Cross-subsidies, and the elasticity of informality to social expenditures

How is the size of the informal sector affected when the distribution of social expenditures across formal and informal workers changes? Given this distribution, how is it affected when the generosity of these transfers changes? We use a search frictions model with informality, (ex post) heterogeneous workers, and conditional taxes and transfers. In the model, formal jobs are "better" than informal jobs, but harder to get. Taxes are proportional to the wage, while transfers are lump sum, implying a cross-subsidy from high-income to low-income workers. As a result, the marginal worker weighs two opposing forces: changes in taxes vs. changes in transfers. We calibrate the model to Mexico and perform counterfactuals. We find that informality is quite inelastic due to frictions, and due to the opposing forces of taxes and transfers.