US embassy cable - 05TEGUCIGALPA1745

UNCLAS SECTION 01 OF 05 TEGUCIGALPA 001745 
 
SIPDIS 
 
STATE FOR WHA/CEN, WHA/ESPC, AND EB/IFD/OMA 
STATE PASS AID FOR LAC/CEN 
STATE PASS USTR, EXIM AND OPIC 
STATE PASS USED WB, AND USED IMF 
TREASURY FOR DORA DOUGLAS 
COMMERCE FOR MSIEGELMAN 
LABOR FOR ILAB 
GUATEMALA FOR COMATT MLARSEN 
 
E.O. 12958: N/A 
TAGS: EFIN, ECON, EAID, ETRD, ELAB, PGOV, HO 
SUBJECT: Honduran Fiscal Policy:  Academicians Present Tax 
Collection Reform Proposals; GOH Pledges Only Discipline 
 
 
1. Summary.  A recent seminar on the importance of tax 
reforms raised a number of interesting themes, but GOH 
officials present limited their remarks to exhortations for 
discipline and calls for increased tax revenue.  Featured 
academic speakers said there must be improved tax 
collection, a more efficient and transparent tax authority, 
and sustainable debt levels overall.  One speaker made the 
case for scrapping the entire current income tax system in 
favor of a flat tax. The World Bank speaker pointed to the 
need to always remember the purpose behind the taxation, 
urging officials to look at quality spending as the driver 
of tax policy.  The closing speaker reminded attendees that, 
as elegant as any economic theory might be, implementation 
is a messy political business and results will often fall 
short of the mark.  End Summary. 
 
2. On August 18, the Honduran NGO Foundation for Investment 
and Export Development (FIDE), with support from USAID, 
sponsored a one-day workshop on fiscal policy focusing on 
tax collection.  In addition to featured academicians, the 
program included interventions by the Minister of Finance, 
William Chong Wong, the Director of Public Credit Orlando 
Garner, and World Bank Senior Economist Dante Mossi. 
Sessions focused on the importance of tax collection to 
development, the role of the tax authorities, sustainability 
of public debt, and lessons learned from the Guatemalan 
"fiscal pact" experience. 
 
Minister of Finance: Cracking the Whip 
-------------------------------------- 
 
3. Speaking for less than ten minutes, Minister of Finance 
William Chong Wong used the occasion to deliver a fiscal 
tough-love message.  The GOH must maintain fiscal 
discipline, he said.  Debt forgiveness is a wonderful thing, 
but it cannot be used as a justification to lower taxes. 
Similarly, CAFTA is a great opportunity for Honduras, but a 
way must be found to make up for the revenue losses from 
cutting customs duties, which he estimated at 750 million 
Lempiras (about 40 million USD) over the next 5 years. 
Finally, he said, Foreign Direct Investment is an important 
source of economic growth, but foreign firms must pay their 
fair share of taxes.  Chong said he is seeking double 
taxation agreements with the U.S. and other countries, to 
ensure that firms pay their taxes in Honduras and receive 
tax credits in their home country.  He also wants greater 
data sharing with trade partners, to minimize the use of 
transfer pricing schemes to evade taxes. 
 
VAT Taxes for Revenue; Social Spending for Progressivity 
--------------------------------------------- ----------- 
 
4. In an information-rich and rapid-fire presentation, 
Interamerican Development Bank (IDB) Senior Economist 
Alberto Barreix focused on why tax reform is needed in 
Central America.  First, he said, the growing 
interconnectedness of economies has removed most freedom of 
choice regarding commercial, monetary, and exchange rate 
policies, leaving only fiscal policy as an economic lever 
for national governments.  Second, there is a growing 
recognition that certain investments -- particularly in 
education -- must be made even in the poorest countries, if 
they are to compete effectively in the future.  If we do not 
grasp this chance, Barreix said, "we will have to answer to 
the future generations for the lost opportunities." 
 
