Fiscal Federalism and Inequality in Latin America

1. Fiscal Federalism and Inequality in Latin America Thornton Matheson International Monetary Fund Presentation for the LAC Tax Policy Forum Panama, September 17, 2010

2. Overview • Theory of fiscal federalism • Practice of fiscal federalism in Latin America • General reform goals • Local Government (LG) revenue instruments • Design of interjurisdictional redistribution

3. Fiscal Federalism: Theory • Where regional preferences differ, devolution of fiscal authority can improve allocative efficiency and welfare. • To achieve this, LGs must be accountable to local constituents • Raise own revenues at the margin • Significant discretion over spending

4. Fiscal Devolution: Constraints • Interregional factor mobility • Local administrative resources • Macroeconomic stabilization • LG soft budget constraints • Excessive devolution • Regional tax base disparities* • Economic activity often concentrated in a few large cities • Natural resource wealth also unevenly distributed

5. Fiscal Federalism and Interpersonal Inequality • LGs often largely responsible for social welfare spending (health, education) critical to reducing inequality • LGs with poorer constituencies often have smaller PC tax bases • Necessitates interjurisdictional transfers

6. Fiscal Federalism in Latin America • Expenditure: Relatively low level of devolution • Revenues: Low level of own revenues

7. Fiscal Federalism in Latin America • Mismatch between revenues and expenditures • Heavy reliance on transfers and revenue sharing • Most major tax bases assigned to center • Transfers/revenue sharing often pro-cyclical • Extensive earmarking of transfers • Many LGs have little discretion over spending • Vertically overlapping spending responsibilities

8. FF in LAC: Tax Assignment • Most major bases assigned to center: • CIT: national • PIT: national (except Brazil and Mexico) • Asset: national • VAT: national (except Brazil) • Sales: national • Excises: national/state • States and local tax bases more limited: • Vehicles: state • Property: state/municipal • Business taxes: municipal • Natural Resources: shared Source: Amhad & Brosio (2008), 7 largest LAC countries

9. FF in Latin America: Consequences • Revenue dependency and earmarking undermine LG accountability • Poor incentives to develop own revenue sources • Poor incentives for efficient service provision • Procyclical revenues and revenue/expenditure mismatch encourage LG deficit financing • Soft budget constraints can threaten macroeconomic stability

10. FF in Latin America: Reform Goals • Develop LG own revenue sources • Low cyclicality • Progressive • Evenly distributed across jurisdictions • Constrain LG deficit spending • Make transfer system transparent, fair and reliable • Reduce earmarking

11. Revenues: Property Tax • Advantages: • Immobile base • Progressive • Low cyclicality • Disadvantages: • Administration complex • Interregional base disparities

12. Revenues: Property Tax • Chief source of own revenue for LGs in LAC • However, productivity relatively low: • OECD average: 2.6% GDP • Developing countries: 0.6% GDP • Mexico: 0.2% • Brazil: 0.5% • Argentina: 0.4% • Colombia: 1% • Problem: Low tax rates, poor cadastres, administrative capacity, lack of political will to enforce

13. Revenues: Consumption Taxes • VAT, sales taxes, destination-based excises • E.g., Brazil (ICMS), Colombia (alcohol, cigarettes, gasoline), Argentina (turnover) • Advantages: • Low cyclicality relative to income taxes • Geographically dispersed • Destination basis generally avoids tax competition (except cross-border shopping) • Disadvantages: • Subnational VAT complex, distortive • Sales taxes cascade, avoidable, narrow bases • Origin-based excises more efficient

14. Revenues: Income-type VAT • Advantages: • Broader base than CIT, buoyant revenue source • Benefit charge for local businesses • Alternative to commercial property tax • Disadvantages: • Geographic concentration • Tax competition (origin-based) • Cyclicality (but less so than CIT) • Examples: • IRAP (Italy, regional) raises 2.5% of GDP • IETU (Mexico, federal) has some similarities

15. Revenues: PIT Surcharge • CG sets base, LGs allowed to set own rate (perhaps within limits) • Advantages: • Administrable (CG can collect) • Progressive • Disadvantages: • Cyclicality • Base mobility • Some CGs share PIT revenue with LGs (e.g., Brazil, Mexico). • Unlike surcharge, this is not LG own revenue. • US: Many states impose own PITs on federal PIT base.

16. Revenues: Natural Resource Taxes • Theory dictates these should be CG taxes: • Uneven regional tax base • Potentially complex • Volatile revenues • However, they are often shared with LGs. • Need for infrastructure, environmental cleanup • Local population ownership claims • Examples: • Bolivia: Departments receive about 2/3 of gas rents and 1/3 hydrocarbon income tax (IDH). Municipalities receive ¼ of IDH. • Colombia: 48% oil royalties go to departments, 13% to municipalities, 8% ports. • Possible alternative: Production excises with redistribution • May also create stabilization fund to counter revenue volatility

17. Interjurisdictional Redistribution • Given disparities in LG tax bases and administrative constraints, LAC countries will likely remain fairly reliant on revenue sharing and transfers. • Greater decentralization itself leads to more transfers • OECD: elasticity of total transfers with respect to LG own revenue share = 1.5 • Redistribution therefore needs to be well designed to promote LG accountability and hard budget constraints.

18. Transfer Design • Transfers should not be based on historical LG revenue or spending patterns • This creates incentive for LGs to undertax and/or overspend. • Transfers should be based on the difference between ex ante LG revenue capacity and spending requirements • Revenue capacity: Apply average tax rate to average base, or macroeconomic measure of GRP, income PC • Transfers could be varied anti-cyclically • In practice, transfers are often pro-cyclical • “Rainy day funds”