Report No: ACS3529 . United Mexican States Mexico Policy Notes . May 2013 . LCSPR LATIN AMERICA AND CARIBBEAN . . Document of the World Bank . Standard Disclaimer: . This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. . Copyright Statement: . The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development/ The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://www.copyright.com/. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org. 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 Mexico Policy Note 1 FOSTERING SOUND FINANCIAL SECTOR DEVELOPMENT EXECUTIVE SUMMARY Message 1. Mexico needs to broaden and deepen its financial system while preserving the financial stability gains of the last decade. Message 2. Sound financial development requires continuing (i) improving financial infrastructure (including retail payment O systems, BJECTIVE credit bureaus, and collateral registries), (ii) fostering capital market development, and (iii) strengthening consumer protection and financial literacy. Message 3. The government should periodically review its strategy of lowering regulatory barriers to foster competition in the financial sector and its procedures for resolving failed institutions. The state’s role in financial services should be comprehensively evaluated. OBJECTIVE This note outlines a short- to medium-term reform agenda to foster sound financial sector development. Mexico needs to broaden and deepen its financial system without compromising the financial stability gains of the last decade. Much more private investment is needed to transform the economy to boost productivity, and despite improvements in recent years, many households and firms still lack adequate access to financial services. Using the financial payments system to promote financial inclusion is a sound way to broaden access. However, experience in several countries has shown that accelerated (or forced) expansion of credit can harm rather than benefit customers. If financial institutions do not follow sound practices, they can fail, harming borrowers and depositors alike and creating social unrest. Institutional failures may also lead to costly bailouts, with substantial fiscal cost. An oversight system (both micro- and macro-prudential) that encourages prudent-risk taking and facilitates prompt resolution of failed institutions ensures that strategies for financial deepening do not compromise financial stability. KEY CHALLENGES Mexico’s financial sector is small for the country’s stage of development, impeding the channeling of financial savings into long-term productive investments. Commercial bank credit to the private sector is well below the level in countries with similar characteristics and below the regional average (figure 1). Similarly, the size and depth of capital markets are well behind levels in peer countries. While the market for government debt is deep and liquid, there are few issuers in the nongovernmental bond and corporate equity markets. The system has done a fair job of mobilizing savings in recent years but continues to lag in risk taking and maturity transformation, limiting its contribution to growth. At less than 35 percent of GDP, total financing to the private sector (including domestic and external sources) has yet to recover to its mid-1990s levels (figure 2). Commercial bank lending is increasingly focused on consumer credit, which has higher intermediation margins.2 Institutional investors, including pension funds and mutual funds, hold most of their assets in fixed-income securities, mostly government bonds. World Bank- Financial Sector 1 Mexico Policy Note 1 Figure 1. Financial development in Mexico Source: Finstat, World Bank. World Bank- Financial Sector 2 Mexico Policy Note 1 Figure 2. Total financing to the private sector has yet to recover to its mid-1990s levels While a variety of financial institutions operate in Mexico, the financial system is dominated by conglomerates that control banks and distribution channels for securities. Barriers to entry have been reduced to deepen credit markets. Unregulated, non-deposit-taking financial institutions (Sofoles and Sofomes) were permitted to operate in the market, and paid-in capital and regulatory requirements were lowered for niche banks, which engage in a more limited range of activities than regular banks. In addition, unregulated credit cooperatives operate (mostly) in rural areas, reaching more than 2 million customers. Public financial institutions provide about a third of total credit to the private sector, largely through two provident housing funds (INFONAVIT and FOVISTE). Despite the important size of public institutions, commercial banks still account for more than half of total credit to the private sector. The seven largest financial groups hold or manage about three-quarters of total financial assets, undermining efforts to increase competition among financial providers and diversify sources of funding. Conflict of interest problems pervade financial transactions. Despite extensive efforts to expand access, the financial system does not meet the financial services needs of many households and firms. Half the population still does not use financial services despite recent reforms to simplify accounts and regulate correspondent banking services and mobile phone banking services. Findex data indicates that only 27 percent of the population 15 years of age and older have an account in a formal financial institution (compared to a regional average of 39 percent). According to 2010 World Bank Enterprise Surveys, only 32 percent of manufacturing firms have a bank loan or credit line, well below world (56 percent) and regional averages (48 percent). Widespread informality and high collateral requirements (more than double the value of the loan) limit access to credit. Large banks typically require firms seeking loans to hold compensatory balances, which are particularly high for small and medium-size enterprises (SMEs). Only 20–25 percent of SMEs have access to bank credit, mainly through public credit guarantee schemes. Commercial bank lending tends to be short term and costly, with deficiencies in the procedures for collecting on collateral reflected in high bank charges. World Bank- Financial Sector 3 Mexico Policy Note 1 POLICY OPTIONS Expanding the infrastructure for financial payments services to bring households into the financial system Household use of financial payment services can be expanded by widening the correspondent bank network, encouraging the use of non-cash payment services by revising fee regulations, and increasing competition in the newly launched mobile payments platforms. Correspondent bank networks need to be expanded beyond the more established retail franchises (such as OXXO, Telecomm, 7-Eleven) to reach into individual mom-and-pop shops. Otherwise, cash in/cash out prices may remain high because of limited competition, and correspondent banks will not spread into underserved poor and rural areas. One way to expand access is to allow deposit-taking credit cooperatives to sign up correspondent banks on the same terms as banks. Fee regulations should support the development of new, cheaper channels and product offerings.3 For example, because banks do not charge customers for making cash deposits and withdrawals at the bank’s own automated teller machines (ATMs) or branches, customers often believe that cash is costless. In fact, debit cards and electronic payments are more cost-effective for many transactions. Also, banks may be discouraged from expanding their network of ATMs or branches to remote areas because of higher restocking, safeguarding, and cash collection costs, forcing customers to use higher priced correspondent banks. Finally, recent regulatory changes have paved the way for mobile phone providers to operate mobile payment/banking schemes through banks. Care is required to ensure that the leading mobile operator is not able to transfer its dominance in the telephony market into mobile payments (and back). Strengthening creditor rights and insolvency procedures Improving the collateral registration system, especially for real estate, and introducing certificates of collateral could improve firms’ access to credit. Setting up the Unified Secured Transactions Registry for security interests over movable assets is an important step toward modernizing the collateral registration system. However, the cost to register real estate assets is high (largely because of high notary fees), and inefficiencies persist, especially in some states. Registry systems are not computerized or connected, and there are discrepancies in cadastral information, making the system slow and unreliable. Application of the Federal Model for the Modernization of Registries could improve the situation. Also, real estate assets could be used more efficiently by introducing a Chilean-style reform. Following this reform, the registry would issue certificates of collateral that fragment the value of the pledged asset to cover only the loan amount (plus an overcollateralization margin). This would allow using the real state asset to secure more than one loan. Strengthening enforcement proceedings for secured and unsecured credits is essential for reducing economic losses and credit costs. Debtors have a variety of means to delay insolvency enforcement, and local courts lack adequate enforcement capacity.4 Secured creditors’ recovery prospects are hampered by the unlimited priority of worker claims on liquidation procedures, debtor recourse to judicial procedures, and weak police support in executing court resolutions. While trusts can be used to pledge assets and avoid the need for judicial procedures, the cost is prohibitive for small firms. Using more out-of-court enforcement World Bank- Financial Sector 4 Mexico Policy Note 1 mechanisms and simplifying inefficient judicial procedures would benefit the entire credit protection system. Small and medium-size firms need easier access to insolvency procedures. Though the insolvency law was reformed in 2000 and 2007, it is rarely used. Thousands of businesses are liquidated every year, with serious loss of economic value, but only about 400 insolvency cases were brought in the law’s first 10 years—and more than a third of those were dismissed. The chief reasons are the lack of civil liability of company directors and officers for insolvency, weak incentives for debtor and creditors to use the system, and high financial and transaction costs. While the law contains a complete framework for liquidating a business, important technical flaws remain. For example: criteria for initiating a claim are unnecessarily complex, resolution of the insolvency proceedings does not discharge the debtor of its obligations, and creditors do not participate in the process through a creditors’ meeting or creditor committees. Reorganizing a businesses is extremely difficult. Especially disappointing has been the “conciliation� phase of insolvency proceedings, meant to facilitate an agreement that could preserve the business. Fewer than 100 insolvency plans have been approved under the new insolvency law, and no data are available about the success of those plans. The legal framework sets out numerous obstacles to successful reorganization that leave large groups of creditors unaffected by the insolvency plan, including inflexible procedures, lack of post-petition finance, lack of appropriate treatment for executor contracts, the ability for some creditors (such as the workers) to bring claims outside the insolvency process, and the opaqueness of the rules for approving insolvency plans. Enhancing credit information systems to facilitate sound credit expansion Credit histories provided by the Mexican credit information system are often inaccurate, incomplete, and fragmented, despite recent reforms. Efficient credit reporting systems improve access to credit by reducing asymmetric information problems between borrowers and lenders. Deficiencies in Mexico’s credit information system prevent it from serving this function (box 1). The fact that there are credit histories for some 70 million people (63 percent of the population) is obvious evidence of fraud and errors, considering the country’s low access to credit. A national identification system with unique individual identifiers is needed to reduce fraud and error. Several steps could be taken to expand information coverage and lessen fragmentation. An unresolved legal impediment to plans for exchanging borrower information between credit bureaus needs to be settled. In addition, credit information sources could be expanded to include utilities, government credit programs, unregulated financial institutions, court judgments, fraud alerts, and property registries. Mexico’s National Banking and Securities Commission could also consider sharing information from its credit registry. The legal and oversight framework for credit reporting needs strengthening. The legal and regulatory framework needs to be modernized to encourage innovation and competition and better serve industry needs. By strengthening data quality and facilitating data sharing, asymmetries of information between borrowers and financial institutions will be narrowed and new lending institutions will gain access to records—all of which should encourage competition and provision of new services by bureaus such as scoring models and facilitate access to credit. System upgrading should go beyond legislative changes and address mandate overlaps (in World Bank- Financial Sector 5 Mexico Policy Note 1 consumer protection issues, for example) and regulatory gaps and ensure that supervision covers more than legal compliance. Box 1. The Mexican credit reporting system Two consumer credit reporting bureaus operate in Mexico, Buró de Crédito and Círculo de Crédito .1 Buró de Crédito collects credit information from most banks and some nonbank financial institutions, retailers, and other creditors on more than 68 million individuals and 3 million firms. For firms, the database includes information on credit only, not on balance sheets, accounts receivable, or other information related to trade credit. Firms provide the information voluntarily. Círculo de Crédito focuses on consumer credit and microcredit and provides information from two retail banks and cable and telephone companies on 40 million individuals. In addition, specialized law firms provide information on court judgments. The Law on the Regulation of Credit Information Societies (SIC) establishes the legal framework for credit reporting. The law includes mechanisms for protecting privacy rights, such as requiring consent before accessing an individual’s or firm’s credit reports, and low-cost procedures for consumers challenging erroneous information. It also mandates that all regulated financial institutions report their loan activities to and access information from the credit bureaus as part of their credit application process. Credit bureaus are required to exchange negative information in their databases monthly and to exchange positive information on individual borrowers whenever they issue a report on a borrower (this provision has been challenged in court). Banxico issues rules governing how long credit bureaus may retain negative information in their databases. Under SIC, private credit reporting bureaus must be authorized to operate by the Secretariat of Finance and Public Credit, and they are supervised by the National Banking and Securities Commission, subject to regulations issued by Banxico. The commission conducts annual and ongoing examinations to verify adherence to the law. Examinations focus on consumer privacy and legal compliance. The commission is limited in its ability to address problems proactively, as it has no mandate to deal directly with the public on potential violations or with nonbank authorizers of credit. Additional consumer protection laws establish mechanisms for consumers to dispute credit agency data.2 The National Commission for the Protection of Financial Services Users deals with all disputes involving credit bureaus, all regulated financial institutions, and non-deposit-taking financial institutions, such as Sofomes. The National Consumer Protection Agency handles disputes involving commercial entities, including credit cards issued by nonfinancial institutions (such as department stores) and telecommunication companies. 1 Buró de Crédito is made up of two firms, TransUnion de México S.A., S.I.C. and Dun & Bradstreet S.A., S.I.C. The first firm is a joint venture of TransUnion and the Mexican commercial banks. 2 The Law on Consumer Protection for Financial Services (2005), Law on Transparency, and the Federal Law on Consumer Protection. Developing capital markets to deepen the financial system To foster capital market development, priority should be given to reforms that strengthen access and competition, while preparing the grounds for more extensive reform. Near-term reforms should focus on facilitating access, opening the market to independent players, and deepening integration with foreign markets. Access could be improved by streamlining the regulatory framework for investment funds and encouraging the growth of independent distribution channels. Narrow licenses for intermediaries (such as specialization in brokerage activities only) could be reconsidered to make it more affordable for independent players to enter the market. The financial regulator could consider creating a hybrid regime within the public offer framework for specialized instruments that waives the prospectus requirement for issues targeted to professional investors.5 The regulatory framework for pension funds needs to incentivize risk-taking (see discussion below). Another way to raise the quality of services would be to deepen integration with other markets, such as Brazil, the Mercados Integrados Latinoamericanos (comprising Chile, Colombia, and Peru), and the United States. World Bank- Financial Sector 6 Mexico Policy Note 1 Over the medium term the strategy should include bringing large issuers into securities markets and improving capital markets oversight. Bringing the energy and banking sectors into the public equity market could greatly increase the supply of securities and market capitalization and boost participation by both foreign investors and domestic retail investors. State-owned companies will need to upgrade their governance and line up political support. The regulator will need to strengthen supervision and enforcement related to potential conflicts of interest by large financial conglomerates; strengthen regulation and supervision of related-party transactions to boost investor comfort; harmonize Mexican standards with those of Brazil, Chile, and other peers;6 develop a legal framework for derivatives; and strengthen the power and enforcement capacity of the National Commission for the Protection of Financial Services Users (CONDUSEF), so that it can effectively discharge its mandate. The plans for capital market development should be spelled out in a road map that can serve as a reference point for future administrations and for an effective promotion campaign. The campaign should include a joint public-private effort to promote all segments of the Mexican capital market domestically and abroad. Aggressive financial education efforts with domestic investors and potential issuers should also be promoted, while the Mexican Stock Exchange could provide special services (such as independent research for smaller companies) to attract new issuers. To improve financing before an initial public offering, consideration should be given to incentives (such as tax credits or deductions) that could mitigate the large risks of investing in initial public offerings and debt placements by the second-tier group of companies. The pension system should be reformed so that capital markets are more effective for insuring against longevity risks, especially by raising replacement rates and reforming the regulatory framework. Contribution rates may need to be raised to achieve reasonable replacement rates.7 In addition, a regulatory shift is needed from a value-at-risk approach that limits short-term return volatility to an approach focused on long-term investment performance. Other concerns include excessive and socially wasteful competition between funds driven by participants’ focus on factors other than replacement rates; the use of derivatives for leverage rather than hedging; limited diversification and rapid accumulation of resources, which could lead to mispricing of domestic assets; and a need for more balanced corporate governance of pension funds. The overregulated annuities market, especially restrictions on pricing and technical parameters, discourages effective competition. Other features of the regulatory framework that could be improved include selection of the reference interest rate, investment regulations, and contract policies. Improving financial literacy and strengthening consumer protection The powers and financing of CONDUSEF should be increased to deal with the complexities of financial services. CONDUSEF is responsible for promoting financial education, establishing consumer protection rules, and responding to consumer complaints about financial services firms, while the National Consumer Protection Agency (PROFECO) is responsible for protecting consumers from deficiencies in general goods and services. CONDUSEF is particularly important because of the prevalence of conglomerates, which increases the scope for conflict of interest, and the low level of consumer financial education. However, CONDUSEF lacks the power to demand compensation or arbitrate disputes, and its financing is inadequate to meet its objectives. Some functions handled by PROFECO should be transferred to CONDUSEF. In coordination with other entities, including National Banking and Securities Commission and the Ministry of Education, and based on the results of an ongoing financial capabilities survey, World Bank- Financial Sector 7 Mexico Policy Note 1 CONDUSEF could mount a comprehensive program of financial literacy, as Brazil and Peru have done. Revising the national strategy to develop the financial system to support sound access Lowering prudential requirements to ease entry may help develop the system, but constant monitoring is required to ensure that failing institutions can exit the market in an orderly fashion. Broadening the range of financial operators and services by lowering regulatory barriers to entry implies some risk to sound financial development. Thus, this strategy needs to be continuously monitored and adjusted in line with the system wide risks posed by a collective failure of the growing number of financial institutions. Flexibility needs to be built into the system for creating and liquidating such institutions to avoid disrupting the system or causing social upheaval. A priority is devising a plan for resolving the credit cooperatives that did not met the end-2010 deadline imposed by the Credit Cooperative Law. Options should include supporting mergers of weaker entities with stronger ones and resolving failing cooperatives through purchase and assumption techniques. Resolution procedures need to be improved for bank and corporations (non-regulated financial intermediaries). The state has a large presence in the Mexican financial system, and it is important to ensure that its interventions foster rather than impede financial development. State development banks and provident housing funds provide about a third of private sector credit. The state also provides partial credit guarantees and subsidizes other financial products, such as agricultural insurance. Over the last decade reforms have greatly reduced the size of development banks, improved their governance and professionalism, and focused their activities on catalyzing financial sector participation. It is important to preserve and continue advancing on such reforms to ensure effectiveness of development bank operations. The provident housing funds, however, still focus on direct lending. As part of important countercyclical measures during the recent financial crisis, credit guarantee programs and development bank balance sheets expanded substantially (increasingly through tier I operations), though their portfolio remained below 2006 levels. A strategy for public sector engagement in the financial sphere should clearly define when direct lending is preferred to tier II operations and when to switch between the two. The strategy should also include plans for partner arrangements between provident housing funds and private credit institutions, and mechanisms for reducing development bank’s balance sheet once a crisis has passed in order to maintain profitability and avoid excessive risk taking. Finally, to ensure that resources are being used efficiently, the addition of multiple public interventions in the financial sphere should be evaluated to assess the impact on productivity and growth and to rationalize program portfolios. World Bank- Financial Sector 8 Mexico Policy Note 1 Matrix of short- and medium-term policy reform options* Reform areas Short-term policy options Medium-term policy options Improving  Simplify authorization  Introduce a national financial procedures for correspondent identification system to improve infrastructure banks (AR) the quality of credit bureau data  Allow deposit-taking credit (AR). cooperatives to sign up  Review the legal and oversight correspondent banks on the framework for credit bureaus same terms as banks (LR). (LR).  Revise fee regulations to  Reform real estate registries encourage the use of non-cash along the lines of the registry payment methods (AR). for movable guarantees (LR).  Allow registries to issue  Reform the legal framework for certificates of collateral for insolvency and business more efficient use of eligible reorganization to increase its assets (AR). use (particularly by smaller  Simplify procedures for firms). (LR) executing collateral (LR). Developing  Create narrow licenses for  Require the listing of banks and capital markets intermediaries (LR). partial listing of public  Create a hybrid regime within companies (LR). the public offer framework  Review the regulatory (LR). framework for annuities  Formulate a strategy for (HI/AR). regional capital market  Streamline the regulatory integration (AR). framework for investment funds  Reform the regulatory (HI/ AR). framework for pension funds and increase replacement rates (LR). Strengthening  Strengthen CONDUSEF’s consumer powers and resources (LR). protection and  Formulate a strategy to enhance financial financial literacy (AR). literacy Revising  Develop a strategy for the  Review public sector credit overall strategy resolution of cooperatives programs and formulate a for increasing (AR). comprehensive strategy for competition in  Review the role of provident development bank operations the financial housing funds and increase (AR). sector their cooperation with the  Approve draft modifications to private sector (AR). bank resolution procedures (LR). *LR/AR= Legal or Administrative Reform. Preliminary Classification. World Bank- Financial Sector 9 Mexico Policy Note 1 NOTES  This note was prepared by Eva Gutierrez (Lead Financial Sector Specialist, LCSPF), supported by the substantial package of advisory services that the World Bank has provided in recent years to the Mexican financial authorities. These services include the 2011 Financial Sector Assessment Update (FSAP), the 2011 Report on Compliance with International Standards for Insolvency and Creditor Rights, ongoing work on designing a strategy for the resolution of weak unregulated cooperatives in Oxaca, and the 2010 advisory and convening services on public development institutions. 2 Housing and household credit account for 36 percent of total credit and 66 percent of the interest generated from commercial bank loans. Business loan portfolios account for 47 percent of total portfolios but generate only 25 percent of interest income. 3 In July 2010 Banxico published reforms dealing with financial charges and fees (Circular 22/2010). The new rules prohibit credit-granting institutions from charging fees for opening and closing on-demand savings accounts; for cancelling credit cards, debit cards, or prepaid credit cards; for e-viewing balances; for withdrawing cash at automated teller machines belonging to the customer’s own bank; and for accessing banking services at a teller window at a branch bank. 4 Mexican banks that handle large volumes of collections report an average recovery time of two years for secured creditors; unsecured creditors are rarely taken to court. Mortgage foreclosures can be frustratingly slow, averaging three to five years. 5 Pension funds have been able to invest in private equity only through special instruments called Certificados de Capital de Desarrollo (CKDs). However, CKDs are a second-best solution that limits the scope of investor due diligence to public information. As a result, not all relevant players have agreed to use CKDs, and pension funds are extremely selective about which fund managers they choose to operate with. 6 For example, by strengthening supervision and enforcement. 7 Under reasonable assumptions, the 6.5 percent contribution rate will be unlikely to allow that —particularly for middle-class contributors. World Bank- Financial Sector 10 Mexico Policy Note 2 TOWARD A MORE COMPETITIVE BUSINESS ENVIRONMENT EXECUTIVE SUMMARY Message 1. Government regulations that restrict competition, especially in non-tradable sectors, increase the costs of key inputs for doing business and essential goods and services, reducing Mexico’s competitiveness. A coherent mechanism to remove anticompetitive and market- distortive national and sub-national regulations is needed to overcome the negative effects of limited market competition. Lack of pro-competitive regulations in such key strategic input sectors as telecommunications and air transport has negative economic externalities that translate into a costly and less efficient environment in Mexico for producers and consumers. In addition, removing foreign ownership restrictions will allow for more contestability. Message 2. Significant progress has been made in simplifying federal regulations related to the business environment. Further reforms that could improve the business environment include streamlining procedures related to electricity connectivity and new business registration (particularly at the sub-national level), improving mechanisms for contract enforcement, and reducing the costs of formal sector employment by increasing labor mobility. OBJECTIVE Strengthening competition and streamlining key regulations for firms are key to increasing Mexico’s competitiveness. Firm-level productivity and business entry for formal enterprises in Mexico are low relative to international peers. Factors that hinder productivity include concentrated markets with dominant firms in strategic sectors and lack of effective pro- competition regulations, both of which increase the price of inputs and reduce the overall economy’s competitiveness. Furthermore, cumbersome business regulations hinder connectivity to electricity, registration of new businesses, and enforcement of contracts and increase the cost of formally employing workers. KEY CHALLENGES Limited competition Mexico’s economic underperformance can be partly explained by concentrated markets, restrictive regulation, and anticompetitive behavior.1 The Central Bank of Mexico has estimated such costs at 1 percentage point of GDP growth each year. Worldwide empirical evidence confirms that anticompetitive behavior results in higher prices, inefficient allocation of resources, rent seeking, consumer welfare deadweight loss, and suboptimal economic performance in the form of adverse incentives to innovate and invest, reduced productivity, and lower output.2 Studies on the Mexican economy point out that inefficiencies in key sectors (such as telecommunications, electricity and oil) create wide spread and amplified negative externalities throughout the economy.3 Striking examples of such inefficiencies in Mexico include the telecommunications and transport sectors, discussed below. World Bank- Business Environment and Competition 1 Mexico Policy Note 2 Lack of competition reinforces existing inequities by affecting low-income households disproportionally. On average, 31 percent of household spending is used to buy products and services provided by highly oligopolistic or monopolistic markets. Such market power implies an average price premium of around 40 percent for about 7 percent of spending by Mexico’s poorest households. Higher prices reduce welfare 19.8 percent more in the poorest income decile than in the richest decile and 22.7 percent more in rural areas than in urban areas.4 Internationally, Mexico lags behind other countries in terms of indicators on market competition. Market structures in Mexican subsectors are less prone to competition: 27 percent of subsectors have only one provider (fixed line telecommunication infrastructure, oil and gas and electricity transmission and distribution, among others), compared with only 8 percent in other Organization for Economic Co-operation and Development (OECD) countries and 12 percent in other Latin America and the Caribbean (LAC) countries.5 According to the Global Competitiveness Report, Mexico ranks in the bottom quintile regarding the extent of market dominance (124/142) and the effectiveness of antimonopoly policy (120/142). Comisión Federal de Competencia (COFECO)6 is empowered to enforce competition law but must rely on other entities to implement and execute its decisions, weakening its institutional powers. COFECO promotes competition principles in federal, state, and municipal acts. The government retains the power to reject COFECO’s opinions but is obliged to publish its rejection. COFECO can also issue nonbinding opinions on existing laws, regulations, agreements, and other administrative acts, which must be published. According to Article 14 of the Competition Law, on request or by its own initiative COFECO may analyze the compatibility of laws, regulations, and other administrative acts adopted by states and municipalities with article 117 of the Mexican Constitution, which guarantees the free movement of people, goods, and services). COFECO’s decisions are reported to district and state attorneys, who ultimately put forward the relevant judiciary action. Major changes to the Competition Law came into force in 2011, but clear implementation rules and actions are pending to ensure its effective enforcement. Expanded investigative powers for COFECO, added provisions on leniency, and increased fines are powerful instruments to encourage compliance with the law, but clear and transparent rules are needed for their application in order to increase predictability and transparency and mitigate business risks. A specialized court for regulatory matters related to COFECO decisions has been created, but trained personnel on competition law and economics are lacking. COFECO’s binding opinions on government legislation that affect competition and collaboration agreements with Comision Federal de Mejora Regulatoria (COFEMER)7 and Procuraduria Federal del Consumidor (PROFECO)8 are a step forward to integrating pro-competition principles in regulatory policies, but further action is needed to render them effective. Several national and subnational regulations restrict competition in Mexico. At the national level restrictions on foreign ownership and the number of firms in key sectors (such as oil, natural gas, and electricity) reduce the likelihood of entry into key nontradable and service sectors. On a scale of 0, no foreign ownership allowed, to 100, full foreign ownership allowed, the maximum shareholding for Mexico is 0 in electricity, 54.4 in transport, and 24 in media—all below LAC and OECD averages (between 70 and 80). According to OECD data on the level of restrictiveness of sectoral regulations, Mexico lags significantly behind best practices in World Bank- Business Environment and Competition 2 Mexico Policy Note 2 electricity, gas and telecommunications.9 Subnational regulations, for instance on the production of maize flour, tortillas, fuel retail, and licensing for ground passenger transportation, can restrict entry and facilitate cartel behavior or discriminate against entrants (see Table 1). Such regulations can raise prices and harm quality and product variety. Anticompetitive regulations for professionals such as notaries also increase the cost of doing business. Even deployment of network services can be affected by subnational regulations on rights of way, boosting costs for network and coverage expansion, especially for mobile operators. Table 1. Cases of competition issues in subnational regulatory frameworks Product or Anticompetitive regulation issued or proposed Importance (1) service by subnational governments Maize and Municipal regulations: entry restrictions 7 percent of consumer related (incumbents participate in the entry process for expenditure on food and products new firms), minimum distances protect against beverages. competition, mechanisms allow for price From a sample of 78 coordination. municipalities, 51 have regulations that restrict competition, affecting 6.5 million of people. Automotive Municipal regulations: minimum distance 4 percent of total fuels restrictions protect incumbents from competition. consumer expenditure Ground Municipal regulations: restrictions in licensing 4 percent of total passenger new terminals lessen competition. Consideration consumer expenditure transportation of local conditions according to federal regulations affects entry as well. Notaries State regulations: statutory limitations in the 30–85 percent of cost of number of notaries restrict entry, minimum fees registering a firm lessen price competition for standard services. (1) Based on Instituto Nacional de Estadistica y Geografia, Documento Metodologico: Indice Nacional de Precios al Consumidor, 2010; PROFECO, Inhiben ayuntamientos competencia en tortillas, Brujula de Compra,2010; World Bank Group, Doing Business in Mexico 2009. Anticompetitive regulations and distortive government interventions in Mexico’s telecommunications sector have negative spillovers. Sectors with horizontal impact throughout the economy (often referred to as input markets and subject to network externalities) will likely have spillovers that affect performance and efficiency not only sectorally, but also economy-wide. Such sectors, often deemed to be strategic and to have public good characteristics, have been subject to heavy government involvement and restrictive regulation, thereby preventing effective competition and ultimately discouraging foreign direct investment and growth. For example, telecommunications market practices have resulted in broadband costs 45 percent higher than the OECD average (130 percent higher in purchasing power parity terms10) and low penetration of service (11.3 broadband connections per 100 people, compared with 71 for the OECD). Overall economic welfare loss from the dysfunctional telecommunications sector are more substantial—around $129.2 billion over 2005–09, or 1.8 percent of GDP a year.11 America Movil has earned an estimated additional $6 billion a year by maintaining its market dominance with little investment in infrastructure and minimal innovation.12 World Bank- Business Environment and Competition 3 Mexico Policy Note 2 Anticompetitive practices in air transport and other infrastructure sectors that are strategic inputs into productive sectors harm the Mexican economy. Fares for routes to and from Mexico City are 40–80 percent higher than for comparable routes in Mexico, due partly to a restrictive slot allocation mechanism to manage congestion.13 In addition, inadequate regulation of airport services resulted in direct costs to airlines and costs per airplane higher than the LAC average and in major LAC airports.14 Other important network industries restrict competition as well; for instance, limitations to private participation in the electricity sector and lack of vertical separation between the operation of infrastructure and the provision of railway services (transportation of passengers or freight). Regulatory burden Mexico has made substantial progress in streamlining regulations for business, but some activities remain less efficient than in comparator countries, and sharp disparities remain between states. The government’s new ambitious and comprehensive reform program to move toward a Base Cero regulation approach has simplified many procedures and norms, reducing costs for businesses. According to the 2010 World Bank Enterprise Surveys, approximately 14 percent of senior management time is spent dealing with the requirements of government regulation, down from 21 percent in 2006. Yet a third of Mexican firms surveyed identify business licensing and permits in general as a major constraint to doing businesses, well above the LAC average of 16 percent. Variation in regulatory burden across states is substantial: the percentage of senior management time spent dealing with the requirements of government regulation is 17 percent in Distrito Federal and 20 percent in Coahuila, compared with 9 percent in Nuevo Leon. Regulatory challenges for businesses remain in four key areas:  Accessing electricity. Nearly half of Mexican firms consider electricity a major constraint to business activity, well above the regional average of 38 percent, according to results from World Bank Enterprise Surveys. The demand for electricity from a growing population and industries is increasing, straining both generation and transmission capacity. The number of days needed to obtain a new electricity connection can exceed 30 and is longer in Distrito Federal and Estado de Mexico than elsewhere in the country. Moreover, the duration of a typical electrical outage (2.6 hours) for firms is twice the regional average, and losses due to electricity outages (3.4 percent of sales) are also higher than the regional average. Facilitating connections can be worthwhile, as a recent study shows that the time and cost to obtain an electricity connection in major business cities are inversely correlated with the electrification rate.15  Registering a business. Few firms take advantage of federal improvements in business registration procedures, and state and municipal requirements remain a challenge. Although many of Mexico’s informal firms are not viable enough to warrant the costs of formalization, some high-potential firms are deterred by the cost of the procedure. The government launched the tuempresa.gob.mx portal in August 2009 to allow some companies to register online for name clearance and incorporation. However, usage is low, with approximately 3,000 new businesses created since launch.16 In Distrito Federal, with the highest system use, just 5–7 percent of firms use the portal to register, while in most other states less than 1 percent do. The system still requires a physical visit to a notary; few notaries use electronic tools, and many view the system as a threat. World Bank- Business Environment and Competition 4 Mexico Policy Note 2 Additional bottlenecks include acquisition of an operating license, which according to the Enterprise Surveys takes 54 days, 17 percent longer than the LAC average. Furthermore, although the majority of steps for opening a business are federal requirements, state requirements (from the Registro Público de Comercio) and municipal requirements (obtaining operating licenses and public notices of opening) remain hurdles.17 Lack of formal registration reduces firms’ ability to access productivity-enhancing services such as finance.  Enforcing contracts. Enforcement of claims is costly and slow. An efficient judicial system makes it easier for firms to engage in transactions and to stay in business while awaiting the outcome of a court dispute.18 World Bank Doing Business indicators for 2012 suggest that the cost of executing claims in Mexico is high. Although access to tribunals is constitutionally protected and free, related charges (mainly the attorney to execute the claim)19 can raise the cost to 32 percent of the claim total, well above the OECD average of approximately 20 percent. Furthermore, there is an uncertainty about the likelihood of obtaining a real return, given the number and characteristics of appeals and challenges to judicial decisions and numerous cases in which citizens refuse to comply with court orders. Mexico requires 38 procedures to execute a contract, more than several comparator countries, with processes related to trial and judgment and enforcement taking relatively more time. A 2012 World Bank report on Insolvency and Creditor Rights Systems20characterized the enforcement of claims as slow, formalistic, and subject to numerous delay tactics by debtors.21 One challenge is the constitutional limitations hindering out-of-court enforcement proceedings for security interests. Another source of inefficiency is the jurisdiction of commercial matters, currently shared by the federal and state judiciaries, as most commercial lawsuits filed and solved in the local jurisdiction, end up being debated and decided in the federal jurisdiction.  Formally employing workers. The cost of formally employing workers remains high due to rigid labor market regulations. Surveys such as the 2011/2012 Global Competitiveness Report score Mexico poorly on issues related to labor market efficiency. Compared with other OECD countries, Mexico’s labor regulation is perceived to emphasize job security over employment creation.22 Major impediments to hiring workers and creating and expanding business activities include restrictions on night work and fixed-term contracts (which are prohibited for permanent tasks) and on certain types of temporary work, including seasonal labor. Flexibility is limited for both collective and individual dismissals: third-party notification is required if a worker is dismissed, and priority rules for redundancies make workers with significant tenure very difficult to dismiss. Average severance pay for a worker with 1–10 years of experience can be as much as 22 weeks of salary, much more than in Brazil and Chile.23 Tax administration appears more complicated in Mexico than in regional comparators. The percentage of firms identifying tax administration as an obstacle to doing business in Mexico (27 percent) is higher than the LAC average (23 percent). According to the World Bank’s Doing Business 2012 survey, a medium-size Mexican company averages 347 hours a year on reporting taxes, far more than the 186 hours in OECD countries. Tax declaration and payment procedures have been simplified and reduced—for example, a 2010 decree eliminated the monthly declaration of the flat-rate World Bank- Business Environment and Competition 5 Mexico Policy Note 2 business tax and the annual declaration of the value added tax—but surveys of firm employees suggest that further simplification is possible. POLICY OPTIONS 1. Supporting Competition Strengthening the effectiveness of the economy-wide competition policy framework It is essential to ensure effective implementation of the current Competition Law. To this end, actions should be taken to:  Finalize the design of a mechanism to ensure that COFECO systematically assesses the potential anticompetitive effects of priority legislation and regulations under the current mandate on binding opinions; define a specific collaboration plan between COFECO, COFEMER, and PROFECO to establish an early warning system to identify competition issues; and establish protocols with key sector regulators for collaborating and addressing issues related to regulated conduct defense.  Build expertise in competition law and economics and economic regulation within specialized courts in charge of dealing with disputes and judicial injunctions on COFECO’s and other regulators’ decisions.  