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The Political Economics of Tax Reform

in Chile
a b
Leonardo E. Letelier S. & Mireya Dávila A.
a
Instituto de Asuntos Públicos, Universidad de Chile, Santa Lucia
240, Santiago, 8320208 Chile; Padre Román 4721, Santiago,
7630026 Chile
b
Instituto de Asuntos Públicos, Universidad de Chile, Santa Lucía
240, Santiago, 8320208 Chile
Published online: 20 May 2015.

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Tax Reform in Chile, New Political Economy, DOI: 10.1080/13563467.2015.1041475

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 New Political Economy, 2015
http://dx.doi.org/10.1080/13563467.2015.1041475

The Political Economics of Tax Reform

in Chile
LEONARDO E. LETELIER S. & MIREYA DÁVILA A.

This paper explores the political economy at the time of the 2012 tax reform,
Downloaded by [New York University] at 01:09 23 May 2015

which paved the way for a radical tax increase in 2014. Both were an explicit
response to demands to improve public education. As opposed to the 2014
reform, the 2012 tax adjustment was an unplanned decision made in the wake
of a pact of long-term fiscal stability during the government’s last year in office
and was partially negotiated with student associations and pressure groups. We
hypothesise that the existing institutions were not strong enough to meet emerging
social demands through formal channels. We will show evidence for the hypoth-
esis that the government’s incorporation of students’ demands in its agenda was
mainly a response to the role of the media, the fact that it is not difficult for stu-
dents to organise themselves and express their demands, the support of students’
families and the ruling government’s fear of missing out on a second term in
office.

Keywords: tax Reform, political economy, education, Chile

1. Introduction
Since the return of Chile to democracy in 1990, significant efforts were made to
raise socially oriented public expenditure, of which education has been particu-
larly favoured. The proportion of public funds spent on education increased 533
per cent in real terms in the period 1990 –2012 (DIPRES, 2004 –2013), which
raised its share of the GDP from 2.5 per cent to 4.0 per cent. Nevertheless,
there has been increasing political pressure over recent years to further raise
that expenditure and change the existing model of funding for and provision of
public education. Up until a Constitutional amendment being passed in January
2015, the institutional context in which any policy reform took place in Chile
was based on the original version of the Constitution that was established in

Leonardo E. Letelier S., Instituto de Asuntos Públicos, Universidad de Chile, Santa Lucia 240, San-
tiago, 8320208 Chile; Padre Román 4721, Santiago, 7630026 Chile. Email: lletelie@iap.uchile.cl
Mireya Davila A., Instituto de Asuntos Públicos, Universidad de Chile, Santa Lucı́a 240, Santiago,
8320208 Chile. Email: miredavila67@gmail.com

# 2015 Taylor & Francis

 Leonardo E. Letelier S. & Mireya Dávila A.

1980 by the military government that ruled the country between 1973 and 1989.
The ruling version of the Constitution at the time being examined contained
numerous restrictions that diminished the likelihood of radical reforms, since it
favoured broad political agreements (Aninat et al. 2011). By far the most impor-
tant of these referred to the representation of binomial legislators, which forced
parties to join ample and moderate coalitions. So far, the two dominant blocs
have been the centre-right Alianza por Chile (Alliance) and the centre-left Concer-
tación por la Democracia (Concertation). After one period with the Alianza in
power (2010–2013), the Concertación returned to power in 2014. This new
version of the former Concertation was renamed the Nueva Mayorı́a (New
Majority) and incorporated the Communist party. The above-mentioned 2015
Constitutional reform re-established the proportional representation system,
which promises to change significantly the political scenario.
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This research intends to examine the political economic content of the 2012
increase in taxes in Chile, concentrating on three of its features. First, it was under-
taken by a centre-right coalition that ruled the country between 2010 and 2013,
whose original plans were far removed from raising taxes. Second, it was
carried out in this government’s last year in office. Thirdly, despite this being a
rather tame tax adjustment, inspired by the view that the existing tax structure
should be ‘perfected’ rather than ‘changed’, it paved the way for the more radical
and fully planned tax increase implemented by the centre-left coalition that took
office in March 2014.We hypothesise that the long-lasting stability of tax regu-
lations from the late eighties onwards was mainly due to the political institutions
involved and the implicit social pact agreed upon by those involved in recovering
democracy in 1989. As income per head rose and emerging social groups gained
access to full high school and further education, new demands for improving
equity and the quality of public education emerged. Had the existing rules of the
political game been ‘strong’ enough, a counter factual scenario of formal delibera-
tion and bargaining would have prevailed and a relatively smooth path of incremen-
tal changes would have occurred. Nevertheless, existing political institutions were
unable to channel these changes, leading to political riots on the streets, forcing
the government to negotiate directly with the groups involved. This was the
result of two main factors. On the one hand, it was the first time a centre-right
coalition had been in power since democracy was restored. This achievement
would most likely have been put in jeopardy had the above pressures been disre-
garded. On the other hand, although Chile was recognised as a stable and economi-
cally successful Latin American democracy, it was also seen as the stage for a
unique set of social policies, of which the lack of active State involvement in edu-
cation was increasingly pointed out as a source of segregation, income inequality
and social unrest. The media played a major role in getting this message across,
causing the government to change its original agenda in the belief that spending
more on public education was both desirable as well as unavoidable.
The remainder of this paper is organised as follows: Section 2 presents the current
debate on the causes of the tax reforms and some stylised facts on the case being
analysed. Section 3 presents the evolution of recent tax reforms. Section 4 addresses
the political economy of tax reforms in Chile. Section 5 describes the passing of the
2012 reform and its aftermath and conclusions are presented in Section 6.
2
 Political Economics of Tax Reform

