PARAGUAY'S PLAN TO FORMALIZE CDE

UNCLAS SECTION 01 OF 03 ASUNCION 001242

SIPDIS

STATE FOR WHA/BSC, WHA/EPSC, EB/TPP/IPE
STATE PASS TO USTR FOR LYANG, MSULLIVAN
USAID FOR AA/LAC ADOLFO FRANCO
TREASURY FOR OSIA MAUREEN WAFER
COMMERCE ITA SARAH COOK
NSC FOR MIKE DEMPSEY AND SUE CRONIN
SOUTHCOM FOR POLAD

E.O. 12958: N/A
TAGS: ECON EFIN ETRD KIPR KCRM KMCA KTFN PREL PA
SUBJECT: PARAGUAY'S PLAN TO FORMALIZE CDE

REF: ASUNCION 423

--------------
SUMMARY
--------------


1. The GOP has announced a new tax plan designed to help
formalize the economy of Ciudad del Este, situated on the
border with Brazil. The system will be voluntary and is
expected to take effect in November. Participants will
receive benefits such as lower tariffs and lower up-front
tax payments upon importation. In return, participants must
commit to claiming the full value of imported merchandise,
sharing financial information to allow for verification that
purchase prices match declared values, and the collection of
customer data. The GOP expects to increase revenues with
the plan, while minimizing opportunities for corruption.
Pitfalls abound: Customs is unsure how to implement the
decree, and businesses are concerned about the potential for
harassment from prosecutors for past practices. USAID-
funded Paraguay Vende played an important role in the
development of the plan. The initiative is another example
of the political will to push forward with economic reforms.
End Summary.

--------------
A STEP TOWARD FORMALIZING CDE
--------------


2. On September 15, Minister Bergen invited the Ambassador
to a private briefing on the GOP's plan to create tax and
other incentives to formalize the economy in Ciudad del
Este, Paraguay's second largest city located in the tri-
border area. The Director of the Tax Administration,
Andreas Neufeld, and Vice Minister of Economy Jorge von
Horoch also attended the briefing, as did Econchief.
Minister Bergen briefed the Brazilian Ambassador separately
the same morning, with the rationale that Brazil is the
largest market for information technology products sold in
CDE, and the United States is the largest provider of those
products. After three months of low profile work, largely
based on a study as well as the promotion of dialogue by
USAID-funded Paraguay Vende, Neufeld announced the
initiative to the public on September 19, with an expected
implementation date of November 1.

--------------
CREATING THE RIGHT INCENTIVES
--------------


3. The initiative has two basic principles: firms will have
to sign up and commit to certain actions that will
facilitate enforcement in order to qualify for the benefits
of lower taxes, and the new rates and rules should minimize
incentives to cheat or pay bribes. It was designed with two
constraints in mind: the GOP must collect at least the same
amount under the new regime (Paraguay depends heavily on
customs revenues),and it must be entirely consistent with
Paraguay's obligations under Mercosur.


4. The program, which is supposed to take effect in
November, will technically apply to all items covered under
Paraguay's Tourism Regime, which includes information
technology and telecommunications equipment (IT),
electronics, perfumes and other luxury items. Initially,
however, the GOP anticipates heavy IT participation
eventually leading others to join. The GOP will take
advantage of a special Mercosur preference that allows
Paraguay to charge a zero tariff on IT products through the
end of 2005, after which the tariff will return to the
current level of two percent.


5. The plan includes a few fundamental changes. First,
most tourism regime goods have hitherto been exempt from the
value added tax (VAT),which runs ten percent on most goods.
Beginning with implementation of the new tax regime, though,
all sales of these items throughout Paraguay, to Paraguayan
citizens, will be subject to the ten percent VAT. Sales to
foreigners will be exempt. Importers who sign up for the
new regime will only be charged an advance of 1.5 percent of
the 10 percent VAT, with the balance (on sales to
Paraguayans) to be collected later. In practice, though,
most sales are to foreigners, and importer sales to
distributors would not trigger the VAT, meaning that the 1.5
percent will be the final VAT for most importers. Importers
who choose not to sign on will be charged the entire ten
percent up front upon importation of the merchandize, thus
providing an incentive for importers to register.


6. Second, advance collection of income tax by customs will
be reduced for participants from three percent to 0.3
percent, with the balance collected later. Vice Minister
Neufeld considered this change to be fundamental. The
ability to offset future income tax liability creates a
strong incentive for businesses to justify their expenses:
by demanding legal receipts from suppliers, registering
workers, etc. The current system collects all taxes in
advance, leaving little or no incentive to operate legally.
In comments to the press after the September 19
announcement, Neufeld said he expected tax revenues to
increase, both through a higher volume of merchandize and
through the increased VAT collections.

