The incidence of Social Security regulation: Evidence from the reform in Mexico

This paper contributes to the literature that evaluates the cost of labor regulations by studying how wages and employment respond to the new legislation that ties benefits to costs. The contribution of this paper is twofold. First, it derives a general equilibrium model to determine the effects of Social Security programs when there is a sector that does not comply with the regulation and workers self-select into the covered sector. Second, this paper provides estimates on the incidence of Social Security taxation consistent with this economic environment.I find that even if wages adjust completely between the complying and the noncomplying sector, there are still several important equilibrium effects that must be considered. First, regulation is not neutral across economic sectors. Regulation increases the relative cost of labor to firms with higher costs of non-compliance. Second, Social Security regulation distorts the optimal allocation of factors between sectors when firms that have the highest cost of avoiding the regulation differ in their production technology to the rest of the economy.Because regulation is not neutral across economic sectors, workers' employment prospects in the non-complying sector vary according to their skills. Consequently, workers selection into the covered sector is determined by preferences for coverage, but also by comparative advantage. A result of the model is that when benefits from coverage are heterogeneous, Differences-in-Differences estimators offer little evidence on the incidence of labor taxes on wages. Instead, I provide evidence based on structural labor parameters that determine equilibrium wages.