XXIV MEETING OF THE LATIN AMERICAN NETWORK OF CENTRAL BANKS AND FINANCE MINISTRIESIAB Research Department – Regional Policy Dialogue

FISCAL POLICY THROUGH THE CYCLE: THE COLOMBIAN EXPERIENCE

Ignacio Lozano and Jorge Toro

Banco de la República, Colombia

October 19/20, Washington, D.C.

1. Business cycle and public finances in Colombia: An historical review

2. Trends and Cycles in Colombian Fiscal Accounts 2.1 Methodology 2.2 Results

3. The Colombian fiscal stance through the real cycle

4. Current fiscal stance and prospects

CONTENTS

Real Business Cycles (RBC) in Colombia

The Colombian economy has exhibited at least two large RBC during the last thirty years

• The 1st cycle started in 1978 with a boom-phase which lasted about 4 years That economic expansion was closely related to high external coffee prices

• Subsequently, the economy entered a low-growth-phase between 1982 and 1985 (common for all LAC). It was related to a decline of external commodities prices, the slowdown of world demand and the debt crises in LAC

• The 2th cycle began at the late 80´s The boom-phase spanned from the late 80´s to the mid 90´s (more irregular). Capital Inflows stimulated by structural reforms and an expansionary fiscal policy played a key role.

• The last and deepest crises took place by the end of the 90´s (growth rate of -4,2% in 1999). After a lengthy recovery, the economy is currently expanding again at a rapid rate.

Fiscal balance has been closely related to GDP performance

1. Business cycle in Colombia: 1977-2005

8.000

10.000

12.000

14.000

16.000

18.000

20.000

22.000

77 78 79 80 82 83 84 85 87 88 89 90 92 93 94 95 97 98 99 00 02 03 04 05

GD

P -

Bill

ions

of

Col

ombi

an P

esos

( 1

994=

100)

-8%

-6%

-4%

-2%

0%

2%

4%

GD

P -G

AP

GAP GDP Trend GDP

1st Crisis 2th Crisis

The Fiscal balance is closely associated to GDP performance GAP (Above) and Fiscal Balance (Below)

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

77 78 79 80 82 83 84 85 87 88 89 90 92 93 94 95 97 98 99 00 02 03 04 05

% G

DP

-8

-6

-4

-2

0

77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

(% G

DP

)

NFPSC-Government

1st Crisis 2th Crisis

And the fiscal balance is directly related to the Debt Ratio Fiscal Balance (Above) and Debt Ratio (Below)

-8

-6

-4

-2

0

77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

(% G

DP

)

NFPSC-Government

0

5

10

15

20

25

30

35

40

45

50

55

60

77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

(% G

DP

)

Government Debt

1st Crisis 2th Crisis

• 1st Crisis-Phase: The deficit of the Non-financial public sector (NFPS) reached 7,6% of GDP in 1982-83. Half of this deficit was explained by the Central Government. Three years later, the deficit was adjusted thanks to an effective economic program. By 1986 the public deficit was only 1,2% of GDP and Government debt reached 18,4% of GDP

• 2th Crisis-Phase: The NFPS reached a deficit of 6,4% of the GDP in 1999, due entirely to imbalance of the central government. Government debt attained a critical level of 54% of GDP in 2002. The government is currently facing additional challenges because of the narrow margins of its expenditure policy.

• Even though the balance of the NFPS improved markedly in the last two years, the central government fiscal position is still highly imbalanced.

Comments

st

at

ct TTT

YT

at

pta

ts

t Y

YTT

,

*

n

i

iYBBTYT T

Tiii

1,,, **

Tax Revenue: For t, the actual-tax-revenue (Ta ) has two components: structural (Ts) and cyclical (Tc). Hence,

The structural-component could be estimated using actual (Ya) and Potential output (Yp)

represents output-tax-elasticity. According to Blanchard & Perotti (1999), the output-tax-elasticity could be calculated as:

where = elasticity of taxes of type i to their tax base; = elasticity of the tax base to GDP, and . Trade taxes are adjusted for an exchange factor.

ii BT YTi

i

iTT

2. Trends and Cycles in Fiscal Accounts: Methodology (Traditional Approach)

iiYT

a

t

pta

ts

t Y

YDPDP

1

1*

a

t

LTta

ts

t P

PEPEP

1

1*

Oil Revenue: Profits obtained by Ecopetrol in t are transferred in t+1 to central government. One fraction of actual profits arise from domestic sales of gasoline ( ), and the other one from external sales of petroleum ( ).

