Tax Reform: Contributions to the Debate

Tax Reform: Contributions to the Debate

September 2nd, 2011

The review of the empirical literature suggests that permanent tax increases may have harmful effects on the economic activity, which normally act through minor investment. In the particular case of the Chilean economy, the contractive effect on investment would be more significant for the medium and small business (PYME), due to their financing constraint from external sources. This is a key issue, since these businesses are the greatest employment generators

In the last weeks, different actors of national politics have proposed again a tax reform with the aim of increasing the tax burden. They argue the need to rely on more resources to face the higher spending on education and social projects, such as the extension of the maternity leave and the elimination of the 7% health contribution. Although the Ministry of Finance, Felipe Larraín, has discarded the need of increasing taxes to finance this spending, since the economic growth itself and the reallocation of expenses should provide the resources, it is clear that this discussion will continue.

In general, when a tax increase is put forth, its effects on the economic activity and the country’s welfare are not discussed; therefore, it is very helpful to review the empirical evidence both national and international concerning the possible effects of a tax increase on investment, employment and GDP growth.

On the other hand, it is also argued that a tax reform could help mitigate inequity, suggesting that the tax burden would be the great redistributive tool. The empirical evidence analyzed in the following paragraphs discards this hypothesis. Moreover, an initiative regarding higher taxes could end up increasing inequity by reducing investment, employment and economic growth, and this would adversely affect the poorest because of higher unemployment rates.

Therefore, we have hard evidence along the lines of the arguments presented in recent Public Issuesi, indicating that the best way to increase tax revenues, in a permanent and sustainable manner, to finance education policies which improve quality and equity, is growth, which increases the tax assessment base year after year. In fact, a 5% growth would imply additional incomes for the Treasury around US$2,500 millions.

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