Costa Rica has recently taken significant steps to strengthen its macroeconomic framework. Monetary policy has been improved and key steps to improve the fiscal framework have also been taken. Complying with the commitments established and keeping sound macroeconomic policies over time is fundamental to boost trust.

Full and timely implementation of the fiscal reform approved in December 2018 is critical. The fiscal situation deteriorated significantly in the last decade, with the overall budget balance moving from a surplus in 2007 to a projected deficit of close to 9% of GDP in 2020 (Figure 1). Authorities have appropriately increased health and social protection spending to respond to the pandemic. Looking forward, once the economic recovery is underway, returning to a deficit-reduction path is vital. A critical element of the reform is a fiscal rule that constrains gradually the growth of current spending. Debt simulations suggest that adhering continuously to the fiscal rule, as planned by authorities, would halt over time the increase in public debt. The trajectory is very sensitive to the implementation of the fiscal reform and slippages from the planned tightening would put the debt ratio on a rising trend.

Creating additional fiscal space would help Costa Rica to respond to potential unexpected shocks. Adopting additional measures, such as those recently announced, would also create more room for capital spending and to respond to ageing. The political economy of increasing taxes once again is challenging, but Costa Rica has room to broaden tax bases without increasing rates. There is also room to improve the tax mix.

Improving public spending efficiency is a social challenge. Increases in public spending since 2008 have not been matched by an improvement in performance. A priority area for reform is public sector employment, as compensation of government employees accounts for half of total revenues. A reform of the public sector, to eliminate duplications and non-functional bodies, and of public procurement, to cover more purchases by government agencies outside central government, would help to boost efficiency.

Improving debt management is key. As the interest rate bill is increasing, containing the cost of debt servicing and reducing risks become critical. Attracting international investors to local currency denominated debt can reduce both interest burden and currency risks.

Contingent liabilities are large. The explicit blanket public guarantee on deposits held by state-owned banks and other debts implies sizeable contingent liabilities and systemic risks of doom loops, as state-owned banks have large exposures to sovereign debt and state-owned enterprises. The pension system does not generate enough resources to be sustainable. A parametric reform, avoiding further increases in social security contribution rates, is needed. A more diversified investment strategy of pension assets, which are heavily concentrated in Costa Rica’s sovereign debt, would reduce risks.

Universal health care and pensions have led to remarkable social outcomes but inequality remains high (Figure 2). Social spending has increased, but this has not lowered inequality markedly. In light of the fiscal situation, policy efforts to ensure social spending leads to tangible improvements and solving existing inefficiencies are key to foster inclusive growth.

The commitment to education is strong, but outcomes remain weak. PISA results are low, despite high spending on education. Ensuring that all Costa Ricans have access to good and relevant education is critical to establish a more inclusive and productive economy. Teacher evaluations would help to tailor additional training opportunities. Updated curricula need to be implemented in classrooms and the university system needs to become more accountable, performance-based and responsive.

Early childhood education has been strengthened to boost female labour market participation. Women taking on family care responsibilities face difficulties to complete education or continue in the labour force after maternity. Access to early childhood education should be also expanded for children under the age of 4. Introducing paid and non-transferable paternity leave entitlements for fathers is also key.

Despite recent improvements, financial inclusion outcomes still display large regional disparities and gender gaps. Financial literacy is low. Complementing access to financial products with enrolment in financial education can help avoid excessive households indebtedness. A state-of-the-art electronic payments system provides Costa Rica with untapped potential to make FinTech a powerful catalyst for financial inclusion. Granting FinTech firms full access to the electronic payments system, while preserving security and consumer protection, would foster the development of this sector.

High informality contributes to inequality and hampers pension sustainability. There is no silver bullet to reduce informality. A comprehensive strategy, covering multiple policy areas, is required. This includes adapting regulations to facilitate compliance. The minimum wage system has been simplified, but there is still room to make the system even more job-friendly.

Growth potential has fallen due to weak productivity. Further advances on living standards will hinge on raising productivity by setting the right conditions for domestic companies to thrive and, at the same time, maintaining and reinforcing the commitment to foreign direct investment and trade, which has been key to increasingly diversify the export basket. Maintaining the commitment to preserving natural resources and biodiversity and pressing ahead with the decarbonisation plan will pay off also in terms of growth and jobs.

Improving regulations would boost productivity and job creation. Regulations in Costa Rica are among the most burdensome in advanced and emerging economies (Figure 3). Barriers to entry are particularly large. There is also room to further improve the performance of state-owned enterprises and upgrade the methodology to set up administered prices.

Strengthening competition would boost growth significantly. Many of the weaknesses in the competition framework, such as the lack of independence and resources of the competition authority, have been addressed in the new competition law. Complying strictly with the implementation road map is key. Existing exemptions to competition rules, such as those granted to rice, sugar, coffee, maritime transport and professional services, are regressive and inefficient and should be phased out.