Small firms are responsible for much of the job creation in Latin America. At times, they are considered repositories of entrepreneurial talent and innovation. For these and other reasons, governments deploy special policies to help them, like subsidized credits from development banks or set-aside purchases from the government. In Latin America, one policy stands out: special tax regimes with substantially lower tax burdens.

In Peru, for example, firms face four different social insurance and corporate tax regimes depending on their level of sales and number of employees; the tax burden gets larger as firms get bigger. In Brazil, small firms can jointly cover their social insurance and corporate tax obligations through a single payment if they are small, but separately and at higher rates if they are large. In Mexico, firms with sales below a certain threshold face a lower tax burden than firms with sales above it. In Costa Rica, small firms—as determined by a formula combining sales, purchases, assets, and employees—jointly pay their value added and income taxes through a single tax. Although eligibility requirements vary, as well the implicit subsidy, with the exceptions of exceptions of El Salvador, Panama, and Venezuela, every country in Latin America has some form of a special regime for small firms.

Despite their popularity, the objectives of these special tax regimes are not always clear. Is it to promote employment or entrepreneurship? Or is it to promote smallness for its own sake, despite the tendency for small firms to be much less productive than larger ones? Is it the hope that these firms will grow and become more productive?

Tilting against productivity

My view is that these special tax regimes may be counterproductive, because they allow low productivity firms to survive in the market and impede higher productivity firms from growing and creating more productive and better paying jobs. These regimes may be one reason why productivity in Latin America has grown so slowly.

To illustrate one of the main problems (see Table 1), assume that small and large firms are distinguished by their sales, the threshold separating them is 2 million pesos in annual sales, and firms are taxed at 2 percent of sales if they are small and 30 percent of profits if they are large. The first line depicts a firm with sales of 1 million pesos a year, paying 700,000 pesos in materials and wages. So profits before taxes are 300,000 pesos. Because sales are below the threshold, the firm pays 20,000 pesos in taxes (2 percent of 1 million) and makes 280,000 pesos in after-tax profits.

Note that in the absence of this special regime the firm would have paid 90,000 pesos in taxes (30 percent on gross profits of 300,000) and earned 210,000 pesos in after-tax profits. After-tax profits are 33 percent higher than they would have been had the firm not been favored.

Table 1: Hypothetical example of a firm taxed under a special and normal regime (pesos)

N.A. = Not an available option.

If sales double, the firm still qualifies for the special regime. In the second line of Table 1, the firm now makes gross profits of 600,000 pesos, pays 40,000 pesos in taxes, and makes 560,000 pesos in after-tax profits (again, 33 percent higher than the 420,000 in after-tax profits it would have made in the absence of the special regime). Since after-tax profits increase with sales, the firm has all the incentives to grow.

The problem begins after this point. If sales grew again, say, by 5 percent to 2,100,000 pesos, the firm would no longer qualify for the special regime. The third line of table 1 shows that the firm would have to pay 30 percent of its gross profits of 630,000 pesos in taxes, so its after-tax profits would fall to 441,000 pesos, less than what the firm was making before it grew (560,000 pesos). The firm is better off staying small. In fact, the firm will only grow if its sales increase by at least 34 percent, at which point after-tax profits (at 562,800 pesos) will be higher than under the special regime. And even if sales grow by more than a third, after-tax profits would barely increase by 0.5 percent.

More productive might mean less profitable

The problem is that a firm with sales of 1,999,999 pesos may be substantially less productive than a firm with sales of 2,000,001 pesos, but substantially more profitable. The less productive firm will survive in the market, and maybe even get bank credit—it is very profitable, after all—while the more productive firm may not survive.

This is a hypothetical example but the tax regime is real. This is what actually happens in Mexico. Figure 1 uses firm-level data from Mexico’s Economic Census for 2013 to show the effects of Mexico’s tax regime. As it turns out, there are 7,755 firms whose sales levels are 5 percent or less than the threshold established in Mexican law separating large from small firms. The figure plots the change in after-tax profits for each firm if sales increase by 10, 20, or 30 percent.

Figure 1: Changes in after-tax profits for “close to but below the threshold firms” (percentage change)

Amazingly, if sales increased by 10 percent, 88 percent of all firms under consideration would experience a drop in after-tax profits (point A in the figure). If sales increased by 20 percent, 80 percent of firms would experience lower after-tax profits (point B). Even if sales could increase by 30 percent, more than half of all firms would be better off not growing (point C).

Mexico is not alone

These problems are endemic. In Latin America, they are a big reason for the large number of small firms that characterize the region’s economies. The details of how these regimes operate vary from country to country, but the general effect is the same: inadvertently, these regimes allow unproductive firms to survive and impede productive firms from growing, exactly the opposite of what is needed to create well-paid jobs.

Tax policies are distorting the size distribution of firms. Smaller firms have higher entry and exit rates and can induce greater labor rotation, impeding learning on the job. These firms may be creating many jobs, but these jobs are both less stable and compromise wage growth.

Other things contribute to the overabundance of small and unproductive firms in Latin America, but special tax regimes are clearly culpable. Policymakers should be asking themselves whether favoring small firms with special regimes is the best way to create good jobs.

       

The fifteenth Brookings Blum Roundtable will explore challenges to, and opportunities for, U.S. foreign assistance and global leadership. With U.S. government resources for global development now secured, the next steps on redesigning the State Department and USAID are looming, with legislation to create a new development finance agency well advanced.

Other reform options being considered by Congress and the Administration are how the U.S. can best reduce fragility, how it can best use and support multilateral institutions, and how it can compete or collaborate with China on promoting global development. In each of the sessions, participants will share ideas on specific opportunities for U.S. leadership in the development arena.

The agenda topics deal with live policy issues on which participants are engaged. Thus, the discussions could have a direct impact on policy.

       

Why has an economy that has done so many things right failed to grow fast? Under-Rewarded Efforts traces Mexico’s disappointing growth to flawed microeconomic policies that have suppressed productivity growth and nullified the expected benefits of the country’s reform efforts. Fast growth will not occur doing more of the same or focusing on issues that may be key bottlenecks to productivity growth elsewhere, but not in Mexico. It will only result from inclusive institutions that effectively protect workers against risks, redistribute towards those in need, and simultaneously align entrepreneurs’ and workers’ incentives to raise productivity. For this transformation to take place, substantive changes to the country’s tax, labor, and social insurance regimes are required.

Santiago Levy, nonresident senior fellow in the Global Economy and Development program at Brookings, published this book with the Inter-American Development Bank.

Learn more about the book and view the full PDF version in English or in Spanish.

       

Education tops the to-do list for development experts, and with good reason. A broad understanding that education is central to people’s welfare has led governments to devote considerable resources to increase the coverage and quality of their education systems. While these efforts are certainly welcome, and will undoubtedly increase social welfare, the tacit assumption has been that they will contribute to growth everywhere. In other words, if only the supply of human capital could be enhanced and increased, then growth would accelerate.

Figure 1 depicts the financial returns from education in Mexico from 1996 to 2015. These are measured as the percentage difference in average wages of workers who completed primary education, junior high, senior high, and university education, relative to workers who did not complete primary education.

The figure illustrates a puzzling trend: If education constrained growth in Mexico over the past two decades, why did returns fall for those with more years of schooling? Would we not expect the opposite, that is, given growing shortages of skilled human capital, the market would increasingly reward those with more education?

