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Costa Rica: Recent Economic Developments

Author(s):
International Monetary Fund
Published Date:
June 1998
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II. Progress in Reform of the Public Sector Since the 1980S9

A. Introduction and Summary

32. This chapter describes the origins of the structural imbalances in the public sector in Costa Rica that emerged following the economic crisis of 1980–82, and the efforts of successive governments to address them. Significant progress has been made in improving the tax system and in privatizing state enterprises. However, progress has been more limited in other key areas such as reducing the size of the civil service, relaxing rigidities in government expenditure, and permitting a larger role for the private sector in the public utilities and other state monopolies such as insurance.

33. The main reason for the slow progress has been a lack of consensus between the two major political parties on the priorities and content of structural change, which in turn, has led to delays in the approval of legislation required to implement reforms. Also, even in the presence of some consensus, reform has been delayed repeatedly because of the political-economic cycles that have affected policies in Costa Rica every four years. As a result, the essential tasks of placing the public sector finances on a sound footing, reducing the heavy domestic debt burden, generating adequate levels of saving, and permitting the much needed upgrading of infrastructure have remained unfulfilled.

B. The Pre-Reform Period 1969–79

34. During 1966–79, and particularly following the coffee boom of 1976–77, successive governments adopted policies aimed at promoting growth and improving social conditions through heavy involvement of the state in a wide range of economic activities, and industrialization based on import substitution behind high tariff barriers and exports to the Central American Common Market. Public sector investment (in roads, public utilities, health, and education) rose sharply, as did transfers to state enterprises involved in activities ranging from cement production to liquor manufacturing. Initially, this strategy resulted in a rapid acceleration in real GDP and income per capita, and one of the highest levels of social standards in Latin America.

35. Subsequently, however, real GDP growth slowed as a substantial deterioration in the terms of trade (following the decline in coffee prices in 1978 and the second oil crisis of 1979) led to a slowdown in demand and a weakening in government revenue. Faced with these difficulties, the authorities did not adjust government spending levels as warranted, and the fiscal deficit widened from about 4 percent of GDP in 1976–77 to 8 percent in 1980. The weakened fiscal position and the deterioration in the external current account resulted in a serious balance of payments crisis, at the same time as external financing from commercial banks dried up. As a result, the authorities were forced to suspend servicing of the external debt in mid-1981. Also in that year, real GDP fell by 2.5 percent following 20 years of uninterrupted growth, the overall deficit of the nonfinancial public sector widened to 14 percent, inflation rose to 65 percent, and the unemployment rate doubled to 9 percent. The crisis exposed the difficulties of fiscal adjustment and the structural weaknesses in the Costa Rican economy, and made clear the need for a comprehensive reform of the size, scope, and functioning of the public sector.

C. Early Attempts at Reform 1984–93

36. By the second half of 1982 the government had initiated an adjustment program, supported by a Stand-by Arrangement from the Fund. The program aimed at containing inflation by reducing the fiscal imbalance (through temporary import surcharges, increases in the sales tax and public sector tariffs, and measures to reduce the wage bill). Subsequently, beginning in 1983 the government embarked on a program of structural reform (supported by program loans from USAID and the World Bank) aimed at containing employment in the public sector, reducing the deficit of the state enterprises,10 easing rigidities in fiscal policy by, inter alia, limiting the practice of revenue earmarking, and privatizing most of the enterprises under the CODESA umbrella.11

37. The early efforts at fiscal adjustment and restoring macroeconomic stability were broadly successful. By end-1985, following a second Stand-by Arrangement, the fiscal deficit had narrowed to less than 2 percent of GDP, inflation had fallen to 12 percent, and the balance of payments strengthened. Also, the Stand-by Arrangements facilitated reschedulings of Costa Rica’s external debt with official and commercial bank creditors. However, by 1990 financial imbalances, associated in part with another political cycle, had re-emerged. The combined fiscal deficit increased to 5 percent of GDP, inflation accelerated to 27 percent, the external current account deficit widened to 9 percent of GDP, and gross international reserves fell from 4.2 months of imports in 1989 to 2.6 months.

38. Progress in structural reform during this period was mixed. Most significant progress was made in privatizing the state enterprises controlled by CODESA. Despite early delays, by 1991 the sale, merger, or liquidation of about 40 companies (out of a total of 43 companies) had been completed, with the proceeds used to retire CODESA debt with the central bank. A major factor that contributed to this success was the setting up of a trust fund financed by USAID that purchased those enterprises which could not be sold in the public auctions, and later liquidated their assets within a specified time period. Also, the trust fund helped finance severance payments to former employees of the enterprises sold or liquidated.

