Labor Market Policies in a Dual Economy

A structural model of heterogeneous agents is built to account for the labor market dynamics of an economy with a large informal sector and to quantify effects of labor market policies on employment, worker flows, savings and welfare in a dual economy. The introduction of unemployment insurance has only a small impact on unemployment but induces a sectoral reallocation of formal labor into informality. Generous severance payments lower the wage of formal jobs and reduce flows from unemployment to formality. In financing expenditures, shifting a tax burden from labor income to consumption increases the size of a formal sector, enhancing productivity and welfare. Economic and welfare consequences of policy reform can significantly differ from those in a single-sector economy due to workers' incentives to avoid taxes and maximize transfers by moving across sectors.