Central American Tax Reform
Trends and Possibilities

Contributor Notes

Authors’ E-mail Addresses: jstotsky@imf.org, awoldemariam@imf.org

Central American tax systems are modern in their orientation, though there remains scope for beneficial reform. Value-added taxes are the mainstay of collections, but their performance varies. Income and property taxes remain relatively underused and should apply to higher income taxpayers more comprehensively. Tax reform needs to be mindful of global competition. Continuing improvement in administrative performance is also essential.

Abstract

Central American tax systems are modern in their orientation, though there remains scope for beneficial reform. Value-added taxes are the mainstay of collections, but their performance varies. Income and property taxes remain relatively underused and should apply to higher income taxpayers more comprehensively. Tax reform needs to be mindful of global competition. Continuing improvement in administrative performance is also essential.

I. Introduction

Central America economic performance improved markedly in the 1990s.2 But there remain many challenges for this region, especially in strengthening the public finances and revenue yields. Achieving and maintaining a sound fiscal position is essential for macroeconomic stability and for creating the appropriate conditions for sustained economic growth. Key issues are to reform the system of taxation to achieve a sound structure that is buoyant in generating revenue, distorts economic decisions as little as possible, and achieves the degree of redistribution that is consistent with equity goals. Because Central American countries are small, open economies, another goal is harmonization of their tax systems with each other to better enable producers to compete with surrounding, larger neighbors, such as Mexico or Colombia, and to avoid harmful tax competition for scarce resources such as capital and skilled labor. Harmonization can also facilitate tax and customs administration. Harmonization of the domestic tax system is complementary to harmonization of trade regimes, through efforts such as those made by the Central American Common Market.

Central American tax systems are modern in their orientation, especially now that every country has a value-added tax (VAT). However, there remain a number of significant challenges for countries in the region with regard to tax policy. First, revenue collections and tax productivities in many countries arc still relatively weak. The causes underlying this weakness appear to be a combination of tax policies that have eroded tax bases as well as continuing weaknesses in tax and customs administration. Second, harmonization of taxes on domestic goods and services, primarily VAT and excises, would enhance efforts at strengthening both revenue collections and tax productivity. The European Union (EU) model could usefully be adapted to Central America. Third, property taxes and other, more locally-based charges or taxes are currently minimal but could contribute to strengthening both the budget and efforts at fiscal decentralization.

There is an extensive literature on taxation in developing countries, including Latin America. Tanzi and Zee (2000) present general reflections on tax policy for developing countries. Bird (1992) and Shome (1999) offer a review of recent developments in Latin America. This paper examines recent trends in tax systems in Central America. Section II lays out some general principles of taxation; Section III offers some general reflections on recent trends in taxation in the region; Section IV discusses domestic taxes on goods and services; Section V discusses income taxes; Section VI reviews administrative trends; Section VII examines tax harmonization in the region; and Section VIII concludes.

II. General Principles of Tax Reform

The most important economic principles underlying sound tax reform are:

  • The tax system should be efficient in that private consumption, saving, production, and investment decisions should differ as little as possible from what they would be in the absence of taxes. However, in the presence of market imperfections, such as externalities some distorting taxes may improve efficiency and enhance growth. The tax system should thus support efforts to increase economic growth.

  • The tax system should be fair or equitable in the distribution of the tax burden. Vertical equity implies that those with greater ability to pay tax should pay a larger proportion of their income or wealth in taxes while horizontal equity implies that those with equal ability to pay tax should pay the same proportion in taxes.

  • The tax system should facilitate tax administration and reduce taxpayer compliance costs.

  • The tax system should be stable, often with phasing in of significant changes, to ensure that taxpayers can make rational economic decisions. It should also match tax instruments to tax objectives.

  • The tax system should be transparent and rules-driven, with scope for discretion on the part of administrators minimized, to reduce uncertainty and the incentive for corruption. The legal framework should be clear and applied in a uniform manner.

Efficiency considerations suggest that, for a given revenue requirement, the degree to which economic decisions are altered by taxes should be minimized, unless the purpose is to address externalities (distortions not taken into account by the market) and other market imperfections. This implies that tax bases should be broad-based and the tax rate should be as low as possible to achieve revenue goals. Income taxes should have relatively few tax rate brackets and corresponding rates, and few deductions or allowances. VATs are best levied at one rate, and should have few exemptions. Only exports should be subject to zero rating. Luxury or excise taxes serve certain purposes, like discouraging certain activities (for example, excise taxes on alcohol or cigarettes) or adding progressivity to indirect taxes (for example, excise taxes on cars) but should not apply to a wide range of activities.

