Costa Rica: Selected Issues and Analytical Notes

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

III. Assessing Fiscal Vulnerability and Medium-Term Sustainability1

This note presents Costa Rica’s fiscal position and the outlook for the medium and long term, discusses the need for fiscal adjustment, and assesses the optimal pace of fiscal consolidation. The main conclusion is that the threat of unsustainable public debt dynamics calls for early corrective action. A moderately front-loaded adjustment would strike the appropriate balance between achieving fiscal sustainability and maintaining robust growth. Postponing fiscal consolidation further could endanger macroeconomic stability.

1. The fiscal position of the central government has deteriorated sharply in recent years and attempts to correct it have been unsuccessful so far. After posting a small surplus in 2008, the fiscal balance of the central government turned into a deficit of 5½ percent of GDP by 2010. The fiscal position worsened as a result of an endogenous fall in revenue (which was above trend in 2008) and a sharp increase in expenditure (mainly wages and transfers) on account of countercyclical policies implemented in response to the 2008–09 crisis. The efforts to restrain public spending in 2011 mainly through cuts in capital expenditure were undermined by rising transfers and interest bill in 2012–13. Meanwhile revenues stagnated as a tax reform aimed at placing the public sector balance on a sustainable path was voided by the Supreme Court in 2012 due to procedural irregularities with its approval by Congress. As a result, central government deficit returned to 5½ percent of GDP in 2013, well above debt stabilizing levels, and debt reached 36 percent of GDP (up from 25 percent of GDP in 2008).

A03ufig1

Fiscal Balances of the Central Government

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: National authorities and Fund staff estimates.

2. Trends in the other levels of government have been more stable. The deterioration in the fiscal situation has been driven by developments at the central government level. The pay-as-you-go social security system (CCSS) currently has a small surplus—about 0.75 percent of GDP in 2013, while public sector enterprises have been broadly in balance since 2010. The central bank has a small deficit—of about 0.75 percent of GDP—as a result mainly of interest expenses on securities issued for liquidity management purposes (AN 4). The analysis of fiscal vulnerabilities, medium-term sustainability issues, and related adjustment needs in the remainder of this analytical note focuses on the central government, while also briefly discussing longer-term sustainability issues in the social security system.2, 3

A03ufig2

Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: National authorities and Fund staff estimates.

3. The new government acknowledges the need for fiscal consolidation, but the announced measures are insufficient to bring the debt to a sustainable path. After the nullification of the 2012 tax reform, the previous administration prepared a fiscal consolidation plan with total adjustment of about 3½ to stabilize debt in the medium-term, broadly in line with previous staff recommendations.4 However, the plan was not implemented before the 2014 elections. The new administration, which took office in May 2014, has formulated a proposal to consolidate public finances by about 4 percent of GDP. The initial focus of the plan was on reducing tax evasion and exemptions, while also introducing some expenditure cuts. The staff’s assessment of the measures at a more advanced stage of elaboration—including broadening of the VAT base to include services and basic goods at a preferential rate, cuts in transfers and partial hiring freeze in 2015, and a move to a global income tax—is that they are likely to yield about 2¼ percent of GDP.5 Under this baseline scenario of fiscal consolidation, the central government deficit would stay close to 6 percent of GDP and public debt would continue rising to about 51 percent of GDP by 2019.

4. Large gross financing needs make Costa Rica vulnerable to changes in market sentiment, although a stable domestic investor base mitigates risks. Sustained high fiscal deficits and substantial amortizations coming due result in large projected gross financing needs of 10½ and 12 percent of GDP in 2014 and 2015 respectively.6 While these large financing needs expose Costa Rica’s public finances to changes in market sentiment, the existence of a stable domestic investor base mitigates risks. Notwithstanding increased Eurobond issuance in recent years, domestic debt still represents about 80 percent of total central government. Moreover, about 60 percent of domestic debt is held by local institutional investors, including the CCSS, nonfinancial public sector institutions, and banks.

