The Policy Roots of Socioeconomic Stagnation and Environmental Implosion: Latin America 1950–2000

The Policy Roots of Socioeconomic Stagnation

and Environmental Implosion: Latin America

1950–2000

RAMON LOPEZ *

University of Maryland, College Park, MD, USA

Summary. — The persistence of growth and its equity and environmental effects heavily depend onthe composition of asset investments. Physical, human, and natural capital are the key assetsbehind the development process. Market failures tend to affect the accumulation of such assetsasymmetrically, leading to underinvestment in human and natural capital. Public policy in LatinAmerica has generally exacerbated such market failures by promoting physical capital investmentsusing massive public subsidies instead of relying on the expansion of public and semipublic assetsthat complement physical capital. The result: economic stagnation, deep social inequities andenvironmental destruction.� 2003 Elsevier Science Ltd. All rights reserved.

Key words — capital subsidies, stagnation, Latin America, environment

1. INTRODUCTION

Until some time ago, the development liter-ature viewed economic growth as mostly de-pendent on the accumulation of physicalcapital and (exogenous) technological change. 1

In addition, economic growth and welfaregrowth were seen almost as synonymous. Morerecently, as a result in part of the ‘‘endogenousgrowth revolution’’ in the mid-1980s, there hasbeen increasing recognition that economicgrowth is dependent on a variety of assets andnot merely physical capital accumulation andproductivity. Moreover, long-run growth de-pends not only on the speed of asset accu-mulation (including of knowledge) but also onthe ‘‘blend’’ of at least three key assets, physi-cal capital, human capital and natural capital(The World Bank, 2000).It has been shown that the composition

of the asset investment portfolio is essentialin determining: (a) whether economic growthis likely to be sustained and environmentallysustainable over time; (b) the speed of growthin the long run; (c) the social equity implica-tions of economic growth (L�oopez, Anriquez, &Gulati, 2001). There are asset accumulationblends that make significant long-run economicgrowth with equity possible while others arelikely to lead to economic stagnation over the

long run, social inequity and environmentaldestruction. The emphasis in this paper is onasset accumulation and composition as asource of wealth and productivity growth. Thefact that we ignore other more traditionalsources of productivity does not mean that weregard the contribution of such sources as un-important. It only reflects our belief that theliterature has ignored for too long the issue ofasset composition and its impact on growth,equity and the environment. 2

The ‘‘right blend’’ of assets is, of course,achieved if savings are allocated to investmentsin any of the three assets that have the highestsocial rate of return so that in the long run thenet social rates of return to investments in eachasset are equalized. Does a market economyassure such an efficient asset allocation? Asshown below, the answer to this question is ingeneral, no. There are market imperfections

World Development Vol. 31, No. 2, pp. 259–280, 2003� 2003 Elsevier Science Ltd. All rights reserved.

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* I am grateful for extremely useful comments provided

by two anonymous referees. This paper has also bene-

fited from comments by Gil Nolet, Ricardo Quiroga,

Diego Rodriguez and Steve Stone. Excellent research

assistance was provided by Liisa Harmoinen. Financial

support for this research was provided by the Environ-

ment Division of the IDB and by the World Bank In-

stitute. Final revision accepted: 13 October 2002.

259

that distort the asset choice and, more impor-tantly, such market imperfections affect someassets more deeply than others. In particular,we argue below that market imperfections havea large negative effect on private agents� in-vestments in human and natural capital whileinvestments in physical capital are less affectedby market imperfections. 3 Thus, there is aclear role for public policy in mitigating theeffects of market failure on asset accumulationchoice. A key point argued in the remainder ofthis paper is that most governments in LatinAmerica have failed to mitigate these marketfailures and, in a sense, have exacerbated theeffects of such failures.The most pervasive market imperfections

impinging upon the asset investment choice arecredit market failures affecting especially poorhouseholds, and environmental property rightimperfections. A consequence of credit marketfailure is that socially profitable investments,especially in human capital of poor and semi-poor households, may not be undertaken dueto lack of financial resources. Similarly, envi-ronmental property right imperfections andexternalities lead to overuse environmentalassets and underinvestment in natural capital asfirms that invest in natural capital protectionand enhancement may fail to receive the returnsto such activities. Insufficient or inadequatepublic intervention in mitigating the effects ofthese market failures causes underinvestmentin human and natural capital. This, in turn, islikely to cause secular economic stagnation orslow growth. In addition, the economy mayremain socially inequitable and environmen-tally destructive.A key hypothesis developed in this paper is

that environmental and natural resource de-gradation should be looked at as an integralpart of a pattern of growth followed by LatinAmerica, not in isolation. We argue that thedisappointing performance of the region interms of growth, poverty reduction and socialequity on the one hand, and generalized envi-ronmental destruction on the other, are justtwo outcomes that have a common root: apolicy framework dominated by futile efforts topromote physical (and financial) capital accu-mulation almost at all costs relying on instru-ments that tend to exacerbate, rather thanaddress, the above-mentioned market failures.This has been a loss–loss–loss strategy, caus-

ing slow economic growth or even stagnationaccompanied by perverse social and environ-mental effects. Despite the significant policy

changes that took place in the 1980s and early1990s in the context of so-called structuraladjustment, key elements of the old strategyhave remained intact or perhaps they have evenbeen magnified. After 50 years of trying such anunsuccessful strategy it is high time to changeit! A new approach should emphasize, (i) thetransfer of savings from the corporate sectorand high-income groups of the economy to thehousehold sector (especially poor and lowermiddle income households) so that financialrestrictions cease to be a binding constraint forhuman capital accumulation; (ii) effective gov-ernment enforcement of environmental regula-tions and public investment in natural capitalto allow for environmental and natural re-source sustainability; (iii) the promotion ofphysical capital investments and innovationusing long run means such as increased avail-ability and quality of public or semipublicgoods that include human and natural capital,rather than short-run instruments such as fi-nancial capital subsidies, arbitrary tax conces-sions and wasting natural resources as a way ofenticing investors.We argue, however, that past policy failures

have not been the product only of lack of un-derstanding or information. Rather, at the rootof such policy failures is often the interplay ofpowerful politico-economic interests as well asideological factors that induce biased policiesfavoring the interest of the powerful to thedetriment of the rest of society. The historicalsocio-economic inequities that have character-ized Latin America lead to deep imbalances inthe political lobby capacities between theowners of physical and financial capital vis-�aa-vis the rest of society. In several countries thepolitical lobby of the wealthy has been domi-nated by a ‘‘quick profit’’ mentality directed toobtain maximum benefits over the short run.Such political imbalances caused biased policiesthat effectively perpetuated social inequities andenvironmental destruction. True policy changesresulting in sustainable and equitable develop-ment may require that such political lobbyimbalances be ameliorated so that the generalcivic society and grassroots organizations inparticular attain a greater weight in the politicalgame. Policy changes may also be facilitated ifentrepreneurs with a longer term perspectiveincrease their influence within the traditionalpolitical lobby of the wealthy.The remainder of this paper is organized as

follows: Section 2 provides a stylized concep-tual framework that allows us to analyze the

WORLD DEVELOPMENT260

historical experience of Latin America from aperspective different from the traditional one;Section 3 presents certain extensions to the coremodel as a way of increasing its usefulness inpolicy analysis; Section 4 provides a succinctinterpretation of the development experience ofLatin America at the light of the conceptualframework developed in the previous sections.Section 5 discusses the role of public policy inshaping certain key characteristics of the his-torical experience of the region. Section 6 con-tains certain political economy considerationsunderlying the growth strategy chosen andSection 7 concludes.

2. CONCEPTUAL FRAMEWORK 4

Consider an economy comprising two sec-tors, a primary sector and an industrial sector.Production in the primary sector uses naturalcapital as a basic input, as well as labor, humanand physical capital. The primary sector ex-tracts natural capital to use it as an input in itsproduction. Production in the industrial sectordoes not extract natural capital, but it generatespollution that reduces the value of the naturalresource as a factor of production and as aconsumer good. Industrial sector production isintensive in physical capital; it also uses humancapital. Apart from being a factor of produc-tion, natural capital is assumed to have a directpositive effect upon the welfare function.

(a) Investments

The economy can invest in three assets,physical capital, general human capital, andnatural capital. Investment in human capital(consisting in formal schooling and health)enhances the productivity of labor in bothsectors by the same proportion. Investment inphysical capital is entirely financed by indus-trialists, while investments in human and nat-ural capital must be financed at least in part bya tax on industrialists and an additional tax onworkers� and primary producers� income. Theneed for financing part of these investments outof tax revenues is due to credit and environ-mental property rights imperfections thatprevent implementation of socially desirableinvestments in human and natural capital, re-spectively. The private sector, particularly thecorporate sector, invests in physical/financialcapital as well as in firm-specific human skills.Private firms, however, do not invest in general

human capital given the semi-public good na-ture of general human capital. Firm-specificskills and general human capital are comple-ments in the sense that a well-educated laborforce in good health can more easily learnspecific skills at a lower cost to firms than alabor force that has little general human capi-tal.Investment in natural capital includes in-

vestments such as cleaning-up of ecosystems,tree planting, restoration and protection ofaquatic, forest and marine ecosystems, fish re-plenishment including aquaculture investment,soil protection including terracing, drainage,agriculture fallowing as well as investments inpollution abatement technologies. These in-vestments directly or indirectly contribute toenhance the carrying capacity of ecosystemsand the natural environment.