--------------
BREAKING THE CYCLE OF CORRUPTION
--------------


7. Neufeld provided a side-by-side comparison of the taxes
paid by a firm undervaluing a shipment by 50% but paying
taxes under the current system, and the taxes paid by a firm
declaring the full value of a shipment under the new system.
The tax paid under the new system for a $1,000 importation
would be $18.25 versus $26.00 under the current system, even
with undervaluation. The $26.00, though, does not include
the additional costs of bribes to facilitate the
undervaluation in the first place. Neufeld also pointed out
that minimizing taxes collected upon importation also
minimizes the potential savings to be had by paying a bribe
to avoid those taxes.


8. To guard against fraud in the new system, participants
must agree to report all financial payments and explicitly
link those payments to particular imports. The goal is to
verify declared values of imports by checking that outgoing
financial transfers match the declared values. If transfers
exceed declared values, one would suspect undervaluation.
The GOP intends to police the new arrangement by relying on
the cross-referencing of taxpayer customs, tax and financial
data, with the vetted tax crime investigative unit being
developed with help from Treasury's Office of Technical
Assistance (OTA) having primary responsibility.


9. The plan was developed in close consultation with
municipal authorities and the portion of the local private
sector in CDE that wants to formalize (i.e., pay taxes and
compete honestly and legally). USAID-funded Paraguay Vende
played an important intermediary role that included the
publication of a study on real business practices in the IT
sector on the border which provided a neutral assessment as
a basis for designing the initiative. Bergen explained that
while they know the plan is not a panacea, they see it as an
important first step toward the formalization of CDE's
economy. He said he fully expects to be attacked, perhaps
indirectly and in the press, by those interests that will be
negatively affected.

--------------
BERGEN REQUESTS HELP - TTU FITS THE BILL
--------------


10. Since the US is the primary source country for IT
products imported into Paraguay, Bergen asked the Ambassador
for help with either providing specific valuation
information for particular shipments (to cross-reference
with the declared values upon entry into Paraguay),or with
independent reference values. Bergen was concerned that if
the GOP itself devised a list of reference values, it would
be accused of being arbitrary, whereas if values came from
the U.S. or elsewhere, it would be more transparent and
defensible. Post's Resident Enforcement Advisor is looking
into the request.


11. The Ambassador explained that the Department of
Homeland Security is working with Paraguayan Customs to
establish a vetted Trade Transparency Unit (reftel) that
would be able to share container-level valuation information
as reported upon export from the US. Neufeld said such data
would be a great help, even if a few months behind real
time.

--------------
POTENTIAL PITFALLS ABOUND
--------------


12. Several pitfalls await implementation of the
initiative. Sacrificing inclusiveness for secrecy, Tax
Administrator Neufeld did not include Customs in the
planning process. In a September 27 meeting, the Customs
Director told USAID that Customs was unsure how to implement
the initiative, and lamented that Customs had not been
brought into the planning process earlier.


13. USAID-funded Paraguay Vende worked with the IT Chamber
of Commerce for several months studying how to design the
regime specifically for that sector so that it could be both
formal and competitive. At the last minute, the GOP decided
to issue a general decree applying to all tourism regime
items, instead of starting with the IT as originally
expected. Paraguay Vende personnel worry that the lack of
analysis of the competitiveness of other sectors could lead
to implementation problems.


14. Finally, both members of the IT sector and Paraguayan
Customs are concerned about their vulnerability to
harassment from prosecutors since the Presidential decree
that was signed does not provide immunity for participants
for past business practices. In theory, prosecutors could
develop legal cases against participants who suddenly change
the valuation of their products (i.e., declare the full
value),after years of under-valuation. Neufeld told the
DCM that he had briefed the new Attorney General, who agrees
that they will not/not prosecute those who come clean. He
said he understood the desire of some to have formal
guarantees against prosecution, but said that would set a
bad precedent and undermine the rule of law. Companies
legitimately formalizing would not face problems, he added,
but there would be no amnesty.

--------------
COMMENT
--------------


15. The plan could work, and is another demonstration of
the political will of Minister Bergen and his team to
formalize Paraguay's economy. President Duarte spoke for an
hour at the announcement ceremony about the importance of
formalizing and modernizing the economy. The planned TTU
fits in perfectly with the new initiative, which, if
successful, would make it easier to identify and counter the
criminal elements operating in CDE involved in piracy, money
laundering and terrorism finance. Time will tell if the
significant pitfalls that await implementation are enough to
derail the initiative.

KEANE