10/03/2013 03:30 pm ET Updated Dec 06, 2017

Mexico's Fiscal Reform Leaves More Questions than Answers

Between a flagging economy, endless social protests and the ravages caused by hurricanes Manuel and Ingrid, 2013 is turning into a terrible inaugural year for Enrique Peña Nieto and the PRI. In all fairness, most of the reasons why Mexico has recently been struggling to live up to its hype are not entirely his government's fault - if anything, the balance during his first year in power has been surprisingly positive, not least for managing to push through unprecedented reforms in areas such as education and telecoms. That much of this was done with the support of the opposition PAN and PRD is all the more commendable and proves that pragmatism has not been entirely lost to Mexico's traditionally obstructionist political class.

The energy reform (which was discussed in a previous article) may be the one on which global investors' attention is focused, but we have argued that the fiscal reform would be the make or break deal for the agenda's success, one without which the government's lofty commitments in infrastructure and social spending would be impossible to fulfil. Unfortunately the reform leaves many questions unanswered.

The reform is mostly progressive, but various measures will hit the middle class hardest.

It is laudable that the reform is balanced on the progressive side, and that the one measure that would have hit lower income households the hardest - a broadening of the VAT base to include food and medicine - was written off at the last minute, most likely a calculated move to avoid opposition from the PRD as well as from protestors eager to add another cause to rally against. Still, the reform was ultimately left with those measures that appear to have a stronger impact on higher earners such as capital gains tax (which inexplicably did not exist), a slightly higher income tax top rate (32%), and elimination of a plethora of exemptions, deductions and special regimes. Big businesses have been fuming about some of these proposals (particularly the so-called consolidated regime which benefitted large conglomerates) which should serve as evidence that many of them have been used to paying far less than they should. Other new taxes, such as that set to be imposed on soft drinks, may be unquestionably regressive but make sense in light of the country's obesity epidemic, especially among children.

However, it is disconcerting that some of these measures may also have an unduly strong impact against small/medium businesses and the middle class, particularly since the reform doesn't focus as much as it should toward reducing informality. In particular, the extension of VAT to rent and mortgages is disconcerting as this is a type of tax that is rarely applied elsewhere. And while the tax on private school tuition appears at first glance as a measure targeted towards the rich, it should not be forgotten that a large chunk of the middle class sends their children to private school as well. To this end, it is encouraging to see that the legislative debate is currently focused on cushioning the effects for lower earners, and possibly scrapping these measures altogether.

The reform will raise nearly 3% of GDP, but from a lower 2013 base and mostly from oil.

The finance ministry (SHCP) claims that the reform will ultimately raise 3% of GDP, which is arguably the minimum that any comprehensive fiscal reform should attempt. What is not mentioned is that this 3% is added to the much lower revenue base expected in 2013, which according to the SHCP's estimates will be 21.6% of GDP. This is understandable, given that the economy is currently undergoing a severe slowdown. However, one wonders why the baseline of the previous couple of years was not used instead: revenue as a share of GDP averaged 22.7% in 2010-12. The result is that by 2019 - the far end of the SHCP's fiscal estimates - revenues are expected to rise to 24.6%, only 1.9 percentage points higher than in 2010-12. This will still be (by far) the lowest among the OECD. Even worse, this increase is mostly thanks to higher expected oil income from the energy reform. SHCP projects a rise in oil income of 1.6 percentage points, to 9.2% of GDP by 2019. In contrast, non-oil revenue will rise only 0.3 percentage points, to 15.4%. The result is that revenues will actually become more dependent on oil in 2019 than in 2013!

Of course, in order to keep the fiscal deficit at around 2% of GDP, spending is not going to rise substantially during this period either. According to the SCHP's estimates, public spending will rise to 26.6% of GDP by 2019; that's only 1.3 percentage points higher than in 2010-12 and will also be the lowest in the OECD. On the positive side, the government is planning to make significant efficiency gains on the spending side. The wage bill, for example, will fall 0.9 percentage points in 2014-19, while transfers to state-owned firms will drop 0.6 percentage points. This will help finance most of the increase in capital expenditure (2.2% of GDP), much of it which will go to infrastructure. Unfortunately, this still leaves out the resources needed to eventually provide universal social security, a plan that could cost at least 3% of GDP. Two elements in this plan have already been incorporated to the reform proposal but these amount to increases of just 0.7% in pensions (of all types) and 0.3% for unemployment insurance, which still leaves the bulk out. In the end, something might have to give, and that something will probably be social security.

Too much stimulus

Lastly, the planned stimulus spending appears extraordinarily high for a country that is facing only a slowdown in growth rather than an outright recession. Plus, it comes in one year late and will erase the short term benefits of the fiscal reform (expected at 1.4% of GDP, which contrasts with the planned stimulus of 1.5%). There's little reason to maintain the stimulus further, but another 1% of GDP in 2015 and 0.5% in 2016 is projected, something that looks more like an excuse to ramp up spending to meet the government's commitments before the fiscal reform fully kicks in. For a government so initially fixated on a "zero deficit" budget (which in SHCP-speak means 2% of GDP since Pemex investments are disingenuously not included in the budget targets), this sudden transformation from fiscal hawk to dove is disconcerting to say the least.

To compensate, the reform has proposed the setting up of a Chilean-style fiscal rule to allow for countercyclical spending while capping spending during the good years. Unlike Chile, however, the baseline assumptions for the fiscal rule will be set up by the government itself, rather than an independent panel of academics and experts. In a country where political meddling is the rule rather than the exception, the independence and transparency of these assumptions may come into question.

Good but not enough

Notwithstanding the reform's deficiencies, it's hard to argue that Mexico be better off without it. The PRI appears open to negotiating some of the more contentious aspects of the reform, which would bode well for ensuring that it creates a fiscal framework that is fairer and more efficient. However, for Peña Nieto to fulfill his promises, he will need more.