More than Revenue: Taxation as a Development Tool

More than Revenue

More than Revenue Taxation as a Development Tool

Edited by

Ana Corbacho , Vicente Fretes Cibils , and Eduardo Lora

MORE THAN REVENUE Copyright © Inter-American Development Bank, 2013.

All rights reserved.

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First edition: February 2013

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Contents

List of Boxes vii

List of Figures ix

List of Tables xiii

Acknowledgments xvii

About the Contributors xxi

Preface xxv

Part I The Tax Forest

1 Undressing the Myths 3

2 The Politics of Taxation 27

3 Tax Systems for a Smooth Ride 49

4 Beware of Informality 65

5 Local Taxes for Local Development 79

6 Making the Most of Tax Administration 99

Part II The Trees: Tax by Tax

7 Personal Income Tax: An Empty Shell 115

8 Corporate Income Tax: The Art of Competing for Investment and Increasing Revenue 135

9 Value Added Tax: Let It Be 159

10 Taxing Commodities with the Future in Mind 177

11 Protecting Goods by Taxing “Bads” 195

12 Heterodox Taxes: The Good, the Bad, and the Ugly 221

vi CONTENTS

Part III Harvesting for Development

13 Growing a Reform Agenda 247

Notes 257

References 279

Index 301

Boxes

1.1 The Concepts of Tax Burden, Adjusted Tax Burden, and Fiscal Burden, as Captured by the IDB-CIAT Fiscal Database 11

2.1 The Power of the Elites and Tax Revenues in Guatemala 30 2.2 Economic Crisis and Tax Reforms 41 3.1 Decomposing Excess Volatility—Latin America vs. OECD 54 5.1 Reforming Subnational Taxes 88 7.1 The Tax Wedge in Latin America and the Caribbean 124 7.2 Dual Taxes and Competitiveness 129 8.1 The Incidence of Corporate Income Tax: A Review of

the Theory 139 8.2 The Future of Free Zones 142 10.1 Fiscal Regimes for the Nonrenewable Resource Sector 179 10.2 International Initiatives on Governance and Transparency

in Extractive Industries 189 11.1 Economic Instruments for Water Management in

Latin America 199 11.2 Environmental Taxes in Caribbean Countries 205 12.1 A Second-Best Option: The Single-Rate Business Tax 231

Figures

1.1 Tax Burden as Percentage of GDP, 2008– 10 4 1.2 Tax Burden Gap, 2007 – 09 5 1.3 Income Tax Gap, 2007 – 09 6 1.4 Tax Burden by Region, 1990 and 2010 7 1.5 Changes in the Tax Burden since the Early 1990s 8 1.6 Structure of Fiscal Revenue in Latin America and the

Caribbean, 1990 – 2010 9 1.7 The VAT Burden, Select Latin American Countries 9 1.8 The Fiscal Burden: Tax Burden, Contributions to

Social Security, and Other Fiscal Revenue from Natural Resources 12

1.9 The Antilabor Bias of Taxes: Ratio of the Labor and Capital Tax Burdens 15

1.10 Incidence of VAT by Income and Consumption Deciles 16 1.11 Incidence of Personal Income Tax 17 1.12 Tax Evasion Rates 19 1.13 Tax Evasion Is Unjustifiable, 1998 – 2008 20 1.14 Volatility of Adjusted Tax Burden, 1990–2010 25 2.1 Tax Burden Gap by System of Government 28 2.2 Legislative Malapportionment and Personal Income Taxes 33 2.3 Chile’s Electoral System: Support for Pinochet and

District-Level Legislative Malapportionment, 1992 34 2.4 The Shift to the Left in Latin America, 1994–2009 35 2.5 Impact of Left-Wing Presidents on Revenues 36 2.6a Relationship between Tax Reforms and the Variations of

Tax Revenues and Tax Neutrality: Tax Reforms and Variation of Revenues 38

2.6b Relationship between Tax Reforms and the Variations of Tax Revenues and Tax Neutrality: Tax Reforms and Variation of Neutrality 39

2.7 Argentina’s Law Initiative 0005-PE-1998 46 2.8 Number of Amendments by Legislative Substance

Scale per Tax 47

x FIGURES

3.1a Gross Domestic Product (GDP) Volatility: World Regions 51 3.1b Gross Domestic Product (GDP) Volatility: Latin America 51 3.2a Gross Domestic Product Volatility in Latin America, Select

Countries: Standard Deviation of GDP’s Growth Rate 52 3.2b Gross Domestic Product Volatility in Latin America, Select

Countries: Standard Deviation of Gap Respect to Hodrick-Prescott Trend 53

B3.1a Decomposition of Excess Volatility in Latin America vs. OECD Countries: 1970–95 55

B3.1b Decomposition of Excess Volatility in Latin America vs. OECD Countries: 1995–2010 55

3.3 Tax Semi-elasticities to Output 59 3.4 Gross Domestic Product (GDP) Volatility and Tax

Automatic Stabilizers 60 3.5 Size of Automatic Stabilizers in Europe, United States,

and Select Latin American Countries 61 3.6 Policy Simulations on Personal Income Tax 62 3.7 Policy Simulations on VAT 63 4.1 Informality, 1990–94 and 2006–10 68 4.2 Social Security Contribution Rates, Latin America and

the Caribbean Average, 1985–2009 68 4.3 Social Security Contributions and Other Payroll Taxes,

1987–2009 69 4.4 Real Monthly Minimum Wage, Latin America and

the Caribbean Average, 1980–2009 70 4.5 Real Minimum Wage, 2009 vs. 1995 70 5.1 Size and Financing of Subnational Government Spending,

Select Regions, 2009 81 5.2 Size and Financing of Subnational Government Spending,

Latin America, 2000 – 09 82 5.3 Composition of Total Revenue of Subnational Governments,

Latin America, 2000 – 09 83 5.4 Subnational Tax Collection and Per Capita GDP, Latin

America, 2009 84 5.5 Tax Gap of Subnational Governments, Latin America, 2009 85 5.6 Composition of Subnational Own-Source Revenue by

Level of Government, 2000 – 09 87 6.1a Tax Administration Costs: Breakdown of Budget Executed

and Administrative Costs, 2010 102 6.1b Tax Administration Costs: Cost of Revenues as Percentage

of Net Tax Revenue and GDP, 2010 102

FIGURES xi

6.2 Allocation of Tax Administration Staff by Function, 2010 103 6.3 Technological Support to Tax Administration 106 6.4a Tax Debt in Select Latin American Countries: Percentage of

Debt Collected Compared to Delinquent Debt Recovered 109 6.4b Tax Debt in Select Latin American Countries: Projection

of Accumulated Debt for 2015 110 7.1a Differences between the Tax Burdens in Latin American

Countries and Other Groups of Countries, 2000–10: With OECD 116

7.1b Differences between the Tax Burdens in Latin American Countries and Other Groups of Countries, 2000–10: With Middle-Income Countries 116

7.2 Maximum Marginal Rate for Each Income Level, 2010 118 7.3 Tax Expenditure and Revenue from Personal Income Tax 120 7.4 Evasion of Personal Income Tax 121 7.5 Taxpayers Paying Personal Income Tax, 2010 123 8.1 Revenue from Personal and Corporate Income Tax, 2006–10 136 8.2a Revenue from Corporate Income Tax (CIT) and Its

Nominal Rate: Comparison between Regions: Latin America and the Caribbean and OECD 137

8.2b Revenue from Corporate Income Tax (CIT) and Its Nominal Rate: Comparison between Regions: Eurozone and Middle-Income Countries 137

8.3a Sectoral Incentives by Country and Sector: Number of Sectors Receiving Incentives by Country 143

8.3b Sectoral Incentives by Country and Sector: Number of Countries Giving Incentives by Sector 144

8.4 Treatment of Extraterritorial Corporate Income 149 8.5a Share of the Five Most Important Export Items and

Commodities in Total Exports, 1970–2010: Five Most Important Items Exported, Including Tourism 152

8.5b Share of the Five Most Important Export Items and Commodities in Total Exports, 1970–2010: Commodities 153

8.6 Three-Way Transfer Pricing of Export Operations to Avoid Taxes in Country A 154

8.7 Revenue from Tourism as Percentage of Total Revenue from Exports of Goods and Services, 2010 156

9.1 VAT: Productivity and Efficiency in Latin America and the OECD 163

9.2 VAT: Potential Revenue Decomposition, Select OECD and Latin American and the Caribbean Countries 165

xii FIGURES

9.3 Evasion of VAT in Select Countries 166 9.4 Tax Expenditure and Progressivity 168 10.1 Simulations on Effective Tax Rate (ETR) and Internal

Rate of Return 184 10.2 Simulations on Internal Rate of Return with Different

Copper Prices 185 10.3a Simulations on Gas and Gold Taxation in Peru:

Production Path for the Gas Sector 186 10.3b Simulations on Gas and Gold Taxation in Peru:

Production Path for the Gold Sector 186 10.4a Simulations on Copper Taxation in Chile and Peru:

Production path for Peru 187 10.4b Simulations on Copper Taxation in Chile and Peru:

Production path for Chile 187 10.5a Revenue Structure of Resource-Rich Countries and

Other Countries in Latin America and the Caribbean: 1994–98 192

10.5b Revenue Structure of Resource-Rich Countries and Other Countries in Latin America and the Caribbean: 2005–10 193

B11.1a Number of Economic Instruments for Water Management in Latin America: By Function 200

B11.1b Number of Economic Instruments for Water Management in Latin America: By Area of Application 200

11.1 Environmentally Related Taxes, 2009 204 B11.2 Environmental Tax Revenue in Caribbean Countries 205 11.2a Pump Price for Gasoline, 2010: Latin American

Countries 206 11.2b Pump Price for Gasoline, 2010: Regions 207 11.3a Distributional Impacts of Energy Tax Reforms in

Uruguay by Decile: Environmental Benefits 213 11.3b Distributional Impacts of Energy Tax Reforms in

Uruguay by Decile: Price Impact 213 12.1 Productivity of Bank Transaction Taxes in Select Latin

American Countries, 1988 – 2010 225 12.2 Collection of the Minimum Tax or Substitutes for the

Income Tax, Select Latin American Countries, 1996–2010 230

Tables

1.1 Statutory Rates of Main Taxes and Contributions, 1995 and 2010 14

1.2 Tax Expenditures in Latin America, 2000–09 18 1.3 Tax Expenditures in Latin America by Type of Tax, 2007 18 1.4 Hours Required to Pay Taxes, 2010 22 2.1 Type and Number of Tax Reforms in Latin America,

1990–2004 37 2.2 Explaining the Probability of Tax Reforms: A Statistical

Approach to Tax Reforms 43 2.3 Tax Dimensions in the Legislative Substance Scale (LESS) 44 5.1 Size and Financing of Subnational Government

Spending, Latin America, 2000 and 2009 83 5.2 Composition of Subnational Taxes, Latin America,

2000–09 85 5.3 Pros and Cons of Possible Subnational Taxes 92 6.1 Legal Nature and Function of Tax Administration

Offices 101 6.2 Sources of Systematic Information Used by Tax

Administrations 104 6.3 Most Relevant Aspects of International Taxation 105 6.4 Registered Taxpayers, Active Taxpayers, and Nonfilers 107 6.5 Invoice Controls, Mass Audits, and In-depth Audits,

2010 108 6.6 Total Audit Determined Debt Objected and Collected in

Mass Audits, 2010 109 7.1 Income Needed to Reach the Minimum and Maximum

Rates of Personal Income Tax, 2010 117 7.2 Revenue from Personal Income Tax if the Brackets Were

Structured as in Middle-Income Countries 119 7.3 High Formal Progressivity, Yet Virtually No Redistributive

Capacity of Personal Income Tax in Latin America 122

xiv TABLES

B7.1 Tax Wedge for Wage Earners without Children in the Sixth Decile 124

B7.2 Tax Wedge for Wage Earners without Children with Annual Income of US$60,000 125

7.4 Worldwide Expansion of Flat and Dual Models 127 7.5 Different Models of the Personal Income Tax 128 8.1 Tax Incentives for Corporate Income Tax 141 8.2 Tax Incentives in the Dominican Republic, Peru,

and Uruguay 145 8.3 Effectiveness of Tax Incentives in Peru, 2001–08 146 8.4 Tax Expenditure for Corporate Income Tax (CIT) 147 8.5 Evasion of Corporate Income Tax 147 9.1 VAT: Revenue and Rates, 1990 and 2010 161 9.2 VAT: Productivity and Efficiency Indexes 162 9.3 VAT: Regressive or Progressive Depending on the

Calculation Method 167 9.4 The “Error of Inclusion” of Reduced Rates and Exemptions

of VAT 169 9.5 P-VAT: Results of Simulating a Generalization of VAT,

with Refund by Direct Transfer to the Poorest Groups 173 10.1 Fiscal Revenues Derived from the Exploitation of

Nonrenewable Resources 178 10.2 Instruments and Desired Characteristics 181 10.3 Revenue Instruments in Latin America and the Caribbean 182 10.4 Impact of a General Reform to the Venezuelan Oil Sector 188 10.5 Fiscal Revenues in Latin America and the Caribbean 191 11.1 Main Environmental Problems in Select Caribbean

Countries 197 11.2 Types of Environmentally Related Taxes 203 11.3 Congestion Pricing Schemes 208 12.1 Bank Transaction Taxes, Select Latin American Countries,

2000–10 223 12.2 Taxes on Primary Sector Exports, Select Countries, 2010 227 12.3 Minimum Taxes or Substitutes for the Income Tax,

Select Latin American Countries, 1986– 2010 229 12.4 Special Regimes for Small Taxpayers, Select Latin American

Countries, 2010 235 12.5 Simplified Tax Regimes for SMEs: Maximum Income

Limits Established by the Tax Administrations, Select Latin American and OECD Countries, 2011 238

TABLES xv

12.6 Small Taxpayer Regimes: Number of Taxpayers and Revenue, Select Latin American Countries, 2006–10 239

12.7 Comparison of the Tax Wedges of Simplified Regimes and Salaried Worker Regimes, Select Latin American Countries, 2010 241

Acknowledgments

Preparation of this book was a joint effort by the Research Department (RES) and the Institutions for Development Department (IFD) of the

Inter-American Development Bank (IDB). Eduardo Lora was in charge of overall coordination of the project, with

the support of coeditors Ana Corbacho and Vicente Fretes Cibils and ex-ternal advisors Mario Marcel and Teresa Ter-Minassian. Santiago Levy provided guidance and encouragement throughout the project.

The principal authors are:

Chapter 1 . Javier Beverinotti, Eduardo Lora, and Luiz Villela. Johanna Fajardo, Juan Carlos G ó mez-Sabaini, Claudino Pita, and Ernesto Stein provided technical assistance. Chapter 2 . Fabiana Machado, Carlos Scartascini, and Ernesto Stein. The background papers for this chapter were written by the authors as well as by Mart í n Ardanaz, Sebasti á n Auguste, Alejandro Bonvecchi, Ernesto Calvo, Lorena Caro, Natasha Falcao, Diego Focanti, Juan Sebasti á n Gal á n, Ó scar Grajeda, Mark Hallerberg, Jos é I. Larios, and Hilen G. Meirovich. Chapter 3 . Ana Corbacho, in collaboration with Alberto Gonz á les-Castillo. Emilio Espino and Mart í n Gonz á lez Rosada collaborated with the authors to write the background papers for this chapter. Chapter 4 . Eduardo Lora and Johanna Fajardo. Santiago Levy and Carmen Pag é s provided academic advice; Leonardo Gasparini and his CEDLAS team prepared the database for the research; and Adriana Kugler supplied additional reference material. Chapter 5 . Jaime Bonet, Rafael de la Cruz, and Vicente Fretes Cibils authored this chapter, with advice from Teresa Ter-Minassian. The chapter draws on country studies prepared by: Luciana D í az Frers, Lucio Castro, Ana Claudia Alfieri, and Ana Bovino, for Argentina; Claudia M. De Cesare, Rubens Alves Dantas, and Jos é Luiz Portugal, for Brazil; Juan Robalino, Luis J. Hall, Pablo Slon, and Catalina Sandoval, for Costa Rica; and Fabio S á nchez and Irina Espa ñ a, for Colombia. Pamela

xviii ACKNOWLEDGMENTS

Albornoz, Emma Monsalve, and Alex Gir ó n also provided technical assistance. Chapter 6 . Alberto Barreix and Fernando Velayos, in collabora-tion with Luis Cremades, Fernando D í az Yubero, Miguel Pecho, and Ó scar V á zquez. Technical inputs were provided by Manuel Alarc ó n, Domingo Carbajo, Horacio Castagnola, Patricio Castro, Santiago D í az de Sarralde, Roc í o Ingelmo, Ra ú l Junquera, Gaspar Maldonado, Manuel M á rquez, Enrique Rojas, and Marcio Verdi. Chapter 7 . Alberto Barreix, Carlos Garcimart í n, and Fernando Velayos. Mart í n B è s and Santiago D í az de Sarralde provided technical assistance. Chapter 8 . Fernando Velayos, Carlos Garcimart í n, and Alberto Barreix. Technical assistance was provided by Daniel Artana, Juan Carlos Ben í tez, Santiago D í az de Sarralde, and Jer ó nimo Roca. Chapter 9 . Alberto Barreix, Mart í n B è s, Santiago D í az de Sarralde, and Fernando Velayos. Technical inputs were provided by Juan Carlos Ben í tez, Carlos Garcimart í n, and Jer ó nimo Roca. Chapter 10 . Gustavo Garc í a, Ó smel Manzano, and Andrew Powell. This chapter draws on background papers by Lenin Balza and Ram ó n Espinasa; Luis Carranza, Rudy Laguna, Á ngela Ru í z-Uccelli, and Raquel Yamujar; Claudia Cooper and Eduardo Mor ó n; Malaika Culverwell and Juan Vierya; J. Rodrigo Fuentes, Bernardita Piedrabuena, and Mauricio Calani; Enrique Kawamura; Rolando Ossowski and Alberto Gonz á les; Guillermo Perry and Sebasti á n Bustos; and Guillermo Perry and Sui-Jade Ho. Paloma L ó pez de Mesa and Pilar Tavella also provided technical assistance. Chapter 11 . Sebasti á n Miller and Carlos Lude ñ a. This chapter draws on background papers by Marlene Attzs, Malini Maharaj, and Gopiechand Boodhan; Omar Chisari; Paolo Giordano and Masakazu Watanuki; ICEFI/IARNA; and Fernando Navajas, M ó nica Panadeiros, and Ó scar Natale. Technical assistance was provided by Fernando Cafferata, Julia Mohs, and Mauricio Vela. Chapter 12 . Alberto Barreix, Juan Carlos Ben í tez, Mart í n B è s, and Fernando Velayos. This chapter draws on background papers by Ó scar Cetr á ngolo, Juan Carlos G ó mez-Sabaini, Dar í o Gonz á lez, Miguel Pecho, and Pedro Velazco. Chapter 13 . Teresa Ter-Minassian. A large number of researchers and officials from various public and

private entities provided statistical information and documentary sources during the preparation of this book. Our appreciation goes to Francisco

ACKNOWLEDGMENTS xix

Abea, Jos é R. Afonso, Marco Aguirre, Manuel Alarc ó n, Mauro Andino, Daniel Artana, Juan Carlos Ben í tez, Mart í n B è s, Domingo Carbajo, Marvin Cardoza, Irene Carrizo, Patricio Castro, Leonardo Costa, Santiago D í az de Sarralde, Ida Fern á ndez, Jorge Gaona, Carlos Garcimart í n, Gustavo Gonz á lez, Kai Hertz, Roc í o Ingelmo, Miguel Jorrat, Ra ú l Junquera, Jos é Larios, Juan Manuel L ó pez Carbajo, Gaspar Maldonado, Luis Marcano, Manuel M á rquez, Belinda P é rez, Carlos P é rez Trejos, Jorge Rachid, Jer ó nimo Roca, Agnes Rojas, Enrique Rojas, Silvana Rubino-Hallman, Jos é Salim, Jorge S á nchez Vecorena, Á ngel Rub é n Toninelli, Ricardo Varsano, and Marcio Verdi.

Many people made valuable comments and suggestions during the review process. We are particularly grateful to Mart í n Ardanaz, Dan Biller, Enrique Fanta, Edgardo Favaro, Marianne Fay, Marcos Fretes, Valeriano Garc í a, Á ngel Melguizo, Carmen Pag é s, Robert Perlman, and Steven Webb. Helpful feedback was also provided for the background papers in various technical and academic forums such as the International Conference on Taxation and Economic Growth (hosted by the Brazilian Finance Ministry, the International Monetary Fund [IMF], and the Inter-American Center of Tax Administrations [CIAT]) in Brasilia; the United Nations Conference on Sustainable Development (Rio+20) in Rio de Janeiro; the Organisation for Economic Co-operation and Development (OECD) Global Forum on Development in Paris; the Latin American and Caribbean Economic Association (LACEA) Annual Meeting in Lima; the Fiscal Policy for Sustainable and More Equitable Growth Seminar (hosted by the Korea Institute of Public Finance and the IDB) in Washington, DC; the Latin American and Caribbean Research Network workshops in Washington, DC; the Eleventh World Copper Conference in Santiago; and the Twenty-Fourth Regional Seminar on Fiscal Policy (hosted by the Latin American and Caribbean Institute for Economic and Social Planning [ILPES] and the Economic Commission for Latin America and the Caribbean [ECLAC]) in Santiago.

Editorial production of this book was managed by Rita Funaro, who worked closely with Andr é s G ó mez-Pe ñ a. Cathleen Conkling-Shaker and John Dunn Smith also contributed to the editorial process. Gabriel Dobson and Alberto Magnet were responsible for translation.

Regarding administrative and logistical support, the authors would like to acknowledge Patricia Arauz, Myriam Escobar Genes, Raquel G ó mez, Kai Hertz, Elton Mancilla, and Mariela Semidey.

Finally, the authors and the IDB would like to express their gratitude and appreciation for the governments and international institutions that

xx ACKNOWLEDGMENTS

have supported tax development in Latin America and the Caribbean, particularly the Inter-American Center of Tax Administrations (CIAT), the Spanish General Cooperation Fund, the Institutional Capacity Strengthening Fund (China), and tax administrations in the region.

The authors and editors of this book take responsibility for any inac-curacies in the information or in their analyses. Similarly, the policy rec-ommendations and opinions are strictly those of the authors and editors and do not reflect the official position of the Inter-American Development Bank, its president, or its board of directors.

Contributors

Alberto Barreix , an Uruguayan citizen, holds a master’s in Public Admin-istration and a PhD in Regional Economics from Harvard University. He is a principal specialist in the Fiscal and Municipal Management Division of the Institutions for Development Sector at the Inter-American Development Bank.

Juan Carlos Ben í tez , a Salvadoran citizen, is currently a master’s degree candidate in Public Policy at the University of Chicago. He is a consultant for the Fiscal and Municipal Management Division of the Institutions for Development Sector at the Inter-American Development Bank.

Mart í n B è s , an Argentine citizen, received a master’s in Economics from the Pontificia Universidade Cat ó lica do Rio de Janeiro and a master’s in International Public Policy from Johns Hopkins University. He is a consul-tant for the Economic Commission for Latin America and the Caribbean (ECLAC) and for the Inter-American Development Bank.

Javier Beverinotti , an Argentine citizen, received an MS in Economics from the University of Texas in Austin and a PhD in Public Policy from George Mason University. He is a specialist in the Fiscal and Municipal Management Division of the Institutions for Development Sector at the Inter-American Development Bank.

Jaime Bonet , a Colombian citizen, holds a PhD in Regional Planning from the University of Illinois at Urbana-Champaign. He serves as a fiscal and municipal management senior specialist in the Fiscal and Municipal Management Division of the Institutions for Development Sector at the Inter-American Development Bank.

Ana Corbacho , an Argentine citizen, holds a PhD in Economics from Columbia University. She is the Sector Economic Advisor of the Institutions for Development Sector of the Inter-American Development Bank.

Luis Cremades , a Spanish citizen, is an economist from the Complutense University of Madrid, civil servant of the Tax Administration State Agency

xxii CONTRIBUTORS

(Spain), and director of the School of Tax Administration (Spain). Currently, he is the head of the Spanish Mission at the Inter-American Center of Tax Administrations (CIAT) and financial adviser of the Embassy of Spain in Panama.

Rafael de la Cruz , a Venezuelan citizen, holds a PhD in Economics from Paris University. He is the country representative for Colombia of the Andean Group Country Department of the Inter-American Development Bank.

Santiago D í az de Sarralde , a Spanish citizen, received a PhD in Economics from the Complutense University of Madrid. He is a professor at the Rey Juan Carlos University, Spain.

Fernando D í az Yubero , a Spanish citizen, is an economist from the University of Madrid, currently inspector State Finance (Spain) and a con-sultant at the Inter-American Development Bank.

Johanna Fajardo , a Colombian citizen, is currently pursuing a PhD in Applied Economics at the University of Minnesota.

Vicente Fretes Cibils , an Argentine citizen, holds a PhD in Economics from North Carolina State University. He is the chief of the Fiscal and Municipal Management Division of the Institutions for Development Sector at the Inter-American Development Bank.

Gustavo Garc í a , a Venezuelan citizen, completed his graduate studies at Boston University. He is a principal specialist of the Fiscal and Municipal Management Division of the Institutions for Development Sector at the Inter-American Development Bank.

Carlos Garcimart í n , a Spanish citizen, received his PhD in Economics from the Complutense University of Madrid. He is a professor at the Rey Juan Carlos University, Spain.

Alberto Gonz á les-Castillo , a Peruvian national, received a master’s in Economics from the University of Virginia. He is a consultant in the Institutions for Development Sector of the Inter-American Development Bank.

Eduardo Lora , a Colombian citizen, holds an MSc in Economics from the London School of Economics. He is a special advisor at the Inter-American Development Bank.

Carlos Lude ñ a , an Ecuadorian citizen, received his PhD in Economics from Purdue University. He is a senior associate in the Climate Change Division

CONTRIBUTORS xxiii

of the Infrastructure and Energy Department at the Inter-American Development Bank.

Fabiana Machado , a Brazilian citizen, holds a PhD and an MA in Political Science from the University of Rochester. She is a researcher in the Research Department of the Inter-American Development Bank.

Ó smel Manzano , a Venezuelan citizen, holds a PhD in Economics from the Massachusetts Institute of Technology. He is a principal specialist for the Central America, Mexico, Panama and Dominican Republic Country Department of the Inter-American Development Bank.

Sebasti á n Miller , a citizen of the United States and Chile, received a PhD in Economics from the University of Maryland at College Park. He is a research economist in the Research Department of the Inter-American Development Bank.

Miguel Pecho , a Peruvian citizen, holds an MSc in Economics from University College, London. He is Tax Studies and Research director at the Inter-American Center of Tax Administrations (CIAT).

Andrew Powell , a British citizen, received his PhD in Economics from the University of Oxford. He is the principal advisor in the Research Department of the Inter-American Development Bank.

Carlos Scartascini , an Argentine citizen, received his PhD in Economics from George Mason University. He is a principal economist in the Research Department at the Inter-American Development Bank.

Ernesto Stein , an Argentine citizen, received his PhD in Economics from the University of California, Berkeley. He is a senior advisor of the Research Department at the Inter-American Development Bank.

Teresa Ter-Minassian , an Italian citizen, holds a PhD in Economics from Harvard University. She was a director of the Fiscal Affairs Department at the International Monetary Fund, and is currently a consultant for the Inter-American Development Bank.

Ó scar V á zquez , an Argentine citizen, holds a bachelor’s in Informatics from CAECE (Centro de Altos Estudios de Ciencias Exactas), Buenos Aires. He is resident expert on tax administration at the Central America, Panama, and Dominican Republic Regional Center of Technical Assistance (CAPTAC-DR).

Fernando Velayos , a Spanish citizen, a lawyer and economist from the University of Madrid, holds a master’s in Taxation from the Institute for

xxiv CONTRIBUTORS

Fiscal Studies, Spain. He is a consultant for several international organiza-tions, including the Inter-American Development Bank.

Luiz Villela , a Brazilian citizen, received an MSc in Public Sector Economics from the Pontificia Universidade Cat ó lica do Rio de Janeiro. He is a lead spe-cialist of the Fiscal and Municipal Management Division of the Institutions for Development Sector at the Inter-American Development Bank.

Preface

No major reform is more important for the sustainable and inclusive growth of Latin America and the Caribbean than the one pending

in the region’s fiscal and tax systems. We have known this for a long time. In 2007, the San Jos é Consultation, convened by the IDB to identify the

most promising policy reforms, concluded that improving tax institutions and rules represented not only one of the biggest challenges facing the region, but also one of the best opportunities to advance economic and social development.

As a result of robust growth recently enjoyed by most countries and changes in the tax structures in some countries, Latin America and the Caribbean has reduced its public debt ratio and can now devote more public resources to productive investment and poverty reduction programs.

When the international crisis unraveled in 2008, many countries in the region had improved their fiscal situations enough to allow them to adopt countercyclical economic policies to alleviate the loss of welfare in their societies.

Notable progress has been made in the quality and effectiveness of fis-cal policies, as highlighted in this new edition of “Development in the Americas” (DIA), IDB’s annual flagship publication on economic and social policy challenges in Latin America and the Caribbean. Recent growth of tax revenues in the region has been the fastest in the world. However, since the region began at such a low point compared to its level of development, it still has a long way to go. The reason why the region’s task is still so great is twofold.

First, given the shortcomings of taxation in the region, most countries’ systems are still far from exhausting their revenue potential.

Second, taxes, apart from providing the revenue needed to support the functions of a modern state, must also—indeed preferably—be designed as a powerful tool for stimulating development.

As this book shows, existing tax structures in Latin America and the Caribbean are still far from meeting this objective. This is the main

xxvi PREFACE

message that we at the IDB would like to convey to the citizens of the continent.

Our practical recommendation for action is also very clear: we must take rigorous and decisive steps to reform and replace our existing tax systems with structures designed to be real instruments of growth and inclusive development. This new generation of tax reforms is one of the great items of unfinished business in our region.

Both our societies and our authorities must understand the nature and scale of the great opportunity ahead of us: reform our distortionary, inad-equate, and regressive tax systems to convert them into allies of economic growth, mobility, and social equality. Our continent now has the oppor-tunity to enact tax reforms that not only generate revenue but fundamen-tally support the sustained and inclusive development of our societies.

Although the tax situations in our region vary widely, the analysis shows that the prodevelopment tax reforms required by our countries must respect five basic principles:

1. The reforms must include taxes that favor the poor . The first priority is to improve the progressivity of existing tax systems with an income tax that has fewer exemptions, real redistributive capacity, and that preserves the income of poorer households.

2. The reforms must establish tax systems that are simpler with broader tax bases. Most of the region’s tax systems are overly complex due to a plethora of exemptions and privileges for certain activities, sectors, or groups of tax-payers. The outcome is usually taxes that severely distort the allocation of resources and result in narrow and fragile tax bases. Shifting to simple tax systems with broad bases that create an environment conducive to innova-tion and business startups is one of the surest ways to promote higher pro-ductivity growth and a sustainable improvement in the region’s well-being and equity.

3. Tax administrations must be strengthened so that all citizens and businesses meet their tax obligations. Reducing the high rate of tax evasion and cre-ating institutions that guarantee that all economic agents and citizens con-tribute their share to the collective effort is an essential element of social legitimation and, as such, a requirement for the sustainability of any tax system designed to support development.

4. Institutional agreements and consensuses must be reached to ensure that local governments have the local resources needed to act as agents of development. For decentralized spending to be sustainable, the own-source resources of local governments must be strengthened. Much of the great potential of local revenue is still wasted, especially property taxes.

PREFACE xxvii

5. Prodevelopment tax reforms should build tax systems that look to the future. Latin America and the Caribbean enjoy an extraordinary endowment of natural resources. However, environmental taxes or the current design of taxes on commodities do not reflect this situation. To adapt our future to our reality, our tax systems must create incentives for the more efficient use of the finite natural resources available to all of us and take into account the needs of future generations of Latin Americans. We cannot afford to lose the idea of intergenerational solidarity.

As president of the IDB and as a Latin American, I know that the path to an ideal fiscal reform is neither easy nor unique. Each country must build its own consensus, set priorities, and choose the commitments that can make real improvement of its tax system possible. Each country must negotiate its own fiscal pact.

But I also know that our countries are not willing to continue tolerating fragile, unjust, and vulnerable tax systems that generate high private and social costs in terms of lost growth and opportunity. I am convinced that the countries of the region will recognize that the time has come to tackle these inclusive prodevelopment tax reforms.

The opportunity is now. We must grasp it. The debate must take place and this book is bound to serve as one of

its key references. Since the IDB could not be absent from the discussion, we wanted to contribute with arguments and analytical rigor. With this edition of DIA, More than Revenue: Taxation as a Development Tool , we strived to add a meaningful voice to the debate.

Beyond its results and recommendations, the IDB, as a development institution, is ready to support all the partners and stakeholders that decide to take on these crucial reforms.

Luis Alberto Moreno President

Inter-American Development Bank

Part I

The Tax Forest

1

Undressing the Myths

The structure of taxation in Latin American and Caribbean coun-tries is usually described as suffering from four major shortcomings:

collection is very low, taxes are barely progressive, tax evasion is ram-pant, and tax administrations are very weak. 1 These characteristics cre-ate a self-reinforcing vicious circle, whose deep historical roots can be found in the distribution of wealth and effective political rights in the region. 2 One of the rent-seeking mechanisms that the most affluent have imposed on the rest of society is the regressive design of the tax struc-ture. Opportunities to evade taxes that vary greatly across income groups compound this perverse structure, shrinking the effective tax bases and resulting in low levels of revenue. 3

This description is not very encouraging, but fortunately it does not do justice to the current state of taxation in Latin America and the Caribbean. Although these characteristics are valid as stylized facts, they do not apply equally to all countries and are becoming less accurate in light of recent developments in taxation. While they may once have been good descrip-tions of reality, they are now approaching myths.

The Myth and Reality of Low Taxation

It is often claimed that Latin American and Caribbean governments col-lect little tax revenue. This claim is immediately associated with problems such as the concentration of income and the public sector’s incapacity to respond to the demand for social spending and public goods of all types, from transportation infrastructure to citizen security. But like all often-repeated claims, this claim obscures a much more complex reality.

True, the tax burden (taking into account all taxes, but not social security contributions and other fiscal revenues) in Latin America is low compared with other regions. In Latin America, national and subnational

4 MORE THAN REVENUE

governments collect 17.5 percent of GDP in taxes ( figure 1.1 ). Tax revenue is higher in Eastern European countries (24.1 percent of GDP) and the 32-member countries of the Organisation for Economic Co-operation and Development (OECD) outside of Latin America (25.4 percent). This group will be considered representative of developed countries for purposes of this analysis. 4

The richer countries generally tend to collect a higher proportion of GDP in tax revenues. Thus, it is not entirely surprising that tax receipts in Latin America and the Caribbean are higher than in Africa and lower than in the OECD. However, taken individually, most Latin American countries collect less tax revenue than might be expected for their income levels. For example, Guatemala, Mexico, Panama, and Trinidad and Tobago have tax burdens close to 10 percent of GDP, well below the typ-ical burdens of other countries with similar income levels. According to the criterion of per capita income level, the tax collection gap is 7 points of GDP for Guatemala and 11.5 percentage points of GDP for Mexico. On average, the 23 Latin American and Caribbean countries considered have a collection gap of about 2 percentage points of GDP ( figure 1.2 ). 5

The fact that higher-income countries have higher tax burdens is due, above all, to income tax. Globally, very few low-income countries raise more

7

16

17

17

24

25

0 5 10 15 20 25 30

Middle East

Africa

Asia

Latin America and theCaribbean

Eastern Europe

OECD

Tax burden (percentage of GDP)

Figure 1.1 Tax Burden as Percentage of GDP, 2008–10 (simple average)

Note : The tax burden does not include social security contributions. Africa does not include Angola, Malta, Lesotho, and Swaziland. OECD is the Organisation for Economic Co-operation and Development. Source : Authors’ estimates based on IDB and CIAT ( 2012 ) and IMF ( 2011b ).

UNDRESSING THE MYTHS 5

than 3 percent or 4 percent of GDP through taxes on personal income and businesses. By contrast, the government of a high-income country usually garners the equivalent of more than 15 percent of GDP from these sources. But the richest Latin American societies enjoy fairly modest income tax burdens. Argentina, Costa Rica, and Uruguay—relatively wealthy and egalitarian societies by the standards of the region—have large income tax deficits (more than 4.5 percentage points of GDP, according to the per capita income criterion). Even Brazil, which has a burden of taxes and social security contributions comparable to that of the OECD countries, has an income tax deficit ( figure 1.3 ). 6

This low tax effort is not exclusive to central governments. Since the 1980s, Latin America has undergone a rapid process of political and fiscal decentralization, which should have helped raise the tax revenue of subna-tional governments. 7 However, as discussed in chapter 5 , with the notable exceptions of Argentina and Brazil (whose subnational governments col-lect 5.9 percent and 9.8 percent of GDP, respectively), 8 subnational taxa-tion is very modest. Even countries that have made relatively rapid progress in decentralizing expenditure, such as Colombia (where subnational

Figure 1.2 Tax Burden Gap, 2007 ‒ 09 (percentage points of GDP)

Notes : The “gap” is the excess or deficit in tax collection with respect to international patterns, based on GDP and “other variables”: the proportion of the population under 15 years of age and over 65, percentage of the labor force that is self-employed, coefficient of exports and imports with respect to GDP, and coefficient of rents from natural resources with respect to GDP. OECD is the Organisation for Economic Co-operation and Development. Source : Authors’ calculation based on IDB and CIAT ( 2012 ) and IMF ( 2011b ).

–15 –10 –5 0 5 10

MexicoPanama

Trinidad and TobagoGuatemalaVenezuelaCosta RicaEl Salvador

ParaguayDominican Rep.

HaitiEcuador

ColombiaPeruChile

BoliviaHondurasUruguay

NicaraguaArgentina

JamaicaBelize

BarbadosBrazil

Middle EastLatin America and the Caribbean

AsiaAfrica OECD

Eastern Europe

Taking into account GDP Taking into account other variables

6 MORE THAN REVENUE

governments obtain only 2.9 percent of GDP from their own taxes), fare poorly. Excluding Argentina and Brazil, the tax burden of subnational gov-ernments averages only 0.8 percent of GDP, confirming the assertion that Latin American countries collect very little tax revenue.

One defense of the paltry collections posits that Latin American coun-tries have less need to raise taxes because they have abundant natural resources that can provide tax revenue. Alternatively, low tax receipts may reflect not so much the availability of other sources of revenue as the relatively high importance of “hard-to-tax” activities, such as small busi-nesses. Although these arguments are valid (as shown by the econometric analysis on which figures 1.2 and 1.3 are based), 9 they explain relatively little: the tax gaps (in total or income tax) do not disappear when they are calculated to include these criteria, and in some cases are even higher than when the calculation is based only on the per capita income level.

Thus, it is true that tax collection is low relative to the per capita income levels of countries, even after taking into account various characteristics of the economic structure that may affect taxation. However, this styl-ized fact can obscure very important distinctive features of taxation in

Figure 1.3 Income Tax Gap, 2007 ‒ 09

Notes : The “gap” is the excess or deficit in collection with respect to international patterns, based on GDP and “other variables”: the proportion of the population under 15 years of age and over 65, percentage of the labor force that is self-employed, coefficient of exports and imports with respect to GDP, and coefficient of rents from natural resources with respect to GDP. OECD is the Organisation for Economic Co-operation and Development. Source : Authors’ calculation based on IDB and CIAT ( 2012 ) and IMF ( 2011b ).

–6 –5 –4 –3 –2 –1 0 1 2 3

UruguayArgentina

Costa RicaDominican Rep.

MexicoParaguay

GuatemalaPanama

El SalvadorBolivia

VenezuelaEcuador

HaitiTrinidad and Tobago

ColombiaPeru

HondurasChileBrazilBelize

NicaraguaBarbados

Jamaica

Middle EastLatin America and the Caribbean

Eastern EuropeAfrica

AsiaOECD

Taking into account per capita GDP Taking into account other variables


Latin America and the Caribbean and risk disregarding some potentially far-reaching changes. First, the tax burden has increased more in Latin American and Caribbean countries than anywhere else in the world: by 2.7 points of GDP from the early 1990s to the second half of the 2000s ( figure 1.4 ). Two decades ago only Middle Eastern countries had lower tax burdens than Latin American countries. Today taxpayers in Latin America and the Caribbean pay more taxes (as a proportion of income) than they do in Asian or African countries.

Second, the significant increase in the tax burden is not a phenomenon limited to just a few countries in the region. The tax burden has grown in almost all Latin American and Caribbean countries, whether relatively rich economies, such as Argentina, Chile, and Uruguay; or lower-income countries, such as Guatemala and Bolivia; in countries rich in oil and minerals, such as Colombia, Ecuador, and Peru; in economies with fewer natural resources, such as the Dominican Republic and El Salvador; or in tourism-dependent countries, such as Barbados; as well as in those depen-dent on external transfers, such as Nicaragua. The tax burdens fell in only

Figure 1.4 Tax Burden by Region, 1990 and 2010 (simple average, percentage of GDP)

Notes : Africa does not include Angola, Malta, Lesotho, and Swaziland. The tax burden does not include social security contributions. There are no data for Eastern Europe for the period 1990–96. OECD is the Organisation for Economic Co-operation and Development. The 1990–96 data for Eastern Europe correspond to the 1997–2003 period. Sources : Authors’ estimates based on IDB and CIAT ( 2012 ) and IMF ( 2011b ).

0 5 10 15 20 25 3

Middle East

Africa

Asia

Latin America and theCaribbean

Eastern Europe

OECD

Percentage of GDP1990–96 2004–10

8 MORE THAN REVENUE

three countries (Mexico, Trinidad and Tobago, and Venezuela)—all oil exporters—in the three-year periods from 1991 to 1993 and 2008 to 2010 ( figure 1.5 ).

Third, tax increases have taken place across all tax sources, with the exception of taxes on international trade and excise duties ( figure 1.6 ). The value added tax (VAT) has become the main source of tax revenue in Latin America and the Caribbean, with receipts now reaching 6.3 percent of GDP. VAT tax burdens on average hover already at levels similar to those of developed countries. In Brazil and Uruguay, they sit far above world standards, and in seven other Latin American countries, they surpass the world standard ( figure 1.7 ).

Apart from VAT, revenue from other taxes has grown significantly. Corporate income tax currently generates 3.4 percent of GDP in the region, substantially more than the 1.9 percent of GDP raised in the early 1990s (figure 1.6). However, part of this increase is due to higher taxation of the agricultural and mining sectors, thanks to the recent boom in for-eign prices. Even the tax burden of individuals, although still very low by world standards, has grown modestly: from 1.6 percent of GDP in the first half of the 1990s to 2 percent in the second half of the 2000s.

Figure 1.5 Changes in the Tax Burden since the Early 1990s

Note : The tax burden does not include social security contributions. The data correspond to (average tax burden 2008–10) – (average tax burden 1991–93). For those countries without data for the 1991–93 period, data from 1994 or 1995 was used. Source : Authors’ calculations based on IDB and CIAT ( 2012 ) and IMF ( 2011b ).

–2.9–1.9

–1.10.0

0.50.60.8

2.32.73.03.13.13.23.43.53.63.73.8

4.44.5

6.07.9

11.9

–4 –2 0 2 4 6 8 10 12 14

Trinidad and TobagoMexico

VenezuelaHonduras

ChilePanama

NicaraguaGuatemala

BelizeLatin America and the Caribbean

UruguayBrazil

BarbadosEl SalvadorCosta Rica

JamaicaParaguay

Dominican Rep.Peru

ColombiaBolivia

EcuadorArgentina

Figure 1.6 Structure of Fiscal Revenue in Latin America and the Caribbean, 1990 ‒ 2010

Note : The data correspond to the simple average of 21 countries in the region. Source : IDB and CIAT ( 2012 ).

1.6 1.7 1.8 2.01.9 2.1 2.6 3.4

4.35.0

5.76.32.7

2.11.9

1.7

0.4 0.40.5

0.5

1.9 1.71.7

1.63.0 3.54.1

4.21.1

0.9

1.4

1.9

2.83.1

3.4

4.3

0

5

10

15

20

25

30

1990–95 1996–2000 2001–05 2006–10

Personal taxes Corporate taxes VAT Trade Property

Excises Social security Natural resources Others

Per

cen

tag

e o

f G

DP

Figure 1.7 The VAT Burden, Select Latin American Countries

Source : Authors’ calculations based on IDB and CIAT ( 2012 ) and IMF ( 2011b ).

Brazil

Uruguay

BarbadosChile

ArgentinaNicaragua JamaicaEl SalvadorBolivia

EcuadorHonduras Peru

Guatemala

Costa RicaVEN

ParaguayColombia

Dominican Rep.

Mexico Trinidad and Tobago

Panama

0

2

4

VAT

bu

rden

as

per

cen

tag

e o

f G

DP

(av

erag

e 2

007–

10)

6

8

10

12

14

16

18

20

6 7 8 9 10 11 12

Logarithm of GDP per capita (average 2007-10)

All Latin America and the Caribbean

10 MORE THAN REVENUE

Fourth, the tax burden considered so far is only part of the fiscal burden, which also encompasses social security contributions and non-tax fiscal revenue, including that derived from exploitation of natural resources (mainly in the form of royalties and transfers to government from public utility companies). When considering all the sources of fis-cal revenue of national and subnational governments, the fiscal burden in Latin American countries on average has increased 4.7 percent of GDP, from 18.6 percent in the first half of the 1990s to 23.2 percent in the second half of the 2000s. 10 Of this increase, 2.6 percentage points are attributable to the tax burden proper; 1.2 percentage points due to compulsory contri-butions to social security (health and pensions, including contributions to private pension funds); and 0.9 percentage points to nontax fiscal rev-enue. These significant increases have been largely overlooked because there has been no consistent supply of information on the various sources of fiscal revenue for Latin American and Caribbean governments. The Inter-American Development Bank (IDB), in partnership with the Inter-American Center of Tax Administrations (CIAT), has collected this infor-mation for the first time for the 1990 ‒ 2010 period (see box 1.1 )

Some argue that the fiscal strengthening of Latin America and the Caribbean is simply a by-product of the boom in commodity prices. 11 Undoubtedly, rising prices of oil, minerals, and agricultural products, especially during the spike of 2008, contributed to improving the fiscal position of several countries. As analyzed in chapter 10 , in eight countries with abundant nonrenewable natural resources, 12 fiscal revenue derived from their exploitation (including taxes, royalties, and revenue from state enterprises transferred to the government) doubled between 1994 ‒ 98 and 2005 ‒ 10 (an average increase of 3.9 percent of GDP to 7.9 percent of GDP). However, for the region as a whole, this phenomenon was less pronounced. According to the new information from IDB-CIAT, fiscal revenue from taxes and royalties from natural resources grew from 1.1 percent of GDP in the early 1990s to 1.9 percent in the second half of the 2000s on average in the 21 countries of the region with comparable information. 13 While significant, this increase certainly is not the main cause of the growth in the overall fiscal burden in the same period. 14

The differences between the tax burden and the fiscal burden are sub-stantial in almost all countries, and in some cases mean that a country with a very low tax burden, such as Trinidad and Tobago, carries one of the highest fiscal burdens in the region (30.7 percent of GDP in the 2006 ‒ 10 period; see figure 1.8 ). Considering its income level, Bolivia has a hefty fiscal burden (26.3 percent of GDP), which relates more to other


revenue-raising mechanisms than to tax revenue. Likewise, Mexico also has a fairly high fiscal burden (21.7 percent), after including contributions, royalties, and other forms of income transfer to the state. And although Panama and Paraguay do not figure among the big league tax collectors, their fiscal revenue from nontax sources is still noteworthy. 15

Although the often-repeated claim that tax burdens are low in Latin America and the Caribbean may still be true, it is not very descriptive of the trend in the fiscal situation of the region. No other region has

Box 1.1 The Concepts of Tax Burden, Adjusted Tax Burden, and Fiscal Burden, as Captured by the IDB-CIAT Fiscal Database

The main source of information for this book was the new fiscal database compiled by the Inter-American Development Bank (IDB) and the Inter-American Center of Tax Administrations (CIAT) covering 21 Latin American and Caribbean coun-tries a from 1990 to 2010. The database has the virtue of using uniform criteria for all countries, following OECD nomenclature and using previous compilations of OECD (OECD, CIAT, and ECLAC 2011 ) and the Economic Commission for Latin America and the Caribbean (ECLAC 2012 ).

The accounts have been constructed bearing in mind that all states have three main ways of creating pecuniary obligations. First, they can use their taxing power to collect taxes, charges, and contributions. Fiscal revenue originating from this power constitutes the tax burden , which is usually measured as a percentage of GDP. Second, they can use their regulatory power to create contributions to finance an activity organized by or regulated by government (though not neces-sarily a state activity). This is the case of contributions to social security, mainly pensions and health. Social security contributions plus the tax burden form the adjusted tax burden. Third, the state can obtain revenue from resources in the public domain , especially but not exclusively from natural resources. This rev-enue includes receipts from public companies through royalties, dividends, and other income freely available to government, and revenue from private companies through royalties and extraordinary taxes on the income and assets of companies licensed to exploit natural resources and other resources in the public domain (Barreix et al. 2012 ). When revenue derived from natural resources and the public domain is added to the adjusted tax burden, it becomes the fiscal burden.

To make comparisons with countries in other regions of the world, this book uses tax data from the International Monetary Fund (IMF 2011b ). The advantage is that it covers 177 countries. The disadvantage is that it uses criteria of tax rev-enue classification and coverage that are not entirely uniform for all countries.

a The 21 countries included in the database are: Argentina, Barbados, Belize, Bolivia, Brazil, Chile, Colombia, Costa Rica, the Dominican Republic, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Mexico, Nicaragua, Panama, Paraguay, Peru, Trinidad and Tobago, and Uruguay.


experienced such sharp increases in tax revenues in the last two decades (the tax burden fell in only three countries, all oil exporters). Receipts from important taxes, such as VAT and corporate income tax, have grown sig-nificantly since the early 1990s. The real fiscal burden in the vast majority of countries is substantially higher due to social security contributions, royalties, and other sources of income available to national governments. In short, a big gap exists between the reality and the myth of low tax col-lection in Latin American and Caribbean countries.

The Myth and Reality of the Lack of Tax Progressivity

Another familiar refrain claims that tax revenue in the region is not progressive because it depends excessively on taxes that are considered regressive, such as VAT, or that fall too heavily on workers, such as social

Figure 1.8 The Fiscal Burden: Tax Burden, Contributions to Social Security, and Other Fiscal Revenue from Natural Resources (average, 2006 ‒ 10)

Note : The fiscal burden is the sum of the tax burden, contributions to social security (including those deposited in private funds), and other fiscal income from the exploitation of natural resources. Source : IDB and CIAT ( 2012 ).

0 5 10 15 20 25 30 35

GuatemalaDominican Rep.

El SalvadorPeru

ParaguayHonduras

EcuadorPanama

Costa RicaMexico

ColombiaJamaica

NicaraguaBelizeChile

BoliviaUruguay

ArgentinaTrinidad and Tobago

BarbadosBrazil

Central America

Latin America andthe Caribbean

South AmericaCaribbean

Tax burden Contributions to social security Other fiscal revenue from natural resources

Percentage of GDP


security contributions. In fact, VAT and social security contributions con-stitute the two most important sources of fiscal revenue: on average, in the 2006 ‒ 10 period they contributed 6.3 percent and 4.2 percent of GDP, respectively. These levels represent substantial increases over the early 1990s when they were raising 4.3 percent and 3 percent of GDP, respec-tively. Moreover, these are the only two major sources of tax revenue whose nominal (or statutory) rates have risen, since the rates of other sources are now lower. Between 1995 and 2010, the VAT basic rate rose from 13.4 percent to 15 percent, on average, and social security contributions rose from 19.8 percent to 21.6 percent. In contrast, average tariffs fell one-third (from 12.9 percent to 8.8 percent), and the highest personal and corporate income tax rates both fell 3 percentage points on average ( table 1.1 ).

In addition, new evidence suggests a bias against labor revenue in the tax structures of Latin America and the Caribbean, not only because the sum of the nominal rates levied on work (that is, social security and per-sonal income tax) is higher than the nominal rates on capital, but because the effective rates of taxation on labor are higher than those on capital in almost all the (few) countries for which the available information makes these calculations possible. In Brazil, Colombia, Guatemala, and Venezuela, wage earners’ income has effective tax rates of approximately double the rate on profits in the business sector. In Bolivia, Chile, and Mexico, these tax burdens are more equal. In only one country (Honduras) do wage earners support effective tax burdens that are lower than capital ( figure 1.9 ). The tax bias against wage earners and in favor of capital is not unique to the region. However, in European countries where there are similar biases, the high taxation of labor accompanies very extensive social security systems, which do not exist in Latin America. The Anglo-Saxon countries, which have more limited public social security systems, tax capital more heavily than labor.

Thus, there are grounds for claiming that Latin American tax systems are not very progressive, especially when compared with those in Europe. But this claim ignores crucial aspects of the distributional impact of taxes in Latin America and the Caribbean.

First, it is not correct to assume that VAT is necessarily a regressive tax—meaning that higher rates are levied on the poor than on the rich—and still less that any effort to increase VAT receipts is harmful for income distribution.

Hypothetically, a totally f lat VAT, which taxes all the goods and ser-vices consumed by families equally, would be regressive because the poor consume a higher proportion of their income than the rich. This is

Tabl

e 1.1

St

atut

ory

Rate

s of M

ain

Taxe

s and

Con

trib

utio

ns, 1

995

and

2010

Pers

onal

inco

me t

ax a

Cor

pora

te in

com

e tax

a VA

T b Im

port

tari

ffs (

aver

age)

c M

anda

tory

cont

ribu

tions

to

soci

al se

curi

ty b

Cou

ntry

19

95

2010

19

95

2010

19

95

2010

19

95

2010

19

95

2010

Arg

entin

a30

3530

3521

2112

.112

.645

.044

.0Ba

rbad

osn.

d.35

n/d

25n.

d.15

n.d.

n.d.

n.d.

n.d.

Beliz

en.

d.25

n/d

25n.

d.10

22.2

11.0

n.d.

n.d.

Boliv

ia13

1325

2513

139.

711

.222

.022

.5Br

azil

3527

2534

3129

13.1

13.7

28.0

28.0

Chi

le45

4015

1718

1911

.06.

017

.921

.0C

olom

bia

3533

3533

1416

13.7

12.5

26.5

34.0

Cos

ta R

ica

2525

3030

1013

10.0

5.4

27.0

31.6

Dom

inic

an R

ep.

2525

2525

816

14.8

8.6

11.0

21.8

Ecua

dor

2535

2525

1012

12.9

11.2

18.5

19.0

El S

alva

dor

3025

2525

1313

10.1

5.9

13.5

20.5

Gua

tem

ala

3031

2531

712

10.1

5.6

14.5

15.5

Hon

dura

s46

2540

257

129.

95.

610

.510

.7Ja

mai

ca25

2533

33.3

1316

.521

.27.5

5.0

5.0

Mex

ico

3528

3428

1516

13.1

9.0

19.6

16.0

Nic

arag

uan.

d.30

n.d.

30n.

d.15

10.0

7.215

.019

.8Pa

nam

a56

2745

305

512

.75.

4n.

d.n.

d.Pe

ru30

3030

3018

1816

.55.

423

.023

.0Pa

ragu

ay0

1030

1010

1010

.710

.219

.019

.0Tr

inid

ad a

nd T

obag

o38

2538

2515

15n.

d.n.

d.8.

410

.8U

rugu

ayn.

d.25

n.d.

25n.

d.22

10.9

10.5

36.5

30.5

Vene

zuel

a34

3434

3413

1213

.712

.515

.017

.5Av

erag

e30

.927

.630

.227

.313

.415

.012

.98.

819

.821

.6M

edia

n30

.027

.030

.026

.513

.015

.012

.48.

818

.520

.5

Not

e : Th

e tar

iff d

ata f

or 1

995

for B

eliz

e and

Jam

aica

are

for 1

996,

and

for t

he D

omin

ican

Rep

ublic

and

Pan

ama a

re fo

r 199

7. a M

axim

um ra

tes.

b Mai

n ra

te.

c Mos

t fav

ored

nat

ion

(MFN

). n.

d.: n

o da

ta.

Sour

ce: F

or 1

995:

Lor

a (20

07).

For 2

010:

Wor

ld B

ank

(201

2b);

KM

PG (2

011a

, b).


the logic that leads to the common belief that VAT is a regressive tax by definition. But in practice, depending on what goods are exempted or taxed at lower rates and depending on what measure of income is used, VAT may or may not be regressive. In Latin America and the Caribbean, the most important components of the consumption of the poor, such as food, housing, and transport, are exempt from the VAT or are taxed at very low rates. However, VAT appears to be a regressive tax with respect to income because the income reported in the household surveys dur-ing the reference period is normally used as the measure, rather than the average income of families over a longer period. Since families that occasionally have no income (due to unemployment, transition between jobs, or a very unstable income pattern over time) are necessarily clas-sified in the lowest-income groups, regardless of their consumption, it is not surprising that these measurements always show VAT as regres-sive. In contrast, if families are classified not by their income level at the time but by their consumption level (which best approximates their permanent income), 16 VAT is slightly progressive in most countries

Figure 1.9 The Antilabor Bias of Taxes: Ratio of the Labor and Capital Tax Burdens

Note : Data for Latin American countries refer to 2005; data for non-Latin American countries correspond to 2002. Source : Lora and Fajardo ( 2012b ).

0.0 0.5 1.0 1.5 2.0 2.5 3.0

AustraliaJapan

CanadaUnited Kingdom

United StatesNew Zealand

NorwayDenmarkPortugal

FranceSwitzerland

SwedenSpain

NetherlandsBelgium

ItalyFinlandAustria

GermanyIrelandGreece

HondurasBolivia

ChileMexico

BrazilColombia

GuatemalaVenezuela

Labor effective tax burden / Capital effective tax burden


(although not all). Figure 1.10 presents averages for those countries for which information is available. This point is analyzed in more detail in chapter 9 .

Compared with personal income tax, which is strongly progressive ( figure 1.11 ), VAT seems to be at a great disadvantage. However, this com-parison ignores the fact that the distributional effect of any tax depends not only on how progressive or regressive its collection is, but on how much is collected and how that revenue is spent. Since VAT receipts are on average about three times those of the personal income tax, their redistributive potential is substantially greater, even assuming that the tax is regressive. Moreover, as discussed in chapter 9 , the regressive aspects of VAT can be corrected with a “customized” design that returns the tax paid by the poor to the poor, instead of granting exemptions for products that end up benefiting those who consume most—the rich. Obviously, the redistributive capacity of personal income tax could also be improved, but in a very different way than the attempts made by Latin American coun-tries—which has been to exclude the bulk of potential taxpayers from the base by fixing exempt basic income at a very high level, and by starting

Figure 1.10 Incidence of VAT by Income and Consumption Deciles

Source : Authors’ calculations based on estimates for various countries by Barreix, B è s, and Roca (2009); Jorrat ( 2009 ); G ó mez Saba í ni, Harriague, and Rossignolo ( 2011 ); and Roca ( 2010a ).

0

5

10

15

1 2 3 4 5 6 7 8 9 10

Income and consumption deciles

Average effective rate (percentage of income) Average effective rate (percentage of consumption)


the maximum income tax rate at a very high income level. For personal income tax to be more redistributive it must, first of all, raise more rev-enue, which is feasible with a better design of the brackets and exemptions, or—better yet—with new design schemes, such as the dual and semidual systems discussed in chapter 7 . 17

Since the claim that tax structures are not very progressive focuses on comparing VAT with personal income tax, not enough attention is paid to the redistributive effects of other taxes. Receipts from corporate income tax have increased significantly. It is difficult in practice to assess the incidence of corporate taxes because, depending on the working of the markets, the burden of the tax can fall on business owners or can be shifted onto consumers or workers. But the increased tax revenue from corpo-rate income tax demonstrates that it is possible to raise more revenue with lower nominal rates because lowering rates eliminates special exemptions and treatments that not only erode collection but distort investment and production decisions.

More serious than the lack of progressivity is the fact that individuals or companies with similar income levels or profit rates (within the same

Figure 1.11 Incidence of Personal Income Tax

Source : Authors’ calculations based on Barreix, Villela, and Roca ( 2006 ); Barreix, B è s, and Roca (2009); G ó mez Saba í ni, Harriague, and Rossignolo ( 2011 ); and Servicio de Administraci ó n Tributaria de M é xico (2008).

0

1

2

3

4

1 2 3 4 5 6 7 8 9 10

Income decile

Average effective tax rate (percentage of income)


Table 1.2 Tax Expenditures in Latin America, 2000–09 (percentage of GDP)

Country 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Argentina n.d. 3.01 2.71 2.41 2.01 2.21 2.11 2.20 2.14 2.08Brazil 1.58 1.51 1.78 1.70 1.40 1.69 1.99 2.29 2.77 3.20Chile n.d. 4.43 4.22 3.87 3.45 4.38 4.05 4.88 3.96 3.96Colombia n.d. n.d. n.d. n.d. n.d. 3.70 3.96 3.52 n.d. n.d.Guatemala 12.00 12.30 12.70 12.50 12.30 8.40 8.50 8.60 n.d. n.d.Mexico n.d. n.d. 5.26 6.05 5.28 6.32 5.59 5.38 n.d. n.d.Peru n.d. n.d. n.d. n.d. 1.83 2.07 2.24 2.22 2.05 1.81

n.d.: no data. Source : Villela, Lemgruber, and Jorrat ( 2009 ), based on official reports of the countries.

Table 1.3 Tax Expenditures in Latin America by Type of Tax, 2007 (percentage of GDP)

Tax Argentina Brazil Chile Colombia Ecuador Guatemala Mexico Peru

VAT 1.14 0.36 0.76 1.92 3.40 1.96 2.15 1.44Income 0.51 1.11 4.21 1.60 1.20 5.28 3.02 0.29

Individual n.d. 0.66 3.31 0.24 0.80 4.35 1.56 0.19Corporate n.d. 0.45 0.90 1.36 0.40 0.93 1.45 0.10

Social Security

0.25 0.74 n.d. n.d. n.d. n.d. n.d. n.d.

Excise 0.13 0.00 n.d. n.d. n.d. n.d. n.d. n.d.Foreign trade 0.16 0.08 n.d. n.d. n.d. 0.20 n.d. n.d.Others 0.02 0.00 n.d. n.d. n.d. 0.46 0.76 0.32 Total

(percentage of GDP)

2.21 2.29 4.97 3.52 4.60 7.91 5.92 2.05

Total (percentage of revenue)

8.90

9.10

24.60

22.00

35.30

63.50

50.70

11.90

Note : Because of the considerable methodological differences between the countries analyzed, it is not possible to compare the values presented. For example, in Guatemala, the nontaxable minimum for income tax is computed as tax expenditure, which is an exception to the generally accepted rule. Also, Chile includes as tax expenditure the difference between the marginal rate of corporate income tax and the maximum marginal rate of the same tax on dividends paid to individuals.n.d.: no data. Source : Villela, Lemgruber, and Jorrat ( 2009 ), based on official reports of the countries.

country) pay very different effective tax rates, leading to horizontal inequity. The exemptions on corporate income tax that benefit many sectors are based on very varied arguments and demonstrate no proven effectiveness. The tax expenditure stemming from exemptions to this tax


represents a quarter of the effective collection and costs the Treasury on average 1 percent of GDP, as analyzed in chapter 8 .

Even so, in the other countries for which information is available—except for Brazil—tax expenditures (on all taxes) tended to decrease or remained unchanged in the 2000s ( tables 1.2 and 1.3 ).

Accordingly, while recognizing that Latin American countries could make more effective use of their tax systems to improve equity, the claim that existing tax revenue is not progressive focuses on the wrong aspects of the problem, such as the fact that VAT is regressive relative to the (current) income of families, or that the personal income tax is very progressive. This mistaken emphasis ignores the fact that the insistence on improving the formal progressivity of these taxes has significantly impaired the redistributive capacity of these taxes. It also ignores the serious problems of horizontal equity in Latin American tax systems.

The Myth and Reality of Tax Evasion

Who can doubt that tax evasion is rampant in Latin America and the Caribbean? Evasion rates of personal income tax are between 30 percent and 70 percent in Peru and Guatemala, and average about 50 percent in the 10 countries for which information is available. Corporate income tax presents a similar situation, with a tax evasion rate averaging around 50 percent ( figure 1.12 ).

Figure 1.12 Tax Evasion Rates (percentage)

Sources: CAF ( 2012 ); Cardoza ( 2012 ); Jim é nez, G ó mez Saba í ni, and Podest á (2010); Pecho, Pel á ez, and S á nchez ( 2012 ); and Salim ( 2011 ).

0 10 20 30 40 50 60 70

Guatemala

Ecuador

Dominican Rep.

Argentina

Chile

Costa Rica

Mexico

El Salvador

Peru

Personal income tax Corporate income tax VAT


Evasive practices are so ingrained in Latin American societies that less than half of Latin Americans believe that tax evasion is a totally unjusti-fiable act, according to the Latinobar ó metro polls for 2010 ( figure 1.13 ). Only 29 out of 100 Dominicans and 35 out of 100 Bolivians consider eva-sion reprehensible. When the generosity of tax expenditures is combined with the intensity of evasive practices, the result is a severe loss of revenue, especially from personal and corporate income tax.

This situation is discouraging, particularly if evasive behavior is in-grained in the social fabric and in the minds of individuals. If, as men-tioned at the beginning of this chapter, the historical and institutional roots of Latin American tax systems are to blame for evasion, the pros-pects for correcting this behavior and boosting revenue appear dim.

However, the blame for evasion may be misplaced. Although citizens’ attitudes affect evasive practices, the design of taxes carries more of the blame. Consider the case of VAT. This tax is applied at all stages of pro-duction, which means that each company has an interest in claiming the VAT receipts from their suppliers in order to credit them to their own

Figure 1.13 Tax Evasion Is Unjustifiable, 1998 ‒ 2008 (percentage of persons)

Note : The percentage of people who consider tax evasion unjustifiable. Data are an average for the years the question was included in the Latinobar ó metro surveys. Source : CAF ( 2012 ) based on Latinobar ó metro.

0 10 20 30 40 50 60

Dominican Rep.

