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The Labor Market Effects of Introducing Unemployment Benefits in an Economy with High Informality

  • Mariano Bosch

    (Inter-American Development Bank)

  • Julen Esteban-Pretel

    (National Graduate Institute for Policy Studies)

Unemployment benefit systems are non-existent in many developing economies. Introducing such programs in these economies poses many challenges, which is partly due to the high level of informality in their labor markets. In this paper we study the consequences on the labor market of implementing an unemployment benefit system in economies with large informal sectors and high flows of workers between formality and informality. We build a search and matching model with endogenous destruction, on-the-job search and inter-sectoral flows, where agents in the economy decide optimally whether or not to formalize jobs. We calibrate the model for Mexico and show that the introduction of an unemployment subsidy system, where workers contribute during formal employment and collect benefits when they lose the job, can deliver an increase in formality in the economy while also producing small increases in unemployment. The exact impact of incorporating such benefits depends on the relative strength of two opposing effects: the generosity of the benefits and the level of the contributions that finance those benefits. We also show important policy complementarities with other interventions in the labor market. In particular, combining the unemployment benefit program with policies that reduce the cost of formality, such as lower firing costs or taxes, can produce decreases in informality and lower impacts on unemployment than when the subsidy program is applied in isolation.

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Paper provided by National Graduate Institute for Policy Studies in its series GRIPS Discussion Papers with number 12-20.

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Length: 37 pages
Date of creation: Feb 2013
Date of revision:
Handle: RePEc:ngi:dpaper:12-20
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  1. Daron Acemoglu & Robert Shimer, 1999. "Efficient Unemployment Insurance," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 893-928, October.
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  11. Ulyssea, Gabriel, 2010. "Regulation of entry, labor market institutions and the informal sector," Journal of Development Economics, Elsevier, vol. 91(1), pages 87-99, January.
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  16. Zenou, Yves, 2008. "Job search and mobility in developing countries. Theory and policy implications," Journal of Development Economics, Elsevier, vol. 86(2), pages 336-355, June.
  17. Mariano Bosch, 2006. "Job Creation and Job Destruction in the Presence of Informal Labour Markets," CEP Discussion Papers dp0761, Centre for Economic Performance, LSE.
  18. Christopher A. Pissarides, 1983. "Efficiency Aspects of the Financing of Unemployment Insurance and Other Government Expenditure," Review of Economic Studies, Oxford University Press, vol. 50(1), pages 57-69.
  19. Antunes, Antonio R. & Cavalcanti, Tiago V. de V., 2007. "Start up costs, limited enforcement, and the hidden economy," European Economic Review, Elsevier, vol. 51(1), pages 203-224, January.
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  22. Fiess, Norbert M. & Fugazza, Marco & Maloney, William F., 2010. "Informal self-employment and macroeconomic fluctuations," Journal of Development Economics, Elsevier, vol. 91(2), pages 211-226, March.
  23. Cahuc, Pierre & Lehmann, Etienne, 2000. "Should unemployment benefits decrease with the unemployment spell?," Journal of Public Economics, Elsevier, vol. 77(1), pages 135-153, July.
  24. Loayza, Norman V. & Rigolini, Jamele, 2006. "Informality trends and cycles," Policy Research Working Paper Series 4078, The World Bank.
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