OECD/ECLAC REGIONAL CONSULTATIONInclusive Growth in Latin America and the Caribbean

Fiscal Policy options to Minimize Trade-offs between Growth and Inclusiveness in LAC

Teresa Ter-Minassian

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• A recap of recent trends in growth and equity in LAC

• Macro-economic and fiscal constraints

• Tax policies for growth and equity

• Minimizing growth-efficiency trade-offs in the design of public expenditure policies

• Improving equity in intergovernmental fiscal arrangements

Outline of presentation

Growth and equity in LAC: is the cup half full or half empty?

• The 2000s: a good decade for LAC– A growth performance significantly better on average than in the previous two

decades– Significant declines in poverty and inequality

• But,– Growth performance still below the average of EMs and developing economies,

despite historically high commodity prices and access to external financing– Persistently large infrastructure gaps– Labour markets still characterized by high informality and skill mismatches– Poor growth of TFP– Inequality remains high on average for the region– Wide economic and social disparities both among and within countries– Access to, and quality of, essential public services often poor

• Therefore , it is crucial to identify and put in place policies that are both growth- and equity-enhancing

Source: WEO, Oct. 20134

Real GDP growth: LAC vs. other EMs and developing countries

Emerging and devel-oping countries' av-

erage

LAC

-2

0

2

4

6

8

10

Av. 1995-2004200520062007200820092010201120122013

• Ensuring macro-economic stability remains crucial for both growth and equity, but faces increased challenges ahead

– The external environment looks less favorable going forward• Declining terms of trade• Slowdown in China• Sluggish recovery in the advanced countries• Eventual exit of advanced economies from unconventional monetary policies

likely to reduce availability of external financing and increase its cost for EMs in the region

– Macro-economic imbalances are rising in some countries of the region, with risks of significant adverse spillovers on their neighbors

• These challenges will increase the cost of deviations from prudent and consistent monetary, fiscal, and external policies in the years ahead

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Macro-economic constraints

• Most countries in the region have not used the good years to build adequate fiscal buffers

– For EMs in the region• Cyclically adjusted fiscal deficits have averaged 2.7 % of GDP since 2010; and• Gross debt levels have remained above 51% of GDP (17 percentage points above the

EM average)

– For LICs • Fiscal balances have steadily deteriorated since 2010, and debt levels, after declining

briefly, have started rising again

• Public debt dynamics, and therefore prospects for fiscal sustainability can be expected to be adversely affected over the medium term by the foreseeable rise in international interest rates

• This reinforces the case for an efficient and equitable use of the available fiscal space in individual countries of the region

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Fiscal constraints

2006 2007 2008 2009 2010 2011 2012 20130

10

20

30

40

50

60

EM averageLAC

Source: Fiscal Monitor, Oct. 2013 7

Gross debt: LAC vs. EM average (as percent of GDP)

• The scope for increasing fiscal space through an increase in the tax burden varies widely within LAC, ranging from substantial (e.g. in Mexico and Guatemala) to limited or nil (Brazil and Argentina)

• But, all countries have significant scope to improve equity and efficiency through tax policies. The recent IDB flagship “More than Revenue” provides compelling evidence in this respect

• Main shortcomings from efficiency standpoint– High burden of social contributions: deterrent to formal employment, growth of firms, and ultimately

productivity– Proliferation of tax expenditures, which sap revenues and induce distortions– Privileging administrative expediency

• Proliferation of heterodox taxes• Heavy reliance on royalties from natural resources• Extensive use of presumptive methods of taxation

• Main shortcomings from equity standpoint– Low effective progressivity of the PIT, because of high thresholds, exemptions of certain types of

incomes and high levels of evasion– Large weight of regressive indirect taxes– Exemptions and preferential rates are a costly and ineffective way of mitigating the VAT’s

regressivity, because their budgetary cost increases along income deciles

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Tax policies for growth and equity (I)

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Too few pay the PIT

Bolivia

Nicaragua

Dominican Rep.

