Cyclicality of Fiscal Policy in Latin America over the last decades

Fiscal Policy
Macroeconomics - Economic growth - Monetary Policy
Fiscal Policy - Public and Welfare Economics

Contrary to the prior two decades, fiscal policy in Latin America was not procyclical during the years 1990-2008, while it was countercyclical during the crisis years (2008-2011).

Historically, the Latin American countries have been characterized by high economic volatility prompted by the inconsistency of their policies in the field of public finance. The dramatic dependence on external markets, and the weakness of spending and tax structures, reduced the room of manoeuvre of fiscal policy which was mainly dependent on the economic cycle, losing, in this way, its role of macroeconomic stabilizer.

However, something changed during the last decade. Many Latin American countries consolidated their fiscal positions. This was possible for several reasons including a growing capacity to contain public expenditure. Indeed, since the late 1990s the reform of the public administration allowed to reduce current spending. Moreover, “a silent revolution” (Lora’s description, 2007) evolved in the vast majority of countries that implemented fiscal reforms to improve fiscal discipline and raise the credibility of public finance. Beyond this, the region recorded an extraordinary capacity to mobilize revenue. This was partially due to positive external conditions. Indeed, the revenue collection capacity of commodity exporters was favorably affected by the surge in the international prices and demand of their commodities. Nonetheless, important changes were realized also in the field of tax policy marking an explicit turning point with respect to the past. Many governments reformed their tax system increasing the contribution of direct taxes. The most emblematic case is represented by the 2007 Uruguayan Tax Reform, which introduced a dual tax system based on a progressive taxation on labor income and a flat rate on capital income (Martorano, 2012). Several countries enlarged their tax base, by reducing the number of exemptions and removing several kinds of deductions. Moreover, many governments used new instruments to mobilize tax revenue by means of heterodox approaches. One of the most interesting examples is related to the adoption of a simplified regime of presumptive taxation to reduce tax evasion. Governments also tried to levy taxes on financial transactions considered similarly a heterodox form of taxation. Finally, tax administration was improved thanks to the implementation of a number of administrative reforms as well as the introduction of new technologies, the increase of resources available and the reduction of political interference (Cornia et al, 2011).

Thus - when the international crisis arrived - Latin American countries were better positioned with respect to the past. As a consequence, they were able to implement countercyclical policies in order to face the economic crisis in the proper way (Martorano, 2014) (Figure 1).

Figure 1. Fiscal indicators (% of GDP), between 1995 and 2010 Fiscal indicators between 1995 and 2010

Source: author’s elaboration on Cornia, Gomez-Sabaini and Martorano (2011) and CEPALSTAT data

Yet, not all countries performed in the same way. Their different behaviours could be explained in part by different ideological orientations. Social Democratic governments emphasized more than others the role of fiscal policy in pursuing macroeconomic stabilization (Cornia, 2014)1. The differences in each country’s reactions were also related to their specific initial fiscal conditions. As can be seen in Figure 2, pre-crisis conditions differed substantially across countries. While Social Democratic and Center countries – excluding Honduras – started off in better fiscal condition, the Rightwing and Radical Left countries could count on a lesser fiscal space. Some of the commodity exporters, such as Chile and Peru, began from a strong fiscal position, and were able to finance stimulus packages thanks to the resources accumulated during the years of economic bonanza. Yet, the situation was less favorable in other countries, like Mexico, where the government had to increase taxes starting from 2010.

Figure 2. Required Structural Adjustment in 2007
Required structural adjustment

Source: author’s elaboration on CEPALSTAT data, Fernández-Arias and Montiel (2010), World Development Indicators database. NOTE: Target primary balance is computed as in Fernández-Arias and Montiel (2010)

To sum up, Latin American countries - and especially those run by Social Democratic and Centrist governments – performed relatively well during the recent economic crisis. Indeed, their experiences highlight the crucial role of fiscal policy in promoting macroeconomic stabilization. In particular, prudent fiscal policy in normal times assures the necessary conditions to better face macroeconomic challenges once they arise.

1. Cornia (2014) distinguishes between four groups of countries according to their political regime: Centrist countries such as Costa Rica, the Dominican Republic, Honduras and Peru; Radical Left countries, i.e. Bolivia, Nicaragua and Venezuela; countries run by Right-wing parties, i.e. Colombia, El Salvador and Mexico; finally, countries run by Social Democratic governments, i.e. Argentina, Brazil, Chile and Uruguay.

Cornia, G. A. (2014), Falling Inequality in Latin America: Policy changes and Lessons, Oxford University Press.

Cornia, G. A., Gomez – Sabaini , J. C. & Martorano, B. (2011). A new fiscal pact, tax policy changes and income inequality: Latin America during the last decade. UNU – WIDER, Working Paper N. 2011/70.

Fernández-Arias, E., & Montiel, P. (2010). The Great Recession, 'Rainy Day' Funds, and Countercyclical Fiscal Policy in Latin America. Department of Economics Working Papers 2010-17, Department of Economics, Williams College.

Lora, E. (2007). The State of State Reform in Latin America. IABD, Stanford University Press.

Martorano, B. (2012), “The Impact of Uruguay’s 2007 Tax Reform on Equity and Efficiency”, Working Papers Series n. 06/2012, Universita' degli Studi di Firenze, Dipartimento di Scienze Economiche

Martorano, B. (2014), “From Volatility to Stabilization: Cyclicality of Fiscal Policy in Latin America over the Last Decades,” Working Papers - Economics WP07/2014, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.

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