Public Expenditure in Latin America: Trends and Key Policy Issues

WP/07/21


Public Expenditure in Latin America:
Trends and Key Policy Issues

Benedict Clements, Christopher Faircloth,
and Marijn Verhoeven

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© 2007 International Monetary Fund
WP/07/21




IMF Working Paper



Western Hemisphere and Fiscal Affairs Departments

Public Expenditure in Latin America: Trends and Key Policy Issues

Prepared by Benedict Clements, Christopher Faircloth,
and Marijn Verhoeven1

February 2007

Abstract

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.

This paper examines trends in government spending in Latin America from the mid-1990s to
2006. It also examines key policy issues, including the cyclicality of spending, public
investment, public employment, and social expenditures. It finds that primary expenditures
have trended upward for the past ten years as a share of GDP, driven by increases in current
spending, in particular for social expenditures. Fluctuations in real spending have continued
to follow a procyclical pattern. The paper finds that there is substantial scope to improve the
efficiency of public investment, public employment, and social spending.

JEL Classification Numbers: E6, H5, O54
Keywords: Public Expenditure, Fiscal Policy, and Latin America
Author(s) E-Mail Address: bclements@imf.org; cfaircloth@imf.org; mverhoeven@imf.org


1 The authors would like to acknowledge the useful comments received by Pablo Pereira, Roberto Steiner, and
numerous colleagues in the IMF’s Fiscal Affairs and Western Hemisphere Departments. Valuable research
assistance was provided by Takahiro Atsuta, Priya Joshi, and Victoria Gunnarsson.

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Contents
Page

I.
Introduction.......................................................................................................................4

II. Trends in Public Spending ................................................................................................4

A. Overview of Aggregate Fiscal Trends .....................................................................4

B. Trends in Government Expenditure.........................................................................6

III. Key Expenditure Policy Issues .......................................................................................11

A. The Cyclicality of Government Spending .............................................................11

B. Public Investment...................................................................................................14

C. Public Sector Employment ....................................................................................17

D. Social Spending .....................................................................................................21

IV. Summary and Policy Implications ..................................................................................24

Appendices
I.
Econometric Methodology Used to Assess the Cyclicality of Spending .......................26
II. The Efficiency of Public Investment in Latin America ..................................................27

References ................................................................................................................................31

Tables
1.
Estimates of the Short-Run Response of Spending to Output Shocks............................12
2.
Response of Expenditure to Output Gaps.......................................................................13
3.
Public Investment in Latin America and Other Regions, 1990–2006 ............................15
4.
General Government Wages and Salaries in Latin America and Other

Regions, 2004 .............................................................................................................17
5.
Government Employment in Latin America and Other Regions, 1990s ........................18
6.
Government Effectiveness in Latin America and Other Regions...................................18
7.
General Government Social Spending in Latin America and Other

Regions, 2004 .............................................................................................................21
8.
Distribution of Benefits from Social Spending to the Top and Bottom Quintiles..........24

Figures
1.
Fiscal Trends.....................................................................................................................5
2.
Primary Public Spending by Region.................................................................................6
3.
Initial Primary Spending Levels (1995) and Increases (1995–2006) ...............................7
4.
Real GDP, Revenues, and Primary Spending...................................................................8
5.
Public Sector Expenditures ...............................................................................................9
6.
Average Public Sector Capital Spending..........................................................................9

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7.
Trends in Social Spending ..............................................................................................10
8.
Institutional and Infrastructural Performance—Deviation of Actual Indices from

Values Predicted by PPP-Adjusted Per Capita Income ...............................................16
9.
Public Share of Infrastructure Spending and Efficiency.................................................16
10. Relationship Between GDP Per Capita and Bureaucratic Quality .................................19
11. The Quality of the Bureaucracy......................................................................................20
12. Government Effectiveness ..............................................................................................20

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I. INTRODUCTION
The appropriate role of government spending in fostering economic growth remains an
important element in the policy debate in Latin America. Beyond their macroeconomic
impact, expenditure policies can affect growth through a number of channels, including their
effects on the development of physical and human capital.2 These policies have an especially
important role in Latin America, given the wide disparities in living standards among the rich
and the poor in the region (de Ferranti and others, 2004). At the same time, public debt
ratios—notwithstanding recent reductions—remain high at over 50 percent of GDP, limiting
the ability of governments to meet social needs and bolster the region’s infrastructure.