Develop internal protocols to conduct searches under cartel investigations, including the use forensic information technology tools, issue confidentiality guidelines to safeguard the integrity of sensitive commercial information, and increase COFECO’s staff skills in cartel investigations.  Develop guidelines on criteria for settlements and desist commitments following international best practice.  Finalize guidelines to transparently and predictably determine the optimum value of fines.  Update guidelines on leniency and settlements and provide specialized training on leniency and settlements to COFECO officials. A high-level commission with the mandate and ability to recommend eliminating anticompetitive practices at the subnational level should be created to complement COFECO’s efforts at the national level. The experience of the Australian National Competition Commission can be useful for the design of such a commission. To ensure the commission’s effectiveness, states should commit to accept the commission’s recommendations or justify why they are not complying, and an incentive scheme should be devised to reward states that accomplish targets on removing restrictive market regulations. In addition, states should apply a simple standard screening tool to ensure that new regulations do not impede competition and use a framework to identify whether public interest reasons exist to issue regulations that restrain market competition. COFECO could help design both instruments. For instance, specific market regulations at the subnational level (such as those on tortillas, fuels World Bank- Business Environment and Competition 6 Mexico Policy Note 2 retail, ground passenger transportation, professionals, and network infrastructure deployment) need to be revised to minimize their distortive effect. Promoting competition in key infrastructure sectors In the telecommunications sector pro-competition policies should be oriented to facilitate entry in the sector and properly regulate essential inputs for competitors of incumbent companies. Greater regulator independence is needed to increase the effectiveness of the telecommunications legal framework. Also, the intervention of the Secretary of Transport and Communications should be limited to policy, and training should be provided to the Specialized Court assessing COFETEL decisions. A clearer pro-competition framework where regulatory decisions are implemented will stimulate entry and effective competition. In addition, the limitations on foreign ownership for telecommunications companies should be loosened. Liberating and competitively allocating publicly owned spectrum may stimulate entry and competition, particularly if auctions limit allocations to participants by market share, as recently done. Additional criteria such as expansion of network coverage to rural areas could also be considered in spectrum auctions. In addition, based on the international experience 24 and in line with COFETEL’s Plan, the following technical regulatory measures should be considered:  Finalizing an integral interconnection policy that includes a transparent forward-looking cost-based methodology to calculate interconnection fees, quality of service regulations for interconnection services, nondiscriminatory treatment among operators that use the same interconnection facilities, special provisions for operators with significant market power, and options to adapt current interconnection regulations to next generation networks.  Developing regulations to allow infrastructure sharing, roaming, unbundling and bit stream access, and resale of telecommunications services in order to foster competition at the retail level, particularly in the mobile services and broadband markets.  Implementing accounting separation regulation for operators with significant market power in order to prevent and detect price-squeezing, cross-subsidization, and discriminatory treatment to competitors in final markets.  Foresee regulatory reforms on interconnection and licensing to adapt to technology convergence (such as capacity charges for interconnection, interconnection of packet switched networks and services, and general authorizations with open entry regime). If these measures fail to substantially increase competition in the Mexican telecommunications market, consideration should be given to increase COFECO powers to break up companies with monopolistic power in cases where 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. Measures are needed to manage airport congestion in Mexico City and allow for greater competition. The goal of slot policy is to control congestion while ensuring reasonable retribution to airline and airport investments and encouraging market discipline to allow operators to face the opportunity cost of their access rights. Various options, including secondary World Bank- Business Environment and Competition 7 Mexico Policy Note 2 trading of slots rights, slots auctions, and congestion fees, should be assessed, taking into account the characteristics of demand to minimize delay costs for passengers, increase market access, and allow for redistribution of benefits. Current rules that differ from best practices should be amended to apply economic criteria in declaring congestion, avoid incumbents’ blocking their competitors’ entry or expansion even in non-congested schedules, increase clarity and effectiveness of rules for removing slots rights, and set more transparent rules for allocating slots. Additional actions to address weak air transport regulations include facilitating open skies agreements that allow for the operation of foreign airlines and reducing foreign ownership restrictions.25 2. Streamlining Business Regulations Improving electricity connectivity The process to acquire permits for an electricity connection could be streamlined in some areas. For example, the process to acquire an excavation permit for external connection works in Mexico City could be simplified, particularly at the municipal level. Although procedures vary across municipalities, they could be facilitated by having permit seekers go to only one site, rather to than multiple agencies, as is often the case now. Another medium-term possibility is to have the utility obtain the permit on behalf of the customer. To further streamline the connection process in Mexico City, a certified contractor program could screen and accredit contractors, who would then require less scrutiny by the utility and other government agencies. Facilitating the registration of new businesses Enhancing electronic tools for business registration and increasing their use would reduce the cost of these transactions to firms. A better communications strategy with firms, chambers of commerce, lawyers and their associations, and notaries could boost use of the tuempresa.gob.mx electronic registration portal. The portal could be further enhanced by a standard set of incorporation documents that can be downloaded by simple firms registering through the platform, a faculty that has worked well in other countries. Enhancing the portal by integrating federal, state, and municipal systems of business registration would allow firms to complete all their paperwork at reduced time and cost, as would removing the obligation to use notaries. Information sharing and integration between national and subnational government systems in other areas, such as property registration, could enhance other aspects of the business environment; for example, linking property registries of municipalities and the office of property titles to streamline property registration. Improving contract enforcement Strengthening commercial dispute resolution could encourage new business relationships. Mexico has been facilitating more efficient contract enforcement through reforms to the Commercial Code designed to increase the speed and certainty of commercial arbitration proceedings and the enforcement of interim measures and arbitral awards. Further efficiency gains could be achieved through by adding out-of-court enforcement mechanisms, particularly for enforcement of secured claims as well as mechanisms of alternative dispute resolution in debt collection. The specialization in commercial matters of some courts, in the main commercial centers of the country, should also be considered along with assigning exclusive competence to World Bank- Business Environment and Competition 8 Mexico Policy Note 2 the federal jurisdiction on commercial matters. Using less complicated procedures tailored to smaller claims and increasing the threshold of the value of claims permitted in small claims court could also increase efficiency of claims, mostly for businesses that deal with retail customers, with the bonus of freeing courts for more serious business cases. The addition of a case manager has also been effective in speeding judicial proceedings in some cities. Finally, electronic notifications of claims could also increase the efficiency of judicial proceedings. Reducing the cost of formally employing workers Supporting labor mobility through less rigid labor laws and reducing the transaction costs of business tax compliance could reduce the costs of creating jobs in the formal sector. Mexico’s Federal Labor Law (Ley Federal de Trabajo) could be amended to permit seasonal labor, short-term trial, and training contracts, which would likely encourage firms to incorporate younger and less skilled workers into formal employment. Mexico could also consider procedures to ease restrictions on dismissals for redundancy, such as third-party notification.26 A study in India found that the decrease in informal firms was 25 percent larger and the gains in real output were 18 percent larger in states with more flexible employment regulations than in states with less flexible labor regulations.27 Further streamlining the main business taxes and reducing the required frequency of filing could lower the costs of formalization for high-potential informal firms. More analysis of tax compliance costs is also needed—perhaps through a rigorous survey—to understand how these costs affect different types of firms. A more inclusive banking system to increase the convenience of cashless and especially electronic transactions and improvements to the quality of government services and overall transparency would also complement improvements in the quality and efficiency of tax administration. MATRIX OF SHORT- AND MEDIUM-TERM POLICY REFORM OPTIONS* Reform area Short-term options Medium-term options 1. Supporting competition Effectively  Strengthen the scale and scope of  Build expertise in competition law enforcing the advocacy by COFECO through and economics within specialized Competition binding opinions and establish courts on competition matters. Law protocols with key sector (AR) regulators and relevant  Increase COFECO’s staff skills in government bodies. (AR) cartel investigations and provide  Develop guidelines and internal specialized training on leniency protocols to increase the and settlements. (AR) effectiveness of cartel enforcement, including bid rigging. (AR) Integrating  Establish a high-level  Devise an incentive mechanism to competition commission to eliminate reward states and government principles in anticompetitive market bodies that accomplish targets on national and regulations at the subnational removing restrictive market subnational level (LR) regulations and integrate World Bank- Business Environment and Competition 9 Mexico Policy Note 2 regulations competition policy considerations (HI, LF) into policies and decisions. (LR) Integrating  Increase the independence of the  Free up spectrum for broadband competition sector regulator with respect to and mobile services; allocate principles in the its line ministry. (LR) spectrum to facilitate entry, telecommuni-  Remove restriction on foreign competition, and expansion of cations sector ownership. (LR) network coverage; and manage (HI, HF)  Complete and enforce an integral number allocation in an efficient interconnection policy (including and nondiscriminatory manner. cost model, quality of service (LR) indicators, nondiscrimination).  Define regulatory reforms (AR) regarding interconnections and  Develop and implement pro- licensing to adapt to technology competition regulations convergence. (AR) (infrastructure sharing, roaming, unbundling, and resale). (LR)  Implement accounting separation regulation for operators with significant market power. (AR) Integrating  Identify the best option to  Facilitate open skies agreements competition allocate airport slots. (AR) and reduce foreign ownership principles in the restrictions. (LR) transport sector (LI, HF) Integrating  Remove entry and ownership competition restrictions that limit private principles in participation (such as electricity) other network and introduce vertical separation industries between the operation of the (HI, LF) infrastructure and the provision of services (such as freight and passenger railways). (LR) 2. Streamlining key regulations for business Facilitating  Streamline the process to obtain  Develop a certified contractor connectivity to excavation permit for external program by an independent body electricity electricity connection works at (with a list of certified contractors the Mexico City municipal level publicly available) that would by having the contractor visit a require less scrutiny by the utility single site to obtain the and other agencies to obtain a new permit.(AR) electricity connection. (LR)  Allow the utility obtain the excavation permit on behalf of its customer. (AR) Facilitating  Improve and implement  Streamline state and municipal business communications strategy for the requirements for obtaining registration World Bank- Business Environment and Competition 10 Mexico Policy Note 2 tuempresa.gob.mx portal and operating licenses and public enhance its capabilities.(AR) notices of initiation of business operations. (AR) Improving  Increase the limit of the value of  Out-of-court enforcement contract cases allowed in small claims proceedings should be introduced enforcement courts and allocate sufficient for all security interests, as well as resources to meet resultant mechanisms of alternative dispute demand. (AR) resolution in debt collection (LR)  Implement electronic  Simplify the judicial process for notifications of claims. (AR) the enforcement of claims. (LR)  Promote specialized courts and consider assigning exclusive competence to the federal jurisdiction on commercial matters (LR) Reducing the  Conduct a rigorous survey of tax  Modify the Federal Labor Law cost of formally compliance costs.(AR) (Ley Federal de Trabajo) to employing increase flexibility of hiring workers through short-term trial and training contracts.(LR)  Ease restrictions on dismissals for redundancy. (LR) *LR=Legal Reform; AR=Administrative Reform. Preliminary Classification Note: For the purpose of this table, “legal reform� refers to new laws or amendments to existing laws, while “administrative reform� refers to secondary legislation and administrative act ions. World Bank- Business Environment and Competition 11 Mexico Policy Note 2 NOTES 1 Arias and others 2010; Chiquiar and Ramos-Francia 2009. 2 See Syversen (2011) for a review of within country, cross country and panel data studies. 3 See Hanson G.H. “Why isn’t Mexico rich?�, Journal of Economic Literature 2010, 48/4, 987 -1004; or Guerrero I., Lopez-Calva L.F., and Walton M. (2009) “The Inequality Trap and its Links to Low Growth in Mexico� in No Growth without Equity? Inequality, Interests and Competition in Mexico, World Bank (Washington DC) 4 Urzua 2009. 5 World Bank 2010. The report covers 34 subsectors. OECD and LAC averages exclude Mexico. The total sample includes 15 OECD and 13 LAC countries. 6 COFECO enforces the Competition Law and promotes competition principles in the whole country, at the national and subnational levels. According to the competition framework, all entities and dependencies of federal, state, and municipal administration are subject to the Competition Law (Article 4). The competition framework includes typical antitrust provisions to deter anticompetitive business behavior (such as cartel agreements and abuse of dominant positions) and to apply a merger control policy that prevents economic concentrations with anticompetitive effects. In addition, COFECO can issue binding opinions under its own initiative or on request with regards to draft laws, regulations, agreements, and other administrative acts of general scope that might affect market competition (Article 24). 7 COFEMER promotes transparency in preparing and enforcing regulations, ensuring that they generate benefits that surpass their costs and maximize social welfare. 8 PROFECO promotes and protects consumer rights, boosts intelligent consumption, and seeks equity and legal certainty in the relationship between suppliers and consumers. 9 The latest OECD indicators of sector regulation are available at http://www.oecd.org/document/1/0,3746,en_2649_37443_2367297_1_1_1_37443,00.html 10 COFECO 2009. These costs are as of September 2011 for speeds of 2.5 –15 Mbps, including line charge. 11 OECD 2012b. 12 Mircea 2012. 13 Ros 2010. 14 Serebrisky 2012. 15 Geginat and Ramalho 2010. 16 Investment Climate Advisory Reform 2012. 17 World Bank 2012. 18 World Bank 2012. 19 World Bank 2012. 20 World Bank 2011. 21 Challenges related to enforcement of claims and insolvency proceedings are discussed in greater detail in Mexico Policy Note 2 on fostering sound financial sector development. 22 OECD 2011. This assessment is based on specific requirements for collective dismissal, regulation on temporary forms of employment, and protection of permanent workers against individual dismissal. 23 This issue is addressed in greater detail in Mexico Policy Note 4 on labor markets. 24 For more information on telecommunications regulation and best recommended practices, Infodev (2010) or the ICT Regulation Toolkit (www.ictregulationtoolkit.org/en/index.html). 25 For additional information that compares Mexico and other LAC countries, see Serebrisky (2012). 26 OECD 2011. 27 Sharma 2009. World Bank- Business Environment and Competition 12 Mexico Policy Note 2 REFERENCES Arias, Javier, Oliver Azuara, Pedro Bernal, James J. Heckman, and Cajeme Villarreal. 2010. “Policies to Promote Growth and Economic Efficiency in Mexico.� Discussion Paper 4740. Institute for the Study of Labor, Bonn, Germany. Chiquiar, Daniel, and Manuel Ramos-Francia. 2009. “Competitiveness and Growth of the Mexican Economy.� Working Paper 2009-11. Banco de México, Mexico City. COFECO (Comisión Federal de Competencia, México). 2009. “Competencia y distribución del ingreso.� Mexico City. Geginat, C., and R. Ramalho. 2010. “Connecting Businesses to the Electrical Grid in 140 Economies.� Presentation at the International Conference on Infrastructure Economics and Development, January 14–15, Toulouse, France. Guerrero I., Lopez-Calva L.F., and Walton M. (2009) “The Inequality Trap and its Links to Low Growth in Mexico� in No Growth without Equity? Inequality, Interests and Competition in Mexico, World Bank (Washington DC) Hanson G.H. “Why isn’t Mexico rich?�, Journal of Economic Literature 2010, 48/4, 987 -1004; Infodev. 2010. Telecommunications Regulation Handbook. Washington, D.C. www.infodev.org/en/Document.1057.pdf. Instituto Nacional de Estadistica y Geografia, Documento Metodologico: Indice Nacional de Precios al Consumidor, 2010 Investment Climate Advisory Reform. 2012. “Report on Tuempresa.gob.mx.� Unpublished memorandum. World Bank, Mircea, Valentin. 2012. “America Movil Abuse of Dominance Case Seems to be a “Happy -End� Story but Not for Everybody.� Kluwer Competition Law Blog, May 15. http://kluwercompetitionlawblog.com/2012/05/15/america-movil-abuse-of-dominance-case-seems-to-be- a%E2%80%9Dhappy-end%E2%80%9D-story-but-not-for-everybody/. OECD (Organisation for Economic Co-operation and Development). 2011. “Economic Survey: Mexico, 2011.� Paris. ———. 2012a. “OECD Indicators on Employment Protection.� Paris. ———. 2012b. OECD Review of Telecommunication Policy and Regulation in Mexico. Paris. http://dx.doi.org/10.1787/9789264060111-en. Ros, A.J. 2010. “A Competition Policy Assessment of the Domestic Airlines Sector.� Organisation for Economic Co-operation and Development, Paris, and Comisión Federal de Competencia, México, Mexico City.. Serebrisky, T. 2012. Airport Economics in Latin America and the Caribbean: Benchmarking, Regulation and Pricing. Washington, D.C.: World Bank. Sharma, S. 2009. “Entry Regulation, Labor Laws and Informality.� Working Paper. World Bank, Enterprise Analysis Unit, Washington, D.C. Syversen C. (2011), What Determines Productivity? Journal of Economic Literature 2011, 49:2, 326–365Urzua, C. 2009. “Efectos sobre el bienestar social de las empresas con poder de Mercado en Mexico� Finanzas Publicas 1 (1): 79–18. World Bank. 2010. Investment Across Borders 2010. Washington, D.C. ———. 2011. “Report on the Observance of Standards and Codes: Insolvency and Creditor Rights Systems.� Washington, D.C. World Bank, 2009. Doing Business in Mexico 2009. Washington, D.C. World Bank. 2012. Doing Business in Mexico 2012. Washington, DC. World Economic Forum. 2011. “Global Competitiveness Report 2011-2012,� Geneva. World Bank- Business Environment and Competition 13 Mexico Policy Note 3 FOSTERING INNOVATION FOR PRODUCTIVITY AND COMPETITIVENESS EXECUTIVE SUMMARY  Message 1. Mexico can exploit better the opportunities for technological progress and productivity offered by its proximity to the United States. Given the multisectoral nature of innovation, better coordination in policymaking, stronger mechanisms to define budgetary priorities, and greater synergies among public policy interventions is necessary. A holistic innovation strategy as used in highly innovative economies such as Finland could help guide such efforts. A policy of more systematic impact evaluations of programs related to innovation needs to be in place along with the development of the necessary capabilities to be able to implement it.  Message 2. The research base needs to be strengthened through increased investments in public R&D, and much further collaboration needs to be encouraged between universities and the productive sector to better use existing technological capacities and deploy incremental R&D investments to move the productive sector up the value chain. Such collaborations could be encouraged through funding, more adequate rules on intellectual property rights and incentives at universities, and the development of specialized skills and intermediaries that facilitate technology transfer.  Message 3. A policy on human resources for innovation should be defined that addresses challenges at various stages of human resources formation Efforts to increase the formation of advanced human resources need to be sustained, with attention to enhancing the quality of domestic graduate education programs along with greater students’ participation in international programs. . World Bank- Innovation 1 Mexico Policy Note 3 OBJECTIVE This note provides a medium-term agenda for supporting Mexico’s competitiveness by fostering greater innovation. Globalization and the dynamism of economies that compete with Mexico, particularly those in East Asia, bring a renewed urgency to Mexico’s innovation policy agenda. While the firm is at the center of innovation, empirical evidence shows that public policy can generate an external environment more conducive to innovation. The past decade has brought several policy changes and new programs, but further changes would help the country catch up with more innovative economies and move up the value chain. Given the multisectoral nature of innovation and multiplicity of programs, better coordination in policymaking, stronger mechanisms to define budgetary priorities for innovation, and greater coherence and synergies among public policy interventions are necessary. A comprehensive innovation strategy as used in highly innovative economies such as Finland could help guide such efforts. KEY CHALLENGES Boosting innovation is critical to Mexico’s growth and competitiveness. Mexico’s growth, low relative to the country’s potential, has been driven mainly by accumulation in labor and capital. Over 2005–08 the contribution of total factor productivity was small and negative (–2 percent). This raises serious concerns because empirical research has shown that total factor productivity explains a substantial share of the difference in per capita income between developed and developing countries (Bosworth and Collins, 2003). According to the research, a substantial share of differences in total factor productivity are explained by technological progress or innovation broadly defined, meaning new combinations of existing resources (Romer 1990, and Aghion and Howitt, 2007), . Innovation can occur through organizational changes, changes in managerial practices, new methods of production, new sources of supply, development of new products, or upgrades to the quality of existing products. Technological progress can result from adopting knowledge that is globally available (“catching up�) or developing new knowledge. Both are relevant to Mexico, depending on the sector’s state of development. Information on Mexico’s performance with regard to a variety of indicators follows. Some caution in their interpretation is important given the challenges faced in measuring innovation as the literature points out. Intermediary indicators for technology-based innovation such as investments in research and development (R&D) and patents suggest that Mexico faces an innovation shortfall. The country’s overall investment in R&D remains low compared with countries with similar GDP per capita: 0.4 percent of GDP in 2009 (figure 1), well below other emerging markets such as Brazil (1.2 percent) and China (1.7 percent) and even farther from top innovation countries such as the Republic of Korea (3.7 percent) and Sweden (3.4 percent). Over the past decade Mexico’s private sector expenditure on R&D rose but remains low. Despite a recent increase, public expenditure on R&D as percent of GDP is barely above levels at the beginning of the last decade. In highly innovative economies R&D expenditure is driven primarily by the private sector, but the public sector is likely to play a greater role in emerging markets that are building core technological capabilities and that confront more acute market failures.1 The number of patents granted to Mexican nationals by the U.S. Patent Office has not changed much since the late 1990s and remains low; by contrast, the number of patents granted to many Organisation for Economic Co-operation and Development (OECD) countries and select emerging markets has World Bank- Innovation 2 Mexico Policy Note 3 surged.2 Between 2000 and 2008, for example, the number of patents granted to China more than tripled, and the number granted to the Republic of Korea more than doubled. Mexico’s stagnation in patenting occurred despite an increase in R&D, which could signal weak connectivity between research centers and the productive sector. Technology licensing by firms--a mechanism to benefit from globally available technologies--also appears lower than in peer countries. According to World Bank Enterprise Surveys, the percentage of Mexican firms using foreign licensed technologies is close to 10 percent, compared with 13 percent in Brazil and 16 percent in Turkey. Figure 1. Research and development Figure 2. Management skills expenditure (most recent year available) (percent of GDP, most recent year available) 3.7 3.4 1.7 1.2 0.7 0.8 0.4 Source: UNESCO, Science and Technology Data Tables. Source: World Bank and surveys by N. Bloom The gap in non-technological inputs and forms of innovation appears less acute. A recent survey showed that management practices of Mexican firms—another important input to firm performance—were superior to those of Brazil and Chile but still below those of more advanced economies (figure 2). This could result from the country’s greater connectivity with the United States. Further, the quality of exports, measured by the price that Mexican goods command in the United States, has been rising faster than the regional average, though it started at a below- average level.3 Several factors help explain gaps in Mexico’s innovation performance. Innovation is a process of knowledge creation and accumulation by economic agents that depends heavily on the external environment and available resources. At the center of growth and innovation is the firm, and barriers to accumulation of either physical capital (K) or knowledge capital (A) can stimulate or stifle innovation. Figure 3 illustrates drivers of innovation, on both the demand and knowledge supply sides. In Mexico’s case less than adequate competition, labor market rigidities, serious gaps in human resources, very limited financing for startups, and—critically important—weak links between the productive sector and knowledge institutions have all contributed to the World Bank- Innovation 3 Mexico Policy Note 3 shortfall. While various market failures justify government intervention, little information is available on the impact of most government programs to foster innovation. These issues are further discussed below. Figure 3. National innovation system The demand for innovation: need to improve the investment climate Mexico’s investment climate does not favor the demand for innovation. Competition, which has a substantial impact on firm behavior, can be an important driver of innovation. Moreover, competition from innovative new firms can be particularly important in achieving productivity gains. Yet Mexico’s competition environment is less than favorable in many sectors. 4 The World Economic Forum ranks the intensity of local competition at 84 out of 142 countries and the extent of market dominance at 124. Restrictions on foreign ownership in key network industries are not contributing to competition and innovation in those industries either. In addition, regulations constraining labor reallocation have also likely had an adverse impact on the density of startups and reduced existing companies’ demand for investment in new technologies. Broadly speaking, universities’ rules on intellectual property rights are not incentivizing researchers to transform their knowledge into innovations and collaborations with industry as further discussed below. The supply side: need to enhance human resource development Over the past decade Mexico has made very important progress in the development of its human resources, a critical pillar of an innovative economy, but further efforts will be necessary since it has not closed the gaps with its peers. Quality and quantity gaps remain at all stages of the education system. Mexico has seen impressive growth in the participation rate in secondary education but still lags rates in Brazil, Chile and the OECD. Graduation rates for students in secondary education are low, at just 45 percent. International learning tests also point to quality problems in the basic education system, creating a severe bottleneck to expanding the tertiary system.5 Enrollment in tertiary education among the relevant age cohort was 27 percent in 2009, a good progress over the past decade, but still below the rate in Brazil (36 percent), World Bank- Innovation 4 Mexico Policy Note 3 Turkey (46 percent), and Chile (59 percent). The tertiary system also confronts quality challenges, with many graduates often not meeting the skills demanded by the labor market, for example skills demanded by the software industry. To address this gap, Mexico First, part of a larger initiative to support the growth of the software industry (Prosoft 2.0), has facilitated the development of a public-private partnership that has helped overcome skills mismatch; similar partnerships could be replicated in other key industries.6 In addition, few universities offer entrepreneurship training. Despite Mexico’s increased investment in advanced human capital, the number of researchers has not caught up with its peers. The number of researchers has increased about 80 percent over the last decade, a result of sustained government efforts to fund training and education in technical areas. However, Mexico’s 1 researcher per 1,000 members of the labor force in 2009 is still below that of comparator countries (1.5 in China, 1.3 in Brazil, and 2.4 in Turkey) and substantially below advanced economies (10 in the Republic of Korea). Moreover, the share of researchers in the private sector in Mexico (less than 40 percent in 2009) is lower than in highly innovative economies (69 percent in the Republic of Korea). This limits the adoption of new technologies, solving of production issues, and development of new products. The low share of international graduate students limits knowledge transfer from abroad and international integration of the Mexican innovation system. Despite higher cultural and linguistic obstacles, data from UNESCO indicates that the Republic of Korea, Malaysia, and Thailand have more students studying in the United States than does Mexico. The country’s share has hovered around 2.1-2.4 of the total. Even Vietnam, with a much lower GDP per capita than Mexico, has nearly caught up. International students bring new ideas and knowledge to Mexico’s innovation system and are a critical bridge to the global scientific and economic community once in the labor force. Weak links and missing agents in Mexico’s innovation ecosystem Collaborations between industry and research centers have increased modestly in recent years but remain far and few compared with the active knowledge exchanges in dynamic innovation ecosystems (figure 4). Cooperation between industry and academia has been minimal due to different incentives and cultures. Public funding of science and technology programs have traditionally not favored such collaborations, as discussed below; initiatives to foster technology transfer have emerged only since the mid-2000s. In addition, regulations on intellectual property management (that is, regulations on how to share the monetary benefits derived from technology transfer with researchers) of many research centers and universities has not encouraged the transfer of knowhow, and capacity for managing intellectual property at these institutions has been very low. At the same time, skills gaps and lack of capacity to absorb knowledge in the productive sector have constrained demand for such exchanges. World Bank- Innovation 5 Mexico Policy Note 3 Figure 4. University-industry collaboration, 2011 5.7 5.52 5.4 4.53 4.2 4.04 Source: World Economic Forum, 2011. In addition to investment climate issues, inadequate financing and other missing links are holding back the entry of higher value firms with the potential to contribute to Mexico’s structural transformation. The number of newly registered firms is very low in Mexico at 0.6 per 1,000 workers compared with 2.4 in Brazil and 4.4 for the OECD according to the World Bank Entrepreneurship snapshots and 6.3 in China according to the Global Entrepreneurship Monitor (2010). Forming higher value firms (whether technology-based or not) is notoriously challenging worldwide and more so in emerging markets, which have few angel investors and inadequate venture capital funding. New entrepreneurs also face a steep learning curve, making support structures that facilitate mentoring and networking to markets and financiers very valuable. A few initiatives are trying to address these gaps; Nacional Financiera is fostering a venture capital industry through a “fund of funds�; the Ministry of Economy is supporting incubators and business accelerators; and Consejo Nacional de Ciencia y Tecnología (CONACYT) has piloted some initiatives to support the creation of new technology-based firms. Diversity of science, technology, and innovation programs but incomplete information on outcomes Over the past decade several policy changes have been implemented to address key market failures and build the capabilities needed for innovation, but little information is available on the impact of these initiatives. Policy changes started with the Law on Science and Technology in 2002, and subsequent amendments in 2009 emphasized the importance of innovation and incorporated better incentives for technology transfer by CONACYT’s public research centers, which has led to several new programs. Many other institutions (most prominently the Ministry of Economy) also support innovation-related activities. But not enough information is available on the performance and impact of these programs. Adopting existing knowledge is as important as developing new knowledge, and to address this gap, the Mexican government has deployed multiple programs for small and medium- size enterprises. Nelson and Winter (1982) point out that firms face a “bounded rationality� and often find difficulty adopting new knowledge because they do not know where the frontier is. In most cases firms develop the knowledge of how to do things incrementally, and such knowledge then becomes routines. Routines contribute to the day-to-day operation of the firm but constrain World Bank- Innovation 6 Mexico Policy Note 3 the adoption of new knowledge. Enhancing management ability to adopt and manage best practices and new technologies through well targeted support can increase firm productivity dramatically, as the rigorous randomized experiment conducted Bloom et al. (2011) in the textile sector illustrates.7 Aware of these difficulties, the Mexican government has several programs (for example, Fondo de Apoyo para la Micro, Pequeña y Mediana Empresa) that help small and medium-size enterprises enhance absorptive capacity through new forms of work organization, improved business practices, modern manufacturing processes, and investment in worker training. Program effectiveness is unclear, and the large number of existing programs suggests pulverization and overlaps. A 2011 World Bank study identified 151 small and medium-size enterprise programs administered by government agencies.8 Impact evaluations of the programs are rare in Mexico—and are mostly qualitative and narrow in scope, measuring either beneficiary satisfaction with support services or easily quantified program coverage indicators. The World Bank study found positive and significant impact for firms participating in a few of the programs (a 5 percent increase in value added in one case and a 6 percent increase in employment, among other outcomes). Technology extension programs for the agricultural sector appear to face similar challenges. These programs, largely sponsored by SAGARPA, present gaps in monitoring and evaluation, which weaken the focus on results and accountability. In addition, they could make a more efficient use of state based agricultural foundations that have successfully taken off during the last decade. Along with these basic innovation programs for small and medium-size enterprises, the Mexican government has supported R&D, though funding has been low and needs to be reoriented to better respond to Mexico’s development needs. CONACYT has been the primary institution financing advanced human capital and research and, since the mid-2000s, technology transfer (that is, commercialization of research). Other public institutions, most importantly Pemex, also have research funds. Overall public funding for R&D has been low compared with countries with similar GDP per capita. A substantial share of funding is allocated to the Sistema Nacional de Investigadores, which prevented brain drain in the 1980s but rewards researchers on an individual basis for publications, which does not facilitate today’s needs for multidisciplinary research or favor collaboration with industry or commercialization of research. CONACYT’s public research centers, a valuable pillar of Mexico’s technological infrastructure, could also work more closely with industry, and more of their resources could come from competitive funding, rather than direct budgetary transfers. More than 15 sectoral funds were jointly created by CONACYT and other federal institutions. Most resources were thinly spread among funds, and little information is available on outcomes. A few initiatives encourage technology transfer and R&D-related innovation by private firms. For example, CONACYT established Proinnova and several other programs to encourage public-private collaborative research. The 2009 amendments to the Law of Science and Technology seek to improve intellectual property rights of researchers at CONACYT’s public research centers. The current challenge is to create the capabilities and a culture within CONACYT’s centers for greater technology transfer activities to take root. World Bank- Innovation 7 Mexico Policy Note 3 Federal initiatives to promote innovation at the subnational level have not yielded all the desired results due to lack of capacity. Recognizing that opportunities and needs differ across states, CONACYT has developed initiatives (such as mixed funds and regional funds) to foster science and technology at the subnational level. Jalisco and Nuevo Leon, for example, have actively used these funds to support their innovation strategies. Government officials in Jalisco have involved multiple statekholders in the design of the strategy and committed public resources to it. Among others, the strategy seeks to encourage greater industry-university collaboration, and supports pre-competitive research funding, investments in research infrastructure and human capital. Many of the interventions are targeted at addressing gaps that are specific to key local clusters (e.g., skills in the rapidly growing software sectors, quality gaps in traditional industries). Many other states have yet to formulate a clear vision of how science and technology can contribute to their development agenda and have not been able to use the mixed funds as effectively. Similarly, proposals submitted to the regional funds have been suboptimal. POLICY OPTIONS Enhancing policymaking coordination and governance Given the multisectoral nature of innovation and multiplicity of programs, better coordination in policymaking, stronger mechanisms to define budgetary priorities for innovation, and greater coherence and synergies among public policy interventions are necessary. A comprehensive strategy developed by a high-level council could be a useful tool to help coordinate policymaking and guide budgetary decisions as many other countries committed to innovation (e.g. Finland since the early 1990s) have shown. Several options are available to formulate such a strategy. The General Council of Scientific Research and Technology, headed by the president and entrusted with developing the six-year Science, Technology and Innovation Program, could be responsible for it. Previous programs emphasized building Mexico’s scientific and technological capacities but overlooked broader innovation challenges. The council requires a broader mandate and nongovernmental members who are innovation experts. Another option is the Innovation Committee, headed by the Ministry of Economy, but it might not have enough seniority to lead a national policy. Alternatively, the president could form and lead a new high-level council with representatives from relevant ministries. The National Innovation Strategy will be effective only if the council remains an active policymaking body as other international experiences such as Finland have shown. It would need to define budgetary priorities for innovation annually and ensure that rigorous impact evaluations inform its decision making. A secretariat (for example, in the Ministry of Economy) would also be needed. Enhancing firms’ absorptive capacity and linking them to Mexico’s technological base Consolidating small and medium-size enterprise support programs and greater efforts at evaluation should be priorities. Effectively implementing well targeted technology extension services is crucial for Mexican firms, particularly small and medium-size ones, to move into World Bank- Innovation 8 Mexico Policy Note 3 higher value added activities. The country’s huge array of programs suggests that Mexico needs a more coherent framework to orient resources more strategically and avoid program overlap. The lack of information on budgets, activities, and beneficiaries points to a need for better consolidation of information on support for small and medium-size enterprises. Technology extension programs targeted at small producers in the agricultural sector are equally critical. Such programs could also benefit from stronger monitoring and evaluation mechanisms that would inform program design. State-based agricultural foundations could be more actively involved as intermediaries in these programs. Much more collaboration between Mexico’s research base and productive sector is needed. Such collaborations are pervasive in all dynamic innovation systems, whether in Israel, Sweden, or Taiwan (China). Technology transfer needs to become a higher priority, supported with appropriate financing. Funding would have a market-enhancing purpose that develops missing capacities (such as technology transfer offices) and addresses other market failures (such as coordination). However, there is scope for integrating similar programs—such as Innovatec, Innovapyme, and the Innovation Technology Fund—to reduce costs and confusion to users. Programs such as Magnet in Israel and similar ones sponsored by Tekes in Finland could be good reference points for collaborative programs. Stronger incentives for technology transfer at public research centers and universities are also needed. A culture of collaboration with the private sector—as is prevalent in universities in Israel, Taiwan (China), and the United States—needs to be developed. Many universities in Europe, such as Cambridge and Oxford, have successfully made such cultural transitions. To this end, CONACYT’s core funding allocation to its public research centers could incorporate technology transfer activities as a performance parameter, career promotion for its researchers could recognize patenting and other technology transfer activities. Such changes together with the new rules on intellectual property management noted above could set an example for universities in Mexico to follow. Similar changes in funding and incentives by public technology institutes in Finland (e.g., VTT) and other OECD countries could be a model for Mexico to consider. Mexico’s research base can be further expanded and strengthened. Every innovative economy has benefited from a strong science and technology base. The objectives and impact of the programs developed to foster research must be assessed. For example, little is known of the impact of the more than 15 sectoral funds created during the last decade. Changes to programs should encourage larger scale, collaborative, and multidisciplinary research that can resolve more complex problems and should forge more international collaboration. CONACYT’s research centers could use more competitive funding to continuously foster excellence. Institutional funding of 25–35 percent is a common practice in OECD countries. The revised funding model would pave the way for further collaboration with other research centers and the private sector. A transition plan could make this possible. Finally, the Sistema Nacional de Investigadores system could benefit from more participation of international evaluators, bringing greater objectivity to the evaluation, as well as a study on potential system reforms. Greater efforts should be made to enhance the states’ capacities to formulate their own innovation strategies so they can make better use of their resources and benefit from programs at the federal level. World Bank- Innovation 9 Mexico Policy Note 3 Enhancing human resource management for innovation A policy on human resources for innovation should be defined to address challenges faced at each stage of human resources formation. The policy needs to improve the relevance and quality of curriculum and teaching methods. Further efforts are needed to address the causes of secondary school dropout and to enhance teaching quality. (For further discussion, see Mexico Policy Note 4 on labor markets for inclusive growth). And mechanisms and standards for evaluating the quality of universities need to be strengthened. Efforts to increase the formation of advanced human resources need to be sustained, with attention to increasing the innovation system’s absorptive capacity. On the public sector side this means increasing support for research centers, and on the private sector side it implies boosting demand for innovation. For example, Finland and Israel show that university and industry research consortia are effective in forming industry-connected human capital. Enhancing the quality of graduate education in Mexico needs to go hand in hand with graduate students’ participation in international programs. Mexican students’ participation in international programs will bring global knowledge to Mexico’s industry and public research base. Greater exposure of domestic graduate programs to external assessments is also needed. The certification process of these programs should be changed to allow for more international participation. Moreover, the overall system would benefit from an external evaluation of its own evaluation processes by an international independent panel formed ad hoc or through a formal structure such as the European Association for Quality Assurance in Higher Education. Integrating Mexico’s innovation system globally and removing barriers to the demand for innovation The rapidly growing body of international knowledge makes it imperative to connect Mexico globally. This includes attracting international students to Mexico; encouraging international research collaborations; and incorporating more international evaluators in large- scale research programs, the Sistema Nacional de Investigadores, and Mexico’s system of graduate programs. Enhancing the investment climate A stronger investment climate—and in particular a more competitive business environment and more flexible employment regulations—would increase firms’ demand for innovation. A more competitive telecommunications sector would favor expanded Internet services and lower connectivity costs, facilitating smaller business integration into more productive activities. World Bank- Innovation 10 Mexico Policy Note 3 Matrix of short and medium-term policy reform options* Reform Short-term options Medium-term options option  Develop an innovation strategy to  Have the Innovation Council Enhance help coordinate policymaking and monitor strategy performance and policymaking guide budgetary decisions. (AR) advise on budgetary allocations coordination  Develop medium-term plans to and programs (AR) and conduct impact evaluations of  Regularly implement and dislose governance innovation-related programs and to the council and the public initiate implementation of plans. impact evaluations of innovation- (AR) related programs. (AR)  Enhance states’ capacities to  Conduct independent evaluations formulate their own innovation of large-scale programs and strategies. (AR) reviews of the overall performance of key institutions related to innovation (such as CONACYT and the broad innovation portfolio under the Ministry of Economy, including its small and medium- size enterprise programs). (AR) Enhancing  Improve monitoring and  Consolidate support programs for absorptive evaluation of existing and new small and medium-size enterprises capacity for support initiatives for small and based on evaluation results. (AR) firms and a medium-size enterprises by  Enhance programs on technology link between improving information on extension services for small Mexico’s program budgets, activities, and farmers based on evaluation technological beneficiaries and on assessment results. (AR) base and the of program effectiveness. (AR)  Increase percentage of productive  Improving monitoring and CONACYT’s research centers’ sector evaluation of technology funding that comes from extension services programs for competitive funding rather than small farmers (AR) direct allocations. (AR)  Improve monitoring and  Encourage larger scale, evaluation of various programs collaborative, and supporting research and examine multidisciplinary research that can options for integration (AR) resolve more complex problems,  Increase university-industry including greater international collaboration through (AR): collaborations. (AR) o Targeted programs to support  Continue stimulating university- research consortia, contract industry collaboration inter alia by research, licensing of providing funding for such technologies, and technology research consortia, and improved spinoffs. incentives for researchers. (AR) o Development of technology  Conduct a study to explore reform transfer offices with options of the (SNI). (AR) World Bank- Innovation 11 Mexico Policy Note 3 Reform Short-term options Medium-term options option administrative independence, a clear commercialization focus. o Greater participation of international evaluators in the Sistema Nacional de Investigadores (SNI) (AR) Enhancing  Improve the relevance and quality  Further increase the formation of human of curriculum and teaching advanced human capital, including resources at all methods (see Mexico Policy Note the participation of Mexican levels 4 on labor markets for more students in overseas graduate and detail). (AR) post-doctoral programs.