IV A Review of Fiscal Policy During the 1990s and Current Policy Considerations
Author:
Mr. Jaime Cardoso
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Mr. Philip M Young
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Language:
English
Print Publication Date:
29 Jan 2002
Keywords:
OP; debt; tariff reform; trade reform; government operation; government's creditworthiness; tax progressivity; Public sector; Income and capital gains taxes
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Abstract

The New Economic Program adopted in late 1990 established fiscal discipline through a comprehensive tax reform and expenditure controls, and paved the way for an extended period of strong economic growth and macroeconomic stability. Moreover, the New Economic Program reduced economic distortions and initiated a shift in the tax base toward more stable, broad-based domestic taxes on income and consumption. Although there were some slippages during the mid-1990s, and a lack of political consensus slowed down the reform process, fiscal discipline was generally maintained over the latter part of the decade. In particular, substantial improvements in administration lifted tax collection to 15 percent of GDP by 1998, the highest level in more than 20 years.

The New Economic Program adopted in late 1990 established fiscal discipline through a comprehensive tax reform and expenditure controls, and paved the way for an extended period of strong economic growth and macroeconomic stability. Moreover, the New Economic Program reduced economic distortions and initiated a shift in the tax base toward more stable, broad-based domestic taxes on income and consumption. Although there were some slippages during the mid-1990s, and a lack of political consensus slowed down the reform process, fiscal discipline was generally maintained over the latter part of the decade. In particular, substantial improvements in administration lifted tax collection to 15 percent of GDP by 1998, the highest level in more than 20 years.

At the end of 2000, facing deteriorating public finances, the authorities accelerated the process of fiscal reforms: administrative discretion was removed from the setting of domestic fuel taxes, external tariffs were reduced, and the tax code was streamlined. Furthermore, in order to enhance transparency in the management of public funds and to tighten fiscal control mechanisms, an integrated financial program was started with the support of the IDB. These steps are intended to enhance public savings, while still allowing increased spending on priority areas, including health, education, and basic infrastructure.

Contribution of Fiscal Policy to Macroeconomic Stability During the 1990s

The monetization of fiscal deficits is a leading cause of high growth in monetary aggregates and of high inflation, which is a serious deterrent to economic growth. During the 1980s, the Dominican Republic fell into this trap. Overall public sector deficits remained high throughout the decade, averaging almost 6 percent of GDP per year, including the quasi-fiscal losses of the central bank.36 When external financing of these deficits largely dried up in the early part of the decade, the recourse to domestic financing, primarily from the state-owned commercial bank. Banco de Reservas. quickly led to an excessive monetary expansion.37 In turn, this set off an acceleration in inflation, which contributed to exchange rate pressures, a loss of official international reserves, and an accumulation of external payments arrears. During 1984–90, annual inflation averaged over 35 percent, peaking at 80 percent during 1990, despite at least one short-lived attempt to stabilize the economy in 1985. Institutional and economic rigidities, such as price controls, exacerbated the disruptions to the economy, with annual real GDP growth during this same period averaging less than 2 percent, including a plunge of nearly 6 percent in 1990.

In contrast to the previous decade, the generally disciplined fiscal policy position assumed during the 1990s played a central role in creating a stable macroeconomic environment that was conducive to high economic growth rates. Domestic bank financing of the public sector was reduced, monetary expansion slowed, and annual inflation rates were held to single digits for nearly all of the 1990s (Figure 3). More specifically, the initial stabilization effort embedded in the New Economic Program shifted the overall public sector balance from a deficit of about 7 percent of GDP in 1989 to balance in 1992 (Table 15). This, along with other important structural adjustments included in the program,38 helped reverse the economic deterioration, with real GDP growing by 1 percent and inflation falling to just under 8 percent during 1991, followed by 8 percent real GDP growth and 5 percent inflation during 1992. Following this strong initial stabilization, aside from some slippages associated with the political crisis in 1994, 39 overall public sector deficit remained under control. During 1993–2000, the deficit generally remained less than 2 ½ percent of GDP, annual real GDP growth averaged about 6 percent, and inflation (end-period basis) averaged about 7 ½ percent a year.

Table 15.

Summary of the Consolidated Public Sector

(In percent of GDP)

article image
Sources: National Budget Office (ONAPRE); BCRD and IMF staff estimates.

Net of intrapublic sector transector transfers.

Equal to the difference between the above-the-line balance and the identified financing. Positive values are treated as an accumulation of domestic arrears and added to the domestic financing.

Includes the financing of the central bank’s quasi-fiscal losses.

