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Abstract
We set out a general equilibrium model for the evaluation of a domestically
financed transfer program, which helps to combine the results from a computable general
equilibrium model with disaggregated household data. We separate the indirect welfare
impact into three components: (1) the redistribution effect arising from the need to
finance programs, (2) the reallocative effect arising from the transfer of resources
between households with different “tax propensities,” and (3) the distortionary effect
arising from the need to use distortionary finance instruments. We show how all these
effects can be usefully subsumed within one parameter, namely, the cost of public funds.
Using a Mexican cash transfer program as an illustration, we use the approach to show
that the substantial welfare gains that result from the switch from universal food subsidies
to targeted cash transfers reflect both the improved targeting efficiency of the latter as
well as a relaxation of the trade-off between equity and efficiency objectives when
designing tax systems. More generally, the indirect costs of finance can be substantially
lowered when such programs are combined with appropriate tax reforms.