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AmericasSeptember 2 2007

Tax make or break

Brian Caplen reports on Mexico’s plans to build on its financial stability and raise pitiful tax take levels.
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Economists have spent years studying debt crises in emerging markets only to see their prey become close to extinct. Now, however, they have a new quarry to track – let us call it the emerging market revenue crisis, in which Mexico is out front with both the problems and, possibly, the solutions.

Mexico has had more than its fair share of external debt crises over the years, most spectacularly the Latin American collapse of the 1980s that led to the issuance of Brady bonds, as well as the Tequila and banking crises in the mid-1990s. But right now the external debt situation of Mexico is probably the best it has ever been in the country’s entire history. The government debt burden is a mere 31% of gross domestic product (even lower than the 34% that is the median level of other similarly rated sovereigns) and even adding in other public sector borrowers only brings this number up to 46% – inconsequential by European standards.

Yet for all that, Mexican finances are not a cause for complacency and, in fact, general government debt in 2007 is projected by ratings agency Standard & Poor’s at 160% of revenues – way above the 127% figure for Mexico’s peers.

The reason is a rickety old tax system that collects a mere fraction of the revenues needed to finance the infrastructure and social requirements of an emerging economy. Tax evasion is widespread and there is a culture of tax avoidance. The gains made in modernising the debt structure have yet to be translated into the revenue side of the balance sheet.

Oil dependence

A tax take of a mere 11% of GDP makes Mexico an outlier in both the Organisation of Economic Cooperation and Development and Latin American rankings. Finance minister Agustín Carstens, whose job it is to tackle the problem, says: “By any standards we have very low tax revenues. We live from oil revenue [it accounts for 40% of government revenues] and in the short to medium term, considering the health of our public finances, we are not vulnerable [to a crisis]. But we have price risk with oil and uncertainty over the continuation of the production platform [Mexico’s oil sector needs substantial investment].

“We need to substitute oil revenue with tax revenue and under this administration [of president Felipe Calderón, which took office in December 2006] we hope to raise tax revenues by three percentage points of GDP. Given that we have healthy public finances and that next year with or without reform we will have a balanced budget, we have the opportunity to gradually increase tax revenues.”

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President Felipe Calderón: his administration seeks to substitute oil with tax revenue

The challenge will be to get the proposed fiscal reforms through the Mexican Congress and onto the statute book without them being watered down. Tax reform is always controversial and attempts by the previous Fox administration to raise revenues by overhauling value added tax (VAT) – where the largest single loss by tax evasion occurs – failed. Legislators would not accept VAT being imposed on medicine and food.

Formalisation measures

The new reforms take a different approach, proposing a corporate flat tax to improve revenue collection from business, pushing the huge informal sector into the formal economy with a tax on cash holdings, giving Mexico’s 32 states enlarged revenue raising powers and proposing several measures to improve auditing and transparency of public spending.

But in tackling its revenue crisis – a problem that other emerging markets such as Brazil and the Philippines also face – Mexico is only taking the first step.

Mr Carstens says: “I would not dare say that this reform will do the trick for all administrations. If it [the fiscal reform bill] goes through it will give us a good push forward but the issue of the fiscal situation is something future governments will need to study on a yearly basis and take appropriate measures.

“We will do our work in this administration but the fiscal discussion will be in the minds of the Mexican governments for the next 20 years. The key to success will be to extinguish the pressures in a responsible way and to enhance tax revenues so that we are ready when the future arrives and oil can no longer be our main source of income.”

Mr Carstens says that over 20 years Mexico needs to increase its tax revenues by 10 percentage points of GDP, taking them to more than 20% of GDP in total. The current proposals, if passed in full will only produce three percentage points of GDP and critics have said that even some of that will be lost to the states and to the state oil company Pemex, leaving only half for central government coffers.

Debt delights

Jonathan Heath, chief economist with HSBC in Mexico, comments that the country’s external debt position is “the lowest ever in historical terms”.

He says: “100% of all renegotiated debt has been eliminated through the market, the amortisation profile is the best it has ever been and the political risk indicators are highly favourable. We have much deeper local capital markets and a year ago the Mexican government started placing 30-year fixed rate peso bonds.”

But Mr Heath says that fiscal reforms can only be regarded as the first step in an ongoing reform process if Mexico wants to raise its growth rates above the current 3% to 4% a year that are considered insufficient for an economy at Mexico’s stage of development. Necessary reforms cited by Mr Heath and other commentators include energy reforms that would allow the sector to upgrade its currently declining production capacity, labour reforms to make labour markets more flexible, as well as improving the judicial system and creditor rights.

Standard & Poor’s revised its outlook on Mexico’s long-term ratings in July from stable to positive but affirmed its BBB long-term foreign debt rating, saying that it was not in a hurry to upgrade the country further. “Positive outlooks typically last about one and a half years on average before resulting in either an upgrade or a reversal back to stable,” says the agency in a report on Mexico’s outlook.

Now the emerging market challenge starts to become clearer. Countries such as Brazil and Mexico, which have put their finances in order to the point where crisis no longer threatens, still have a long way to go to construct an institutional and microeconomic environment that will lift growth rates and reduce poverty. Higher growth rates would in themselves create larger tax revenues and put Mexico in a virtuous circle.

Mr Carstens agrees that other reforms are important but he does not think that the lack of labour reforms (unions are very powerful in Mexico) is “a major factor affecting competitiveness in Mexico” and that workers have proven flexible in adapting to tough economic situations. He thinks Mexico will become more competitive if it delivers on the president’s recently announced national infrastructure plan and improves security – currently a top government priority – and the application of the rule of law.

“There are other reforms that are important and not all require legislation. In some cases we need to strengthen the application of the law,” says Mr Carstens, citing the work of the competition commission.

One of the most tricky parts of the fiscal reform bill to get congressional approval for will be the measures affecting the states. Currently 85% to 90% of state funding comes from the federal government and in the past this has been used as an instrument of control. Now the view is that the states should become more fiscally responsible and raise more of their own revenues.

Tax evasion

Then there is the challenge of widening the tax net and eliminating tax avoidance and evasion. “We expect to raise over five years a full one percentage point of GDP in tax revenue just through better administration,” says the finance minister. “We know where most tax evasion is taking place. It is widespread in the informal sector and we are going to tackle it head on.”

But as Mr Carstens says, some improvements in Mexican growth rates can be expected from changes not directly connected with the current legislative programme. The recovery of the banking sector and the growth in credit is one of these. Mr Heath notes that before the mid-1990s, banking crisis commercial banking credit to the non-financial private sector was 41% of GDP. After the crisis it fell to 7% and has only now recovered to 12.2%. “There is a long way to go to get back to 41%,” he says.

Mr Carstens adds: “We have strengthened the financial system since 1994. We spent 10 years without an effective financial system. For the past two years we have had a financial system that is contributing to growth with credit growing at a healthy rate.”

The positive scenario is that the Mexican economy has enough impetus to keep going until further reforms are put in place. The betting would seem to be in the country’s favour. Other emerging market governments will be watching with interest.

TABLE: MEXICO'S TAXING TIMES

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