President Piñera's corporate tax on big companies will likely be passed on to consumers by through higher prices, warns Jorge González, a professor of political science at the School of Government at Adolfo Ibáñez University.        Font Size ..... Small Normal Big Very Big

Months after February’s devastating earthquake, Chilean president Sebastian Piñera’s decision to raise taxes on large corporations to pay 40 percent of the cost of rebuilding the country is causing heated reactions among academics and business leaders. Because of the announcement, Piñera, a successful entrepreneur who used to own such businesses as the Chilevision TV channel and Clinica Alemana, has become unpopular among a large portion of the country’s business leaders, who argue that the tax could have a significant impact on consumer prices, the country’s distribution of wealth and its economy at large.

Starting in 2011, the measure would increase taxes of the First Category -- collected directly from corporate profits -- from 17 percent to 20 percent, and then reduce them to 18.5 percent in 2012 before returning to 17 percent in 2013. Piñera has been reassuring the public that the initiative will be a temporary one and that it will not affect small and midsize companies. His goal is to collect $3.23 billion, the equivalent of almost 40 percent of the $8.43 billion needed for reconstruction, according to the latest government calculations.

The remaining 60 percent of reconstruction financing will be obtained through a package of measures, including a 0.25 percent increase in real estate taxes to the holders of houses valued at more than 97 million pesos (about $178.850). In addition, the country’s mining royalty -- a 5  percent tax on mining profits -- will vary between 3.5 percent and 9 percent, depending on the international price of copper, and smokers will also be required to pay 3 percent more for tobacco products.

At the same time, the government will sell a portion of the shares of public-sector healthcare companies and issue a 10-year sovereign bond worth $1 billion in international markets. These initiatives are currently being discussed in the Chilean Congress, which will vote on whether to approve them.

According to Javier Bronfman, professor of public policy at the School of Government at Adolfo Ibáñez University, the proposed corporate tax measure makes sense. “The current tax of 17 percent paid by companies is relatively low if you compare Chile with the countries that comprise the Organization for Economic Cooperation and Development (OECD), where the average company pays a tax of 24.3 percent.” In his view, companies will need to deal with higher taxes for some time.

However, Jorge González, a professor of political science at the School of Government at Adolfo Ibáñez University, notes that the taxes paid by companies in the other OECD members are higher than in Chile because those nations are industrialized countries that have more efficient economic policies and higher per capita income. “This reality is quite different from that in Chile.” According to González, the tax hike announced by authorities is “a very bad measure because you need to consider that public spending in Chile has grown by about 10 percent in recent years -- above the [rate of] economic growth.” As a result, he says, public spending is a significant source of financing that can be used by the government, through reallocation of public resources, without having to resort of raising taxes. It is likely that big companies will pass along these tax increases to consumers by raising the prices of their products and services, he adds.

CORPORATE INVESTMENTS

Another factor is the local business community. Daniel Daccarett, general manager of Producto Protegido, a Chilean company that offers an advanced service for protecting goods against theft, applauds the tax increase because, in his view, it is a good way to finance recovery from the economic and social crisis created by the earthquake without affecting corporate investment plans. “The three percentage points that the tax will rise starting in 2011 can become a problem, but I doubt that it is going to limit companies’ investment plans.” He adds that expectations of high economic growth in 2011 are an inducement for companies to invest more. The Central Bank of Chile recently projected 6% economic growth for the country this year. Nevertheless, a portion of the business community fears that the tax increase, said to be temporary, will become permanent --  a scenario that would have a negative impact on corporate investment decisions, according to Juan Pablo Swett, general manager of Trabajando.com, Chile’s leading job search portal. “Some historical precedents could lead you to believe that the measure will wind up being a permanent one. In 1985, the government temporarily increased its tax on fuels with the goal of financing reconstruction after the earthquake that we had that year, but it became a permanent measure.”

Much the same way, during the 1990s the government applied a temporary increase in the VAT tax (the direct tax on consumption), raising it from 16 percent to 18 percent. Over time, this increase wound up being permanent and even increased to 19 percent. “As a result, it is quite hard to believe that a measure of this sort, which they announced as temporary, is really going to be temporary.” The most likely thing that will happen, he warns, “is that companies will delay or suspend their investments in projects, putting aside their plans to purchase inputs, build infrastructure and hire labor. All of that will have a negative impact on the economy.”

What’s more, in either of those two scenarios -- a temporary or a permanent tax increase -- companies are going to opt for one of two methods to counteract the payment of higher taxes, anticipates Swett. “Either they will pass on the tax increase to consumers by raising their prices or they will apply legal techniques to avoid the increase, such as dividing the company into two firms, thus recording lower profits [for each of the two companies] and remaining exempt from the tax increase.”

