Chile passes ambitious reforms to avoid middle-income trap

Chile passes ambitious reforms to avoid middle-income trap

When Chilean president Michelle Bachelet and her center-left coalition won the election last year, it was clear that reform was on her mind. President Bachelet and the National Congress have signed a deal that will put nearly all the proposed reforms into place.

The centerpiece of the compromise is an ambitious plan to raise $8.2 billion in tax revenue – 3% of Chile’s GDP – to fund public secondary education. The plan has been the largest response yet to the three year-long Chilean Winter student protests that decried the country’s income inequality and poor public education system. The leaders of those protests are now part of Bachelet’s legislative coalition. Chile’s inequality has decreased in its two decades of democracy but remains the highest in the OECD.

To pay for an expanded educational system, the compromise will raise corporate income tax rates from 20% to 27% and drop the Taxable Profits Fund (FUT), a favorite tax break of conservatives and business leaders.

Continuing Chile’s long-standing commitment to fiscal responsibility, the plan is largely budget neutral. Finance Minister Alberto Arenas forecasts that the structural deficit will disappear by 2018 under the reforms.

Just four months after her second inauguration, Bachelet has already made her presidency transformative. Within Chile and abroad, this period could turn out to be a blueprint for middle-income countries, although risks associated with Chile’s dependence on the copper industry could spoil the legacy of the reforms.

Bridging demands of students and business

President Bachelet’s decisive election did not give her the wide mandate expected. On one hand, Bachelet had embraced the leaders of the Chilean winter protests into her coalition. Their agenda was as left-wing as one would expect from a prolonged student demonstration, with some describing the leaders as further left than the Communist Party.

On the other hand, Bachelet and her center-left party are firmly rooted in pro-market, free-trade and low regulation ideology that Chile has followed since the 1970s. Despite its connections to the brutal Pinochet regime, a focus on low taxation and small welfare state have been a mainstay of Chile.

In her first days in office, Bachelet reassured markets she would not overhaul the system: “We’re still committed to public-private partnerships and the free market, we’re still open to foreign investment and free-trade agreements. None of that is going to change.”

Bridging the gap between these two groups took great political skill. The reforms have tried to address this. Investment has increased and tax schemes that were widely abused and ineffective have been eliminated.

If the expansion of public education is successful in building a strong economy, Chile has the potential to join South Korea and Taiwan as counties to emerge from the middle-income trap. The way that Chile would have done it may be easier for other countries to copy than previous models of ‘escaping’ the trap. It offers a plan that is relatively appealing to a broader range of the political spectrum. Countries from Argentina to Malaysia would be able to benefit.

Reforms success depends on copper and China

No discussion of the Chilean economy is complete without including the copper market. As much as 20% of the nation’s GDP is tied to copper mining and exports, with the massive Escondida mine producing 5% of the world’s copper.

With such a dependence on the commodity, major fluctuations in global demand have a magnifying effect on Chile.

There are two reasons for concern for the Chilean economy and Bachelet’s reforms stemming from the copper market: the financial health of the state-owned mining operation Codelco and the slowdown in the Chinese economy.

Recent leadership changes underline the uncertainty facing Codelco. Previous leader Thomas Keller was replaced after not being able to work closely enough with unions. More worrying, however, is the state of investment in mining infrastructure. Only 5%of profits are reinvested, compared to nearly 50% by the private sector. New equipment will prove vital to the long-term viability of the business as it will allow Codelco to extract minerals from deeper in the earth.

Above all other risks, the risk of a Chinese slowdown is most worrying for Chile. Because of China’s voracious need for copper in infrastructure and housing, Chile is more vulnerable than any other emerging market to a Chinese slowdown.

Given the impact of the internaitonal copper market and Chinese demand on Chile’s economy, the success of Bachelet’s new reform compromise will likely depend on developments out of her control.

Categories: Latin America, Politics

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.