Colombia’s Fiscal Balancing Act
For years, Colombia’s very strong policies have underpinned resilient growth and have helped to build a solid economic foundation . These cornerstones of the Colombian economy enabled it to achieve its strong economic performance and qualify for the IMF’s Flexible Credit Line ( FCL ), as recently reaffirmed during the latest FCL review in 2019. To sustain the impressive performance, Colombia will need to address a rising fiscal challenge of meeting both old and new spending needs, such as those stemming from the large migration flows from Venezuela. Policies that support continued tax reform can help raise inclusive growth while keeping public finances on a sound footing.
Some elements of the fiscal challenge are long standing—relatively high-income inequality, dependence on oil revenues, and sizable infrastructure investment needs. At the same time, new spending pressures have emerged in the wake of large migration flows from Venezuela. More than 1.5 million migrants from Venezuela--including 350,000 returning Colombians---flowed into Colombia as of March 2019. This sizeable spillover from the economic collapse translates into more Venezuelan migrants than in any other country and has created added fiscal pressures at a time when Colombia’s public debt has been rising.
While Colombia’s commitment to provide humanitarian support such as health care and education to migrants is commendable, it has added to its fiscal spending pressures. We project that the net fiscal costs associated with the migration crisis are projected to peak at 0.4 percent of GDP in 2020 before gradually declining over the next five years as migrants gradually integrate into the economy.
Adjustment under the fiscal rule
To accommodate this exceptional shock, Colombia’s fiscal rule (which places limits on the structural fiscal deficit of the central government after accounting for economic cycles and oil prices) was moderately relaxed in March to allow for a higher headline budget deficit in 2019—though the government has announced its intention of having a lower deficit than that recommended by the Fiscal Rule’s Consultative Committee.
The medium-term target remains unchanged and continues to anchor public debt. The structural deficit rule, which is at the heart of Colombia’s strong policy frameworks, calls for a sizeable reduction to the structural deficit to one percent of GDP by 2022. To achieve the needed fiscal adjustment, additional revenue will need to be mobilized because spending rigidities make significant cuts to government expenditure difficult.
The Commission on Government and Investment Spending (2018) noted that non-investment expenditures, notably transfers, are highly inflexible due to legal constraints that can determine the amounts to be disbursed by the Central Government. For instance, transfers to local governments through the Sistema General de Participaciones (SGP) are based on the average growth rate of revenues over the previous four years.
So, the key to fiscal adjustment lies on the tax side. Tax reforms—partly motivated by the decline in oil revenues after the 2014-16 oil price collapse—aim to raise inclusive growth and have improved several aspects of the tax system .
These include lowering payroll taxes to reduce informality, reducing the tax burden on corporates, and increasing income tax progressivity. Other improvements include strengthening indirect taxes, modernizing international taxation and introducing anti-abuse measures. However, these reforms have not significantly boosted tax revenues as a share of the economy.
Instead, the tax system continues to suffer from a narrow tax base and many preferential regimes. These make for a complex tax system that raises relatively modest revenues, particularly from personal income and consumption taxes, when compared to other Latin American and OECD countries. And after the last reform, in which the corporate income tax is set to be gradually reduced from 33 percent in 2019 to 30 percent in 2022, corporate income taxes are also likely to yield less revenues than before.
So, what can be done to address these rising fiscal challenges? As discussed in our latest economic assessment of Colombia, the solution crucially involves raising tax revenues by 2-3 percent of GDP over the medium term.
The way forward
How can this be done? The staff report for Colombia makes some suggestions. With respect to taxes, eliminating preferential regimes for businesses (which lose tax revenue); base broadening for personal income taxes (including a lower standard exemption and threshold at which the tax is levied); and raising value added tax (VAT)—to include all exempted and zero-rated goods—would close key loopholes. On the latter, higher VAT on basic goods can be compensated with direct transfers to the most vulnerable households to ensure there is no adverse effect on poverty. These measures could yield revenue gains of around 2 percent of GDP.
Better tax administration to improve efficiency and to collect lost revenues from tax evasion and avoidance should complement these measures. For example, changes to the arrears, VAT refund and audit processes could be made.
Additionally, improving the IT systems of the National Directorate of Taxes and Customs (the DIAN)—including the introduction of electronic invoicing which is currently being implemented —and enhanced governance, through increased staffing and training for example, would contribute to reducing widespread tax evasion. Similar efforts with e-invoicing in Brazil and Mexico, for example, may have successfully increased tax revenues there by between ½ and one percent of GDP.
Raising tax revenues will help safeguard key public investment and social programs, while fostering inclusive growth. It will also allow the government to meet new spending pressures while at the same time preserving fiscal credibility and the soundness of the public finances in Colombia. Overall, this will help sustain Colombia’s strong macroeconomic performance into the future.