The Chronicle of a Reform Foretold
The tax reform is ready. Who wins and who loses?
Will it bring equity or change things in any real way?
What should it change? Will it also be a fiscal reform?
The government promised it would be comprehensive,
but what does that mean? Julio Francisco Báez,
a lawyer specializing in fiscal law who sat on
the reform’s Technical Advisory Committee,
shares his views on these questions.
Julio Francisco Báez Cortés
The Technical Committee consisted of José Luis Medal, Sergio Santamaría, Róger Cerda, Néstor Avendaño, Ricardo Zambrana and me. Our group decided to assume the risks of accepting the government’s invitation and imposed only two conditions: that we would not be bound to silence and that we would be respected. The government honored those conditions. We spent three months in intense discussion and reached a very broad consensus with few formal differences on all the basic elements. We reached no consensus, however, with the sectors that made their presence felt throughout the process, pressuring and lobbying for their own interests. The representatives of small businesses, peasants and salaried workers never came to talk to us, they didn’t lobby. The only ones who did were from big business.
The starting pointAll over the world it is traditional for new governments to make some tax adjustment, whether updating, modifying or reforming. This government committed the deadly sin of not exploiting that opportunity, not optimizing the fact that it had taken office with tremendous legitimacy to make a change that would inspire the population. Unlike the four previous governments—Somoza, the Sandinistas, Violeta Chamorro and Arnoldo Alemán—the Bolaños government let over a year to go by without ordering its public finances in the areas of income and the taxes the country relies upon to implement the government project. The Sandinista government took just 20 days to implement its tax measures, while the governments of Violeta Chamorro and Arnoldo Alemán took 45 and 80 days respectively.
Before this reform, the Bolaños government just “patched” the system with “emergency” taxes, as happened in September 2002 and February 2003. But the effect has been negative or neutral at best. The government did not just fail to increase its revenue; it actually collected less. We are now on the verge of an integral tax reform that must be approved and in force by July 1. And we are faced with the following scenario: a government that was late getting started, inherited a damaged institutional structure and civic, political and legislative erosion and only now, after a number of erratic tax patches, has decided to do something important. Objectively speaking, we must recognize that the scenario isn’t very favorable to making a comprehensive change.
A tax system on the verge of collapseA country can never be expected to develop just as the result of a tax reform (to bring in resources) or a fiscal reform (to order income and expenditure). Tax laws do not represent the heart of a nation’s economic administration. Development depends on a strategy, which we still don’t have in Nicaragua. Fiscal reform and tax policies are just levers and tools that help improve income distribution and introduce greater rationality into the economy, which naturally also contributes to development.
For all that, tax reform is very necessary in Nicaragua. The legal and operational tax system is on the verge of collapse. Some of our tax laws are 40 years old, while the income tax law itself is 30 years old and the sales tax law is 20 years old. The stamp duty law goes back to colonial times. In short, our system is obsolete.
Just mentioning taxes in Nicaragua causes uproar. Any tax hike is immediately followed by the organization of a broad front in which the unemployed, wage earners, shoemakers, traders and small producers protest right alongside the big businesses represented by the Supreme Council for Private Enterprise (COSEP). All join forces to reject any tax increase, claiming that the economy can’t stand any more taxes. And the fact is, the Nicaraguan tax burden is the highest in Central America. But this is a half-truth, and half-truths end up as lies. The broader truth is that the problem is not the size of the tax burden but its totally inequitable distribution, in which those left bearing it are the poorest sectors. The country’s tax burden is indeed terrible. But the idea behind a “comprehensive” reform starts with asking who is bearing this terrible load. First, any reform should be fair, balancing the system and making those who earn more pay more. More specifically, it should make those people who have never contributed anything pay their taxes.
