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

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  • Alonso-Ortiz Jorge
  • Leal-Ordoñez Julio C.

Abstract

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.

Suggested Citation

  • Alonso-Ortiz Jorge & Leal-Ordoñez Julio C., 2014. "Cross-subsidies, and the elasticity of informality to social expenditures," Working Papers 2014-26, Banco de México.
  • Handle: RePEc:bdm:wpaper:2014-26
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    Cited by:

    1. Leyva, Gustavo & Urrutia, Carlos, 2020. "Informality, labor regulation, and the business cycle," Journal of International Economics, Elsevier, vol. 126(C).
    2. Alberola, Enrique & Urrutia, Carlos, 2020. "Does informality facilitate inflation stability?," Journal of Development Economics, Elsevier, vol. 146(C).

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    More about this item

    Keywords

    Informality; elasticity of informality; social expenditures; cross-subsidies; taxes and transfers; search frictions;
    All these keywords.

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • J6 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers
    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • J46 - Labor and Demographic Economics - - Particular Labor Markets - - - Informal Labor Market

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