Colombia’s Informal Economy An Analysis of Corporate Taxes and Non-Wage Labour Costs

Abstract

This paper uses a case study approach to explore the causes of the relatively high employment in the informal sector of Colombia’s economy. In particular, Colombia`s corporate taxes and non-wage labour costs are examined as primary causes of the large informal sector. The Economic Motivations theory is used to guide this major research project. The theory states that individuals are rational calculators who weigh the costs and benefits of operating within the formal versus informal sector. Therefore, their decision to enter the formal or informal sectors depends on which option provides the individual or firm with the most benefits. Government policies from comparable countries (Brazil and Ecuador) are examined in this light and reinforce the notion that reducing the costs of entering the formal economy is crucial to the containment of the informal sector. Moreover, evidence from Ecuador suggests that such policies need to be complemented with greater enforcement to ensure that companies follow labour and tax regulations. Based on these findings, it is recommended that Colombia strengthens its tax administration and increase labour and tax inspections on firms to increase the cost of operating informally and generate additional tax revenue. Also, Colombia could gradually reduce its corporate tax rate closer to the revenue maximizing rate with reference to the Laffer Curve theory and decrease non-wage labour costs. We argue that these measures would consequently increase government revenues and economic activity in the long-run. These policies could also be complemented with a minimum wage reform which would allow each Colombian department to set its own minimum wage to better reflect each department`s cost of living and productivity levels. This reform would allow Colombian departments to set the minimum wage at a rate that is much less binding than the current national minimum wage which could reduce unemployment and the size of the informal economy.