The Effect of Trade Liberalization on Informality and Wages: Evidence from Mexico

This paper studies the impact of NAFTA on informality and real wages in Mexico. Using a dynamic industry model with firm heterogeneity, it is predicted that import tariff elimination could reduce the incidence of informality by making more profitable to some firms to enter the formal sector, forcing the less productive informal firms to exit the industry, and inducing the most productive formal firms to engage in trade. The model also predicts market share reallocations towards the most productive firms, and an increase in real wages due to the increased labour demand by these firms. Using data on Mexican and U.S. import tariffs together with the Mexican National Survey of Urban Labour (ENEU), I find that reductions in the Mexican import tariffs are significantly related to reductions in the likelihood of informality in the tradable industries. I also find that informality decreases less in industries with higher levels of import penetration, while it decreases more in industries that are relatively more export oriented. Finally, I confirm that the elimination of the Mexican import tariffs is related to an increase in real wages, and that the elimination of the U.S. import tariff has contributed to the expansion of the formal-informal wage differentials.