Bolivia

Peru

Guatemala

Ecuador

Panama

Mexico

Colombia

El Salvador

Chile

Costa Rica

Honduras

Uruguay

Nicaragua

Brazil

Paraguay

Venezuela

Argentina


VAT payments. Thus, even though the VAT receipts from a consumer good from its first point of production up to its final buyer can involve dozens of companies—which is more complex than taxing only the final seller—the VAT controls evasion very effectively, albeit not totally. 18 VAT evasion ranges from 11 percent in Chile to 38 percent in Nicaragua, with an average of 27.6 percent in Latin America, which is about half the rate of income tax evasion. Effective VAT collection rates in Latin America are very similar to those of the non-Latin American OECD countries: for each point of VAT and every $100 of private consumption in Latin America, $0.53 are collected, while in the OECD, $0.59 are collected, as analyzed in chapter 9 .

The new design proposals for various taxes presented in this book ( chapters 7 to 9) are based on the assumption that it is possible to sub-stantially reduce evasion by improving the design of tax regimes. These proposals recognize the success of design experiences in Latin America and the Caribbean that have helped fight tax evasion.

Of course, the design of taxes is not the only factor that influences whether or not evasion occurs. The literature on taxation has traditionally recognized that it is easier to control evasion in more urban and industri-alized economies with less self-employment and larger firms. Moreover, evasive practices and low fiscal effort are more likely to occur in an insti-tutional environment where corrupt practices are accepted in the public administration or where there are no channels for voters to express their discontent or for accountability (Bird, Mart í nez-V á zquez, and Torgler 2008). And, of course, the effectiveness of taxes depends on the capacity of the tax administration, which leads to the last myth (Bird and V á squez-Caro 2011; Shome 2009 ).

The Myth and Reality of Bad Tax Administration

Low receipts and evasion are largely due to the complexity and mediocre capacity of tax administrations—at least that is the common charge. The main problem with these claims is that there is insufficient statistical information to substantiate, or refute, them.

In recent years, the Doing Business indicators have become the bench-mark for measuring the capacity of tax administrations. The World Bank produces these indicators to encourage countries to improve their climate for private investment. To illustrate the complexity of tax systems and the obstacles they create for productive activity, the indicators report the hours companies spend preparing returns and paying the most important taxes,


and the number of different payments that must be made. Among the 183 countries covered by Doing Business 2010, only five Latin American and Caribbean countries (of the 21 listed in table 1.4 ) totaled fewer hours than the world average to pay taxes. Latin America and the Caribbean as a region requires the highest average number of hours to pay taxes (503) of the seven regions into which all countries are grouped, and the second highest number of payments (31), second only to Eastern Europe and Central Asia (37 payments). These indicators suggest that Latin American tax systems are very complex in practice. Yet it is difficult to jump from these indica-tors to a verdict as to the quality of the design of tax systems 19 and even less to a judgment on the capabilities or efficiency of tax administrations.

Table 1.4 Hours Required to Pay Taxes, 2010

Country

Number of hours per year needed by a median company to

pay the most important taxes Ranking among

183 countries

Belize 147 44Colombia 208 80Trinidad and Tobago 210 82Nicaragua 222 87Honduras 224 90Costa Rica 272 116Paraguay 311 129Chile 316 131El Salvador 320 132Dominican Republic 324 134Uruguay 336 137Guatemala 344 141Peru 380 151Mexico 404 155Jamaica 414 156Argentina 453 162Panama 482 163Ecuador 654 172Venezuela 864 179Bolivia 1080 182Brazil 2600 183 Average of Latin America

and the Caribbean 503 134

World average 276 n.a.

n.a.: not applicable. Source : IFC and World Bank ( 2012 ).


Brazil ranks worst in the world in the number of hours spent by com-panies; however, it is internationally recognized that Receita Federal is a modern tax administration, with excellent technical skills and good per-formance indicators. Among Latin American tax administrations, there is an enormous diversity in structure, coverage, and performance, ranging from some very modern and effective setups, such as Brazil’s, to other very weak systems, such as those in most of Central America.

The only existing international comparative indicator for measuring the efficiency of tax administrations is administrative cost as a percentage of revenue. On average, Latin American administrative costs represent 1.4 percent of revenue, a figure only slightly higher than the average for the developed OECD countries (1 percent). High costs in Argentina, Guatemala, and Paraguay weigh heavily in the Latin America figure. Tax systems that other indicators highlight for their complexity, such as that of Bolivia and Brazil, do not seem to incur excessive administrative costs. None of this suggests that tax administrations in the region are particu-larly inefficient.

The recent emergence of easy-to-collect but highly distortionary taxes, such as taxes on financial transactions and exports, could be seen as a consequence of the supposed incapacity of tax administrations to cope with taxes that are more difficult to collect but less harmful to produc-tive activity. Taxes on financial transactions, which a dozen countries in the region have adopted (not all are currently in force), now raise about 2 percent of GDP in some countries and contribute more than 5 percent of total tax revenues in Argentina, Brazil, Colombia, and Venezuela (see chapter 12 ). 20 However, these taxes have been introduced to generate higher revenue (in political contexts that prevent better exploitation of the potential of other taxes), rather than as a response to the incapacity of tax administrations.

In practice, Latin American tax administrations have become stronger in the last two decades. To a greater or lesser extent, they have been given technical and budgetary autonomy, their staffs have been professional-ized, their collection function has been beefed up—especially the large taxpayer units—and they have extensively adopted new information tech-nologies. However, large deficiencies in the enforcement of tax obligations remain. As mentioned, the design of taxes, public attitudes, and percep-tions of the quality of public services all influence the incentives for citi-zens to pay their taxes. But the risk of being discovered and the cost of the penalty surely affect this decision. The probability that a taxpayer in the region will be audited and prosecuted for tax fraud is less than winning


in the casino. On average, only 3 of every 100 taxpayers are subject to any inspection of their tax returns (in Mexico, the figure is only 1 in 200; in Chile, it is 1 in 7). Integrated inspections or audits are practically nonexis-tent, and only three judgments are processed annually for tax offenses on average in each Latin American country.

In short, although tax administrations are much more capable than in the past and do not generally suffer from serious problems of inefficiency, they vary greatly from one country to another, and still have much room to improve compliance with tax obligations.

New Realities, New Myths?

Since the 1990s, Latin American and Caribbean tax systems have faced the challenges created by low collections, lack of tax progressivity, widespread tax evasion, and weak tax administrations. Although these four deficien-cies have not been completely remedied, progress has been remarkable and, as the remaining chapters of this book attest, a valuable arsenal of experiences and innovations can be used to advance even further. But there are other problematic characteristics of the region’s tax systems that are not getting the attention they deserve.

The first trouble spot is the high level of volatility of fiscal revenue. Typically, from one year to another, the adjusted tax burden (which comprises taxes and social security contributions) in a Latin American or Caribbean country can go up or down by about 8 percent. With an average adjusted tax burden of 22 percent of GDP, this leads to increases or decreases of nearly 2 percentage points of GDP in tax revenue every year. The volatility of fiscal revenue is a very powerful channel of fiscal instability, which often requires adjustments of similar magnitude in public spending, creating extreme instability in revenue and output. The volatility of the adjusted tax burden is enormous in countries like Bolivia, the Dominican Republic, Trinidad and Tobago, and Venezuela, where sources of tax revenue are highly concentrated in a few sectors. Volatility tends to be less in more diversified economies with more effective tax systems, such as Brazil and Uruguay ( figure 1.14 ). The volatility of the adjusted tax burden in Latin American and Caribbean countries is several times greater than in the OECD countries, where burdens typically change only about 1 percent from year to year. Apart from moderating the vol-atility of tax revenues, tax policies face the challenge of helping low- and middle- income families stabilize their own income. Chapter 3 analyzes the macroeconomic and social implications of tax revenue volatility in the


region and discusses how the tax system can help stabilize working-class incomes.

Second, the limited efforts by subnational governments to levy and col-lect taxes are a prominent feature of tax systems in the region and does not receive the attention it deserves. Excluding Argentina and Brazil, the tax burden of subnational governments is only 0.8 percent of GDP, despite the significant process of decentralizing expenditures and important gov-ernment powers, such as provision of social services and infrastructure. Improvement of the subnational tax effort is desirable not only to increase tax revenue and redistributive capacity in some countries, but also to give local governments more flexibility to respond to citizens’ demands and more incentives to monitor the use of public resources and participate in political decisions (see chapter 5 ). The involvement of local governments is also essential for a new challenge faced by tax systems: contributing to environmental sustainability.

Figure 1.14 Volatility of Adjusted Tax Burden, 1990–2010

Source : IDB and CIAT ( 2012 ) and IMF ( 2011b ).

0.6

Standard deviation of percent annual change 1990–2010

1.1

3.4

4.0

4.4

4.7

5.6

5.6

5.7

5.9

6.7

7.0

7.1

7.5

7.5

7.6

7.8

7.9

8.3

8.3

9.2

9.3

9.4

10.2

13.2

13.4

0 2 4 6 8 10 12 14 16

OECD (1990–2000)

OECD (1990–2010)

Uruguay

Brazil

El Salvador

Jamaica

Peru

Belize

Colombia

Panama

Chile

Argentina

Paraguay

Latin America (1990–2010)

Barbados

Costa Rica

Honduras

Ecuador

Latin America (1990–2000)

Mexico

Bolivia

Trinidad and Tobago

Guatemala

Nicaragua

Venezuela

Dominican Rep.


A third largely overlooked characteristic of Latin American and Caribbean tax systems is the almost complete absence of taxes designed to correct externalities, especially environmental ones. Greenhouse gas emissions; pollution of air, rivers, and lakes; deforestation; and land deg-radation are some of the environmental problems resulting from produc-tion or consumption activities where businesses and consumers do not assume the cost to society of environmental degradation. These negative externalities could be corrected with environmental taxes, which in some cases are more effective than controls or permits because they create the economic incentives for producers and consumers to reduce environmen-tally harmful activities; they also generate the fiscal revenue governments need to take action to counteract the damage.

Revenue from taxes on high-impact environmental activities amount to barely 1.3 percent of GDP in Latin America (compared with around 2.5 percent of GDP in developed countries). In contrast, Ecuador and Venezuela allocated fiscal resources totaling more than 5 percent of GDP in 2010 to subsidize fossil fuel consumption by fixing retail prices sub-stantially below the market. Substantial subsidies of this kind also exist in Trinidad and Tobago, Argentina, and Mexico (amounting to 1.9 per-cent, 1.7 percent, and 0.9 percent of GDP, respectively) (IEA 2011 , p. 515). Other externalities related to the use of vehicles such as congestion, noise, and the deterioration of roads could also be tackled with an appropriate system of taxes and charges (see chapter 11 ).

The high level of volatility of fiscal revenue, the low tax effort of sub-national governments, and the largely overlooked use of taxes to correct externalities are three notable features of regional tax systems that war-rant much greater attention. Exploring these areas would help advance the use of taxation as not only a means of collecting revenue for the Treasury, but as a tool for development.

2

The Politics of Taxation

Tax revenues in Latin America are comparatively low. There are many potential explanations for this fact, including the level of develop-

ment, the level of informality, the structure of the economy, and the age composition of the population. Yet, as chapter 1 shows, tax revenues in Latin America are low even after controlling for these factors.

Why are tax revenues low in a region where high inequality should lead to high preferences for redistribution? Is it because of the presiden-tial system of government? Is it because of the disproportionate power of the elites, which have succeeded in avoiding taxation? Or is it because of the weakness of the states, which have been powerless to impose taxes on the elites? What drives tax reforms in the region? To explain the region’s tax revenue gap, this chapter turns to considerations of polit-ical economy. The chapter also looks into two other important stylized facts—the low reliance on personal income taxes, and the recent surge in tax revenues—and the potential to close the tax revenue gap relative to other countries after the shift in ideology to the left that has occurred in recent years in the region.

System of Government and Tax Revenues

One of the main factors linking fiscal outcomes (types and levels of taxes, and tax revenues) to political institutions is the system of govern-ment. In particular, presidential systems tend to produce smaller bud-gets, as well as lower tax revenues. Some authors attribute this result to important differences in the budgetary process. In presidential systems, decisions regarding budget size (or tax revenues) and those regarding budget allocation are made sequentially, by different political actors with different bases of support, such as the president and the legisla-ture. If the actors who propose the size of the budget do not have a say


in its allocation, and the actors who decide the allocation want to benefit themselves and their constituents, then taxes are going to be set at low levels, leading to smaller government. In parliamentary systems, with no separation of powers, a more cohesive government makes both decisions simultaneously. The absence of checks and balances makes it easier for politicians to collude and extract higher revenue from the population at large (Persson and Tabellini 2000 , 2003 ). 1 Persson and Tabellini ( 2003 ) find the impact of the system of government to be large: other things equal, tax revenues in countries with presidential systems are roughly 5 percentage points of gross domestic product (GDP) lower than those in parliamentary democracies.

Most Latin American countries have presidential systems of gov-ernment. Could this factor explain the relative performance of tax rev-enues in the region? Figure 2.1 provides a first glimpse at the relationship between system of government and taxation in countries in the region. Parliamentary countries exhibit a positive revenue gap of 2.9 percent of GDP. Presidential countries, in contrast, exhibit a negative gap of 3.8 per-centage points of GDP. These results are confirmed by regression analysis for a wider sample of countries. 2 Other things equal, presidential systems are associated with tax revenues that are roughly 4 to 5 percentage points of GDP lower than parliamentary countries. 3

Figure 2.1 Tax Burden Gap by System of Government

Source : Authors’ calculations based on data from IDB and CIAT ( 2012 ) and IMF ( 2011a ).

–12.2–10.7–10.3

–8.7–7.9–7.7

–6.1–6.0

–5.5–4.1–4.0–3.6–3.5

–1.9–1.4

0.72.0

3.63.94.0

7.57.6

10.7–3.8

2.9

–15 –10 –5 0 5 10 15Mexico

PanamaGuatemalaEl Salvador

The BahamasParaguay

Dominican Rep.Costa RicaVenezuela

PeruHonduras

EcuadorColombiaUruguay

ChileBelize

NicaraguaJamaica

ArgentinaBoliviaBrazil

BarbadosTrinidad and Tobago

PresidentialParliamentary

Presidential Parliamentary

THE POLITICS OF TAXATION 29

A key element in the argument discussed earlier is the separation between those actors who decide on taxation (or budget size) and those who decide on budget allocation. This may be a good characterization of the US budget process. But are all presidential systems alike? What if the president has significant discretion not just regarding budget size, but also its allocation? This is the case in many Latin American countries. In Chile, after the executive submits the budget, the legislature may only reduce budget items, and cannot even reallocate by increasing one item at the expense of another. In Brazil, while legislators do amend the budget proposal, the president can ultimately decide whether these “approved” amendments are actually funded. And while in most countries the leg-islature can de jure affect both the size and composition of the budget, in countries such as Bolivia, the Dominican Republic, and Paraguay, the executive has de facto a lot of power to cut or reallocate spending while executing the budget. 4

To understand the importance of the executive’s discretion within pres-idential systems, this chapter uses a measure of budget hierarchy based on Filc and Scartascini ( 2005 , 2007 ). More hierarchical budgets imply higher executive power vis- à -vis the legislature. 5 The results show that when the hierarchy index is high enough, and the executive power holds sufficient power vis- à -vis the legislature, presidential and parliamentary systems collect similar amounts of revenue. 6 While presidentialism may be one of the explanations behind lower tax revenues in Latin America and the Caribbean, the movement toward more hierarchical budget institutions that has granted more power to the executive may explain more recent surges in revenues in the region.

Political Power and Tax Revenues

Theoretical models propose that in highly unequal and democratic coun-tries, the relatively poor median would demand higher taxation to bring about redistribution (Meltzer and Richard 1981 ). Latin America is unequal and democratic. Why then are tax revenues so low?

Irrespective of theoretical predictions, empirical studies are often unable to find evidence that inequality leads to redistribution, or actually find the opposite relationship. 7 In response to these findings, a rich liter-ature has developed to address this puzzle. One strand of this literature focuses on preferences, independently of the workings of political insti-tutions (see Machado 2012 ). Another strand pays particular attention to


how the functioning of political institutions may lead to disregard for the majority’s wishes, and thus to low redistribution. The focus of this section will be on this second strand.

Representation failures can result from a number of factors. Although the poor might be a majority in the population, they may not be a majority among those who actually turn out to vote. Clientelistic politics may also play a role. In their quest to hold office, clientelistic parties distribute goods and patronage instead of winning over voters by implementing the poli-cies they favor. Voters, especially the poor who may place a high value on goods, engage in such exchanges by “selling” their votes for the handouts and favors. 8 Robinson ( 2010 ) argues that parties engaging in clientelism have no incentive to improve the lot of the poor through redistributive policies since this would increase the price of their votes. Bribes and cam-paign contributions are another way for the elites to provide an advantage to candidates representing the wealthy, leading to underrepresentation of the poor.

Other ways in which the elites may tilt the playing field in their favor include exercising their disproportionate influence in order to shape political institutions, policymaking processes, and public policies. Box 2.1 illustrates how the elites have shaped political institutions and tax policies in Guatemala, one of the countries with the lowest tax revenues in the region. 9

Box 2.1 The Power of the Elites and Tax Revenues in Guatemala

Guatemala clearly illustrates the disproportionate influence of elites. Initially, the armed forces were the main mechanism of influence. More recently, elites have resorted to lobbying in Congress, or appealing to the Constitutional Court to block tax reforms that affect their interests.

During the transition to democracy, most left-leaning parties were banned by the military and were unable to participate in the Constitutional Assembly. Thus, the Assembly was dominated by conservative groups, which instilled into the Constitution a philosophy of limited government, placing constraints on the autonomy of the state with regard to fiscal policy. Article 243 of the 1995 Constitution prohibits double taxation, and citizens that feel that their rights are being violated may present a “recurso de amparo” (writ of amparo) before the Constitutional Court.

The democratic period ushered in more liberal governments. In his first administration (1986–91), liberal president Vinicio Cerezo attempted to increase revenues through an increase in value added tax (VAT) and by raising income and


property tax rates, as well as instituting temporary taxes on exports. In response to the pressure of the economic elites, Congress rejected export taxes, while the Constitutional Court overturned the tax hikes. As a result, tax revenues at the end of President Cerezo’s administration were just 7 percent of GDP.

The administration of conservative president Jorge Serrano that followed (1991–93) introduced a reform that was more palatable for the elites, including the broadening of tax bases and reducing the marginal rates of the income tax. It also introduced a heterodox element that guaranteed the support of the elites: a deduction of VAT payments from the personal income tax. Needless to say, the reform sailed through Congress, and was not blocked by the Constitutional Court.

Subsequent efforts to increase tax revenues present a similar pattern. Increases in the VAT and some temporary taxes were allowed to pass. However, increases in income or excise taxes, creation of new taxes on businesses, con-version of temporary taxes into permanent ones, or revenue-raising changes to property taxes or the vehicle tax were either rejected by Congress or overturned by the courts.a The pressure by the economic elites, represented by the peak business association (CACIF),b was instrumental for this outcome. The Peace Agreements of 1996, which established the goal of increasing tax revenues to 12 percent of GDP by 2006, and the associated Fiscal Pact, failed to reverse this trend.

Lack of own-party support for tax reform during the Colom administration prompted Finance Minister Fuentes Knight to seek an alliance with the oppo-sition Partido Patriota. The idea was to take advantage of a critical juncture: both parties believed they had chances in the upcoming election, so both could potentially benefit from increased revenues. While these efforts fell through at the time, the constructive dialogue that took place provided the basis for the new reform proposal sent to Congress at the beginning of the P é rez administration (2012–present).

In spite of some concessions during the legislative approval process, the mod-erately progressive tax reform, approved in February 2012, included a 5 percent tax on dividends, a new tax on the first registration of vehicles, and partial elimi-nation of the VAT deduction for income taxes, all of which had long been resisted by the elites. Only time will tell whether this reform will constitute a significant break with the past, or whether it will ultimately be overturned by the courts as a result of pressure by the business sector.

a The case of the vehicle tax is fascinating. The 2009 proposal by the Colom adminis-tration was modified to such a degree in Congress that the government withdrew it from the legislative agenda. In the words of Finance Minister Fuentes Knight, “What used to be a horse first became a camel and now was turning into Frankenstein.” The amendments introduced by Congress were so substantial that the reform, which was supposed to produce a modest increase in tax revenues, was expected to reduce them.

b Comit é Coordinador de Asociaciones Agr í colas, Comerciales, Industriales y Financieras.


Income and political inequality can also influence the government’s decision to invest in state capacity and influence tax revenue collection. C á rdenas ( 2010 ) proposes that if the elites are in power and are overrepre-sented in the preferences of the government, they may decide not to invest in state capacities to avoid being taxed in the future, particularly if they fear that the next government may respond to the citizens at large. 10 When the elite are in power, incentives to invest in state capacity will be fewer in more unequal societies for two main reasons. First, the lower citizens’ income, the less the elites can extract from them through future taxation, even if the elites maintain power. Second, the elites will have to pay higher taxes if they are displaced from power. This may also explain why greater inequality within an (imperfectly) democratic context does not neces-sarily result in higher taxation. It also helps explain why Latin America continues to lag behind on tax revenues—in particular, personal income tax revenues, which require more state capacities than other forms of tax-ation (such as VAT or payroll taxes) and are the ones most resisted by the elites. 11

Democratic regimes come in different varieties and have different con-stitutional arrangements and institutions. The extent to which decisions regarding tax revenues are in the hands of the median voter or are con-trolled by the elites may depend crucially on these differences. One of the characteristics of political institutions that can matter in this regard is the degree of legislative “malapportionment”—the discrepancy between the share of legislative seats and the share of population by electoral dis-tricts. Focusing on this issue, Ardanaz and Scartascini ( 2011 ) show that malapportionment is accompanied by relatively lower levels of personal income taxation (see figure 2.2 ). A one standard deviation increase in the level of malapportionment leads to a reduction of about half a percentage point of GDP in the share of personal income taxes.

Malapportionment, they argue, is shaped by the political conditions at the time of the constitutional convention, or during transitions to democ-racy. Groups holding political power at such junctures have strong incen-tives to manipulate political institutions in order to protect their economic interests in the future.

Consider a society where assets and income are distributed unequally among two groups: the elite and the masses. Under a dictatorship, the elite hold political power and set taxation on the wealthy at a low level. Now suppose the regime is forced to democratize. If policies were decided by the median voter, tax rates would be set at high levels to redistribute wealth. However, the elite may attempt to build a democracy with biased political


representation, where this group holds a disproportionate amount of political power (Acemoglu and Robinson 2008 ). A transition to a democ-racy of this sort is more likely to occur whenever the elite have vested eco-nomic interests that are potentially threatened by the policies preferred by the masses in the new democratic regime. This outcome is also more likely to emerge when the society is more unequal. The greater the inequality, the greater the incentives for the masses to vote for taxes targeted at the elite and thus the greater the incentives for the elite to protect its inter-ests by biasing political representation in its favor during a transition to democracy. Samuels and Snyder ( 2001 ) have argued that this occurred in countries such as Argentina, Brazil, and Chile, where outgoing military governments redistributed seats in the lower house just before the demo-cratic transition in order to overrepresent conservative districts. 12

Chile provides one of the most salient examples of malapportionment. A plebiscite to determine whether Pinochet would continue in power was held in October 1988. Forty-four percent of voters at the national level supported him, but the percentage was much lower in Santiago’s Metropolitan region. While the results of the referendum forced Pinochet to step down, they also provided information about electoral strong-holds and sources of weak support, which were taken into account by the

Figure 2.2 Legislative Malapportionment and Personal Income Taxes

Notes : Malapportionment is the discrepancy between the share of legislative seats and the share of population held by geographical units. OECD is the Organisation for Economic Co-operation and Development. Source : Authors’ compilations based on Ardanaz and Scartascini ( 2012 ).

0 2 4 6 8 10 12

Eastern Europe

OECD

Asia

Latin America and the Caribbean

Africa

Personal income tax(percentage of GDP)

Malapportionment (100 = maximum degree)


military junta as they redrew the districts and redesigned the electoral system following the plebiscite (Siavelis 2000 ; Rojas and Navia 2005 ). 13 Thus it is not surprising that the vote share in favor of Pinochet during the 1988 plebiscite is a fairly good predictor of the level of malapportion-ment at the district level after the transition to democracy (see figure 2.3 ). Far from an unintended outcome, the design of the electoral map reflected an insurance strategy followed by the military elite to secure representation of the authoritarian regime’s political heirs in the newly democratizing system (Navia 2003 ).

The Influence of Ideology

The previous section discussed means by which the elites use their dis-proportionate power to prevent redistribution and keep tax revenues low, even under democratic rule. This can explain why tax revenues in Latin America lag behind those of other regions, even when the region has tran-sitioned to democracy.

Recently, however, Latin America is closing this revenue gap. Is it pos-sible that the elites are losing their grip? The recent shift to the left in Latin

Figure 2.3 Chile’s Electoral System: Support for Pinochet and District-Level Legislative Malapportionment, 1992

Note : Every point represents an electoral district. Source : Authors’ compilations based on Ardanaz and Scartascini ( 2012 ).

0.5

1.0

1.5

2.0

2.5

3.0

0.3 0.4 0.5 0.6 0.7

Sea

t to

po

pu

lati

on

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io

Share of yes vote in the 1988 plebiscite


America has been one of the most discussed political developments in the region. Left-leaning governments are often characterized as having prefer-ences for more government involvement in the economy, and thus higher taxes and spending. Could this shift in ideology be partially responsible for the reduction of the revenue gap with the rest of the world?

Recent work by Stein and Caro ( 2012 ) looks at the impact of ideology on both the level and composition of tax revenues in Latin America and the Caribbean. 14 Their measure of ideology, taken from Debs and Helmke ( 2008 ), is based on data drawn from surveys of experts. 15 According to this measure, up to 1997, no governments in Latin America were classified as left ( figure 2.4 ). Since the election of Ch á vez in Venezuela in 1998, the left has been gaining ground; currently, half the countries in the sample are governed by left-leaning parties. To identify the impact of ideology on taxation leaving aside other country-specific factors, the question asked by these authors is not whether countries with left-leaning presidents col-lect more taxes than countries with right-leaning governments. Rather, the question is whether countries collect more taxes at times in which they are controlled by a left-leaning president, compared to times in which they are not.

Figure 2.4 The Shift to the Left in Latin America, 1994–2009

Note : There were no left-wing presidents from 1994 to 1997 in the 18 countries studied: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Peru, Paraguay, Uruguay, and Venezuela. Source : Authors’ calculations based on data from Debs and Helmke ( 2008 ).

0

5

10

15

20

25

30

35

40

45

50

1994

1995

1996

1997

1998

1999

2000

2001

2002

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2005

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2007

2008

2009

Lef

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ents

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The results suggest that total tax revenues increased by just over 2 per-cent of GDP under presidents from the left ( figure 2.5 ). This is a sizable effect, considering that average tax revenues as a share of GDP are just over 15 percent in the Latin American countries in this sample. The figure also presents evidence that ideology affects different revenue sources in diverse ways. This is expected since the burden of taxation for different revenue sources falls on different groups. Not surprisingly, the impact is much stronger for income taxes, which in the region affect only the rich, than for the value added tax (VAT), a more regressive tax, or for taxes on social security, which tend to fall on workers. 16 The results are very similar under alternative measures of ideology. Moreover, Stein and Caro ( 2012 ) show that changes in ideology precede changes in tax revenues. This sug-gests that the impact of ideology on taxation may in fact be causal.

Reforming the Tax Code

Is the higher level of tax revenues a consequence of tax reforms? Do some of the determinants of the level and composition of tax revenues, such as

Figure 2.5 Impact of Left-Wing Presidents on Revenues

* Coefficient is statistically significant at the 10 percent level; ** at the 5 percent level; *** at the 1 percent level; no asterisk means the coefficient is not different from zero with statistical significance; a NC = noncommodity. Source : Authors’ calculations based on data from Debs and Helmke ( 2008 ), IDB and CIAT ( 2012 ), and IMF ( 2011a ).

2.08**

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0.18

1.36***

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cent

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ts o

f GD

P

1.5

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aNC taxrevenue/NC

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VAT Incometax

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ideology, also lie behind the pattern of tax reforms in the region? More importantly for policy prescriptions, how easy is it to reform the tax system in a given country, under a given administration, at a given time? How are reforms processed by the political system? What is the moti-vation for the reforms? The rest of the chapter attempts to answer these questions.

Countries in Latin America have been active reformers during the last couple of decades. Table 2.1 presents an overview of the number of reforms according to the type of tax, and whether the reform attempted to increase or decrease revenues. For example, VAT reforms were widely popular in Latin America during the period and included VAT creation (3 reforms),

Table 2.1 Type and Number of Tax Reforms in Latin America, 1990–2004

Number of reforms

Total Net total Increase Decrease Tax system reform/overhaul 10 n.a. n.a. n.a. Comprehensive administrative reform 3 n.a. n.a. n.a.

Major taxes 152 34 93 59VAT 64 48 56 8

Creation 3 3 3 0Base change 24 22 23 1Rate increase/reduction 37 23 30 7

Personal income tax 45 �9 18 27Base change 7 1 4 3Rate increase/reduction 38 �10 14 24

Corporate income tax 43 �5 19 24Base change 4 �2 1 3Rate increase/reduction 39 �3 18 21

Minor taxes 183 47 115 68Financial transactions taxes 19 3 11 8Excise taxes and duties 41 15 28 13Other taxes 52 18 35 17Tax incentives creation/elimination 37 �23 7 30Minor or hard-to-classify reforms 34 34 34 0

Total 348 81 208 127

Note : “Increase” refers to those reforms that implied the creation of a tax, the broadening of the tax base, or a rate increase. “Decrease” refers to reforms that implied the elimination of a tax, narrowing its tax base, rate reduction, or incentive creation. Net total refers to the difference between increases and reductions. n.a.: not applicable. Source : Focanti, Hallerberg, and Scartascini ( 2012 ).


broadening the tax base (23), increases in tax rates (30)—as well as some decreases (7) later on.

The objective of increasing revenues seems to have been the most prev-alent. Overall, the ratio of tax increases to decreases is about 2 to 1. In contrast, the search for higher efficiency and tax neutrality has not been a priority. While tax bases for the VAT increased, bases for income taxes narrowed as often as they widened; there was no net reduction of mar-ginal income tax rates; and there was net creation of special tax incentives. Figure 2.6 confirms these patterns. Countries that introduced more reforms from 1990 to 2004 have a greater increase in revenues later (panel a). The opposite was the case for tax neutrality (panel b). This pattern is consistent with Lora ( 2007 ), which documents that effort to increase tax neutrality, while popular at the beginning of the period, generally stalled in the mid-1990s.

These stylized facts warrant discussion. First, countries have differed in their reforming activity. Second, there are important differences across tax bases with regard to reform activity and direction of changes. Third, some active reformers have not been able to reap the benefits of reforms. For example, tax revenues in Mexico have been stable (or even declined) in spite of wide reform efforts. This suggests that tax reforms are very

Figure 2.6 Relationship between Tax Reforms and the Variations of Tax Revenues and Tax Neutrality

a. Tax Reforms and Variation of Revenues

Argentina

Bolivia Brazil

Chile

Colombia

Costa Rica

Dominican Rep.

Ecuador

GuatemalaHonduras

Mexico

Nicaragua

Panama

Peru

Paraguay

El Salvador

Uruguay

Venezuela

–80

–60

–40

–20

0

20

40

60

80

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diverse, and the objectives behind the reforms may very well vary across countries according to the institutional constraints they face.

What Explains Tax Reforms?

The ability of governments to introduce and raise taxes is constrained by the economic characteristics of the country and by the existing level and composition of taxes. While a developed country can introduce highly complex tax schemes, a developing country will usually need to limit com-plexity and the need for self-reporting. It may also have to rely on taxes that are not highly demanding on government and bureaucratic capacities. In contexts like these, when the need for financing is pressing, reforms to indirect taxes may be more likely than reforms to direct taxes, particularly personal income taxes.

The overall tax burden to GDP ratio and the tax rates of the main taxes (business, income, and VAT) may affect the ability of the government to introduce reforms. High tax burdens may lead to reforms to lower them, particularly in cases in which the marginal tax rates are too high.

Do crises make tax reforms more likely? To the extent that crises increase the cost of not reforming, they may lead to tax reforms, despite the existence

b. Tax Reforms and Variation of Neutrality

Note : This scatterplot represents the results of an econometric regression between tax reforms and the variation in tax revenues using as control variables the GDP per capita and tax revenues from 1990. Source : Authors’ calculations based on data compiled in Lora ( 2007 ) and Focanti, Hallerberg, and Scartascini ( 2012 ); and revenue data from IDB and CIAT ( 2012 ).

Argentina

Bolivia

Brazil

Chile

Colombia

Costa Rica

Ecuador

Guatemala

Mexico

Peru

Paraguay

El Salvador

Venezuela

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of groups that may oppose them (Alesina and Drazen 1991 ; Drazen and Grilli 1993 ). Moreover, reformers may use a crisis as a “window of opportu-nity” (Kingdon 1984 ) to introduce reforms that had been planned but not executed because they were difficult to introduce during “normal” times.

Countries facing a crisis usually look for external help , particularly that of the International Monetary Fund (IMF). The IMF or other interna-tional financial institutions (IFIs) such as the World Bank may require tax reforms as a condition to disburse loans. In such cases, the expectation is for tax changes to increase revenues so that countries can repay the loans. Mahon ( 2004 ) and S á nchez ( 2006 ) find that such conditionality increased the likelihood of reform, while Biglaiser and DeRouen ( 2011 ) do not find confirming evidence.

The decision to introduce tax reforms in a country may also be influ-enced by what other governments in the region are doing . Because of tax competition, countries may reduce taxes if others are doing so. Also, coun-tries may copy successful new approaches from their neighbors.

Partisanship , or the ideological orientation of the government in office, may also affect tax reforms. Because left-leaning governments tend to favor a higher government involvement in the economy, the overall tax take they would prefer is higher and so is the probability that they will introduce reforms aimed at increasing tax revenues. Moreover, ideology may affect the objectives of the reform, as well as the type of taxes subject to reform. Left-leaning governments may focus more on the objective of redistribution, such as increasing income tax rates, while right-wing gov-ernments, which presumably are more business-friendly, may put more weight on tax neutrality and on reducing market distortions.

Another political determinant for the timing and content of tax reforms is the electoral calendar . Politicians running for reelection may want to cut taxes or favor their preferred constituency in the run-up to an election. Therefore, the likelihood of reforms in the years leading to elections, par-ticularly if these are revenue-reducing, may be higher than in other years.

However, governments may have difficulty pushing through their pre-ferred policies even if they want to institute a change; thus, the third cate-gory of explanations focuses on institutional barriers to change. Increasing the number of “ veto players ” who can block change in any policy may mean that change in taxation in response to international factors or a change in the partisanship of the president is less likely and, if it does happen, is more incremental (Tsebelis 2002 ). The expectation is that an increase in the number of veto players will make change along any of the dimensions less likely.

Finally, electoral systems may affect the type of reform introduced. Personalistic electoral systems in which legislators have a close electoral


connection with voters provide incentives for them to deliver public goods to their jurisdiction (Hallerberg and Scartascini 2011 , 2012b ). If these public goods are financed from a common pool of resources, legislators may be more willing to introduce reforms that increase tax revenues, since only a portion of these public goods are financed by individuals in the jurisdiction (Hallerberg and Marier 2004 ).

What Does the Empirical Evidence Say?

Economic context and past decisions constrain reforms. Higher develop-ment, more closed economies, and worse economic outcomes, such as high inflation and debt service, tend to make reforms more likely. On the other hand, higher marginal rates and more access to revenues from nat-ural resources make reforms to increase taxes less likely. Crises are (sometimes) conducive to reforms. Banking crises seem to stim-ulate reforms, more prominently of the VAT, which is the main source of revenues in the region. Debt crises, however, are less likely to trigger reforms. 17 This is illustrated by the experience of several countries in the region ( box 2.2 ).

Box 2.2 Economic Crisis and Tax Reforms

Argentina is one of the countries in the region with the most reforms (Focanti, Hallerberg, and Scartascini 2012 ). One of the key factors explaining this fact has been the numerous negative shocks experienced by the country, some of which have pushed the country into deep crises (Bonvecchi 2010 ).

Large crises have also triggered or facilitated difficult reforms in other coun-tries. In Mexico, in the middle of the Tequila Crisis in 1995, the government was able to increase VAT rates from 10 to 15 percent, which helped revenues remain constant despite the economic slowdown. The reform could not increase efficiency or tax neutrality, however, as food and medicines remained exempt in order to limit the negative impact on the popularity of the government (Magar, Romero, and Timmons 2009 ). Reforms to increase the efficiency of the tax system were attempted in Mexico in noncrisis times, but did not fare well.

In Colombia, periods of economic and fiscal crises have also coincided with the approval of revenue-enhancing reforms. For example, in the 1990s, President Pastrana was able to pass several reforms despite being the first president without no majority (Olivera, Pach ó n, and Perry 2009). In Brazil, crises favored increasing revenues but conspired against those reforms that would boost economic effi-ciency. Overall, the government preferred the status quo of a highly extractive, inefficient tax system to an improved system with uncertain revenue outcomes (Melo, Pereira, and Souza 2010 ).


External pressures may not be that important after all. IMF programs do not seem to have a significant effect on the overall probability of reform other than lowering the probability of increasing income taxes for the corporate sector. This result may be the outcome of the first generation of reforms in the region that pushed for increases in economic efficiency and growth.

Regarding diffusion, VAT reforms may come bunched across coun-tries particularly moving from the more developed to the least developed ones—and to a certain extent corporate income tax (CIT) reforms. Again, this result may well respond to a coordinated effort of increasing revenues, supported by several of the multilateral organizations, and the lessons learnt from those few countries that were pioneers in the expansion of the VAT. Ideology matters. Governments on the left are more likely to introduce tax reforms. This is particularly true with reforms that increase personal income taxes, which affect the rich more. In contrast, leftist governments are less likely to reform taxes such as the VAT, which fall more heavily on the poor, and the CIT. Years in which these changes occur reduce the probability of reform even more. These results are consistent with those discussed earlier and suggest that ideology may impact revenues through tax reform. Elections prevent higher taxes. In electoral and pre-electoral years, overall reforms are more likely and tax increases are less likely. Political institutions (may) shape incentives. More personalistic electoral systems are more likely to favor increases over decreases of taxes, in particular increases in the VAT, which is the main source of revenue in most Latin American countries. This evidence is consistent with what happened in Colombia after the constitutional reform of 1991. All tax laws approved after 1991 were of the “quick fix” or “piece meal” type: increases in some tax rates and introduction of distortionary taxes (such as financial transactions and net wealth). The only two initia-tives driven by efficiency (1995 and 2007) suffered significant changes in Congress and ended up being two more “piece meal” laws, a conse-quence of fragmented and weakened political parties and Congressmen more responsive to specific narrow economic interests (Olivera, Pach ó n, and Perry 2009 ). 18

Table 2.2 shows a summary of the regression analysis results in Hallerberg and Scartascini ( 2012a ). Instead of presenting several regres-sion tables, each cell summarizes the results out of multiple multivariate regressions. 19

Tabl

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The Legislative Arena: Spotlight on Argentina

Despite the willingness of many governments to pass the necessary reforms, governments often find their initiatives blocked, or substantially modified, during the legislative process. 20 As a result, tax reform propos-als that are ambitious at the outset often end up being severely watered down, and emerge from the legislative process as inefficient quick fixes that generate limited additional revenue. 21

How pervasive is this problem of changes in the content of tax legis-lation as it navigates through Congress? What determines the success of the executive in approving and preserving the content of the tax legisla-tion it initiates? Is the extent of changes different for different types of tax legislation? What are the characteristics of reforms that make them more likely to pass without substantial changes? These are important questions. Congress is, after all, the most important arena in which the tax policy-making game is played. Yet, until now, lack of data prevented a systematic study of these issues.

For the purposes of this study, Bonvecchi et al. ( 2012 ) put together a remarkable dataset on tax lawmaking in Argentina that makes it possible

Table 2.3 Tax Dimensions in the Legislative Substance Scale (LESS) Dimension Categories

Taxes VAT Income Excise/selective Social security Personal assets Financial assets/transactions

Duration Permanent/provisionalScope General

Sectoral Local/regional Particular Sectoral + local/particular

Potential revenue High/low/neutral/negativeEfficiency Less efficient/mixed/more efficientEquity Regressive/neutral/progressiveImpact on intergovernmental decisions Pronational government/neutral/mixed/

prosubnational government

Source : Bonvecchi et al. ( 2012 ).


to look inside the black box. Their Legislative Substance Scale (LESS) captures the substantive content of tax bills and their amendments in a variety of dimensions: duration, scope, potential revenue, efficiency, impact on equity and on intergovernmental relations, and whether or not they involve earmarking of revenues. 22 Table 2.3 shows the dimensions and their categories.

LESS codifies each new version of each tax bill as it emerges from the different stages of the lawmaking process by comparing it to the origi-nal version. 23 Its values indicate how close each version is from the origi-nal intent, characterizing the significance of the changes from 0 (no significant change) to 5 (substantial changes in at least five of the seven dimensions). 24

Figure 2.7 shows how LESS works, for the case of one specific bill. The two top rows present the economic dimensions and their categories; the first column shows the legislative stages the bill went through, as well as the names of amendment proposers. The full lines indicate amendments incorporated into the bill; the dotted lines show failed amendments. Bill 0005-PE-1998, submitted by the Menem presidency, was a comprehen-sive tax reform establishing permanent, general, more efficient, equity-neutral, nonearmarked albeit low-revenue-yielding changes in the value added, income, and excise taxes. 25 Congressional amendments pushed the bill toward temporary, inefficient, regressive rules that benefited specific sectors, and would yield negative revenues, and packaged it with another bill (0164-PE-98), which channeled revenues to the provinces. The presi-dent used his veto to reject some of these amendments (making the bill more general in scope), but was overturned by Congress. All these changes drove the LESS score to 3, indicating that the final version of the bill was modified significantly, but the changes were not extreme.

Figure 2.8 shows that most bills tend to be substantially modified dur-ing the legislative process. Out of 110 amendments to VAT-related bills, for example, only 7 were coded with LESS scores of 0 or 1, indicating that amendments did not modify the substance of the original bill signifi-cantly. In contrast, 57 of them received LESS scores of 4 or 5, indicating very substantial changes during the legislative process. A similar pattern can be observed with regard to other taxes.

What are the characteristics of executive-sponsored tax bills? What types of bills are more likely to be approved? Bonvecchi et al. ( 2012 ) sug-gest that executives get more bills approved if they are tilted toward estab-lishing taxes that are more regressive, targeted to specific sectors, and in favor of the provinces rather than the nation as a whole.

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Politics Counts

Tax revenues in Latin America are low by international standards. Economic considerations alone do not explain this fact. Political consid-erations are important as well.

The presidential system of government, a feature of the majority of countries in the region, plays a role in explaining low revenues. Presidential countries collect lower tax revenues than parliamentary ones. However, the gap between presidential and parliamentary systems depends on the nature of the budget institutions in place. Presidential systems with more hierarchical budget institutions, which reduce the de facto separation of powers between the presidency and the legislature, tend to look more like parliamentary ones and collect relatively more revenue than presidential systems with less hierarchical budget institutions.

The power of the elites also seems to have played a role in keeping revenues depressed in Latin America. The design of the institutions of democracy has awarded various elites disproportionate influence in the political game and hence has reduced the likelihood of highly redistribu-tive policies.

Figure 2.8 Number of Amendments by Legislative Substance Scale per Tax

Notes : Each bar (from 0 to 5) represents how substantive changes are, with 5 being the most substan-tive change. How tall they are represents the frequency of these types of changes. Source : Authors’ compilations on the basis of information from the Honorable Chamber of Deputies, Argentina.

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The recent move to the left in many countries in the region seems to be closing the revenue gap. Left-leaning governments are associated with tax reforms yielding higher revenues, particularly in the case of per-sonal income taxes, and represent one of the factors behind the recent catch-up in tax revenues compared to the rest of the world. Crises have also been opportunities for passing tax reforms that are not feasible in good times. However, while reforms passed during crises tend to be rev-enue enhancing, they may not deliver in terms of improving the efficiency of the tax system.

3

Tax Systems for a Smooth Ride

Like a wild rollercoaster, steep ups and downs describe the economic performance of the Latin American and Caribbean region. 1 Economic

booms have been followed by deep and long recessions, sometimes driven by poor domestic policies, other times precipitated by negative exogenous shocks, often times fueled by both. Notwithstanding considerable prog-ress since the notorious lost decade of the 1980s, managing volatile eco-nomic cycles remains an important policy challenge for most countries in the region.

Macroeconomic volatility is bad for long-term growth and social welfare. 2

It holds back investment in physical and human capital through higher risk. It also exposes the poor to substantial income instability, as they generally lack access to effective protection mechanisms against shocks. Hence, reducing macroeconomic volatility may not only boost economic opportunities but also safeguard the well-being of the most vulnerable households.

Tax systems can be a powerful development tool to stabilize private consumption and help moderate macroeconomic volatility because they can act as automatic stabilizers. Automatic stabilizers are budget revenue and expenditure items that adjust automatically to cyclical changes in the economy, increasing fiscal deficits during downturns and reducing them during times of strong economic growth. Automatic stabilizers take the steam out of the economy when things are going well and add support when things turn sour. Their beauty is that they are embedded in the structure of revenue and expenditure programs, operating without the need for discretionary and possibly lengthy political decisions.

Take the personal income tax, for example. During economic down-turns, tax liabilities generally decline more than household pretax income. This helps sustain disposable income and private consumption during eco-nomic hardship. The opposite occurs during periods of strong economic


activity. In general, these effects are stronger the more progressive the tax system is. Other automatic stabilizers operate on the expenditure side of the budget, such as unemployment benefits. Unemployment benefits pro-vide transfers to households during recessions, helping them buffer neg-ative income shocks. Yet, in the region, unemployment benefit schemes cover relatively few households, limiting their power as automatic stabiliz-ers. It is mostly up to the tax system to help smooth economic cycles.

Despite their potential advantages, automatic stabilizers have been rel-atively understudied (Fat á s and Mihov 2011), especially in developing countries. This chapter aims to deepen the understanding of the role of automatic stabilizers in moderating volatility in the Latin American region. The primary objective is to document the potential for tax systems to play an automatic role in consumption and macroeconomic stabiliza-tion. The analysis constitutes an important input for tax reform, whose debate has focused on efficiency, sufficiency, and equity, but generally not on economic stability goals.

Economic Volatility in Latin America: Has the Great Moderation Arrived?

Over the last four decades, the developed Western economies have enjoyed a generalized decline in output volatility. In the United States, volatility dropped significantly in the mid-1980s, by about one-half from the high levels of the 1960s and 1970s. This process has been dubbed the Great Moderation (Debrun, Pisany-Ferry, and Sapir 2008 ). The three main explanations for the Great Moderation have been improvements in the performance of macroeconomic policies (especially monetary policies), structural change relaxing liquidity constraints on consumer spending, and a temporary reduction in the magnitude of shocks. Similar trends have been observed in some European countries, most clearly in Germany and the United Kingdom (Stock and Watson 2003 ), although the modera-tion in volatility has not been as sizable as in the United States.

Latin America and the Caribbean has experienced a smooth reduction in output volatility since the 1980s, following the peak during the debt cri-sis and in tandem with the trend observed in advanced economies. Figure 3.1 shows output volatility in a sample of 15 Latin American economies, split between major commodity exporters and importers given the differ-ent cycles and types of shocks faced by these two groups of countries. Latin American indicators are plotted against relevant comparators around the world. 3 In the early 1970s, volatility in Latin America and the Caribbean

a. World Regions

Figure 3.1 Gross Domestic Product (GDP) Volatility

b. Latin America

Notes: Volatility is measured as the regional median of the 8-years standard deviation of the growth rate. Advanced Commodity Exporters (ACE-4) includes: Australia, Canada, New Zealand, and Norway. Europe, Middle East, and Africa (EMEA) includes: Czech Republic, Hungary, Israel, Poland, South Africa, and Turkey. East Asia includes: India, Indonesia, Korea, Malaysia, Philippines, and Thailand. G-7 countries includes: Canada, France, Germany, Italy, Japan, United Kingdom, and United States. Latin America’s exporters include: Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Trinidad and Tobago, Uruguay, and Venezuela. Latin America’s importers include: Costa Rica, El Salvador, and Honduras. Latin America-15 includes: Latin America’s exporters and importers. Source: Corbacho and Gonz á les-Castillo (2012), IMF ( 2012b ), and World Bank (2012b ).

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was similar to that in other emerging markets, but it spiked to a record high during the 1980s lost decade. It took the region about 20 years to start closing the gap in volatility. Macroeconomic volatility today remains as large as (or larger than) that in other countries.

Looking beyond these aggregate results, significant heterogeneity exists across countries in the region. Corbacho and Gonz á les-Castillo (2012) document a regime change toward lower output volatility for the median Latin American country at the beginning of the 1990s. In gen-eral, commodity importers have exhibited lower output volatility than commodity exporters. Yet within the major exporters, important dif-ferences arise. For example, Colombia has exhibited low output vola-tility throughout the decades, with levels today not far off from those in advanced economies. Chile, by contrast, had very high levels of volatility in the 1960s and 1970s, with a drastic drop since then. Brazil started a process of smooth reduction in volatility in the mid-1980s, while Peru achieved the most significant progress only toward the early 2000s. In Argentina and Venezuela, however, output volatility has trended upward,

Figure 3.2 Gross Domestic Product Volatility in Latin America, Select Countries a. Standard Deviation of GDP’s Growth Rate (percent)

Source : Corbacho and Gonz á les-Castillo (2012).

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TAX SYSTEMS FOR A SMOOTH RIDE 53

amply surpassing even the peak of the 1980s in the most recent decade ( figures 3.2.a and 3.2.b ).

Stoking the Fire: The Role of Fiscal Policy

Procyclical fiscal policies have been at the epicenter of macroeconomic volatility for many countries in Latin America. 4 Rather than help smooth economic cycles, fiscal authorities have tended to increase spending (or cut taxes) during booms, to then mimic the deep fall in output with spending cuts (or tax hikes) during busts. 5 The result has been even more volatile economic cycles.

Yet, there has been a noticeable improvement in recent periods. Indeed, several authors have highlighted that in many countries in the region, fiscal deficits declined and debt ratios improved during the 2000s; a few countries even managed to implement a countercyclical, or at least acycli-cal, fiscal policy. 6 This was critical to allow the injection of sizable fiscal stimulus packages in the global crisis of 2008–09. 7

Notwithstanding these gains, fiscal volatility, measured through varia-tions in public consumption growth, remains relatively high. Corbacho and

b. Standard Deviation of Gap Respect to Hodrick-Prescott Trend (percent)


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Gonz á les-Castillo (2012) decompose Latin America’s excess output vola-tility relative to countries of the Organisation for Economic Co-operation and Development (OCED) in three main sets of factors: terms of trade shocks, macroeconomic policies, and financial links with domestic and foreign markets. Over the last 15 years, fiscal policy explained about 10 percent of the excess output volatility of Latin America with respect to the OECD. This compares favorably with earlier periods, when fiscal policy accounted for about 20 percent of Latin America’s excess output volatility (box 3. 1). Still, by and large, public expenditure in the region remains a destabilizing force in economic cycles, being four times more volatile in the median Latin American country than in advanced economies.

Box 3.1 Decomposing Excess Volatility—Latin America vs. OECD

To identify the factors that make the average Latin American country more vola-tile than other countries in the world, Corbacho and Gonz á les-Castillo (2012) decomposed the excess output volatility in Latin America compared to the OECD.a Following the empirical framework in de Ferranti et al. ( 2000 ), the authors char-acterize the relationship between output volatility in 1970 to 2010 and three sets of factors: external volatility (standard deviation of terms of trade of shocks and the coefficient of variation of gross private capital flows), policy volatility (real public consumption growth, reserve money growth), and financial depth (logarithm of the private credit/GDP ratio and sum of the private capital inflow and outflows relative to GDP). The model also controls for a dummy variable for oil and min-eral exports. In spite of its simplicity, the model accounts for close to 60 percent of the variation in output volatility.

The results for the whole period show that Latin America’s higher output vol-atility relative to OECD countries arises from three main sources: terms of trade, macroeconomic policies (both fiscal and monetary), and capital flows. However, there has been a substantial reduction in the contribution of macroeconomic pol-icies since the mid-1990s. In particular, the contribution of fiscal policy volatility drops from 20 to 10 percent ( figure B3.1 ).

Countries with abundant nonrenewable natural resources are exposed to additional sources of volatility. In the region, eight economies derive substantial fiscal revenues from nonrenewable resources (Bolivia, Chile, Colombia, Ecuador, Mexico, Peru, Trinidad and Tobago, and Venezuela), accounting for over 40 percent of the region’s gross domestic product (GDP). For these countries, swings in commodity prices bear important implications for macroeconomic and fiscal management. For instance, Ossowski and Gonz á les ( 2012 ) estimate that overall GDP tends to be much more volatile in these economies than in others. Moreover, fiscal

a For more on the sources of volatility in Latin America, also see Loayza et al. ( 2007 ) and Calder ó n and Fuentes ( 2010 ).

Figure B3.1 Decomposition of Excess Volatility in Latin America vs. OECD Countries


Terms of trade15%

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a. 1970–95

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revenues from nonrenewable resources are over four times more volatile than general tax revenues. 8 Medina ( 2010 ) concludes that the response of fiscal revenues to commodity price shocks does not differ substantially across countries, but the response of public expenditures varies widely. For example, public expenditures in Chile tend to have a muted response to commodity price booms, in line with what is observed in Norway or New Zealand, while public expenditures in some of the major oil export-ers in Latin America tend to react strongly and in a procyclical manner, aggravating economic volatility. The availability of nonrenewable fiscal revenues also has important implications for the design of tax systems. Chapter 10 elaborates on the trade-offs in the taxation of both the nonre-newable sector and the rest of the economy.

Tax Automatic Stabilizers and Economic Cycles

The role of fiscal policy in macroeconomic management combines both discretionary fiscal interventions and automatic stabilizers. Much of the literature on cyclicality has focused on discretionary fiscal interventions, particularly on the expenditure side. 9 Discretionary fiscal policy has two main shortcomings: it suffers from implementation lags, including a political decision-making process influenced by multiple and possibly contradictory considerations; and it is not automatically reversed when the economic cycle improves, giving rise to a potential deficit bias and fiscal sustainability concerns (Baunsgaard and Symansky 2009 ). Studies have broadly concluded that discretionary fiscal policy is either neutral or countercyclical in advanced countries, but primarily procyclical in devel-oping countries. Woo ( 2009 ), in turn, documents that procyclical discre-tionary fiscal policy leads to fiscal and macroeconomic volatility.

Automatic stabilizers present certain advantages with respect to dis-cretionary fiscal interventions. Automatic stabilizers reflect revenue and expenditure items that adjust automatically to cyclical changes in the economy, reducing fiscal deficits in economic expansions and increasing them in recessions. During recessions, tax liabilities decline, smoothing changes in private disposable income and consumption. Similarly, more households qualify for unemployment and welfare benefits, helping them buttress the impact of weak economic conditions. There is no need for political decisions, implementation is timely and gradual, and lags are minimized. This is unique even compared to monetary policy. From a sustainability point of view, automaticity also provides a reversal of any fiscal expansion.


Automatic stabilizers still have some pitfalls. For countries with weak fiscal positions, allowing automatic stabilizers to work may conflict with financing constraints. If markets focus on the bottom line of the budget, higher deficits during downturns may raise risk premiums and compro-mise medium-term fiscal sustainability. Even in countries with sound initial fiscal positions, stabilizers may operate more strongly during slow-downs than booms. Importantly, stabilizers do not distinguish among the types of shock driving economic cycles that may require different policy responses. 10

There is growing awareness of the advantages of fiscal automatic stabi-lization. The most recent studies have focused mainly on advanced econ-omies. Automatic stabilizers are quantitatively important in all OCED countries, and several authors have found that automatic stabilizers have contributed to sizable reductions in output volatility. 11

In Latin America, policy discussions have started to emphasize the im-portance of automatic stabilizers to contain the need for discretionary fis-cal interventions and reduce volatility. With greater emphasis on fiscal institutional reforms that constrain discretion, such as fiscal rules based on structural balances, strengthening automatic stabilizers becomes a critical policy challenge (Ter-Minassian 2010 ; Garc í a 2012). 12 In the end, constraining fiscal policy discretion to reduce procyclicality and strengthening fiscal automatic stabilizers to reduce volatility should be seen as complementary tasks.

Automatic Stabilizers in Latin America: How Small and (In)effective Are They?

Estimating the size of automatic stabilizers involves some conceptual and technical decisions. In general terms, automatic stabilizers depend on two key components. The first is the size of government tax and expenditure programs. The second is their cyclical responsiveness: that is, their elas-ticity with respect to the economic cycle. 13 Larger government programs imply larger automatic stabilizers because the public sector can influence a larger portion of aggregate demand. More elastic government programs also imply larger stabilizers because the fiscal stance will react more to cyclical conditions.

On the expenditure side, unemployment and welfare benefits are prime examples of automatic stabilizers, increasing (decreasing) government expenditure during recessions (booms). For Latin America, automatic stabilizers on the expenditure side are virtually nonexistent. It is indeed


common to assume that public expenditures do not react automatically to the economic cycle (that is, that they have an elasticity of zero). This reflects the low coverage of unemployment benefit schemes and the gen-eral absence of other expenditure programs that are tied to cyclical condi-tions. Absent structural reforms of expenditure programs, tax systems are the only potential automatic stabilizers in the region.

On the revenue side, direct taxes provide stronger automatic stabiliza-tion than indirect taxes. Direct taxes exhibit larger elasticities to the eco-nomic cycle. Personal income taxes are generally progressive. This means that as household income falls during a recession, households will pay a smaller proportion of their income in taxes. Therefore, personal income tax revenue tends to fall relatively faster than the fall in household income. Corporate income taxes are also quite reactive to the cycle, since they are generally based on profits that tend to decline much more than activity during downturns. Indirect taxes, in turn, broadly move in proportion to activity, hence exhibiting lower elasticities than direct taxes.

Given the predominance of indirect taxes in the region, many studies have assumed that tax revenues move in proportion to activity (that is, that they have an elasticity to the cycle equal to one). However, the more recent literature has increasingly found that tax systems in the region are more elastic than traditionally assumed. For example, Machado and Zuloeta ( 2012 ) and Corbacho and Gonz á les-Castillo (2012) estimate revenue elas-ticities higher than one for several countries in Latin America.

To assess the degree to which the overall fiscal stance reacts to cyclical conditions, it is necessary to combine the expenditure and revenue sides. A useful summary metric is the semi-elasticity of the fiscal balance to the output gap. It measures the change in the fiscal balance in response to a 1 percent change in the output gap. Figure 3.3 presents estimates for var-ious countries in the region based on an expenditure elasticity of zero and revenue elasticities that discriminate by type of tax. The regional average of the semi-elasticity of the fiscal balance is about 0.25: that is, for a 1 per-centage change in the output gap, the fiscal balance changes by 0.25 percent of GDP. Within the region, estimates range from over 0.35 in Argentina and Brazil to 0.1 in Trinidad and Tobago. In all cases, the semi-elasticity of the fiscal stance is smaller than in OECD countries, highlighting the limited role of the tax system in smoothing shocks to economic activity in the region. It is clear that, for the vast majority of countries in the region, the personal income tax is the weakest link in terms of its contribution to automatic stabilizers.


Finally, how effective are automatic stabilizers? How do they relate to output volatility? Previous studies have documented that larger auto-matic stabilizers are correlated with lower output volatility. This negative relationship has been shown to work particularly well in OECD countries. For developing economies, there has been some divergence in results. For example, Suesc ú n ( 2008 ) concludes that automatic stabilizers bear no relationship to output volatility in middle-income countries and have a positive—rather than negative—relationship with output volatility in lower-income countries (that is, larger stabilizers are found in more unstable econ-omies). In turn, Debrun and Kapoor ( 2010 ) revisit the literature and provide new empirical evidence supporting the claim that automatic stabilizers work “everywhere and always.” For the Latin American region, tax automatic sta-bilizers show no evident link with volatility ( figure 3.4 ). In an econometric study, Corbacho and Gonz á les-Castillo (2012) document that stabilizers are indeed less effective in this region than in advanced economies.

Figure 3.3 Tax Semi-elasticities to Output (percentage of GDP or non-resource GDP)

Notes : Latin America-15 includes: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Honduras, Mexico, Paraguay, Peru, Trinidad and Tobago, Uruguay, and Venezuela. Semi-elasticities calculations based on GPD or nonresource GDP. Regional average is unweighted, OECD does not include Chile and Mexico. a Nonrenewable resource producer. Source : Corbacho and Gonz á les-Castillo (2012), Girouard and Andre ( 2005 ), and Ossowski and Gonz á lez ( 2012 ).

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Tax Reform for Stable Welfare

The previous section concluded that tax automatic stabilizers are relatively small and ineffective in Latin America. This stems from both the small size of government and the underutilization of direct taxes that generally exhibit larger elasticities compared to indirect taxes. Raising tax ratios would then be a straightforward way of enhancing automatic stabilizers. 14

A further challenge is making automatic stabilizers more effective without raising the size of government. In this respect, a rebalancing to progressive personal income taxes would reinforce both equity and sta-bilization objectives. But how is this progressivity best achieved? For instance, minimum exemptions in the personal income tax induce a posi-tive association between income and tax-income ratios. Value added tax (VAT) exemptions on basic goods may produce a similar pattern. Are these properties stabilizing or destabilizing? Is it worth also considering the progressivity embedded in VAT exemptions? What is the payoff of structural tax reforms in terms of stability of not only income, but impor-tantly of private consumption?

Figure 3.4 Gross Domestic Product (GDP) Volatility and Tax Automatic Stabilizers

Note : Latin America-15 includes: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Honduras, Mexico, Paraguay, Peru, Trinidad and Tobago, Uruguay, and Venezuela. Source : Corbacho and Gonz á lez -Castillo (2012).

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To tackle these analytical questions, Espino and Gonz á lez-Rozada (2012) estimate the size of stabilizers and the payoff of tax reforms in Argentina, Brazil, Mexico, Nicaragua, and Peru. Using household survey data for around mid-2005, they perform microsimulations when the economy is struck with a shock that raises the unemployment rate by 5 percent. 15 The shocks affect disposable income of households depending on their employment profile, the taxes they must pay, and the benefits they receive. The degree to which the tax and benefit system is able to smooth the shock to disposable income is called the income stabilization coefficient . For households that are liquidity constrained, the change in disposable income will translate directly into changes in consumption. 16 The degree to which the tax and benefit system is able to smooth the shock to consumption is called the consumption stabilization coefficient .

The authors confirm that the degree of automatic stabilization in Latin American economies is much smaller than in the United States or the European Union ( figure 3.5 ). As expected, personal income taxes are “the weakest link.” Nicaragua stands out as the country with the least pow-erful automatic stabilizers. When faced with an unemployment shock,

Figure 3.5 Size of Automatic Stabilizers in Europe, United States, and Select Latin American Countries (stabilization effect of a 5 percent unemployment shock, in percentage)

Note : The simulations show the consumption and income stabilization coefficients under reform scenarios. The consumption and income stabilization coefficients measure the extent to which the tax and benefit system is able to absorb a shock to disposable income or consumption, respectively. Source : Dolls, Fuest, and Peichl ( 2010 ) and Espino and Gonz á lez-Rozada (2012).

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stabilizers in Nicaragua are able to absorb less than 5 percent of the fall in disposable income. Moreover, given extensive poverty, income shocks translate into sizable consumption shocks and declines in household welfare.

Which tax reforms hold the most promise to strengthen stabilizers? As discussed in further detail in chapter 7 , the current structure of the personal income tax in the region differs widely from that in comparator middle-income countries. In the region, a vast majority of workers are exempt from the income tax. Those workers who actually pay taxes do so at generally lower and less progressive rates than in other countries. Against this backdrop, Espino and Gonz á lez-Rozada (2012) perform sim-ulations to understand the benefits of aligning the personal income tax with the structure in comparator countries by: (i) lowering the minimum tax exemption; and (ii) adding a change in the rate structure to the first simulation. 17

A reform that mimics the structure of the personal income tax of com-parator middle-income countries outside the region would have sub-stantial payoff in terms of stabilization. Figure 3.6 presents the results. The simulations show that in Argentina and Brazil, the reduction in the

Figure 3.6 Policy Simulations on Personal Income Tax (stabilization effect of a 5 percent unemployment shock, in percentage)

Note : The simulations show the income stabilization coefficient under reform scenarios. The income stabilization coefficient measures the extent to which the tax and benefit system is able to absorb a shock to income. Source : Espino and Gonz á lez-Rozada (2012).

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Minimum Exemption Rate Progressivity Informality Base Flat rate Baseline - Income


minimum tax exemption accounts for most of the improvement, while in Mexico, Nicaragua, and Peru, significant additional benefits arise from making the rate structure more progressive. To be effective, these reforms would need to be complemented with significant efforts to improve tax compliance, including promoting a tax-paying culture for large segments of the population that have been traditionally exempt from income taxes.

What about reforms to the value added tax (VAT)? Espino and Gonzalez-Rozada also perform two simulations for the VAT: (i) eliminat-ing exemptions except for education, health, transport, financial services, and housing rental fees; and (ii) adding to the first scenario an increase in the VAT rate of 50 percent of the standard rate. These simulations are done for Mexico and Nicaragua, where household surveys contain detailed information on consumption patterns at the household level ( figure 3.7 ). In Nicaragua, these reforms would produce some gains in terms of stabi-lization, but the size of the effect pales in comparison to the reforms of the personal income tax. In Mexico, the effects are negligible. There may be good reasons to rationalize exemptions and broaden the base of the VAT, as put forth in chapter 9 . These reasons, however, do not seem to include strengthening automatic stabilizers.

Figure 3.7 Policy Simulations on VAT (stabilization effect of a 5 percent unemployment shock, in percentage)

Note : The simulations show the consumption stabilization coefficient under reform scenarios. The consumption stabilization coefficient measures the extent to which the tax and benefit system is able to absorb a shock to consumption. Source : Espino and Gonz á lez-Rozada (2012).

