Can a wealth tax reduce inequality in Latin America and the Caribbean?

The COVID-19 pandemic had strong economic and social impacts that have exacerbated the problems of inequality between rich and poor. While the wealthier classes were able to preserve their jobs and work remotely, many low-income workers lost their sources of income overnight, or saw their incomes shrink dramatically. This increase in inequality, coupled with large fiscal deficits, has led several countries in the world and in Latin America and the Caribbean (LAC) to consider introducing or reforming wealth taxes, either permanently or temporarily.

The discussion about the role of tax systems in the redistribution of income is a welcome one in LAC, since, as is known, our region is the most unequal in the world. According to an IDB study[1], the richest 10% of the population earns 22 times more than the poorest 10%, and the richest 1% of the population earns 21% of the income of the entire economy. This inequality is even greater when wealth, instead of income, is analyzed. A study by Credit Suisse[2] finds that the richest 1% in the region owns 41% of total wealth, and that the wealthiest 10% in the region concentrates 72% of it.

Despite this enormous inequality in the region, the current tax policy has not significantly contributed to reducing it. This is largely the result of tax systems that rely heavily on consumption taxes, high levels of evasion, high tax expenditures that favor the wealthiest, and low levels of personal income and wealth tax collection. Thus, the current discussion on the wealth tax represents an opportunity for governments in our region to increase the redistributive impact of their tax systems.

Wealth tax design and implementation

Wealth taxes are an instrument that can increase the redistributive impact of tax systems. In practice this impact can be very limited if they are not properly designed and managed.

In fact, most countries that implemented wealth taxes observed low levels of collection, a consequence of high evasion or aggressive tax planning by taxpayers to evade the tax. These low collection levels, coupled with concerns about efficiency losses in the economy discussed below, led several countries to eliminate this tax.

Thus, while 12 countries of the organization for Economic Cooperation and Development (OECD) had a personal wealth tax in 1990, currently only 3 countries (Spain, Switzerland, and Norway) have such tax. In LAC, only 3 countries (Argentina, Colombia, and Uruguay) had this tax before the crisis generated by the COVID pandemic. In both regions the collection of such tax is low. In OECD countries, the average wealth tax collection in 2018 represented only 1.8% of total government revenue (or 0.56% of GDP[3]), while in the LAC countries this figure was 0.25% (or 0.06% of GDP).

Main difficulties related to wealth tax management that facilitate its evasion

To understand the difficulties faced by tax administrations in managing a wealth tax or, looking at the other side of the coin, the ease with which taxpayers can evade or avoid their payment, it is useful to think of an “ideal” design of the tax.

A wealth tax should be structured as a tax on a person’s or family’s total net worth. In this sense, the tax base should include the total assets (gross assets) and deduct the debts or obligations that the individual has. The assets to be considered should be all of them, that is, both the financial assets (bank deposits, bonds, shares, etc.) and physical assets, including property, works of art, jewelry, luxury goods (such as yachts and private jets), vehicles, etc.

In addition, the assets to be considered should be both those that are in the individual’s country of residence, and abroad. Assets that are indirectly in the name of the individual, through organizations, foundations or trusts owned by the individual, should also be included.

When analyzing this “ideal” design, two major challenges for the effective administration of this tax clearly emerge. The first challenge is to know what assets are owned by a person. While tax administrations may have information about certain assets in the country, such as ownership of real estate, vehicles, bank accounts; many other assets can be easily hidden, such as jewelry or works of art. In addition, tax administrations often have very little information about assets in trusts or abroad. While the latter challenge has been reduced in recent years thanks to international efforts to exchange information for tax purposes[4], there are still significant challenges in this area.

The second big challenge is knowing the value of the assets owned by a person. While it may be easy to know the values of certain financial assets, such as bonds and stocks, knowing the value of physical assets that are not traded frequently on the market can be more complex. What is the value of a family business or a work of art? For these cases, the valuation of the asset is usually self-reported by the taxpayer, which creates incentives to underreport the value of the asset to reduce the tax payment.

