CORREA ASKS CONSTITUENT ASSEMBLY TO APPROVE BROAD

C O N F I D E N T I A L QUITO 002659 SIPDIS SIPDIS TREASURY FOR MARIE EWENS E.O. 12958: DECL: 12/18/2017 TAGS: EFIN ECON EINV PGOV EC SUBJECT: CORREA ASKS CONSTITUENT ASSEMBLY TO APPROVE BROAD TAX REFORM REF: A. QUITO 2580 ¶B. QUITO 2626 ¶C. QUITO 06 1722 Classified By: Classified by DCM Jefferson Brown. Reason: 1.4 B and D . ¶1. (U) Summary. The Correa Administration sent an ambitious tax reform package to the Constituent Assembly, with a request that it be approved before the end of the year. The package retains the value-added tax at 12%, creates a 0.5% capital outflow tax, raises the excise tax on a number of products and services (including expensive private schools), and sets a higher personal tax rate for high-income earners. It also seeks to establish new taxes on "unproductive" rural land and new natural resource contracts that benefit from higher prices. The proposal also seeks to close some tax loopholes and improve the government's ability to crack down on tax evasion. End summary. ¶2. (U) On December 17, the Correa administration sent a 60-page package of tax reforms to the Constituent Assembly. The administration has asked that the Assembly approve the package before the end of the year, so the changes can enter into effect in 2008. If the changes are approved after December, they will not go into effect until 2009. The tax reform, along with a new transit law, were the first two pieces of legislation that the administration has presented to the Assembly, which has legislative authority as well as authority to draft a new constitution (ref a). ¶3. (U) The Correa administration maintained tight control over the details of the tax reform package, not sharing it with the private sector until it provided a copy to the Constituent Assembly. Some of the broad elements of the plan were discussed with the media in early December after Correa met with his economic team, but even so at the last minute some important details changed, such as lowering the tax on capital outflows from 1% to 0.5%. Value-Added Tax -------------- ¶4. (SBU) The headline news in the tax reform package is that which did not change. Correa, on the advice of his economic team, decided to maintain the value-added tax (VAT) at 12%. This reversed a campaign pledge to lower the VAT from 12% to 10%. In announcing the decision to remain at 12%, Correa stressed that studies from when the GOE lowered the tax from 14% to 12% show that lowering the VAT did not result in lower prices for the consumer. However, many analysts, including, we were told, the Minister of Finance, opposed the reduction since it would lower revenues from the GOE's most reliable source of tax income. ¶5. (C) Although the basic VAT rate remains unchanged, the GOE is proposing to change some of the rules on how the VAT is applied. One notable example is an article stating that petroleum companies cannot claim VAT rebates for oil exports. Several oil companies, including Occidental Petroleum, have won international arbitration cases ruling that they were entitled to a VAT rebate, which President Correa called a loophole that his government would close (ref b). Capital Outflow Tax -------------- ¶6. (U) The tax package includes a new tax on capital outflows, which will be taxed at 0.5%. The proposal includes an exemption for imports, dividends on foreign investment, interest and amortization of registered foreign loans, and insurance premiums. Banks that handled foreign transactions are responsible for collecting the tax. The proposal also requires that transactions that do not go through banks also have to pay the tax, but exempts transfers under $2,000. ¶7. (C) The head of Citibank Ecuador told us that the capital outflow tax would impose administrative burdens on the banks. It would also require them to determine whether the transfer was exempt or not, and she said that the banks would not be in a position to challenge a client's statement as to the nature of the transaction. ¶8. (C) Speaking before they had seen the details of the tax proposal, a wide number of business representatives criticized the concept. Most asserted it would be counterproductive and provoke an outflow of capital rather than retain more capital in Ecuador. They noted that Ecuador had had a capital tax in the late 1990s, and shortly before the tax went into effect there was a large outflow of capital. (Note: Most large companies and wealthy Ecuadorians already keep most of their financial assets offshore, and finance their Ecuadorian operations through loans, partly because of the tax benefits ) see para 13 below. This trend accelerated under the Correa administration, to the point that a bank told us that many companies are now borrowing to cover their operating expenses.) Excise Tax for Social Purposes -------------- ¶9. (U) The Correa administration is proposing a number of changes to the excise tax. On the one hand, it intends to eliminate the 15% excise tax on telecommunications, arguing that this would benefit the poor more than lowering the VAT. Interestingly, this change will not have a direct effect on federal government revenues, since the tax on telecommunications (totaling around $210 million/year) was earmarked for municipal water and sewage companies as well as local sports facilities. ¶10. (U) The tax package proposes to increase the excise tax for a number of goods, such as tobacco, alcoholic beverages, and soft drinks. It establishes increasingly higher rates for more expensive cars (currently there is a flat rate),and imposes the excise tax for the first time on jewelry, perfumes, fire arms, incandescent bulbs (100%), cable/satellite TV, and casinos. It also imposes, for the first time, an excise tax on high-end social clubs (fees over $1,500/year) and "luxurious" private schools (fees over $5,000/year). ¶11. (C) The government asserts that the tax on expensive schools will only affect six schools. We heard that Correa argued that most schools would not be affected by the tax, noting that the school his children attend is under the limit, but our interlocutor told him that was only because the French government subsidizes the teachers' salaries. Another observer quipped that the schools would attempt to get around the tax by lowering tuition and raising other fees, as they had done when a previous government froze tuition rates. Income Tax -------------- ¶12. (U) The tax reform proposes to expand the number of tax brackets for personal income tax, assessing a 30% tax for those making $60,000-80,000, and 35% for those earning over $80,000. Currently the highest income tax bracket is 25% for those earning over $40,000. ¶13. (U) The corporate tax rate will remain unchanged at 25%, although the GOE has proposed several measures that should increase its tax collection. One stiffens the requirements for anticipated tax payments, using a new formula based on a corporation's sales, assets, and costs. The advance payment is creditable against the corporate income tax. If the advance payment exceeds the income tax, the company can request a rebate. The tax reform will also restrict companies ability to deduct interest payments, by allowing the Central Bank to establish a maximum interest rate that can be used for tax deductions. ¶14. (U) The government is also seeking to raise the inheritance tax, replacing the current 5% flat tax with a graduated scale, from zero (for inheritances up to $50,000) up to 70% (over $500,000). Tax on "Unproductive Land" -------------- ¶15. (U) The reform package includes a new tax on "unproductive rural lands." The proposal would impose a $5/hectare tax on all rural land holdings that exceed 25 hectares. Some land would be exempt, including that over 3,500 meters in altitude, ecological reserves, natural forests, and communal property. The land tax can be applied against income tax attributable to the property, but not against other income tax. Tax on "Extraordinary Income" -------------- ¶16. (U) The Correa administration is also seeking to create a tax on "extraordinary income" that would apply to contracts signed with the state to develop nonrenewable resources. Clearly modeled after the hydrocarbons law reform that required petroleum companies to pay at least 50% of extraordinary income (reftel c),it would require companies to pay a 70% tax on income generated by prices that exceed the prices established or envisioned in the contracts, adjusted for inflation. However, in contrast to the hydrocarbons law, which imposed the requirement after the contracts were already in force, this provision would only apply to contracts signed after the law enters into force. The legislation provides that other fees paid on extraordinary income (in other words, the hydrocarbons surcharge) can be credited to extraordinary income tax. Simplified Tax Regime -------------- ¶17. (U) The government also proposes to establish a new simplified tax regime for small companies, which will establish a simpler method for those companies to pay income tax and the VAT. Tighter enforcement -------------- ¶18. (U) In addition to closing some loopholes, the tax reform proposal includes a series of changes to the general tax provisions that appear to increase the government's ability to crack down on tax evasion and potentially punish tax evaders. Comment -------------- ¶19. (C) It is breathtaking that the Correa administration is asking the Constituent Assembly to approve such broad changes to the tax law in less than two weeks, during the holiday season no less. It will be interesting to see how rigorously the Assembly will review the legislation, and whether it will comply with the tight timeline. ¶20. (C) The proposals themselves are a mixed bag, but probably more good than bad. Before he had actually seen the details, the IMF Resident Representative argued that overall package, with the exception of capital outflow tax, was fairly good. Retaining the IVA at 12% is good fiscal policy, and shows that Correa is willing, at least in this instance, to reverse his position when presented with strong arguments by his advisors. The tax on capital outflows could well be counterproductive, although its does exempt certain broad categories and its immediate impact could be limited, since a significant share of Ecuadorian capital is already offshore. However, it is likely to discourage some sorts of capital inflows: for example, exporters will likely find ways to keep an additional share of their revenues outside of Ecuador. ¶21. (C) The changes to excise tax, personal tax rates, and inheritance tax reaffirms that the GOE is seeking to use tax policy for social purposes, although they will also raise revenue. The efforts to close loopholes and improve tax enforcement appear reasonable for the most part, given the high level of tax evasion in Ecuador. It remains to be seen whether the new tax on extraordinary revenue from natural resources will affect future investment, but it at least establishes the new ground rules in advance, a distinct improvement over what happened with the hydrocarbons law. The tax on unproductive land is an odd creature, but the rate of $5/hectare does not appear onerous and the existence of the tax could forestall other proposals that might have challenged the ownership status of "underutilized" land. JEWELL