Fiscal Policy in Latin America
Fiscal Policy in Latin America
Fiscal Policy in Latin America
Focusing on current issues, this chapter discusses four topics that distinguish Latin
America from other regions, and discusses the most compelling explanations provided in
the analytical literature, starting with the broad topic of fiscal state capacity in Latin
America. The second topic is the well-documented pro-cyclical nature of fiscal policy in
Latin America. This is a critical issue because fiscal policies should allow countries to
achieve macroeconomic stability, rather than exacerbating economic fluctuations. The
third topic is fiscal decentralization. Despite very low tax-revenue generation at the
subnational level, government expenditures are increasingly decentralized in Latin
America. The last section deals with sustainability issues. The main point is that very few
countries in the region issue sovereign debt internationally rated as investment grade.
Keywords: fiscal policy, fiscal state capacity, Latin America, macroeconomic stability, fiscal decentralization,
investment grade
11.1 Introduction1
Fiscal policy is a broad subject. Entire volumes can be written about the performance of
each one of its main components—public revenues, expenditures, and debt—in Latin
America. The same can be said about fiscal policy in each of the countries of the region.
Therefore, this chapter narrows the subject to a few tractable topics of special relevance
and impact for overall economic development in the region.
Fiscal policy plays a central role in at least three key areas. First, the provision of public
goods is determined by the capacity of the state to collect taxes and spend effectively and
efficiently. Second, fiscal instruments can be used to engage in redistribution, by taxing
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some groups and targeting expenditures to others. Thirdly, fiscal policy can offset or
amplify shocks that affect the business cycle. Although in theory fiscal policy should
contribute to the delivery of public goods, redistribution, and macroeconomic stability, in
practice this has not always been the case in Latin America. In fact, many analysts argue
that the failure to achieve the goals of fiscal policy is an esential factor in why the region
has performed poorly in terms of growth and equity.
We are aware that much of what we observe today in terms of fiscal policy outcomes has
deep and fundamental determinants—such as the institutions inherited from colonial
times—but we leave that for other chapters in this Handbook to discuss. Focusing on
current issues, the chapter is organized around four topics where we present the key
stylized facts that distinguish Latin America from other regions, and discuss the most
compelling explanations provided in the analytical literature. We start with the broad
topic of fiscal state capacity in Latin America. With the exception of a few countries, such
(p. 267) as Brazil, low tax revenues have been a distinctive feature in Latin America. Of
course, low fiscal capacity translates into inadequate provision of public goods and
limited ability to engage in effective redistribution (Cárdenas 2010).
The second topic is the well-documented pro-cyclical nature of fiscal policy in Latin
America. This is a critical issue because fiscal policies should allow countries to achieve
macroeconomic stability, rather than exacerbating economic fluctuations. Although
countercyclical fiscal policies were adopted in a few Latin American countries in response
to the 2008–9 global recession, pro-cyclical policies are still deeply ingrained in the
region.
The third topic is fiscal decentralization. Despite very low tax revenue generation at the
subnational level, government expenditures are increasingly decentralized in Latin
America. Most countries have complex systems of fiscal transfers from the central
government to subnational governments that often lead to overspending, low local tax
efforts, local capture, and wide regional divergence in the quantity and quality of public
service provision. But, here too, progress has been made in some countries which have
been able to combine regional and local development with sound fiscal management.
The last section deals with sustainability issues. The main point is that very few countries
in the region issue sovereign debt internationally rated as “investment grade.” This
means that there is a non-negligible risk of fiscal crises involving public debt defaults and
rescheduling. In line with recent research on the topic, we argue that in addition to fiscal
deficits—due to the lack of expenditure restraint and the low tax revenues—public debt
management has been the cause of frequent fiscal crises. For example, a depreciation can
lead to a fiscal crisis when the public debt is denominated in foreign currency, even if the
fiscal deficit is small. The same can happen when much of the public debt is short-term
and cannot be rolled over due to a change in financial markets. These are areas of high
relevance, where progress has also been made: some countries are developing deeper
markets for domestic currency-denominated long-term public debt. Furthermore, many
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countries have adopted fiscal responsibility laws that require governments to improve
transparency and reveal contingencies in the balance sheet, reducing the likelihood of
defaults.
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11.2.1 Taxation
Taxation is a good starting point for the analysis of fiscal policies. To a large extent, tax
revenues determine the capacity of governments to provide public goods and redistribute
resources. The size of the state, the amount of redistribution from the rich to the poor—or
from one region to another—and the allocation of resources across sectors and time are
all fundamentally related to tax policy. Tax revenues also reflect previous (p. 268)
decisions that shape the capacity of governments to collect taxes, and thus are very
revealing of how economic policies are designed, approved, and implemented in a
particular society. In general, actors that play key roles in the broader policymaking
process tend to be also active players in the process of discussing, enacting, and
implementing tax policies. For all these reasons, it is hard to think of a more relevant
area of policy with ramifications over almost every aspect of the economy and society.
