Costa Rica: IMF Recommends Raising Taxes

Reducing the income tax exemption threshold for individuals, increasing property taxes and raising VAT from 13% to 15% is part of the institution's proposal, arguing that in the country "the tax/GDP ratio is relatively low."

Tuesday, February 26, 2019

In the medium term, the positive effects on confidence and progress of structural reforms, including those related to OECD membership, should reduce risk premia and stimulate investment, boosting growth to 3.25%, reported the International Monetary Fund (IMF).

From the IMF press release:

February 25, 2019. Passage of the fiscal reform bill was a critical step to restoring fiscal sustainability. Given the difficult external environment and high near-term fiscal financing needs,full and timely implementation of the fiscal reform should be a central part of the policy mix. To reduce near-term financing needs and help debt fall faster, further front-loaded fiscal consolidation is recommended, accompanied by measures to protect the poor. Other elements of the policy mix include: keeping monetary policy data dependent while further increasing its transparency and maintaining exchange rate flexibility; enhancing financial resilience; and leveraging the OECD accession process to boost competitiveness and inclusive growth through structural reforms.

Context

1. Costa Rica was buffeted by multiple shocks in 2018, which led to a moderation of growth and an increase in unemployment. Growth is estimated to have slowed to 2.7 percent in 2018, reflecting the impact of the public-sector strike, developments in Nicaragua, rising global interest rates and tighter domestic financial conditions, and the uncertainty surrounding the fiscal reform. In part because of this, but also due to a sharp rise in the participation rate, the unemployment rate increased to 12 percent in 2018Q4, with the rate for youths crossing 30 percent.

2. Passage of the fiscal reform bill was a critical step, but market reaction has been cautious and financing costs remain high. A fiscal reform had been in the works for nearly two decades, and passage of the bill in December 2018 involved seeing off a three-month public sector strike. Shortly following passage, however, three rating agencies downgraded Costa Rica’s sovereign credit rating and placed the country on a negative outlook, citing continued worsening of debt dynamics and significant short-term funding challenges. Local markets have started to normalize, allowing the government to secure financing at longer maturities and swap some short-term debt for longer maturity paper, though at interest rates above 9 percent in U.S. dollars. The EMBI spread also remains above 450 bps.

3. The government recognizes the challenges and is planning a broad array of reforms to complement the fiscal package and stimulate growth. The authorities are requesting legislative authorization to issue “eurobonds” and are also seeking financing from multilateral sources. Access to external financing would help ease pressure on local debt markets, reduce financing costs and lengthen debt maturities. Moreover, reforms regarding public employment, tax exemptions, and public administration are being planned. To boost competitiveness and employment, the government is working in a series of reforms, some of which come under the OECD accession process. In this context, the establishment of a special committee in Congress solely for legislation related to OECD accession is a welcome sign of political consensus regarding the importance of the process.

Outlook and Risks

4. Growth is expected to remain subdued in the near-term and gradually rise toward potential in the medium term. Fiscal consolidation and tight financial conditions are expected to keep growth moderate in 2019-20 (around 2¾-3 percent), notwithstanding a pickup in public investment, base effects associated with the 2018 public-sector strike, and improving terms of trade. In the medium term, positive confidence effects and progress with structural reforms, including those related to OECD accession, should lower risk premia and boost investment, pushing growth up towards 3½ percent. Inflation is expected to remain within the target range.

5. Growth risks are tilted to the downside. Key downside risks include partial implementation of the fiscal reform, an escalation of global trade tensions, and a sharp tightening of global financing conditions. Any of these, if materialized, could adversely affect Costa Rica via an abrupt deterioration in investor sentiment, resulting in capital outflows, pressure on the currency, a sharp rise in interest rates, and financing strains.

