Social Welfare and Productivity underSocial Welfare and Productivity underUniversal Social Rights in MexicoUniversal Social Rights in Mexico

Santiago Levy,Santiago Levy,Inter-American Development Bank.Inter-American Development Bank.

2

BackgroundBackground 1.) In Levy (2008) I argue that two aspects of social policy need to

be considered simultaneously:

• its impact on social indicators properly (how effectively are workers protected against risks, how effectively is income being redistributed, and so on); and,

• its impact on incentives to workers and firms along dimensions that affect productivity and growth.

2.) Here I review the key arguments with a focus on the productivity aspect, and then present work-in-progress for a proposal to extend universal social rights to workers.

3.) I argue that this allows Mexico to escape from its present dilemma and increase equity and productivity.

4.) This issue is also relevant to poverty and the “post-CCT” discussion.

3

Labor market implications of social programs Labor market implications of social programs

(1 )f fT

Econometric estimates suggest that for unskilled workers:

Tax on salaried labor = 26% of the formal wage rate

Subsidy to non-salaried labor = 8% of the informal wage rate

•The total tax-cum-subsidy to salaried vs. non-salaried unskilled labor implicit in Mexico’s social programs is in the order of 34%. This: (i) generates differences in the MPL between workers of similar characteristics and abilities, and (ii) distorts firms’ behavior along dimensions that hurt productivity (evasion and allocation of capital).

•On the other hand, evidence shows that the minimum wage in Mexico is not binding, and that there are barriers to entry only into a small sub-set of formal jobs, mostly in the public sector and some in very few private firms with monopoly power. There is very high formal-informal mobility.

i iT

(1 )f fT

Salaried labor Non-salaried labor

Costs to firms w f + T f w i

Benefits to workers w f + b f T f w i + b i T i

Total costs and benefits of salaried and non-salaried labor

4

Illegal behavior: evasion of regulations on Illegal behavior: evasion of regulations on salaried labor salaried labor

• When workers and firms hiring salaried employees have incentives to evade the Law.

• Firms pay fines of F > Tf if they are caught evading.

• Enforcement may be imperfect and there is a probability of being fined, ,

which is an increasing function of the level of evasion.

• Evasion creates salaried workers without social security, Lif, receiving a wage wif that compensates them for not receiving social security benefits.

Although the illegal act is committed by the firm, both firms and workers may benefit from evasion. As a result of it, not all salaried

workers are formal.

[0,1]

1f

5

Minimum structure of the problem:Minimum structure of the problem:• Firms hiring salaried workers maximize profits mixing Lf and Lif

• Firms engaging with non-salaried workers maximize profits

• Workers maximize utility and all are employed

informal employment

salaried employment

Note: The equilibrium probability of being fined, , is determined endogenously along with wage rates [wf*, wi*, wif*] and employment levels [Lf*, Li*, Lif*]

( ) / [ (1 ) ] 0wf f if f f f fp Q L L L w T

( ) / [ ( ( ) / ). . ] 0wf f if if if if if ifp Q L L L w F L L F L

( ); ' 0ifL

/ 0wi i ip Q L w

( ) ( )i i i if i iw T w T ( ) ( )if i i f f fw T w T

i if fL L L L

*(.)

6

(1-βf ) Tf Lf = De facto taxes paid on

formal labor

≈ 2.4% of GDP

θf Tf Lf = Subsidies to formal labor

≈ 0.6% of GDP

(Lif + Li )Ti = Subsidies paid to informal labor

≈ 2% of GDP(of which 0.65% of GDP are subsidies to workers

hired illegally)

This is the distribution of Mexico’s non-public labor force in 2006.

Observed labor allocations and wage rates in Mexico reflect Observed labor allocations and wage rates in Mexico reflect large tax-cum-subsidies associated with social policylarge tax-cum-subsidies associated with social policy

7

Policy needs an integrated view of social programsPolicy needs an integrated view of social programs

Tf Ti

Lf- + + - -

Li+ - - + +

Lif+ - - + +

wf+ - - + +

wi- + + - -

wif- + + - -

It is essential to go beyond the effects of individual programs (components of Tf or of Ti) and consider their interaction.

Note that so the gap in marginal products increase with Ti.

One can show that but

so that the government is caught in a dilemma.

ff i

(1 )f i f f i i f fMPL MPL T T T

/ 0iTFP T / / 0f i i iU T U T

8

Firms have large incentives to engage in illegal Firms have large incentives to engage in illegal behavior…..behavior…..

