Selected Issues


Selected Issues

Formality and Equity—Labor Market Challenges in Mexico1

This note documents the composition, trends, and labor market implications of informality using data from the National Employment Survey (ENOE). Over half of the employed population has informal contractual relationships in Mexico both at formal and informal firms. Informality is found to be associated with lower levels of pay –even when accounting for worker composition differences– and lower wage growth over the life cycle. Policy drivers of this market duality, including minimum wage policy, are discussed.

A. Stylized Facts

1. Informality in Mexico takes many forms. Using data from the National Employment Survey (ENOE) from 2005 to 2017, this paper focuses on informality as defined from the perspective of the worker. Following criteria from INEGI, the definition of informal workers includes those at non-agricultural informal firms, self-employed agricultural workers, unpaid workers, non-salaried workers (at both formal and informal firms), and workers without access to social security health services in both formal and informal firms. None of the workers in this definition have access to Mexican Social Security Institute (IMSS) benefits. All other workers are defined as formal in the discussion that follows.

2. Labor market informality in Mexico remains stubbornly high. The growth of formal jobs has outpaced the growth of overall employment in recent years. However, from a medium-term perspective, formality has only slightly increased from 42 percent in 2005 to 44 percent by the end of 2017.


Formality in Mexico

(Share of employment)

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE and staff calculations

3. An important feature of Mexican informality is that a substantial share of informal workers is employed in firms that can be classified as formal. The definition of informal firms in this context includes subsistence agriculture, domestic work, and firms classified as informal by INEGI based on reported name, family ownership, and accounting practices. All other firms are classified as formal. Under this definition, around 22 percent of workers work at formal firms, but are not salaried or do not have access to full benefits. That is, there is a significant number of informal workers at formal firms under a variety of contractual relationships, from unpaid work to non-salaried contracts, without access to formal benefits. The variety of contractual relationships within formal firms provides an additional degree of freedom in hiring and firing decisions.

4. Formalization levels vary significantly across sectors. Agriculture and construction are the two sectors with the lowest rates of formalization with rates of 9 and 20 percent, respectively. Formalization is higher in other services (48 percent) and highest in manufacturing (64 percent) where formal salaried contract relationships are more common. There is also substantial variation in the type of firms that employ informal workers in different sectors. While only 8 percent of informal workers in the construction sector work at formal firms, 33 percent of informal workers in other services and 42 percent of informal workers do so.


Formality by sector

(Percentage of employed)

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE; and staff calculations.Note: 2017 data. Informal firms include subsistence agriculture, self-employed and domestic workers without access to IMSS, and firms classified as informal by INEGI. Informal workers in formal firms are those who do not have access to IMSS.

5. Moreover, informality is not only a feature of labor markets among the poorest. There is substantial inequality in both the formal and informal sectors, with variance of log wages2 of .74 and .65 respectively. Importantly, there is substantial overlap in the distribution of wages in both sectors, as informality is prevalent both among low and high paying jobs as well as across levels of education. The prevalence of informality across sectors and income strata at both formal and informal firms are indicative of a market duality that permeates the Mexican economy.


Distribution of wages

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE; and staff calculations.

B. Labor Market Implications of Informality

6. Informality has important productivity and labor market implications. Formal jobs are better paid by 49 percent on average. Part of this is the effect of payroll and income taxes that are only faced by formal salaried workers. These costs to formality are only partially offset by net benefits received from contributory social security programs3, which are moderately higher when compared with non-contributory ones. To the extent that these differences in pay reflect labor productivity differences, the duality of formal and informal work can have aggregate productivity implications.

7. Much of the difference in pay between formal and informal workers stems from differences in worker composition. Informal workers are on average younger and less educated than formal ones, which explain part, but not all, of the gap in pay. To quantify the contribution of worker composition in this pay gap, wage premiums are estimated as follows:

wageit = α + βXit + ψt + θi+ εit

where wageit is the log of the wage of worker i at time t, α is the wage premium, Xit is a vector of observable worker characteristics including age and education, and ψt are time fixed effects. Since the ENOE is designed as a five-quarter rotational panel, specifications controlling for worker fixed effects, θi, are also estimated.


Formality wage premiums

(Premiums in log points)

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE; and staff calculations.

8. Differences in education and demographics account for about half of the overall gap in wages. Once education and demographic differences between informal and formal workers are controlled for, the residual gap is reduced from 49 to 24 percent. This implies that differences in these observable characteristics account for 51 percent of the overall wage gap. There is also substantial variation of wages within formal and informal groups even after accounting for differences in observable demographics (including age and education). Altogether, observable demographics do not account fully for neither the wage gap between formal and informal workers nor the dispersion of wages within each group.


Distribution of wages – Residual after accounting for differences in observables

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE; and staff calculations.

