2012 Budget: Financing Social Demands

A perfect storm – that is what Sebastián Piñera, Chile’s president since March 2010, faced in October and November as Congress debated his government’s proposed budget for 2012.

By November, student protests, and public support for them, appeared to be waning. But, over the previous six months, their demands for changes in the structure and financing of state education had left no doubt that strong economic growth – and, crucially, the sense of wealth induced by high prices for copper, the country’s main export – were fuelling, rather than placating, Chileans’ impatience to see tangible benefits.

But, at the same time, international organizations like the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) had been urging the government to restrain spending. While recognizing the solidity of Chile’s fiscal position, they had both suggested a need to move faster in rebalancing the budget after the inroads made by the 2009 recession and the 2010 earthquake.

And then, further increasing the tension, there was the increasingly certain prospect of a downturn in the external conditions that are so important to the small, open Chilean economy. That not only threw into doubt the assumptions on which the government had based its proposed budget – 5.0% GDP growth next year and an average annual copper price of US$3.70/lb – but also suggested a possible need for emergency stimulus measures not envisaged in the budget.

Finance Minister Felipe Larraín recognizes that 5% growth is now “a little over average forecasts”. However, he argues that, given Chile’s strong fiscal position, lower than budgeted growth wouldn’t be a problem.

Its fiscal situation is “unique”, he points out. Chile is, after all, a net international creditor and, if the world were to slip back into recession, it would, as in 2009, be able to draw on the Economic and Social Stabilization Fund (FEES), an offshore sovereign wealth fund worth some US$13 billion.  

Under the draft budget – which, by law, Congress must approve or reject by the end of November and, despite all the noise, actually has little power to modify – government spending would rise by 5.0% next year, up from an estimated 4.6% increase this year, reaching just over US$60 billion (22.7% of estimated annual GDP).

It is an expansive budget although that’s not necessarily bad, says Leonardo Suárez, chief economist at the local Larraín Vial investment bank. GDP growth will be significantly less than 5%, he forecasts, with tax revenues almost certainly below their budgeted level. However, this latter effect would, he notes, be partly offset if – as widely expected – a temporary increase in corporate tax from 17% to 20%, introduced last year to help finance post-earthquake reconstruction and due to start to come down in 2012, were made permanent.  

The largest increase under the budget in dollar – although not percentage – terms would be for the Education Ministry which would see its allocation rise by US$781 million to US$11.7 billion. But its 7.2% increase is mostly inertial growth, says Suárez, who, contrary to the government’s claims, maintains that there is “zero emphasis on education in this budget”.

Other important increases include the Health Ministry, with its budget rising by US$568 million (6.7%) to US$9.1 billion and the new Social Development (formerly Planning) Ministry whose budget would rise by 8.5% to US$930 million. But, rather than the details of these allocations, attention has tended to focus on the broader and longer-term issue of whether Chile can finance ever more vociferous social demands while remaining within the bounds of the fiscal policy it has adhered to for the past decade.

The rule

The concept behind this policy is extremely simple. Essentially, it states that the government’s spending in a given year should be determined not by the revenues it happens to receive in that particular year but by its structural or cyclically-adjusted income or, in other words, the average level of revenues it can expect to receive over a much longer period.

During a boom year, the government doesn’t, therefore, go on a spending spree but, instead, sets aside some of its higher revenues for leaner times. That was what happened between 2004 and 2008 when a series of fiscal surpluses went largely into the FEES and the Pension Reserve Fund (FRP), the country’s other sovereign wealth fund.

But, although the concept is simple, calculating structural fiscal revenues is far from straightforward. Some of the problems were addressed when the policy was introduced and, for example, the two key determinants – the long-term copper price and the economy’s capacity for non-inflationary growth – are estimated each year by committees of independent experts summoned by the Finance Ministry.

But that still leaves a lot of room for argument. What, for example, about the price of molybdenum? And how should interest earnings on the government’s sovereign wealth funds be treated? Should they be included in structural income? 

These were among the issues debated by a special committee set up last year to advise the government. But its findings triggered another argument that is at the root of much of the current debate about Chile’s fiscal sustainability.

In 2009, its last year in office, President Michelle Bachelet’s government aimed to run a structurally balanced budget or, in other words, to spend exactly its structural revenues. But the international recession had a greater impact than it had anticipated and the end result, according to its figures, was a structural deficit of 1.2% of GDP.

But the Fiscal Rule Committee questioned that figure and argued that the structural deficit in 2009 was, in fact, 3% of GDP. The discrepancy is almost entirely explained by some tax reductions introduced in 2009 as part of measures to stimulate the economy.

Because they were temporary – and were, in fact, reversed as planned – the Bachelet government did not subtract them from structural income as, according to the Committee, it should have done. The Committee’s argument is that temporary tax changes have a habit of becoming permanent so, as a prudential measure, should be considered when calculating structural fiscal income.

