The Tillinghast Lecture, NYU School of Law
On how Federal Revenue Sharing has Emasculated Local Empowerment[1]. Also, a few Comments on Customs Reform and NAFTA
September 10th, 2013
Francisco Gil Díaz
Not being a tax lawyer, when the NYU School
of Law invited me to deliver the Tillinghast lecture, I struggled to find a
subject of interest to this international audience. I hope I did find one. I
chose to explore one of the consequences of the formula Mexico adopted for federal
tax revenue sharing with the states.
Something else of potential interest to a
NAFTA audience is a brief note on how Customs was reformed to cope with the
expected increase in foreign trade because of, at the time, a probable free
trade agreement.
Countries with a federal organization may derive
some lessons from our experience with a tax sharing formula intimately related
to the adoption of a Value Added Tax (VAT). The new tax was a welcome change
over an outdated fiscal structure. It brought about considerable improvements but
it also required another formula to distribute federal tax revenue. The
incentives provided by this formula would with time influence the behavior of
state and municipal governments.
We shall see how, as a consequence of such
incentives, state governments and their citizens have gradually become passive
agents. People are now unable or indifferent to involve themselves in one of
their most important public policy issues: public spending. Waste, leaping wage
bills and excessive debt are another corollary of the formula adopted.
The first precedent for the VAT reform was
an overhaul to indirect taxation that took place in 1970. Between 1970 and
1980, when the VAT was introduced, there was an evolution in the administrative
prerogatives of state governments that led them to become predominantly processors
of federal revenue.
The reform on indirect taxation
Constitutionally the taxing powers of our
different levels of government mirror those of the USA. The Mexican
constitution of 1857copied a central feature of the US constitution, it
separated Mexico from the centralized political design of the Spanish
colonization. Federal states would be borne with concurrent taxing powers.
However, the new 19th century arrangement did not go far enough;
municipalities were left out and have never been accorded sufficient elements
for self-government nor taxing powers.
This constitutional definition is useful to
frame the substantial transformations undergone by Mexico´s taxes. The tax
reform continuum is the outcome of reforms initiated 43 years ago. At the
beginning of 1970 there was a need to do something about a chaotic mosaic of
state and federal indirect taxes.
The reform undertaken sought to
substantially raise revenue, to simplify the structure of indirect taxation and
to prevent state governments to compete for investments through tax
concessions.
The changes maintained at the outset the
administrative tax prerogatives of the states, but required them to subordinate
some of their constitutional rights in order to obtain larger federal
transfers. This happened in combination with a substantial increase in federal indirect
taxes.
The new relationship between the two levels
of government became thus a radical departure from the old scheme. A novel
centralist approach was about to begin with progressively negative consequences
for the incentives state governments face regarding fiscal responsibility.
Also, and perhaps of greater transcendence, public policy and expenditure
decisions became even more distanced from constituents.
The 1970 reform performed the first of two
drastic changes in the taxing faculties of the states. At that time they where
induced to relinquish their most important local revenue sources in exchange
for a substantial increase in federal transfers. However they kept their
administrative functions as collectors of the federal tax. They would retain
their share and pay up the amounts due to the federal government.
Prior to this reform there were concurrent
federal and state sales taxes. They were based on a turnover or cumulative
design with no credit for tax paid in previous stages. The state taxes mirrored the federal tax. The
reform made upon this structure prepared the ground for an eventual
introduction of the VAT. On this occasion states agreed to subordinate part of
their sovereignty thanks to an offer designed in such a way none could refuse
it: because their revenue would increase substantially piggybacking on a much higher
federal consumption tax they agreed to abandon their most important taxing
power.
The formula proposed by the federal
government was ingenious. It was based on offering the states larger portion of
a bigger pie.
Prior to the reform, with the same tax base
and design the states turnover tax rate had been 1.2% with the federal one at
1.8%. The proposed reform would increase the federal rate to 4%, an apparently
timid increase, but its cumulative effect was equivalent to 13% of the value of
consumer purchases. The reform also touched some excises by sharply raising
their rates.
The income from the new federal 4% rate was
to be divided equally between the federal government and the states, while administration
would be shared. Because of their constitutionally backed prerogatives, the
states could abstain from the coordination offered, but acceptance of the new
arrangement meant a revenue increase of 66.7%, while a refusal implied no
additional income with double taxation at state level. As predicted, all states
accepted the offer and derogated their taxes.
Together with the turnover tax, the country
had accumulated a plethora of production and consumption taxes distortive of
consumer choices, of productive-investment decisions and of exports. These
considerations eventually led to the adoption of a value added tax (VAT).
From a purely efficiency public finance
stance the decision to adopt the new tax made sense, a turnover tax has several
defects: it biases firm’s decisions in favor of vertical integration and taxes
exports and investments. It also produces an indeterminate rate of taxation because
of the several productive and commercial stages before a product reaches the
consumer.
