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State Capture and Fiscal Policy in Latin America

State Capture and Fiscal Policy in Latin America

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Given the existence of extreme inequality in the world—and especially in Latin America, its most unequal region—it is only natural to wonder why states do not redistribute income and wealth so as to significantly reduce inequality and eradicate poverty. Although there has been progress, high levels of inequality and poverty persist. One explanation for this situation could be that states, and specifically their fiscal policy, have been captured by business groups or political elites so as to favor their own interests, thereby blocking or eroding efforts to ensure wider public welfare.

By “capture” I mean the process whereby actors, mostly business groups and political elites, intentionally skew public policy away from the public interest and toward special, narrow interests (Dal Bo 2006; Carpenter and Moss 2013, Introduction).  It is a process that I, as former Minister of Finance, have witnessed firsthand, and which I will try to illustrate by referring to the evolution of the state, capitalism, and fiscal policy in Latin America while taking into account my personal experience.

In the case of fiscal policy a first approximation to potential capture can be surmised by evaluating the tax burden, tax evasion, the redistribution effects of fiscal policy, and the evolution of fiscal deficits; in short, by contrasting emerging patterns with what would be a fiscal policy implemented in the public interest.  Potential capture is of course only one possible reason for a divergence between a policy that favors public interests and one that favors private or narrow interests, but it can be a significant reason, as I will attempt to illustrate.

Latin American states have been called “paper Leviathans” (Centeno and Ferraro 2014) because in spite of significant progress over the last decade, most of them are characterized by ongoing weakness, understood as their weak legitimacy, absent monopoly of violence in all of the territory, weak enforcement capacity, mostly low tax burden, difficulty in ensuring sustainable and universal public policy results, underperforming bureaucracies, and high-level corruption.

I would like to stress two factors that appear to explain, at least in part, this ongoing weakness.

The first of these common historical factors is the absence of interstate wars and the fragmentation of Latin American countries.  The second is clientelism, associated with political competition in a democratic framework and especially important in newer democratic regimes. 

With regard to the first factor, sociologist Miguel Angel Centeno (2002) has argued that the absence of prolonged wars between states, as opposed to civil wars, and in contrast to cases like those of Europe or China, impeded the development of collective identity.  Cuba is the exception that proves the rule, as identity between the state and the nation in this case has been strongly inspired by more than 50 years of constant harassment by the United States.

The absence of interstate wars may also be one of the explanations for weak state capacity, especially in the area of taxation, in contrast with wars in Europe and China, which stimulated not only resource mobilization but also the creation of bureaucracies and logistical services required to sustain long-term war efforts.    

Elites in Latin America, mostly fragmented and involved in long-term internal conflicts, avoided wars with other countries in part because they did not want to turn to the masses for help, since this could threaten their privileges.  Protecting these privileges did not require a strong state. As Centeno indicates, “the central role of the state was not the creation of a nation but the creation of social privilege” (Centeno  2013).   

The second factor that explains the weakness of Latin American states has been that democratic competition, as in other parts of the world, resulted in clientelism. The state, or public administration, became a source of employment and favors in exchange for political support on a large scale, often requiring intermediaries.  This is different from patronage, understood as face to face relations which may occur in democracies or authoritarian regimes (Fukuyama 2014, p. 86).  Regarding Latin American countries Francis Fukuyama states it nicely: “Nineteenth century patronage became full-blown twentieth-century clientelism” (p 266). 

This is the main explanation for the difficulty of establishing modern and independent professional bureaucracies in Latin America: offering employment in the public sector, on a large scale, became a crucial component of clientelism. Or as Ceteno and Ferrero (2015, p. 15) note: “mass democracy and the consolidation of electoral machines turned public bureaucracies into vast systems of political clientelism.”

Furthermore, Latin America’s mostly weak states—or paper Leviathans—have coincided with the development of a peculiar form of capitalism that has become consolidated in the past 30 years, and that Ben Ross Schneider (2013) has called “Hierarchical Capitalism.” 

The breed of capitalism that tends to predominate in Latin America is different from capitalism in other areas where, although free markets and private property predominate, different mechanisms exist through which the gains from investment, production, and exchange are allocated. These mechanisms in other regions involve markets, negotiations, and trust.  Markets predominate in liberal market economies, mostly in countries of Anglo-Saxon origin; negotiations prevail in coordinated market economies in continental Europe, and trust is the basis of the network market economies that exist mostly in Asia.

However, in the hierarchical capitalism of Latin America, markets, negotiations, and trust as mechanisms to allocate gains have been substituted by hierarchy, involving asymmetrical power relations.

According to this view, hierarchical capitalism in Latin America has several distinctive characteristics.  First, and most importantly, it involves very large diversified domestic business groups owned and managed mostly by families which maintain direct hierarchical control over dozens of separate firms.  Second, it includes an important presence of Multinational Corporations, strengthened in the past years by waves of mergers and acquisitions, but with limited political links to domestic business and dependent hierarchically on their headquarters abroad.  Third, labor markets are atomized and segmented, with low union density, short job tenure, and a high proportion of informal employment.  Fourth, domestic business and Multinational Corporations are less constrained by financial systems than in other countries, because they have developed their own sources of finance. They are also less constrained by formal labor institutions, both because of the segmented nature of the labor market and as a result of the uneven enforcement of regulations. 

