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Ricardo Lagos: The wealth problem

Sep 1, 2013

Latin America faces a problem it has never before experienced: how to meet the demands of a rapidly emerging middle class. Part of the solution, says Chile’s former president Ricardo Lagos, lies in tax reform

The last quarter century has been a period of tremendous change for Latin America. Twenty-five years ago, many countries in the region were just emerging from authoritarian regimes and dictatorships.

Over this period we have learned to manage our economies. When it comes to sound macroeconomic policy, we all now know what that means. The fact that we had so many economic and financial crises in the past meant, for example, that we were better prepared to resist the 2008 crisis in the developed world.

From a political point of view, we now have democratic institutions across the region. From an economic point of view, most Latin American countries are rapidly approaching middle-income status. From a social point of view, the number of people living under the poverty line has also decreased significantly.

According to the IMF, over the next decade a large number of Latin American countries are expected to reach per capita GDP of above $20,000.

Avoiding the trap

With many Latin American countries approaching middle-income levels, the big question now concerns the middle-income trap: once you reach a certain income level, how do you keep growing? From an economic point of view, this is the number one question.

Meanwhile, we now have an emerging middle class: people that have left poverty behind them. In Chile, the social demands are much bigger than they used to be. People have another demand: education for their children. They hope that their children will achieve what they were unable to. The demand for education is the top priority.

We may have learned how to defeat poverty, but we still do not know how to satisfy the growing demands of the emerging middle class.

It is also much more expensive to satisfy the demands of that emerging middle class than to mobilize the fiscal expenditures to reduce poverty. Those middle classes also feel more empowered and so present their demands in a stronger way. The unrest in Brazil and student demonstrations in Chile are primarily middle class phenomena. At least in Chile, that is very clear.

Taxing times

This takes me to the question of taxation. Is it possible to have the same level of taxation that we had in the past? Or, once you are middle-income countries with middle-income demands, do you need to increase the amount of taxation?

In a country like Chile our tax to GDP ratio is roughly 19% to 20%. However, the average for OECD countries is much higher, at around 34%.

Taxation is very difficult to tackle. Apart from Brazil, that has a ratio of 35%-36% of GDP, the rest of Latin America fares poorly with regards to taxation. In most of the countries the average is roughly 15% of GDP.

At the same time, Latin America is still one of the most unequal continents on the planet.

We have been successful in reducing poverty but that hasn't meant that we've been improving our Gini coefficient with regard to income distribution. OECD countries in general, on average, have a Gini coefficient of 0.48 [out of 1, where 1 is most unequal]. In Latin America it's about 0.56.

The big difference is that these numbers are before taxes. After taxes, the OECD's 0.48 average drops to roughly 0.29. Whereas, in Latin America, after taxes that change is one or two points, to 0.54 or 0.53.

This is partly behind the sense of discontent, especially in Chile: we have growth, good numbers, strong macroeconomics. But there is dissatisfaction about how that growth is being distributed and to what extent social cohesion has increased.

This is also similar to what is happening in Turkey. Over the past 10 years, Turkey has been seen as an economic miracle in that part of the world. But suddenly, protests have erupted, because of something that at first seemed unrelated. In the case of Brazil, the trigger came from an increase in bus fares.

So what are the future challenges of Latin America?

First, what kind of institutions are we going to have from the political point of view to listen better to the growing demands of much more empowered citizens. Second, how are we going to avoid the middle-income trap and at the same time meet the demands of the middle class? And third, those social policies that were successful in reducing poverty will have to change.

On domestic policy, we have to undertake reforms according to our new stage of development. To maintain our success in the future, we need different economic and social policies: economic policies to overcome the middle- income trap; and social policies to satisfy the growing demands of the middle classes.

End of the cycle

We are approaching the end of a cycle in three respects.

From the political point of view the question is now how you make room for people who are asking for more participation. All of us know that democracy, by definition, must be representative. But political institutions need to be established to provide more participation because people feel more empowered and they want to be heard.

It is also the end of an economic cycle. The most important issue now is how to achieve growth, because only with growth are we going to increase per capita income and then we're going to have better social and economic indicators.

Finally, it is the end of a social cycle with regards to fighting poverty. Therefore, from an economic point of view, the issue has changed: to have growth the policies of the past no longer work, because we now have a different degree of development. So it's essential to have growth, but with the redistribution of income.

In today's Chile, we are proud of our per capita income, but we fail to mention that more than 80% of Chileans are unable to get that level of earnings. Chile is in the front pages because of the things we have done well. But we must not forget our problem with income distribution.

Unfortunately there is still a lot of ideology in the political debate. The most difficult part is for politicians to answer the question: why, if we've been so successful, don't people recognize that we've been successful?

The answer, for Chile, is: this is now a different country. In the long run, income distribution will improve through education, but that will take a long time and we have people protesting in the streets today. It's this generation that's making its voice heard.

Ultimately, some kind of institutions will emerge. But we still do not know what they will be.

The China factor

There is another reason why we have to undertake domestic reforms. The success of the past 10 years partly comes from China's incredible growth rate. As the OECD points out, when China has a 1% increase in economic growth, Latin America's growth automatically increases by 0.4%. Therefore, an average 10% growth rate in China automatically means at least an additional four percentage points of growth in the major South American economies.

We need to keep this success in perspective.

If China grows at 6%-7% annually - which is the expectation for the coming years - and we accept the metric of a 0.4 percentage point effect on Latin growth for each percentage point of Chinese GDP growth, that means at least a 2.4% growth drop for Latin American countries from the norm of the past decade.

Instead of the growth rate of 5%-5.5% that we had in last three or four years, in Chile we'll have average growth of 4%-4.5%.

This is important in countries where commodities are so important. You have to work according to long-term trends and not today's prices. During the sunny days you save - and during the rainy days you use those savings. That is very important to avoid the extreme cyclicality of fiscal income.

Under my administration, we introduced the structural surplus rule in the budget. If the long-term copper price was high, we could spend more. But if the long-term copper price were lower, then we could not spend more than what is acceptable according to that long-term price. This way we could spend more in the 2000 to 2002 period, when copper prices were extremely low, roughly $0.60 per ounce. Now that price is more than $3.

In 2008, when the crisis hit Chile, the government was able to take 4% of GDP for subsidies and to increase fiscal expenditure. That 4% was from the savings we already had from the copper fund. LF

Ricardo Lagos was President of Chile from 2000 to 2006. He was interviewed by Taimur Ahmad.

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