Honduran Fiscal Policy: Academicians Present Tax

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E.O. 12958: N/A
TAGS: EFIN ECON EAID ETRD ELAB PGOV HO
SUBJECT: Honduran Fiscal Policy: Academicians Present Tax
Collection Reform Proposals; GOH Pledges Only Discipline



1. Summary. A recent seminar on the importance of tax
reforms raised a number of interesting themes, but GOH
officials present limited their remarks to exhortations for
discipline and calls for increased tax revenue. Featured
academic speakers said there must be improved tax
collection, a more efficient and transparent tax authority,
and sustainable debt levels overall. One speaker made the
case for scrapping the entire current income tax system in
favor of a flat tax. The World Bank speaker pointed to the
need to always remember the purpose behind the taxation,
urging officials to look at quality spending as the driver
of tax policy. The closing speaker reminded attendees that,
as elegant as any economic theory might be, implementation
is a messy political business and results will often fall
short of the mark. End Summary.


2. On August 18, the Honduran NGO Foundation for Investment
and Export Development (FIDE),with support from USAID,
sponsored a one-day workshop on fiscal policy focusing on
tax collection. In addition to featured academicians, the
program included interventions by the Minister of Finance,
William Chong Wong, the Director of Public Credit Orlando
Garner, and World Bank Senior Economist Dante Mossi.
Sessions focused on the importance of tax collection to
development, the role of the tax authorities, sustainability
of public debt, and lessons learned from the Guatemalan
"fiscal pact" experience.

Minister of Finance: Cracking the Whip
--------------


3. Speaking for less than ten minutes, Minister of Finance
William Chong Wong used the occasion to deliver a fiscal
tough-love message. The GOH must maintain fiscal
discipline, he said. Debt forgiveness is a wonderful thing,
but it cannot be used as a justification to lower taxes.
Similarly, CAFTA is a great opportunity for Honduras, but a
way must be found to make up for the revenue losses from
cutting customs duties, which he estimated at 750 million
Lempiras (about 40 million USD) over the next 5 years.
Finally, he said, Foreign Direct Investment is an important
source of economic growth, but foreign firms must pay their
fair share of taxes. Chong said he is seeking double
taxation agreements with the U.S. and other countries, to
ensure that firms pay their taxes in Honduras and receive
tax credits in their home country. He also wants greater
data sharing with trade partners, to minimize the use of
transfer pricing schemes to evade taxes.

VAT Taxes for Revenue; Social Spending for Progressivity
-------------- --------------


4. In an information-rich and rapid-fire presentation,
Interamerican Development Bank (IDB) Senior Economist
Alberto Barreix focused on why tax reform is needed in
Central America. First, he said, the growing
interconnectedness of economies has removed most freedom of
choice regarding commercial, monetary, and exchange rate
policies, leaving only fiscal policy as an economic lever
for national governments. Second, there is a growing
recognition that certain investments -- particularly in
education -- must be made even in the poorest countries, if
they are to compete effectively in the future. If we do not
grasp this chance, Barreix said, "we will have to answer to
the future generations for the lost opportunities."


5. Barreix then listed five specific reasons why tax reform
is urgent in Central America: (1) to fund improvements in
social infrastructure and competitiveness; (2) to reach
fiscal sustainability in highly-indebted countries; (3) to
identify and implement substitutes for forgone revenues from
tariff cuts under CAFTA; (4) to improve revenue collection
by phasing out income tax exemptions in freeports
(maquilas); and (5) to promote regional coordination in tax
policies to prevent a "race to the bottom." Tax theory says
taxes must be equitable, efficient, and simple, he said; now
we must add to that list that taxes should be easy to
coordinate across borders.


6. Drawing from his own forthcoming book, Barriex cited a
positive evolution of tax collection in the region:

Tax revenues as a percentage of GDP:

1990 1995 2000 2003
CR 10.8 11.4 11.9 13.0
ES 7.6 11.9 11.0 12.6
GT 6.9 8.0 9.5 10.3
HO 15.0 17.3 16.6 15.9
NI 8.1 12.2 14.5 15.8
AVG 9.7 12.2 12.7 13.5

While the rest of the region continues to improve in tax
collections, Honduras runs against the trend, actually
seeing a decline in tax revenues as a percentage of GDP over
the last decade. This could be due in part to tax evasion,
but also to the web of tax exemptions and incentives created
to attract investment, particularly in the maquila (light
assembly) sector. 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. As Post reported previously, 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 percentage is only half of that which
is considered healthy for a developing country. This level
of tax collection is not adequate to fund the key government
services and investments that are needed.


