From issue: Social Inclusion (Spring 2012)
The Next Step in Improving Equity: Tax Reform
To continue improving economic equality, governments have to address their progressive and ineffective tax systems.
In the last decade, inequality has decreased in the majority of countries in Latin America. This historic shift was largely the result of unprecedented, steady economic growth and increased public spending that targeted the most vulnerable populations—mainly through conditional cash transfer programs.
Nevertheless, income inequality is still unacceptably high. With a Gini coefficient of 0.52, Latin America and the Caribbean remains the most unequal region in the world. The average income of the wealthiest quintile is 14.5 times higher than the poorest—a ratio greater than that of other developing regions, such as Sub-Saharan Africa (9.1), East Asia and Pacific (7.7), Middle East and North Africa (6.4), and South Asia (6.1).
The differences are even starker when measured by decile—indicating the concentration of wealth in the highest economic strata. In Latin America the richest decile exceeds 27.9 times the income of the poorest decile, a concentration that is almost double Sub-Saharan Africa, the region with the next greatest concentration of income, whose ratio is 15.6 times.
Addressing the region’s endemic inequality and its features, though, is going to require tackling distortions of state fiscal policy; in particular, it will mean addressing how tax policy could play a more important role in the redistribution of income.
Fiscal policy can influence the redistribution of income and equity through social spending or through tax policy. When analyzing the impact of tax policy on inequality, both the level and structure of the tax system are relevant. Not every tax policy affects income inequality or equity the same way.
Direct taxes—if structured progressively—tend to have a positive impact on the redistribution of income. In contrast, indirect taxes such as value-added taxes (VAT) tend to be neutral or negative. However, within the category of direct taxes, personal income tax typically has a more salutary effect on redistribution than corporate income tax, because corporations often transfer the tax burden to consumers through the prices of the goods or services. Moreover, when analyzing the equity impact, it is important to distinguish between horizontal equity (equal treatment to those who are in similar circumstances) and vertical equity (up and down the income line).
Historically, fiscal policy in Latin America has had a relatively low impact on income redistribution. For example, compared to the European Union (EU), Latin American tax policy has only a minimal effect on reducing inequality. In EU countries, after considering all fiscal adjustments, the Gini coefficient (0.46) decreases by 0.12 points; in contrast, Latin America’s Gini coefficient (0.52) decreases by a mere 0.01 points after fiscal adjustments.1
Figure 1 compares the individual and combined effects of taxation and public transfers on inequality in Latin America and the EU. When analyzing the impact of social spending and of the tax system separately, a higher impact of social spending is observed in the EU than in Latin America. But also, the impact of the tax system, mainly through direct taxes, is much higher. The impact of indirect taxes is regressive in both regions.
The bleak conclusion is that current tax systems are failing to achieve their full potential in addressing severe socioeconomic gaps. The reasons are clear: a narrow and volatile tax base, an unbalanced tax structure with very little emphasis on direct taxes, and low levels of tax compliance are the region’s biggest impediments to forming equitable and robust tax policies.
The Rich in Latin America Can Bear Higher Burdens
Latin America has the second lowest tax burden in the world, after the developing countries of Asia. When compared to more developed regions, the average tax burden in Latin America (18.4 percent of GDP) is nearly half the average in OECD countries (34.8 percent of GDP) and the EU (39.2 percent of GDP). [SEE FIGURE 2]
Within the region, however, there are profound differences. Brazil, Argentina and Uruguay have tax burdens closer to the levels of developed regions, representing more than 25 percent of GDP. In most countries of the region, though, national levels remain below 20 percent of GDP. In extreme cases such as Mexico and Guatemala, the tax burden dips to about 11 percent.
These differences among countries are not only due to political legacies, macroeconomic circumstances, past tax patterns, or recent reforms. They also are rooted in differences in the origin of other fiscal revenues, such as the exploitation of nonrenewable resources.
Those revenues, often in countries with a high level of dependence on the production and trade of commodities, represent a high proportion of total revenues. And they often reduce the need for taxing other sources, such as income or capital gains. For example, in Bolivia (natural gas), Ecuador (oil), Mexico (oil), and Venezuela (oil) fiscal revenues from commodities represent over 8 percent of GDP and around 30 percent of total revenues.
But fiscal revenues derived from the exploitation of natural resources are highly volatile. And dependence on such resources has made fiscal revenue streams in Latin America much more bipolar than in other regions. Tax revenue volatility, measured by the standard deviation, is three times higher in Latin America (12.3) than in developed countries (4.5).2 This high volatility reduces fiscal space and hinders governments from addressing social expenditure and public investment…
1. The study of Goñi, López and Servén (2011) includes six countries of Latin America: Argentina, Brazil, Chile, Colombia, Mexico and Peru. See Goñi, E., H. López and L. Servén, "Fiscal Redistribution and Income Inequality in Latin America," World Development 39(9) (2011): 1558-1569.
2. Jiménez, J.P. and O. Kacef, “Volatilidad macroeconómica, espacio fiscal y gobernanza”, in Bárcena, A. and O. Kacef, eds., La política fiscal para el afianzamiento de las democracias en América Latina: Reflexiones a partir de una serie de estudios de caso (Santiago de Chile: CEPAL, 2011).
3. Argentina, Brazil, Chile, Colombia, Guatemala, Mexico and Peru. See Villela, L., A. Lemgruber and M. Jorrat (2009), "Los presupuestos de gastos tributarios. Conceptos y desafíos de implementación", Working Document, No. IDB-WP-131, Inter-American Development Bank, December.
4. Gómez Sabaíni, J.C., J. P. Jiménez and A. Podestá, “Tributación, evasión y equidad en América Latina,” in Jiménez, J.P., J. C. Gómez Sabaíni and A. Podestá (Eds.), Evasión y equidad en América Latina (Santiago de Chile: CEPAL, 2010).
5. Christie, E. and M. Holzner, “What Explains Tax Evasion? An Empirical Assessment based on European Data”, wiiw Working Papers 40, (Vienna: The Vienna Institute for International Economic Studies, 2006).
6. Organisation for Economic Cooperation and Development, Latin American Economic Outlook 2011: How Middle Class is Latin America? (OECD Publishing, 2010).