Long-term sustainability

The problem, according to Bachelet’s finance minister Andrés Velasco, is that the present government, which had initially promised to put the budget back into structural balance, took political advantage of this point and has used it as grounds for continuing to run a structural deficit. “We ran three years of structural surpluses with just a small deficit in the last year; with this government, we’re looking at four years of deficits,” he points out. 

Disputing Minister Larraín’s claim that the government has to tighten its belt each year in order to close the deficit to its target of 1% by 2014, Velasco maintains that, because the tax cuts were reversed, the Piñera administration started out with an inherited structural deficit of only 1.2% of GDP. “So moving to 1% over four years implies no fiscal effort; there really is no excuse for not going back to a 0% structural deficit,” he argues.  

The risk is not this year or next, he says, but further in the future. “The problem with fiscal sustainability is that if you persevere on even a slightly wrong track for, say, ten years, then you end up getting it really wrong,” he warns.

However, Klaus Schmidt-Hebbel, an economics professor at the Catholic University and president of the committee that advises the government on management of its sovereign wealth funds, maintains that the speed at which the structural deficit is closed is not a key issue. “Whether it takes two, three or four years is marginal,” he says.

Indeed, he argues that Chile, which passes the test of fiscal sustainability with “flying colors”, could afford to run a permanent structural deficit, even if it used up its sovereign funds and became a net international borrower. Debtor countries are still fiscally sustainable, he says, as long as their growth exceeds the interest rate on their borrowing.

But, in Chile’s case, it’s unlikely to come to that. In 2011, thanks mainly to strong growth and high copper prices, government spending will fall short of actual – although not structural – fiscal revenues and the Finance Ministry has recently confirmed that the difference – some 1.2% of annual GDP or around US$2.6 billion – will be deposited in its sovereign wealth funds.

Even while maintaining a structural fiscal deficit, the government would, in other words, leave Chile in a stronger position than when it took office in 2010, argues Schmidt-Hebbel. That would, however, change if the world were to go into recession next year since not only would tax and copper revenues drop accordingly but the chances are that the government would dip into the FEES to finance contingency measures.  

How much tax is enough?

But that still leaves the problem of responding to the social demands that have surfaced with such vigor this year. The government cannot, as Minister Larraín insists, be expected instantly to solve demands that have been brewing for years.

And so far, the amounts of money it has committed are, in fact, relatively small but the issues being debated – principally education but also, for example, healthcare – could potentially require massive amounts. And new programs, even if small, all add to inertial expenditure and, without new sources of permanent fiscal revenues, shrink the space for future governments to implement new initiatives of their own.

There’s broad agreement that new programs which imply a permanent spending commitment should be matched by a new source of permanent revenues and that’s positive, says Larraín Vial’s Leonardo Suárez. But, he adds, what the structural deficit tells us is that medium-term sustainability will require higher taxes.                                                                                                                                                             

As countries get richer, they also tend to increase their tax burden or, in other words, the ratio of tax revenues to GDP and the question now being asked is whether Chile isn’t at the point where it should consider this option.  There will have to be an increase at some time in the future but it’s not an issue the government is prepared to discuss in the heat of the budget debate, says Minister Larraín.

Comparing tax burdens across countries is notoriously complex and, in Chile’s case, more than usually so. In Chile, unlike many other countries, most social security payments are, for example, paid into private pension funds, rather than as taxes. And how do you key in the tolls paid for the use of roads built as private concessions or the usually high percentage of spending on education that is borne by households?

There is, however, a fair degree of consensus that Chile’s tax burden is not far out of line with its current level of per capita income. But where it does have a lot of room for improvement, says Schmidt-Hebbel, is in the efficiency of its tax system.

It is neither efficient nor fair, he says, that a high-earning individual on a company payroll pays a marginal income tax rate of 40% and an average of perhaps 30% – higher than in many other OECD countries, he points out – while a self-employed person earning a similar amount pays much less tax.

Chile’s tax system has also been criticized as being regressive and, therefore, helping to lock in income inequality. But knowing whether a tax is regressive or progressive is not easy, points out Velasco.

Take, for example, fuel tax. Levied at a fixed rate per liter, it is apparently regressive, hitting the poor harder than the rich, but, in practice, is paid mostly by better-off households because they have more cars.

In any case, the tax system is not an efficient way to transfer resources to those who need them, points out Schmidt-Hebbel. What matters far more is how the money is spent and, in particular, how well spending is targeted.

In other words, the current debate about tax reform is back-to-front. Before deciding whether higher taxes would be in order, Chile first needs to agree on the initiatives it would like to implement – and, on education at least, that may not be easy. 

Ruth Bradley is a freelance journalist based in Santiago and a former editor of bUSiness CHILE.