These conditions of strong, hierarchical, and concentrated economic power would almost certainly facilitate the capture of what I have characterized as weak states. Furthermore, and with some variation between countries, the relative power of business vis a vis the state and labor organizations has become stronger as a result of its growth, propelled by the processes of liberalization and privatization that began almost 40 years ago.   

However, Ross Schneider also points to the fragmentation among business and labor groups in Hierarchical Capitalism.  Different interests do not favor cooperation between Multinational Corporations and domestic business, and relative disengagement of labor and business does not facilitate long-term relationships as it does in the coordinated market economies.  This weak relationship pushes each of them to deal exclusively with the state.  This fragmentation between domestic business and Multinational Corporations, and of labor between formal and informal workers, along with extreme inequality of society at large, makes it very difficult to build the coalitions needed to upgrade institutions and move towards a more balanced type of capitalism, with allocative mechanisms based on markets, negotiation, or trust. 

This leads to my hypothesis that the possibility of a negotiated coalition of diverse business, labor, and civil society groups resulting in a wider provision of public goods, and of a solid fiscal policy, tends to be sacrificed in favor of an alternative outcome focused on protecting the privileges of a smaller group of powerful domestic business groups who favor a weak fiscal policy. This would be history repeating itself: it is the protection of privileges rather than nation or state-building, as Miguel Angel Centeno has argued.  The massive presence  of clientelism, at the same time, suggests that political elites may also try to capture fiscal policy.

Analysis of fiscal policy serves both to evaluate this hypothesis and to explore ways in which the state may be captured by business or political elites. Fiscal policy in general, and taxation in particular, can be taken as one of the fundamental determinants of the relationship between citizens and the state and, more specifically, of how influence on public policy is institutionalized, as Mick Moore has argued (Moore, 2008). Taxation is a crucial determinant of state building. But this relationship can take different forms. Evaluating the strength of business groups and their actual capacity to veto tax reforms and thereby capture fiscal policy, is a way of evaluating how states are transformed and built. Analyzing the structural and instrumental power of business groups, as Tasha Fairfield has done (2015a), helps us to evaluate their capacity to capture fiscal policy.

Structural power of business sectors arises from the mostly perceived threat that they may reduce investment as a result of reforms, which is often significant in the context of hierarchical capitalism where economic activity depends heavily on the private sector.  Furthermore, structural power resulting from threats to reduce investment is usually reinforced by the instrumental power resulting from lobbying, media campaigns and even more radical actions such as business strikes or lock outs, as undertaken in Argentina and Guatemala. 

Business groups have several sources of instrumental power in Latin America, which can be considered a form of inequality of influence (Hellman 2005, Fairfield 2015, Schneider 2013): 

First, revolving doors guarantee intimate relations between government officials, business groups and think tanks financed by the latter.  They may lead to informal practices that include appointments to top economic positions in governments, suggested or vetted by business groups. The fact that as Minister of Finance I was part of a cabinet in which several ministers or other high government officials came from the private sector and were opposed to the very tax reform I proposed, one backed by the President, is a clear example of this source of power.

Second, campaign contributions and illicit lobbying take the form of business investment in long-term relationships with legislators and political parties, which is particularly effective in proportional representation systems with multiple parties, as opposed to systems with a small number of institutionally strong parties, as exists in the UK.

Third, relations with the Judiciary may also be part of a long-term investment by business, and here I mean that:  

-a. Tax reforms can be blocked through court decisions that declare them unconstitutional.

-b. The debate on tax reforms can be shifted towards technical and constitutional issues to reduce their public exposure and take them to arenas where business groups have greater influence, as has been done in Chile, Costa Rica, and specifically Guatemala, where all tax reforms have been subject to a total or partial rejection due to decisions of the Constitutional Court.

-c. Biased enforcement of court decisions that favor larger firms may further strengthen their instrumental power at the same time that it weakens the credibility of institutions, giving rise to a self-reinforcing dynamism that further strengthens inequality of influence (Hellman, Jones and Kaufmann, 2000).

Fourth, finance of think tanks and control of large media outlets, may lead to something close to a cognitive capture, understood as the process whereby policy makers become convinced of the merits of the arguments against potential reforms espoused by those who are to be regulated (Del Bo 2006) or who would have to pay higher taxes.

In the presence of a fragmented legislature and a weak executive with a porous bureaucracy, it is therefore not difficult for organized business veto power to be effective or exercise undue influence.  In order to gauge this degree of influence, or capture of fiscal policy, I will go on to evaluate what has occurred with total public revenue, with the impact of taxes and public expenditure on income distribution, and with tax evasion.