5. Sovereign credit risk perceptions are moderate but could intensify, especially after the recent loss of investment grade rating. Spreads on Costa Rican external sovereign bonds are about 350 basis points, at the mid-point between the highest-rated countries in Latin America and lower rated countries like El Salvador, Ecuador, and Jamaica. Costa Rica is the only country in the region, together with Venezuela, where spreads are now noticeably higher than before the start of the U.S. tapering tantrum in May 2013. The country appears particularly vulnerable to renewed episodes of financial volatility related to U.S. monetary policy normalization, given its fiscal vulnerabilities (AN2). Costa Rica lost its only investment grade rating in September, with rating agencies lamenting continued weakness in the fiscal position and political obstacles to fiscal reform.7 The risk of a debt spiral with potentially non-linear increases in financing costs cannot be discarded if debt continues to rise unabated.

A03ufig3

External Bond Spreads

(Basis points)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: Bloomberg and Fund staff estimates.
A03ufig4

Latin America: Public Debt Expected in 2019 and External Debt Spreads

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Source: WEO, Bloomberg and Fund staff estimates.

6. There are substantial upside risks to the projected debt path. A plausible macro-fiscal shock as defined in the Fund’s DSA framework for market access countries would result in central government debt reaching 61 percent of GDP by 2019, 10 percent above the level in the baseline scenario (DSA Annex to the staff report).8 Debt dynamics are most sensitive to a growth shock, with an isolated one standard deviation shock to growth in 2015-16 resulting in an increase in central government debt of about 6 percent of GDP by 2019 relative to the baseline scenario.9 A fiscal shock equivalent to an additional 1¼ of GDP increase in the primary deficit in 2015-16 would increase debt by about 3 percent of GDP by 2019, while a sizeable shock of 200 basis points to the average real interest rate at which the government borrows would raise the debt-to-GDP ratio by less than 2 percentage points of GDP.10 The sensitivity of public debt to currency depreciation is limited, with a 15 percent depreciation in the nominal exchange rate having an impact on debt of less than 1 percent of GDP by 2019.11 A stochastic simulation of the debt path also produces a median debt forecast slightly higher than in the baseline—about 53 percent of GDP—while the probability that debt rises to above the 60 percent of GDP projected in the combined macro-fiscal shock is greater than 10 percent according to the simulation.12

A03ufig5

Gross Nominal Public Debt

(percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Source: Fund staff estimates.
A03ufig6

Fan Chart Evolution of Debt-to-GDP ratio

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Source: Fund staff estimates.

7. To ensure medium-term sustainability and build resilience to shocks, Costa Rica needs to pursue fiscal consolidation of at least 3¾ percent of GDP. Frontloaded gradual adjustment of this magnitude would bring the central government deficit to about 3½ of GDP and stabilize debt just below 45 percent of GDP by 2019, about 2½ and 6 percentage points below the baseline, respectively.13

  • Projected continued deterioration in the primary deficit contributes to increase adjustment needs. The primary deficit is projected to rise from 2.8 percent of GDP in 2013 to 3.1 and 3.6 percent of GDP in 2014 and 2015, respectively, in the passive scenario without fiscal consolidation.14 This reflects mostly a constitutional provision to raise expenditure on education, which increases the need for adjustment in other parts of the budget (Table 1). 15

  • Stabilizing the debt-to-GDP ratio by 2019 requires reaching primary balance. The adjustment scenario assumes that real interest rates converge to real GDP growth at potential over the medium-term, implying that reaching primary balance by 2019 would suffice to stabilize debt. The underlying assumption is that increases in market rates induced by U.S. monetary policy normalization are mitigated by the authorities’ commitment to a credible fiscal adjustment plan.16

  • Risks to the total adjustment needs are tilted to the upside. The fiscal sustainability gap, defined as the difference between the primary balance in a passive scenario and the debt stabilizing primary balance is estimated at 3¾ percent of GDP. (Table 1) Shortfalls in the implementation of fiscal consolidation, as in the staff’s baseline scenario with more limited and backloaded adjustment, would increase the size of the total adjustment needed, while also stabilizing the debt ratio at a higher level. The total adjustment eventually needed would also be larger if the authorities maintained the commitment to raise education expenditure to 8 percent, or if greater than expected market turbulence in context of U.S. policy normalization resulted in less favorable than assumed market reaction to consolidation plans.

A03ufig7

Overall Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: National authorities and Fund staff estimates.
A03ufig8

Public Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: National authorities and Fund staff estimates.

