Costa Rica: Selected Issues and Analytical Notes

Costa Rica: Selected Issues and Analytical Notes

Abstract

Costa Rica: Selected Issues and Analytical Notes

Recent Fiscal Developments 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 early corrective action remains critical to restore debt sustainability. A moderately front-loaded adjustment as part of a balance policy mix with supportive monetary policy (AN III) would strike the appropriate balance between achieving fiscal sustainability and maintaining robust growth. Postponing fiscal consolidation further could endanger macroeconomic stability.

A. Recent Developments

1. Fiscal sustainability remains elusive as debt continued its rapid ascent, with the primary fiscal deficit stabilizing at post-crisis peak levels.

  • The fiscal position of the central government deteriorated sharply during the global credit crisis. After posting large primary surpluses for several years, and even a small overall surplus in 2007, the primary and overall fiscal deficits reached 3 and 5½ percent of GDP by 2010, respectively. The worsening of the fiscal position was the result of both an endogenous fall in revenue (after above-trend GDP growth in the run up to the 2008-09 crisis) and a sharp increase in expenditure (mainly wages and transfers) on account of countercyclical policies implemented in response to the 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 arguing procedural irregularities in its Congressional approval. As a result, the central government primary and overall deficits returned to their post-crisis peaks by 2013.

  • The new administration that came into power in mid-2014 conducted a broadly neutral fiscal policy with respect to the economic cycle, with the primary deficit remaining broadly flat at 3 percent of GDP aided by substantial expenditure under-execution relative to the original 2014 budget and strong efforts to reduce tax evasion in 2015.

  • Despite the continued increases in public debt—to 42½ percent of GDP in 2015, up from 24 percent of GDP in 2008—the interest bill increased only moderately, helping to keep the overall deficit around 6 percent of GDP in the last few years. This was made possible by the relatively low financing costs, in the context of historically low international rates. In 2015, domestic government financing costs declined further, especially at the short-end of the yield curve, amid strong disinflation and associated aggressive monetary policy response.

Figure 1.
Figure 1.

Costa Rica: Recent Fiscal Developments

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

Sources: National authorities and Fund staff estimates.
A06ufig1

Implied interest rates on government debt

(In percent)

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

Sources: National authorities.
A06ufig2

Domestic sovereign yield curve

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

2. Trends in the other levels of government have remained more stable. The pay-as-you-go social security system (CCSS) has maintained a small surplus of 0.75 percent of GDP in 2015, while the balance of public sector enterprises turned to a small deficit of 0.1 percent of GDP—reflecting mainly losses at the public refinery driven by lower sales prices, in line with international oil prices, while operating costs remained high. The central bank operational deficit was also broadly constant at about 0.75 percent of GDP, reflecting interest expenses on securities issued for liquidity management purposes. Our analysis of fiscal vulnerabilities, medium-term sustainability issues, and related adjustment needs is therefore focused on the central government, while also briefly discussing longer-term sustainability issues in the social security system.2, 3

A06ufig3

Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

Sources: National authorities and Fund staff estimates.

B. Sustainability Gap and Recommended Adjustment

3. A total adjustment of about 3¾ percent of GDP is necessary to restore debt sustainability. In a passive scenario, without any adjustment measures, the primary deficit is projected to rise to 3¼ percent of GDP in 2016, and to 3½ over the medium term as the Constitutionally-mandated objective of reaching 8 percent of GDP in expenditure on education is gradually achieved. According to staff analysis, a primary surplus of ¼ percent of GDP is needed to stabilize debt in the medium term within “safe levels” given projected increase in real rates above real GDP growth as global monetary conditions normalize.4 Further postponing fiscal retrenchment is costly, since, the longer the delay, the larger will be the improvement in the primary balance required to stabilize the public debt ratio.

Costa Rica. Fiscal Sustainability Gap

(In percent of GDP, unless otherwise stated)

article image
Source: Fund staff estimates.

The primary deficit is projected to reach 3.3 percent of GDP in 2016 in the absence of measures. The commitment to continue raising spending on education toward 8 percent of GDP will also add to adjustment needs in the medium term.

