A streamlined levy: Progressive fiscal reforms passed in late 2012 restructured the tax code

On December 26, 2012 Colombia’s Congress passed and approved Law 1607, a fiscal reform bill designed to modernise the tax system and in the process help stimulate job creation. The reform is also anticipated to have tangible effects in combating the high level of inequality by raising the top income tax rates and creating vehicles for increased social spending, while improving government tax revenue stability.

The administration’s initial proposal for tax and fiscal reform called for changes that would result in no dip in government tax revenues while simplifying the tax code. However, following several legislative changes in Congress, the end product is now expected to produce a net revenue loss of $280m, according to the Ministry of Finance.

INEQUALITY: Measures for reducing poverty and income disparity are high on the administration’s agenda. While poverty has been reduced thanks to steady economic expansion over the past decade, the country’s Gini coefficient of 0.559 in 2011 was unchanged from its last measurement in 2003.

Several factors contributed to preserving the status quo, including a large informal economy, high unemployment and – according to Lars Christian Moller, the World Bank’s senior economist for Colombia – a regressive tax system. “The personal income tax system is regressive. The richer you are, the lower your effective tax rate is,” said Moller. “The government is proposing to overcome this problem by introducing a progressive system, letting the richer households pay a higher effective tax rate.”

POLITICAL WILL: Thus one of the main drivers of fiscal reform was the high level of inequality in the economy. The bill, which required significant political capital from the administration, has caused some controversy, despite being broadly supported in Congress. The bill implements several mechanisms for increasing social spending, including a “fairness tax” designed to tackle the issue of income disparity. However, some leftist politicians feel that the bill does not go far enough, particularly opposition senator Jorge Robledo, who labelled the bill the worst tax reform in the country’s history.

The World Bank fully backed the initiative, granting a $200m loan to support the reform (the official purpose of the loan was to “consolidate economic recovery and fiscal sustainability”). It also chose to support the reform based on its ability to “improve the predictability and stability” of the budget. Mauricio Cárdenas Santamaría, the minister of finance and public credit, told local press, “This operation represents a new step in the relationship between Colombia and the World Bank, which goes back many years and is now focused on moving forward in terms of fiscal consolidation and state modernisation in areas of crucial importance for development.”

Law 1607 is one of several fiscal reforms passed by the current administration, following reform in the extractive sectors with respect to royalty distribution (see Energy chapter) and the addition of a constitutional requirement for a balanced budget.

LEGISLATION: Law 1607 brought numerous changes, most of which went into effect on January 1, 2013, to what was an overcomplicated and antiquated system. While a corporate income tax cut will see the corporate tax rate drop from 33% to 25%, a new “fairness” or “equality” (CREE) tax of 8% will be imposed on corporate profits, though the effective rate will be 9% for 2013-15, before dropping to 8%.

Funds collected through the CREE will go directly towards social programmes such as the National Learning Service and the Colombian Institute of Family Welfare, while it will also be used to help support public health and education initiatives and social investment in agriculture. In addition, corporations paying the new CREE tax will not be required to pay payroll taxes on employees whose salary is up to 10 times the statutory minimum wage, which is currently COP589,500 ($354). Individuals, non-profit organisations and firms already located within free trade zones or having applied by December 31, 2012 are all exempt from the CREE.

Furthermore, according to a report published by KPMG Colombia, to help simplify the corporate tax system – and hopefully prevent tax evasion – the reform also modifies the tax code to circumvent partner/shareholder “double” taxation and work to close various loopholes.

INCOME TAX: Reclassification of individual tax returns now sees individuals divided into two categories: employees and self-employed. Individual and self-employed taxpayers will also be allowed to take a monthly deduction of up to 10% of gross income (although limitations exist); prepaid health payments may also be used as deduction for up to a family of four and voluntary pension fund contributions will also represent tax-free income. An alternative minimum income tax system (Impuesto Mínimo Alternativo, IMAN) has also been introduced allowing for additional deductions. The IMAN runs concurrently with the normal income tax regime, with the lesser amount being the final tax due. Another important change, following an Ernst & Young review of the reform, is that the individual tax code will see the capital gains tax rate reduced from 33% to 10% for foreigners and nationals. Foreigners who claim residency will, however, be taxed on a worldwide basis, and the rules for qualifying tax and residency status have been modified (see Tax chapter).

VAT: The value-added tax (VAT) regime has also been altered through the introduction of a three-tiered system at 0%, 5% and 16%, while the product base for VAT has been broadened and rationalised. According to Ernst & Young, income used to pay VAT will be deductible from the broader income tax, though limitations exist based on previous collections.

MACROECONOMIC IMPACT: World Bank support for the fiscal adjustments is based on predicted knockon effects on public accountancy and social services. Under the new tax regime the administration has forecast a reduction in the structural fiscal deficit from 3.2% of GDP in 2011 to 2.7% by 2013, despite predicted losses of $280m in tax revenues.

The World Bank and the government also expect to see a dose of financial efficiency added to the national health system, with the ultimate goal being the reduction of non-insurance costs to $1.44m per year. Total insurance coverage with regards to agricultural land is also expected to significantly increase.

One of the stated goals of the administration is to increase formal employment. Colombia, like many of its Latin American peers, has a large informal economy and high unemployment. The administration is hoping to rein in the unemployment rate to the single digits by 2014, and the recent tax reform is seen as key to accomplishing this. The reform aims to cut income tax for companies from 33% to 25% and increase the formal workforce by reducing payroll taxes to 16% of monthly pay (down from the current 29.5%). The Ministry of Finance expects this to result in roughly 1m informal employees being brought into the formal economy. Meanwhile, according to World Bank estimates, the introduction of the IMAN alone has the potential to reduce the Gini coefficient by up to two points.

LOOPHOLES: The tax code has been modified several times in recent years, although this most recent and dramatic fiscal reform generally received broad support and theoretically should accomplish the administration’s goals. Nearly all modern tax systems are complex enough to allow shrewd individuals and organisations with funds to spare for teams of accountants to find loopholes. Thus, while reform has closed loopholes and raised top rates within the income tax regime, it could have simultaneously opened another loophole through the significant reduction of the capital gains tax (a loophole popularly exploited in the US). Although structurally the legislation is strong and has excellent potential to achieve its goals, as with nearly all reforms, implementation will be as significant as the bill itself.