In addition, efficiency considerations mean that production decisions should not be distorted in the presence of externalities and other market imperfections. Tax incentives, such as tax holidays, should not be used to encourage particular activities because such incentives tend to distort economic decisions and lead to revenue losses that require higher tax rates overall to achieve revenue goals.

Equity considerations suggest that taxes should be based on taxpayers’ ability to pay, though it is also appropriate to base tax payments on the principle that those who benefit from a public service should pay for it. Achieving equity goals based on ability to pay requires reliance on a broad measure of income, which is the best indicator of underlying ability to pay, or else consumption, which is closely related to income but excludes the saving component. An income tax can be made more progressive through a schedule of increasing marginal tax rates (the tax rate applied to each bracket of income), or through a general allowance or one for family members and high expenses on necessities, such as medical care. Similarly, a VAT can be made more progressive by exempting certain goods or taxing them at a lower than standard rate, such as basic foodstuffs largely consumed by poorer households. A few luxury excises and targeted spending in the budget can also help achieve the desired progressivity of the fiscal structure.

The goal of administrability requires that the tax system be simple (or as simple as necessary to account for the complexity of economic decision-making). This goal can be accomplished by using final withholding for certain forms of income tax, making the tax system schedular to some extent, and relying on a limited number of rates under the different taxes. Finally, the goals of stability and transparency require that tax laws and regulations be clear and comprehensive. Judicial reform is critical in this regard. Tax liabilities should be determined in accordance with the tax law and not negotiated. The tax administration should have sufficient powers to enforce the tax laws. Taxpayers should have recourse through the legal system to challenge or clarify the tax laws.

III. Structure of Tax System in Central America

Central American countries have modern tax systems. However, they still differ in certain respects. One notable feature of Central American tax systems is the variation in the overall revenue and tax revenue to GDP ratio (Tables 1, 2, 15, and 16).3 The average tax yield for Central American countries differ little from the average tax yield for Latin America overall (including Central America) despite the lower average level of income in Central America (Figure 1). Whether Central American countries should strengthen their revenues depend on the purposes for which that revenue would be spent, for example, on worthwhile government programs or used to reduce budget deficits rather than on propping up or subsidizing poorly run parts of the public sector or on public expenditures with little social value. Many of these countries have faced significant fiscal imbalances, and this has led to pressures to increase the revenue yield.

Figure 1.
Figure 1.

Latin American Countries: Tax Revenue Structure, 1990–94 and 1995–99

(In percent of GDP)

Citation: IMF Working Papers 2002, 227; 10.5089/9781451875423.001.A001

Sources: Government Finance Statistics (IMF), International Financial Statistics (IMF); and World Economic Outlook (IMF).
Table 1.

Consolidated Central Government: Tax Structure for Latin American Countries, 1990–94

(In percent of GDP)

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Sources Government Finance Statistics (IMP): International financial Statistics (IMF); and World Economic Outlook (IMF)

Total lax revenue shown is net of tax revenue transferred back to subcentral levels of government due to revenue sharing agreements.

Budgetary central government.

For each revenue classification, only countries for which data arc available arc included in the calculation

Table 2.

Consolidated Central Government: Tax Structure for Latin American Countries, 1995–99

(In percent of GDP)

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Sources: Government Finance Statistics (IMF); International Financial Statistics (IMF); and World Economic Outlook (IMF).

Total lax revenue shown is net of tax revenue transferred back to subcentral levels of government due to revenue sharing agreements.

Budgetary central government.

Por each revenue classification, only countries for which data are available are included in the calculation.

Table 3.

Consolidated Central Government: Tax Structure for Latin American Countries. 1990–94

(In percent of tax revenue)

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Sources: Government Finance Statistics (IMF), International Financial Statistics (IMF); and World Economic Outlook (IMF)

Total tax revenue shown is not of tax revenue transferred back to subcentral levels of government due to revenue sharing agreements.

Budgetary central government

For each revenue classification, only countries tor which data are available are included in the calculation

Table 4.

Consolidated Central Government: Tax Structure for Latin American Countries, 1995-99

(In percent of tax revenue)

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Sources: Government Finance Statistics (IMF): international Financial Statistics (IMP), and World Economic Outlook (IMF).

