June 2006

Document of the World Bank

Report No. 33501-CL

ChileDevelopment Policy Review(In Two Volumes) Volume I: Summary Report

Poverty Reduction and Economic Management UnitLatin America and the Caribbean Region

Report N

o. 33501-CL

Chile

Developm

ent Policy Review

Volume I

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

OECD OMIL OTC PACES PASIS PAYGO PEE PEPS PISA P M U PRIES0 PRIS PROGRESA PSU R & D RICYT

SBIF S&T SCI SCMR SCOM SENCE SFIN SIMCE

SINTEF SME SNED TEKES TFP TIMSS TRAN UNCITRAL WB UK us USD VARX VAT VTT

Organization o f Economic co-operation and Development Oficina Municipal de Intermediacibn Laboral Over-the Counter Instruments Colombia’s Targeted Voucher Program Non Contributory, Social Assistance Benefit to Elderly Indigent Pay-as-you-go Financing for Social Insurance Institutions Plan Especial de Empleo Public Employment Programs Programme for International Student Assessment Survey o f Households in Grater Santiago Chile’s Social Risk Management Survey Public Research Institutes Programa de Educacibn, Salud y Alimentacibn University Entrance Exams Research and Development Ibero-American and Inter-American Network on Science and Technology

Indicators Communal Services Science and Technology Science Publications Relative to a Number of FTE Second Capital Market Reform Communal Services Sector Chile’s Servicio Nacional de Capacitacibn y Empleo Financial Services Sector System o f the National Performance Evaluation for Education

Establishments Norway’s Foundation for Scientific and Industrial Research Small and Medium Entreprise Skills-renewal and financial assistance National Technology Agency o f Finland Total Factor Productivity Third International Mathematics and Science Study Transportation and Communications Sector United Nations Commission on International Trade Law World Bank United Kingdom United States United States Dollar Vector Autoregressive Model with Exogenous Variables Value Added Tax Technical Research Center o f Finland

Pamela Cox Country Director: A x e l van Trotsenburg Sector Director: Ernest0 May Sector Manager: Mauricio Carrizosa Task Managers: Daniel Oks and James Parks

TABLE OF CONTENTS

ACKNOWLEDGEMENTS ..................................................................................................................... 111 PREFACE ................................................................................................................................................. I V EXECUTIVE SUMMARY ........................................................................................................................ V DEVELOPMENT POLICY REVIEW ..................................................................................................... 1

STRATEGIC SETTING OF DPR ................................................................................................ 1 GROWTH AND POVERTY OUTCOMES: DEVELOPMENT CHALLENGES .................. 1

Sustaining Dynamism ........................................................................................................................... 6 Lowering Exit Costs ......................................................................................................................... 7 Facilitating the Reallocation o f Labor ............................................................................................. -7

Improving Access to Credit .................................................................................................................. 9

Does Chile Have an Innovation Problem? .......................................................................................... 13

Weaknesses? .................................................................................................................................. 14

to Foster Innovation? ...................................................................................................................... 16

Universities and the formation o f human capital ........................................................................... 18

Private Sector Led Innovation Related Tasks ..................................................................................... 19 Other Barriers to Innovation: An Open Research Agenda ................................................................. 20

Investment in Education ..................................................................................................................... 21

Higher Education Expansion, Quality and Equity .............................................................................. 22 The Quality of Primary and Secondary Education ............................................................................. 23

The Role o f the State in Ensuring Quality and Equality o f Educational Opportunity ........................ 26 Supporting the Evaluation o f Education Policies and Programs ........................................................ 28

Protection ....................................................................................................................................... 30 Changes in Risks and Coverage ..................................................................................................... 30 Changes in the Risk o f Job-loss and Extended Periods o f Unemployment ................................... 3 1 The Risks to Income and Impoverishing Impact o f Health Costs .................................................. 34

Covering the Risks to Income that Arise with Ageing ....................................................................... 35 Summary o f Key Policy Options for Social Protection ...................................................................... 37

Public Expenditure - Development Needs .......................................................................................... 39 Public Expenditure and Economic Growth ........................................................................................ 41 Financing Development - Taxes ......................................................................................................... 43 The Tax System .................................................................................................................................. 43 Tax Avoidance and Evasion ............................................................................................................... 44 Policy Options to Lower Tax Evasion and to Improve Efficiency and Equity .................................. 46 Financing Development - Fiscal Rule ................................................................................................ 47

Sources o f Vulnerability ..................................................................................................................... 49

A . B . C . PROMOTING SUSTAINABLE PRODUCTIVITY GROWTH ............................................... 5

Business Environment and Enterprise Dynamism ............................................................................... 5 . .

Strengthening Competition ................................................................................................................. 11

What i s Meant By Innovation and what are the Aspects o f Innovation in which the Country Exhibits

What Does Recent Experience and the Literature Suggest for Principles and Broad Policy Measures

Government Sponsored Innovation Related Tasks.. ........................................................................... 18

Public Research Institutes .............................................................................................................. 19

E . EDUCATION ............................................................................................................................... 20

Access to Schooling and Inequality .................................................................................................... 21

The Education Market in Chile ........................................................................................................... 25

F . ENHANCING SOCIAL PROTECTION ................................................................................... 29 The Main Risks to Household Income Security, Outcomes, and Remaining Challenges in Social

G . PUBLIC FINANCE ISSUES IN DEVELOPMENT ................................................................. 38

H . RISKS TO CONVERGENCE WITH ADVANCED ECONOMIES ....................................... 49

1

Reducing vulnerability: International risk-diversification through the fmancial system ................... 50

Agenda for Future Research ............................................................................................................... 55 Summary o f Policy Options ............................................................................................................... 56

I . CONCLUSIONS ............................................................................................................................... 53

MATRIX: REMAINING CHALLENGES AND POLICY OPTIONS ............................................ 57 REFERENCES ...................................................................................................................................... 60

LIST OF TABLES

Table 1 . Cost of Starting and Closing a Firm. Job Security and Cost o f Hiring and Firing Workers ........ 8

Bounced Check, Effective Creditor Rights. and Volatility o f Credit ....................................................... 11 Table 2 . Creditor Rights. Rule o f Law. Days Needed to Enforce a Contract. Days to Collect a

Table 3 . Chile’s educational performance i s low when compared to the OECD ..................................... 24 Table 4 . SIMCE 8th Grade Test Results. 2004 ........................................................................................ 27

LIST OF FIGURES

Figure 1 : Chile GDP per capita Growth. 1990-2004 (percent) ................................................................. 2

Figure 3: Active population. employment and unemployment rate. 1990-2004 ....................................... 4 Figure 4: Stocks and Flows o f Credit to the Private Sector (Million o f Real Pesos) ............................... 10 Figure 5: Recipes for Development- Innovation Related Investments. Conditional on GDP/Capita ...... 15

Figure 8: Years o f schooling by income decile for population aged 25 years or more ............................ 22 Figure 9: Minimum cost o f labor in Chile and OECD countries ............................................................ 32

Figure 1 1: Targeting o f Social Expenditures: Shares o f Public Subsidies Received ............................... 40 Figure 12: Tax Ratio vs . GDP per capita ................................................................................................. 44 Figure 13: Effective Average Tax Rates with and without Credits, Deductions ..................................... 46 Figure 14: Real Copper Prices and GDP growth, 1960-2004 ................................................................. 50

Figure 2: Official Poverty Lines (National): Chile. 1990-2003 (percent) ................................................. 3

Figure 6: Innovation Expenditures as % o f Sales .................................................................................... 16 Figure 7: Education expenditures: Chile. L A C and OECD ..................................................................... 21

Figure 10: Real Expenditures: 1990-2003 ............................................................................................... 39

.. 11

ACKNOWLEDGEMENTS

The Development Policy Review (DPR) was co-managed by Daniel Oks (Lead Economist, LCSPR) and James Parks (Sector Leader and Lead Economist, LCSPR). Daniel Oks and Frank Earwaker (consultant) put together Volume 1. Emily Sinnott (LCC7A) put together Volume 2 based on contributions fiom a team o f Bank staff and consultants following missions held during the second half o f 2004. It draws upon discussions with a wide range o f individuals in Government, think tanks, academia, consultants, and international organizations. I t also draws upon material presented by experts at two workshops held in Santiago de Chile during November-December 2004. A l ist of the team members who wrote or contributed to the various chapters in Volume 2 follows below:

Chapter 1 :

Chapter 2:

Chapter 3:

Chapter 4:

Chapter 5:

Chapter 6:

Chapter 7:

Development Challenges. Emily Sinnott (LCC7A)

Promoting Sustainable Productivity Growth. Sara Calvo (LCSPE)

Background papers: Alejandro Micco (IDB) and Alex Galetovic (consultant)

Innovation. William Maloney (LCRCE), K r i s t i an Thorn (LCSHE), Andres Rodriguez (IDB) and Andres Zahler (consultant)

Education. Emiliana Vegas (LCSHE) and Alejandra Mizala ('Universidad de Chile)

Social Protection. Truman Packard (LCSHD)

Public Finance Issues in Development. Daniel Oks (LCSPR)

Staff: Alvaro Vivanco (LCSPE)

Background papers: Alvaro Vivanco (LCSPE), Claudio Agostini, Francesco

Giavazzi, Roberto Perotti (consultants)

Risks to Convergence. Emily Sinnott (LCC7A) and James Parks (LCSPR)

Background paper: Alvaro Vivanco (LCSPE)

The team would l ike to thank various Government officials including the Finance Minister - Mr. Nicolas Eyzaguirre - and the Budget Director - Mr. Mario Marcel - for their cooperation and assistance in identiflmg the agenda and obtaining the information. Sara Calvo (LCSPE) and Mr. Luis Escobar (Director at Ministry o f Finance) led the organization o f the workshops in Santiago. Valuable suggestions and support were received from Axel van Trotsenburg (LCC7C Director), Jesko Hentschel (Sector Leader LCSHD), Carter Brandon (Sector Leader, LCSES). The report also benefited fiom the able assistance o f Maritza Bojorge (LCC7A) and Maria Estrella (LCC7A).

... 111

PREFACE

The Chile Development Policy Review (DPR) covers economic developments in the country through early 2005. The Summary Report was sent to the previous Government in September 2005 and the Main Report (volume 2) was submitted to the new Government in March 2006. Following consultations with the Government in June 2006, i t was agreed to proceed with circulation o f the report to the Board in grey cover in the present form. In addition, i t was agreed to organize a seminar in Chile to disseminate the report. The DPR complements the Policy Notes presented to the new administration in March 2006.

Since the DPR was communicated to the authorities, the new Government, which took office in March 2006, has launched its development strategy. The new strategy reiterates Chile’s commitment to the pursuit o f prudent macroeconomic management, further development o f market institutions, innovation and strengthening o f social policies and education. The new Government has strengthened the focus on enhancing equality o f opportunity through education, pension reform and child development. It has appointed a Pension Commission, an Education Commission and a Child Development Commission, all charged with preparing policy proposals in consultation with stakeholders, including c iv i l society. The Government has also moved to create an Innovation Council with representatives o f 5 ministries and non-government stakeholders. All these areas - social security, education and innovation - are at the core of the DPR and the new Government’s policies are fully consistent with the options presented in the report. The other key areas covered by the report - investment climate, labor markets, taxation and public finances - are also important elements o f the new Government’s strategy. Therefore, the themes and policy options discussed in the DPR remain relevant for Chile today.

Since the new Government has taken office, the main economic developments that have emerged are the further accumulation o f fiscal surpluses stemming from copper-related revenues and growing demands for social expenditure. The Government has committed to continued full compliance with the fiscal rule and has prepared proposals to invest copper surpluses (in a pension h d that will cover State pension liabilities, in central bank recapitalization and in a Fund for Economic and Social Stability). Managing the copper surpluses and assessing the effectiveness and fiscal impact o f new public spending initiatives will be key challenges for the Government.

iv

EXECUTIVE SUMMARY

As the fastest growing economy in the region during 1990-2004, Chile has become a benchmark for reform in the L A C region. There i s consensus in Chile on the need for a new round o f reforms to foster a more knowledge-based economy that will ensure the continuation o f high and equitable growth. The aim i s to achieve convergence with the lower t ier o f advanced economies by 2020. At the same time, the Government wants to reduce poverty which, although cut in hal f over the last 15 years, is s t i l l a high 18 percent. Poverty reduction will be the key to improving the distribution of income which i s currently one o f the most unequal in the world.

The Development Policy Review (DPR) examines policy options that could help Chile to achieve the twin goals o f fast and equitable growth. Rather than attempting a comprehensive coverage, the report focuses selectively on areas with the greatest potential impact on growth and equity. The proposed strategy aims, on one hand, to enhance the investment climate for fast knowledge-based growth and, on the other, to improve equity through better social protection and education. To enhance the investment climate, “micro- flexibility” can be enhanced, which i s to say eliminating obstacles to the reallocation o f resources and factors o f production at the enterprise level. At the same time, innovation policies can be strengthened and fiscal incentives can be refined, To improve equity, options are proposed to cushion the poor f iom adverse shocks-such as job loss, costly treatment o f injury or sickness, and the loss o f income associated with o ld age-as well as deeper education reforms to ensure access to high quality education, especially for the poor. An agenda for reform i s proposed along the following lines:

(a) Promoting Sustainable Productivity Growth. It is imperative for Chile to reduce obstacles that impede a fast adjustment to shocks. While Chile has a favorable investment climate relative to many other countries and has done well in establishing generally adequate competition policies, there remain obstacles that, if reduced or removed, will lead to M e r increases in productivity and make the economy more resilient to shocks. The report recommends: strengthening the enforcement o f creditor rights; improving the efficiency o f bankruptcy proceedings; restructuring job security; and decreasing wage rigidity by further de-indexing wages. The report also recommends (i) strategies to promote access to credit by small and medium enterprises; and (ii) strengthening institutions that guarantee competition.

(b) Innovation. Innovation i s crucial for sustaining growth in a knowledge-based economy. Compared to the OECD, Chile lags substantially in Research and Development (R&D) expenditure; private sector participation in R&D; patenting and in the relative importance o f applied, as opposed to basic, research. L ike Spain and Italy, Chile has relied heavily on FDI and has a large number o f successfid f i rms that focus on innovation in both production and management. There i s a considerable potential for fbrther TFP growth unrelated to R&D. Nevertheless, investment in Science and Technology (S&T) and R&D is important over the medium and long term. Increasing S&T capability requires more than increasing the number of‘ research units and wel l trained workers. It also requires improving the d i f f k i o n o f knowledge, and that in turn implies viewing the National Innovation System (NIS) as a network to facilitate the transmission o f

V

knowledge. The actual structure o f the NIS may be less important than incentives within institutions and wel l designed l i n k s between them.

Education. Education i s critical for achieving high and sustained growth in a knowledge- based economy and for improving equity. The educational reforms begun in 1990 resulted in a significant increase o f investment in education and they also led to a substantial expansion in the coverage and quality o f education. However, there remain problems o f access that negatively affect quality and equity in the education system. Differences between subsidized private and municipal schools have impeded the creation o f an “education market” that would improve educational efficiency and quality. The Government can help by supervising and encouraging schools to achieve desired results; ensuring equality o f educational opportunity through wel l targeted subsidies; improving the information available to parents and c iv i l society on school quality; attracting and retaining qualified teachers; creating a more level playing field between subsidized private and municipal schools in terms o f admissions; and conducting regular evaluations o f education policies and programs.

Social Protection. Whi le education can go a long way toward creating equal opportunities, i t cannot dispel the r isks to welfare that affect the most vulnerable segments o f society. Many households remain vulnerable to poverty from adverse income shocks such as job loss, costly treatment o f injury or sickness, and the losses to income associated with o ld age. Extending the coverage o f social protection to a greater number o f the most vulnerable without creating moral hazard and dependence while, at the same time, fostering opportunity and enterprise continues to be the over-arching challenge for policy makers. Some specific recommendations for enhancing social assistance include a complete and rigorous evaluation o f Chile SoEidario (specially i t s failure to achieve the goal o f stable income and employment); assessing the impact o f the minimum wage on employment opportunities for the poorest; and evaluating the possible financing o f Plan Auge from general-taxation. Improvements to household welfare from reforms to the second and third pillar o f the pension system could be enhanced by consolidating and strengthening instruments for preventing poverty in old age.

(e) Public Finance Issues for Development. Over the medium and long term, Chile is l ikely to experience pressures on Government expenditures stemming from demographic factors, social needs and new public goods. The efficiency and equity o f the tax system can be improved while simultaneously reducing tax avoidance. Numerous income tax credits, deductions and exemptions which benefit the relatively better-off and which unnecessarily complicate tax administration could be eliminated. A reduction o f the withholding tax on dividends of foreign corporations would also reduce tax avoidance while having a positive net effect on FDI. The reduction or elimination o f VAT exemptions and special regimes (e.g., construction) could boost revenue while simplifying tax collection. There are also opportunities to refine the fiscal rule so as to increase i t s anti-cyclical effect and stabilize the seasonal impact o f fiscal policy. Over the longer term, once a firm basis for fiscal policy has been consolidated, the Government could consider adopting a rule whereby the ratio o f debt/GDP would eventually converge to the ratio o f public-capital-stocMGDP. That would avert an undue reduction o f the public debt which may cause public investment to be deferred even when the rate o f

vi

social return i s high. At the same time, the anti-cyclical features o f the fiscal ru le would be preserved

( f ) Risks to convergence to advanced economies. Being a small open economy, Chile remains vulnerable to regional and global developments, and to shifts in demand fkom i t s major trading partners. A slump in the demand for primary products such as copper or fluctuations in capital flows would substantially reduce short-term growth prospects. In the past 100 years, most major fluctuations in output were caused by adverse external shocks. In particular, there is a close correlation between output growth and the price o f copper. This represents a significant risk for Chile, since prices are currently at extremely high levels. External risks remain important even though the country has diversified towards non-traditional exports - which have doubled as a share o f exports since 1970 - and has greatly enhanced its macroeconomic framework with a low public debt, a well regulated and deep financial sector and a market-driven exchange rate. A continued emphasis on increasing the dynamism o f the private sector, deepening global integration and diversifying economic activity will help to reduce this vulnerability still further. There is also room to reduce vulnerability through international capital markets. The cross-border transfer o f real and financial assets is an alternative. For example, relaxing the restrictions on pension funds by allowing them to invest abroad has already helped to diversifl risk. Over-the-counter derivatives such as equity swaps are another option that merits consideration.

vii

DEVELOPMENT POLICY REVIEW

A. STRATEGIC SETTING OF DPR

1. The development policy review’ (DPR) seeks (i) to present a broad overview o f the development challenges facing Chile, and (ii) to address selected issues o f importance in attaining the goal o f high growth with equity. I t includes in-depth coverage o f private sector development; innovation; education; social protection, and public finance. The DPR is intended to contribute to the dialogue on overall policy and institutional priorities. The report is prepared at the request o f the Chilean authorities. The focal areas o f the report emerged from consultations with the Government; including a preparatory brainstorming session with the Ministry o f Finance in mid-2004 and two workshops held in Chile in November and December 2004.

