Selected Issues and Analytical Notes

Abstract

Selected Issues and Analytical Notes

Implications of the New U.S. Administrations Economic Plans for Central America1

This note describes Costa Rica’s vulnerabilities to potential policy changes in the United States after the November 2016 Presidential election and its effects on Central America. In the near term, the most likely U.S. policy shift is for a change in the macroeconomic policy mix, involving an expansionary fiscal policy, implemented initially through tax cuts, and a tighter than previously expected monetary policy stance. The results suggest that Costa Rica may potentially be more affected through the FDI and trade channels, contrary to the rest of Central America, where the remittances and immigration channels play a key role.

A. Potential Policy Changes in the United States

1. The outcome of the 2016 U.S. Presidential elections may mark a strategic shift in U.S. policies along several key dimensions that will have cross-border implications. In the near term, staff’s baseline scenario assumes a change in macro policy mix, essentially: (i) an expansionary fiscal policy, implemented initially through tax cuts; and (ii) a tighter-than-previously-expected monetary policy stance, leading to a steeper path for future increases in the Fed funds rate. U.S. economic activity is projected to expand solidly by 2.3 and 2.5 percent in 2017 and 2018, respectively, as private consumption and fixed investment should benefit from actual and anticipated fiscal stimulus. Potential ramifications for countries in the Central America region will vary depending on trade exposures to the U.S., financial interlinkages, and changes in migration and remittances flows.

2. In the medium-term a structural overhaul of the U.S. tax system is expected to involve the simplification of the corporate income tax (CIT). One proposal under consideration seeks to replace the current CIT with a cash flow tax with border adjustment and a lower tax rate for U.S. firms. The idea is to reduce the tax burden and relevant distortions by transforming the current 35 percent CIT—the highest among OECD economies2—to a 20 percent destination-based cash flow tax (DBCFT) to encourage investment and employment in the United States. However, the border adjustment inherent in a DBCFT may prove inconsistent with existing WTO rules which could precipitate trade disputes and possible retaliation from trading partners. Other options being considered are less comprehensive and involve reducing the rate of the CIT while eliminating some exemptions and special treatments.

3. On the trade side, the United States intends to renegotiate existing trade agreements, including the North American Free Trade Agreement (NAFTA). If well executed, such efforts could potentially generate growth dividends for all the signatories of the agreement. However, if there were a unilateral imposition of tariffs on imports, this could prove damaging for both the United States and its trading partners, resulting in weaker trade, higher production costs, more expensive imported consumer goods, and eventually lower potential growth.

4. There is also a risk that more restrictive migration policies could negatively affect Central America. Potential changes in migration policies include stiffening immigration controls, increasing deportations of unauthorized immigrants, and an imposition of a tax on remittances that would likely dampen such flows. The net impact on the region due to changes in migration and remittances is likely to be negative. This is because the adverse impact of a decline in remittances from abroad is unlikely to be offset by the increase in labor participation at home that could be expected from a reversal of migration, particularly given that most migrants from Central America are low skilled and their re-absorption in their home labor markets could take time.

B. Costa Rica’s Main Exposures

5. Central America and especially Costa Rica are highly exposed to the Unites States through trade. The United States accounts for close to 40 percent of total goods exports from Central America, and the indirect exposure of these countries to the U.S. is also high through intra-regional trade—at about 20 percent. In CAFTA-DR, the trade agreement between the U.S. and Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and the Dominican Republic, the U.S. has a trade surplus in goods, but a trade deficit in services. Notably, Costa Rica had a services surplus with the U.S. of US$820 million in 2015.3 Exports of services to the U.S. have been growing at a faster pace than imports, reaching 12.6% in 2015, while imports have grown only at 1.2%. On the other hand, Costa Rica trade balance with the U.S. had a deficit of US$1.7 billion in 2016.

A01ufig1

CAPDR: Bilateral Services and Trade Balance of the US

(Millions of US dollars)

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A001

6. U.S. and Mexico represent almost half of Costa Rica’s total exports of goods. While there is less concern about modifications in the CAFTA-DR agreement, because the U.S. has a surplus, the NAFTA agreement may suffer modifications, which would have a negative impact on Costa Rica.

7. FDI flows and stocks in North and Central America are concentrated mainly in Costa Rica and NAFTA US-counterparts. For Costa Rica on the one hand and for Mexico and Canada on the other, out of their total FDI stock, the U.S. represents 60 percent and 50 percent, respectively (over 30 percent and 18 percent of GDP respectively).

