www.ifc.org/thoughtleadership NOTE 55 • JUNE 2018 Peru’s Works for Taxes Scheme: An Innovative Solution to Accelerate Private Provision of Infrastructure Investment Created in Peru in 2008, Works for Taxes is an innovative approach to accelerating infrastructure investment. It allows private firms to “pay” their income taxes in advance through the execution of public works projects. By accepting infrastructure projects in lieu of future taxes, national, regional, and local governments can forego mobilization of public funds and reduce the burden on government budgets, as the private sector assumes the upfront costs and management of new infrastructure projects. The mechanism’s success derives from its ability to align public and private sector incentives for better quality projects and more efficient use of funds. Works for Taxes has great potential for replication in other emerging market countries with similar obstacles to infrastructure investment. In 2008 the Peruvian government devised a unique public spending significantly less than their annual budgets on investment mechanism called “Works for Taxes” that them. For example, regional and local governments spent allows private firms to “pay” a portion of their income less than half of their annual budgets on public works in taxes in advance in the form of public works—from public 2007. 2 Local communities remained impoverished and buildings to transport infrastructure and beyond. The goal lacked basic public services, creating tensions between them of the mechanism is to accelerate and improve the quality and the extractive companies. of investment in public works and services, many of which Others have been severely underfunded. Security 10% The Works for Taxes mechanism can currently be 6% Transport applied to public investment in urban development, telecommunications, agriculture, water and sanitation, Health 35% 11% tourism, public safety, transport, education, health, fishing, sports, protection and social development, culture, environment, and rural electrification. Figure 1 shows the 15% distribution of projects by sector. Sanitation 23% Prior to Works for Taxes, the mining and extractive industries enjoyed a revenue boom due to higher Education commodity prices. Yet despite significantly increased tax revenue from mining profits paid to the central government Awarded and concluded projects by sector, FIGURE 1 2009–2017 (% of total investment amount) and transferred to regional and local governments where Between 2009 and 2017, more than $1 billion was invested though the extractive industries operate,1 subnational governments Works for Taxes, benefiting more than 15 million Peruvians. Source: lacked capacity to effectively provide public works, ProInversion 1 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Works for Taxes offered those and other companies a new part of the stock of available projects in the public investment level of accountability and an opportunity to incorporate system (public initiative) or proposed by the private firm or public works into their social responsibility efforts, while group of firms interested in financing it (private initiative). at the same time ensuring that their tax payments directly Subsequently, the project is awarded by public contest benefited local communities. to a private firm or a group of firms associated with the Local Infrastructure Gap construction firm, previously selected in a private contest. Works for Taxes was created to address infrastructure gaps Once an agreement is made with the government, private in Peru, as well as multiple obstacles to investment in public companies (financing firms) pay for the public works with works, including:3 their own resources in lieu of future income tax payments. • A lack of technical criteria to properly identify and The financing firm receives certificates from the Ministry select public investment projects of Economy and Finance after the project has been checked • Low quality pre-investment and investment studies that for quality and approved by the government. These failed to match real costs and work schedules certificates can be used annually to deduct up to 50 percent • Substantial cost and project overruns of a firm’s annual income tax until the total value is used up, or they can be sold in the market to firms interested • Numerous disputes with construction companies at the judicial and arbitration levels. in buying debt. The certificates have a 2 percent annual revaluation for the unpaid balance and keep their value The Peruvian infrastructure gap has been estimated at for 10 years from the date of issuance. After this period, approximately $160 billion over the 2016–2025 period.4 companies can request a devolution from the National The Process Superintendence of Tax Administration. Although Works for Taxes was initially created to support The value of the certificates is charged by the Ministry of public works for subnational governments, the legal frame- Economics and Finance to the accounts of the public entity work has since been simplified to allow almost all entities (a ministry, subnational government, or other entity) that throughout Peru’s three levels of government to implement it.5 signed the agreement. Future transfers of up to 10 years are To be eligible, a project must close an existing infrastructure discounted from the public entity royalty accounts or other or service gap in the local community. Projects can either