Informality, Public Employment and Employment Protection in Developing Countries

This paper proposes an equilibrium matching labor market model for developing countries where the interaction between public, formal and informal sectors is considered. Theoretical analysis shows that labor markets' liberalization reforms can be evicted by shifts in public employment. Since the public sector accounts for a substantial share of employment in developing countries, this approach is crucial to understand their labor market outcomes. Wage offers to public sector employees increase the outside option value of workers during their bargaining processes in the formal and informal sectors. It becomes more profitable for workers to search on-the-job to access more attractive and stable jobs. The public sector therefore acts as an additional tax imposed on private firms. Using workers flows data from Egypt, we show that labor markets' liberalization plays against informal employment by increasing formal jobs' profitability, but is evicted by the increase of public sector wages observed at the same time.