Tax reforms and the labor market in an emerging market economy

High non-wage labor costs, particularly payroll taxes, are a major obstacle to job creation and labor market formalization in developing countries. This paper assesses the macroeconomic implications of Colombia’s 2012 tax reform, which reduced payroll taxes by 13.5 percentage points to foster formal employment. To this end, we develop and estimate a dynamic stochastic general equilibrium (DSGE) model in which informal employment coexists with unemployment and labor force inactivity, highlighting the search frictions and regulatory constraints faced by the formal sector relative to the informal sector. Our findings show that lower payroll taxes strengthens firms’ incentives to hire and retain formal workers, leading to a substantial reallocation towards the formal sector. As a result, formal employment increases, informality declines, wages rise across both sectors, and unemployment falls modestly. This reallocation also enhances aggregate productivity and boosts GDP. Consistent with the Colombian evidence, our results suggest that payroll tax reductions can be an effective policy for promoting formalization without adverse effects on unemployment. Moreover, the reform is largely self-financing through higher economic activity and a broader tax base, although complementary financing measures are required to address fiscal challenges. *** RESUMEN: High non-wage labor costs, particularly payroll taxes, are a major obstacle to job creation and labor market formalization in developing countries. This paper assesses the macroeconomic implications of Colombia’s 2012 tax reform, which reduced payroll taxes by 13.5 percentage points to foster formal employment. To this end, we develop and estimate a dynamic stochastic general equilibrium (DSGE) model in which informal employment coexists with unemployment and labor force inactivity, highlighting the search frictions and regulatory constraints faced by the formal sector relative to the informal sector. Our findings show that lower payroll taxes strengthens firms’ incentives to hire and retain formal workers, leading to a substantial reallocation towards the formal sector. As a result, formal employment increases, informality declines, wages rise across both sectors, and unemployment falls modestly. This reallocation also enhances aggregate productivity and boosts GDP. Consistent with the Colombian evidence, our results suggest that payroll tax reductions can be an effective policy for promoting formalization without adverse effects on unemployment. Moreover, the reform is largely self-financing through higher economic activity and a broader tax base, although complementary financing measures are required to address fiscal challenges.