2. On the causes of tax reforms

2.1. The debate
When it comes to general tax policy targets, literature acknowledges that a socially
desirable tax policy should promote ‘efficiency’, ‘equity’ and ‘simplicity’.
However, the question remains as to how close to reaching each target one can
get, since achieving them involves numerous policy trade-offs. By following
North’s definition of institutions, collective choice regarding the above dilemma
hinges upon ‘humanly devised constraints that structure human interaction.
They are made up of formal constraints (rules, laws, constitutions), informal con-
straints (norms of behaviour, conventions, and self-imposed codes of conduct),
and their enforcement characteristics’ (North 1994). In this view, political insti-
tutions establish the way in which social preferences are expressed at the polls
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and the extent to which the ruling government is able to interpret what people
want. Concerning tax reforms, two political economic issues are worth looking
at. On the one hand, it is interesting to know what kind of specific circumstances
caused them. On the other, it is equally important to ask whether such a reform
took place in the context of the existing institutions or if it was the outcome of
demands being through informal channels. Should this be the case, the question
is why such a situation occurred and how the government in power was expected
to react.
In trying to address this first question, literature has identified a number of feas-
ible causes for tax reforms. They include the effect of economic crises (Ascher
1989, Bird 1992, Drazen and Grilli 1993, Weyland 1998, Sanchez 2006), inter-
national influences (Sanchez 2006) and certain features of the country’s politics
(Spiller and Tommasi 2003). A study by Mahon (2004) on the Latin American
case shows that polarised parties and governments with a long time in power
are less likely to undertake tax reforms. Conversely, the number of existing
parties, partisan dominance, fractionalised legislature and the degree of party
institutionalisation all contribute to whether reforms are carried out or not. Simi-
larly, Lora and Olivera (2004) find support for the hypothesis that, in Latin
America, inflation crises tend to trigger downward tax reforms. Based on a
similar set of countries, Hallerberg et al. (2009) show evidence to support the
role being played by the president’s ideology, the type of political institutions
in place and the impact of a crisis on the likelihood of a tax reform occurring.
Regarding how reforms take place, Machado et al. (2011) state that political
demands in democratic regimes may lead either to conflict on the streets or to
some type of institutionalised deliberation. Based upon a sample of 17 Latin
American countries, they provide evidence to show that ‘strong’ institutions
will work through political demands using deliberation in Congress and think
tanks, among others. On the other hand, weak institutions promote conflictive
solutions, in which pressure on the streets plays a significant role.

2.2. Stylised facts and hypotheses

Despite Chile generally being regarded as a relatively well-performing and insti-
tutionally strong country – a fact acknowledged by its incorporation into the
3
 Leonardo E. Letelier S. & Mireya Dávila A.

OECD in 2010 – some features of its development appear to be lagging behind

that of other countries with a similar GDP per head. While this has become appar-
ent in a variety of indicators, the case of education is particularly relevant, as
student associations, teaching unions, students’ parents and even some members
of academia represent a visible, highly cohesive and potentially strong group.
As opposed to beneficiaries of public health services or compulsory pension
schemes, members of the educational community are more likely to know each
other and face fewer difficulties when it comes to pushing for demands that
work in their favour. Undoubtedly, a direct connection exists between the edu-
cational demands presented in 2011 in Chile and the tax adjustment that took
place in 2012, which opened the way to the radical increase in taxes implemented
in 2014. Nevertheless, the question remains as to how a centre-right coalition –
such as the one in power at the time this occurred – ended up making such an
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unplanned decision and why these demands were expressed on the street,
beyond formal institutional channels. The answer probably lies in a rigid political
institutional framework unable to capture the dynamics of social movements.
Interestingly, the media managed to incorporate these demands into the govern-
ment’s agenda, as it was made clear that the students’ problems did exist and
needed to be addressed.
As far as education is concerned, Chile is certainly a special case if compared
with its OECD partners. Its educational model was conceived to let private and
public providers compete in a market-friendly environment, reflected in the
high private share of Chile’s total educational expenditure compared to the
OECD’s (Table 1). School-level education operates in three parallel sub-
systems, made up of public-run municipal schools, public-funded private

T ABLE 1. Educational indicators

Chile OECD

Public and private share of educational expenditure (2011)

Per cent of public education expenditure 59.9 83.9
Per cent of private education expenditure 40.1 16.1
Mean PISA score (2012) 243 494
Total expenditure per student (2009)
Public expenditure per student in US dollars 2218 7407
Public and private expenditure per student in US dollars 5522 9487
Expenditure on further education (2011)
Annual total expenditure per student in further education in US dollars 7897 9635
Annual public expenditure per student in further education in US dollars 3276 7876
Per cent of students who receive public loans and/or scholarships (further 50.0 N
education)
Per cent of students who receive scholarships (further education) 20.0 N
Source: OECD Education at a Glance 2014.
Notes (N): In the case of Chile, this data was taken from the chilean Ministry of Education. While no
equivalent measurement is available for the OECD group as whole, N is close to 100% in most of
advanced countries.

