San José, Costa Rica, since 1956

Is Tax Reform to Reduce Deficit on Tap?

Even in these times of economic recovery, the Costa Rican financial deficit is growing.

In a report released Friday by the Finance Ministry, the government deficit stands at over ¢292 billion ($556 million), more than double the ¢127 billion mark ($242 million) through the first four months of 2009.

And it’s expected to keep growing. In his first press conference as finance minister, Fernando Herrero explained that the current deficit represents 1.6 percent of the country’s gross domestic product (GDP). By the end of 2010, he anticipates it to hover around 4.8 percent. If his prediction comes to fruition, the deficit by the end of 2010 will be ¢876 billion ($1.67 billion).

“The worldwide economic crisis enveloped Costa Rica at the end of 2008. The government responded by increasing public spending to compensate for the fall of external demand and internal private demand (for goods and services),” Herrero said. “It was a successful program from that point of view and provided a smaller economic contraction than seen in other countries. To put our situation in context, remember that the average deficit for developed countries in the Organisation for Economic Co-operation and Development (OECD) was around 9 percent of the GDP, much higher than ours.”

The government spending increase that Herrero alluded to amounted to over ¢1.15 trillion ($3.19 billion) in first four months of 2010, a 27 percent increase over the same period in 2009 and the highest recorded first quarter expenditure. The balance sheet provided by the Finance Ministry indicates significant increases in salaries, debts and interest expenses in the past year. Many of the salary hikes stem from the approval of Law 8783, which moved the financing of several educational programs, such as Avancemos, under the umbrella of central government expenditures.


Government Revenues

Can’t Keep Up

In the first four months of the year, income tax collection is up almost 6 percent, bringing in ¢43 billion ($82 billion), more than the same time frame in 2009. The increase in tax revenues is attributed to this year’s economic improvements. Taxes on imports, sales and customs have all improved considerably. The government has collected over ¢859 billion ($1.63 billion) in 2010.

Yet the deficit keeps growing.

Because the broadening gap reflects an unequal balance between expenditures and income, Herrero mentioned that the Finance Ministry would have to implement new measures to regulate government spending while increasing revenues.

“We’ve arrived at the conclusion that, in order to reduce fiscal deficit, our efforts should center on increasing revenues, while creating administrative and legislative measures.”

Herrero then mentioned that the measures required to increase government revenue include improving the collection of unpaid taxes, which are estimated at over ¢7 billion ($13 million); registering informal businesses; and combating tax evasion.

He also cited tax reform, which is widely considered the most logical, and the most overdue, method for reducing the fiscal deficit.


Tax Reform:

The Unfulfilled Promise


Herrero’s goal of eradicating the fiscal deficit through tax reform seems to be pulled from the things-to-do list of past finance ministers. Herrero, who mentioned that discussion of reform would begin in the “next few weeks,” is now the third consecutive finance minister to announce the goal of tax reform within the first month of taking office following an inauguration.

In 2002, then-President Abel Pacheco considered tax reform to be one of his “top priority projects.” During his administration, Pacheco and then-Finance Minister Walter Bolaños created the Permanent Fiscal Reform Package, a comprehensive overhaul of the existing tax system that was created to solve the country’s fiscal crisis and provide funding for infrastructure and schools.

After years of grueling debate, which saw the resignation of Bolaños and two other finance ministers, the plan was approved in February 2006, only to be rejected by the Constitutional Chamber of the Supreme Court (Sala IV) (TT May 18, 2007).

When Pacheco’s reform plan flopped soon after former President Oscar Arias took office in 2006, Arias preached that a “new tax project” would be devised and that “something must be done to increase the funds to the central government.” Yet, as the Arias administration started, efforts shifted towards passing the Central American Free-Trade Agreement with the United States (CAFTA). The promise of tax reform dropped from the priority list.

With the beginning of the administration of President Laura Chinchilla, tax reform is again considered a priority.

“Costa Rica has pursued tax reform for many years,” Chinchilla told The Tico Times in December last year. “It is understood that the system needs to be changed and it is one of the important things on our agenda … if we want to invest and put money into things such as infrastructure, we must provide the country a better social standard by which taxes are paid in the country.”

Chinchilla said that her tax reform would center on creating a “progressive tax” to be installed amongst different income tax brackets (TT Jan. 22).

Yet, in a separate interview with The Tico Times last October, Chinchilla said that she planned to launch a tax reform discussion in May.

“We consider an income tax reform to be something that needs to be reassessed and revised,” she said. “When the time comes, maybe by May of this year, we will sit down and discuss the idea of improving the system we have in place right now.”

The end of May has arrived and Chinchilla has spent much of the month focused on the association agreement between Central American and the European Union (EU).

While the association agreement with the EU is expected to provide significant economic and trade benefits to the country down the road, it bumped tax reform further down on the priority list.

“I think the objective of the Arias administration was to push for the approval of CAFTA and free trade and, afterwards, during the economic crisis, it was not the right time to look for a tax reform,” said Andrés Víquez, the director of the trade for Aldesa, a Costa Rican economic analysis firm. “But it seems to me that now is the time for a restructuring of the tax system. It was one of the promises of the (Chinchilla) campaign and, at a time when public financing is in demand, it seems that the right time has arrived.”


Supporting Cast


If the time has arrived for tax reform, it appears Chinchilla would have support from other political parties. In 2006, legislators of the Libertarian Movement vehemently opposed the idea of tax reform and spearheaded the bill’s demise (TT May 18, 2007). But 2010 is a different year.

In late April, prior to Chinchilla’s swearing-in, members of her party, the National Liberation Party (PLN), and members the Libertarian Movement signed a nine-page agreement on several initiatives and government objectives (TT April 30).

Otto Guevara, the former Libertarian Movement presidential candidate, also campaigned on the idea of a tax reform, though his idea of a flat tax differs from the progressive tax system envisioned by Chinchilla. However, given the recent increase in cooperation of the two parties, it appears that agreement on a reform proposal might be reachable.

Ottón Solís, the former presidential candidate and current head of the Citizen Action Party (PAC), also campaigned on the idea of creating a progressive tax reform. Together, the PLN, PAC and Libertarian Movement account for 44 of the 57 seats in the Legislative Assembly.


‘The Next Few Weeks’


Tax reform discussions might begin in the “next few weeks,” unless something of greater administrative significance steps in the way to push them back yet again. In the meantime, the fiscal deficit continues to bulge, with no foreseeable prescriptions to reduce the swelling.

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