A Brick in the Wall

How will the US tax reform hit Mexico?

While the three partners seemingly attempted to put commercial relations back in order, Trump was working on an aggressive tax reform behind the scenes.

With the objective of achieving the most beneficial conditions for the US, the Trump administration forced Canada and Mexico to come to the negotiating table and modernize the North American Free Trade Agreement (NAFTA), which the President had deemed the “worst treaty in history.”

While the three partners seemingly attempted to put commercial relations back in order, Trump was working on an aggressive tax reform behind the scenes.

The reform will negatively affect the Mexican economy without even having to tear up NAFTA.

Congress passed the USD1.5 trillion tax overhaul in late 2017, introducing a significant reduction of corporate tax that dropped the rate from 35% to 21%.

Ostensibly aimed at making the US more appealing to foreign direct investment (FDI), the bill is also hoped to convince corporations to repatriate operations and overseas profits to help grow and develop businesses on US soil.

In all, the Republicans plan is to boost competitiveness and employment in the US.

But for Mexico, the reform could negatively impact economic growth.

With the US by far its largest investor, representing up to 44% of FDI in 2016, Mexico inevitably bears the brunt of US economic policy changes.

And at a time when Uncle Sam is taking steps to become more fiscally attractive to the private sector, Mexico has little room to maneuver in response

Firstly, most Mexicans work in the informal sector. It is estimated that jobs paid under-the-table represent nearly 50% of employment, meaning that cutting or increasing direct taxes will not make a significant difference.

Second, inflation has skyrocketed over the past year, recording the highest rate seen in 17 years.

The Bank of Mexico (Banxico) has unsuccessfully tried to control inflation and keep it under the 3% goal by aggressively hiking interest rates up from 6% up to 7.25% over the course of the year.

There are two main factors that have fostered inflation in Mexico.

On the one hand, the peso has still depreciated significantly against the dollar. Although the MXN recovered steadily from its late 2016 plunge, the Mexican currency it is still 27% weaker than the American as compared to 2015 prices.

On the other hand, gas prices surged 20% in January last year as a result of ongoing oil reforms, which opened the energy sector up to FDI for the first time in nearly a century.

Lowering taxes in Mexico would spur consumption and, consequently, inflation would be expected to increase as well, just the opposite what the government wants.

In addition, the country’s public debt has piled up since President Enrique Peña Nieto took power in late 2012. While the debt-to-GDP ratio was of 35% back then, it hit 50% in 2016 as falling oil prices led the Mexican government to borrow more money to meet the budget.

Oil represented a third Mexico’s income in 2014, but generated just a fifth in 2017.

And although oil prices have recovered since the 2015 slump, the days of USD100 for a barrel of Brent seem distant.

These declines in government revenues make it hard to believe that Mexico would consider a massive tax cut in the short term, given that it can’t afford to lose any competitiveness with the US.

But, on the bright side, the country has created its first free trade zones (ZEE by its Mexican acronym) in a move to increase FDI inflows into rural areas.

So far, the program is overseeing the development of ZEEs in the states of Chiapas, Michoacán, and Veracruz, and it is expected to attract around USD5.3 billion over the next three years.

Nevertheless, Trump’s tax cut will still be a major threat to the US’s southern neighbor, while attempts to counter the move could pose even bigger challenges to the incoming president in July 2018.