Even before the COVID-19 crisis, Latin America and the Caribbean faced stagnant growth. GDP, however, fell by 7.4% in 2020, and the region’s public finances were hit hard. With tax collection dropping 25% (and bouncing back only partially), and spending rising by about 3.5% of GDP as governments sought to attend to health and preservation policies to save households, jobs, and firms, the average fiscal deficit rose to about 9% of GDP in 2020, way above pre-crisis levels of 3%. IDB projections suggest that average debt may ascend to almost 80% of GDP by the end of 2022, a frightening rise from its pre-crisis average of 58%.
Fiscal sustainability is clearly at stake and fiscal reform, including significant changes in tax and spending policies, are urgently needed. They are essential to reversing fiscal deterioration, promoting growth, enhancing equity, and preventing the next fiscal crisis. How is the region going to tackle these reforms? What is the likelihood that this dramatic deterioration will be reversed? And which are the right tools to get the job done?
As activity recovers, tax collection will likely recoup as well. However, governments will not necessarily revert to previous spending levels. For comparison, consider public spending behavior in the region in response to the Great Recession of 2008-2009 and beyond. Supposedly countercyclical policies ended up with large increases in public expenditure. These included, most significantly, salaries and transfers that proved quite difficult or even impossible to undo. As a matter of fact, those two components represented, on average, almost two-thirds of the expansion, and they were the seed of fiscal imbalances that persist today.
Countries during the pandemic have not boosted wages. But they have engaged in massive, much needed -and, in theory, temporary- transfers to households and firms. Although expenditure could return to pre-crisis levels, that is unlikely. First, the experience of the Great Recession illustrates the difficulty of reversing spending increases. Second, it is not clear that governments will end temporary transfers to households. Even if COVID-19 transfers were phased out as intended, the region will face an increase in poverty and in jobs lost in the aftermath of the pandemic. That means that structural transfers will likely rise in the foreseeable future relative to pre-crisis levels, potentially erasing the effect of cuts in temporary transfers. Third, in many cases public sector wages have lost their purchasing power, and there will be pressure from unions to increase wages once the pandemic is over.
With ever greater social demands, increasing debt levels, and difficulties in reversing recent expenditure increases, governments must implement policies yielding higher growth as the health crisis subsides. A recent IDB report, emphasizes not only the need to work on sanitary and economic preservation measures, but also to jumpstart reforms conducive to higher and more inclusive growth, whose effects will show once out of the sanitary crisis. Otherwise dire problems with fiscal sustainability may, if unattended, lead to defaults and the risk of another Lost Decade.
An Expenditure Strategy
The first line of defense must undo COVID-19 expenditure increases as much as possible. Expenditure reallocation, which has been underutilized in the region, is also essential. Unfortunately, governments lack agencies that can evaluate expenditure efficiency so as to -at least partially- reallocate resources to sectors with better social returns. Rethinking expenditure allocation is mandatory. To begin with, countries with some fiscal space will have to massively switch from using resources for preservation policies during the pandemic to pro-growth spending after it. Fiscal space for pro-growth spending -particularly in countries where sustainability is clearly at stake- will also have to be created from savings in technically inefficient spending.
Assessing returns to different types of expenditures so as to ensure efficient allocation may take time, but a good way to start is by identifying technical inefficiencies that provide room for pro-growth spending. A recent IDB report identifies three areas worth exploring: 1) waste in government procurement 2) excessive wages to public sector workers relative to those in the private sector, and 3) leakages in social transfers. Inefficiencies in these three areas amount to 1.4%, 1.2%, and 1.7% of GDP, respectively, bringing potential overall savings to almost 4.4% of GDP that could be allocated to pro-growth spending. These estimates of technical inefficiency in spending and strategies to deal with it have also recently been emphasized by other international organizations such as the IMF.
Reassessing how to cover old age dependents in a context of rapid aging without relying fully on ongoing -and worrisome- increases in pension and health spending is also critical. This structural issue has been aggravated by the pandemic, even in the case of defined contribution systems, due to currently lower interest rates and contributions. Thus, fiscal risks stemming from guaranteed minimum pensions have increased and overall sustainability has been threatened. Recent measures allowing individuals to withdraw pension savings during the pandemic with no prospect of repayment have only exacerbated the problem.
Gains in allocative and technical efficiency present several options for spending, the most obvious of which is quality public investment, for several reasons. First, it has the largest fiscal multiplier, ranging as high as two. Moreover, it has lost more than 10% of its share of the budget relative to the 1980s in Latin America and the Caribbean, due to expenditure consolidation and the lack of fiscal rules that protect public investment. This must be rectified to avoid further deterioration. Third, the region has a long-standing deficit in infrastructure and infrastructure services. Before the pandemic, public investment, which should be on the order of 5% of GDP, was less than 2%. of GDP. During the pandemic, it declined even further.
Other items that would certainly benefit from more fiscal space would be labor market reforms that lower labor taxes, thus increasing hires and reducing informality, or reductions in import tariffs on capital goods to boost private investment. Pro-growth spending on quality health and education would also boost human capital, particularly when provided to lower income groups as early in the life cycle as possible.
