How Taxes Can Support Growth and Reduce Inequality in Latin America and the Caribbean

IMF News, December 14, 2021

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Public debt ratios in Latin America and the Caribbean (LAC) increased by about 10 percentage points of GDP in 2020.
Rising debt service costs are creating pressure to cut public spending and/or raise taxes while pandemic-related needs persist.
The IMF Regional Economic Outlook finds that well-crafted tax reforms can support growth, maintain fiscal sustainability, and help reduce income inequality.

LAC countries raise 13 percentage points of GDP less in tax revenue than the average OECD country, a gap that remains even after controlling for GDP per capita levels.
Main tax revenue sources and patterns:
- Value-added tax (VAT) is the main tax revenue source in LAC and is broadly aligned with the region’s level of development and comparable to OECD countries (except for Mexico), though there is room for improvement.
- Corporate income tax (CIT) revenues share in the region is higher than in OECD countries and above what income levels would predict; heavy reliance on corporate taxes can discourage investment.
- Personal income tax (PIT) revenues share is low in the region, although reforms in Mexico and Uruguay show promising results.

Design flaws in PIT across the region include low statutory rates, excessively high income thresholds, and widespread and regressive deductions that tend to benefit the rich.
Comparisons:
- In the five largest LAC economies (LA5)—Brazil, Chile, Colombia, Mexico and Peru—a worker would have to earn 10 times the country’s GDP per capita to pay the maximum statutory rate for personal income taxes.
- In an OECD country, that same worker needs to earn an income of just 3.5 times the country’s GDP per capita to face the maximum PIT rate, which is on average significantly higher than that of LAC countries.
Reform effects:
- Leaving other parameters unchanged, if personal income tax deductions were eliminated (stripping the PIT system down to its statutory rates), the average LA5 country would see a twofold increase in PIT revenues, by raising the effective rate faced by the top 10 percent of wage earners.
- Eliminating regressive deductions would increase revenue and make taxation more progressive without levying additional taxes on low- or middle-income formal workers.

Provide well-targeted incentives to low-wage earners, for example an earned-income tax credit (EITC), to:
- Encourage labor market participation.
- Help reduce the gender gap.
- Incentivize labor formalization by partially compensating social security contributions, thereby improving revenue collection.

CIT recommendations:
- Aligning CIT rates could help attract investment and alleviate profit shifting.
- Reducing tax benefits and deductions could level the playing field.
- Ongoing global corporate income tax reforms are an important opportunity to revisit corporate taxation in LAC.
VAT recommendations to address equity and base erosion:
- Tackle reduced rates and exemptions.
- Combine VAT adjustments with well-targeted transfers that encourage electronic payment use (example cited: the social card program in Uruguay).
- Tax the digital economy with the VAT the same way as other sectors to avoid tax base erosion.

Public support is essential for implementing tax reforms; low public confidence that taxes are well spent necessitates accompanying improvements in:
- The quality and composition of public expenditure.
- Overall fairness of fiscal policy.
Timing considerations:
- Continue supporting livelihoods until the pandemic is brought under control to secure a robust recovery.
- Countries with tighter fiscal space may need to reform tax systems earlier to boost confidence in medium-term fiscal frameworks.

"increased by about 10 percentage points of GDP in 2020"
"raise 13 percentage points of GDP less in tax revenue than the average OECD country"
LA5 = Brazil, Chile, Colombia, Mexico and Peru
"would have to earn 10 times the country’s GDP per capita to pay the maximum statutory rate for personal income taxes" (LA5)
"needs to earn an income of just 3.5 times the country’s GDP per capita to face the maximum PIT rate" (OECD comparison)
"twofold increase in PIT revenues" (average LA5 if deductions eliminated)
"top 10 percent of wage earners"

Santiago Acosta Ormaechea and Samuel Pienknagura Loor, Western Hemisphere Department, December 14, 2021.