Mexico’s Fiscal Reform: the Good, the Bad, and the Ugly

On Sunday, Mexican President Enrique Peña Nieto unveiled a fiscal reform bill that is an important corollary of his energy reform proposal. The legislation’s main goal is to increase the federal government’s tax intake in the face of diminished oil revenues due to the reforms that will let Petróleos de México (Pemex) keep more of its money for investments.

Approximately one third of the government’s revenues comes from oil. The fact that oil production is declining significantly (it dropped 25 percent in the last decade), adds urgency to generating new sources of tax revenue or reducing spending. Mexico’s fiscal deficit last year was 2.6 percent of its GDP, but without oil revenues it would have been close to 8 percent instead.

The good: The bill will simplify Mexico’s complex tax system. In the World Bank’s Doing Business report, Mexico ranks 107th among 185 economies on its ease of paying taxes. It takes an average Mexican businessman 337 hours every year to calculate and pay his taxes, whereas his peers in the mostly developed nations of the OECD have to spend an average 176 hours every year doing their taxes. A complex tax system constitutes a burden on the economy and can also be extremely inefficient since it encourages people to elude and evade taxes (particularly in developing countries with weak institutions). Thus, you can have a country such as Mexico with high tax rates and yet low tax revenues. This is a problem because it can lead to a slippery slope where politicians try to extract more revenue via higher taxes from a dwindling pool of taxpayers.

The current top rate on the personal income tax is 30 percent. The corporate tax rate is also 30 percent. The Value Added Tax (VAT) is 16 percent. And yet Mexico’s tax intake was only 9.7 percent of its GDP in 2012. This is not to say that Mexico should have a higher tax burden, but to point out that there is something wrong with a tax system if it has fairly high tax rates that don’t generate much revenue.

The reform introduced by the government aims to simplify the tax code by closing loopholes, getting rid of inefficient taxes, and eliminating or capping tax deductions. As a result, the income tax law will go from having 299 articles to 186. A tax on bank savings will be scrapped, along with a corporate version of the Alternative Minimum Tax. The bill will eliminate distorting provisions, such as having some border towns paying a lower VAT rate of 11 percent or allowing corporate groups to offset the losses of some of its subsidiaries against the profits of others. This will make the tax code more neutral and reduce the scope for rent seeking by interest groups.

The bad: The bill is a significant tax increase. First, a “fiscal reform” worth its name would tackle both sides of the equation: taxes and spending. In this case, Peña Nieto’s proposal only deals with taxes while forgoing spending cuts. There are many areas where government spending can be cut. One of them is energy subsidies, which include gasoline, electricity, and gas. According to John Scott from CIDE, a think tank, those subsidies amount to 14 percent of GDP from 2006 to 2012. Agricultural subsidies are also high and they tend to benefit the well-off and are easily abused. If the government’s goal was to put its finances in order before reducing its reliance on oil revenues, it should have included spending cuts.

Second, it’s good that the bill aims at simplifying the tax code by getting rid of loopholes, capping and scraping deductions and eliminating distorting special tax rates that benefit certain regions or groups. As I mentioned earlier, that makes the tax code more neutral and diminishes rent seeking by interest groups. It weakens the discretional power of politicians and bureaucrats too. But the bill should also have lower tax rates to stimulate the private sector. It doesn’t. The corporate tax rate will stay at 30 percent but a new top personal income tax rate of 32 percent will be created for people making over $38,000 a year. The VAT will remain at 16 percent but it will cover more products and services, such as private education, concerts, transportation (outside cities), pet food, jewelry, etc. The bill creates a new capital gains tax of 10 percent. It also introduces a carbon tax and flirts with social engineering by creating a tax on sugary drinks aimed at fighting obesity.

Taking more money from the private sector and giving it to the government will hardly help the Mexican economy grow. Let’s keep in mind that Mexico only grew by an average of 2 percent a year in the last decade, one of the lowest rates in Latin America. The fiscal reform bill will increase the burden of those who already pay taxes while doing little to reduce the informal sector where 59 percent of the Mexican labor-force works. According to Doing Business, the total tax rate paid by an average Mexican businessman (as a percentage of his profits) is 52.5 percent while the average in the OECD is 42.7 percent. If the economic research of the last 30 years is any indication, increasing taxes won’t reduce the size of the informal sector.

On a positive note, if Mexicans want big government, the burden of such a system will be more direct and visible. Bloated and wasteful government spending heavily financed by oil revenues is a curse to any economy. Perhaps if Mexicans feel the pinch in their pockets from higher taxes they will have an incentive to demand less government.

The ugly: The fiscal reform will increase the size of government. Instead of simply filling the hole left by lower oil revenues, Peña Nieto already stated that the expected revenue for the reform (1.4 percent of GDP by next year and 3 percent of GDP by 2018) will pay for more social spending including a universal pension for people over 65 years and a new unemployment insurance scheme. If the tax increase will pay for higher spending, then more tax revenue will be needed in the medium term to make up for lower oil revenues.

The bill will probably undergo changes in the legislature. If those amendments undermine the goal of simplifying the tax code, then there will be little, if anything, good in this fiscal reform.