In Brazil, labour inspections reduce informality but harm workers and firms when rigid labour regulations leave them with little room to adjust.
Editor’s note: For a broader synthesis of themes covered in this article, check out Issue 2 of our VoxDevLit on Informality.
The challenge of reducing informality in developing countries
In many developing countries, policymakers face a familiar dilemma: how to reduce widespread labour informality without undermining firm performance. Informal employment deprives workers of legal protections and governments of revenue, yet addressing it through enforcement is complex, particularly in environments where formal employment is heavily regulated.
Labour inspections—used to detect and sanction firms that evade labour laws—are a primary policy tool for promoting compliance. But how do inspections interact with rigid labour regulations, and what are their consequences for firms operating in such environments?
Brazil offers a particularly instructive case. It has one of the most regulated labour markets in the world, with formal employment subject to numerous obligations such as the minimum wage law, income tax obligations, social security contributions (INSS), severance payment fund (FGTS) contributions, severance fees in case of lay-offs, a mandatory 13th-month salary, vacation stipends, among other obligations. Unsurprisingly, many formal firms in Brazil hire part of their workforce informally to mitigate these costs. This dual practice—formal firms employing informal workers—has significant implications for policy.
Studying compliance with labour regulations in Brazil
In our recent paper (do Prado, Santos, and Van Doornik 2025), we investigate the consequences of enforcing compliance with labour regulations on firms’ outcomes in Brazil. Using a rich set of administrative data, we track formal firms that were inspected and found to be in breach of labour laws for employing unregistered workers.
Our analysis combines three datasets: labour inspection records from Brazil's Ministry of Labor, matched employer-employee data (RAIS), and corporate credit data from the Central Bank of Brazil. This comprehensive approach allows us to examine not just employment outcomes, but also revenue, credit conditions, and firm survival.
To identify the causal impact of inspections, we use a difference-in-differences methodology, comparing inspected firms to similar firms not yet inspected, while accounting for differences in timing and firm characteristics.
Inspections were harmful to workers and firms in the long run
Our findings are striking. Although inspections improved short-term outcomes for workers, they prove damaging to both employees and firms in the long run:
- Inspections increase formalisation, but only temporarily: We find that labour inspections trigger an immediate increase in formal employment. In the year of the inspection, formal hiring surges by nearly 30% as firms are compelled to register previously informal workers to comply with regulations. However, this effect is short-lived. Over the following years, formal employment steadily declines, falling by nearly 60% relative to non-inspected firms within five years. This is primarily driven by a sustained drop in hiring rather than a surge in separations.
- Revenues decline sharply over time: Initially, inspections do not affect firms' revenues, consistent with the view that firms respond by formalising existing workers rather than expanding their workforce. But over the longer term, revenues plummet by about 25%, reflecting the rising costs associated with maintaining formal employment.
- Inspections increase firm closures: Perhaps most concerning is the impact on firm survival. Inspected firms are significantly more likely to close within five years of an inspection compared to their non-inspected counterparts. This suggests that for many firms, hiring informally is not just a cost-saving measure but a survival strategy. When that margin is removed, some firms cannot remain viable.
Financial distress intensifies: Inspections also have important consequences for firms’ access to finance. We find that inspected firms experience a sustained reduction in outstanding loans and an increase in non-performing loans (NPLs). In other words, inspections not only strain firms’ operating margins but also their financial health, limiting their ability to obtain new credit.
Why does formalisation harm employees and employers in Brazil?
Brazil’s labour regulations impose substantial costs on formal employers. Upon inspection, firms are required to formalise any unregistered workers identified. This involves not just paying fines but also assuming ongoing costs such as social security contributions, severance pay, and other statutory benefits.
For firms operating on thin margins, these additional costs can be crippling. Our findings suggest that many firms rely on informal employment precisely to manage these high labour costs. When enforcement removes this option, firms struggle to adjust, often cutting back on hiring, reducing their operations, or exiting the market altogether.
Policy implications: Enforcement is necessary, but regulation must be flexible
Our results show that while labour inspections can effectively induce formalisation, the associated risks arise when firms operate under highly rigid and costly regulatory frameworks. In such environments, enforcement alone may not be sufficient and could even backfire by impairing firm performance and survival.
Thus, policymakers must carefully weigh not only the extent of enforcement but also whether the regulatory environment allows firms to sustain compliance. Without addressing the rigidity of labour regulations, efforts to reduce informality through inspections may lead to unintended economic harm, especially in countries with similarly rigid regulatory environments.
These adverse outcomes stem not from inspections themselves, but from the rigidity of the formal labour regulations that constrain firms' ability to adapt. Our findings underscore the importance of pairing enforcement with reforms that provide firms sufficient flexibility to comply without compromising their viability.
References
Do Prado, T, M Santos, and B Van Doornik, 2025, “Enforcing compliance with labor regulations and firm outcomes: Evidence from Brazil,” Journal of Development Economics, 176: 103493.