1 Distributional Impact of VAT Reform in the Dominican Republic By Anna Fruttero and Omar Arias LCSPP Frontiers in Practice Reducing Poverty Through Better Diagnosis Analyzing Fiscal Impacts on Poverty Reduction March 23, 2006

2  PSIA request from DR Gov in support of fiscal reform process (tax loss due to CAFTA, financing of social spending gaps)  Developed as part of the 2005 PA in collaboration with the Technical Secretariat of the Presidency Background

3 Why interest in VAT (ITBIS) reform analysis ? VAT is not fully exploited (exemptions), Other taxes (income, property) harder Public opinion Regressivity bias: Need to assess distributional impact

4 DR tax effort has increased but is still around LAC average and below similar countries % taxes in GDP Source: World Development Indicators and OECD

5 DR still relies heavily on trade taxes (though less so in recent years) % total revenues circa 2000 Regional averages Source: Based on Government Finance Statistics 2004, IMF and OECD

6 VAT revenues are particularly low % total revenues Source: Based on Government Finance Statistics, IMF

7 …Largely a result of low and declining productivity of the tax (loopholes, evasion) VAT RateVAT productivity Source: Government Finance Statistics, International Finance Statistics and World Economic Outlook (IMF)

8 VAT is a means to tax the well off 20% poorest 20% richest Source: authors’ calculations based on ENCOVI 2004 Sources of income:

9 Exempt G&S Non exempt G&S Source: authors’ calculations based on ENCOVI 2004 Distribution of expenditures by quintiles (%) The rich account for more than half of consumption of exempt goods & services

10  Exemptions of G&S from VAT implicitly subsidize the consumption of the rich at a significant revenue loss  Increasing revenues from this tax should come from expanding the tax base with due equity considerations

11  Remove all exemptions (benchmark)  Remove all exemptions except for Health, Education and Electricity (SEE)  Remove all exemptions except for basic food + SEE  Apply a lower rate to basic food, SEE exempt Options to expand the VAT tax base

12  Tax burden= % total tax paid by each Q  Tax pressure= tax burden/income share of each Q  Effective tax rate= total tax paid/total income by Q  By simulating the VAT code with data on incomes and expenditures from a 2004 household survey (no behavioral responses) To assess distributional impacts for each scenario we compute:

13 All options to broaden the base increase the tax pressure for the poor but this remains much lower than for the rich SEE = Health, education and electricity Source: authors’ calculations based on ENCOVI 2004 Ratio of share of tax paid to income share

14 Revenues could increase substantially even exempting basic food and SEE, or with a differential tax rate Note: estimates do not account for behavioral responses and only capture private consumption of households, but account for tax avoidance by small firms SEE = Health, education and electricity. Source: authors’ calculations based on ENCOVI 2004

15 1. Main results were derived under the assumption that consumption patterns are not affected by changes in prices …  Sensitivity analysis using various plausible values of price elasticities indicate tight orders of magnitude of the results Two BIG caveats

16 2. Distributional impact of fiscal reform depends on how spending is distributed…  Less than one third of social assistance $$ reach the poorest 40 percent (helicopter allocation is better).  Only the high-revenue reforms can generate transfers significantly higher than the extra tax burden on the poorest 40% under existing expenditure allocations. Two BIG caveats

17 Policy implications  DR has room to increase IVA revenues without too high a cost on equity, by expanding the base while maintaining exemptions on (or applying a different rate to) basic food  To maximize overall equity impacts it is critical to simultaneously improve targeting of social expenditures  Although these results were effectively used by the DR Government in the public debate, lack of power in congress led to a 1 st phase curtailed reform (maintaining many exemptions).