US embassy cable - 02TEGUCIGALPA3004

UNCLAS SECTION 01 OF 03 TEGUCIGALPA 003004 
 
SIPDIS 
 
SENSITIVE 
 
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 IDB, USED WB, AND USED IMF 
TREASURY FOR JOHN JENKINS 
 
LABOR FOR ILAB, ROBERT WHOLEY 
PANAMA FOR CUSTOMS 
 
E.O. 12958: N/A 
 
TAGS: EFIN, ECON, EAID, ETRD, ELAB, PGOV, HO 
SUBJECT: GOH Faces Unpalatable Choices on Increasing 
Government Revenues 
 
 
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Summary 
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1. (SBU) A new IDB-sponsored diagnosis of structural 
problems in Honduras's tax policy documents the failure of 
the GOH to raise sufficient revenues to fund vital state 
functions, resulting in steady growth in the central 
government's fiscal deficit.   The authors recommend an 
immediate repeal of extensive tax exemptions and loopholes 
that have reduced the tax base significantly over the years, 
and a long-term structural overhaul of the tax system. 
These sensible and needed recommendations will be 
overwhelmingly difficult to implement in the Honduran 
political context and it remains to be seen how tough the 
IMF will be.  There is high-level political commitment to 
work on an equally important improvement of Honduras' tax 
administration (collection and audits), with help from the 
U.S. Treasury Department's tax administration technical 
assistance office.  The high percentage of Honduran tax 
receipts collected by customs officials indicates that a 
customs service technical assistance project may be needed 
as well.  Washington agencies preparing for U.S.-Central 
American Free Trade Agreement (USCAFTA) negotiations may 
wish to consider carefully our position on GOH tax 
incentives for non-traditional exporters (including U.S. 
companies) in the context of the investment chapter.  End 
Summary. 
 
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Honduran Tax Collection: Too Low, Too Unfair and Too 
Uncontrolled 
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2. (SBU) A team of consultants hired by the IDB is currently 
putting the finishing touches on a report entitled 
"Honduras: Toward a More Transparent and Diversified Tax 
System."  The study repeats the recommendations of earlier 
studies and analyses.  It is well-documented, albeit based 
on Honduras' extremely limited statistical data base, and 
provides policymakers the kinds of details needed to target 
loopholes in Honduran tax law.  Obtaining a substantial 
increase in tax revenues in the near-term is going to be an 
important issue in upcoming Article IV review and discussion 
of a new three-year Poverty Reduction and Growth Facility 
program with the IMF team that is expected to arrive 
November 4.  To ensure adequate attention and coordination 
on this aspect of macroeconomic policy, the USAID mission in 
Honduras has coordinated an extremely useful series of 
meetings of the G-15 Macroeconomic group to evaluate 
Honduras' tax system.  At a recent meeting of this donor 
group, the key results of the IDB study were presented and 
discussed. 
 
3. (SBU) The scope of the problem is fairly clear.  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 is only half of the percentage that 
is considered healthy for a developing country.   This level 
of tax collection is not adequate to fund the key government 
services and investment that are needed; growth in tax 
receipts has not kept up with expenditure growth over the 
last ten years, resulting in ever growing deficits (with the 
exception of 1995-98).  The percentage of government 
expenditures that were covered by tax revenues has declined 
from 88 percent of GDP in 1998 to only 63 percent in 2001. 
The tax structure also is highly regressive, since most of 
the tax exemptions are provided to the wealthy.  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. 
 
4. (SBU) The IDB consultants noted that the rapid growth in 
the public sector wage bill in recent years (up from 45 
percent of tax receipts in 1997 to more than 60 percent in 
2001) as a result of the wage provisions in the special 
framework laws (estatutos) for teachers and health service 
professionals.  They also commented that the size of the 
state is not the real problem.  They noted that Honduras' 
central government budget as a percentage of GDP is smaller 
than even Nicaragua's.  The state simply does not collect 
enough revenue.  Finally, the lack of sufficient income has 
led the GOH to fail to transfer five percent of net 
government income to municipalities, as required by the 
Municipality Law that went into effect in January 1991. 
 
5. (SBU) As the GOH began to reduce customs tariffs in 1991 
in an effort to liberalize trade, the sales tax (a modified 
VAT tax) has gradually grown in importance and now accounts 
for 33 percent of total government tax revenues.  Income tax 
accounts for 22 percent of tax receipts, and taxes on oil 
and oil products come in third, representing 21 percent of 
total taxes.  The 1990s were also a period of export 
promotion, resulting in a web of generous tax incentives for 
textile and apparel companies, mining, and tourism services. 
The IDB team notes that the country has paid a high price 
for these incentives, in terms of transparency, fair 
treatment across taxpaying groups, and control of its own 
tax administration. 
 
