## cr17174

## Source details

**Canonical URL:** [cr17174](https://www.imf.org/-/media/files/publications/cr/2017/cr17174.pdf)

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---

### System overview and structure
- Nicaragua’s social security system (INSS) provides pension, disability and healthcare benefits and is managed by the Nicaraguan Institute of Social Security (INSS).
- The pension system (IVM: Invalidez, Vejez y Muerte) is a defined benefit, pay-as-you-go system providing pension, disability and survivor benefits.
- Additional INSS programs: Enfermedad-Maternidad (health insurance), Riesgos Profesionales (RP, occupational risks), and Víctimas de la Guerra (VG, disability and survivor benefits for civil war victims).
- Beneficiaries of RP and VG typically shift to receiving an IVM pension once they reach age 60.
- As of end-2016, the INSS had about 857,000 active contributors.
- Two other social security systems (military; police, firefighters, and prison employees) are outside public sector accounts and lack published data.

### Financing, contributions, and benefit rules
- Benefits financed by mandatory employer and employee contributions, and interest revenue from the INSS reserve fund.
- Contributor regimes:
  - Régimen de IVM-RP: pension and occupational risks.
  - Régimen Integral: includes health.
  - Régimen Facultativo (Integral or IVM): voluntary for self-employed.
- Pension eligibility: age 60 and at least 750 weeks (about 15 years) of contributions; special retirement age of 55 for teachers and miners.
- Benefits determined by formula based on average salary and weeks of contributions; two formulas apply (RBM ≤ two times minimum wage and RBM > two times minimum wage). Minimum starting pension cannot be lower than the minimum wage. Pensioners receive a thirteenth payment in December.
- Healthcare: three months of continuous contributions required; children covered up to age 12; female spouses/partners covered for maternity. INSS pays providers a fixed per capita amount and pre-negotiated tariffs.

### Contribution rates (preserved exactly)
- Regimen Integral (Percent of pensionable salary):
  - Employer: Health insurance 6; Pension (IVM) 10; Workplace-related disability 1.5; War victims 1.5; TOTAL - Regimen Integral 19.6
  - Employee: Health insurance 2.25; Pension (IVM) 4; Workplace-related disability 1.5; War victims 1.5; TOTAL - Regimen Integral 5.25
  - Govt: Health insurance 0.25; Pension (IVM) 4; Workplace-related disability (—); War victims (—); TOTAL - Regimen Integral 8.5
  - TOTAL (Employer+Employee+Govt) - Regimen Integral 25.5
- Regimen Facultativo Integral TOTAL 18.25
- Regimen Facultativo IVM TOTAL 10

### Recent financial trends and balances (2012–2016, percent of GDP)
- INSS Revenue and Expenditure:
  - Revenue: 2012 4.8; 2013 5.1; 2014 5.3; 2015 5.5; 2016 5.9
  - Old-age pensions (IVM) revenue: 2012 2.2; 2013 2.4; 2014 2.6; 2015 2.9; 2016 3.1
  - Healthcare revenue: 2012 1.6; 2013 1.7; 2014 1.7; 2015 1.7; 2016 1.8
  - RP revenue: 2012 0.3; 2013 0.3; 2014 0.3; 2015 0.3; 2016 0.3
  - War victims revenue: 2012 0.3; 2013 0.3; 2014 0.3; 2015 0.3; 2016 0.3
  - Other revenue 1/: 2012 0.4; 2013 0.4; 2014 0.3; 2015 0.3; 2016 0.3
  - Expenditure: 2012 4.7; 2013 5.2; 2014 5.5; 2015 5.8; 2016 6.3
  - Old-age pensions (IVM) expenditure: 2012 2.1; 2013 2.3; 2014 2.5; 2015 2.7; 2016 3.0
  - Healthcare expenditure: 2012 1.5; 2013 1.6; 2014 1.6; 2015 1.8; 2016 1.8
  - Administrative 3/: 2012 0.6; 2013 0.7; 2014 0.8; 2015 0.8; 2016 0.9
  - Balance: 2012 0.2; 2013 -0.1; 2014 -0.3; 2015 -0.3; 2016 -0.4
  - Notes: 1/ Includes investment income from the reserve fund. 3/ Including expenditure on wages, goods and services, and capital expenditure.