Although Latin America is far from homogeneous in this regard, tax revenues of central
governments in the average country in the region were barely 14.7% of GDP in 2005, in
contrast to 27.1% in developed countries. Using data from the IMF for 127 countries, and
regressing tax revenues over GDP on a Latin American and Caribbean dummy, yields a
highly significant coefficient of -8.8, implying that the region is nearly a full one standard
deviation below the world's average. Of all the countries in the region, only Brazil can be
considered to have a level of tax revenues comparable to that of the OECD countries. The
composition of tax revenues is also quite different relative to developed counties: on
average income taxes represent 12.4% of GDP in OECD countries and only 4.6% of GDP
in Latin America. But the most remarkable feature of the tax system in Latin America is
related to the role of personal income taxes: nearly 75% of the total income tax revenue is
collected through personal income taxes in OECD countries, in contrast to only 39% in
Latin America. With the exception of Brazil, Colombia, and Peru, virtually every country
in the region collects less than 2% of GDP in personal income taxes (which are practically
nonexistent in countries like Bolivia and Guatemala), compared to 9% of GDP in the
average OECD country.
Although lower per capita incomes reduce the personal income tax base, in practice the
number of exemptions and deductions has gone beyond what can be justified on
economic grounds. For example, in Colombia individuals earning less than 3.5 times the
national per capita income level are not subject to this tax (meaning that individuals with
relatively high incomes do not pay income taxes). The corresponding figures are 2.6 times
in Argentina and Peru, and 2 times in Brazil. The fact that the incomes of individuals at
the very top end of the distribution are not taxed results in very low personal income tax
revenues. Goni, López, and Servén (2008) argue that this feature explains why taxes play
a very limited redistributive role in Latin America than in Europe.
Underscoring the fundamental forces that explain why fiscal state capacities in Latin
America are relatively weak is a daunting task. Sokoloff and Zolt 2006 argue that,
historically, tax policy has been a mechanism for the reproduction of inequality. Elites
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favor low vat tax collections (and more regressive taxes such as the sales and VAT taxes)
as well as the private provision of education, health, and other services such as security.
Limited access to these services—or outright exclusion—is one of the mechanisms
explaining why economic and social inequality has been Latin America's most distinctive
feature.
Although fiscal capacities remained unambiguously weak during most of the 20th century,
the region has experienced a significant transformation in recent years. The wave of
democratization, which has taken place since the late 1980s, has made political systems
more pluralistic and inclusive. As a consequence of the greater degree of participation
(p. 269) and representation, demands on the Latin American state have been extensive.
Countries have tried to respond to those demands by raising tax revenues and increasing
the coverage of basic services.
Table 11.1 shows how tax revenues as a percentage of GDP have performed in the region
since 1990. While there is some disparity, the general point is that there has been an
increase in tax revenues in most countries. Moreover, there is evidence of some
convergence in tax efforts: countries with the greatest increases in tax revenues between
1990 and 2005 are precisely those with lower tax efforts in 1990. This is the case, for
example, of Venezuela, Bolivia, Nicaragua, Colombia, and the Dominican Republic.
Change has been lower (in percentage terms) in countries where tax revenues were
already relatively high in 1990 (such as Uruguay and Brazil). Tax revenues fell between
1990 and 2005 in Mexico and Panama, providing two remarkable exceptions to this norm.
Tax revenues have increased in spite of globalization: every country in the region has
faced a generalized reduction in tariffs that, on average, were slashed from 46% in 1985
to 12% in 1999 (the sharpest declines took place in earlier part of the 1990s). In addition
to the reduction in tariffs, greater capital mobility forced countries to trim tax rates on
(p. 270) business and individuals (see Figure 11.1). The loss of revenues from the
reduction of import tariffs has been largely offset with revenues from value added taxes
(VAT), introduced in most countries between the mid-1980s and the mid-1990s, that now
generate 37% of all tax revenues (equivalent to 5.5% of GDP). These changes imply that
tax policy has been a very active area of reform. As documented in Lora and Cárdenas
(2006), every country has undertaken 2.5 important tax reforms since 1990, on average,
and 11 countries have overhauled their tax systems radically.