2. The report aims to present a clear picture o f Chile’s development challenges and policy options to address them. The DPR concentrates on a few selected areas which the Government, the Bank and many stakeholders believe are crucial to the country’s growth and social agendas. Many other areas that are also key to sustained growth -- l ike trade, financial markets and infi-astructure -- in which Chile has already made important advances have been left out o f the report. The report also identifies priority areas for future research where important knowledge gaps exist - e.g. female participation in labor markets, pre-school education, regional decentralization and informality. The DPR is an important tool for guiding the future policy dialogue between Chile and the World Bank. I t covers many key areas o f the Bank-supported program in Chile and will be a key analytical input into the forthcoming country assistance strategy (CAS).

3. The DPR i s composed o f a summary report (Volume 1) and a main report (Volume 2) which comprises a more detailed analysis o f sector issues. Volume 1 i s organized as follows: Section B reviews growth and poverty outcomes and challenges; Section C discusses policy options to foster a dynamic enterprise sector; Section D proposes strategies for strengthening innovation; Section E discusses options for deepening education reform and improving equality o f access to quality education; Section F proposes options to enhance social protection; Section G proposes tax and fiscal measures to finance future development needs; and Section H concludes with a discussion of risks associated with convergence to high per capita income countries, a summary o f recommendations and a proposed research agenda.

B. GROWTH AND POVERTY OUTCOMES: DEVELOPMENT CHALLENGES

4. Chile has become a benchmark for reform in the LAC region. With an average annual per capita growth rate of 4.1 percent, i t was the fastest growing economy in Lat in America from 1990 to 2004 (Figure 1). Chile has doubled i t s income since 1990, reducing the gap between its per capita income and that o f high-income OECD economies. Chile’s growth performance, while assisted by favorable external conditions,

1

owes much to a strong institutional framework built on structural reforms put in place since the 1970s, solid fiscal fundamentals, prudent monetary policies, deep integration into the global economy, and the development o f a solid and deep financial sector. Economic stability i s reflected in single-digit inflation, a structural fiscal surplus, low public debt, sovereign spreads equal to those o f advanced economies, and a high degree o f financial sector stability.

Figure 1: Chile GDP per capita Growth, 1990-2004 (percent)

12 , - 10 8 6 4 2 0

-2 -4

Source: World Bank, Development Data Platform and staff estimates,

5. The slowdown in growth over the recent past associated with the Asia/Russia/Brazil crises illustrates the continued vulnerability of Chile - a small open economy - to external conditions. During 1998-2003, GDP per capita grew at an average o f 1.3 percent per annum, far below the rate experienced in the previous 1 0-year period. Yet, Chile was able to withstand the shocks o f the late 1990s far better than many other countries in the LAC region. I t was the only country in LAC to reduce the gap between its GDP per capita and that o f advanced economies. In addition, the decline in growth resulting from adverse external shocks was far less severe than in the past, showing the increased resilience o f the Chilean economy. Structural reforms, the continuity o f sound economic policies and good institutions go a long way toward explaining th is performance.

6. The slowdown also shows the importance of eforts to further enhance the macroeconomic and microeconomic flamework and reduce the vulnerability to shocks. The Government has introduced a number o f macroeconomic measures since 1999 designed to consolidate credibility and stability. These include the adoption o f a free- floating exchange rate regime, the institution o f an explicit fiscal policy rule, the move to a purer form o f inflation-targeting, and a deepening o f the foreign exchange derivatives market. In spite o f substantial progress on the macroeconomic front, much remains to be done to address microeconomic rigidities and to foster institutional capacities. Recent evidence suggests that microeconomic inflexibilities that impair the reallocation o f resources and factors at the level o f the firm have prolonged adjustment to the shocks o f the late 1990s.

____

However, macroeconomic policy inconsistencies - in particular, defending a target exchange rate through unsustainably high interest rates - have also played a role in the 1998-99 slowdown.

2

7. Achieving fast and sustained growth in Chile wil l involve improving education and enhancing the adoption of innovation/technoloa. There is consensus on the importance o f a new round o f reforms to move toward a more knowledge-based economy that will ensure high growth and convergence towards the advanced economies. The aim for Chile is to achieve convergence with the lower tier o f advanced economies by 2020. Meeting th is objective will require fast and sustained growth. A growth rate o f 5 percent per annum will bring Chile’s GDP per capita to the present level o f Spain by 2023. Chile i s faced with the challenge o f following the example o f successful resource-rich countries l ike Australia, Finland and Sweden and becoming a more knowledge-based economy. An environment that is deficient in human capital and innovation would slow or impede income convergence with advanced economies.

8. Considerable gains have been made in the fight against poverty. Strong growth, coupled with well-targeted social policies, led to a sharp drop in poverty. Since the return to democracy, poverty levels have more than halved to around 18 percent in 2004 (Figure 2). Chile now has the second lowest headcount poverty rate in the L A C region, after Uruguay. Social indicators, including enrollment in primary education, youth literacy, infant mortality and l i fe expectancy have also improved, reaching levels close to advanced economies.

Figure 2: Official Poverty Lines (National): Chile, 1990-2003 (percent)

40 35 30 I Poor and indigent 0 Indigent 25 20 15 10 5 0

1990 1992 1994 1996 1998 2000 2003 ~~~ ~ ~ ~ ~

Source: MIDEPLAN, Encuesta CASEN (1 990, 1992, 1994, 1996, 1998,2000 and 2003).

9. The integration of the poor into the labor market was a major factor that contributed to a reduction in poverty. Between 1990 and 2003, the total number o f people active in the labor market increased by 29 percent, from 4,824 thousand to 6,199 thousand (Figure 3). The rise in participation was due in large part to the incorporation o f unskilled and semi-skilled women into urban labor markets. The gap between the participation rate o f the well-educated and the poorly-educated fel l substantially over the 199Os, as the unskilled became increasingly active in the labor market. Over the same time period, employment increased by 27 percent, from 4,450 thousand to 5,653 thousand.

3

Figure 3: Active population, employment and unemployment rate, 1990-2004

I W I o y e d -.-.-

1990 19%- 1994 1996 1998 2000 2002 2004

Notes: Includes active share o f total population over 15. Source: INE, CMle.

T o

10. Despite progress, almost one in five of the population remains poor. Households with incomes close to the poverty line remain vulnerable. This vulnerability can be acute when members o f households become unemployed, particularly if they were self- employed or had jobs in the informal sector. For the informal or self-employed worker, there remain institutional barriers to even the most basic forms o f social protection.

11. Chile also faces a formidable challenge in terms of reducing high levels of inequality, especially inequality of opportunity. The distribution o f income in Chile i s highly skewed, with a Gini coefficient close to the most inequitable countries in Latin America and Africa. The only country with a higher level o f inequality and a higher level o f income is South Africa. Reducing inequality remains a substantial challenge for both the Government and society. Increasing equality o f opportunity and the number o f highly-educated individuals in the labor force will be key to reaching the high income levels o f advanced economies.

12. Income inequality is mirrored by inequality in educational attainment across the dzferent socioeconomic classes in Chile. Those in the top quintile o f income earners have twice the number o f years o f education than do the bottom quintile. Therefore, improving access to quality education and increasing the participation o f the poor in adult training programs is an important means o f addressing inequality. One key factor underlying inequality and poverty is the low rate o f female participation in the labor force. Low female participation deprives households o f a valuable opportunity to raise income and overcome poverty. The low rate o f female participation is partly explained by an under- developed system o f pre-school education. Pre-school education not only facilitates access to jobs for women, but i t also ensures a more level playing field in terms o f access to education and educational performance. The 2006 World Development Report cites evidence that pre-school education is a good investment with a high rate o f re tu rn2

The return per dollar invested in pre-school education i s well above the opportunity cost of capital. See World Bank (2005b), Figure 7.2 (page 133).

4

13. I n sum, the twin challenge for Chile is to achieve high and equitable growth. The strategy outlined in th is report is based on policy options that fall under two broadly defined pillars. An investment pillar which comprises policies and reforms to improve conditions for investment in physical and human capital; and a social pillar which includes policies and reforms aimed at reducing inequality and strengthening social protection. Policies in the investment pillar include: (i) measures to improve allocative efficiency by reforming labor market regulations, improving access to credit, and strengthening competition, (ii) measures to improve TPF by encouraging innovation and enhancing education, (iii) fiscal reforms to improve equity and efficiency in the tax system and to improve conditions for investment in general, and (iv) measures to reduce or eliminate micro-rigidities - strengthening creditor rights, bankruptcy procedures - that slow-down adjustment to shocks. Policies in the social pillar include: (i) guaranteeing that al l children have access to education o f an adequate quality and that the education system does not discriminate against opportunities o f low income population; and (ii) reducing vulnerability to poverty f iom adverse income shocks such as j ob loss, costly treatments for injury or sickness, and the loss o f income associated with o ld age.

C. PROMOTING SUSTAINABLE PRODUCTIVITY GROWTH

14. For Chile to succeed in converging with the lower tier o f advanced economies by 2020, a key challenge is to eliminate the institutional and policy obstacles that prevent enterprises f iom adjusting rapidly to economic shocks. More generally, improving Chile’s competition policies and institutions will contribute to sustainable growth in productivity and GDP. Chile has done wel l in establishing generally adequate competition policies, and i t ranks on a level with developed countries. Some recent studies point to current labor policies and difficult access to credit - among other factors3 - as contributing to the loss o f dynamism o f f i r m s after the shocks o f the 1990s. A recent World Bank Investment Climate Survey o f f i r m s o f a l l sizes and in al l sectors, revealed that about 25 percent o f f i r m s believe that labor regulations, access to finance, and anti- competitive practices severely limit the expansion o f their enterprise.

15. This section examines three issues. First, the dynamism o f Chilean firms as a contributor to higher factor productivity through the efficient allocation o f factors o f production. Second, the importance o f sustaining corporate dynamism through lower exit costs, increased labor market flexibility and enhanced access to credit. Third, the challenge to strengthen competition policies and remove restrictive regulations in order to foster greater competition.

Business Environment and Enterprise Dynamism

16. Recent studies highlight the importance o f a dynamic process o f market entry and exit in order that enterprises may contribute to growth and job creation in industrial and developing countries alike. As new f i n n s enter and less efficient ones leave the market,

For example, macroeconomic policy inconsistencies - targeting the exchange Wget through unsustainably high interest rates in a fiscally expansionary context - played an important role as well.

5

there i s a reallocation o f factors which results in higher factor productivity. In the case o f the manufacturing sector, 50 percent o f total factor productivity growth o f the last decade i s explained by reallocation o f factors from low-productivity firms to high-productivity firms. The key i s having in place a business environment or investment climate that facilitates the process o f entry and exit o f firms and an efficient reallocation o f factors o f production.

17. Chile has a favorable business environment relative to many other countries and there is signzjkant enterprise dynamism. Government policies and institutional reforms provide a secure macroeconomic policy environment and a stable financial sector. In addition, the cost o f doing business i s relatively low as a result o f privatization, market liberalization and a competitive environment. As a result, the process o f market entry and exit has been easy and labor turnover has been rapid, ranking on a level wi th OECD economies. On average, there i s a turnover o f one o f every four jobs each year. The entry-exit process is mainly concentrated in small and medium-sized f i rms. The market behavior and productivity o f enterprises, both large and small, i s diverse and that augurs well for further productivity gains under an improved business environment that could promote even greater dynamism.

18. The process of entry and exit andjob reallocation slowed down after the shocks of the late 1990s. Since then, small manufacturing f i r m s have exhibited a lower net rate o f entry-exit and a lower growth in employment and sales than have larger f i rms. These findings are consistent with the loss o f microeconomic flexibility o f manufacturing f i r m s observed since the late 1990s by Caballero, Engel and Micco (2004). A flexible economy i s one in which actual employment can be quickly adjusted to the desired level. In Chile, it takes manufacturing f i r m s a year to adjust their actual payroll to within 72 percent o f the desired level. That indicates that microeconomic flexibility in Chile i s higher than in Brazil and Mexico, but lower than in the U S where the full adjustment can be completed withn one year. The speed o f adjustment o f small and medium-sized f irms (SMEs) dropped significantly after the shocks o f the late 1990s. These results are consistent with the view that labor regulations and credit constraints - which may have become more binding in the late 1990s - have slowed the adjustment o f SMEs.4

Sustaining Dynamism

19. The reduction of microeconomic flexibility after the shocks of the late 1990s points to difzculties such as the cost of closing of afiwn and enforcing creditor rights as well as obstacles that restrict the mobility of labor andJinancia1 resources between firms. Reducing obstacles to microeconomic flexibility for small and medium-sized firms is particularly important because those firms account for a large part o f total employment and they could play a key role in fostering the overall dynamism o f the productive sector.

Flexibility didn’t drop in the case o f smal l and medium-sized firms with small employment gaps or o f large firms with large or small employment gaps. For small gaps, internal resources may suffice to fund adjustment. Larger firms tend to be better positioned to finance labor mobility - their access to bank credit did not suffer as much during the late 1990s as in the case o f small firms.

6

Lowering Exit Costs

20. Closing a business remains costly. International rankings point to the high cost o f closing a business in Chile relative to other industrial and emerging economies - Table 1. Exit costs are elevated because o f complex bankruptcy procedures and poor enforcement o f creditor rights. As discussed in the recent World Bank Report on Observance and Standards & Codes (2004b), under the bankruptcy law, an enterprise may be reorganized under judicial proceedings, but creditors are not given voting rights, in contrast to modem bankruptcy laws. Moreover, the current law does not take account o f the business needs o f the debtor during reorganization, making it more difficult for a firm to remain afloat during the transition. Judicial proceedings to collect defaulted loans are also lengthy and costly.

21. The Second Capital Market Reform Bill, (SCMR), submitted to Congress last year, would address some of the problems. The proposed legislation would (i) create a Uni f ied Registry for a l l movable assets pledged as collateral, as well as other information pertinent to lenders; and (ii) introduce modern rules to deal with the off-set and netting- out o f financial contracts under insolvency proceedings including provisions to clarify the treatment o f subordination debt agreements in bankruptcy.

Facilitating the Reallocation of Labor

22. Labor markets in Chile are flexible, ranking better than industrial and emerging economies alike. However, the costs offiring workers (i.e., the cost of required advance notice, severance payments and penalties due when dismissing a redundant worker expressed in weekly wages) is relatively large - Tablel. Recent studies reveal that measures to enhance job security resulted in a loss o f labor flexibility following the shocks o f the late 1990s. The provisions for job security increase the cost o f reducing a pay-roll and therefore lead to fewer dismissals when f i r m s face negative shocks. Conversely, when they experience a positive market boost, the employment response i s smaller because firms take into account that workers may have to be fired in the future. According to one recent study, i f Chile were to adopt the level o f job security o f New Zealand, i t would increase the speed o f employment adjustment by 14 percentage points and accelerate growth by 0.3 percentage points - Micco (2005).

23. The problems engendered by the flamework of job security in Chile may impair labor mobility and increase administrative costs (Box 1). For example, the judicial process which settles disputes between employees and employers is extremely slow in Chile and, hence, it increases the administrative costs o f the system. Gazmuri (2004) shows that labor disputes take around 250 days to be settled in Chile. If one party appeals, the process can last an additional 230 days. A recent study based on a sample o f 60 countries during the period 1980-1998 found that industrial employment adjusts at a slower pace in countries with high legal protection against dismissal, especially when such protection is l ikely to be enforced (Caballero, Cowan, Engel and Micco, 2004).

7

Table 1. Cost of Starting and Closing a Firm, Job Security and Cost of Wiring and Firing Workers

& Caribbean 1 Pacific

24. In Chile the minimum wage and wage indexation became increasingly binding constraints following the shocks of the late 1990s (Box I). A high minimum wage and wage indexation prevent the downward adjustment o f nominal wages and that leads to the dismissal o f employees if a firm needs to retrench. Chile’s statutory minimum wage increased in the late 1990s. As a result, the minimum wage doubled to around 60 percent o f the market wage for unskilled workers between December 1997 and December 2002, putting more pressure on the wage bill o f S M E s and thereby discouraging employment. That could partly explain the slow growth o f employment in small f i rms after 1998. Those f irms have a higher proportion o f unskilled labor and, therefore, o f low-waged workers than larger establishments. A binding minimum wage therefore affects them more.

I I

8

Box 1. Job Security, Minimum Wage, and Wage Indexation

Job security. Chile’s regulatory provisions governing job security consist o f severance payments and a type o f unemployment insurance. Severance payments have been the traditional legal mechanism to protect employees because they are easy to implement. However, severance pay i s inefficient as an insurance mechanism and it distorts hiring and firing decisions. Severance payments account for more than 80 percent o f all benefits. Furthermore, unemployment insurance i s also inefficient as an insurance mechanism and generates problems o f moral hazard.

Minimum wage. The minimum wage has increased since the late 1990s. In May 1998 Congress decided to increase the minimum wage by 12.7 percent in June, 1998, 12.4 percent in June, 1999, and 10.5 percent in 2000, moving towards a minimu monthly wage target o f 100,000 pesos by the year 2000. T h i s policy entered into effect just before growth decelerated in the third quarter of 1998, and when growth was s t i l l projected at over 6 percent per year.a Around 6 percent o f Chilean workers were affected by the minimum wage hike that took place between 1997 and 2000 (Cowan et al, 2004) based on data from the Chilean employment survey. A M e r 12 percent increase took place on July 1,2005.

Wage indexation. Information about indexed wage contracts i s limited but, reportedly, wage indexation has decreased in recent years. Collective bargaining has led to wage contracts extending over a period o f two years on average. They include provision for full backward indexation to inflation every six months, and they have not changed significantly over the last 15 years, despite falling inflation. In the manufacturing sector coverage amounts to 35 percent o f total sector employees.

See Cowan and Micco (2005) and Cowan et a1 (2004) for a discussion on the rationale o f this measure.

25. Reducing the severance-payment component and increasing the employment insurance component o f job security and in general reducing wage rigidities will contribute to a faster adjustment to shocks.

Improving Access to Credit

26. Tlze stock of bank credit to the private sector stagnated in 1998-2000 (Figure 4) with large f i rms crowding out credit to smaller firms. Chile has a well-functioning financial sector that compares favorably with other countries at a similar level o f development. Competition in the banking sector has increased in recent years as new entrants, including foreign banks, have joined the sector and as capital markets have further deepened. This has contributed to sustained increases in bank credit, particularly for larger f i r m s which also have better access to foreign credit and local capital markets. As highlighted in the IMF-World Bank Financial Sector Stability Assessment (IMF 2004), competition has not significantly improved access to credit by small and medium f m s . Restricted access to credit by smaller firms i s not an exclusively Chilean phenomenon. In fact the shortfall i s lower in Chile than in Brazil, Hungary or Slovenia. Nevertheless, after the shocks o f the 1990s small and medium firms in Chile faced tighter credit markets and credit constraints became more binding, forcing them to exit the market more for reasons o f liquidity than o f profitability.

