Self Employment in Developing Countries: a Search-Equilibrium Approach

Self employment comprises around thirty percent of the workforce in Latin America. Most self employed evade payroll taxes, have low education, and run small businesses requiring low skills. I develop and estimate a life cycle search model where workers can be wage earners in the formal or informal sector, self employed or unemployed. Firms in the formal sector pay payroll and severance taxes, and in the informal sector, they can be fined. The estimated model (i) reproduces well the composition of workers over the life cycle as observed in Brazilian Labour Force data, and (ii) shows that the job value of the self employed is similar to that of informal wage earners. The model is used as a tool to evaluate the welfare impact of labour market policies, where self employment may be an option. When simulating an increase in the cost of informality by ten percent, results showed (i) small impact on employment composition and informality; (ii) significant cost pass-through to wages in the informal sector, meaning a reduction in the lowest wages in the economy, hence higher wage inequality. On the other hand, (iii) it led to substantial improvement in the welfare of formal firms and of all workers. These results prove that taking into account labour market frictions is important in welfare analyses of policies in multisectoral labour markets. As simulations which increase the cost of informality suggest, stricter enforcement of labour regulations (at least to a certain degree) can be a way towards efficient labor markets.