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The ability of the political system to deliver revenues through complex and improvised
taxes is not specific to Colombia. In Brazil, tax revenues as a proportion of GDP have
increased significantly over the last two decades and are now the highest in Latin
America. Gross federal government tax revenues increased from 20.2% of GDP in 1990 to
25.5% in 2005. One third of the revues come from a version of the VAT, which is collected
by the states. The power of the executive has been instrumental in strengthening the tax
enforcement capabilities of the tax administration office. However, the federal
government has not been able to implement comprehensive tax reform. In late 1997, and
not for the first time, the government considered some proposals that were quite radical.
The main proposal was to discard turnover and cascading taxes, as well as the state VAT
taxes, and replace them with three new taxes: a consistent broad-based nationally
managed VAT; a new federal excise tax on a small number of goods and services; and a
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local retail sales tax. Since then, governments have made unsuccessful efforts to arrive at
a consensus about tax reform.
Tax revenues in Guatemala have traditionally been among the lowest in Latin America.
The tax burden was 7.6% of GDP in 1990. Following the stabilization of the economy and
the partial compliance with the peace accord, tax revenues increased to 11.2% of GDP in
2005. Much of the increase is attributable to the VAT, while efforts to raise income
taxation have been systematically overturned by the Constitutional Court in response to
legal action by the private sector. The effectiveness of the business sector in influencing
policies essentially rests on the institutional weakness of the executive and the
Guatemalan political parties.
In sum, tax revenues have increased in the majority of Latin American countries
reflecting significant action in terms of tax reform. However, personal income taxation
remains underdeveloped in contrast to progress with the VAT and some economically
inefficient taxes (though effective in terms of tax collections) such as the financial
transactions tax. Although politically difficult, increasing effective taxation on personal
income is a crucial issue in Latin America's pending development agenda. The same
applies to tax administration, which needs to be able to effectively audit a much larger
number of taxpayers.
11.2.2 Expenditures
Although finding
consistent and comparable
measures of government
expenditures is difficult,
the general pattern is that
central government
outlays have increased
(p. 272) significantly in the
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While fiscal populism cannot be ruled out as an explanation in countries which have
increased expenditures in unsustainable ways, greater expenditures to reduce poverty
and exclusion have been a direct consequence of political democratization since the
mid-1980s. Also, greater use of budget rigidities and entitlements, often embodied in
constitutions, has made increases in expenditures hard to reverse posing problems for
macroeconomic stabilization which we will discuss in the next section.
These trends have made social spending in Latin America higher than in Emerging Asia
(but still lower than in the OECD countries). One positive consequence has been the
improvement in some social indicators. This is the case in primary and secondary
enrollment rates and various measures of health outcomes such as access to clean water,
immunization rates, and infant mortality rates. This is perhaps Latin America's major
development achievement in recent decades.
But gaps relative to advanced countries remain high and, as documented elsewhere in
this Handbook, Latin America continues to underperform in many aspects, including
educational quality, repetition rates, and access to early age development programs. The
very few Latin American countries that have participated in international standardized
tests assessing educational quality in science and mathematics have tended to rank very
low.
Despite increased social spending, poverty and inequality remain high, suggesting that
social expenditures have been poorly targeted. Again, there are important differences:
social expenditures are progressive in Chile, Costa Rica, and Uruguay, while very
regressive in Bolivia, Peru, and Nicaragua (ECLAC 2006). But in general it is accurate to
say that the distributive effect of this spending has been modest in most Latin American
countries. Breceda, Rigolini, and Saavedra (2009) look at the distributional effects of
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social spending (separating pensions from spending in education, health, and direct
transfers) and compare the results for Latin America to those of the UK and the US.
According to their results, (p. 274) in their group of Latin American countries social
spending to the poorest quintile corresponds to 92% of social spending to the richest
quintile, against 233% for the UK. This means that it is often the better off that benefit
the most from social expenditures.
The analysis also differs greatly depending on the types of spending. It is well established
that a high proportion of outlays in pensions and higher education accrue to upper-
income groups, while primary education and social assistance benefit the poor (de
Ferranti et al. 2004; ECLAC 2006). Targeted social programs—such as conditional cash
transfers—have overall improved the welfare of the poor (see World Bank 2009).
However, spending on these and other social assistance programs remains low in terms of
GDP and as a share of total social spending. In fact, in countries such as El Salvador,
Honduras, Bolivia, Ecuador, and Guatemala, only a small fraction of the population has
access to social protection, in contrast to Argentina, Chile, and Uruguay, where there is
universal or near universal coverage.
