May 20, 2003 | Backgrounder on Latin America
One of the most fascinating topics in economic and social research is the issue of development. What allows some countries to "quantum leap" to higher levels of income per capita, and how do they remain at those high levels?
The literature on economic growth, development, and prosperity mostly agrees that the key to prosperity is open markets, sound institutions, and particularly a strong rule of law.2 The reason is simple. Open markets allow for competition, which is the only method, as F. A. Hayek wrote in the Road to Serfdom, "by which our activities can be adjusted to each other without coercive or arbitrary intervention of authority."3 Competition, at the same time, requires the organization of institutions, such as stable money, minimal and transparent regulation, minimal participation of the state in economic activity, and a strong enforcement of property rights and regulations.
The annual Heritage Foundation/Wall Street Journal Index of Economic Freedom provides a framework for understanding how open countries are to competition; the degree of state intervention in the economy (whether through taxation, spending, or overregulation); and the strength and independence of a country's judiciary in enforcing rules and protecting private property.
The 10 factors of the Index show the degree of economic freedom in a given country. Some countries may have a substantial degree of freedom in all factors; others may have a degree of freedom in just a few. One of the most important findings of the Index is that, as Hayek foresaw more than 60 years ago, economic freedom is required in all aspects of economic life--that is, in all of the 10 factors--in order for countries to improve their economic efficiency and, consequently, the living standards of their people.
Chile illustrates Hayek's idea. For more than 30 years, the country has persisted in opening its markets, allowing more and more competition, and fostering a strong rule of law, and these efforts have paid off in many ways. Chile today has one of the highest per capita gross domestic products (GDPs) in Latin America, has experienced high levels of economic growth, and conveys an institutional trust that has attracted local and foreign investment. Most important, it has severed itself from reliance on international aid, on which most Latin American countries depend. By following the 10 steps to economic freedom, Chile has become more prosperous. Continuing on this road will transform Chile into a developed economy for future generations.
Chile has set the example of how a country can escape from the cycle of aid and dependence to the cycle of self-generated growth. Other Latin American countries and the rest of the developing world should be encouraged to follow the Chilean example. Many developing countries have slipped back from reforms into aid and bailout dependency, while others have never exited aid dependence at all.
The United States should do all it can to support the Chilean effort and publicize the great triumph of prosperity through free and open markets. Success breeds imitation. As more and more countries begin to imitate the "Chilean model," the world will experience more growth, development, stability, and peace.
Chile's reforms began in the mid-1970s under the government of General Augusto Pinochet and have continued to the present. Using the Index as a framework, it is possible to identify the areas of economic freedom in which reform has progressed in Chile.
STEP 1: Trade
Trade policy was one of the first things Chile reformed, beginning in 1974 with the dismantling of quotas and other non-tariff barriers. In addition, the Chilean government established a uniform tariff rate of 10 percent on all imports, with the exception of a few agricultural products.4 During a crisis in the early 1980s, the tariff was temporarily increased to 15 percent, remaining at that level until 1990.5 The reduction process continued until 1998, when the Chilean Congress approved a law reducing the tariff rate by 1 percentage point per year until it reached 6 percent in 2003.
The lowering of tariffs had four important effects. First, the influence of special interests and the corruption associated with them was significantly reduced; with all sectors of the economy facing the same protection, the government could no longer offer special deals. Second, the flat tariff eliminated the distortions that usually retard domestic economic growth. Third, exports increased considerably, from $3 billion in 1974 to $29 billion in 2000.6 (See Chart 1) Fourth, it diversified exports; the share of copper exports, for example, decreased from 76 percent of total exports in 1970 to 38 percent in 2001, while non-traditional exports share increased from 10 percent to 38 percent during the same period.7
Overall, the implementation of a low uniform tariff helped to boost the domestic economy by giving producers access to inputs of better quality at lower prices, increased consumers' welfare by increasing the variety of and lowering prices for goods and services, generated more income for the country, and helped to eliminate corruption.
