VAT Reform in a Developing Country. A CGE Model with an Informal Sector

I develop a computable general equilibrium model that quantifies the redistributive effects and the efficiency gains of broadening the base of the Value Added Tax (VAT) by removing the zero-rating of food. I incorporate an informal retail sector in the supply of goods with two distinctive features: an indirect tax on the informal retail sector and a productivity gap between the formal and informal retail sectors. In the model the efficiency effect of the reform not only depends on the correction of the price distortion between food and the rest of the goods, induced by the zero-rate on food, but also on the changes of the average productivity of the retail sector. The size of the effect is determined by the indirect tax on the informal sector and by household's elasticity of substitution between purchases in the formal and informal sector. I calibrate the model for Mexico and I simulate a revenue-neutral harmonization of the VAT. The results show that the efficiency gains from uniform taxation are partially offset by a reallocation of resources to the less productive informal sector. The reform has a regressive effect despite the incorporation of the informal sector as low income households can not fully avoid the tax by buying food in the informal sector.