Figure 3.
Figure 3.

The Overall Public Sector, Net Domestic Bank Credit to Public Sector, and Inflation

Sources: BCRD; and IMF staff estimates.

The 1990–92 stabilization effort was achieved mainly through tight expenditure controls and strengthened tax revenues. All fiscal operations, including the discretionary spending of the presidency, were placed under a strict cash management system. A swing of 3 ½ percentage points of GDP (from a deficit of 3 ½ percent of GDP in 1990 to a balanced budget in 1992) was achieved in the public sector accounts. The latter encompass off-budget revenues, unidentified discretionary spending, and the overall balance of the nonconsolidated public enterprises. Government tax revenues climbed by nearly 3 ½percent of GDP between 1990 and 1992 (Table 16). Most important, increases of 200–300 percent in the state-controlled price of petroleum derivatives during late 1990 resulted in a sharp increase in annual revenues from fuel taxes (the so-called petroleum differential), to about 2 percent of GDP in 1991–92 from virtually zero in 1990.40 Revenue from customs duties rose by about 1 ½ percent of GDP in 1992, as imports surged with the improvement in the economy and the liberalization of tariffs. Equally important, however, was the switch to a market-based exchange rate for valuing customs duties, instead of the previously overvalued official rate. The increase in the VAT rate from 6 percent to 8 percent in 1992 also lifted revenue by about ½ percent of GDP.

Table 16.

Summary Operations of the Central Government

(In percent of GDP)

article image
Sources; ONAPRE; the BCRD; and IMF staff estimates.

Includes notional transfers to public enterprises to service interest payments on their external debt.

Includes extrabudgetary expenditures not reported by ONAPRE.

Includes notional transfers to public enterprises to service amortization payments on their external debt.

Excluding grants.

Equal to the difference between the above-the-line balance and the identified financing. Positive values are treated as an accumulation of domestic arrears and added to the domestic financing.

Reflect net payments deferred to the following year.

The large increase in tax revenue and a reduction in net off-budget spending allowed for some increases in budgetary spending without disrupting the stabilization effort. In particular, capital spending increased by about 2 percent of GDP between 1990 and 1993. Reductions relative to GDP in the government wage bill and interest on external debt (mainly due to debt relief received from Venezuela, Mexico, and Paris Club members) ameliorated the impact of the increase in capital expenditure on total spending. In addition, the operational balance of the public enterprises was brought to near zero by 1992, compared with operational tosses of about ½ percent of GDP in 1990.

As noted above, there was a temporary deterioration in the fiscal accounts in 1994, as the overall public sector deficit jumped to more than 3 percent of GDP. Election year pressures weakened the cash management system as government spending, particularly capital spending, rose and a net off-budget deficit reemerged for the first time since 1990. Moreover, revenues fell, mainly due to administrative problems in the customs area.

The setback in 1994 was only temporary. Due to a lack of political consensus, however, the overall public sector deficit had initially to be brought under control again through spending restraint and administrative measures. In 1995. the overall public sector deficit was again reduced sharply, to less than 1 percent of GDP, this time through significant cuts in central government capital spending. Tax revenue remained weak, however, falling further to only 13 percent of GDP in 1996, the lowest level since the start of the stabilization program. Customs revenue collection continued to fall and a surge in international oil prices cut deeply into revenue from the petroleum differential. At the end of 1996, the authorities had also raised domestic fuel prices to strengthen revenues from the petroleum differential. During 1997–98, a concerted effort to improve tax administration through automation of customs, creation of large taxpayer units, tough penalties for late payment (following a brief amnesty period), and cross-checking devices enabled tax collection to climb to a new high of 15 percent of GDP by 1998, with no major changes to the tax law.

Since the spending cuts in 1995, central government current expenditures have climbed sharply relative to GDP, rising to 12 percent of GDP in 1998 from nearly 9 percent of GDP in 1996. An increase of roughly 50 percent in public sector wages from March 1, 1997, and a steady increase in current transfers, mostly to the public sector,41 were largely responsible for the rise in current spending. In 1998, some curbs on this spending growth were implemented such as a freeze on public sector wages, but hurricane-related spending during the fourth quarter negated earlier efforts to reduce current spending during the year.

Growth in total government spending was moderated however, by cutbacks in capital spending. Between 1996 and 1998, capital spending fell by about 2½ percent of GDP from earlier, excessive levels, when the outgoing government hurried to complete some major construction projects before leaving office in 1996.

