Oct. 21 (Bloomberg) -- Mexico’s lower house of congress approved the income portion of the 2010 budget and tax laws designed to strengthen finances and avert a credit rating downgrade as revenue and oil production decline.

The legislation scraps President Felipe Calderon’s plan for an additional 2 percent consumption tax that would apply to all goods, including food and medicine. Deputies instead passed a measure calling for an increase in the current sales tax, which excludes food and medicine, to 16 percent from 15 percent.

It’s unclear whether the measures are strong enough to avoid a downgrade because they stop short of providing a long- term solution to falling public revenue, said Luis Flores, senior economist at IXE Grupo Financiero SA in Mexico City. That uncertainty will probably cause volatility in Mexico’s currency and bond markets in coming days, he said.

“Structurally, they’re not really doing a complete job. They’re doing it halfway,” Flores said. “That’s where the uncertainty comes in if this will satisfy the rating agencies.”

Budget Gap

Calderon is seeking to boost consumption and income taxes and reduce spending. Standard & Poor’s and Fitch Ratings say they’ll cut Mexico’s BBB+ rating, which is three levels above junk, should Mexico fail to narrow a budget gap that’s widening as oil output falls.

The budget legislation, which forecasts 3.18 trillion pesos ($244 billion) in total revenue, calls for a wider deficit next year of 0.75 percent of gross domestic product, compared with 0.5 percent in Calderon’s original proposal. It also increased estimated revenue by raising the forecast for next year’s average oil price to $59 a barrel from $53.90 a barrel.

Mexico’s peso rose for a second time this week after the lower house approved the legislation. The currency climbed 0.6 percent to 12.9659 per U.S. dollar at 4:00 p.m. New York time, from 13.0434 yesterday.

Yields on Mexico’s 10 percent bond due December 2024 rose 0.11 percentage point to 8.21 percent, according to Banco Santander SA. The price declined to 115.47 centavos per peso.

The Institutional Revolutionary Party, or PRI, the largest party in the lower house, pushed for modifications to Calderon’s original proposal, including the rejection of the 2 percent tax. Calderon needs the PRI’s support to pass his proposals.

Protest

The vote was delayed late yesterday and pushed to today as opposition lawmakers seized the podium in the lower house to protest tax increases. Legislators from the Workers Party and the Party of the Democratic Revolution covered the podium and walls with signs and banners criticizing Calderon, the PRI and the budget legislation.

The Senate is scheduled to vote on the income part of the budget by Oct. 30 and the lower house is due to pass the spending portion next month.

The legislation forecasts the economy will grow 3 percent next year, and foresees inflation of 3.3 percent in 2010.

Lawmakers also cut to 3 percent Calderon’s proposal to apply a 4 percent tax to telecommunications services.

The income tax rate for high-earning individuals as well as corporations would rise to 30 percent in 2010 to 2012, before dropping to 29 percent in 2013 and returning to 28 percent in 2014.

Widening Deficit

The change of the 2 percent consumption tax to a 1 percent increase in the sales tax will reduce the budget’s effect on accelerating inflation, Roberto Melzi, a strategist at Barclays Plc in Mexico City, wrote in a note.

“The replacement of the sales tax would require a less significant effort by the central bank to fight inflation expectations,” Melzi said. “It would not necessarily affect the timing of potential hikes.”

Still, Congress’s revenue plan probably won’t satisfy credit-rating agencies and a “one-notch downgrade is likely,” according to a Bank of America Corp. report.

“If economic recovery falters, international commodity prices retrench and the strong spending inertia, particularly from Mexican states and municipalities, is not properly addressed, a shortfall in tax revenues could remain a latent threat for Mexican public finances,” Bank of America analysts wrote in a report dated Oct. 20.

Cash Deposits

The lower house approved Calderon’s proposal to tax all cash deposits of at least 15,000 pesos at a rate of 3 percent. The tax is now 2 percent and only applies to deposits exceeding 25,000 pesos.

Lawmakers also passed changes to tax rules for state-owned oil company Petroleos Mexicanos aimed at promoting investment at new fields.

Mexico’s $1.09 trillion economy, the region’s second biggest, contracted 10.3 percent in the second quarter and job losses accelerated as the recession in the U.S., which buys about 80 percent of the country’s exports, sapped demand for its products. The economy will shrink as much as 7.5 percent this year, according to the central bank.

Government revenue tumbled as the recession reduced remittances and tax collection, while output of oil, which funds about 38 percent of the budget, slumped. Production at Petroleos Mexicanos declined 7.9 percent in August from a year earlier to 2.54 million barrels a day.

Total non-oil revenue, including sales and income tax, fell 13 percent in the first eight months of the year compared with the same period last year, according to the Finance Ministry.

-- With assistance from Catarina Saraiva in New York and Jose Enrique Arrioja in Mexico City. Editors: Brendan Walsh, Andrew Atkinson

To contact the reporter on this story: Adriana Lopez Caraveo in Mexico City at adrianalopez@bloomberg.net; Jens Erik Gould in Mexico City at jgould9@bloomberg.net

Last Updated: October 21, 2009 16:53 EDT