Enforcing Compliance with Labor Regulations and Firm Outcomes: evidence from Brazil

We study the impacts of enforcing compliance with labor regulations on firm dynamics by combining firm-level administrative records and labor inspection data on formal Brazilian establishments committing “unregistered employee” infractions. We first provide suggestive evidence that inspected firms employing informal workers are more likely to exit following a labor inspection, compared to firms never penalized for such infractions. Next, we apply a difference-in-differences framework using firms not yet penalized for “unregistered employee” infractions as the control group to estimate the effect of labor inspections on firm-level outcomes. We find that formal employment and formal labor hiring experience a positive spike in the year of the inspection, indicating the formalization of unregistered employees. However, formal employment declines steadily over time, dropping nearly 60% by the fourth year after inspection. Among firms with active bank relationships, revenue falls sharply by about 24% over the same period. We also observe a persistent reduction in the outstanding loan amount and significant rise in the non-performing loan ratio. The average formal wage drops by about 1% in the year of inspection, but returns to pre-inspection levels in later years. Our findings are consistent with firms reducing their overall labor usage due to higher labor costs, which arise from increased compliance with labor regulations following a labor inspection.