The battle for fiscal space in LAC

What is fiscal space and who wants it?

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There are various definitions of ‘fiscal space’, all broadly based on the idea of having some kind of financial reserve or money held ‘in the back pocket’ which would allow a government to deal with unexpected spending needs. Economist Peter Heller has defined it “as room in a government’s budget that allows it to provide resources for a desired purpose without jeopardising the sustainability of its financial position or the stability of the economy”. Various multilateral institutions such as the IMF and the World Bank have their own definitions. US-based credit rating agency Moody’s Services defines fiscal space as the difference between an estimated upper limit of public debt, beyond which action would have to be taken to avoid default, and actual public debt, expressed as a percentage of GDP.

How governments get and use fiscal space has been at the forefront of discussions about post-pandemic recovery in Latin America and the Caribbean (LAC), particularly as analysts are highlighting the need to create new jobs, rebuild infrastructure, strengthen public health systems, and invest in the energy transition. Where is the money going to come from? One possible answer has been sketched out by the Economic Commission for Latin America and the Caribbean (Eclac) which in April this year published its annual fiscal report for the region in 2020. The report said growth in 2021 would be insufficient to offset the unprecedented fall in economic activity last year, to replace lost jobs, or to fully roll back Covid-19 led increases in poverty and inequality. It called on governments to boost the role of public spending in pursuit of inclusive and sustainable development. Eclac Executive Secretary, the Mexican economist Alicia Bárcena, called for increases in direct taxes, and the introduction of a wealth tax, adding “it is essential that international cooperation, through financing for development, support the expansion of countries’ fiscal space in the short and medium term,” something she said would entail “the expansion and redistribution of global liquidity, debt relief, strengthening of the lending capacity of development banks, and the use of innovative financing instruments.”

Record fiscal deficits in 2020

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The Covid-19 pandemic was a major shock to the LAC economies. In some senses it was the latest in a long line of external shocks, which have included the Great Depression of the early 1930s and more recently the foreign debt crises of the 1980s, the Asian economic crisis of 1997, and the Great Recession of 2007-2009. These crises have all been characterised by destabilising external events which caused uncertainty, led to capital flight from the LAC countries, and/or triggered widening fiscal deficits as governments struggled to stimulate their faltering economies. In some senses the pandemic was different and more serious, because it involved combined demand and supply-side shocks - a rapid fall in external demand coupled with simultaneous domestic supply reductions as quarantines, lockdowns, and mobility restrictions were imposed. In other respects, the pandemic was more benign – it did not, for example, lead to a sharp reduction in foreign currency reserves across the region. However, the sheer scale of the latest ‘shock’ does differentiate it from its predecessors. Contraction in economic activity in 2020 was the deepest in a generation.

In effect, LAC GDP fell 7.7% in 2020, which according to Eclac was the sharpest fall registered in the last 120 years. Formal unemployment (which excludes the large contingent of informal workers in LAC) rose from 8.1% in 2019 to 10.7% in 2020. Eclac estimates that the poverty rate rose by three percentage points between the two years, from 30.5% in 2019 to 33.7% in 2020, continuing to reverse the reductions that had been achieved during the commodity boom in the 10 years prior to 2012. The IMF estimated that nearly 20m people had fallen into poverty as a result of the pandemic.

At the global level, governments responded to the crisis by ramping up emergency spending. This included medical spending on vaccine development, equipment, and supplies, but also on a whole range of subsidies to help cover costs for furloughed workers, tax relief schemes for companies, and cash-transfer programmes to help poor and informal workers. The IMF has estimated that globally the extra spending was of the order of US$7.8tn (a figure which is set to rise further as the pandemic continues, and as governments continue making cash injections to support economic activity).

In LAC one of the first impacts of the crisis was a significant fall in government revenues. On average (for 16 major economies) government revenues dropped by 0.5 percentage points, from 18.4% of GDP down to 17.9%, a contraction caused mainly by reductions in tax revenues, particularly in the economies of South America. In the three months to May 2020 VAT revenues, closely linked to economic activity levels, dropped by as much as 40% in real terms in some countries. They later rebounded quite strongly, however, as the cash transfer programmes for poor households helped boost private consumption levels. After the initial shock, some countries were able to respond to the crisis by introducing policies to boost the tax take. These included offers to waive interest payments, fines, and surcharges in return for advance payments of 2020 income tax. Mexico' s tax collection agency SAT (Servicio de Administración Tributaria) was able to find additional resources amounting to 2.2% of GDP by targeting previously high levels of evasion and avoidance. In El Salvador, a tax amnesty helped boost corporate income tax receipts. Another important factor affecting economies like Chile and Peru is that mining royalties remained resilient. During the Great Recession of 2007-2009 international mineral and metal prices dropped abruptly, pushing down related royalty payments, but in the 2020 pandemic, the prices of mining exports such as copper actually increased. In the Caribbean countries, the fall in government revenues was partly the result of the collapse in tourism and, for hydrocarbons exporters like Trinidad & Tobago and Suriname, of the fall in international oil and gas prices.

