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Distributional Impact of VAT Distributional Impact of VAT Reform in the Dominican RepublicReform in the Dominican Republic

By Anna Fruttero and Omar AriasLCSPP

Frontiers in PracticeReducing Poverty Through Better Diagnosis

Analyzing Fiscal Impacts on Poverty ReductionMarch 23, 2006

22

PSIA request from DR Gov in support of PSIA request from DR Gov in support of fiscal reform process (tax loss due to fiscal reform process (tax loss due to CAFTA, financing of social spending gaps)CAFTA, financing of social spending gaps)

Developed as part of the 2005 PA in Developed as part of the 2005 PA in collaboration with the Technical collaboration with the Technical Secretariat of the PresidencySecretariat of the Presidency

BackgroundBackground

33

Why interest in VAT (ITBIS) reform analysis ?Why interest in VAT (ITBIS) reform analysis ?

VAT is not fullyexploited (exemptions),

Other taxes (income,property) harder

Public opinion Regressivity bias:Need to assess

distributional impact

44

DR tax effort has increased but is still around DR tax effort has increased but is still around LAC average and below similar countriesLAC average and below similar countries

% taxes in GDP% taxes in GDP

Source: Source: World Development Indicators and OECDWorld Development Indicators and OECD

0

5

10

15

20

25

30

35

DR CR ESGUA HO NI

PA

Centra

l Am

erica

*

Rest of L

AC*

OECD*

East A

sia*

% o

f GD

P

1990-1994 Circa 2000

* Unweighted regional averagesNote: data for GUA and HO for 99 from CEPALFor NI, data from 91 and not 90.

55

DR still relies heavily on trade taxes (though DR still relies heavily on trade taxes (though less so in recent years)less so in recent years)% total revenues circa 2000

•Regional averages

Source: Based on Government Finance Statistics 2004, IMF and OECD

0%

10%

20%

30%

40%

50%

60%

Income G & S Property Int'l trade SS

DR CA* Rest LAC* OECD* East Asia*

66

VAT revenues are particularly low VAT revenues are particularly low

% total revenues% total revenues

SourceSource: Based on Government Finance Statistics, IMF: Based on Government Finance Statistics, IMF

0

10

20

30

40

50

60

PA MX DR VE HA CO BO BR UR CR PY EC NI CL AR ES PE

77

……Largely a result of low and declining Largely a result of low and declining productivity of the tax (loopholes, evasion)productivity of the tax (loopholes, evasion)

VAT Rate VAT productivity

Source: Government Finance Statistics, International Finance Statistics and World Economic Outlook (IMF)Source: Government Finance Statistics, International Finance Statistics and World Economic Outlook (IMF)

0

2

4

6

8

10

12

14

16

18

CR DR ES GUA HO NI PA RestLAC

CA EastAsia

OECD

1994 Present

0

10

20

30

40

50

60

70

80

CR DR ES GUA HO NI PA CA RestLAC1994 1997 Present

88

VAT is a means to tax the well off

20% poorest

20% richest

Source: authors’ calculations based on ENCOVI 2004

National Remittances

6%

Home Self-consumption

10%

Other13%

Overseas Remittances

3%

Imputed Rent12%

Labor Income56%

National Remittances

2% Labor Income44%

Imputed Rent5% Overseas

Remittances18%

Other25%

Home Self-consumption

6%

Sources of income:

99

Exempt G&S

Non exempt G&S

Source: authors’ calculations based on ENCOVI 2004

Distribution of expenditures by quintilesDistribution of expenditures by quintiles (%) (%)quintile 2

8.8

20% richest53.8

quintile 313.2

quintile 419.6

20% poorest4.5

20% poorest2.5

quintile 417.0

quintile 39.6

20% richest65.3

quintile 25.5

The rich account for more than half of The rich account for more than half of consumption of exempt goods & servicesconsumption of exempt goods & services

1010

Exemptions of G&S from VAT Exemptions of G&S from VAT implicitly subsidize the consumption of implicitly subsidize the consumption of the rich at a significant revenue lossthe rich at a significant revenue loss

Increasing revenues from this tax Increasing revenues from this tax should come from expanding the tax should come from expanding the tax base with due equity considerationsbase with due equity considerations

1111

Remove all exemptions (benchmark)Remove all exemptions (benchmark) Remove all exemptions except for Health, Remove all exemptions except for Health,

Education and Electricity (SEE)Education and Electricity (SEE) Remove all exemptions except for basic food + Remove all exemptions except for basic food +

SEESEE Apply a lower rate to basic food, SEE exemptApply a lower rate to basic food, SEE exempt

Options to expand the VAT tax base

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Tax burden= % total tax paid by each QTax burden= % total tax paid by each Q Tax pressure= tax burden/income share of each QTax pressure= tax burden/income share of each Q Effective tax rate= total tax paid/total income by QEffective tax rate= total tax paid/total income by Q

By simulating the VAT code with data on incomes By simulating the VAT code with data on incomes and expenditures from a 2004 household survey and expenditures from a 2004 household survey (no behavioral responses)(no behavioral responses)

To assess distributional impacts for each scenario we compute:

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All options to broaden the base increase the tax pressure for the poor but this remains much lower than

for the rich

SEE = Health, education and electricity

Source: authors’ calculations based on ENCOVI 2004

0.40

0.60

0.80

1.00

1.20

20% poorest quintile 2 quintile 3 quintile 4 20% richest

Actual No exemptions SEE

Basic food/gas/SEE Rate differentiation

Ratio of share of tax paid to income share

1414

Revenues could increase substantially even exempting basic food and SEE, or with a

differential tax rate

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

Revenue estimates (% GDP)

0123456789

10

Actual No exemptions Exemption SEE Exemptionsbasic food + SEE

Ratedifferentiation

1515

1. Main results were derived under the 1. Main results were derived under the assumption that consumption patterns are not assumption that consumption patterns are not affected by changes in pricesaffected by changes in prices……

Sensitivity analysis using various plausible Sensitivity analysis using various plausible values of price elasticities indicate tight orders values of price elasticities indicate tight orders

of magnitude of the resultsof magnitude of the results

Two BIG caveats

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2. Distributional impact of fiscal reform 2. Distributional impact of fiscal reform depends on how spending is distributed…depends on how spending is distributed…

Less than one third of social assistance $$ Less than one third of social assistance $$ reach the poorest 40 percent (helicopter reach the poorest 40 percent (helicopter allocation is better). allocation is better).

Only the high-revenue reforms can generate Only the high-revenue reforms can generate transfers stransfers significantly higher than the extra tax ignificantly higher than the extra tax

burden on the poorest 40% under existing burden on the poorest 40% under existing expenditure allocations.expenditure allocations.

Two BIG caveats

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Policy implicationsPolicy implications DR has room to increase IVA revenues without too high a cost on equity, by expanding the 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 foodbase 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 To maximize overall equity impacts it is critical to simultaneously improve targeting of

social expendituressocial expenditures

Although these results were effectively used by Although these results were effectively used by the DR Government in the public debate, lack of the DR Government in the public debate, lack of power in congress led to a 1power in congress led to a 1stst phase curtailed phase curtailed reform (maintaining many exemptions).reform (maintaining many exemptions).