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Distributional Impact of VAT Reform in the Dominican Republic By Anna Fruttero and Omar Arias LCSPP Frontiers in Practice Reducing Poverty Through Better Diagnosis Analyzing Fiscal Impacts on Poverty Reduction March 23, 2006 1 Background PSIA request from DR Gov in support of fiscal reform process (tax loss due to CAFTA, financing of social spending gaps) Developed as part of the 2005 PA in collaboration with the Technical Secretariat of the Presidency 2 Why interest in VAT (ITBIS) reform analysis ? VAT is not fully exploited (exemptions), Other taxes (income, property) harder Public opinion Regressivity bias: Need to assess distributional impact 3 DR tax effort has increased but is still around LAC average and below similar countries % taxes in GDP 35 30 % of GDP 25 20 15 10 5 0 DR CR ES U G A HO * Unweighted regional averages Note: data for GUA and HO for 99 from CEPAL For NI, data from 91 and not 90. Source: World Development Indicators and OECD NI PA m lA a r nt e C * ica r e o st e R * AC L f D EC O * 1990-1994 i As t s Ea a* Circa 2000 4 DR still relies heavily on trade taxes (though less so in recent years) % total revenues circa 2000 60% 50% 40% 30% 20% 10% 0% Income G&S DR CA* Property Rest LAC* Int'l trade OECD* SS East Asia* •Regional averages Source: Based on Government Finance Statistics 2004, IMF and OECD 5 VAT revenues are particularly low % total revenues 60 50 40 30 20 10 0 PA MX DR VE HA CO BO BR UR CR PY EC Source: Based on Government Finance Statistics, IMF NI CL AR ES PE 6 …Largely a result of low and declining productivity of the tax (loopholes, evasion) VAT Rate VAT productivity 18 80 16 70 14 60 12 50 10 40 8 6 30 4 20 2 10 0 0 CR 1994 DR Present ES GUA HO NI PA Rest CA LAC East OECD Asia CR DR 1994 1997 ES GUA HO NI PA CA Rest LAC Present Source: Government Finance Statistics, International Finance Statistics and World Economic Outlook (IMF) 7 VAT is a means to tax the well off Other 13% National Remittances 6% Imputed Rent 12% Labor Income 56% 20% poorest Sources of income: 20% richest Source: authors’ calculations based on ENCOVI 2004 Overseas Remittances 3% Home Selfconsumption 10% National Remittances 2% Other 25% Imputed Rent 5% Overseas Remittances 18% Labor Income 44% Home Selfconsumption 6% 8 The rich account for more than half of consumption of exempt goods & services 20% poorest quintile 2 4.5 8.8 quintile 3 13.2 Distribution of expenditures by quintiles (%) 20% richest 53.8 quintile 4 19.6 Exempt G&S 20% poorest 2.5 20% richest 65.3 quintile 2 quintile 3 5.5 9.6 Non exempt G&S Source: authors’ calculations based on ENCOVI 2004 quintile 4 17.0 9 Exemptions of G&S from VAT implicitly subsidize the consumption of the rich at a significant revenue loss Increasing revenues from this tax should come from expanding the tax base with due equity considerations 10 Options to expand the VAT tax base Remove all exemptions (benchmark) Remove all exemptions except for Health, Education and Electricity (SEE) Remove all exemptions except for basic food + SEE Apply a lower rate to basic food, SEE exempt 11 To assess distributional impacts for each scenario we compute: Tax burden= % total tax paid by each Q Tax pressure= tax burden/income share of each Q Effective tax rate= total tax paid/total income by Q By simulating the VAT code with data on incomes and expenditures from a 2004 household survey (no behavioral responses) 12 All options to broaden the base increase the tax pressure for the poor but this remains much lower than for the rich Ratio of share of tax paid to income share 1.20 1.00 0.80 0.60 0.40 20% poorest quintile 2 quintile 3 Actual No exemptions Basic food/gas/SEE Rate differentiation quintile 4 20% richest SEE SEE = Health, education and electricity Source: authors’ calculations based on ENCOVI 2004 13 Revenues could increase substantially even exempting basic food and SEE, or with a differential tax rate Revenue estimates (% GDP) 10 9 8 7 6 5 4 3 2 1 0 Actual No exemptions Exemption SEE Exemptions basic food + SEE Rate differentiation Note: estimates do not account for behavioral responses and only capture private consumption of households, but account for tax avoidance by small firms SEE = Health, education and electricity. Source: authors’ calculations based on ENCOVI 2004 14 Two BIG caveats 1. Main results were derived under the assumption that consumption patterns are not affected by changes in prices… Sensitivity analysis using various plausible values of price elasticities indicate tight orders of magnitude of the results 15 Two BIG caveats 2. Distributional impact of fiscal reform depends on how spending is distributed… Less than one third of social assistance $$ reach the poorest 40 percent (helicopter allocation is better). Only the high-revenue reforms can generate transfers significantly higher than the extra tax burden on the poorest 40% under existing expenditure allocations. 16 Policy implications DR has room to increase IVA revenues without too high a cost on equity, by expanding the base while maintaining exemptions on (or applying a different rate to) basic food To maximize overall equity impacts it is critical to simultaneously improve targeting of social expenditures Although these results were effectively used by the DR Government in the public debate, lack of power in congress led to a 1st phase curtailed reform (maintaining many exemptions). 17