After early speculation that President Peña Nieto would unveil his much anticipated tax reform during the 2013 spring congressional session (February 1st – April 30th), Finance Minister Luis Videgaray recently confirmed that the comprehensive tax and expenditure package would not be unveiled until the second half of this year.
According to Videgaray and other PRI officials, the tax package is being delayed to give the administration more time to negotiate its components internally as well as with opposition leaders and the private sector. This is to ensure the bill has strong inter-partisan support before it is officially presented to Congress and to avoid a drawn out congressional debate.
This strategy is consistent with the PRI’s traditional negotiation style of ironing out internal and inter-party differences before presenting an actual bill to Congress. This contrasts starkly with the PAN, which preferred to present a bill and then hash out negotiations in Congress – a strategy that tended to lead to stalemates and watered-down legislation.
Mexico’s Tax Problem
The goals of comprehensive tax reform are to strengthen the government’s revenues and tax base, while creating a fairer tax system. According to the Finance Ministry, the Mexican government collected 9.8% of GDP in taxes in 2012 and is expected to collect 9.7% of GDP in 2013. Even including revenue from Pemex and other government-run companies, Mexico collects a smaller percentage of its GDP in taxes than any other country in the OECD (19.7% in 2011). The average OECD country collects a third of its GDP in public revenue. For the Mexican government to meaningfully reduce its dependence on Pemex, it must increase its non-oil tax revenue by at least 6% of GDP.
A number of observers have suggested that the PRI could try to pass the bill in various segments. However, given the short window of opportunity for the administration to pass the reform, there is consensus within the PRI that tax reform must be presented as one big package. Likely components of the bill include:
(1) Expanding the sales tax (value added tax – VAT). The VAT is a regressive tax but it is the most effective tax source for the government since people cannot usually evade it.
(2) Eliminating the alternative minimum business tax (known in Mexico as IETU). The IETU was introduced in 2008 to ensure corporations and businesspeople paid a baseline tax. This tax has caused much confusion because businesses have to calculate two tax burdens and pay the higher one.
(3) Increasing the cap on personal income tax and improving enforcement. Personal income tax is capped at 30% but it currently scheduled to decrease to 28% in 2015. Few people actually pay income tax since it is easy to avoid and difficult to actually calculate and pay.
(4) Eliminating corporate tax loopholes including those that allow conglomerates to consolidate their corporate taxes based on net earnings from subsidiary businesses. Some companies are set up to operate at losses to lessen their parent company’s tax burden.
(5) Incentivizing state and local governments to enforce payment of taxes that are under their jurisdiction (state and local governments have neglected their duties to collect smaller but still important taxes). Reforming the way the federal government distributes tax revenues to state and local governments.
(6) Reducing Pemex’s tax burden. This is a necessary step for saving Pemex’s finances and granting the company more financial and managerial autonomy. It is unclear at this point by how much Pemex’s tax rate will be reduced. Roughly 60% of Pemex’s revenues go to the government every year.
(7) Introducing a dividend tax and keeping the capital gains tax at 30% (capital gains tax is set at 30% and is currently scheduled to decrease to 29% in 2014 and 28% in 2015).
(8) Increasing the phase out speed of certain consumer subsidies, primarily for fuel and other petroleum products. The government currently spends roughly 1% of GDP subsidizing gasoline prices.
(9) Introducing new mechanisms to incorporate informal, family owned business into the tax system, thereby reducing the number of people who operate businesses without paying taxes. One half of Mexico’s labor force works in the informal economy and roughly a third of Mexico’s GDP circulates in this untaxed economy.
Possible IVA Variations
There are many options for expanding revenue from VAT, which is currently set at 16% for all products except basic foods and medicines.
(i) Increase VAT above 16% on all currently applicable products but leave food and medicines exempt;
(ii) Keep VAT at 16% but expand it to non-essential foods (soft drinks, luxury foods, candies) and medicines;
(iii) Expand VAT to all foods and medicines but create variable VAT rates for different products (lower for basic foods and higher for non-essential goods). These variable rates could increase over time, with many tax experts pointing to an initial 5-8% VAT baseline on foods and medicines.
We believe the third option (variable VAT rates) to be the most viable. Medicine may remain exempt from VAT because revenue from taxing medicine is small change compared to the potential tax revenue from taxing food. The political sensitivity of taxing medicine may not be worth the marginal increase in revenue. By offering to leave medicines untaxed, Peña Nieto could more easily sell the idea of taxing non-essential foods, especially if he frames it as closing a loophole for large food conglomerates.
A big question is whether all food will be taxed or just non-essential food. The idea of taxing beans and rice is much more controversial than taxing soft drinks. Nevertheless, many tax experts would like to introduce at least a minimal tax on all food products to create a precedent for possible future increases to the VAT on food products. According to the Finance Ministry, not taxing food and medicine represents a 1% of GDP loss to the government in terms of foregone tax revenue.
