Issues in Brief

Mexico’s Fiscal Reform May Have Limited Impact on U.S. Manufacturers

Economic Consultant
October 21, 2013

On September 8, Mexican President Enrique Peña Nieto sent his fiscal reform proposal to the nation’s Congress, which has until November 15 to discuss the bill. This tax reform bill is part of a broader reform agenda that includes the telecommunications, financial, and energy sectors. The overall objective is to make the Mexican economy more competitive by fighting monopolies and freeing up public resources to be redirected to improve the country’s poor infrastructure, lagging education, and rising crime.

The fiscal reform aims at generating a larger state capable of delivering much-needed public goods for the benefit of Mexican citizens and companies doing business there. It should be highlighted that Mexico’s current tax collections are among the lowest in Latin America, relative to the size of the economy. According to the 2013 Fiscal Monitor published by the International Monetary Fund, government revenues in Mexico are equivalent to 23 percent of GDP (including oil receipts), well below Latin America’s average of 32 percent.

Mexico’s fiscal reform may affect U.S. manufacturing companies already doing business in Mexico and those exploring investing in the country. In general, relatively lower manufacturing costs and potentially efficient supply chains have been the major drivers for U.S. investments south of the border. An ambitious tax reform that increases government revenues by heavily taxing corporations, either by raising taxes or eliminating special tax exemptions, will have a sizable effect on companies’ bottom lines and on the economics behind U.S. manufacturers’ location decisions. This comes at a time when China’s rising labor costs and complicated logistics are leading senior executives to revise their location decisions and view Mexico as an attractive destination for manufacturing plants supplying U.S. and global customers.

The Executive’s Proposal
The original bill proposed to increase government revenues by 3 percentage points of GDP by 2018 by taxing higher earners. By failing to broaden the tax base—something that most economists wanted to see—the same few Mexicans or large corporations that currently pay taxes will pay more. The proposal thus came short of analysts’ expectations. A heavily criticized aspect of the proposal is that almost two-thirds of the increase in government revenues in the next five years is expected to come from a gradual elimination of a gasoline subsidy, showing that the bill does not really address the government’s oil dependence. The proposed tax increases accounted for only 1 percent of GDP.

The bill’s original main proposals for increasing tax collections were centered on:

  • Raising the VAT paid at border zones from the current 11 percent to 16 percent, the rate charged in the rest of the country
  • Eliminating the VAT exemption on temporary imports of subcomponents
  • Increasing the income tax on dividends and profits earned by local and foreign entities by 10 percent
  • Changing the definition of a “maquila,” negatively impacting those firms’ income tax obligations
  • Raising income taxes for high earners from 30 percent to 32 percent
  • Eliminating the VAT exemption on private schooling, housing proceeds (from rental or sale of real estate), and mortgage interest

Legislators on the center right have heavily criticized some of these proposals, notably those related to education, housing, and mortgages, with the argument that the burden on middle-class families is too great and the actions would negatively impact an already sluggish economy. Trade associations across Mexico are vocally complaining about the proposals to eliminate the exemption on VAT for subcomponents and raising the VAT at border zones. As a result, the government accepted some changes put forward by the opposition in order to reach a consensus and move on, particularly on items targeting middle-income families.

A Relatively Benign Outcome for U.S. Manufacturers
On October 17, the lower house passed a watered-down bill that excludes the proposal to apply the VAT on educational services or real estate income. No agreement has been made on lowering the impact on businesses of a higher VAT at border zones. The proposal to eliminate the VAT exemption on temporary imports was trimmed down and may not affect U.S. manufacturing companies—this is likely the most significant change in favor of MAPI members from a financial and operational standpoint. While some of the proposals in the original bill would have had sizable impact on U.S. manufacturers by raising their tax burden, this version seems much more benign.

Although most economists view the fiscal reform approved by the lower house as a timid effort to boost tax receipts and reduce Mexico’s oil reliance, it is essential to remember that politics are a key part of the equation in polarized societies such as those in Latin America. A more ambitious fiscal reform plan, such as one proposing to raise government revenues by more than 3 percentage points of GDP, would not have been approved in Congress. Gradual changes to legislation and economic policies are more likely to be enacted. The modest reach of the tax reform proposal could provide Peña Nieto’s administration with the political credit to make progress on the broader reform agenda, especially the partial opening of the energy sector, a boon for U.S. manufacturing companies.

Clearly, once the tax reform is enacted, U.S. manufacturers with operations in Mexico will see their bottom lines impacted since they will eventually have to pay more taxes. Focusing on just that aspect may be shortsighted, however. It is important to look at the fiscal reform in the context of the broader reforms being undertaken in Mexico that, if implemented properly, will reduce the costs of manufacturing. Successful energy reform that frees up resources to invest in infrastructure and education is an obvious example. The short-term impacts of the fiscal reform could be partially offset by longer-term productivity gains, assuming no policy slippage. Relative to the original proposal, the bill approved in the lower house will have limited impact on U.S. manufacturing companies. The next step is for the bill to be discussed in the Senate.

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