GOH Faces Unpalatable Choices on Increasing

UNCLAS SECTION 01 OF 03 TEGUCIGALPA 003004

SIPDIS

SENSITIVE

STATE FOR WHA/CEN, WHA/ESPC, AND EB/IFD/OMA
STATE PASS AID FOR LAC/CEN
STATE PASS USTR, EXIM AND OPIC
STATE PASS USED IDB, USED WB, AND USED IMF
TREASURY FOR JOHN JENKINS

LABOR FOR ILAB, ROBERT WHOLEY
PANAMA FOR CUSTOMS

E.O. 12958: N/A

TAGS: EFIN ECON EAID ETRD ELAB PGOV HO
SUBJECT: GOH Faces Unpalatable Choices on Increasing
Government Revenues


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Summary
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1. (SBU) A new IDB-sponsored diagnosis of structural
problems in Honduras's tax policy documents the failure of
the GOH to raise sufficient revenues to fund vital state
functions, resulting in steady growth in the central
government's fiscal deficit. The authors recommend an
immediate repeal of extensive tax exemptions and loopholes
that have reduced the tax base significantly over the years,
and a long-term structural overhaul of the tax system.
These sensible and needed recommendations will be
overwhelmingly difficult to implement in the Honduran
political context and it remains to be seen how tough the
IMF will be. There is high-level political commitment to
work on an equally important improvement of Honduras' tax
administration (collection and audits),with help from the
U.S. Treasury Department's tax administration technical
assistance office. The high percentage of Honduran tax
receipts collected by customs officials indicates that a
customs service technical assistance project may be needed
as well. Washington agencies preparing for U.S.-Central
American Free Trade Agreement (USCAFTA) negotiations may
wish to consider carefully our position on GOH tax
incentives for non-traditional exporters (including U.S.
companies) in the context of the investment chapter. End
Summary.

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Honduran Tax Collection: Too Low, Too Unfair and Too
Uncontrolled
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2. (SBU) A team of consultants hired by the IDB is currently
putting the finishing touches on a report entitled
"Honduras: Toward a More Transparent and Diversified Tax
System." The study repeats the recommendations of earlier
studies and analyses. It is well-documented, albeit based
on Honduras' extremely limited statistical data base, and
provides policymakers the kinds of details needed to target
loopholes in Honduran tax law. Obtaining a substantial
increase in tax revenues in the near-term is going to be an
important issue in upcoming Article IV review and discussion
of a new three-year Poverty Reduction and Growth Facility
program with the IMF team that is expected to arrive
November 4. To ensure adequate attention and coordination
on this aspect of macroeconomic policy, the USAID mission in
Honduras has coordinated an extremely useful series of
meetings of the G-15 Macroeconomic group to evaluate
Honduras' tax system. At a recent meeting of this donor
group, the key results of the IDB study were presented and
discussed.


3. (SBU) The scope of the problem is fairly clear. Honduras
collects (using official measures) taxes equivalent to 16
percent of GDP. Assuming GDP in Honduras is underestimated
by 35 percent, this tax receipt measure falls to 12 percent
of GDP using the appropriate estimate of GDP. The World
Bank advises that this is only half of the percentage that
is considered healthy for a developing country. This level
of tax collection is not adequate to fund the key government
services and investment that are needed; growth in tax
receipts has not kept up with expenditure growth over the
last ten years, resulting in ever growing deficits (with the
exception of 1995-98). The percentage of government
expenditures that were covered by tax revenues has declined
from 88 percent of GDP in 1998 to only 63 percent in 2001.
The tax structure also is highly regressive, since most of
the tax exemptions are provided to the wealthy. The poorest
Hondurans pay a percentage of their income in taxes that is
75 percent higher than the average taxpayer, whereas the
richest Hondurans pay a percentage of their income in taxes
that is 20 percent lower than average.


4. (SBU) The IDB consultants noted that the rapid growth in
the public sector wage bill in recent years (up from 45
percent of tax receipts in 1997 to more than 60 percent in
2001) as a result of the wage provisions in the special
framework laws (estatutos) for teachers and health service
professionals. They also commented that the size of the
state is not the real problem. They noted that Honduras'
central government budget as a percentage of GDP is smaller
than even Nicaragua's. The state simply does not collect
enough revenue. Finally, the lack of sufficient income has
led the GOH to fail to transfer five percent of net
government income to municipalities, as required by the
Municipality Law that went into effect in January 1991.