This paper assesses trends in public expenditures in Latin America and discusses key
policy issues in the period ahead. The analysis covers 17 countries and trends in spending
from the mid-1990s to 2006.3 In addition, the paper examines several key expenditure policy
issues, including: (i) the cyclicality of government spending; (ii) public investment;
(iii) public employment; and (iv) social expenditures.

II. TRENDS IN PUBLIC SPENDING
A. Overview of Aggregate Fiscal Trends
Fiscal balances generally weakened in the latter half of the 1990s. Rising primary
spending tended to outpace increases in revenues, contributing to a deterioration in primary
balances of over 1 percentage point of GDP (Figure 1).4 Average primary balances fluctuated
over a relatively narrow range over the period, although there were significant differences
across countries. Revenue ratios rose in about half of the countries of the region, and on
average increased by about a percentage point of GDP.

2 For a more extensive overview of how fiscal policy and government expenditures affect growth, see Clements,
Gupta, and Inchauste (2004).
3 Countries comprise Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, Paraguay, Uruguay,
and Venezuela (South America and Mexico) and Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua,
and Panama (Central America). 2006 data refer to IMF staff projections as of end-August 2006.
4 Figures based on the broadest definition of government available. For 14 of the 17 countries, expenditure data
refer to the public sector or nonfinancial public sector (that is, general government, plus the capital expenditures
of the public enterprises). For Argentina and Mexico, expenditures also include the current outlays of the public
enterprises (e.g., wages), although in the case of the former these outlays are very small. For Chile, data cover
general government; and for Guatemala, central government.

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Figure 1. Latin America: Fiscal Trends
(In percent of GDP) 1/
3.0
30
2.5
Primary Balances (LHS)
28
Primary Expenditures (RHS)
2.0
Revenues (RHS)
1.5
26
1.0
24
0.5
22
0.0
-0.5
20
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: Authors' calculations.
1/ Unweighted average of 17 countries. Based on the broadest definition of government available. See
footnote 4 in the main text for details.


Fiscal positions have improved this decade, based largely on a strengthening of
revenues. After a slight decline over 2000–02, average primary balances have trended
upward, with primary surpluses in recent years exceeding substantially their mid-1990s
levels. This owes largely to surging revenues, especially from commodities. Revenues have
risen by an average of about 3½ percentage points of GDP since 2002, with oil producers
experiencing a boost in receipts of over 7 percent of GDP.5 Bolivia, Chile, and Peru have also
benefited from the boom in metals prices and export-based revenues. Noncommodity
revenues have also risen, on average, since 2002 in the 17 countries of the region—reflecting
also improved tax administration—but by a more modest amount (about 1 percent of GDP)
than commodity revenues. Higher primary surpluses, as well as other improvements in
macroeconomic policies, have helped underpin the region’s ongoing economic expansion.6

Notwithstanding strengthened primary balances, public debt ratios remain above
desirable levels in many countries in the region. On a weighted average basis, public debt
in Latin America is projected to remain above 50 percent of GDP by end-2006, little changed
from the ratio prevailing in the mid-1990s. Given that the prudent maximum level of debt for
a typical emerging market is generally much lower—according to some estimates, as low as
25 percent of GDP—debt burdens remain a challenge to entrenching macroeconomic
stability.7

5 Oil producers comprise Ecuador, Mexico, and Venezuela.
6 See IMF (2006b) for further discussion.
7 See, for example, IMF (2003).

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B. Trends in Government Expenditure
Trends across country groups and subperiods

Primary outlays have drifted upward over time. In both Central America and South
America and Mexico, primary spending has edged upward as a share of GDP since the mid-
1990s (Figure 2). The rise in outlays has not been continuous, however. During what could
be called the “first phase” of spending increases (1995–2001), spending rose by 3 percentage
points of GDP (the median increase was 1½ percent). Average spending ratios then
experienced a period of decline during the economic downturn of 2002 and the first two
years of the recent recovery (2003–04). The decline in spending was widespread, with 13 of
the 17 countries trimming spending-to-GDP ratios between 2001 and 2004. More recently,
there has been a “second phase” of spending increases with the maturation of the recovery,
with outlays rising by about 1½ percentage points of GDP between 2004 and 2006. With this
second round of spending increases, outlays have now surpassed their previous peak ratio to
GDP of 2001.
Figure 2. Latin America: Primary Public Spending by Region
(In percent of GDP) 1/
30
Latin American Average
27
South America & Mexico
Central America
24
21
18
15
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: Authors' calculations.
1/ Unweighted average of 17 countries. Based on the broadest definition of government available.

