The Cost of Non-Compliance: Firm Adjustments to Threshold-Based Labor Policies

This paper examines the unintended consequences of size-dependent formalization policies that raise the cost of informality for firms, focusing on a provision in Vietnam’s Labor Code 2012. The policy sharply increases the financial penalty for firms with at least 10 formally contracted, paid employees that fail to comply with pre-existing labor regulations at this threshold. I develop a profit maximization model illustrating how this policy incentivizes firms to avoid compliance by substituting toward unregulated labor arrangements or partially formalizing. Using Vietnamese micro-, small-, and medium-enterprise panel data, I employ a difference-in-discontinuities design to estimate the causal effect of the increased financial penalty at the threshold. McCrary density tests indicate no evidence of bunching below the 10-formal paid employee threshold post-policy. Instead, firms adjusted along alternative margins: those just below the threshold increased their reliance on unpaid labor while those just above it registered with the government while employing informal workers. Firms just above the threshold also experienced profit and labor productivity gains. These findings show that threshold-based labor policies can lead to selective—rather than comprehensive—firm formalization, suggesting informality is restructured instead of reduced.