Costa Rica. Fiscal Sustainability Gap

(In percent of GDP, unless otherwise stated)

article image
Source: Fund staff estimates.

In passive scenario with no adjustment, the primary deficit is projected to reach 3.1 percent of GDP in 2014, and increase another 0.5 percent of GDP in 2015. Increase in primary deficit projected for 2016-19 is related to continued but partial progress toward Constitutional target of S percent of GDP for expenditure on education.

A03ufig9

Real GDP Growth and Interest Rate

(Percent)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: National authorities and Fund staff estimates.
A03ufig10

Primary Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: National authorities and Fund staff estimates.

8. Gradual but frontloaded fiscal consolidation would strike an appropriate balance between lowering the sustainability gap and limiting the adverse impact on growth.

  • To gauge the optimal fiscal consolidation path, we resort to a model of quadratic preferences in which the authorities’ relative preferences for closing the fiscal sustainability gap and the output gap are taken into account.17 The moderate output gap before the start of the adjustment period—½ percent of GDP negative gap projected for 2014—relative to the large sustainability gap implies that more than one third of the total adjustment should be effected in 2015 according to the model even if the authorities have strong preferences for minimizing the effect on growth (Table 2).18

  • A simple illustration of the cost-benefit of fiscal consolidation based on typical fiscal multipliers observed in the region shows that gradual frontloaded consolidation succeeds in substantially moderating the increase in debt19—more than 10 and 15 percentage points of GDP lower by 2019 in the baseline and adjustment scenarios relative to a passive scenario—at a relatively low cost in terms of foregone output growth—about ½ and ¼ percentage points of GDP of cumulative output loss by 2019.

  • More sophisticated estimates using a general equilibrium model for Costa Rica yield similar results indicating a relatively small output cost of closing the sustainability gap over the medium term.20 The model incorporates the mitigating effects of the monetary policy response to the small additional output gap that opens up as a result of the adjustment, as well as the benefits of assumed improvements in the sovereign-risk premium as market perceptions improve following the consolidation. The long-term effects of these favorable developments—especially the lower risk premium—imply that output would actually be higher over the longer term in the baseline and full adjusment scenarios, compared to a passive scenario.

Costa Rica: Optimal Fiscal Consolidation Path Under Model of Quadratic Preferences 1/2/

(In percent of GDP, unless otherwise stated)

article image
Source: Fund staff estimates.

Assuming that the authorities place 90 percent weight on growth objective.

See footnote 18 in main text for explanation of differences between these model results and actual adjustment path recommended in the staff report.

A03ufig11

Growth and Public Debt

(Percent)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: National authorities and Fund staff estimates.1/ Gradual adjustment scenarios based on model of fiscal adjustment based on authorities’ preferences for growth and fiscal objectives.
A03ufig12

Public Debt

(Difference with Passive Scenario, Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: Fund staff estimates.
A03ufig13

Real Output

(Difference with Passive Scenario, Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Sources: Fund staff estimates.
Figure 1.
Figure 1.

Costa Rica: Long-Term Fiscal Sustainability

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Source: Fund staff estimates and projections.1/ This path is the baseline through 2019, with a constant primary balance thereafter.2/ The immediate and gradual adjustment scenarios aim at closing the same initial sustainability gap with consolidation starting in 2015 in both scenarios. The debt stabilizing primary balance is calculated based on medium-term baseline projections of real interest and growth rates under the adjustment scenario; these are maintained constant over the projection period in line with the requirements of the optimization model. The gap is then measured relative to the 2014 projected fiscal outturn.3/ The gradual scenario assumes that the authorities place 90 percent weight on growth objective. Impact of growth is based on fiscal multiplier of 0.3, with a self-correction parameter for the output gap of 0.5, implying that the effect on the output gap of a fiscal adjustment of 1 percent of GDP almost dissipates—is less than 0.1 percent of GDP—in the second year following the adjustment.4/ The immediate adjustment scenario assumes that the full fiscal adjustment takes place in 2015 and has no impact on growth.