9

Figure 4. Stocks and Flows of Credit to the Private Sector (Million of Real Pesos)

300 1 % I 3 0 1 -4

250

200

150

100

Source: Banco Central de Chi le

27. The sudden reduction in credit to small and medium firms in the late 1990s may be explained by the likely increase in risk aversion of banks which privileged the lower risk profile of large firms. Under those circumstances, smaller firms found it more dificult to roll over credit. In Chile, bank loans account for around 20 percent o f short- term financing for all f i rms. I t is typically used for working capital. The higher cost of credit for SMEs relative to large f i r m s is the result o f their higher credit r i sk and the higher monitoring cost for creditors. High credit risk stems in part from the poor enforcement o f creditor rights. While Chile fares better than other Lat in American economies in enforcing creditor rights, it still falls behind countries l ike Australia, Korea and New Zealand. These countries have been able to weather crises more successfully than Chile, and they have faced a less volatile market for credit (Table 2). Improved enforcement o f creditor rights will afford smaller f i r m s a more secure access to credit.

28, The continued development of the financial sector wi l l help to improve access to credit for smaller j r m s . Specific recommendations to m h e r develop the financial sector include: (i) broadening and diversifying investment opportunities for private pension funds; (ii) filling gaps in market structure to improve liquidity; and (iii) adapting the supervisory kamework to meet the needs o f an increasingly integrated and complex financial system. Banks have recently increased their lending to small and medium firms through leasing. Measures such as unifying the legislation on movable collateral and creating a single registry for pledges will further foster bank lending.

29. The Government may also consider specific actions to facilitate access to credit by small and medium-sized enteqrises. As proposed in the Wor ld Bank - A Strategy to Promote Innovative Small and Medium Enterprises (2004~) - the following actions may be considered: (i) a feasibility study o f market driven schemes including mutual guarantee associations; (ii) credit scoring (estirnating the creditworthiness o f a loan

10

applicant based on profiling) and (iii) credit self-evaluation (based on standardized formats developed by the financial institutions themselves). Building on the success o f Banco del Estado with micro-credit, other commercial banks could be encouraged to develop specialized lines o f credit for small and medium enterprises.

Table 2. Creditor Rights, Rule of Law, Days Needed to Enforce a Contract, Days to Collect a Bounced Check, Effective Creditor Rights, and Volatility of Credit

Definitions: Creditor Rights: secured creditors protection in bankruptcy procedures. The higher the score in a 1-4 scale the greater i s the enforcement o f creditor rights. Rule of Law: Includes several indicators that measure the extent to which agents have confidence in and abide by the rules o f society. Days to Enforce a Contract: number o f days to resolve a payment dispute through courts. Total Duration of the Procedure: the number o f days needed to collect on a bounced check. Effective Creditor Rights is the product o f Creditor Rights and Rule o f Law (both normalized between 0 and 1). Source: Djankov et a1 (2004), Kaufmann et a1 (2003 and 2004), and Galindo and Micco (2001).

Strengthening Competition

30. Enhanced competition leads to lower prices and higher average productivity. Ease o f entry is not, in itself, sufficient to ensure competition because the number o f firms i s not the only determinant o f price competition, as discussed in Galetovic (2005). For example, in the case o f fixed-line telephony, increasing the number o f competitors barely affects tariffs. Reducing and simplifying regulations is one way to foster stronger competition; another way is to redesign the market. Chile has been very successful in achieving effective price competition in the long-distance telecom sector but not in fixed- line telecoms, nor in the bus system (where small f i r m s predominate) or pension funds.5 Redesigning these markets will help reduce business costs, increase productivity and welfare. According to some estimates, removing barriers to competition in the pension system could halve current costs (Valdes, 2005).

See chart 2.1 in VoIume 2.

11

31. The evidence is inconclusive when it comes to perceptions of competition being restricted bjj bank concentration. Cross-country comparisons suggest that Chile i s not different from the international norm with regards to bank concentration. But high profits reinforce perceptions o f low conipetition. IMF (2005) tentatively associates low competition with high effective entry costs (in the form o f high capitalization ratios), limited competition from other non-bank financial intermediaries and regulatory restrictions on the investment o f private pension funds (which are the largest institutional depositors). Further analysis i s needed on this issue.

32. Measures to reduce costs or<foster tough price competition are market specific. To identify the determinants o f market structure from cross-industry regressions i s difficult if not impossible. The f i rs t order o f business i s to make a systematic survey o f sector rules and regulations that impair competition. That could be done by the competition policy authorities. For example, there i s potential scope for redesign and further liberalization o f markets for public transport, telecoms, electricity retailing and private social security funds.

33. The two main legal institutions in charge of compelition in Chile are the “Fiscalia Narional Econdmica ” and the Competition Tribunal. The Fiscalia i s charged with monitoring market behavior and prosecuting anticompetitive acts; i t s aim i s to defend the public interest. The Tribunal hears and decides cases involving alleged anticompetitive practices. The Tribunal cannot initiate an investigation but i t can suggest changes to laws if it deems them harmful to competition. Unfortunately, many times the rulings of these institutions have protected the market from f i r m s that were cutting prices aggressively, as opposed to those involved in anticompetitive practices (Galetovic, 2005). Government also affects competition through discretionary administrative decisions by sector ministries, as well as through regulations applied by Government agencies.

34. Strengthening institutions w i l l help to increase effective competition. Two potential safeguards that might be used to prevent f i r m s misusing the system and forestalling competition are (a) higher standards o f economic analysis by competition institutions (for claims are seldom supported by rigorous analysis, let alone by empirical evidence); and (b) allowing the Tribunal to dismiss cases that are have no economic justification and are not well justified b y the plaintiff.

D. INNOVATION

35. Cross-country analysis indicates that the roughly 50 percent o f growth that i s unexplained by physical factor accumulation - total factor productivity - i s often associated with advances in the use and generation o f knowledge and innovation. This has led Chile, as many OECD governments, to focus on how to enhance their perfomiance in this area and to consider reforms o f the national innovation system. This section examines three issues. First, how can Chile know if it has an “innovation problem” that needs to be addressed? Second, given that the evidence suggests that Chile does indeed have an innovation problem, what i s meant by innovation and in what way

12

does the country exhibits weaknesses? Third, what do recent experience and the literature suggest by way o f measures to foster innovation?

Does Chile Have an Innovation Problem?

36. Compared to the OECD, Chile lags substantially with respect to several common indicators o f innovation performance. These include expenditure on Research and Development (R&D), participation o f the private sector in R&D, the issuance o f relatively few patents and the excessive relative importance o f basic vs. applied research. Chile also performs relatively poorly with respect to international benchmarks for educational (see section E) and human resources devoted to R&D.

37. However, neither these, nor low TFP necessarily suggest deficiencies given the country ’s level of development. There is strong international evidence that TFP i s closely linked to the capital-labor ratio. I t i s possible that Chile’s relatively low level o f TFP simply reflects more general barriers to physical capital accumulation. However, it appears that this i s not the case. Chile has a relatively low TFP even taking account o f i t s capital stock and that suggests a problem that goes beyond general constraints affecting physical investment. I t is an open question whether the shortfall in TFP i s due to a lack o f innovation or to other types o f inefficiencies. Nevertheless, given the need for key industries to remain internationally competitive, and given the important role that innovation has played in comparator countries such as New Zealand and Spain, i t would appear that that innovation merits a prominent place on the reform agenda o f the next decade. Two issues are particularly important in that context.

38. First, “innovation policy” goes hand in hand with the development o f entrepreneurship focusing, as in New Zealand, on business mentorship, competition policy, and incentives to “get o f f the island” and export-- thereby creating a demand for innovation. Because o f i t s small domestic market and the distance fkom larger metropolitan markets, Chile i s more l ike New Zealand than Spain or Italy which, within the European Community, were readily exposed to competition and other ways o f doing business in a broad market.

39. Second, innovation policy goes beyond Science and Technology (S&T) policy. Even if low TFP were entirely a fimction o f insufficient technological progress rather than other factors, those other factors may s t i l l need to be addressed (including underdeveloped venture capital markets and labor market rigidities) because they may act as barriers to the adoption o f new technologies and S&T investments. Hence promoting innovation requires a broad vision barriers to the adoption of new technologies and S&T investments and a broader set o f diagnostics than those related to S&T alone.

40. In sum, i f there i s no demand for innovation on the part o f the private sector, either because o f investment-related issues or specific barriers to innovation, efforts to improve S&T on the supply side will not lead to productivity growth. The firm remains central to the discussion.

13

What i s Meant By Innovation and what are the Aspects of Innovation in which the Country Exhibits Weaknesses?

41. There are diferent recipes - combinations of innovation inputs - that have served to achieve high-income levels. Adjusting four commonly cited ingredients for technological transfer-R&D, Foreign Direct Investment (FDI), licensing, and higher education - for level o f development suggests that Chile and the high tech miracles Finland, Israel and Korea have followed very different recipes. Chile has relied little on R&D or licensing and heavily on FDI. In that respect, i t resembles Spain and Italy both o f which converged rapidly to high income levels over the last 30 years (Figure 5) .

42. There exists a large potential for non-R&Ll driven TFP growth in Chile. In both I ta ly and Spain, the literature suggests that gains occurred largely through moving the work force from low productivity to higher productivity sectors and increasing the productivity o f those sectors through the adoption o f existing technologies and through improvements in organization and management. The system o f Technological Centers in Spain in particular, has been central to enhancing the capacity o f SMEs through clustering, networking and cooperatives. I t is important to foster those less glamorous aspects o f innovation

43. Investment in S&T/R&D is nevertheless important over the medium term and appears essential over the longer term. R&D, and a strong scientific capacity i s critical not only to generate new knowledge, but also to enhance the “absorptive capacity” o f enterprises-the ability to use and benefit from existing information. The ability to absorb local publicly funded, or globally available research and FDI is an acquired sk i l l . Technology transfer is closely tied to the private sector’s capacity to understand, adapt and commercialize knowledge and technology. That, in turn, depends on having a pool o f technologically literate employees in the private sector. I t is they who will engender the demand for innovation, identify and act on opportunities for innovation and, as they gain experience, manage a f i rm’s innovation strategy. At present, a large majority o f researchers in Chile work in universities or public research institutes and only about 6 percent are employed in the private sector. Thus, i t is important for Chile to provide stronger incentives for the cross-sector mobility o f researchers, expand on recent efforts to employ young researchers in industry, and stimulate a culture o f entrepreneurship in graduate education.

14

Figure 5. Recipes for Development- Innovation Related Investments, Conditional on GDPKapita

Finland

7 - 4

1972 1977 1962 1987 1992 195%

Chile

- 1

1972 1977 1982 1987 1B2 1

New Zealand

- 1

1972 1977 1982 1987 1992 1998

Spain

"172 1977 1982 1

44. The recent slow growth in Italy and Spain points to the importance over the longer term of investment in S&T which are incorporated into R&D. Though the process o f technology adoption and invention cannot be neatly divided into distinct phases there is, particularly in Spain, an acute sense o f having exhausted the "easy" phase o f technological progress. Figure 6 suggests that, in Chile and Argentina, businesses rely more upon physical capital accumulation as a means o f acquiring innovative technologies than upon R&D and training. The contrasting behavior o f Finnish enterprises may reflect their specialization in electronics. The overall picture for Europe suggests a greater emphasis upon building human capital and in-house research capabilities over the long run.

15

Figure 6. Innovation Expenditures as YO of Sales

A m a

Source: Authors elaboration based on enterprise innovation surveys in Europe and C1 le.

45. Strengthening the S&T capability of Chile requires going beyond increasing the number of research units and the stock of well trained human capital, to the diffusion of knowledge. Hence the National Innovation System is to be viewed as a network that facilitates theflow of knowledge. Evidence from the OECD suggests that, at the micro level, knowledge generation i s subject to decreasing returns to scale whi le at the aggregate level, there are constant returns to scale. That, in turn, suggests significant synergies. In Chile, however, knowledge creation is subject to diminishing returns at the national level which suggests that synergies may be less prevalent.6 The explanation may relate to such factors as the level o f education, the perceived quality of research institutes, the degree o f collaboration between research institutes and the private sector and issues relating to intellectual property rights. These are a l l central aspects o f pol icy design in the context o f a National Innovation System.

What Does Recent Experience and the Literature Suggest for Principles and Broad Policy Measures to Foster Innovation?

46. Although there still remains room for less exotic sources of productivity growth, a well functioning National Innovation System (?LIS) is indispensable for full participation in the international S&T community. Reform of the N I S and particularly the S&T System - realigning incentives, building or dismantling institutions, identifying successful interventions - may take several decades. Basic challenges o f the N I S include: (i) providing a pol icy framework for innovation with a longer term focus o n S&T; (ii) ensuring an environment consistent with a l l types o f capital accumulation by redressing

See Bosch, Lederman and Maloney (2005).

16

bottlenecks in the markets for credit and labor and by encouraging competition; (iii) attending both to innovation i tse l f and to the entrepreneurial and scientific capacity required to effectively innovate; (iv) placing the private sector at the center o f innovation policy in order to establish a clear link with productivity; (v) evaluating policies and procedures constantly and thoroughly.

47. I n practice, the actual structure of the NIS in Chile may he less important than a well-designed system of incentives and linkages between institutions. Despite recent progress, the policies and programs for R&D in Chile are still uncoordinated and there are significant overlaps in content and objectives. That reduces the impact o f expenditures, generates duplication and leads to an excessive dispersion o f programs including to some areas with relatively low social rates o f return. Until recently, the National Commission o f Science and Technology (CONICYT), the entity mandated by law to define an S&T policy, was unable to coordinate policy among the various actors, or effectively monitor Government programs. The recent proposal o f a “Consejo Nacional de Innovacidn” establishing a central Council for policy definition, implementation, coordination and evaluation is likely to lead to better overall coordination and less redundancy. I t would also have the power to allocate the proceeds o f a recently enacted Mining tax.

48. Much of the evolving strategy wi l l focus on redressing problems arisingfrom the partly public-good nature of innovation. Good policy design balances the cost and effectiveness o f taxes, subsidies, and other methods o f “internalizing the externality,” including intellectual property rights. Policies can be broadly divided into:

Government sponsored innovation-related tasks: Governments often finance or perform basic research that may have high social value but l ow private retums. I t i s important to carry out an evaluation o f the areas that are l ikely to yield high social returns. Two principle institutions developed for that purpose are Universities and Public Research Institutes (PRIs).

Private sector Zed tasks: Private initiatives are preferred in areas where the gap between the social rate o f return and the private rate o f return i s smaller. There are three common instruments for transferring resources to the private sector: Tax Credits, Intellectual property generated rents and Public-private hybrids (matching grants).

49. A clear policy pamework can support private-sector innovation with public funds. Notwithstanding successful examples fkom the OECD and Asian experiences, there is, as yet, little best practice that enjoys the broad support o f theoretical and empirical literature. Furthermore, i t is not known how effectively the apparently successful experiences o f other countries can be transplanted to Chile. Hence, the principles proposed below can be viewed as a process o f trial and error.

17

Government Sponsored Innovation Related Tasks

Universities and the formation of human capital

50. From the point of view of developing a strong capability in science and technology, it is of paramount importance to strengthen the universities. The local production o f research-trained scientists and engineers remains low in Chile with just 144 PhDs in 2003. However, the number i s likely to increase in the near future due to efforts by CONICYT and the Ministry o f Education through its MECESUP program to strengthen doctoral programs. Between 1999 and 2003 enrollment in PhD programs almost doubled. Despite their prominent role, universities are severely constrained by a lack o f faculty with advanced education and by a lack o f research equipment and laboratories. Efforts to stimulate quality research are slowed by conservative practices and structures o f compensation that emphasize seniority rather than performance.

51. At the most general level, the universities’ mandate can benefit from greater clarity. Even though universities are the principal agents o f research (45 percent o f R&D) and the main employers o f researchers (60 percent o f all researchers) they do not turn science into business. More than 55 percent o f R&D resources are dedicated to basic research (compared with 18 percent in the US) and that indicates there is room for realigning the focus o f research towards the needs o f a middle-income country. Chile would benefit from a practical vision o f university research as the handmaiden o f industry.

52. Establishing a role for stakeholders in the governance structure and allowing a larger role for competitive funding would increase the accountability of universities to external audience. Chile i s in the process o f introducing institutional performance agreements for publicly funded universities that would tie funding from “Aporte Fiscal Directo” to more effective collaboration between universities and industry in matters o f research. A partial shift of h d i n g to a competitive basis, as both Finland and New Zealand have done, would encourage researchers to heed the needs o f the private sector. Other issues o f high-level education are addressed in greater detail in Section E.

53. The mix of competitive and base funding in both universities and PRTs would benefit from enhanced monitoring. Competitive financing, particularly relating it to l i n k s with the private sector has the advantage o f getting the incentives right in terms of maintaining quality, encouraging linkages, and aligning research with established national goals. However, the burden o f constantly applying for grants, the fragmentation o f the research agenda, and the inability to take a long run view o f more r i s k y research can discourage research in projects with a potentially very high social rate o f return. This suggests that some degree o f base financing will always be necessary.

54. Chile has made important advances in shifting from a system dominated by small individual grants to multiyear grants to finance equipment and advanced training for research groups. Chile now has about 80 research groups - including centers o f excellence, science nuclei, advanced research teams and consortia - fimded by CONICyT, MIDEPLAN, C O W 0 and FIA. Building a critical mass by further

18

concentrating funding in a few strategic areas would stimulate excellence and strengthening Chile’s ability to tap into networks o f international knowledge.

55. Some universities have begun to develop polices for intellectual property rights, and there is growing interest in incubators. The most successful i s the Engineering Department o f the Catholic University which has supported the creation o f f ive new spin- o f f companies. However, in general, there i s a lack o f tradition among universities for stimulating entrepreneurship. Incentives to establish such amenities as accessible laboratory space or expanded access to young researchers are s t i l l quite limited. Again, the Catholic University Engineering Department has the most developed program in terms o f promoting exchanges.

Public Research Institutes

56. The role o f Public Research Institutes in the N I S varies greatly from the relatively diminutive in Sweden to the protean ITRI in Taiwan. PRIs are most relevant where they work with the private sector, but are independent o f it. Their task i s to set standards, and to a lesser extent, disseminate technologies and coordinate the various actors in the field. In practice, some functions, especially dissemination, are discharged by universities (such as agricultural technologies by Universidad de Chile). However, the dissemination o f applied technologies may require quite different incentive structures from basic research so that separate institutions may be called for. With that in mind, an evaluation o f PRIs would be useful in Chile. As yet there has been no comprehensive evaluation of how wel l they may bridge the gap between the private and academic sector, what is the social return on their research or how important i s the public good component within their research. The role o f technical institutes such as those in Spain as intermediaries between PRIs and businesses may also be worth exploring.

