report no. 44939-uy uruguay poverty and social impact assessment …documents.worldbank.org › ......

May 19, 2008

Document of the World Bank

Report N

o. 44939-UY

U

ruguay Poverty and Social Im

pact Assessm

ent of the Tax Reform

Report No. 44939-UY

UruguayPoverty and Social Impact Assessmentof the Tax Reform

Argentina, Chile, Paraguay & Uruguay Country Management UnitPoverty Reduction and Economic Management UnitLatin America and the Caribbean Region

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TABLE OF CONTENTS

FOREWORD AND ACKNOWLEDGMENTS .............................................................. v EXECUTIVE SUMMARY ................................................................................................ i 1 . INTRODUCTION .................................................................................................... 1 2 . URUGUAY’S TAX REFORM ................................................................................ 1 2.1. Description o f the Tax Reform ................................................................................... 2 2.2. Existing Studies on Tax Incidence and The Tax Reform in Uruguay ........................ 6 3 . METHODOLOGY ................................................................................................... 6 3.1. Simulation o f Impact o f IRP and IRPF ...................................................................... 8 3.2. Simulation o f Impact o f Indirect Taxes ...................................................................... 8 3.3. Income Capture through the Household Survey ....................................................... 10 3.4. Scenarios Simulated in the Analysis ........................................................................ 12 4 . IMPACT OF THE TAX REFORM ON EQUITY AND POVERTY ................ 12 4.1.

4.3.1 Workers ..................................................................................................... 13 4.3.2 Pensioners .................................................................................................. 17

Impact o f Direct Taxes ............................................................................................. 13

4.2. Impact o f Indirect Taxes ........................................................................................... 19 4.3. Impact o f Combined Total Effect o f the Tax Reform .............................................. 20

4.3.1 Change in Tax Burden ............................................................................... 20 5 . CONCLUSION ....................................................................................................... 28 References ......................................................................................................................... 29 Annex 1 . Summary o f the Principal Modifications Under the Tax Reform: New taxes and Eliminated taxes ................................................................................................................ 31 Annex 2 . Uruguay Tax Incidence Studies ......................................................................... 39

Annex 4 . Sensitivity Analysis To Assumptions On COFIS And Income Data ................ 47 Annex 5 . Concentration Curves And Progressiveness Indices .......................................... 51

Horizontal Inequality, Reranking and Vertical Inequality ................................. 55 Annex 6 . Statistical Annex ................................................................................................ 57

Annex 3 . Poverty, Inequality and Progressiveness Indicators ........................................... 41

LIST OF TABLES Table 1 . Uruguay. Lat in America and OECD: Comparison o f tax structure (% o f GDP) .............. 2 Table 2 . Uruguay: Estimates o f the revenue-neutral impact o f the tax reform ............................... 5 Table 3 . Treatment of various incomes to estimate IRPF deductions ............................................. 8 Table 4 . Comparison o f the average household income. EGM vis-a-vis ECH. per geographical area (in percent) ............................................................................................................................. 11 Table 5 . Consistency o f IRP estimates (UR$ thousands. unless otherwise stated) ....................... 11 Table 6 . Capture o f rental income in the E C H .............................................................................. 11 Table 7 . Mean tax rate o f IRP and IRPF by decile (%) ................................................................. 13 Table 8 . Workers paying more under the post-reform system ...................................................... 14 Table 9 . Situation o f workers under the post-reform tax system. by worker characteristic .......... 15 Table 10 . Situation o f workers under the post-reform tax system. by industry ............................ 17 Table 1 1 . Pensioners: Mean tax rate o f IRP and IRPF by decile (%) ........................................... 18 Table 12 . Uruguay tax reform: Summary o f impacts on workers and pensioners ........................ 19

Table 13 . Mean indirect tax rate (IVA + COFIS) on households before and after the reform. by

Table 14 . Disposable income and average tax burden before and after the tax reform (in decile (%) ....................................................................................................................................... 20

December 2006 prices) .................................................................................................................. 21 Table 15 . Inequality measures before and after taxes ................................................................... 24 Table 16 . Confidence intervals for inequality measures before and after the taxes ...................... 24 Table 17 . Uruguay. Latin America and OECD: Comparison o f inequality before and after taxes ....................................................................................................................................................... 25 Table 18 . Impact o f the tax reform on poverty and extreme poverty ............................................ 26 Table 19 . Confidence intervals for poverty measures before and after the reform ....................... 26 Table 20 . Effect o f the tax reform o n poverty for those aged under 18 and above 64 .................. 27

LIST OF TABLES Table A 1 . Disposable income and average tax burden before and after the tax reform (in

Table A 2 . Inequality measures before and after taxes .................................................................. 49

Table A 4 . Breakdown of the redistributive effect o f taxation ...................................................... 56 Table A 5 . Pre-reform and post-reform tax system ....................................................................... 57

Table A 7 . Variation in labor income (disposable) by decile (UR$) ............................................. 58

December 2006 prices) .................................................................................................................. 48

Table A 3 . Impact o f the tax reform on progressiveness (scenarios 1.1 and 11.2) ......................... 55

Table A 6 . Labor Income: Minimum, mean and maximum income, per decile (in UR$) ............ 58

Table A 8 . Situation o f workers under the post-reform tax system, by occupation (one digit) .... 59 Table A 9 . Situation o f workers under the post-reform tax system, by worker characteristic ...... 60

Table A 11 . Situation o f workers according to type o f occupation (selected occupations) .......... 62 Table A 12 . Pensions: Minimum, mean and maximum value, by decile ...................................... 62

Table A 10 . Situation o f workers under the post-reform tax system, by industry ......................... 61

Table A 13 . Variation o f average pensions by decile (UR$) ......................................................... 63

LIST OF FIGURES Figure 1 . Mean tax rate on labor income IRP and IRPF ............................................................... 14 Figure 2 . Variation in average income by decile due to the tax reform (%) ................................. 14 Figure 3 . Mean tax rate on pensions under the IRP and IRPF. by vingtile (%) ............................ 18

Figure 5 . Mean indirect tax rate (IVA + COFIS) on households before and after the reform. by

Figure 6 . Tax burden as share o f per capita pre-tax income: Comparison between the pre-reform

Figure 7 . An example o f a concentration curve for a progressive tax ........................................... 42 Figure 8 . Pre-reform concentration and post-reform curves: Indirect and direct income taxes .... 52 Figure 9 . Differences between the Lorenz after tax income curve and the concentration curves:

Figure 10 . Differences between the Lorenz after tax income curve compared to the concentration

Figure 11 . Non-Parametric estimate o f the differentiation o f taxes with respect to income level 54

Figure 4 . Variation in average pensions due to the tax reform. by decile (%) .............................. 19

vingtile (%) .................................................................................................................................... 20

regime and the post-reform situation ............................................................................................. 23

. . . Tax burden redistnbution approach ............................................................................................... 53

curves: Income redistribution approach ........................................................................................ 53

FOREWORD AND ACKNOWLEDGMENTS

The objective o f the poverty and social impact (PSIA) analysis o f the Uruguay tax reform is to assess whether the tax reform i s likely to have significant effects on equity and poverty. The tax reform came into effect in July 2008. Here, an assessment o f the impact o f the reform on equity and poverty i s presented. Rather than being a discrete piece o f work, the PSIA is intended to be a programmatic activity. The PSIA analysis commenced as an activity to support the f i rs t Programmatic Reform Implementation Development Policy (PRIDPL I) operation, approved by the World Bank Executive Board in M a y 2007, which supports the implementation o f the tax reform. The study is consistent with the FY2005-2010 Country Assistance Strategy (CAS) objectives for the Bank’s non-lending program, which aimed at mainstreaming the use o f PSIAs. When post-tax reform data becomes available, the team aims to follow-up with a further analysis on the impact o f the reform as requested by the Government. It i s intended that the second stage study wil l take into account modifications in individual behavior in response to the tax reform.

This report was prepared by a team o f World Bank staff and consultants under the guidance o f Mauricio Carrizosa (former Sector Manager, LCSPE), Rodrigo Chaves (Sector Manager, LCSPE), James Parks (Lead Economist and Sector Leader, LCSPR) and David Yuravlivker (Country Representative, LCCUY). The study team included Veronica Amarante, Rodngo Arim and Gonzalo Salas, researchers at the Universidad de la Republica, who prepared a background paper containing the micro-simulation analysis presented in the study. The report was written by Emily Sinnott (Country Economist, Task Team Leader, LCSPE), with excellent research assistance provided by Paula Cobas Barque (Junior Professional Associate, LCSPE) and Bemardo Diaz de Astarloa (Consultant, LCSPE).

The team benefited greatly from comments from Fernando Lorenzo, Director o f the Macroeconomic Advisory Office, Ministry o f Economy and Finance, Uruguay. The finalization o f the report profited from the comments given by Carlos Grau (CINVE), Hugo Vallarino (DGI) and participants at a seminar at the Universidad de la Republica in Montevideo held in December 2007. Finally, the team i s grateful to the peer reviewers for comments: David Coady (PSIA Group, Fiscal Affairs Department, IMF), Eduardo Ley (Lead Economist, PRMED), and Maria Beatriz Orlando (Senior Economist, LCSPP).

EXECUTIVE SUMMARY

The Poverty and Social Impact Assessment (PSIA) analyzes the impact o f the tax reform, which came into effect in July 2007, on tax incidence and poverty in Uruguay. The essence o f the reform i s the introduction o f a dual personal income tax, which taxes labor income at progressive rates and capital income at lower, proportional rates. A further modification is the reduction in the revenue share o f indirect taxes. The study aims to provide information to inform pol icy discussion on distributional implications o f tax reform. In addition, i t gives impetus for further more sophisticated analysis o f current and proposed tax reforms.

In designing a tax system, a trade-off exists between efficiency, equity and administrative simplicity. The paper focuses on one aspect o f this trade-off by evaluating the equity impact o f the tax reform in Uruguay. Neither the efficiency o f the post-reform tax system nor the effect on tax administration i s examined. Assessing the distributional impact o f a tax reform i s important, firstly, as there is a potential to mitigate the equity-efficiency trade-off in the design o f tax structures, and secondly, as the expenditure side o f the budget can then be employed to diminish any adverse distributional impacts.

The aim o f the tax reform in Uruguay i s to create a more efficient and equitable tax structure, and to promote productive investment. The reform i s designed to be broadly revenue neutral. The report concentrates o n the equity dimension o f the reform. In this regard, the pre- reform tax system was somewhat inequitable due to the importance o f consumption taxes and the partial taxation o f income. The pre-reform tax system did not meet the basic criteria for horizontal equity. Direct taxes on individual income were derived almost exclusively from labor income from employees and pensions, while personal income from capital sources, such as financial assets and property, was tax exempt, irrespective o f whether i t was generated domestically or abroad. With regard to the impact o f the reform on equity, the study focuses on the impact o f eliminating the personal receipts tax or wage tax (Impuesto a las Retribuciones Personales, IRP) and the implementation o f the dual personal income tax (Impuesto a la Renta de la Personas Fisicas, IRPF), as wel l as the effects o f reducing the VAT rate and eliminating the social security financing contribution tax (Contribucibn a1 Financiamiento de la Seguridad Social, COFIS).

The analysis employs a static micro-simulation model using household survey data to calculate for each individualhousehold the total amount o f direct and indirect taxes due before and after the tax reform. This makes i t possible to assess how each individualhousehold i s affected, and thus calculate the poverty and income inequality indicators before and after the reform. These static models, unlike behavioral models, do not incorporate changes in individuals’ behavior in response to changes in the tax system. However, using a simple micro- simulation approach for the analysis entails certain benefits: i t allows comparison with previous studies done on Uruguay and other countries; and i t i s a transparent method that generates results, which are easy to communicate to a general audience.

The welfare measure used i s individualhousehold income taken from the 2006 Expanded National Household Survey (Encuesta Nacional de Hogares Ampliada, ENHA). Income rather than a consumption measure is used as at the time when the analysis was done the latest

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household expenditure survey was over a decade old. Nevertheless, the Household Income and Expenditure Survey is employed in the analysis in order to provide detail on consumption patterns (Encuesta de Gastos e Ingresos de 10s Hogares, EGIH 1994-1995).

The average income tax rate falls for the bottom 80 percent o f income earners under the post-reform tax structure

(in percent) 14 , 1 12 10 8 6 4 2 0

1 2 3 4 5 6 7 8 9 10

Deciles o f labor income

Pre-reform wage tax (IRP) W Dual personal income tax(IRPF)

Source; Based on the ENHA.

To begin, the study examines the impact o f the replacement o f the wage tax (IRP) with the dual personal income tax (IRPF). Results indicate that the replacement o f the IRP with the IRPF results in an improved situation for the bottom 80 percent o f labor income earners, for whom the mean tax rate falls. The mean direct tax rate increases for the top 20 percent o f taxpayers. The mean tax rate here refers to the average IRP and IRPF payments by decile as a share o f labor income, including any labor income from secondary occupations. Workers in the tenth decile are calculated to pay, on average, 7 percentage points more tax on their labor income, which implies an increase in their tax burden by 150 percent. For the ninth decile, the increase in the mean tax rate i s much lower at 0.3 percentage points.

For pensioners, the tax burden i s increased from the eighth decile onwards due to the introduction o f the IRPF. Pensioners paid l i t t le wage tax on pension income prior to the tax reform. The top 20 percent o f pension earners faced a tax rate o f 2 percent prior to the tax reform. Following the reform, for the top 30 percent o f pension earners the difference between the average tax rates before and after the reform i s in excess o f 8 percentage points. The bottom 70 percent o f pension earners continue to pay no tax.

.. 11

Indirect tax rates fall by over 2 percentage points on average for under the post-reform tax structure

(in percent) 17

10 8 6 4 2 0

1 2 3 4 5 6 7 8 9 10

Deciles o f household income

Pre-reform indirect tax rate Post-reform indirect tax rate

Source: Based on the ENHA.

The analysis next examines the impact o f the reform o f indirect taxes on household income. The pre-tax reform situation i s estimated to have been regressive, in that the percentage decrease in income due to indirect taxes is higher for the bottom 40 percent compared to the top 60 percent o f income-earning households. All households benefit from a reduction in the indirect tax rate due to the tax reform, which falls by on average over 2 percentage points over the different income groupings. In terms o f average indirect tax rates, the post-reform indirect tax structure remains regressive. To restate-as i s regular in this type o f analysis-it i s assumed that indirect taxes on goods are shifted completely to consumers.