6. (SBU) Although only 12 percent of tax receipts come from 
import duties, the IDB report notes that 50 percent of all 
tax revenues (including customs duties, sales tax, excise 
taxes, etc.) are collected by the customs service.  Tax 
payments are highly concentrated.  In the year 2000, 703 
large companies paid 77 percent of the income tax and 1,129 
large firms accounted for three-quarters of sales tax 
payments. 
 
7. (SBU) The IDB study also noted the weakness of the 
Honduran tax and customs service, the DEI.  Although some 
improvements have been made (including the new installation 
of an automated tax payment transfer system integrated with 
the commercial banks, a project paid for by the IDB), there 
remains a great deal of work to do.  Note: The U.S. 
Department of Treasury's tax administration technical 
assistance project begins in earnest at the beginning of 
November.  This work will focus on tax collection and 
auditing.  The Treasury experts have recommended that the 
Embassy also contact U.S. Customs about possible technical 
assistance for the DEI's customs operations.  End Note. 
 
8. (SBU) Extensive exemptions are provided in almost all the 
tax categories, resulting in a greatly reduced tax base.  A 
wide range of companies receive exemptions from the sales 
tax for purchases of raw materials and other inputs.  As 
result of the granting of extensive exemptions from customs 
duties, revenues from this tax source are only 56 percent of 
the theoretical tax collection (calculated by multiplying 
the value of imports by the appropriate ad valorem tariff). 
In addition, the consultants estimate that 41 percent of 
imported goods enter the country exempt from sales tax as 
well. 
 
9. (SBU) 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.  Current 
administration of these exemptions provides ample 
opportunity for abuse.  It is believed that at least one 
firm in the power sector is reselling large quantities of 
fuel to gas stations, instead of using the tax-exempt 
product strictly for electricity generation.  Many goods 
imported duty-free as inputs for assembly or manufacturing 
are instead sold on the retail market. 
 
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Solutions Are All Politically Unpalatable 
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10.  (SBU) The IDB team recommended a series of changes to 
the tax code, for the short term, designed to broaden the 
tax base for the GOH's main revenue sources.  They believe 
these measures would increase tax collections by two percent 
of GDP, annually.  The key provisions in this list are the 
elimination or dramatic reduction of tax exemptions and the 
application of minimum amounts of taxes to limit tax 
avoidance schemes.  As these tax exemptions benefit the 
largest and most important companies and individuals in the 
country, and in many cases these changes would be tantamount 
to violation of contractual terms and shifting rules of the 
game for investors, many donors are skeptical that 
sufficient political will exists for major tax policy 
shifts. 
 
11. (SBU) For this reason, some experts are proposing that 
the GOH raise the sales tax in order to increase revenues 
quickly, lower the fiscal deficit, and allow the government 
to reach an agreement with the IMF.  Some of these observers 
cite the case of Chile, in which an eighteen percent tariff 
is applied across the board, with almost no exceptions.  In 
Chile and Mexico, these analysts noted, the sales tax is not 
nearly as regressive as one would think, because the 
elimination of exemptions and incentives ensures that the 
wealthier part of the population is not able to avoid taxes. 
While the simplicity and effectiveness of this approach is 
attractive (and senior advisors in the GOH have noted that 
this was the case when the sales tax was raised from seven 
to twelve percent in 1998), it would put the GOH on the 
political defensive for raising taxes on the poor and 
allowing the rich to continue receiving exemptions. 
 
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Comment 
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12. (SBU) We expect that the IMF will push the GOH to 
increase tax revenue in order to help achieve macroeconomic 
stability.  The GOH is well advised to improve its tax 
administration, but this will not be sufficient to achieve 
fiscal balance.  At least some tax exemptions will need to 
be eliminated to help reduce the budget deficit.  While 
raising the sales tax represents a simple alternative, we 
believe it would be politically difficult in the current 
context of high unemployment and slow growth.  The GOH may 
also look to privatization and concessions of government 
infrastructure projects, as a way of both increasing 
government revenues and improving efficiency (currently, the 
only privatization proceeds that are included in the 2003 
budget are the planned sale of a wireless phone concession). 
The final important factor is economic growth.  If Honduras 
can find a way to improve its investment climate 
sufficiently, it may be able to grow itself out of the 
conundrum it finds itself in. 
 
Pierce