57. As with the universities, a central design issue for PRIs is the structure o f funding. In New Zealand, for example, a reduction in base financing led the Crown Research Institutes to behave more l ike private consulting firms and to deemphasize their role in providing public goods. Fundacibn Chile has successfully identified new products within the framework of Chile’s natural resource endowment, has conducted the necessary research to develop them, and has introduced them to the market. It has played a central role in discovery that has helped introduce new products, most notably the salmon. A fundamental question is whether there are other long term investment projects in their portfolio that could be undertaken if higher levels o f base financing were forthcoming.

Private Sector Led Innovation Related Tasks

58. There are areas o f innovation where governments lack the ability to choose projects and where the gap between the social rate o f return and the private rate o f return i s small. In those areas the preferred strategy i s to let the private sector take the lead. Two main policy instruments have been used to assist firms invest in R&D: tax credits and matching grants. Tax credits (which are not used by Chile at present) can lower the cost o f innovation without specifying the sector, leaving the individual firm to assess profitability. The econometric evidence suggests that tax credits effectively increase total

19

R&D. However, they often subsidize investments that would have taken place anyway without tax credits and there may be a mismatch between private and social returns. Furthermore, tax auditors frequently lack the expertise to distinguish between true R&D and other expenditures that firms may claim. In HybridMatching Grant Schemes, the private sector proposes projects and helps finance them, but a Government agency monitors performance in return for sharing the project cost or facilitating co-financing. These schemes encourage networking between sectors with relevant expertise and they permit better targeting to projects with high social returns.

59. In Chile today, technological institutes, together with firms, universities, researchers, etc, compete for a diverse array o f demand driven subsidies offered mainly by C O W 0 and CONICYT. They provide co-financing o f between 30 percent and 100 percent, depending on a number o f criteria including the benefit to the private sector, the nature o f the research, the involvement o f universities and technological institutes, the size o f the project and so forth. Econometric evaluations suggest that they increase investment in technology and also increase productivity. The amount o f co-financing could be fine-tuned to ensure active private sector commitment.

Other Barriers to Innovation: An Open Research Agenda

60. There are other barriers that constrain TFP apart from the N I S as i t relates to S&T issues. According to a recent survey o f businesses, resistance to change from senior management, and the cost o f labor redundancy both act as barriers to the adoption o f new technologies. However, the evidence for this i s weak at the present juncture and i t merits more research. The same survey finds that f i r m s do not undertake more innovation because o f technological r isks and long gestation periods. Credit markets may not provide the type o f finance needed by f i r m s to deal with the lumpiness, risk and long gestation periods o f innovative projects. It i s not known whether the l ow utilization o f venture capital constitutes a constraint or whether i t reflects a l ow demand for innovation. Numerous V C firms have been started and their failure is potentially suggestive o f barriers to innovation. Some VC managers argue that the lack o f a project pipeline reflects a shortage o f upstream financing by angel or other start-up investors. Other managers suggest that the pipeline exists but that V C f i r m s previously neglected the management dimension o f financing that plays a central role in the US. A more careful examination o f innovation financing i s warranted within the broader context o f business start ups.

E. EDUCATION

61. One of the more important barriers to innovation in Chile is an insuficiency of human capital. Education is critical to achieving high and sustained growth. I t also may be the most useful tool for increasing equality o f opportunity and thereby improving equity in Chile.

20

62. The education reforms begun in 1990 led to signzjkant increases in education investments and to a substantial expansion in the quantity and quality of education. The additional education investment has meant significant gains in terms o f education coverage. However, challenges remain with respect to access at certain levels and, especially, with respect to improving quality and equity in the education system. The State has an important role to play in easing constraints in the education market and in guaranteeing that al l children have access to education o f an adequate quality.

Investment in Education

63. Investment in education is high in Chile. Total expenditure in education as a percentage o f GDP almost doubled between 1990 and 2002, increasing from 4 to 7.6 percent. As a result of increased education investments, the level o f education expenditures relative to GDP i s similar to developed countries and even greater than the average o f OECD countries. The proportion o f private expenditure in education i s greater than most other countries (Figure 7).

Figure 7. Education expenditures: Chile, LAC and OECD (percent of GDP 2000 for all levels of education)

I

W Private 0 Public

Ireland Mexico OECD Argentina Korea USA Chile (averape)

Source: OECD (2004a).

Note: There are differences between data reported by OECD and MINEDUC, OECD considers academic year from September to May and MINEDUC considers calendar year from January to December.

Access to Schooling and Inequality

64. Despite significant increases in the educational attainment of the population at all income levels, 53 percent of today’s adult population in Chile has not completed secondaiy school. Low schooling levels are particularly prevalent among the poor (Figure 8). A remaining challenge is to provide educational opportunities to under- schooled adults, especially to those from low income backgrounds. In 2002, the Government launched “Chile Calzfica ”, a program designed to provide opportunities for adults to complete their basic education and acquire technical skills for the labor market.

21

65. Substantial gains in access to secondary school were achieved in the 1990s, with secondary school enrollment rates reaching 87percent in 2002. At the same time, there was a significant reduction in secondary school dropout rates, from 10.3 percent in 1991 to 8.5 percent in 2002. The increase in coverage i s associated with a notable expansion o f private subsidized schools, a product o f the early 1980s reforms, particularly in secondary education. The coverage o f preschool and higher education has expanded greatly since 1990, although preschool enrollment rates remain low by international standards.

66, while the secondary school enrollment gap between high- and low-income students narrowed between 1990 and 2003, the gap between high- and low-income students in preschool and higher education enrollment rates remains substantial. Inequalities by ethnic background also persist.

Figure 8. Years of schooling by income decile for population aged 25 years or more 1992-2002

16

14

12

10

8

6

4

2

0 1 2 3 4 5 6 I 8 9 10 (poorest) (richest)

SOCIOECONOMIC DECILE

Sample 20 percent with lower income and sample 5 percent total country Source: 1992 and 2002 Census.

Base: individual aged 25 years or more.

Higher Education Expansion, Quality and Equity

67. Since 1990, traditional universities have doubled their enrollment, while there has been a substantial expansion of enrollment in private higher education institutions. In the coming years, the demand for higher education is expected to increase as a result o f demographic trends as wel l a higher rate o f secondary school completion (Eyzaguirre, Marcel, Rodriguez and Tokman 2005).

68. Impfovements in eflciency, especially in universities, have lagged. While the graduation rate in non-university tertiary institutions is comparable to that o f OECD countries, i t i s substantially lower in universities with only 29 percent o f university entrants graduating in the required time compared with an OECD average o f 76 percent (Brunner et al, 2005). This low graduation rate implies that resources are not being used efficiently, and that Chile i s developing advanced human capital at a slower pace than its potential.

22

69, Equity of access to higher education remains a challenge, but the current administration has taken important steps to provide students with financing options. Funding for the “crkdito solidario” program has increased but it is confined to students who attend traditional universities and they constitute only a ha l f o f all students in higher education. In 2005, a parallel financing system was introduced for students attending private and non-traditional universities, as well as technical and professional institutes. Moreover, the Government is modi f jmg the principles for allocating resources under the old student aid system. Beginning in 2006, students will receive support based on their score in the university entrance exam, their socioeconomic profile and a newly introduced reference tuition fee which reflects the efficiency o f the institution they are attending with respect to teaching and research. Universities are divided into four sub- groups according to the results o f institutional accreditation. Each year the reference tuition fee for each group will be equal to the actual tuition fee o f the university with the highest performance rating and the lowest tuition fee. Hence, the new system promises to strengthen the link between tuition and quality while providing an incentive for institutions to improve their performance.

70. The recent expansion of higher education has also created challenges for prospective students and employers because information on the quality of new programs and new institutions is lacking. In an effort to reduce the information gaps, a national accreditation system for higher education systems i s being developed (Brunner 2004). Finally, since 1998, the Government has sought to improve the quality and relevance o f tertiary education by introducing competitive fbnding. Financing &om this source has been extended to over 300 university-based projects designed to improve teaching and university management.

The Quality of Primary and Secondary Education

7 1. National and international test results suggest that educational quality in Chile is low and shows little improvement. Average scores in the national S lMCE assessments during the last few years - and in particular since 1998 when the tests began to be standardized - show a worrying lack o f progress. Furthermore, a substantial gap exists between the average test scores o f Chilean students and those o f students from other countries in international assessments o f student learning, including the Third International Mathematics and Science Study (TIMSS) and the Programme for International Student Assessment (PISA). Even the best Chilean students -- those in the highest percentile o f achievers (who, in most cases, attend private fee-paying schools) do not perform well when compared with their counterparts in other countries or even with the national average o f other countries (Table 3).

23

Table 3. Chile’s educational performance i s low when compared to the OECD (Percentile Distribution of P ISA 2000 Mathematics Scores, by Country)

Japan

t Percentiles 5 1 75 I 95 Country Average

557 I 402 I 504 I 617 I 688

72. Schools that show no progress co-exist alongside schools that show continuous progress. Differences are not necessarily associated with the socio-economic level o f the students. They appear related to educational processes that are difficult to identify and replicate. I t will be difficult to redress shortcomings in the absence o f a strong technical capacity in schools as well as in municipalities and private providers (sostenedores).

73. The large increase in education coverage in recent years has depressed average test scores, especially in secondary education, because children who otherwise would have been outside the school system and who tend to have poor educational scores are now enrolled in school and are included in the assessments. Comparisons o f SIMCE scores across school types (private fee-paying, private subsidized, municipal) do not accurately measure quality differences, because they do not take account o f differences in the resources available to schools. Studies that adjust for available resources reveal that differences scores are substantially less when school and family resources are taken into account. Nevertheless, private fee-paying schools continue to show better results than private subsidized schools, which, in turn, show better results than municipal schools (Mizala and Romaguera 2001, Sapelli and Vial 2002, Gallego 2002).

74. Although diferences in average SIMCE scores between private and municipal schools are signijkantly reduced after adjusting for student socioeconomic background, the gap has important implications for public policy. To guarantee equal educational opportunity, all students should have access to a high quality education independent o f their circumstances.

75. Given the resource gaps that exist today, the poorest students deserve to be provided with additional resources. The standard subsidy per student discriminates against students from low socioeconomic backgrounds because they require above- average attention and educational resources. However, increased resources alone will not solve the problems faced by the Chilean education system. Education reforms in Chile would need to take account o f existing market failures and could foster competition between schools that may lead to improved education quality. A particularly difficult challenge will be to enable students f iom the lowest income quintiles to access higher education. Recent efforts to diversie student finance options for higher education are a

24

step in the right direction. To improve the overall cost effectiveness o f education, the continuous evaluation o f policies and programs i s important.

The Education Market in Chile

76. Decentralization, initiated in the early 1980s, transferred public school administration to municipal governments. I t also opened the way for private sector providers to participate in publicly financed education by establishing a voucher-type student-based subsidy. The goal was to generate an “education market” that would foster competition and thus encourage efficiency and improve the quality o f education.

77. However, diferences between subsidized private and municipal schools have impeded the creation of an “educational market ”. Public and private schools compete under different conditions, thus limiting the gains in efficiency and quality that would have been expected from the voucher-type student subsidy. As a result, the Chilean education “quasi-market” has been unable to raise average student achievement in the system as a whole, and it does not even ensure a high quality education for the elite (Eyzaguirre, Marcel, Rodriguez and Tokman 2005).

78. The most important differences between subsidized private and municipal schools are threefold. First, as far as student admissions are concerned, subsidized private schools can select their students while municipal schools are required to admit all applicants. Second, with respect to teacher contracting, subsidized private schools can directly hire and dismiss teachers, but municipal schools cannot. Third, private schools have alternative sources o f finance.

79. For a competitive education system to encourage quality, parents need to be fully informed about school quality. Well-informed parents can exercise control, demand quality from the schools and, if the school does not respond, they may transfer their children to a different school. In th is sense, information on the quality o f education institutions may be considered a public good. To be effective, th is information should be comparable among institutions, easily understood, timely, and accurate. The greater the proportion o f well-informed consuiners, the more efficient will be the education market (Gonzalez 2004). Indeed, the success o f market-based education reforms depends on the extent to which parents can make informed decisions over the range o f options that are available.

80. A recent study by Elacqua and Fhbrega (2004) finds that the reforms in Chile have not generated a critical mass o f informed education consumers that can effectively demand improvement. Parents, they find, have few sources o f information and have weak information networks. They have few options in choosing between schools and their choice i s based on very little specific information. Information on school quality available to parents i s limited to the average S M C E score for the school. That infomation i s not very usefbl because school averages mask important differences o f education quality. More importantly, as Elacqua and Fhbrega (2004) document, parents are concerned with factors other than test scores. The information that parents are able to

25

access depends more on their socioeconomic background than on the education system itself.

81. There is limited information on the quality of higher education institutions in Chile which creates real constraints to informed decision-making by students and their families (Brunner 2004). A promising initiative to improve the information available to potential entrants to tertiary education programs consists o f a labor market investigation o f tertiary education graduates. The country has set up a tracking system to follow the performance o f tertiary-level graduates in the labor market in order to monitor the quality and relevance o f programs. This investigation uses tax information to track the earnings o f tertiary-level graduates in all major occupations. Reliable information on labor market outcomes has enhanced the transparency o f Chilean tertiary education and provides prospective students with a basis for making informed decisions.

The Role of the State in Ensuring Quality and Equality o f Educational Opportunity

82. The accountability of public institutions could be improved. The presence o f multiple actors - the Education Ministry, municipalities and private owners, head teachers, teachers, pupils and parents - often leads to confusion about who has the responsibility for the quality o f education. Publicly financed private and municipal schools in Chile have little accountability to Government and to the public in general regarding how they use resources from the student-based subsidy. Raising standards for schools to access public subsidies would be an important step towards increasing accountability in the education system. As Eyzaguirre, Marcel, Rodriguez and Tokman (2005) observe, an education system as decentralized as Chile’s requires higher teaching standards to guarantee that children will have a command o f basic ski l ls . In that regard, the hment administration i s designing “maps” o f student skills for each grade to guide schools and teachers in their classroom work as wel l as to help in evaluating school performance.

83. The respective roles of the Central Government and Municipal Governments could be reformulated and schools could be granted a degree of autonomy depending on results. In the current education system, the Ministry is in charge o f technical-pedagogic issues, while the municipalities are responsible for administration. In practice, the municipalities’ assume little responsibility for student learning while the Ministry underestimates problems related to school management. Under an alternative model, a centralized system could design and evaluate policies and a decentralized apparatus could be charged with effective school management and supervision. However, given the diversity o f the education system, schools and municipalities would benefit fiom differentiated levels o f autonomy and supervision. Greater responsibility and autonomy could be granted to high performing schools, including authority for the use o f financial and human resources. Thereby, decentralization would be enhanced and there would be a stronger link between quality and finance, which today is weakened by the role o f the municipality. Greater decentralization and autonomy would be predicated on explicit performance standards for schools and their teachers. Under-performing schools would receive greater attention and supervision f iom the Ministry and municipal govemments, which would increase their pedagogic and administrative assistance. Intervention in

26

schools with consistently poor performance could be considered, including the transfer o f students to other schools.

84. Teachers play a central role in ensuring school quality. Attracting and retaining highly qualified and motivated teachers i s a necessary prerequisite for education quality. This will require a multi-year agreement with teachers to secure their participation and commitment to educational reform. Chile has made important reforms with respect to teacher incentives. Between 1990 and 2002 teachers’ salaries increased 156 percent in real terms. During this period, the Government launched a recruitment drive and established a scholarship program for outstanding students to study pedagogy. At the same time, the Government allocated substantial additional resources to schools, thereby improving overall working conditions for teachers. During this period, there was a 39 percent increase in the number o f students and the average score o f applicants to education programs increased by 16 percent.

85. The structure o f teacher salaries in Chile continues to be relatively flat, especially when compared to that o f non-teachers (Mizala and Romaguera, forthcoming). Teacher pay increases with seniority with l i t t le regard for the scope o f the teachers’ activities or the teachers’ effectiveness in the classroom. High-performing teachers are underpaid. In spite o f the awards that have been introduced for teaching performance, a large part o f the teacher salary supplement reflects years on the job rather than performance. Beginning in 2006, a school-based performance award for teachers, Sistema Nacional de Evaluacibn del DesempeKo de 10s Establecimientos Educacionales (SNED), will account for a bigger proportion o f a teacher’s salary. The size o f the award will have increased by 91 percent between 2004 and 2006, and as a result, teachers in a SNED-winning school will earn about double what they earn today.

86. Ensuring equity of educational opportunity remains one of the biggest challenges for Chile’s educational system. Students fi-om low and medium low socioeconomic backgrounds have substantially lower test scores than do students who come fi-om more privileged socioeconomic backgrounds (Table 4). Even more important than differences in test scores i s the school segregation by socioeconomic background that has taken place as a result o f the student-based voucher system (Cox 2005). Indeed, Hsieh and Urquiola (2003) find that the voucher program has led to increased polarization, with middle-class students leaving municipal schools for the private sector.

Table 4. SIMCE 8th Grade Test Results, 2004

Source: SIMCE, MINEDUC.

27

87. The current student-based subsidy i s provided equally to all students, independent o f the student’s socioeconomic background. A standard voucher leads to significant differences in educational results and encourages discrimination against students from lower socioeconomic backgrounds by schools that are able to select their students. Several countries have introduced differentiated vouchers to compensate for differences among students. Recently proposed legislation would introduce a student subsidy differentiated by socioeconomic background. The law would include a preferential subsidy to qualified students in pre-kinder through fourth grade o f basic education. Under the scheme, schools would comply with certain quality criteria to receive students with preferential subsidies and s ign an Equal Opportunity Agreement ((‘Convenio de Igualdad de Oportunidades”) with the Ministry agreeing not to reject students.

88. While most children from the highest income quintile attend preschool, the proportion of children @om low-income families attending preschool is ve ry low. The gap in preschool enrollment rates by income background is troubling because preschool attendance has been shown to have important effects later on school outcomes. Raising preschool enrollment rates overall and especially among the poor would l ikely improve educational outcomes and reduce inequality both in education and in the labor market.

89. Improving equity of access to higher education is also important, and Chilean secondary and tertiary institutions face the challenge to work together to bridge the gaps in access to tertiary education. To a great extent, inequities in tertiary education stem from problems o f quality in secondary education and low completion rates among students from poor and indigenous backgrounds. Recent efforts to expand access to financing for students attending tertiary education institutions deserve to be strengthened. Moving toward a results-based framework for allocating resources to tertiary education institutions will foster improvements in quality. With only 5 percent o f direct public funding (AFD) for traditional universities allocated on a performance basis, there i s room for strengthening accountability by tying incentives to the achievement o f key sector priorities.

