Reducing Inequality in Latin America

The Role of Tax Policy

María Fernanda Valdés Valencia

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9780367596101
• eBook ISBN: 9781317069720
• Edition: 1
• Topic: Social Sciences
• Subtopic: Social Classes & Economic Disparity
• Index: Social Sciences

This book examines the role of tax policy in the incidence of socio-economic inequality. With a focus on Latin American, the author demonstrates that while inequality has decreased remarkably in the last decade – during the very period in which inequality was increasing almost everywhere else in the world – this reduction cannot be attributed to a better use of tax policy. Offering both quantitative and qualitative reviews of tax policies pursued by Argentina, Chile, Colombia, Mexico and Peru over the last two decades, Reducing Inequality in Latin America contends that these countries continue to make insufficient use taxation measures in combating startlingly high levels of inequality. Drawing on legal texts, interviews with researchers and experts in the field, and official monetary statistics to obtain a complete picture of how discretionary tax policy has been pursued in the region, this volume engages with a range of recent economic theories to argue for the importance of using the tax system to reduce inequalities, whilst also offering new methods for measuring tax policy in subsequent research. As such, it will appeal both to scholars of social science and policy makers with interests in economics, social inequality, public policy and international political economy.

Part I

Taxation and the inequality decline in Latin America

1 Introduction

Taxation and the inequality decline in Latin America

Although inequality in Latin America remains scandalously high, the region is experiencing an unprecedented equality momentum. Since the beginning of the 2000s, there has been laudable progress in reducing inequality. According to recent studies, income inequality has unambiguously declined in virtually every Latin American country.

This reduction in inequality has taken many observers by surprise, not only for its unusual timing – inequality has decreased precisely in the years when it increased everywhere else – but also for the fact that the reduction was in Latin America, a region that has for decades held the dubious honor of being the most unequal region in the world. Latin American countries have been so flagrantly and persistently unequal that for some, inequality is as Latin American as lively dance music and magical-realist fiction (The Economist 2003). Not many would have predicted that Latin America could eventually escape from the vicious circle of increasing inequality in which the region had seemed trapped mere decades ago. But it has – at least for the time being.

Understanding the key factors behind this unprecedented decline in inequality has been a focus of recent research, and central to the discussion has been the question of whether the inequality reduction observed in the region has resulted predominantly from effective policies or, rather, from plain good luck. This question is, in fact, a very relevant one, because it relates to the sustainability of the reduction: the more the decline in inequality reflects policy changes (rather than transitory and unexpected factors, such as favorable economic circumstances), the more lasting it is likely to be – since good luck rarely lasts forever. Moreover, the region is now heading indisputably into a lean period. There is a sudden weakening in the region’s economic prospects, with no economic growth projected in the region in the upcoming years and with some countries, such as Brazil, Argentina and Venezuela, even heading for deep recessions. Thus, the question of whether the inequality reduction was based only on high economic growth takes on even greater significance, since if growth was the reason for the inequality decline, one may expect levels of inequality to stagnate or even increase in the upcoming years.

Some are inclined to believe that the inequality reduction has indeed been largely a product of plain good luck,¹ for the equality momentum coincided with extraordinarily positive global economic conditions, characterized by increases in remittance inflows, the convenient influx of foreign capital at declining interest rates and, above all, astonishingly high prices of commodities. Under these extraordinary circumstances, the region was able to grow more strongly and generate more employment than before, and higher growth and employment have been named by some as the roots of the inequality decline.

But the fact that the majority of regions did not experience comparable distributive gains despite similar extraordinary global economic conditions has been used as evidence that these inequality outcomes may not stem from simple good fortune. Most studies associate the inequality reduction with important policy shifts and new approaches to public policy in the region. Changes in social policy in the 2000s have been singled out as contributing to the inequality reduction of the region (López-Calva and Lustig 2010; Barrientos 2014). In particular, the 2000s were characterized by the creation and the propagation of social assistance programs focused on the poor, including conditional cash transfer programs such as Bolsa Família in Brazil, Oportunidades in Mexico, and others.² Today, virtually every Latin American country has a conditional cash transfer program, and such programs have been increasing in terms of coverage, generosity and general design over time. A policy shift has also been identified in labor market policies, with a shift in the 2000s towards a much more pro-union and pro-formalization stance, as well as towards an increase in the minimum wage.³ Another commonly cited policy shift has been in educational policy. The indisputable improvements achieved by Latin American countries in enrollment and completion rates have been the result of efforts in educational policy that began in the 1990s but intensified in the 2000s. Improvements in educational policy have been highlighted as an important factor contributing to the reduction in skill premiums and inequality of earnings (López-Calva and Lustig 2010; Lustig et al. 2013).

