Fiscal policy to drive the recovery in Latin America: the “when” and “how” are key

Fiscal Policy
Fiscal Policy - Public and Welfare Economics

The socio-economic consequences of the COVID-19 crisis in Latin America have been devastating. Urgent and sustained policy actions are needed to spark a robust recovery (OECD, 2020).

Fiscal policy is at the core of the response to the ongoing crisis and will determine, in large part, how inclusive and strong the recovery will be. To that effect, fiscal policy must help drive a productive transformation generating formal employment, fully leveraging digital transformation and prioritising the environment. This means increasing investment in human and physical capital, including infrastructure, well targeted spending to support the most vulnerable populations and improving the quality of public services. To finance these investments, there needs to be greater resource mobilisation at both national and international levels, which in turn implies greater progressivity of the taxation system, and better tax administration and debt management. Ensuring fiscal sustainability will be instrumental to the success of these efforts, as well as strengthening citizens’ trust in government to overcome the “institutional trap” that many countries were experiencing even before the COVID-19 crisis (OECD et al, 2019a).  

Moreover, for fiscal policy to be effective it must take into account the current complex context through well-defined sequencing of actions. It also needs to be backed by a broad consensus built through national dialogue and clear communication. The political economy of fiscal policy is more important than ever. Additionally, there is no unique approach or solution to ensuring that fiscal policy translates into a strong and inclusive recovery. Context-specific socio-economic characteristics in each country coupled with the different impacts of the crisis call for a tailored approach. However, some overarching considerations can help countries in the region get their “policy menu” right and achieve a good balance between public spending, tax policy and public debt management.

Better targeted public spending and more investment in the recovery

In response to the COVID-19 pandemic, public spending in the region increased significantly in 2020 to support public health systems, families and firms. However, in part due to the limited fiscal space (in 2020 the average overall deficit in Latin America reached 6.9% of GDP (ECLAC, 2021)), the region adopted relatively smaller-scale measures (3.4% of GDP for additional spending and foregone revenue) compared to emerging Asia (5.5% of GDP) and advanced economies (8.4% of GDP) (IMF, 2021a). While in some countries, including Argentina, Brazil, Dominican Republic or El Salvador, central government primary expenditure rose by more than 20% in the first nine months of 2020 compared to the same period in 2019, others continued with their fiscal consolidation policies and even reduced public spending (OECD et al., 2021).

The quality, timing and sequencing of efficient and effective public spending is crucial to embark on a pro-development path. As long as the pandemic continues to put lives at risk, the priority should continue to be to protect them, support the most vulnerable families and continue to save firms and jobs. Vaccination is key to secure an exit from the pandemic and reduce the uncertainty of stop-and-go confinement measures. Throughout the crisis, governments have made significant efforts to reach informal workers and households that were not covered by traditional social assistance mechanisms, especially among poor and vulnerable socio-economic groups (Figure 1). Recent experiences provide lessons on how some countries were able to implement well-targeted mechanisms to support these vulnerable populations. Some examples of these mechanisms are Ingreso Familiar de Emergencia in Argentina, Auxilio emergencial in Brazil, Ingreso Familiar de Emergencia in Chile, Ingreso Solidario in Colombia, Subsidio Pytyvõ in Paraguay and Bono Familiar Universal in Peru. Additionally, countries focused public spending on preserving productive capacity and especially protecting MSMEs.

Moving towards the expansion of well-targeted social assistance programmes suppose the need to design mechanisms that include long-term economic effects. For instance, there is evidence that targeted cash transfers, especially conditional, can spur investment in child schooling (OECD, 2019).

Public spending should gradually be reallocated from general to targeted support – with a focus on the sectors that need it the most – and from current towards capital expenditure. Traditionally, only 20% of public spending in Latin America and the Caribbean is concentrated in capital expenditure (OECD et al., 2019). As a result, the region lags behind in terms of gross capital formation. Before entering the COVID-19 crisis, the gap was 4 percentage points of GDP with advanced economies and more than 21 percentage points of GDP with Emerging and developing Asia (IMF, 2021). More and better capital expenditure is fundamental for a robust recovery and to drive the infrastructure investments (including in digital and green technologies) needed to promote quality jobs and production transformation. Furthermore, especially with regards to infrastructure, capital expenditure has a high multiplier effect, reaching as high as two, in both economic activity and employment (Izquierdo and Pessino, 2021). Finally, Latin America and the Caribbean must also gradually return to fiscal frameworks, including fiscal rules to protect investment, ensure clarity, efficiency and equity of expenditure, and add adequate escape clauses for exceptional events.