Luis Felipe López-Calva and I have explored the hypothesis that growth in Mexico has not been constrained by a shortage of human capital. The returns from education fell because while the supply of workers with more education has increased noticeably and its quality improved, demand for more educated workers lagged. In other words, the answer to the puzzle is on the demand side.

But what has happened to the demand for human capital in Mexico? The key observation is that the demand by businesses (what I will refer to as firms) for workers of various schooling levels depends on the type of firms present in a given market. In Mexico tortillas are produced by large firms with sophisticated machines, and by small firms with simple technologies. The former require engineers, accountants, and managers with business degrees; the latter, only workers with basic literacy and numeracy. If there are many large firms, the demand for more educated workers is stimulated; if there are few, it is depressed.

A similar situation occurs in the transportation industry: Services can be provided by hundreds of self-employed drivers each operating his own truck, or by a large firm hiring hundreds of drivers. In both cases, the number of workers and trucks is the same, but in the case of the large firm, there is also a need for an accountant to manage payroll and for a logistics engineer to coordinate dispatch. Think of apparel, food processing, or retail commerce: In these and many other cases, firms of various sizes and technological complexity produce similar goods, but with different demands of workers’ education.

In all countries, firms of different productivity levels co-exist, but Mexico distinguishes itself from other countries in the extent to which this is so. As a comparison, in the United States manufacturing sector, the most productive firms are approximately four times more productive than the average firm, versus 16 times in Mexico; at the opposite end, in the United States the least productive firms are about 1/16 less productive than the average, versus 1/256 in Mexico. Comparing Mexico with other Latin American countries, the differences are less dramatic, but still quite substantial.

The co-existence of heterogeneous firms in the same narrowly-defined market is one manifestation of widespread resource misallocation in Mexico. If somehow the hundreds of self-employed truck drivers could be grouped in a firm, the productivity of the transportation sector would increase and, critically, so would the demand for more educated workers. Similarly, if more tortillas could be produced in larger and more complex firms, the productivity of the tortilla sector would increase as well, and so would the demand for more educated workers. There is an important debate as to what blocks such efficiencies and perpetuates misallocation. However, as Figure 1 makes clear, lack of educated workers is certainly not the reason.

Small low productivity firms producing tortillas and self-employed truck drivers are often described as being part of the informal sector, while large high productivity firms producing tortillas and transportation services constitute the formal sector. Much ink has been devoted to these terms (and, at times, much confusion generated!). Yet, labels aside, there are two critical points. First, the demand for educated labor depends on the type and size of firms present in the economy. Second, when resources are misallocated toward small informal firms, the relative demand for workers with more years of schooling will be depressed.

To see how differences in the size and type of firms would affect the returns to education, López-Calva and I estimated how wages of informally employed workers would change if they worked for formal firms. The exercise measures the impact of lower misallocation on the demand for workers of various educational levels, keeping the supply of each educational group constant. Figure 2 shows the results for workers with university and primary education (the horizontal axes measures wages per hour in pesos of 2008, but note that the scales differ).

The contrast is sharp: In both cases the distribution shifts to the right toward higher wages, but while average wages of workers with primary education increase by only 3 percent, those of workers with university education do so by 29 percent. These results serve to make two points: First, misallocation is costly to workers, as the implied productivity losses lower everybody’s wages. Second, more relevant here, lowering misallocation widens the differences in average wages across educational groups, in turn raising the returns to education.

Figure 2 implies that, without misallocation, the distance between the lines shown in Figure 1 would increase; but it does not necessarily imply that the slopes would change. This matters because one could argue that misallocation only causes a one-off fall in the returns to education, but should not affect the trends.

To understand what is driving the trends, two phenomena need to be put together. On the supply side, over the period considered in Figure 1, the labor force grew on average at 2.3 percent a year, but its educational composition changed drastically: The supply of workers with completed primary grew only 0.8 percent, while that of workers with completed senior high and university education grew 6.1 and 4.4 percent, respectively.

On the demand side, a surprising feature of Mexico is that, despite many reforms over the past two decades, misallocation increased somewhat. To give one statistic, in 1998, the difference in productivity between firms in the 25th and 75th percentiles of the productivity distribution was 23 percent; in 2013, it was 39 percent. (The same numbers for firms in the 10th and 90th percentile are 139 and 180 percent.) On the flip side, informal firms grew more than formal ones and have attracted more resources.

In other words, over these two decades the imbalance grew between the supply of, and demand for, more educated workers; an imbalance directly associated with the persistence of misallocation. In its absence, the trends in demand for educated labor would have been different, and, given the behavior of supply, so would the trends in the returns to education.

Misallocation is by no means unique to Mexico. Many developing countries in Latin America have numerous small low productivity firms and many self-employed workers. In other words, they have large informal sectors and misallocation is a significant issue. While the specific factors that generate misallocation probably differ between countries, in each economy the phenomenon drives two undesirable outcomes: low productivity and depressed demand for more educated workers.

Many countries are investing heavily in education and pursuing reforms to improve its quality. These efforts are welcomed and must be pursued. However, in cases such as Mexico, misallocation is thwarting the returns on these efforts. The potential productivity gains from a more educated labor force can, in those circumstances, be just that, potential. It is not all about supply.

       

Contributory Social Insurance

Latin American countries created social insurance systems in the 1930s and 1940s with the promise of providing protection to all workers against various risks. These systems, the cornerstone of the region’s welfare states, were forged on the European model, with benefits financed through a contribution paid by firms and workers proportional to the latter’s wages. For this reason, they are at times labelled “contributory social insurance,” or CSI.

Over a half a century later, the promise remains unfulfilled. Although there are important variations across countries, considering the region as a whole, less than half of all workers are covered by CSI systems. Some countries have relatively high coverage rates: Uruguay 77 percent, Chile 71 percent and Brazil 64 percent. But these are the exception. For the majority, coverage rates are low: Mexico 40 percent, Dominican Republic 38 percent, Colombia 37 percent, Paraguay 23 percent, Peru 22 percent and Bolivia 17 percent. In Central America, with the exception of Costa Rica, coverage rates are 23 percent on average.

A basic design flaw explains why: In most countries only workers hired by firms that comply with the law are enrolled. These workers, known as formal workers, are mostly urban and employed by relatively larger firms, or directly by the government as public employees. The rest, known as informal workers, are employed in a variety of ways that leaves them without coverage. They can be self-employed or work in rural areas or in small firms in urban areas where it is difficult to enforce social insurance laws.

Aside from low, coverage is also unevenly distributed across income levels. Formal workers have on average higher wages than informal ones, often because they have more years of schooling, or as a result of the stronger bargaining power associated with working for larger firms or belonging to public sector unions. Thus, CSI fails to reach those who need it most.

The range of benefits offered by CSI systems varies across countries, but they are always bundled in a package that usually includes health, life, and disability insurance. In some cases, it also includes child allowances (Argentina); training programs (Colombia); or daycare services and housing (Mexico). In all countries, however, a key component of the package is pensions for retirement These pensions are motivated by the notion that workers on their own would fail to save sufficiently for their old age. Their consumption levels as retirees could then be substantially lower than when working. As a result, to “smooth consumption overtime,” governments force workers to put away a share of their wage for the future.

Pay-As-You-Go Pensions

Retirement pensions started in Latin America under the so-called “pay-as-you-go” (PAYG) model, whereby the pensions of those already retired are paid with the contributions of those currently working.