An analysis o f the total impact o f the reform shows it to be progressive. The grey and black smooth lines represent total taxes before and after the reform, respectively. Under the pre- reform system, the tax burden as a share o f pre-tax income remains relatively constant (close to 12 percent) throughout the distribution curve. The pre-reform system was neutral from the point o f view o f inequality. This neutrality arose from the combination o f regressive consumption taxes and progressive personal income taxes. The reform alters the relative neutrality o f the pre- reform tax system. There i s a monotone increase o f the tax burden from the median onwards. As a result, the global tax burden o f the households below the 16th percentile falls, while i t becomes markedly higher in the last three vingtiles (five-percent bands) o f the distribution.

If the total impact on households i s considered, the reform represents a progressive change. Taking into account changes to VAT, COFIS and the introduction o f the IRPF, along every measure considered the tax reform has a small, but positive impact on equity. The Gini coefficient o f after tax income i s estimated to fa l l due to the reform: The Gini coefficient o f before tax income i s calculated as 0.45 and the Gini coefficient o f after tax income following the reform i s calculated as 0.44 (the pre-reform Gini o f after tax income is 0.45).

... 111

4%

2%

0%

8%

6%

4%

2%

0%

1-8% '

The combined impact of the tax change i s to reduce the tax burden for the bottom 80 percent and to increase that of the top 20 percent of income earners

(Tax burden as a share o f per capita pre-tax income)

I

I 2 3 4 5 6 7 8 9 I O 11 12 13 14 15 16 17 18 19 20

Household income vingtile - - VATtaxes beforetax reform 4 'IRP - Total taxes before tax reform *IRPF VATaftertaxreform -Total taxes after tax reform


Disposable income increases for the bottom 80 percent of households after the reform, but falls for the top 20 percent of households due to the direct tax change

- Variation due to change in direct taxes

- Variation (total)


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The reform also has a small, but beneficial, impact on the poverty headcount. Poverty incidence is estimated to fall by 0.7 percent due to the change in the tax structure. The slight reduction in poverty i s fimdamentally due to the price reduction effects generated by the modified consumption tax regime on the basic food basket and the poverty line.

Ineaualitv measures are estimated to fall following the tax reform

Before tax reform After tax reform

Af te r A f te r Af ter After A f te r A f te r Before taxes indirect direct taxes indirect direct v u k d h

taxes (1) taxes taxes (2) taxes taxes ( 2 H 1 ) Gini coefticient 0.454 0.453 0.457 0.448 0.442 0.456 0.440 -0.011 Entropy 0 0.351 0.350 0.357 0.341 0.338 0.361 0.334 -0.012 Entropy 1 0.376 0.376 0.382 0.366 0.353 0.380 0.349 -0.023 Source: Based on the EGIH and the ENHA.

V

1, INTRODUCTION

1. The Poverty and Social Impact Assessment (PSIA) analyzes the impact of the reform of the tax system on tax incidence and poverty in Uruguay. The tax reform, which came into effect in July 2007, has been a centerpiece o f the government’s reform program.’ The essence o f the reform i s the introduction o f a dual personal income tax, which taxes labor income at progressive rates and capital income at lower, proportional rates. The a im i s to create a more efficient tax structure, while promoting greater horizontal and vertical equity, and stimulating productive investment and employment.

2. The PSIA study provides an analysis of the impact o f the tax reform on equity and poverty based on micro-simulations using household data. I t builds on existing studies on the impact o f the tax reform in Uruguay. The analysis adds value in a number o f ways. It i s the first study to look at the impact o f the actual tax reform implemented. Previous studies were based o n the 2005 government proposal for tax reform. The PSIA is the first analysis to quantify with precision the magnitude o f the impact on equity, as wel l as its incidence for different groups o f households and individuals. The study i s more comprehensive than those preceding it, both in terms o f the equality and tax incidence indicators analyzed and in that i t corrects the household income data for underestimation. An additional subject covered, deserved o f attention but not treated to date, i s the impact o f the reform on poverty.

3. The study proceeds as follows. In section 2, a description o f the pre- and post-reform tax system i s given. A summary o f existing studies on tax incidence and the impact o f the tax reform on equity in Uruguay is presented. Section 3 provides a description o f the data and methodology used in the analysis. This is followed by a presentation o f the main results regarding the impact o f the tax reform on equity and poverty in section 4. Conclusions are presented in section 5.

2. URUGUAY’S TAX REFORM

4. In reforming the tax system, the economic costs of collecting and administering taxes need to be considered. Not al l taxes have the same costs. Taxes may be associated with economic distortions if they cause changes in market prices. The incidence o f taxes may differ for different groups. There may be ease o f tax collection reasons to favor one tax over another. In designing a tax system, a trade-off then exists between efficiency, equity and administrative simplicity. The paper focuses on one aspect o f this trade-off by evaluating the equity impact o f the tax reform in Uruguay. Neither the efficiency o f the post-reform tax system nor i t s effect o n tax administration i s examined. Assessing the distributional impact o f a tax reform i s important, firstly, as there is a potential to mitigate the equity-efficiency trade-off in the design o f tax structures, and secondly, as the expenditure side o f the budget can be employed to diminish any adverse distributional impacts .

1. The tax reform legislation was approved by the Uruguayan Parliament in December 2006.

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2.1. DESCRIPTION OF THE TAX REFORM

5. The aim of the tax reform in Uruguay i s to create a more efficient and equitable tax structure, and to promote productive investment. The reform i s designed to be broadly revenue neutral. The reform introduces a dual personal income tax (IRPF), which combines a progressive tax schedule for labor income with a l ow flat tax rate on capital income. It reduces VAT and corporate tax rates, streamlines and eliminates minor taxes, and broadens the VAT base. In addition, the government has made substantial efforts to strengthen tax administration. Details o f the tax reform are provided in Box 1. A more detailed description o f the post-reform tax regime i s given in Annex 1.

6. Personal taxation has constituted a small share of overall tax effort in Uruguay (Table 1). In contrast, consumption taxes have been a substantially more important source o f revenues than on average for Latin America or the OECD. Tax revenue i s the main source o f income for the government in Uruguay. Excluding social security, taxes represented 71 percent o f total revenue on average over 2004-06. The tax burden i s unlikely to be reduced in the medium term. Following the 2002 crisis-with public sector debt reaching a high o f 97 percent o f GDP in 2004'-the government has sought to strengthen the fiscal position in order to reduce macroeconomic vulnerability. The level o f disposable fiscal income, i.e. resources available to the state after servicing debt and meeting the commitments o f the social security system, i s about 40 percent o f the total revenues (Barreix and Roca, 2007).

Table 1. Uruguay, Latin America and OECD: Comparison of tax structure (YO of GDP) Uruguay La t i n America OECD (2005) (2004) (2005)

Tax revenuea 28.0 20.2 36.2 Value added tax (VAT)b 12.8 5.8 6.5 Income tax 4.0 3.8 13.0

Corporation tax 3.1 2.6 3.8 Personal income tax 0.9 1.2 9.2

Social security contributions 7.0 2.8 9.2 Source; IMF (Uruguay), Barreix and Roca (2007) (Latin America) and OECD. a Includes social security contributions (pensions).

For Uruguay, value added taxes include specific regimes and other indirect taxes.

7. Prior to the tax reform, direct taxes on individual income were derived almost exclusively from labor income from employees and pensions, while personal income from capital sources, such as financial assets and property, were tax exempt, irrespective of whether it i s generated domestically or abroad. The system was based on the principle o f only taxing labor and capital when they came together in a business enterprise, when labor income would be subjected to the wage tax and capital income to one o f the corporate income tax regimes. This tax structure led to capital income from financial investments being exempt from taxation, while income for independent professionals paid fixed taxes o f a small amount. Indirect tax rates in the pre-reform system were relatively high. The country had the highest consumption tax rate o f Latin America (26 percent), when the joint effect o f V A T and COFIS is taken into account (23 percent and 3 percent, respectively) (Barreix and Roca, 2003).

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Box 1. Uruguay: Main Components of the Tax R e f o r m

The tax reform bill became effective on July 1,2007. The main reforms to the tax system are as follows:

Introduction of a personal income tax, the Impuesto a las Rentas de Personas Fisicas (IWF), on al l domestic sources o f income. This tax replaces the wage tax (IRP). The tax has a progressive tax schedule with six income tax brackets and rates ranging from 0 to 25%. Deductions are permitted for social security contributions, fixed health allowances for pensioners and fixed deductions for children. Capital income i s taxed at 12%, a lower rate than for labor income. Nonresidents’ income generated in Uruguay i s taxed at 12%. Interest income from public debt i s to remain tax exempt. Rationalization of the corporate income tax with the introduction o f a tax-Impuesto a las Rentas Empresariales (1RAE)-replacing four business taxes (Impuesto a las Rentas de Industria y Comercio (IRK), Impuesto a las Rentas Agropecuarias (IRA), Impuesto a las Comisiones (ICOM), Impuesto a las Pequefas Empresas (IMPEQUE)). These are be consolidated into a single 25% corporate income tax, a reduction from the former rate o f 30%. There i s a surtax o f 7% on dividend income. Reduction of the rate of the value-added tax (VAT). The basic VAT rate i s reduced from 23% to 22% and the reduced rate falls from 14% to 10%. The VAT base i s broadened and various IVA exemptions eliminated. The base expands by incorporating the formerly exempt tobacco products, and financial services at the 22% rate, and h i t s and vegetables, health services, public transportation, and the f i rs t sale o f real estate properties at the 10% rate. VAT tax exemptions remain in place for certain agricultural products such as milk. Unification of the employer’s social security contribution rate and elimination of sectoral exemptions. The contibution rates paid are unified into a single 7.5% general rate. The exemptions for employers’ contributions in the rural, industrial, and transportation sectors are eliminated; in the case o f the rural sector through the adoption o f a special regime. Elimination of several taxes (equal to an estimated revenue reduction o f about 5% o f GDP), including the taxes on corporate income and wages; the consumption tax on industrial goods used to finance social security contributions (Impuesto de Contribucidn a1 Financiamiento de la Seguridad Social, COFIS), and the taxes on banking assets, health services.

8. The key change to the system i s the introduction of a dual personal income tax, combining a progressive tax schedule for labor income with a low flat tax rate on capital income. The progressive labor income tax-the dual personal income (Impuesto a la Renta de las Personas Fisicas, IRPF)-has six marginal income tax rates ranging from zero in the first bracket to 25 percent in the 6th bracket. The flat corporate tax, the tax on income from corporate activities (Impuesto a la Renta de las Actividades Empresariales, IRAE), varies from 0 percent in the case o f assets held abroad to 12 percent in the case o f foreign currency domestic deposits. The personal income tax to be levied on al l labor and capital income sources results in a broadening o f the tax base and improves horizontal equity in the system. The introduction o f the dual system was based on the need to balance fundamental equity objectives with the need to provide conditions that favor investment and make the tax structure compatible with current revenue collection capacities. The dual tax system in Uruguay follows a similar “small country” strategy as that pioneered by the Nordic countries in the 1990s. It responds the plight o f small open economies that are unable to trace non-domestic sourced income in the face o f increased capital mobil i ty across borders. For these countries, a l ow flat tax on capital income reduces the risk o f tax evasion from residents with capital investments abroad.

9. The pre-reform system was judged not to provide adequate incentives to promote investment. The corporate income tax was relatively high (although lower than in the regional

3

economies) and distortive, whereby some activities contributed a substantially lower share o f their income than was the average for the economy. Manufacturing and construction firms, for example, were exempt from paying social security contributions; instead, retail and services paid a 12.5 percent rate. In addition, the pre-reform tax system included certain taxes, such as the IMABA, which increased the cost o f credit, and therefore deterred investment. A thorough overview o f the shortcomings o f the pre-reform tax system is presented in Barreix and Roca (2003).

10. The reform increases the neutrality of the tax system across factors of production and the reduction in the corporate income tax from 30 to 25 percent i s expected to foster private investment. The unification o f the employer’s social security contribution at a 7.5 percent rate creates a more level playing field between manufacturing and construction on one hand (which were exempt from social security contributions) and retail and services (which paid 12.5 percent contributions) on the other. Similarly, the elimination o f various VAT exonerations creates a more level playing field across sectors. By taxing income from al l factors (labor, capital, or any combination o f the two), the reform creates less perverse incentives in terms o f the business structure adopted. For example, professionals which were not taxed under the previous regime faced disincentives to be incorporated. Finally, the elimination o f COFIS implies that there i s no longer an asymmetry between firms that were allowed to collect this tax on their sales (thereby taking credit for what they paid on their inputs) and those that were not. Under the pre-reform regime, the latter s t i l l had to pay COFIS on inputs and so faced a larger net tax burden.

11. The pre-reform tax system was based on a large number of taxes; yet, the bulk of revenues came from just a few. During the last twenty years, a customary practice to sustain revenue collection in Uruguay under adverse conditions has been to incorporate new taxes or to increase the rates o f some already existing taxes. This generated a sizable number o f taxes, many o f which turned out to be difficult to administer and to generate l o w levels o f revenue. Pre- reform, there were 12 different direct taxes and 18 indirect taxes, with 20 taxes each individually accounting for less than 1 percent o f revenue. Just five taxes, three consumption taxes (VAT, IMES12 and COFIS3) and two income taxes-the personal receipts tax/wage tax (Impuesto a la Renta de la Personas Fisicas, IRP) and the income tax rate for corporations and individuals (Impuesto a las Rentas de Industria y Comercio, IRIC)-provided over 85 percent o f tax revenues (excluding social contributions). The proliferation o f small taxes was inefficient as it led to a large number o f distorting and low-revenue generating taxes, and substantial tax exemptions.

12. The elimination of various low-yield distortive taxes and a number of tax exemptions brought about a substantial simplification of the tax system with beneficial efficiency implications for tax collection resource allocation. The tax reform repealed fourteen taxes and empowered the Executive to annul another three, some o f which are incorporated in the new taxes, while others are eliminated with the aim o f reducing the indirect tax weight, and some merely for reasons o f administrative simplification. The tax reform also unified the

2. including alcoholic beverages, soft drinks, cosmetics, tobacco products, and motor vehicles. 3. used to finance social security.

I M E S I (Impuesto Especifico Interno or Specific Internal Tax) is an excise tax levied on the f i rst sale o f goods

COFIS (Impuesto de Contribucion a1 Financiamiento de l a Seguridad Social) was a type o f wholesaler’s VAT

4

contribution rate o f employers to social security, with the objective o f eliminating the sector discriminations with regard to labor inputs.

13. The reform aims at an improvement in vertical equity through the reduction of the revenue share of indirect taxes and the increase in the revenue share of direct taxation The elimination o f the COFIS tax (3 percent) and a small reduction in the VAT rates (from 23 to 22 percent) along with the introduction o f the personal income tax reduces the share o f indirect taxes in total revenue. The proportionally higher reduction in the VAT rate for basic consumer goods (from 17 to 10 percent) also contributes to equity.