Despite the fall in their revenues LAC countries faced inescapable pressure to increase their spending levels during 2020. Eclac estimates that on average governments boosted spending by an amount equivalent to 4.6% of GDP. Primary spending (excluding interest on borrowing) rose by over 10% in a number of countries, and by over 20% in four of them (El Salvador, Dominican Republic, Brazil, and Argentina). Measured as a proportion of GDP central government spending reached 24.7%, the highest level recorded since Eclac began publishing fiscal data in the 1950s. The previous peak had been 23.3% in 1983, in the midst of the debt crisis known as ‘the lost decade’. In general, LAC governments increased their spending at a speed and volume comparable to the increase in the developed economies such as the US and Europe. The difference, however, is that the developed economies with hard currencies are able to borrow greater amounts to fund their exceptional spending at much lower rates of interest. For developing countries, borrowing costs are significantly higher.

Year-on-year variation in central government primary spending 2019–2020 (percentages)

Source: Economic Commission for Latin America and the Caribbean (ECLAC), on the basis of official figures

One of the main factors driving the increase in primary spending last year was pandemic-related growth in cash transfers and subsidies. These increased by the equivalent of 2.5 percentage points of GDP, or more, in Argentina, Brazil, Chile, Colombia, the Dominican Republic, El Salvador, and Peru. In Brazil two cash transfer programmes, one of which is popularly known as the 'corona voucher' but has the formal name of Auxílio Emergencial de Proteção Social a Pessoas em Situação de Vulnerabilidade Devido a Pandemia da Covid-19, together represent a cash injection into the economy equivalent to 3.9% of GDP. Similar programmes, as a proportion of GDP, represented 1.6% in Argentina, 1.9% in Chile, 2.7% in El Salvador.

There was also more modest growth in capital spending in the LAC countries, equivalent on average to around 0.2 percentage points of GDP. This was positive since capital spending had been falling consistently year on year since 2013, in part to offset rising spending on interest on loans. However, there was significant variation across the region. Capital spending rose in Brazil, Mexico, Panama, and Paraguay, but it fell in Chile, Colombia, Costa Rica, Guatemala, Honduras, Peru, and Uruguay. For the region as a whole, capital spending has traditionally exceeded interest payments, but the gap between the two has narrowed dramatically.

Latin America central government capital spending and interest payments 2000–2020 (percentages of GDP)

Source: Economic Commission for Latin America and the Caribbean (ECLAC), on the basis of official figures

The net result from these trends was that in 2020 the LAC region experienced one of its largest-ever fiscal deficits, totalling 6.9% of GDP (the primary deficit - before interest payments - was 4.2%). To fund this increase, LAC governments had to increase their public borrowing, which in turn drove up their overall public debt levels. There were some differences by sub-regions. The total deficit in Central America and Mexico was a little lower than average, at 6.3% of GDP. However, for this sub-region, known for traditionally achieving fairly balanced budget outcomes (an average deficit of 2.5% in the preceding five years) the shortfall more than doubled in 2020, the year of the pandemic. In South America, where budget deficits were already significant in the pre-pandemic period, at a five-year average of 3.6% of GDP, they widened further to 7.5% of GDP. In the Caribbean overall deficits were either unchanged or grew, increasing financial stress for already heavily indebted countries like Barbados, Belize, and Jamaica, where public debt is in excess of 100% of GDP.

Latin America central government fiscal indicators 2010–2020 (percentages of GDP)

Source: Economic Commission for Latin America and the Caribbean (ECLAC), on the basis of official figures

Higher deficits led directly to higher borrowing and to higher total public debt. Eclac calculates that, on average, LAC's central government public debt rose from 45.6% of GDP in December 2019 to 56.3% in December 2020, an increase of 10.7 percentage points. The most heavily indebted governments were those of Argentina (104.5% of GDP), Brazil (89.3%) and Costa Rica (67.9%). The least heavily indebted were Guatemala (32.5% of GDP), Chile (32.5%), and Paraguay (30.1%). The most rapid increases in public debt during 2020 were experienced by the Dominican Republic, followed by Brazil and Panama. The country with the lowest increases in public debt during the year was Chile. In a number of countries, a significant proportion of public debt is denominated in US dollars or other hard currencies, a potential source of financial stress in the event of significant national currency depreciation, which would make it more difficult to meet debt service obligations.

Gross central government public debt December 2019 and 2020 (percentages of GDP)

Source: Economic Commission for Latin America and the Caribbean (ECLAC), on the basis of official figures

The struggle for fiscal adjustment

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LAC has plentiful experience of what can be called vicious fiscal cycles. Very crudely, something like an 8-step process (or more) is at work.

