This Selected Issues paper and Statistical Appendix analyzes economic developments in Colombia during 1996–99. Output growth slowed sharply in 1996 and early 1997, but subsequently rebounded owing to stronger exports, a temporary boom in world coffee prices, and an easing of credit policy. Despite efforts at addressing the fiscal imbalances, the nonfinancial public sector deficit widened further to more than 4 percent of GDP in 1997. Monetary policy during 1996 and most of 1997 was geared toward stimulating domestic demand.

Abstract

This Selected Issues paper and Statistical Appendix analyzes economic developments in Colombia during 1996–99. Output growth slowed sharply in 1996 and early 1997, but subsequently rebounded owing to stronger exports, a temporary boom in world coffee prices, and an easing of credit policy. Despite efforts at addressing the fiscal imbalances, the nonfinancial public sector deficit widened further to more than 4 percent of GDP in 1997. Monetary policy during 1996 and most of 1997 was geared toward stimulating domestic demand.

VII. Cyclically Adjusted Fiscal Position38

A. Introduction and Summary

103. Colombia’s fiscal position has deteriorated substantially in recent years, with the nonfinancial public sector balance (before asset sales) shifting from near balance in 1992 to a deficit of 4.3 percent of GDP in 1997. While a number of structural factors underlie this weakening, spending pressures have also been aggravated by higher investment and social spending under the Development Plan initiated in 1994, as well as by a need for increased security and military outlays. However, the deterioration in the fiscal stance in more recent years has also coincided with a marked weakening in economic activity. Specifically, output growth fell from an average of 5¼ percent in 1992-95 to 2½ percent in 1996-97, and the unemployment rate rose to nearly 16 percent by June 1998. The effects of the cyclical downturn were particularly evident in the behavior of public sector revenues. Despite a comprehensive tax reform package enacted at end-1995 which included a rise in the VAT rate from 14 to 16 percent, tax revenues were little changed at around 19 percent of GDP during 1995-97 compared with the pace in the preceding two-year period.

104. This note examines the extent to which the evolution of the actual public sector balance in Colombia during the period 1993-97 has been attributable to the effects of cyclical movements in economic activity. This is done through analysis of the cyclically adjusted fiscal balance, which is obtained by excluding from the actual balance the portion that, under unchanged policies, is related to the business cycle—i.e., the output gap when actual and potential GDP differ.

105. The following conclusions emerge from the analysis:

  • the public finances were allowed to weaken relative to what would have been a cyclically neutral position during the period 1994-95. That is to say when GDP was above potential, the fiscal impulse was expansionary;

  • a considerable part of the deterioration in the fiscal stance in 1996 appears to be explained by cyclical factors. However, the deterioration in 1997-98 is considerably greater than warranted by the cyclical downturn for the nonfinancial public sector, pointing to expansionary fiscal policy during this period. For the central administration, the weakening of the actual balance with respect to the cyclically neutral balance was reduced in 1997 and is projected to be moderately expansionary in 1998.

B. Framework

106. For the purposes of this analysis, the public sector broadly defined comprises the central administration, social security system, national decentralized agencies, and the local nonfinancial public sector.39 Measurement of the cyclically neutral budget stance starts by establishing a base year in which actual and potential real output are judged to be the same.40 The “cyclically neutral” budget balance is derived from the actual balance by assuming that nominal tax revenues are unit elastic with respect to actual nominal income, and government expenditures are unit elastic with respect to potential output valued at current prices. On this basis, government revenues are characterized as cyclically neutral if they increase proportionally with respect to changes in actual nominal output. A similar characterization holds for changes in government expenditures with respect to potential output. More specifically, cyclically neutral revenues are defined by relating actual GDP in each year to the revenue ratio established in the base year—i.e., it is equal to actual GDP multiplied by the base year revenue to GDP ratio. Cyclically neutral expenditures are estimated by relating potential GDP to the expenditure/GDP ratio established in the base year—i.e., potential GDP multiplied by the base year non-interest expenditure/GDP ratio. The difference between cyclically neutral revenues and cyclically neutral non-interest expenditures are defined to be the cyclically neutral primary balance. The fiscal stance indicates the difference between the cyclically neutral and the actual balance. If the actual balance is less than the cyclically neutral balance (a larger deficit or a smaller surplus), then the fiscal stance is deemed to be expansionary. The fiscal impulse is the change in the fiscal stance, in percentage points of GDP, from one year to the next.

C. Estimates of Potential GDP

107. Estimates of potential GDP are crucial for analysis of the cyclically adjusted budget deficit. Several approaches were followed to arrive at such estimates. First, a Hodrick-Prescott (H-P) time-series filter was used on long time series of quarterly real GDP data for the period 1981-97. This filter smooths actual output so that potential output is a weighted average of past and future actual values, or alternatively, the trend in actual output. According to this methodology, Colombia’s potential GDP was growing at a range of 4-4.5 percent per annum by the mid-1990s. (Table 1 and Figure 1). Although the principal advantage of this technique is its simplicity, it also has several drawbacks. First, it suffers from an “endpoint” problem that occurs because, although the smoothed series is calculated as a centered weighted average of actual observations throughout most of the period analyzed, it depends only on past values at the end (and on future values at the beginning). As a result, the potential output estimates are highly sensitive to the chosen sample period. Second, this method will usually produce a potential output series that approximates the average level of actual output over time, that is, the estimated output gap will generally have an average value close to zero. This technique thus does not allow for the possibility that output may be above potential more often than it is below or vice versa. Finally, given that the potential output estimates given by the Hodrick-Prescott technique are essentially smoothed versions of actual output, permanent shocks to the level or growth rate of output resulting from structural changes in the economy may not be fully captured. In Colombia’s case, the far-reaching and ambitious liberalization program of the early 1990s, and the shift to a system of exchange rate bands in 1994 likely resulted in changes to potential output growth which may not be fully reflected in these estimates.

