CCA President Ken Frankel Discusses Chilean Reforms in a Globe Op-ed

Chile’s Bachelet has the right ideas, but her reforms need work

By Ken Frankel in a special to The Globe and Mail
Friday, July 04, 2014

“Deliberate” and “disciplined” are two adjectives that Chileans and foreigners alike might use to describe the Chilean way of conducting business and personal matters. These traits helped Chile avoid the swings in government economic and social policy experienced by its neighbours over he past generation.

Chile became a darling of foreign and domestic investors and the regional pacesetter in economic and social development. Canadian business and pension plans have $16.6-billion invested in Chile.

So, the hemisphere raises its eyebrows when critics, including economic advisors in President Michelle Bachelet’s first successful administration, characterize as misguided, hasty and worrisome her twinned proposals to reform Chile’s tax and education systems. The cost of the government’s educational overhaul is estimated at several billion dollars. This money is supposed to come primarily from increased revenue yielded by tax-code reforms.

President Bachelet returned to power in March feeling the extreme urgency of now. Her first 100 days in office have produced a flurry of proposed reforms aimed at positioning Chile to take the last leap upward to become a developed country in the Nordic image.

A casual observer might wonder why Ms. Bachelet feels so much urgency. Chile is a member of the exclusive Organization for Economic Cooperation and Development club. Since 1990 its GDP per capita quintupled and poverty declined from 40 per cent to 15 per cent. Its educational results outpace the rest of Latin America.

Still, Chile is one of the world’s most unequal countries as measured by the GINI coefficient. Its public funding for education ranks well below those of developed and many developing countries. Its student test scores rank near the bottom of the OECD in part because access to pre-school and quality, affordable education at all levels for the less affluent are wanting. Responsibility for monitoring and taking corrective action on how schools perform is uncoordinated and underfunded.

These are longstanding structural problems that hold Chile back from reaching the development and social-justice goals Ms. Bachelet has laid out. Studies repeatedly show that providing excellent and universally accessible educational opportunities is one sure way to raise standards of living and social development.

Consensus exists that the tax and education systems should be reformed. There is general acknowledgment that investors have done well under low tax rates and other preferential measures, and that the economy could support tax adjustments to free up money for increased educational spending.

The consensus breaks down over the design, ultimate goals and implementation of the reforms. Critics claim that the tax reforms will stifle investment and destabilize the economy, and that the educational reforms will be ineffective and don’t address the most critical element (and the one that would elicit the most union opposition): the quality of teaching. They allege that the reforms are designed to appeal to the social and economic ideology of the most leftist voices in Ms. Bachelet’s coalition and the powerful student movement that throttled the country in 2011.

The educational proposals include converting all private schools that receive government subsidies (they are akin to voucher schools and educate 50 per cent of Chile’s students) into not for-profit, non-copayment schools, taking away their discretion in selecting students for admission, and providing free tuition to universities regardless of the ability to pay.

There are two salient features to the tax reform. Companies currently pay taxes of 20 per cent on corporate income as it is earned. A further tax of 15 per cent of earnings kicks in when those earnings are distributed. Under the proposals, the basic corporate tax rate will increase to 25 per cent and the additional 15 per cent will apply as income is earned, rather than when distributed. These rates are higher than the OECD average, but not out of line with a number of regional competitors. Interest deductability on acquisition debt (a structuring technique often used by foreign investors that can lower the overall effective tax rate and is commonly applicable among OECD countries) will now be denied.

In addition, the government has discontinued a longstanding law – similar to one that exists in Peru and Colombia – that provides special protection to foreign investors. According to Ms. Bachelet, such guarantees are a vestige of the Pinochet dictatorship when Chile’s international prestige was rock bottom and Chile needed to provide deep incentives to attract foreign investors. Now, investors know that Chile is a stable and secure country and will invest even without these incentives.

Both proposals will be modified in the Congress by the more centrist partners in Ms. Bachelet’s coalition, but there is anecdotal evidence in Chile that the proposals have already rattled domestic and foreign investors. Many see the wooing of investors as a zero-sum game and are watching. One major newspaper in the region, Peru’s El Comercio, has urged Peru to take advantage of the Chilean proposals affecting investors by seizing “the economic leadership in the region that our neighbour to the south would probably abandon.”

Ms. Bachelet is negotiating a difficult balancing act that awaits all of the region’s countries. It’s in everyone’s interest that Chile once again rely on discipline and deliberation.

Originally published in The Globe and Mail.