Much depends on the starting point (1) – whether government finances are reasonably healthy, or, on the contrary, overstretched at the beginning of the cycle.
Then, as the normal ebb and flow of economic activity continues, an external shock or shocks of varying degrees of intensity may reduce overall government revenues (2).
While at the same time forcing an increase in government expenditure (3) which works together with the fall in revenue
to create or widen a fiscal deficit, measured as a percentage of GDP (4).
The government then has various immediate options on what to do about the widened deficit. It can print money to cover the gap (5), a short-term step that most often leads to rising inflation, currency depreciation, and economic stagnation (Venezuela is currently one of the most extreme examples of these risks).
It can increase its borrowing (6), a viable short-to-medium term approach provided it can afford the future repayment and interest charges, and that its overall debt levels are sustainable.
If none of these options are sufficient, a government can also try to renegotiate its foreign debt (7) to reduce immediate debt service costs,
or if that too fails to offer sufficient relief, it can find itself forced to take a drastic measure, defaulting (8) on the foreign debt.

Keynesian economists argue that in a normal business cycle governments should use counter-cyclical fiscal policies. In other words, when economic growth is at its strongest, governments should run a fiscal surplus, in effect taxing more than they spend. On the other hand, when the economy is in recession, it is argued, they should do the opposite, spending more than they tax. In that way business cycles and the variations in aggregate demand that underpins them will be smoothed out, with less sharp peaks and troughs of activity and, ideally, a fiscal buffer where governments use the surpluses created in the good times to fund the deficits racked up in the bad times. In this approach deficit-spending for some part of the business cycle is not only permissible but essential to optimise growth rates. Theoretically at least the process could be self-funding without the need to incur long-term public and foreign debt.

That said, in the real world most developing economies need to borrow on international capital markets to attract resources that cannot be internally generated. Given that fiscal deficits and foreign borrowing are regular occurrences in most or the world, discussion has focused on trying to define what are sustainable levels for both. Numerous metrics have been used. For many years member countries of the European Union (EU) were formally committed to limiting their fiscal deficits to not more than 3% of GDP per annum. The EU also suggested that public debt should be kept to not more that 60% of GDP. Both these targets have been subsequently missed in Europe and elsewhere. As we have seen in the previous section, in 2020 the LAC region had an average fiscal deficit equivalent to 6.9% of GDP (more than double the former EU recommended rate) while its central government public debt, at 56.3% of GDP, was just within the 60% guideline. But that number conceals wild variations from country to country. Argentina’s public-debt-to-GDP ratio was a barely manageable 104.5%, and Brazil’s was 89.3%. At the other end of the spectrum, Chile’s public debt was a comfortable 32.5% of GDP, while Paraguay’s debt was even lower, at 30.1% of GDP

A further element in fiscal management is the idea of forward planning. A number of governments have set out their immediate fiscal objectives – usually contained in the annual budget voted by the legislature – but have also added a medium- and longer-term framework. In some cases, this is presented as a ‘fiscal responsibility law’ (FRL), a legally binding mechanism to protect against over-spending. In Brazil, for example, the fiscal responsibility law establishes that, after accounting for inflation, aggregate year-on-year government expenditure cannot increase. It has the status of a constitutional amendment, meaning that to change it a supermajority of congress is required. However, in 2020 this protection did not stop the government from effectively side-stepping the FRL: the government approved regulations that meant Covid-19 related emergency expenditure was considered to sit off the main budget and therefore not subject to the strictures of the FRL.

Panama took a different approach. Before the advent of the pandemic, it had approved an FRL which set out a series or gradually narrowing targets for the size of the fiscal deficit. Panama’s non-financial public sector (NFPS) deficit was set to fall from 2.75% of GDP in 2020 to 2.5% in 2021, and to not more than 2.0% in the subsequent years. After the pandemic hit with full force in early 2020, the government announced a new set of targets, with the deficit to be capped at not more than 10.5% of GDP in 2020, 7.5% in 2021, 4% in 2022, 2.0% in 2023-2024, and 1.5% in 2025. The modified FRL was seen as a way of being transparent while sending a reassuring message to investors that despite the necessary short term pandemic related surge in spending, the government remained committed to reducing the deficit over time, and therefore to maintaining a stable operating environment.

Who’s Stimulating

Among the G-20’s emerging economies, Brazil has run the most expansionary policy during the pandemic

Source: International Monetary Fund

It is generally recognised that escaping from a cycle of widening deficits and unsustainable increases in debt is not, to put it bluntly, rocket science. There is unlikely to be a single silver bullet style solution. On the contrary, regaining fiscal space is best achieved as a series of incremental changes and reforms. In our crude model of fiscal adjustment set out at the beginning of this section, there are eight different components of the adjustment process, each of which offers some scope for improvement.