Retirement pensions started in Latin America under the so-called “pay-as-you-go” (PAYG) model, whereby the pensions of those already retired are paid with the contributions of those currently working. Once a worker qualified for a pension, she would get a regular payment from the common fund of contributions of active workers regardless of how many years she lived after retirement. As some would live more years than others, the risks of longevity were pooled.

Setting aside the coverage problem, initially PAYG systems worked well. Since there were few retired workers relative to those actively working, the contributions of those working were more than sufficient to cover the pensions of those retired. But a combination of causes eventually led to financial difficulties. First, in some cases, even at the start, from an actuarial point of view contribution rates were lower than those required to pay for benefits. Second, demographics changed so that overtime the proportion of people working relative to those retired gradually fell while life expectancy increased. Third, the region’s endemic macroeconomic crises limited the growth of formal employment. Finally, here and there, benefits were increased without matching contributions.

Gradually, PAYG systems began to generate deficits. Since retirement pensions took the form of legislated rights guaranteed by the state, those deficits had to be covered from the public purse. Today, many governments in Latin America use general revenues to cover the deficits of PAYG pension systems, de facto establishing a subsidy from all tax payers to the subset of workers who benefit from them. And since, as noted, those are workers with relatively higher wages, it follows that these systems introduce a regressive bias to public expenditures, a bias that can be quantitatively relevant. Brazil spends 4 percent of its GDP in subsidies to its PAYG system, Colombia 3.5 percent, Mexico 2.1 percent, El Salvador 2.0 percent, and Peru 1.7 percent. These figures can be put in perspective noting that countries in the region spend on average 0.5 percent of their GDP on conditional cash transfer programs targeted on the poor.

Defined Contribution Pensions

The shortfalls of PAYG pensions motivated important design changes. Starting in Chile in the 1980s, and then in Mexico, Peru, El Salvador, Colombia, Argentina, and Bolivia in the 1990s, countries turned to systems where contributions would be deposited directly in workers’ individual accounts (as opposed to a common fund in the PAYG system); and where pensions would be proportional to the amounts accumulated by each worker. The new system, usually known as “defined contribution,” would avoid cross-subsidies from one set of workers to another. A novel feature was that deposits to workers’ accounts would be managed by private firms, known as pension fund administrators. These firms, on one hand, would actively compete among themselves for workers’ accounts; on the other, would invest workers’ funds to maximize expected returns. At the time of retirement, the accumulated funds would be used to purchase the worker an annuity; longevity risks, rather than being absorbed from a no-longer existent common fund, would be shifted to private insurance companies, protecting workers.

The new system was expected to have important benefits. First, it would eliminate the regressive features of the PAYG system. Since benefits would simply depend on accumulated contributions, there would be no need for government subsidies. Second, it would stimulate workers’ voluntary savings since their additional savings would be deposited directly in their personal accounts and reflected in the size of their pensions. Third, it would give greater depth to financial intermediation, augmenting the supply of long-term savings that, through the pension fund administrators, could be channeled to long-maturity investments.

Time has shown that some of these benefits have failed to materialize. Certainly, eliminating the regressive system of cross-subsidies was beneficial. On the other hand, the system has done little to stimulate voluntary savings; few workers have channeled additional resources to their accounts. Further, the market for workers’ individual accounts has been far from competitive. On the demand side, workers as consumers of financial products for retirement had difficulty comparing the various combinations of fees and investment options offered by pension fund administrators, particularly when the “product” that workers were buying (or rather, were being forced to buy) would be delivered many years from today. On the supply side, there were few private firms competing, partly because the presence of economies of scale in the administration of funds naturally led to a monopolistic market structure. The result was that returns to workers, net of commissions, were lower than would have been under more competitive conditions.

Persistence of Coverage Problem 

Critically, however, the change from PAYG to defined contribution pensions left unchanged the system’s original design flaw. Pensions would still be financed from a contribution paid by workers and firms proportional to workers’ wages; or, put differently, pensions would still be associated with workers’ formal status. Thus, despite the change, informal workers continued without coverage.

Depending on the country, on any given year between 15 and 20 percent of workers change employment status from formal to informal, or vice versa.

Experience has shown that labor markets in Latin America are more complex than what was envisaged at the time when these changes were carried out. In particular, many workers have periods of formal and informal employment over their working lives. A formal worker might voluntarily leave his job to try his luck with his own business and be self-employed; or, he may be fired and fail to find another formal job and instead work informally for some time. There are, of course, a large number of possibilities. Depending on the country, on any given year between 15 and 20 percent of workers change employment status from formal to informal, or vice versa. Thus, it is more accurate to refer to “when workers are formally employed” rather than to “formal workers,” and similarly for informal ones. On average, workers with more education, and thus with higher wages, have longer spells of formal employment; and only a small subset of workers—public sector ones being a relevant example—are employed formally throughout their working lives.

Formal-informal transits represent a major challenge for contributory systems since workers save for their pension only when formally employed; the so-called contribution density, the share of the time that workers contribute to their pension relative to the time that they work, will be less than one. Clearly, the lower the contribution density, the lower is the pension relative to the worker’s wage (the so-called replacement rate). This makes it harder to reach the consumption smoothing objective. A good example is Chile, the country with the oldest defined contribution system: replacement rates are in the order of 35 percent (so that the pension is 35 percent of the worker’s wage), which compares unfavorably with replacement rates of about 70 percent in member countries of the Organization for Economic Cooperation and Development.

But there is another more troublesome implication of formal-informal transits. Pension systems in the region, of either variety, usually require workers to contribute a minimum number of years to qualify for even the minimum pension. This requirement varies from country to country: 20 years in the case of Peru, 23.5 years in Colombia, and 25 years in El Salvador and Mexico, for example. When formal-informal transits are large, or there are long spells of informal employment, workers will not accumulate the required years of contributions to qualify for a pension.

What happens to these workers? Their savings are returned to them in one lump-sum payment at the time of retirement, to do with them as they please. They will not have access to an annuity, in case they were in a defined contribution system, or to a life-long payment from the common fund, in case they were in a PAYG system; the risks of longevity will be borne by them. Further, the objective to smooth consumption between their life as workers and their lives as retirees—the raison d’etre of pensions—will be partly defeated. This situation, unfortunately, is the rule rather than the exception. In Colombia, it is estimated that only 25 percent of workers contributing to their pension will actually qualify for one. In Mexico, less than one-third will. For a majority of those contributing, the promise of a pension will be unfulfilled, surely a major social and political issue in the future.

It is worth highlighting that this problem is present whether the pension system is of the PAYG or defined contributions variety. In the end, it is a reflection of the failure of the underlying assumption made when contributory systems started in the Region: that eventually all workers would be formal, and would contribute to their pension during most, if not all, of their working lives. Pension systems —of any variety—will hardly be able to smooth consumption overtime if workers are only forced to save for their pension during, say, half of their working lives.

Importantly, the problem is not a result of low contribution rates. Peruvian workers contribute 13 percent of their salary to their retirement pension; a rate higher than that of Canada or the United States. But this does not improve workers’ pattern of formal-informal transits, and it is estimated that less than half of those contributing will qualify for a pension upon reaching retirement. In fact, raising the contribution rate might worsen the problem. Consider this: Peruvian workers, if employed formally, are forced to save 13 percent of their salary in an account that they cannot pledge as collateral for any other loan, nor use in case of an emergency; and, when they reach 65 years of age, are more likely than not to have their savings returned to them in one lump-sum payment (with interest net of commissions). From this point of view, it is not surprising that workers will perceive that a part of their contribution, rather than being a future benefit for them, is really a tax associated with their formal status.