be income sources applicable to the mechanism. Selection of a Emission Selection of an Project public investment Agreement and use of enterprise Execution project certificate Prioritization of Organization and execution of Signature of agreement Supervision of Request “public investment PUBLIC SECTOR relevant public the public contest process Recognition of works through certificate” (CIPRL/ investment Selection of an enterprise or modifications on costs supervising CIPGN) to the Ministry of projects to be group of financing enterprises of the project (after enterprise Economics and Finance executed under studies) Approve certificate the mechanism Selection of a supervising enterprise of accordance with advance of works Selection of Private selection of Signature of agreement Execute works Use “public investment PRIVATE SECTOR a project of construction enterprise (Re)formulation of pre- certificate” (CIPRL/ their interest or Financing enterprise (or group investment studies and CIPGN) at the National proposal of a of enterprises) participates in detailed engineering Superintendence of Tax new project that the process with the selected studies and define costs Administration responds to a constructor prioritized need FIGURE 2 Simplified Process of “Works for Taxes” Mechanism Source: AC Pública. 2017. “Mecanismo de Obras por Impuestos”; AC Pública. 2017. “Ayuda Memoria: Financiamiento de proyectos de inversión pública a través del mecanismo de obras por impuestos.” 2 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Aligning Incentives Between Parties Time reductions are attributable primarily to the detailed Works for Taxes is not governed by traditional contracts engineering studies involved with Works for Taxes projects, law. A comparison of the mechanism and contract law as well as to the fact that the contract with the construction (used for public investment) can be seen in Table 1. firm is held by the private financing firm. Projects already in the pipeline are often based on low quality studies, and these don’t accurately reflect actual Table 1. Works for Taxes Versus Traditional Contracts costs or completion timeframes. As a result, the law allows WORKS FOR TAXES TRADITIONAL- the financing company to recalculate and reformulate the LAW CONTRACTS LAW project’s investment study. This significantly reduces the The contract between financier Constructor deals directly with risk of cost overruns and project delays. So far there have and constructor is dealt privately the government been no documented cases of a poorly executed project (under private law) under Works for Taxes.7 Moreover, private companies put Selection of the supervising Public tenders to contract a enterprise is made in parallel, supervisor are made after the their brand identity at stake when they take on a project. saving time contract with the constructor So reputational risk provides an incentive to complete Direct award if no bidders Abandon process if no more projects efficiently. Private firms also stand to benefit from bidders and start of a new improved public works and services in the areas where they contest are located. Source: Salinas, Sergio. 2017. “Obras por impuestos: mecanismo para The Works for Taxes mechanism benefits multiple facilitar el cierre de brechas de servicios en el Perú.” Nota de Política 2. stakeholders, including: Escuela de Gestión Pública, Universidad del Pacífico. • The government – Works for Taxes provides government entities with access to financial resources in advance, Depending on the magnitude and complexity of a private allowing them to provide quality public works and initiative project, it can have the following schedule:6 services within a shorter timeframe. In addition, it • Receipt of a declaration of relevance 20 days after liberates human and physical resources for use in other sending a letter of interest relevant projects. • Six months to prepare the pre-investment study • The financing firm – By providing public works and • Two months to select a construction firm (private services, firms can have a direct impact on their contest), conducting the public contest for the financing communities and can improve relationships with firm and signing of the agreement stakeholders. In addition, companies can invest in • Six months to prepare a detailed engineering study works that facilitate their operations or bring positive • 18 months to execute the public work externalities such as greater local competitiveness or • Two months for the reception and settlement of the works. crime reduction. • The local community – The improved execution of The Private Investment Promotion Agency (ProInversion) is public works provides local communities with better currently conducting a comparative study between Works public infrastructure and services, including roads, for Taxes and traditional public works for a sample of 38 bridges, and schools. These in turn can improve projects related to transport, water and sanitation, and the local labor force and raise household revenues. other sectors to compare project execution times. Initial In addition, construction projects generate local results from the study indicate that there are significant employment. time reductions when investing through Works for Taxes (time reductions vary according to sector and project size): Use of the Mechanism in Peru and • Transportation projects are concluded between 12 Remaining Limitations percent and 67 percent