Fiscal Policy and Inequality in a CGE Model for Colombia

In this article we use a Computable General Equilibrium model (CGE) calibrated for the Colombian economy, to analyze the efficiency and the impacts of changes in the tax system on growth, welfare and income distribution. Three scenarios are considered: The first analyzes an increase in VAT rate like the one conducted in Colombia’s 2017 tax reform, where the general VAT rate increased from 16% to 19%, leaving the exceptions of the system unchanged. The second scenario evaluates an extension of VAT to all products, including those products of the basic basket. In the third scenario, a decrease on the corporate tax rate of 20% is evaluated, reducing the nominal tax rate from 39% to 31.2%, without altering the other conditions that determine the tax collection and compensating the reduction of the tax collection with a progressive increase of the tax to the people of the decile 5 onwards, whose new rate is between 3% and 14% of their income. The most important findings are: first, the low cost of compensation that is required to avoid the reduction of welfare of households with lower incomes, so that they do not see their welfare altered (measured through compensated variation) after an increase on indirect taxes. Secondly, it is convenient to move from taxing the production process to taxing the results of the process (through taxes on personal income), decreasing corporate income tax rates and compensating for it, with an increase in personal income tax, even maintaining a zero tax on the lower income population. By mitigating the tax burden of companies, the accumulation of capital can be encouraged, with important positive consequences for medium and long-term growth, without negatively affecting the progressivity of the system.