Firms, policies, informality, and the labour market

In this paper we study how firm-level policies affect labor market outcomes in the developing world. For a large set of low- and medium-income countries, we document that high corporate income tax rate is associated to a higher rate of informal employment, lower GDP per worker and lower unemployment rate. To interpret this evidence, we build a general equilibrium model that features: 1) industry dynamics dictated by heterogeneous firms, 2) search and matching friction, 3) imperfectly enforced legislation, leading to informal employment along the intensive and the extensive margin. We estimate the model using firm and worker-level data from Peru — a country where more than 70 per cent of the population is employed in informal jobs, and use the model as a laboratory to assess the distributional consequences of firm-level taxes and policies. The model generates the observed cross-country relation between corporate income tax rate and labor market outcomes: a reduction in corporate taxes concentrates employment over a smaller mass of larger and more productive firms, increasing efficiency and reallocating workers to formal employment at the expense of a higher unemployment rate. Quantitatively, changes in tax rates account for about 60% of the difference in unemployment rate and 45% of the differences in GDP per worker observed across countries. The model provides a basis for the evaluation of various firm-level policy interventions.