THE BLOG
11/07/2013 11:10 am ET Updated Jan 23, 2014

The PRI's Pyrrhic Fiscal Victory

It was perhaps too optimistic to think that Mr Peña Nieto would have had it easy: politics in Mexico never is. The surprising ease with which many of the PRI's reforms were negotiated and passed in Congress over the past year belied the fact that many entrenched interests were trampled in the process, interests that even in the face of a more assertive government remain powerful and influential. But although the PRI has been winning its political battles one by one, the enormity of fiscal reform may in some ways prove pyrrhic. Independently of the merits and shortcomings of the reform, over the past few months the PRI has managed to alienate the country's business community, sideline its tenuous PAN ally (whose support it will need to pass the upcoming energy reform), and rile the middle classes upon which its electoral success depends.

Cynical by nature

In all fairness, Mexicans may well be the most difficult people in Latin America to please. The results of the latest Latinobarometer survey show that Mexicans have some of the most cynical and pessimistic views on political and economic matters in the entire region. Most shocking is the degree of disappointment with democracy: just 37% of Mexicans believe that democracy is the preferred form of government, the lowest in Latin America. Likewise, Mexicans topped the list when asked whether they believed that democracy could be achieved without political parties (45%) or without a Congress (38%). Only Honduras, a country with an abhorrent level of political ineptitude, beat Mexico in terms of overall dissatisfaction with democracy (just 21% of Mexicans felt satisfied). And when asked whether they feel their country is progressing, only 19% agreed, the fourth lowest in the region after Paraguay, Costa Rica and Honduras.

Add to this an economy that has been limping along throughout 2013 and you have a perfect storm of disappointment. It is certainly true that the government deserves its share of the the blame for its bad economic start, mainly due to the unnecessarily austere level of fiscal spending undertaken in order to meet its "zero deficit" target. But responsibility is less evident with regards to the other two main factors behind the slump: the recession in the construction sector caused by the homebuilders crisis (a legacy of the PAN administrations' ham-fisted social housing policy), as well as weak external demand seen earlier in the year. With this in mind, it's hard to believe that the slowdown was entirely avoidable even though some of the pain could have been eased if the government had kicked off with a slightly more expansionary agenda.

Pleasing nobody

If the fiscal reform has been the administration's crowning achievement in its drive for structural reform, it has also been its biggest public relations disaster. Middle classes have complained that they will be shouldering the burden of the bill, which is partly true although many of the most damaging measures (VAT on rents and mortgages as well as private tuition) were thankfully scrapped. Businesses have been fuming over the loss of many of their advantageous fiscal regimes and have launched frank threats of layoffs and relocating investment once the reform is implemented. Opposition to the bill has even gone to the extreme of triggering a few "independence movements" on social media. One of these, the República de Baja California, claims the support of thousands of northerners who object to the elimination of the special border VAT rate. These movements are, of course, largely symbolic but the sentiment is real.

Which brings us to the main point: the fiscal reform may have been a good idea, but it has come at a very bad time. While many of the complaints appear nonsensical coming from groups that have been pampered by fiscal privileges for far too long (the border states, for example, are among the richest in the country yet paid a lower VAT), it's hard to deny that the added fiscal burden on many individuals and businesses will end up denting demand to some degree over the next year or two. This will be worsened by the lack of any meaningful adjustment period for many of the new measures. In this sense, therefore, the critics of the reform may well be right in suspecting that it will do more harm than good, at least in the short run.

A necessary evil

But this of course, does not mean that the reform wasn't necessary, especially in a country with such low levels of tax intake and such pressing spending needs in areas like infrastructure and social development. If anything, the reform's sin is that it hasn't gone far enough as even total revenues of 24.6% of GDP (what the government initially expected to be taking in by 2019) will still be the OECD's lowest by some margin. And notwithstanding certain areas where the reform may have gone too far (such as mining, and possibly the maquila sector), Mexico's fiscal regime will remain no less advantageous than that of many other emerging economies in terms of affecting the conditions for investment. However, the government is not likely to shake off the hit to its popularity anytime soon, and the loss of support within the business community - which hitherto had been supportive of the PRI's return to power - could prove costly.

To silence its critics, the government will have to make sure that the extra revenue raised by the reform will be spent wisely and not squandered. One can forgive Mexicans for believing that the latter is most likely outcome given the PRI's track record on fiscal irresponsibility in both the past (pick your crisis) and the present (pick your PRI-run state). However, the government will also fail to win the hearts of minds of Mexicans if the burgeoning middle classes continue to feel that they are unfairly shouldering the country's fiscal burden. In the absence of a comprehensive strategy to bring the mass of informal workers (a colossal 60% of the labor force) into the formal sector, and without a guarantee that big businesses will pay according to their means - in practice, rather than just on paper - government justifications that the reform is "fair and progressive" will ultimately fall on deaf ears.