(AR)  Increase the formation of advanced human capital, including the participation of Mexican students in overseas graduate and postdoctoral programs. (AR)  Change the certification process of domestic graduate programs to allow for more international participation in the evaluation process. (AR)  Conduct an external evaluation of the certification process of domestic graduate programs. (AR) *LR=Legal Reform; AR= Administrative Reform. Preliminary classification. NOTES 1 The percentage of R&D expenditure that comes from the private sector is close to 72 percent in 2010 for the Republic of Korea and 60 percent in 2009 for Sweden. 2 Although an imperfect proxy for innovation outcomes, patents are one indicator of potential to commercialize R&D activities. 3 Lederman and Maloney forthcoming. 4 For further information, see Mexico Policy Note 1 on a more competitive business environment. 5 See Mexico Policy Note 4 on Labor Markets for further detail. 6 The program provides practical training in a variety of technical and managerial topics as well as English. The curricula are jointly developed between universities and the software industry. 7 Bloom and others 2011. 8 Lopez and Tan 2011. These also included programs other than technology extension services, such as programs to encourage training and conservation and improve earnings and safe working conditions for the workforce in small and medium-size enterprises. REFERENCES Aghion P. and P. Howitt (2007). Capital, innovation and growth accounting, Oxford Review of Economic Policy, volume 23, Number 1, 2007, pp. 79-93. World Bank- Innovation 12 Mexico Policy Note 3 Bloom, N., B. Eifert, A. Mahajan, D. McKenzie, and J. Roberts. 2011. Does Management Matter? Evidence from India. Working Paper 16658. Cambridge, MA: National Bureau of Economic Research. Bosworth B. and S. Collins. 2003. The Empirics of Growth: An Update, Brookings Papers on Economic Activity, Vol. 2003, No 2, pp. 113-179 Global Entrepreneurship Monitor. 2011 Global Report. http://www.gemconsortium.org/docs/2201/gem-2011- global-report. Lederman, Daniel, and William F. Maloney. Forthcoming. Does What You Export Matter: In Search of Empirical Guidance for Industrial Policy. Washington, D.C.: World Bank. Lopez, A.G., and H.W. Tan, eds. 2011. Impact Evaluation of Small and Medium Enterprise Programs in Latin America and the Caribbean. Washington, D.C: World Bank. Nelson, R. and Winter, S.. 1982. An Evolutionary Theory of Economic Change Belknap Press Romer, P (1990), Endogenous Technological Change, Journal of Political Economy, 98, pp. 71-102. World Bank- Innovation 13 Mexico Policy Note 4 LABOR MARKETS FOR INCLUSIVE GROWTH EXECUTIVE SUMMARY Message 1: Mexico has low unemployment rates (by global standards), its most skilled labor force ever, and has streamlined procedures to facilitate business development. Nonetheless, the country has a history of low labor force productivity that constrains economic growth and the well-being of its population. Message 2: Macro-economic policies in place helped mitigate the impact of the crises of 2008. However, economic recovery is occurring with limited job creation and persistently higher unemployment and underemployment, raising concerns of new joblessness and limited poverty reduction. Message 3: Policy options include:  Promote labor market productivity and job creation by reducing labor market rigidity and increasing the relative benefits of formalization.  Create a more productive labor force by raising the level and labor market relevance of skills through a national skills strategy that recognizes labor-market skills acquisition throughout the life-cycle, continued reorientation of upper-secondary school toward the labor market, and portability of skills across the education, training, and labor market systems.  Improving allocative efficiency, and thus productivity, of the labor force by facilitating job search and matching through integrated employment services, including unemployment insurance, and strengthening competency-based certification. OBJECTIVE This policy note outlines short- and medium-term policy options for addressing critical challenges affecting labor markets in Mexico, and in particular labor productivity. As labor is the main source of income for most of the population, poverty is closely linked to underemployment and low wages. Yet labor markets have played a limited role in poverty reduction in Mexico. Labor income accounted for just 22 percent of the decline in poverty in Mexico over the last decade compared with 38 percent in the rest of the region.1 Between the third quarter of 2008 and the third quarter of 2011, the labor income poverty index 2 continued to decline in Brazil, Ecuador, and Peru but increased in Mexico (figure 1).3 The equivalent measure produced by CONEVAL (Consejo Nacional de Evaluación), shows the labor poverty trend to be increasing through the first quarter of 2012. Finding the right bundle of policies to improve labor productivity and the functioning of the labor markets can serve to improve economic growth and welfare outcomes. Labor Market 1 Mexico Policy Note 4 Figure 1. Labor income poverty index for selected Latin American countries, 2005–11 Source: Labor Database for Latin America and the Caribbean (LABLAC), World Bank and CEDLAS, 2012. KEY CHALLENGES Labor productivity is low in Mexico and economic crises have played a key role in the lack of growth in productivity. Over the past 20 years, labor productivity grew 2.1 percent, as compared to a 64 percent increase in Ireland or an 82 percent increase in South Korea over the same period.4 This is partly due to economic crises that reversed gains. The 1995 crisis caused labor force productivity to fall drastically and the crisis in 2008 derailed the slow recovery that was occurring. In real terms, labor productivity in 2011 is below its 1995 level. So increases in productivity have been insufficient to offset the various crises suffered by the country. Capital accumulation has accounted for a greater share of growth than labor. Despite economic growth in the past decade, real wages have been falling since 2007, driven by low labor productivity, and are low by regional standards. By 2010 real wages had fallen to about 90 percent of their 2008 level (figure 2). GDP per capita is 65 percent lower than in the richest third of OECD countries, more due to low labor productivity than low labor resource utilization.5 The crisis aggravated this trend. The number of jobs paying below two times the minimum wage rose during the crisis and these jobs now make up the largest share of jobs. Before the crisis, jobs paying between two and three times the minimum wage were the most common (figure 3). The increase in the size of the labor force in recent years has also created a downward pressure on wages. The sectoral composition of jobs has changed over the past decade, with a decline in the share of employment in the tradable sectors (figure 4) and a rise in the services sector. To some extent this can be seen as the effects of the crisis of 2008. Demand for exports fell and labor moved into the non-tradable sectors. However, this shift in employment began prior to the crisis so while the crisis may have exacerbated the shift it is not the sole cause. Labor Market 2 Mexico Policy Note 4 Low productivity persists despite large gains in school enrollment. Mexico has nearly achieved universal coverage in primary and lower secondary school enrolment rates. 6 Over the past five decades, completion rates for upper secondary education doubled (from 21 percent among people ages 55–64 to 42 percent among those ages 25–34).7 Net enrolment in upper secondary was 53 percent in 2010.8 Today, 16 percent of the economically active population in Mexico has an upper secondary education or higher.9 However, school enrollment takes time to translate into increased worker productivity: despite impressive gains in enrollment and completion rates, the average education level of the labor force only increased by 2.1 years between 1995 and 2010, more than the regional average of 1.4 years but still with substantial room for improvement.10 Figure 2. Decline in real wages, 2006–10 Figure 3. Employment by earnings relative to the minimum wage, 2006–11 30 Wage Index for selected workers (males age 15-to-64) 115.0 25 110.0 105.0 20 Index (Q3 2008 = 100) 100.0 Percentage 15 95.0 10 90.0 85.0 5 80.0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2006 2007 2008 2009 2010 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Agriculture + Low Tech Manufacturing High Tech Manufacturing + Construction 2005 2006 2007 2008 2009 2010 2011 Commerce 4 per. Mov. Avg. (Agriculture + Low Tech Manufacturing) Less than 1 min wage Between 1 and 2 min wages Between 2 and 3 min wages 4 per. Mov. Avg. (High Tech Manufacturing + Construction) 4 per. Mov. Avg. (Commerce) Between 3 and 5 min wages More than 5 min wages Source: Labor Database for Latin America and the Caribbean (LABLAC); Note: The categories “not specified� and “no income� were World Bank and CEDLAS 2012 excluded .Source: Banco de Informacion Economica, INEGI, 2012. Figure 4. Share of employment in the tradable and nontradable sectors, 2006 –11 40 38 36 34 32 Percentage 30 28 26 24 22 20 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2005 2006 2007 2008 2009 2010 2011 Tradables Non-tradables (excluding Services) Services Note: Tradables are agriculture, manufacturing; nontradables (excluding services) are construction and commerce. It excludes the public sector. Source: Banco de Informacion Economica, INEGI, 2012. Labor Market 3 Mexico Policy Note 4 Factors behind the limited job creation and low productivity Labor market rigidities increase labor costs in Mexico and may partly explain why recovery from the crisis has been accompanied by only limited job creation. Mexico ranks 23 of 183 countries on a composite index of rigidity of employment that includes difficulty of hiring, constraints on hours, and difficulty in firing (figure 5). Its score was above the world average and above the averages for the OECD and for the newly emerging economies of Brazil, China, India, Russian Federation, and South Africa. Extremely high severance pay requirements, particularly for short-term workers, play a large role, creating strong disincentives to hiring. New labor market entrants are likely disproportionately affected. Together with inadequate skills, this helps explain why youth unemployment rates are double the average rate. Rigid labor regulations may prevent labor markets from operating efficiently: when GDP rises, unemployment falls less in countries with more rigid labor markets.11 The high costs of hiring and firing reduce the total number of jobs in the formal sector,12 affect the composition of the labor force (youth and female unemployment is higher13), and constrain productivity (firms adopt less technology or adopt it more slowly, cannot adapt to new environments, and invest less in training, especially small firms14). Figure 5. Rigidity of employment index for regions and selected countries, 2012 50.00 45.00 40.00 35.00 30.00 25.00 20.00 15.00 10.00 5.00 0.00 Dificulty of Hiring Index (0-100) Rigidity of hours Index (0-100) Rigidity of Redundancy Index (0-100) Source: World Bank Doing Business, Employing Workers Indicators, 2012. Labor market rigidities that increase informality also impede economic growth. Informal firms have little access to formal credit and formal contracts, which constrains productivity improvement and job generation. The “missing middle� in Mexico, where firms are concentrated at the small and large ends of the distribution, is one outcome of the high rate of informality.15 Reducing the cost of becoming formal (lower social security contributions and taxes and simplification of registration requirements) can make it easier for firms to start up and grow.16 Inadequate levels of skills and the limited labor market relevance of skills constrain productivity and economic growth. As defined by Article 45 of the Ley General de Educacion, skills are the set of knowledge, abilities, and attitudes that an individual requires to perform effectively at the workplace. A low-skilled workforce may inhibit economic growth because Labor Market 4 Mexico Policy Note 4 firms will be less willing to invest in more productive, high-skill technologies. Furthermore, it causes society to forgo the benefits of additional productive workers, their relatively greater earnings and tax revenues. Productivity is affected by both the quantity and quality of skills. The importance of knowledge in math, language, and sciences – often referred to as “cognitive skills� – is the main focus of Mexican schools. The role of technical skills, as defined by abilities that are specific to a narrowly defined occupation, is most commonly understood as job-relevant and is the realm of technical training schools. New research, primarily from the US and Europe, finds, however, that socio-emotional skills – defined as team work, communications skills, customer relations, punctuality, honesty, etc. – are much more responsible for higher wages than are cognitive skills and they are negatively associated with unemployment.17 However, socio- emotional skill development is still not seen in Mexico as important for job preparation and there is not a systematic way to teach these skills. Employers report that the level and type of cognitive, technical, and socio-emotional skills in the labor market do not match their demands. In the Mexico Enterprise Survey, three firms in ten cited inadequate skills as an obstacle to productivity growth.18 And 43 percent of Mexican employers surveyed by Manpower cited difficulties filling vacancies, as compared to a global average of 31 percent. Difficulties are not limited to highly specialized jobs; the top-10 jobs that firms in Mexico have the greatest difficulty filling include sales representatives, secretaries, assistants, administrative personnel, laborers, and receptionists.19 Employers place a premium on cognitive and technical skills, but 40 percent of firms in the Mexico World Enterprise Survey identified socio-emotional skills as the most difficult skill set to find.20 Socio-emotional skills are increasingly critical in economies where jobs are more interactive, as in the service sector, which is the largest sector in Mexico.21 While school enrolment rates have increased significantly over the past few decades, insufficient labor market–related skills are still partly a result of low education levels. Levels of upper secondary education among the working age population in Mexico are on par with Brazil at 35 percent and 41 percent respectively, half the share found in Chile and the OECD.22 Enrollment rates among youth ages 15–19 and 20–29 remain well below those in Brazil, Chile, and the OECD. Only 45 percent of Mexican youth are expected to complete an upper secondary education, compared with the OECD average of 82 percent. Tertiary enrolments of 30 percent lag behind the LAC average of 37 percent.23 Similarly, while Mexican students have improved their performance on tests of cognitive skills acquisition, as reflected on international tests in science, math and reading, they still lag behind countries of a similar level of development suggesting that education quality is an issue. Results from the 2009 PISA test show that Mexican students score above the LAC average. However, among the 14 benchmarking countries worldwide with a similar GDP per capita, Mexico ranks 10th in reading and 11th on the PISA math and science tests (figure 6), that measure knowledge, the ability to apply it in different contexts, and attitudes toward learning. 24 Labor Market 5 Mexico Policy Note 4 Figure 6. Proficiency levels in science, math, and reading among 15-year-olds, 2009 Below level 2 Level 2-4 Level 5 or m ore Mexico 47 52 Science Sim ila r countries 29 68 4 OECD a vera ge 18 74 9 Mexico 51 49 1 Mathematics Sim ila r countries 39 56 5 OECD a vera ge 21 66 13 Mexico 40 60 0 Reading Sim ila r countries 28 69 3 OECD a vera ge 18 74 8 0% 20% 40% 60% 80% 100% Source: OECD, Education at a Glance, 2011 The institutions responsible for skills development in Mexico—schools as well as training institutions—-do not fully prepare the labor force with the skills required by the productive sector. Rates of return to education in Mexico have been healthy and stable for several decades, with an extra year of schooling raising earnings by an average of 12 percent in 2010. Nonetheless, there have been fluctuations around this trend, especially by level of education.25 As depicted in figure 7, rates of return for tertiary have increased by approximately 24 percent for males since 1992 while other levels have experienced significant declines in returns at times since the 1990s. Notably, the largest decline in rates of return has been in upper secondary education. These rates of return are likely overestimated since dropout rates are still quite high among (disadvantaged) Mexican youth. In themselves, these high dropout rates highlight shortcomings in education quality. On average, 14.5 percent of the country’s upper secondary students failed to complete upper secondary in the 2010-2011 school year, with dropout rates varying between 13.8 percent among general track students and 20.9 percent among students of technical programs.26 Together, the relatively low returns to upper secondary education, as compared to tertiary education, and high dropout rates underscore the need to encourage skills development at this level. Figure 7. Rates of Returns to Schooling by Level, males Labor Market 6 Mexico Policy Note 4 Sources: Garcia-Moreno and Patrinos 2012. Standard regression estimates (OLS) using ENIGH 1992, 1994,1996,1998, 2000,2002,2004,2006,2008,2010. There is both underinvestment in training and concentration of training among higher- skilled workers. Especially where education quality is low or mismatched to labor markets, such training can be critical for developing technical and socio-emotional skills. 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, for example.27 In Mexico, 35 percent of industrial workers and 44 percent of services workers report having received training.28 Overall, however, workers in other OECD countries report receiving more training than their peers in Mexico: six times more in Denmark, Switzerland, and the United Kingdom and three times more in Canada and the United States. Training tends to be concentrated among workers who already have higher education, among white-collar workers and managers, and among people who are already employed, partly because succeeding in technical training requires a strong cognitive and socio- emotional skills base. Most job training (outside of formal education) is, appropriately provided by (and funded by) firms,. However, much of this is less than 20 hours, is classroom-based, and does not provide competency certification.29 Mexico’s skills development institutions – schools and training centers – have recognized these challenges and have begun to reform their policies and teaching methods to this end. Efforts have been made across all levels of education to increase the professionalization of teachers by improving teacher training, competitively selecting new teachers, and certifying teacher competencies. After poor results in the 2000 PISA assessment, Mexico has been evaluating student performance through ENLACE in primary, lower secondary and, more recently, in upper secondary school. Furthermore, a competency-based curriculum – which included development of socio-emotional, cognitive, and technical skills – was introduced at the upper secondary level (through the Reforma Integral de la Educación Media Superior – RIEMS) and at the lower secondary level. The RIEMS also introduced a single national certificate for all secondary school graduates and remedial support to vulnerable upper secondary students to reduce dropout rates. In 2010-2011, almost 1.3 million scholarships were provided to upper secondary students.30 With the additional 600,000 scholarships planned under the Program for the Expansion of Upper Secondary Education (Síguele) starting in 2012, overall approximately 6 in 10 young people will receive scholarships for upper secondary education.31 At the tertiary level, financial resources provided to economically disadvantaged students increased their attendance from 5 percent in 2003 to 20 percent by 2011. 32 And, in 2012, Mexico introduced a Labor Market 7 Mexico Policy Note 4 Constitutional Reform that makes upper secondary education universal. But the gains have not yet been institutionalized and there is more to do. While skills-development institutions and organizations are individually contributing to improving labor productivity, they are not sufficiently coordinated to create a cohesive, efficient skills system. A review of the legal documents that articulate Mexico’s education system, labor relations, and the organizations involved in skills development shows that all define “skills� and “training� differently.33 Several institutions regulate and approve the training sector, but there is no clear division of labor between institutions. The legal framework for skills development does not foresee ministerial or sectoral collaboration, even if some institutions have in practice initiated bi-lateral dialogues. As a result, while each organization is developing strong strategies, they tend to work separately, making it difficult for individuals to navigate the system and access what they need most. To maximize the effectiveness of training and schooling changes, employment services that connect individuals with appropriate employment are key. However, existing employment services to better match skills and employment opportunities have inadequate scope and coverage. More than half of Mexican workers at all education levels reported finding their jobs through relatives, friends, or acquaintances.34 This informal matching mechanism, while common across the world, likely results in misallocation of skills and lower productivity as one’s circle of relatives and friends is unlikely to have a broad knowledge of job opportunities. Mexico’s Servicio Nacional de Empleo serves a very small segment of the workforce and is not commonly used by employers.35 As in other countries in the region, spending on intermediation services is lower than in other OECD countries, and there is a greater focus on programs that support startup firms or self-employment, especially in rural areas, whereas most unemployment is in urban areas among those seeking wage-employment. Furthermore, in spite of significant advances by CONOCER, the system of competency-based skills certification, which can signal skills and improve matching, is incomplete. The importance of this matching system is particularly critical in the wake of the financial crisis. The crisis’ impact on growth was deep and brief, however it served to delink labor force growth and employment growth, increasing unemployment and underemployment (figure 8). Before the crisis, the economy was able to absorb all the growth in the labor force, keeping unemployment low. In the second half of 2008 and in 2009, however, a gap developed between labor force growth and employment growth (figure 9). By the second quarter of 2010, employment growth again matched labor force growth, but the economy has not been able to generate enough jobs to employ all the potential new workers who joined the labor force during the crisis, so unemployment has risen. Figure 8. GDP growth and unemployment rate, 2005– Figure 9. Decoupling of labor force growth and 11 employment growth, 2005–11 Labor Market 8 Mexico Policy Note 4 10.00 7.00 120 6.75 6.50 8.00 118 6.25 6.00 5.75 116 6.00 5.50 5.25 114 4.00 5.00 4.75 Year-to-year GDP Growth Index (2005 Q1 = 100)) 112 Unemployment rate 4.50 2.00 4.25 4.00 110 0.00 3.75 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 3.50 2005 2006 2007 2008 2009 2010 2011 108 3.25 -2.00 3.00 2.75 106 -4.00 2.50 2.25 104 2.00 -6.00 1.75 1.50 102 1.25 -8.00 1.00 100 0.75 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 -10.00 0.50 2005 2006 2007 2008 2009 2010 2011 GDP Growth (% change wrt same Qtr of previous Year) Unemployment Rate Unemployment Rate (4 Qtr Moving Avg) Growth of Employment (Index) Growth of Labor Force (Index) Source: CONEVAL and Banco de Informacion Economica, INEGI, 2012 Source: Banco de Informacion Economica, INEGI, 2012. Mexico’s labor force has grown substantially over the last decade, rising 18 percent since 2006, due to a convergence of several factors. The population has continued to grow faster than expected (fertility did not fall as much as projected), and labor force participation rates have risen 5 percent since 2005. Net migration to the United States, which formerly absorbed some excess labor, dropped to zero between 2005 and 2010, a result of the impact of the crisis on the U.S. economy.36 The flattening of the upward trend in enrollment among children under age 17 in urban areas and the effect of the crisis on female labor force participation also affected the labor supply. POLICY OPTIONS The following short- and medium-term policy actions address the challenges facing the Mexican labor market—recovery with limited job creation, low productivity, high informality, and weak links to poverty reduction—and focus on both supply and demand. Reducing labor market rigidities and simultaneously improving social protection for the unemployed, such as unemployment insurance and job-matching services, to increase the demand for labor and reduce informality If Mexico increased the flexibility of its labor markets to levels found in the United States, its unemployment rate would be 2.4 percentage points lower and less persistent.37 Making hiring more flexible could boost job creation and productivity. Mexican labor laws consider employee-employer relationships as permanent, with little room for any but open-ended contracts. The legislation further constrains contracts by restricting hours of work and nonstandard work schedules.38 Contracting modalities that can lower the costs of hiring workers and provide more opportunities for formal employment would allow for probationary periods, training/skill development using self-selection contract provisions (specific age group, lower wages), fixed-term appointments, and seasonal variations in employment that protect worker rights while allowing industries with cyclical demand to function efficiently. Legislation to allow for more contract modalities would need to strike a balance between protection and flexibility, to avoid abuse.39 Labor Market 9 Mexico Policy Note 4 Reducing mandatory severance payments could also encourage job creation. Mandatory severance payments, unlike unemployment insurance, place the burden on individual firms and discourage formal employment. Reducing severance pay can have a positive impact on labor markets. When Spain lowered severance pay requirements and social security taxes in 1997 and 2001, the probability of permanent employment increased among young workers. 40 Total employment also rose when Chile capped severance payments.41 There is a need to balance this reduction in severance costs with a comprehensive system of protection for the unemployed that should include income protection as part of a broader set of employment services. The system would need to promote risk pooling and redistribution while limiting moral hazard, perhaps through a combination of individual accounts and a solidarity component. The system would need to avoid dampening the incentives of the unemployed for job search by the unemployed, for instance by keeping benefits fairly low, by limiting the amount that can be accumulated in the individual account, or by decreasing benefits over time. Benefits are most effective when combined with or conditioned on other services (search requirements in particular). Part of the funding for the broad set of employment services could come from eliminating some of the services that are now bundled within the payroll tax (such as housing and child care), as well as some of the least effective active labor market programs. Reducing the uncertainty of how the labor courts (JCA) will resolve dismissal cases. The current incentive structure does not favor the swift resolution of labor disputes. Furthermore, the composition of tribunals—composed of employers, employees, and government—often results in the government casting the deciding vote, usually a compromise between employer and employee interests. The high level of discretion undermines transparency and creates incentives for both sides to bring cases to the court. Improving the efficiency, transparency, and timeliness of judicial proceedings would lower an important cost associated with termination of employment and could boost formal employment. Incentives could be introduced to encourage mutual agreement (deadlines, maximum salary caps, and guidelines for reaching decisions), the grounds for bringing a case before the JCA could be narrowed, and the JCA’s independence could be strengthened. Collecting timely data for monitoring and evaluation will be vital for identifying other bottlenecks. Replacing severance payments with unemployment insurance could lower employer costs and encourage firms to create higher productivity jobs. The labor code’s reliance on high severance payments to provide income support during unemployment is ineffective. More than half the cases before the JCA end in private settlements below legal mandates, legal fees absorb 30–40 percent of severance payments,42 and many workers do not even bring suit for these reasons.43 Formal workers can draw on their pension savings during periods of unemployment, but this option is primarily for those in the formal sector and has the negative consequence of lowering retirement savings. Replacing mandatory severance payments with a well designed unemployment insurance scheme could lower the costs of employment, encourage firms to create higher productivity jobs,44 better protect workers against risk, and allow for more effective job search.45 Adjusting social security contributions could lower the costs of formality. One option would be to remove some benefits bundled together with old-age pension and health insurance under social security contributions and payroll taxes, such as housing and child care. How large an Labor Market 10 Mexico Policy Note 4 effect this has on employment will depend on the extent to which workers undervalue the benefits provided through social security contributions and payroll taxes. Research shows this undervaluation is particularly high for low income workers who are not willing to surrender wages in exchange for the current benefits.46 Another option is to create a universal system of health insurance and old-age pensions that is delinked from labor status. Again, understanding the implications for labor market incentives is critical. Aligning the skills development system with the needs of the labor market by improving institutions and programs to deliver labor market–relevant skills A national strategy for building labor market–relevant skills at appropriate periods of the life cycle would mobilize all actors around a common goal. Defining the broad range of skills valued by the labor market, articulating a strategy for people to acquire those skills, and setting up institutional and coordination mechanisms can help Mexico make the leap to higher skills and earnings, as was recently done in South Korea and Ireland.47 This strategy would identify the cognitive, technical, and socio-emotional skills that the market values. Developing the mechanisms for a meaningful, continuous, and actionable dialogue between public actors (ministries of education, labor, the economy, and social development; state governments) and private actors (trade associations, unions, training and education institutions, firms, 48 and others) will help ensure that the productive sector’s needs inform the design of education and training programs. Such a strategy would also need to identify, and include in the dialogue, the appropriate service providers at each stage of the life-cycle.49 A full matching of skills training needs with appropriate providers will allow for the definition of organizational roles. Finally, the legal and institutional framework would need to be updated to reflect the focus on skills, establish roles for core actors, and setup mechanisms for coordination.50 National or regional development strategies would complement the more general skills development strategy. These sub-strategies would identify the sectors and regions that are likely to generate jobs in the future, so that clear investments plans for specific technical skills development can be decided. This could reduce the over- and under-supply of workers for some types of skills51 and thus boost productivity. Interventions that help vulnerable groups to acquire labor market-oriented skills will increase social inclusion. Having the skills the labor market needs is the best way to increase income-generating capacity and escape poverty. On the basis of a deeper understanding of the main causes of dropout, especially at the upper secondary level, efforts should be made to identify appropriate policies to overcome these constraints.52 For those who have already dropped out of formal education, training services should be tailored to take into account the lower cognitive, technical, and socio-emotional skills of this group, as well as providing other services that address the broader set of employment barriers they face. And for those who have completed secondary school, the PRONABES student scholarship program should be continued and expanded into a hybrid loan-scholarship program for less disadvantaged youth who are financially restricted from entering quality tertiary education programs. Continue implementing the RIEMs, with a particular emphasis on integrating the priority skills identified by employers into the curriculum and teaching methods in education and training institutions. The recent reforms to improve the quality and labor market orientation of education at all levels, by raising the quality of basic education and of competency-based Labor Market 11 Mexico Policy Note 4 curricula at the upper secondary level, are still fragile.53 To institutionalize these reforms, it is important to continue to bolster teacher development and certification; expand the new training to support even more teachers in modern, interactive pedagogical methods; monitor classroom success through the EXCALE and ENLACE to improve the targeting of training; and continue to implement regular assessments and enhanced quality assurance and accountability systems to boost teacher quality. Efforts to improve labor market–relevant skills need to start early, and an early child development system that focuses on developing socio-emotional skills will reduce school dropout, improve school performance, and boost labor market access and productivity. Support lifelong learning through greater integration of different education streams and of education and training systems. The integration of the upper secondary education system, that the RIEMS has started, should expand to the larger skills-development system. The next step is to ensure compatibility and integration between institutions that transfer skills, such as between community colleges and universities in the United States. It will also be important to ensure portability of skills between the skills-development system and the labor market so that individuals can move easily between skills development in formal education and on-the-job training. A system of competency-based certification (discussed below) is required to signal the acquisition of skills recognized by all the major players. Multiple sectors, including the private sector, have a role in preparing people for the labor market. The government’s chief contributions are convening stakeholders, generating and disseminating labor statistics and information about training offers, and creating a regulatory framework to ensure quality and provide incentives. Strengthening the accreditation system for education and training institutions is also important for ensuring that training programs align with the skills demanded by the productive sector. Linking public funding for training programs to job placement or retention can encourage a focus on results. Facilitating job search and matching through comprehensive employment services Linking employment services with other interventions and with the private sector can support transitions to the labor market. Employment services include job intermediation services as well as more intensive interventions such as guidance, counseling, remedial education, and training or re-training for those with the greatest difficulties. Investing in employment services has demonstrated impacts—greater success finding a job, less informal sector employment, and higher wages—and intermediation and job counseling are among the most cost-effective services. Combining a comprehensive set of job-oriented services could help systematically tackle the most binding constraints to employability, especially for the poor. Evidence shows that a combination of training programs (that teach cognitive, technical and social-emotional skills), job search assistance, temporary financial support (for transport and basic maintenance), and referrals to other social services is often a key to success—even if they might best be provided by different institutions. Orientation and counseling can also direct people to the right training, reducing discrepancies between labor demand and supply.54 Finally, experience shows that it is critical that employment services refer individuals to a broader set of services when needed (education, training, scholarships, social workers, transport subsidies, and so on). Labor Market 12 Mexico Policy Note 4 Tools and a methodology are needed to manage integral employment services that are closely linked to the productive sector. Building on the experience of the national employment service and numerous private providers, such a model would need to ensure greater participation by the private sector. It should also have a specific component for the poor that links employment services to social assistance programs. Developing clear objectives and a strong information system would help manage services on the basis of results (services will typically be provided by a range of public and private providers). Because employment services have to be decentralized, the quality of local services will influence success. The national system of competency needs to be strengthened . A competency system can promote efficient matching in labor markets by signaling skills across professions, regions, and jobs. A competency system can also ease transitions between the education and training systems and guide the development of curricula that are directly related to skills in demand in the labor market. Such a system would also recognize skills acquired outside of formal training programs. Currently, many employers prefer to rely on experience or references rather than on diplomas or certificates as indicators of skills, because these do not indicate that skills have actually been acquired but are mainly evidence of attendance or completion of training.55 The government can also promote the use of competency certification by providing and funding only competency- based courses (in sectors where these are sufficiently developed). The political and legal foundations of the competency system also need to be stronger to promote collaboration. Mexico should strengthen CONOCER, providing it with the autonomy it requires and ensuring that its mechanisms involve all actors at the national and local levels (including employers, education and training providers, and students). The system needs to serve all workers by certifying on demand those who have acquired skills in formal education, training, or on the job. Ultimately, the success of a competency system depends on its use by all actors, particularly the private sector, which needs to lead the effort. Matrix of short and medium-term policy options* Policy area Short-term policy options Medium-term policy options Reducing labor market rigidities to increase the demand for labor and reduce informality Making hiring  Build consensus on the best options  Implement legal changes required to modalities more for expanding hiring modalities. expand contracting modalities (LR) flexible  Monitor and evaluate effectiveness.(AR) Reducing the cost  Review previous proposals to  Reform labor courts.(AR, LR) of terminating increase the efficiency and  Implement alternative severance pay employment predictability of labor courts. (with introduction of unemployment  Review international experience on insurance mechanism; see labor tribunals and labor court below).(LR) reforms.  Propose ways to reduce the costs of employment termination. Reducing the cost  Identify mechanisms to provide  Remove some (noninsurance) of formality social security with fewer services from social security bundles. distortions (unbundling benefits, for (LR) Labor Market 13 Mexico Policy Note 4 example).  Implement feasible option for  Explore options to de-link old- age delinking old-age income support and income support and health health insurance from labor insurance from labor status status.(LR) (including fiscal implications). Improving institutions and programs to deliver labor market–relevant skills Developing a  Build consensus on skills and  Identify necessary legal adjustments national skills develop skills strategy, including as  Propose institutional mechanisms for strategy part of broader national or regional implementation (LR). development strategy.  