Toward the end of November, Ecuador’s Congress approved President Jamil Mahuad Witt’s financial tax and bank bailout plan designed to reactivate the country’s flagging economy and strengthen its fragile banking system.

Yet while support has been strong for the president’s measure-based on widespread sentiment that something has to be done to revive the Ecuadoran economy-criticism has also been flung at the plan. Detractors says that the tax is unconstitutional and that the bank bailout won’t solve the financial system’s extreme liquidity problems.

The plan, called the Law of Taxation and Financial Reform, not only includes debt relief for banks, but also a somewhat controversial 1% tax on all financial transactions, including transfers to offshore accounts. Effective since January 1, the new tax replaces the nation’s income tax and is being charged on all deposits, withdrawals and checks written. Transactions between banks and on the stock markets in Guayaquil and Quito are not subject to the tax.

After passage of the president’s plan, Finance Minister Fidel Jaramillo told reporters: “This gives us an instrument to collect more income and strengthen the productive and financial sectors.” The government estimates that it will be able to collect an extra $600 million in taxes-reportedly twice the amount generated through income taxes and an extra income that will be used to meet infrastructure needs.

“It’s a tax that can be questioned on technical grounds, but it has a very powerful incentive: easy collection,” said Nicolas Landes, named president the of proposed Banco Pacifico-Popular. “Ecuador has been unable to collect income tax under the traditional scheme. It was a pragmatic decision to go with a system that offers a high percentage of collections and will permit authorities to create a database for future income tax collection. Most people view this financial transaction tax as an interim measure.”

Income tax evasion is a historic problem in Ecuador and has gotten worse during recent years. With the collapse of oil prices and the damaging effects of El Niño on the economy, businesses began to default on loans and even more individuals avoided paying income taxes.

Couple that problem with the traditionally low bank capitalization requirements and it’s easy to see how a bad situation became much worse virtually overnight. Illiquidity in the economy quickly led to insolvency in the banking system. A case in point: Filanbanco, which the government recently intervened to save.

Some people, such as Antonio Acosta Espinosa, general manager of Banco del Pichincha CA, see the new tax as self-defeating. “The idea of this tax was interesting and credible, but it should have been maintained as a general tax for everyone as the president wanted,” he said. “The one thing this law was designed to improve-tax evasion-will continue to be a problem.”

Just after the inauguration of the Mahuad administration in August, Moody’s Investors Service downgraded the country’s credit rating on foreign debt in September from B3 to Caa2.

Despite reforms being implemented, Moody’s senior analyst Ernesto Martinez-Alas reported that “the impact of those reforms, however, is not likely to provide the authorities with enough room for maneuver in an environment of uncertainty, capital flight, weakness in the banking system, and limited access to voluntary external financing.”

Peter Shaw, vice president of Thomson BankWatch, said: “The current crisis is the result of an accumulation of economic downtime. They’ve had three full years of an economy that certainly hasn’t seen any sustained growth. The banks have had lousy profitability ever since the first border conflict with Peru.”

Bank Bailout
The new law also creates the National Finance Corp., which is a development arm of the central bank. The corporation has the authority to issue bonds worth up to 25% of the capital in Ecuador’s system-an amount equal to about $1.75 billion. According to the legislation, commercial banks may swap bad debt for these bonds, a move designed to relieve payment pressure on businesses and improve the system’s liquidity. Also, a single financial group may swap up to $8.8 million worth of the bonds. But one source said the measure is only cosmetic. “It is no real swap.

It will not improve liquidity because it is only a rescheduling of loans whereby the government issues bonds which the banks themselves will have to redeem upon maturity.”

Critics say the president has violated the constitution by addressing two separate issues in his emergency economic measure, instead of just one as is legally allowed. Furthermore, Victor Hugo Sicouret Olvera, leader of the Partido Roldosista Ecuatoriano (PRE), also says the president’s debt relief plan is a copy of one that the PRE petitioned before Congress in October. Additionally, the original idea of the 1% tax on financial transactions came from Jaime Nebot Saadi, head of the Partido Social Cristiano (PSC). While Sicouret says the income tax should not have been abolished and qualified the 1% tax as unnecessary, Nebot believes it will function well and effectively raise wages by not taxing income directly.