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

Depending on production technologies (particularly capital indivisibilities) firms may find it profitable to be fully legal, semi-legal or fully illegal. The distribution of firms across legal status is endogenous to social programs.

Steel or auto productionare not profitable at small scales(relative to ), andtherefore firms arealways formal; but manyactivities in light manufacturing,services, commerceand transportation are.These are “informalityprone” activities.

(.)

9

…… …… which matters a lot for productivitywhich matters a lot for productivity

• firms mixing legal and illegal workers face increasing MCL so producing more output is more costly than for fully legal or fully illegal firms;

• goods that are close substitutes or even the same goods are produced by firms

of various sizes, with similar workers having different productivities.

As a result:

(i) the marginal productivity of salaried labor ranges from a low of wif to a high of (wf + Tf), so that there is a continuum of labor productivities;

(i) the average of the marginal productivities of labor depends on the distribution of salaried workers across firms and on the size distribution of firms. The greater the proportion of workers employed in illegal or semi-illegal firms the lower is this average, and because the level of illegality of firms is inversely correlated with their size (measured by number of workers), the greater the proportion of micro and small firms, the lower is the average.

10

INEGI vs. IMSS registries of workers and firms, 2003INEGI vs. IMSS registries of workers and firms, 2003

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

(number of workers) number of

firms workers number of firms workers number of

firms workersfrom to

0 2 2,118,138 3,011,902 350,459 488,727 1,767,679 2,523,1753 5 581,262 2,078,023 183,432 686,515 397,830 1,391,5086 10 153,891 1,135,021 95,886 725,253 58,005 409,768

11 15 47,601 604,387 38,855 494,430 8,746 109,95716 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 69,50451 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 54,442251 500 4,029 1,379,532 3,804 1,314,357 225 65,175501 more 2,636 3,199,628 2,626 3,082,169 10 117,459

Total 3,005,014 16,101,322 763,791 11,178,508 2,241,223 4,922,814

Arguably 75% of all firms in Mexico are illegal; this excludes economicactivity in the streets and in rural areas. Considering firms with 6 or moreworkers, this share drops to 25%.

11

On average, TFP is positively correlated with On average, TFP is positively correlated with firm sizefirm size

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Productivity relative to the average sector. Average sector=1.

[0-10]-Mx'04 [11-100]-Mx'04

[101-500]-Mx'04 [+500]-Mx'04

All manufacturing establishmentscaptured in the

2004economic

Census(fixed premises)

Source: IDB Productivity Flagship (2009).

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Weighted Productivity relative to the average sector. Average sector=1.

[0-10] [11-100]

[101-500] [+500]

12

Average TFP is a function of the size distribution of Average TFP is a function of the size distribution of firms. The very large number of small firms is a cause firms. The very large number of small firms is a cause of loss of TFP. of loss of TFP.

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Weighted Productivity relative to the average sector. Average sector=1.

[0-10] [11-100]

[101-500] [+500]

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Weighted Productivity relative to the average sector. Average sector=1.

[0-10] [11-100]

[101-500] [+500]

Plant size (# workers) # Plants % Plants # Workers

% Workers

0-10 298,678 90.8 762,103 18.111-100 23,610 7.3 708,766 16.9101-500 5,006 1.5 1,104,901 26.3500+ 1,424 0.5 1,622,809 38.6Total 328,718 100 4,198,579 100

13

TFP dispersion in Mexico is much higher than in the US. If TFP dispersion in Mexico is much higher than in the US. If dispersion in Mexico was the same as in US, TFP in dispersion in Mexico was the same as in US, TFP in manufacturing would increase by 36%.manufacturing would increase by 36%.

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Productivity relative to the average sector. Average sector=1.

México 2004 EE.UU. 1997

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Productivity relative to the average sector. Average sector=1.

Mexico 2004 US 1997Similar comparisons for servicesand retail commerce are notavailable, but gains would bepresumably larger sincedispersion of TFP in thesesectors is larger than inmanufacturing.

