Formalisation through taxation: Paraguay's approach and its implications

Jonas Richter, 7 May 2018

The informal economy encompasses all transactions of legal goods which are not reported to the government. It is estimated that, globally, one third of the non-agricultural workforce makes their living from the informal economy. In Latin America, sub-Saharan Africa, and Central Asia, 40% of GDP is informal.

The benefits of formalizing the informal sectors of a given economy are clear. Most obviously the government would see an increase in revenue from taxes, and such economies would be given access to credit and the ability to legally enforce contracts. It has also been shown that there is correlation between a broad tax base and successful democracy. This is quite logical as citizens who pay tax will be much more likely to take interest in how the government spends their money. While it is obvious that it is desirable to formalize an economy, convincing a large segment of a given population to start paying taxes is a difficult proposition.
Jonas Richter focusses on Paraguay as an instance of successful formalization. In the period from 2002 to 2015 Paraguay increased the government's revenue with respect to GDP from 8% to 12.9%. Targeted tax reforms were able to create a larger, more compliant tax base. In 2004 Paraguay introduced a 10% VAT tax for most products and reduced its corporate income tax from 30% to 10%. In 2012 Paraguay introduced a 10% income tax on all citizens above a given income level and made all expenses fully deductible. This deductibility incentivized consumers to buy from formal vendors, thereby incentivizing vendors to formalize themselves. It also incentivized these now formal businesses to buy from formalized suppliers and in this way the incentive to formalize made its way up the chain of production. The period following the imposition of these taxes saw a 135% increase in active formal businesses in Paraguay.

by Solomon La Piana