Taxes and income distribution in Chile: some unpleasant redistributive arithmetic

Income distribution remains one of the most debated economic issues in developing countries, and Chile is no exception.(1) Although poverty has declined fast and steadily during the last decade, inequality has not changed much. Quite often it is concluded that the stagnation of income distribution is due to inappropriate policies that should be replaced by direct redistributive measures. Given that one of the ways the state can affect income distribution is through the tax system, there is permanent discussion on the distributional effects of taxes. This discussion heats up whenever the government proposes some tax amendment. For example, whenever it has announced its intention to raise the rate of the Value Added Tax (VAT), a heated debate has ensued over its incidence end distributional impact. On the other hand, many people react with concern when the possibility of reducing the progressivity of income taxes is raised, because they think that it will significantly increase income inequality. The purpose of this paper is to quantify the distributional impact of the Chilean tax system and to assess the sensitivity of the distribution of income to changes in the structure of taxes and rates. We do so by constructing a model that incorporates the main taxes and allowances in place in Chile in 1996. We estimate the true income of individuals(2) with data from the 1996 National Socioeconomic Characterization Survey (CASEN) taken by the Planning Ministry, and 'match' this information with taxpayer records kept by the Chilean Internal Revenue Service (SII). In this way we are able to estimate the extent of underreporting of income, as well as deductions for allowances which we impute for each income percentile. At the same time, using data from the Family Budget Survey (EPF) from the National Institute of Statistics (INE), carried out in 1996-1997, we estimate the composition of household consumption and the amount of indirect taxes that each household pays.