We find that the existence of a large informal sector with high
inequality has an important implication for fiscal policy. Labor income tax has a significant redistribution effect among informal
(poor) and formal (rich) workers that is most preferred in terms of
social welfare. By contrast, if the informal sector can no longer
avoid income tax, capital income tax will be most preferred.
This study contributes to the literature that analyzes health/
social insurance and government fiscal policy issues while
considering effects on both individuals and the aggregate economy,
as pioneered by Auerbach and Kotlikoff (1987). Among the recent
studies, the study byAttanasio et al. (2010)is similar to the current
study. These authors analyze the effect of population aging on
financing Medicare, a public health insurance program covering the
elderly in the US. As most studies in this literature have focused on
the US and other developed countries, the current paper studies the