Unemployment Compensation and the Allocation of Labor in Developing Countries

• Published date: 01 June 2016
• DOI: http://doi.org/10.1111/jpet.12144
• Date: 01 June 2016

UNEMPLOYMENT COMPENSATION AND THE ALLOCATION

OF LABOR IN DEVELOPING COUNTRIES

OLIVIER CHARLOT

University of Cergy-Pontoise

FRANCK MALHERBET

CREST

MUSTAFA ULUS

Galatasaray University

Abstract

This paper studies the effects of the introduction of unemployment

compensation (UC) in countries characterized by pervasive informal-

ity. We provide a simple framework to analyze the impact of UC on the

allocation of workers between formal and informal activities, as well as

the allocation of workers between sectors featuring different incentives

to go informal. We show that a reasonable amount of UC may reduce

informality, while larger amounts of UC induce large disincentives to

go formal because of the level of taxation involved. We also argue that

the financing of UC should be part and parcel of a well-conceived UC

system. We show that UC finance based on payroll taxes is likely to en-

tail an excess level of informality resulting from cross-subsidies between

heterogenous sectors. The introduction of a simple layoff tax meant

to finance the UC system is then shown to reduce informality, hence

highlighting how a well-designed financing scheme may be used as a

supplementary instrument to curb informality.

1. Introduction

Pervasiveness of informal economic activities is a prominent feature of developing coun-

tries. In developing economies 30% to 40% of total employment is informal (Schneider,

Buehn, and Montenegro 2010). Broadly speaking, the informal sector is beyond the

reach of any kind of regulations including labor market regulations, and at the same

Olivier Charlot, THEMA, University of Cergy-Pontoise (ocharlot@u-cergy.fr). Franck Malherbet,

CREST, Ecole Polytechnique, IZA and fRDB (franck.malherbet@ensae.fr). Mustafa Ulus, Galatasaray

University (mulus@gsu.edu.tr).

We thank the editor (Myrna Wooders), an associate editor, and an anonymous referee for helpful

comments and suggestions. Weare also grateful to John Bennett, Fabian Gouret, Andrey Launov, and to

seminar participants at: THEMA-University of Cergy-Pontoise, joint Vienna Macroeconomics Seminar,

Galatasaray University, the Rouen Search and Matching Workshop, the Annual Search and Matching

conference (Mainz), and the 8th IZA/World Bank Conference on Employment and Development for

helpful comments and suggestions. The usual disclaimer applies.

Received October 6, 2014; Accepted October 15, 2014.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 18 (3), 2016, pp. 385–416.

385

386 Journal of Public Economic Theory

time informal workers are excluded from the coverage of benefits associated with for-

mal work. Nevertheless, labor market policies have direct or indirect implications on the

size and composition of informal employment. In this paper, we focus on the impact of

unemployment compensation (hereafter, UC) on the informality.

The incidence of UC is strongly positively related to economic development

(Vodopivec 2004, 2009). Few developing countries have UC systems, and some of them

are contemplating introducing unemployment insurance (UI). For instance, Mexico is

among the largest countries in the Americas that does not have a nationwide UC sys-

tem. It is characterized by a large informal sector that accounts for about 30% of total

employment. According to the OECD (2011), this reflects the limited role of income

support measures for job losers, and introducing UC should be a priority for the coun-

try. The country is actually planning to introduce such a system at the nationwide level

and has led experiments at a smaller scale since 2007.1

Given the significant level of informality in developing countries, alongside the stan-

dard implications of UC on the protection provided to workers as well as on the dura-

tion and the level of unemployment, its impact on informality has to be questioned.

Accordingly, our purpose in this paper is to analyze the impact of UC on the allocation

of workers between formal and informal activities, along with the allocation of workers

between sectors featuring different incentives to go informal.

There is a large and still growing literature aimed at understanding the nature,

causes, and consequences of informality. According to the traditional dualistic approach

dating back to Lewis (1954), labor markets are segmented in developing nations: the for-

mal sector is incapable of creating enough jobs to absorb the whole active population.

Inasmuch as it is easier to access informal employment opportunities,2an important

portion of workers who have neither the means nor the time to afford waiting for a for-

mal job accept work in the informal sector at the expense of lower wages and absence of

social protection. Consequently, it can be argued that in the absence of state-provided

UC, informal employment act as an unofficial safety net for the workers. Informality

would then be much less widespread if the unemployed had access to UC. However, at

the same time UC can have adverse effects on the labor demand because of the addi-

tional costs that have to be borne by the firms.

