Chile Congress Passes Tax Bill to Finance Free Education

Chile’s congress approved tax increases as the government looks to fund free education from primary school to university, while the opposition accuses it of endangering 30 years of economic growth.

The bill, passed late yesterday, needs to be signed into law by President Michelle Bachelet, with the tax changes introduced gradually over the next four years.

The legislation seeks to raise $8.2 billion, or 3 percent of gross domestic product, through higher taxes on companies and the closure of loopholes for wealthy individuals. Bachelet says the revenue will fund spending on education and health care, helping to narrow inequality in Latin America’s wealthiest nation. The opposition says the prospect of higher taxes has contributed to a drop in investment and the weakest growth in five years.

“There is an enormous number of public policies that can become reality thanks to the approval of this reform,” Finance Minister Alberto Arenas told reporters. “This is a day for Chile to celebrate because we have given signals of stability and security.”

Chile has the highest level of income inequality in the 34-member Organization for Economic Co-operation and Development, according to a study released by the organization in March. Chile also has the fourth-highest level of relative poverty in the OECD area, the study showed.

“The tax reform is a fundamental tool to attack the structural inequality in Chile,” Bachelet said Aug. 28. “The idea is to level the field.”

Slowing Down

Bachelet came to office on pledges to provide free education for all following three years of student protests that had brought hundreds of thousands onto the streets. The bill has coincided with a steep slowdown in growth.

The economy grew 1.9 percent in the second quarter from a year earlier, the slowest pace since the recession of 2009. Investment in machinery and equipment tumbled 21 percent from a year earlier, after dropping 19 percent in the previous quarter, when the economy grew 2.4 percent.

Felipe Larrain, finance minister in the previous administration of President Sebastian Pinera, who left office in March, blames the slowdown in part on the prospect of higher taxes.

“There were far less harmful ways of raising the money,” Larrain said Aug. 6. “What was introduced to the country is a badly elaborated project full of mistakes.”

Economic Growth

Chile has enjoyed economic growth averaging 5.4 percent over the past 30 years with some of the lowest corporate tax rates in the OECD.

The country raises the equivalent of 7.5 percent of its GDP 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.

The tax increases approved yesterday will raise revenue by 2.5 percent of GDP, while measures to reduce evasion will collect an additional 0.5 percent.

The new system will be complicated to implement, said Eduardo Vargas, partner of the tax group of Deloitte Chile´s Financial Industry.

Unable to reach an agreement over the tax changes, the government and the opposition on July 8 agreed to create two parallel systems. Companies can chose between paying higher rates with discounts for reinvesting profits, or lower rates and no discount.

Tax Simplicity

“If there is something this reform doesn’t accomplish, it is making the tax system simple, and that is what tax systems look for,” said Vargas by phone from Santiago. “Companies will have to assign more money to comply with the new obligations.”

Companies will be able to pay a corporate rate of 25 percent, plus 10 percent in income tax for shareholders, or 27 percent and higher income taxes, with the right to discount some earnings that are reinvested. The current corporate tax rate is 20 percent, with an additional maximum of 20 percent in income tax for shareholders.

The tax changes also remove one feature that is unique to Chile. Under the current tax code, companies can roll over earnings in an account called the Taxable Profit Fund, known by its initials in Spanish as FUT, without paying taxes. Chilean companies held about $270 billion in FUTs at the end of 2012, according to the tax regulator, equivalent to the country’s GDP.

Economic Cost

Eliminating the FUT will reduce the growth rate by one percentage point and cut investment by 3.5 percent of GDP, according to a study done by Larrain and two other economists in May.

The introduction of the system during the dictatorship of Augusto Pinochet helped double the investment rate to 24.5 percent in 1988 from 11.9 percent in 1983, according to the International Monetary Fund.

The government says the FUT helps people elude taxes.

“We are closing the FUT which was a well-known source of potential evasion, bad practices and abuses in our tax system,” Finance Minister Alberto Arenas on Aug. 19.

The tax debate has been overshadowed by the economic slowdown. On Sept. 3 the central bank cut its growth forecast for this year for the fourth consecutive quarter. GDP will expand 1.75 percent to 2.25 percent, compared with the previous estimate of 2.5 percent to 3.5 percent, policy makers estimate.

The government has cut its 2014 growth forecast twice this year to 3.2 percent, citing a steep slowdown in domestic demand. Pinera’s administration had forecast growth of 4.9 percent for the year.

“This reform brings good news to the middle class, to small companies, and creates incentives for savings and investment,” Arenas said yesterday. “It is an historic moment.”

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