Non-Contributory Pensions

Lack of pension coverage, particularly among low income workers, represents a major social problem. In response, starting in Brazil in the 1990s but then spreading to practically all of Latin America, countries have introduced pensions to the elderly even if they never contributed to the pension system when they were workers, or even if they never participated in the labor force. Because these pensions are financed from general government revenues and not from a tax on wages, they are usually labelled as “non-contributory pensions,” although of course this is a misnomer, as all tax payers contribute to general revenues (at times they are also called “social pensions,” another misnomer, as if contributory pensions were not social). Although again there is variation across countries, these pensions are given to people usually after 65 or 70 years of age. The amounts paid are the same to all who receive them, although the rules to qualify vary: in some cases, subject to a means test, in others subject to the beneficiary not having access to a contributory pension, and in other cases universal. This variation is reflected in their fiscal costs, which can range from 0.1 percent of GDP in Peru, to 1.0 in Brazil, and 1.2 percent in Bolivia (with a regional average of 0.5 percent).

Non-contributory pensions serve a critical role in reducing old-age poverty, and from this perspective they are very welcome. They also contribute to extend the coverage of retirement pensions. But it is hard to argue that they help to increase the coverage of contributory systems. In fact, the opposite is more likely. Depending on amounts and conditionality, workers will eventually ask: “If when I reach old age I can obtain a pension without being forced to save at all while working, why should I participate in the contributory system when it is not even assured that I will qualify for a pension?” And because the non-contributory pension is more significant for low wage workers than for others (as a share of their income), this question will be more relevant to them than to those with higher wages.

Moreover, recall that formally employed workers have to pay for a bundled package of benefits, not only for retirement pensions. If “non-contributory health programs” are also offered, as is the case in seven countries in Latin America, the relevance of the question posed above is increased. It is useful to note that, on average, governments in the region spend 1.7 percent of their GDP on non-contributory programs (retirement pensions, health, and others). From a social perspective, this is understandable and indeed desirable. But from an economic perspective the result is that informal employment is implicitly subsidized (while formal employment is taxed to the extent that workers undervalue the benefits of participating in the contributory system).  This combination of taxes and subsidies is particularly worrisome for two reasons: First, because there are large productivity differences between the formal and informal sectors; and second, because stagnant productivity growth is the main reason why the region has grown slowly in the last decades (ignoring the 2003-2008 commodity-driven boom).

Where Are We Now?        

A variety of circumstances characterize the status quo of pensions in the region. In Chile, the country that pioneered the defined contribution model and where the first cohorts of beneficiaries are reaching retirement age, there is disappointment because replacement rates are below expectations. This has led some voices to propose a return to PAYG pensions. A similar proposal is under discussion in El Salvador. These proposals are unfortunate since, as argued, they will not fix the underlying problem. In Brazil, reform of contributory pensions is at the heart of the unavoidable fiscal correction currently underway. In Argentina, a few years ago workers’ deposits in their individual savings accounts were nationalized as part of a return to the PAYG system. In Peru, last year legislation was passed eliminating the obligation to buy an annuity even for workers who do qualify for a contributory pension (de facto, turning pension fund administrators into saving fund administrators); workers are now allowed to take 95 percent of the funds accumulated in their individual account immediately at the time of retirement. In Colombia, the PAYG system co-exists with the defined contribution one, and workers arbitrage between the two. In parallel, many countries are saddled with the actuarial deficits of their PAYG systems and will have to deal with the burden of subsidizing them from the government’s budget for many years to come, regressive as these expenditures may be.

In parallel, demographic transition in Latin America implies longer life expectancies and the fading of the “demographic bonus” (so that the elder population, say 70 years of age or more, will grow faster than the rest). Larger cohorts of workers will be reaching retirement, and a majority will do so without a pension, because they worked informally all their lives and never contributed to one; or because even if they did contribute, they failed to accumulate the minimum years of formality required to qualify for one. In this context, one can visualize further expansion of non-contributory pensions, putting further pressure on already stressed fiscal budgets, on one hand; and negatively affecting the incentives to participate in contributory systems, on the other. At the same time, there may be increasing dissatisfaction, perhaps even a feeling that an important promise is being unfulfilled, with difficultly to foresee political implications.

Why Did We End Here?

Economists have also debated how to best regulate pension fund administrators, or how to adjust the retirement age, or how to deepen the market for annuities, or how to stimulate voluntary savings with nudges and the like.

There are usually no simple explanations for complex problems and retirement pensions are not the exception. But two elements are central. First, there has been a persistent underestimation of the challenge posed by informal employment. The expectation was that it would gradually fade away, as a result of faster growth or of increased education. In hindsight, this has not been the case. Informality is not a transitory nuisance; it is a structural characteristic of many countries, with deep and complex roots. Nevertheless, economists and policymakers have yet to fully reflect this fact in the technical design of contributory pension systems; the core building block—forcing workers to save through a tax on wages—persists. Economists have long debated the merits of PAYG versus defined contribution systems. Economists have also debated how to best regulate pension fund administrators, or how to adjust the retirement age, or how to deepen the market for annuities, or how to stimulate voluntary savings with nudges and the like. And yet, important as all these debates are, they are clearly second order compared to the challenge that informal employment represents. Informality is the elephant in the room that needs to be faced directly and placed at the center of the analysis.

Second, Latin America’s political systems have difficulty dealing with the long-lived nature of pensions. Projecting a deficit in a PAYG system 10 or 20 years hence is a weak incentive to induce a timely response. Similarly, a projection that over half of workers contributing to the pension system will not qualify for one is a weak incentive to act, grave as the implication of that projection is. A political calculus of the inter-temporal distribution of costs and benefits is, more often than not, unfavorable. The thinking may be that pensions are a future problem that a future government will have to deal with. If so, this thinking is flawed: The future has been with us for some years already. But the region has not developed the legal framework to induce presidents and congresses to put this problem high in the public policy agenda; often the urgent has dominated the important. In the end, the institutions necessary to effectively manage a process with long lags between benefits and costs have been absent.

       

Advances in poverty reduction in Latin America over the last decade and a half have been remarkable. With a $4 a day poverty line, the region’s population living in poverty fell from 45 to 25 percent between 2000 and 2014; and with a stricter poverty line—$2.5 per day—from 28 to 14 percent. Three more facts show the depth of this improvement. First, with some variation, poverty fell in every country in the region; second, poverty did not increase between 2008 and 2010, the critical years of the global financial crisis; and third, despite a substantial deceleration in the region’s growth rate since 2011, poverty has not increased either.

What explains these improvements? The underlying story has two parts. First, there is growth. The initial decade of this century was beneficial for Latin America as a result of unusually favorable conditions in international capital markets and high commodity prices. This contributed to doubling the region’s growth rate to over 5 percent a year, compared to the 1990s, when it averaged between 2.5 and 3 percent.

