Small firms are responsible for much of the job creation in Latin America. At times, they are considered repositories of entrepreneurial talent and innovation. For these and other reasons, governments deploy special policies to help them, like subsidized credits from development banks or set-aside purchases from the government. In Latin America, one policy stands out: special tax regimes with substantially lower tax burdens.
Nonresident Senior Fellow - Global Economy and Development, Brookings Economic and Social Policy in Latin America Initiative
In Peru, for example, firms face four different social insurance and corporate tax regimes depending on their level of sales and number of employees; the tax burden gets larger as firms get bigger. In Brazil, small firms can jointly cover their social insurance and corporate tax obligations through a single payment if they are small, but separately and at higher rates if they are large. In Mexico, firms with sales below a certain threshold face a lower tax burden than firms with sales above it. In Costa Rica, small firms—as determined by a formula combining sales, purchases, assets, and employees—jointly pay their value added and income taxes through a single tax. Although eligibility requirements vary, as well the implicit subsidy, with the exceptions of exceptions of El Salvador, Panama, and Venezuela, every country in Latin America has some form of a special regime for small firms.
Despite their popularity, the objectives of these special tax regimes are not always clear. Is it to promote employment or entrepreneurship? Or is it to promote smallness for its own sake, despite the tendency for small firms to be much less productive than larger ones? Is it the hope that these firms will grow and become more productive?
Tilting against productivity
My view is that these special tax regimes may be counterproductive, because they allow low productivity firms to survive in the market and impede higher productivity firms from growing and creating more productive and better paying jobs. These regimes may be one reason why productivity in Latin America has grown so slowly.
Note that in the absence of this special regime the firm would have paid 90,000 pesos in taxes (30 percent on gross profits of 300,000) and earned 210,000 pesos in after-tax profits. After-tax profits are 33 percent higher than they would have been had the firm not been favored.
Table 1: Hypothetical example of a firm taxed under a special and normal regime (pesos)
Labor and Materials
|Tax||After Tax Profits||Tax||After Tax Profits|
N.A. = Not an available option.
If sales double, the firm still qualifies for the special regime. In the second line of Table 1, the firm now makes gross profits of 600,000 pesos, pays 40,000 pesos in taxes, and makes 560,000 pesos in after-tax profits (again, 33 percent higher than the 420,000 in after-tax profits it would have made in the absence of the special regime). Since after-tax profits increase with sales, the firm has all the incentives to grow.
The problem begins after this point. If sales grew again, say, by 5 percent to 2,100,000 pesos, the firm would no longer qualify for the special regime. The third line of table 1 shows that the firm would have to pay 30 percent of its gross profits of 630,000 pesos in taxes, so its after-tax profits would fall to 441,000 pesos, less than what the firm was making before it grew (560,000 pesos). The firm is better off staying small. In fact, the firm will only grow if its sales increase by at least 34 percent, at which point after-tax profits (at 562,800 pesos) will be higher than under the special regime. And even if sales grow by more than a third, after-tax profits would barely increase by 0.5 percent.
More productive might mean less profitable
The problem is that a firm with sales of 1,999,999 pesos may be substantially less productive than a firm with sales of 2,000,001 pesos, but substantially more profitable. The less productive firm will survive in the market, and maybe even get bank credit—it is very profitable, after all—while the more productive firm may not survive.
This is a hypothetical example but the tax regime is real. This is what actually happens in Mexico. Figure 1 uses firm-level data from Mexico’s Economic Census for 2013 to show the effects of Mexico’s tax regime. As it turns out, there are 7,755 firms whose sales levels are 5 percent or less than the threshold established in Mexican law separating large from small firms. The figure plots the change in after-tax profits for each firm if sales increase by 10, 20, or 30 percent.
Figure 1: Changes in after-tax profits for “close to but below the threshold firms” (percentage change)
Amazingly, if sales increased by 10 percent, 88 percent of all firms under consideration would experience a drop in after-tax profits (point A in the figure). If sales increased by 20 percent, 80 percent of firms would experience lower after-tax profits (point B). Even if sales could increase by 30 percent, more than half of all firms would be better off not growing (point C).
Mexico is not alone
These problems are endemic. In Latin America, they are a big reason for the large number of small firms that characterize the region’s economies. The details of how these regimes operate vary from country to country, but the general effect is the same: inadvertently, these regimes allow unproductive firms to survive and impede productive firms from growing, exactly the opposite of what is needed to create well-paid jobs.
Tax policies are distorting the size distribution of firms. Smaller firms have higher entry and exit rates and can induce greater labor rotation, impeding learning on the job. These firms may be creating many jobs, but these jobs are both less stable and compromise wage growth.
Other things contribute to the overabundance of small and unproductive firms in Latin America, but special tax regimes are clearly culpable. Policymakers should be asking themselves whether favoring small firms with special regimes is the best way to create good jobs.