On 7 August, a new administration will take office in Colombia. It is likely to struggle to meet strict fiscal deficit targets.

• The top four presidential candidates all advocate fiscal reform, including some form of corporation tax reduction, confirming an ongoing trend of tax instability, with 14 fiscal reforms passed since 1990.
  
• There is divergence on how to pay for tax cuts beyond a reliance on a broader tax base and tackling tax evasion and exemptions.
  
• Candidates across the political spectrum favour relaxing the fiscal stability law, suggesting the next government will struggle to meet that mandated target of 1% fiscal deficit by 2023.
  

The election debates have shown that there is appetite among the top four presidential candidates for fiscal reform. The top four presidential candidates in order of polling hierarchy - Iván Duque, Democratic Centre (Centro Democrático: CD); Gustavo Petro, Colombia Humana; Luis Fajardo, Coalición Colombia; and Germán Vargas Lleras, Mejor Vargas Lleras - have all advocated a degree of corporate tax reduction.

For right- and centre-right-wing candidates Duque and Vargas Lleras, this would involve a broad corporate tax reduction. In the case of Vargas Lleras, corporation tax would be reduced to 30% and taxes on capital goods would be eliminated. Left and centre-left candidates Petro and Fajardo advocate more targeted corporate tax reductions, to benefit manufacturing and agriculture in the case of Petro and small and medium-sized enterprises in the case of Fajardo.

Successive governments in Colombia have enacted 14 fiscal reforms since 1990, the last in December 2016. Changes included a gradual reduction in corporation tax from 40% to 33% by 2019, an increase in VAT from 16% to 19% as well as measures to broaden the tax base and improve tax enforcement.

Economic restraints

Colombia's fiscal stability law currently mandates that a reduction in the fiscal deficit to 2.1% of GDP in 2019 and 1% of GDP by 2023. The deficit target was met in 2017, but relaxed in 2018 from 2.7% of GDP to 3.1%. Meeting the ambitious goal of a 2.1% GDP fiscal deficit in 2019 will not be easy as increased spending is needed to support the 4G infrastructure project and the FARC peace process, while revenue from oil production continues to fall and the value-added tax (passed in 2016, implemented in 2017) has underperformed. The recently passed 2018 budget was lower than the previous year in real terms, with 50% allocated to mandatory spending, including debt service payments, personnel expenses, and overhead, and 14% to investments. The next administration will need to balance all these needs, while maintaining the confidence of risk rating agencies. In December 2017, the rating agency Standard & Poor's Global Rating lowered Colombia's rating to BBB-, citing the constraints in its ability to meet deficit fiscal targets.

To maintain its hard-earned investment rating, Colombia needs to find ways to decrease spending and boost revenue while supporting important investment and infrastructure programmes.

Duque is the most explicit in in advocating a cut in government spending - targeting state bureaucracy - while the other candidates are more reliant on an expansion of the tax base and increasing revenue collection through by tackling evasion and exemptions as an avenue for greater fiscal revenues. The uncertainty around whether the next government could meet its deficit target of 2.1% in 2019 was expressed again by a Moody's rating agency in February 2018, downgrading its outlook from Stable to Negative (see Colombia: 25 February 2018: Moody's affirms Colombia's rating at Baa2, downgrades outlook from Stable to Negative).

Congressional constraints

The legislative elections on 11 March produced a Congress dominated by right and centrist parties supportive of foreign direct investment and pro-market policies (see Colombia: 13 March 2018: New Colombian legislature likely to support market-friendly policies, support for FARC peace agreement finely balanced). The dominant parties in the legislature, the Liberal Party (Partido Liberal), CD, CR, and the Social Party of National Unity (Partido de la U), support presidential candidates that advocate a corporate tax reduction. However, the risk of lengthy debates delaying policy implementation is high as there is likely to be disagreement among the parties on the extent of such corporate tax reductions and to what extent the fiscal stability rule should be compromised.

Outlook and implications

Without a clear path to fiscal revenue growth, the next administration is likely to seek to review the fiscal stability law. This would give it more policy options, but would likely negatively affect its credit outlook, resulting in higher borrowing costs.

The fiscal stability law has become a major constraint and it appears highly likely that the next government would seek ways to modify it. Less stringent targets would provide more scope to negotiate with Congress on how to pay for tax cuts and where they should be targeted, but would not be taken kindly by the rating agencies. Colombia's tax collection rate - approximately 17% of GDP compared to an OECD average of 34.3% of GDP in 2016) - has plenty of scope to improve but successive governments have failed to address one of the main drivers of poor tax collection rates, and approximately 50% of the workforce remains employed in the informal sector. It is unlikely that the next government will be able to rectify this structural issue in the short term. IHS Markit anticipates the unemployment rate to increase to 9.7% in 2018, from 9.4% in 2017. It is likely to take considerable effort to increase formal work opportunities in this environment. Although economic growth is set to improve, reaching 2.4% in 2018 and 2.7% in 2019, this is unlikely to result in a large surge in tax revenue that compensate for the proposed tax cuts.

A legislative bill aimed at relaxing the fiscal stability law will provide an early indicator of how the next government will seek to approach fiscal policy. If it remains restrained, it is likely to find negotiations on reform difficult in Congress, despite a majority in favour of cuts. A fiscal pact among the major parties, agreed separately to other government policy, would facilitate the next government's task, and indicate an improved likelihood of another set of fiscal changes. A diluted tax reform that results from political compromise will likely lead to further downgrade of Colombia, undermining its credit outlook.