Identify specific needs of the vulnerable and program design adjustments to meet these needs Improving the  Review the private sector  Modernize teacher training and quality, labor orientation of curricula. strengthen monitoring to improve market orientation,  Review the design of core training teacher performance (LR). and accessibility of programs and identify reform  Implement changes for training skills development agenda. programs (including incentive through the  Explore options to link funding for mechanisms for a focus on results) education and training to results in labor markets. (LR) training sectors  Strengthen the design of  Implement the accreditation system accreditation system for education (LR) and training programs  Strengthen the early childhood development system. Strengthening and  Identify areas where bridges need to  Set up mechanisms to allow expanding be established or strengthened individuals to switch between systems mechanisms to between systems or institutions. (LR). integrate skills  Review options for mechanisms to institutions and establish bridges and switch programs between systems. Facilitating job search and matching through comprehensive employment services Developing an  Identify services needed by  Develop an integral model, including integral model of different population groups to enter for the vulnerable (AR). employment the labor market. services  Identify existing services and possibilities for linking them. Developing a  Design models, explore institutional  Establish the system (LR). mechanism to arrangements, estimate costs, and provide income- explore mechanism to switch from protection during severance to unemployment unemployment insurance. Strengthening the  Explore options to provide more  Expand certification system to cover national system of autonomy to CONOCER and to all skills sets, ensuring its competency-based increase the demand for compatibility with external labor certification certification from workers and the markets (particularly the United Labor Market 14 Mexico Policy Note 4 private sector States) (AR) * LR= Legal Reforms; AR=Administrative Reforms, Preliminary Classification Labor Market 15 Mexico Policy Note 4 1 Azevedo, Inchauste and Sanfelice 2012. 2 The index measures the ability to purchase the basic food basket with labor income. 3 World Bank 2011. 4 Centro de Investigación para el Desarrollo A.C. 2011. 5 OECD 2011d. 6 Puryear, Santibañez,and Solano 2012. 7 OECD 2011c. 8 SEP 2012 9 Based on author’s calculations using INEGI, Encuesta Nacional de Ocupación y Empleo, first trimester of 2010. 10 Author’s calculations using Barro-Lee data on population aged 25 years and more. The LAC Average is derived from average education rates of 25 Latin American countries. 11 Bertola 1990; Di Tella and MacCulloch 2005; Blanchard and Summers 1986; and Lindbeck and Snower 1989. 12 Kaplan, Sadaka, and Silva-Mendez 2008. 13 Feldmann 2009; Djankov and Ramalho 2009; and Samaniego 2010. 14 Acemoglu and Shimer 2000; Lopez-Acevedo 2002; and World Bank 2006. 15 OECD 2011b. 16 Koettl and Weber 2011. 17 Gintis 1971, Edwards 1976, Bowles and Gintis 1976 and 2002, and Bowles et al. 2001 find that the returns to schooling attributable to cognitive skills are rather small when compared to the effects to non-cognitive skills, with about 80 percent of the return to schooling formally assigned to non-cognitive skills. More recently, Carneiro et al. 2007 and Heckman and Rubinstein 2001 have found similar results. Non-cognitive skills also affect unemployment, as demonstrated by Anger and Heineck 2006 and Lindqvist and Vestman 2011. 18 Data from the 2010 World Bank Enterprise Survey for Mexico. 19 The share of firms reporting difficulties is also high in many other Latin American countries, including Argentina, Brazil, Colombia, Costa Rica, Guatemala, Panama, and Peru. Manpower 2010. 20 Authors calculations from 2010 World Bank Enterprise Survey for Mexico. 21 The demand for, and shortage of, socio-emotional skills are observed by employers across the world, in countries as diverse as India, North Africa (8 countries surveyed), Vietnam, Botswana, the Caribbean, and Tonga (Bassi, Busso, Urzua, and Vargas 2012, Blom and Hobbs 2008, Blom and Saeki 2011, Castro, Yamada, and Arias 2011, Di Gropello 2010, and IFC 2010). See also OECD and Statistics Canada 2011; Brunello and Schlotter 2011; Carneiro and Heckman 2003; World Bank 2009 and 2011; OECD 2007 and 2011c. 22 OECD 2011e, table A1.2a. The share of 25 -64 year olds with at least upper secondary education is 69 percent for Chile, and 73 percent for OECD countries on average. 23 An estimated 2.1 million 15-18 years-old are not studying nor working (about 22 percent of that age group), many of which have not completed primary schools. Cardenas, de Hoyos and Szekely 2011. 24 The 14 benchmarking countries include Argentina, Brazil, Chile, Croatia, Estonia, Hungary, Latvia, Lithuania, Mexico, Poland, Romania, Russian Federation, Trinidad and Tobago, and Turkey. 25 Garcia-Moreno and Patrinos 2012. 26 SEP 2011 27 Puryear, Santibañez,and Solano 2012 28 Author’s calculations from the 2009 ENOE. 29 Villaseñor 2012. 30 These were provided predominantly under Oportunidades and the Programa de Becas de Educación Media Superior , and represent an increase of 77 and 40 percent for these programs, respectively, since 2006-2007. 31 Presidencia de la República Mexicana 2012. 32 Programa Nacional de Becas para la Educación Superior —PRONABES. 33 For example, the General Law of Education uses interchangeably the concepts of knowledge, abilities, capacities and/or skills, when dealing with training and education contents (Articles 45 and 47). In the Federal Labor Law, training refers to acquiring knowledge and abilities, without a competence-based approach (Article 153). Only the regulatory framework of CONOCER uses the concept of labor competences, which includes knowledge, abilities, skills and attitudes (Article 1). Both laws regulate the registry, approval and/or delivery of training services in Mexico, and the creation of different types of training commissions, which purpose is not clear. 34 ENOE 2011. Labor Market 16 Mexico Policy Note 4 35 Villaseñor 2012. 36 Cohn, D., A. Gonzalez-Barrera and J. Passel, 2012.2012. 37 Based on the methodology of Di Tella and MacCulloch 2005 using data from the World Bank (various years) and Fraser Institute 2012. These scenarios compare Mexico with OECD countries over 2000 –10. Over this period, the mean labor market flexibility index (as defined by the Fraser Institute 2012 using data from the World Bank, the World Economic Forum, and the Institute for Strategic Studies) for Mexico was 53.2 on 0 –100 scale, where 0 is very rigid and 100 is very flexible. The mean labor market index was 88.1 for the United States, 37.1 for Germany, and 55.7 for Chile. 38 Articles 5 and 123 of the 1917 Constitution provide for a maximum of 8 hours of daytime work, 7 hours of night shift work, and overtime premiums of 100 percent. 39 Spain’s 1984 reform, which expanded the use of temporary contracts, resulted in a segmented labor market that reduced efficiency and equity (Dolado, García-Serrano, and Jimeno 2002; Feldmann 2009; Bank of Spain 2009). 40 Kugler, Jimeno-Serrano, and Hernanz 2003. 41 Pages and Montenegro 1999. 42 Kaplan, Sadaka, and Silva-Mendez 2008. 43 Dávila Capalleja 1997 and Kaplan and Sadka 2004. 44 Acemoglu and Shimer 2000. 45 Hopenhayn and Nicoloni 1997. 46 There is evidence in Mexico that some segment of the workforce undervalues benefits (Levy 2008; Cunningham and Maloney 2001). Reviewing the social security system is beyond the scope of this note, but see Mexico Policy Note 5 on social protection for recommendations. 47 Villaseñor 2012. 48 Many enterprises organize or contract training programs, especially among larger firms (84 percent of firms with more than 100 employees, 71 percent of firms with 31 –100 employees, 53 percent of firms with 11 –30 employees, and 39 percent of firms with 6 –10 employees, according to World Bank Enterprise Surveys). According to the 2009 ENOE, half of the training in the industrial and services sectors is provided by the firm, a colleague or supervisor. 49 For example, the most fundamental socio-emotional skills for the labor market – impulse control, working with others, for example – are best taught in pre-school and in the home, reading and numeracy are best taught in primary education, and firm-specific skills are best learned on the job. 50 These include the Federal Labor Law, the General Education Law, and the Organic Law of the Federal Public Administration, as well as other legal documents such as the Partnership for Education Quality and the Comprehensive Reform of Upper-Middle School. 51 Many graduates do not hold jobs that match their skills, as is the case for about 40 percent of those with industrial, electrical, electromechanical, and computer science training are in jobs that do not match their skills. This is also the case for 45–50 percent of those who studied management, marketing, or economics (ENOE 2009). 52 The 2010 survey of dropouts at the upper secondary level undertaken by the Secretaría de Educación Pública is an important source for this. According to Bravo 2009, 34 percent of dropouts cited economic conditions, 29 percent cited family reasons such as childbirth, and 11 percent cited a perception that studies are too difficult. 53 Defined in the Integral Upper Secondary Education Reform of 2007. 54 In most countries, student preference remains the main driver of educational choices, and better career guidance in support of individual choices could play an important role in reducing discrepancies in supply and demand of workers by field of study (about two in five overqualified OECD workers are employed in a job that is unrelated to their field of study; OECD 2011a). 55 Less than a third of workers were certified or received a record of their skills after their last training in the industry and service sectors. ENOE 2009. REFERENCES Acemoglu, D., and R. Shimer, 2000. “Productivity Gains from Unemployment Insurance.� European Economics Review 44 (7): 1195–1224 Almlund, Mathilde; Angela Lee Duckworth, James J. Heckman, and Tim D. Kautz. 2011. “Personality Psychology and Economics.� NBER Working Paper No. 16822 Azevedo, J., G. Inchauste and V. Sanfelice, 2012. � Decomposing the Decline in Income Inequality in Latin America. Mimeo. Labor Market 17 Mexico Policy Note 4 Bank of Spain. 2009. “El funcionamiento del Mercado de trabajo y el aumento del paro en España.� Boletín Económico (Julio–Agosto): 96–115. Bassi, Marina; Busso, Matias; Urzua, Sergio and Vargas, Jaime. 2012. “Desconectados,� IDB. Bertola, G., 1990. “Job security, employment and wages.� European Economic Review 34 (4): 851 -879. Blanchard, O. and L. Summers, 1986. Hysterisis in Unemployment. NBER working paper No. 2035. Blom, Andreas and Hobbs, Cynthia, 2008. “School and Work in the Eastern Caribbean�, Washington, DC: The World Bank. Blom, Andreas and Saeki, Hiroshi. 2011. “Employability and Skill Set of Newly Graduated Engineers in India“, World Bank Policy Research Working Paper 5640 Bravo, Espino 2009. “Analysis of Mexico’s 2008 National Survey of Education and Labor Trajectories (ENTELEMS).�Mimeo. Brunello, Giorgio and Schlotter, Martin, 2011. "Non Cognitive Skills and Personality Traits: Labour Market Relevance and their Development in Education & Training Systems," IZA Discussion Papers 5743, Institute for the Study of Labor (IZA). Cardenas, Mauricio, de Hoyos, Rafael and Szekely, Miguel, 2011. “Idle Youth in Latin America: A persistent problem in a decade of prosperity.� Carneiro, Pedro and Heckman, James J., 2003. “Human Capital Policy," IZA Discussion Papers 821, Institute for the Study of Labor (IZA). Castro, Juan Francisco; Yamada, Gustavo; and Arias, Omar. 2011. “Higher Education Decisions in Peru: On the Role of Financial Constraints, Skills and Family Backgrou nd�, World Bank Mimeo. Cohn, D., A. Gonzalez-Barrera and J. Passel, 2012. Net Migration from Mexico Falls to Zero – and Perhaps Less. Pew Hispanic Center, Washington, DC. Consejo Nacional de Normalización y Certificación (CONOCER). 2009. “Estrategias para el Fortalecimiento del Capital Humano del Sector, Reports 1 to 7 (Tourism, BPO, Software Development, Automobile Industry, Mining, Construction, and Logistics).� Mimeo. Centro de Investigación para el Desarrollo A.C. (CIDAC). 2011. Hacerlo Mejor: Indice de Productividad Mexico . CIDAC. Mexico. Cunningham, W.V., and W.F. Maloney. 2001. “Heterogeneity among Mexico’s Microenterprises: An Application of Factor and Cluster Analysis.� Development and Cultural Change 50 (1): 131–156. Dávila Capalleja, E.R. 1997. Mexico: The Evolution and Reform of the Labor Market. Washington, DC: Brookings Institution. Dearden, Lorraine, Reed, Howard and Van Reenen, John, 2000. "Who Gains when Workers Train? Training and Corporate Productivity in a Panel of British Industries," CEPR Discussion Papers 2486, C.E.P.R. Discussion Papers. De Hoyos, Rafael. 2010. “Situación Actual de las Políticas deVinculación en EMS.� Presentation at international conference on April 29, 2010. Di Gropello, Emanuela. 2010. “Indonesia Skill Report: Trends in Skill Demand, Gaps and Supply in Indonesia� World Bank Report No. 54741-EAP. The World Bank: Washington, DC. Di Tella, R. and R. MacCulloch, 2005. “The consequences of labor market flexibility: Panel evidence based on survey data. European Economic Review 49 (5), 1225 –1259. Djankov, Simeon and Rita Ramalho. 2009. “Employment Laws in Developing Countries.� Journal of Comparative Economics 37 (1): 3–13. Dolado, J., C. García-Serrano, and J.F. Jimeno.2002. “Drawing Lessons from the Boom of Temporary Jobs in Spain.� Economic Journal, 112 (480): F270–F295. ENOE. 2009 and 2011. “Encuesta Nacional de Ocupación y Empleo.� Instituto Nacional de Estadística y Geografía. Mexico. ENTELEEMS. 2009. “Encuesta Nacional de Trayectorias Educativas y Laborales.� Module of the ENOE. Instituto Nacional de Estadística y Geografía. Mexico. Feldmann, H. 2009. “The Unemployment Effects of Labor Regulation around the World.� Journal of Comparative Economics 37 (1): 76–90. Fraser Institute, 2012. Economic Freedom of the World. Vancouver, British Columbia: Fraser Institute. Garcia-Moreno, V. and Patrinos, H.A., 2012. “Non-linearities in the returns to education in Mexico�. Mimeo The World Bank: Washington DC. Labor Market 18 Mexico Policy Note 4 Hopenhayn, H., and J.P. Nicoloni. 1997. “Optimal Unemployment Insurance.� Journal of Political Economy 105 (2): 412–38. IFC. 2010. “Education for Employment: Realizing Arab Youth Potential�, International Finance Corporation, The World Bank: Washington, DC. Kaplan, D., and J. Sadka, 2004. “Enforceability of Labor Law: Evidence from a Labor Court in Mexico,� Policy Research Working Paper 4483, World Bank, Washington D.C. Kaplan, D., S. Sadaka, and J.L.Silva-Mendez. 2008. “ Litigation and Settlement: New Evidence from Labor Courts in Mexico.� Journal of Empirical Legal Studies 5 (2): 309–50. Koettl, J., and M. Weber. 2011. “Does Formal Work Pay? The Role of Labor Taxation and Social Benefit Design in the New Member States.� [institutional affiliation and city]. Levy, S. 2008. Good Intentions, Bad Outcomes: Social Policy, Informality, and Economic Growth in Mexico. Washington, DC: Brookings Institution. Lindbeck, A. and D. Snower, 1989. The Insider-Outsider Theory of Employment and Unemployment. The MIT Press Classics Series, Cambridge, Massachussets. Lopez-Acevedo. 2002. “Determinants of Technology Adoption in Mexico.� In World Bank, Mexico Technology Wages and Employment. Washington, DC. Manpower. 2010. “Aprendiendo a Aprender: Una Forma de Enfrentar la Escasez de Talento.� Mexico City Mexicanos Primeros. 2009. “Contra la Pared: Estado de la Educación en México, 2009. � Mimeo. OECD (Organisation for Economic Co-operation and Development). 2005. “Mexico Case Study,� in Promoting Adult Learning. Paris. ———. 2007. “Mexico: Education at a glance.� Paris. ———. 2009. “Creating Effective Teaching and Learning Environments: First Results from TALIS.� Paris. ———. 2011a. Employment Outlook 2011. Paris. ———. 2011b. “Informality in Mexico.� Economics Department Working Paper 896. Paris. ———. 2011c. “Mexico: Education at a Glance.� Paris. ———. 2011d. “OECD Economic Survey Mexico.� Paris. ———. 2011e. “Education at a Glance 2011.� Paris. OECD (Organization for Economic Co-operation and Development), Statistics Canada. 2011. “Literacy for Life: further results from the Adult Literacy and Live Skills Survey�. OECD Publishing. Paris: France. Pages, C., and C. Montenegro. 1999. “Job Security and the Age-Composition of Employment: Evidence from Chile.� Working Paper 398. Inter-American Development Bank, Washington, D.C. Presidencia de la República Mexicana. 2012. Anuncio de becas universitarias y para educación media superior. http://www.presidencia.gob.mx/el-blog/anuncio-de-becas-universitarias-y-para-educacion-media-superior/ February 1st 2012 Puryear,Jeffrey, Lucrecia Santibañez,and Alexandra Solano. 2012. “Education in Mexico� in Claudio Loser and Harinder Kohli (eds) A New Vision for Mexico 2042: Achieving Prosperity for All. Samaniego, Norma. 2010. “El empleo y la crisis: Precarización y nuevas válvulas de escape,� Economía UNAM 7 (Special Issue, May): 47–70. SEP (Secretaría de Educación Pública) 2011. Sistema Educativo de los Estados Unidos Mexicanos. Principales Cifras Ciclo Escolar 2010-2011. Retrieved August 20th from http://www.dgpp.sep.gob.mx/Estadi/principales_cifras_2010_2011.pdf SEP (Secretaría de Educación Pública) 2012. Sistema Nacional de Información Educativa. Reporte de Indicadores Educativos. Retrieved July 17th, 2012 from http://www.snie.sep.gob.mx/indicadores_y_pronosticos.html Tan, Hong. 2000. Malaysia Skill Needs Study. World Bank Institute, Washington DC. Tan, Hong. 2005. The Skills Challenge of New Technology: Training, Technology, and Productivity Growth in Malaysian Manufacturing in the 1990s. joint World Bank-UNDP-EPU book, Washington, D.C. Tan, Hong, and Gladys Lopez-Acevedo. 2003. “Mexico: In-firm training for the Knowledge Economy.� WP# 29571, Washington, DC: World Bank. Villaseñor, Paula. 2012 “Institutional and Organizational Analysis of the Sector of Skills Development in Mexico.� Mimeo. LCSHS. World Bank. World Bank. 2006. “Enterprise Surveys – Mexico Country Profile.� Washington, DC. www.enterprisesurveys.org/. ———. 2009. EdStats database. Washington, DC. http://go.worldbank.org/ITABCOGIV1. ———. 2011. “On the Edge of Uncertainty: Poverty Reduction in Latin America and the Caribbean during the Great Recession and Beyond.� LCSPP Poverty and Labor Brief, 3, Washington, DC. ———. Various years. World Development Indicators database. Washington, DC. Labor Market 19 Mexico Policy Note 4 Labor Market 20 Mexico Policy Note 5 PROMOTING AN INTEGRAL SOCIAL PROTECTION SYSTEM EXECUTIVE SUMMARY Message 1. Despite much recent progress, Mexico’s social protection system faces equity and efficiency challenges. The social protection system comprises social security (insurance) regimes, social assistance programs, and labor market interventions. Pending challenges include system fragmentation, program design weaknesses, regressiveness, and coverage gaps. Message 2. Further reforms are needed to build on the gains achieved and effectively reduce inequities and inefficiencies in order to achieve an integral social protection system that provides protection to all from income shocks, helps smooth consumption over the life cycle, and promotes greater human development. To improve the design and targeting of interventions, Mexico could consider actions to strengthen the performance of health insurance schemes, Oportunidades, and some of its other core programs. To close gaps in coverage, Mexico could strengthen or create interventions that improve labor market outcomes, especially among youth and the urban poor; provide old-age income security and services for the elderly poor; and mitigate the impact of disasters and crises. And, to promote an integral social protection system that articulates policies and programs, Mexico could develop a unified registry of beneficiaries or interoperable information systems, increase functional integration across health insurance schemes, improve coherence and compatibility across programs, and establish institutional arrangements for better coordination. OBJECTIVE This note reviews the challenges in Mexico’s social protection system and possible options to achieve an integral and effective system that is more than the sum of its parts. Mexico’s social protection system includes contributory social security schemes, social assistance programs, and labor market programs. The contributory social security schemes offer pensions and health insurance to formal sector workers to protect against income shocks and help smooth consumption over the life cycle. The recent noncontributory Social Protection System in Health (SPSH) provides health insurance to people not covered by formal schemes. To prevent poverty and promote greater human development, Mexico has several social assistance interventions, including Oportunidades, a conditional cash transfer program for the chronically poor, and 70 y Más, a noncontributory old-age income-support program. Finally, the social protection system also includes several labor market interventions that promote employability, facilitate job matching, and protect workers against economic shocks. This note reviews the progress achieved so far by Mexico’s social protection system and its remaining challenges to achieve an integrated system that provides effective protection to all Mexicans from income shocks, that helps them smooth consumption over the life cycle and promotes greater human development. KEY CHALLENGES Despite recent progress, the social protection system faces equity and efficiency challenges Major reforms over the last two decades—establishing Oportunidades, Seguro Popular, and El Consejo Nacional de Evaluación de la Política de Desarrollo Social (CONEVAL)—have improved the coverage and effectiveness of the social protection system. A critical reform in the late 1990s was the creation of the conditional cash transfer program Oportunidades World Bank- Social Protection 1 Mexico Policy Note 5 (originally called Progresa) to replace general food subsidies. This social assistance program aims at breaking the intergenerational transmission of poverty by providing 5.7 million families with a cash transfer when they comply with their co-responsibilities in terms of investments in their children’s human capital; and in parallel the Government provides basic health, nutrition and education services. The program has increased poor households’ consumption, school attendance, and use of health services. Oportunidades is highly progressive, and simulations suggest that transfers from the program result in a reduction of extreme poverty by 3.4 percentage points in 2010, with a particularly strong impact in rural areas (reducing poverty 9.6 percentage points). Because of its demonstrated impacts on health, nutrition, and education, the program has served as a model for numerous countries in the region and beyond.1 Another major reform was the creation of a health insurance, Seguro Popular, for people not covered by the social security regimes. A 2003 reform of the General Health Law institutionalized Seguro Popular, the main pillar of the noncontributory Social Protection System in Health (SPSH). It replaced the public health system’s historical budgets, which were linked mainly to preexisting infrastructure and personnel, with actuarially calculated insurance premiums and replaced user fees with contributions based on household ability to pay (though in practice few affiliates contribute). This reform substantially increased public health expenditure—from 2.6 percent of GDP in 2006 to 3.1 percent in 2010, still low compared with other countries in the region and the OECD—and reduced the differential in public expenditure between those covered by formal insurance schemes and the uninsured from 2.2. to 1.5. The program expanded rapidly to cover virtually all its target population, about 51.8 million people by the end of 2011, becoming one of the world’s largest subsidized health insurance programs targeted to people outside the formal sector. Seguro Popular increased use among its affiliates 5 percentage points, decreased out-of-pocket expenditure 25 percent, and reduced the incidence of catastrophic health expenditure slightly more than 15 percent.2 Progress has also been made in putting in place some of the legal, institutional, and operational elements required for an integral system. In particular, the 2004 Social Development Law established a legal framework for social protection, defining its contours and associated social rights. It also set up the CONEVAL, which was instrumental in defining and measuring multidimensional poverty, setting up guidance and criteria for targeting of interventions, and putting in place elements for greater results-based management through its monitoring and evaluation system. Despite these significant reforms, the social protection system still faces challenges : fragmentation, design and targeting weaknesses, and coverage gaps. Fragmented social protection system In health insurance, multiple contributory schemes and the SPSH function in parallel with little coordination. Each scheme has its own funding sources, insurance pools, administration structures, financial reserves, and service provider networks, resulting in large inefficiencies. There is very little functional integration and coordination across these subsystems because affiliates are limited to services provided by their scheme’s own network. In 2011 administration and insurance costs accounted for an estimated 10.8 percent of total expenditure on health, the highest in the OECD.3 World Bank- Social Protection 2 Mexico Policy Note 5 Fragmentation can result in unequal access when insurance subsystems offer different packages of services. For example, despite recent improvements, the health insurance schemes of the Instituto Mexicano del Seguro Social (IMSS) and the Instituto de Seguridad y Servicios Sociales de los Trabajadores del Estado (ISSSTE) cover services at all levels of care, while the SPSH covers only a small set of highly complex health services.4 Service quality also varies across schemes. For example, in 2000, before the introduction of the SPSH, the maternal mortality ratio was nearly three times higher among women with access only to the public health care service system than among women with contributory social health insurance. Among old- age income-security programs, the average benefits or annuities also vary widely across schemes, ranging from 500 Mexican pesos a month for beneficiaries of 70 y Más to 17,500 Mexican pesos for beneficiaries of the contributory regimes Régimen de Jubilaciones y Pensiones and Luz y Fuerza del Centro.5 In labor markets multiple programs overlap and are duplicative. For example, there are 63 federal programs and actions in seven federal entities aimed at promoting income-generation and economic well-being, and at least 10 provide micro-credits. Many have the same objectives and target populations (mostly indigenous and rural citizens). The large number of programs directed at similar dimensions of poverty suggests some dispersion and highlights the challenge of coordination. State and municipal interventions likely add to duplication and overlap.6 Some fragmentation of the social protection system in Mexico stems from the design and financing of interventions. As discussed above, services vary across contributory and noncontributory regimes (range of health services, risks covered, bundle of benefits, and the like). Contributory programs are (at least partly) funded from contributions from formal sector workers, while noncontributory programs are typically financed largely from general government resources. This dichotomy can create incentives for individuals to adjust their labor market behavior, which can affect their individual coverage, the financing and risk-pooling of the system, and labor markets7. Weaknesses in program design and targeting Mexico has very strong experience in targeting programs to the vulnerable, but some programs still disproportionately benefit the wealthiest while absorbing an important share of resources. While Oportunidades and Seguro Popular are amongst the most progressive interventions, and despite overall improvements in the targeting of social spending over the past few years, several programs benefit richer households disproportionately. In particular, general subsidies for liquid gas, gasoline, and residential electricity, initially put in place to protect the poor from increases in energy prices, benefit the richest households most (figure 1). Other programs are regressive by design; for example, the Employment Subsidy Program (Subsidio para el Empleo), which covers only formal workers (less than 5 percent of the subsidies goes to the poorest household decile). Even many targeted programs do not reach the poorest. Programs targeted to the indigenous population and programs of the Social Development Ministry (SEDESOL) tend to be progressive in rural areas, but programs of the Secretariat of Agriculture, Livestock, Rural Development, Fisheries, and Food (SAGARPA) are concentrated in richer municipalities. The most regressive programs account for a substantial share of expenditure: consumption and agricultural subsidies account for 47 percent of income-support programs and, World Bank- Social Protection 3 Mexico Policy Note 5 with the special value added tax regimen for selected food and medicines, they are four times larger than all targeted programs put together. As mentioned in Mexico Policy Note on medium- term fiscal sustainability, energy subsidies have been estimated at over 1.5 percent of GDP.8 Figure 1. Incidence of major subsidies and selected programs by income decile, 2010 Source: Scott 2001 Despite recent efforts to address inequalities in social outcomes, there remain large regional variations in service provision, which tend to reinforce prevailing patterns. An analysis of major federal programs reveals that some cover better-off municipalities and states more than they cover the most vulnerable ones. For instance, Liconsa, a nutrition program that provides milk to low-income households, is less present in municipalities with a higher nutrition deficit, a pattern repeated within some States, such as in Oaxaca, where the most vulnerable municipalities tend to be less covered (figure 2). An analysis of the federal funds transferred to states and municipalities to perform core decentralized functions, in health and education in particular (known as the Ramo 33 and accounting for 20–26 percent of federal expenditure), shows that not all programs are closely aligned with the depth of the issues they address. Similarly, despite the introduction of the Social Protection System in Health, access to health services “when needed� remains around 86 percent in some states, and the provision of medicines included in the system’s benefit package ranges from 43 to 88 percent. These differences can also be found in health resource distribution and in their intensity of use, resulting in large performance variations between state health systems (Sistemas Estatales de Salud, SESAs).9 World Bank- Social Protection 4 Mexico Policy Note 5 Figure 2. Coverage of Liconsa for decile of municipalities ranked by nutrition status All Mexican municipalities Municipalities in Oaxaca Source: Calculations from Liconsa and CONEVAL data. In addition to the inefficiencies created by the lack of functional integration across health insurance schemes, their internal organization and functioning can also generate inefficiencies. For instance, health insurance schemes integrate financing and service provision. Together with provider payments mechanisms unrelated to production, this can result in inefficiencies because strategic purchasing of services (the option to decide what to buy, how often and from whom)10 is precluded. The government, aware of this issue, has deployed important efforts to reorganize the systems, particularly in the case of the SPSH; however, progress has been limited. Coverage gaps affecting the poor and vulnerable and those in the informal labor market Employment services, which promote employability and intermediation, have limited coverage. The bulk of resources for active labor market policies and programs, broadly defined, goes to income-generation and productive programs. Many of these programs focus on agricultural production, where they tend to reach large agricultural producers and have limited impact on poverty. In contrast, few employment services promote greater employability and inclusion in the labor market (services of labor intermediation, counseling, financial aid for job search, skills upgrading or training, child care, and the like). Such programs—including Instancias Infantiles, which focuses on vulnerable mothers and single fathers—can have substantial impacts on labor force participation and duration. The overall distribution of programs translates in greater coverage in rural areas, while important gaps in the coverage of employment services persist in urban and peri-urban areas, despite increased urban poverty.11 In terms of old-age income security, about 37 percent of Mexican workers contributed to a pension system in 2010, significantly below the regional average of 45 percent. While this percentage has increased over time, progress has been limited since the early 1990s, and contribution rates are only marginally higher among younger workers. The poor have particularly low rates, with less than a tenth of workers in the poorest quintile contributing, compared with two-thirds of workers in the richest quintile. As a result, only 7 percent of those ages 65 or older in the poorest quintile receive a pension, compared with 41 percent in the richest quintile. The low rates are due partly to the fact that less than half of lower wage workers retain jobs in the formal sector for 25 years, the minimum time needed for a pension.12 The recent expansion of noncontributory programs such as 70 y Más and Seguro Popular addresses some of World Bank- Social Protection 5 Mexico Policy Note 5 the gaps, but they remain insufficient to ensure full protection and attention in old age. Overall, the system remains highly fragmented and rigid. While some instruments can protect households in emergencies or crises, the social protection system lacks the adequate panoply of mechanisms needed to mitigate impacts. The Temporary Employment Program and Oportunidades protected beneficiaries during recent economic crises; the Climate Emergency Program covered more than 3 million smallholder farmers against crop losses related to natural disasters in 2009, increasing yields and incomes; and formal workers were allowed to withdraw part of their pension savings during the recent economic crisis. However, these programs reach only some population groups and are not sufficient to completely mitigate crises (the Temporary Employment Program focuses mostly on rural areas, although it expanded to urban areas during the most recent crisis; Oportunidades is not designed to quickly sign up transient populations; and the Climate Emergency Program does not reach the poorest). And they do not cover all risks; in particular individual unemployment risks (experience from Chile suggests that those most likely to be affected by unemployment are least likely to have accumulated enough to provide for effective protection).13 More financing will be needed to close these gaps, which will likely be exacerbated by Mexico’s demographic and epidemiological transitions. Even if Mexico achieves efficiency gains within programs, targets programs more effectively, and exploits synergies across programs, filling existing gaps will require greater financing, which would have to be part of a broader fiscal reform to increase tax collection capacity and alter revenue allocation, as discussed in Mexico Policy Note on medium-term fiscal sustainability. The option of more systematic funding of social protection programs from general revenues to reduce system fragmentation and de-link services from labor status could be considered within the context of a broader fiscal reform. In addition, in the medium to long term, population aging and exposure to unhealthy diets, physical inactivity, and tobacco use and alcohol abuse can threaten the financial sustainability of health insurance schemes, as the burden of non-communicable diseases (e.g. cardiovascular diseases, diabetes, cancer, etc.) grows, and will call for a sharper focus on prevention. Longer lives will also affect labor markets and incomes because people will be able to work longer, but will require old-age income protection longer. POLICY OPTIONS 1. Improving the design and targeting of interventions The performance of the health insurance schemes must continue to be strengthened. Doing so requires changing their organization and functioning, including clearly separating financing and provision, as well as provider payment mechanisms to allow strategic purchasing. 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. The 2003 health reform envisioned these changes in the state health systems to ensure better management of Seguro Popular and established incentives to promote equality, technical efficiency, and responsiveness. These incentives included new provider payment mechanisms that would facilitate insurance portability across states and schemes, thereby allowing greater functional integration (as discussed below). In contrast to other reform objectives, there has been little progress in reforming the organization and functioning of the state health systems,14 though some have started to purchase services from other states and social security institutions.15 World Bank- Social Protection 6 Mexico Policy Note 5 Finally, the health system urgently needs to be reformed to better respond to the increasing burden of non-communicable diseases. This requires shifting from a system organized to deal with episodes of acute illnesses to a system focused on preventing and controlling chronic conditions. The creation of the SINOS (Sistema de Información Nominalizado de Salud) and its health risk management strategy (Consulta Segura) is a step in this direction. The performance of Oportunidades must also continue to be improved. Oportunidades has been strengthened over the years: it improved its targeting mechanism to take into account updated poverty lines and multidimensional poverty, paid better attention to indigenous groups, and redefined its recertification and exit criteria. To provide transfers to isolated population groups that lack access to basic services, the government also set up the Food Support Program (PAL, Programa de Apoyo Alimentario), an unconditional transfer program operated by Oportunidades since 2009. Oportunidades has also expanded in urban areas. More generally, some of the conditions that originally motivated the program have changed, and analyses have revealed the need for greater focus on promoting the employability of beneficiaries, both in terms of greater skill acquisition and in terms of transition to labor markets. 16 As a result, Oportunidades is evaluating whether to modify or add co-responsibilities, including strengthening the focus on early childhood development and preschool; making health co- responsibilities more effective (taking advantage of SINOS) while reducing the number of visits required, for which there is little or no evidence of benefits; generating mechanisms to promote completion of upper secondary school and supporting the transition from school to higher education or to work. In addition, the questions of efficiency in urban areas, mechanisms of intervention in indigenous areas, and the quality of the services received by beneficiaries merit further attention. Resources and programs must be better targeted to improve the progressivity and design of interventions. Mexico has substantially improved the progressiveness of its social protection interventions over the past decade. But many programs could still be retargeted or eliminated, and resources could be better allocated. In particular, some of the subsidies initially put in place to protect the poor—including energy subsidies and some tax exemptions and special regimes— could be eliminated and existing targeted programs used to compensate the poorest. Other programs could be better targeted, on the basis of the measures of rezago, pobreza, or carencia developed by CONEVAL. This could be facilitated by the creation of a unique registry, as discussed below. Federal resource allocation, both within federal programs and in transfers to municipalities and states, could also better address some regional disparities in outcomes. This would call for allocation mechanisms related (at least partially) to the severity of the issue they are designed to address, while providing incentives for efficient service delivery and for allocation of local resources.17 The systematic evaluation efforts led by CONEVAL have significantly improved the design and implementation of some programs, and this should be replicated for programs that still lack clearly defined objectives, targets, or implementation mechanisms. Clearer targets and design can increase program efficiency and impact. Strengthening states’ capacity and mandate to monitor and evaluate would also be critical. Stronger results orientation is important for more effectively allocating resources based on results on the ground, including through contracting public or private providers based on results. World Bank- Social Protection 7 Mexico Policy Note 5 2. Closing gaps in coverage by strengthening or creating interventions Effective programs are needed to improve labor market outcomes, especially among the youth and the urban poor. While multiple factors affect labor market productivity and job creation beyond the scope of this note (some of which are discussed in Mexico Policy Note on business environment and competition), interventions that build skills and promote employability can improve outcomes in terms of productivity overall and for the most vulnerable groups. These policy options are presented in greater detail in Mexico Policy Note on labor markets and include integral employment services for the most vulnerable and a national skills strategy that aims to increase labor market productivity and reduce poverty through inclusion. In addition, social assistance programs could better link their exit strategies with labor market interventions and more generally ensure that their beneficiaries are connected with such interventions when appropriate, with a view to promoting their income-generation capacity. In particular, as discussed above, it is important that Oportunidades explores options to reduce dropout among youth—promoting transition from school to college—and to broaden the range of institutions that can verify co-responsibilities (to reflect other options for developing skills that are labor market–relevant). The elderly poor should be provided with old-age income security and services. To increase coverage of the elderly with transfers sufficient to ensure income security, existing contributory systems need greater portability of services (to reflect labor market movements), more flexibility (for instance, in the minimum number of years required to qualify for benefits), and greater efficiency (by unbundling services that do not protect or redistribute income, such as contributions for housing funds, sports or cultural facilities, and child care).18 Another action, now under way, is the expansion of noncontributory schemes targeted to vulnerable groups. In the medium term, with the population aging, Mexico could identify needs for broader services for the elderly in order to set up mechanisms for these services to be available and financed as needed. In the longer term, building on these shorter-term actions, Mexico could pursue an integrated system, within which benefits evolve according to an individual’s condition and that provides incentives for individuals to save for old age. This system could be at least partially delinked from labor markets, as in Chile. Mechanisms are needed to mitigate the impact of disasters and crises. To protect households against crises—whether affecting one family or a larger group—Mexico needs to go beyond existing programs to offer a range of mechanisms adapted to different situations. Some programs would be permanent (such as unemployment insurance); others would need to be ready for deployment at specific times to respond to crises. Guidelines for activation would also be needed, including as part of response to disasters (see Mexico Policy Note on disaster risk management). To address unemployment risks, Mexico could replace severance payments with a model that combines individual accounts with a solidarity fund that pools some unemployment risks (see Mexico Policy Note on labor markets). The design of programs such as the Temporary Employment Program should easily adapt to multiple crises, which can affect population groups differently. This is particularly critical in urban contexts, where fewer programs exist and where the vulnerable cannot resort to subsistence farming, as initiated with the Temporary Employment Program. World Bank- Social Protection 8 Mexico Policy Note 5 3. Promoting an integral social protection system that articulates policies and programs to ensure greater impact Creating an overarching system that ensures that policies and programs are compatible, synergies are exploited, services are provided in a coordinated and efficient manner, and the like is a difficult endeavor that remains a challenge even for countries at the cutting edge of the issue. Mexico has made some progress through technical coordination of some of its core programs on the ground, and institutional arrangements exist for greater consolidation. But the country still lacks some of the fundamental tools and mechanisms to promote greater integration. Many of these actions are complex and will require concerted efforts. A unified registry of beneficiaries or interoperable information systems should be considered. Each program and subsystem has its own management information system, including the roster of beneficiaries, functioning in parallel to the others. Even within institutions, these registries are typically not integrated, although some use common tools, such as the CUIS (Cuestionario Único de Información Socio-económica de Hogares, Unique Questionnaire of Socio-economic Household Information) used by programs in the Social Development Ministry and the unique identifier called CURP (Clave Única de Registro Poblacional) which all social programs are required to use by Presidential Decree. Interoperable information systems or a unified registry of beneficiaries could foster better coordination and integration of the social protection system’s components, promote a national targeting system (adapted to each program’s needs but built on the same information system) as discussed above, allow greater coordination across programs (promoting referral mechanisms, sharing data on beneficiaries, encouraging portability, and facilitating shared service delivery mechanisms) as discussed below. A unified registry is critical for greater efficiency and targeting but will require addressing complex identification issues. Functional integration across health insurance schemes should be increased. This is critical to ensure portability of benefits and reduce inefficiencies and inequalities. Functional integration would solve many weaknesses in the current health system (such as parallel delivery networks, administration structures, and the like). Contracts and payment mechanisms would need to be standardized across health providers to allow cross-purchasing of services, a common information system would need to be established, a sector-wide investment plan would need to be developed, and common standards for accrediting health facilities would need to be adopted.19 Functional integration is compatible with different health insurance schemes but could also be a step toward a unification of these schemes if the country decides to pursue that. Coherence and compatibility across programs should be improved. For all elements of the social protection system, it would be important to explore options for coordinating across interventions,20 including for situations when bridges should be established for individuals to move from program to program; situations when programs should refer beneficiaries to other interventions; situations when programs could choose joint service delivery (with one person or institution interacting directly with beneficiaries of numerous programs); situations when portability of entitlements and services across providers is necessary in light of the mobility of individuals; and situations when synergies warrant joint interventions. Given the federal nature of the country, coherence and compatibility are required both within and across levels of government. World Bank- Social Protection 9 Mexico Policy Note 5 Institutional arrangements for improved coordination should be established . In the long term Mexico would benefit from defining institutional leadership to articulate a long-term vision and strategy and guide its implementation. Only concerted efforts can address the system challenges. Past attempts to articulate social assistance and income-generation or employment programs, including the Vivir Mejor (Live Better) strategy in 2007, have not been fully operationalized because of lack of a lead agency to coordinate programs and budgets. A first step could be revising the legal basis for existing coordination institutions, including the Social Cabinet, the Social Development Council, or the Social Development Commission established by the Social Development Law, with a view to propose institutional arrangements for the social protection system. As part of the tools needed to orient resources efficiently and strategically and promote synergies while avoiding overlaps, it is also critical to continue strengthening CONEVAL in its role of monitoring and evaluating the system and its components and proposing reforms, in particular at the sectoral level. It is also critical to ensure that performance evaluations are considered in the budget allocations (as started in 2011). Matrix of short- and medium-term policy reform options* Reform area Short-term options Medium-term options Objective 1: Improving the design and targeting of core interventions Continue to  Evaluate progress in the state health  Separate financing and purchasing strengthen the systems (SESAs) and the social security functions of health insurance schemes. performance of the schemes in separating financing and (AR) health insurance purchasing functions and reforming  Reform the provider payment mechanism schemes provider payment mechanisms. (AR) for health service delivery networks.  