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The Road to Economic Stability

The Latin American and Caribbean region has come a long way from the bouts of very high volatility of past decades. But there is still another long way to go to achieve economic stability.

Graduating toward economic stability will require reforms to anchor countercyclical and sustainable fiscal policies. Much of the current debate is zooming in on fiscal institutional reforms that constrain fiscal policy discretion and let automatic stabilizers work. In the end, constraining fis-cal policy discretion to reduce procyclicality and strengthening fiscal auto-matic stabilizers to reduce volatility are two sides of the same challenge.

Yet automatic stabilizers are small and relatively ineffective in the region. This stems from small governments and inelastic fiscal balances to cyclical conditions. On the expenditure side, government programs have essentially no built-in stabilizers. On the revenue side, low tax ratios with predominantly indirect taxes take out much of the traction to stabilize economic cycles.

This chapter provides evidence that structural reform of the personal income tax would considerably strengthen automatic stabilizers in the region. In this respect, the policy simulations unanimously show that reducing minimum tax exemptions in line with thresholds observed in comparator countries outside the region would have a significant payoff. For some countries, additional benefits would materialize from making the rate structure more progressive.

If successful, these reforms would not only increase fiscal revenues. They would improve tax systems as a development tool to avoid the wild rollercoaster and ensure a smooth ride.

4

Beware of Informality

The words “taxes” and “informality” often occur together, and for good reason. In its currently most widely accepted definition, “infor-

mality” is failure by individuals or businesses to comply with regular tax obligations (and other regulations). Informality can hamper tax collec-tion, but its consequences do not end there. Informal workers who are not covered by social security services lack protection against the risks of ill-ness and economic insecurity in old age, and may not enjoy other benefits that their peers who are employed by formal firms receive. Meanwhile, firms that operate in the informal sector tend to operate on a very small scale, which in practice eliminates the risk of penalties. But operating on such a small scale may mean sacrificing productivity gains and possibly limiting access to productive resources, from credit to technology. Thus informality has costs for the economy and society that go far beyond loss of tax revenue.

The possibility of not paying taxes is an important motivation for indi-viduals or businesses to operate in the informal sector. However, the causes of this phenomenon are much more complex. Factors ranging from edu-cation levels and family structures to the paperwork required by govern-ments to register a business can contribute to informality. Thus, simply reducing or eliminating certain taxes will not necessarily decrease infor-mality substantially.

As this chapter shows, despite strong evidence that tax policies can con-tribute to informality, there is no conclusive evidence as to which types of taxes have relatively more harmful effects. In this chapter, particular taxes are put on trial and accused of the crime of informality. First, the evidence is presented; it presumes that taxes are guilty. Then, a forensic investi-gation looks for detailed evidence on the ground. The chapter concludes with a tentative verdict, given the limitations of the evidence, and presents some recommendations as to how to proceed with tax designs that take into account their possible effects on informality.


Why Care about Informality

Conceptually, informality can be defined as lack of compliance with regular tax obligations. Although sometimes considered synonymous, informality and illegality are different. All formal firms are legal, since they abide by the tax code. 1 But not all informal firms are illegal, since the tax code itself may exempt some of them from the regular tax obli-gations imposed on other firms. For instance, in most countries, social security contributions are compulsory for salaried workers, but not for independent workers or unpaid workers in family businesses (which are then considered informal, but not illegal). More importantly, all Latin American countries—except for El Salvador, Panama, and Venezuela—have established simplified tax systems for small firms in lieu of the reg-ular tax code with respect to corporate income and value added taxes (VAT; and in Argentina and Brazil, with respect to social security con-tributions as well). As discussed in chapter 12 , the size threshold for benefitting from simplified tax systems is usually very high: firms with gross income of up to 15.9 times per capita income in Mexico and up to 9.7 times per capita income in Colombia benefit from the simplified tax system. Actual tax payments by the individuals and firms under these regimes are extremely low: for instance, more than 3.6 million taxpayers of the 43 million workers in the simplified regimes in Mexico (known also as small contributors regimes, or Repecos in Spanish) pay a mere 0.02 percent of GDP in taxes. Obviously, there are also many firms that do not honor their tax responsibilities and are therefore illegal. Using Mexico’s economic census, Busso, Fazio, and Levy ( 2012 ) calculate that two-thirds of all firms reported in the census are informal but legal (col-lectively, they account for 35 percent of all workers). In contrast, only 3 percent of all firms in Mexico are formal and legal (they employ 20 percent of workers), while 23 percent of all firms hire workers illegally (representing 20 percent of all workers). 2

The possibility of not paying taxes (either legally or not) makes small production units more attractive and more economically viable, while cre-ating employment options that would not exist in an economy with full tax compliance. Consequently, informality reduces the direct impact of taxes on employment and wage levels, but creates other effects. Workers who opt for an informal job will pay less tax but may have less job security and inferior working conditions than their peers in the formal sector (IDB 2003 , Chapter 7 ). Importantly, the option of informality also means that taxes can have harmful effects on productivity because smaller firms are

BEWARE OF INFORMALITY 67

less productive (Levy 2008 ). As shown by Busso, Fazio, and Levy ( 2012 ), informality, not illegality, is associated with lower productivity. The same amount of capital and labor allocated to legal and formal firms in Mexico is 50 percent more productive than if allocated to firms that are also legal, but informal.

Unfortunately, precise data on informality in Latin America and the Caribbean are scarce. Mexico is the only country in the region that has fairly precise data on the number of informal firms and workers. Given this lack of data, studies tend to use information about the size of firms, and informal workers are considered to be all those who work indepen-dently or in firms with fewer than 10 workers—or some other arbitrary number. This is a rather crude approximation, and has probably limited research and understanding of informality.

The Evidence

More than half of Latin American workers work independently or in small establishments with fewer than 10 employees, and can therefore be con-sidered informal. On average, in the 18 Latin American countries the rate of informality measured by this method was 52.8 percent from 2006 to 2010. In countries with lower income levels, such as Bolivia, Guatemala, Nicaragua, and Paraguay, two out of three workers are informal. Colombia and Ecuador also have rates above 60 percent. Only Chile and Costa Rica have informality rates of less than 40 percent ( figure 4.1 ).

Although informality is widespread, it has been decreasing since the early 1990s in Argentina, Bolivia, Brazil, Chile, Ecuador, and Mexico. The rate is significantly higher today only in El Salvador, Honduras, Uruguay, and Venezuela.

Several factors suggest that taxes have contributed to these high rates of informality. Payroll taxes are the most visible aspect, and in many coun-tries the most discussed of all the burdens imposed on workers. The most important component of payroll taxes is social security contributions, but they also include other contributions and surcharges for a variety of pur-poses. The average rate of social security contributions (paid by workers and employers for pension and health programs) has risen steadily from the mid-1980s, when it was less than 19 percent, to 22 percent by the late 2000s ( figure 4.2 ). In some countries payroll taxes other than social security contributions also increased. Currently, the total of social security contributions and other payroll taxes is higher than in the late 1980s in every country, except for Argentina, Peru, and Uruguay, where there were

Figure 4.2 Social Security Contribution Rates, Latin America and the Caribbean Average, 1985–2009 (percentage of wages)

Note : See list of countries included in figure 4.3 . Source : Lora and Fajardo ( 2012b ).

Figure 4.1 Informality, 1990–94 and 2006–10 (percentage of total employment)

a The averages do not include Colombia, the Dominican Republic, or Guatemala. b The first data point for Paraguay and Peru is 1997. Source : Authors’ calculations based on household surveys processed by Center for Distributive, Labor and Social Studies (CEDLAS).

0 10 20 30 40 50 60 70 80

Chile

Costa Rica

Argentina

Uruguay

Panama

Mexico

Venezuela

Brazil

Dominican Rep.

El Salvador

Honduras

Colombia

Ecuador

Perub

Nicaragua

Guatemala

Paraguayb

Bolivia

Averagea

2006–10 1990–94

17

18

19

20

21

22

23

1985

1986

1987

1988

1989

1990

1991

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1993

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some reductions, and Honduras, Jamaica, and Paraguay, where there were no changes ( figure 4.3 ). 3

Minimum wages have combined with higher payroll taxes to signifi-cantly increase the labor cost of middle- and low-wage workers in formal firms, especially since the mid-1990s. The average minimum wage in the region was fairly stable at about US$200 a month (in constant 2000 US dollars in purchasing parity terms) from the early 1980s to the mid-1990s. Since then, the average has steadily risen to current levels of around US$400 per month ( figure 4.4 ). The increase in the minimum wage in real terms has been common to practically all countries of the region, although it has occurred at different speeds ( figure 4.5 ).

The increases in the minimum wage would not result in higher labor costs and higher tax burdens per unit of output if accompanied by con-comitant increases in productivity. But in general, labor productivity has lagged the combined increase in minimum wages and payroll taxes (Lora and Fajardo 2012b ). 4

Consequently, along with the minimum wage and other labor pro-visions, social security contributions and other payroll taxes have con-tributed to rising labor costs for formal firms and thus may be partially responsible for the high levels of informality. 5

Figure 4.3 Social Security Contributions and Other Payroll Taxes, 1987–2009 (rates as percentage of wages)

Source : Lora and Fajardo ( 2012b ).

0 10 20 30 40 50 60

JamaicaTrinidad and Tobago

HondurasGuatemala

EcuadorPeru

El SalvadorNicaragua

ChileDominican Rep.

VenezuelaBolivia

ParaguayUruguay

BrazilCosta Rica

MexicoColombiaArgentina

Latin America and the Caribbean

2009 1987

Figure 4.4 Real Monthly Minimum Wage, Latin America and the Caribbean Average, 1980–2009 (US$ at 2000 purchasing power parity)

Note : See list of countries included in Figure 4.5 . Source : Lora and Fajardo ( 2012b ).

Figure 4.5 Real Minimum Wage, 2009 vs. 1995 (US$ at 2000 purchasing power parity)

Source : Lora and Fajardo ( 2012b ).

150

200

250

300

350

400

450

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

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1998

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0 100 200 300 400 500 600 700

Mexico

Bolivia

Nicaragua

Uruguay

Brazil

Venezuela

Peru

Colombia

Chile

El Salvador

Ecuador

Panama

Dominican Rep.

Paraguay

Honduras

Jamaica

ArgentinaCosta Rica

Latin America andthe Caribbean

2009 1995


A comparison of total taxes on labor with taxes paid on capital reveals an antilabor bias in the tax structures of Latin America and the Caribbean. As shown in chapter 1 , effective tax rates on labor are about twice those on capital in Brazil, Colombia, Guatemala, and Venezuela. In Bolivia, Chile, and Mexico, the tax burden on labor and capital are more equal. Only Honduras has a higher tax burden on capital than labor. This antilabor tax bias can contribute to labor informality if the high relative cost of labor with respect to capital discourages formal firms to create employment and induces workers to take jobs in small establishments where they can evade taxes.

Further evidence that taxes may be partially responsible for labor in-formality is the growing importance of VAT as a tax resource. As seen in chapter 1 , about one-third of tax revenues now come from the VAT, following its adoption by almost all countries in the region. In addition, its base rate rose from 12.1 percent in 1985 (in the 13 countries with VAT) to 14.8 percent in 2009 (in 18 countries). Although VAT as a system has collection advantages compared to other taxes, which will be discussed in this chapter, it also offers a cost advantage for small production units that can avoid payment (either because they evade the tax or because they ben-efit from the simplified systems mentioned earlier).

Consequently, there are sufficient reasons to believe that tax structures might play a role in producing the high rates of informality in the region. But the evidence outlined is not enough to find taxes guilty. The rest of this chapter reviews studies that have tried to answer this question: Are taxes guilty of increasing informality?

The First Suspect: Payroll Taxes

Although payroll taxes are mentioned more often than any other tax as possible culprits of informality, the evidence needed to document this charge is surprisingly scarce. Two of the few conclusive studies on the sub-ject relate to Colombia, where taxes and payroll surcharges have risen con-siderably since the 1980s. One of them (Mondrag ó n-V é lez, Pe ñ a, and Wills 2010 ) concluded that a 10 percent increase in payroll taxes (and other non-wage labor costs) increased informality by 8 percent. 6 The other (Kugler and Kugler 2009 ), which focused on manufacturing plants, found that a 10 percent increase in payroll taxes lowered formal employment by between 4 and 5 percent. 7 According to a comprehensive assessment of the impacts of taxes on 15 Latin American countries, the changes in payroll tax rates since the early 1990s have had no clear impact on informality, measured


as the share of workers in self-employment or in establishments with fewer than 10 workers (Lora and Fajardo, 2012a ).

How can that be? Does this mean that payroll taxes do not affect the behavior of workers or firms? Obviously not, but the reactions of workers or firms are somewhat more complex than the theory implicitly predicts, which is that any payroll tax leads to informality.

To understand how workers react, it is necessary to ask first if they believe they are receiving some benefit from paying payroll taxes. These “taxes” include contributions to social security systems, which may entitle them to health services and a pension in old age. They also include other contributions that can provide access to child-care services, job training programs, or housing loans.

If workers believe that the benefits they receive have exactly the same value as the payroll taxes that they and their employers pay together, then workers have no reason to try to evade payment. Under these hypothetical conditions, there would be no change in employment or in the informal sector. Workers would simply receive a gross salary (including payroll taxes) just as if there were no such taxes and benefits. In other words, they would be using part of their pay to buy health care, pensions, and other benefits offered them by the payroll taxes.

Naturally, this rarely happens in reality. In general, Latin American workers value benefits only partially (possibly 60 percent or less of the value of the payroll taxes they have to pay). 8 Thus, some workers will be unwilling to assume the full burden of these taxes, and will try either to evade paying by turning to the informal economy, or require the firm to raise their pay slightly to make up the difference.

However, how the benefits are valued can be very different depending on which tax is involved, on what conditions, and who obtains the ben-efits. It is probable, for example, that workers find paying payroll taxes unattractive when they are used to funding general programs that benefit nontaxpayers, as found in studies on Mexico and Colombia (Levy 2008 ; Camacho, Conover, and Hoyos 2009 ). In these cases, there is a double reason for becoming informal: to stop paying payroll taxes and to ben-efit from subsidized programs for informal workers. However, there are not sufficient grounds to extend these results to all payroll taxes or all countries.

As mentioned, on average for 15 Latin American countries between 1990 and 2009, the many changes that payroll taxes have gone through in one or other direction (a total of 80) have not affected rates of informality. However, considering social security contributions for health separately,


the study by Lora and Fajardo ( 2012a ) found that, instead of increasing informality (as would be expected if their benefits were undervalued), the higher contributions were associated with increases in labor participa-tion and employment, especially for workers with low levels of education, implying that these workers assign great value to their health insurance entitlement. 9 But even the other payroll taxes, which may generate fewer benefits, do not seem to increase informality, perhaps because they reduce the labor participation of certain groups or because of other reasons not well understood.

Very possibly no common pattern applies to all the countries, since the reaction of workers and firms to higher payroll taxes may depend on fac-tors such as the efficiency of the tax administration, taxpayers’ patterns of behavior and respect for the law, the severity of regulations on hiring and firing, and in general the costs for workers and firms of operating in small-scale production units working outside the regulations.

In conclusion, although there is insufficient evidence to declare payroll taxes in general guilty of increasing informality, such taxes are potentially less of a problem when they generate individual benefits for workers than when they are used to fund programs for the general benefit or, worse still, when they indirectly subsidize informal workers. Also, opportunities for formal employment for certain groups of workers, especially women and the young, are more sensitive to rising labor costs resulting from payroll taxes when those increases do not generate individual benefits.

The Second Suspect: VAT

The second suspect is value added tax or VAT. At first glance, VAT is a better tax option than payroll taxes because it is harder to evade and causes firms to make fewer changes in investment, production, and em-ployment patterns. For these reasons, it is considered desirable to partially or completely replace payroll taxes with a higher VAT (Ant ó n, Hern á ndez, and Levy 2012). Yet, like any other tax, VAT can encourage some firms to move into the informal sector. It is important to understand under what circumstances this effect tends to be stronger.

The distinctive feature of VAT, as opposed to a traditional sales tax, is that it is levied on the valued added on each stage of production and dis-tribution of all consumption goods. This feature makes it less distortive than turnover taxes or other taxes that are levied on only some stages, some goods, or some types of income. VAT also becomes an effective tool for collecting revenue, especially in economies with some informality,


because firms have an incentive to ask their suppliers for accurate receipts since they can deduct input costs from their VAT bill. In developing coun-tries, where informality is rampant and tax capabilities are weak, the self-enforcing nature of VAT appeals to governments and tax administra-tions, and has no doubt contributed to its growing adoption throughout the world, from 47 countries in 1990 to over 140 today (Bird and Gendron 2007 ; Keen and Lockwood 2010 ).

However, VAT may encourage further informality and may have other effects on the labor market, issues that until recently had been largely ig-nored in the academic literature. 10 A VAT may induce informality, like any other tax, because it implicitly gives a cost advantage to the firms that can escape the purview of the tax administration. Since smaller firms have a better chance of being undetected if they do not pay taxes, firms may decide to become (totally or partially) informal by operating on a smaller scale, although their productivity may decline. As a result of this trade-off, the most productive firms operate in the formal sector and the less pro-ductive firms operate in the informal sector, as observed in practice. 11 In turn, this affects workers, whose wages may decline as a result of the lower productivity of the smaller firms and may be left without social security coverage due to the informal status of most of the smaller firms. 12

This does not mean that informal firms can completely evade VAT because the taxes paid by their (formal) input suppliers cannot be passed on to their customers (Keen 2008 ). 13 If tax compliance is incomplete because of informality, firms in the final sector face a trade-off, since higher eva-sion in the intermediate sector implies lower input prices but also lower tax credit claims. 14 Therefore, the credit method of collecting VAT rein-forces relations between formal firms, but may also set in motion a mech-anism for transmitting informality: that is, the organization of production into small units that stand a better chance of evading the tax (as well as other taxes). Since purchases from informal suppliers do not generate tax credits and informal buyers cannot use tax payments from formal suppli-ers, informal firms have an incentive to deal with other informal firms.

Data from about 48,000 small firms in Brazil show that various mea-sures of the formality of suppliers and purchasers are correlated with the formality of a firm, lending support to the hypothesis that VAT reinforces informality (De Paula and Scheinkman 2010 ). However, the tax admin-istration can counteract that process: enforcement efforts can affect the transmission of evasion of VAT, as found in a randomized experiment among 2,800 Chilean firms by Pomeranz ( 2010 ). In this experiment, the possibility of being audited resulted in higher VAT payments not only by


the firms that received the notification but also by their supplier firms. In their assessment of the labor effects of taxes, Lora and Fajardo ( 2012a ) find evidence that higher VAT rates do increase informality: for each per-centage point of increase in the basic VAT rate, informality increases by 0.3 percentage points. 15

Consequently, evidence exists that higher VAT rates can lead some firms to operate informally. The evidence is not strong enough to declare VAT guilty of increasing informality, but it is strong enough to look cau-tiously at the proposal, common in economists’ circles, that replacing pay-roll taxes with VAT can substantially reduce informality. Achieving this outcome depends not only on what type of payroll taxes are to be replaced, as discussed earlier, but also on the practical possibilities of firms oper-ating in the informal sector without incurring costs that would exceed the benefit of evading VAT. These costs tend to be higher for larger firms with closer ties to other formal firms than for medium and small enterprises that buy from and sell to informal enterprises. Tax administrations need to redouble their inspection and sanctioning efforts with respect to these firms because, as the studies suggest, such actions can help prevent VAT from producing more informality. As discussed in chapter 12 , the simpli-fied tax regime for small enterprises is not the most appropriate mecha-nism for incorporating these businesses into the tax system because the firms benefiting from these schemes lose the incentives to buy inputs from other formal firms.

The Third Suspect: Corporate Income Tax

The final suspect is corporate income tax (CIT). In principle, like any tax, changing the CIT can lead to behavioral changes. Some firms will try to downsize, or not grow, because this improves their chances of evad-ing income tax. But this is not the only effect, and perhaps not the most important one: a profits tax may encourage firms to invest less and employ fewer formal workers. Or it may encourage them to invest in a different way, such as using technology that requires less capital, and replacing it with more unskilled labor. As a result, taxes on corporate income or prof-its can have differentiated effects on the formal employment of skilled and unskilled workers.

The evidence on the labor effects of corporate income taxes is even more limited than that of payroll taxes and VAT. In the developed world, taxing profits tends to reduce employment, but there is a dearth of empirical studies on the effects on informality or on the employment


possibilities of workers with different skill levels. 16 In the developing world, the case of Chile has attracted attention because its corporate income tax system has undergone multiple changes, especially between 1981 and 1996. A study for that period (Cerda and Larra í n 2010) found that each 1 percent increase in corporate income tax revenue reduces labor demand by 0.2 percent. Of special interest is the asymmetric effect of taxation according to firm size. The impact on labor demand is signif-icantly higher in large corporations than in small firms, while demand for capital is more responsive to corporate tax changes in small firms (possibly because larger firms can more easily cover the high costs of firing workers because they are less credit-constrained). Since the data-set used in this study includes only registered firms with more than 10 employees, its findings are silent on the impact of corporate income taxes on firms with fewer employees, which are usually considered a good indicator of informality. However, a study covering most Latin American countries in the early 1990s (Loayza 1996 ) did find that the size of the informal sector 17 depends positively on the maximum cor-porate income tax rate, and that the effect is stronger in countries with weak government institutions. 18

Taking into consideration the changes in the corporate income tax rates in 15 Latin American countries between 1990 and 2009 (a total of 56), the study by Lora and Fajardo ( 2012a ) found evidence that low-skilled and highly skilled workers are affected differently. For low-skilled workers, the effect of a higher corporate income tax is to reduce informality (implying a very strong substitutability with capital). Their econometric estimates indicate that for each percentage point of increase in the CIT rate, infor-mality among workers with primary education will fall 0.12 percentage points. Given the complementarity between capital and skilled labor, it could be expected that a higher CIT rate would induce more informality among skilled workers. Although this happens to some extent, most skilled workers who lose their jobs in formal firms become unemployed or leave the labor force. Interestingly, these job losses depend directly on the capabilities of the government to enforce the tax code: in a country with a level of government effectiveness equal to the average in the region, an increase of 1 percentage point in the CIT rate reduces the occupation rate of the highly skilled by 0.2 percentage points, while for a country with a level of government effectiveness one standard deviation higher, the same CIT increase reduces the occupation rate of the highly skilled by 0.44 percentage points. In summary, according to this study, higher CIT rates increase the demand for unskilled labor, and through this channel


tend to reduce informality. Demand for highly skilled labor will decline, but if tax enforcement capabilities are strong, highly skilled labor will not be able to “hide” in the informal sector, and hence their employment opportunities will be reduced.

Consequently, the scant evidence for the impact of corporate income tax on informality is inconsistent and provides no basis for claiming that these taxes are a cause of informality. Moreover, corporate income taxes may reduce the informality of unskilled workers, but apparently at the cost of wasting the talents of more skilled workers. The few studies that exist consistently find that good tax administration can limit the effect of income tax on informality.

Policy Implications

Informality remains one of the most pressing challenges in Latin America and the Caribbean. Informality clearly undermines the tax base. But it raises concerns beyond revenue collection. It leaves about 50 percent of workers in the region without access to social insurance and is a drag on productivity and future economic prospects.

Unfortunately, “fixing” informality is much more complex than just “fixing” tax design. The solution is not simply to reduce some tax rates or to replace social security contributions and other payroll charges with higher value added taxes. Each country requires a different analysis, which has to take into account several dimensions of the problem of informality. Factors that may limit creation of formal employment and encourage informality include lack of credit and capital resources and obstacles to starting new formal firms, as pointed out by the regular series of World Bank “Doing Business” reports. Factors on the labor supply side can also influence informality, such as inadequate provision of child-care and other support services that allow women with young children to take jobs with rigid working hours, as well as gaps in the coverage and quality of public domestic utilities (water, electricity) and public transport services.

Payroll taxes have often been found guilty of promoting informality. But the evidence is far from conclusive. These taxes pose potentially less of a problem when they generate individual benefits for workers than when they fund general benefit programs or, worse still, indirectly subsidize informal workers. And payroll taxes that do not generate benefits valued by workers can have harmful effects beyond informality, such as reducing incentives for participating in the labor force and disproportionally affect-ing women and young workers.


In contrast, VAT has generally been exonerated from any links to informality. However, the proposal, commonly advanced by economists, of replacing payroll taxes with VAT to reduce informality, warrants fur-ther scrutiny. Achieving that outcome depends not only on what type of payroll taxes it plans to replace, but also on the practical possibilities of firms operating in the informal sector without major costs. These costs tend to be higher for larger firms with closer ties to other formal firms than for medium and small businesses that buy from and sell to informal firms. In this respect, the simplified tax regimes for small businesses do not work well as an incentive for firms to join the formal economy because firms that benefit from these schemes lose incentives to purchase inputs from other formal firms.

Finally, corporate income taxes have by and large been kept out of the courtroom. Yet, by making capital more expensive, they may encourage firms to hire more unskilled workers and thereby reduce informality through this channel. Unfortunately, this benefit may come at the cost of wasting the talents of more skilled workers.

The evidence is more conclusive on the role of tax administrations. As suggested, tax authorities need to redouble their inspection and sanc-tioning efforts with respect to small and medium enterprises to prevent VAT from resulting in more informality. A good tax administration is the key to reducing the effect of income taxes on the informality of highly skilled workers.

5

Local Taxes for Local Development

Subnational governments in Latin America and the Caribbean must take more responsibility for generating their own-source revenue in order to

promote local development and meet the growing demand for local infra-structure and services arising from growing urbanization. 1 Why is greater fiscal responsibility at the subnational level desirable? First, it grants author-ities greater autonomy to choose and implement their policy decisions. Second, it reduces dependence on central government transfers. Third, it increases the efficiency and transparency of spending, since when citizens pay taxes they tend to demand more accountability from their leaders.

Latin America suffers a clear imbalance in fiscal decentralization, which limits the potential for local development. As the decentralization process deepened in the region, spending by subnational governments as a percentage of total government expenditure grew from 20 percent in 1985 to 30 percent 2 in 2009; however, the percentage of own-source revenue collected by these governments remained unchanged at about 10 percent of the national total. 3 This difference between subnational government spending and revenue creates highly inflated vertical fiscal gaps in most economies, leaving them heavily dependent on transfers from national to local governments. Almost two-thirds of subnational revenue is trans-ferred from national governments. This large gap also makes local govern-ment finances more vulnerable and less predictable.

The Pros and Cons of Subnational Taxation

Fiscal federalism recognizes the benefits of granting autonomy to subna-tional governments to make decisions about the level and composition of their revenue. These benefits can be grouped into four categories, but all recognize the advantages of keeping both ends of financial decisions—from revenue to spending—close to home, whenever possible.


Efficient allocation. It is preferable to transfer to subnational governments those taxes and charges that they can administer more efficiently than the central government. For example, in the case of taxes on property and motor vehicles, subnational governments can know and manage their respective tax bases better. The same principle applies to charges for ser-vices that subnational governments manage. Autonomy and budget predictability . Financing with their own-source revenue allows subnational governments to guarantee adequate and pre-dictable revenue, in contrast to transfers, which are usually more volatile (especially when based on natural resources). A stronger local tax base allows for preparation of more realistic and stable budgets, as well as a more adequate response to the needs of urban services and infrastructure. Accountability . Subnational taxation also favors accountability to the com-munity, since it creates incentives for citizens to exercise control over the use of resources. By making the costs of services and subnational invest-ment visible to the electorate, politicians feel pressured to report informa-tion on revenue and spending more transparently. In turn, transparency promotes improvements in fiscal management and provision of local pub-lic services. Response to community preferences . Finally, for similar reasons, subna-tional taxation leads to resource allocation that takes citizens’ preferences more closely into account.

Despite these benefits, various economic, institutional, and political obstacles limit subnational tax collection. Economic obstacles . Economically, the tax bases are unevenly distributed across regions, which leads to serious inequalities from one subnational government to another in their capacity to finance and provide public goods and services. In addition, tax payers tend to move within a country, which reduces the collection discretion of subnational governments and can result in tax competition between jurisdictions. Institutional obstacles . Institutionally, subnational tax collection is limited by the capabilities of the subnational tax administrations and the small scale at which many of them operate. High compliance costs for taxpay-ers that operate in several jurisdictions also limit collection. These costs increase significantly in the absence of a common legal framework and provisions to reduce differences among subnational tax laws. Political obstacles . Politically, subnational tax revenue is limited by central governments’ control over the most important tax bases and their power over subnational governments due to fiscal dependence. For their part,

LOCAL TAXES FOR LOCAL DEVELOPMENT 81

subnational governments are rarely willing to assume the political costs and administrative difficulties involved in levying local taxes and being more directly accountable to the public for allocating public resources.

The balance between the benefits and costs of tax decentralization in each country and time period necessarily reflects these economic, insti-tutional, and political conditions. These factors affect the composition of subnational revenue between own-source resources, shared taxes, and transfers, as well as the design of each tax, charge, or contribution.

Tax Decentralization and Subnational Government Finances

In Latin America, expenditures by subnational governments far exceed own-source revenue, producing larger vertical imbalances than in other regions of the world: twice those of Eastern Europe and over three times those of Asia. This reflects a combination of higher spending and very low subnational tax revenue in Latin America ( figure 5.1 ).

Some Latin American countries with centralized tax systems—Chile, El Salvador, and Panama—have insignificant imbalances, averaging less

Figure 5.1 Size and Financing of Subnational Government Spending, Select Regions, 2009 (percentage of GDP)

Notes : Asia: Afghanistan, Azerbaijan, Armenia, Georgia, India (2008), Iran, Israel, Jordan, Kazakhstan, Mongolia, and South Korea.Eastern Europe: Belarus, Bulgaria, Croatia, Slovenia, Slovakia, Latvia, Lithuania, Moldovia, Poland, Rumania (2008), Czech Republic, Serbia, and Ukraine.Latin America: Argentina (2002, local governments), Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Panama (2007), and Peru. Source : IDB ( 2012 b), IMF ( 2011 b), and OECD ( 2010 a).

0 2 4 6 8 10 12 14

Asia

Latin America

Eastern Europe

Financed with own-source revenue Vertical imbalance


than 1 percent of GDP in the 2000 ‒ 09 period ( figure 5.2 ). In contrast, countries with a federal structure and more mature processes of tax decentralization—Argentina, Brazil, and Mexico—have substantial gaps of around 8 percent of GDP. The gaps of countries in intermediate stages of the decentralization process are less inflated but still substantial.

During the 2000s, some countries sped up the process of spending decentralization, but subnational governments fell behind in raising their own revenue, which resulted in higher vertical imbalances. In Bolivia, Ecuador, and Peru, the difference between the spending and revenue of subnational governments doubled between the beginning and end of the decade. In contrast, in Argentina, Chile, and Panama, there were no sig-nificant changes ( table 5.1 ).

With the exception of Brazil, in countries where relatively more prog-ress has been made in decentralizing spending, subnational governments are heavily dependent on central government transfers ( figure 5.3 ). This situation is evident in countries where a large part of central government revenue is derived from natural resources—especially Bolivia, Mexico, Peru, and Venezuela. Transfers in these countries risk replicating the severe volatility of national tax revenue at the subnational level.

Figure 5.2 Size and Financing of Subnational Government Spending, Latin America, 2000 ‒ 09 (percentage of GDP)

Note : All calculations relate to simple averages. The periods vary for the following countries: Chile (2001 ‒ 09); El Salvador (2004 ‒ 07); Panama (2000 ‒ 08). Source : IDB ( 2012 b).

0 5 10 15 20 25

Panama

El Salvador

Chile

Ecuador

Peru

Bolivia

Colombia

Mexico

Argentina

Brazil

Own-source revenue Vertical imbalance

Table 5.1 Size and Financing of Subnational Government Spending, Latin America, 2000 and 2009 (percentage of GDP)

Spending Own-source revenue Vertical imbalance

2000 2009 2000 2009 2000 2009

Argentina 15.4 15.6 6.2 6.3 9.2 9.3Bolivia 5.8 10.2 2.5 2.7 3.3 7.5Brazil 19.8 21.5 12.7 13.1 7.2 8.4Chile 2.3 2.2 1.6 1.3 0.7 0.9Colombia 8.6 10.4 3.7 4.2 4.9 6.2Ecuador 2.4 6.2 0.6 1.2 1.7 5.0El Salvador 1.3 1.8 1.1 1.5 0.2 0.3Mexico 7.6 10.6 1.1 2.0 6.4 8.6Panama 0.8 0.6 0.7 0.6 0.0 0.0Peru 4.3 8.0 1.2 1.4 3.2 6.6 Note: Vertical imbalance is the difference between spending and own-source revenue. Source : IDB ( 2012 b).

Figure 5.3 Composition of Total Revenue of Subnational Governments, Latin America, 2000 ‒ 09 (percent)

Note : All values are period averages. The periods vary for the following countries: Chile (2001 ‒ 09); El Salvador (2004–07); Panama: (2000 ‒ 08). Source : IDB ( 2012 b).

0 20 40 60 80 100

Panama

El Salvador

Chile

Brazil

Colombia

Argentina

Bolivia

Ecuador

Peru

Mexico

Venezuela

Transfers Own-source revenues Other


Where the Region Stands

Even by the modest standards of the region, many Latin American coun-tries have serious deficiencies in subnational tax collections, based on their level of per capita income ( figure 5.4 ).

For example, Mexico and Brazil have similar per capita GDPs, but Brazilian subnational tax revenue is 20 times higher than Mexico’s. Although Guatemala and Bolivia have a relatively similar level of devel-opment, Bolivian subnational revenue is five times Guatemala’s. Figure 5.5 suggests that—in addition to Mexico and Guatemala—Costa Rica and Panama have an untapped potential of subnational tax revenue close to 1 percent of GDP, while El Salvador, Paraguay, and Peru could increase their subnational revenue by 0.6 to 0.8 percent of GDP to catch up with their Latin American peers. These comparisons are relevant because they sug-gest how far some countries could move ahead with local taxes using exist-ing tax powers and emulating successful experiences in other countries.

The subnational tax structure in Latin America focuses on taxes on economic activity, which generates distortions in some markets for goods and service ( table 5.2 ). For example, in Argentina, the gross receipts tax

Figure 5.4 Subnational Tax Collection and Per Capita GDP, Latin America, 2009

Source : Authors’ estimates based on IDB and CIAT ( 2012 ) and IMF ( 2011 b).

El Salvador

Nicaragua

Bolivia

Guatemala

EcuadorParaguay

HondurasPeru

Colombia

Costa RicaPanama

Argentina

Mexico

Brazil

Uruguay

Chile

Venezuela

0

2

4

6

8

10

12

5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0

Su

bn

atio

nal

tax

co

llect

ion

as

per

cen

tag

e o

f G

DP

Natural logarithm of per capita GDP


( impuesto sobre ingresos brutos ), which taxes sales on all stages and activi-ties, results in multiple taxation (Artana and Templado 2012 ). Similarly, in Colombia, the tax on industry and commerce imposes double taxation on the industrial sector (Zarama 2005 ).

Figure 5.5 Tax Gap of Subnational Governments, Latin America, 2009 (percentage of GDP)

Source : Authors’ estimates based on IDB and CIAT ( 2012 ) and IMF ( 2011 b).

Table 5.2 Composition of Subnational Taxes, Latin America, 2000–09 (percent)

Property Economic

activity Payroll Vehicle Property transfers Fuel

Sporting and cultural

events Gambling Other

Argentina 12.6 64.4 0 6.3 0 0 0 0 16.8Brazil 5.0 84.6 0 5.0 1.6 0 0 0 3.8Colombia 20.8 49.2 0 2.7 0 12.0 0 0 15.2Ecuador 29.4 31.0 0 0 2.3 0 3 0 34.3Mexico 27.6 2.1 39.7 1.8 18.0 0 0.1 0.6 10.1Panama 0 59.7 0 0 0 0 0 0 40.3Peru 54.1 15.8 0 7 0 0 1.6 5.7 15.9Venezuela 2.3 97.0 0 0 0.2 0 0.5 0 0

Note : Averages for 2000 ‒ 09, except for Chile (2001 ‒ 09), El Salvador (2004 ‒ 07), and Panama (2000 ‒ 08). Source : IDB ( 2012 b).

–2 –1 0 1 2 3 4 5 6 7 8

Costa Rica

Panama

Guatemala

Mexico

Paraguay

Peru

El Salvador

Ecuador

Honduras

Bolivia

Chile

Venezuela

Uruguay

Nicaragua

Colombia

Argentina

Brazil


In Brazil, the effective rates of the tax on consumption of goods and ser-vices (ICMS), which is the largest revenue raiser, vary widely among goods and services and from one district to another. This has led to “fiscal war” between states and high administrative costs for taxpayers (Ter-Minassian 2012 ). In Mexico, the main revenue raiser for the states—payroll tax—distorts the formal labor market, encouraging expansion of the informal labor market and negatively affecting productivity and economic develop-ment (D í az-Cayeros and McLure 2000 ).

Property taxes generate little revenue in Latin America, except in Peru, where they rank first in tax revenue raised by local governments. Overall in the region, property tax occupies a secondary position among subna-tional governments’ own-source revenue.

A miscellaneous set of minor taxes represents a significant fraction of subnational revenue in several countries. For example, in Mexico, the “other taxes” category includes taxes on real estate purchases and advertising, and a payroll surcharge. In Colombia, this category covers tax stamps, taxes on sports and entertainment events, and a contribution from public contractors.

In most countries, subnational governments have limited taxation powers. In many cases, local taxes are determined by national legislation, resulting in a waste of potential revenue. For example, property taxes are often underexploited because of delays in assessing property, which is a central government responsibility, or because the national authorities set very low rates.

Tax collection between the two levels of government—regional (state, provincial, or departmental) and local (municipality)—is asymmetric ( figure 5.6 ) due to the roles assigned to the administrative system in each country. In federal countries—Argentina, Brazil, and Mexico—regional governments have greater power and resources (and raise more revenue). In unitary countries, local governments are the main collectors of subna-tional revenue.

In most countries, the unequal distribution of tax bases results in the concentration of subnational revenue in a few areas. For example, four cit-ies in Bolivia (La Paz, Santa Cruz, Cochabamba, and El Alto) raise almost three-quarters of total municipal revenue. Similarly, in Colombia, five cit-ies (Bogot á , Medell í n, Cali, Barranquilla, and Cartagena) collect almost two-thirds of total municipal revenue. In Ecuador, two cities (Quito and Guayaquil) raise about half of municipal tax revenue. Almost two-thirds of total subnational revenue is collected in Argentina from the province and city of Buenos Aires; in Peru, from Lima; and in Brazil, from four


Brazilian states (Sao Paulo, Minas Gerais, Rio de Janeiro, and Rio Grande do Sul).

These results also reflect asymmetries in the tax effort inside each country and region. In Colombia in 2009, the average efficiency of collec-tion of property taxes was about 46 percent of collection potential, while for industry and commerce it was about 30 percent (S á nchez, Espa ñ a, and Zenteno 2011 ). There is also considerable dispersion between Colombian regions: as a proportion of their economic activity, the Andean region col-lected twice as much as the Caribbean region.

In Mexico in 2011, exploitation of potential tax revenue (relative to a hypothetical optimum calculated with econometric methods) fluctuated between about 2 percent in Campeche State to over 90 percent in the State of Mexico (Casta ñ eda and Pardinas 2011 ). Average efficiency in munici-pal governments ranges from 45 percent in the center of the country to over 60 percent in border areas. In Argentina, the subnational tax effort of Catamarca, Formosa, and Tucum á n provinces is greater than the prov-inces of Entre R í os and Santa Fe (Artana et al. 2012 ). In Brazil, differences in collection of property taxes reflect a clear geographic pattern: the South and Southeast perform better than the North and Northeast (De Cesare, Dantas, and Portugal 2012 ).

Figure 5.6 Composition of Subnational Own-Source Revenue by Level of Government, 2000 ‒ 09 (percent)

Note : All values are period averages. The periods vary for the following countries: Chile (2001 ‒ 09); El Salvador (2004 ‒ 07); and Panama (2000 ‒ 08). Source : IDB ( 2012 b).

0 10 20 30 40 50 60 70 80 90 100

Chile

El Salvador

Panama

Ecuador

Peru

Bolivia

Venezuela

Colombia

Mexico

Argentina

Brazil

Local Regional


Tailoring Reforms

When it comes to reforms to strengthen subnational governments’ capacity to raise their own revenue, one size does not fit all. Reforms must reflect the peculiarities of the various subnational government entities, including differences in the depth and system of tax decentralization. They must take into account the distortions caused by the existing tax system, and the limitations of alternative systems. In particular, they must factor in the high degree of informality in Latin American economies and the challenges this poses for tax collection (see chapter 4 ). Public support for taxation depends, among other factors, on taxpayers having access to essential public services and adequate infrastructure. But this is difficult when large segments of cities are occupied by slums and similarly large percentages of the population work in the informal economy. Including these marginalized sectors in tax collection is one of the main challenges facing subnational taxation.

Subnational revenue must be increased not only to reduce vertical imbalances but also to stabilize local spending, especially in countries that depend on highly volatile transfers from central governments. To boost revenue, some countries need to improve the return from existing taxes, while others need to create new tax bases, especially for regional govern-ments. Additionally, in several countries, reforms must reduce the distor-tions produced by some existing taxes, such as the gross receipts tax in Argentina, the ICMS in Brazil, and the payroll tax in Mexico (see box 5.1 ). Apart from reforming local taxes, other complementary reforms are desir-able, particularly the systems for transferring revenue from national to subnational governments, since these transfer systems can weaken local tax efforts.

Box 5.1 Reforming Subnational Taxes

Some local taxes create distortions, critics charge, notably the gross receipts tax ( impuesto a los ingresos brutos ) in Argentina, the ICMS and ISS in Brazil, and the payroll tax in Mexico. To address these distortions, various reforms have been proposed.

In Argentina, a proposal to replace the gross receipts tax with a provincial value added tax (VAT) or a retail sales tax has been suggested (Artana et al. 2012). In Brazil, a reform to replace the ICMS and ISS and consolidate VAT into a sin-gle tax supplemented with a retail sales tax in the municipalities has been pro-posed (Ter-Minassian 2012 ). In Mexico, a reform to replace the payroll tax with


A Sleeping Giant: Property Taxes

The tax on urban and rural property is greatly underutilized in Latin America, yet it is the number one candidate for increasing local tax col-lection in most jurisdictions. Receipts from this tax reached barely 0.37 percent of GDP during the 2000s, about half the figure in other devel-oping countries and only one-sixth of what is collected in OECD coun-tries (Sep ú lveda and Mart í nez-V á zquez 2009 ).

In Brazil, with some improvements in administrative tax management, revenue from property taxes could triple (De Cesare, Dantas, and Portugal 2012 ). In Colombia, correcting the number and value of properties and maintaining the effective rate of recent years could double receipts from property taxes (S á nchez and Espa ñ a 2012 ). 4

Administration of property taxes is complex. Most local governments are not in a position to independently develop or improve a global operat-ing model and would have to devote considerable resources to improv-ing tax collection capacity. The use of advanced technologies to keep the property registry updated and improve collection may be technically and financially unsustainable.

Political economy concerns also play an important role in the design and operation of property taxes. In Costa Rica, the balance of political power in municipal councils has led to higher revenue from the prop-erty tax in the cantons (Robalino 2012 ). However, in the year prior to

a single-stage retail sales tax and/or various excise taxes on goods and services, such as gasoline, electricity, and cell phones, has been discussed.

To adopt the proposed changes, certain limitations must be recognized. Although inefficient, these taxes raise considerable tax revenue. Any option must be at least neutral in terms of revenue and try to compensate the regions where tax revenues would decline.

The restrictions imposed by the current tax system also must be recognized. For example, to facilitate political acceptance of the reform in Brazil, it would be better to maintain the current level of the total tax burden and only pursue distri-bution within each level of government. In contrast, in Mexico, the subnational tax burden should be increased with taxes that create few distortions. But attempts to grant the states a single-stage sales tax have received little support in the federal Congress. Given the political constraints, implementation of changes in Mexican subnational taxation will require a comprehensive review of the country’s fiscal burden in order to achieve a better balance among all levels of government.

Source : Authors’ elaboration.


elections, receipts from this tax have typically fallen, especially in mu-nicipalities where the mayor and council were aligned with the ruling national party. Likewise, in Colombia, the probability of approving updated property values for the tax is higher when a larger number of parties are represented on the municipal council (S á nchez and Espa ñ a 2012 ). Property taxes in Mexican municipalities raise more revenue when there is a higher level of political competition, and less revenue when the mayor and governor belong to the same political party (Casta ñ eda and Pardinas 2011 ). 5

Given all these factors, the options for viable policy recommendations fall into three areas: technical and administrative support for municipal-ities with the greatest relative deficiencies; development of strategies for municipalities with greater capacity; and complementary national reforms covering all municipalities.

The first group of policies includes setting up of a national body or agency to support the less capable municipalities. This agency would pro-vide administrative support to develop competent local governments by providing standards, supervision, training, and technical assistance. The advice would not be binding, and each municipality would have flexibility in using the services offered.

For municipalities with more administrative capacity, six options could be considered: integrate the property registry with other databases managed by the organizations responsible for social policy, public ser-vices, and public registries, nationally and locally; combine traditional methods of property registration and valuation with self-reporting and self-assessment; adopt solutions to maximize the use of information in local government, creating a single property register and updating citi-zens’ personal data, which would be available to all municipal offices; maintain property valuations close to market value by making selection of the valuation method more flexible; disseminate information on prop-erty valuation to taxpayers, building confidence in the tax system; and recognize the importance of the tax payment system as an important part of the process.

National reforms to complement these local efforts include: applying legal measures to ensure regular property valuation; eliminating the polit-ical control exercised by the municipal legislative body over property valu-ations; defining minimum standards, close to market values, for national valuations, guaranteeing an acceptable level of interregional equity; inte-grating public registries and municipal land registries; using tax incen-tives to ensure that intergovernmental transfers guarantee more resources


for local governments, increasing their own-source tax receipts; and inte-grating rural and urban property taxes.

Strengthening Semiautonomous Tax Agencies

The capacity of subnational tax administrations is a serious constraint to increasing local revenue. The semiautonomous tax administration agen-cies that have been set up in some municipalities and regions have proved to be useful for this purpose. For example, the establishment of the Tax Administrative Service (SAT) in some Peruvian municipalities was an important step toward increasing municipal tax receipts. The revenue of municipalities that adopted SAT grew at an annual average of around 10 percent between 1998 and 2007, while those outside the system grew only 7 percent. This revenue increase seems to stem from less political interfer-ence in the administrative process, combined with a more client-oriented management that is more aware of customer service and less tolerant of corrupt practices. 6

Assigning New Taxes

To achieve an increase in own-source revenue, new tax bases need to be assigned to subnational governments in some countries. This would be particularly effective in the case of the intermediate governments (that is, provincial, regional) in Bolivia, Colombia, Peru, and Venezuela. In these countries, while municipalities have relatively strong tax bases, provinces, states, departments, and regions have very inelastic bases with limited col-lection capacity.

The ideal characteristics of a subnational tax are: a relatively stable tax base; equitable distribution of the tax base between states or regions; sig-nificant revenue potential; efficiency, which means low risk of creating distortions and negative externalities (in the same or in other regions); low sensitivity to economic fluctuations and other exogenous factors; low administrative costs; and low compliance costs. Table 5.3 evaluates how various types of subnational taxes fare in terms of these characteristics.

No single tax option is clearly superior to the others. For example, VAT enjoys very extensive collection potential but carries high administrative and compliance costs, which distort the location of companies. Payroll taxes have medium revenue potential and low administration and com-pliance costs, but can negatively impact efficiency and are very sensitive to the economic cycle. Property taxes, despite offering strong collection

Tabl

e 5.3

Pr

os a

nd C

ons o

f Pos

sible

Sub

natio

nal T

axes

Ba

se w

ith li

ttle

m

obili

ty

Effic

ienc

y Eq

uita

ble

dist

ribu

tion

of b

ase

Col

lect

ion

pote

ntia

l In

sens

itivi

ty

to cy

cle

Ease

of

adm

inis

trat

ion

Ease

of

com

plia

nce

Pers

onal

inco

me

tax

. . .

Pro

Con

Pro

Con

Con

Con

Cor

pora

te

inco

me t

axPr

oPr

oC

on . .

. C

on . .

. Pr

o

Inco

me t

ax

surc

harg

ePr

oPr

oC

on . .

. C

on . .

. Pr

o

Reta

il sa

les t

axC

onC

onC

on . .

. . .

. Pr

o . .

. Va

lue a

dded

tax

Con

Con

Con

Pro

. . .

Con

Con

Cor

pora

te v

alue

ad

ded

tax

. . .

. . .

Con

. . .

. . .

. . .

. . .

Exci

se ta

xes

Con

. . .

Con

. . .

Pro

Pro

Pro

Prop

erty

tax

Pro

. . .

. . .

. . .

Pro

. . .

Pro

Roya

lties

Con

Pro

Con

Pro

. . .

Pro

Pro

Cha

rges

for

serv

ices

Pro

. . .

Pro

. . .

. . .

. . .

. . .

Fina

ncia

l tr

ansa

ctio

ns ta

xC

onC

onC

on . .

. . .

. Pr

oPr

o

Stam

p du

ty . .

. C

onC

onC

onPr

oPr

oPr

oPa

yrol

l tax

. . .

Con

Con

. . .

Con

Pro

Pro

Impr

ovem

ents

ta

xPr

oPr

o . .

. . .

. Pr

oC

onPr

o

. . . :

not

a sa

lient

feat

ure o

f the

tax.

Sour

ce : A

utho

rs’ c

ompi

latio

ns.


potential and a fixed base, incur high administration costs. The final deci-sion as to which tax to adopt will depend on the particular conditions in each country, including the need for subnational revenues. The arguments for and against the subnational administration of certain taxes are dis-cussed in greater detail in the following sections.

Surcharge on National Income Tax Creating a surcharge on national income tax could reduce the fiscal dependence of small municipalities with tax collection problems. The mechanism would require every municipality to impose a surcharge on national income tax within a range set by the central government. The autonomy granted for fixing the surcharge would offer the benefits of direct competition between governments. Municipalities could help improve national tax collection by exchanging information with the central government and cooperating with inspections. The competition between municipalities would also benefit citizens by improving the quality of public services.

The return from this surcharge, however, would be limited by the low receipts from this tax. In the last 20 years, personal income tax in the region has contributed around 2.5 percent of GDP (see chapter 7 ). The impact of this proposal would also be limited by the existence of high nontaxable minimums on national income, relatively high marginal rates, high levels of informality, and complex administration of the tax.

Although the surcharge on national income tax would not raise a sig-nificant amount of resources in the short term, it could become a signifi-cant source of funds in those municipalities with inadequate management capacity. For example, in Venezuela, a 1 percent surcharge would bring in revenue equivalent to 8 percent of municipalities’ own-source revenue (R í os, Ortega, and Scrofina 2011). In Bolivia, a 1 percent surcharge on national income tax would yield revenue of between 0.08 percent and 0.13 percent of GDP, depending on whether the minimum base for application was four or two minimum wages, respectively (Brosio 2012 ).

Corporate Value Added Tax This type of tax would be similar to the regional tax on productive activities (IRAP) created in Italy in 1998. The IRAP base is basically the same as the traditional VAT, calculated as the difference between sales revenue and the sum of all purchases and depreciation. IRAP is, there-fore, a tax levied on a VAT-based source. The rate applied by the Italian central government is 4.25 percent, which the regions may increase or


decrease by 1 percentage point. IRAP contributes about 2.5 percent to Italian GDP.

Application of this type of tax could generate significant subnational revenue in some countries in Latin America. It would be relatively easy to administer because taxpayers are currently paying VAT. However, to collect the tax, subnational governments would require a certain level of administrative capacity, which in many cases is lacking. It is also likely that only a portion of this tax could be used as credit against corporate taxes in other countries, which would be a disincentive to foreign invest-ment. Moreover, this type of VAT acts in favor of imports and against domestic production and exports because it is not deductible from the tax base. Last, it is an additional tax on labor, and therefore could produce undesirable effects on wages, employment, and informality.

Retail Sales Tax The retail sales tax offers another alternative for raising new subna-tional revenue. Some Latin American countries have experimented with excise taxes on sales of products such as liquor, tobacco, and gasoline. A single-phase sales tax charged to final consumers can be an improvement over taxes on production and sales imposed on companies in many coun-tries because it does not have the “cascade” effects of multiple taxation. However, this type of tax is not easy to administer due to the high rate of informality prevalent in the economies of the region 7 and because retail sectors are often very “atomized” and have little capacity to properly main-tain the accounting records required for control. This tax would probably be viable in countries with lower levels of informality where formal com-merce is more prevalent.

In addition, the tendency to grant exemptions from wholesale taxes would severely erode the collection capacity of these taxes. Last, results for Colombia suggest that the application of a sales tax to raise local revenue would have a greater impact in the more developed regions. This could intensify inequalities within countries, although the disparities would be less than that caused by taxes based on production or income (S á nchez, Espa ñ a, and Zenteno 2011 ).

Subnational VAT (or Surcharge on National VAT) A subnational VAT (or a surcharge on existing national VAT) promises higher revenue potential than some other alternatives. For example, if Venezuela applied a 1 point surcharge on VAT, it could generate a 13 per-cent increase in the revenues of the states (R í os, Ortega, and Scrofina 2011).


However, the increase would be unequal across states since it would ben-efit the states with large urban populations to the detriment of the more rural states. In Mexico, a surcharge on VAT would have a similar impact, without broadening the tax base and redefining the criteria for allocation of revenue sharing. It would also negatively impact the distribution of rev-enue between Mexican states (Casta ñ eda and Pardinas 2011 ).

Although VAT’s capacity to generate tax revenue is well known (see chapter 9 ), the Brazilian experience illustrates the practical problems posed by this tax at the subnational level. The difficulties of maintain-ing good records of commercial transactions between states with different tax systems complicate administration of a subnational VAT and result in high compliance costs.

Excise Taxes Another possible source of new tax revenue for subnational governments could be excise taxes. Alternatives include a surcharge on national excise taxes, a tax on public services such as electricity and mobile phones, a regional and/or local fuel tax, and a tax on tourism. Where these taxes have been implemented, they generate moderate amounts of revenue with low administrative and compliance costs for taxpayers. Moreover, these taxes can be attractive because taxation on public services creates fewer distortions due to the low price elasticity of demand.

However, these taxes should be used with caution since they can dis-courage consumption of goods and services with positive externalities. Taxes on sales of certain inputs, such as fuel and electricity, also affect production costs in industries where they are used intensively, with a consequent loss of competitiveness. To reduce economic distortions, residential electricity consumption should be the main tax base, as shown in Peru (Canavire-Bacarreza, Mart í nez-V á zquez and Sep ú lveda 2012 ).

Green Taxes Green taxes, also known as environmental taxes, can be an innovative source of subnational revenue. Since many of the negative effects on the environment are localized, a wide range of green taxes can be applied by subnational governments to mitigate these effects (see chapter 11 ). Examples are taxes on air pollutants such as carbon dioxide (CO 2 ), sulfur dioxide (SO 2 ), nitrogen dioxide (NO 2 ), and fuels; on transport in the form of a tax on car sales or traffic; and on waste products such as tires, bev-erage containers, plastic bags, and batteries, among others.


One of the most interesting green taxes is a congestion charge in cities. Establishing tolls for entering congested areas in a city or to access certain routes can be a way to reduce the negative externalities of traffic, such as congestion, accidents, and pollution. Another attractive alternative for local governments is charging for management of solid and liquid waste to cover handling costs and discourage their generation.

Although their collection potential may be limited in the short term, green taxes can help correct externalities, make the development of cities more fiscally and environmentally sustainable, and facilitate provision of certain local services.

Betterment and Valorization Tax Another option is to charge for the betterment arising from public in-vestment by local governments. Based on the benefits provided in a given geographical area, the local government can charge for improvements to property that has benefitted from public investment. This tax tends to be a single payment in a specific period of time to cover all or part of the investment.

Although this tax exists legally in most countries of the region, it is rarely implemented because it demands considerable local institu-tional capacity and because the public often resists it. However, as seen in Colombia, where this instrument has a long history of continuous (if irregular) application, it can be an important source of tax resources in some cities. 8

Complementary Reforms

A number of complementary reforms would further strengthen subna-tional taxation. These range from reforms of existing transfer systems, to changes in the systems for allocating revenue from nonrenewable natural resources and development of revenue stabilization mechanisms.

The existing transfer systems discourage the tax effort of subnational governments in many countries in the region. In Argentina, discretionary transfers reduce own-source revenue and stimulate more public invest-ment (Artana et al. 2012). In Peru and Venezuela, transfers to subnational governments of revenue from natural resources adversely affect the local tax effort (Canaviere-Bacerreza, Mart í nez-V á zquez, and Sep ú lveda 2011; R í os, Ortega, and Scrofina 2011). In Colombia, transfers decrease the like-lihood of updating municipal property registries (S á nchez and Espa ñ a 2012 ).


The reforms needed in this area include clear ground rules that create incentives for the subnational tax effort and simplification of the transfer system. Systems that attempt too much at the same time end up failing.

Transfers from exploitation of nonrenewable resources create severe interregional distortions. Besides the evident regional inequalities in income distribution, the extreme variability of the prices of oil and cer-tain minerals also results in extreme volatility in the public finances of the beneficiary regions. To correct these limitations, the rules for distribution of revenue from mineral and hydrocarbon production must establish dis-tribution systems for all regions; implement savings schemes to smooth subnational expenditures financed by those revenues; and implement sys-tems to monitor and control the use of resources, which should be linked to the outcome indicators of the projects financed.

In most countries, transfers are determined by current government rev-enues, which tend to fluctuate sharply with the domestic economic cycle and with the prices of some export products. Through this transmission channel, the resources of subnational governments are subject to uncer-tainty and volatility. The procyclical nature of transfers to subnational governments reinforces the procyclical behavior of national fiscal policies and intensifies fiscal crises. As a result, subnational governments need a stabilization and savings system to correct the volatility of transfers.

Strengthening Local Development

Subnational tax revenue has great untapped potential. Apart from helping finance local spending, it could improve the accountability and transpar-ency of subnational fiscal management. But this potential is difficult to exploit. Proposals for reform of subnational tax systems aim to improve the use of existing tax powers, especially in relation to property taxes, both rural and urban. The reforms also seek to strengthen subnational tax administrations. Subnational governments can also benefit from new taxes through surcharges on existing national income and consumption taxes or new excise and/or green taxes.

There is no single recipe for implementing these suggestions because they depend on the degree of economic and social development at the national and local levels, the capacity of subnational governments, and political constraints. The final objective of any reform must be to boost local development. Consequently, in addition to assuring effective collec-tion, any reform must consider economic efficiency, distributive equity, and environmental sustainability.

6

Making the Most of Tax Administration

Without an institution to collect taxes, taxation is nothing more than inert legislation. Even the best tax code has no life without the

support of a collection agency. But the role of tax administrations goes beyond revenue collection. A tax administration that aspires to be a de-velopment tool should be determined to reduce tax evasion and provide the best possible service to taxpayers—to the point of being considered a necessity in their business and personal progress, rather than that feared institution that goes after their money.

Tax administrations in Latin America and the Caribbean have achieved significant advances. Over the last two decades, tax collection as a per-centage of GDP has increased by over 30 percent in the region. Part of this increase owes to improvements in tax administration. In many countries, tax administrations now boast technical and budgetary autonomy and well-trained professional staff. Their collection function has been empha-sized, focused on large taxpayers, and has been supported by the extensive use of technology.

However, the remaining challenges are perhaps even bigger than the achievements. A large number of workers and firms in the region never interact with the tax administration. Some are exempt from filing taxes by law. Many simply hide from the tax administration by resorting to elusion strategies or outright illegal evasion. As discussed in part II of this book, better tax design can help improve tax compliance. But the tax administration needs to make this happen. Poor audit capacity and client services combines with weak tax morale to make tax evasion so-cially acceptable in some Latin American countries. These are priority areas for tax administrations to make the leap forward and become a development tool.


Steps Forward: Resources and the Autonomy to Manage Them

This chapter takes advantage of a comprehensive survey of tax administra-tions in 17 countries in the region. 1 The survey, the first of its kind in Latin America, was conducted jointly by the Inter-American Development Bank (IDB), the Inter-American Center of Tax Administration (CIAT), and the International Monetary Fund (IMF) and consists of more than 300 ques-tions that have been standardized to allow full comparability across Latin American countries and also with OECD countries. The survey focuses on the functions of tax administrations dedicated to collecting domestic taxes, excluding social security contributions and customs duties. The tax administration covers all three sources of revenue in only three countries: Argentina, Brazil, and Peru ( table 6.1 ). 2 In contrast, in the OECD, the integration of taxes and social security is more common.

Many countries in the region have granted tax administrations signifi-cant autonomy and flexibility. The survey shows that tax administrations have an important degree of autonomy in 11 of 17 Latin American coun-tries. In this respect, Latin America is in line with global trends. For in-stance, in the OECD, about 20 tax administrations have autonomy versus 14 that do not (OECD 2011 c).

Financial autonomy is perhaps the litmus test of true autonomy. Technical autonomy is necessary but not sufficient to allow modern administrations to operate adequately. In this respect, it is encouraging that tax administrations count on not only increased technical autonomy but also substantially higher financial resources compared to previous years. Importantly, tax administrations appear to be relatively efficient. On average, operational costs account for about 1.4 percent of total rev-enue collection, compared with 1 percent in the OECD. 3 The allocation of the budget for personnel costs is also in line with the OECD. However, capital expenses, at 3.7 percent of the budget, are clearly insufficient, sig-naling a potential threat to the future of tax administrations ( figure 6.1 ).

Tax administrations in the region also have better human resources than in the past. Staff levels increased by 9 percent on average from 2006 to 2010. However, there is scope to improve the allocation across functions. About 30 percent of staff regionwide works in overhead activities—double the share of the OECD—at the expense of audit and collection ( figure 6.2 ). With respect to qualifications, hiring practices generally target candidates with sufficient education, and most tax administrations require specific qualification exams. About 56 percent of staff in tax administration has a postsecondary degree, surpassing the average of 46 percent in the OECD.

Tabl

e 6.1

Le

gal N

atur

e and

Fun

ctio

n of

Tax

Adm

inis

trat

ion

Off

ices

Le

gal n

atur

eFu

nctio

ns

One

or s

ever

al

unit(

s) lo

cate

d in

the

Min

istr

y of

Fin

ance

(o

r its

equi

vale

nt)

Aut

onom

ous b

ody

or d

epen

dent

on

Min

istr

y of

Fi

nanc

e (or

its e

quiv

alen

t), w

ith so

me o

r tot

al

auto

nom

y in

hum

an re

sour

ces a

nd b

udge

t in

rela

tion

to th

e res

t of t

he p

ublic

adm

inis

trat

ion

Adm

inis

trat

ion

of d

omes

tic

taxe

s

Adm

inis

trat

ion

of cu

stom

s du

ties

Adm

inis

trat

ion

of so

cial

secu

rity

co

ntri

butio

ns

Arg

entin

aN

oYe

sYe

sYe

sYe

sBo

livia

No

Yes

Yes

No

No

Braz

ilYe

sN

oYe

sYe

sYe

sC

hile

No

Yes

Yes

No

No

Col

ombi

aN

oYe

sYe

sYe

sN

oC

osta

Ric

aYe

sN

oYe

sN

oN

oD

omin

ican

Rep

.N

oYe

sYe

sN

oN

oEc

uado

rN

oYe

sYe

sN

oN

oEl

Sal

vado

rYe

sN

oYe

sN

oN

oG

uate

mal

aN

oYe

sYe

sYe

sN

oH

ondu

ras

No

Yes

Yes

Yes

No

Mex

ico

No

Yes

Yes

Yes

No

Nic

arag

uaN

oYe

sYe

sN

oN

oPa

nam

aYe

sN

oYe

sN

oN

oPa

ragu

ayYe

sN

oYe

sN

oN

oPe

ruN

oYe

sYe

sYe

sYe

sU

rugu

ayYe

sN

oYe

sN

oN

o

Sour

ce : A

utho

rs’ c

ompi

latio

n ba

sed

on ID

B, C

IAT,

and

CA

PTAC

-DR/

IMF

( 201

2 ).

b. Cost of Revenues as Percentage of Net Tax Revenue and GDP, 2010

Note : The values in parenthesis represent the cost of revenues as percentage of GDP. Source : Authors’ calculations based on IDB, CIAT and CAPTAC-DR/IMF ( 2012 ).

Figure 6.1 Tax Administration Costs

a. Breakdown of Budget Executed and Administrative Costs, 2010

0 10 20 30 40 50 60 70 80 90 100

Paraguay

Costa Rica

Bolivia

Guatemala

Panama

Dominican Rep.

Peru

Ecuador

Brazil

El Salvador

Nicaragua

Chile

Mexico

Honduras

Uruguay

Argentina

Percent

Staff expense Rest of current expense Capital expense

(0.04%)

(0.1%)

(0.2%)

(0.1%)

(0.1%)

(0.1%)

(0.1%)

(0.3%)

(0.2%)

(0.1%)

(0.2%)

(0.2%)

(0.2%)

(0.7%)

(0.3%)

(0.2%)a

0 0.5 1 1.5 2 2.5 3

Mexico

Costa Rica

Bolivia

Ecuador

Nicaragua

Guatemala

Peru

Uruguay

Argentina

Panama

El Salvador

Domincan Rep.

Chile

Paraguay

Brazil

Honduras

Percent

Cost of revenue as a percentage of net tax revenue

MAKING THE MOST OF TAX ADMINISTRATION 103

In some cases, tax administrations even have their own human resource and compensation policies. Notably, all tax administrations in the region have compensation levels that are at least on par with the rest of the public administration, and in eight countries, compensation is significantly higher. Moreover, variable compensation schemes aligned with results are becoming a widespread practice.

Finally, tax administrations have access to a significant amount of information. At the very least, tax administrations have been granted autonomy to obtain this information ( table 6.2 ). Yet information is not being exploited to its full potential (Jim é nez, G ó mez-Sabatini, and Podest á 2010 ; Pecho, Pel á ez, and S á nchez 2012 ). The challenge for tax adminis-trations is to maintain reliable and high-quality information and use it to actively undertake risk analysis and monitor compliance with the tax code. In cases where customs and social security are not covered under the same agency, it is crucial not only to exchange but share information to boost enforcement potential. This is true across agencies at the national and subnational levels. It is also increasingly important at the international level. For example, while in the OECD there are 63 double taxation treaties and information exchange conventions, there are fewer than 10 in Latin America ( table 6.3 ). And most countries in the region lack specialized units on international taxation, undermining effective control (Velayos 2007 ).

