A compensating differentials model of informal labor markets

Advisor: Rodrigo Reis Soares

We develop a search and matching model of informality with heterogeneous workers and minimum wages. In an equilibrium, the informal firms are smaller, less productive and employ less skilled workers as a result of self-selection. Informal workers are generally compensated for the lack of mandated benefits by receiving higher wages, but a binding minimum wage can break this equalizing differentials relation. We calibrate the model using Brazilian data and use it to explain the evolution of labor market outcomes in that country from 2003 to 2012. Our results suggest that the rise in schooling levels was the most important cause behind the reversal of the informality trend in Brazil, which remains as a puzzle in the literature. We also show that, for this calibration, a progressive payroll tax would lead to a decrease in both unemployment and informality.