Evaluate the effectiveness of Sistema de (AR) Información Nominalizado de Salud  Reform health care model so that it more (SINOS) in managing health risks. (AR) effectively prevents and controls noncommunicable diseases.(AR) Continue to improve  Identify mechanisms to increase  Implement changes as relevant. (AR) the performance of Oportunidades’ focus on early childhood Oportunidades and preschool; make health co- responsibilities more effective; and promote upper secondary school completion and transitions from school to higher education or work. (AR) Improving the  Identify poorly targeted programs and  Eliminate or transform regressive targeting and design propose closing or updated targeting programs. (AR) of selected mechanisms.(AR)  Design core targeting system for interventions and the  Design mechanisms to allocate federal programs to adapt to their objectives allocation of resources. (AR) (AR) resources  Improve objectives, targets, and design  Revise federal resources allocation of key programs, using CONEVAL’s mechanism (LR) assessments. (AR)  Implement changes to reflect revised design, exploit synergies, and limit incompatibilities. (AR) Closing gaps in coverage by strengthening or creating interventions Improving labor  Define options for Oportunidades to  Develop a national skills policy (see market outcomes, promote greater skills accumulation (see Mexico Policy Note on labor markets). especially for the above). (AR) (AR) World Bank- Social Protection 10 Mexico Policy Note 5 young and urban poor  Develop an integral employment services  Implement integral services for the most model for the vulnerable, linked to social vulnerable. (AR) assistance.(AR) Providing old-age  Strengthen existing programs by  Explore options for a unified system that income security and increasing flexibility and unbundling provides incentives for saving for old services for the some services. (AR) age. (AR) vulnerable elderly  Finish the rollout of the targeted  Identify needs in terms of broader noncontributory scheme(AR) services for the vulnerable elderly. (AR) Mitigating the impact  Identify non-covered risks and options to  Set up an unemployment insurance of emergencies or improve functioning of programs in mechanism.(LR) crises on households times of crises (especially in urban  Set up a mechanism to trigger timely areas). (AR) emergency response and funding. (LR)  Explore options for the design of an  Adjust operational procedures for core unemployment insurance program.(AR) programs to better respond to crises. (AR) Promoting a more integral social protection system Developing a unified  Develop a platform for a unified registry  Migrate core programs to the unified registry or of beneficiaries, building on the Social registry and use it for targeting, interoperable Development Ministry’s Unique portability and coordination. (AR) information systems Questionnaire of Socio-economic Household Information (CUIS) and international experience.(AR) Increasing functional  Design joint information systems.(AR)  Standardize contract and payment integration across  Developing a sector-wide infrastructure mechanisms across health providers to health insurance plan.(AR) allow cross-purchasing of services. (AR) schemes  Set up common standards for facility  Establish joint information systems.(AR) accreditation.(AR) Improving coherence  Explore options for coordination between  Apply mechanisms for greater portability and coordination programs, including joint service across programs. (AR) across programs delivery. (AR)  Implement coordination mechanisms  Identify mechanisms for service across programs, including joint service portability. (AR) delivery. (AR)  Identify incompatibilities and synergies between programs and across government levels. (LR)(AR) Developing  Review existing legal framework and  Define institutional arrangements for a institutional assigned responsibilities of core actors. system steward and make normative arrangements for (LR) adjustments.(LR) improved  Continue strengthening CONEVAL  Link budget allocation to needs coordination capacity, including to inform resource diagnostic and performance allocation (AR) evaluation.(LR) *AR: administrative reform; and LR: legal reform. Preliminary classification. NOTES 1 The program and independent researchers undertook a series of rigorous impact evaluations that demonstrated these impacts and shaped the program’s design (www.oportunidades.gob.mx/evaluacion). Simulated reduction in poverty (measured with the linea de bienestar minimo) is from Araujo and Sandoval (2012). World Bank- Social Protection 11 Mexico Policy Note 5 2 The Social Protection System in Health includes Seguro Popular, the Fund for Protection against Catastrophic Health Expenditure, Insurance for a New Generation, Strategy of Healthy Pregnancy, and other policies. See Gakidou and others (2006); Frenk and others (2006); and Bosh and others (2012). Data on coverage are from the National Commission of Social Protection in Health. 3 See Ribe, Robalino, and Walker (2010) and http://stats.oecd.org/index.aspx?DataSetCode=HEALTH_STAT. 4 As of 2012 Seguro Popular covers 284 primary and secondary interventions with 522 pharmaceutical products; the Fund against Catastrophic Health Expenditure covers 57 highly complex services; and Health Insurance for a New Generation covers 128 child care services. 5 In some states beneficiaries of noncontributory pensions also receive state-provided social pensions. See Scott (2010). 6 Extensive analysis of the inventory of programs and their progressivity is presented in CONEVAL (2011a) . 7 Since the creation of the SPSH brought the services of the subsidized regime closer to those offered by IMSS; it can potentially create an incentive for firms and individuals to choose labor market informality; thereby decreasing IMSS affiliation and increasing Seguro Popular’s. In the past few years, several studies have tried to estimate this impact, mostly finding an overall impact on IMSS affiliation that is smaller than anticipated, but an impact that increases over time and that is higher in rural areas and for certain population groups. See World Bank (2012) “Mexico Social Protection System in Health and Labor Market Affiliation 8 See Coneval (2011a), Scott (2009), and the database of Centro de Estudios para el Desarrollo Rural Sustentable y la Soberania Alimentaria. 9 See CONEVAL (2011b); Blum and others (2011); OECD (2005); and Centro de Estudios Económicos y Sociales en Salud del Hospital Infantil de México Federico Gómez (2012). 10 See Ribe, Robalino, and Walker (2012) and Busse and others (2007). 11 For an evaluation of the Programa de Estancias Infantiles, see Angeles and others (2011). Poverty in rural areas increased from 62.4 percent in 2008 to 64.9 percent in 2010 (Coneval 2012). 12 See Rofman and Oliveri (2011) and Anton, Hernandez, and Levy (2011). 13 See CONEVAL (2011); Scott (2009, 2010); Dávalos, Haddock, and Freije-Rodríguez (2011); Skoufias and Vinha (2010); De Janvry and others (2006); and Fuchs and Wolff (2010). In Mexico withdrawals are limited to a maximum of 90 days of last wage every five years. In Chile those least likely to have sufficient resources include employees with short-term contracts or with frequent moves in and out of the formal labor market. For these people withdrawals further jeopardize their retirement income (Reyes et al. 2011). 14 World Bank (2012c). 15 There is a national agreement for the exchange of emergency obstetric health services across the different insurance schemes. 16 Yaschine Arroyo (2012). 17 Already, transfers for Fondo de Aportaciones para los Servicios de Salud destinados a la Persona and for other funds from the federal government to the states are discounted from the federal solidarity contribution, one of the tripartite funds transferred to states to finance Seguro Popular. This mechanism has reduced the difference in per capita expenditure between the state receiving most and the state receiving least from five times in 2002 to four times in 2006. See Frenk and others (2006). 18 Rural day laborers and construction workers can already waive part of the contributions to services that they do not access. 19 See Ribe, Robalino, and Walker (2012); World Bank (2008); and World Bank (2012). 20 There have been examples of coordination; for instance, some states discontinued their old-age income security noncontributory programs when the federal program 70 y Más was deployed or between Seguro Popular and Oportunidades, but these have not been systematic. REFERENCES Angeles, Gustavo, Paola Gadsden, Sebastian Galiani, Paul Gertler, Andrea Herrera, Patricia Kariger, and Enrique Seira. 2011. “Evaluación de Impacto del Programa Estancias Infantiles para Apoyar a Madres Trabajadoras.� Centro de Investigación en Evaluación y Encuestas, Instituto Nacional de Salud Pública. Mexico. World Bank- Social Protection 12 Mexico Policy Note 5 Anton, Arturo, Fausto Hernandez, and Santiago Levy. 2011. “The End of Informality in Mexico? Fiscal Reform for Universal Social Insurance.� Inter-American Development Bank, Washington, D.C. Araujo, Maria Caridad, and Carlos Sandoval. 2012. “La contribución del Programa de Desarrollo Humano Oportunidades a los ingresos de los hogares de México: un análisis de la Encuesta Nacional de Ingresos y Gastos de 2010.� Inter-American Development Bank, Washington, D.C. Blum, J., Kurowski C., Villar M., Ortiz L., Macias C., Matsuda Y., and Manning N.. 2011. “Learning from the Case of Health Sector Reforms in Mexico to Improve the Diagnostic Protocol for the 2010-2020 PSM Approach.� World Bank: mimeo. Bosch, M., M.B. Cobacho, and C. Pagés. 2012. “Taking Stock Eight Years after the Implementation of the Seguro Popular in México.� Inter-American Development Bank, Washington, D.C. Busse, R., J. Figueras, R. Robinson and E. Jakubowski. 2007. “Strategic Purchasing to Improve Health System Performance: Key Issues and International Trends�. Healthcare Papers. 8(Sp) 2007: 62-76. Centro de Estudios Económicos y Sociales en Salud del Hospital Infantil de México Federico Gómez. 2012. “Evaluación Estratégica de la Política Pública de Protección Social: Propuesta de un Sistema Nacional de Servicios de Salud.� Mexico City. CONEVAL (Consejo Nacional de Evaluación de la Política de Desarrollo Social). 2011a. Informe de Evaluación de la Política de Desarrollo Social en México 2011. Mexico City. ———. 2011b. El Ramo 33 en el Desarrollo Social en México: Evolución de ocho fondos de política pública. Mexico City. ———. 2012. Poverty Estimates. Mexico City. Dávalos, Maria, Sarah Haddock, and Samuel Freije-Rodríguez. 2011. “Temporary Employment Programs: International Evidence and Mexico’s Experience during t he 2009-2010 Crisis.� The World Bank: Washington, D.C. De Janvry, Alain, Frederico Finan, Elisabeth Sadoulet, and Renos Vakis. 2006. “Can conditional cash transfer programs serve as safety nets in keeping children at school and from working when exposed t o shocks?� Journal of Development Economics Vol. 79 (2), 349– 373 Frenk, Julio, Eduardo González-Pier, Octavio Gómez-Dantés, Miguel A. Lezana, and Felicia Marie Knaul. 2006. “Comprehensive Reform to Improve Health System Performance in Mexico.� The Lancet 368(9546): 152434. Fuchs, Alan and Hendrik Wolff. 2010. ‘Drought and Retribution: Evidence from a Large Scale Rainfall -Indexed Insurance Program in Mexico’ October 26, 2010. Gakidou, Emmanuela, Rafael Lozano, Eduoardo González-Pier, Jesse Abbott-Klafer, Jeremy T. Barofsky, Chloe Bryson-Cahn, Dennis M. Feehan, Diana K. Lee, Hector Hernández-Llamas, and Christopher J.L. Murray. 2006. “Assessing the Effect of the 200106 Mexican Health Reform: An Interim Report.� The Lancet: 368 (9550): 192035. OECD (Organisation for Economic Co-operation and Development). 2005. OECD Reviews of Health Systems: Mexico. Paris. Gonzalo Reyes Hartley, Jan C. van Ours, Milan Vodopivec. 2011. “Incentive Effects of Unemployment Insurance Savings Accounts: Evidence from Chile�. Labour Economics, 18 (6), 798-809 Ribe, Helena, David A. Robalino, and Ian Walker. 2010. Achieving Effective Social Protection for All in Latin America and the Caribbean: From Right to Reality. Washington, D.C.: World Bank. Ribe, Helena, David A. Robalino and Ian Walker. 2012. From Right to Reality: Incentives, Labor Markets and the Challenge of Universal Social Protection in Latin America and the Caribbean . The World Bank: Washington, D.C. Rofman and Oliveri. 2011. “La cobertura de los sistemas previsionales en América Latina: conceptos e indicadores.� Serie de Documentos de Trabajo sobre Políticas Sociales Nº 7. The World Bank: Washington, D.C. Scott, John, 2009. “Who benefits from social spending in Mexico?�. Mimeo. Scott, John. 2010. “Subsidios agrícolas en México: ¿Quién gana y cuanto?� In Jonathan Fox and Libby Haight, eds., Subsidios para la desigualdad. Las políticas públicas del maíz en México a partir del Libre Comercio. Santo Cruy el Distrito Federal: CIDE and Woodrow Wilson International Center for Scholars. Scott, John, CIDE and CONEVAL. 2011. “Gasto Público para la Equidad: Del Estado excluyente hacia un Estado de Bienestar Universal.� Serie ¿Gastamos para Mejorar? México Evalúa Centro de Análisis de Políticas Públicas, Santa Catarina Coyoacán el Distrito Federal. World Bank- Social Protection 2 Mexico Policy Note 5 Skoufias, Emmanuel; Vinha, Katja; Conroy, Hector V.. 2011. The impacts of climate variability on welfare in rural Mexico. The World Bank: Washington, D.C. Yaschine Arroyo, Iliana. 2012. “Oportunidades? Movilidad Social Intergeneracional e Impacto en Mexico.� Ph.D. thesis. Colegio de México. World Bank. (2012) “Missing in Action? - Part Two of Mexico’s 2003 Health Sector Reform�. (draft) World Bank, Washington DC. World Bank (2012) “Mexico Social Protection System in Health and Financial Protection of Citizens without Social Security.� (draft) World Bank, Washington DC. World Bank (2008) Mexico Health Programmatic AAA: Towards Greater Equality and Efficiency through Functional Integration Concept Note. Prepared by Christoph Kurowski. The World Bank: Washington DC. World Bank- Social Protection 3 Mexico Policy Note 6 REDUCING THE FOOTPRINT OF GROWTH EXECUTIVE SUMMARY Message 1. With 77 percent of its population living in urban areas and producing more than 84 percent of its GDP, as well as an estimated 75 percent of its GHG emissions, Mexico needs to focus on making urban development greener, more efficient and resilient, and socially inclusive. This requires developing a sound urban land management system that could be the basis to: (i) increasing urban densities in search of efficiency and livability; (ii) providing the urban layouts needed to promote bus rapid transit systems and non-motorized transport; (iii) using land based financing instruments to provide infrastructure in new low-income housing developments; and (iv) integrating risk reduction policies in urban development instruments. Message 2. The estimated cost of environmental degradation in Mexico was estimated to be 6.3 percent of GDP in 2008. While Mexico has undertaken effective measures to control air contamination and the costs associated with it, the costs of land and water degradation due to solid and liquid wastes have been increasing at higher annual rates, harming human health, the environment, and the economy. Two areas require particular attention: (i) developing integrated solid waste management strategies at national, state, and municipal levels; and (ii) addressing the problems posed by hundreds of contaminated sites and planning for their redevelopment as brownfields. Message 3. Energy production and consumption are the largest source of GHG emissions in Mexico, with a total share of 60%. Enhancing energy efficiency is therefore a key element in promoting low carbon development for the country. The needed policy reforms include: (i) revising energy subsidies; (ii) expanding the use of energy efficiency labels and standards for buildings, urban infrastructure, transport, and waste management; (iii) promoting energy- efficient self-sustained companies; and (iv) encouraging the participation of banks in energy efficiency retrofitting projects. OBJECTIVE Reducing the footprint of growth requires a focus on three key issues:  Transforming urban areas into greener, more efficient, resilient, and socially inclusive cities, better able to capture the economic benefits associated with urbanization.  Ensuring sound management of the brown environmental agenda to provide the conditions for continued sustainable economic green growth while preventing and minimizing negative impacts and risks for human health and the environment.  Promoting energy efficiency in housing, transport, urban infrastructure, and waste management to enhance the sustainability and competitiveness of the Mexican economy. World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 1 Mexico Policy Note 6 KEY CHALLENGES Urban management Urbanization is associated with economic growth and prosperity but also with negative environmental externalities. Population growth and rapid urbanization have had marked impacts on resource conservation in and around urban areas, as well as on environmental pollution. Urban areas have become major contributors of carbon emissions; cities around the world are responsible for 75 percent of all greenhouse gas emissions.1 Intensive use of built-up areas in cities leads to increased traffic congestion, air pollution, lack of affordable housing, lack of vegetation, and loss of open green space. Urbanization can also exacerbate exposure to hazards as well as social and spatial exclusion, which can in turn be associated with the prevalence of crime and violence. Urban density is a key factor in capturing the economic benefits associated with agglomeration economies and mitigating the negative externalities. Scale economies in production, movements of labor and capital, and falling transport costs can interact to produce rapid economic growth in cities. City density also has important impacts on sustainability, since it is associated with reductions in carbon footprint, greenhouse emissions, and resource intensity. Data from the 100 largest cities in the world shows the strong negative correlation between density and CO2 emissions as well as between density and per capita water consumption, electrical use, and solid waste generation. The growth pattern in Mexican cities reduces their potential to promote green urban growth. 77 percent of Mexico’s population resides in urban areas and although the pace of urbanization has slowed since the 1940s, the concentration of economic activity in certain regions continues to increase2, to a point that the seventy largest cities produce 84 percent of the country’s GDP. A worrisome trend observed in the past thirty years is the expansion of urban areas at a much higher rate (one to seven) than the growth of population (one to two), according to a recent study conducted by SEDESOL on 10 metropolitan areas and 50 cities.3 The housing sector has contributed disproportionately to the expansion of urban areas, through low-density single-use large housing developments built on the outskirts of urban areas. Mexico initiated a radical transformation of its housing sector in 2000. Aided by macroeconomic stability and policy reform, the country successfully increased the supply of low-cost housing by around 1 million units each year between 2006 and 2011. Most of these new units have occupied around 60 percent of the land in new urban settlements. As housing developers further seek to produce more housing units (for which substantial subsidies are available) while reducing the cost of land (for which no financing is available), they acquire rural land plots distant from city centers. These plots are later transformed into urban land on a plot- by-plot basis. The result is a patched urban pattern that exacerbates social exclusion, with dispersed housing developments that lack adequate services. The increased distance to the city implies higher transport costs for new dwellers. Estimates suggest that households in a sample of new developments spend as much as half of their family income on transportation and allocate an average of two hours a day to get to and from employment or education centers. 4 This comes World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 2 Mexico Policy Note 6 at a great cost—urban sprawl cannot be reversed, and communities are compelled to live with the inefficiencies and costs of this shortsighted strategy. Urban sprawl has been associated with the exceptional expansion of private motorized transportation. Over 1996–2006 Mexico’s vehicle fleet nearly tripled. Moreover, dispersed urban patterns make public transport systems unviable because these depend on higher densities to become cost-effective. In addition, transport is one of the largest and fastest growing sectors in Mexico in terms of greenhouse gas emissions and energy consumption. The provision of infrastructure in far way housing developments is extremely costly. Since 2000 about 60 percent of the newly urbanized land has been dedicated to housing as the country strives to reduce the housing deficit, which is estimated to be around 9 million. Yet 5 million vacant houses (14 percent of the total housing stock)5 have been abandoned because they lack minimum infrastructure services (38 percent) or because added transport costs for the household makes them unaffordable. Poor urban and land use planning is a key factor underlying the increase in disaster risk. Mexico is prone to a wide range of natural hazards, including earthquakes, hurricanes, and floods. Although the country has made important progress in: (i) responding to natural disasters through the creation in 1996 of the National Fund for Natural Disasters (FONDEN) with a minimum annual allocation of 0.4 percent of total programmable public expenditure; and (ii) developing innovative risk financing and insurance strategy including risk transfer instruments like the catastrophic bonds issued in 2006 and 2009, it has been less successful in the area of prevention and risk reduction. In fact, vulnerability to adverse natural events is rising along with the expansion of Mexico’s cities, the growth of its population, and the increased concentration of physical assets, combined with poor urban and land use planning. Brown agenda As urbanization and economic growth have steadily increased in Mexico, the brown environmental agenda has become crucial. Issues include the insufficient number of solid and hazardous waste disposal facilities; the pollution of rivers in urban areas and of coastal environments by municipal sewage and industrial effluents; and serious air, water, and land pollution, especially in urban centers. The estimated cost of environmental degradation in 2008 was approximately 6.3 percent of GDP.6 While Mexico has taken significant policy and related actions in attempting to deal with the brown agenda, present conditions clearly demonstrate the need for improving current policies and developing new policies and actions. This section addresses two areas: solid and hazardous waste management and contaminated sites. Estimated municipal solid waste generation was approximately 38.3 million tons a year in 2009 and continues to grow each year. It has increased approximately 16 percent since 2003,7 and while approximately 87 percent of it is collected, only 64 percent is reportedly disposed of in either 88 sanitary landfills or 21 controlled sites.8 The 2009–2012 National Waste Management Program proposed a minimum of 50 new sanitary landfills, of which it appears that only a few have been started. Approximately 53 percent of sanitary solid waste is organic material. And World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 3 Mexico Policy Note 6 while this presents an excellent opportunity for waste-to-energy projects, only a limited number of them have become operational. While many municipalities have initiated recycling programs (primarily focused on aluminum, glass, certain plastics, and paper), in 2008 only 3.3 percent of Mexico’s total urban waste was recycled. Approximately 9.1 million tons a year of improperly managed hazardous waste are reportedly generated by Mexican companies. Reported estimates of inadequate hazardous waste disposal range from 60 to 80 percent of the total produced. 9 Substantial quantities of mining waste and petroleum sector wastes are also generated in Mexico. An additional average daily production of special wastes of approximately 17,149 tons is reported, including 13,130 tons of construction waste and 3,201 of sludge waste from municipal wastewater treatment plants.10 There is not adequate management or infrastructure for the treatment or disposal of the special waste generated.11 Although Mexico has developed some good environmental legislation and protection strategies for waste management,12 they are not being properly implemented, especially locally, and are not sufficient. While many municipalities have developed Municipal Programs for Integrated Prevention and Management of Waste, many—especially smaller ones—have not. 13 Limitations in municipal legal and political frameworks result in an ineffective implementation of integrated waste management,14 such as a lack of technical and management capacities as well as recurrent difficulties in the financing and sustainable operation of the necessary infrastructure. Moreover, the private sector lacks incentives. Environmental awareness is only beginning to take hold among the general public and political decision makers. Municipal waste financing mechanisms have had limited success. There are reportedly more than 700 contaminated sites in Mexico, and the number has been steadily increasing over the last few years.15 Roughly half of the contaminated sites are under federal jurisdiction (for example, hazardous waste generators) and half are under municipal or state jurisdiction (such as municipal landfills or dumpsites that received hazardous wastes, special waste generators, and disposal facilities). Contaminated sites can result in very significant human health impacts, often associated with poor or marginalized communities due to their proximity to industrial areas/sites, and also can result in significant environmental impacts. These contaminated sites in urban areas also represent a major deterrent to economic development. Mexico has established some important policy actions to help address contaminated sites. They include the General Law for Prevention and Integral Management of Wastes and its associated regulatory standards (for example, Norma Oficial Mexicana for heavy metals and polychlorinated biphenyls). In 2011 the National Program for Remediation of Contaminated Sites was established, with its main objectives being to reduce the number of contaminated sites where human health and natural resources are affected, reintegrate remediated contaminated sites into the economic cycle, and contribute to urban renovation and the improvement of living conditions in inner cities. Successful cleanup of more than 50 contaminated sites with a responsible party have been reported, including 13 large-scale sites.16 World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 4 Mexico Policy Note 6 However, effective implementation of the National Program for Remediation of Contaminated Sites in Mexico faces several obstacles. The lack of financial resources is typically the principal reason that remediation projects are not implemented. Other key obstacles include:  Government institutions without appropriate management and technical skills.  Lack of standard and consistent technical guidelines for remediation.  A legal framework that is not consolidated with respect to sustainable soil use, sustainable city planning, and the revitalization of inner city areas.  Lack of risk communication procedures and guidelines related to contamination.  Incomplete information system to provide the decisionmakers with solid information for sustainable land use and site revitalization.  Lack of financial mechanisms to support public and private sector remediation efforts. Energy efficiency Enhancing energy efficiency is essential to reduce the footprint of economic growth in urban areas. Recent studies in Mexico confirm the extent of the energy-efficiency potential that could be tapped at low cost and show that the investment required in all electricity efficiency interventions is significantly less than the investment in power plants that would otherwise be needed. 17 The case of Mexico is of special interest because it is the second largest power producer in Latin America and the Caribbean and the largest consumer of hydrocarbons for power generation (figure 1). Figure 1. Market share of total electricity production, 2009 Chile Central America Caribbean 4.4% 3.1% 3.8% Paraguay 4.5% Colombia Brazil 4.6% 35.8% other 4.6% Venezuela, RB 9.0% Argentina 9.4% Mexico 20.8% Source: World Development Indicators database (2009). World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 5 Mexico Policy Note 6 Energy efficiency opportunities in urban areas are considerable in air conditioning, lighting, and refrigeration, as well as in transport. Average energy demand could be reduced 28 percent if inefficient equipment were replaced. Replacing incandescent lamps with efficient halogen lamps may reduce electricity consumption for lighting by 30 percent. 18 In 2010, 23 million homes had refrigeration equipment. With the current standard for refrigerators, in some cases, savings of up to 60 percent can be achieved, compared with equipment manufactured before 1993.19 The transport sector, which accounted for 45.5 percent of all energy consumed in Mexico in 2010, also has untapped opportunities for energy efficiency gains. According to the 2009–2012 National Program for the Sustainable Use of Energy, energy consumption in this sector could be reduced from 1,739 TWh to 2,736 TWh by 2030. The industrial sector provides interesting opportunities to implement policies to reduce energy consumption. Motors represent 36 percent of national electricity consumption and 62 percent of industrial sector consumption (figure 2). Any initiative promoting more efficient motor equipment will have a major impact on electricity demand. The state oil company PEMEX and state power company CFE have vast opportunities to enhance energy efficiency. The main areas of opportunity for PEMEX’s lie in its production processes and the reduction of high levels of gas flaring and venting. The amount of gas that is currently flared and vented is significant, approximately equal to Mexico’s total gas imports (which amounted to about a quarter of Mexico’s total gas demand in 2008). Energy efficiency opportunities in CFE are in generation, transmission, and distribution. Figure 2. End uses of electricity in the industrial sector Illumination 8% Refrigeration 13% Process 17% Motors 62% Source: FIDE 2008 Energy efficiency in water pumping is critical. The use of efficient equipment for water pumping offers a potential reduction in electricity consumption of 15–20 percent.20 The Mexican government has also developed a variety of programs to replace inefficient systems with efficient ones, but this has not achieved great success, mainly as a result of the high subsidy to electricity for water pumping. World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 6 Mexico Policy Note 6 POLICY OPTIONS Urban management There is a need to strengthen urban and land use planning. At the federal level, responsibilities for urban transport, land use and environmental protection, disaster risk management, and housing are divided among several agencies without coordination mechanisms. At the state and municipal levels, low capacity and limited resources have restricted urban and land use planning functions to the preparation of plans for specific investment projects and to the development of intricate land use regulations, without any comprehensive assessment of population growth, housing and basic service needs, land use and pricing trends, growth corridors, and social issues. As a result, typically, cities do not develop a strategic vision of the future (and plan accordingly) rather they only lay out unarticulated sector programs. An urban and land use planning system capable of: (i) coordinating efforts among agencies that deal with urban development issues; (ii) designing comprehensive policies to manage urban growth; (iii) defining guidelines for efficient municipal urban and land use planning; (iv) integrating prevention and risk reduction policies; and (v) developing strategic studies related to the future of Mexican cities, is very much needed, and could be housed in a new agency. This agency could integrate various responsibilities and teams currently scattered amongst several ministries. One of the functions of a land use planning system would be to design a range of instruments, including market-based ones, to promote compact cities. These include transferable development rights, additional transferable rights, and dual tax rates. Transferable development rights can be one of two types: the right to convert rural land to urban use, and the right to build at greater densities than normally allowed by zoning laws. Dual property taxes that tax land differently from buildings are useful to avoid idle land in the center of the city and to promote the supply of serviced urban land. Another tool is densification subsidies to attract people to the center. Mexico has started to foster densification through public policies and programs, such as the guidelines and sustainability criteria within the Esta es Tu Casa program of Mexico’s National Housing Commission. Moving forward, cities need to develop market instruments to leverage private resources into densification. A densification strategy for Mexican cities should be accompanied by a mobility policy. Promoting more sustainable transport policies, including mass transit and non-motorized transport, can provide numerous co-benefits in addition to reducing global emissions (box 1), including reductions in traffic congestion, a decrease in commuting times, a decrease in accidents, and improvements in public health as a result of reduced air pollution. The Programa de Transporte Masivo launched by the current administration should be maintained and strengthened, because it has initiated a transformation in the urban transport paradigm for medium size and large cities. World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 7 Mexico Policy Note 6 Box 1. Energy efficiency and bus rapid transit systems Given the historical and projected urbanization pattern in Mexico, urban transport and related land-use planning issues will be a critical component of overall energy use by the transport sector and associated emissions. A World Bank study, the Low-Carbon Development for Mexico (2010), determined that the optimization of bus systems —namely, through integrated Bus Rapid Transit Systems (BRT)—is considered to be the intervention with the highest positive net benefits from a marginal cost abatement perspective. Mexico is not new to such systems. The Metrobus Bus Rapid Transit System in Mexico City—with dedicated bus lanes, pre-board fare collection, clean technologies, efficient intermodal connections, and rapid boarding—was conceived as a way to simultaneously reduce traffic congestion (caused by high volumes of paratransit “colectivos� and growing private auto use) and improve transit service in a major corridor. Early results showed, along with significant improvements in mobility along the corridor, a number of co-benefits. An outstanding example is the first corridor of Metrobus where, without any specific effort undertaken to reduce carbon dioxide emissions, a 10 percent reduction in GHG emissions was generated just by reducing fuel consumption. In the medium and long term, as BRT corridors are integrated to other networks such as the subway, clean technologies are deployed, and corridor densifications starts to settle, energy efficiency gains become even more substantial. High-quality urban design is required to make high-density developments more acceptable. For existing urban areas, urban redevelopment—including redevelopment of contaminated brownfields within cities—will prove essential to gauge the economic benefits of urbanization and to make densification attractive for private sector investment and labor mobility. In the future, urban planners should be required to attach price tags to their urban plans to better understand the costs and benefits of low- versus high-density development.21 For new developments, land-based financing instruments can pay for the provision of urban infrastructure. The underlying premise of land-based financing of infrastructure is that the benefits of infrastructure projects are capitalized into land values. As long as the special distribution of project benefits can be internalized within a well-defined “benefit zone,� it is economically efficient to finance infrastructure projects by tapping the increments in land values resulting from them. Land-based financing instruments include betterment levies, developer land sales, value capture via project-related land sales, the sale of development rights, developer exactions and impact fees, and land asset management. Most land-financing techniques generate revenue up-front, thereby reducing dependence upon debt and the fiscal risks that debt financing introduces. Mexico has started to require guidelines for sustainable new developments. These call for investments in green spaces, social services, public transport, and other infrastructure to ensure that new developments will be socially inclusive and linked to employment and economic opportunities. Since 2010 several housing institutions have incorporated the core elements of the guidelines into their policy and programs as part of the country’s Sustainable Housing Program World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 8 Mexico Policy Note 6 (Programa Sustentable de Vivienda). Importantly, the Instituto del Fondo Nacional de la Vivienda para los Trabajadores, which finances 70 percent of all mortgages in Mexico, is aligning its operational and financial plan toward this end. But more should be done, specifically regarding the development of financial instruments to accompany green urban growth. Land use planning and reinforced building codes are effective tools to reduce natural disaster risks and should be part of Mexico’s comprehensive disaster risk management strategy. Besides strengthening FONDEN’s operational efficiency and making sure that risk financing and insurance strategies and mechanisms trickle down to the states, there is an urgent need to focus attention and resources toprevention and risk reduction measures. This can be done through several mechanisms: (i) establishing a standard methodology for risk identification, assessment, and quantification to enable the federal and sub-national governments to design, prioritize, and implement disaster risk reduction programs for existing infrastructure, build resilience into new infrastructure, strengthen the public investment system, and integrate design standards for priority sectors, such as education, health, transport, water and sanitation, and low- income housing; (ii) linking federal resources for reconstruction to the development of a comprehensive disaster risk management strategy at state and local level; (iii) incorporating risk reduction policies in urban and land use planning. States are ideally positioned to play a coordinating role in disaster prevention and risk reduction as they are able to assess risk on a regional and local scale. Building sub-national capacity and creating incentives for better and informed investments at that level are key contributors to Mexico’s sustainable growth. In addition, local governments need to work on preparing and enforcing strict construction standards linked to federal housing programs. Brown agenda Integrated waste management strategies and solutions at the national, state, and municipal levels are crucial. Overall it is necessary to reinvigorate the implementation of the National Waste Management Program. Specifically, action is required to do the following:  Install a significant number of new sustainable municipal or regional solid waste disposal facilities and special waste management systems (collection, transport, treatment, and disposal).  Establish financial mechanisms to facilitate the long-term sustainability of municipal solid waste disposal systems, including both construction and operation.  Resolve limitations in municipal legal frameworks to allow for an effective development and implementation of Municipal Programs for Integrated Prevention and Management of Waste.  Establish conditions to allow installation of waste-to-energy projects that use the high organic material content in Mexican sanitary solid waste.  Create market mechanisms and conditions to significantly expand waste recycling.  Implement actions to enhance private sector actions in solid waste and hazardous integrated waste management, including waste generation reduction, so as to create market conditions that promote more waste recycling companies and establish fair, open, World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 9 Mexico Policy Note 6 and transparent conditions for promoting private sector hazardous waste disposal companies.  Take actions to increase public awareness and thus public demand for sound waste management. The government should develop and implement various actions to more quickly address the full range of existing issues related to contaminated sites in Mexico, associated with both the public and private sector. A National Program for the Remediation of Contaminated Sites exists but needs to be strengthened. This should include development of appropriate alternative financial instruments and mechanisms to provide the capital needed for site remediation, for both public and private sector–driven site remediation. These need to include a range of instruments, from governmental budgetary funding, remediation, and redevelopment funds, to financial mechanisms to promote cleanup at private companies’ existing operations. There is a need to establish policy instruments that promote brownfield redevelopment of contaminated sites, such as revenue and incentive frameworks to compensate developers for the risks involved in site remediation, building upon international best practices of brownfield redevelopment, legal and contractual conditions that resolve ownership issues and establish effective liability protection, and clear and uncomplicated processes for environmental licensing and land use should be developed. There is also a need to establish further regulatory guidance (for example, cleanup standards and risk assessment); improve institutional capacity to investigate, reduce, and prevent contamination, and establish policy and market instruments to address site contamination at mining and oil and gas operations. It is also important to keep in mind policy and related actions to improve the availability, quality, and cost of Mexican-based environmental goods and services. These will produce jobs, goods, and services to measure, prevent, minimize, correct, and manage environmental damage. Cleaner industrial technologies, wastewater treatment, solid waste disposal, waste recycling, soil and water contamination investigation and remediation, noise and vibration control, environmental analytical and testing services, and environmentally preferable products should be emphasized. Energy efficiency Energy subsidies need to be revised. The price of energy is a crucial signal to consumers. If energy prices are distorted, energy rationalization gets harder. In general, the government should assign greater priority to public policies aimed at poverty reduction than to the use of subsidies on energy products. In this regard, it should be ensured that prices reflect the costs of providing goods and services or their international benchmarks, as the case may be. Energy efficiency labeling, and standards in housing, transport, and small businesses, should be used. While Mexico has been implementing standards of equipment and systems, this only covers a portion of the domestic market. For this reason, Mexico’s government should promote the implementation of a greater number of standards. For instance, Mexico could move toward the adoption of standards similar to those in developed countries, creating new demand for already locally produced goods. Without creating barriers to trade, Mexico could seize the World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 10 Mexico Policy Note 6 opportunity to align energy efficiency standards for cars with those in the United States or Europe (where many of its cars are sold). Mexico could consider the whole urban environment to achieve significant energy efficiency gains, taking into account not only appliances or equipment but buildings, urban infrastructure, transport, and waste management. The private sector can be more involved in financing investments in energy efficiency. The recent reform of the oil and gas industry represents a positive step in promoting greater efficiency in the sector and attracting investments from private companies. The development of nationally appropriate mitigation actions could also be pursued to encourage the private sector’s participation through the development of industrywide coordinated efforts to phase out ozone- depleting substances and increase appliances’ efficiency. It is intended that any new mechanism will be defined no later than in 2015 and its implementation will take place no later than in 2020. Finally it is expected that the Government of Mexico will play an important role in the configuration of these private sector mechanisms. The creation of Energy Service Companies (ESCOs) should be promoted. ESCOs have been successfully implemented in some countries. The ESCO concept is that these companies invest their own resources in energy efficiency programs, and the costs and benefits are paid from the savings; in all cases benefits are shared from day one between the company and the investor. ESCOs could be particularly useful in the case of PEMEX and CFE. Often these state-owned enterprises are constrained by federal budget ceilings that leave them little room to invest in energy efficiency or perform at their potential. This gap, however, can be closed by ESCOs, which offer shared savings, the guarantee of investments by the ensuing efficiencies, and even the potential to unlock the required initial capital investment by tapping specialized firms. Banks can be familiarized with energy-efficiency lending to reduce perceived risk. Lack of access to commercial financing has been a major impediment to expanding the market for energy-efficiency retrofitting projects. Banks are not accustomed to this type of project lending. They do not accept receivables from performance contracts as collateral. And they are uncomfortable with lending to project developers, such as ESCOs, which are usually poorly capitalized. A step-by-step process is needed to familiarize banks with this market to reduce perceived risk, which can enable the adaptation of loan-evaluation criteria and possibly the design of appropriate instruments. A first step would be to get financial and technical experts working jointly to identify and design financing schemes based on energy savings. Both financial and technical experts must create strategies and schemes that show the economic benefits of implementing sustainable projects. World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 11 Mexico Policy Note 6 Matrix of short- and medium-term policy reform options* Reform area Short-term options (1 year) Medium-term options (2–3 years) Urban  Strengthen and broaden the  Design market-based instruments management DUIS initiative to achieve for densification and land-based intersectoral coordination (AR & financing of infrastructure. LR) (AR&LR)  Design and set in place an urban  Promote high-quality urban design management database at and innovation through government municipal and metropolitan level programs. (AR& LR) (AR)  Improve coordination of territorial  Strengthen PROTRAM (AR) planning (state level) and urban  Support state and municipal development plans (municipal level building codes that level). (AR&LR) contribute to disaster prevention  Improve quality and standardization (AR) of risk identification instruments (that is, risk atlas) and promote integration with city planning. (AR&LR) Brown  Resolve limitations in municipal  Install a significant number of new agenda legal framework to allow for an sustainable municipal or regional effective development and solid waste disposal facilities and implementation of Municipal special waste management systems. Programs for Integrated (AR) Prevention and Management of  Establish conditions to allow Waste. (LR) installation of waste-to-energy  Establish financial mechanisms projects that use the high organic to facilitate long-term material content in Mexican sanitary sustainable municipal solid solid waste. (AR&LR) waste disposal systems.  