Abstract
In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.
Chile’s Tax System and the 2014 Tax Reform1
The design of any tax system is confronted with tradeoffs between different objectives such as equity and economic efficiency. This chapter compares the tax system in Chile with broad guidelines derived from cross-country experience and discusses the potential impact of some key elements from the tax reform proposed by the government.
A. Background
1. The design of any tax system often requires striking a balance between different objectives.
First, tax revenue is instrumental in providing the needed financing for expenditure commitments.
Second, the selection of specific tax instruments often aims to address equity (income or consumption redistribution) and/or efficiency (e.g. economic growth) objectives.2
Third, tax system design also considers the ease of implementation and tax administration. Of course, there could be some important interdependence among these objectives. For instance, a larger tax collection could help expand pro-equity or pro-efficiency expenditure programs; a complex or difficult to manage tax system could lead to tax evasion and avoidance that often weaken the equity and/or efficiency impact of the system.
2. In Chile, the government has submitted to Congress, a tax reform with both equity and efficiency objectives.3 The reform aims to raise 3 percent of GDP to finance an expansion in education and other social programs and to close the structural deficit (1 percent of GDP in 2014). Additional goals include improving tax progressivity, revamping incentives for savings and investment and fighting tax evasion and avoidance. The reform centers on changes to the income tax system, and a key component is the proposal to include profits, regardless whether distributed as dividends, in the personal income tax (PIT) base. In other words, the PIT on profits would be on an accrued rather than distributed basis. Section D provides a preliminary analysis of its key elements.
Planned Allocation of Tax Reform Yield
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: Budget Directory (DIPRES).Planned Allocation of Tax Reform Yield
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: Budget Directory (DIPRES).Planned Allocation of Tax Reform Yield
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: Budget Directory (DIPRES).3. The purpose of this paper is twofold. First, drawing on the Fund’s tax expertise and crosscountry experience, the paper compares Chile’s tax system with those of its peers. Second, it provides a preliminary qualitative analysis of the authorities’ tax reform with an emphasis on income tax reforms, and possible implications for equity, efficiency, and tax administration. Data limitations prevent a fuller, quantitative assessment and this is an important caveat. Another caveat is that this paper focuses only on the revenue side of the reform whereas a fuller analysis of the effects on growth and equity should take into account also the planned education and health reforms.
B. Overview of tax design principles
4. While there is no one-size-fits-all solution, the literature has identified some broad principles regarding efficiency/growth considerations in tax design.
Growth-friendly taxes. Recent OECD (2010, 2013) and IMF (2013a) studies conclude that taxes on property are typically the least distortive taxes for growth. Broad-based consumption taxes, and particularly the VAT, also have moderately negative effects on growth as they do not discourage saving and investment.
Growth-inhibiting taxes. The same studies suggest that income taxes and social contributions have the most adverse effects on growth as they interfere directly with key economic decisions. Within income taxes, corporate taxes are typically seen as the most harmful to growth primarily because they discourage capital accumulation and productivity improvement.
5. Cross-country experience also suggests some broad lessons in how taxation can address equity goals (IMF 2013b). Taxation often takes a second place, behind expenditure measures, in the pursuit of equity goals. Thus, spending and taxes should be looked at together. Notwithstanding, there are some broad guidelines regarding how taxes by themselves can contribute to achieving equity goals.
Equity-friendly taxes. In most countries improving the progressivity of the tax system, including of PIT and social contributions can help achieve equity goals. A zero-rate PIT threshold can improve progressivity, provided is not too high as to significantly erode the tax base. While tax deductions are a common feature in many tax systems, it is important that deductions do not accrue disproportionally on the rich (often the case with mortgage interest deduction) and do not generate large tax expenditures. Taxes on capital income and wealth, especially on immovable property, are also an option to achieve more progressive taxation.
Equity-inhibiting taxes. In contrasts, consumption taxes are often considered inferior for achieving redistributive policies.
6. These findings illustrate some of the tradeoffs often found in the design of a tax reform. Income taxes stand to help on equity goals but might hurt efficiency goals. Consumption taxes offer the opposite trade off. Property taxes, in contrasts, could help achieve both goals simultaneously. The focus of this paper is on the government’s tax reform, but it is important to note that its overall reform agenda, which includes energy, education and tax reform among other, also aims to advance simultaneously on equity and efficiency grounds.