The second component for example – a fall in government revenues - can be tackled by various measures and reforms. Last year Eclac calculated that as a result of tax evasion and avoidance, LAC was losing US$325bn, or 6.1% of GDP every year, due to non-compliance. Simply enforcing existing laws, therefore, could almost completely eliminate the regions’ fiscal deficit (which, as we have seen, was around 6.9% of GDP last year). Even if it is assumed that fully enforcing existing tax laws will have a significant cost, it is clear that there are savings to be made which will significantly reduce the deficit. There are also arguments to be made in favour of a more equitable and progressive tax system, including greater reliance on income tax and the possible introduction of a wealth tax as proposed by Eclac.

A significant issue is posed by the LAC region’s very high rates of informality – the proportion of the work force that is active outside the formal tax and social benefits system. Informal workers tend to be poorer, to earn less than the minimum wage and to be excluded from social benefits such as regulated hours, sick pay, maternity and paternity leave, health insurance, and pension payments. Increasing the proportion of formal workers will boost both government revenues (through additional tax contributions) and expenditures (through extending access to social benefits). There is a strong argument for formalisation because it is likely to reduce poverty and inequality and can lay the basis for more inclusive, and therefore sustainable economic growth. The impact of the pandemic over the last two years has also shown that greater levels of formality make it easier for health authorities to fight the virus, for example by implementing social distancing, tracking and tracing, and mass vaccination programmes. Informal workers are hard to reach, may often live-in congested shanty towns, and often work on the streets, therefore being exposed to greater contagion risks.

Percentage of informal employment in selected Latin American countries, 2018 or latest available year

Source: OECD

It is also clear that there is scope under component (3) to limit the rise in government spending during an emergency, or to increase the efficiency of the existing spend. As we shall see, controlling government spending has over the years become a politically toxic subject, when it is associated with a type of austerity perceived to increase inequality and poverty (often described as part of market-led neoliberal economic policies). But in principle it is possible to reduce waste and corruption, and to better target government spending on areas that will increase the chances of inclusive and sustainable future growth. The pandemic has made obvious the importance of investment in universal public health. There are also social and economic cost-benefit gains to be secured through investment in education, improved infrastructure, innovation, and the transition to green/renewable energy. In fact, spending money on a green transition may be one of the most efficient ways of reducing long-term vulnerability to the increasing risk of future climate-change related shocks.

Component (4) – the widened fiscal deficit caused as a result of the pandemic or other disruption - is also open to a degree of management. Governments that are transparent over the nature of the financial shortfall and that present a clear policy response, including some kind of fiscal responsibility mechanism and credible short- and medium-term plans to limit future deficits, are more likely to generate financial markets confidence in a sovereign borrower. A credible plan for funding the deficit (components 5 and 6) should limit the possibility of short-term financial turbulence. Finally, components (7) and (8) – debt restructuring and, in the worst-case scenario, a default on foreign debt payments, are also open to management. Although the situation may be extreme, there is such a thing as a well-managed financial default, if the outcome is a resumption of growth and financial sustainability over the medium and longer term. Argentina, which has defaulted on its debt nine times, is often cited as an example of missed opportunities to use the post-default period to correct underlying structural imbalances. As component (1) shows, the process is circular. Countries like Argentina that entered the pandemic in a position of pre-existing financial weakness are less likely than others to come through it in a resilient fashion. Or to put it in other words, fiscal space is relatively easy to lose, but much more difficult to recover.

The pensions problem. The ebb and flow of available fiscal space is influenced by a multitude of different factors. One factor, however, may be consistently pushing up government deficits and therefore reducing available fiscal space in all countries in the region, and doing so over the long term. This is demographic change and the ageing of the LAC population. According to a report by Andean Development Bank (CAF) around 8% of the region’s population is currently aged 65 years or more, well below the comparable 18% in Europe. It is predicted that as a proportion of the total population, the LAC over-65s will double by 2050, reaching 17.5% and will then surge further to over 30% by the end of this century. At present, according to CAF economist Fernando Álvarez, the region’s pensions systems have a financial shortfall equivalent to around 2.0 percentage points of GDP. As the dependency ratio worsens (the ratio of the economically active, who are paying into pension funds, vs the dependents, who are drawing down their pensions) that deficit is likely to increase further.

Pablo Sanguinetti, another CAF economist, points out that pension and health reforms are likely to be costly in the short term, but will yield significant long-term benefits. They also require what he calls “a wide political consensus maintained over time to support practical implementation”. The report says that maintaining decent minimum pension levels for the elderly is a major challenge for the region, since experience has shown that employer and worker-financed schemes struggle to cover their costs, meaning that public sector funding is needed to ‘top up’ pension provision and cater for the poor (for example by offering non-contributory pensions). Sanguinetti also recognises that efforts to close or reduce the pensions deficit need to be accompanied by evidence-backed and independent assessments to help citizens understand the need for reform.

