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Symposium 2010

Proposal - Incentives to Formal Employment: A Proposal for Colombia

The Challenge

Informality of employment is a way of life throughout the developing world. In poor Sub-Saharan African countries, the informal sector employs the vast majority of the nonagricultural labour force ...

Informality of employment is a way of life throughout the developing world. In poor Sub-Saharan African countries, the informal sector employs the vast majority of the nonagricultural labour force. Informal jobs continue to account for a high share of employment in the middle-income Latin American countries, The global economic crisis is likely to cause a further surge of informal employment because of job losses in the formal sector.

The creation of formal employment is currently the main challenge of economic policy in Colombia. The year 2010 began with unemployment in the double digits and high rates of underemployment and informal employment, which disproportionately affects young people and those with low educational levels.

The current high level of unemployment, underemployment and informal employment in Colombia, rather than a situational phenomenon, is a structural problem. Even during a period of expansive growth, from 2003 to 2007, the unemployment rate remained in the double digits. The 2.5% GDP growth forecast for 2010 is insufficient to avoid a deterioration of current labor market indicators.

To assure the issue of employment receives the attention it deserves, the massive generation of formal work must become the central objective of the Colombian political economy, not the spin-off of another. That is the change of focus we recommend.

Formal employment creation in Colombia is taxed with social security contributions and payroll taxes that equal roughly 60% of the base salary for each worker. On the one hand the employer considers these contributions as true payroll taxes, and on the other the worker does not view them as deferred wages. It is likely that only the provisions for severance pay, transportation allowance, and wardrobe are perceived by workers as a deferred or in-kind salary.

This high payroll tax is the direct result of a decision made with the best of intentions. However, its effect has been to harm the very persons that were intended to benefit from its implementation. In recent years a series of tax exemptions have been adopted aimed at reducing the cost of capital, with the purpose of stimulating investment.

The combination of taxes that raise the cost of work and tax exemptions that reduce the use of capital create a perverse structure of incentives that distort relative cost factors. Economic agents respond to incentives that support them. If public policies promote the substitution of labor for capital, this causes a suboptimal utilization of production factors that do little to encourage the generation of formal employment.

Our proposal is simply to reverse this incentive scheme: to replace the current investment incentives by formal employment incentives. The viability of our proposal that is presented below requires far-reaching political consensus. It is clear there are obstacles to changing current labor structures. We suggest a strategy that overcomes them by maintaining contributions to entities that benefit from payroll taxes, and financing these transfers with fiscal resources that are set aside for promoting investment.

The Fiscal Cost of Investment Incentives

The Ministry of Finance estimates the fiscal cost of granted tax benefits in relation to income tax. In 2008 the estimated fiscal cost from the deduction of 40% of the investment in fixed real assets rises to 3.8 billion pesos. Assuming that the cost is proportional to income subjected to taxes, the 2009 projection of the said cost climbs to 4.4 billion pesos. These numbers can be found the database prepared by “Marco Fiscal of Mediano Plazo” in 2009.

The same source provides information that compares this fiscal cost with the amount of payroll tax businesses pay. For 2009 the estimate of this amount rises to 3.8 billion pesos. This is a rate of 30.2% over basic wages (21.5% of Social Security and 8.6% plus quasi fiscal taxes of 8.6%). The fiscal cost of the deduction for investment is to 116% of the total payroll tax paid by businesses.

These numbers show the magnitude of the fiscal incentive that could lead to the creation of formal employment, if the current deduction on investment is replaced by deduction on payroll tax generated by those new investments. The replacement of the 40% tax deduction on the income of new investment for a 120% tax reduction on the increase of payroll tax would add to the formal economy roughly the same number of informal and unemployed workers to the number of current workers in formal employment.

The Proposal

Our proposal seeks to transform current investment incentives into incentives that bring about formal employment. We propose the real increase in the Wage Bill paid by each company from a base year as the basis for the formal employment incentive.

To calculate this real increase the Wage Bill for the base year is adjusted by the Consumer Price Index. If the tax benefit became applicable in 2010 the calculation would start from the 2009 wage sum adjusted by the increase of the IPC between 2010 and 2009. For 2011 and the following years, the base will be still the same but with an additional year of adjustment of CPI.

To maintain a five year horizon, once five years have passed since the first time the benefit was applied, the base year will be moved to the next year. This means, if the initial base year was 2009, in 2015 that the base year is moved to 2010, following 2011 in 2016, and so on.

The proposal suggests replacing the current investment credit of 40% from Income Tax, for a fiscal credit of 60% of Payroll Tax paid on the real increase in the Wage Bill.

Moreover, it is proposed that 60% of paid payroll tax for workers in the base year not enrolled in social security, because they were inactive, unemployed, or working informally, will be deductible. In this way, if the real increase of the Wage Bill is produced because the company adds staff that in the base year were not registered in social security, it would reduce its income tax 120% from the real increase in the wage sum.

This incentive is less onerous than the current one. It would be the same only if in 5 years the real increase in the Wage Bill is equal to 97% of the Wage Bill in the base year. This would only occur if after five years nearly all the informal economy and the unemployed would have moved into the formal economy.

Acquired Rights

Firms that have acquired rights to fiscal stability and currently enjoy the 40% investment credit to Income Tax would not be forced to comply with the new scheme proposed here. Resultantly, the change should be applicable from here forward and to all other companies, unless those with acquired rights opt for the new regime. It is impossible to calculate what the fiscal effect would be from the continuity of investment incentives.

The new fiscal credit of 120% of the taxes on the increment of real Wage Bill would be the same than the prior investment incentives when the Wage Bill doubles with respect to the base year. Therefore, it is likely the fiscal cost of the two added benefits, while existing together, would not surpass the cost of the investment credit that would be eliminated.

Effect on the Wage Cost

The proposal entails a reduction to the labor cost for all firms in the private sector that generate new formal employment in the order of 24%, if those not incorporated into the formal economy were not registered in social security in the base year. If the new jobs correlate to persons that were working in the formal economy in the base year, the reduction to the labor cost would around 12%.

Fiscal Amnesty

To assure the benefits of this incentive effectively reach businesses that have been operating partially or totally in the informal economy, it would be necessary to grant fiscal amnesty for Payroll Tax, on Value Added Tax and Income Tax that would have been avoided while the worker was a part of the informal economy.

Expected Results

The granting of fiscal incentives attached to increases in Payroll Tax paid by firms should not harm the growth of the economy, because the fiscal incentive granted, as a proportion of value added, is the same. Rather, it should have a positive effect on growth, at least for a period of time, because it should produce efficiency gains due to better allocation of resources.

The effect on employment, at least on formal employment, should be considerable taking into account the reduction of the wage cost for firms lowers significantly, and that businesses will officially receive the benefits from fiscal amnesty towards obligations they have evaded in the past.

The number of firms benefiting from employment incentives would be much greater than the number of firms benefiting from investment incentives. Moreover, the new incentive small and medium businesses that currently are unable to take advantage of investment incentives.

Funds for social security benefits, health, education, and family support that are currently financed with Payroll Tax would benefit with the new incentives due to the increases in tax collection that would be proportional to the increase in formal employment. This is different from the result that would be obtained if instead of changing the basis for granting fiscal incentives, it was decided to decrease the Payroll Tax Rate.

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