14. One of the aims o f the reform i s to increase horizontal equity (treating equally those of equal income) and vertical equity (treating unequally those of unequal income). Horizontal equity should improve as a system that only taxed dependent labor income i s replaced by a comprehensive personal income tax. It is additionally l ikely to lead to an improvement in vertical equity as the labor income tax has progressive marginal rates. In spite o f the overall beneficial impact on equity o f the reform, the implication o f capital income being taxed at a lower rate than labor income is that neither horizontal nor vertical equity are being maximized by the reform. The justification for the adoption o f a lower tax rate on capital compared to labor income sources i s that as capital is a highly mobile factor the dual tax treatment mitigates arbitrage toward (untaxed) foreign capital instruments.

Table 2. Urueuav: Estimates of the revenue-neutral imDact o f the tax reform Losses Gains (Yo o f Gains (% of 2005 Losses Concept

("$ ml) GDP 2005) GDP)

Eliminated taxes 825 4.9 Modification to VAT taxes 155 0.9 163 1 .o

o/w Reduction in VAT rate 155 0.8 o/w Elimination of COFIS 25 0.2 o/w Broadening o f V A T base 163 1 .o

New taxes 743 4.4 o/w Corporate income tax (IRAE) 394 2.3

Total 980 5.8 907 5.4 Deficit 73 0.4

o/w Personal income tax (IRPF) 349 2.1

Source: Ministry o f Economy and Finance, Uruguay, 2006. Note: Calculated by the Ministry o f Economy and the Finance based on 2005 revenue collection.

15. The tax reform i s designed to be broadly revenue neutral, with a slight fall in revenue of 0.4 percent of GDP projected by the Government during the preparation of the tax reform legislation (Table 2). The losses from the eliminated taxes and the reduction in VAT rates are due to be made up by gains from the broadening o f the VAT base, and the introduction o f the personal income tax (IRPF) and the corporate income tax (IRAE). Therefore, i t i s not expected to impact negatively on government expenditure.

16. I t i s assumed that there i s full compliance with the post-reform tax system. If tax compliance was instead to vary with the income o f an individual, then this would impact on the

5

progressiveness o f the post-tax regime. For example, in increasing the marginal tax rate, i t may be the case that tax compliance falls for higher-income individuals. The Government has reduced the probability o f a fal l in tax compliance ensuing due to the tax reform by substantially strengthening tax administration and collection efforts in Uruguay.

2.2. EXISTING STUDIES ON TAX INCIDENCE AND THE TAX REFORM IN URUGUAY

17. Studies of the pre-reform tax system find it to have been slightly regressive or neutral in terms of i t s distributive impact (Grau and Lagomarsino, 2002; Perazzo, Robaina and Vigna, 2002). All the existing studies use a direct tax incidence approach and apply a partial equilibrium approach. Findings are that the aggregate impact o f the taxes on which the pre- reform revenue collection mostly relied upon-VAT, IMESI, and IRP-was regressive, if analyzed by the average tax rate imposed by decile and through indicators o f income inequality.

18. The IRP had a neutral impact on the income distribution according to the Grau and Lagomarsino (2002) analysis. The average IRP tax rate rose with income until the seventh decile. This result i s due to the lower income share o f wages and pensions (as opposed to other income sources) in the income o f the highest and lowest deciles compared to the middle deciles, and also due to the a higher propensity for self-employment and informal work. Thereafter, for these higher income strata, the increase in the IRP tax rate i s not adequate to compensate for the reduction in the share o f overall income taxed by IW.

19. The effective VAT rate by decile shows i ts weight to be greater for the five lowest income deciles (in proportion of overall income, not in absolute terms). The inequality indices are somewhat lower before compared to after the imposition o f VAT tax. With regard to IMESI, the effective imposition rate does not show a clear pattern by income decile, while the variation o f inequality indicators i s almost zero, indicating neutrality.

20. Existing studies agree that the impact of the tax reform i s likely to be relatively progressive, if the post-tax reform system i s compared with the pre-reform system. Prior to the presentation o f the tax reform to parliament a number o f studies as to its l ikely impact on equity had been carried out and some o f the analysis was used as an input for the preparation o f the reform (Grau and Lagomarsino 2002; Perazzo et a1 2002, Barreix and Roca 2003,2005). The general conclusion o f these studies was that the tax system could be modified to have a positive impact on inequality. A summary o f the various studies on the equity o f the tax system in Uruguay is given in Annex 2.

3. METHODOLOGY

21. The study evaluates the impact on equity and poverty of eliminating the IFW tax and the implementation of the IRPF, as well as the effects of reducing the VAT rate and eliminating the social security financing contribution tax (Contribucidn al Financiamiento de la Seguridad Social, COFIS). An assessment o f the impact o f the tax reform on economic efficiency or tax administration i s not attempted. The welfare measure used i s individualhousehold income taken from the Expanded National Household Survey (Encuestu Nucionul de Hogures Ampliudu, ENHA) 2006. Income rather than a consumption measure i s used as at the time when the analysis was done the latest household expenditure survey was over

6

10 years old. Nevertheless, the Household Income and Expenditure Survey is employed in the analysis where detail on consumption patterns was needed (Encuesta de Gastos e Ingresos de 10s Hogares, EGIH 1994-1995).

22. The analysis uses a static micro-simulation approach to assess the impact of the tax reform. Using household survey data, the direct and indirect tax burden i s calculated for each individualhousehold. This makes it possible to assess how each household i s affected, and thus calculate the poverty and income inequality indicators before and after the reform. The approach used for the analysis i s static in that i t does not take into account second order or general equilibrium effects. In the study, the direct impact o f the change in the tax system parameters on income is assessed. Using a simple micro-simulation approach for the analysis entails certain benefits: a recent CGE model i s not available; it allows comparison with previous studies done on Uruguay and other countries; and it is a transparent method that generates results, which are easy to communicate to a general audience.

23. Changes to the tax system are analyzed using different indicators of income inequality, poverty and tax incidence before and after the reform. A tax i s defined as progressive when the average rate (i.e. proportion o f income paid in tax) increases with income. Measures o f tax progressivity, inequality and poverty are presented before and after the reform o f the tax system. For the poverty analysis, a simulation exercise is carried out for the change in the value o f the poverty line due to changes in the prices o f the goods, on the basis o f different assumptions on the price elasticity o f supply and demand. A full account o f the indicators used is given in Annex 3.

24. There are certain limitations associated in applying a static approach. These static models, unlike behavioral models, do not take into account modifications in an individual’s behavior in response to changes in the tax structure. For instance, people o f a working age could change their labor participation decisions with regards to working hours or number o f jobs, as a f h c t i o n o f how they are affected by the changes in indirect taxes. Something similar happens with consumption expenditure: i t i s reasonable to assume that household decision-making is impacted by changes in relative prices caused by the reform. However, these types o f modifications in individual behavior are not included in this exercise, since to do so it would be necessary to have information on demand functions for various goods, price elasticities and elasticities o f substitution. A complete modeling o f these aspects would require using a CGE (computational general equilibrium) model, or specific studies for subsets o f goods that merit i t because o f their relevance. In short, the results o f the micro-simulation presented in this report are an estimation o f the f i rs t order changes in tax incidence, since behavioral changes are not captured.

25. Regarding assumptions for the transfer of the tax incidence, markets are assumed to be competitive and the total indirect tax burden i s assumed to fall on the buyers. In the case o f consumption, it i s assumed that there i s no tax evasion. For direct taxes this assumption i s not made, since the household survey makes i t possible to identify those workers that pay into social security and those who do not (information that i s included in the analysis).

7

3.1. SIMULATION OF IMPACT OF IRP AND IRPF

26. The analysis of the impact of eliminating the IRP and implementing the IRPF i s conducted based on the 2006 ENHA. The survey collects information on disposable income received in the previous month. To calculate the IRP and IRPF payments corresponding to each individual, the before-tax nominal income must be estimated by adding tax contributions to disposable income. In calculating tax contributions, the specific tax conditions facing each occupational group o f workers are considered, both for the main and secondary occupations. For example, the case o f members o f the military and policemen (contributors to the Military and Police Funds) i s distinguished to take into account health insurance and pension contributions.

Table 3. Treatment of various incomes to estimate IRPF deductions Concept Deductions allowed Annual tax rate

Marginal tax rates Health coverage for chi ldren under 18 years: 6.5

Salaries, commission, BPC in a year distribution o f profits Aportes a la seguridad From 120 to 180 BPC: 20%

social From 180 to 600 BPC: 22%

25%

No payment Up to 60 BPC: From 60 to 120 BPC: 15% Labor income

From 600 to 1200 BPC: Retirement Retirement and pensions Health coverage: Over 1200 BPC:

and pensions Flat tax rates

12 BPC in a year

None Rents, leases 12%

7% Profits Interest 12%

Capital income

Source: Amarante, Arim and Salas (2007). Notes: The value o f Base de Prestaciones Contributivas (BPC) in February 2008 was UR$1,775.

27. At the household level, income also includes income for rentals, leases, interests and other capital incomes, which are subject to the IRPF. These capital incomes have their own rates and are taxed separately (dual system) (Table 3). In the case o f rental and lease income, income above UR$5,000 per month is taxed at 12 percent. All deposit interest i s assumed to be taxed at 12 percent-the tax rate for foreign currency deposits. While tax rates on interest income differ depending on the type o f deposit, approximately 86 percent o f the deposits in Uruguay's financial system are foreign currency deposits. Therefore, i t is assumed that al l interest income i s for foreign currency deposits, as the household survey does not indicate the type o f deposit from which interest income originates. Deductions on capital income such as real property tax and the primary tax on leases are not taken into account. This capital income i s underestimated in the household survey, so the value o f making this type o f adjustment i s doubtful.

3.2. SIMULATION OF IMPACT OF INDIRECT TAXES

28. The analysis considers the reduction in the two indirect taxes, namely the elimination of the 3 percent consumption tax on industrial goods that was used to finance social security contributions (Impuesto de Contribucih a1 Financiamiento de la Seguridad Social, COFIS), and the reduction in the VAT maximum rate from 23 percent to 22 percent and the VAT minimum rate from 14 percent to 10 percent. With regards to the other

8

consumption tax, the excise tax levied on specific goods such as certain alcoholic beverages (IMESI), gradual modifications are being planned to adjust its structure, but no specific changes have been specified. For that reason, the I M E S I is not considered in this analysis. Information from the EGM 1994-95 i s combined with data from the ENHA 2006 to calculate the effect o f the reduction in indirect taxes. Previous household income surveys also are used for comparison with other available sources for income data to calculate the underestimation o f household incomes associated with different types o f income. For these calculations the Encuesta Continua de Hogares (ECH), which was replaced by the ENHA in 2006, i s used.

29. The first issue to be addressed i s the treatment of the de facto VAT surcharge, the social security financing contribution tax (COFIS), which i s eliminated under the post- reform tax regime. The tax is legally applied to al l taxpayers registered with the Revenue Authority (Direccidn General Impositiva), and it i s not possible to know with certainty the extent to which consumer prices incorporate the COFIS. One alternative i s to assume that consumer prices do not include the COFIS, and that this tax i s fully borne by the producers. Another alternative i s to assume that COFIS i s fully passed through to the end consumer. This i s the assumption used in the previous analysis reviewed (Barreix and Roca, 2003) and in background analysis undertaken on the reform by the Ministry o f the Economy, which stated that the effective tax burden on goods drops from 26 to 22 percent for those that pay VAT at the maximum rate (consisting o f the joint effect o f reducing VAT by 1 percent and eliminating the COFIS).

30. Two alternative scenarios are considered in the analysis. The first assumes that the COFIS i s not passed through to the end consumer, i.e. that the reduction in indirect taxes consists solely o f the reduction o f the VAT rate. The second considers that COFIS i s passed through in full to the end consumer and thus that the effective tax burden on goods is reduced from 26 to 22 percent in the case o f goods subject to the maximum VAT rate and from 17 to 10 percent for goods subject to the minimum VAT rate. In both cases, the assumption i s that VAT is paid 100 percent by households, an assumption which i s usual in this type o f estimates. In the case o f the first scenario, households pay only VAT before and after the reform, while in scenario two before the reform the households pay VAT and COFIS and after the reform they only pay VAT. The actual transfer o f COFIS i s probably an intermediate point between these two scenario^.^

31. The assumption that the full burden of VAT or COFIS falls on the consumer implies that the pre-reform tax system i s more regressive than the situation in which part of the burden i s taken on by the producer. The assumption o f full pass-through o f consumption taxes to the consumer impacts on equity by passing on to the consumer the full reduction in indirect taxes. Simulations are presented in Annex 4 showing an opposing assumption for COFIS, i.e. assuming that the final burden o f COFIS i s not passed through to consumers.

32. A special treatment i s given to health care expenditures. These were exempt from V A T prior to the reform, but now are taxed at 10 percent. However, a tax that affects the sector directly i s eliminated: the specific tax on health care services (Impuesto Espec$co a 10s

4. VAT, n o major increase is detected at the time o f introduction o f the COFIS.

It should be noted that if the evolution o f consumer prices i s analyzed, and in particular for goods subject t o

9

Sewicios de Salud, IMESSA). It i s difficult to forecast how the final price o f these services i s affected, and to the extent that the dues paid to the mutual (HMO) are a major expense for households, this aspect o f the tax reform could be relevant. Since this is a regulated price, the degree to which these changes are passed on to consumers wil l depend on the final pol icy decision. Based on consultations with a specialist on the subject, the assumption used in the analysis is that the price o f health care expenses would increase by 3 percent.

33. The micro-simulation analysis assumes that households do not change consumption decisions in response to a shift in relative prices, Le. that the demand i s completely inelastic. While this i s a strong assumption, the difficulty in building in behavioral modifications means that i t is used in most studies on tax incidence, both in developed and developing countries. An additional assumption i s that the household’s consumptiordincome ratio i s kept constant when the shares o f indirect taxes resulting from the EGIH 1994-95 are allocated to the ENHA 2006. This implies assuming that the household’s savings rate i s the same in those two years. The ratio between final private consumption expenditure and gross national disposable income from the national accounts estimated by the Central Bank o f Uruguay amounts to 74.1 percent in 1994 and to 76.8 percent in 2004 (the last year available). The ratio shows a slight increasing trend in the period under analysis (with the exception o f 2002). T h i s would indicate that indirect tax payments may be underestimated in the study as a result o f the methodology adopted. However, i t i s difficult to infer the potential effect on the distributional findings, since no information is available on the evolution o f the savings rates for the various income strata.

