Reducing the Tax Gap on Work Revenue in Peru
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REDUCING THE TAX GAP ON WORK REVENUE IN PERU Carlos Gallardo Torres and Yazan Al-Karablieh SYNOPSIS This paper tackles the earned income tax gap, a loss of potential revenue that, if generated, can target development objectives by mobilizing government expenditure. The current design results in (1) large jumps in the marginal tax rates, (2) a high threshold to paying taxes, and (3) lower tax burden on the higher-income taxpayers. The paper proposes a design showing an immediate response of increasing income tax revenue by up to 5.7% only in the first year, with higher potential in the following years. In addition, this paper recommends a massive and innovative usage of electronic invoicing. The Authors: Carlos Gallardo Torres Master in Public Administration in International Development at Harvard University. B.A. in economics from Universidad del Pacifico, Peru. Former consultant at the Ministry of Economy and Finance of Peru to develop and evaluate reforms related to customs, investment, competitiveness and taxation, and to the negotiation of Free Trade Agreements and Taxation Agreements. Yazan Al-Karablieh. Master in Public Administration in International Development at Harvard University. B.A. in economics from Harvard College, 2012. Research associate and assistance experience with Jameel Poverty Action Lab, Evidence for Policy Design at Harvard Kennedy School, and National Bureau of Economic Research. A full version of this paper was written in fulfillment of the requirements for the degree of Master in Public Administration in International Development at the John F. Kennedy School of Government, Harvard University. The full version is available upon request. Carlos Gallardo Torres and Yazan Al-Karablieh Administration practices, tax culture, and target Content the self-employed. The self-employed remain the largest obstacle to raising taxable income. 1. The need for reform Therefore, any tax table design attempting to 2. Current income tax structure and recent reduce distortions must be accompanied by trends in peru measures to encourage compliance. 3. Lessons from theory and global trends In addition to redesigning the tax table, the paper points to an electronic invoicing policy option 4. Deconstructing the problem and that can respond to tax collection limitations. identifying constraints Because invoices can be deductible from taxable income, up to a limit, electronic invoicing creates 5. Review of policy options incentives for customers to demand receipts, 6. Implementation design: making reform especially from the higher-income professionals. happen To achieve an effective implementation, the paper also recommends Tax Administration 7. Conclusion to release information about rising audits to create credible threats for evasion, especially 8. Bibliography targeting the self-employed. Authorities should additionally focus on expanding effective programs attempting to increase public service In an attempt to raise additional revenue, provision awareness and engage voluntary Peru has achieved progress in the areas of taxpayer compliance. indirect and corporate taxation, but is yet to achieve similar progress in raising revenue The analysis then considers the Tax from the earned income tax, prompting the Tax Administration’s ability to administratively Administration and the Ministry of Economy and implement the recommended policy option and Finance to seek reform recommendations. This the political system’s ability to pass the tax paper tackles the earned income tax gap, a reform law. Administrative capacity requires loss of potential revenue that, if generated, can attention, yet there is rising confidence in target development objectives by mobilizing vital current efforts to handle the tax reform. The government expenditure and transfer spending. largest implementation constraint will be political Earned income refers to wage and self- support. For this purpose the paper suggests employed labor income, but this paper focuses efforts to build a political coalition in Congress on the self-employed professionals and labor by engaging stakeholders according to their workers, since sole proprietorship businesses interests, such as highlighting the progressivity are not subject to the earned income tax, but benefits embodied in the proposal to groups are instead subject to a simplified corporate tax representing the lower-income workers. regime. This paper proceeds as follows: (1) highlighting In the Peruvian case, the main potential the problem and the need for reform, (2) a constraints to earned income tax reform are tax description of the tax structure and recent trends design, Tax Administration performance, and tax in Peru, (3) a review of tax reform lessons from culture. The paper proposes a design showing theory and global trends, (4) a diagnosis of the an immediate response of increasing income tax constraints to increasing revenue from the earned revenue by 5.7% only in the first year, with higher income tax in Peru, (5) a consideration of policy potential in the following