Without pension reform, inflation cannot be lower than 40% - IDESA

Report Nº: 81616/07/2019

Without pension reform, inflation cannot be lower than 40%

The economic authorities project a significant drop in inflation in 2020. This will destabilize public finances because pension spending increases due to adjustments based on past inflation. Pension reform must not be postponed to solve this inconsistency. The government presented the progress of the 2020 Budget. Among other definitions, economic activity is expected to shrink […]

The government presented the progress of the 2020 Budget. Among other definitions, economic activity is expected to shrink by 0.8% in 2019 and grow at 3.5% in 2020. Inflation is projected to close around 40% in 2019 and fall to 26% annually in 2020. Compliance with the fiscal target agreed with the IMF stand on; this means zero primary deficit for 2019 and a primary surplus of 1% of GDP for 2020.

The projected reduction in inflation is consistent with a lower fiscal imbalance. But there are doubts about the possibility of maintaining and continuing with the improvement in public finances. Uncertainties arise because one of the factors that contributed the most to lowering public spending and the fiscal deficit was the loss in the real value of pensions due to the substantial increase in inflation.

The pension adjustment rule establishes that pensions are updated quarterly based on prices and wages increases with a lag of 6 months. For example, the increase in retirements in June has been based on inflation and wage increases of the fourth quarter of last year. This means that the real value of pension expenditure falls when the cycle of inflation rises and recovers when inflation falls. Applying this rule to the projections provided by the government, it is observed that:

  • In 2019, real pension expenditure will fall compared with the previous year by -0.6% of GDP as a consequence of the acceleration of inflation.
  • In 2020, pension spending will increase by 0.6% of GDP, given that inflation in 2019 will be higher than in 2020.
  • For pension spending not to rise, inflation in 2020 should not be 26%, as the government projects, but it should remain at around 40% annually.

These data show the high incidence of inflation on pension expenditure. The acceleration of inflation in 2019 makes a decisive contribution to the deficit reduction through the loss of the real value of pensions. However, if inflation goes down, the opposite effect occurs, since applying inflation with a 6-month lag makes pensions rise more than prices. This phenomenon leads to project a real increase in pension expenditure in 2020 similar to the fall recorded in 2019. Therefore, for pension expenditures not to increase in real terms (that is, to maintain the fall of 0.6% of the GDP produced in 2019), the inflation rate should not fall but remain at around 40% per year.

Given that pension expenditure represents almost half of the total fiscal spending, its increases are hard to compensate with reductions in other expenses. On the one hand, margins to lower other expenses are limited, and some, such as public investment, has been adjusted a lot more of what is recommended. On the other side, the margin to increase revenue through higher tax pressure is even more limited. On the contrary, to achieve economic growth, it is necessary to eliminate many highly distortionary taxes such as export taxes.

These antecedents define the importance and urgency for the pension reform. Well-designed is a much more equitable alternative than continue adjusting public spending by eroding the real value of pensions with inflation. Other needed reforms are: level the retirement ages in 65 years old; recognize years of service to women with children; replace moratoria with the Universal Pension for the Elderly (PUAM); take all the years of contributions instead of the last 10 years to determine the initial benefit and establish a homogeneous calculation rule; set the option between one’s own retirement and one’s spouse’s pension, limit the accumulation of the two benefits; establish a differential inflation adjustment rule for people who accumulated double benefits with moratoria.

The depth of the current fiscal crisis leaves few alternatives. The strategy so far was to let the inflation to make the fiscal adjustment. But a more equitable and sustained approach relies on a public sector ordering through a pension reform based on more efficiency.

Variation in pension expenditure compared to the previous year according to inflation. 


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