Looked at from the angles of added revenue
and economic efficiency the value added tax was a success: it increased federal
revenues, it eliminated the distorting effects of multiple taxation stages and
it zero rated investment expenditures and exports. Because states agreed to
abolish hundreds of local taxes on agriculture with the revenue lost incorporated
into the revenue sharing fund, another benefit was the elimination of state
restrictions to interstate traffic dating from the Spanish Colony.
The reform also simplified considerably the
travails of taxpayers since a considerable number of federal taxes were
eliminated: the Stamp Tax, a relic from the 19th century, as well as
an assortment of peculiar taxes, on bases such as glass, tires, etc. With time
other taxes would be eliminated as well, such as a tax on soft drinks and a special
tribute on mining. The latter unjustified because of the volatility of metals
prices that provide either profit gluts or famines.
The distortions to be corrected led the
government to adopt the VAT. However, how Mexico evolved to the new tax and how
the states’ renunciation of their taxing powers contributed to extremely
wasteful municipal and state governments is the gist of our story. It is a
narrative full of lessons.
Once the decision to migrate to a VAT was
made, there was a need to determine the rate that would produce an amount of
revenue equivalent to the income provided by the taxes to be eliminated. Beyond
revenue considerations, the implication of the mechanics of the new tax for the
distribution of taxing powers amongst the states was of greater transcendence.
The reason is that to avoid a radical regional redistribution of tax revenues a
completely different revenue sharing formula needed to be adopted. The solution
to this potential problem was the seed of an additional weakening of states’
prerogatives, of profligate expenditures and hence, paradoxically, of their
plunge into financial woes.
Differences in the regional distribution of
tax collections were the source of a potential revenue sharing problem. State
income from a turnover tax is collected from the establishments where goods and
services are sold and is attributed to that location. However under a VAT
collections need to be made at corporate headquarters. The change would
redistribute and concentrate revenue in four entities: the Federal District,
the State of Mexico, Nuevo Leon and Jalisco.
Because it would have been unfair and
politically impossible to decrease the revenue of 28 states, a formula divorced
from local collections had to be adopted. The new method used a simple rule: a
General Revenue Fund would be created taking federal revenue shared before the
reform plus revenue from local taxes to be eliminated. A general coefficient
was created dividing this sum by all federal tax revenue. The reform was
sweetened by increasing this ratio. To determine local revenue individual
coefficients calculated using the same procedure would be applied to the newly
created General Revenue Fund. States would thus receive not only a greater sweetened
share of federal tax income, but would share on the total amount and ride on
its buoyancy, which was experiencing rapid increases because of rising oil
prices.
It seemed like a good idea at the beginning
and the states did garner substantial revenue increases. In 1979, before the
entry of the VAT in 1980, revenue shared was 13% of total federal non-financial
revenue. It jumped to 34% in 2012[2].
The states dependence ratio also rose substantially. 90% of states’ fiscal
resources are now obtained from revenue sharing and discretionary handouts.
The public
policy problem created with this succession of changes is that the relationship
between tax pain and expenditure accountability has been lost. With such an
embarrassment of riches state governments and municipalities hardly bother to
collect those taxes and service fees within their realm: many have abolished or
reduced the tax on the circulation of vehicles[3],
few or none make any effort to keep vehicle registration up to date, few tax
the wage bill, or do it lightly and only when their bulging current expenditures
and heavy debt force them to, nor do they take advantage of their legal possibility
to add surcharges on gasoline and diesel sales. The same is true of their
possibility to tax lotteries, or to tax real estate or real estate transfers;
the latter pertain to municipalities but depend on legislation by states’
congresses. Municipalities in any case hardly bother to administer their own
tax bases or to charge efficiently for potable water distribution, waste
management, etc.
Under such an institutional arrangement the
bottoms up benefits of federalism are impossible to achieve. Citizens assume a
mostly passive role at the two crucial levels of the political structure.
The consequences of a top down fiscal
relationship are what one can expect. At the municipal level the problems
associated with lack of accountability worsen. One of the reasons is that municipal
taxes are not a local prerogative; they have to be legislated by the states. As
a consequence citizens are removed from the decisions that allocate revenue
from the states to the municipalities.
Our political-constitutional arrangement
makes another contribution to this outcome. Municipal presidents are one term
only and last merely three years.
With scant tax pain municipal citizens have
few incentives to participate in or complain about local expenditure decisions.