Difference 90/10 percentile (in logs)

Manufacturing 3.89 times Retail Commerce 4.90 times Services 4.15 times

Distribution of Mexico's Occupied Labor Force, 2003

1% in 51 or more

1% in 11-50

18% in 51 or more

10% Public workers1% in rural areas

16% in rural areas

3% in more than 5

3% in more than 5

15% in 2 to 5

12% alone

1% in 0 to 2 6% in 0 to 22% in 3 to 5

3% in 3 to 5 2% in 6 to 10

1% in 6 to 10

5% in 11 to 50

Total: 40.6 million

The Census Data fails to capture workers in urban areas that carry out activities outside a fixed establishment. Excluding public workers, about 45% of all urban workers are in this category……(and are at times missed in econometric analysis).

Dark Light

Informal Formal

Blue + Red= urbanGreen= rural

15

Can Social Policy Increase Welfare Can Social Policy Increase Welfare and Growth?and Growth?

16

Policy needs to begin by recognizing that the Policy needs to begin by recognizing that the government is trappedgovernment is trapped

• The institutional distinction between the rights of salaried and non-salaried workers creates a formal-informal dichotomy;

• From the social point of view, the government cannot leave workers excluded from social security without protection against social risks;

• However, the instruments used do not really solve the social problem (contribution densities to pensions are low, workers are only protected against some risks when they are formal, and so on), while at the same time deepen the reasons that account for bad firms and bad jobs, low productivity and low growth;

• In parallel, the government de facto subsidies illegal behavior, and undermines the tax base and the Rule of Law (as Lif workers cannot be left without social benefits).

17

The policy challenge has two parts:The policy challenge has two parts:

• From the social point of view, to insure that all workers are protected all the time against the relevant social risks regardless of whether they are salaried, self-employed, or comisionistas;

• From the economic point of view, to provide benefits with programs that by-pass the distortions in the allocation of labor and capital and place the economy on a higher growth path with faster increases in labor productivity.

• It is essential to focus on both objectives

SIMULTANEOUSLY.

(A big problem in Mexico is “piece-meal” policymaking.)

18

Proposal for universal social entitlementsProposal for universal social entitlements

Simple idea: provide all workers with (almost) the same bundle of social benefits; make these benefits a legal entitlements; and fund all these benefits with a consumption tax earmarked for these benefits.

Key point: Firms and workers cannot avoid this tax by changing status between salaried and non-salaried employment, so:

– no taxes on firm growth;– no subsidies to self-employment;– no subsidies to small illegal firms;– no reasons to change the duration of labor contracts or disguise salaried employment relationships as non-salaried;– distortions in the allocation of capital and labor coming from social programs are (practically) eliminated.

Observation: The result would be the same as if all workers were salaried and social security contributions were fully enforced. But since there are efficient reasons for non-salaried employment, and enforcement will never be perfect, universal social security will never be reached under the formal-informal dichotomy.

19

Social security contributions (A) vs. consumption taxes (B)Social security contributions (A) vs. consumption taxes (B)

If all workers were salaried, and if there was no evasion, and if consumption taxes could be ear-marked to pay for social security benefits, then social security contributions and consumption taxes would be equivalent.

20

Social Policy: Status-Quo vs. Core ProposalSocial Policy: Status-Quo vs. Core Proposal

[... ... ... ... ...]

[... ... ...]

/ [ (1 ) ] 0

/ [ ' ] 0

/ 0

[ ( )]

f

i

f f f f f

f if if if

i i i

f f f if i i i i i

f if i

ns os f f f i if i c

T

T

Q L w T

Q L w F FL

Q L w

w T w T w T

L L L L

G G T L T L L R R OR

Status-Quo Core Proposal

*

* *

* *

[... ... ...]

/ 0

/ 0

( )

f f f

i i i

f i

f i

ns os f i c c

T

Q L w

Q L w

w T w T

L L L

G G T L L R R R OR

T* is the bundle of social benefits that the government considers that all workers should have (see below), and is worker’s valuation of that bundle; R*c reflects those consumption taxes that are specifically earmarked to pay for universal social benefits and that result from higher consumption tax rates, so that: T*(Lf + Li) = R*c.

21

Workers’ utility: status quo vs. core proposal Workers’ utility: status quo vs. core proposal withoutwithout redistribution redistribution

Status quo Core proposal

Worker’s utility

Government’s budget

SQ SQf f f f cU w T t

SQ SQi i i i cU w T t

* * * ( )f c cU w T t t * * * ( )i i c cU w T t t

( ) [ ( )]SQ SQ SQc f f f i i ift L T L T L L *( )c ct t L T L

Under the core proposal the government’s objectives are fulfilled with all workersbut worker’s utility may or not be higher.

