Social protection has emerged as a key policy instrument to alleviate poverty and vulnerability in many developing countries. It has evolved into different forms of mechanisms in terms of focus and targeting population, coverage and scope, and ways of mobilization and utilization of resources. The main mechanism of social protection relies on the redistribution and the use of social services and assets. However, the financing of social protection remains a key constraint in developing countries. Efforts to improve revenue mobilization (e.g. tax capacity) face the informal sector which drives a large part of the economy and which escapes taxation.
We develop a life-cycle model to relate optimal taxation and social protection in the context of informality. Individuals consume a good and offer jobs either in the formal or in the informal sector, and face idiosyncratic shocks that characterize their types. The payoffs from arbitrage between public and private social protections are evaluated and the optimal contribution is derived accounting for moral hazard. We derive two main theoretical results: i) Welfare gain from taxation is obtained using the ousting of private contributions (elasticity of public taxation with respect to private contribution) and the covariance between marginal utility and wage. Therefore, the government should take on any social protection, both formal and informal, and this involves formalizing fully the informal sector. ii) Next, we consider the situation of adverse selection, i.e. there are private information about individuals’ abilities and public information on these skills. Optimal taxation is given in terms of transition probabilities and the aforementioned variables. We show that, even without government intervention, the informal sector can ensure optimal protection. These findings offer rich policy strategies regarding taxation and redistribution in developing countries.