Financial disincentives for formal work in Ecuador and Colombia

Rodríguez, David; Jara, Xavier

doi:https://doi.org/10.48713/10336_18256

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Financial disincentives for formal work in Ecuador and Colombia

http://repository.urosario.edu.co/handle/10336/18256
https://doi.org/10.48713/10336_18256

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Rodríguez, David

Jara, Xavier

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2018-03-28

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Abstract

High and persistent labour informality has been a major problem for Latin American economies where most workers are excluded from social protectionandhave low and variable incomes.In the case of Ecuador and Colombia, despite recent formalisationpolicies, there is still a long way aheadto reduce informality which affects near half of the workforce.This paper seeks to quantifythe role of tax and benefit systems on financial incentives to enter formal work.In order to do so, weassess the formalisationcosts for Ecuadorian and Colombian informal workers using multi-country tax-benefit microsimulation techniques. In particular, we make use of representative microdata and simulate transitions from the informal into the formal sector to calculate the proportion of earnings that will be taxed away in the form of increased taxes andsocial insurance contributionsor reduced cash transfers, when a worker enters formality. We test the sensitivity of our results to different assumptions about the wage level individualswouldface when entering the formal sectorwith several imputation strategies.Our findingsshow that financial costs of formalisation are almost equaltopossible labour income gainsafter a transition to the formal sector. In other words, despite counterfactual formal income is in most of the cases higher than in the informal sector,the design of the tax system, and particularly, of social insurance contributions, erase mostpotential monetary gains of such a transition. This is espe-ciallytrue for self-employment workers.Furthermore, assuming workers self-select into the sector offering a comparative advantage we find even higher formalisations costs.Lastly, taking into account compliance with minimum wage legislation labour income gainsare muchhigher than using only counterfactual estimates, however,formalisation costs do not decrease substantially.