39. Attempts to implement reforms in other areas were less successful. Initial efforts to reduce public sector employment comprised steps to freeze employment;12 eliminate vacant positions; oblige all civil servants and state enterprise employees at age 65 and eligible to receive a pension to retire; and provide incentives for early retirement.13 Despite these initiatives, and various attempts to set quantitative targets for employment reduction,14 net employment in the public sector increased by about 3 percent in 1985-86, and by about 15 percent between 1987 and 1990. The difficulties in this area resulted mainly from the lack of agreement on the mechanisms for achieving the targeted reductions; difficulties in measurement, which made monitoring and attempts to enforce the freeze almost impossible; successful legal challenges in the constitutional court to mandatory employment reductions; and the lack of political support related to the political campaigns in 1986 and 1990.

40. In the area of expenditure control, key objectives in the World Bank SALs were reorganization, closure, or merger of institutions experiencing chronic financial and operational weaknesses.15 However, little progress was made in reducing the losses of the CNP. Indeed the losses increased sharply during 1984–85 and again during 1989–91, due to the subsidies to producers and consumers of basic grains. There was little progress in containing revenue earmarking, a major source of inflexibility in expenditure, although toward end-1992, some of the inflexibility in fiscal policy had been eased through legislation which provided for the elimination of the export incentive system (CATs) by 1996; and of price subsidies to consumers of basic grains.

41. While pension reform was not explicitly included in the initial reform program, the importance of restructuring the various pension regimes funded from the budget16 became increasingly recognized following studies which showed that without fundamental reform, the schemes would be bankrupt in the long run due to the excessive generosity in benefits, juxtaposed with inadequate contribution rates. Beginning in 1992 steps were taken to rationalize and unify the various pension regimes in the civil service. The objectives have been to reduce the burden on the budget, encourage the transfer of contributors from those regimes to that of the social security system, and make the latter the basic pillar of a restructured pension system. In the first phase of reforms instituted under the 1992 Framework Law on Pensions, the retirement age was raised from 50 to 55 years, the maximum pension lowered, the rate of contribution by employees increased, and the minimum number of years of contribution required for eligibility for a pension increased from 25 to 30 years.

D. Reforms in 1994–97

42. The administration which took office in early 1994 shared the broad objectives of the reforms noted above, except for that related to employment reduction which they regarded as unrealistic. The government’s priorities for structural reform and progress toward achieving them may be summarized as follows:

Tax reform

43. The main priority was to modernize the tax system and its administration. A major step was the approval of a new tax code (Ley de Justicia Tributaria) in September 1995, which was able to improve efficiency and equity in the tax system by eliminating 30 minor taxes; reducing the bias in the corporate income tax in favor of debt financing; authorizing crosschecking between tax returns and other sources of information on income and business activity; and introducing a gross assets tax. Also, the tax code classified some acts of tax evasion as criminal offenses punishable by imprisonment; and strengthened the legal framework for enforcing tax collections including by streamlining procedures for imposing fines and closing businesses. In addition, during 1992-95 exemptions and tax incentives to the tourism, manufacturing, and nontraditional export sectors were gradually phased out.

44. In 1997, the number of large taxpayers subject to close scrutiny by the ministry of finance increased from 280 (representing 60 percent of total income tax collections) to 535 (80 percent); a new computerized information system was installed; and agreement was reached with the banks on revenue collection procedures as well as information to be supplied by them. In the customs area, institutional improvements, comprising mainly seeking a more efficient organizational structure, upgrading professional skills, and automating most customs procedures, were supplemented in 1995 by legislation17 which provides for suffer penalties for customs duty evasion.

45. A Tax Reform Commission was set up in 1996 to review the tax system and propose revisions to the tax structure. Proposals for the next steps in tax reform include completing the elimination of those taxes for which the marginal yield is small relative to collection costs, and reducing the large number of exemptions. Also, they envisage continued progress in decentralizing tax collection, and setting targets and norms to enhance revenue performance.

Budget and expenditure reform

46. Various practices including the increased earmarking of revenue,18 and legislation requiring specific budget allocations to, for example, universities and social programs, have resulted over time in limiting severely the scope for discretionary expenditure policy. Consequently, when faced with the need for adjustment, governments had often to resort to cuts in spending for infrastructure. Capital expenditure of the government has stagnated at about 2 percent of GDP since 1990 (compared with 3 percent in 1986-89), and infrastructure has deteriorated.

47. With technical assistance provided by Spain, the IDB, and the Fund, the government has developed a set of procedures to better control expenditure and improve its payments and procurement systems. The new procedures were put in place in the 1997 budget, which included for the first time extrabudgetary items such as bank commissions. Other key reforms being implemented include development of a master account system for payments and cash management, training of staff, explicit inclusion of additional extra-budgetary items in the budget, effecting government payments exclusively through the banking system, and computerization of the procurement process. Next steps will include the preparation of an annual report to the assembly on performance relative to fiscal targets, and consolidation of the entire nonfinancial public sector in the budget process.

Pension reform

48. The changes (referred to above) initiated in 1992 were followed in 1995 by actions which obliged all members of the teachers’ regime under age 30 to transfer to another regime, and barred entry in the civil service schemes to new members.19 As a result, with continued efforts to bring benefits and contributions closer in line, it is expected that by about year 2040 the civil service schemes will have been phased out. In the interim period, contribution rates may need to be raised and benefits lowered to maintain the actuarial viability of the schemes.