5. Barreix then listed five specific reasons why tax reform 
is urgent in Central America:  (1) to fund improvements in 
social infrastructure and competitiveness; (2) to reach 
fiscal sustainability in highly-indebted countries; (3) to 
identify and implement substitutes for forgone revenues from 
tariff cuts under CAFTA; (4) to improve revenue collection 
by phasing out income tax exemptions in freeports 
(maquilas); and (5) to promote regional coordination in tax 
policies to prevent a "race to the bottom."  Tax theory says 
taxes must be equitable, efficient, and simple, he said; now 
we must add to that list that taxes should be easy to 
coordinate across borders. 
 
6. Drawing from his own forthcoming book, Barriex cited a 
positive evolution of tax collection in the region: 
 
Tax revenues as a percentage of GDP: 
 
          1990     1995     2000     2003 
CR        10.8     11.4     11.9     13.0 
ES         7.6     11.9     11.0     12.6 
GT         6.9      8.0      9.5     10.3 
HO        15.0     17.3     16.6     15.9 
NI         8.1     12.2     14.5     15.8 
AVG        9.7     12.2     12.7     13.5 
 
While the rest of the region continues to improve in tax 
collections, Honduras runs against the trend, actually 
seeing a decline in tax revenues as a percentage of GDP over 
the last decade.  This could be due in part to tax evasion, 
but also to the web of tax exemptions and incentives created 
to attract investment, particularly in the maquila (light 
assembly) sector. Tax incentives have been provided to the 
majority of manufacturing and assembly firms (operating in 
free trade zones of several types) and companies in the 
tourism, mining, and energy fields, providing these 
companies with exemptions from customs duties, sales tax, 
and income tax.  As Post reported previously, Honduras 
collects (using official measures) taxes equivalent to 16 
percent of GDP.  Assuming GDP in Honduras is underestimated 
by 35 percent, this tax receipt measure falls to 12 percent 
of GDP using the appropriate estimate of GDP.  The World 
Bank advises that this percentage is only half of that which 
is considered healthy for a developing country.   This level 
of tax collection is not adequate to fund the key government 
services and investments that are needed. 
 
7. Clearly, Central American countries must collect more 
taxes to better fund social obligations, Barriex said. 
However, the relatively young populations in these countries 
mean a lower social security bill, softening the blow 
somewhat and providing time to improve collections. 
According to Barriex, the fiscal situation looks like this 
(all figures in percentage of GDP as of 2003): 
 
          Total      Debt      Social      Available 
          Income    Service   Security      Income 
CR         22.3       4.3       4.4          13.6 
ES         12.6       2.0       1.3           9.3 
GT         10.0       1.0       0.3           8.7 
HO         16.9       2.0       0.9          14.0 
NI         17.8       3.8       1.8          12.2 
AVG        17.1       2.7       2.9          11.6 
 
OECD       37.4       1.6      12.2          23.6 
 
8. On the topic of value-added taxes (IVA, in Spanish) 
Barriex advocated improved tax design and improved 
collection through IVAs, since they avoid "tax cascades" 
(where taxes are being paid on previous taxes) and 
facilitate competition with the region.  He suggested 
harmonizing tax bases within the region, while allowing 
competition and fiscal flexibility in the rates.  He agreed 
that the IVA is a regressive tax, noting that "an IVA is not 
a redistributive tax; it is a tax for collections."  To 
counteract the regressive attributes of an IVA, he 
recommended targeted social spending for the poor, and 
increased application of personal income taxes.  Finally, he 
agreed with Minister Chong that as regional integration 
moves forward, data sharing among countries must be improved 
to minimize tax evasion through transfer pricing schemes. 
 