(b) Market imperfections

Two types of market imperfection are as-sumed, (i) a capital market failure that preventspart of the population from financing invest-ments even if their rates of return are high, and(ii) property right inefficiencies and externalitiesaffecting natural assets that cause a wedge be-tween the social and private rate of return tonatural capital which, in turn, prevents sociallydesirable investments in natural assets frommaterializing. In addition, in the absence ofregulation, environmental externalities inducefirms to use production methods characterizedby too high pollution to output intensities.Despite the fact that credit or capital market

failure negatively impinges upon investments inhuman capital, it does not, significantly affectinvestment in physical capital. The distributionof physical capital across the population isirrelevant from the point of view of its effec-tiveness in yielding output and growth. Thatis, there is close to perfect substitution acrossphysical capital owned by different firms.Hence, imperfections of credit markets maysignify that only larger corporations haveaccess to sufficient savings to finance their in-vestments. The bulk of physical capital invest-ment may be concentrated in a subset of firmsbut this is of little consequence for output,employment and growth. 5 Thus, in the case ofphysical and financial assets there is a ‘‘marketsolution’’ to capital market imperfectionswhich consists in increasing concentration ofinvestments in the hands of firms that are largeenough to be immune to credit restrictions.

SOCIOECONOMIC STAGNATION AND ENVIRONMENTAL IMPLOSION 261

This ‘‘market solution’’ may involve static in-efficiencies but it may not necessarily lead tounderinvestment in physical capital.The case of human capital is, however, dif-

ferent: By definition, to be effective as a sourceof productivity and growth, human capital hasto be spread across the population. Thus, un-like physical capital, human capital owned bydifferent individuals has only a limited degreeof substitution. The limits to asset concentra-tion are much tighter for human capital thanfor physical capital. Consequently, the ‘‘marketsolution’’ to financial credit constraints is thathouseholds for whom such constraints arebinding underinvest in human capital whilehouseholds unaffected by financial constraintscan only partially make up for this underin-vestment. 6 The net result may be underin-vestment in human capital.The asymmetric response to capital market

imperfections of physical and human capitalexplain the origin of an important empiricalstylized fact: Physical and financial assets aremore concentrated than human assets. Twocorollaries follow: (i) Income originated inhuman capital is more spread than incomeoriginated in physical and financial capital; (ii)growth based mostly on physical and financialcapital is likely to be less socially equitable thana more balanced growth based on human cap-ital accumulation.

(c) Sources of growth and sustainability

A key potential engine of growth is labor-enhancing endogenous technical change, i.e.,investment in human capital increases laborproductivity in all sectors of the economy.Economic growth is also fueled by physicalcapital accumulation. As the economy grows,however, it imposes increasing demands uponits natural capital due to the greater level ofextraction of natural resources, and the in-creasing levels of pollution that accompanygrowth. This threatens not only the sustain-ability of natural resources but also the conti-nuity of economic growth in the long run. Ifgovernments do not raise enough financialresources and devote them to human capitalinvestment and to enforce environmental reg-ulation and invest in natural capital, growthcannot be sustained. Investment in physicalassets would decline over time due to the fallingmarginal productivity of physical capitalcaused by insufficient growth of human andnatural assets that are complements to physical

capital itself. That is, slow growth of humanand natural capital eventually leads to slowgrowth of physical capital and productivity aswell, and hence to slow overall growth.Environmentally sustainable growth can be

achieved by adopting adequate pollution regu-lation on the pollution intensity of output,increasing levels of investment in environmen-tal and natural resources and by endogenousstructural change causing the primary sectorto shrink relative to the rest of the economyalong the growth process. Given the said mar-ket failures this cannot happen without gov-ernment intervention that include: (i) pollutionintensity regulation; (ii) adequate taxes onprofits to mobilize savings to finance invest-ment in human and natural capital; (iii) directpublic investment in environment and naturalresources to neutralize the detrimental effects ofgrowth on natural capital.Though industrial investment contributes to

natural capital degradation, growth induced byexpansion of the primary sector also causesenvironmental degradation. In fact, if the in-dustrial sector is more intensive in physicalcapital than the primary sector and if the pol-lution intensity of the industrial sector is lessthan the natural resource intensity of the pri-mary sector, then greater industrial investmentscause less natural capital degradation thangrowth of the primary sector. In this casegrowth causes the structure of the economy toshift more toward the less environmentally de-manding industrial sector. The issue, however,is not so much the impact of industrial invest-ments in natural capital but rather the instru-ments used to promote them. If the governmentpromotes them via expensive subsidies or lowcapital taxation, the necessary public invest-ments in natural resources to ensure sustain-ability may be crowded out thus causing greaterresource degradation regardless of the nature ofgrowth.

(d) Optimal policies

Optimal public policies are defined as thosethat effectively address the above market fail-ures. As most income and savings are generatedby the owners of physical (and financial) capi-tal, some of these savings should flow to thehousehold sector to finance investments inhuman and natural capital. Due to credit mar-ket imperfections, however, this flow of savingsdoes not happen and the credit market becomeseffectively segmented. An optimal tax on the


corporate sector and high-income householdspermit a redistribution of savings from thecorporate/high income sector to the rest of theeconomy. This tax is effectively an instrumentto reduce the credit market segmentation be-tween the corporate/high income sector and therest of the economy. The tax should be ac-companied by the necessary pollution regula-tion. Part of the tax revenues need to be used infinancing the human capital investments of thehouseholds affected by the credit market im-perfections and another part should pay forenforcing pollution regulation as well as forfinancing investment in natural capital.Thus if the government wants to maximize

the present value of welfare of the medianhousehold, it would set a tax on profits andhigh income households and regulate pollutionintensity at certain optimal levels, and deter-mine an optimal distribution of tax revenuesbetween financing investments in human andnatural capital. Suboptimal investment inhuman and natural capital causes welfare lossesand reduces economic growth for reasons to bediscussed later.There is no single level of the tax rate that is

optimal but rather an optimal trajectory ofsuch rate over time. Moreover, under fairlygeneral conditions, in a growing economy theoptimal tax should be increasing over time. Thetax rate should converge toward a certain sec-ular tax rate from below: a richer economyshould have a higher tax rate than a poorerone, ceteris paribus.

(e) Wage determination and natural capital

The primary sector that typically may includeagriculture, fisheries, forest extraction, part ofthe energy sector as well as manufacturing witha high intensity of natural resource inputs, suchas food and wood processing, is a key sector insetting the wage rate for the economy. Thoughthe primary sector in most middle-incomecountries generates only between 10% and 20%of total GDP, it often employs a much greatershare of the labor force, usually in excess of30% and an even greater fraction of unskilledworkers. A critical role of the primary sector isto set the most basic opportunity cost for un-skilled labor in the economy. As is well known,unemployment in rural areas is usually low soworkers that cannot find jobs in the rest of theeconomy have the possibility of employment inthe primary sector as a last resort. Moreover, ifthe labor market is more or less competitive,

wages in other sectors (correcting for skill lev-els) are likely to be closely aligned to this op-portunity cost.Degradation of natural capital causes a de-

cline of the productivity of labor in the primarysector and, consequently, on the opportunitycost of the labor force. 7 This, in turn, impliesthat natural capital degradation, ceteris pari-bus, is likely to be associated with declining realwages and possibly with increasing poverty.Thus, failure to regulate pollution and to investin natural assets tends to be ultimately detri-mental for workers.It is often believed that pollution regulation

is not good for workers as employment in thefirms affected by such regulation falls. If pol-lution regulation is too loose, however, pro-ductive natural capital will degrade which willeither reduce the opportunity cost of workersand, hence real wages and/or force governmentto invest more in natural resources to preventexcessive degradation. This could crowd outpublic resources that otherwise would go to fi-nance investment in human capital reducing,therefore, human capital expansion especiallyof the poor that are most dependent on thepublic sector to finance their investment inhuman capital. The slowdown in human capitalaccumulation would cause slower growth andreduced real wages. In addition, pollutionunder regulation is likely to negatively affect thehealth status especially of poorer householdscommonly living in the most contaminatedareas. 8

(f) Optimal growth

If optimal policies are implemented, the long-run equilibrium of this economy is character-ized by positive growth of welfare over time,with unbalanced growth in assets: Naturalcapital reaches a stationary level, physical andhuman capital grow at different and varyingrates over time. Growth is also sectorally un-balanced in the sense that the two sectors growat different rates, with the likely scenario beingthat the primary sector grows at a slower ratethan the rest of the economy. Moreover, grossinvestments in all three assets (including natu-ral capital) must be positive. That is, envi-ronmental sustainability is achieved using allinstruments available, including environmentalregulation and increased investments in theenvironment. The intuition behind this result isthat, ruling out certain nonconvexities, cornersolutions are rarely optimal. If there are two


instruments available it is often more efficientto use both of them to some extent rather thanrelying exclusively on one of them.

