Tax Reform in Central America Work at IDB Manuel R. Agosin Regional Economic Advisor for Central America, Mexico, Haiti and Dominican Republic, IDB 17 th Regional Seminar on Fiscal Policy CEPAL, Santiago, January 24-27, 2005

2 Work on tax reform over the past three years, sponsored by funds from Norway and Sweden Work on tax reform options open to governments in the region: Work on tax reform options open to governments in the region: Studies for BL, CR, DR, ES, HA, GU, HO, NI, most of them available on RE2 website: Studies for BL, CR, DR, ES, HA, GU, HO, NI, most of them available on RE2 website: Closed-door meetings with governments to present results of studies Closed-door meetings with governments to present results of studies Workshops for civil society, business, Congress, labor unions Workshops for civil society, business, Congress, labor unions Active participation of donor governments Active participation of donor governments –In the design of the project, in parts of its execution, in planning follow-up Book summarizing findings (early 2005) Book summarizing findings (early 2005)

3 The first set of studies on tax reform revealed that … Central American countries collect much less than they should in tax revenue, and this hampers their ability to pursue social policies Central American countries collect much less than they should in tax revenue, and this hampers their ability to pursue social policies Income distribution is rendered more regressive by the tax system Income distribution is rendered more regressive by the tax system The basic problem is the narrowness of the tax base, not tax rates The basic problem is the narrowness of the tax base, not tax rates

4 All the countries in the region have space to raise the tax burden Tax burden, % of GDP, 2001 Source: IDB, based on CEPAL.

5 As a consequence, and contrary to popular opinion, states are small... Source: IDB, based on CEPAL. Public expenditures, % of GDP, 2001

6... and spending on education and health is low Spending on education, % of GDP, 2000 Source: IDB, based on CEPAL.

7 Years of schooling in the population between 15 and 65 are low (1999) Source: Barro and Lee database.

8 Deficiencies of tax systems in Central America… Personal income taxes: Personal income taxes: –Much non-wage income escapes taxation –Large informal sector, mostly poor but also some well off –Generalized evasion and avoidance through offshore arrangements Corporate incomes taxes: Corporate incomes taxes: –Excessive use of “development-oriented” exemptions (tourism, mining, exports, to name a few) –The most dynamic sectors are tax exempt, which renders tax revenues inelastic to income increases

9 Deficiencies of tax systems in Central America… Value added taxes: Value added taxes: –Numerous exemptions, many for dubious reasons –Generalized use of zero rate, which means that backwards value chain is tax exempt – this generates tax credits all along the line and undermines tax collections Excises: Excises: –Excessive reliance on gasoline taxes, which raises costs and makes user firms uncompetitive –Proliferation of low-yielding excises with widely varying rates Foreign trade taxes: Foreign trade taxes: –Owing to trade liberalization, revenues from this source have been declining relative to GDP –Inefficiency and low yields in customs collections

10 Reasons that make tax reform urgent Provision of infrastructure, economic and social public investment Provision of infrastructure, economic and social public investment CAFTA and FTAA will reduce tax revenues from tariffs, which will have to be made up CAFTA and FTAA will reduce tax revenues from tariffs, which will have to be made up Countries will have to abolish income tax exemptions in EPZ, to comply with WTO Countries will have to abolish income tax exemptions in EPZ, to comply with WTO It is important to harmonize corporate income tax legislation in order not to engage in race to the bottom, particularly in context of CAFTA and MCCA It is important to harmonize corporate income tax legislation in order not to engage in race to the bottom, particularly in context of CAFTA and MCCA Achieve fiscal sustainability in highly indebted countries Achieve fiscal sustainability in highly indebted countries

11 The two TCs have led to encouraging developments … IDB has placed the issue of tax reform on the forefront of its lending program in Central America (particularly PBL loans) IDB has placed the issue of tax reform on the forefront of its lending program in Central America (particularly PBL loans) Tax reform programs have been launched in Nicaragua and Honduras (the most ambitious project in the region) Tax reform programs have been launched in Nicaragua and Honduras (the most ambitious project in the region) IDB has supported tax reform in Costa Rica, the most ambitious and best designed in the region IDB has supported tax reform in Costa Rica, the most ambitious and best designed in the region Other countries have placed tax reform on their policy agenda (El Salvador, Guatemala) Other countries have placed tax reform on their policy agenda (El Salvador, Guatemala)

12 Major problem: lack of social acceptability of government Society does not trust that governments will use effectively the resources generated by any tax increase Society does not trust that governments will use effectively the resources generated by any tax increase Legitimacy of governments is questioned by many social groups, not only business Legitimacy of governments is questioned by many social groups, not only business Vicious circle: the less effective and less transparent is government, the less willing are citizens to provide it the resources; but the less resources it has, the more this fosters lack of transparency and inefficiency Vicious circle: the less effective and less transparent is government, the less willing are citizens to provide it the resources; but the less resources it has, the more this fosters lack of transparency and inefficiency

13 A new approach to the issue of fiscal reform is needed Emphasize building confidence and improving the capacity of governments to deliver effective public services needed for growth and poverty reduction Emphasize building confidence and improving the capacity of governments to deliver effective public services needed for growth and poverty reduction Tax reform is needed to raise the share of income that can be used to produce indispensable public goods Tax reform is needed to raise the share of income that can be used to produce indispensable public goods But governments improve the efficiency, transparency and targeting of government spending But governments improve the efficiency, transparency and targeting of government spending Need to improve equity through the fiscal system Need to improve equity through the fiscal system –But make sure you don’t look at taxes alone, but at the combination of taxes and spending

14 A follow-up project has just been approved: Regional TC financed by and designed with the participation of Sida, NORAD and DFID The philosophy of the project: Tax reform is an ongoing process and needs to continue Tax reform is an ongoing process and needs to continue Expenditure reform is also essential, for political and economic reasons: move toward managing for results Expenditure reform is also essential, for political and economic reasons: move toward managing for results Build packages of reform: improvements in the quality of spending and raising tax revenues, at the same time, so as to improve the capabilities of government and create increasing confidence in it Build packages of reform: improvements in the quality of spending and raising tax revenues, at the same time, so as to improve the capabilities of government and create increasing confidence in it Create consciousness and consensus as to the importance of fiscal reform oriented toward greater and better government services, not just balancing the budget Create consciousness and consensus as to the importance of fiscal reform oriented toward greater and better government services, not just balancing the budget Anchor the work in a national institution Anchor the work in a national institution

15 Thank you for your attention