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Monday, October 22, 2007
Special Reports

Tax Reform: Mexico Marks the Path 

Increased tax collection will help wealth distribution in Mexico, but corruption needs to be reduced, experts say.
Mexico’s first significant tax reform in a decade was crafted by Mexican President Felipe Calderón, thanks to his greater capacity for dialogue and negotiation than former president Vicente Fox, experts say. (Photo: Mexican Presidency)

CHRONICLE SPECIAL
Knowledge@Wharton

One of the most serious problems in Latin America is the poor distribution of income, in large measure “because public policies are insufficient,” says Rafael Pampillón, a professor at the IE business school in Spain. “Public spending programs are not adequate and they are poorly designed. Tax systems have very little capacity to collect revenues, and there are a lot of exemptions and deductions. Beyond that, a large part of the economy still operates on the black market.”

According to Pampillón, “Throughout Latin America, there is a general perception that resources are very limited, inequality is very substantial and social spending is not well focused.” As a result, he says, in many countries “tax reform is necessary, and this is as good a time to undertake it as any because we are living in an era of growth. Apart from Brazil, which has a relatively high tax rate of 35 percent, the other countries, especially Mexico, have extremely low tax rates of about 10 percent to 12 percent.”

OPTIMUM TAX STRUCTURE

Pampillón suggests that an optimum tax structure is based on the best ways to collect money and the best places to spend it. He cites the example of public expenditures on education and health. “Rather than the excessive spending currently [targeted to] university education, perhaps it would be better to spend more on primary education. Or, instead of creating large urban hospitals, it would be better to spend funds on primary health care.” In addition, the distribution of wealth is so skewed that “you would have to make an effort to focus spending on primary health care, public assistance pensions, highways, drinkable water…. If the goal is to redistribute wealth, public spending should be directed toward that goal.”

Regarding tax collections, he says that it is necessary “to have tax systems that redistribute wealth and are progressive. It seems that most revenues in Latin America are derived from imports and state-owned enterprises. They are not doing much to promote significant fiscal reforms.”

A VICTORY OF CONSENSUS

To achieve those goals, Pampillón warns that you need consensus. This is hard to achieve because there is a high level of corruption in some countries. Transparency International, a non-governmental organization headquartered in Berlin, recently published its 2007 Corruption Perceptions Index. The highest-rated (i.e., least corrupt) countries in Latin America were Chile and Uruguay, which scored 7 points and 6.7 points, respectively. A rating of 10 on the scale means that a country is extremely transparent. Mexico and Brazil rated only 3.5, and Venezuela scored 2.0. “It is very hard to sell civil society on the idea of increasing taxes when you don’t know what you are going to use your tax revenues for,” notes Pampillón. The new agreement on tax reform in Mexico “is a good time to decide that, but you have to reduce corruption and increase efficiency” before it can be done.

Mexico’s first significant tax reform in a decade was crafted by Mexican President Felipe Calderón. Like his predecessor Vicente Fox, Calderón belongs to the PAN party. On two occasions, Fox tried unsuccessfully to garner the support of various political forces to get approval for tax reform. With his success, Calderón has achieved his second big victory in less than a year. It came on the heels of the reform plan for Mexico’s public pension system that was approved at the beginning of 2007.

What has changed in Mexican politics? “Calderón has shown a greater capacity for dialogue and negotiation than Fox,” says Carlos Malamud, chief researcher on Latin America at the Real Instituto Elcano in Spain. In addition to the president’s leadership skills, the political situation itself has also changed. “In the [Mexican] legislature, they are realizing the need for negotiating certain things, and that you cannot block everything permanently. You also have to add the particular situation played by the PRI (Party of Revolutionary Institutions), which holds the balance of power in some respects.”

A LIMITED REFORM

Tax reform was urgent for Calderón because, as Pampillón notes, when petroleum revenues are excluded, Mexico only collects 12 percent of its gross domestic product (GDP) from taxes. Currently, the government depends on petroleum revenues for 40 percent of its revenues.

According to Ignacio Trigueros, a member of the economic research and analysis division of ITAM, the autonomous technological institute of Mexico, the main goal of the tax reform is to strengthen the collection of public revenues. In coming years, the country will have to confront various commitments made in the past, such as public pension programs and investments in the energy sector. In addition, it will face a decline in petroleum production.

“Merely as a result of those factors, the fiscal deficit will increase by 3 percent of GDP over the coming five years,” Trigueros says, adding that tax reform would generate revenues equivalent to about 2.4 percent of GDP. Even if you factor in revenues that will not directly strengthen the government’s finances, this reform plan could come up short. Malamud says that the reform plan “could have gone deeper but political conditions would not allow for anything more.” As a result, it is more likely that planners and politicians will have to take another look at the reform plan within a year or two after it goes into effect at the beginning of 2008.  

