1 – What reform was chosen (major components) and why?
The Government of Nicaragua (GON) negotiated a PRGF program, approved by the Board of the IMF in December 2002, which incorporated specific fiscal targets to strengthen Nicaragua’s fiscal situation and support a path for improving its primary balance. In the context of this new PRGF, the GON started work on a fiscal reform to initiate implementation in calendar year 2003. The main reasons for selecting a PSIA of the Nicaraguan Tax Reform (the Fiscal Equity Law) were: (i) first, because the World Bank was asked by the GON to provide support to analyze the potential distributional impact of this fiscal reform; (ii) second, while attention was given to the quality of the tax reform, the need to generate more revenues was clearly a more pressing motivation for the reform so all stakeholders and donors had expressed concern about its poverty and social impact; and, (iii) third, because of the explicit intention expressed by the GON to incorporate these findings into the 2nd PRSP Progress Report.
The Tax Reform (the Fiscal Equity Law) was selected, whose main objectives are: to simplify the tax system, to expand the tax base, to better manage the nation’s public finances, to promote equitable distribution of the tax burden, to reduce tax evasion, and to make the tax system more efficient and progressive.
The Reform simplifies the tax system through eliminating the zero-rate Sales Tax on the sale of items for the domestic market and lowering excise tax rates; improves equity through reducing the number of exonerations and exemptions, taxing financial profits, increasing the income tax rates paid by higher income individuals, and introducing a minimum tax on corporate earnings; and strengthens tax administration through implementing various administrative measures and creating related civil service positions. In addition, the government will maintain its commitment to an austerity policy, thereby rationalizing public spending.
Some of the Reform’s specific measures include: modification of the progressive individual income tax rates for those with the highest incomes; institution of a definitive minimum Income Tax payment by individuals or corporations dedicated to business activities; elimination of the zero-rate for domestic market products and the declaration of products from the basic basket of consumer goods that had previously been part of the zero-rate regime as exempt; elimination of discretionary exemptions; and institution of a legal basis for different taxes and regulation of their application. Finally, the reduction of the Sales Tax rate to 14% is expected if the tax revenue increase is more than anticipated (0.6% more of the GDP).
The distributional impact of the tax reform was analyzed, and it was found to positively improve income distribution.
2 – What are the institutional mechanisms through which the reform will be carried out?
The Reform professionalizes tax and customs administration through strengthening the faculties of the Treasury Department (MHCP), aiding its implementation of this Law. It also endows revenue-collecting agencies such as the Internal Revenue Service (DGI) and the General Customs Department (DGA) with all power needed to fully implement the Law’s regulation. It authorizes the legal and penal systems to exercise their powers in the case of non-compliance. The Law also assigns other institutions the faculty to collect revenues, such as Banks, Financial Institutions and NGOs, giving them a normative and supervisory character. Eventually, the Reform will facilitate approval of the new tax code and fiscal responsibility law.
The shifting assumptions methodology was used to evaluate the Reform’s distributional impact. This method uses different hypotheses about which social groups bear the burden of tax changes. Thus, it is assumed that increases in taxes on consumption (sales tax) will be borne by each decile of the population in proportion to their share of consumption of the goods whose prices increase because of the Reform. Similar assumptions were made for each of the changes introduced by the Tax Reform.
3 – What stakeholders are likely to be affected by the reforms? Which stakeholders are likely to affect the reform and how? / 4 – Through which channels are the stakeholders affected? / 5 – What are the expected direction and order of magnitude of impact(s)? What are the underlying assumptions?
