Colombia: Selected Issues Paper

International Monetary Fund. Western Hemisphere Dept.

doi:10.5089/9781513546261.002.A001

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Colombia: Selected Issues Paper

Author: International Monetary Fund. Western Hemisphere Dept.

Publication Date:: 08 Jun 2015

eISBN:: 9781513546261

Language:: English

Keywords:: ISCR; CR; labor market; enterprise; youth entrepreneurship strategy; Colombia's experience; paper reviews Colombia's success; skill gap; Colombia's success; Income; Income distribution; Global

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Colombia: Selected Issues Paper

Abstract

Colombia: Selected Issues Paper

Overview¹

1. Colombia has enjoyed several years of macro-financial stability and strong growth, which supported improvements in the labor market and social conditions. Economic growth in Colombia has been among the highest in Latin America during the last several years, underpinned by macroeconomic stability and a strong policy framework, including an inflation-targeting regime, a flexible exchange rate, and fiscal policy guided by a structural balance rule. Prudent financial supervision and regulation have supported financial deepening and macro-financial stability. Colombia’s broad-based growth has underpinned important gains in social indicators, including a decline in poverty, inequality, and unemployment.

2. Against the backdrop of a dimmer external outlook, Colombia’s key medium-term challenge will be to preserve macroeconomic stability while sustaining strong and inclusive growth. Colombia faces significantly weaker terms of trade and potentially less favorable external financial conditions. In addition, growth prospects in trading partners, including other emerging market countries have weakened. As in other countries, Colombia faces the challenge of achieving “high quality growth” that reduces social gaps such as income inequality. Structural reforms and continued improvements in the macroeconomic and financial frameworks will be important for supporting medium growth, offsetting the headwinds from external conditions.

3. This Selected Issues Paper addresses key areas that would contribute to maintaining macroeconomic stability and inclusive growth:

Labor market and structural reforms to achieve inclusive growth.
Reducing infrastructure gaps through an ambitious investment program.
Recent progress and remaining challenges in financial inclusion and the financial regulatory and supervisory framework, and improvements in the quality of capital.

4. Strong economic growth in Colombia has significantly reduced poverty, but has had limited impact so far on reducing inequality. As in other countries, the performance of the labor market affects not only efficiency (growth) but also income distribution, including through informality and skill formation (Chapter 1: Colombia’s Experience with Inclusive Growth). Strong growth and social programs have helped reduce poverty. Going forward, efforts to further strengthen education, pension and tax systems stand to yield important social gains, as recognized by the national development plan.

5. Labor market distortions have declined in recent years, but challenges remain. The reduction in labor market distortions—estimated through a reduced-form real business cycle decomposition—has had a quantitatively important association with GDP, investment, and employment growth (Chapter 2: The Role of Labor Market Frictions in the Recent Economic Performance of Colombia). In addition, the sensitivity of the unemployment rate to GDP growth in Colombia has declined (Chapter 3: Unemployment-Growth Trends in Colombia and Selected Emerging Markets). The Okun’s coefficients seem to be related to the level of informality, size of the agricultural sector, and education attainment. These trends in aggregate employment developments can, however, mask large differences across social groups. Chapter 4 (Youth Entrepreneurship Initiatives in Colombia) reviews ongoing public and private sector efforts to tackle high youth unemployment, which is considerably higher than overall unemployment, as in other many other countries, with an emphasis on youth entrepreneurship.

6. The elimination of infrastructure gaps will play a key role in sustaining strong and broad-based growth, and supporting further economic diversification. Relatively weak road infrastructure represents an important obstacle not only for overall GDP growth, including through export diversification, but also for achieving a more evenly-distributed economic performance across regions in Colombia. Chapter 5 (Infrastructure Investment in Colombia) reviews recent progress in setting the proper conditions to foster private sector participation in infrastructure investment, so as to ensure efficient allocation of risks and macrofinancial stability.