In mid-1999, the fiscal situation started deteriorating. Election-related expenditure overruns were compounded by delays in adjusting domestic fuel prices in line with increasing international oil prices, resulting in dramatically reduced government proceeds from the oil differential. In October 1999, growing difficulties in servicing the external debt induced the Monetary Board to raise the foreign exchange commission from 1.75 percent to 5 percent,42 and the government raised domestic fuel prices by about 20 percent on average.43 Despite this measure, the central government deficit widened by one percentage point of GDP to more than 2 percent of GDP The overall consolidated public sector deficit widened marginally to 2 ½ percent of GDP, but fell short of the authorities’ original target of near balance. The fiscal slippages contributed to put upward pressure on domestic demand and prices, and in turn on the external current account.

Reflecting a rapid pace of government expenditure, the central government deficit continued to widen in the first half of 2000, reaching almost 4 percent of GDP. The new administration, sworn in on August 16. reacted to worsening fiscal conditions by implementing severe expenditure controls, increasing domestic fuel prices,44 and eventually introducing a new hydrocarbon law that removed administrative discretion in the setting of domestic fuel prices. As a result, by the end of 2000, the central government had narrowed its deficit to some 2 percent of GDP.

Another development in recent years, since the relaxation of the cash management system, has been the accumulation of domestic arrears, mainly to contractors and suppliers. The lack of transparency in the budget process, together with limited coordination between revenue and spending agencies allowed domestic arrears to accumulate. In the second half of 1999, congress approved a law that allowed the conversion into marketable government securities of arrears accumulated before August 1995. A commission was set up to assess claimants’ rights.45 However, domestic arrears continued to accumulate. Information is still incomplete, although it is roughly estimated that at mid-2000, domestic arrears may have totaled some 3 ½ percent of GDP.46

Tax Reform and Administration

The tax system in the Dominican Republic went through two major reforms: the first one at the beginning of the 1990s and the second at the end of 2000. The tax reform of 1990–92 had to be comprehensive in order to correct a tax system of immense complexity that had lost much of its revenue-generating capacity due to high inflation in the late 1980s and 1990. The reform encompassed taxes on international trade, personal and corporate income taxes, VAT, and excise taxes. The tax reform was successful in gradually shifting the tax burden to the broad-based income tax and VAT, and thus securing a more stable revenue base with growth potential. Toward the end of 2000, in order to address the deterioration in public finances and to compensate for foreseen revenue losses associated with a planned reduction in external tariffs, the VAT and some excise taxes were raised, a minimum tax on gross sales was introduced and the domestic fuel tax system was reformed.

The tariff reform initiated in September 1990 addressed numerous problems in the existing system.47 As noted in Chapter II, Trade Reform Continues, the tariff reform simplified customs duties by reducing the number of tariff rates from well over 100 to 8, ranging from 5 percent to 35 percent,48 and eliminating an array of specific import taxes. While this represented a sharp reduction in the maximum tariff rate (from over 100 percent), average tariffs were still high by regional standards and the tariff structure allowed for a continuation of high rates of effective protection for domestic industries. Also, concomitant with the tariff reform, the authorities imposed new selective consumption taxes on various import items with rates of 5–80 percent. As a result, despite having taken a major step forward, the Dominican Republic still retained a relatively restrictive trade regime. The reform did however, eliminate export taxes.

The new tax code issued in May 1992 (Law 11–92) modified domestic taxes in a profound way. For the personal income tax, it reduced marginal income tax rates substantially, with the maximum rate falling initially from 70 percent to 30 percent and then to 25 percent by 1995. The number of tax brackets was reduced to 3 from 16 with tax rates of 15 percent and 20 percent applied to the lower brackets. The level of minimum taxable income was raised (to about three to four times the minimum wage), effectively exempting 90 percent of wage earners from the income tax, thus greatly enhancing tax progressivity and simplifying administration. Tax brackets were also adjusted annually for inflation during the previous year and most tax deductions were eliminated.

The corporate income tax underwent similar reforms. The tax rate was lowered from 46 percent to 30 percent in 1992 and then to 25 percent by 1995, which not only reduced the disincentives to formalizing operations, but also harmonized the corporate income tax with the personal income tax.49 The reform also introduced mechanisms to adjust the tax base for inflation, eliminated the double taxation of dividend income, and expanded tax coverage.

The new tax code also raised consumption taxes. In particular, the VAT rate was raised from 6 percent to 8 percent and various excise taxes were converted from specific to ad valorem taxes, after having lost much of their effectiveness due to the previously high rates of inflation.

