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Increasing tax collection

If Central America wants to improve social equity and achieve fast and continuous economic growth, its countries need to increase tax collection and modernize their tax systems, according to a recent study by IDB economists Manuel R. Agosin and Roberto Machado entitled Tax Reform and Human Development in Central America.

Regional tax reform is necessary because “Central American states are too small and vulnerable to provide essential public goods for the economic growth and the people’s well being.”

Average tax collection in the region is less than 13 percent of GDP, too low a figure to cover the governments' expenses. If government cannot fulfill its essential function of providing public goods and services, private investment needed for economic growth will be hard to come by, states the study. Increased collection would also help macroeconomic stability, making public debt more sustainable and fiscal balance less troublesome.

Furthermore, trade liberalization in Central America and its insertion in international markets has made tax reform an urgent matter. During the early 1990s, the subregion relied heavily on tariffs for revenue, but today it depends more on domestic taxes, particularly those linked to consumption. This trend will only increase with the eventual approval of an Central American Free Trade Agreement (CAFTA).

Another reason for pursuing a tax reform, the authors noted, is to comply with the World Trade Organization’s standards. The countries in the subregion must eliminate the current free-trade zones tax exemptions before 2009. This will require a single tax treatment for domestics companies and companies in free trade zones. “Without regional tax coordination, it will be impossible to avoid tax arbitration,” the authors explain. “This will involve production loss and too low collection for some countries while others profit.”  

Agosin and Machado favor a fiscal decentralization strategy, suggesting local tax collection, stricter enforcement of particularly land taxes, which now yield collections below their potential.