Good intentions that facilitate avoidance

In view of such difficulties, and as a result of pressure from stakeholders, wealth taxes often exclude certain assets from the taxable base, such as:

• Family businesses, to promote entrepreneurship
• Primary residences, for social reasons, because they are fixed assets and because they are usually subject to the property tax
• Pension assets, so as not to penalize families´ savings due to social concerns
• Agricultural properties, as they are unmovable businesses, and their payment can force the sale of property
• Assets abroad because they are difficult to know
• Works of art and antiques, because they are difficult to value, and to protect the cultural heritage of the country

These exclusions, while often well-intentioned, involve preferential treatment of certain assets. This distorts individuals’ investment decisions by generating incentives to invest in tax-exempt assets. Spaces for avoidance are also created. For example, people can borrow to buy exempt assets, debt that they then discount against non-exempt assets.

Possible negative impacts on savings

Taxes on wealth can affect certain decisions of people, which reduces the efficiency in the allocation of resources in the economy. Two decisions that can be affected are those about how much to save and what assets to invest in[5].

Regarding savings decisions, the wealth tax, like other capital taxes, can discourage savings by reducing the financial return on investments. While this outcome is theoretically possible, in practice, the few studies on this issue do not find significant impacts of wealth taxes on the amounts saved by the taxpayers[6]. The literature finds that this is partly due to the wide margins given to taxpayers to avoid paying taxes, which counteracts the tax effects on the investment returns.

While the wealth tax may not impact the amount of people’s savings, the literature has found strong effects on decisions about the types of assets in which people invest. As mentioned, a wealth tax generates incentives to invest in tax-exempt assets, or in non-exempt assets that are difficult to detect or appraise by tax administrations.

Possible negative impacts on investment

An example of this change in the composition of wealth is well documented for Spain. In 1994, an exemption was introduced that established the non-payment of taxes on shares of companies in which an individual owns at least 15% of the shares (or the individual and his family at least 20%) and is actively involved in their management. In 1994, for the richest 0.01%, exempt shares accounted for 15% of their investments in companies. This percentage has increased over time, reaching 77% in 2002[7]. Another interesting example is in Catalonia. After the reintroduction of the wealth tax, there was a sharp increase in investment in corporate assets and primary residences, which are exempt from the tax[8].

Another important distortion is about the decision of the wealthiest citizens about where to reside, or in which jurisdictions to invest their wealth in order to evade payment of the tax[9].

Evidence of these effects was documented regionally in Switzerland, where reductions in the tax rate in one canton attracted investments from taxpayers from other cantons[10]. Another regional example is found in Spain, where the decentralization of the wealth tax led to it being applied throughout the territory, except for Madrid. This led to an increase in Spaniards who declared tax residence in Madrid[11].

At the national level, although there is no robust evidence in the literature, there are numerous anecdotal cases of billionaires moving from country to country, as is the case of several French billionaires who established tax residence in Belgium, to avoid the Solidarity Tax on Fortunes and a likely future increase in the income tax rate[12].

Finally, another often-mentioned distortion is that wealth tax can lead to inefficient selling of assets for cash reasons, as many assets may have high value but do not generate large cash flows. Such is the case with farms.

The real estate tax and other complementary options to improve the fairness of the tax system

Despite the difficulties to effectively implement a wealth tax, it is important to recognize that this tax is not the only instrument to make the national tax system more equitable. There are various taxes that can increase the progressiveness of the tax system, which are less complex to collect and distort less. Many of these taxes are not being exploited sufficiently in LAC.

The most obvious case is the property tax. This tax is clearly related to household wealth, because it is a tax on assets that focuses exclusively on land and real estate. This is a simpler tax to manage, as governments have information from property records and a better idea of property values. In addition, it is a tax on immovable property, which reduces the elasticity of the tax base.

Despite the various benefits of the property tax, it is not being sufficiently exploited in LAC. While in the OECD the collection of real estate tax has increased over the last decade, from 0.9% to 1.2% of GDP, in Latin America the level of collection has remained virtually stagnant at around 0.4% of GDP.

