income tax revenues. Household data simulations by Jorratt (2010) suggest that these five income tax exemptions raise the Gini coefficient by about 0.7 percentage point.

23. **Tax retentions at the source of income penalize independent workers, who are not entitled to reimbursements through income tax declarations.** Colombia‟s tax system facilitates the retention of income at the source (e.g. wage income, commissions, interest income), which is good practice. Unfortunately, the system of retention is not fully integrated with the annual tax declaration. In effect, not all persons have to present an annual income declaration, which implies that the original tax retention remains definitive. This is the case for independent workers who are subject to a retention of 6.1 percent of their income, on average, but do not have to present a declaration if their income is lower than US$43,000 per year. This legislation, undoubtedly, does not encourage formal job generation.<sup>16</sup> The resulting „overtaxation‟ is equivalent to 0.5 percent of GDP.

24. **The introduction of a voluntary income tax declaration combined with a reduction of the income tax could reduce the Gini coefficient by 1.9 points at a fiscal cost (in terms of lost revenues) of 0.4 percent of GDP.** One difficulty in changing current legislation related to retention of income taxation at the source would be the associated loss in tax revenue. To compensate for this effect, the income tax threshold could be reduced to 75 percent of its current value (which would still make it the highest in the region), yielding a saving of 0.1 percent of GDP. Under the assumption that all independent workers would now voluntary declare annual income, most income tax would be paid by the richest quintile, while the poorest three quintiles would not contribute.

# **3.2 Indirect Taxation**

25. **The Value Added Tax (VAT) in Colombia is regressive as it increases income inequality by 1.2 Gini points.** VAT is the single most important source of revenue in Colombia, raising 5.4 percent of GDP in 2010. More than half of the revenues are collected from the richest 30 percent of the population given that this group account for the bulk of total consumption (Table 2). The tax is regressive when the tax amount paid is compared with income: Value added taxes account for a relatively large share of the incomes of the poor, and this share is declining as incomes rise.

26. **The regressive nature of the Colombian value added tax may be surprising given tax exemptions of many basic goods consumed by the poor.** The value added tax is regressive, by design, if a flat tariff is applied, as the amount paid in taxes is relatively higher for low-income individuals compared to high-income individuals. Colombia, meanwhile, operates a system of multiple tariffs. In addition to the general rate of 16 percent there are six additional rates of 0, 1.6, 10, 20, 25 and 35 percent, as well as exemptions and exclusions. Examples of basic commodities which have a zero rate include: maize, rice, potatoes, legumes, tomatoes, yucca, bananas, most fruits, milk, eggs, some breads, salt, beef, fish and pork.

> 16 A number of changes to the rules regarding retention of income were recently introduced through Law 1430 of 2010, Decree 3590 of 2011 and the National Planning Law of 2011, but the effects of these changes are unclear.

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