World Bank Responds:  Quality, Not Just Quantity 
--------------------------------------------- --- 
 
9. Dante Mossi, Senior Economist with the World Bank, 
responded to these points, noting that the choice of the 
level of tax revenue collections is a sovereign one and 
dependent on the quality of social services the State wants 
to deliver.  The quality of that spending is a key factor, 
as is the political choice of allocation (for example, 
whether to allocate a certain quantity of funds to educate 
one university student or six elementary students). 
Finally, the quality of tax collections is important -- that 
is, who is paying the tax burden?  What is the overall 
impact on the poor?  A 2002 IDB report entitled   "Honduras: 
Toward a More Transparent and Diversified Tax System" noted 
that the current Honduran tax structure is highly 
regressive, since most of the tax exemptions are provided to 
the wealthy.  According to the report, the poorest Hondurans 
pay a percentage of their income in taxes that is 75 percent 
higher than the average taxpayer, whereas the richest 
Hondurans pay a percentage of their income in taxes that is 
20 percent lower than average. 
 
Tax Administration Design 
------------------------- 
 
10.  While not addressing Honduras specifically, Dr. Erick 
Thompson of the University of International Cooperation 
(UCI) in Costa Rica identified the key elements in creating 
a modern tax authority (TA).  The TA should induce large- 
scale compliance, based on the fear felt by evaders of 
detection and sanction.  This fear of getting caught should 
be amplified by self-policing in the private sector, which 
should see tax evasion by a competitor as unfair competition 
and work with the TA to identify and minimize such fraud. In 
carrying out these tasks, the TA's twin emphases should be 
customer service to contributors and revenue controls. 
 
11. After a lengthy discussion of the need for and proper 
design of quality-assurance indictors for TAs, Thompson 
turned to his recommendations for Central America.  His key 
recommendation was that rather than attempt to establish a 
single, regional customs service, which would suffer from 
questions of composition and financing, Central America 
should strive for a European Union-style system, where each 
national service is preserved, but policy is harmonized. 
Enforcement must be implemented at the local level, he said, 
but policy must be centrally set and enforced to prevent 
differing enforcement regimes in the field. Asked what would 
be the duties of a Central American customs service in the 
wake of CAFTA reducing most duties to zero, Thompson pointed 
to two key additional responsibilities that would also 
contribute to revenue collection:  First, Customs would be 
responsible for administering the levying of IVA on imports. 
Second, Customs should integrate closely with internal tax 
authorities to facilitate integrated taxpayer audits by 
cross checking tax receipts with import records. 
 
Debt Sustainability:  How Much Is Too Much? 
------------------------------------------- 
 
12. Dr. Oswald Cespedes of the Assessment Commission on High 
Technology (CAATEC) of Costa Rica presented the results of a 
financial analysis seeking to evaluate debt sustainability 
and compare it to the recently proposed measure of the 
Natural Debt Limit (NDL).  For methodological reasons, the 
NDL theorem could not be applied to Honduras, but Cespedes 
nevertheless hazarded a number of recommendations.  The 
Honduran ratio of public debt to GDP (currently 75.5 
percent) "is on track to improve over the medium term, 
despite currently being considered unsustainable.  It is 
foreseen that this ratio will fall to 61 percent by 2010, 
principally due to the debt forgiveness resulting from the 
attainment of the HIPC Completion Point in April 2005." 
(Note:  He bases this prediction on an estimated debt 
service reduction of $120 million per year.  The GOH 
estimates the actual debt service savings under HIPC at $212 
million per year, which would imply a substantially lower 
debt/GDP ratio in 2010 than that predicted here. End Note.) 
He concluded by saying that while counter-cyclical fiscal 
policies would be desirable, the current low ratios of 
revenues/GDP do not permit adequate countercyclical 
operations. 
 
Laffer Strikes Back:  The Case for a Flat Tax 
--------------------------------------------- 
 
13. Dr. Daniel Wisecarver, Director of the Graduate School 
of Economics and Business (ESEN) in El Salvador, spoke on 
the need for reforming income taxes in Central America.  In 
each of the five countries of the region, income taxes 
represent about one-quarter of total tax revenues, or about 
three to four percent of GDP.  A government cannot be very 
progressive, Wisecarver said, with collection rates so low. 
Unfortunately, there is no culture of trust in these 
countries, or any indication that the governments have the 
political will to reform the current income tax system. 
 
