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Tackling the three main challenges in Costa Rica: fiscal reform, reverting the slowdown in productivity and reducing inequality

By Paula Garda and Mauro Pisu, Country Studies Branch, OECD Economics Department

Costa Rica’s economic, social and environmental achievements are impressive. It has succeeded in combining rising living standards, virtually universal health care, pension and primary education systems with sustainable use of natural resources. Incomes per capita have nearly doubled in real terms over the past three decades and some well-being indicators (health, environment and life-satisfaction) are comparable with or even above the OECD average. However, as the latest Economic Assessment of Costa Rica highlights the country faces old and new challenges that will need be addressed to continue developing in a sustainable way.

In the period 2008-2015, the public debt-GDP ratio almost doubled to 42.4% (Figure 1, Panel A and B) and interest payments on government debt rose from 15 to 19% of central government revenues. The budget deficit reached 6% of GDP in 2015. Measures to restore fiscal sustainability are now urgent.

In addition, Costa Rica faces long-standing structural problems:

  • Inequality has been increasing since the mid-1990s to high levels by OECD standards. This is in stark contrast with many other Latin American economies, which have recently made significant progress in reducing inequality and poverty (Figure 1, Panel C).
  • Labour productivity growth has been disappointing mainly because of sluggish technical progress. This has taken place despite policies promoting international markets openness and attracting foreign direct investment (FDI) inflows (Figure 1, Panel D).

Costa Rica Fisc

How can policymakers address the three challenges?

The fiscal challenge is the priority. The two bills the government proposed in 2015 – as part of a tax reform package – to replace the sales tax with a full-fledged VAT system and reform the income tax are still under discussion in the legislative assembly. It is urgent to approve them as soon as possible. The VAT and the income tax reform would cut the deficit by about 2% of GDP over the following two years (mostly due to the introduction of the VAT) and would help stabilise the debt-GDP ratio. The two bills are well thought out and consistent with OECD advice: broadening tax bases and relying more on VAT are growth friendly ways to raise tax receipts. Also, most OECD countries have VAT systems, including Mexico and Chile. Additional fiscal or expenditure control measures of 1% of GDP will be needed to put debt on a firm downward path (Figure 1, Panel B). These should focus on reforming the public employment system to prevent excessive automatic salaries increases and raise public sector efficiency. Reforming the public employment system is key to boost productivity and lower inequality as public administration inefficiencies hamper business dynamism and public sector employment contributes to rising inequality in Costa Rica.

Structural reforms and institutional changes are necessary to increase productivity and build a more inclusive society by reducing inequality and poverty.

The three main areas of reforms to boost productivity include: 1) improving the framework of competition policy by strengthening the power of the competition authority and improving the governance of state-owned enterprises, which play a dominant role in many key sectors such as banking, electricity, insurance and telecoms; 2) enhancing links between the foreign and domestic firms and encouraging innovation by local enterprises through better links with universities; 3) improving transport infrastructure by simplifying the sector institutional framework and accelerating project execution.

Reforms to increase productivity need to go hand in hand with making Costa Rica a more inclusive society, especially for women. This will require improving the quality of education – and not just increasing spending on it – enhancing the effectiveness of cash transfers– by reducing programmes’ fragmentation and improving targeting – and lowering informality – by strengthening enforcement, reducing administrative burdens to entrepreneurship and enabling the poor to become formal workers. Costa Rica should also reinforce environmental protection by reducing emissions from the transport sector and improving wastewater treatment.

Find out more:

OECD (2016a), OECD Economic Surveys: Costa Rica 2016, OECD Publishing, Paris.




Policymakers: Act now to break out of the low-growth trap and deliver on our promises

By Catherine L. Mann, OECD Chief Economist

Policymaking is at an important juncture. Without comprehensive, coherent and collective action, disappointing and sluggish growth will persist, making it increasingly difficult to make good on promises to current and future generations.

Global growth has languished over the past eight years as OECD economies have struggled to average only 2 per cent per year, and emerging markets have slowed, with some falling into deep recession. In this Economic Outlook the global economy is set to grow by only 3.3 per cent in 2017. Continuing the cycle of forecast optimism followed by disappointment, global growth has been marked down, by some 0.3 per cent, for 2016 and 2017 since the November Outlook.

