Job search inefficiency and optimal policies in the presence of an informal sector

In this paper I use a search and matching model to analyze efficiency in an economy with an informal sector, defined as unregulated self‐employment that cannot be observed by the government. Initially I show that the market solution for this kind of economy is inefficient. Subsequently I introduce various government policies that could correct this inefficiency. These policies include social security payments, severance payments, formal taxes, and job creation subsidies. According to this analysis the most effective policy, which restores efficiency while at the same time reducing informality levels in the labor market, is a tax credit. In this model a tax credit provides incentives for informal workers to participate in the formal sector by reducing the tax burden they have to pay as formal employees. As a consequence these workers have a higher probability of finding a higher‐productivity job in the formal sector, which in turn increases the overall efficiency of the economy. This finding is interesting in so far as it provides a theoretical rationale for anti‐informality policies that reduce informality through more rather than less social protection. The paper is therefore a modest contribution toward a policy paradigm in which reducing levels of informality and poverty and providing social protection for workers are seen as complementary rather than contradictory goals.