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Authors: Joel Tan, Ivan
Region Head: Ace Chua
Editor: Akshat Daga
Illustration by Sonja Lam
Abstract
Over the years, Mexico has been enjoying a steady growth of about 2-3% (WorldBank, 2020). However, beneath her bright future lies her mightier shadow economy. Mexico’s shadow economy, characterised by undeclared production of goods and services makes up 28% of her GDP in 2015 (Medina and Schneider, 2018). This article analyses the causes and effects of Mexico’s huge shadow economy, thereafter recommending possible insights to reduce the extent of it.
The rise of Mexico’s shadow economy
The excessive tax burden in Mexico has led many producers to the shadow economy. With a highly aggressive tax regime comprising 35% Corporate Tax, 16% Value-Added Tax and up to 30% of Income Tax, many producers are incentivised to increase their profit margins under the shadows where they are free from taxes. Coupled with a weak rule of law, rife corruption with a ranking of 130th out of 180 countries in the Corruption Perceptions Index (Transparency, 2019), it is not surprising to see Mexico’s shadow economy thriving. Due to such poor law enforcements, the marginal cost of engaging in the shadow economy (probability of getting caught from it) is significantly lower than the marginal benefit of engaging in it (high tax evasions). As a result, economic agents are incentivised to exploit this.
Consequences of Mexico’s shadow economy
Boon: Constituting 28% of Mexico’s GDP in 2015, the shadow economy provides informal employment opportunities for those who are otherwise unable to seek employment in the formal economy; be it due to frictional unemployment from the inefficiencies of Mexico’s institutions or due to their perceived low standings in society (Raa & Greene, 2019). The lower prices and increased variety of goods also enhance consumers’ welfare, allowing them to enjoy counterfeit goods or even recreational drugs not found in the formal economy.
Bane: However, the shadow economy has been widening the income gap in Mexico, with her Gini Coefficient at a high of 0.42 in 2016. Mexico was ranked 15th in terms of GDP but came in last for GDP per capita and her average income of the 80th percentile is 10 times higher than the bottom 20th percentile (OECD, 2015). This is likely due to the shadow economy promoting the exploitation of labour especially due to the lack of a minimum wage and deprivation of social and labour protection rights. In fact, the average wages from formal labour is 49% higher than that of informal labour (IMF, 2018). Hence, workers in the informal labour are vulnerable to lower wages, lose out on social security benefits such as pensions in the formal economy and also face higher risks from engaging in criminal activities.
The large incidences of tax evasions also significantly reduces Mexican’s governmental revenue for investment in more productive sectors. Over the years, 8,000 shell companies have falsified 9 million tax receipts leading to evasion of about 400 billion pesos (Bloomberg, 2019). Hence, this increases the fiscal burden of the Mexican administration.
The poor political institutions amidst a widespread shadow economy deters potential entrepreneurs from investing in Mexico due to poor intellectual property rights, and unattractive tax rates. From the graph above, we notice the size of the informal economy shares an inverse relationship with intellectual property rights ratings (Vertical Axis). Compared to more developed countries such as Singapore, Mexico has relatively lower intellectual property rights, widely attributed to a higher informal sector. Since property rights is one of the factors in attracting FDI, Mexico’s is likely to be limited by her high shadow economy activity in increasing FDI.
Current Policies and Recommendations
Although the Mexican authorities improved its labour policies in 2013 (ILO, 2014) that incentivises conversion of informal labour to formal with substantial social security benefits as well as unemployment benefits, more are needed to deter informal activities such as tax evasion as well as reducing relative benefits of being involved in the informal economy. According to a research on modelling Mexico’s Economy (Macias & Cazzavillan, 2008), Mexican government should focus on resolving key drivers of shadow economies such as matching salaries along with its inflation, reduce excessive regulation and tax burdens by the government. The idea here is that by increasing formal wages, it helps to curb inflation effects and motivates formal employment. Tax regulations are vital here as it should reduce inequality gap which means transferring tax burdens from the low income to the high income. Lastly government regulations should not be excessive but more importantly, the downsides of being caught in shadow activities should be amplified in order to rationalise conversion. Although all of these implies higher government spending, the crux here lies on the fact that marginal benefits of formal economy outpace its rival which leads to a better outcome in the long run for Mexico.
Conclusion
Shadow economy affects all countries, but the magnitude to which it affects Mexico depends very much on the policies put in place by the government. Unless the Mexican administration commits to nullify the advantages of the shadow economy, it is likely that the inherent shadow economy of Mexico will be here to stay, at least for the foreseeable future. Especially against a covid-19 backdrop coupled with poor governmental response, it is likely the shadow economy will continue to grow.
References
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