The Government’s Lifeblood Thins as Oil Prices Keep Falling

One hundred years ago, Ramon Lopez Velarde, a renowned Mexican poet, proclaimed that the country’s oil resources were a curse underwritten by the devil. Today’s government officials understand what he meant: For two decades, oil has saved the Mexican government from financial catastrophe, but it also has impeded the government from developing a modern tax structure that could pick up the revenue slack if commodity prices fell.

The current debate on the 1999 budget illustrates the curse. The dramatic falloff in oil prices has reduced the government’s revenue by more than $5 billion since 1997. The shortfall has forced the Zedillo administration to make four budget cuts this fiscal year to avoid expanding the deficit. In so doing, government officials displayed fiscal responsibility and clarity of mind. But they also have highlighted the dire limits that the country’s oil policies have imposed upon Mexico and, more important, the inadequacy of the government’s tax policies.

The issue is not new. Beginning in the 1970s, Mexican presidents discovered that rapidly growing oil revenues were a way to increase government spending beyond their wildest expectations without having to raise taxes. Deficit spending became the way to govern. During these years, the deficit grew to as much as 18% of gross domestic product. Oil revenues and, more specifically, the expectation of greater future income from petroleum emboldened the government to borrow abroad. When the first oil-price crunch came, in the early 1980s, the government went bust.

In part, the economic policies of the last three administrations have aimed to correct the oil-generated imbalances that began in the 1970s. Extraordinary progress has been made. Public spending was brought under control by the end of the 1980s, and tax policy was revamped with a eye toward raising more revenue. Little by little, tax rates were lowered to a maximum of 35%, and enforcement has been strengthened to the point that tax evasion has ceased to be a joke. During the early ‘90s, tax revenue increased by more than 3.5% of GDP.

The collapse of Mexico’s economy in 1982 because of falling oil prices also set off a structural transformation. Oil accounted for more than 70% of Mexico’s exports in the early 1980s. Today, it represents less than 10%. Mexico will export around $120 billion in goods and services this year, compared with less than $20 billion 15 years ago. Thus, oil is no longer a critical factor in the country’s economy or balance of payments.

But oil remains key to the government’s accounts. Taxes on oil comprise nearly 40% of total public revenues, an astounding percentage compared with the world’s other large oil producers. This dependency not only restricts the overall progress of the economy, it also creates a vicious circle. When oil prices fall, the government scrambles for cash by seeking to draw revenue from everything and everywhere, regardless of the economic or political consequences of its actions. By the same token, the government cannot afford the massive investment that Pemex requires to maintain the flow of oil; but if it doesn’t, export revenues will inevitably decline even more.

Despite progress, Mexico’s tax revenue, at about 10% of GDP, is still well below that of economically comparable nations. Government spending today runs at about 15% of GDP. When the price of oil was at about $14 a barrel, the government was able to square its accounts. As oil prices have fallen this year, to around $10 a barrel, the government has incurred a deficit, violating an implicit rule born out of the experience of the 1980s: Once a deficit, even if “small” or “manageable,” becomes legitimate, every politician and political party will find new pet projects to finance.

As a result, the government is caught in a Catch 22. It cannot introduce new taxes, or raise old ones, because all political parties are conservative when it comes to changes that affect their constituents. The government, for example, has spent the entire year lobbying for an increase in the value-added tax, from 0% to 15%, for processed foods and medicines. With the extra revenue, officials had hoped to roughly balance the budget. But members of the Institutional Revolutionary Party (PRI) objected and, without warning, rewrote the bill in the spirit of the undisciplined ‘80s. Instead of streamlining taxes, simplifying compliance, expanding the tax base and stimulating investment, the amended bill proposed to tax captive taxpayers even more. At its core, the financial constraints that the government faces have a lot to do with a loss of credibility, both on the part of the administration and the political parties.

The issues are straightforward. The government essentially collects money from four sources: oil, income taxes, a value-added tax on consumption and federal excise taxes on gasoline, alcohol, beverages and tobacco. About 5 million individuals and companies pay their taxes, out of a population of 100 million. The value-added tax, which supposedly facilitates tax administration and enforcement by taxing one layer after another in a production and consumption chain, is so full of exemptions that it raises half the money it’s supposed to. To be blunt about it, too few people pay very high taxes, while a great number of economic transactions take place outside the gaze of the tax man.

The congressional debate has brought two substantive questions to the fore. One is whether, at a time when big-oil mergers like the proposed Exxon-Mobil marriage may become commonplace, a company like Pemex, Mexico’s oil firm, still makes sense. Pemex cannot compete, it is extremely inefficient and, given the fact that the government is strapped for cash, cannot invest its money as a private company would. Unfortunately, debate on oil policy inevitably leads to nationalistic posturing, which doesn’t diminish the importance of the issue. For example, were there more oil producers in the country, additional production could make up the loss tax revenues.

The other question has to do with the tax structure. Just as Mexicans overwhelmingly perceive that the law should be followed only when it is convenient or when it is perceived to be fair, people see taxes as the price they have to pay for being misgoverned. If so, an appropriate tax structure and policy may be unenforceable in a society that is no longer a soft dictatorship or a true democracy.

Every country encounters similar challenges, but Mexico’s are largely the result of a political system that rewards opposition rather than action. The risk is that democracy, or whatever Mexicans have advanced in the process, will end up being blamed for what it did not do.