KEY POINTS

Until then, Mexico has adopted a gradual approach to tax reform that consists of the following: A new tax of 2 percent on all cash bank deposits above 25,000 pesos, the equivalent of $2,270; a 5.5 percent increase in the price of gasoline and diesel oil, to take place gradually over 18 months; a corporate tax of 16.5 percent, that will rise to 17.5 percent by 2010; and, finally, a reduction in the taxes paid by PEMEX, the state-owned petroleum company.

The goal of the tax on bank deposits is to suppress the country’s informal [or black] markets. Many specialists believe that this goal will not be achieved, however. “I doubt it will happen,” says Trigueros. “The reform contemplates only a new obligation on cash deposits, which frankly I do not believe contributes all that much to combating black market activity.” Some argue it is unlikely that those who are active in the black economy will utilize banks for their transactions. The other tax, covering gasoline and petroleum, has also been the subject of criticism on the part of the opposition, which has called it “the gasolinazo” [or “gasoline trap”] because of its possible impact on the pocket books of consumers and on inflation.

Trigueros says that the heart of the fiscal reform is the new tax on corporate earnings. “Companies will wind up paying the maximum tax as well as another new duty. The latter duty is neutral with respect to investments since it is totally deductible from the former. Nevertheless, the other kinds of deductions that you can take on income taxes are not contemplated for the new duty. When all is said and done, it seems strange that a duty aimed at control has a different foundation from which it tries to control. Among other things, this can mean that companies will wind up paying more, which would discourage investment.” As a result, he notes, “The new obligation introduces different kinds of tax treatment for labor expenses incurred by different companies. Nevertheless, it also eliminates some kinds of special treatment that were conferred by the income tax [regulations].”

The business community complains that the burden of the reform has been placed on corporations. Experts say that this strategy on the part of Calderón is intended to prevent leftist political parties from vetoing the reform. During the earlier attempt at tax reform, explains Malamud, “an important part [of the controversy] hinged on the Value-Added Tax and on the need to extend it to an entire series of products, some of which were popular consumer goods. The [parties of the] left, especially the PRD and the PRI, opposed the VAT on the grounds that there were other, more popular solutions. This new approach, focusing reforms on corporate taxes, has had the effect of weakening that sort of criticism…. t is a thoughtful strategy but we’ll have to see whether it succeeds or it doesn’t. The first test will come when the reform starts to be enacted. The second test will be when we see how the tax collections mount up.”

Next year, the plan is to use a good deal of the additional tax revenues to strengthen infrastructure. According to Trigueros, “This goal would be practically impossible without [tax] reform.” The infrastructure plan, approved recently by the Mexican government calls for investing more than $225 billion, and it would have a positive impact on economic growth. On the other hand, the PEMEX tax reform plan means that the state-owned oil company will have to pay lower taxes to the Mexican government. This will enable PEMEX to invest more in exploration and research, which is another goal of the reform. Trigueros explains that “a portion of the additional tax collections will wind up with PEMEX: 0.3 percent of GDP in 2008 and 0.6 percent of GDP thereafter.” Trigueros worries, however, that this measure will not be backed by a commitment to increase the productivity of the state-owned company. “The problem for PEMEX is not a lack of resources but the way in which they are used. During the last administration, about $50 billion was invested in PEMEX.”

OTHER PENDING REFORMS

Another major reform of the Calderón government involves the energy sector as a whole. According to Pampillón, one of the most surprising things when you arrive in Mexico is that “all the gas stations are PEMEX. It is a good idea to provide PEMEX with higher tax revenues but it is much more important to improve competitiveness in the [energy] sector by permitting the arrival of companies from other countries -- and even by privatizing PEMEX, although the current practice [of state control of PEMEX] is deeply rooted in Mexican tradition.” Pampillón believes that it would be very beneficial to introduce more competition into the Mexican energy sector. “There is nothing in the Mexican constitution itself that requires that the exploitation of hydrocarbons be a monopoly of the State.”

For Trigueros, reforming the energy sector is also a top priority. However, he points out other barriers to the growth of the Mexican economy. These include “primary education, where Mexico invariably scores very poorly in achievement tests; inappropriate regulations that discourage economic activity outside the black market; and a telecommunications sector where there is not enough competition.” These burdens make it impossible for Mexico’s economic growth to match up with such emerging economies as China, India and Korea, Trigueros says.

To improve Mexico’s performance, Calderón will also need to undertake labor reforms in the near term. That “would enable the country to create better jobs and avoid emigration to the U.S.,” says Pampillón. Meanwhile, tax reform will enable Mexico to make progress elsewhere, including strengthening education. Pampillón agrees that education is a key area. “The best way to reduce such brutal inequalities is to provide better education, whatever the level, to the population. We don’t have the tax revenues to do this; without those revenues, you can’t give free education to the population.”

Pampillón enumerates the major problems facing Latin America. “The first one is tax collection. If you don’t resolve that problem, you will not solve the second problem: the poor distribution of wealth. The third big problem is corruption. And if you don’t put an end to corruption, it will be very hard to overcome the first two problems.”

Republished with permission from http://www.knowledge.wharton.upenn.edu -- the online research and business analysis journal of the Wharton School of the University of Pennsylvania.

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