It takes two to tango • Focus: SMEs and low growth

Informality and a weak SME environment are holding back Mexico’s growth.

IN SPITE OF ITS LONG-RUNNING FIGHT WITH CORRUPTION and inequality, Mexico’s economic growth in the last decade has been one of moderate growth; it has managed to maintain a GDP growth rate hovering around 2% over the past three years, thanks to macroeconomic policy reforms undertaken since 2010. Only recently in 2019 did the country report a dip in GDP growth to 1.6%, a result of slowing global trade winds. Unfortunately, as a result of COVID-19, this number is now projected to hit -6%. This is partly to do with the economy’s reliance on SMEs, which will be hit hard, but also its informal economy, which, along with weak competition, drives low growth found persistently in Latin American countries. By directly addressing informality with microeconomic policy changes, Mexico is setting itself up for a better economic course in the aftermath of COVID-19.

According to OECD 2019 estimates, informal labor affects about 60% of the Mexican labor force, while the informal economy accounts for around 30% of Mexico’s GDP. Persistent and high levels of informality in Mexico is driven by a number of interrelated factors, which also affect the private sector environment for SMEs. Incentives for SMEs to formalize are low, while incentives for workers to join the informal market is high.

On the labor-side, many laborers are driven to informal means to make ends meet as they often lack skills and education. Furthermore, it is claimed that workers in the informal market can make more than MX15,000 monthly while a professional biological scientist makes only MXN13,812 on average, according to a study by the Ministry of Labor and Social Welfare (STPS). Unfortunately, informality hurts these workers in the long term because it offers no social security, pension, or protection of rights.

Meanwhile, many SMEs stay informal because of multiple structural reasons that also affect formalized SMEs. Hiring formal workers, both wage and non-wage, comes at a high cost, both because of rigid labor regulations but also in relation to general low labor productivity found in Mexican firms. Another area of concern that particularly affects the private sector is the lack of ability to obtain local credit. This, in turn, reduces SMEs’ ability to upscale and invest in technology, making them less efficient and not helping them produce quality needed for local and regional markets. Informality is linked to private sector SMEs, both because SMEs make up the number of informal businesses but also because a weak SME sector environment actually enables informality by making the path to formalization difficult. And as a large informal market reduces the tax base for corporate and personal income taxes, it places a larger tax burden on larger formal companies, further creating increasing costs for SMEs. To better combat the informal economy, microeconomic policies need to focus on SMEs. Sustainably oriented SMEs should be of particular interest, as it has been shown that they will lead to greater employment in the long run. The country must also develop SME clusters, which can increase technological adoption and thus increase innovation. Mexico has made some small strides in reducing informality: 2014 saw fiscal and financial reforms aimed at encouraging large movement of informal businesses into the formal economy by implementing stricter tax, regulatory, and supplier surveillance and dismantling business monopolies, thus opening the market to competitors. However, by specifically targeting the strengthening of the private SME sector, greater strides can be made against informality. Simple regulatory and tax systems that introduce gradual increases as firms grow, keeping marginal tax rates as low as possible, along with better enforcement, can bring about a better SME environment. Improvements in universal education can also lower informality by producing higher-skilled workers for the formal market. Other ways could be through lowering administrative burdens to do business, including tax compliance costs and reduced dismissal costs while stepping up social protection. No matter the future course of COVID-19, Mexico’s macroeconomic policy vision must directly address informality in order to create both greater GDP growth and to address poverty, as poverty and informality are highly correlated in a number of Mexico’s regions.