Swaffield, 2002). Bhorat et al. (2013) found that in South Africa employers also adjusted to the rise in costs by cutting back on workers’ hours.

# **d. Fourth Adjustment Channel: Leaving the Formal Sector, Partially or Entirely**

The fourth strategy is to get out of the formal sector, either partially or entirely, and operate on an informal basis with employees who are not protected by labor legislation. This strategy is quite common in developing countries, where informal employment is especially prevalent in sectors that are more human capital‐intensive and productivity is low. In Latin America, it has been found that labor rigidity, coupled with little oversight of the businesses could lead some of them to operate illegally to avoid having to pay the required social benefits and taxes (Loayza, Oviedo, and Servan, 2005). Businesses that operate partially on an informal basis can decide which employees to assign to formal positions. In theory, businesses would choose to pay social benefits to their most productive workers, whose marginal productivity compensates for the additional cost (Bosch, 2006). There is little empirical evidence on decisions made by businesses to hire personnel under formal or informal arrangements. Most of the predictions are based on theoretical models (for example, Bosch, 2006). However, country‐level studies based on panel data have shown that increased labor costs tend to increase the size of the informal sector (for example, Loayza et al., 2005; Hazans, 2011; Fialová and Schneider, 2011; and Lehmann and Muravyev, 2012).

A study by Hazans (2011) based on 30 European countries over the period 2004‐2009 found that rises of 1 percentage point in the minimum wage increased informal employment by about 0.3 percentage points. Similarly, Fialová and Schneider (2011), studying panel data for 2000‐2007, concluded that the work of labor institutions helped to promote the growth of the informal sector in Europe. The authors found that the strictest labor regulations on worker protection (as measured by the OECD Employment Protection Legislation Index) had a significant effect on the growth of informal employment in the European economies. A more recent study of a sample of European and Latin American countries found that stricter regulations and higher payroll taxes are the main determinants of informal employment in emerging economies in Europe and Latin America (Lehmann and Muravyev, 2012). For example, a 10 percent increase in the Employment Protection Legislation Index would correspond to a 13 percent increase in informal employment, while a 10 percent increase in the payroll tax would increase informal employment by 1.3 percent.

Overall, a number of studies suggest that introducing or increasing the level of the minimum wage in the economy increases informal employment for two reasons: primarily because businesses, when faced with labor costs, choose to avoid paying social benefits for some of their workers, and also because they have to lay off workers and much of this manpower is absorbed by low‐productivity enterprises that operate in the informal sector. Evidence of this type of relationship between the minimum wage and the informal sector has been seen especially in Brazil, Honduras, Nicaragua, and Indonesia. In Brazil, for example, Carneiro (2001) was able to demonstrate that rises in the minimum wage over the period 1982‐1999 reduced formal 25