9. The required fiscal adjustment rises by an additional 1½ percentage point of GDP if the actuarial deficit facing the public pension system is considered. The largest program in Costa Rica’s pension system is a pay-as-you-go defined-benefit plan covering Old Age, Disability and Survivor Insurance (Invalidez, Vejez y Muerte –IVM) administered by the Social Security Fund (Caja Costarricense de Seguro Social—CCSS), an autonomous public sector institution.21 The system currently runs a cash surplus of ¾ percent of GDP, but is projected to turn a cash deficit over the medium and long term due to system maturation and population aging. Simulations indicate that, to achieve actuarial balance, pension reforms equivalent to about [1½] percent of GDP would be required in the form of higher contributions, reduced replacement rates, and/or an increase in the retirement age.

10. Fiscal consolidation will require action on both revenue and expenditure sides. The significant size of the required adjustment calls for a multipronged strategy, aimed at increasing revenue and restraining the pace of growth of expenditure (Table 3).

  • As in other Central American countries, revenue mobilization should be the cornerstone of fiscal consolidation. Tax revenues are generally low in the region compared to other middle-income countries.22

  • While the authorities’ actions to strengthen tax compliance—including the draft anti-tax evasion law recently submitted to parliament—are welcome, international experience with such initiatives suggests that yields tend to be uncertain and far from immediate. The fact that tax evasion rates in Costa Rica are broadly in line with regional averages supports the assessment that tax evasion measures are unlikely to have higher yields than suggested by international experience.

  • Therefore, it will be critical to approve planned measures to reduce sizeable tax expenditures, both in the VAT—extending coverage to services and selected basic goods and services—and in the income tax—with a move from schedular to global taxation system. Gradual increases in the VAT tax rate (from 13 to 15 percent) and in marginal income tax rates on higher income brackets as part of the move to global determination of the income tax liability will also be needed in outer years of the adjustment program given large adjustment needs.23 24

    A03ufig14

    Tax Revenue, 2010

    (Percent of GDP)

    Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

    Sources: National authorities and Fund staff estimates.
    A03ufig15

    Tax Evasion Rates

    (Percent)

    Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

    Sources: Corbacho, Fretes Cibils, and Lora (2013); CAF (2012); Cardoza (2012); Jiménez, Gómez Sabaini and Podestá (2010); Pecho, Peláez and Sánchez (2012); and Salim (2011).
    A03ufig16

    Tax Expenditure in Central America

    (Percent of GDP)

    Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

    Sources: WGTC; Sabatini, Pecho, Moran: ‘Los gastos tributarios en Honduras, 2013; national authorities and Fund staff estimates.

  • Substantial measures are also needed on the expenditure side, especially to reverse part of the increase in the wage bill as a share of GDP that was a big driver of the fiscal deterioration since 2008. Modifying indexation to prevent automatic real salary increases and a gradual reduction in government employment will be critical to contain the wage bill. Enforcing legal pension caps and increasing contribution rates in the special pension regimes for civil servants and teachers paid out of the budget could also contribute significantly to the consolidation package. The objective of raising expenditure on education to 8 percent of GDP could also be reconsidered, given that current expenditure levels are already in line with more advanced OECD countries, and there appears to be significant scope for increasing efficiency.25 Over the medium term, reform of the private pension system to address its actuarial imbalance should also be considered—including larger contributions, lower replacement rates, and higher retirement age.

A03ufig17

Public Expenditure on Education as Percent of GDP vs. GDP Per Capita, PPP (Constant 2005 International $)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A003

Source: World Bank and Fund staff estimates.

Costa Rica: Fiscal Consolidation Measures

(In percent of GDP)

article image
Source: Fund staff estimates.

The baseline scenario incorporates staff’s assessment of measures in the authorities’ fiscal plan that are at a more advanced stage of elaboration. Includes expenditure cuts equivalent to 0.3 percent of GDP, other cuts in transfers, a partial hiring freeze, broadening of the VAT base from the second half of 2015, a move towards global income tax, miscellaneous cuts in exemptions, and moderate gains from improvements in tax evasion.

The full adjustment scenario includes additional measures in the authorities’ plan that were at a less advanced stage of elaboration at the time of the Article IV mission. Includes measures as in the baseline scenario as well as measures to contain growth in the wage bill, and increases in the VAT rate and marginal income tax rates in outer years.

Includes mainly effects of 2014 anti-tax evasion law.

Includes measures envisaged in draft law that would reduce exemptions on income tax for cooperatives and public entities, as well as reinstate an excise on lottery sales.