7. There are also some general principles regarding how a tax system can address expenditure financing and tax administration goals. As expenditure programs often require continued fiscal financing, it is important to match commitments with permanent revenue sources. In this context, in designing a tax system is important to identify its steady state yield potential and to adjust expenditure plans accordingly specially during the transition to such steady state. Regarding tax administration, the overall accepted principle is to design tax systems in line with existing institutional capacity at the tax authority; going forward, capacity building efforts will make room for more complex systems.
C. Chile’s current tax system
8. Tax revenue in Chile stems mostly from indirect taxes and is concentrated at the central government level. General government tax revenue equaled about 18 percent of GDP in 2006–13 on average. The bulk (16.5 percent of GDP) accrued to the central government. VAT and excise taxes represent about 55 percent of tax revenue; while income taxes, including mining-related taxes, represent about 40 percent of central government tax revenue. Municipalities’ tax revenue (1.5 percent of GDP) is mostly composed of real-estate taxes and patent fees.
Tax Revenue Composition
(Central government; in percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Sources: Budget Directory (DIPRES) and Fund staff estimates.Tax Revenue Composition
(Central government; in percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Sources: Budget Directory (DIPRES) and Fund staff estimates.Tax Revenue Composition
(Central government; in percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Sources: Budget Directory (DIPRES) and Fund staff estimates.Chile: Fiscal Gap, 2012 1/
(In percent of GDP)
For General government (central government plus municipalities). Includes social contributions
Based on a regression that controls for country characteristics. Based on IMF (2013).
Chile: Fiscal Gap, 2012 1/
(In percent of GDP)
| Outturn | Norm 2/ | Gap | ||
|---|---|---|---|---|
| Total non-mining tax revenue | 18.8 | 20.1 | 1.2 | |
| Income (non-mining) tax | 5.8 | 6.3 | 0.5 | |
| Consumption tax | 9.5 | 8.9 | −0.6 | |
| Payroll tax | 1.4 | 3.7 | 2.3 | |
| Other tax | 2.1 | 1.1 | −1.0 | |
| Memo items: | ||||
| Municipalities tax revenue | 1.4 | |||
| Private health contribution | 0.9 | |||
| Private pension contribution | 2.4 | |||
For General government (central government plus municipalities). Includes social contributions
Based on a regression that controls for country characteristics. Based on IMF (2013).
Chile: Fiscal Gap, 2012 1/
(In percent of GDP)
| Outturn | Norm 2/ | Gap | ||
|---|---|---|---|---|
| Total non-mining tax revenue | 18.8 | 20.1 | 1.2 | |
| Income (non-mining) tax | 5.8 | 6.3 | 0.5 | |
| Consumption tax | 9.5 | 8.9 | −0.6 | |
| Payroll tax | 1.4 | 3.7 | 2.3 | |
| Other tax | 2.1 | 1.1 | −1.0 | |
| Memo items: | ||||
| Municipalities tax revenue | 1.4 | |||
| Private health contribution | 0.9 | |||
| Private pension contribution | 2.4 | |||
For General government (central government plus municipalities). Includes social contributions
Based on a regression that controls for country characteristics. Based on IMF (2013).
Stochastic Frontier: Tax Effort, 2012
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Sources: Fenochietto and Pessino (2013) and Fund staff estimates.1/ Includes private mining incomeStochastic Frontier: Tax Effort, 2012
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Sources: Fenochietto and Pessino (2013) and Fund staff estimates.1/ Includes private mining incomeStochastic Frontier: Tax Effort, 2012
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Sources: Fenochietto and Pessino (2013) and Fund staff estimates.1/ Includes private mining income9. Tax revenue in Chile is somewhat below its peers’; and it is somewhat more reliant on consumption taxes.4 In comparing Chile with other countries, two methodologies are presented next, which suggest that Chile’s tax burden is up to 6.5 percent of GDP lower than in similar countries. First, a comparison of total tax revenue (including mining taxes), contrasts Chile’s tax ratio with the maximum that other countries with similar characteristics have achieved. It controls for country characteristics such as GDP per capita, trade openness, public expenditure in education and the Gini coefficient and suggests the current tax burden leaves 25 percent of tax capacity untapped, which represents about 6.5 percent of GDP. A second methodology only compares non-mining (or more generally, on non-natural resource based) tax revenue controlling for country characteristics, such as GDP per capita, old dependency ratio, and population growth, and suggests Chile collects 1.2 percentage points of GDP less than the norm (i.e., conditional average). This methodology also suggests Chile has a higher reliance on consumption taxes (55 percent) than countries with similar characteristics (45 percent). An important caveat of both of these methodologies is that Chile is among the countries in which a fraction of pension (and health) contributions are not reflected as tax revenue but rather as private contributions to individual accounts. This factor could explain part of the measured difference between Chile’s tax revenue and its peers’.