An IDB study on this subject, called The Hidden Potential, recommends that in order to enhance the collection of this tax in the region, governments must, among other measures, modernize their property registry systems to have information on existing real estates, as well as on their current value. It is also important to strengthen the local tax administrations, as these taxes tend to be collected by subnational governments, with significant weaknesses in tax management.

Taxes on donations, successions, and inheritances

In addition to the real estate tax, there are other wealth-related taxes that may be easier to manage, and in some cases distort less. Such is the case with taxes on donations, successions, and inheritance.

Like wealth taxes, these taxes can be highly progressive and lead to greater equality of opportunity. One of the main advantages of these taxes is that they usually generate fewer behavioral changes than wealth taxes. Studies on inheritance taxes tend to find that net worth in late life stages is not very sensitive to changes in the inheritance tax rate[13].

With regard to the tax on donations, empirical evidence often finds that donations respond a lot to taxes, although they also find that donations are often significantly underutilized as a strategy to reduce inheritance taxes[14]. The management of these taxes, while presenting some complexities, is very convenient administratively, since the tax is collected at the time the assets are transferred, thus increasing the ability of the tax administration to detect them.

In addition, in many cases the assets need to be valued at the time of transfer, which facilitates the problem of knowing the value of the assets. These taxes on the transfer of wealth do not have a significant level of collection in the region (0.01% of GDP, compared to 0.13% in OECD countries), so their design or implementation could be revised to increase the progressivity of the tax system.

Personal income tax

Finally, it is also important to recognize that there is a relationship between personal income tax and wealth tax. Wealth is nothing more than income accumulated through savings, while part of personal income is financial return to wealth. For the wealthiest, this return on wealth is usually the bulk of their total income, since labor income represents a low proportion of their income.

Recognizing this is important, as it is often argued that the wealth tax represents a double taxation on income. This is because people already paid taxes on the income saved to acquire the assets taxed by the wealth tax. In LAC, the amounts of income tax paid by the wealthiest are usually relatively low, a consequence of numerous preferential treatments and high evasion rates.

For this reason, before introducing a wealth tax, it may be advisable to correct the deficiencies in the policy and management of the personal income tax. This tax indirectly taxes wealth, can distort less and be easier to manage than a wealth tax.

Recommendations for a good design and implementation of the wealth tax

For those countries wishing to make progress in introducing or reforming a wealth tax, it is important to emphasize that the effectiveness of wealth taxes depends not only on decisions about which assets to tax and how to determine their value; but also, on decisions about the exempted minimum and the rates applied from that threshold.

In determining these elements, governments need to consider that these cannot be defined in isolation, but that the interaction with other existing taxes, such as personal income tax or property tax, must be considered.

This dependence on other taxes is especially important for defining the threshold from which one starts paying the wealth tax. Many countries exclude from the payment of this tax people with net worth below a certain amount, so that the tax affects only the rich. The definition of this threshold will depend, for example, on the characteristics of income tax. If the country already has an income tax in place that taxes capital returns, the thresholds for exemption from wealth tax should be high, to ensure that the tax only applies to the rich. If there are no taxes on broad-based capital income, the exemption thresholds should be lower.

Regarding the level of tax rates, since they are a tax on shares, it is recommended that they be relatively low in those countries where capital income taxes exist. This will prevent capital flight due to excessively high tax burdens. Tax rates should also be progressive, especially in those cases where income taxes have numerous exemptions and deductions, or where there are no taxes on the transfer of assets.

It is essential to be cautious with tax exemptions and reliefs

Finally, governments must also be very cautious with tax exemptions and deductions, always defining very clear criteria for their application. In this regard, it is important to establish that debts are deductible only if they have been contracted to acquire taxed assets. In addition, rules should be established to prevent international double taxation on property.