faster. Between 2009 and 2017, approximately $1.25 billion was • Sanitation projects are concluded between 27 percent pledged or invested in 318 Works for Taxes projects, with and 52 percent faster. the participation of 82 private enterprises, six ministries, 14 • Other sectors analyzed indicate projects are concluded regional governments, and 114 local governments. Several between 35 percent and 53 percent faster. private companies that have used the mechanism have been 3 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Furthermore, in the interest of working together and BOX 1. IFC AND THE 2030 WATER reducing transaction costs, private companies involved in RESOURCES GROUP financing public works through this mechanism formed The International Finance Corporation, or IFC—a an organization called ALOXI (“Alliance for Works for sister organization of the World Bank and member Taxes” in Spanish).13 This organization analyzes lessons of the World Bank Group—is the largest global learned, as well as best practices that could be used by development institution focused on the private all parties when coordinating with the government. In sector in emerging markets. addition, a new market for experts to link the government The 2030 Water Resources Group (WRG) is a unique and private firms along the Works for Taxes process has public-private-civil society collaboration that facilitates trust-based dialogue processes to drive been developed in recent years. International organizations action on water resources reform in water stressed such as IFC have also contributed to improvements of the developing countries. This group has been hosted mechanism (Box 1). by IFC since 2012. In Peru, the partnership involves more than 70 institutions, including high-level In the wake of mass damage in 2017 from the El Niño members from the private and public sectors. phenomenon, Peru’s Private Investment Promotion Agency Promoting Works for Taxes is one of WRG’s key water has promoted national reconstruction projects through the resources initiatives in Peru.8 Works for Taxes mechanism to rapidly rebuild damaged WRG has been working with the Ministry of infrastructure and create public works that can prevent Agriculture and Irrigation and the Ministry of future infrastructural damage and casualties.14 Housing, Construction and Sanitation to encourage the private sector to participate in this mechanism, What limitations remain? and to identify and provide methods to create a more agile and streamlined process.9 Works for Taxes is considered an overall success in Peru. Yet limitations to the program remain that prevent more firms Thanks to the 2030 WRG promotion and negotiation activities with more than 30 companies, large from participating. One critical challenge is that public private companies from different sectors (beverages, officials lack sufficient understanding of how the mechanism construction, mining, etc.) are now involved works and how it differs from operations affiliated with in generating water infrastructure works with traditional public works. This, coupled with a fear of tangible benefits for the communities in the areas potential sanctions imposed by the Comptroller’s Office for in which they operate. Currently, the Ministry of projects that go awry, have led to a restrictive view of what Housing, Construction and Sanitation has awarded three projects and has over 20 potential projects the law requires. This is aggravated by a lack of confidence in nine regions that are being negotiated and in the private sector on the part of some public officials, could benefit thousands of citizens. Furthermore, who tend to delay approval for certificates because of it.15 given the technical support, the ministry has implemented internal actions for a more efficient Furthermore, public officials are sometimes under political application of the mechanism.10 pressure to reduce costs associated with studies that are reformulated by the private sector. As a result, some officials continue to ask financing firms for a “donation,” which implies that officials expect firms to cover some of closely linked to the extractive sector. For instance, as of the costs of the project without recognition.16 July 2017, ten mining companies had financed 83 projects with a total value of $280 million, and five banking and Moreover, the Works for Taxes mechanism is not yet insurance companies had financed 84 projects with a total accessible to all public entities, and it does not account for value of over $260 million.11 There has also been significant operational costs, just investment costs (the exception is participation by mass consumer industries.12 projects in the sanitation sector that allow the mechanism to be used for operational costs for one year). This affects A key reason for the Works for Taxes mechanism’s success the sustainability of completed public works, as well as the has been the Peruvian government’s receptiveness and reputation of financing firms. willingness to connect with the private sector, while regularly improving the processes and regulation of the Furthermore, the law does not recognize the management mechanism based on private-sector feedback. expenses the firms must confront when negotiating with 4 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. 