Disentangling the Effects of Large Minimum Wage and VAT Changes on Prices: Evidence from Mexico
Published:
In January 2019, Mexican authorities increased the minimum wage by 100% in Mexico’s Northern Border Free Zone (ZLFN, by its spanish acronym, Zona Libre de la Frontera Norte), and at the same time, they reduced the VAT tax rate from 16% to 8%. In the rest of the country, the minimum wage increased 16.21% and the VAT rate did not change. In a recent article with Mariana Calderón, Josué Cortés and Alejandrina Salcedo, we study the effects of these substantial policy changes on prices.
The mexican context is important because of the magnitude of these minimum wage and VAT changes, since they may induce large price adjustments. Moreover, the simultaneous implementation of both policies is interesting in itself, as their effects may cancel out. The policy combination of a greater minimum wage and a reduced VAT rate may be specific to the mexican context. Nevertheless, the challenge of separating the effects of policies that are implementes simultaneously is frequent in policy evaluation. It is essential to be able to disentangle the effects to be able to rigurously evaluate the policies. In this case, we identify the effects of both policies separately using geographical differences in the policies and industry variation in their incidence.
Research Strategy
First, to estimate the effects of the minimum wage increase on the prices of VAT goods, we take advantage of variation in minimum wage incidence across industries in the ZLFN, and we compare the evolution of prices between industries. We measure incidence as the fraction of workers for whom the minimum wage increase is binding in each industry. These workers are those who earned less than the 2019 minimum wage in the ZLFN (176.72 pesos) in December 2018, and therefore should receive a wage increase in January 2019.
Second, to identify the effect of the minimum wage increase on the price of goods not subject to the VAT tax, we compare the prices of these goods between the ZLFN and the rest of Mexico’s northern region, taking advantage of the differential increase in the minimum wage across places.
Last, to estimate the effect of the VAT rate reduction, first, we compare the prices of VAT goods in the ZLFN with the rest of the northern region. This comparison yields a combined minimum wage increase plus VAT rate reduction effect. Then, we subtract the minimum wage effect from this combined effect, obtaining a VAT effect.
We estimate the minimum wage and VAT effects on both VAT and Non-VAT goods’ prices using a triple differences econometric model. To do this, we use administrative data from the Mexican Social Security Institute, and product level price information from the National Consumer Price Index.
Results
Figures 1 to 3 shows dynamic estimates of the effect of the policies on prices. Figure 1 shows the estimated effect of the minimum wage increase on the prices of VAT goods. The coefficient measures the effect of each percentage point of workers bound to the minimum wage increase on prices. Comparing the coefficients before and after the minimum wage increase, the coefficient is 0.00084. The average fraction of workers affected is 30.53%. Multiplying the effect and the average fraction affected yields an average price increase of 2.56%.
Figure 1. Effect of a larger fraction of workers affected by the minimum wage on VAT goods
Figure 2 shows estimates of the effects of the minimum wage increase on the prices of Non-VAT goods. This effect is small and not statistically significant, standing in contrast to the effect on VAT goods.
Figure 2. Effect of the minimum wage on the price of Non-VAT goods
The differences in the fraction of informal labor used to produce each good seem to play a role on the impact of the minimum wage on prices. Non-VAT goods tend to be produced with more informal labor, relative to VAT goods. This difference may explain the smaller effect of the minimum wage on Non-VAT goods prices. Even among VAT goods, those with a larger fraction of informal labor in production show smaller price increases associated with the minimum wage hike.
Figure 3 shows estimates of the effect of the VAT rate reduction on VAT goods’ prices. The estimated effect is a price reduction of about 4%.
Figure 3. Effect of the VAT on the price of VAT goods
Weighting these effects by their contribution to the ZLFN’s consumer price index, we find that the VAT rate reduction offset the price increase due to the higher minimum wage. The minimum wage increase led to an estimated 1.2% increase in the ZLFN’s consumer price index. The VAT rate reduction led to an estimated 2.57% reduction in prices. Combining both effects, the net effect was a 1.37% decrease in the ZLFN’s price index. Since the policy combinaton led to a price reduction, it increased workers’ real wages.