(g) Undertaxation of capital and othergovernment failures

Assume that initially the economy is not inlong-run equilibrium because it has too littlehuman capital relative to physical capital. Alsoassume that the natural resource stock is lessthan the optimal long-run level of the stock.Suppose that either because of the existence oflarge capital subsidies or a low nominal taxrate, the effective capital tax rate is subopti-mal. 9 Because the capital tax rate is too low,public revenues are insufficient to finance in-vestments in human and natural capital atthe optimal level, while investment in physicalcapital is excessive to achieve a social optimum.It is possible that the tax rate is so low that itsimply does not allow the economy to move inthe direction of sustainable growth and humanand natural capital decrease overtime instead ofrise as would be required if the economy is toachieve a long-run equilibrium with permanentgrowth. 10

In this case the economy may still grow butexclusively on the basis of physical capital ac-cumulation. Moreover, if natural capital is de-creasing and human capital is falling orgrowing too slowly, for example, it is possiblethat real wages deteriorate as growth takesplace. The fall of natural capital is crucial be-cause, as previously discussed, the level ofnatural capital plays a vital role in determiningthe opportunity cost of workers. So a decreaseof natural capital may be detrimental not onlyfor producers directly employed in primaryactivities but also for workers employed innonprimary industries who may see their realwages erode. Even if real wages do not fall, adeclining natural capital may lead to a deepimbalance between a fast growth of (after-tax)profits and wages. That is, corporate tax belowthe optimal one is detrimental for the envi-ronment and for social equity.Even physical capital accumulation is even-

tually reduced as the lack of a concomitantgrowth of human and natural capital causes the(marginal) returns to physical capital to fall asphysical capital increases. This, in turn, reducesthe incentives to invest and slows down eco-nomic growth. That is, undertaxation of phys-ical (and financial) capital may lead not only toenvironmental degradation and underinvest-

ment in human capital but ultimately to eco-nomic stagnation.Undertaxation of physical capital may be due

to either low legal tax rates and/or to largesubsidies to physical capital. In turn, capitalsubsidies may entail direct financial subsidiesincluding tax exemptions, credit subsidies,public grants, etc. Subsidies may also be non-financial including concessions of monopolypowers, licenses and, particularly, giving awaypublicly owned natural resources for free orunder charging the corporate sector for theirexploitation. 11

Underregulation of pollution and of the ex-ploitation of renewable and nonrenewablenatural resources is normally related not somuch to the lack of environmental laws butrather to weak enforcement of such laws. Thereis ample evidence of lack of enforcement ofenvironmental laws and regulations in devel-oping countries that are in part attributed toweak environmental institutions (Nolet, 2000;World Bank, 2000, Chapter 4).Underinvestment in human and natural

capital may be due not only to the inability orunwillingness of governments to tax capitalat sufficiently high effective rates but also topublic expenditure allocations that do not giveenough priority to public investment in humanand natural capital. Government failures dueto bureaucratic inefficiencies, corruption andwrong priorities may contribute to the wastingof a significant part of government revenues.The lack of a clear understanding among policymakers of the crucial responsibility of govern-ment in fixing credit market segmentation andenvironmental externalities may also be a con-tributing factor. Transferring savings from thecorporate/high income sector to the rest of so-ciety through the tax/subsidy mechanism andcorrecting environmental market failure viaregulation and direct public investments in en-vironmental protection is not, apparently, re-garded as a key role of government. Instead,old notions such as the ‘‘promotion of indus-trialization’’ are still regarded by many policymakers as the best characterization of their roles.

3. EXTENSIONS

The previous section describes a basic con-ceptual model for the analysis of governmentintervention in the context of a growth frame-work. Such a model is highly stylized and doesnot consider several issues of importance in


real-world economies. Here we extend theanalysis to consider some of these issues.

(a) Capital taxation and capital subsidies

The theoretical model of the previous sectionuses the concept of net taxation defined as taxesless capital subsidies. That is, for the sake oftheoretical tractability, it imposes neutrality onthe instrument chosen; lowering taxes by onedollar or increasing subsidies by the sameamount leads to identical outcomes. In reality,capital subsidies can have significantly different(and more deleterious) effects compared toacross-the-board capital tax reductions.Subsidies are not usually uniformly allo-

cated; instead subsidies favor certain industriesover others, certain firms over others. More-over, part of the subsidies consists in givingexclusive rights over real or financial resourcesand markets that lead to the creation of mar-ket segmentation and monopoly power. Othersubsidies consist in underpricing natural re-sources for firms, which cause resource exploi-tation beyond socially optimal levels. Finally,subsidies create optimal breeding conditions forcorruption. The fact that governments havepowers to arbitrarily allocate massive financialand real resources to wealthy firms and indi-vidual generates conditions for bribery, andnontransparent political contributions to poli-ticians. 12

Thus, subsidies are likely to not only be amuch less effective mechanism to promote in-vestments than uniform tax reductions butalso have much more deleterious effects oneconomic efficiency, environmental destructionand corruption. Subsidies are less effective inpromoting investments because they tend to becapitalized as rents originated in firms� con-nections with powerful government officers.They cause losses of efficiency because theyincrease monopoly powers. They contribute tonatural capital destruction because natural re-sources become instruments of subsidization.All this greatly enhances the opportunities forcorruption. For these reasons the concept ofnet capital taxes (taxes minus subsidies) is notused in the empirical analysis below and weinstead treat taxes and subsidies separately.

(b) Financial debt accumulation and otherinternational issues

The use of massive capital subsidies is in partresponsible for the tendency to generate fiscal

deficit and public sector debt. Access to worldcapital markets considerably facilitates therapid growth of the public debt. The processmay be described as follows: Structural ad-justment and increasing economic openness incombination with generous capital subsidiesand low taxes tend to spur growth in the shortrun. This early growth is based mostly on in-creased investment in physical and financialcapital. But, given insufficient attention to theprovision of public goods (including education,health, infrastructure, social expenditures, andothers) and the rapid depreciation of naturalresources, that this early growth process bringsabout, the marginal productivity of investmentsin physical and financial capital starts decliningafter a few years. This causes a deceleration ofinvestment and growth with a consequent re-duction of government revenues. The responsesof government to the slowdown of growth maytake at least two different avenues with dra-matically different effects on the economy overthe medium term: (i) some governments opt forincreasing capital subsidies and reducing taxeseven further while at the same time are reluc-tant to cut significantly the social and publicgood expenditures; (ii) others cut social andpublic good expenditures to avoid large fiscaldeficits and wait for ‘‘more favorable externalconditions.’’Response (i) often leads to ballooning fiscal

disequilibria and dramatic increases in debtservice that in turn reduce even further theflexibility of the public sector, that is, to fi-nancial unsustainability that may potentiallycause financial crises and economic depression.Response (ii) has less dramatic consequences:Chronic slow growth or even stagnation.The low effective tax rates make fiscal reve-

nues extraordinarily dependent on rapid growth.At the same time, given that governments arecommitted to large capital subsidies, public ex-penditures have little flexibility. For these rea-sons even a mild deceleration of growth tends tocreate large fiscal disequilibria. In case (i) publicdebt increases dramatically and the burden ofdebt service rapidly expands, worsening thecrowding out of expenditures in public goodsand increasing public deficit. Thus we have avicious cycle originating in the use of the wronginstruments to promote growth: from capitalsubsidies and undertaxation to fiscal deficit anddebt accumulation to fiscal adjustments thatdeepen the inadequacy of such instruments thusfrustrating the revival of growth and continu-ously aggravating public sector imbalances.


It has been argued that the option of in-creasing capital taxes or reducing subsidies isnot really available because of the great mo-bility of corporate capital due to globalization.As companies move to countries where taxesare low and subsidies are large, countries areforced to maintain low taxes and high subsi-dies. 13 Although it is true that financial capitalmobility has indeed increased dramatically,firms investing in real assets still have an in-centive to look at the medium and long-termprospects of the host countries which, for sev-eral reasons, including highly imperfect mar-kets for used capital goods, are affected bymuch greater exit costs.Though investors in real assets do benefit

from low taxes and subsidies they also are likelyto see the big picture: that if a government doesthis beyond a certain point, the health of theeconomy over the long run will suffer and do-mestic financial crises �aa la Argentina are likely.This may become a sufficient deterrent for long-term investments to materialize. So countriesoffering low taxes and large capital subsidiesare likely to attract speculative capital, espe-cially financial capital, and less real invest-ment. 14 Unlike real investments, speculativefinancial investments face few entry and exitcosts, which prompts their owners to exploitthe short-run benefits offered by governments.Paradoxically, countries that are ‘‘too businessfriendly’’ may be affected by adverse selection:They tend to attract more financial and specu-lative capital and less real capital than countriesthat offer more realistic incentives. Countriesrelying too much on speculative capital flowsface greater risks of financial instability andcrises than countries that are able to attract amore balanced mix of capital.In summary, consideration of international

factors is likely to exacerbate the implicationsof a policy strategy that bases growth incen-tives on low capital taxes and/or large subsi-dies. Depending on the fiscal strategy chosen,such a strategy could lead to escalating fiscaldeficits and rapid public debt accumulation.The increasing debt and concomitant increasein interest payments reduce the ability ofgovernments to continue promoting growththus causing stagnation and further erosionof tax revenues. The final outcome is pro-longed stagnation, which is qualitatively justthe same conclusion obtained when one ig-nores financial and international debt mech-anisms. Consideration of these aspects,however, shows that because of the inherent

volatility of international financial capitalflows, it may also cause large financial crisesleading not to stagnation but to economicdepression.

