The effect of payroll taxes on production and labor productivity : theoretical and empirical model for a developing economy

We use firm-level data to evaluate the effect of payroll taxes on production and labor productivity. By introducing a theoretical framework which combine distinctive elements of the “efficiency wages” theory with standard developments of production theory, we derive analytical forms to compute the effect of payroll taxes on production and labor productivity. We make this computation for a wide range of tax tariffs, but in particular, we are interested on the productivity gains of the sizeable reduction of payroll taxes introduced by the 2012 Colombian tax reform, which implied a reduction of 13.5 pp in total payroll taxes rate. Our results of the theoretical model show a negative relationship of both product and labor productivity with payroll taxes, suggesting that this type of legislation could affect the productive performance of firms. Moreover, our empirical results show great within-firms gains in terms of product and labor productivity from the reduction in payroll taxes established in the tax reform. In addition, our results show possible gains at the aggregate TFP level associated with a between-firms efficient re-allocation effect among firms.