7. Clearly, Central American countries must collect more
taxes to better fund social obligations, Barriex said.
However, the relatively young populations in these countries
mean a lower social security bill, softening the blow
somewhat and providing time to improve collections.
According to Barriex, the fiscal situation looks like this
(all figures in percentage of GDP as of 2003):

Total Debt Social Available
Income Service Security Income
CR 22.3 4.3 4.4 13.6
ES 12.6 2.0 1.3 9.3
GT 10.0 1.0 0.3 8.7
HO 16.9 2.0 0.9 14.0
NI 17.8 3.8 1.8 12.2
AVG 17.1 2.7 2.9 11.6

OECD 37.4 1.6 12.2 23.6


8. On the topic of value-added taxes (IVA, in Spanish)
Barriex advocated improved tax design and improved
collection through IVAs, since they avoid "tax cascades"
(where taxes are being paid on previous taxes) and
facilitate competition with the region. He suggested
harmonizing tax bases within the region, while allowing
competition and fiscal flexibility in the rates. He agreed
that the IVA is a regressive tax, noting that "an IVA is not
a redistributive tax; it is a tax for collections." To
counteract the regressive attributes of an IVA, he
recommended targeted social spending for the poor, and
increased application of personal income taxes. Finally, he
agreed with Minister Chong that as regional integration
moves forward, data sharing among countries must be improved
to minimize tax evasion through transfer pricing schemes.

World Bank Responds: Quality, Not Just Quantity
-------------- ---


9. Dante Mossi, Senior Economist with the World Bank,
responded to these points, noting that the choice of the
level of tax revenue collections is a sovereign one and
dependent on the quality of social services the State wants
to deliver. The quality of that spending is a key factor,
as is the political choice of allocation (for example,
whether to allocate a certain quantity of funds to educate
one university student or six elementary students).
Finally, the quality of tax collections is important -- that
is, who is paying the tax burden? What is the overall
impact on the poor? A 2002 IDB report entitled "Honduras:
Toward a More Transparent and Diversified Tax System" noted
that the current Honduran tax structure is highly
regressive, since most of the tax exemptions are provided to
the wealthy. According to the report, 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.

Tax Administration Design
--------------


10. While not addressing Honduras specifically, Dr. Erick
Thompson of the University of International Cooperation
(UCI) in Costa Rica identified the key elements in creating
a modern tax authority (TA). The TA should induce large-
scale compliance, based on the fear felt by evaders of
detection and sanction. This fear of getting caught should
be amplified by self-policing in the private sector, which
should see tax evasion by a competitor as unfair competition
and work with the TA to identify and minimize such fraud. In
carrying out these tasks, the TA's twin emphases should be
customer service to contributors and revenue controls.


11. After a lengthy discussion of the need for and proper
design of quality-assurance indictors for TAs, Thompson
turned to his recommendations for Central America. His key
recommendation was that rather than attempt to establish a
single, regional customs service, which would suffer from
questions of composition and financing, Central America
should strive for a European Union-style system, where each
national service is preserved, but policy is harmonized.
Enforcement must be implemented at the local level, he said,
but policy must be centrally set and enforced to prevent
differing enforcement regimes in the field. Asked what would
be the duties of a Central American customs service in the
wake of CAFTA reducing most duties to zero, Thompson pointed
to two key additional responsibilities that would also
contribute to revenue collection: First, Customs would be
responsible for administering the levying of IVA on imports.
Second, Customs should integrate closely with internal tax
authorities to facilitate integrated taxpayer audits by
cross checking tax receipts with import records.

Debt Sustainability: How Much Is Too Much?
--------------


12. Dr. Oswald Cespedes of the Assessment Commission on High
Technology (CAATEC) of Costa Rica presented the results of a
financial analysis seeking to evaluate debt sustainability
and compare it to the recently proposed measure of the
Natural Debt Limit (NDL). For methodological reasons, the
NDL theorem could not be applied to Honduras, but Cespedes
nevertheless hazarded a number of recommendations. The
Honduran ratio of public debt to GDP (currently 75.5
percent) "is on track to improve over the medium term,
despite currently being considered unsustainable. It is
foreseen that this ratio will fall to 61 percent by 2010,
principally due to the debt forgiveness resulting from the
attainment of the HIPC Completion Point in April 2005."
(Note: He bases this prediction on an estimated debt
service reduction of $120 million per year. The GOH
estimates the actual debt service savings under HIPC at $212
million per year, which would imply a substantially lower
debt/GDP ratio in 2010 than that predicted here. End Note.)
He concluded by saying that while counter-cyclical fiscal
policies would be desirable, the current low ratios of
revenues/GDP do not permit adequate countercyclical
operations.

