May 2001
Watch Out, Canada! Here Comes Mexico
by Herb Grubel
It came as a shock to many Canadians earlier this year that newly-elected US President George W. Bush made his first foreign visit to Mexico rather than to Canada. Canadians had better get used to playing second fiddle to Mexico. Canadian politicians will soon wake up to some new realities as they go about their negotiations at the Western Hemisphere meetings in Quebec City.
Mexico, for so many Canadians the country of manana, tequila, and cheap holidays, has enjoyed a surge in trade with the United States. Since NAFTA was created in 1993, Mexico’s bilateral trade with the United States (exports plus imports) expanded at an average compound annual rate of 17.3 percent compared to Canada’s 9.8 percent. Mexico’s superior performance accelerated in 1999/2000, when its trade with the United States grew 26 percent while that of Canada grew only 12 percent. Projecting on the basis of the long-run average growth rate, Mexico will surpass Canada in 2007. If this happens, it will be quite an achievement since in 1993, US-Canada trade was $211.6 billion while US-Mexico trade was only $81.6 billion.
The stirring of the Mexican giant is partly due to the shift of the US population from the Northeast to the South and Southwest. Greater geographic and cultural affinity of this population will result in larger US trade with Mexico than Canada. The population shift was accompanied by a shift in political power. Since the 1960s, 5 of 7 elected presidents came from states bordering on Mexico: Texas supplied 3 (Johnson, the two Bushes) and California 2 (Nixon, Reagan). These presidents and their advisers have more experience dealing with Mexico than Canada, and their political agendas are influenced by this fact.
Mexico itself has contributed its own, recent impetus to these developments. Under President Salinas, economic policy turned from almost socialist dirigisme to one giving more rein to competition and markets. The success of the new policies was delayed by the currency crisis in the mid-1990s. There was much bureaucratic backtracking during the regime of President Ernesto Zedillo on the economic reforms, but he left as his legacy a more democratic political system. However, the pace to market reform is almost certain to pick up again under President Vincente Fox.
Mexico’s new President is free from the political baggage of his predecessors, who had owed their power to the Institutional Revolutionary Party (PRI). The 71-year rule of this party was ended by last year’s victory of the National Action Party (PAN), which is widely described as centre-right in its political outlook. Fox’s personal background, which saw him at one time head the Mexican subsidiary of Coca Cola, has inclined him to favour more market-oriented economic policies.
Leading this charge is his Secretary (Minister) of Finance, Francisco Gil-Diaz. Gil-Diaz was recruited from the private sector under the same political system that allows US Presidents to appoint to cabinet non-elected professional experts. He brings to his job an impressive set of qualifications. Gil-Diaz obtained a PhD in Economics from the University of Chicago at a time when such free market advocates and now Nobel laureates Milton Friedman, Robert Mundell, and Gary Becker dominated the curriculum. He wrote his dissertation Three Essays in the Taxation of Capital under Arnold Harberger, who is highly respected as a specialist in public finance. Gil-Diaz is just one in a long line of his students who have had influential public offices in Latin America.
Gil-Diaz has had practical experience in government for over 30 years. He has worked at the Bank of Mexico in several positions, was a member of a presidential advisory group on tax reform during the 1970s, and in 1988 became the Deputy Minister of Finance in charge of Taxation, a post he held until 1994.
During this latter period he was able to accomplish major tax reforms indicative of what is ahead. He reduced the top income tax rates from 55 to 35 percent, and fully indexed tax brackets to inflation. He reduced the value-added tax rates from 15 to 10 percent and eliminated surcharges on luxury goods. One of his most important changes was to eliminate the double taxation of business income by fully integrating it with the personal income tax and eliminating the capital gains tax on shares.
Gil-Diaz’s reforms also benefited lower-income Mexicans. He removed an array of excise taxes on phone services, soft drinks, and similar products. Not only did he simplify the tax code, but he eliminated a one-percent payroll tax paid by employers, and increased the basic exemption from all taxes to a level 3 times the minimum wage.
Gil-Diaz became feared and unpopular by jailing proven tax evaders and firing (after paying severance) a large proportion of tax collectors and customs officers. He replaced these officials with 1,600 high school graduates, whom he had trained secretly for a year.
For most economists it was not surprising that these reforms so stimulated economic activity and tax compliance that the lower tax rates actually increased total revenue. Unfortunately, after 1997 under President Zedillo, the administration of Mexico’s tax system slid back towards its old ways.
Gil-Diaz is now in a position to take up where he left his work in 1997. A new package of tax reforms has just been released and is being debated in the legislature. These reforms continue his program for greater tax efficiency and improved incentives.
The most controversial proposal is to increase the value-added tax to 15 percent and to broaden its base by including food. This aspect of his reform proposal is getting a rough ride as a regressive measure by the public and in the PAN-dominated legislature. However, the reforms of the value-added tax are considered highly desirable by economists because they allow a corresponding reduction in taxes on work and investment, which will have positive effects on incentives and economic growth. The proposed reforms also make the tax easier to administer and they avoid distortions in relative prices. (If we had such reforms in Canada, one doughnut would be taxed as much as 6, and there would be the same tax on frozen and freshly baked pizza.)
It is not certain that the new tax reforms, modernization in other economic policies, and efforts to eliminate corruption will be passed by the legislature. However, markets have a way of assessing such matters and sending appropriate signals. Since the beginning of this year, the Mexican peso has appreciated against the US dollar by about 3.8 percent. During the same period, the Canadian dollar has depreciated 4.3 percent. Investors appear to prefer Mexico to Canada.
These developments in Mexico are important for Canadians. The exchange rate changes will increase the cost of holidays in Mexico, possibly by as much as 10 percent. Mexico’s economic might will rise rapidly and, given its large population, will soon outstrip Canada’s. Mexico’s ascendancy is inevitable and beyond our influence. What counts is that Canada learns from the Mexican experience with tax and other economic reforms. I hope that Finance Minister Paul Martin spoke to Gil-Diaz during their meeting in Toronto on April 3rd about such policies. As unbelievable as it seems, Minister Martin might have learned something from Mexico’s system and principles of taxation.
Herbert Grubel (herbg@fraserinstitute.ca) is the David Somerville Chair in Taxation and Finance at The Fraser Institute and Professor Emeritus of Economics at Simon Fraser University. He is also a former Reform Party Finance Critic. A shorter version of this article previously appeared in the National Post.
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