(c) Poverty and income distribution

As we indicated above, nonsustainable andunsustained growth is highly deleterious for thepoor and for social equity. Indeed growth that isexcessively dependent on physical capital ac-cumulation with slow growth of human capitaland rapid environmental degradation is almostdefinitionally equivalent to growth that isunstable and ineffective in reducing poverty(World Bank, 2000). Insufficient expansion ofhuman capital means that most poor peoplewill not be able to achieve skills that wouldallow them to become nonpoor and levels ofhealth that increase their chance of workingproductively over their working life. Naturalresource deterioration affects the productivecapital of the poor disproportionately, espe-cially in rural areas where a significant part ofthe extremely poor are located thus reducingtheir potential to benefit from economic growth(Dasgupta, 1995). Finally, increasing ambientpollution also affects the health of the urbanpoor disproportionally as they usually live inthe most polluted areas of the city and have theleast means to face pollution. The consequentdeterioration of the health of the poor affectstheir human capital and, consequently, theirability to increase their income during thegrowth process.As previously discussed, the very features

that prevent the benefits from economic growthto favor the poor are also responsible for thelack of persistence of economic growth and,eventually, stagnation. If positive growth is notparticularly effective in reducing poverty, eco-nomic stagnation is certainly highly detrimentalto the poor. After going through a physicalcapital dependent/natural resource exploitativegrowth boom, countries commonly end updeeply in debt with severe fiscal disequilibria asa consequence of budgetary costs and ulti-mately vain efforts by governments to boostphysical/financial investments through directand indirect subsidies. The impact of the in-duced stagnation, recession and necessary fiscalcorrections falls disproportionately on the pooras social services are cut back and educationand health expenditures are reduced even fur-ther.


(d) Population growth and unskilled labor

In several countries of Latin America (e.g.,Central America) rapid population expansionhas been a major factor causing environmentaldegradation. Natural capital destruction is notonly the product of economic growth-cum-lowinvestments in natural capital and inadequateenvironmental regulations, but also of rapidpopulation increases even in the absence ofeconomic growth pressures. Population growthhas a double effect on the wages of unskilledlabor: (i) the usual effect associated with in-creasing labor supply that reduces real wages;(ii) increased pressure on natural resourcescausing their degradation that reduces the op-portunity cost of workers that further cut realwages for the unskilled.The natural capital destruction caused by

population growth itself leads to the reductionof the marginal product of physical investmentsthat use natural capital as complementary fac-tors of production. This induces governmentsto spend even greater public financial andnonfinancial resources to ‘‘promote’’ invest-ments in physical/financial capital as a way ofcompensating firms for the degraded naturalresources. Thus, rapid population growth ag-gravates the process described above as it in-duces governments to spend even more publicmonies in subsidies leading to a more intensecrowding out of public expenditures in humanand natural capital. In general one would ex-pect that countries that have experienced thefastest rates of population growth would haveto spend more public resources to attract thesame level of capital investments than countriesexhibiting slower population growth.

(e) Global values of environmental services

Several countries in Latin America are par-ticularly rich in natural resources that providesignificant services to the world as standingecosystems. In particular, tropical forest eco-systems generate two important global services,carbon sequestration and biodiversity. Thesevalues are potentially much larger than thevalues obtained by exploiting certain foreststhrough conventional means for the sake oftimber, mineral extraction, agricultural andlivestock exploitation (L�oopez & Oca~nna, 1999).Consequently, this could imply that the pres-ervation of many tropical ecosystems for thesake of obtaining global values may be moreprofitable than its exploitation through con-

ventional means. But, while the institutionaland market conditions to realize the conven-tional values of ecosystems already exist, insti-tutional and market conditions that allowglobal services to materialize are just beginningto emerge.International trade in environmental services

between industrialized countries and develop-ing countries still rich in biodiversity andcarbon sequestration capacities could greatlyincrease the benefits of environmental sustain-ability in developing countries. North–Southtrade in global environmental services could bemutually beneficial for the North (industrial-ized countries) and South (developing coun-tries). The cost of reducing carbon emissions inthe North is much higher than in certaincountries in the South which could producesimilar services through the enhancement andpreservation of tropical ecosystems. Countriesin the South can also greatly benefit as theNorth would be in many cases willing to paythe South more for protection and enhance-ment of ecosystems than for the product oftheir conventional exploitation (L�oopez, 1998).Consequently, there is potential for mutuallybeneficial North–South trade in environmentalservices. But such trade requires the develop-ment of international and local institutions thatare still in early state of development.

(f) Defensive expenditures

As ambient pollution worsens and naturalresources degrade, people do try to replacethese lost environmental services with man-made goods that are substitutes for such ser-vices (Antoci & Bartolini, 2001). The affluentcan afford to substitute environmental serviceswhile such substitution is more difficult in thecase of less economically powerful segments ofsociety. For example, as air pollution worsensin lower areas of the city, the affluent build newhouses in higher areas where the air is cleaner.As local beaches become more contaminated,the wealthy vacation in more remote areas and/or in foreign resorts where it is more costly togo. As commercial fish species become extinct,corporations invest in aquaculture to cultivatesuch species, a possibility that is generally moredifficult for artezanal fishermen who mustsimply accept the economic damage of thescarcity of naturally grown fish.When natural forests become sufficiently de-

graded many natural products such as wildfruits, nuts, animals, fuelwood, etc. become


scarce, thus prompting firms to produce morecoal to substitute for natural fuelwood, treeplantations to substitutes the lost timberproducts, etc. Deforestation and degradation ofwatersheds and river basins that supply waterto cities force large investments in water puri-fication and treatment that would either not benecessary or be much less costly if watershedswere in pristine condition.These examples, have certain common ele-

ments: (i) products and services that at a pointin time were more or less freely produced bynature such as air/water purity, recreation,fish and forest products become unavailable aseconomic growth takes place; (ii) substitutingsuch natural products and services for man-made products and services requires morecostly productive inputs that otherwise wouldhave been used for other purposes; (iii) while ahigh proportion of the natural services and rawmaterials were not accounted for as income asthere was no market for them (clean air anduncontaminated beaches generally have noeconomic price even if they are scarce; raw fishand in site natural forest products are also notpriced if exploited under more or less openaccess regime, etc.), the new products and ser-vices are very much part of the national ac-counting system. Thus, part of the ‘‘new’’outputs and services generated as economicgrowth takes place are not really new but sim-ply newly accounted for in the conventionalgrowth statistics; 15 (iv) in most cases the lossof environmental services can be replaced to thebenefit of the affluent but the poor generallycannot access the goods and services that re-place the natural ones as they are much moreexpensive items. That is, while the affluent areable to substitute natural for man-made goodsand services, the poor generally cannot.The fact that segments of society are able to

respond to environmental degradation via de-fensive expenditures means that environmen-tally destructive growth is reflected in nationalstatistics as ‘‘faster’’ growth than environmen-tally benign growth. More importantly, envi-ronmentally destructive growth fuels ‘‘moregrowth’’ as conventionally measured. And such‘‘increased’’ growth itself promotes even fasterenvironmental degradation and, therefore,more defensive expenditures and more nationalaccount ‘‘growth.’’ That is, a vicious cycle ofenvironmentally destructive growth––defen-sive, expenditure––more environmentally de-structive growth is generated if governments donot implement adequate environmental regu-

lation and if it fails to invest in the protection ofnatural ecosystems.

4. LATIN AMERICA: 1950–2000

As the vast majority of the countries con-sidered ‘‘developing’’ in the 1950s, the devel-opment experience of Latin America since thenhas been largely frustrated. The economicstagnation of the region is a fact that is by nowa commonplace in practically all analyses of theregion.

(a) Slow per capita income growth

During 1950–98 per capita income in LatinAmerica has increased from US$2,100 toUS$3,500 (expressed in purchasing power par-ity of 1987); that is, at an annual averagegrowth rate of 1.3%. More important, the trendhas been a reduction rather than an accelera-tion of growth rate. While in 1950–70 thegrowth rate was 2.2% per annum it fell to 0.1%in 1980–98. Even in the 1990s when manycountries in the region went through their muchacclaimed structural adjustment, that includedelimination of many government-induced dis-tortions and dramatically increased the role ofmarkets, the annual per capita growth rate wasa mediocre 2%, below the rate prevailing in1950–70. 16

Economic stagnation describes not only theaverage picture of the region but there is anamazing degree of homogeneity across coun-tries. In fact, only seven countries experiencedgrowth rates between 2% and 2.5% per annumover 1950–98. All others had growth ratesbelow 2%.