But growth is not all. As mentioned, as of 2011 growth has decelerated; in fact, since then each year’s growth rate has been lower than the previous year, and in 2015 was negative (with a similar result expected in 2016). The second part of the story is associated with improved public policies. In particular, starting in the late 1990s, governments have transformed all sorts of targeted and generalized consumption subsidies into monetary transfers to the poor conditional upon investments in their human capital; an approach that Latin America pioneered. Multiple evaluations have shown that these new programs, generally known as conditional cash transfers (CCTs), have made a considerable difference in the lives of the poor. Food is more plentiful at the table and families are enjoying more diversified diets, more children and youngsters are attending school (particularly girls), and families are periodically receiving basic health services. Today, governments in the region directly transfer between 0.5 and 1 percent of GDP to the first two to three poorest deciles of the income distribution. And even though there is considerable heterogeneity across countries in terms of coverage, conditions and generosity of transfers, they are occurring in almost all countries in the region.

Despite these advancements, three shortcomings still need to be addressed. First, in some countries there are significant portions of the poor not being reached by these programs (while non-poor groups benefit from them). In principle exclusion errors could be resolved via expanded coverage, but in the tighter fiscal context faced by the region, this is more difficult. Looking forward, exclusion errors will need to be corrected through the politically more costly route of reducing the number of non-poor households that are currently being covered.

Second, these programs have changed the allocation of poor household time, inducing more time to consume health and educational services. However, deeper indicators of human capital accumulation, like learning, show fewer improvements. In hindsight, it is clear that CCTs stimulated the demand for these services, but that governments failed in parallel to expand supply with appropriate quality, particularly in rural areas. Put differently, distributing money was relatively easy for governments, but it has proven to be significantly more complicated to set strong incentives for quality to (mostly public) providers of health and educational services in poor localities, and monitor their performance. As a result, although poor households are consuming more health and educational services than before, they are accumulating less human capital than they could.

Finally, the original design of interventions underestimated the complexities of early child development, convinced back then that better nutrition and health were sufficient to improve children’s well-being before they started school. Today we have a better understanding that issues like language acquisition and socio-emotional stimulation in the first three or four years of life are equally critical. As a result, more poor children are attending school than before, but as a result of lags in their pre-school development they are approximately two years behind in language use and understanding compared to non-poor children of the same age. These and related results indicate that it is urgent to complement traditional CCTs with enhanced interventions in early child development in order to fully achieve the objective of increasing the human capital of the poor. In this context, it is important to note that while there is evidence of specific interventions that have worked on a small-scale (a few hundred or, at best, thousands of children), we do not know enough about cost-effective interventions that can be scaled up similar to that of CCTs (covering millions of children).

In short, the public policy agenda for poverty programs needs to focus on improving targeting and extending coverage to the truly needy that are still left out; on reforming incentives to providers of health and educational services to noticeably increase quality; and on designing cost-effective and scalable interventions that can address dimensions of early child development beyond nutrition and basic health. Thus, while the balance of poverty policies over the last decade and a half is clearly positive, there is ample room for improvement.

If poverty policy is to help poor households to gradually escape poverty with their own efforts, the poor need to earn higher incomes. At the end of the day, the best poverty policy is one that is eventually not needed. This is the meaning of breaking the intergenerational transmission of poverty. If this is not achieved, poverty policy would, de facto, validate a situation where poor households live permanently from public welfare. Thus, CCTs and related transfer mechanisms may need to be complemented with further measures. To identify those measures, it is first useful to address a critical question: Will the accumulation of more human capital among poor households automatically translate into higher earnings, net of the transfers received from CCTs and similar programs?

Unfortunately, as yet few studies have identified whether poor household incomes are increasing as a consequence of the human capital acquired through CCTs. In fact, the preliminary evidence emerging from some countries points in the opposite direction: Younger cohorts of poor workers have more years of schooling and better health than their elder peers, but are not earning higher incomes. However, these results are based on preliminary data and a small sample of countries and, therefore, need to be interpreted with care.

Almost by definition, the poor have few productive assets beyond their own labor. Thus, their earnings can be increased only by raising their labor productivity. More human capital is necessary but not sufficient for this to happen. Aside from being healthier and more educated, poor workers also have to find better jobs. Thus, critically, the challenge of breaking the intergenerational transmission of poverty is inevitably associated with the performance of the region’s labor markets and, in particular, with the productivity of the jobs that these markets generate.

Unfortunately, in many Latin American countries labor markets are highly dysfunctional, reflected by the fact that over half of the region’s labor force is informally employed. In parallel, since at least the early 1990s the region’s productivity performance has been quite disappointing. Indeed, this is one of the characteristics that most distinguishes Latin America from other emerging regions in the world. Dysfunctional labor markets and stagnant productivity growth are matters of great concern for economic growth generally and, for the reasons stated above, for the poor in particular.

Moreover, from the perspective of poverty alleviation, increasing productivity growth is more important today than 15 years ago, when there was more room to increase the coverage of CCTs and associated transfers. Ignoring the subset of poor households that today are not covered by these programs, today we are at the point where it is probably counter-productive to attempt further reductions in poverty through yet more transfers, as opposed to more productive employment. Even if the fiscal space to do so was there, it is important to consider the impact of ever increasing transfers on labor-leisure choices. It is also important to consider the social implications of having increasingly educated poor youth that end up with the same low earnings that their parents have. And it is important to consider as well the long term implications for growth of having between a quarter and a third of a country’s labor force permanently engaged in low productivity activities. For all these reasons, increasing productivity needs to be at the center of poverty policy.

Latin America faces a complex international environment: Monetary normalization in the United States and slower growth in China and elsewhere imply that the factors that were tailwinds before the global financial crisis are now acting as headwinds. In addition, with perhaps one or two exceptions, Latin American economies have exhausted the space for counter-cyclical fiscal spending; in fact, many are now engaged in fiscal consolidation. Therefore, faster growth will not come from the rest of the world, or from stimulating public spending. At the same time, the region’s demographic transition implies that a previous growth factor—a labor force that increases more rapidly than the population—is declining in some countries and will soon decline in others. Barring an unexpected and lasting positive external shock, growth in Latin America will have to depend more on faster capital accumulation and faster productivity growth for the foreseeable future. This is quite a challenge, as these two factors have long been the region’s Achilles heel.

On the other hand, despite the gains over the last 15 years, poverty is still high and may still increase if low or even negative growth rates persist for some years. These gains need to be preserved, but further advances are needed. In a tighter fiscal context and more complex growth scenario, this will only occur if there is a clear understanding of what objectives poverty policy should pursue.

As Section 2 noted, there is substantial room for improvements to the operation of programs directly focused on the poor: better targeting, higher quality services and attention to early child development. These tasks may not be glamorous, but the welfare of the poor could increase noticeably if governments sharply focused their efforts on them. But aside from these improvements, the majority of the efforts required to reduce poverty are not associated with poverty programs. They are instead directly connected with policies that can increase productivity growth and, most critically, improve the functioning of the region’s labor markets.    

Many factors, with variations from country to country, simultaneously account for stagnant productivity and dysfunctional labor markets in the region. Trying to identify “the” factor is like trying to identify which of the five bullets in the heart killed the victim. In some countries it will be necessary to revise the balance between taxation of labor versus income or consumption, most likely lowering the former. In other countries, a sober assessment is needed of the effects that regulations on severance pay and minimum wages, or the combination of “contributory” and “non-contributory” health and pension programs, have on the formal-informal composition of firms and employment. Further, many countries will have to revisit tax regulations that affect the size of firms (like simplified regimes or compliance costs) as well as credit regulations (like subsidies to small firms or micro-credits for undertakings that have no potential for higher productivity). And yet some countries may need to consider whether credits from public development banks are inadvertently allowing unproductive firms to survive. But in all cases, the same question must be asked: Is this policy contributing to or hindering productivity growth?

