The effect of tax on income inequality and growth in Latin America

UNU-WIDER / Sept 2014
Findings After tax reforms in the 1980s and 1990s, income inequality increased in many Latin American countries

The tax reforms of the 2000s have been more equalizing in terms of income inequality: Argentina, Honduras and Nicaragua have seen the most redistribution of income

Taxation remains unequalizing in about one-third of Latin American countries, especially in Central America

During the 1980s and 1990s, tax reforms in Latin America were primarily focused on economic efficiency, horizontal equity and revenue adequacy. To accomplish these goals, governments tried to widen tax bases by implementing VAT and other domestic consumption taxes and reducing direct personal income taxes.

Overall, these reforms resulted in decreased revenue for governments, slow growth and a general erosion of the tax base by inflation. Many of the Latin American countries were also forced to cut public expenditures on investments and human capital in order to meet debt servicing obligations; the long-term impact on growth and budget deficits of the taxation reform was therefore negative. These reforms contributed to a rise in income inequality over the 1980s and 1990s as tax burdens shifted from the wealthy to the middle and lower classes in many locations.

Tax reforms in Latin America during the 2000s

Tax reforms representing a big shift in fiscal policy took place in Latin America in the 2000s. These reforms were initially prompted by the lack of adequate growth and the failure of previous policies to reduce income inequality. Over time, governments in the region had realized the urgent need to address inequality with revised fiscal policies. The need for ‘fiscal exchange’, in which governments raise taxes and increase the quantity and quality of social services provided, was also promoted.

Family in Colombia. © Scott Wallace / World BankTax reforms during the 2000s came in several forms. First, administrative reforms attempted to decrease the cost of tax collection and reduce tax evasion. Second, changes in tax policies introduced direct progressive income taxation in some countries and reduced exemptions and reductions. Presumptive taxes – taxes based on estimates conducted by tax authorities rather than on income declared by the tax payer – and so called ‘surrogate’ taxes on financial transactions were also introduced in some countries, including Brazil. No major changes were implemented to VAT or trade taxes, but some governments did introduce other indirect taxes to increase revenue, such as Ecuador, where a tax on luxury items was introduced in 2008.
As a result of policy modifications, many countries marked notable increases in tax/GDP ratios during this decade. In fact, the increases in Latin America were the fastest of all developing regions. Specifically, Argentina, Brazil, Bolivia and Nicaragua reached levels of taxation near those of the USA and Japan by the mid-late 2000s; increases were also considerable in Colombia and the Dominican Republic. In other countries, such as Guatemala, Paraguay, Venezuela, El Salvador and Panama, the rate of increase was below the regional average; in Mexico, the rate dropped.

In addition to policy reforms, the external environment was also favourable during the 2000s. With the price and demand of commodities rising, both tax and non-tax fiscal resources grew in a number of Latin American countries. Oil- and gas-rich countries such as Bolivia and Ecuador reported significantly large increases in revenue.

A Metrobus system bus, part of the new mass transportation system in Panama City, Panama. © Gerardo Pesantez / World Bank

The impact of fiscal reform

In terms of growth, Latin America experienced increases in public investments, investment in infrastructure, education and health and an overall improvement in fiscal balances after fiscal policy modifications in the 2000s.

While taxation had a negligible effect on income inequality in previous decades, reforms focusing on direct taxes and excises in the 2000s contributed to the redistribution of some income, with the largest improvements witnessed in Argentina, Honduras and Nicaragua. The redistributive effect of income was also positive in the Southern Cone countries of Brazil, Chile and Uruguay. Overall, however, taxation was unequalizing in approximately one-third of Latin American countries, especially in Central America.

Moving forward

While tax reforms of the 2000s have certainly been beneficial in most cases, there is still room for improvement. In the future, a concerted effort must be made to raise tax/GDP ratios to international standards in order for Latin American governments to generate greater revenues. There must also be a greater balance between direct and indirect taxes, with more emphasis placed on the direct progressive personal income and wealth taxes which make a tax system more equitable. Additionally, initiatives must be undertaken to reduce tax evasion and increase tax compliance. Finally, in order to increase citizens’ willingness to pay taxes, the ‘fiscal exchange’ must be stressed to a larger extent to reinforce the link between taxation and the improved provision of public goods for all social classes.

There must be a greater balance between direct and indirect taxes, with more emphasis placed on progressive personal income and wealth taxes

Initiatives must be undertaken to reduce tax evasion and increase tax compliance

The link between taxation and the improved provision of public goods for all social classes should be emphasized

This Research Brief is based on WIDER Working Paper 2011/70 'A New fiscal pact, tax policy changes and income inequality: Latin America during the last decade’, by Giovanni Andrea Cornia, Juan Carlos Gómez-Sabaini, and Bruno Martorano.