MexECON Blog

Congress OKs Increased Taxes, Higher Spending for 2014

In October and November, legislators in Mexico gave final approval for a modest "reform" of the country's fiscal system and an expansionary budget for 2014.  The government's original proposal was designed to broaden the tax base in order to generate a substantial increase in federal revenues.  The increased resources could then be used to redress Mexico's chronic underfunding of public investments and excessive reliance on revenues from the state-owned oil company.  However, political resistance to some of the proposals was intense.  The end result is likely to produce only a modest increase in resources, mostly by raising tax rates rather than broadening the tax base or reducing evasion.

Tax increases under the new reform generally take place at the beginning of 2014.  Those tax hikes are likely to impede economic growth in the coming year, just as tight spending held down growth in 2013.  However, the government has tried to ease the impact of the tax increases by boosting 2014 spending substantially faster than the expected increase in revenues.  The discussion below examines the key tax changes, the revenues and spending envisioned for 2014, and the possible impact on the Mexican economy.

Boosting Revenues

Without a doubt, the level of tax revenue in a country can have a big impact on its economic success.  If tax rates are too high or the tax base too narrow, capital investment and hiring is likely to be muted, and economic growth will probably be slow.  If tax revenue is too low, the government may resort to deficit spending and borrowing, or it may simply forego public investment in roads, water systems, law enforcement, or other programs that the private sector cannot provide but that generate substantial benefits for the economy.  Mexico's fiscal system over the last couple of decades has been marked by a narrow tax base and extensive tax evasion, to which the government has responded by underfunding public investment.  As shown in the table below, general government revenues and outlays as a share of gross domestic product (GDP) are much lower in Mexico than in the major developed economies.  They are even lower than in many important emerging markets.

Special - 131213 Fiscal Reform Table 1

The fiscal reform promoted by President Enrique Peña Nieto aimed to improve and simplify the collection of taxes, broaden the tax base, reduce the government's reliance on oil revenues, and combat tax evasion.  The government estimated that the original proposal would have boosted federal revenues by 1.4% of GDP in 2014 alone.  The final changes approved by the Congress were in some cases more than the president requested, but in many other cases they were watered down.  Among those that were rejected were proposals to apply the value added tax (VAT) to private school tuition and mortgage interest.  The overall increase in revenues from the reform is therefore expected to be just 1.0% of GDP.  The reform relies much more on increased tax rates and reduced deductions for current payers, rather than broadening the tax base.  In some cases, it also seems to work against the longstanding goal of bringing more workers into the "formal" economy.  They key changes approved by Congress include the following.

Corporate Income Tax. Under the reform, Mexico's corporate income tax rate remains at 30.0% for most businesses.  However, dividends paid to individuals or other entities will be subject to a new tax of 10.0%.  The dividend tax will apply to recipients domiciled in Mexico or abroad, and the taxes will have to be withheld by the payer.  The reform ends the immediate write-off of fixed investment for tax purposes, replacing it with a mandatory straight-line depreciation regime.  Among other new deduction limits, the reform caps the amount of a new automobile that can be written off to 130,000 pesos (approximately $10,000), and it allows only 8.5% of the value of a restaurant meal to be deducted.  On a more positive note, however, the reform takes a small step toward tax simplification by eliminating the complicated "IETU" alternative minimum tax.

Individual Income Tax. Under the reform, the top income tax rate for individuals rises to 35.0% for incomes above 3,000,000 pesos (approximately $230,000).  The reform also establishes several other new tax brackets, all of which are above the previous maximum rate of 30.0%.  In addition, it establishes a new 10.0% tax on capital gains income related to the sale of stocks.  Deductions are capped at four times the annual minimum wage (currently 94,550 pesos, or approximately $7,300) or 10.0% of the individual's income, whichever is smaller.  The reform also tightens the rules for what medical expenses can be deducted.

Value Added Tax. After the income tax, the VAT is Mexico's second-most important tax.  The reform eliminates the preferential VAT rate of 11.0% that had long been in place along the U.S. border, so that the general VAT rate of 16.0% now applies throughout the whole country.  The reform also eliminates the VAT exemption on short-term imports.  Beginning in 2014, firms that import intermediate goods for processing and re-export will have to pay the VAT and await later reimbursement, just as the tax is handled for other industrial inputs.  The reform also eliminates the VAT exemption for lodging.  Many observers have urged Mexico to broaden its tax base by eliminating the VAT exemption for food and beverages, but because of political opposition, the president did not even propose such a dramatic step.  Instead, the reform merely extends the VAT to chewing gum and pet food.