Tax Rate Comparison
(In percent)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: SII (Chile’s internal revenue service).Tax Rate Comparison
(In percent)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: SII (Chile’s internal revenue service).Tax Rate Comparison
(In percent)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: SII (Chile’s internal revenue service).10. Chile’s tax rates differ somewhat from international averages. Chile’s VAT and (maximum) personal income tax (PIT) rates are higher than the Latin America average, but in line with OECD averages.5 In contrast, the corporate income tax (CIT) rate is lower than both regional and OECD averages. Furthermore, it is notable that Chile has a relatively large gap between the maximum PIT rate and the CIT rate. As will be discussed below and in the appendix, given the tax system in Chile, this gap provides incentives for keeping profits inside the firm but also creates strong incentives for tax planning and evasion.
11. Chile’s income tax system has some distinguishing design features. First, there is full integration between the CIT and the PIT, that is, any CIT paid at the firm level is credited in the firm’s shareholder’s PIT bill and shareholders can obtain a partial refund if their (average) PIT is lower than the CIT rate. The annex includes a more detailed description of the system including a comparison with other types of income tax systems. The PIT combines all sources of income, including dividends, labor and income; is progressive (0 to 40 percent, with some 80 percent of the taxpayers with income levels that fall into the zero bracket); and has identical schedules for dependent workers and recipients of other income (income from self-employment, dividends, etc.). Further, at the personal level, PIT on profits is deferred until distribution and a special ledger (FUT) is used to keep track of undistributed profits—during 2001–2010, some 30 percent of profits were distributed (Jorrat, 2013). Further, this system avoids the common “double taxation” of profits, and offers a progressive taxation of dividends income (in contrast with dual income systems with a flat tax on income from capital including dividends). Other features include inflation indexation; and unlimited carry-back and carry-forward of loses.
Tax Incidence by Household Income Decile
(Percent of decile’s mean disposable income, mid-2000s)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: OECD (2013).Tax Incidence by Household Income Decile
(Percent of decile’s mean disposable income, mid-2000s)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: OECD (2013).Tax Incidence by Household Income Decile
(Percent of decile’s mean disposable income, mid-2000s)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: OECD (2013).12. Key implications for equity, efficiency, and tax administration of the existing tax system include.
Equity. Recent OECD studies (Castelletti, 2013) have found that the current Chilean tax system is somewhat regressive. The chart below shows that the tax incidence (tax payments as a fraction of disposable income) for the highest income decile is in fact lower than the one faced by the lowest income decile. Another evidence of regressivity comes from the fact that tax incidence peaks at the third decile and then falls between the third and ninth deciles. This result could be interpreted as in part due to the dominance of indirect taxes, which are typically regressive, and the income tax system not having enough offsetting impact. In practice, evasion and avoidance by the top income earners is also a significant contributor to the low impact of income taxes (Fairfield and Jorrat, 2014).
Efficiency. Based on cross-country experience (mentioned above), the low CIT rate, the deferral of PIT on undistributed profits, and the tax mix with a higher reliance on consumption taxes and a lower reliance on income taxes, all represent pro-growth characteristics of the tax system. This PIT deferral until distribution combined with a relatively low CIT rate has underpinned corporate savings although its effect on investment is less clear (Jorrat, 2013). Other recent research suggests higher CIT rates can result in lower investment but also illustrate that there could be mitigating factors which could offset such impact.6
Tax administration. In broad terms, the tax system in Chile appears to work well. According to the World Bank Doing Business Indicators, in terms of ease of paying taxes, Chile ranks 38th worldwide, which represents the best in Latin America and above the median among OECD members. However, the income tax system is administratively complex—in particular the administration of the FUT. In practice, the correct implementation and enforcement of the system requires the internal revenue service (SII) to track and monitor decades of inflows and outflows into the FUT and the corresponding credit for every shareholder. The complexity of the system makes it prone to avoidance and evasion. SII’s estimated that tax evasion in the income tax was about 31 percent in 2009 and that VAT evasion stood at 20 percent in 2011.
