How do the Tax Burden and the Fiscal Space in Latin America look like? Evidence through Laffer Curves by Ignacio Lozano and Fernando Arias published by Banco de la Republica – Colombia (5/2020).
“How much fiscal space do Latin American countries have to increase their tax burdens in the long term? This paper provides an answer through Laffer curves estimates for taxes on labor, capital, and consumption for the six largest emerging economies of the region: Argentina, Brazil, Chile, Colombia, Mexico, and Peru. Estimates are made using a neoclassical growth model with second-generation human capital and employing data from the national accounts system for the period from 1994 to 2017. Our findings allow us to compare the recent effective tax rates on factor returns against those which would maximize the government’s revenues, and therefore to derive the potential tax-related fiscal space. Results suggest that joint fiscal space on labor and capital taxes would reach 6.5% of GDP for the region, on average, and that there are important differences among the countries.
Introduction
Professor Arthur Laffer from the University of Southern California made the following assertion in 1974: “…there are always two tax rates that yield the same revenues…” (Wanniski, 1978). To explain his statement, he drew an inverted u-shaped curve where the government revenue (on the vertical axis) increases with the tax rate (on the horizontal axis) until a maximum point from which they begin to decrease. Since then, the simple design of the Laffer Curves has crucial implications given that an increase in taxes could have two opposite effects regarding fiscal revenues: On the one hand, an increase; on the other, a reduction, because a higher tax could disincentivize the labor supply and the desire to invest.
Which of the two effects will predominate in an economy depends on the tax burden level with respect to the maximum point. If it stands below, increasing taxes could generate more revenues. However, if it stands above, increasing taxes could end up reducing government revenues. Therefore, each curve shows how government revenues at steady state vary when there are changes on the effective labor tax rate, while keeping the other tax rates and the remaining parameters constant. Hence, policymakers are usually concerned with knowing the rates that maximize their country’s fiscal revenues and therefore how close/far the current tax burden is with respect to such maximizing rates.
In this paper, we estimate the Laffer Curves for taxes on labor, capital, and consumption expenditures for the six largest Latin American emerging economies: Argentina, Brazil, Chile, Colombia, Mexico and Peru. Estimates are made employing a neoclassical growth model with human capital accumulated both exogenously and endogenously, as suggested by the literature (Trabandt and Uhlig, 2011; Lucas 1988; Uzawa, 1965). The model is calibrated with annual data coming from the national accounts of each country (United Nations system) for the period from 1994 to 2017.
The effective tax rates—one of the most important parameters—are calculated following the procedure applied by Mendoza et al. (1994) to G7 countries, although we include some extensions considered by Prescott (2004) and Trabandt and Uhlig (2012).When effective tax rates on return of production factors (tax burden)are contrasted against those that would maximize the government’s revenues (obtained from the model), the long-term government’s potential tax-related fiscal space is found.
By comparing the effective tax rate that maximizes revenues coming from labor versus the most recent rate, results suggest that governments in Latin American Countries (LAC) would have an important labor tax-related fiscal space. Fiscal space reaches 13.7%, on average, for the region, meaning that for every 100 bp (basic points) of increase in the effective tax rate on labor, the tax collection on labor income would increase 44 bp. Regarding the Laffer curves associated to capital taxes, figures suggest that fiscal space is a little smaller. Thus, on average, the regional space would reach10% of capital rents, meaning that for every 100 bp of increase in the effective tax rate, the capital tax collection would increase only by 25 bp. As a share of potential GDP, fiscal space on labor and capital incomes achieves 3.7% and 2.7%, respectively.
Adding up the figures on labor and capital rents, results suggest that fiscal space could achieve nearly 6.5%of potential GDP, on average for the region, which gives an important margin to adjust the tax burden in the long term. This percentage would be larger if we added the potential space by the consumption taxes. Of course, there are important differences in fiscal space for both factors when they are assessed and compared between countries. Mexico and Chile seem to have the highest fiscal space, while Brazil and Argentina the lowest. To the best of our knowledge, this is the first time that a human capital growth model has been considered to estimate Laffer curves and the fiscal space for the main Latin American emerging economies
The paper contains five sections in addition to this brief introduction. Section 2presents the theoretical model of human capital with exogenous accumulation, which we use as baseline and is labeled as 2nd generation. In section 3 we describe the calibration and parameterization of the model, with special mention to the computation of effective tax rates. Section 4 presents the main results, and in section 5 we compare our results with respect to those coming from an endogenous human capital model. Section 6 contrasts the findings for Latin America on tax burden and fiscal space with respect to international evidence (USA and the 14 main European Union economies, or 14-EU). Finally, Section 7 presents some final remarks. The paper includes an appendix with methodological details on the effective tax rates and two Appendices with some additional results for each country in the sample…”
