Challenging informality: Tax reform is expected to reduce the weight of the informal sector

In line with reforms pertaining to energy, education and telecommunications, Mexico is also amending its tax system (see Tax chapter). In late 2013, President Enrique Peña Nieto signed the new reform into law, which was thereafter approved by Congress. The reform aims to reduce dependence on energy revenues and to boost tax collection through a series of measures, including higher taxes for the wealthy and additional levies on a variety of different products.

However, a big part of making the taxation system more efficient will depend on the government’s ability to reach Mexico’s massive informal sector. To do this, authorities are easing access to social benefits as a way to enhance the attractiveness of operating in the formal economy. This arguably remains one of the biggest challenges for the current administration but one that could have an enormous impact on the state’s fiscal position over the near future.

Majority Priority

Increased expenditure on infrastructure and the need to improve health and education services are putting pressure on government finances, while a large proportion of the country’s economic activity takes place outside of the tax system’s reach.

Successive governments have had little effect on curbing the number of people working informally, leaving the country’s fiscal machinery unable to tap into a considerable amount of income.

According to the National Institute of Statistics and Geography (Instituto Nacional de Estadística e Geografía, INEGI), Mexico’s key statistics bureau, six out of 10 workers operate in the informal sector. In 2013, labour minister Alfonso Navarette Prida said that the Mexican economy was losing between 3% and 4% of GDP because of its inability to collect taxes from such a large proportion of the working population.

The problem has an impact on the government’s ability to capture resources that are needed to improve its infrastructure and boost competitiveness. Mexico has the lowest level of tax collection among the 34 countries in the OECD. The Tax Administration Service ( Servicio de Administración Tributaria, SAT) has reported that of Mexico’s 53m economically active people, some 29.6m of those work informally. Besides the lower tax collection, there is also a relevant opportunity cost in terms of competitiveness.

“This has consequences for economic growth, since the productivity levels of the informal segment are much lower than those of formal firms. Informality has a negative impact on productivity, thus reducing income levels and economic well-being,” Luis Videgaray Caso, minister of finance and public credit, told OBG.

Enter The System

Despite the daunting challenge, the government is hoping that a series of reforms and legal instruments can better channel informal operations into the country’s tax system. Mexico’s informal economy woes are deeply connected to economic patterns. Although growth has meant that the level of unemployment has dropped, this has mostly impacted the informal side of the country’s economic structure. This dynamic was clearly visible in the last quarter of 2013. According to INEGI, unemployment was reduced to 4.6% in the fourth quarter of 2013, compared to 4.9% two months earlier. This represented an increase of more than 75,000 in the number of employed people in the formal sector. However, over the same period of time, INEGI also estimated that the overall percentage of informal workers reached 58.8% of the active population, totalling approximately 29.6m people. However, their distribution depends on the sector of activity.

Non-Taxable Workers

According to INEGI figures for 2013, the agricultural sector employed more than 6.2m informal workers as of December 2013, and an additional 2.2m are employed in paid domestic work. Furthermore, 7m workers are employed in formal companies, government positions and institutions, but are not registered in the social security system. The biggest slice of Mexico’s informal economy is made up of people working entirely in informal business, mainly using home-based resources, which are not legally constituted as companies, amounting to around 14m people.

Broad Target

Small and medium-sized enterprises (SMEs) will be one of the main targets for the government’s inclusion objectives (see overview).

The tax reform is putting in place a new Fiscal Incorporation Regime (Régimen de Incorporación Fiscal, RIF) in order to encourage informal enterprises and workers to enter the system. SMEs with annual revenues less than MXN2m ($155,400) will be able to receive tax breaks and discounts in social security payments in exchange for sharing transaction information with the tax authorities. Additionally, the government will also offer training programmes and credit lines as further encouragement. The plan is to reduce benefits to firms entering the new regime, but also to offer enough of an incentive that these informal businesses will see the real benefits in joining the formal economy. In early March 2014, SAT announced that approximately 1.1m workers had already started the process to join the new incorporation system.

The benefits are designed to promote modernisation and efficiency increases, allowing companies operating outside the system to exchange informality for the possibility to upgrading their businesses. This, the government hopes, will translate into better-operated and more profitable businesses in the long run, coupled with an enlarged tax base for the fiscal system. “People in the informal economy do not have access to credit to boost their businesses or social security coverage, training or new technology,” Videgaray Caso told OBG.

To achieve the goal of reducing informality from the current 60% of workers to roughly 50% by the end of the presidential term in 2018, the authorities will need to clearly tilt the cost-benefit equation of operating under the law towards the side of formality.

Other more localised programmes are helping to stem informal commerce at the city level. For the past two years the Mexico City Chamber for Commerce, Services and Tourism (Cámara Nacional de Comercio, Servicios y Turismo de la Ciudad de México, CANACO) has been running a pilot programme to upgrade small shops, by providing shop owners with training and equipment to improve inventory management and promote formalisation of businesses. The programme is being tested on 2000 vendors in the capital, and CANACO is hoping to expand it to thousands of Mexico City’s commerce owners over the coming years.

Enhancing Interaction

Facilitating contact between citizens and the state will also help to encourage businesses and individual workers to formalise. A study by INEGI in 2013 found that about 31% of Mexican citizens had to wait “several hours” to pay their taxes, and more than 60% of those surveyed noted that they had been asked to pay a bribe to tax employees in order to accelerate the process.

Technology is already proving a good way to bring more companies into the system and speed up processing times. Tax payment is currently only possible through the internet, and although some businesses still chose to do it via professional accountants, the move towards digital payment has facilitated a greater audit trail. Since the beginning of 2014, digital business invoices have become mandatory, helping authorities get a better grasp of business activity by private companies. However, strengthening collection will also be dependant on the economy’s ability to develop formal job opportunities across the country, especially outside major urban centres. According to 2013 figures from the Ministry of Finance and Public Credit, about 60% of the country’s informal workers live in rural areas, many of who are employed in agriculture or small informal commerce operations. Lack of sufficient formal employment options in some regions will continue to push workers towards parallel economic activities.

Looking Ahead

Despite the government’s focus on reducing the weight of unregistered economic activity, some parallel measures included in the current fiscal reform might have counter-productive effects. One example is the government’s goal to establish a new unemployment fund that, by 2015, might allow workers who lost their jobs to receive a minimum salary for a period of six months. The fund does not include a mechanism for the large amount of Mexicans working outside the tax system. Although this might encourage informal workers to try to secure legally registered work, the creation of the unemployment fund might also discourage formal business owners that employ informal workers to channel them to full legal status for fear of increased social benefit charges.

Implementation of a new unemployment benefit system will thus depend on how the government fine-tunes the details to ensure it remains an additional encouragement to reducing informal work. The current fiscal reform has the potential to give much-needed impetus to Mexico’s economic growth. The objective to increase the country’s overall tax base will help the authorities to better channel fiscal resources in support of development. Further, it will also assist Mexico’s mass of underpaid and informal workers to access social benefits and better-paid employment options. To succeed then, the government will need to make it more advantageous to work inside the tax system.