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The reform that got away: Mexico may pay a high price for Enrique Peña Nieto’s failure to discourage the informal economy

The reform that got away: Mexico may pay a high price for Enrique Peña Nieto’s failure to discourage the informal economy

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May 31st 2014 | From the print edition

SINCE taking office as Mexico’s president 18 months ago, Enrique Peña Nieto has implemented an extraordinarily ambitious set of reforms. He has swept away a constitutional taboo on private investment in energy, gained new tools to bust private oligopolies, and wrested power from the teachers’ union, whose leader is in jail. This month a limited political reform was approved as well.

Yet this impressive list has one striking omission. In the opening pages of a book in which he set out his campaign platform (translated into English as “Mexico: The Great Hope”), even before detailing any of the measures that he has since accomplished, Mr Peña promised first and foremost “a new Universal Social Security System”, to be financed largely from general tax revenues, rather than the current system which relies on payroll contributions. This new proposal would reduce incentives to enter or remain in the “informal” economy, he wrote. As a result, “job quality, productivity and economic growth all go up.”

Quite so. Yet this reform has not just all but vanished from the government’s agenda, but Luis Videgaray, the finance minister and reform tsar, appears to have shut the door on it. After implementing a limited tax measure last year that raised a ragbag of imposts and was deeply unpopular with business, Mr Videgaray promised no more tax changes until 2017.

That is a mistake. The main reason for Mexico’s mediocre economic performance (annual growth has averaged just 2.3% since 1982) is low productivity. And the most plausible explanation for it is the prevalence of a huge informal economy of unregistered and mainly small businesses, in which three Mexicans in five work. Santiago Levy, a former Mexican official now at the Inter-American Development Bank, has long argued that this figure is high because public policies perversely encourage informality through subsidies, while taxing formality.

The heart of the problem is the way social-security provision and labour laws have evolved in Mexico. Formal-sector workers contribute to their pensions, health care, child care and the like through payroll taxes that add an extra 30% or so to wage costs. Yet as democracy has come to Mexico, governments have added a parallel system of non-contributory pensions, health and child care for informal workers, paid out of general government revenues.

The gap in quality between the two systems is narrowing. After employee and employer contributions totalling 6.5% of salary for 24 years, a low-paid formal worker might get a pension of 1,700 pesos ($132) a month at 65. Under a law close to approval by Congress, an informal worker under 50 can expect a pension at 65 of at least 1,050 pesos a month, gratis. Meanwhile, firms are discouraged from hiring formal workers by rigid and expensive rules for severance pay.

Mr Levy’s proposal, initially endorsed by Mr Peña, was to scrap most payroll taxes and phase in over five years a universal pension and health system (similar to Britain’s NHS), mainly financed from general taxes. Separating pension and health coverage from employment would in turn facilitate a reform of the labour laws, replacing severance rules with an unemployment-insurance fund. All this would add two percentage points a year to economic growth, Mr Levy reckons.

Some economists question his argument, insisting that informality is a result rather than a cause of low growth. But Mr Peña’s volte-face appears to have been driven by a more practical worry: the size of the increase in VAT and other taxes required to replace payroll taxes renders the proposal “unrealistic”, a senior official argues. Instead, the government is offering small carrots to encourage formalisation. These are unlikely to have much effect.

The president’s problem is that his other reforms have not yet born tangible fruit. His approval rating, at around 40%, is the lowest for a Mexican president since polling began. The economy has performed poorly on his watch, growing by only 1.1% last year; despite hefty deficit spending, the government this month slashed its forecast for 2014 to 2.7%. Ministers insist that the benefit of the reforms—especially of energy—will be felt only in the medium term; they expect growth to rise to 5-6% by the end of the six-year term.

If they are right, Mexicans will warm to Mr Peña, and Mr Videgaray will no doubt be elected as his successor. Certainly, the energy and competition reforms are important steps towards the modernisation of Mexico. But if Mr Levy is right, Mr Peña may have forgone the single most important measure to boost his country’s economic performance. That failing may come to haunt him.

 

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About bambooinnovator
KB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing. KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund. Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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