Expenditure financing. Chile has a well-entrenched practice of following the general principle of matching expenditure commitments with permanent revenue (the tax reform discussed in the next section is a case in point). Further, Chile’s structural balance fiscal rule shields expenditure from cyclical fluctuations in revenue, including in tax revenue.
D. Government’s tax reform
13. As mentioned before, the reform’s objectives include both efficiency and equity considerations. The revenue yield (3 percent of GDP) will be used in part to eliminate the structural deficit and to finance an education reform which aims to provide more equal access to quality education. The specific tax measures of the reform aim to improve progressivity and revamp tax incentives for investment and savings.
Tax Reform Instruments and Yields 1/
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: Budget Directory (DIPRES).1/ Steady state yields (2018 onwards)Tax Reform Instruments and Yields 1/
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: Budget Directory (DIPRES).1/ Steady state yields (2018 onwards)Tax Reform Instruments and Yields 1/
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 219; 10.5089/9781498328357.002.A003
Source: Budget Directory (DIPRES).1/ Steady state yields (2018 onwards)14. The reform’s key component is a change in the income tax system in Chile. On April 1, 2014, the government submitted to Congress a proposal for tax reform. The three main components are: (i) PIT on profits would be on an accrued basis; that is, profits, regardless of distribution, will be included in the personal income tax base, de facto eliminating the Taxable Profit Fund (FUT); (ii) the corporate tax rate will be increased from 20 to 25 percent; and (iii) the top marginal personal income tax rate will be reduced from 40 percent to 35 percent.7 It is important to note that the reform preserves the full integration between the CIT and the PIT. The government estimates that the income tax reform would yield about 1.4 percent of GDP (first two items in the chart).
15. The new income tax system will have different implications for firms (and their shareholders) depending on their size. Under the reform, PIT on accrued profits will be charged to whoever owns the firm at end-year, regardless of whether he/she received dividends during the year.
Large firms. For simplicity of administration, for large companies (traded, with foreign owner, or with non-personal shareholders) the tax will be withheld at corporate level. These firms will withhold an additional 10 percent of profits at the end of the year (the difference between the maximum PIT rate and the CIT) which firms could credit against the mandatory dividend distribution (30 percent). Virtually, all shareholders will be eligible for a refund which will depend on their average PIT rate.
Small and Medium. For all other companies, the shareholder will be responsible to pay the tax bill even in the case that no dividend was received.
16. The reform also includes tax administration measures and green and excise taxes. Tax administration gains are the third largest component of the reform, yielding 0.5 percent of GDP from lower evasion and avoidance. Specific measures include improving access to information for the SII, introducing a general anti-avoidance rule and strengthening auditing capacity. The reform will also allow for instant depreciation of physical capital investment for small firms, increase the stamp (financial transactions) tax and excise taxes on alcoholic drinks, impose an emission tax on industrial activity and modify some real-estate related taxes.
17. The reform will be implemented gradually over four years and some transitory measures are also included. The CIT increase would be gradual over four years but starting in 2014; on the other hand, the switch to a PIT on accrued basis and the reduction in the maximum PIT rate will only come into effect in 2018. Instant depreciation will also be available for medium and large firms for twelve months after the enactment of the reform.
18. The reform’s overarching goals appear appropriate and broadly in line with past Fund recommendations. Closing the structural deficit is a welcome step toward protecting policy buffers. The matching of new education expenditure commitments with new permanent revenue is prudent and welcome. And a more equal access to high quality education would help improve productivity and income distribution.
19. The emphasis on income taxes is in line with the reform’s equity goals and Chile’s relatively low CIT rates and burden. Amid the highly skewed income distribution in Chile, the reform’s emphasis on income taxes seems appropriate. In particular, the reduction of the CIT-PIT gap would help reduce evasion/avoidance opportunities currently being exploited by the well-off. As indicated above, Chile collects relatively less income taxes than its peers; and the increase in the CIT rate will bring it close to the regional average.
20. The tax reform’s impact on growth and savings is subject to a great deal of uncertainty and will require careful assessment. The proposal includes measures that are likely to affect savings, investment, and growth in different ways and with opposing signs. At this point it is not possible for staff to make a full analysis of the net effect of all these measures. But a few things can be said.