Supporting the Evaluation of Education Policies and Programs

90. Evaluation of education policies and programs is necessary both to make adjustments if necessary during implementation as well as to design efective reforms for improving quality and equity. The Chilean education system has made substantive progress in designing indicators for the evaluation o f policies and programs. However, more can be done. Panel data o f students, teachers and schools would enable the evaluation o f education policies and programs to be improved. The evahation o f policies and programs has positive externalities that can benefit a broad range o f public interests. Hence, Government support for the evaluation o f education policies and programs is important.

91. Evaluation can be built into program design. In Chile, the introduction o f a preferential subsidy for students from low-income households as wel l as the introduction o f a new student loan scheme for students attending non-traditional universities and non- university institutions could be accompanied by a comprehensive impact evaluation.

28

F. ENHANCING SOCIAL PROTECTION

92. While education can go a long way toward creating equitable opportunities, it is rarely suficient for overcoming the risks to welfare aflecting the most vulnerable. Recovery from economic shocks may undermine human capital or hinder investment. Although there are wide differences between countries, social protection policies are generally intended to safeguard human capital. Social protection systems (comprising policy interventions, public institutions, and the regulation o f private institutions) aim at helping families manage shocks to their income that may otherwise threaten their human capital. Given the well-established l i n k s between human capital and economic wellbeing, social protection is a key instrument in the fight to alleviate poverty and increase equity.

93. Protecting human capital is also critical to promoting and sustaining economic growth. Where households do not have a sufficiently wide array o f tools with which to insure against risks, they may need to spend scarce resources recovering from shocks that could otherwise be put to productive use. Where there exist few options for mitigating the losses k o m shocks, households may avoid potentially profitable but risky investments- for example, adopting a new, more productive technology,-for fear o f failure. Since there are many risks that cannot be covered by private insurance, there is a clear role for Government in sheltering households from those risks.

94. Social insurance-the principal instrument for social protection in most countries-should protect households from poverty provoked by an income shock. Social assistance should gradually lift the currently-poor above the poverty line. Thus, a country’s poverty indicators are ultimately the most relevant and objective criteria against which to evaluate i t s social protection policies.

95. Judged by these criteria Chile has done extraordinarily well, even if the progress in eliminating poverty is due to a broader set of policies than social protection. For most o f the late 1980s and 199Os, poverty in Chile declined. This achievement was mainly associated with economic growth-the h i t o f market-fiiendly policies and prudent economic management-as wel l as with increases in targeted social spending. However, although there are fewer poor households the level o f indigence remained stubbornly high since the mid 199Os, and has only recently begun to fall. Chile continues to have one o f the highest levels o f economic inequality in the developing world. Finally, many households remain vulnerable to poverty from adverse income shocks such as job loss, costly treatments for injury or sickness, and the losses to income associated with o ld age. A recent Bank report-“Household Risk Management and Social Protection in Chile” (World Bank, 2004a)--concluded that Chile largely succeeds in providing households with the instruments needed to mitigate shocks to their income and to protect their human capital.

96. The instruments Chile has put in place to help households mitigate losses from income shocks are generally well designed. Nevertheless, too many Chilean households, even among the non-poor, s t i l l do not have access to social protection. Lack o f coverage continues to be a pressing concern. The principal shocks to income are often correlated. Households who earn incomes close to the poverty line are made particularly vulnerable

29

to an array o f shocks if members have lost employment. If they have lost a job in the informal sector or are among the self employed whose businesses fail, their vulnerability i s compounded by explicit and implicit barriers to even basic forms o f social protection. Since a significant number o f uncovered workers are not counted as poor, the relatively well targeted social safety net that Chile has in place-including its flagship policy initiative for the poorest, Chile Solidario, launched in May 2002-will not extend to them.

97. As an indication o f the magnitude o f the problem, 12 percent o f working men from urban households and 20 percent f iom rural households were employed without a formal contract o f employment, while 21 percent and 33 percent respectively, were self employed. The percentages are even higher further down the income distribution. Thus the over-arching challenge for policy makers in social protection is to extend coverage to these vulnerable groups without creating moral hazard or dependence, and without impairing opportunity and enterprise.

98. The following sections explore the main shocks to household welfare - unemployment, the costs o f health care, and the losses that arise with ageing. I t provides a summary assessment o f the institutions Chile has in place to cover the losses. The final section contains policy recommendations.

The Main Risks to Household Income Security, Outcomes, and Remaining Challenges in Social Protection

Changes in Risk and Coverage

99. The point o f departure for th is analysis i s an assessment o f the risks households face, and how they vary between urban and rural households and between income groups. Risks to earnings-capacity and income are classified by age bracket (see Tables 5.1 and 5.2 in Chapter 5, o f Volume 2). For example, the risks to h tu re earning capacity that affect ages 0 to 5 are malnutrition and failure to attend pre-school. Later in life, lags in educational attainment, unemployment or employment without a contract (Le. “informal employment”) can pose a risk to income and human capital. Risk indicators are specified. The coverage o f Government programs to help households manage risks i s assessed.

100. I n every age group there was noticeable improvementfiom 2000 to 2003. Risks are generally lower, particularly in the area o f education. For example, failure to send children to primary school fe l l by over 18 percent among indigent households in urban areas, and by over 35 percent among the poor in rural areas. However, progress towards mitigating risks to earnings directly related to the labor market-fiom low labor force participation; unemployment; non-professional self employment-has been mixed. Although more job seekers from poor and indigent households found jobs with a contract, unemployment among the rural indigent increased by 33 percent and among the rural poor by 16 percent. The poorest households continue to be the most vulnerable in the labor market.

30

10 1. Chile ’s households are relatively well covered by social protection programs, and beneflciaries of these programs tend to be fiom the lower income brackets; however, gaps in coverage are still apparent especially among the poor and in rural areas. From 2000 to 2003, Chile succeeded in reducing many o f the gaps in coverage, particularly among lower income groups. For example, coverage o f health and pensions rose among indigent and poor households in rural and urban areas alike. While definitive evidence i s sti l l pending, much o f the progress may be attributable to the Government’s concerted efforts to eliminate indigence since 2002 through Chile Solidario. Yet there remain many gaps in coverage. For instance, unemployment benefits (both non-contributory transfers and payments from insurance) cover less than 6 percent o f jobless in poor and indigent households.

102. Preliminary evidence concerning the impact o f Chile Solidario may help to explain some o f the outcomes observed among households in the lowest income groups. After June 2004, the first families who entered Chile Solidario through FOSIS’ Puente program in 2002 began to graduate from the first two-year phase o f the initiative. During the first stage o f the Puente program, the degree to which households met the 53 minimum conditions targeted by the program varied greatly from region to region. Participating household found it especially difficult to (i) keep household income above the indigence line; (ii) secure adequate housing; and (iii) keep at least one working-age adult in regular employment.

Changes in the Risk of Job-loss and Extended Periods of Unemployment

103. The functioning o f the labor market is particularly important for social protection since that i s where most households gain access to Government programs designed to help manage risks. From the household’s perspective, labor i s among the most important o f family assets, particularly for the poor, and earnings from employment are typically the largest source o f income. Thus, the income lost from extended periods o f unemployment i s serious in most cases and may even be catastrophic. From the perspective o f social protection policy, the critical question i s whether the risk o f extended unemployment i s high, and whether social protection policies-including minimum wage and job security provisions-are compounding the risk or hindering the effectiveness o f other instruments o f social protection.

104. There is increasing concern that Chile’s labor may be losing eficiency (Figure 9). These concerns have been compounded by the relatively high rate o f unemployment since the last major recession in 1999 when unemployment rose to levels not observed since the mid- 1980s. Since 1998 minimum wages have increased by about 20 percent in real terms. Social protection policies-including the minimum wage and social insurance contributions-raise the cost o f labor. Comparative research shows that the minimum wage in Chile i s relatively high and an effective constraint upon the labor market. However, despite the rise in labor costs, contracted employment increased slightly from 2000 to 2003.

31

Figure 9. Minimum cost of labor in Chile and OECD countries'

43

Source: OECD (2004b and 2004c)

105. Although the long economic slowdown that began in 1998 took a serious toll, the incidence and duration of unemployment in Chile can be attributed in part to policy factors. The effect upon the labor market o f changes in job security remains ambiguous. However, after adjusting for the impact o f the business cycle, increases in the minimum wage significantly raise not only the risk o f unemployment but also the risk of losses from protracted periods o f joblessness. The duration o f unemployment fell in 2001 but the average duration has held steady since then and slightly increased in 2004 despite a lower rate o f unemployment.

106. A preliminary assessment of "Chile Solidario " shows that even families who have graduated j?om the first phase of the program find it hard to stabilize income and employment. Despite three years o f economic growth and a fall in the overall rate o f unemployment, men from the poorest households in urban areas did not experience a reduction in unemployment. Among men from the poorest households in rural areas unemployment increased by 7.3 percent.

107. Chile's new unemployment insurance system wil l help cushion losses of income, but the new system does nothing to increase coverage. By shifting to pay-roll contributions as the main source o f financing, the system draws a sharper distinction between the protection enjoyed by workers with a legal contract, and those without one, including the se l f employed. Nor i s unemployment insurance, even if based on individual accounts, l ikely to increase incentives for greater "formalization". The new accounts are

The cost o f labor indicator shows the legal minimum wage and the corresponding social security/pay-roll contributions paid by employers where there i s one, as a percentage o f the average wage. The data are taken from 2002, the last year for which comparable statistics have been published.

32

not replacing a PAYGO system, as old-age savings accounts did in 1981, and their introduction has added to non-wage labor costs. However, it is too soon to draw any definitive conclusions about the new system. N o w that the new unemployment insurance system has completed i t s third year o f operation, it would benefit fi-om an early and rigorous evaluation.

108. A recent evaluation of Chile’s public employment programs found that they covered only 9.7 percent of the unemployed and 30.3 percent of unemployed heads of household in 2003. The evaluation shows that direct programs seem to do a better job o f targeting the poor and indigent. Data are not available that would allow an assessment o f the extent to which the Government’s preferred employment-subsidy program favors poor or indigent groups.

109. The new programs are not likely to reach the most vulnerable. First, employers are l ikely to use the subsidies to hire the most employable workers-that is, those who need the subsidy the leas t -o r to formalize workers already employed informally. Second, by paying the minimum wage, and offering pensions and social security coverage, the Government may have created relatively attractive jobs with above-market wages as wel l as social insurance coverage. To the extent that publicly created or subsidized employment i s relatively attractive (especially to workers who would not otherwise j o in the labor force), i t will be politically very difficult to eliminate those positions and move workers into private sector jobs or eliminate job-creating subsidies in periods o f economic growth. If the Government cannot easily dismantle costly public employment programs, i t may hesitate to introduce them again in future recessions.

110. Workers in the informal sector, and the self employed whose income suffers in a down-turn, have easier access to public employment programs than to contributory schemes such as unemployment insurance. The PEPS, particularly FOSIS PRLE and the SENSE employment subsidy, seem to be succeeding in placing some o f the unemployed in jobs and in upgrading their skills. There remain concerns, however, not with the programs’ job-placement function, but with their income-protection function. Participation i s conditional on the presentation o f a Jiniquito (proof o f unemployment) and that excludes informal sector workers and leaves them without an alternative instrument to mitigate losses fi-om unemployment.

11 1. Furthermore, ifthe minimum wage continues to rise as quickly as it has in recent years, there could be fiscal consequences. Offering above-market wages imposes three separate economic costs. It attracts more workers to public employment programs, pays each o f them more than they would otherwise earn, and it may crowd out private employment. As Chile’s Government has discovered, if public employment programs offer (or subsidize) above-market wages, the fiscal costs o f these programs can increase unless access i s rationed. But th is places the Government in the uncomfortable position o f operating with quantitative rather than price incentives. Since 2001 the number o f hours and work days under the direct employment programs has been significantly reduced, and the number o f beneficiaries o f the indirect programs was strictly limited to contain costs. In effect, with regard to public employment programs, the Government has substituted un-rationed, self-targeting forms o f income protection, with employment assistance that

33

i s relatively expensive in terms o f above-market wage costs and which is strictly rationed and thus o f limited coverage. Should it again be faced with a deep recession in the wake o f an external shock as i t was in 1998 and 1999, the Government may have to re-consider th is choice.

112. A binding minimum wage may be limiting employment prospects for the very poorest groups that “Chile Solidario” aims to integrate into society. In addition to targeting public employment programs even more effectively to the very poorest, Chile can learn much from the pro-active approach o f the United States and the United Kingdom to training and job-search assistance. At the same time, i t may be necessary for Chile to reconfigure the minimum wage ta ensure that i t does not discourage employment at the lower end o f the earnings scale. Further empirical research may be required on that issue.

The Risks to Income and Impoverishing Impact of Health Costs

113. In the event o f sickness or injury, medical expenses may crowd-out other basic household expenditures and may even constrain human capital development. The cost o f medical care can plunge households into poverty, and make i t difficult for the already- poor to escape from poverty. Hence, it is not only important to maintain and improve the health o f the population, but also to ensure that households are protected financially. Chile has recently taken significant strides to ensure greater financial protection in the event o f sickness or injury.

114. Out-of-pocket medical expenses are a good indicator o f financial vulnerability. In Lat in America, 85 percent o f private health expenditures on average are paid out-of- pocket by households. In Europe and the OECD the average i s only 72 percent. By this measure, Chilean households may be relatively less vulnerable, paying only 60 percent out-of-pocket for health care.

115. Nationally, about 1 percent o f households are newly-poor as a result o f health spending.8 Households in the third income quintile are the most vulnerable to impoverishment provoked by health costs. About 5 percent o f households in that group are made poor by the cost of health care. Households in the f i rs t and second quintile also have a substantial degree o f vulnerability.

116. To address th is problem Chile, since 2002, has been gradually introducing a new health insurance benefit package (the Universal Access with Explicit Guarantees-or AUGE Plan). AUGE establishes a minimum basic package of health cover for all Chileans, along with guaranteed medical treatment within specified time periods. Co- payments are capped and the poorest households are h l ly subsidized. The Chilean health finance reform i s very recent and l i t t le evidence exists yet concerning i t s impact on the poor. Initial results look promising. The “explicit entitlements approach” is already reducing financial vulnerability to health costs and also raising the quality o f health service delivered.

* See Bitran et al. (2002).

34

117. However, there are concerns for the financial sustainability o f AUGE. The subsidies implied by the ceiling on co-payments imply new fiscal costs. The Government chose to meet these costs through a modest increase in VAT and through extending mandatory contributions to the self employed who have previously been outside public health schemes. There is interest in possibly shifting the financial base for health coverage even further to VAT, which experts agree would be more efficient and might even allow a reduction in Chile’s pay-roll taxes.

118. However, only a small number of countries have succeeded in making such a transition, and the Government’s earlier attempts to raise value added taxes were met by stiff opposition. Among the countries that have succeeded, Spain’s experience i s o f particular relevance. The shiR away f iom pay-roll tax contributions to broader based taxes could not be done quickly. I t would require a transition period during which some risk-rating would have to be introduced to encourage workers currently outside the system to take up coverage. At the same time, poorer households would be protected with subsidies.

Covering the Risks to Income that Arise with Ageing

1 19. The elderly fiequently experience a loss o f earnings and increased health care costs. These stem from the loss o f earning ability, unanticipated longevity (that increases the period o f l i f e when an individual has to consume but cannot earn income f iom work) and, fkom these, an increased vulnerability to poverty in o ld age. Chile’s Government has an array o f instruments to help households manage these risks, both directly and through the regulation o f private pensions. Structural reforms in 1981 shifted the system away from a single-pillar “defined benefit” public pension to a “multi-pillar” system in which the private financial sector plays a leading role. The instruments are broadly efficient and effective. Chile’s multi-pillar pension system has two “first pillar” instruments, the minimum pension guarantee (MPG) and the targeted social assistance pension (PASIS) which pool the risk o f poverty. “Second pillar” savings (AFP accounts) and annuities ensure and protect a minimum level o f consumption. In addition a voluntary “third pillar” o f savings (“ahorro provisional voluntario”, APV) receives encouragement through tax incentives and regulated private instruments.

120. In terms o f protecting consumption and preventing poverty, the benefits yielded by Chile’s f i rs t and second pillars can be compared favorably to mandatory plans in the OECD, provided that workers fully participate. Whereas policy makers in most OECD countries are concerned at the prospect o f financially unsustainable pension systems, Chile’s pension deficit is largely related to the transition-cost o f the 1981 reform. The deficit currently averages 5.6 percent o f GDP and is gradually declining. However, in Chile (as in other Lat in American countries), participation in the system falls short o f the minimum necessary to secure financial targets.

121. I n the past Jiften years, the proportion of the labor force that contributes to the pension system on any given month has rarely been higher than 60 percent.’ While this

~

Valdes and Beyer, 2004. 9

35

participation rate is high by regional standards, surpassed only by Uruguay, i t i s wel l below participation rates in the OECD. Contributions to the system from most participants are irregular and are subject to frequent interruptions. Upon reaching retirement, most contributors do not have sufficient years o f contributions compared with other OECD pensions systems. The regulators o f the pension system in Chile estimate that wel l over 50 percent o f articipants will not even be eligible for the Government minimum guaranteed pension. Po

122. Although research is far @om conclusive, all else equal, low rates of participation may be linked to the perceived high costs of the system which stem from insuficient competition between private fund managers. The three most important issues confronting Chile’s pension system are coverage, cost and competition. There has been increasing criticism o f private fund managers who make high profits and fail to deliver greater efficiency and cost-savings to households through market competition. l1 L o w system coverage, lack o f competition and high costs are not only detrimental to the effectiveness o f system, they also threaten the system’s credibility. To the extent that the system loses credibility, the important gains from structural reforms in the 1980s could come under attack.

123. Recent changes to the retirement security system in Chile have increased investment options for the private second pillar, increased price competition in the annuities market which caters to second-pillar aflliates, and have increased savings in the voluntary third pillar. The Government i s considering further changes to the second pillar, with three specific objectives in mind: first, to increase the rate o f participation by further enhancing incentives and lowering the transactions cost o f participation for the self employed; second, to lower administrative costs by exploiting economies o f scale in account management; and third to ensure cost savings are passed onto workers in the form o f lower commissions, by ensuring greater competition in the industry through the strategic use o f auctions.

124. The Government’s ideas for changes to the second pillar are very promising, and recent moves to strengthen the third pillar are also extremely positive. However, as mentioned above, up to hal f o f participants have poor contribution records and as many as 19 percent o f men and 32 percent o f women are not even enrolled in the pension system. Furthermore, the tax incentives for voluntary retirement savings-which have been found to be regressive in several countries-are l ikely to have only a modest impact on savings because few Chileans pay income taxes. Gains from reforming the second pillar and giving greater weight to the third pillar could go hand in hand with consolidating and strengthening the set o f instruments intended to prevent poverty in o ld age-both the non-contributory, rationed PASIS (currently set roughly equal to the poverty line), and the contributory minimum pension guarantee (which i s roughly twice the poverty line).

lo Bernsteiq Larrain and Pino (2004 and 2005). l1 Valdes (2005), Gill, et a1 (2005).