years. Tax design, and reform options, and (6) recommendations however, cannot raise substantial revenue of policy options, an implementation plan, and without an active effort to continue to improve Tax administrative and political analysis. July 2014 31 1. THE NEED FOR REFORM Peru, like many Latin American and other problem on the agenda as a result of Peru’s developing countries, faces high informality, potential to raise more revenue, and the tax’s tax evasion and avoidance, and suboptimal revenue performance relative to the corporate collection practices. Yet Peru’s loss of potential tax and indirect taxation. Despite achieving some revenue from the earned income tax is also progress with raising revenue as a percentage of characterized by an inefficient tax design. This GDP, Peru (15.7% of GDP in 2012) lags the Latin paper will break down the tax design constraint American average of 17%.2 Interesting enough, and recommend changes to its current shape. Peru’s 2012 indirect tax revenue is on par with Additionally, realizing that changing design must Latin America (10.3%) at about 9.6% of GDP.3 be enforced by higher compliance and improved Peru’s 2012 corporate tax revenue is also at 5.3% practices in collection, the analysis will also focus of GDP compared to the Latin American average on tackling other factors constraining earned of 3% of GDP.4 Having achieved progress in income tax collection. other tax domains, closing the earned income tax gap is now a priority. The importance of increasing revenue from the earned income tax is reflected in the need for The problem diagnosis begins with Peru’s additional expenditure by the government. Much personal and earned income tax revenue relative of development economics has centered on the to Latin America. Peru’s personal income tax government’s delivery of goods and services, performance is higher at 1.8% of GDP, though such as education, because of the contribution the earned income tax revenue generated is only of these goods to economic growth. Peru also 1.5% of GDP in 2012.5 Despite not falling below uses transfer spending as a development tool the Latin American average, the low revenue to to reduce poverty and inequality. Despite a GDP ratio from the earned income tax clearly moderate increase in expenditure since 1990, lags the improving performance of other sources Peru’s social expenditure remains among the of tax collection. The overall tax burden gap, lowest in Latin America. Additionally, Lustig1 et defined as the deficit in tax collection with respect al. find Peruvian transfer programs effective at to international standards, is about 3.5% of GDP poverty and inequality reduction achieved per and the income tax gap is about 1.5% of GDP.6 percent of GDP spent. Thus, closing the earned The figures reflect that less revenue is collected income tax gap serves as an essential step in Peru relative to other countries with similar towards achieving these development goals. levels of GDP, size of the labor force, percentage of the self-employed, trade openness and rents Additionally, the Ministry of Economy and from natural resources, indicating room for Finance is pushing the earned income tax increased collection. 1. Lustig, N., Pessino, C., & Scott, J. (2013). The Impact of Taxes and Social Spending on Inequality and Poverty in Argentina, Bolivia, Brazil, Mexico, Peru, and Uruguay: Introduction to the Special Issue. Public Finance Review No. 1313. 2. Corbacho, A., Cibils, V. F., & Lora, E. (Eds.). (2013). More than Revenue: Taxation as a Development Tool. Palgrave Macmillan. 3. Calculation based on the 2012 CEPALSTAT and Central Bank of Peru databases. 4. Ibid 5. Author’s calculations based on 2012 Tax Administration data 6. Ibid. 2 32 CIAT/AEAT/IEF Tax Administration Review No. 37 Carlos Gallardo Torres and Yazan Al-Karablieh Table 1 Peru in a nutshell Social expenditure : Ranks 18th in LAC Tax revenue (%GDP) : 15.7, below LAC average Earned income tax revenue (%GDP) : 1.5, lags performance of other sources Income tax gap : 1.5 %GDP less revenue collected To start paying taxes : More than 1.7 times GDP per capita. Higher than LAC and middle income countries Tax evasion : 32% earned income tax, 51% self-employed Labor informality : 64% in urban areas Source: CEPAL, Tax Administration, Central Bank of Peru Tax design and non-design issues contribute to to collection as a proportion of tax revenues in the earned income gap. On one hand, the tax Peru relative to the Latin American average. It is design component shows large jumps before the clear that Peru faces at least some of the typical first marginal tax rate (15%) that might constitute developing country limitations to collecting the a signal of individuals misreporting their income earned income tax. These limitations form, to not to pay taxes. It also shows a high threshold for a large extent, part of the larger problem of the taxpayers to pay taxes on earned income, at 1.7 earned income tax gap, and therefore require times GDP per capita, above the Latin American attention during diagnosis and a role in policy and OECD averages (1.4 and 0.24).7 In addition, interventions.