Informal employment and its effect on the income distribution in urban China

•Informal employment had increased rapidly during 2005-2010 in urban China.•The wage gap between informal workers and formal workers has been becoming larger.•The widening wage gap worsened income distribution by raising the Gini coefficient.•Consequently informal employment has a significant effect on income inequality.•China should remove employment discriminations and regulate the labor market.

This paper discusses the issue of informal employment and its effect on the income distribution in China using datasets from the China Urban Labour Surveys of 2005 and 2010. Based on a new definition of informal employment, we estimated the proportion of informal employment relative to total non-agricultural employment in urban China and found it to be 49.7% in 2005 and 40.3% in 2010. Meanwhile, our study illustrated that informal employees' earnings were 67% that of formal employees, and this large earnings gap raised the Gini coefficient to 0.42 in 2005. The Blinder-Oaxaca decomposition result shows that the earnings gap explains more than half of the overall personal income inequality in urban China. These results indicate that informal employment has a significant effect on the income distribution in urban China. Consequently, regulating the labour market, eliminating job discriminations and legislating the informal employment should be considered as alternative means of reducing inequality in China.