Although the gap between Latin America’s actual fiscal policy and a fiscal policy that would favor public interest cannot be taken as the sole indicator of undue business group pressure, it serves as a first approximation which then needs to be qualified.   Later on I will evaluate the potential for capture of fiscal policy by political elites.

A first indicator of the degree of capture to which a state is subject is the ratio between total public revenue, including taxes of central and local governments and social security contributions on the one hand, and GDP on the other.

According to preliminary ECLAC statistics, the simple average ratio between total public revenue and GDP in Latin America as a whole increased from 22.6% in 2000, before the commodity boom, to 27.1% in 2015, after the commodity boom—an increase of 4.5 percentage points of GDP.  At this aggregate level the 4.5 percentage point increase in total revenue as a proportion of GDP suggests that large domestic business groups were not very successful in blocking increased taxes or tax reforms in the region, and that the capture of fiscal policy does not appear to have been very significant. 

However, valid conclusions require a more disaggregated approach, distinguishing between groups of countries.  I will distinguish between 4 groups of countries.

First, it is convenient to distinguish between those countries closer to state capitalist economies like Bolivia, Ecuador, and Venezuela, due to the importance of fuel and state-led development, as opposed to the rest of Latin America, which conforms more closely to hierarchical capitalism. 

Second, within countries of the region marked by hierarchical capitalism I would also like to distinguish between three groups: those with significantly higher revenue/GDP ratios than the rest, which include Argentina and Brazil, those with intermediate revenue/GDP ratios, that correspond to most South American countries and Mexico, and those countries with very low revenue/GDP ratios, that correspond mostly to Central American countries. 

Bolivia, Ecuador, and Venezuela, identified by Ross Schneider as “petro states,” are among the countries where the tax burden increased to the greatest extent during the boom years of primary commodity prices, in turn strengthening their autonomy vis a vis the business sectors. 

The structural power of business arising from the threat to stop investment has been very small in these cases, since the role of the private sector has been less important than the state as a source of investment.   

Its instrumental power has been further weakened by government mobilizations that have included active fiscal policies which have benefited from extraordinary revenues generated by the commodity boom.  Given their high revenue/GDP ratios, these countries clearly avoided capture of their fiscal policy at the hands of business groups.

A second group of countries includes Argentina and Brazil, both with total revenue as a percentage of GDP above 35% in 2015, greater than what would be expected on the basis of their income, and similar to most OECD developed countries.  Both countries merit special analysis, as both appear to have escaped from fiscal policy capture by business groups. 

Part of the explanation of fiscal policy’s high extractive capacity in Argentina has been the relative weakness of its large domestic business groups, as part of a political system of what has been called Segmented Neo-corporatism (Etchemendy and Collier, 2007).   This system has involved a form of corporatism in which business, labor, and the state participated, but each with a certain autonomy.  In the past decade and a half, it involved a closer relationship between labor and the state as a result of the coalition-building strategy of a left-wing government that tended to weaken the position of business groups.   

This situation, along with the extremely weak cohesion of business groups—an aspect stressed in a detailed study on the politics of tax reforms undertaken by Tasha Fairfield (2015a)—tended to erode their instrumental power and made it almost impossible for them to stop a barrage of tax reforms pushed forth aggressively after the year 2000.

Within the context of an economy just emerging from a major crisis, and then benefitting from a major boom resulting from higher commodity prices, the perception that tax reforms would reduce investment was not compelling, and this led to a decline in the structural power of business groups. 

The government also mobilized popular sectors in favor of tax reforms, including members of associations of the unemployed, who benefitted from increased social spending.  On the basis of a heightened political capacity, the government introduced reforms between 1998 and 2008 that included corporate tax reform, greater controls to prevent tax avoidance in international transactions and agriculture, taxing interest earnings, expanding tax agency authority to obtain information from banking accounts, taxing of financial transactions and agro-exports.   Business groups were initially able only to avoid the implementation of taxing interest earnings, mostly because of a widely held perception that it could favor capital flight. 

However, a more cohesive business sector was able to block an important increase in the rate already applied to agricultural exports in 2008.  This tax reform, considered a strategic error on the part of then newly appointed president, Cristina Fernández de Kirchner, actually served to catalyze and unite agricultural producers and exporters, already with a large amount of accumulated grievances, who lobbied, called for strikes, and managed to have this initiative repealed by Congress. 

Further increases in Argentina’s tax burden resulted mostly from increased taxes at a regional level, and the elimination of export taxes by the new Macri government in 2015 suggests two conclusions. 

-First, it would appear that the tax burden in Argentina has reached an upper limit and could actually fall in the near future.

-Second, this can be associated with a growing instrumental power on the part of business groups, now much closer to the new government.  

Argentina might be moving closer to the traditional model of hierarchical capitalism that prevails in Latin America, and the likelihood of some degree of capture of fiscal policy and of the state by business groups appears greater now than it has over the past decade and a half.

