76575 Overview Mexico Policy Notes MEXICO REFORM AGENDA FOR INCLUSIVE AND SUSTAINABLE GROWTH PREFACE This note presents an overview of Mexico’s forthcoming reform agenda—from the World Bank’s vantage point. It distills the main messages in the policy notes that make up this compendium. The purpose is not to provide definitive answers to the many policy questions likely to occupy the new Mexican administration, or to provide a comprehensive account of progress to date and policy recommendations. Instead, it is to provide a view of the main challenges facing Mexico in its quest for inclusive and sustainable growth—and to propose feasible policy options to address them1. Because implementing them will prove a daunting task for any government, prioritization is critical. The analysis in these notes attempts to structure policy priorities with a proposed sequencing (short-term policy options, or quick gains in the first year; and medium-term reform options, which may take longer to bear fruit). World Bank Page 1 Overview Mexico Policy Notes OVERVIEW In its quest for inclusive growth Mexico needs to address four main challenges. These key challenges are i) to increase productivity; ii) to ensure that poorer segments of society benefit from and are able to contribute to the growth process; iii) to combine the economic and environmental aspects of sustainable development; and iv) to strengthen public finances and improve government efficiency. Achieving these objectives involves technical work and the political challenge of addressing entrenched interests in the public and private sectors. First, productivity is central to accelerating growth. Despite progress on macroeconomic and financial stabilization, growth in Mexico has failed to converge with high-income economies. A reform agenda focused on unleashing productivity could place Mexico on a path to higher long- term growth. Such agenda includes: deepening and broadening the financial system; promoting market competition and removing regulatory barriers for doing business; liberalizing key input sectors such as telecommunications and energy; reducing labor market rigidities; developing a workforce with skills for the 21st century; and boosting innovation. Second, growth can only be sustained with equity. Reducing poverty and inequality should be at the center of the reform agenda. Mexico has made great progress on reforming social policies with its flagship social programs that have achieved universal health insurance coverage (Seguro Popular) and have strengthened social protection for the poor (Oportunidades). Over the last decade, the country has also witnessed the rise of an emerging middle class. Yet, Mexico still faces high levels of poverty and inequality that are also a drag on economic growth. The reform agenda needs to focus on second-generation social policy reforms to develop the skills and the mobility of the workforce; strengthen the performance of existing social protection programs; and broaden the coverage of the social protection system to include the elderly and those affected by shocks - such as natural disasters and economic crises; and reduce the middle class’s vulnerability to poverty. Third, a growth strategy that is accompanied by a deterioration of the environment is likely to be self-defeating. The reform agenda should also promote green growth—growth that is efficient, clean, environmentally sustainable and socially inclusive. Mexico, a global leader on climate policy, has a long and distinguished record on promoting environmental sustainability and managing climate change. But the country’s vulnerability to climate change continues to have negative impacts on some segments of the population and environmental degradation poses challenges to the sustainability of growth. As Mexico continues to industrialize, the incidence of pollution and the societal pressures to use water, energy, and forests will rise. This calls for a green growth reform agenda that reduces the environmental footprint of growth and optimally manages natural assets. Fourth, sound public finances and a more efficient government are critical for inclusive and green growth. Mexico is a model of prudent fiscal management and a global pioneer on public debt and fiscal risk management. Fiscal policy, through tax measures and expenditure programs, has a central role to play in promoting productivity, reducing poverty and inequality, and promoting green growth. Yet, the ability of fiscal policy to deliver on these goals is constrained by several factors. Non-oil tax collection rates are low – reflecting a narrow tax base, a complex tax system, low citizen’s trust in the state, and weak tax administration capacity of sub-national governments that are highly reliant on federal government transfers. These World Bank Page 2 Overview Mexico Policy Notes challenges are compounded by mounting medium-term expenditure pressures as oil revenue declines and age-related public spending rises. This calls for an integrated fiscal and public sector modernization reform agenda that raises non-oil tax revenue, improves the transparency and quality of public spending, and strengthens sub-national fiscal management. UNLEASHING PRODUCTIVITY Mexico has achieved remarkable economic and social progress over the past several decades. The country has become an investment grade borrower with solid global standing in capital markets. It is a model of financial and commercial integration and of prudent macroeconomic management. It is also a pioneer of innovative public programs that have been replicated around the globe (in areas as diverse as fiscal risk management, social assistance, and climate change). Globalization, urbanization and democratization have given rise to an emerging middle class that demands a modern and responsive state—a state that not only ensures macroeconomic stability but also provides opportunities for all. Like many other countries in Latin America, however, Mexico faces challenges in its quest for inclusive growth. It is a country of contrasts—rich and poor states, dynamic urban centers and isolated rural areas, small informal enterprises serving the domestic market and large companies competing abroad, top executives graduated from top universities abroad and youth who “neither work nor study.� Unlike some major emerging market economies, Mexico has failed to catch up with high- income economies. It enjoyed macroeconomic and financial stability, market-oriented economic policy reforms, openness to foreign trade and investment, and a “demographic bonus,� with a rising share of the working-age population over the past decades. But Mexico has not unleashed high growth rates, failing to close the gap with high-income economies. Over the past decade the Mexican economy grew at less than 2 percent a year, well below the regional average (4 percent). Its per capita income has remained at about 30 percent of that of the United States.2 By contrast, East Asia’s per capita income, which tripled over the past three decades, is currently at about 60 percent of that of the United States (see Figure 1). Figure 1.Unleashing productivity could help Mexico accelerate growth and converge to higher income levels. Per capita income ,1980-2011 , Growth in income per capita, 1960-2011 (GDP PPP per capita, percent of the United States) (1960=100) 90 2.80 GDP per capita 80 2.60 2.40 70 2.20 60 2.00 50 1.80 Labor 40 Productivity 1.60 30 1.40 20 1.20 Total Factor 10 LAC East Asian Tigers Mexico Productivity 1.00 0 0.80 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: World Development Indicators / World Bank (April, Source: World Bank estimates based on data from Penn World Table World Bank Page 3 Overview Mexico Policy Notes 2012). Version 7.0 (June, 2011). Mexico’s trailing productivity partially explains its slow income convergence. The country’s growth has largely been driven by capital and labor accumulation, not by growth in labor productivity (average output per worker) or total factor productivity (combined efficiency of labor and capital). While physical capital accumulation rates are within reasonable range by international standards, labor productivity and total factor productivity collapsed during the eighties and have remained low since then. This explains the limited contribution of productivity to Mexico’s economic growth over the last fifteen years. Total factor productivity is interpreted in the economic literature as a measure of technological progress and explains a substantial share of the per capita income differences across countries. 3 2010 Table 1. Mexico Sources of growth (1961–2011), annual average GDP growth Period GDP Labor Capital GDP per TFP Contribution to GDP growth worker Labor Capital TFP 1961-1981 6.8 4.1 6.9 2.6 4.0 1.6 2.8 2.4 1982-1995 1.3 2.8 2.9 -1.4 -1.5 1.1 1.1 -0.9 1996-2011 3.1 2.2 3.0 0.9 1.7 0.9 1.2 1.0 Source: World Bank estimates. The methodology assumes a labor augmenting Cobb-Douglass function. Alpha= 0.4; Delta=0.06. The economic literature offers several explanations for Mexico’s low productivity growth. An underdeveloped financial system, labor market rigidities, high informality, scarce skilled labor, regulatory barriers for doing business, and weak innovation and limited market competition are often cited as binding constraints to productivity growth.4 It has proven hard to establish empirically the relative importance of each of these obstacles to productivity growth. In the absence of rigorous empirical evidence of the most binding constraint to growth, this note argues that making progress on several of these obstacles may be a reasonable strategy to accelerate growth, particularly in view of the possible interactions between some of these constraints. The next sections discuss these challenges in greater detail. Deepening and broadening the financial sector Thanks to the financial sector reforms implemented over the last decade, Mexico has a sound banking system and a diversified set of financial intermediaries. Financial sector oversight has been revamped and assessments of compliance with international supervisory standards note the high quality of the current financial regulatory and supervisory framework, especially for the banking sector. Authorities have been pro-active in adopting measures to protect financial sector stability from external shocks and endogenous