(b) Highly inequitable growth

Economic stagnation has been accompaniedby the most inequitable income and wealthdistributions among all continents in the world.Among a group of 14 of the largest countries inLatin America, all but five of them have incomeGini coefficients above 0.53, including Brazil,Paraguay, Ecuador and Chile with Gini coeffi-cients above 0.57, a degree of income concen-tration surpassed by very few countries aroundthe world (World Bank, 2000).Between the mid-1980s and late 1990s, the

income distribution as measured by the Ginicoefficient has worsened in seven out of 13countries for which comparable data exist


(Jamaica, Guyana, Per�uu, Colombia, CostaRica, Honduras and Mexico), has marginallyimproved in two (Brazil and Chile) and it hassignificantly improved only in Dominican Re-public, Panam�aa, Guatemala and Venezuela(IDB, 2000).While the proportion of the population living

in extreme poverty (population living with lessthan US$1 per day) has practically remainedunchanged at about 20% between the mid-1980s and late 1990s (The World Bank, 2000),the absolute numbers of poor have continuedto increase. About 40% of the population livewith less than US$2 per day. During the 1990spoverty has, in fact, been reduced in severalcountries. But with the exception of Chilewhere poverty fell by almost 50%, in all othercases poverty reduction has been modest, lessthan 10%. In Colombia and Brazil povertyrates remained practically unchanged and inPeru poverty rates increased by more than 15%during the same period.

(c) Slow growth of human capital

A proxy for the evolution of human capital iseducation. Education has increased at an ex-tremely slow rate. During 1960–98 the averagelevel of education of the population over 25years of age has increased from 3.2 to 5.0 yearsof schooling, or about 1.2% per annum. Moreimportantly, the pace of education growth hasslowed down in the more recent decades com-pared to earlier ones. Over the 1990s theschooling level only increased from 4.7 to 5.0years at the rate of 0.6% per year, exactly one-half that for the whole period! Men born in1960 have average schooling of 7.7 years whilethe cohort born in 1970s only have eight yearsof schooling (IDB, 2000).Table 1 shows the annual growth rates of

education for 1962–98 compared to GDP percapita and growth of physical capital for fourof the largest Latin American economies. Apartfrom the slow growth in GDP, striking features

for all four countries are the slow growth ofeducation over time and, perhaps more im-portantly, the tremendous imbalance betweenthe growth rate of per capita physical capitaland education. In Brazil, per capita physicalcapital grew 12 times faster than education, inChile almost seven times faster, in Argentinaalmost six times faster and in Mexico morethan four times faster. There is no reason toexpect that physical and human capital shouldgrow at similar rates but the massive gap be-tween the two rates may reflect suboptimalallocations of investment resources. For com-parison the ratio of the physical capital growthrate to that of education over the same periodwas about 2.5 for industrial countries.

(d) Dramatic decline of natural capital

Data on the evolution of natural capitalare much scarcer, but the existing evidencepoints in the direction of a significant degra-dation of the environment and the natural re-sources. During the 1990s, 14 countries of LatinAmerica were among the 40 in the world withthe most rapid rate of deforestation. Nine ofthese 14 countries experienced deforestationrates above 2% per annum while five of themshowed deforestation rates of between 2.5%and 7% (The Economist, 2001).Several studies on genuine savings (defined as

the rate of savings after due account is taken ofthe depletion of natural resources and damagescaused by pollution, adding investments inhuman capital) have been recently imple-mented. They show a major discrepancy be-tween the net saving rate as defined in nationalaccounts and the genuine saving rate, thus in-dicating substantial losses in natural capitalwhich are not entirely offset by the effect ofhuman capital increases. According to WorldBank (1997) estimates, genuine savings forLatin America were 10.4% of GDP in the 1970sdeclining to 1.9% during the 1980s. and in-creasing to about 5% during the first half of the

Table 1. Economic growth and the evolution of assets in the four largest Latin America economies, 1960–99(annual percentage rates)

GDP per capita growth (%) Growth of physical capital per capita (%) Growth of education (%)

Argentina 1.13 2.35 0.41Brazil 1.80 2.45 0.20Chile 2.16 1.68 0.25Mexico 1.35 2.26 0.53

Source: World Bank.


1990s. These rates (especially those of the lasttwo decades) are among the lowest across allregions of the world, being higher only thanthose estimated for Africa.A dramatic example of low genuine savings

in Latin America is the case of Ecuador. Ac-cording to a World Bank study (Kellenberg,1996), natural capital depreciation over 1970–90 amounted to $7.8 billion (in 1987 dollars) orabout one full annual GDP if a depreciationmethod to estimate genuine savings is used.That figure grows four times, to $37.5 billion(also in 1987 dollars) if a user cost method isutilized.The fact that net savings rates as defined by

national accounts are more than twice thegenuine rates indicate that net physical capi-tal accumulation has been the overwhelmingcomponent of genuine savings. Gross domesticinvestment (in physical capital) was above 20%of GDP in practically all the major economiesin Latin America during the first half of the1990s. Assuming a physical capital to GDPratio of 2.5 and a 5% annual depreciation thisimplies that physical capital was growing at arate in excess of 7% per year during the firstpart of the decade. Recent data, however,indicate that physical capital accumulation hasdramatically decelerated over the last fouryears. Thus, consistent with the predictions ofthe conceptual model presented above, fastgrowth of physical capital combined with slowgrowth of human assets and the degradation ofnatural assets have led a reduction of incentivesto continue investing in physical capital itself.A rough estimate of the rate of natural cap-

ital degradation can also be obtained using avery basic growth accounting framework. Weuse the indicated long-run average annual percapita growth figures of: 1.3% for GDP, 1.2%for human capital per capita, 3% per capitagrowth of capital. We assume shares in nationalincome consistent with those estimated by theWorld Bank for the region of 60% of GDP for

capital income and, therefore, 40% of GDP forhuman and natural capital. Assuming that a40% share is distributed equally between hu-man and natural capital with no productivitygrowth, the growth rate of natural capital percapita has been )4.5% per annum. 17 If pro-ductivity growth is assumed at 1% per annumthen the implicit degradation of natural capitalreaches 7.5% per annum.The above finding is consistent with existing

empirical evidence on the ‘‘residual’’ estimatesobtained by several growth accounting analysesimplemented for Latin America and other ar-eas. This residual that is usually attributed to‘‘total factor productivity’’ is often found to benegative for Latin America. Bosworth, Collins,and Chen (1995), for example, found that thecontribution of ‘‘total factor productivity’’ togrowth per capita in 1970–92 was negativeon the order of )0.55% per annum (Table 2).Hoffman (2000) shows similar low or negativetotal factor productivity for several LatinAmerican countries. Of course, the authors didnot include natural capital in their growth ac-counting exercise. This negative ‘‘total factorproductivity’’ may in fact capture a large de-gradation of natural capital as shown in theprevious analysis.

5. HOW POLICIES HAVE CONTRIBUTEDTO THIS PATTERN OF GROWTH

Policies seem to have played an importantrole in inducing the pattern of growth describedin the previous section. We focus on a numberof key policy issues that in our view have beenmost important in forging such pattern ofgrowth. The key issue appears to be that gov-ernments in the region have generally failed torecognize fully their essential roles in reducingthe impact of market failures in the economy.Slow growth of human capital and progres-

sive degradation of natural capital over time is

Table 2. Contribution of ‘‘total factor productivity’’ to per capita growth; Latin America and other regions 1970–92(annual percentage)

Annual output per capita growth rate Contribution of total factor productivity

Latin America 0.57 )0.55Industrial countries 1.66 0.57South Asia 2.18 0.83East Asia (excluding China) 4.28 0.79Africa 0.00 )1.15

Source: Bosworth et al. (1995).


at the heart of the frustrated development ex-perience of the region. Instead of concentratingtheir efforts in raising enough public revenuesto finance the necessary investment in humanand natural capital and the necessary institu-tional capacities to effectively enforce environ-mental regulation, governments have focusedon the generation of an expensive and oftenincoherent system of short-run incentives topromote investments in physical capital. Gov-ernment financial and human resources havebeen minimized by undertaxing capital incomeand wasted in massive subsidies to the corpo-rate sector in a futile effort to promote invest-ment and economic growth. 18 The promotionof capital has not only crowded out essentialpublic investments in human and natural as-sets, but some of the incentives to physical (andfinancial) capital have resulted in the wasting ofnatural resources and, to a lesser extent, thelack of enforcement of environmental regula-tion, as a means of boosting the profitability ofphysical capital investments.We now provide some empirical evidence

and illustrations of the above hypotheses.Much more detailed country studies are neededto provide proper empirical support for suchideas. Yet some of the ensuing illustrationshopefully may persuade the reader that the in-dicated policy failures are real, and that theyhave had something to do with both the lack ofpersistence and lack of sustainability of eco-nomic growth in the region.