3.3. INCOME CAPTURE THROUGH THE HOUSEHOLD SURVEY

34. Household surveys, in all countries, often present underestimations of household incomes, fundamentally due to the difficulties individuals have in reporting variable incomes and also due to intentional under-reporting of income. This i s an important limitation for this work, which i s completely based on the income captured by household surveys. Attempts at estimating the underestimation in household surveys are often based on comparisons with the income reported in income and expenditure surveys or with the estimates o f the System o f National Accounts (SNA or Sistema de Cuentas Nacionales, SCN). CEPAL (2001) reports on efforts at investigating the pattern o f misreporting in Uruguay by matching the incomes captured by the E C H with those o f the National Accounts (SNA). For example, Amarante and Carella (1997) find that the average under-reporting rate for 1989 and 1990 was around 23 percent and 22 percent respectively). Regarding the comparison between household surveys and surveys o f income and expenditures, an existing study for Uruguay found a considerable level o f income sub-capture in the household income survey (ECH) (Mendive and Fuentes 1996). The study finds that the under-capture i s concentrated in the higher income quintiles. The income and expenditures survey (EGM) captures income better since in the process o f data gathering it develops a financial balance sheet at the individual household level and goes deeper into controlling the consistency o f the micro data. The data collection methodology o f the EGIH also implies longer-term contact o f the surveyor with the households, which favors a better capture o f the income.

35. A recent paper by Arim and Vigorito (2006) states that the 2006 household survey captures around 95 percent of the pensioners based on the administrative records. This

10

result is consistent with Mendive and Fuentes (1 996) for pensions, and reaffirms the idea that for that source o f income, the household survey gives a very good approximation (Table 4).

36. Simulations suggest that the ENHA 2006 i s an adequate source to analyze wages and salaries. Regarding salaries, an indirect way o f considering the quality o f their capture by means o f the household survey i s comparing the tax revenues for IRP that result from the expansion o f the household survey with the effective tax receipts. Such a comparison was made for 2006. The results suggest that the survey captures 9 percent more than the actual receipts (Table 5).

Table 4. Comparison o f the average household income, EGIH vis-&vis ECH, per geographical area (in percent)

Salaries Retirements

wages ensions

Household and Rents and Transfers and Imputed incomes employed and interests subsidies Rent

Montevideo 111.2 103.3 114.4 147.0 99.3 146.0 164.3 110.7 Interior 111.9 105.1 112.1 129.4 95.2 181.0 131.3 125.6 Source: Mendive and Fuentes (1 996).

Table 5. Consistency of IRP estimates (UR$ thousands, unless otherwise stated) IRP Tax Collection

Household survey (ENHA, 2006) 5,566,420 Accounting General (Contaduria General de la Nacidn, CGN) 5,092,120

9% Source: Amarante, Arim and Salas (2007). Capture o f IRP 2006 (ENHNCGN)

37. Rental income would seem to be significantly underestimated in household surveys. An attempt was made to quantify the underestimation problems in the 1997 ECH, by comparing the rental data that emerged from this survey with those o f the SNA in 1997.5 Comparing the two sources, the E C H only be captures 32 percent o f the total rental income. The E C H does collects information about the implici t rent from own-housing by asking each household head to estimate how much it would cost to rent the dwelling he owns. However, as the SNA figure refers to the gross production value o f the real estate services activity, in theory i t does no correspond to household income reported by the ECH. The SNA category includes not only rental o f own property, but also real estate intermediation activities for the renting and the management o f real estate on a fee or contract basis. If it is assumed that the rental income that accrues to households i s approximately 80 percent o f the gross rental income (excluding these other activities), the result i s that the E C H underestimates rental income by about 60 percent (Table 6).

Table 6. Capture of rental income in the ECH Estimate in National Accounts (SNA) and Household Survey (ECH)

Estimation o f gross rental production SNA (UR$ million) (1) Estimation o f net rental production SNA (UR$ million) (2) Estimation rental income ECH (UR$ million) ECH/SNA (taking gross rental measure) 1997 (1) ECH/SNA (taking net rental measure) 1997 (2)

8,055 6,444 2,555

31.7% 39.7%

Source; Amarante, Arim and Salas (2007).

5 . component corresponding to households.

That total includes rentals collected by the households and also by companies, thereby overestimating the

11

38. Simulations suggest that interest income i s underestimated in household surveys. An attempt was made to assess the performance o f the household survey in capturing interest income derived from deposits. For the calculation o f aggregate interest accruing to households, an estimate o f the stock o f household deposits in the banking system in 2005 was used (Miraballes, 2006) and the corresponding interest was calculated based on the average annual interest rates for 30-day deposits. The total interest resulting from this calculation was compared to that resulting from the aggregation o f deposit interest recorded in the E C H in 2005. This estimation indicates that the E C H captures a mere 23 percent o f the total interest received by resident households from bank deposits. Interestingly, interest income captured by the E C H i s strongly concentrated in the higher quintiles (8 percent in the fourth quintile and 86 percent in the fifth in 2006).6

39. The household survey would then seem to be a good source to analyze wages and salaries and pensions, but one with strong limitations with respect to capturing rental and interest income. Based on these considerations, the decision was made to work with two scenarios with regard to household income. The f i rs t considers the income reported in the ENHA without introducing corrections. The second adjusts income from each source to correct for the average sub-capture estimated by Mendive and Fuentes (1 996) in Montevideo and in the Interior, since this i s the only source that analyzes the global capture o f the E C H and gives a breakdown o f sub-capture by source. If no adjustment is made to the income measure, pre-tax income and therefore, the equity-enhancing impact o f the tax reform are underestimated.

3.4. SCENARIOS SIMULATED IN THE ANALYSIS

40. The results presented in the study, unless otherwise stated, correspond to the following scenario: (i) ENHA household income i s not corrected (scenario 1.1); and (ii) COFIS i s fully passed on to the end consumers (scenario 11.2). The sensitivity o f the results to a change in these two assumptions is investigated in annex 4. The alternative assumptions are as follows: (i) With respect to income, ENHA income i s adjusted with the Mendive and Fuentes (1996) sub-capture coefficients (scenario 1.2); and (ii) COFIS is not passed through to the end consumer (scenario 11.1). In al l scenarios, VAT is assumed to be fully shifted forward to the final consumer.

4. IMPACT OF THE TAX REFORM ON EQUITY AND POVERTY

41. The section analyzes the impact of the tax reform on poverty and income distribution. The results are presented in three sections. First, the impact o f the elimination o f the wage tax (IRP) and introduction of the dual personal income tax (IRPF) for individuals is considered in section 4.1. The section looks at the impact on an individual’s labor income. Next, the impact o f the reduction in the indirect tax rate on household income i s analyzed in section 4.2. Finally, the overall impact o f tax changes, including a decomposition o f the effects o f direct and indirect taxes, on household income i s presented in section 4.3. Here, the impact o f the introduction o f the dual personal income tax (IRPF) on non-labor income is taken into account.

6. Part o f the underestimation o f bank deposits could be due to the households having bank accounts to support their productive activity when self-employed. In this case, interest income i s not considered as “household” income, but rather as “business” income.

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4.1. IMPACT OF DIRECT TAXES

42. The analysis here is focused on the impact o f the reform on the labor income o f active individuals and pensioners. To construct income by decile, total nominal income i s used for active individuals, including those who do not contribute to social security, and total pension income for pensioners.

4.3.1 Workers 43. The bottom 80 percent of workers face a lower average tax rate following the tax reform. It i s only for the individuals in the ninth and tenth deciles that the post-reform tax system implies a higher mean tax rate compared to the pre-reform system.’ The mean tax rate before and after the tax reform, by decile, is given in Table 7. The mean tax rate here refers to the average IRP and IRPF payments by decile as a share o f labor income, including any labor income from secondary occupations. Workers in the tenth decile are calculated to pay, on average, 7 percentage points more tax o f their labor income, which implies an increase in their tax burden by 150 percent. For the ninth decile, the increase in the mean tax rate i s much lower at 0.3 percentage points. Figure 1 illustrates the differences in the mean tax rate o n labor income per vingtile (or twentieth), illustrating the significant increase in the burden at the upper end o f the distribution. The increase in the average income o f deciles one to eight due to the tax reform i s minor, while the drop in the average income o f the tenth decile i s o f a considerable magnitude (Figure 2).

44. Due to the reform on average a greater tax burden results from the ninth decile onwards. Although there are workers who pay more from decile six onwards due to the introduction o f the income tax, there i s a high concentration o f the workers who pay more in the last two deciles. O f the al l workers, 17.5 percent pay more when the IRP i s removed and the IRPF implemented (Table 8). If formal workers only are considered-that i s those making social security contributions-27 percent o f them pay more under the post-reform tax system.

Table 7. Mean tax rate of IRP and IRPF by decile (YO)

Deci le IRP (a) IRPF (b) (b-a) ((b-a)/a)* 100 1 0.66 0.00 -0.66 -100.0 2 0.04 0.00 -0.04 -100.0 3 0.26 0.00 -0.26 -100.0 4 0.33 0.00 -0.33 -100.0 5 1.16 0.00 -1.16 -100.0 6 1.93 0.01 -1.93 -99.7 7 2.34 1.01 -1.33 -56.8 8 4.21 2.82 -1.39 -33.1 9 4.88 5.15 0.27 5.4 10 4.62 11.59 6.97 150.8

Difference Dif ference


7. The minimum, average and max imum incomes per decile are presented in Table A 6.

13

Figure 1. Mean tax rate on labor income IRP and IRPF

I 14

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Vmgtile o f labor mcome


Figure 2. Variation in average income by decile due to the tax reform (%)

l o h

-2

-4

-6

-8

, I

1 2 3

Deciles o f labor mcome


Table 8. Workers paying more under the post-reform system Distribution o f those who

Decile pay more Percentage who pay more 6 0.1 0.2 7 5.2 9.0 8 16.5 28.8 9 24.6 43.1 10 53.6 93.8

100.0 17.5 Source: Based o n the ENHA.

14

45. Next, the impact of the reform on different categories of workers i s examined (Table 9). I t is important to look at the effect o f the reform on different groups o f workers as there has been concern that those some maybe overly penalized by the reform. For instance, pre-reform those with more than one job were not assessed according to their aggregate labor income, but rather separately according to the amount o f each wage contract. Post-reform, marginal tax rates are imposed based on aggregate labor income. Workers in the health and education sector are among those negatively affected by the reform as it is common in these sectors to hold more than one position. In terms o f the category o f the workers’ main occupation, the most affected are public sector employees and entrepreneur/employers, with 32 and 35 percent o f workers in these categories paying more due to the tax reform, respectively. Given the distribution o f employees across occupational categories, i t in the private sector that the majority o f those who lose out f iom the tax reform are found: over ha l f o f the workers negatively affected are in the private sector.

Table 9. Situation of workers under the post-reform %

Losers Distribution by Distribution o f occupied

category o f losers workers A l l 17.5 ... ... Private 15.8 48.9 54.2 Public 31.9 28.5 15.6 Entrepreneur/employer 35.3 9.6 4.7 Self-employed (w/o site) 1.9 0.7 6.5 Self-employed (w site) 12.6 11.9 16.5

Non-Professional 15.1 81.9 94.7 Professional 59.3 18.1 5.3 One job 14.7 75.4 89.6 More than one job 41.3 24.6 10.4 Women 14.1 35.1 43.5 Men 20.1 64.9 56.5 Interior 12.6 41 57.1 Montevideo 24.1 59 42.9 Mayor urban 18.7 92.9 86.7 Minor urban 9.1 3.0 5.9 Rural 9.5 4.0 7.4


Other 0 0 2.2

tax system, by worker characteristic

All IRP IRPF Difference Difference (a) (b) (b-a) ((b-a)/a)*lOO

3.58 5.8 2.2 61.8 3.7 5.8 2.1 55.4 4.5 6.6 2.0 44.8 4.3 8.4 4.0 92.4

0.2 0.6 0.5 306.9 1 3.2 2.2 222.7

3.4 5 1.6 46.4 4.6 10.6 6.0 129.7 3.6 5.3 1.7 46.5 3.5 8 4.5 128.3 3.4 4.9 1.5 42.6 3.7 6.3 2.6 71.6 3.3 4.3 1.1 32.7 3.9 7.1 3.2 83.2 3.7 6 2.4 65 2.8 2.9 0.1 3.3 2.8 3.8 1 .o 35.2

0.4 0 -0.3 -93.1

46. The greatest differences between pre- and post-reform tax payments are found in the case of entrepreneur/employers and the self-employed. The mean tax rate on income has doubled for entrepreneur/employers. For the self-employed, there are large differences in the effect o f the tax reform on individuals due to their different locations in the income distribution. Among professionals, 60 percent pay more taxes due to the reform, represents 18 percent o f the total workers who pay more under the reform. The average tax rate increases by six percentage

15

points for this group that, on average, pays 130 percent more in taxes.* Overall, for workers who are negatively affected by the reform, the mean tax rate increases by almost six percentage points, which implies that these taxpayers pay an additional 132 percent. For those that benefit, the taxes bill decreases by 46 percent.

47. Regarding multiple jobs, 41 percent of workers with more than one job pay more with the reform, as compared to 14.7 percent of those with one job. Prior to the reform, individuals paid a single tax rate applied to each work contract. With the introduction o f a marginal income tax based on total income from al l labor contracts, multi-jobholders with higher incomes pay more. In spite o f the greater burden for workers with more than one job, i t should be noted that 75 percent o f the workers that pay more under the post-reform tax system have only one job. Salary differences and differences in labor market participation rates between men and women mean that 65 percent o f the workers with an increased tax burden are men. On average, the tax increases by 2.6 percentage points for men, while for women the variation i s 1.4 percentage points.

48. Due to the salary differentials between Montevideo and the urban interior, the post- reform tax system impacts more negatively on workers in the capital. Salaries are in general higher in Montevideo compared to the rest o f the country and therefore, the average tax rate for workers increases by 3.2 percentage points, as compared to 1.1 percentage points for the workers in the interior o f the country. Thus, almost 60 percent o f the workers affected negatively belong to the country’s capital. The workers who negatively affected by the changes in the tax system are concentrated in urban localities with more than 5000 inhabitants. There i s little difference in the impact o f the reform on minor urban zones and rural ones, although the mean tax rate increases on average by one percentage point in the latter.

49. Construction workers and domestic servants in private households are those who gain most from the tax reform, with these low-salaried workers paying on average 40 percent and 20 percent less in taxes, respectively (Table 10). Manufacturing, trade, public administration and defense, health care and social services and education are the sectors with almost 60 percent o f the workers affected negatively by the reform. Financial intermediation is the industry with the largest share o f workers who pay an increased tax burden due to the tax reform (63 percent), followed by the electricity, gas and water sectors (40 percent). Social services and health workers, some o f whom have more than one employment contract, on average pay 3.5 percentage points more due to the tax reform). I t i s those in professional occupations that lose out in terms o f greater taxes paid due to the reform.