Restoring Fiscal Sustainability

6. The fiscal reform constitutes a critical step towards restoring fiscal sustainability, although full and timely implementation is key. The reform—which includes the conversion of the sales tax into a value added tax (VAT), higher income taxes, wage restraint, and a fiscal rule that ties down the growth of spending—is expected to yield savings of about 4 percent of GDP over 2018-23. It should also improve the progressivity of the tax system and likely reduce inequality.

7. An additional front-loaded adjustment of around ¾ percent of GDP is recommended to further reduce debt and near-term financing pressures. The fiscal reform should allow central government debt to peak at 61½ percent of GDP in 2023, and gradually decline thereafter. However, the government faces sizable financing needs in the near term. This, combined with the need to rebuild fiscal space to manage potential shocks and major contingent liabilities (e.g. pensions), presages the need for further front-loaded fiscal measures to improve market confidence and reduce financing needs. IMF staff estimate that an additional adjustment of ¾ percent of GDP over 2019-20 would help debt decline faster and reach 50 percent of GDP by 2030, consistent with studies on sustainable levels of debt in emerging markets.

8. Given the fiscal reform is largely spending based and Costa Rica’s tax-to-GDP ratio is relatively low, further adjustment should be underpinned by well-designed revenue measures while protecting the poor. Potential measures include:

  • Increasing the VAT rate from 13 to 15 percent, closer to regional standards and the OECD average of 19 percent.
  • Increasing property taxes given associated revenues are around half the Latin American average, as long as they can be allocated to the central government.
  • Lowering the tax-free threshold of personal income tax (PIT), which is currently about twice the average wage, reducing tax progressivity.
  • Increasing excise taxes on selected goods and services.
  • Taxing the profits of the cooperatives.

9. The authorities should build on recent measures to further improve public spending efficiency, debt management, and the institutional framework , which would allow fiscal policy to better contribute to growth and equity:
  • Improving the efficiency and quality of public spending . The fiscal reform eliminated significant revenue earmarking, thereby improving government control of the budget. The low efficiency of public spending in certain areas (e.g. education and social protection), however, suggests the need for performance-based reforms. IMF staff welcome the planned rolling out of debit cards as a vehicle to channel cash transfers to low-income households. The mission recommends more effective targeting and coordination of social assistance programs to better protect the poor, especially in the context of ongoing tax reforms.
  • Streamlining public debt management. The authorities have created an interinstitutional team to improve the coordination and the division of responsibility between different agents involved in debt management. IMF staff advise using only market-based mechanisms as financing conditions improve, strengthening price discovery, and improving communication with markets.
  • Introducing a multi-year expenditure framework (MTEF) and a fiscal council . Congress is in the process of passing a constitutional reform for an MTEF, and the authorities are taking steps to create a fiscal council. An independent fiscal council could prevent possible conflicts between the Ministry of Finance and the Comptroller General of the Republic—who have shared responsibility for the implementation of the fiscal rule—and act as a watchdog. In addition, IMF staff encourage the implementation of an MTEF consistent with international best practice, something which has proven to be an effective tool in OECD countries to control public expenditure over the medium term.

Keeping Monetary Policy Data Dependent and Enhancing Transparency

10. The current monetary stance is appropriate and should remain data dependent. The slightly accommodative stance is appropriate given the projected negative output gap and inflation persistently at the floor of the target range. Going forward, monetary policy will need to remain data dependent and balance downside risks to inflation stemming from slower activity and upside risks to inflation arising from a sharp tightening of global financial conditions. If growth disappoints, space remains for increased monetary stimulus, but room would be limited if this coincides with fiscal or financing concerns leading to a deterioration in investor sentiment, capital outflows, and pressure on the currency.

11. Significant progress has been made to enhance the inflation targeting framework. IMF staff welcome: (i) the passage of the bill on delinking the designation of the President of the central bank from the political cycle and improving the clarity of dismissal rules; and (ii) the increase in FX flexibility since September 2018 and limited use of FX intervention to addressing episodes of large exchange rate volatility. Transparency could be further improved by publishing the calendar of monetary policy meetings and their corresponding meeting minutes.

