Good intentionsGood intentions

Bad outcomesBad outcomes

Social Policy, Informality and Economic Social Policy, Informality and Economic Growth in MexicoGrowth in Mexico

Santiago LevySantiago LevyInter-American Inter-American

Development BankDevelopment BankIndia Policy Forum 2008, NCAERIndia Policy Forum 2008, NCAER New Delhi, 14-16th July, 2008New Delhi, 14-16th July, 2008.

2

OutlineOutline

• 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

3

Workers and Social Programs

4

Social programs and labor statusSocial programs and labor status

Types of firms’ relationships with workersTypes of firms’ relationships with workersTypes of firms’ relationships with workersTypes of firms’ relationships with workers

• In Mexico’s institutional framework In Mexico’s institutional framework social securitysocial security is a right of is a right of salaried workerssalaried workers only (having a boss and being paid a wage). All only (having a boss and being paid a wage). All firms hiring salaried workers have to enroll them in social security firms hiring salaried workers have to enroll them in social security regardless of income level. regardless of income level.

• On the other hand, On the other hand, non-salaried workersnon-salaried workers have access to various have access to various social protectionsocial protection programs. Non-salaried workers can be self- programs. Non-salaried workers can be self-employed or be in a non-wage contractual arrangement with firms.employed or be in a non-wage contractual arrangement with firms.

Non-salariedNon-salaried SalariedSalaried

No non-wage No non-wage costs of laborcosts of labor

non-wage costs non-wage costs of at least 35%of at least 35%

Legal implicationsLegal implications

5

Social security Social security forfor salaried workers salaried workers

1. 1. Benefits are bundled [ ]. Its costs are:Benefits are bundled [ ]. Its costs are:

Tf = [health insurance retirement pensions disability pensions life insurance work-risk

pensions day care centers housing loans….]

2. 2. Workers value benefits at less than costs.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. 3. Benefits are paid out of wage-based contributions by Benefits are paid out of wage-based contributions by firms and workers and are at least 35% of the wage.firms and workers and are at least 35% of the wage.

f

[0,1]

f f f fU w T

6

Social protectionSocial protection forfor non-salaried workersnon-salaried workers

11. . Benefits are unbundled [+]. Its costs areBenefits 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 2. Workers may also value benefits at less than their costs, so thatcosts, so that .

Hence, the utility of a non-salaried job is:

33. Benefits are paid from general revenues and are Benefits are paid from general revenues and are conditional on being informal.conditional on being informal.

[0,1]i

i i i iU w T

7

Formality and informality

8

Social programs create a formal-informal dichotomy.Social programs create a formal-informal dichotomy.

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.

The The informal informal sector is heterogeneous, sector is heterogeneous, partly legal partly legal andand partly illegal partly illegal..

The The formalformal sector is homogeneous and sector is homogeneous and all legalall legal..

Formality is defined with respect to the “governance structure that applies to 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 salaried labor”, not with respect to the income level of workers or the size of firms, or urban or rural locationfirms, or urban or rural location..

9

Distortions in labor costsDistortions in labor costs

Total Costs and Benefits of Salaried and Non-Salaried Labor Salaried labor Non-salaried labor Costs to firms

f fw T iw

Benefits to workers f f fw T i i iw T

There are two wedges:

•one between the costs to firms and the benefits to workers in salaried labor; and

•one between the costs to firms and the benefits to workers in non-salaried labor.

However, both act in the same direction: taxing salaried employment and subsidizing non-salaried employmenttaxing salaried employment and subsidizing non-salaried employment.

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Composition of the labor force, 2006Composition of the labor force, 2006

Formal38%

Informal58%

Salaried57%

Non-salaried40%

Unemployed 4%

Informal employment has a legal and an illegal component.

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Mobility of workers in the labor market

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WorkersWorkers mobility: IMSS registries 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.