5. (SBU) As the GOH began to reduce customs tariffs in 1991
in an effort to liberalize trade, the sales tax (a modified
VAT tax) has gradually grown in importance and now accounts
for 33 percent of total government tax revenues. Income tax
accounts for 22 percent of tax receipts, and taxes on oil
and oil products come in third, representing 21 percent of
total taxes. The 1990s were also a period of export
promotion, resulting in a web of generous tax incentives for
textile and apparel companies, mining, and tourism services.
The IDB team notes that the country has paid a high price
for these incentives, in terms of transparency, fair
treatment across taxpaying groups, and control of its own
tax administration.


6. (SBU) Although only 12 percent of tax receipts come from
import duties, the IDB report notes that 50 percent of all
tax revenues (including customs duties, sales tax, excise
taxes, etc.) are collected by the customs service. Tax
payments are highly concentrated. In the year 2000, 703
large companies paid 77 percent of the income tax and 1,129
large firms accounted for three-quarters of sales tax
payments.


7. (SBU) The IDB study also noted the weakness of the
Honduran tax and customs service, the DEI. Although some
improvements have been made (including the new installation
of an automated tax payment transfer system integrated with
the commercial banks, a project paid for by the IDB),there
remains a great deal of work to do. Note: The U.S.
Department of Treasury's tax administration technical
assistance project begins in earnest at the beginning of
November. This work will focus on tax collection and
auditing. The Treasury experts have recommended that the
Embassy also contact U.S. Customs about possible technical
assistance for the DEI's customs operations. End Note.


8. (SBU) Extensive exemptions are provided in almost all the
tax categories, resulting in a greatly reduced tax base. A
wide range of companies receive exemptions from the sales
tax for purchases of raw materials and other inputs. As
result of the granting of extensive exemptions from customs
duties, revenues from this tax source are only 56 percent of
the theoretical tax collection (calculated by multiplying
the value of imports by the appropriate ad valorem tariff).
In addition, the consultants estimate that 41 percent of
imported goods enter the country exempt from sales tax as
well.


9. (SBU) Tax incentives have been provided to the majority
of manufacturing and assembly firms (operating in free trade
zones of several types) and companies in the tourism, mining
and energy fields, providing these companies with exemptions
from customs duties, sales tax, and income tax. Current
administration of these exemptions provides ample
opportunity for abuse. It is believed that at least one
firm in the power sector is reselling large quantities of
fuel to gas stations, instead of using the tax-exempt
product strictly for electricity generation. Many goods
imported duty-free as inputs for assembly or manufacturing
are instead sold on the retail market.

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Solutions Are All Politically Unpalatable
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10. (SBU) The IDB team recommended a series of changes to
the tax code, for the short term, designed to broaden the
tax base for the GOH's main revenue sources. They believe
these measures would increase tax collections by two percent
of GDP, annually. The key provisions in this list are the
elimination or dramatic reduction of tax exemptions and the
application of minimum amounts of taxes to limit tax
avoidance schemes. As these tax exemptions benefit the
largest and most important companies and individuals in the
country, and in many cases these changes would be tantamount
to violation of contractual terms and shifting rules of the
game for investors, many donors are skeptical that
sufficient political will exists for major tax policy
shifts.


11. (SBU) For this reason, some experts are proposing that
the GOH raise the sales tax in order to increase revenues
quickly, lower the fiscal deficit, and allow the government
to reach an agreement with the IMF. Some of these observers
cite the case of Chile, in which an eighteen percent tariff
is applied across the board, with almost no exceptions. In
Chile and Mexico, these analysts noted, the sales tax is not
nearly as regressive as one would think, because the
elimination of exemptions and incentives ensures that the
wealthier part of the population is not able to avoid taxes.
While the simplicity and effectiveness of this approach is
attractive (and senior advisors in the GOH have noted that
this was the case when the sales tax was raised from seven
to twelve percent in 1998),it would put the GOH on the
political defensive for raising taxes on the poor and
allowing the rich to continue receiving exemptions.

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Comment
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12. (SBU) We expect that the IMF will push the GOH to
increase tax revenue in order to help achieve macroeconomic
stability. The GOH is well advised to improve its tax
administration, but this will not be sufficient to achieve
fiscal balance. At least some tax exemptions will need to
be eliminated to help reduce the budget deficit. While
raising the sales tax represents a simple alternative, we
believe it would be politically difficult in the current
context of high unemployment and slow growth. The GOH may
also look to privatization and concessions of government
infrastructure projects, as a way of both increasing
government revenues and improving efficiency (currently, the
only privatization proceeds that are included in the 2003
budget are the planned sale of a wireless phone concession).
The final important factor is economic growth. If Honduras
can find a way to improve its investment climate
sufficiently, it may be able to grow itself out of the
conundrum it finds itself in.

Pierce