Costa Rican Tax Reform Needed, Says IMF

by Mike Godfrey, Tax-News.com, Washington

15 April 2011

Concluding its mission to Costa Rica, the International Monetary Fund has said that the medium term economic outlook is broadly positive, and that tax reform is key to the securing of a higher revenue base.

As part of consultation discussions with Costa Rica, the IMF mission visited the country from March 28-April 12, and met with senior officials, including the Vice President, Minister of Finance and head of the Central Bank. The mission concluded that private consumption led a recovery in economic activity, with inflation remaining within official targets. The current account deficit widened, but, according to the IMF, this was comfortably financed by large foreign direct investment and private capital inflows.

However, despite significant foreign exchange intervention, Costa Rica's exchange rate appreciated, nearing the exchange rate band's ceiling, and the combined public sector deficit rose to 5.5% of GDP. This rise is attributed to subdued tax revenues and higher government expenditure. Nonetheless, in the medium term, the IMF sees Costa Rica's economic outlook as positive, with real growth GDP expected to hover around 4% - 4.5% in 2011, with inflation declining in subsequent years.

The mission's chief Marco Piñón also issued a warning as to the fiscal issues that the government must now address. He said: "In the medium and long term, the key challenge is to lower the fiscal deficit significantly. In this regard the mission considers that the draft tax reform recently sent to Congress is key to secure a higher revenue base that increases the country’s capacity to respond to adverse shocks. However, efforts on the revenue side will need to be supplemented by prudent expenditure policies, including through a medium-term framework to help reduce the share of current government spending over GDP".

Planned reform of the tax system in Costa Rica has stalled over a number of years, hitting various stumbling blocks since the then government first attempted to introduce a Permanent Fiscal Reform Package in 2002, designed to tackle the deficit. The package sought a move away from a territorial tax system, proposing to switch instead to one taxing worldwide income. In addition, repeal of the sales tax was proposed, to be replaced by a value added tax (VAT) system. After four years, a constitutional controversy brought the bill down in 2006, only for a newly elected government to reignite discussion of reform the same year. Many of the 2002 proposals were to be retained, but important additions such as the levying of real estate tax on luxury properties, a financial transactions tax, and a tax on all legal persons, were explored.

More recently, the administration of president Laura Chinchilla has indicated its intention to push ahead with tax reform, with the country's Finance Minister arguing in November, 2010 that a substantial increase in income could only come through tax reform. In January, 2011, the government introduced its proposals to the legislature. The proposal to introduce VAT, on the table since 2002, was a key component of the new package - the change would see the 13% sales tax replaced by a 14% VAT, a figure reduced from a previously mooted figure of 15% in the face of opposition. In addition, the reforms would, among other provisions, introduce changes to corporate deductibility and small business tax rules, harmonize the taxation of capital income at 15% and increase taxes on vehicles by 10%. However, evidence of the ongoing struggle tax reform faces in the country came in April, when it was reported that plans to levy a 15% gross revenue tax on land-based casinos had been sidelined, as the government attempted to push through the more crucial of its tax reforms.

In light of Costa Rica's complex history of dealing with the thorny issue of tax reform, the IMF's most recent comments in fact only add to a raft of recommendations it has previously made in this area. In 2008, it stressed that the approval of substantial tax reform, including changes to the income tax and VAT systems, was a priority. This was followed in 2009 by an observation similar to that made by Piñón this April. It was argued that tax reform was required to aid deficit reduction, but that consensus was required on the need to increase revenues, which would then pave the way for the passage of reform. It is therefore debatable as to whether the IMF's latest urgings will provide any substantial impetus in the direction of reform.

Mission staff are set to prepare a report to the IMF’s Executive Board, which will then form the basis for a basis for a Board discussion in late May.

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