Firms, Policies, Informality, and the Labor Market, joint with c. cisneros-acevedo
Revise and Resubmit, International Economic Review, [pdf, slides]
This paper studies how taxes and regulations affect firms and labor market outcomes in the developing world. We build a general equilibrium model of firm dynamics subject to search frictions, taxes, and imperfectly enforced legislation. This setup leads to informal employment along the intensive and extensive margin. Estimated to match firm and worker-level data from Peru, the model sheds light on the effect of corporate income tax on informality and unemployment. On the one hand, a reduction in corporate taxes concentrates employment in larger and more productive firms, increasing efficiency and reallocating workers to formal jobs. On the other hand, employment shifts to a smaller mass of firms creating higher unemployment duration and higher income inequality. Holding tax revenues constant, we compare a simulated reduction in corporate income tax to an equivalent reduction in payroll taxes. We find that cuts in corporate income taxes are more effective in reducing the informality rate and increasing real GDP per worker, while not generating as much unemployment as cuts in payroll taxes, +1.8 versus +3.3 percentage points. A revenue budget-neutral welfare-maximizing policy shifts the burden from corporate income to payroll taxes, reducing informality by 2.2 percentage points and increasing output per capita by 2.4 percent.