Employment Protection Legislation and Informality: Theory and Evidence from India

Abstract

We present causal evidence on how employment protection legislations (EPL) that penalize firms for hiring contractual workers can have adverse effects in contexts characterized by high levels of informality. While they increase compliance and reduce informality on the "intensive margin'' as formal sector firms reduce hiring contract workers, they increase informality on the "extensive margin'', as firms move to operating in the informal sector instead. This lowers aggregate productivity, wages, and welfare in equilibrium. Counterfactual simulations demonstrate the significance of carefully designing EPL in contexts where informality is prevalent.

Keywords: Contract labor, Employment Protection Laws, Firms, Informality

JEL Classification: D22, E26, J46, O12, O17