Labor regulations and the informal economy

The informal economy, which evades labor regulations, provides employment for much of the labor force in developing countries. The author explores how labor regulations and imperfections in informal capital markets affect income inequality and the speed of industrialization. Empirical evidence shows that labor costs are higher in the formal sector, and that the cost of capital is higher in the informal sector (in part because many informal activities are illegal, so contracts are unenforceable). The author develops a theoretical model based on such factor-cost asymmetry. He applies it to an urban economy with and without ample supplies of labor from the rural sector. The dynamic analysis considers rural-urban migration and optimal capital accumulation. He finds the following. First, labor regulations that mandate workers'compensation above its market-dictated level induce the formation of an informal sector and thus the dispersion of wages across homogeneous workers. And labor regulations slow capital accumulation and retard the process of rural-urban migration. Second, when capital allocation to informal producers becomes more efficient, the informal sector expands relative to the formal sector, the gap between formal and informal wages narrows, and rural-urban migration speeds up. Finally, policies with an urban bias hasten rural-urban migration, inducing an expansion of the informal labor force relative to the total labor force. Post-World War II experience in informal economies in Latin America motivates and in some respects supports the theoretical findings, says the author.