500 90 77 76 80 400 70 60 300 55 50 294.4 34 238.0 43 40 200 227.2 197.5 30 19 20 100 104.5 113.0 5 10 2 70.2 2.0 3.6 7 0 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 Total Investment (Millions of Current USD) Number of Awarded Projects FIGURE 3 Total investment made or pledged through Works for Taxes (2009–2017) Source: ProInversion the construction firm, multiple government entities, and Use of the Mechanism in Other Countries the supervisor, all of which are normally commissioned Peru’s Works for Taxes program has the potential to to consultancy firms that manage these relationships and benefit other countries facing low governance standards, negotiations. As a result, the financing firm may end up insufficient fixed capital investment, and significant paying more than its actual taxes for works that generate infrastructure and services gaps. For example, Colombia no profits.17 has been exploring replicating the mechanism to build In addition, some parties have expressed concerns that public works related to the peace agreement signed in the Works for Taxes mechanism would respond mainly to 2016 with the Revolutionary Armed Forces of Colombia.19 private interest rather than public interest, in terms of the Public works would include rebuilding shattered villages selection and location of projects.18 In fact, most projects and clearing mines, among other reconstruction efforts. executed through Works for Taxes are located in the areas As a result, teams from Peru have made visits to Colombia of influence of the financing firms, which are not always to provide training to individuals in both the public and the areas most in need of development. As the projects are private sectors. 20 first prioritized by each public entity, this concentration Colombia enacted a law to launch Works for Taxes in problem should be somewhat mitigated. Yet Peru’s lack November 2017. Within a month, 28 firms related to food, of a national infrastructure plan remains a challenge beverages, insurance, banking, tax auditing, cement, basic here. Better-quality planning would allow for better sanitation, legal services, mining, and oil have expressed prioritization of projects. interest in participating. 21 The government plans to So far, only larger firms with an established social prioritize investments in water, sanitation, energy, health, responsibility program have been able to afford to education, and roads. 22 participate in the Works for Taxes program, as it remains Based on Peru’s experience, it is clear that there are too costly for smaller firms. This is due primarily to crucial elements to consider before launching Works for transaction and management costs, as well as the high Taxes programs in other countries. 23 Developing a system degree of liquidity needed to disburse large capital amounts for prioritizing public investment projects, identifying to fund major public works projects. It also must be noted infrastructural gaps, and subsequently defining which that firms that currently use the mechanism are among the projects to develop are all critical, as is evaluating a project biggest tax contributors in Peru, which may also complicate based on a cost effectiveness analysis. 24 In addition, a access to liquidity by the government in a country with government could also offer private companies additional high tax evasion rates. incentives to invest in remote areas or in areas of greatest 5 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. public interest, thereby preventing concentration in just a She has worked as a Senior Consultant in AC Publica few areas. (Lima, Peru), advising the Peruvian government on public management issues related to policy design, management, For Works for Taxes programs to work, it is also essential and evaluation of social programs, including projects related to make public officials aware of the mechanism’s benefits, to competitiveness for better public and private investment, as well as how it differs from other forms of public and the reform of institutional arrangements of public investment. In addition, the government should provide a institutions. (paodelcarpio@gmail.com) straightforward system to resolve disputes by assigning an entity to mediate administrative conflicts. And simplifying ACKNOWLEDGMENTS and standardizing projects could help reduce or prevent The author would like to thank the following colleagues such conflicts. for their review and suggestions: Omar Chaudry, Head, Finally, as Peru has demonstrated, it is critical for Sector Economics and Development Impact - Infrastructure, the government to keep open lines of communication Economics and Private Sector Development, IFC; Cesar between the public and private sectors, as this creates Fonseca, Head of Latin America at 2030 Water Resources Group, IFC; Marc Tristant De Laney, Country Head and opportunities to provide and receive feedback about how Principal Investment Officer, Andean Region, Latin America & to enhance the mechanism’s regulation and adapt it to Caribbean Region, IFC; Álvaro Enrique Quijandría Fernandez, country-specific needs. Lead Private Sector Development Specialist, Latin America Conclusion & the Caribbean, Lima, Peru, IFC; Eduardo Wallentin, Senior Manager, Country Economics and Engagement, A key aspect of the success of Works for Taxes in Peru has Economics and Private Sector Development, IFC; and been the alignment of the incentives of all parties involved, Thomas Rehermann, Senior Economist, Thought Leadership, in order to provide the highest quality public works. As Economics and Private Sector Development, IFC. a result, all parties