### Coverage and recent changes (2006 vs 2016)
- Share of labor force contributing to INSS (active coverage) 1/: 2006 19; 2016 32
- Share of population 60+ with INSS old age/survivor pension (passive coverage): 2006 17; 2016 32
- Share of INSS pensioners receiving a reduced pension: 2006 0; 2016 33
- Share of working-age population receiving a disability pension: 2006 1; 2016 1
- Share of INSS members with health insurance: 2006 n.a.; 2016 83
- Note: 1/ Total labor force, including informal sector.
- Coverage low but improved; about 80 percent of businesses operate informally in Nicaragua (COSEP, 2015).

### 2013 pension reform and immediate impacts
- Key reform elements:
  - Increase in the contribution rate for employers from 7 to 10 percent, implemented between 2014 and 2017.
  - Increase in the maximum monthly pensionable salary to C$72,000 (US$2,774), with annual adjustments in line with average wage growth.
  - Minimum pensions to be adjusted in line with average wage growth, link between minimum starting pension and minimum wage maintained.
  - Benefit formula for people earning at least twice the minimum wage made somewhat less generous; indexation changed to 5 percent annually (in line with the rate of crawl of the exchange rate against the U.S. dollar).
  - Agreement for state to pay US$10 million annually over 50 years (US$500 million obligation) for unpaid 0.25 percent contribution on total wage bill.
- INSS estimates savings from the reform about 1 percent of GDP in 2016, with about four-fifths from increased contributions.
- The 0.25 percent contribution continued not to be included in the government budget despite the end-2013 agreement.

### Introduction and impact of the reduced pension (pensión reducida)
- Pensión reducida introduced in 2013 for participants with 250-750 weeks of contributions.
- Reduced pension amounts fixed in law, not indexed to exchange rate, inflation, or wages; related to number of contribution weeks.
- Average monthly reduced pension in 2016: about $83, or 27 percent of the average wage.
- As of March 2017: 46,071 pensioners (out of 236,565 total) received the reduced pension.
- Estimated cost of reduced pension in 2016: about 0.36 percent of GDP.
- Savings from the 2013 reform began to be eroded immediately as the partial pension benefit was introduced.

### Reserve fund, investment policy, and liquidity
- Reserve fund assets:
  - Increased from US$392 million in 2007 to US$592 million in 2012.
  - Declined to US$410 million (3.1 percent of GDP) at end-2016.
- Reserve fund composition (end-2016):
  - $36.3m, Bank accounts
  - $74.5m, Government bonds
  - $149.5m, Private equity investments (mainly medical)
  - $141.3m, Loans to institutions (mainly construction-related)
  - $8.1m, Other
- Liquid assets about $91m at end-2016, or 22 percent of total (accounting for illiquid government bonds).
- INSS used reserves to purchase real assets and finance subsidized mortgage loans; share of liquid assets reduced significantly.
- INSS ran a deficit since 2013 financed from the reserve fund; projected to exhaust liquid reserves by 2019.

### Pension adequacy, incentives, distributional features, and demographics
- Gross replacement rate for an average income earner estimated at 97 percent (OECD/IDB/World Bank, 2014).
- Average old age pension in 2016 about 80 percent of the average wage.
- Pensioner distribution (end-2016): 42 percent minimum pension; 33 percent reduced pension; 26 percent higher than minimum pension.
- Minimum pension distortions: minimum wage earners contributing 15 or 20 years receive no difference in pensions because minimum starting pension cannot be less than the minimum wage.
- NPV calculations assume average life expectancy after retirement of 15 years and a retirement date of end-2016.
- Demographics:
  - Fertility rates: five children per woman in 1990 to 2.3 in 2015.
  - Life expectancy: 62 years in 1990 to 75 years in 2015.
  - Currently 5 percent of population over 64; expected to rise to 12 percent by 2040.
  - Old age dependency ratio expected to increase from 7.8 percent to 17.8 percent by 2040.