STEP 2: Fiscal
The Chilean tax code went through two major reforms. The first, in 1975, introduced a flat-rate value-added tax of 18 percent.8 The second, in 1984, simplified and reduced the corporate tax, which is currently set at 16 percent.9 In 2002, according to the Index, "the top income tax rate [was]...lowered from 45 percent to 43 percent and will be lowered to 40 percent in 2003."10 According to the Centro de Estudios Publicos (CEP), a public policy foundation based in Santiago, Chile, "tax evasion in Chile, estimated at around 22 percent of potential tax revenues, is the lowest in Latin America and not significantly different from many developed countries"11
In addition to the tax reform, the reform of the mid-1970s included a rationalization of public expenditures, which in prior years had gone out of control. According to the CEP, "measures to adjust public spending [were implemented]...in three areas: public investment, public sector wages, and the elimination of most of the subsidies implicit in the operations of the state owned companies."12 By 1976, the government had a fiscal surplus of 1.37 percent of GDP; since then, it has averaged a fiscal surplus of 0.87 percent. (See Chart 2)
According to the CEP, the first of three major rounds of Chilean privatization began in 1974. The first, which lasted from 1974 to 1983, included "most farms and some industries [as well as]...industries that had been acquired by the state during the government of President Allende. This included mostly industries and banks."13 The second round, in 1985, included "public utilities plus the re-privatization of companies that had returned to the government during the [1982-1983] crisis." The third round, in 1990, "comprised basic infrastructure (through concessions) and water companies." The CODELCO (a copper company), a bank, and the principal oil company still remain in state hands, but the share of public enterprises in the GDP declined from 39 percent in 1973 to 9 percent in 1998. (See Chart 3)
board of...five members nominated by the president and approved by the senate. Each one has a 10-year term. Every two years there is a change in one of the board members. They are independent from the government (cannot be removed from their position.) The Ministry of Finance has the right to participate in board meetings but does not have a voting power.14
Prior to the reform, Chile's inflationary history was horrible. The inflation from 1961 to 1989 averaged about 75 percent, reaching as high as 500 percent in 1974. (See Chart 4) The new independent Central Bank set and reached inflation targets, successively lower each year, until inflation was at very low levels. Since 2000, the target has become permanent--2 percent to 4 percent annually.15
Two other factors may have contributed to the decline in inflation: a general fall in global inflation during the 1990s and the growing strength of the Chilean economy, which increased confidence that the Central Bank could maintain the value of the currency. Nevertheless, giving the Central Bank more independence was a key domestic decision in strengthening an important institution and ensuring a stable currency.
STEP 5: Banking
Liberalization of the banking system began in the mid-1970s. The CEP reports that the major reforms included the privatization of all but one state-owned bank, liberalization of interest rates, reduction in reserve requirements, and enlargement of the scope of banking businesses.16 The financial crisis of 1982-1983 led the government to implement more reforms. This time the government strengthened banking supervision with the introduction of a banking law in 1986.17 Today, Chile's supervision of banks is considered one of the best in emerging markets.
The liberalization of the banking system and stronger bank supervision have led to increased penetration--measured by the increase in deposits and loans as a percentage of GDP--and more bank consolidation. According to the Bank for International Settlements, "Banking loans amounted to 70 percent of GDP and total deposits to 61 percent of GDP in 2000. These figures compare with 54 percent and 47 percent, respectively, in 1990."18 In addition, "the Chilean regulatory environment has been stable since the 1980s"19 Today, the Economist Intelligence Unit (EIU) reports, "the banking system is well capitalized and prudently managed, and it is ranked among the most solid in the world."20
Another major reform in the financial system was privatization of the pension system. This reform allows individuals to save retirement money in fully funded privately managed accounts rather than relying on the government transfer program of collecting payroll taxes from the active population and transferring them to retirees as pensions. Administradora de Fondos de Pensions (AFP) are private companies in charge of managing retirement funds. Under the new reform, people can move their money to another AFP if they think their funds are not being managed properly.
Eliminating transfers had enormous implications for economic growth and the advancement of other reforms. According to the CEP, pension funds have increased continuously since 1981 and, in 2001, represented more than 50 percent of GDP.21 Perhaps more important, the growth of the pension system exerted pressure to privatize state-owned companies and liberalize trade in order to provide pension owners with domestic and foreign investment opportunities.
