2.2.1 The education system in Chile

For primary and secondary education, the current education system is organized in public (municipal), subsidized (through a voucher system) and private schools. About 47 percent of the students go to municipal schools, 47 percent to private subsidized schools and 6 percent to non-subsidized schools. For tertiary education, 80 percent of the students are enrolled in private universities or technical institutions. The strong presence of private providers has resulted in a highly segregated education system, especially at the primary and secondary levels, where the distribution of students is strongly dependent on socioeconomic status (Figure 4). Since the introduction of the current vouvher system in 1981, not only education segregation has increased but has also not translated into higher aggregate education quality, as measured both as cross-country comparison and as change in education performance after the introduction of the voucher system (OECD, 2010; Hsieh and Urquiola, 2006). However, it still remains unclear whether it was the voucher system per se that generated higher segregation or other factors contributed to that increase. Gallego (2013) finds the introduction of the voucher system did not increase educational inequality in Chile but that instead the education system became unequal or segregated because of the absence of voucher schools in some geographical areas.

Attendance of primary and secondary schools by socioeconomic status

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

Note: In percent of each income decile. Sources: Ministry of Planning (Mideplan) CASEN Surveys 1990 and 2006 and OECD.

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Attendance of primary and secondary schools by socioeconomic status

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

Note: In percent of each income decile. Sources: Ministry of Planning (Mideplan) CASEN Surveys 1990 and 2006 and OECD.

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Attendance of primary and secondary schools by socioeconomic status

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

Note: In percent of each income decile. Sources: Ministry of Planning (Mideplan) CASEN Surveys 1990 and 2006 and OECD.

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2.2.2 The human capital gap

Chile shows a significant gap relative to OECD standards in terms of human capital. As of 2010, the average years of schooling of Chiles labor force was about 12 percent below OECD level, using Barro and Lee (2014) (Figure 5). Based on the 2012 PISA scores (widely used as a measure of education quality and cognitive skills of the labor force), Chile ranks 15 percent below the OECD average. Lower human capital affects GDP through its impact on labor productivity, as shown in the seminal work by Mincer (1974). The productivity-augmenting effect of higher human capital has been traditionally measured through estimating the relationship between an individual’s schooling and his labor earnings (Bills and Klenow, 2000).

Education gap

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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Education gap

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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Education gap

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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2.3.1 Energy

The economic agenda announced in 2014 aims at reducing electricity marginal costs and increasing generating capacity. To do so, the agenda involves improving the connectivity between the two main national grids (SING and SIC); boosting incentives to utilize renewable sources (so that they represent 45 percent of the electricity generation capacity over the next decade); and facilitate the involvement of private sector by easing the regulatory practices behind the release of permits (with spot marginal costs lowered by a more competitive tender process among distributing firms). Those progresses are estimated to decrease energy cost and increase electricity generation capacity (by more than 40 percent by 2020), according to data by the Ministry of Energy on projects already approved.

2.3.2 Transportation and telecommunication

The agenda aims at strengthening urban and intercity connectivity and port infrastructure (including through the construction of a large port in the central area of the country), by direct investment and also by incentivizing the direct involvement of the private sector, through new and expedite procedures for public-private partnership (PPP). For telecommunication, the agenda aims at boosting internet access, data transmission, and coverage of the fiber optic national network, including through establishing a Fondo de Desarollo de Telecommunicaciones.

2.3.3 Education

Three main pillars (Ley de Inclusion) of the reforms agenda for primary and secondary education have been passed in January 2015: i) the abolition of co-payments that allowed families to send their children to more expensive schools, ii) the repeal of for-profit subsidized schools (by 2018), and iii) the end of early-education selection entry-tests. Private co-payments will be replaced by public resources, expanding the possibility of lower income families to choose the optimal school for their children. For tertiary education, authorities program is to ensure free tertiary education for students in the bottom 60 percent of the income distribution attending universities, both public (16) and private (9), belonging to the so called Consejo de Rectores or other professional institutions meeting similar standards. However, large uncertainty still surrounds this plan, on how it can be implemented in the case of private universities and on future extensions of free education to larger fringe of the society. The reform agenda also contemplates greater spending on public education, including on teachers formation, schools infrastructure, and child care facilities.

2.3.4 Income tax

To help finance the cost of the reforms (in particular, the education reform) the authorities completed a fundamental tax reform in September 2014, which changed Chile income tax system. The new tax law introduced several changes, including by i) gradually increasing corporate tax rates, and ii) offering firms the choice between an integrated tax system which is less generous than the old one mainly because dividends are now taxed when accrued, independently if distributed or not, and a new semi-integrated regime, where dividends are taxed only when distributed but at a higher rate and shareholders can only partially deduct that tax from their final taxes.

