FISCAL FEDERALISM IN MEXICO: ANALYSIS FIRST, THEN REFORM

Pablo Camacho-Gutiirrez, Texas A&M International University

POLICY RECOMMENDATIONS FOR REFORM OF THE

fiscal federalism regime in Mexico areevaluated in this paper to (1) improve the

understanding of intergovernmental relations inMexico and (2) contribute to the current debateover the reform of the fiscal federalism regime.'The observed centralization of public spendingresponsibilities in Mexico departs from what thefiscal federalism literature prescribes as optimal,but this is not the case for the centralization ofpublic revenue sources. Nonetheless, the primaryfocus in Mexico is on revenue decentralization.

The policy recommendations, to increase finan-cial resources to subnational governments, includeincreasing revenue-sharing transfers, allowingstate surtaxes on federal revenue sources, like theincome tax and value-added tax. increasing statecollection of own revenues, and ihe devolutionof some tax bases. The implementation of thesepolicies, however, may not be practical, mayhave minimal budget impact, or may make thegeographical allocation of resources more inequi-table. In particular, this paper raises concerns aboutpotential welfare losses and equity problems fromincreasing revenue-sharing transfers.

The next two sections describe the fiscal federal-ism regime and the system of federal transfers inMexico. This is followed by an analysis of policyalternatives to reform the fiscal federalism regimein Mexico and the conclusions.

MEXICO: A CENTRALIZED FISCAL REGIME

Mexico is a federal republic with three layersof government: federal, state, and municipal. TheConstitution of Mexico establishes the intergov-ernmental assignment of public responsibilities,albeit in a broad sense. Intergovernmental agree-ments further specify revenue sources and spend-ing responsibilities across layers of government.The outcome of this institutional arrangement is acentralized fiscal regime.

The constitution assigns exclusive spendingresponsibilities and revenue sources to the federaland municipal governments.- Stale governmentsmay perform any public function that is notprohibited to them or exclusively assigned to an-

other government level. The constitution explicitlystates the concurrence in spending responsibilitieslike education, public health, city planning, andenvironmental protection. The constitution alsoimplicitly allows for tax concurrence when it grantsthe National Congress the faculty to collect all therevenues needed to finance the federal budget. Fed-era! and subnational governments have addressedfiscal concurrence through different coordinationmechanisms over time.

Figure 1 shows that subnational governmentsin Mexico have a low participation in both totalgovernment expenditures and revenues.' Overthe period 1972-1997, on average the shares ofsubnational governments in total governmentexpenditures and revenues are 21.15 and 20.25percent, respectively. Figure 2 shows that subna-tional governments in Mexico have a greater fiscalrole ihan those in centralized countries like Chileand France. The reverse is true when Mexico iscompared to decentralized countries like Argentina,Brazil, Canada, and the United States.''

The observed centralization of tax collection inMexico follows the fiscal federalism lilerature.'The federal government collects revenues frommobile tax bases, like income and consumption,whereas subnational governments collect revenuesfrom immobile tax bases, like land, and rely onbenefit taxation. The federal government alsocollects excise taxes on gasoline, tobacco, andalcoholic beverages, the consumption of whichcau.ses negative externalities. The decentralizedcollection of such taxes may suffer from tax com-petition. Table I shows that the federal governmentcollects revenues from tbe richest sources whereassubnationat governments rely more on non-tax*than on tax revenues, with the main source beingrevenue-sharing transfers.

In contrast, the actual intergovernmental assign-ment of public spending in Mexico departs fromwhat the fiscal federalism literature prescribesas optimal. Mexico presents a centralized fiscalregime where the federal government is involvedin functions that are better suited for subnationalgovernments, such as provision of water, hous-ing, hospitals, culture, sewerage, streets, amongothers. Similarly, state governments are involved

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96™ ANNUAL CONFERENCE ON TAXATION

Figure: 1 Sub-National Governments Percentage Share in Total Government Revenues andExpenditures, 1972-1997

• Revenues ' Expenditures

' OmpA tfunHfthwf by lutt i

Figure. 2 Sub-National Governments Percentage Share in Total Public Revenues andExpenditures: Selected Countries, 1997

I Revenues D Expenditure

000Chile

Sourcai Orxfih fumichMl by author wHh dat* from WorM Bank.