### Revenue, spending trends, and projections
- Contributions increased from 2.4 percent of GDP in 2013 to 3.1 percent of GDP in 2016.
- Total pension spending rose from 1.4 percent of GDP in 2006 to 3.0 percent of GDP in 2016.
- Major drivers: increases in minimum wage (2008–2009), doubling of ordinary pensioners, introduction/take-up of reduced pension (about 0.4 percent of GDP in 2016).
- INSS projections:
  - IVM pension expenditure projected to reach 5.9 percent of GDP by 2040.
  - IVM contributions projected to grow rapidly until 2020 then stabilize at around 3.4 percent of GDP from 2020 onwards.
- Healthcare:
  - Number of insured approximately doubled since 2006; healthcare expenditure increased almost six-fold and exceeded contributions since 2015.
  - Health care expenditure per capita in the INSS system fell by 3 percent in 2016.
- Administrative:
  - Administrative expenditures rose from 0.3 percent of GDP in 2006 to 0.9 percent of GDP in 2016.
  - Personnel expenditure rose from 0.2 percent of GDP in 2006 to 0.5 percent of GDP in 2016.
  - INSS had 4,090 staff on payroll at end-2016; 65 percent earned monthly salary of C$20,001 or more.
  - Average economy-wide monthly salary in 2016 was C$9,386; average central government salary C$10,131.
  - INSS staff receive a “doble aguinaldo”—two extra months of salary every year.
  - Medium-term projections imply a 14 percent reduction in administrative expenditure in nominal terms in 2017.

### Reform options, simulations, and feasibility
- Coverage expansion limits:
  - Authorities assume increase to about 37 percent labor force coverage after 2020 (from end-2016).
  - Simulation: coverage would need to reach about 90 percent by 2040 to close gap with additional contributors alone.
  - Additional contributors may worsen finances because benefits can exceed contributions’ value.
- Individual reform scenarios simulated:
  - Scenario 1: gradual increase in retirement age to 63 by 2025.
  - Scenario 2: keep pensions fixed in dollar terms (index all pensions to ER only).
  - Scenario 3: increase contributions by 1 percent in 2020 and further 1 percent in 2021 (total increase of 2%).
  - Scenario 4: reduce average benefits by 20 percent.
  - None of these on their own achieves full sustainability over next 20 years; combinations could.
- Case for raising retirement age:
  - Life expectancy now 13 years higher than in 1990 while retirement age unchanged.
  - Options: gradual increases; retain option to retire at 60 with penalty; consider raising teachers’ retirement age (currently 55) to at least 60.
- Contribution rate constraints:
  - Overall contribution rate to INSS is 25¼ percent of wages.
  - Little scope to increase contributions further due to political and formalization concerns.

### Illustrative reform packages and modeled outcomes (IVM balance and savings relative to baseline, % of GDP)
- All reforms assumed implemented over 2020-2025; indexation changes immediate or phased; indicative only.

- Reform package 1:
  - Policies: Index all pensions to US$ exchange rate; increase retirement age to 63 by 2025; reduce average benefits by 20%.
  - IVM system balance (% of GDP): 2020: 0.8; 2025: 1.5; 2030: 1.2; 2035: 1.1; 2040: 0.7
  - Savings relative to baseline (% of GDP): 2020: 0.9; 2025: 2.0; 2030: 2.4; 2035: 2.7; 2040: 3.1

- Reform package 2:
  - Policies: Index all pensions to inflation (inflation assumed 7 percent p.a. over the long term); reduce average benefits by 30%; contributions for war victims shifted to IVM.
  - IVM system balance (% of GDP): 2020: 0.8; 2025: 1.5; 2030: 1.4; 2035: 1.0; 2040: 0.6
  - Savings relative to baseline (% of GDP): 2020: 1.0; 2025: 2.1; 2030: 2.4; 2035: 2.7; 2040: 3.0

