The Uruguayan Tax Reform of 2006: Why Didn’t it Fail?

This paper (available for download below) is part of a series of publications from an event the Latin American Program hosted in December 11, 2012.

EXECUTIVE SUMMARY

The success of Uruguay’s 2006 tax reform was the result of the county’s somewhat unique social, economic, and political characteristics and smart choices on the part of government reformers. The reform created a more progressive and comprehensive tax system, improved the balance between direct and indirect taxes, and strengthened tax enforcement and compliance. A new, unified income tax replaced a collection of schedular income taxes, sales and value added taxes were reduced, and many tax exemptions and special treatments were removed. In contrast to most tax reform undertakings, however, there was not powerful and sustained movement against these changes. Although these reforms would benefit the majority of the population, analysts were surprised that popular and political opposition to the 2006 tax reforms was limited and short-lived. In his paper, Andrés Rius explains the reasons behind the initial resistance to reform and examines two sets of factors that explain the government’s ultimate success.

The reforms were designed to benefit the lower and middle classes, with only the very wealthiest Uruguayans facing a greater tax burden after they went into effect. Nevertheless, many citizens balked at the reforms when they were first presented. A group of pensioners even challenged a portion of that law that taxes social security benefits in the Supreme Court, prompting the government to re-write part of the law. Rius explains these negative reactions by drawing on research from the field of behavioral economics and behavioral political economy: first, many people mistakenly believe themselves to lie much closer to the median income level in their society than they actually do (perception bias); second, most people are unable to make complex calculations to accurately understand how fiscal reform impacts them; and third, people are loss-averse and weight potential costs more heavily than similar gains. Rius then explains why the resistance to reform was brief and did not continue after implementation: a thorough national information campaign, economic growth, and taxpayers’ own paychecks confirmed that the great majority would not suffer a heavier tax burden under the new regime. Even among those who would pay higher taxes post-reform, a sense of “fair play” may have contributed to a lack of negative reactions.

Especially surprising was the lack of opposition from the upper strata of Uruguayan society, who would almost assuredly pay more taxes as a result of the reforms. Rius’s analysis draws on deep rooted social characteristics of the Uruguayan elite that made them less likely to mount a strong counter-reform.  The upper strata in Uruguay have historically been ideologically and organizationally divided, without strong linkages between political and economic elites through personal, religious, or family connections.  The country’s rural wealth was periodically depleted by internal and international conflicts and competition with nearby Buenos Aires limited mercantile wealth in Montevideo. This historically weak and fragmented elite also failed to gain a substantial advantage through higher education, which in Uruguay has been dominated by the state and middle class. There are few associations or organizations that unite the country’s elite even today, and Uruguay’s political parties tend to develop broad “catch-all” coalitions that refrain from aligning to closely with the wealthy and alienating the majority of voters. Thus, the economic elite tend to have very weak influence on political decision making, including tax reforms.  Rius underscores the impact of a fragmented elite by contrasting the success of the 2006 reforms with the defeat of an attempted reform in 2011-2012. In this case, Uruguayan reformers created a new tax that would discourage the concentration of rural landholding by taxing larger holdings at higher rates. The tax was successfully overturned by a traditionally organized coalition of landowners, where large agricultural companies and ruralistas with deep family ties in the region were able to challenge the legitimacy of the tax on constitutional grounds.

In the last segment of his paper, Rius pulls some potential lessons for other progressive tax reformers from the Uruguayan case, beyond the unusual structural characteristics of that society. First, accurate information effectively disseminated to taxpayers about the real impact they should expect from new taxes can be very effective at overcoming negative perceptions, if it is accompanied by signals that show the government is creating a fair system and not one favoring the rich (e.g. equal enforcement of tax evasion). Second, a diverse, catch-all political coalition that favors progressive reform can help neutralize opposition. Third, reformers in Uruguay set up public forums in advance of reform implementation to provide additional transparency about the changes. Fourth, reformers separated an investment promotion regime from the progressive tax reform, splitting the negotiations and allowing for greater focus on the key principles of each project.