14. The solution, he said is to scrap the whole system. 
Scrap the income tax; scrap the exemptions.  Instead, he 
said, turning to the Laffer curve for support, Central 
American states should move to a flat tax on income.  A 
simplified system with lower tax rates would improve 
collections rates and total revenue, Wisecarver said, 
pointing to Russia and Estonia as examples.  Because there 
would be no exemptions, and the taxes would be based on 
income alone, it would be horizontally equitable. To ensure 
progressivity, he suggests a large, universal exemption, and 
proposes the level of that exemption be set at the median 
income level for the country.  That would ensure that right 
from the start half of the population is entirely exempt, 
reducing political opposition to the plan, while also 
ensuring vertical equity by obliging the rich to pay their 
share.  The plan would succeed, Wisecarver said, because the 
new tax would be simple, neutral, and progressive. 
 
Director of Public Credit Sticks to the Script 
--------------------------------------------- -- 
 
15. Keeping his remarks short and on-message, Ministry of 
Finance Director of Public Credit Orlando Garner laid out 
GOH priorities without commenting directly on the proposal 
floated during the sessions.  Echoing his Minister's earlier 
remarks, Garner said that if Honduras is to benefit from the 
recent debt reduction, it must maintain fiscal discipline. 
GOH policies must be sustainable, and any external financing 
must be on concessional terms.  The problem, he said, is 
that as Honduras grows its access to concessional financing 
declines.  Making matters worse, concessional financing 
(such as IDA subscriptions) is drying up globally. 
Nevertheless, the GOH -- including whatever party is elected 
in the upcoming November 27 elections -- must limit its use 
of borrowing according to the ability of the country to pay. 
Garner admitted that regional harmonization of tax policies 
will be a challenge; but, he said, recent events offer 
Honduras many opportunities, and Honduras must find a way to 
take advantage of them. 
 
Fiscal Pacts:  Great Idea; Shame They Don't Work 
--------------------------------------------- --- 
 
16. The final speaker of the day, Dr. Hugo Maul of the 
National Center for Economic Research (CIEN) of Guatemala, 
outlined the nature and challenges of the much-touted 
"fiscal pact." A fiscal pact is "a national agreement on the 
amount, origin, and use of State resources in carrying out 
its designated functions."  It comprises several elements: 
a fiscal balance requirement (no spending beyond earnings); 
sufficient government revenues to carry out government 
activities; efficient and transparent tax administration; 
prioritized spending; controls on public debt (not to be 
used as a substitute for revenue); responsible management of 
public goods; accountability and social auditing; and fiscal 
decentralization. 
 
17.  Unfortunately, Maul said, in the case of Guatemala the 
pact has failed.  After tracing the causes of this failure, 
Maul extracted the following lessons-learned from the 
experience.  First, agreeing to a plan and carrying it out 
are two very different things.  If goals are not met, who is 
responsible, and what measures are there to require 
compliance?  Second, an agreement that tries to accomplish 
everything ends up accomplishing nothing.  Third, levying 
taxes is a sovereign exercise, and one unlikely to happen if 
consensus is required.  (Or, as he pointed out, there's a 
reason they are called "impuestos" -- making a pun with the 
Spanish word, which can be translated as either "taxes" or 
"that which is imposed.") Fourth, the legislature is the 
elected representative of the people, and that 
responsibility cannot be arrogated by other groups.  By what 
authority does an NGO claim the right to veto a 
Congressional act?  Finally, a pact that imposes burdens on 
any part of society, yet requires consensus, is doomed to 
fail, as special interests will either refuse to approve or 
refuse to comply.  At the end of the day, Maul, said, 
economists must remember that no matter how beautiful or 
well-proven the theory, the practice is always a political 
decision, taken by politicians.  Designing a perfect pact is 
not the same as implementing one. 
 
Williard