A vast literature has already documented the effects of UI on unemployment. Some

recent work has also highlighted the potentially beneficial impact of UI on job qual-

ity (e.g., Acemoglu and Shimer 2000, Acemoglu 2001, Belzil 2001, Centeno and Novo

2009, Tatsiramos 2009), but those studies focus on developed rather than developing

countries and do not consider informality.

The search and matching literature has recently devoted a growing attention to

the study of the labor markets of developing countries, characterized by high unem-

ployment and high informality (e.g., Kugler 2000, Fugazza and Jacques 2004, Boeri and

Garibaldi 2005, Zenou 2008, Albrecht, Navarro, and Vroman 2009, Satchi and Temple

2009, Ulyssea 2010, Basu, Chau, and Kanbur 2011, Robalino, Zylberstajn, and Robalino

2011, Margolis, Navarro, and Robalino 2012, Meghir, Narita, and Robin 2012, Charlot,

Malherbet, and Terra 2015). These studies mainly analyze the implications of labor

1An unemployment benefit scheme has been introduced in the city of Mexico. It pays unemployment

benefit to persons aged 18 and older who lose their job. One of the aims of the programme is explicitly

to promote the incorporation of workers into the formal economy. Over 150,000 unemployed had

benefited from the scheme in 2010.

2Informal jobs often correspond to self-employment, or can be found through social networks, friends

or relatives, so that in general, they can be found faster than formal jobs.

Unemployment Compensation 387

market policies such as severance payments, payroll taxes, enforcement of regulations,

subsidies, and unemployment benefits on the size and composition of informal sector

as well as on the whole economy. Compared to that literature, our aim is to give a

closer look at the impact of UC and UC finance on the (re)allocation of workers and

unemployment. In this respect, the papers closest to our contribution are Robalino

et al. (2011) and Zenou (2008). Robalino et al. (2011) used a search model to assess the

Brazilian unemployment benefit system’s effects on the transitions from unemployment

to formal and informal jobs. In line with our results, their policy simulations indicate

that removing the UI component of the system increases the transition probabilities

to informal employment both for eligible and ineligible unemployed workers. Zenou

(2008) proposes a Harris and Todaro (1970) type model of labor market where there

are search and matching frictions in the formal market while the informal sector is

perfectly competitive. Then, he investigates the impact of several labor market policies

such as UI, entry costs, wage/employment subsidies and hiring subsidies on the size of

the informal sector and unemployment.

We generalize and extend Zenou’s paper in the following ways: (i) we consider not

only the allocation of labor between formal and informal work within each sector, but

also the allocation of labor between sectors with different incentives to go informal; (ii)

we show that contrary to Zenou’s claim, a rise in UC will always increase the returns to

search for formal jobs in each sector, in spite of the reduction in labor demand induced

by UC, and therefore, UC should be increased rather than cut to reduce informality;

(iii) Our analysis is, to the best of our knowledge, the first to consider the incidence of

UC financing on informality.

To this aim, we provide a simple search and matching framework with two sectors.

In accordance with the view that informality seems to be omnipresent in virtually all

sectors of the economy in developing countries, we assume that there can be both

formal and informal jobs in different sectors, e.g., in the construction sector or in

the services, while these sectors do not have the same (endogenous) proportions

of formal and informal jobs. Workers allocate themselves between and within each

sector on the basis of expected returns. Informal jobs can be found more easily: in

each sector, the formal segment is characterized by matching frictions, whereas jobs

can be found instantaneously in the informal segment. The characteristics of the

formal jobs are different between the two sectors and the heterogeneity of formal

jobs induce differences in the incentives to go formal/informal. We consider two

sources of heterogeneity, i.e., differences in the productivity, and the labor turnover

rates.

In this setup, UC gives rise to several opposite effects: it increases the job seekers’

outside options and makes them more demanding. This pushes wages up, which is detri-

mental to labor demand. Lower employment prospects then lead more workers toward

informality. On top of that, UC needs to be financed, and taxation raises the incentives

to go informal. However, introducing UC also increases the return to search for formal

jobs, and this causes a reallocation of workers from informal towards formal work within

each sector. Finally, UC can also cause a shift of the workforce between sectors where

the incentives to take informal jobs differ. In any case, it is not clear which of these

effects will prevail, though this may be particularly important in the context of develop-

ing countries with high unemployment and pervasive informality. Accordingly, we aim

to shed light on these problems.

Our framework allows us to highlight an overall beneficial allocative effect induced

by reasonable amounts of UC. We also emphasize the importance of UC finance to

the extent that UC facilitates cross-subsidies between heterogeneous sectors and that