The prolonged period of low growth has precipitated a self-fulfilling low-growth trap. Business has little incentive to invest given insufficient demand at home and in the global economy, continued uncertainties, and a slowed pace of structural reform. In addition, although the unemployment rate in the OECD is projected to fall to 6.2 per cent by 2017, 39 million people will still be out of work, almost 6.5 million more than before the crisis. Muted wage gains and rising inequality depress consumption growth. Global trade growth, at less than 3 per cent on average over the projection period, is well below historical rates, as value-chain intensive and commodity-based trade are being held back by factors ranging from spreading protectionism to China rebalancing toward consumption-oriented growth.

Negative feedback-loops are at work. Lack of investment erodes the capital stock and limits the diffusion of innovations. Skill mismatches and forbearance by banks capture labour and capital in low productivity firms. Sluggish trade prospects slow knowledge transfer. These malignant forces slow down productivity growth, constraining potential output, investment, and trade. In per capita terms, the potential of the OECD economies to grow has halved from just below 2 per cent 20 years ago to less than one per cent per year, and the drop across emerging markets is similarly dramatic. The sobering fact is that it will take 70 years, instead of 35, to double living standards.

The low-growth trap is not ordained by demographics or globalization and technological change. Rather, these can be harnessed to achieve a different global growth path – one with higher employment, faster wage growth, more robust consumption with greater equity. The high-growth path would reinvigorate trade and more innovation would diffuse from the frontier firms as businesses respond to economic signals and invest in new products, processes, and workplaces.

What configuration of fiscal, monetary, and structural policies can propel economies from the low-growth trap to the high-growth path, safeguarding living standards for both young and older generations?

Monetary policy has been the main tool, used alone for too long. In trying to revive economic growth alone, with little help from fiscal or structural policies, the balance of benefits-to-risks is tipping. Financial markets have been signalling that monetary policy is overburdened. Pricing of risks to maturity, credit, and liquidity are so sensitized that small changes in investor attitude have generated volatility spikes, such as in late 2015 and again in early 2016.

Fiscal policy must be deployed more extensively, and can take advantage of the environment created by monetary policy. Governments today can lock in very low interest rates for very long maturities to effectively open up fiscal space. Prioritized and high-quality spending generates the capacity to repay the obligations in the longer term while also supporting growth today. Countries have different needs and initial situations, but OECD research points to the kind of projects and activities that have high multipliers, including both hard infrastructure (such as digital, energy, and transport) and soft infrastructure (including early education and innovation). The right choices will catalyse business investment, which, as the Outlook of a year ago argued, is ultimately the key to propelling the economy from the low-growth trap to the high-growth path.

The high-growth path cannot be achieved without structural policies that enhance market competition, innovation, and dynamism; increase labour market skills and mobility; and strengthen financial market stability and functioning. As outlined in the special chapter in this Outlook, the OECD’s Going for Growth and the comprehensive Productivity for Inclusive Growth Nexus Report of the OECD Ministerial Summit, there is a coherent policy set for each country based on its own characteristics and objectives that can raise productivity, growth and equity.

The need is urgent. The longer the global economy remains in the low-growth trap, the more difficult it will be to break the negative feedback loops, revive market forces, and boost economies to the high-growth path. As it is, a negative shock could tip the world back into another deep downturn. Even now, the consequences of policy inaction have damaged prospects for today’s youth with 15 per cent of them in the OECD not in education, employment, or training; have drastically reduced the retirement incomes people are likely to get from pension funds compared to those who retired in 2000; and have left us on a carbon path that will leave us vulnerable to climatic disruption.

Citizens of the global economy deserve a better outcome. If policymakers act, they can deliver to raise the future path of output – which is the wherewithal for economies to make good on promises – to create jobs and develop career paths for young people, to pay for health and pension commitments to old people, to ensure that investors receive adequate returns on their assets, and to safeguard the planet.

 




Does monetary policy increase income and wealth inequality?

by Rory O’Farrell, Łukasz Rawdanowicz, and Kei-Ichiro Inaba,  Macroeconomic Policy Division, OECD Economics Department

As asset prices have risen in recent years, so have concerns that monetary policy, and quantitative easing in particular, has increased inequality. Concern has moved from being the preserve of central bankers and the pages of the financial media to entering popular discourse with calls for “People’s QE” in the United Kingdom. However, recent research shows that not only are the impacts via financial channels of such policies on inequality small, they even have the potential to reduce it.

