Fitch Ratings Not Impressed With Colombian Government’s Fiscal Strategy

Fitch Ratings released an analysis on Colombia’s tax reforms, stating they will likely signify revenue losses in 2020, underscoring the view that meeting this year’s fiscal deficit target will be challenging and reliant on extraordinary revenues, the ratings firm says. Structural deficit reduction may be hampered by social and political considerations.

The Ivan Duque Administration’s recently released 2020 Financing Plan targets a central government deficit of 2.2% of GDP, down from 2.5% last year. However, Fitch believes this is based on optimistic assumptions for GDP growth (3.7%, versus Fitch’s 3.3% forecast) and tax revenues, which the plan sees remaining stable at 14.3% of GDP.

The Economic Growth Act  approved by Colombia’s congress late last year contained a number of tax measures. Some, such as corporate tax rate cuts and tax credits for VAT on capital imports, were retained from the 2018 Financing Law that the Constitutional Court had declared unconstitutional on procedural grounds. Others, including VAT tax holidays on three days of the year and VAT rebates for the poorest 20% of the population, were late additions to the act and will further undermine fiscal performance.

“Frequent revisions to fiscal targets and reliance on one-off extraordinary measures have reduced policy credibility.”

Even without these additions, the tax credits would have made meeting the 2020 deficit target difficult. Fitch estimates that the act could result in lost revenue worth as much as 1% of GDP with the additional measures. Efforts to improve tax administration could mitigate, but will not fully offset, these losses. Revenues from divestments and higher dividends from Ecopetrol and the Central Bank will likely help contain fiscal underperformance again this year. However, the gains would not be permanent, and the revenue impact of further corporate tax cuts will be felt from 2021 and 2022.

Last year’s central government revised deficit target of 2.7% of GDP was met, and the deficit still narrowed from 3.1% in 2018. Tax revenues rose 9.8% to yield an additional 0.4% of GDP, where we had expected 0.6%, but the government boosted revenues with one-off measures, using “excess reserves” at state-owned Ecopetrol for an additional dividend worth 0.3% of GDP.

The Colombian authorities’ record of prudent and consistent macroeconomic policies has underpinned macroeconomic and financial stability. However, frequent revisions to fiscal targets and reliance on one-off extraordinary measures have reduced policy credibility and contributed to Fitch’s revision of the Rating Outlook on the country’s ‘BBB’ sovereign rating to Negative in May 2019.

General government debt/GDP has steadily risen over the past six years to an estimated 44.7% in 2019 (versus the ‘BBB’ median of 41.1%) from 29.9% in 2013, although this has partly been driven by the recognition of contingent liabilities as well as the weaker peso. Debt to GDP is expected to rise modestly again in 2020, due in part to a weaker peso.

Structural improvements in public finances, for example through measures that permanently increase revenues, could face political and popular opposition. The additional VAT holidays and rebates were added to the act after large protests in November and December against rumored pension cuts, inequality and the slow implementation of policies agreed in the 2016 peace deal that ended the FARC insurgency.

An uptick in cyclical economic growth has supported revenues. Fitch estimates that real GDP growth accelerated to 3.2% in 2019 from 2.6% the previous year, and domestic demand will keep growth broadly stable this year. The VAT rebates will support consumption, while VAT credits and lower corporate taxes should boost private investment. Strong consumption has contributed to a widening current account. This has been largely financed by robust FDI, but a sustained rise in external debt could put additional pressure on the sovereign rating.