Fiscal Reform in Mexico

Twenty five years ago, Mexico had a dream: to fund ambitious State-led industrialization through the use of external debt and its vast oil export revenues and join the ranks of rich, developed countries. When the international oil market collapsed in the first half of the 1980s and the country’s access to foreign capital was drastically interrupted, the dream became a nightmare. Economic activity stagnated, consumer prices soared, and Mexico became one of the most heavily indebted nations in the world.

In the aftermath of this failed experiment, the Mexican government decided to abandon its, until then, traditional development strategy based on trade protectionism and a strong intervention of State-controlled firms in the economy. With a budget deficit equivalent to 15% of gross domestic product (GDP)way above internationally accepted norms the government found itself needing to increase its revenue and/or cut down its expenditure. Indeed, downsizing of the public sector and slashing of the fiscal deficit began soon afterwards. Today, there are fewer than a hundred state-controlled firms, down from more than 1,150 in 1986. In turn, the fiscal deficit shrank, averaging 1.5% of GDP in the 1990s. These are major achievements. However, Mexico’s fiscal structure still has fundamental weaknesses that must be corrected to achieve high and sustained economic growth and to improve the standard of living of its largely impoverished population.

First, the impressive contraction of the deficit was achieved by cutting down public investment. This strategy threatens to bring about a severe deterioration of basic infrastructure and has already eroded the capital stock of key industries where state-controlled firms play a main role (oil, basic petrochemicals, and electricity). In fact, the stringent limits to capital expenditure by PEMEX Mexico’s State-run oil monopoly have ultimately led to a reduction in oil reserves and an extremely low level of extraction of natural gas which must now be imported in significant volumes.

Second, about one third of Mexico’s fiscal income depends on oil revenues. These highly volatile revenues may lose importance if the international market oil price keeps declining in real terms. Furthermore, this dependence is guaranteed by a rather distorted tax scheme imposed on PEMEX that, in practice, deprives it from all profits and provides no incentive to make oil extraction more efficient.

Third, and most important, Mexico’s tax revenues excluding oil are extremely small ( approximately 11% of GDP). This is the lowest proportion registered by any OECD country and is similar to the tax performance of much poorer countries. More, tax performance drops below the 15% considered to be the minimum proportion of GDP that a government should absorb in taxes in order to provide the public services and basic infrastructure required by a modern society. Such limited revenues are the consequence of endemic tax evasion and an outdated fiscal regime that has significant distortions and fails to cover the activities of Mexico’s large informal sector. In Mexico, unlike in the United States, capital gains in the stock market are not taxed.

Finally, although Mexico’s fiscal deficit is low, its conventional measure fails to register certain disbursements so called contingent liabilities which have grown massively in recent years. In particular, it ignores the billions of dollars provided by the government to avoid the default of the domestic banking sector in the aftermath of the tequila crisis of 1994-95. According to some World Bank estimates, the size of this rescue package mounts to approximately 19% of GDP! In addition to this bank bailout, the public sector has other liabilities related to the highway rescue package to bad loans of development banks as well as to local governments’ debt. To avoid the latent threat of an acute financial imbalance the government will have to make important changes in Mexico’s fiscal structure. According to one of the largest banks in Mexico, if all such liabilities are converted into public debt, the government will have to generate a budget surplus for the next 20 years just to keep its finances under control.

The need to raise considerably more tax revenues has been recognized by practically all of the previous presidents of Mexico. There is a big difference, however, between identifying a problem and solving it. Who will pay the new taxes? What will the government do with the increased revenue? These questions require clear answers to convince citizens, organizations, and political parties to support any fiscal reform. Clearly a government that is perceived as legitimate and democratically elected will be more likely to successfully implement such reform. Unfortunately, in the case of Mexico, where until last year one party, the PRI (Partido Revolucionario Institucional), had ruled for more than seven consecutive decades, such governments have been the exception and not the rule. July 2, 2000 marked a new era in Mexico’s political system when Vicente Fox, the candidate from a coalition of opposition parties, won the presidential election. During his campaign Fox said that his government would rule more democratically. In passing, he also stated his intentions to carry out a fiscal reform. In his inauguration speech last December, he argued that from then onwards the political power would effectively rest on Congress and not on the Presidency.

Keeping his campaign promise, President Fox sent to Congress in April an initiative presenting his detailed proposition of fiscal reform, sparking a far-from-settled national debate. In any case, Congress and not the President will have the final word. According to Mexico’s legal system, a majority in both chambers of Congress must approve any change in the fiscal regime. However, agreement won’t come easy. No political party holds a majority of seats in the Lower Chamber or in the Senate. Fox’s own party, the PAN (Partido de Acción Nacional), is 44 votes short of a simple majority in the Lower Chamber and 19 in the Senate.