7. Financial inclusion is an important element of inclusive growth, and also contributes to financial stability. Chapter 6 (Informal Finance and Financial Inclusion Policies in Colombia) discusses the success that Colombia has achieved in financial inclusion. Informal finance, typically associated with not having access to traditional financial products, remains widely used. Factors such as age, work status, income, education and financial knowledge are key determinants of the observed used of this type of financing. A richer set of information on financial inclusion and informal finance, including through expanding existing household surveys, would allow a deeper assessment of existing programs and remaining challenges.

8. The authorities continue to further improve the regulatory and supervisory framework of the financial system. The 2012 FSAP found Colombia’s financial system to be sound and resilient to a variety of shocks, but it also indentified key areas that warrant further strengthening, especially in connection with the importance of complex financial conglomerates and cross-border connections. Chapter 7 (Colombia 2012 FSAP Recommendations Status and Implementation Report) takes stock of measures being made to address FSAP recommendations and finds overall good progress.

9. Colombia continues to strengthen bank capital in order to further enhance the loss absorbing capacity of the financial sector. The quality of capital has been strengthened considerably in recent years, including after an enhanced capital measure was introduced in 2012. The needs for high-quality loss-absorbing capital buffers has increased in recent years as Colombian banks, either as part of banking groups or as part of financial and mixed conglomerates, have expanded operations into Central America and parts of Latin America. Chapter 8 (Colombian Banks’ Capital) discusses bank capital adequacy from a cross-country perspective and in connection with the characteristics of Colombia’s banking system, and also documents ongoing efforts to fully introduce Basel III capital definitions to enhance the quantity and quality of capital.

Colombia’s Experience with Inclusive Growth¹

Colombia has achieved remarkable gains in poverty reduction in the last decade. However, reductions in income inequality have been more limited. This chapter summarizes the existing literature that studies Colombia’s experience, pointing toward education, labor, pension and fiscal issues as key explanatory factors behind these outcomes.

A. Introduction

1. Achieving strong and inclusive growth represents a global challenge. The medium-term global growth outlook is generally favorable but also uneven, with emerging markets facing gloomier growth prospects this year relative to last, even as advanced economies are projected to pick up. As many emerging markets still face relatively high levels of poverty and inequality, a key priority remains to achieve “high quality” inclusive growth. For financially-integrated commodity exporters, such as Colombia, well-designed structural reforms could help offset the headwinds to growth arising from a subdued outlook for commodity prices and less favorable global financial conditions.

2. Recent research shows that reducing inequality and strengthening growth could be mutually reinforcing objectives. According to Ostry, Berg, and Tsangarides (2014), lower inequality leads to higher and more durable growth (see also Berg, and Ostry, 2011). Similarly, Dabla-Norris and others (2015) find that increasing the income of the bottom 20 percent of the population can enhance growth, whereas more concentration among the top 20 percent would reduce growth. These results suggest that Colombia may benefit from higher and more even growth by implementing policies to reduce inequality.

3. During the last decade, economic growth in Colombia has been “pro-poor” but to a lesser extent, inclusive. Growth can be considered as “pro-poor” if it is conducive to a reduction in poverty (Ravalion and Chen, 2003) and can be defined as inclusive if it reduces income inequality (Rauniyar and Kanbur, 2010). In Colombia, poverty has declined markedly since the late 1990s (from 50 percent in 2002 to 28½ percent in 2014 using the national definition), underpinned by both skillful macroeconomic policies and well-targeted social programs. Nonetheless, the benefits of stronger growth have not resulted in equally strong reductions in income inequality (the Gini coefficient declined only from 57.2 percent in 2002 to 53.8 percent in 2014), and inequality in Colombia remains among the highest in the world.

4. This paper reviews Colombia’s success in poverty reduction during the last decade, and examines the main drivers of inequality. The paper builds upon previous studies on Colombia but also draws from cross-country experiences that have documented key determinants of both poverty and inequality. The paper first focuses on the relation between poverty and growth, including the role of social programs. Second, in line with the most important determinants of income inequality according to the literature, the paper examines issues related to the labor market, education, pensions, and fiscal policy.