Canada Argentina Brazil

in functions that are better suited for municipalgovernments, such as city planning, transit, andlocal trade regulation.

Indeed, the decentralization of some publicfunctions took place during the previous decade.In 1992, the federal and subnational governmentsagreed to the decenlralization of elementaryeducation. Yet, the federal government retainscontrol over the nationwide education system:

education programs, developing curricula, teach-ers' training and evaluation, as well as wages andbenefits, among others. Subnational governmentsreceive earmarked federal transfers to meet theirincreased responsibilities in education. Municipalgovernments are responsible for the maintenanceof school buildings and provision of equipment andeducation materials. On the other hand, since 1996,state governments are responsible for public health

137

NATIONAL TAX ASSOCIATION PROCEEDINGS

Table 1Effective Own Revenues by Level of Government, 1999

(millions of current pesos)

Total

Tax Revenues

Income TaxValue Added TaxExcise TaxesOrdinary IncomePayrollPropertyTransfer of PropertyVehicle ownershipOccupancyCommerceOther

Non-Tax Revenues

Oil FeesOthersDerechos (Fees)ProductosAprovechamientos

Revenue-Sharing Grants

FEDERAL

674,348.1

521,682.4

216,123.4151.183.5106,703.7

47,671.8

162,666.7

90,465,062,2007

%

100.00

77.36

32.05

22.4215.82

7.07

22.64

13.42

9.22

STATE

143,309.3

7.037.3

2.868.42,3475

41.7648.4178.7323.0

729.4

17,031.0

6,054.96,319,94,656.2

119,241.0

%

100.00

4.91

2.00

1.64

0.03

0.38

0.120.23

0.93

11M

4 23

4.41

325

83.21

MUNICIPAL

49,139.6

6,684.1

3,964.01.775.7

51.4

7328406

8,823.4

3,73351,575 33.514,6

33,732.0Scum Cuantg de Is Hacienda PLbtcB Fedwal 1099. Finanzas POUKaa WurtopalBa r Eunalaa MMAaco 1906.1909Nan psrcentagM may not add up to m due \o rounang armn

%

100.00

13.40

6.11

3.61

O.iO

1.49

0.08

17.96

7.603.21715

68.$S

services for ihe "open population;" that is. the seg-ment of the population with no health insurance.Also, the construction and maintenance of ranchroads started a decentralization process in 1996.

INTERGOVERNMENTAL TRANSFERSIn Mexico, the federal government transfers

funds to siibnalional goveminenis through revenue-sharing transfers (participaciones). conditionalgrants (aportaciones). decentralization agreements,and the program to strengthen state governments(PAFEF). According to the size of their funds.participaciones and aportaciones are the mostimportant." Aportaciones and PAFEF are the mostrecent programs, dating from 1998 and 200(). re-spectively. Figure 3 shows the evolution of federaltransfers over the period 1994-2(XX).*' Notice that theaportaciones program replaced most of the fundstransferred through decentralization agreements.

Before 1998. federal and subnational govern-ments addressed the concurrence in spending

responsibilities through bilateral expenditure co-ordination agreements. There was no nationwidesystem that specified clearly and objectively themechanisms or programs for decentralization ofpublic spending. In 1998. the Zedillo administra-tion (1994-2000) established a system of condi-tional block grants called Aportaciones FederalesaEntidadesyMunicipios.' 'in order to improve thedecentralization of public resources.

