Taxation, Informality, and Labor Market Responses: What Do We Really Know?

Gustavo Canavire Bacarreza (), Susana Herrero-Olarte () and Yeon Soo Kim ()
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Gustavo Canavire Bacarreza: World Bank
Susana Herrero-Olarte: Universidad de Barcelona
Yeon Soo Kim: World Bank
Authors registered in the RePEc Author Service: Gustavo Javier Canavire-Bacarreza

No 18449, IZA Discussion Papers from IZA Network @ LISER

Abstract: This paper critically reviews the empirical and structural literature on the effects of income taxation on informal economic activity. Although labor taxation has been widely studied for labor market outcomes, evidence linking income taxes to informality remains fragmented and uneven across countries. Synthesizing findings from both developed and developing economies, the review finds that income taxes have limited effects on formal employment but significant impacts on labor informality, particularly in contexts with weak enforcement, fragile institutions, and highly vulnerable labor markets. Estimated elasticities of informality with respect to income taxation generally range between 3 and 5 percent, averaging around 3.5 percent. The literature, however, is skewed toward high-income countries and relies mainly on reduced-form empirical approaches, limiting understanding of behavioral responses, long-term dynamics, and institutional heterogeneity. Standard theoretical models, grounded in labor supply frameworks, often fail to treat informality as an endogenous margin under weak compliance and regulatory capacity. Consequently, studies may overstate revenue gains and understate distributional impacts.

Keywords: income taxation; labor informality; developing economies; behavioral responses; labor markets; fiscal policy; critical review (search for similar items in EconPapers)
JEL-codes: H22 H24 H26 J08 J21 J46 O17 (search for similar items in EconPapers)
Date: 2026-03
New Economics Papers: this item is included in nep-inv, nep-iue, nep-pbe and nep-pub
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