(as in the previous experiment, the policy leads to a higher incidence of unemployment among the unskilled workers). With regard to distributional effects, the density of formal-sector productivity shifts to the right, reflecting the upward shift in the reservation productivity, while in the informalsector, it shifts to the left.

Two forces may affect log wage inequality in opposite ways: a lower relative price of formalsector goods entails a lower wage rate in the bargaining negotiation, but the rightward changes in the distribution of types and productivities push the average formal-sector wage up. The first effect dominates so mean log wages in the formal sector decrease.

Despite the higher informal-sector good price, the mean wage in the informal sector drops as well as a result of the downward shift in productivities, so the overall impact on the log-wage gap is quite small. Both wage distributions shift to the left slightly (see Figures 38-43). Overall wage inequality is not affected significantly.

Table 11 summarizes the results of the simulated experiments.

# **5 Concluding Remarks**

In this paper I build a search and matching model to understand the impact of labor market policies and social assistance programs on steady state unemployment, informal sector size and wage distribution in a small open economy with search frictions and idiosyncratic productivity shocks. I solve the model numerically and estimate the structural parameters using Colombian household-level data. The model accounts for the division of the labor force among unemployment, informal and formal sector employment, selected moments of the earning distribution, and formal-sector employment duration. I simulate the model and perform a set of policy experiments consistent with the policy reforms implemented in this developing economy in the last two decades.

My contributions to the literature are on two fronts: within the literature of reforms, I provide a new perspective on the impact of the reforms using a structural model; within the search and matching frictions literature with an informal sector, I generalize previous settings by building the informal sector as a ‘disadvantaged’ sector of a dualistic labor market (consistent with empirical evidence), and add an extra dimension of heterogeneity to fit better the wage distribution.

An expansion of public health insurance to informal sector workers, high payroll taxation and changes in relative prices (tradables vs non-tradables) may affect the division of the labor force into unemployment, employment in the formal and informal sectors (aggregate effects), the mix of workers in the two sectors (compositional effects), and the distribution of productivities and wages (distributional effects). From a policy perspective, it is critical to quantify these effects.

The counterfactual experiments performed suggest that the valuation of social security services and subsidized health is crucial.

Changes in labor taxes have small effects if workers do not value social security services, but may have quite sizable aggregate, compositional and distributional effects if workers associate high payroll taxes with more valuable and efficient services. This perception of labor taxes as net 35