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Shadow Sorting

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  • Tito Boeri
  • Pietro Garibaldi

Abstract

This paper investigates the border between formal employment, shadow employment, and unemployment in an equilibrium model of the labor market with market frictions. From the labor demand side, firms optimally create legal or shadow employment through a mechanism that is akin to tax evasion. From the labor supply side, heterogeneous workers sort across the two sectors, with high productivity workers entering the legal sector. Such worker sorting appears fully consistent with most empirical evidence on shadow employment. The model sheds also light on the "shadow puzzle", the increasing size of the shadow economy in OECD countries in spite of improvements in technologies detecting tax and social security evasion. Shadow employment is correlated with unemployment, and it is tolerated because the repression of shadow activity increases unemployment. The model implies that shadow wage gaps should be lower in depressed labor markets and that deregulation of labor markets is accompanied by a decline in the average skills of the workforce in both legal and shadow sectors. Based on micro data on two countries with a sizeable shadow economy, Italy and Braziil, we find empirical support to these implications of the model. The paper suggests also that policies aimed at reducing the shadow economy are likely to increase unemployment.

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Bibliographic Info

Paper provided by Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 10.

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Length: 40 pages
Date of creation: 2006
Date of revision:
Publication status: Forthcoming in NBER Macroeconomic Annual-ISOM Conference
Handle: RePEc:cca:wpaper:10

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Keywords: Unemployment; Matching; Shadow Activity.;

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References

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  1. James Albrecht & Susan Vroman, 2002. "A Matching Model with Endogenous Skill Requirements," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 43(1), pages 283-305, February.
  2. Feige, Edgar L, 1994. "The Underground Economy and the Currency Enigma," Public Finance = Finances publiques, , vol. 49(Supplemen), pages 119-36.
  3. Kenneth Burdett & Dale T. Mortensen, 1977. "Labor Supply Under Uncertainty," Discussion Papers 297, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Pietro Garibaldi & Etienne Wasmer, 2005. "Equilibrium Search Unemployment, Endogenous Participation and Labor Market Flows," Sciences Po publications info:hdl:2441/8921, Sciences Po.
  5. Saint-Paul, Gilles, 1992. "The High Unemployment Trap," CEPR Discussion Papers 670, C.E.P.R. Discussion Papers.
  6. Boeri, Tito & Garibaldi, Pietro, 2002. "Shadow Activity and Unemployment in a Depressed Labour Market," CEPR Discussion Papers 3433, C.E.P.R. Discussion Papers.
  7. Davis, Steven J. & Henrekson, Magnus, 2004. "Tax Effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich-Country Comparisons," Ratio Working Papers 57, The Ratio Institute.
  8. Fredriksson, Peter & Holmlund, Bertil, 1998. "Optimal Unemployment Insurance in Search Equilibrium," Working Paper Series 1998:2, Uppsala University, Department of Economics.
  9. Gustavo Gonzaga, 2003. "Labor Turnover and Labor Legislation in Brazil," JOURNAL OF LACEA ECONOMIA, LACEA - LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
  10. Dominik H. Enste & Friedrich Schneider, 2000. "Shadow Economies: Size, Causes, and Consequences," Journal of Economic Literature, American Economic Association, vol. 38(1), pages 77-114, March.
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