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Fiscal Sustainability: Lessons and Challenges from the New World

May 2012

Fretes Cibils, V. and García Osío, G. 2012. Fiscal Sustainability—Lessons and Challenges from the New World. GREAT Insights, Volume 1, Issue 3. May 2012 . Maastricht: ECDPM

The Latin American and the Caribbean (LAC) region learned its fiscal policy lessons from past mistakes—and it learned them very well. For several decades in late last century, pro-cyclical fiscal policies worsened LAC’s economic growth volatility. Policy makers increased (or decreased) spending and decreased (increased) taxes, enlarging the economic cycle’s boom (bust). Over the last two decades, however, most LAC countries reverted from the past and implemented structural reforms and strengthened fiscal sustainability – a necessary condition to accelerate and sustain economic growth. 

Fiscal reforms, together with a favorable external environment (both in developed and emerging markets, led by China) and high commodity prices paid off during the 2000s. As a result, for 2003-2007, LAC’s real GDP grew at 5 percent per year – and LAC’s income per capita expanded on an average annual growth rate of about 4 percent. This article reviews the fiscal response LAC countries implemented in the face of the crisis. It then goes on to consider the impact of fiscal reforms undertaken in the past on this policy response. It concludes by underlining the necessity to further strengthen fiscal institutions and to take into account the federal nature of fiscal policy in LAC.

Latin America and the Caribbean and the financial and economic crisis

During the 2000’s most LAC countries simultaneously implemented prudent (and relatively well-coordinated) macroeconomic policies, improving fiscal outcomes and accumulating net international reserves (NIR). LAC’s fiscal policy was less pro-cyclical as it saved much of the fiscal revenues “windfall”. The region also decreased public debt as percentage of GDP. This together with high NIR strengthened the region’s solvency and liquidity position making it more robust to confront external shocks (see figure 1). There were however significant intra-regional and country differences across the region, with large (e.g., Mexico and Brazil) and mid-size (e.g., Chile, Colombia and Peru) countries well prepared for absorbing external financial and economic shocks.


LAC’s economic growth, fiscal consolidation and policies determined its ability to confront the external crisis of late 2000s. These initial conditions – fiscal balance, debt/GDP ratio, and NIR – and the extent and duration of the shocks were critical for LAC’s policy response. In contrast to OECD/European countries, LAC’s initial conditions “opened” fiscal and financial space. The region was thus relatively well prepared for responding to the external crisis, limiting the impact on economic growth to only one year (see figure 2).

LAC’s GDP growth sharply slowed from 2008 as a result of the external crisis, with the recovery starting in 2010. The downturn in GDP depressed tax collections, and the fall in commodity prices reduced commodity-linked fiscal revenues, particularly for commodity-exporting countries. As a result, overall fiscal revenues as a percentage of GDP declined in 2008 and 2009, recovering when the domestic and global economy (led by emerging markets) recovered. Primary fiscal balances plummeted (typically by about 4 percentage points).

Most countries in the region did however respond with countercyclical fiscal policy, expanding primary fiscal expenditures and, in some cases, reducing taxes, providing effective fiscal stimulus. And, by the end of 2010, the vast majority of fiscal stimuli were progressively scaled back.(1) There were intra-regional differences, both in terms of initial conditions and external impacts. Small economies (Central America and Caribbean) and Mexico were significantly affected by the external crisis (see figure 3). These economies are closely integrated to the US economy through trade of goods and services and remittances. Mexico nevertheless had fiscal and financial space to implement countercyclical policies and recovered fast—by 2010, Mexico’s GDP grew at 5 percent.

LAC’s initial condition, policy response, including fiscal stimuli, together with Asia’s fast recovery and growing demand of the region’s commodities contributed to (i) LAC’s rapid economic recovery; and (ii) its fiscal outcomes post-crisis, contrasting significantly with OECD/European countries. LAC’s strengthened fiscal institutions also contributed to these results.

Fiscal reforms and the financial crisis: what lessons?

Over the last two decades, LAC made significant progress on fiscal reforms and on strengthening fiscal institutions to conduct credible, stable and sustainable fiscal policy. Most countries adopted fiscal rules and, more specifically, adopted numerical limit rules on fiscal aggregates without adjusting them to the business cycle. (2) These quantitative rules helped the region’s fiscal consolidation, contributing to fiscal discipline. They however proved to remain pro-cyclical (even though less so than before).

Furthermore, to comply with the quantitative rules during the international crisis and to enhance the stabilization role of fiscal policy, most LAC’s countries modified or abandoned (temporarily) the fiscal rules because these did not explicitly include escape clauses (except in Mexico) to confront severe external shocks. With the exception of Chile, no country in LAC adopted fiscal rules based on structural fiscal balance – until mid-2011, when Colombia became the second country in the region to adopt such a type of rule.

