Reforms of Mexico’s tax, labor and social insurance policies are essential to accelerate economic growth and increase social inclusion, a study by the Inter-American Development Bank shows.

Under-Rewarded Efforts: The Elusive Quest for Prosperity in Mexico is a groundbreaking analysis of millions of firms using census data going back two decades to reveal bottlenecks that stifle Mexico’s growth rate – which averaged just 1.2 percent between 1996 and 2015 on a per capita basis, well below many of its Latin American peers and far behind fast-growing Asian economies.

“Mexico’s economic performance is a paradox,” said Santiago Levy, the book’s author and IDB Vice-President for Sectors and Knowledge. “No country in Latin America has made greater efforts to integrate into the world economy. Mexico has been prudent in managing its economy and has invested heavily in education, yet it is one of the slowest-growing economies in the region. The question is, why? We found that the answer lies in the microeconomic realm, in productivity-stifling policies and institutions that impact how firms and workers interact.”

The misallocation problem

The book argues that persistent misallocation of resources is the main explanation behind Mexico’s stagnating productivity and, consequently, of its poor growth. Under misallocation, unproductive firms survive while productive firms die or fail to grow. Workers are not matched with firms where their abilities are used, like the paradigmatic engineer driving a taxi.

Put another way, without misallocation, the same individuals with the same education and abilities, working the same number of hours, investing the same amounts of money, and with access to the same technologies, would produce more and Mexico would grow faster, the report says.

The book looks at the relationship between the high degree of informality in the Mexican economy and productivity. The informal sector is not just street vendors and small companies. It encompasses over 90 percent of all firms and 55 percent of all employment and is pervasive across many activities. Informal firms are on average 50 percent less productive than formal ones, but because of misallocation, both coexist in the market. The book documents that despite many reforms, informal firms in Mexico have grown more than the formal ones, capturing a larger share of investment and employment.

The book also finds that, contrary to widespread belief, none of this is caused by a lack of education. The quantity and quality of education in Mexico has improved. On the contrary, the existence of so many informal firms despite large advances in education depresses wages of all workers, but especially those of skilled ones. Nor is misallocation caused by insufficient infrastructure: in fact, firm informality in the Mexico City area -the region with the best infrastructure and access to financial services—is no different than in the rest of the country.

Policy solutions

The book identifies a multitude of reasons that explain the misallocation, grouped around policies that regulate taxes, social insurance and labor protection. These policies fail to protect workers effectively but end up taxing the high productivity sector of the economy and subsidizing the low-productivity segment, exactly the opposite of what is required to create good jobs.

The study argues that the most effective way to increase growth and productivity, and to enhance social inclusion, is to reform the policies and institutions that underpin misallocation. The book proposes, among other measures, replacing the current array of social and transfer programs with a single system of social insurance for all, replacing severance pay and dismissal regulations with proper unemployment insurance, eliminating exemptions to the value-added tax (while compensating low-income households for lost income), lowering payroll taxes, and increasing the autonomy of judicial institutions in charge of contract enforcement.

“Many proposals have been put forth to accelerate growth in Mexico, from investing more in infrastructure to improving education,” said Levy. “These proposals are positive but, as things stand today, the efforts invested in them will continue to be under-rewarded. So long as the policies and institutions that stand behind misallocation persist, Mexico will continue to grow slowly and fail to create the productive jobs required for a prosperous country. A policy shift is required to ensure that growth with social inclusion translates from political rhetoric into measured outcomes.”