21. In particular, possible effects of the reform include:
Equity. The reform should make tax incidence more progressive by eliminating the PIT tax deferral that currently benefits disproportionally the well-off (e.g. firm’s owners). The final impact on equity would also depend on the balance between the lower progressivity resulting from lowering the PIT and the gains from reducing evasion by high-income individuals through closing the gap between the CIT and PIT.
Efficiency. Again, the proposal includes measures that are likely to have different effects on savings, investment, and growth. Based on the findings in the literature mentioned above, the CIT increase in itself could have a dampening effect on investment, and growth. The elimination of the FUT would make corporate savings less attractive and could result in higher corporate leverage. At the same time, the proposal includes measures—e.g., faster depreciation of capital—that should support investment and growth. Further, the decrease in the maximum PIT rate could increase the attractiveness of equity investment. In all, the reform could affect firms differently according to their size.
Large firms. As explained above, large firms will withhold 10 percent of profits and will only be eligible for instant depreciation for the first year. These factors could hamper firms’ investment plans. On the other hand, large firms are often less cash constrained and have better access to external financing.
Small firms. As small firms often rely on equity/internal financing to finance working capital and investment, the CIT increase could affect their production and growth plans. At the same time, instant depreciation allowance should provide some offsetting effect and Chile’s deep local capital markets should also help provide ample firm financing. Shareholders could face some liquidity pressures to pay PIT on accrued profits, but in this type of firms, the owners have more direct control over the distribution of profits.
Tax administration. The proposal to include non-distributed profits in the personal income tax base while allowing for the elimination of the FUT would resolve some but not all administrative challenges in the current system and will likely introduce additional difficulties. In particular, the SII would likely still need to collect detailed information about the ownership structure of each company. Additional complications might arise depending on firms’ size. In particular, for large firms, the SII would have to handle a potentially large number of refunds very efficiently.
E. Concluding remarks
22. The authorities have launched a large tax reform to finance increased outlays on education and health and to raise public savings. The overall objectives are welcome. Improving access to high quality education will help improve both Chile’s long term growth prospects and reduce Chile’s skewed income distribution. And eliminating the structural fiscal deficit will help preserve Chile’s strong public finances and fiscal buffers. The proposal is also prudent in that it matches new spending commitments with new permanent revenue. The tax reform’s emphasis on income taxes and reducing loopholes used by the well-off will also help improve income distribution.
23. The tax reform involves a substantial increase in tax revenue and important changes to the tax regime. The proposal involves a large number of changes with different implications for investment, savings, and growth. At this time it is not possible to provide a full, quantitative assessment of the net effects. But the size of the reform and in particular the uncertainty surrounding the implications of the changes to the tax regime (especially the change to dividend taxation which has little similarity in the rest of the world) would likely have a dampening effect on investment and growth though a fuller analysis of long term implications would also need to take into account the effects from education reform. There is also some uncertainty about the revenue yield of the tax reform, stemming from how the private sector will adapt. The planned gradual implementation and strengthening of tax administration are thus welcome. It will remain important to monitor the effects on investment and savings and stand ready to adjust the reform if warranted.
Annex I. Chile’s Full Integration Tax System8
Full integration means that enterprises and their shareholders are considered in the end as a single taxpayer, so that all corporate income taxes paid by the business entity are creditable against the personal tax liability of the owner that ultimately perceives the business profit. From a conceptual point of view this is a desirable feature in an income tax system, making it more neutral between different forms of financing investment. However, few income tax systems are fully integrated in such way. One of the reasons is that, in practice, they are vulnerable to tax planning, minimizing shareholders’ tax burden.
Different imputation systems
The Chilean full integration system
Chile’s full integration system is probably one of the purest in design. Firms pay a ‘provisional’ tax rate of 20 percent on profits as these are accrued by the firm,9 but this is in reality a payment on account of shareholders’ personal income taxes (PIT), which are due when profits are distributed to them;10 at that time they can fully credit against their tax liability the tax paid by the company.11 The PIT rate will be that in the schedule which corresponds to the individual (total) income bracket. The current maximum PIT rate is 40 percent, twice the rate applicable to accrued profits.
Full integration means in the Chilean system that shareholders may in fact get refunded if their PIT is below 20 percent. In the extreme, a small shareholder that has a sufficiently low annual income to be exempt from PIT would obtain a full refund of the tax paid by the firm.12 Moreover, as Chile permits unlimited carry-back and carry-forwards of losses, shareholders could possibly obtain credits or refunds on past taxes paid as the fortune of the firm reverses. This aspect of the system adds uncertainty to government’s tax revenues and a sizeable complication to tax administration.
