In the past two decades and even during the recent crisis, progress in Latin America and the Caribbean in the area of public finances has been remarkable, although significant challenges remain. The level of public debt has been reduced and tax revenues have increased, thereby reducing budget rigidities and expanding fiscal space. However, levels of spending on social programmes and productive support are still very uneven, both within countries and between countries in the region. This reflects different institutional designs, but also insufficient coverage in health, education, employment protection, pensions and infrastructure.

This chapter discusses these major trends in public finances (section 3.2) and their recent development. These advances have led to increased public spending, contributing to poverty reduction in the region. However, the level of inequality in the distribution of personal income remains substantially higher than in other regions of the world. Low levels of personal direct taxes, limited targeting of public spending and the small size of direct transfers to poor households explain the low redistributive role of public finances (section 3.3). In addition, low tax revenues in most Latin American and Caribbean countries, with certain exceptions mainly in South America, represent a major obstacle to the development of a modern state that provides the public goods and services needed to accelerate economic growth and reduce inequalities. This limited tax revenue —due to high levels of evasion, informality and tax expenditures— reflects the weak social contract in the region between citizens and the state. As a result, in order to regain citizen confidence and restore the transformative role of the state, it is necessary to strengthen the social contract through a fiscal pact that focuses on resolving socio-economic challenges in the short and long term and on obtaining the material means to do so (section 3.4).

In countries with high levels of inequality the redistributive function of fiscal policy must be reinforced. In most OECD economies, fiscal policy is able to significantly reduce income inequality both because of the importance of transfers to lower income sectors and because of progressive tax systems. In Latin America, fiscal policy must also close regional equity gaps (present in both federal systems —Argentina, Brazil— and in decentralised unitary systems such as Colombia) as well as gender and intergenerational gaps. To do this, the region’s states need to extend income-transfer programmes for low-income citizens (following the good practices of conditional transfer programmes for health and education in Brazil and Mexico), and the solidarity pillars of social protection systems. Of particular importance are pensions (which must be designed not to discourage formal employment) and the implementation of stable policies for the development of infrastructure, innovation and education. These programmes should be complemented with better social safety nets, which reduce vulnerabilities in the events of unemployment, illness or retirement.

The state requires stable resources to perform its functions. States must strengthen their capacity for macroeconomic stabilisation —both automatic and discretionary— and their regulatory capacity. They must also expand their tax base, especially from income and assets, reducing tax evasion, avoidance and exemptions, and strengthen tax administration. Other innovative proposals in the area of taxation must also be considered in order to increase revenues, such as environmental taxation. This should be done while considering its impact on long-term growth.

The fiscal financing gap in the region is still significant. However, there are important differences among countries. Argentina, Brazil and Uruguay have levels of tax collection similar to the average for OECD economies, while in Central America and the Caribbean the rates are lower. But on the whole, the tax burden is low, as the structure is biased towards non-progressive taxes and levels of non-payment are significant.

The main difference in tax revenue from OECD economies is a result of the lower contribution of personal income tax, the base of which is severely limited by the combination of high income inequality, high labour informality, a multiplicity of tax expenditures, the high concentration of revenue from income from wages, weak tax administration, as well as tax evasion and low tax morale. However, according to the Latinobarómetro survey, Latin Americans who perceive a higher quality of public services (for example in health care and education) are less likely to justify tax evasion or to consider the tax burden excessive. States must therefore strengthen tax administration and expand the income-tax base in conjunction with increasing the quality of public services. 

Tax bases are also limited by the extent of tax expenditures in the form of exemptions, deductions and reduced rates. The effectiveness of existing tax expenditures need to be quantified and evaluated. Some of them could be transformed into more transparent spending policies, in accordance with criteria of efficiency and relative management capacity across government revenue and expenditure departments.

The transformative role of the state requires planning tools and greater co-ordination of policies, programmes and projects. Institutionalisation must be strengthened based on fiscal rules and medium-term frameworks, transparent accountability, mechanisms to evaluate policies and programmes, and national systems of public investment. Additional measures include strengthening human resources by developing a body of well-trained and motivated civil service professionals.

One of the greatest challenges for the countries in the region is to regain public trust. A fiscal pact can strengthen the social contract between citizens and the state. These pacts can be comprehensive, or it may address a specific sector such as education, employment, social protection or infrastructure. Or they pact may also be focused on a specific issue such as equality, public safety or the fight against poverty or hunger. Parliaments have a key role in these pacts, in the definition of public policies and their linkages with the budget, and in the negotiation of tax reforms that aim to improve tax systems.