The effect of trade liberalization on payroll tax evasion and labor informality

Several developing countries that underwent trade liberalization experienced changes in the share of informal workers in manufacturing industries. This phenomenon deserves careful examination because informal jobs are not only generally viewed as low-quality and low-paying jobs, they also account for more than 30% of the workforce in some countries. In this paper, I develop a theoretical model of the impacts of trade liberalization on labor markets in which domestic and foreign import tariffs affect firms’ payroll tax compliance decisions, which in turn determine the types of jobs (i.e., formal or informal) created. The model is able to replicate several stylized facts such as some small firms hiring formal and informal workers and large firms hiring only formal workers. Moreover, it predicts that a decrease in domestic import tariffs decreases both the share of informal workers and the average formal wage, whereas a decrease in foreign (i.e., trading partner) import tariffs decreases the informality share but increases the average formal wage. The effect on the average informal wage is ambiguous.