Caribbean & Central America - June 2020

The coronavirus (Covid-19) pandemic has elicited a range of responses among Central American nations but increased fiscal pressures due to the health emergency is one thing that many have in common. Two countries facing such pressures but for different reasons are Costa Rica and Guatemala. In Costa Rica, the fiscal concerns were already rife amid a rising fiscal deficit due to high government spending. Meanwhile international credit ratings agency Fitch Ratings and local think-tank Central American institute of fiscal studies (Icefi) have warned of Guatemala’s “fiscal vulnerability” due to low tax take - a perennial weak point.

Costa Rica

While Costa Rica has been widely praised for its response to Covid-19 in terms of public health, the pandemic looks set to intensify existing worries over fiscal policy. Even before the outbreak, experts were concerned about mounting fiscal deficits, and a forecast economic contraction will make things worse.

President Carlos Alvarado has implemented a number of policies to help workers and companies during the pandemic. They include an interest-free three-month moratorium on value-added tax (VAT), customs duties and business income tax charges, as well as pegging social security contributions proportional to time worked, and deferral of contributions; a four-month moratorium on taxes paid by companies in the tourism sector to the Costa Rican tourism institute; a freeze on salary increases for public sector workers; and a ₡100,000- ₡200,000 (US$175-US$351) payment to 375,000 vulnerable households every month for three months. The government will also make ₡3.1bn in public investments in 2020-2021.

These policies add to the troubling fiscal panorama for Costa Rica given the economic shock of the pandemic. At the end of April Costa Rica’s central bank predicted a GDP contraction of 3.6% this year. However, a week later the economic sciences research institute (IICE) at the Universidad de Costa Rica forecast a 4%-5.8% GDP contraction this year. Fitch Ratings is one agency that believes there is choppy water ahead for Costa Rica. On 12 May it downgraded the country’s long-term foreign-currency issuer default rating from ‘B+’ to ‘B’, with a ‘negative’ outlook. Fitch cited increased risks of financing stress in the near term due to widening fiscal deficits, combined with an economic contraction. “The ongoing health crisis comes at a time when Costa Rica’s fiscal space is limited and rapidly narrowing, raising risks to post-crisis debt sustainability”, wrote the agency in a briefing note. “The interest bill is climbing rapidly, and the debt burden is on a relatively steep upward trajectory”.

Pre-coronavirus Costa Rica was grappling with a number of fiscal challenges. In November 2019 Icefi published a worrying analysis which looked at the reasons behind uncertainty about fiscal sustainability. This is not a new problem for Costa Rica; indeed, the country passed a fiscal reform in 2018 designed to relieve these pressures. However, Icefi believes the reform is “insufficient to solve Costa Rica’s fiscal sustainability problems” due to stagnant tax revenues and insufficient spending cuts to close, or even maintain, the fiscal deficit. “The 2020 budget initiative reaffirms Costa Rica’s need to build a comprehensive fiscal agreement that effectively addresses its structural fiscal problems”, wrote Icefi, with a failure to do so endangering the social protection model that makes the country stand out among its Central American neighbours. Structural problems include stagnating incomes; stubbornly high levels of inequality, with a Gini coefficient score of 48 in 2018 almost unchanged since the country scored 46.7 in 1989; and increasing consumer debt, with total credit card debts up 14.6% in 2020 compared with 2019, according to figures from the economy, industry & trade ministry released in May. Low birth rates and low death rates make for an ageing population that places increased demands on social services as tax take stagnates.

Icefi has previously criticised Costa Rica’s tax take projections as “extremely optimistic” as the 2020 budget plans for tax revenue of 13.3% GDP, but the think-tank predicts 12.9%. Icefi says the government needs to prioritise fiscal justice and the closing of loopholes. Now Fitch Ratings predicts the fiscal deficit will widen to over 9% of GDP due to the pandemic, which it says will cause government revenues to decline more than 3%. The agency reports the government will temporarily activate an emergency escape clause in the fiscal responsibility law, which will affect all those public institutions affected to the health crisis, in order to give itself some more wiggle room.

Prior to the pandemic Costa Rica had seen signs of social discontent with strikes involving health and education workers as well as students, fishermen, and transport unions. It seems likely that these sectors will remain restive as the government will have fewer resources to deal with their demands and will likely have to make some further cuts. Another problem for the Alvarado administration is the fractured congress, which means reforms are subject to complicated negotiations.

However, despite these apparent problems on 15 May Costa Rica was invited to become the 38th member of the Organisation for Economic Co-operation and Development (OECD), and the fourth member from Latin America and the Caribbean. “As part of its accession process, Costa Rica successfully completed in-depth technical reviews by 22 OECD Committees and has carried out important reforms that have allowed the country to align its legislation, policies and practices to OECD standards in areas such as competition, statistics, anti-bribery, corporate governance of state-owned enterprises, financial markets, tax transparency and industrial chemicals management”, an OECD statement said. 

