Tax disincentives to formal employment in Latin America

To finance increased public spending and social programs, Latin America's tax systems need to develop further. Yet taxation can reduce the tax base by discouraging formal employment. Evidence on the intensity of the problem is limited and tends to focus on specifically large reforms of the tax system. Conversely, and to improve external validity, we study whether routine changes in tax policies also alter labor market formalization. Our approach is based on grouped-data estimations of formal employment responses to policy changes. We exploit tax variation across three countries (Bolivia, Ecuador and Colombia) and three periods (2008, 2014/15, 2019). We use precise calculations of counterfactual tax burdens when moving from informal to formal jobs, i.e. formalization tax rates (FTRs). For most countries and pairs of years, FTRs have a negative and significant effect on formal employment, particularly when wages are held constant across periods – in order to extract the pure policy effect – and in a series of sensitivity checks.