Accelerating Economic Growth and Strengthening the Middle Class in Latin America

Having spent a long and distinguished career as economists for the Inter-American Development Bank (IDB), Rafael de la Cruz and Osmel Manzano have jointly authored a new book, How to Accelerate Economic Growth and Strengthen the Middle Class in Latin America (IDB, 2020). In this new book, the authors share with the readers their insights about gaps and untapped potential in Latin America’s economy. Their recommendations are not only timely and appropriate for the region, but are applicable to other regions when considering robust growth of the middle class. While the book was finished shortly before the Covid-19 pandemic, it remains relevant as a longer-term strategy to economic growth.

The conversation, moderated by Erol Yayboke, has been edited for purposes of brevity and clarity.

EY: Thank you both for joining us. So, let us start at the beginning. Why did you decide to write this book?

RC: This book is a long-term strategy to incentivize accelerated economic growth. While Asia has been growing at high rates (averaging 4-6 percent GDP per capita), rapidly reducing poverty, and creating a middle class, Latin America has been lagging. It has decreased poverty (from approximately 50 percent of the population to 23 percent) over a 15-20-year period but has also hurt its middle class.

Our book shares the evidence that social opportunities are dependent on rapid economic growth. A larger world economy equates to more opportunities, more investment, more employment, all of which alleviates poverty and grows the middle class.

There is a path for an accelerated growth over the next 20 years during which many Latin American countries can become developed economies with over $30,000 per capita income (approximately the GDP per capita of some Southern European economies.

Many development banks and development specialists think that we need to prioritize poverty. We, however, focus on the middle class since ultimately the actual basis for sustained growth is hinged upon their resilience.

EY: As you were describing the genesis of the book, the saying “a rising tide lifts all ships” came to mind. International development is not just poverty-focused development banks. It is also finding new solutions or technologies that can transform our approach to global challenges.

One of the points that was made in the book was about accelerating some of the trends that we are already seeing. For instance, Colombia recently became an OECD [Organization for Economic Cooperation Development] member, with many other countries in the region getting up to that point. Could you talk more about how the development community can accelerate growth, given where we are now?

OM: We focus on accelerating growth because we lived through a period of high growth. That led to the case of Colombia, which is on the cusp of becoming a high-income country.

A key driver of growth is infrastructure investments. The region has significant gaps in infrastructure and some countries have wage gaps of up to 120 percent of GDP. This is despite some infrastructure investment during the economic boom. Of course, any talk of infrastructure development should look at financing. Hence, a section focusing on financing infrastructure and building on recent successes in countries like Colombia and Peru. Last, we acknowledge the need for improvements in institutions to facilitate all this.

Even before the pandemic, many Latin American countries had no fiscal space for infrastructure.

Another important point is “the Death Valley” in Latin America, which refers to private sector “crowding,” where there are many small firms and several large firms but nothing in between, leaving a nominal gap. That prompted us explore fostering growth of mid-size firms can provide significant private investment.

We also discuss how economic growth should be harnessed to consolidate and strengthen the middle class. One key finding is that the Latin America’s middle-class composition jumped from 20-30 percent to 60-70 percent. However, half of that middle class is in a vulnerable position. Therefore, consolidating and strengthening the middle class is a priority.

EY: A key takeaway here is that until Covid-19, many of the countries in the region were in a decent fiscal situation but did not necessarily have the capital for infrastructure development. This is what makes the IDB and the World Bank critical for infrastructure development and their involvement should be seen as a catalyst for private sector investment and growth. If that is the case, what types of infrastructure are we talking about?

RC: The gap in public goods in Latin America is huge, and any effort in this area would have long-term payoffs. Take the digital economy in the United States—a typical working family can have access to high-speed internet. In Latin America, a similar family would probably have 30 percent of internet bandwidth due to infrastructure capacity. Translate that to the economy at large and see how companies are unable to take advantage of the latent potential of the digital economy.

