CENTER FOR RESEARCH ON ECONOMIC DEVELOPMENT AND POLICY REFORM Working Paper No. 76 Taxation in Latin America in the Last Decade by Vito Tanzi* December 2000 Stanford University John A. and Cynthia Fry Gunn Building 366 Galvez Street | Stanford, CA | 94305-6015 * International Monetary Fund and Carnegie Endowment TO BE REVISED Taxation in Latin America in the Last Decade1 By Vito Tanzi2 Abstract This paper presents a broad view of progress and challenges in tax policy in Latin America, which, in the last decade, experienced a high degree of activism and several reforms and reform attempts. It first identifies the most influential factors affecting tax developments in the region: (i) The debt crises of the early 1980s reduced the ability to finance public spending through foreign borrowing and increased the costs of servicing the debt forcing. (ii) High inflation throughout the 1980s and early 1990s, eroded real tax revenues due to the collection lag, “the Tanzi effect.” (iii) Trade liberalization lowered tariff revenues. (iv) Capital account liberalization forced reductions in tax rates to maintain competitiveness. The main body of the paper is devoted to describing major tax policy developments. (a) The fall in trade taxes has been compensated by the rising importance of the Value-Added Tax (VAT). The VAT has become the workhorse tax in Latin America but there is still heterogeneity in its collection productivity. (b) With few exceptions, Latin American countries continue to have difficulties implementing income taxes, especially the individual income taxes. The paper then argues that fiscal needs have introduced interesting experimentation with new taxes and new approaches to taxation, such as the gross asset taxes, taxes on bank debits, and simplified regimes for small taxpayers. The paper also discusses achievements and reform challenges in tax administration. Finally, it concludes that although tax systems in Latin America have made important headway, improvements in tax equity, efficiency of tax administration, and obstacles posed by fiscal federalism remain important challenges that need to be overcome in the future. 1Paper prepared for the conference on "Fiscal and Financial Reforms in Latin America," held at Stanford University, on November 9-10, 2000. Valuable advice and assistance received from Carlos Silvani, Juan Toro, and Howell Zee was much appreciated. Asegedech Woldemariam was helpful in collecting some of the statistical information. 2 International Monetary Fund and Carnegie Endowment 1 I. INTRODUCTION Next to the weather, taxes must rank as one of the most discussed topics of conversation. This is true universally but it is especially true for Latin America which, in the last decade, has experienced a high degree of tax activism and several attempts aimed at reforming the countries' tax systems. Most governments have come into office promising to improve the tax systems to make them simpler to administer, easier to comply with, and more equitable. Most governments, however, have quickly resigned themselves to tinkering with the tax systems rather than truly reforming them. Strong political opposition to reform and administrative difficulties have been obstacles that governments have found difficult or even impossible to remove. Yet, as we shall show in this paper, gradually some important changes have taken place so that the tax systems of today are significantly different from those of a decade or more ago. Many of the Latin American countries that have faced macroeconomic difficulties and that have chosen to go to the IMF for Fund-supported programs have given particular importance to the objective of raising revenue. However, at times, this objective has been pursued or achieved at the cost of simplification or of equity improvement. Several Latin American countries have been only partially successful in raising the level of taxation in neutral and equitable ways. However, as we shall show, many countries succeeded in raising their tax levels. This paper will survey some of the major developments in taxation that occurred in Latin America over the last decade. Given the number of countries involved and the many changes that have taken place, only the most important changes can be discussed. Furthermore, more attention will be given to developments in larger countries. In Section II we identify the major factors that have influenced tax developments in Latin America. In Section III we identify major developments in tax systems. In Section IV we discuss distinctive features of the Latin American tax reform efforts. In Section V we discuss some developments in tax administration. Section VI draws some conclusions. II. MAIN INFLUENCES ON TAX DEVELOPMENTS Although most governments inherit tax systems that do not fully conform with their desires or goals, and that they would, thus, like to change, there are often more immediate or fundamental influences that at times force governments to take action. In this section