Laffer Strikes Back: The Case for a Flat Tax
--------------


13. Dr. Daniel Wisecarver, Director of the Graduate School
of Economics and Business (ESEN) in El Salvador, spoke on
the need for reforming income taxes in Central America. In
each of the five countries of the region, income taxes
represent about one-quarter of total tax revenues, or about
three to four percent of GDP. A government cannot be very
progressive, Wisecarver said, with collection rates so low.
Unfortunately, there is no culture of trust in these
countries, or any indication that the governments have the
political will to reform the current income tax system.


14. The solution, he said is to scrap the whole system.
Scrap the income tax; scrap the exemptions. Instead, he
said, turning to the Laffer curve for support, Central
American states should move to a flat tax on income. A
simplified system with lower tax rates would improve
collections rates and total revenue, Wisecarver said,
pointing to Russia and Estonia as examples. Because there
would be no exemptions, and the taxes would be based on
income alone, it would be horizontally equitable. To ensure
progressivity, he suggests a large, universal exemption, and
proposes the level of that exemption be set at the median
income level for the country. That would ensure that right
from the start half of the population is entirely exempt,
reducing political opposition to the plan, while also
ensuring vertical equity by obliging the rich to pay their
share. The plan would succeed, Wisecarver said, because the
new tax would be simple, neutral, and progressive.

Director of Public Credit Sticks to the Script
-------------- --


15. Keeping his remarks short and on-message, Ministry of
Finance Director of Public Credit Orlando Garner laid out
GOH priorities without commenting directly on the proposal
floated during the sessions. Echoing his Minister's earlier
remarks, Garner said that if Honduras is to benefit from the
recent debt reduction, it must maintain fiscal discipline.
GOH policies must be sustainable, and any external financing
must be on concessional terms. The problem, he said, is
that as Honduras grows its access to concessional financing
declines. Making matters worse, concessional financing
(such as IDA subscriptions) is drying up globally.
Nevertheless, the GOH -- including whatever party is elected
in the upcoming November 27 elections -- must limit its use
of borrowing according to the ability of the country to pay.
Garner admitted that regional harmonization of tax policies
will be a challenge; but, he said, recent events offer
Honduras many opportunities, and Honduras must find a way to
take advantage of them.

Fiscal Pacts: Great Idea; Shame They Don't Work
-------------- ---


16. The final speaker of the day, Dr. Hugo Maul of the
National Center for Economic Research (CIEN) of Guatemala,
outlined the nature and challenges of the much-touted
"fiscal pact." A fiscal pact is "a national agreement on the
amount, origin, and use of State resources in carrying out
its designated functions." It comprises several elements:
a fiscal balance requirement (no spending beyond earnings);
sufficient government revenues to carry out government
activities; efficient and transparent tax administration;
prioritized spending; controls on public debt (not to be
used as a substitute for revenue); responsible management of
public goods; accountability and social auditing; and fiscal
decentralization.


17. Unfortunately, Maul said, in the case of Guatemala the
pact has failed. After tracing the causes of this failure,
Maul extracted the following lessons-learned from the
experience. First, agreeing to a plan and carrying it out
are two very different things. If goals are not met, who is
responsible, and what measures are there to require
compliance? Second, an agreement that tries to accomplish
everything ends up accomplishing nothing. Third, levying
taxes is a sovereign exercise, and one unlikely to happen if
consensus is required. (Or, as he pointed out, there's a
reason they are called "impuestos" -- making a pun with the
Spanish word, which can be translated as either "taxes" or
"that which is imposed.") Fourth, the legislature is the
elected representative of the people, and that
responsibility cannot be arrogated by other groups. By what
authority does an NGO claim the right to veto a
Congressional act? Finally, a pact that imposes burdens on
any part of society, yet requires consensus, is doomed to
fail, as special interests will either refuse to approve or
refuse to comply. At the end of the day, Maul, said,
economists must remember that no matter how beautiful or
well-proven the theory, the practice is always a political
decision, taken by politicians. Designing a perfect pact is
not the same as implementing one.

Williard