Informal and Formal Employment in a Liberalizing Economy

This chapter examines the phenomenon of growing informal employment in the formal registered sector of the economy. Increased liberalization has not resulted in formalization of jobs in the formal sector of the economy but rather the growth of informal employment. Even in the public sector it is estimated that a third of all jobs are informal. We adopt the lens of an employer in the formal sector who offers formal employment for those jobs requiring initiative and which are not easy to monitor. A typical informal job, in contrast, would be one that is short-lived, relatively simple, and most importantly, easily supervised. The intensity of enforcement of employment protection regulation influences the effort of workers in the formal sector since such workers are protected by regulations that provide them relatively more employment security. Employment protection regulation makes firing difficult and employers have to pay an additional amount to offset the reduction in effort induced by employment security. As employment protection regulation is eased in a liberalizing economy, it increases the effort of those with formal employment contracts and incentivizes the employer to offer formal contracts. However, since a decrease in regulatory enforcement reduces the cost of evading regulations, there is an incentive to substitute towards informal contracts and we investigate the conditions under which this factor could dominate and increase the proportion of informal employment in a formally registered enterprise. We show that this has implications for the declining share of wages in the economy.