In both new regimes, marginal tax rates on capital will increase (De Gregorio, 2014). While matching the increase in outlays with new permanent revenues is prudent, higher taxes on capital income might have a dampening effect on corporate savings and investment (Santoro and Wei, 2012).

3.1.1 Households

Each country is populated by two types of households, optimizing agents with a finite time horizon and liquidity-constrained, respectively in measure (1—ψ) and ψ. The optimizing agents are overlapping generations (OLG) households with finite planning horizons as in Blanchard (1985), whose horizon is determined by some degree of myopia. In each instance, an index a denotes household’s age and an index t denotes a time period and each period corresponds to one year. Each of these agents faces a constant probability of death in each period, at which point they are replaced by new households so that the proportion of households in the economy remains constant.

Labor productivity declines at a constant rate over the lifetime of both types of households. Both households pay direct taxes on labor income, indirect taxes on consumption spending, and a lump-sum tax. Additionally, they receive transfers from the government. They optimally choose consumption, savings, and labor supply to maximize the following lifetime utility function:

where θ is the degree of myopia, γ > 0 is the coefficient of relative risk aversion, η is the preference parameter for consumption, and β is the discount factor, which accounts also for the probability of dying. In equation (2), $(S_t-l_{a,t}^{OLG})$ is the available time for leisure of the OLG households of age a in period t, where S_t is the total available time and l_a,t is the time resource devoted to labor supply. In turn,$c_{a,t}^{OLG}$ denotes the2 consumption of the OLG household of age a in period t and is given by a CES aggregate over final retailed consumption varieties $c_{a,t}^{OLG}(i)$, with elasticity of substitution a_R:⁶

$\begin{array}{cc}{c}_{\alpha ,t}^{OLG}={\left({\int }_0^1{\left(c_{\alpha ,t}^{OLG}\left(i\right)\right)}^{\frac{{\sigma }_{\text{R}}-1}{{\sigma }_{\text{R}}}}\text{d}i\right)}^{\frac{{\sigma }_{\text{R}}}{{\sigma }_{{\text{R}}^{-1}}}}& \left(3\right)\end{array}$

Preferences in equation (2) allow for external habit persistence on previous aggregate consumption, where the intensity of the persistence is governed by ν. The maximization is constrained by the following household’s budget identity:

where P_t is the price of consumption goods, used as a numeraire, $P_t^R$ is the retailer price, W_t is the nominal wage, i_t is the nominal interest rate, τ_L;t is the tax rate on labor income, ${{\rm Y}}_{a,t}^{OLG}$ are the lump-sum transfers that OLG households of age a receive from the government, ${\tau }_{a,t}^{ls,OLG}$ is a net lump-sum taxes tax paid to the government by an households of age a, $B_{a,t}^G$,$B_{a,t}^N$, and $B_{a,t}^T$ are age a household’s holdings of bonds issued respectively by the government, the banks lending to the nontradables and tradables sectors, F_a,t is age a household’s holdings of foreign bonds denominated in foreign currency, and converted at the nominal exchange rate ϵ_t. The interest rate paid on domestic bond accounts for the domestic risk-premium ξ_t,b, with a value of ξ_t,b < 0 indicating that the private sector faces a larger marginal funding rate than the public sector. Likewise, for foreign bond holdings, the interest rate is adjusted to account for a foreign exchange risk-premium, ξ_t,f.

The liquidity-constrained households decide how much to consume and how much to work but they do not have access to credit markets. Their decision does not aim to smooth consumption and therefore they are constrained to consume their after-tax income in every period. Their objective function is similar to the utility function of the OLG households, but we can ignore generations in this case, since they all behave identically given that they do not save:

where $c_t^{LIQ}$ features preferences for variety as in equation (3). Optimization is subject to the following budget constraint, which outlines their dependence on current income:

The model allows to treat the labor supply decision of the liquidity constrained as exogenous, in which case their decision problem boils down to setting consumption equal to after-tax income.

3.1.2 Production

In the model, the production process takes place in several layers. In each layer of production, except for distribution, agents face competitive input markets and monopolistically competitive output markets. First, there is a continuum of manufacturing firms, indexed by z ∈ [0,1], that produce tradable and nontradable goods, using capital from capital goods producers and labor from unions, in a CES fashion:

where A_t is a country-specific total factor productivity (TFP) shock, K_t(z) is the capital used by manufacturing firm z and L_t(z) is its labor demand, α is the capital share in the production function, ξ_z represents the elasticity of substitution between capital and labor, and T_t is the labor-augmenting productivity level. Trend growth productivity can be defined as g = T_t/T−1_t. Manufacturing firms are subject to nominal rigidities in price setting, and real rigidities in their labor hiring. The production of capital stock K_t is subject to quadratic adjustment costs G_I,t (I_t, I_t−1), which depend positively on the deviation of investment I at time t from of investment at t—1. The presence of adjustment costs causes the shadow value of capital or marginal q to deviate from a simple price in terms of consumption goods. Thus, the marginal q is a function of the adjustment costs, the capacity utilization (u_t), the interest rate (r_t), the marginal product of capital (MPK) and the tax rate on capital income (τ_K,t).

where $\frac{dq}{d{\tau }_K}<0.$

Manufacturing firms sell intermediate tradable and nontradable goods to domestic distributors, and intermediate tradable goods to import agents in foreign countries, who in turn sell to distributors in those countries. There are three layers of distributors until the last one that produces final consumption and investment goods, respectively, combining domestic and foreign final output. Their price setting is subject to nominal rigidities and changes in the volume of their imports are subject to quadratic adjustment costs.