Because most municipal expenditures are sourced from state revenue sharing,
there are few incentives to demand accountability. There is little interest for
incumbents to respond to their constituents. Unable to seek reelection a
municipal president is more interested in looking at a political future as a
state or federal legislator. Three-year
tenures with no reelection possible contribute to a short-term outlook, to lack
of planning, create waste and foster a subservient attitude towards instances
where anointments to other political appointments are made. Real estate tax
revenues reflect the nonchalance of municipal citizens and governments
regarding the comfort derived from revenue sharing. In relation to GDP real
estate income in Mexico was a mere .3 of 1 percent in 2010, only 1/10 of the
equivalent percentage in Argentina[4].
The lack of municipal and state level
accountability has also contributed to debt excesses. At the end of 2012 state
debt amounted to 32 billion dollars, not a burden at a national level, as
percentage of GDP it reached only 2.5%, but a heavy load for the citizens of
the most irresponsible state governments: Coahuila increased its debt 123 times
during the 6 year term of its former governor, the state of Tabasco 20 times, the
state of Chiapas 45 times, with more local crises to come as hidden commitments
come to life in these states and in others.
Together with its shortcomings revenue
sharing with the states has been transformed into a web of diverse programs, so
complex, that its overhaul could prove politically unfeasible. There are many
different rules for assigning revenue and each has a vested interest. Because
of these perhaps insurmountable difficulties, reform of local finances should
perhaps start at the most local level if one wishes to attain goals such as
accountability, better resource allocation and citizens’ involvement in public
issues.
The ideal political unit for this purpose
is the much-neglected municipal level. But to become an instance with intense
empowerment and participation, municipalities need profound reforms that
require constitutional changes. A three-year term limit has to be extended,
reelection has to be possible to provide local presidents with a long-term
outlook and mechanisms for removal of corrupt or incompetent public officials
have to be established. Furthermore the Cabildos or town councils should be
able to legislate real estate taxes and service fees. Since their revenue base
potential is high a reform of this sort should contribute to improve municipal
services and to provide them with a closer fit to what people need. Higher
voter participation at this level will also raise civic consciousness, which
could eventually percolate into higher levels.
Some Interesting Aspects of Administrative
Reform
Reform of customs procedures might seem a
somewhat exotic subject in a lawyers’ conference related to tax issues. However
customs administration, revenue and internal taxes are intimately connected
when there is a VAT. Value added taxes are collected at the border to be
credited in subsequent commercial exchanges. To appraise the importance of
customs for tax revenue in Mexico, consider that half of our VAT is collected
at the border.
With tariffs plunged to the bottom as a
result of tax treaties (12 treaties with 44 countries, more than twice as many
as China’s and four times more than Brazil’s) and unilateral tariff reductions,
the VAT is now the main source of Mexico’s border revenue.
In Mexico customs’ administrative reform
was intimately related to the country’s entry into NAFTA. Prior to NAFTA
merchandise dispatch procedures were in a dismal situation. They were slow,
discretionary, and rife with corruption and excessive costs. There was an implicit understanding prior to
the negotiation of NAFTA that a substantial transformation of Mexico’s customs
was indispensable.
It is therefore instructive and interesting
to observe the state of customs procedures prior to reform. There is no
question that their design was optimal according to their objective. The requirements
hosted upon importers up to 1970 were highly efficient when you consider their
purpose: they were designed to maximize discretion, minimize control and to therefore
maximize corruption.
Take for instance the physical set-up of
the buildings, instead of beside the border or the Rio Bravo as they are today,
they were invariably a few blocks inside urban areas. After crossing the border
trucks were able to take left or right turns before arriving at Custom’s buildings.
But these evasions were convenient for only some type of merchandise. All sorts
of irregularities could easily bypass Customs once in front of the formal
dispatch.
The concern about a customs impediment to
NAFTA at the beginning of President Salinas Administration led to a mandate to
modernize it. The first logical action for novices like us was to get
acquainted with its processes. So we visited the entry point with the greatest volume
of traffic and complications: Nuevo Laredo, where 1/3 of Mexico’s Northern land
traffic takes place. In addition to the questionable location of the buildings,
a casual inspection revealed a brilliant design had taken place to make cargo
hostage to extortion:
-Despite a huge volume of traffic, with
30,000 trucks crossing the border every day, the law required an inspection of
each.
-A voluminous batch of documents per truck also
had to be inspected before cargo was allowed to continue.
-Payment of duties was allowed only:
After the clearance of documents;
The supposed inspection of the merchandise,
And the acceptance by the authority that
everything was in order.
The ingredients detailed above led to a
clever process:
Document revision took place across
fourteen tables aligned along a corridor. The dispatcher would approach the
first table with a sheaf of papers and have the inspector in charge skim over
the first document. Given a pre set bribe, the bundle would pass to Table 2. If
not, the process would not continue. With the cargo as hostage there was no
question that cash would be delivered. Table 2 required a similar amount to
pass on to Table 3, and so on. The sum accrued amounted to 50 dollars per
truck, or 350 million dollars per year. Since Nuevo Laredo accounts for 1/3 of
Northern traffic, the national yearly take for the US Mexico border may have
been in the order of 1.1 billion dollars.
