Small fiscal reforms can deliver big results

WASHINGTON, DC :Despite decades of progress in many areas, persistent structural weaknesses that impede effective tax collection and public spending continue to hurt economic growth and development across Latin America and the Caribbean (LAC).

Government revenues and spending have remained close to their pre-pandemic averages, leaving countries across the region with limited fiscal space. Consequently, efforts to reduce budget deficits – currently averaging 3% of GDP – have largely stalled. Between 2014 and 2024, public debt rose from 45% of GDP to 60%, according to our calculations based on IMF data, pushing interest payments to 2.7% of GDP – roughly equivalent to the annual investment needed to close the region’s infrastructure gap.

While some economists argue that drastic austerity measures are required to overcome these fiscal pressures, we believe there is a gentler, smarter, more politically feasible path to reversing LAC’s debt trajectory.

The key to achieving fiscal sustainability lies in reforming how public funds are raised and allocated. Governments across the region face growing pressure to invest in public services and infrastructure, yet they are constrained by outdated and ineffective fiscal tools. Their tax systems collect too little revenue and tend to distort investment decisions and labour markets. At the same time, government spending is often inefficient or poorly targeted, eroding public trust. According to a forthcoming study, wasteful spending amounts to 4.6% of the region’s GDP – slightly higher than a decade ago.

These structural weaknesses don’t just constrain growth. They also hinder efforts to reduce inequality, because high levels of labour informality and a heavy reliance on regressive value-added taxes (VAT) make Latin American and Caribbean economies less effective than their developed counterparts at using taxes, social spending, and transfers to narrow income gaps. In fact, in six countries, fiscal systems actually exacerbate poverty.

This reality underscores the need for fiscal reform. Yet sweeping change remains politically difficult, as deep-rooted mistrust in state institutions fuels public scepticism toward proposals aimed at boosting revenue or reallocating funds, even when such measures are clearly necessary. A survey conducted in eight countries across the region found that, although a large majority of respondents viewed their country’s income distribution as unfair, only 30% supported expanding the personal-income-tax base.

Put simply, people want a progressive tax system but expect someone else to pay for it. In this environment, seeking a broad political consensus on ambitious fiscal reform could mean waiting indefinitely.

Still, governments can build public trust and make meaningful progress by focusing on practical, incremental improvements in fiscal policy and management. Such low-profile initiatives may not make headlines, but they can deliver tangible results.

One proven approach involves digitalizing tax systems, using data analytics to combat evasion, piloting better-targeted subsidies, and strengthening budget frameworks. These steps make fiscal systems more efficient, equitable, and credible, enabling more ambitious reforms to be undertaken later. For example, after El Salvador introduced real-time electronic invoicing and integrated it with third-party data on personal wealth and consumption, VAT revenue increased from 3.5% of GDP in 2017 to 8.7% in 2023, generating an additional $1 billion in revenues.

Data analytics and digital tools for targeting and delivering payments can make VAT more progressive without sacrificing efficiency or growth. In our own work at the Inter-American Development Bank (IDB), we have helped governments shift from costly, poorly targeted VAT exemptions toward direct VAT refunds for low-income households.

Our experience using microsimulation calculations shows that strengthening fiscal systems requires investment in robust social and tax registries, along with well-designed delivery systems. For instance, in Uruguay, families in need use a card-based digital payment system to lower their VAT payments when they make their purchases, reducing the burden from 16% to 14.8%, and further improvements in targeting could cut it by an additional couple of percentage points, boosting their disposable income and helping them cover other essential needs.

In Honduras, the IDB financed a comprehensive tax-system modernization that increased the share of taxpayers using electronic filings from 50% to 95%. As a result, tax revenues rose by three percentage points of GDP – an outcome comparable to what would be achieved through a painful fiscal adjustment. Similarly, in Brazil, improvements to state-level tax systems led to an 11.7% increase in tax collection across 23 states between 2012 and 2019.

We have also supported efforts to reduce wasteful expenditures. In Chile, the digital modernization of public procurement through ChileCompra has enhanced transparency and curbed unnecessary spending. Meanwhile, the state government of Brazil’s Rio Grande do Sul linked tax e-invoicing data to procurement price references, enabling it to rein in overpricing and ensure better value for public money.

Even politically sensitive reforms, such as subsidy reductions, can be implemented without triggering social unrest. In Argentina, we helped the government replace electricity subsidies that disproportionately benefited wealthier households with more targeted assistance. This shift saved the country more than $6 billion, nearly 1% of GDP, while protecting low-income households.

Stronger fiscal institutions are critical to creating the fiscal space needed to pursue bold economic policies. In El Salvador, the IDB provided technical support to design and implement a new budgetary rule – now part of the country’s standby program with the International Monetary Fund – which is expected to reduce public debt by nine percentage points of GDP by 2030. And IDB-financed projects helped Brazilian states bolster their fiscal frameworks, doubling tax collection from accounts receivable between 2023 and 2024.

Perhaps most importantly, these nuts-and-bolts measures can help build confidence in economic governance. When citizens see that taxes are collected fairly and spent wisely, they are more likely to support more ambitious reforms down the road. The faster LAC governments take meaningful steps to improve governance, modernize underperforming tax systems, and eliminate waste, the faster they can lay the groundwork for sustained and equitable growth.

Copyright: Project Syndicate, 2025.
www.project-syndicate.org

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