- Reform package 3:
  - Policies: Index all pensions to inflation; increase retirement age to 65 by 2025; contributions for war victims shifted to IVM.
  - IVM system balance (% of GDP): 2020: 0.9; 2025: 1.4; 2030: 1.2; 2035: 0.8; 2040: 0.3
  - Savings relative to baseline (% of GDP): 2020: 1.0; 2025: 2.0; 2030: 2.2; 2035: 2.4; 2040: 2.7

- Reform package 4:
  - Policies: Index all pensions to US$ exchange rate; reduce average benefits by 20%; increase contribution rate by 2%.
  - IVM system balance (% of GDP): 2020: 0.8; 2025: 1.4; 2030: 1.1; 2035: 0.8; 2040: 0.3
  - Savings relative to baseline (% of GDP): 2020: 1.0; 2025: 2.0; 2030: 2.1; 2035: 2.4; 2040: 2.7

- Note: combinations of reforms needed for sustainability; full actuarial analysis recommended.

### Reduced pension distortions and targeted non-contributory option
- Reduced pension has a much larger beneficiary pool than originally foreseen; beneficiaries’ contributions have NPV substantially below benefits implying cross-subsidies.
- Policy options:
  - Re-scale reduced pension to match NPV of actual contributions, including associated health benefits.
  - Close reduced pension to new beneficiaries and replace with a non-contributory pension targeted to families below the poverty line.
- Targeted non-contributory example: a pension of $24 per month (15 percent of minimum wage or about 1.1 percent of GDP per capita) for one-quarter of population 65+ would cost about 0.2 percent of GDP.

### Administrative, governance, and investment recommendations
- Administrative costs are high; baseline assumes administrative costs decline from 0.9 percent of GDP in 2016 to stabilize after 2020 at around 0.6 percent of GDP.
- Efficiency measures:
  - Outsource pension payments to banks and non-bank financial institutions.
  - Sell a large part of branch network to generate income.
- INSS payroll:
  - 2016 average annual salary of an INSS employee: C$417,000 ($14,570), 3.2 times average central government salary; in 2007 ratio was 1.9.
  - Bringing ratio to 2007 levels would save about 0.2 percentage points of GDP (equivalent to reducing average pension benefit by five percent or a 0.75 percent increase in contribution rate).
- Reserve management and governance:
  - Social security law does not regulate INSS’s investment fund; reserves have departed from low-risk investments.
  - Lack of disclosure and ability to shift reserves between regimes reduces transparency.
- Recommendation: conduct deep actuarial, economic and operational analysis and act quickly to avoid a costly bailout.

### Technical annex (formulae and modeling assumptions)
- Old Age Pension formula essentials preserved exactly in source (RBM, FSCE, formula coefficients, family benefits percentages, caps).
- Reduced pension monthly amounts by contribution weeks (preserved exactly):
  - 250-349 weeks: C$ 1,910
  - 350-449 weeks: C$ 2,356
  - 450-549 weeks: C$ 2,884
  - 550-649 weeks: C$ 3,290
  - 650-749 weeks: C$ 3,656
- Key modeling assumptions preserved:
  - Inflation assumed 7 percent p.a. over the long term (for scenarios referencing inflation).
  - Wage growth historical average (2012-2016): 7.1; 2017: 3.4; 2018: 10.4; 2019: 7.3; 2020: 6.3; Average 2021-2040: 7.5
  - Other demographic and labor force projection figures preserved as presented.