Monetary policy effects on inequality are ambiguous in theory. A fall in interest rates reduces debt servicing costs and returns on financial assets and may increase, reduce or leave unchanged income inequality. The impact depends on the relative size of variable-rate liabilities and interest-paying assets, or the ease at which rates can be re-negotiated, and on differences in the distributions of income, assets and liabilities. Similarly, an increase in asset prices has an uncertain impact on the inequality of net wealth (households’ assets minus liabilities). As poorer households tend to have high debts in relation to assets, their net wealth stands to benefit most from asset price increases.

Interest rate cuts have a small impact on income inequality in advanced economies. Simulations show that the Gini coefficient – a popular measure of inequality – for the income distribution increased in all the countries studied, except the United States, as a result of a 4-percentage point reduction in interest rates. However, this was only a tiny fraction of the overall changes in the Gini coefficient observed during the Great Recession for all the countries except Belgium and Germany (Figure 1). Moreover, these inequality-raising effects of monetary policy could have been partially, or even more than fully, offset by the stabilising effects of monetary easing on employment that benefit low-income workers disproportionally.

Figure 1. Simulated changes in Gini coefficients due to 4 p.p. lower interest rates

Lukasz

Note: Negative changes imply a decline in inequality. Squares mark actual changes in the Gini coefficients for market income between 2007 and 2010.
Source: OECD Income Distribution and Poverty Database; and O’Farrell et al. (2016).

Likewise, asset price changes are unlikely to have had a large effect on net wealth inequality. Even if asset valuations vary by as much as they changed during the Great Recession, it would not alter the Gini coefficients for the net wealth distribution significantly in most of the countries analysed. Moreover, the reversal of asset valuations since 2010 suggests that net effects over the business cycle are even smaller. The muted overall impact of changes in asset prices is in part due to rising house prices generally reducing net wealth inequality and thus offsetting the inequality-raising increase in equity and bond prices.

Interactions between monetary policy and inequality pose communication challenges. Even if cyclical implications of monetary policy for inequality as measured by the Gini coefficient are small, larger losses or gains for very specific and vocal groups tend to attract media attention. This calls for clear explanations of the advantages and disadvantages of various inequality measures and all possible channels affecting the overall net effect. It also needs to be communicated that current effects are likely to be reversed during the monetary policy tightening cycle and that inequality fluctuations would be much larger without monetary policy intervention.

References

O’Farrell, R., Ł. Rawdanowicz and K.-I. Inaba (2016), “Monetary policy and inequality”, OECD Economics Department Working Papers, No. 1281, OECD Publishing, Paris.




Europe’s top 1%: Who they are and how you get in

by Oliver Denk,
Economist, Policy Studies

Extreme inequality at the top of the earnings scale has been high and rising in countries around the globe. But who are the select few with the highest labour incomes? And what determines who they are?

That’s the theme of my new working paper on Europe’s 1%, which for the first time puts hard numbers on who the top earners are across 18 European countries. Answers to these questions are important. They inform debates on the causes of inequality and what governments can do to ensure that those who earn the highest incomes deserve them.

The data source I use is the Eurostat Structure of Earnings Survey for 2010. It is the largest harmonised dataset on earnings across Europe, covering 10 million people. The sample covers only employees, not self-employed, though checks suggest that self-employed make little difference to the results.

The analysis shows that the typical person in the top 1% is male, in his 40s or 50s, has a tertiary education degree, works in finance or manufacturing, and is a chief executive, manager or professional.

What determines who gets into the 1%? My paper suggests that two different sets of decisions matter: the choices you make, and the choices your governments make.

People with only secondary education are less likely to be in the 1%. Therefore, going to university improves the chances of earning a very high income.

The industry matters a lot. The average probability of being in the top 1% is 1%, but it is 3.8% for people working in finance, 2.7% for those in the ICT industry, and 2.5% for those in the professional services (see figure). At the other end of the spectrum, education and construction are two sectors for which the chances of earning a top income is low.

So, education and career paths, which to some extent are in everyone’s hands, are important for who is in the 1%. But so can be institutions and policies. Let me highlight this with two examples.

Top earners are 4½ years younger in Eastern than Western Europe. The difference is probably related to the economic transformation of Eastern Europe after the fall of the Iron Curtain. Workers already in the labour market during the 1980s, the last years of communism in the East, have less chance than in the West of having moved up to the top 25 years later.

A distinct feature of the top 1% is the large gender imbalance. The chance of being in the top 1% is much smaller for women, 0.3%, than men, 1.6% (see figure). Germany and Luxembourg have especially few women among top earners. What could be done about it? Comparing countries with one another shows that, where overall female employment is higher, more of the 1% are women. Thus, policies to broaden female participation in the labour market may also promote female representation at the top.

