OECD Survey Points Way For Mexico To Improve Fiscal Management

by Ulrika Lomas, Tax-News.com, Brussels

14 August 2009

An OECD survey on Mexico states that public consumption and GDP are highly volatile and that price fluctuations affecting Mexico's oil revenue tend to be synchronized with the world economic cycle. The tendency for pro-cyclicality – more spending in good times and spending cuts during downturns – is, moreover, reinforced in Mexico by their balanced-budget rule, according to the OECD. Their survey includes recommendations on how to improve fiscal management in these circumstances.

The OECD survey warns that Mexico faces the challenge of managing the macroeconomic impact of oil revenue. While such revenue provides useful resources to the economy, its management raises a number of difficult issues. Oil revenue tends to be highly volatile and the budget risks channelling this volatility to the non oil parts of the economy.

The OECD recommends that the fiscal framework should be adjusted to shield public expenditure from the high volatility of oil revenue. In some countries, this is achieved by transferring the bulk of oil wealth to future generations, thus minimizing the injection of oil revenue into domestic demand. In Mexico, according to the OECD, it seems both efficient and fair that the current generation uses oil revenue to finance economic development, so as to raise present as well as future living standards. Thus the OECD consider the objective of fiscal policy should be to smooth the injection of oil revenue into the economy over the cycle and avoid abrupt changes in public spending. Mexico established several oil-stabilization funds for this purpose but the OECD think that accumulated savings were capped at relatively low levels, which made the funds less useful for the purpose of macroeconomic stabilization.

Mexico decided recently to raise the maximum size of the oil stabilization funds, but the OECD prefer the idea of eliminating this limit altogether. To strengthen the counter cyclical framework of the budget, the OECD recommends adopting a new fiscal rule, adjusted for the cycle, and aimed at:

• smooth growth of public spending in line with economic growth,
• automatic savings of oil revenue above what is implied by the rule when the oil price is high and
• automatic spending of accumulated savings when oil revenue is low.

According to the OECD, this would phase in gradually the injection of oil wealth into the economy and would contribute to long-term sustainability. With the limit for the non-oil structural deficit being reviewed regularly, the OECD point out that increases in net financial assets would suggest that there is space for running a higher non-oil structural deficit, while increases in net financial liabilities would call for tightening the non-oil structural deficit target.

Since declining oil production will reduce contributions to the budget over the next two decades, the OECD recommends preparing the public finances for this decline. The OECD regards the policies of keeping gasoline prices constant in real terms and subsidies on LP gas and electricity for household use, as inefficient and unfair – gasoline prices should move in line with international reference prices, and an energy excise tax should be introduced, while subsidies on other energy products are removed.

The OECD contend that the subsidy is mainly captured by well-off social groups and tends therefore to be regressive; it also leads to a distortion in the allocation of resources, reducing interest for alternative and sustainable sources of energy; finally it encourages the burning of hydrocarbons, with detrimental effects on greenhouse gas emissions and global climate change. Helping low-income groups with the price of energy can be achieved in better ways, for instance with means-tested income support schemes or subsidies to cooking gas in poor areas.

In Mexico, about 30-40% of budget revenues depend on oil, while non-oil taxes are only about 10% of GDP. The OECD are encouraged by recent tax reforms but consider that more needs to be done to broaden the tax base. Further reform that tackles in particular exemptions in both direct and indirect taxes is needed in line with recommendations in the 2007 OECD Survey.

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