Oct. 16 (Bloomberg) -- A system set up by former Chilean dictator Augusto Pinochet in 1984 to boost investment is being used to help the rich avoid taxes, according to the favorite in November’s presidential election.
In a country of 17 million people, only 0.3 percent of tax payers pay the top income rate, depriving Chile of the money it needs to improve education and tackle the worst income inequality in the 34-nation Organization for Economic Cooperation and Development, says opposition candidate Michelle Bachelet.
The rich in Latin America’s wealthiest nation evade the 40 percent tax on income over $100,000 a year by keeping earnings in investment companies, says Sergio Endress, a tax attorney at law firm Aguayo, Ecclefield & Martinez. While the system may have boosted savings and fueled growth, it has come at a cost, forcing the government to rely on the sales tax for most of its revenue, a tax that hurts the poor more than the wealthy.
“The system deliberately encourages devising ways so that company owners pay absolutely no tax at all,” Endress, who is also a professor of tax law at Universidad de Chile, said in a phone interview from Santiago.
Chile raises the equivalent to 7.5 percent of its gross domestic product through corporate and income taxes, compared with the 11.3 percent average for the OECD, according to data from the organization and the United Nation’s Latin American unit, or Eclac. Bachelet, a Socialist who was president from 2006 to 2010 and now leads the polls over the ruling alliance’s Evelyn Matthei, says the time has come to narrow that gap by 3 percentage points.
Chile charges a basic 20 percent tax rate on all corporate profits, plus as much as 20 percent more if and when those earnings are withdrawn from the company by an individual.
What is unique to Chile is that the system allows companies to roll over earnings in an account called the Taxable Profit Fund, known by its initials in Spanish as FUT. Chilean companies held about $270 billion in FUTs at the end of 2012, according to the tax regulator, equivalent to the country’s GDP.
The FUT enables professionals, businessmen and wealthy individuals to put their earnings into paper companies and postpone the personal tax on that income indefinitely. Many include other family members as shareholders, dividing up the income when it is withdrawn and lowering their personal income tax bracket.
“The FUT helps people elude taxes and is being used for something for which it wasn’t created,” Alejandro Micco, an economic adviser for Bachelet, said at a conference in Santiago Oct. 4. “There is a bad use of the incentive.”
The rich also can claim back part of the 20 percent corporate tax by limiting how much profit they withdraw, said Endress. According to data from the tax authority, anybody earning up to 34 million pesos (about $68,000) a year falls in the 15 percent tax bracket. A person earning up to 43 million pesos ($86,000) falls in the 25 percent bracket.
“When you take into account these rebates, it means that what Chile collects from corporate profits is actually below the 20 percent,” Endress said. In 2006, the effective corporate tax rate was 15 percent, according to a study he wrote that year.
The system is no longer worth keeping, Bachelet says. As a first step, she plans to raise the basic rate of corporate tax to 25 percent and cut the top rate of income tax to 35 percent. Later, among other measures, she will scrap the system for rolling over earnings in the FUT.
The changes will be gradual and won’t take full effect until the end of the next presidential term in 2018, according to documents on her campaign’s website. The aim is to collect the equivalent of 3 percentage points of gross domestic product to fund spending on education, health and social security.
Bachelet is backed by 34 percent of voters ahead of the Nov. 17 election, followed by Evelyn Matthei with 19 percent and independent Franco Parisi with 15 percent, according to a survey released Oct. 7 by Ipsos. The poll of 985 people between Sept. 24 and Oct. 4 had a margin of error of 3.3 percentage points.
Critics of Bachelet’s plans say she risks undermining one of the pillars of Chile’s economic success. They point out that the introduction of the code helped double the investment rate to 24.5 percent in 1988 from 11.9 percent in 1983, according to the International Monetary Fund.
“Eliminating the FUT is a dangerous and unpractical proposal that can set off an earthquake in saving levels,” Felipe Morande, an economic adviser for Matthei said at the conference.
The think tank Libertad y Desarrollo, which was founded by Hernan Buchi, Pinochet’s finance minister at the time of the system’s creation, said that Bachelet’s plan would damage small and medium-sized companies that rely on retained profits to fund investment, according to a report posted on its website in June.
“The system has been very efficient and has generated massive amounts of private savings,” Christian Blanche, a partner at legal firm Tax Advisors, said in an interview at his office in Santiago. “Even if the savings come from investment firms and not manufacturing companies, they’re in the capital markets, allowing institutional investors to use that money for more employment and growth.”
Chilean companies invested the equivalent of 25 percent of GDP in 2012 and domestic saving reached 21.5 percent, according to Libertad y Desarrollo.
Moreover, Chile’s government is the only net creditor in Latin America, indicating it is not short of funds.
Andrea Repetto, a member of Bachelet’s team working on the tax plan, says changes won’t slash savings and investment and will provide the government with the funds it needs.
“At the margins there may be some projects that are profitable with the current rate and that won’t be” with the new system, Repetto said in an interview with Radio Duna Oct. 7. “There are profitable investments that a society can make in education and health that we aren’t doing because we don’t have the resources for that.”
Chile raised the equivalent of 20 percent of its GDP in taxes in 2010, in line with the average of 19 percent for all of Latin America and below an average of 34 percent for OECD-member countries, according to a report published in December by Eclac.
In a country with at least 53,000 millionaires, according to Credit Suisse AG, many remained shocked that Chile’s system enables so many to avoid the highest tax bracket.
“Whenever I’m abroad and I explain the FUT system to other tax experts, they just can’t believe it,” says Claudio Agostini, an economist at Universidad Adolfo Ibanez and member of the Washington DC-based National Tax Association. “‘It’s evasion through and through,’ is what they say.”
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