Fiscal Policy and Development in Latin America: What is the link?

Fiscal policy is not just an instrument for macroeconomic management, but also a tool which can be wielded by Latin American governments in the pursuit of development. Thoughtful and active use of tax policy, public spending and debt management can boost Latin America’s development by promoting growth and reducing poverty and inequality.

What is more, the performance of a country’s fiscal system provides a snapshot of the social contract that links its government and its citizens. Publicly provided goods and services of reasonable quantity and quality for the one part, and transparent and progressive tax systems for the other, are signs of a healthy social contract. These two parts go hand in hand: if public goods such as health, education and infrastructure are scarce, low-quality or inequitably provided, the social contract is weakened. The same is true of fragile or regressive tax regimes.

This social contract is especially relevant to Latin America today because the region is in the midst of a democratic consolidation. In this context the performance of a country’s fiscal system – and citizens’ perceptions of that performance – is closely linked to the legitimacy of democracy itself. Fiscal legitimacy, the belief that the tax and public spending system is fair, is the key mediator in this. High levels of fiscal legitimacy are found where  the tax and transfer system is effective in addressing income inequality; high-quality public services are equitably delivered; obligations and entitlements are governed by fair and transparent rules; and there exists a reasonable level of public support for the government’s management of the fiscal system.

Fiscal policy choices do not exist in a vacuum and are always subject to politically determined constraints.  Politics matters because fiscal policy is inextricably interwoven with the nature of the welfare state, the shaping of which is a profoundly political process. In short, political economy matters: a consideration of political constraints needs to be added to the technical design of fiscal systems in order to boost prospects for lasting reform in the region.

Contrary to conventional views of fiscal policy as a threat to growth (via the disincentive effect of taxes on work and investment) or as no more than a macroeconomic stabiliser for inflation and unemployment, this Outlook argues that fiscal policy can be a key tool for economic, political and social development in Latin America. Fiscal systems can provide the resources needed to carry out pro-growth investments and structural transformations. Taxes and public spending can directly attack poverty and inequality, twin problems that continue to beset the region.

This potential for good is substantially unrealised in Latin America. While taxes and transfers reduce inequality by 19 Gini points in Europe, the difference is less than two Gini points in Latin America. Social security spending, strongly regressive in the region, is a major culprit in the unfulfilled potential of redistributive fiscal policy. And the quality of basic public goods and services such as health or education neither meets the region’s development needs nor provides a spur to citizens’ engagement with the state. A change of approach is needed if Latin American governments are fully to exploit the potential of fiscal policy as a development tool.