The international crisis unmasked the key weaknesses of the region’s fiscal rules. Their temporary suspensions and/or violations in response to the business cycle and international crisis reduced their effectiveness to achieve sustainability and credibility. In addition, they proved to limit the stabilizing ability of fiscal policy if automatic stabilizers were small—the LAC’s case.(3)

Moreover, transfers to sub-national governments, even with fiscal rules, may have limited fiscal policy’s stabilizing role during the business cycle. Transfers defined as a fixed proportion of revenues automatically vary with the cycle, fluctuating pro-cyclically. In addition, countries with high fiscal dependency on revenues from non-renewable natural resources exports required more specific rules to (i) respond to volatile and unexpected price changes in the international market, and limit its pro-cyclical impact; and (ii) save for future generation and ensure fiscal sustainability. Finally, adopting and implementing fiscal rules, and particularly structural fiscal balance rules, proved to be institutionally and technically complex.

Therefore, they are probably a good option for large-medium size countries/economies with strong institutions and technical capacity. Consequently, LAC should continue to (i) strengthen fiscal rules, including explicitly incorporating escape clauses and adopting structural fiscal balance rules (if justified in large-medium economies); and (ii) use discretionary countercyclical policies, complementing fiscal rules, if international shocks are significant. 

Taking fiscal federalism into account

LAC’s fiscal federalisms further complicate the process of strengthening fiscal rules and the stabilization role of fiscal policy. Three facts characterized LAC’s fiscal federalism: first, sub-national governments (both intermediate and local) are spending a large and growing share of total public resources; second, sub-national governments – with some exceptions such as Argentina and Brazil – have limited tax power (particularly at the intermediate government level); and third, sub-national governments depend heavily on fiscal transfers from the central government.


As a result, most sub-national governments have large vertical fiscal imbalances and pro cyclical public finances—governments’ high dependency on direct transfers from central government that are fixed proportionally to annual central government ordinary revenues correlates positively with the business cycle. Finally, sub-national public finances in most LAC countries are not explicitly included in national fiscal rules. 

There are several reasons behind this exclusion, including (i) a large number of local governments with different institutional, information and management system capacities; (ii) local governments’ high resistance to adopt fiscal rules; (iii) centralized fiscal institutions’ lack of credibility; and (iv) governments’ weak incentives to smooth out and reduce transfers’ pro-cyclicality through stabilization mechanisms – such as stabilization funds. 

In light of these facts, LAC should likely continue to (i) strengthen fiscal rules by including sub-national finances in national fiscal rules; and (ii) reduce sub-national public finances’ pro-cyclicality through stabilization mechanism and expansion of sub-national own resources.

Conclusion

LAC’s performance during last decade and, in particular, during the international crisis of late 2000s provided some lessons and challenges that are important for the region itself and for other regions, including OECD/European countries. First, LAC’s initial condition, policy response, including the fiscal stimuli, together with Asia’s fast recovery and growing demand of the region’s commodities contributed to (i) LAC’s rapid economic recovery; and (ii) its fiscal outcomes post-crisis, contrasting significantly with OECD/European countries. Second, LAC’s strengthened fiscal institutions contributed to these results – most countries in the region improved the overall public finance framework and, with few exceptions, reduced fiscal policy pro-cyclicality. Despite these results, the crisis unmasked the need to (i) further improve public financial institutions to strengthen fiscal policy stabilization role; (ii) increase policy makers’ capacity to counteract exogenous shocks; (iii) strengthen fiscal rules, including adopting structural balance based rules (if justified) with escape clauses and covering sub-national governments public finances in national fiscal rules; and (iv) reduce vertical imbalances and pro-cyclicality of sub-national public finances through stabilization mechanism and expansion of sub-national own resources.

This article expresses the authors’ opinions and does not represent the Inter-American Development Bank’s (IADB) views or policy. It draws on an IADB study: Preconditions for Establishment of Fiscal Rules Based Structural Fiscal Balances, led by Gustavo Garcia (Forthcoming 2012). The authors would like to thank Luis Marcano for his excellent research assistance, including data and article production.

Vicente Fretes Cibils is currently a Division Chief of Fiscal and Municipal Management, of the Sector of Institutions for Development at the Inter-American Development Bank (IDB).

Mr. García Osío is currently a Principal Fiscal Specialist at the IDB. 

This article was published in Great Insights Volume 1, Issue 3 (May 2012)

Footnotes
1. In contrast to OECD/European countries, most LAC’s countries maintained all policy instruments available for policy makers, and complemented the fiscal stimuli with easing monetary policy—expanding credits and reducing domestic interest rates, and with adjustment in the exchange rates to ensure competitiveness for the external sector.
2. Fiscal rules are explicit goals to maintain credibility, sustainability and transparency of fiscal policy in the short and long term. They are established in a legal fiscal framework.
3. LAC’s automatic stabilizers were/are small for three main reasons: first, income tax (and particularly personal income tax) is small proportion of total fiscal revenues; second, the tax structure is not progressive; and third, high labor market informality limits unemployment insurance coverage.

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Economic Transformation and TradeBusiness and DevelopmentDevelopment Finance and TaxationCash transfersDomestic resource mobilisationCaribbeanLatin America

External authors

Vicente Fretes Cibils

Gustavo García Osío