# **1. Introduction**

The question of what is the effect of inequality on crime has been a matter of interest among many researchers and policy analysts. While most of the literature on this topic finds a positive effect of inequality on crime, the empirical evidence has fallen short in establishing an unambiguous direction of causality (see Pridermore, 2011), as well as on whether the effect holds for different types of violent crime. Moreover, when focusing on developing countries the available evidence is weaker given that reliable and comparable crime statistics tend to be scarce. In addition, scholars have faced other major challenges when delving into this subject. For example, cross-country studies are usually biased by measurement error and omitted variables problems, and they are also limited by smallsample sizes. Reverse causality is a matter of concern, since increasing crime rates might also affect inequality by, for example, encouraging richer residents to move out of violent locations.

Neumayer (2005) points out that focusing on within-country variation could be a remedy to the difficulty to control for confounding factors at the country level and to the small-sample problem that arises in cross-country analysis. Nonetheless, even when those problems have been addressed, the reverse causality problem remains. In this paper, we take a step forward seeking to tackle the aforementioned challenges by focusing on within-country variation at the municipal level in crime and inequality in Mexico and proposing an instrumental variable that is related to changes in local income inequality levels but uncorrelated with changes in local crime rates.

We focus our attention on Mexico as it represents a unique case among developing nations. First, in terms of crime rates, while the total rate of homicides in Mexico followed a downward pattern for the 1990-2005 period, the picture is totally different for the period from 2005 to 2010. For example, in 2005 the total rate of homicides was close to 11 deaths per 100,000 individuals, while by 2010 it was 18.5 deaths (Mexico’s National Public Security System, SNSP, 2011). This sharp increase in the rate of total homicides is mainly due to the rising number of violent crimes associated with drugrelated activities e.g., in 2005 there were more than 7,000 deaths related to non-drug crimes, nearly double the number of deaths caused by drug-related homicides; by 2010 the situation had completely turned around, that is, the number of drug-related homicides more than tripled the number of non-drug related homicides (see Figure 1). To illustrate the economic implications of this matter, victimization surveys estimate that in 2010 crime cost victims losses valued at US$12.9 billion. In addition, for that same year, 42.8 percent of Mexico’s firms paid for private security, spending about 2.2 percent of their annual sales on these services (IFC and WB, 2012); and reductions in economic activity and growth were found at the municipal level between 2006 and 2010 (Robles et al., 2013, and Enamorado et al., 2013).

Second, while there have been major advancements in reducing income inequality in Mexico over the last fifteen years—with a decline from 0.547 to 0.475 of the Gini coefficient for the distribution of household per capita income (Lustig et al., 2012)—heterogeneity across regions remains. Between 1990 and 2005, about 90 percent of the municipalities in Mexico registered a decline in income inequality, while between 2005 and 2010 about 78 percent of the municipalities experienced a reduction of their Gini coefficient. Despite an overall decrease in the Gini coefficient at the national 2