4
 Political Economics of Tax Reform

schools and fully paid for private schools. It has been suggested, however, that
neither competition between schools nor municipal decentralisation in education
has worked as expected, with poor educational standards and segregation among
students across all school types and educational providers (Helgø 2002, Hsieh and
Urquiola 2006, Elacqua 2012). Further education is also a case in point, as it was
originally designed to be fully paid for by students, in the belief that a professional
degree would provide a positive private return. Interestingly enough, this principle
was assumed to be true for private and public universities alike, in the context of a
very heterogeneous supply of quality career training. Theoretically, needy stu-
dents would be able to borrow money to fund their university education. Since
the beginning of the 1980s, when the existing model was introduced, significant
efforts have been made to improve student access to scholarships and publicly
funded credit. Nevertheless, only 50 per cent of university students get any
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support from the State, of whom less than half are given some type of scholarship
(Table 1). Private contributions to funding education in Chile are clearly above the
OECD standard, with this share reaching 68 per cent when it comes to further edu-
cation and more than half originating in borrowing from their family. Although no
comprehensive study of the magnitude of families’ debt due to funding university
studies has been made, prima facie evidence suggests that such a debt represents a
major source of distress for students (i.e. Pérez-Roa 2014). Regarding the quality
of school-level education, this appears to digress significantly from the OECD
standard if measured according to the Progamme for international students assess-
ment (PISA) score. Notwithstanding a significant gap in quality with respect to the
OECD’s1 standard, OECD estimates suggest that average tuition fees for the first
year of a type A (public institution) education in Chile were US$ 5885 in 2010/
2011 (OECD 2014), with this being higher than the equivalent figure in the
USA (US$ 5402). A similar comparison among ‘government-dependent insti-
tutions’ shows that Chile also ranks higher than the UK, with the former at US$
6924 per student as opposed to US$ 980 for the latter. Nevertheless, university
tuition fees are 30 per cent higher than in the USA, Australia and Japan when com-
pared to the national per capita income (OCDE-World Bank 2009). While ‘for-
profit’ schools are still formally permitted by law, private universities are not
allowed to operate as profit-oriented entities. Nevertheless, the evidence suggests
that at least some private universities do operate as profit-making enterprises,
paying rent on assets formally owned by members of the university board; signifi-
cant bank transfers have also been detected from specific private universities to
related ‘for-profit’ organisations. Even foreign investors like Laureate, which cur-
rently controls the property of two Chilean private universities, openly acknowl-
edged that investments made in Chile would be fully recovered, since company
shares were expected to significantly increase in value as a result of the fact
that medicine ‘was a profitable career’ taught at one of these universities (Fontaine
2012).
The tax system in Chile up until the reforms introduced in 2012 and 2014 has
been equally unusual, as some evidence has located the country below the inter-
national standard for its level of income per capita (i.e. Ivanyna and Haldenwang
2012). Generally, Chile has exhibited a relatively market-friendly tax system in
which tax efficiency has generally been prioritised over tax equity, with this
5
 Leonardo E. Letelier S. & Mireya Dávila A.

being confirmed by the fact that, up until 2012, the Gini coefficient was almost the
same before and after taxes (Engel et al. 1999). While the tax burden as a percen-
tage of the GDP in Latin America – including social security contributions – rose
from 13.4 per cent to 19.1 per cent between 1990 and 2010, Chile’s went from
17.0 per cent to 19.6 per cent in the same period (Gómez Sabaini and Morán
2012). Despite the OECD group exhibiting a slight downward trend in tax
burden from 2000 onwards, Chile is still lagging behind in this group, which it
has been a member of since 2010 (Table 2). Interestingly, the tax burden in
Chile appears to be less similar to that of Latin America and closer to that of
the OECD when looking at net social security contribution tax revenue. As of
2011, this represented 19.9 per cent of all revenue in Chile, 16.9 per cent in
Latin America and 24.8 per cent in the OECD. This is most certainly the result
of a significant share of social security contributions going to private providers
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in Chile, in the case of both the pension and the health system.
Regarding specific taxes before the last two tax reforms, Chile collected 37 per
cent of all its revenue from VAT in 2011, which was a substantially higher share
than other OECD countries (19.1 per cent). Another feature worth mentioning is
that of corporate income tax (CIT). The pre-2012 reform rate was 17 per cent of
accrued profits, with this payment then becoming a tax rebate in firm owners’
personal income taxes (PITs). It follows that, in practice, the CIT was only
paid when profits were actually distributed to a firm’s owners, as pending taxes
were recorded in the so-called ‘Tax Profit Fund’ (FUT). However controversial,
this ‘integrated’ system remained the same from 1984 until 2014, when it was
eliminated by the drastic 2014 tax reform. Although specific tax conditions
were given to small firms (PYMEs) as well as mining activities and large
foreign investments, the tax regime in force until 2014 was rather simple and
subject to few exceptions. Interestingly, the marginal PIT rate remained relatively
high in Chile (40 per cent for the highest bracket) even after the 2012 reform.
While this rate appeared to be a pro-equity feature, it was argued that it promoted
tax avoidance through the establishment of legal entities that paid taxes in accord-
ance with the previously referred to CIT and so was cut to 35 per cent after the
2014 reform.

T ABLE 2. Tax burdens as a percentage of the GDP (2011)

Chile OECD Latin America

Income, profits and capital gains 8.5 11.4 4.9

Payroll 0.0 0.4 0.4
Property tax 0.8 1.8 0.9
Taxes on goods and services 10.5 11.0 10.3
Other taxes 0.1 0.2 0.4
Social security contributions 1.3 9.1 3.6
Total taxes as a per cent of the GDP
With Social Security 21.2 34.1 20.5
Without Social Security 19.9 24.8 16.9
Source: OECD.