8. Al l those who are employed and declare having completed university education are classified as professionals.

16

Table 10. Situatioi

~~

All A. Agriculture, livestock, game and forestry B. Fishing C. Exploitation o f mines and quarries D. Manufacturing industry E. Supply o f electricity, gas and water F. Construction G. Majo r and minor commerce, vehicle repair H. Hote l and restaurants I. Transport, storage and communications J. Financial intermediation K. Real estate activity L. Public administration and defense M. Teaching N. Health and social services 0. Other activities in provision o f communal, social and personal services P. Private household domestic service Q. Organizations and extraterritorial organs

If workers under the post- %

Losers Distrib. by Distrib. occupied

category o f losers workers

17.5 ... ...

9.9 18.4

24.9 17.1

39.6 3.4

11.9 10.2

30.3 63.4 27.1

27.8 27.6 32.9

14.4

2.1

2.2

6.0 0.3

0.2 13.4

2.4 1.2

13.1 1.5

9.1 5.5 8.8

11.7 9.0 12.8

4.0

1.1

0.0

10.7 0.2

0.1 13.7

1 .o 6.2

19.2 2.6

5.3 1.5 5.7

7.3 5.7 6.8

4.9

9 .O

form tax system, by industry All

IRPF Diff. Diff. IRP (a) (b) (b-a) ((b-a)/a)* 100

3.58 5.8 2.22 61.8

2.7 3.7

4.0 3.7

5.3 3.8

2.7 2.8

4.3 5.2 3.6

4.5 3.8 4.1

3.1

1 .o

4.2 7.7

5.7 6.0

8.5 2.3

4.4 3.3

6.6 12.2 7.6

6.3 5.1 7.6

4.8

0.8

1.5 54.0 4.0 106.8

1.7 41.8 2.3 62.0

3.2 60.3 -1.5 -40.4

1.8 66.3 0.5 16.7

2.4 56.0 7.0 135.9 4.0 112.1

1.8 40.3 1.4 36.3 3.5 87.2

1.7 56.0

-0.2 -24.1

0.3 0.3 0.0 -20.3 Source: Based o n the ENHA.

4.3.2 Pensioners 50. For pensioners, the tax burden increases from the eighth decile onwards due to the reform. The impact o f the reform on pensioners is o f interest as groups o f pensioners in Uruguay have launched a particularly strong challenge against the application o f the personal income tax (IRPF) to pension income. Pensioners paid little wage tax on pension income prior to the tax reform (Table 11 and Figure 3). The top 20 percent o f pension earners faced a tax rate o f 2 percent prior to the tax reform.’ For the ninth and tenth decile o f pension earners, the difference between the average tax rates before and after the reform i s in excess o f eight percentage points

9. The minimum, average and maximum pension values per decile are presented in Table A-10.

17

(Figure 4). Pensioners negatively affected by the tax reform represent 27 percent o f the total pensioners. The bottom 70 percent o f pension earners continue to pay no tax.

Table 11. Pensioners: Mean tax rate of IRP and IRPF by decile (YO) Decile IRP (a) IRPF (b) Difference (b-a) Difference ((b-a)/a)*lOO

1 0.0 0.0 0.0 2 0.0 0.0 0.0 3 0.0 0.0 0.0 4 0.0 0.0 0.0 5 0.0 0.0 0.0 6 0.0 0.0 0.0 7 0.0 0.0 0.0 8 0.4 8.7 8.2 1994 9 2.0 10.0 8.0 390 10 2.0 12.5 10.4 510


Figure 3. Mean tax rate on pensions under the IRP and IRPF, by vingtile (%) I 16 I

14

12

10

e , 8

n

e,

2 i? k 0 6

4

2

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Vmgtile o f pension income


18

Figure 4. Variation in average pensions due to the tax reform, by decile (%)

0

-2

-4

h 8 -6

-8

-10

-12


Table 12. Uruguay tax reform: Summary of impacts on workers and pensioners Reduction in Increase in Difference

(b-a) % o f Losers IRP (a) IRPF (b) disposable income disposable income

for losers (uR$) for winners (uR$) Labor income 17.5 3.58 5.80 2.22 1516 75 Pension income 27.1 1.08 6.86 5.78 1375 0 Source: Based on the ENHA.

4.2. IMPACT OF INDIRECT TAXES

51. The analysis here i s focused on the impact of the reform of indirect taxes on household income. The pre-tax reform situation is estimated to have been regressive, in that the percentage decrease in income due to indirect taxes i s higher for the bottom 40 percent compared to the top 60 percent o f income-earning households (Table 13 and Figure 5). All households benefit from the reduction in the indirect tax rate due to the tax reform, which falls by on average over 2 percentage points over the different income groupings. In terms o f average indirect tax rates, the post-reform the tax structure remains regressive. T o restate, i t i s assumed in the analysis that indirect taxes on goods are shifted completely to consumers. 4

19

Table 13. Mean indirect tax rate (IVA + COFIS) on households before and after the reform, by decile (%)

Pre-reform Difference Difference Dec i l (a) Post-reform (b) (b-a) ((b-a)/a)*lOO

1 11.4 8.6 -2.8 -24.8 2 11.3 8.6 -2.7 -23.8 3 11.3 8.7 -2.6 -23.0 4 11.1 8.6 -2.5 -22.4 5 10.9 8.6 -2.4 -2 1.5 6 10.4 8.1 -2.3 -22.2 7 10.6 8.3 -2.3 -2 1.6 8 10.4 8.2 -2.2 -21.3 9 10.0 7.9 -2.1 -20.9 10 9.6 7.7 -2.0 -20.5


h &? lo -

5 8 - v

$ 6 -

8 4 -

2 -

0

Figure 5. Mean indirect tax rate (IVA + COFIS) on households before and after the reform, by vingtile (YO)

+- - - - - - - 1 2 - - - - - - - - - - - a

*r --- - %

- - pre reform - post reform

I I I , , , , , ~ ~ ~ ~ ~ , , , ~ ~ ,

I 14


4.3. IMPACT OF COMBINED TOTAL EFFECT OF THE TAX REFORM

52. are presented. Household income includes al l non-labor capital income.

Next, the results o f an analysis o f the impact o f direct and indirect taxes on households

4.3.1 Change in Tax Burden

53. The average pre-reform tax burden for households was 12.3 percent of pre-tax income. For the average household, the total impact o f the tax reform on the tax burden o f direct and indirect tax changes i s given in Table 14. In the case o f direct taxes, the reform increases the average burden by 68 percent. In the case o f indirect taxes, the reform reduces the average household tax burden by 21 percent. Overall, the reform causes the household tax burden to fall

20

by 4.8 percent. Falling indirect taxes compensate for the increase in direct taxation. As intended by the reform, the relative weight o f direct taxes and consumption taxes changes on average. Under the pre-reform regime, indirect taxes represent 8 1 percent o f the taxes paid by households. The reform causes the share o f consumption taxes to fall, leading to VAT representing 67 percent o f the household tax burden and the IRPF becoming equal to a third o f the total taxes payable by households.

Disposable income

Averaee income before taxes

Incomes (without adjustment) COFIS (fully passed on)

6646 " Before tmx reform a) Total taxes on households

664 152

12.3%

816

10.0% I Ib) Indirect taxes

a) Total taxes o n households 777 b) Indirect taxes 522 c) Direct taxes 255 Tax burden (as % of income before taxes) a) Total taxes 11.7% b) Indirect taxes 7.9% c) Direct taxes 3.8% Change in tax burden due to tax reform (%) a) Total taxes -4.8% b) Indirect taxes -21% c) Direct taxes 68%

c) Direct taxes 2.3% 1 After tax reform

54. An analysis of the total impact of the reform shows it to clearly be progressive (

21

Figure 6). The grey and black smooth lines represent the situation before and after the reform, respectively." Under the pre-reform system, the tax burden as a share o f pre-tax income remains relatively constant (close to 12 percent) throughout the distribution curve. The pre-reform system was neutral from the point o f view o f inequality. This neutrality arose from the combination o f regressive consumption taxes and progressive personal income taxes.

10. individual) are presented in Tables A-4 (uncorrected income).

The minimum, average and maximum values o f the household per capital income vingtiles (weighed per

22

Figure 6. Tax burden as share of per capita pre-tax income: Comparison between the pre- reform regime and the post-reform situation

4%, /

0% 2% i 1 2 3 4 5 6 7 8 9 I O 1 1 12 13 14 15 16 17 18 19 20

Household income vingtile - - VAT taxes before tax reform --31( ' IRF' -Total taxes before tax reform

*IRPF VATaftertaxreform -Total taxes after tax reform

Source: Based on the EGIH and the ENHA.

55. The reform alters the relative neutrality of the pre-reform tax system. Up to the distribution median (approximately vingtile lo), the total tax burden shows no systematic variation in terms o f the distribution; however, there i s a monotone increase o f the tax burden from the median onwards. As a result, the global tax burden o f the households below the 16th percentile falls, while i t becomes markedly higher in the last three vingtiles o f the distribution.

56. The progressive impact of the reform stems fundamentally from the process of replacing the IRP with the IRPF. The change in indirect taxes does not generate a substantial distributional impact, although it does generate an increase in the income o f al l households. Although both the IRP and the IRPF are progressive, that is the tax rate on the household income increases with the level o f income, the IRPF shows a sharper progressiveness pattern. The tax burden i s lower than that o f the IRP approximately up to the sixteenth vingtile, and then increases exponentially. Nevertheless, i t should be noted that the average direct tax rate remains at relatively moderate levels, below 9 percent for the twentieth vingtile. The net impact o f replacing the IRP with the IRPF turns negative from vingtile fifteen, but the reduction o f consumption taxes more than compensates for that effect up to vingtile eighteen. As a result, only the wealthiest 20 percent o f the population are negatively affected by the reform. The rest o f the households see their disposable income increase by an amount in the range o f 2 to 3 per cent. The results presented correspond to the scenario where household income i s not corrected and it is assumed that COFIS is fully passed through to the end consumer. However, the result also holds under the alternative scenarios analyzed.

23

57. The progressive impact of the reform i s shown by the improvement in inequality that results from the change in the tax system (Table 15 and Table 16). The results illustrate that the pre-reform system is characterized as neutral in terms o f the impact on the distribution. Pre-reform, the synthetic inequality indices remain practically unchanged before and after taxes. Post-reform, the last column o f Table 15 shows that al l the synthetic inequality indicators decrease after taxes. The variation in the inequality indicators due to the tax reform is in the range o f 1 to 2 percentage points." The reform i s estimated to have achieved a modest, but significant reduction in the Gini: An examination o f the upper bound limit o f the confidence interval o f the Gini coefficient after the tax reform reveals that i s smaller than even the lower bound o f the pre-tax Gini (Table 16).

Table 15. Ineaualitv measures before and after taxes

Before tax reform After tax reform

After After Af ter After After After Before taxes indirect direct taxes indirect direct variation taxes (1) taxes taxes (2) taxes taxes (2)-( 1)

Gini coefficient 0.454 0.453 0.457 0.448 0.442 0.456 0.440 -0.011 Entropy 0 0.351 0.350 0.357 0.341 0.338 0.361 0.334 -0.012 Entropy 1 0.376 0.376 0.382 0.366 0.353 0.380 0.349 -0.023 Source: Based on the EGIH and the ENHA.

Table 16. Confidence intervals for ineaualitv measures before and after the taxes Gini Entropy 0 Entropy 1

Average Lower Average Upper Lower Average Upper Lower Upper bound

Before taxes 0.452 0.454 0.456 0.349 0.351 0.357 0.369 0.376 0.381 After taxes (pre-reform) 0.452 0.453 0.456 0.350 0.349 0.358 0.370 0.375 0.381 After taxes (post-reform) 0.443 0.445 0.447 0.335 0.338 0.343 0.349 0.355 0.362

bound bound bound bound bound

58. While progressive, the impact of taxes on the Gini under the post-reform tax structure for Uruguay i s much lower in magnitude than seen in many European countries. The change in the Gini due to taxation in Uruguay i s more broadly in l ine with that found for Latin America than for Europe (Goiii et al, 2008): Taxation has a close to neutral or modestly progressive impact on the Gini (Table 17). Uruguay joins Mexico as one o f the only two Latin American countries where the Gini falls after taxation. The tax structure i s limited as a tool for redistribution in Latin America due to l ow level o f personal income taxation. By contrast, in Europe personal income taxes are higher, better-targeted and more progressive allowing the tax system to have a greater impact on equity.

1 1. which could produce diverse results. However, in t h i s case the conclusions are robust for the index used.

Synthetic inequality indices weigh income transfers differently in the various parts o f the distribution curve,

24

Table 17. Uruguay, Latin America and OECD: Comparison of inequality before and after taxes

Inequality Inequality Contribution before taxes after taxes o f taxes

Latin America Uruguay (Pre-reform) Uruguay (Post-reform) Argentina Braz i l Chile Colombia Mexico Peru

0.454 0.454 0.49 0.54 0.46 0.53 0.50 0.49

Lat in American average 0.50

OECD Benchmarks (Selected countries) Denmark 0.49 Finland 0.49 France 0.42 Germany 0.43 Greece 0.47 Ireland 0.53 I ta ly 0.48 Portugal 0.49 Spain 0.47 Sweden 0.45 United K ingdom 0.52

0.453 0.00 0.445 0.01 0.48 0.01 0.55 -0:Ol 0.46 0.00 0.53 0.00 0.49 0.01 0.49 0.00

0.50 0.00

0.42 0.06 0.45 0.05 0.38 0.04 0.38 0.05 0.44 0.04 0.48 0.05 0.44 0.04 0.44 0.05 0.42 0.05 0.41 0.04 0.48 0.04

Europe average 0.46 0.41 0.05

Source: Goi i i et al. (2008) and OECD.

59. Next, the impact of the reform on poverty and extreme poverty i s analyzed. Again, i t should be recalled that this exercise i s subject to limitations, fundamentally because it does not take into account the potential household behavioral changes that may occur due to the modification in the tax system or other general equilibrium effects such as a potential impact o f the reform on investment. The poverty line used i s that calculated by the National Institute o f Statistics (Instituto Nacional de Estadistica, NE) in 2002. I t i s based on information from the Household Income and Expenditure Survey o f 1994, which is used to design the basic food basket or food poverty basket (Canasta Busica Alimentaria) and non- food consumption, which are the components o f the poverty line. A household is considered to be in extreme poverty if i t s per capita income is below that o f the food poverty basket, while i t i s characterized as poor if i t s income does not reach the value o f the poverty line. The indices FGTo, FGTl and FGT2 are used to measure the effects on the incidence, intensity and severity o f poverty and extreme poverty.'* First, the FGT indices for the year 2006 were calculated using current income reported by the

12. These indices are described in the methodological annex.

25

households. Second, the impact o f the reform on the prices o f goods included in the poverty basket due to changes in the indirect tax structure was taken into account.