Structural component is achieved using potential output while is attained with a long term external price of oil.

atDP

atEP

StDP S

tEP

Expenditures (two items are adjusted):

• Regional Transfers (Between 1994-2001, Law 60/93)• Interests Payments ( Domestic and External)

Outcomes-Elasticities

Tax-Revenue to Base Base to Output Total

Revenues

Total Tax Revenue … … 1,47

Income Tax 1,11 1,06 1,18(0,27) (0,06)

Value Added Tax 2,26 0,91 2,06(0,23) (0,02)

Trade Tax 1,00 1,46 1,46(0,10) (0,07)

Other Taxes* … … 1,00

Oil Revenue … … 1,68

Domestic … … 1,85(0,85)

Foreign … … 1,43(0,39)

Primary Expenditures

Transfers … … 1,47

Data: 1970-2005

Estimates were computed using GLS. Standard Errors appear in parentheses. All estimated elasticities aresignificative at the 5 percent level.

• Relatively high responses of tax revenues to output. In a range from 1,18 for income-tax to 2,06 for value added-tax. • The aggregate tax elasticity with respect to output amounts to 1,47• The parameters are similar to those found in international evidence: The income tax to GDP elasticity is, on average, 1,3 for OECD; 1,5 for the Euro area and 1,1 for new EU members (Girouard and André 2005).• For domestic tax components: tax-revenues response to their bases are more sensitive than its corresponding tax-base response to GDP, and conversely for external taxes. • Using these elasticities, we find the cyclical and structural components of revenues and expenditures. Subsequently, we also find the cyclically adjusted balance.

Comments

Cyclical and Structural Components of Revenues (Percentage of GDP)

(c) Income Tax (d) Value Added Tax

(e) Trade Taxes (f) Oil Revenues

0

1

2

3

4

5

6

7

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

0

1

2

3

4

5

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

0

1

2

3

4

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

-1,0

-0,5

0,0

0,5

1,0

1,5

2,0

-0,1

0,0

0,1

0,2

0,3

0,4

0,5

0,6

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

-0,1

0,0

0,1

0,1

0,2

0,2

Actually Structural Cyclical

Cyclical and Structural Components of the Expenditures(Percentage of GDP)

(c) Regional Transfers (d) Total Interest Payments

(e) Domestic Interest Payments (f) External Interest Payments

0

1

2

3

4

5

6

90 91 92 93 94 95 96 97 98 99 00 01

-0,6

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

0

1

2

3

4

5

6

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

-1,5

-1,0

-0,5

0,0

0,5

1,0

1,5

2,0

0

1

2

3

4

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

-1,5

-1,0

-0,5

0,0

0,5

1,0

0,0

0,5

1,0

1,5

2,0

2,5

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

-0,6

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

Actually Structural Cyclical

Cyclically-adjusted budget balanceCentral Government –Percentage of GDP

(a) Total Balance

(b) Primary Balance

Cyclical Component

Structural Balance

Current Balance

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Cyclical Component

Structural Balance

Current Balance

-4

-3

-2

-1

0

1

2

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

• The evidence shows that the deficit of the central government in Colombia basically has a structural character.

• In times of the deepest recession (1998-1999), the cyclical deficit amounted to -1% of the GDP, equivalent to 15% of the actual deficit (-6,7% of the GDP).

• Recently (2005), when the economy returned to historical growth rates (5%), the cyclical component amounted to +0,8% of the GDP, which corresponds to 15% of the actual fiscal disequilibrium (- 5,3% of the GDP).

• The structural nature of the government fiscal deficit had been widely recognized by analysts and policymakers. This feature of the government finances has motivated a set of fiscal reforms, in particular since the end of the nineties: tax-reforms; regional-transfers-reform; pension-reforms; State-reforms; etc

Comments

3. Colombia´s fiscal stance through the cycle: Methodology

Estimating Fiscal Policy Reaction in Colombia (Traditional approach: Manesse, IMFWP- 2006; Alesina & Tabellini BU-WP 2005; Alfonso ECB-WP-2005, etc)

ttttt uSaDebtaGapaaS 1312110

S = Primary (or total) surplus, in percent of GDP

Gap = output gap

Debt = debt-GDP ratio

a1<0 is evidence of pro-cyclical policy. Primary balance-to-GDP ratio falls when the output increases relatively to potential output

If a2 > 0, government tries to increase its primary balance as a reaction to the existing stock of public debt and then comply with the budget constraint. It could be seen as a sign of a Ricardian-fiscal-regime

Estimating Fiscal Policy Reaction, 1960-2005

Constant 0.42 ** 0.50 **(0.23) (0.25)

GAP t - 1 -0.20 * -0.10 **(0.06) (0.05)

Debt t - 1 -0.02 * -0.05 *(0.01) (0.02)

Primary Balance t - 1 0.64 * …(0.09) …

Total Balance t - 1 … 0.65 *… (0.09)

R-squared 0.77 0.94

Adjusted R-squared 0.73 0.93

Estimated Coefficients

Dependent Variable

Note: Estimates were computed using OLS. Standard errors appear in parentheses. * = significance at 5%and ** = significance at 10%

Primary Balance Total Balance

• The coefficient a1, is significant and negative implying that fiscal policy in Colombia has been pro-cyclical for the last 45 years or so, with the primary surplus falling (and the deficit rising) by approximately 1/5th of a percentage point when the output gap improved by one percentage point

•Coefficient a1 falls from 1/5 (for primary balance equation) to 1/10 (for total balance equation), which means that interest payment “smooth out” or “compensate” the pro-cyclicality policy stance.

