Unlocking Mexico’s Potential: Fiscal Reform
British Embassy Mexico City
Government presents draft bill for fiscal and social security reform, a core part of Peña Nieto’s reform package. Addressing Mexico’s low tax base and reducing informality in the labour market are critical for unlocking Mexico’s full potential and delivering the economic growth on which Peña Nieto has staked his Presidency. Potential to boost revenues by around 3% of GDP in the medium term. Markets react positively, despite higher expectations.
1) Set against the backdrop of demonstrations against education and energy reform, which have at times brought Mexico City to a standstill, on 8 September President Peña Nieto presented details of his fiscal and social security reforms to a mixture of Ministers, Congressional and business representatives in the Presidential garden.
Fiscal reform was an early campaign promise in 2012 and is needed to pay for the wider package of reforms in the Pact for Mexico on which Peña Nieto has staked his Presidency, particularly energy reform, which is partly intended to reduce the government’s dependence on tax revenues from state oil monopoly Pemex. Addressing Mexico’s low tax base, reducing informality in the labour market and increasing productivity are Peña’s priorities to unlock Mexico’s potential.
Although the markets have reacted positively to the draft bill, wider reactions have been mixed. For example, some have argued that the decision not to apply VAT to food and medicines is a missed opportunity. The government has defended the decision saying that the exclusion of certain clauses will help the bill progress faster through both houses. As with the proposals for energy reform, much of the detail has been left for secondary legislation.
The government has also promoted its proposals as the fairest way to increase revenue in a country where 70% of the population are on the lower rungs of the income distribution ladder. There is certainly strong sentiment following the recent hurricanes (affecting more than 250,000 people and causing upwards of US$3.8bn of damage – 0.5% of GDP) that the most vulnerable need to be protected.
Whilst there has been comment from the financial sector, including ratings agencies, that the reform is not ambitious enough, the draft does include a number of proposals that will substantially increase government revenues, thereby boosting growth. One of the most significant of these is the standardisation of VAT to 16% across the country, changing long-standing arrangements whereby the manufacturing-heavy northern Border States benefited from reduced rates (currently 11%) to underpin their competitiveness. Initial estimates show that from 2014 these manufacturers would pay around USD25 bn in tax (equivalent to 3.4% of GDP).
Concern among business leaders and the middle classes has grown since the announcement as the cumulative impact on them has become clearer. The reform will close a number of tax loopholes and privileges, and eliminate fiscal consolidation, which would effectively raise corporate tax rates from 25% to 30%. Income tax for the highest earners (those earning more than Mx $500,000 pa or US$38,200) would be raised from 30 to 32%, providing additional collection of 0.3% GDP. Small and medium-sized businesses (including those represented by the British Chamber) are concerned that the reforms will increase the bureaucratic and financial burden on them – contrary to the government’s stated aim of prioritising SMEs and innovation. Middle class parents have also noted the introduction of a tax on private education, complaining that they already subsidise the state by taking their children out of the hugely overstretched and inefficient state sector.
The government estimates that total incremental tax collection from the changes will be 1.4% of GDP in 2014, increasing to 2.9% of GDP by 2018. While the exclusion of food and medicines continues, it could still be an option in the longer term as it would add US$40.3 bn or 2% of GDP each year.
Social Security Reform
The fiscal reform outlined above goes some way to fulfilling the government’s objective of raising revenue. The social security reform, presented alongside it, aims to meet the other objective of reducing informality in the labour market. An estimated two-thirds of Mexican workers do not pay any tax. The government hopes that proposals such as an unemployment insurance facility for all workers (including those who have paid tax for only a short time) will encourage workers to cross into the formal sector.
Whilst the government’s ‘universal pension’ proposal, where any Mexican not covered by any other pension (regardless of whether they have previously paid tax) will now receive a monthly stipend, will not directly generate growth, it will be funded by a new Sovereign Wealth Fund. The Ministry of Finance is currently deciding whether this will be managed by the Central Bank or an international partner.
The new social security provisions will not be cheap. Cutting spending to free up immediate funds is not an option, and the government is committed to increasing infrastructure spending to drive growth. Peña has therefore requested congressional approval for a budget deficit of 0.4% GDP this year and 1.5% in 2014 to cover the costs., Most commentators believe that the markets will digest the stimulus plan because of its temporary nature.
The President is determined that nothing will detract from this domestic agenda, The fiscal and social security reforms were presented as part of the cross-party Pact for Mexico, indicating government confidence that the majority of proposals will be approved.
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