We analyze how different policy interventions may incentive the transition of workers from the informal to the formal sector. We use Italian data over the period 1998-2008 to evaluate whether the 2003 Italian labor market reform was able to reach the objective to reduce the share of shadow employment. Based on our empirical results, we develop an ex ante evaluation based on a search and matching model, á la Mortensen and Pissarides to determine the right policy interventions which may be effective in generating a significant reduction in undeclared work together with an expansion of the formal sector. We find that, in an economy where permanent and temporary contracts coexist, the combination of lower payroll taxes for permanent jobs and higher probability of being audited generates a compression of the informal sector, leaving unemployment unchanged. A similar result can be obtained through a reduction of the firing cost associated with permanent jobs, even though this causes temporary contracts to increase relatively more than permanent contracts.

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