Mandated benefits, employment, and inequality in a dual economy

The authors study the effect of enforcement of labor regulation in Brazil, an economy with a large informal sector and strict labor law. Enforcement affects mainly the degree of compliance with mandated benefits (severance pay, health, and safety) in the formal sector and the registration of informal workers. The authors find that stricter enforcement leads to higher unemployment but lower income inequality. The authors also show that, at the top of the formal wage distribution, workers bear the cost of mandated benefits by receiving lower wages. This is not true at the bottom, because of downward wage rigidity. As a result, formal sector jobs at the bottom of the wage distribution become more attractive, inducing the low skilled self-employed to search for formal jobs.