Labor Demand Responses to Payroll Taxes in an Economy with Wage Rigidity: Evidence from Colombia

This paper analyzes the effect of payroll taxes on labor demand in an economy where there is a binding minimum wage and a sizable unregulated sector where firms can avoid minimum wage compliance. In particular, I study the... [ view full abstract ]

This paper analyzes the effect of payroll taxes on labor demand in an economy where there is a binding minimum wage and a sizable unregulated sector where firms can avoid minimum wage compliance. In particular, I study the impact of payroll taxes on the creation of formal-sector jobs in Colombia, where about 40 percent of formal-sector workers earn the minimum wage. Using a reform that granted tax breaks to firms hiring workers younger than 28, I obtain estimates of the effect of payroll taxes on formal-sector employment and wages. I show that, consistent with the idea that payroll tax incidence is borne by employers, the reduction in payroll taxes increased formal-sector employment and had no effects on wages. The estimation results imply an estimate of the elasticity of the formal-sector labor demand of -0.44.