36

125. If all workers contributed to the earnings-related pension system, the current structure o f the minimum pension guarantee would be relatively good. I t encourages workers to save privately and guarantees a minimum level o f retirement income at a minimum cost to tax payers. However, in countries l ike Chile where many workers will not have a sufficiently long history o f contributions to the pension system, the current structure o f the MPG as a top up conditioned on participation can not only exclude large segments o f the population but also lead to perverse transfers from all tax-payers to the relatively wel l o f f workers in the formal sector.

126. Chile could move toward consolidating and simplifling its poverty prevention pensions (the PASIS and the MPG) into a single, perhaps pro-rated public risk-pooling device against poverty in old age. Ideally, that would involve setting a single minimum benefit financed from general taxation, indexed to prices, available at a retirement age that i s periodically adjusted to changes in life-expectancy, and targeted to the elderly poor. However, the current limit on the number o f benefits paid needs to be abolished because it leaves uncovered as many as 19 thousand women and 11 thousand men who would otherwise qualify for the PASIS. Once a non-contributory o ld age benefit i s put in place, a contributory minimum pension guarantee or matching contribution scheme targeted at lower-income workers would cease to be a “first-pillar” device and would instead encourage more low-income workers to participate in the second-pillar.

Summary of Key Policy Options for Social Protection

127. The over-arching challenge for policy makers in social protection continues to be extending coverage among vulnerable groups - particularly individuals earning wages near the poverty line, who are engaged in unregulated, informal employment or who are se l f employed - while avoiding moral hazard or dependence and, at the same time, fostering opportunity and enterprise.

128. With respect to unemployment, the coverage o f income protection - including the contributory unemployment insurance system, and public employment programs - i s sti l l very low. There i s concern that unemployment benefits &om the contributory system may be o f too short a duration, in light o f the increasing average length o f unemployment. The structure o f the new public employment programs limits their effectiveness as an instrument o f income protection. In particular, they present explicit barriers to workers in the informal sector. There is particular concern the beneficiaries o f Chile Solidario and other low-skilled groups may find it difficult to find employment in the labor force. Job security regulations and the minimum wage may be limiting the employment opportunities for low-skilled groups. More could be done to improve the efficiency and performance o f local employment offices.

129. With respect to the cost o f health care, the AUGE reforms have put Chile at the fore-front o f financial protection through the shift to an “entitlements approach”. Changes in the delivery o f health that care will be necessitated by the shif t to an entitlements approach will have to be closely monitored. To finance the system, the Government could consider a further shift away from the pay-roll tax toward general revenues.

37

130. With respect to the elderly, the Government has taken bold strides in developing the third pillar o f voluntary retirement savings. I t has also widened options for workers to invest their second pillar mandatory savings and introduced changes that have brought down the price o f annuitizing these savings. However, with respect to protecting a basic minimum level o f consumption, the Government could consider two further measures. The first is a reform o f the second-pillar investment regime to gradually sh i f t from a compliance based approach toward one based on risk management. The second i s a change in the structure o f fund management to exploit opportunities for further cost- savings and to foster competition so that the savings are passed-on to participants in lower fees. Whether or not broader investment opportunities and lower commissions attract greater participation from households - currently a low 60 percent o f the labor force - Chile faces a pressing challenge to consolidate i t s first pillar o f poverty prevention. A good first step would be to lift the numerical limit on social assistance pensions.

131. In Chile, there is no lack o f formal institutions to help workers manage risks to income. However, they are only available to a minority o f workers with legal, regulated farms o f employment. To extend that protection to the majority, the Government can: (i) lower the cost o f labor regulations and increase regulatory enforcement so as to foster formal employment; (ii) finance social security schemes from general taxation rather than from levies on employment, and (iii) introduce "self targeting" instruments o f social protection that are not based on formal labor contracts. Chile has already advanced more than many other Latin American countries in pursuing the f irst o f those options. I t can go further by removing explicit barriers and quotas to minimum forms o f income protection as it improves i t s targeting and enforcement capacity. It can also further encourage households to take up instruments that will afford them more than minimum coverage.

132. Above all, however, the best guarantee o f social protection is good macroeconomic management and employment creating growth. Even the best designed social protection system i s a poor substitute for the welfare that comes from a secure job. Ensuring that the economy is managed so as to generate adequate employment and that labor market policies facilitate rather than impede employment creation i s the most important aspect o f sound social protection policy.

G. PUBLIC FINANCE ISSUES IN DEVELOPMENT

133. Public expenditures will be subject to upward pressure over the medium and long term as a result o f demographic factors, the convergence o f per capita income to the level o f advanced countries and social demands. A key challenge will be to respond to the pressure for increased expenditures without impairing the prospects for growth and development.

134. Even if public expenditures are wel l structured so that they are both pro-growth and pro-equity, the net effect on growth and equity will hinge on how expenditures are financed. That, in turn, depends upon the efficiency and equity o f the tax system as wel l

38

as on other financial arrangements - particularly the fiscal rule - that constrain debt financing o f public expenditure.

135. This section examines three issues. First, i t reviews the performance o f public expenditures and identifies l ikely trends over the medium and long term based on the experience o f comparable countries and Chile's own expenditure needs. Second, it identifies key efficiency and equity issues in the tax system and suggests policy options to lower evasiodavoidance, improve efficiency and equity. Third, it analyses Chile's fiscal rule and examines possible options to improve i t s design over the short term as wel l as longer term alternatives.

Public Expenditure - Development Needs

136. Social expenditures have grown fast since Chile returned to democracy in 1990. The share o f education rose from 11.1 percent o f central Government expenditures in 1990 to 17.8 percent in 2003. Over the same period the share o f health increased from 9.1 percent to 14 percent (Figure 10).

137. In spite of rising social expenditure, Chile was able to maintain Jiscal surpluses for most of the 1990s. This was possible partly due to revenue performance and partly due to a reduction in the relative share of expenditures for defense, debt service and social security. The share o f expenditures for defense decreased from around 10 percent in the early 1990s to 7 percent over 2000-03. Falling debt and lower sovereign risk spreads brought down debt service from 9 percent to 2.2 percent o f GDP over 1990- 2003.

Figure 10. Real Expenditures: 1990-2003 In 2002 pesos

IS90 1981 1992 1993 Is94 1995 1996 1987 1998 lsSe 2wO 2M)I 2 W 2W3

4Wb!&DebtTransectinm +@---Defense -bk& -CEducal!m

Source: Ministerio de Hacienda, DIPRES

138. The ratio of social expenditures to total public expenditures is relatively high in Chile -70 percent compared with an average of 45 percent in all countries for which data was available. This places Chile at the same level as Uruguay, Switzerland or New Zealand. As a share o f GDP (around 15 percent) i t is above the predicted value based on a cross country income comparison. Social expenditures include expenditures on social security, which are low in Chile because the system was privatized in the early 1990s and

39

the Government only pays for those individuals who choose not to participate in the new system. Hence, Chile i s even more o f an upward outlier among international comparators than the 70 percent ratio may suggest.

139. Health, education and cash subsidies provided by the Government are targeted towards the lowest income quintiles (Figure 11). There has been an improvement in targeting in terms o f the share o f subsidies that go towards the lowest three quintiles. These transfers effectively diminish income inequality (World Bank, 1997).

140. There has been little progress with educational subsidies since 1990 and a signiJcant part of them still goes to the wealthiest two quintiles. In 2003, 8 1.2 percent o f education subsidies were received by the poorest 60 percent o f the population, compared with almost 90 percent for cash transfers, and nearly 100 percent for health subsidies. Hence, an improvement in targeting educational subsidies, which currently do not take into account the income o f recipients, can help to reduce income inequality s t i l l further.

However, progress has been uneven.

14 1. International comparisons with countries that started JFom a similar income level and have undergone periods of fast growth suggest that new expenditure pressures are likely to emergeporn: (i) demographic factors, (ii) social development needs and (iii) a demand for new public goods as income increases.

Figure 11. Targeting of Social Expenditures: Shares of Public Subsidies Received by Income Quintile, 1999,2000 and 2003

140

120

100

80

60

40

20

0

Monetaly Subsidies Health Subsidies Educational Subsidies

1990 2000 2003 I990 2000 2003 I990 2000 2003

Source: Ministeno de Hacienda, 2004.

142. Demographics. The proportion o f the population over 65 years o ld is projected to increase fkom the current level o f 7.8 percent to 11 percent by 2020. An aging population will increase the public costs o f health and pensions. First, the elderly have a higher incidence o f sickness and they require more expensive medical attention. The majority o f older people belong to the public insurance system (FONASA) and, hence, the burden o f an aging population will fall on the Government. Second, the pricing system o f public and private insurance provides incentives for individuals at high risk to shift fkom the private to the public provision o f health as they become older. The latter charges a flat

40

fee for service, while private insurances price their services according to the risk profile o f the insured. Third, as the population continues to age, a greater proportion o f the elderly will find themselves with incomes that fall short o f the State-guaranteed minimum pension and they will need to draw upon supplementary public pensions. The fiscal cost o f minimum pensions to cover old age, disability and widowers i s expected to quadruple over the next 15 years to over US$300 mi l l ion by 2020.

143. Some o f the causes o f public expenditure growth can be contained through structural reforms. For example, regulatory reforms on the pricing o f private-public health insurance can help to contain costs. Proposed revisions o f the pension system - as discussed in section F - could also help to contain costs by adjusting the retirement age from time to time in line with life-expectancy.

144. Social development needs. There is an awareness in Chile that public expenditures are an important vehicle for redistributing income. It is also recognized that it i s the task o f the State to ensure equality o f opportunity. Both those factors will l ikely lead to an increased demand for public services. As the system o f primary and secondary education approaches universal coverage, society will demand a higher quality o f instruction which, in turn, will necessitate expensive teacher training and other complementary services. Also, the number o f students in tertiary education will increase thereby requiring greater resources for the Universities and grants to students from low-income households as discussed in Section E. Greater participation o f women in the labor force will require an expansion o f the current system o f childcare. Pre-school education can also help to level the playing field for students o f diverse socio-economic backgrounds. Finally, social programs will need to be expanded in order to lift from poverty the sti l l large numbers o f poor. The likelihood that social expenditures will continue to increase i s supported by the experience o f EU and OECD countries. In those countries public consumption and investment have declined as percentage o f GDP. Only social transfers have shown an upward trend over the past 25 years.

145. Demandfor new public goods. As incomes reach a level comparable to that o f more advanced economies, and the basic needs o f the population are satisfied, it i s l ikely that society will demand new public goods corresponding to a higher standard o f living and the development o f a knowledge-based economy (as argued in Section D). Expenditures relating to citizen’s rights, environmental protection, urban development, transport, pollution, justice and security al l tend to have an income elasticity greater than unity in high income countries. Chile too, i s l ikely to experience increasing expenditures in those areas.

Public Expenditure and Economic Growth

146. The experience of other fast growing emerging economies provides a basis for assessing the likely future trend of aggregate public expenditures in Chile. In the recent past, five countries experienced an increase in income from around US$lO,OOO to around US$20,000 over a period o f twenty years in PPP terms. That is where Chile may expect to be 20 years from now. The fastest growing economy was Hong Kong, whose per capita income went from US$9,043 in 1979 to US$23,863 twenty years later. Singapore

41

followed a very similar path. Ireland lagged in growth during the first couple o f years, but eventually reached the same level o f income by the end o f the period. Portugal

’ provides the relatively low growth scenario, as it reached a GDP per capita o f around US$17,000.

147. These countries experienced a remarkable expansion of total public expenditures during the two decades when their economies were growing fast. Cyprus, Ireland, and Portugal saw their real expenditures more than double, while Singapore saw its expenditures grow fourfold. These experiences indicate that the Chilean Government may expect much higher public expenditures in the long run and, accordingly, that i t would benefit f iom exploring financing options.

148. The relationship between growth and public expenditure is complex. To begin with, the composition and efficiency o f Government spending are potentially more important than size in explaining growth, poverty and inequality. The literature distinguishes between ‘productive’ and ‘unprod~ctive’ public spending and analyses the different effects o f each on growth (Aschauer, 1989). Government expenditures enter the aggregate production h c t i o n directly in endogenous growth models that include human capital as a factor o f production. Since public investments in education and health improve the quality o f human capital, expenditures in those areas should have a positive effect on economic growth.

149. Perceptions that there is a trade-of between growth and equity through the tax and transfer system imply that public expenditures are ineficient. That implication is not supported by the evidence in OECD countries. Lindert (2005) for example found that welfare programs such as basic social assistance, public health and pensions in OECD countries tend to have pro-growth effects. If social public goods are perceived by households to have a net benefit, labor taxes may be neutral in the sense that they don’t distort the labor-leisure choice o f workers. In that case, public spending need not be a drag on growth.

150. The literature shows that well executed public spending on infrastructure complements the eforts of the private sector, and in some cases it might be essential for economic growth. A seminal paper by Aschauer (1989) found that public investment had a significant effect on economic output in the United States. Kamps (2004), using new capital stock estimates for 22 OECD economies found a significant and positive elasticity o f output with respect to public investment, thereby demonstrating that Government investment i s productive. Easterly and Rebelo (1994) found that investment in communication and transportation structures can have a positive impact on growth. However, the empirical link has not been unambiguously established, and the possibility exists that inefficient and costly public projects may have a negative impact on growth.

15 1. In short, economic and social development will require higher public expenditure which, in turn, can become an important engine o f economic growth. The financing o f those expenditures - examined in the following subsections - will also affect growth and equity outcomes.

42

Financing Development - Taxes

152. mether or not taxes impair growth is less controversial than whether public expenditures do. Taxes may distort decisions by reducing labor effort (taxes on income), by creating disincentives to save (taxes on saving), or by inducing a misallocation o f resources (when different sectors or regions are taxed at different effective rates). Tax policy can also affect equity and economic efficiency through collectiodcompliance costs, tax evasion or avoidance. On the other hand, debt financing-to the extent that it is perceived as h t u r e discounted taxes-may also discourage work, saving or investment and it can crowd out private investment through higher interest rates. This subsection evaluates options for reducing tax avoidance and evasion (horizontal equity), improving tax progressiveness (vertical equity) and, more generally, improving the overall efficiency o f the tax system.

The Tax System

153. The Chilean tax structure is dominated by the VAT, which generates 50percent of the total tax revenue. The strong consumption orientation o f taxation implies a relatively regressive structure. Two other main sources o f tax revenue are the income tax (personal and corporate) and excise taxes (cigarettes, alcohol, gasoline), which represent 25 and 13 percent o f federal tax revenues respectively. The shares o f the three main sources o f tax revenue have been relatively constant over the last ten years. Tax revenues increased 46 percent in real terms between 1995 and 2004 but Chile’s tax ratio i s s t i l l below the average o f comparable countries (Figure 12).

154.

a

0

0

0

155.

Chile’s income tax has four categories as follows:

The f i rs t category (corporate) applies a 17 percent uniform tax rate (about ha l f the rate prevailing in most Latin American and OECD countries) to business income on an accrual basis and to capital gains when assets are sold.

The second category (payroll) is a progressive tax with eight brackets and a top marginal tax rate o f 40 percent. I t is applied to salaries, wages and any form o f remuneration paid for personal services.

The third category (surtax) i s a progressive tax applied to the worldwide income o f residents from all sources. It also has eight brackets and a 40 percent top marginal tax rate.

The fourth category (additional) is a 35 percent tax levied on income remitted abroad by non-residents, be they persons or corporations.

Dividends received from Chilean corporations are exempt, because they have already paid the First Category tax when distributed. Taxes paid on f irst and second category taxes can be credited against the surtax. Similarly, first category tax may be credited towards any additional tax. Social security contributions are levied at 19.7 percent and are deducted from the payroll tax. There are numerous other exemptions and

43

deductions f iom the personal income tax including income from investments in mutual funds, investment funds, and rental properties, withdrawals from voluntary savings in the pension system as wel l asincome from interest and capital gains. Deductions include voluntary contributions to pension funds, mortgage payments and scholarships.

156. The VAT, a tax on sales on goods and services, was increased from 16 percent to 18 percent in 1990 and from 18 percent to 19 percent in 2003 to offset tariff reductions in the context o f free trade agreements with the EU, the US and Korea. Exemptions include transport, financial services, education and health, professionals, real estate rentals. There i s a special regime for construction whereby companies may credit 65 percent o f the VAT on their sales against their VAT liability. Chile has a stamp tax levied on credit operations. As far as excise taxes are concerned, i t is noteworthy that the tax on gasoline i s four times higher than the tax rate on (more polluting) diesel.

Figure 12. Tax Ratio vs. GDP per capita

Tax Ratio versus GDP per capita (1995 US$)

0 10000 20000 30000 40000 50000 60000 GDP per capita

Source: C. Agostini (2004).

Tax Avoidance and Evasion

157. Tax evasion and tax avoidance are sources of inequity (because individuals with similar incomes end up paying diferent taxes) as well as market ineficiency (because it is dificult to have a competitive market when some sellers evade taxes whereas others do not). There i s usually a positive relationship between tax evasion and the cost o f compliance. Evasion i s lower when there i s withholding at source. More generally, incentives for tax avoidance or evasion depend upon the type o f tax and the taxpayer as well as institutional and cultural factors. In the case o f Chile the main sources and consequences o f tax avoidance/evasion are:

(a) Foreign direct investment (FDq. The 35 percent additional tax levied on remittances to foreign shareholders i s l ikely to encourage tax avoidance and/or discourage FDI because international capital is highly mobile. Although there is a credit for f irst category income taxes paid, the effective tax on distributed profits is still 35 percent. When evaluating incentives for tax avoidance, it is important to consider the tax regime o f the home country. In order to avoid double taxation,

44

some countries offer a foreign tax credit for income taxes paid to foreign governments. However, a US corporation, for example, only gets full credit for i t s foreign taxes when the average foreign tax rate is less than the domestic tax rate. The difference in the tax rate between the home country and the foreign country becomes a factor in deciding the location o f investment. A high additional tax rate can discourage companies fi-om investing in Chile if their home country does not have a tax agreement with Chile or if it has a lower corporate tax rate than the 35 percent applicable in Chile.

(b) VAT. Evasion was reduced during the early 1990s fi-om 30 percent to 18 percent. I t then increased to 25 percent by 1998 and has since steadily declined to under 15 percent in 2004. There are several mechanisms for evading the VAT: (i) not issuing receipts for sales; (ii) buying counterfeit receipts for supplies to increase the credit against VAT payments; and (iii) reporting personal expenditures as purchases for the business. In addition, Chile has special VAT regimes for some sectors. Exemptions for real estate and for insurance are estimated to have cost US$87 mi l l ion in lost revenue in 2002. Similarly, the special credit to the construction industry cost US$191 mi l l ion in foregone revenue in 2002.