Figure 6.2 Allocation of Tax Administration Staff by Function, 2010

Source : Authors’ calculations based on IDB, CIAT and CAPTAC-DR/IMF ( 2012 ).

0 20 40 60 80 100

Panama

Dominican Rep.

Ecuador

Peru

Chile

Colombia

El Salvador

Paraguay

Nicaragua

Costa Rica

Uruguay

Mexico

Argentina

Guatemala

Percent

Inspection, collection, andlegal services

Orientation, computer support, and administration

Senior management

Tabl

e 6.2

So

urce

s of S

yste

mat

ic In

form

atio

n U

sed

by T

ax A

dmin

istr

atio

ns

Argentina

Bolivia

Brazil

Chile

Colombia

Costa Rica

Dominican Rep.

Ecuador

El Salvador

Guatemala

Honduras

Mexico

Nicaragua

Panama

Paraguay

Peru

Uruguay

With

hold

ings

from

wor

kers

✓

✓

✓

✓

✓

✓

✓

✓

✓

✓

– ✓

✓

✓

–

✓

✓

With

hold

ings

of i

nter

est,

capi

tal

gain

s, an

d di

vide

nds

✓

– ✓

✓

✓

✓

✓

✓

✓

✓

–

✓

✓

✓

✓

✓

✓

Prop

erty

tran

sfers

(rea

l est

ate,

vehi

cles

, shi

ps, a

nd o

ther

s) ✓

–

✓

✓

✓

– ✓

✓

✓

–

– ✓

–

✓

✓

✓

✓

Purc

hase

s, sa

les,

and

prov

ision

of

serv

ices

pro

vide

d by

com

pani

es

and

prof

essio

nals

✓

✓

✓

✓

✓

✓

✓

✓

✓

✓

– ✓

✓

✓

✓

✓

–

Publ

ic-s

ecto

r pur

chas

es–

✓

✓

– ✓

✓

✓

✓

✓

✓

✓

✓

–

– ✓

✓

✓

Pu

blic

-sec

tor s

ubsid

ies

––

✓

– ✓

–

––

✓

––

✓

––

––

–Lo

tter í e

s, pr

izes

, and

tom

bola

✓

– ✓

–

✓

––

✓

✓

––

✓

––

––

–Cu

stom

s ✓

✓

✓

✓

✓

–

✓

✓

✓

✓

✓

✓

✓

––

✓

✓

Fina

ncia

l sys

tem

(ass

et a

nd

liabi

lity

oper

atio

ns)

✓

– ✓

✓

✓

–

– ✓

✓

–

– ✓

–

– ✓

✓

–

Cred

it ca

rds

✓

✓

✓

– ✓

✓

✓

✓

✓

✓

✓

✓

✓

–

✓

✓

✓

Use

of h

igh

deno

min

atio

n ca

sh–

– ✓

–

✓

––

––

––

✓

––

––

–Tr

ansp

ort o

f val

uabl

es ✓

–

––

––

––

––

– ✓

–

––

––

Insu

ranc

e–

––

– ✓

–

✓

––

✓

– ✓

–

––

✓

–Pu

blic

com

plai

nts

– ✓

✓

–

––

✓

✓

– ✓

–

✓

––

– ✓

–

– =

the t

ax a

dmin

istra

tion

does

not

hav

e acc

ess t

o th

e sou

rce o

f inf

orm

atio

n. So

urce

: Aut

hors

’ com

pila

tions

bas

ed o

n ID

B, C

IAT,

and

CA

PTAC

-DR/

IMF

( 201

2 ).

Tabl

e 6.3

M

ost R

elev

ant A

spec

ts o

f Int

erna

tiona

l Tax

atio

n

Li

ftin

g of

ban

k se

crec

y a

Tran

sfer

pri

cing

(TP)

In

tern

atio

nal t

axat

ion

units

(ITU

s) b

Dou

ble t

axat

ion

trea

ty

(CD

T) a

nd a

gree

men

ts o

n in

form

atio

n ex

chan

ge (A

II) c

TP re

gula

tions

be

fore

Jan.

1, 2

008

TP re

gula

tions

af

ter J

an. 1

, 200

8 Pr

ior t

o Ja

n. 1

, 200

8 A

fter

Ja

n. 1

, 200

8

Arg

entin

aYe

sYe

sN

oYe

sN

o23

Barb

ados

Yes

Yes

No

Yes

No

23Bo

livia

No

No

No

No

No

7Br

azil

Yes

Yes

No

Yes

No

32C

hile

Yes (

2009

)Ye

sN

oYe

sN

o24

Col

ombi

aYe

sYe

sN

oYe

sN

o4

Cos

ta R

ica

No

No

Yes d

No

No

3D

omin

ican

Rep

. N

o e Ye

s f N

oN

oYe

s2

Ecua

dor

Yes (

2009

)Ye

sN

oYe

sN

o13

El S

alva

dor

Yes

No

Yes g

No

No

1G

uate

mal

aN

oN

oYe

sN

oN

o1

Hon

dura

sN

oN

oYe

sN

oN

o0

Jam

aica

No

Yes

Yes

No

12 g

Mex

ico

Yes

Yes

–Ye

sN

o49

Nic

arag

uaN

oN

o–

No

No

0Pa

nam

aYe

s (20

10)

No

Yes

No

Yes

8Pa

ragu

ayN

oN

o N

o h N

oYe

s2

Peru

No

Yes

No

Yes

No

5Tr

inid

ad a

nd T

obag

oN

oN

oN

oYe

sN

o15

Uru

guay

Yes (

2010

)N

oYe

sN

oYe

s6

a Eva

luat

ed in

acco

rdan

ce w

ith in

tern

atio

nal s

tand

ards

. b Spe

cial

ized

uni

ts o

r are

as d

edic

ated

to ad

min

istra

tion

of in

tern

atio

nal t

axat

ion

mat

ters

. c In th

e ca

se o

f the

AII

s, al

l tho

se li

sted

com

ply w

ith in

tern

atio

nal s

tand

ards

(see

rela

ted

sect

ion

in th

is ch

apte

r). S

ome C

DTs

may

be o

ld a

nd d

o no

t com

ply.

Inclu

des

mul

tilat

eral

s suc

h as

Car

icom

, CA

N d

ecisi

on 5

78, a

nd A

II m

ultil

ater

als (

all c

ount

ed as

one

). d B

ill aw

aitin

g fin

al p

assa

ge in

the A

ssem

bly.

e Can

acce

ss b

ank

info

rmat

ion

of n

onre

siden

ts, b

ut p

roba

bly d

oes n

ot co

mpl

y with

the i

nter

natio

nal s

tand

ards

(EI).

f Inco

mpl

ete a

ccor

ding

to g

ood

inte

rnat

iona

l pra

ctic

es.

g Cou

ntin

g C

aric

om as

a sin

gle e

ntity

. h Alth

ough

Par

agua

y has

rece

ntly

beg

un p

erfo

rmin

g aud

its co

ntro

lling

com

mod

ity ex

port

s in

acco

rdan

ce w

ith

inte

rnat

iona

l pric

es, t

hese

actio

ns a

re b

ased

on

the g

ener

al a

ntifr

aud

regu

latio

ns o

f its

Tax

Cod

e. Th

ere a

re n

o tr

ansfe

r pric

ing

(TP)

regu

latio

ns as

such

in ef

fect

. So

urce

: Aut

hors

’ com

pila

tions

bas

ed o

n ID

B, C

IAT,

and

CA

PTAC

-DR/

IMF

( 201

2 ).


To a large extent, increased autonomy and resources have gone hand in hand with increased accountability. But much progress remains to be made in improving planning and evaluation systems. With the exception of Panama, all tax administrations in the region prepare and approve stra-tegic and operations plans. However, planning is mostly a formal process and cannot link objectives with operations and results. These are areas where further efforts are clearly needed to make the most of resources and the autonomy to manage them.

The Leap Forward: Enforcement

Despite significant progress, tax evasion remains rampant in most coun-tries in the region, as discussed in chapter 1 . The design of tax systems, the perception of the quality of public services, and even culture are all fac-tors that influence the incentives to comply with taxes. But enforcement efforts by the tax administration are also critical to raise the chances that tax evaders and fraudsters will be detected and charged in cases of noncompliance.

Figure 6.3 Technological Support to Tax Administration

Source : Authors’ calculations based on IDB, CIAT, and CAPTAC-DR/IMF ( 2012 ).

0

2

4

6

8

10

12

14

Data warehouse Sectoral studiesand inspection

guidelines

Electronic invoicein place

Audit software Verification byInternet

Tax printers

Num

ber

of c

ount

ries

ArgentinaBoliviaBrazilChileColombiaEcuadorGuatemalaMexicoPeru

ArgentinaChileDominicanRep.EcuadorGuatemalaMexicoParaguayPeruUruguay

ArgentinaBrazilChileDominicanRep.Mexico

ArgentinaBrazilChileColombiaCosta RicaDominican Rep.EcuadorEl SalvadorGuatemalaMexicoParaguayPeruUruguay

ArgentinaBoliviaBrazilChileCosta RicaDominicanRep.EcuadorPeruUruguay

ArgentinaBoliviaBrazilChileColombiaCosta RicaDominicanRep.EcuadorGuatemalaMexicoPeruParaguayUruguay


Most tax administrations in Latin American countries have formal audit planning, issue internal audit protocols, and evaluate audit perfor-mance. Auditors also count on sector studies, guidelines, and manuals in many countries. Moreover, there have been cutting edge innovations in tax control in the region, such as electronic billing, prior verification of taxpayer documents, and the use of cash registers issued and monitored by the tax administration ( figure 6.3 ). This last innovation, implemented in Argentina, Brazil, Chile, the Dominican Republic, and Mexico, has shown promising results and could be considered in more countries in the region.

Yet the chances of being subject to a tax audit in the region are minimal. To start with, few people are registered taxpayers—only 10.1 percent of the population in Latin America is registered, in contrast with 59.2 percent in the OECD ( table 6.4 ). 4 Among registered taxpayers, only 2.8 percent are subject to mass audits per year, and a negligible 0.2 percent are subject to in-depth audits ( table 6.5 ). Mass audits hold big potential, both in terms of revenue collection and increased voluntary compliance. Moreover, they

Table 6.4 Registered Taxpayers, Active Taxpayers, and Nonfilers

Active taxpayers

(percent of population)

Active taxpayers

(percent of registered)

Nonfilers, by type of tax (percent of active taxpayers)

Consumption tax/VAT Income tax

Corporate tax

Argentina 11.2 43.9 48.2 18.2 30.4Brazil 5.4 74.8 n.d. n.d. n.d.Chile 22.1 80.2 14.7 0.1 0.6Costa Rica 11.0 n.d. 24.0 n.d. n.d.Dominican Rep. 1.5 59.3 42.4 12.8 35.4Ecuador 10.8 57.9 33.0 82.5 60.4El Salvador 9.6 n.d. 28.7 n.d. n.d.Guatemala 4.4 71.9 13.1 43.7Honduras 1.6 99.0 3.9 19.9 26.1Mexico 30.8 86.1 35.2 27.4 46.7Nicaragua 3.1 81.2 n.d. 75.1 21.4Panama 5.3 14.8 n.d. n.d. n.d.Paraguay 7.1 81.6 39.1 n.d. n.d.Peru 17.3 69.7 n.d. n.d. n.d.Uruguay 10.0 34.5 44.2 19.1 36.5 Average 10.1 65.8 29.7 33.2 32.2

n.d.: no data available. Source : Authors’ compilations based on IDB, CIAT, and CAPTAC-DR/IMF ( 2012 ).


can be performed directly in the offices of the tax administration by staff with medium levels of technical training, with the guidance of detailed manuals. 5 In turn, in-depth audits can be targeted to the more advanced forms of tax fraud. In this last respect, risk analysis is becoming more common practice, especially in South America—a practice worth repli-cating elsewhere.

Even if fraud or other improprieties are detected, sanctions are not applied with sufficient rigor. On paper, applicable sanctions for noncom-pliance in the region are in line with those in advanced countries. Similarly, tax fraud is well defined in legislation. But sentences are almost nonexis-tent. On average, three sentences per year are handed down in each Latin American country. In a few countries, there has not been a single sentence for tax fraud in the past five years. (Exceptions are Chile, Colombia, and Mexico, where the number of sentences has been reasonable.) This creates the social perception that sanctions applied by the tax administrations are not effective, undermining voluntary compliance with the tax code.

As a result of these factors, the revenue impact per audit is a meager 1.6 percent of overall tax collection. Excluding Mexico, which appears to be an outlier in the region, the average falls to 0.9 percent ( table 6.6 ). This is

Table 6.5 Invoice Controls, Mass Audits, and In-depth Audits, 2010

Invoice controls Mass audits In-depth audits

Number of taxpayers inspected

Percent of active

taxpayers inspected


Percent of active

taxpayers inspected


Percent of active

taxpayers inspected

Argentina 78,632 1.7 74,500 1.6 18,396 0.4Bolivia 844 n.d. 5,773 n.d. 52 n.d.Chile 225,524 5.9 565,373 14.8 7,693 0.2Colombia 6,948 0.1 8,676 n.d. 38,373 n.d.Costa Rica n.d. n.d. 1,633 0.3 635 0.1Dominican Rep. 6,122 4.2 5,261 3.6 268 0.2Ecuador 159,290 10.0 19,352 1.2 626 0.0El Salvador 180 0.0 5,383 1.0 572 0.1Guatemala 62,826 10.0 5,739 0.9 4,789 0.8Mexico 75,313 0.2 57,820 0.2 26,465 0.1Panama 153 0.1 n.d. n.d. 413 0.2Peru 5,218 0.1 102,193 2.0 1,738 0.0 Average n.d. 3.2 n.d. 2.8 n.d. 0.2

n.d.: no data Source : Authors’ compilations based on IDB, CIAT, and CAPTAC-DR/IMF ( 2012 ).


about one-fourth the amount collected per audit in the OECD. Another worrisome fact is that the stock of collected debt amounted to only 26.8 percent of the audit-determined debt in 2010. Projections in figure 6.4 sug-gest that debt overdue will rise significantly in the next five years. To close the enforcement cycle, it is important that debt collection be undertaken by the tax administrations, rather than the judiciary system, which tend to be less effective in recuperating tax debts.

Table 6.6 Total Audit Determined Debt Objected and Collected in Mass Audits, 2010

Debt collected (percentage of audit determined debt)

Effective revenue from inspection (percentage of net tax revenue)

Argentina 27.8 0.4Bolivia 7.6 0.8Chile 55.5 1.8Dominican Rep. 10.7 0.3El Salvador 26.2 1.2Mexico 41.7 7.2Nicaragua 9.3 0.7Panama 56.3 1.1Peru 6.0 0.5 Average 26.8 1.6

Source : Authors’ compilations based on IDB, CIAT, and CAPTAC-DR/IMF ( 2012 ).

Figure 6.4 Tax Debt in Select Latin American Countries

a. Percentage of Debt Collected Compared to Delinquent Debt Recovered

0 10 20 30 40 50 60 70 80

Uruguay

Honduras

Bolivia

Mexico

Dominican Rep.

Argentina

Costa Rica

El Salvador

Nicaragua

Chile

Percent


These are all indications that tax administrations in the region still have a long way to go. The small revenue impact of audits, coupled with rising levels of uncollected debt, reflects not only the poor quality of audit func-tions within the institution, but also poor overall quality of the taxpayer registry, the data available, the tax returns, and collection capacity.

Tax Administration for Development

Tax administrations currently stand at a crossroads. They have made important strides in the last two decades. At the same time, they face challenges that may be as important as the achievements. Some of these include the old suspects in the pending structural agenda of the region, most notably addressing extensive informality and evasion of taxes. Some loom new on the horizon, such as preparing to implement a tax code that will surely become more complex, given a greater emphasis on income taxes and the impact of globalization. Moreover, new forms of fraud, money laundering, and organized crime call for revamped training and monitoring capacity for tax administrations, in sync with other special-ized units, such as police intelligence.

To take the leap forward, tax administrations must tackle these chal-lenges with determination. They must continue their evolution from an

b. Tax Debt in Select Latin American Countries: Projection of Accumulated Debt for 2015

Source : Authors’ calculations based on IDB, CIAT, and CAPTAC-DR/IMF ( 2012 ).

0 200 400 600 800 1000 1200 1400 1600

Uruguay

Honduras

Bolivia

Mexico

Dominican Rep.

Argentina

Costa Rica

El Salvador

Nicaragua

Chile

Figure 6.4 Continued


organizational model based on different functions to one centered on the taxpayer as a client. The success of large taxpayer units demonstrates the positive impact of focusing on taxpayer characteristics and the potential for models based on cooperation rather than pitting one interest against another (V á zquez-Caro and Bird 2011 ). Tax administrations also must pursue new models for small taxpayers, where informality is most perva-sive. As discussed in chapter 12 , existing special regimes for small firms have not lived up to their promise. Specialized units for small taxpayers that emphasize technical assistance and a transition to the general tax base may be the way forward.

Tax administrations should not go it alone. The institutional frame-work to comply with tax obligations calls for a more encompassing system of revenue institutions, which includes not only revenue agencies such as tax administrations, customs, and social security institutes, but also administrative and judicial tribunals; business, land, and civil registries; vehicle and business registries; and other institutions that gather critical information on economic agents and economic assets. Strong coordina-tion and information exchange are essential for a concerted enforcement effort that can also provide quality services to clients.

Finally, tax evasion must cease being socially tolerated. Compliance should be Latin-American tax administrations’ paradigm, focused on taxpayer-client models that need to be reinforced with the appropriate incentive schemes. This implies both rewarding compliance and sanc-tioning evasion quickly and fairly. The analysis in the chapter shows significant deficiencies in strategic planning, auditing, and debt collec-tion—key functions that promote voluntary compliance and characterize modern tax administrations. Improvements in these areas must constitute the center of a second generation of reforms, which may be politically and technically complex and demanding but are absolutely fundamental.

The outlined steps will increase the legitimacy of the tax regime. So will efforts to reassure taxpayers that their tax payments are being used to fund socially beneficial public goods and services. The transformation will not be complete until social norms evolve to make taxation a daily part of civic life and encourage taxpayers to behave as clients rather than masters of disguise.

Part II

The Trees: Tax by Tax

7

Personal Income Tax: An Empty Shell

Income tax is the backbone of the tax system in many countries because it is the tax that historically has raised the most revenue and has the

greatest redistributive power. However, in Latin American countries, the potential of income tax to raise revenue falls short and its redistributive potential is poorly exploited.

This chapter deals with the income tax of individuals, where these shortcomings are even more pronounced. Despite very progressive regimes officially, very few individuals actually pay personal income tax. Consequently, its capacity to complement corporate income tax and affect work performance, the various forms of capital, as well as savings and investment decisions is limited. 1

Because of its revenue raising potential and the incentives for civic responsibility that it creates, income tax, especially on individuals, is one of the three pillars of the tax system in modern democracies (the other two are VAT and social security contributions; see chapter 1 ). In developed coun-tries, on average, receipts from personal income tax represent 8.4 percent of GDP, about a quarter of the entire tax burden (34.8 percent of gross domestic product, GDP). 2 In contrast, in Latin American countries, the tax on per-sonal income generates only 1.4 percent of GDP, which is a very small part of the total tax burden (23.4 percent of GDP). Personal income taxes are higher in Caribbean countries, but even there the average receipt of 3.8 percent of GDP represents a modest proportion of their total tax burden (29.4 percent of GDP) and is low compared with the level in the developed world.

Why Latin Americans Pay So Little

To a certain extent, it makes sense that tax revenue in Latin American countries falls below the OECD level. Developed countries have social and


institutional structures that facilitate collection of direct taxes. Moreover, as per capita income in the OECD is about five times higher than in Latin America, the tax base is much larger.

Yet even in relation to middle-income countries—which includes all Latin American countries, according to the World Bank classification—tax burdens are low: 23.4 percent of GDP in Latin American countries, compared with 26.9 percent of GDP in the other countries of this group. 3 Much of this difference is due to lower receipts from personal income tax in Latin America ( figure 7.1 ).

There is no intrinsic reason for the low receipts from personal income tax in Latin America. In fact, Brazil, Chile, and Uruguay currently achieve collection figures comparable with countries of similar levels of develop-ment in other regions. And since the 1990s, revenue from personal income tax has grown significantly in some Latin American countries, including Uruguay (where it has risen by over 2 percentage points of GDP), Argentina (1.4 points), Nicaragua (1.3 points), and El Salvador (1.2 points).

The personal income tax regime in Latin America resembles a shell whose contents have been emptying out: outwardly, it has the shape of a genuine, progressive tax system, but inwardly, it has been hollowing out. In practice, Latin American societies have used four devices to convert personal income tax into a half-empty shell: the design of tax rates and

Figure 7.1 Differences between the Tax Burdens in Latin American Countries and Other Groups of Countries, 2000–10 (percent contribution)

Note : Averages for 2000–10. Source : Authors’ calculations based on IDB and CIAT (2012), IMF ( 2012a ), and OECD ( 2012a ).

Personalincome

tax, 52.3

Corporateincometax, 3.7

Othertaxes, 44.0

Personalincome

tax, 24.2

Corporateincometax, 9.6

Othertaxes, 66.1

(a) With OECD (b) With Middle-Income Countries

PERSONAL INCOME TAX 117

brackets; generous deductions or tax benefits; preferential treatment for capital income; and tax evasion.

Setting the Bar Too High

In Latin America, only the rich are fully liable for personal income tax. The minimum income that is exempt or taxed at a zero rate is higher in the region than in other parts of the world. On average, Latin Americans must have an income that is at least 1.4 times per capita income before paying the tax. This nontaxable minimum is not just much higher than in developed countries, but it is more than double the average for middle-income countries. In some Latin American countries, such as Colombia, Ecuador, Honduras, and Nicaragua, the minimum is more than twice the country’s per capita income ( table 7.1 ).

Table 7.1 Income Needed to Reach the Minimum and Maximum Rates of Personal Income Tax, 2010 (number of times per capita income)

Country Income for minimum Income for maximum

Argentina 0.30 3.66Bolivia 0.23 0.23Brazil 1.10 2.74Chile 1.00 11.16Colombia 2.83 10.65Costa Rica 1.90 2.86Dominican Rep. 1.82 3.80Ecuador 2.19 22.30El Salvador 0.38 3.42Guatemala 1.56 14.35Honduras 2.87 13.06Mexico 0.49 3.39Nicaragua 2.07 20.68Panama 1.35 4.05Peru 1.69 14.69Uruguay 0.72 10.28Venezuela 1.45 12.66 Latin America a 1.41 9.06 Rest of middle-income countries a 0.65 6.46 OECD a 0.24 2.38

a Simple averages. Source : Authors’ calculations based on CIAT ( 2012 ), IMF ( 2012a ), and OECD ( 2012b ).


The maximum rate applies only to taxpayers earning at least nine times the per capita income of the country on average, whereas in other middle-income countries, this rate applies to taxpayers earning at least 6.5 times the average per capita income. As a result, few taxpayers are affected by the maximum rate since individuals with very high income levels are often not taxed at the general rate because they receive their income—at least officially—from capital or other sources, which are taxed at lower rates (when taxed at all), as discussed in this chapter.

The few taxpayers who actually pay tax at intermediate rates fall be-tween those who are totally exempt and those who pay the highest rates. These rates are significantly lower in Latin America than the average for all middle-income countries. For example, the top marginal rate of a Latin American taxpayer with an income three times the country’s average per capita income is 15 percent, compared with 20 percent in a middle-income country in the rest of the world. The average rate in Latin America is 20 percent for income six times the average per capita income, compared with 25 percent in other middle-income countries. The gap between the top marginal rate in Latin America and in other middle-income countries is 10 percentage points for income seven times higher than the average per capita income ( figure 7.2 ).

Figure 7.2 Maximum Marginal Rate for Each Income Level, 2010

Source: Authors’ calculations based on ECLAC ( 2012 ), CIAT ( 2012 ), and IMF ( 2012a ).

0

5

10

15

20

25

30

35

0 1 2 3 4 5 6 7 8 9 10

Rat

e

Income level (number of times per capita income)

Average other middle-income countries Latin America


Obviously, the margin for increasing revenue is considerable. Just how big is this margin? A microsimulation exercise calculates the revenue that personal income tax would generate for five Latin American coun-tries (Chile, the Dominican Republic, Ecuador, Guatemala, and Uruguay) if current tax rates remained the same and only the income brackets changed. The simulation covers the middle brackets in countries in the income group to which each country belongs (low-middle-income in the case of Guatemala, and high-middle-income for the others). Revenue would increase by 1.3 percent of GDP in Chile, 1.7 in Ecuador, 0.6 in the Dominican Republic, and 0.2 in Guatemala ( table 7.2 ).

A Laundry List of Deductions

The second factor that contributes to “emptying” the tax is the gener-osity of existing tax benefits. The tax regimes of various countries allow deductions of certain personal expenses (including educational and med-ical expenses) despite a relatively high minimum exemption or zero rate bracket—which, supposedly, performs this function. Similarly, social secu-rity contributions are usually deductible, and pension income is exempted, which is a duplication of tax benefits. Almost no country taxes year-end bonuses—a practice that is hard to justify, despite tradition.

As a result of all this largesse, the tax expenditure on personal income tax averaged 1.1 percent of GDP ( figure 7.3 ), an amount equal to more than 50 percent of actual receipts. Tax expenditures on income tax amount to

Table 7.2 Revenue from Personal Income Tax if the Brackets Were Structured as in Middle-Income Countries (percentage of GDP)

Country Current revenue

(2010) Increase in revenue

(2010) Resulting revenue

Chile 1.4 1.3 2.7Ecuador 0.6 1.7 2.3Dominican Rep. 0.9 0.6 1.5Guatemala 0.2 0.2 0.4Uruguay 2.6 1.4 4.0

Note : Data calculated maintaining the country’s scale of rates. Source : Authors’ calculations based on information supplied by each country’s tax collection offices, except for Chile, which was estimated from the IDB and CIAT (2012), and Ministry of Planning of Chile ( 2009 ).


2.6 percent of GDP 4 in Guatemala—almost eight times revenue—and 2.3 percent of GDP in Chile.

In most Latin American and Caribbean countries, the public and even legislative bodies are totally unaware of the magnitude of the foregone tax revenues that result from the tax benefits granted to income tax. Only ten countries in the region regularly estimate this amount. 5 Such an account-ing is essential for fiscal transparency and public control of lawmakers’ decisions.

A Free Pass for Capital

A third mechanism that has helped empty out the shell of personal in-come tax is the favorable treatment granted to capital income. In many countries, this category of income is hardly taxed at all because of exemp-tions or special regimes. This situation has begun to change only recently in some countries with reforms that have introduced dual schemes, which will be discussed later. Currently, treatment of capital income (basically dividends and capital gains) is overly generous in Argentina, Bolivia, Brazil, Colombia, Mexico, and Paraguay. Obviously, this not only results

Figure 7.3 Tax Expenditure and Revenue from Personal Income Tax (percentage of GDP)

Source: Authors’ calculations based on: Costa Rica—Jim é nez and Podest á (2009), Cardoza ( 2012 ); Chile—Garcimart í n and D í az de Sarralde (2009); Guatemala—Jorrat ( 2007 ); Jamaica—Ministry of Finance of Jamaica ( 2011 ); Uruguay—Direcci ó n General Impositiva (2011).

0 1 2 3 4 5 6

Uruguay (2010)

Colombia (2007)

Brazil (2007)

Jamaica (2009)

Costa Rica (2010)

Ecuador (2005)

Mexico (2007)

Chile (2008)

Guatemala (2006)

Average

Tax expenditure Revenue from personal income tax


in lost tax revenue, but also erodes the equity and legitimacy of the tax system.

People Simply Don’t Pay

Another of the subterfuges for “emptying” the tax on personal income is tax evasion, which also negatively impacts the equity, efficiency, and social perception of the tax system. About half the potential tax receipts from personal income tax are lost because people throughout the region simply don’t pay their taxes (or pay just a fraction of what they should). The near 50 percent evasion rate is much higher than for other taxes such as VAT (see chapter 9 ), although somewhat lower than the rate for cor-porate income tax. The lowest rate of personal income tax evasion is in Peru, and even there it is over 32 percent ( figure 7.4 ). It is often said that the informal economy is a basic channel for fraud, but the estimated in-formality rate for Latin America (44 percent of GDP) does not seem to be substantially different from other countries with similar levels of develop-ment (40 percent). 6

Figure 7.4 Evasion of Personal Income Tax

Note: The evasion rates refer to different years: Argentina (2005), Chile (2003), Costa Rica (2010), Ecuador (2005), El Salvador (2005), Guatemala (2006), Mexico (2004), Peru (2006), and Dominican Republic (2009). Source: Authors’ calculations for Costa Rica based on G ó mez Sabaini, Jim é nez, and Podest á (2010), and Cardoza ( 2012 ). Salim ( 2011 ) for Dominican Republic.

0 10 20 30 40 50 60 70 80

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Guatemala

Domincan Rep.

Peru

Ecuador

Costa Rica

El Salvador

Chile

Argentina

Mexico

Average

Evasion rates (percentages)

Revenue (percent of GDP)

Actual revenue Predicted revenue Evasion


Equity on Paper: Consequences of Low Taxation on Personal Income

At first glance, progressivity seems to be very high in the region because the norm in many Latin American countries is that the richest 10 per-cent of taxpayers generate 90 percent of total revenue. This is the case in Argentina, Chile, Colombia, the Dominican Republic, Guatemala, and Nicaragua. However, the actual (effective) rate these taxpayers pay is very low. The highest effective rate in Chile barely reaches 10 percent.

Table 7.3 High Formal Progressivity, Yet Virtually No Redistributive Capacity of Personal Income Tax in Latin America

Effective tax rate paid by highest income decile

(percent)

Revenue generated by highest

income decile

(percentage of total)

Income received

by highest income decile

(percentage of total)

How progressive is the tax: Kakwani

Index b

How much does income distribution

change: Reynolds-Smolensky

Index c

Argentina (2008) 5.7 91.6 35.8 0.454 0.010Brazil a (2003) 3.0 66.1 50.8 0.123 0.010Chile (2003) 10.3 96.9 45.4 0.389 0.021Colombia (2003) 3.5 98.9 45.8 0.423 �0.005Costa Rica (2004) 3.6 86.1 35.6 0.333 0.008Dominican Rep.

(2004)2.6 96.0 46.6 0.395 0.035

Ecuador (2003) 2.6 74.3 39.8 0.423 0.004El Salvador (2006) 4.1 67.3 36.6 0.325 0.009Guatemala (2000) 0.5 99.0 42.2 0.316 0.001Honduras a (2005) 2.2 59.4 45.4 0.330 0.005Mexico (2008) 3.4 73.1 41.2 0.267 0.007Nicaragua (2001) 2.6 94.3 46.4 0.348 0.006Panama (2003) 4.0 85.9 43.4 0.244 0.005Peru (2000) 1.7 51.0 41.2 0.047 �0.001Uruguay (2006) 7.0 78.3 36.3 0.364 0.012Simple average 3.8 81.2 42.2 0.319 0.008

a Quintiles. b The higher the value of this index, the greater the progressivity. c The higher the value of this index, the greater the redistributive capacity. Source : Authors’ calculations based on Barreix, Roca, and Villela ( 2006 ); Ministry of Finance and Public Credit of Mexico ( 2008 ); Barreix, B è s, and Roca (2009); IDB ( 2010 ); G ó mez Sabaini, Harriague, and Rossignolo ( 2011 ).


Consequently, income tax is concentrated in a very small number of high-income taxpayers who pay a very small part of their income. In other words, taxes on personal income are formally very progressive but have no capacity for redistributing income ( table 7.3 ). In technical language, while the Kakwani indexes, which measure progressivity, have very high values, the Reynolds-Smolensky indexes, which measure the effective change in distribution resulting from tax payments, yield extremely low figures. 7 In developed countries, personal income taxes reduce the Gini coefficient by 0.04, almost five times more than the average for Latin American countries (see Immervoll and Richardson 2011 ).

The second distinctive feature of income tax in the region is the small number of taxpayers. While in developed countries about 40 percent of the population pays personal income taxes, the share is 1 percent in Bolivia and Nicaragua; 4 percent in Argentina; 9 percent in Chile; 10 percent in Brazil; and 14 percent in Uruguay ( figure 7.5 ). With such a small number of taxpayers, it is difficult for personal income tax to be one of the cornerstones of Latin American tax systems—as it should be.

Figure 7.5 Taxpayers Paying Personal Income Tax, 2010 (percentage of population)

Source: OECD ( 2011c ); IDB, CIAT, and CAPTAC-DR ( 2012 ).

0 7 14 21 28 35 42

Bolivia

Nicaragua

Dominican Rep.

Ecuador

Peru

Guatemala

Argentina

Costa Rica

Chile

Brazil

Uruguay

OECD


Box 7.1 The Tax Wedge in Latin America and the Caribbean

The low tax on personal income in Latin America also has implications for the labor market. The higher tax burden that tends to be applied to labor income rela-tive to capital income distorts the labor market with costs that affect the decisions of some individuals as to employment and discourage hiring, encourage unem-ployment, and promote informality.

To analyze the effects of taxation on labor costs in developed countries, for over two decades, the OECD has published the Taxing Wages study, which measures the tax burden on the labor costs of wage earners. This so-called tax wedge cap-tures the percentage of the wage represented by income tax and social contribu-tions over total labor cost. These calculations also include charges for compulsory public and private health insurance and pensions.

Following the same methodology, “tax wedges” have been calculated for Latin American countries.

Due to the low tax on personal income in Latin America, the tax wedge basi-cally reflects contributions to social security (including compulsory health insur-ance and private pensions). On average, for wage earners in the sixth decile, this wedge is 26 percent, compared with 36 percent in the OECD. The entire difference is due to personal income tax (see table B7.1 ).

Table B7.1 Tax Wedge for Wage Earners without Children in the Sixth Decile (percent)

Countries Total tax

wedge [a+b+c] Income tax

[a]

Contributions to social

security paid by worker [b]


security paid by employer [c]

Argentina 34 0 17 17Bolivia 23.5 0 12.2 11.3Brazil 33.7 0 11 22.7Chile 23.3 0 20.6 2.6Colombia 29.2 0 8 21.2Costa Rica 28.9 0 9.2 19.8Dominican Rep. 19.1 0 5.9 13.2Mexico 20.6 0 2.2 18.4Peru 21.2 0 13.1 8.2Uruguay 32.8 0 19.6 13.1Venezuela 23.4 5.8 5.5 12.1Average 26.3 0.5 11.3 14.5OECD 36.4 12.8 8.8 14.8

Note : OECD data relate to an average wage. Source : OECD ( 2012a ) and own calculations based on Aguirre ( 2012 ) and B á ez Arg ü ello (2010).


For higher-income taxpayers, the differences between Latin America and the OECD are also explained almost exclusively by the tax (see table B7.2 ).

Source : B á ez Arg ü ello (2010), Aguirre ( 2012 ), OECD ( 2012a , b ).

Table B7.2 Tax Wedge for Wage Earners without Children with Annual Income of US$60,000 (percent)

Country Total tax

wedge [a+b+c] Income tax

[a]


security paid by worker [b]


security paid by employer [c]

Argentina 41.9 18.1 8.8 15Bolivia 32.5 10.4 12.2 9.9Brazil 33.8 18.4 4.3 11Chile 18.9 6.5 10.6 1.9Colombia 39.1 10.6 9.4 19.1Costa Rica 37.5 10.9 9.2 17.4Dominican Rep. 26.5 19.2 2.3 5Mexico 34.2 24.2 1.7 8.3Peru 34 14.4 13.1 6.5Uruguay 35.1 11.2 14.5 9.4Venezuela 20.4 8.4 3.4 8.7Average 32.2 13.8 8.1 10.2OECD 41 21.39 9.83 9.8

Note : The OECD data relate to a wage of 167 percent of the average. Source : OECD ( 2012a ) and authors’ calculations based on Aguirre ( 2012 ) and B á ez Arg ü ello (2010).

Toward New Models of Income Tax

The traditional income tax model in Latin America is based on the syn-thetic or comprehensive structure of the tax. In this model, tax is cal-culated by adding all income, which is then taxed at a progressive rate on a scale, as shown in figure 7.2 . A better tax administration, analyzed in chapter 6 , and design improvements could boost revenue substan-tially. It would thus be difficult to argue that the traditional model has run its course, despite its failure to raise revenue over the last 40 years. However, the emergence of new models, more suitable to the new char-acteristics of Latin American economies, suggests that there may be a better strategy.


The limitations of the traditional model have been evident in other regions, although less so than in Latin America. This has led to a far-reaching transformation of income tax worldwide since the 1980s. While previous reforms often led to a spiral of rate increases and the prolifera-tion of exemptions, deductions, and special treatments, in the last three decades the direction of reforms has been toward a simpler tax with lower rates and broader bases.

As a result of the reform pressures, countries have increasingly migrated to new schemes designed to further simplify the tax and adapt it to the complexity of existing economic conditions. In practice, this has resulted in the introduction of two new models: the flat tax and the dual tax.

The Flat Tax: Easier to Draw a Horizontal Line than a Ladder

The flat tax applies the same rate to all sources and amounts of income, including corporate income. Progressivity is achieved by minimum exemp-tions from the tax for all individual taxpayers. This system, which has been around since the 1940s, really took off after its adoption by Russia in 2001. Since then it has been adopted by many countries in Eastern Europe and some in central Asia ( table 7.4 ).

The flat tax emerged as a way of introducing a simple tax in countries with weak and inexperienced tax administrations. Although it is too early to evaluate the results, the first analyses suggest that the revenue increases in the countries that pioneered the introduction of the flat tax resulted not so much from the reform of tax design but to improvements in adminis-tration (Keen, Kim, and Varsano 2006 ).

The flat tax scheme achieves a simpler tax by establishing a high min-imum exemption that excludes a large part of the population from pay-ing taxes, and by severely limiting the use of deductions and credits, all of which facilitates administration. Most European countries that have implemented a flat tax have set a low rate, 8 often less than the minimums of the progressive scales of the other European countries. This design lim-its its revenue raising, redistributive, and stabilizing capacity ( table 7.5 ).

The Dual Tax: A Ladder and a Horizontal Line Combined

The dual tax had its origin in the Nordic countries in the late 1980s as a response to the capital flight induced by the high maximum tax rates of the synthetic tax, which covered all income in a single tax base. 9 It has


three key features. First, the base is separated into two components: labor income and another component that includes investment income. Second, the first component is taxed at a progressive rate, and the second at a flat rate. Third, the fixed rate is equal to the minimum applied to labor income, and equal in turn to the tax rate on corporate income.

Although in principle this scheme may appear to have little justifica-tion from the point of view of equity, it does have a number of advan-tages over synthetic schemes. Moreover, its lower progressivity is often only apparent. First, it can be argued that to achieve horizontal equity (equal income should bear the same tax burden), capital income should be taxed at lower rates than income from work, so that the effective taxes are

Table 7.4 Worldwide Expansion of Flat and Dual Models

Flat Dual

Country Flat rate Year of

introduction Country

Maximum rate on wages

Rate on capital

Corporate rate

Year of introduction

Hong Kong 16 1947 Nordic dual Estonia 26 1994 Sweden 56.5 30 28 1991Lithuania 33 1994 Norway 40 28 26 1992Latvia 25 1995 Finland 48.2 28 28 1993Russia 13 2001 Semi-dual Serbia 14 2003 Slovenia 31.9 15 20 2006Ukraine 13 2004 Spain 43 19 30 2006Iraq 15 2004 Uruguay 25 12/7 25 2006Slovakia 19 2004 Germany 47.5 25 30.2 2008Georgia 12 2005 Peru 30 4.1–6.25 30 2008Rumania 16 2005 Nicaragua 30 10 30 2009Kyrgyzstan 10 2006 Honduras 25 10 25 2010Macedonia 12 2007 Panama 25 10 25 2010Iceland 36 2007 El Salvador 30 10 30 2011Mongolia 10 2007 Guatemala 10 5–10 31 2012Bulgaria 10 2008 Countries with incomplete dualization Mauritius 15 2009 Portugal 10–20 25 1989, 2005Czech Rep. 15 2008 Austria 25 25 1990, 2004Hungary 16 2011 Belgium 25–15–33 34 1994, 2005

Italy 12.5–27 27.5 1998, 2005Holland 30 25.5 2001France 16–18 24.4 2008

Greece 0–21 24 2009, 2011

Note : Tax rates on capital are general; some have changed recently, mainly due to the financial crisis. The maximum rates on wages of OECD countries are for 2010 (the last year this organization supplied information) Source: Authors’ compilations.


equal. 10 Second, the dual system reduces administration and enforcement costs since, by taxing capital income through withholdings, subsequent adjustments are unnecessary and it is easier to control the tax. Third, the dual scheme reduces tax arbitrage because it improves neutrality by taxing

Table 7.5 Different Models of the Personal Income Tax Comprehensive Flat Dual

Main characteristics• Integrates all income, and

taxes it according to the structure of progressive marginal rates applied to income brackets

• Flat rate for all sources and amounts of income, and equal to rate applied to corporate income

• Separates income into labor and capital, applying progressive rates to labor, and uniform rate to capital

• Progressivity achieved by minimum exemptions equal for all taxpayer.

• The minimum rate on labor income is equal to the rate of return on capital, and both are equal to the corporate income rate

Advantages• Considers all income and

gives it the same treatment• Greater revenue and

progressivity than in comprehensive models that lack solidity

• Greater revenue and progressivity than in comprehensive models that lack solidity

• Facilitates personalization of the tax

• Possible increase in tax on capital income

• Possible increase in taxation on capital income

• Increased progressivity • Simplicity • Lower administration and enforcement costs

• Lower administration and enforcement costs

• Reduces tax strategies and capital flight

Disadvantages• Usually contains many tax

benefits, which erode the bases

• Less progressivity compared with solid comprehensive models

• Possible arbitrage between income from capital and labor

• Very difficult to administer • Lower revenue at a moderate rate for capital income

• Negative social perception if capital income was previously taxed at a higher rate

• Proper functioning requires tax administrations with great capacity

• Encourages moving savings to other jurisdictions

Source : Authors’ compilations.


all forms of capital income equally. Fourth, the favorable treatment of cap-ital income reduces the risk of evasion. Finally, although it is argued that a dual system (or semi-dual, see later) may not favor competitiveness, the reality is exactly the opposite ( box 7.2 ).

Box 7.2 Dual Taxes and Competitiveness

Especially in small economies, dual and semi-dual taxes can contribute to effi-ciency and competitiveness. The argument that dual taxes harm competitive-ness because they lead to double taxation is incorrect. What is important is not double taxation but effective final taxation. a This is different in each case, and is not necessarily related to double taxation. Investing in Argentina, with a corpo-rate income tax rate of 35 percent but tax-free dividends, is, ceteris paribus, more burdensome than investing in Uruguay, where the semi-dual system imposes a 25 percent rate on corporate income and 7 percent on dividends: the final imposition in case of distributing all earnings would be 30.25% = 25% + (75% X 7%). The case between Panama and Colombia is similar.

In practice, the existence of double and triple taxation is not an anomaly. For example, VAT and personal income tax are levied from the same base. Similarly, duties, selective tax, and VAT are levied on various goods and services, including intermediate inputs such as fuel or some investments, all at the same time.

Moreover, the dual and semi-dual systems favor capitalization because they are levied on distributed profits (and capital gains arising from the sale of a firm’s assets). In countries where taxation of corporate income is unique and levied on the firm, dual and semi-dual systems reduce taxation on retained earnings by means of a lower rate of corporate income tax, compensated (in order to maintain revenue) with a tax on distributed profits. This is important in economies without venture (risk) capital.

The semi-dual model is the only income model that can correct the fiscal ad-vantage of indebtedness over the option to capitalize with the differentiated treat-ment of investment income: that is, taxing dividends at a lower rate than interest. b

The dual tax in Europe was, to a large extent, the result of competition for in-vestment. With trade, exchange rate, and monetary policies equal between coun-tries, taxation of income is especially important in the competition for investment (Barreix, B è s, and Roca 2010 a). In three decades, this has been reduced on average to almost half the corporate income tax rates. But the semi-dual tax can go even further since it can reduce the rate of dividends, and in parallel the rate of capital gains, unlike the dual (Nordic) system. Thus, the semi-dual tax increases fiscal competitiveness, whatever the importance of taxation as a differentiating factor for attracting investments.

a Usually, at the firm level, the tax burden—regardless of its weight in the decision to invest—is compared with the effective rates (Devereux and Griffiths 2003 ) of taxation on alternative investments. At the macroeconomic level, the efficiency of tax policies is measured by general equilibrium models. These are usually difficult to design (and


calibrate) due to data limitations and changes in economic structures and the working of markets.

b A similar effect is achieved by allowing the deduction for cost of capital, as in Brazil and Belgium.

Source : Authors’ compilation based on Barreix, B è s, and Roca ( 2010 a).

Although the dual system was implemented only recently, some results are already evident. In most jurisdictions, there have been changes in the composition but not in the total volume of savings resulting from the greater neutrality introduced by the dual scheme (Strand 1999 ; Picos S á nchez 2003 ). In the case of Germany, because of the reduction in the cost of capital, the dual system seems to have helped raise the investment rate by 1 percent of GDP (Radulescu and Stimmelmayr 2005 ).

Despite these advantages, the dual scheme (Nordic type) has two draw-backs. First, it can induce arbitrage between capital and labor income, which means the latter disguises itself as the former to reduce the tax burden. This problem is very clear in the case of the income generated jointly by both sources (such as business). Second, although the effects of a dual scheme on the equity of the system can be progressive (depending on the structure of brackets, exemptions, and rates, including those for capital), the public perception may be quite the opposite.

Denmark, which first introduced the dual tax in 1987, initially fixed rates on labor income ranging between 38.8 percent and 47.9 percent, with a tax on capital income of 28 percent. Shortly after that, Sweden, Norway, and Finland adopted the system ( table 7.4 ). The experience of these coun-tries was generally positive. In Sweden and Norway, the commissions that analyzed various aspects of the tax system gave a favorable verdict on the dual system. However, due to its unpopularity, it was abolished in Denmark after a few years (which is why this country is not included in the table). To understand this decision, it should be noted that Denmark collects about 25 percent of GDP from personal income tax alone, which finances the bulk of the country’s broad social benefits.

Semi-dual Taxes: Sharpening the Focus on Capital Income

Following the lead of the Nordic countries, many other European coun-tries have introduced semi-dual schemes, with differentiated treat-ment for capital income but not for mixed income. The clearest cases are Germany, Slovenia, and Spain, but Austria, Belgium, France, Greece,


Italy, the Netherlands, Poland, and Portugal have also introduced sys-tems with dual characteristics. In fact, the pure synthetic model has vir-tually disappeared in Europe, giving way to a differentiated treatment of capital income.

In the rest of the world, something similar has happened. While the Nordic countries formalized and introduced consistency into the dual system, the differential treatment of income from labor and capital had ample precedents, even in some Latin American countries like Argentina, Brazil, Colombia, the Dominican Republic, Ecuador, and Mexico, 11 where the failure to tax a good part of capital income impacts negatively on eq-uity and revenue.

For some time, the international trend has been to separate labor and capital income, with a significantly lower tax on the latter, especially in de-veloping countries, including Latin America. Even extreme dual systems are frequent where the return on capital is hardly taxed at all. But this trend has resulted in muddled dual systems, which lack the advantages of the formal dual system and unreasonably favor capital income.

With the aim of greater consistency between the different types of in-come, more rational dual schemes with more formal content have recently appeared in Latin America. Uruguay was a pioneer in this field, intro-ducing a tax in 2006 that applies separately to labor income with pro-gressive rates, and to capital income (interest, dividends, profits, rental income, and capital gains), with a proportional rate of 12 percent, sim-ilar (as originally proposed) to the lower marginal rate applicable to labor income. Also, the top marginal rate levied on labor income is the same as the rate for business income (25 percent). As a result, the Uruguayan scheme limits the possibility of arbitrage present in the Nordic systems. In fact, taxpayers who provide professional services or obtain business-type income can choose between a tax on business income or on personal income. 12 The Uruguayan system establishes a nontaxable minimum that exempts two-thirds of the population from the tax and allows very few deductions. These features facilitate administration and prevent erosion of the tax base.

Although the jury is still out on the Uruguayan dual tax (introduced in July 2007), the first results are clearly positive. Receipts increased from 0.9 percent of GDP in 2006 to 2.4 percent in 2008. The burden borne by the poorest half of the population dropped from 12.2 percent to just 3.5 percent, while the highest income quintile increased its contribution from 60.4 percent to 80.5 percent (Barreix and Roca 2007 ). While average effec-tive rates of the first five deciles increased from 2.9 to 3.2 percent, the rate


of the two highest deciles rose from 6.2 to 11.2 percent. Consequently, rev-enue, progressivity, and the redistributive impact of the tax improved sub-stantially. Since introducing the dual system, Uruguay has not reported capital flight or a decline in investment, as critics of the reform had forecast.

Following Uruguay’s lead, six Latin American countries adopted semi-dual systems. In chronological order they are Peru, Nicaragua, Honduras, Panama, El Salvador, and Guatemala. Several factors inspired the spread of the system. First was the need to tax all income, especially capital, exploit-ing the revenue potential of personal income tax in countries where public revenue was comparatively low and insufficient. Second was the need to introduce greater equity in regimes where returns on capital were liable for very low or zero taxation 13 in a smooth and orderly way with no major upheavals. 14 Although the rates on investment income in the current ver-sions are probably lower than desirable, they have been introduced in an orderly way and can be increased in the future.

Third was the overriding need not to discourage investment. In prac-tice, dual systems promote investment for two reasons. First, the tax on savings is lower than in a comprehensive system. Second, corporate profits are taxed as personal income only when they become dividends, not when they are reinvested.

Fourth was the need for simplicity, since returns on capital can be taxed by a withholding tax (they are withheld at the source at a fixed rate, with no need for settlement later). 15

Filling the Void of the Personal Income Tax

Despite recent advances, personal income tax is still a very fragile pillar of tax systems in Latin America. In most countries in the region, the tax has been hollowed out by high nontaxable thresholds, generous exemptions and deductions, and special treatments, especially for capital income, cou-pled with high levels of evasion. All this creates a very progressive regime on paper; however, in practice, such a regime does not alter income distri-bution, and exempts the vast majority of citizens from tax liability, with negative implications for civic attitudes.

Despite the failures of the personal income tax during almost half a century, it would be foolhardy to write off the traditional comprehensive system when specific reforms to the system could improve collection. In particular, the most pressing reform is a change in the general structure of


brackets and rates; these currently result in very low taxes for most people. Tax rates on income from capital could also be increased.

However, international experience, particularly in European countries, suggests that there are other more promising avenues to explore. Already seven Latin American countries, one way or another, have introduced a semi-dual personal income tax. These schemes, which apply moderate rates on tax bases with almost no exceptions, aim to increase revenue, equity, and efficiency, and to streamline administration and enforcement even further. In short, the new generation of dual models in the region is a fundamental step on the way toward filling the shell of personal income tax.

Although these reforms are too recent to recommend a new model in-discriminately, the future of the personal income tax looks promising.

8

Corporate Income Tax: The Art of Competing for Investment

and Increasing Revenue

The recent increase in revenue from corporate income tax (CIT) is one of the most important features of taxation in Latin America. Although the

rates of this tax have tended to decline around the world, Latin American companies are paying more income tax than ever. But CIT is far from a hor-izontally equitable tax, levied equally on all economic sectors, as is desirable in principle. Instead, the effectiveness of CIT is hampered by the prolifer-ation of incentives and lack of good systems of international taxation. To compete for investment, mainly from large companies, and perhaps also because of weakness in the face of the influence of certain pressure groups, governments have granted a large number of incentives, which have eroded the base of CIT. The fiscal cost of these incentives is enormous and often lacks transparency, since in some countries this cost is not even known. Little has been done to develop new forms of international taxation that would help regulate governments’ relations with international companies and strengthen tax administration to attack evasion and avoidance of the tax. With adequate design and administration of CIT, governments can both raise more revenue and successfully compete for investments.

The Paradox of Higher Revenues with Falling Rates

Although Latin Americans pay very little tax on their personal income, in recent years firms in the region have paid more corporate income taxes than firms in the eurozone countries (see figure 8.1 ). 1 Between 2006 and 2010 Latin American firms paid in CIT the equivalent of 3.7 percent of the gross domestic product (GDP) of their countries, while eurozone firms paid only 3.4 percent of GDP. This comparison can be misleading because the financial crisis has reduced the profitability of firms in the developed


world, while the boom in prices of basic raw materials has been an extraor-dinary source of income for many Latin American companies. However, Latin American firms pay approximately the same proportion of corpo-rate taxes as those in other middle-income countries, many of which have also been favored by the boom.

The performance of CIT has been rather paradoxical since increases in revenue have been achieved with lower rates. This has been the case both in the countries of the Organisation for Economic Co-operation and Development (OECD), where rates fell from 48 percent on average in 1980 to 26 percent in 2010, and in Latin America and the Caribbean, where rates fell from 34 percent in 1990 to 28 percent in 2010. This did not pre-vent receipts from increasing by 21 percent in the OECD and by 85 percent in Latin America and the Caribbean ( figure 8.2 ). The trend was similar in eurozone countries and also among middle-income countries in other

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Figure 8.1 Revenue from Personal and Corporate Income Tax, 2006–10 (percentage of GDP)

Note : Latin America and the Caribbean includes Argentina, Barbados, Belize, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Mexico, Nicaragua, Panama, Paraguay, Peru, Trinidad & Tobago, and Uruguay. The Eurozone countries are Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Other middle-income countries include Albania, Algeria, Armenia, Bhutan, Belarus, Botswana, Bulgaria, Cameroon, Cape Verde, Egypt, Fiji, Georgia, India, Indonesia, Iran, Jordan, Kazakhstan, Lesotho, Lithuania, Malaysia, Mauritius, Moldavia, Morocco, Namibia, Nigeria, Pakistan, the Philippines, Poland, Romania, Russia, Seychelles, South Africa, Sri Lanka, Swaziland, Syria, Thailand, Tunisia, Turkey, and Ukraine. Source : IDB and CIAT ( 2012 ); IMF ( 2012 a ); OECD ( 2012 ).

b. Eurozone and Middle-Income Countries

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CIT rate in eurozone countries (right axis) CIT rate in middle-income countries (right axis)

Figure 8.2 Revenue from Corporate Income Tax (CIT) and Its Nominal Rate: Comparison between Regions a. Latin America and the Caribbean and OECD

Note: All data are simple averages of countries. OECD countries are Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Israel, Italy, Japan, Luxembourg, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, South Korea, Sweden, Switzerland, Turkey, United Kingdom, and United States. See in figure 8.1 the countries included in the other regions. Source : IDB and CIAT ( 2012 ); Eurostat ( 2012 ); IMF ( 2012 a ); KPMG ( 2011a ); OECD ( 2012 ); and University of Michigan ( 2012 ).


regions of the world. 2 Consequently, the so-called paradox of revenue and rates is a universal phenomenon (S ø rensen 2006 ).

The explanation of the paradox reveals much about the possibil-ities and working mechanisms of the CIT. Based on the experiences of countries in the eurozone and the OECD, five explanatory factors have been identified. First, by lowering the rates, it was possible to cut depreciation rates and eliminate special deductions that had reduced the tax base (OECD 2007 ). Second, there was a trend toward corporati-zation for tax reasons against the alternative of paying higher taxes on personal income (Piotrowska and Vanborren 2008 ). Third, the low tax rates encouraged families to invest their savings in the corporate sector, and firms to retain a larger portion of the profits to finance investment, thereby broadening the base of the CIT. A fourth factor, at least until the outbreak of the international financial crisis, was the increased profit-ability of some totally corporate sectors, such as the financial sector, in relation to sectors that are less organized as corporations, such as agri-culture. Finally, control of tax evasion and tax avoidance strengthened collection of CIT, in part because the lower rates decreased incentives for “tax planning” by firms, and partly because of reinforced domestic tax administrations and increased international efforts to coordinate tax controls. 3

It might be thought that these favorable effects would be weak or nonexistent in developing economies. For example, where markets are smaller and the supply of capital is less elastic, there are fewer local investors, so that reducing CIT rates would have very little effect on investment. Similarly, the presence of many small firms that do not pay taxes and of various sectors that enjoy generous tax benefits would shrink the CIT base, which in turn would imply that changes in tax rates would have little effect. An additional factor could be that, since the capacity of tax administrations is limited, “tax planning” by com-panies would always have a good chance of success, no matter how high or low the rates. But, as discussed, the facts do not support these argu-ments. The downward trend of CIT rates, driven by international com-petition for investment, has been a fact for more than three decades; in both developed and developing countries, it has been compatible with higher receipts.

This downward trend in nominal CIT rates has been justified for two main reasons. The first is an ideological shift where the pursuit of com-petitiveness has been given priority in an effort to promote a vibrant pri-vate sector, and create employment and innovation (Loretz 2008 ). The

CORPORATE INCOME TAX 139

second is the stiffer competition between jurisdictions to attract invest-ment and retain domestic savings in a context of growing capital mobility. Moreover, among the member countries of the eurozone, implementa-tion of common trade, monetary, exchange, and regulatory policies might exacerbate tax competition and with it the movements of rates and CIT receipts (Overesch and Rincke 2011 ). However, the evolution of these vari-ables in the 17 eurozone countries in the 2000s was virtually the same as in all OECD member countries and middle-income and Latin American countries ( figure 8.2 ).

As a result, the phenomenon of tax competition for attracting business activity involves more than the size of economies and the depth of their openness and integration processes. It is also clear that firms are continu-ously exploiting the advantages of tax jurisdictions where their profits are taxed less (Grubert 2003 ).

Despite these factors, and contrary to what is often claimed, these trends do not necessarily imply that nominal rates are competing in a “race to the bottom” 4 in either the developed world or in developing coun-tries (Fern á ndez, Mart í nez, and Á lvarez 2008 5 ; Abbas et al. 2012 6 ). This is because tax rates are only one of the factors that firms take into account in their investment decisions and because governments have need of fis-cal resources. Thus, both factors put a brake on this supposed “race to the bottom” and divert it into areas other than cutting nominal rates. In fact, the competition is targeted toward more intensive use of tax incentives and special schemes for new investments, particularly in activities that are more internationally mobile. 7

Consequently, the “race to the bottom” is not for nominal rates but for effective rates (tax paid/tax base) and results from the proliferation of tax incentives. It is a matter of heated theoretical debate who bears the burden of corporate income taxes and, by extension, who has benefitted from these trends ( box 8.1 ).

Box 8.1 The Incidence of Corporate Income Tax: A Review of the Theory

Until the early 1960s, it was widely believed that CIT fell partly on consumers and partly on workers, and the rest fell on company owners. But in 1962, the Harberger model revolutionized the traditional theories of the incidence of CIT.

According to this model, in the case of a closed economy, capital (corporate and noncorporate) bears the brunt of the tax because its performance is reduced (equally in both sectors). The proportion borne by labor depends on the elasticities


of substitution between capital and labor (and on the elasticities of consumption between the product of the corporate and noncorporate sectors).

In the case of an open economy, a domestic tax cannot affect the return on capital when there is perfect international capital mobility. Likewise, it cannot alter the prices of tradable goods because prices are set by international markets, if there is free trade. In principle, income tax tends to reduce the rate of return on capital. However, as this is fixed at the international level, the adjustment variable is the stock of capital. Because the capital stock is lower, its marginal productivity increases, but labor productivity decreases and wages fall. Therefore, labor bears most of the burden, although this also depends on the elasticities (of substitution between capital and labor in production, and of consumption between goods pro-duced). Harberger concludes that in the end corporate tax affects mainly workers, especially in developing countries.

Auerbach ( 2006 ) extends the Harberger model to take into account the form of ownership of the return on capital. The incidence of corporate income tax is different for dividends, retained earnings, or interest received by company creditors.

However, contrary to what Harberger’s conclusions might suggest, Harris ( 2009 ) shows for the case of the United States that, under almost any reasonable assumption of incidence, in practice the impact of CIT on income distribution is progressive because capital income is basically received by higher-income groups. Even in the case where part of CIT falls on workers, it tends to have little effect on income distribution.

In a similar sense, according to Gravelle and Smetters ( 2006 ), when substitution in consumption between local and imported products is imperfect (for example, because of differentiation of products or technological reasons), the incidence of CIT does not fall entirely on the domestic labor force but is transferred mostly to the rest of the world. This result holds even assuming perfect capital mobility internationally. However, given that Latin America and the Caribbean produce mainly commodities and services with little diversification and no market power, it would not be easy to export this tax.

Ineffectiveness of Incentives

To promote investment and economic development, many Latin American governments grant tax incentives to firms, including tem-porary exemptions, investment tax credits, “accelerated depreciation” plans, 8 and free zone regimes. These incentives have been justified by very diverse arguments. In past decades, the infant industry argument was often used to justify exemptions during the maturation of complex activities that required learning. Recently, policymakers have turned to the argument that certain activities generate “positive externalities”: that


is, nonmonetary benefits (related to technology, management, regional development) for someone other than the investor. If there were no tax incentives for investments, their amount would be less than socially desirable. A similar version of this argument is that firms need to be compensated for the adverse effects of the lack of public goods, whether security, physical infrastructure, or adequate judicial and regulatory institutions. It is also increasingly argued that incentives are needed to compete internationally for investment with companies located in coun-tries that grant them.

Aside from the possible validity of these arguments, incentives can lead to many problems (table 8.1). Picking winners is always a gamble, which often leads to a permanent incentive for inefficient activities to avoid the political costs involved in removing an incentive. But as long as they are strictly temporary, incentives can attract investment in short-lived assets at the cost of long-term efficiency. The other side of this coin is that incentives are often redundant, in the sense that they benefit investments that would have been made anyway. For example, in Latin America, various sectors that are clearly internationally competi-tive enjoy a range of incentives. In addition to these effects on resource allocation and productive efficiency, incentives generate administrative

Table 8.1 Tax Incentives for Corporate Income Tax

Advantages Disadvantages

• Possible positive externalities • Fiscal and administrative cost • Attraction of foreign direct

investment • Difficult to select projects with

long-term viability without need for permanent incentives

• Compensate for deficiencies in the investment climate

• Difficult to eliminate ineffective incentives

• Positive impact on employment, technological innovation, or relatively less-developed regions

• Possible benefit for investments that would have been made in any event

• Can encourage tax fraud when not transparent

• Increase in tax burden on activities and companies without incentives

• Can favor fixed assets with short life • Requires continuous in-depth analysis of

their effectiveness, which is rarely done

Source: Authors’ elaboration.


Box 8.2 The Future of Free Zones

More than half the exports of goods from Central America and the Dominican Republic originate in free zones (Padilla et al. 2008 ), which for decades have been the main tool for attracting foreign investment, promoting industrial develop-ment, and generating foreign exchange. In the early 1990s, as part of peace pro-cesses, some of these countries attempted to take advantage of privileged access to the US market through special tax regimes for companies located in free zones. a The incentives apply to income tax as well as customs duties, value added taxes (VAT), and other taxes. In essence, companies are required only to pay social security contributions.

The usefulness and effectiveness of free zones have been the subject of dis-cussion, especially after major changes in international trade regimes following gradual reductions in basic tariffs in the United States since the 1980s, the end of the Multi-fiber Agreement in 1994, which governed international trade in textiles and apparel, and the entry of China (2001) and Vietnam (2006) into the World Trade Organization (WTO).

Aside from this debate, the historical cycle of export-manufacturing free zones is exhausted because WTO rules require elimination by 2015 of the aspects of the regulations that are part of the nature of the free zones, such as exemption from income tax on exports and limitation of sales to the domestic market. The Central American countries and the Dominican Republic have already introduced var-ious changes to tax regimes to comply with these rules. b These countries have also signed an “agreement on good practices,” which lays the bases for the adjustment process and eventual disappearance of the free zones is an orderly and consen-sual way. The countries have agreed not to introduce incentives to covertly reduce

costs and encourage fraud and corruption. Since they generate a fiscal cost, incentives implicitly increase the tax burden on other activities and firms to offset the lost revenue. For all these reasons, an ongoing and deeper analysis of the effectiveness of incentives is needed, but such studies are not very common.

Tax incentives have proliferated in Latin America and the Caribbean. Of the 15 sectors covered by this analysis, Brazil grants incentives to 10 sectors; Colombia, Jamaica, and Mexico grant incentives to 8; and only 8 countries grant incentives to fewer than 5. Free zones are present in 17 countries in the region. Although these have been the main instrument for promoting investment in several countries, their historical cycle is exhausted (see box 8.2 ). Apart from the free zones, incentives are granted to export sectors through other mechanisms in 14 countries, and on re-gional development criteria in 13 countries ( figure 8.3 ).


a. Number of Sectors Receiving Incentives by Country

income tax or that could influence the location of the investment, according to established criteria. c

a This form of support for peace processes also took place in countries in other regions, such as South Korea, Sri Lanka, and Taiwan. In some cases, the recipient countries also obtained privileged access to European markets.

b Costa Rica, for example, has amended its Free Zone Law, limiting access to tax incen-tives for activities classified as of strategic interest. Panama has begun taxing distrib-uted profits at a rate of 5 percent, retained earnings at 2 percent, and company capital at 1 percent annually. In El Salvador and Honduras, dividends are taxed at 10 percent, the same rate as in the rest of the country, and in Panama, they are taxed at 5 percent. The Dominican Republic applies a rate of 2.5 percent on gross domestic sales.

c The criteria are defined as: (a) incentives that involve a higher percentage (initially, 20 percent) of the resulting tax liability in the absence of the incentive; (b) instances when a state can prove relocation to another state due to the incentive; (c) when a state can prove that the volume of activity does correspond with a reasonable and suf-ficient level of investment in the country where the economic activity is nominally located. However, incentives may be allowed for activities that meet a series of criteria on amount, minimum initial investment, and employment requirements.

