The Response of the Informal Sector to Trade Liberalization*

This paper studies the relationship between trade liberalization and informality. It is often claimed that increased foreign competition in developing countries leads to an expansion of the informal sector, defined as the sector that does not comply with labor market legislation. Using data from two countries that experienced large trade barrier reductions in the 1980’s and 1990’s, Brazil and Colombia, we examine the response of the informal sector to liberalization. In Brazil, we find no evidence of a relationship between trade policy and informality. In Colombia, we do find evidence of such a relationship, but only for the period preceding a major labor market reform that increased the flexibility of the Colombian labor market. These results point to the significance of labor market institutions in assessing the effects of trade policy on the labor market. * We wish to thank Hector Mejia at DANE and Andreas Blom at the World Bank for providing us with the data. We are also grateful to Cristina Gamboa, Adriana Kugler, and Ximena Pena for answering our numerous questions about the data and th