(a) Capital undertaxation and subsidies

Several estimates of corporate subsidies forthe exploitation of natural resources and theenergy and industry sectors have recently beenprovided (Ascher, 1999; Myers & Kent, 2001;Van Beers & de Moor, 2001). Among thesethe most comprehensive and also the mostconservative are the estimates provided byVan beers and de Moor. They estimate thatnon-OECD countries gave public subsidiesamounting to $340 billion per annum in 1994–98 or 6.3% of GDP (Table 3). This is equivalentto more than 30% of all government expendi-tures, significantly larger than the 5.5% of GDPthat non-OECD countries spent on educationand health combined during the same years! Itis important to note that while OECD countriesspend twice as much as the fraction of GDP oneducation and health that non-OECD countriesspend, the latter group of countries spends al-most twice as much as the fraction of GDP insubsidies that OECD countries spend. So, thelow share of investments in human capital innon-OECD countries may not only be a prob-lem of low income but also of policy prioritiesthat emphasize corporate subsidies at the costof less investment in human capital.Taxes on capital income in Brazil yielded less

than 2.4% of GDP in fiscal revenue in the early1990s (Estache & Gasper, 1995). This repre-sented an effective tax of less than 5% of thetotal capital income of the country, which

Table 3. The global costs of public subsidies per year, 1994–98 (US$ billion)

OECD Non-OECD World

Natural resource sectorsAgriculture 335 65 400Water 15 45 60Forestry 5 30 35Fisheries 10 10 20Mining 25 5 30

Subtotal 390 155 545

Energy and industry sectorsEnergy 80 160 240Road transport 200 25 225Manufacturing industry 55 – 55

Subtotal 335 185 520

Total 725 340 1065

Total in % GDP 3.4 6.3 4.0

Source: Van Beers and de Moor (2001).


should be compared with a legal profit tax rateof more than 30%. That is, tax exemptions, taxholidays, tax collection failures due to weak taxadministration, etc., have implied a dramaticloss in government revenues as foregone capitaltaxes. Conservative estimates put just theselosses at 20% of all tax revenues.In addition, the Brazilian government has

provided massive direct and indirect subsidies tothe corporate sector. Grants and free conces-sions for the use of natural resources includingforests, mining and fisheries have been fre-quently used (Binswanger, 1991; World Bank,2000). Government subsidies for convertingAmazon forest lands to ranches amounted tomore than US$700 million (Binswanger, 1991).In Chile, taxes on capital produced revenues

in 1994 equivalent to less than 3% of GDP(Silva, 1997). This implies an effective tax oncapital income of about 6%, well below the le-gal capital tax rate of 15% (World Bank, 2000).Royalties and stumpage fees are practicallynonexistent in Chile. It is estimated that inChile the private copper sector alone savesmore than US$500 million a year in royalties.Private copper mines, which have obtainedbillions of dollars in profits, paid practically notaxes over the 1990s (World Bank, 2000).In Costa Rica, low royalties and lax en-

forcement of forest regulations combined withgovernment incentives to convert forests topastures are estimated to have caused morethan US$4 billion in losses over the 1970s and1980s and to have reduced GDP growth by 1.5–2.0% a year (Ascher, 1999). State wood pro-cessing in Honduras costs more than $240million in losses by the late 1980s (Pickles,1989). Fossil fuel subsidies in Venezuela wereabout 66% of the market price totaling 4% ofGDP or 25% of total government revenues(World Bank, 1997). In Mexico the fossil fuelsubsidy in the same period was 16% of themarket price with a fiscal cost equivalent to0.7% of GDP or 3.4% of fiscal revenues (WorldBank, 1997).Industrial subsidies in Latin America also

appear to be extremely large although there areno hard numbers. The automobile industry, forexample, has absorbed huge amounts of publicsubsidies in Brazil, Argentina and other car-producing countries in Latin America. Per jobfiscal costs in Brazil have been estimated at$340,000 for certain automobile plants. Statesubsidies to the main airplane manufacturerin Brazil have been in the billions of dollars(World Bank, 2000), despite that several studies

have shown few positive externalities or spill-overs arising from such manufacturing in Bra-zil.

(b) Evaluation of the impact of public subsidies

Although no detailed econometric studiesabout the impact of subsidies and tax conces-sions on capital exist for Latin America, ana-lyses performed elsewhere unambiguously showthat such schemes are at best ineffective inpromoting long-run growth and at worst sim-ply counterproductive. (See, for example, Bea-son & Weinstein, 1996 for Japan; Bergstr€oom,1998 for Sweden; Bregman, Fuss, & Regev,1999, for Israel; Fakin, 1995 for Poland;Fournier & Rasmussen, 1986 for the UnitedStates; Harris, 1991 for Ireland; Lee, 1996 forKorea) These studies unanimously show theeconomic waste that these programs entail.Investment subsidies according to these studieselicit a very marginal investment response.Moreover, because they are arbitrarily allo-cated across industries and firms they inducesignificant distortions and deadweight losses.There is no reason to expect that capital sub-sidy programs that have shown to be wastefulelsewhere are going to be any more beneficial inLatin America.

(c) Public investment priorities

Public expenditures in human capital (edu-cation and health combined) rarely reach morethan 8% of GDP in Latin America. Accordingto World Bank data, total public expendituresin education and health over the 1990s havefluctuated between 4% of GDP in Mexico andBrazil to 12% in Costa Rica. In Chile suchexpenditures reach less than 6% while in Co-lombia constitute only 4% of GDP (Lloyd-Sherlock, 2000). These levels are quite lowwhen compared with levels generally above15% of GDP in OECD countries and especiallygiven the slow pace of human capital accumu-lation that such allocations have generated.Moreover, given that the prime rationale forpublic spending in human capital is found inthe existence of credit market failures thatprevent poor households from financing prof-itable human capital investment, one wouldexpect that governments in developing coun-tries should spend even greater resources (as aproportion of GDP) in human capital thandeveloped countries. This is so because the


proportion of poor households able to financetheir human capital investment out of their ownsavings is probably much smaller than indeveloped countries as the extent of capitalmarket failure is much greater in developingcountries.Apart from the issue of small allocations of

public expenditures to human capital forma-tion, there is the issue of their allocation amongthe various groups in the population. There isan apparent failure to reach the poor house-holds, which are the ones that face the fullimpact of credit market failures. In fact, ac-cording to recent studies, public expenditures inhuman capital as well as other social sectors(including social security and housing), benefitmuch more the richer segments of society thanthe poor (Lloyd-Sherlock, 2000; World Bank,2000).The low public priorities assigned to health

and education have also caused a low level ofproductivity of the public resources used insuch sectors as shown by recent studies in Chileand elsewhere. One argument against increas-ing public allocations to such sectors has beenthat first one has to deal with the problem ofefficiency and next with the issue of resources.This is seemingly a reasonable argument exceptthat much of the low productivity arises out ofthe great resource scarcity that these sectorsface. Poor quality of teachers, for example, isdue in part to low pay incentives for goodteachers. Good teachers earn low wages due inpart to inadequate pay scale and evaluation ofteachers (an ‘‘inefficiency’’ which is hard toimprove with tight education budgets anyway)but also due to low absolute wages caused bylow salary budgets.Data on public investment in natural capital

are quite scarce. But empirical evidence aroundthe world does show that the social rates ofreturn of investments for controlling air andwater pollution are quite large (World Bank,2000, Chapter 4). According to this and otherWorld Bank studies, investing in clean urbanwater typically pays itself by the net benefitswithin 4–5 years or less. The same is true forinvestments to control for air pollution. Thepermanence of such large rates of return ac-cruing to investment in natural capital suggestssignificant underinvestment in natural capital.Recent estimates for Chile put total public

expenditures on environmental regulation andprotection at about $300 million per year(O�Ryan, Miller, & de Miguel, 2001). Thisamounts to only 0.4% of GDP and about 2% of

total public revenues. Young and Roncisvalle(2000) estimate for Brazil that authorized ex-penditures on environmental activities in 1995–2000 fluctuated between 0.7% and 1.4% of thetotal federal budget, or between 0.1% and 0.2%of GDP. Although these figures do not includeexpenditures of the states, these are just au-thorized expenditures, which does not meanthat they were actually spent. The existing datafor Chile and Brazil confirm the very low pri-ority that investments in natural capital have inthese countries.Although data on public investment in nat-

ural capital are not generally available for othercountries in the region, the genuine saving andnatural capital depreciation data for LatinAmerica provided earlier are suggestive in thisrespect. The large gap between genuine savingsand net domestic savings suggests a dramaticdepreciation of natural capital. This, in turn,indicates that natural capital is not only ex-ploited very intensively but also that govern-ments invest little in natural capital.