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EcuadorParaguay

GuatemalaNicaragua

UruguayBelizeBolivia

ChileCosta Rica

PanamaPeru

Dominican Rep.Trinidad and Tobago

ArgentinaHondurasColombiaJamaica

MexicoBrazil

Figure 8.3 Sectoral Incentives by Country and Sector


Fiscal Profligacy

Costly and arguably unnecessary tax incentives are common in the region. 9 In Peru, rebates and reduced rates on income tax incentives are used to pro-mote investment in certain regions. For example, companies established in the Amazon or in strategically located free zones are granted tax reduc-tions, aside from other special tax treatments such as fuel consumption.

The Dominican Republic uses free zones as the predominant mecha-nism for attracting investment, but tax incentives are also granted by the laws governing the operation of mining, forestry, energy, tourism, and border development areas, among others.

In Uruguay, the benefits granted for corporate income tax and net worth tax are subject to compliance with certain policy objectives, such as employment creation, investing in specific regions, or the use of certain technologies. In 2008, tax benefits were increased, and far-reaching legis-lative changes were made to streamline and increase transparency in the approval and control processes.

Each of these three cases represents a different way of promoting invest-ment through tax incentives to companies. In all these cases, the incentives

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b. Number of Countries Giving Incentives by Sector

Source : Authors’ compilations based on Artana and Templado ( 2012 ).

Figure 8.3 Continued


are really valuable in relation to company value. A comparison of the flow of funds to the favored firms with similar activities that do not receive such ben-efits reveals that the present value of the incentives in Peru may total 125 per-cent of company value. In the Dominican Republic, incentives are between 27 and 84 percent, while in Uruguay they are between 42 and 113 percent. In the three countries considered, the benefits are very high for the receiving compa-nies. By comparison, in Chile, the equivalent of the tax incentives included in the Chile Invests Plan is only 2 percent of company value ( table 8.2 ).

Given the high cost of the incentives, the question is: How effective are they? The available empirical evidence seems to indicate that the impact is modest. In addition, the tax benefits granted by the incentives are heavily concentrated in a very few large companies. In the case of Uruguay, this bias is very clear, since not only do the largest firms benefit most in rela-tive terms, but they have also grown most in size over the analysis period (2001–10). In the case of incentives in the Amazonas region of Peru, a sta-tistical analysis was made of companies in agriculture and manufacturing located in the region, and a control group of companies in the same eco-nomic sectors located in regions with no tax benefits. 10 The analysis con-cludes that incentives have a moderate positive effect on agriculture, but a negative impact on manufacturing: companies in this sector that have enjoyed the tax benefits granted by the Amazonas Law performed worse than companies that had not received exemptions ( table 8.3 ).

Table 8.2 Tax Incentives in the Dominican Republic, Peru, and Uruguay

Value of incentives in relation to value of company (percent)

Dominican Republic Peru Uruguay

Renewable energy 27 Reduction of CIT rate

19 30% tax credit and exemption of net worth tax

42

Industrial competitiveness

30 Exemption of CIT 39 60% tax credit and exemption of net worth tax

113

Free zones 50 Exemption of CIT and 3% sales tax

69

Border development 65 Exemption of CIT and 3% sales tax, and 30% tax credit

125

Textile and footwear 72Tourism 84

Source : Authors’ elaboration.


Corporate Income Tax Leakages: Tax Expenditures and Evasion

Tax incentives are only part of the “tax expenditures” of corporate income tax. They also include all revenue lost through tax holidays, accelerated depreciation schedules, reduced rates of tax on profits earned or rein-vested earnings, and investment tax credits. Tax expenditures are granted with objectives as diverse as providing a more efficient tax structure, stimulating activities or consumption of goods that generate nonpecu-niary social benefits, promoting regional or sectoral development, and strengthening compliance with tax obligations, among others.

In practice, many of these arguments are of doubtful validity because achievement of the supposed objectives is rarely evaluated, and often not even the size of the implied tax expenditure is known. In fact, many com-panies abuse the advantages they are granted by manipulating the prices and tax bases of activities that are not benefited toward those that are.

Although calculation of tax expenditures is essential for the transpar-ency of fiscal policy, only 10 Latin American countries regularly and sys-tematically make the estimate (Argentina, Brazil, Chile, Colombia, the Dominican Republic, Ecuador, Guatemala, Mexico, Peru, and Uruguay). Apart from estimating the total amount, for reasons of transparency, it is necessary to know which sectors are privileged, what types of firms receive the benefits, and how large the benefits are. Tax expenditures on corpo-rate income tax average 0.9 percent of GDP, equivalent to over a quarter of the effective collection of the tax. Uruguay, Mexico, and Colombia are the most generous with their corporate income tax ( table 8.4 ). Erosion of the CIT tax base by incentives has led to very questionable unorthodox solu-tions, such as setting “presumptive” income thresholds calculated as a per-centage of the assets or sales of companies to ensure a minimum payment of tax. Mexico’s Business Flat Rate Tax is an example of such unorthodox solutions (see chapter 12 ).

Table 8.3 Effectiveness of Tax Incentives in Peru, 2001–08

Average annual growth of gross valued added (percent)

Total Agriculture Manufacturing

Five departments with fiscal incentives 5.2 5.1 6.3Rest of Peru (control group) 6 4.4 7.4

Source : Authors’ calculations based on Artana and Templado ( 2012 ).


Like tax expenditures authorized by law, tax evasion, which involves breaking the law, substantially erodes revenue from corporate income tax, undermines the equity of the tax system as a whole, and represents unfair competition for firms that comply with their tax obligations. It is esti-mated that in Latin America the rate of evasion averages 52 percent of the revenue potential of CIT ( table 8.5 ). Through evasion, firms appropriate

Table 8.4 Tax Expenditure for Corporate Income Tax (CIT) (percent of GDP)

Tax expenditure Effective revenue from CIT

Uruguay (2010) 1.70 2.59Mexico (2007) 1.45 2.38Colombia (2007) 1.36 5.36Costa Rica (2010) 1.00 2.66Jamaica (2009) 1.00 5.27Guatemala (2007) 0.93 2.97Chile (2007) 0.90 5.59Brazil (2007) 0.45 3.92Dominican Rep. (2009) 0.45 2.44 Ecuador ( 2005 ) 0.40 2.73Paraguay (2010) 0.26 2.61 Simple average 0.90 3.50

Sources : Authors’ calculations. Uruguay: Direcci ó n General Impositiva ( 2011 ); Costa Rica: Cardoza ( 2012 ), Jim é nez and Podest á ( 2009 ); Jamaica: Ministry of Finance and the Public Service ( 2011 ); Dominican Rep.: Salim ( 2011 ); Paraguay: Salim ( 2010 ).

Table 8.5 Evasion of Corporate Income Tax (percentage of GDP)

Potential revenue

Effective revenue

Evasion rate (percent)

Argentina ( 2005 ) 8.0 4.0 50Chile (2003) 7.3 5.1 30Colombia (2000–10) 7.1 4.8 32Costa Rica (2010) 6.5 2.7 59Dominican Rep. (2008) 4.0 2.8 69 Ecuador (2008) 6.3 2.3 64 El Salvador ( 2005 ) 4.3 2.1 51Guatemala (2006) 7.6 2.8 63Mexico (2004) 3.2 1.7 46Peru (2006) 10.2 4.9 51 Simple average 6.5 3.3 52

Source : Authors’ calculations based on Cardoza ( 2012 ); Jim é nez, G ó mez Sabaini, and Podest á ( 2010 ); Pecho, Pel á ez, and S á nchez ( 2012 ); and Salim ( 2011 ).


one of every two dollars that the tax administration should receive from CIT to finance public spending. 11 The rate is similar to that of income tax on individuals but higher than for VAT (see chapters 7 and 9 ).

A Realistic Adjustment to Worldwide Income: The Reinforced Territorial System

Although Latin America and the Caribbean have enthusiastically embraced the policies of liberalization of international trade and capital movements, 12 the process has not been matched in international taxa-tion. The definition of the tax base applied to cross-border operations is a cornerstone for adapting international taxation to the new conditions of international trade and investment.

An Apparent Dichotomy

The contrast between countries that apply income tax to their residents on income obtained worldwide (pure worldwide income) and others that tax only that income originating exclusively in their territory (territorial income) is now more apparent than real: no country currently taxes its residents on all the income they obtain in the rest of the world, and those that use the criterion of territorial income often tax income obtained by taxpayers outside national territory. In practice, there is an enormous range of standards among countries, mainly depending on whether the income comes from an economic activity or is “passive income” derived from a capital investment. This results in a spectrum of regimes between the two extremes of territorial income and pure worldwide income. This can be seen in figure 8.4 , which shows the treatment of extraterritorial corporate income 13 in 23 countries, 9 of them in Latin America and the Caribbean. 14

Although the countries in the figure are organized into only a few scales defined indicatively, clearly few jurisdictions fit into either of the two extreme categories. Formal definitions by the countries themselves do not always match the material content of the regime applied. For example, while the Dominican Republic’s tax regime for corporate income is for-mally defined as territorial, in practice it is closer to a worldwide income regime with exemption of foreign corporate income. 15

The schemes follow regional patterns. For example, the English-speaking Caribbean countries traditionally adopt the worldwide deferred income


regime, while Latin American countries come from the tradition of ter-ritorial income. However, since the 1980s, they have gradually migrated toward the worldwide income regime. Currently, the seven largest coun-tries of Latin America 16 are formally governed by this regime, while the Central American countries, along with Bolivia and Paraguay, are closer to territorial income.

Over time, the regimes of various countries around the world have tended to move to the center of the scale rather than to the extreme posi-tions. In particular, the most advanced countries have tended to move away from the worldwide income model. At least for corporate income (much

Territorial

Nicaragua, Panama,Uruguaye

Repatriation regimea

Ghana, Nepal,Singaporef

Exemption regimeb

Canadag,Dominican Rep., France,

Germany,Netherlands, Spainh

Deferred regimec

Argentina, Brazil, China,Jamaica, Japani, Mexico,

Trinidad & Tobago,United Kindgom,

United States

Pure world incomed

New Zealandj,South Africak

Tendency Tendency

“Line of extraterritoriality”

Figure 8.4 Treatment of Extraterritorial Corporate Income

a Repatriation regime: Income obtained abroad by a subsidiary or by the company itself is not taxed until repatriated. b Exemption regime: Mechanism for eliminating international double taxation by granting exemp-tion to dividends distributed by a subsidiary resident in a third country to its parent company. c Deferment in this case is the possibility of not taxing income of subsidiaries abroad, until the ben-efit is distributed. d Pure world income: Tax on all income obtained at the time of receipt, in whatever form (directly or through a subsidiary or permanent establishment), place (inside or outside the country of resi-dence), or category (income from business activity or from passive investments). e Uruguay taxes passive income obtained by its resident companies abroad. f In practice, and except for interest, Singapore’s system is more like a pure territorial regime, but formally it is described as a repatriation regime. g With double taxation treaties (DTTs), but in Canada’s case about 100 have been signed. In Canada and the Netherlands, only dividends of foreign subsidiaries are taxed. h In France and Spain, exemptions include income from permanent establishments located abroad. i With a broad exemption for dividends from foreign source, which brings Japan close to the exemp-tion regime. j With certain limitations based on percentage of control and type of income obtained by the sub-sidiary located abroad. k In general, South Africa applies a deferment system, but a taxpayer can choose to bring forward payment of income obtained by a nonresident subsidiary before distribution of dividends. Source : Authors’ compilations based on IBFD ( 2011 ).


more important in terms of cross-border income than personal income), the paradigm is no longer worldwide income but territorial income with some form of expansion. Significantly, in the 2000s, countries like the United Kingdom, Japan, and Spain abandoned worldwide income, and the United States is also officially considering this option (see Tax Reform Advisory Panel 2005 ).

It is difficult to determine the economic rationality of the extraterrito-rial regime chosen. It bears no clear relation to variables that could influ-ence the choice of regime, such as the ratio of foreign direct investment or international trade to GDP. Surely, historical and cultural factors, as well as practical reasons, have weighed more heavily than the intensity of in-ternational economic ties, on balance.

Toward a New Paradigm in the Treatment of Extraterritorial Income

In theory, the use of worldwide income as the tax base has several advan-tages. First, it reflects the taxpayer’s economic capacity better than territo-rial income. It also facilitates calculation of the tax base because it considers the total sum of deductible expenses and computable income regardless of the jurisdiction where each is generated. Last, it automatically brakes the “race to the bottom” between jurisdictions, since any reduction of tax in the country of origin of the income implies a transfer of fiscal resources to the company’s country of residence. 17

In reality, the use of worldwide income faces challenges as to its cor-rect legal design: for example, with respect to the characteristics of the deduction for double taxation or of antiabuse mechanisms, issues that also translate into higher costs of tax administration. Above all, there is a debate about the practical difficulties involved in controlling all types of income originating offshore. Hence, the possibility arises of establishing a new tax on income obtained by residents in other countries.

Thanks to the global trend toward greater transparency and informa-tion sharing, for the first time it is possible to consider an effective con-trol of certain types of extraterritorial income. This is especially the case for interest income because bank secrecy for tax reasons is disappearing. Also, as discussed in chapter 6 , with the improvements in the capabilities of many countries’ tax administration systems, it is now feasible for small countries to initiate the task of controlling some types of international income.

An alternative regime for treatment of extraterritorial income has to recognize the changes that have occurred in the economic and tax model.


Although Latin American and Caribbean countries aim to attract for-eign investment and stimulate their own internationalization, they are unwilling to stop taxing the capital income of their residents.

On this last point, analysis of a possible tax on active extraterritorial income—both personal (wages, fees, and the like) and corporate—leads to the conclusion that taxing this income domestically does not make much sense in Latin America and the Caribbean. First, since the average nom-inal rates of income in the countries of the region are similar to the rest of the world, there can be no expectation of additional revenue in the country of residence because taxes on income and dividends paid in the country where the investment is made generate a credit that is deducted from the CIT payable in the Latin American country (for both individuals and firms). Second, in the case of individuals, the exemption for extra-territorial active income helps retain international quality human capital in the country. In the case of legal entities, repatriation of extraterritorial income, with the incentive of being exempt, results in its capitalization in the country of residence, on the understanding that it will be taxed when it is redistributed as dividends or capital gains on the equity interest of the national parent companies. Last, it is difficult for tax administrations to detect the existence of external active income and establish its actual amount for tax purposes.

These arguments are reversed in the case of passive extraterritorial income, such as interest, dividends, royalties, and capital gains: that is, income that comes mainly from returns on the savings of residents. This income should be taxed in order to discourage the outf low of the capital of residents (who have on occasion evaded taxation at the time the income was generated). Since much of this income, because of its greater mobility, enjoys low levels of taxation in the country where it is generated, a margin is left to be taxed in its owners’ place of residence. Last, taxing passive extraterritorial income makes the alternative of domestic saving more competitive because it levels the tax treatment of both.

The option of taxing only extraterritorial passive income is a selective and realistic option for countries whose tax systems are structured on the concept of territorial income, as is the case of several Latin American countries. It is selective because it applies only to certain income. It is real-istic because it recognizes that this is the income that can be known thanks to the international information exchange agreements. This option would create a new type of territorial income that can be termed “reinforced ter-ritorial” income. 18


Supervised Taxation Methods

Because of its resource base, Latin America and the Caribbean have his-torically relied on exports of commodities. 19 Despite the industrialization and diversification efforts of the past 40 years, the share of commodities in total exports has fallen only from 85 percent to 70 percent. This trend is most noticeable in the countries of South America, where only a few com-modities account for most exports. In the Caribbean countries, tourism plays a similar role (Barreix, B è s, and Roca 2009 ). On average, two-thirds of export revenue (including tourism) of Latin American countries comes from only five items ( figure 8.5 ). For these reasons, adequate taxation of the main sources of foreign income is essential for achieving fiscal sound-ness, promoting the horizontal equity of the tax system, and ensuring that

Figure 8.5 Share of the Five Most Important Export Items and Commodities in Total Exports, 1970–2010

0 20 40 60 80 100

Brazil

Argentina

Mexico

Costa Rica

El Salvador

Guatemala

Honduras

Uruguay

Panama

Peru

Colombia

Chile

Paraguay

Bolivia

Ecuador

Venezuela

Average

Percentage of total exports plus revenue from tourism

2010 1970

a. Five Most Important Items Exported, Including Tourism


the competitiveness of exports of goods and services is based on funda-mental conditions of efficiency and quality. All this requires that the taxes applied to these activities be based on their real prices.

Determining the real export prices of commodities and tourism ser-vices creates challenges similar to those involved in “transfer pricing”: prices agreed between related companies located in different countries. Transfer pricing control mechanisms came into being among OECD mem-bers to protect the income tax base in view of the complexity of interna-tional trade among companies operating in the same sector, particularly manufacturing. The objective of the control is to prevent manipulation of the prices of internal transactions within the same group operating in dif-ferent countries with the aim of declaring profits in the jurisdictions where the effective tax rates are lower. Since the type of trade in Latin America, mostly commodity exports, bears little relation to the foundational basis

0 20 40 60 80 100

El Salvador

Costa Rica

Brazil

Argentina

Mexico

Guatemala

Uruguay

Honduras

Colombia

Panama

Peru

Chile

Bolivia

Ecuador

Paraguay

Venezuela

Average

Percentage of total exports

2010 1970

b. Commodities

Source : Authors’ compilations based on trade data from ECLAC ( 2012 ) and IDB ( 2012 a ).


of transfer pricing, a different solution is required to the five price control methods established by OECD ( 2010 b). 20

“Supervised” Taxation for Commodity Exports: The Sixth Method

In essence, the Sixth Method, which was originally devised by the tax authorities in Argentina, aims to halt three-way transfer pricing of com-modity transactions through an agent located in a country where signif-icantly less tax is paid than in the exporting country. Instead of carrying out the operation directly (as shown in the upper part of figure 8.6 ), when

Country ACIT rate = 10%

Cost = 100

Country CPrice = 200

Country ATax base = 100

Tax = 10

Trade flow

Country ACIT rate = 10%

Cost = 100

Country BCIT rate = 1%Price = 110

Country CPrice = 200

Tax baseB = 90TaxB = 0.9

Tax baseA = 10TaxA = 1

TaxA+B = 1.9

Flow of merchandise

Invoice Invoice

Invoice

Figure 8.6 Three-Way Transfer Pricing of Export Operations to Avoid Taxes in Country A

Note : CIT means corporate income tax. Source : Authors’ elaboration.


there is transfer pricing through an intermediary (located in country B, as shown in the lower part of the figure), this method captures most of the income from the operation devised to take advantage of the low or zero income tax in that country. The question is if it is lawful for an exporter located in country A to agree to any price with an agent in country B (when the export is possibly destined for country C), given that there is an externally verifiable objective price (for example, for many commodities, the price on the Chicago International Commodity Exchange).

Without a proper control method it would be legally permissible, as indeed was the case in Argentina, to fix prices between A and B below the international market or, in a more sophisticated way, manipulate the date of the commercial operation so that the declared price related to a period of low prices. 21 To prevent these manipulations, when an intermediary lo-cated in a country with low or zero taxation participates, whether or not formally related to the exporter, there is justification for a public agency to “supervise” the formula for calculating the international commodity operation. Five more Latin American countries already apply this Sixth Method, in one way or another. 22 It can be understood as an adaptation for commodities of the OECD principles on free competition. 23

Although implementation is very recent, the method has already begun to bear fruit. For example, in Argentina between 2001 and 2007, the tax generated by exporters of cereals and oils increased over 12 times. In Ecuador, for the 2009–10 biennium, the new method in operation since 2008 resulted in an 18 percent increase in the value of declared exports, over $US 6 billion. In Paraguay, audits carried out in 2011 exclusively on agro-export companies for the 2007 financial year resulted in an 8 percent increase in total receipts from income tax for that year.

Supervised Taxation in the “All Inclusive” Hotel Sector

Tourism is a basic source of foreign revenue, especially for the Caribbean countries ( figure 8.7 ). 24 Despite its weight in economic activity, its contri-bution to tax revenue is usually modest. For example, in the Dominican Republic in 2010, the “all inclusive” hotel sector directly generated 2.5 per-cent of GDP, almost one-third of the value added by the entire tourism sector, but contributed tax revenue of only 0.2 percent of GDP.

Companies in the sector have used a range of mechanisms to evade taxes. In almost all cases analyzed by the Directorate General of Internal Taxes (DGII) of the Dominican Republic, the trading companies (linked to the operator) were located in countries with low or zero taxation; the


hotels declared constant losses and high debt with the trading companies, and the hotel tariffs declared to the tax administration were lower than the operating cost per guest. 25

To correct this situation, the DGII established a method of calculating “free competition tariffs” as the base for corporate income tax and value added tax (ITBIS in this country). The tariffs reflect the market prices for similar services (in the hotel category, for a comparable area and season in a sample of countries), adjusted by an intermediation margin of 20 percent to 25 percent, depending on the area and season (which includes the inter-mediation of the trading company, tour operator or wholesaler, and travel agent). This method can be extended in the future to other hotel busi-nesses and other countries. On a more conceptual level, the mechanism is similar in nature to the OECD resale price margin method. 26

To facilitate implementation of the system and reduce fiscal and legal uncertainty, the Dominican government invited the sector to collectively establish a system of advance prices and simple rules for determining prices. 27 Audits show that the new system increases income tax revenue from the “all inclusive” hotel sector by 818 percent and VAT revenue by 70 percent. Without doubt, supervised taxation can help strengthen collec-tion and improve the transparency and horizontal equity of tax systems.

0 10 20 30 40 50 60 70 80

Panama

Uruguay

Costa Rica

Haiti

Dominican Rep.

Belize

Jamaica

Bahamas

Barbados

Average

Figure 8.7 Revenue from Tourism as Percentage of Total Revenue from Exports of Goods and Services, 2010

Source : UNWTO ( 2010 ); IDB ( 2012 a ).


Local Variations in crescendo

The paradox of increasing revenue with declining rates of corporate in-come tax is a universal phenomenon, but its causes are not necessarily the same everywhere. In Latin America, revenue has been favored by the high prices of the major export products, by the improved capacity of tax administrations (see chapter 6 ), and more recently by the homegrown solutions discussed in this chapter, such as the tendency toward “rein-forced territorial income” for taxing passive income from extraterritorial sources, and the “supervised taxation” practices to control the declared prices of commodity exports and tourism services. The semidual income tax model and the proposed personalized VAT, discussed in other chap-ters, are more examples of local solutions.

Some of these innovations still have much to offer and will surely help maintain the rising trend in receipts from corporate income tax and im-prove horizontal equity. But the corporate income tax faces other chal-lenges. The rationality of the existing incentives for attracting investment especially needs to be improved. At present, these incentives are too generous and not very effective. Moreover, the incentives granted to manufacturing in the Central America countries and the Dominican Republic through the free zones are set to disappear by 2015 at the latest due to the World Trade Organization (WTO) agreements. This process has stimulated a regional effort, the Agreement on Good Practices, to pre-vent the emergence of harmful tax competition.

In short, in the past taxation paradigms were dictated by good prac-tices in developed countries, which defined the course of action for other countries. The recent local developments in income tax in Latin America suggest that a significant change is taking place in response to local real-ities and needs.

9

Value Added Tax: Let It Be

The idea of levying a tax on value added emerged in the first half of the twentieth century, and has spread throughout the world. Introduced

in France in 1954, a value added tax (VAT) had been adopted by 10 coun-tries by the late 1960s, by 48 countries by the late 1980s, and is used by more than 140 countries today. It has been so successful because, in com-parison with other revenue sources such as foreign trade taxes, income tax, or social security contributions, VAT offers advantages in terms of revenue, neutrality (equal treatment for all sectors), and ease of adminis-tration (simplicity of monitoring and enforcement).

Nonetheless, VAT is not without its drawbacks, especially in terms of equity and compliance costs, particularly when exceptions are granted. 1 The most common solutions to these problems, such as rate differentia-tion, exemptions, and special schemes, are generally counterproductive and of dubious effectiveness, as this chapter will show. These solutions distort the principles of simple design that make VAT into what it is: a general tax with a single rate applied at each step of the entire transac-tion chain up to the final consumer. The VAT has several advantages. First, it overcomes the inefficiency created by taxes (whether or not single-phase) 2 that tax in cascade: that is, that apply to goods and ser-vices used as inputs or as capital goods for production of other goods that are also taxed. Second, VAT makes investment and savings deci-sions more neutral. Third, VAT avoids discrimination between imports and local production. Fourth, it avoids taxing or covertly subsidizing exports. 3 Finally, it helps capture the maximum information available to control fraud.

Throughout the world, including in Latin America, governments have attempted to overcome VAT’s inherent limitations with methods that undercut its essential characteristics and that have been very costly in


terms of tax receipts. It is possible to reconcile the objectives of revenue, neutrality, 4 equity, and ease of administration—but not in the way that governments have been trying.

How Much Does VAT Raise and How Much Does It Lose?

VAT is the most important source of tax revenue in the countries of Latin America and the Caribbean (from now on, simply Latin America). Although the general rate is, on average, lower than in the non-Latin American countries of the Organisation for Economic Co-operation and Development (OECD) (15.1 percent versus 18.1 percent), receipts are similar: 6.6 percent of GDP in Latin America, and 6.9 percent of GDP in OECD countries. However, its share of total tax revenue is much higher in Latin America, about 28 percent, compared with an average of 19 percent in OECD countries, which raise more through other taxes ( table 9.1 ).

The Latin American bias toward VAT is usually justified because it is more viable and easier to administer compared with the alternatives of direct taxation, particularly personal income tax. This is due to the high level of informality (on average, about 44 percent of the economy is informal) 5 and the extreme inequality of income distribution in the region (the Gini coefficient averages 0.52, compared to 0.34 in OECD countries). 6 A number of improvements in tax administration, particularly control of sales and efforts to expand the tax base, have confirmed the leading role of VAT. Indeed, its collection has doubled as a percentage of GDP in the region and its contribution to total revenue has increased by over 40 per-cent in two decades. 7

Given the weighty role that VAT already plays, it is unlikely to be the main means for increasing revenue (although its potential has not been reached, particularly in Central America). The priority in raising revenue in the region must be income tax, especially personal income, where the lag with international standards is dramatic ( chapter 7 ). However, VAT can be strengthened not only to increase receipts, but also because it is more neutral and easier to collect than other taxes. Moreover, with some supplementary measures, it can even contribute to equity. All this, as dis-cussed in this chapter, can be achieved by means different from those that have been attempted so far in Latin America.

A good starting point for this analysis is to consider that the potential revenue from VAT in an economy is determined by at least four variables: tax rates; the breadth of the tax base; the size and structure of the economy, particularly consumption; and the level of evasion.

VALUE ADDED TAX 161

To understand how much can be raised, it is useful to start with the “VAT productivity” index, defined as the ratio of VAT revenue, mea-sured as a percentage of GDP, to the general VAT rate. The value taken by the index represents revenue raised as a percentage of GDP for each

Table 9.1 VAT: Revenue and Rates, 1990 and 2010

Revenue

General rate b

Reduced rates c Percentage of GDP

Percentage of total fiscal revenue a

2010 1990 2010 1990 2010 2010

Argentina 8.1 5.9 23.3 31.6 21.0 10.5Barbados 8.5 0.0 25.4 0.0 17.5 7.5 + 0.0Bolivia d 6.9 2.3 25.0 19.0 14.9 0.0Brazil e 13.0 11.3 38.1 38.3 22.0 5.2 to 33.3Chile 8.1 7.0 29.9 26.0 19.0 n.a.Colombia 5.3 2.4 23.3 20.7 16.0 0, 1, 6, + 10Costa Rica 4.9 4.1 22.6 22.4 13.0 0 + 5Dominican Rep. 4.3 1.6 27.7 15.1 16.0 0.0Ecuador 6.5 3.2 25.1 24.9 12.0 0.0El Salvador 6.5 0.0 36.7 0.0 13.0 n.a.Guatemala f 5.1 2.2 41.8 27.2 12.0 0.0Honduras 5.5 2.7 29.2 17.2 12.0 0.0Jamaica 7.1 0.8 30.1 3.8 17.5 10.0 + 0.0Mexico 3.8 3.6 18.9 18.7 16.0 11.0Nicaragua 7.4 4.9 27.4 22.1 15.0 0 + 7Panama 2.9 1.4 12.9 7.8 7.0 n.a.Paraguay 7.5 0.0 34.3 0.0 10.0 5.0Peru g 6.7 1.5 36.7 12.0 19.0 0.0Trinidad & Tobago 4.6 4.3 14.4 16.8 15.0 n.a.Uruguay 8.9 5.5 30.0 23.4 22.0 10.0 Simple average 6.6 3.2 27.6 17.3 15.1 n.a. OECD h 6.8 6.1 19.4 17.4 17.8 n.a.

a Total fiscal revenue includes taxes, social security contributions, and other fiscal revenues (see chapter 1 ). b The general rates of Bolivia and Brazil have been calculated to be homogeneous with the rest. c All the countries have exemptions, with differing levels of importance. d The Bolivian rate is the actual rate (14.9), since the nominal rate of 13 percent is defined over the final price of the goods, including the VAT. e Brazil has several rates. Those considered are: Contribu çã o para o Financiamento da Seguridade Social (COFINS), Programa de Integra çã o Social (PIS), Programa de Forma çã o do Patrim ô nio do Servidor P ú blico (PASEP), and Imposto sobre Circul çã o de Mercadorias e Servi ç os (ICMS). The Brazilian data are for 1994. f VAT refund for income was eliminated with the reform of 2012. g Data for Peru include the municipal tax of 2 percent. h OECD does not include Chile and Mexico. Values under 2010 refer to 2009. n.a.: not applicable. Sources : IDB and CIAT ( 2012 ); OECD ( 2012 ).


percentage rate point. This indicator measures the tax collection power of one point of VAT determined by the breadth of the tax base and level of tax compliance.

The latest data show a wide variation among the countries in the index, ranging from 0.24 in Mexico (2010), which has the most eroded tax base in the region, to 0.61 (2009) in Paraguay, which has one of the world’s lowest rate (10 percent). The simple average, which was only 0.29 in 1990, reached 0.41 in 2010 ( table 9.2 ), following expansion of the base and an improve-ment in tax compliance. 8 Variability is also high in the OECD, ranging from 0.27 in Turkey to 0.69 in New Zealand, and averaging 0.40 in 2008, a value that was even lower than the Latin American countries at that time.

However, these comparisons can be misleading because VAT is a tax on consumption, not overall GDP. Comparisons are appropriate only

Table 9.2 VAT: Productivity and Efficiency Indexes (Indexes = 0–1, where 1 = maximum productivity)

Productivity index (2010)

C-efficiency index (over total

consumption net of VAT)

G-inefficiency index (due

to tax expenditures)

X-inefficiency index

(residual)

Argentina (2007) 0.38 0.60 0.08 0.32Chile (2007) 0.43 0.68 0.06 0.25Colombia (2007) 0.33 0.45 0.16 0.39Costa Rica 0.38 0.48 0.41 0.11Dominican Rep. 0.27 0.30 0.23 0.48Ecuador 0.54 0.74 0.19 0.07El Salvador 0.50 0.52 0.22 0.26Guatemala 0.43 0.47 0.19 0.34Honduras 0.46 0.50 0.29 0.21Jamaica (2009) 0.22 0.46 0.15 0.39Mexico (2008) 0.24 0.37 0.32 0.31Nicaragua 0.49 0.53 0.33 0.14Panama 0.48 0.69 0.26 0.05Paraguay (2009) 0.61 0.62 0.16 0.22Peru 0.35 0.55 0.14 0.31Uruguay 0.40 0.56 0.17 0.28 Simple average 0.41 0.53 0.21 0.26 OECD a 0.40 0.59 n.a. n.a.

a OECD data are for 2008 and do not include Chile and Mexico. n.a.: not available. Sources : OECD ( 2010 c); ECLAC ( 2012 ); IDB and CIAT ( 2012 ).

VALUE ADDED TAX 163

Figure 9.1 VAT: Productivity and Efficiency in Latin America and the OECD (Index = 0–1, where 1= maximum productivity)

between economies where consumption represents the same proportion of GDP. This complicates comparisons between Latin America and the OECD, since total rates of consumption as a percentage of GDP average about 82 percent and 75 percent, respectively, for the five years 2006 to 2010 (IMF 2012 a).

This explains the estimate of a second indicator, known as the VAT “consumption-efficiency ratio” or “C-efficiency,” 9 defined as the ratio of VAT revenue, measured as a percentage of consumption, to the general tax rate. 10 (The calculations were made by deducting VAT raised from the value of final consumption.)

C-efficiency in OECD countries in 2008 was 0.59, slightly higher than the 0.53 average for the countries of Latin America ( figure 9.1 ). Importantly, this indicator is determined by the relative share of private and public con-sumption in GDP. While OECD countries have a lower share of private consumption in GDP than Latin American countries, the opposite is the case with public consumption. This structure skews the ratio against Latin America because higher private consumption increases the possibility of evasion. 11

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Productivity (PIB) C-efficiency (privateconsumption)

C-efficiency (totalconsumption)

C-efficiency totalconsumption net of VAT)

Latin America OECD

Source : ECLAC ( 2012 ); IDB and CIAT ( 2012 ); OECD ( 2012 ); and authors’ calculations.


In this respect, Latin American countries raise 5.3 dollars of VAT for every 10 dollars of potential revenue, with productivity (relative to GDP) and a C-efficiency (relative to consumption) at a level similar to that of developed countries. Since the countries of the region have already reached productivity levels similar to those of OECD, it could be argued that it will be difficult to improve productivity even more. But instead of prematurely jumping to that conclusion, one first needs to ask how and why the other 4.7 dollars were lost, and if there is good reason for maintaining those losses.

Breaking Down VAT Productivity

Productivity losses are due, first, to the low rates and exemptions from the tax and, second, to deficient administration and fraudulent behavior. To calculate the potential revenue loss resulting from low rates and exemp-tions, VAT tax expenditures 12 were calculated for various countries. 13 However, although most countries use a standard methodology based on direct calculation of tax receipts lost due to legal provisions, the practical application in each case may result in differences in the estimates. 14

In Argentina and Chile, erosion of the tax is relatively low since revenue would increase by only 10 percent if there were no low rates and exemp-tions. In contrast, in Costa Rica, the Dominican Republic, Honduras, Mexico, and Nicaragua, tax expenditures cause a substantial 60 percent or more decrease in current revenue. Decreases are in a range of about 40 percent in Colombia, El Salvador, Guatemala, and Panama, and around 25 percent in Ecuador and Peru. 15

With respect to the objectives pursued by tax expenditures, the most important ones, which in general explain over 90 percent of the erosion, grant relief to taxpayers and promote meritorious activities or consump-tion, in both cases with the intention of equity. Others, less important, stimulate economic activity in certain geographic areas or specific eco-nomic activities, along with various supposedly technical adjustments.

Because of tax expenditures granted through exemptions and reduced rates, 21 percent of potential revenue from VAT is lost. This is known as “G-inefficiency,” and it is quite large, accounting for a large share of potential revenue lost. 16 The remainder of potential revenue loss, which can be termed “X-inefficiency,” 17 is attributable to tax fraud and distortions in administration (including use of special schemes for small taxpayers or farmers). On average, 26 percent of potential revenue is lost due to fraud and inefficient administration, over half of potential revenue lost ( figure 9.2 ).

VALUE ADDED TAX 165

Figure 9.2 VAT: Potential Revenue Decomposition, Select OECD and Latin American and the Caribbean Countries

In short, in the region, for every 10 dollars of possible receipts, 5.3 dol-lars are collected, 2.1 dollars (tax expenditure) are exempted, and the rest, 2.6 dollars, is lost—mainly through evasion.

In Costa Rica, Honduras, Mexico, and Nicaragua, reduction of tax expenditures is the main area for improving collection (G-inefficiency). In contrast, in Colombia, the Dominican Republic, and Jamaica, the priority should be improving administration (X-inefficiency). Obviously, these results should be interpreted with caution because multiple factors in the estimate—such as tax expenditures or the existence of differential rates—can distort the comparison among countries. 18 The usefulness of these calculations lies in identifying the relative importance of the problems and major areas for potential improvement of the tax in each country.

Last, the multiphase design of VAT, discussed earlier, makes it self- enforcing, since it confronts the interests of taxpayers in successive trans-actions. Indeed, the incentive for sellers to understate the value sold is offset by the incentive of purchasers to overestimate it. Despite this oppo-sition of interests along the production chain of goods and services, which facilitates enforcement, evasion still occurs, especially at the stage of

0 10 20 30 40 50 60 70 80 90 100

Dominican Rep.Mexico

JamaicaColombia

GuatemalaCosta Rica

HondurasEl SalvadorNicaragua

PeruUruguay

ArgentinaParaguay

ChilePanamaEcuador

Latin AmericaSpain

United KingdomThe Netherlands

South Korea

C-efficiency G-inefficiency X-inefficiency

Source : ECLAC ( 2012 ); IDB and CIAT ( 2012 ); OECD ( 2010 c); and authors’ calculations.


consumer sales (Keen and Smith 2007 ; IMF 2011 c). Calculations based on direct estimates reveal that evasion can become very significant, although it has tended to decline in most countries ( figure 9.3 ). To counteract the problem, the countries that have enjoyed the greatest success in adminis-tering this tax invest considerable resources in controlling the supporting documentation (through such measures as electronic invoicing systems, tax printers, and control of issue of invoices and delivery notes).

Sharpening a Spoon That Is Not Made for Cutting: The Role of Reduced Rates and Exemptions

Based on these calculations, a significant part of potential revenue is lost due to lower rates and exemptions, which are granted primarily to correct the regressive nature of VAT. 19 The question is: Is it worth paying this cost, and are there more effective ways of achieving this objective?

On average, in Latin American societies, the poorest 20 percent of the population uses 13.7 percent of the income reported in household surveys to pay VAT, while the richest 20 percent must allocate only 5.8 percent of their reported income ( table 9.3 ). 20 In other words, despite the exemptions

0

5

10

15

20

25

30

35

40

45

50

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Argentina Colombia Chile Peru

Mexico Uruguay Guatemala

Figure 9.3 Evasion of VAT in Select Countries (percentage of revenue)

Source : AFIP ( 2008 ); Pecho, Pel á ez, and S á nchez ( 2012 ); and Fuentes, Zamudio, and Barajas ( 2010 ).

VALUE ADDED TAX 167

and reduced rates aimed at easing the burden on lower-income groups, the poorest sectors are carrying a tax burden that is 2.4 times higher relative to their income than the most favored sector of society. And this regres-sivity is the same in virtually all countries of the region.

Table 9.3 VAT: Regressive or Progressive Depending on the Calculation Method

Country/year Actual

rates on

How progressive is the tax: Kakwani

Index a

How much does income distribution

change: Reynolds-Smolensky Index b

Deciles

1 2 5 9 10

Argentina (2008)

Income 18.6 14.1 11.2 9.6 8.4 �0.0756 �0.0094

Bolivia (2000) c Consumption 5.5 6.2 6.9 0.0260 0.0018Chile (2003) Income 35.3 19.6 15.4 12.9 8.8 �0.1298 �0.0178

Consumption 15.6 15.3 15.2 13.3 12.2Costa Rica

(2004)Income 5.4 4.2 4.1 3.5 3.0 �0.0850 �0.0031Consumption 3.1 3.6 4.3 5.1 5.6 0.0577 0.0030

Colombia (2003)

Income 6.3 5.8 4.4 3.2 2.1 �0.0670 �0.0040Consumption 5.9 5.2 4.5 4.6 4.7 0.0460 0.0030

Dominican Rep. (2004)


Ecuador (2003) Income 4.6 4.2 4.1 4.9 5.2 0.0380 0.0020Consumption 3.8 4.1 4.7 6.3 7.6 0.1060 0.0070

El Salvador (2006)


Guatemala (2006)


Honduras (2005) c

Income 10.2 8.2 5.0 �0.0897 �0.0005Consumption 4.0 5.2 8.8 0.1020 0.0080

Nicaragua (2001)


Panama (2003) Income 4.6 2.2 2.0 1.6 1.7 �0.1035 �0.0018Consumption 0.6 0.8 0.9 1.3 1.7 0.1162 0.0029

Paraguay (2001)


Peru (2000) Income 4.8 4.3 6.0 7.1 6.1 �0.1760 �0.0121Consumption 6.5 6.9 7.7 7.6 6.7 �0.0150 �0.0012

Uruguay (2006)

Income 21.6 12.7 9.9 7.6 6.5 �0.1081 �0.0101Consumption 9.2 9.5 9.7 9.1 8.7 �0.0176 �0.0019

a The higher the value of this index, the greater the progressivity. b The higher the value of this index, the greater the redistributive capacity. c Quintiles 1, 3, and 5, respectively. Sources : Barreix, B è s, and Roca ( 2009 ); Jorrat ( 2010 ); Roca ( 2010 b); G ó mez Sabaini, Harriague, and Rossignolo ( 2011 ).


The regressivity disappears in almost all countries when calculations are made in relation to consumption rather than the income reported in the surveys (the exceptions are Chile, Peru, and Uruguay). As widely accepted, consumption is a better measure of permanent income, and therefore the socioeconomic level of families, than current income. 21 This explains the enormous differences observed in regressivity calculations based on consumption compared with those based on reported income (see the case of Paraguay in the table as an extreme example).

In short, VAT is clearly regressive on income, despite being progressive on consumption. However, evaluating the distributional impact of a tax taking into account only the progressivity or regressivity of its collection is a partial perspective. The ultimate distributional impact depends much more on the amount of revenue raised and how the benefits of public spending are distributed.

There does not seem to be a clear and significant relationship between the amount of tax expenditures (measured as a percentage of revenue) and the degree of regressivity of VAT ( figure 9.4 ). If correction of VAT regressivity by means of exemptions and lower tax rates for basic goods and services involves such a high cost (and sometimes does not even solve

Brazil

Colombia

Costa Rica

Dominican Rep.

Ecuador

Guatemala

Honduras

Peru

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5

Tax

exp

end

itu

re/R

even

ue

Ratio of effective tax rates of deciles 1 and 2 with respect to 9 and 10

Nicaragua

PanamaEl Salvador

Uruguay

ArgentinaChile

Figure 9.4 Tax Expenditure and Progressivity

Source : Authors’ calculations based on IDB ( 2010 ).

VALUE ADDED TAX 169

the problem), the question must be asked: Who is benefiting from the tax expenditures?

The problem of VAT regressivity occurs because it is a tax that does not distinguish between the consumption of the poor and the rich. The poor consume a larger share of their income than the wealthy; thus, with a flat VAT rate for all consumer goods, the poor pay a higher proportion of their income in VAT than the rich. However, it is difficult to think that the problem can be reasonably corrected by reducing the tax on certain prod-ucts, for the simple reason that, except for very few goods, 22 the higher income deciles consume more of all goods than the lower income deciles, especially in Latin America, where income is heavily concentrated.

The attempt to achieve progressivity through lower rates for some products creates substantial “errors of inclusion,” as shown in table 9.4 for the cases of Costa Rica, Mexico, and Uruguay, representing all of Latin America. For example, in Uruguay, the poorest 40 percent of the pop-ulation consumes only 13.9 percent of goods exempt from VAT, while the richest 20 percent consume more than half of these exempt goods. In

Table 9.4 The “Error of Inclusion” of Reduced Rates and Exemptions of VAT (percent)

Costa Rica Mexico Uruguay

Deciles

Consumption exempted or taxed at rate

zero

Consumption exempted or taxed at rate

zero

Consumption taxed at basic

rate

Consumption taxed at the

minimum rate

Consumption exempted from

the tax

1 1.6 4.5 2.2 2.7 2.32 2.0 6.5 3.2 3.8 3.03 2.5 7.2 4.3 5.0 4.04 3.1 7.8 5.4 5.8 4.75 4.7 8.4 6.7 7.3 6.16 4.9 9.5 8.1 9.0 6.97 6.9 9.7 10.4 11.1 9.58 9.0 11.3 12.2 13.5 10.99 15.9 14.0 16.9 16.7 16.410 49.3 21.1 30.7 25.3 36.2 Total 100.0 100.0 100.0 100.0 100.0 40% poorest 9.2 26.0 15.0 17.2 13.9 20% richest 65.2 35.1 47.6 41.9 52.6 20% richest/40% poorest

7.1 1.4 3.2 2.4 3.8

Sources : Trejos ( 2007 ) for Costa Rica; SAT ( 2008 ) for Mexico; Roca ( 2010 b) for Uruguay.


other words, the exemption is appropriated mainly by the higher income deciles. Using reduced rates and exemptions always runs into the dead end of errors of inclusion. Maybe it’s time to think again.

It is important to recall that the main objective of any tax is not to directly redistribute revenue but to raise revenue to finance expenditure that may be more redistributive. 23 It is more sensible to improve exploitation of the intrinsic advantages of each instrument (in the case of VAT, its tax collec-tion power, neutrality, and simplicity) instead of continuing to sharpen a spoon (by introducing exemptions and lower rates) that is not made for cutting. Since it would be illusory to believe that the existing exemptions could be removed, this discussion is more useful for preventing the intro-duction of new incentives and accepting the need for imaginative proposals to reform VAT that offer ways out of the current dead end.

Equity, Neutrality, and Simplicity: Is It Possible?

Achieving equity, neutrality, and simplicity all at the same time is the great challenge of tax policy. 24 When it comes to consumption taxes, it seems like an “impossible trinity.” In the words of Ainsworth ( 2006b ), “No consumption tax has ever had all three critical attributes of a progres-sive consumption tax: a wide base, a uniform rate, and measured relief for those in greatest need.” The various technically and politically efficient and viable options available for overcoming this apparent impossibility are analyzed here. The discussion is based on the proposals implemented in Japan and Canada and the theoretical formulations of the “D-VAT” of Ainsworth ( 2006b , c ) and “personalized VAT” or “P-VAT” of Barreix, B è s, and Roca ( 2010 b, 2012 ).

In short, there are two options for solving the problem. The first is to introduce a mechanism to target exemptions on specific individuals ( directly correcting the “inclusion error”). This inverts the logic used in the universal system implemented in most countries. Instead of identi-fying the goods and services considered to be of social interest and then introducing multiple rates and/or exemptions to the tax base in an effort to reverse the regressivity of VAT, this method starts by identifying the target population and then exempting the group from the tax whenever it consumes this limited set of goods and services.

The second option is to remove all exemptions and lower rates and implement a monetary compensation to correct the regressive effects of VAT for a particular group of taxpayers.

VALUE ADDED TAX 171

The D-VAT

The theoretical proposal of Ainsworth ( 2006a ), Digital-VAT (or D-VAT, in his original proposal), and the system in place in Japan fit into the first option. D-VAT proposes personalized taxing of taxpayers on each trans-action in real time. Taxpayers are identified with an identity card that contains the biometric information of the beneficiaries of the zero rate for certain goods and services. The card would exempt the holder from tax at the moment of the transaction with minimal risk of fraud—at least, in theory. The scope of the Japanese alternative is more limited; it combines the same logic of identifying beneficiaries for a set of goods and services with the universal method for others. 25 In this case, it is the tax legislation that identifies the target population groups that consume the goods and services it proposes to exempt.

The system in place in Canada implies an intermediate solution by combining the universal solution with the introduction of a transfer that benefits a group of taxpayers to partially reverse the impact of the tax. 26 The transfer amount is defined in terms of the taxpayer’s marital status, number of members in the family group, and income level. The transfer is made every quarter by the Canada Revenue Agency, the body responsible for Canadian tax administration. This procedure benefits from the low level of informality in the Canadian economy, the quality of the informa-tion, and capacity of its collection agency.

The P-VAT

Faced with the technological and administrative complexity and invasion of privacy involved in the methods advanced by Ainsworth and Japan, and the loss of revenue and requirements for formality in the economy of the Canadian approach, the theoretical proposal of the Personalized VAT (P-VAT) presents a way to solve the problem (removing all exemp-tions, lowering rates, and offering monetary compensation to low-income consumers).

The proposed P-VAT would generalize the tax base and unify the tax rate. 27 It would also offer tax relief for individuals in the lower income deciles. 28 This proposal has several advantages. First, generalization of the VAT base increases tax receipts: some portion of these greater receipts can then be transferred to the beneficiary target groups, improving equity.


Second, limiting the exclusions from the tax base and the differential treatment strengthen the neutrality and efficiency of the tax by reducing the cascade effect (see earlier discussion).

Third, generalization of VAT facilitates tax administration and pro-motes formality by using electronic payments. Fourth, the determina-tion of the refund amount is based on objective criteria (for example, the impact of the tax on the consumption basket of the corresponding decile), so it is not invasive with respect to individual consumption decisions. 29

Finally, the proposal is tailored to the conditions of informality and levels of institutional development of public administration in Latin America. This is true both for the method suggested for determining the amount of the benefit (the VAT refund, in this case), and for the process of identifying the target population and transferring the compensation, in an effort to minimize the potential for manipulation and patronage. To achieve this, the experience gained in the new generation of conditional income transfer programs could be built upon. 30 In Latin America, the technological requirements are available to deliver the benefits by regular deposits in an electronic card, in an amount equal to the impact of VAT on the consumption basket of the cutoff decile (selected to determine the amount of the subsidy). The card could be used for purchases or with-drawal of the funds deposited through the banking network. This system is already being used in some of the transfer programs implemented in the region. 31

The simulation of this proposal for some countries reveals its effects and limitations ( table 9.5 ). In the case of Costa Rica, the simulation assumes that the rate remains at 13 percent, and that the tax base is generalized with the exception of a few goods and services. 32 The proposed exercise is neutral in terms of revenue, since the entire increase from the generaliza-tion of the base is transferred to the first three deciles of the population. The results show the advantages of the proposal in terms of equity and income distribution: the Gini coefficient is reduced by three points and rates of extreme poverty and poverty fall 30.4 percent and 23.7 percent, respectively.

In the simulation for Uruguay, the VAT rate was unified at 19 percent (instead of the three existing levels of 22 percent, 10 percent, and exempt) on a tax base with few exceptions. 33 Transfers were assumed for the poor-est 30 percent of the population. Individuals in the third decile received transfers 1.75 times the estimated amount they pay in VAT based on their consumption basket. Individuals in the two lowest deciles received sub-stantially higher transfers (2.8 times what individuals in the third decile

Tabl

e 9.5

P-

VAT:

Res

ults

of S

imul

atin

g a

Gen

eral

izat

ion

of V

AT, w

ith R

efun

d by

Dir

ect T

rans

fer t

o th

e Poo

rest

Gro

ups

Chi

le (2

003)

C

osta

Ric

a (2

004)

N

icar

agua

(200

1)

Uru

guay

(200

4)

1. V

AT re

venu

e inc

reas

e and

tran

sfer

VAT

reve

nue i

ncre

ase (

perc

ent)

8.3

011

515

.3Tr

ansfe

r/VA

T re

venu

e inc

reas

e (pe

rcen

t)10

010

094

.774

.6Tr

ansfe

r/act

ual V

AT re

venu

e (pe

rcen

t)8.

333

.910

911

.4

A

fter

the

refo

rm C

hang

e with

re

spec

t to

base

year

A

fter

the

refo

rm

Cha

nge w

ith

resp

ect t

o ba

se

year

A

fter

the

refo

rm

Cha

nge w

ith

resp

ect t

o ba

se

year

A

fter

the

refo

rm

Cha

nge w

ith

resp

ect t

o ba

se ye

ar

2. W

ho p

ays n

et V

AT? a (p

erce

nt)

Dec

iles 1

to 4

8.5

�7.2

�12

.8�

24.9

10.6

�1.

57.4

�8.

1D

ecile

s 5 to

614

.51.

019

.85.

911

�1.

617

.01.

9D

ecile

s 7 to

821

.91.

526

.87.4

17.8

�1.

325

.42.

4D

ecile

s 9 to

10

50.2

4.8

66.2

11.6

60.6

4.5

50.2

3.8

Tota

l10

0.0

100.

010

0.0

100.

0 3.

Disp

osab

le in

com

e b dist

ribut

ion

Gin

i0.

489

�0.

014

0.54

8�

0.03

20.

559

�0.

017

0.46

8�

0.00

9D

ecile

s 1 to

414

.31.

010

.10.

910

.61.1

12.9

0.7

Dec

iles 5

to 6

11.7

�0.

110

.6�

0.2

110.

313

.4�

0.2

Dec

iles 7

to 8

18.1

�0.

217

.2�

0.3

17.8

�0.

321

.5�

0.2

Dec

iles 9

to 1

055

.8�

0.7

62.1

�0.

460

.6�

1.0

52.2

�0.

3To

tal

100.

010

0.0

100.

010

0.0

4. In

dige

nce

Num

ber o

f ind

igen

ts50

2,58

8�

225,

512

166,

418

�72

,798

2,01

7,596

�70

,689

11,4

13�

38,74

7Pe

rcen

tage

of i

ndig

ents

3.2

�31

.03.

9�

30.4

38.8

�3.

20.

4�

1.2

5. P

over

ty

Num

ber o

f poo

r2,

312,

050

�59

5,65

075

5,81

7�

233,

434

3,60

5,56

185

,233

588,

111

�67

,302

Perc

enta

ge o

f poo

r14

.8�

20.0

17.7

�23

.769

.32.

518

.8�

2.1

a Net

VAT

: Gen

eral

ized

VAT

net

of t

rans

fer.

b Gro

ss in

com

e – g

ener

aliz

ed V

AT +

tran

sfer.

Sour

ce : B

arre

ix, B

è s, a

nd R

oca (

2010

b, 2

012 )

.


were assumed to pay in VAT). The results show that even a reform that raises net revenue has a significant impact in terms of reducing inequality and extreme poverty, and a rather more modest impact on poverty.

Three methods can be used to compensate for the impact on the poor of generalization of VAT (Barreix, B è s, and Roca 2012 ). The first is the “pro-gressive” approach used in previous simulations. The amount transferred is incorporated into the disposable income of individuals, increasing their level of current consumption and therefore welfare. 34 The second is the “pro-pension” method. Some of the funds are allocated to an individual account to fund the beneficiary’s pension (that is, the beneficiary’s future consumption) (Anton, Hernandez, and Levy 2012). This approach cor-rects one of the main shortcomings of the social security system in Latin America. The third method is the “regressive” one. It consists of refunding a percentage of the monthly purchase paid through an electronic medium. It is classified as regressive because the refund will be higher, the higher the consumption and the higher the proportion of this consumption paid for by electronic means. Both the level of consumption and the use of elec-tronic means of payment are highly correlated with income level. However, formalization will improve horizontal equity, assuming that the propor-tion of VAT refunded to the taxpayer serves as a sufficient incentive.

The proposed compensation scheme—through which direct trans-fers are made to lower-income individuals who are disadvantaged by the removal of exemptions and lower rates—is not intended to be a viable option in all countries. Viability in this case would rest on two conditions. First, the degree of informality and poverty level would have to fall within certain limits 35 (see the case of Nicaragua 36 in table 9.5 ). Second, admin-istrative capacity must be sufficient to target beneficiaries and make the transfers. 37 Moreover, the effectiveness of the administration is relevant because generalizing the tax involves including the most “hard to tax” sectors. The advantage is that including all goods and services facilitates invoice tracking, an area in which many governments have already made significant progress.

Two possible macroeconomic policy alternatives resulting from the generalized application of VAT must be mentioned. First, if the increase in revenue from broadening the base is used to reduce (employer) contri-butions to social security, the empirical evidence (of DeMooij and Keen 2012 ) suggests that it would operate as a “fiscal devaluation,” resulting in a short-term improvement in the trade balance with the rest of the world. 38 Second, given the weakness of automatic fiscal stabilizers in Latin America (especially tax revenues due to the low weight of personal income tax, as

VALUE ADDED TAX 175

discussed in chapter 3 ), VAT could be used for this purpose, but with dis-cretion. One way would be to reserve in a fund the higher tax receipts from increases in GDP in boom times. A second possibility—which could be combined with the first—would be to increase the rate in boom periods, saving the excess receipts for use in periods of lower economic activity. Both measures could be integrated into a “fiscal rule” framework. The important thing is that a single-rate VAT on a broad base would facilitate their implementation.

Neutrality and Simplicity Above All

VAT is now the cornerstone of tax revenues in Latin America. Although there is significant margin for improvement ready to be exploited, the tax needs to be protected from attempts at reform that threaten its col-lection capacity, neutrality, and simplicity—which are its raison d’être. Exemptions and lower rates undermine receipts, impair neutrality, and handicap administration of the tax without improving its redistributive impact.

While not ignoring the political feasibility of possible reforms, it is desir-able that VAT should achieve the objectives for which it was designed, and which have been adopted as tax pillars in many countries. With respect to the other objectives, such as taxing the wealthy more heavily or increasing the spending power of lower-income deciles, the best recommendation is to use other tools. Examples include levying income or property taxes on the higher deciles, or pursuing transfer programs designed to increase the disposable income of the poor.

In short, VAT is, par excellence, the appropriate tax for raising revenue with the greatest possible neutrality and simplicity. By collecting more revenue in a simpler way, VAT can make a better contribution to redistri-bution by helping finance transfers or targeted expenditure programs. The proposals for VAT refunds to the poorest sectors through direct transfers that have been presented in this chapter do not conflict at all with this spirit. Rather, they can be viewed as an application defined by these prin-ciples. This adherence to first principles could also improve the political feasibility of the reforms that VAT currently needs in several countries to collect more revenue, simply and without distortions.

10

Taxing Commodities with the Future in Mind

Fiscal revenues from nonrenewable resources are critically important for Latin America and the Caribbean. Eight countries, representing

43 percent of the region’s GDP, obtain a significant share of their fiscal revenues from nonrenewable resources such as oil, gas, and minerals. For example, Venezuela and Trinidad and Tobago derive about half their total fiscal revenues from nonrenewable resources, and Bolivia, Chile, Ecuador, and Mexico derive between 25 percent and 35 percent. In Colombia and Peru, while fiscal dependence is much lower, it has increased consider-ably in recent years ( table 10.1 ).

Nonrenewable resources have special characteristics. As their name suggests, these resources—and hence the associated fiscal revenues—will eventually be depleted. In addition, their exploitation requires substantial investments, there is high uncertainty in terms of both potential produc-tion and prices, and the private investor generally has superior information regarding the cost structure of exploration, development, and production. In addition, the political benefits of reneging on agreements to recover all costs are high, given that a large portion of investments are made up front and private operators would continue to produce as long as operational costs can be recovered. 1 There are also potential disputes about how to share fiscal revenues from nonrenewable resources among different levels of government and across generations. Finally, the availability of nonre-newable resources has sometimes been associated with a “resource curse,” leading to weaker institutional capacity and governance and ultimately hurting economic growth.

Nonrenewable resources matter greatly for taxation and development. To a large extent, the design of revenue instruments applied to the non-renewable sector will determine investment and depletion rates of those resources, and the fiscal revenues available to governments and generations


over time. 2 In addition, the availability of such fiscal revenues may tilt the debate on what taxes to extract from the rest of the economy, influencing the level and composition of nonresource general taxes. Against this back-ground, the first part of the chapter looks at the trade-offs involved in the design of revenue instruments that fall on the nonrenewable sector. The second part of the chapter considers how the availability of these fiscal revenues has affected tax systems in general across the region.

Extracting Nonrenewable Resources versus Extracting Fiscal Revenues

Nonrenewable resources are generally owned by the nation in which they are found. Hence rents from the sector should accrue to governments on behalf of the population. In turn, mainstream economic theory suggests that private agents exploiting the resource should obtain a normal level of return, com-mensurate with the risks involved in their investments. 3 In theory, a govern-ment could establish a competitive auction that would yield the expected net present value of the activity, thus capturing the entire rent available. It could then tax the activity at regular rates employed on the rest of the economy. In practice, this first best is generally impossible to implement. 4 If private agents are to exploit the resource, a revenue system must then be designed that will be second best in nature and trade off a set of objectives. 5

Table 10.1 Fiscal Revenues Derived from the Exploitation of Nonrenewable Resources

Countries

1994–98 2005–10 1994–98 2005–10

As a percent of GDP As a percent of fiscal revenues

Bolivia 5.4 10.7 22.8 33.6Chile 1.5 6.5 6.5 25.1Colombia 0.6 1.8 2.8 7.0Ecuador 5.9 7.3 31.4 25.1Mexico 2.9 5.5 17.7 26.8Peru 0.1 1.6 0.8 8.2Venezuela 9.4 11.9 48.6 45.5Trinidad and Tobago

5.2 17.5 19.3 53.1

Average 3.9 7.5 18.7 28.1

Source : Authors’ elaboration based on Ossowski and Gonz á les ( 2012 ), IDB and CIAT ( 2012 ), and IMF ( 2012 b).

TAXING COMMODITIES WITH THE FUTURE IN MIND 179

A first basic trade-off is that higher levies on the resource sector will reduce investment and production. In general, the total rate applicable to the sector will determine the share of the rent accruing to the government rather than private firms. However, the higher the share of the rent cap-tured by the government, the lower will be investment and production of the resource in question. 6 For example, for oil-rich countries, Perry and Ho ( 2012 ) find that an increase of 10 percent in the tax ratio reduces the number of active rigs by about 2.6 percent to 4 percent, which in turn reduces production by between 0.5 percent and 0.75 percent. 7 If govern-ments wish to extract more rents today, this will impact investment in the sector and fiscal revenues tomorrow. The authors also show that countries with better institutions are able to obtain higher investment at a given effective rate relative to countries with weaker institutions. 8

Within this basic trade-off, there are more subtle trade-offs. To a large extent these depend on the revenue instruments employed. The more tra-ditional instruments have been royalties on production and income taxes. Over time, dividend taxes and so-called rent or R-factor taxes have been introduced. More recently, contingent royalties, royalties on profits, or some concept of net income and windfall taxes have been added to the menu ( box 10.1 ).

Box 10.1 Fiscal Regimes for the Nonrenewable Resource Sector

The main instruments to obtain fiscal resources from the nonrenewable sector include both tax and nontax items. Tax instruments include corporate income taxes, withholding taxes, progressive profit taxes, windfall profit taxes, and export taxes. Nontax instruments include royalties, fees and signature bonus payments, production sharing and service contracts, and income from state equity partici-pation in the resource sector, including dividends and transfers from national oil companies.

Traditional Instruments: Royalties and Income Taxes Exploitation of nonrenewable resources normally requires large upfront invest-ments. Once the infrastructure is in place, production entails a second set of costs. Two margins are often then considered: the “operational margin,” related to the decision to produce, once the investment is made; and the “net profit margin,” related to the net return on the investment. Royalties—which normally are spec-ified as a levy on production (either an amount per unit produced or a share of sales)—tend to distort both margins. Royalties thus affect the extraction path and the investment decision and discriminate against “high-investment/cost” projects, such as deep water extraction of oil, or high-priced production, such as refining light crude (Manzano 2000 ).


Table 10.2 summarizes the instruments commonly employed and ranks them according to certain desirable characteristics, including: 9

● Neutrality: A system is said to be neutral if it does not affect the decisions of private agents.

● Flexibility: A system is said to be flexible if it may adapt to changes in external conditions.

● Stability: A system is stable if there are no large changes, or if changes are predictable.

Taxes on income tend to be more neutral. However, they can also affect investment decisions, depending on the depreciation rules regarding the initial investment applicable under the income tax regime. High investment projects are discouraged to the extent that depreciation credits are limited. In addition, both instruments are “regressive” in nature. As the commodity price increases, the proportion of the tax that is pure rent decreases. Royalties and income taxes also tend to fail in terms of flexibility and stability.

Dividend Taxes and “Rent Taxes” Independently of the tax treatment of dividends in a country’s tax system, coun-tries rich in natural resources have adopted a dividend tax on private producers. These taxes are based on the idea that if substantial rents remain after other taxes have been collected, the public sector can capture a further share of these rents. A downside of these taxes is that they tend to induce overinvestment and potentially gold plating: or, in other words, increase incentives for private firms to inflate costs.

An alternative is the “rent” tax—also known as R-factor tax or Rate of Return taxes. Taking into account the potential cash f lows and the risks of the proj-ect, a normal rate of return is calculated; profits in excess of that rate of return are taxed. In theory, such taxes are neutral. In addition, they should be f lex-ible, since any good news in geology or prices should increase the rate of re-turn and increase tax revenues. However, they require excellent information on the part of tax authorities to set appropriate rates of return. Furthermore, since the return should be project-based, not company-based, the tax administration must set provisions for “ring-fencing” to properly measure the project-specific returns for firms with different projects. However, this may also allow for the use of a type of yardstick regulation across different projects. Finally, a non-trivial issue is the treatment of debt. If debt is considered a cost, then this may encourage intrafirm lending.

Contingent Royalties and Windfall Taxes Contingent royalties are royalties whose rate is contingent on different (external) factors, such as prices, profits, or cash flow. Finally, windfall taxes may be considered a hybrid because they are based on net profit but contingent on prices. In recent years, windfall taxes have gained popularity.


Traditional systems of royalties and income taxes score poorly on neu-trality and stability. Profit or net income taxes may be more efficient and may display a greater deal of stability. However, they increase the com-plexity of the system and the administrative burden.

Revenue Systems for Nonrenewable Resources in Latin America

In general, government income from the nonrenewable sector has been relatively high in Latin America and the Caribbean. 10 In terms of the trade-off between production of the commodity and generation of fiscal revenue for each unit of production, the region has tended to favor the lat-ter. Moreover, revenue systems have changed frequently over time, reflect-ing political and price cycles, with rates rising at times of higher prices and with more left-leaning governments. 11 Some governments have also resorted to nationalization of companies in the resource sector.

Table 10.3 details revenue systems for nonrenewable sectors in select Latin American and Caribbean countries. There are significant differ-ences both between countries producing the same product and in the same country across different products. In the case of minerals, the tra-ditional instruments of royalties and income taxes continue to dominate, while there has been a shift toward taxing profits rather than production. The case of oil, however, has made greater use of contingent instruments, perhaps because of the size of the rents available in this sector.

Table 10.2 Instruments and Desired Characteristics

Instrument Neutrality Flexibility Stability Administrative compliance

Output-based taxes a Specific royalty Low Low Low HighAd valorem royalty Low Low Low HighContingent royalty Low Intermediate Intermediate High

Profit-based taxes Corporate income

taxesIntermediate Intermediate Intermediate Intermediate

Remittance taxes b Intermediate Intermediate Intermediate IntermediateRent-based taxes c High High High High

a “Specific royalties” are a fixed amount per unit produced; “ad valorem” is a rate on the value of production; and “contingent” are based on other variables. b Mostly a tax on foreign companies on dividend repatriation. c Different modalities that aim to tax the pure profit. Source : Authors’ elaboration.

Tabl

e 10.

