ABSTRACT – This paper proposes a unified theoretical framework where formal and informal firms coexist and face the same type of product and labor market imperfections: they have monopoly power in the goods market, they are subject to matching frictions in the labor market, and wages are determined through bargaining between large firms and their workers. Our model matches the main stylized facts on informality for developing countries and appears to be a good candidate for policy analysis. In this framework, we study the impact on informality, wages and unemployment of two types of regulatory policies that may be used to reduce informality, labor and product market regulation, and two types of fiscal policies, labor taxes and formality enforcement. We find that lessening regulation decreases informality and unemployment simultaneously, indicating that there is not necessarily a tradeoff between informality and unemployment. The tradeoff appears when fiscal policies are used, though. Additionally, a reduction in labor market regulation is the only informality-reducing policy considered that diminishes wage inequality.
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