---

### Climate change and disaster risk: exposure, impacts, and policy implications
- Projected warming and macro impacts:
  - Mean projected warming absent mitigation about 3 to 4 degrees Celsius by 2100.
  - Tol: increases between 1 and 5.4 °C by 2100 across reviewed studies.
  - Average impact from a 3°C increase projected at about -2 percent of global GDP by 2100.
- Country-specific vulnerability (Nicaragua):
  - Average temperature already increased by about 1°C since 1950.
  - Nicaragua greenhouse gas emissions: 14.3 metric tons of CO2 equivalent in 2013, 0.03 percent of world total.
  - Agriculture, livestock and fishing: 14 percent of GDP (end-2016), 8.4 percent of formal employment.
  - Exports of agricultural products: about 30 percent of total goods exports.
  - 29.6 percent of population lived under national poverty line (2014).
  - Approximately 70 percent of housing constructions insufficient against disasters.
  - Insurance industry assets less than 2½ percent of GDP.
- Historical disaster frequency and costs:
  - 78 disaster events in Nicaragua during 1900-2016 (0.7 disasters per year).
  - 1950-2014: average economic cost per event 2.2 percent of GDP; affected 1.5 percent of population per event.
  - Nicaragua is fourth in world by number of disasters (Global Climate Risk Index 1996-2015); ranks 158 out of 173 in World Risk Index.
- Quantitative disaster impacts (empirical findings for CAPDR/Nicaragua):
  - For CAPDR, most severe disasters decelerate GDP growth by about 2 percentage points in the event year; growth tends to accelerate by about 3.1 percent the following year.
  - VAR pooled model impulse responses (immediate negative impacts on output growth):
    - Floods: immediate negative impact of 0.8 percentage points on output growth.
    - Earthquakes: immediate negative impact of 1.9 percentage points on output growth.
    - Storms: impact magnitude between floods and earthquakes per model.
  - Event-study and VAR results indicate permanent damage to output level despite partial recovery.
- CAPDR vs Nicaragua quantitative comparisons (declines, percentage points):
  - GDP growth decline — Storm: CAPDR 0.85; NIC 1.74
  - GDP growth decline — Flood: CAPDR 1.01; NIC 0.61
  - GDP growth decline — Overall: CAPDR 0.93; NIC 1.18
  - Revenue to GDP growth decline — Storm: CAPDR 0.52; NIC 2.5
  - Revenue to GDP growth decline — Flood: CAPDR 2.04; NIC 8.68
  - Revenue to GDP growth decline — Overall: CAPDR 1.28; NIC 5.59
- Table 8 model items (preserved exactly):
  - Number of Events in Model: Storm 89; Flood 5; Earthquake 4
  - Probability: Storm 0.12; Flood 0.14; Earthquake 0.08; Drought 0.06
  - Impact on revenue as % of GDP: Storm -0.16; Flood -0.39; Earthquake -0.09; Drought -0.11
- Fiscal preparedness and financing capacity:
  - IDD evolution (IDB, 2015): IDD50: 2000 1.17; 2005 1.29; 2010 2.49; 2012 2.74
    - IDD100: 2000 2.52; 2005 2.75; 2010 4.84; 2012 5.22
    - IDD500: 2000 4.02; 2005 4.24; 2010 6.07; 2012 6.30
  - Nicaragua’s National Disaster Fund (NDF) 2016 allocation: 40 million córdobas (about US$1.4 million) — fully spent in 2016.
  - CCRIF: annual premium US$3.5 million (paid by World Bank); catastrophe insurance payouts in 2016: US$1.6 million.
  - Contingent financing: IDB contingent credit up to US$156 million; World Bank would frontload pipeline resources in event.
- Sectoral notes:
  - Climate change projected to reduce annual agriculture output by 0.1 percentage points vs no-climate scenario.
  - For a country with average initial temperature about 25°C (like Nicaragua), marginal impact of +1 °C is ~1 percent reduction in productivity growth (Burke, Hsiang and Miguel, 2015).
  - Applying Dell, Jones and Olken (2012): +1 °C reduces Nicaragua GDP growth by 1.3 percent; equivalent to 0.05 percentage points per year vs no-climate scenario.
- Energy and renewables:
  - Power generation 2015 (GWh): Thermal 268,959.4; Hydroelectrical 2,946.5; Gas Turbine 20.1; Geothermal 67,815.0; Wind 86,519.1; Solar 20.05.
  - Clean energy share of total 50.6; Energy from petroleum 49.9; National Interconnected System 4,531,100.
  - Clean primary energy share increased from 30 percent in 2006 to over 50 percent; plan to increase to over 90 percent by 2020.