TAX EVASION, WEALTH DISTRIBUTION

Tax avoidance is possible because the legal framework of the country is deficient in certain ways, notes González. In addition, the tax collection system is inadequate, which means that “businesspeople will [manage to] avoid paying higher taxes.”

However, Richard Ffrench-Davis, professor of international trade and economic development at the University of Chile, believes that the tax increase is modest enough that companies won’t make an effort to avoid it. In addition, he considers the initiative very necessary -- not only for the urgent task of reconstruction, but also to resolve the inequality in the country’s distribution of wealth. In his view, the proposed corporate tax “should be a permanent measure to combat the inequality in Chile’s distribution of income.”

In 2009, the Organisation for Economic Cooperation and Development (OECD) warned in a report to the government of Chile that the country was one of the OECD nations that had the greatest inequality in its distribution of wealth. The OECD reported that the richest 10 percent segment of the Chilean population had incomes that were 29 times higher than those of the poorest 10 percent segment. Among OECD nations, the average income gap is only 9 times.

Nevertheless, for González, the goal of reducing inequality in the distribution of wealth through tax increases “is something that has never been achieved.” The most efficient policy for redistributing wealth equitably within an economic system, he argues, is to maintain a low tax structure that incentivizes corporate investment, diminish subsidies to the richest population and increase subsidies to the low-income segment of the population.

In that regard, the increase in the real estate tax is the only measure in the entire government package that would really have a positive impact on reducing inequality in Chile, argues Jorge Fábrega, professor of public policy at the School of Government at Adolfo Ibáñez University. “This is a true success story because, unlike [corporate] tax increases – whose impact is always very likely to be passed on to customers through price increases – an increase in the real estate tax directly affects the assets of the higher-income segment of the population.” He emphasizes that this measure produces a truly redistributive effect “between those who have more and those who have less.”

ECONOMIC IMPACT

Although some experts assert that this measure threatens short-term economic growth in Chile, Bronfman argues that its temporary nature will mitigate the negative impact. “Using funds collected for the reconstruction of the country will have a positive impact on economic activity. We expect that there will be some industries that benefit and others that are harmed.”

One sector that could lose from the measure is the tobacco industry, because consumers will have to pay a special 3 percent tax. However, Swett predicts that the industry will not be affected because tobacco “is less sensitive to price changes” and consumers “will wind up paying the tax increase.”

As for the mining sector, Fábrega notes, “It seems to be more of a way to collect cash than a real tax increase, since the law stipulates that taxes on mining companies will not change until 2017. As a result, companies will have to reach an agreement with the government to voluntarily accept the new tax policy.” In any case, the impact on the sector will be minimal, he forecasts, because of the historically high profits that the sector has achieved [recently].

SELF-FINANCING OR EXTERNAL DEBT

González believes that the Piñera administration is sending “an awful signal” to the rest of the world by looking to finance the reconstruction effort with Chile’s own resources. “[The administration] is demonstrating that it does not believe in the market economy, in circumstances where the country is in a perfect position to be able to issue more external debt. Currently, Chile’s external debt is very low.” According to the Central Bank of Chile, in December 2008, the country’s external debt reached a total of $64.77 billion. 

However, Manuel Agosin, professor of economic development at the University of Chile, believes that it is a good thing that Chile continues to maintain a low external debt, “because external indebtedness means greater vulnerability in the international market. In addition, bringing a greater amount of cash into the domestic market means the price of the dollar falls, and that has a negative impact on export revenues. To sum up, it would be a hard blow for the economy.”

The package of measures announced by the authorities, notes Agosin, is quite comprehensive and reasonable, since it includes both a tax component and a foreign indebtedness component. In his view, the government’s initiative could have remained exclusively short-term. “They could have increased other taxes, such as Complementary Global Tax – which is directly collected from personal income – or the tax on gasoline and the VAT [Value Added Tax].” Unlike González, Agosin believes that the government of Chile is going to gain international credibility “because there is a serious effort to carry out a public investment program to finance the reconstruction.”

Nevertheless, the example Chile will be setting for the rest of the world won’t be such a positive one, says Swett. “We’ve already seen how other countries have gone into a crisis – whether or not because of natural disasters – and they turn to the international community to ask for help.” In his opinion, during the days following the earthquake, Chilean authorities sent out signals that showed too much self-sufficiency by telling people that the country could count on its own resources to overcome the tragedy, and in circumstances where “Chile also needs another sort of aid, such as experts in earthquake and reconstruction; in machinery, and glass, among other inputs.”

Republished with permission from http://www.knowledge.wharton.upenn.edu -- the online research and business analysis journal of the Wharton School of the University of Pennsylvania.