Mexico Fiscal Reform: A Brief Analysis

President’s Calderon fiscal reform proposal reached the Congress last week. A preliminary examination of the government’s bill (instruments, coverage and key targets) we believe the proposal may as well be considered to be a solid first sent in the right direction. In brief, the bill has three major goals: 1) raise Mexico’s poor tax collection rate of just 10% of GDP (the lowest among Latin countries); 2) strengthen fiscal federalism and in turn, decrease tax evasion; 3) improve quality of public spending.

In our view, president Calderon has political support in the Congress (in late March, he secured approval of a law to reform the public-sector pension) to ensure the fiscal reform to be approved with minor changes until September. Calderon’s fiscal reform does not include the controversial proposal of raising tax revenues by imposing a VAT on food and medicine. Indeed, it seems that Calderon has learned from former president’s Fox mistakes and his failed attempts to reform the tax code via the VAT. Besides, Calderon significantly raises the probability of reaching consensus in Congress: that is, open negotiation with the political parties and state governors. By approving important reforms at the start of the six-year presidential term, his party will possibly reap the benefits in time for the next congressional (2009) and presidential (2012) elections.

One of the main features of the package is a 19% flat tax on business income, the so-called CETU. The flat tax would be introduced over a two-year period, with a rate of 16% applying in 2008 and 19% in 2009. In practice it would act as a minimum corporate tax and as an alternative to the corporate income tax, whose rate remains 28% (that is companies would have to pay the higher of 28% minus all eligible deductions, or the 19% flat tax). Further, there has been some criticism that only investments would be deductible from the tax rather than investment and labor costs, as under the current asset tax. However, the detailed proposal includes some labor incentives as well, such as employment credits, thus offsetting this effect.

The Ministry of Finance (Agustin Carstens) estimates that the new tax system will increase federal revenues by 1.5% of GDP in 2008and by 2.8% by 2012. According to Mr. Cardenas, the plan aims to tax informality. A new 2% tax will be levied on cash deposits in excess of $1,860. This is designed to bring into the formal economy and the tax system small businesses currently operating without legal status and paying no taxes at all. The 2% would be credited against corporate income tax.

In our view, Mexico is taking an important and positive initiative by proposing (and hopefully approving) the fiscal reform. An important by-product of the fiscal reform is to reduce Mexico’s dependence on Pemex’s oil revenues. The next step, once the fiscal reform is approved, is to eventually discuss changes to tax regime affecting the energy sector, allowing Pemex to keep more of its revenues and hence to use them to increase investment in the oil sector.