(c) Personal income taxes. Income tax may be avoided by shifting reported income into lower tax categories or by inflating “tax-deductible consumption” such as mortgage payments, charitable contributions, and voluntary pension contributions. Tax avoidance is possible because income taxes are levied on a narrow income base equivalent to gross income less deductions, exemptions and credits. Data suggests that taxpayers who receive income from more than one source are better able to reduce their tax liabilities compared with taxpayers earning income from labor only. On average, individuals paying only second category taxes pay an effective rate that i s 0.5 percent points higher than individuals with a s imi lar level o f income who pay surtax.

(d) There are legal loopholes (exemptions, deductions, tax credits) through which taxpayers can reduce their tax burden. In general, high-income taxpayers benefit most from these loopholes. To assess the impact o f loopholes on the progressiveness o f the tax structure, all tax credits (except for tax credits originating in first or second category taxes), exemptions and deductions were subtracted from tax declarations. After subtraction, the rate for the second bracket increases from 1.65 percent to 1.84 percent while the average rate for the top bracket changes from 28.46 percent to 29.79 percent (Figure 13).

45

Figure 13. Effective Average Tax Rates with and without Credits, Deductions and Exemptions

Effective Average Tax Rates

1 2 3 4 5 6 7 8 Bracket

--c Exemptions

-6 Actual and Deductions

Non Tax Credits

(e) Diference between corporate and personal income tax rates. The relatively large gap in taxation between corporations and persons may play an important role in explaining tax avoidance because individuals incorporate in order to benefit f iom a lower tax bracket. However, Gordon (1998) shows that the ability to incorporate and enjoy a low corporate tax rate relative to personal tax rates encourages risk- taking, Le., entrepreneurship. Since entrepreneurship i s beneficial for economic growth, lower tax avoidance needs to be balanced against the benefits o f greater incentives for entrepreneurship.

Policy Options to Lower Tax Evasion and to Improve Efficiency and Equity

158. There is scope for improving the tax structure to increase its eflciency, improve equity, simplijj its administration and increase overall compliance. The following options are proposed:

(a) Income Taxes. Some tax credits, deductions and exemptions can be eliminated to help to improve horizontal and vertical equity, lower tax avoidance and reduce administration costs. Specifically, the Government could consider the gradual elimination o f tax exemptions for capital gains, investments in national mutual funds, income fkom interest, and income f iom house rent. Similarly, the Government could usefully re-examine the rationale for national tax incentives. The Government may consider reducing the additional tax rate o f 35 percent on non-resident dividends which would help lower tax avoidance and foster FDI. The Government may also consider lowering marginal income tax rates in order to reduce incentives for tax evasiodavoidance and thus indirectly improve (horizontal) equity. However, the benefit o f that option needs to be balanced against the negative impact o f lower marginal tax rates on equity.

46

VAT. The special rates on luxury items and non-alcoholic beverages could be reduced to the standard rate o f 19 percent. Revenues from the higher rates are very small and there are no efficiency reasons to have a differential rate on those items. Elimination o f the luxury rates would reduce the administrative and compliance costs o f the VAT. The Government could consider eliminating exemptions on l i fe insurance, professional services, real estate rentals and, in particular, the special regime for construction. There are no externalities or any other efficiency reason just i f j ing these exemptions. If the Government wants to promote those activities it could provide direct subsidies.

Other Taxes. The gap between diesel and gasoline taxes could be bridged with a special tax on diesel consumption. The present tax policy on fuels perversely distorts incentives with respect to externalities such as pollution. Some 16 percent o f cars in Chile have a diesel engine and, if the diesel tax were equal to the gasoline tax, i t would increase revenue by about US$120 million. The Government may consider gradually replacing revenues k o m the stamp tax with revenues from other less-distorting taxes.

Financing Development - Fiscal Rule

159. I n 2000 Chile adopted an anti-cyclical fiscal rule. The rule, l2 binds the central Government to a structural fiscal surplus equivalent to 1 percent o f GDP. To calculate the structural fiscal surplus, fiscal revenues are adjusted assuming that the rate o f economic growth i s on “trend”13 and that copper-Chile’s main export-is trading at i t s long-term equilibrium price.14 Thus, when output i s below trend andor the copper price is below the long-term reference price, a surplus o f less than 1 percent o f GDP or indeed a fiscal deficit may be called-for and that can serve a stabilizing anti-cyclical h c t i o n .

160. The fiscal rule was conceived as a measure to break the pro-cyclical behavior of fiscal policy. When the rule was first introduced, the common expectation was o f buoyant copper prices and an expanding economy. The fiscal rule was designed as a means o f restraining pressures to spend the expected high revenues. Eventually, as the economy slowed down after 2000, the rule served to accommodate higher deficits in an orderly and predictable fashion without impairing the underlying strong structural fiscal stance. In practice, the rule has held up quite wel l so far. In the 4 year period 2001-2004, the average cyclically adjusted surplus has been about 0.8 percent o f GDP compared with a normative 1 percent target. Public acceptance o f the rule - linked in part to its relative simplicity and transparency - has also held up remarkably well.

l2 The new ru le i s a self-imposed measure by the present government on i t s fiscal policy from 2001 to 2005. l3 The methodology used to project GDP for use in Chile’s Structural Balance Rule does not result in an estimate o f the potential output o f an economy at full capacity. Rather it extrapolates the previous actual trend GDP, subject to additional information on domestic and external variables. l4 To increase transparency, the Government has delegated the estimation and projection o f trend GDP and the long-term copper price to two committees o f external experts. Estimates employ a standard production function approach. The estimation o f GDP i s then “filtered” to separate the trend and cyclical components. A Hodrick-Prescott filter i s used; since the H-P technique gives too much weight to the end points o f a series, these are eliminated before projections are made.

47

161. Most criticisms of the Jiscal rule have to do with its implementation. I n particular, there is concern that the counter-cyclical stabilization potential of the fiscal rule may not be fulZy utilized. However, there appears as well to be a strong consensus that any major change to the rule (including abolishing it) after so short a period would be a major blow to the credibility o f economic policy, which in all probability would damage Chile’s creditworthiness.

162. Thus, any amendment to the rule should focus on technical improvements at the margin. Possible improvements include: (i) extending the role o f automatic stabilizers to expenditures such as unemployment insurance and social programs, (ii) improving the consistency between GDP and copper price forecasts; and (iii) avoiding short-term changes in fiscal policy within any fiscal year. To that end, the Government could plan to correct the effects o f shocks over a period o f time by, for example, aiming to reach a 1 percent structural fiscal surplus on average over a number o f years. The effects o f irreversible, and presumably larger, shocks could be adjusted over a longer period than temporary ones. Similarly, adjusting the structural surplus according to potential output i s a desirable and feasible option to help reducing variability o f fiscal policy within any one year. More substantial modifications to the fiscal ru le should only be considered on the basis o f experience once the rule has acquired enough credibility.

163. One key concern has been that the normative target of I percent for the structural surplus is arbitraiy. In the context o f Chile’s growth performance and the prevailing interest rate structure, a one percent structural surplus implies that the ratio o f debt to GDP wi l l fa l l even though, at about 35 percent (consolidating the central bank), the ratio i s already relatively low. Even if the quasi-fiscal deficit o f the central bank were close to 1 percent o f GDP, the rule would imply-as long as GDP grows-a continuous fall in the ratio o f consolidated debt to GDP. A falling debt ratio may constrain the ability o f the Government to finance investments with a potentially high rate o f social return. I t would also limit opportunities for inter-generational consumption smoothing. Moreover the financial markets would be progressively deprived o f an important investment instrument and a useful benchmark in the form o f the yield curve. Over the medium term, as creditworthiness i s further consolidated and the credibility o f the fiscal rule i s more firmly established, the Government may consider a revision o f the 1 percent structural fiscal surplus target. The pros and cons o f such a change would need to be carefully examined and explained to the public. I t would need to be introduced gradually so as to test i t s potential impact on perceived creditworthiness and credibility in general.

164. Over the longer term, as creditworthiness becomes a less important consideration, the Government could consider adopting a rule whereby the debt/GDP ratio eventually converges to the ratio of the stock of public capital to GDP (Giavazzi and Perotti, 2005). This would avoid a scenario under which al l public debt i s eliminated at the cost, for example, o f foregoing public investments or expenditures with a high rate o f return. A fiscal rule that implies a convergence between the stock o f debt and the stock o f public capital over time will also ensure that the budget, excluding net public investment, would remain balanced throughout the business cycle.

48

165. Such a rule would require an appropriate accounting framework and the development o f institutions that can separate conceptually and in practice current expenditures from capital investments. I t would allow anti-cyclical fiscal policy to be employed during the business cycle without reducing net investments, which could be financed through new borrowing. mether this is a good idea in practice is not yet demonstrable. I t would depend upon the eflectiveness of incentives to reclasszjj current spending so that the rule could be efectively implemented.

H. R I S K S TO CONVERGENCE WITH ADVANCED ECONOMIES

166. The Chilean authorities expect real GDP to grow at more than 5 percent annually during the period 2005-2008. This i s equivalent to an annual growth in per capita real GDP o f about 4 percent. At these levels o f growth, Chile would reach Spain’s current level o f GDP in per capita PPP terms by about 2023. That level of output growth is achievable, barring any substantial change in the world economic environment and assuming that macroeconomic policies continue to be managed prudently as expected.

167. Chile i s an outward-looking country and the policy environment i s conducive to the introduction o f fizther measures that would reduce i t s vulnerability to shocks, achieve high growth rates and reduce the continued vulnerability o f the s t i l l numerous poor. Yet, some risks do remain.

168. This section will identify possible impediments that may obstruct the convergence to Spain’s current PPP GDP per capita. I t will also assess strategies - and policy options - to reduce vulnerability to external shocks.

Sources of Vulnerability

169. In 2004-a year when Chile’s main exports enjoyed particularly high prices - exports accounted for about 41 percent o f GDP and copper accounted for 45 percent o f exports. The high growth rates seen in 2004 were due, in part, to very favorable external conditions. Copper prices were extremely high and continued to grow yet further to historically high levels in 2005.

170. Being a small open economy, Chile remains sensitive to regional and global developments, and shifts in demand from its major trading partners. A slump in the international demand for primary products such as copper or fluctuations in capital flows would substantially reduce short-term growth prospects. In the past 100 years, major periods o f output fluctuation were caused mostly by adverse external shocks. O f the six major economic fluctuations in Chile, five were precipitated by exogenous shocks: the crisis in the nitrate industry in the 1910s, the mining income collapse precipitated by the Great Depression in the 1930s, the oi l and copper crisis o f 1975, the debt and banking crisis o f 1982, and the slump in capital flows and commodity prices in the aftermath o f the Asia/Russia/Brazil crisis.

49

171, Looking at changes in copper prices plotted against GDP growth over 1960-2004, the association i s clear (Figure 14). This close correlation with the price of copper represents a signijicant risk for Chile, since prices are currently at extremely high levels. Although there might be structural reasons (such as continued strong demand fkom China) to expect a high equilibrium price, the risk o f a reversal towards the mean remains a strong possibility.

Figure 14. Real Copper Prices and GDP growth, 1960-2004

-7 60

I -+e- GDP annual growth -Change in real cooper price - right

Sources: Central Bank o f Chile, the Federal Reserve Bank o f St. Louis and WDI.

172. Assisted by a trade liberalization agenda - including FTAs with the EU, the U S and various Asian countries - Chile has diversified i ts exports towards non-traditional goods and sefiices w h i c h have doubled as a share o f exports since 1970-and towards new markets. Vulnerability to external shocks wil l be reduced even more by continuing to increase the dynamism of the private sector, further diversifiing economic activity and trade and integrating thefinancial system within the world economy. There i s also room to reduce vulnerability through fiscal policy (section G), financial sector deepening and international diversification in capital markets.

Reducing vulnerability: International risk-diversification through the financial system

173. Chile has consistently pursued fiscal and financial policies aimed at strengthening its creditworthiness, and increasing the depth, stability and international integration of itsfinancial sector. The adoption o f a fiscal rule and a floating exchange rate regime combined with full-fledged inflation-targeting go a long way towards insulating Chile from terns o f trade shocks and/or sudden-stops o f capital inflows. Similarly, the development o f a sound regulatory and supervisory framework for financial markets has reduced the vulnerability o f the financial sector.I5

174. Chile’s financial system is large and well diversijied. The mandatory pension funds created in the 1980s’ reform have grown at a fast rate pulling in their wake most o f

l5 See “Chile - Financial Sector Assessment”, World Bank/IMF, August, 2004.

50

the financial system including banks, l i fe insurance companies, the mortgage industry and corporate bonds. The 1998 liberalization o f the capital account and, in particular, allowing pension funds to diversify their assets abroad has helped Chile to deepen international financial integration. Chile’s foreign assets and liabilities as a share o f GDP i s about 50 percent higher than the share o f the average emerging country. Also, since mid-1998, there has been an increased association between returns from local and international equity markets. The rapid expansion o f the market for exchange rate hedges, facilitated by the expanding adoption o f hedging by pension funds, should also contribute to the overall stability and resilience o f the currency market.16

175. There is scope for designing specific instruments which would help to reduce yet further Chile’s exposure to terms o f trade volatility - particularly, fluctuations in the price o f copper which weighs heavily on the budget. In emerging-market economies the domestic financial market typically allows only a limited diversification o f risks. In such a situation, diversification through international capital mobil ity is the obvious alternative. Cross-border transfers o f the ownership o f real and financial assets-e.g. v ia privatizations-- is one way to achieve diversification but it can be costly to implement and even more costly to reverse. Implementing these approaches to diversification often conflicts with political objectives and constraints.

1 76. Over-the-counter (OTC) derivative contracts provide an appealing alternative for risk t ran~fer . ‘~ In the case o f equity swaps, for example, the total return per dollar on the small country’s stock market may be exchanged annually for the total return per dollar on a market-value weighted-average o f the world stock markets. An equity swap would enable a small country to diversify internationally without contravening possible restrictions on the investment o f capital abroad. * * Risk diversification through derivative instruments i s more flexible than diversification through the transfer o f assets.” The

l6 See previous footnote. ” See Giavazzi-Perotti (2005) and Mario Draghi, F. Giavazzi and R. C. Merton, “Transparency,Risk Management and International Financial Fragility”, M E R Working Paper Series, June, 2003. ’’ Swaps are over-the counter (OTC) instruments, traded outside organized exchanges. Trading swaps requires no capital. There are no rules governing market conduct such as risk management, obligatory centralized trading, defrned clearing and settlement rules, and loss-sharing rules in case o f default. OTC derivative markets lack a formal structure; have no physical central trading place, and no clearing or settlement system. There i s also no central mechanism to limit individual or aggregate risk taking and risk management i s completely decentralized. l9 Caballero and Panageas (2003) suggest that Chile could eliminate most, if not all, deep recessions by embedding into i t s external bonds a long put option, yielding US$ 6-8 billions when the price o f copper falls by more than two standard deviations for one or more semesters. They estimate that such an insurance, if fairly priced, might cost a lump s u m o f US$ 500 million. Caballero (2003) argues, however, that currently “there i s no natural market for holding such an instrument, and the corresponding derivatives markets would not suffice to cover the position o f the writer o f the option.” Even in the best emerging economies, he argues, uggregute r isk management i s being done with stone-age instruments and methods. H e thus concludes suggesting that the IMF has a key role to play here in resolving th is impasse and becoming a catalyst for such a development. H e proposes that “the IMF creates a new Contingent-Markets Department which should have three primary tasks: (i) To help idenw each country’s contractible contingent basis and develop the corresponding contingent bonds; (ii) To help create and regulate contingent market CDO-like funds; (ii) To help design a macroeconomic policy framework consistent with the insurance mechanism developed for the country, and monitor i ts fulfilment.”

51

possibility o f using swaps to diversify risk has been around for a long time. What i s different today, and allows swaps to be used in significant volume and at low cost in practice, is the convenience o f an existing legal infrastructure. The value o f international equity-linked derivative notional contracts rose from US$2.8 tri l l ion in mid-2003 to US$4.4 tri l l ion at the end o f 2004.20 Over the same period, commodity linked contracts rose from US$ 1 tri l l ion to US$ 1.4 trillion.

177. DiversiJication through derivative instruments is thus an alternative which the Government could explore to further reduce its vulnerability to terms of trade volatility. The specific type o f instrument would need to be defined. For example, the Government could consider a swap with a global pension intermediary in which it offers to exchange annually part o f its per-dollar “copper dividend” in CODELCO for the per-dollar return on a market value weighted average o f world stock markets. An equity basket which i s negatively correlated with copper prices may actually do even better in terms o f risk diversification. However, there is no guarantee that the correlations would never go the wrong way, and an episode o f “wrong” correlations would be very difficult for the Government to explain to the public.

178. Without pursuing the details o f implementation, the swap effectively transfers the risk o f the “copper dividend” to foreign investors and provides the Government with the risk-return pattern o f a well-diversified world portfolio. Since there are no init ial payments between parties, there are no initial capital flows in or out o f the country. Subsequent payments, which may be either inflows or outflows, involve only the difference between the copper dividend and the retum on world stock market index, and no “principal”.

179. Alternatively, the swap could involve exchanging the copper dividend for a risk- f iee interest rate denominated in a “strong” currency or in units of constant purchasing power. T h i s hypothetical swap would work the same way as the one in the previous example, except that the net cash flows produced by the swap would result in the Government receiving a risk-free rate o f return. The counter-party must have a very good credit rating, or the swap must be guaranteed by a third party with a strong credit rating, or by a two way mark-to-market collateral. In economic terms, this swap would not be very different fkom what the Government is currently doing with excess copper revenues when copper prices are above the reference price set under the fiscal rule, i.e., accumulating reserves or buying back debt.

180. While capital markets may be prepared to accommodate such financial transactions, the political economy o f the country may not be as well-prepared. The average voter may be ready to accept that the Government i s protected against falling copper prices but may regard with scepticism that the Government gives away part o f its copper dividend when copper prices are rising. Moreover, citizens may not l ike the idea o f the country paying a premium to buy into the contract. Over time, some o f these issues could be addressed however. In this respect i t is encouraging that the public seems

2o See “OTC derivatives market activity in the 2nd half o f 2004”, BIS.

52

prepared to accept a fiscal rule that forgoes the potential short run benefit of high copper prices whenever these are estimated to be above the long run price.

I. CONCLUSIONS

181. Chile is in a strong position to achieve high growth and increase equity, and to move towards convergence with the advanced OECD economies. Achieving the objective o f strong and equitable growth will require a combination o f factors: fostering growth through a dynamic and innovative enterprise sector; and raising the capabilities o f the population, particularly the poorer members o f society, through increased education access and quality, and enhanced social protection. The biggest challenge for future growth in Chile will be to reduce the high levels o f inequality and vulnerability to poverty. The country cannot attain i t s growth potential if a large share o f the population is unable to reach their full human capacity potential. Not one advanced economy has levels o f inequality approaching those found in Chile, and the accompanying inequality o f opportunity cannot but penalize Chile’s growth prospects.

