the share of productivity paid to employees in the formal sector. On the other hand, the increase in the consumption tax reduces the disposable wage. However, this moderation is proportional to the weight of the unemployment benets in the wage: as it is weak for workers in the formal sector, this wage moderation induced by the increase of the consumption tax is of small amplitude for the formal sector. The rst channel clearly dominates and leads to wage increases in the formal sector after the tax reform.

Given that the search eort is endogenous, the tax reform also changes workers' reservation wage. Indeed, the cut in payroll taxes stimulates rms to open new vacancies in the formal sector, which in turn increases the chance for unemployed agents to nd a job in the formal sector. The optimistic job prospect in the formal sector encourages unemployed to focus their search eorts more on this sector. Hence, search eorts increase in the formal sector and decline in the informal sector (see Figure 3, red dotted lines). Overall, the tax reform ultimately redirects the labor force toward formal employment.<sup>21</sup> Figure 3 shows that, following the tax reform, unemployment increases on impact and in the short-run. The underlying reason is that benets from trade liberalization are gradual, while the tax reform is immediate: given the lack of attractiveness of the informal sector, search eorts devoted to nd a job in the informal sector before the implementation of the tax reform now decrease, leading to an increase of unemployment in the short run (see Figure 3, red dotted lines). At the beginning of the trade liberalization process, the marginal value of intermediate goods and workers' productivity, although higher, are not large enough to absorb the excess of unemployed workers who stop searching for an informal job. This explains why unemployment increases on impact and in the short-term especially in the emerging country, which is characterized by higher incidence of informality. To sum up, we observe that a tax reform switching the tax burden from payroll taxes to the VAT supports labor formality. Overall, output and economic eciency improve as the share of formality increases by 1 percentage point. However, as shown in Figure 4, these gains in formalization come at the cost of widening inequality between formal and informal workers. Our model estimates that the wage gap will rise from 65.7 to 69.2 percent in the advanced economy and from 10.6 to 14.4 percent in the emerging economy. Widening inequality may be attributed to the specic design of this tax reform, since the VAT has traditionally deemed to be regressive and hence harmful to equity. However, more recently some commentators and especially international organizations have pointed out that the VAT is not necessarily bad for redistribution. For instance, the distributional consequences of a tax reform switching the tax burden on the VAT have to be assessed in the perspective of the whole tax-spending system, of which the VAT is just one part (OECD (2010)). The VAT can still be progressive, if VAT revenues are used to nance benets targeted for poorer households. Notwithstanding these caveats, the empirical evidence (albeit limited) for a few

> 21Similar conclusions are drawn in Antón (2014) who analyzes the eects of the 2012 tax reform in Colombia. He suggests that the reform would increase total employment by between 0.3 to 0.5 percent and formal employment by between 3.4 to 3.7 percent over the pre-reform scenario. In Brazil, tax cuts for small rms introduced by the reforms in 1996 and 2006 have led more than 9 millions of businesses into the formal sector.

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