VAT revenue and inflation in Mexico

The Value Added Tax (VAT) is the second largest source of tax revenue for the Mexican government after the income tax. A VAT is a sort of wholesale sales tax levied on the value added at each stage of production of a product until it is sold to the final consumer. It is popular with governments because it is thought to be relatively economically neutral and can raise large amounts of tax.

VAT tax rates and the revenue generated have, like inflation rates and the value of the peso compared to other currencies, varied widely in Mexico. After analysing the interaction between these variables over the 1981 to 1997 period, researchers show that whether VAT increases will result in larger tax revenues depends on price inflation and currency values.

In 1982, for example, VAT revenue dramatically fell as a result of quarterly inflation rates of up to 25 percent during the year after a substantial devaluation of the Mexican peso.

Later, beginning in 1983, VAT revenues increased as a result of a five percentage-point increase in the VAT rate.

By November 1991, the VAT rate had come back down to 10 percent; but in April 1995 the Mexican government increased the rate from 10 percent to 15 percent in response to the 1994 peso crisis.

Following this 50 percent rate increase, VAT revenue as a percentage of Gross Domestic Product remained essentially unchanged through 1997.

Thus in inflationary eras in Mexico, increases in the VAT tax rate did not increase revenues; in eras with relatively lower inflation, with a time lag, a decrease in the VAT tax rate eventually brought in roughly the same revenue.

Although VAT rate increases generally raise government revenues, a 1997 proposal for a VAT tax rate reduction by the National Chamber of Commerce (CANACO) estimated that reducing the rate would actually lead to increases in VAT revenues, due to increased economic growth and reduced tax avoidance.

Source: Jose A. Pagan, Gokce Soydemir and Jose A. Tijerina-Guajardo, The Evolution of VAT Rates and Government Tax Revenue in Mexico, Contemporary Economic Policy, October 2001.

For CEP abstract http://cep.oupjournals.org/cgi/content/abstract/19/4/424
For more on Value Added Tax (VAT) http://www.ncpa.org/iss/tax

FMF Policy Bulletin/03 April 2002