Baseline projection includes extending VAT coverage to services sector, with basic goods and private education and health taxed at preferential rate of 2 percent. Additional measures include gradual increase from 13 to 15 percent tax rate.

Baseline projection includes move from schedular to global basis for income tax. Additional adjustment measures include gradual increase in marginal rates on higher income brackets.

Baseline projection includes partial hiring freeze. Additional adjustment measures include freezing salaries in real terms.

Baseline projection includes cuts in transfers in the 2015 budget. Additional measures include enforcement of the legal cap on pensions paid out of the budget.

Costa Rica. Fiscal Consolidation Path

(In percent of GDP)

article image

References

  • Estevao, M., and Samake, I., 2013, “The Economic Effects of Fiscal Consolidation with Debt Feedback,” IMF Working Paper 13/136 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Garza, M., Morra, P., and Simard, D., 2012, “The Fiscal Position: Prospects and Options for Adjustment,” Central America, Panama and the Dominican Republic, Challenges Following the 2008–09 Global Crisis (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Kanda, D., 2011, “Modeling Optimal Fiscal Consolidation Paths in a Selection of European Countries,” IMF Working Paper 11/164 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

1

Prepared by Jaume Puig-Forné, Patrick Blagrave, Lennart Erickson, and Anna Ivanova.

2

The analysis of debt sustainability at the central government level abstracts from the fact that the social security system holds a non-negligible part of this debt (about 16 percent), as maintaining the capacity of the central government to service and repay this debt is also important for the long-term sustainability of the social security system.

3

The DSA Annex to the staff report includes a DSA for the consolidated public sector. Resulting adjustment needs are lower than at the central government level, given lower primary deficits and lower average interest rates at the consolidated level.

4

The total adjustment was estimated as the difference between the projected primary deficit in 2019 absent fiscal consolidation measures, and a debt stabilizing primary balance of zero, assuming real interest rates in line with real growth in the medium term. The projections included increases in education expenditure broadly in line with constitutional requirement to raise these expenditures from 7.2 percent in 2013 to 8 percent of GDP.

5

The estimate of the additional income from the move from schedular to global approach for the income tax is based on the proposal in the previous administration’s fiscal reform plan, The new administration has indicated the intention to introduce a more ambitious reform that would in the staff’s view still require increases in marginal tax rates on higher income brackets, but details of the proposal still need to be fleshed out.

6

The average maturity of Costa Rica’s central government debt stands at about 6 years.

7

Costa Rica is the highest rated credit in Central America, after Panama. After the recent loss of its only investment grade rating by Moody’s, the sovereign is now rated one (Moody’s and Fitch) to two notches (S&P) below investment grade. Fitch also warned in September of downside risks to its current rating for the same reasons cited in Moody’s downgrade.

8

The combined macroeconomic shock incorporates the largest effect on relevant variables (growth, inflation, primary balance, exchange rate and interest rate) of standard individual shocks in the Fund’s DSA for market access country including: a fiscal shock equivalent to 50 percent of planned cumulative adjustment or to half of a standard deviation of historical observations of the primary balance, whichever is greater; 1 standard deviation shock to real GDP growth for 2 consecutive years; a nominal interest rate increase by the difference between the maximum real interest rate over the last 10 years and the average real interest rate over the projection period, or a 200 basis point shock, whichever is larger; and a shock to the exchange rate equivalent to the correction of the Fund’s estimate of real exchange rate overvaluation, or maximum historical depreciation of the exchange rate, whichever is the highest.

9

The growth shock would result in growth of 0.9 and 1.5 percent in 2015 and 2016 respectively, implying a less severe shock than the one-year economic contraction of 1 percent in 2009 in the context of the global financial crisis.

10

The fiscal shock is moderate compared to the increases in primary deficit over the last few years. The interest rate shock is double the peak 100 basis points widening in Costa Rica’s external spreads following the taper tantrum of May 2013.

11

This shock compares with actual peak depreciation of about 13 percent during the first few months of 2014. If sustained, the effect of the exchange rate shock on refinancing of external debt would be greater over the longerterm, given that Costa Rica’s external debt is of a longer maturity than the standard DSA’s 5-year horizon. The share of foreign-currency denominated debt in total central government debt stood at 31percent at end-2013.