have been driven to provide the best quality product to protect their respective reputations. PREVIOUS EM COMPASS NOTES ABOUT PRIVATE Since the construction firm is selected privately by the INVESTMENT IN INFRASTRUCTURE financing firm, which risks its own reputation, the Please see also these EM Compass Notes about trends in financing firm has the incentive to strictly monitor the private Investment in Infrastructure: Crowding-In Capital costs and quality of the project. Attracts Institutional Investors to Emerging Market Infrastructure Through Co-Lending Platform (Note 53); Queen Alia International This particular form of private participation in public Airport – The Role of IFC in Facilitating Private Investment in a investment can benefit other countries with similar Large Airport Project (Note 35); Creating Markets in Turkey’s characteristics, provided that the government is open Power Sector (Note 33); Private Provision of Infrastructure— to private sector feedback. In addition, multilateral Opportunities for Emerging Markets (Note 26); Energy Storage development organizations can play a significant role Business Solutions for Emerging Markets (Note 23); Attracting by gathering lessons learned and best practices, and by Private Investment Through Power Sector Reforms (Note 21); promoting more efficient ways to implement the mechanism. Mitigating Private Infrastructure Project Risks (Note 20); Seven Sisters: Accelerating Solar Power Investments (Note 18); How to ABOUT THE AUTHOR Scale Solar Power Generation in Emerging Markets (Note 17); How Paola Elvira Del Carpio Ponce, Research Assistant, Thought To Make Infrastructure Climate Resilient (Note 14); Infrastructure Leadership, Economics and Private Sector Development, IFC. Financing Trends (Note 5); Infrastructure Finance (Note 4). 1 Peru has a mining code that provisions for the sharing of natural resource profits between the regional and local governments where the mining company operates (Canon Minero), provided that these revenues are used for public investment projects. With the commodity prices boom, these profits grew significantly while physical and technical capacity remained low in subnational governments. Hence, low municipal and regional government capacity to manage, formulate, and execute public investment projects that meet standards and procedures set by the National Public Investment System has resulted in large unused amounts of revenues. 2 Ministerio de Economía y Finanzas. “Portal de Transparencia Económica.” www.mef.gob.pe/es/portal-de-transparencia-economica 3 Salinas, Sergio. 2017. “Obras por impuestos: mecanismo para facilitar el cierre de brechas de servicios en el Perú”. Nota de Política 2. Escuela de Gestión Pública, Universidad del Pacífico. 4 AFIN (Asociación para el Fomento de la Infraestructura Nacional). 2015. “Un plan para salir de la pobreza: Plan Nacional de Infraestructura 2016- 2025.” 6 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. 5 AC Publica. 2017. “Ayuda Memoria: Financiamiento de proyectos de inversión pública a través del mecanismo de obras por impuestos” 6 AC Pública. 2017. “Mecanismo de Obras por Impuestos.” 7 Salinas, 2017. 8 The 2030 Water Resources Group. 2017. “Water for Growth, People and Environment: Peru.” 9 The 2030 Water Resources Group. 2016. “Innovative Mechanism in Peru Facilitates Public-Private Partnerships”. Corporate News. December 15, 2016. www.2030wrg.org/innovador-mecanismo-en-peru-facilita-las-alianzas-publico-privadas/ 10 Salardi, José. 2017. “Obras por Impuestos del MVVCS”. Dirección General de Programas y Proyectos en Construcción y Saneamiento. 11 AC Pública. 2017. “Mecanismo de Obras por Impuestos” 12 ProInversion. Agencia de Promoción de la Inversión Privada - Perú. www.obrasporimpuestos.pe/ 13 See https://aloxi.org.pe/ 14 El Comercio. 2017. “Obras por impuestos se usará en 140 proyectos de reconstrucción”. https://elcomercio.pe/economia/obras-impuestos-usara-140- proyectos-reconstruccion-422716 15 Von Hesse, Milton. 2017. “Obras por impuestos en el Perú.” Interview by Paola del Carpio. (September 26). Mr. Von Hesse is a Peruvian economist and the former Minister of Agriculture and of Housing, Construction and Sanitation. He is an expert on public investment. 16 Escaffi, José Luis. 2017. “Funcionamiento del mecanismo de obras por impuestos.” Interview by Paola del Carpio. (September 28). Mr. Escaffi is the General Manager of AC Publica, having extensive experience in the design, implementation, and evaluation of public policies, in the conduction of strategic and operational planning processes, integral control panel design for the public sector, development of pre-investment studies (SNIP), and project management of public investments through the Works for Taxes and Public-Private Partnership mechanisms. 17 Escaffi, 2017. 18 Presidencia de la República de Colombia. 2017. “Empresarios podrán pagar impuestos con obras en zonas afectadas por el conflicto.” http:// es.presidencia.gov.co/noticia/171122-El-Presidente-Hoy-Empresarios-podran-pagar-impuestos-con-obras-en-zonas-afectadas-por-el-conflicto 19 Presidencia de la República de Colombia. 2017. 20 Escaffi, 2017. 21 El Colombiano. 2017. “Nuevas obras por impuestos, el canje de la paz.”www.elcolombiano.com/colombia/nuevas-obras-por-impuestos-el-canje-de-la- paz-FA7893117 22 Presidencia de la República de Colombia. 2017. 23 Escaffi, 2017. 24 Von Hesse, Milton. 2017. 7 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.