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The following OECD assessment and recommendations summarise Chapter 4 of the Economic Survey of Mexico 2005 published on 12 September 2005.
The fiscal framework lacks a medium-term focus
The annual budget process has been much improved in recent years and, for some time now, budget deficit targets are achieved with very small margins of error. . If oil revenues exceed the – usually prudent – budget projections, a mechanism permits part to be saved, part to pay down debt and part to finance additional investment. Conversely, there are budget rules to implement spending cuts – in practice falling mainly on investment - should oil or other revenues come in below budget projections. Fiscal credibility is therefore high in financial markets, and has led to low interest rates and insulation from contagion from crises in other emerging markets. But in other respects, Mexico’s fiscal framework leaves much to be desired:
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But low levels of physical and social infrastructure (health and education services in particular) and high rates of poverty mean that there is a need for stable, large-scale, long-term public spending programmes;
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There is a consensus on the need for a tax reform that would broaden the base, especially for indirect taxes, and generate higher and more stable revenues, while reducing distortions. But serious reforms have failed to emerge because of political squabbling;
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Although the impacts of short-term oil-price fluctuations are dealt with efficiently, there is no budgetary mechanism for dealing with prolonged periods of either high or low oil prices. Instead, the use of core oil-related revenues is decided upon each year in the context of the annual budget exercise;
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Most of the taxes (direct and indirect) are set at the Federal level, but much of the spending is done by the states and municipalities, often in ways that reflect historical endowments rather than current needs.
Oil prices and budget assumptions
1. Adjustments made to the 1998 budget assumptions.
Source: Ministry of Finance; PEMEX.
Higher oil prices are not a windfall, but a harvest to be reaped over the years…
It is likely that revenues will be higher than previously expected for some years to come, thanks to buoyant oil prices (and assuming that oil production remains stable or rises). Higher oil prices present an opportunity, but also pose a two-fold risk. First, oil prices are prone to large and unpredictable fluctuations and therefore they must not be the basis for financing development programmes that require stable sources of revenue. Hence currently high prices are not a reason for postponing tax reforms that will permanently broaden the tax base and generate a stably higher flow of revenues. Second, there is no rule in place for allocating a medium-term stream of higher oil-related revenue in the analogous way that exists for dealing with annual fluctuations. Higher revenues could thus be frittered away by a succession of annual compromises between the political parties and between different levels of government. Should oil prices fall back to lower levels, there could then be a prolonged period of painful belt-tightening. A new Federal Budget and Fiscal Responsibility Law has been proposed, including principles for multi-annual budgeting. In particular, it includes a transparent mechanism for setting the annual oil reference price in terms of recent historical developments and futures prices. This will insulate the reference price from political manoeuvring. The draft law proposed in March 2005 contains rules to distribute extra revenues: 50% would go to the Oil Stabilisation Fund and the rest would be allocated in equal proportions to two other stabilisation funds, one to smooth transfers to states and municipalities, the other for investment by the state-owned oil producer PEMEX. It establishes that these Funds have a legal basis and can be drawn on only when oil prices fall below the agreed long-term level. Once the three funds reach a certain level, extra revenues would be used to improve the public balance and to finance infrastructure projects. The proposal should be adopted. A fully-fledged medium-term framework should go even further than this proposal and include a mechanism for preventing persistently high oil prices from translating into permanently higher current spending.
… and their fruits must be used wisely
Mechanisms for a rational allocation of higher, but not permanently higher, oil revenues could contain the following elements:
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Since the costs of adjusting to lower prices are large, agree on a deliberately prudent long-term oil price and use revenues arising from higher ones in ways that improve public sector net worth.
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Of equal importance, multi-year outcome-oriented spending targets should be introduced for current expenditure so as to avoid excessive increases in the public sector wage bill.
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Finally, there should be guidelines to limit federal transfers to sub-national levels of government.
Adjusting to higher oil prices: stylised options
1. Recurrent spending is current spending plus core investment spending.
2. Extra revenue is total public sector revenue minus revenue financing recurrent spending.
3. The annual adjustment mechanism implies i) cuts in spending and desaccumulation from oil stabilisation fund, (OSF), if oil revenues are lower than projected; ii) increases in spending, accumulation of reserves in the OSF and debt reduction, if oil revenues are higher than budgeted.
Source: OECD Secretariat.
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For further information please contact the Mexico Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by Bénédicte Larre, Stéphanie Guichard and Isabelle Joumard under the supervision of Nicholas Vanston.
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