4. 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.5 Relative to the model results obtained in the 2014 Article IV, the optimal fiscal consolidation path is somewhat less frontloaded reflecting the moderate widening of the negative output gap in 2015-16, with a bit less than one third of the adjustment now recommended in the first year of fiscal adjustment. The distribution of the total adjustment in the adjustment scenario of the staff report, which takes into account sequencing of fiscal reforms taking into account political considerations, is less frontloaded in the first year, and more concentrated in the second and third years of adjustment, with the full sustainability gap assumed to be closed by the end of the 5-year projection period.6

A06ufig4

Optimal Fiscal Adjustment Path

(annual share of total adjustment, in percent)

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

Figure 2.
Figure 2.

Costa Rica: Long Term Sustainability

(percent of GDP)

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

Source: National authorities and Fund staff estimates.1/ This path is the baseline through 2021, 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 2016 in both scenarios. The debt stabilizing primary balance is calculated based on medium-term baseline projections of real interest and growth rates that are maintained constant over the projection period in line with the requirements of the fiscal-adjustment-optimization model. The gap is then measured relative to the 2015 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 2016 and has no impact on growth.

5. The required fiscal adjustment rises by an additionaliy 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.7 The system currently runs a cash surplus of about 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 to maintain actuarial balance over the next 50 years—the gap would increase to almost 4 percent of GDP under a longer-term horizon of 100 years.8 These reforms could take the form of higher contributions, reduced replacement rates, and/or an increase in the retirement age.

6. 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. As in other Central American countries, revenue mobilization should be the cornerstone of fiscal consolidation, given generally low tax revenues compared to other middle-income countries.9

A06ufig5

Tax Revenue, 2014

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

C. Authorities’ Plans and Fiscal Scenarios

7. The authorities have developed a strategy for fiscal consolidation focused on strengthening revenue, but expenditure measures need to be further clarified. After the nullification of the 2012 tax reform, the previous administration prepared a fiscal consolidation plan with total adjustment of about 3½ percent of GDP to stabilize debt in the medium-term, broadly in line with previous staff recommendations. However, the plan was not implemented before the 2014 elections. The new administration has developed a new fiscal consolidation plan that is also broadly in line with staff recommendations regarding size, composition and pace of adjustment, although measures on the expenditure side need to be further clarified.

  • The government has already submitted to Parliament measures that would yield some 2¾ percent of GDP. On the revenue side these include VAT and income tax reforms that would yield slightly more than 2 percent of GDP over the medium-term, and other provisions—further amendments to the corporate income tax and anti-tax evasion measures—that would generate almost ½ percent of GDP. The VAT reform envisages broadening the tax base to include services and a gradual increase in the rate from 13 to 15 percent, starting in 2016, as well separate increases of taxes on sales of vehicles and real estate. The bill also foresees a radical reduction in the basic goods basket, conditional on the establishment of a transfers system that would make this element of the reform broadly revenue-neutral for lower-income households. The income tax reform introduces two additional marginal rates of 20 and 25 percent on higher-income brackets, unifies taxation of income on capital at 15 percent, and introduces taxation of capital gains. On the expenditure side, the government has presented to Congress provisions that would reduce outlays by ¼ percent of GDP in 2016—these include caps on budgetary pensions and paring down transfers to decentralized institutions.

  • In addition to these legislative proposals, the government has agreed with the main opposition party to make miscellaneous cuts of ¼ percent of GDP to be implemented through a supplementary 2016 budget.

  • The authorities agree that the additional ¾ percent of GDP of fiscal consolidation measures needed to close the sustainability gap should focus on the expenditure side. They have identified administratively-determined spending cuts that would contain the growth of current spending—mostly transfers and public sector wages—to keep it through the medium term below the expansion of nominal GDP, yielding the total adjustment needed in percent of GDP.

  • The authorities also presented a fiscal rule proposal aimed at the preservation of government debt sustainability. This is broadly in line with Fund advice on the desirability of two-pillar frameworks with an anchor (e.g. debt) and an operational target (expenditure)., though the proposals still requiring greater specification of its key elements.10

8. Scenarios of partial and full implementation of the fiscal adjustment needed to restore debt sustainability highlight the importance of reaching political agreement on fiscal reforms.