developments, and following lessons from the recent global financial Mexico was among the first countries in the world in creating a formal body in charge of systemic risk monitoring. Also, in recent years there have been substantial efforts to improve financial inclusion through the operation of banking correspondent agents, propitiating the use of new technologies (such as mobile phones) for financial transactions, improving financial infrastructure (i.e. collateral registries and credit bureaus) and using public institutions and resources to catalyze private sector funding towards small and medium enterprises as opposed to crowding private sector activity (i.e. through the creation of an electronic factoring platform and public credit guarantees schemes). World Bank Page 4 Overview Mexico Policy Notes Yet, Mexico’s financial sector remains small for its stage of development, impeding the channeling of financial savings into long-term productive investments. The market for government debt is deep and liquid, but there are few issuers in the private bond and corporate equity markets. The financial system has done a fair job of mobilizing savings in recent years but continues to lag in risk taking and maturities, limiting its contribution to growth. Commercial bank lending focuses on consumer credit, which has higher intermediation margins. Institutional investors, including pension funds and mutual funds, hold many of their assets in fixed-income securities, mostly government bonds. Deepening and broadening Mexico’s financial system could support the growth and investment of credit constrained SME’s and households, raise productivity, and spur growth. Improving creditor rights and insolvency procedures could also enhance firms’ access to credit. Continued efforts are required to foster financial sector development and inclusion while maintaining the soundness of the financial system (see Mexico Policy Note 1). Figure 2. A more developed financial sector mobilizing domestic savings and credit could raise productivity. Gross Domestic Savings 1970-2011 Domestic credit to the private sector 45 (percent of GDP) (percent of GDP) 140 127 40 120 35 100 100 87 89 30 25 80 61 55 51 20 60 45 45 42 15 40 31 24 26 17 10 20 5 East Asian Tigers Mexico LAC 0 1990 2011 1990 2011 1990 2011 1990 2011 1990 2011 1990 2011 1990 2011 0 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Korea China Chile Brazil India Colombia Mexico Source: World Development Indicators / World Bank (April, 2012). Promoting competition and streamlining business regulations Strengthening competition and reducing the costs of doing businesses are key to boost productivity. The availability, quality and cost of inputs in the production process, such as capital, labor and intermediate goods and services, as well as the cost to operate a business are critical for firm productivity. In international benchmark exercises, including the World Bank’s annual Doing Business exercise, Mexico at times stands out for the high cost and/or low availability for key inputs in the production process (see Mexico Policy Note 2). High concentration in key sectors of the economy and restrictive regulation hinder competition and aggregate productivity growth. Monopolistic behavior results in higher prices, inefficient resource allocation, consumer deadweight loss, and disincentives to innovate or invest. Similarly, regulatory burden for firms can also increase the costs of doing business. National and subnational regulations, such as those related to the cost of enforcing contracts and the time needed to obtain licenses and permits, restrict the ability of firms to do business, while monopolistic behavior reinforces inequalities by hurting low-income households disproportionally (see Mexico Policy Note 2). World Bank Page 5 Overview Mexico Policy Notes In recent years, Mexico has made progress in supporting a more competitive business environment and streamlining of business regulations. Amendments to the Federal Competition Law have been adopted that strengthen the power of the Federal Competition Agency to investigate non-competitive market behavior as well as to impose more significant monetary and criminal sanctions to deter economic agents from such practices. With regards to the streamlining of business regulations, progress has been made in facilitating tax filing and payment procedures, the elimination of redundant testing and certification requirements by recognizing the equivalence of Mexican product standards and certifications with international ones and the development of a Single Trade Window that will allow enterprises to comply with all trade related regulations through a single electronic platform. But more needs to be done to remove barriers to competition and reduce the costs of doing business. Reforms to promote market competition could focus on ensuring an effective implementation of the Federal Competition Law; and creating a high-level commission with the mandate of recommending the elimination of anticompetitive practices at the sub-national level. The cost of doing business could be substantially reduced with reforms aimed to simplify firm registration procedures, reduce the cost of formal hiring and firing processes and ensure effective and prompt contract enforcement. Figure 3. Limited competition reduces firm productivity and competitiveness. Global Competitiveness Intensity of Local Competition (higuest 1, lowest 142) (highest 1, lowest 142) 0 10 20 30 40 50 60 70 0 20 40 60 80 100 Korea, United Switzerl Korea, United Switzerl 2005 4 2009 20 and and 2012 1 2012 24 2005 1 2009 4 Rep. States Rep. States 2012 5 2012 18 2005 19 2009 49 2012 24 2012 15 2005 48 2009 27 China China 2012 26 2012 22 2005 27 2009 19 Chile Chile 2012 31 2012 36 2005 57 2009 43 Mexico Brazil Mexico Brazil 2012 53 2012 48 2005 59 2009 78 2012 58 2012 84 Source: Global Competitiveness Index and Table 6.01 Intensity of Local Competition 2011-2012 rankings. – In: Global Competitiveness Report of the World Economic Forum. As a network industry, telecommunications is critical for promoting firm productivity. The telecommunications sector is undergoing radical technological and regulatory changes throughout the world. In Mexico, the overwhelming dominance of the incumbent in the sector has caused improvements to be far smaller than those observed elsewhere. Penetration of telecommunication services in Mexico still shows a lower level and slower growth compared to OECD countries or Latin American peers. In 2010, the penetration rates (number of subscribers per 100 inhabitants) for fixed telephony, mobile telephony and broadband services in Mexico were 18, 78 and 10, respectively compared to 36, 114 and 25 in OECD countries, and 21, 106 and 10.3 in Chile. This is partly attributed to higher prices and low-network coverage in rural areas. Using the OECD methodology of representative baskets on consumption, prices for World Bank Page 6 Overview Mexico Policy Notes moderate use of mobile phone services exceed the OECD average by around 30% and fixed-line prices for moderate-use consumer and business services exceed OECD averages by 67 and 82 percent respectively in purchasing power parity terms.5 Recent reforms sought to improve investment and competition in the telecommunications sector. But a more ambitious reform is required to boost productivity. Examples of recent reforms include auctions for the lease of part of the optic fiber network owned by the state- owned Federal Electricity Commission for data transmission and for the use of radio spectrum for mobile telephony, as well as a program to support the reduction of interconnection rates for mobile telephony termination. Additional regulatory interventions are needed to facilitate entry in the telecommunications sector. Eliminating restrictions to foreign ownership and developing an integral and transparent interconnection policy are key elements of the reform agenda. In the event that such measures fail to increase competition, sector regulators could be given the power to break up companies with monopolistic power whenever they abuse their dominant position in the market. While such powers are difficult to implement in practice, the mere threat of being able to do so could induce more competitive behavior. Opening the energy sector to private participation in core activities could also contribute to productivity growth. Mexico’s energy sector is dominated by state-owned companies that, as a result of being insulated from meaningful competition, have been slow to adapt and innovate in response to changing market conditions, technologies and management practices. The operation of state-owned electricity companies is constrained by federal budget controls and ceilings that have led to insufficient investment, and political interference in pricing policies and investment priorities. These constraints hamper longer term prospects for oil and gas supply and the development of downstream capacity, pipelines and storage facilities to meet rising domestic demand. Similarly, relatively high prices for electricity use by the industrial and commercial sectors (as opposed to subsidized rates for residential and agricultural use) as well as low quality of service delivery increase the cost of doing business. An energy reform promoting greater efficiency and a diversification of financing sources for investment will enable a more dynamic energy sector and a more adequate provision of a key production input that could raise firm productivity. The energy reform goes hand and hand with fiscal and green growth policy reforms. The discussion of the fiscal dependence on oil revenues, energy pricing and subsidies, the promotion of energy efficiency and the reduction of green-house gas emissions are discussed in more detail in this compendium (See Mexico Policy Notes 6, 7 and 10). Reducing labor market rigidities Labor market rigidities constrain the efficient allocation of labor across firms and industries. Rigid labor market regulations prevent the Mexican labor from working efficiently. The cost of employing formal sector workers remains high because of fairly rigid labor market regulations, particularly regarding dismissal (see Figure 4). Furthermore, severance pay regulations likely reduce companies’ willingness to adopt new productivity enhancing technologies, for fear