Table 18. Impact of the tax reform on poverty and extreme poverty Indicators o f Poverty

FGT(0) FGT( 1) FGT(2) Indigence Indicator before the reform 0.019 0.004 0.001 Indicator post reform (indirect taxes) 0.017 0.004 0.001 Effect of indirect taxes -0.002 0.000 0.000 Indicator post reform (indirect + direct taxes) 0.017 0.004 0.001 Effect of direct taxes u.000 0.000 0.000

Poverty Indicator before the reform Indicator post reform (indirect taxes) Effect of indirect taxes Indicator post reform (indirect + direct taxes) Effect o f direct taxes

0.270 0.088 0.040 0.265 0.085 0.038

-0.005 -0.003 -0.002 0.263 0.084 0.036

-0.002 -0.001 0.000 _1_1 .,

r'iggregatc effect of the reform -0.007 -0.004 -0.002 Source: Based o n the EGIH and the ENHA.

Table 19. Confidence intervals for poverty measures before and after the reform FGT(0) FGT( 1) FGT(2)

Lower Upper Lower Aver age Upper Lower Average Upper bound bound bound bound bound Average bound

Before thereform 0.269 0.270 0.271 0.088 0.088 0.089 0.040 0.040 0.040 After the reform (direct taxes) 0.264 0.265 0.266 0.085 0.085 0.086 0.038 0.038 0.038 After the reform (direct and indirect taxes) 0.262 0.262 0.263 0.084 0.084 0.085 0.036 0.036 0.036 Source: Based o n the EGIH and the ENHA.

60. There i s a small, but beneficial, reduction in poverty due to the reform (Table 18 and Table 19). The simulated reduction in poverty represents a reduction o f about 0.7 percentage points in poverty incidence. The small variation in poverty observed stems from the changes in VAT and the elimination o f COFIS, rather than being due to the variations in direct taxes. This result i s in contrast to that obtained in the analysis o f the redistributive impact, where the main force that made it possible to characterize the reform as progressive i s linked to direct taxes. Individuals in the poorer segments o f the income distribution were in general not taxed by the IRP. Around the third decile-the location o f the poverty line-the amount o f IRP paid was less than 1 percent o f pre-tax income, so that a reduction o f this amount does not substantially alter the availability o f resources for households. The impact o f the tax reform on extreme poverty i s

26

practically ~ e r 0 . l ~ This result i s to be expected as the share o f individuals below the extreme poverty line i s low, at about 2 percent o f the total population.

Table 20. Effect of the tax reform on poverty for those aged under 18 and above 64 FGT(0) FGT(1) FGT(2)

Less than 18 years Indicator before the reform 0.461 0.160 0.074 Indicator post reform (indirect taxes) 0.447 0.153 0.071

Indicator post reform (indirect + direct taxes) 0.444 0.152 0.070 Effect o f direct taxes -0.003 -0.001 -0.001

Effect of indirect taxes -0.014 -0.006 -0.004

-JJ - - -.! Aggregate effect of the re form -0.0 I 7 -0.008 -0.004 Greater than 64 years Indicator before the reform Indicator post reform (indirect taxes) Effect of indirect taxes Indicator post reform (indirect + direct taxes)

0.085 0.021 0.008 0.079 0.019 0.007

0.080 0.019 0.007 -0.005 -0.001 -0.001

Ejfect of direct t a w s 0.000 0.000 0.000 Aybpgdte effect o f the reform -0.005 -0.001 -0.001 Source: Based on the EGIH and the ENHA.

61. One of the characteristics of poverty evolution in Uruguay since the beginning of the 1990s i s the dynamics according to age groupings. While poverty among the elderly (age 65 and over) fe l l during most o f the period-with the exception o f the period between 2001 and 2004, when, as a consequence o f the deep economic crisis, the poverty headcount increased for al l age segments-poverty among children and young adults increased markedly (Amarante et al, 2005; PNUD, 2005). Therefore, i t i s important to analyze whether the tax reforrn has a differential impact depending on age group. The results o f this analysis reflect that the impacts per age group are analogous to those obtained for the total population. Poverty indicators are slightly reduced with the implementation o f the reform, with the drop somewhat higher among younger individuals for whom the absolute value o f the change is around 1 percent. The low impact on the elderly i s not surprising, since the pensioners who tend to be close to the poverty l ine were not subject to the LRP and do not pay the IRPF (Table 20).

13. i s no off icial poverty l ine available for rural areas.

The poverty calculations were only made for urban areas (localities with 5000 inhabitants and more), as there

27

5. CONCLUSION

62. The focus of the PSIA i s on the equity impact of the changes in the tax system on households, specifically the changes in VAT and COFIS and those related to the IRP and the IRPF. Results indicate that the replacement o f the IRP with the IRPF results in an improved situation for the bottom 80 percent o f labor income earners, for whom the mean tax rate falls. The mean direct tax rate increases for the top 20 percent o f taxpayers. The mean tax rate here refers to the average IRP and IRPF payments by decile as a share o f labor income, including any labor income from secondary occupations. Workers in the tenth decile are calculated to pay, o n average, 7 percentage points more tax on their labor income. For the ninth decile, the increase in the mean tax rate i s much lower at 0.3 percentage points.

63. For pensioners, the tax burden i s increased from the eighth decile onwards due to the introduction of the IRPF. Pensioners paid little wage tax on pension income prior to the tax reform. The top 20 percent o f pension earners faced a tax rate o f 2 percent prior to the tax reform. Following the reform, for the top 30 percent o f pension earners the difference between the average tax rates before and after the reform is in excess o f 8 percentage points. The bottom 70 percent o f pension earners continue to pay no tax.

64. With regard to indirect taxes on household income, the pre-tax reform situation i s estimated to have been regressive, in that the percentage decrease in income due to indirect taxes i s higher for the bottom 40 percent compared to the top 60 percent o f income-earning households. All households benefit from a reduction in the indirect tax rate due to the tax reform, which falls by on average over 2 percentage points over the different income groupings. In terms o f average indirect tax rates, the post-reform indirect tax structure remains regressive. To res ta teas i s regular in this type o f analysis-it i s assumed that indirect taxes on goods are shifted fully forward to consumers.

65. An analysis of the total impact of the reform on households shows it to represent a progressive change. Under the pre-reform system, the tax burden as a share o f pre-tax income remains relatively constant (close to 12 percent) throughout the distribution curve. The pre- reform system was neutral from the point o f view o f inequality. This neutrality arose from the combination o f regressive consumption taxes and progressive personal income taxes. The reform alters the relative neutrality o f the pre-reform tax system. There i s a monotone increase o f the tax burden from the median onwards. As a result, the global tax burden o f the households below the 16th percentile falls, while i t becomes markedly higher in the last three vingtiles (five-percent bands) o f the distribution.

Taking into account changes to VAT, COFIS and the introduction of the IRPF, along every measure considered the tax reform has a small, but positive impact on equity. The Gini coefficient o f after tax income i s estimated to fall due to the reform: The Gini coefficient o f before tax income is calculated as 0.45 and the Gini coefficient o f after tax income following the reform is calculated as 0.44 (the pre-reform Gini o f after tax income i s 0.45).

28

References

Amarante, V., Arim, R. and Salas, R. (2007). Impact0 Distributivo de la Reforma Impositiva. Mimeo.

Asociacion Rural del Uruguay (2006). Informe de coyuntura. Direccion de Estudios Agroeconomicos. Disponible en: htt~://~~~.aru.org;.uy/Documentos/Info%2007-06.pdf

Barreix, A. and Roca, J. (2003). Sistema Tributario: condiciones actuales and propuesta. Universidad Catolica del Uruguay, Montevideo.

Barreix, A. and Roca, J. (2005). Propuestas para la reforma tributaria de Uruguay. Documento elaborado para e l Ministerio de Economia y Finanzas, Montevideo.

Barreix, A. and Roca, J. (2006). Arquitectura de una propuesta de reforma tributaria. Universidad Catolica del Uruguay, Montevideo.

Barreix, A. and Roca, J. (2007). Strengthening a fiscal pillar: the Uruguayan dual income tax. CEPAL Review 92.

CEPAL (2001). Analisis estadistico de 10s efectos sobre 10s principales indicadores socio- econdmicos resultantes de 10s cambios metodoldgicos introducidos en la encuesta continua de hogares. By Bucheli, and M. Furtado, M. Montevideo, Uruguay.

Cinve (2005). Implicancia de la reforma de 10s aportes patronales sobre la demanda laboral. Montevideo.

Duclos, J.Y. and Araar, A. (2006). Poverty and Equity. Measurement, Policy, and Estimation with DAD. Springer/IDRC. Ottawa.

Gasparini, L. Horenstein, M, and Olivieri, S. (2006). Economic Polarisation in Latin America and the Caribbean: What do Household Surveys Tell Us? CEDLAS Working Papers 0038, CEDLAS, Universidad Nacional de La Plata.

Goiii, E., Lopez, H. and L. Serven L. (2008), Fiscal Redistribution and Income Inequality in Latin America. World Bank Policy Research Paper 4487, World Bank, Washington, D.C.

Grau C. and Lagomarsino G. (2002). La estructura tributaria de Uruguay y su incidencia en la distribucidn del ingreso de 10s hogares. Fundacion de Cultura Universitaria.

Grau C., Lorenzo F. and Oddone G. (2004). Ideas y lineamientos para la reforma tributaria. Centro de Investigaciones Economicas (CTNVE).

Instituto de Economia (2006) Impactos de la reforma tributaria sobre 10s ingresos de 10s hogares. Anexo del Informe de Coyuntura del Instituto de Economia, Montevideo.

Mendive C. and Fuentes A. (1996) "Evaluation de l a captacion del ingreso de 10s hogares” in Aspectos metodoldgicos sobre la medicidn de la linea de pobreza: el cas0 uruguayo. CEPAL, Oficina de Montevideo, Instituto Nacional de Estadistica.

Ministerio de Economia y Finanzas. (2006). Proyecto de Ley de modijkacidn del sistema tributario.

29

Miraballes G. (2006). Sewicios de Intermediacidn Financiera Medidos Indirectamente. Una propuesta alternativa para Uruguay. Tesis para l a obtencion del titulo de Magister en Economia, Facultad de Ciencias Economicas y Administracion, Universidad de l a Republica.

Perazzo I., Robino C. and Vigna A. (2002). Sistema impositivo y distribucidn del ingreso en Uruguay. Trabajo monografico presentado en la Facultad de Ciencias Economicas y de Administracion, Universidad de la Republica.

World Bank. (2007). Income Transfer Policies in Uruguay: Closing the Gaps to Increase Welfare. Report No. 40084-UY, October 18,2007.

30

€

2 k 0 cw

5 c

W W

C .I

e,

a

Figure Al. Uruguay: Tax Revenue Composition Before and After Tax Reform

Before reform: Tax as a YO of revenue

After reform: Tax as a YO of revenue

Source: Ministry o f Economy and Finance, Uruguay. Note: Elaborated by the Ministry o f Economy and the Finance based on 2005 revenue collection

38

J

s 2 3 3

m 0

2 8 x 2 9

P

W

0 d

Annex 3. Poverty, Inequality and Progressiveness Indicators

66. To analyze the changes in poverty, the class o f indicators proposed by Foster, Geer and Thorbecke (1984) (FGT (a)) i s used. FGT (a) i s a poverty index that includes a family o f indices based on different values o f the parameter, a, which represents the degree o f poverty aversion in society. The FGT (a) index i s defined as:

1 4 n i= l

FGT(a) =-C[(Z-Y,)/Z] a

67. where n i s the total sample size; yi i s the standard o f living indicator for person i, for which typically a measure o f income i s used. Let Y = ( y ~ , y2 ,.. ., y,, ) be a vector o f incomes in increasing order. z > 0 i s the pre-determined poverty line, with z - yi i s the income shortfall o f the ith individual; and q = q(y; z) i s the number o f poor individuals having income no greater than z. The measures are defined for a 2 0, and a i s a measure o f the sensitivity o f the index to poverty. If a = 0, the FGT index i s transformed into the equivalent o f the poverty headcount, since it quantifies the percentage o f households below the poverty line. If a = 1, the FGT index i s transformed into the poverty gap, measuring the gap between the income o f the poor and the poverty line. If a = 2, the FGT index includes the relative variance o f income across the poor.

68. To analyze changes in inequality, the Gini coefficient and entropy indices are used. The Gini coefficient o f incoem, G,, i s an indicator that increases with the degree o f inequality, with 0 representing equidistribution and 1 representing the extreme case when only one person receives the whole income o f ~ 0 c i e t y . I ~ This index may be defined as the average difference between all possible pairs o f incomes o f the population (yJ, expressed as a share o f total income, i.e.:

where i s the mean income.

69. are defined as:

The Entropy indices o f grade 0 (Eo) and 1 (Theil Index, (E,)) o f income distribution

i = I, ..., n (3)

14. The Gini coefficient (G) i s a measure that may be visualized geometrically in terms o f the Lorenz curve as the equivalent to a quotient. The numerator i s the area between the equidistribution straight line and the Lorenz curve, and the denominator is the area below the diagonal.

41

where yi represents the per capita income o f individual i, p i s the mean income o f the population, and X j i s the share in the income o f individual i. The index Eo has greater sensitivity in the lower strata (tending to infinite when the income approaches zero). In the case o f El the weight of a transfer i s greater the lower the income o f the receiver, and the greater the distance between the individual who receives and the individual who i s deprived from the income.

Figure 7. An example of a concentration curve for a progressive tax

70. The concentration curve i s an important tool for examining the impact o f taxation transfer policies. This may be used to capture the equity o f tax systems when it i s compared to the before-tax income Lorenz curve. The Lorenz curve, Lx(p), i s defined as the proportion o f total income, x, received by the lowest pth fraction o f the population, arranged in ascending order o f income. The Gini coefficient i s the area between the line o f equality (the 45-degree line) and the observed Lorenz curve (the observed deviation from the line o f perfect equality) divided by the total area under the diagonal (the maximum possible deviation from perfect equality). Th is i s equal to two times the area between the diagonal and the observed Lorenz curve:

71. The concentration curve o f a tax CT(P) i s defined similarly to the Lorenz curve, replacing the cumulative proportion o f income received by each fraction p, by the cumulative proportion o f taxes or other payments contributed by each fraction o f the population ordered by income. The tax concentration index CT i s analogous to the Gini coefficient and corresponds to one minus twice the area between the concentration curve and the l ine o f equality divided by the total area under the diagonal. The index takes a negative (positive) value when the tax concentration curve lies above (below) the line o f equality. A negative value indicates a disproportionate concentration o f taxes among the poor. The index has a range o f [-1,1].