6. POLITICAL ECONOMY ISSUES:WHY GOVERNMENTS PERSIST INUSING A FAILED POLICY MODEL?

We do not pretend here to provide a com-prehensive political economy explanation forthe insistence of governments on implementingpolicies that have failed over so many years.One aspect that should be emphasized, how-ever, is that though these policies are generallyperverse for the vast majority of the popula-tion, there are groups, especially among therichest and economically most powerful elitesin society that have obtained large dividendsout of such policies. These are the groups thathave become enormously rich by benefitingfrom tax exemptions, tax holidays, financialgrants, cheap public credit, free access to nat-ural resources, almost unlimited effective rightsto pollute air, water, etc. The priority given tothese programs has effectively implied that bil-lions of dollars of public resources have beenchanneled to them instead of directing them topromote human and natural capital as well asother public goods.At the root of these biased priorities for the

use of public resources there are political andideological elements that vary in importanceacross countries. There is also a factor associ-ated with democracy and (lack of) participationof the civil society in the resource allocation


decisions. In addition, as influence in policydecisions is heavily based on economic power,the resulting political economy equilibrium ishighly unbalanced in favor of the economicelites. Apart from the dramatic lack of balancein political lobby capacities, the nature of thelobby itself is important. The most perversepolicies often originate in countries where thehegemonic lobbying forces are dominated bygroups that have little long-run stake in thecountry (financial speculators and, in general,capital owners that face few entry and exitcosts). Moreover, in several countries in theregion the lack of credibility that governmentproject among the economic elites (in turn, dueto a track record of breaking commitments andpolitical instability) is a factor behind thedominance of short-run ‘‘quick profit’’ consid-erations among the political lobby.Earlier we have referred to several studies

showing how weak and insufficient is publicenvironmental monitoring and enforcement inLatin America. The proximate causes are usu-ally identified as lack of financial and humanresources of the agencies nominally in charge ofsuch tasks. Behind these proximate causes thereis the lack of political willingness to investpublic resources in these activities. It is not aproblem of lack of funds, but rather it is anissue of political priorities that induce gov-ernments to spend public resources in otheractivities instead, including large capital subsi-dies.More generally, the biased allocation of

public resources in favor of powerful economicinterests may obey to several factors:

(a) Political support and corruption. Re-maining in power (under both democraticand nondemocratic regimes) is costly. Gov-ernments need to convince people that theyare efficient, compassionate, transparent,concerned about social welfare, etc. To dothis they can either be truthful and/or theycan spend large amounts of resources ongovernment propaganda to keep the generalpublic misinformed and, in democracies, tofinance political campaigns. In reality theyseem to opt for a combination of policies,some of them consistent with social welfareimprovements and many others not. A keysource of political support is the corporatesector, which is willing to provide such con-tributions in exchange for direct and indirectpublic subsidies. Government officials obtainimplicit or explicit bribes in return for favorsto those rich enough to bribe them. 19 To a

large extent corruption is both the cause andthe effect of a policy system based on capitalsubsidies as the main instrument to stimulateeconomic growth. Such a system which putsbillions of public dollars up for grab providesan ideal breeding ground for corruption. Atthe same time the more corrupt a govern-ment is the greater is its disposition to usecapital subsidies.(b) International and national recognition.High-level government figures seek recogni-tion as a means to remain in power and to berewarded with respect (including high lecturefees) and influential positions after they haveleft government. One of the best ways ofobtaining this is by maximizing short-termGDP growth (as measured by conventionalnational accounts) at all costs, even if suchgrowth cannot be sustained once the currentgovernment abandons power or if its ef-fectiveness as a means to enhance socialwelfare is negligible or frankly immiserizing.Biased policies and subsidies favoring therich owners of capital is one instrument toachieve short-term GDP growth at least asmeasured by national accounts. In particu-lar, as argued in Section 3, the elimination ofservices provided by natural capital is likelyto accelerate production in the short run asa consequence of the need to replace suchnatural services with man-made services.Hence, the use of environmental degradationas a means to subsidize capital may play adouble role of stimulating investment in theshort run and creating ‘‘space’’ for the pro-duction of the services foregone through en-vironmental degradation.(c) Ideology. One reason some governmentsfollow a pro-physical capital and anti-humanand natural capital bias is ideology. The ideathat development is synonymous with in-vestment in physical and financial capital isso ingrained among certain policy makersthat it has come close to become a fetish. Thekey role of the state is considered to be thepromotion of physical/financial capital ac-cumulation at all costs frequently using quickpay-off instruments.Ideological biases are reflected in the fol-

lowing phenomenon: Policy makers readilyrecognize the role of investments in physicalcapital as a source of new jobs but they tend torecognize less the job creation potential of in-vestment in human and natural capitals (or attimes they perceive them as ‘‘nonproductive’’jobs). In countries plagued by high unemploy-


ment as most in Latin America, politicians arepermanently compelled to create more jobs.They try to do this by throwing public re-sources to supporting physical/financial invest-ment and leaving little to support human andnatural capital investments. Few studies showthe job creation potential of investments inhuman and natural capital and comparingthem with job creation of conventional invest-ment in physical/financial capital. This dearthof such studies has perpetuated what appears tobe a mistaken perception even among well-meaning politicians.Rarely have politicians and even government

economists considered neutralizing marketfailures as a main task for the state and evenmore rarely have they fully appreciated thatwhether or not the state deals with marketfailures may make the difference between sus-tained growth and stagnation, between socialequity and injustice, between environmentalsustainability and destruction.

7. CONCLUSIONS AND IMPLICATIONSFOR INTERNATIONAL

ORGANIZATIONS

Fifty years of frustrated development inLatin America beg a change of the developmentstrategy. We have argued that, despite signifi-cant policy adjustments through the so-calledstructural adjustment, certain fundamentalfactors of this strategy have not really changed.The new approach calls for making the offset-ting of the effects of credit and environmentalmarket failures the centerpiece of governmentintervention in the economy. As part of such anapproach this calls for a drastic reallocation ofpublic expenditures: greater financial transfersto the poor and lower middle-income groups inthe form of much increased education, healthand social investments to reduce the impact ofcapital market imperfections on human capitalformation. It also calls for increasing effectiveprotection of the environment and greater in-vestment in natural capital to strengthen theability of natural capital to absorb the in-creasing impacts of economic growth. All thismust be financed by substantive reductions ofexplicit and implicit subsidies to physical andfinancial capital.It is postulated that the best way of pre-

serving the incentives for investment in physi-cal/financial capital is by attaining a highlyeducated and physically healthy labor force,

able to acquire new specific skills provided bythe corporate sector at low cost, and by assur-ing an abundant and healthy supply of naturalcapital, and other public goods, not by in-creasing capital subsidies or by undertaxingcapital. The massive capital subsidy approachusually becomes a trap: Large direct or indirectcapital subsidies crowd out public investmentin human and natural capital. This causesscarcity of human and natural capital, which, inturn, reduces even further the profitability ofphysical capital as vital assets that are com-plementary to physical capital become scarce.To prevent further erosion of the profitabilityof physical capital, even more subsidies areoften considered necessary. Thus a vicious cycleor trap is sustained.Will such a change in strategy require an in-

ordinate degree of government intervention inthe economy? Not really, and certainly notcompared to the current situation. It is a matterof changing the nature of intervention ratherthan of increasing it. The new approach requiresthe progressive elimination of the massive directand indirect subsidies to capital, including en-vironmentally destructive subsidies and the useof these resources to deal with the market fail-ures by rapidly increasing public investments inhuman and natural capital. It does not neces-sarily require much new environmental regula-tion but rather a genuine effort to enforceexisting regulations nor does it require newtaxes but rather enforcing existing tax laws.Past mistakes associated with undercollection

of capital taxes, undercharging for governmentservices to the well-off, low royalties for naturalresources, and massive capital subsidies haveled to chronic fiscal deficits that, since the early1990s, have been financed mostly with in-creasing public indebtedness. After severalyears following this policy, the result has been asignificant fiscal burden caused by the need toserve a large debt. In some countries a largeproportion of the government budget is cur-rently spent in servicing the debt. This limitstheir ability to reallocate resources to priorityareas. For countries that have such large stocksof debt it is even more urgent to move towardthe elimination of subsidies to corporations andto the wealthy. Relying on the traditional ap-proach to fix fiscal imbalances, cutting publicexpenditures in social sectors and educationwhile keeping the so-called development ex-penditures more or less intact, can only worsenthe slow growth trap and even the fiscal prob-lems in the long run.


The needed dramatic policy changes may nottake place unless certain key changes occur:(a) A much greater equilibrium is achieved inpolitical participation and lobbying so thatthe community organized is able to exertpolitical counterbalance to the currentlyoverwhelming political weight of the largecorporate sector and the wealthy in affectingpublic policies and public expenditure allo-cations. It may also require a change in theapproach of the traditional lobby forces toemphasize a more long-term view: Businessorganizations should be able to internalizethe fact that if they induce governments toadopt excessively generous policies towardthem, they are risking their own profits overthe long run. If governments fail to investsufficiently in public and semipublic goods,profits are not likely to be sustained over thelong run.(b) More efforts are spent in institutionalchange that promote greater involvementand fiscalization of the public sector by thecivil society. Efforts to increase and improvethe flow of information and transparency ofpublic policies are important in this respect.(c) Institutional capacity in the public sectorand the agencies dealing with education,health, social sectors and the environmentneed to be dramatically strengthened to in-crease the productivity in such sectors. Theability to collect taxes in many countriesshould also significant improve as it has suc-cessfully already happened in a few countriesin the region.(d) Policy makers have to discard old andobsolete development ideologies and the so-cial groups that most directly benefit with thenew strategy need to be developed into aforce of change to counter traditional politi-cal lobby efforts.(e) The new strategy, especially its envi-ronmental sustainability component, willalso need adequate international conditions,namely, (i) the development of North–Southconditions for trade in environmental ser-vices as opposed to purely of goods pro-duced through conventional exploitation ofnatural resources; (ii) expanded internationalcooperation and assistance to promote theinstitutional changes described above; (iii)the technical and financial support of inter-national organizations that must take aleadership role by placing their advice withinthe context of a clear set of long-run objec-tives.

