The Search and Matching Equilibrium in an Economy with an Informal Sector: A Positive Analysis of Labour Market Policies

Revista Desarrollo y Sociedad 75 51 Primer semestre 2015 pp. 51-99, issn 0120-3584 The Search and Matching Equilibrium in an Economy with an Informal Sector: A Positive Analysis of Labour Market Policies Equilibrio del modelo de búsqueda en una economía con sector informal: análisis positivo de políticas del mercado laboral Luz Adriana Flórez1 DOI: 10.13043/DYS.75.2 Abstract This paper contributes to the theoretical analysis of the informal sector through the search and matching framework. Building upon the work of Albrecht, Navarro and Vroman (2009), where the informal sector consists of unregulated selfemployment, I describe the search and matching equilibrium in an economy with an informal sector where workers are risk neutral and the government is able to see whether a worker is in the formal sector or in the informal one. In this case, I solve the matching equilibrium by introducing three policies: unemployment benefits, a formal lump sum tax, and a job creation subsidy. I analyze the effects of these policies on unemployment rates, formal employment and informal employment. I show that these policies affect the incentives of 1 Junior Researcher, Regional Unit of Economic Studies, Central Bank of Colombia. This paper is part of the first chapter of my PhD thesis at Essex University that was founded through the Scholarship by the Central Bank of Colombia. The opinions expressed here do not necessarily correspond to Banco de la República or its Board of Directors. Email address:. Este artículo fue recibido el 10 de julio de 2014, evaluado el 1º de septiembre de 2014 y finalmente aceptado el 16 de junio de 2015. desarro. soc. 71, primer semestre de 2013, pp. x-xx, issn 0120-3584 52 The Search and Matching Equilibrium in an Economy workers insofar as joining the formal or informal sectors, changing the composition of these two types of workers in the labor market. Key words: Labor market policies, search and matching, informal sector. JEL classification: J46, J65, J68. Resumen Este artículo contribuye al análisis teórico de la informalidad con el enfoque de los modelos de búsqueda. Siguiendo como guía el trabajo de Albrecht, Navarro y Vroman (2009), en el cual el sector informal esta constituido por aquellos trabajadores cuenta propia que no tienen ninguna regulación. En este artículo se describe el equilibrio en un modelo de búsqueda, con un sector informal, donde los trabajadores son neutrales al riesgo y el gobierno observa cuando un trabajador es formal e informal. Para este caso se resuelve el equilibrio usando tres instrumentos de política: el beneficio del desempleo, impuesto de suma fija para los empleados formales y subsidio a la creación de empleo. Se analiza el efecto de estas políticas en la tasa de desempleo, el empleo formal y el empleo informal. Finalmente se muestra cómo estas políticas afectan los incentivos de los trabajadores a ser formales e informales, cambiando la composición de estos tipos de trabajadores en el mercado laboral. Palabras clave: políticas de mercado laboral, modelos de búsqueda, sector informal. Clasificación JEL: J46, J65, J68. Introduction Informality is one of the major characteristics of developing economies. It is an especially important phenomen in the case of Latin America, where informality levels range between 30% and 70% of the total non-rural employment. According to the Economic Commission for Latin America and the Caribbean, ECLAC, informality levels in Latin American economies have been increasing from an estimated 57% of total non-rural employment in 1990 to desarro. soc. no. 75, bogotá, primer semestre de 2015, pp. 51-99, issn 0120-3584 Luz Adriana Flórez 63.3% in 2005. The most recent data from 2009, given by the International Labor Organization (ILO), shows that Colombia presents one the highest levels of informality in the region (61.4% of non-rural employment), compared to Brazil (42.3%), Mexico (54.3%), and Argentina (50%). Given the relevance of this sector in the developing economies, the informal sector has become one of the most important topics in the research agenda of the developing countries. However, to understand how to reduce informality, we need to understand the motivation that makes workers decide to be informal and how governments can affect these decisions. In this way, even though this paper is theoretical it may help to understand how specific government policies may help to increase or reduce the level of informality in developing economies, such as Colombia. In other words, the theoretical findings of this paper can guide future empirical research on the impact of specific government policies on informality levels. The paper aims to build a model that takes into account the informal labor market, typical of developing countries, using the search and matching framework. Such a model allowed me to analyze how three different policies, unemployment benefits, a formal lump sum tax, and a job creation subsidy, affect the levels of informality in the labor market. Through a search and matching model, I would like to answer three questions. First, how do workers decide to be employed in the formal or the informal sector? Second, what does equilibrium look like in economies with high levels of informality? Third, assuming the search effort is observed, how do the three policies that I have mentioned above affect the optimal decision of workers and the optimal decision of firms? To answer these questions I have set up a model that builds upon the work of Albrecht et al. (2009), where the informal sector consists of unregulated selfemployment. However, unlike Albrecht et al. (2009), in my model, I allow for the transition of workers between the formal and the informal sectors. Following Albrecht et al. (2009), I find that there are three type of workers in the economy, those with high productivity who work only in the formal sector, whom I call “pure formal workers”; those with low productivity who work only in the informal sector, whom I call “pure informal workers”; and those with medium productivity who remain in informal employment while searching for a formal job, whom I call “informal searchers”. Assuming the government can observe when a worker is formal or informal, I explore the impact desarro. soc. no. 75, bogotá, primer semestre de 2015, pp. 51-99, issn 0120-3584 53 54 The Search and Matching Equilibrium in an Economy of three different labor market policies on informality: unemployment benefits for those workers who are “pure formal”, a formal lump sum tax for those workers who are formally employed, and a job creation subsidy. I show that there is an equilibrium where the probability that a firm contacts a worker will depend on the composition of workers in the economy, i.e. the proportion between “pure formal workers” and “informal searchers” in the labor market. These policies affect the workers’ incentives to join the formal or informal sectors, changing the (...truncated)