Asking this question and, more importantly, effecting the required policy changes, does not mean that countries must give up on the redistribution efforts that are at times the underlying motivation for these policies. But it does mean that redistribution efforts must be carried out through other instruments that are not so costly in terms of productivity.

The policy changes needed to accelerate productivity growth are technically complex, but the real challenge is political and, in a region that has a long tradition of attempting redistribution through labor market interventions, ideological. This makes change very difficult indeed. However, from the point of view of the poor, a glimmer of hope could come from the realization that, in addition to further improvements to targeted programs, the policies needed to allow them to escape poverty with their own efforts are by and large the same ones that are needed to accelerate growth.

       

I. Introduction

Over the last decade and a half, countries in Latin America (henceforth LA or the region) have, by-and-large, crafted societal consensuses in favor of macroeconomic stability, and have invested heavily in policies and institutions necessary for that stability. Seen from the lens of previous decades, this is a major achievement.

Over roughly the same period, these countries also developed new programs to combat poverty. Beginning in 1995, a simple idea began to take hold in Mexico and later in Brazil: that rather than transferring income to the poor through price subsidies, food stamps, or direct distribution of foodstuffs (milk, tortillas, bread, etc.), it is better to transfer income directly in monetary form. However, to ensure that such transfers are not permanently needed, they should be conditioned directly on those households’ investments in their human capital, in particular, their health, nutrition, and children’s education. The bet is that healthier and more educated youngsters will enter the labor market under better conditions than their elders did, allowing them to earn more income through their own efforts, breaking the intergenerational transmission of poverty. In short, rather than the older thought, “transfers of income today and transfer of income tomorrow,” the new paradigm emphasizes “transfers of income today to facilitate greater owned earn income tomorrow.”

Greater macroeconomic stability and these new poverty programs, more commonly known as Conditional Cash Transfer programs (CCTs), have contributed to the region’s reduction in the proportion of households living in extreme poverty and lowering of income inequality. Other forces have also contributed, like the expansion in coverage of primary education, potable water, and electricity. But it is the combination of faster growth and lower inflation associated with macroeconomic stability, on one hand, and more effective transfers of income to the poor through CCTs, on the other, that has meant that for the majority of the poor in LA the present is better than the past and, equally important, the promise that the future can be better than the present is more credible than in the past. 

I argue here that CCTs, despite their notable contributions to the reduction of poverty in the region, are insufficient in bringing about further and lasting gains in social welfare, and that some trends in social policy are worrisome and may actually be acting against the long term interests of the poor. There is a deep flaw in the overall architecture of the region’s social policy, understanding by social policy a broader set of programs than those transferring income to the poor through CCTs. This flaw is a major obstacle to reducing inequality further and to construct a more effective social safety net that goes beyond the elementary goals of providing poor households with minimum levels of consumption and facilitating their investments in nutrition and education. In fact, under the current architecture the region’s governments are caught in a dilemma between increased productivity and faster growth, on one hand, and increased social spending, on the other. In the context of more democratic contests for political power, governments will lean in the direction of higher social spending at the cost of faster growth and, eventually, long-term fiscal sustainability. My main point is that if this flaw is corrected—no minor matter—countries in the region can make a qualitative jump in the direction of reduced inequality, greater social inclusion, and faster growth.    

Two dimensions of social policy need to be separated. The first dimension concerns a policy’s objectives. For our purposes here I distinguish between programs that provide social insurance and programs that redistribute income. Social insurance helps households manage events like losing one’s job (unemployment insurance), getting sick (health insurance), suffering an accident (disability insurance), or facing old-age poverty (retirement pensions). Social insurance programs target all households, regardless of their income level, and their objective is to protect those households against risks. In most OECD member countries, these programs have broad coverage, are a core component of social policy, and absorb a significant percentage of public spending. Programs to redistribute income, on the other hand, focus on a subset of households, usually the poor, and their objective is to increase those households’ consumption. In OECD countries these programs take various forms (food stamps, negative income taxes), but their coverage is narrower than social insurance programs, and their costs are substantially less onerous to the public purse.

The second dimension is access. Since the origins of social insurance in LA in the middle of the past century, access has been limited to workers with a salaried job (an inheritance, as it happens, from Bismarck’s first social insurance programs in Germany at the end of the 19th century!). The reason is that these programs are paid by firms with contributions based on workers’ wages. But many workers do not have a salaried job because they work on their own; others are employed by firms that evade these contributions. As a result, many workers (referred to as informal workers in the region’s lingo) are left without access. Anchoring social insurance on salaried labor has resulted in Latin America’s “truncated welfare State”: Formal workers are covered; informal ones are not. This is a key flaw: Clearly, informal workers can also get sick, lose their job, suffer an accident, or face old-age poverty.

Figure 1 depicts the two dimensions of social policy. Objectives are separated into social insurance (columns) and income redistribution (rows). In turn, access to social insurance programs is depicted separating workers by labor status, formal and informal; and access to income redistribution programs dividing workers by income level, poor and non-poor. Note that formal and informal is not equivalent to non-poor and poor. A large informal sector is a distinguishing feature of LA economies vis-à-vis those belonging to the OECD. Its social implications have already been noted, but there is also a key economic implication: On average, workers are more productive when they are formally employed than when they are informally employed.

Perhaps the most important innovation in social policy in the region over the last 15 years concerns the bottom row of Figure 1. The myriad of programs to transfer income to poor households through programs like price subsidies for food, electricity, fuel and transportation, or through direct distribution of bread, tortillas, milk and the like, has been gradually replaced by programs that give monetary transfers while imposing conditions associated with attendance to school and health clinics. These new programs are LA’s flagship CCTs. Evaluations of Mexico’s Progresa-Oportunidades, of Brazil’s Bolsa Familia, of Colombia’s Familias en Acción, and of similar undertakings in Honduras, Nicaragua, the Dominican Republic, and Ecuador, among others, show that these programs have been more effective in reaching the poor than previous ones, and have had a positive effect on critical indicators like school attendance, grade progression, nutrition, and health. They have also helped, indirectly, reduce inequalities in the distribution of income.

Three things need to be noted about CCTs. First, all poor households benefit from them, regardless of whether their workers hold formal or informal jobs. Second, the size of the income transfer is not meant to, by itself, raise households from poverty. The transfer complements the income that they earn with their own efforts, and aims to provide some minimum consumption and compensate parents for the lost income of having their children in school rather than helping on the family farm or begging in the streets. Larger transfers can undermine households’ incentives to work creating a “poverty trap.” Third, these programs do not create jobs, although by giving youngsters more education they should help them find jobs with higher productivity when they enter the labor market. The program’s exit door is a more productive job. Put differently, CCTs are not meant to be permanent welfare, but temporary investments in the human capital of the poor.

IV. Social Insurance

Most workers in Latin America are informally employed and therefore are excluded from social insurance. This exclusion creates a major problem because governments should not leave those workers unprotected against risks. As a result, and in addition to the CCT programs described above, governments in the region have been creating new programs to provide social insurance to informal workers. These programs have been less noted and are usually confused with CCTs, as they are all are lumped together under the label of social safety nets (and, because they increase social spending, applauded by all, comme il faut). However, social insurance programs for informal workers and CCTs are quite distinct: Their objectives are different (protection against risks vs. redistribution), their time horizon is different (permanent vs. temporary); their target population is different (informal vs. poor) and, as noted below, so are their economic implications.