regarding job security. While informality is partly a reflection of Mexico’s stage of development and of labor market rigidities, the large number of informal firms reinforce low productivity levels. Lower wages in the informal sector reflect a productivity gap, resulting from credit and technology constraints, limited access to employee training, and a bias against growth in order to continue to hide their activities. Addressing regulatory hurdles in hiring and World Bank Page 7 Overview Mexico Policy Notes firing workers, reducing formalization costs and, strengthening unemployment insurance could improve labor market efficiency and enhance productivity (see Mexico Policy Note 4). Figure 4. Labor market rigidities, in particular dismissal costs, remain high. Labor costs (Higher values indicate higher labor costs) Employment Rigidity Index (Higher values indicate higher rigidity) 50.00 Cost of increasing hours 45.00 worked 1.00 40.00 Unemployment Benefits 0.75 Costs of firing workers 35.00 30.00 0.50 25.00 0.25 20.00 Sickness and health benefits Dismissal procedures 15.00 0.00 10.00 5.00 0.00 Old Age, Disability and Alternative employment Death benefits contracts Collective Disputes Labor Union Powers Mexico Canada USA Dificulty of Hiring Index (0-100) Rigidity of hours Index (0-100) Rigidity of Redundancy Index (0-100) Source: Botero J.C. [et al.] (2004) “The Regulation of Labor�. – Source: Doing Business 2012: Doing Business in a More Transparent In: The Quarterly Journal of Economics, 1339-1382. World / International Finance Corporation. Promoting innovation Boosting innovation in Mexico is critical for growth and productivity. Empirical evidence suggests that sustained productivity growth is contingent upon increasing knowledge generation and absorption.6 Intermediate indicators for innovation, such as investments in research and development (R&D), technology licensing, and patenting, suggest that Mexico faces an innovation shortfall. Investments in R&D remain low relative to countries with a similar GDP per capita: 0.4 percent of GDP in 2009, well below other emerging markets such as Brazil and China and even farther below such top innovators as the Republic of Korea and Sweden (see Figure 5). Furthermore, Mexico has yet to fully exploit the opportunities that its proximity to the United States offers for technological progress and productivity. Despite the long history of computer assembly in Mexico for U.S. companies, there is little indigenous patenting or evidence of new startups or spillovers, as in Korea. The quality of scientific institutions and collaboration between universities and firms also remains below a number of comparator countries (see Mexico Policy Note 3). World Bank Page 8 Overview Mexico Policy Notes Figure 5. Low investments in innovation and weak scientific institutions hinder productivity. Research and development expenditure, 2009 Quality of scientific institutions, 2011 (percent of GDP) (survey of entrepreneurs, scale 1-7) 7.0 3.7 6.5 3.4 6.0 5.5 5.0 4.5 4.0 1.7 3.5 1.2 3.0 0.7 0.8 2.5 0.4 2.0 Mexico Chile Brasil China Korea Israel Finland United States Quality of Scientific Institutions Collaboration University-Firms Mexico Poland Turkey Brazil China Sweden Korea Source: World Bank estimation;. Creating effective teaching and learning environments: first results from TALIS 2009 / OEC;. Global Competitiveness Report 2011-2012 / World Economic Forum. The reform agenda to boost innovation seeks to raise public R&D, improve the quality of scientific institutions and strengthen links between universities and businesses. Policy reforms to promote innovation started with the enactment of the Law on Science and Technology in 2002. These reforms were followed by programs that sought to encourage technology transfer and R&D by private firms. In 2009, subsequent amendments to the Science and Technology Law expanded its scope to incorporate business innovation as a key policy objective; and to remove regulatory constraints to technology transfer. Going forward, the challenge is to strengthen the capacity of public research centers for technology transfer activities to take root. Sectoral programs to encourage applied research have been put in place as well as increased investment in human capital to improve the quality of scientific institutions. Further resources need to be devoted to increase R&D funding, improve the quality of R&D programs and develop monitoring and evaluation tools to assess their impact. Developing worker skills and facilitating job matching Mexico has achieved near universal primary school completion, but it lags its LAC and OECD peers in higher education enrollment. While 35 percent of the Mexican labor force has completed secondary school, more than 70 percent of OECD workers have done so (see Figure 6). Despite a 50 percent increase in tertiary education enrolment over the past decade, current enrollment rates of 30 percent lag behind the LAC average (37 percent). Enrolments rates in vocational training programs in Mexico are half of those in Brazil and Colombia and only one- fifth of those in Turkey and Poland. In addition to improving the coverage of education and training programs, Mexico needs to strengthen the quality of education. Mexico’s performance on international cognitive skill tests has improved over recent years. But it lags OECD peers, and the quality of the skills development system remains low. Over the past decade, the performance of Mexican students on the PISA international learning test (measuring largely cognitive skills) has improved. But Mexico still lags its peers. Among the 14 countries with a similar GDP per capita as Mexico that applied the PISA test, Mexico ranks 10th in reading and 11th in math and science tests (see Figure 6). Going forward, Mexico needs to improve its skills development system, both in schools and training institutions, to provide workers with the broad set of skills required to innovate and compete globally. World Bank Page 9 Overview Mexico Policy Notes Figure 6. The low quality of education hinders innovation and productivity. 90 600 82 82 Mexico Educational quality relative to income per capita 80 73 75 73 69 Bra sil 68 70 Chile 60 OECD 52 500 PISA score, 2009 50 45 41 40 35 30 26 21 23 20 400 Mexico 11 10 0 15-19 yea rs old 20-29 yea rs old 300 Sha re of 25-64 Upper seconda ry Enrolment ra te yea rs-old with a t gra dua tion ra te 0 10,000 20,000 30,000 40,000 50,000 60,000 lea st upper Gross National Incom (GNI) per capita (U.S. dollars, PPP), 2009 seconda ry Source: OECD 2011; The PISA 2009 International Database Mexican firms report skill mismatch – in cognitive, technical, and social-emotional skills - as a constraint to labor demand and firm expansion. Socio-emotional skills are increasingly been promoted, as reflected in the recent Upper Secondary School Reform. But they are not sufficiently valued and taught by the skills development system. Roughly a third of firms consider inadequate worker skills an obstacle to firm expansion, and more than two-fifths struggle to fill vacancies for low-skilled jobs (compared with 31 percent on average in other countries). While employers continue to demand cognitive (numeracy, literacy, problem-solving) and technical skills, a recent survey found that 40 percent of Mexican firms identified socio- emotional skills (such as communications, customer relations, teamwork) as the most difficult skill set to find (see Mexico Policy Note 4). Productivity is also constrained by inefficient matching of workers and firms. More than half of Mexican workers find their jobs through family, friends, and other personal contacts. This informal matching mechanism likely results in the misallocation of skills and lowers productivity. Public spending on job intermediation services is lower in Mexico than in other OECD countries. The absence of unemployment support may be responsible for quick rather than efficient job matches. Reform options for addressing these challenges include a national strategy for building labor market–relevant skills; continued reorientation of upper-secondary school toward the labor market; portability of skills across the education, training, and labor market systems; and facilitating job search and matching by developing integral employment services, including unemployment insurance (See Mexico Policy Note 4). REDUCING POVERTY AND INEQUALITY Low productivity growth is linked to high levels of poverty and inequality. Inequity of opportunity in access to key economic and social services (such as education, credit and infrastructure) prevents a large segment of the Mexican population from fully realizing their economic potential. This reduces productivity and slows growth, and perpetuates existing poverty and high income inequality. Breaking this vicious circle is difficult and requires an integrated reform agenda focused on economic and social objectives that are mutually reinforcing.7 World Bank Page 10 Overview Mexico Policy Notes Poverty in Mexico remains high and increased in recent years. Between 2006 and 2010, the moderate poverty rate increased from 42.7 percent to 51.3 (to 57.7 million people) and the extreme poverty rate from 13.8 percent to 19.8 (to 21.2 million people; Figure 7). The increase in poverty, in 2008 and 2010, broke a decade-long trend of poverty reduction. In 2010, 57.7 million people suffered from patrimony poverty, 12.2 million more than in 2006 (see Figure 7). Until 2006 Mexico kept pace with the rest of Latin America and the Caribbean in poverty reduction. But since 2008 the economy suffered a series of shocks—global food price crisis, global financial crisis, the AH1N1-flu epidemic, natural disasters, and a recent wave of drug- related crime—that slowed economic growth. The recent increase in poverty was largely driven by a rise in urban moderate poverty. As of 2010, poverty rates are higher in rural areas (with 6 of 10 households in rural areas poor) but the largest share of people living in poverty is located in urban areas (35 million people in urban areas vs. 17 million people in rural areas based on multidimensional poverty measures)8. The sharp increase in urban poverty that began in 2008 is at the center of the social policy and labor market reform debates. Stagnant real wages and higher unemployment and underemployment likely drove the increase in moderate