Peru: Is PPK's Government Plan Sound Economics?

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Summary

Pedro Pablo Kuczynski's plan of 5% GDP growth by 2018 strikes as being overly ambitious, and the means to achieving it is not clear.

Peru’s new government has the advantage of inheriting a country with positive inertia and a sound macroeconomic standing.

The true size of the gap between political rhetoric and policy- making reality will become clear soon enough.

Source: WSJ Click to enlarge

On July 28th, Pedro Pablo Kuczynski -better known as PPK- was sworn in as president of Peru, culminating what was a great political upset against Keiko Fujimori, daughter of former president Alberto Fujimori.

Following the ceremony PPK, a technocrat economist with a stellar career spanning 5 decades in the public and private sector, presented the government plan which puts forward the goals and actions that will set the tone for his 5 years in government. What are the main points in this outline and how do they fit into Peru's present economic landscape?

Over the past decade Peru has displayed remarkable macroeconomic stability and growth. In this period GDP has grown at an average rate of 5.9%. Even though the economy is undergoing a deceleration due in part to the fall in commodity prices, the World Bank forecasts Peru's growth to remain at 3.5% in 2016 and 2017, which would make it one of the regions' top performers. On the other hand, inflation, while slightly above the BCRP's goal of 1% to 3%, has remained low.

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Sound fiscal policy has played a large role in this period of stability. Over the past 10 years debt to GDP ratios have fallen by 15 pp to under 23%. This has been reflected in increases in investment, while current expenditure has been kept stable at approximately 63% of total expenditure.

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Nonetheless, there are some issues that need solving if Peru is to keep up this good performance. First and foremost, the problem of informality needs to be addressed. The informal sector in Peru encompasses approximately 68% of all non-agricultural labor, the highest amongst large Latin American economies. Also, the economy is still highly concentrated on "traditional" industries (mining and agricultural products), which make up approximately 70% of total exports; diversification is paramount to ensure continued growth and reduce sensibility to commodity price shocks.

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In this context, the incoming administration's economic agenda seems out of focus. While the government plan recognizes the need for diversification and for a shift towards a more productive formal sector; the core of the economic plan boils down to economic stimulus via investment expenditure and tax-cuts. The proposal's main goal is to achieve annual GDP growth of 5% by 2018, 1.5 pp above World Bank forecasts and 1 pp above the BCRP's potential GDP growth estimation. This is to be attained through a fiscal push, increasing investment and decreasing taxes, starting with a VAT reduction from 18% to 15% by 2019 in gradual changes of 1 pp per year (the first of which is slated to take place in January 2017). Also, in order to boost the formal sector, the government proposes to introduce tax breaks for small companies, including a reduction of income tax from 27% to 10% for firms making less than a minimal threshold.

Since there seems to be no intention of downsizing expenditure, how would the tax reductions be paid for? In the short run the answer is debt. PPK's government plan explicitly states his administration intends to keep deficits at a 3% per year level (higher than the 1% ceiling established by law) at least until 2019. In the medium and long run the reduction in tax rates should, according to the incoming government, be more than offset by an increase in the taxable base-the government projects an increase in total tax income of 0.6% - 2% of GDP by 2019.

Peru's good economic performance in recent years has given them the leeway to operate deficits for some time, but introducing large tax cuts with the hope that economic growth and drastically reduced informality will eventually fill in the gap is a risky proposition for any developing country.

PPK's plan of 5% GDP growth by 2018 strikes as being overly ambitious, and the means to achieving it is not clear. Peru's new government has the advantage of inheriting a country with positive inertia and a sound macroeconomic standing. Now hardly seems the time to risk overheating the economy through fiscal stimulus, but rather to lay the ground for continued success by focusing on fixing the country's structural weaknesses, such as high informality and low diversification. The true size of the gap between political rhetoric and policy- making reality will become clear soon enough.

Author: Marco Rojas

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