Death and taxes are said to be the only certainties in life. In the case of the maquiladora industry, though, the fear is that a lack of tax certainty may cause at least a decline, if not death. This Cross-Border Economic Bulletin looks at some of the reasons why the outstanding tax issues are likely to be settled and outlines the key tax issues still under discussion. Key points are:

• The industry has become the leading source of foreign exchange and a major employer.

• Consequently, the Mexican government cannot afford to impose punitive taxes.

• Nevertheless, import duties and income taxes for 2001 are still up in the air.

• Anti-dumping duties may be the biggest surprise for the industry next year.

The maquilas' increasing importance

To set the background for a brief overview of some of the tax uncertainties, it is useful to first recognize the growing importance of the maquila industry to the Mexican economy. Whatever decisions the federal government ultimately makes about taxes for the industry, they are likely to be tempered by a desire to avoid damaging what has become an extremely important source of foreign exchange earnings, employment and foreign direct investment.

The 1999 trade surplus for the maquiladora industry (Figure 1) contributed nearly $US12 billion to the country's net accumulation of foreign reserves. In addition, the industry continues to draw into Mexico a considerable amount of foreign direct investment (Figure 2). According to CIEMEX-WEFA, the Mexican arm of a U.S.-based economic consulting firm, total 1999 foreign investment (purchases of machinery and equipment, buildings, rentals and inventories) in the maquila industry was over $US11 billion.

Between the industry's $US12 billion trade surplus and its $US11 billion in foreign direct investment, Mexico's foreign exchange reserves remain in good shape. This loosens some of the constraints on non-maquiladora companies that need foreign exchange for purchases of foreign-made capital goods. It also benefits consumers and wage earners by helping to keep the peso strong. As long as the overall trade balance does not turn steeply negative, a strong peso is beneficial.

In addition to its role as a major foreign exchange provider, the maquiladora industry is also a major employer (Figure 3). The industry has continued to provide a growing number of jobs, even as total manufacturing employment fell by about 12 percent between 1994 and 1996. As a result, by 1999, maquiladora industry employment was estimated to be around 40 percent of total manufacturing employment.

Given its overall importance to the Mexican economy, resolution of the remaining tax issues is likely to be done in a way that avoids serious damage to the industry. Nevertheless, a number of unresolved tax issues continue to generate uncertainty.

Three tax issues are facing the maquiladora industry: import taxes, income and asset taxes, and anti-dumping taxes (duties). Under Article 303 of the North American Free Trade Agreement (NAFTA), duty-free imports from non-NAFTA countries will end in January. This has been a source of concern over the last few years (see "Whither the Maquila?"), but the Mexican Commerce Department (SECOFI) announced last year that it would develop "sectoral programs" allowing qualified applicants to apply for reduced tariffs of 0 to 5 percent. These sectoral programs cover most of the products coming into the maquiladora industry, including electronics, electrical equipment, chemicals, textiles, autos and others. However, SECOFI has been slow both to define the process for applying to the sectoral programs and to specify the tariffs.

A second, more complicated issue concerns income and asset taxes. In 1998, the Mexican government announced that as of January 2000, the U.S. parent company of maquilas will be treated as though it has a permanent establishment (PE) in Mexico, forcing the parent to pay Mexican taxes on the share of the income derived in Mexico, plus a 1.8 percent asset tax on machinery, equipment and inventories. The National Association of Maquila Manufacturers opposes these rules, noting significant uncertainty about the share of income derived from a Mexican operation and the potential for double taxation because of a lack of U.S. tax credits.

In response to the latter concern, the Mexican internal revenue agency and the U.S. Internal Revenue Service worked out an agreement they call Safe Harbor. Under its terms, companies can avoid the PE designation and its taxes, electing instead to pay a 6.9 percent tax on assets employed in Mexico or a 6.5 percent tax on the cost of the maquila operation, whichever is greater. If profits are less than either of these two amounts, they have the option of signing an advanced pricing agreement (APA) with the Mexican government, which is an agreement over the methodology used to calculate costs of production and the value of assets. Theoretically, if they qualify, the APA enables companies to pay lower taxes.

Based on anecdotal evidence, representatives of the maquiladora industry dislike all these options. First, the PE rules subject them to double taxation. Second, the Safe Harbor and APA rules will expire in 2002, so they are medium-run solutions, rather than long-run. Third, the government has been exceedingly slow to approve the advanced pricing agreements that companies have already begun to use.

Another wild card is the loss of its exemption from anti-dumping duties (ADD). These are compensating tariffs on imports that are levied when an import sells below "fair market value" and it is determined that the low price has hurt a domestic producer. There are a number of current maquila industry imports, particularly goods coming from China, that have ADDs. Under current rules, the maquila industry is exempt from these duties, but this changes in 2001. All companies will have to do their homework on their imports and any ADDs that might affect them.

The future of the maquiladora industry

In the give and take between the Mexican government and the maquiladora industry, several points stand out:

* First, it seems reasonable to expect a rapidly expanding industry to pay an average amount of taxes, particularly if the industry constantly needs new or upgraded public infrastructure.

* Second, the government seems to be caught in a struggle between its needs to generate revenue and to foster industrial development. This explains the delay in defining a new tax regime. The fact that the industry has become a leading earner of foreign exchange, as well as a major employer, probably tips the balance toward industrial development rather than tax collection.

* Third, in spite of the uncertainty, the industry has continued to grow rapidly (see Cross-Border Economic Bulletin, September 2000). Rapid growth in the face of uncertainty indicates at least two possibilities: The fundamental conditions for growth are so strong that they overcome uncertainties about future tax liabilities, and/or the maquiladora industry has become more skilled in its lobbying and is able to obtain assurances from policymakers even when official policy remains undefined. Either possibility implies a growing maturity within the industry.

* Fourth, with regard to the income and asset taxes, the path of least resistance (lowest cost) for many companies will be to restructure as independent contractors. This requires that all managers be put on the Mexican company's payroll and that all machinery and equipment be owned or rented by the maquila.

All these changes may mean that the maquila industry takes several steps toward becoming more like the rest of Mexican manufacturing (and pulls Mexican industry toward it) while maintaining its ties to the capital and technology of foreign companies.

The Cross-Border Economic Bulletin is prepared monthly by Dr. Jim Gerber, professor of economics at San Diego State University. It is underwritten by Concert, a global venture of AT&T and BT.