urban poverty from 2008 to 2010. At the same time, safety nets in urban areas are not as well targeted as those in rural areas. The Temporary Employment Program (Programa de Empleo Temporal) focuses mainly on rural areas. It was expanded to urban areas in 2009 but could not prevent the increase in urban poverty. The flagship social protection program Oportunidades was not designed to quickly sign up transient populations that may fall into poverty when a crisis hits. Inequality and the vulnerability of the Mexican middle class have also risen. Over the last decade, Mexico has seen the emerging rise of the country’s middle class9. However, the vulnerability of the middle class to shocks and downward economic mobility is at the center of economic policy debates. Following the recent global economic crisis per capita income growth (2008-2010) turned negative for all income deciles (by more than 2 percentage points). The largest income losses were for those in the top and bottom of the income distribution, with those in moderate poverty experiencing the smallest loss. Limited social security coverage (limited unemployment insurance and high “out of pocket� health spending) explains Mexico’s middle class vulnerability to fall back into poverty when a crisis hits. The expansion of social programs, targeted at the lowest income households, has not been accompanied by an increase in social security insurance for those vulnerable groups earning incomes above the poverty line. 10 World Bank Page 11 Overview Mexico Policy Notes Figure 7. Poverty, inequality, and the vulnerability of the middle class increased in recent years. Source: CONEVAL (2012). Poverty Estimations. Source: From 1992 to 2006, World Development Indicators / world Bank (April, 2012); from 2008 to 2010, CONEVAL (2012), Poverty Estimations. 50 People living on US$ 10-50 a day Middle class headcount (%) 40 30.94 30 23.01 26.32 20 19.23 10 0 Mexico Latin America and the Caribbean Source: Socio-Economic Database for Latin America and the Source: Socio-Economic Database for Latin America and the Caribbean (SEDLAC) / Center for Distributional, Labor and Social Caribbean (SEDLAC) / Center for Distributional, Labor and Social Studies (CEDLAS) of the University of La Plata (2012) and World Studies (CEDLAS) of the University of La Plata (2012) and World Development Indicators / World Bank (2012).* Development Indicators / World Bank (2012). * Note: Vulnerable individuals are defined as those individuals with a per capita income between US$4-10. Middle class individuals are those with a per capita income between US$10-50. Per capita income is expressed in international prices (2005 US dollars, purchasing power parity terms). Regional income disparities remain a concern. Income per capita in the richest state was 6.7 times that of the lowest in 1950, and 6.1 in 2000. In 2010 the state with the highest moderate poverty was Chiapas (78.4 percent), followed by Guerrero and Oaxaca (each at 67.2 percent), while Nuevo Leon had the lowest (28.7 percent). Income disparities across Mexican municipalities are also large. In addition, access to and quality of public service delivery also varies significantly across regions. The states and municipalities with higher poverty rates tend to be those more prone to crime and/or natural disasters, and those where the population is spread in mountainous locations with limited accessibility to basic social services. World Bank Page 12 Overview Mexico Policy Notes The rise in poverty and vulnerability, underscores the urgency of a reform agenda focused on reducing the inequity of opportunities through inclusive growth. In Mexico, most of the decline in poverty over the past decade was driven by demographic factors (the increase in the adult population). In contrast, for Latin America the rise in labor income was the main contributor to poverty reduction (see Figure 8). Since 2008, the labor poverty trend index (a leading indicator of poverty which tracks the number of individuals who cannot obtain the basic food basket with their labor income) has been on the rise, suggesting that poverty is likely to remain high. To reduce poverty and inequality, Mexico’s reform agenda needs to address several related challenges: (i) labor market failures that hinder the creation of more and better jobs; (ii) the impact of natural disasters and economic crises on the poor; (iii) lack of protective measures to reduce households’ vulnerability s; and (v) regional disparities reflected in unequal opportunities in access and quality of basic social services. Figure 8. Labor income drove poverty reduction in Latin Figure 9. A leading indicator of poverty tracking America- and to a much lesser extent in Mexico (2000– individuals with labor incomes insufficient to obtain 2010). the basic food basket- has been on the rise (2005- 2011). 50% 46% 41% 40% 30% 23% 23% 20% 14% 13% 11% 11% 10% 10% 7% 7% 6% 5% 3% 0% -2% 0% 0% MEXICO LAC -10% -16% -20% Adult population Occupation share Labor income per hour Hours worked Capital Pensions Transfers Other Non-labor Residual Source: World Bank estimates;J. Azevedo [et al.] (2012). Source: CONEVAL 2012. Poverty Estimates. Note: Moderate poverty at US $4/day PPP 2005. Promoting labor markets for inclusive growth Mexico faces challenges as it seeks to develop a labor market that protects workers, creates more and better jobs for men and women, and improve their long term standard of living. A move toward labor formalization, institutionalization of universal social protection and improved education and skill development for all workers, could contribute to higher labor productivity and economic growth. Labor is the main source of income for most of the population, particularly for low income households. The reliance on labor income by low income households reinforces the importance of promoting a dynamic labor market that can contribute to poverty reduction. While labor income has been the main driver of poverty reduction and upward mobility in Latin America, it has not delivered similar results in Mexico. Between 2000 and 2010 it only contributed 23 percent to the decline in moderate poverty in Mexico compared to 41 percent in the region (see World Bank Page 13 Overview Mexico Policy Notes Figure 8). Gender disparities in labor income remain, with female workers earning on average 20 percent less than their male peers11. Mexico’s large informal sector reinforces inequality. The mobility between the formal and the informal labor markets provides a buffer against unemployment during economic downturns. But informality limits the Government’s public spending capacity and restricts social insurance benefits. The prevalence of informality leaves approximately half the workforce outside the social security system, thereby exacerbating inequities. During the 2008 crisis, only workers with access to the formal pension system were able to use early withdrawal from retirement accounts as a protective mechanism to smooth consumption. The informal workforce also generates fiscal pressures for the government. On the one hand, it results in a narrow tax base. On other hand, the government needs to fund a parallel set of non-contributory social programs for the informal sector. Programs seeking to protect informal workers can have unexpected implications, as they can make informality more attractive for new entrants and lead to a reallocation of workers to lower productivity activities. In spite of the economy recovery since 2010, informality rates have remained constant with two in every three new entrants to the labor market being informal. Recent economic shocks added to existing labor market pressures. Labor supply is outpacing labor demand. Higher than expected population growth, a 5 percent rise in labor force participation rates since 2005, and a sharp reversal in migration to the United States have significantly increased the labor supply. Before the 2008 crisis the Mexican economy was able to absorb labor supply, maintaining steady and fairly low unemployment. However, in the second half of 2008 and in 2009 a gap opened between labor supply and labor demand. By 2010 employment growth once again matched labor supply, but the gap remains. Labor force composition has shifted toward lower quality jobs. The share of the workforce in tradable sector jobs declined since 2005 but increased in non-tradable services—the latter characterized by low productivity. Despite the economic recovery, real wages have remained stagnant, and even fallen; in 2010 they still remained around 90 percent of their 2008 levels. The number of jobs paying below two minimum wages, up during the crisis, represents the highest share of all jobs, unlike previous years where jobs paying between two and three minimum wages were most common. The reform agenda should focus on increasing worker skills, addressing labor market rigidities and improving social protection. Due to the importance of labor income for lower income households, social inclusion should be fostered through interventions that help the most vulnerable groups acquire labor market-oriented skills and access the labor market. More generally, the Government should aim to strengthen skill development through education and training services, improve employment intermediation services, address labor market rigidities, and promote active labor market programs. The agenda also needs to strengthen the social protection system, in particular unemployment insurance, for the poor and the non-poor vulnerable to sudden income losses in a crisis. Improving social protection Despite recent progress, social protection faces important equity and efficiency challenges. Mexico’s social protection system includes several contributory social security schemes, social World Bank Page 14 Overview Mexico Policy Notes assistance programs, and labor market programs. Social protection programs such as Oportunidades are globally recognized as quite successful. But the social protection system as a whole suffers from fragmented programs, weak design, and gaps in coverage (see Mexico Policy Note 5). The social protection system remains fragmented. In health insurance the different contributory schemes and the Social Protection System in Health operate in parallel with little coordination. Each scheme has its own funding source, insurance pool, administration