• The interest payments role is not surprising because in bad times, when financial markets are more restricted, the indebtedness cost rise increasing public spending (via higher spreads on public bonds, depreciation of exchange-rate and so on). In good times, the opposite takes place.

Comments

• Regarding a2, they are significant and negative in both cases. When a2 >0, government tries to increase its primary balance in order to react to the existing stock of public debt and comply with the budget constraint. We don´t find evidence to support this behavior for C-Government in Colombia.

• Our fiscal pro-cyclicality results confirm the findings of other studies in Colombia. Using various fiscal impulses definitions, Lozano and Aristizabal (2003) found that fiscal policy was pro-cyclical between1991 and 2002. For a longer period (1881-2005) and using also fiscal impulses technique, Cárdenas et. al. (2006) found the same pro-cyclical results

Comments

4. Current fiscal stance and prospects

-5,7-5,3 -5,3

2,2

3,6

4,7

3,33,1

-5,1-5,7

-3,6

-2,1

-0,4

-2,0-2,3

-8,0

-6,0

-4,0

-2,0

0,0

2,0

4,0

6,0

2003 2004 2005 2006 2007

Decentralized Sector

Central Government

NFPS

Forecast

• As a result of economic recovery, high international oil prices, tax reforms and fiscal tightening at local and regional levels, the NFPS deficit narrowed to 0,4% of GDP in 2005 (0% including quasi-fiscal operations)

• This fiscal outcome in 2005 was much better than expected and than the results in 2004 and 2003 ( 2,1% and 3,6%, respectively). The C-Government deficit widened to 5.1% of GDP and this was offset by a surplus in the decentralized sector

•The current administration has made progress on structural reforms and fiscal adjustment. However, 2005 fiscal outcome was influenced by exceptional factors

• The government has made a preliminary commitment to narrow the fiscal deficit to 2% of GDP in 2006 (for NFPS). However, for 2007, the budget includes an spending plan of Col$117,6 billons, a 7% increase in real terms compared to 2006, and targets a NFPS deficit of up to 2,3% of GDP.

Comments

Understanding Fiscal Balance in 2005:

I nitial Projection

Outcome Difference

Consolidated Fiscal Balance (I ncluding quasi-fiscal balance

Percentage of GDP) -2,4 0,0 2,4

Explaining better fiscal balance in 2005

I temInitial

ProjectionOutcome Effect (as percentage of GDP) :

Real GDP Growth 4,0 5,1

Growth of Imports 18,4 26,8

Exchange Rate -Nominal Appreciation 0,4 11,7 Lower external interest payment 0,1

Lower domestic interest payments -By Placement-Bond-Primium

0,6

Portfolio Valorization - Social Security Funds 0,3

WTI Price (US$/b) 37,0 56,3 Higher Ecopetrol Surplus 0,5

* Average yield rate in 2004 vs. 2005

Higher Government Tax Revenue 0,7

Yield Bonds - TES* 12,1 9,2

• Official preliminary predictions pointed out to a consolidated fiscal deficit of 2,4% of GDP in 2005 (including quasi-fiscal operations). The actual result was

a fiscal equilibrium. • This outcome was influenced by exceptional factors, such as higher than expected world oil prices and the accounting treatment of interest government expenses

• In addition, economic growth –above expectations– together with favorable external conditions also helped to obtain a fiscal equilibrium.

•We quantify each of these factors. Notice that better than expected GDP growth rate increased tax revenue in 0,7% of GDP. This outcome is roughly consistent with what we showed in section 2 (cyclical budget in 2005)

Comments

Conclusions

• Like in other economies, fiscal balance in Colombia has been closely related to GDP performance

• We found relatively high responses of tax revenues to output. The aggregate-tax- elasticity with respect to output is 1,47 (similar value to those found in international evidence)

• The evidence shows that the deficit of the central government in Colombia basically has a structural character (the cyclical component amounted 15% of the actual deficit)

• Fiscal policy in Colombia has been pro-cyclical in the last four decades, with the primary surplus falling (and the deficit rising) by approximately 1/5th of a percentage point when the output gap improved by one percentage point.

• The fiscal outcome in 2005 was much better than expected and the outcomes in 2004 and 2003 ( 2,1% and 3,6%, respectively). However, that was influenced by exceptional factors

Conclusions

• The higher than expected world oil prices; the accounting treatment of interest government expenses; economic performance –which surpassed expectations– as well as a favorable macroeconomic environment; helped to obtain equilibrium in public finances

• The government has made a preliminary commitment to narrow the fiscal deficit to 2% of GDP in 2006 (for NFPS). Nonetheless, for 2007, the budget entails spending plans of Col$117,6 billons, a 7% real rise compared to the 2006 budget, and targets a NFPS deficit of 2,3% of GDP