One policy that is usually disregarded in the analysis is tax policy. So far, only a few have inquired as to whether authorities’ use of the tax instrument in the 2000s has significantly differed from its use before in a way that can help to explain the inequality reduction in Latin American countries over the past several years. This is precisely the gap that I want to fill with this book. Therefore, in these pages I will assess whether tax policy in Latin America has been more pro-equity during this period of declining inequality compared to the period of high and increasing inequality in the 1990s, with the ultimate objective of contributing to the growing literature on the causes of the inequality decline in Latin America.

I believe that the lack of interest in the taxation factor can certainly be explained by the particular difficulties inherent in the investigation of the topic of taxation itself. To ask whether a possible shift in taxation policy can explain the reduction in inequality in Latin America presumes that taxation does indeed have a role to play in determining distributive outcomes: as I will show later in this book, this is an argument that needs to be analyzed before being assumed; it is also an argument that fell out of fashion in economic circles for almost 40 years. Moreover, the concept of “pro-equity taxation” contains certain ideas of fairness, distributive justice and other philosophical normative considerations that we economists have tended to circumvent in recent decades; it involves, for instance, talking about the super-rich and questioning the origins of their circumstances and the desirability of redistributing their income, among other distasteful topics. Thus, the mere concept of pro-equity tax policy pushes many economists to the limits of their comfort zone.

The topic is also empirically challenging. In economies so dependent on international factors – particularly on prices of commodities – as is the case in most Latin American economies, it is difficult to differentiate which changes in tax outcomes (such as level of revenue or tax structures) are the result of discretionary tax policy and fiscal efforts of the authorities, and which are the result of business cycles, commodity prices and simple good luck. Thus, evidencing policy shifts is much more difficult in the case of tax policy than for other policies, such as social expenditures, where a clearer distinction between policy outcomes and policy instruments can be made.

These difficulties explain to a certain degree why the few studies on the subject have, as a matter of simplicity, avoided any significant discussions about inequality and taxation. These studies have also resorted, in the absence of other more accurate empirical alternatives, to presenting changes in tax outcomes such as tax/gross domestic product (GDP) ratios and/or a few cherry-picked tax reforms as evidence of possible policy shifts.

Regardless of all the problems and limitations of this topic, there are excellent reasons to immerse oneself into it. The most convincing one is certainly that the problem of inequality in Latin America is so deep and widespread that any insight about the reasons behind inequality trends over time is always welcome. A further argument is that today is certainly a good moment to talk about taxation in relation to inequality. The public finance difficulties faced nowadays by many countries, particularly in Europe; the rise of inequality in the latest 40 years in many developed countries; and the interest sparked by books such as Piketty’s Capital in the Twenty-First Century (2014) and Deaton’s The Great Escape (2013), among many others, have made the subject somehow trendy again, and a topic which used to be confined to groups of specialized economists is now a source of lively debate and interest among the general public.

The remainder of this book is divided into four parts. The aim of Part II is to provide an overview of the role of taxation in the process of inequality reduction. With this objective in mind, I start by providing, in Chapter 2, an analytical review of the most relevant studies which stress the important role of taxation in shaping and reshaping inequality. This chapter demonstrates clearly that regardless of the study, taxation appears as a relevant variable in explaining inequality within countries as well as trends in inequality over time.

I then examine in particular ways how taxation may determine inequality outcomes. I start in Chapter 3 by reviewing theories from the public finance field, particularly with regard to the role of taxation in explaining inequality. The relationship between taxation and inequality has been at the heart of public finance studies, but its conceptualization has changed dramatically over time. In this chapter, I review such changes in chronological order, showing that, according to the most recent view – that initiated by the economists interested in the 1% and those interested in new Mirrlees models – taxation is very important as an explanation of distributional outcome. According to this approach, taxation affects inequality outcomes not only by affecting individual incomes, as many would think, but by modifying individual behavior.

In Chapter 4, I repeat the exercise but this time from a macroeconomic perspective, attempting to determine the macroeconomic view of the importance of taxation in determining inequality. In general, I do not find a theory in the macroeconomic field that links taxation with inequality; as I explain in this chapter, this has to do with the lack of interest that economists have shown in inequality issues and issues of economic cycles and taxation. But as I explain further in the chapter, there are fragments of research that one can put together to construct a coherent and robust framework. From this framework, one can extract the insight that taxation does have a role to play in the process of inequality reduction by creating an equality-friendly macroeconomic atmosphere – that is, a more stable economy.

In Chapter 5, the exercise is repeated again, but from a political economy perspective. From this perspective, taxation can play a vital role in the process of inequality reduction, since it has the capacity to create a political configuration that favors redistribution. In particular, as will be explained in detail in this chapter, taxation can be used to restrict and even reduce the accumulation of wealth and income of economic elites, and in this way to change the redistribution of political power from the top to the bottom. The more equally redistributed that political power is, the more the political configuration favors redistribution, not only through a more pro-equity tax system, but also through a self-reinforcing, more pro-equity public policy in general.

