An Overview of Objectives and Alternatives

I. Introduction

In December 1986 Colombia enacted Law 75, making fundamental changes in its income tax. Tax thresholds were raised, withholding was made a final tax for many taxpayers, and the top bracket rate paid by individuals was reduced from 49 percent to 30 percent. Especially important were the changes in the tax treatment of income from business and capital.

The taxation of corporations (sociedades anónimas) and limited partnerships (sociedades limitadas) was unified. This was accomplished by subjecting all the taxable income of both types of companies (sociedades) to the 30 percent rate and excluding dividends paid by corporations and partners' shares in the earnings of limited partnerships from the tax base of individuals. Interest income and expense are to be indexed for inflation; except in the case of interest income received by individuals from financial institutions and other payors subject to government regulation, which immediately qualifies for indexation, this inflation adjustment is to be phased in over a ten-year period, beginning in 1986. Inflation adjustment was not extended to depreciable assets or to inventory accounting, which already benefit from accelerated depreciation and the use of last-in, first-out (LIFO) accounting.

Law 75 of 1986 provides the Government of Colombia with «extraordinary faculties» (facultades extraordinarias) that allow it, among other things, to specify further changes in law needed to eliminate the effects of inflation from the measurement of taxable income. The present Report is intended to provide guidance to the Government as it considers how best to satisfy that mandate.

The discussion of this Report goes beyond the narrow issue of whether and how the inflation adjustment scheme of Law 75 of 1986 might be improved. (Chapter 7 is devoted to an examination of that issue.) Rather, it takes the view that the rationale behind much of Law 75 — the achievement of equity and neutrality — requires the creation of a more accurate measure of real economic income for tax purposes. Since there may be little to be gained from making a highly defective tax System inflation-proof, the Report, especially in Chapter 5, examines fundamental issues of the taxation of income from business and capital that would arise even in the absence of inflation. Moreover, it recognizes that problems caused by the failure to make the tax system of Colombia inflation-proof extend beyond the income tax to include the measurement of net wealth; Chapter 6 thus examines the taxation of net wealth, and Chapter 5 also considers the measurement of presumptive income, which is based primarily on net wealth. Finally, the examination of the tax system of Colombia contained in this Report goes beyond merely reforming the existing income and net wealth taxes. The Report also considers a more drastic reform of a type that in many ways is attractive in concept but that has not been implemented in any country, a system of direct taxation based on consumption, rather than income.

II. Alternative Solutions

Before the reforms adopted in December 1986, little systematic allowance was made for inflation in the measurement of income under the Colombian income tax. As a result, taxable income could be either understated or overstated, resource allocation was distorted by taxation as it interacted with inflation, and equity suffered. All these defects, which are explained further in the next section, were generally more important, the higher the rate of inflation.

There are two primary alternative means of dealing with this Situation. One is to provide systematic Inflation adjustment for crucial items of income and expense, including interest, capital gains, depreciation and similar allowances, and cost of goods sold from inventories. The result would be an «inflation-adjusted» income tax in which only real income would be taxed. This was the general approach followed in the 1986 reforms, although these reforms stopped short of the complete adjustments that would be required to make the measurement of real income accurate and independent of the rate of inflation. Consistent application of this approach would also produce a net wealth tax (and a measure of presumptive income) based on current values of assets and liabilities. The 1986 reforms made little progress on this front. Part One of this Report (Chapters 2-7) describes current law and the changes that would be required to convert the current System to one based more closely on real economic income and net wealth.

An alternative would be to adopt a System of direct taxation based on consumption, rather than on income. Such a System is described in detail in Part Two (Chapters 8 and 9) of this Report. A consumption-based tax has the considerable advantage that inflation adjustment is generally unnecessary, since all quantities relevant for the calculation of tax liabilities are measured on a cash flow basis in current-year pesos. (That is, payments are realized for tax purposes when cash is received, and deductions are allowed for expenses when cash is disbursed.) Under one variant of a consumption-based tax, businesses are allowed immediate deductions for all purchases, including those of depreciable assets and inventories; interest income of businesses is exempt, and dividends paid and interest expense are not deductible, while at the individual level interest income and dividends are exempt, and interest payments are not deductible.

A consumption-based tax enjoys another powerful administrative advantage over an income-based tax, because realization is tied to cash flow. The timing of cash flow is a relatively easily identifiable event. By comparison, under an income tax it is much less obvious when a taxable event occurs, that is, when income and expense should be recognized for tax purposes. For example, if taxable income is to reflect economic income, depreciation allowances for tax purposes must reflect economic depreciation, that is, the decline in the value of a depreciable asset (as measured by its ability to generate a future flow of income). It is, however, notoriously difficult to know the appropriate pattern of depreciation allowances to use for tax purposes. A large number of other difficult «timing» issues, sometimes called «time value of money» issues, must also be addressed in designing an income tax; these are...