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Tax Policy Can Help Spur Economic Growth

National Congress building in Brasilia, Brazil. Policymakers from across Latin America convened to discuss growth-friendly taxation policy and administration (photo: Paulo Fridman/Corbis)

Fiscal Policy & Economic Growth

Tax Policy Can Help Spur Economic Growth

IMF Survey online

November 19, 2012

  • Well-designed tax policy improves prospects for economic growth
  • Strong tax collection systems help raise revenue for governments
  • Growth-friendly objectives must be balanced with improved distribution of income

Taxation plays an important role in promoting economic growth: it generates the revenue needed to finance governments’ economic development policies and creates a framework for development of private sector activities.

However, growth objectives must be balanced with those to promote an improved distribution of income, a regional tax conference heard in Brasilia, Brazil.

Most Latin American economies continue to perform well, despite many economic uncertainties elsewhere in the world. Yet across Latin America, policymakers continue to work to find ways to boost economic growth.

One way for governments to help grow their sluggish economies is by improving their tax systems, according to the IMF and other international organizations gathered in Brasilia to discuss the role taxation plays in promoting economic growth.

Topping the conference agenda was the impact of tax policy and administration on the development of private sector activities and providing resources needed to boost economic development. The potential impact of tax policy and administration on reducing inequality—so far discussed to a much lesser extent throughout the region—also drew attention.

Taxation of natural resources and of financial institutions also generated debate at the conference, where it was agreed more discussion and sharing of experiences were needed across the region in these two areas.

Organized by the Inter-American Center of Tax Administrations, the Receita Federal do Brasil (Brazil’s federal revenue agency) and the IMF, the conference brought together policymakers and tax administration officials from across Latin America, and featured presentations by representatives from countries across the region, including Argentina, Brazil, Bolivia, Costa Rica, El Salvador, Mexico, Paraguay, and Uruguay.

Stable revenue base needed

Improved government balance sheets, lower external debt, and higher international reserves have helped Latin American economies remain resilient in the face of a global economic slowdown.

Yet with global risks and uncertainty persisting into the foreseeable future, strengthening taxation and public spending frameworks could offer an opportunity for emerging market economies across the region to secure government revenues while at the same time boosting economic growth.

“Strengthening fiscal frameworks requires building stronger and more reliable revenue bases,” said IMF Deputy Managing Director Naoyuki Shinohara, who delivered opening remarks at the conference. “This is necessary to help countries weather global shocks—and limit income volatility that comes with increased commodity dependence—but also sustain growth over the medium term. A stronger revenue base would provide a more stable source of income to finance much needed public investment in the region. Better designed tax structures could encourage growth while promoting equity.”

Focusing on the structure of the tax system, Gilbert Terrier, deputy head of the IMF’s Fiscal Affairs Department, emphasized that a key challenge in the region will be to increase the revenue productivity and structure of the personal income tax so that it can contribute to growth-enhancing public expenditure while helping attain distributional goals.

Continued efforts toward improving the effectiveness of tax administration in the region would help bolster tax revenues, the IMF said. Countries in the region with relatively more effective tax administrations also have the best tax revenue performance.

Natural resource revenues

Across Latin America, many countries boast substantial natural resources that generate significant revenues for both the private sector and governments.

While there are certainly many benefits associated with mineral and natural resource wealth, the IMF said countries face a number of challenges in managing the tax revenues associated with the sale of these commodities. Some countries in the region may be vulnerable to sharp reversals in commodity prices, if they have not saved enough of the commodity windfall. Others may lack effective administration systems to collect taxes and royalties, or require stronger institutions to make good quality public investments.

Saul Lizondo, Associate Director in the IMF’s Western Hemisphere Department, cautioned that the volatile nature of commodity prices can also be problematic, because it tends to lead to volatility in natural resource revenue. This often means that volatility of government expenditure delivering needed services is higher in resource-rich countries.

Still, Victoria Perry, chief of tax policy in the IMF’s Fiscal Affairs Department, suggested that there are ways to address these gaps in policy frameworks. Chief among these is to ensure the taxation of nonrenewable natural resources captures the gains from this sector effectively, while encouraging needed investment in these vital sectors. A robust framework for natural resource taxation needs to reflect each country’s circumstances, but would ideally combine a royalty on gross revenue, a tax targeted explicitly on rents (and thus on the achieved results of extraction), and a standard corporate income tax.

Taxing the financial sector

Financial sectors across many Latin American countries have weathered the global economic downturn and sluggish recovery with marked resilience. But as policymakers across the region look for ways to improve financial sector regulation and taxation, the IMF cautioned that they must consider the special nature of the financial sector when designing taxation policies.

Given the mobile nature of financial services, tax systems must be designed appropriately so as to not induce capital flight to jurisdictions with more favorable tax treatment. One concern in Latin America relates to “bank transaction taxes”—which are levied on different types of banking transactions such as cash deposits or withdrawals—that have been introduced in many countries. While easy to administer and generating short-term tax revenue, they may lead to distortions in economies including a reluctance on the part of financial institutions to fulfill their traditional roles as financial intermediaries.

Policymakers need to also be aware of the potential economic impact of taxes on financial activity. In this regard, a well designed bank tax would help ensure that the financial sector pays for direct support in future financial crises. Such a tax could also dampen potential damage economies face from future banking crises, while also addressing existing tax distortions, such as the bias in favor of debt financing.

In its report to the Group of Twenty advanced and emerging market economies on financial sector taxation, the IMF proposed a Financial Activities Tax (FAT), which is a type of value-added tax for the financial sector. The rationale for the FAT is twofold: to raise revenue from the financial sector while also reducing the economic distortions associated with taxation of this sector.