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Analysis

The Outlook for Future Fiscal Reform

Tue, 01/22/2013 - 13:43

Mexico is, by far, the member of the Organization for Economic Co-operation and Development (OECD) that raises the lowest federal income through tax; whereas member countries raise an average of 34.0% of their GDP in taxes, Mexico’s government tax income only represents 19.7% of the country’s economic output, and Pemex provides around 35% of this share. Several factors are contributing Mexico’s tax revenue, the most salient of which is the country’s large informal employment sector. The country’s latest employment figures place 29.3 million workers in the informal sector, which accounts for 60.1% of the country’s economically active population. Despite reforms made to the Federal Labor Law at the end of 2012 aimed at increasing the flexibility of the labor market, formal job creation was 22.6% lower in the first two months of 2013 compared to the same period in the previous year. Given the relaxation of contracting regulations by the recent labor law reform and the current economic growth rate in Mexico, it seems that flexible hiring schemes and a positive economic outlook alone are unable to fix this structural problem.

Starting up and developing a business in Mexico is extremely di·cult, mainly because of the country’s lending rate, which is the lowest in Latin America. Loans for new businesses often do not provide su·cient credit to survive the di·cult startup period, the amount of time and money that is put in often does not pay o†. Moreover, in some ways Mexico’s informal sector serves as a type of interest group that has been known to receive incentives in exchange for votes. As such, political motivations have added to the systemic causes of informality in Mexico, thus constraining the country’s tax base. Another of the factors a†ecting Mexico’s tax collection is evasion, a common phenomenon among the country’s biggest and highest-grossing companies. The country’s out-of-date, ambiguous tax code allows companies to deduct a high percentage of their tax load under a number of legally permitted schemes. According to the Chief Audit O·ce of Mexico, the body in charge of disclosing and analyzing the Public Account, 78.1% of the MX$285 billion that the Tax Administration Service (Servicio de Administración Tributaria, SAT) lost in tax devolutions was returned to large contributors who reported a minimum income of MX$500 million. Moreover, a great number of companies both large and small consistently commit fiscal fraud, of varying seriousness, without being prosecuted. The hundreds of billions of pesos that are lost as a result of evasion and elusion mechanisms greatly reduce the public revenue collected from an already reduced tax base, and make non-progressive taxes such as the Value Added Tax (VAT) very prominent in Mexico’s public revenue structure.

Both public opinion and the political class in Mexico are fully aware of the weakness of the country’s fiscal structure. Several reform initiatives addressing this problem have been proposed in Congress, since as early as 1962 and more recently in 2012, but few of the proposed changes have been implemented and those that have been approved have failed to significantly improve tax collection.

The political cost of these reforms has been to render the politicians behind them unpopular, and leveraging economic value from Mexico’s natural resources remains the easier option. The nationalization of hydrocarbons in Mexico has allowed lawmakers and politicians to overlook the need to improve tax collection for more than seven decades, thus allowing policymakers to avoid the challenge of generating urgently needed structural changes that are unsurprisingly widely unpopular among the country’s citizenship. After the discovery of the giant oil field Cantarell in 1974, Mexico’s oil dependence grew steadily until Pemex became the contributor of 46.0% of the country’s federal income in 1987; since then, the government’s income pool has diversified slightly, but oil still remains the source of over one third of public resources.

This combination of a low taxation rate and high dependence on natural resources makes Mexico’s fiscal system very vulnerable to the volatile commodities sector, of which the oil and gas sector remains the government’s most valuable playing card. As the cracks in the fiscal system become ever more prominent, it becomes clear that the ambitious reform scheme and large-scale public policy actions planned by Mexico’s new administration cannot overlook fiscal reform. In order to succeed in making Pemex a flagship in the international oil and gas sector while simultaneously implementing capital-intensive social programs (like the Crusade against Hunger and the endowment of pensions to all Mexicans aged 65 years and above), President Enrique Peña Nieto’s government will need to derive public income from Pemex’s revenues as well as increasing the e·ciency of tax collection in Mexico. Peña Nieto has already started tackling some of the issues surrounding Mexico’s fiscal weakness, such as the high level of evasion by large corporate entities. In the first 100 days of the current presidential term, the Ministry of Finance initiated 150 lawsuits for tax evasion against large contributors; this figure surpasses the number of complaints presented by the previous administration in the whole of 2012. However, the most important step that has been taken towards fiscal reform so far is the ample political consensus that surrounds it; this consensus is important, given that it is a subject that has long been neglected due to the negative attitudes held by several interest groups to potential change in this area.

The commitment to fiscal reform is mentioned in the Pact for Mexico, an agreement that has been signed by the President and the four biggest political parties in the country. In fact, in order to achieve 46 of the 95 goals mentioned in this document, Mexico’s tax code must be modified. According to the Secretary General of the OECD, José Ángel Gurría, accomplishing the objectives stated in the Pact for Mexico will cost between 7% and 10% of Mexico’s GDP; thus, the prospects of meeting these goals without a fiscal reform that improves the government’s capacity for income generation do not look promising. This is arguably why the reform timeline included in the pact predicts the approval of a fiscal reform in the second semester of 2013, and envisions it being implemented by 2014. Given that the commitment of the main political actors to fulfilling the terms of the pact has already been demonstrated with the negotiation and approval of the education and telecommunications reforms, the time for the approval of a fiscal reform is now.

The Pact for Mexico’s Governing Council, which is composed of the President and representatives of all the signatory political parties, is already working to formulate a new version of the Federal Fiscal Code, as well as potential modifications to other laws that relate to the fiscal system. Mexico’s Ministry of Finance is also collaborating in this e†ort, both technically and in the promotion of the reform. Luis Videgaray Caso, Finance Minister, detailed the three main objectives that the initiative will pursue: 1) Strengthening the government’s financial capacity at all levels – Federal, State, and Municipal – in order to finance education, health and infrastructure projects geared towards fostering economic growth; 2) Creating a fair tax system, where those who earn the most contribute the most; and 3) Simplifying the taxing process and reducing costs for small businesses in order to increase competitiveness.

The specifics of how these objectives will translate into a modification of Mexico’s fiscal code remain to be seen. However, if the reform proposal addresses the targets mentioned by Videgaray Caso, Pemex would benefit greatly. The increased revenue that could be collected from other sources would reduce the pressure on Pemex’s finances, which in turn would pave the way towards an increased investment in the oil and gas sector and to the modernization of both its upstream and downstream operations. In the words of Héctor Moreira Rodríguez, Professional Board Member for Pemex, “We can’t continue to ask Pemex for 100% of its income in taxes; the world does not work like that. A fiscal reform should be pushed forward in order to rescue Pemex from the budget and turn the company into a proper business. It may sound scary or daunting, but we need to look for other sources of income.”