Unemployment Insurance with Informal Labor Markets: Evidence from Brazil

Recent years have seen a rapid expansion of unemployment insurance (UI) programs to mid-income and developing countries with large informal labor markets. Using the universe of formal labor contracts in Brazil and an unexpected UI reform, this paper examines how UI affects workers’ incentives in the presence of informal labor markets. Exploiting a sharp discontinuity in the reform’s effect, we find that eligibility for UI benefits increases formal unemployment inflow by nine percent. This effect is mainly driven by workers in labor markets with a high degree of informality. Collusion between workers and their employers accounts for at least 16-17 percent of strategic unemployment; firms hire workers informally while they are eligible for UI benefits and rehire them formally when benefits are exhausted. Additionally, making it easier to qualify for UI benefits leads to a shift in labor supply from informal to formal labor markets and a decrease in wages for formal relative to informal jobs within the same local industry.