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1997 generation: average permanence1997 generation: average permanence

9.35.9

19.5

0.0

7.8

5.5

13.8

2.4

6.7

4.4

10.7

3.9

6.6

4.7

8.9

5.3

6.4

4.9

7.3

6.4

6.4

4.8

6.4

7.5

6.6

4.9

5.7

8.8

7.3

5.4

5.4

10.9

9.7

8.0

6.1

15.2

33.2

51.6

16.2

39.5

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

All Always high Always low Low/high

10

9

8

7

6

5

4

3

2

1

6.7 7.7 4.9 8

Weighted average permanence (years):

Years enrolled:

6.7 7.7 4.9 8 Years enrolled:

9,279,273 workers 2,320,389 workers 3,707,089 workers 3,251,795 workers

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Frequency of mobility: high wageFrequency of mobility: high wage

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

Years in formal employment f(1) f(2) f(3) f(4) f(5) f(6) f(7) f(8) F(9) f(10) Total

1 - 5.918 - - - - - - - - 5.9182 - 4.921 0.088 - - - - - - - 5.4543 - 3.581 0.155 0.577 0.025 0.043 - - - - 4.384 - 3.771 0.21 0.577 0.065 0.076 0.007 0.004 - - 4.7115 - 3.764 0.325 0.57 0.111 0.089 0.019 0.007 0.001 0.0 4.8876 - 3.398 0.488 0.548 0.19 0.088 0.035 0.006 0.002 - 4.7547 - 3.137 0.795 0.51 0.326 0.063 0.048 - - - 4.8798 - 2.872 1.513 0.438 0.554 - - - - - 5.3769 - 3.34 4.705 - - - - - - - 8.04610 51.596 - - - - - - - - - 51.596

10016.9930.013 0.003 0.01.466 0.635 0.215 0.076

Weighted average 5.16 6.94 2.484

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Frequency of mobility: low wageFrequency of mobility: low wage

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.

Years in formal employment f(1) f(2) f(3) f(4) f(5) f(6) f(7) f(8) f(9) f(10) Total

1 - 19.51 - - - - - - - - 19.512 - 9.782 0.499 3.567 - - - - - - 13.8483 - 6.203 0.575 3.004 0.273 0.612 - - - - 10.6674 - 4.71 0.618 2.288 0.421 0.697 0.085 0.073 - - 8.8935 - 3.421 0.694 1.801 0.541 0.578 0.158 0.082 0.012 0.0 7.296 - 2.78 0.825 1.373 0.677 0.444 0.204 0.05 0.016 - 6.3697 - 2.234 1.102 1.07 0.858 0.258 0.192 - - - 5.7158 - 1.88 1.736 0.757 1.071 - - - - - 5.4439 - 1.887 4.167 - - - - - - - 6.05410 16.211 - - - - - - - - 16.211

10024.8250.447 0.164 0.026 0.0

Weighted average 1.621 10.482 3.065 5.544 1.921 1.554

Relative Frequencies of Entry and Exit, Low Wage Workers(by years of permanence, 1997 – 2006)

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1997-2006 generation: worker flows vs. job flows 1997-2006 generation: worker flows vs. job flows

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.

Permanence 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006Enrollment

1997 9.279 7.445 6.348 5.608 4.957 4.421 3.978 3.623 3.331 3.0841998 - 10.474 8.171 6.962 6.011 5.279 4.699 4.247 3.883 3.5801999 - - 11.104 8.726 7.279 6.264 5.504 4.931 4.479 4.1102000 - - - 11.864 9.060 7.530 6.489 5.743 5.172 4.7172001 - - - - 11.928 9.163 7.659 6.666 5.938 5.3752002 - - - - - 11.847 9.208 7.794 6.834 6.1262003 - - - - - - 11.852 9.357 7.986 7.0552004 - - - - - - - 12.102 9.630 8.2872005 - - - - - - - - 12.409 9.9932006 - - - - - - - - - 13.049

Evolution of Total IMSS-Registered Employment, 1997-2006 In millions of workers

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With formal-informal mobility:With formal-informal mobility:

wi + i iT = wf + f fT

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 differentBut 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.

