A Pact to Confront Latin America’s Fiscal Challenges

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By Mauricio Cardenas, Luca Antonio Ricci, Jorge Roldos and Alejandro Werner

(Español)

Fiscal policy in Latin America faces multiple challenges related both to the continued response to the COVID-19 shock and to issues that existed before the pandemic and in some countries contributed to significant social unrest starting in 2019. In a recent paper, we analyze these challenges and argue that a broad fiscal pact is needed in many countries in the region.

The objective of this fiscal pact would be twofold: tackle the need to continue to support households and firms during the next stages of the pandemic, as well as the medium-term challenges of broadening the social safety net and improving the quality of public services, while also guaranteeing the medium-term sustainability of public finances and the build-up of adequate buffers to cope with possible future shocks.

A two-stage process is needed to meet these goals: first, the urgent matter at hand is dealing with the next stage of the pandemic response in a way that supports the recovery without triggering sustainability concerns. In the medium to longer term, redesigning the social safety net and the tax and expenditure systems requires an in-depth social dialogue on the role of the state and how to finance budget pressures in a sustainable fashion.

Responsibly supporting the recovery in a first stage…

The first, and urgent, stage should cover the optimal path for fiscal policy in a way that avoids an early and excessive withdrawal of fiscal support during the pandemic while at the same time reassuring financial markets of the medium-term sustainability of public finances. Avoiding an early withdrawal of support in 2021 and 2022 is important given that countries are still facing high rates of contagion and deaths, vaccination is likely to proceed slowly in most countries, and the economic recovery is likely to be partial, uncertain, and not strong enough to help those most affected by the twin public health and economic crisis.

We believe fiscal space is not set in stone and responds dynamically to the medium-term targets and commitments undertaken by governments throughout the region. The fiscal policy response to COVID-19 in most of the region has been much larger than during the global financial crisis, suggesting that fiscal space was not as tight as suggested by public debt-to-GDP ratios. Thus, besides supporting households and firms and upholding the post-pandemic economic recovery, the pact’s first stage can also lay the foundations for the corresponding consolidation that needs to take place in the future.

In particular, pre-announcing future tax and expenditure measures that guarantee a strong medium-term fiscal anchor, and credibly communicating a clear path on how to reach those targets once conditions normalize, would help create fiscal space upfront and reassure investors about the value of their claims.

Different fiscal responsibility frameworks used in the region allowed countries to act aggressively during the most severe shocks in the last 15 years, the global financial crisis and the pandemic. However, the frameworks have been less effective in bringing fiscal balances back to normal levels in the medium term, creating an upward bias for public debt.

In several countries, resuming fiscal rules suspended in 2020 offers the opportunity to upgrade and complement them—where needed—with supporting institutions, such as fiscal councils and multi-year budgeting, thus improving the ability of fiscal frameworks to anchor medium-term debt and correct deviations from targets.

Moreover, low-for-long international interest rates and easy market access allow the interest cost on public debt to remain contained in the foreseeable future, despite higher debt levels overall. This would open additional space to preserve support for the recovery. To complement this strategy, support from international financial institutions could help limit negative market effects by reducing the issuance of sovereign debt and increasing the credibility of medium-term fiscal commitments.

…and sustainably addressing social gaps in a second stage

After consolidating the recovery and establishing a solid medium-term fiscal outlook, the second stage of the fiscal pact should start with a national consultation on how to broaden and finance social safety nets, to understand societies’ preferences on how their tax dollars are spent, and to ensure that the very consequential tradeoffs involved are fully understood. This public dialogue should serve as the basis to a legislative process over the next couple of years to revise pensions, health, and educational systems as well as reforming the tax frameworks that will pay for them.

Latin America’s fiscal system is not progressive enough given regional development levels and societies’ preferences, as shown by recent social protests and political developments. It is also much less effective in improving income distribution than in advanced economies. The reduction in inequality (as measured by Gini coefficients) due to direct taxes and cash transfers is less than in other emerging markets. While some countries in the region need to improve the coverage and targeting of their spending, others need to increase tax revenues and their progressivity as well as expand and better target their safety nets.

This agenda is definitively challenging and risky. But neglecting it is far more dangerous. The continuation of low growth, social discontent, and political polarization risks driving Latin America towards a very dangerous path of institutional and economic decay. We believe a fiscal pact is the best way for catalyzing major changes that require broad social consensus and political cohesion around several crucial dimensions of countries’ public finances.