Junk Food Tax. In a move ostensibly aimed at promoting good health, the reform applies a new sales tax of 8.0% to any food with a caloric density greater than 275 calories per 100 grams.  The tax is expected to apply to foods such as candy, peanut butter, ice cream, and puddings.  In addition, the reform imposes a new tax of 1 peso (about $0.08) per liter of sweetened beverages, such as soft drinks.

Mining Tax. Under the reform, firms with mining rights are subject to a new 7.5% tax on the value of their gross sales minus certain deductions.  They will also have to pay a tax on any of their mining acreage not exploited within certain time limits.  The law imposes an additional tax of 0.5% on sales of gold, silver, and platinum.

Boosting Spending in 2014

As approved, the 2014 budget calls for federal spending of 4.47 trillion pesos (approximately $345 billion).  That represents an increase of some 12.9% from 2013, or 8.8% after stripping out inflation.  Spending on infrastructure alone is expected to rise 14.0% after inflation.  The increased spending includes some 7 billion pesos (about $538 million) for reconstruction in the state of Guerrero, which was devastated several months ago by two strong storms, and 3 billion pesos ($231 million) to help the border states adjust to the higher VAT rate discussed above.  The fiscal reform also committed the federal government to extending the social security system to all citizens and establishing a new unemployment insurance program, but it is unclear how much of an impact that will have on the budget.  In any case, the big increase in spending is projected to boost the fiscal deficit from 2.4% of GDP in 2013 to 3.5% of GDP in 2014.

Conclusion

President Peña Nieto's fiscal package is probably best seen as a series of tax hikes on those who are already shouldering Mexico's tax burden.  It is a "reform" only in the sense that it has moved Mexico very slightly in the direction of broadening the tax base.  For example, applying the VAT to chewing gum and instituting the new tax on high-calorie foods and sugary beverages could eventually help break the taboo against applying the VAT to all food and medicine.  The failure to enact a more significant and immediate increase in the tax base is disappointing for Mexico's longer-term economic outlook, but the tax hikes on current payers will also pose more challenges for Mexican economic growth in 2014.  That explains why the government proposed such an expansionary spending plan for 2014.  One key question now is whether the financial markets will eventually punish Mexico for the increased budget deficit.  In sum, Mexico's new fiscal "reform" and 2014 budget seem like very modest successes, and nothing more.