Labor market / Prices / Access to goods & services / Assets / Transfer and taxes
Stakeholders affected positively:
Export sector: The 0% rate (sales tax) is maintained for exports. The benefit of accelerated depreciation is limited to only those firms participating in the Temporary Import Law, and the minimum annual exports required for participation in the Temporary Import Law is lowered from US$100,000 to US$50,000, / The prices of inputs are less expensive for smaller export firms. / The acquisition of inputs for small export firms is simplified and therefore easier. / The accel-erated depre-ciation regime is main-tained for most exports. / Allows sales tax paid for inputs to be refunded, assigns a 1.5 tax credit line to the FOB value of exports, and permits a credit of 25% of the value of excise taxes paid for fuels toward Income Tax. / Short term: Facilitates access to imported goods and services for the smallest export firms.
Long term: Maintains the tax regime for the export sector, in a context of important changes to tax norms.
Agriculture sector, small-scale industry, small-scale fishing, and the coffee sector. / Allows sales tax paid for inputs to be refunded, excise taxes paid for fuels to be refunded, and exonerates these sectors from the minimum Income Tax payment. / Short term: Permits these sectors to benefit from temporary fiscal provisions.
Stakeholders affected negatively:
Individuals with savings accounts containing more than US$5,000 or with bonds that mature in less than 4 years. / 10% interest is applied to interest. / Short term: The tax burden is transferred to individuals with savings accounts, reducing their net revenues.
Long term: Promotes long term investment, or investment in government bonds (CENIS).
Foreign consultants (business or transactions via internet). / 20% interest is applied and withheld by the service contractor. / Short term: Although this represents a net loss for foreign consultants, it makes the system more uniform and increases revenues.
Consumers / The changed tax status of various products from the basic basket of goods (from zero-rate to exempt) could cause price increases to final consumers. / Products not included in the basic basket will continue being taxed. / Short term: 53 products from the basic basket will be exempt from Sales Tax. These products, as well as electricity service, constitute the basic needs of the lowest-income deciles of the population. Prior to the Reform, these products were subjected to a zero-rate sales tax. Their exemption eliminates bureaucratic procedures for receiving refunds under the zero rate system, and simplifies the tax system (15% sales tax for the remaining products), but will certainly increase prices, since the State will not refund Sales Tax fiscal credits.
Long term: Authorities should find a more efficient channel for allocating resources, such as focalized assistance or a voucher system for the poorest members of society.
Sectors that lose exonerations: Production of goods and services (transportation and agro-industrial cooperatives, Nicaraguan air transport, forestry, and mining), the Social Sector (Ministries of Health and Education), the Government (state institutions, the executive branch, the electoral branch, National Assembly Deputies, municipal governments, etc.), and Other Sectors (returning citizens) / If sectors lose competitive-ness due to the loss of fiscal benefits, there could be losses and a reduced demand for labor. / Sectors that lose benefits and are productive may transfer higher taxes to prices. / These sectors could experi-ence reduced competi-tiveness, which would affect the supply of goods and services. / Eliminates exonerations and exemptions from Sales Tax, Excise Taxes, Income Tax and Import Duties for sectors that had benefited from 57 legal provisions. / Short and Medium term: Permits expansion of the tax base, and makes the tax system more neutral, with uniform treatment for all sectors.
Long term: Permits competition on the basis of greater efficiency, and not on the basis of special treatment mechanisms that translate into greater tax pressure on other sectors of the economy.
Individuals and corporations dedicated to economic activities. / Increases the progressive Income Tax Table for one stratum of the population, unifying the maximum individual and corporate Income Tax rates.
Establishes the definitive Income Tax payment of 1% of the total value of gross assets. / Short term: Eliminates differences in the tax rates paid by individuals and corporations, preventing the erosion of the tax base and increasing vertical equity.
Minimum Income Tax payment increases this tax’s revenues by putting a limit on tax evasion. This strengthens vertical equity, and increases effective tax collection.
The taxation of assets could lead to over-taxation.
Small-scale fishing industry. / Establishes annual payment for fishing licenses and permits, as well as monthly fees for use of natural resources. / Short term: Controls the use of natural resources, requiring payments to regulate the industry.
Stakeholders with significant influence over the reform: / Possible support or opposition:
Exporters / Maintain their fiscal benefits.
