Taxation, Informality, and Labor Market Responses: What Do We Really Know?

This paper critically reviews the empirical and structural literature on the effects of income taxation on informal economic activity. Although labor taxation has been widely studied for labor market outcomes, evidence linking income taxes to informality remains fragmented and uneven across countries. Synthesizing findings from both developed and developing economies, the review finds that income taxes have limited effects on formal employment but significant impacts on labor informality, particularly in contexts with weak enforcement, fragile institutions, and highly vulnerable labor markets. Estimated elasticities of informality with respect to income taxation generally range between 3 and 5 percent, averaging around 3.5 percent. The literature, however, is skewed toward high-income countries and relies mainly on reduced-form empirical approaches, limiting understanding of behavioral responses, long-term dynamics, and institutional heterogeneity. Standard theoretical models, grounded in labor supply frameworks, often fail to treat informality as an endogenous margin under weak compliance and regulatory capacity. Consequently, studies may overstate revenue gains and understate distributional impacts.