The final consumption good is sold to retailers and to the government. The final investment good is sold to capital goods producers and to the government. Retailers sell their output to households in a monopolistic competitive market and they are subject to real price rigidities. Finally, capital goods producers produce the capital input used by manufacturing firms and are subject to investment adjustment cost. The financial accelerator mechanism, in the spirit of Bernanke, Gertler and Gilchrist (1999), enters at this layer of the model.

3.1.3 Fiscal and monetary policy

where ${\left(\frac{\sum }{Y}\right)}_t$ is the budget surplus as a share of GDP, ${\left(\frac{\sum }{Y}\right)}^{SS}$ is the equivalent long-run ratio, $\frac{B}{Y}$ is the debt-to-GDP ratio and $\frac{Y_t}{Y^{SS}}$ is the output gap. The parameters d^B and d^Y govern the strength of the stabilization channels, through a reaction to deviations of debt and to the output gap.

Fiscal policy is conducted using a variety of fiscal instruments related to taxation and spending, and through the issuance of government debt. The sources of tax revenues are labor income tax, consumption taxes, taxes on the return to capital, and lump-sum taxes. Government spending takes the form of consumption and investment expenditures, and lump-sum transfers to all households.

Regarding monetary policy, we consider a central bank that follows a strict inflation targeting regime, in order to capture the case of Chile. In this case, the monetary authority varies the policy rate in order to achieve a stable target rate of inflation over time, using a Taylor rule of the following type:

where i_t is the policy rate, which depends on: (i) previous period rate i_t−1 with intensity δi; (ii) a weighted average of present and forward inflation π (with weight δ_ρ) and its deviation from target inflation level π*, with intensity δ_π; (iii) the deviation of GDP from its steady-state (non-inflationary) level; (iv) the depreciation of the nominal exchange rate η from some reference level η* with intensity δ_η.

3.2.1 Macroeconomic aggregates

Table 4 displays the expenditure-to-GDP ratios for the three economies. The most important feature of Chile is the high external dependence. The domestic economy is highly reliant on imports of final goods (about 25 percent of GDP versus 12.6 in the case of the EA and 4.4 in the case of the RW) and, in particular, of investment goods (7.6 percent of GDP) relative to EA (3.4 percent) and the RW (1.1 percent). At the same time, the exports are considerably concentrated in terms of intermediate goods, given the strong reliance on copper exports (15 percent of GDP in intermediate goods versus 8 percent in final goods). I set the import and export shares for distributors in the domestic economy to hit the ratios of imports-to-GDP and exports-to-GDP for each of the intermediate and final goods.

Private consumption is set to 63 percent of GDP, and total investment at 22 percent, roughly comparable with the EA and the RW. Chile government net debt-to-GDP ratio of about -5 percent (an average level in 2013 and 2014) is the lowest among the three regions, with the EA ratio at 33 percent and and the RW at 50 percent. Chile public spending at 14 percent of GDP is lower than in the EA (18 percent) and in the RW (20 percent). The tax rates on labor income, capital income and consumption are calibrated based on average tax rates in Chile in 2014 at 27.7, 12.9 and 17.1 percent, respectively.

3.2.2 Main parameters

Most of the parameters are calibrated according to Kumhof et al. (2010) for the case of the US, except for some parameters that are key to pin down the specific behavior of the Chilean economy, reported in Table 5. Given the strong reliance of Chile on imports of final goods, the domestic economy is characterized by higher levels of real adjustment costs to imported final goods (1.5 for Chile versus 1 for the other two regions, following Kumhof et al., 2010). This captures the fact that in small open economies agents cannot quickly substitute imported goods with domestic goods, as the economy’s production scale and variety is limited and this gives rise to high adjustment costs. Consistently, the share of tradable goods on real income is 50 percent, higher in Chile than in the RW (40 percent).

For simplicity and tractability, the CES parameter is set to ξ_z=1 so that the equation (7) collapses to a Cobb-Douglas:

I set the capital factor share parameters α to 0.52 percent, in the tradable sector, and of 0.38 percent in the nontradable sector, higher than in the RW (0.45 for the tradable and 0.30 for the nontradable sectors) to capture both the high intensity of capital in the mining sector and high inequality in the distribution of assets and income in Chile.⁸ I calibrate the time preference parameter β to be consistent with a capital-to-GDP ratio of 179 (this implies β = 0.966).