The tax reform has been successful, albeit gradually, in shifting the tax burden to the more stable, broad-based domestic taxes with improved revenue growth potential. That is, the share of total tax revenue generated by the income tax and VAT grew from about 33 percent in 1992 to 44 percent in 2000 (Table 17). As a share of total tax revenue, revenue from import duties fell sharply between 1992 and 1995, before leveling off at 29 percent.50 Revenue from the petroleum differential, in contrast, has averaged about 15 percent of total tax revenue, but its variation has been substantial, ranging from 14 percent to 19 percent of total tax revenue during 1991–98.

Table 17.

Tax Revenue by Source

(In percent of total tax revenue)

article image
Sources: ONAPRE; and the SCRD.

Starting 1999, it includes proceeds from the increase in the foreign exchange commission.

Consists of income taxes and VAT.

The structure of petroleum taxation in force until end-2000 made it susceptible to large swings in revenue-generating capacity. The tax was determined as the difference between the pump price of various fuels (gasoline, diesel, kerosene, aviation fuel, fuel oil, and propane gas),51 which were controlled by the state, less their ex-refinery price and a distributor’s margin. The ex-refinery price varied directly with international oil prices and changed in the official exchange rate.52 The pump prices, however, were seldom adjusted, so that a fall in world prices provided a boost to revenues, while an exchange rate depreciation or an increase in world prices reduced revenues. For example, fuel prices were left essentially unchanged between late 1990 and late 1996, at which lime higher international oil prices and a devaluation of the peso cut deeply into revenues. Although a price adjustment mechanism was then incorporated into the differential’s regulations, it was used infrequently, and mostly for price decreases.

Following the 1994 presidential election and strong gains by the opposition in the legislature in the 1996 election, the tax reform process slowed as the political climate became more difficult. Thus, prior to the administration of President Mejia, the tax code had been left essentially unchanged since the mid-1990s.53

After the 2000 presidential election, the new government, facing a deteriorating fiscal situation, put forward a package of fiscal reforms, including a new hydrocarbons tax law and several changes to the tax code that were approved by congress toward the end of 2000, together with a reduction in external tariffs.54

The new hydrocarbons law converted the previous system of fuel price differentials into an array of specific excise taxes (indexed to the CPI). Administrative discretion was thus removed and retail prices started being revised weekly in line with wholesale prices. This reform will help to reduce the volatility of government revenues.

A number of changes to the tax code were also made. In particular, the VAT rate was raised to 12 percent—closer to the average in Latin America—and its base was enlarged to include a number of services previously subjected to specific taxes. About half of the economy’s value added continues, however, to be exempt, thus limiting revenues and complicating administration. Excise taxes on alcoholic beverages and cigarettes were also increased by 5—30 percentage points and a minimum tax of 1.5 percent on gross sales was introduced, with an exception for companies with gross sales of less than RD$2 million a year (about US$120,000).55

Considerable advances have been achieved in the area of tax administration in recent years. In 1997, an automated system for customs administration was implemented at the major air and seaports. This system greatly reduced the discretion of customs officers in administering import duties, which was a major source of revenue losses and potential corruption. Since 1996, customs revenues have increased by ½ percent of GDP, With regard to imports of large items, such as vehicles, machinery and equipment, and large consumer durables, the customs administration has been building the capacity to cross-check information with income tax and VAT to ensure consistency in taxpayers’ declarations of these taxes.

To facilitate the coordination of domestic taxes, the administrative agency for income taxes was combined with the agency responsible for VAT and other domestic taxes to form the Directión General de Impuestos Internos (DGII) in 1996. The first priority of the DGII was to establish a large taxpayer unit for the capital district, which was accomplished in late 1997, with about 450 registered taxpayers. These taxpayers would be subject to a full tax audit at least once every three years. The authorities have also made a strong effort to register all taxpayers, big and small, with a unique identity code. As a result of these efforts, and the development of the cross-checking system, tax collection (particularly from VAT) from small and medium-sized firms has also been growing rapidly. To encourage voluntary compliance with the tax code and taxpayer registration, the government offered a temporary tax amnesty in 1997, which was followed by the enforcement of stiff penalties, such as a penalty interest rate of 25 percent a month for late payment. Tax administration is still hampered, however, by the existence of numerous small taxes and fees, which generate little or no revenue.56

Reforming the Budget Process and Redirecting Public Expenditure

Recently, the authorities have begun to reform the budget process, which currently lacks transparency and accountability. The Office of the Presidency maintains discretionary spending accounts that are generally free from congressional oversight. Although the last administration reduced the use of these accounts, discretional spending still accounts for about 20 percent of total government spending (down from about 50 percent under previous administrations).

