Governments in Latin America and the Caribbean face a perfect economic and social storm as they seek to accelerate their post-pandemic recovery. Vulnerable communities need help in the face of increased inequality and poverty. Health, education and other social services require more resources. Rulers must find a way to grow equitably and sustainably amid higher inflation, weakening global demand and rising debt levels.
The challenge is even more complex for countries with a low ratio of tax revenue to gross domestic product (GDP), as is the case for several of them. There is a positive correlation between the quality of public services and the tax burden.
The best way for governments to get out of this apparent trap is to move simultaneously on three fronts: improve the efficiency of fiscal spending, combat tax evasion, and move large segments of their economies out of informality (a process known as ‘economic formalization’). ).
The good news is that these actions are much more feasible than many believe, and can generate significant economic and political returns.
The best way to get out of this apparent trap is to move forward on three fronts: improve the efficiency of fiscal spending, combat tax evasion, and remove large segments of the informal sector.
First, the evidence shows that governments can do more with what they already have. Our research estimates that inefficiencies in public procurement processes, i.e. giving benefits to those who don’t need them (a phenomenon known as ‘leakage’), along with other waste, add up to around 4.4% of GDP region of.
This equates to some 200 billion dollars a year, enough to eliminate extreme poverty in these countries. However, inefficiencies are often overlooked due to the misconception that the rewards are small, are too difficult to implement, and do little to achieve important policy goals. The truth is that efficiencies can generate huge savings in the short term and give the government the necessary credibility to tackle more difficult reforms.
Digitize and modernize
Take the case of public procurement. By digitizing and modernizing paper-based purchasing systems, Argentina and Peru achieved cost reductions of 4% and 10%, respectively. In Brazil, the switch to a procurement system based on electronic catalogs of products and pre-approved suppliers led to a 10% drop in the average price paid for products at the federal level, and 20% in the city of São Paulo.
In Colombia, digital tools made it possible to lower the average time to process purchase orders from 31 days to less than eight hours. This is one of those win-win situations: we improve our public services and we do it with fewer resources.
A second strategic area for improvement is to reduce evasion, which represents an average of 5.6% of GDP in Latin America and the Caribbean. Many countries have achieved good results by modernizing their tax administrations, using digital tools. For example, the introduction of electronic invoices in Argentina, Brazil, Mexico and Uruguay, among others, led to an increase in tax collection of up to 11% for several years after its implementation.
In Colombia, digital tools made it possible to lower the average time to process purchase orders from 31 days to less than eight hours
The use in Colombia of algorithms that detect errors led more than 100,000 taxpayers to pay their value added taxes (VAT) for the first time. Half a million individuals completed their tax returns for the first time thanks to these algorithms. Tax administrators can use data analysis and big data techniques to facilitate tax compliance by pre-filling tax forms and having them ready for submission.
In Chile, nine out of ten taxpayers use this type of automatic forms to pay their value added taxes, with a reduction in processing times of 60%.
A third strategic area of action is to reduce the shadow economy. 60% of workers have no contracts, and 90% of companies are informal. This means that our countries are less productive and there is more inequality.
Informality has a real and detrimental effect on people’s lives. I was Minister of Finance of Paraguay when we had to close the economy for three months at the beginning of the pandemic to protect the health of our population. This meant implementing an assistance program, and doing it without delay.
A third strategic area of action is to reduce the shadow economy. 60% of workers have no contracts, and 90% of companies are informal.
Developed countries typically use taxpayer records to determine who should receive financial assistance. This option was not viable in Paraguay due to the large number of people – from street vendors to farm workers – who did not file taxes. For many of them, stopping work meant going hungry.
The benefits of formalizing
We used a process of elimination to determine who would receive the transfers: public employees were not eligible, neither were those who contributed to social security, or who paid their taxes, and so on. The reasoning was that these people had some source of income and had less need for emergency help. Although the system was imperfect, it prevented many from going hungry. On the other hand, it reinforced the notion that those who pay their taxes and follow the rules must bear an increasing burden without necessarily enjoying the benefits.
Informality has many causes, but fiscal policy is a critical ingredient. When Brazil and Uruguay simplified their tax regimes for small and medium-sized companies, the result was greater economic activity and more jobs that generated income taxes and contributions to pension systems, among other benefits.
Research from the Inter-American Development Bank (IDB) has identified policies that have a positive impact on formalization. For example, we find that giving workers tax credits on their formal earnings can be a powerful incentive to reduce informal hiring.
In the same way, the wider use of the VAT, in combination with tax refunds for populations in vulnerable communities on their formal purchases, can promote formalization. It also generates more tax revenue and builds progressive tax systems.
The wider use of the VAT, in combination with tax refunds for populations in vulnerable communities on their formal purchases, can promote formalization.
As a minister I had to implement a tax reform to generate more income. I understood that a successful tax and tax reform must be based on a concept of equity: most people are content to pay more taxes if they perceive that everyone is paying their fair share.
Governments that adopt an integrated strategy based on efficiency improvements in combination with an optimization of revenue collection and the reduction of informality will be rewarded by receiving more revenue which, in turn, allows for an expansion of social assistance and of other public services.
As a public bureaucracy has more financial and human resources, it can provide better quality services. This creates a scenario where citizens trust their governments more, which will make more people willing to pay more taxes. In this way we will have a solid foundation to grow sustainably and equitably.
BENIGNO LOPEZ
AMERICAS QUATERLY
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