Working Paper: CEPR ID: DP13353
Authors: Gilles Saint-Paul
Abstract: Economists recommend to partly redistribute gains to losers from a structural reform, which in many cases may be required for making the reform politically viable. However, taxation is distortionary. Then, it is unclear that compensatory transfers can support a Pareto-improving reform. This paper provides sufficient conditions for this to occur, despite tax distortions. I consider an economy where workers have sector-specific skills and some sectors are regulated by a price floor. Transfers have to be financed by proportional taxation on firm's revenues or, equivalently, labor income. Labor supply is elastic to net post-tax real wages, and hence reduced by taxation. In a setting where preferences are isolelastic, deregulation is implementable in a Pareto-improving way through compensatory lump-sum transfers, despite that these are financed by distortionary taxes. In a more general setting, there always exist Pareto-improving reforms but they may involve tightening regulation for some goods. I provide sufficient conditions for deregulation, i.e. a general reduction in price floors, to be Pareto-improving. They imply that demand cross-price elasticities should not be too large and that the reform should not be too unbalanced. Finally, I consider counter-examples where some people earn rents associated with informational or institutional frictions. In such situations, Pareto improvements are unlikely. If losers have veto power, the reform may only be supported by a minority of people. Broadening reform scope is especially useful to raise its political support when its impact is uneven across consumers.
Keywords: structural reform; deregulation; price controls; Pareto optimality; rent seeking; taxation; compensatory transfers
JEL Codes: E64; H21; P11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Structural reforms (E69) | Pareto improvement (D61) |
| Taxation (H20) | welfare losses (D69) |
| Compensatory lump-sum transfers (H23) | offset welfare losses (D69) |
| Deregulation (L51) | reduction in price floors (D41) |
| Reduction in price floors (D41) | efficient allocation of resources (D61) |
| efficient allocation of resources (D61) | aggregate gains (E10) |
| Compensatory transfers (H23) | Pareto improvement (D61) |
| Informational or institutional frictions (D89) | hinder Pareto improvements (D61) |
| Losers' veto power (D72) | hinder reforms (D72) |