B. Pro-Poor Growth

5. The deep economic crisis of the late 1990’s led to a large increase in poverty and a strong reduction of the middle class.² In 1999, Colombia suffered the worst economic crisis in recent years driven by a sharp reversal of capital inflows around the time of the Asian and Russian crises. Real GDP fell by 4.2 percent, the unemployment rate reached 20 percent, and poverty skyrocketed to 60 percent of the population (defined as people living under US$4 a day, PPP). Further, the middle class (US$10 to US$50 a day, PPP) shrank to 11 percent, from 20 percent in early 1990s.³ As a result, the crisis reshuffled the structure of the society, displacing the majority of the population into either poverty or into a state from which there was a 10 percent probability to fall into poverty (also referred as vulnerable state). After the crisis, the middle class took off, but persists as one of the lowest in the region (Angulo, Gaviria and Morales, 2013).

6. Growth has been “pro-poor” since the crisis, helping to lift many people out of poverty. In response to the crisis, the government implemented a comprehensive reform package, in coordination with the Fund, which helped restore macroeconomic stability.⁴ The combination of the reform package, successful efforts to improve the security situation, and favorable terms of trade underpinned growth in the last decade and helped reduce poverty rates and restore the middle class in Colombia. GDP per capita improved dramatically starting in 2003. The income of the bottom 40 percent of the population has been growing faster than average income, with major gains occurring toward the end of the 2000s. Consequently, poverty rates (national definition) declined rapidly, from about 50 percent in 2002 to 28.5 percent in 2014. Further, under a uniform cross-country definition (US$4 per day, PPP), Colombia’s poverty rate was almost halved from 2001 to 2013, to about 31 percent, which represents a slightly stronger poverty reduction than the regional average.

7. Social transfers have been a key factor contributing to poverty reduction. The share of transfers in household income of the poorest doubled during 2000–10 and reached 20 percent, which is a level that exceeds the regional average (Azevedo, et al., 2013). Cord, Genoni and Rodríguez-Catalán (2015) estimate that between 2002–13, transfers accounted for 39.7 percent of the reduction in extreme poverty (US$2.5 per day, PPP) and 16.8 percent of the reduction in moderate poverty (US$4 per day, PPP) in the country (see Appendix for an overview of key social programs).

8. Recent research also confirms the central role that economic growth has had in reducing poverty. Cord, Genoni and Rodríguez-Catalán (2015) decomposed reductions in poverty across Latin America during 2003–12 into the contributions from income growth and changes in the income distribution. The methodology is as follows. Poverty is measured as US$4 income per day (PPP). The contribution from income growth refers to changes in poverty due to changes in the mean of the income distribution while keeping constant all other aspects of the distribution of income as in the base year (2003). In turn, the contribution from income redistribution refers to changes in poverty due to changes in the distribution of income keeping the mean of the base year constant. For the regional average, Lustig, Lopez-Calva, and Ortiz-Juarez (2013) find that about 57 percent of the progress in poverty alleviation relates to mean income growth, and 43 percent stems from redistribution. In contrast, mean income growth drove all of the reduction in poverty in Colombia. In fact, it more than compensated for the negative contribution of redistribution. The result implies that income growth was strong for all income groups in Colombia in recent years, which helped lift many people out of poverty, but also boosted to a greater extent the income of the richest people.

C. Limited Inclusiveness of Economic Growth

9. The reduction of income inequality in Colombia has been modest. In Colombia, the Gini coefficient declined by about 3.4 percentage points from 2002 to 2012, and has remained broadly unchanged since then. This achievement is lower than the 5.8 percentage points reduction obtained on average within Latin America. The current level of the Gini coefficient is the 7th highest in the world, comparable to Haiti, South Africa and Honduras. Further, the concentration of income among the top 1 percent is the highest in the dataset compiled by Piketty and others. In 2010, the richest top 1 percent in Colombia held around 20 percent of the total national income.⁵