Subnational governments do not regard apotia-ciones as own resources due to their conditionalnature. Moreover, aportaciones convey programsformerly ruti by federal agencies. For instance,the aportaciones fund for elementary educationamounted to 63.5 percent of total aportacionesmonies in 2000. and ii is the channel the federalgovernment uses to support the decentralized pro-vision of elementary education. Similarly, the apor-taciones fund for health services amounted to 12.6percent of total aportaciones monies in 2000, and itIs the channel the federal government uses to supportthe decentralized provision of health services. States

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Figure. 3 Decentralized Spending by Type of Transfer: 1994-2000 (Millions of 2000 Pesos)

D Ravenuo-Sharing Transfers •Decentralization Agreements DCondltionil Grants • Strengthen State Govsmment

400,000- •

350.000' •

300,000- •

250.000' -

200,000' -

150,000 - - I

100.000' • - -

50.000 • -

1994 1995 1996 1997

I s m * : Onpn (umtohad bv luthsi with d m (rom SHCP.

1998 1999

complain that they have received more responsibiii-lies wilhout enough funds to meet them.

Federal and subnational governments have ad-dressed the issue of tax concurrence through taxcoordination mechanisms.'" The current nationallax coordination system (SNCF) dates from 1980.Following the adhesion agreement to ihe SNCF.the federal government has exclusive access tothe most productive revenue sources and shares aportion (currently 20 percent) of its revenues withsubnational governments through revenue-sharingtransfers." As expected, subnational governmentsbecame financially dependent on participacionesafter 1980 (see Figure 4).'-

Given that states adhesion was voluntary, theSNCF guaranteed state governments at least thereal revenues they collected under Ihe former taxcoordination system. Furthermore, participacioneswere initially allocated according to the revenuesstates received under the previous tax coordinationsystem, which favored wealthy and oil producingslates. Arellano (1996 a. b) states that this deriva-tion mechanism perpetuated unusually high par-ticipaciones per capita to Ihe oil producing statesCampeche and Tabasco.

The allocation of the general revenue-sharingfund (FGP) across state governments has evolvedfrom a system based on tax effort solely to onethat aUempts to internalize local needs for publicgoods and promote an equitable allocalion ofresources across states." The proxy for tax efforthas also changed over time: in 1980, state revenuescollected in 1978: from 1981 to 1987, slate collec-tion of own tax revenues; in 1988 and 1989, state

collection of VAT; and since 1990, slate collectionof federal assignable taxes (i.e.. taxes on purchaseof new automobiles, automobile registration, andexcise taxes on production and services).

The level of participaciones a state receives inyear r depends directly on the level of participa-ciones it received in year / - I. Modifications lothe allocation of participaciones across states havebeen made on the margin. Since 1994. increasesin the participaciones fund are allocated in directproportion to state population (45.17 percent)and state collection of federal assignable laxes(4.'i.l7 percent). The remaining share of the FGP(9.66 percent) is allocated among those states thatreceive the lowest participaciones per capita fromthe previous two criteria.

The issue with the lax effort criterion is thatwealthy states have benefited the most from it.These slates may collect more tax revenues notnecessarily due to higher tax effort but rather as aresult of having more developed markets. In fact,the population and compensating criteria wereadded to the lax coordination agreement to mitigateils built-in equity problems. Modilications to theparticipaciones system, however, have been tnadeon the margin. As a result, the inequity effects fromthe derivation principle and tax effort criterion usedduring the first decade of the SNCF remain.

ANALYSIS

This section evaluates policy recommendationsfor the reform of the Mexican (iscal federalismregime. Mexico has a centralized fiscal regime.

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NATIONAL TAX ASSOCIATION PROCEEDINGS

Figure: 4 State Government Revenues: Own Revenues vs. Participaciones, 1970-1999(Millions of 2001 Pesos)

150,000 T

125,000

100,000

75,000

50,000

25.000

0

•Participaciones Own Revenues

Sauna: Gnph rumWwl by lullMr urttti diu from IWO),

Literature on Mexican fiscal federalism'"" propttsesdecentralization of both spending functions andrevenue sources. As discussed above, decentraliza-tion of public spending is a valid request as higherlevels of government perform functions that arebetter suited for lower levels of government, butthe observed centralization of revenue collectionfollows what the fiscal federalism literature pre-scribes as optimal.