6
 Political Economics of Tax Reform

3. Evolution of the Chilean tax system

3.1. From radical reforms to tax stability
Chile has undergone several tax reforms over the last 40 years. Nevertheless, a
compulsory turning point was the wave of radical tax changes that took place in
the wake of the 1973 coup, as part of a profound pro-market institutional redesign
by the military government. The advent of a non-democratic regime plus the econ-
omic and political crisis that hit the country in the first half of the 1970s were una-
voidable features of this period. Whatever their effect and the political context in
which they occurred, a new era in Chilean economic history was established,
whereby a complete reshaping of academic and political debate was launched.
Generally, large business groups were acquiescent about most ongoing polices,
despite some entrepreneurs being severely hit by certain tax measures. While sig-
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nificant reductions in corporate profits taxes were implemented in this decade,

these occurred along with a rapid import tax cut, which negatively affected
local manufactures and some (albeit not all) food producers (Edward and Leder-
man 1998). Interestingly, a clearly opportunistic decision was taken at the end of
the military regime, as the ruling government took advantage of the fiscal leeway
that emerged due to the high price of copper in the late 1980s in order to
implement a significant tax cut, which included – among other measures – an
accrual-based CIT to replace the existing effective profit-based tax (Marcel 1997).
When the Concertación came to power in 1989, political negotiations began in
order to re-establish a solid process of collecting tax revenue and to reverse the
aforementioned tax cuts in the context of a renewed fiscal pact (Prichard 2010).
The main changes included a transitory increase in CIT from 10 per cent to 15
per cent and a return to the effective income base, the incorporation of large agri-
cultural producers into the effective (as opposed to imputed) income regime and a
transitory two-year VAT increase of 2 per cent (Figure 1). A minor follow-up to
this first democratic reform was the reduction of the import taxes implemented in
1991, whose effect on revenue collection was compensated by an extension of the
external stamp credit, plus a reserve requirement on capital inflows. While most of
the changes being made were to expire in 1993, a new round of negotiations began
in 1992 in order to avoid an abrupt change in public revenues. A major private
actor in this case was the Confederation of Production and Trade (CPC), which
was potentially affected by the government’s desire to maintain the former tran-
sitory increase on corporate taxes at 15 per cent, which was still low by inter-
national standards, as well as to extend the transitory increase in VAT (18 per
cent) for two more years. Other minor changes included ‘tax expenditures’ to
promote personal savings and individual and private company contributions and
donations to publicly subsidised schools. A few minor reforms were introduced
in 1997, when the transitory 18 per cent VAT rate became permanent and some
pro-personal saving incentives were partially curtailed. Later, in 1999, a
number of tax exemptions to support geographically isolated zones were approved
and a new round of import tax reduction was carried out.
The new government led by Ricardo Lagos (2000–2006) initiated another
round of upward tax adjustments so that a more aggressive socially oriented
public policy could be implemented, of which the strengthening of public
7
 Leonardo E. Letelier S. & Mireya Dávila A.
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FIGURE 1. Tax burden as a percentage of the GDP (OECD data).

health funding was an explicit goal. This began with VAT being increased to 19
per cent in 2003 and a slight increase in CIT, which was left at 17 per cent perma-
nently in 2005. Nevertheless, a real breakthrough was Lagos’ initiative to intro-
duce a royalty on the mining industry, to be paid on top of regular corporate
taxes. Strong lobbying from the mining industry was a major obstacle to the
bill, which was initially rejected by parliament (Napoli and Navia 2012). Never-
theless, the government re-established the bill in 2005, with a formal royalty being
replaced by a ‘specific mining profit tax’ and the bill was finally passed. Since
then, some minor adjustments to the existing structure have been introduced, as
is the case with some improvements to capital market regulations in 2007,
made in the context of a process that was agreed upon and which confirmed the
view of Chile as a strongly institutionalised country (i.e. Zuvanic et al. 2010).
As can be seen from Figure 1, the main tax reforms implemented since the
beginning of the 1990s were mostly incremental. While the total tax burden has
exhibited an upward trend since the early 1990s onwards, this is highly correlated
to a similar pattern in the tax on income and profits. The significant downturn in
2008 –2009 is mainly explained by the world crisis that began in 2008 and the fall
in the price of copper in 2009. Most of the changes being shown generally suggest
that CITs have been raised and PITs cut. This is in line with a long-term reversal of
the fully integrated model implemented in the 1970s and 1980s, when taxes were
mainly paid by people as opposed to corporations. While several increases to VAT
occurred in the same period, these were explained away by the need to fund more
government expenditure in the context of severe political restrictions to raising the
CIT. A feature worth mentioning on above tax changes is the fact of having been

8
 Political Economics of Tax Reform

gradual and fully planned by the government in power. More importantly, while
interest groups did play a role, they were not the result of street pressure, but
mainly the outcome of a diagnosis made by political authorities before they
came into power.