3 Re

venu

e Ins

trum

ents

in L

atin

Am

eric

a an

d th

e Car

ibbe

an

Sect

or

Cou

ntry

Roya

lty

Inco

me T

ax

Win

dfal

l ta

xes

Div

iden

d O

ther

taxe

s St

ate

part

icip

atio

n C

ontr

act

cont

inge

ncy

Dif

fere

nt ra

te

to co

rpor

ate

Oil

Arg

entin

aYe

s—fix

ed ra

te o

f 12

per

cent

No

Yes

No

No

No

No

Yes

Mex

ico

No

No

No

No

Yes—

righ

t on

hydr

ocar

bons

for

the s

tabi

lizat

ion

fund

(pai

d w

hen

pric

e exc

eeds

a th

resh

old)

No

Ord

inar

y ri

ght o

n hy

droc

arbo

ns: 7

3.5

perc

ent o

f sal

es v

alue

; ri

ght f

or th

e Fun

d fo

r Te

chno

logi

cal a

nd

Scie

ntifi

c Res

earc

h,

amon

g ot

hers

Yes—

natio

nal

com

pany

onl

y pr

oduc

er

Trin

idad

and

To

bago

Yes—

10 p

erce

nt o

n on

shor

e sal

es a

nd

12.5

per

cent

on

offs

hore

sale

s

No

Yes—

50

perc

ent

of g

ross

re

venu

es

No

No

No

Supp

lem

enta

l pet

role

um

tax:

0 p

erce

nt to

35

perc

ent d

epen

ding

on

oil p

rices

Yes

Vene

zuel

aYe

sYe

sYe

sYe

sYe

sN

oTe

rrito

rial

tax

Yes—

natio

nal

com

pany

; 60

perc

ent o

n jo

int

vent

ures

Gas

Arg

entin

aYe

s—fix

ed ra

te o

f 12

per

cent

No

Yes

No

No

No

Expo

rt ta

xYe

s

Boliv

iaYe

s—12

per

cent

No

Yes

No

No

No

Dire

ct ta

x on

hy

droc

arbo

ns (I

DH

); 32

per

cent

of g

ross

ou

tput

; add

ition

al

32 p

erce

nt ta

x on

m

egaf

ield

s’ pr

oduc

tion

Yes

Trin

idad

an

d To

bago

Yes—

Fixe

d ra

te o

f 12

.5 p

erce

ntN

oYe

s—35

pe

rcen

t on

prof

its

No

No

No

No

Yes

Peru

Yes—

37.2

4 pe

rcen

t for

loca

lly

cons

umed

gas

; 30

per

cent

to 3

8 pe

rcen

t for

gas

ex

port

ed

Yes

Yes,

30

perc

ent

No

No

No

No

Yes

Cop

per

Arg

entin

aYe

s—0

perc

ent t

o 3

perc

ent d

epen

ding

on

the p

rovi

nce

No

Yes

No

No

No

Sale

s tax

Yes

Chi

leYe

sA

fter 2

006,

0

perc

ent

to 5

per

cent

de

pend

ing

on

scal

e

Yes

Yes (

min

ing

inco

me t

ax,

depe

nds o

n sc

ale)

No

Yes (

4.1

perc

ent o

n no

ndom

icile

d)

No

Yes

Peru

Yes

1 pe

rcen

t to

12

perc

ent (

paid

if

no st

abili

zatio

n ag

reem

ent)

Yes

Yes (

spec

ial

min

ing

tax,

pa

id if

no

stab

iliza

tion

agre

emen

t)

No

Yes (

4.1

perc

ent o

n no

ndom

icile

d)

Wor

kers

pro

fit

shar

ing

Yes

Mex

ico

No

No

Yes

No

No

No

Wor

kers

pro

fit sh

arin

g an

d sp

ecia

l m

inin

g du

ty

No

Gol

dPe

ruYe

sYe

sYe

s, fix

ed

rate

of 3

0 pe

rcen

t

No

No

Yes (

4.1

perc

ent o

n no

ndom

icile

d)

No

No

Sour

ce :

Car

ranz

a et

al.

( 201

2 ); C

arre

ó n-R

odr í

guez

, Ros

ell ó

n, a

nd Z

en ó n

(200

9); C

oope

r and

Mor

on ( 2

012 )

; Fue

ntes

, Pie

drab

uena

, and

Cal

ani (

2012

); Je

mio

( 200

8 ); K

awam

ura

( 201

2 );

and

Man

zano

( 201

2 ).


There has also been a tendency to increase the complexity of instru-ments. In Peru, the design of royalties currently mimics taxes on net profits. The arrangement is similar in Chile, which has a “Specific Tax on Mining.” Venezuela’s windfall tax in the oil sector is a royalty contingent on the price. The mix of instruments further complicates the analysis of the tax burden. For example, Chile has adopted lower income taxes for copper than Mexico and Peru, but a higher tax on dividends. Chile is also more generous in terms of depreciation allowances.

What is the overall impact of these differences? Figure 10.1 shows some results. For the typical mine in private-sector hands, the net present value and the internal rate of return in Chile exceeds that of both Mexico and Peru, while the total government take is the highest in Peru. Not surpris-ingly, the Chilean system has made the sector more attractive for invest-ment. 12 However, the Chilean system has placed the greatest risks on private sector companies. As seen in figure 10.2 , the system has greater volatility of internal rates of return relative to both Mexico and Peru. Recent reforms of the Peruvian system will place greater emphasis on taxing profits versus taxing sales in hopes of attracting greater investment in the sector.

Figure 10.1 Simulations on Effective Tax Rate (ETR) and Internal Rate of Return

Source : Carranza et al. ( 2012 ).

40.9

46.9

56.9

30.7

35.0

46.0

0

10

20

30

40

50

60

Chile Mexico Peru

Per

cent

ETR discounted ETR not discounted Internal rate of return


Are Regimes in Latin America Costly in Terms of Efficiency?

Just as revenue regimes in the region vary significantly, so too do their efficiency. Figure 10.3 illustrates simulated production paths for two products in Peru (gas and gold) given the actual revenue structure (base), a pure roy-alty system, a pure income tax system, and assuming the sector was untaxed. Comparing the untaxed simulations to the actual revenue structure (base), an estimate can be made of the extent of the distortions created by the current system. In most cases, the pure income tax system is very close to the untaxed system, indicating that, for these sectors, a pure income tax would be the most neutral regime. In turn, a pure royalty system would create greater distor-tions, delaying private production over time.

Turning to the copper sector, figure 10.4 compares the cases of Chile and Peru. In Chile, the current system of royalties based on net income is very close to the optimal path. In Peru, the actual system (base) is farther from the untaxed path. However, recent reforms in Peru will make the system

Figure 10.2 Simulations on Internal Rate of Return with Different Copper Prices (percent)

Source : Carranza et al. ( 2012 ).

64.0

59.2

54.7

38.535.0 33.4

17.7 17.3 16.8

0

10

20

30

40

50

60

70

Chile Mexico Peru

Per

cent

High price Base price Low price

0

20

40

60

80

100

0 5 10 15 20 25 30

Y a

xis

= In

dex

; 100

= m

ax p

rod

uct

ion

Untaxed Base Income tax Royalty

0

20

40

60

80

100

0 5 10 15 20 25 30

100

= m

ax p

rod

uct

ion

Time in years

Untaxed Base Income tax Royalty

Figure 10.3 Simulations on Gas and Gold Taxation in Peru

a. Production Path for the Gas Sector

b. Production Path for the Gold Sector

Source : Cooper and Moron ( 2012 ).

0

20

40

60

80

100

0 5 10 15 20 25 30

Y a

xis

= In

dex

; 100

= m

ax p

rod

uct

ion

Time in years

Untaxed Base Income Tax Royalty

Figure 10.4 Simulations on Copper Taxation in Chile and Peru

a. Production path for Peru

Source : Cooper and Moron ( 2012 ); Fuentes, Piedrabuena, and Calani ( 2012 ).

0

1

2

3

4

5

6

7

0 10 20 30 40 50 60

Mill

ion

met

ric

ton

s

Time in years

Untaxed Royalty Gross revenue tax

b. Production path for Chile


similar to the income tax case, and hence more neutral and less distortion-ary, despite higher effective rates. The simulations illustrate that when the system moves toward a more profit-based system, effective tax rates may matter less in terms of efficiency. Of course, the attractiveness to investors will be affected, but as long as internal rates of return exceed the cost of capital, there are incentives to invest. 13 Furthermore, the case of Peru indi-cates that there will be increases in tax collection with efficiency gains.

In the case of oil in various countries, the instrument mix tends to place a greater weight on traditional royalties. Hence, these systems tend to be less neutral and would be more distant from the untaxed case. For instance, in Venezuela in the 1990s, the government introduced three dif-ferent regimes in addition to the regime that was already in place. The regimes were applied to certain “marginal areas” to foster investment. However, as shown in table 10.4 , the government would have been able to increase total fiscal revenues had it followed a general reform using

Table 10.4 Impact of a General Reform to the Venezuelan Oil Sector

Variables

Effects on traditional areas of applying . . . . . . regime A (Base)

. . . regime B

. . . regime C

. . . regime D

Reserves (percent of stock) 68,40 84,97 72,55 88,62Change with respect to base n.a. 16,51 4,15 20,22Social value of the marginal

barrel91,880 49,280 90,438 18,108

Tax Revenue (2,000 US$ billions)

628.6 418,26 706,66 646,57

Change with respect to base n.a. –210,32 78,08 17,99

Notes :Regime A: 1/6 royalty and 66.7 percent income tax.Regime B: 34 percent income tax and variable royalty ranging from 1 to 16.67 percent, depending on the profitability. Regime C: A firm operates a field on behalf of the national oil company (NOC) and receives a fee per barrel. In this case, the company producing for NOC pays the tax rate that applies to all nonoil companies (30 percent) and the NOC pays 1/6 royalty and 66.7 percent income tax. Competitive bidding would imply that the income tax distortion is removed. Regime D: (1) There is a variable royalty; (2) the tax rate is still 67 percent; and (3) an auction was called in which companies bid upon the government participation rate in the post-tax “economic” profits—that is, including developmental costs. This was called the PEG rate. However, the PEG was set to a maximum of 50 percent. Therefore, if two or more companies bid 50 percent, a second auc-tion was made but firms bid upon an up-front payment. n.a.: not applicable. Source : Manzano ( 2000 ).


Box 10.2 International Initiatives on Governance and Transparency in Extractive Industries

Dodd-Frank legislation in the United States. The Dodd-Frank Wall Street Reform and Consumer Act, including the Cardin-Lugar Energy Security through Transparency (Cardin-Lugar) provision, contains comprehensive financial reg-ulatory reform measures. The US Securities and Exchange Commission (SEC) approved on August 22, 2012, the rule implementing Section 1504 (Cardin-Lugar provision) of the Dodd-Frank Wall Street reform bill. Extractive sector com-panies, including those with operations in Latin American countries, will be required, as part of their annual filings to the SEC, to disclose what they pay to the US government and foreign governments. This information must be posted online on a disaggregated country and project basis. Since all oil, gas, and mining companies registered with US stock exchanges will be covered by this legislation,

regimes C and D. These regimes would have increased the development of reserves in all areas of production. Furthermore, the original (base) regime leaves barrels of oil in the ground that have a high marginal value for the society. The main characteristic of the superior regimes C and D is their emphasis on profit taxation or profit sharing.

To summarize, the instrument mix applied to the nonrenewable resource sector varies greatly across countries in the region. While some countries continue to maintain traditional systems of royalties and income taxes that score poorly in terms of neutrality and stability, others have moved to tax profits or net income. These systems may be more efficient and stable and have allowed some countries to increase effective tax rates as prices have risen.

However, systems have also become more complex, and there is now a greater emphasis on monitoring costs and transparency in general. In this respect, an important innovation has been the development of inter-national standards on the exploitation of nonrenewable resources. The Extractive Industry Transparency Initiative (EITI) is probably the most important initiative in this area; box 10.2 lists other relevant standards. EITI provides a framework for governments, the private sector, and other stake holders to obtain information and participate in decisions regarding natural resource extraction. If this process can also serve to enhance trust between the parties and reduce information asymmetries, then revenue systems might be designed to reduce distortions and enhance economic efficiency. However, given the political economy, it seems doubtful that politics will ever be removed from decision-making in this area.


the measure covers 90 percent of the world’s largest internationally operating oil and gas companies, and eight of the world’s ten largest mining companies. Hong Kong Stock Exchange requirements. These rules require listed natural resource companies to disclose on a country-by country basis all payments of tax, royalties, and other significant payments made to host country governments (HKEx 2010 ). Legislation at the EU level. On September 18, 2012, the European Parliament’s Committee on Legal Affairs (the “Committee”) voted in favor of proposed EU legislation to impose disclosure obligations aimed at deterring corruption by large companies involved in extracting oil, gas, and minerals and in the logging of pri-mary forests. The legislation requires extractive sector companies to report pay-ments at the country and project level. G8 and G20 initiatives. At the 2011 meeting in Deauville, France, the G8 wel-comed “efforts to increase revenue transparency and commit to setting in place transparency laws and regulations or voluntary standards that require or encourage oil, gas and mining companies to disclose any payments they make to governments.” The Kimberely Process for diamonds. It is a joint government, industry, and civil society initiative to stem the f low of conflict and illicit diamonds. Representing 75 countries, it focuses less on revenue disclosures and more on the transpar-ency of the entire supply chain of diamond mining. It promotes the Kimberley Process Certification Scheme, which imposes extensive requirement on its members to enable them to certify shipments of rough diamonds as “conflict-free.”

Extracting Resource Revenues versus General Tax Revenues

The previous section established that tax design can impact the amount of fiscal revenue from nonrenewable resources accrued by the government and highlighted the importance of striving for neutral, efficient, and flex-ible instruments.

Yet more fiscal revenues from nonrenewable resources have not always been associated with good news. Indeed, many have referred to the avail-ability of such revenues as a “resource curse,” arguing that resource abun-dance has an adverse impact on institutional capacity and governance, and ultimately economic growth. A prevailing hypothesis is that the availability of fiscal revenues from resources lowers incentives to collect general taxes from the rest of the economy. And governments less reliant on general taxes are prone to be less accountable, responsive, and efficient. Moreover, fiscal dependence on resource revenues increases fiscal risks, as these revenues are


volatile, 14 and importantly, finite. Hence, policymakers need to plan ahead to make up for fiscal revenues from resources that will be depleted over time.

In a new empirical study, Ossowski and Gonz á les ( 2012 ) analyze the implications of the availability of fiscal revenues from nonrenewable resources for general taxes in the Latin American region. The authors look at the evolution of overall tax levels and their composition in the Latin American resource-rich countries against a comparator group of countries. 15 Indeed, fiscal revenues from nonrenewable resources have had a significant displacement effect on general tax revenues. As shown in table 10.5 , both groups of countries collected about 26.5 percent of GDP in total fiscal revenues from 2005 to 2010. And the resource-rich countries have increased overall fiscal revenues more rapidly over the last decade than the comparator countries. Yet, while resource-rich countries collected 13.6 percent of GDP in general taxes, the comparator countries collect about 18 percent of GDP.

Econometric analysis by Ossowski and Gonz á les ( 2012 ) confirms that the availability of fiscal revenues from resources has had a displacement effect on general tax revenues of about 20 percent; that is, for every 1 per-cent of GDP in resource revenues, general tax revenues decline by 0.2

Table 10.5 Fiscal Revenues in Latin America and the Caribbean Percent of GDP

Difference

1994–98

Difference

2005–10

Resource-rich countries

Other countries

Resource-rich countries

Other countries

Total revenues 21.0 22.1 –1.1 26.5 26.5 0.0Revenues from

nonrenewable sector

3.9 n.a. n.a. 7.5 n.a. n.a.

General revenues 17.1 22.1 –5.0 18.8 26.5 –7.7Ordinary

revenues15.3 18.0 –2.7 16.9 22.0 –5.1

Tax revenues 12.2 14.6 –2.4 13.6 18.1 –4.5Nontax revenues 3.2 3.4 –0.2 3.3 3.8 –0.5

Social security contributions

1.8 4.1 –2.3 1.9 4.5 –2.6

Notes : Resource-rich countries: Bolivia, Chile, Colombia, Ecuador, Mexico, Peru, Trinidad and Tobago, and Venezuela. Central government revenues for Trinidad and Tobago and Venezuela. Other countries: Argentina, Brazil, Costa Rica, El Salvador, Honduras, Paraguay, and Uruguay. Central government revenues for Costa Rica and Paraguay. Source : Ossowski and Gonz á les ( 2012 ), IMF ( 2012 b), and IDB and CIAT ( 2012 ).


percent of GDP. This substitution became accentuated since the rise in commodity prices from 2005 onward and is generally more pronounced in those countries with more abundant nonrenewable resources. The authors also find that institutional quality and greater political stability tend to reduce the displacement effect that can be caused by abundance of nonrenewable resources.

Despite the rising difference in general tax revenues observed in resource-rich (RR) countries and other comparator countries, the dis-placement effect does not occur in the two main pillars of Latin American tax systems: value added tax (VAT) and income tax. On the contrary, the gap in tax collection in these pillars between the two groups of coun-tries has tended to close over recent years ( figure 10.5 ). And as shown in Ossowski and Gonz á les ( 2012 ), the efficiency of the VAT in both groups of countries is about the same.

Where does the most sizable displacement take place? The most important differences in tax revenues are concentrated in selective taxes on the consumption of certain goods and services and in “other” taxes. With respect to selective taxes, the difference between the two groups

4.7

3.4

1.4

2.7

3.2

1.8

5.9

3.0

1.7

4.1

3.4

4.10.0

2.0

4.0

6.0VAT

Income tax

Selective taxes

Other tax revenues

Nontax revenues

Social securitycontributions

Resource-rich countries(percentage of GDP )

Other countries (percentage of GDP)

Figure 10.5 Revenue Structure of Resource-Rich Countries and Other Countries in Latin America and the Caribbean

a. 1994–98


5.8

4.4

1.0

2.3

3.4

2.0

7.3

4.5

2.0

4.3

3.8

4.50.0

2.0

4.0

6.0

8.0VAT

Income tax

Selective taxes

Other tax revenues

Nontax revenues

Social securitycontributions

Resource rich countries(percentage of GDP )

- Other countries (percentage of GDP)

b. 2005–10

Source : Ossowski and Gonz á les ( 2012 ).

of countries evolved from a negligible magnitude of 0.3 percent of GDP in 1994–98, to a sizable 1 percent of GDP in 2005–10. A big share of this difference is explained by substantially lower revenues from excises on domestic petroleum products in the resource-rich countries. In some of the oil-producing countries in the region, price hikes in international mar-kets have not been passed on to the consumer, and collection of excises on domestic petroleum products has decreased noticeably since 2005. This implies a hidden subsidy of considerable magnitude; Venezuela and Ecuador stand out, as does Mexico, albeit to a lesser degree. These sub-sidies entail a high opportunity cost and fiscal sacrifice for the region’s resource-rich countries.

Among the so-called other taxes, tax revenues are significantly higher in comparator countries. However, comparison becomes very problem-atic due to the diversity of existing taxes. Some of these taxes have been of only a temporary or transitory character. And many of these taxes gen-erate significant economic distortions, such as the taxes levied on finan-cial transactions that exist in various Latin American countries, or the export duties in Argentina.


Policy Conclusions

For many countries in the Latin American and Caribbean region, non-renewable resources provide an important and growing source of fiscal revenue. Much of the recent increase in these revenues has been supported by a very favorable commodity price cycle. Yet there is considerable room to increase revenue mobilization from the resource sector. Many coun-tries in the region continue to rely on traditional systems of royalties and income taxes, which tend to be non-neutral and unstable. The simula-tions in the chapter show that instruments based on net income, profits, or taxes designed to capture rents have greater scope to increase both effi-ciency and revenue collection. Indeed, countries that have shifted toward profit-based taxation have seen double dividends in both dimensions. However, the new taxes raise the bar in terms of information and trans-parency requirements. Only with improved institutions and enhanced trust between the relevant parties—national governments, the private sec-tor, and local governments and communities—can tax systems provide greater revenues today without sacrificing private sector investment and production, and hence future fiscal revenues.

Yet more fiscal revenues from resources have tended to undermine efforts to collect general taxes from the rest of the economy. Indeed, the gap between general taxation in resource-rich and other countries in the region has widened over the last decade. A key driver has been lower col-lection of excises on domestic petroleum products by the resource-rich countries, entailing a large and costly hidden subsidy. These results pre-sent another set of challenges for taxation in the resource-rich economies. Fiscal revenues from resources tend to be more volatile than general taxes. Moreover, they will be exhausted as nonrenewable resources are depleted over time. It is thus critical that policymakers plan ahead to strengthen the general tax base to meet expenditure needs.

11

Protecting Goods by Taxing “Bads”

The Case for Taxing “Bads”

The production of “bads” is nearly as old as man and most certainly pre-dates the market economy: it is believed that some species of large North American mammals were exterminated by nomadic hunters who corralled and killed large herds, depleting the hunt for later generations. “Bads”—or in economic terms, negative externalities—are an undesirable by-product of either the production or consumption of goods.

Externalities usually arise involuntarily in the process of producing or consuming goods when one agent generates benefits or costs from an-other agent without having negotiated any payment or compensation. Externalities can be either positive or negative. This chapter focuses on “bads” or negative externalities, and what taxes can do to solve or mitigate the problems that arise from their production.

Taxing “bads” yields at least two benefits. First, taxes generate revenues, which can be used to deal with the “bad”—such as cleaning up pollution—expand the provision of public goods and services, or lower other taxes. Second, and as importantly, they act as disincentives and reduce the pro-duction of “bads,” increasing environmental quality and thus improving the well-being of the population.

In Latin American and the Caribbean, environmentally related taxes are low compared to the “bads” generated. Thus, there is room to increase these taxes, collect more revenues, and improve the quality of life.

What Are Environmental “Bads”?

There are many types of environmental “bads.” Some arise from greater population densities in cities (so-called urban agglomerations) and are


present in many cities or parts of cities around the world; these include air pollution, noise pollution, the generation and disposal of waste and waste-water, traffic congestion, and foul odors. Other environmental problems are more widespread and may even have a regional or global impact; these include desertification, transboundary air and water pollution, depletion of the ozone layer, and climate change.

Latin America suffers from numerous environmental problems, in-cluding air pollution in cities; water pollution in rivers, lakes, under-ground streams, and coastal areas; waste and wastewater management issues; deforestation and land degradation; desertification; and loss of bio-diversity. Table 11.1 illustrates for the Caribbean region the most impor-tant environmental problems affecting each country.

Global, Regional, and Local “Bads” One useful distinction is to classify “bads” by their geographic incidence: global, regional, or local. Global “bads” are those that may affect popula-tions in different parts of the world, although the economic activity that generated the “bad” was undertaken in some specific location. The most notable global “bad” is climate change due to greenhouse gas (GHG) emis-sions. Other global environmental problems include depletion of the ozone layer from the use of chlorofluorocarbons (CFCs) and loss of biodiversity due to deforestation and overfishing.

Perhaps the most commonly known regional “bad” is acid rain. This problem arises from sulfur dioxide emissions, most of which originate as a by-product of burning coal to generate electricity. These emissions are carried by prevailing winds to neighboring areas (other states or coun-tries), and then generate acid rain in these areas—sometimes very far away from where the emissions were generated. Downstream pollution in rivers also has the potential to be regional in nature. An example is the “dead zone” in the northern part of the Gulf of Mexico, which has resulted from agricultural fertilizer washing down the Mississippi River.

Most “bads” are of a local nature, however. Many economic activi-ties, including industrial production, mining, forestry, aquaculture, and agriculture, tend to affect the air, water, or land quality in localized areas. Agriculture, for example, pollutes nearby bodies of water through the use of fertilizers, causing algae “blooms” and choking off aquatic life. Deforestation degrades the land, increasing the risks of flooding and landslides, releases large amounts of greenhouse gases, and contributes to the loss of biodiver-sity. Mining activities tend to pollute the air and water with toxic pollutants such as arsenic and lead that may severely compromise human health.

Tabl

e 11.

1 M

ain

Envi

ronm

enta

l Pro

blem

s in

Sele

ct C

arib

bean

Cou

ntri

es

Exte

rnal

ities

Ba

ham

as

Barb

ados

Be

lize

Guy

ana

Jam

aica

Sur

inam

e Tr

inid

ad a

nd T

obag

o

Land

D

egra

datio

n of

man

grov

es a

nd w

etla

nds

✓

✓

✓

✓

✓

✓

✓

Beac

h er

osio

n an

d lo

ss o

f acc

ess

✓

✓

n.r.

n.r.

✓

n.r.

n.r.

Def

ores

tatio

n an

bio

dive

rsity

loss

✓

✓

✓

✓

✓

✓

✓

Solid

was

te m

anag

emen

t and

disp

osal

✓

✓

✓

✓

✓

✓

✓

Haz

ardo

us a

nd m

edic

al w

aste

man

agem

ent

✓

✓

✓

✓

✓

✓

n.r.

Floo

ding

due

to la

nd sl

ippa

gen.

r. ✓

n.

r.n.

r. ✓

n.

r.n.

r.Po

llutio

n du

e to

oil a

nd m

inin

g ac

tiviti

esn.

r. ✓

n.

r. ✓

✓

✓

✓

Po

llutio

n du

e to

agric

ultu

ral a

ctiv

ities

(fer

tiliz

er u

se)

n.r.

✓

n.r.

✓

✓

n.r.

✓

Air Gre

enho

use g

as (C

O 2 )

emiss

ions

✓

✓

✓

✓

✓

n.r.

✓

Cor

al re

ef d

egra

datio

n du

e to

dust

pol

lutio

n ✓

✓

n.

r.n.

r.n.

r.n.

r.n.

r.In

crea

sed

inte

nsity

and

freq

uenc

y of

hur

rican

es a

nd st

orm

s due

to

clim

ate c

hang

e ✓

✓

✓

n.

r. ✓

n.

r. ✓

Vehi

cle p

ollu

tion

n.r.

n.r.

n.r.

n.r.

✓

n.r.

✓

Wat

er

Deg

rada

tion

of co

asts

and

coas

tal e

cosy

stem

s ✓

✓

✓

✓

✓

✓

✓

D

egra

datio

n of

cora

l ree

fs se

dim

enta

tion,

nut

rient

co

ntam

inat

ion,

and

sea w

ater

tem

pera

ture

chan

ge ✓

✓

✓

n.

r. ✓

n.

r.n.

r.

Ove

rfish

ing

✓

n.r.

✓

✓

✓

✓

✓

Sew

er m

anag

emen

t and

disp

osal

✓

✓

✓

✓

✓

✓

✓

Fres

h w

ater

qua

lity

and

avai

labi

lity

✓

✓

✓

n.r.

✓

✓

✓

Pollu

tion

due t

o m

inin

g ac

tiviti

esn.

r. ✓

n.

r. ✓

n.

r. ✓

✓

Po

llutio

n du

e to

agric

ultu

ral a

ctiv

ities

(fer

tiliz

er)

n.r.

✓

✓

✓

n.r.

✓

✓

Sea l

evel

rise

due

to cl

imat

e cha

nge

✓

✓

✓

✓

✓

✓

✓

Seaw

ater

/sal

twat

er in

trus

ion

into

fres

hwat

er ec

osys

tem

sn.

r.n.

r. ✓

n.

r. ✓

n.

r.n.

r.

n.r.:

this

exte

rnal

ity is

not

rele

vant

in th

e cou

ntry

. So

urce

: Attz

, Mah

araj

, and

Boo

dhan

(201

1).


Air pollution, noise, waste management, and congestion are also largely local “bads.” These environmental problems tend to be associated with human activities in urban centers. Air pollution and congestion are both collateral effects of humans trying to move through the city. Disposal of both waste and wastewater is another problem associated with urban settlements. Despite these ills, dense human settlements are still inher-ently more efficient in terms of resource use from an overall perspective. Providing water and sanitation, disposing of waste, transporting people, and using energy are all done more efficiently in dense urban agglomera-tions than in dispersed areas. Even congestion may be less of a problem in dense areas since transit becomes more cost-effective.

In the end, the question is how to deal with all the “bads” that inevi-tably arise from human activities. Since at least the time of the Romans, public officials have recognized that one key role of governments is to address these problems. This rationale gives rise to various public policies to reduce externalities.

What Can Be Done?

Reducing these externalities is no simple task. Early efforts by govern-ments usually involved some sort of prohibition. In England, for example, as early as 1271, King Edward I addressed a problem of smoke by banning the burning of sea coal. Since then, and especially in the two centuries fol-lowing the Industrial Revolution, governments have taken an active role to regulate activities to reduce the production of “bads.” This has yielded a number of policy instruments to deal with negative externalities.

Environmental Policy Options From an economics perspective, the literature distinguishes between two types of instruments for environmental policy: rules and regulations (also called command-and-control) and incentive-based instruments. 1 The former usually delimit the actions of individual. Common examples include different types of standards, such as those governing emissions, consumption, or content. These instruments have the advantage of sim-plicity. Generally, the set of rules is the same for all; thus enforcement tends to be simple and straightforward. However, economists have shown that these instruments may be inefficient from an economic perspective since they do not allow much flexibility in compliance.

By contrast, incentive-based instruments use prices or other market instruments to generate changes in the behavior of agents. The most

PROTECTING GOODS BY TAXING “BADS” 199

common ones are taxes, subsidies, and systems of tradable permits. Economists have promoted the use of these instruments since they appear to be more flexible and at least in theory can achieve the policy goals at a lower social cost (see box 11.1 for instruments used to manage water in Latin America).

It is often said that the choice of a tool to solve a problem should depend on the problem. Thus choosing the right instrument to address an exter-nality should require looking at all the options. Taxes are one of many options. Taxes will not be the most efficient, equitable, politically advan-tageous, or feasible option in all cases, however.

Environmental Taxes: Efficiency and Other Considerations In theory, the optimal tax rate is such that it can achieve the policy goal at the lowest social cost. 2 However, this outcome is the result of a number of assumptions that may or may not be present in a given case. The market structure of the regulated sector; the degree of knowledge about costs and benefits and their inherent uncertainty; and the type of externality are all important considerations that must be taken into account when analyzing the idea of an environmental tax. All of these affect the op-timal tax rate.

Box 11.1 Economic Instruments for Water Management in Latin America

Economic instruments are classified in many ways in the economics literature. In the case of economic instruments for water management (EIWM) in Latin America, ICEF and IARNA ( 2012 ) categorized them according to the role they play: namely, financial, fiscal, and incentives instruments ( figure B11.1 ). Figure B11.1a summarizes the number of instruments deployed in a sample of 17 Latin American countries; figure B11.1b shows areas of application. Within the region, the vast majority of these instruments are incentives, including user charges/fees, property rights, and market creation systems. User charges/fees are by far the most common. Market creation instruments are used more often than any other financial instrument. This suggests an initial intent of allowing market mecha-nisms to internalize externalities.

Financial instruments are the second most used type of instrument in Latin America. They include subsidies and investments, liability and compensation systems, bonds, and deposit refund systems. Fiscal instruments, including green taxes, are not used at all for purposes of water management. There are two rea-sons for this. First, water pollution taxes are complicated from a design perspec-tive, since the pollution is often generated far from the area it affects. Second,

the design and implementation of water management tools often occur at the local level, where authorities generally seek to recover costs rather than to achieve efficient allocation. Moreover, they do not always have the power to impose fiscal instruments as taxes.

0

4

4

8

2

9

28

39

0 5 10 15 20 25 30 35 40 45

Fiscal-total

Financial-compensation

Financial-subsidiesand investments

Financial-total

Incentive-property rights

Incentive-market creation

Incentive-charge systems

Incentive-total

0

1

1

16

9

1

1

1

67

16

1

2

2

2

15

22

0 5 10 15 20 25

Market creationSubsidies and investment

Compensation

Property rights

Charge systems

Total

Subsidies and investment

Compensation

Property rights

Market creation

Charge systems

Total

Property rights

Subsidies and investment

Compensation

Market creation

Charge systems

Total

Wat

ersh

edLo

cal

Nat

iona

l

Figure B11.1 Number of Economic Instruments for Water Management in Latin America

b. By Area of Application

Source : ICEF and IARNA ( 2012 ).

a. By Function


Looking at economic instruments by geographic scope, the largest number (22 instruments, or 47 percent of the sample) is implemented at the national level. This large percentage reflects the fact that water management is still highly cen-tralized. This, in turn, explains why the majority of instruments are systems of user charges.

Applying economic instruments at the basin level is still very limited, despite the fact that there is some consensus that the application of EIWM at the basin level is the best way to manage water resources sustainably. Applications at the basin level are fertile ground for the implementation of EIWM: particu-larly the creation of markets through systems and payments for environmental services.

Source : Authors, based on ICEFI and IARNA ( 2012 ).

The dynamic nature of policies is also relevant. In the case of taxing “bads,” the tax rate must be adjusted continuously to achieve the “ optimal” tax rate. Both the costs and the benefits of reducing pollution vary over time as economies grow and change. The pressure to pollute may increase. At the same time, the costs of “cleaner technologies” may fall as they are more widely adopted. 3 The net effect for the sake of estimating the optimal tax becomes uncertain. From a policymaking perspective, this can be problematic. Sometimes, policymakers simply ignore the problem. In the United States, for example, the federal fuel tax has been constant in inflation-adjusted terms since 1993.

The legitimacy of environmental taxes has been challenged many times. For example, Oates and Portney ( 2003 ) point out that environ-mental organizations generally do not favor market-based instruments, as they consider them to be immoral and to amount to tacit consent to continue contaminating the land, water, or air. Another argument is that environmental taxes will not work in practice because it is politically difficult to set high enough rates to actually solve the environmental problems at hand. Recently, however, attitudes have shifted because of the need to raise revenue in developed countries. Environmentalists have been keener to propose taxes as a way to increase revenues and reduce pollution. This is sometimes referred to as the double dividend hypothesis. 4

Revesz and Stavins ( 2007 , p. 539) argue that fairness may also be an important issue for (the lack of) environmental taxes. As they state, “Despite the fact that such systems minimize aggregate social costs, these systems may be more costly than comparable command-and-control


instruments for regulated firms. This is because with the tax approach, firms pay both their abatement costs plus taxes on their residual emis-sions.” Thus, firms that will be regulated may prefer other instruments that may be more costly for society but less costly for themselves. For example, the industry as a whole might be better off under an emission standard than under a tax.

Another issue looms with regard to the fairness of environmental taxa-tion. In most cases, increasing environmentally related taxes is believed to affect lower-income households disproportionately because such house-holds devote a larger share of their income to energy use. Thus, the higher energy prices that may result from taxing “bads” would decrease their welfare and hurt income distribution. 5 The distributive effects of environ-mental taxes are discussed further later.

A final issue to take into consideration is the existing tax system. Any environmental tax will interact with other taxes, some of which may already generate distortionary outcomes. Thus, the optimal tax rate in this second-best world will probably be different from the optimal theoretical tax. 6 As usual, the devil is in the details.

Since attempting to achieve the optimal environmental tax is probably a lost cause, does this mean governments should abandon the idea of taxing “bads”? No. While these taxes may not be optimal, they can still change incentives in a way that improves well-being.

Environmental and Environmentally Related Taxes

Since the pure environmental tax generally does not exist, a close cousin that is worth analyzing is environmentally related taxes (ERTs; table 11.2 ). ERTs are defined as “any compulsory, unrequited payment to the general government levied on tax bases deemed to be of particular environmental relevance” (OECD 2001 , p. 15).

ERTs have existed for many years, mostly in the form of fuel excise taxes, but also in more subtle forms such as motor vehicle registration fees, and other environmental charges such as toxic waste disposal fees and plastic bag fees. 7 Revenue collected from ERTs varies considerably across countries. For example, in Europe they accounted for between 1.6 and 4 percent of GDP, or between 4.2 and 10.1 percent of tax rev-enues, in 2009. In contrast, the United States and Canada collect only about 4 percent of taxes and about 1 percent of GDP from ERTs (OECD 2011a ).


ERT levels are relatively persistent over time. The correlation for a sample of countries between ERTs as a percentage of GDP in 1995 and 2009 is 0.62. Only three countries in the sample (Costa Rica, Estonia, and Turkey) show a significant change in their ERTs as a percentage of their GDP over the last 15 years. 8 However, revenues from ERTs in these same three countries more than tripled. This suggests that even large changes are possible over a relatively short period of time, if countries are willing to travel down that road.

The next key question is whether these ERTs are effective in improving environmental quality. Using a sample of 41 countries, Miller and Vela ( 2012 ) show that countries with higher ERTs as a percentage of GDP tend to exhibit greater reductions in their pollution levels and larger increases in the use of renewable resources. They find a positive correla-tion between the improvements of nine different environmental quality variables between 1995 and 2009 and the initial level of ERTs in each country. 9

Table 11.2 Types of Environmentally Related Taxes

Main taxes Subtaxes

Fuel Mineral oil Tax Vehicle Motor vehicle registration fee Tax on import cars, tires tax, railway

tax, duty of airway securityMotor vehicle tax (payment/year) Gas guzzler taxRoad tax (euro/year) Tax on congestion, tax on permits to

enter historical city district Energy Energy consumption tax Tax on installing nuclear equipment

Air pollution tax Tax on CO 2 emissions in petroleum activities

Waste Packaging charge Duty on tires, hazardous wasteWaste Deposit Levy Tax on the landfilling and

incineration of waste, charge on exceeding of GHG emission limits

Water Water pollution tax Tax on pesticides, charge to discharging of wastewater, oil release charge

Taxes on water quantity Tax on ground water Other Duty on ozone depleting chemicals Duty on raw materials

GHG: greenhouse gas. Source: OECD (2011a ).


The Current State of ERTs

In Latin America, environmentally related taxes historically have been either fuel excise taxes or motor vehicle fees. Using these instruments, some countries in the region have brought in as much as 14 percent of total revenues; others have collected barely any revenue (OECD 2011a ). Revenues as a percentage of GDP are generally lower than in Europe, but not too different than in other developed countries such as Australia, Canada, New Zealand, and the United States (see figure 11.1 ).

For the Dominican Republic and Guatemala, ERTs represent a high share of their modest tax burden. In general, the low levels of ERTs suggest that there is ample room to increase revenues using these instruments. Costa Rica has led the way in environmental tax reform, tripling the rev-enue they raise (see box 11.2 for a description of environmental taxes in the Caribbean).

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5

0 2 4 6 8 10 12 14 16 18

Japan

Switzerland

Australia

United Kingdom

Netherlands

Korea

Mexico

Colombia

Peru

Argentina

Uruguay

Chile

Guatemala

Costa Rica

Dominican Rep.

Percentage of tax revenue

Percentage of GDP

Energy product (including motor fuels) Motor vehicles OtherEnvironmental taxes as percentage of GDP (top horizontal axis)

Figure 11.1 Environmentally Related Taxes, 2009 (percentage of tax revenue and GDP)

Source: CIAT and ECLAC ( 2011 ) and OECD ( 2011a ).


Box 11.2 Environmental Taxes in Caribbean Countries

In the Caribbean ( figure B11.2 ), tax revenues account for as little as 17 percent of GDP (in the Bahamas, which has no income tax) to as much as 33 percent (Barbados). The main sources of revenue (with the exception of the Bahamas) are from income taxation, profits and capital gains, taxes on goods and services, and international trade. The exception is the Bahamas, where tariffs on international trade generate 43.3 percent of total revenue (World Bank 2012c ). Using a similar definition of ERTs, Attzs, Maharaj, and Boodhan ( 2011 ) find that environmental taxes in the Caribbean account for a significant percentage of total tax revenue. (The exception is in Guyana, where the paucity of data might have led values to be significantly underestimated.)

For the Caribbean countries, many of the taxes were not environmental taxes per se, according to the OECD definition, as the tax base was mainly profits, sales, or incomes.

Source: Authors based on Attz, Maharaj, and Boodhan (2011).

0 5 10 15 20 25 30 35 40 45 50

Jamaica

Barbados

Trinidad and Tobago

Bahamas

Percentage of total tax revenue Percentage of GDP

Fuel Taxes and Motor Vehicle Fees Fuel prices vary widely around the world and in particular within Latin America and the Caribbean. Although final gasoline prices result from

Figure B11.2 Environmental Tax Revenue in Caribbean Countries

Source : Attz, Maharaj, and Boodhan (2011).


the combination of production and transportation costs, monopoly rents, and different taxes (value added taxes and excise taxes), the variation is mainly explained by the differences in the taxes and monopoly rents: the cost of the gasoline itself does not vary that much. The monopoly rents in the case of oil-producing countries are an implicit subsidy to fuels (which can be thought of as a negative tax). Since the subsidy promotes the use of vehicles, this tends to aggravate the externalities of air pollution and con-gestion in cities where the subsidies exist.

Fuel prices in Latin America and the Caribbean are relatively low on average compared to other regions (with the exception of North America and the Middle East). However, not all countries in the region are created equal. As figure 11.2 shows, prices in Brazil are basically as high as the European average, while Venezuela has one of the lowest gasoline prices in the world. It can be argued that fuel prices in Venezuela do not internalize the externality costs at all. Chronic congestion and air pollution in a few Venezuelan cities are the result.

As in most places, ERTs in Latin America were originally set up to raise revenue mostly to pay for roads, rather than to discourage environ-mental damage. This pattern is apparent in the case of motor registra-tion fees, which often are based on the value of the vehicle, without any

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

VenezuelaEcuador

BoliviaUnited States

MexicoPanama

El SalvadorGuyana

GuatemalaArgentina

JamaicaHondurasNicaragua

BelizeCosta Rica

SurinameDominican Rep.

ParaguayChile

ColombiaPeru

UruguayBrazil

Figure 11.2 Pump Price for Gasoline, 2010 (US$ per liter)

a. Latin American Countries


consideration for pollution. Thus, older, more polluting vehicles tend to have lower fees, compared to newer and cleaner ones.

Congestion Pricing/Fees Congestion pricing is another tool with significant potential. It has been used as a means of dealing with the negative externalities of traffic such as congestion, road accidents, and pollution. Users, ideally, must pay for the cost they impose on society when using their private vehicles. Greater con-gestion in many cities, as well as concerns about climate change—along with the potential for new revenue—have increased interest in this type of policy ( table 11.3 ).

Singapore was the first to introduce an electronic road toll, with its electronic road pricing (ERP). The scheme is an upgrade of the Area Licensing Scheme implemented in 1975. It consists of a price scheme to induce motorists to travel in off-peak hours. The rates charged increase gradually before the peak hour and decrease gradually after the peak, in a method called “shoulder pricing.” Rates are constantly revised to keep good traffic speed. With ERP, traffic f low volume was reduced by 20 percent in the restricted zone, traffic speed rose from 40 to 45 kilometers per hour, and congestion was efficiently reduced. Annual net revenues from the scheme are around 40 million dollars. In addi-tion to the extra revenue, there are clearly positive effects on envi-ronmental quality. Similar schemes have been implemented in other

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8

Middle East andNorth Africa

North America

Latin America andCaribbean

South Asia

East Asia andPacific

Sub-Saharan Africa

Europe and CentralAsia

b. Regions

Source : World Bank (2012c ).

Tabl

e 11.

3 C

onge

stio

n Pr

icin

g Sc

hem

es

Sing

apor

e Lo

ndon

Sa

ntia

go

Ger

man

y M

ilan

Stoc

khol

m

Type

of s

chem

eC

ordo

nZo

nal

Faci

lity

Dist

ance

Cor

don

Cor

don

Scop

eU

rban

Urb

anU

rban

Nat

iona

lU

rban

Urb

anIn

itial

reas

onC

ontr

ol

cong

estio

nC

ontr

ol co

nges

tion

Infr

astr

uctu

re,

cont

rol c

onge

stio

n,

air p

ollu

tion

Infr

astr

uctu

reC

ontr

ol co

nges

tion

Con

trol

cong

estio

n,

envi

ronm

enta

l im

prov

emen

tTr

affic

vol

ume

Redu

ced

10 to

15

per

cent

Redu

ced

16 p

erce

ntn.

d.n.

d.Re

duce

d 12

.3 p

erce

nt

in re

stric

ted

zone

Redu

ced

22 p

erce

nt

Trav

el ti

mes

n.d.

Redu

ced

40 p

erce

ntRe

duce

d 40

per

cent

n.d.

n.d.

Redu

ced

betw

een

33

perc

ent a

nd 5

0 pe

rcen

tSp

eed

Incr

ease

d 22

pe

rcen

tIn

crea

sed

betw

een

14 p

erce

nt a

nd 2

1 pe

rcen

t

n.d.

n.d.

Incr

ease

d 4

perc

ent

n.d.

Impa

cts o

n ac

cide

nts

n.d.

Redu

ced

acci

dent

s in

5 pe

rcen

tRe

duce

acc

iden

ts at

in

ters

ectio

nsn.

d.A

ccid

ents

redu

ced

by

20.6

per

cent

Acc

iden

ts re

duce

d by

3

perc

ent

Effe

cts o

n em

issio

nsn.

d.Re

duce

d 12

per

cent

in

PM

10; r

educ

ed

12 p

erce

nt in

NO

x;

redu

ced

3 pe

rcen

t in

CO

2

n.d.

n.d.

Redu

ced

14 p

erce

nt

in P

M10

; red

uced

19

per

cent

in N

Ox;

re

duce

d 15

per

cent

in

CO

2

Redu

ced

8.5

perc

ent i

n PM

10; r

educ

ed 1

3 pe

rcen

t in

NO

x; re

duce

d 14

pe

rcen

t in

CO

2

Ann

ual r

even

ues

(US$

mill

ions

)36

036

0n.

d.2,

860

n.d.

105

Ope

ratin

g co

st

as p

erce

ntag

e of

reve

nue

7 pe

rcen

t48

per

cent

n.d.

16 p

erce

ntn.

d.25

per

cent

PM10

: par

ticle

pol

lutio

n le

ss th

an 1

0 m

icro

met

ers i

n di

amet

er; N

O X :

nitr

ogen

oxi

des;

CO

2 : ca

rbon

dio

xide

. n.

d.: n

o da

ta.

Sour

ces:

Ana

s and

Lin

dsey

( 201

1 ); B

ucha

nan

( 200

7 ); R

eplo

gle (

2006

); an

d Sa

ntos

( 200

5 ).


cities, including Milan, Oslo, and Stockholm, with positive impacts on congestion.

London’s Congestion Charging Scheme has been a model for others since its implementation in 2003, and is one of the largest schemes in the world. To tackle the congestion problem during peak hours, a flat fee was introduced for motor vehicles entering central London—an area of about 22 square kilometers. Transport for London, the local government body in charge of the transport system in London, reports that during the first years after implementation, traffic flows in the charging zone were reduced by 30 percent, 60,000 fewer vehicles crossed the charging zone, and travel-time reliability improved 30 percent, on average. Net annual revenues have amounted to between 160 million to 200 million dollars per year. Some studies suggest that the relative changes in air pollution con-centration in outer areas cannot be associated with the introduction of the scheme. Some critics have charged that the system suffers from very high operational costs that exceed economic benefits and curtail retail business in the area.

In Latin America, the closest experience to London’s is in Chile. In 2004 and 2005, nonstop urban tolls in Santiago were implemented in the system of urban highways operated by private concessionaires. A sophisti-cated traffic-management system with electronic sensors attached to each car controls and levies charges based on the distance and time of day trav-eled by all vehicles entering the highway. Among other aims, the system seeks to reduce travel times and air pollution. It has become a model of advanced urban transportation infrastructure, and has reduced the time needed to get from one end of the city to another by 40 percent.

Waste and Wastewater Fees Traditionally, local governments have collected fees or taxes for waste dis-posal management. For the most part, these have not been set in a way to discourage waste production, but rather as a way to cover the costs of waste disposal. Waste disposal faces two distinctive problems. The first is the NIMBY (not in my back yard) problem: no one wants to live near a waste disposal facility, no matter how clean it is. The second issue is how to encourage people to generate less waste.

Recently, fees for plastic bags have become fashionable. Both countries (such as Ireland) and cities have begun charging customers fees for the use of plastic bags. Generally, fees are small. Although the jury is still out in terms of the effects, initial assessments suggest these instruments are helping to reduce the use of plastic bags.


Under deposit refund schemes, consumers receive a small refund for recycling glass and plastic bottles. The refund functions as an incentive for people to reduce waste. These schemes have been used with some suc-cess in several countries in Latin America and elsewhere.

Energy Tax Reforms with an Environmental Wink

What can be done to reduce “bads” from energy and fuel use in Latin America and the Caribbean? One option is to reform existing energy taxes to bring them closer to the optimal tax rate. What is the optimal tax rate? In principle, as Pigou ( 1920 ) argues, the optimal tax rate should equal the marginal damage occasioned by the externality/externalities. Thus, the tax should include all of the externalities that are involved. In the case of fuel, taxes from motor vehicle use should include at least the effects of air pollution on human health, agricultural productivity, damage to build-ings, and of course climate change.

However, there are other externalities associated with vehicle use: namely, noise, congestion, road damage, and traffic accidents. Fuel taxes could incorporate all of these effects. However, other policies such as con-gestion pricing might also be feasible—and perhaps in some cases more desirable.

As mentioned, a key element that is very important to consider is the interaction of the tax with other elements in the tax system and other environmental policies (Goulder 1995 ; Parry and Small 2005 ). However, there is no consensus on the assumptions used to estimate the second-best optimal tax rate. For example, two recent papers that look at the optimal second-best tax rate on motor fuels in the United Kingdom and the United States arrive at significantly different results.

Parry and Small ( 2005 ) developed a formula for the second-best optimal fuel tax that not only incorporates externalities (congestion, air pollution, and traffic accidents) but also takes into account the interaction with the tax system. They find that the gasoline tax rate in the United Kingdom is more than twice the optimal tax rate, whereas in the United States, the actual tax rate is less than half the optimal rate. Newberry ( 2004 ) calculates an optimal tax rate of € 0.60 per liter for gasoline in the United Kingdom. The actual tax rate in the United Kingdom was quite close to this as of 2006: € 0.53 per liter.

Bringing Energy Taxes Closer to the Optimal Two recent studies have attempted to answer the question of how far energy taxes in Latin American and Caribbean countries are from their optimal


level. Parry and Strand ( 2012 ) looked at fuel taxes in Chile to assess their optimal level, closely following the methodology used by Parry and Small ( 2005 ). They conclude that Chile’s gasoline tax rate was about 25 percent below their estimated (second-best) optimal tax rate. In principle, this finding would suggest that gasoline taxes are relatively close to the optimal level. However, the situation with diesel was very different. They found that the tax on diesel fuels was less than half the optimal amount. Parry and Strand ( 2012 ) also found that most of the “bads” from vehicle use could be attributed to traffic accidents and congestion. A lower fraction could be ascribed to health issues from local pollution, and even a smaller frac-tion to GHG emissions. Nevertheless, the magnitude of the health effects is important. Moreover, the study focuses only on transportation fuels and leaves out other important sources: energy pollutants from industries, min-ing, and the power sector. The value added generated by these sectors can be lower than the external environmental damage, as Mueller, Mendelsohn, and Nordhaus ( 2011 ) show for coal-fired power plants in the United States. These findings imply that environmental taxes may also be desirable for point sources of pollution.

The main conclusion is that there is plenty of room to increase diesel fuel taxes—at least—in Chile toward more optimal levels. This would increase tax revenues while reducing congestion, traffic accidents, and road deterioration. Higher taxes should also lead to improved air quality, reducing several upper-respiratory diseases, early mortality, and loss of productivity due to work days lost.

Other experiences in the region also show that energy taxes more gen-erally are not set optimally. Navajas, Pandeiros, and Natale ( 2012 ) looked at these for Argentina, Bolivia, and Uruguay for three sectors: transport, household, and industrial use. 10 The study found that more often than not, energy taxes are set significantly lower than they should be to recoup the costs of environmental damage associated with energy use.

Navajas, Pandeiros, and Natale ( 2012 ) analyze three efficiency-enhancing energy tax reforms for Argentina, Bolivia, and Uruguay. Their analysis focused on whether and how changes in fuel prices affect fuel consump-tion patterns and government revenues. They looked at both direct and indirect effects (changes in household welfare due to price changes and improvements in health quality due to less air pollution). The analysis showed that energy goods in all three countries were greatly under-taxed. The amount of revenue raised and the welfare improvement depend on the case analyzed. In Uruguay, for example, the analysis suggests that fuel prices should rise for all fuels except gasoline for vehicles, jet fuel, and


electricity. 11 These efficiency-enhancing energy tax reforms increase rev-enue by at least 20 percent; between US$200 million and US$500 million.

In all three countries, tax revenues from energy use increase substan-tially. The increase is smallest in Uruguay. Environmental costs are also substantially reduced: by around 10 percent in Uruguay and close to 30 per-cent in Argentina. In all cases, the most benefits arise from levying higher taxes on the transport sector, particularly diesel, since it contributes the most to air pollution. The study suggests that energy tax reform designed to increase efficiency can improve well-being in the countries studied, while raising revenue. Moreover, these impacts can be significant.

Who Pays for ERTs? Distributional Impacts When designing energy tax reforms, one key element to consider is who benefits and who loses. Since energy burdens vary across rich and poor households, this consideration can be examined empirically. Conventional wisdom has long held that energy taxes are regressive. The argument is that the poor devote a larger share of their income to consumption, and to energy goods in particular. However, this is not always the case. For example, in Argentina, energy subsidies in the form of generalized lower utility rates have mainly benefited urban households that are connected to the gas-grid in the city of Buenos Aires, which are generally wealthier than households in the rest of the country.

Navajas, Pandeiros, and Natale ( 2012 ) look at the distributional impacts of the policies discussed in the previous section. They find that efficiency- enhancing energy tax reforms have positive distributional effects in Uruguay and Argentina. For Bolivia, the results are somewhat mixed; the poorest households have small gains, while almost all other households face small or minimal losses. In any case, the proposed tax reforms cannot be considered regressive.

In Uruguay, as figure 11.3 shows, the environmental impacts are always positive and are much larger for lower-income deciles. Although price impacts in some cases offset part (or all) of the positive environmental benefits, they do not undercut the progressive nature of the reform.

The main reason for the progressive impact has to do with improvements in human health. These improvements are very significant, especially for poorer households that may have fewer options to protect themselves from the effects of air pollution. They also have fewer resources to deal with the effects of upper-respiratory diseases for themselves and their children; in many cases, they must take more time off from work to take care of them-selves or their relatives.

0

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Case I: non-Ramsey excises Case II: Ramsey excisesCase III: constrained non-Ramsey reform

–3.0

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Case I: non Ramsey excises Case II: Ramsey excises Case III: constrained non Ramsey reform

Figure 11.3 Distributional Impacts of Energy Tax Reforms in Uruguay by Decile (percent)

a. Environmental Benefits

b . Price Impact

Source : Navajas, Pandeiros, and Natale ( 2012 ).


Carbon Taxes Climate change is one of the biggest challenges humans will face in the coming decades. One way of tackling the sources of greenhouse gas emis-sions that cause climate change is to impose carbon taxes. The rationale for this type of tax is that putting a price on carbon emissions will spur market development of new low-carbon technologies and perhaps solve the climate crisis. Economists have been promoting carbon taxes for at least 25 years. They have argued about the appropriate “size” of the tax and how it should change over time, 12 but most agree that it would be a sensible way of tackling the challenge of climate change.

Carbon taxes have already been implemented in many countries, from Denmark, Norway, and Sweden early in the 1990s, to more recently the European Union (EU), which has imposed a carbon fee for air travel, to Australia, British Columbia, and Canada. Many other countries have studied the feasibility of a carbon tax, including the United States. In Latin America, Chile began exploring the possibility of introducing a carbon tax as part of the latest round of tax reforms proposed in late 2011.

Before implementing a carbon tax it is important to understand the effects that a tax like this may have on different agents. A commonly used framework in the literature consists of using computable general equilib-rium (CGE) models for this purpose. The advantage of using CGE models is that they provide a rich representation of a country’s economy, distinguish-ing different economic sectors, types of workers, households, trade part-ners, and many other factors. CGE models also allow analysts to look at the general equilibrium or feedback effects that are usually absent in other types of economic models. Two recent studies have used CGE models to look at the effect of a carbon tax in Latin American and Caribbean countries.

Chisari ( 2012 ) analyzes the effect of two different carbon tax schemes on six Latin American countries. 13 The results are somewhat surprising; they show positive or negligible aggregate GDP effects for even a relatively large carbon tax ($20 per ton of CO 2 ) in four of the six cases. 14 In terms of revenue, the simulation shows small increases for Chile and Brazil, but very large potential effects for Peru, where revenue could increase by more than a quarter. Finally, carbon emissions tend to decrease significantly in Peru and Brazil, and drop somewhat less in Argentina, remain virtually unchanged in Chile and El Salvador, and increase in Jamaica.

Results at the sectoral level are very different. For example, depending on the country, agriculture can be a net winner or loser. The fact that there are winners and losers underscores the political economy issues that sur-round the carbon tax.


The model used by Chisari ( 2012 ) provides a useful way to look at the effects of policies within a country. The drawback is that single-country models do not look at international trade channels that may affect the implications of a carbon tax. To overcome some of the limitations of single- country models, Giordano and Watanuki ( 2012 ) use the INT-ENERGY model to look at the effects of a global carbon tax and a few variants over the same time horizon and using the same scenario as Chisari ( 2012 ); they also add some other interesting variants. One scenario looks at the effects on Latin America if the OECD enacted a carbon tax on its own, without imposing any tax or other restrictions on Latin American economies. The policy would impact the region anyway through the trade channel. Negative effects—although small—would occur in all Latin American countries, even though they were not participating in the regime.

Another scenario looked at the global effects on CO 2 emissions if a uniform US$20 per ton carbon tax is levied globally. Interestingly, there would be a great deal of variation from country to country in terms of emission reductions. Within Latin America, the emissions reduction in Argentina, Brazil, and Venezuela would be relatively larger—as shown in Chisari ( 2012 ). Reductions would be smaller in Chile and Peru. The impact would also be large in the United States.

The results of these models imply that a carbon tax can be used as a tool to reduce emissions in Latin America and the Caribbean, and that the economic effects are far from devastating. It is important to put these findings into context: even a relatively high carbon tax of US$20 per ton of CO 2 emissions is unlikely to reduce emissions to the levels required to sta-bilize concentrations of greenhouse gases around the globe. However, the choice Latin American and Caribbean governments may end up facing is either to impose a carbon tax on their own or face border tax adjustments (a carbon tariff) imposed from abroad. The World Trade Organization, in a recent ruling, has allowed this type of policy instrument. Should trad-ing partners impose such tariffs, Latin American governments may well choose to impose the tax and keep the revenue rather than face higher tariffs from abroad. 15

Lessons Learned

Environmental taxes and environmentally related taxes can play an important role in improving environmental quality. Their main advan-tage is that they use the price system to affect consumer/producer behav-ior, enabling them to internalize the costs of the “bads” that are being


produced. ERTs can also be an effective way of reducing pollution and raising revenue.

The Goal Must Be Efficiency! But Efficiency Is Hard to Achieve

Perhaps the most important lesson is to recall that the first and foremost goal of ERTs must be to improve efficiency by reducing the production of “bads” and their consequences. From a policy perspective, this means that policymakers must devote resources to understand and quantify the effects of ERTs. As mentioned, an environmental tax may be efficient but only when certain conditions apply, and these vary from case to case. This is even more important in the context of developing countries, where ERTs tend to be established for other purposes than to improve efficiency, sometimes making the problems worse. Subsidized fuel prices are a case in point.

There is still some low-hanging fruit, especially with regard to sub-sidies—and particularly energy subsidies. The cost of some subsidies includes not only the budgetary costs, but the costs of worsening envi-ronmental problems, especially in the case of energy subsidies. Moreover, the subsidies tend to be enjoyed by wealthier households. Thus, these subsidies are economically, socially, and environmentally inefficient. For this reason, for more than 20 years, the international environmental com-munity has called for the elimination of these perverse subsidies in both developed and developing nations. However, powerful lobbies and dis-gruntled citizens have in many cases resisted scrapping these subsidies—against their own interest.

The hope is that Latin American countries will eliminate these sub-sidies entirely, and set up a price system that recognizes and prices the externalities in a way that improves economic efficiency and environ-mental quality, which would also improve income distribution.

Environmentally Related Taxes Are Not the Only Tool to Reduce Environmental “Bads”

A second important lesson is to recall that ERTs are just one tool in the toolkit to address negative environmental externalities. Addressing externalities efficiently may require the use of different tools for differ-ent problems. Governments may favor taxes because of their potential to raise revenues. Economists may like them since they change incentives. However, in many cases, when enforcement and administrative costs are


taken into account, specific controls and standards may be more desirable and cheaper to implement overall.

Moreover, when studying the implementation of ERTs, studies should acknowledge and incorporate the fact that ERTs often interact with other policies, and that collecting taxes also has a cost. This will likely alter the optimal tax rate. These considerations should be taken into account to avoid harmful interactions, double taxation, or less-than-optimal taxes that will not internalize pollution costs fully. Otherwise, the end result may do more harm than good.

The Future of Environmental Taxation

As noted, there is evidence that countries that levy ERTs have improved their environmental quality over the past 15 years. However, increasing revenue from ERTs is not an easy task. Looking into the future, there might be some instances where ERTs can increase revenue, but more importantly can improve well-being through better environmental quality.

Global Carbon Taxes The most pressing global environmental problem today is climate change. It will be difficult to solve under any circumstances (IPCC 2007 ). The lev-els of concentration of greenhouse gas emissions in the atmosphere and the current dynamics suggest increases in global temperature of close to 2 degrees Celsius. Avoiding greater increases will require collaboration, co-ordination, and participation by most countries. Most increases in GHG emissions today and those expected in the future will be from the devel-oping world.

A global carbon tax has the potential to solve some of the prob-lems, since it will both generate revenue for governments and may help the coordination problem, if a common tax rate can be agreed upon. Moreover, it can be done gradually, as the experiences of Australia and British Columbia illustrate. As seen in Australia, carbon taxes can be used as an initial step to set up a market permit system, since the carbon tax in its initial stage acts as a price that is observed by agents, generating the information required to establish a permit system.

In any circumstances, carbon taxes should be considered as part of the menu of solutions, as they have the potential to raise revenue and reduce emissions. The revenues can also be used for transfers toward developing nations, reducing the cost of mitigating GHG emissions in developing countries.


“Real Congestion” Pricing and the GPS Solving congestion problems in urban settings is by no means a simple task. As the examples in the chapter show, congestion pricing schemes appear to be effective in reducing traffic and other environmental prob-lems. Of course, commuters will need good alternatives to driving their own vehicles in peak times, but as Singapore and London show, resources from the schemes may also be used to improve public transportation.

With the arrival of newer vehicles and GPS systems preloaded into them, cities are already experimenting with charges based on GPS systems that can charge vehicles according to the distance traveled, the average speed, and other considerations. As these devices become more common, they have the potential to move toward a system of real-time pricing and other schemes that may be more effective at the margin to control conges-tion, and perhaps ozone pollution as well.

Distance-weight truck tolls have been implemented mainly in Europe to charge trucks according to the distance they travel and the weight they carry. Similarly, satellite-based systems charge drivers depending on the distance driven. Vehicles are equipped with on-board units that register mileage, which later is billed to users, typically on a monthly basis. This type of system has been implemented for truck tolling in Germany and other European countries. In the Netherlands, a scheme tied to actual driving patterns rather than car ownership has been proposed. Under the scheme, called Paying Differently for Mobility, car owners would pay for using the road infrastructure, rather than paying a tax for owning a car (Mahendra 2008 ).

Experiences around the world suggest that congestion pricing has been a good instrument to reduce congestion by changing behavior. Many cost-benefit analyses emphasize that the benefits—in the form of lower congestion, public transport, increase in revenue, and environmental improvements—exceed the cost of implementation. Therefore, congestion pricing has good potential to manage congestion in an economically effi-cient way.

However, there are many challenges to overcome for congestion pric-ing to be adopted widely, especially in developing countries. The need for a critical mass of vehicles with GPS and the infrastructure and insti-tutions to charge effectively for vehicle use are all necessary elements that must be present. In a region where avoiding fees and charges is still commonplace, it may still be some time before this approach becomes a reality.


Differential Waste/Wastewater Fees and “Nudges” There are many places in the developed world where waste fees are dif-ferentiated by the amount of waste generated. Some cities have systems that charge different fees based on the size of trash bins. Households can choose between different sizes of bins; they pay higher fees for trash col-lection for larger bins. This system of user fees effectively helps internalize the cost of waste disposal. The differentiated fees also encourage house-holds to reduce their waste production, since the fee is proportional to the bin size, a proxy of the waste generated by the household.

Another area where efforts have been made to change behavior to re-duce waste is in curtailing the use of plastic bags. These bags clog drainage systems, can lead to flooding, and can be dangerous for fish and wildlife. For many years, cities have spent large amounts of resources cleaning up plastic bags from drainage systems. Reusable shopping bags were distrib-uted to shoppers for free, and discounts were offered if shoppers used them instead of plastic bags. However, consumption of plastic bags remained unaltered until a 5 cent plastic bag fee was imposed. Preliminary evidence in US cities shows that the effect of these fees is large. For example, in Montgomery County, Maryland, the consumption of plastic bags was cut in half after the fees came into effect.

This example demonstrates the potential that nominally small fees may have on changing behavior and social norms. Casual observation in Montgomery County and nearby Washington, DC suggests that consum-ers use reusable bags or no bags at all much more frequently.

To sum up, as the many examples and studies in this chapter show, the taxation of “bads” deserves to be part of the policy menu to improve envi-ronmental quality, raise revenue and efficiency, and perhaps even change social norms and behavior.

12

Heterodox Taxes: The Good, the Bad, and the Ugly

Innovations in the design of certain taxes, analyzed in other parts of this book, demonstrate that the frameworks for a good tax do not have

to be imported from developed countries. This does not mean that all new taxes are good, nor does it mean that there is a “black list” of bad taxes. As is always the case with tax issues, adopting a tax implies a com-promise between sometimes competing objectives. Thus, enacting and administering a tax is not simply a matter of collecting more revenues, but also of taking into account the effects—good and bad—that the taxes could have on various aspects of development such as equity, efficiency, macroeconomic stability, and environmental sustainability.

This chapter analyzes the Latin American experience with four het-erodox taxes: a tax on bank transactions; a tax on primary sector exports; a minimum income tax (as a substitute for the income tax); and simpli-fied regimes for small and medium-sized enterprises (SMEs) and small taxpayers.