Social insurance programs for informal workers have been increasing in the region. In the early 2000s a program to provide free health insurance to informal workers was created in Mexico (although similar efforts started decades before). In Colombia there is a legal mandate to provide informal workers with the same health benefits as formal ones (paid partly with taxes on formal workers). Programs to provide income to retired workers without a pension have been created in Uruguay, Panama, Brazil, and Mexico. Argentina recently extended family allowances previously reserved for formal workers to informal ones.

More programs like these will emerge, or existing ones will be strengthened, for three reasons. First, increased life expectancy, aging populations, and previous histories of informality imply that many workers are reaching retirement age with no pension. Second, the transition from preventable to chronic-degenerative diseases generates more expensive health challenges. The third, a bit different in nature but equally relevant, is that in the region’s more democratic environments, governments rightly feel the need to overcome the limitations of their “truncated welfare State” and extend social insurance to informal workers (and why not enjoy the political advantages of doing so). So, willy-nilly, in a somewhat disorderly way, and to various degrees across countries, a system of social insurance for informal workers parallel to the existing one for formal workers is being created; a different phenomenon than CCTs which, it is useful to reiterate, are transitory programs that enhance the human capital of the poor.

Having two parallel systems of social insurance, one for formal workers and one for informal ones, is not a good idea. As noted, programs for formal workers are paid with wage-based contributions. But for a variety of reasons workers and firms believe that these programs’ costs exceed their benefits and therefore perceive them partly as a tax. The same happens with employment protection rules (regulations that make it very difficult or costly to fire workers), an important component of social insurance in a region where unemployment insurance is the exception rather than the rule: These regulations create barriers to formal jobs that are also equivalent to a tax on formality. On the other hand, even if informal workers do not fully value the benefits of the social insurance programs at their disposal, from their point of view they are free, as they are paid from general government revenues and not by any direct contribution from them. Moreover, in some cases informal workers can lose access to these free benefits if they get a formal job. Thus, this set-up results in a tax on formal employment and a subsidy to informal employment, a combination that goes a long way in explaining the very large informal sectors observed in LA.

The critical questions are how workers and firms react to these taxes and subsidies. Consider the message to a firm: If it hires a salaried worker legally it must pay for his health insurance, but if it does so illegally, the worker will get it free (or highly subsidized). If the firm is small and unlikely to be detected by the authorities—the situation of the vast majority of firms in LA—the temptation to evade is large indeed. Or consider the message to the worker: If she is formally employed she is obliged to save for her pension, but if she is informally employed, she will receive a free pension from the government. In the end, the most important social institution in these countries, the labor market, is strongly distorted.

None of this is good for productivity. Informal firms tend to be small under-exploiting economies of scale, and engage little in labor training, technology adoption, or innovation. Informal workers peddle wares in the streets instead of learning new skills in firms. The large presence of informal firms in the region is also not good for fiscal sustainability: A small formal sector narrows the tax base while social insurance programs for informal workers increase spending and erode the tax base. And it is clearly not good for the rule of law.

The economic shortcomings of social insurance start with its original design. It is limited only to formal workers, funded through a tax on salaried labor that creates costly distortions, and characterized by counterproductive employment regulations. But these shortcomings are compounded by adding a parallel system of social insurance for informal workers. The social raison d’être for this addition is unquestionable: Doing nothing to protect large segments of the labor force from various risks is unacceptable. But that social fact should not ignore the economic fact that these programs are aggravating, not mitigating, the long-standing problems in the labor market that social insurance programs and employment regulations for formal workers have already created.

V. The Formal-Informal Dichotomy

Let’s return to Figure 1. The labor force in LA is divided between the four quadrants. As a general proposition, the upper left and lower right quadrants are more populated than the other two. This situation is exactly the opposite of what one would expect, particularly in a region where more than two-thirds of the total population is urban. Poor workers have low education and few financial resources; the expectation is that they would be salaried, and therefore formal. However, if formal jobs are taxed and informal ones subsidized, this is not the case. Moreover, if as it also happens in the region, many social insurance programs for informal workers are targeted on poor workers, the trend is even stronger. The point here is that the distribution of the labor force among the four quadrants of Figure 1 is not independent of the incentives to firms and workers implicit in the formal-informal combination of social insurance programs. Indeed, this combination may be contributing to trap poor workers in low-productivity informal jobs.

More generally, the formal-informal dichotomy is a major stumbling block in breaking the intergenerational transmission of poverty. As a result of the region’s CCTs, in the years ahead poor youngsters will enter the labor market with more human capital than earlier entrants. However, as things stand, it is unlikely that they will find more productive jobs. Put differently, the exit doors from CCTs are being obstructed by the flaws in the region’s social insurance architecture.

Critically, note that the problem is in the columns of Figure 1, not in the rows. Thus, the problem cannot be solved by creating new CCTs; or increasing transfers in the existing ones. Moreover, attempts to reconvert or extend existing CCTs to also provide social insurance for the poor may deepen the problem. A targeted program to invest in the human capital of the poor cannot simultaneously provide them with social insurance conditioned upon their holding informal jobs, and at the same time expect the poor to transit out of poverty by finding higher-productivity formal jobs. And if the poor’s earnings lag behind those of the rest of the population as a result of their lagging productivity, inequality will increase and, with it, the temptation to reduce it by increasing transfers to the poor—focusing on the rows again, not on the columns.     

LA has reasons to feel proud of the CCTs that it pioneered almost two decades ago. With some variations, they are being replicated in other regions of the world, including the United States. In some countries, like Colombia, Mexico, and Brazil, these programs provide benefits to around a quarter of the total population, exceeding sometimes the population estimated to be in poverty; they need to grow no longer. In others, like Peru, Guatemala, and Paraguay, there is a need to expand their coverage. In all, there is room to improve their operations by focusing more, in particular, on early child development. These programs have already made a large contribution to poverty alleviation. To continue to do so effectively, they need to focus sharply on their objectives to invest in the human capital of the poor, and resist the temptation to use them to respond to any circumstance, be the only instrument to reduce poverty through ever increasing transfers, or transform them into hybrids with many goals, in the end reaching none, like the eagle that pursues two rabbits at the same time.

After reaching full coverage of those in need, the greatest triumph of LA’s CCTs would be to gradually shrink and over the long run become unneeded, as extreme poverty is progressively eradicated from a region benefiting from macroeconomic stability and a healthier and more educated labor force. To reach that point, the region needs to eliminate the tax on formality and the subsidy to informality and provide all workers with the same social insurance programs. Poor workers need, most of all, a more productive job; but they also need to benefit from unemployment, health, life, and disability insurance, retirement pensions, and related protection mechanisms enjoyed by other workers, not much different from what currently occurs in OECD countries. Reaching this goal is essential for genuine social inclusion. Therefore, after ensuring that CCTs reach all of their target population and operate effectively, the weight of the additional efforts to help the poor need to focus in raising their productivity; this requires facilitating their getting a higher productivity formal job. It is time for LA to move on and tackle new social challenges beyond those that can be solved through CCTs.

