IZA DP No. 11995: Pareto-Improving Structural Reforms
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 isoelastic, 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 involved 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.