Of course, you can be more technocratic and do a finer analysis to see what the best return on investment we can get. Let us consider an anecdote from 1896 Spain. The government decided to build the first high-speed train between Madrid and Sevilla. This was a good political decision, although poor technocratically. But soon after, Spain created the Madrid-Barcelona line and you saw a proliferation of high-speed trains across Spain, leading to massive expansion and modernization and increasing infrastructure investments. The lessons here are that whatever political strategy is feasible and can help increase investments should be embraced in the short run as long as we make gains in the long run.

Over the last 30 years, Latin America has invested an average 3 percent of GDP in public investment. We posit that Latin America needs to invest between 6-7 percent to add 2-3 points to GDP growth. In 20 years, this will help increase GDP per capita from around $12,000 per capita to around $30,000 per capita.

EY: I am glad you mentioned digital infrastructure because I think this relates to the challenges posed by the Covid-19. The digital divide is growing significantly, including in advanced countries such as the United States, and manifests into other socioeconomic sectors.

How does Covid-19 impact your findings (if at all)? How do we build back for a post-Covid-19 world?

OM: In the end, you do wish that the book had reflected on Covid-19. Outside the region, people are trying to get back growth, and everybody is contemplating a large fiscal stimulus. This is true for the Latin American context except there are opportunities for infrastructure. There are two advantages for a fiscal push for new infrastructure. First, it is a kind of temporary spending, because when you want to do this fiscal push you don't want all of a sudden to commit to expenditures that in the future you will have to maintain.

Second, it generates employment. In the book we define “future spaces.” Per country, we have identified spaces of up to 10 percent of GDP, which means it can help cover all the fiscal impact of Covid-19. It can also help cover infrastructure bills. To that end, we identify strategies to help countries realize this relief. Worth noting is we don't measure the social infrastructure gap in terms of health and education, but they are a necessary investment. Thinking about recovery, you must focus on helping your economy and the opportunities that the Covid-19 shock is creating. One of these opportunities is nearshoring. We can attract investments to facilitate nearshoring through better infrastructure that integrates intra- and inter-country manufacturing and market hubs. Alternatively, a sector that holds potential is food and agriculture, one of the few sectors still growing despite Covid-19.

The economic crisis triggered by Covid-19 highlights one of the more prevalent issues among the middle class, which is the lack of a social insurance. States were often more focused on poverty-alleviation measures, gain growth, and progress. Initiatives like conditional cash transfers help bring people out of poverty. But the same states are not as much geared toward the middle class, particularly regarding ensuring social insurance. Social insurance can help with health coverage, pensions, and unemployment insurance for the middle class. While some countries have a social welfare system, it only covers a small portion and is expensive. Naturally, this net needs to be cast wider.

EY: It is great for us to be here and say there should be more infrastructure spending, but we all recognize that money does not grow on trees. Could you talk to us a little bit about how we finance the infrastructure agenda?

RC: This is a key question in our book. Not only do we provide ideas for short- and long-term strategy in terms of how to accelerate growth, but we also offer suggestions to do so in terms of financial needs. Most countries in Latin America have low fiscal income (around 15 percent of GDP). For these countries, including the Andean countries, we propose finding methods to increase it. There are three main reasons as to why these countries have low fiscal incomes: tax evasion, fiscal exemptions, and too many central government subsidies. If fiscal exemptions are reduced, then you get better results in terms of collecting taxes, and you can raise fiscal income between 4-8 percent profit. That takes your fiscal income to above 20 percent of GDP because you preserve 2 or 3 points of this from increased investment, which is about 6 to 7 percent GDP investments per year.

We propose that Latin America needs to build a foundation and make a big effort toward “fiscalization,” such as taxes and construction projects. Latin America needs to also reshape the old fiscal exemptions, which mainly include interest groups that have large political influence and exert political pressure. Consider higher fiscal income countries such as Argentina, Brazil, and Uruguay (each boasting a fiscal income around 30 percent of GDP). Although they have higher fiscal incomes, they spend too much on subsidies. As a result, both low-fiscal-income and high-fiscal-income countries alike have low private and public investment rates, around 3 percent per year. We include a chapter on ways to recuperate money that is not being invested and not contributing to fiscal income.