The fat cats and banks pay nothingThe figures demonstrate the inequity. All countries organize offices that attend to the “big contributors” and act as a kind of petty, medium or big cash supply for the state, according to how much they bring in. Nicaragua’s General Tax Division (DGI) also has a Major Contributors Office that deals with the 680 companies that qualify in this category, and this is where things start to get scandalous. In the last eight years, these 680 businesses ended up with an overall negative balance, meaning that taken as a whole, they paid nothing to the state. Worse still, the revenue service actually owes them money! In other words, the biggest businesses in Nicaragua have not paid a single dollar in eight years and the state has to reimburse the taxes they paid in advance, because at the end of the year they declared losses. This is a scandalous fact that should rock the country’s conscience.
Another scandal has grown out of the banks’ current attitude towards taxes. The national debate over the presidential veto of legislative changes to the 2003 budget highlighted the fact that the banks have paid no income tax for seven years. They were called on this and arguments were deployed, but in the end the banks openly confessed that not only had they paid no income tax but that they owed nothing because they had already paid other indirect taxes.
Direct taxes are levied on individuals: if I earn, I pay taxes; if I have a house, I pay taxes on that house. Businesses also pay direct taxes: if they make profits, they pay taxes; if they own something, they pay taxes on it. An indirect tax is levied on goods but only through people’s consumption: I only pay indirect taxes if I buy something. The banks are obliged to pay, but like confessed criminals they say they are not paying because they have other expenditures they call “indirect taxes.” But which individual contributors, which wage-earners are allowed to say that they aren’t going to pay their income tax because they crashed their car, a relative got sick or they had to take a trip and these mishaps generated extra costs, which in turn generated new indirect taxes? Nobody else can do this, why should the banks be allowed to?
What the banks owe usAccording to the DGI, the Nicaraguan banks combined owe 100 million córdobas a year in unpaid income tax, or 400 million over the last four years, which they are now obliged to pay. By law, people who fail to pay their taxes are fined 100%, doubling the debt to 800 million, approximately $54 million at the current exchange rate. Then there is the interest on the back payments, which amounts to another $13.5 million, not including the tax year ending March 31, 2003. In other words, the banks owe the state over $67.5 million, more than the 900 million córdobas (nearly $61 million) additional that the government anticipates collecting through the comprehensive tax reform.
In February, we heard DGI General Director Róger Arteaga firmly declare that the banks had to pay their income tax, that DGI auditors would figure out exactly how much they owed, that the public would be informed of the results at the end of March and that the banks would be duly charged. But nothing more was ever heard of the case and we can be sure we will not be informed.
In fact, after so many declarations and throwing up of hands up in horror, the government closed this debate by issuing a kind of concealed “tax amnesty” for the banks. It’s a scandalous decision entirely lacking in national logic. Here we have the country making an effort to design a good law and obtain an extra $61 million while the government is pardoning the banks $67.5 million! How can this be? Quite simply, the efficacy of any reform depends on the nature of the government, and this one is closely linked to the banks and has not honored its word that “nobody will be above the law.” With what moral authority can the government see this tax reform through having pardoned the banks?
Fiscal inequity and tax lossesThis reform cannot be exclusively aimed at generating state resources through tax collection. Its prime objective should be equity, and its main result should be income redistribution. And that brings us to another scandal that should move us to reflection: income distribution in Nicaragua is totally inequitable. The average taxes paid indirectly and above all directly by the 20% of the population with the lowest income amounts to 96% more than the average paid by society as a whole! And the 20% of the population with the highest income, the richest, pays 20% less than the average paid by society as a whole. Such scandalous figures make Nicaragua the most fiscally inequitable country in the world.
Another scandal that has to be addressed is the problem of contraband. But we shouldn’t imagine this to be some small-time smuggler crossing a river with a television set on his back. Contraband isn’t smuggled across rivers; it comes in trucks and airplanes. Tax evasion in Nicaragua amounts to the equivalent of 8% of the gross domestic product: some $216 million compared to a GDP of $2.7 billion. This is approaching four times the expected increase in taxes generated by the tax reforms. The United States is spending 1% of its GDP on its genocidal war against Iraq, so smuggling represents the same burden for Nicaragua as 8 Iraqi wars for the US state.