When during this first visit we questioned
the customs administrator about possible fines and penalties if a manifesto
omission was found, the response was: the importer has to pay the duties
omitted. So all the importer has to do is pay up the amount it is supposed to
pay any way, we asked? The response was that nothing more could be done because
the merchandise had not yet legally entered the country.
With the information from this first visit
we set about to immediately change the process. It is almost a truism that good
corporate management requires identifying key end-to-end processes to have them
streamlined and efficiently operated. This is perhaps even more important when
dealing with bureaucratic-administrative processes rife with discretion. The modifications
were:
a) Duties would have to be paid before
cargo entered the country. That way, since a paid return has been submitted,
omissions and outright fraud become punishable notwithstanding that the
merchandise has not exited customs.
b) The 14 tables were eliminated. There is
no need to detain cargo to force document revision since after goods clear, Customs,
the broker and the importer remain liable for irregularities and taxes omitted.
That way trucks, or trains, or ships could no longer be held hostage in order
to collect a bribe.
c) A random selection mechanism was
established to eliminate the supposed need to examine all cargo. Random
selection is sufficient as a fraud deterrent because a single grave omission
can lead to the cancellation of a customs’ broker license, a highly profitable
privilege, and/or to the incarceration of the customs broker and the importer.
These simple quick hits increased
substantially border revenue from one month to the next. The flow of illicit
cash was also substantially curtailed. An episode can be quite telling. A few
weeks after the new methods were in force we made one of the weekly surprise
visits to the city of Matamoros. The customs house was located beside the river,
five hundred meters from the Black Bridge (El Puente Negro it is called) that
takes you from Brownsville into Matamoros. When walking along this route we noticed
that all the buildings on the opposite side of the river were abandoned and their
windows boarded up. We asked why and were told that prior to the new procedures
these buildings had thriving whorehouses and bars.
With time more changes were introduced:
1.
Customs brokers were required
to digitalize all the information required for a dispatch and to interact in
real time with Customs’ computers.
2.
Greater control was achieved
when all pertinent information to border crossings was required to reside in Customs
computers before the initiation of the dispatch and before a truck could enter
Customs’ premises.
3.
A code bar was added to the
document that a trucker has to present when crossing; there information is
recognized in real time by the government’s computer. This way the same paid
declaration cannot be used more than once by the importer.
4.
Buildings were moved to the
edge of the border and all procedures underwent a complete computerization.
5.
The fiscal police was revamped.
Former members were given the opportunity to comply with new rules. The
requirements included physical fitness, no drug addiction and the approval of polygraph
tests. None passed. For the new members of the force a continuous geographical
rotation was established to prevent their acquiring a local clientele or a
chummy complicit relationship with their fellow officers. The government
provided vehicles, uniforms and weapons. Members of the former fiscal police
had been so gracious, that they provided everything out of their supposedly
meager pockets.
6.
Intelligence was programmed
into the “random” selection of merchandise to be inspected. Goods with greater
security, health or tax evasion risks have greater possibilities of being
inspected.
7.
A random second inspection of
the first inspection was introduced, owned and managed by private firms.
8.
Audits, collection and other
areas with overlapping procedures and potential synergies between customs and
internal revenue were transferred to internal revenue.
9.
The steps described show how discretionary
authority has gradually been eliminated. Other steps in this direction have
been the random selection of the individual that performs merchandise
inspections; his identification through digital thumb recognition; the authorization
for trucks to cross the customs area through a computer activation of physical
barriers to entry and exit; the centralized revision of documents submitted,
instead of as before at the point of entry; etc.
In summary, the reform came just in time
for the additional volume of trade, or conversely trade could not have been
handled without the reform. Dispatches are now expeditious and Customs has been
able to handle at lower costs the huge increase in transactions that has come
about because of our free trade treaties and the unilateral measures undertaken
to dismantle barriers to trade. Foreign trade evolved from 16% of GDP in 1980
to 70% in 2013. If trade opening is measured without oil the spike is even more
dramatic. Furthermore, administrative corruption has drastically fallen and
collections improved.
[1] A description of Mexico’s Federal Revenue Sharing is
contained in Análisis Jurídico
Administrativo de los Ingresos Municipales, Chapter 1 by Norma Estela
Pimentel Méndez. Dec. 2003. Thesis to obtain a law degree at Universidad de las
Américas-Puebla.
[3] The State of Sonora for example,
announced that beginning 2014 the yearly tax on vehicle ownership will
disappear. (August 14th, 2013)
[4] From IMF Working Paper: Taxing Immovable Property. 2010. John Norregaard. From the same
source other relevant ratios are: USA, 3.21%; Brazil 1.12%; Colombia 1.51%.
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