Evaluating Transfer Programs Within A General Equilibrium Framework

We set out a general equilibrium model for the evaluation of a domestically financed transfer program, which helps to combine the results from a computable general equilibrium model with disaggregated household data. We separate the indirect welfare impact into three components: (1) the redistribution effect arising from the need to finance programs, (2) the reallocative effect arising from the transfer of resources between households with different “tax propensities,” and (3) the distortionary effect arising from the need to use distortionary finance instruments. We show how all these effects can be usefully subsumed within one parameter, namely, the cost of public funds. Using a Mexican cash transfer program as an illustration, we use the approach to show that the substantial welfare gains that result from the switch from universal food subsidies to targeted cash transfers reflect both the improved targeting efficiency of the latter as well as a relaxation of the trade-off between equity and efficiency objectives when designing tax systems. More generally, the indirect costs of finance can be substantially lowered when such programs are combined with appropriate tax reforms.