Fiscal Federalism and Inequality in Latin America

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					Fiscal Federalism and Inequality
         in Latin America
              Thornton Matheson
         International Monetary Fund
   Presentation for the LAC Tax Policy Forum
        Panama, September 17, 2010
•   Theory of fiscal federalism
•   Practice of fiscal federalism in Latin America
•   General reform goals
•   Local Government (LG) revenue instruments
•   Design of interjurisdictional redistribution
       Fiscal Federalism: Theory
• Where regional preferences differ, devolution
  of fiscal authority can improve allocative
  efficiency and welfare.
• To achieve this, LGs must be accountable to
  local constituents
  – Raise own revenues at the margin
  – Significant discretion over spending
    Fiscal Devolution: Constraints
• Interregional factor mobility
• Local administrative resources
• Macroeconomic stabilization
  – LG soft budget constraints
  – Excessive devolution
• Regional tax base disparities*
  – Economic activity often concentrated in a few
    large cities
  – Natural resource wealth also unevenly distributed
           Fiscal Federalism and
         Interpersonal Inequality
• LGs often largely responsible for social welfare
  spending (health, education) critical to
  reducing inequality
• LGs with poorer constituencies often have
  smaller PC tax bases
  – Necessitates interjurisdictional transfers
 Fiscal Federalism in Latin America
• Expenditure: Relatively low level of devolution
• Revenues: Low level of own revenues
                                       Table 1:
       Region           LG Share of Expenditure           LG Share of Revenues
OECD                               30.6                             22.7
Latin America                      19.4                             11.7


Data include shared revenues, but exclude transfers
 Fiscal Federalism in Latin America
• Mismatch between revenues and
• Heavy reliance on transfers and revenue
  – Most major tax bases assigned to center
  – Transfers/revenue sharing often pro-cyclical
• Extensive earmarking of transfers
  – Many LGs have little discretion over spending
  – Vertically overlapping spending responsibilities
                    FF in LAC: Tax Assignment
• Most major bases assigned to center:
        –     CIT: national
        –     PIT: national (except Brazil and Mexico)
        –     Asset: national
        –     VAT: national (except Brazil)
        –     Sales: national
        –     Excises: national/state
• States and local tax bases more limited:
        – Vehicles: state
        – Property: state/municipal
        – Business taxes: municipal
• Natural Resources: shared

Source: Amhad & Brosio (2008), 7 largest LAC countries
FF in Latin America: Consequences
• Revenue dependency and earmarking
  undermine LG accountability
  – Poor incentives to develop own revenue sources
  – Poor incentives for efficient service provision
• Procyclical revenues and revenue/expenditure
  mismatch encourage LG deficit financing
  – Soft budget constraints can threaten
    macroeconomic stability
 FF in Latin America: Reform Goals
• Develop LG own revenue sources
  – Low cyclicality
  – Progressive
  – Evenly distributed across jurisdictions
• Constrain LG deficit spending
• Make transfer system transparent, fair and
  – Reduce earmarking
        Revenues: Property Tax
• Advantages:
  – Immobile base
  – Progressive
  – Low cyclicality
• Disadvantages:
  – Administration complex
  – Interregional base disparities
           Revenues: Property Tax
• Chief source of own revenue for LGs in LAC
• However, productivity relatively low:
  – OECD average: 2.6% GDP
  – Developing countries: 0.6% GDP
     •   Mexico: 0.2%
     •   Brazil: 0.5%
     •   Argentina: 0.4%
     •   Colombia: 1%
  – Problem: Low tax rates, poor cadastres, administrative
    capacity, lack of political will to enforce
    Revenues: Consumption Taxes
• VAT, sales taxes, destination-based excises
   – E.g., Brazil (ICMS), Colombia (alcohol, cigarettes, gasoline),
     Argentina (turnover)
• Advantages:
   – Low cyclicality relative to income taxes
   – Geographically dispersed
   – Destination basis generally avoids tax competition (except
     cross-border shopping)
• Disadvantages:
   – Subnational VAT complex, distortive
   – Sales taxes cascade, avoidable, narrow bases
   – Origin-based excises more efficient
      Revenues: Income-type VAT
• Advantages:
   – Broader base than CIT, buoyant revenue source
   – Benefit charge for local businesses
   – Alternative to commercial property tax
• Disadvantages:
   – Geographic concentration
   – Tax competition (origin-based)
   – Cyclicality (but less so than CIT)
• Examples:
   – IRAP (Italy, regional) raises 2.5% of GDP
   – IETU (Mexico, federal) has some similarities
         Revenues: PIT Surcharge
• CG sets base, LGs allowed to set own rate (perhaps
  within limits)
• Advantages:
   – Administrable (CG can collect)
   – Progressive
• Disadvantages:
   – Cyclicality
   – Base mobility
• Some CGs share PIT revenue with LGs (e.g., Brazil,
   – Unlike surcharge, this is not LG own revenue.
   – US: Many states impose own PITs on federal PIT base.
 Revenues: Natural Resource Taxes
• Theory dictates these should be CG taxes:
    – Uneven regional tax base
    – Potentially complex
    – Volatile revenues
• However, they are often shared with LGs.
    – Need for infrastructure, environmental cleanup
    – Local population ownership claims
• Examples:
    – Bolivia: Departments receive about 2/3 of gas rents and 1/3
      hydrocarbon income tax (IDH). Municipalities receive ¼ of IDH.
    – Colombia: 48% oil royalties go to departments, 13% to municipalities,
      8% ports.
• Possible alternative: Production excises with redistribution
    – May also create stabilization fund to counter revenue volatility
  Interjurisdictional Redistribution
• Given disparities in LG tax bases and
  administrative constraints, LAC countries will
  likely remain fairly reliant on revenue sharing and
• Greater decentralization itself leads to more
   – OECD: elasticity of total transfers with respect to LG
     own revenue share = 1.5
• Redistribution therefore needs to be well
  designed to promote LG accountability and hard
  budget constraints.
                  Transfer Design
• Transfers should not be based on historical LG revenue
  or spending patterns
   – This creates incentive for LGs to undertax and/or
• Transfers should be based on the difference between
  ex ante LG revenue capacity and spending
   – Revenue capacity: Apply average tax rate to average base,
     or macroeconomic measure of GRP, income PC
• Transfers could be varied anti-cyclically
   – In practice, transfers are often pro-cyclical
   – “Rainy day funds”