Labor Market Reforms, Flexibility, and Employment Transitions Across Formal and Informal Sectors

Abstract

In this paper, I investigate the 2017 labor market reform in Benin, which reduced firing costs and allowed firms to renew short-term contracts indefinitely. Using micro-data from the Harmonized Household Living Standards Surveys and a two-way fixed effect approach with nearby countries as the control group, I assess the reform's impact on employment, worker tenure, contract types, and wages. My empirical results reveal a 2.6 percentage point (24.5 percent) increase in formal sector employment and a 2.8 percentage point (3.2 percent) reduction in informal employment. Formal sector tenure decreased by 0.23 months for short-term contract workers, reflecting higher turnover, while long-term contract tenure increased by 0.15 months. The likelihood of securing a permanent contract rose by 23.2 percentage points (41.6 percent) in the formal sector, indicating that firms used long-term contracts to retain high-productivity workers. Wages in the formal sector increased by 33.6 USD per month on average, with workers on short-term contracts experiencing a wage increase of 19.6 USD and those on long-term contracts seeing an increase of 23.4 USD. I complement these findings with a theoretical job search model, which explains the mechanisms through which lowered firing costs affected firm hiring decisions, market tightness, and the sorting of workers across sectors. This study provides robust evidence of labor market reallocation and highlights the complex trade-offs between flexibility, employment stability, and wages in a developing country context.