Social Policy, Informality and Economic Growth in Mexico Good intentions Bad outcomes Santiago Levy Inter-American Development Bank India Policy Forum 2008, NCAER New Delhi, 14-16th July, 2008.

Outline Workers and social programs Formality and informality Mobility of workers in the labor market Social programs, welfare and productivity Productivity and illegal firms Investment and growth under informality

Workers and Social Programs

Social programs and labor status Types of firms’ relationships with workers Non-salaried Salaried Legal implications No non-wage costs of labor non-wage costs of at least 35% In Mexico’s institutional framework social security is a right of salaried workers only (having a boss and being paid a wage). All firms hiring salaried workers have to enroll them in social security regardless of income level. On the other hand, non-salaried workers have access to various social protection programs. Non-salaried workers can be self-employed or be in a non-wage contractual arrangement with firms.

Social security for salaried workers 1. Benefits are bundled [ ]. Its costs are: Tf = [health insurance retirement pensions disability pensions life insurance work-risk pensions day care centers housing loans….] 2. Workers value benefits at less than costs. Valuations depend on workers’ preferences, access and quality of services, and so on. Let denote the value to the worker of social security benefits. The utility of a salaried job is then: 3. Benefits are paid out of wage-based contributions by firms and workers and are at least 35% of the wage.

Social protection for non-salaried workers 1. Benefits are unbundled [+]. Its costs are: Ti = [health insurance + retirement pensions + housing loans + day care centers + …]. 2. Workers may also value benefits at less than their costs, so that . Hence, the utility of a non-salaried job is: 3. Benefits are paid from general revenues and are conditional on being informal.

Formality and informality

Social programs create a formal-informal dichotomy. The informal sector is heterogeneous, partly legal and partly illegal. The formal sector is homogeneous and all legal. Formal workers  salaried and registered with IMSS; legal. Informal workers  (i) salaried and non-registered, illegal. (ii) comisionistas and self-employed; legal. Formal firms  hiring salaried workers and registered with IMSS; legal. Informal firms  (i) hiring non-salaried workers (i.e., comisionista); legal. (ii) hiring salaried workers but not registered with IMSS; illegal. Formality is defined with respect to the “governance structure that applies to salaried labor”, not with respect to the income level of workers or the size of firms, or urban or rural location.

Distortions in labor costs There are two wedges: one between the costs to firms and the benefits to workers in salaried labor; and non-salaried labor. However, both act in the same direction: taxing salaried employment and subsidizing non-salaried employment.

Composition of the labor force, 2006 Informal employment has a legal and an illegal component.

Mobility of workers in the labor market

Workers mobility: IMSS registries 1) Large data base with 9.2 million registries of the “1997 generation” that records formal and non-formal status during 10 years along with age, gender and wage. 2) Enlarged data base with 26 million registries of the “1997-2006” generations. I follow one generation’s entry and exit into formality for a decade. I then compare 1997-2006 worker flows vs. job flows.

1997 generation: average permanence

Frequency of mobility: high wage Relative frequencies of entry and exit, high wage workers (by years of permanence, 1997 – 2006)

Frequency of mobility: low wage Relative Frequencies of Entry and Exit, Low Wage Workers (by years of permanence, 1997 – 2006) Compared to high wage workers, low wage workers enter more often into formality. The problem is not entering formality; the problem is that, for whatever reasons, low wage workers enter and exit more than high wage workers.

1997-2006 generation: worker flows vs. job flows Evolution of Total IMSS-Registered Employment, 1997-2006 In millions of workers 1) In the period July 1, 1997 to July 1, 2006 26,742,308 million individuals were registered at IMSS. But in the same period, average formal employment was 11.6 million on average. 2) From July 1, 1998 to June 30, 2006 17,463,035 individuals entered IMSS, or 1.94 million each year on average. However, each year on average only 0.418 million net jobs were created.

With formal-informal mobility: ignoring preferences for work based on hierarchy, flexibility and innate abilities, the labor market is best described by: But from the point of view of firms the situation is different. Those hiring salaried labor pay for social security; the rest do not. So, (cost of formal labor) / (cost of informal labor)….. This ratio exceeds one; it is probably around 1.5. Note that it increases with resources channeled to social protection programs.

Social programs, welfare and productivity

The Labor Market without Social Programs

The Labor Market with Incomplete Valuation of Social Security Unless social security is fully valued by workers, it acts as a tax on salaried employment. Note that social security contributions are paid by all workers.

