[R-G] Fiscal Positions in Latin America: Have They Really Improved?

[Yoshie Furuhashi]

<http://www.rgemonitor.com/latam-monitor/253072/fiscal_positions_in_latin_americahave_they_really_improved>
Fiscal Positions in Latin America:Have They Really Improved?
Ivanna Vladkova-Hollar and Jeromin Zettelmeyer | Jul 23, 2008

The improvement of fiscal balances has been a cornerstone of Latin
America's macroeconomic stabilization and recovery following the
crises of 1994–2002. After hovering around 5 percent in the last
decade, the average fiscal deficit in Latin America declined steadily
beginning in 2003, and reached a surplus in 2006. Initially, this
reflected a reduction in government spending as a share of GDP, which
reached a low around 2004. Beginning in 2005, spending picked up
again, but was outpaced by an even larger increase in revenue growth.
As a result, fiscal balances continued to strengthen (Table 1).

<http://media.rgemonitor.com/images/blogs/image002_400.png>

Are these improvements sustainable? Or do they merely reflect
exceptionally favorable external economic conditions—including an
unprecedented boom in commodity prices—and the strong cyclical
recovery that Latin America has enjoyed in the last few years? The
fact that Latin America's recent fiscal improvements have come
exclusively from the revenue side is a cause for concern (IMF, 2006,
2007; IADB, 2008; Izquierdo, Ottonello, and Talvi, forthcoming). In
light of continued high debt levels, a return to the deficits of the
1990s could jeopardize the region's newfound stability. The key
question is hence how much of the recent revenue growth can be
expected to be "permanent"—i.e. to survive a return to normal cyclical
conditions—and how strong fiscal balances would be in these
circumstances. This is the subject addressed in this paper.

We proceed in three steps. First, we analyze the sources of recent
increases in the revenue to GDP ratio, distinguishing between revenues
from commodity and noncommodity sources, and decomposing increases in
the latter into three components: changes due to tax policy or tax
administration; changes due to the economic cycle; and a residual.
Based on this analysis as well as medium-term commodity price
projections from two different sources, we compute "structural"
revenue to GDP ratios separately for noncommodity and commodity
revenues. Finally, we combine these with estimated structural
expenditure ratios, under the assumption that expenditures in Latin
America are not (automatically) linked to the economic cycle, to
compute structural balance estimates for a number of countries in the
region.

The approach used in this paper [LINK:
<http://www.imf.org/external/pubs/ft/wp/2008/wp08137.pdf>] differs
from standard structural balance methodology (Hagemann, 1999) in two
ways. First, following Marcel et al. (2001), we distinguish between
noncommodity and commodity revenues, and separately estimate the
"structural" level for each. Second, when estimating noncommodity
structural revenue, we consider the history of tax regime changes in
each country in addition to the standard cyclical adjustment of
observed revenues using the output gap. Conventional structural
balance methodology implicitly assumes that all changes in the revenue
ratio that are not identifiably cyclical— that is, cannot be
statistically linked to the output fluctuations—are "structural,"
whether or not they can be attributed to changes in the tax system.
This approach might give too rosy a picture of the fiscal balance if
revenue ratios are buoyant for temporary, but not identifiably
cyclical reasons.

To address this problem, we adjust the observed tax revenue series,
for each country, using the estimated revenue impact of all changes in
the tax system that we are aware of, before regressing the adjusted
series on changes GDP.2 The residual from this regression reflects the
portion of revenue that is unexpected, given the state of both the tax
system and the tax base (GDP). Structural revenue and balance
estimates are computed both under the (conventional) assumption that
this residual is structural, and under the alternative view that it is
not.

