Enforcing compliance with labor regulations and firm outcomes: Evidence from Brazil

In developing economies, many formal firms hire a portion of their workforce informally to bypass the costs of stringent labor regulations. While labor inspections serve as an important policy tool to ensure compliance, promoting a more competitive labor market, they may also have unintended consequences on firms’ outcomes. Using a unique set of administrative data that includes information on labor inspections, matched employer–employee data (RAIS), and credit registry data from the Central Bank of Brazil, this paper provides novel findings on post-inspection dynamics at the firm level within Brazil’s heavily regulated labor market. Employing a difference-in-differences approach, we observe a surge in formal employment without any immediate impact on revenue, suggesting that inspected firms tend to formalize their unregistered workers after an inspection. However, our results also reveal a large negative impact on firm performance and an increased likelihood of exit in the long run, indicating that audited firms struggle to offset the costs of formal labor. In addition, we find that inspected firms face tighter credit conditions, emphasizing the broader economic implications of enforcing labor regulations. By exploring heterogeneity across municipalities, we discern that the adverse effects of inspections are more pronounced in areas with lower informality rates. All in all, this research fills a gap in understanding how labor law enforcement affects firm dynamics, offering insights into the trade-offs faced by firms in heavily regulated environments.