Latin America’s public finances

Economics Department

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Governments in Latin America have made enormous progress in improving their fiscal management in recent years. But what are the next steps?

Fiscal responsibility is no longer a taboo in Latin America. Just look at Mexico. Once a country with burgeoning budget deficits, it is now a stable global economic player. But this OECD member is not the only example. New governments have been elected in Brazil and Chile, each promising fiscal rectitude.

The countries that have achieved economic stability in the region have gone a long way to put their public finances in order and appear to share the view that fiscal discipline is a prerequisite for the sustained growth and resilience needed in today’s global economy. But some Latin American countries are still grappling with chronic budget deficits and high public debts, the so-called imbalances that were at the root of so much market disarray in the region during most of the 1980s and part of the 1990s. What can they learn from the experiences of their more robust neighbours?

Quite a lot, according to a recently released monograph on public finances in Latin America from the OECD Economics Department. It argues that fiscal adjustment was more than just a key aim. It was a central part of a concomitant effort by the region’s more reform-minded governments to strengthen the institutions for fiscal management, reining in excess at subnational level, enhancing transparency and boosting market confidence. For example, Brazil’s Fiscal Responsibility Law from 2000 is the outcome of a long institutional process to introduce binding budget constraints at all levels of government. The framework has been put to the test in times of financial duress and has been working well, thereby anchoring expectations.

Then there is Chile’s structural budget surplus rule which calls for a surplus of 1% of GDP, taking account of the effects on revenue of the business and copper price cycles. Though not set in law, the rule works well and is expected to be adhered to by the recently elected administration. Another feature of these relatively robust economies has been structural reform, including the deregulation of product markets, such as utilities. Pension reforms, too, have helped to underpin the overall fiscal adjustment process. Despite these remarkable achievements, several challenges remain. Many governments have delivered an impressive upswing in their fiscal accounts, even in difficult times, often on the back of tax hikes and cutbacks in public investment, rather than a retrenchment of current spending commitments.

As the report shows, fiscal effort needs to lead to a sustained reduction in public indebtedness so that fiscal policy can play more of a stabilising role in the economy, instead of creating vulnerabilities. Everyone accepts that high debt takes a toll on the government’s ability to pull the economy out of a recession with higher spending and tax cuts. This is true of more developed countries, but is especially so in emerging market economies in general, not least in Latin America, where access to international markets for budget financing can never be taken for granted, particularly in difficult times.

The experience of several OECD countries also suggests that fiscal adjustment is more sustainable when achieved by cutting spending, particularly outlays on the likes of public-sector wage bills, rather than raising taxes. In other words, the quality of fiscal consolidation measures counts, too.

How can high-quality adjustments be kept up? The to-do list is long. Budgets should be more flexible, for a start. Revenue from a given tax should not be automatically earmarked to a pre-determined programme, for instance, as still happens in some countries, because it constrains the ability of governments to respond to changing macroeconomic conditions. It also makes it hard to reallocate resources in the budget to finance more meritorious programmes where funding may be in short supply.

Another job on the list is to improve Latin America’s skewed distribution of income. Many countries already spend a lot of their national income on social programmes, but the outcomes are rarely commensurate with high spending. Again, this points to a quality problem. True, some innovative programmes are paying off, including efforts to improve the targeting of social programmes, as in Brazil’s Bolsa Família, Chile’s Chile Solidario and Mexico’s Oportunidades, and to ensure people have access to vital services. But in general, a sharper focus on results is needed.

At the same time, the need for public investment in infrastructure should not be underestimated. In fact, Latin America still suffers from a large “infrastructure gap”, which weighs on its growth potential, as well as budgets. Some countries, including Chile and Mexico, are relying on public-private partnerships to finance infrastructure. By the end of 2002, Chile’s most important highways, ports and airports had been franchised, with investments to the tune of US$5 billion. In general, for these joint ventures to work, they should be based on judicious project evaluation, a fair sharing of risk between the government and the private sector, and strong governance to safeguard the budget.

On the revenue side, the main challenge is to broaden tax bases, reducing reliance on the most distorting taxes, such as on exports in Argentina. Bank debits are still taxed in Brazil, as well as in several other countries in the region, discouraging financial intermediation in most cases. On the other hand, Brazil’s federal levies on enterprise turnover, which lead to the cascading of taxes, have been converted into value-added taxes. This is a positive development.

Another contingency to address is the heavy reliance of some countries on natural resource-related revenue. This can be managed, however, as Chile has shown, by insulating its public finances from copper price fluctuations through a wellfunctioning price stabilisation fund. Then there is the issue of raising more tax revenue. Brazil’s tax-to-GDP ratio, at 36% of GDP in 2004, is already closer to the OECD average than that of the other Latin American countries. But in some countries, such as Peru or Mexico, government revenue is much lower, usually in a range of 15-20% of GDP. This reflects the inability of the government to bring more dynamic sectors of the economy into the tax net.

The consolidation of fiscal adjustment naturally has political dimensions. Policymakers may understand that fiscal rectitude pays off, and that short-term largesse can actually do lasting damage. Yet, public support for reform has waned in some countries, leading to a wave of populist measures. But most genuine reforms, because they require institutional and cultural change, take time to bear fruit. They can also cause short-term pain.

Policymakers must therefore build solid constituencies in support of reform; they must embrace such measures as the introduction of affordable, cost-effective safety nets for vulnerable social groups. Communicating the benefits of reform effectively to society at large and other stakeholders would also help. For instance, they might ask how many Latin Americans today would like to return to the days of rampant inflation?

People know that reform can be a long, hard job to get right. Shortcuts may be tempting but, in a competitive world, fiscal mismanagement is a luxury Latin America can no longer afford.

References

OECD, Challenges to Fiscal Adjustment in Latin America: The Cases of Argentina, Brazil, Chile and Mexico, Paris.

OECD (2005), Brazil Economic Survey, Paris.

OECD (2005), Chile Economic Survey, Paris. More articles on Latin America by the same author are available on this site.

©OECD Observer No 254, March 2006




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