VoxEU Column Development

Higher growth needed: The case of Latin America and the Caribbean

The rate of economic growth in Latin America and the Caribbean in coming years is predicted to be below that of the rest of the world and substantially below that of the fast-growing countries of emerging Asia. This column looks at the drivers behind these growth gaps. To converge more rapidly to higher-income status, the region needs not only to boost investment but critically to raise investment efficiency.

Faster economic growth is a top priority for Latin America and the Caribbean. Although expected to increase in coming years, growth for the typical country in the region seems likely to converge to around the 50-year average. That means about 2.4% per annum (per capita), below that in the rest of the world (2.6%) and substantially below the growth rate of countries in fast-growing emerging Asia (4.9%).1 Income per capita of the typical country in Latin America and the Caribbean rose to just 24% of that of the US in 2017 from about 20% in 1960. In comparison, the relative income per capita of the typical emerging Asian nation increased to 57% from 11% of the US value over the same period. With the disappointing economic performance as a backdrop, it’s no wonder the political landscape has been changing, with fascinating contests looming for several presidential elections this year (in Brazil, Colombia, and Mexico, to name just three).2

Modern theories of economic growth have emphasised the accumulation of capital and the role of technological progress (e.g. Solow 1956, Lucas 1988, Romer 1990, Aghion and Howitt 1992).3 The IDB’s 2018 Latin American and Caribbean Macroeconomic Report, A Mandate to Grow (Cavallo and Powell 2018), includes a growth accounting analysis, following Klenow and Rodriguez-Clare (1997) and Jones (2016), to identify such growth drivers. Employing the ‘intensive form’ of an aggregate production function, the contribution of changes in inputs such as capital and labour (augmented by changes in skills) can be disentangled.  The change in output not explained by identified factors is then the change in the overall efficiency of the use of those inputs, normally labelled ‘total factor productivity’ (TFP).4 Comparing the results of this analysis for Latin America and the Caribbean (LAC) vis-à-vis comparators is particularly revealing – see Table 1 that details ‘growth gaps’, namely, values for LAC minus those for comparator regions.

Table 1 Growth gaps (values are those for LAC minus comparators – average, 1960-2017)

Notes: Linear growth accounting decomposition using Cobb-Douglas production function (IDB 2018: Appendix A, equation A4). Average annual growth rates (in percent).
Source: IDB staff estimates based on data from Penn World Table 9.0 database.

On average (from 1960 to 2017), per capita growth in Latin America and the Caribbean has been almost 2.5 percentage points below that of emerging Asia, and almost all of this gap is accounted for by slower TFP growth; namely, by the (lack of) efficiency in the use of inputs rather than the amount of the inputs themselves, at least when labour is augmented by skills.5

However, this does not necessarily imply that investment levels have been adequate. The output gain of each buck of investment (let’s call this investment efficiency) has been lower than in other regions so then investment rates (and the contribution of capital investment), when measured as a percentage of GDP, while lower than in emerging Asia does not appear to be so out of whack with other comparators. 

There is also significant variation within the region; many countries in LAC are far from the 25% of GDP benchmark recommended by the Commission on Growth and Development.6 The regional average between 1980 and 2017 was just 20%, below the 25% threshold even during the years of 2002-2012 commodity boom.7

Low public investment, particularly in infrastructure, contributes to low overall investment. Estimates suggest Latin America and the Caribbean requires additional infrastructure investment of around 2.5% of GDP, or approximately $150 billion, per annum to close current gaps. Lifting infrastructure investment especially in a world of tight fiscal constraints, will require an increase in both public and private investment.

Why is productivity low?

The change in TFP is the change in the weighted average of individual firm-level productivity. Why might LAC productivity lag? First, there seems to be a large tail of relatively small firms dragging down average productivity levels. Second, there is evidence that while there is entry and exit, about as many unproductive firms survive as exit, and about as many productive firms exit as survive. Third, it appears that while (more productive) firms do grow they do not grow at the same rate and with the same consistency over time as in some advanced economies.

What might account for these stylised facts? Given fiscal imbalances, tax collection (particularly enforcement efforts) has naturally focused on the larger, formal firms. But these tend to be precisely the more productive. More productive firms then face higher effective tax rates.  Moreover, given high informality, some countries have introduced special regimes to try to induce very small firms to formalise. But they may have had the unintended consequence of creating negative incentives for those firms to grow. 

