Mexican investors. In the case where Canada is the host country (Panel 2, Table 22), the higher withholding tax on dividends between Canada and Mexico (10 percent compared to 5 percent with the US) further increase Mexico's tax disadvantage compared with the U.S. When we look at the case where Mexico is the host country (Panels IA and lB, Table 22), we are unable to draw such a clear-cut conclusion. This is true in particular for the services sector where not only the Canadian CIT rate is higher but also Mexico's withholding tax rate for dividends repatriated to Canada are higher than to the U.S. Obviously, the effect of the higher withholding tax on the dividends to Canada appears to more than offset the effect of the higher CIT rate (for the interest deduction) in Canada.

# **How Does Mexico Compare and What Needs to be Done?**

In summary, given the existing differences in the taxation of capital income within NAFTA, Mexico does well in being competitive for attracting cross-border investment flows. Mexico could do better if it were to follow the U.S. and Canada in exempting from import duty all capital imports for both exporters and non-exporters. Although Canadian foreign direct investment flows into Mexico are not large, bringing the current withholding tax rate on repatriated dividends between Mexico and Canada from 10 to 5 percent (the latter again is the rate between Canada and the U.S. and Mexico and the U.S.) would increase Mexico's attractiveness to Canadian investors vis-a-vis the U.S.

The differences in METRs estimates could encourage investment to move to Mexico because of its lower rates even if Mexico has lower before-tax rates of return for those investment activities. If this were the case, the overall pool of capital available in the three countries would be used less efficiently, or in other words, the overall level of output for NAFTA would be lower. But clearly, a more efficient allocation of resources within NAFTA would not necessarily mean that Mexico would become better off. At any rate, it would not be possible for Mexico alone to eliminate existing distortions in cross-border investment flows. In addition, the welfare losses arising from these distortions are not likely to be large. Note that the METRs are only an approximation of the manner in which the current tax systems favor or discourage investment relative to other countries, but they do not provide an estimate of the actual welfare losses.31

# **SUMMARY AND CONCLUSIONS**

NAFTA has so far had a very significant impact on Mexico's economy. Even though the tremendous increase in exports since 1994 can be partly explained by other factors, mainly the devaluation of the peso in December 1994 and the pressure to export that followed with the recession of 1995-96, NAFTA also appears to have played a significant role in the sustained increase in the level of exports. The positive impact of NAFTA on the sharp increase in crossborder investment flows is much less controversial. Mexico's dependence on oil exports in the past has been shed for a strong export oriented manufacturing sector based not only on the maquiladora sector but also on the general economy fueled by sustained foreign direct 31 In an early estimate, Brown et al. (1992) concluded that NAFTA could add around 0.1 percent to U.S real income and around 4 percent to Mexico's real income. We would expect the distortions to investment flows be a fraction of those gains.

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