To mobilise the necessary resources will require a fiscal strategy that combines more effective taxation, improved public expenditure and greater access to capital markets (OECD, 2020; IDB, 2021). However, the implementation of such a strategy must take into account the political economy of reform and the diverse implications of each measure on the strength and distributional impacts of the recovery. Clear communication and pedagogical dialogue with citizens is fundamental to build the necessary support and consensus. In the absence of fiscal support (fiscal austerity) or premature fiscal tightening, the recovery might not be sustainable. Lack of fiscal support would entail a fall in public transfers, in capital investment and/or in the adoption of new technologies, which in turn may deter the recovery, jeopardise lives and jobs, and put the fiscal stability it is trying to preserve at risk (Carriére-Swallow et al., 2021; Bianchi et al., 2019).

Tax policy: further progressivity and well-targeted sequence of actions

Tax revenues remain low, as the average tax-to-GDP ratio in the LAC region was 22.9% in 2019, considerably below the OECD average of 33.8%, and total tax revenues declined by 11.2% in 2020 from the previous year (OECD et al., 2021). Thus, the sequencing of tax policies backed by a national consensus will be fundamental to finance the recovery, guarantee long-term fiscal stability and incentivise job formalisation.

A set of tax policy options available to Latin American and Caribbean countries could help increase revenues without compromising the economic recovery or well-being of citizens. These include measures to reduce tax evasion and avoidance, which costed Latin America around 6.1% of GDP - in lost Personal Income Tax (PIT), Corporate Income Tax (CIT) and Value Added Tax (VAT) receipts (ECLAC, 2021). Similarly, other options include policies to increase tax compliance, strengthen tax administration and eliminate some tax expenditures that bring low benefits in terms of equity or job creation. Overall tax expenditure averaged 3.7% of GDP in Latin America from 2015-2019. Coupled with international measures to avoid tax base erosion and profit shifting by multinational enterprises (e.g. through the implementation of the OECD/G20 Base Erosion and Profit Shifting - BEPS project), these measures have an additional benefit: they improve fiscal morale and therefore the credibility of institutions. Finally, another key international area for the region is the digital economy and tackling the challenges it brings (OECD et al., 2020).

Countries may need to consider additional ways of raising revenue to restore long-term fiscal sustainability and achieve further progressivity in taxation systems (OECD, 2021a). The timing, speed and shape of these policies should be adapted to each country and closely linked to citizen consensus. While in OECD economies, taxes and transfers contribute to the reduction of the Gini coefficient by approximately 16 percentage points, the comparable reduction in LAC is below 3 percentage points on average (OECD et al., 2019). In most countries, actions should be considered to increase PIT revenues from top deciles. PIT is the principal factor behind the tax gap between the region and the OECD (Figure 2) (on average 2.1% of GDP in LAC compared to 8.1% of GDP in OECD economies), limiting not only potential revenues but also the redistributive power of the tax system (OECD et al., 2021). Further action on specific taxes, including the taxation of immovable property (OECD et al, 2019b; Izquierdo and Pessino, 2021) and individuals’ capital gains should contribute to increase revenues to finance the recovery and improve the progressivity of the taxation system. Other measures include wealth and inheritance taxes (OECD, 2021b), where their effective implementation requires better capacity of tax and statistics administrations.

As the recovery advances, there are further tax policy options that can be put in place by building consensus across actors. These include corrective taxes, such as environmentally related taxes. In LAC, on average, revenue from environmentally related taxes amounted to 1.2% of GDP in 2019 (mainly energy taxes, most commonly from diesel and petrol), a lower level than the OECD average of 2.1% of GDP. Similarly, taxes related to public health objectives – such as on consumption of tobacco, alcohol, sugar and beverages - can play a key role in shaping incentives for economic actors to promote healthier diets, ultimately generating better health outcomes and reducing health-related costs. Likewise, measures to improve VAT efficiency by reducing the number and scope of exemptions and compensating the most vulnerable populations could be envisaged (OECD et al., 2021).

