Argentina has to get out of the co-participation trap

Argentina’s social and economic decadence can be explained by several factors. An important one is the malfunctioning of the public sector. Citizens bear a high tax burden and suffer very limited production of public goods. The mismanagement of public resources is at the core of this impossibility to progress.  

One reason for the public sector mismanagement is the perverse incentives of the federal tax co-participation regime. Co-participation operates as a trap since there is no possibility of achieving the unanimous consensus necessary to modify it. Therefore, the solution is to eliminate it and each province finances itself with the taxes paid by its citizens. In order to move forward, it should be established that the national State should keep all the proceeds from the Income Tax and the provinces should keep all the VAT collected in their respective territories.  

The question that arises is how financially viable this change is. According to data from the Ministry of the Economy corresponding to 2019 (pre-pandemic), it is observed that:

• VAT collects approximately 7% of GDP which is distributed 4% to the provinces and 3% to the national government.
• Income Tax collects 5% of GDP and is distributed 3% to the provinces and 2% to the national government.
• This means that assigning the Income Tax to the national State and the VAT to the provinces would not alter the current situation.

These data show that co-participation could be eliminated. By appropriating 100% of the income tax revenues, the national government would have a volume of resources similar to what it has today. The same happens with the provinces as a whole by appropriating 100% of the VAT revenues. There would be no secondary distribution among the provinces, but each jurisdiction would receive the net VAT paid by the taxpayers of its territory. With this new rule, the provincial states will be encouraged to implement policies to increase their geography’s value-added since this would be the way to increase fiscal resources. The more value-added it generates, the more resources the provincial state will obtain.

The change does not require major modifications to the current fiscal collection system. The AFIP would continue collecting VAT as it has been doing, but instead of distributing it by applying the rules set in the co-participation, it would do so by sending to each province the net VAT generated by taxpayers in its territories. Under this scheme, it would be possible to eliminate the provincial Sales Tax, an extremely distorting and difficult to administer tax for both companies and provincial governments. The VAT rate, indeed, would have to be increased to compensate for the elimination of the Sales Tax. This is not an increase in the tax burden, but rather is to make explicit the current overlap between VAT and the Sales Tax.

The provinces that lag behind in terms of development would not generate with its net VAT the resources they currently receive from co-participation. To address this issue, it is advisable to create a Convergence Fund to compensate for the loss of income. This is a transitory compensation mechanism that must contemplate specific development policies to shorten their gaps with the rest of the country. Thus, the provinces that are currently lagging behind will generate more of their own resources through VAT.

The 1994 constituents imposed on Congress an impossible task: to agree on a new co-participation law before 1996. Remaining trapped in this perverse scheme of co-participation implies feeding the decadence. The solution is to eliminate the co-participation so that each province can finance itself with the value-added they generate in its geography.