Informality as a stepping stone: A search-theoretical assessment of informal sector and government policy

Abstract

This paper develops a model of sequential job search to understand the factors determining the effect oftax and enforcement policies on the size (i.e., employment share) of informal sector. The focus is on therole of informal sector as a stepping stone to formal jobs. I argue that the stepping-stone role of informaljobs is an important concept determining how strongly government policies affect the size of informalsector. I measure the extent of the stepping-stone role with the intensity of skill accumulation in theinformal sector. If informal jobs help workers acquire skills, gain expertise, and build professional networks for boosting the chances to switch to a formal job, then the size of informal sector is less sensitive togovernment policy. In this case, the option value of a job in informal sector will be high and a worker withan informal job will not rush to switch to a formal job when a policy encouraging formal employment is ineffect. If, on the other hand, informal sector does not provide satisfactory training opportunities, then thesize of informal sector becomes more sensitive to government policy. Calibrating the model to the Brazilian data, I perform numerical exercises conŞrming that the effect of government policy on the size ofinformal sector is a decreasing function of the intensity of skill acquisition in the informal sector.© 2016 Central Bank of The Republic of Turkey. Production and hosting by Elsevier B.V. This is an openaccess article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/).