structure, financial reserves, and service provider network—resulting in large inefficiencies. For labor markets, programs overlap and are duplicative. At the federal level, 63 programs and actions promote income generation and economic well-being, many with the same goals and target populations (mostly indigenous and rural). The social protection system faces weaknesses in the design and targeting of programs. Mexico has gained experience in targeting social protection programs to the poor (Oportunidades and Seguro Popular). But some social programs (such as the energy subsidies) continue to disproportionately benefit the wealthiest while absorbing a large share of resources. Other programs are regressive by design, such as the Employment Subsidy Program (Subsidio para el Empleo), which covers only formal sector workers (less than 5 percent of the subsidies go to the poorest household decile). Even the most successful programs suffer from inefficiencies. An organizational and functional reform of health insurance schemes, in particular related to the separation of financing and provision, as well as provider payment mechanisms to allow strategic purchasing could strengthen performance. Using production-based payments more would offer incentives for providers to decrease inefficiencies while improving quality, particularly if purchasing across different schemes becomes the norm. Oportunidades would benefit from reviewing those conditions that originally motivated the program and making appropriate adjustments, including the need for greater focus on promoting the employability of beneficiaries, support to those living in disaster-prone regions, efficiency in urban areas, and mechanisms of intervention in indigenous areas. Gaps in coverage particularly affect the poor and vulnerable and those in the informal sector. Employment services, which promote employability and intermediation, have limited coverage, while important gaps persist in urban and peri-urban areas. The pension system also poses challenges. Only 7 percent of those age 65 or older in the poorest decile receive a pension, compared with 41 percent in the richest. The recent expansion of noncontributory programs— such as 70 y más and Seguro Popular—address some of the gaps, but they remain insufficient to ensure full old-age protection. While some instruments can protect households in times of emergencies or crises, the Social Protection System lacks the full range of mechanisms to mitigate the negative impact of economic shocks. PROMOTING GREEN AND INCLUSIVE GROWTH While inclusive growth is central for income convergence and poverty reduction, the environment, and the use of the country’s natural resources, must be recognized as an World Bank Page 15 Overview Mexico Policy Notes integral part of Mexico’s reform agenda. It is widely recognized that economic growth is a critical driver of social and human development. But international experience has demonstrated that it is often accompanied by the deterioration of the local and global environment, while adversely impacting the poorest and most vulnerable members of society. This highlights the importance of a green growth agenda that mitigates environmental damage while ensuring sustainable and inclusive development.12 Green growth is defined as growth that is efficient, clean, environmentally sustainable and socially inclusive. While sustainable development is often treated as a longer term objective, green growth is the short term path to this longer term objective, with a focus on more immediate concerns. The green growth approach is concerned with what needs to occur in the short term (over the next 5–10 years) before the world gets locked into patterns that would be irreversible and extremely expensive to modify, and it aims to maximize synergies and economic co- benefits.13 Mexico has a long and distinguished record on many aspects of environmental sustainability and climate change. The country is widely recognized as a global leader on climate change and is a pioneer among developing countries in climate change policy and negotiations. The country’s comprehensive strategy for climate resilient, low carbon economic growth is one of the most ambitious in the world. Yet, the country’s vulnerability to climate change remains high-- especially in the rural areas. Mexico is experiencing longer and hotter periods resulting in droughts, more intense rains and hurricanes, frequent flooding and mudslides. Environmental change is having, and will continue to have, disproportionally negative effects on poor and indigenous groups who depend on climate sensitive sources of income. A World Bank study found that: “Estimates of the macroeconomic cost of climatic natural disasters suggest that on average, each of them causes a 0.6 percent reduction in real GDP per capita. To the extent that, since the 1990s, such events have taken place on average once every three years—compared to once every four years in the period since 1950—their average impact on the affected countries would be a 2 percent reduction in GDP per capita per decade�.14 As one of the largest contributors of CO2 in LAC, Mexico has adopted an ambitious plan to drive down Green House Gas emissions. Mexico ranks 12th in the world in carbon dioxide (CO2) emissions (with emissions of 471.46 million tones CO2)15 (see Figure 10). The climate change agenda includes partnership with the states as well as the recently approved General Climate Change bill (Ley General de Cambio Climático), which calls for a 30 percent CO2 reduction by 2020 and a 50 percent reduction by 2050 (compared with 2000 level). Figure 10: Mexico is a large contributor to global CO2 emissions, mostly driven by the energy sector World Bank Page 16 Overview Mexico Policy Notes 500 471.46 Waste, 450 Land use 14.3% 400 368.32 change 350 and 300 forestry, Energy 9.8% Sector, 250 183.73 59.9% 200 165.55 150 Industrial 71.71 63.44 processes, 100 42.99 9.7% 50 13.19 0 Agriculture ,6.3% Source: Mexico: Fourth National Communication of Mexico to the United Nations Framework Convention on Climate Change / Secretaría de Medio Ambiente y Recursos Naturales, Instituto Nacional de Ecología (2009); UNDP (2007). Figure 22. Energy and Environment. – In: Human Development Report 2007-2008: Fighting Climate Change: Human Solidarity in a Divided World. Note: World Bank estimations based on 2006 data. In spite of Mexico’s commendable performance on the global and domestic climate agenda, local environmental pressures continue to rise. One commonly used aggregate indicator is the Environmental Performance Index (EPI), which is a summary of 25 different measures of environmental pressure.16 The EPI combines air and water pollution estimates, resource depletion and aspects related to policy and institutional frameworks. As with any broad measure there are problems with aggregation and interpretation, but the EPI is a useful starting point to assess how countries perform relative to their peers. Latin America scores well relative to other developing economies, and Mexico is a mid-range performer within the region (see Figure 11). Figure 11: Mexico is a mid-range environmental performer in Latin America. EPI Scores by Region. EPI Scores: Mexico and Latin American and Caribbean Countries. 80 100 71 70 63.5 90 86.4 61 78.1 76.8 58 80 60 54.3 54.3 73.3 71.4 69.9 69.8 69.3 69.3 69.1 68.4 68.2 70 67.3 47 63.5 63.4 62.9 50 61.0 59.2 59.1 58.0 57.1 58.4 60 54.2 54.0 49.9 40 50 44.3 39.5 40 30 30 20 20 10 10 0 0 Africa Est Asia Europe Latin MENA South Asia OECD and and America Pacific Central and Asia Caribbean Source: Environmental Performance Index (EPI)/ Yale University (2012) and World Bank estimations. Note: Higher scores indicate better environmental performance. Mexico has adopted innovative reforms to promote green and inclusive growth. Policy innovations such as the “Green Mortgage Program� –Hipoteca Verde - have unleashed market forces in the service of environmental efficiency. The Green Mortgage Program offers loans for the installation of green equipment accessory packages (such as solar heaters, low energy bulbs and low water consumption toilets and faucets). Initially designed as an addition to the regular World Bank Page 17 Overview Mexico Policy Notes mortgage loan, the green mortgage program has evolved and now also applies to remodeling, expansion and construction activities. The program began in March 2008 and was modified in 2011 in an attempt to broaden the choices to select accessory packages and hence promote ‘greener consumption patterns. Before 2011 the program package was fixed and depended on climatic zones. Currently the beneficiary can either buy a house with installed equipment or chose the equipment to install in the house. Going forward, two critical policy concerns need to be addressed to promote greener and more inclusive growth – tackling the environmental footprint (externalities) and managing natural assets under pressure. As Mexico grows and industrializes further, so too will the incidence of pollution if there are no compensating policy responses. Similarly, demands on common property natural resources such as water and forests will continue to rise, enhancing the need for policy innovation and stewardship. Greening growth requires reducing the environmental footprint of the urban economy. In particular, addressing pending policy issues related to land use planning, waste collection, urban pollution, and energy efficiency (see Mexico Policy Note 6): - Urban planning: Mexico is a highly urbanized country. Reducing the resource intensity of current urban development might lead to significant efficiency gains, and an improvement of economic activities, thus enhancing the efficiency and quality of growth. Urbanization also has negative externalities that impact and adversely affect quality of life, environmental sustainability, and exposure to natural disasters, mainly for the most vulnerable. Addressing these externalities (in an economically appropriate manner) would yield a double dividend –efficiency and economic gains in terms of improved land use management and greater productivity and resilience. - The Brown agenda: Although Mexico has developed good environmental legislation and protection strategies related to waste management17, these are not being adequately implemented, especially at the local