Finally, greater social expenditures in Latin America during the last two decades have
tended to crowd out expenditures in public infrastructure affecting longer-term output
growth. According to Calderón, Easterly, and Serven (2002a; 2002b)), infrastructure
spending as a share of GDP has fallen in most Latin American countries since the
mid-1980s for two reasons. First, privatization in the 1990s did not deliver the expected
results in terms of private investment in infrastructure. Second, social expenditures have
been constitutionally and legally protected, leaving investment in infrastructure as the
more flexible and adaptable component of the budget. In other words, emphasis on the
social sectors has reduced the ability of governments to invest in infrastructure, and the
private sector has not been able to off set that trend.
Underinvestment in infrastructure has resulted in low public capital per person in Latin
America compared with the fast-growing East Asian economies. According to the IMF
(2004), this has lowered long-run GDP growth by an estimated one percentage point per
year, but results vary from 3 percentage points in Argentina, Bolivia, and Brazil to 1.5–2
percentage points in Mexico, Chile, and Peru.
11.3 Stabilization
Latin America has traditionally exhibited high levels of output and consumption volatility,
largely as a consequence of its high exposure to shocks to terms of trade, demand for
exports, and capital flows.2 Rather than mitigating these shocks, Latin American fiscal
policies have been highly pro-cyclical, according to a large number of empirical studies.3
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distinguish between the effect of automatic stabilizers (variations in fiscal balances that
are directly due to the business cycle and exogenous shocks) and discretionary fiscal
policies. Most available studies argue that the variation in real public expenditures
(excluding debt service) is largely due to discretionary policies, as the region does not
have major automatic expenditure stabilizers, such as broad unemployment insurance
programs. In contrast, most of the variations in real fiscal revenues are automatic
(determined by terms of trade volatility and the business cycle) because tax policy is
rarely used as a discretionary countercyclical tool in the region, given that statutory tax
changes require lengthy congressional approvals and their revenue consequences take
place with important lags.
Suescún 2007 estimates a “structural fiscal balance” by subtracting the effects of the
business cycle and cycles in commodity prices on tax revenues. The resulting balance
gives a good approximation of how pro-cyclical or countercyclical are discretionary fiscal
policies. Focusing on the revenue side only, he finds that automatic stabilizers have a
lower effect in Latin America as compared to OECD countries. This is a consequence of
both low effective tax collections and low estimated income elasticities of tax revenues,
which suggest deficiencies in design and administration of the tax system. Adjusted by
the effects of automatic stabilizers, he further finds that most Latin American countries
have run significant pro-cyclical discretionary fiscal policies in contrast with many,
though not all, industrial countries (see Figure 11.4).
As a consequence of both these results, the overall net effect of fiscal balances is
destabilizing in the region. Thus, surprisingly, countries with larger public sectors in
Latin America tend to have more volatile economies, contrary to what happens among
industrialized countries (see Figure 11.5). Of course, a complete analysis of
macroeconomic instability has to include other dimensions, such as the magnitude of
external shocks and the monetary and exchange rate frameworks.
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In addition to
(p. 276)
augmenting, instead of
mitigating, the effects of
commodity price shocks
and business cycles, the
pro-cyclicality of fiscal
policies in Latin America
often has two other
pernicious effects. First, it
contributes to the
previously mentioned bias
against public investment
in Latin America,
especially during fiscal
adjustment periods, which
Click to view larger
has led to severe lags in
figure 11.4 Discretionary fiscal policy response to
cyclical conditions infrastructure investment.
Source: Suescún 2007. Indeed, boom periods
Notes: A positive sign is countercyclical. The
normally lead to increases
coefficient of the output gap in a regression with a in both public investment
cyclical adjusted primary balance (a proxy for
and current expenditures.
discretionary policy) as the dependent variable.
Later on, when
governments are forced to
cut expenditures for lack of
financing during busts, such
cuts fall basically on public
investment, as reducing
public wages or (p. 277) (p. 278)
firing public servants usually
carry higher political costs.
Such an effect of pro-cyclical
fiscal policies has been
documented in some recent
studies.6
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strong real exchange rate appreciation (after the Euro and Real depreciations vis-à-vis
the dollar to which the Argentinean peso was fixed). The government, facing severe
financing constraints, undertook a sharp pro-cyclical contraction of public expenditures.
This was seen by the markets as aggravating the recessionary forces, leading to
perceptions of fiscal unsustainability in the short term and resulting in even higher
spreads (contrary to what the authorities and the IMF expected).