Spending increases were widespread across countries during the first phase
(1995–2001). Outlays rose in all but 2 countries of the region—Paraguay and Peru—where
spending was largely unchanged in relation to GDP. At the same time, there was a wide
variance in spending increases across countries. In Brazil, spending rose by 8½ percentage
points of GDP, driven by higher nonwage current outlays. In Honduras and Uruguay, outlays
rose by over 5½ percent of GDP, with a large increase in the wage bill explaining much of
the spending increase in the former. In Bolivia and Chile, spending also rose briskly (by
about 4½ percent of GDP), owing to higher outlays for pensions (Bolivia) and higher social
spending and capital expenditures (Chile).

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Spending increases were broad-based across the region in the second phase (2004–06).
Expenditures climbed in all but 4 countries of the region. Spending hikes varied widely
across countries, as reflected in the lower median increase in spending (½ percentage point of
GDP) than mean increase (1½ percent of GDP). The disparity reflected especially large
increases in Venezuela (over 9 percent of GDP), as well as Bolivia, Brazil, and Nicaragua
(all 2½ percent of GDP or greater). On average, increases were notably lower in Central
America (about ½ percent of GDP), where countries have not benefited from the buoyant
commodity revenues enjoyed by South America and Mexico.

There has been no tendency for convergence in the size of government across the
region. In fact, countries with higher levels of initial spending in 1995 have experienced
somewhat sharper increases in outlays (Figure 3). One notable exception is Uruguay, where
fiscal adjustment in the wake of the crisis earlier this decade has left spending ratios below
those prevailing in the mid-1990s.
Figure 3. Latin America: Initial Primary Spending Levels (1995) and
Increases (1995 - 2006)
12
P
,

Venezuela
D
10
Brazil
Bolivia
8
Nicaragua
6
Honduras
4
Mexico
Colombia
a
r
y

s
p
e
n
d
i
n
g

t
o

G
Guatemala
El Salvador Costa Rica
1
9
9
5

-

2
0
0
6
2
Chile
Ecuador
Argentina
Panama
0
Uruguay
Peru
-2
I
n
c
r
e
a
s
e

i
n

p
r
i
m
Paraguay
-4
5
10
15
20
25
30
35
Primary spending to GDP, 1995
Source: Authors' calculations.

Budget rigidities have contributed to rising spending. In Brazil, for example, the revenue-
based fiscal consolidation strategy in place since 1999, combined with extensive budget
rigidities, has contributed to the large increase in spending since the mid-1990s. Revenue
earmarking, in particular, led to spending increases as the revenue effort increased. Budget
rigidities have also led to spending pressures in Colombia, especially during the late 1990s
when both revenue and expenditure ratios rose. In Chile, in contrast, the relatively low level
of budget rigidities, in tandem with its fiscal policy rule, have helped contain public spending
increases in the face of rising revenues.8

8 See Alier (2007) for a discussion of budget rigidities in Argentina, Brazil, Chile, and Ecuador.

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Relatively small overall changes in spending-to-GDP ratios mask the volatile and
procyclical behavior of real expenditures. Real spending growth in the past decade has
varied considerably from year to year, and has tended to follow the economic cycle and
growth of real revenues (Figure 4). Real spending fell, for example, during the economic
downturns in Argentina and Venezuela early in the decade, but since then has rebounded
markedly. While real spending increases were well contained across the region during 2003–
04, they have accelerated over the past two years, with outlays climbing by an average of
8 percent per annum.9 Spending increases have been somewhat higher among commodity
producers, but the expenditure boom has been a common phenomenon in the region, with
governments in 15 of 17 countries increasing real outlays by 5 percent or more per annum in
2005–06.
Figure 4. Latin America: Real GDP, Revenues, and Primary Spending
(Annual percent change) 1/
12
Real Revenues
10
Real Primary Expenditures
8
Real GDP
6
4
2
0
-2
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: Authors' calculations.
1/ Unweighted average of 17 countries. Based on the broadest definition of government available.

Trends in spending categories

The trend toward rising spending to GDP ratios over the past 10 years is attributable to
higher primary current outlays (Figure 5). Wage bills have risen by about ½ percentage
point of GDP over this period—mostly in the late 1990s—while nonwage current outlays
have increased by about 3 percentage points of GDP. As indicated below, rising social
outlays appear to have accounted for this higher spending, including social insurance
benefits.

Capital expenditures have tended to decline over time, although there has been a
reversal of this trend of late. These outlays hovered near 6 percent of GDP in the latter half

9 For a further assessment of recent trends in real spending growth by country, see IMF (2006b).

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