Full imputation system
Full imputation is the mechanism whereby companies pass on credits for the tax paid on their accrued profits to their shareholders when they distribute dividends. Shareholders declare in their annual income tax return the gross value of the dividends before corporate income taxes (CIT) distributed to them, as well as the imputation credits received. They will then pay any PIT in excess of the imputation credits, eliminating double taxation of business profits. However, imputation credits cannot be claimed as a tax refund.13
Instead, Chile’s income tax system—conceptually at least—does not have a CIT per se; most countries do. This means that in most countries with an imputation system CIT may be credited against shareholder’s PIT up to the amount of PIT liability, but not further, so that individuals cannot obtain refunds for the tax paid by the company on its accrued profits. Thus, PIT on distributed dividends may be zero if the CIT is equal or higher than the PIT rate, but the CIT cannot be diminished as a consequence of PIT calculations. CIT is a separate and final tax.
Partial imputation
There is a variety of partial imputation systems, where CIT may be credited against shareholders’ PIT at different rates and under different conditions. Mexico’s system (until 2013), for example, simplified quite significantly the imputation mechanism: it exempted from PIT all dividends distributed after CIT had been paid. This implied that all shareholders received their dividends net of the same CIT rate—which equaled the top PIT rate, irrespective of their total personal income. The regime carried a certain degree of inequity as shareholders belonging to lower income brackets (with lower PIT rates) paid the same tax rate for the dividends they earn. However, it can be safely assumed that most shareholders are in the top PIT income brackets, so that dividends were probably rarely overtaxed
Classical system
Commonly, countries do not have an imputation system, so that profits are subject to CIT and distributed dividends are also taxed with the corresponding PIT once in shareholders hands, as in the U.S.A. There is no question that such system subjects business profits to double taxation and generates a potentially costly debt bias. Often, in order to minimize such disadvantage and simplify the system, dividends are subject to a relatively small flat withholding tax when distributed.
Dual income tax system
Some 30 years ago, Nordic European countries broke the notion of a global income tax by introducing a flat uniform (relatively low) tax on corporate income and all capital income, separate from the progressive tax on labor income. Dividends could be distributed subject to no further taxation.14
Tax planning around Chile’s integration system
Tax planning opportunities around Chile’s integration regime arise for more than one reason and they need to be distinguished in order to identify policy design challenges. There are at least three issues that deserve specific attention: tax deferrals on undistributed dividends; differential CIT and PIT rates; tax avoidance by shareholders on perceived dividends.
Tax deferral
Capital gains arising from unrealized increases in the value of an asset are not generally subject to income taxes. Though the wealth of the person might have increased, there are potential liquidity constraints that make it advisable to tax only when those gains are realized, i.e., when the asset is sold. Taxation of undistributed profits follows the same logic; even if accrued by the company, they are not subject to PIT before they are in the hands of the shareholder. The same liquidity concerns apply, leading to a tax advantage commonly ingrained in income tax systems.
It could be argued that companies could withhold PIT as profits accrue, before they actually distribute dividends, but they would need to know the residence of shareholders and the total income of each domestic shareholder. Since this is administratively impractical, such regime would in fact force distribution profits as they accrue, limiting incentives for the expansion of business.
Tax deferral privileges can be abused however if shareholders find ways to increase their personal consumption at the expense of undistributed profits, avoiding therefore paying PIT. Any deductible expenditure made by the company which in reality is personal consumption of the shareholder represents a way to distribute dividends without paying PIT and often anti-avoidance rules are insufficient or administratively not cost efficient to combat such practice.
Tax rates
The incentive to disguise private consumption as a company expense (i.e., to withdraw undistributed profits without paying PIT) is exacerbated with any other additional asymmetry between PIT and CIT. It is particularly notorious in Chile’s income tax system that the top marginal rate is now twice the CIT rate. This in itself is a powerful incentive to disguise personal income as company income, quite independently of the integration system.