Link to Social Security Reform
Throughout the 2012 presidential campaign season, and following Peña Nieto’s victory, there were rumors that a comprehensive social security reform would also be part of Peña Nieto’s tax overhaul. However, for tax reform to finance a robust reform of the social security system the VAT would need to increase to roughly 18-20% and expand to most food and medicines.
This marked increase to the VAT is obviously not a politically viable option; it would have little support from the opposition at a time Peña Nieto is trying to achieve broad consensus with the PRD and the PAN. No political party wants to bite the bullet and raise the IVA much beyond 16%.
The ideal time to introduce the tax reform bill is during a special session of Congress in late summer after the upcoming state and local elections scheduled for July 7th. However, this special session could take place as early as May. The logic behind a special session exclusively devoted to tax reform is to keep public discussion of the reform as limited as possible and avoid other legislative distractions.
Realistically, the reform must be passed before September, before the Finance Ministry delivers its 2014 budget proposal to Congress. Doing this would allow the Finance Ministry to base its revenue projections on the new tax changes.
Key Political Considerations
Before presenting tax reform to Congress, the PRI must amend its internal statutes. Currently, the PRI’s platform prohibits legislators of that party from voting in favor of certain components that will likely be included in the tax reform. These include any measures that raise or expand the IVA to basic foods and medicines.
The PRI is scheduled to hold its annual National Assembly on March 3rd. According to sources interviewed for this report, the key purpose of the assembly is to modify the party’s internal statutes to allow PRI legislators to vote in favor of the upcoming tax reform.
Horse Trading with the Opposition
The PRD has not yet expressed its support for expanding the IVA to non-essential food and medicines. We foresee the PRD defending the status quo at the outset of the negotiation process but then compromising in exchange for the PRI’s support for progressive legislation regarding assistance programs for lower-income families. The PRD is also looking for concessions in other areas, namely a political reform that would grant Mexico City—a PRD bastion, full statehood rights.
Similarly, the PAN will seek to extract concessions from the PRI in exchange for supporting the bill; it may seek changes to electoral laws as well as other issues related to political reform (e.g. changing to a two-round presidential election system, reducing the size of Congress, creating stricter campaign spending laws).
In addition to the imminent legislative hurdles, Peña Nieto will face tough opposition from Andres Manuel Lopez Obrador (AMLO) and his nascent party, Morena. AMLO has already announced plans to lead a public awareness campaign against Peña Nieto’s future energy reform. Seeking to polarize the tax debate, AMLO will hold a similar campaign against tax reform over the summer.
Despite his ups and downs, AMLO still has tens of thousands of diehard supporters, clustered mainly in Mexico City and surrounding states. These people are willing to take to the streets at AMLO’s beck and call. As such, AMLO remains a wildcard factor to consider in this debate.
Buying Time and Political Capital
Between now and the unveiling of tax reform, Peña Nieto will seek to pass reforms in other areas to legitimize his status and consolidate his political capital. This could include a new telecom law that alters the oligopolistic nature of the telecom sector, amendments to the country’s electoral system and more measures to fight government corruption. Peña Nieto has already passed various laws aimed at improving his public perception and political capital, such as education reform and a state transparency and accountability law.
Other Corollary Reforms to be Delayed
While a comprehensive tax reform is urgently needed, there are other pending reforms that are not being addressed that are critical to improving the country’s public finances.
One gaping issue for the federal government’s finances is what to do with the pension obligations of some its largest agencies and state-controlled companies, principally Pemex and the National Social Security Agency (IMSS). Because such reforms are politically sensitive, it is impossible to think that they will be presented before or along with tax reform. Both Pemex and IMSS face enormous pension gaps; nearly 90% of IMSS’s budget is allocated to payroll, a majority of which goes to pensions. Some have suggested addressing Pemex’s pension problem along with passing tax reform so as to create optimal wiggle-room to pass meaningful energy reform.
The Big Picture
The political considerations listed in this article are of particular importance in the context of Mexico’s reform agenda. Peña Nieto must ensure broad inter party support in order to minimize damage to his political persona, maintain good standing in Congress and keep his party’s electoral outlook strong.
Despite the wisdom in waiting to pass tax reform, further delays would be very hazardous. Delayed action on tax reform will stall energy reform and will hinder the country’s potential for economic growth at a particularly critical juncture.
In the past, Peña Nieto has demonstrated a strong aversion to political confrontation and a desire to have strong inter-partisan support for legislative issues before presenting them to Congress. This thinking has so far worked on less complex legislative issues like education and labor reform, however, some level of political confrontation is inevitable when it comes to tax and energy reform.
Nevertheless, as opposed to energy liberalization, tax reform’s most controversial components are not nearly as politically sensitive as they are perceived. For this reason, we believe the Peña Nieto administration will be able to pass more meaningful tax reform than his predecessor, even if he does not get everything he wants.
Of all the tax reform components, adjusting the sales and business tax will likely be at the center of the debate. At the same time, devising new mechanisms to make informal businesses pay taxes and reduce tax evasion will be equally if not more important in determining the success of Peña Nieto’s tax reform.