The wild card: Politics

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So far, the discussion has made little mention of politics, a critical omission. In a hypothetically politics-free society losing and regaining fiscal space would be a largely technical matter, with the population passively accepting the necessary changes in taxation levels, standards of living, and public services needed to edge the fiscal cycle onto a more sustainable path. The reality of course is that there is no such thing as a politics-free society and political considerations in the LAC region have had, and will continue to have, a vast impact on fiscal management. For a start, there is the question of timing. Latin American governments are usually elected for terms of between four and six years. Among those with four-year presidents are Argentina, Chile, Colombia, and Brazil, while the five-year group includes Peru and Panama. At the other end of the spectrum lies Mexico, whose president serves a six-year term. Those periods in power are also sub-divided by various types of mid-term congressional, municipal, and regional elections, during which the balance of power and political complexion of the government may change. Presidents usually try to engineer an economic feel-good factor and avoid any form of austerity or belt tightening for at least a year ahead of elections, which immediately restricts the nature of the reforms that can be considered.

In addition, politicians with a one- or two-year time horizon (until the next election) are likely to be wary of investing time, energy, and political capital on long-term structural reforms – critical issues like education quality, pensions, or labour productivity. In these areas, success may take ten years or more to measure and assess, running across more than one presidency. Populist politicians, present in many countries over the last few decades, tend to promote simplified and electorally popular short-term solutions. In effect, it may be in their narrow electoral interest to postpone tackling the more difficult and intractable issues, simply opting to kick the ball forward and let someone else deal with them. Politics can introduce a kind of tyranny of the short term. The long timescales required by fiscal management on the one hand, and the short ones dictated by political imperatives on the other, do not fit together comfortably: there is often intense friction between them.

To this must be added the fact that, since at least the 1960s (more than half a century) the whole notion of fiscal adjustment has become politically toxic. The widespread popular perception in Latin America is that fiscal adjustment is a euphemism for savage spending cuts and inequality-intensifying austerity. Governments with widening fiscal deficits and debt repayment difficulties have been forced to turn to the IMF which is perceived to have offered funds in exchange for a standard and harsh recipe of sharp reductions in public expenditure, privatisations, wage controls, higher public utility tariffs, and a host of other measures seen as disproportionately affecting the poor and perpetuating and intensifying an unequal distribution of income. Although in recent years the IMF has argued the case for inclusive growth and ‘pro-poor’ adjustment policies, large sectors of the political centre and left in LAC remain deeply distrustful of its policy recommendations. It is as if the IMF brand has become inseparably connected with regressive austerity.

Argentina postpones the IMF reckoning

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Some recent examples may cast further light on the type of political tensions involved. In Argentina, a centre-left government led by president Alberto Fernández was elected in late 2019 and immediately faced two major problems: a foreign debt crisis and, starting in early 2020, the economic and social upheaval caused by the arrival of the coronavirus pandemic. With gross debt levels in excess of US$320bn at the end of 2019, by May 2020 the country had defaulted on its debt, but was subsequently (in August) able to reach a restructuring agreement with a large group of bondholders. At that point, one of its most pressing requirements was to renegotiate outstanding debt to the IMF. The previous centre-right government had signed a US$56bn stand-by agreement with the IMF in 2018, but it had been an almost complete failure. It failed to stabilise the economy, or to end repeated waves of turbulence on the foreign currency markets, or to reduce high domestic inflation rates. The new government therefore faced the need to renegotiate the outstanding debt to the IMF (calculated at around US$45bn) as well as agreeing a new economic programme. Reaching a new agreement with the IMF would be essential to reassure other creditors that Argentina would be able to get back onto a track of sustainable economic growth and to continue servicing its foreign debt. Both economy minister Martín Guzmán and the IMF authorities agreed to set May 2021 as the target date to complete their negotiations.

It was at this point that political complications began to come into play. Guzmán and President Fernández are widely seen as moderates, with a more radically nationalist wing of the government led by Vice-President Cristina Fernández de Kirchner (a powerful figure who was herself president in 2007-2015). For most of her political career, Fernández de Kirchner has repeatedly criticised the IMF for following neoliberal economic policies that favour the rich rather than the poor. In early 2021 the vice-president lobbied strongly and successfully to postpone any agreement with the IMF until after the mid-term congressional elections due at the end of the year (initially set for October, but later moved to November). Her argument was that announcing IMF-backed austerity measures in the months running up to the elections would be a disastrous vote-loser for the Frente de Todos, the governing coalition. She also maintained that postponement would allow Argentina more time to recover from the impact of the pandemic. Fernández de Kirchner also intervened to restrain Guzmán’s attempts to increase public utility tariffs (such as gas and electricity). For the economy minister raising tariffs would help begin to reduce the public-sector deficit. For the vice-president raising tariffs would be unpopular and another potential vote loser.

