Unemployment Insurance, Strategic Unemployment and Firm-Worker Collusion

Recent years have seen a spread of unemployment insurance (UI) programs to mid-income and developing countries. Yet little is known about how labor market characteristics in these countries, for example large informal labor markets, interact with the incentive effects of UI. In this paper, we show that firms and workers collude to extract rents from the UI system in the presence of large informal labor markets. Exploiting a discontinuous effect of an unemployment insurance reform in Brazil, we document layoff and rehiring patterns consistent with collusion between firms and workers to extract rents from the UI system. Firms and workers time formal unemployment spells to coincide with workers' eligibility for UI benefits. Survey evidence suggests that firms employ workers informally while they are eligible for UI benefits and rehire them when benefits end. Combined with a lower probability of hiring replacement workers when laying off workers eligible for UI benefits, this suggests that firms employ workers informally while they are on benefits. Firms and workers share the rents extracted from the UI system through lower equilibrium wages. All the observed patterns are mostly driven by industries and municipalities with large informal labor markets. Our findings thus suggest that optimal UI design in mid-income and developing countries needs to take into account adverse incentive effects generated by collusion between firms and workers in the presence of informal labor markets.