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How Labor Informality in Mexico Hinders Socioeconomic Progress

Updated: Feb 22

By Abril Rodriguez Diaz

Approximately sixty percent of Mexico’s labor force are informal workers; that is, they work low-skill jobs that are neither taxed nor monitored by the government. Informal workers are either hired by informal firms, hired illegally by formal firms, or work on their own in professions such as domestic work. Like many other emerging economies, Mexico requires a significant amount of low-skill labor that does not necessitate formal education or training, which is why informal work is common. In fact, the services sector, which includes professions such as domestic work, street vending, and repair services accounts for about two-thirds of labor. Furthermore, even formal firms tend to employ workers informally, since firms can avoid payroll taxes, severance payments, and other costs. Additionally, relaxed enforcement of employment laws by the Secretaría del Trabajo y Previsión Social (STPS) fails to discourage informal employment by these firms.

In recent years, Mexico has seen high and persistent levels of informal employment while experiencing sluggish economic growth. According to the Organisation for Economic Co-operation and Development (OECD), Mexico’s tie to informality hinders its economic growth, and informal sector employment has been demonstrated to be both a direct cause and consequence of low economic productivity. This is demonstrated in Figure 1 from a FORLAC (Programme for the Promotion of Formalization in Latin America and the Caribbean) report, which shows that increased informal employment is associated with decreases in GDP, and vice versa.

Figure 1. Informal employment tends to decline in years of economic growth and increases during crisis periods. After the financial crisis in 2009, the rate of informal employment as a percentage of total employment remained high. (Source: INEGI (2013) via FORLAC)

Although many Mexican workers willingly accept informal work in order to avoid the exigencies of formal employment, research demonstrates that informal employment is significantly more pervasive and pays considerably less. Furthermore, informal workers face more barriers in accessing public education and social programs than any other group. Not only do informal workers lack labor rights and social protection, but also often do not have social security, pension plans, insurance, access to medical care, or benefits such as paid leave. As a result, these workers are particularly vulnerable in circumstances where they find themselves unexpectedly unable to work, such as cases of injury or illness.

Because of these vulnerabilities, in 2020, informal workers throughout Mexico protested the COVID-19 lockdown, and most continued to offer their services throughout the entirety of the pandemic.“If I don’t sell, I don’t eat. It’s as simple as that,” Leonardo Meneses Prado, a hamburger vendor in Mexico City, told The New York Times at the time of the lockdown.

Due to the government’s low levels of public spending, programs including healthcare, education, and public insurance tend to be underfunded, inefficient, and difficult to access, especially for informal workers. Additionally, spending on and coverage of social programs is concentrated in urban areas and wealthier states. For example, under public insurance, medical care is administered through different avenues depending on whether employment is formal or informal. For informal workers, coverage is often inefficient and difficult to access, especially in lower-income areas.

Due to the government’s low levels of spending on noncontributory programs and public insurance, both low- and high-income households exhibit high rates of out-of-pocket spending for services through the private sector. This fragmentation between public and private systems leaves Mexico’s poorest—predominantly informal workers who live day-to-day—with minimal access to quality public services. Although public investment has increased in recent years, it still remains low, and the coverage of social security has not expanded in over twenty five years. About one percent of informal workers have health insurance, or are on track to receive pensions.

To address informality, Mexico should adopt strategies that create formal jobs and eliminate incentives for remaining informal. One such policy suggestion is to establish a federal unemployment insurance plan. A lack of unemployment protections has been shown to reinforce informality, especially in developing countries. Because Mexico has a low unemployment rate, unemployment insurance—which has already been enacted in a few states—shows promise in discouraging informal work and developing social protections. With an increase in unemployment benefits, the marginal opportunity cost for the time and effort it would take for Mexicans to secure formal jobs would decrease, thus encouraging Mexican workers to seek out formal employment.

Beyond increasing unemployment benefits, increasing the availability and quality of pensions for formal jobs would decrease informality while pushing people towards the formal sector. Currently, the majority of Mexicans live day-to-day and cannot retire at old age due to a lack of retirement savings. Therefore, establishing federal laws concerning pensions for formal workers would encourage informal workers to seek out formal jobs, and also ensure higher standards of living for people of retirement age.

