FISCAL REFORM: CURRENT STATUS

UNCLAS SECTION 01 OF 03 MEXICO 004280

SIPDIS

SENSITIVE
SIPDIS

SECSTATE FOR A/S SHANNON
SECSTATE FOR WHA/MEX, WHA/ESP, EB/IBF/OMA
SECSTATE FOR EB/ESC MCMANUS AND IZZO
USDOC FOR 4320/ITA/MAC/WH/ONAFTA/GWORD
USDOC FOR ITS/TD/ENERGY DIVISION
TREASURY FOR IA (ALICE FAIBISHENKO)
DOE FOR INTERNATIONAL AFFAIRS KDEUTSCH AND ALOCKWOD
SECSTATE PASS TO USTR (EISSENSTAT/MELLE)
SECSTATE PASS TO FEDERAL RESERVE (CARLOS ARTETA)
NSC FOR DAN FISK


E.O. 12958: N/A
TAGS: ECON BEXP SENV EAID PGOV EFIN EINV MX
SUBJECT: FISCAL REFORM: CURRENT STATUS

REF: A. MEXICO 3246


1. (U) Summary: Mexico's opposition parties continue to deliberate
on whether to allow a Special Session so that Congress could rule on
Calderon's fiscal reform proposal before the FY 2008 budget must be
submitted on September 8. Despite criticism of the CETU minimum
alternative tax by business, a leading Mexico NGO, the Mexican
Competitiveness Institute (IMCO),sees the CETU as a needed
modernization of Mexico's current fiscal regime that would increase
investment and job creation. Because expanding Mexico's tax base is
not currently politically possible, the Calderon Administration has
little leeway to meet industry demands to lower the CETU rate or
increase deductions. Even critics of the CETU acknowledge that the
worst outcome would be for the Congress to block Calderon's attempt
at fiscal reform. End Summary.


PRI and PRD Views
--------------


2. (U) While Finance Secretary Augustin Carstens and President
Calderon continue to lobby for their tax reform proposal, the PRI
and PRD opposition parties are debating whether to call a special
Congressional session in August to approve the reform before the FY
2008 budget package is due to be sent to Congress on September 8.
The PRI will discuss its proposed changes to the fiscal reform
during its party plenary on August 19-21 in Veracruz. Proposed
changes being considered by the PRI include reducing the Single Rate
Business Tax (CETU) by 3%, eliminating the tax on spray paint,
earmarking resources from the "informality tax" on cash deposits
over 20,000 Mexican pesos a month, and preventing taxes being
collected on remittances. Some PAN legislators have proposed
reducing the CETU by 2%. The Finance Ministry warned that each
percentage point drop in the CETU would reduce government revenue by
USD 1 billion.


Praise for the Fiscal Reform
--------------


3. (U) Whether the fiscal reform will generate enough revenue, and
how that revenue will be used is a key part of the ongoing debate.
Those analysts publicly supporting fiscal reform note the importance
of increasing government revenue. Moody's senior economist for
Latin America, Alfredo Coutino predicted that financial markets
would rally with the approval of the tax reform due to the
importance of generating the additional revenue equivalent to 2% of
GDP.


4. (U) Roberto Newell, Director General of the Mexican
Competitiveness Institute (IMCO, a leading non-governmental
organization) used an Op-Ed piece in a leading newspaper to defend
Calderon's proposal. Newell noted that given PRI and PRD opposition
to expanding the Value-Added tax (VAT),the CETU was the best
available option. While Newell admitted the CETU tax was not
perfect, he said it was a necessary means to get around the many
exemptions that keep collections of the current income tax (ISR)
well below what is needed for a healthy economy. He explained that
the CETU puts a much-needed floor on collections, ensuring that
businesses pay a minimum level of tax. He claimed that the CETU
will actually increase incentives for investment and job creation in
the formal economy. Because the CETU is a much simplified tax, and
the CETU's rate is well below the marginal rate for the current
"ISR" income tax, it would be a step toward a more modern, effective
tax regime that would promote investment and growth. Newell
expressed the hope that that over time, the old fiscal regime would
be replaced by the simpler, more modern system started with the
CETU.