Brazil is the other exception but, in contrast to Argentina, its greater capacity to extract revenue is in part a legacy of a historically strong Brazilian state. Since the 19th century an alliance between the Portuguese crown and Brazil’s elite gave rise to a parliamentary monarchy that had a wide territorial reach and ensured a stable social order.

The Federal Republic that followed ensured fiscal capacity at the central and regional levels, as the historian Joseph Love (2011) has demonstrated, even though it was an uneven process that has been characterized as one of subnational state building. But I cannot fail to draw attention to the contrast between the fiscal strengthening of the Brazilian First Federal Republic that was established in 1890, and the earlier Central American Federation, that disintegrated a decade and a half after independence, partly due to insufficient fiscal resources.  

In Brazil, total government expenditure of national and regional authorities passed from 10.2% of GDP in 1885 to 16.4% of GDP in 1907, already above present public expenditure proportions in some Central American countries.  At the turn of the 20th century the revenue per capita captured by the central government in Brazil was already double the revenue per capita obtained at the same time by the dictatorship of Porfirio Diaz in Mexico (Love, 2011).   

The developmentalist state that was later established during the 20th century in Brazil, including the significant strengthening of the state during the Estado Novo period of 1937 to 1945, must be placed within this historical evolution.

By 1970 Brazil already had a tax burden that surpassed 25%, above the present Latin American average and significantly greater than the level that could be predicted on the basis of its income per capita. 

It was also the first country in the world to introduce a comprehensive VAT, even before France, where it was designed. 

This history of greater state capacity also explains the more restrained way in which the later process of liberalization, privatization and other recommendations of the Washington Consensus was pursued in Brazil, as compared to its neighbors. 

From the late nineties until 2014 the Brazilian state increased its revenue by almost ten percentage points of GDP (Melo, Barrientos and Coelho, 2014).  This hike was not characterized by major reforms, and governments preferred to have a highly inefficient tax system as long as it was characterized by high buoyancy, that is, the tax burden increased automatically as GDP grew. 

According to Brazilian scholars Melo, Barrientos, and Coelho (2014), favoring this incremental growth of the tax burden resulted from the combination of a historical legacy of strong state capacity, including an effective tax administration bureaucracy, with a solid political capacity resulting from a strong presidency, effective coalition building, and a social preference for redistributive policies which increased significantly after the mid-1990s, when financial stability was guaranteed.

This combination gave rise to an implicit social pact that combined an increasing tax burden with a highly redistributive social expenditure as long as financial responsibility was assured.  Given the absence of significant tax reforms during this period, as well as strong state and political capacity, one can also assume that the space for capture, particularly by business groups, was not significant in the field of taxation.

In the third group of countries to evaluate, that of other South American countries and Mexico, the growth of the total revenue/GDP ratio between the year 2000 and 2015 has not been very significant, amounting to 1.9 percentage points in Mexico, 1.3 percentage points increase in Perú, a 0.4 percentage increase in Chile, and a reduction of -0.3 percentage points in Colombia (ECLAC figures). 

In all of these cases there were significant but transitory increases in revenue collected as a result of the commodity boom.  With the end of the commodity boom these states have become more dependent on revenue of traditional sources and particularly on domestic business groups, and therefore the potential for undue influence of these groups has increased.

Mexico is the case that most dramatically illustrates how decreasing revenue obtained from oil exports, which has fallen because of lower prices and production, has been only partly compensated by increased tax revenue.  Tax intake of the central government increased from 10.5% of GDP in 2014 to 12.7% in 2015, but revenue from natural resources, mostly oil, fell from 12.7 to 9.5% of GDP that same year.

 Mexico, with its extremely low tax burden, is the clearest example of hierarchical capitalism in which large diversified family-controlled business groups have strong political influence, granting them the capacity to capture sectors like telecommunications, and maintain oligopolies and monopolies intact.  While the presence of natural resources allowed the petro-states to strengthen state capacity, in Mexico it postponed the need to increase its tax burden.  At the same time, the more traditional corporatism in which power was shared among the state, unions, and business, has been replaced by the predominance of business groups at the national level.   

At a local or regional level, on the other hand, there is in Mexico a growing illegal corporatism and capture resulting from the interaction of local and state authorities and illicit business groups, including drug trafficking organizations.  Within this context Mexico’s last significant tax reform, which included a considerable proportion of revenue assigned to states and not to the central government, is not immune to local capture by illicit business groups.

Capture at the local level, especially when illicit activities are involved, is a relevant issue that goes beyond Mexico and also applies to other large countries like Colombia and Peru, and even to smaller ones like those in Central America where drug trafficking has become important.  

The Central American countries—the fourth group of countries I am evaluating with regard to the revenue/GDP ratio—illustrate what happens when fiscal revenue depends basically on traditional tax revenue and not on natural resources.  These have been among the Latin American countries with the lowest total revenue/GDP ratio. 

In recent years they were forced by extreme conditions to implement tax reforms, partly focused on the income tax.  However, these reforms have been highly conditioned by the combined influence of large diversified family-controlled business groups and emerging business groups that have benefitted from globalization by expanding mostly footloose investments and non-traditional exports, either on their own or through partnerships with foreign investors (Aaron Schneider, 2013).  

