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Measuring Price Distortions from Commodity Taxation in Brazil A THE WORLDBNK iTDP-0OZI - Public Disclosure Authorized Internal Discussion Paper LATIN AmERICA AND THE CARIBBEAN REGION Report No. IDP-078 Public Disclosure Authorized Measuring Price Distortionsfrom Commodity Taxation in Brazil A. Estache Public Disclosure Authorized and A. Fernandez and I. Roy (consultants) July 1990 Infrastructure Operations Country Department I Public Disclosure Authorized Discussion Papers are not formal publications of the World Bank. They present preliminary and unpolished results of country analysis or research that is circulated to encourage discussion and comment; citation and the use of such a paper should take account of its provisional character. The flndings, trpretations, and canclusions eressed in this paper are entily those of fth autr(s) and shoul ro be attut In any man to theWorld Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent LAC DISCUSSION PAPER SERIES Report No. T1.i Author and Date IDP-3 "An Analyss of the Sources of Earnings Vari Among BrazIlan Mals" by Ma~clo Dabo and Geoge Psacharpouloe, December 1987 ID?-4 "The Ef am Ek of Export Credit and Export Crealt Insurance Programs" by Bruce Fitzgerald and Tmny Monson (Cosufant, Dce~ 1987 113.9 "Export Procesing Zone: The Economics of Offthore Manufactudng* by Peter 0. Warr (Consu~tant), August 1987 IDP-10 "Dumping, Ant-dumping and Effolency" by Bruce Yandle and ElIzabeth M. Young (Consultant), August 1987 IDP-1 1 "The Regulaton of the Qualty of Traded Commodie and Services- by Simon Rotenberg and Bruce Yandle (Consultants), June 1987 IDP-12 "Argentina: Proble for Achieving Macro Stabity" by F. Desmond MoCarthy and Alfrdo E. Thome, January 1988 IDP-13 "Argentna: Toward tO Year 2000" by F. Deomond McCarthy, June 1987 IDP-14 "Trade Uberlzation: The Lessons of Expedence", Papers presented In the conference *Toward a New Trade Policy for Braz9, Sao Paulo. April 11 and 12, 1988 IDP-18 *Aspect of Privatization: The Case of Argentna 1976-81w by R. Luders (ponsultant), Apr 1988 IDP-17 "Aspects of Privatization: The Case of Chile 1974-85, by D. Hachette (consultant), April 1988 IDP-18 "Privatization In Argentina and Chile: Leesons from a Conpadon" D. Hachefe and R, Luders (consultants), Aprl 1988 IDP-19 "Principles of Water Supply Pricing In Developing Countes* by Mohan Munainghe, June 1988 IDP-20 "The Status of Energy Economic: Theory anJ Applkcation" by Mohan Munadinghe, June 1988 IDP-21 *What are the Prospect for Land Reform?" by Hans Binswanger and Miranda Elgin (consultant), August 1988 IDP-24 *Managlng Argentina's External Debt The Contribution of Debt Swap", Cad N~ Afrdo Rodrguez (oonsultmnt), January 1989 IDP-29 *Managing Mexc's Extemal Debt: The Contributon of Debt Reduc~on Schemes", Allen SanginUs (con~ulant), January 1989 IDP-30 *Debt Reduction Schems and the Management of Chflean Deb, Fepe Laraifn (consultant), March 1989 DP-31 *Managiril~ Exterral Dobt The Contributfon of Debt Reducion Schemes", Dionisio D. Camelro and Rogedo LF. Wemeck cnulrt), Juluafy 1969 DP-32 "Leading Econoi* Indicators for BraH: At Atempt at Forecasng Turning Ponts", Antonio Estache, February 1989 (DP-33 *Recoverig Growth wh Equity, World Bank Povery Alevlation ActMis In LatIn Amedlca", George Pacharopoulos, Aprl 1989 IDP-34 Brazil- External Dobt Development and Prospect", SivIna Va~nick, December 1988 IDP-40 'Cash Debt Buy Back and the Insurance Vake of Reserves", Sweder van WIjnbergen, June 1989 IDP-41 «Growth, Extemal De and the Real Exchange Rate In Meidco", Sweder van Wijnbergen, May 1989 IDP-43 "The Macroeconomics of Social Secudty In Braz: Flecal and Financial ~ese*, Douglas Puet (Consultant) and Emmanual Y. j~enez, June 1989 IDP-40 "Feedlng Latin Amedca's Chdren", Human Resources DMslon, Techncal Department October 1989 IDP-50 *Marginal Effetive Tax Rate* on Capital Income In Argentina", Luca Babone and Michael McKee (Consuant), August 1989 DP-53 "A Bblography on Poverty and income DistrIbution In Latn Ameca", Human Resources DMslon, Techncal Depadment, November 1989 IDP-S4 'Ecuador Development lsues and 0pone for the Amazon Region", Country Department IV, December, 1989 DP-55 "Fiscal DefIcis, Ination and intere t Ratos", Rul Coutlnho, June 1989 DP-56 "Regulating Industdal Poflutfon In Developing Coun~des: Some Po~sible Framewor*s", Paul R. Poney (Consultant), December 1989 IDP-0 "Strategy for the Promoton of Non-Tradional Agricultural Expod~", Martin F. Raine, December 1989 IDP-61 "A Portfollo Model for Braz", Rul Counho, June 1989 IDP-64 "Why Tax Incenbies Do Not Promote ineetment In Brazil, A. Estache and V. Gaspar (consultant), February 1990 IDP-68 "Publc Sector "Debt Distrss" In Argenina's Recent Stablzation Eforis, Paul Beckemn, July 1990 IDP-69 "Affocatng Credit: How to D1et, Prie or Aucion", 8. Ramachandran, June 1990 DP-70 *LAC Ecoromic and Seator Work: A Cddial Review of Selected ~ssues", L Auernhelmer (consulant), June 1990 IDP-71 -Agricultural Trade in th Caribbean Community , John Nash, July 1990 IDP-72 *Poverty Allevlation in Braz, 1970-7, M. Louis Fox, July 1990 IDP-73 "F~scal Defcits, Exchange Rate Crisis and Infaton", Sweder van Wijnbergen, Januay 1990 July 1990 MEASURING PRICE DISTORTIONS FROM COMMODITY TAXATION IN BRAZIL A. Estache The World Bank A. Fernandez Instituto Tecnologico Autonomo de Mexico I. Roy Universite de Montreal * The findings, interpretations and conclusions are ours. They should not be attributed to either of the Institutions with which we are affiliated. Also, we are grateful to J. Mintz, J. Seade and J. Consentino Tavares for comments on an earlier version of this paper. The other usual disclaimers apply. ABSTRACT The measurement of tax driven price distortions is based on the computation of effective tax rates imposed by the domestic indirect taxis on each sector. The accumulated effect of indirect taxes on prices across sectors is tracked through a system of simultaneous equations provided by the 1980 input- output matrix. This accumulated effect of taxes on prices is the effective tax rate. It has two components. First, there is the effect on prices of statutory tax rates. Second, there is the effect on prices stemming from taxes levied on inputs by cascading sales taxes or by the use of exemptions rather than zero- rating to provide relief from VAT. This second effect is also referred to as the implicit tax effect. It illustrates the unexpected price distortions due to the reliance on indirect taxes other than VATs or on imperfectly designed VATs. The methodology is then used to assess the effects of the 1989 changes imposed on the indirect tax system by the New Constitution. The tax reform component of the new Brazilian Constitution improved the overall design of the indirect tax system by widening the base of one of its value added taxes (VATs) and suppressing some of the excises. According to simple computations based on the "Harberger triangle" formula, the reform reduces the welfare loss imposed by the indirect tax system by about 2.3%. However, the improvement in the design is insufficient as many intersectoral price distortions remain. The paper shows that the effective tax rates increase a little as a results of increase in statutory tax rates but that the implicit effect due to the unplanned taxation of inputs is somewhat lower but not significantly. The explanation for this weak effect of the reform is found in the failure to change the fundamental design of the two Braziliar VATs. In most cases, activities benefiting from tax incentives are excfpted from the VATs rather than zero rated and hence end up paying an implicit tax on their purchases of inputs. Table of Contents Page No. A. Introduction . 1 B. The Taxes . 2 1. Value-Added Taxes . 2 2. Other Significant Indirect Taxes . 3 C. The Importance of Tax Exemptions for Effective Tax Rates . 3 D. A Method to Measure Distortions Due to Indirect Taxation . 6 1. The Framework . 7 2. A Formalization of the Framework . 8 E. Intersectoral Tax Driven Distortions Before the New Constitution 14 1. The Value Added Taxes . 15 2. The Other Indirect Taxes . 18 3. Summing up the Individual Effects of Indirect Taxes . 20 F. Did the 1989 Reform Reduce Distortions? . 20 G. Concluding Remarks . 25 Bibliography . 27 Tables: Table ls TOTAL IMPACT OF TAXES ON PRICES PER ACTIVITY IN 1988 . 15 Table 2: COMPARING TAX EFFECTS BEFORE AND AFTER THE NEW CONSTITUTION 22 Table 3: SECTORAL IMPACT OF INDIRECT TAXES ON PRICES . 25 Graphs Graph 1: BRAZIL - EFFECTIVE AND STATUTORY DOMESTIC INDIRECT TAX RATES 16 Graph 2: BRAZIL - TAX EFFECTS BEFORE AND AFTER THE NEW CONSTITUTION . 23 Graph 3: BRAZIL - IMPACT OF INDIRECT TAXES ON PRICES - PRE- vs. POST-CONSTITUTION TAX SYSTEMS . 24 A. Introduction Brazil's new Constitution, voted in 1988, includes significant changes in indirect taxes aiming at increasing the tax independence of subnational governments. The resulting redistribution of tax jurisdiction increases the proportion of economic activities subject to value added taxes (VATs) and reduces the number of excise taxes. This paper assesses the impact of these changes on intersectoral price distortions. The quantification of the tax-driven distortions is based on a calculation of effective tax rates for final goods.11 The rates are defined as the tax element in the price of that good, accounting for taxes on inputs which arise through the production process. The effective rates are calculated using the 1980 input-output matrix for the current tax system and for the system prevailing after a full implementation of the major reform elements of the New Constitution. Even though the current production structure is not fully comparable to the 1980 structure, the results provide a useful quantitative approximation of the tax-driven distortions and raises some conceptual issues regarding the design of the Brazilian domestic indirect taxes. The paper shows that the Brazilian indirect taxes were and remain, in spite of the changes brought by the new Constitution, a major source of intersectoral price distortions.
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