level. There are still important gaps including an insufficient number of solid and hazardous waste disposal facilities, municipal sewage and industrial effluents polluting rivers in urban areas and costal environments, serious air, water and land pollution especially in urban centers. Contaminated sites can result in very significant human health impacts, often associated with poor or marginalized communities. - Energy efficiency: Energy is one of the most important sectors in the Mexican economy. First, oil revenues contribute at least one third of the federal budget, yet oil production and reserves have been steadily declining. Second, being state owned and financially constrained by the federal budget ceiling, the energy sector has been limited in terms of technological progress, corporate practices, and pricing policies. Third, energy consumption and production contribute over 60 percent of Mexico’s total GHG emissions. Enhancing energy efficiency would improve the country’s competitiveness and mitigate the fiscal burden from energy subsidies, as well. However energy policies involve crucial economic, environmental and social tradeoffs – so paying close attention to this issue would need to be a high priority going forward. World Bank Page 18 Overview Mexico Policy Notes Greening growth also requires managing the use of natural resources optimally. Progress and challenges regarding forests, water management and the energy sector (see Mexico Policy Note 7) include: - Forest and biodiversity management: While Mexico’s forests have long been valued as a source of timber, they are increasingly being appreciated for their role in helping to regulate the environment. Mexico ranks twelfth worldwide in forest cover, with 33 percent of its area being classified as either forests or “wooded land�.18 Poverty is widespread in forest communities, owing to degradation (the usual common property problem) as well as market failures that do not recognize the value of environmental services generated in forests. Hence stewardship of forests and biodiversity must continue to rank highly on the policy agenda. - Water management: Reduced water availability and poor water quality are two of the main factors that will affect economic growth and development in Mexico. Water resources in Mexico are scarce and heterogeneously distributed across the country, with the bulk of the water supply is concentrated in the south, while the population and demands are greatest in the more arid north of the country (see Figure 12). About 63 percent of the supply comes from surface water sources, and 37 percent is from groundwater sources.19 Despite steady improvements in water management across the country, there is ample evidence of the costs associated with poor water governance and includes diseases, rising costs of alternative sources, and the costs of the implicit electricity subsidy to Mexican farmers.20 But it is the unsustainable extraction of groundwater that remains by far the biggest unresolved challenge in Mexico. Figure 12. The spatial water challenge in Mexico: most of the water supply is concentrated in the south while water demand is greatest in the more arid north of the country. 100% 90% 23% 20% 80% 70% 69% 60% 50% 40% 77% 80% 30% 20% 31% 10% 0% Natural average Population GDP availability North, Center and Northwest Southeast Source: World Bank estimations based on Atlas del Agua / CONAGUA (2011). - Renewable energy: The possibility of Mexico turning into a net oil importer poses the challenge of radically transforming the energy matrix composition. The heavily based hydrocarbon structure and the declining oil production affect the configuration of the power sector and other industrial energy uses. Through the introduction of newer technologies and regulatory changes, the power sector has become the main driver of World Bank Page 19 Overview Mexico Policy Notes natural gas demand in Mexico. Diversification through the expanded use of renewable energy sources is a key element to strengthening the long-term sustainability of the Mexican economy. Finally, a comprehensive system for tracking and monitoring progress and environmental pressures needs to be developed. Mexico’s leadership and early efforts at developing Green GDP accounts are steps in the right direction. Going forward, the remaining challenge is to (i) strengthen available measures for each sector (physical and economic indicators of environmental progress); and (ii) build on the Green GDP accounts to guide macroeconomic and sectoral policies. PROMOTING SOUND PUBLIC FINANCES AND EFFICIENT GOVERNMENT Sound public finances and an efficient government are critical to achieve and sustain a green and inclusive growth agenda. A modern public administration is fundamental for executing public programs effectively and efficiently and for raising the resources required to finance these programs. An efficient and coordinated public administration with well articulated institutions is also required to manage medium term fiscal pressures through policy choices consistent with available resources. In some areas (such as macroeconomic policy and public debt management) Mexico has developed the necessary institutions and systems. In others, such as the management of expenditure to achieve quality results, progress has been made at establishing a framework, but challenges remain to improve the working of the entire budgetary and policy cycle. Finally, although improvements have taken place in tax administration in recent years, Mexico faces the challenge of developing a broad based taxation system that substantially enhances public revenue to finance its development effort without discouraging investment and formal sector employment generation. Improving service delivery and the quality of expenditure management In recent years Mexico has undertaken a number of important initiatives to improve the quality of expenditure and service delivery. These include: developing a new legal framework to increase expenditure efficiency, including a Performance Evaluation System (Sistema de Evaluación del Desempeño, or SED), affecting all three levels of government, which defines new policies on results-based management and budgeting; strengthening budget discipline by improving budget management across the budget cycle, from planning through execution to audit and evaluation; introducing a financial management information system (Sistema Integral de Administración Financiera Federal, or SIDAFF), which began implementation in 2012; the establishment of a specialized function for comprehensive evaluation of selected federal government policies and programs within the Ministry of Finance (see Mexico Policy Note 9). All of these initiatives have yielded benefits, but require institutionalization for Mexico to improve public sector performance and the quality of expenditures. Budget and financial management covering key functions in the budget cycle, from planning to execution to evaluation, have traditionally focused on process compliance and input control. These functions and systems need further upgrading to provide public sector managers and decision-makers with World Bank Page 20 Overview Mexico Policy Notes relevant, timely, high-quality information on financial inputs and outputs and on outcomes from public projects and programs. This challenge requires actions on several fronts: continue to implement modern harmonized accounting standards and performance-informed budgeting policies, using information technologies more intensively for public sector management (e- government), raising standards of administrative procedures and procurement, and strengthening the capacity of federal and subnational governments to deliver high-quality public goods and services in a timely fashion. The performance budgeting and evaluation system reform led by the Ministry of Finance has advanced a results- and performance-informed orientation in the federal budget process. To incorporate results and performance dimensions into resource allocation, the new system uses performance indicators for public sector programs, along with systematic evaluations of public sector policies and programs. Consolidating performance-based budgeting at the federal and state level depends on consolidating the SIDAFF and equivalent state financial management systems, improving the quality of the performance information, institutionalizing the evaluation function, and working with sector ministries to consolidate the performance culture, implement the new tools and processes, and expand capacities to use them. As experience from other countries shows, setting up a performance-informed system requires a cultural change, with a new management style based on performance incentives, management delegation, and a focus on inputs, outputs, and outcomes. In addition, because results-informed management requires mechanisms for accounting, reporting, and consolidating information, accounting systems are being modernized and harmonized. Completing the accounting harmonization program will remain a challenge for the next administration. This task, not simply technical, will require strong political leadership to ensure that the accounting and reporting changes are implemented as the basis for effective resource management in the public sector. At the subnational level, supporting the country’s 1,200 smaller and less developed municipalities must be a priority. At the subnational level, it will be important to provide support and incentives for implementing state-level financial management systems consistent with the accounting harmonization. For states and municipalities, establishing a common budget classification system in parallel with accounting harmonization would enhance fiscal transparency and support standardization across levels of government. A more transparent and consolidated accounting framework would improve expenditure monitoring and encourage efficiency and accountability. Incentive mechanisms for subnational governments that adopt an integrated system, and support to those that are willing to move forward first, to implement the new accounting standards will be important through 2013. Improving the efficiency of government delivery of goods and services requires continuing the procurement system reform initiated in 2009. Mexico’s public procurement system has a large