Peruvian “Solidarity Tax” Unlikely to Offset Deficit Spending

July 10, 2020

Due to the COVID-19 crisis, Peru has found itself with high levels of government spending that has resulted in a significant deficit. In order to offset costs, the government is considering a temporary wealth tax that has been termed the “Solidarity Tax.” However, while it is important that Peru find ways to offset its deficit spending, the Solidarity Tax may introduce more problems than it solves.

Impact of Crisis and Policy Response

Peru is one of the countries most affected by the COVID-19 crisis. As of July 7th, Peru’s number of new COVID-19 deaths per million people was only exceeded by that of Chile, according to data from the European Centre for Disease Prevention and Control.

Peru’s economy, which is export-reliant, has been hit heavily by the pandemic. The country was under complete lockdown from March 16th to June 30th. These early lockdown requirements reduced mining, hitting copper exports particularly hard, a major blow for the country, which is the world’s second-largest copper producer. Peru’s central bank has predicted an economic contraction of 12.5 percent in 2020.

As of July 1st, the government passed fiscal support measures exceeding 7 percent of the country’s GDP. Funding was directed to pandemic-related spending, transfers to vulnerable populations, and other relief measures. Payment deadline extensions for taxes and utilities were also made available.

The country’s central bank has cut its policy rate to 0.25 percent and reduced bank reserve requirements. In order to facilitate financial system liquidity, it has engaged in open market repo operations and passed a 60 billion sole (US $17 billion) liquidity assistance package. The package amounts to over 8.8 percent of GDP.

The central bank has predicted a fiscal deficit of 9.7 percent of GDP this year. So far, Peru has handled increased spending by making use of reserves and selling bonds.

Solidarity Tax Proposal

In order to offset the deficit, the Martín Vizcarra government has been considering raising taxes on the wealthy. One such proposal is the Solidarity Tax. The Vizcarra government has made multiple comments regarding the proposed tax. Mr Vizcarra has claimed that it is necessary for Peru’s wealthiest to show “solidarity” during the pandemic. The Finance Minister, Maria Antonieta Alva, affirmed that the government is looking to raising taxes on the wealthy “inspired by the principle of solidarity.”

The tax would be a temporary measure imposed through 2020 targeted at raising 300 million soles (US $85 million), which would amount to roughly 0.5 percent of GDP. The Solidarity Tax would function as a wealth tax. However, exact details for the proposal have not been released. In a comparable case, Colombia introduced a 3-month solidarity tax from May to July, 2020, which applied to public servants with monthly salaries exceeding 10 million pesos (US $2,500).

Wealth taxes vary in structure across different Organisation for Economic Co-operation and Development (OECD) countries. Only Italy, the Netherlands, Norway, Spain, and Switzerland currently have net wealth taxes. Net wealth taxes are generally levied on an annual basis on an individual’s assets and property less liabilities. In OECD countries, wealth tax rates range between 0.1 and 0.7 percent. Revenues do not tend to exceed 1.0 percent of GDP.

Due to high levels of inequality in Peru, a net wealth tax there could differ in the scope of its redistribution effects compared to OECD countries. In 2014, Peru’s Gini Index coefficient, a statistical measure of income inequality in a country, was 0.44, a high score relative to the European Union 2010 average of 0.29.

The Peruvian economy functions largely in the informal sector. Most of the population does not pay income tax. The bulk of government revenues come from the value-added tax (VAT), a consumption-based tax. In developing countries, such as Peru, the burden of a VAT can be progressive due to unequal enforcement between formal and informal sectors. A wealth tax, as a direct tax, would diversify Peru’s revenue streams and move the country away from VAT-dependence.

The ability of a wealth tax to raise significant money is questionable. The number of countries with wealth taxes in the OECD dropped from 12 to 4 between 1990 and 2017 due to their low ability to raise revenue and implementation issues. In the long run, wealth taxes lower GDP as a result of increased consumption and decreased investment. A wealth tax could also induce some high-earners to move capital abroad, where it is harder to tax.

While a temporary wealth tax would likely be less damaging to GDP than a permanent one, doubts over how effectively it could raise revenue remain.

The Solidarity Tax has gained in popularity as the result of positive media coverage, but economists including Alfredo Thorne, the former economy minister of Peru, have warned that the proposal is unlikely to raise much revenue. Furthermore, the tax would only be able to be levied by municipalities due to constitutional limitations, creating another potential problem for its implementation.

Despite its popularity, the Solidarity Tax proposal is unlikely to achieve its stated goals.

Conclusion

It is important for Peru to offset projected deficit spending of nearly 10 percent of GDP. However, a wealth tax is a poor way for the government to reach this goal due to implementation difficulties, constitutional concerns, and the historical lack of success of wealth taxes in raising revenue in other countries.

Instead, Peru should look to formalizing its informal economy in order to bring more workers under the tax umbrella and further diversify its sources of revenue for sustainable public finances.

To achieve this, Peru can take advantage of virus-related crisis payments as a way to expand government registries, which can be used in formalization projects. For example, Brazil’s 600-real (US $152) per month emergency aid required formalized documentation in the form of a taxpayer number. The project succeeded in registering over 22 million informal workers in the first 24 hours.

Given other available policy measures, Peru should rethink the Solidarity Tax.

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