The timing of any IMF agreement is clearly open to reasonable debate, and public opinion needs to be taken into account. But there is much to suggest that Argentina’s moves to delay the agreement during the course of 2021 introduced new risks. One was that the pandemic might again intensify, increasing the country’s economic losses at a time of uncertain external financial support. It extended the period in which the country, with extremely low hard currency reserves, remained vulnerable to speculative attacks on the peso. It also complicated and delayed attempts to refinance debts to other groups of creditors such as Paris Club governments. In addition, it extended the period in which the country was facing heavy repayments to the IMF (over US$8.5bn was due for repayment between June 2021 and March 2022).

A more favourable debt repayment schedule would only be achieved after an IMF agreement, not before. At the time of writing, and bearing opinion polls in mind, it was likely that the government would lose seats in the congressional mid-term elections, and that the IMF agreement might be finally reached in December or in early 2022. There was also a risk that the whole issue might cause a major political split within the government. In other words, the start of an economic adjustment plan to rebuild Argentina’s drastically reduced fiscal space would have been delayed by between seven and ten months. At its mid-way point in December 2021, the Fernández administration would therefore have only two years to try and get the country back onto a fiscally sustainable growth path, before new general elections and another possible change in government policy.

Street protests in Colombia

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Colombia’s right-wing government also got itself into political difficulties over fiscal adjustment. Colombia, with an economy similar in size to Argentina, contrasts with its southern neighbour because it has a long history of fiscal prudence, a more consistent record of economic growth, and significant fiscal space (the public debt-to GDP ratio stands at 61.4%). Nevertheless, as in other countries, the pandemic shock to the economy in 2020 was severe. In response, President Iván Duque and finance minister Alberto Carrasquilla drew up a tax reform plan designed to raise an extra US$8bn or 2% of GDP. The money was to be used to help fund the widened fiscal deficit (which was 8.1% of GDP in 2020) and to pay down some of the public debt – in other words, to rebuild fiscal space.

Increased revenues were to be achieved by raising VAT and personal income taxes. Less products would attract the discounted VAT rate (charged at 5%) and more would be put on the standard rate (19%). To compensate for the regressive effects of widened VAT, the government was to offer VAT refunds to the poor. An existing one-off 1% asset tax would be raised to 3% and made annual. The government was hoping the tax reform package would be approved in congress by May 2021.

But these calculations were dramatically thrown out of joint with the eruption of demonstrations across the country on 28 April of this year, which were to last for around six weeks and leave a toll of over 70 dead and billions of US dollars in economic losses. The outburst of anger had many causes. There had already been extensive anti-government street protests in November 2019, backing demands relating to inequality, poverty, corruption, the peace agreement with FARC guerrillas, human rights, and other issues. In September 2020, during the time of the pandemic, there were also violent demonstrations in Bogotá over police brutality (which came after the death of a taxi driver in police custody). The 2021 protests repeated these demands but were particularly focused on the government’s proposed tax increases, coming on top off a long pandemic lockdown during which GDP contracted 6.8% and unemployment soared.

The upheavals killed the tax reform plan. The government withdrew its proposals. Finance minister Carrasquilla resigned in a matter of days, and was replaced by José Manuel Restrepo, who had previously been serving as minister for commerce. The government said the new minister would consult widely on an alternative tax reform package, which was unlikely to include the controversial VAT changes, but which might focus on a temporary increase in corporate taxes, an extension of the asset tax, and possibly a temporary increase in dividends tax. An initial assessment was that the new tax reform package would be diluted and raise less revenue than had originally been hoped. Members of congress representing Centro Democrático (CD), the president’s party which is the pivotal member of the ruling coalition, said they now believed it was inadvisable to increase the tax burden on the middle and working class ahead of the 2022 general election.

A further negative effect of the crisis in Colombia was that international credit rating agencies began to downgrade the country in their risk assessments. In May, almost immediately after the withdrawal of the tax package, Standard & Poor’s (S&P) withdrew its investment grade ranking for the country downgrading it from ‘BBB-‘ to ‘BB+’ with a ‘stable’ outlook. It said that the mass protests and withdrawal of the tax reform bill had resulted “in a significantly lower likelihood of Colombia improving its fiscal position following a recent and marked deterioration”. While recognising that there was likely to be an “institutional solution” to unrest, and that the country remained creditworthy and had a flexible credit line with the IMF, S&P still concluded that Colombia’s financial fundamentals remained weaker than those of similarly rated peers.

This was followed in early July by a similar downgrade to junk status by Fitch which attributed the decision to “deteriorating public finances” and “reduced confidence around the capacity of the government to credibly place debt on a downward path in the coming years”. A third ratings agency, Moody’s, was also expected to announce a downgrade. The net effect of these downgrades is to reduce investor interest in Colombian assets and increase interest rates on the country’s sovereign borrowing.

