Mexico's Economic Challenges

Last weekend, Mexican President Felipe Calderon delivered to the Mexican Congress his first report on the state of the nation and summarized the main points in a nationally-televised address. Though the report covered five areas, including security, foreign policy, environmental sustainability, and immigration, the economy took center stage—nearly half of the report's 392 pages are devoted to economic growth and job creation.

Mr. Calderon's report pointed to the four most important economic challenges Mexico faces in the next twenty years. Competition with low-cost manufacturers has heated up significantly since the mid-1990s, when Mexico became the United States' second-largest trading partner. Today, Mexican manufacturers compete head-to-head with China's, often in the same product lines, and despite Mexico's strategic geographic advantage close to US markets, Chinese labor costs and production volumes are making it difficult for Mexico to preserve it share if US and global markets. In an economy where exports account for 30 percent of GDP, flagging competitiveness is a serious concern.

Second, Mexico's oil wealth is running out. According to the President's report, Mexico has nine years left of proven oil reserves, and average daily production is falling steadily. This trend casts a worrisome shadow on the country's fiscal future, as oil revenues have traditionally accounted for some 40 percent of the government's budget. At the same time, non-oil tax revenue—at around 10 percent of GDP—remains alarmingly low. (OECD countries average 25 percent, while Mexico's developing-country peers collect about 15 percent of GDP in taxes.)

Finally—and this Mr. Calderon recognized less explicitly—the Mexican economy remains perilously dependent on the country's northern neighbor. Ninety percent of Mexico's exports and 70 percent of its imports go to and come from the United States, while some 65 percent of Mexico's foreign direct investment comes from US investors. Nearly a third of Mexico's commercial bank assets are owned by US financial institutions. And crucially, over $20 billion in remittances from Mexicans working the United States flow into the economy every year, providing the country with a major source of foreign exchange and improving the lives of thousands in some of the country's most depressed areas.

This economic relationship means that as long as the US economy is booming, Mexico will prosper. But if the US economy catches a cold, Mexico can easily contract pneumonia. Unfortunately, Mexico has few cushions to soften such a shock. The main safety valve remains letting the unemployed flow north.

To be sure, the President's plan contains an ambitious list of proposals to help overcome these obstacles. Most of these call for massive investment in infrastructure, education, agriculture, telecommunications, and energy. There are also plans for strengthening social safety nets and expanding the programs that would be crucial to cushion the poorest in case of a slowdown in the US economy.

Yet, little will come of these proposals unless Mr. Calderon's government can deliver on tax reform. Most of the planned investments are too large and the returns too far in the future to ensure that the private sector will deliver them. Private-sector investors will be crucial partners, but the state will have to up most of the cash. Without increasing non-oil tax revenue, the Mexican government will have little choice but either to forgo these much-needed investments or to pay for them by borrowing heavily. The later is a risky option Mr. Calderon's fiscally-conservative government is unlikely to pursue.

On the road to tax reform, the Calderon administration will have to confront two powerful groups through a bold and intelligent mixture of carrots and sticks. First, it will have to persuade the thousands of Mexicans who operate in the informal economy (which may account for some 30-40 percent of GDP) to join the formal sector and pay taxes in exchange for public services and legal recognition. This will be very hard to achieve in practice, so the government will have to come up with clever ways of taxing informal commerce—most likely though its use of the financial system—in order to force these businesses to pay their share of public investment.

The second group will be no easier to tax. It is composed of some of Mexico's biggest companies and wealthiest people, companies and individuals that have become highly adept at shielding assets—often through dubious means—from the taxman's searching hand. Calderon's government will have to persuade these fat cats to pay their share, and this will likely require a high-profile crackdown on large delinquent taxpayers, in addition to closing legal loopholes and reducing "leakage" within the tax collection system itself.

Tackling these two groups will require impressive political and management skills. After a year in office, Mr. Calderon's team has identified all the right problems and has come up with some thoughtful and promising solutions. Now his administration has five years to fight the political battles that will be required to implement them.