The Unequal Incidence of Payroll Taxes with Imperfect Competition: Theory and Evidence

This paper provides a comprehensive examination of a Brazilian corporate tax reform targeted at the sector and product level. Difference-in-differences estimates instrumented by sector eligibility show that a 20 percentage point cut on payroll tax rates caused a 9% employment increase at the firm level, mostly driven by small firms. This expansion is not driven by formalization of existing workers, and it is explained by reduction on separations rather than additional hires. In terms of earnings, there is a significant 4% earnings increase in the long run, which is concentrated at leadership positions. The unequal pass-through worsen within-firm wage inequality. I exploit the exogenous variation on labor cost to document substantial labor market power in Brazil, where wages are marked down by 36%. Consistent with the empirical findings, I develop a model of factor demand with imperfect competition in the goods and labor market to shed light on the mechanism through which imperfect competition drives corporate tax incidence. The model is identified by the reduced form elasticities, and allows me to structurally estimate the capital-labor elasticity of substitution, which differs from the benchmark case of perfect competition.