Chile, South America's economic tiger, races to avoid 'middle-income trap'

Oct. 5, 1988, was a good day for Chile. In a plebiscite voters rejected a proposal by Augusto Pinochet, who had taken power 15 years before, to extend his dictatorial rule.

That led to free elections a year later and to more than two decades of strong economic growth, underpinned by pro-market policies, social reforms and, from the early 2000s, a commodity boom. The economy tripled in size and the poverty rate dropped from nearly 40 percent to less than 10 percent. Economists dubbed Chile "the tiger of Latin America."

Recent years have been less tigerish. The price of copper, the biggest export, began falling sharply in 2014. Michelle Bachelet, the president from 2014 to 2018, rewrote the tax code, strengthened labor unions and proposed a new constitution. Her aim was to reduce inequality, but she also unnerved business. Investment contracted for four consecutive years. Economic growth dropped from an average of 5 percent in the post-Pinochet years to 1.7 percent in 2013-2017.

Under Sebastián Piñera, who took over from Bachelet in March, the economy has begun to purr again. GDP in the second quarter of this year was 5.3 percent higher than in the same quarter last year, the fastest rate of growth since his first term as president in 2010-2014. Investment grew at 7.1 percent. The central bank has raised its forecast for growth this year to 4-4.5 percent.

But this is not yet a return to glory days.

Growth has recovered partly because copper prices have. Potential growth — the economy's capacity to grow without inflationary pressure — is only around 3 percent.

In the past 15 months, the three big credit-rating agencies have downgraded Chile's sovereign debt. This has grown from 4.9 percent of GDP in 2008 to 23.5 percent in March this year. Although that is not high, the agencies fear growth will not be fast enough to justify Chile's strong credit ratings.

Voters elected Piñera, a billionaire businessman, to guide Chile away from that trap.

His critics say he has been slow to seize the steering wheel. He unveiled his first big reform proposal, a shake-up of corporate tax, in August. It faces resistance in congress, where his center-right coalition lacks a majority.

The economy's growth spurt has so far not produced many more jobs. Consumer confidence fell into negative territory in August; business confidence is also down. The pace of reforms and economic recovery have lagged behind expectations, said Jorge Desormeaux, a former vice president of the central bank.

"Our job is to defeat this pessimism with action," said José Ramón Valente, the economy minister. He is in charge of three new units — for investment, productivity and "the economy of the future" — to encourage entrepreneurs and reduce the economy's dependence on copper.

The government wants to keep growth in investment at 6 to 7 percent a year. The goal for productivity is growth of 1 percent a year. If all goes well, the potential growth rate will rise from 3 to 4 percent.

The plans include a five-year concession program, under which investors will spend nearly $15 billion, about 6 percent of this year's GDP, to build roads, airports and hospitals.

The government itself will invest $8 billion in the Araucanía region, Chile's poorest. It wants to provide free nursery school for every child, which should bring more women into the labor force and raise productivity in the long run. Employers will pay into a fund for that.

The government also plans to reduce regulation of business, which is more complex than in any other member of the OECD. More controversial is a scheme to make rules for employing students more flexible than for other workers.

The government has picked as its first big battle an assault on the confidence-killing tax system introduced by Bachelet. It will be one of the hardest to win. Bachelet's tax reform raised corporate taxes to provide more money for education.

It brought in two corporate-tax regimes, which confused both business folk and tax inspectors. It also limits business-owners' scope for deducting from their personal tax bills the tax their company has paid on its profits. Among the angry entrepreneurs are 80,000 owners of small businesses, who previously paid no tax at all.

To spur investment, the new scheme would let companies speed up depreciation. With more money in their pockets, owners of businesses, both prosperous and poor, will spend more, the government predicts.

The reform proposal has had mixed reviews. Business-owners cheer the return of the integrated model, but are disappointed that Piñera has not kept a promise to reduce corporate-tax rates (27 percent for big firms).

It may also increase debt. The government, which promises to cut the fiscal deficit from 1.8 percent of GDP this year to 1 percent by 2022, when Piñera's term ends, claims the tax plan will raise a bit of revenue. It says the scheme will compensate for any shortfall by making electronic sales-tax invoices mandatory. Many observers doubt that.

If the tax reform does not pay for itself, the government will have less money to spend on more popular policies, like the investment in Araucanía.

The window for enacting bold policies will not stay open for long. Rising global interest rates and the trade war between the United States and China have not yet hurt the economy, thanks to Chile's relatively solid finances and a floating exchange rate, which has allowed the peso to depreciate.