42

72. There are two leading approaches to look at the distribution o f a tax (Duclos and Araar, 2006). Under the tax redistribution (TR) approach, a tax structure i s progressive if the tax concentration curve lies below the Lorenz curve for pre-tax income (Figure 7). When tax payments are regressive, the concentration curve o f taxes l ies above the Lorenz curve, i.e. the bottom pth fraction o f the population pay more than p% o f tax. In addition, a tax A i s more TR-progressive than a tax B if the tax concentration curve o f the tax A lies below that o f tax B.

where the subscript T refers to taxes and the subscript Y refers to pre-tax income.

73. The second approach i s that focuses on the income redistribution (IR) impact o f the tax. A tax i s IR-progressive if the after-tax income distribution i s more progressive than the pre-tax income distribution. Let N denote post-tax income and Y continues to denote pre-tax income, then IR-progressiveness requires the after tax income concentration curve CN(P)(= CY-T(P)) to be greater than the pre-tax income Lorenz curve:

‘ N ( P ) ’ LY (P) ti’P E [OJI (9)

74. The evaluation criteria derived from conditions (7) and (9) make it possible to characterize taxes as globally progressive provided that the conditions stipulated are met for all percentiles. If the concentration curves, however, cross the Lorenz gross income curve, these criteria are not sufficient to characterize the p01icies.I~ In turn, if the concentration curves cross, even when a classification o f the taxes as globally progressive or regressive may be possible, the policies could not be ranked according to their relative degree o f progressiveness. In other terms, conditions (7) and (9) provide a qualitative and partial ranking.

75. A comparison between the tax concentration curves and the pre-tax income Lorenz curve may lead to erroneous conclusions regarding the distributional impact o f taxes should taxation cause strong household reranking processes across the distribution, which could potentially cause their redistributive effect to be sharply reduced. Reranking may reduce the redistributive effect because o f a difference in pre-tax and post-tax ranking. The underlying income distribution could alter substantially, but have no impact on the concentration index if income ranks are preserved. Therefore, the distribution o f taxation needs to be related to the income distribution and the degree o f pre-tax income inequality.

15. This problem i s similar to that stemming from using the Lorenz curve as a ranking criterion. If the Lorenz curve corresponding to pre-tax income intersects with the concentration curves, it i s not possible to determine the global effect o f the tax on inequality.

43

76. The Kakwani index, IIK, o f tax progressivity measures the divergence from proportionality. It i s given by the difference between the concentration index o f taxes (CT) and the Gini coefficient o f pre-tax income:

77. For a progressive tax, the tax concentration index i s higher than the Gini o f the init ial income distribution, i.e. the tax i s less equally distributed than init ial income. Therefore, the higher the positive value o f IIK the more globally progressive i s the tax. For a given pre-tax income Gini, Gy, the value o f IIK varies from (-Gy) to (l-Gy), a negative IIK representing a regressive tax. If the income tax i s proportional CT = Gy and the IIK would equal zero.

78. The Reynolds-Smolensky index, IIRs, often referred to as the redistributive/vertical equity effect (VE), i s a measure o f the extent to which the tax system redistributes income. The after tax Gini i s denoted by GN (= GY-T). The IIRs i s given by:

The nk index has a range o f [-1,1]. For nRS are greater than zero, taxes redistribute income to the poor and are characterized as progressive. A negative value for the index represents a regressive tax.

79. As in the case o f the Gini coefficient, these indicators provide the same weight to the distance between both curves across the whole o f the distribution, which causes the segments where the difference i s greater to have more weight in the final result. However, i t i s possible to generalize these progressiveness indicators by incorporating a weighing function K indexed by a parameter p which captures the priority given to the various percentiles:

Using this family o f linear weights, the generalized Kakwani and Reynolds-Smolensky indices adopt the following form:

Increasing the parameter p increases the priority attached to the lower percentiles o f the distribution. Note that p = 2 results in the traditional Gini and Concentration indices.

80. Finally, i t i s possible to break down the net redistributive effect o f taxes into a factor measuring the vertical equity (VE) and another one that captures the reranking induced by the tax system (RR). The vertical equity effect measures the tendency o f taxes to reduce the

44

dispersion o f after tax income with respect to the before tax income distribution, i.e. the progressiveness o f the tax system. If the tax induces rerankings, the RR effect will always have a negative impact, reducing the effectiveness o f the tax system as a mechanism to achieve a more egalitarian distribution o f income.

81. The concentration curve CN@) for net incomes i s defined as

and typically estimated as:

1 ’ ~ P N j= l

C,(p=i/n)=- C N.i

where the Nj have been ordered in increasing values o f the associatedpre-tax incomes r j . Note that CN@) i s different from the Lorenz curve o f net incomes, L&), which i s defined as:

82. Empirically, the Lorenz curve for net income i s typically estimated as

but where the observations have been re-ordered in increasing values o f post-tax incomes, with Nl 5 N2 1..1 N,. Thus, CN@) sums up the expected value o f post-tax incomes up to pre- tax income percentilep. LN@) however, sums up post-tax incomes up to a post-tax income percentilep.

83. The income concentration curve after taxes CN(P)(= CY-T(P)) will always be above the Lorenz curve o f income after taxes LN(P)(= Ly-~(p)), except if there i s no reranking o f any type, in which case both curves may coincide (Lambert, 1993). Thus, a tax will cause rerankings if and only if CN(P) > LN(P) for some p. The distance CN(P)- LN(P) can therefore be used as an as an indicator o f reranking. A reranking index i s based on the distance between both functions using a similar procedure to before, the reranking index can be defined as (Duclos y Araar, 2006):

where IN(p) i s the weighted inequality index o f after tax income and 1C~(p ) i s the index o f concentration o f after tax income. Thus, by using the progressiveness indices defined above,

45

i t i s possible to breakdown the difference between the Lorenz curves o f income before and after taxes as follows:

The greater the difference between the vertical equity effect and the reranking effect, the more redistributive the tax. These results may b e used to form a synthetic index (indexed to the parameter p):

84. The differences between the indices o f pre-tax and post-tax inequali ty measure the net redistributional effect. The f irst term on the right hand side o f equation (20) captures the redistributional effect and the second term, the reranking effect. No te that if p=2 i s assumed, the previous expression i s s imply the difference between the pre-tax and post-tax Gini coefficients, the vert ical equity (VE) effect i s captured by the tradit ional Reynolds- Smolensky index and the redistr ibution effect i s the reranking index (RR) known as Atkinson-Plotnick.

G, -G, =nz-RJ YE RR

46

ANNEX 4. SENSITIVITY ANALYSIS TO ASSUMPTIONS ON COFIS AND INCOME DATA

85. The main results o f the analysis are presented showing a variation in the assumptions in income and COFIS pass-through as a sensitivity analysis. To recap, with respect to income, two scenarios are defined:

0 ENHA income without adjustment (scenario 1.1); and 0 ENHA income adjusted with the Mendive and Fuentes (1996) sub-capture

coefficients (scenario 1.2).

Regarding the COFIS, two scenarios are defined:

0

0

COFIS i s not passed through to the end consumer (scenario 11.1); and COFIS i s fully passed through to the end consumer (scenario 11.2).

86. The pre-reform tax burden for households was around 10 percent to 12 percent, depending on the hypothesis made on the transfer of the COFIS. The adjustment for under-reporting o f income results in an average per capita income that i s approximately 11 percent higher than the uncorrected amount captured by the ECH. The income correction hypothesis impacts more on the nominal amount o f income before and after taxes, while the proportion o f income paid in tax remains roughly the same.

87. The total impact on the tax burden o f direct and indirect tax changes depends on the assumption made regarding income (adjustedhot adjusted) and the pass-on o f COFIS to the final consumer. Table A 1 presents the impact o f the reform on the mean income as a function o f the four scenarios described. The income assumption affects the outcome o f the reform in terms o f average household tax burden. In the case o f direct taxes, the reform increases the average burden by 68 or 95 percent depending on the income hypothesis used. In the case o f indirect taxes, the reform reduces the average household tax burden by 5 or 2 1 percent, depending on the hypothesis used with regard to the transfer o f the COFIS. Overall, the reform causes the household tax burden to rise, in the range o f 10.8 and 15.6 percent, depending on the income scenario used. T h i s increase i s fundamentally due to the rise in direct taxes. If COFIS i s assumed to have been included in retail prices, the reform causes a small decrease in the tax burden, which varies between 0.8 and 4.8 percent depending on the income scenario considered. This reduction i s due to the joint effect o f the increase in direct taxation and decrease in indirect taxes.

47

Table A 1. Disposable income and average tax burden before and after the tax reform

10.6% 12.3% 10.4% 12.2% 8.3% 10.0% 8.3% 10.0%

581 581 522 1 310 310

b) Indirect taxes 522 c) Direct taxes I 255 255 Tax burden (as YO o f income before taxes) a) Total taxes 11.7% 11.7% 12.1% 12.1% b) Indirect taxes 7.9% 7.9% 7.9% 7.9% c) Direct taxes 3.8% 3.8% 4.2% 4.2% Change in tax burden due to tax reform (%) a) Total taxes IO. 8% -4.8% 15.6% -0.8% b) Indirect taxes -5% -21% -5% -21% c) Direct taxes 68% 68% 95% 95% Source: Based on the EGIH and the ENHA.

88. The reform has a moderate redistributional impact. The last column o f Table A 2 shows that al l the synthetic inequality indicators decrease, whichever income and COFIS pass-through scenarios considered. As expected, the reduction in inequality i s greater when the elimination o f COFIS i s assumed to be transferred in full to the final consumer (scenario 11.2). The reform i s progressive: An examination o f the upper bound limit of the confidence interval o f the Gini coefficient after the tax reform reveals that i s smaller than even the lower bound o f the pre-tax Gini.

48

Table A 2. Inequality measures before and after taxes Before tax reform After tax reform

After After After After After Before After indirect direct taxes indirect direct Variation taxes taxes (1) taxes taxes (2) taxes taxes (1)-(2)

11.1 COFIS i s not passed through A- Income: Uncorrected (1.1) Gini coefficient 0.454 0.453 Entropy 0 0.351 0.349 Entropy 1 0.376 0.375 B- Income: Corrected

Gini coefficient 0.456 0.459 Entropy 0 0.356 0.356 Entropy 1 0.380 0.395

(1.2)

11.2 COFIS i s passed through A- Income: Uncorrected (1.1) Gini coefficient 9.454 0.453 Entropy 0 0.351 0.350 Entropy 1 0.376 0.376 B- Income: Corrected

Gini coefficient 0.456 0.459 Entropy 0 0.356 0.357

(1.2)

0.457 0.356 0.381

0.461 0.361 0.398

0.457 0.357 0.382

0.462 0.362

0.448 0.341 0.366

0.454 0.348 0.386

0.448 0.341 0.366

0.454 0.348

0.442 0.338 0.353

0.448 0.340 0.370

0.442 0.338 0.353

0.448 0.340

0.456 0.361 0.380

0.461 0.361 0.395

0.456 0.361 0.380

0.461 0.361

0.440 0.334 0.349

0.446 0.337 0.367

0.440 0.334 0.349

0.446 0.337

-0.024 -0.032 -0.059

-0.024 -0.045 -0.063

-0.024 -0.034 -0.061

-0.024 -0.048

Entropy 1 0.380 0.396 0.399 0.386 0.370 0.395 0.367 -0.066 Source; Based on the EGIH and the ENHA.

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Annex 5. Concentration Curves And Progressiveness Indices

89. An analysis of the distributional impact of the reform can be made based on tax concentration curves. A f i r s t approximation to the relative progressiveness o f the taxes i s a comparison o f their concentration curves wi th the Lorenz curve. The concentration curve shows the relative share in the total tax receipts o f the tax corresponding to different individuals, ranked by gross income. Figure 8 gives a comparison o f the income concentration curves before and after the reform considering the total taxes paid by households, and distinguishing between direct and indirect taxes. The blue lines identify the pre-reform taxes while the red lines show the situation after the reform. In turn, the smooth lines reflect the total effect, the thick dotted l ines represent the concentration o f direct taxes and the thinner dotted lines represent the indirect taxes.16

90. The Lorenz income curve before and after taxes and the concentration curve of the pre-reform tax system practically overlap. That is, the pre-reform system tends to generate a tax burden proportional to the share o f pre-tax per capita income; the tax structure does not significantly alter the distribution o f income before and after taxes. This situation i s modified by the reform. The concentration curve o f the taxes paid directly by households after the implementation o f the reform (full red curve) i s systematically below the Lorenz curve before taxes, which indicates that the tax burden i s reallocated, generating a more progressive distribution. These results are consistent with the synthetic inequality indices presented previously, which showed that the pre-reform system did not generate changes in the indicators related to the gross income distribution, while the reform resulted in a moderate reduction in inequality.

91. In the case of direct taxes, both tax concentration curves (for the IRP and IRPF) are below the Lorenz curve, although the IRPF i s clearly more redistributive. For example, almost 5 percent o f the IRP i s accumulated by the distribution median (p=0.5), while in the case o f the IRPF the figure falls to 2 percent. The concentration curves for indirect taxes reflect the regressive nature o f this tax (as per the definition used in the study). Both the before and after reform curves are above the Lorenz curve, indicating that the lower income percentiles account for a greater share o f total revenues than their share o f pre-tax income. T h i s regressive pattern i s not altered by the reform, but indirect taxes are slightly more progressive compared to the previous tax system. However, the relative share o f the various percentiles in total indirect tax revenues does not alter substantially, unlike the case o f direct taxes. Figure 9 and Figure 10 show that the reform may be characterized as redistributive both based on the tax burden redistribution approach and in terms o f income redistribution, which i s not the case for the pre-reform tax system.”

