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Shadow Sorting

In: NBER International Seminar on Macroeconomics 2005

  • Tito Boeri
  • Pietro Garibaldi

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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This chapter was published in:
  • Jeffrey A. Frankel & Christopher Pissarides, 2007. "NBER International Seminar on Macroeconomics 2005," NBER Books, National Bureau of Economic Research, Inc, number fran07-1, June.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 0339.
    Handle: RePEc:nbr:nberch:0339
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    1. Pietro Garibaldi & Etienne Wasmer, 2005. "Equilibrium Search Unemployment, Endogenous Participation and Labor Market Flows," Sciences Po publications info:hdl:2441/8921, Sciences Po.
    2. Gustavo Gonzaga, 2003. "Labor Turnover and Labor Legislation in Brazil," ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION, ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
    3. Saint-Paul, Gilles, 1992. "The High Unemployment Trap," CEPR Discussion Papers 670, C.E.P.R. Discussion Papers.
    4. Edgar L. Feige, 2005. "The Underground Economy And The Currency Enigma," Macroeconomics 0502004, EconWPA.
    5. 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.
    6. Steven J. Davis & Magnus Henrekson, 2004. "Tax Effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich-Country Comparisons," NBER Working Papers 10509, National Bureau of Economic Research, Inc.
    7. Fredriksson, Peter & Holmlund, Bertil, 1998. "Optimal Unemployment Insurance in Search Equilibrium," Working Paper Series 1998:2, Uppsala University, Department of Economics.
    8. 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.
    9. Boeri, Tito & Garibaldi, Pietro, 2002. "Shadow Activity and Unemployment in a Depressed Labour Market," CEPR Discussion Papers 3433, C.E.P.R. Discussion Papers.
    10. 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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