International aid organizations may play aleading role in promoting the discussion anddebate of new approaches to development in asystematic way. Many of the ideas presented inthis paper are simple but may require muchpersistence to be more widely accepted in thepolicy world. As usual, the new approachwould have to clear several obstacles in orderto even start to have policy impact: First isthe ideological barrier. Old and deeply in-grained preconceptions are extremely difficultto change. Second, powerful economic interestsboth within government and in the privatesector that have benefited dramatically fromthe old model are likely to constitute anotherformidable barrier to change. Third, imple-menting institutions, especially those publicinstitutions in charge of monitoring and en-forcing programs and investing in the envi-ronment will need to be developed and/orperfected.I see four areas that may be important for

international organizations over the mediumterm:(i) More efforts on the international front.Here there are several priority activities thatinclude: promoting and supporting the in-ternational monitoring and diffusion of in-formation on government corruption andother nontransparent practices; more partic-ipation in arrangements to reduce interna-tional competition across countries to attractforeign investments on the basis of publicsubsidies; greater involvement in the de-velopment of new or emerging interna-tional institutions that may allow for greaterNorth–South trade on environmental ser-vices including carbon sequestration and bi-odiversity.(ii) Gradual shift in the country lending andtechnical support priorities. More emphasisshould be given to supporting the privatesector (broadly defined) thus increasing itsshare in the volume of international lendingand technical support. At the same time, thedefinition of the private sector should bebroaden to include organizations of the poor,community organizations, nongovernmentalorganizations (NGOs), ethnic organizationsand others. Within the conventional supportto the private sector by international orga-nizations, such as the World Bank and Inter-American Development Bank, a significantreallocation of such support from the cor-porate sector to social and civil organizationsshould take place.


(iii) A shift of the international support togovernments increasing the emphasis onpublic investment in the social sectors (edu-cation, health, social security, etc.) and theenvironment and reducing the support forconventional ‘‘development’’ expenditures.(iv) Promote more country research. It is verydifficult to provide good lending and espe-cially good policy advice if it is not backedby appropriate socioeconomic research. Theevaluation of public expenditure allocations,measurement of public subsidies to corpora-tions and the wealthy and shedding light onthe implementation of reforms including se-quencing, pace, institutional demands, etc.,

are important areas where more knowledge isneeded.To be sure, none of the tasks enumerated

above are ‘‘new’’ to international aid organi-zations. They have been active in several ofthese areas, particularly in (iii) and to someextent (ii). The issue is not whether such orga-nizations are active at these tasks but rather it isa matter of priorities. Obviously to act in theseareas in a significant way, other areas need tobe curtailed. This is the real choice, whetherinternational organizations are willing to focustheir work more in such an agenda to thecost of curtailing their more traditional activi-ties.

NOTES

1. The neoclassical growth model pioneered by Robert

Solow�s famous contributions provided the intellectual

support to these views.

2. Much controversy exists about the roles of total

factor productivity (TFP) vis-�aa-vis asset accumulation as

sources of growth. Several empirical studies have found

that even in the rapidly growing East Asia countries,

TFP has not been nearly as important a source of

economic growth as asset accumulation has been (Col-

lins & Bosworth, 1996; Kim & Lau, 1994; Krugman,

1996; Young, 1995). Others have pointed to method-

ological refinements that could significantly alter the

conclusions reached by the above authors (Klenow &

Rodriguez-Clare, 1997; Nelson & Pack, 1998). Contro-

versy also exists regarding the importance of human

capital as a source of growth. While a large literature

using micro-level data has shown the value of education

as a source of household income (since the pioneering

works of Mincer (1974), many others have confirmed

these findings), some recent crosscountry studies have

found low or even negative effects of education on

growth (Pritchett, 1996, and others). This rather per-

plexing result, however, appears to be due to major data

problems encountered by cross-country studies. Krueger

and Lindahl (2001), show that, after accounting for

measurement errors, the effects of education on income

growth across countries is at least as great as micro-

econometric estimates of the rate of return of schooling.

3. One would expect that if an economy underinvests

in two of the three assets, it would necessarily overin-

vests in the other. But, the total volume of savings

available for investments is not fixed. Market imperfec-

tions may induce lower savings and/or a deviation of

part of the savings abroad.

4. This section is a nontechnical version of the analysis

developed by L�oopez et al. (2001) using a formal

multiasset endogenous growth model.

5. In the long-run firms face little if any diseconomies

of scale.

6. As documented by the empirical literature (e.g.,

Psacharopoulos, 1994) individuals experience decreasing

marginal product of schooling due among other things

to obvious life cycle factors (including the limited span

of life). This impedes human capital concentration

beyond a certain point.

7. There is some empirical evidence regarding the

impact of natural resource degradation on the real wage

of unskilled workers. L�oopez (1997, 2000) for example,

found that a 10% reduction of soil biomass induces a

reduction of the marginal product of labor employed in

rural areas of the order of 1.5–2.0%.

8. See, for example, UNDP (1998), which provides

empirical evidence for several countries showing how air

and water pollution disproportionately affect the poor.

See also Dasgupta (1995).

9. We focus here on ‘‘capital taxes,’’ which should be

interpreted as encompassing taxes on all revenues of the

high income (and high saving) households. Given that

most of their income is usually derived from physical

and financial capital, we focus here on profit taxes.

10. Cases of massive decline of natural capital are well

documented. Periods of decline of human capital are less

well documented but are more frequent than one would


expect if, education, for example, is measured consider-

ing its quality as represented by standardized tests or

other means.

11. See Ascher (1999), Myers and Kent (2001) and Van

Beers and de Moor (2001), for empirical evidence on the

existence of massive environmentally destructive subsi-

dies provided to the corporate sector as an incentive to

promote capital investment.

12. The importance of this last point cannot be

overemphasized. During the 1990s Germany offers a

prime Example: The reconstruction of the former DDR

was implemented through gigantic subsidies to firms,

perhaps on a scale never seen before in history.

Coincidentally Germany has been transformed into

‘‘die Schmiergeld Republik’’ (‘‘the Republic of the

Bribes’’) as the prestigious Der Spiegel magazine called

it in its front page. Since the mid-1990s the cases of

confirmed bribery have increased almost six-fold (Der

Spiegel, March 18, 2002).

13. See, for example, the article by Kenneth Rogoff in

The Economist, August 3–9, 2002, pp. 62–64.

14. A famous German automotive investor has said

that to invest in areas of the former East Germany, he

needs more infrastructure and a more educated labor

force, not subsidies.

15. The ‘‘genuine savings’’ concept has been a useful

tool to understand this phenomenon. By accounting for

changes in the value of environmental assets as well as

other assets, studies using this concept have shown that

wealth even in fast growing countries has declined or

grown at a much slower pace than what conventional

national accounts lead us to believe (Hamilton, 2000;

Hamilton & Clemens, 1999).

16. This without including the rather disastrous 1998–

2002 period.

17. Assuming a growth accounting framework (under

constant returns to scale),

_yy=y ¼ aK_KK=K þ aH

_HH=H þ ð1� aK � aH Þ _RR=Rþ _AA=A

where ai (i ¼ K;H ) are the share of capital and human

capital in national income, _yy=y is per capital annual in-

come growth, _KK=K and _HH=H are annual per capita

growth of capital and human capital respectively, _RR=Ris annual per capita growth of natural capital and _AA=Ais annual productivity growth. Using _yy=y ¼ 0:013,_KK=K ¼ 0:03, _HH=H ¼ 0:012, aK ¼ 0:6, aH ¼ 0:2, and_AA=A ¼ 0 we obtain that _RR=R ¼ �0:045. If we assume

that _AA=A ¼ 0:01 (a 1% annual productivity growth) we

obtain that _RR=R � �0:08. That is, this simple growth

accounting procedure suggests that natural capital has

been degraded at fast rates of the order of 4.5–8% per

year.

18. In many cases, e.g., Argentina, undertaxation of

capital and the wealthy arises not because tax rates are

particularly low but because of a chronic lack of

capacity of governments to collect taxes. This lack of

capacity is often regarded as a ‘‘technical problem’’ that

is fixed by ‘‘institutional building,’’ but in reality it is also

likely to be linked to political economy factors that

generate ‘‘incentives’’ to government bureaucrats to

spend little effort in collecting taxes from economically

powerful groups. So, inadequate tax collection may be

regarded as just one other instrument to undertax

capital.

19. The importance of corruption as a source of

perverse government allocations and distortions has

been thoroughly analyzed both conceptually (e.g., L�oopez

& Mitra, 2000; Mookherjee & Png, 1995) and empiri-

cally (Kaufman & Zoido-Lobaton, 1999). In addition, a

number of recent works have developed rigorous polit-

ical support models. Since the pioneering work of

Bernheim and Whinston (1986), a number of authors

have applied their model to a variety of government

policy biases such as those arising from overweighting

the income of large corporations that provide political

campaign contributions to the government in the gov-

ernment�s objective function (Fredriksson, 1997; Gross-

man & Helpman, 1994, 1995).

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The Policy Roots of Socioeconomic Stagnation and Environmental Implosion: Latin America 1950–2000

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