Who Benefits from Payroll Tax Cuts? Market Power, Tax Incidence and Efficiency

Abstract: This paper focuses on the role of market power to study a historically large payroll tax cut that affects a subset of Brazilian firms. Difference-in-differences estimates based on plausibly exogenous legal variation indicate that the payroll tax reduction causes an increase in employment, wages, and profits, while capital decreases. Responses are substantially more pronounced among small firms, which are estimated to possess less market power. Two-thirds of the employment effect arises from plant size expansion and one-third from input substitution. Reduced-form estimates reveal that consumers pay 75% of payroll taxes, firm owners 11%, and workers 14%. Estimates of a monopsonistically competitive model of factor demand suggest that a targeted alternative tax policy focusing on small firms could amplify the efficiency gains of the tax cut by 36% and enhance workers' welfare gains by 95%. These results establish that market power not only mitigates the distortionary costs of taxation but also redistributes the tax burden from workers to firm owners and consumers.