3.2. The breakdown of tax stability

At least two basic factors explain the period of tax stability previously referred to.
First, the institutional framework in which the political game was played severely
restricted the chance of significant changes being approved. Second, since basic
economic indicators had been widely favourable since the country returned to
democracy in 1989, expressing – among other factors – rapid economic
growth and a sharp reduction in the rate of poverty, an implicit fiscal pact pre-
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vailed and thereby existing political rules were accepted in return for increasing
economic prosperity (Cornia et al. 2011). Nevertheless, despite Chile reaching
an income of US$ 22,534 per capita in 2013, which is the highest in Latin
America (according to the IMF database), a persistently unequal income distri-
bution, increasing discontent with the low-quality and rather segregationist
design of Chilean public education and a rising awareness of ill-represented pol-
itical preferences put the aforementioned stability in jeopardy. The question thus
arises as to whether the country’s tax burden and tax structure before the reforms
made in 2012 and 2014 were indeed politically sustainable as defined by Bird
(2003) or if they were condemned to converge in a more redistributive-oriented
structure.
A relevant political turning point took place in 2010, when a centre-right
coalition (Alianza) won the presidential elections for the first time since 1958,
staying in power between 2010 and 2013. The Alianza is made up of two
parties. One is the Independent Democratic Union (Unión Demócrata Indepen-
diente), which is clearly doctrinaire in its pro ‘subsidiary state’ view of the
economy and a conservative approach to social issues. The second one is the
National Renovation party (Renovación Nacional), which claims to be liberal in
both economic and social terms, this being also the president’s party in the
period at stake. A combination of factors made this coalition’s success possible
in 2010, which include an increasing disaffection with the Concertación, a lack
of political leadership of the salient coalition, and the hope that a renewed govern-
ment could deal more successfully with pending social and economic challenges.
Paradoxically, the new government made an unplanned upward tax adjustment in
2012, this not being in line with the ideological imprint of the Executive (Stein and
Caro 2012). Furthermore, this occurred on the eve of the upcoming presidential
elections, thus contradicting some empirical evidence (Lora and Olivera 2004,
Hallerberg et al. 2009). Equally interesting is the fact that, over the four-year
term of this same government, the Chilean economy grew 5.4 per cent per year
on average, as opposed to the 3.3 per cent achieved during the former government
and in a worldwide context of 3.8 per cent in the same period. A similar record can
be observed in the unemployment rate, which fell from 9.0 per cent at the begin-
ning of 2010 – when the government took office – to 6.2 per cent by the end of
2013. While such a reform was not part of the government’s original plans, we
9
 Leonardo E. Letelier S. & Mireya Dávila A.

hypothesise that it can be understood in the context of the long-term breakdown of

the aforementioned fiscal pact, which occurred as a result of political pressure
from student organisations, which managed to get their demands included in the
government’s agenda. The Executive was willing to innovate as soon as it
became aware of a sharp drop in political support as a result of the student riots
in 2011 and 2012 (Table 3). A new, fully planned and far more radical tax
reform was undertaken during the first year of the new centre-left ruling coalition
that came into power in 2014.
In May 2012, the government decided that a tax reform was needed in order to
honour their commitment to supporting education and equity, as explicitly
declared in April of that year by the Minister of Finance. In his official speech
to Congress, the President stated that the reform at hand ‘was intended to fund
the new education-related challenges that were mainly to benefit vulnerable
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groups, as well as the middle class’. It can be hypothesised that this was mainly
inspired by the view that the promises being made concerning a substantial
increase in scholarships and other related benefits were incompatible with the
need to preserve a satisfactory fiscal balance, which in itself was a widely accepted
target across the national political spectrum.
At least two important assumptions were implicit in the bill. First, the govern-
ment stated that the Chilean tax system had a significant number of loopholes that
favoured tax avoidance and that correcting them would raise tax revenue collec-
tion significantly. Second, the fact that Chile had a globalised, OECD-integrated
economy demanded a tax system more in line with countries with a similar GPD
per capita. In this respect, a higher CIT, a lower structure of PIT rates and a pro-
gressive elimination of import tariffs were in order. As far as generalities are con-
cerned, the Executive argued that the bill was intended to support the middle class
by collecting more resources to support education, while avoiding putting Chile’s
record of growth in jeopardy. However, although this was an acceptable reason for
moderate tax reform, a politically inspired purpose was the more likely reason for
the bill. While the closure of tax loopholes was in line with the government’s quest
for economic efficiency, the tax relief measures being considered were more

T ABLE 3. Survey information on government approval

Approval Disapproval
(%) (%)

Government has done well in

Period Sebastian Piñera education (%)

2010 November –December 44.3 3.3 32.5

2011 June –July 26.3 52.6 9.9
2011 November –December 22.8 62.0 6.9
2012 April 23.6 59.2 9.3
2012 July –August 27.4 52.3 12.3
2012 November –December 31.4 50.6 10.6
Elaborated in-house, based on data from the Center for Public Studies (CEP)

10
 Political Economics of Tax Reform

politically oriented, since promoting an upward tax adjustment had to be sup-

ported by the government coalition’s congressmen.
On closer inspection, the set of provisions intended to close tax loopholes was
innovative in as far as they (i) made income from ‘permanent establishments’ gen-
erated abroad by foreign branches of a local company subject to tax in the same
way as if they had originated in separate branches in Chile, (ii) established
OECD-compatible transfer price regulations, (iii) introduced a stricter regime
on the presumed income tax currently applied on agriculture and transportation
and (iv) homologised tax regulations between stock corporation and non-stock
corporation firms on ‘non-allowed expenses’, capital gains from the disposal of
shares and/or liabilities and ‘excessive’ profit withdrawals with respect to the
accumulated FUT. As far as income tax revenue is concerned, two measures
were considered. The first was an increase in CIT from 17 per cent to 20 per
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cent, which made the transitory increase in tax established in the wake of the
2010 earthquake permanent. Despite maintaining the CIT’s ‘withdrawal tax
base’, a new regulation was introduced in order to avoid excess profit withdrawals
beyond the firm’s accumulated FUT and regardless of the firm’s legal status. In
order to alleviate the tax burden on middle-income groups, the original bill
included a general cut in PIT rates, the recognition of school-level expenditure
and the withholding of taxes on payroll as a tax rebate for the Complementary
Global Tax paid at the end of the year. The government argued that these measures
would preserve the pro-savings incentives of the tax system, recognise education
as a long-term investment and promote horizontal equity for taxpayers. Finally, a
number of changes to indirect taxes were proposed, which included a cut to import
taxes, a green tax on the first sale of environmentally unfriendly products, the
elimination of the existing additional tax on mobile phones, higher excise taxes
on high-grade alcoholic beverages and cigarettes along with lower ad valorem
taxes per cigarette, a reduction of stamp duty on credit operations and the elimin-
ation of tax surcharges on imported software and e-books.
Interestingly enough, the bulk of these additional tax revenues were supposed
to come from an increase in CIT and from the set of technical improvements
resulting from the closure of tax loopholes. While ‘tax perfection’ measures
would together generate US$ 439 million by 2014, a higher CIT would produce
US$ 1151 million by the same year. As these increments were to be netted out
by the lowering of PIT, education expenditure tax rebates and other minor down-
ward tax adjustments, the net increase in tax revenue would be US$ 761 million by
that same year.