STEP 6: Capital
Flows and Foreign Investment
According to the EIU, in the mid-1970s, the Chilean government took two major steps toward liberalizing foreign direct investment. First, it enacted Decree Law 600 to define the rules for foreign investment. Second, it "withdrew from the Andean Pact, a regional organization whose protectionism and bias against foreign investment were incompatible with Chile's new development strategy."22
RWINC Consultants, a Chilean business consulting firm, reports that Decree Law 600 "has been recognized by the international business community as one of the most modern and flexible legal frameworks for foreign investment in the world."23 The decree law guarantees non-discriminatory and non-discretionary treatment of foreign investors. When the investment application is approved, the foreign investor enters into a contract with the state, a contract that neither the Chilean government nor a regulation can modify unilaterally.24 Foreign investment is acknowledged in the form of freely convertible currency, physical goods that can be imported, technology in any form that can be capitalized, capitalization of foreign loans and debts in freely convertible currency and whose contract was authorized by the Central Bank, and capitalization of profits transferable abroad.25
RWINC also reports that "the policy of the Chilean State is that in case more favorable regulations than those established in the contract are enacted, the investor has the right to request an amendment to reflect the new regulations." This reform has resulted in a massive inflow of foreign direct investment, increasing from $12.7 billion in 1974-1994 to $35.9 billion in 1995-2001.26
Chile now has a very open policy for capital controls. In the 1990s, the government required that "foreigners wishing to move funds into Chile...make non-interest bearing deposits at the Central Bank."27 In 1998, the percentage of money required to be deposited in the Central Bank was reduced to 10 percent, and later that year, the rate was reduced to zero.28 This year, within the framework of the U.S.-Chile Free Trade Agreement, the Chilean government agreed to repeal the law.
STEP 7: Wages
Wages and prices were liberalized at the beginning of the reform process, in 1974. That year, the government lifted restrictions on all prices in the economy.29 This was a clear signal of a nascent market economy, which uses the price system as an "information" mechanism that leads to a more efficient allocation of resources.
Wages were also liberalized. In the mid-1970s, according to Vittorio Corbo, professor of economics at Chile's Catholic University, "collective bargaining was suspended and, with the exception of the minimum wage and public sector wages, the government did not intervene much in the determination of private sector wages."30
STEP 8: Property
Chile has a long tradition of respect for private property rights and enforcement of contracts. According to the EIU, "contractual agreements in Chile are probably the most secure in Latin America, and the local public administration is generally honest."31 The respect for and strong enforcement of private contracts continued even through the 1973-1989 dictatorship. Throughout society, there is a widespread understanding and trust that the law must be respected, and the courts enforce the law effectively.
The reforms of the past three decades have simplified--where possible--and reduced the regulatory cost of doing business in Chile. One major reform in the mid-1970s was the liberalization of the labor market, making it more flexible. Until 1974, the labor market was extremely rigid. According to Vittorio Corbo, "Rigidities took the form of labor immobility, unlimited compensation for labor dismissal, minimum wages...[and] special salary conditions."32
The 1974 reform established that negotiations between employer and employee would determine wages in the private sector. It also set new, more flexible conditions for hiring and laying off employees, reduced restrictions on the severance pay for layoffs, and reformed the collective bargaining process into one in which the union negotiates at the company level.33 At the same time, the 1974 reform made starting a new business in Chile more expeditious, and applications are now typically approved within a month.34 Corruption in the bureaucracy is very low.
STEP 10: Black
Chile has an informal economy, but it is very small. Friedrich Schneider, professor of economics at Johannes Kepler University of Linz in Austria, did a study on the size of the informal economy in 110 countries around the world. According to Schneider's study, Chile's informal economy is about 19.8 percent of gross national product (GNP)--the lowest proportion of informal economy to GNP in Latin America and lower than the informal economy in Belgium, Spain, Italy, Portugal, and Sweden, all of which are developed economies.35
The Chilean reform process has continued for almost 30 years, turning Chile into one of the freest economies in the world today. The Chilean reform process over the past nine years has been remarkable, particularly compared to the rest of the region (see Chart 5), as chronicled by The Heritage Foundation/Wall Street Journal Index of Economic Freedom. While the rest of Latin America has remained, on average, near the threshold between "mostly unfree" and "mostly free" economies, Chile not only has moved across the "mostly free" category of economic freedom, but also has crossed--in 2002--the threshold into the "free" category.
What is most remarkable in Chart 5 is that to move from "mostly free" to "free," a country must undertake extensive reforms in all 10 fronts of economic freedom. In achieving the status of a "free" economy, Chile undertook reforms in the fiscal, trade, monetary policy, wages and prices, banking, and black market fronts in just the past nine years, in addition to the comprehensive reform efforts carried out in all 10 fronts since 1974.
And it paid off. Chile's reforms paid off with more investment, more consumption, more economic efficiency, and sustained economic growth. Since 1995, Chile's compounded growth rate has been 12 percent, while the average for the rest of Latin America has been only 1 percent.36 (See Chart 6) Chile's income per capita has doubled since 1974, when the reforms started.