8. On the other hand, remittances and immigration are not relevant channels for Costa Rica. In contrast with the rest of Central American countries, remittances from limited migration to the U.S. do not play a critical role in Costa Rica’s economy—these accounted for less than 0.5% of GDP in 2015.

C. Estimations and Results

C1. Partial Elasticities approach

9. Spillovers from higher U.S. growth resulting from expansionary U.S. fiscal policy are larger for partners with higher trade exposures, such as Costa Rica. Previous studies indicate that NAFTA countries, plus Costa Rica and Honduras, have been historically more sensitive to U.S. growth shocks than other countries in Central America or Latin America. These countries therefore are more likely to benefit from higher demand from the United States—i.e., the direct impact of U.S. fiscal expansion.

A01ufig2

CAPDR: Bilateral Trade Balance of the U.S.

(Billions of U.S. dollars)

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A001

A01ufig3

Direct Investment from the United States, 2015

(Percent)

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A001

10. Higher global interest rates, resulting from tighter U.S. monetary policy may partially offset positive spillovers from U.S. higher growth. Financially integrated economies in the region like Costa Rica are likely to face higher external funding costs (both public and private) due to higher global interest rates following a faster normalization of monetary policy by the Federal Reserve and/or the increase in risk premium. While the financial channel is weak for most Central American countries—because of thin financial markets and less financial integration—the EMBI spreads of Costa Rica, Panama and El Salvador are more reactive than those of other neighboring countries to global shocks.

A01ufig4

Response of Real GDP Growth in Latin America to a One Percentage Point U.S. Growth Shock

(Percentage points)

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A001

11. Greater U.S. trade protectionism through higher tariffs would hurt export volumes from Central America, including Costa Rica. Possible policy changes include modifying some of the provisions of NAFTA, CAFTA-DR, and other bilateral trade agreements—including by raising tariffs for imports of some manufactured goods from U.S. companies operating in foreign countries. To quantify the impact of such scenarios, one can look at the increase in effective tariff rates if NAFTA and/or CAFTA-DR were repealed and tariffs were increased to WTO MFN (most favored nation) levels.4 In this scenario, the effective tariff rates for Central America would increase by 2–8 percentage points (more only in the Dominican Republic). Staff estimates that this would reduce real exports by about 1–7 percent5 in the short run and by 1-16 percent if the long run (for Costa Rica 0.2 and 1.3 percent respectively).

12. A shift of corporate taxation to a lower rate could lead to a reallocation of FDI flows away from Costa Rica. Modifications in the U.S. corporate income tax could generate incentives for U.S. companies to repatriate a larger share of current and future foreign profits, if the marginal effective tax rates in the foreign countries become higher than those on profit repatriation and distribution in the U.S. This could also result from other types of CIT reform in the U.S.

13. Costa Rica may be more vulnerable to reductions in the U.S. CIT rate, as taxation might have played a bigger role in U.S. companies’ decision to invest there. Average effective tax rates during 2010-13 in Costa Rica (9 percent) and Honduras (11 percent) were relatively low compared to other Central American countries (Guatemala, El Salvador, and Nicaragua: 20 percent). In addition, some U.S. corporations in CAPDR countries operate from free enterprise zones, with essentially zero corporate tax rates (and low other taxes, particularly if their production is exported). This fact makes it even more complex to understand the final implications for the region if CIT in the U.S. were finally to be modified. If all the currently generated income from FDI by U.S. companies is repatriated, this could amount to annual outflows of 0.2-2 percent of GDP, but this seems unlikely.

14. However, taxation is not the only consideration in companies’ decision to invest abroad, and Costa Rica may benefit from these other factors. Long-term profit considerations, based on relative labor costs, other costs, logistics and infrastructure, proximity to markets, global value-added chains, security, rule of law, and, more generally, “optimal” international distribution of productive capacity should also be taken into consideration and are likely to be more important than just the corporate tax rate.6 Costa Rica seems overall to be doing pretty well along several of these dimensions. This may mitigate vulnerabilities to tax policy spillovers from the U.S.

15. Overall, vulnerabilities to changes in U.S. policies appear elevated across Central America. Most countries in the region are highly exposed to possible changes toward more restrictive migration policies and to trade shocks from more protectionist trade policies in the U.S. Costa Rica is not affected by this channel, and also has high exposure to upside risks from higher growth from expansionary fiscal policies and deregulation in the U.S. On the other hand, the country faces greater downside risks than other countries in Central America from tighter external financial conditions, given its relatively stronger financial linkages with the U.S.