In the short term, some of these taxes can serve as mechanisms to expedite revenue collection, but they are not appropriate instruments to promote efficiency, equity, or stability. They can even erode the sound-ness of the rest of the tax system. For example, several countries have implemented taxes on bank transactions because of their collection potential, only to discover that that potential diminishes over time as businesses and consumers find ways to evade those taxes—which in turn have harmful effects on the collection of other taxes. Similarly, taxes on exports of primary products introduced to bring in economic revenue under extraordinary circumstances (for example, as a result of a massive devaluation of the domestic currency) have harmed the stability of the tax system, as well as private investments and economic activity. On the other hand, both the minimum tax and the simplified regimes


for SMEs and small taxpayers are basically alternative tax management mechanisms that aim to at least partially overcome the limitations of tax administration and the low administrative capacity of many small firms. Nevertheless, the collection of these taxes decreases, the longer they stay in effect.

It would not be realistic to expect these heterodox taxes to disappear overnight. It is more reasonable to ask which aspects of their design and administration can be modified to mitigate their negative effects, and when that is not feasible, what strategies can be followed to dismantle them over a reasonable period of time.

Taxes on Bank Transactions

There are three types of taxes on financial transactions. 1 The most com-mon is the bank transaction tax, 2 which is applied on debits and/or cred-its of bank accounts and which, generally, taxes the clearing of checks, cash withdrawals from automatic teller machines (ATMs) and teller win-dows, and on occasion, the issuance by banks of credit cards. 3 A second type is the tax on securities transactions, which was initially proposed by Keynes in The General Theory of Employment, Interest and Money (1936) to reduce destabilizing speculation on the stock market. Finally, there is the tax on exchange transactions and operations deriving from them—futures, options, and “swaps”—which aim to discourage interna-tional movements of capital that are speculative. 4 This section focuses exclusively on bank transaction taxes that several Latin American and Caribbean countries have adopted at various times over recent decades, 5 especially as an expedited tax collection resource (although usually a temporary one) ( table 12.1 ).

Currently, six countries in the region have taxes on bank transactions. They fall into three groups, according to what they tax. Colombia and the Dominican Republic tax the debits of transactions at banks. Argentina, Bolivia, and Peru impose taxes on debits and/or credits from checking accounts and other financial system operations (Gonz á lez 2009 ). 6 Mexico taxes only cash deposits, with the aim of promoting the use of checks and bank transfers. In addition, the Dominican Republic (between 2011 and 2013) and Uruguay (between 1988 and 2007) taxed the assets (credits and investments) of financial entities (including banks), and Chile imposed a tax of a specific amount per transaction on checks and ATM transfers (between 1980 and 2008).

HETERODOX TAXES 223

It Seems So Easy . . .

The main virtues of bank transaction taxes are the ease in administering them, the scant public opposition to them, and the potential they offer for short-term collection (Gonz á lez 2009 ). Given that the banks handle collection of the tax, the collection costs for tax administration are lower than those for other taxes. Bank transaction taxes have the additional advantage that they indirectly reach incomes that are not captured by the traditional tax system. In Colombia, for example, approximately one of every five pesos collected through the bank transaction tax comes from illegal activities, according to some estimates (Coelho, Ebrill, and Summers 2001 ).

The bank transaction tax yields more revenue in countries that have deeper financial markets and high levels of inflation, since under these circumstances it costs more for businesses and individuals to use alterna-tive methods to carry out transactions and to keep money in the form of savings (Baca-Campod ó nico, de Mello, and Kirilenko 2006).

Table 12.1 Bank Transaction Taxes, Select Latin American Countries, 2000–10

Country Year

Effective tax rate (percent, except

as indicated) Percent of

GDP Percent of total

tax revenue

Argentina 2010 1.20 1.9 5.5Bolivia 2010 0.30 0.3 1.1Brazil a 2007 0.30 0.7 2.1Colombia 2010 0.40 0.6 2.7Chile b 2008 $155 per check 0.2 0.7Dominican Rep. 2010 0.15 0.2 1.3Ecuador a 2000 1.60 2.0 11.4Mexico c 2010 3.00 0.1 0.5Peru 2010 0.10 0.2 1.1Uruguay a, d 2006 0.01 and 2.0 0.2 0.8Venezuela a 2008 1.50 0.9 3.6

a Repealed. b Created in 1980 as a tax per check and on automatic teller transactions; it was repealed in 2008. c The tax on debits in cash applies a 3 percent rate on the amount net of the value exempted. d The 0.01 percent rate levied on loans to prefinance exports; the 2 percent rate levied on the re-mainder of taxed assets. Source : Authors’ calculations based on Baca-Campod ó nico, de Mello, and Kirilenko (2006); Coelho ( 2009 ); IDB and CIAT ( 2012 ); MPF ( 2012 ); RFB ( 2012 ); and SUNAT ( 2012 ).


From the standpoint of tax administration, taxing bank transactions also has the advantage of helping to obtain information protected by banking secrecy; this helps detect possible tax evaders, as has occurred in Brazil and Peru. 7 In Mexico, the tax on cash deposits, which aims to control money laundering, has helped control tax evasion by facilitating audits and the updating of taxpayer records (OECD 2011b ).

. . . But It Is Harmful

Despite these apparent benefits, the tax on bank transactions is a mecha-nism that should be used with caution because in the long term it can have harmful effects on economic efficiency. It leads to financial disinterme-diation, induces businesses to integrate vertically (in order to internalize transactions that would otherwise be taxed), and raises the costs to pro-duce complex goods that require multiple stages of production (Arbel á ez, Burman, and Zuluaga 2002; Albuquerque 2006 ).

Figure 12.1 presents the actual experience of some Latin America coun-tries with bank transaction taxes, and underscores the fact that the pro-ductivity of the bank transaction tax is much lower when its rate is higher, and that collection tends to decline over time (Baca-Campod ó nico, de Mello, and Kirilenko 2006; Coelho 2009 ).

How much financial disintermediation is produced by the tax on bank transactions can depend on many factors that have not been well deter-mined. What is clear is that, regardless of the level of financial disinter-mediation caused, intermediation lost is very difficult to recover. 8 The introduction of the tax in Venezuela in 1994 prompted the use of foreign bank accounts and increased the circulation of bills and coins by 20 per-cent, all of which reduced the expanded money supply—M2 (Coelho, Ebrill, and Summers 2001 ). 9 Similarly, to avoid this tax in Ecuador, start-ing in 1999, banks were created in small border cities, where evasion was easier.

The harmful effects of the bank transaction tax have a distributive dimension. Obviously, the tax falls directly only on those who have access to the banking system, which might seem progressive, since the poor are usually excluded from banking services. But the indirect impact can be regressive due to a “pyramidization” effect that occurs if the same indi-vidual pays the tax several times when making multiple transfers between his or her own accounts as part of a transaction. This can happen in the case of food producers and intermediaries (with costs that are passed on to the final consumer). It can also be the case for members of the middle

HETERODOX TAXES 225

class who use basic banking services, such as savings accounts and debit cards.

However, some aspects of the design of the tax can be modified to mod-erate its harmful effects. Exemptions regarding certain debits—transfers between an individual’s accounts in the same financial entity, or on salary deposits—can reduce the pyramidization of the tax. In addition, differen-tial exemptions or rates can be applied to activities involving large move-ments of funds, with the aim of diminishing the damage done by them (Gonz á lez 2009 ). There is also the possibility of crediting payments of this tax against other tax obligations (for example, VAT, income taxes, or social security contributions). Currently, only Mexico follows this practice (crediting the tax on bank cash deposits, known as the IDE, against the income tax).

However, these palliative measures cannot fix the main problem of the bank transaction tax, which is the tendency of tax revenues to erode over time and its implicit consequences on financial intermediation and efficiency. Consequently, the use of the tax can only be justified as an

Argentina-88Argentina-90

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Figure 12.1 Productivity of Bank Transaction Taxes in Select Latin American Countries, 1988 ‒ 2010

Note : The productivity of the tax is total collection as a percentage of GDP divided by the effective tax rate. Source : Baca-Campod ó nico, de Mello, and Kirilenko (2006); IDB and CIAT ( 2012 ).


exceptional and temporary low-rate tax collection measure (Kirilenko and Summers 2003 ).

Taxes on Primary Sector Exports

Taxes on foreign trade have been around since the existence of commerce itself. But economic theory and historical experience have shown that other methods of taxation are preferable, which is why trade tariffs such as taxes on exports have been gradually eliminated. Taxes on exports, which were common in the past, currently exist in only a few countries, which use them to capture income from the production of certain commodi-ties and/or to take advantage of pronounced fiscal depreciations of their currencies.

After having fallen into disuse, export taxes experienced a resurgence during the 2000s in several countries that depend on primary products. This occurred in response to the extraordinary increase in the prices of these products ( table 12.2 ). In Latin America, Argentina was ahead of the trend, introducing taxes on exports following the collapse of the convert-ibility regime in order to regain fiscal solvency and moderate the distrib-utive impact of the devaluation. Between 2002 and 2011, revenues from export taxes in Argentina averaged almost 9 percent of total tax collection, the equivalent of 3 percent of GDP.

The most justifiable case for a tax on exports is when a country has monopoly power over a good or service in the international market, which allows for using the tax to reduce supply and improve the export price. However, in practice, it is rare for any country to have such market power. Thus, the cases for these taxes in some countries are to collect revenue easily or to isolate domestic prices from the external prices of products that they export.

The collection objective derives from the ease of administering the tax and the low cost of collection. 10 The tax is particularly attractive fis-cally when certain exports enjoy extraordinary revenue as a result of high commodities prices in the international market and/or strong exchange devaluations.

Moreover, the aim of limiting the transmission of high external prices of exported products to the domestic market makes sense when it involves products with a strong share in the consumption basket, since it can lead to an improvement in the real incomes of consumers. 11 Of course, this occurs at the expense of reducing the incomes of producers and poten-tially affecting their investment and production decisions. To the extent that the tax reduces the expected profitability of producers, it will generate

HETERODOX TAXES 227

incentives to redirect productive resources toward products that are not taxed. 12 By increasing consumption and decreasing production, the inev-itable consequence is a lower export share, with its consequent negative effects on the balance of payments, as noted by D í az Alejandro ( 1969 ) in

Table 12.2 Taxes on Primary Sector Exports, Select Countries, 2010

Countries Products Rate

Argentina Soy 35%Corn 25%Wheat 28%Soy oil and flour 32%Biodiesel 20%Soy biodiesel 2.5%, effectiveCorn and sugar ethanol 1%Agricultural products of regional economies

5% to 10%

Hydrocarbons and their derivatives

Calculated by a formula that takes into account the international price and reference price

Nonspecified products 5%Belarus Potassium fertilizers 75 euros per ton

Wheat and meslin 40%Egypt Broken rice $18 per tonCambodia White rice n.d.China Fertilizers n.d.

Wheat, buckwheat, barley, oats, rice and soy flour, wheat flour, sorghum, millet, wheat, and rice

20% (wheat, buckwheat, barley, and oats); 10% (rice and soy flour); 8% (wheat flour); 5% (sorghum and millet); and 3% (wheat and rice)

Nonalloy pig iron 25%Coal gas, liquid gas, producer gas, and similar gases, except petroleum gas and other hydrocarbon gases

1%

Mineral nickel and its concentrates

15%

High-purity polysilicon of weight less than 99.99% silicon

2%

India High-grade basmati rice US$200 per tonIndonesia Raw leather and skins 15% Crude palm oil 3%

n.d.: no data. Source : Authors’ calculations based on Bou ë t and Debucquet (2010); MECON ( 2012 ); and Sharma ( 2011 ).


his study of the Argentine experience during the middle of the last century. In the long run, consumers reaped no benefits whatsoever from the taxes that dampened supply, even in the domestic market, and the lack of export revenue ultimately brought about large exchange rate adjustments.

As happens with many taxes that substitute for the income tax, in the medium term, the tax on imports reduces the tax base as much as wealth taxes (since they tax land and natural resource deposits, which lose value due to the effect of the export tax). Export taxes are an imperfect substitute for income or property taxes. In addition, they are not a permanent and efficient source of public revenue for a stable tax system. Unless they are levied by a country with an international monopoly on the taxed product, such taxes can be justified only as a temporary measure to obtain fiscal resources under extraordinary circumstances involving price or exchange adjustments.

Minimum Taxes or Substitutes for the Income Tax

In order to ensure a collection threshold per taxpayer for the income tax, some countries have established minimum tax systems. These systems have a certain attraction in terms of administration and collection when tax systems are weak and/or the income tax regime is complex and has a multitude of tax incentives and increasing rates—characteristics typical of Latin American countries (see chapters 6 , 7 , and 8 ). The tax base for the minimum tax can be the value of assets or the total amount of the busi-ness’s gross sales or gross earnings. When the income tax calculated under the regular regime indicates an amount less than that derived by applying the minimum tax, the taxpayer must pay the higher amount.

Although there are a range of tax systems that tax holdings of wealth or portions of income—for example, presumptive taxes 13 and simplified regimes for small and medium enterprises (SMEs) 14 —the discussion that follows considers only minimum taxes that can be credited to the income tax.

In industrialized countries, minimum taxes are little used. A promi-nent exception is the United States, 15 where a revised concept of the cor-porate income tax is used for application of this tax. Most Latin American countries have used systems of minimum taxes at one time or another, although there is a notable variety and inconsistency in their design and characteristics ( table 12.3 ).

Although the main objective of minimum taxes is tax collection, their income-generating capacity is generally modest and, in some

Tabl

e 12.

3 M

inim

um T

axes

or S

ubst

itute

s for

the I

ncom

e Tax

, Sel

ect L

atin

Am

eric

an C

ount

ries

, 198

6 ‒ 20

10

Cou

ntri

es

1986

19

92

2000

20

10

Arg

entin

a1.

5% o

f net

wor

th2%

of g

ross

ass

ets

1.0%

of g

ross

ass

ets

1.0%

of g

ross

ass

ets

Col

ombi

a8%

of n

et w

orth

(c

onst

itute

s the

m

inim

um ta

xabl

e in

com

e)

7% o

f net

wor

th

(con

stitu

tes t

he m

inim

um

taxa

ble i

ncom

e)

5% o

f net

wor

th

(con

stitu

tes t

he m

inim

um

taxa

ble i

ncom

e)

3% o

f net

wor

th (c

onst

itute

s the

min

imum

ta

xabl

e inc

ome)

Cos

ta R

ica

0.36

–1.17

% o

f fix

ed

asse

ts0.

36–1

.17%

of f

ixed

ass

ets

1.0%

of a

sset

sN

one

Dom

inic

an R

ep.

Non

eN

one

Non

e1.

0% o

f ass

ets

Ecua

dor

0.15

% o

f pro

pert

y0.

15%

of n

et w

orth

0.15

% o

f net

wor

th0.

15%

of n

et w

orth

El S

alva

dor

0.1 ‒

1.4%

of n

et w

orth

0.9–

2.0%

of a

sset

sN

one

1.0%

of g

ross

inco

me a

Gua

tem

ala

0.3–

0.8%

of p

rope

rty b

0.3–

0.9%

of p

rope

rty b

1.5%

of a

sset

s1%

on

25%

of n

et a

sset

s, or

on

25%

of g

ross

in

com

e, w

hich

ever

is la

rger

(Sol

idar

ity T

ax)

Hon

dura

sN

one

Non

e0.

75%

of a

sset

s1.

0% o

f ass

ets

Mex

ico

Non

e2%

of g

ross

ass

ets

1.8%

of a

sset

s17

.5%

of t

axab

le in

com

e (ca

sh fl

ow)

Nic

arag

ua1.

0% o

f pro

pert

y b 1.

5–2.

5% o

f net

wor

th1.

0% o

f pro

pert

y1.

0% o

f gro

ss in

com

ePa

nam

a1.

0% o

f net

wor

th c

1.0%

of n

et w

orth

c 1.

0% o

f net

wor

th c

Alte

rnat

ive c

alcu

latio

n of

the t

ax: 2

5% o

n w

hich

ever

is la

rges

t—ne

t tax

able

inco

me a

nd

4.67

% o

f tax

able

gro

ss in

com

e (1.

4% o

f gro

ss

inco

me)

Para

guay

1.0%

of p

rope

rty

Non

eN

one

Non

ePe

ru1.

0–2.

5% o

f net

wor

th2%

of n

et w

orth

Repe

aled

0.4%

of n

et a

sset

s d U

rugu

ay2.

8% o

f net

wor

th2%

of n

et w

orth

1.5–

3.5%

of n

et w

orth

1.5–

3.5%

of n

et w

orth

Vene

zuel

aN

one

Non

e1.

0% o

f ass

ets

Non

e a In

effe

ct si

nce 2

012

beca

use o

f a re

cent

tax

refo

rm.

b The

bas

e was

real

esta

te, b

ut th

e tax

was

not

conc

eive

d as

a pr

oper

ty ta

x; ra

ther

it w

as co

ncei

ved

as a

n ad

ditio

nal t

ax o

n bu

sines

s pro

fits.

c Thi

s tax

was

in th

e for

m o

f a li

cens

e to

do b

usin

ess a

nd th

e max

imum

tax

amou

nt w

as 2

,000

bal

boas

per

yea

r. d E

ven

thou

gh th

e Tem

pora

ry T

ax o

n N

et A

sset

s ( Im

pues

to T

empo

ral a

los A

ctiv

os N

etos

—IT

AN

) doe

s not

cons

titut

e a d

efin

itive

min

imum

tax,

it is

inde

ed o

ne

duri

ng th

e fisc

al y

ear i

n pr

ogre

ss b

ecau

se it

s sur

plus

es a

re o

nly

refu

ndab

le a

s fisc

al cr

edits

in fu

ture

appl

icat

ions

. So

urce

: Aut

hors

’ cal

cula

tions

bas

ed o

n C

etr á

ngol

o an

d G

ó mez

Sab

a í ni

(200

7); C

etr á

ngol

o, G

ó mez

Sab

a í ni

, and

Vel

asco

(201

2); a

nd IB

FD ( 2

010 )

.


cases, tends to stagnate. However, Mexico’s Single-Rate Business Tax ( Impuesto Empresarial de Tasa Ú nica —IETU) seems to be an exception ( figure 12.2 ).

Tax Shortcuts

Some of these substitutes for the income tax aim to increase collection by expanding the tax base and increasing the number of taxpayers. In this way, they seek to reduce tax evasion, as shown by the Mexican experience with the IETU (Bulutoglu 1995 ; see box 12.1 ). However, the application of the minimum tax hides, without solving, the problems of tax administra-tion and the legal shortcomings of the income tax (Baer 2006 ). In the end, the collection objective is eroded by subsequent complications that the tax brings about in tax administration.

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Per

cen

t o

f G

DP

Argentina Mexico Peru Dominican Rep. Guatemala

IMPAC (Mexico)

IETU(Mexico)

0.38

0.35

Figure 12.2 Collection of the Minimum Tax or Substitutes for the Income Tax, Select Latin American Countries, 1996–2010

Note : IMPAC = tax on assets ( Impuesto al Activos ); IETU = single-rate business tax ( Impuesto Empresarial a Tasa Ú nica ). Source : IDB and CIAT ( 2012 ).

HETERODOX TAXES 231

Box 12.1 A Second-Best Option: The Single-Rate Business Tax

Since 2008, Mexico’s Single-Rate Business Tax ( Impuesto Empresarial de Tasa Ú nica —IETU) has been a novel way to establish a minimum for the income tax. The tax rate is uniform (17.5 percent) and is applied on the difference between sales and expenditures:

Tax base = Sales ‒ Salaries (taxed by income) ‒ Purchases ‒ Investments

In essence, the IETU is a simplified income tax that protects against the exemp-tions and preferential regimes of the income tax. The IETU supports investment and allows it as a deductible expenditure, which is favorable for productivity (of capital and even labor associated with the use of capital). By allowing salaries taxed by income to be deducted, the tax is neutral with respect to labor.

During the short time period that the tax has been in effect, its results have been encouraging: in 2010 it increased the collection of tax revenues by more than 0.5 percent of GDP and income tax revenues by 10 percent. The IETU has expanded the base and the number of income taxpayers by better incorporating into the system those who benefit from special regimes under the tax. In this way, the proportion of taxpayers who do not pay income tax decreased from 41 per-cent to 31 percent between 2006 and 2010. Given these results, it is worth asking whether the IETU could replace the income tax and if it might be the best tool for the minimum tax for other countries.

In practice, however, the IETU would not be a good substitute for the corporate income tax for three main reasons. First, the inevitable transition costs could be very high. Second, the IETU would not be advisable in other countries because it operates as a single tax; in practice, it does not tax “income” (profits). a Third, it would be technically impossible to resolve the double taxation on dividends if the country were to decide to maintain or include an integrated system for the taxa-tion of dividends (as occurs in Mexico). In other words, it is difficult to make it a coherent part of the entire income tax system if, on the one hand, it taxes income (natural persons), and, on the other, it taxes factors of production (legal persons). This coherence could be achieved only with a flat tax on all types of income, b an option that no country has followed and that is probably not viable. In addition, since the IETU does not take interest payments into account, it incorrectly mea-sures profits.

Nor does it seem feasible for the IETU to be the most advisable form of min-imum tax. Clearly, if countries continue to erode the income tax bases, there will come a time when they will have to put in place some type of exit like the IETU. But the IETU cannot serve as the foundation of a good income tax because it implies sacrificing the coherence of the tax system by taxing a portion of activ-ities based on the cash flow and the remainder on income; because it reduces the possibilities for action through tax policies by eviscerating the income tax; and because, by putting international fiscal credit into play, it could hurt foreign investment and international integration processes. It would not even be a relief


for weak tax administrations: it is just as difficult to monitor cash flow as it is net income.

In summary, the IETU might be a better type of minimum tax than some other possibilities, but that does not mean it is better than good examples of an income tax.

a Even now, operating as a minimum tax, the United States recognizes it only provision-ally. (Press Release 115/2007, December 10, 2007, Mexican Ministry of Finance and Public Credit ( Secretar í a de Hacienda y Cr é dito P ú blico —SCHP)

b As proposed by Hall and Rabushka ( 1981 ).

Source : SHCP ( 2011 ).

A well-designed minimum tax can help compensate for the deficien-cies of a badly designed income tax. If its design is simple and clear, a minimum tax can partially offset the variety and size of deductions and exemptions allowed and reduce the distortions generated by special treat-ment afforded certain sectors. Moreover, it can limit the erosion of income tax collection caused by high inflation rates—the so-called Oliveira-Tanzi effect 16 —that occurs in part because inflation exaggerates the deductions of expenditures due to nominal interest payments. However, there are other formulas to correct these effects, such as periodic inflation adjust-ments of the tax base.

Help that Harms

A minimum tax system, however, can cause many problems. If a very high minimum tax is established, it can generate incentives for informality, especially by small taxpayers that are more difficult to keep track of. It can also generate a risk of administrative slackness, since it enables the tax administration to abandon more complex tasks because these taxes are easier to control and pose few technical challenges. Even worse, depend-ing on the technical design of the tax, it can harm productive efficiency. In effect, it can be a confiscatory tax if it is imposed on businesses with legitimate losses; harm investment projects with long gestation periods; and discourage productive investment when it taxes fiscal or investment capital with wide fluctuations in income. In addition, it can cause illi-quidity when it taxes assets whose value fluctuates considerably in the short term.

Among the various types of minimum taxes, the one that taxes the value of business assets boasts the most solid theoretical fundamentals. 17

HETERODOX TAXES 233

This is because the economic income is related to the assets, and thus taxes the same tax base as the income tax and comprises a good substitute for it, especially in markets with high levels of capital mobility (Krelove and Stotsky 1995 ). However, the assumption of perfect mobility of capital rarely occurs in reality, as shown by the persistence of significant differences in the profitability of assets from country to country. Under these conditions, the minimum tax on assets is not a good substitute for the income tax.

The type of minimum tax that taxes net assets poses an additional problem: it favors assets and investments financed with debt and thus encourages financial “leveraging” (Krelove and Stotsky 1995 ). On the other hand, the option to tax gross income has the serious disadvantage that the earnings are not necessarily related to the volume of operations, and thus punish very competitive or regulated activities that operate with a reduced margin. A minimum tax on gross income is the equivalent of a sales tax, whose major disadvantage is that it is applied in a cascading fashion because it taxes earlier phases of production that have already been taxed (as opposed to the value added tax).

Minimum taxes, in their different forms, are not new. Despite their disadvantages, and although they sometimes are used as a temporary resource, they are rarely abandoned. On the contrary, they become an enabling mechanism for the political system to continue the tax incen-tives that erode the income tax, and prop up a tax administration that operates with limited resources and capacity. Although some improve-ments in the design of minimum taxes might be advisable, the long-term strategy should be to dismantle them, while at the same time simplifying and rationalizing the basic income tax regime.

Simplified Tax Regimes for SMEs and Small Taxpayers

Complying to the letter with a tax regime requires having a certain admin-istrative and managerial sophistication, which is not usually the case with SMEs. Even if all the businesses were incorporated into the tax system, tax administrations would not have the capacity to handle the routine man-agement and control of such a large number of clients, most of them small in size. The challenge for tax systems is to tax small businesses without inducing them into informality. SMEs are not only numerous and gen-erate very low revenues, but they also come and go much more frequently than large businesses. In view of these circumstances, simplified regimes for small businesses would reduce the costs of compliance for businesses and the administrative difficulties for the tax administration.


Normally under these regimes, small taxpayers are exempted from the general requirements of the value added tax and income tax, and even in some cases from social security contributions. In their place, presumptive methods are established to determine the tax, usually at reduced rates. The purpose of this simplification of administrative procedures and pro-cesses is to serve as a bridge to bring these small businesses into formal tax status.

These simplified tax regimes are widespread in Latin America. With the exception of El Salvador, Panama, and Venezuela, all the countries in the region currently have some system of differential treatment for small taxpayers. In some cases, several of these schemes are applied simultane-ously ( table 12.4 ).

The initial problem with simplified taxation is in classifying the small taxpayers into specific categories defined by some notion of size, and in determining whether, and to what extent, to impose the different taxes of the overall tax system on these categories.

In the countries of Latin America, the simplified schemes are basically applied to fiscal entities that carry out economic activities, although in some countries they also extend to certain types of juridical persons—as is the case in Brazil, Costa Rica, Chile, Mexico, Peru, and Uruguay. The sim-plified systems provide for voluntary adherence and self-classification, and are directed mainly toward businesses and service providers. 18 Among the most common technical approaches is what is called the “fixed payment.” It is based on the payment of a certain amount of money—as established per category by the legislature—as a replacement for tax obligations. This simplifies payment of the tax, with the consequent reduction in compli-ance costs. Payments are usually made monthly.

A few countries have established a presumptive tax as a fixed per-centage of the taxpayer’s gross earnings, but this implies difficulties in terms of control for the tax administration, which must determine the small taxpayer’s level of billing. As mentioned, these mechanisms nor-mally substitute for payment obligations for the VAT and the income tax. In Argentina, Brazil, and Uruguay, they also include other national taxes and contributions to social security. Because contributions provide access to pensions and health plans, social security operates as a motivational tool to get small taxpayers to meet their tax obligations. Even then, there is no single criterion to include social security contributions among the sub-stitutes for taxes. In Argentina and Uruguay, the single tax ( monotributo ) substitutes only for payment by the autonomous taxpayer, while in Brazil the SIMPLES regime substitutes for contributions from the employer.

Tabl

e 12.

4 Sp

ecia

l Reg

imes

for S

mal

l Tax

paye

rs, S

elec

t Lat

in A

mer

ican

Cou

ntri

es, 2

010

Cou

ntry

N

ame

Year

initi

ated

Ta

xes i

nclu

ded

in th

e reg

ime

Arg

entin

aSi

mpl

ified

regi

me f

or sm

all t

axpa

yers

(sin

gle t

ax)

1998

Subs

titut

es fo

r nat

iona

l tax

es (t

axes

on

prof

its a

nd th

e VAT

) and

estim

ated

co

ntrib

utio

nsBo

livia

Sim

plifi

ed T

ax R

egim

e (RT

S)19

97Su

bstit

ute f

or th

e VAT

, the

tax

on p

rofit

s of

busin

esse

s, an

d th

e tra

nsac

tion

tax

Inte

grat

ed T

ax S

yste

m (S

TI)

1996

Uni

fied

regi

me f

or a

gric

ultu

re (R

AU)

1996

Braz

ilIn

tegr

ated

syst

em fo

r the

pay

men

t of t

axes

and

co

ntrib

utio

ns (S

IMPL

ES)

1997

Subs

titut

es fo

r all

fede

ral t

axes

and

soci

al

secu

rity

cont

ribut

ions

Chi

leSi

mpl

ified

regi

me f

or th

e inc

ome t

ax (m

inin

g,

busin

ess,

indu

stry

, and

fish

ing)

2007

The s

impl

ified

regi

me a

nd th

e reg

ime f

or

pres

umed

inco

me s

ubst

itute

exclu

sivel

y fo

r th

e inc

ome t

axPr

esum

ed in

com

e reg

ime (

agric

ultu

re)

Sim

plifi

ed ta

x re

gim

e for

smal

l tax

paye

rsTh

e sim

plifi

ed ta

x re

gim

e and

the

exch

ange

regi

me f

or ta

xpay

ers s

ubst

itute

ex

clusiv

ely

for t

he V

ATC

olom

bia

Sim

plifi

ed re

gim

e19

83Su

bstit

utes

for t

he V

ATC

osta

Ric

aSi

mpl

ified

tax

regi

me

1996

Subs

titut

es fo

r the

gen

eral

sale

s tax

(typ

e of

VAT

) on

the i

ncom

e tax

Dom

inic

an R

ep.

Sim

plifi

ed T

ax P

roce

dure

s (PS

T)20

09Su

bstit

utes

for t

he in

com

e tax

and

the T

ax

on T

rans

fers

of I

ndus

tria

lized

Goo

ds a

nd

Serv

ices

(ITB

IS)

Ecua

dor

Sim

plifi

ed R

egim

e (RI

SE)

2008

Subs

titut

es fo

r the

val

ue ad

ded

tax

and

the

inco

me t

axEl

Sal

vado

rD

oes n

ot h

ave i

tn.

a.n.

a.G

uate

mal

aSi

mpl

ified

tax

regi

me f

or sm

all t

axpa

yers

1997

Subs

titut

es fo

r the

val

ue ad

ded

tax

and

the

inco

me t

ax

Cont

inue

d

Hon

dura

sSi

mpl

ified

regi

me f

or th

e sal

es ta

x20

03Su

bstit

utes

for t

he sa

les t

axM

exic

oRe

gim

e for

Sm

all T

axpa

yers

(REP

ECO

S)20

03Su

bstit

ute f

or th

e val

ue ad

ded

tax,

inco

me

tax,

and

Sin

gle-

Rate

Bus

ines

s Tax

(IET

U)

Inte

rmed

iary

regi

me

Sim

plifi

ed re

gim

e for

bus

ines

ses

(agr

icul

ture

-live

stoc

k, fi

shin

g, a

nd ca

rgo

tran

spor

t)N

icar

agua

Spec

ial r

egim

e for

adm

inist

rativ

e est

imat

ion

for

fixed

-pay

men

t tax

paye

rs20

03Su

bstit

utes

for t

he v

alue

adde

d ta

x an

d th

e in

com

e tax

Pana

ma

Doe

s not

hav

e it

n.a.

n.a.

Para

guay

Inco

me T

ax fo

r Sm

all T

axpa

yers

(IRP

C)20

07Su

bstit

utes

for t

he in

com

e tax

Peru

Sing

le S

impl

ified

Reg

ime (

RUS)

2004

The R

US

subs

titut

es fo

r the

gen

eral

sale

s ta

x (ty

pe o

f VAT

) and

the i

ncom

e tax

. The

RE

R su

bstit

utes

onl

y fo

r the

inco

me t

axSp

ecia

l tax

regi

me (

RER)

Uru

guay

Smal

l Bus

ines

s Tax

(IPE

) for

SM

Es19

91Th

e IPE

subs

titut

es fo

r the

Tax

on

Indu

stry

and

Com

mer

ce (I

RIC)

and

the

valu

e add

ed ta

xSm

all B

usin

ess T

ax (I

PE) f

or S

MEs

2007

Vene

zuel

aD

oes n

ot h

ave i

tn.

a.n.

a n.

a.: n

ot ap

plic

able

Sour

ce : C

etr á

ngol

o, G

ó mez

Sab

a í ni

, and

Vel

asco

( 201

2 ).

Tabl

e 12.

4 C

ontin

ued

Cou

ntry

N

ame

Year

initi

ated

Ta

xes i

nclu

ded

in th

e reg

ime

HETERODOX TAXES 237

In terms of classifying small taxpayers, there are several criteria to establish thresholds and to limit the application of the simplified regimes. The variable most used is the taxpayer’s income, measured by gross earn-ings or total sales. To delimit income under these schemes, some countries set limits on the maximum amount of land under cultivation, number of establishments, consumption of electricity, number of employees, or avail-able capital. Argentina, Colombia, and Peru apply several of these criteria simultaneously.

In addition, in exempting eligible small businesses from the normal VAT process, most of these regimes do not allow the tax paid to suppli-ers of inputs to these businesses to be deducted. This undercuts the con-trol flow based on VAT invoicing and transforms that tax into a cost that hinders efficiency.

Excessive Simplification

Compared to some developed countries that also use these schemes, the income threshold established by tax administrations in Latin America is very high, in general ( table 12.5 ).

This raises the possibility of having a very high number of taxpayers, which in some cases can be too many to deal with from an administrative standpoint. In addition, when the income threshold is very high, these schemes can in some cases open the door for these taxpayers to evade other taxes. This is the case in Brazil, the country that collects the most taxes through the application of these simplified schemes both as a share of GDP and of total collection amounts ( table 12.6 ).

In the other countries, however, the tax revenue obtained is extremely low—even more so when considering that the system covers several taxes and a very high number of taxpayers. Despite the fact that many of these regimes have been in place for decades, the revenues remain stagnant over time. In some cases, not even administrative costs are recovered. 19

This is due to the low amount set for the fixed payment and to the high levels of delinquency and evasion (Gonz á lez 2009). Although estimates exist only for Mexico (Fuentes Castro et al. 2011 ), it can be assumed that in general the small taxpayers have levels of evasion that are higher than those of larger businesses, 20 in large part because the cost of complying with their tax obligations is proportionally higher for small taxpayers (Perry et al. 2007 ; Schneider, Buehn, and Montenegro 2010 ). 21 In addition, these regimes create incentives for businesses to intentionally dismantle


certain units in order to take advantage of tax benefits provided to small taxpayers, generating what has been called “fiscal dwarfism.”

Finally, it is important to point out that the simplified regimes exac-erbate the horizontal inequity characterized by the personal income tax. Consider the tax burden of the income tax and contributions to social secu-rity for a salaried single taxpayer under the general tax system as opposed to that of a small taxpayer with a net profit margin of 50 percent under the simplified regime. Table 12.7 presents the tax calculations for both types of taxpayers. Under the first assumption, both are in the third income decile;

Table 12.5 Simplified Tax Regimes for SMEs: Maximum Income Limits Established by the Tax Administrations, Select Latin American and OECD Countries, 2011

Country Threshold in dollars Threshold as percentage of per capita GDP

Argentina 48,760 (services) 73,140 (commerce)

5.36 (services) 8.05 (commerce)

Bolivia 19,625 (RTS) 10.0 (RTS)Brazil 152,592 13.9Chile 1,644 (VAT) 0.1Colombia 60,316 9.7Costa Rica RTS: 107,531 (annual purchases),

250,905 (fixed assets)12.4 (annual purchases), 28.9 (fixed assets)

Dominican Rep. 199,648 36Ecuador 60,000 14.3Guatemala 19,112 6.0Honduras 9,522 4.5Mexico 148,624 15.9Nicaragua 28,200 22.76Paraguay 22,570 (IRPC) 6.2 (IRPC)Peru 131,256 (RUS)–191,415 (RER) 24.6 (RUS)–35.9 (RER)Uruguay 21,745 (single tax)–36,242 (IPE) 1.82 (single tax)–3.03 (IPE)Canada 121,400 2.8United Kingdom 114,072 3.2United States 48,000 1.0

Note : IRPC = Income Tax on Small Taxpayers ( Impuesto a la Renta de Peque ñ os Contribuyentes ); IPE = Small Business Tax ( Impuesto a la Peque ñ a Empresa ); VAT = value added tax; RER = Special Regime Income Tax ( R é gimen Especial del Impuesto a la Renta ); RTS = Simplified Tax Regime ( R é gimen Tributario Simplificado ). Sources : Cetr á ngolo, G ó mez Saba í ni, and Velasco ( 2012 ); Pecho Trigueros ( 2012 ); World Bank (2012b ).

Tabl

e 12.

6 Sm

all T

axpa

yer R

egim

es: N

umbe

r of T

axpa

yers

and

Rev

enue

, Sel

ect L

atin

Am

eric

an C

ount

ries

, 200

6–10

Num

ber o

f di

ffer

ent

regi

mes

N

umbe

r of

taxp

ayer

s Re

gim

e

2006

20

07

2008

20

09

2010

(Rev

enue

as a

per

cent

of G

DP)

Arg

entin

a2

2,39

9,74

0Si

ngle

tax

0.13

0.13

0.13

0.14

0.15

Sing

le ta

x re

sour

ces f

rom

so

cial

secu

rity

0.10

0.09

0.10

0.11

0.19

Boliv

ia4

64,2

24Si

mpl

ified

Tax

Reg

ime

(RTS

)0.

010.

010.

010.

010.

01

Inte

grat

ed T

ax R

egim

e (S

TI)

0.00

010.

0001

0.00

010.

0001

0.00

01

Sim

plifi

ed R

egim

e for

A

gric

ultu

re o

r Rur

al

Prop

erty

Tax

(IPR

)

0.01

0.01

0.01

0.01

0.01

Braz

il2

4,32

8,00

2C

olle

ctio

n su

mm

ary

for

SIM

PLES

nat

iona

l pro

gram

n.d.

n.d.

0.80

0.84

0.97

Chi

le5

122,

965

Inco

me (

smal

l co

ntrib

utor

s)0.

350.

350.

360.

340.

35

Sim

plifi

ed T

ax fo

r the

VAT

0.01

0.01

0.01

0.01

0.01

Cos

ta R

ica

138

,407

Sim

plifi

ed T

ax R

egim

e0.

020.

020.

020.

010.

02D

omin

ican

Rep

.3

4,35

3Ta

xes o

n In

com

e0.

0027

0.00

340.

0042

0.00

460.

0049

ITBI

S0.

0008

0.00

140.

0015

0.00

130.

0010

Oth

ers

0.00

050.

0005

0.00

060.

0004

0.00

04Ec

uado

r1

379,

604

Sim

plifi

ed E

cuad

orea

n Ta

x Re

gim

e (RI

SE)

n.d.

n.d.

0.00

0.01

0.01

Cont

inue

d

Gua

tem

ala

123

2,09

1Si

mpl

ified

Reg

ime f

or

Smal

l Con

trib

utor

s: Q

uart

erly

pay

men

t an

d de

clar

atio

n re

gim

e (si

mpl

ified

), de

term

ines

cr

edits

and

deb

its w

ith a

norm

al ra

te

0.00

620.

0083

0.00

520.

0054

0.00

49

Sim

plifi

ed R

egim

e for

Sm

all

Con

trib

utor

s, w

ith a

fixed

pa

ymen

t of 5

% o

n gr

oss

inco

me o

btai

ned

quar

terly

0.07

0.06

0.06

0.06

0.07

Mex

ico

33,

650,

000

Smal

l Con

trib

utor

Reg

ime

(REP

ECO

S, in

clude

s VAT

an

d IS

R)

0.02

0.02

0.02

0.02

0.02

Para

guay

340

9,64

1In

com

e Tax

for S

mal

l C

ontr

ibut

ors

0.01

0.01

0.01

0.01

Sing

le Ta

x0.

010.

010.

000.

000.

00Pe

ru2

940,

983

Sim

plifi

ed S

ingl

e Tax

0.03

0.02

0.02

0.03

0.02

Spec

ial T

ax R

egim

e0.

020.

020.

020.

020.

03U

rugu

ay

3

101,

054

Tax

on S

mal

l Bus

ines

s0.

100.

05n.

d.n.

d.n.

d.M

inim

um V

ATn.

d.0.

050.

090.

080.

07

Sing

le T

axn.

d.0.

080.

020.

020.

03

Not

es : V

AT =

val

ue ad

ded

tax;

ISR

= in

com

e tax

( im

pues

to so

bre l

a re

nta )

; ITB

IS =

tax

on th

e tra

nsfe

r and

impo

rtat

ion

of in

dust

rial

goo

ds ( i

mpu

esto

a la

tran

s-fe

renc

ia e

impo

rtac

i ó n

de b

iene

s ind

ustr

ializ

ados

); n.

d. =

no

data

. So

urce

s : A

utho

rs’ c

alcu

latio

ns b

ased

on

IDB,

CIA

T, a

nd C

APT

AC-D

R ( 2

012 )

; Pec

ho T

rigu

eros

( 201

2 ).

Tabl

e 12.

6 C

ontin

ued

Num

ber o

f di

ffer

ent

regi

mes

N

umbe

r of

taxp

ayer

s Re

gim

e

2006

20

07

2008

20

09

2010

(Rev

enue

as a

per

cent

of G

DP)

Tabl

e 12.

7 C

ompa

riso

n of

the T

ax W

edge

s of S

impl

ified

Reg

imes

and

Sal

arie

d W

orke

r Reg

imes

, Sel

ect L

atin

A

mer

ican

Cou

ntri

es, 2

010

(per

cent

)

Tota

l fis

cal g

ap

[a+b

+c]

Inco

me t

ax

[a]

Wor

ker

cont

ribu

tions

to

soci

al se

curi

ty [b

]

Empl

oyer

co

ntri

butio

ns to

so

cial

secu

rity

[c]

Tota

l fis

cal

gap

[a+b

+c]

Inco

me

tax

[a]

Wor

ker

cont

ribu

tions

to

soci

al se

curi

ty [b

]

Empl

oyer

co

ntri

butio

ns to

so

cial

secu

rity

[c]

Inco

mes

equi

vale

nt to

the t

hird

inco

me d

ecile

of t

he co

untr

ySi

mpl

ified

regi

mes

Regi

mes

for s

alar

ied

wor

kers

Arg

entin

a10

.93.

27.7

n.a

34.0

0.0

17.0

17.0

Boliv

ia30

.56.

623

.9n.

a27

.66.

615

.06.

0Br

azil

3.8

0.6

3.2

n.a

34.7

0.0

11.5

23.2

Chi

le23

.03.

020

.0n.

a23

.30.

020

.62.

7C

osta

Ric

a12

.51.

011

.5n.

a37

.20.

012

.824

.4M

exic

o9.

30.

09.

3n.

a25

.80.

02.

323

.5Pe

ru18

.03.

814

.2n.

a40

.20.

027

.612

.6U

rugu

ay20

.10.

020

.1n.

a32

.80.

019

.613

.2 Av

erag

e 16

.0

2.3

13.7

n.

a 32

.0

0.8

15.8

15

.3

Inco

mes

of U

S$12

,000

Sim

plifi

ed re

gim

esRe

gim

es fo

r sal

arie

d w

orke

rsA

rgen

tina

6.8

4.5

2.3

n.a

34.0

0.0

17.0

17.0

Boliv

ia24

.40.

523

.9n.

a29

.16.

412

.210

.5Br

azil

0.0

n.a

0.0

n.a

33.9

0.3

11.0

22.6

Chi

le20

.0n.

a20

.0n.

a23

.20.

020

.62.

6C

osta

Ric

a14

.81.

013

.8n.

a28

.90.

09.

219

.7M

exic

o1.

6n.

a1.

6n.

a27

.412

.62.

212

.6Pe

ru14

.00.

913

.1n.

a24

.73.

913

.17.7

Uru

guay

5.2

0.0

5.2

n.a

32.8

0.0

19.6

13.2

Aver

age

10.9

1.

4 10

.0

n.a

29.3

2.

9 13

.1

13.2

n.a.

: not

appl

icab

le.

Not

e : Th

e tab

le a

ssum

es th

at n

et in

com

e rea

ches

50

perc

ent o

f gro

ss in

com

e tot

als.

Sour

ce : A

utho

rs’ c

alcu

latio

ns b

ased

on

Agu

irre

( 201

2 ).


under the second, each has an annual income of US$12,000. On average over the years analyzed, under the first assumption, the salaried worker has double the tax burden of the taxpayer under the special regime; under the second assumption, the tax burden is three times greater.

Simplify Does Not Mean Ignore

Three lessons emerge from the analysis of simplified regimes to improve their design. First, simplified regimes increase the risk and the incentive to transfer over to them activities that are taxed at higher rates under the normal regime. For reasons related both to collection and equity, maximum earning levels (and other criteria) to trigger the simplified regime should be very low (in countries with high inflation this can be easily achieved by freezing nominal values). Second, simplified regimes increase the risk that small businesses will submit false receipts that underestimate their sales, given that they are not incorporated into the general VAT regime chain, which aims to stop these practices (since the purchasing business has the incentive to credit the VAT paid by the provider). Consequently, VAT credit should not be given for purchases originating from partici-pants in the simplified regime.

Third, advances in information technology have facilitated mechanisms for the declaration and payment of taxes, as well as for the implementa-tion of simplified accounting methods adapted for small businesses. For this reason, the authorities should effectively consider these regimes as a bridge to the general tax system, and not as a permanent situation over the long term. Ideally, for purposes of tax neutrality and equity, these special regimes will cover fewer and fewer taxpayers, who over the long term will be absorbed into the general tax system.

Rosy and Rocky Outlooks

Challenging the precepts of tax and economic theory, the countries of Latin America have routinely turned to various heterodox taxes as mechanisms to resolve fiscal shortfalls rapidly. Taxes on bank transactions, primary sec-tor exports, and minimum income, along with certain simplified regimes for SMEs and small taxpayers, fall into this category. Although some of these taxes meet their collection objective in the short term, they cannot become fixtures of the tax system because they erode their own bases as well as those of other taxes, generate distortions and inefficiencies, and

HETERODOX TAXES 243

discourage investment and economic growth. In addition, even though some of them appear to be progressive, they are a channel for horizontal inequity because they introduce differential treatment for businesses or individuals operating under similar economic circumstances.

Since they cannot constitute a permanent and efficient source of public resources for a stable tax system, these taxes need to be examined critically. The tax on bank transactions harms the fabric of the financial system, generating losses in terms of financial depth and reducing efficiency and economic activity. It should therefore be used on a strictly exceptional, temporary, and limited basis.

Taxes on exports are a collection option to respond to fiscal emergencies when there is excessive exchange rate volatility or sudden price increases in basic export products. Despite being an effective channel for capturing and redistributing income and a protective barrier for consumers against external price increases in the short run, export taxes also harm produc-tive structures and economic activity. Without putting fiscal solvency at risk, authorities should look for an opportune moment to eliminate taxes on exports.

Taxes on minimum income are a collection alternative in the face of the imperfections of the income tax and the limitations of tax administra-tions. But they can cause more problems than they resolve because they tax in a distortionary manner, can induce administrative slackness, and are an excuse for the proliferation of exemptions under the basic tax in-come regime for businesses. Consequently, they should not be considered a substitute for the income tax, but rather as a transitory modality that should be withdrawn.

Similarly, simplified regimes for SMEs and small taxpayers attempt to ameliorate the limitations of tax administration and the low adminis-trative capacity of many taxpayers. Since it is difficult to eliminate these problems in the medium term, the future of such simplified regimes is assured. However, advances in information technology have facilitated mechanisms for the declaration and payment of taxes, as well as for the implementation of simplified accounting measures adapted to small-scale businesses. For this reason, instead of considering these regimes as perma-nent for small businesses, they should be redesigned to serve as a bridge to move these enterprises into the general tax system, which better respects the principle of tax neutrality, does not induce businesses to remain small or break up, and does not allow for the horizontal inequities created by the simplified regimes.

Part III

Harvesting for Development

13

Growing a Reform Agenda

Taxation is an essential ingredient of public policymaking. Taxes provide a fundamental—arguably the best—source of financing for

public expenditure programs. They also link citizens to their govern-ments. If properly designed, tax systems can enhance governance, trans-parency, and accountability.

This book has looked at taxation in the Latin American and Caribbean region with a development lens. While recognizing that revenue collec-tion is a central goal of tax policy, the book has emphasized that taxation is about more than revenue. Taxation can be a powerful development tool to promote equity; enhance revenues for social programs; and support investment, productivity, and economic growth. With this development perspective in mind, the authors have provided an overview of the state of taxation in the region, its needs for reform, and proposals that take into account the economic, institutional, and political constraints that shape reform processes.

In the area of taxation, as in other economic areas, the region is diverse, encompassing countries with relatively high tax revenues-to-GDP ratios, countries with very low ones, and countries in between. The composi-tion of fiscal revenues also varies significantly across countries, as does the degree of revenue decentralization. Recognizing these differences is crucial to identify reform needs and reform avenues. Hence, the book has eschewed one-size-fits-all proposals. Nevertheless, some features are com-mon to many tax systems in the region and salient messages are worth summarizing in this chapter.

Latin America and the Caribbean stand out as the region of the world where tax revenues have increased the most in the last two decades. Political and institutional factors have played an important role in shap-ing these trends. However, by and large, tax systems in most countries still generate less revenue than is warranted by their level of development and by their substantial unmet needs for social programs and infrastructure


investment. Accordingly, with few exceptions, revenue mobilization should be a reform priority for countries in the region.

There is also ample scope to improve tax systems in the region in other desirable dimensions, notably in their ability to cushion macro-economic volatility and to promote efficiency, equity, simplicity and ease of compliance, effectiveness of enforcement, and adequate revenue decentralization:

● Fiscal revenues in the region tend to be highly volatile, particularly in countries dependent on nonrenewable natural resources. At the same time, automatic stabilizers are few and ineffective, exacerbating the exposure of low-income households to significant income shocks.

● A range of distortions hampers efficiency. These include lack of equity across similar taxpayers (horizontal equity); widespread use of tax expenditures (exclu-sions from tax bases, deductions, and reduced tax rates); a bias against labor income and an excessive reliance on payroll taxes to finance social security pro-grams that hinder employment and may promote informality; indirect taxes that apply at multiple stages (cascading); and a tendency to resort to distortive instruments, such as minimum income taxes, financial transactions taxes, and export taxes, and simplified tax regimes for small and medium-size firms on grounds of expediency and ease of tax collection.

● The region’s tax systems exhibit several regressive features, including the large weight of consumption taxes in total revenues and the insufficient coverage of the personal income tax, which combines with the exclusion of certain types of incomes from the tax base and high minimum exemption levels to make this tax an empty shell in many countries. More importantly, the relatively low tax revenues of the personal income tax limit the scope for using public policies to address the high income inequality that—despite significant progress in the last decade—still prevails in the region.

● Enforcement remains ineffective and tax evasion is widespread. These phenomena reflect the high degree of informality in input, product and property markets, and, in some countries they are also a result of cumber-some tax filing procedures. It is also testament of a pending reform agenda for tax administrations in the areas of tax audits, litigation processes, and collection.

● In most Latin American and Caribbean countries, revenue decentraliza-tion has been limited, especially at the regional level. Regional governments need to be assigned meaningful sources of revenue. Meanwhile, local gov-ernments, despite having appropriate taxing powers (or tax handles) such as property taxes, are not taking advantage of their full potential.

The region has not been shy when it comes to implementing tax reforms. However, tax reforms have frequently taken place in the context

GROWING A REFORM AGENDA 249

of macroeconomic crisis, driven by the urgent need to raise more revenues. The next generation of tax reforms cannot obviate other fundamental goals to be fulfilled by tax systems, with a clear focus on the future. Early and significant progress becomes paramount in light of a number of chal-lenges facing most countries over the medium-to-long term. These chal-lenges include the need to increase the low levels of national savings and investment and strengthen human capital and total factor productivity—all conducive to sustainable growth and international competitiveness.

For many economies in the region, one of the greatest pending tasks is to reduce dependence on volatile and exhaustible natural resource revenues. In addition, governments must fulfill rising expectations of a continuous improvement in living standards and prepare for the popula-tion aging that looms ahead. As with all areas of public policy, there are often trade-offs among tax reform objectives. Therefore, country-specific reform proposals should be designed taking into account the relative importance of the objectives in each country and factoring in the eco-nomic, social, political, and institutional circumstances. But there are also reform options that exploit potential synergies among all or some of the objectives.

A number of significant reforms would help tax systems in the region become powerful development tools. A summary of proposals put for-ward in this book follows.

Personal Income Tax Reforms

A reform of the personal income tax should seek to improve its revenue yield, its redistributive power, and its stabilizing potential, and to reduce its “de facto” bias against labor. In most Latin American countries, such a reform would likely involve these steps:

● Reducing the personal exemption threshold to levels below (or, at least, in line with) average income per capita.

● Capping those deductions whose value rises along the income distribution (such as the deductions for interest on housing mortgages).

● Broadening the tax base to include certain types of currently exempt income (such as interest, dividends, or pensions) and capital gains.

● Establishing a dual rate structure that is (i) moderately progressive for incomes from wages, self-employment, pensions, and rents and (ii) propor-tional—at a reduced rate—for income from capital, including capital gains.

● Aligning the top marginal rate of the personal income tax with that of the corporate income tax to avoid arbitrage opportunities.


A personal income tax with such features would be easier to admin-ister and would not concentrate its revenues on the top income earners alone. This would increase its revenue-raising capacity, while preserving a degree of progressivity (enhanced by the elimination or capping of regres-sive deductions). At the same time, the reduced rate for capital incomes would safeguard efficiency. Recent reforms in some countries of the region (in Central America and South America) lean in this direction and show promising results.

Corporate Income Tax Reforms

In light of the current good revenue performance of the corporate income tax in many Latin American and Caribbean countries, reform priorities for these taxes relate more to efficiency and horizontal equity than to rev-enue mobilization. However, growing trade openness and global finan-cial integration pose challenges for effective enforcement and continued sound revenue performance.

The area most in need of reform is the proliferation of tax incentives that erode the base of the corporate income tax without generating a payoff in terms of additional investment and employment creation. These incentives complicate tax administration, foster corruption, and can ignite a “race to the bottom,” where countries increasingly use tax incentives in response to neighbor countries’ actions, further complicating the tax system and eroding the tax base. The costs and benefits of existing incentives should be reviewed on a regular basis and the findings of such reviews should be disseminated in a transparent fashion. These reviews can help over-come the inevitable (and often politically influential) resistance of interest groups to phasing these incentives out. Regional cooperation agreements barring, or at least severely limiting, the granting of new incentives are especially useful.

A second priority is to reduce tax avoidance, particularly through var-ious forms of aggressive tax planning by large firms and multinationals operating in the region, including the use of transfer pricing from high to low taxation countries. Some successful measures have been imple-mented in the region. The so-called sixth method relies on international commodity prices to limit three-way transfer pricing of commodity trans-actions. Also, the “supervised” taxation of international tourism services relies on market prices for similar services to halt tax avoidance. These homegrown solutions are worth replicating by more countries in the region.


Strengthening both the relevant legislation and the capacity of national tax administrations to effectively audit large multinational corporations constitute vital steps to reduce tax avoidance. Ongoing international efforts to eliminate bank secrecy and promote a more systematic and effective exchange of information among tax administrations, as well as to eliminate tax havens, are crucial for sustained progress in combating tax avoidance and evasion.

Broadening the base of the corporate income tax along the avenues just described could open up room to reduce rates in line with international trends, enhancing the region’s attractiveness to foreign direct investment, promoting domestic investment, and boosting demand for higher-skilled workers.

Value Added Tax Reforms

The VAT is the workhorse of taxation in most of Latin America and the Caribbean, raising revenues nearly comparable to those in the member countries of the Organisation for Economic Co-operation and Develop ment (OECD). It is also a relatively efficient tax, as it promotes savings and does not damage external competitiveness. Moreover, when levied at a uniform rate and with limited exemptions, it does not affect resource allocation.

However, by applying a common tax rate across all consumption goods, the VAT implies a heftier burden for low-income people who consume a large share of their income than for high-income people who save more, making it a regressive tax. To overcome this feature, several countries have resorted to exempting or taxing at reduced rates those goods that are more prominent in the consumption basket of the poor. But these measures are inefficient because a large share of the foregone revenues benefits middle- and upper-income groups.

Alternatively, a reform that taxes all goods and services subject to the VAT at a unified rate, complemented by a limited number of excise taxes on goods whose consumption the government wants to discourage—such as alcohol, tobacco, and fuel products—could simultaneously increase efficiency and equity. At the same time, all or part of the additional reve-nues from this reform could be redistributed to lower-income groups based on the estimated value of the VAT paid by them in their consumption baskets. Such redistribution could be implemented by making use of the administrative and technological capabilities of existing conditional cash transfer programs, such as Bolsa Fam í lia in Brazil and Oportunidades in Mexico. This so-called personalized VAT would have the added advantage


of facilitating VAT administration and compliance. Simulations of its im-pact on revenue, income distribution, and poverty levels for Costa Rica and Uruguay are encouraging.

The additional revenues could also be used in part to reduce labor taxes. In particular, reducing labor taxes that finance benefits that are not valued by workers would boost formal employment and productivity. Moreover, replacing some labor taxes with a VAT would improve external compet-itiveness, since labor taxes are not refundable for exports and not levied on imports.

Taxes on “Bads”

In principle, well-designed environmental and environmentally related taxes hold the promise of reducing “bads,” such as pollution and green-house gas emissions. Taxes on “bads” could also promote efficiency in the use of scarce resources such as energy and water, while helping mobilize additional revenues: this is the so-called double-dividend.

Critics argue that carbon taxes would take a toll on growth. However, assessments for the Latin America and Caribbean region suggest that the impact on growth would not be large, although affecting some coun-tries and sectors more than others. Revenue-enhancing and price effects would also vary significantly across countries. Energy tax reform repre-sents a clear policy priority in the region since most Latin American and Caribbean countries underutilize such taxes and several waste large fiscal resources by subsidizing fuel prices, implicitly encouraging energy con-sumption. Contrary to popular belief, lower-income groups would likely benefit from such reforms, especially if due allowance is made for the en-vironmental and health benefits of the change.

There is also scope to increase the use of congestion charges, especially in large metropolitan areas, utilizing new global positioning system tech-nologies to track the movement of vehicles in and out of the center of cities at different times of the day. Finally, differentiated fees for waste manage-ment could provide municipal governments with an additional source of revenue, while helping improve environmental quality.

Local Taxes for Local Development

Subnational governments, especially at the regional, but also at the local level, lack adequate tax handles in most Latin American and Caribbean countries. In principle, subnational taxes should exhibit a number of


desirable characteristics, which include, for instance, low mobility of the tax base, no adverse spillovers on other jurisdictions, and ease of compli-ance. All potential subnational tax handles fall short on one or more desir-able criteria, and trade-offs need to be made among them.

● A regional personal income tax (or surcharge on the national personal income tax) is one possibility. A surcharge on the national personal income tax would be preferable to a regional tax, given the complexity of administering the per-sonal income tax and limited subnational capacity in this area.

● Regional or local retail sales taxes represent another option. The main drawbacks to this alternative are its regressive nature and likely enforce-ment difficulties in a retail sector characterized by strong fragmentation and high levels of informality.

● A regional VAT (or regional surcharge on national VAT) offers significant revenue potential, but the taxation of interstate trade creates serious difficul-ties. Other shortcomings include its likely regressivity and its relatively high administration and compliance costs. A variation on this might be a tax on the value-added of individual enterprises, calculated by subtracting the cost of inputs from sales. It has good revenue potential, but since it neither exempts exports nor taxes imports, it adversely affects competitiveness.

● Regional or local excise taxes (or surcharges on national excise taxes) could be levied on fuel products, electricity, cellular phones, and tourism, among others. They have a relatively good revenue-raising potential, but for some of them (such as the tax on tourism), the bases may be heavily concentrated in certain regions; others affect production costs and might undermine competitiveness.

At the same time, subnational governments must improve existing tax handles, particularly real estate taxes, already assigned to governments. Local governments should invest in modernizing land and property reg-istries (cadastres) and in updating them more frequently. Other improve-ments in local tax administration might include systematically exchanging information with regional and national tax administration.

Finally, subnational tax reforms should be complemented with reforms of intergovernmental transfer systems—to make them less discretionary, and tighten borrowing controls—to reduce expectations of bailouts, hence inducing subnational governments to adequately exploit their tax handles.

Reforms of Taxes on Nonrenewable Commodities

Nonrenewable commodities constitute an increasingly important source of fiscal revenues for many countries in Latin America and the Caribbean.


While proving a most welcome source of financing, fiscal dependence on these revenues poses important challenges. Fiscal resources from nonre-newable commodities are highly volatile and have tended to undermine efforts to collect general taxes from the rest of the economy. More funda-mentally, they will eventually be exhausted and need to be replaced. It is, hence, critical that policymakers plan ahead and strengthen the general tax base as these resources become depleted.

There is also considerable room to improve the design of revenue instruments applied to the commodity sector. Many countries continue to rely on traditional systems of royalties and income taxes. Unfortunately, they distort investment incentives of the private sector and are prone to frequent alterations as they are not good at capturing extraordinary rents when prices increase. A move toward taxes based on net income, profits, or rents are better at promoting private-sector investment and produc-tion without sacrificing current or future fiscal revenues. These reforms need to be accompanied by renewed efforts to strengthen transparency in the extractive industries and are paramount to enhance intergenerational equity.

Reforms of Heterodox Taxes

Challenging the precepts of fiscal and economic theory, several coun-tries in the region have used various heterodox taxes as expeditious mechanisms to confront fiscal imbalances. Taxes on bank transactions and on primary commodity exports, the minimum income tax, and some simplified regimes for small- and medium-sized taxpayers are in this category. Some of them have served well to increase fiscal reve-nues, but they have failed to become pillars of the tax system. They have eroded their own tax base, as well as the base of other taxes, generated distortions and inefficiencies, and discouraged investment and growth. In addition, they have become a channel of horizontal inequity, intro-ducing differential treatment for companies or individuals of similar economic conditions.

These taxes must be revised since they cannot become an efficient and permanent source of public resources for a stable tax system.

● The tax on bank transactions damages the financial fabric, generating losses in terms of financial depth and efficiency and likely taking a toll on economic activity. Its use should therefore be exceptional, moderate, and temporary.


● The export taxes on commodities, despite being an effective way to capture and redistribute rents and a barrier to protect consumers against external price increases in the short term, can damage production structures and economic activity. Thus, these taxes need to be phased out, taking into con-sideration fiscal solvency needs.

● The minimum income tax represents an alternative to mitigate the imper-fections of the traditional income tax and the constraints of tax adminis-trations. But it distorts the tax system, can induce administrative lethargy, and provides an excuse for the proliferation of exemptions from the general income tax. It should not be thought of as a substitute for the income tax, but as a transitional mechanism that should eventually disappear.

● Similarly, simplified regimes for small- and medium-sized taxpayers try to overcome the limitations of the tax administration and the low administra-tive capacity of many taxpayers. These challenges are not easily resolved. Hence, these regimes are likely here to stay. Nevertheless, the progress in information technology and the introduction of simplified accounting for small-scale businesses have facilitated tax filing and payment. Therefore, rather than regarding simplified regimes as the steady state for small busi-nesses, they should be reconsidered as a bridge for those companies transit-ing toward the general taxation system. Such a move would improve tax neutrality, avoid incentives for firms to remain small and fragmented, im-prove horizontal equity, and boost productivity.

More than Revenues

This book has presented both the forest and the trees of tax systems in Latin America and the Caribbean. From the overarching goals of raising revenue, redistributing income, and promoting efficiency, to the details of administration and enforcement, this volume has collected informa-tion that can serve as a valuable resource for policymakers throughout the region. For them, the most important first step is to view taxes as more than a vehicle for raising revenue and as a valuable tool for development.

Notes

1 Undressing the Myths

1 . For example, a recent report on public finances by the Andean Development Cor-poration (CAF) states: “There are several problems which can be identified and which are clearly closely interrelated: i) low tax effort; ii) tax structures overly biased toward indirect taxes that compromise the objective of equity; and lastly iii) high levels of evasion” (CAF, 2012 , p. 172). See also G ó mez Saba í ni ( 2006 ) and Jim é nez, G ó mez Saba í ni, and Podest á (2010).

2 . See Engerman and Sokoloff ( 2005 ) and Sokoloff and Zolt ( 2007 ). 3 . Chapter 2 analyzes the political economy of taxation. 4 . The 32 countries are Australia, Austria, Belgium, Canada, Czech Republic,

Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea (South), Luxemburg, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, United Kingdom, and United States. Note that this group includes devel-oping countries, such as Turkey, and does not include some countries with very high income levels, such as Singapore.

5 . These gaps relate to the estimated residuals of a regression that explains the tax collection rate as a function of the logarithm of per capita income.

6 . The income tax gaps (or deficits) are calculated in the same way (see previous note). Low taxation is much more pronounced in the case of personal income tax than corporate income tax, as discussed in chapters 7 and 8. However, there is insufficient information to calculate separate gaps for either tax with the econo-metric methodologies used in this chapter.

7 . See Daughters and Harper ( 2007 ). 8 . These figures are averages for 2008 ‒ 10. 9 . The additional variables included are the proportion of the population aged under

15 and over 65, the percentage of the workforce that is self-employed, the ratio of exports and imports to GDP, and the ratio of revenue from natural resources to GDP.

10 . These figures include contributions to social security systems managed by private funds, but do not include other state-mandated contributions that do not enter the treasury, such as payroll surcharges collected by the Cajas de Compensaci ó n (family benefit funds) in Colombia. Similarly, the fiscal burden does not include taxes and user fees paid to public providers of goods and services.

11 . See IDB ( 2008 ).

258 NOTES

12 . Bolivia, Chile, Colombia, Ecuador, Mexico, Peru, Trinidad and Tobago, and Venezuela.

13 . Note, however, that the IDB-CIAT database does not distinguish which part of corporate income tax relates to the natural resource sectors.

14 . The external price boom may also have contributed indirectly (although margin-ally) to increasing the tax burden, insofar as increases in income and consump-tion came to be taxed at higher effective rates.

15 . In 2010, the government of Panama received social security contributions of 6.1 percent of GDP, and fees on services and dividends from the Panama Canal of 3.1 percent of GDP. Once the new set of locks comes into operation, the canal’s fiscal contributions will be even more substantial. Similarly, in Paraguay, social con-tributions in 2010 represented 4.1 percent of GDP and revenue from the Yaciret á and Itaip ú hydroelectric plants a further 3 percent of GDP.

