Monday, June 15, 2009

The Political Economy of the Next Fiscal Reform

Mexico will have to face a crude fact. A deep fiscal reform can not be postponed any more. In fact there are a few reasons to expect it in the last quarter of the present year. Starting with basic facts, Mexico's tax revenues are just above 8 percent of its GDP, there are just two countries in Latin America with a lower proportion, Haiti and Costa Rica. Lets just add to the latter that marginal tax rates in Mexico are just about the average of OECD countries, Value Added Tax (VAT) of 15 percent Corporate Income Tax (CIT) of 28 percent and the Personal Income Tax (PIT) with 4 brackets, its highest of 28 percent.

Another important fact that reveals the weakness of the present tax system is found in the figures of tax evasion and delusion. The Tax Management Service (SAT) published in 2006 that evasion of the entrepreneurial activities income tax (EAIT) for individuals related to earnings had a 5 to 1 ratio. This is, for every peso earned from this tax, 5 were not payed illegally. Taking the same ratio for the CIT it was 5 to 6. For the VAT it was 11 to 20, and for PIT 1 to 7. Clearly all efforts in the next fiscal reform should aim to EAITand the CIT.

In 2007, the last fiscal reform, an innovation of tax policy born. The Entrepreneurial Tax of Single Rate (so called IETU), became law after long discussions in the lower chamber. This tax aimed to reduce evasion of the CIT and the EAIT, however, its design has not helped to increase tax revenue since it looks to be far more pro-cyclical than the VAT, even though it works mostly as an indirect tax.

This is the current picture of the tax system, intermediate pollings in July have provide with a deterrent to propose major tax changes. It is also necesary to assess the fact that oil prices, although recently their trend is upwards, are still volatile, furthermore, they have just equalized the price projected in the public budget.

Government has invested a lot of effort, political capital and resources to the public safety issue, but is not clear that the latter helps to win the intermediate pollings. Moreover, without political support from opposition parties, a fiscal reform will not only will be weak but it may be impossible.

This is probably why Government has put a lot of attention to political campaigns lately. It surely needs to balance to its favor all votes of the lower chamber. This is also why we will not see a fiscal reform package until July. Of course it is not profitable in terms of votes to rise taxes, however, this may not be necesary since the problem are not the marginal rates, but the exception rules that apply in the CIT and the EAIT. Other tax reforms should aim to reduce inefficiencies in the production chain.

Unfortunately, there are some taxes in Mexico that are implemented not to increase efficiency and thus employment, but to protect some industries. Sugar refinery and alcohol processes are an example. Ecological taxes such as a higher price for gasolines will be surely evaluated. It is hard to avoid the latter discussion given a high positive correlation between income and car ownership, and income distribution and car traffic levels. The more income a city shows, the more cars it has.

A new fiscal reform will face the usual political obstacles, but it is becoming ever harder to stop.

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