16. In the previous section, it was noted that the qualitative results do not vary systematically with the assumption on the effects of the elimination of the COFIS. The importance of the assumption regarding COFIS relies, rather, on estimating the magnitude of the redistributional effect. The same applies to the adjustment of income. To the extent that the results presented below are qualitative, i t was decided to present in the study only the results under scenarios 1.1 and 11.2 (uncorrected income and full transfer o f the COFIS to retail prices). 17. The figures corresponding to the other scenarios are included in the statistical Annex (Figures A-10 to A- 18)

51

Figure 8. Pre-reform concentration and post-reform curves: Indirect and direct income taxes

. . . . . . . Pre-reform indirect taxes - - I IRP - Pre-reform total taxes - - 'IRPF . . . . . . . Post-reform indirect taxes -Post-reform total taxes I- Lorenzcum (after taxes)


92. T h e tax burden redistribution approach posits that a tax is progressive if i t s concentration curve i s systematically below the Lorenz curve. That i s undoubtedly the case with the post-reform tax system. However, the pre-reform system does not comply with this global property, since the proportion o f the fiscal burden borne by the higher strata (in particular for the last decile) i s lower than their share o f the total income. In Figure 9, the full thick blue and red curves represent the difference between the concentration and Lorenz curves for the tax system ex ante and ex post reform, respectively. The curve for the pre- reform regime has a section below zero, towards the end o f the distribution, so it i s not possible to characterize it as globally progressive.

93. T h e income redistribution approach produces similar results. While the after tax income concentration curve i s systematically above the pre-tax income Lorenz curve in the case o f the post-reform tax system, this characteristic i s not met in the last centiles o f the distribution for the pre-refom regime. In other words, the cumulative share in pre-tax income i s greater than in gross income for all percentiles in the case o f the reform, while under the pre-reform regime, the cumulative share in net income i s higher than in gross income when reaching the last centiles, so that i t cannot be stated globally that the pre-reform tax system redistributes resources from the higher to the lower strata, as i s the case with the post-refom system.

52

Figure 9. Differences between the Lorenz after tax income curve and the concentration curves: T a x burden redistribution approach

Difference between Lorenz and concentration curves: Progressivityl Tax:TR Approach _______


Figure 10. Differences between the Lorenz after tax income curve compared to the concentration curves: Income redistribution approach

Difference between concentration and Lorenz curves: Progressivityl Tax:IR Approach oo,s- _ _ _ _ . - - - - -__- . - - _ _ - -. . .- - __ __ __ - _ -

I


53

94. Both approaches indicate that both the IRP and the IRPF are broadly progressive, since the differences shown in the figures are always positive. However, the IRPF i s systematically above the IRP, reflecting i t s greater concentration in the higher strata. The curves o f consumption taxes take on negative values along their entire trajectory, which once again reflects their regressive character. However, the curve corresponding to the post- reform situation i s slightly above the pre-reform curve, confirming that the changes in the consumption tax regime are slightly progressive.

95. In turn, the position of the concentration curves shows that the post-reform tax system globally dominates the pre-reform regime in terms of distributional impact. It should be recalled that given two tax regimes, A and By regime A dominates regime B globally if the post-tax income concentration curve o f regime A i s systematically above the curve o f regime B (income redistributive approach), or alternatively, if the tax concentration curve i s higher in the case o f regime B. Figure 8 to Figure 10 clearly show that both conditions are met.

Figure 11. Non-Parametric estimate of the differentiation of taxes with respect to income level

Non parametric derivate regression of Y on X

0 131 I

0 121 , 0 I l t

I 0 l o t

h

0 03-

Source: Based on the EGIH and the ENHA Note: Non-parametnc estimation o f the derivative o f taxes with respect o f income.

96. Unlike in the post-reform case, the pre-reform tax system is not globally progressive, i.e the level of taxation does not increase systematically with the income level. However, i t i s possible that even without being globally progressive, the system could be locally progressive in some o f the distribution segments. T h i s i s confirmed by Figure 11, which shows the estimate o f a non-parametric regression o f the differentiation o f the taxes vis-a-vis per capita income. The increase in tax receipts as a function o f the per capita income i s observed both under the pre-reform and post-reform regimes, approximately up to the 70th

54

percentile. However, while the marginal change in the tax level per additional income unit remains at positive but constant levels under the pre-reform regime, it continues to increase markedly in the case o f the post-reform tax system. T h i s means that the pre-reform regime meets the condition o f local progressiveness only in the distribution segments that are below the 70th percentile-the tax differentiation with regard to the level o f income i s increasing in income-while that condition i s met in the case o f the post-reform tax system for the whole o f the distribution. These differences in the local progressiveness pattern explain why the pre- reform regime cannot be characterized as globally progressive.

p=l.5 0.010 0.080 -0.028 -0.024 0.009 0.335 p=2 0.01 1 0.095 -0.033 -0.028 0.010 0.382

p=3 0.01 1 0.093 -0.032 -0.027 0.010 0.359

97. The post-reform tax system can be characterized as globally progressive, but this does not imply that it i s possible to assert, based on that characteristic only, that the new regime “dominates” the pre-reform regime in terms of the impact on inequality. This judgment depends on an assessment to be made on income transfers across the distribution. As can be seen in Figure 11, there are segments o f the distribution where the marginal tax burden increases more under the pre-reform regime. The judgment on the equity effect depends on the relative weight assigned to income variations in different parts o f the distribution curve. Table A 3 shows the generalized indices o f Kakwani and Reynolds- Smolensky synthetic progressiveness indices. A positive (negative) value o f the index being an indication that the tax i s progressive (regressive). The parameter p gives the priority assigned to lower percentiles o f the distribution. Increasing the parameter p increases the priority attached to the lower percentiles o f the distribution.

98. The results in Table A 3 show the post-reform tax regime to be more progressive than the pre-reform regime. The results are not sensitive to changes in the parameter p. The index values are slightly positive under the pre-reform regime and increase in a systematic and considerable way with the reform. The indices for indirect taxes, however, are negative, illustrating their regressive character. After the reform this pattern i s slightly attenuated (the absolute value o f the indicators i s lower). Progressiveness indices confirm that the IRPF i s more progressive than the IRP wage tax.

Horizontal Inequality, Reranking and Vertical Inequality

99. This section analyzes an aspect that receives less attention in the empirical literature on the distributional impact of public policies, the issue of horizontal inequality. Within the framework o f redistributive justice theory, the most classical

formulation o f the horizontal equity principle posits that individuals who enjoy a similar welfare level ex ante government intervention should receive equal treatment from the policy under analysis. An alternative approach conceptualizes horizontal equity based on the absence o f reranking in welfare distribution induced by public policies. For a tax to be horizontally equitable, the ranking o f individuals in accordance with their welfare level should not be altered by the tax system (Duclos and Araar, 2006).

100. There i s a potential problem of rerankings generated by the implementation of a tax system aiming at greater vertical equity. At one extreme, if the tax system generates a perfect exchange in ranking between individuals without altering the mean income, vertical inequality-measured by means o f the Lorenz curve-would not change. In that sense, it i s possible to disaggregate the net redistributive effect o f taxes into one factor measuring vertical equity and another that captures the rerankindreordering induced by the tax system. The first component measures the proclivity o f taxes to reduce the dispersion o f after-tax income compared to pre-tax income. If the tax system induces rerankings, the reranking effect will always be negative, reducing the effectiveness o f the tax system as a tool to achieve a more equitable distribution o f income. Table A 4 summarizes the results obtained from the calculation o f the net redistribution index and i t s breakdown into a vertical equity effect and reranking effect. The parameter p i s varied according to the degree o f aversion to inequality.

Table A 4. Breakdown of the redistributive effect of taxation ComDonents

Vertical equity

(2)/(1) (314 1) effect (VE) Re-ranking (Redistribution o f Effect (RR)

Change in inequality

GN(P)-GY(P) incomes)

(1) (2) (3) Before tax reform

p=1.5 0.003 0.003 0.000 1.040 0.040 p=2 0.004 0.004 0.000 1.030 0.030 p=3 0.004 0.004 0.000 1.030 0.030

After tax reform p=1.5 0.009 0.009 0.000 1.020 0.020 p=2 0.010 0.01 1 0.000 1.010 0.010 p=3 0.010 0.010 0.000 1.010 0.010


10 1. Reinforcing the previous results, the net redistributive effect of the tax system i s positive in both cases, but i t s magnitude i s greater after the tax reform. This increase in progressiveity o f the post-reform tax system i s due to the greater progressiveness o f the IRPF. T h i s i s captured in Table A 4 by the Reynolds-Smolensky family o f indices, which measure the vertical equity effect (VE). For both pre- and post- reform tax systems, the progressiveness i s not negatively impacted by the reranking effect. In other words, the pre- and post- tax reform does not cause major reranking problems for households in the distribution.

56

Annex 6. Statistical Annex

Table A 5. Pre-reform and post-reform tax system Tax Pre-reform Post-reform

1 Impuesto a las Rentas Industria y Comercio (IRIC) 30%

3 Impuesto a las Rentas Agropecuarias (IRA) 30% 2 Pequeiias empresas Fixed basic

4 Impuesto a las Rentas de Actividades empresariales (IRAE)

Impuesto a la Enajenaci6n de Bienes Agropecuarios (IMEBA)

6 Impuesto a las Retribuciones Personales (IRP) 7 Impuesto Renta de las Personas Fisicas (IRPF)

Multiple

2% - 6%

8 Impuesto a las Sociedades Financieras de Inversi6n (SAFI) 0.30%

9 Impuesto a1 Patrimonio de las Personas Juridicas 1.5% - 2.8% 10 Impuesto de Control de las Sociedades Anhimas Fixed base

Max. 2% Min. 0.01% 11 Impuesto a 10s Activos de las Empresas Bancarias (IMABA)

12 Impuesto a1 Control del Sistema Financier0 Max. 0.36% Min. 0.01%

13 Impuesto al Patrimonio de las Personas Fisicas Progresive 0.7%-3%

0.20%

5%

14 Compra Venta Bienes Muebles en Remate Publico

15 Impuesto Cesiones o Permutas Derechos Deportistas

16 Impuesto a las Trasmisiones Patrimoniales

17 Impuesto al Valor Agregado (IVA)

l8 (COFIS) Contribuci6n al Financiamiento de la Seguridad Social

High 4% Low 3%

Minimum 14% Basic 23%

3%

19 impuesio Especifico Interno (IMESI)

2o Agropecuarios (adic. IMEBA)

Multiple

0.2% - 0.4%

2% 1%

20%

Adicional Impuesto a la Enajenaci6n de Bienes

21 Impuesto Compra Moneda Extranjera (ICOME) 22 Fondo Inspecci6n Sanitaria (FIS) 23 Impuesto a 10s Sorteos (Fondo Nac. de Recursos)

24 Impuesto Especifico a 10s Servicios de Salud (IMESSA) 3 yo 25 Impuesto a 10s Ingresos Compaiiias de Seguros 26 Impuesto a las Comisiones 27 Impuesto a las Ventas Forzadas 28 Impuesto a las Telecomunicaciones 29 Impuesto a las Tarjetas de Credit0

Multiple

2% Multiple

Fixed sum

9%

30 Detracciones a l a Exportacion Multiple Source: Based on MEF (2006).

25%

Multiple

10%-25%

0.30%

Fixed base 1.5% - 2.8%

0.10%

High 4%

Minimum 10% Basic 22%

L O W 3%

Multiple

0.2% - 0.4%

2% 1%

Multiple

Multiple

57

Table A 6. Labor Income: Minimum, mean and maximum income, per decile (in UR$) Minimum Average Maximum

1 0 354 1,040 2 990 1,637 2,300 3 2,179 2,887 3,574 4 3,370 4,061 4,800 5 4,538 5,325 6,105 6 5,763 6,720 7,696 7 7,253 8,428 9,716 8 9,162 1 1,075 13,211 9 12,467 15,834 20,192 I O 19,040 35,457 402,578

Source: Based on the ENHA

Table A 7. Variation in labor income (disposable) by decile (UR$) Before the tax Variation in average

reform After the tax reform income 1 352 352 0 2 1,636 1,637 0 3 2,879 2,887 7 4 4,048 4,061 14 5 5,263 5,325 62 6 6,590 6,720 130 7 8,23 1 8,343 112 8 10,608 10,762 154 9 15,061 15,019 -42 10 333 19 3 1,349 -2,470

58

N

N 9 % 2 09 -

0 w

4 I G e,

E 0

s B 3 m h; 2 s 3

: ; .. C

1 7

f U $

P P

f 3 E 6 a

a

a f

E c 7

U c

4 c I b c e .. c

E c ii 5 i a

c 3

7 e

. . . . . d r n U Q W r i

, Table A 11. Situation of workers according to type of occupation (selected occupations)

Difference YO Losers by IRp (b) (a-b) occupation IRPF (a)

Losers Directors and company senior managers Other department managers Managers o f production and operation departments Specialists in business organization and administration and related Civil service managers Member o f the executive branch and o f legislative bodies Physicians and related Architects, engineers and related Technical personnel in maritime and aeronautic navigation Professionals in biological sciences and other disciplines IT Professionals Physics, chemistry and related L a w professionals

Winners Glass, ceramics and related Machine operators for the fabrication o f wood products Drivers o f vehicles and heavy machinery Officials and operators in construction and related Day laborers in mining and the

14.6 15.2

14.0

12.6 13.6

13.0 11.5 10.9

10.9

10.4 10.1 9.9 10.7

1.4

1.4

0.5

2.0

3.9 5.5

5.3

4.2 5.3

5.0 4.7 4.7

4.8

4.4 4.6 4.8 5.6

2.7

2.8

2.0

3.5

10.7 9.7

8.7

8.5 8.3

8.0 6.8 6.1

6.1

5.9 5.5 5.1 5.0

-1.3

-1.4

-1.5

-1.5

79.7 88.0

83.3

78.7 81.4

46.3 73.7 70.9

62.7

66.7 68.3 50.7 46.7

52.5

50.9

25.9

57.3

construction 1.7 3.6 -1.9 47.9 Source; Based o n the ENHA.

Table A 12. Pensions: Minimum, mean and maximum value, by decile

1 0 1,141 1,800 2 1,804 2,257 2,500 3 2,501 2,667 2,800 4 2,801 3,103 3,400 5 3,403 3,799 4,200 6 4,201 4,798 5,300 7 5,302 6,189 7,000 8 7,006 8,115 9,000 9 9,001 10,842 13,228 10 13,239 22,131 92,600

Total 0 6,438 92,600

Minimum Average M a x i m u m

Source: Based o n the ENHA.

62

Table A 13. Variation of average pensions by decile (UR$) Variation in average

Before the reform After the reform income 1 1,141 1,141 0 2 2,257 2,257 0 3 2,667 2,667 0 4 3,103 3,103 0 5 3,799 3,799 0 6 4,798 4,798 0 7 6,189 6,189 0 8 8,081 7,4 13 -669 9 10,621 9,758 -863 10 21,680 19,375 -2,305

Total 6,368 5,996 -372 Source: Based o n the ENHA.

63

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