Mandated Benefits, Employment, and Inequality in a Dual Economy

Abstract

We study the effect of enforcing labor regulation in an economy with a dual labor market. We use data from Brazil, a country with a large informal sector and strict labor law, where enforcement affects mainly the degree of compliance with mandated benefits (severance pay; health and safety conditions) in the formal sector, and the registration of informal workers. We find that stricter enforcement leads to higher unemployment but lower income inequality. We also show that, at the top of the formal wage distribution, workers bear the cost of mandated benefits by receiving lower wages. Wage rigidity (due, say, to the minimum wage) prevents this downward adjustment at the bottom of the income distribution. As a result, formal sector jobs at the bottom of the wage distribution become more attractive, inducing the low skilled selfemployed to search for formal jobs.