the formalization decision and other decisions facing the firms’ decision-makers. The limited ability of decision-makers to include and process all relevant variables into the decision process means that the formalization decision is a risky and uncertain decision driven by bounded rationality. A complete understanding of firm formalization decisions must account for the behavioral mechanisms that are triggered by decision-makers’ bounded rationality. Furthermore, improvements in the knowledge of the formalization decision should translate to progress in the design and implementation of formalization policies.