Create market mechanisms and (AR&LR) conditions to significantly expand  Establish adequate long-term waste recycling. (AR&LR) budget for implementation of  Implement actions to enhance updated National Waste private sector actions in solid waste Management Program. and hazardous integrated waste (AR&LR) management. (AR)  Develop appropriate alternative  Establish appropriate alternative financial instruments/ financial instruments/mechanisms to mechanisms to provide the provide the capital needed for site capital needed for site remediation, for both public and remediation, for both public and private sector–driven site private sector–driven site remediation. (AR&LR) remediation. (AR)  Establish policy instruments that World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 12 Mexico Policy Note 6 Reform area Short-term options (1 year) Medium-term options (2–3 years)  Establish adequate long-term promote brownfield redevelopment budget for implementation of of contaminated sites. (AR) updated National Program for  Establish policy and market the Remediation of instruments to address site Contaminated Sites. (AR&LR) contamination at mining and oil and  Establish regulatory guidance gas operations. (AR & LR) (such as cleanup standards, risk  Ensure adequate resources are assessment, and so on); improve allocated to environmental institutional capacity in management. (AR & LR) regulatory compliance to investigate, reduce, and prevent contamination. (AR&LR)  Establish framework/types of multistakeholder comprehensive sustainable environmental management planning in coastal tourism areas, including institutional and financing aspects. (AR)  Strengthen institutional capacities and enhance coordination between governmental authorities and relevant stakeholders. (AR) Energy  Use labeling and standards  Promote access to commercial efficiency programs for electric appliances financing. (AR) used in residences and small  Promote the creation of energy businesses. (AR) service companies. (AR)  Revise energy subsidies. (AR)  Capture energy efficiency opportunities in PEMEX and CFE through Energy Service Companies. (AR)  Involve the private sector in financing investments in energy efficiency. (AR)  Capture cogeneration opportunities in PEMEX. (AR) * LR= Legal Reforms; AR=Administrative Reforms, Preliminary Classification World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 13 Mexico Policy Note 6 NOTES 1 Urban anchor, powerpoint 2012. 2 Urban population growth rates for 1970–90, 1990–2010, and 2010–30 (estimates) were 3.4 percent, 1.9 percent, and 1.2 percent, respectively. During these same periods total population increased by 2.4 percent, 1.5 percent, and 0.9 percent, respectively. 3 Average data. Sedesol, la expansion de las ciudades en México 1980, 2010, and 2012. List of metropolitan areas and cities selected. 4 UAM-Xochimilo, Estudio de impacto de las políticas de vivienda. 5 Instituto Mexicano de la Competitividad (2010). 6 SCNM. Sistema de cuentas económicas y ecológicas de México, 2003 –2008. 7 Secretario de Desarrollo Social, Mayo 2010. 8 Programa Nacional para la Prevención y Gestión Integral de los Residuos 2009 –2012. SEMARNAT. 9 Programa Nacional para la Prevención y Gestión Integral de los Residuos 2009 –2012. SEMARNAT. 10 Diagnostico Básico para la Gestión Integral de los Residuos, SEMARNAT( 2006). 11 Programa Nacional para la Prevención y Gestión Integral de los Residuos 2009 –2012. SEMARNAT. 12 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) 13 One undocumented estimate says that approximately 200 out of nearly 2,500 municipalities may have a complete plan; Mexican GIZ Waste Management Program. 14 For example, annual budgets and a three-year mayor’s tenure do not allow for long -term sustainability planning or the capacity to access financing. 15 Communication SEMARNAT. 16 Talleres de FNM en Aguascalientes, Paseo Santa Lucia, IMMSA en Monterrey, IMMSA en San Luis Potosi, Refinería 18 de marzo, Arenque, La Venta, Azufrera Panamericana II, Pozo Dos Bocas, TAD Aguascalientes Mexico National Program for the Remediation of Contaminated Sites. Presentation by SEMARNAT at ICCL Meeting, Washington DC (2011). 17 Johnson, T., and C. Alatorre, “Low Carbon Development for Mexico.� Washington, DC: World Bank (2010). 18 Equipos de Aire Acondicionado y Principales Usos Finales en el Sector Doméstico de la Ciudad de Mérida, Yucatán; FIDE Review; Energía Racional No. 44 Jul.– Sep. 2002 (M. Maqueda et al.). 19 La Experiencia de México en Ahorro de Energía; Ing. Odón de Buen; Santiago de Chile; Julio de 2005. http://www.cepal.org/drni/noticias/noticias/2/22062/Odon.pdf. 20 Estudio de Mercado para Estimar la Magnitud del Potencial de Ahorro de Energía Eléctrica en Bombeo Municipal, a Nivel Nacional 2009–2030; study prepared for FIDE by Applied Technology Center de México S.A. de C.V. (L. Gámiz, January 2009. 21 By planning higher density residential land uses, cities can shorten the length of all linear infrastructure networks (roads, streets, water lines), thus substantially reducing the capital and life-cycle costs per household. Recent estimates suggest that initial capital costs for urban infrastructure per household in high-density (272 units per hectare) developments are more than 250 percent lower than in low-density ones (22 units per hectare). World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 14 Mexico Policy Note 6 REFERENCES CONAVI. Instituto Mexicano de la Competitividad. 2010. Johnson, T., and C. Alatorre. 2010. “Low Carbon Development for Mexico.� World Bank, Washington, DC. Programa Nacional para la Prevención y Gestión Integral de los Residuos 2009 –2012. SEMARNAT. Secretario de Desarrollo Social, Mayo 2010. Sedesol, la expansion de las ciudades en México 19802010, 2012. List of metropolitan areas and cities selected. Talleres de FNM en Aguascalientes, Paseo Santa Lucia, IMMSA en Monterrey, IMMSA en San Luis Potosi, Refinería 18 de marzo, Arenque, La Venta, Azufrera Panamericana II, Pozo Dos Bocas, TAD Aguascalientes Mexico National Program for the Remediation of Contaminated Sites. Presentation by SEMARNAT at ICCL Meeting, Washington DC (2011). UAM-Xochimilo, Estudio de impacto de las políticas de vivienda. World Bank- Green and Inclusive Growth: Reducing the Footprint of Growth 15 Mexico Policy Note 7 USING NATURAL RESOURCES IN AN OPTIMAL WAY EXECUTIVE SUMMARY Message 1. In a country where forests play a very strategic environmental and social role, high forest degradation is a cause for concern. Policy options to reverse this trend include shifting funds from reforestation to community forestry and paying for environmental services; strengthening advisory and monitoring systems; fostering sustainable and competitive community enterprises; developing approaches for forests with high biodiversity values but relatively low commercial value; and promoting cross-sector coordination and public participation in policymaking. Message 2. Per capita water availability has decreased by a factor of four in the last 50 years. This situation is compounded by an inefficient use of resources in agriculture as well as in urban water services; service quality is below OECD standards. Recent projections show the situation will worsen if no action is taken. The new administration should therefore give priority to establishing a set of policies and incentives to promote a more efficient allocation and usage of water resources, and improve the quality of service. Message 3. The possibility of Mexico turning into a net oil importer poses the challenges of radically transforming the country’s energy matrix composition and also reducing its competitiveness. A key option to promote green growth, enhance energy security, and reduce vulnerability lies in further exploiting the use of renewable energy sources; involving the private sector in financing investments in renewable energy; and exploring the potential to expand solar and wind power. OBJECTIVES To ensure sustainable and optimal use of its common property natural resources, Mexico will need to strengthen its focus on enhancing stewardship in three key sectors—forests, water, and energy resources. The key objectives include the following:  Identifying options that would contribute to Mexico’s climate agenda and build social resilience through forest management  Ensuring economically efficient and environmentally and socially sustainable water management to promote “green� growth in the context of water scarcity and climate uncertainty  Assessing the impacts of declining oil and gas reserves and the role of renewable energy as an alternative and cleaner source KEY CHALLENGES Forest management While forests contribute a modest 1 percent of GDP, 1 they represent an essential source of employment, income, and livelihood for some 12 million people.2 Almost nine thousand agrarian communities and ejidos3 own around 70 percent of the country’s forests under a legally recognized collective land ownership system––a situation unique in the world. In 2008, 57 percent of the poorest quintile of rural households obtained almost one-quarter of their income from natural resource extraction, most of which was forest-related.4 In many cases, managing forests collectively strengthens social capital within communities, enabling the pursuit of other World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 1 Mexico Policy Note 7 development activities. In some instances, collective management of forests increases social cohesion and reduces conflict. Forests can play an important role in mitigating and adapting to climate change. Reducing Emissions from Deforestation and Forest Degradation (REDD+) and other forest-related activities could account for almost 20 percent of reductions in greenhouse gas emissions that Mexico could achieve by 2030. If agriculture and livestock activities are included, then the entire land use, land use change, and forest sector has a mitigation potential of 30 percent (15.3 million tonnes of carbon dioxide a year).5 Forests also play an important role in adapting to climate change. By reducing erosion, regulating hydrological cycles, and protecting watersheds, forests lessen the physical impacts of floods, droughts, and other climate-related disasters that inflict loss of life and other significant damage. In addition, social capital built through collective forest management may strengthen community resilience to climate-related disasters and economic downturns. Although much remains to be done, Mexico has become a global leader in forest management. Mexico’s approach, which combines community forestry, the enhancement of environmental services such as water and biodiversity, and REDD+ is increasingly recognized as a reference worldwide for its innovativeness, scale, and results. As many as four thousand communities have participated in the demand-driven programs operated by the National Forestry Commission (CONAFOR) since 2001. An estimated 2,380 communities use forest management, and about 50 are independently certified. Furthermore, Mexico led the initial global agreement on REDD+ at the UNFCCC Conference of Parties in Cancun in 2010, where it also presented its own REDD+ Vision focusing on cross-sector integration at the landscape level. Promising REDD+ efforts are underway in selected Early Action Areas, with a learning potential of global relevance. Continued high-profile efforts and innovative thinking for REDD+ could further strengthen Mexico’s position as a leader in global negotiations and attract green investors. Allocation of resources among the various programs is not optimal. Reforestation efforts have obtained modest results despite receiving 38 percent of Mexico’s forest investments in 2011 (US$486 million). Of the area that was reforested nationwide, only half was in good or excellent condition one year later, and no systematic monitoring occurs beyond the first year.6 Meanwhile only 12 percent of forest investments went to managing natural forests. 7 There seems to be room for a better balancing of the budget among the various programs based on their performance. Existing forest programs can be improved. Although the community forestry and environmental services programs seem successful, their effectiveness falls short of potential. For example, the Instituto Nacional de Ecologia (INE) estimates that deforestation among participants in the payment for environmental services (PES) program could have been reduced by 3.5 percent, rather than the observed 1 percent, if areas at high risk of deforestation had been targeted specifically.8 The capacity to monitor investments is lagging compared with the scale of the programs. During the last decade, annual public investments increased 20-fold, to US$486 million. But CONAFOR’s ability to effectively monitor results on the ground––in terms of forest cover, welfare of local communities, water services, and biodiversity––has lagged behind and needs to be strengthened. The capacity and supervision of private technical service providers also needs World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 2 Mexico Policy Note 7 improvement.9 The significant achievements in policy performance assessments will need to be expanded to include strategic impact assessments to better identify potential synergies and conflicts across sectors. Other policies undermine the competitiveness of community forest production. Despite the overall success of community forestry, legal timber production nationwide fell by 30 percent since 2000, and the trade deficit for forest products more than doubled.10 Other policies seem to undermine public investments in the sector. These include unnecessary requirements and slow approvals of management plans by the Ministry of Environment (SEMARNAT), which make community efforts less competitive. Diverse circumstances that vary across the landscape may aggravate the problem, including difficult access to credit; land tenure issues; and insufficient infrastructure, public services, and marketing assistance, as well as weak institutional efforts to curtail illegal logging. Few options exist for forests with low commercial value. To harvest forest products legally, communities must have management plans. However, many forests lack sufficient valuable timber to justify the cost and complications of getting a plan approved. In other cases the government will not approve plans due to conflicts or tenure issues. Consequently, about 85 percent of forests outside conservation areas lack management plans.11 Most deforestation and degradation occurs in these forests, and informal forestry activities are widespread there. The federal attorney for the environment estimates that almost half of the industrialized timber might come from these areas. However, these forests have received limited attention, and existing regulations and programs are poorly adapted to their needs. Rural policies are still too fragmented, thematically and geographically. In spite of recent progress, remaining inconsistencies among forestry, agriculture, livestock, and other regional and economic development policies reduce the impact and sustainability of public investments in rural areas. Public subsidies for forest management and protection, agriculture, ranching, mining, and urbanization often compete with each other in the same location. The lack of inter- institutional collaboration heightens the risk that public policies and subsidy programs work at cross-purposes with each other. In addition, forest and agricultural programs usually operate at the relatively small level of individual communities and parcels, hence missing economies of scale. A broader landscape approach including forests, agriculture, pastures, and other rural lands could foster synergies among various land uses and among various levels of governance. Public engagement in policymaking is still limited. For almost two decades Mexico has been actively supporting consultation platforms such as the Consejos Forestales, Promotorias Forestales, and Foros Regionales de Recursos Naturales, and most forest investments are driven and implemented by communities themselves as owners of the forests. However, until recently there was insufficient space for civil society and community inputs into broader policymaking, especially in relation to REDD+. The creation of the national multi-stakeholder consultative committee for REDD+ (CTC REDD+) was a key step in that direction. Nevertheless, greater civil society participation, especially grassroots organizations and indigenous peoples’ groups at the local level, is needed to promote successful climate change adaptation and mitigation programs in the field, including REDD+. World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 3 Mexico Policy Note 7 Water management Mexico faces increasing stress on water resources resulting from population and economic growth as well as a suboptimal management (including inefficiency, overexploitation, and pollution). While significant regional disparities with regard to water availability exist,12 Mexico is dealing with increasing water stress.13 Increasing population and economic activities only partially explain the water scarcity experienced by some areas of Mexico. Water use is relatively inefficient. Irrigation techniques are generally highly water-intensive, farmers tend not to select crops with regard for changing climate conditions and water availability, and electricity tariffs for agriculture are highly subsidized. Many of the water supply and sanitation utilities also do not make efficient use of water resources,14 generating significant impact, especially in predominantly urban watersheds such as the Mexico Valley.15 Overexploitation of groundwater resources remains a significant problem.16 Mexico already faces water stress, which is exacerbated by the impact of climate change. Climate change is increasing the frequency and intensity of weather-related extreme events and changing precipitation patterns. There is a pressing need to incorporate climate change impacts into water resources management policy and to develop planning exercises to reverse the negative trends in the sector. In recent years, Mexico has strengthened its position in the field of climate change adaptation, taking the lead in the region. Nevertheless, great challenges still lay ahead, in particular in implementing the proposed policies, especially on the demand management side, and making efficiency improvements. The provision of accurate and timely weather and climate information still needs to be developed. The existing institutional framework does not easily allow the development of the inter-institutional arrangements that are often required for the development of multi-sectoral projects, which are usually required for climate change adaptation. Water scarcity and climate uncertainty combined with generally poor water services represent a serious threat to green growth prospects in Mexico. World Bank projections show the situation will worsen if no action is taken. The importance of water for green growth is evident, and successive Mexican administrations have declared water to be a “strategic matter of national security.� Ample evidence is available about the economic costs associated with water problems in Mexico. In the Valley of Mexico alone, more than 30 percent of water uses are not economically efficient, and annual economic costs resulting from poor urban water management (including poor water services) is estimated at US$2.4 billion annually, or 1 percent of the Valley’s GDP (figure 1). These costs are largely borne by lower income residents dealing with high coping costs, and could grow to US$3.5 billion and 1.7 percent of GDP by 2030 if no action is undertaken.17 Despite very significant investments in the sub-sector, only about one-third of large Mexican utilities provide continuous supply to their customers, with no significant improvement over the past 10 years,18 a glaring exception in the OECD zone. The implicit electricity subsidy provided to Mexican farmers for pumping groundwater has been estimated to be about US$700 million per year.19 World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 4 Mexico Policy Note 7 Figure 1. Sources and uses of urban water in the Mexico Valley today and in 2030 in a business-as-usual scenario 120 100 80 Local Aquifers Deficit Flow (m3/s) (overexploitation) 60 Inter-basin 40 transfers Local Aquifers (sustainable) 20 Surface water 0 unsustain. sustainable efficient inefficient unsustain. sustainable efficient inefficient Water sources Water uses Water sources Water Uses 2011 2030 Source: World Bank staff calculations The water sector is also challenged by incomplete reforms of its institutional and legal framework. In spite of the institutional innovation conveyed in the reform of the legal system in 1993 and 2004, the implementation of key legal and administrative instruments has not fully or efficiently taken place. For instance, the water rights, originally conceded based on self- declarations, should have been renovated every 20 years based on field surveys of actual use and water availability, but in most cases they have been extended automatically. The decentralization initiated in the nineties, transferring service provision responsibilities to municipalities, was not accompanied by the expected improvement in financial sustainability or service quality. In fact no mechanisms were put in place to ensure that service quality, sustainability, and affordability were regulated in a consistent and nonpolitical manner. Despite very significant federal investments in the sector, the Sistema Financiero del Agua proposed in the 2004 Water Law has not been implemented; most operators and water users associations continue to depend on unpredictable and sometimes arbitrary federal investment programs (50 percent of total investment in the sector) that, overall, tend to undermine the ownership, efficiency, and sustainability of local entities. Energy diversification The heavily based hydrocarbon structure determines the configuration of the power sector. For instance, 73 percent of Mexico’s installed power generation capacity is fossil fuel–based. Through the introduction of newer technologies and regulatory changes, the power sector has become the main driver of natural gas demand in Mexico. Oil supplies are declining, and this affects the future performance of the energy sector. The outlook for Mexico’s supply-and-demand energy structure in the near to medium term is molded by the country’s declining oilfields. The effects from the declining oil production can be felt presently, as the country’s energy trade balance surplus has decreased. The sharp decrease in oil production and the country’s high dependency on hydrocarbons are the two main factors World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 5 Mexico Policy Note 7 affecting the sustainability of the energy matrix. This has important implications for the way the government should handle energy subsidies and overall energy policy. The possibility of Mexico turning into a net oil importer poses the challenge of radically transforming the energy matrix composition and affecting its competitiveness. PEMEX’s net trade balance has decreased since 2006. Most of that decrease is explained by the growing tendency of hydrocarbon imports to fill the gap between domestic supply and demand. If this tendency continues in the years to come and domestic hydrocarbons supply does not offset it, PEMEX’s trade balance may turn negative (figure 2). Such a scenario would profoundly affect the energy sector and the fiscal balance. Figure 2. PEMEX trade balance 30 Trade Balance of PEMEX ($US Billion) 25 20 $US Billion 15 10 5 0 2006 2007 2008 2009 2010 2011 Source: PEMEX Energy sector challenges have broader policy implications. High oil dependence, an undiversified energy matrix, reduced investment in oil and gas exploration and production, declining oil production, and reduction in the hydrocarbons trade surplus are interdependent and have important implications for fiscal balance, public investment policy, and debt management. Any significant changes in the pricing or availability of primary fuels, whether in power production, transport, or other energy-intensive sectors, will affect consumers throughout the economy. Oil revenues are projected to fall as reserves and production decline in the years to come. Oil revenues contribute at least one-third of the federal budget and are a major source of funds for general social spending. The burden of fiscal adjustment to oil price swings and other external shocks has therefore fallen on public expenditures. Given that current expenditures are difficult to reduce in the short term, the primary fiscal response to external shocks has been to make drastic cuts in capital expenditures. Because PEMEX and CFE investments comprise a large share of the capital budget, the investment budgets of these enterprises have borne an important share of such unanticipated cuts. Mexico’s energy sector has found itself in a vicious circle, in which reduced budget and borrowing capacity has restricted sector investment, in turn limiting the expansion of World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 6 Mexico Policy Note 7 production and government revenues. This has made it more difficult to fund future financial needs. The government is increasingly forced to choose between the call to spend on urgent social programs now, and the need to invest in energy now to maximize value creation from oil production, meet the growing demand for energy, and accumulate funds for future public spending. Renewable energy provided only 14 percent of Mexico’s electricity generation in 2009 despite important endowments in wind, geothermal, and solar energy. Since 1990 there has been a decline in the share of renewable energy sources (table 1). This is primarily due to the declining relative share of hydro; the total share of non-hydro renewable sources increased slightly. Over the past two decades the main shift in energy generation has been from oil-fired plants to natural gas and, to a lesser extent, coal. For the period 2009–2012, the goal of the Programa Especial para el Aprovechamiento de Energías Renovables has been to increase renewable capacity (excluding hydro capacity larger than 30 MW) by up to 7.6 percent and its share in total energy generation to 4.5–6.6 percent. Almost all of the planned increase to 2012 would be from wind energy. In addition, the program has the goal of making electricity available to 2,500 rural communities by using renewable sources. Table 1. Evolution of share of energy sources in electricity output in Mexico, 1973–2009 (percent unless otherwise noted) Energy source 1973 1980 1990 2000a 2009 Total (including self-generators), (TWh) 37.1 67.0 115.8 204.2 261.0 Oil-fired 41.1 57.9 53.6 46.2 17.5 Natural gas–fired 14.2 15.5 12.5 20.3 53.1 Coal-fired 0.6 0.0 6.7 9.5 11.3 Nuclear 0.0 0.0 2.5 4.0 4.0 Hydro 43.6 25.2 20.3 16.2 10.2 Non-hydro renewable 0.4 1.4 4.4 3.7 3.9 Biomass 0.0 0.1 0.0 0.8 1.0 Geothermal 0.4 1.3 4.4 2.9 2.6 Wind and solar 0.0 0.0 0.0 0.0 0.2 Note a. 2009 was a relatively dry year, which diminished hydro output by ~15 percent from the mean, equivalent to a reduction of about 2 percent in the share of total generation. The other years shown had river flows within the “typical� range (CFE, 2011). Source: International Energy Agency, http://www.iea.org, Energy Statistics of OECD Countries. More broadly, and over the longer term, the National Energy Strategy has the goal of achieving a 35 percent share of generation capacity- through renewable energy (including large hydro), nuclear energy, and “clean fossil fuel� technologies by 2024. 20 Overall, the share of renewables in terms of output is expected to remain almost unchanged by the end of the period— 14 percent of the projected total of 415 TWh for public service. In the next sections the projected expansion is reviewed in light of the potentials of the different renewable energy resources. Recently there has been increased emphasis on the development of small and micro hydro, which is seen as having lower environmental impacts than larger hydro projects. It is estimated World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 7 Mexico Policy Note 7 that there are roughly 3.3 GW of remaining small hydro potential. The inventory of small hydro potential is quite sketchy outside of a few states. But even a rapid development of most small hydro potential would not have a large impact on the generation mix. For example, tripling the planned expansion of small hydro from 375 MW to 1,125 MW would increase output by about 2 TWh, or 0.5% of total generation in 2025. Development of wind generation has steadily grown but wind generating capacity in 2009 was still only 85 MW. However, it is increasing rapidly and is projected to exceed 3,000 MW in 2014 and 5,500 MW by 2025 (SENER 2010). Assuming a capacity factor of 33 percent (average of the capacity existing in 2009), this would be equivalent to 16 TWh, less than 1 percent of total generation. Since 1973, Mexico has been one of the world’s pioneers in exploiting geothermal energy for electricity generation. Capacity has grown fairly slowly over the years and was 965 MW in 2009 (1.9 percent of total installed capacity). Geothermal plants are base load with high capacity factors, which have ranged between 78 percent and 88 percent since 1999. Output in 2009 was 6.7 TWh, or about 2.9 percent of total generation. Mexico is one of the best-endowed countries in Latin America for solar energy, but this advantage has not translated into commensurate electricity generation because of the high cost of the associated technologies. Their use has been restricted to mostly small isolated rural systems. But the cost of photovoltaic systems fell dramatically from 2009 to 2011. While far from competing with alternatives for central station supply to the grid, this cost reduction has put PV systems close to economic viability for distributed generation among segments of consumers paying higher prices for electricity. Mexico is also developing the first concentrated solar power (CSP) plant in Latin America in Agua Prieta, Sonora. The potential of Mexico’s shale gas development is vast, yet many challenges must be overcome to realize it. According to the EIA estimate, potential reserves of shale gas are more than three hundred times what was consumed in 2010. Worldwide development of shale gas, especially in the United States, will be important to revolutionize technology, incentivize production in Mexico, and help to lower the market price of gas, making it a competitive alternative source against other fuels and energy sources. Some challenges lay in the future development of gas. The investments required to develop shale gas reserves in Mexico are huge and the adoption of new technologies may be difficult at the beginning. In addition, several environmental concerns will have to be settled in an appropriate manner and an underdeveloped internal gas transportation system will need to be upgraded. POLICY OPTIONS Forest management Rethinking the balance and packaging among programs would seem relevant at this time. In particular, it would be useful to provide communities with more integrated support, combining multiple programs and seeking optimal policy mixes at the local level. Shifting funds from plain reforestation to a combination of community management of standing forests, restoration of degraded lands, and payment for environmental services would be a logical step considering the World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 8 Mexico Policy Note 7 positive social, economic, and environmental outcomes these programs have generated so far. Reforestation efforts can be improved, but this will require major changes in approach and will take time. There are often cheaper alternatives for promoting forest regrowth than reforestation, and where economically justified, reforestation efforts could be more integrated, selective, and geographically focused. In addition to rebalancing funds among programs, it is important to provide flexibility for communities to mix programs in ways that better recognize the complexity of rural landscapes. Strengthening CONAFOR’s advisory and monitoring systems is essential for the success of forest programs in the field. Priority could be given to the staffing and training of regional offices, and to the development of cutting-edge remote sensing and geographical information systems. The training and accreditation of private experts who advise communities is also critical. This effort will be all the more important because monitoring, reporting, and verification (MRV) will be a key element for a future REDD+ system. Fostering the ability of community enterprises to compete with other suppliers would greatly contribute to environmental sustainability and socioeconomic development. Simplifying the requirements for community management plans and reducing the time required to approve them, particularly for forests with low timber volumes and for non-timber products, could allow large additional areas to be legally managed for production. New mechanisms that recognize long-standing informal forestry activities could enable them to get help to become more sustainable. Communities with forests certified by recognized third-party auditors could be exempted from many regulatory requirements. Efforts should be made to resolve unclear tenure situations and allow communities to manage forests legally, especially where no opposing claims to those forests are present. New loan guarantees and collateral instruments could facilitate communities’ access to private credit for forestry activities. Given limited resources, forest law enforcement efforts would be more effective if they were concentrated on critical areas. Mexico’s Congress approved a bill for climate change that mandates the use of economic, market, fiscal, and financial instruments to promote the principle that those who conserve also shall receive the benefits. Since many communities actually bear the cost of public services and infrastructure, fiscal incentives should be considered to recognize their contributions to the population and the environment. Developing approaches for forests with lower commercial value is an integral part of the solution. A combination of reducing regulatory burdens, providing small payments for managing forests with low timber volumes and for protecting forests from fires and grazing, and improving technical support services, could make it possible to greatly improve forests’ condition and livelihoods in forest areas outside the main timber production regions. This approach, facilitated by greater integration between the different forest programs, could increase carbon stock in approximately 20 million forest hectares nationally. For example, payments for environmental services could be expanded from strict protection and used to complement sustainable management in less profitable areas, or in high-biodiversity areas at risk of degradation. Promoting cross-sector coordination and a landscape approach would enhance comprehensiveness. CONAFOR and the Ministry of Agriculture (SAGARPA) are developing joint databases and making efforts to align policies, ensure consistency among subsidy programs, and develop new incentives for climate-smart management of land and forests at the landscape World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 9 Mexico Policy Note 7 level. A series of inter-municipal collaborations are also emerging, following the model of the Junta Municipal del Río Ayuquila (JIRA), with the aim of improving integration of public policies at the territorial landscape level, fully engaging local actors, and leveraging additional resources. Pursuing these nascent efforts and promoting the scaling up of successful pilots will be essential to using forests as a platform for sustainable development and a buffer against climate change impacts in rural areas. Fostering public participation in policymaking can bring positive effects. Efforts are already underway to foster greater public participation in policymaking, especially in the innovative REDD+ area. These include the creation of local consultative committees for REDD+, direct engagement with grassroots organizations in designing and implementing pilot programs, a new collaboration with the Comisión Nacional para el Desarollo de los Pueblos Indígenas (CDI) and the Instituto Nacional de las Mujeres (INMUJERES), the development of a consultation protocol for REDD+ jointly with civil society organizations, and a comprehensive communication strategy. Moving forward, it will be essential to intensify and expand these partnerships. Water management Implementing an effective Water Financing System will set the incentives for a more optimal use of water resources. The 2004 Water Law states that the creation of a Water Financing System is critical to supporting the integrated and sustainable management of the nation’s water resources. The Water Financing System should determine the financial needs of the sector; identify current revenue levels and all sources of funding being channeled to the sector (ODA, federal, state and local transfers, the private sector, tariffs, and other financing instruments); define key principles governing sector financing; identify potential sources of revenue generation for the sector; monitor and evaluate the impact of financing; propose measures to increase and diversify the funding base; and improve the optimal use of financial resources. Additionally, federal investment programs should be reformed to link the decisions of resource allocation with actual performance in improving efficiency and quality of service, ensure that activities financed are consistent with the overall SFA and do not generate perverse incentives, and improve the predictability and transparency of resource allocation. Finally, requirements to account for climate variability in future investments should be embedded in all federal programs. Consolidating the information base for climate, water management, and water services will improve policy and decisionmaking. Critical steps have been taken to ensure the modernization of the Servicio Meteorológico Nacional; however, the task is far from complete, and there is a need to continue strengthening the information base ranging from climate predictions to water management, water rights allocation, aquifer behaviors, and the quality and efficiency of water services. For this to happen, a culture of openness, accountability, and transparency should be promoted throughout the sector, starting with CONAGUA making its sector data available more easily and systematically. Efforts should also be made to extend climate data as well as aquifer monitoring. Groundwater extractions should be measured whenever possible, and water balances should be made on real extractions, not unmonitored extraction rights. The quality of service provided by water utilities, as well as the efficiency with which they provide that service, should be reported and made publicly available for benchmarking purposes. World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 10 Mexico Policy Note 7 Improving and strengthening enforcement of water rights will help to cope with competing uses and climate variability. The water rights registry in Mexico covers 95 percent of all water users and represents an impressive accomplishment. But the amount of water rights greatly exceeds sustainable levels in water-scarce areas, the errors in the records remain relatively high, and effective enforcement needs to be substantially strengthened. Climate change further threatens current allocations. Making the system work fully will require cleaning up records, implementing a complete administrative system to measure and control water usage, and setting up transparent enforcement mechanisms. The system of water rights should be used to address the issue of water over-allocation and the need for an optimal use of water resources in the most water-scarce areas—in particular, in extreme events—by letting the market rather than government fees push up the perceived marginal value and allowing water users to capture the capital value of their water allocation through the establishment of tradable water rights in critical watersheds. Improving the efficiency of water services in the agriculture sector will have large payoffs. Agriculture is the primary user of water, as it accounts for about 80 percent of total water withdrawals. The efficiency of agricultural water services is therefore instrumental to achieve an optimal use of water resources. The new administration should consider modifying the electricity tariff subsidy policies, generalizing volumetric water pricing, and continuing the modernization of irrigation techniques. Capacity building among producers will be needed to move to irrigation of higher value crops in water-scarce areas. Bringing efficiency and quality of urban water services up to regional OECD standards is necessary to sustain green growth in dense urban areas. However, dramatic improvements are difficult to achieve in the absence of a change of approach in the promotion of service quality and efficiency. The new administration should consider establishing and enforcing a comprehensive policy addressing the shortcomings of the urban water sector, in close coordination with states and municipalities. This policy should focus on establishing effective service quality and economic regulation; developing more sustainable and self-financed utilities; improving technical capacity of their staff; reforming the existing sub-sector financing approach; and promoting long-term planning in the face of climate change and other constraints. The recent Public Policy drafted by CONAGUA should serve as a guiding policy. 