Nonetheless, the primary focus in Mexico is ondecentralization of revenue sources. This may bedue to the fact that there is a consensus as to whatpublic functions should be devolved, but this isnot the case regarding how to increase revenuesto subnational governments. The claim that subna-tional governments suffer from a lack of resourcesto finance its spending responsibililies-especiallyafter the devolution of some public functions dur-ing the 1990s-is another factor that explains thefocus on revenue decentralization.

The claims for fiscal decentralization in Mexicoare based in part on the assumption that it is aPareto improving policy." Nonetheless, one shouldnot make such assessment a priori. For instance,should one then presume that Mexico would bebetterofl having a more decentralized fiscal regimelike ,Argenlina or Brazil? Or should one presumethat France and Chile would be better off havinga more decentralized fiscal regime like Mexico?

Decentralized provision of public functions isdesirable on the grounds that tastes and needs varyacross jurisdictions within a country. Following thesame argument, a less decentralized fiscal regimemay be desirable as tastes and needs vary acrosscountries.

Analysts also support decentralization ofrevenues following decentralization of spendingresponsibilities. If both spending and revenuesare decentralized, then subnational governmentsand their constituency would be aware of the linkbetween revenue collection and public spending,that is. they would internalize bt>th the benefitsand costs from public decisions. Such fiscal cor-resptjndence would make subnational governmentsmore accountable and responsive to their localconstituency.

The fiscal correspondence argument is. however,normative in nature, it assumes the existence of aneffective democratic system where policymakersare resptmsive to the demands of their constituency.In Mexico, in contrast, there is no reelection topublic office: even worse, policymakers may holdan elected office without being actually elected.For instance, out of the 500 seats in the House ofRepresentatives, the people elect 280 and politicalparties select the remaining 220 according to aformula that depends on the total number of voteseach party gets. Similar processes apply to the Sen-

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ate, state legislatures, and city councils. Moreover,both the House and Senate are lead by individualsselected by political parties. The future of policy-makers does not depend on the constituency theyserve but on their political party.

Regarding the policy options to increase rev-enues to subnational governments in Mexico,these include; increasing the participacionesgeneral fund, increasing state collection of ownrevenues, devolution of revenue sources, and taxconcurrence.

Subnational governments support increasingparticipaciones and tax concurrence. The NationalConference of Governors proposes a gradual in-crease of the FGP from 20 lo 45 percent of federaltax collection.'" On (he other hand, the state gov-emment of Nuevo Leon (2001) proposes a ralereduction for the VAT from 15 to 12 percent, inorder to make room for a 3 percent state sales tax.Similarly, this state proposes that income tax ratesbe broken into two segments, such that 80 and 20percent of the rates become the federal and stalesegments respectively. Subnational governmentswant to increase their revenues without having toface the political cost of collecting more revenues.In 2002, state governments had the authority to levya general sales tax of up to 3 percentage points inaddition to the \5 percent VAT rate, bul no statelevied this surtax.

Analysts reject the option of increasing iheFGP since " . . . an increasing dependency fromthe federal government is exactly what shouldbe avoided" (Sempere and Sobarzo. 1996b, p.39, author's translation). Arellano (1996a) evensuggests that the SNCF harms the sovereignty ofsubnational governments, given the financial de-pendency of subnational governments with respectto participaciones.

Dfaz-Cayeros and McLure (2000) propose a 3percent payroll tax rate in all states, devolution ofautomobile registration, and excise taxes on alco-holic beverages and tobacco products, a dual fed-eral/state VAT where slates receive revenues from3 percentage points of the VAT. and the transfer of50 percent of revenues from excise taxes on motorfuels. Astudiilo-Moya (1999) proposes a state sur-tax of up to 3 percent on excise taxes and a transferof 50 percent of revenues collected from ihe incometax and VAT to state and municipal governments,respectively. Sempere and Sobarzo (1996a and1996b) propose to allocate only 50 percent ofthecurrent FGP according to the population criterion

and a slate surtax on personal income-the federalgovernment would reduce its tax rate to allow fora maximum surtax rate.

