Tax Reform: Mexico's Fox Is Pushing The Case

With his popularity high, the President-elect is eyeing a radical fiscal overhaul

Taxes. That's a word politicians dare not speak, unless of course it's cuts they're talking about. Yet, fresh from his July 2 victory, Mexico's President-elect, Vicente Fox, is taking the issue head-on. Inauguration day may be five months away, but Fox has already commanded his team of economic advisers to begin work on what is sure to be one of the biggest challenges facing his administration: A wholesale overhaul of Mexico's antiquated and hopelessly inefficient tax system.

It might seem odd that Fox, a former Coca-Cola Co. executive, would choose to place such a controversial issue at the top of his agenda. But he really has no choice. Tax receipts in Mexico amount to about $65 billion a year, or 17% of gross domestic product. That's paltry compared with Poland's 41% or the U.S.'s 30%. Fox must find a way to boost that figure if he is to make good on his long list of campaign promises--from doubling education spending to defeating poverty. It won't be easy. "We have a very serious problem with the tax regime that will require a lot of work," says Francisco Gil Diaz, who was Mexico's chief tax collector in the early 1990s.

Still, there may be no better time for the incoming government to tackle fiscal reform. Fresh from his triumph over the long-ruling Institutional Revolutionary Party (PRI), Fox's popularity is sky-high. "He should take advantage of the political capital he has accumulated to carry out key reforms right away," says Claudio X. Gonzalez, CEO of Kimberly-Clark de Mexico and president of the Business Coordinating Council (CCE), Mexico's most influential business group.

Fox and his team of advisers have already begun crafting their tax proposals. They're soliciting advice from universities, think tanks, and business associations to ensure that the legislation they deliver to Congress will have broad support. Luis Ernesto Derbez, a former World Bank official who is Fox's chief counsel on economic matters, says that one of the main goals of a fiscal overhaul is to protect public finances against swings in oil prices. State-run oil company Petroleos Mexicanos currently supplies one-third of all tax revenue.

To curb the dependence on oil, the tax base must be broadened to include the estimated 15 million Mexicans--roughly half of the national workforce--who toil in the underground economy. Of course, even if the government managed to extract taxes from these gray-market enterprises, the resulting revenue would initially come to far less than 1% of GDP. Still, most agree the effort is critical to beating Mexico's culture of tax evasion.

LOOPHOLE WATCH. But pulling this off may be the biggest hurdle of Fox's tax reform: Other Latin countries have tried it, with minimal success. To turn underground workers into taxpayers, Derbez says the government may offer a one-time cash payment that can be applied to a pension fund or government-backed loans. Some outsiders advocate that, as another lure, Fox should lower tax rates for low-income individuals. Under the current system, Mexicans earning just $650 a month are taxed at 32%. A rate of 10% would be more equitable and politically palatable. Another proposal from outside the Fox camp is to introduce a capital-gains tax as a way of making the tax system more progressive.

But roping in tax evaders would just be the start of a fiscal overhaul. At 35%, Mexico's corporate income-tax rate is already a couple of points higher than in the U.S. So far, Fox has not proposed hiking the rate, but he may take aim at the myriad loopholes in the tax code, especially those benefiting the agriculture, fishing, and book publishing industries. "Maybe in the past they were necessary, but today it's not clear they are," Derbez says.

Even if loopholes get closed, Mexican companies remain adept at exploiting well-meaning tax reforms. A simplified tax regime introduced several years ago allows companies with less than $200,000 in annual sales to pay a flat fee. That has encouraged some large Mexican businesses to split themselves into a number of small companies that are less scrutinized for underreporting earnings. So Fox will have to make doubly sure any change to corporate taxes won't get nullified by savvy corporate accountants.

Then there's the explosive issue of the value-added tax. Most Mexicans are still smarting over the 50% increase, to a 15% VAT, that President Ernesto Zedillo pushed through in 1995. They also rebelled against a proposal floated a few years ago to extend the VAT to food and medicines. Yet Fox's advisers have hinted at reviving that controversial plan. Its effects on the poor, they argue, could be minimized by compensating them through targeted social programs.

FUR FIASCO. Taxes on luxury items are one quick way to boost revenues. But experts say they are not the answer for Mexico, because of the country's proximity to the U.S. For instance, in the 1970s, President Luis Echeverria slapped a 30% tax on fur coats, thinking it would be an easy source of cash. Instead, tax proceeds from sales of furs fell 65%. "Beautiful models would fly down from Dallas wearing $5,000 coats from Neiman Marcus, and none of the customs agents would say anything," recalls Gil Diaz. Similarly, high taxes on cigarettes, liquor, and gasoline could fuel a cross-border contraband trade, as U.S. levies on these items are often lower.

Derbez and company are also weighing options that will encourage investment. They like the idea of tax breaks to boost job creation in Mexico's poorest states, such as Chiapas. And they want to give breaks to multinationals to encourage them to reinvest their profits in Mexico. No such incentives exist now, so some $3 billion in profits gets repatriated each year.

Fox's number crunchers will have to rush to have legislation ready to present to Congress once he takes office on Dec. 1. That's when the real battles will start. The PRI and the center-left Party of the Democratic Revolution, whose votes Fox needs to pass tax legislation, are sure to put up some obstacles. That's why most analysts believe reforms won't be implemented until 2002, which could make it hard for Fox to realize his goal of boosting tax collection by 6% of GDP by the time his term ends in 2006. "Fox's team has a big list of nice proposals, but there is no consensus at all," says independent economist Jonathan E. Heath. Probably so. But to do big things, you have to start by thinking big.

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