21 The recent adoption of a constitutional right to access affordable water in sufficient quantity and quality, together with the mandate to pass a new Water Law within a year, offers an opening to address the challenges mentioned at the legal level, creating effective regulatory and accountability mechanisms for the sector. Energy diversification Energy diversification is essential to use natural resources in an optimal way. The possibility of Mexico turning into a net oil importer calls for radically transforming the energy matrix composition as well as the energy subsidies policy. Mexico should focus subsidies on the poorest consumers, while using some of the freed-up resources to boost renewable energy. Such measures are key to avoid a difficult financial situation if the government decides to keep its current subsidies policy without having compensation through fiscal reform. As for renewables, their projected share in Mexico’s electricity supply is expected to be about the same in 2025 as in 2009—roughly 14 percent. In the short term (2009–2014), the World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 11 Mexico Policy Note 7 share of renewables in new output is higher, roughly 21 percent, but then it falls. The existing plan is more ambitious in the short term than in the long term. This is much preferable to the inverse: little action in the short term, with ambitious long-term targets. The short-term actions can bring experience and conditions to build on. If the share of new output added by renewables in 2009–2014 were maintained over the subsequent decade, the additional output required after 2014 would be about 13 TWh. In that case, the share of renewables in the country’s electricity output in 2025 would increase to 17 percent. The private sector has considerable room to finance investments in renewable energy . The recent law to promote renewable energy represents a positive step attracting investments from the private sector. This law (as well as the Power for Public Service Law) now considers externalities but needs to be strengthened. The Independent Power Producer model could be improved and extended to promote investments in renewable energy generation. Banks could also have a role in promoting renewable energy in Mexico. Households could create a strong market for solar technologies, which (depending on the region) could be integrated into mortgages and other long-term financing mechanisms. In partnership with the private sector, Mexico could also pursue the creation of Nationally Appropriate Mitigation Actions (NAMAs) in the renewable energy sector. Matrix of short- and medium-term policy reform options* Reform area Short-term options (1 year) Medium-term options (2–3 years)  Provide more integrated  Strengthen advisory and monitoring support to communities by systems. (AR) combining programs at local  Develop approaches for forests with level, and balancing lower commercial value. (AR&LR) reforestation and community  Promote cross-sector coordination Forest forestry, restoration, and and landscape approach, especially management payment for environmental with agriculture and livestock land services funds. (AR) uses. (AR&LR)  Start addressing bottlenecks  Promote greater public participation and foster competitiveness in policymaking with explicit focus of community enterprises. on REDD+. (AR) (AR&LR)  Conduct a review of all  Develop and implement the Water federal programs to improve Financing System to promote a vision their targeting, alignment, of sustainable and efficient sector and predictability. (AR) financing. (AR& LR)  Prepare a new water law to  Implement the new law and related address key challenges urban water service quality and Water signaled in the policy note, efficiency policy. (AR) management in particular with regard to  Continue improving the information water rights management basis on sector data, and require and water and sanitation nonfederal actors to report on their service provision. (LR) performance and service quality as a  Consider replacing the condition for federal transfers. (AR) electricity subsidy for  Improve and strengthen the World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 12 Mexico Policy Note 7 Reform area Short-term options (1 year) Medium-term options (2–3 years) agriculture with targeted enforcement of the system of water subsidies. (AR& LR) rights to cope with competing uses, in particular in the most critical basins. (AR&LR) Renewable  Continue promoting energy renewable energy. (AR)  Involve the private sector in financing investments in renewable energy. (AR)  Explore potential to expand solar and wind power. (AR) * LR= Legal Reforms; AR=Administrative Reforms, Preliminary Classification NOTES 1 Centro de Estudios de Competitividad 2010. 2 CONAFOR 2010. 3 Communities and ejidos are landholdings with either indigenous or non-indigenous members with rights, stipulated by law, to communal resources under which an individual family has a right to an individual plot of land allocated formally by the community as well as access to communally owned lands (often forest lands, pastures, and waterways). 4 Lopez Feldman 2011. 5 Johnson and others 2009. 6 Universidad Autónoma de Chapingo 2010. 7 Consejo Civil Mexicano de Silvicultura Sostenible 2010. 8 Muñoz Piña 2011. 9 Universidad Autónoma de Chapingo 2009. 10 CONAFOR 2008. 11 About 7 million of Mexico’s 65 million hectares of forest have management plans, 8 million hectares are in national protected areas, and 2 million hectares are in Payment for Environmental Service schemes (Merino. 2011). 12 The semiarid and arid northern and central regions account for 79 percent of GDP and contain 77 percent of total population, but they receive only 31 percent of the total runoff (CONAGUA 2011a). 13 In 1955, water availability in Mexico was 11,500 m3 per person per year. By 2005 this amount had decreased to 4,288 m3 (CONAGUA 2010). 14 The weighted average rate of Non-Revenue Water for a selection of water utilities in communities with a population of more than 50,000 inhabitants is estimated at 40 percent according to the CONAGUA (2011c); another source reports it at 49 percent, considering all larger utilities of the country (Consejo Consultivo del Agua 2011). 15 In 2009 the availability of renewable water in the Mexico Valley was only 164 m3/hab/year, well below international standards for acute water scarcity established at 1000 m3/cap/year (CONAGUA 2011b). 16 Of the 256 aquifers that supply more than 90 percent of total groundwater demands, 102 are currently considered overexploited. 17 World Bank 2012 (forthcoming). 18 Extrapolated from Consejo Consultivo del Agua 2011. 19 Guevara-Sangines 2006. 20 SENER 2010. World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 13 Mexico Policy Note 7 21 World Bank and CONAGUA 2012 (forthcoming). REFERENCES Centro de Estudios de Competitividad. 2010. “El sector forestal en Mexico: diagnostic, prospective y estrategia.� CONAFOR (National Forest Commision). 2008. “Producción y productividad forestal maderable .� Internal document. ———. 2010. “Mexico’s draft Readiness Preparation Plan (R-PP).� Submitted to the World Bank Forest Carbon Partnership Facility. CONAGUA. 2010. Estadísticas del Agua en México. ———. 2011a. Atlas del Agua en Mexico. ———. 2011b. Estadísticas del Agua en México. ———. 2011c. Situación del Subsector Agua Potable, Alcantarillado y Saneamiento. Consejo Civil Mexicano de Silvicultura Sostenible. 2010. “Analisis del proyecto de presupuesto para CONAFOR en 2011.� CCMSS Nota informativa 29. Consejo Consultivo del Agua. 2011. Gestion del Agua en las Ciudades de Mexico. Guevara-Sangines, A. 2006. “Water Subsidies and Aquifer Depletion in Mexico’s Arid Regions.� Occasional Paper No. 23. Human Development Report. United Nations. New York. Johnson, T.M., C. Alatorre, Z. Romo, and F. Liu. 2009. Low Carbon Development for Mexico. Washington D.C: World Bank. Lopez Feldman, A. 2011. “Environmental Dependence of Mexican Rural Households: Exploring the Role of Income, Shocks, Rules, and Roads.� Manuscript. Merino, L., ed. 2011. Encuentros y desencuentros. Las comunidades forestales y las políticas públicas en tiempos de transición, p. 134 (ANP statistic). Mu oz Pi a, C. 2011. “Programa de Pago por Servicios Ambientales Hidrológicos de los osques.� Presented at the International PES Congress, Ixtapan de la Sal, Estado de México, México, August 3–5. SEMARNAT. Programa Especial de Cambio Climático 2009-2012 – DOF 28/08/2009. www.cambioclimatico.gob.mx/images/stories/PDF/peccanexos.pdf. SENER. 2010. Prospectiva del Sector Electrico: 2010–2025. Direccion General de Planeación Energética, Secretaría de Energía. Universidad Autónoma de Chapingo. 2009. “Evaluación de la Operación de los Programas de Desarrollo Forestal, Informe Final.� Universidad Autónoma de Chapingo. 2010. “Informe de evaluación externa de los apoyos de reforestación, Ejercicio fiscal 2009.� Texcoco. p. xiii. World Bank. 2012 (forthcoming). “Urban Water Management in the Mexico Valley.� World Bank and CONAGUA. 2012 (forthcoming). “Política Pública para la Eficiencia Sostenible de los Organismos Operadores.� World Bank- Green and Inclusive Growth: Using Natural Resources Optimally 14 Mexico Policy Note 8 MANAGING MEDIUM-TERM FISCAL CHALLENGES EXECUTIVE SUMMARY Message 1. Mexico needs a comprehensive fiscal reform to alleviate the looming medium-term pressures on its budget. The country’s fiscal accounts rely heavily on oil revenue (about a third of total public revenue). But falling oil revenue and an expected increase in spending (aging-related spending, public investment, and social spending to reduce poverty and inequality) will put pressure on its public finances. This calls for a greater tax revenue collection effort, increased efficiency and improved targeting of public spending, and more accurate measurement of medium-term spending and revenue trends. Message 2. Mexico’s fiscal agenda needs a revenue-enhancing tax reform. The country’s tax collection effort is low by international standards (nonoil tax revenue amounts to about 10 percent of GDP). Adopting an integral fiscal-reform strategy that broadens the tax base, simplifies the tax system by eliminating tax loopholes, and reduces tax expenditures could bolster revenue substantially. Message 3. Mexico needs energy pricing reform and budget stabilization measures as part of its fiscal reform. Energy subsidies are estimated at nearly 2 percent of GDP. Removing these subsidies could help the country raise revenues, avoid distorted price signals, and reach its climate change mitigation goals. Institutionalizing the oil-price hedge, lifting the stabilization fund caps, and adopting a structural balance rule could all strengthen budget stability. Message 4. Mexico’s fiscal reform agenda should include a careful evaluation of the distributive impacts of the full range of proposed measures. The loss in household purchasing power resulting from increased tax collection and the removal of energy subsidies must be evaluated in parallel with an increase in public spending capacity for more targeted programs. OBJECTIVE This policy note contributes to the debate on Mexico’s looming fiscal challenges. The country’s fiscal framework, centered on the 2006 Budget and Fiscal Responsibility Law, and prudent fiscal risk management has helped maintain short-term budget stability and a fairly stable public debt path, even in times of economic volatility. However, Mexico faces serious longer term fiscal challenges that are not always recognized, measured, and addressed in policy debates, which tend to focus on approving the annual budget. And though Mexico has adopted several policies to mitigate oil-price volatility on the budget, oil production has fallen substantially over the past few years, drawing renewed attention to the longer term challenge of replacing part of the oil-related public revenue base with other, more permanent sources of revenue. Further, spending pressures associated with increasing aging-related spending, public investment, and social spending needs call for a discussion of the fiscal implications of additional impending outlays. KEY CHALLENGES Mexico’s falling oil revenue and rising public spending needs over the medium term require increased tax revenue and more efficient and better targeted public spending. Even if greater economic growth and lower real interest rates provide some space for deficit financing without endangering the sustainability of public debt, the onus on fiscal adjustment is likely to rest on raising the country’s public revenue collection effort. An integral revenue-enhancing World Bank- Managing Medium-Term Fiscal Challenges 1 Mexico Policy Note 8 fiscal reform that broadens the tax base, reduces the scope of special regimes and preferential rates, and generates information flows on economic transactions that facilitate tax compliance and administration could boost tax revenue substantially. Reducing public subsidies, especially prevalent for energy, would also increase public revenue. Mexico’s public finance depends heavily on oil revenue, with recent high oil prices masking a decline in oil production. In 2011, public revenue reached more than 3 trillion pesos (21.7 percent of GDP),1 a third of it oil-related. Crude oil production and exports have declined steadily following a peak in 2004. The government estimates that production will stabilize at 2.5 million barrels a day over 2011–15, but after years of decline, these estimates are highly uncertain. Even if production were to stabilize, a growing economy would cause oil revenue to fall as a percentage of GDP. In addition, a greater share of oil revenue is being cycled back to PEMEX and thus is not reaching government coffers, due to greater needs in oil investment and higher extraction costs. If current macroeconomic parameters, including average annual economic growth of 3.3 percent, remain constant—and the real price of oil remains stable—oil revenues would fall by 2.5 percent of GDP over 2011–30.2 And if oil prices remain constant in nominal terms, revenues would fall by 4 percent of GDP over the same period. Mexico’s long-term spending pressures are related to its demographics. The country’s increasing life expectancy and declining birth rates have led to an unprecedented demographic shift toward a rapidly aging population. Since 1990, life expectancy has risen 8.3 percent for men and 6.0 percent for women, and the increase is projected to continue. At the same time, Mexico’s fertility has declined steadily, from an average of seven children per woman in 1960 to just more than two today. And the population older than age 65, 6.2 percent in 2010, is projected to double to an estimated 12.5 percent by 2030. The aging population is adding to public spending on health, long-term care, and pensions. Increasing health costs associated with the aging population, and an epidemiologic transition, will gradually put pressure on government spending. Mexico spends nearly 6 percent of GDP on health, approximately 2.7 percent of it public spending. Public and private health spending will gradually trend toward the OECD average of 8.9 percent of GDP, in parallel with Mexico’s demographic and epidemiologic transition. Public health spending will likely outpace private health spending, due to the low base and expansion of Seguro Popular, a noncontributory public health subsystem that provides health insurance for people without social security.3 Transition costs from pension reform are higher than estimated. Though the switch to a defined-contribution pension system for most formal-sector workers improved long-term fiscal sustainability, public spending has risen, as worker contributions no longer fund defined-benefit pensions granted to the current and transition generation of retirees. Government transfers to finance existing contributory pension programs doubled from 1.2 percent of GDP in 1999 to 2.4 percent of GDP in 2010. Transfers to the Mexican Social Security Institute (Instituto Mexicano del Seguro Social, or IMSS) reached 1.2 percent of GDP in 2009–10, far earlier than estimated. High labor informality and the associated low contributory pension coverage generate significant contingent liabilities. Many Mexicans lack pension benefits because they are employed informally or because they shift between formal and informal employment and are thus unable to meet the minimum contributory pension requirements. Low contributory pension World Bank- Managing Medium-Term Fiscal Challenges 2 Mexico Policy Note 8 coverage has released the pent up demand for noncontributory pensions, reflected in the recent expansion of the program 70-plus (70 y Más) to urban areas.4 Providing a basic pension in 2012 for everyone age 70 and older without an IMSS or Institute for Social Security and Services for State Workers (Instituto de Seguridad y Servicios de los Trabajadores del Estado, or ISSSTE) pension would cost the government approximately 0.2 percent of GDP.5 Looking more closely at these medium- and long-term revenue and spending trends and publishing a medium-term budget outlook would allow for long-term budget planning. The government produces a National Development Plan (or Plan Nacional de Desarrollo) every six years and includes a section on fiscal risks in its annual budget presentation,6 but a more dynamic, strategic, and effective medium-term budget plan is needed. Projecting federal spending and revenues over the coming decades under multiple scenarios would help identify and evaluate upcoming budget pressures earlier than before—and promote the proposal of mitigation measures and analysis of their budgetary impacts. POLICY OPTIONS Adopting a revenue-enhancing tax reform Mexico’s tax collection effort is low by international standards. And though its federal tax collection (13.8 percent)7 is well below the OECD average (19.2 percent), it is above that of Canada, Spain, and the United States. When local taxes and social security contributions are included, however, Mexico drops to last place among its OECD peers (figure 1). And while Mexico’s social security contributions amount to 2.9 percent of GDP and local government tax collection to 0.6 percent of GDP, those averages for the OECD are 8.6 percent and 6 percent, respectively. The property tax is an important revenue generator for local governments in other countries but in Mexico amounts to just 0.2 percent of GDP. The general features and statutory rates of Mexico’s tax system compare favorably with those of other OECD countries.8 But a large informal economy and a complex tax system with loopholes and exemptions lower the tax revenues collected and the productivity of most tax categories.9 In addition, preferential corporate and individual tax regimes, value added tax (VAT) exceptions, and multiple rates limit collection, facilitate noncompliance, and further complicate the tax system. These exemptions, deductions, and credits (known as tax expenditures) generate substantial revenue losses, have the same effect on the budget as government spending (like subsidies), and alter the tax system’s horizontal and vertical equity. Adopting an integral reform that simplifies the tax system and broadens the tax base could boost revenue substantially. Recent reforms, including a higher VAT, the introduction of an alternative minimum tax on business income, a tax on cash deposits, and a temporary increase in the corporate tax rate and marginal personal income tax10 have not boosted tax revenues sufficiently (figure 2). A more comprehensive reform strategy is needed to close the projected fiscal gap and guarantee that public services are provided in a sustainable manner. Spending on social security and social services, so critical for developing human capital and unlocking growth, is constrained by limited revenues. World Bank- Managing Medium-Term Fiscal Challenges 3 Mexico Policy Note 8 Figure 1. International comparison of public revenues Figure 2. Evolution of tax revenues (% of GDP) Graph 1. International Comparison of Public Revenues, 60 2009 Social security cont. Local taxes Federal taxes 50 40 OECD average 34.8% % of GDP 30 20 17.3 2.9 0.6 10 13.8 0 Slovenia Turkey Belgium Luxemb. Korea Iceland Israel Sweden France Germany Spain Finland UK Greece Chile Czech Rep. Canada Denmark Austria Mexico Hungary Norway Ireland Slovak Republic Switzerland USA Italy N. Zealand Source: OECD Source: OECD 2011. Source: SHCP and INEGI Reducing or withdrawing tax expenditures would broaden the tax base and increase revenues. Foregone tax revenues due to tax expenditures are substantial. Tax expenditures not only lower revenues but also ease noncompliance through tax evasion. Withdrawing these expenditures would raise revenue, simplify the tax system, reduce tax evasion, and provide useful information for tax authorities. Revenue foregone due to differential tax rates, tax exemptions, and subsidies are estimated at nearly 5.1 percent of GDP for 2011. There is a growing international consensus that differential VAT rates on goods and services may be a poor way of achieving income distribution objectives. Transition to a broad-based single-rate VAT system, the best policy option, would minimize compliance costs and thus increase efficiency and revenues. But if over the short term removing VAT exemptions and zero rating is not politically viable, an exemption or lower rate could initially be retained on a small basket of staple goods. There seems to be no rationale for reduced VAT rates in border areas, so border rates should be increased to the standard rate. The tortilla subsidy’s 1990s elimination in favor of a cash transfer to lower income levels demonstrates the possibility of reforming politically difficult fiscal benefits. Adopting energy pricing reform and budget stabilization measures Mexico’s energy subsidies are high and have increased substantially over the last few years. Domestic energy prices, set by the Ministry of Finance and Public Credit (Secretaría de Hacienda y Crédito Público, or SHCP), are considered subsidized if their price is below a reference price representing the opportunity cost (for tradable goods, such as fuel) or representing the cost of production (for non-tradable goods or services, such as electricity). There is no explicit budget appropriation; rather, subsidies show up as lower revenue to the federal government or its state-owned companies. The energy subsidies also mask resource costs, are inefficient in alleviating poverty, and are highly regressive. Subsidies for electricity, gasoline, diesel, and liquefied petroleum were more than 1.5 percent of GDP on average each year over 2005–09, according to government estimates. Electricity subsidies in Mexico—though harder to quantify because the reference cost of production is based on an administratively set rate of return of capital and also may include inefficiencies in the state-owned power utility—are prevalent in the rate structure for electricity World Bank- Managing Medium-Term Fiscal Challenges 4 Mexico Policy Note 8 use in housing and agriculture and are considered among the largest in the world. Subsidizing domestic energy consumption both encourages wastefulness and discourages investment in energy efficiency. And despite being a net gasoline importer, Mexico sells gasoline domestically at a much lower price than do most OECD and Latin American countries (figures 3 and 4). Figure 3. Mexico does not fully pass through the Figure 4. Subsidies have increased as a result of the sharp increases in international gasoline prices domestic fuel-price adjustments Graph 3. Mexico and US gasoline prices* Chart 4. Energy Subsidies as a percentage Gap MX US 14 of GDP 3.5 12 3 Gas LP Electricity Gasoline (IEPS) 10 2.5 8 1.8 2 6 1.5 0.4 0.1 0.7 4 1 0.4 2 1.2 1.2 0.9 0.5 1 1 1 0.9 0.9 0 0 0 0.1 0.22 0.1 0.2 -0.6 -0.2 -2 -0.5 -1.2 -4 -1 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 -1.5 2002 2004 2005 2006 2007 2008 2009 2010 * Magna price for Mexico and Regular Conventional Retail price for the US; in pesos/liter. Source: ThomsonReuters Datastream Source: Scott, John (2011) Quien se beneficia de los subidios energeticos en Mexico?, Source: ThomsonReuters Datastream Source: Scott 2011. Domestic fuel-price adjustments have not kept up with international price increases. Mexico for years followed a fuel-pricing policy of monthly price adjustments that until 2009 aligned with expected inflation. But today, prices are adjusted at an accelerated pace, to close the growing price gap between domestic and international prices. The difference between the sales price to the public and the (international) reference price is made up by a variable excise tax that turned negative following the sharp rise in oil prices over the past few years. A negative excise tax equals a subsidy of the same size. Fuel-pricing policies have served economic and fiscal stabilization purposes in the past, but today there are better alternatives. Predictable, monthly price adjustments avoid the impact that international oil- and fuel-price volatility has on inflation elsewhere. This may have been important when monetary authorities were still battling to bring inflation down to levels in line with overall economic stability. With inflation within the target range established by the monetary authorities, the artificial suppression of fuel-price volatility may no longer be needed, given the moderate impact on overall inflation and inflation expectations. Similarly, the monthly fuel-price adjustment has moderated the impact of oil-price volatility on public finances. Higher oil prices add oil export revenue, but do not lead to higher domestic sales revenue. At the same time, a sudden drop in oil prices and export revenue is not accompanied by lower domestic sales revenue. Removing energy subsidies would help Mexico raise revenues, avoid distorted price signals, and reach its climate change mitigation goals. The added revenue from the withdrawal of subsidies for electricity use in housing and agriculture—along with the adoption of a positive fixed excise tax on fuel— could be used in part to mitigate the effect of higher energy prices on lower income households. Additional transfers to beneficiaries of the Oportunidades program to compensate for higher energy prices in 2008 could be an efficient mitigation tool. Because reducing fuel subsidies at a time of high oil prices would be politically difficult, a temporary World Bank- Managing Medium-Term Fiscal Challenges 5 Mexico Policy Note 8 option could be to accelerate the price-smoothing mechanism for gasoline and diesel, to quickly align them with international prices. Once a target excise tax on fuel has been reached, fuel prices should be allowed to fluctuate with international price movements. A fixed excise tax on fuel would increase the sensitivity of government revenues to energy price fluctuations and in turn, the importance of a strong stabilization mechanism. Budget stability and transparency would benefit from institutionalizing the oil-price hedge and lifting the stabilization fund caps. Lifting the caps would create a more effective fiscal buffer against large negative shocks, by promoting greater savings during economic upturns and periods of high oil prices. Further, greater energy-related savings could help protect future generations instead of financing current government consumption. The best solution would be to reform the stabilization funds so that they not only protect and stabilize the budget and the economy from excess volatility but also increase savings for future generations. Institutionalizing the oil price hedge would reduce the pressure to use these funds for other needs, such as to meet budget shortfalls. Adopting a structural balance rule could help reduce the procyclicality of public spending under the current rule. The obligation to target the nominal balance and reserve fund caps imply that public spending rises and falls with revenue fluctuations linked to economic growth and oil revenue. This results in a close correlation between changes in expenditures from one year to another and changes in nonoil tax and oil revenues. A structural balance rule would also further smooth spending patterns. A structural budget would allow for an endogenous response to changes in revenue deriving from the economic cycle while promoting fiscal discipline and sustainability of the deficit and debt levels. Improving the distributional impact of fiscal policy Mexico’s tax-benefit system does not improve income equality as much as in other OECD countries. While taxes lower income inequality in almost all OECD countries, Mexico’s Gini coefficient falls only slightly, from 0.515 before taxes to 0.509 after. It falls a bit more, to 0.465, when including targeted social spending. For an average EU country, however, the Gini coefficient falls from 0.46 before taxes and transfers to 0.34 after, largely through transfers.11 High inequality in Mexico is due partly to the failure of fiscal policy to perform its redistributive function. While income taxes are generally progressive, high informality and high poverty reduce the share of income tax in the overall tax base. 12 Easier-to-collect indirect taxes, such as VAT, are largely regressive. But using multiple VAT rates can achieve some progressivity, despite increasing skepticism about their effectiveness in achieving redistribution objectives. (See Annex 1 for a discussion on progressivity.) Despite better targeting of social spending, some programs in Mexico disproportionally benefit the higher income population deciles and worsen inequality. Some programs are very progressive, as the per capita public transfer falls with higher income levels (as shown in a negative concentration coefficient). Others are less so, as the per capita public transfer rises with higher income levels (as shown in a positive concentration coefficient; figure 5). As long as the concentration coefficient is below the market income Gini coefficient, these transfers are only moderately redistributive. Like energy subsidies, VAT exemptions and zero rating are in effect nontargeted consumption subsidies. The amount of the subsidy obtained depends on household World Bank- Managing Medium-Term Fiscal Challenges 6 Mexico Policy Note 8 spending on the subsidized products, which tends to rise with income. Devoting a larger share of public spending (including tax expenditures) to programs with a negative concentration coefficient (or a small positive one) would help make the tax-benefit system more progressive13. Figure 5. Concentration coefficients for selected programs, 2010 Chart 5: Concentration coefficientes for selected programs, 2010 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 Oportunidades-0.54 IMSS-Oportunidades -0.47 Adultos Mayores -0.39 Seguro Popular -0.35 Procampo -0.33 Salud SSA -0.32 70 y mas -0.29 Programa Alimentario -0.29 Empleo Temporal -0.25 Subsidio Eléctrico Doméstico 0.19 Becas (excl. Oportunidades) 0.2 Salud IMSS 0.24 Subsidio GAS LP 0.25 Subsidio Empleo 0.29 Subsidio Gasolina 0.33 Saludud ISSSTE 0.47 Pensiones 0.49 Scott, John (2010) "Gasto Público para la Equidad: del Estado Truncado hacia el Estado de Bienestar Universal "Mexico Evalua Woking Paper Series, Mexico City. Source: Scott 2010. The distributional incidence of individual fiscal interventions should be less of a concern than the overall distributional incidence of the tax-benefit system. The loss in purchasing power generated from higher levels of tax collection and a removal of energy subsidies must be evaluated in parallel to an increase in public spending capacity for more targeted 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 communication strategy for fiscal reform is needed to show the costs and benefits of the suggested policy options and to build political consensus. World Bank- Managing Medium-Term Fiscal Challenges 7 Mexico Policy Note 8 Matrix of short- and medium-term policy reform options* Reform area Short-term options Medium-term options Fiscal reform Tax reform  Implement revenue-enhancing tax reform that broadens the tax base, simplifies tax filing, reduces tax expenditures, and eliminates special regimes and preferential rates. (LR) Energy pricing reform  Accelerate price adjustment for  Adopt a fixed excise tax domestic fuel sales to align on domestic fuel sales with international prices (LR) . and allow prices to fluctuate with  Reduce subsidies on electricity international price for use in housing and movements (LR) agriculture (LR) Measures to improve  Compensatory programs:  Strengthen capacity to distributional impacts of tax provide compensation for estimate overall and energy pricing reforms lower income households distributional incidence negatively affected by tax and of the tax-benefit system energy pricing reform (LR). (AR). Budget stabilization  Institutionalize oil-price hedge  Adopt a structural measures and remove caps on balance rule (LR). stabilization funds (LR). Improved measurement of  Prepare medium- and long-  Maintain and publish medium-term revenue and term budget projections and annually medium- and expenditure trends analyze fiscal reform options long-term budget (AR). projections. (AR) * LR= Legal reform; AR= Administrative Reform. Preliminary classification. World Bank- Managing Medium-Term Fiscal Challenges 8 Mexico Policy Note 8 Annex 1. Fiscal policy and income redistribution: absolute versus relative progressivity Analyzing the distributional impact of a tax or benefit on per capita income is essential for comparing policy options. If a government’s goal is to improve income distribution (lower inequality and poverty), it should allocate the largest share of spending to programs that are progressive in absolute terms. Transfers are progressive in absolute terms when their per capita value declines with market income. In the figure above, absolute progressive transfers are those above the 45-degree perfect-equity line. Cash-transfer programs, such as Oportunidades, are progressive in absolute terms, as the poor receive more transfers than the nonpoor in absolute terms. Transfers are regressive in absolute terms but progressive in relative terms when their per capita value increases with market income, while their value relative to the market income declines. Examples of these transfers, for which the concentration coefficient is positive but smaller than the market income Gini coefficient (reflected in the graph by a curve between the market-income Lorenz curve and the 45-degree line), are value added tax exemptions and zero rating on food and energy subsidies, as well as public spending on tertiary education. Taxes are called progressive and transfers regressive in absolute and relative terms when their relative value with respect to market income goes up. In this case, the line reflecting the distribution of the tax or transfer is below the market-income Lorenz curve (and the concentration coefficient is higher than the market income Gini coefficient). Source: Lustig and others 2011. World Bank- Managing Medium-Term Fiscal Challenges 9 Mexico Policy Note 8 NOTES 1 This amount reflects the budgetary public sector, including revenues generated by state-owned enterprises in energy and social security. 2 IMF, 2011, 2011 Article IV Consultation, p 32. 3 Seguro Popular was introduced in 2001 as a health insurance program for low-income households not covered by social security. In 2012, the government claimed full coverage of the population without social security. 4 The expansion of 70-plus also followed the creation of universal pension systems by a number of states and Mexico City. 5 Assuming 3.6 million people age 70 and older without a pension and a basic pension of 500 pesos a month. 6 See Criterios Generales de Política Económica (2012). 7 To compare Mexico’s tax base with that of other countries, the OECD includes transfers by PEMEX to the federal government, because if the oil company were a private enterprise, it would pay the equivalent in royalties. 8 However, tax rates are toward the lower end of the international spectrum. 9 Mexico’s Tax Administration Service (Servicio de Administración Tributaria) estimates that approximately 77 percent of income tax due on nonsalary income is not paid and that VAT tax evasion is estimated at 35 percent. 10 The individual maximum marginal rate was temporarily increased from 28 percent in 2010 to 30 percent in 2012 but will fall to 29 percent in 2013. 11 OECD, 2011. Economic Surveys: Mexico 12 The two richest income deciles pay almost 80 percent of income taxes and, as a result of an in-work tax credit, the three poorest income deciles pay negative income taxes on average. 13 Birdsall, Lustig, and McLeod 2011. REFERENCES Birdsall, Nancy, Nora Lustig, and Darryl McLeod. 2011. “Declining Inequality in Latin Ame rica: Some Economic, Some Politics.� CGD Working Paper 251. Center for Global Development, Washington, DC. Secretaría de Hacienda y Crédito Publico 2012. Criterios Generales de Política Económica. Mexico City, Mexico. IMF. 2011, Mexico 2011 Article IV Consultation Selected Issues, IMF Country Report No. 11/249, Washington, DC. Lustig, Nora, Carola Pessino, George Gray Molina, Wilson Jimenez, Veronica Paz, Ernesto Yanez, Claudiney Pereira, and Sean Higgins. 2011. “Fiscal Policy and Income Redistribution in Latin America: Challenging the Conventional Wisdom.� Economics Working Paper 1124. Tulane University, New Orleans, LA. OECD. 2011. Economic Surveys: Mexico, Paris, France. OECD, 2011. Revenue Statistics 1965-2010, Paris, France. Scott, John. 2010. “Gasto Público para la Equidad: Del Estado Excluyente hacia un Estado de Bienestar Universal.� Centro de Investigación y Docencia Económicas (CIDE), Mexico City, Mexico. Scott, John. 2011. “Quién se beneficia de los subsidios energéticos en México?�Centro de Investigación y Docencia Económicas (CIDE) y Consejo Nacional de Evaluación de la Política de Desarrollo Social, Mexico City, Mexico. World Bank- Managing Medium-Term Fiscal Challenges 10 Mexico Policy Note 9 STRENGTHENING PUBLIC REVENUE AND EXPENDITURE MANAGEMENT TO ENHANCE SERVICE DELIVERY EXECUTIVE SUMMARY Message 1. Public service delivery is hindered by low tax collection and inefficient expenditure at the federal, state, and municipal levels. On the revenue side, upgrading public service delivery requires improving tax administration and incentive frameworks, especially in subnational governments. Message 2. On the expenditure side, Mexico needs to improve public sector performance and expenditure quality. Mexico lags behind its OECD peers on management of key functions in the budget cycle—from planning to execution and evaluation. Under a new legal framework intended to increase expenditure efficiency, Mexico has made considerable progress in improving the quality of expenditures and of the decision making process on budget formulation and reallocation. Message 3. Mexico needs to strengthen public sector management systems, complete accounting harmonization, implement performance-informed budgeting, consolidate implementation of the new financial management system, and strengthen the federal procurement system. OBJECTIVES To achieve higher growth and reduce poverty and inequality, Mexico needs to improve public service delivery. Mexico is a middle-income country with continuing high levels of poverty (46.2 percent of the population) and inequality (a Gini coefficient of current disposable income close to 0.50). It has maintained macroeconomic stability over the past 15 years, a necessary but not a sufficient condition for growth and poverty reduction. To accelerate growth and reduce poverty, it needs to build the capacity of its public sector institutions to collect revenue and execute public programs effectively and efficiently. To improve public sector service delivery, Mexico needs to ensure sufficient financial and human resources relative to the needs of the population, and effective and efficient public management of spending programs to address those needs—two basic prerequisites for an effective public sector. Mexico’s public service delivery is hindered by low tax collection and expenditure inefficiencies at all three levels of government: federal, state, and municipal. KEY CHALLENGES Mexicans’ trust in the state is among the lowest in Latin America (figure 1). Contributing factors are the uneven quality of public spending programs and low tax collection rates, reflecting taxpayers’ disappointment with the use of their taxes. Improving the quality of public spending programs should gradually enhance the perceived trustworthiness of the state. World Bank- Public Sector Modernization 1 Mexico Policy Note 9 Figure 1. Citizens’ trust in the state, 2011 70% 62% 62% 60% 52% 51% 51% 48% 50% 40% 40% 39% 37% 37% 36% 36% 40% 34% 34% 31% 29% 30% 25% 18% 20% 10% 0% Guatemala Honduras Panama Mexico LAC Colombia Dominican Rep. Argentina Paraguay Nicaragua Venezuela El Salvador Costa Rica Peru Chile Uruguay Bolivia Ecuador Brasil Source: Latinobarómetro 2011. Revenue management Mexico’s tax collection is low by Organization for Economic Co-operation and Development (OECD) standards. Mexico has one of the lowest tax collection rates in the world. It has the lowest share of tax revenues to GDP in the OECD (figure 2).1 And its share of tax revenue (including oil income) was a little over half the OECD average in 2010 (18 percent of GDP compared with 33 percent). Mexico’s tax collection is also low by Latin American standards. It can be argued that comparing Mexico’s tax revenues with those of the OECD economies is unfair because of the income gap between Mexico and those economies. But comparing Mexico’s tax revenues with those of other Latin American countries (drawing on Economic Commission for Latin America data, which measure tax collection rates more accurately than OECD data) produces striking results: Mexico has the lowest tax-to-GDP ratio and is well below other Latin American countries in the collection of both direct and indirect tax revenues (figure 3). Figure 2. Total tax revenues as percentage of GDP, Figure 3. Tax revenues for selected Latin American 2010 countries, 2010 30 Denmark 48 Germany 36 25 Average OECD 34 20 Argentina Brasil Spain 32 15 Chile USA 25 10 Colombia Chile 21 Mexico 5 Mexico 18 0 0 10 20 30 40 50 60 Total Tax Revenues Direct Taxes Indirect Taxes Source: OECD provisional data (2010). http://stats.oecd.org/ Source: Economic Commission for Latin America (CEPAL) (2010). World Bank- Public Sector Modernization 2 Mexico Policy Note 9 Mexico has made substantial progress in tax administration in recent years. Tax administration has been a major policy priority, but weaknesses in tax policy (such as the scope and amount of tax exemptions) limit its effectiveness. Over the past few years, the country has modernized its tax administration, including by making intensive use of information technology, such as Internet-based tax declaration and payment mechanisms. There has been a substantial reduction in value added tax (VAT) fraud. And as part of the government’s strategy to increase nonoil revenues, changes were made to the fiscal code in 2009 to improve tax administration and enforcement. The problem of low tax collection is particularly acute at the local level, as many subnational governments lack incentives and administrative capacity. At the local level, improving tax collection faces additional challenges. First, many small and medium-size municipalities suffer from low institutional and administrative capacity, and local tax collection teams lack the tools, training, and systems to implement corrective actions related to key tax administration functions (tax revenue collection, enforcement, and audits). Second, states depend on federal transfers for most of their revenue (figure 4), so they have little incentive to focus on improving tax collection. Figure 4. State own revenues as a share of the total, 2010 (percent) 60 50 40 30 20 10 - Jalisco Colima Puebla Oaxaca Querétaro Durango Chiapas Sinaloa Tabasco San Luis Potosí Yucatán Michoacán Baja California Sonora México Guerrero Zacatecas Hidalgo Nayarit Tamaulipas Aguascalientes Quintana Roo Morelos Guanajuato Tlaxcala Baja California Sur Distrito Federal Coahuila Veracruz Chihuahua Nuevo León Campeche Source: Ministry of Finance and Public Credit [2010] (SHCP). Low subnational tax collection increases the volatility of subnational finances within Mexico’s fiscal federalism framework.2 During the recent economic slowdown and drop in oil prices, federal public finances were partially protected from exogenous shocks by the government’s fiscal risk management strategy (mainly the oil hedging program). However, the amount of federal revenues shared with subnational governments fell dramatically. Mexican states thus faced greater external risk than did the federal government, and subnational public finances were hit hard. Subnational governments need incentives and assistance to improve their tax administration to increase own revenues. Subnational tax administration functions are in general weak, with low institutional capacity and inadequate collection and enforcement processes. Key areas needing to be strengthened are transitioning from manual to electronic tax collection systems, moving to a single tax registry, enforcing tax collection through a more efficient taxonomy of cases and subjects, enhancing tax audit capacity and the human resources devoted to tax auditing, implementing information management systems with a wide range of performance indicators and better information databases, and carrying out business process World Bank- Public Sector Modernization 3 Mexico Policy Note 9 reengineering of state administrations, particularly for property and payroll taxes. Also crucial are consistency in property valuation techniques, support to cadastre management and improved inter-agency coordination for property tax administration (including property registry, public notaries, and construction licenses). In addition to promoting better tax administration capacity, the federal government could promote incentives for tax collection and reduce discretionary transfers. Stronger incentives are needed for the states, for example by building on the one that the Tax Administration Service (Servicio de Administración Tributaria) introduced under the Régimen de los Pequeños Contribuyentes (For more details on proposals to raise federal and subnational tax revenue see Mexico Policy Notes 9 and 10). Expenditure management Mexico needs 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 upgrading to provide public sector managers and decision- makers with 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: implementing 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. A modern financial management system and harmonized accounting standards would allow proper financial management, costing, execution, control, and transparency of federal, state, and municipal public programs, increasing accountability to the public and Congress and contributing to an open government. Information on the performance of public programs and policies would enable the government to measure progress toward its goals, revealing which public programs are working and which are not, and giving decision-makers some impartial information on the performance of departments, agencies, and programs. Although Mexico has developed a new legal framework to increase expenditure efficiency, the country still lags behind its OECD peers on key functions of budget management. Remaining challenges include strengthening cash management and harmonizing budget information on public expenditures, revenues, debt, and contingent liabilities at both the federal and state levels. The Performance Evaluation System (Sistema de Evaluación del Desempeño, or SED), anchored in a new legal framework affecting all three levels of government, defining new policies on results-based management and results-based budgeting. The new legal framework includes the 2007 Fiscal Reform, which details the SED framework; the 2008 Constitutional Reform on Expenditure, which requires all levels of government to adopt results-based budgeting, performance evaluation, and multiyear budgeting for investment projects; the Ley de Fiscalización y Rendición de Cuentas de la Federación, which regulates and strengthens oversight of government accounts (cuenta pública) and includes newly defined performance audits as part of the oversight function; and the Ley General de Contabilidad Gubernamental (LGCG), approved in December 2008, which dictates the rules underlying government accounting and financial information with a view to harmonizing all levels of government and decentralized government institutions. World Bank- Public Sector Modernization 4 Mexico Policy Note 9 Several key actions have been taken to institutionalize this legal framework. Critical measures include integration of the SED, including the development of methodologies, guidelines, and procedures for its implementation (2008); implementation of budgetary programs and their alignment with performance indicators (2008–11); integration of performance information with budgeting to inform decisions about program and activities (2011 budget); and design of the Evaluation and Fiscal Transparency Unit in the Ministry of Finance and Public Credit (2011) and of a Performance Evaluation and Fiscal Transparency System (2011). Under this legal framework, the Ministry of Public Administration (Secretaría de la Función Pública, or SFP) is implementing the Special Program for Management Improvement in Federal Public Administration (Programa Especial de Mejora de la Gestión en la Administración Pública Federal, or PMG; 2008–2012). Also critical have been consolidation of the Evaluation Council (CONEVAL), development of an evaluation program for federal transfers (Ramo 33) to subnational governments (2011), and development of key principles for implementing the performance-informed budgeting agenda at the subnational level. Implementing these reforms at all levels of government is expected to enhance public sector performance, improve the expenditure quality, increase public sector accountability, and enhance fiscal discipline and sustainability. By linking government finance and actions to results-based budgeting, the reforms should help achieve announced public policy goals. Simplifying expenditure execution procedures and