Exit, but mostly exclusion: Policy options for reducing the size of Mexico’s informal economy

Abstract

Fifty-nine percent of all workers in Mexico labor in the informal economy, which is defined in this thesis as any economic arrangement or transaction that is not regulated or taxed, but would otherwise be legal. While many scholars and policymakers argue that the informal economy is a seedbed of entrepreneurship that should be harnessed for growth, Mexico’s current administration has pledged to reduce informality, which currently produces about 30 percent of the country’s Gross Domestic Product. President Enrique Peña Nieto points out that informal workers neither contribute to nor benefit from social security programs, and that informal firms are inherently less productive than formal ones, stunting the country’s economic development. Furthermore, informality deprives the government of much-needed tax revenue, and given that the recent energy reform package will almost certainly reduce the state-owned oil company’s profits, expanding Mexico’s paltry tax base is crucial. This thesis seeks to determine the root causes of informality in Mexico and provide policymakers with an evaluation of which tools could successfully reduce the size of the informal economy, and which could backfire. This evaluation is framed within the context of the debate over whether exit or exclusion from the formal economy is the principal driver of informality. I use a qualitative analysis of Mexico’s economic history and the composition of Mexico’s informal economy today to evaluate ways in which escape and exclusion have contributed to informality. I demonstrate that throughout Mexican economic history, a series of crises and policies favoring capital-intensive growth rather than labor-intensive growth resulted in the formal economy’s failure to absorb a growing labor pool. With data from the World Bank and Mexico’s National Institute of Statistics and Geography (INEGI), I then quantitatively analyze the impact of the ease of doing business and the level of economic development on informality in 16 Latin American countries and the 32 Mexican federal entities. I find through a series of regressions that the cost of doing business and the level of economic development both have significant effects on the size of a country’s or state’s informal economy, but that the impact of the level of economic development is more significant, particularly within Mexico itself. Based on these results, I argue that Peña Nieto would be remiss not to include deregulatory tools in a package to combat informality, and that deregulation should focus on reducing the costs of registering property and obtaining construction permits in the Federal District. Nevertheless, the results show that deregulation alone would not make a significant dent in the size of the informal economy, and if the administration is serious about reducing informality it must couple deregulatory policies with direct formalization campaigns, macro-level stimulus, or both. I suggest gradual formalization followed by strict enforcement to incorporate Mexico City’s street vendors into the social security pool and the tax base, and labor-intensive stimulus in the poor, agricultural southeast to create formal jobs where few currently exist.