Table 1.

Colombia: Cyclically-Adjusted Fiscal Stance

(In billions of Colombian pesos unless otherwise indicated)

article image
Sources: Ministry of Finance; and Fund staff estimates.
Figure 1.
Figure 1.

Colombia Actual and Potential GDP

(In billions of Colombian pesos)

Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A007

Sources: Colombian authorities; and Fund staff estimates.

108. To account for these possible deficiencies, an alternative estimate of potential output was used which is based on the work by Prieto and Rodriguez (1997).41 Their analysis was based on the “production-function” approach, which explicitly models output in terms of underlying factor inputs, and involves specifying and estimating a production function linking output to capital, labor, and total factor productivity. Potential output was calculated as the level of output that results when the rates of capacity utilization are normal,” when labor input is consistent with the natural rate of unemployment, and when total factor productivity is at its trend level. Although this methodology clearly corrects for some of the deficiencies of the Hodrick-Prescott technique—particularly the ability to account for permanent shocks to potential output—the calculations are contingent on reliable information on capital stock and labor force participation as well as sometimes arbitrary assumptions on the technique for adjusting the latter to its “full-employment” level. According to this approach, growth in potential output in Colombia averaged 5.5 percent during 1993-97—somewhat higher than indicated by the Hodrick-Prescott technique.42

109. Based on the above estimates, the note uses two scenarios of potential GDP growth, one assuming 4 percent and the alternative assuming 5.5 percent a year. Regardless of the scenario used, the potential and actual level of GDP would appear to have been approximately equal around 1992-93. For this note, the levels of actual and potential GDP in Colombia are assumed to have coincided in 1993.

D. Results

110. Estimates of actual and potential GDP are shown in Figure 1, assuming potential real GDP growth of 4 percent and 5.5 percent and assuming 1993 as the base year. According to both measures, the output gap was strongly positive from early 1994 through the first half of 1996 and turned negative thereafter. The production function-based measure of potential output points to a larger output gap in 1997 (4.1 percent) than that based on the Hodrick-Prescott filter (1.3 percent). On the basis of projected real GDP growth of just under 3 percent in 1998, the two measures point to existing output gaps of 2 percent and 4.7 percent, respectively.

111. Table 1 summarizes the actual fiscal balance, the fiscal stance, and the year-on-year fiscal impulse under each scenario. In both scenarios, the cyclically neutral fiscal balance is estimated to have been positive (a surplus) during the high growth years 1994-95. Instead, the actual stance was in balance in 1994 and showed a deficit in 1995, indicating that the fiscal stance was expansionary. As output growth subsequently slowed relative to potential in 1996, the cyclically neutral balance swung into a deficit and started to narrow its difference with the actual balance. This implies that while the fiscal stance remained expansionary relative to the base year 1993, the fiscal impulse was about neutral in 1996 relative to the year before according to both measures of potential output. Despite the continued output gap in 1997 which resulted in a widening of the cyclically neutral deficit, the fiscal stance appeared to have been strongly expansionary in that year, as the public sector balance deteriorated well in excess of that estimated on the basis of cyclical factors. For the central administration, the shortfall of the actual balance with respect to the cyclically neutral balance was reduced in 1997, as an increase in the cyclically neutral deficit was accompanied by a contraction in the actual deficit.

E. Caveats

112. A number of caveats should be considered in interpreting these results. First, the cyclically neutral budget is calculated under the assumption of unitary elasticities of expenditure and revenue with respect to actual and potential output, as noted previously. In practice, however, the elasticity of tax revenues with respect to output is, as an empirical matter, not equal to unity in most countries and is likely to vary with the rate of inflation, reflecting inter alia the effects of progressivity and administrative lags in collection.

113. Second, the above analysis does not consider the general equilibrium conditions for sustainable growth and external and internal balance. This means that there is no assurance that the elimination of the output gap and achievement of a neutral fiscal impulse would be consistent with external viability over the medium term at existing relative factor prices. More specifically, there has been a significant increase in the structural fiscal deficit in recent years which is expected to continue over the medium term reflecting (i) fiscal decentralization; and (ii) an increased burden of the pension system on the public finances.

38

Prepared by Reva Krieger

39

Asset sale receipts are excluded, as are nonrecurrent revenues from telephone concessions.

40

The methodology follows Heller, Peter S, et al., “A Review of the Fiscal Impulse Measure,” International Monetary Fund, Washington D.C., May 1986.

41

Prieto, William O.B., and Norberto Rodriguez, “Una Aproximación al PIB Potencial en Colombia: El Enfoque de Una Función de Productión,” mimeo, Banco de la República, September 1997.

42

Although the estimated degree of slack in the Colombian economy at end-1997 may appear low in comparison with the actual unemployment rate, several studies point to a large structural component to unemployment in Colombia, i.e., one that is invariant to deviations of aggregate output from potential. For example, Henao and Rojas (1998) estimate the natural rate of unemployment to have been about 10.5 percent during the period 1982-96; see Henao and Rojas, “La Tasa Natural de Desempleo en Colombia,” National Planning Department Working Paper No. 89, July 1998. A recent study by the IDB found that only about one-fifth of the current unemployment rate is Colombia is attributable to cyclical factors, with the remainder reflecting structural and frictional elements; see IDB, “Desempleo en Colombia,” IDB mimeo, 1998.