Financing Social Policy in the Presence of Informality

We present a framework for the analysis of tax and benefit policy in countries with significant informality. Our framework allows us to jointly analyse the effects of various taxes and benefits on incentives for firms and workers to be informal and evade taxation. We find that payroll taxes and targeted minimum income guarantees targeted to households without formal employment are particularly harmful to labour formality and participation in the modern sector labour force. Conversely, Bismarkian benefits targeted to formal sector workers and basic benefits targeted to low income households represent the least distortionary way to redistribute. Attempts to use holes in the VAT to “protect” the poor are generally ineffective and open up avenues for rent seeking. We also find that a uniform value added tax and a corporate income tax represent the least distortionary way to raise revenues. The information generated from a simple VAT can be used, given an appropriately designed tax administration, to enhance the probability of detection of informal activities. Distributional issues are best handled by social policy measures and the personal income tax. Indeed, given the gainers and losers from tax reforms, social policies and intergovernmental transfers will be needed to ensure the political acceptance of the reforms. The precise mix of taxation and social policy will vary given different country characteristics and institutional structures