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

In the quest to alleviate the lack of protection of an important group in the population, social programs directed to informal workers are being introduced in developing countries. How is the size of the informal sector affected when the distribution across formal and informal workers and/or the generosity of social transfers change? The nature of many tax and transfer systems imply a cross subsidy from high-income to low-income workers. Thus, depending on the wage of the worker, the transfers tied to formal jobs could be bigger, equal, or smaller than the taxes paid. The effects of changes in taxes and transfers greatly depend on which of the three situations above is the one prevailing for the marginal worker. In this paper, we use a search frictions model with an informal sector, heterogeneous workers, and conditional taxes and transfers to address this question. In the model formal sector jobs are tied to larger benefits, and are less risky, but harder to get. We calibrate the model to the Mexican economy and perform a number of counter-factuals. We find that the size of the informal sector is quite inelastic to marginal changes in the generosity of transfers due to the presence of two opposing forces on the marginal worker: more taxes vs. more transfers. In comparison, the informal sector is more elastic to changes in the distribution of transfers because only one force is present in this case. Our results are consistent with the novel empirical evidence found in Almeida and Carneiro (2012) for Brazil, and with the evidence found in Azuara and Marinescu (2013) on the effects of Seguro Popular in Mexico.