( ) /( )f f f f f i iw T w T T

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Social programs, welfare and productivity

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The Labor Market without Social ProgramsThe Labor Market without Social Programs

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The Labor Market with Incomplete Valuation The Labor Market with Incomplete Valuation of Social Securityof Social Security

Unless social security is fully valued by workers, it acts as a tax on Unless social security is fully valued by workers, it acts as a tax on salaried employment. Note that social security contributions are salaried employment. Note that social security contributions are paid by paid by allall workers. workers.

wi*

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The Labor Market with Social Security and The Labor Market with Social Security and Social ProtectionSocial Protection

Social protection programs act like a subsidy to non-salaried Social protection programs act like a subsidy to non-salaried employment.employment.

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Productivity and illegal firms

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INEGI vs. IMSS Registries of Workers and Firms, INEGI vs. IMSS Registries of Workers and Firms, 20032003

Approximately 75% of all firms in Mexico are illegal;Approximately 75% of all firms in Mexico are illegal; this excludes this excludes activities in the streets and rural areas.activities in the streets and rural areas. Only 1.1% of all firms have more Only 1.1% of all firms have more than 50 employees.than 50 employees.

Size   INEGI   IMSS   Difference (1) (2) (1) - (2)

(number of workers)

number of firms

workersnumbe

r of firms

workersnumber of firms

workers

from to

0 22,118,13

83,011,90

2 350,459 488,7271,767,67

92,523,1

75

3 5 581,2622,078,02

3 183,432 686,515 397,8301,391,5

08

6 10 153,8911,135,02

1 95,886 725,253 58,005 409,76811 15 47,601 604,387 38,855 494,430 8,746 109,95716 20 24,361 433,741 21,342 379,795 3,019 53,94621 30 25,171 627,011 22,399 556,830 2,772 70,18131 50 20,927 812,729 19,125 743,225 1,802 69,504

51 100 16,1001,135,60

8 15,3371,077,90

9 763 57,699

101 250 10,8981,683,74

0 10,5261,629,29

8 372 54,442

251 500 4,0291,379,53

2 3,8041,314,35

7 225 65,175

501 more 2,6363,199,62

8 2,6263,082,16

9 10 117,459

Total  3,005,0

1416,101,

322  763,79

111,178,

508  2,241,2

234,922,8

14

24

0

10

20

30

40

50

60

70

80

90

100

0 to 2

3 to 5

6 to 10

11 to 15

16 to 20

21 to 30

31 to 50

51 to 100

101 to 250

251 to 500

501 and more

83.8

3.7

Firm size (number of workers)

%

Share of Illegality by Firms SizeShare of Illegality by Firms Size

Illegal FirmsIllegal Employment

Illegality is inversely correlated with firm size.Illegality is inversely correlated with firm size.

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Firms’ demand for labor under illegalityFirms’ demand for labor under illegality

Max ( , ) [ ,( )] ( ) [ ( , ) ]wf if f f if f f f if f if ifL L p Q K L L w T L w L L F L

= 0 for ( )f ifL L [0, L] (A8.2) ( , )f ifL L = 1 2( , ) ( , )f if f ifL L L L for ( )f ifL L [L, L-] = 1 for ( )f ifL L [L-, ]

Lf

D 1 2/ [( ) ( / / ). . ]wf f f f f ifp Q QL w T L L F L

(A8.5) Lif

D 1 2/ [ ( , ) ( / / ). . ]wif if f if if if ifp Q QL w L L F L L F L

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

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Illegality, Firms’ Size and the Marginal Costs of Salaried LaborIllegality, Firms’ Size and the Marginal Costs of Salaried Labor

wif

Fully illegal and informal

L

Registered with IMSS but mix of formal and infor-

mal workers

Registered with IMSS and all formal workers

L1 L2 L3

wf + Tf

MCL

D1s

D2s

D3s

A

B

C

Firms endogenously divide between being formal, informal or Firms endogenously divide between being formal, informal or mixed (hiring a mix of workers).mixed (hiring a mix of workers).

27

Legal status matters for productivity: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 workers with similar abilities have different productivitiesproductivities.