D. Some key Drivers of the Recent Decline in Income Inequality

10. Globally, key determinants of income inequality include skill-biased technological change, international trade, educational gaps, and labor market policies and institutions. Kierzenkowski and Koske (2013) present a detailed review of the factors considered in the literature as drivers of labor income inequality. They found that an increase in the relative demand for skilled workers caused by technological innovations drove the increase in inequality observed in the early 1980s. They also noted that international trade contributed to inequality in the 1990s and 2000s, by increasing the wage skill gap of some labor segments, including among countries at similar stages of development. They also find that inequality arises from uneven returns to education among different levels of income. Recently, economic research has also shown that labor unionization and minimum wages reduce income inequality by raising incomes of the poor (Jaumotte and Osorio Buitron, 2015).

11. There are several factors that drove the reduction of inequality in Latin America. The main drivers of the decline in inequality in the region include factors related to the labor market (increases in minimum wages; increases in earnings per hour across lower income population; reduction in skill premiums and increases in skills of the labor force), government transfers, and demographic changes (decline in dependency ratio and higher shares of adults with labor earnings) (Gasparini and Lustig, 2011; Lopez-Calva and Lustig, 2010).

12. A few factors stand out in Colombia’s experience in reducing inequality. Azevedo, and others (2013) shed light on the main determinants of the inequality reduction in Colombia, albeit only for the period 2002–10, during which inequality declined by about 1.2 percentage points. In particular, they found that there were three main factors: rising labor income among the poor, an increase in the share of employed adults, and public transfers. In contrast, they find that pensions and capital income have been a drag on improving the income distribution.

E. What Could be Behind the Still High Income Inequality?

13. In Colombia, issues related to labor market, education, pensions and fiscal policy are key determinants of the still high level of inequality. This section will elaborate on each of these issues. In short: (a) in Colombia there is a relatively large share of informal and/or unskilled employment; (b) the quality of education is low by international standards and unevenly distributed across social groups and regions; (c) further, the pension system is regressive and the redistribution power of fiscal policy is low.

Labor Market Issues

14. Labor income inequality is the main source of income inequality. A World Bank (2011) report on inequality in the region evaluates the contribution of each of the components of household income (labor income, pensions, transfers and other factors) in explaining the persistence of inequality. They find that around 73 percent of inequality in Latin America in 2009 relates to labor income disparities and 14 percent to pensions.

15. In Colombia, the wage gap between skilled and unskilled workers has narrowed, yet remains an important contributor to inequality.⁶ Since 2002, in Colombia as in other countries in the region, real wages for unskilled workers have been growing faster than the rest, underpinned by the commodity boom that increased the demand for low skilled workers (Gasparini and Lustig, 2011). Despite these gains, wages for skilled workers in Colombia are still four times the level for unskilled workers, on average. This wage gap is the largest in the region and reflects in part limited access to pre-primary and tertiary education for poor households (OECD, 2015).

16. Data suggests labor informality could also be a factor behind wage income inequality. In Colombia, informality stands at 52 percent of the employed population in Colombia, around the mid-range of informality rates in the region.⁷ Informality is mostly concentrated at the lowest level of income, with the bottom 40 percent income segment of the population working mainly in the informal sector. The wage gap between the formal and informal sectors is between 38 percent and 62 percent, depending on the definition of informality that is used (Daza, and Gamboa, 2013). In general, a vast majority of the informal workers (80 percent) has less than tertiary education, earn on average less than the formal sector, and have not benefitted as much from recent job creation. High informality also contributes to inequality because the informal sector has limited access to finance and public benefits (OECD, 2015).