For example, a special tax regime in Peru provides lower tax rates for small firms (Azuero et al. 2017). And somewhat larger firms are subject to a more-costly labour code depending, among other things, annual sales. One requirement is that all firms have to pay two additional monthly wages per year to employees – except micro firms. Larger firms must also extend a minimum of 30 days annual leave – it’s 15 days for micro and small firms. The result is a set of disincentives for firms to grow (see Figure 1, which illustrates the hypothetical net profits of a firm as a function of annual sales). Considering the distribution of firms by size, firms appear to be bunched just below these thresholds. If firms choose to stay small then they are likely to stay less productive, dragging down aggregate productivity. Some larger firms may also attempt to evade taxes or labour code requirements by claiming they are in the less stringent regimes, and/or may keep some part of their workforce informal. And if these distortions affect firm growth and alter who exits and who enters, then they may also slow aggregate productivity growth.

Figure 1 Distortions in tax and labour market regimes in Peru

Tax regimes: Special: fixed rate of sales; General: 28% of profits. Labour regimes: Codes 1 and 2: lower labor benefits than general code.

Source: Azuero et al. (2017).

The region’s credit markets may also stunt the growth of productive firms. Financial systems remain relatively small and expensive, with high lending spreads affecting the potential growth of productive firms. The typical growth diagnostics analysis suggests problems of domestic intermediation as the binding constraint to growth in many cases. 

The role for macro policies

Fiscal policy is fraught with tough trade-offs. Very few countries in the region have the fiscal space to contemplate simply reducing taxes or increasing productive public investment to boost growth.  In Cavallo and Powell (2018), we present recent work on fiscal multipliers and argues that in some countries, especially where taxation is low such as in Central America, increasing taxes and increasing spending could enhance growth. In others, where the size of government is large, higher productive capital spending might be financed by enhancing efficiency or reducing subsidies that leak to middle and even higher income households. In those cases where public investment multipliers are low, strengthening investment frameworks to ensure good project selection and execution is a pre-requisite.   

The majority of countries in the region are in the midst of fiscal adjustments. Announced adjustment plans indicate an improvement in fiscal balances of around 2% of GDP over the next four to five years. This gradual approach may be justified in many cases as growth is below potential, but gradualism can bring complications. If a plan lasting several years is not viewed as credible then the private sector may demand higher interest rates, servicing debt will be more expensive, and more adjustment will actually be required. Ensuring that deeds match promises boosts credibility and reduces the cost of debt servicing. Multi-annual budgeting, greater transparency, an independent agency to assess performance, and other measures can play useful roles.8

Growth in the region has also been volatile. LAC learned some lessons from its banking and currency crisis and managed to avoid extensive contagion from the Global Crisis. Countries have a variety of monetary regimes but median inflation has been low and relatively stable in each.9  Simulations of a neo-Keynesian dynamic stochastic general equilibrium model suggest that with an estimated (historical) monetary policy, the five established inflation-targetters should see inflation fall below target and negative output gaps narrow this year.10 A somewhat less restrictive monetary policy could still see inflation around the respective targets and aid somewhat in closing output gaps. But such models assume full credibility and an analysis of expectations indicates that they have diverged from targets in some cases. As output gains from a more aggressive loosening appear relatively slim, central banks will no doubt wish to calibrate monetary loosening very carefully, also given the prospect of new external shocks. 

The global economy still faces significant risks.  Measures restricting trade, higher inflation in advanced economies, and faster monetary normalisation may have considerable fall-out for financial markets and capital flows. These risks may be particularly acute for countries that have chosen to fix or manage exchange rates more actively. While reserves have increased as a percentage of GDP for the typical country, across exchange rate regimes, as vulnerabilities (such as domestic dollarization and fiscal and external deficits) have risen, then estimated optimal reserve levels have also increased. Taming these imbalances would bring optimal reserves closer to actual levels. Peru has been particularly successful in reducing domestic liability dollarization (e.g. Powell 2014). Other measures may include finding ways to enhance reserves, for example by signing a Flexible Credit Line with the IMF or seeking other contingent financing liquidity arrangements.


Despite strong global fundamentals, Latin America and the Caribbean is projected to grow at only the mediocre average rates achieved over the last 50 years. To converge more rapidly to higher-income status, the region needs not only to boost investment but critically to raise investment efficiency and get more out of each peso of capital. How to improve on the disappointing economic performance will surely be a key element in forthcoming presidential elections.  The current favourable global fundamentals provide an opportunity for the elected governments to implement policies to boost underlying growth and that would also serve as a hedge against the external risks.


