It is widely believed that the presence of a large informal sector increases the efficiency cost of social programs in developing countries. We evaluate such claims for the case of unemployment insurance (UI).We introduce informal work opportunities into a canonical model of optimal UI that specifies the typical tradeoff between workers’ need for insurance and the efficiency cost from distorting their incentives to return to a formal job. We then combine the model with evidence drawn from 15 years of comprehensive administrative data to quantify the efficiency cost of the UI program in Brazil. We first show that beneficiaries respond to UI incentives. Exogenous increases in UI maximum benefit duration led to falls in formal sector reemployment rates due to offsetting rises in informal employment. However, because reemployment rates in the formal sector are low, most beneficiaries would draw the UI benefits absent behavioral responses. Consequently, only a fraction of the cost of (longer) UI benefits is due to perverse incentive effects and the efficiency cost is thus relatively small. Using variation in the share of formal and informal workers across regions and over time, we then show that the efficiency cost of longer UI benefits in fact increases with labor market formality. In sum, the results go against the conventional wisdom, and indicate that efficiency considerations may
even become more relevant as the formal sector expands. Finally, we provide evidence that the insurance value of longer UI benefits may be sizeable in Brazil. Join twith Gustavo Gonzaga.

(JEL H00, J46, J65)