Do Payroll Tax Breaks Stimulate Formality? Evidence from Colombia’s Reform

Alternative work arrangements have grown rapidly around the world. In Latin America, these alternative work arrangements have long been part of the labor market and have continued to grow. The informal sector grew rapidly in Latin America over the past few decades comprising up to half of the working population in many countries. Some attribute the growth in alternative work arrangements and informality to regulations and taxes, while others argue that it is precisely the lack of enforcement of regulations that allows unprotected employment arrangements to flourish. We examine whether reducing taxes associated with employment stimulates formal sector employment. We exploit the fact that the tax reform introduced in Colombia in 2012 affected only certain types of workers and not others. In particular, workers earning less than ten times the minimum wage and self-employed workers with more than two employees experienced a reduction of payroll taxes of 13.5 percent between 2013 and 2014. We use the Colombian household surveys, social security records and the monthly manufacturing sample to conduct difference-in-differences analyses of the reform. We find evidence of increased formal employment for the affected groups after the reform using all three data sets. We find that the probability of formal employment and the likelihood of transitioning into registered employment increased for the affected groups after the reform. We also find that the level and share of permanent employment relative to temporary employment grew after the reform for those earnings less than ten times the minimum wage. The results are greatest for those in smaller firms and for those earnings close to the minimum wage. JEL Codes: H2, J2, J24, and J31