Total tax revenue shown is net of tax revenue transferred back to subcentral levels of government due to revenue sharing agreements.

Budgetary central government.

For each revenue classification, only countries for which data are available arc included in the calculation.

Table 5.

Cross-Country Comparisons: Value-Added Tax Rates, 1994, 1997, and 2001 1/

(In percent)

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Sources: Corporate Taxes: Worldwide Summaries (PriccwaterhouseCoopers); Taxation in Latin America (IBFD); and International Tax Summaries-A Guide for Planning and Decisions (Coopers & Lybrand International Tax Network).

Rates shown in bold type are so-called effective standard rates (tax exclusive) applied to goods and services not covered by other especially high or low rates. Some countries zero rate a few goods and exports.

VAT revenue as a percentage of final consumption expenditure, divided by the VAT standard rate. This is often termed the “c-efficiency” ratio

Supplementary VAT rates of 8 percent and 9 percent on noncapital goods imports; through “catch-up,” these can revert to 18 percent retail.

Effective rate (legislated tax-inclusive rate is 13 percent).

Tax exclusive equivalent rates to tax inclusive rates. Top line arc rates 17, 18, and 25 on intra-state trade and bottom line are rates 7 and 12 on inter-state trade.

No calculation is made because the VAT is a state-level lax.

The rate of cigarettes and alcoholic beverages is 10 percent.

Venezuela was the last country to introduce a VAT in October 1993, had removed it by March 1994, but reintroduced it soon thereafter.

Only standard rates.

Table 6.

Cross-Country Comparisons: Value-Added Revenue Productivities 1/

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Sources: Corporate Taxes: Worldwide. Summaries (PricewaterhouseCoopers); Taxation in Latin America (IBFD); and International Tax Summaries: A Guide for Planning and Decisions (Coopers & Lybrand International Tax Network). Revenue and consumption data are from Government Finance Statistics (IMF); International. Financial Statistics (IMF); and World Economic Outlook (IMF).

VAT revenue as a percentage of final consumption expenditure, divided by the VAT standard rate.

No calculation is made because the VAT is a state-level tax.

Table 7.

Central Latin American Countries: Excise Tax Summary 1/

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Source: Country documents tax summary tables.

“…” where the countries have not reported the figures.

B. 0.05 per liter on each alcoholic beverage not classified as wine, where the alcoholic content does not exceed 20 percent proof by volume, except beer.

6 percent, syrups or concentrate used in the production of carbonated beverages.

Prices in effect on May 8, 2002. Resolution 112-00 allows for prices to be adjusted periodically for, inter alia, changes in the consumer price index, world oil prices, and the official exchange rate, but in practice, adjustments have been infrequent.

Tax on tobacco, percentage applied to the taxable base, which is no less than 44 percent of the retail price, which the manufacturer or importer must suggest and report to the superintendency of tax administration, net of value-added tax in Guatemala.

Tax on long distance communication services at home and abroad, which includes radio, cable, telegraph, and satellites.

Exemption on diplomatic travelers.

Note Currency and exchange rates:Costa Rica: Colones per U. S. dollar, January 1996, period average = 196.23Dominican Republic: Pesos per U. S. dollar. January 2002, period average = 17.310El Salvador: Colones per U. S. dollar, January 2002, end of period = 8.750Guatemala: Quetzales per U. S. dollar, January 2002, period average = 7.8829Honduras: Lempiras per U. S. dollar, January 2002, period average = 15.9727Nicaragua: Gold Cordobas per U. S. dollar, January 2002, period average = 13.88Panama: Balboas per U. S. dollar, January 2001, end of period = 1.00
Table 8.

Enterprise Income Tax Rates, 1986, 1992, 1997–2002

(In percent of taxable income)

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Sources: International Bureau of Fiscal Documentation (IBFD): “European Taxation,” “Taxes and Investment in Asia and the Pacific,” and “Taxation in Latin America” (Loose-leaf; Amsterdam); and Corporate Taxes, Worldwide Summaries (PricewaterhouseCoopers).

The data, unless otherwise indicated, present the tax rates in effect at January 1, 2000.

The data, unless otherwise indicated, present the tax rates in effect at January 1, 2001.

Data are for 1999 in column “1999 or 2000.”

Data are for 1998 in column “1999 or 2000.”

Data are for 1999 in column “2001 or 2002.”

Data are for 2000 in column “2001 or 2002.”

Excluding Mexico.