Taxing Venezuelan bonds

March 28, 2007

A couple of weeks ago, the tx superintendent said that the Government was planning to tax Venezuelan Government bonds because banks were making too much money because of their tax free status. I meant to write about it, but things have been hectic. This is an eminently reasonable proposal in terms of tax fairness and equality. However, nothing is ever simple in economics. As a trained scientist I have learned that the problems in economics is that mankind makes up the rules and once you alter one, it may affect a whole chain of them. In science the rules are there and you study them. Even better, you can rn the experiment again, which in economics its hard to do particularly if you wait too long.

There is an example of a similar tax exemption that would make sense to remove in another country, that of the capital gains tax exemption for foreigners in the US. It would be fair to remove it for US citizens who have to pay taxes, the problem is legislators in the US are afraid that if removed, there might be a mini crash in US stock markets as foreigners decide to take tehir money elsewhere.

The case of Venezuelan bonds is very similar. It may sound fair, but it has too many edges that in the end hurt the Government and its financing needs.

But first, let’s look at the history of this tax free status. Venezuelans, both citizens and corporations have always been weary of Government. This is a Government that decades ago forced banks to give up all their gold, so that in general Government bonds are frowned upon. In fact, this reluctance to invest in Government bonds makes many Venezuelan citizens act irrationally preferring to have their money in banks that in the end depend anyway in Government bonds to pay them interest.

Up to the debt crisis in the early 90’s Venezuela had no dollar denominated bonds, but depended on bank loans, that almost made many foreign banks go belly up. Then came the Brady bonds, which provided a solution to the crisis. But in order to work, Governments had to grant these bonds tax free status to make it attractive for foreigners. Venezuela, for example, taxes foreigners at a rate of 30% if they are not in the country. Thus, when Venezuela’s Brady bonds were created, they were granted tax free status by the Organic Bill that created them. Since then, all new issues have been tax free, because otherwise, the Government would have to pay more interest to make their return comparable to those with tax free status.

The same became true of Bolivar denominated binds, which were not that large, as banks used most of their deposits to grant credits. Then, when Chavez came to power, when the initial stock of Bolivar denominated binds was no more than US$ 1 billion, the Government began issuing more and more local bonds to finance the deficit. To do this, it had to pay high interest to make it interesting, as the stock in these bonds ballooned to some US$ 10 billion by 2002. And they were tax free.

Then came the exchange controls and the Government began forcing interest rates down to the point that today they are extremely negative, with inflation near 20% and Government bonds paying 6%. Banks invest in it, because there is so much liquidity that they have little else to invest in.

Thus, while the proposal is good and seems quote fair, the problem is how to implement it, without creating a crisis. (By the way, interest earned in Venezuela in a savings account or a CD is also tax free).

All bonds, or only those in Bolivars? The first question is whether the exemption would be removed for both local bonds or those denominated in foreign currency. You see, if all of a sudden you removed the tax exemption from all foreign bonds, then foreign investors will ask for a premium to invest in Venezuelan bonds in order to compensate for the new tax. Sfter all, funds that invest in Venezuelan Sovereign bonds look at them in comparison with those of other countries, if all of a sudden you implemented a 30% tax on them, the prevalent 7% yield on Venezuela’s bonds would be cut to 4.9%, making it quite unattractive. Thus, whatever the Government is paying would have to be increased by exactly the tax and nothing would be gained. In fact, its is easy to see this in the new PDVSA bonds. Because they are from a Government owned hydrocarbons company, these bonds are tax exempt. If they weren’t the coupons would have to be much higher tah they were set this week.

Only those in Bolivars? While banks have nowhere to turn because of the exchange control and the legal limitations in foreign currency for local banks, the current yield in local bonds also makes it hard for the Government to remove the tax free status. Since it is the Government that needs the financing, it can not afford to have banks stop buying the bonds. Since yields are near 6%, a 30% tax would drop it to 4%, banks may prefer to lend money cheaper to good risks, at rates near 9%, or more expensive to bad risks, say 20%, rather than get so little from the Government. In the end, it would force the Government to pay a higher interest, because it is the Government that is running a deficit and needs the financing.

All bonds, or only from now on? Finally, the question is whether they say all bonds will have a tax from day one, or they will work them in gradually. Clearly, forcing all of the to have axes from day one creates more of a dislocation, than working them in slowly. This would seem to be the only way for having it work. At the beginning the Government would have to pay more for new bonds to compensate, but as the old ones expire, they could lower yields and there would be a net positive effect for the Government.

In the end, the proposal is good, but the whole thing boils down to the Government needing the bonds more than local banks or investors or foreign investors needing them. It would seem that unless the Government curtails it appetite for spending, removing the tax free status is sort of like running in the same place, the bonds would not be tax free, but the Government would turn around an pay an almost equivalent amount in interest to compensate for the taxes on the bonds.

In the end, it is always excess Government spending which is at the root of all current economic distortions in Venezuela. In the end it is the only problem that is not being attacked.

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