Skills Formation and Education

17. The skill level among the employed population is highly uneven in Colombia. In 2012, only around 16 percent of the employed population in Colombia was skilled, a level slightly lower than the 19 percent average among regional peers (Mexico, Brazil, Chile and Peru).⁸

18. Educational enrollment has increased in recent years, but remains lower than in peer countries. Gains in educational enrollments rates in primary and secondary education are remarkable, with around 17 percent points increase in primary education between 1991-2010 and 11 percent points increase in secondary education from 2005–10. However, the net enrollment rate in primary education is still lower than peer countries—87 percent in 2010 compared to an average of 94 percent for Mexico, Peru and Chile.⁹

19. Education enrollment also remains uneven across income groups. As the accompanying chart below shows, access to secondary education is lower for the poor (70 percent for the first income quintile; 90 percent for the fifth quintile). Reduced levels of enrollment among the poor are even more marked in tertiary education. Despite some recent improvements, enrollment in tertiary education for the bottom 40 percent of the income distribution is very low (less than 9 percent for the lowest quintile and 13 percent for the second lowest quintile) and is only one third of the level of access of the top 20 percent richest. This is in part a reflection of the low quality of primary and secondary education for the poor.

20. Data on aggregate coverage mask important differences in quality. Access to quality education remains limited in Colombia. Colombia’s expenditure on education—around 5 percent of GDP in 2013—is roughly similar to several countries in Europe and the United States. However, the quality of education, measured by math Pisa scores, is among the lowest in the world. The data also suggest that the socioeconomic background of the pupils is a significant determinant of tests scores. In particular, the Pisa scores are significantly lower for pupils in the bottom 10 percent of income distribution. The correlation between socioeconomic background and test results point to the possibility that the education system might be hindering social mobility, including by limiting skill formation and access to better paid jobs later-on. The results of other national standardized tests (Saber) also show significant variation across regions, which also reflect uneven quality and coverage of education (DNP, 2015b).

Pensions

21. Pension coverage is low, and pension benefits are received disproportionately by the better-off. Only 37 percent of the elderly received a pension in 2013 due in part to the relatively large labor informality. Some data, albeit only for 2010, suggest that most of the richest top 20 percent receive a pension while almost none of the poorest 20 percent receive one. Also, the largest gains in coverage in recent years accrue to wealthiest women (Azevedo and others, 2013—see chart). As pension benefits are not taxed in Colombia, the uneven distribution of pension benefits directly worsens the income distribution.

Fiscal Policy

22. The redistributive power of fiscal policy in Colombia is limited. Fiscal policy is usually a key redistribution tool, including through progressive tax systems and/or social transfers. However, in Colombia, direct taxes, indirect taxes, and monetary transfers have been ineffective in reducing income disparities. The redistributive potential of the tax system is limited by the low direct income taxation and heavy reliance on VAT (Moller, 2012). In sum, as shown in the accompanying chart, fiscal policy only reduces the Gini coefficient by 1 percentage point.¹⁰

F. Conclusion

23. Since the late 1990s, Colombia has achieved strong economic performance while restoring macroeconomic stability. Colombia’s recent growth performance stands out in the region both in terms of its level and stability (see accompanying Chapter 2). In contrast with the late 1990s crisis, Colombia successfully navigated the 2008-09 global crisis, drawing on the policy buffers that were built in the previous years.

24. Colombia has also achieved remarkable success in reducing poverty levels. The combination of economic growth and social programs has led to halving the poverty levels over the last decade. As a reflection of strong social programs and safety nets, the downward path in poverty levels continued throughout the years of the global financial crisis (2008–10).

25. As in other countries in the region, Colombia has had more limited success in reducing income inequality. Existing studies suggests that factors related to education, labor markets, pensions, and fiscal policy might be limiting the improvements in income distribution.

26. Recent policy changes and the national development plan (2014–18) include measures in the key areas discussed in this chapter. These include:

a. Education. The development plan considers education as the “most powerful tool to reduce social gaps (DNP, 2015; page 67)” and aims to introduce policies to strengthen quality and availability of public schools. The plan also calls for extending preferential educational loans for eligible low income students.
b. Labor markets. Ongoing efforts include streamlining the requirements to make formal contributions to pension and health systems, which could reduce labor informality. Plans also include establishing a centralized database for vacancies to help first time job-seekers, mainly unemployed youth.
c. Pensions. Ongoing plans include strengthening the safety net of the poor through an expanded coverage of non-contributory pensions (Colombia Mayor).
d. Fiscal policy. The 2012 tax reform aims to improve tax progressivity including through the introduction of an alternative minimum personal income tax. Looking ahead, an expert commission was recently formed to make recommendations for a broad tax reform aimed to further strengthen progressivity.