A Tax Strategy
Given the need for fiscal consolidation, policymakers can directly increase tax revenues by increasing tax rates, levying new taxes, or expanding the tax base by reducing tax expenditures or improving enforcement. It may be tempting to increase taxes (tax rates or the creation of new taxes), thereby increasing collection, but it might be difficult to do so, and in some cases, even counter-productive. A long-term issue in Latin America is its relatively low tax collection, averaging 22.4% of GDP, which is lower than in developed countries (it is 34.3% in the OECD, see Figure 1). However, there is substantial heterogeneity across the region, ranging from high taxation countries like Brazil, Barbados, Belize, Uruguay, and Argentina -where it lies between 29% and 34% of GDP- to low taxation countries such as Guatemala, Dominican Republic, Paraguay, Panama, Mexico and Peru – where it lies between 12% and 16% of GDP. For high taxation countries, policies different from increasing tax rates—and involving expenditures more heavily—will be in order. For low-taxation countries increasing tax bases as recovery gains momentum and ultimately increasing tax rates is the way to go to increase tax collection. But it should be done in a way that does not substantially damage growth and inequality.
Figure 1: Tax collection in Latin America and the Caribbean, Including Estimated Losses in Revenues (lined) from the Pandemic in 2020
The best way to boost tax revenue is to support solid growth. The region, however, was struggling even before the coronavirus took hold, and such growth cannot be expected unless substantial reforms take place. Other than boosting taxes through growth, what else can be done? Tax effort -the percentage of effective tax collection relative to its potential- could make a significant difference. Tax effort in the region today is about 60%, compared to 77% in advanced economies. If the region could catch up to advanced economies in this regard, it could increase tax collection by about 7% of GDP.
Increasing overall taxation has a negative tax multiplier on output. However it may be possible to increase taxation in low taxation countries, because their multiplier is much lower than in high taxation countries. Another issue in the region is the high degree of informality, which can increase the size of tax multipliers. Informality has exacerbated with the pandemic, increasing tax multipliers even further. Hence, as much as low taxation levels can diminish the value of tax multipliers, increasing informality has the opposite effect. This is an important problem for Latin American and Caribbean countries where informality is high.
Informality is one reason for the low tax effort. But simply increasing tax rates may result in greater informality and still greater inefficiencies. Rather, the focus must be on tax and benefit structures coupled with better enforcement, to reduce incentives for informality. One useful way to boost formality is through programs that reward formal employment, such as the Earned Income Credit (EIC), particularly for low-income groups. This can be done while gradually phasing out noncontributory social programs for informal workers and, if necessary, reducing payroll taxes for small firms hiring low-wage workers.
Working to increase tax effort by reducing tax evasion and informality is key, particularly for high taxation countries. But is there any room left for hiking taxes in low-taxed countries? And which taxes should be raised?
- Governments frequently exempt value-added taxes (VAT) on specific goods (e.g., basic food) to lessen their effect on inequality, but this can be inefficient: As much as 70% of this forgone revenue in current VAT systems in the region accrues to the nonpoor. Applying a unified VAT tax rate without exemptions and raising more revenue, but then using some of those resources for a well-targeted system of transfers to the poor, would be more efficient.
- Among income taxes, there is less scope for raising either the personal income tax (PIT) rate or the corporate income tax (CIT) rate. PIT rates are already at levels similar to advanced economies and, on paper, they are progressive. CIT rates at 27% on average in Latin America and the Caribbean are higher than in advanced economies (22.6%). Moreover, when adding labor contributions and other taxes, the “effective” taxation on profits of firms that comply can approach 60%, compared to 40% in advanced economies and 30% in emerging Asia. With CIT tax rates falling across the globe, it would be unwise to increase them. However, there is room to lower CIT exemptions and to push for formalization of informal firms to increase income tax collection.
- Taxation of wealth is receiving much attention. While net wealth taxes have been widely discussed, few countries have them, as they are easy to avoid and difficult to enforce. An alternative is property taxation. Many countries in the region employ such taxes but at low rates. Moreover, only about 0.4% of GDP is collected, roughly half the amount collected in other developing countries and one-sixth that in the OECD. Much of property tax collection is imposed by subnational governments, which usually have less capacity and fewer incentives to pursue this source of tax revenue. Their capacity and incentives must be revamped to increase property tax collection in the region.
- Imposing carbon taxes to combat climate change could be timely and beneficial. The region has ample room to increase fuel taxes (or alternatively, diminish subsidies) in a context of relatively low oil prices.
- Digital services can also be taxed. These services have experienced a surge in demand, yet their taxation is low. Only a few countries such as Argentina, Chile, and Ecuador, currently tax digital platforms.
- Another revenue-raising possibility is reducing tax expenditures, currently about 3.9% of GDP. These are not only distortionary. They also negatively impact redistribution due to their generally regressive nature.
- Beware of increasing rates on gross receipts, wages (including payroll taxes), exports, and financial transactions, all of which are easy to collect but highly distortionary. These taxes should be replaced by less distortionary options to avoid the perilous effects on much needed investments.
Despite much heterogeneity in Latin America and the Caribbean, all governments in the region will need to put in place fiscal reform agendas, with precise timing for expenditure and tax management if they are to avoid the next fiscal crisis. Working on expenditure reallocation and the creation of fiscal space for pro-inclusive growth reforms is essential. Tax policies must account for current tax collection levels, informality and tax effort when introducing new taxes (or reductions in exemptions) that are as little distortive and as much equity enhancing as possible. Tackling these issues early on will make the difference between fiscal success and failure.
* Note: Some of this material is also available in IDB’s 2021 Macroeconomic Report.