Informality, regulation and productivity: do small firms escape EPL through shadow employment?

Compliance with labour laws has costs and benefits which depend on the institutional environment in which firms operate. Although several studies have shown a negative effect of informality on firms’ productivity and growth, it is a fact that firms may resort to undeclared employment to escape excessive tax or regulatory burden. Our analysis documents empirically that stricter labour market regulation drives small firms to informality to gain flexibility in hiring and firing decisions. By exploiting the geographical heterogeneity of labour informality across Italian provinces as well as a different firing cost regime for firms above the 15-employee threshold, we provide evidence that firms facing stricter employment protection regulation adjust less in the formal labour market when the cost of accessing informal employment is lower. As a result, we show that an easier access to the informal labour market (partially) offsets the negative effects of stricter labour market regulation on productivity.