Looking forward, a large challenge for reforming social policy in LA is focusing on the root causes of the formal-informal dichotomy. Tackling this challenge requires revising regulations in the region’s labor markets, and the methods of financing its social insurance programs—put more bluntly, tax and labor market reform. These issues, long unaddressed, are as difficult as they are urgent. In fact, one can see the gradual emergence of social insurance programs for informal workers as a way of by-passing reforming the design flaws in tax, labor and social insurance programs for foramal workers that are behind the formal-informal dichotomy; a by-passing facilitated perhaps in some cases by a favorable international environment characterized by high commodity prices and associated revenue windfalls. This is understandable, but maintaining this dichotomy is unlikely to be a fiscally sustainable solution over the long run; and even if it were, it is a costly solution from the point of view of productivity and growth. It is also questionable whether this solution strengthens social inclusion as workers are permanently segmented into formal and informal categories, on one hand; and whether a social contract based on asymmetries in rights and obligations across labor categories is politically desirable, on the other.The technical difficulties in an integrated reform of tax, labor and social insurance regulations are large, and reasonable people can have different views as to how best to address them. However, at this point how governments design and implement this integrated reform is not immediately crucial. What is crucial is to recognize that, given where we are today, further lasting advances in social policy in the region can hardly be obtained by continuing along the route of ever higher transfers for the poor that distort the original intent of CCTs, on one hand; and more taxes to formality and subsidies to informality, on the other.

Tax, labor, and social insurance reforms will only occur if there is a societal consensus for them, much the same as what happened with macroeconomic stability. However, in constructing this consensus there is a political opportunity, when noting that these reforms rather than being ends in themselves acquire meaning as building blocks for an ambitious social reform. In particular, a social reform that resolves the design flaws at the root of the region’s truncated welfare State, extends the same social insurance to all and in particular the poor, and amplifies opportunities for productive jobs. This social reform will provide a sound basis to effect a clearly desirable increase in social spending without augmenting costly economic distortions; and it will enhance the foundations of a lasting prosperity based on higher productivity. A reform of this nature will need technical expertise and ideological agility but, most of all, bold political leadership. The region faces a great opportunity.

       

From 2003 to 2008, Latin America experienced an annual average growth rate of 4.7 percent. Understandably, as a result of the global financial crisis, during 2009-2010 the region’s growth rate declined to 2.4 percent. However, for the period 2011-2013 it increased to only 3.5 percent, and for 2014 the expectation is that it will drop again to 2.7 percent. Further, forecasts for 2015-2018 estimate growth at 3.3 percent. Although these are averages across countries, and there are relevant differences between them, growth rates are declining in most cases. It is thus increasingly clear that Latin America’s mediocre growth performance can no longer be attributed to the global financial crisis, but, rather, is a reflection of deeper issues intrinsic to the region. Unless these challenges are tackled, it is unlikely that Latin America will repeat the growth performance observed in the first years of this century.

In the context of macroeconomic stability, high and sustained growth is associated with strong productivity growth, and it is in this last dimension that Latin America faces its greatest challenge. Unfortunately, the region’s achievements in terms of better macroeconomic management have yet to translate into improved productivity numbers. Compared to countries in East Asia average annual productivity growth in Latin America between 1980 and 2011 was -0.54 percent versus 0.15 percent (although both regions were affected by the global financial crisis).

Why does productivity lag behind in Latin America? There is broad agreement that three elements are critical for raising productivity (although the relative importance of each varies across countries). First, a country’s human capital, the education and skills of its workers, must be high. Second, the labor market, the central arena where the interactions of firms and workers translate into how much value is produced, must function well. And third, savings rates must be high in order to support investments, particularly in infrastructure.

Evidence points to large gaps between Latin America and other regions of the world in indicators of human capital. The Program for International Student Assessment (PISA) exams provide measures of educational achievement (as opposed to attendance or coverage) comparable between countries. In 2012, 62 countries participated, including eight from Latin America (Argentina, Brazil, Costa Rica, Chile, Colombia, Mexico, Peru and Uruguay). These Latin American countries all fell in the lowest third of the rankings, and seven out of the eight fell below the minimum levels of basic competency in mathematics. Data on workers’ skills are even scarcer, but what there are show low investments in developing workers’ abilities and shorter tenure in individual jobs vis-à-vis developed countries, resulting in less time for on-the-job learning and reduced investments in workers’ training by firms.

Measuring performance in labor markets is even more difficult, but a central feature of Latin America is its high rate of informal employment: On average, more than half of the region’s labor force is informally employed. High informal employment goes hand-in-hand with high rates of firm informality, and result principally from a complex interaction between the region’s segmented social insurance systems, its labor laws, and its tax regimes. Contributory social insurance systems bundled with cumbersome labor regulations create a tax on formality, and informal employment is subsidized by well-intended but poorly designed non-contributory social insurance programs.

Informality is an enemy of productivity: Too many individuals with few skills work as self-employed or as micro-entrepreneurs, and there is excessive worker rotation from job-to-job. In addition, too many small and inefficient firms survive because enforcement of tax, labor and social insurance laws is focused on large firms, and in some cases explicitly exclude the self-employed or family firms with non-salaried workers. The resulting dispersion of economic activity into myriads of small and often illegal firms is an environment that is hardly conducive for exploiting economies of scale and scope, facilitating firms’ access to credit, applying modern management techniques, training workers, and innovating; in short, for increasing productivity. A study on Mexico, for example, found that one peso of capital and labor invested in an informal firm yielded between 35 and 50 percent less value than the same peso invested in a formal one. More generally, research shows that misallocation of labor and capital in Latin America is substantially higher than in the United States or in emerging economies for which data is available, a result of the dysfunctional labor and credit markets associated with informality.

Finally, the region’s savings rates are low compared to other developing countries. The country with the highest savings rate in Latin America saves less as a share GDP than the country with the lowest savings rate in emerging Asia. Because high and persistent current account deficits cannot be sustained for very long, low savings translate into low rates of investment, particularly in infrastructure. It is estimated that to develop an infrastructure comparable to that of its competitors, Latin America should be investing about 2 percent more of its GDP than what it currently does.

There are no surprises: Latin America’s growth rate is low because, ignoring Asian tail winds and abnormal conditions in international capital markets, there are no good reasons for it to be high. While in some countries demand management policies may yet produce short-term growth spurts, these policies are not substitutes for addressing the factors behind stagnant productivity, and could hurt more than help if they generate uncertainty about the sustainability of the country’s fiscal position and distract policymakers’ administrative and political capital.  

In the years ahead accelerating growth in Latin America will be doubly challenging. On the macro side, countries have to pay more attention to fiscal issues: While the region’s fiscal position now is more solid than in the 1990s, the opposite is true when the comparison is made to 2007, the year before the global financial crisis. In parallel, countries will face global monetary normalization. On the micro side, Latin American countries need to urgently accelerate productivity growth, which is not an easy task as policies to do so are complex: They deal with sensitive issues like taxes and the architecture of the region’s labor and social insurance systems. In addition, some of these policies, like efforts directed at increasing workers’ human capital, need time to bear fruit. But this is what is needed for fast growth to return to Latin America.

The author’s opinions do not necessarily coincide with those of the institutions he is affiliated with.

       

On February 7, the Global Economy and Development program at Brookings convened a high-level panel to discuss how social inclusion should fit into the post-2015 development agenda. Panelists included Club of Madrid members: Kim Campbell, former prime minister of Canada; Wim Kok, former prime minister of the Netherlands; and Cassam Uteem, former president of Mauritius. They were joined by Santiago Levy, vice president for Sectors and Knowledge at the Inter-American Development Bank and John Podesta, a former member of the High-level Panel on the Post-2015 Development Agenda. Brookings Senior Fellow Homi Kharas moderated the discussion.

Join our discussion during the event using #SharedSocieties.