The share of liquidity constrained agents in the economy (ψ) is parametrized to 0.5, higher than in the RW (0.3). This is intended to capture some difficulty to access credit in Chile due to high income inequality and therefore a skewed distribution of collaterals.

Regarding fiscal policy, the particular design of the fiscal rule allowed Chile in the past to use some degree of countercyclical policy behavior. Chile’s fiscal policy does not target a specific debt-to-GDP ratio. The coefficient that regulates the reaction of fiscal surpluses to the output gap d^Y is set at 0.25 as in Kumhof et al. (2010) for EA, while the coefficient that regulates the reaction of fiscal policies to the debt-to-GDP ratio is instead set at 0.

The objective of the monetary authority in Chile is to target a given long-run level of inflation, with a single mandate. The coefficients on t – 1 interest rate, and on the deviation from inflation target for the Taylor-type reaction function are set similar to the case of the euro area as in Kumhof et al. (2010) at 0.3 and 1.5, respectively. The coefficients that govern the response for the policy rate to the output gap and to the exchange rate are set to zero given that the Chile’s central bank follows a single mandate.

4.4.1 The reforms dimensions: credibility, effectiveness and speed

In the long run, the net impact of the reforms mainly depends on their effectiveness, whereas, in the short and medium run, the degree of credibility and speed of implementation are more important. Figure 6, Panel A, shows two paths for a medium effectiveness scenario, in which 50 percent of both infrastructure and human capital gaps are closed at a medium speed in implementation (10 years for infrastructure and 15 years for human capital). While the long-run results are identical, the level of real GDP after 5 years is 2-3 percentage points lower in a low credibility scenario relative to the high credibility scenario.

Dimensions affecting the outcome of reforms

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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Dimensions affecting the outcome of reforms

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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Dimensions affecting the outcome of reforms

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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Figure 6, Panel B shows the same medium effectiveness scenario under a high credibility scenario. Again, while the long-run results are the same, real GDP is 3 percentage point lower after 5 years when infrastructure and human capital gaps are closed at a low speed (after 15 and 20 years, respectively) relative to when the gaps are closed at high speed (in 5 and 10 years).

Under the worst possible scenario, with a combination of low effectiveness, low credibility, and low speed, real GDP immediately falls relative to the no-reform baseline and is still -0.6 percent below baseline by 2020 and only marginally above by 2025 and in the long run. Under the most optimistic scenario, GDP immediately increases by 1.3 percent and is about 15 percent above baseline by 2025 (Figure 7).

Range of possible outcomes: GDP (% difference from baseline)

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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Range of possible outcomes: GDP (% difference from baseline)

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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Range of possible outcomes: GDP (% difference from baseline)

Citation: IMF Working Papers 2015, 282; 10.5089/9781513537634.001.A001

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4.4.2 The median scenario

A close look at the median scenario will help us unveil the forces at work in the simulation of the reforms. The scenario underscores that the measures to boost infrastructure will be able to close 50 percent of the present gap in 10 years and that the policies to improve education will help closing 50 percent of the human capital gap in 15 years. The public is assumed to only believe that the policies will be effective after two years (black line in Figure 7).¹³

This scenario achieves an increase of real GDP by about 6 percent in 2025 and 8 percent in the long run, with a small negative impact during the first two years. Private investment declines by about 2 percent in the first two years, reflecting higher taxes on capital income. However, the impact on real GDP in the short term is small, with real GDP only slightly (by 0.3 percent) below its no-reform baseline level in 2015 and about 0.4 percent in 2016.

There are a few reasons why in GIMF the short-term impact of higher taxation is relatively small. First, weaker private demand prompts firms to demand less labor, which lowers the marginal cost of production and thus the price for domestically produced goods. The resulting fall in inflation leads the monetary authority to reduce the nominal policy rate. The resulting lower real interest rate reduces the cost of capital, offsetting the initial impact of higher taxation. Lower real interest rate also leads to a depreciation of the real effective exchange rate (REER), which boosts net exports. In addition, the higher revenue from the tax reform that gradually accrues is used to financed higher government spending (equivalent to 3 percent of GDP), which supports aggregate demand. This is consistent with the government’s plan, contemplated by the government 2015-18 agenda to use the higher structural revenue from the tax reform to finance higher education spending.

By 2020, as the positive effects of the structural reforms are fully internalized by agents, real GDP will be about 2 percent higher than in our no-reform baseline, with TFP growth increasing by percent. Investment and consumption would be 3 and 0.4 percent higher than the baseline case by 2020, respectively, and exports are 1 percent higher as the REER further depreciates with reforms increasingly bearing fruits.