9. The gap is significant reduced if observable and unobservable characteristics are accounted for. Wage premiums estimated after controlling for individual fixed effects is significantly lower at 6 percent. This implies that differences in worker composition as controlled by observable and fixed unobservable characteristics account for 88 percent of the overall wage gap. It is important, however, to qualify this statement as the latter wage premiums are only estimated using workers who switch across sectors. These switchers do not form a representative sample of the population; therefore, it might still be the case that gains from formalization are greater for workers who do not switch across sector. In addition, given that the panel structure of the dataset follows a worker for only five quarters, wage premiums are exclusively affected by short-term gains from transitioning across sectors. This implies that, although estimated short-term wage premiums are relatively small, long-term gains from formalizations might still significant.

10. Informality can also lead to depressed human capital accumulation, with potential long-term productivity costs. Returns to education (relative to no education) are lower for informal workers than for formal ones, particularly for workers with completed high school and professional degrees. To the extent that lower returns are an intrinsic feature of informality, this can decrease the incentives for schooling for workers and potentially lead to substantial human capital lags.


Returns to education

(Premiums in log points)

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE; and staff calculations.

11. Beyond schooling, informality can also depress on-the job human capital accumulation. Returns to experience—as depicted by conditional wage growth profiles4 over the life cycle— are significantly lower for informal workers. This is consistent with research highlighting limited on-the job training outside of formal jobs in Mexico.5 Interestingly, informal workers at formal firms—which include non-salaried workers without health benefits—appear to exhibit lower wage growth than informal workers at formal firms—which include the self-employed. While formal workers peak wages arrive around age 50, the peaks occur before the mid-40s for informal workers. These flatter wage pattern among informal workers occurs at both small informal firms as well as large formal ones. To the extent that wage levels reflect productivity differences across age groups, the flatter informal wage growth profiles can be indicative of poor on-the-job human capital accumulation. Altogether, the evidence suggests a human capital channel—through both schooling and experience—connecting informality to poor long-term labor productivity.


Wage growth over life cycle

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE; and staff calculations.

C. Regulatory Drivers of Informality

12. Regulation that treats differentially formal and informal workers and firms hinders the formalization process in Mexico. Formal firms that employ salaried workers face social insurance contributions, taxes, and hiring/firing costs that do not apply to non-salaried workers both at formal and informal firms. Most prominently, formal firms must enroll salaried workers in the social security registry (IMSS) and pay a contribution proportional to worker’s wages in a scale that contains a regressive fixed cost component. Non-compliance is subject to monetary fines in the rage of 20–350 daily minimum wages per non-registered workers.6 Formal salaried workers also face state payroll taxes that do not applied to non-salaried informal workers, and the fact that federal income taxes are withheld while non-salaried ones are filed directly has led to greater tax evasion among the later.

13. Formal firms hiring salaried workers can also be sued for unfair dismissals, implying a contingent liability for hiring formal salaried workers at formal firms. Labor lawsuits arising from this regulation often leads to long legal dispute processes that, in the past, led to an accumulation of payments owed by firms directly linked to the length of the dispute.7 The 2017 labor reform has limited these firing costs and has allowed for processes aimed at facilitating dispute resolution processes. The regulation needed to fully implement this reform, however, is yet to be passed.

14. There is now extensive research suggesting that these and other barriers create a dual incentive system that induces high informality rates and provides an implicit subsidy to small unproductive informal firms. Adding to the measures discussed, the literature has also emphasized the role of non-contributory benefits in discouraging formality,8 the limited value of contributory benefits,9 and the effect of size-specific tax regimes such as Repeco10 and enforcement policies11 in inducing labor and capital misallocation towards the informal sector. Levy (2018) provides a relevant summary and expanded discussion of this research and concludes that formalization frictions lead to significant aggregate TFP losses in Mexico.

15. Policy changes in Mexico over the last two decades have likely worsened market duality. Two main policy trends have likely have widened the incentive gap preventing formalization. On the one hand, there has been significant increases in the collection of payroll taxes that are only applicable to salaried workers.12 On the other hand, non-contributory programs, such as non-contributory health and pension programs have expanded their coverage and size in Mexico,13 which has lowered the relative benefits of contributory programs enjoyed by formal workers. In this context, proposed minimum wage increases by the incoming administration would likely contribute to this incentive gap. We turn to this latter aspect of labor policy next.

D. Minimum Wage Policy and Informality

16. After an extended period of stability, minimum wages have only recently started to increase. Real minimum wages collapsed in the 1990s, remained relatively stable in the 2000s, and started rising significantly in the past three years, when minimum wages went from 37 to 40 percent of median wages. According to comparable OECD data, the ratio of minimum to median wages in Mexico remains below OECD peers and other Latin American economies.


Real minimum wages

(index, 1994=100)

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: Banxico; and staff calculations.