Swings and roundabouts: Mexico and Brazil

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April-September, which was subsequently halved until the end of the year. After a gap, the payments were temporarily resumed in early 2021. The programme had a short-term and favourable political effect for the government, boosting Bolsonaro’s approval ratings, particularly in poorer areas of the country, which traditionally voted for centre-left politicians. At the economic level they were highly successful since they are estimated to have reached an estimated 67m people, or 32% of the population, giving them meaningful financial support, and offsetting some of the contraction in aggregate demand caused by the pandemic.

Best in Class - Brazil’s economy shrank less than latin peers in the pandemic

Source: International Monetary Fund

There is an interesting debate to be had over which government had the better approach. It can be argued that Brazil’s decision to boost emergency spending despite its stretched finances was one of the main reasons its economy contracted by a relatively mild 4.1% in 2020, less than half Mexico’s much sharper fall of 8.2%. Mexican economist Héctor Villareal from Monterrey Tec says his country’s public spending was “extremely low – that was a mistake”. He acknowledges that the Amlo government did launch some emergency spending programmes, but it did so by cutting back on other spending budgets, which was unnecessarily restrictive. “In theory we have a government of the centre left, but as far as public debt is concerned, we have a conservative administration”, Villareal says.

Another Mexican economist, José Luis de la Cruz, from Instituto para el Desarrollo Industrial y el Crecimiento Económico (IDIC), says “there was no countercyclical fiscal policy” and believes the government took a conscious decision to protect public sector finances from the pandemic hit. “Most of the social and economic cost was born by society” he says, estimating that over a million companies closed down and at least 2m workers lost their jobs, and by early 2021 had still not been re-employed. Other analysts focusing on the Mexican case have suggested that if it had approved a large fiscal stimulus package, to demonstrate financial sustainability the government would have also had to address major, and politically controversial, tax and spending reforms. Amlo, who frequently reiterates a promise not to increase taxes, may have simply chosen not to innovate. As we have seen, the subsequent upheavals in Colombia were a reminder of how politically sensitive tax and spending changes can be.

Economists have, on the other hand, also had criticism for Brazil’s high-spending approach. Many say the massive Brazilian deficit which increased the country’s high public-debt-to-GDP ratio, while initially good for the domestic economy, was by 2021 beginning to cause heightened nervousness in the financial markets and driving down the value of the national currency, which in turn was triggering higher inflation and pushing the central bank to tighten interest rates.

Neil Shearing of consultancy Capital Economics commented “Brazil’s problem is not that they didn’t have sufficient fiscal response, it is the fact that it wasn’t combined with efforts to actually get on top of the virus”. In fact, the chaotic management of the pandemic and the slow progress of the vaccination programme in 2021 implies that the virus’s negative impact on the economy, and the need for emergency spending, will last for longer than hoped, meaning Brazil will again be running big fiscal deficits which erode investor confidence, and which threaten to create a vicious circle of currency depreciation and domestic monetary tightening.

In some scenarios Mexico may now outperform Brazil, as it has entered 2021 with a lower debt servicing burden and, with close economic links, particularly in manufacturing, is poised to benefit from the strong recovery in the US. The difficulty for all governments is that the exact intensity and duration of external shocks is difficult to predict. If the Covid pandemic proves to be essentially a one-year dislocation of the global economy and society, Brazil’s massive counter-cyclical stimulus package in 2020 may prove to have been the better approach. If, on the other hand, the pandemic lasts for longer – say two or three years – Mexico’s initial decision to maintain austerity may have given it more room for manoeuvre in the subsequent years. What is clear, however, is that preserving fiscal space while never actually using it is self-defeating. Governments need clear criteria over how best to manage fiscal space throughout economic cycles, unpredictable external shocks, and an often complex political and electoral calendar.

Towards a new consensus on fiscal management?

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Not surprisingly, perhaps, the crippling impact of the Covid-19 pandemic has led many to question traditional approaches to fiscal management. While some consider the pandemic to be a one-off external shock, unlikely to be repeated for a generation, others argue that the world will actually see a quickening pace of similar disruptive events, whether they be new and destructive diseases or extreme weather events connected to climate change, on top of natural disasters such as earthquakes. The future cannot be accurately predicted, but for governments that were unprepared for Covid-19, it seems reasonable that they should now try to get ahead of the curve, trying to develop robust fiscal policies to manage future disruption.

One approach was mapped out earlier this year in a research paper and linked blog by former Colombian finance minister Mauricio Cárdenas (2012-2018) along with IMF economists Luca Antonio Ricci, Jorge Roldos, and Alejandro Werner. Given the crippling impact of Covid-19 and pre-existing economic imbalances (which led to mass protests in some countries in the region in 2019) the authors suggest LAC countries could benefit from negotiating “a broad fiscal pact”. This would have two objectives: first, to continue supporting households and private sector companies during the remaining stages of the pandemic, and, second, to meet medium term challenges to broaden the social safety net and improve the quality of public services, while at the same time ensuring the sustainability of public finances and building fiscal space to cope with possible future shocks.