Enhancing Financial Sector Resilience

12. Stress tests suggest the banking system is sufficiently well-capitalized to absorb sizable shocks, but it remains important to monitor and tackle financial vulnerabilities. The latter are related to sizable FX lending to unhedged borrowers; significant net foreign liabilities of banks; sharply growing household borrowing; and high sovereign exposure. To further incentivize de-dollarization, staff recommend: (i) reversing all the June 2018 measures that relaxed FX lending requirements; (ii) introducing different reserve requirements in domestic and foreign currency; (iii) imposing additional capital requirements contingent on the expansion of credit to unhedged borrowers; and (iv) allowing private banks more competitive access to the domestic-currency deposit market.

13. IMF staff welcome the government’s planned push for financial sector reforms, which are broadly in line with the 2018 FSSR recommendations. The planned reform on consolidated supervision provides SUGEF and CONASSIF with essential supervisory tools and strengthens fit-and-proper rules, and provide legal protection for supervisors to carry out their duties. Staff encourages its rapid approval. Staff welcome the BCCR´s implementation of an emergency liquidity support mechanism, and encourage further progress in establishing crisis management protocols. Rapid approval of the planned law establishing a deposit guarantee fund is important. In addition, staff recommend rolling back the blanket guarantee for deposits in state-owned banks should be considered to promote a more level-playing field for all banks.

Boosting Competitiveness and Inclusiveness Through Structural Reforms

14. Structural reforms are still needed to boost competitiveness and inclusiveness, and the authorities are developing an agenda in this regard. Costa Rica ranks favorably in many business indicators and remains a regional leader in attracting FDI. Additional steps are still needed to improve competitiveness and reduce inequality. IMF staff welcome the government’s plans to boost potential growth and the political consensus regarding the OECD accession process, and underscore the importance of leveraging the latter to implement impactful structural reforms. Many of the plans still need to be turned into concrete policies, and an assessment of their fiscal impact is still pending. Staff view promoting female labor force participation and addressing weaknesses in transport infrastructure as key priorities. Similarly, staff support the OECD’s recommendation to undertake an in-depth review of key sectors (e.g. electricity) exempted from the competition law, and measures to increase banking sector competition.



More on this topic

IMF: Costa Rican Economy Still Underdeveloped

February 2020

"Growth remains susceptible to adverse shocks to global growth, economic and socio-political stress in Nicaragua, the continued weakness in consumer and business confidence, and uncertainty regarding the implementation of the fiscal reform.”

After the slowdown in growth between 2017 and early 2019, the economy has recovered since mid-2019, as a result of a rebound in services, agriculture and manufacturing, which produced an estimated 2.1% growth in 2019, reported the International Monetary Fund (IMF).

Does Costa Rica Need More Fiscal Measures?

April 2019

For the IMF, the country "may need additional fiscal measures, focused on the short term, to alleviate financing pressures and improve debt dynamics.”

After analyzing the current economic situation in Costa Rica, the directors of the International Monetary Fund (IMF) commended the recent fiscal reform, which is important to restore fiscal sustainability.

El Salvador As Seen by the IMF in March 2018

March 2018

The institution highlights the progress that has been made in reducing the fiscal deficit and stabilizing the debt, but warns that a greater effort is needed to place the debt on a downward trajectory.

From a statement issued by the International Monetary Fund:

The IMF staff team visited San Salvador during February 5—16 for the 2018 Article IV consultation [1] and held productive discussions with the Salvadoran authorities, parliamentarians, business community, and social partners. The consultation was based on revised National Accounts statistics.

Costa Rica As Seen by the IMF in January 2015

February 2015

Despite being reduced compared to 2013, the IMF insists that the fiscal deficit remains a thorn in its side for preventing the economy from reaching its full potential.

From a statement issued by the International Monetary Fund (IMF):

January 30, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Costa Rica.

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