Why are discretionary fiscal policies so pro-cyclical in Latin America? Explanations have
typically underscored either political incentives and/or the pro-cyclicality of financial
markets. Most analysts of budgetary processes find that, unless there are strong
institutional constraints, political incentives normally lead to greater spending during
booms.7 Such political incentives exist as long as voters and supporters value the
immediate provision of additional goods and services (and campaign financiers value
additional contracts), and do not fully understand or punish the potential future effects of
such actions. Furthermore, governments may find difficult to impose austerity during a
boom after a cut in expenditures during the previous bust. In addition, due to
distributional concerns, some governments may find it politically hard to reduce public
expenditures to compensate for booming private expenditures (see Marfán 2005). When a
slowdown or recession arrives, revenues fall sharply and governments often find
themselves without access to either credit or previously saved resources, so they have no
option but to cut public expenditures.
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If political incentives are behind the observed pro-cyclicality of fiscal policies in Latin
America, as these hypotheses suggest, avoiding such an outcome would require
institutional changes that constrain expenditure growth in good times. Several countries
fiscally dependent on commodity revenues, for which the degree of pro-cyclicality of
fiscal policies tends to be higher, have attempted in the past to establish “stabilization
funds” that require compulsory savings when commodity prices reach a threshold, in an
attempt to smooth public expenditures and limit their high pro-cyclicality.9 Early
examples were the National Coffee Fund in Colombia (created in 1940) and Chile's
Copper Stabilization Fund, operative since 1985. Venezuela, Colombia, and Ecuador have
also enacted oil stabilization funds with similar purposes in different periods. The
experience with such funds is mixed. In the case of Venezuela and Ecuador, governments
were able to change the rules as soon as they found them too binding. In the case of
Colombia, (p. 280) the coffee fund was very successful until the early 1990, when coffee
ceased to be a driver of the business cycle, and the oil fund was not successful in
stabilizing government expenditures during the 1990s, when oil became Colombia's
leading export, as overall expenditures increased, in spite of the savings in the oil fund,
financed through increased debt. In Chile, the fund was instrumental in avoiding
overspending during the copper price boom that coincided with the return to democracy,
but it failed to allow the application of countercyclical policies during the 1999 slowdown,
given that it did not have clear dissaving rules, and that the attempt by the government to
use part of its resources to increase expenditures was contested politically and by the
markets.10
The design and enactment of the Chilean Structural Surplus Rule (SSR) came as an
answer to these limitations. This rule requires estimating a “structural balance” by
subtracting (or adding) revenues in excess (or deficit) of those estimated on the basis of
potential GDP and long-term expected copper prices, and putting aside from the budget
(or using) such excesses (or deficits). Further, it demands that such structural balance
should equal a surplus of 0.5% of GDP (until recently 1% of GDP), to permit coverage of
the central bank quasi-fiscal deficit arising from the high levels of debt incurred during
the bank rescue of 1982. Recently, the SSR became a law providing clear saving and
dissaving rules, overcoming the problems experienced in 1999, and covering overall
revenues and expenditures, avoiding the shortcomings encountered in the Colombian Oil
Fund experience. Actually, Chile was the only Latin American country that maintained
significant surpluses during the 2004–7 boom (see Table 11.2), and was able to implement
a strongly countercyclical fiscal policy during the 2008–9 crisis.11
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Country GDP Growth 2004 General government Central government Central government
fiscal balance, 2004– fiscal balance, 2004– primary balance,
7 7 2003–7
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(p. 281)It is unclear to what extent other countries in the region could imitate this
success. The SSR requires credible potential GDP, tax elasticities, and long-term copper
prices estimates (through independent panels of experts). More importantly, it requires a
broad political backing. Otherwise a government will be able to scrap it when it becomes
binding (as happened in the Venezuelan and Ecuadorian cases, and more recently in
Colombia in 2003, when the oil stabilization law was changed to allow the government
additional spending during a boom period) without facing significant opposition and
political costs.
In addition to perverse political economy incentives, IMF lending during crises, which has
normally been conditioned to fiscal adjustment, has contributed to the pro-cyclical
pattern in fiscal policies. More generally, the excessive focus of fiscal policy on current
debt and balances has been another contributor to the pro-cyclicality of fiscal policies in
Latin America and in the rest of the developing world. This has been to a large extent a
consequence of the excessive focus of the IMF and the markets on such indicators, under
the erroneous assumption that they are adequate indicators of intertemporal
sustainability of fiscal policies. In fact they do not take into account either cyclical effects
or intertemporal effects of public investment (thus reinforcing anti-investment biases.)12
Thus, IMF and country programs, as well as fiscal responsibility laws promoted by the
IMF in the early 2000s, usually set rigid short-term goals (in terms of deficit and debt
levels), without correcting for cyclical effects of economic activity and commodity prices,
leading to (or reinforcing the incentives in favor of) pro-cyclical fiscal policies. It has been
suggested that the IMF should instead apply to developing countries a structural balance
approach (as is already the case for developed countries), and help design and apply
adequate rules, like the Chilean SSR.13
11.4 Decentralization
The last decades of the 20th century witnessed a major move towards decentralization of
political power and/or public expenditures in many if not most Latin American countries.
