The End of Informality in Mexico?: Fiscal Reform for Universal Social Insurance

Abstract

Mexico is characterized by a dual social insurance architecture. Firms and workers in salaried contractual relations are obligated to pay for a bundled set of health, pension and related programs. Non-salaried workers benefit from an unbundled set of parallel programs paid by the government. We develop a model to study the implications of this architecture in a context of informality and imperfect tax enforcement. We argue that this architecture: (i) provides workers with erratic and incomplete coverage against risks, (ii) fosters evasion and narrows the tax base, (iii) delinks contributions from benefits undermining fiscal sustainability, and (iv) distorts the labor market lowering real wages and total factor productivity. We propose a reform to shift taxation for social insurance from labor to consumption. We show that by setting a uniform value added tax rate of 16 percent it is possible to provide all workers with the same health and pension benefits and Hicks-compensate poor households for the VAT increase at a net fiscal cost of 0.3 percent of GDP. We argue that our proposal: (i) effectively protects all workers against risks, (ii) reduces distortions in the labor market stemming from social insurance tax-cum-subsidies allowing for an increase in the real wage despite the higher VAT, (iii) raises total factor productivity, (iii) contributes to reduce poverty and income inequality, (iv) links contributions with benefits ensuring fiscal sustainability, (v) increases aggregate savings for retirement, and (vi) reduces evasion and widens the tax base.