Simulation tax policy reforms and fiscal gains in the Andean Region

Background

Tax collection in the Andean region low compared with other countries in Latin America and with developed economies (OECD countries). On average, Andean countries collect 15% of GDP in taxes, while the OECD collects 25%, excluding contributions to social security. These differences can be partially explained by a lower collection of Personal Income Tax (PIT), due to high levels of informality, generosity of thresholds due to tax exemptions and available deductions, among others.
Description
The overall aim of the project is to assess the budgetary and distributional effects of tax policy reforms in Bolivia, Colombia, Ecuador, Peru and Venezuela. More precisely, the project is comprised of three interlinked research blocks.

1. Personal income tax reforms and its budgetary and distributional effects
   The aim of the first research block is to provide evidence on the fiscal gains and distributional effects of applying the structure of personal income tax from advanced economies (Spain and Italy) and other LAC countries (Uruguay) in Bolivia, Colombia, Ecuador, Peru and Venezuela.
   The analysis presents before-and-after-reform comparisons of tax revenue indicators such as marginal/average income tax, total net tax revenue (sum of income tax plus employee social insurance contributions minus cash transfers), number of tax payers, size of the tax base; as well as income distribution indicators such as the Gini coefficient. Additionally, disaggregated results are presented by relevant socio-economic groups such as income deciles, and social stratum with the following categories as defined by the Inter-American Development Bank: poor, vulnerable middle class, consolidated middle class, and rich.
2. Financial incentives to formal work
   The aim of the second research block is to assess the financial cost that informal workers would incur in the event of entering formality in Colombia, Ecuador and Peru, with informality defined as non-affiliation to social security, and to analyse the budgetary and distributional effects of incorporating a fraction of informal workers into formality.
   The analysis follows recent studies using microsimulation techniques to quantify the cost that informal workers would incur in the event of entering formality. More precisely, the approach consists of moving informal workers in household survey data into formal employment, by means of tax-benefit microsimulation, and comparing their household disposable income before and after the transition. Indicators of formalization tax rates are calculated, which capture the proportion of earnings taxed away as a result of social insurance contributions and tax payments or benefit withdrawal upon entry to formal employment.
   The analysis presents results of the distribution of formalization tax rates, the contribution of social insurance contributions, personal income tax and cash transfers to formalization tax rates, and formalization tax rates by relevant socio-economic groups. Moreover, the budgetary and distributional effects of moving a fraction of informal workers into formal employment are presented.
3. Incidence of indirect taxes
   The aim of the third research block is to evaluate the incidence of indirect taxes in Colombia, Ecuador and Peru and to discuss potential reforms to indirect taxes which could lead to an increase in tax revenue.
   The analysis exploits information on expenditures available in household survey data to simulate indirect taxes in Colombia, Ecuador and Peru. The resultscompare the incidence of indirect taxes in each country and discuss differences in the design of indirect taxes in view of exploring potential reforms to increase tax revenue.
   Outputs

Results of the project have appeared in two publications:

• Financial Disincentives to Formal Employment and Tax-Benefit Systems in Latin America
• Simulating Personal Income Tax Reforms and Fiscal Gains in the Andean Region

Additionally, the research findings have been showcased in the book ‘How to Accelerate Economic Growth and Strengthen the Middle Class in Latin America’ published by the Bank and edited by the General Director of the Department of Andean countries, launched at an online event Strategies for Economic and Social Growth After COVID-19