Inequality, Informality, and Optimal Progressivity

How should governments tax labor income when workers can shift into untaxed informal work? Combining Latin American household surveys with a heterogeneous-agent model of search, savings, and sectoral labor supply, we quantify the effects of progressivity in Mexico. Welfare-maximizing progressivity is over six times the current level, as gains from formalization among low earners initially outweigh the costs of evasion among high earners. The reform raises steady-state welfare by 4.3% of consumption and reduces informality by 5.4 percentage points. At equal revenue, progressivity delivers three to four times the welfare gain of higher labor- or capital-tax levels. Greater earnings inequality increases these gains while leaving optimal progressivity nearly unchanged.