4. The political economics of tax reform

4.1. Restrictions to the political game
On acknowledging that electoral rules do indeed affect public policy outcomes
(Persson and Tebellini 2005), theory predicts that the type of representation
systems in force may bias government expenditure and taxes (i.e. Milesi-Ferreti
et al. 2002). In this respect, Chile is halfway between a proportional and a majority
system, in which gradual changes and large- to mid-sized political conglomerates
11
 Leonardo E. Letelier S. & Mireya Dávila A.

have prevailed, mainly as a result of the Constitution established in 1980 by the

military government that ruled the country between 1973 and 1989. Originally
this Constitution was meant to promote political stability and avoid sudden devi-
ations from the institutional legacy being left by the military government (Angell
2010, Garreton 2012). In this context, the aforementioned tax stability comes as no
surprise, given the informal political constraint imbedded in the fiscal pact
referred to above, and the fact that the dominant political elite was aware of the
threat from sudden increases in tax had the average voter been given the power
to decide (Samuels and Snyder 2001).
For the purpose of our case study, the Chilean Constitution contains some
important features worth mentioning. First, it concedes almost exclusive powers
to the Executive to present new bills, with the only exception being the unlikely
case in which the bill does not affect public resources. The Executive is also in
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full command of the degree of ‘urgency’ allocated to the bill, with the option of
forcing parliament to make a decision in record time. Second, despite the govern-
ment’s power of agenda, both the structure of parliament and the rules to pass a
bill severely restrict the power of government. Thus, the Executive needs to
have the support of at least 20 double-seat deputy districts and 6 senator districts
to pass a bill, which was certainly not easy. Alternatively, the government may
persuade the opposition and/or independent MPs to vote for the bill, which was
seen by some as a way to ensure that only a bill with broad political support
was likely to pass (Aninat et al. 2011). Nevertheless, the most severe limitation
was the kind of political representation held by legislators. Up to the amendment
made in 2015 (Section I), this was based on a ‘binomial’ system, in which each
district got only two seats, distributed between 120 deputies and 38 senators.
Unless one of the competing coalitions got two-thirds of the votes, that particular
district was represented by two MPs from the same coalition. Although this pro-
moted the formation of large coalitions, it also clearly subsidised minority ones, as
it makes it feasible for a minority coalition to get one of the seats.

4.2. Socio-economic framework

A persistently unequal income distribution (ECLAC 2012), increasing discontent
with the low quality and rather segregationist design of Chilean public education
policies and a rising awareness of the existing, ill-represented political interests
tended to put the aforementioned tax stability at jeopardy. Paradoxically, a tax
reform took place during the time of the centre-right coalition government
which ruled the country between 2010 and 2013. While such a reform was not
part of the government’s original plans, we hypothesise that it can be understood
in the context of the ‘agenda-setting’ framework of public policy, with the
demands for better public education becoming a politically acceptable issue. As
opposed to its predecessor, the ruling government that came to power in March
2014 was committed to implementing profound institutional reforms, which
included a significant raise in taxes and the establishment of a new Constitution.
In order to fully understand the political rationale of the 2012 tax reform, an
overview of the socio-political context in which this occurred is in order.
Despite Chile’s main economic indicators performing relatively well, the
12
 Political Economics of Tax Reform

country also exhibits some rather rare features regarding how certain basic ser-
vices such as education and health are funded, as well as in the design of its
pension system. These are mainly based on a demand-led subsidy approach, in
which private stakeholders provide services in return for a mixture of individual
and State contributions. Regardless of the merits of such a system, there is increas-
ing pressure at both an academic and political level to enhance equity, a target in
which Chile is lagging behind compared to similar OECD (OECD 2011) and Latin
American countries (ECLAC 2013).
Paradoxically, the uncontestable fact that significant progress was made in
improving access to all levels of education coexists with a rising collective aware-
ness that the Chilean educational model promotes segregation at the school level
(Elacqua 2012) and provides an expensive, low-quality public (and private) uni-
versity-level education (Section II). As opposed to other public services, education
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is unique in the fact that advocacy groups are well-organised and can easily cause
significant political impact. Segregation itself makes this more likely to happen, as
relatively homogenous students are allocated to specific schools and well-known
universities. In particular, high school students have an organisation of their own
called the High School Students Federation (FESES). Although this group was
created at the beginning of the twentieth century, the intensity of its demands
has varied over time. Its sudden return to the public arena occurred with the
so-called Penguin Movement in 2006 (Donoso 2013). While the demands being
made were generally aimed at free-from-payment benefits for students, a major
request focused on the need to change the General Law of Education (LOCE),
which was passed in a non-democratic context. Controversial issues about this
law include the emphasis on ‘freedom of teaching’ as one of its main aims,
even above the ‘right to be educated’ and the relatively minor role given to the
State as the major provider of public education (Muñoz 2012). The political
response of the centre-left coalition in power at the time was a new General
Law of Education (LGE) that was passed in 2009, replacing the LOCE. Although
the new law was a step forward, giving the State a more important role in super-
vising the quality of education, it did not innovate regarding the entities that
provide public education. A new radical reform is now being drawn up, through
which the fundamental elements of the educational model are about to be fully
reshaped.

