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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
5487.
Tito Boeri & Pietro Garibaldi, 2005.
"Shadow Sorting,"
NBER Chapters,
in: NBER International Seminar on Macroeconomics 2005
National Bureau of Economic Research, Inc.
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Find related papers by JEL classification: J30 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - General
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Kenneth Burdett & Dale T. Mortensen, 1977.
"Labor Supply Under Uncertainty,"
Discussion Papers
297, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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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.
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