Implementation of Labor Laws and Informality

We examine the role of the informal sector in understanding the implications of policies that penalize firms for not complying with Employment Protection Legislations (EPLs). Specifically, we study a policy reform that penalized firms for hiring workers "off-the-books" and show that it reduces informality on the "intensive margin" i.e., formal sector firms hire fewer contract workers and more on payroll. However, it increases informality on the "extensive margin", as firms are now more likely to operate in the informal sector instead. This lowers real wages and welfare in equilibrium. Counterfactual simulations indicate that policies reducing costs associated with hiring payroll workers can increase EPL compliance, decrease both margins of informality, and increase real wages and welfare