12

The stochastic simulation of the public debt path is constructed by producing frequency distributions of debt paths under shocks to real GDP growth, effective real interest rate, primary balance and the change in real exchange rate based on historical variances.

13

The optimal nature of a gradual frontloaded fiscal consolidation path is discussed further below.

14

According to the draft 2015 budget submitted to Parliament.

15

Staff projections assume only partial fulfillment of commitment to raise education spending to 8 percent of GDP over the medium term, in line with advice from the World Bank to increase efficiency of spending on education (see below).

16

Interest rate projections in the adjustment scenario assume some gradual tightening in spreads vis-à-vis U.S. rates. This compares favorably with the assumption in the baseline that spreads tend to also rise when U.S. rates rise, consistent with recent experience during the 2013 taper tantrum (AN 2).

17

Quadratic preferences imply that the pressure to act to reduce the output and sustainability gaps increases in a nonlinear fashion with the size of the gap. For the detailed methodology, see Kanda (2011).

18

The quadratic model is used to illustrate the desirability of a gradual but frontloaded adjustment to meet the dual but conflicting objectives of closing the sustainability and output gaps. The actual adjustment path recommended in the staff report (Table 4) is based on the results of the model (Table 2), but differs slightly from this in three ways. First, the fiscal sustainability gap driving the total recommended adjustment in the staff report is larger than in the quadratic model as it incorporates projected continued fiscal deterioration that would bring the medium-term sustainability gap to 3¾ percent of GDP under the passive scenario—due mostly to the increased expenditure on education. In contrast, the quadratic model estimates the sustainability gap based only on the fiscal situation before the start of the fiscal adjustment—i.e. the projected primary deficit of 3.1 percent of GDP in 2014—as fiscal projections are generated endogenously in the model after that. Second, the adjustment path in the staff report assumes that the full sustainability gap is closed by 2019, consistent with the objective of stabilizing debt by the end of the projection period. In contrast, the quadratic model by construction optimizes again in every period, and hence the adjustment is in principle spread over an infinite period albeit with smaller and eventually irrelevant adjustments over time. Third, the adjustment path in the staff report is adjusted relative to model results to take into account the potential sequencing of fiscal reforms given existing political constraints, such as the electoral commitment not to raise tax rates until 2016—hence implicitly allowing for a slightly lower preference for closing the sustainability gap than in the model simulation.

19

The estimated effect on growth is based on a fiscal multiplier of 0.3, which may be high for a consolidation package that relies mostly on revenue measures (see below): Estevao and Samake (2013) find that the medium-term effect of fiscal consolidation on output can be positive in most Central American countries, especially if it is based on increases in tax revenues or cuts in current spending. They estimate that the contemporaneous impact multiplier in the adjustment year ranges from 0 to 0.4 for spending cuts, while tax multiplier estimates are closer to zero and not statistically significant. The estimated output costs of ½ percentage points of GDP is also conservative in that it does not assume self-correction of the additional output gap that opens up as a result of consolidation.

20

See brief description of the general equilibrium model in AN 2.

21

The IVM currently covers ⅔ of the labor force (approximately 1½ million workers) and has about 165,000 beneficiaries. In addition to the IVM, the judiciary and the teachers have their own social security plans.

22

For a more detailed discussion, see Garza, Morra and Simard (2012).

23

A schedular income tax—where gross income, deductible expenses, and tax rates are determined separately for each type of income—is more likely to be exploited by taxpayers engaging in tax planning and restructuring, and is also less amenable to progressive taxation. Under a pure global income tax system, all income and expenses are considered together to arrive at a single net gain that is subject to tax.

24

The average value-added tax rate in Latin America is about 14 percent. The increase in marginal income tax rates on higher-income brackets can help compensate for any distributionally regressive impact of hiking VAT rates

25

A recent social sector expenditure review conducted by the World Bank found that efficiency of education expenditure is at the low end of the Latin America region. The education wage bill is high by international standards, including a substantial portion on administrative salaries, and learning outcomes are below those of other countries with comparable GDP per capita.

Costa Rica: Selected Issues and Analytical Notes
Author: International Monetary Fund. Western Hemisphere Dept.