Size Dependent Policies, Informality and Misallocation

We examine the effect of size-dependent policies in developing economies by focusing on a setof regulations that are applicable to firms with 20 or more formal employees in Peru. Firms canadjust to the regulations by (a) reducing their size, (b) shifting employment composition, or (c)splitting into subunits that fall below the regulatory threshold. We show that these actions areconsistent with observed discontinuities in the distributions of firm size and employmentcomposition. We extend the framework proposed by Garicano et al. (2016) to model andestimate the Peruvian economy and perform counterfactual exercises. Size-dependentregulations are costly for the economy, especially in the presence of labor market rigidities, andlead to lower aggregate wages, profits, and output. We also find that access to informal labordoes not mitigate the economic impact of the size-dependent regulations, as the increase ininformal employment is largely offset by a decline in formal employment