We also take a position on which view is closer to the truth by
examining the statistical properties of the residual. We are aware of
four related recent studies of fiscal performance in Latin America.
Alberola and Montero (2006) examine the relationship between the
fiscal stance and the economic cycle in a paper that is primarily
interested in debt sustainability. As an intermediate step, they
estimate structural fiscal balances in nine Latin American up to 2004
using the standard assumption that all non-cyclical revenue changes
are structural, and disregarding changes in tax structure in their
regressions.3 Lozano and Toro (2007) compute structural balances for
Colombia, based on the standard approach, and a revenue series that is
adjusted for changes in the tax structure. Cubero and Sowerbutts
(forthcoming) analyze structural revenue in Costa Rica using a very
similar methodology as this paper, with consistent results. Finally
Izquierdo, Ottonello, and Talvi (forthcoming; see also IADB, 2008,
which is based on their analysis) calculate structural balances for a
group of Latin American countries using a different methodology, which
relies on statistical filtering of the observed fiscal data. The
flavor of their results is different from those of this paper, in that
they attribute a much larger portion of the recent revenue increase to
cyclical factors.4

Our study [LINK:
<http://www.imf.org/external/pubs/ft/wp/2008/wp08137.pdf>] has three
main findings.

First, not surprisingly, commodity related revenues play an important
role in the recent revenue boom of commodity producing countries.
Whether or not these revenue increases should be viewed as permanent
or not depends on the commodity. For fuel commodities, medium term
projections by the IMF and World Bank envisage largely flat prices in
the
medium run. For non-fuel commodities, declines are envisaged,
particularly for some metals. Furthermore, the assessment of whether
non-fuel commodity price increases should be viewed as permanent or
not turns out to depend on the forecast source. Model-based forecasts
by the World Bank envisage greater declines over the medium term than
IMF projections, which are largely based on futures markets data.

Second, revenue increases that are identifiably due to the business
cycle play virtually no role in explaining the rise of the
revenue-to-GDP ratio. The main reason is that estimated income
elasticities of revenue are close to unity in most cases (they range
between 0.8 and 1.35, with most elasticities clustered between 0.95
and 1.11). Hence, while noncommodity revenue levels are highly
cyclical, revenue ratios should be quite insensitive to the cycle.
Moreover, the estimated cyclical position of most Latin American
countries is currently not very far from neutrality, namely in the
order of 0–4 percent above "potential output." Hence, a return to a
cyclically neutral position would not have a big impact on revenue
ratios.

Third, residual revenue changes that can be attributed neither to
cyclical factors not to identifiable changes in the tax regime are
quite large in a handful of countries, in the order of 1–3 percent of
GDP. In these countries, structural balance estimates are sensitive to
whether these residuals are interpreted as reflecting unobserved
structural changes, or as temporary. Statistical tests indicate that
for the most part they ought to be interpreted as temporary, but there
are some exceptions.

In sum, there is little doubt that fiscal positions in Latin America
have "really" improved in recent years. The business cycle cannot have
played a significant direct role in raising revenue ratios. Improved
fiscal positions seem to mostly reflect persistently higher commodity
prices, as well as changes in taxation and tax administration. This
said, structural balances in Latin America are weaker than reported
balances, particularly in the case of nonfuel commodity exporters,
which are projected to suffer significant price declines in the medium
term. Furthermore, they are subject to a large margin of uncertainty,
both because of uncertain commodity price projections, and because
some of the recent changes in noncommodity revenues as a share of GDP
are hard to attribute either to cyclical conditions or to changes in
the tax system.

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Footnotes:

(2) This approach follows Swiston, Mühleisen and Mathay (2007).
(3) Alberola and Montero (2006) do not take account of changes in
revenue regimes when estimating elasiticies of revenue with respect to
income and commodity prices. This may explain the fact that their
estimated income elasticities of revenue are generally much higher
than ours (see section II below).
(4) Their methodology consists in applying a Hodrick-Prescott filter
with a smoothing parameter calibrated to reproduce the degree of
smoothing that is implicit in the structural fiscal balance estimates
of the Chilean authorities. Because the commodity prices that drive
the Chilean balance exhibit much less persistence than those of other
commodities produced in Latin America (see appendix 3), this leads to
a far larger adjustment than if structural balances are based on
country-by-country properties of commodity prices, as in this study.

Paper published by the IMF [LINK:
<http://www.imf.org/external/pubs/ft/wp/2008/wp08137.pdf>] and
introduction reproduced here with the author's permission.