Informal Sector Under Saving: A positive Analysis of Labour Market Policies

A number of authors have utilised theoretical models to analyse informality in the labour market. While such analyses have produced valuable insights they all share a common shortcoming; their theoretical models do not take into account the impact of savings on worker's decision to participate in the informal sector. The objective of this paper is to fill this important gap in the literature. To this end, I explore the impact of social security and severance payment policies on levels of informality in the labour market using a search and match model. The novelty of my model is that it allows workers to save. I find that high levels of social security payments, while protecting workers from being liquidity constrained, do increase levels of informality. However, I also find that other social security programs, such as severance payments, can reduce levels of informality while producing gains in efficiency. Severance payments increase the incentives for workers to become employed in the formal sector, reducing thus the size of the informal sector

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