4.3. Social movements and the media

When trying to understand the government’s unplanned decision to introduce a tax
reform in 2012, the public policy viewpoint should be examined, placing it in the
context of the so-called ‘agenda-setting’ framework. According to this view,
actors seek to influence current public policy debates by turning certain issues
into socially acceptable problems and, therefore, into matters that concern the gov-
ernment (Birkland 2007). By looking at the evolution of the student street riots in
2011 and 2012, it is easy to conclude that the Executive was forced to change its
agenda to get more funding for public education. In our case, the so-called ‘student
movement’ became a major agenda setter that managed to create a new debate, in
which education as profit began to be seen as dubious and the need to improve
13
 Leonardo E. Letelier S. & Mireya Dávila A.

public education became a politically acceptable demand. In the context of King-

don’s Multiple Stream Framework (1984), a ‘window of opportunity’ emerged as
both the ‘problem’ and the ‘political’ stream merged to produce change. The gov-
ernment’s willingness to negotiate reforms was severely affected by a clear
decline in political support during the course of the conflict and by the opportunity
that arose to reverse this trend by being responsive to the demands being made on
the streets (Table 3).
A new wave of student riots began in 2011 and lasted for six months. This time,
a centre-right coalition, led by Sebastian Pinera, was in power. In contrast to the
2006 episode, this new social movement originated at the university level, when
the Confederation of Chilean Students (CONFECH), which groups together the
main university student organisations in Chile, officially presented, in April of
that year, a list of demands intended to improve the educational system. Their
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main demands were (i) a more democratic access to university education, (ii)
student participation in university-level decisions, (iii) an increase in university
education public expenditure, (iv) a restructuring of the scholarship system and
(v) the end of for-profit education. Among the specific points above, the for-
profit issue was certainly the most emblematic, as it was at the heart of the ideo-
logical differences between the main coalitions and specific political parties. Two
days after delivering the above document, the CONFECH itself called for a
massive protest march, in which the Teachers’ Confederation, the United
Workers Front (CUT) and the Confederation of Public Employees participated,
among others. Afterwards, the National Confederation of High School Students
(CONES) also became part of the movement. Two massive protest marches
occurred in Santiago in May 2012, after which an official document was
handed over to the Minister of Education, Joaquin Lavin. Interestingly enough,
Lavin was a co-founder and board member of a well-known for-profit university.
After three months of intense negotiations, protests and a wave of school and
university sit-ins, president Piñera presented his first proposal for funding edu-
cation, which was followed by a significant cabinet change and the replacement
of the incumbent Minister of Education for Felipe Bulnes, who himself resigned
in December of that same year. The proposal included the strengthening of State
supervision of private universities and a significant increase in scholarships to uni-
versity students. At the same time, the government announced the establishment
of a US$ 4000 million endowment fund to improve education. While such a
fund was to be created from the so-called Fund of Social and Economic Stability
established in 2006, it became clear that more public funding for education was to
be taken from other areas and/or from public savings. As the conflict continued, a
new government proposal was presented, without significant changes. Despite
various attempts to set up a round table to resolve the conflict, students finally
abandoned their attempts at negotiation because of the government’s refusal to
consider free education as an acceptable demand. By the end of 2011, the need
to improve education was high on the government’s agenda and a new tax
reform was announced, intended to collect between US$ 700 and US$ 1000
million a year.
We hypothesise that one of the fundamental reasons why the government was
willing to react to increasing unrest on the streets was the sharp decline in popular
14
 Political Economics of Tax Reform

support that it faced from the beginning of 2011 onwards, which diminished the
chance of the ruling centre-right coalition getting a second term in power. Data
from a survey carried out by the Centro de Estudios Públicos (CEP) report that
this decline coincided with the student conflict and stabilised afterwards, although
there was a slight recovery in 2012 (Table 3). As expected, the public’s assessment
of government educational policies was particularly affected. Despite the moves
made by the government, mainly as a reaction to ongoing events, there were
two issues in which political negotiations maintained their ideological clout.
These were the very existence of profits made by providers of education and
the way in which additional resources were to be channelled to potential benefici-
aries. While the government was not willing to fully ban for-profit providers, stu-
dents were committed to keeping this demand on the table for as long as possible.
As for the second issue, students demanded that all additional funds should be
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given to public-run universities as an unconditional base grant. The government

wanted this money to be turned into more scholarships, according to the view
that individual choice on where to study was a fundamental aspect of a well-func-
tioning and efficient educational market.

5. The Passing of the 2012 Reform and its Aftermath

The Executive sent the bill to the Chamber of Deputies (DCH) in August 2012,
requesting it be ‘discussed immediately’ and it was finally passed in September
2012. Needless to say, several changes were made to the original bill. While
the increase in CIT was approved, the cut to PIT was less than originally proposed
and slightly more biased towards lower and middle-income groups. The tax rebate
on education expenditure was also passed, although it had a cap per student and
only benefited low- and middle-income families. The elimination of import
duties, the establishment of specific green taxes and an increase in the excise on
alcoholic beverages were all rejected.
The last version of the bill was passed with 64.2 per cent of deputies and 81.6
per cent of senators, of which 51 out 56 deputies and 15 out of 16 senators from the
ruling Alianza voted in favour. As for the Concertation members, a decisive
although less than unanimous support was given by the Christian Democrats
and the liberal For Democracy Party (PPD). While no socialist deputies voted
in favour, all but one of socialist senators did. None of the three communist depu-
ties supported the bill. While students unions did not officially declared this
outcome as a satisfactory one, they were acknowledged by the media as the
ones who dared to get a significant message across. An interesting question is
why this reform, contemplating an upward adjustment of the tax burden, was
not generally supported by all left-wing and moderate centre-left MPs. The
answer is twofold. On the one hand, the education expenditure tax rebate was con-
sidered by some as a clear consolidation of the private education-orientated model
that exists in Chile, as it mostly benefits those who send their children to private
schools. Additionally, while the government wanted to increase the number of
scholarships awarded to students belonging to low-income groups on account of
the regressive bias towards university-level public education expenditure, many
opposition groups were publicly in favour of completely free access to higher
15
 Leonardo E. Letelier S. & Mireya Dávila A.