EY: I was glad about the book’s focus on domestic resource mobilization and public expenditure. When I was in West Africa doing research, I learned that places with incredible natural wealth have these 99-year tax exemptions and not as much of the knock-on benefits of foreign direct investment as hoped. Today, they are living with the repercussions. Businesses and investors don’t like uncertainty, and the fastest way for any politician to lose an election bid is to talk about canceling a contract negotiated in the past by their opponents.

OM: It is important that we don’t discuss raising the tax rate. In fact, we recommend reducing tax rates in some countries and considering more exemptions. We also discuss fiscalization (to reduce retailer fraud and tax evasion) and electronic invoicing. We emphasize that instead of increasing tax rates, be more effective in enforcing (or collecting) existing tax laws. The key here is effective public policy, developed through a robust political discussion.

EY: I’d love to talk about the political side as well. When lots of people think about big infrastructure and the type of fiscal stimulus that you are talking about, and the reform of the taxation systems, they talk about leakage. How can this be done in a way that address corruption concerns?

RC: Corruption is a problem, but it is not the biggest problem. Corruption must be addressed with more institutional transparency. At the IDB, we have been working on this issue, including through an online reference tool that anybody can visit and look at what exactly has been invested and where. You can compare the investment parameters for two similar deliverables and check for unusual variances. The tool is helpful for NGOs and watchdogs and for tracking ongoing projects combatting corruption.

But anti-corruption efforts and strengthening institutions are a work in progress. More important is the need to have consensus around development policies as these policies have long-term consequences for sustained economic growth and progressive investments.

Corruption in development projects does raise legitimate concerns and hampers political consensus. The region is very polarized, and policy continuity is not easy to achieve. We are optimistic but also realistic in our expectations.

We are hopeful that promoting sound infrastructure investment strategies is perceived to benefit everybody, regardless of political ideology. This includes fighting poverty with a growing middle class and more public investments. Our book calls for people to pay what they need to in exchange for that.

EY: Okay, so I am a nerd. I love getting up in the morning and reading about accelerating economic growth and strengthening the middle class in Latin America, but it may not be everybody’s cup of tea. This book is an important contribution not just intellectually, but also in a technical and practical sense. Osmel, why do you think people should read this book, and what are some main takeaways?

OM: It becomes hard to gain the big picture when we fractionalize the policy discussion and only discuss exemptions or certain investments. The book brings together issues surrounding fiscal planning, poverty, investment strategy, infrastructure, and the private sector all at once. The full picture gives us the benefit of having a comprehensive and coherent policy toward middle class-centered economic growth.

EY: I agree, and if I might add, this book is not to say that we should forget about poverty. In fact, we should provide social safety nets.

However, following Covid-19, perhaps there is an opportunity to refocus not just on the most vulnerable people, but also on building robust economic growth in the middle class.

RC: Thank you, Erol. As always, this was a stimulating conversation.

70 percent of why Latin America dramatically reduced poverty in the last two decades was because of economic growth, a function of having a dynamic and productive economy. The public sector is critical in strengthening economies.

Our book proposes a more effective way to fight poverty and produce more quality employment and opportunities overall. Due to the pandemic Latin America will experience a relatively slower recovery. Hard work is needed, and people and politicians should clearly understand the importance of increased socioeconomic opportunities through accelerated growth.

Growth is more important than ever to get back on track, but once we get back on track, our main messages include: Don’t accept mediocrity; instead, reach for long-term growth and prosperity. Believe that Latin America can truly evolve into a developed region in a few years, benefitting everybody, particularly the United States, which has special commercial links with Latin America. We believe our strategy is politically moderate and presents gains across the board. Ultimately, we hope that this book is received as a recipe for success.

EY: “Do not accept mediocrity” is inspiring advice—one which we can all take into our lives and in our jobs. Thank you, Osmel and Rafael, for writing this important and relevant book given the times we live in, and for your willingness to talk about it. I wish you both the very best of luck and look forward to having you back again at CSIS soon.

Erol Yayboke is deputy director and senior fellow with the Project on Prosperity and Development at the Center for Strategic and International Studies in Washington, D.C.

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