* * *( ) ( )SQ SQf f f f f f cU U w w T T t

+ ? -

22

Workers’ utility: status quo vs. core proposal Workers’ utility: status quo vs. core proposal withwith redistribution redistribution

Status quo Core proposal

Worker’s utility

Government’s budget

SQ SQf f f f cU w T t

SQ SQi i i i cU w T t

* * * *( )f f c cU w T t t s

* * * *( )i i c cU w T t t s

( ) [ ( )]SQ SQ SQw f f f i i ift L T L T L L * *( ) ( )c ct t L T s L

To achieve both the objective of changing the composition of all worker’sconsumption and increasing the level of some worker’s consumption you needtwo instruments. The proposal is to Slutsky-compensate (or more) a subset ofworkers with direct income transfers, choosing s* such that:

* * * *( ) ( ) 0SQ SQf f f f f f cU U w w T T t s

23

How much would universal entitlements cost?

Estimated Net Fiscal Costs of Universal Social Entitlements(millions of pesos of 2007)

Workers and Governmentfirms contributions contributions

Total 14.1million workers

Total 41.4million

workers

1. Health insurance2. Retirement pensions3. Life and disability Insurance

90,275 39,154 58,681 18,932

23,177 0

129,42977,61323,177

375,344184,56154,896

Gross total Less: resourcesalready in budget Net total (% of 2007 GDP)

172,133 58,086 230,219614,801218,586396,215

(4.3)

t*c = 4.3% GDP But was 2.7% and now is 0, so net t*c = 1.6% GDP

The proposal implies increasing the VAT and (almost) eliminating labor taxes: a large change in the composition of taxation from labor to consumption.

(1 )f f fT L

24

Social security and social protection Social security and social protection programs impact the budget on both sidesprograms impact the budget on both sides Resources for social security and social protection programs for active workers

• It is important to separate social spending on social security and social protection programs as defined from other social spending.

• As Ti increases there are more pressures on the budget, since incentives to firm’s illegal behavior are higher (and profit taxes lower), while the number of informal workers receiving free social benefits increases.

• The question is how the reform changes the budget constraint of the government as output levels and the incentives to evade change .

(..) [ (..) (..)] (..) (..)ns os f f f i i if cG G T L T L L R R OR

Resources for education, targeted poverty programs,

and other socialspending.

Consumptiontaxes depend on real wagesand evasion ofVAT

Profit taxesdepend on thenumber of firmsthat are formal andevasion behavior

25

Structure of benefits Observations1. Income transferss* same amount all workers Workers in households up to the third decile

receive a net income transfer

2. Re-design of social security

T* = [health insurance retirement pensions Bundled protection for all workers for these risks

life insurance disability insurance]

Tf Tf* = [work-risk insurance unemployment Salaried workers get additional protection for insurance (extra retirement pensions?)] risks specific to salaried work

Other = [housing loans + day care centers benefits + sports and cultural facilities] These benefits are not legal entitlements

Labor Market Firms hiring salaried workers pay for Tf*

( 4%)

Non-salaried workers do not get Tf*

Wage-based benefits distort only if ; note

that Tf* contains only monetary benefits, so

Full de-linking and full un-bundling is not desirableFull de-linking and full un-bundling is not desirable

*/ ( ) 0f f f fQ L w T

/ 0i i iQ L w

* * * *f f f iw T T w T

* 1f

Note: This scheme allows for a two-pillar retirement pension system (only when workers are salaried-employed), by including a retirement pension component in Tf*.

* 1f

26

A Digression: The VAT in MexicoA Digression: The VAT in Mexico

27

Note that:Note that:• In 2006 VAT revenues in Mexico were only 4.2% of GDP, with

an average VAT rate of around 8% because of many exemptions on food, medicines and the like justified on redistributive grounds;

• The proposal takes advantage of Mexico’s extremely high unequal distribution of income and consumption: out of every peso of additional revenues from VAT only 10 cents are required to Slutsky-compensate the first two deciles and 27 cents the first five deciles (Davila and Levy, 2003);

• The proposal implies setting a VAT rate of 15% with no exceptions, and compensating all workers with a direct income transfer that leaves households in the first two deciles of the distribution with the same real income as before.