Maquiladoras Criticize the Reform Proposal

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5. (U) The National Council for the Maquiladora Export Industry
(CNIME),took the opposite view in their August 7 discussion with
Econoff. The CNMIE said the CETU would stifle investment and job
creation, particularly in labor intensive sectors such as their own.
CNIME President Jose de Jesus Calleros said that the maquila
industry is particularly affected by the CETU because of the
inability to claim deductions for labor costs which constitute 70
percent of the industry's expenditures. He said that if the CETU is
passed as currently presented, Mexico would become less competitive
as investors and businesses move to countries with a more favorable
tax structure.


Mexico Needs Help to Expand its Tax Base
--------------


6. (U) Citibank, Proctor and Gamble, Daimler Chrysler and 33 other
corporations under the Executive Council on Global Corporations
(CEEG) have written to authorities requesting changes in the tax
reform to expand the base of taxpayers, and improve control and
transparency of government spending. The CEEG said investors needed
certainty that government resources will be spent on social programs
such as health, education, housing and infrastructure.


7. (U) The CEEG gets at the heart of Mexico's fiscal reform debate.
The PRI and PRD will not accept expansion of the VAT, and the
government is finding it extremely difficult to expand the tax base
beyond those firms and people currently paying taxes. Recent
visitors from U.S. Treasury's Office of Technical Assistance told
Emboffs of the very great need of Mexico's tax authorities (SAT) for
technical assistance to learn how to go after businesses and people
who do not pay taxes. OTA also noted the strong commitment and
desire of the SAT managers who want to improve tax collection
processes. OTA said that SAT clearly recognizes that they need to
go after tax evaders.


More Tax Revenue is Needed
--------------


8. (U) The CEEG has joined many politicians and other observers in
making demands that the increased government revenue from the fiscal
reform fund badly needed infrastructure, education, health and
housing. It is unclear whether that will happen, however. Francisco
Suarez Davila, PRI former Undersecretary of Finances and former
chairman of Congress' Committee publicly warned that most of the
expected resources from the tax reform will be channeled to the
teachers union SNTE due to an agreement made by then-President Fox
and the SNTE in October 2006 (Ref A). Suarez claimed little will
remain to address social needs, explaining that the Finance Ministry
expects to collect 130 billion Mexican pesos form the CETU, but 50
billion will go to pay teachers salaries, and 3 percent net of GDP
will go to pay pensions and Pidieragas (off-the books government
debt) maturities.


Comment
--------------


9. (U) Although Calderon's fiscal reform proposal is not the broad
reform most had expected, and does not significantly expand Mexico's
narrow tax base, it is a step forward; and many observers expect
Calderon to propose a broader fiscal reform later during his term if
the current reform passes the Congress. The government is in a
difficult position. Investors are claiming that the CETU rate must
be reduced, and increased deductions allowed from the CETU or
employment will suffer. The government desperately needs to
increase tax revenue, however. The maquiladora industry, which is
de-crying increased taxes of upwards of 600%, currently pays a tax

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rate of 1% on total income (see septel). The current tax regime
keeps taxes extremely low through a complicated system of deductions
and exemptions. There is currently no political will in the Mexican
Congress, and perhaps within the Calderon Administration, to take on
the special interests to dismantle these special privileges.
Finance Secretary Carstens said both publicly and privately that
success in achieving economic reform depends on the Administration
knowing when to pick its battles. As long as oil production
continues to decline, Mexico must increase the taxes that its firms
and individuals pay. Since PRI and PRD opposition prevents
expanding the VAT, the government will have limited options for
finding other revenue sources if it agrees to reduce the amount to
be collected through the CETU.


10. (SBU) Comment: Even those who complain about the tax reform,
such as the American Chamber of Commerce, note that the worst case
would be for the reform to fail. Not only would financial markets
be disappointed at Mexico's failure to make even a moderate fix to
its broken fiscal regime, but it would weaken President Calderon's
credibility to achieve consensus to advance his reform agenda. End
Comment


GARZA