49. Proposals currently being discussed for further reforms of the pension system comprise:

  • Ensuring the actuarial viability of the basic pension regime administered by the social security agency;

  • Enacting legislation to complete the rationalization of the public sector pension regimes, and regulate the complementary systems; and

  • Complementing the basic pillar with voluntary, individual retirement/savings accounts administered by private sector managers, thereby fostering increased savings and easing pressure on the basic system.

Privatization

50. The process of privatization has slowed considerably since the sale or liquidation of the enterprises covered by CODESA. Since then efforts focused on privatizing the remaining three state enterprises still operating under CODESA (a cement plant, a fertilizer company, and a liquor manufacturing company). The sale of the first two was completed in early 1997, but efforts to sell the liquor manufacturing have been suspended due to lack of political support. In June 1997 the government created a commission to be in charge of privatization, attached to the president’s office and consisting of representatives from the ministries of finance and planning. The government announced plans in December 1996 to privatize two banks (BICSA—an international bank owned by the state commercial banks—and the Banco de Costa Rica), forty percent of the National Insurance Institute, and RACSA (telecommunications). In line with these plans, the privatization of BICSA is proceeding with an investment bank selected in August 1997, and draft legislation for the privatization of the Banco de Costa Rica was sent to the assembly in October 1997. However, the sale of the other companies did not progress as anticipated due to lack of political support.

51. In addition to outright privatization, the authorities have considered options for increasing private sector involvement in activities previously carried out solely by the state. Mechanisms considered have included subcontracting, leasing, joint ventures, and permitting the private sector to build, own, operate, and transfer projects, especially in the telecommunications and electricity sectors. In 1995 legislation (the Law of Public Works Concessions and the Law of Incorporated Workers’ Companies)20 was approved, allowing private sector participation in areas, including infrastructure and operations of ports, previously reserved for the public sector. However, subsequent examination of the legislation has revealed a number of important flaws. These include the lack of definition of which areas fall under the scope of concessions, and the treatment of monopolies. Revised draft legislation was sent to the assembly in October 1997. Partly reflecting these uncertainties, to date only one concession in infrastructure (for highway repair) was granted, but this was not implemented because of questions related to the legality of the bidding process. However, the concessions to the private sector to operate the Port of Limón have been successful, and have resulted in an improvement in port facilities, and a reduction in handling charges from US$26 per ton to US$6 per ton.

Restructuring the public sector

52. The government reduced the emphasis of past administrations on cutting back employment in the public sector as an end in itself,21 and placed more effort into restructuring and increasing efficiency in the public sector. Efforts in this area since 1993 have focused on the merger of government ministries, the closure of institutions including the national railway (INCOFER) and some specialized agencies,22 the reform of the agricultural sector including eliminating the granting of subsidies to grains by the CNP, and reducing duplication among the various agencies of the ministry of agriculture. In addition, the government has begun to introduce better mechanisms of performance evaluation and reward in the public sector. To this end, in 1996 a national evaluation system was introduced in selected agencies on a pilot basis. It is expected that following the pilot stage, agencies which participate in the system will specify performance objectives and indicate how these would be measured. Also, a unit of administrative efficiency has been established with the objectives of defining the criteria for selecting institutions to be restructured, and determining activities inconsistent with fiscal priorities.

Prepared by Michael DaCosta.

Efforts focused on reducing the losses of the state marketing agency (CNP—responsible for setting producer prices of corn and other basic grains and international trade in these grains). The overall balance of the agency swungfroma small surplus in 1982 to a deficit equivalent to about 1 percent of GDP in 1984.

CODESA was the holding company for most state enterprises.

For example, the budgets for 1985-86 incorporated guidelines for freezing staff in all public sector agencies at the January 1984 level.

These included loans from the Banco Popular (at subsidized interest rates) to establish companies that could supply services to the government.

The most ambitious target was a reduction in public sector employment by 25,000 (19 percent of total public sector employment) over the period 1991-94. The target was not met.

Institutions included under this category included the CNP, the railway company (INCOFER), the ministry of public works, and the cement and fertilizer companies which were sold.

These regimes include those covering teachers, members of the assembly, and judicial workers.

Código Aduanero Uniforme Centroamericano and Ley General de Aduanas.

In 1994 about 25 percent of current expenditure comprised transfers (including mainly pensions, family allowances, export subsidies, support for universities) linked to earmarked revenue. Wages, pension payments, and interest accounted for about 70 percent of current expenditure.

Related reforms in the pension scheme of the social security agency (CCSS) in 1995-96 raised the retirement age, and tightened eligibility requirements for disability benefits. These changes will help maintain the pension system of the CCSS in good standing until about 2015.

Under this law, former public sector workers are encouraged to establish businesses that would provide services to the public sector in areas such as law, accounting, engineering, secretarial services, transportation, and maintenance and security services.

Employment remained unchanged during 1993–96.

These included IFAM, CONICIT, and DINADECO.

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