Decentralization of revenue collection is con-strained by the fact that the broader and moreproductive revenue sources are mobile (laxes on per-sonal and corporate income), difficult to administerby subnational governments (VAT), reserved to thefederal government by ihe constitution (charges onoil production, excise taxes on tobacco and alcoholproducts, among others), or have minimal budgetimpact (payroll tax and automobile registration).Furthermore, the devolution of tax bases wouldtrade away Ihe efficiency gains from a centralizedtax collection. On the other hand, states with moredeveloped markets would benefit the mosl from statesurtaxes on income and consumption.

The fiscal coordination system is blamed forthe lack of subnational government revenues sinceit prevents them from using the most productivesources. The SNCF has increased the revenues tosubnational government, but it is argued that theseare still insufficient. As a result, the reform ofthefiscal federalism regime in Mexico would neces-sarily involve a revision of the SNCF. Althoughparticipaciones are unconditional transfers, onemight expect that recipient governments do nottreat them as fungible resources since these repre-sent most of their revenues. Camacho'^ finds thatstate collection of own revenues is insensitive tochanges in both participaciones and state GDP;also, nominal delerminants-state collection ofassignable federal taxes, slate population, and thecompensating criterion-in the allocation of partici-paciones are ineffective. Stale GDP and previousparticipaciones level are the actual determinants ofthe allocation of participaciones among states.

The fact that state governments do not react tochanges in participaciones or state GDP impliesthat they make no decision as to the optimalconsumption of public versus private goods. In-creasing participaciones would then increase theprovision of local public goods by almost the sameamount, regardless of the need for private goods.In this sense, increasing participaciones may notbe a desirable policy to transfer more resourcesto subnational governments. On other hand, thefact that nominal determinants in the allocation ofparticipaciones are indeed ineffective points to theinequities still built in the SNCF. Thus, increasingparticipaciones would not be desirable on equitygrounds.

141

NATIONAL TAX ASSOCIATION PROCEEDINGS

The previous discussion shows thai the analysisofthe refonn ofthe Mexican fiscal federalism re-gime is not complete. Other policy options oughtto be explored, like a system in which revenuecollection remains centralized whereas spendingis decentralized in an asymmetric fashion. In or-der to minimize welfare losses, public functionswould be devolved only to those subnationalgovernments that meet minimum standards in theprovision of the devolved functions. Financialresources would then follow through conditionalgrants. To the extent that the federal governmentunwillingly devolves public functions, it will be inits best interest to enforce the minimum require-ment standards. This yardstick competition wouldinduce subnationat governments to improve theirperformance.

CONCLUSIONS

Mexico observes centralization in public spend-ing and revenue collection. Centrali/,ation of spend-ing responsibilities departs from what the literatureprescribes as optimal, but the observed centraliza-tion in revenue collection does not. Nonetheless.the main concern is how to increase revenues tosubnational governments. Policy recommendationsinclude increasing participaciones, increasing statecollection of own revenues, allowing a state surtaxon federal revenue sources, like income tax andVAT. and tax devolution.

The implementation of such policy alternativesmay not be practical, may have minimal budgetimpact, or may make ihe geographical allocationof resources more inequitable. In particular, taxconcurrence, as proposed by state governments,and increasing revenue-sharing transfers wouldfavor states with more developed markets; thus.they may nol be desirable options on inequitygrounds. Furthermore, the insensitiveness of stategovernments to changes in participaciones pointsto the welfare losses that may occur from increas-ing them, which would then increase the provisionof local public goods by almost Ihe same amountregardless of the need for private goods.