After explaining in detail the importance of studying taxation to explain inequality, and after evidencing relevant channels through which taxation can influence the inequality reduction process, I deal in Part III with all the methodology issues. As mentioned above, measuring tax policy is not a simple task; therefore, I begin this part with the basics. In Chapter 6, I define the concept of tax policy and review all the options for measuring it based on other studies. This information serves as an input to my own methodology proposal, which comes in Chapter 7. In this chapter, I propose using structural tax revenues (tax revenues adjusted for the economic cycle and for prices of commodities) as a proxy for tax policy, together with complementary qualitative information derived from case studies and a narrative exercise obtained from other qualitative studies of tax reforms. To measure whether tax policy has become more pro-equity over time, I define this qualifying term pro-equity such that the more a tax policy manages to collect, the more progressively it collects and the more countercyclical it is, the more pro-equity it will be. In this chapter, I also discuss the case-selection procedure that led me to choose the five largest Latin American countries dependent on one single commodity for which data exist: Argentina, Chile, Colombia, Mexico and Peru. Here it is important to state that although the country selection was data- and methodology-driven, the chosen countries do represent the region in one fundamental way. These five countries typify the three types of economic structure found in most countries in the region: countries that are dependent on oil (Colombia and Mexico), generally called petro-states; countries that are dependent on minerals (Chile and Peru); and countries that are dependent on agriculture (Argentina). However, given the short sample, it is difficult to make inferences from the case studies and to generalize to the region as a whole without the benefit of additional research, and the results found in my case studies are only suggestive in reference to other Latin American countries.

In Part IV, after all the methodological issues have been dealt with, I apply the proposed methodology to the five case study countries – Argentina, Chile, Colombia, Mexico and Peru – for the period 1990–2013. This part is divided into two chapters. Chapter 8 is devoted to obtaining and analyzing the structural tax revenues of each country in order to see whether taxation was more pro-equity in the years of inequality reduction in comparison with the period of increasing inequality. Chapter 9 uses the narrative approach based on qualitative information from tax reforms to assess tax reforms of the last 23 years in my countries of analysis.

Part V is a single chapter, a concluding chapter; here I interpret the results from the previous two chapters and come to the difficult conclusion that the way the tax instrument was used by the authorities in the years when inequality was declining was no more pro-equity compared to the 1990s, when inequality was high and rising. Thus, if one is looking for reasons for the decline in inequality, one may want to look elsewhere. I maintain that tax policy has not improved in terms of its redistributive capacity due to an insufficient increase in the level of both collection and progressivity in recent years, and I propose possible reasons for these deficiencies. On the one hand, the positive economic conditions disincentivized authorities from engaging in revenue-increasing tax reform; on the other hand, the factor of progressivity most likely did not improve due to the fact that only a few reforms were aimed at increasing progressivity – most likely due to obstruction from political economy factors, such as the influence of economic elites.

This book provides two important policy implications. The first is the importance of recognizing not only that much should be done to improve the situation, but also that much more can be done. The fact that collection improved more in the 1990s, when issues of inequality and taxation were out of fashion, is very telling of what can be done now that governments, academia and others recognize at least the distributive role of taxation, contrary to the situation a few years ago. The second related implication is that increasing progressivity is possible, as attested by a few reforms that passed in the countries I studied (e.g. the 1990 tax reform in Chile, increasing personal income tax [PIT] rates in Colombia during Uribe, etc.); thus, it is not a problem of institutional incapability or structural difficulties, as many have suggested. Instead, as I will show in this book, the lack of such reforms is more likely due to political economy limitations – limitations that should always be taken into account when analyzing and proposing new tax reforms.

This book evidences a deficient management of the tax tool in recent years, compared to the 1990s, in a way that has not facilitated the inequality reduction process in the region. This book does, however, have a happy ending in the sense that from it, one can see opportunities that lie ahead in the region in the new context of low economic growth. I will show that unfavorable economic situations and political uncertainty, such as those now facing Latin American economies, are strongly associated with tax reforms. This implies that we may expect a new wave of reforms to come. In fact, voices for structural tax reforms have been raised very recently in countries such as Colombia and Argentina. Reforms may come, and with them new opportunities for change; and this time, unlike during the difficult times of the 1990s, there is not only a broad agreement about the shortcomings of current regional tax systems regarding their redistributive power, but there is a huge interest in equity considerations of tax policy, as we will see in this book. Hopefully the years to come will find a more conducive political and ideological atmo...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of figures
• List of tables
• List of boxes
• List of annexes
• Acknowledgements
• Part I Taxation and the inequality decline in Latin America
• Part II The taxation and inequality link
• Part III A methodological approach to measuring pro-equity tax policy
• Part IV Is taxation becoming more pro-equity? Case studies
• Part V Tax policy before, during and beyond the Latin American inequality momentum
• References
• Annexes
• Index