Aghion, P and P Howitt (1992), “A model of growth through creative destruction”, Econometrica 60(2): 323–351.

Azuero, R, M Bosch, and J Torres (2017), “Special Tax Regimes, Informality, and Productivity”, Inter-American Development Bank, unpublished.

Busso, M, J Cristia, D Hincapié, J Messina, and L Ripani (eds), (2017), Learning Better: Public Policy for Skills Development, Development in the Americas series, Inter-American Development Bank.

Cavallo, E and A Powell (coord.) (2018), A Mandate to Grow. 2018 Latin American and Caribbean Macroeconomic Report, Inter-American Development Bank.

Cavallo, E and T Serebrisky (eds) (2016), Saving for Development: How Latin America and the Caribbean Can Save More and Better, Development in the Americas series, Inter-American Development Bank and Palgrave Macmillan.

Commission on Growth and Development (2008), The Growth Report: Strategies for Sustained Growth and Inclusive Development, World Bank.

Klenow, P J and A Rodriguez-Clare (1997), “The neoclassical revival in growth economics: Has it gone too far?”, in B S Bernanke and J J Rotemberg (eds), NBER Macroeconomics Annual 1997, MIT Press.

Jones, C J (2016), “The Facts of Economic Growth”, Handbook of Macroeconomics, Vol. 2A, pp. 3-69.

Lucas, R E (1988), “On the mechanics of economic development”, Journal of Monetary Economics 22(1): 3–42.

Powell, A (2015), “Commodity prices: Over a hundred years of booms and busts” VoxEU.org, 28 April.

Powell, A (coord.) (2017a), Routes to Growth in a New Trade World. 2017 Latin American and Caribbean Macroeconomic Report, Inter-American Development Bank.

Powell, A (2017b), “The Big Adjustment: Fiscal Challenges for Latin America and the Caribbean.” Ideas Matter, Inter-American Development Bank, 27 December.  

Powell, A (2017c), “Inflation targeting and interest rate procyclicality in the UK and in Latin America” VoxEU.org, 25 November.

Romer, P M (1990), “Endogenous technological change”, Journal of Political Economy 98(5): S71–S102.

Solow, R M (1956), “A contribution to the theory of economic growth”, Quarterly Journal of Economics 70(1): 65–94.


[1] Estimates based on data from PWT 9.0, using real GDP series in 2011 US$ PPP units. Latin America and the

Caribbean is the simple average of Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic,

Ecuador, Guatemala, Honduras, Jamaica, Mexico, Panama, Paraguay, Peru, Uruguay, and Venezuela, RB.

[2] An event, “Mind the Middle Income Trap” on 26 April at the London School of Economics organised by CEPR, EBRD, IDB and LSE will consider growth challenges and the political economy of structural reforms.

[3] For a more recent treatment and literature review, see Jones (2016)

[4] This approach disentangles the process of physical capital accumulation caused by growth in TFP (that increases returns to investment), from other possible drivers (such as higher investment effort caused by a reduction in the cost of capital).

[5] Since the 1960s, Latin America has benefited from the ‘demographic bonus’ of falling dependency ratios. Furthermore, labour participation (among the working age population) increased on the heels of higher female labor participation rates. The expanded labour force has also become more educated. Going forward, however, these vibrant sources of growth will naturally taper off: the demographic bonus will disappear as the population ages; growing female participation rates will slow down as they approach parity with men; and the massive extension of the education system, will reach the limit of universal coverage. Still, while coverage has become nearly universal, the level of actual measured skills remains low compared to other regions (Busso et al. 2017).

[6] The Commission on Growth and Development is a group sponsored by four government organizations from Australia, the Netherlands, Sweden, and the UK, plus the William and Flora Hewlett Foundation and the World Bank Group. It consists of 19 policy, government, and business leaders, mostly from the developing world, and two Nobel Laureate economists.

[7] Low investment rates are the dual of low saving rates – see Cavallo and Serebrisky (2016) for an analysis of the saving problem in Latin America and the Caribbean. On commodity booms and busts, see Powell (2015).

[8] See Powell (2017a) and, for a more succinct discussion, Powell (2017b).

[9] See Powell (2017c) on monetary policy dilemmas in Latin America and the Caribbean.  Venezuela is an exception to the mostly low inflation rates in the region, it is in a very deep economic crisis and has now entered a period of hyperinflation.

[10] Brazil, Colombia, Chile, Mexico, and Peru.

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