Development Lunch: The Cost of Informality: An Optimal Taxation Approach

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Submitted by Brandon Eltiste on September 01, 2020
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Tuesday, September 22, 2020 - 12:30
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Felipe Lobel, Economics

What is the cost of informality? On the one hand, an informal sector restricts the policies that can be implemented, on the other, it is an important alternative for those who cannot cope with the costs of formal markets. Using data from Brazilian PNAD (Pesquisa Nacional por Amostra de Domicílios) encompassing earnings of both formal and informal workers we recover the joint distribution of productivities in both sectors and formalization costs which rationalize the level of participation in both sectors. We then evaluate the welfare consequences of eliminating the informal sector while retaining those costs. Using a simple progressivity preserving reform to rebate taxes to agents, we derive the distribution of welfare gains and losses in such counterfactual world. Next a revealed social preferences approach is used to asses the objective underlying the design of Brazilian’s actual tax system. Given the social objective recovered from the data counterfactual exercises are performed to assess the full potential gain from eliminating the informal sector.