education. The scholarship-based model was also seen as promoting the status
quo, as it left students free to choose from all the accredited universities, some
of which were accused of being profit-oriented. Finally, the tax reform was also
regarded by some as a mere cover-up, leading to only a slight increase in tax rev-
enues in light of the significant social changes needed in order to achieve a more
equitable society.
What began as a timid, technically oriented and politically reactive tax reform
in 2012 opened the door to a wave of profound institutional change, initiated by
the centre-left coalition that returned to power in March 2014 under the name
of the New Majority, led again by Michelle Bachelet. This new coalition included
the Communist party and came to power with substantial support in both the
Senate and the lower chamber. For the first time since the return to democracy,
Congress was politically aligned with a reform-oriented government, making pro-
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found tax and educational reforms feasible. Among other changes, the new gov-
ernment promised free access to all levels of education and even a new
Constitution. In order to fund additional educational expenses, a radical new tax
reform was launched in order to collect an additional 3 per cent in taxes,2 of
which 2.5 per cent would come from a set of pro-equity tax changes and 0.5
per cent from a reduction in tax evasion. In her first year in office, Bachelet
managed to significantly increase tax rates and eliminate various tax rebates,
through, among other measurements, the elimination of the Tax Profit Fund
(FUT), an increase in CIT to 25 per cent and a gradual reduction in the marginal
rate of PIT from 40 per cent to 35 per cent. In order to avoid a downward spiral in
private investment, an accelerated depreciation method was implemented.
Regarding indirect taxation, the VAT tax base was expanded to the construction
industry – until then a VAT-free sector – and a green tax on carbon dioxide emis-
sions was established. Finally, the existing Foreign Investment Statute (DL 600) –
which provided favourable tax treatment for foreign investors – was eliminated.
Although the implementation of the whole package of educational reforms is still
in progress, a big step ahead was made in January 2015, when the so-called
‘Inclusion Law’ was passed. This eliminates the co-private funding of public
schools, and rules out for profit publicly subsidised private schools. New impor-
tant reforms are still to come, some of which will be geared to support free
access to further education and diminished the role for private stakeholders.

6. Conclusions
A fiscal pact of moderate and gradual tax adjustments proved to be a feasible
arrangement in Chile over the first two decades after the return to democracy in
1989. Nevertheless, such a pact began to weaken as a new generation gained pol-
itical power and demanded new deeper reforms. Second, we have found that
underlying political pressures may have far-reaching political consequences,
even if macroeconomic performance seems to be doing well. In this regard, the
role of education is a key topic in the case being analysed. Since education-
related advocacy groups can be more easily organised and can make their
demands known via the media, they have played a key role in pushing the
government towards including these in their agenda. Interestingly enough, the
16
 Political Economics of Tax Reform

centre-right coalition that ruled the country between 2010 and 2013 had an out-
standing record of economic growth and job creation, in comparison both to
Latin America as a whole and to other similar countries in the world. Furthermore,
the Chilean experience supports the view that unexpected events can dramatically
affect a government’s agenda when these are accompanied by a significant loss of
support for the government. This is even more likely if the coalition in power is
expected to leave office after the next election and/or it is its first time in office
after a long break. Finally, we have shown that political institutions in Chile
appeared to be weak as far as their capacity for channelling collective action
into formal decision-making procedures is concerned. Street riots, informal
contact between government authorities and multiple direct negotiations
between the actors involved have been the norm in this case. While the 1980
Chilean Constitution played a role in moderating sudden policy changes for
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more than 20 years, it also impeded the implementation of the adjustments

needed to reflect the demands of the people.

Acknowledgements
We acknowledge the contribution made by two anonymous referees as well as useful suggestions to improve a
former draft of this paper by Juan Pablo Jimenez and Christian von Haldenwang at the Workshop on “The Poli-
tics of Taxation in Developing Countries” held at the German Development Institute (Bonn) in September 2013.

Disclosure statement
No potential conflict of interest was reported by the authors.

Notes
1. According to the 2014 QS ranking, only two Chilean universities are among the 220 top universities: The
Catholic University (167) and University of Chile (229).
2. The new regime is expected to collect US$ 8300 million a year by 2018, since the package of reforms will be
gradually implemented.

Notes on contributors
Leonardo Letelier S. holds a Ph.D. in Economics from the University of Sussex, United Kingdom. He belongs to
the academic stuff of the Instituto de Asuntos Públicos, Universidad de Chile (http://www.inap.uchile.cl). His
area of research is public economics with emphasis on political economy issues: lletelie@iap.uchile.cl.

Mireya Dávila A. holds a Ph.D. in Political Science from the University of North Carolina, Chapel Hill, USA.
She belongs to the academic stuff of the Instituto de Asuntos Públicos, Universidad de Chie (http://www.inap.
uchile.cl). Her area of research is the study of public policies with emphasis on the politics of public policy:
mireya.davila@iap.uchile.cl.

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19