Informal work in a flexible labour market

Informal employment is a pervasive and persistent feature of most developing and developed economies. Labour taxation and labour market regulations are deemed two major causes for operating in the informal sector. Using data from France, Italy, and Spain, we analyse gross job flows and gross worker flows in the formal and informal sectors in the presence of lenient employment protection legislation, and investigate the way traditional policy interventions may favour transitions from one sector to the other. We show that optimal outcomes in terms of reduction and formalisation of informal jobs across the three countries examined are achieved with the combination of lower payroll taxes for permanent contracts and higher inspection rate for firms operating in the informal sector. Coupling lower firing costs with more frequent labour inspections also reduces informality, but this comes at the cost of an increased ratio of temporary to total employment.