Financing Social Expenditures in Developing Countries: Payroll or Value Added Taxes?

Richard Bird and Michael Smart

International Center for Public Policy Working Paper Series, at AYSPS, GSU from International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University

Abstract: At present most social protection programs in Latin American countries are financed by payroll taxes levied on the formal sector. Increasingly, some countries are both extending some benefits similar to those received from these programs to non-contributors and financing such extensions as well as some benefits for contributors from general revenues, which at the margin in most countries means from the value added tax. In this paper we consider the efficiency of payroll taxes compared to value-added taxes as a way of financing expanded social programs in countries with large informal sectors. To do so, we construct a simple formal model that indicates, in general, that a revenue-neutral move from payroll to value-added taxes will reduce informality and increase wages, output and welfare. While the issue is not a simple one, and the specific conditions in each country need careful consideration, this analysis suggests that in countries with large informal sectors it is probably best to finance incremental expansions of social programs from broad-based taxes like VAT instead of payroll taxes.

Pages: 39 pages
Date: 2012-01-13
New Economics Papers: this item is included in nep-iue and nep-pub
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Citations: View citations in EconPapers (4)

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