Effects of Payroll Taxes on Employment and Wages: Evidence from the Columbian Social Security Reform

In this paper, we assess the effect of higher payroll taxes on employment and wages. We use a panel of manufacturing plants from Colombia to analyze how the sharp rise of 10.5% in payroll tax rates following the Social Security Reform of 1993 affected the labor market. We exploit the time-series and cross-section variation in payroll taxes in Colombia over the 1980’s and 1990’s. Unlike previous studies using cross-section variation in payroll taxes within a country over time, we find partial shifting rather than full shifting of payroll taxes to workers in the form of lower wages. Our estimates indicate that wages fall by about 2% as result of a 10% rise in payroll taxes. Partial shifting in the Colombian context is likely to be the result of weak linkages between benefits and taxes and the presence of downward wage rigidities introduced by a binding minimum wage. The partial shifting of the costs of taxation from employers to employees, implies that equilibrium employment must be affected. This is borne out by our estimations. Our results indicate that a 10% increase in payroll taxes lowers employment by about 4%. In addition, we find greater shifting and smaller effects of payroll taxes on the employment of non-production than of production workers. These results suggest that policies aimed at boosting the relative demand of low-skill workers by reducing social security taxes on those with low earnings may be effective in a country like Colombia, especially if tax cuts are targeted to indirect benefits.