182. A dynamic enterprise sector. Growth has already been accompanied by a large reduction in poverty. Future high growth rates will be central to continued efforts to eliminate poverty and reduce the vulnerability o f the poorer strata o f society. A dynamic enterprise sector in an economy that fosters competition and innovation will generate the growth and employment needed for Chile to reach its goal o f social equity and convergence with the income level o f advanced countries. Productivity growth in the traditional export sectors and further efforts to develop the nontraditional export sectors will be needed for the country to fully exploit the new opportunities opened up by free- trade arrangements. Policy options to dynamize the enterprise sector include: strengthening competition policy, reducing the cost to firms o f entry and exit (particularly bankruptcy procedures), lowering the cost o f reallocating labor across f i r m s (job security provisions and minimum wage), and improving access to credit.

183. A stronger National Innovation System. In spite o f substantial progress, Chile s t i l l has an uncoordinated wide array o f policies and programs for R&D and technology diffusion with significant overlap across programs and between content and objectives. This reduces the potential effectiveness o f limited funding. Basic challenges for Chile’s National Innovation System include: (i) providing a policy framework for innovation with a special longer-term focus on S&T; (ii) fostering innovation as well as the entrepreneurial and scientific capacity required to effectively innovate through the creation, adoption and adaptation o f new knowledge; (iii) placing the private sector at the center o f innovation policy in order to ensure the link to productivity growth and to limit Government failures; iv) evaluating existing initiatives constantly and thoroughly; (v) increasing the stock o f wel l trained personnel and research units; and (vi) improving the diffusion o f knowledge across units.

184. Increased education access and quality. Increasing education levels is a means o f targeting both high growth and income equity. The education reforms begun in 1990

53

brought important increases in education investment and led to a substantial expansion in the quantity and quality of education inputs. The additional investment has translated into significant gains in terms o f education coverage. Important challenges remain though: improving the quality o f education and raising the equality o f opportunity. The State can play an important role in guaranteeing that all children have access to an education o f good quality. The State faces as well the challenge to ensure equality o f educational opportunity, particularly by promoting preschool education and higher enrollment among the poor. Another substantial challenge i s to tackle the high levels o f inequality in adult educational attainment. The majority o f today’s adult population in Chile has not completed secondary education, and low schooling levels are particularly prevalent among the poor. This is a huge barrier to innovation and to equity. But raising adult education levels will not involve education policy alone; the high levels o f informality in the Chilean economy deserve to be confionted as they act as a barrier to on-the-job training.

185. Enhanced socialprotection. Nearly 18.8 percent o f the population falls below the official poverty line. Vulnerability to poverty remains high. Many households remain vulnerable to poverty from adverse income shocks, such as job loss, costly health events, and loss o f earnings-ability in old age. This not only threatens the equity goal, but also damages the outlook for growth. Recovery from shocks can even impair households’ human capital or hinder further investment. The over-arching challenge for policy makers in social protection i s to improve coverage among the potentially vulnerable groups, primarily through the elimination o f explicit barriers to programs o f social protection where they exist. This has to be complemented by further improving incentives for households to take up instruments that promise more than minimum coverage. Ensuring that the economy is managed so as to generate adequate employment and that labor market policies facilitate rather than impede employment creation remains the most important aspect o f sound social protection policy.

186. Financing develupment. It i s unlikely that the Government will suddenly depart from the supportive macroeconomic policy environment that has been put in place. However, the quest for higher growth and the achievement o f higher growth will put pressures on Chilean Government finances. This report has assessed likely pressures on Government expenditures that will arise from further growth and development needs as well as the financing options that are available to the Government. In particular, there i s scope for improved efficiency and equity and reduced tax avoidance/evasion through: eliminating numerous income tax credits, deductions and exemptions; reducing the withholding tax on dividends o f foreign corporations; eliminating VAT exemptions such as those for l i fe insurances, professional services, real estate rentals, or the special regime for construction. There are also opportunities to refine-and over the longer term reform-the fiscal rule so as to increase its anti-cyclical effectiveness while protecting public investments with potentially high social returns. Finally, risk diversification through international capital markets provides a suitable option to further reduce Chile’s vulnerability to terms o f trade volatility.

54

Agenda for Future Research

187. The DPR has covered selected important issues o f concern for the development agenda in Chile. The report was not designed to be comprehensive. A number o f key policy challenges have not been covered and they could be considered potential areas for future research. They include labor market participation, pre-school education, determinants o f informality, decentralization and pension reform. An overarching theme for future research is the strategy for reducing inequality. Several sections o f this report (specially sections E and F and to a lesser extent section G) have partially dealt with policies aimed at improving equity. The issues and policies to be addressed in h ture research are strategically important for - and indeed should focus on - the equity issue.

1 88. Labor market participatiodpre-school education. Differences in labor income are closely related to inequality. Diverging labor income can be explained by differences in education, but also by differences in labor market participation. Increasing labor market participation among the poorer groups in society is then central to increasing equity. Bringing under-employed groups into the labor market would also boost growth. In Chile, the participation rate o f women i s less than half that o f men. Employment amongst young people i s also low. Family size and childcare options are other important factors in decisions to participate in the labor force. An increase in preschool facilities may be one means o f assisting women. This would have the added advantage o f helping to equalize opportunities in terms o f educational outcomes because there i s growing evidence that socio-cultural factors influence performance from an early age. Likewise, increasing the availability o f temporary and part-time jobs for the young in education may be important for raising their participation rates. Ensuring that institutional rigidities do not discourage female or youth employment i s also crucial for labor market participation.

189. Znformality. If entrepreneurs, salaried workers in large f i r m s and in the public sector, and self-employed professionals are included in the formal sector, there has been a moderate decline in informality over the period 1990-2003. However, at 37 percent in 2003, informality in Chile i s still high. High informality has implications for equity as i t hampers the effectiveness o f the social protection system and, typically, those employed in the informal sector have lower incomes. Also, as discussed, i t may impact on growth because the informally employed have fewer prospects for improving their human capital. A dual labor market i s an obstacle to the reduction o f inequality in general, and tends to deepen inequity in difficult times.

190. Decentralization. Given Chile’s objectives with respect to decentralization and efficiency, it would be useful to cany out a review o f institutions at the regional level. There may also be grounds for a realignment o f support schemes for regional development to better reflect existing regional income disparities, productive potentials and the differential regional impact o f structural reforms - in particular, o f Chile’s FTAs .~~ For example, the southern regions that specialized in import-competing crops

Chile’s progressive integration into the world economy i s likely to impact the regional landscape in different ways. Agricultural products of the south face increasing competition from imports. O f special

55

such as wheat may not easily diversify towards nontraditional exports, particularly since they are not well-endowed with human capital and infrastructure. One way o f tackling th is problem may be through integrated regional or territorial policies. More generally, decentralization faces severe institutional constraints - the capacity o f regional and local administrations to manage efficiently the resources transferred by the central Government. This suggests a need for strengthening institutional capabilities at the local and regional level prior to further decentralization. There is also scope to deepen decentralization, fine-tune the respective responsibilities o f different levels o f government, and improve the effective utilization o f revenues and transfers by giving more discretion to municipalities along with greater accountability.

191. Pensions The shortcomings o f the private fund management industry are widely recognized, especially in relation to the objective o f providing greater efficiency and cost-savings for households through market competition. The fundamental concern- which i s related to the high operating costs o f the private system-is l ow system coverage and, hence, high contingent fiscal liabilities. As mentioned, Chile could consider moving toward consolidating and simplifying its public pension schemes into a single public risk-pooling device against poverty in old age. Once a non-contributory old age benefit i s in place to cover poverty, a contributory guaranteed minimum pension or matching contribution scheme targeted at lower-income groups would cease to be a first- pillar device and could instead increase incentives to participate in the second-pillar. These and other options deserve to be carefblly examined.

Summary of Policy Options

192. achievement of high and equitable growth in Chile.

A matrix is presented of the key policy options presented in the DPR for the

concern i s the situation o f low income wheat producers. There has already been a 28 percent reduction in the land under wheat cultivation since 1989 and many farmers have abandoned wheat cultivation altogether. On the other hand, some areas surrounding the northern ports stand to benefit from a very dynamic trade with Asia and China in particular.

56

z Y

x

Agostini, Claudio (2005). “Analysis o f the Chilean Tax System”. Background paper for the DPR.

Arellano, J. P. (2004). “Politicas sociales para e l crecimiento con equidad Chile 1990-2002”. (Mimeo). Santiago, Chile.

Aschauer D.A. (1 989). “Is Public Expenditure Productive?” Journal of Monetary Economics, 23 (2), March.

Bellei, C., Muiioz, G.; Raczynski, D.; PCrez, L.M. Unicef and Asesorias para e l Desarrollo. (2003). “Escuelas Efectivas en Sectores de Pobreza: LQuiCn dijo que no se puede?”. In Hevia, R. (ed.). La Educacidn en Chile h6y. Santiago, Chile: Ediciones Universidad Diego Portales.

Beyer, H., B. Eyzaguirre and L. Fontaine. (2000). La reforma educacional: una apreciacidn critica. Documento de Trabajo No. 306. Santiago, Chile: Centro de Estudios Publicos.

Bitran, Ricardo & Associates. (2002). “The Risk o f Poverty fkom Health Shocks in Chile”. Background Paper for Chile: Household Risk Management and Social Protection. Washington, DC: The World Bank.

Bosch, M., D. Ledeman, and W. Maloney. (2005). “Patenting and R&D: A Global View.” Mimeo.

Botero, J., S. Djankov, F. Lopez-de-Silanes, and A. Shleifer. (2003). The Regulation of Labor. NBER Working Paper No. 9756. Cambridge, Massachusetts: National Bureau o f Economic Research.

Botero, J., R. La Porta, and F. Lopez-de-Silanes. (2004). “The Regulation o f Labor”, The Quarterly Journal ofEconomics, Vol. 119 (4), pp. 1339-1382.

Brunner, J., G. Elacqua, A. Tillett, J. Bonnefoy, S. Gonzalez, P. Pacheco and F. Salazar. (2005). “Guiar a1 mercado. Infome sobre la educacidn superior en Chile.” (Processed.) Santiago, Chile.

Brunner, J. (2004). “Politicas de mercado de educacidn superior: necesidades de informacidn.” In J. Brunner and P. Meller (eds.). Oferta y demanda de profeeionales y tkcnicos en Chile. El rol de la informacidn pziblica. Santiago, Chile: RIL Editores.

Caballero, R., K. Cowan, E. Engel, and A. Micco. (2004). Microeconomic Inflexibility and Labor Regulation: International Evidence. NBER Working Paper No. 10744. Cambridge, Massachusetts: National Bureau o f Economic Research.

Caballero, R. E. Engel, and A. Micco. (2004). “Microeconomic Flexibility in Latin America.” Economia Chilena, Volume 7 (2): 5-26. 2004. Also: NBER Working Paper No. 10398. Cambridge, Massachusetts: National Bureau o f Economic Research.

Cowan, K. and A. Micco. (2005). “Crecimiento, Empleo y Estabilidad del Tngreso”. Documento Mimeografiado. Washington, D.C.: Banco Interamericano de Desarrollo.

Cowan, K., A. Micco, A. Mizala, C. PagCs and P.Romagera. (2004). Un Diagnostico del Desempleo en Chile. Centro de Micro-Datos. Santiago, Chile: Universidad de Chile.

R. La Porta,

60

Cox, Cristih. (2005). “Las politicas educacionales de Chile en las idtimas dos dbcadas del siglo XX”. In Cox (ed.). Politicas educacionales en el cambio de siglo. Santiago, Chile: Editorial Universitaria.

Di Gropello, E. and J. Marshall. (Forthcoming). “Teacher Effort and Schooling Outcomes in Rural Honduras.” in E. Vegas (ed.). Incentives to Improve Teaching: Lessons from Latin America. Washington, DC: The World Bank.

Djankov, S., C. McLiesh, and A. Shleifer. (2004). Private Credit in 129 Countries. NBER Working Paper No. 11078. Cambridge, Massachusetts: National Bureau o f Economic Research.

Easterly, W. and S. Rebelo. (1994). Fiscal Policy and Economic Growth: An Empirical Investigation. NBER Working Paper No. 4499. Cambridge, Massachusetts: National Bureau o f Economic Research.

Elacqua, G. and R. Fabrega. (2004). “El consumidor de l a educacibn: e l actor olvidado de la libre eleccibn de colegios en Chile” (Mimeo). Santiago, Chile : Universidad Adolfo Ibfiez.

Eyzaguirre, N., M. Marcel, J. Rodriguez C. and M. Tokman. (2005). “Hacia la economia del conocimiento: El camino para crecer con equidad en e l largo plazo.” Estudios Publicos No. 97 (Verano). Santiago, Chile: Centro de Estudios Phblicos.

Eyzaguirre, N. (2004). “El Chile que Queremos”. Presentation Prepared for ENADE 2004, December 2004.

Gallego, F. (2002). “Competencia y resultados educativos: teoria y evidencia para Chile”, Cuadernos de Economia 39 (1 18): 309-352.

Galindo, A. and A. Micco. (2001). Creditor Protection and Financial Cycles. Working Paper No. 443. Washington, DC: Inter-American Development Bank.

Galetovic, A. (2005). “Competition policy in Chile”. Background paper for the DPR, June 2005.

Giavazzi, F. and R. Perotti, “Chile’s Fiscal Rule”. Background paper for the DPR, June 2005.

GonzAlez, P. (2004). “Una mirada econbmica de las politicas y de las necesidades de informacibn en educacion superior.” In J. Brunner and P. Mel ler (eds.). Oferta y demanda de profesionales y tkcnicos en Chile. El rol de la informacidn publica. Santiago, Chile: R E Editores.

Gonzalez, P. Mizala, A. y P. Romaguera. (2004). Vouchers, inequality and the Chilean experience. Documento de Trabajo CEA No. 150. Santiago, Chile: Universidad de Chile.

Gordon, R.H. (1998). Can high Personal Tax Rates Encourage Entrepreneurial Activity? IMF Staff Papers. Washington, DC: International‘Monetary Fund.

Heckman, J. (1999). Policies that Foster Human Capital. NBER Working Paper No. 7288, Cambridge, Massachusetts: National Bureau o f Economic Research.

Hoxby, C. (2000). Peer Effects in the Classroom: Learningporn Gender and Race Variation. NBER Working Paper 7867, Cambridge, MA: National Bureau o f Economic Research.

Hsieh, C. and M. Urquiola. (2003). When Schools Compete, How Do They Compete? An Assessment of Chile’s Nationwide School Voucher Program. NBER Working Paper 10008, Cambridge, MA: National Bureau o f Economic Research.

61

lMF. (2004). Chile: Financial System Stability Assessment, including Reports on the Observance of Standards and Codes on the Following Topics: Monetary and Financial Policy Transparency, Banking Supervision, and Securities Regulation. Country Report No. 041269. Washington, DC: International Monetary Fund.

-. (2005). Chile: Selected Issues. Country Report No. 05/31 6. Washington, D C : International Monetary Fund.

Kaiser, Robert G. (2005). “Focus on Schools Helps Finns Build a Showcase Nation.” The Washington Post, May 24.

Kamps, Christophe. (2004). The Dynamic Macroeconomic Efects of Public Capital: Theory and Evidence for UECD Countries. K i e l Studies Vol. 33 1. Heidelberg and New York: Springer.

Karsten, S. (1 999). “Neoliberal Education Reform in the Netherlands.” Comparative Education

Kaufinann, D., A. Kraay and M. Mastruzzi. (2003). Governance Matters III: Governance Indicators for 1996-2002. Policy Research Working Paper No 3 106. Washington, DC: The World Bank. . (2004). Governance Matters IV: Governance Indicators for 1996-2004. Policy Research

Working Paper No 3630. Washington, DC: The World Bank. Kloprogge, J. (2003). “Educational Policies and Equal Opportunities in the Netherlands. Recent

Developments in Policies for Children at Risk” (Mimeo).

Lindert, Peter H. (2005). “Growing Public: I s the Welfare State Mortal or Exportable?” DEC Lectures. Washington D.C.: The World Bank.

Marcel, M. (2004). “Oportunidades y desafios para la politica social en Chile” presentacidn Seminario “Enfientando 10s desafios del desanollo en Chile: Los sectores sociales” Ministerio Hacienda-Banco Mundial. Santiago, Chile.

Micco, A. 2005. “Microeconomic Flexibility and Finns’ Behavior in Chile”. Background paper for the DPR.

Mizala A. y P. Romaguera. (2005a). “Teachers’ Salary Structure and Incentives in Chile.” In E. Vegas (ed.). Incentives to Improve Teaching: Lessons from Latin America. Directions in Development Series. Washington, DC: The World Bank.

Mizala A. y P. Romaguera. 2005b. “Calidad de la educacih chilena: una asignatura pendiente” (Mimeo), Santiago, Chile: Universidad de Chile.

Mizala, A. and P. Romaguera. 2001. “Factores explicativos de 10s resultados escolares en la educacidn secundaria en Chile.” Trimestre Econcimico 272 (October-December): 5 15-549.

OECD. (2004a). Education at a Glance. Centre for Education Research and Innovation. Paris: Organization for Economic Cooperation and Development.

. (2004b) Employment Outlook 2004. Paris: Organization for Economic Cooperation and Development.

. (2004~) Taxing Wages. Paris: Organization for Economic Cooperation and Development.

35 (3).

62

Patrinos, H. (2003). “Private Education Provision and Public Finance: The Netherlands as a Possible Model” (Mimeo). Washington, DC: The World Bank.

Sapelli, C. and B. Vial. (2002). “The performance o f private and public schools in the Chilean voucher system” Cuadernos de Economia 39 (1 18): 423-454.

Sawada, Y. and A. Ragatz. (Forthcoming.) “Decentralization o f Education, Teacher Behavior and Outcomes: The Case o f El Salvador’s EDUCO Program.” In E. Vegas (ed.). Incentives to Improve Teaching: LessonsJi.om Latin America. Washington, DC: The World Bank.

Thorn, K., L. Holm-Nielsen, and J. Jeppesen. (2004). Approaches to results-based funding in tertiary education: identifiing finance reform options for Chile. Policy Research Working Paper No. 3436. Washington, DC: The World Bank.

Tokman, A. (2005). “Diagnbsticos y propuestas para la educacibn chilena” Economia Chilena 8

Traverso, A. (2004). “Las nuevas reformas que la refonna engendra.” En Foco 26, Expansiva.

ValdCs, S. (2005). “Para aumentar la competencia entre las AFP”. Estudios Pziblicos 98, 87-142.

Vegas, E. and I. Urnansky. (2005). Improving Teaching and Learning Through Efective Incentives: What Can We Learn from Education Reforms in Latin America? Washington, DC: The World Bank.

(1).

63