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Costa Rica Politics December 2018

Costa Rica: Landmark reform bill signed into law on 3 December but skepticism lingers about fiscal sustainability

A long-awaited fiscal reform bill was passed by the Legislative Assembly after a second reading on 3 December, becoming law the following day. The bill includes revenue-generating changes to Costa Rica’s tax regime and puts limits on government spending, following a significant deterioration of public finances in recent years. Despite the reform, however, some analysts remain wary of whether the reform goes deep enough, remaining skeptical of government fiscal projections.

The government originally hoped to use the fiscal reform package to reduce the fiscal deficit by 1.9% of GDP. However, several exemptions were introduced during the parliamentary process which have reduced the final estimated impact. Although this should reduce the deficit—which hit an multi-decade high of 6.2% of GDP in 2017 and is forecast to have risen further in 2018—and also give a boost to investor confidence, it is unlikely to eliminate the fiscal gap and stop the rise in the public debt-to-GDP ratio on its own, leaving more work for the government to do in the coming months and years.

The reform bill swaps the old general tax on sales for a value-added tax with the same standard rate of 13%, while also incorporating reduced rates of 4%, 2% and 1% for selected goods and services. It limits government spending increases by setting fiscal rules linking spending to GDP growth as well as the public debt-to-GDP ratio. The bill also increases income tax rates for high-income earners and raises the capital gains tax in most cases. The government expects these measures to bring the fiscal deficit to below 4% of GDP by 2023. However, on 5 December Moody’s cast doubt on its achievability and reduced Costa Rica’s credit rating from Ba2 to B1 with a negative outlook. Moody’s explained that most of the forecast reduction comes from limiting expenditures over time, which it believes will be difficult in an environment of popular opposition to austerity and headwinds to economic growth. Moreover, on 21 December S&P Global Ratings downgraded Costa Rica’s credit rating from B+ to BB- with a negative outlook for similar reasons. Meanwhile, FocusEconomics panelists appear broadly unconvinced that the government will succeed in markedly reducing the fiscal deficit, which they see remaining above 5.5% through 2023.

The new measures could weigh on private and government consumption in the near-term. However, there will likely be a boost to private fixed investment growth as businesses will have greater clarity for their long-term planning and more confidence in the governance of Costa Rica. The effect of the reform on inflation will likely be mixed: On the one hand, a greater range of goods and services being taxed should stoke price rises overall; on the other hand, weaker consumption growth should have the opposite effect. The colón, meanwhile, has strengthened slightly following the reform’s approval due to reduced uncertainty, although it could come under pressure if subsequent measures to put the public finances on a sustainable footing are not implemented.

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