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The Formal Sector Wage Premium and Firm Size for Self-employed Workers


  • Bargain, Olivier

    () (University of Bordeaux)

  • El Badaoui, Eliane

    () (University Paris Ouest-Nanterre)

  • Kwenda, Prudence

    () (University of the Witwatersrand, Johannesburg)

  • Strobl, Eric

    () (Aix-Marseille University)

  • Walsh, Frank

    () (University College Dublin)


We develop a model where formal sector firms pay tax and informal ones do not, but informal firms risk incurring the penalty associated with non-compliance. Workers may enter self-employment or search for jobs as employees. Workers with higher managerial skills will run larger firms while workers with lower will manage smaller firms and will be in self-employment only when they cannot find a salary job. For these workers self-employment is a secondary/informal form of employment. The Burdett and Mortensen (1998) equilibrium search model turns out to be a special case that we amend by incorporating taxes and a penalty for non-payment of taxes. Our model is also consistent with some of the empirical literature in that the informal wage penalty does appear to be limited to low wage/skill workers while firm size is an important determinant of the employee formal sector premium. We test theoretical predictions using empirical evidence from Mexico and find that firm size wage effects for employees and self-employed workers are broadly consistent with the model.

Suggested Citation

  • Bargain, Olivier & El Badaoui, Eliane & Kwenda, Prudence & Strobl, Eric & Walsh, Frank, 2012. "The Formal Sector Wage Premium and Firm Size for Self-employed Workers," IZA Discussion Papers 6604, Institute for the Study of Labor (IZA).
  • Handle: RePEc:iza:izadps:dp6604

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    References listed on IDEAS

    1. Pradhan, Menno & van Soest, Arthur, 1995. "Formal and informal sector employment in urban areas of Bolivia," Labour Economics, Elsevier, vol. 2(3), pages 275-297, September.
    2. Mortensen, Dale & Pissarides, Christopher, 2011. "Job Creation and Job Destruction in the Theory of Unemployment," Economic Policy, Russian Presidential Academy of National Economy and Public Administration, vol. 1, pages 1-19.
    3. Olivier Bargain & Prudence Kwenda, 2011. "Earnings Structures, Informal Employment, And Self‐Employment: New Evidence From Brazil, Mexico, And South Africa," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 57, pages 100-122, May.
    4. repec:dau:papers:123456789/1888 is not listed on IDEAS
    5. James Albrecht & Lucas Navarro & Susan Vroman, 2009. "The Effects of Labour Market Policies in an Economy with an Informal Sector," Economic Journal, Royal Economic Society, vol. 119(539), pages 1105-1129, July.
    6. Günther, Isabel & Launov, Andrey, 2012. "Informal employment in developing countries," Journal of Development Economics, Elsevier, vol. 97(1), pages 88-98.
    7. El Badaoui, Eliane & Strobl, Eric & Walsh, Frank, 2010. "The formal sector wage premium and firm size," Journal of Development Economics, Elsevier, vol. 91(1), pages 37-47, January.
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    Cited by:

    1. Alan Finkelstein-Shapiro & Miguel Sarzosa, 2012. "Unemployement Protection for Informal Workers in Latin America and the Caribbean," IDB Publications (Working Papers) 4542, Inter-American Development Bank.
    2. Haanwinckel, Daniel & Soares, Rodrigo R., 2016. "Workforce Composition, Productivity, and Labor Regulations in a Compensating Differentials Theory of Informality," IZA Discussion Papers 9951, Institute for the Study of Labor (IZA).

    More about this item


    informality; self-employment; Burdett and Mortensen model;

    JEL classification:

    • J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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