  • A baseline scenario incorporating the measures already submitted to Congress that have a higher probability of being approved as well as the agreed expenditure cuts under a supplementary budget would imply partial adjustment of about 2¼ percent of GDP. Under this scenario, the CG fiscal deficit would decline moderately to around 5½ percent of GDP and the public debt ratio would continue to increase to almost 55 percent of GDP by 2021.

  • An alternative scenario incorporating the full fiscal adjustment necessary to restore debt sustainability would yield a more favorable outlook. A tighter fiscal stance consistent with restoring debt sustainability could be achieved without significantly affecting growth, as it would allow for a more balanced macro policy mix with a looser monetary policy stance consistent with achieving the inflation target over the medium-term. Moreover, the focus on revenue measures that increase the progressivity of the tax system and have mainly an effect on higher earner with lower propensity to consume—including higher income tax rates on higher income brackets, higher VAT tax rates accompanied by a transfers system to make the VAT reform broadly revenue-neutral for lower-income households, and anti-tax evasion measures—is also likely to contribute to the limited impact of fiscal consolidation on growth. Frontloaded fiscal adjustment would also mitigate increases in market rates associated with the normalization of U.S. monetary policy (USMP), and reduce the current account deficit.

Table 1.

Costa Rica: Central Government Fiscal Consolidation Measures

(in percent of GDP)

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Sources: Authorities and IMF staff estimates.

On the revenue side, includes staff’s assessment of the expected yield from revenue measures submitted to Congress. On the expenditure side, includes measures already submitted to Congress.

In addition to the lower yield assumed from anti-tax evasion meaures, the difference with the authorities’ plans is that it incorporates only measures that are deemed to have a higher probability of approval. The assumption in the baseline is that the proposed VAT tax rate increases will not be approved by Congress.

Reflects total adjustment needed to close the sustainability gap.

The VAT tax reform proposal submitted to Congress envisages full move from sales tax to VAT, extending coverage to services sector in the baseline scenario, and gradual increase in the tax rate from 13 to 15 in the full adjustment scenario.

The income tax reform introduces two additional marginal rates of 20 and 25 percent on higher-income brackets, unifies taxation of income on capital at 15 percent, and introduces taxation of capital gains.

Amendments to the corporate income tax law directed at reversing budgeted decline in 2016 revenue resulting from Constitutional Court ruling that proper procedure was not followed to introduce amendments made in 2010 to among other things include subsidiaries of foreign companies in the tax base.

Includes cuts in transfers to finance capital expeditures of decentralized government institutions and enforcement fo legal cap on pensions paid out of the budget.

Includes measures to contain nominal growth of public wages, so that their share in GDP is gradually reduced. Also includes freeze in hiring outside education, and cuts to public compensation bonus schemes.

Includes miscellaneous cuts to the 2016 budget agreed between the ruling party and the main opposition party, to be introduced through a supplementary budget.

Figure 3.
Figure 3.

Costa Rica: Baseline and Adjustment Scenarios

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

Source: National authorities and Fund staff estimates

D. Risks and Mitigating Factors

9. 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 rising above 65 percent of GDP by 2021, more than 10 percent above the level in the baseline scenario (DSA Annex to the staff report).11 Debt dynamics are most sensitive to a growth shock, with an isolated one standard deviation shock to growth in 2016-17 resulting in an increase in central government debt of about 5 percent of GDP by 2021 relative to the baseline scenario. A fiscal shock equivalent to an additional 1¼ of GDP increase in the primary deficit in 2016-17 would increase debt by about 3 percent of GDP by 2021, 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. 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 2021.

A06ufig6

Gross Nominal Public Debt

(percent of GDP)

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

Source: Fund staff estimates.

10. Relatively large gross financing needs and uncertain access to external financing pose upside risks to sovereign funding costs. While the fiscal situation has benefitted from fairly low financing costs in recent years, especially since the approval of the external bond issuance for 2012-15, uncertainties about Congressional approval of new external bond issuance and expected upward normalization of global interest rates over the medium term, with potential periods of financial volatility during the transition to higher rates, suggest that Costa Rica’s financing costs are likely to increase going forward. Spreads on external sovereign bonds have already increased substantially since the troughs reached before the start of US tapering, and are now among the highest of CAPDR and LA-5 countries. Sustained high fiscal deficits and substantial amortizations coming due result in average projected financing needs of close to 10 percent in 2015-16, also among the highest of CAPDR and LA-5 countries. Costa Rica already lost its only investment grade rating in 2014, and rating agencies lament continued weakness in the fiscal position and political obstacles to fiscal reform.12 The risk of a debt spiral with potentially non-linear increases in financing costs cannot be discarded if debt continues to rise unabated.