In general terms, individuals will face the choice (depending on the weaknesses of each legal system) of incorporating themselves in order to offer their labor services or/and act as holding companies in order to receive dividends. In the first case, even if individuals have a subordinated relationship with an employer, they will have the strong incentive to invoice for labor services as independent contractors. They would then pay only CIT (20 percent) and defer the difference with their PIT liability until such time they formally withdraw the dividends (or never pay it if they find the way to spend those dividends in their benefit but somehow within the realm of the business activity). Precisely to avoid the rush of wealthy individuals to incorporate and avoid a higher PIT, countries typically have the top marginal PIT rate equal to the CIT rate (or at least very close).
In some cases, the profits of personal holding companies are taxed on accrued basis, so as to eliminate the incentives for individuals incorporating themselves and avoiding tax consequences on labor income. In the U.S., for example, personal holding companies are defined to be firms with 50 percent of the value of the stock owned by five or fewer persons, and 60 percent of gross income arising from passive sources. A withholding of 15 percent applies to accumulated earnings above a certain amount or above what may be considered to be a reasonable accumulation of undistributed earnings, explained, for example, by future expansion plans. There is some consensus that this regime is complicated to administer.
Tax avoidance
It is a qualitatively different problem when legitimate shareholders (of legitimate companies) avoid the tax on distributed dividends. Shareholders can constitute holding companies to be the first-tier recipient of dividends, instead of the individual; if the ownership of the holding company is dispersed for example among a number of family members with no additional earnings, the second-tier distribution of dividends could be sufficiently subdivided so that the income of each individual shareholder was low enough not to warrant an additional PIT liability.15
Furthermore, shareholders could incorporate as any other entity enjoying special tax privileges. For example, a variety of small companies and, more importantly, private investment societies are subject to no income tax until funds are withdrawn, but they can buy durable goods or invest in real estate which might be for the exclusive enjoyment of the individual shareholder. In general, to the extent that exemptions are juxtaposed with Chile’s particular integration system, more escape routes may potentially open for business earnings of high income individuals to remain tax free.
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IMF (2013a), October 2013 Fiscal Monitor—Taxing Times.
IMF (2013b), Fiscal Policy and Income Inequality. IMF Policy Paper.
Jorrat, M., (2013), “Gastos tributarios y evasión tributaria en Chile: evaluación y propuestas” Tributacion para el Dessarollo, Ed. Arellano, JP., Corbo, V.
OECD (2010), Tax Policy Reform and Economic Growth.
OECD (2013), Reconciling Fiscal Consolidation with Growth and Equity. OECD Journal: Economic Studies.
Prepared by Daniel Rodríguez-Delgado (WHD) in collaboration with Roberto Schatan (FAD).
In practice, tax systems also aim to correct externalities (e.g., pollution, road congestion). While this goal could also be seen as part of efficiency goals, this note will focus only on the growth component.
Based on the tax proposal as submitted to Congress on April 1, 2014.
Analysis based on IMF Fiscal Monitor –Taxing Times, 2013 and Fenochietto and Pessino (2013). See these publications for further methodological details.
In this paper, PIT refers to both Impuesto de Segunda Categoria (e.g., for dependent workers) and Impuesto Global Complementario (e.g. for dividend earners). Both tax categories have the same tax schedule.
See, for example, Cerda and Larrain (2005 and 2010), reference therein and Hsieh and Parker (2006) on the potential negative impact of CIT rates on investment. On the other hand, see Bustos, Engel, and Galetovic (2004) on how depreciation and interest deductions could offset such negative impact.
With the second highest bracket currently having a marginal tax rate of 35.5 percent, the reform will make the top two brackets equal at 35 percent.
Prepared by Roberto Schatan (FAD).
Impuesto de primera categoría.
The fact that there is a tax on accrued profits, even if it is strictly a temporary down-payment on shareholders PIT, might give grounds for some to conceive the system as only partially integrated. For one year, in 1990, Chile’s tax system was fully integrated in that even the impuesto de primera categoria was levied only when profits were distributed.
Impuesto de Segunda Categoria applies to labor income and the Global Complementario for all other income, and are all subject to the sale PIT schedule.
A similar system operates in Australia; see http://www.investors.asn.au/education/shares/understanding-shares/franking-credits/
See for example New Zealand’s system; http://www.ird.govt.nz/business-income-tax/imputation/imputation-basics/
J. Norregaard and T. Khan, “Tax policy: recent trends and coming challenges”, IMF Working Paper 07/274.
Potentially, it could be sufficiently subdivided so as to claim a refund of the initial CIT, if the taxpayer is willing to run the risk of exposing the scheme to the tax authority when examining the merits of the refund.