impact on the country’s economy: public procurement accounts for 40 percent of the federal budget and about 10 percent of GDP, and the estimated savings from effective procurement are substantial. Until recently, the procurement system was overregulated, focused heavily on the administrative function, and based primarily on legal regulations. The key challenges are to consolidate the current system and to target more areas. Especially important is continued emphasis on performance outcomes. Because the risk of waste and corruption in World Bank Page 21 Overview Mexico Policy Notes procurement systems is high, procurement reform and monitoring can yield substantial gains for the economy and society. Managing medium-term fiscal pressures Health and pension spending will rise as the population ages and experiences an epidemiological transition. Age-related public spending needs will materialize alongside demands for filling the existing gaps in the country’s social security and social protection system (see Mexico Policy Note 10). Over the next two decades the population 65 years of age and older is projected to double as a share of total population (see Figure 13). This demographic transition is expected to lead to an increase of public spending on pension and old-age income provisions by about one percent of GDP over this period. Similarly, health expenditure is bound to increase due to the country’s demographic and epidemiological transitions. Total health spending is likely to grow from 6 to 8 percent of GDP over the next two decades. Approximately half of this increase will be on account of the public sector. Figure 13. Medium-term expenditure pressures related to population aging are mounting. Population ages 15–64 years, 2005–50 35 Youngest and oldest population, 2005–50 (percent of total population) (percent of total population) 70 30 69 25 0–14 years 68 20 67 66 15 Older than 65 10 65 years 64 5 63 - 62 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 Source: World Development Indicators / World Bank (April, 2012). Mexico’s public finance depends heavily on oil revenue, but recent high prices mask an alarming decline in oil production. Crude oil production has declined by 25 percent following a peak in 2004. Estimates of oil reserves and production are surrounded by a large margin of uncertainty, though even if production were to stabilize at the current level of 2,500 thousand barrels per day, a growing economy would result in a fall of oil revenue as a percent of GDP. Over the next two decades such a stabilization of oil production could represent a reduction of oil revenue as a percent of GDP by 3 percentage points. Declining oil revenue, increasing medium term health and pension spending as well as other public sector spending requirements call for a strengthening of tax collection. Federal tax collection in Mexico (13.8 percent) is below the OECD average (19.2 percent). When local taxes and social security contributions are included, Mexico drops to last place among OECD countries (see Figure 14). Though the general features and statutory rates of the World Bank Page 22 Overview Mexico Policy Notes Mexican tax system compare favorably internationally, tax collection efficiency remains substantially below peers. Figure 14. Falling oil production and low tax revenues pose a challenge for revenue management. Oil production and trade 3,500 (thousand barrels daily) 3,250 3,000 2,750 2,500 2,250 2,000 1,750 1,500 1,250 1,000 750 500 250 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 (e) (e) Crude oil production Crude oil exports Imports of oil related products Source: Banco de Información Económica / INEGI (2012). Source: Economic Survey of Mexico / OECD (2011). A large informal economy narrows the tax base, and numerous tax loopholes and exemptions hinder tax collection and ease tax evasion. The Mexican tax collection agency, the Servicio de Administración Tributaria, estimates that about 77 percent of income tax due on non- salary income is not paid, and that value-added tax evasion is 35 percent. Preferential corporate and individual tax regimes, value-added tax exceptions and multiple rates complicate the tax system and facilitate noncompliance. Exemptions, deductions, and multiple rates generate substantial revenue losses, have the same effect on the budget as does government spending (like subsidies), and alter the horizontal and vertical equity of the tax system. Adopting an integrated fiscal reform that simplifies the tax system, reforms energy subsidies, and broadens the tax base could meaningfully bolster revenue. Reducing or withdrawing tax expenditures would broaden the tax base and strengthen revenues. Forgone tax revenues due to these expenditures are large and mainly regressive. Similarly, reducing public subsidies, especially prevalent in the energy sector, would likely enhance public revenue as well. Energy subsidies, highly regressive in Mexico, mask resource costs. Withdrawing them would raise revenues, avoid distorted price signals, and help Mexico reach its climate change mitigation goals. The fiscal reform should also aim at improving equity. The Gini coefficient in Mexico has remained virtually the same before and after taxes, in contrast with European Union countries, where taxes and public transfers substantially lower income inequality (see Figure 15). This is partly the result of a low share of progressive income taxes in overall tax revenues. The fiscal reform should include a careful evaluation of its distributional impact. But the distributional incidence of the individual fiscal measures should be less of a concern than the overall distributional incidence of the tax-benefit package. Energy subsidies, VAT exemptions and zero rating are in effect non-targeted consumption subsidies. The amount of the subsidy obtained depends on household spending on the subsidized products, which tends to rise with income. The loss in purchasing power for lower income households generated from broadening the tax base World Bank Page 23 Overview Mexico Policy Notes and the removal of energy subsidies would need to be evaluated in parallel to an increase in targeted social spending programs. Eliminating subsidies and preferential tax regimes, along with a compensation mechanism for lower income households, could lead to a net benefit in the income redistribution function of the tax-benefit system. A fiscal reform that focuses on improving the redistributive impact of taxes and public transfers could improve citizen trust in the state, currently lower than in other Latin American countries, reflecting taxpayer disappointment with public service delivery (Figure 14). Figure 15. Fiscal policy did not have much Figure 16. Citizen trust in the state remains low in redistributive impact in Mexico and Latin America and Mexico, compared to its Latin American peers. the Caribbean. Gini Coefficient, 2009, 70% Citizen's Trust in the State, 2011 (before and after taxes and transfers) 0.6 60% 0.51 0.52 0.51 0.49 50% 0.5 0.46 40% 0.4 0.34 30% 0.3 20% 0.2 10% 0% 0.1 Uruguay Bolivia Colombia Venezuela Chile Honduras Guatemala Panama El Salvador LAC Mexico Paraguay Nicaragua Peru Costa Rica Dominican Rep. Argentina Brasil 0 Ecuador Mexico LAC European Union Source: Gasto público para la equidad: del estado excluyente hacia un Source: Confianza en el Gobierno – In: Informe Latinobarómetro estado de bienestar universal / John Scott. – CIDE (2010). (2011). – p. 51 Improving subnational public finances The high centralization of Mexico’s tax system has reduced the incentives of subnational governments to collect taxes. A number of subnational governments suffer from limited administrative capacity to fulfill key tax administration functions, while the dependence on federal transfers remains high (90 percent of subnational public revenue). These vertical imbalances, combined with the rise in discretionary federal transfers, have reduced states incentives to raise their own revenue. Property tax, for example, is an important source of public revenue for subnational governments in OECD countries, but in Mexico amounts to only 0.2 percent of GDP. Meanwhile, rapidly growing subnational expenditures now constitute more than half of total subnational public expenditures. Dependence on federal transfers increases the volatility of subnational public finances during periods of economic instability and puts pressure on state public debt (Figure 16). The lack of fiscal discipline has led to unsustainable fiscal positions in some states. This calls for fiscal consolidation programs that combine financing (conditional on fiscal and service delivery targets) with technical assistance to mobilize state revenues and improve expenditure management. It also calls for a transparent crisis resolution mechanism for states that fall into fiscal distress (see Mexico Policy Note 11). World Bank Page 24 Overview Mexico Policy Notes Figure 17. Subnational public finances face low tax revenue and rising public debt since 2009. Own revenues, 2010 Subnational debt (Mex$ billion, 2011 prices) 35 (percent of total revenues) 450 30 400 25 350 20 300 15 250 10 200 150 5 100 0 50 National VER SIN NL AGS YUC QROO BC DGO CAM COL MOR DF BCS MICH TLAX TAB CHIH QRO ZAC PUE OUE GTO HGO SON TAMPS JAL CHIS SLP OAX EDOMEX COAH GRO NAY 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Banco de Información Económica / INEGI (April, 2012). Source: Estadísticas de Deuda Publica de Estados y Municipios / Secretaría de Hacienda y Crédito Público (Abril, 2012). World Bank Page 25 Overview Mexico Policy Notes *** The reform agenda summarized in this overview, and described in more detail in the attached compendium of policy notes, is challenging but feasible. It proposes an integrated reform agenda that seeks to promote productivity, reduce poverty and inequality, promote green growth and strengthen public finances and government efficiency. Mexico has a unique opportunity in the next sexenio to promote inclusive and sustainable growth. But it will require setting priorities and sharing responsibilities between the elected government and its citizens. *** It was prepared by a World Bank team of economists and sector specialists. The team was led by Paloma Anós Casero, and included: Arturo Ardila, Pedro Arizti, Tania Begazo, Raja Bentaouet, Diomedes Berroa, Kristyna Bishop, María