In recent decades, the government has attempted to institute federal programs that reach the majority of Mexicans, but has been largely unsuccessful due to inefficient systems, insufficient coverage in marginalized areas, and corruption. Additionally, Mexico has lower levels of fiscal revenues and coverage of noncontributory programs than other Latin American countries such as Brazil, Argentina, Uruguay, and Costa Rica. This is largely due to the government’s lack of funding for programs that would help encourage formalization. Because informal work is not taxed, the government makes reduced revenue as a result of a smaller tax base.

To procure sufficient funds for an effective federal unemployment insurance plan, the government would need to find ways to gradually increase its tax revenues. Forty percent of Mexico’s wealth is held by the top one percent, so recommendations for increasing tax revenues include raising property taxes, increasing the efficiency of tax collections, and strengthening the rule of law to avoid instances of tax evasion.

While instituting federal programs may help to address issues of fragmentation, studies have shown that existing federal programs in Mexico are unequally accessible. This means that tax reforms can only have a limited impact on reducing informality. Poorer states, which are concentrated in the south of Mexico, have the highest rates of labor informality and the lowest rates of insurance coverage. Northern states, on the other hand, benefit from the influence of American firms, as well as from practices that have been established in recent years such as unemployment insurance, labor workshops, and efforts to encourage the formalization of small enterprises. Therefore, increasing access to federal programs in marginalized regions must be prioritized. By working to consolidate fragmented social programs that already exist, and by focusing on increasing coverage for neglected areas and marginalized groups, the government would ensure that its public spending on social programs would be utilized effectively.

Beyond increasing access to social programs that discourage informality, another policy recommendation is to reduce the costs associated with formalization and facilitate the process. By reducing firm registration costs and simplifying the formalization of enterprises, more firms would formalize and switch their workers over to formal jobs. This policy would be particularly impactful in regards to small, informal businesses, which could expect to see productivity gains and more integration into the market as a result of formalizing.

As discussed previously, many formal firms in Mexico employ workers informally under the table to avoid spending costs associated with formality. Under this type of informal employment, workers are not enrolled in social security, nor do they receive standard job benefits. One suggestion to reduce this type of informality is to increase the costs of illegal hiring practices for firms.

In Mexico, formal employers must register wage-earning employees with the Mexican Social Security Institute (IMSS) and are inspected periodically by random selection by the STPS. To increase the costs of informal employment, the STPS could double down on inspections of the employment practices of formal firms, which as of now occur randomly and infrequently. Furthermore, the IMSS could increase the probability and severity of fines for illegitimate hiring practices. Ideally, this would lead to an overall transition from illegal informal employment to formal employment. However, inspections are rather relaxed, as are the punishments for illegal hiring practices. The STPS itself has no authority in punishing firms, but rather reports to the IMSS in cases of bad hiring practices.

Although increasing the costs of informality may discourage informal hiring practices, a study by Banco de Mexico and researchers at the University of Santa Cruz, California suggests that there may be negative consequences. According to this study, increasing the cost of informal workers may lead to a decline in formal employment growth, a decline in formal job creation, and increased exit of firms from the formal sector. After inspection visits, employers must make the decision to either formalize their workers, terminate them or transition their entire firm to the informal sector. If the costs of formalizing are too high, firms will lean towards one of the latter two options; that is, either terminating the workers they hired informally or exiting the formal sector.

All in all, the actual effects of increasing the costs of informal workers are difficult to predict, since illegal informal employment is excluded from administrative records. If the government institutes measures that increase the costs of informal employment, it should ensure that the cost for firms to formalize their workers is lower than the costs of exiting the formal sector. This aligns with the previous policy suggestion, which is to facilitate and cheapen the formalization processes.

High levels of informal employment in Mexico have contributed to its sluggish economic growth and persistent low living standards. In order to accelerate its economic growth and improve the life quality of its citizens, Mexico should work towards reducing informality and strengthening the social safety net. This can be achieved by the government by focusing on introducing programs that incentivize firms and individual workers alike to transition to formality. Developing institutions that offer unemployment protection, especially in poor southern states which lead in rates of informality, would be an impactful first step. Reforming retirement pensions for formal workers would also encourage workers to willingly transition from the informal sector to formal jobs. In order to acquire funds for unemployment insurance and other social programs, the government must work to gradually increase its tax revenue by raising property taxes, doubling down on tax evasion, and growing its tax base. However, at the same time the government should be wary of increasing the costs of illegal informal employment for formal firms, since this could potentially raise levels of informality.

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