28

The distribution of consumption is very The distribution of consumption is very skewed in Mexicoskewed in Mexico

0

10

20

30

40

50

60

70

80

90

100

20 40 60 80 100% share of households

% s

hare

of m

onet

ary

cons

umpt

ion

31.915.010.98.24.9

70.9% of GDP

45.021.115.411.56.9

100% consumption

The poorest four deciles account for less than 18% of all consumption, while the richestfour deciles represent more than 66%, according to the 2006 income-expenditure survey.

29

The VAT is a good instrument to raise revenues in Mexico. The VAT is a good instrument to raise revenues in Mexico. The proposal is to tax all goods at the same 15% rateThe proposal is to tax all goods at the same 15% rate

2.741.401.050.800.48

6.5% del PIB

010002000300040005000

6000700080009000

1000011000

20 40 60 80 100Percentile of households

Add

ition

al c

onsu

mpt

ion

taxe

s (p

esos

per

mon

th)

Only 7.3% of the additional revenues would come from the first two deciles, and 20% from the first four deciles, while the richest four deciles would pay 64%.

30

Additional VAT collections are fully returned Additional VAT collections are fully returned to workers at the level of the second decile to workers at the level of the second decile

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

11000

10 20 30 40 50 60 70 80 90 100

Percentiles de los hogares

Impu

esto

adi

cion

al a

l con

sum

o (p

esos

por

mes

)

Beneficios sociales universales adicionales 4.2% del PIB*

Transferencia Monetaria por compensación 2.3% del PIB**

Recaudación adicional del IVA 6.5% del PIB

-2.74-1.40-1.05-0.80-0.48+0.44+0.46+0.47+0.46+0.48+0.74+0.85+0.87+0.84+0.89

-1.36+0.2+0.29+0.50+0.89

-6.5+2.3+4.2

-0.0

* Equivalente a 800 pesos mensuales por trabajador** Equivalente a 435 pesos mensuales por trabajador

31

Redistributive impactRedistributive impact

I (más pobre) 6.9 7.3 8.2II 11.5 11.8 12.3III 15.4 15.5 15.8IV 21.1 21.1 21.0V (más rico) 45.0 44.3 42.7Total 100.0 100.0 100.0Coef. Gini 0.459 0.448 0.429Indice Theil 0.390 0.371 0.340

Quintil AntesAfter transfers

por compensación

para beneficios socialesQuintile Before Compensation Social Benefits

After

(Poorest)

(Richest)

32

A note on productivity and povertyA note on productivity and poverty

• This line of work is relevant to the “post CCT” discussion.

• In Levy (2008) I argue that and that and show that this helps to explain this puzzle:

– why, if most poor workers have no assets other than their labor, they end up in informal jobs, when the expectation would be that they should have formal jobs?

• There is an incentive-compatibility problem between Progresa, on one hand, and social protection and social security programs, on the other.

P NPf f P NP

i i

33

a ) L P+1 = L P

– R P + L P – L P,NP

+ L NP,P

b) L NP+1 = L NP

– R NP + L NP + L P,NP

- LNP,P

Poor workers futurecapabilities

Incentives to firms andworkers

Outcomes in the labormarket

Progresa -Oportunidades subsidizes the demand for health and education

of poor children and youngsters

Social security and social protection programs distort firm’s and workers decisions in the labor market

fP <

fNP ; i

P > iNP

T i

P > T iNP ; T f

P = T fNP

U fP = U i

P

U f

NP = U iNP

but

MPL f > MPL i

and

(L fP /L P) < (L f

NP /L NP )

c) L f +1 = L f – R f + L f – L f,i + L i,f

d) L i+1 = L i – R i + L i + L f,i - L i,f

Progresa cannot fix the problems created by the formal-informal dichotomy. Raising benefits in Progresa indefinitely cannot substitute for a job with higher labor productivity. And raising Ti to increase the welfare of poor workers in a context of stagnant real wages makes the productivity problem worse.

34

Work in progress (my KCP):Work in progress (my KCP):

• Study the incentives to evade VAT under the proposal, comparing a VAT reform on its own with a (VAT + social) reform;

• Study firms’ incentives to evade income taxes, again in the two scenarios;

• Study an unemployment insurance that has lower efficiency costs than the current system of severance pay and improves benefits to workers; and,

• Consider the productivity and the social welfare side at the same time, but think of all these themes as “pieces of a puzzle” and not in isolation.

Thank you.