Size-dependent firm regulations and the return to skill: Evidence from the Mexican labor market

I develop a general equilibrium model which endogenizes the occupational choices and the assignment into firms of varying sizes of a mass of heterogeneous workers. I use the framework to study the allocation of talent if only large firms comply with regulations and thus face higher costs than smaller firms, which I model as a size-dependent tax on labor. I find that the size-dependent tax encourages employers in the middle of the managerial skill distribution to constrain the size of their firm and effectively avoid the tax, and disincentives their wage-workers to fully exploit their talent. The tax unambiguously lowers the return to skill for workers in the constrained firms and at the top of the skill distribution. If complementarities in production are not strong enough size-dependent regulations could significantly lower the average return to skill in the economy. Next I argue that in Mexico small firms face lower taxes and more lenient regulations than larger firms. I show that the distribution of workers of varying years of schooling across occupations and firm sizes in Mexico is consistent with the predictions of the model, and rely on cross-country evidence to argue that size-dependent policies partly explain the significantly large fraction of workers in micro-firms in Mexico. Finally, I calibrate the model to match the average return to schooling in the Mexican data, and solve for the equilibrium allocation of workers under a lower tax rate on all firms regardless of their size and without distortions. My results suggest that in Mexico size-dependent regulations eliminate the marginal return to improving the quality of their match by increasing schooling by one year for workers at the bottom of the skill distribution. Size-dependent taxes also significantly affect the incentives of workers at the top to match with more talented wage-workers in marginally larger firms (by approximately a quarter of a percentage point per year). The estimates also suggest that on average a uniform tax on all firms does not significantly misallocate workers to affect the return to schooling relative to a market with no distortions.