The agreement, which will be carried out over a period of 10 years, marks a major advance in consolidating the integration of the Andean Community. Formally titled “The Harmonization of Indirect Taxes,” the accord will contribute to more trade, greater legal stability and uniformity in the investment climate, as well as enhanced tax collections.

“These resolutions were a real breakthrough,” says Luiz Villela, a tax expert who was among the IDB advisors who, jointly with the Andean Community Secretariat, assisted the negotiations prior to the agreement, which was adopted by Bolivia, Colombia, Ecuador, Peru and Venezuela.

“There is only one other trade bloc in the world that has a unified VAT system, and that’s the European Union,” said Villela. “It took Europe 15 years to establish a common system,” he added. “When you consider that the VAT accounts for 50 percent of the tax revenue of the Andean countries, and that this may increase as tariff duties are phased out under trade agreements, you can understand the importance of this achievement,” he said.

Years of negotiations. The new agreement, adopted in 2004, is the result of years of negotiations by the Andean Community, which in 1999 named harmonization of the VAT tax as a priority. The IDB participated in the process by furnishing technical assistance and a baseline study. The Bank acted as an “honest broker,” helping to guide the agenda of nine meetings held over two and a half years that provided a framework to reach a consensus.

“A harmonized system does not mean that the tax will be equal in all countries,” says Villela. “It means that the national systems among the Andean countries will be compatible with one another, so that no country has an unfair advantage.”

The VAT system, though complex, has for decades been a preferred system of revenue raising in Europe and Latin America. The VAT is different from a U.S. sales tax, which is applied to the point of final sale of a product. The VAT is applied to each stage of the production process of the product. Under the VAT system a merchant or supplier typically saves receipts and gets a rebate on intermediary sales taxes. He or she must pay the VAT tax only on the amount of value added after they sell a product.

“Let’s say you are a tailor, and you have to buy cloth, thread and buttons to make a coat, which you sell,” explains Alberto Barreix, an IDB tax expert. “Let’s say the VAT tax rate is 19 percent. When the tailor buys the cloth, thread and buttons, he pays a VAT tax of 19 percent on each of those items. He saves the receipts. He sells the coat as the final product, for which the customer pays the 19 percent VAT tax. The tailor will get a rebate on the VAT tax he has already paid when buying the cloth, thread and buttons.”

Investors will find the Andean Community as a whole a more attractive place to do business because key parts of the tax system will be similar in all of the countries, and there will be less likelihood of changes, Barreix says.

How did five countries with diverse populations, geography, and political histories reach agreement on a sensitive issue like taxation?

According to Villela and Barreix, it took patience, persistence, and involvement on the part of both the political leadership and the professional tax administrators to forge a consensus. Typically, the policymaking arm of the government was represented during negotiations by a vice minister for tax policy, while technical expertise was provided by other senior tax officials.

Rules were set so that the negotiations could not backtrack once issues were resolved from one meeting to another, thereby preventing interminable delays.

Many tax exemptions were eliminated, but not all. Educational services, the financial system, medical services and public transportation can be excluded from the Andean VAT.

“Nevertheless, there are fewer exemptions in the Andean Community than in Europe,” says Barreix. In fact, he says, the Andean Community VAT agreement could be a model for tax integration of other subregional blocs, such as the Central American Common Market and Mercosur.

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