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 The privatization of Mexicos government-runpay-as-you-go social security system, which wentinto effect in July 1997, is the Ernesto Zedilloadministration’s most important structuralreform. It is a measure that, if successful, will helpbring much-needed social and economic stability. The Mexican peso crisis of 1994–95 underscoredthe fragility of Mexico’s economy, its need forindependent institutions, and its need for a largepool of long-term domestic savings. An increase inthe rate of private savings in Mexico, which thisreform will promote, would make the Mexicaneconomy less dependent on short-term fluctua-tions of international capital flows and, thus,more stable. More important still, the privatiza-tion of social security will erect one of the basic pil-lars of a free society by turning Mexico into acountry of property-owning workers.  The private system, however, has several struc-tural flaws that should be corrected in the nearfuture if it is to provide workers with the rightincentives. Chief among those flaws is the require-ment to invest a
minimum
of 65 percent of work-ers’ savings in government instruments, a rule thatis not consistent with the notion of pension priva-tization. Other flaws include prohibiting invest-ment in equities or abroad; allowing the govern-ment agency that administered the old pay-as-you-go system to establish a pension fund compa-ny while retaining some regulatory functions; pro-hibiting public-sector workers from joining thenew private system; and having the governmentsubsidize every worker’s retirement account, ameasure that politicizes the private pension sys-tem and weakens the link between individualefforts and rewards.President Zedillo should use his remainingtime in office to strengthen the new pension sys-tem so that Mexican workers can enjoy financialsecurity and other benefits in their old age.
In Praise and Criticism of MexicosPension Reform
by L. Jacobo Rodríguez
 _____________________________________________________________________________________________________ 
L. Jacobo Rodríguez is assistant director of the Project on Global Economic Liberty at the Cato Institute.
Executive Summary
No. 340April 14, 1999
 
Introduction
Latin American nations from Tierra delFuego to the Rio Grande are fundamentallychanging the role of the state in the provisionof social services in a way that is more consis-tent with the principles of a free society.
1
In thearea of old-age retirement income, that newrole consists of the establishment of a regula-tory framework and the provision of a mini-mum safety net for those in need of it, leavingto most individuals the responsibility and sat-isfaction of providing for their own retire-ment. Chile led the way in 1981, when the gov-ernment there replaced its bankrupt pay-as-you-go social security system with a system of compulsory individual pension savingsaccounts managed by the private sector.
2
Sincethen, seven other Latin nations—Peru (1993),Argentina (1994), Colombia (1994), Uruguay(1996), Bolivia (1997), Mexico (1997), and ElSalvador (1998)—have also privatized theirpension systems along the lines of the success-ful Chilean model.
3
In Mexico, the substitution of an invest-ment-based private system of individual pen-sion savings accounts for a government-runsocial security system is the latest in a series of structural reforms that have radically trans-formed the Mexican economy in the pastdecade.
4
Mexico’s Pay-As-You-GoRetirement System
Mexico’s public pension system for private-sector workers was established in 1944 andhas since been managed by the InstitutoMexicano de Seguridad Social (IMSS).
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 TheIMSS also manages the national health caresystem and provides unemployment insur-ance and daycare services for private-sectorworkers. From its inception, the IMSS systemhas been plagued by numerous problems;some of those problems are general to all pay-as-you-go systems, and some are specific toMexico. Pay-as-you-go retirement programs have anintrinsic flaw that helps explain the crisis of Mexico’s public pension system. That flaw isthat old-age financial security depends on thepolitical process, in which different groupscompete against one another to determinewhich one benefits at the expense of the oth-ers. A public pension system is a compulsorygovernment program that redistributeswealth among different groups and genera-tions. Its universality is based on the faultyassumption that people are unable or unwill-ing to plan for their retirement during theirworking years and will thus be unable to pro-vide for themselves in their old age. The sub-stitution of political action for private actionhas severed the link between individual effortsand rewards, making this a self-fulfillingprophecy. In other words, individuals try tominimize their contributions to the systemwhile they are active workers and to maximizetheir retirement benefits.
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In a pay-as-you-go system, the governmenttaxes active workers to pay for the benefits of retired workers. Under such systems, retire-ment benefits are a function of the rate of growth in the tax base, which in turn dependson the rate of growth in the labor force and therate of growth in real wages per worker (i.e.,increases in labor productivity). But payrolltaxes are a tax on the use of labor, not aninvestment. Thus, they have a negative effecton employment and distort the allocation of resources.
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In the case of Mexico, total payroll taxeswere high—31.5 percent of total payroll at thetime of the reform (see Table 1)—and con-tributed to underreporting of wages, tax eva-sion, and the growth of the informal sector,where labor productivity is considerably lowerthan in the formal sector. When workers movefrom the formal to the informal sector, the taxbase usually grows smaller. As revenues failedto keep up with promised benefits, the gov-ernment had to reduce those benefits (until1989, benefits were not indexed, whichresulted in their erosion through inflation),raise taxes, or both.  The conceptual flaw was aggravated in
2
The cumulativeeffect of the sys-tem’s conceptualflaws and admin-istrative short-comings was toput it in a precari-ous financialposition.
 
Mexico by additional defects in the design of that country’s retirement program. Chief among those defects was the existence of dif-ferent retirement systems for different types of workers. As stated above, the IMSS covers onlyprivate-sector dependent workers and thoseindependent private-sector workers whodecide to register with the IMSS. That has ledto significant portability losses for workersmoving in and out of the private sector. Inaddition, private-sector workers affiliated withthe IMSS could also lose their accrued benefitseven if they changed jobs within the privatesector. Finally, under the IMSS program, someworkers could obtain a retirement pensionafter participating in the system for only 10years, whereas other workers (those choosingearly retirement, for instance) might notreceive a pension at all, even if they had beencontributing to the system for a longer periodof time. Benefits under the IMSS program arebased on the average base salary of the last 5years of a worker’s working life divided by theminimum wage at the time of the calculation.Workers also receive a fraction of their salaryfor every year they have contributed to the sys-tem in excess of the minimum requirement of 10 years. Finally, total benefits cannot exceedthe worker’s average salary in the last 5 years. The system has been plagued by otherproblems, such as corruption, bureaucraticmismanagement, and inefficiency. Theresources from the old-age retirement fundhave been used for other purposes, especiallyto shore up the national health care system. Thus, the social security trust fund in Mexico,which was supposed to have reserves equiva-lent to 11 percent of GDP in 1995, hadreserves equivalent to just 0.4 percent of GDP.
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 The cumulative effect of the systems con-ceptual flaws and administrative shortcom-
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TotalEmployerEmployeeGovernment __________________________________________________________________________ IMSS systemOld age, disabiltyand life insurance8.570255Health and maternity12.570255Workers' compensation2.510000Child care110000SAR system
a
INFONAVIT
b
5 10000Old-age retirement210000Total31.525.25.251.05 __________________________________________________________________________ 
Source: IMSS.
a
The Sistema de Ahorro para el Retiro (SAR), or Retirement Savings System, was established in 1992as a fully funded savings program to complement the IMSS system.
b
Instituto del Fondo Nacional de la Vivienda para los Trabajadores (INFONAVIT) is a government-runhousing credit agency for private-sector workers.
Table 1Total Payroll Taxes in Mexico as Percentage of Payroll _________________________________________________________________________ 

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