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A quarterly magazine of the IMF	June 2007, Volume 44, Number 2

Getting Spending Right
Benedict Clements, Christopher Faircloth, and Marijn Verhoeven

Latin America needs to reform public spending to make it more efficient, better help the poor, and address infrastructure bottlenecks

Latin America's recent economic performance has been strong. The region is in the midst of its most vigorous expansion since the 1970s, with average growth of more than 5 percent over the past three years. Inflation has also declined to an average of about 5 percent in 2006, and the IMF projects external current account balances to be in surplus in 2007 for the fifth consecutive year. Stronger growth has also helped reduce poverty rates.

Still, there is widespread recognition that more needs to be done to raise growth—which continues to lag the average for developing countries as a whole—and reduce macroeconomic vulnerabilities, including high levels of public debt. Fiscal positions have improved because of rising government revenues, mostly derived from commodity-based receipts. But public debt remains high at 52 percent of GDP (as a weighted average at the end of 2006). As such, a key challenge will be reducing the growth of government spending, which has risen rapidly in recent years and precluded an even deeper reduction in public debt burdens. At the same time, the region suffers from the low quality of its infrastructure and high levels of income inequality. If governments in the region are to reduce spending while improving infrastructure and providing a greater level of services, including to the poor, they must improve the efficiency and equity of public spending.

Recent trends in public spending

Public outlays in Latin America (net of interest payments) have drifted upward since the mid-1990s (see Chart 1). Spending increases have not been continuous, however. Increases were well contained in the early phases of the region's ongoing economic expansion, especially in 2003–04. Since then, however, they have resumed their upward trend, rising in 11 of 17 countries between 2004 and 2006. Real spending grew an average of 7½ percent a year over the past two years but, as a percentage of GDP, grew a moderate 1 percentage point because GDP grew rapidly too.

Expenditure increases since the mid-1990s have been driven by current spending. Capital outlays have declined in relation to aggregate output and total spending, while social spending has become more prominent in government budgets, especially for education and social insurance. Between 1995 and 2004, for example, social spending rose by an average of about 2 percentage points of GDP, roughly equal to the increase in total primary (that is, noninterest) outlays during the period.

Expenditure reform will be essential if the countries are to reduce public spending while maintaining public services at existing—and preferably higher—levels. Much of the region's spending is inefficient—a higher level of public services could be provided with the same level of public outlays. Improving the composition of spending across different categories and programs could also help catalyze faster growth and poverty reduction. Some key priorities include the following:

Reforming the stop-and-go pattern of government spending. Government spending has tended to surge in good times, only to be curtailed sharply during economic downturns (see Chart 2). Akitoby and others (2006) found that in about two-thirds of Latin American countries, there is a statistically significant short-term relationship between shocks to real output and real primary expenditure, with spending and output moving procyclically—that is, in the same direction. The share of countries in which spending is procyclical is higher in Latin America than for developing countries as a whole. Capital expenditures appear to be the most sensitive to macroeconomic developments, reflecting the tendency in the region to cut these outlays sharply during recessions.

The surge in spending over the past two years raises to the fore the challenge of ensuring that spending growth is consistent with a sustainable fiscal position over the longer term. Toward this end, fiscal rules that limit spending growth could be useful, although such rules will need to be backed by an effective system of monitoring and sanctions to ensure that they are effective.

Improving the efficiency of public investment. Rates of public investment have declined in the region, dropping from 5.8 percent of GDP in 1995–99 to 5.1 percent since 2000, but this has been partially compensated for by higher private spending for infrastructure. Inefficiencies in public investment spending are contributing to infrastructure shortfalls. The value-for-money from these outlays, as measured by the relationship between public investment and improvements in infrastructure indicators, varies markedly across countries. This suggests that there is scope for improvement, in particular by following the best practices in the region in project selection, evaluation, and monitoring (IMF, 2005). Countries should also implement stable multiyear budgets for public investment and strengthen staff capacity (Aldunate, 2007).

Improving the effectiveness of the civil service. Public sector wage bills, at about 7 percent of GDP, are close to the averages prevailing in other regions. The quality of government services, however, is lower than in many fast-growing regions of the world, and has not improved since the late 1990s. A recent assessment (Echebarría and Cortázar, 2006) indicates that in more than half of the countries of the region, civil service systems are inadequate to attract qualified staff and ensure the efficient performance of employees.

As in many countries, there has been no correlation, over the past decade, between increases in the wage bill and improvements in the quality of government services. This suggests that there is room to achieve better value-for-money on the wage bill and that higher compensation alone is unlikely to bring about better public services. Instead, the focus of reform efforts should be on making bureaucracies more merit-based and addressing the core weaknesses of administrations in the region. These weaknesses include patronage in hiring and promotions; the absence of performance evaluation; and internal inequities in remuneration, such as different pay for similar jobs (Echebarría and Cortázar, 2006).

Improving the efficiency and targeting of social spending. Outlays for health care, education, social protection, and housing are substantial, at about 13 percent of GDP (roughly half of government noninterest spending). But they have produced mixed results on social indicators. Education attainment and health indicators are broadly in line with the region's level of development (ECLAC, 2006), and health and education indicators such as school enrollment rates, access to clean water, and immunization rates all climbed in the 1990s. But there are significant lags in human capital relative to the industrial countries and fast-growing regions of the world. The quality of education—for example, as measured by performance in international examinations in reading, science, and mathematics—is also low. Although poor quality can reflect a number of factors, the large share of education spending allocated to wages, as opposed to nonwage inputs such as teaching materials, may be a contributing factor, as well as weak incentives for good performance (De Ferranti and others, 2003).

Social spending has had a limited effect in reducing poverty and in shrinking the large gap between rich and poor. On average, the poor receive a less-than-proportionate share of social spending benefits, but their share varies markedly by spending program (see Table). A large share of the outlays on higher education and social insurance goes to upper-income groups; primary education and social assistance largely benefit the poor (De Ferranti and others, 2004; ECLAC, 2006; Lindert, Skoufias, and Shapiro, 2006).

One bright area for the region has been the success of conditional cash transfer programs, which have proved to be effective in channeling resources to the poor and reducing poverty. These programs often make cash assistance dependent on self-help steps by recipients, such as sending family members to school, that improve the prospects for escaping poverty on a long-term basis. In most countries, spending on these and other social assistance programs averages about 1–1½ percent of GDP and comprises a small share of social spending.

A road map for reform

To make spending more efficient, governments must reduce the tendency of expenditures to rise sharply in good times, only to collapse during downturns. Effective fiscal rules that help contain spending during economic upswings would be useful. Governments should also step up their capacity to evaluate and manage investment projects. The efficiency of spending would be assisted by implementing merit-based systems of employment and compensation.

The region's recent experience provides useful lessons for forging a more pro-poor pattern of outlays. Steps in this direction could include continuing reform of public pension systems to reduce their generosity and place them on an actuarially sound footing; increasing user fees for higher education, combined with subsidies for low-income families; improving the quality of secondary education; and expanding targeted social assistance programs. Restructuring social spending—most of which bypasses the poor—will be politically challenging, but is essential if the state is to fulfill its role in building a more equitable society.