Period of reform: Several new initiatives will shape the economy for the medium term

Having faced several financial crises in recent decades, Mexico has pursued a relatively prudent fiscal policy since the mid-1990s in a largely successful effort to sustain confidence in the country’s financial markets. While the government’s relatively low debt – at only 38.3% of GDP – would suggest that there is significant scope for fiscal stimulus, compared to other countries, this has to be balanced against the country’s immediate capacity to generate revenue. At less than 20% of GDP, tax revenues make up the smallest proportion of the national economy of any other country in the Organisation for Economic Cooperation and Development (OECD), meaning that the national debt to tax revenue multiple is actually above the OECD average. In the past, this has limited the capacity of the government to invest in the infrastructure and services needed to sustain long-term productivity growth.

Policy For Growth

Banco de Mexico’s room for manoeuvring in monetary policy is constrained, in large measure, by the actions of the US Federal Reserve, thus the Mexican government will be counting on fiscal policy in order to help economic growth rebound in 2014. A modest fiscal stimulus is planned for 2014, with the deficit expected to reach 1.5% of GDP, up from 0.3% in 2013, as investment in infrastructure and oil production capacity is ramped up.

Public finances have been flattered in recent years by high oil prices and a sophisticated hedging strategy, with Petróleos Mexicanos (PEMEX), the national oil firm, contributing over 30% of government revenues in 2013. This makes Mexico’s one of the most hydrocarbons-dependent budgets of any large nation. This dependency is emphasised by the country’s narrow tax base, with some 60% of workers employed in the informal labour market and paying no tax, for example. Each of the four oil stabilisation funds designed to manage windfall revenues due to high oil prices have been depleted in recent years to plug gaps in the annual budget. Thus, Mexico’s fiscal position is regarded as superficially strong and fundamentally vulnerable.

Reforms

Mexico’s prudent approach to fiscal policy is underpinned by the 2006 Fiscal Responsibility Law which, among other measures, introduced a balanced budget rule (albeit excluding PEMEX’s capital investment in oil exploration and production). A number of other incremental reforms were subsequently introduced to strengthen the fiscal framework, including:

• 2007 Integral Fiscal Reform aimed at further improving fiscal responsibility and transparency, including the creation of a performance budgeting and management framework;

• 2007 Instituto de Seguridad y Servicios Sociales de los Trabajadores des Estado (ISSSTE) Law to reform public sector pensions and put the pension system on a more sustainable financial footing; and the

• 2008 General Fiscal Accounting Law to harmonise budgeting and accounting standards across all levels of government. These piecemeal reforms have served as appetisers to the sweeping reforms introduced in late 2013. Neither the economics nor the politics of these latest “big bang” fiscal reforms can be viewed in isolation from President Enrique Peña Nieto’s reform programme, and energy reform in particular. These reforms aim to boost fiscal revenues in several ways, by broadening the tax base, by increasing tax rates, and by supporting growth (and revenue), generating investment in the energy sector. According to Luis Videgaray Caso, head of the Secretariat of Finance and Public Credit, “As a result of these measures, tax revenues are projected to increase by 1% of GDP in 2014. By 2018, when they are fully in force,” he told OBG, “these measures are projected to increase tax revenues by close to 2.5% of GDP.”

While the reforms proposed in September 2013 were watered down as they made their way through Congress, they still represent an important piece in the jigsaw of the reform programme and pave the way for meaningful energy reforms that will free the hand of PEMEX to invest in raising oil production. Having been signed into law by the president, the reform package was published in the Official Gazette on December 11, 2013, with most of the reforms coming into effect on January 1, 2014. The tax reforms include:

• Corporate tax rate remains at 30%, having been slated for reductions to 29% in 2014 and 28% in 2015;

• The marginal rate of income tax rises to 35% for those earning more than MXN750,000 ($58,275);

• A new 10% dividend tax has been imposed on shareholders, which will be collected by means of a withholding regime for distributing companies, impacting on profits generated after 2013;

• Capital gains from trading on the Mexican Stock Market are also to be subject to a 10% withholding tax, to be remitted by those intermediaries trading on the stock exchange;

• The special tax status of real estate investment companies has been eliminated;

• Net profits of mining firms are to be subject to a 7.5% fee, while gross earnings from the sale of gold, silver and platinum will attract an additional fee of 0.5%. The allowance for deductibility of pre-operating expenses for mines has been repealed, although this will not come into effect until January 1, 2015;

• The Business Flat Tax was repealed, having first been introduced in 2008;

• Value-added tax (VAT) in regions bordering the US was increased from the special 11% rate to the 16% rate applied nationally;

• Accelerated depreciation of assets has been disallowed and assets will now be subject to straight-line depreciation;

• A new 8% “junk food” tax has been introduced on the sale of foodstuffs with high calorie counts and a MXN1 ($0.78) tax has been imposed on soft drinks;

• The domestic gasoline subsidy is to be phased out by end-2014;

• Notably, the Fiscal Responsibility Law was amended so as to also target the Public Sector Borrowing Requirement, a wider and more realistic measure of the deficit than that used heretofore given that it takes PEMEX’s investment into account. Permitted increases in inflation-adjusted government spending have also been capped.

New Taxes

Several of President Peña Nieto’s more controversial proposals were rejected during the reform’s passage through congress. While the definition of what constitutes a maquiladora (a re-export manufacturing facility) has been tightened for tax purposes, with a certification requirement from January 1, 2015, the proposal to eliminate the segment’s VAT exemption was not enacted. Similarly, proposals to remove income tax deductions for mortgage interest, the sale of personal residences and tuition for private schools were dropped. The government signalled its intention to introduce a carbon tax and carbon credit trading mechanisms, as well as a tax on pesticides.

In January 2014, Videgaray moved to draw a line under the reforms, and to give households and businesses some certainty going forward, by announcing a fiscal pact. Among other things, this series of eight pledges commits the government to not introduce new taxes during the remainder of the president’s term of office, which runs until November 30, 2018. There are also commitments to give investors legal certainty on fiscal rules for at least the next three years, to put the deficit on a declining trajectory and alter how the government manages its hydrocarbons revenues.

Reaction

One common criticism of the tax reforms is that they simply increase the amount of tax paid by those already paying rather than bringing more people into the tax net. The government ultimately decided against extending VAT to food and medicines, a measure which would certainly have raised substantial revenues and ensured many more people paid tax but which may have compromised political support for the broader reform agenda. The introduction of excise taxes on junk food and soft drinks will go some way towards redressing this balance, with added benefits for public health, while the carbon tax can similarly be expected to impact more heavily on lower income earners. It should be noted, moreover, that Mexico has one of the widest income disparities in the OECD.

Alongside its tax reforms, the government also announced the introduction of a universal pension system and employer-funded unemployment insurance. While both measures will boost incomes for the less well-off, unemployment insurance for up to six months will be available only to workers in the formal labour market. Furthermore, the cost to employers – a 2-5% increase in contributions to the National Workers’ Housing Fund Institute – may reduce the attractiveness of formal contracts and further reforms may be needed to tackle the informal labour market.

Agustín Carstens, the governor of Banco de Mexico, has noted, “Any passed fiscal reform is a good fiscal reform.” While the final package has attracted criticism for failing to meet its objectives and increasing taxes, this must be weighed against the sustained political support for the broader reform agenda, most notably in the energy sector. To this extent, the recent fiscal reforms are being regarded as a qualified success.