Governments in Latin America and the Caribbean must improve spending policy and management, generating smart public spending that contributes to growth and equity.
It may seem obvious, but it is not obvious how governments can achieve reengineering by identifying inefficiencies and redirecting spending toward sectors or functions with higher social returns. This process requires estimating the size and origin of inefficiencies, and how to remedy them. To contribute solutions to this problem, we have investigated the issue in depth, the results of which are presented in the IDB's most recent flagship publication. Better spending for better lives: How Latin America and the Caribbean can do more with less.
Unlike tax policy and management, there is very little modern theory and research on the optimal allocation of public spending. Countries with weaker governance and institutions expanded spending without a baseline theory or optimal management, generating technical and allocative inefficiencies.
The exogenous growth experienced during the last two decades contributed to an increase in public spending of more than 8 percentage points on average in the largest economies in the region, mostly in transfers, many of them pro-rich, and wage increases in the public sector. In other words, governments favored current spending, consuming the economic boom and mortgaging the future, without planning, prioritizing and efficiently allocating spending and particularly investment in the medium and long term.
Spending did not return to initial levels once the commodity boom ended, resulting in ever-widening fiscal imbalances. To achieve fiscal sustainability again, without waiting for exogenous growth to return, a government can either increase revenues or decrease expenditures.
But in most cases, Increasing tax revenues through new taxes or higher rates is not the best option given that several countries have exceeded their tax capacity, and others, even if they have room, would require greater tax pressure on a small formal sector that would end up suffocating it. All this advises against adjustment through taxation and focuses on the reform of expenditure policy and management as the priority way to ensure sustainability.
A reform towards smart spending entails great challenges, but also offers great benefits. The roadmap for countries to move towards smart spending begins with diagnosing and estimating (in)efficiencies in public spending, which are of two types:
- Allocative inefficiency: Governments do not allocate resources in ways that maximize social returns, equity and economic growth.
- Technical inefficiency: implies that countries use more resources than necessary to provide a good or service of a given quality.
Allocative inefficiencies
Doing the wrong thing – not allocating spending where the net social benefit is greatest – carries costs and much lower growth than if it were allocated well. This pushes the region deeper into the middle-income trap.
We focus on four of the most pressing issues in the allocation of public spending in Latin America and the Caribbean.
1. Are countries allocating spending efficiently and equitably for current and future generations? Latin American countries now spend four times more on older people than on children due to higher expenditures on pensions and health than on education and programs for children. This is exacerbated in countries such as Argentina, Brazil and Uruguay. The region is aging and increasing its spending on old age before it has time to sufficiently increase its income (“getting old before getting rich”). In fact, due to population aging, spending on pensions and health would go from 35% to 78% of total spending within 50 years, assuming that spending as a proportion of GDP remains constant (Chart 1).
Nor should spending on older adults be so high today compared to that on future adults tomorrow or at the expense of spending on infrastructure and human capital.
2 How efficiently is spending allocated between physical capital, human capital and transfers? Efficiently allocated spending based on rates of return and their contribution to growth and improved quality of life helps boost economic growth and reduce inequality. But that is not what happened. Much of the increase in public spending during the commodity boom years was oriented towards current spending, not capital spending: between 1980 and 2018, current spending per capita in Latin America and the Caribbean increased by 72%, a similar increase to that in the rest of the world. However, capital spending per capita in real terms remained stagnant and declined significantly as a share of total spending, more than in any other region in the world.
Both investment in physical capital and quality human capital are essential for growth: improving spending that contributes to quality education contributes to growth, but excessive spending on pro-rich or poorly targeted transfers, or spending on education that does not improve quality, does not.
3 If we want to address the problem of the low quality of human capital in the region, which is essential for growth, How efficiently is spending on skills training allocated throughout the life cycle? Although spending has focused on closing enrolment gaps, it has not been effective in closing skills gaps that persist throughout the life cycle. Skill differences between children from advantaged and disadvantaged families appear at very early ages, even before preschool, and persist over time.
Studies show that the benefits of investing in early education for children with low abilities are greater than the average rates of return demonstrate. For this reason, programs targeting disadvantaged children are likely to be more cost-effective and beneficial than universal preschool coverage. But the opposite is true for higher education, where average rates of return of 16% overestimate the benefits for students from vulnerable families that can be negative; for the rich, private returns are even much higher: 30 or 40%; as we estimate for Peru and Chile.
Redirecting resources allocated to higher education towards younger disadvantaged children would result in a more efficient and equitable allocation of resources. One reason is that by not investing in early capacities, it is very difficult and expensive to do so later when the child has lost the greatest capacity to learn. Despite this compelling evidence, sometimes misinterpreted, the opposite is currently the case: on average, countries invest 0.4% of GDP in early childhood expenditure and almost 4 times as much, 1.1% in tertiary education. This policy is inefficient and inequitable.
Technical inefficiencies
Technical inefficiencies in public spending abound as governments use more resources than necessary for the same purpose when delivering a service of a given quality, hampering governments' ability to do more with less.
Taking a conservative estimate of inefficiencies in public procurement, public sector payroll and targeted transfers, which represent approximately 70% of consolidated spending, The average waste in the region is approximately 4.4% of the regional GDP (Chart 3), or US$220 billion. Estimates vary widely across countries and regions.
Three conclusions can be drawn from the above regarding the inefficiency of spending.
Corruption matters. Public procurement is, in its current state, an open window to corruption that costs the region around 1.4% of the regional GDP; and this occurs mainly with public works. The quantification methodology extrapolated the data on inefficiency and corruption in countries of the European Union. For LAC, the lowest threshold of the European Union data is used and corrected for the intensity of corruption.
In LAC, working for the government is profitable for less qualified officialsIn the region, we see the largest wage differentials between the public and private sectors compared to other regions of the world. The wage gap estimate corrects for observed levels of education, experience and other sociodemographic variables and shows that the public sector pays approximately 25% higher wages than the private sector. The difference is even greater for lower-skilled jobs, so wage waste is estimated at 1.2% of GDP.
Transfers that are intended to be targeted are a sieve. 45% of spending on social programs is filtered down to the non-poor, but the problem is much greater in the areas of energy subsidies and tax spending, where around 80% is filtered down to the non-poor, causing waste to total 1.7% of GDP.
If we were to expand the analysis to consider spending on pensions, the amount of inefficiencies in LAC would increase. This estimate is not a minor issue and is very complex. A first approximation would be given by the surplus of pension spending that is not explained by the old-age dependency rate, that is, by the number of older adults as a proportion of potentially active people (Chart 4). If this inefficiency were considered, the countries of the Southern Cone would lead the ranking of technical inefficiency in the region.
How can governments increase spending efficiency?
- Reducing waste in transfers, public sector payroll and public procurement.
- Reallocating spending, particularly that which is least effective in reducing poverty or stimulating growth, prioritizing spending with the highest internal rates of return.
- Decentralizing spending accompanied by improved administrative capacity and greater decentralization of income.
Implementing this modern management requires objectives, planning and prioritization based on evidence, and professionalized officials to carry it out. These are not simple reforms, but there are great rewards in carrying out a gradual but profound reengineering of spending: The profits would be enough to eradicate extreme poverty in Latin America and part of moderate poverty..
In terms of allocative efficiency, governments would lay the foundations for the region to move towards sustainable and equitable growth, recovering the future that is currently under threat.
By: Carola Pessino, Principal Specialist in the Fiscal Management Division of the IDB |Juan Carlos Benítez, Fiscal economist with a master's degree in public policy from the University of Chicago.
The article is a publication of the Blog «Raising Welfare»
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