Public debt management: a global crisis calls for global responses  

The magnitude of the fiscal response to the crisis has led to a substantial increase in public debt levels. Central government gross public debt in 2020 reached an average of 56.3% of GDP, an increase of 10.7 percentage points from 2019 (ECLAC, 2021). Contrary to previous global crises, high levels of international liquidity maintained capital markets open for emerging economies, and often in favourable terms.

Nevertheless, financial conditions may change rapidly in the medium term. If following large stimulus packages monetary policy normalises in advanced economies, this could affect yields, capital flows and debt pricing. If this is the case, issuer or creditor inaction can lead to debt defaults and debt crises, adding to an already complicated scenario. This underlines the need for adequate debt management, proper fiscal frameworks, including fiscal rules, and for globally co-ordinated debt management under key guidelines (OECD et al., 2020; Nieto-Parra and Orozco, 2020). In particular:

  • Official support should prioritise economies that have little or no access to capital markets.
  • Countries that had strong public finances going into the crisis must retain access to capital markets.
  • Another group of countries might have access to capital markets but face high debt costs. There are several policy options, including debt standstills or moratorium, the creation of a special vehicle to finance the crisis or pay the debt, and greater use of Special Drawing Rights.
  • Strong debt transparency supported by the necessary technical assistance so countries can strengthen their debt management capacity (Subacchi, 2020)

There are new debt tools and options that can help to raise additional resources. For instance, debt-to-COVID or debt-to-SDG swaps as well as social and environmental sustainability linked-bonds. These could all benefit lender and debtor governments, as well as private creditors, while avoiding potential debt crises and addressing pressing issues (UN/DESA, 2020; Caputo Silva and Stewart, 2021).

Regarding debt restructuring mechanisms, recent debt restructuring experiences in Argentina and Ecuador show the importance of including Collective Action Clauses in sovereign bond contracts.

There is no single solution to public debt management in the region: countries differ in terms of their initial fiscal conditions, type of foreign creditors (Figure 3) and capacity to tap into capital markets (OECD et al., 2020). Coordination should involve multilateral banks, developed countries and private creditors (Nieto-Parra and Orozco, 2020; Bolton et al., 2020).  So far, private creditors have not engaged enough, and some countries have opted out of international programmes to avoid possible credit ratings downgrades (OECD, 2021c).

In sum: well-coordinated actions at both national and international levels are fundamental for the recovery

There is no doubt: fiscal policy is at the core of the recovery but its design and implementation is more complex than ever. Some of the recommendations we might have envisaged in normal times, such as increases in personal income tax base, cannot be fully implemented in such a difficult context for most families, workers and firms across the region.

In short and despite highly varied national contexts across the region, countries should consider some common factors and fiscal measures on the road to recovery. First, a holistic fiscal response should make use of all fiscal policy tools. There are arguments for “bundling” reforms into a comprehensive package to build fiscal legitimacy in the region. Bundling reduces political constraints, facilitates political support for fundamental reforms and addresses distributional issues. Second, in order to achieve a sustainable and inclusive recovery, fiscal measures should be coordinated under a well-defined sequence of policies that can be adapted to the different stages of the recovery. Third, there needs to be a consensus and national dialogue surrounding the timing and dimensions of required public spending and taxes. A consensus that can help to renew the social contract (OECD et al., forthcoming). Fourth, well-focused actions both in terms of expenditure and income should promote further progressivity and sustainable formal job creation. Fifth, new and innovative fiscal frameworks, including fiscal rules, should be implemented to ensure long-term fiscal sustainability. They should be clear, transparent and protect investment, with adequate escape clauses. Finally, national responses are not enough, the nature of this crisis and the interlinkages across countries require further coordination and co-operation at the international level.

Overall, there is a growing need for a coordinated and sequenced fiscal strategy that is built on a contract between State and citizens. In that respect, the supported role of international partners and development banks is valuable. Well-coordinated fiscal actions, both at the national and international levels, should contribute to manage a sustainable and inclusive recovery for the region.


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