A policy framework for addressing inequality in developing countries
Box 7.7. Tax reform in Uruguay: from a regressive to a redistributive tax system Few countries exemplify the effects that tax reform can have on equity and redistribution as clearly as Uruguay. In 2007, the Uruguayan Government implemented a set of tax reforms including a progressive labour income tax, a flat capital income tax and reduced indirect taxes with the aim of improving fiscal balance while redistributing income. Personal income went from formerly being taxed at two brackets, with rates of 2 percent and 6 percent, to a system of 6 tax brackets with rates ranging from 0 percent to 25 percent. The reforms taxed capital income at a flat rate of 12 percent. Corporate income taxes were simplified, introducing one tax to replace several ad hoc taxes. Indirect taxation was lowered as part of the reform, with VAT rates decreased by 1 point and 4 points, and the tax base was increased to include certain goods and services before tax.
Tax administration was also modernized through technological and infrastructure improvements. The government dedicated efforts to increase tax morale and decrease evasion through a combination of stricter enforcement and fiscal education campaigns targeting younger generations. As a result, tax revenue grew at a yearly average rate of 7.3 percent, while the ratio to GDP increased from 18.2 percent to 18.9 percent between 2006 and 2010. The contribution of indirect taxation to total revenue fell significantly from 74 percent to 54 percent, while the contribution of direct taxation rose from 17 percent to 35 percent. Empirical evidence on the impact of the reform on distribution confirms that these reforms reduced the tax burden of the poorest taxpayers while increasing that of the richest, reducing inequality by 2 Gini points.
Source: Martorano (2012).
Certain excise taxes, when applied to goods consumed by the higher income groups, such as tobacco, alcohol and cars, are another way of raising additional revenue while improving progressivity (Ross and Chaloupka, 2001, cited in IMF, 2011). Expanding the tax base
Besides improving the progressivity of taxes, it is important to expand the tax base in developing countries as a way to mobilize additional resources. This means looking for ways to tax firms operating outside the rule of law. Since the informal sector represents a large share of GDP,5 its potential as a source of tax revenue is significant (Schneider and Klingmair, 2004; Schneider et al., 2010). A recent study in developing countries estimates that taxing the informal economy could add between 35 percent and 55 percent to total tax revenues in some countries (Brautigam et al., 2008). It is critical, however, that firms in the informal sector be taxed in a way that improves the distribution of income. Although commonly associated with survival activities, free-entry, little capital, low labour productivity and family-based labour, the informal sector has a modern side characterized as more entrepreneurial and capitalintensive, with more hired workers per firm, more dynamic technology, and substantial incomes (Ranis and Stewart, 1999). Thus, many tax evaders in the modern informal sector operate well above the margin of subsistence. A progressive tax schedule can ensure that larger informal companies comply with taxes, improving revenue collection, while the smallest are taxed at very low rates. Furthermore, small informal businesses are burdened by a number of costs such as penalties and bribes that tend to be discretionary and can be higher than tax rates (Alm et al., 2003; Joshi et al., 2012). Bringing these firms into the tax system could reduce the burden of penalties and bribes and actually increase their
246 Humanity Divided: Confronting Inequality in Developing Countries