Age-Dependent Taxation in Emerging Markets: A Quantitative Assessment

We study the design, short- and long-run implications of a major reform that sub¬stitutes the pay-as-you-go social security system and the personal income tax scheme, with a simplified age-dependent tax schedule, in the context of an emerging market. Our model features overlapping generations, rich heterogeneity among households and informal labor markets, where informality and unemployment are modeled as exclusion mechanisms. We show that the optimal reform triggers a welfare gain of 6.1% measured in compensated equivalent variations, and that most of such gain is explained by a significant wealth effect triggered by the reform. In the short run, however, the reform produces a 12.8% welfare loss mainly explained by the migra¬tion from a pay-as-you-go social security schedule to a system of private accounts, in which older cohorts during the transition are the ones more affected. The pres¬ence of informality in the labor market, moreover, is key to explain the redistributive consequences of the reform.