Working Papers

 Optimal Income Taxation with a Large Informal Sector

In this paper, I explore the optimal income taxation of individuals in settings with a large informal labor market. The informal sector, estimated to be around one-third of the world economy, limits tax capacity in two important ways. First, most informal workers do not pay taxes and thus taxation is limited to formal workers. For example, only 60% of income tax revenue is collected in Mexico because of high income tax evasion, a rate that is average among similarly developed countries. Second, governments may choose low tax rates in order to prevent workers from moving to the informal sector, further narrowing the tax base. The extent of distortionary effects on the allocation of labor across sectors depends on the extensive- and intensive-margin labor supply responses to taxation. In addition to these behavioral responses, there are distributional implications associated with tax reform. Though there is a substantial literature that studies optimal income taxation in the context of developed countries, the corresponding evidence for developing countries is extremely limited. In fact, there is no micro-based study that considers the optimal income taxation problem in such settings. In this paper, I incorporate the behavioral responses and distributional effects associated with taxation to study optimal income tax policy. I provide carefully calibrated numerical simulations for Mexico to explore how the optimal tax program varies with the government’s redistributive preferences, the magnitude of the intensive and extensive elasticities, and government expenditures.

The Equilibrium Effects of Income Taxation on Formal and Informal Labor Markets

Many developing countries face constrained tax capacity due to the presence of an informal sector. Informal workers often evade taxation, and governments may choose low tax rates in order to prevent workers from moving to the informal sector, further reducing tax revenue. The extent of distortionary effects on the allocation of labor across sectors depends on the extensive- and intensive-margin labor supply and wage responses to taxation. I estimate the equilibrium effects of taxation on sectoral choice, work hours and wages in Mexico, a developing country with a large informal sector. I exploit uniquely advantageous sources of variation in worker and firm incentives generated by the Mexican tax and trade policies in the 1990s to study these effects. I find that workers are sensitive to income taxation: the elasticity of formal sector participation with respect to relative after-tax income is 0.4 and the elasticity of hours with respect to the net-of-marginal tax rate is 0.08. On average, 25.1% of sectoral mobility, from 1988-2004, is explained by changes in the average tax rate. In addition, equilibrium wages respond to tax-induced changes in the relative supply of imperfectly substitutable labor inputs. A ten percentage point increase in the net-of-average tax rate causes an increase in formal participation of 2.5%, an effect two-thirds the size of that when labor demand is perfectly elastic and wages do not adjust. These wages responses limit the effectiveness of tax instruments designed to encourage formal sector employment, such as a formal sector tax credit.

The Consumption Smoothing Effects of Health Insurance

In this paper, I study the consumption smoothing effects of health insurance in rural Mexico. Major illness is one of the largest and least predictable shocks to the economic wellbeing of families, inducing both high health care expenditures and loss of labor earnings. In rural areas that lack access to financial intermediation, households smooth consumption via informal insurance mechanisms such as selling assets, drawing from savings, and borrowing from friends. However, these coping mechanisms do not provide full consumption insurance. In 2004, the Mexican government introduced one of the largest expansions of public health insurance in the world. The reform extended health insurance coverage to the families of all informal sector workers and significantly decreased out-of-pocket medical expenditures among beneficiaries. I use data from an experimental evaluation of the program to explore the effect of insurance on household financial outcomes. On average, receipt of insurance is associated with an increase in annualized household per capita expenditure of 10.5%. In addition, I find that health insurance offsets illness-induced declines in household consumption by 57.6%.

Social Insurance and Electoral Behavior: Redistribution and Clientelism in Mexico (with Elizabeth Kaknes)

Does the provision of social insurance affect electoral outcomes in developing countries? Recent studies by Zucco (2012) and De La O (2012) show that receipt of conditional cash transfers increases the propensity to vote for incumbent presidents who promulgate such policies. However, it is unclear if this finding generalizes to other types of social programs with less individualized targeting regimes. Using a fixed effects estimation strategy, we test the degree to which provision of Mexico’s social insurance program, Seguro Popular en Salud, increases the propensity to vote for the incumbent political party, the PAN. To isolate the mechanisms through which provision affects support for incumbents, we estimate the differential effects of social insurance provision by per-capita beneficiaries and baseline political support for incumbents. Our analysis suggests that the effects of health insurance provision on voting behavior are more complicated than these prior papers let on. Specifically, it seems that the PAN’s attempt to inculcate new, and drastically different, socio-economic groups into its voting base did not work entirely to their benefit in the larger scope of the election. Indeed, while it may be true that recipients vote in larger numbers for the incumbent, perhaps erstwhile supporters—in the case of the PAN, middle- and upper-class Mexicans- punish the PAN by either not voting, or voting against them. Either way, the results of our analysis suggest that the PAN’s bold attempt to win the loyalties of unaffiliated voters, and incorporate disparate elements of Mexican society into their core of support had unintended effects, we suggest here the disengagement of their pre-existing core.

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