17. The effects of minimum wage hikes on inequality and formality are however hard to assess. This is challenging due to limited exogenous policy variation in Mexico. Nonetheless, using 2005–2017 data from ENOE, we can document how past changes in minimum to median wage ratios have been associated with changes in both formality and inequality and the municipal level. Policy variation comes from two sources. First, minimum wages levels are periodically updated creating significant variation across time. Second, Mexico has reformed its minimum wages system from a multi-zoned system to a single federal minimum wage inducing policy variation across regions. Using this variation, the following models are estimated:

Percentilemt = γ Min_Wagemt + βXmt + ψt + θm + εmt

Formalitymt = γ Min_Wagemt + βXmt + ψt + θm + εmt

where Min_Wagemt is the ration of minimum to median wages in municipality m at time t, Xmt is a vector containing the demographic characteristics of the municipality (including mean age and education levels), ψt are time fixed effects, and θm are municipality fixed effects. For robustness, linear municipality-specific time trends are also included in some specifications. The model is estimated with the 10th, 25th, 50th, 75th and 90th percentiles as dependent variables as well as the share of formal workers over total employed.


Minimum wage relative to median

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: OECD.

18. Past increases in minimum wages were associated with significant changes in the wage distribution among both formal and informal workers. Coefficients on minimum-to-median wage ratios from percentile regressions are plotted in the figure for formal and informal workers separately. Past minimum wage increases were associated with larger increases among the lowest percentiles of the distribution of both formal and informal workers. The pattern document is consistent with spillover effects from minimum wages discussed in the structural labor literature.14


Minimum wage rises and wage percentiles

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE; and staff calculations.Note: Coefficients on minimum to median wage ratio from municipality-level fixed effect percentile regressions.

19. However, past increases in minimum to median wage ratios were also associated with increasing informality.15 Coefficients on minimum-to-median wages using formality as the dependent variable show significant negative coefficients with and without a vector of controls. The results document a pattern where informality increased the most in municipalities that experienced the greatest increases in minimum-to-median wages. These effects appear to be driven by both movements from formal to informal firms as well as by the movement from formal to informal Formality changes associated to minimum wage increases contractual arrangements within formal firms.


Formality changes associated to minimum age increase

Citation: IMF Staff Country Reports 2018, 308; 10.5089/9781484383711.002.A001

Sources: ENOE; and staff calculations.Note: Coefficients on minimum to median wage ratio from municipality-level fixed effect regressions with time effects and formality as a dependent variable.

20. Overall, past correlations suggest that minimum wage increases, while potentially inequality-reducing, risk increasing informality. There are important caveats to this statement, however. First, the patterns documented reflect associations that do not prove a causal relationship between minimum wages and both distributional and formality outcomes. Second, past minimum wage changes over the period of study (2005–17) have been relatively smooth and may not be informative of non-linear effects that might occur from larger abrupt policy changes.

E. Conclusions

21. The results suggest that informality tends to select workers with lower earnings potential and limits their development. Informality indeed tends to be more prevalent among younger and less educated workers, for which better paid jobs are harder to come by. Moreover, it appears to lead workers towards a path of limited earnings and perhaps skill growth potential. These gaps in earnings growth and potential resonate with firm-data evidence documenting lower output levels and growth in informal firms16 and highlight a channel linking labor market duality and aggregate productivity.

22. Future labor market reforms should take a holistic approach that addresses both distributional concerns and formality barriers. One alternative is to reduce dependence on payroll taxes that are biased towards formal salaried workers while transitioning towards a social insurance system that provides good-quality services for all, irrespective of their salaried/non-salaried status. Another is easing firing and hiring restrictions of salaried workers while increasing protections to the unemployed through a more universal unemployment insurance scheme. This type of profound long-term transformations should, of course, only be implemented after careful review of policy alternatives guided by experiences in other countries and detailed impact analysis.

23. Short-term reforms should build towards a system where the non-exclusive targets of boosting social protection and removing distortionary restrictions are achieved. Policy proposals, such as hikes in the minimum wage, should be gradual, viewed in the context of other distortionary polices, and carefully weigh equity benefits against the potential displacement of labor towards unproductive informality.


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Prepared by Jorge Alvarez (WHD).


Wages are calculated as the ratio of total labor cash income over worked hours reported.


See Levy (2008), Antón, Hernández, and Levy (2012), and Levy (2018) for a more detailed discussion.


Reported age and education returns estimated after controlling for worker observables, location, and time fixed effects.


Heckman and Pages (2004) estimate significant costs associated by severance pay regulations in the order of 3 percent of wages. Da-Rocha, Tavares, and Restuccia (2016) show that this type of regulations can have large negative effects on TFP.


See Bosch, Cobacho, and Pagés (2014) for a meta-analysis of these studies.


Levy (2009) document the value of contributory programs relative to required contributions and conclude that net benefits are limited for the average worker. Most workers who can opt in but are not mandated to enroll in these programs do not do so.


Special regime for small enterprises.


Levy (2018) estimates that there was an increase of 1.9 percent of GDP in the collection of income and payroll taxes collected from formal workers.


See Anton (2016) for a documentation of the increase of non-contributory benefit spending in Mexico.


See Burdett and Mortensen (1998), Bontemps et al. (1999), and more recently Engbom and Moser (2018).


The patterns documented for Mexico are consistent with moderate negative effects on employment as summarized in Card and Krueger (1995) and Neumark and Wascher (2008).


See Chapter 2 of this paper; and Busso, Fazio, and Levy (2012) and Levy (2018) for firm-level evidence on productivity differences.

Mexico: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.