Their structural power, arising from threats to reduce their investment as a result of tax reforms, is linked to competition for foreign investment. This has created a race to the bottom that has further weakened an already very low tax burden. Political elites find this a comfortable way of supporting business groups without having to establish a major bureaucratic apparatus to implement these policy changes  (A.Schneider 2013, p. 406). 

When I was Minister and tried to implement a tax reform in Guatemala, the private sector formulated catastrophic scenarios of confrontation and of economic and social chaos associated with the approval of the tax reform. These scenarios were widely communicated by mass media.  This was part of its structural power. In addition to public declarations, business groups also exploited links with powerful allies, including the then US ambassador in Guatemala, even though his view on this matter was not necessarily shared by the US State Department (Fuentes Knight 2011, p. 361).  Its instrumental power was also strong.

More recently, low economic growth in El Salvador, exposed corruption in Guatemala’s tax administration, and political gridlock in Costa Rica have limited the possibilities for greater growth of tax revenue in these countries in particular.  Panama has been in a more favorable situation mostly because of the revenue it obtains from its canal, not subject to extreme fluctuations as is the case with commodity exports.

Corporatism, based on strong business power, is particularly acute in all Central American countries (Mendoza 2011).  Throughout Central America there exist numerous councils, with business group representation, that have responsibilities in the formulation and implementation of public policies.

The most extreme case is Guatemala, where these corporatist councils are dominated almost exclusively by business group representatives, as occurs in the Central Bank’s monetary council. In other Central American countries, business groups still dominate but sometimes have to share this power with unions or other interest groups. This represents a clear case of strong instrumental power that is reflected in the capture of different state institutions by business groups and that has complemented the other sources of instrumental power open to business groups in Central America. As Minister of Finance, it was clear that a successful fiscal reform in Guatemala had to be negotiated with the G-8, the group of eight families which own the largest business groups in the country (Fuentes Knight 2011, p.11-6).

-The comparison of these 4 groups of countries suggests, first, that the combination of very weak states and comparatively strong domestic business groups has favored the capture of fiscal policy in most Central American countries. 

-Alternatively, in countries with strong states and relatively weak business groups, like Bolivia, Ecuador, and Venezuela, and to a certain extent Argentina, the danger of capture of fiscal policy by business groups was much smaller. 

-Brazil, with strong business groups but an even stronger state, did not face a similar danger of capture. 

-The remaining Latin American countries stand in the middle, with variations, as in the case of Chile, closer to countries with a strong state, and Mexico, Colombia and Peru, closer to countries with a strong business sector, not always licit, and therefore with greater potential for capture of fiscal policy.

A second fiscal indicator that, together with the tax burden, can provide some insight on potential capture, is the incidence or impact of fiscal policy on income distribution or equality. Greater redistributive capacity can be interpreted as an indicator of a lower likelihood of capture by business groups. Progressive taxation will reduce the disposable income of business groups, and progressive expenditure will not benefit them directly, either through contracts or subsidies.

A recent and outstanding evaluation of the impact of fiscal policy on income distribution and poverty, including the measurement of its effect on Gini concentration indexes, has been made by the Commitment to Equity (CEQ) initiative coordinated by Nora Lustig (2016). Figures from this study suggest the existence of four groups of countries based on whether their respective fiscal policies resulted in a significant redistribution of income or not. 

Significantly, Argentina, Brazil, Uruguay, and Costa Rica are part of a first group of Latin American countries that around the year 2010 redistributed the most through direct taxes and subsidies or through the total effect of taxes, transfers, expenditure on health and education, and social security contributions.  This lends support to the conclusion that these countries’ fiscal policies were less vulnerable to capture by domestic business groups in the recent past, and supports earlier conclusions arrived at by analyzing their tax burden.

A second group of countries that have a significant redistributive capacity, without reaching the levels of the previous group, includes Chile and Mexico. The exercise of strong structural and especially instrumental power by powerful domestic business groups in both cases suggests that some capture is possible. 

A third group of countries with low redistributive capacity includes several Central American countries, as well as Colombia and Perú.  The three Latin American countries that least redistributed income through direct taxes and subsidies were Colombia, El Salvador, and Honduras.  These studies also found that Honduras, Guatemala, El Salvador, and Peru are significantly below the redistribution that could be expected from countries with similar levels of income concentration, measured by the Gini index. 

These indicators, along with those involving the tax burden, would also suggest that the three Central American countries have fiscal policies that have been subject to at least some degree of capture by powerful business groups.  Low redistribution effects of fiscal policy in Peru, in addition to Colombia, where direct taxation does not contribute to equity, and which has been subject to significant erosion as a result of special tax exemption regimes, suggests a certain degree of capture as well.  However, it requires a closer analysis of the interaction of business groups’ structural and instrumental power, with a fragmented legislative and party system, to evaluate this hypothesis more carefully.