Consumers / The population deciles that consume the basic basket of consumer goods could oppose the reform. However, the impact of the approved package of measures on income distribution is positive, especially if the additional resources generated are used to finance focalized public spending for the lowest-income groups.
Political Parties / It is possible that political divisions and Nicaragua’s governmental history could generate opposition to this Law’s implementation.
Civil Society and the Media / Could exert pressure to take part in the design of the Reform’s regulations, or in the definition of future Legislative Reforms.
What information basis and techniques were used to answer questions 3, 4 and 5?
Laws published in La Gaceta were referred to (Law 439: Tax Base Expansion Law; Law 453: Fiscal Equity Law; and other laws that were modified by the Reform). Also, the Treasury Department’s method of evaluating the impact of taxation was used, together with revenue estimates from the Internal Revenue Service (DGI) and income estimates provided by the Central Bank of Nicaragua. The study also evaluates the Reform’s distributional impact through use of a “shifting assumptions” methodology.
6 – What are the main risks which would change the expected impact of the reform? What are their likelihood and expected magnitude?
Type/nature of risk: / Likelihood / Expected magnitude
- Economic Policy Risks:
Those seeking profits can obtain many benefits that are not available to other sectors. / Given that some sectors maintain their fiscal benefits, it is possible that they will defend these benefits or want to obtain others through modifying the Law’s regulations or the Law itself. Sectors without access to these fiscal benefits could generate opposition to the Reform.
Civil society and the private sector. / These could protest because they were not included in formulating the Law or its regulations, or because they have been assigned a greater tax burden.
Political opposition groups. / Polarization of the National Assembly makes agreement more difficult, weakening good governance.
- Exogenous shocks:
Free Trade Agreement / If a Free Trade Agreement with the US is approved in the short term, or if the tariffs of the Central American Common Market are reduced or unified, revenue goals could be negatively affected since additional measure will be needed to guarantee compliance with the revenue and tax targets.
- Institutional risks:
Constitutional provisions could be applied to some Articles of the Law, due to the failure to publish its regulation. / Once the Regulation of the Law is published and implemented, the boundaries for action by sectors opposing the Reform will be stipulated.
- Other country risks:
Slow economic reactivation. / The Government’s 2 year effort to promote economic reactivation is an inducement for macro and political stability, good governance, the reduction of opposition to the Reform, and finally for the transition to a more efficient and equitable tax system. Although the economy has not yet been reactivated, the Reform contains elements that promote both medium and long-term growth.
7 – What impact has the analysis had on national policy discussions?
The Nicaragua PSIA on the Fiscal Equity Law was fully concluded by October 2003. Its major findings were discussed on time for PRSC preparation before its presentation to the Board on February 2004. This PSIA was reviewed by the IMF, providing favorable and useful comments. Findings were incorporated into the PRSP 2nd Progress Report presented to the Boards in February 2004.
Discussions of PSIA findings in Nicaragua took place in three workshops, one with the MHCP and donors, another one with PSIA Committee members and a third one with civil society members of the National Council for Economic and Social Planning (Consejo Nacional de Planificación Económica y Social or CONPES). CONPES was the main group for consulting civil society representatives for the PRSP.
At present, multilateral and bilateral donors are working towards Joint Financing Arrangement (JFA) on General Budget Support between the GON and the donor group. The Performance Assessment Matrix (PAM) has incorporated a condition that further increases in tax collection should continue to increase vertical and horizontal tax equity on the basis of the findings of this PSIA. The condition states that the VAT tax exemptions should limit exclusively to the ten items identified comprising three-quarters of the extreme poor’s food consumption.
The GON is currently preparing a PRSP-II, so the study could also be incorporated in this revised Poverty Reduction Strategy. The study could be more widely disseminated to decision-makers in the public sector and representatives of the other branches of government, such as the National Assembly, to political parties, the private sector and the media. Any future components of the Reform would also make use of the findings of the study.
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