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

Mean wage difference

Treated Control Treated Control Counter- (did move) (did move) factual

(similar to treated but did not move)#

Low wage 154 1,280 1,434 15.85 16.22 15.97 0.02 0.892 0.024High wage 98 2,178 2,276 44.61 49.91 43.43 6.33 2.884 2.196**

Low wage 234 605 839 15.79 13.84 14.16 1.04 0.218 0.858 High wage 142 143 285 41.58 40.16 45.26 4.03 1.295 1.295

(did not move) (did not move)

Informal to formal

(change in treated minus

change in counter-factual) T-stat

Total

Formal to informal

Workers Wage

Standard error

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Productivity growth is more difficult Productivity growth is more difficult under informalityunder 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.

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Investment and growth Investment and growth

under informalityunder informality

31

Investment Options in New or Existing FirmsInvestment Options in New or Existing Firms

InformalityInformality impacts the allocation of investment.

Option

Output level in 1

Formal-informal status

workers firms

A

1

1 1 1( , )a a aQ Q K L 1

aL 1 aL L all informal

the existing informal firm grows but remains informal

B

1 ( , )b b b bQ Q I L

bL all informal a new informal firm is created

C

1

1 1 1( , )c c cQ Q K L

1cL 1 cL L

mix of formal and informal

the informal firm turns formal but does not register all workers

D

2

1 1 1( , )d d dQ Q K L 1

dL = 2 dL L informal converted to formal and new formal hired

the existing formal firm previously cheating turns fully legal

E

3

1 1 1( , )e e eQ Q K L 1

eL = 3 eL L all formal

the existing formal and fully legal firm expands

F

1 ( , )f f f fQ Q I L

fL all formal a new formal and fully legal firm is created

32

Impact of social programs on the profitability of Impact of social programs on the profitability of investment optionsinvestment options

Social Programs and Rates of Return on Investment Options Social program/

Investment option

Tf

f

Ti

i

A: expand and stay informal + - + + B: create new informal firm + - + + C: register and mix workers - + - - D: become fully legal - + - - E: expand fully legal - + - - F: create new fully legal firm - + - -

Increased social protection programs increase the relative private profitability of investments in the

informal sector where the productivity of labor is lower.

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Social Programs and the Ranking of Rates of ReturnSocial Programs and the Ranking of Rates of Return

The change in the profitability of investment projects The change in the profitability of investment projects increases the economy’s increases the economy’s incremental capital to output incremental capital to output ratioratio (ICOR). This is independent of distortions in the (ICOR). This is independent of distortions in the market for credit.market for credit.

Social programs Rankings of rates of return

privately unprofitable r* privately profitable Case 1: [[ 1, 0]f iT

r1

1, r12,---------------------------- , r*,-------------------------------------, r

1N

Case 2: [[ 1, 0]f iT

formal informal r2

1, r22,---------------------------- , r*,-------------------------------------, r

2N

34

Informality and growth, at least three Informality and growth, at least three effects: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 Under informality Mexico is probably saving less and investing in less efficient projects. Informality and investing in less efficient projects. Informality acts like a drag on output and productivity growth. acts like a drag on output and productivity growth.

35

Concluding remarks:Concluding remarks:

• Social programs have effects on firms and workers. Social programs have effects on firms and workers.

• Mexico imposes a large tax on labor in the formal Mexico imposes a large tax on labor in the formal sector sector andand uses fiscal resources to subsidize informal uses fiscal resources to subsidize informal employment and investments in small informal and employment and investments in small informal and mostly illegal firms mostly illegal firms andand pays for this with a mix of oil pays for this with a mix of oil rents and reduced public investment.rents and reduced public investment.

• Informality contributes to Mexico’s low growth/low Informality contributes to Mexico’s low growth/low productivity situation. Reforming this is complex as itproductivity situation. Reforming this is complex as it

is associated with theis associated with the link between social programs, link between social programs, political legitimacy and the government’s ability to tax.political legitimacy and the government’s ability to tax.

Thank youThank you