Finally, the project coordinated by Nora Lustig (2016) found limited redistributive effects in Bolivia and Ecuador.   These limited effects appear to be mostly the result of government policy decisions, including a universal rather than a redistributive public expenditure approach in Bolivia and very low expenditure on health in the case of Ecuador.  This case also illustrates the difficulty of associating too closely low fiscal capacity to redistribute income with capture, since other variables may affect fiscal capacity to a greater extent.

Apart from the tax burden and the redistributive capacity of fiscal policy, figures on tax evasion provide a third important indicator of state capacity, and especially of an effective bureaucracy.  They may also be taken as an indicator of possible capture of tax administration institutions. 

Danger of capture in this area is much greater in some countries than in others.  Examples in the past include the tax authority (SUNAT) in Perú under President Fujimori, when it was utilized as an instrument of harassment against the opposition, or the relatively more recent use of Honduras’ tax authority as a source of employment for pro-government political activists, a clear example of clientelism. 

Data on tax evasion provides some insight on possible capture of tax administrations, though there have been significant improvements in this area over the past decade and a half throughout Latin America.  Unfortunately comparable data on tax evasion is not available for Argentina and Brazil, but according to ECLAC (CEPAL 2016, p. 71), Uruguay was the Latin American country with the lowest tax evasion of the VAT in the region in 2013, slightly above 10% and similar to the levels in European countries like Germany. 

Uruguay is a state with a long history of solid institutions, in which state capacity has been combined with a highly professional tax bureaucracy.  It shares with Costa Rica its similarity to a Latin version of Democratic Corporatism, in which smallness contributed to avoid fragmentation and facilitated negotiations to build a relatively strong state.  In Costa Rica there is a higher rate of tax evasion of its sales tax, that probably reflects the very imperfect nature of this cascading tax, full of exemptions, which has for some time been a prime candidate for reform.

Other Latin American countries that have VAT evasion proportions around 20% include Chile, Colombia, and Mexico, not so far from Spain, where it is estimated to have been 17% in 2013.   Older figures for Brazil suggest it would be close to Chile on this count.  All these countries have high state capacity with highly professional tax bureaucracies.  Capture of tax administration in this group of countries is not likely.

In the rest of Latin America capture of tax administration appears more likely.  VAT tax evasion rates equal or above 30% can be found in Central American countries like El Salvador and Guatemala, in addition to the Dominican Republic and Paraguay, which suggests much weaker institutions in these countries, more vulnerable to capture in the case of tax administration in particular.

The Guatemalan tax administration authority became an actual and extreme case of capture by a corrupt political elite, and its revelation detonated a strong social mobilization which in 2015 led to the resignation of the president and vice president.

In general, figures on tax evasion also tend to confirm the strong vulnerability to capture of some of the smaller Latin American countries if one takes into account their weak extractive and redistributive capacity, noted earlier.

Beyond these groups of countries, exceptional circumstances, like macroeconomic crisis, have been associated with major tax reforms in many Latin American countries. Given the power of domestic business groups in hierarchical capitalism, one can argue that under normal conditions it would appear much more difficult both to escape from the stronghold of business groups and to implement important tax reforms.

An example of exceptional circumstances is Chile, where strong business interests combine with a strong state that has included a strong executive, an effective bureaucracy and a parliamentary majority capable of promoting significant tax reforms. 

 After more than a decade of cohesive business groups successfully blocking any significant tax reforms through the exercise of structural but mainly instrumental power, a reform in Chile was finally approved in 2014 (Fairfield 2015b).   The exceptional circumstances in this case were a massive student revolt.   This tax reform was triggered by the student mobilizations that took place in 2010-11 demanding education reform, which in turn required significant additional funding.

The student mobilization opened up a critical juncture that allowed the parliamentary majority of the newly elected (2011) center-left government, backed by a competent bureaucracy, to formulate and implement an important tax reform.  This occurred in spite of the combination of structural and instrumental power utilized by business groups that had successfully blocked the approval of tax reforms for more than a decade. 

Colombia, where a tax on wealth was introduced to finance security programs, is another case in which exceptional circumstances, in this case widespread violence, created conditions that allowed for taxes to be increased, although not sufficiently to reach a level higher than that existing 15 years earlier.  A final peace agreement could result in a critical juncture allowing for a significant tax reform in the near future.

The literature on capture also makes reference to capture by political elites, which may or may not reinforce the power of business groups. Capture by political elites is potentially greater when institutions are weak and clientelism is strong. In what follows, two indicators to evaluate capture by political elites shall be addressed: the existence of a fiscal deficit cycle and the presence or absence of budget transparency and/or corruption.   

The existence of a fiscal deficit cycle, or of a close relation between electoral or political events and fiscal deficits, can also be interpreted as a form of capture. William Nordhaus (1989) explained it as the result of politicians’ interest in consolidating their power at the cost of uninformed (or cheated) voters concerned about the economy. 

