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

In this paper we construct a search and matching model that allows us to analyze the effects of labor 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 labor market policies such as severance or payroll taxes. Nonetheless we find that labor market policies in effect only in the formal sector affect the size and the composition of employment in the informal sector. This is important since in many economies, there is substantial economic activity in the informal sector. This is particularly true in developing countries. Estimates for some Latin American countries put the informal sector at more than 50 percent of the urban work force.1 There is also evidence that the informal sector is important in many transition countries as well as in some developed economies.2 ∗We thank Mauricio Santamaría for stimulating conversations that inspired our interest in this topic. We also thank Bob Hussey and Fabien Postel-Vinay for their helpful comments. According to Maloney (2004), the informal sector includes 30 to 70 percent of urban workers in Latin American countries. Schneider and Enste (2000) give estimates for a wide range of countries. They calculate that the informal sector accounts for 10 to 20 percent of GDP in most OECD countries, 20 to 30 percent in Southern European OECD countries and in Central European transition economies. They calculate that the informal sector accounts for 20 to 40 percent for the former Soviet Union countries and as much as 70 percent for some developing countries in Africa and Asia.