Is Formalizing the Labour Market Counter-Productive for Job Creation?

Abstract: Informality is disproportionately concentrated on women, the youth, and those with lower levels of education and wealth. As such, formalization is a desired yet elusive goal for developing economies as a way to afford informal workers better protection and working conditions. On the other hand, formalization may increase labor turnover costs for firms—hiring and firing costs will exist in formerly informal employer-employee relationships, adversely affecting labor demand. In light of these potentially countervailing mechanisms, this paper addresses whether formalization affects unemployment and whether this nexus is nonlinear in nature. Using Blundell and Bond's (1998) and Windmeijer’s (2005) Two-step System Generalized Method of Moments (SGMM) on a balanced panel dataset of 90 developing countries from 2001-2019, the paper finds robust evidence that for at least half of the countries in the sample, there is a long-run positive relationship between formalization and unemployment. However, this relationship is also nonlinear—formalization solves the unemployment problem only in countries with extremely low levels of formal employment.

Keywords: Formalization, Unemployment, Persistence, System

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