C2. Model Simulations

16. IMF’s Flexible System of Global Models (FSGM) was used to simulate the effect of various financial shocks on macroeconomic variables in Costa Rica. The model was developed by the Economic Modeling Division of the IMF’s Research department for policy analysis (Andrle and others, 2015). It comprises a system of multi-region globally consistent general equilibrium models combining micro-founded and reduced-form relationships for various economic sectors.

17. Model simulations suggest that changes in U.S. policies could decrease GDP growth by ½ percent over the medium term. FDI could suffer from sizable reductions in the U.S. effective corporate tax rate, although the impact is likely to be contained given the importance of other pull factors, including an educated workforce, security, rule of law, and geographical location. Assuming a 20 percent reduction in FDI to Costa Rica originating from the U.S., GDP growth would be reduced by ½ percent over the medium term. The decline would take place gradually given the existing pipeline of FDI projects at different stages in the investment decision process. Simulations of a combined scenario with the same decline in FDI, increases in tariffs to WTO MFN levels, and a 50 basis points increase in the U.S. term premium (related to concerns about the U.S. fiscal position) would have a similar but more immediate negative impact on GDP growth of almost ½ percent. The impact would remain fairly constant over the medium-term, as the authorities would likely respond with an easier monetary stance than in the baseline scenario, thereby mitigating the impact of the combined external shock on growth through both lower policy rates and associated currency depreciation.

A01ufig5
Source: IMF/RES WHDMOD simulations.Note: The FDI scenario a ssumes a 20% decline in FDI from the US, implying a permanent reduction in investment of 0.55% of GDPfrom 2018. The combined shock scenario assumesa combination of: (i) the FDI scenario; (ii)an increase in tariffs to the WTO MFN; and(iii) a temporary yet persistent 50 bps increase in the US term premiumwith spillovers to globalcommodities.

D. Conclusions

18. Uncertainties about U.S. policies weigh on the economic outlook for Central America, including Costa Rica. Much will depend on the actual nature and extent of possible future changes to U.S. tax, trade and immigration policy, and financial and business regulations. These uncertainties create important spillovers and risks. Isolationist measures in the U.S. and retaliatory responses would lower global growth through reduced trade, migration, and cross-border investment flows. Risks from more protectionist trade policies are greater in Mexico and Central America. Possible policy changes include modifying some of the provisions of NAFTA, CAFTA-DR and other bilateral trade agreements—including by raising tariffs for imports of some manufactured goods from U.S. and companies operating in foreign countries. In addition, sharper than expected tightening of global financial conditions driven by substantial further strengthening of the U.S. dollar, a more rapid monetary policy normalization, or rising concerns about a weaker fiscal position in the U.S. could inflict significant damage on more financially integrated emerging markets. The FDI channel is the main risk for Costa Rica, though the country’s open economy is also vulnerable to weaker global growth and to tighter global financial conditions, given its weak budgetary situation, bank reliance on foreign funding, and high credit dollarization.

References

  • Andrle, Michal and others, 2015, “The Flexible System of Global Models - FSGM”, IMF Working Paper No. 15/64, Washington, D.C.

  • Auguste, Sebastián, Mario Cuevas, and Osmel Manzano, 2015, Partners or Creditors? Attracting Foreign Investment and Productive Development to Central America and Dominican Republic, IDB.

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1

Prepared by Victoria Valente.

2

The effective rate is considerably lower however, owing to various provisions narrowing the base of the CIT. OECD Tax Database.

3

U.S. Bureau of Economic Analysis. Latest value available.

4

In current usage, MFN tariffs are those that countries commit to impose on imports from other members of the WTO, unless the other country is part of a preferential trade agreement (such as a free trade area or customs union).

5

To gauge the impact on exports to the U.S. from the repeal of CAFTA and the associated increase in tariffs to the level of WTO (MFN tariffs), a VECM model is used as in Hooper and others (2000). The model relates the log volume of a specific product import by the U.S. from a CAPDR country to the log relative price of this good in relation to U.S. PCE price index as well as to the log of U.S. GDP. The model is estimated on monthly data for 9 individual product categories. The three variables in the model were found to be integrated of order 1 for almost all the combinations (good, country). The number of lags was chosen according to several lag length selection criteria (AIC, BIC). For Mexico and Canada, the elasticities are obtained from the estimated import price elasticities of Hooper and others (2000).

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