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New IDB book outlines need for tax reforms in Latin America and the Caribbean to further region’s development

The Bank’s flagship study, “More than Revenue: Taxation as a Development Tool,” says governments should renew efforts to modernize their tax systems

Latin America and the Caribbean have made great strides in boosting tax collection in recent years, but they need a new generation of fiscal and tax reform to reduce income inequality, cut evasion, boost productivity, strengthen local governments and preserve the region’s natural resources, according to a new book from the Inter-American Development Bank (IDB).

“More than Revenue: Taxation as a Development Tool,” the latest edition of the IDB’s flagship Development in the Americas series, was launched May 15 at the Woodrow Wilson International Center for Scholars in Washington, D.C. Every year, the IDB conducts an in-depth comparative study of an issue of concern to Latin America and the Caribbean. This year’s edition presents taxation in the region as a missed opportunity.

The study argues that taxation is largely viewed in the region as a means of generating income to pay governments’ bills, rather than as a valuable instrument to achieve important development goals.

“Taxation is one of the unfinished areas of reform left for the region to tackle,” says Ana Corbacho, IDB Sector Economic Advisor and co-editor of the book. “Smart tax policies will help us fight poverty and inequality, diminish the effects of climate change, and improve private sector productivity.”

The book outlines advances made in the region’s tax systems in recent years and proposes tax reforms to advance equitable development.

Countries in the region have strengthened their tax administrations, boosting collection by 2.7 percent of GDP over the past two decades, the fastest rate in the world. However, the region still takes in just 17 percent of GDP in tax revenue, less than it should, given its per capita incomes.

One reason is that the revenue potential of personal income tax, which should be one of the pillars of any tax system, is largely wasted in Latin America. Income tax should be progressive, either directly improving income distribution, or raising funds for public spending that could be redistributive and ultimately help the poor. In Latin American countries this tax generates a mere 1.4 percent of GDP, compared to 8.4 percent in developed countries.

That is in part because only the relatively rich—those with taxable income of at least 6.5 times per capita income—are subject to personal income tax in most countries. In addition, allowable tax deductions are overly generous, and in many countries, capital income is hardly taxed at all. Finally, tax evasion is rampant, consuming half of the potential collection of individual and corporate income tax along with more than one fourth of what VAT should raise.

Existing tax policies stymie the growth of micro, small and medium enterprises (SMEs), contributing to the low productivity that plagues the region. “Tax systems should be modernized to encourage the formation of larger, more productive companies in the formal economy,” says Santiago Levy, the IDB’s Vice President for Sectors and Knowledge.

Taxes that help protect the environment are another largely untapped source of revenue in the region. In Europe, such taxes collect an average of 2.5 percent of GDP, but in Latin America barely 1 percent.

Although tax situations in the region vary widely, the book argues that pro-development tax reforms should respect five basic principles:

  • First, the reforms should include taxes that favor the poor. Existing tax systems should be made more progressive and reduce the number of exemptions.
  • Second, tax systems should be simpler, with broader tax bases. That will help create an environment conducive to innovation and business startups, promoting productivity.
  • Third, tax administrations must be strengthened so that all citizens and businesses meet their tax obligations.
  • Fourth, reforms should ensure that local governments can generate their own resources of revenue, to match their increasing responsibilities as agents of development.
  • Fifth, given the region’s extraordinary yet finite endowment of natural resources, tax systems should create incentives for their more efficient use, taking into account the development needs of future generations.