This trend was associated to the return to democracy (Argentina, Brazil, and Chile) or the
consolidation and deepening of democracy (Colombia, Bolivia, Mexico after the end of
PRI hegemony, and Peru after Fujimori). Decentralization of political power and public
expenditures is presently deeper in some federal countries (Argentina and Brazil), but it
has become quite significant also in some unitary republics, through elections of
governors and mayors and significant decentralization of public expenditures, as in the
case of Colombia and Bolivia (see Figure 11.7).
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designed fiscal transfers from the center (which erode accountability links between
authorities and citizens) and severe mismatches in the allocation of responsibilities and
authority over resources (human or financial) in specific services.
The high dependence on transfers is partially a reflection of the fact that the major
revenue—producing taxes can be more effectively administered centrally. Though in some
mature federal countries, states effectively administer personal income taxes or VAT
surtaxes, such experiences have been rare in Latin America. Only Brazil has at present a
statelevel VAT, which as mentioned above has given rise to repeated unsuccessful
attempts to reform, as it is imposing severe economic efficiency costs according to most
available studies.15 Mexico also experimented with a decentralized state VAT in the 1980s
and recentralized it afterwards. No Latin American country has experimented with
decentralized income taxes. But even taxes that can be efficiently decentralized, such as
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property, transit (vehicle permits and taxes), and specific consumption levies (on fuels,
alcoholic beverages, tobacco, etc.), are relatively underdeveloped in most countries in the
region, in some cases due to rigid central law statutes and in others because of poor local
incentives or political capture. There is a generalized opinion in favor of the need of
strengthening regional and local taxation, but no clear agreement on how best to
proceed.
The design of transfers to subnational governments has suffered from many drawbacks,
arising partly from conflicting objectives. On the one hand, transfers should “equalize”
capabilities among subnational entities. On the other, transfers should reflect local tax
effort in order to avoid substituting local sources of funds. In practice, neither of these
goals is achieved and the final design of the transfer system has been an outcome of
complex political transactions. The richer and most powerful states or provinces usually
oppose equalization effectively. At the other extreme, small states and municipalities,
often get a fraction of transfers to be distributed evenly among jurisdictions, excessively
benefiting low—density regions with low development capacities, thus stimulating
inefficient subdivisions and creation of new provinces and municipalities in order to
maximize received transfers.
Furthermore, earmarking has been pervasive—a practice which reflects the central
government mistrust of subnational capabilities and which, though it effectively protects
allocations to priority sectors (such as education and health), often results in excessive
expenditure rigidities and inefficiencies. In addition, transfers have been initially set, in
many cases, to respond to historical expenditures and existing capacities in specific
services, with no incentives for improved performance. Changes towards allocations
proportional to the population being served, and/or to be served (e.g. children actually in
school or to be enrolled: the so called “capitation” criteria), as in Brazil and Colombia,
have resulted in important increases in efficiency.16 In some cases transfers have been
too discretionary, limiting subnational entities, autonomy and planning capacity.
Automatic transfers linked to specific central revenues have often generated distortions
(as governments favor those taxes that are not shared) and volatility, while at the (p. 284)
same time contributing to the overall pro-cyclicality of public expenditures. Problems
encountered have led towards delinking automatic transfers from national revenue, as in
the case of Colombia and Argentina.
The frequent allocation of a fraction of oil and mineral royalties to producing regions and
localities deserve a special mention. Although a case could be made in favor of such a
practice (compensating regions for negative externality effects), in practice royalties have
exacerbated regional and local disparities, creating serious waste during revenue booms
and painful fiscal adjustments during busts. This is an area for urgent reform in several
countries, as the recent experience with Brazilian municipalities receiving oil royalties
testifies.
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Mismatches in the allocation of responsibilities and authority over resources have also
often led to a serious problem of accountability and efficiency. Thus, for example,
subnational entities have frequently been assigned responsibilities over primary and
secondary education, but key decisions on teacher's wages, hiring, firing, allocation to
schools, and/ or promotions have remained centralized, responding to pressures from
powerful centralized unions. Leaving subnational entities with a theoretical responsibility,
but without any meaningful control over the most important inputs for educational
outcomes, cannot produce effective or efficient results. Further, in such a case neither
the central government nor subnational governments can be held accountable. Further,
decentralization of decisions rarely reaches the schools, where it has been found that it
really matters.