16 . This statement may not be true for families in the higher percentiles, but this does not invalidate the argument.

17 . Chapter 3 also shows that the volatility of the disposable income of low- and middle-income families would be lower if they paid income tax (which would allow a reduction in the VAT rate).

18 . VAT tends to increase labor informality and encourages informal firms to in-teract commercially with one another, as discussed in chapter 4 .

19 . In particular, the number of payments that a company must make during the year is not a good indicator of the costs of complying with tax regulations. If payments do not require filing of extensive documentation and can be done electronically with simple procedures, the number of payments has very little meaning. In fact, the correlation between this indicator and the number of hours spent is only 0.2 for the 183 countries covered by Doing Business. For the Latin American and Caribbean countries included in table 1.4, the sign is negative (�0.126).

20 . Brazil eliminated the tax on financial transactions in 2008.

2 The Politics of Taxation

1. The confidence requirement in parliamentary systems is another mechanism that, according to these authors, generates the legislative cohesion needed to fa-cilitate collusive behavior. See also Persson, Roland, and Tabellini ( 1997 , 2000).

2. Since the theory applies to robust democracies, the sample is restricted to such countries, defined in the analysis as those for which the variable Polity 2 in the Polity IV database (a measure of the quality of democracy) is greater than 5.

3. The results are less robust than those found by Persson and Tabellini. In par-ticular, they are not always significant when regional dummies and/or colonial origin are taken into account. These results should not be interpreted as causal. Even if the system of government is hard to change, it could be the result of his-torical experience, geographical location, or cultural traditions, which, to the extent that they shape preferences of the relevant political actors, could also be influencing tax policy outcomes (see Acemoglu 2005 ).

NOTES 259

4. See Hallerberg, Scartascini, and Stein ( 2009 ). 5. See Ardanaz and Scartascini ( 2011 ) for a more detailed discussion. 6. Note that the 95% confidence interval overlaps zero for high values of the hierar-

chical index, suggesting that within that range (Hirarchical > 6.5) the marginal effect of presidentialism on taxes cannot be distinguished from zero. Results bor-rowed from Ardanaz and Scartascini ( 2012 ).

7. See B é nabou ( 1996 , 2000 ). 8. See Kitschelt and Wilkinson ( 2007 ) and Stokes ( 2007 ). 9. The discussion on Guatemala draws on Larios, Meirovich, and Grajeda ( 2012 ).

10. His work in turn builds on work by Besley and Persson ( 2009 ). 11. This is an example of Acemoglu and Robinson’s ( 2012 ) argument that political

institutions that are not inclusive tend to generate economic institutions that are not inclusive.

12. “In all three cases—Argentina, Brazil, and Chile—malapportionment seemed to increase the representation of less developed, more rural areas that tended to send conservative representatives to the national legislature.” Samuels and Snyder ( 2004 , p. 150).

13. They settled for an electoral system including 60 districts for the lower chamber with a uniform district magnitude of two legislators per district the Law of 1989.The binominal district size by itself increases representation of the minority, since the winning coalition needs to double the number of votes of the second legislator in order to obtain both seats. The redrawing of the district map results in further overrepresentation of the conservative groups in Chile.

14. There is a long tradition of research on the impact of partisanship and ideol-ogy on macroeconomic outcomes, going back to Hibbs ( 1977 ). Recent work on the impact of ideology on taxation includes Angelopoulos, Economides, and Kammas ( 2009 ), for the Organization of Economic Cooperation and Development (OECD), and Hart ( 2010 ), for Latin America.

15. These authors, in turn, build on the initial work of Coppedge ( 1997 ), among oth-ers. Stein and Caro also use an alternative measure of ideology, based on the Parliamentary Elites of Latin America (PELA) survey. This survey asks legisla-tors to place themselves, as well as other politicians such as the president, on a left to right ideological scale ranging from 0 to 10. Stein and Caro ( 2012 ) use the average placement of the president’s (rather than the party’s) ideology as their second ideology measure.

16. In the case of the VAT, as well as that of social security taxes, the results are not statistically significant.

17. This result should be viewed cautiously because in the region all debt crises have also been accompanied by banking crises (therefore, it may not be that it does not matter, but that its impact cannot be isolated statistically).

18. According to an empirical analysis, using a database of reforms for 18 Latin American countries during the period 1990–2004. See Hallerberg and Scartascini ( 2012a ).

19. The reason to run so many different specifications is to ensure having a complete model but at the same time having the highest possible number of observations.

260 NOTES

Persson and Tabellini ( 2003 ) use a similar approach to summarize the results from their empirical analysis.

20. This section borrows extensively from Bonvecchi et al. ( 2012 ). 21. In countries in which legislators have strong policymaking capabilities in the

fiscal area, tax legislation may actually be strengthened during the process of approval. In Latin America, however, this seems to have been the exception rather than the rule.

22. LESS is a modified version of a similar scale proposed by Barrett and Eshbaugh-Soha ( 2007 ).

23. It also characterizes the original version of each bill in comparison to the extant legislation.

24. Characterizing a tax bill or amendment in terms of its potential impact on effi-ciency, revenue potential, or equity is necessarily subjective. In order to reduce coding biases, two experts in tax legislation independently coded all bills and amendments and checked each other’s codes, and a third expert supervised and adjudicated all standing disputes.

25. In addition, it introduced new taxes on presumptive minimum income and the cost of firms’ indebtedness.

3 Tax Systems for a Smooth Ride

1 . For brevity and ease of reading, the terms “Latin America” and “Latin Americans” are used inclusively to embrace the countries and people of the Caribbean as well.

2 . For evidence relating macroeconomic volatility and growth, see Hnatkovska and Loayza ( 2004 );Koren and Tenreyro ( 2007 ); Aghion and Marinescu ( 2008 ); Fat á s and Mihov ( 2008 ).

3 . The definitions of volatility are typically associated with “tending to vary often or widely,” “unstable,” and “changing suddenly” in time series (Wolf 2005 ). The standard deviation or variance is the mathematical approximation to these con-cepts. Figure 3.1 uses a popular metric of volatility computed as the standard deviation of growth rates over an 8-year moving average. The 8-year window was chosen on the basis of the average length of cycles in the region since the 1960s. Corbacho and Gonz á les-Castillo (2012) also analyze other measures of volatility with similar conclusions.

4 . While Gavin and Perotti ( 1997 ) first called attention to the issue in Latin America, Kaminsky, Reinhart, and V é gh (2004) and Talvi and V é gh (2005) subsequently claimed that such procyclicality was the rule across the developing world.

5 . Fiscal procyclicality has a parallel with fiscal volatility. Unlike the automatic fis-cal response to macroeconomic conditions, discretionary and procyclical fiscal changes can be harmful to growth by amplifying economic volatility (Aghion and Marinescu 2008 ; Woo 2009 ).

6 . For instance, Avenda ñ o, Reisen, and Santiso (2008) and IMF ( 2009a and b) document that fiscal policy has been more neutral over the cycle since 2000. See also Izquierdo and Talvi ( 2008 ); Vladkova-Hollar and Zettelmeyer ( 2008 );

NOTES 261

Villafuerte, L ó pez-Murphy, and Ossowski ( 2010 ); Daude, Melguizo, and Neut ( 2011 ); Frankel, Vegh, and Vulletin ( 2011 ).

7 . See, for instance, ECLAC ( 2009 ); IMF ( 2009a and b); World Bank ( 2010 ). 8 . Bustos and Perry ( 2012 ), using a worldwide sample, also show that countries

with access to abundant nonrenewable fiscal revenues have more volatile tax revenues.

9 . An exception is V é gh and Vulletin ( 2012 ), who analyze the cyclical behavior of tax rates and conclude that, by and large, tax policy is acyclical in industrial countries but procyclical in developing countries.

10 . For instance, Suesc ú n ( 2008 ) shows that when the amplitude of business cycles is driven by supply shocks, automatic stabilizers have a negligible impact.

11 . The seminal paper by Gal í (1994) observed that countries with large stabiliz-ers tended to have less volatile business cycles. Fat á s and Mihov ( 2001 ) provided broad support for this result. Debrun and Kapoor ( 2010 ) provided confirmation of these earlier estimates.

12 . On the advantages of limiting political discretion in the context of fiscal policy, see Fat á s and Mihov ( 2003 ).

13 . As detailed in Cottarelli and Fedelino ( 2010 ), the correct measure of tax auto-matic stabilizers is scaling by the revenue ratio, rather than the expenditure ratio.

14 . Buti et al. ( 2003 ) find that there may be a critical level of the tax burden beyond which a reduction in taxation may increase the effectiveness of automatic stabi-lizers and result in a “double dividend”: gains in efficiency and better automatic stabilizers. Given the low level of taxation in the region, this argument is not likely to apply.

15 . This allows a comparison with the estimates for the United States and the European Union by Dolls, Fuest, and Peichl ( 2010 ). Espino and Gonz á lez-Rozada (2012) also look at a shock that increases informality.

16 . If the income shock is perceived as transitory (as is the case with economic cycle fluctuations) and households can borrow, demand will not change and the impact of automatic stabilizers on consumption will be zero. If households are liquidity constrained, current demand depends on disposable income and auto-matic stabilizers play a role. The authors use the poverty line of US$4 dollars per day to identify liquidity-constrained households in each country.

17 . The authors also study scenarios that: (iii) apply a flat income tax rate of 18 per-cent; and (iv) broaden the base to include informal workers in the economy. These reforms do not show as significant gains as the ones described in this chapter.

4 Beware of Informality

1 . In practice, however, some firms do pay some taxes but not others, or do so in an incomplete way. However, this case is ignored for ease of exposition.

2 . Busso, Fazio, and Levy ( 2012 ) point out that, in addition, almost 50 percent of all private-sector workers are not counted in the census. The vast majority of these workers works in informal firms or is self-employed.

262 NOTES

3 . In the pension component, the link between contributions and benefits has strengthened in the five countries that have adopted individually funded systems (Bolivia, Chile, the Dominican Republic, El Salvador, and Mexico) and to a lesser extent in the six that have opted for mixed or parallel systems (Argentina—which returned to the pay-as-you-go state system in 2007— Colombia, Costa Rica, Ecuador, Peru, and Uruguay). Consequently, the higher contributions have not necessarily led to increases of equal size in the burden perceived by the workers.

4 . IDB (2004, Chapter 7) has a wider discussion of the effects of minimum wages on labor outcomes.

5 . It is important to note that labor costs include other costs besides wages and various payroll taxes. Latin American labor regimes tend to offer workers pro-tection in relation to various aspects of their employer relationship, apart from pay, including severance pay, overtime, and paid vacation. For an international comparison of these provisions, see Botero et al. ( 2004 ). IDB ( 2003 , Chapter 7) discusses the labor implications of these regulations.

6 . The authors also find that higher nonwage labor costs are associated with increased transitions from formal to informal employment and with decreased transitions from informal to formal employment.

7 . Similarly, a study for Turkey (Betcherman, Daysal, and Pag é s 2010) concluded that a reduction in social security contributions (which affected some provinces but not others) increased the number of registered establishments and the num-ber of employed workers registered. An oft-cited study on the effects of pay-roll taxes is Heckman and Pag é s (2004), which finds that a 10 percentage point increase in contributions reduces total employment by 4.5 percent in a panel of Latin American countries. However, a reduction of total (or even formal employ-ment) does not imply an increase in informality.

8 . As found by the work of Heckman and Pag é s (2004). Lora and Fajardo ( 2012a ) offer a worldwide review of the studies on this topic.

9 . The fact that participation increases implies that the higher contributions must have been used to improve services and expand coverage, and that the higher contributions may have been accompanied by other administrative and design efforts in that direction.

10 . The recent wave of academic papers on the issue includes Piggott and Whalley ( 2001 ); Emran and Stiglitz ( 2005 ); Ahmad and Best ( 2012 ); and Ant ó n, Hern á ndez, and Levy (2012); and Bird and Smart (2012). For a survey, see Lora and Fajardo ( 2012a ).

11 . Bird and Smart (2012) develop a general equilibrium model that incorporates this assumption. Levy ( 2008 ) and Pag é s ( 2010 ) present evidence of the strong relationship between firm size and productivity in Mexico and other Latin American countries.

12 . Ahmad and Best ( 2012 ) construct a theoretical general equilibrium model that considers both the decision of the workers to move between formality and infor-mality and the decision by firms to underreport their sales and profits in order to evade VAT and corporate income taxes.

NOTES 263

13 . Keen ( 2008 ) uses a general equilibrium model with informality and intermediate goods to highlight the importance of a feature of VAT that is stressed by prac-titioners but overlooked by models with no intermediate goods: that VAT func-tions, in part, as a tax on the purchases of informal operators from formal sector business. However, the model shows that an increase in the VAT rate reduces aggregate output and raises the share of the informal economy. But the impli-cation is not that tariffs are preferable to VAT (as stated in Emran and Stiglitz [ 2005 ]), because it is more efficient to use a combination of VAT and withholding taxes that differentially tax the inputs of firms that are not tax-compliant.

14 . See Ant ó n, Hern á ndez, and Levy (2012) for a general equilibrium model that incorporates this trade-off. As they demonstrate, the relative sizes of the sectors are affected by the degree of compliance with VAT in each sector, as well as by the degree of differentiation of VAT rates.

15 . Lora and Fajardo ( 2012a ) also find that VAT affects workers of different skill lev-els in uneven ways. Overall, VAT does not have much effect on unskilled work-ers, but it does on skilled workers.

16 . Assessing the effect of the 1986 tax reform in the United States on labor demand by sole proprietors, Carroll et al. ( 2000 ) find that a reduction of 10 percent in the personal income tax rate (of the proprietors) increases the probability that a firm (or the proprietor) would hire someone by 12.1 percent and reduces the rate of growth of the wage bill. Focusing on the European Union (EU), Bettendorf, van der Horst, and De Mooji ( 2009 ) analyze the impact of corporate taxation on employment and unemployment, taking into consideration specific features of the labor markets of the 17 EU countries. They find that raising corporate income tax revenue by 0.5 percent leads to a 0.2 percentage point increase in unemployment and a 0.2 percent reduction in labor supply (on average for the 17 countries).

17 . The informal sector is defined in the study “as the set of economic units that do not comply with government-imposed taxes and regulations.”

18 . A sequel to Loayza’s work is Vuletin ( 2008 ), which includes corporate income taxes as part of the tax burden variable that is causally related to informality. Vuletin finds that the tax burden (measured as the average between the max-imum personal and corporate income tax rates) explains around 35 percent of the overall size of the informal economy on average among the 32 countries con-sidered (29 of them Latin American or Caribbean countries).

5 Local Taxes for Local Development

1 . Latin America and the Caribbean is the most urbanized developing region in the world—in 2010 almost 80 percent of its population lived in cities—and urban growth is expected to continue (United Nations 2008 ). Urbanization imposes heavy demands on local governments for provision of public services and infrastructure. For example, between 80 and 120 million people in the region lack adequate water provision and between 100 and 150 million have no access to proper sanitation (Satterthwaite and McGranahan 2007 ).

264 NOTES

2 . This figure is an average of Argentina, Brazil, Bolivia, Chile, Colombia, Ecuador, Mexico, Peru, and Venezuela. In the large Latin American economies, subnational governments administer approximately half of national public investment.

3 . The only exception to this trend is Brazil, where subnational revenue accounts for almost 30 percent of the national total.

4 . This estimate should be treated with caution because updating the property reg-istry may also affect the effective rate.

5 . Bonet and Rueda ( 2012 ) found a similar relationship in the case of the tax rev-enue of the Mexican states: receipts are lower when the governor and the presi-dent are from the same party.

6 . For more information, see von Haldenwang et al. ( 2009 ). 7 . The average rate of informality in Latin America and the Caribbean was approx-

imately 35 percent of GDP from 1999 to 2007, with a low of 20 percent of GDP in Chile and a high of 66 percent of GDP in Bolivia (Schneider et al. 2010 ).

8 . In 2011, collections from an improvement tax generated financing for almost $1 billion in public works for Bogot á . Eight other intermediate cities achieved sub-stantial amounts of financing (Borrero Ochoa 2011 ).

6 Making the Most of Tax Administration

1 . See IDB, CIAT, and CAPTAC-DR/IMF ( 2012 ). 2 . In cases where the tax administration also collects customs duties and social

security contributions, these areas have been taken out of the analysis to the extent possible.

3 . Cost indicators or ratios require a case-by-case analysis. A high level of efficiency could be due to the good performance of the tax administration, but also due to changes in the tax code or inappropriate cuts in investment or expenses. The meaning of the efficiency indicator is of course different in these cases.

4 . The percentage is so much higher in OECD countries particularly because of the personal income tax regime, which requires taxpayers to register in many OECD countries.

5 . The success of specialized large taxpayer units, focused on a small but strategic number of clients and allowing backward and forward desk audits, suggests that the model could be replicated for other types of taxpayers.

7 Personal Income Tax: An Empty Shell

1 . Because of its size and capacity to influence economic activity, income tax can be analyzed from three different perspectives: by taxpayer, whether as a legal entity (corporation) or as an individual; by remuneration to the factors of production: whether income for labor, capital (in the form of dividends and capital gains, interest and royalties, and the like), or mixed (labor and capital combined); and by the taxpayer’s location: whether resident or nonresident.

NOTES 265

2 . For the rest of this chapter, the term “developed countries” refers to members of the Organisation for Economic Co-operation and Development (OECD), except for Chile and Mexico. The tax burden figures are taken from the IDB and CIAT database ( 2012 ), which includes revenue from exploitation of natural resources freely available to the government (such as oil and mining products) and com-pulsory social security contributions (mainly to public and private pensions and health). This method is used because otherwise the (adjusted) tax burden would be undervalued in Latin American countries with respect to the OECD.

3 . In most jurisdictions in Latin America, taxation of individual and non incor-porated firms is computed as part of corporate income taxation, whereas in the OECD countries, it is considered part of personal income taxation.

4 . One of the fundamental causes of such a high figure in Guatemala is that VAT paid was treated as a credit to personal income tax, until the reform of 2012.

5 . Argentina, Brazil, Chile, Colombia, the Dominican Republic, Ecuador, Guatemala, Mexico, Peru, and Uruguay.

6 . The data on the informal economy are taken from Buehn and Schneider ( 2007 ). They should be used with caution because the multiple indicators and multiple causes methodology (MIMIC) used has been debated.

7 . The Kakwani Index measures the progressivity of a tax and is defined as the difference between the quasi-Gini of the tax payments and the Gini of incomes: that is, comparing distribution in payment of the tax with income distribution. The higher the value of this index, the greater the progressivity. The Reynolds-Smolensky Index measures the difference between income distribution before and after payment of the tax; it quantifies to what extent inequality has been reduced due to payment of the tax. The higher the value of this index, the greater the redistributive capacity.

8 . This is done to avoid increases in effective tax rates on middle-income groups. 9 . For a more comprehensive description of the Nordic dual tax, see Cnossen ( 1997 )

and Picos S á nchez ( 2003 ). 10 . This is the case for two reasons. First, if the base is not adjusted for inflation,

the effective rates are higher for capital income because they apply to both the real returns and the portion that is due solely to inflation. Second, from a life-cycle perspective, taxing capital income punishes the savings that originated in income from prior periods and which is already taxed. Moreover, human capital is a special form of accumulation since it is financed, at least partially, by all of society. This is justification for taxing the income generated at maximum mar-ginal rates equal to or higher than the corporate income tax rate.

11 . In most countries of the region, as well as in many emerging countries, capital income, especially dividends, is not liable to tax.

12 . To prevent arbitrage between interest (taxed at 12 percent) deducted to deter-mine corporate income (taxed at 25 percent), the deduction must be adjusted to the proportion between the rate at which capital is taxed and the rate applied to corporate income (12/25).

13 . Nevertheless, due to deficient provision of public goods, the required return on an investment project in Latin America is higher than in developed countries.

266 NOTES

Consequently, the same tax rate penalizes investment in Latin America more heavily. However, nominal rates of 27.5 percent on average were slightly higher than in developed countries (25.2 percent) in 2010. In contrast, taxation on cap-ital income is lower in Latin America, particularly for residents.

14 . In this respect, capital income is taxed on the gross at lower rates than corporate and labor income since both are taxed on net income (that is, deductions are permitted).

15 . This mechanism also allows some degree of anonymity with this type of return, which may facilitate acceptance of the system by high-income taxpayers.

8 Corporate Income Tax: The Art of Competing for Investment and Increasing Revenue

1 . Corporate income tax goes by different names in Latin America and the Caribbean and the OECD countries: company tax, tax on income of legal entities, corporate income tax, or tax on business activity. Also the taxation of sole proprietorships in Latin America is considered part of corporate income tax, while in OECD countries it is considered part of personal income tax. Nonincorporated firms receive similar treatment.

2 . The countries are: Albania, Algeria, Armenia, Belarus, Bhutan, Botswana, Bulgaria, Cameroon, Cape Verde, Egypt, Fiji, Georgia, India, Indonesia, Iran, Jordan, Kazakhstan, Lesotho, Lithuania, Malaysia, Mauritius, Moldova, Morocco, Namibia, Nigeria, Pakistan, the Philippines, Poland, Romania, Russia, Seychelles, South Africa, Sri Lanka, Syria, Swaziland, Thailand, Tunisia, Turkey, and Ukraine.

3 . However, Clausing ( 2007 ), in his study of the evolution of CIT for OECD mem-bers, recognizes that revenue grew faster in smaller economies that have lower rates of CIT (except Japan) and are more open. Given these characteristics, Clausing finds that multinational corporations continue to use avoidance mech-anisms, such as transfer pricing (manipulation of prices of international opera-tions between related companies so as to declare more income in countries with more advantageous CIT) or weak capitalization (reduction of the income base by paying interest on debts to related companies operating in countries where these payments are taxed at lower rates).

4 . OECD ( 2007 ) gives three economic reasons why there has not been a “race to the bottom” in the types of CIT: (a) despite the nominal rate of tax on their earn-ings, companies usually decide where to produce in a country for other reasons, such as size of domestic market, availability of inputs, and quality of labor force; (b) the need for fiscal resources; and (c) the efforts of governments to apply stricter international taxation rules to prevent avoidance of income by strata-gems involving offshore operations.

5 . They analyze CIT in a sample of 4,561 large companies (listed on stock exchanges) from 19 European Union countries, including the eurozone, from 1995 to 2005.

6 . They study 50 developing countries, including 11 from Latin America, from 1996 to 2007, calculating average effective rates.

NOTES 267

7 . The authors add that implementation of these privileged treatments can be even more damaging in terms of tax expenditure due to lack of control in developing economies.

8 . Accelerated depreciation permits deduction of tax depreciation of assets from CIT in a shorter period than usual.

9 . This section is based on Artana and Templado ( 2012 ). 10 . Authors’ calculations based on ibid. The analysis used a method known as differ-

ence in differences. 11 . However, the estimates of evasion should be viewed with caution; they are subject

to serious methodological problems since they are very sensitive to changes in the parameters assumed for calculation.

12 . Since the early 1990s, tariff revenues have fallen 46 percent, the nominal pro-tection rate has fallen 79 percent, nontariff restrictions have been eliminated in most countries, and foreign direct investment has increased 209 percent (World Bank 2012; IDB 2012; IDB and CIAT 2012 ).

13 . “Extraterritoriality” in the case of individuals is more complex, making it more difficult to fit the various countries along a single line. This is why the analy-sis focuses on corporate income. In any event, the discretionary nature of the classification should be emphasized. The tax result (how much “extraterritorial” income is finally taxed by the tax sovereign) may vary over time, depending on the legal definitions and interpretations of each scheme; the application of the antiabuse rules for passive income; and, on a broader level, the structure of the foreign investment made by the country, its type of international participation, and the economic cycle, among other factors.

14 . This work is part of a more exhaustive analysis of this issue, which is in prepara-tion. The main source of information was IBFD ( 2011 ). Figure 8.4 has a relatively greater bias for the two extreme cases (territorial income and pure worldwide income) because of a more than proportional presence of Latin American coun-tries and the inclusion of New Zealand, known as the extreme case of income “globalization.”

15 . The Dominican Republic gets to this point by “expanding” territorial income (todividends and interest from abroad). Others reach the same point from a definition of world income, but waive or exempt certain categories of world income.

16 . Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. 17 . Obviously this (neutrality in the export of capital) is why it is less attractive for

promoting the internationalization of local firms. 18 . This category has been applied in Uruguay since 2011. 19 . In this chapter, the term “commodities” is synonymous with raw materials. 20 . The first three OECD methods were mainly oriented toward goods. Later, with

the rise of services and intangible operations, the system was reinforced with two more methods, bringing the total to five. In addition, control of transfer pricing because of its higher value added was oriented toward services and intangibles. See OECD Transfer Pricing Guidelines ( 2010b ) applicable to transfer pricing for multinational companies and tax administrations (Chapter II).

268 NOTES

21 . For example, operations were arranged from 180 days to more than 500 days before the shipment date, well below the prices in effect at that date. Economically, this led to an absurd situation: in all cases, the agreed prices were the lowest in the market. This means that these taxpayers, who should have opposing inter-ests, were prepared to agree well in advance to a definitive price, which always turned out to be lower than the market.

22 . In Argentina, the method was established by Law 25.784 of October 22, 2003. Uruguay passed an equivalent law (Law 18.083) on January 18, 2007. Ecuador added the Sixth Method in 2008 in Article 85 of the Implementing Regulations of the Internal Taxation Organic Law. Honduras adopted a similar measure in December 2011; Article 10 of Decree 232–2011 regulates the Transfer Pricing Law. Guatemala established equivalent legislation in February 2012 (Article 60 of the Tax Modernization Law). Paraguay is also implementing a similar method, although on a more restricted legal basis. Finally, Article 38 of Chile’s Income Tax Law (originally 1997, amended 2002) has a mention that could be used in a similar sense, although there is no evidence that it is being used. Brazil has also changed its transfer pricing rules to accommodate valuation based on inter-national stock market prices (while maintaining its distinctive transfer pricing policy).

23 . Although the OECD has never ruled on it officially, unofficially it is not con-sidered a “method” because of the technicality that there is no real compar-ison (between a transaction between related companies and others between independents).

24 . This section is based on Gonz á lez-Carcedo ( 2010 ) and Montero ( 2012 ). The Directorate General of Internal Taxes (DGII) of the Dominican Republic pro-vided valuable support for the analysis in this section.

25 . The DGII’s analysis is available at http://www.dgii.gov.do/publicaciones/estu-dios/Documents/AnalisisSectoriServiciosalojamientotodoincluido.pdf . These practices are contrary to OECD regulations in developed countries. See OECD Guidelines ( 2010b , p. 68).

26 . See OECD Guidelines ( 2010b , pp. 79–85). However, resale margins are obtained from actual transactions between independents through a verification process, and these data are compared and validated with other companies (tour opera-tors) orally. Similarly, the final price is obtained from offers (market research, as mentioned) and from closed or concerted operations. This is what technically determines the novelty of the analysis by the DGII. However, the characteristics of the sector ensure that these are the prices since there is not usually any bar-gaining in the travel agency, let alone the Internet. This is not the only possible option: Gonz á lez-Carcedo ( 2010 ) proposed the net transactional or operational margin method. See ibid., pp. 93–109.

27 . In technical language, the system is known as Advance Pricing Agreement (APA) or Prior Valuation Agreement. The tax administration agrees to the transfer pric-ing for a given period with the taxpayer prior to the actual operations between the related companies. See ibid., pp. 198–211. The set of simple rules whose mon-itoring determines automatic acceptance of transfer pricing by the national tax

http://www.dgii.gov.do/publicaciones/estu-dios/Documents/AnalisisSectoriServiciosalojamientotodoincluido.pdf

http://www.dgii.gov.do/publicaciones/estu-dios/Documents/AnalisisSectoriServiciosalojamientotodoincluido.pdf

NOTES 269

administration is known in technical jargon as “safe harbor.” It can involve, for example, permitting taxpayers to determine their (transfer) prices by applying a simplified method. See ibid., pp. 187–96.

9 Value Added Tax: Let It Be

1 . There are three problems with the design of VAT. The first is economic in nature: whether health and education expenditures can be considered, and in what pro-portion, as consumption and investment (human capital). The second problem is technical in nature: VAT is a simple tax when the value chain is unidirectional, as in the case of from agriculture to industry to commerce to final consumption. It is more complicated when it is multidirectional (as in the case of the banks that provide services to savers and borrowers at the same time) or when the flow is reversed (as in the sale of used or second-hand goods). The difficulty is in deter-mining the value for each of the agents involved. A third problem is the adminis-trative complexity of taxing home rentals. This would add a significant number of new taxpayers, the vast majority of whom would be individuals.

2 . A single-phase tax is a tax on sales volume applied at a single point of the produc-tion and distribution process. Unlike other consumption taxes (such as retail sales or selective consumption), VAT is multiphase since the amount is determined at each step of the transaction chain up to final sale of the goods or service.

3 . Since exporters are refunded the VAT paid by their input suppliers. 4 . Covering all goods and services favors neutrality but does not necessarily

improve economic efficiency. The neutrality and efficiency of a tax are two dif-ferent concepts. Neutrality means equal treatment for all goods and services across sectors, while efficiency means reducing the economic cost of a tax: that is, the loss of well-being in the economy due to application of the tax. It is almost impossible to achieve economic efficiency in the design of a generalized indirect tax because the rate at which each good is taxed would have to be differentiated to minimize its impact on the well-being of society. Hence, determination of the economic impact of the tax must be based on its own supply and demand elastici-ties (Ramsey 1927 ), the cross-elasticities of complementary and substitution with other goods, and other subsequent general equilibrium effects.

5 . ECLAC ( 2012 ). While the average level of informality in OECD countries is 17.1 percent (Schneider, Buehn, and Montenegro 2011), for Latin America and the Caribbean the CEPALSTAT definition for the informal sector of labor market has been used: urban workers in low productivity sectors.

6 . World Bank (2012). 7 . The fiscal revenue reported by the IDB (Inter-American Development Bank)

and CIAT (Inter-American Center of Tax Administrations) databases (2012) includes, in addition to national and subnational tax revenues: (i) compulsory public and private contributions to social security (mainly, health and pensions); and (ii) income from renewable and nonrenewable natural resources, including net contributions by public companies to the government, royalties, special taxes on natural resource exploitation, and dividends from state enterprises.

270 NOTES

8 . Collection has improved because of both the strengthening of the tax adminis-trations and design of the collection function around large taxpayers through the use of withholding and collection schemes.

9 . The concept of C-efficiency is deeply rooted in VAT terminology and literature, and should not be confused with use of the concept of efficiency prevailing in general economic literature.

10 . In the cases of Argentina, Bolivia, Chile, Colombia, Ecuador, Panama, Paraguay, Peru, and Uruguay, the index has grown steadily in recent years. Significantly, the rate fell sharply in most countries in 2009, only to recover fully or partially in 2010.

11 . This is partially offset, however, because the supply of public goods and services is generally exempt from VAT.

12 . A tax expenditure occurs each time a tax treatment deviates from the previ-ously defined benchmark tax. Craig and Allan ( 2001 ) identify three approaches to defining benchmark taxes: conceptual, legal, and analogous subsidy. The first approach uses a comparison with a theoretical “normative tax structure” (such as a pure VAT that taxes all final consumption, with no exceptions). The legal approach takes current tax legislation as the basis for defining the benchmark tax and thereby identifying tax expenditures. Finally, the analogous subsidy approach identifies as tax expenditures only the tax concessions that are clearly analogous to a direct subsidy, with practical consequences very similar to the legal approach. In Latin America, the legal approach prevails (only Chile and Mexico use the concep-tual approach), a practice recommended by CIAT mainly for practical reasons.

13 . Currently ten Latin American countries conduct regular systematic estimates of tax expenditures: Argentina, Brazil, Chile, Colombia, Ecuador, Guatemala, Mexico, Peru, Dominican Republic, and Uruguay. All the others make sporadic estimates.

14 . The literature describes three “methods” to estimate the cost: foregone revenue (the most direct and immediate); earned revenue (which takes into account induced changes in taxpayer behavior); and equivalent direct expenditure (the relationship between tax expenditures and disposable income and spending by taxpayers). In practice, all countries use the foregone revenue method. Argentina, Chile, and Uruguay also apply the assumption of constant total expenditure asso-ciated with the equivalent direct spending methodology. For details, see Villela, Lemgruber, and Jorrat ( 2009 ).

15 . The legal basis of these tax expenditures and their detailed description can be consulted on CIATData at http://www.ciat.org/index.php/en/products-and- services/ciatdata.html .

16 . More technically, this is calculated by multiplying the C-efficiency ratio by the ratio of tax expenditures ( GT ) to revenue ( R ), where C is consumption and TG is the general rate (the tax rate for most goods and services):

G inefficiency C efficiency GT

RR

C TG GT

R GT

C TG− = − = =�

��

�

..

17 . The term makes an analogy with the concept of “X-inefficiency” used to describe explanatory components not explicitly defined that account for the loss of internal efficiency in a firm.

http://www.ciat.org/index.php/en/products-and-services/ciatdata.html

http://www.ciat.org/index.php/en/products-and-services/ciatdata.html

NOTES 271

18 . Other factors include calculation of net receipts from refunds; possible deficien-cies in the measurement of consumption (especially in countries with a higher level of informality and an underground economy); and the specific method-ology for calculating tax expenditures. For example, in the cases of Argentina, Colombia, Mexico, and Uruguay, the calculation of tax expenditures could be skewed, given the difficulty of measuring the impact of exemptions and lower rates. In addition, both the theoretical basis of VAT and the calculation of its tax expenditures may be influenced by their connection with selective taxes. For example, in most oil-producing countries, Central America, and the Dominican Republic, fuel is taxed only with selective taxes, reducing the productivity of VAT and increasing tax expenditures. In contrast, Argentina, Chile, and Uruguay levy VAT on diesel. In short, these results should be used only in terms of ascertaining the relative importance of the different factors that explain the loss of revenue; concern about one of them should not justify neglect of others.

19 . Given its widespread use, this option could be called the universal solution to the problem of VAT regressivity. There are detailed analyses of VAT that show the distribution of the burden by decile and the value of the Kakwani and Reynolds-Smolensky indicators discussed in chapter 7.

20 . Although several studies of fiscal equity have tried to correct the undervaluation of capital income, on which table 9.3 is based, it is very unlikely to have been fully computed. The regressivity should be even greater because this income is received almost entirely by the richest decile in each country.

21 . Moreover, declared income is often an understatement of current income, espe-cially in families where informal activities and production for self-consumption predominate.

22 . This redistributive mechanism would work only in cases of very specific and tar-geted consumption at the lowest income levels. However, this is not usually the case. Notably, several basic goods—food, health, education, and clothing—do not follow this pattern. Moreover, discrimination within a category (for example, food for the poor compared with food for the rich) does not work in practice, resulting only in complicating the tax administration and opening avenues for fraud.

23 . The redistributive impact of social public spending in Central America, the Dominican Republic, and Panama is approximately 4.4 times greater than that of the tax system (Barreix, B è s, and Roca 2009 ).

24 . This section is based on Barreix, B è s, and Roca ( 2010b , 2012 ). 25 . According to Ainsworth ( 2006c ), and Beyer and Ishimura ( 1993 ), the goods and

services proposed for elimination from the Japanese consumption tax base are grouped into 13 categories and two types: universal and targeted. The distinctive feature of this system are the 5 categories of targeted goods and services, which Ainsworth terms “surgical” since they affect specific groups of beneficiaries pre-viously identified in the legislative process.

26 . The Canadian VAT has a uniform rate and includes exemptions for goods and services with significant incidence on the consumption basket of the lower income sectors.

27 . The only exemptions that would remain would be those that make sense from the point of view of the administration of the tax (financial intermediation and

272 NOTES

home rents) and/or that in some cases are necessary to maintain consistency according to the concept of tax treatment of similar items (for instance, educa-tion and health expenditures could be considered investment expenditures—in human capital—and treated as such).

28 . There would be other possible criteria for the use of increased revenue, as dis-cussed later.

29 . Its use is also ruled out for purposes of discouraging consumption of a good or service that has negative externalities. In such cases, the appropriate instrument would be a selective consumption tax, which must be applied without discrimi-nation by socioeconomic stratum.

30 . There are successful examples of targeting in Brazil, Chile, Colombia, Mexico, and Uruguay.

31 . The region has acquired valuable experience from the conditional cash transfer programs, which have used this system for several years. Even before these pro-grams, the Argentine tax authorities (AFIP) had implemented VAT refund pro-grams using electronic media. This mechanism was later extended to social programs such as income transfers. The Dominican Republic successfully imple-mented a similar process for granting the subsidy on liquefied petroleum gas in 2008. In this case, the subsidy is limited to consumption of this good, which is included as one more item on the magnetic card through which the transfers are credited to each beneficiary of the Solidarity Program (conditional transfers).

32 . Specifically, education, health, passenger transport, financial intermediation, and property sales and rentals are exempted.

33 . For health services, the current minimum rate of 10 percent is maintained. The following items are excluded from the tax base: education, gasoline (which is already taxed at a higher selective tax), financial intermediation, and property sales and rentals.

34 . This approach is proposed in B è s ( 2008 ). Another alternative is to apply only part of the revenue to compensate the poorest deciles and allocate the surplus to other measures, as discussed in Barreix, B è s, and Roca (2010).

35 . These limits are derived not from theoretical considerations but from subjective criteria based on experience. The study of the proposed P-VAT for eight countries (Barreix, B è s, and Roca 2010b )finds that the poverty level should not exceed 25 per-cent of the population, considering the average capacity of the public administrations of the region to manage transfers efficiently. There are three elements to consider: The first is the level (incidence) of poverty and extreme poverty. The second is the intensity of poverty, which is also crucial when considering the composition of the consumption basket (what is the weight in the basket of those who actually benefit). The third is the initial level of the tax rate and degree of generalization.

36 . Nicaragua has reduced poverty by about 15 percent and extreme poverty by over 30 percent in the last decade. Despite this significant progress, implementation of the proposed Personalized-VAT is not considered to be feasible with exist-ing poverty levels. In cases like this, considering the conditions of the country, the recommendation would be to generalize VAT by stages, and where possible, accompany it with compensatory transfers to the lower income deciles.

NOTES 273

37 . Proxy means testing mechanisms are used based on a statistical analysis, which compares the information on the target population with other sources, such as data from household surveys, field visits, and cross-checking of eligibility requirements with the conditionality of the transfers.

38 . However, countries where the tourism sector has significant weight, especially those in the Caribbean, could lose competitiveness, depending on the VAT treat-ment of tourism in alternative destinations.

10 Taxing Commodities with the Future in Mind

1 . Manzano and Monaldi ( 2008 ) and Monaldi ( 2012 ) discuss these issues, and introducing political economy concerns, argue that investment and expropria-tion cycles may be generated.

2 . See van der Ploeg and Venables ( 2011 ) for a recent treatment of the investment, savings, consumption decision of natural resource producers, with special refer-ence to developing countries.

3 . See van der Ploeg and Venables ( 2011 ) for a discussion. 4 . Reasons include: the great uncertainty about the value of the nonrenewable

resources; the possibility that future governments representing generations not yet born may change the rules; and the sizable amounts of money involved, which could limit the number of firms competing in the bidding process in less-developed financial systems.

5 . See Daniel, Keen, and McPherson ( 2010 ) and Sinnott, Nash, and de la Torre ( 2010 ). 6 . Carranza et al. ( 2012 ) discuss tax rates and investment for copper in Chile,

Mexico, and Peru. 7 . The range of the effect is related to alternative specifications for the tax rate in the

econometric work. 8 . In a somewhat similar vein, Balza and Espinasa ( 2012 ) find that countries with

certain institutional frameworks in their oil sectors obtained more investment in their oil sectors in the past decade as oil prices rose. They found three key insti-tutional factors that increased investment in the oil sector: a regulatory agency that administered the development of the oil-bearing lands—even if there is a national oil company; some level of independence of the state oil company from direct government intervention; and the presence of a professional and indepen-dent regulatory agency that has a transparent set of rules.

9 . See Tordo ( 2007 ) for further elaboration. 10 . See Carranza et al. ( 2012 ) and Monaldi ( 2012 ). 11 . See, in particular, Monaldi ( 2012 ). 12 . There is also a special mining income tax. For larger mines, which produce

the equivalent of more than 50,000 tons of fine copper a year, it could be quite significant.

13 . In principle, if the Internal Rate of Return (IRR) after taxes is higher than the cost of capital, the project should be undertaken. However, prices are volatile, and the IRR could be affected by them. Also, if the IRR after taxes in other coun-tries is higher, investors will prefer to invest there first.

274 NOTES

14 . For recent evidence, see Perry and Bustos ( 2012 ) and Ossowski and Gonz á les ( 2012 ), for instance.

15 . The comparator group includes Argentina, Brazil, Costa Rica, El Salvador, Honduras, Paraguay, and Uruguay.

11 Protecting Goods by Taxing “Bads”

1 . A third category that has recently been advanced is the behavior/information type of policy. See, for example, Shogren and Taylor ( 2008 ), for a review of behavior economics in the context of environmental policy; Thaler and Sunstein ( 2008 ), for the roles behavior changes through nudges; and Weber, Apri, and Carrigan ( 2011 ), on the role of information in affecting policies.

2. This is achieved by equating the marginal benefits and the marginal costs of abatement, which is equivalent to setting the tax equal to the marginal damage.

3 . Some authors argue that as economies grow, consumers shift demand from dirty goods to cleaner goods; thus an Environmental Kuznets Curve comes into play. However, the most likely reason for the change in consumption patterns is more regulation, which changes relative prices. Thus it is not the case that consum-ers independently demand cleaner goods; rather, they demand more regulation, which reduces the relative price of the cleaner goods. This generates the inverted “U” shape relation between environmental quality and income per capita.

4 . The double dividend hypothesis basically states that a green tax reform may be achieved at a near zero social cost for the economy if accompanied by the reduc-tion of other distortionary taxation. Goulder ( 1994 ) summarizes the basic con-cept, which is that eliminating or reducing the inefficient tax increases economic activity. Thus, the effect of an environmental tax on economic welfare may be positive, yielding a double dividend. The first dividend is improved environ-mental quality. The second dividend is higher economic activity.

5 . In theory, this can be corrected by compensating the loser of the policy. However, since transaction costs tend to be high, this tends not to occur.

6 . Bovemberg and De Mooij ( 1994 ) and Bovemberg and Goulder ( 1996 ) show that the optimal tax rate in the United States should be lower than the mar-ginal environmental damage or Pigouvian tax, taking these considerations into account.

7 . However, except for a few cases, such as Belgium, Denmark, Estonia, Hungary, and the Netherlands, almost all government revenue derives from taxing energy products or from motor vehicle fees.

8 . Taking away these three cases increases the correlation to 0.86. 9 . Carbon dioxide (CO 2 ) emissions per capita and particulate matter (PM-10) emis-

sions, water pollution, the increase in fossil fuel consumption, and electricity production from fossil resources have a negative correlation with the initial level of ERTs. Simultaneously, the use of renewable energy as a percentage of total energy, particularly for electricity production, and the percentage coverage area of forests, increased more in countries with high ERTs.

NOTES 275

10 . The study looks at 18 different fuels including gasoline, diesel, and jet fuel for transport; LPG, natural gas, kerosene, and electricity for households and indus-trial use; plus fuel oil for industrial use.

11 . The analysis does not distinguish the method by which electricity is generated; the generation source is assumed to be fixed.

12 . For example, Nordhaus ( 2009 ) has proposed a low initial tax that slowly increases over time, while Weitzman ( 2009 ) has proposed a very high initial tax with a flat-ter curve. Williams III ( 2010 ) finds that the optimal tax schedule is probably flat, rather than increasing.

13 . The countries are Argentina, Brazil, Chile, El Salvador, Jamaica, and Peru. The social accounting matrix for each country was constructed from the best avail-able local data, taking into consideration differences in the economies of each country.

14 . The only negatively affected countries are Argentina and Brazil. 15 . In addition, as Fern á ndez and Miller ( 2011 ) show, it might be optimal for coun-

tries to preannounce carbon taxes early on to reduce the policy uncertainty and therefore avoid investing in dirty technologies in certain sectors.

12 Heterodox Taxes: The Good, the Bad, and the Ugly

1 . See Coelho, Ebrill, and Summers ( 2001 ), Honohan and Yoder ( 2010 ), Matheson ( 2011 ), and Shome ( 2011 ).

2 . In the middle of the last decade, bank transaction taxes were also in effect in Australia, India, Pakistan, Papua New Guinea, and Sri Lanka (Coelho 2009 ). Of these, they are currently in effect only in Pakistan.

3 . As a result of the 2009 ‒ 11 international financial crisis, some developed coun-tries, especially in the European Union—including Austria, France, Germany, and Portugal—introduced taxes on the balances of banking entities in order to create stabilization funds and/or to finance public-sector interventions to address the crisis.

4 . Within this category is the so-called Tobin tax, which aims to mitigate the vol-atility of international exchange markets through a tax imposed collectively by several countries (Tobin 1978 ).

5 . Argentina was the first country in Latin America to implement this type of tax in 1976.

6 . To combat evasion, Brazil, Peru, and Venezuela also tax the movement of funds through organized payment systems that are not carried out through finan-cial entities. Payrolls are exempt and so are interbank payments and payments between financial system institutions and the central bank, in general.

7 . Peru imposes a minimum rate given that its ultimate purpose is to detect income tax evaders. Brazil’s use of the tax through its SIMPLES system (a sim-plified national tax for microenterprises and small businesses) helped increase income tax collection and avoid “fiscal dwarfism” (when taxpayers intentionally reduce the scale of their operations in order to avoid being taxed under general

276 NOTES

tax rates). By cross-checking data, officials were able to identify taxpayers under SIMPLES whose financial transactions amounted to significant sums.

8 . The resulting permanent loss of financial intermediation in Argentina, Brazil, Colombia, Ecuador, Peru, and Venezuela was equivalent to 0.5 percent of GDP, on average, from the introduction of the tax (Kirilenko and Perry 2004 ).

9 . M2 includes the total amount of bills and coins in circulation, accounts depos-ited in the central bank, savings accounts, checking accounts, and certificates of deposit of less than US$100,000.

10 . When there are a large number of small producers, there are administrative advantages to imposing taxes on producer incomes because of the low moni-toring costs. See Sturzenegger ( 2006 ).

11 . This reduction in the price benefits the entire population, regardless of income level or the capacity to pay the full price for the product. In this case, the same considerations apply as those with regard to the VAT, as discussed in chapter 9.

12 . The objective to maximize collection of the tax on agricultural exports can have three additional negative effects. First, it discourages investment, especially the incorporation of technologies. Second, to the extent that the profitability of alter-native crops is not taken into account, the tax stimulates monoculture, causing ecological damage to the soil due to the lack of crop rotation. Third, it discour-ages production in the relatively less productive areas generally associated with the least development. To mitigate these effects, compensation can be incorpo-rated into the design of the tax. However, this would neutralize the argument as to the simplicity in the implementation and control of the tax.

13 . Presumptive taxes estimate a tax based on certain objective and verifiable param-eters, as opposed to the minimum tax, which quantifies a tax base that is certain or real (the value of assets or income). Tax regimes for SMEs do not compare their results with the income tax per se, but rather substitute for it, as they have different objectives, such as simplification or bringing large numbers of potential taxpayers into the formal system (see discussion later).

14 . There is a wide range of possibilities, from fixed-sum taxes (no longer used) to various tax base rates on fixed assets or income. A more restrictive definition of the income or worth of businesses (both gross and net) can also be used, applied both to businesses and individuals (Krelove and Stotsky 1995 ).

15 . The case of the alternative minimum tax on corporations (AMT) in the United States, established in 1986, is a more representative example of implementation of this tax for the purpose of remedying shortcomings of the income tax. Its particular methodology uses a 20 percent rate, and taxpayers pay whichever is the larger amount: the AMT calculation or the general income tax. Additional payments that are a product of the AMT payment can be credited toward future income tax obligations. Although not without shortcomings, the tax succeeds in emphasizing progressivity and protecting the tax base of the general tax eroded by deductions and allowances.

16 . See Tanzi ( 1977 ). 17 . This is the type of minimum tax most used in Latin America. 18 . In some cases, they are extended to other hard-to-tax sectors such as agriculture,

livestock production, crafts, and aspects of overland transport.

NOTES 277

19 . However, the administrative costs of these regimes are probably less than what would be required to include these taxpayers in the general tax regime.

20 . Fuentes Castro et al. ( 2011 ) estimated evasion for the small taxpayer regime at more than 90 percent and evasion for the rest of the system at approximately 40 percent. In addition, they report that while total tax evasion declined from 2000 to 2008, evasion levels for the small taxpayer regime were unchanged during the period.

21 . Another reason is that large firms limit their tax obligations through tax plan-ning schemes that are not within reach of small-scale taxpayers.

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Acemoglu, D., 33 , 259 Ainsworth, R. T., 170–71 , 271 Albuquerque, P. H., 224 Alesina, A., 40 Anton, A., 174 Arbel á ez, M., 224 Ardanaz, M., 32–34 Argentina

automatic stabilizers and, 58–62 capital income and, 120 corporate income tax and, 143 ,

146–47 , 149 dual taxes, 129 , 131 ERTs, 204 , 211–12 , 214–15 Great Moderation and, 52–53 informality and, 67–70 Law Initiative 0005-PE-1998, 46 legislative arena, 44–45 nonrenewable resources, 193 personal income tax and, 116 ,

122–24 , 129 politics and, 33 , 35 sectoral incentives, 143 Sixth Method and, 154–55 SMEs and, 234 , 237–38 subnational taxes, 81–87 tax administration, 22–23 , 100–10 tax burden, 5–8 , 11–12 , 25–26 tax evasion, 19–20 , 120–21 , 147 tax expenditures, 18 tax reforms, 38 , 39 , 41 , 44–46 , 88 , 96 taxes on bank transactions, 222–23 , 225 taxes on primary sector exports,

226–28 VAT and, 66 , 161–62 , 164–67

Artana, D., 85 , 87–88 , 96 , 144 , 146 Attzs, M., 205 Auerbach, A. J., 140

Baca-Campod ó nico, J., 223–25 “bads”

case for taxing, 195–202 dealing with, 198–202 economic instruments for water

management in Latin America, 199–201

energy tax reforms, 210–15 environmental, 195–98 environmental policy options, 198–99 ERTs, 202–15 global, regional, and local, 196–98 taxes, 199–202 see also environmentally related taxes

(ERTs) Baer, K., 230 Balza, L., 273 bank transactions, taxes on

benefits of, 223–24 harm of, 224–25 overview, 222 productivity of, 225

Barreix, A., 11 , 16–17 , 122 , 129–31 , 152 , 170 , 174

Baunsgaard, T., 56 Biglaiser, 40 Bird, R. M., 21 , 74 , 111 Bolivia

corporate income tax, 149 ERTs, 211–12 informality, 67 , 71 nonrenewable resources, 54 , 177 personal income tax, 120 , 123–25 subnational taxes, 82 , 84 , 86 , 91 , 93 tax administration, 23 tax burden, 7 , 10–11 , 13 , 24 , 29 tax evasion, 20 taxes on bank transactions, 222

Index

302 INDEX

Bolsa Familia, 251 Bonvecchi, A., 41 , 44–45 Bovemberg, L., 274 Brazil

bank transaction taxes, 223–24 dual taxes, 130–31 ERTs, 206 , 214–15 GDP volatility, 52 , 58 informality and, 66–71 personal income tax, 116 , 120 , 123–25 politics, 33 property taxes, 89 subnational taxes, 84–89 tax administration, 23–25 , 82 , 100 , 107 tax bias, 13 tax burden, 5–6 , 8 , 11 , 28–29 tax expenditure, 19 , 146 tax incentives, 142 tax rates, 71 tax reforms, 41 , 61–62 , 88–89 , 234 , 237 VAT, 71 , 74 , 95 , 251

Brosio, G., 93 Buehn, A., 237 , 265 Bulutoglu, K., 230 Busso, M., 66–67 , 261 Buti, M., 261

Camacho, A., 72 Canavire-Bacarreza, G., 95–96 carbon taxes, 214–15 Cardenas, M., 32 Casta ñ eda, L., 87 , 90 , 95 Cerda, R. A., 76 Chavez, Hugo, 35 Chile

corporate income tax, 76 , 145–46 economic volatility, 52 ERTs, 209 , 211 , 214–15 government and tax revenues, 29 informality and, 67 , 71 , 76 malapportionment, 34–35 nonrenewable resources, 54 , 56 , 177 ,

184–85 personal income tax, 116 , 119–20 ,

122–23 subnational taxes, 81–82 tax administration, 24 , 107–8 , 234 tax burden, 7–9 , 11 , 13

taxes on bank transactions, 222 VAT, 21 , 74 , 164 , 168

Chisari, O., 214–15 Clausing, K., 266 Coelho, I., 223–24 Colombia

dual taxes, 129 , 131 economic volatility and, 52 enforcement of tax law, 108 ERTs and, 204 , 206 exports, 152 fiscal policy, 54 informality and, 66–71 minimum tax exemptions, 117 nonrenewable resources, 177–78 payroll taxes, 71–72 personal income tax, 120 , 122 , 124–25 property taxes, 89–90 SMEs and, 238 subnational taxes, 82–87 , 89–91 , 94 , 96 tax administration, 23 tax bias, 13 , 15 tax burden, 5–9 , 25 , 28 tax evasion, 20 tax expenditures, 18 , 146–47 tax incentives, 142–43 tax reforms, 38 , 41–42 , 96 taxes on bank transactions, 222–23 , 225 VAT, 161–62 , 164–67 , 237

copper, 184–85 , 187 , 273 Corbacho, A., 52–55 , 58–59 corporate income tax

fiscal profligacy, 144–46 local variations in crescendo, 157 overview, 135 paradox of higher revenues with falling

rates, 135–44 reinforced territorial system, 148–51 supervised taxation methods, 152–56 tax expenditures and evasion, 146–48

Craig, J., 270

De Cesare, C., 87 , 89 de Ferranti, D., 54 De Paula, 74 Debrun, X., 50 , 59 Debs, A., 35–36 DeMooij, R., 174

INDEX 303

D í az Alejandro, C. F., 227 D í az-Cayeros, A., 86 Dodd-Frank legislation, 189 Dominican Republic, 7 , 11 , 20 , 24 , 29 , 107 ,

119 , 122 , 124–25 , 131 , 142–46 , 148 , 155–57 , 164–65 , 204 , 222

Drazen, A., 40 dual tax, 126–30

Ecuador, 7 , 11 , 26 , 54 , 67 , 82 , 86 , 117 , 119 , 131 , 146 , 155 , 164 , 177 , 193 , 224

effective tax rates, 13 , 18 , 71 , 127 , 153 , 184 , 188–89 , 223 , 225

El Salvador, 7 , 66–67 , 81 , 84 , 116 , 132 , 143 , 164 , 214 , 234

environmentally related taxes (ERTs) bringing energy taxes closer to optimal,

210–12 carbon taxes, 214–15 in Caribbean countries, 205 congestion pricing/fees, 207–9 current state of, 204–10 differential waste/wastewater fees and

“nudges,” 219 distributional impacts, 212–13 efficiency and, 216 energy tax reforms, 210–15 fuel taxes and motor vehicle fees, 205–7 future of, 217–19 global carbon taxes, 217 overview, 202–3 “real congestion” pricing and GPS, 218 types, 203 waste and wastewater fees, 209–10

Espino, E., 61–63 excise taxes, 8 , 31 , 37 , 44–45 , 89 , 94–95 , 97 ,

193–94 , 202 , 204 , 206 , 251 , 253

Fernandez, E., 139 , 275 Filc, G., 29 f lat tax, 13 , 126–28 , 146 , 169 , 231 Focanti, D., 41 Fuentes Castro, H., 237 , 277

gasoline, 89 , 94 , 177 , 185–86 , 189–90 , 205–6 , 210–12

Gavin, M., 260 Giordano, P., 215

Gonzales-Castillo, A., 52 , 54 , 58–60 Gonzalez-Rozada, M., 61–63 Goulder, L., 210 , 274 Gravelle, J., 140 Great Moderation, 50–56 green taxes, 95–97 , 199 , 274 greenhouse gas (GHG), 26 , 196 , 197 , 203 ,

211 , 214–15 , 217 , 252 Grubert, H., 139 Guatemala

commodities, 152–53 effective tax rates, 71 ERTs, 204 high costs in, 23 income tax gap, 6–8 informality and, 67–69 personal income tax, 119–23 power of elites and tax revenues in, 30–31 sectoral incentives, 143 semi-dual system in, 132 subnational taxes, 84–85 tax administration, 23 , 84 , 101–4 , 107–8 tax bias, 13 , 15 , 30 tax burden, 4–8 , 11–12 , 28 tax evasion, 19–20 , 147 tax expenditures, 18 , 146–47 VAT, 161–67

Hallerberg, M., 41–42 Harberger, A. C., 139–40 Harris, B. H., 140 Heckman, J., 262 heterodox taxes

minimum taxes or substitutes for income tax, 228–33

overview, 221–22 simplified tax regimes for SMEs and

small taxpayers, 233–42 single-rate business tax, 231–32 tax shortcuts, 230–32 taxes on bank transactions, 222–26 taxes on primary sector exports, 226–28

Hibbs, D., 259 hotel sector, 155–56

ICMS (tax on consumption of goods and services), 86 , 88 , 161

Immervoll, H., 123

304 INDEX

income tax see corporate income tax ; personal

income tax inflation, 41 , 82 , 180 , 201 , 223 , 232 , 242 informality

corporate income tax and, 75–77 evidence of, 67–71 importance of understanding, 66–67 overview, 65 payroll taxes and, 71–73 policy implications, 77–78 VAT and, 73–75

INT-ENERGY model, 215 international financial institutions

(IFIs), 40 International Monetary Fund (IMF), 40 ,

42 , 100

Jimenez, J. P., 103

Keen, M., 74 , 126 , 166 , 174 , 263 Keynes, John Maynard, 222 Kingdon, J., 40 Kirilenko, A., 223–26 Knight, Fuentes, 31 Krelove, R., 233 Kugler, R., 71

Levy, S., 66–67 , 72–73 , 174 Loayza, N., 76 , 263 local taxes

assigning new taxes, 91–96 betterment and valorization tax, 96 complementary reforms, 96–97 corporate value added tax, 93–94 excise taxes, 95 green taxes, 95–96 overview, 79 property taxes, 89–91 pros and cons of subnational taxation,

79–81 reforming, 88–89 retail sales tax, 94 strengthening local development, 97 strengthening semiautonomous tax

agencies, 91 subnational VAT, 94–95

surcharge on national income tax, 93 tailoring reforms, 88–97 tax decentralization and government

finances, 81–87 Lora, E., 38 , 69 , 72–73 , 75–76 low taxation, 3–12

Machado, F., 29 , 58 Magar, E., 41 Mahendra, A., 218 Mahon, J. E., 40 Manzano, O., 179 , 273 Medina, L., 56 Melo, A. C., 41 Meltzer, A., 29 Mexico

“bads” and, 196 informality and, 66–67 , 71–72 nonrenewable resources, 54 , 177 , 184 , 193 personal income tax, 120 , 124–25 ,

131 , 142 single-rate business tax, 231–32 subnational taxes, 82–90 tax administration, 107–10 , 230 tax bias, 13 tax burden, 4 , 8 , 11 , 26 tax expenditures, 146–47 tax reforms, 41 , 61 , 88–89 , 234 , 237 tax revenues, 38 taxes on bank transactions, 222–25 VAT, 63 , 95 , 162 , 164–65 , 169 , 251

Miller, S., 203 minimum tax exemptions, 62–64 , 117 ,

119 , 126–28 , 131 , 146 , 221 , 228–33 , 242–43 , 248 , 254–55

minimum wage, 69–70 , 93 Modragon-Velez, C., 71 Mueller, N., 211 myths regarding taxation

bad tax administration, 21–24 lack of tax progressivity, 12–19 low taxes, 3–12 new realities and, 24–26 tax evasion, 19–21

Navajas, F. M., 211–12 Navia, P., 34

INDEX 305

Newberry, D. M., 210 nonrenewable resources

dividend taxes and “rent taxes,” 180 efficiency of Latin American regimes,

185–88 extracting resource revenues vs. general

tax revenues, 190–93 fiscal regimes for, 179 fiscal revenues and, 178–90 impact of general reforms to

Venezuelan oil sector, 188 international initiatives on governance

and transparency in extractive industries, 189–90

overview, 177–78 policy considerations, 194 revenue systems for, 181–84revenues derived from exploitation of, 178 royalties and income taxes, 179–80

Nordhaus, W. D., 211 , 275 Nordic countries, 126–27 , 129–31

Oates, W. E., 201 Oliveira-Tanzi effect, 232 Olivera, M., 41–42 Oportunidades, 251 Organisation for Economic Co-operation

and Development (OECD), 4–5 , 11 , 21 , 23–24 , 54–55 , 58–59 , 89 , 100 , 103 , 107 , 109 , 115–17 , 124 , 136 , 138–39 , 153–56 , 160 , 162–64 , 215 , 251

Ossowski, R., 54 , 191–92 Overesch, M., 139

Padilla, R., 142 Panama, 4 , 11 , 66 , 81–84 , 106 , 129 , 132 ,

143 , 164 , 234 , 268 Paraguay, 11 , 23 , 29 , 67 , 69 , 84 , 120 , 149 ,

155 , 162 , 168 Parry, I., 210–11 Partido Patriota, 31 personal income tax

consequences of low taxation, 122–25 deductions, 119–20 dual tax, 126–30 filling void of, 132–33 f lat tax, 126

free pass for capital income, 120–21 new models for, 125–32 nonpayment of, 121 overview, 115 semi-dual taxes, 130–32 setting bar too high, 117–19 tax expenditure and revenue from, 120 why Latin Americans pay so little, 115–21

Persson, T., 28 Peru

corporate income tax, 144–46 economic volatility, 52–54 ERTs, 214–15 informality, 67 nonrenewable resources, 177 , 184–88 personal income tax, 121 semi-dual taxes, 132 simplified taxation, 234 , 237 subnational taxes, 82–86 , 91 , 95–96 tax administration, 100–9 tax burden, 7–9 , 11 tax evasion, 19 tax incentives, 144–46 tax reform, 61 , 63 , 96 taxes on bank transactions, 222–24 VAT, 63 , 164 , 168

Picos-Sanchez, F., 130 Pigou, 210 Piotrowska, J., 138 politics of taxation

Argentina, 44–46 influence of ideology, 34–36 overview, 27 political power and tax revenues, 29–34 reforming tax code, 36–39 system of government and tax revenues,

27–29 tax reforms explained, 39–43

Pomeranz, D., 74 presumptive taxes, 146 , 228 , 234 property taxes, 9 , 31 , 80 , 85–87 , 89–91 , 97 ,

175 , 228 , 248

Radulescu, D. M., 130 reforms

corporate income tax, 250–51 heterodox taxes, 254–55

306 INDEX

local taxes for local development, 252–53 overview, 247–49 personal income tax, 249–50 taxes on “bads,” 252 taxes on nonrenewable commodities,

253–54 VAT, 251–52

regional tax on productive activities (IRAP), 93–94

retail sales tax, 94 Revesz, R., 201 Robalino, J., 89 Robinson, J., 33 , 259 Roca, J., 131 , 152 , 170 , 174

sales tax, 73 , 85 , 88–89 , 93–95 , 184 , 231 , 233 Samuels, D., 33 Sanchez, F., 87 , 89–90 , 94 , 96 , 103 Sanchez, O., 40 Scartascini, C., 32–34 Schneider, F., 237 semi-dual taxes, 130–32 Sepulveda, C., 89 , 95–96 Shome, P., 21 Siavelis, P., 34 Sixth Method, 154–55 , 268 small and medium-sized enterprises

(SMEs), 221–22 , 228 , 233–43 Sorensen, P. B., 138 Stein, E., 35–36 Stock, J., 50 Strand, H., 130 , 211 Suescun, R., 59 surcharges, 67 , 71 , 86 , 93–95 , 97 , 253

tax administration development and, 110–11 enforcement, 106–10 overview, 99 resources and autonomy to manage,

100–6 tax evasion

Argentina and, 19–20 , 120–21 , 147 Colombia and, 20 Guatemala and, 19–20 , 147 myths regarding, 19–21

tax systems automatic stabilizers and economic

cycles, 56–60 Great Moderation, 50–56 overview, 49–50 road to economic stability, 64 role of fiscal policy and, 53–54 tax reform for stable welfare, 60–63

Templado, I., 85 , 87–88 , 96 , 144 , 146 Ter-Minassian, T., 57 , 86 , 88 Tobin tax, 275 Tsebelis, G., 40

Uruguay corporate income tax, 144–45 economic volatility, 24 ERTs, 211–13 informality and, 67 personal income tax, 116 , 119 , 123–25 semi-dual taxes, 129 , 131–32 tax administration, 234 tax burden, 5–8 , 11–12 , 25 , 28 tax expenditures, 146 taxes on bank accounts, 222–23 VAT, 168–69 , 172 , 252

value added tax (VAT) breaking down productivity, 164–66 corporate, 93–94 D-VAT, 171 equity, neutrality, and simplicity, 170–75 error of inclusion of reduced rates and

exemptions, 169 evasion of, 166 overview, 159–60 potential revenue decomposition, 165 productivity and efficiency in Latin

America and OECD, 163 productivity and efficiency indexes, 162 pros and cons of, 160–66 P-VAT, 171–75 regressive or progressive, 167 revenues and rates, 1990 and 2010, 161 role of reduced rates and exemptions,

166–70 subnational, 94–95 tax expenditure and progressivity, 168

Radulescu, D.M.—Continued

INDEX 307

Velayos, F., 103 Venezuela

economic volatility, 52 , 54 ERTs, 26 , 206 , 215 informality, 66–67 nonrenewable resources, 54 , 177 , 184 ,

188 , 193 personal income tax, 124–25 politics and, 35 simplified taxes, 234 subnational taxes, 82–85 , 87 , 91 , 93 ,

94 , 96

tax administration, 23 tax bias, 71 tax burden, 8 , 13 , 24 taxes on bank transactions, 224 VAT, 94

Vuletin, G., 263

Weitzman, M. L., 275 Williams, R. C. III, 275 World Bank, 21 , 40 , 77 , 116

Zarama, C., 85