The efficiency of the Value-Added Tax (VAT) in Central America
By Abelardo Medina, Senior Economist, Icefi (Central American Institute of Fiscal Studies)
The data… can serve as a tool for the Finance Ministries and the tax agency managers of the region who will need to investigate why their taxes are becoming less productive, and therefore decreasing the resources their societies can use to address the needs of their populations.
The design of a country’s tax system should be the responsibility of a country’s Finance Ministry, which is the agency responsible for managing public funds, not the Congress, which is the case in many countries. Hence, the first step for a Finance Ministry is to develop a perfectly articulated theoretical approach that respects taxation principles, especially those of universality, equity, and feasibility, so that it can accomplish the social objectives set out in its country’s Political Constitution, with the highest possible level of efficiency in tax collection.
In practice, however, the effectiveness of the Finance Ministry is determined by (along with the competence of its bureaucrats): the interests of legislators who have the responsibility to approve corresponding laws; the investment incentives and economic policies of each country; the effectiveness of the tax collection agency; and, above all, by the tax ethics of its contributors.
Even so, it remains the responsibility of the Finance Ministry to evaluate the efficiency of the tax system, determining whether it meets revenue goals and other objectives laid out for it. Among the indicators that are used internationally to try to measure efficiency in tax collection is “Tax Productivity,” which is simply a comparison of what is collected through a tax with what should theoretically be collected. In the specific case of the Value Added Tax (VAT), the most important tax in Central America, its theoretical potential actually depends on what level of consumption is taxed. Due to the variability of tax legislation, however, it’s more appropriate to use GDP as a common denominator to compare data between countries.
To show the trajectory of tax productivity for all of Central America (with the caveat that Costa Rica has no VAT, but instead a General Sales Tax), Icefi compiled data for the region for the period 2010 – 2016 (post-crisis) into a graph that presents the percentage of revenue collected, if the tax base were each country’s total GDP. [In other words, each country has its own VAT rate. The graph measures how much each country actually collected from its VAT, as a percent of what would be collected if that rate were applied to a country’s total GDP. The graph is useful only to compare a country’s tax efficiency over time, not to compare tax efficiency between countries.
The graph is useful to observe changes in efficiency in the collection of the VAT for each country. The trajectory shown for each country is more significant than the specific percentages because the data are rough. Further, it’s not appropriate to compare the numbers of different countries for their policy differences [because GDPs, tax policies, and other factors are so different as are tax policies.]
The graph shows that Costa Rica’s VAT has a downward trajectory during the period 2011 – 2016, showing a loss of efficiency on the order of 1.5% of its theoretical potential, which should motivate its Finance Ministry to evaluate the causes for which one of its principal taxes is being systematically collected at rates below what they should be, compared to GDP. These causes could even be to blame for the increase in their fiscal deficit.
But the most pronounced downward trajectories in the region, which should be cause for concern for the respective authorities, are:
Guatemala, with a reduction of 6.1% in its productivity since 2012, after experiencing an improvement of 1.8% between 2010 and 2012;
Panama, with an 8.8% reduction since 2011, its first full year with a VAT of 7%;
and El Salvador, which has seen a 3.1% reduction since 2013. From 2010 – 2013, there was an improvement of 3.8%, which effectively means that the country’s efficiency in collection of the VAT was the same in 2016 as in 2010.
Nicaragua is an interesting case that shows an increase in the productivity of the VAT of 6% between 2010 – 2014, though it’s endured a reduction of 1.9% since 2014.
Finally, the case of Honduras is worthy of closer study, since it shows a 6.4% rise in productivity, the majority of which came since 2014, when its tax reform took effect.
The data, though it should be refined, can serve as a tool for the Finance Ministries and the tax agency managers of the region who will need to investigate why their taxes are becoming less productive, and therefore decreasing the resources their societies can use to address the needs of their populations.
These causes could be increases in tax evasion, increases in contraband, or the presence of different applicable taxes. They require that tax system managers respond in the short term with new mechanisms of control and regulation to regain lost efficiency and to ensure that the fulfill their mandates.