The blog recognises that after the initial pandemic shock in 2020 more support will be necessary in 2021 and 2022, because LAC countries are still facing high rates of contagion and death, vaccination programmes are progressing slowly, and the economic recovery is “likely to be partial, uncertain, and not strong enough to help those affected by the twin public health and economic crisis”. It also suggests that fiscal space is “not set in stone” meaning there is some flexibility in its use. To support this Cárdenas et al note that the injection of fiscal stimulus in the 2020 pandemic has been much larger than during the Great Recession of 2007-2009, “suggesting that fiscal space was not as tight as suggested by public-debt-to-GDP ratios”.

The blog says that in the medium-term fiscal policy should have an “anchor” consisting of a series of deficit/surplus targets, similar to the way many Latin American countries now have monetary policy anchors, with central banks setting a target band for the annual inflation rate, and raising, lowering, or holding stable benchmark interest rates to nudge actual inflation closer to the target rate. In the case of fiscal policy, the anchor would include pre-announcing future tax and expenditure measures, and credibly communicating a path towards regaining fiscal space to reassure investors. Fiscal councils and multi-year budgeting frameworks might also contribute a degree of additional credibility to the process. The blog notes that while LAC governments have adapted their fiscal policies quite flexibly in response to the external shocks of the last 15 years, they have been notably less successful at bringing their fiscal balances back down to more normal levels once the shocks have passed. In other words, there has been a consistent upward bias for public debt levels.

The current situation is not without opportunities. One of them is that global conditions up to and during the pandemic have favoured comparatively low interest rates. This means that, despite an increase in debt, interest payments have fallen, giving LAC governments a little more room for manoeuvre.

Low for longer – Debt has increased, but interest payments went down (percentage of GDP)

The authors make a particularly interesting point about politics and fiscal management. They believe it is necessary to begin a public dialogue on the need for legislation to revise pension, health, and educational systems. At a technical level, they believe the current fiscal system in the region is not progressive enough for society’s preferences, as expressed in recent social protests and political developments. The tax and cash transfer system across the region is less efficient than in advanced economies in terms of its ability to reduce income inequalities. Therefore, change is needed. The do-nothing option is risky because it leads to low growth, social discontent, and political polarisation. Taking action also has risks, but the proposed fiscal pact is seen as “the best way for catalysing major changes that require broad social consensus and political cohesion around several crucial dimensions of countries’ public finances”.

Conclusion: politics holds the key

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This paper has argued that in the post-pandemic era LAC countries will in principle be able to recover and rebuild lost fiscal space so that they will eventually reduce the public debt burden and get themselves back on a pathway of sustainable economic growth. Getting back on track will be achieved not by a single dramatic policy decision, but by a combination of incremental changes affecting the fiscal cycle. A crude eight-stage model of fiscal adjustment was described, with opportunities for deficit reduction in each of its stages. These include reducing tax avoidance and evasion, raising income and wealth taxes, undertaking profound reforms on the spending side (particularly relating to health, social programmes, and education), introducing multi-year budgets, strengthening fiscal responsibility rules, and managing debt levels in the most efficient ways possible. Other factors are also in play, capable of making the fiscal cycle more or less difficult. Relatively low global interest rates provide an opportunity to ease fiscal pressures; Latin America’s gradually ageing population profile is likely to act in the opposite direction.

While in principle this, therefore, looks like a problem that can be solved, introducing the political dimension makes it more intractable. Although there are exceptions, many Latin American governments and politicians shy away from the necessary structural reforms. Governments are in office for relatively short periods between elections, and short-term electoral priorities often seem to delay reforms. Major reforms are likely to be resisted by some interest groups, and putting together an effective coalition for change is often an arduous task. Pension reform in Brazil was first proposed in 1995 and not finally approved until 24 years later in 2019; even then, to gain the necessary support, its provisions were diluted to the extent that many argue a second pension reform will now need to be undertaken.

The current crop of Latin American leaders appears less than enthusiastic about fiscal reform. The Argentine government of Alberto Fernández has postponed an agreement with the IMF; Brazil’s Jair Bolsonaro is under intense political pressure and may not get relatively modest tax reforms approved this year; street protests caused Colombia’s Iván Duque to perform a U-turn over the planned extension of VAT; and Mexico’s Amlo appears to be a fiscal conservative unwilling to consider a wider modernisation of his country’s tax and spend rules.

In short, politics gets in the way. But this is not a reason to do away with politics or somehow ignore the democratic mandate. It does suggest however that the region’s current leaders will make only limited progress in the rebuilding of fiscal space. It will be down to the next generation of leaders to better engage with their electorates and stakeholders so as to achieve more politically sustainable fiscal pacts.

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