Shining Ecuador

PRESIDENT RAFAEL CORREA at a rally commemorating his five years in power, in Cuenca, Ecuador, on January 14.-RODRIGO BUENDIA/AFP

The small Latin American country demonstrates how to maximise revenues and use the same in the social sector and for building public infrastructure.

ALL too often, when citizens of India (and, to be fair, many other developing countries) demand increases in public spending that would go some way towards ensuring their social and economic rights, they are told that there is simply no fiscal space for this. Where is the money? is the usual response. It is no matter that the demands are for essential public provision that every civilised society must provide for its people, such as minimum food and shelter entitlements, health and sanitation, education, and so on. The basic perception is that even if increasing such spending is desirable it is unfortunately a luxury the country cannot afford given the global concern on fiscal consolidation and the difficulty (if not near impossibility) of raising tax revenues.

Two fiscal myths have been perpetuated in this regard. First, that fiscal consolidation (in the form of reducing public deficits and bringing down public debt to gross domestic product (GDP) ratios) is always the preferred strategy, regardless of the cyclical conditions of the economy. Second, and perhaps more significant, that fiscal austerity in the form of cutting public spending is the only way to achieve such consolidation. Both myths deserve to be broken.

In particular, the idea that globalisation and particularly cross-border mobility of capital have meant that governments cannot afford to raise tax revenues has got deeply implanted in the minds of policymakers across the world. It is, in fact, a completely false argument. The extent of the falsity is shown clearly in a powerful counter-example coming from Ecuador, a small country that is usually described as having little or no policy space.

Until recently, Ecuador was very much a banana republic exporting primary products (oil and agricultural products) and people (migrants to the United States) but still running balance of payments deficits and prone to instability in a context of economic inequality, widespread poverty and backwardness. Dollarisation of the economy curbed the hyperinflation but did not resolve any of the systemic problems, and the economy continued to lurch from crisis to crisis combined with rapid political changeovers. From 2007, however, the government led by Rafael Correa has attempted to change many of these features, and the extent of its success in a relatively short time is remarkable.

One of the most impressive changes has been in the area of tax collection. Ecuador is an oil exporter (only of crude oil, however, since it does not have domestic processing facilities), and any increase in public revenues is commonly attributed to the increase in global oil prices. That has indeed been important, not least because the Correa government has successfully renegotiated the terms of its contracts with multinational oil companies.

Thus, whereas in the past the government received only an average of 13 per cent of the gross sales value of the oil, it now gets as much as 87 per cent. Despite this major switch, more than half of the foreign oil companies continue to operate in the country, which is a sign of the massive surplus profits that were accruing to them earlier. In any case, this has meant that the government has been able to benefit much more substantially from higher global oil prices. Incidentally, while this led to substantially increased hydrocarbon royalties for the state, it also meant lower tax revenues from this source.

But what is extraordinary is that, despite this very large increase, the public exchequer has actually reduced its dependence on oil during the Correa regime. The share of oil revenues in total government revenues has come down from 30.4 per cent in the period 2001-05 to only 26.1 per cent in 2006-10 in other words, non-oil revenues now account for nearly three-quarters of government revenues.

This is mainly because of a massive effort towards efficient tax collection, which has caused tax revenues to more than double in five years. Total tax collection rose from $4.67 million in 2006 to $9.56 million in 2011. As a result, direct taxes mainly corporation taxes account for more than 40 per cent of the government's revenue collection, up from around 35 per cent.

This is hugely important because it shows that this is something all governments can do, if only there is the political will to do so. Remarkably, the government did this without any adverse effects on either the rate of investment (which kept increasing over the period and is now a healthy 26 per cent of GDP) or the aggregate growth rate (expected to be as high as 8 per cent in 2011). So the usual arguments against such a drive that it will affect investor confidence and therefore investment have clearly not been relevant.

What exactly did the Correa government do to ensure this direct tax increase? Carlos Marx Carrasco, the head of the Internal Revenue Service (SRI), argues that this success is due primarily to better enforcement, collection of tax arrears and reduction of tax avoidance, which in turn has only been possible because of breaking the cosy political nexus that existed between the tax administration and the large businesses that reaped most of the benefits of domestic economic growth.

The SRI achieved this through the systematic use of information technology and the introduction of more detailed reporting requirements for companies, combined with strict measures to punish tax evaders. Since April 2006, the SRI has required companies to submit a range of detailed information on monthly value-added tax (VAT) filings, financial yields, credit-card movements and income tax withholdings. Despite complaints from businesses about the time taken and difficulty in filling out these forms, they have proved to very useful in curbing tax evasion. The SRI has used the information to monitor exports, imports, purchases, sales, voided receipts and withholdings in general. This has allowed it to come up with much more systematic (and higher) estimates of the revenues due to it.

Once these estimates have been made, companies have been forced to pay up their taxes and the estimated arrears. Commercial outlets and private professional offices of proven tax evaders in most main cities have been shuttered until they have met their tax obligations. The process is still only partially complete, and the SRI estimates that there is much more potential to increase tax revenues through further tightening and better compliance. The stick of more stringent and effective enforcement has been combined with the carrot of lower rates corporation tax rates are to be lowered to 22 per cent from the current 25 per cent.

These increased revenues both from oil royalties and from tax collection have been directed towards increased social spending and public investment. Ecuador now has the highest rate of public investment (10 per cent of GDP) in the Latin American region. In addition to spending on much-needed physical infrastructure, an important part of this has been devoted to public housing. In the period 2007-09, the housing deficit was reduced as more than 200,000 homes were handed over to the public. The number of homes with a sewage system increased from 2.78 million in 2006 to 3.33 million in 2010, which is more than two-thirds of urban households.

Social spending has also doubled, from 5 to 10 per cent of GDP between 2006 and 2011. Much of this has gone towards increases in public employment in activities such as health, sanitation and education and in ensuring that all public sector workers are part of the formal employment sector, with minimum wages and proper regulated working conditions, rather than working in subcontracted companies. (Incidentally, this move, along with enforcement of social security and labour laws, has had a knock-on positive effect in the labour market in general. Even in the private sector, formal employment has increased and informal employment has fallen in sharp contrast to trends in most of the rest of the world.)

Investment in health has increased by 129 per cent, driven also by the requirement of the 2008 Constitution that all citizens have access to free health care. Education is also to be available free at all levels, and the education budget has more than tripled, from $235 million over 2003-06 to $941 million in 2007-10.

So it can be done, after all. Tax revenues can be increased, by enforcing proper tax collection and cracking down on evasion. Big companies both domestic and multinational can be disciplined without adversely affecting investment or GDP growth. The increased public revenues can be used for more public provision in necessary areas to ensure the social and economic rights of citizens. All this is clearly possible, even for a small country operating with several constraints in the globally integrated world.

This is a message that must reach policymakers everywhere, especially in India where the general attitude towards both revenue mobilisation and social spending is defeatist and conservative in the extreme. Even more, this message should reach people everywhere so that they can create much more public pressure to achieve what turns out to be eminently doable.