budget execution and procurement processes will in turn contribute to more effective programs and service delivery. Implementing performance-informed budgeting requires a cultural change that implies a very different budget management style, particularly in a federal system with sovereign states. Mexico has strengthened budget discipline by improving budget management across the budget cycle, from planning through execution to audit and evaluation. The new legal framework has been followed by specific actions and the adoption of policy reforms in line with best international practice: the conceptual model for the financial management information system (Sistema Integral de Administración Financiera Federal, or SIDAFF), approved by the Ministry of Finance in July 2009, began implementation in 2012; the General Accounts Plan (Plan General de Cuentas), approved by the Ministry of Finance in September 2010; the General Government Accounting Manual (Manual General de Contabilidad Gubernamental), approved in November 2010; the Government Accounting Manual for the Executive Branch (Manual de Contabilidad Gubernamental para el Poder Ejecutivo); and the reforms for implementation of the treasury single account. With these reforms, plus the fiscal and expenditure reforms, budget management is expected to become a policy and planning tool, and SIDAFF will be able to produce real-time reports, thereby strengthening budget control, accountability, and transparency. In 2009, the Ministry of Public Administration created the Management and Government Performance Evaluation Unit to guide and lead its internal efficiency effort. The PMG is being implemented throughout the entire federal government. In 2010, the federal government approved nine regulations standardizing the internal public administration procedures that all federal government agencies should use for auditing, procurement, control, financial management, human resources, asset management, information technology, transparency, and accountability. This reform eliminated 3,549 regulations in federal administration. The PMG will also improve public sector management efficiency by simplifying and standardizing external regulations and procedures for 10 key public services. The PMG, though it has had some impact World Bank- Public Sector Modernization 5 Mexico Policy Note 9 and has been able to mobilize resources, has not been consolidated as a cross-cutting tool to enable better public sector management across agencies. A number of fundamental cross-cutting public sector reforms (not addressed in this note) remain to be addressed—for example, civil service and regulation simplification. Over the coming years, the government needs to either consolidate the PMG effort or consider an alternative implementation strategy. The performance budgeting and evaluation system3 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 evaluation of public sector policies and programs. The Ministry of Finance has developed guidelines with standardized logical framework instruments for federal government entities to use in formulating their strategic plans. Performance indicators were developed for each program, and recently the Ministry of Finance also developed a complex methodology to synthesize, prioritize, and monitor federal government programs using results and performance information. Budget classifications used in budget allocation have been adjusted and expanded to facilitate effective monitoring and accountability of government programs, allowing for effective results-informed budget deliberations (even though implementing the programmatic classification is still a pending issue). Consolidating performance-based budgeting at the federal and state level depends on consolidating the SIDAFF and equivalent state financial management systems, completing the harmonization agenda, 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. The Ministry of Finance recently established a specialized function for comprehensive evaluation of selected federal government policies and programs . Based on an annual evaluation plan, the Ministry of Finance commissions evaluations that analyze government programs: conceptualization, technical approach and design, efficiency and effectiveness in implementation, achievement of intended objectives, and impact. The evaluations highlight positive aspects of each program and point out deficiencies and areas for further improvement. Several evaluations have been completed, and the results are starting to inform resource allocation through the budget process. The evaluations have also served as the basis for creating an evaluation capacity and culture within the federal government. The challenge now will be to clarify the process of generating and using evaluations. Currently, the law provides competencies for generating evaluations to three institutions—CONEVAL, the Ministry of Public Administration, and the Ministry of Finance—creating potential competency conflicts and uncertainty on who will do what (aside from the general rule that CONEVAL focuses on social programs). Program discussion during budget preparation and program redesign remains informal, and mechanisms need to be developed to provide incentives for good program performance. Finally, it is essential to institutionalize the evaluation function to move forward and consolidate the reform. Mexico has also achieved substantial progress in fiscal transparency. After a broad consultation and participatory process involving specialized nongovernmental organizations and experts, and in collaboration with the regulatory entity for access to information (Instituto Federal de Acceso a la Información y Protección de Datos), the Ministry of Finance launched a fiscal transparency portal to detailed information on the allocation and use of federal government World Bank- Public Sector Modernization 6 Mexico Policy Note 9 resources. The portal includes a citizen-friendly application—city budget (presupuesto ciudadano)—that facilitates access to budget information and describes the budget process in a very accessible way. The initiative has been successful, but if it is to contribute fully to improving citizens’ trust in government, it needs to be consolidated, scaled up, and explicitly linked to the action plan on open government. At the state level, progress has been uneven; accounting harmonization will be a prerequisite to further progress. As part of an ambitious strategy to modernize public sector financial management, the government has started to harmonize the public accounts and accounting practices of the federal and subnational governments. Because results-informed management requires mechanisms for accounting, reporting, and consolidating information, accounting systems are being modernized and harmonized. At the federal level, the Ministry of Finance has developed a new conceptual model to integrate core public financial management functions (budget, treasury management, and accounting) and related administrative procedures (human resources, procurement, use and maintenance of assets and materials, and provision of services) as the basis of SIDAFF. Besides providing a common framework and instruments for integrating core public financial management functions within the Ministry of Finance, SIDAFF helps simplify and harmonize activities across the federal government, emphasizing back-office functions. 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, the Ministry of Finance has developed guidelines for the accounting harmonization; supporting the country’s 1,200 smaller and less developed municipalities must remain a priority. In partnership with the government’s technology department and complemented by an ambitious capacity-building program, the Ministry of Finance needs to do more work on developing the new web-based solution for modernizing, harmonizing, and consolidating municipal financial information using a common platform. Finally, the Ministry of Finance needs to prepare guidelines for decentralized entities and state-owned companies at the federal level and develop the consolidation model and associated instruments for automated integration and consolidation of public accounts at all government levels and for the production of consolidated accounting reports for the entire public sector, following international best practices. Improving the efficiency of government delivery of goods and services requires continuing the procurement system reform that begun 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.4 Until recently, the procurement system was overregulated, focused heavily on the administrative function, and based primarily on legal regulations. The electronic procurement system was outdated by 2009, incapable of improving transparency, generating competition, or streamlining processes. In addition, procurement staff lacked both knowledge and professionalism. Recent efforts have resulted in savings for the government and have improved delivery of works, goods and services, but further improvements are needed. 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- Public Sector Modernization 7 Mexico Policy Note 9 procurement systems is known to be high, procurement reform and monitoring can yield substantial gains for the economy and society. Mexico aims to align its public procurement system more closely with expenditure policy to generate value for money, ensure transparency and efficiency, and improve the quality of the works, goods and services procured. Over 2009–11, operational changes and amendments to the legal and regulatory framework have addressed several weaknesses. Among the most important reforms are introducing framework agreements and reverse auction mechanisms, establishing a more comprehensive role for the electronic procurement management system, Compranet (including the possibility of electronic bidding), addressing some of the bid-opening procedures, and establishing a non-judicial conciliation process. By reducing red tape and improving the management of public sector operations, these reforms are expected to improve public service delivery. POLICY OPTIONS On the revenue side, subnational governments need incentives and assistance to improve their tax administration to increase own revenues. There is a blueprint to guide further reforms of tax administration at the federal level, but more work is needed at the subnational level, where tax administration functions are in general weak. Problems include low institutional capacity and poor collection and enforcement processes. Several key areas would benefit from federal support to state governments (see below). On the expenditure side, Mexico needs to strengthen its public sector budget management functions, focusing on performance in formulating, executing, and evaluating public spending programs. Mexico has made good progress on three main fronts of its public sector modernization agenda: harmonizing accounting at the federal and subnational levels, introducing performance-informed budgeting, implementing SIDAFF and the treasury single account, and building on the success of procurement reform in centralized government and sector delivery units to strengthen core public sector management functions. However, further actions are needed to strengthen those core functions, particularly at the subnational level. 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. On procurement, the legal, institutional, and operational frameworks must remain dynamic and responsive to the challenges in the market as new technologies and ways of doing business arise in Mexico and elsewhere. The transformation of the procurement system has strategically targeted key legal, institutional, and operational aspects. Legal reforms involved amending procurement law (2009) and secondary legislation (2010–11) and eliminating many internal regulations. Institutional and operational changes strengthened the roles and capabilities of the Ministry of Public Administration with the development of a Procurement Intelligence Unit,5 improved stakeholder engagement, a procurement certification process for procurement professionals, and process standardization and system improvements in the e-procurement platform, Compranet. Future short- and medium-term policy reforms should focus on achieving greater efficiency and best-value-for-money outcomes, and increasing competition and transparency by shifting procurement toward performance outcomes. World Bank- Public Sector Modernization 8 Mexico Policy Note 9 Progress on performance-based budgeting requires progress on accounting harmonization. A strong financial management system, as envisioned by SIDAFF and the accounting harmonization agenda, is fundamental to performance-based budgeting. Pursuing the agenda of the Accounting Harmonization Council (CONAC) and consolidating performance-based budgeting will be critical. However, CONAC’s ambitious agenda needs to be revised to ens ure smooth implementation, and an enforcement mechanism needs to be established since there is no incentive mechanism to truly engage the states. In addition, evaluation functions—including those of CONEVAL, the Ministry of Finance, and the Ministry of Public Administration6—need to be clarified and consolidated. Finally, Mexico should continue working on its open budget/government transparency agenda, a proven tool for citizen influence on service delivery standards in other countries. The federal government needs to complete the implementation of SIDAFF’s systems and apply the accounting manual principles throughout the government, including in state- owned enterprises. Going forward, the key issue is to preserve the role, effective application, and maintenance of SIDAFF. That makes it critical to reach the so called “point of no return�— the implementation strategy milestone that secures all those requirements through the end of the current administration and the six years of the next. It is thus important to have in place a program to advance ownership and effective application, with proper indicators. The program should include strengthening the staff capacity of the Government Accounting Unit (Unidad de Contabilidad Gubernamental e Informes para la Gestión Publica, UCGIGP). In addition to having an implementation strategy and building political and technical consensus, political leadership, training, and dissemination strategies are key to the successful implementation and sustainability of SIDAFF. Establishing a strong fiscal accounting culture will protect all the products developed under SIDAFF (accounting manual, guides, functional specifications, and system integration) and implemented after years of painstaking preparation. Continuing training and communication activities will complement the sound accounting rules. The training has to be done within UCGIGP and the rest of the Ministry of Finance, including the Oficialías Mayores and the rest of the federal administration. 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. Fiscal transparency at the subnational level would promote accountability and fiscal consolidation. In addition, a more transparent accounting framework would improve expenditure monitoring and encourage efficiency. The Ministry of Finance and CONAC7 will be important if SIDAFF implementation at subnational level is to continue according to the LGCG. Incentive mechanisms for subnational governments that adopt an integrated system, and support to those that are willing to move forward with the requirements of the LGCG, will be important through 2013. World Bank- Public Sector Modernization 9 Mexico Policy Note 9 MATRIX OF SHORT- AND MEDIUM-TERM POLICY REFORM OPTIONS* POLICY AREA SHORT-TERM OPTIONS (1 YEAR) MEDIUM-TERM OPTIONS (2–3 YEARS) Improve tax collection  Transition from manual to electronic tax  Implement a more ambitious tax and administration revenue collection systems. (AR) revenue reform (LR, see Policy Note  Improve management of collection 8). enforcement through a more efficient  Move toward a single tax registry taxonomy of cases and subjects (AR). (AR).  Enhance tax audit capacity and increase  Implement information management related human resources (AR) systems with a wide range of  Carry out business process reengineering performance indicators and better of state administrations (AR). databases (AR).  Improve consistency in property valuation techniques, cadastre management, and interagency coordination (AR).  Promote incentives for tax collection and reduce discretionary transfers (AR). Improve quality of  Implement CONAC’s agenda with a  Implement and consolidate public expenditure: realistic framework that facilitates and performance-informed budgeting public financial enforces implementation at the state level reforms across sectors and coordinate management, (AR) with the accounting harmonization accounting  Consolidate evaluation functions and agenda and SIDAFF (LR). harmonization, and clarify evaluation competencies among  Strengthen public sector budget performance- CONEVAL, the Ministry of Finance and management functions to gradually informed budgeting Public Credit, and the Ministry of Public move to a performance orientation Administration (AR). (LR).  Institutionalize the specialized unit into a formal evaluation unit within the Ministry of Finance (AR)  Clarify the process and roles for using evaluations in program redesign (AR).  Continue to implement the treasury single account (AR).  Develop training and dissemination strategies for SIDAFF (AR).  Provide support and incentives for subnational implementation of SIDAFF (AR).  Advance the open budget/government transparency agenda (AR). Improve quality of  Conduct risk and benefit assessments of  Professionalize the procurement public expenditure: the market and suppliers (AR). workforce. (AR) procurement  Support the Procurement Intelligence  Introduce management tools and Unit and Compranet (AR) functions (such as monitoring and  Review the legal framework for civil evaluation, data collection, works, goods, and services (including performance indicators, and outcome framework agreements, reverse auctions, evaluations). (AR) and standardization process). (LR) *LR=Legal Reform; AR=Administrative Reform. Preliminary Classification World Bank- Public Sector Modernization 10 Mexico Policy Note 9 NOTES 1 OECD data combine property tax collection with proceeds from state-owned enterprises, which tend to overestimate Mexico’s collection rate. 2 See World Bank policy note “Subnational Public Finances in Mexico: Main Challenges and Possible Solutions.� 3 The Presupuesto Basado en Resultados y Sistema de Evaluación del Desempeño (PBR-SED). 4 Unidad de Política de Contrataciones Públicas, Política General de Contrataciones Públicas, 2012. 5 Unidad de Políticas de Contrataciones Públicas, Subsecretaría de Responsabilidades Administrativas y Contrataciones Públicas, Ministry of Public Administration. 6 The law designates CONEVAL, the Ministry of Public Administration, and the Ministry of Finance as the public entities to coordinate evaluations. CONEVAL covers evaluations for social programs, and the Ministry of Public Administration and the Ministry of Finance cover the other evaluations for public programs. Having these competencies dispersed across three major players is a valid yet sometimes confusing framework. 7 The LGCG created CONAC, which has issued most of the harmonized accounting instruments for the government accounting system required to implement the law. REFERENCES Latinobarómetro. 2011. OECD (Organisation for Economic Co-operation and Development), OECD Stats extracted on 29 May 2012. http://stats.oecd.org/ CEPAL (Economic Commission for Latin America) Statistics (2010). World Bank- Public Sector Modernization 11 Mexico Policy Note 10 STRENGTHENING SUBNATIONAL PUBLIC FINANCE EXECUTIVE SUMMARY Message 1. Mexico’s intergovernmental transfer system needs to reduce vertical imbalances and discretionary federal transfers. The dependence of Mexico’s states on federal transfers has increased dramatically and now amounts to about 90 percent of subnational public revenue. These vertical imbalances, combined with the rise in discretionary federal transfers, have lessened the states’ incentive to raise their own revenue. The fiscal federalism reform should focus on addressing these challenges. Message 2. Mexican states need to raise more of their own revenues and improve the transparency and efficiency of expenditures. A salient characteristic of the Mexican fiscal federalism framework is the states’ low level of subnational tax effort (about 10 percent of GDP compared with 20 percent in Brazil). At the same time, subnational expenditures (half of the country’s total public expenditures) have been growing rapidly and now constitute two-thirds of total subnational public expenditures. The rise in state expenditures is partly explained by growing societal needs. But it is also the result of unfunded mandates that emerged from an incomplete fiscal decentralization process. This problem is compounded by limited budget flexibility, as most of the subnational revenues are earmarked federal transfers. In addition, there is a need to standardize subnational budgets and increase their transparency. Message 3. Mexico’s subnational borrowing framework could be strengthened to improve fiscal discipline. The borrowing framework relies on market mechanisms, as reflected in the state credit risk premium charged by private lenders. While successful in keeping subnational debt at low levels (about 2.5 percent of GDP, compared with 10 percent in the United States), the framework has not prevented fiscal distress. Subnational debt has risen rapidly since 2008. 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 the states’ own revenues and improve expenditure management. And it calls for a transparent crisis resolution mechanism for states that fall into fiscal distress. OBJECTIVE This note assesses Mexico’s pending subnational fiscal reform agenda. Mexico is a federal country divided into 31 sovereign states and one federal district. Each state is composed of municipalities. The fiscal federalism framework in this three-tier government structure consists of the set of laws, rules, and institutions that allocate spending and tax responsibilities and of the transfers and institutional framework for the subnational debt. Mexico has made great progress in strengthening its fiscal federalism framework over the past 10 years, but there is room for improvement. The pending Mexican fiscal federalism reform should focus on decreasing the large vertical gaps that states face, increasing local revenue mobilization, increasing the transparency and effectiveness of local expenditures, and strengthening the subnational borrowing framework to improve states’ fiscal discipline. World Bank- Subnational Public Finance 1 Mexico Policy Note 10 KEY CHALLENGES The federal transfer system faces vertical imbalances and a growing discretionary component The Mexican federal transfer system is affected by growing vertical imbalances. States depend heavily on federal transfers to cover their expenditure needs and debt obligations. Federal transfers account for about 90 percent of Mexican states’ revenues. There are three types of federal transfers: federal tax revenue shares (participaciones), which represent about 38 percent of states’ revenues; federal grants earmarked for mandated expenditures (aportaciones), amounting to about 40 percent of states’ revenues; and ad hoc federal transfers for sector-specific expenditure agreements (convenios), which make up about 10 percent of subnational revenues. Participaciones were set up to “reimburse� tax revenues to states, whereas aportaciones emerged as a response to the Mexican expenditure decentralization process. Figure 1 shows the amount of transfers going to Mexican states. 1 Richer states tend to receive higher non- earmarked transfers. This is consistent with the reimbursement principle (principio resarcitorio), which assigns more resources to states that contribute a greater amount to the federal tax pool.2 Aportaciones are more progressive, as suggested by the positive slope of the trend-line (though there is a lot of variability around the trend). A recent evaluation from CONEVAL suggests that the allocation of aportaciones could be improved (see Policy Note 5). Figure 1. Richer Mexican states tend to receive larger participaciones, whereas aportaciones tend to be more progressive—though there is great variation around the trend 2011 Participaciones per capita (Pesos) 2011 Aportaciones per capita (MX Pesos) 6500 7500 6000 7000 5500 6500 5000 6000 5500 4500 5000 4000 4500 3500 4000 3000 3500 2500 3000 QROO AGS SIN MOR NL PUE VER BC COL DGO DF YUC QRO CAM BCS TLAX ZAC MICH CHIS TAMPS HGO CHIH TAB JAL SLP GTO SON NAY OAX COAH EDOMEX GRO AGS DGO MICH TLAX DF YUC QRO HGO CHIH TAB COAH JAL SLP SON OAX EDOMEX Source: Ministry of Finance and Public Credit (SHCP). Convenios are sector-specific expenditure agreements that opened up the possibility of additional discretionary transfers from the federal government. Convenios play an increasingly important role in the Mexican intergovernmental transfer system (figure 2). They are determined according to agreements signed throughout the budget year between state governments and federal government agencies. This arrangement opens up the possibility of additional discretionary transfers from the federal government to the states. In addition, other, less transparent venues for providing additional financial assistance to states exist: taxes condoned, social security contributions (for federalized teachers insured with the federal ISSSTE), or payments of public services (such as electricity or water fees). The amount of annual discretionary transfers and financial assistance provided to states is increasing, though World Bank- Subnational Public Finance 2 Mexico Policy Note 10 exact information is difficult to obtain. These discretionary transfers soften the budget constraint that subnational governments ought to face to avoid excessive spending financed out of a common pool of resources. Rather than raise their own revenues, control expenditures, or even borrow from the markets, states have the incentive to lobby for more resources. Figure 2. Convenios have been growing fast in recent years Convenios to Own-State Revenues (%) Convenios to Total State Revenues (%) 85.0 7.5 80.0 7.0 75.0 70.0 6.5 65.0 6.0 60.0 5.5 55.0 50.0 5.0 2006 2007 2008 2009 2010 2006 2007 2008 2009 2010 Source: Ministry of Finance and Public Credit (SHCP) and National Institute of Statistics and Geography (INEGI). Low level of states’ own-revenues States’ own-tax revenues have increased in recent years but are still low. Own-tax revenues moderately increased over the past few years (the average growth rate over 2005–10 was about 6 percent). Their share in total revenues currently stands at about 12 percent, which is still lower than in other countries in the region such as Argentina (17 percent) or Colombia (30 percent). The increase in subnational revenues after 2000 was partly due to stronger economic activity and partly to an increase in the number of taxes collected by subnational governments (an increase in their tax base). For example, by 2000, 23 of 32 states collected the payroll tax; by 2009, all 32 states did. State-specific information reveals some degree of heterogeneity among Mexican states. The Federal District and a few other states (Baja California Sur, Chihuahua, and Nuevo Leon) show a higher tax effort. But the share of own-revenues collected by other states is very low, representing less than 5 percent of total revenues in Guerrero, Nayarit, Oaxaca, Puebla, Tabasco, and Tlaxcala). The share of own-revenues is lower than 7 percent for more than a third of Mexican states (figure 3). Mexican states surrendered their most valuable taxing powers to the federal government in 1980. The states gave up their ability to tax income and commercial activities and allowed the federal government to impose an income tax (ISR) and a value-added tax (VAT).3 The aim of the reform was to improve tax collection efficiency, unify the tax authority, and reduce tax evasion. In exchange, the federal government agreed to share revenues with subnational governments. This was the origin of the current system of participaciones (non-earmarked transfers to subnational governments). World Bank- Subnational Public Finance 3 Mexico Policy Note 10 Figure 3. Subnational own-revenues increased recently but remain low. Own-revenues are less than 7 percent of total revenues for more than a third of Mexican states Own Revenues/Total Revenues (%) 2010 Subnational Revenue Composition 45 100% 40 90% 35 80% 30 70% 25 20 60% 15 50% 10 40% 5 30% 0 20% -5 10% VER SIN AGS COL NL BC MOR QROO DGO MICH TLAX DF BCS SLP YUC QRO CAM National ZAC GTO HGO CHIS OUE CHIH TAMPS TAB JAL NAY SON COAH OAX EDOMEX GRO 0% Own revenue/ Total revenues Ratio 2010 Federal Transfers Own Revenues 2005-2009 Growth Own Revenue Financing Other Source: Ministry of Finance and Public Credit (SHCP). Today, the largest tax handle for Mexican states is the payroll tax. The payroll tax accounts for almost 80 percent of state tax revenues, and states are free to set the tax rate. But rates are rather homogeneous across the states, at around 2 percent; in Baja California Sur and the State of Mexico, the rate is higher, at 2.5 percent. The “local tenencia� (on cars older than 10 years) and the lodging tax are also relatively important (even if much less than the payroll tax). The “federal tenencia� (on car ownership and use) and the ISAN (on new cars) are “federally coordinated.� This means that tax rules (including the definition of the tax base and the determination of the tax rate) are set by the federal government, but states collect these taxes and keep the proceeds. The special tax on gasoline and diesel fuel (fixed fee per liter), which was introduced in 2008, has similar features. Its base and rate are determined by the federal government), but it is administered by the states, which keep all of the proceeds collected from this tax. Overall, the amount collected through “federally coordinated� taxes is similar to what is collected through the payroll tax and therefore constitutes a critical source of revenue for Mexican states. The low level of subnational tax effort is one of the main vulnerabilities of the fiscal federalism framework in Mexico. States’ dependence on federal transfers constitutes a severe vulnerability, as confirmed by the Lehman crisis. The slowdown of economic activity and the drop in oil prices led to a dramatic reduction in the amount of federal revenues shared with subnational governments. While federal public finances were partly protected from exogenous shocks because of the government fiscal risk management strategy (for example, the oil hedging program), Mexican states were defenseless and subnational public finances were hit hard.4 Subnational expenditures have been on the rise and should be more transparent and efficient Subnational expenditures have been growing in recent years. They currently constitute more than half of total public expenditures (figure 4). During the 1990s spending powers were largely transferred from the federal government to states and municipalities. In 1992 Mexico’s federal government decentralized primary education, effectively transferring to the states the responsibility to finance basic education. This implied also transferring the teachers’ large wage bill. In 1996 health services were decentralized to the states, too. Expenditure pressures kept World Bank- Subnational Public Finance 4 Mexico Policy Note 10 increasing in recent years (up 100 percent during the last decade). The rising cost of state retirement plans will create additional pressures. They currently represent 2.3 percent of total retirement accounts in the country but are projected to increase during the next decade. Figure 4. Subnational expenditure responsibilities increased and led to significant vertical imbalances Subnational Expenditure / Total Public Expenditure (MXN billion, 2010 prices) Expenditure (2010) 1400 1300 1200 1100 1000 Subnational 900 Expenditure 52% 800 700 600 500 400 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Ministry of Finance and Public Credit (SHCP) and National Institute of Statistics and Geography (INEGI). Source: Ministry of Finance and Public Credit (SHCP). States' Operational Expenditures Expenditure/Own-Revenue Ratio as a Percentage of Ordinary Fiscal Revenue 45 Bottom 3: PUE+ TLAX + YUC 11.5 82 40 Top 3: BCS+ HGO + SLP 80 35 National 11 78 30 10.5 76 25 74 20 10 72 15 70 10 9.5 68 5 2004 2005 2006 2007 2008 2009 0 9 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Fitch Ratings. Source: Ministry of Finance and Public Credit (SHCP). Greater expenditure management efficiency is needed to gradually reduce the burden of current expenditures as well as budget rigidity. States’ current expenditures have been increasing in recent years. According to Fitch data, operational expenditures (defined as current expenditures and transfers) increased from MXN 300 billion in 2007 to MXN 370 billion in 2010. On top of that, some recurrent expenditures (such as social transfer programs) have been classified as part of the state investment program. The large and increasing amount of operational expenditures limits states’ budget flexibility. To address this issue, the increasing trend of current expenditures needs to be reversed by increasing the efficiency of expenditures (for example, in education). Subnational debt is also on the rise and some states are in fiscal distress The global financial crisis severely affected the amount of federal transfers to subnational governments. The decrease in oil prices meant significantly lower oil revenues, which are World Bank- Subnational Public Finance 5 Mexico Policy Note 10 shared between levels of government. In addition, the subdued level of economic activity implied a significant reduction in federal tax revenues, 5 which are also shared. Overall, the combined impact of these shocks implied significantly reduced transfers for subnational entities and created an aggregate gap in their balances of about 70 billion pesos (three times the amount accumulated in the FEIEF, the “rainy day� fund created through annual federal surplus revenues). To fill the gap created by high expenditures and lower revenues, subnational governments borrowed resources from commercial banks and debt levels increased. Subnational debt showed a particularly strong increase in the period following the Lehman crisis. Subnational debt registered by SHCP amounted to MXN 390.8 billion ($30.0 billion) by the end of 2011 after increasing at an annual rate of nearly 20 percent in real terms since 2008. Over 2001–08 subnational debt had expanded at a much more moderate average annual pace of 6 percent in real terms. Subnational borrowing capacity has shrunk since the global crisis. Compared with GDP, aggregate subnational debt in Mexico appears low relative to international standards since it accounts for about 3 percent of GDP, well below its share in countries such as Argentina, Brazil, and the United States (7, 12, and 19 percent of GDP, respectively). However, in view of the limited ability of subnational governments to impose taxes, the debt-to-GDP statistic can be misleading, and subnational borrowing capacity is probably better measured by comparing subnational debt with the percentage of subnational revenues that can be used or pledged for debt service payment. With this aim, shared federal tax revenues (participaciones) have often been used as the denominator, because these resources are not earmarked for the use of specific expenditures or in predetermined sectors. According to SHCP, the average level of subnational debt as a percentage of participaciones increased to 79 percent in 2011 after hovering around 50 to 55 percent over the past decade.6 Subnational debt is high and has been growing rapidly in some Mexican states. To assess subnational indebtedness levels, it is essential to go beyond national aggregate figures (which are still relatively low) and consider state-specific situations. Figure 5 shows that heterogeneity is high and has increased since the Lehman crisis (the coefficient of variation is equal to 80 percent, up from 64 percent in 2008). In some states the debt to participaciones ratio is very low (such as Campeche or Tabasco) and/or has decreased during the last three years (Estado de Mexico, Oaxaca, and Sinaloa). But there are states where debt exploded after the Lehman crisis (such as Coahuila and Quintana Roo) and became a significant source of vulnerability. In several states, the growth of subnational debt was driven by the increase of short-term debt. In Mexico, state legislatures have the right to define what constitutes debt. Most states do not consider liabilities whose maturity is less than a year to be debt. This has had important consequences. If the state definition of debt does not include short-term debt, the contracting of debt does not need to be approved by the local congress. If short-term debt is not officially considered as debt, it can be used to finance current expenditures. In addition, the 2009 modification of bank prudential regulations exempted short-term debt from a higher risk rating and the need to establish prudential reserves. 7 Consequently, short-term debt increased significantly during the past two years (figure 5) and the rapid accumulation of short-term World Bank- Subnational Public Finance 6 Mexico Policy Note 10 liabilities resulted in unsustainable debt levels and fiscal problems in some states (such as Coahuila). Figure 5. Subnational debt significantly increased over the last three years, particularly in some states Total Subnational Debt (MXN billion, 2011 Short-term Debt Evolution 500 Prices) 27 43 400 41 26 39 billion pesos 25 37 300 24 35 23 33 200 31 22 29 100 21 27 20 25 July 09 Oct 09 Jan 10 Apr 10 July 10 Oct 10 Jan 11 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 ST debt/Total banking credit ST debt Average National Debt/Participaciones (%) Debt/Participaciones Ratio in Each State 350 (%) 100 79 300 80 2011 2008-2011 Growth 250 60 200 40 150 100 20 50 0 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 -50 SIN HGO GRO BCS TABS COAH COL DF QRO VER JAL SLP SON PUE OAX MOR QROO NAY MICH TAMPS GTO NL BC DGO MEX CHIH CHIS AGS ZAC YUC CAMP TLAX Source: Ministry of Finance and Public Credit (SHCP). Nonregistered short-term debt led to growing discrepancies between debt included in the federal debt registry and actual subnational debt. This issue became particularly relevant for states such as Chihuahua, Coahuila, Michoacán, Tabasco, and Zacatecas. In Coahuila the actual amount of debt turned out to be four times higher than the amount registered in SHCP. As a result, in 2011 its financial distress took the authorities and market participants by surprise, partly because there was misreporting and underreporting of the state’s debt and partly because these loans were not considered when monitoring loan concentration. The lack of complete and reliable information on subnational entities’ liability position raised questions regarding the borrowing framework. Credit ratings were used by bank regulators to assign capital risk weightings and prudential reserves for bank loans to subnational governments. But the overdependence on rating agencies, and decreased regulation of short-term debt, reduced due diligence by some financial institutions and led to fast debt growth and high lending concentrations. The borrowing framework was recently improved. In September 2011 the government modified banking regulation, linking prudential reserve requirements for lending to subnational entities with a comprehensive set of indicators. However, additional reforms are still needed. World Bank- Subnational Public Finance 7 Mexico Policy Note 10 POLICY OPTIONS Raise subnational own-tax effort Subnational governments in Mexico should raise more taxes. Higher subnational tax efforts would have several advantages, including: improving the resilience of Mexican states to exogenous shocks; reducing the dependence on oil-related revenues, which are projected to decline; preparing states to face the growing burden of retirement benefits; and increasing subnational states’ capacity to repay their debt (thus lowering the borrowing costs). Several strategies could be considered to achieve this objective. Improving tax administration would offer states an opportunity to raise more revenues. In addition, states could levy surcharges on a tax defined and administered by the federal government. Another option is to improve property tax collection. Property taxes are the ideal tax at the subnational level of government, as the tax base cannot be shifted easily from one jurisdiction to another. The collection of property tax (which is levied at the municipal level) is very low (0.2 percent of GDP compared with an average for OECD countries of almost 10 times as much). Mexican states could be involved in strengthening property tax collection for their municipalities. Political economy factors complicate states’ incentives to increase tax collections. For political reasons, it is difficult for states to raise or even maintain tax collection levels (especially when taxes are closer to the voters). The recent experience with tenencia offers a clear example of these political limitations. In 2007 the federal government proposed to transform the federal tenencia and gave states five years to enact local tenencia laws. Notwithstanding the importance of this tax, many states decided to repeal it, particularly those having elections. Political disincentives could be managed through the imposition of “federally coordinated taxes .� But beyond political reasons, states’ incentives to raise more taxes are also limited by the possibility of receiving discretionary transfers, which soften the budget constraints that states should face. A hard budget constraint is essential to promoting fiscal consolidation at the state level. Improve the transparency and efficiency of subnational expenditures Fiscal transparency would promote accountability and efficiency of subnational expenditures. The importance of state expenditure responsibilities requires the standardization of the classification of states’ budgetary expenditures. Currently, subnational budgetary reporting is not homogenized. Teacher payrolls are a clear example. According to the National Institute of Statistics and Geography, state teachers’ payroll may be filed under “Personal Services� or “Transfers� in official public finance statistics. States report spending less than 20 percent of their budget on payroll. In reality, a large part of the payroll is filed under transfers. The Mexican Institute for Competitiveness estimates that, due to the lack of transparency, hidden payroll costs amount to 4 percent of GDP. It is critical to make expenditure reporting more transparent to verify the actual destination of earmarked transfers and promote accountability and efficiency of expenditures. Classifying all payrolls under Personal Services (Chapter 1000) would constitute a step in the right direction. A clearer distinction between federal and state expenditure responsibilities, especially in the basic education sector, could improve service delivery. Education is the main area that presents an issue of overlapping responsibilities. The decentralization of expenditures for this World Bank- Subnational Public Finance 8 Mexico Policy Note 10 sector, and in particular for basic education, is often criticized. Even though states continue to have limited responsibilities in implementation or actual delivery (as norms and financing are determined centrally), they perceive significant expenditure pressures generated by this decentralization. An example is provided by increases in teacher salaries. Negotiations on wages take place at the federal level, but the additional fiscal burden is borne by the states. Limited control of spending negatively affects expenditure efficiency. Improve subnational fiscal discipline The intergovernmental federal system requires better defined procedures for crisis resolution as an alternative to the ad hoc federal transfers. A framework for state insolvency could be developed to provide incentives to good practices in exchange for federal assistance. This may take the form of federally supported subnational fiscal adjustment plans, in which fiscal and service delivery targets are set on measures to expand revenue, rationalize expenditures, or restructure public debt. Fiscal adjustment plans would be accompanied by transfers or loans from the federal government conditioned on the implementation of the program. The main differences with the current practice of ad hoc federal additional transfers may include the conditioning of the financial support and the transparency with which the program is implemented. A more transparent debt reporting is also needed to strengthen subnational fiscal discipline. Strengthening debt data accuracy and particularly, the automatic inclusion of short- term debt in the definition of state debt would be a relevant policy reform. The establishment of a common budget classification system in parallel with the harmonization of accounting across government levels is also required to enhance transparency and fiscal discipline (see Mexico Policy Note on Public Sector Modernization). Matrix of short- and medium-term policy reform options* Reform area Short-term options (1 year) Medium-term options (2–3 years) Improve  Reduce discretionary  Review the subnational subnational fiscal transfers to subnational borrowing framework to include discipline states (LR) a crisis resolution mechanism in  Include short-term debt in case of state’s fiscal insolvency the definition of debt for all (LR) states (LR) Raise subnational  Impose federally  Strengthen tax administration at own-revenues coordinated taxes (such as the subnational level (AR) ISAN) to promote state  Strengthen property tax own-revenues (LR) collection efforts by states (LR). Improve  Harmonize accounting of  Standardize subnational transparency and state payroll expenditures budgetary reporting (LR). efficiency of (LR)  Distinguish clearly between expenditures state and federal expenditure responsibilities (LR). *LR=Legal Reform; AR= Administrative Reform. Preliminary classification. World Bank- Subnational Public Finance 9 Mexico Policy Note 10 NOTES 1 The income ranking for these charts is based on non-oil mining GDP per capita. Standard state’s GDP figures carry a distortion due to the fact that a large share of the offshore oil production is assigned to Campeche. When GDP except oil mining is used, Campeche moves from the first to the fifth position. 2 This trend is gradually evolving. In recent years, the “regressivity� of participaciones was gradually diluted, as shown by the decreasing steepness of the participaciones trend-line (see the red line in figure 1). 3 In 2009 these two taxes represented about 80 percent of Mexican public sector tax revenues. 4 This example underlines the importance of having a fiscal risk management strategy in place. States could consider designing a fiscal risk management strategy to smooth the flow of federal transfers. 5 Federal non-oil tax revenues during 2009 decreased 10.5 percent in real terms. 6 More recently, SHCP has started to integrate a series which broadens the definition of subnational resources that can be used and pledged for debt service payment, including state and local government own-revenues (local taxes and fees) and part of federal transfers for basic infrastructure. Using such a broader denominator, subnational debt increased to an average of 61 percent of subnational governments’ available revenue in 2011 fro m 41 percent in 2007, according to SHCP data. 7 The 2011 reform of banking regulations addressed this specific issue. World Bank- Subnational Public Finance 10