Men in finance have the highest chance of being in the 1%

denk
Note: The panels depict the simple average across 17 (for industry) and 18 (for gender) European countries. In the left panel, public administration is removed from the sample as data for this industry are not available for all countries.

Source: Oliver Denk (2015), “Who Are the Top 1% Earners in Europe?”, OECD Economics Department Working Papers, No. 1274, OECD Publishing, Paris




Yes, finance fuels income inequality


by
Boris Cournede,
Senior Economist, Public Economics Division
OECD Economics Department

The Great Financial Crisis has prompted a lively debate, where the financial sector has been accused of not only triggering crises but also concentrating income in the hands of a few. The Occupy Wall Street movement in New York coined the slogan “we are the 99%”, that is to say the bottom 99% in the income distribution. The OECD in Paris has extensively probed the data to examine how finance influences the distribution of income.

The main conclusion is that, indeed, financial expansion exacerbates income inequality. Econometric investigations uncover that more finance, in the form of more bank credit or larger stock markets, goes hand in hand with higher income inequality across OECD economies (see Chart). Further expansion in bank credit from the levels observed in OECD countries is associated with slower household income growth, but the negative effects are particularly acute at the bottom of the distribution, while simulations suggest that the top 10% benefit. Stock market expansion is linked with stronger household income growth, but the benefits are concentrated at the top and the very bottom of the income distribution is simulated to lose out. These effects, which have been identified on average across OECD countries, might not apply at lower levels of development.

The effects of credit and stock market expansion vary a lot across income levels
A. Simulated effect of a 10% of GDP expansion of financial
sector credit on household income growth
credit
 B. Simulated effect of a 10% of GDP expansion of stock market
capitalisation on household income growth
stockmarket
Note: Household income growth is household disposable income growth per capita. Stock market capitalisation is the value of all shares listed in a stock market. The horizontal line indicates the change in household income growth for the economy as a whole.

The estimates suggest the strong expansion of private credit over 1990-2010 contributed 0.8 Gini points to the 3.1 Gini-point widening of household disposable income inequality observed during the period (in the OECD countries for which the data are available). In other words, by growing much faster than GDP, private credit accounted for a quarter of the increase in income inequality: a non-negligible driving force.

OECD empirical work highlights three key mechanisms (while not excluding other ones) behind this link:

  1. Financial sector workers are very concentrated at the top of the income distribution.

Financial sector employees are concentrated high up in the income distribution. In Europe, financial sector employees make up only 4% of the workforce but 20% of the top 1% earners. In Luxembourg and the United Kingdom, more than 30% of employees in the top 1% work for financial firms. The high number of financial sector workers among top earners is justified as long as very high productivity underpins their earnings. However, detailed econometric investigations find that financial firms pay wages well above what employees with similar profiles earn in other sectors. Even worse, the premium is especially large for top earners.

  1. High income earners can and do borrow more.

The distribution of credit is twice as unequal as the distribution of household income in euro area countries (where detailed, internationally comparable data are available). More than 45% of total household credit goes to the top 20% of the income distribution in Austria, Finland, France, Germany and Italy. Credit expansion fuels income inequality, because the well-off gain more than others from the investment opportunities that they can identify.

  1. Much of the benefits of stock market expansion go to affluent households.

Stock holdings are disproportionately concentrated in the hands of high-income people. In the euro area, stock market wealth is four times more unequally distributed than household income. As a consequence, larger stock markets, which generate more dividends and capital gains, widen the income distribution.

As a result, more finance means more income inequality.

Find out more:

Cournède, B., O. Denk and P. Hoeller (2015), “Finance and Inclusive Growth”, OECD Economic Policy Papers, No. 14, OECD Publishing, Paris.

Denk, O. (2015), “Financial Sector Pay and Labour Income Inequality: Evidence from Europe”, OECD Economics Department Working Papers, No. 1225, OECD Publishing, Paris.

Denk, O. and A. Cazenave-Lacroutz (2015), “Household Finance and Income Inequality in the Euro Area”, OECD Economics Department Working Papers, No. 1226, OECD Publishing, Paris.

Denk, O. and B. Cournède (2015), “Finance and Income Inequality in OECD Countries”, OECD Economics Department Working Papers, No. 1224, OECD Publishing, Paris.