If we add to the tax evasions the 4% of the GDP lost in exonerations, we can calculate how much we will continue losing if the tax reform does not seriously address these drains on state resources. Nicaragua is an immense free trade zone, an enormous tax haven. A great many sectors are exempted from paying taxes, with no justification for this privilege whatsoever. But when it comes to identifying them, only the NGOs and universities are maliciously mentioned; just as only Managua’s Eastern Market is mentioned when people talk about black market goods. It’s a gross oversimplification. The “big fish” involved in both the smuggling and the exonerations are well hidden behind the walls of power.
Some of the exonerations are totally unjustified. Very little mention is made, for example, of the existence of an obscure Nicaraguan law that provides a truly outrageous fiscal incentive, a deduction of 70% of the income tax owed in return for dedicating the equivalent amount to a private tourist project, whatever that may be. In a bankrupt country that is making a national effort to produce a comprehensive tax reform, where is the logic of letting someone get away with deducting 70% of what they owe and pumping that money into private projects, particularly when no regulations are established for this scandalous one-line clause of the law?
Wage earners bear the burdenAnother shocking fact: while the big fish don’t pay or receive exonerations or engage in “dignified” smuggling and the banks justify not paying, wage earners bear the bulk of the income tax burden in Nicaragua. Of the total amount of income tax that the tax system collects, only 15%—yes, 15%!—comes from people who declare once a year while the other 85% is the amount withheld by businesses each month. And of that 85%, no less than 70% is withheld from the wage earners themselves, not from the company income! In other words, government tax collection is most ensured among wage earners, because the employer always withholds their tax payments.
All of this has to change. All of these scandalous facts prove that it makes real sense to change our tax system. Any tax reform that prides itself on being comprehensive must definitively modify such irregularities and inequities; it must affect those who have not been affected for so many years and should not touch those who have always been affected, such as wage earners, the poorest sectors and those who bear the brunt of indirect taxes. It is time to affect the richest people who have contributed to society least by evading or legally avoiding paying their taxes. In other words, a change in the tax system is totally indispensable if we want to achieve development.
Some of our proposals
In the Technical Committee we designed concepts to make the system more progressive, more equitable, to improve things. For example, we proposed that businesses pay a minimum amount of income tax even when they post losses, because a business with fabulous assets cannot be allowed to pay nothing at all, as is currently the case. We also floated the idea of raising the progressive income tax floor for wage earners, because it has not been updated in six years while the loss in the value of their wages has risen steadily through inflation. We suggested that luxury commodities, currently subject to a ridiculously low 3% luxury tax, should be taxed at a much higher rate, so that those who buy such whimsical fancies pay dear for them. Nicaragua currently has the lowest tax on luxury vehicles in the whole of Central America. We felt that a group of 200 luxury products should be taxed at a fixed rate of 20%.
The tax world is divided into four main areas: the national taxes collected by the DGI; the import duties collected by the Customs Office (DGA); the social security taxes collected by the Nicaraguan Social Security Institute (INSS); and the local taxes collected by the municipal governments. Our proposal doesn’t mention the local governments. Why not? We bore in mind that all previous tax reforms have negatively affected the municipal governments and decided that unless a serious and profound tax proposal was designed to back up the municipal governments, it was better not to touch them in this reform. In fact, we instead proposed transferring the national cadastre to the municipalities to give local governments the ability to charge real estate tax.
We also proposed lowering the sales tax by one point, from 15% to 14%. Another suggestion was that the 53 products included in the “basic basket” of essential goods not be taxed across the board but that the sales tax applied to some and the exemptions to others should be revised. The die-hard defense of the basic basket merits reflection. For example, no sales tax is paid on fresh meat, which means that even the most expensive restaurants in Managua pay no taxes on the filet mignons they serve, though I then pay tax for the privilege of eating it there. Wouldn’t it make sense to revise the tax on meat? Should filets be exonerated the same as soup bones, as is currently the case? Another example is the fact that the Constitution exempts school supplies from taxes, but only 50% of all tax-free pencils are actually used in schools; the rest are used in offices and businesses that should pay taxes on them. All of this shows the need for an in-depth review to ensure that all taxes are based on the logic of equity, recognizing that exonerations and exemptions often conceal injustices.
