Effect of payroll taxes on informality: Evidence from Colombia

This study evaluates the influence of payroll taxes in the Colombian labor market by assessing the relationship between a reduction of labor costs and the number of informal workers relative to the overall number of workers. The paper relies on two natural experiments implicit on the Colombian 2010 reform---that reduced payroll taxes for specific groups of the working population---to assess the influence of payroll taxes. The study of the drivers of the size of the informal sector takes on significant importance in Colombia since the number of informal workers has represented between 50 percent and 70 percent of the working population over the years, depending on the definition used. This research shows that after the reform formality rates among young workers increased in relation to formality rates of other groups of workers. These results suggest a negative relationship between payroll taxes and formality rates. However the results considering low income workers didn't reflect the same relationship. Further research on the potential fiscal costs of the reform must be considered to assess the true impact of future similar reforms.