Appendix. 1. Selected Social Programs in Colombia

1. Several social programs targeted to the most vulnerable populations, including conditional cash transfers programs have been in place since the mid-2000s.¹

Mas familias en acción offers assistance to low income families, providing nutrition and education benefits. Around 2.6 million families (4.8 million individuals) were beneficiaries in 2014, with a total investment of around US$853 million. Participants in the program are from displaced or indigenous populations, and meet the criteria of vulnerable populations under the System for Identification and Classification of Potential Beneficiaries for Social Programs (Sisben) or are subscribed to Unidos, the strategy for the reduction of extreme poverty.
Jovenes en acción offers youth living under poverty and vulnerable conditions an incentive to pursue a technical, technological, or bachelor’s degree. In 2014, the program covered 152,370 students, at a cost of US$95 million.
Ingreso para la prosperidad offers an incentive to needy families looking to improve their labor skills. There were around 6,083 beneficiaries of the program in 2014, at a cost of 6 million dollars.
Familias en su tierra is a program targeting displaced people who return to the place where they used to live or relocate to a new municipality. It offers a cash and in-kind transfer conditional upon their permanence residence in the area where they subscribe to the program. The program covered 209,106 families in 2014.
Red de Seguridad Alimentaria (RESA) is a program to improve access and consumption of basic goods for families living under extreme poverty conditions.
Infrastructure. This program aims at building infrastructure in areas affected by poverty conditions or by violent attacks. In specific, the program executes roads, ports, recreation facilities, generation and distribution of energy, improvements in sewerage, water treatment plant, and other facilities that improve the living standards of the population.

2. In total, the combined social programs implemented by the Department of Social Prosperity (DPS) reached about 5 million people, at a cost of US$1.2 billion. In addition to the DPS, other institutions also contributed to the overall social strategy including the ANSPE (National Agency to Overcome Extreme Poverty), ICBF (Colombian Family Welfare Institute) and the Unit for Attention and Reparation of Victims with programs offering assistance to families living under extreme poverty, children and victims of the conflict, respectively.

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Prepared by Valerie Cerra and Daniel Rodriguez (both WHD).

Prepared by Zulima Leal and Daniel Rodríguez-Delgado (both WHD). We would like to thank Valerie Cerra, Maria Angelica Arbelaez, Luis Fernando Mejía, Gabriel Armando Piraquive, Nancy Daza, and Cesar López Villada for useful comments.

Ferreira, and others (2013) estimate the upper and lower band of the middle class based on survey data considerations for the region. Although low, the lower band of $US10 a day represents the 68th percentile of the income distribution for the region in 2009.

See Castellani, Parent and Zentero (2014), Daza, and Cortés (2013), Angulo, Gaviria and Morales (2013) and Castellani and Parent (2011) for alternative definitions of middle class.

For instance, see IMF (2005) for more details on the crisis and the set of policies that were adopted at the time.

Alvaredo and others (2014).

Skilled workers refer to employees with more than 13 years of formal education (high skills).

Informality corresponds to the definition adopted by DANE which includes employees and owners of business with less than 5 workers, unpaid family members and housekeepers. In the literature there are other definitions of informality; some are related to tax compliance or social security contributions. See Hamann and Mejia, (2011); Perry et al. (2007) and Garcia and Adolfo (2008) for recent studies on determinants of informality.

Data available in the Socio-Economic Database for Latin America.

Gross enrollment refers to the total enrollment rate regardless of age while net enrollment only considers the population of official school aged that is enrolled.

Gini net is calculated using household disposable income (after taxes and transfers). For more details see Solt, 2009.

Data in this section corresponds to the latest information available as of March 2015 in the Department of Social Prosperity.

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