Essays on Taxation, Formal Sector Work, and Social Insurance in Mexico

My dissertation is comprised of three essays on taxation, the formal sector, and social insurance in Mexico. In the first chapter, I study the consumption smoothing effects of health insurance in rural Mexico. Major illness is one of the largest and least predictable shocks to the economic wellbeing of families, inducing both high health care expenditures and loss of labor earnings. In rural areas that lack access to financial intermediation, households smooth consumption via informal insurance mechanisms such as selling assets, drawing from savings, and borrowing from friends. However, these coping mechanisms do not provide full consumption insurance. In 2004, the Mexican government introduced one of the largest expansions of public health insurance in the world. The reform extended health insurance coverage to the families of all informal sector workers and significantly decreased out-of-pocket medical expenditures among beneficiaries. I use data from an experimental evaluation of the program to explore the effect of insurance on household financial outcomes. On average, receipt of insurance is associated with an increase in annualized household per capita expenditure of 10.5%. In addition, I find that health insurance offsets illness-induced declines in household consumption by 57.6%.

In the second chapter, I explore how income taxation affects formal and informal labor markets. Many developing countries face constrained tax capacity due to the presence of an informal sector. Informal workers often evade taxation, and governments may choose low tax rates in order to prevent workers from moving to the informal sector, further reducing tax revenue. The extent of distortionary effects on the allocation of labor across sectors depends on the extensive- and intensive-margin labor supply and wage responses to taxation. I estimate the equilibrium effects of taxation on sectoral choice, work hours and wages in Mexico, a developing country with a large informal sector. I exploit uniquely advantageous sources of variation in worker and firm incentives generated by the Mexican tax and trade policies in the 1990s to study these effects. I find that workers are sensitive to income taxation: the elasticity of formal sector participation with respect to relative after-tax income is 0.4 and the elasticity of hours with respect to the net-of-marginal tax rate is 0.08. My results show that 25.1% of sectoral mobility from 1988-2004 is explained by changes in the average tax rate. In addition, equilibrium wages respond to tax-induced changes in the relative supply of imperfectly substitutable labor inputs. A ten percentage point increase in the net-of-average tax rate causes an increase in formal participation of 2.5%, an effect two-thirds the size of that when labor demand is perfectly elastic and wages do not adjust. These wages responses limit the effectiveness of tax instruments designed to encourage formal sector employment, such as a formal sector tax credit.

In the third chapter, I study the optimal income taxation of individuals in settings with a large informal labor market. This study of optimal income taxation brings together the efficiency and distributional considerations associated with taxation in such settings. I model labor supply responses along the intensive margin (intensity of work on the job) and extensive margin (sectoral participation). The concentration of labor supply responsiveness along the sectoral participation margin has important implications for the welfare evaluation of tax policy. I provide carefully calibrated numerical simulations for Mexico to explore how the optimal tax program varies with the government's redistributive preferences, the magnitude of the intensive and extensive elasticities, and government expenditures.