The Labor Market with Social Security and Social Protection Social protection programs act like a subsidy to non-salaried employment.

Productivity and illegal firms

INEGI vs. IMSS Registries of Workers and Firms, 2003 Size   INEGI IMSS Difference (1) (2) (1) - (2) (number of workers) number of firms workers from to 2 2,118,138 3,011,902 350,459 488,727 1,767,679 2,523,175 3 5 581,262 2,078,023 183,432 686,515 397,830 1,391,508 6 10 153,891 1,135,021 95,886 725,253 58,005 409,768 11 15 47,601 604,387 38,855 494,430 8,746 109,957 16 20 24,361 433,741 21,342 379,795 3,019 53,946 21 30 25,171 627,011 22,399 556,830 2,772 70,181 31 50 20,927 812,729 19,125 743,225 1,802 69,504 51 100 16,100 1,135,608 15,337 1,077,909 763 57,699 101 250 10,898 1,683,740 10,526 1,629,298 372 54,442 251 500 4,029 1,379,532 3,804 1,314,357 225 65,175 501 more 2,636 3,199,628 2,626 3,082,169 117,459 Total 3,005,014 16,101,322 763,791 11,178,508 2,241,223 4,922,814 Approximately 75% of all firms in Mexico are illegal; this excludes activities in the streets and rural areas. Only 1.1% of all firms have more than 50 employees.

Share of Illegality by Firms Size Illegal Employment Illegal Firms Illegality is inversely correlated with firm size.

Firms’ demand for labor under illegality 1. Firms chose optimally between legal and illegal workers 2. The probability of being fined depends on size and proportion 3. For some ranges of employment firms mix legal and illegal workers

Illegality, Firms’ Size and the Marginal Costs of Salaried Labor Firms endogenously divide between being formal, informal or mixed (hiring a mix of workers).

Legal status matters for productivity: Firms equate the expected MCL to them to the MPL. Ui = Uj is consistent with MPLi <>MPLj. With labor mobility worker’s utilities are equalized, not productivities. Some firms only hire illegal workers, some mix legal and illegal, and some only legal. The MPL is different in each case ranging from wif to (wf + Tf). Thus, workers with similar abilities have different productivities.

for Male Kernel-Matched Salaried Workers, 2005-2006 Wage Rate Means in Formal-Informal Transits for Male Kernel-Matched Salaried Workers, 2005-2006 (number of workers and hourly wage rates in pesos of 2007) The average wage of low wage workers who move between sectors is not statistically different. This suggests that the difference in the MPL of similar unskilled workers is about 35% between the formal and the informal sector.

Productivity growth is more difficult under informality Fanjzylber et al. (2006) show that less than 10% of micro and small firms receive credit or participate in labor training programs in Mexico. Lopez-Acevedo and Tan (2006) show that small and micro firms in Mexico are between one fifth and one sixth less likely than large firms to invest in worker’s training. Lopez-Acevedo (2006) finds that small firms in Mexico are substantially less likely to adopt new technology than large firms.

Investment and growth under informality

Investment Options in New or Existing Firms Informality impacts the allocation of investment.

Impact of social programs on the profitability of investment options Increased social protection programs increase the relative private profitability of investments in the informal sector where the productivity of labor is lower.

Social Programs and the Ranking of Rates of Return The change in the profitability of investment projects increases the economy’s incremental capital to output ratio (ICOR). This is independent of distortions in the market for credit.

Informality and growth, at least three effects: 1) For a given volume of savings the ICOR is higher as investment is tilted towards informal firms and low productivity jobs. 2) Only Lf workers are forced to save (14 million) for retirement, and (Lif + Li = 28 million) are not. Effects here depend on the substitution between forced and voluntary savings (and the impact on savings of non-contributory pensions). 3) There is less public investment. Under informality Mexico is probably saving less and investing in less efficient projects. Informality acts like a drag on output and productivity growth.

Concluding remarks: Social programs have effects on firms and workers. Mexico imposes a large tax on labor in the formal sector and uses fiscal resources to subsidize informal employment and investments in small informal and mostly illegal firms and pays for this with a mix of oil rents and reduced public investment. Informality contributes to Mexico’s low growth/low productivity situation. Reforming this is complex as it is associated with the link between social programs, political legitimacy and the government’s ability to tax. Thank you