Rigorous academic studies have found that this fiscal cycle does in fact exist.  Its significance is greater in cases of electoral polarization, and where actual knowledge by voters about the fiscal situation (fiscal transparency) is lower (Shi and Svenson 2006, Alt y Lassen 2006,  Lema y Straub 2013). The existence of a political business cycle has also been demonstrated econometrically in many Latin American countries, both at a national and at a local level (Lema y Straub 2013).

The political business cycle tends to be less important in developed countries, where there are stronger institutions that keep voters informed about fiscal policy, than in developing countries, where these institutions are weaker and information on the part of voters is less.  Clientelism, especially through increased cash transfers disbursed during electoral processes, or a more lenient application of tax laws to large businesses during electoral years to obtain favors from them, will strengthen this pattern. 

But this is not inevitable. An initial response to the existence of this political business cycle was to establish strict rules with laws setting limits on the deficit that was to be allowed.  However, these arrangements proved to be counterproductive.  They favored a pro-cyclical fiscal policy, reducing public expenditure during crisis since they had to adjust to lower revenue, and allowing for greater expenditure during booms, when revenue was greater.

One institutional answer to this problem, adopted early on by Chile and later by Colombia, has been to establish fiscal deficit rules that attempt to combine the need for exceptional increases in the fiscal deficit during periods of recession with a limit to fiscal deficits under normal conditions.  Generating savings during the normal or boom periods would then serve to cover the greater deficits allowed for during recessions.  This is a case in which a relatively straightforward rule, plus greater transparency, might limit the possibilities of capture of fiscal policy and allows for an active countercyclical fiscal policy.

Cases of very large and sustained fiscal imbalances, as those observed in Argentina and Venezuela in 2014 and 2015, or of the Dominican Republic in 2012, can be interpreted as extreme examples of a political business cycle.  Specifically, I would argue that populism—understood as the implementation of unsustainable redistribution policies through increasing expenditure without an equivalent growth of revenue, extended consumption subsidies and price controls, inflation, and exchange rate overvaluation—represents a form of capture of the state and of fiscal policy by political elites, even though it may not be subject to business capture.

A second indicator of fiscal policy captured by political elites could be the degree of budget transparency.  It is difficult to establish a direct relationship between budget transparency and capture by political or business elites, or between budget transparency and corruption, which can be interpreted as an extreme case of state capture and of capture of fiscal policy.  The impact of budget transparency would appear to be dependent on other factors, such as civil society participation, the competitive nature of the political system, and the existence of an independent judiciary (Wehner and Renzio 2012). 

Both Brazil and Mexico were among the Latin American countries with the highest Open Budget Index in 2015 (IBP 2015), yet the much greater impact that accusations of corruption have had in Brazil in contrast to Mexico would appear to be at least in part the result of a Judiciary with greater independence in Brazil than in Mexico, in addition to the differing participation of civil society, among other factors.  

When I was Minister we managed to improve Guatemala’s Open Budget ranking significantly, but its deteriorating ranking over the following years was closely associated with increased corruption.  Part of this corruption was already visible in the case of some members of Congress, who at a local level established their own construction firms to execute infrastructure projects with public funding (Fuentes Knight 2011, p. 205-11). This became even more apparent in later years.  By 2015 Guatemala, along with Nicaragua and Honduras, were again among the Latin American countries with the lowest Open Budget Index.  Fortunately, in the case of Guatemala, a stronger judiciary system, along with the UN International Commission Against Impunity and an engaged civil society, had a much greater impact on investigating and trying those responsible for corruption.

In contrast, the absence of strong independent judiciaries in Honduras and Nicaragua can be interpreted as a reason why corruption in both countries has not been visible or prosecuted, even though cases of corruption did lead to massive demonstrations of civil society in Honduras in 2015.

There are plenty of historical examples of countries in which the balance of power, and the independence of the Judiciary vis a vis the Executive, has been rhetoric rather than real.  But the analysis of fiscal policy also provides examples of undue influence of business groups that through intensive lobbying or because of very close relations with magistrates and judges, have managed to have tax reforms declared unconstitutional, as I mentioned earlier.

Overall, evaluating capture of fiscal policy provides insight on potential capture of the state.  On the one hand, analysis of the tax burden, of the redistributive capacity of fiscal policy, and of tax evasion suggests greater degrees of capture by powerful business groups in some countries than in others. Some Central American countries with weak states appear the most vulnerable on all counts, whereas other variables, including original state capacity, the strength of political parties, the ability to build coalitions, and access to extraordinary revenues associated with the commodity boom can temper those dangers to various degrees.  This also suggests that the degree of capture of fiscal policy by business groups changes over time and is reversible. 

On the other hand, analysis of fiscal deficit cycles, as well as budget transparency and corruption reveal possible capture by political elites. This appears to be subject to contingent factors to a greater degree than capture by business groups, but it has also been significant, particularly in populist and less transparent regimes.  It is more likely to emerge in the presence of weak judiciaries although, somewhat paradoxically, a weak Judiciary may also serve to disguise this type of capture of fiscal policy, in contrast to countries with a strong Judiciary, where corruption may be rendered more visible.

