Inflation has risen to a 30-year high, fuelled by expansionary fiscal policy in 2021 and exacerbated by global supply constraints and the Russian aggression on Ukraine. This triggered a strong and timely monetary policy response (Figure 2). Inflation expectations, which had been solidly anchored for decades, rose significantly above the target. The pandemic policy response is leaving a strong mark on Chile’s traditionally deep financial markets. Pension fund withdrawals required funds to liquidate long-term assets in their portfolio and reduced financial market depth, at the same time as many households depleted their pension savings.

Looking ahead, growth is projected to slow sharply (Table 1). In the near future, quarterly GDP contractions are likely to continue until the last quarter of 2022, as high inflation and rising interest rates curtail household purchasing power. Pre-pandemic employment levels will be recovered gradually, supported by ongoing hiring subsidies. Inflation will only return to the target in early 2024.

Significant underlying growth challenges will have to be addressed over the next years. Rapid population ageing will reduce Chile’s labour force, and with that the economy’s growth potential, despite a positive impulse from immigration. Productivity has been stagnant or even decreasing, and structural reform efforts have fallen short of what is needed to lift it. Without policies that boost productivity, the scope for further economic and social progress will be severely limited.

Low competitive pressures in a number of sectors are one reason behind weak productivity. Lengthy and complex regulations and licensing procedures hamper entrepreneurship and competition (Figure 3). A comprehensive review of existing regulations and a wider recourse to “zero-licensing” schemes would facilitate entry and strengthen competition. Better funding for the competition authority could support its competition advocacy role, including through more market studies that take stock of competition bottlenecks.

Foreign competition is also hampered by regulatory barriers. These barriers affect specific areas such as cabotage transport and public procurement, but there is also scope for improving trade facilitation and simplifying border procedures. Exports remain dominated by natural resources.

Overall spending on research and development and innovation is relatively low. Public support for innovation and technology upgrading is being strengthened to boost productivity. Looking ahead, innovation support could be better coordinated and aligned with strategic priorities such as sustainability. Regular impact evaluations would help to focus R&D spending on the most effective policy instruments.

Covid-19 has reversed previous declines in poverty and inequality. Around one third of the population is economically vulnerable, meaning that they remain at risk of poverty, with few financial buffers to cushion themselves against adverse events. Income inequality remains high by OECD standards, while labour informality affects more than a quarter of the population.

The pandemic has highlighted significant gaps in social protection. There is a need for developing a better social protection system that does not differentiate between formal and informal workers. Ensuring some basic social protection coverage for all, including in pensions, health and unemployment insurance, while simultaneously reducing the cost of formal employment, would reduce labour informality.

Few people have adequate old-age pensions, owing to low contributions and contribution gaps due to informal employment. A recently established universal basic pension will significantly improve the level of pension benefits for many low-income earners. Income-support programmes are highly fragmented, and unifying social assistance programmes into a single cash benefit scheme will allow increasing coverage and benefits.

Social contributions may affect incentives for formal job creation, especially among low-income workers. Future pension reforms should pay particular attention to formalisation incentives, while raising pension replacement rates.

Education is key for reducing inequalities and raising productivity at the same time. Learning outcomes remain well below the OECD average and pandemic-related school closures have exacerbated these longstanding challenges, as fewer students from vulnerable backgrounds used digital tools to remain connected. Expanding access to quality early childhood education would bridge early and often decisive gaps in cognitive and social progress and allow more women to work. Working conditions for teachers fall short of OECD average standards, with lower pay and longer working hours.

Tax revenues of only 21% of GDP are insufficient to meet rising social demands while preserving necessary public investment in infrastructure, education and health (Figure 4). Personal income taxes, which only 20% of Chileans pay, are one explanation behind this low tax collection. Raising public revenues by 4 percentage points of GDP, as currently planned by the authorities, is ambitious but within reach through a comprehensive tax reform.

A legally-binding long-term strategy for climate mitigation and adaptation aims at carbon neutrality by 2050 and is expected to generate emission reductions before 2025, giving rise to a declining trend only slightly above the 1.5-degree-compatible pathway range.

Renewable sources currently account for 47% of electricity generation, after a steady decline of the role of fossil fuels as solar and wind energy have gained importance. This development is set to accelerate over the next decades (Figure 5), to exploit a unique potential in the generation of electricity from renewable energy sources, estimated at over 70 times of current electricity supply. This makes Chile well-placed to produce and export green hydrogen, which is the only technology known so far that can decarbonise some hard-to-abate processes in heavy industry.

Despite this potential in renewables, coal combustion remains a major source of electricity today. Plans to phase it out by 2030 are ambitious but necessary and will reduce energy-related emissions. Transport-related emissions are set to decline through the electrification of the vehicle fleet, with new vehicle sales restricted to zero-emission models as of 2035.

Carbon prices remain distant from international best practice. The current level of the carbon tax is too low to promote renewable energy sources and the low carbon price hampers the development of an emission-trading scheme. Potential effects of higher carbon prices on low-income households could be mitigated through targeted cash transfers, building on recent success in this area.