Taxing labor income in an economy with high employment informality

This paper develops a static general equilibrium model of occupational choice with heterogeneity in both labor and entrepreneurial skills that generates high levels of employment informality. The model uses a detailed structure of personal income taxes (PITs) and subsidies to formal workers to capture the labor wedges present in many countries. These features enable the model to assess how changes in PITs and subsidies affect labor market outcomes and the government’s fiscal accounts. The model is calibrated for Mexico, which, like many developing countries, has high levels of labor informality. The model’s simulations shed light on the impact of a series of reforms to PITs and subsidy schemes aimed at increasing labor formality among low-income workers. The results suggest that adjusting the current structure of the formal employment subsidy combined with PIT exemptions for low-income workers could reduce informality while marginally improving the government’s fiscal balance.