Finally, the analysis of capture of fiscal policy provides insight not only into when and why fiscal policy may be ineffective in contributing to general welfare, but also into when it can be effective.  It helps to identify critical junctures in which fiscal policy can reduce poverty and inequality in a sustainable fashion, at the same time that the state is strengthened while remaining accountable.  Critical junctures have been quite clear in countries as different as Brazil in the 1930s, Costa Rica in the 1940s, and Chile more recently.  This means that different degrees of capture of fiscal policy and of the state may at times appear quite pervasive, but they are not inevitable.

Click here to see the Bibliography

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Wehner, J. and P. de Renzio (2012) “Citizens, Legislators, and Executive Disclosure: The Political Determinants of Fiscal Transparency,” World Development, July.Latin American Studies on which Nora Lustig’s (2016) review is based are the following:

Argentina (2012-13; I) Rossignolo, Darío. 2016. CEQ Masterworkbook, CEQ Institute, Tulane University (February 28, 2016)

Bolivia (2009; I): Paz Arauco, Verónica, George Gray Molina, Wilson Jiménez Pozo, and Ernesto Yáñez Aguilar. 2014. “Explaining Low Redistributive Impact in Bolivia.” In Lustig, Nora, Carola Pessino and John Scott. 2014. Editors. The Redistributive Impact of Taxes and Social Spending in Latin America. Special Issue. Public Finance Review, May, Volume 42, Issue 3. (September 22, 2014)

Brazil (2009; I): Higgins, Sean and Claudiney Pereira. 2014. “The Effects of Brazil’s Taxation and Social Spending on the Distribution of Household Income.” In Lustig, Nora, Carola Pessino and John Scott. 2014. Editors. The Redistributive Impact of Taxes and Social Spending in Latin America. Special Issue. Public Finance Review, May, Volume 42, Issue 3.  (November 4, 2014)

Chile (2013, I): Martínez-Aguilar, Sandra and Eduardo Ortiz-Juarez. 2015. CEQ Masterworkbook, CEQ Institute, Tulane University and the World Bank (December 9, 2015)

Colombia (2010, I): Melendez, Marcela, Nora Lustig and Valentina Martínez. 2015. CEQ Masterworkbook, Tulane University (December 17, 2015)

Costa Rica (2010; I): Sauma, Juan and Diego Trejos. 2014.  Social Public Spending, Taxes, Redistribution of Income, and Poverty in Costa. CEQ Working Paper No. 18, Center for Inter-American Policy and Research and Department of Economics, Tulane University and Inter-American Dialogue, January.  (February 2014)

Ecuador: Llerena Pinto, Freddy Paul, María Christina Llerena Pinto, Roberto Carlos Saá Daza, and María Andrea Llerena Pinto. 2015. Social Spending, Taxes and Income Redistribution in Ecuador. CEQ Working Paper No. 28, Center for Inter-American Policy and Research and Department of Economics, Tulane University and Inter-American Dialogue, February.

El Salvador (2011; I): Beneke, Margarita, Nora Lustig y José Andrés Oliva. 2015. El impacto de los impuestos y el gasto social en la desigualdad y la pobreza en El Salvador. CEQ Working Paper No. 26, Center for Inter-American Policy and Research and Department of Economics, Tulane University and Inter-American Dialogue, February.  (March 11, 2014)

Guatemala (2011; I): Cabrera, Maynor, Nora Lustig and Hilcías Morán. 2014. Fiscal Policy, Inequality and the Ethnic Divide in Guatemala. CEQ Working Paper No. 20, Center for Inter-American Policy and Research and Department of Economics, Tulane University and Inter-American Dialogue, October.  (April 13, 2014)

Honduras (2011; I): Castañeda, Ricardo e Ilya Espino . 2015. CEQ Masterworkbook, CEQ Institute, Tulane University (August 18, 2015)

Mexico (2010; I): Scott, John. 2014. “Redistributive Impact and Efficiency of Mexico’s Fiscal System.” In Lustig, Nora, Carola Pessino and John Scott. 2014. Editors. The Redistributive Impact of Taxes and Social Spending in Latin America. Special Issue. Public Finance Review, May, Volume 42, Issue 3. (September 2013)

Peru (2009; I): Jaramillo, Miguel. 2014. “The Incidence of Social Spending and Taxes in Peru.” In Lustig, Nora, Carola Pessino and John Scott. 2014. Editors. The Redistributive Impact of Taxes and Social Spending in Latin America. Special Issue. Public Finance Review, May, Volume 42, Issue 3. (May 1, 2013)

Uruguay (2009; I): Bucheli, Marisa, Nora Lustig, Máximo Rossi, and Florencia Amábile. 2014. “Social Spending, Taxes and Income Redistribution in Uruguay.” In Lustig, Nora, Carola Pessino and John Scott. 2014. Editors. The Redistributive Impact of Taxes and Social Spending in Latin America. Special Issue. Public Finance Review, May, Volume 42, Issue 3. (August 18, 2014)