Ecuador

Peru

Guatemala

Argentina

Costa Rica

Chile

Brazil

Uruguay

OECD

0 7 14 21 28 35 42

Taxpayers Paying Personal Income Tax, 2010 (percentage of population)

Source: IDB: More than Revenue : Taxation as a Tool for Development, 2013

• Main reform options

– PIT• Reduce the personal income exemption level

• Cap deductions whose value rises with income

• Broaden the tax base, including by adopting a dual income tax, if capital income or gains are not taxed under existing PIT

• These reforms would– Increase the PIT’s revenue and stabilizing capacity

– Improve horizontal equity and efficiency

– Increase the redistributive capacity of the tax; and

– Facilitate tax administration and enforcement

– VAT• Substantially reduce exemptions

• Unify rates

• Use part of additional revenues to compensate poor households, and the rest to reduce payroll taxes

• These reforms would – Reduce informality

– Improve productivity and external competitiveness

– Not hurt the poor; and

– Facilitate tax administration

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Tax policies for growth and equity (II)

• There is no “one size fits all” desirable public expenditures reform strategy to increase both efficiency and equity in LAC, because:

– Both the level and the composition of public expenditures vary substantially across the region

– So do political and social preferences about the size of government, and the extent of weaknesses in public expenditure management

• Much more work is needed in collecting and analyzing relevant evidence, both across countries and in individual countries, regarding:

– The effectiveness of major spending programs in attaining their desired outcomes– Their effects on the determinants of potential growth– Their distributional impact– Their cost drivers and related efficiency gains

• Multilateral institutions active in the region need to increase their efforts in this area, and cooperation among them is important to avoid duplications and promote synergies. This seminar is a good step in this direction

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Public expenditure policies for growth and equity (I)

• With these caveats clearly in mind, some generalizations can be attempted here

• Efficiency- and equity-enhancing public expenditure reform options

– Elimination of energy subsidies– Improved targeting of social assistance programs– Provision of universal basic old-age pension financed by tax revenues

and indexed to prices, coupled with mandatory defined-contributions pension regimes

– Redirection of budgetary resources to improving access to, and quality of, basic education and primary health care

– Reforms to facilitate mobility and strengthen capacity of civil servants – Strengthening PEM systems, and systematic use of cost-benefit analysis of

public investment projects, to maximize value-for -money of expenditure programs, increase transparency and minimize corruption

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Public expenditure policies for growth and equity (II)

• Politically- or efficiency-driven decentralization can be dis-equalizing

• Steps that can be taken to simultaneously improve efficiency and equity in decentralized systems

– Introducing low-rate regional surcharges on national PITs– Improving administration of local property taxes, especially the

valuation of real estate to better reflect market values– Increasing resort to user charges to finance improvements in

access to, and quality of, local services, with reduced rates for basic consumption levels

– Setting and enforcing realistic national minimum standards for the provision of decentralized public services

– Introducing equalization mechanisms in revenue-sharing or other inter-governmental transfer formulas

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Efficiency- and equity-enhancing reforms in intergovernmental fiscal arrangements

• Main political economy obstacles to efficiency and equity enhancing reforms– Opposition of powerful groups benefiting from status-quo– Lack of understanding in society at large of benefits from the reforms– High discount rate of politicians

• There is no magic bullet to overcome these obstacles

• But, communication matters– Benefits from reforms must be explained clearly to the public– Pressure groups of potential beneficiaries of reforms can be created

• Reform packages need to include (fiscally affordable) compensations/ trade-offs to reduce opposition of affected interests

• Timing and sequencing of proposed reforms must be decided taking into account political economy factors

• The region offers some good examples of politically viable fiscal reform packages in recent years.

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Political economy considerations

Teresa Ter-Minassian, former Director of the IMF’s Fiscal Affairs DepartmentE-mail: tterminassian@post.harvard.edu