Therefore, to guarantee votes, President Fox must negotiate with the opposition’s main political parties: the PRI and the left-to-center PRD (Partido de la Revolución Democrática). And, most important, he must guarantee the full support of his own party. The problem is that the Mexican political system does not have a long tradition of bargaining between the Legislative and the Executive Branch. In the seventy years of PRI rule, there was no need for negotiation because the President and the ruling party had absolute control over the Congress. Today this need is obvious and the Executive and the political parties are learning to negotiate. Apparently, at first the President took for granted the support of all the deputies of the PAN for his fiscal reform. It was an unwarranted assumption. In his first seven months in office there have been so many frictions between President Fox and the leaders of his own party (PAN) that Demetrio Sodi, a congressman for the PRD, stated, it seems that radical opposition to Fox’s proposals and initiatives comes even from his own party. The PRI and the PRD have heavily criticized the fiscal reform as originally proposed.

Fox’s initiative for fiscal reform suggests modification of different policy instruments to strengthen Mexico’s tax revenues and create a more efficient fiscal regime. However, independent of the reform’s content, strategic mistakes were made in its marketing to the public. Essentially, it seems that the political challenge of making this reform acceptable to the public was grossly underestimated.

The first mistake was that the earlier drafts and ideas of fiscal reform were not sufficiently consulted or negotiated with the different political parties. Such consultation would have helped to gain it support. Instead, in April, when the Executive sent the fiscal initiative to the Congress a massive media campaign began to gain public support for the reform. The implicit assumption seemed to be that President’s Fox popularity, plus such blitzkrieg of TV and radio advertising, would put enough pressure to induce Congress to approve the reform.

However, Mexico’s real politik had a different opinion. Many politicians and congressmen as well as ordinary citizens were unconvinced by the government campaign. Turning off their TV sets and ignoring the President’s approval ratings, they expressed strong criticism of the proposal. A few days after the initiative was sent, it was obvious that it wouldn’t get enough votes in Congress. The message was clear: no negotiation, no reform! Though there is consensus among the political parties regarding the government’s urgent need for higher tax revenues, wide disagreements persist on how to achieve it.

The second shortcoming of the fiscal proposal’s marketing strategy was the government’s failure to specify expected additional tax revenue use, making it difficult to galvanize support. Some concluded that the resources would be used to redeem government liabilities, while others considered that the revenues should help alleviate poverty. But beyond the adequacy or inadequacy of the marketing strategy, the proposed fiscal reform has two particularly contentious elements.

First is its commitment to eliminate exemptions on the VAT regime. This implies, in particular, that purchases of food and medicines as well as school tuition would now be taxed. To compensate for some of the adverse social effects of this measure, the government would implement a subsidy targeted to cover 5 million households in poverty conditions. Note, however, Mexico has at least 12 million impoverished households. According to some estimates, more than half of them won’t be covered by that subsidy. Second is the reduction of the highest rate of the income tax from 42% to 32%. This reduction will, allegedly, induce higher compliance and help to harmonize Mexico’s income tax regime with that of the United States.

Independently of the rationale behind them, these two measures have been seen rightly or wrongly as evidence that the fiscal reform will have a particularly adverse effect on the poor and the middle class. Most of its opponents state that the fiscal reform should be modified to allow for VAT exemptions on food products, medicines, and other key items that are mainly and typically bought by poor families. They also consider that the decision of lowering the tax rates for high-income families should be revised.

In any case, it is safe to say that given the current political climate, Congress won’t approve the original proposal for fiscal reform without some modifications. A main concern of all parties is to avoid getting the political blame for raising taxes. In 1995, in the middle of the most severe financial crisis in Mexico’s modern history, Congress then ruled by the PRI approved a presidential initiative to raise the value added tax rate (VAT) from 10% to 15%. The PRI paid a hefty political cost for this decision; to some extent it contributed to its subsequent setbacks including the lost control of the Chamber of Deputies (1997) and the presidency (2000). Undoubtedly Mexico must and will implement a fiscal reform in the near future. How profound will this reform be? How will different sectors and groups in society share the increased tax burden? When will the reform be implemented? All these are open questions that Mexicans are learning to answer through way more democratic procedures than they dreamed some years ago. This, in itself, is a major achievement.