Patrick Fearon, CFA
Vice President, Fund Management

In October and November, legislators in Mexico gave final approval for a modest "reform" of the country's fiscal system and an expansionary budget for 2014.  The government's original proposal was designed to broaden the tax base in order to generate a substantial increase in federal revenues.  The increased resources could then be used to redress Mexico's chronic underfunding of public investments and excessive reliance on revenues from the state-owned oil company.  However, political resistance to some of the proposals was intense.  The end result is likely to produce only a modest increase in resources, mostly by raising tax rates rather than broadening the tax base or reducing evasion.
Tax increases under the new reform generally take place at the beginning of 2014.  Those tax hikes are likely to impede economic growth in the coming year, just as tight spending held down growth in 2013.  However, the government has tried to ease the impact of the tax increases by boosting 2014 spending substantially faster than the expected increase in revenues.  The discussion below examines the key tax changes, the revenues and spending envisioned for 2014, and the possible impact on the Mexican economy.
Boosting Revenues
Without a doubt, the level of tax revenue in a country can have a big impact on its economic success.  If tax rates are too high or the tax base too narrow, capital investment and hiring is likely to be muted, and economic growth will probably be slow.  If tax revenue is too low, the government may resort to deficit spending and borrowing, or it may simply forego public investment in roads, water systems, law enforcement, or other programs that the private sector cannot provide but that generate substantial benefits for the economy.  Mexico's fiscal system over the last couple of decades has been marked by a narrow tax base and extensive tax evasion, to which the government has responded by underfunding public investment.  As shown in the table below, general government revenues and outlays as a share of gross domestic product (GDP) are much lower in Mexico than in the major developed economies.  They are even lower than in many important emerging markets.
[INSERT TABLE HERE]
The fiscal reform promoted by President Enrique Peña Nieto aimed to improve and simplify the collection of taxes, broaden the tax base, reduce the government's reliance on oil revenues, and combat tax evasion.  The government estimated that the original proposal would have boosted federal revenues by 1.4% of GDP in 2014 alone.  The final changes approved by the Congress were in some cases more than the president requested, but in many other cases they were watered down.  Among those that were rejected were proposals to apply the value added tax (VAT) to private school tuition and mortgage interest.  The overall increase in revenues from the reform is therefore expected to be just 1.0% of GDP.  The reform relies much more on increased tax rates and reduced deductions for current payers, rather than broadening the tax base.  In some cases, it also seems to work against the longstanding goal of bringing more workers into the "formal" economy.  They key changes approved by Congress include the following.
Corporate Income Tax.  Under the reform, Mexico's corporate income tax rate remains at 30.0% for most businesses.  However, dividends paid to individuals or other entities will be subject to a new tax of 10.0%.  The dividend tax will apply to recipients domiciled in Mexico or abroad, and the taxes will have to be withheld by the payer.  The reform ends the immediate write-off of fixed investment for tax purposes, replacing it with a mandatory straight-line depreciation regime.  Among other new deduction limits, the reform caps the amount of a new automobile that can be written off to 130,000 pesos (approximately $10,000), and it allows only 8.5% of the value of a restaurant meal to be deducted.  On a more positive note, however, the reform takes a small step toward tax simplification by eliminating the complicated "IETU" alternative minimum tax.
Individual Income Tax.  Under the reform, the top income tax rate for individuals rises to 35.0% for incomes above 3,000,000 pesos (approximately $230,000).  The reform also establishes several other new tax brackets, all of which are above the previous maximum rate of 30.0%.  In addition, it establishes a new 10.0% tax on capital gains income related to the sale of stocks.  Deductions are capped at four times the annual minimum wage (currently 94,550 pesos, or approximately $7,300) or 10.0% of the individual's income, whichever is smaller.  The reform also tightens the rules for what medical expenses can be deducted.
Value Added Tax.  After the income tax, the VAT is Mexico's second-most important tax.  The reform eliminates the preferential VAT rate of 11.0% that had long been in place along the U.S. border, so that the general VAT rate of 16.0% now applies throughout the whole country.  The reform also eliminates the VAT exemption on short-term imports.  Beginning in 2014, firms that import intermediate goods for processing and re-export will have to pay the VAT and await later reimbursement, just as the tax is handled for other industrial inputs.  The reform also eliminates the VAT exemption for lodging.  Many observers have urged Mexico to broaden its tax base by eliminating the VAT exemption for food and beverages, but because of political opposition, the president did not even propose such a dramatic step.  Instead, it merely extended the VAT to chewing gum and pet food.
Junk Food Tax.  In a move ostensibly aimed at promoting good health, the reform applies a new sales tax of 8.0% to any food with a caloric density greater than 275 calories per 100 grams.  The tax is expected to apply to foods such as candy, peanut butter, ice cream, and puddings.  In addition, the reform imposes a new tax of 1 peso (about $0.08) per liter of sweetened beverages, such as soft drinks.
Mining Tax.  Under the reform, firms with mining rights are subject to a new 7.5% tax on the value of their gross sales minus certain deductions.  They will also have to pay a tax on any of their mining acreage not exploited within certain time limits.  The law imposes an additional tax of 0.5% on sales of gold, silver, and platinum.
Boosting Spending in 2014
As approved, the 2014 budget calls for federal spending of some 4.47 trillion pesos (approximately $345 billion).  That represents an increase of some 12.9% from 2013, or 8.8% after stripping out inflation.  Spending on infrastructure alone is expected to rise 14.0% after inflation.  The increased spending includes some 7 billion pesos (about $538 million) for reconstruction in the state of Guerrero, which was devastated several months ago by two strong storms, and 3 billion pesos ($231 million) to help the border states adjust to the higher VAT rate discussed above.  The fiscal reform also committed the federal government to extending the social security system to all citizens and establishing a new unemployment insurance program, but it is unclear how much spending will be associated with those initiatives.  In any case, the big increase in spending is projected to boost the fiscal deficit from 2.4% of GDP in 2013 to 3.5% of GDP in 2014.
Conclusion
President Peña Nieto's fiscal package is probably best seen as a series of tax hikes on those who are already shouldering Mexico's tax burden.  It is a "reform" only in the sense that it has moved Mexico very slightly in the direction of broadening the tax base.  For example, applying the VAT to chewing gum and instituting the new tax on high-calorie foods and sugary beverages could eventually help break the taboo against applying the VAT to all food and medicine.  Not only is that disappointing for Mexico's longer-term economic outlook, but the increase in taxes will pose even more challenges for Mexican economic growth in 2014.  That explains why the government proposed such an expansionary spending plan for 2014.  One key question now is whether the financial markets punish Mexico for the increased budget deficit.  In sum, Mexico's new fiscal "reform" and 2014 budget seem like very modest successes, and nothing more.
Patrick Fearon, CFA
Vice President, Fund Management

 

 

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