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Shadow Sorting

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  • Boeri, Tito
  • Garibaldi, Pietro

Abstract

This paper investigates the border between formal employment, shadow employment, and unemployment in an equilibrium model of the labour market with market frictions. From the labour demand side, firms optimally create legal or shadow employment through a mechanism that is akin to tax evasion. From the labour 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 labour markets and that deregulation of labour 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 Brazil, 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 C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5487.

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Date of creation: Feb 2006
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Handle: RePEc:cpr:ceprdp:5487

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Keywords: matching; shadow activity; unemployment;

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References

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  1. Davis, Steven J. & Henrekson, Magnus, 2004. "Tax Effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich-Country Comparisons," Working Paper Series in Economics and Finance 560, Stockholm School of Economics.
  2. Gustavo Gonzaga, 2003. "Labor Turnover and Labor Legislation in Brazil," Journal of LACEA Economia, LACEA - LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
  3. Pietro Garibaldi & Etienne Wasmer, 2005. "Equilibrium Search Unemployment, Endogenous Participation, And Labor Market Flows," Journal of the European Economic Association, MIT Press, vol. 3(4), pages 851-882, 06.
  4. Kenneth Burdett & Dale T. Mortensen, 1977. "Labor Supply Under Uncertainty," Discussion Papers 297, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  5. Fredriksson, P. & Holmlund, B., 1998. "Optimal Unemployment Insurance in Search Equilibrium," Papers 1998-2, Uppsala - Working Paper Series.
  6. James Albrecht & Susan Vroman, 2000. "A Matching Model with Endogenous Skill Requirements," Econometric Society World Congress 2000 Contributed Papers 0774, Econometric Society.
  7. Boeri, Tito & Garibaldi, Pietro, 2002. "Shadow Activity and Unemployment in a Depressed Labour Market," CEPR Discussion Papers 3433, C.E.P.R. Discussion Papers.
  8. 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.
  9. Saint-Paul, Gilles, 1995. "The High Unemployment Trap," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 527-50, May.
  10. Edgar L. Feige, 2005. "The Underground Economy And The Currency Enigma," Macroeconomics 0502004, EconWPA.
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