Breaking with history: Why Colombia needs a more progressive tax system

December 17, 2012

Lars Christian Moller Colombia Reports

Colombia is the seventh most unequal country in the world. Inequality here is very similar to countries such as Haiti, Angola and South Africa. The administration of President Juan Manuel Santos is uncomfortable about this and has taken a number of steps to reduce inequality, including a recent tax reform proposal.
Gini coefficient of income, country ranking
Why is the Administration right to be concerned about high income inequality? The first reason is democratic. Ordinary Colombians express concern about the high inequality they see every day and believe that it is the Government’s job to deal with it.  Close to 85 percent of the population finds the income distribution unfair. More than 70 percent of Colombians believe that the Government should implement firm policies to reduce inequality, according to the 2010 LAPOP survey carried out by the University of Vanderbilt.
The second reason is poverty. While it is on the decline in Colombia, progress could have been much faster with a less unequal income distribution. Income poverty fell from 47.7 percent in 2003 to 34.1 percent in 2011. Poverty fell exclusively as a result of income growth as income inequality remained largely unchanged: the Gini coefficient was 0.55 in 2011 – the same as in 2003.Our calculations show that if Colombia had the same income distribution as Peru, poverty would have been ten percentage points lower than it is today, i.e. around 25 percent.
The third reason is stability. High inequality can be a source of distributive conflict and social tension. This tends to undermine the legitimacy of policies and institutions as well as their stability, and in particular weaken property rights, thus discouraging investment and thereby growth. While the decade long conflict in Colombia has many roots, most observers agree that the perception of inequality is an important factor.
Why is income inequality so high in Colombia? Since labor income is the largest component of household income, the performance of the labor market is critical in understanding income inequality. Colombia has the highest level of unemployment in Latin America (still above ten percent despite a healthy economy) and this contributes to inequality as the unemployed have lower incomes than the employed. Moreover, the labor market is segmented between formal and informal workers generating further income discrepancies.

" The personal income tax system in Colombia is regressive. This means that the richer you are, the lower is your tax effective rate. The Government proposes to overcome this problem by introducing a progressive tax system, i.e. to let the richer households pay a relatively higher effective tax rate.  "

Lars Christian Moller

World Bank's Senior Country Economist for Colombia

Informality and unemployment are complex issues which economists grapple to understand. There is no doubt, however, that employers apply some economic logic when deciding to hire and fire workers. Few employers would hire a new worker if the expected extra earnings of doing so are lower than the wage. Formal labor in Colombia is very expensive for two reasons. First, because of the minimum wage which is equivalent to more than 70 percent of the average wage. Second, because of the high non-wage labor cost that the employer pays (amounting to 45 percent of the labor cost). Both are among the highest in the world, according to the OECD.

Bringing down the cost of formal labor, as proposed in the current tax reform, should therefore help reduce informality and unemployment, and therefore inequality. Employer contributions to SENA (a training institute), ICBF (a family welfare program) and health insurance will now be financed from a new equity tax (known as CREE) levied on firm profits and the Government has guaranteed full financing of these programs. Lowering the cost of formal labor, however, is not the only necessary remedy. Worker skills are equally important. High-skilled workers are attractive to firms because hiring them can increase profits. The other major challenge, therefore, relates to improving Colombia’s education and vocational training systems to ensure that workers become even more productive.

Colombia aspires to join the OECD. As mentioned by President Juan Manuel Santos, the OECD is a club of ‘good practices’. OECD countries have levels of income inequality that are considerably lower than in Colombia. These countries use their tax and transfer system effectively to achieve such results. They do so by taxing the rich households relatively more than the poor and by implementing monetary transfers to low-income households. Take the example of the United Kingdom. The distribution of incomes generated by the market is very similar to Colombia. However, when considering the effect of taxes and transfers, the United Kingdom has reduced inequality by 16 points on the Gini scale, while government intervention has no impact on inequality in Colombia.

Income equality before and after government intervention

The personal income tax system in Colombia is regressive. This means that the richer you are, the lower is your tax effective rate. The Government proposes to overcome this problem by introducing a progressive tax system, i.e. to let the richer households pay a relatively higher effective tax rate. The World Bank estimates that this intervention (known as the IMAN, or alternative minimum income tax) could potentially reduce the Gini coefficient by up to 2 points. This could bring inequality in Colombia to the level of Brazil – a country which used to be highly unequal, but which has reduced inequality substantially over the past decade. Achieving this goal, of course, requires appropriate implementation to ensure that taxes are collected as intended.

To reduce inequality further, Colombia could also consider raising more income tax and spending more on the poor. The country only collects 1.1 percent of GDP in personal income taxes compared to 1.8 percent of GDP in Latin America and 9.0 percent of GDP in the OECD. Moreover, one of the most cost-effective ways of reaching the poor and reducing inequality through the national budget is the Familias en Accion conditional cash transfer program. This program currently has a budget of 0.3 percent of GDP and 7.8 million beneficiaries. By comparison, the ‘pay as you go’ pension system, which costs 3.3 percent of GDP annually, and has 1.4 million (almost exclusively rich) beneficiaries. By taxing and spending more progressively, Colombia could potentially reduce inequality to levels similar to Chile or Costa Rica, even without raising taxation (though doing so could reduce inequality even further).

Undoubtedly, Colombia has a long way to go if it is to reach OECD levels of inequality. Not that this is an accession requirement, but it's a relevant benchmark. Experience shows that inequality is a very difficult social indicator to improve, so expectations should be managed accordingly. On the other hand, there is no doubt that the Government of Colombia has taken a big step in the right direction by attempting to tackle inequality via tax reform. For the millions of Colombians concerned about high inequality this represents a welcome development.

Author Lars Christian Moller is the World Bank's Senior Country Economist for Colombia

Published in Colombia Reports.