Complex tax systems and widespread evasion are distorting investment decisions by companies in Latin America and the Caribbean, reducing the efficiency of markets and preventing governments from investing in infrastructure, education and other key public goods. This hinders the productive possibilities of the region’s economies, according to a newly released study by the Inter-American Development Bank (IDB).
Latin America and the Caribbean have low tax collection by international standards, with collection concentrated on large corporations. Tax rates as percentage of profits are high, reaching an average of 48 percent compared with 41 percent in high-income countries.
Moreover, taxes are also associated with high transaction costs. Latin Americans spend on average 320 hours a year to prepare, file and pay (or withhold) their taxes, almost twice as much as high-income countries. Processing taxes takes 2,600 hours in Brazil. Firms spent less time processing taxes in Grenada, Dominica and St. Lucia (see graph below).
High taxes can reduce the firms’ incentives to invest in technology and other productivity-enhancing strategies because taxes reduce the potential profits generated by those investments. As a result, productivity is reduced in the formal sector, hurting the overall long-term economic growth, the study concludes.
By shifting to smarter tax programs, governments can increase their revenue intake to finance much-needed social and investment programs without hurting productivity and growth. The region needs to ensure its tax systems to promote a better allocation of resources that will pave the way for increased productivity, the study says. This means not only simplifying taxes but also reducing taxes for corporations, in general, to reduce the level of informality.
Source: Authors' calculations based on World Bank (2009). Note: Information based in 181 countries, with data from 2007–2008. Time is recorded in hours per year, and it measures the time to prepare, file and pay (or withhold) three major taxes and contributions: the corporate income tax, value added or sales tax, and labor taxes, including payroll taxes and social contributions.
Currently, 61 percent of the region’s tax revenues come from corporations while in the industrial world that accounts for only 25 percent of total revenues. Despite the high taxes on companies, tax revenues in the region, excluding social contributions, are only about 17 percent of gross domestic product (GDP), compared with 27 percent in the United States and 36 percent in industrial countries, according to the study.
The findings are part of the upcoming IDB book The Age of Productivity: Transforming Economies from the Bottom Up. The IDB will announce these findings during the Bank’s Annual meeting to be held on March 20–23, in Cancún, Mexico. The book, part of the series Development in the Americas, the IDB’s annual flagship publication, offers a comprehensive analysis of productivity in the region, its impact on economic growth and recommendations for policymakers on how to address the causes of low and stagnant productivity.
High taxes triggers widespread evasion
Since tax rates and transaction costs are high, it is not surprising that tax evasion is widespread in Latin America. Tax evasion among both small and large companies is rampant, with the great majority of small and micro companies paying no taxes and formal companies underreporting as a much as 40 percent of sales in some countries, such as Brazil and Panama, according to the study.
According to a survey by Mckinsey & Company, nearly 70 percent of microenterprises (firms with 10 or fewer employees) in Mexico report that they are not registered and hence do not pay any taxes. Among small and medium-sized firms, the largest share, 63 percent, are registered but report not paying taxes. In the case of large firms, 48 percent do not pay taxes.
The situation is even more dramatic in El Salvador. Only 1 percent of all microenterprises and 3 percent of all non-microenterprises are registered. While tax evasion is much lower in Chile, it is not negligible for some types of taxes. An estimated 66 percent of establishments with 10 or more workers pay less than they should in value added taxes (VAT), 58 percent underpay profit taxes and 34 percent social security contributions.
Evasion hurts productivity
“The high level of evasion hurts productivity,” said Carmen Pagés, coordinator of the study, “because it prevents the government from investing in productivity-enhancing public goods like infrastructure and education. In addition, it gives informal firms, which are usually less productive, an unfair advantage in the marketplace against those companies that pay taxes”.
If governments target larger, more productive firms, tax evasion becomes a subsidy for less productive companies and an additional burden for the most productive ones. From this point of view, tax evasion may be lowering average productivity, as the competition from tax-evading firms and informal firms reduces the market share of tax abiding companies, according to the study.
Anti-competitive practices from the informal sector rank as the third most important constraint to formal firms’ growth in Latin America, after corruption and macro instability. Other restraints to growth include inefficient regulations, high tax rates, the economic cost of crime, low access and high cost of financing, high electricity costs and inefficient tax administration, according to data from the World Bank Enterprise Survey, cited in the study.
Special tax regimes can also undermine productivity
In order to reduce the level of informality and increase the tax base, several countries in the region have adopted special tax regimes for micro and small companies. These regimes also seek to reduce labor contributions by employers and expand labor benefits for low-income workers and reduce costs for the government in administering taxes on small companies so they can devote resources in fighting evasion among large corporations.
However, despite their good intentions, these regimes can have harmful effects on productivity and, therefore, may erode long-term economic growth. The main problem with these regimes is that they can deter growth of small companies because they lose the special tax treatment if they grow beyond a certain point, according to the IDB study.
“At the end, these regimes create incentives for firms not to grow beyond a certain point,’’ said Pages. “If they invest and grow, they will not be entitled for such a special treatment and their taxes will increase dramatically. The additional taxes they will have to pay will, many times, not pay for the investments they make. So they simply don’t invest.”
The study urges governments in the region to simplify their tax regimes, reducing the hurdles and the time required to comply with them. In addition, countries in the region should establish gradual increases in tax rates among the different regimes to reduce the barriers for micro and small companies to invest and expand their businesses.
- Romina Tan Nicaretta