Can Social Programs Reduce Productivity and Growth

Social programs can reduce productivity and growth as they inadvertently generate perverse incentives for workers and firms. The core hypothesis is that these programs segment the labor market, tax formal salaried employment and subsidize informal salaried and non-salaried employment. Larger than optimal self-employment and employment by informal firms lowers aggregate labor productivity. In turn, differences in the cost of labor produce differences in returns to capital across firms, some formal legally hiring salaried workers and some informal illegally hiring salaried workers. Given the cost of credit, higher labor costs for formal firms distort the allocation of investment in favor of the informal sector; this investment is distributed in many small firms that may fail to exploit advantages of size as a result of firms’ strategies to evade social security contributions. This lowers the average productivity of capital causing dynamic productivity losses. The analytical argument is linked to empirical evidence indicating that differences in labor and capital productivity between sectors and firms contribute to explain differences in productivity growth across countries, on one hand; and to evidence suggesting a negative association between productivity and informality, on the other. A subsidiary hypothesis is that social programs are partly financed by reducing public investment rather than raising taxes, limiting the expansion of growth-promoting public infrastructure. The paper suggests that social programs that lower total factor productivity together with the effects of lower public investment partly account for Mexico’s lackluster growth and productivity performance in the context of intensified international competition and the erosion of the advantages of the North American Free Trade Agreement.