This paper shows that the analysis ofthe reformof the Mexican fiscal federalism regime Is notcomplete. The regime has observed too manychanges over the last three decades. A thoroughanalysis ofthe Mexican fiscal federalism regimemust be completed before it undergoes yel anotherreform.

Notes

' The federal governmenl and National Conferenceof Governors are set lo work on the reform of theliscal federalism regime from February 5 to July 31,

• The federal governmenl has exclusive responsibil-ity over national defense, international relations,international and interstate Irade. monetary policy,and regional development, among others. Municipalgovernments have exclusive responsibility over streetcleaning, parks and public gardens, local police and fireprotection, cemeteries, public markets, and slaughter-houses, among others. On the other hand, the federalgovemment has exclusive faculty to collect revenuesfrom international trade, natural resources, insuranceand credit institutions, and excise taxes (tobacco, al-coholic beverages, electric power), among others. Mu-nicipal governments have exclusive faculty to collectproperty taxes; other sources include federal grants,userfees.lease/saleof own properties, as well as thoserevenue sources approved by local legislatures.

' Subnational governments' revenues include tax andnon-tax revenues, intergovernmental transfers, andother grants.

' Surprisingly, the dala show thai subnational govern-ments in Mexico have a larger role in public spendingthan subnational governments in the United States.This result may be explained by the fact that centralgovernment expenditures include defense and inter-est payment, which are rarely decentralized and varyacross countries.

' Oatcs (1972) and Musgrave and Musgrave (1980)are classical references. Boadway and Wildasin(1984) and Rosen (1985) provide excellent treatmentofthe tisca! federalism literature. See Oates (1999)for a review ofthe new issues in the fiscal federalismI iterature.

" These include user-fees (derechos); sale and leaseof public assets and interest charges (productos);and other revenues that include penalty and late fees(aprovechamientos).

' Participaciones and aportaciones accounted for 44 and48 percent of total federal transfers in 2(X)0, respec-tively. Both programs were created under the FiscalCoordination Act (Ley de Coordinacion Fiscal).

" The drop in total transfers observed in 1995 is dueto a 6.9 percent drop in real output Mexico sufferedin tbat year.

" The aporlaciones program is divided inio seven fundsaccording to the type of expenditure each serves; el-ementary education (FAEB); health services (FASS A);social infrastructure (FAIS);'" public safety (FASP);multiple purposes (FAM), commonly used to financesocial assistance projects, school breakfasts, andschool construction; public technical education and foradults (FAETA); and improvement of municipalities(FORTAMUN).

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ANNUAL CONFERENCE ON TAXATION

'" See Astudillo-Moya (1999) and Martfnez-Almazln(1988) for a description of the evolution of intergov-ernmental tax coordination mechanisms.

" A state government may also sign an administrationcoordination agreement with the federal government inwhich the former commiis lo act as a federal tax collec-tor agent in exchange for an agreed compensation.

'- The abnormal behavior of state own revenues overthe 1993-1995 period was due to the education grantsstates received after the decentralization of elementaryeducation that began in l'^93. Conditional transfers,including education grants, were recorded as state ownrevenues until 1994.

" Aguiiar-Vil!anueva(l996),Arellano-Cadena(1996a,b) and Hem^ndez-An-e(>rtiia( 1997) discuss the evolu-tion of the SNCF in more detail.

'" See Aguilar-Villanueva (1996), Arellano-Cadena(1996a. b). Astuttillo-Moya (1999), Diaz-Cayeros(1996). Flores-Hernandez (1996), and Sempere andSobarzo (1996a, d), among others.

" Arellano-Cadena (1996a) lisls the cenlralizaiion inrevenue collection and spending as one of three reasonsfor profound changes in the current Mexican fiscalfederalism regime.

"• See editorial by Ricardo Monreal, Governor of theState of Zacatecas, which appeared in Milenio Diario.October 30. 2002.

" Pablo Camacho-Gutl^rrez, doctoral dissertation inprogress, University of Texas at Austin.

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