Dominican Republic

1. Dominican Republic Victor A. Canto

2. Qualityof the Data • Available data is fairly limited and so is the quality • According to the data, during the late 1980’s the DR inflation was higher than the current levels. • My best guess is that the data is wrong and it overestimated the DR inflation rate • But that is not all, given the Central Bank estimation methodology; an overestimation of the Inflation rate requires an underestimation of the real per capita income of the country. • If we are right the inflation rate and the decline in real GDP were not as bad as the data shows. • Another implication is that the gains made during the early 1990’s were overestimated also. • The data is of very poor quality and all one can make is some generalizations regarding the overall picture. • One that I like to make is that the per capita income in constant US dollar only increased 33% during the period and from 1975-1995 there was no net gain in real per capita income. • To put this numbers in perspective, during the same time period the US per capita income in constant dollars increased better than 130%

3. Peso Depreciation • Reasons for depreciation are numerous and will be discussed later on • Point we want to make is that the data suggests that the exchange rate regime changed during the early 1990’s • There is a clear brake in the data and it covers all three administrations

4. Incidence and burden of Adjustment • Lest consider the following numerical example: A Dominican Product sold in the world market for $100 of which labor gets $60 as compensation and capital gets $40. • Next lets consider what happens when the government imposes a 10% Export/ITBS on the product • The first question an economist asks is will the producer be able to shift the tax forward to the consumer or backward to the suppliers? • The technical answer is that it depends on the demand and supply elasticity’s

5. Consumer Demand Elasticity • If the product is something that is sold in the international market and the DR has no monopoly power it will be quite hard to argue that we will be able to shift the tax to the consumers. • Tourist and Maquialdoras can easily go elsewhere if we increase their prices. • In technical terms the demand is very elastic and the tax cannot be shifted forward to the foreign consumers • Proposition 1 The bulk of the export and tourism taxes will not be paid by foreigners, the will be paid by the domestic factors of production.

6. Supply Elasticity: Capital • In or example the 10% export/ITBS tax will have to be absorbed by domestic factors. • That means there is only $90 to pay labor and capital. • The question is who will pay the tax in the form of lower return. • Again how the tax is shifted backwards depends on the supply elasticity’s. • If capital is perfectly mobile, it will go where the risk adjusted returns are the highest • The returns to capital will never be lower than the rest of the world. • Proposition 2: A mobile capital will not suffer the burden of taxation. Alternatively stated the burden of taxation cannot be shifted backwards to the owners of capital

7. Supply Elasticity : Labor • The process of elimination tells us that the burden of taxation fall on labor • The $10 tax collection will reduce the labor’s payment to $50 in our example • Proposition 3: The burden of all taxes will always fall on the immobile factors of production • The nature of the tax imposed does not matter , the fixed factor always pays. • All the nature of the tax determines is the collection mechanism, not who pays.

8. Mobility and Elasticity: Generalizations • The description of the mobile factor as capital and the fixed factor as fixed is a simplification. • While capital is certainly mobile, so are high skilled workers or people that for luck or family affiliations are able to freely leave the country. Mobile factors are part of the dollar economy. • In contrast land is clearly a fixed factor that is not able to leave the country. Immobile factors are part of the peso economy. • We make the distinction between these two factors and generalize it to economic sectors. Tourism, maquiladoras and nontraditional exports are part of the dollar economy. Domestic services are part of the peso economy

9. The great divide between the peso and dollar economies • The incidence of the government polices will cause the decline of the peso sector relative to the dollarized sector of the economy • One way to measure this is by looking at the loss of purchasing power in relation to the US dollar. (i.e. the peso depreciation less the increase in the cost of living index) • Even though the data is not reliable . Form 1990 on there has been a major and almost steady deterioration in standard of living of the peso economy. • We have a simple explanation for the great divide between the two sectors

10. Economic Horizons • The value of a dollar worth of income in perpetuity is nothing more than the inverse of the discount rate • That figure also tells us how many years worth of income are we willing to pay upfront for that income stream. We call that the investment horizon. • For the dollar part of the economy the relevant interest rate is the 10 year us government bond • For the peso part of the economy the relevant is the active interest rate charged by commercial banks in DR • The story is evident the dollar sector is willing to be patient while the peso sector is not • At current rates the peso sector must recoup its investment in less than 3years while the dollar sector is willing to wait 20 to 25 years

11. Government Revenues and Expenditures • Spending increased dramatically in the 1990’s • The greater the spending the greater: • The pressure on tax increases • The greater the negative impact on the peso sector of the economy • The greater the great divide between the peso and dollar sectors • Remember that the impact is greater than the spending increase because of government exemption of taxes increases the effective tax rate • An additional negative effect that uneven taxation leads to corruption avoidance and evasion

12. Tax Collections • The increased government expenditures created the need for higher tax revenues . • The ITBS was a new tax created to satisfy the need for additional revenues. Hence the collections amount to a net increase the divide between the peso and dollar economies. • Revenues collected on taxes on goods and services increased as percent of PBI during this time. Since these taxes are usually proportional, the higher revenues imply that either new taxes or more “effective” enforcement of existing laws. Either way the higher tax revenues meant a higher level of distortions. • The data shows that the pressure on the corporate and personal income tax began around 1994-96. This is interesting for under a progressive tax system when an economy grows one would expect to see revenues collection increase faster than the growth rte. The fact that they did not means that either we did not have the growth reported .or there were too many leakages due to exemptions etc.