How Does Informal Employment Affect the Design of Unemployment Insurance and Employment Protection?

The authors use a simple model to study the optimal design of unemployment insurance and employment protection. Workers are risk averse and face the possibility of unemployment. Firms are risk neutral and face random shocks to productivity. Workers can participate in a shadow economy, or informal sector. The model yields several lessons. First, countries should encourage formal employment to address the issue of informal employment. In extreme cases, such encouragement translates into high severance payments and negative payroll taxes. Along these same lines, unemployment payments cannot be too large. In fact, when the risk of informality is extreme, the authors find that unemployment benefits should be negative, which is (in effect) a positive tax on the lack of formal employment.