LSE research on taxation and top income shares in Chile has directly informed the design of major national tax reforms.
What was the problem?
Chile has long been known for its extreme levels of economic inequality. In the 1980s, the Pinochet dictatorship had established an integrated income tax regime that advantaged many of the wealthiest. Corporate tax (20 per cent in 2012) served as a credit against a business owner’s personal income tax, which they became subject to upon receiving dividends or distributed profits. Since the top marginal personal income tax rate was much higher (40 per cent), capital owners left most of their profits in their firm, where they paid only the low corporate tax. While this system was intended to promote investment, the large gap between the two rates also stimulated massive tax avoidance and evasion.
Shortly after her inauguration in March 2014, President Michelle Bachelet and her administration seized the opportunity created by student movement mobilisation on inequality and planned to introduce an ambitious overhaul of this tax system to eliminate these problems.
What did we do?
Dr Tasha Fairfield’s comparative research analyses the political economy of inequality and redistribution, the politics of policy formulation, and business-state relations in Latin America.
Her 2016 article in Review of Income and Wealth, co-authored with Michel Jorratt, presented the first calculations of Chilean top income shares and effective tax rates using individual tax return microdata from 2005 and 2009. This research paid special attention to business income, which dominates at the top. The analysis included not only distributed profits but, for the first time, also the large proportion of accrued profits retained by firms, which were rarely the subject of analysis given the difficulty of identifying individual owners. This work represented a significant breakthrough given Latin American tax agencies’ reluctance to provide any access to tax returns information. Fairfield submitted multiple requests over a period of seven years, all of which were turned down, before ultimately obtaining approval from the Chilean tax agency.
Analysis of the data revealed even the most conservative estimate of the income share of Chile’s top one per cent to be 15 per cent. When distributed profits were adjusted to account for evasion, the share of the top one per cent reached 22–26 per cent. After broadening the income concept to include accrued profits, the top share increased to a minimum of 23 per cent. Despite this impressive concentration of income, the top one per cent paid an average effective income tax rate of just 15–16 per cent. Based on this evidence, Fairfield and Jorratt concluded: “there is substantial room to increase taxes on the rich in Chile. Such initiatives could contribute to reducing inequality, both by raising more revenue to finance social spending, and by helping to curtail the growth of top incomes.” They also recommended redressing the incentives for evasion and avoidance that were created by the country’s peculiar integrated income tax system.
This study builds on Fairfield’s previous research in Private Wealth and Public Revenue in Latin America: Business Power and Tax Politics, which analysed political obstacles to enacting more progressive taxation in Chile, specifically, and in highly unequal democracies more broadly. In Chile, business’s very strong instrumental (political) power, arising from close ties to right-wing parties, strong organisation, and institutionalised consultation with the executive branch, had long hindered efforts to increase progressive taxation, until student movement mobilisation counterbalanced business power and created opportunities for reform in 2014. Fairfield’s later works have analysed the political circumstances leading up to reform.
What happened?
This body of research has had a significant and direct influence on the design of major tax reform in Chile, which was enacted by the Bachelet government. This reform was designed by Michel Jorratt, drawing extensively on his collaboration with Fairfield. The previously unavailable data on undistributed profits they had managed to get hold of provided an evidence base that helped to shape the government’s proposals. It had quantified the scale of the problem, identifying the high tax exemptions on reinvested profits and the high concentration of accrued earnings. It had also revealed the low tax rates paid by the richest one per cent in Chile, which amounted to just two-thirds of what the equivalent cohort pays in the United States.
In the government’s proposals, all profits, whether reinvested or distributed to owners, would enter the individual income tax base, ensuring wealthier taxpayers would pay higher effective rates. The reform package also included multiple measures to curtail evasion and avoidance, many of which had been considered by previous administrations but deemed politically infeasible given business’s strong instrumental power. Overall, the government’s projections for increased tax revenues were equivalent to three per cent of national GDP.
The administration succeeded in moving the tax reforms quickly though Chile’s Lower House with only minor modifications, but in December 2015 concerted opposition from business in the context of an economic slowdown prompted the Finance Ministry to draft a compromise bill in the Senate, introducing some amendments. Even with these compromises, the reform remained a major tax increase on the wealthiest Chileans – the most significant since democratisation in 1990.
The reforms have proven successful in redistributing income in Chile. Average taxes paid by the top one per cent of earners rose by 47.5 per cent between 2014 and 2018. Additional revenues have helped to finance a major education reform, which extended scholarships for low-income university students as part of measures to strengthen public education.
The original research has made –and continues to make – important contributions to public debate on inequality in Chile. It has been cited in media articles on the strategies of control used by political elites, on corporate corruption, on Thomas Piketty’s analysis of inequality in Chile, and in various pieces on tax avoidance and evasion. The enduring impact of the research is perhaps best exemplified by former President of Chile Ricardo Lagos:
I believe that the document written by Tasha Fairfield and Michel Jorratt is very important. For a long time this document will be the source for discussing the issue of income and wealth distribution in Chile … I believe that there will be a before and an after in Chile in this matter.