Optimal decentralization of service provision depends on many factors that vary from one
service to another: the presence of economies of scale and network effects (trunk roads,
railroads and power transmission cannot be efficiently decentralized); the degree of
heterogeneity of the service and the intensity of interactions with citizens (health and
education require effective decentralization to hospitals and schools, though with proper
accountability procedures); the degree of participation of private providers (it is normally
inefficient to decentralize regulation of water supply provision); technological and
administrative complexities and capabilities (poor and backward municipalities cannot be
expected to organize and run efficient water supply companies). Getting the balance right
requires some flexibility and capacity to adapt, which “one size fits all” constitutional and
legal statutes rarely permit.
(p. 285)Concerns over public finances stability, and ambivalent results in service delivery,
have often led (as indicated in the case of Colombia and Brazil) to significant revisions of
original decentralization laws. Some observers interpret these episodes as required fine
tunings to guarantee the long-term sustainability of an essentially irreversible long-term
political decentralization process. Others see them as part of a “re-centralization” trend,
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Finally, while there is wide agreement on the need to actively build capacities and
promote transparency and accountability at regional and local levels, there is no clear
agreement on how to proceed, and most initiatives have been rather timid, disintegrated,
and eventually ineffective. A key institutional weakness of decentralization processes in
Latin America has been the lack of a central agency that effectively supports capacity
building at the local level. While this is a serious shortcoming, transparency and
accountability at the local level can be partially supported from above: success ultimately
depends on political competition, strong leadership, and the strength of the local civil
society.
11.5 Sustainability
This last section looks at the issue of public finance sustainability, mainly because the
frequency of defaults and fiscal crises in Latin America deserves an explanation. In part,
lack of public finance sustainability is the mirror image of the pervasiveness of fiscal
deficits. In the previous sections we alluded to the causes of high fiscal deficits such as
the existence of a narrow tax base, the tendency to overspend, the separation of taxation
and expenditure decisions, and the limited expenditure flexibility.
But fiscal crises are not just a consequence of the accumulation of fiscal deficits. The
Latin American experience shows that the composition and management of public debt
matters a great deal. Questions related to whether public debt is issued in local or foreign
currency, whether it is in the hands of external or internal creditors, or whether it has
short or long-term maturities are critical in order to assess the fiscal vulnerability of a
given country. It has been argued that these features are more relevant in explaining why
countries experience severe fiscal crises than a cursory look at the level of public debt
would imply.17 In other words, the analysis of sustainability has to go beyond the causes
of fiscal imbalances.
Sustainability is a somewhat elusive concept. However, most analysts would agree that
the long run-fiscal position of a country is financially viable when the future flow of
primary surpluses (adequately discounted) is high enough to cover the existing level of
public debt. In more formal terms, for public debt to be sustainable the following
condition has to be satisfied in the long run:
s = (r - g) d
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where d is level of public debt as a proportion of GDP, r is the real interest rate, g is the
(p. 286)
economy's growth rate, and s is the government's primary surplus as a percentage of GDP. The
equation provides a simple way of calculating the primary surplus that the government would
need to generate to stabilize its debt (given the historical averages of the interest rate and GDP
growth).
The estimated primary surplus can then be compared with its observed value. Countries
are more likely to default on their debts when the primary surplus required to assure
sustainability is much greater than its actual value. The IDB recently estimated these
values using the average return on Latin America's debt between 1992 and 2004 (7.5%)
and each country's own long-run growth rate. The results of this calculation indicate that
the primary surpluses observed were too low given the value of public debt for a large
number of countries in the region (see Figure 11.8).
Second, increases in outstanding debt often result from government interventions that
are not expected and, in some cases, not even reflected in the standard fiscal accounts.
During banking crises—which provide the canonical example—governments issue large
amounts of debt to rescue financial institutions. In fact, government exposure to financial
—sector crises has been one of the most important sources of debt burdens. The cost of
these hidden exposures is estimated to have been 19% of GDP in Mexico (1995–7), 14.5%
of GDP in Argentina (1999–2002), and 8.5% of GDP in Brazil (1996–2000). This is also the
case of contingent liabilities and the recognition of fiscal “skeletons” that have the power
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to explode public debt. The general point is that if governments do not really know the
details about future contingencies, it is virtually impossible to determine what constitutes
sustainable fiscal policy.
The third reason for unexplained changes in the stock of debt has to do with defaults and
write—offs. As the recent experiences of Argentina and Ecuador suggest, this is not a
minor issue in a region where defaults have been frequent. The unexplained residuals can
sometimes be significantly large. For example, in Argentina public debt/GDP increased
from 50% in 2001 to 140% in 2004 (mostly due to a currency depreciation), then fell to
80% in 2005 as a result of a write—off. But even after leaving aside extreme values like
these (excluding the top and bottom 2% of the distribution of the unexplained residuals),
the value of public debt in developing countries increases 3 percentage points of GDP
faster on average per year than the fiscal deficit would predict.
