Colombia is about to embark on an ambitious overhaul of its tax code to end a series of loopholes and deductions that have spawned what Finance Minister Juan Carlos Echeverry called a preposterous tax system.
The overhaul will be a test for the administration of President Juan Manuel Santos and especially for Echeverry, a self-defined supply-side economist with a doctorate from New York University. While lowering taxes as a way of igniting economic growth is a principle of the supply-side economics school, Echeverry contends in a country with Colombia’s social and economic inequality, raising taxes is necessary.
Loopholes create what Echeverry said is an unfair system that forces workers earning minimum wage to pay an effective rate of around 11%, while a middle-class employee can end up paying half that figure.
“Middle-class Colombians are not going to pay higher taxes, they are going to start paying taxes for the first time,” Echeverry said in an interview. “We want to establish effective minimum tax rates so there’s an upward slope.”
For companies, it will be similar. “We may reduce tax rates in many cases, but we are also going to do away with a lot of deductions and loopholes,” he added.
The tax overhaul targets nearly 900 articles in the tax code and will need the approval of Congress, which is dominated by Santos supporters. Echeverry said he has held long meetings with Santos to study how companies are circumventing the tax code and determine what changes are necessary. “We are targeting the whole system,” he said.
The aim isn’t to immediately raise revenue and the proposed changes will be applied gradually. They will include incentives for workers and companies operating in the informal economy to start paying taxes.
Ratings companies are keeping a close eye on the overhaul as a prerequisite for giving a positive outlook to the investment-grade rating Colombia recovered last year after the government moved to reduce its chronic fiscal deficit.
“We are now working very hard for the positive outlook and I want to leave my job with Colombia comfortable within the range of investment grade,” Echeverry said. “Our goal is to bring the fiscal deficit to equilibrium.”
A key component of the government’s efforts to balance its budget is the potential sale of a stake in Ecopetrol SA (EC, ECOPETROL.BO, ECP.T), Colombia’s state-run oil company. The sale, however, will depend largely on the government’s financing needs and tax revenue, the finance minister said.
“The need for privatization depends on tax revenue, so as long as we have higher-than-expected tax revenue the need to sell goes down,” Echeverry said. “We keep the message that we are going to sell, but the timing is very flexible.”
Echeverry said he is confident the economy expanded 6% last year. For this year, he expects economic growth of 5.5%.
“Our goal is to reach cruise speed of 5% to 7%,” he said. “All the signs for the start of the year have been very positive.”
Foreign investment has been pouring in to the oil and mining industries, driving economic growth as the government continues to curtail a decades-old Marxist insurgency largely financed by the cocaine trade. The strong growth has been accompanied, however, by faster price increases and higher inflation expectations.
The central bank, which includes Echeverry on its seven-member board, unexpectedly raised its benchmark lending rate by 25 basis points to 5% last month in a unanimous decision.
“I was worried about inflation and we raised rates,” Echeverry said. “Inflation expectations have now gone down and in the next meeting we’ll probably see that inflation pressures are not as strong as before…Inflation will move in the right direction in 2012 and I think the worst is over.”
Consumer prices were up 3.54% in the 12 months through January, within the central bank’s target range of 2% to 4%.
The government also is struggling to deal with the appreciation of the peso, which has strengthened more than 8% against the dollar so far this year. Echeverry maintains the government doesn’t want to impose limits on foreign investment, as local business federations have demanded.
“The foreign-exchange problems are basically a U.S. issue. When you look at the figures, it’s basically an issue of excess supply of dollars,” he said.
An economic recovery in the U.S. could force the U.S. Federal Reserve to end its lax monetary policy sooner than it has signaled, and higher U.S. interest rates could help Colombia’s and other emerging markets’ currencies to weaken, making their exports more competitive.
Echeverry considered that Federal Reserve Chairman Ben Bernanke may be overly pessimistic about the prospects for the U.S. economy. “His announcement of lax monetary policy for the coming years I think is an overstatement that sends terrible signals for us,” he said.