Chile's sustained growth increased the country's standard of living, particularly for the poor. The poverty rate has fallen since the 1980s in terms of incidence, depth, and severity. In 1998, the World Bank reported that 17 percent of Chileans were living in poverty (compared to 40 percent in 1987), while 4 percent were living in extreme poverty.37 The number of pupils enrolled in primary education "jumped from 28 percent in 1991 to 82 percent in 1996 and the average time to graduate from primary school fell from 12.4 years to 9.7 years during the same period."38 Today, 94 percent of the population has access to improved water, and 97 percent has access to improved sanitation.39
The reform process in Chile provides important insight into what developing countries need to do in order to actually develop. The first lesson is that reform should proceed simultaneously across all 10 fronts of economic freedom. Hernan Buchi, Chilean Minister of Finance from 1985 to 1989, has stated simply that "it is necessary to proceed with all reforms simultaneously and increase the pace in accordance with the perceived prospects for success.... [T]here is synergy among reforms: one reform helps another."40
Progress is impossible in the absence of a properly functioning financial sector operating in accordance with the rules of the market. A private banking sector channeling credit to profitable projects is of primary importance for setting the economy on the proper path.... [T]here is another reform that must be implemented at [the] initial stage.... I refer to the opening of trade. If the entire economy is moving towards an increase in efficiency resource distribution, it is important that the changes in the competitiveness of the various sectors be stimulated by opening foreign trade. Belated reform in this area modifies the conditions facing economic agents and lessens the credibility of the entire reform process.41
While bold reforms do require some degree of political consensus, two things are critical to advance reform and place a country on a sustainable growth path. The first is leadership. As Buchi suggests, successful liberalization requires "a strong visible leader, someone who is willing to absorb criticism and who, in addition to requirements in the area of technical competence, must also possess perseverance and an overriding faith in the market and free enterprise."42 Leadership--unfortunately lacking in the developing world and much of the developed world--is essential to advance reforms over long periods.
Economic freedom leads to prosperity because free economies allow for competition, which is the only method by which the daily activity of millions of people can be coordinated without coercion. Competition, at the same time, requires the organization of institutions, such as stable money, minimal and transparent regulation, minimal participation of the state in economic activity, and a strong enforcement of property rights and regulations.
The 10 factors of the Index of Economic Freedom provide an excellent framework for evaluating the degree to which different countries permit competition, intervene in the economy, and protect property rights. One of the most important findings of the Index is that economic freedom is required in all of the 10 factors in order for countries to improve their economic efficiency and, consequently, the living standards of their people.
The reform process in Chile illustrates this fact. In addition, the Chilean reform experience indicates that leadership is an essential component in helping a country's economy reach its full potential.
The United States should support countries like Chile in their reform efforts and hold them up as examples to the rest of the developing world. The Chilean history of economic freedom says that development is possible. It takes leadership, faith, and political will, but it pays off.
For that reason, the United States government should encourage Chile to continue on its path to prosperity by doing all in its power to support the Chilean reforms. Success breeds imitation, and the world will experience more growth, development, stability, and peace as more and more countries imitate the Chilean model.
Ana I. Eiras is Senior Policy Analyst for Economic Freedom in the Center for International Trade and Economics at The Heritage Foundation.
1. The author wishes to thank Jamie Homer, an intern in the Center for International Trade and Economics at The Heritage Foundation, for her valuable research assistance during the preparation of this paper.
2. Examples of these studies include Richard Roll and John Talbott, "Why Developing Countries Just Aren't?" at www.worlddevelopmentnow.com/id21.htm; Robert J. Barro, Determinants of Economic Growth: A Cross-Country Empirical Study (Cambridge, Mass.: MIT Press, 1997); Robert Cooter, "The Rule of State Law and the Rule-of-Law State: Economic Analysis of the Legal Foundations of Development," 1996, in Edgardo Buscaglia, William Ratliff, and Robert Cooter, eds., Law and Economics of Development (Greenwich, Conn.: JAI Press, 1997); and Hernando de Soto, The Other Path (New York: Harper and Row, 1989).
4. Rodrigo Vergara, "Reform, Growth and Slowdown: Lessons from Chile," paper prepared for presentation at the Fourth International Conference of TIGER, May 16, 2002, Centro de Estudios Públicos, at www.cepchile.cl/curric/rvergara/02_reformgrowth.pdf.
29. Jose de Gregorio et al., "Chile: Trade Liberalization, Employment and Inequality," Chapter 9 in Enrique Gamuza et al., Desigualdad y Pobreza: America Latina y el Caribe en los 90, United Nations Development Program, at www.undp.org/rblac/liberalization/docs/Ch5-Chile.pdf.