The Effects of Labour Market Policies in an Economy with an Informal Sector

Abstract

In this article, we build an equilibrium search and matching model of an economy with an informal sector. Our model extends Mortensen and Pissarides (1994) by allowing for ex ante worker heterogeneity with respect to formal-sector productivity. We use the model to analyse the effects of labour market policy on informal-sector and formal-sector output, on the division of the workforce into unemployment, informal-sector employment and formal-sector employment, and on wages. Finally, we examine the distributional implications of labour market policy; specifically, we analyse how labour market policy affects the distributions of wages and productivities across formal-sector matches. In this article we construct a search and matching model that we use to analyse the effects of labour market policies in an economy with a significant informal sector. What we mean by an informal sector is a sector that is unregulated and hence not directly affected by labour market policies such as severance or payroll taxes. We find that labour market policies that apply only to the formal sector nonetheless affect the size and the composition of employment in the informal sector. This is important since there is substantial economic activity in the informal sector in many economies, particularly in developing countries. Estimates for some Latin American countries put the informal sector at more than 50% of the urban work force.1 The informal sector is also important in many transition countries as well as in some developed economies.2 Although much of the literature treats the informal sector as a disadvantaged sector in a segmented labour market framework, this interpretation is not consistent with recent empirical evidence from Latin America. Under a segmented or dual labour market interpretation, one would expect jobs to be rationed in the primary sector and workers to be in the secondary or informal sector involuntarily and to be queuing for formal-sector jobs. Maloney (2004) presents evidence for several Latin American countries that challenges this view and instead interprets the informal sector as an unregulated micro-entrepreneurial sector. Similarly, using data from the Argentinian household survey, Pratap and Quintin (2006) reject the notion that labour markets are segmented in the greater Buenos Aires area, concluding that there is no evidence of a formal-sector wage premium after controlling for individual and establishment * We thank Mauricio Santamaria for stimulating conversations that inspired our interest in this topic. We also thank Bob Hussey and Fabien Postel-Vinay as well as our editor, Steve Pischke, and two anonymous