Another key dimension from the viewpoint of risk is the debt's maturity structure.
Naturally, shorter maturities imply a higher refinancing risk, exacerbating the
transmission between overall macroeconomic instability and public finances. A sudden
increase in the value of public debt imposes a much harder problem when it needs to be
refinanced in the short run, in comparison to when amortizations are spread over a large
number of years. There are many examples of this problem, such as Mexico's experience
with the rollover of its short term public bonds (CETES) during the 1994 “tequila crisis.”
One way of incorporating the uncertainty associated with variables such as interest rates,
exchange rates, and the stock of debt is to compute the maximum value debt-to-GDP ratio
that would be sustainable under stressed scenarios. This is what credit rating agencies
do, as illustrated by the fact that a country's credit rating is not necessarily related the
debt/gdp level (see Figure 11.9), but to measures of uncertainty such as the exposure
associated with a currency mismatch, the volatility in the cyclical component of GDP and
the maximum interest that allows debt to remain sustainable.
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Governments in Latin
America have been trying
to reduce their
dependence on external
financing, and hence their
exposure to external risks,
by increasing the domestic
component of public debt.
In fact, on average in Latin
America the share of
Click to view larger domestic bonds in total
figure 11.10 Share of domestic debt over total debt public debt increased to
and GDP per capita, average for 2000–4
36% in 2000–4 from 26%
Source: IDB (2007).
in 1990–4. But there is
large heterogeneity in this
dimension. Differences in the size of the domestic market (measured by per capita GDP)
seem to play a role (although it is not the only factor). According to Figure 11.10,
domestic public debt is more than 50% of public debt in (p. 288) (p. 289) counties like
Brazil, Chile, and Costa Rica that have relatively high income per capita. But it is also
high in Colombia, where reducing the debt's exposure to external shocks has been a clear
policy goal.
But progress should not lead to complacency. On the one hand, fiscal frameworks remain
relatively weak. A large number of countries still lack the political consensus and the
institutions necessary to support sound fiscal policies. On the other hand, more progress
needs to be done in the other aspects of fiscal policy discussed in this chapter. Widening
the tax bases, making the tax system simpler and more neutral, increasing tax revenues,
and improving the efficiency of expenditures are pending issues in the fiscal reform
agenda. The decentralization drive of expenditures show some successes but also many
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failures: further fine tuning is required to achieve the potential promises of fiscal
decentralization while reducing potential adverse impacts in terms of increased regional
inequality and local capture and waste. But few goals are as important as enhancing the
redistributive capacity of fiscal policies. The last two decades have witnessed a stellar
increase in social spending. What the evidence suggests is that much more has to be done
in the design of these interventions (including better targeting) in order to reduce
inequality in a significant and enduring way.
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Notes:
(1) The authors would like to thank Victor Saavedra for excellent research assistance and
the editors of this volume for comments and suggestions.
(3) Gavin and Perotti 1997, Mailhos and Sosa 2000, Kaminsky, Reinhart, and Végh (2004),
Alesina and Tabellini 2005, Talvi and Végh 2005, Sturzenegger and Wernek 2006, Suescún
2007, Strawczynski and Zeira 2009, Ilzetski and Végh (2008).
(5) Ilzetski and Végh (2008) also find some evidence (not always robust) that public
expenditures also behave pro-cyclically in developed countries (in contrast with most
previous estimates), though less so than in developing countries, and that their effect on
the economic cycle is not significant.
Page 28 of 29
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(7) Tornell and Lane 1999, Talvi and Végh 2005, and Alesina and Tabellini 2005.
(8) See Gavin and Perotti 1997, Prasad et al. (2003), Riascos and Végh 2003, Kaminsky,
Reinhart, and Végh (2004), Mendoza and Oviedo 2006, Perry 2009.
(9) They have also been justified as attempting to mitigate abrupt variations in real
exchange rates in order to reduce the risk of Dutch Disease effects.
(10) See Perry and Leipziger 1999, Kumhof and Laxton 2009.
(11) The IMF (2009) estimates the Chilean fiscal stimulus package in 2.9% of GDP, while
other packages in the region were smaller.
(14) Burki, Perry, and Dillinger (1999), Dillinger, Perry, and Webb (2003).
Mauricio Cárdenas
Mauricio Cárdenas is Senior Fellow and Director of the Latin America Initiative at
the Brookings Institution, Washington, DC.
Guillermo Perry
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