A06ufig7
Sources: Bloomberg; national authorities; and Fund staff estimates.1/ Gross financing needs for LA-5 are based on data from latest Article IV reports, published in 2015.

11. Risks are mitigated by the existence of a captive domestic investor base, although their share of total debt has declined in recent years. In 2008, domestic institutional investors, including the CCSS, nonfinancial public sector institutions, and banks, held about 80 percent of domestic government bonds. By 2014, this share had fallen to 60 percent, as the non-financial private sector disproportionately absorbed the increase in the debt resulting from the worsening of the fiscal position. While holdings of the banking sector are not high by regional standards, additional increases in their exposures to the sovereign could have negative consequences for financial stability under downside scenarios of limited fiscal adjustment. Simulations of a similar increase in domestic sovereign yields as in 2012—before the approval of $4 bn external sovereign bond issuance for 2012-15—show that banks could be close to failing regulatory capital requirements in the medium term from mark-to-market losses on their growing exposures to the sovereign in a passive scenario of no fiscal consolidation. Losses would be even larger under more plausible assumptions of much higher government financing costs under this scenario.

Figure 4.
Figure 4.

Costa Rica: Sovereign-Financial Linkages

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A006

References

  • Cordes, Kinda, Muthoora, and Weber, 2015, “Expenditure Rules: Effective Tools for Sound Fiscal Policy?,IMF Working Paper 15/29, Washington: International Monetary Fund.

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  • Dirección Actuarial, 2015, Valoración Actuarial de Largo Plazo del Seguro de Invalidez, Vejez y Muerte (San José: CCSS).

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

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  • Garza, Mario; Morra, Pablo; and Simard, Dominique, 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.

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  • Kanda, Daniel, 2011, “Modeling Optimal Fiscal Consolidation Paths in a Selection of European Countries,IMF Working Paper 11/164, Washington: International Monetary Fund.

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1

Prepared by Jaume Puig-Forné.

2

Moreover, the analysis of debt sustainability at the consolidated public sector level could be misleading, as it would net out relatively large central government debt holdings by the social security system (about 16 percent of the total). 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

See Debt Sustainability Analysis in Annex III.

5

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).

6

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 in the adjustment scenario of the staff report differs 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 to increased expenditure in the 2016 budget and Constitutionally-mandated increases in education over the medium-term. 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 primary deficit of 3 percent of GDP in 2015—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 2021, 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 taking into account political considerations.

7

The IVM currently covers ⅔ of the labor force (approximately 1½ million workers), including civil servants who joined civil service after 1992, and has about 165,000 beneficiaries. In addition to the IVM, there are special pension regimes for the judiciary (Fondo de Jubiliaciones y Pensiones del Poder Judicial, FPJPJ) and for teachers who started working after 1992 (Collective Capitalization Regime, RCC). There are also legacy regimes for civil servants and teachers that were closed to new entrants in 1992; these are currently financed with transfers from the central government budget (reaching about 2½ percent of GDP in 2015).

8

Calculated as a one-time permanent improvement in the balance of the CCSS—relative to the projections in the baseline scenario of the latest actuarial report available from the CCSS, published in 2015—that brings the present value of the stream of projected net income of the CCSS—including return on reserves until their projected depletion—to zero. The actuarial report’s baseline scenario incorporates the agreement reached in 2005 to gradually increase contribution to 10½ percent by 2035, from current rate of 8½ percent. The other key assumptions in the report’s baseline scenario are: (i) an increase in coverage from 65 to 75 percent by 2050, (ii) real salary increases in line with historical average of about 1½ percent of GDP, and (iii) pensions continue to be indexed to consumer prices. The staff makes an additional assumption that the real return on reserves—as well as the real discount rate used to estimate the present value of the future stream of net income—is 1 percent higher than the projected real growth rate of the economy, in line with the standard approach of the Fund’s fiscal department to estimate actuarial balances.

9

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

11

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.

12

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.

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