Other recommendations, related to the management of the tax, are:

• Create agreements with local institutions, to have information on the holding of assets and the market values of such assets.
• Strengthen mechanisms for the exchange of information with third countries on assets held by residents in other jurisdictions.
• Strengthen mechanisms to know the assets of individuals in trusts.
• Keep the value of hard-to-value assets constant for a few years, to avoid annual revaluations.
• Allow installment payments for taxpayers facing liquidity constraints.

The role of the wealth tax within a redistributive tax policy

To conclude, it is important to remember that the wealth tax, despite having the potential to achieve more progressive tax systems, is not the only solution to reduce the inequality problem in a country. This tax is just one more instrument in a toolbox.

It is also important to mention that the progressiveness of the tax system depends not only on tax policy, but also on the levels of evasion. Since the rich are the ones who evade the most, the most effective way in the short term to make tax systems fairer and more equitable is by strengthening tax administrations, so that they can reduce high levels of evasion.

Finally, it is important to emphasize that, from a social welfare perspective, what is ultimately relevant is the progressivity of fiscal policy, including not only taxes, but also social spending. In fact, in countries where the fiscal policy is more redistributive, most of this redistribution occurs through public spending and not through taxation. For this reason, to increase the impact of fiscal policy on LAC it is important that countries adopt a comprehensive vision, considering all the taxes and the social spending.

This blog was translated from the original version in Spanish by the Inter-American Center of Tax Administrations

[1] IDB (2020): the crisis of inequality: Latin America and the Caribbean at the crossroads.
[2] Credit Suisse (2019): Global Wealth Report 2019.
[3] Data comes from 2018 and the from the OECD Global Revenue Statistics Database.
[4] Major international cooperation efforts for the exchange of information for tax purposes came under the U.S. foreign accounts Tax Compliance Act (FATCA) and the Common Reporting Standard (CRS) for the automatic exchange of financial information, an OECD-led effort at the request of the G20.
[5] Scheuer, y Slemrod. 2021. “Taxing Our Wealth.” Journal of Economic Perspectives, 35( 1): 207-30.
[6] See studies by Brülhart et al. (2021) y Agrawal et al. (2021), mentioned in subsequent footnotes. This result is also found in Seim (2017),Behavioral Responses to Wealth Taxes: Evidence from Sweden, American Economic Journal: Economic Pol icy 2017, 9(4): 395–421.
[7] Alvaredo y Saez. 2009. “Income and Wealth Concentration in Spain from a Historical and Fiscal Perspective.” Journal of the European Economic Association 7 (5): 1140-67.
[8] Duran-Cabré, Esteller-Moré, and Mas-Montserrat. 2019. “Behavioural Responses to the (Re)Introduction of Wealth Taxes. Evidence from Spain.” IEB Working Paper 2019/04.
[9] It can also discourage foreign investments in the country, if these investments are taxed with the wealth tax.
[10] Brülhart, Gruber, Krapf, y Schmidheiny. 2021. “Behavioural Responses to Wealth Taxes. Evidence from Switzerland.” CEPR Discussion Paper 14054.
[11] Agrawal, David, Dirk Foremny, and Clara Martínez-Toledano. 2021. “Tax havens, Wealth Taxation and Mobility”  Working Papers 2020/15, Institut d’Economia de Barcelona (IEB)
[12] https://www.france24.com/en/20140914-france-super-rich-fortunes-belgium
[13] For the case of USA, Kopczuk y Slemrod (2001) enfound elasticities between 0,1 y 0,2. Kopczuk, Wojciech y Joel Slemrod 2001. “The Impact of the Estate Tax on Wealth Accumulation and Avoidance Behavior”, in Rethinking Estate and Gift Taxation, W. Gale, J.R. Hines and J. Slemrod eds., The Brookings Institution, 299–349.
[14] For the case of the United States, Joulfaian and McGarry (2004), find that: (I) only one-third of people who pay inheritance tax make donations throughout their lives, (ii) donations are infrequent, and (iii) on average donations only account for 10% of the estate. Joulfaian, David y Kathleen McGarry, Estate and Gift Tax Incentives and Inter Vevo’s Giving,” National Tax Journal, June 2004, 57 (2 (part 2)), 429-444.