What’s good for the goose…We felt that the income tax levied on wage earners should not be charged on their total wage, but rather on the amount remaining after deducting their social security contribution. They should at least be allowed that reduction, because it’s not fair that business owners pay income tax not on their total income but on what is left after they deduct all of their operating expenses in accordance with the law, while wage earners cannot even deduct their other taxes. In the United States, wage earners have the same rights as employers, and can deduct medical expenses, expenses incurred by dependent children and other expenses that represent fundamental investments that allow them to produce.
So we proposed that wage earners should not pay income tax on their whole wage, but at the very least only on what was left after the social insurance contribution had been subtracted, as is the case in all other Latin American countries. But there’s another great scandal related to the INSS. The fact is that hundreds of employers have deducted their employee’s INSS payments without ever turning the money over to INSS. Combined, these businesses owe the state no less than 1.1 billion córdobas ($73,825,500)! If we want a truly comprehensive reform, the state has to decide to be a good collector. Just by charging the banks and these employers what they are supposed to pay but have not paid, we could collect double the extra taxes that will supposedly be generated by the reform.
People will react to the tax reform if it really opts for equity. And we should be on the watch to see where such reactions come from. It’s logical that certain taxes will increase as the result of the reform, but the trick is to differentiate, discern which ones should be increased and which sector will be affected by the increase. There are winners and losers in all tax reforms, but what cannot be allowed to happen is for those who have always paid more to end up losing again. The reactions will very likely come from big business, from those with most power who have always avoided taxes. They are the ones who came to lobby us to ensure that the reforms would not affect them in the slightest.
What does “comprehensive” mean?The government promised a “comprehensive” reform. That means that the reform should be both a tax reform and a fiscal reform. A tax reform just covers income, whereas a fiscal reform covers income and expenditure. In other words, a fiscal reform doesn’t just cover how to collect, but also how to spend. To qualify as “comprehensive” the reform must also be accompanied by everything that the government promised. It promised a new budgetary system law; the country’s first ever tax code (a kind of tax constitution); and a civil service law in which public officials would be trained, levels and responsibilities established, and a wage scale designed based on merit and not party backing. To be comprehensive, this reform should also be accompanied by a reduction in expenditure. The President should make an exemplary gesture and renounce the pension he receives as a former Vice President, which is not only immoral in a country like ours, but is also illegal. It should also be accompanied by a reduction of the ministers’ exaggerated salaries, and they should understand that being a minister is a modus operandi, not a modus vivendi. Only if the executive and legislative branches provide a good example of austerity will they have the moral authority to push through their tax reform and ensure that it is well received and works.
Our fearsThose of us in the Technical Committee have justified fears that the tax law the executive branch presents to the National Assembly will not reflect our efforts and proposals, which would open the doors to a decisive national debate. We also fear that the reform could end up as a political sell-out. That’s the risk involved. The presidential budget veto was accepted on the condition that the tax reform would guarantee an extra $16.1 million for wage rises for the low-paid teachers, nurses, police personnel and the like. On the other hand, the executive branch promised the International Monetary Fund it would have the reform passed and in force by July 1. Thus the tax reform is subject to both the specific wage increase objective and an urgent deadline, which could politically contaminate the whole discussion and the final results of a process that is so important and necessary for the country, as has happened with so many other important and necessary processes in Nicaragua.
A male bastionOn three occasions, the Technical Committee met with President Bolaños, his economic Cabinet and economic advisers; some 25 to 30 people in all. I was really struck, indeed shocked, by the fact that not a single woman participated in those meetings. This alone creates a degree of uncertainty about the reform. Woman are always more direct in what they say and in their ideas. Men posture more; our words are more vain. The fact that not one female technical expert, adviser or minister was involved does not bode well for the reform.