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OPINIONSeptember 5, 2023

Tax reform: paying attention to the issue of inequality

Pending decisions need to be based on evidence to increase the progressivity of the reform proposal

On July 7th, the Brazilian Congress approved a Constitutional Amendment Proposal (PEC 45/2019) that establishes the first phase of a historic tax reform in the country. The new legislation substantially modifies consumption taxation in Brazil through the implementation of a dual value added tax (VAT), which will replace five taxes currently in force. The VAT adoption has the potential of increasing the progressivity of the Brazilian tax system and thus contribute to the reduction of persistent inequalities in the country. However, there are still some fundamental decisions to be taken that can have a significant impact on families' purchasing power. These decisions need to be based on evidence.

Among the fundamental decisions that are still pending is the general rate of the dual VAT on consumption and the choice of economic sectors that will have a reduced rate (i.e., a partial exemption of 60% of the general VAT rate). Probably more important for vulnerable families is the definition of the list of products from a “basic food” basket that will be exempted from VAT. The list will be defined through a complementary law. The definition of the products that will be part of the aforementioned basket is a central stage of the reform and a key part of its potential impact on the country's inequality. Here, we can turn to data to inform this crucial decision.

Forthcoming work by the World Bank compares different scenarios for implementing the reform and reaches three main conclusions. First, the reduction in standard VAT in the education and health sectors leads to a reduction in the regressivity of indirect taxes, as these sectors represent a significant part of the consumption of low-income families. Second, the exemption from the basic food basket would have an even greater impact on reducing the regressivity of the VAT-based system. Third, if only some items of the basic basket were exempt from VAT and a cashback mechanism is applied to benefit families registered in the Cadastro Unico[1], the system could have the same revenue as in the previous scenario, but the impact on reducing inequality would be larger.

The idea of cashback is already included in the government’s current proposal. In this study, we simulated a cashback scheme that, instead of exempting all products from the basic basket, which are consumed by the vast majority of the population, applies the full VAT rate on certain items – for example those that are mainly consumed by the richest – and with the tax revenue derived from the non-exemption returns part of the amount paid in consumption taxes to the poorest. Therefore, the cashback could have a much larger effect on increasing the progressivity of the Brazilian tax system than the total exemption of items from a basic basket. Furthermore, the results remain the same even when considering different general VAT rates.

The approval of the tax reform after 30 years of discussions is a major achievement for the country. The proposed model brings Brazil closer to the best international standard of consumption taxation, adopted in several countries and seen as an instrument to increase the efficiency of the domestic economy. Using evidence to inform the debate and the definition of issues that still require decision will be crucial for the reform to realize its potential of reducing inequalities. Favoring the elaboration of technical studies that aim to contribute to the fine-tuning of regulations and mechanisms such as cashback seems a promising choice to mitigate lobbying from groups of interest and, thus, move towards a reform that makes the fiscal system fairer and more efficient.

This column was written in collaboration with my World Bank colleagues Gabriel Lara Ibarra, senior economist, and Otavio Conceição, consultant.


[1] This is Brazil’s Social Registry where families sign up to be considered for social programs.


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