Financing Social Security Programs in Mexico: Who Bears the Cost?

This paper studies the effects of social security taxes on wages and employment when there is a large prevalence of non-compliance and taxes are used to finance a broad range of programs, some of them extend their benefits to workers employed by non-complying firms. The paper addresses two questions: What fraction of the cost of regulation is shifted to wages? Specifically, to what extent is the degree of shifting exceeds the level of benefits received by covered workers? The model separates the wage effects of reducing social security taxes from the effects of tying workers’ benefits to their contributions. I extend Harberger’s two sector model by including worker's decision to be employed in the covered sector and by allowing firms to pay lower wages in exchange for benefits. A key insight of the model is that because coverage varies widely among economic sectors, some workers would have to give up their comparative advantage in order to be in an economic sector typically covered with social security. Moreover, when taxes are used to finance benefits that do not exclude workers not paying social security taxes, these programs represent a burden to those workers that have a comparative advantage in an economic sector typically covered by social security. Evidence from Mexico shows that increasing social security taxes by 10 percent reduces wages for covered workers by 4.3 percent, even if benefits received exclusively by covered workers remain constant.