Political Economy of tax reforms in colombia

1. Political Economy of tax reforms in colombia Natalia Salazar Fedesarrollo The Political Economy of Tax Reform in Latin America Wilson Center Washington, December 2012

2. Main political actors since the 1991 Constitution • The President: • The main agenda setter, however the 1991 Constitution limited his powers • The Congress: • Proliferation of political parties (electoral rules and State funding to campaigns), high political fragmentation and low party discipline • More independent from the Executive (elimination of auxiliosparlamentariosand recovery of public spending initiative) • Congressmen more responsive individually to particular private sector interests • The Constitutional Court: • The Constitution strengthened the process of constitutional revision and the Court has veto power • The 1991 Constitution expanded guarantees, promoting judicial activism (Cárdenas et al., 2008, Cárdenas and Pachón 2010, Olivera et al., 2010, Clavijo, 2001).

3. Fragmentation of Congress indicator* 2003 Political Reform Ley de Bancadas *Measured as the probability that two deputies picked at random from the legislature will be of different parties. Source: Keefer (2010), Political Institutions Database, World Bank.

4. Main political actors since 1991 Constitution • The private sector: • Large firms, business groups and business associationsare important players in the policy making processfor several reasons:i) their relevance in output and employment, ii) their importance as financing source of political campaigns, and iii) their influence on public opinion through their control of media • Private sector lobbying increasingly fragmentedas a result of economic diversification. Their influence in policy making became also increasingly widespread • Given the reduced Government intervention on economic matters, the private sector reacted through a diversification of lobbying efforts between the Executive and Congress Eslava and Meléndez, 2009, Olivera et al., 2010,.

5. Central Government spending (% of GDP) Reforms to increase control on public spending • Constitutional amendments to change regional transfers rule (2001 and 2007) • New pension system and three pension reforms • Fiscal Responsibility Law (Ley 819/2003): MFMP • 2010 Fiscal Rule law • The royalties reform • Introduction of the fiscal sustainability principle in the Constitution 1991’s Constitution Law 819 - MFMP Growth 1991-2003=7.9p Growth 1981-1990=-0.3p

6. Tax reforms in Colombia 1980-2011

7. 1991 – 2005 period • 7 tax reforms were approved (one every 2 years). • The main purpose of all initiatives was to increase tax revenue to cope with strong increase in public spending • Tax revenue increased in 5p of GDP in that period but remains low in relation to public spending levels and also compared vis-a-visother countries • A complex, inefficient, inequitable and non-progressive tax system was the result of the interaction between revenue needs and the political game • Numerous special tax treatments (deductions, exemptions, exclusions, discounts) in corporate and personal income tax and VAT • Distortionary taxes are an important source of revenues (wealth tax, financial taxation tax and payroll taxes) and compensate low productivity in income tax and VAT Olivera et al., 2010

8. Tax revenue is about half of the OECD average and below the LAC average Source: OECD

9. PIT: low productivity and little progressive impact PIT as a % of gross income Source: OECD(2010) and Ministerio de Hacienda (2012)

10. 1991-2005 period: political economy constraints • Lower powers of President, high political fragmentation, greater autonomy of Congress and lack of political discipline made difficult for the Government to build coalitions and gain support to tax initiatives • Obtaining additional revenues in the presence of a high political fragmentation and incentives to defend particular interests in Congress, required the protection of existent tax benefits and/or the extension of new special tax treatments • Likewise, to protect middle and low-income classes (also important from an electoral point of view) and to defend the tax system from proposals (wrongly perceived) as regressive (for example, VAT on basic necessities), Congress ended up by accepting new taxes with a high distortionary impact.

11. 2006 – 2012 period: • 4 tax approved reforms + 1 reform in discussion in Congress (one reform every 15 months) • The drivers of these reforms have not been exclusively the increase in tax revenues. Almost all reforms contain elements that aim at restoring simplicity, efficiency and/or progressivity to the tax system • But the introduction of these structural changes have been gradual • Structural reform attempts have failed as a result of strong political constraints

12. Failed structural reform attempt: 2006

13. Too many opponents • Congress • (Wrong) perception about regressive impact of VAT proposals, reduction in tax rate and elimination of FTT • Defense of private sector particular interests • Private sector (the Ministry received 200 letters and more than 500 requests) • Members of the Government Based on Fedesarrollo (2006) and Olivera (2010)

14. Second failed attempt: 2012 • The opposition (based on a non official draft) began before the Government socialized the reform. The bill was not submitted to Congress • The Government announced it as an integral tax reform • New Tax Code (with a name: Elissa) • Introduction of IMAN • Reduction in income tax rate (to 27%) • VAT on basic necessities? • Reduction in the number of VAT rates and income tax credits • Introduction of a dividend tax • Fiscally neutral • Prediction? the reform would have face an important number of losers who would oppose it • Interesting element: the IMAN

15. The current tax reform proposal (approved in first debate) • Cuts payroll taxes in 13.5 pp (from 29.5% to 16% of wages), by reducing employers contributions to health system, SENA and ICBF • Cuts income tax rate for companies to 25% (from 33%) and introduces a new “equity tax” of 8% on profits (CREE). CREE income will compensate for the lower revenues from payroll taxes • Proposes a progressive personal income tax schedule, with a minimum tax in order to limit deductions and exemptions (IMAN). People with incomes below COP$3.3 millions (US$1.800) will not pay income tax • The reform reduces the number of VAT rates to 3 (0%, 5% and 16%)

16. Political management reduces the political constraints • Limiting the scope of the reform: it is concentrated on improvements on income tax structure (although it does not deal with all problems). No measures oriented at broadening the VAT taxable base • By selecting a group of “losers” and at the same time gaining the support of other groups: the private sector backs the reform (mainly large companies with low employment generation will pay the CREE). Congress (and society) support improvements in labor market and income distribution • Avoiding individual negotiations: the IMAN neutralizes opposition of individual private interests. It does not eliminate exemptions and deductions, but puts a limit on them. Discussions with Congress are focused on the threshold at which people begin to pay taxes (to minimize the impact on middle class)

17. And the Constitutional Court? • The inclusion of basic necessities in VAT’s taxable base has had an enormous political opposition • In 2002, after difficult discussions, the Congress approved the government’s proposal of a VAT rate of 2% on these goods. But considering its impact on the vital minimum income,the Constitutional Court ruled this reform as unconstitutional. • The Court left opened the possibility of taxing basic necessities as long as the Government creates a scheme to back to poor households paid taxes. Because of informality (in retail sector) the design of such a scheme has not been an easy task

18. The road ahead • Dividend distribution tax • Free Trade Zones • Broadening VAT taxable base (efficiency elements – capital goods)