we identify 2 the most important for the Latin American countries among these although, undoubtedly, there were additional factors or influences that, in particular countries, might have been as important. The Debt Crisis of the 1980s Perhaps the first influence worth mentioning is the Debt Crisis which started in Mexico in 1982 and spread to most other Latin American countries. The debt crisis reduced the ability of these countries to finance their public spending through foreign borrowing and, because of the increase in the cost of servicing the debt, it forced most Latin American countries to cut public spending or to increase the level of taxation. These countries were faced with the need to increase their primary surplus (the difference between ordinary revenue and non-interest expenditures) in order to service their debt. This situation, per se, would have created strong incentives for governments to increase the level of taxation especially when, for political or legal reasons, non-interest spending could not be reduced. As it was, capital spending was often reduced thus, in part, contributing to the reduction of the rate of growth through the 1980s but, more immediately, increasing the primary surpluses of these countries. The fact that many of these countries negotiated adjustment programs with the IMF exposed them to additional pressures to improve their fiscal accounts. The Fund often provided technical assistance in the tax area, assistance that aimed at strengthening the tax systems so that they would become more efficient. It is important to stress two points in this context. First, that Fund or no Fund the fiscal situation needed to be strengthened because of the macroeconomic situation. Thus, the argument often heard, that these countries were forced by the Fund to cut spending or increase taxes, ignores reality. Second, that whenever possible the Fund's advice was to strengthen the tax administration and to widen the tax bases, rather than simply to increase the rates or to cut expenditure as some Fund critics have argued. The Inflationary Context The Debt Crisis was accompanied by economic developments that had strong influences on the tax systems of these countries. One such development was inflation. Many factors contributed to inflation but, surely, inflationary financing of public spending (i.e., recourse to monetary expansion) must have been the most important. Throughout the 1980s and until the mid-1990s Latin America experienced strong inflationary pressures which in some countries 3 reached very high levels. In 1990, the average increase in the cost of living index for the Western Hemisphere reached 461.1 percent per year. In Argentina it reached 3080 percent in 1989. In Bolivia it reached almost 12,000 percent in 1985. In Brazil it reached almost 13,000 percent in 1990 and around 2,000 percent in 1993-94. In Mexico it reached 58 percent in 1985. The period after 1995 has seen much lower rates of inflation for most countries. When inflation reaches very high levels and the collection lags are significant, the positive impact of the "fiscal drag" on tax revenue is overwhelmed by the negative impact of what came to be called the Tanzi effect.3 This effect stipulates that the longer is the collection lag and the higher is the rate of inflation, the larger will be the proportional, negative effect on tax revenue. However, the absolute effect depends also on the initial level of the average tax ratio. The higher is the initial average tax ratio, the greater will be the absolute fall in tax revenue given the average collection lag for the whole tax system and the rate of inflation.4 Because income taxes generally have longer lags than other taxes, their relative contribution to total tax revenue generally falls during the period of inflation. The countries tried to react to the impact of inflation on their tax revenue by: (a) attempting to reduce the collection lags through administrative changes;5 (b) by relying more on taxes with shorter collection lags such as value-added taxes and excises; (c) by anticipating tax payments through withholding; and (d) in extreme cases (Brazil and Chile) by indexing the tax liabilities for the period of the lag. The indexation factor was supposed to reflect the rate of inflation over the period of the delay. Through this latter mechanism Brazil significantly reduced, but did not completely neutralize, the negative impact of inflation on its tax revenue. See Gianbiagi, 1987. The impact of inflation on the tax system was very important especially for high inflation countries such as Argentina, Bolivia, Nicaragua, Peru, and some others. While the acceleration of inflation until the early 1990 reduced the average tax ratios, the deceleration of inflation in the 3 The collection lag is the time that elapses between an event that creates a tax liability and the time when the government receives the payment. 4 For the technical details the reader is sent to Tanzi (1977 and 1989).