Trade and Informality in the Presence of Labor Market Frictions and Regulations
We build an equilibrium model of a small open economy with labor market frictions and imperfectly enforced regulations. Heterogeneous firms sort into the formal or informal sector. We estimate the model using data from Brazil, and use counterfactual simulations to understand how trade affects economic outcomes in the presence of informality. We show that: (1) Trade openness unambiguously decreases informality in the tradable sector, but has ambiguous effects on aggregate informality. (2) The productivity gains from trade are understated when the informal sector is omitted. (3) Trade openness results in large welfare gains even when informality is repressed. (4) Repressing informality increases productivity, but at the expense of employment and welfare. (5) The effects of trade on wage inequality are reversed when the informal sector is incorporated in the analysis. (6) The informal sector works as an "unemployment," but not a "welfare buffer" in the event of negative economic shocks.
This project was supported by award SES-1629124 from the National Science Foundation and by the Early Career Research Grant 15-150-04 from the W.E. Upjohn Institute for Employment Research. We would like to thank Nina Pavcnik, Jean-Marc Robin, and Jim Tybout, as well as numerous seminar and conference participants, for helpful comments and discussions. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.