Revenue is directed to these discretionary accounts through two main sources. First, as part of the budget process, a revenue target for the upcoming year is determined. Any revenue collected during the course of the year in excess of this amount becomes available to the Office of the Presidency (through account 1401). Second, the budget approved by congress sets maximum spending limits on each item. If spending is held below these limits, the unspent resources are also redirected to discretionary accounts. If congress fails to approve the administration’s budget proposal, the revenue estimates and spending limits of the previous budget remain in effect, unadjusted for growth or inflation. These rules create extraordinary leverage for the administration in the approval of the budget, weakening the role of congressional oversight. If congress rejects the administration’s proposal, it increases the discretionary funds available to the presidency as tax revenues grow.

Under the present institutional procedures for execution of the budget, slippages in the coordination and control of expenditures may occur,57 giving rise to domestic arrears. This can happen because the main revenue collection agencies (customs and the DGII) report to the secretary of finance,58 while the budget office (ONAPRE) reports to the technical secretary of the presidency. The controller’s office, which is a separate branch of the administration, serves as an intermediary between the two. Thus, over the course of the year, ONAPRE notifies the spending agencies of their spending limits. The agencies then proceed with their spending programs. However, there is no firm commitment by the government to cover these expenses until they are approved by the controller’s office. Once a commitment has been approved, however, the national treasury makes payments only if the resources are available. As a result, domestic arrears have accumulated when the coordination between the budget execution agencies has been relaxed. As these arrears have become a regular feature of government operations, procurement costs have risen and the government’s creditworthiness has been damaged. The authorities are considering a comprehensive proposal for the modernization of the state, which, in addition to streamlining the public sector and enhancing the efficiency of government operations, would also address the problems in the budget process.

At the end of 2000, congress approved a technical cooperation loan from the IDB to fund an integrated financial management program (IFMP), aimed particularly at making fiscal policy more consistent with national development objectives; strengthening the institutional setting; and increasing transparency in the management of public funds and the effectiveness of internal controls. In order to strengthen policy formulation and improve budget monitoring, policy decisions will be centralized, but the operational execution will be decentralized in the relevant public agencies. The program also aims at (1) enhancing coordination among institutions (Secretariat of Finances, the central bank, and the Technical Secretariat); (2) improving the accounting practices and the information processing system with the goal of producing comprehensive, timely, and reliable information; and (3) strengthening the role of the Office of the Comptroller General through the development of a modern internal control system to analyze budget management from the economic, financial, and legal point of view. The program should improve substantially the financial management capacity of public sector institutions as well as enhancing governance by making management of public funds more transparent and accountable.

The authorities have acknowledged that while the primary approach toward improving social conditions and poverty alleviation is to sustain high real GDP growth rates for the economy, more government resources also need to be directed toward social services, including health and education, and basic infrastructure. During 1998–99, spending on health and education rose to about 4 percent of GDP, compared with just over 3 percent of GDP in 1995. But these spending levels are still low by international standards. It is anticipated that over the medium term spending in these priority areas, as well as on basic infrastructure, could grow by 2–3 percentage points of GDP. The additional spending would come from savings obtained from the reduction in transfers to public enterprises, largely achieved through the ongoing privatization process,59 and a rationalization of the civil service.

Conclusion

A remarkable fiscal adjustment and comprehensive tax reform during the early 1990s were instrumental in achieving high real GDP growth rates and moderate inflation for the remainder of the decade. Largely due to the difficult political climate that prevailed during the mid-1990s, however, the pace of fiscal reform slowed. Momentum picked up again toward the end of 2000, when a new hydrocarbons tax law and a number of changes to the tax code were approved, and an integrated financial management program was initiated to enhance transparency and accountability in the management of public funds. The IFMP should also foster a rationalization of public expenditure, providing room for augmenting government spending in priority areas, such as health, education, and basic infrastructure, without undermining fiscal discipline.

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Cover The Dominican Republic
The Dominican Republic
Stabilization, Structural Reform, and Economic Growth
ISBN:
9781589060463
ISSN:
0251-6365
Publication Date:
29 Jan 2002
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589060463.084
Pages:
78
  • Figure 3.
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    Figure 3.

    The Overall Public Sector, Net Domestic Bank Credit to Public Sector, and Inflation

Figure 3.

The Overall Public Sector, Net Domestic Bank Credit to Public Sector, and Inflation

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