While many will celebrate the accession, there are more problems at home. On 19 May congress voted to allow local authorities to break spending limits set by the 2018 public finance law to deal with the pandemic. Finance Minister Rodrigo Chaves sent a letter to President Alvarado asking him to partially veto the initiative. However, Alvarado refused, and Chaves resigned on 28 May. Chaves only took up the post in November 2019, replacing Rocío Aguilar, who also resigned. Elian Villegas, executive director of the national insurance institute (INS), has taken over as the new finance minister. Turmoil at the finance ministry does not bode well for Costa Rica’s ability to deal with the crisis while increased spending by local authorities would make reducing the fiscal deficit harder.

Guatemala

Guatemala’s President Alejandro Giammattei has prioritised economic concerns over public health in his response to Covid-19. Lockdown measures have been less stringent than other nations, with a 5:00pm – 5:00am curfew and a full lockdown only in force on weekends, while certain businesses, including maquila textile factories, have been allowed to stay open.

In terms of fiscal policy, congress approved three economic rescue packages worth around 3.4% of GDP. Those packages include extra resources for healthcare as well as support for economic sectors through cash transfers, salary subsidies, and payments to small and medium-sized enterprises (SMEs). Other measures include increased electricity subsidies and support for low income households, as well as deferring income tax payments and social security contributions for one quarter; and waiving taxes on medical supplies and streamlining tax credit refunds to exporters.

As with Costa Rica, these measures add extra stresses to an already complicated fiscal situation. This was set out by Fitch on 3 April, when the agency downgraded Guatemala’s long-term foreign-currency issuer default rating to ‘BB-’ from ‘BB’. Fitch cited “diminishing fiscal flexibility due to the government's low tax collection amid continuous political gridlock preventing forceful fiscal measures, as well as a downward revision to growth prospects related to the global pandemic”. While Guatemala is known for running small fiscal deficits, Giammattei inherited a public finance crisis from his predecessor, Jimmy Morales (2016-2020), under whose watch social spending remained around a paltry 8% of GDP, but the military budget ballooned thanks to purchases of weapons and a new ship. The fiscal deficit rose from 1.1% of GDP in 2016 to 2.5% in 2019, according to Icefi. Guatemala has the third-lowest government revenue/GDP ratio of any country rated by Fitch, after Bangladesh and Nigeria. This is due in part to weak tax collection, which Fitch blames on institutional challenges at the tax authority (SAT), high levels of tax evasion, a narrow tax base, and corruption.

Icefi estimates that VAT evasion stands at around 37% of the potential collection while the SAT itself has estimated that income tax evasion is at around 80%. Reforms are desperately needed to reduce these figures. But an institutional crisis at the SAT- which was involved in huge corruption scandals such as ‘La Línea’ that brought down former president Otto Pérez Molina (2012-2015), has been compounded by the difficulty of passing reforms through a fragmented congress, whose members have been implicated in corruption. As Icefi noted in a January 2020 report, the Giammattei government needs to pass a fiscal reform but has been hamstrung by the damage inflicted by the Morales administration. Government institutions suffered a loss of legitimacy under Morales, and Giammattei will have to overcome low levels of public trust after the 2015-2019 congress approved a number of tax amnesties and privileges.

Giammattei will also face mounting political problems if he does decide to take on vested interests that benefit from the current taxation system. For one, there are export companies that have been traditionally afforded tax breaks, which Icefi recommends should end. Not only would this anger an influential sector, Giammattei has been consistent in his support for the export sector and appears committed to maintaining the current system. A reformed SAT also needs to improve tax take by reducing informality in labour markets and tackling forms of tax evasion such as contraband and customs fraud, according to Icefi. One visible sector to tackle is market wholesalers who avoid VAT, but this would be unpopoular and could disrupt supply chains. Investigating income tax evasion is another priority, but such a move would undoubtedly anger powerful business lobbies. Whichever way Giammattei tries to go he will upset people, and he arguably isn’t in a strong enough political position to drive through reforms.

Fitch predicts a “further erosion of government revenues” and forecasts a fiscal deficit of 3.8% by the end of 2020, up from 2.3% in 2019. One problem is Giammattei’s commitment to liberal trade policies such as offering tax breaks to attract foreign investment. These policies do nothing to encourage individuals or other business to pay their taxes, contributing to a widespread culture of avoidance. If he can’t increase the tax take Icefi suggests Giammattei could cut military spending in favour of social spending, but that seems even less likely given the armed forces’ continued influence in Guatemalan politics. Giammattei’s own cabinet includes figures with links to old military networks dating back to the 1960-1996 civil war. Giammattei has previously spoken of a desire for reform, but only to change the date of the new fiscal year from 1 January to 1 July. He will have to do far more than that to deal with mounting problems.