Eugenia Bonilla, Alessandra Campanaro, Roland Clarke, Andrea Coppola, Aline Coudouel, Wendy Cunningham, Richard Damania, Laurent Debroux, Charles Delfieux, Jozef Draaisma, Svetlana Edmeades, Gerardo Esquivel, Eva Gutiérrez, Ricardo Hernández, Carolina Hoyos, Jane Hwang, Óscar Ishizawa Escudero, Todd Johnson, Theresa Jones, David Kaimowitz, Markuz Kitzmuller, Esperanza Lasagabaster, Marth Licetti, Luis Felipe López Calva, William Maloney, Catalina Marulanda, David Michaud, Robert Montgomery, Edgardo Mosqueira, John Nash, Angélica Núñez, María Catalina Ochoa, Alexandra Ortiz, Stefano Pagiola, Alan D. Poole, Cristian Quijada, Karina Ramírez, Gaudencio Ramos, Rekha Reddy, Paula Restrepo, Graciela Reyes Retana, Carlos Rodríguez Castelar, Luis San Vicente, Jordan Schwartz, Kinnon Scott, Rodrigo Serrano, Francisco Sucre, Guadalupe Toscano, Azul del Villar, Ariel Yépez, Natasha Zamecnik, and Javier Zuleta. The note benefited from guidance from sector management (Rodrigo Chaves, Lily Chu, Louise Cord, Malcom Cosgrove-Davies, Wambui Gichuri, Maninder Gill, Joana Godinho, Keith Hansen, Arturo Herrera, Ede Jorge Ijjasz-Vásquez, Karin Erika Kemper, Aurelio Menéndez, Laurent Msellati, Reema Nayar, Marialisa Motta, Mansoora Rashid, Ethel Sennhauser, Auguste Tano Kouame, and Anna Wellenstein); the Country Management Unit (Harold Bedoya, Gloria Grandolini, Sabine Hader, Eguiar Lizundia González, and Fernanda Zavaleta); and the International Finance Corporation (Roberto Albisetti, Yvy Figueroa, and Laura Vila). It also reflects the guidance received from internal and external reviewers, including: Erik Bloom, Carter Brandon, Augusto de la Torre, David Gould, Stephane Hallegatte, Rafael de Hoyos Navarro, and Marcelo Selowsky (International Monetary Fund). Patricia Chacón-Holt, Beatriz Franc, and Rosa María Hernández- Fernández provided valuable assistance during the production process. Bruce Ross-Larson and his team from Communications Development Incorporated (CDI) provided useful editing assistance. NOTES 1 This compendium does not discuss economic and social challenges related to citizen security. Parallel research efforts are being launched to shed light on trends of citizen insecurity and their implications for inclusive and sustainable growth in Mexico. World Bank Page 26 Overview Mexico Policy Notes 2 In terms of Purchasing Power Parity (PPP) adjusted GDP per capita. 3 Bosworth B. y S. Collins. (2003). The Empirics of Growth: An Update, Brookings Papers on Economic Activity. -- (2). – pp. 113-179. 4 Hanson, G.H. (2010). “Why isn’t Mexico rich?�. – In: Journal of Economic Literature. -- 48 (4), pp. 987-1004. 5 OCDE (Organización para la Cooperación y el Desarrollo Económico) (2011). Estudios Económicos de la OCDE: México, Paris. 6 Evidence based on the US manufacturing sector shows that increasing an industry’s intensity in R&D by 1 percentage point increases the growth rate of output per worker in that industry by between 0.08-0.16 percentage points (Zachariadis, 2003). 7 Bourguignon François and Sébastien Dessus (2009). Equity and Development: Political Economy Considerations. In Levy, Santiago and Michael Walton (Eds.), No Growth Without Equity? Inequality, Interests, and Competition in Mexico (45-69). The International Bank for Reconstruction and Development, Washington DC. 8 Consejo Nacional de Evaluación (CONEVAL) (2011). Pobreza en México y en las Entidades Federativas 2008- 2010. – México: In: www.coneval.gob.mx. -- Julio 2011. 9 The middle class headcount is the number of individuals with daily incomes between 10 and 50 dollars (in 2005 US dollar, PPP terms). They fall approximately between the 66th percentile to 98th percentile in the household survey (see Economic Mobility and the Rise of the Latin America Middle Class. – Washington, D.C. : The World Bank, 2012). 10 Torche, Florencia and Luis Felipe López-Calva (2010). “Stability and Vulnerability of the Latin American Middle Class�, to be published in Katherine Newman, ed. Dilemmas of the Middle Class around the world. 11 World Development Report: Gender Equality and Development (2012). – Washington, D.C. : The World Bank. 12 Hallegatte Stéphane… [et al.] (2011). From Growth to Green Growth: A Framework.—Washington, D.C. : The World Bank. – (Policy Research Working Paper ; 5872). 13 Ibíd. 14 De la Torre Augusto, Pablo Fajnzylber, John Nash. (2009). Low Carbon-High Growth: Latin America & Climate Change. – Washington, D.C. : The World Bank. – pp. 4. 15 United Nations Environmental program (UNEP) (2007). Environmental Indicators. 16 There are a number of measures that identify and emphasize different aspects of the environment - such as resource exhaustion, or pollution, or impacts on health and economic activity. 17 For example, Ley General para la Prevención y Gestión Integral de los Residuos y su Reglamento y sus Normas Oficiales Mexicanos; Programa Nacional para la Prevención y Gestión Integral de los Residuos 2009-2012 (SEMARNAT). Secretaría de Medio Ambiente y Recursos Naturales. 18 Food and Agriculture Organization (FAO) (2010). Global Forest Resources Assessment 2010. – Roma, Italia : FAO. 19 Comisión Nacional del Agua (CONAGUA) (2011). Atlas del Agua México. – México : CONAGUA. 20 Muñoz Piña Carlos… [et al.] (2006). Agriculture Demand for Groundwater in Mexico: Impact of water right enforcement and electricity user-fee on Groundwater level and quality. – México INE : SEMARNAT. -- Working Paper INE-DGIPEA/0306. REFERENCES AZEVEDO, J., G. Inchauste and V. Sanfelice (2012). Decomposing the Decline in Income Inequality in Latin America. -- Mimeo. BOURGUIGNON, Francois and Sébastien Desus (2009). “Equity and Development: Political Economy Considerations�. -- In: No Growth Without Equity? Inequality, Interests, World Bank Page 27 Overview Mexico Policy Notes and Competition in Mexico / Santiago Levy and Michael Walton, editors. – Washinton, D.C. : The World Bank : Palgrave Macmillan . -- pp. 45-69. BOSWORTH, Barry P., Susan M. Collins (2003). The Empirics of Growth: An Update -- Brookings Papers on Economic Activity. -- 2003(2). -- pp. 113-179. BOTERO, Juan C. Simaeon Djankov, Rafel La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer (2004). “The regulation of labor�. – En: The Quarterly Journal of Economics, 1339-1382. CEDLAS (Center for Distributional, Labor and Social Studies) (2012). Socio-Economic Database for Latin America and the Caribbean (SEDLAC). – Buenos Aires, Argentina : Universidad de la Plata : The World Bank. CONAGUA (Comisión Nacional del Agua) (2011). Atlas del Agua en México 2011. – México : SEMARNAT. CONEVAL (El Consejo Nacional de Evaluación de la Política de Desarrollo Social) (2012). Estimaciones de Pobreza. – México : In: http://www.coneval.gob.mx/cmsconeval/rw/pages/medicion/cifras/pobrezaporingre sos.es.do --- (2011). Pobreza en México y en las Entidades Federativas 2008-2010. – México : Documento obtenido en www.coneval.gob.mx. -- Julio 2011. Foro Económico Mundial. (2011). Informe de Competitividad Global 2011-2012, Geneva. HANSON, Gordon H. (2010). “Why isn’t Mexico rich?�. – In: Journal of Economic Literature, 48 (4), 987-1004. HESTON, Alan, Robert Summers, Bettina Atten (2011, June). “Penn World Table Version 7.0�. -- Center for International Comparisons of Production, Income and Prices, University of Pennsylvania, United States. INE (Instituto Nacional de Ecología). 2009. México: Cuarta Comunicación Nacional ante la Convención Marco de las Naciones Unidas sobre el Cambio Climático. Secretaría de Medio Ambiente y Recursos Naturales. México. INEGI (Instituto Nacional de Estadística y Geografía). 2012. Banco de Información Económica. – Mexico : INEGI. ---- (2012). Finanzas Públicas Estatales y Municipales. – México : INEGI. World Bank Page 28 Overview Mexico Policy Notes IFC (International Finance Corporation) (2012). Doing Business 2012: doing business in a more transparent world. – Washington, D.C. : CFI. LATINOBAROMETRO (2011). Informe.-- Santiago de Chile, 28 de Octubre -- 112 p. No Growth Without Equity? Inequality, Interests, and Competition in Mexico / Santiago Levy, Michael Walton, editors – Washinton, D.C. : The World Bank : Palgrave Macmillan, 2009. – 449 p. OCDE (Organización para la Cooperación y el Desarrollo Económico) (2011). Education at a Glance, 2011: OECD Indicators. – Paris : OECD Publishing. ---- (2011). Estudios Económicos de la OCDE : México. ---- (2009). Creating Effective Teaching and Learning Environments: First Results from TALIS. PISA (OECD Programme for International Student Assessment) (2009). The PISA 2009 International Database. PNUD (Programa de las Naciones Unidas para el Desarrollo) (2007). “Cuadro22. Energía y medio ambiente�. – In: Informe de Desarrollo Humano 2007-2008: La Lucha contra el cambio climático: Solidaridad frente a un mundo dividido. SHCP (Secretaría de Hacienda y Crédito Público) (2012). Estadísticas de Deuda Pública de Estados y Municipios. – México : SHCP. SCOTT, John (2010). “Gasto Público para la Equidad: Del Estado Excluyente hacia un Estado de Bienestar Universal�. – México : CIDE : CONEVAL. Yale University (2012). Environmental Performance Index. – �ndice disponible en: http://epi.yale.edu/ ZACHARIADIS, Marios (2003). “R&D, innovation, and technological progress: a test of the Schumpeterian framework without scale effects�. – En: Canadian Journal of Economics / by Canadian Economics Association. -- Vol. 36(3). – pp. 566-586. World Bank (2012). World Development Indicators Database. – The World Bank : Washington, D.C. – Base de datos disponible en: http://data.worldbank.org/data-catalog/world- development-indicators World Bank Page 29 Overview Mexico Policy Notes POLICY NOTES: Policy Note No. 1: Fostering sound financial sector development. Policy Note No.2: Toward a more competitive business environment. Policy Note No.3: Fostering innovation for productivity and competitiveness. Policy Note No.4: Labor markets for inclusive growth. Policy Note No.5: Promoting an integral social protection system. Policy Note No.6 Reducing the footprint of growth. Policy Note No.7: Using natural resources in an optimal way. Policy Note No.8: Managing medium-term fiscal challenges. Policy Note No.9: Strengthening public revenue and expenditure management to enhance service delivery. Policy Note No.10: Strengthening subnational public finance. For more information visit: http://www.worldbank.org.mx World Bank Page 30