### Policy recommendations on climate and disaster risk
- Strengthen technical institutions (INETER): hazard mapping, early warning systems; World Bank: every US$1 invested yields US$4 in reduced losses.
- Strengthen agricultural resilience: diversify products, extend irrigation, improve crop resilience; new Agricultural and Livestock Insurance by INISER.
- Continue reforestation/deforestation-prevention plans (World Bank-assisted); aim to reduce CO2 emissions by 11 metric tons in 20 years; partial financing from Green Climate Fund (GCF).
- Use catastrophe risk insurance (CCRIF) and contingent credit lines; build disaster-specific fiscal buffer at least equal to average revenue cost of natural disasters plus estimated impact on expenditure.
- Integrate CCDs’ risk into fiscal risk reports and medium-term budget framework; adopt broadly counter-cyclical fiscal policy.
- Improve enforcement of building codes and zoning; strengthen social safety nets; promote private sector incentives for resilient investment.
- Monetary/financial recommendations:
  - Strengthen financial regulation and supervision to integrate CCD risk; increase bank capital buffers and insurance technical reserves; develop reinsurance market.
  - Maintain higher gross international reserves under crawling peg; consider exchange rate flexibility to absorb external shocks.

---

### Trade, transfer pricing (TP), and Free Zones (FZ) — revenue risks and recommendations
- TP legal developments:
  - TP legislation adopted in 2012 (Ley No. 822); entry into force postponed till June 30, 2017 (Ley No.922, December 17, 2015).
  - Operational capacity to implement TP rules remains uncertain.
- Commodities and TP vulnerability:
  - Commodities are important: top five commodities (meat, coffee, gold, sugar and oil seeds) represent around 60 percent of Nicaragua’s total non-FZ export.
  - Another US$397 million of commodity exports originate in the FZ (2016).
- Common TP schemes:
  - Use of related intermediary in low-tax jurisdiction to buy low and resell at spot prices; variants include retroactive contract date selection (backdating) and profit-based valuation methods.
  - Risk: profit methods can misplace taxation of economic rents.
- Regional practices to protect tax base:
  - Argentina “Sixth Method”: strict CUP at date of shipment for exports to related conduit entities.
  - Uruguay: CUP with adjustments for insurance and shipping; internal comparables and contemporaneous contract registration allowed.
  - Mexico: prioritizes CUP as defined by OECD.
- Nicaragua lacks commodity-specific TP regulation — concern given commodity trade importance.
- Design considerations for commodity TP regime:
  - Prioritize CUP for controlled commodity transactions; allow measured adjustments (shipping, insurance, quality).
  - Anchor valuation to shipping date or short-period average; contemporaneous contract registration recommended.
  - Broad anti-abuse rules preferable to narrow “paper conduit” tests.
- Free Zones (FZ) concerns:
  - FZs attract investors via tax exemptions; FZ activity large and labor-intensive (maquila/manufacturing).
  - Risks: primary goods purchased into FZ could shift profits into FZ via TP; simple manufacturing in FZs can concentrate residual profits in Zone despite limited functions.
  - Current law requires arm’s length pricing for related-party transactions with FZ, but absence of commodity-specific rules leaves loopholes.
- Tax expenditure (TE) from FZ CIT exemption estimates:
  - Earlier study: TE 0.24 percent of GDP (2013) — likely underestimated.
  - More recent estimate: TE 0.48 percent of GDP (2014).
  - Benchmarked arm’s length return assumption (6.5 percent) implies TE above 0.4 percent of GDP.
- Policy options for FZ sunset/exit:
  - Transition to a TP Safe Harbor after initial ten-year term: define a minimum taxable profit margin (safe harbor) with full statutory CIT applied to that margin instead of renewing tax holiday.
- Concrete TP and tax policy recommendations:
  - Develop TP focus on commodities and maquiladoras.
  - Identify key commodities for special treatment; prioritize CUP; define allowed TP adjustments (transport, quality, volume, contract type).
  - Set reference price on shipping date or short average; allow contract registration.
  - Reassign tested party to foreign or FZ-related party where appropriate to place residual profit in domestic value chain.
  - Consider exit tax on deemed sale when intangible property moved to FZ or abroad.
  - Adopt TP Safe Harbor as exit strategy for FZ beneficiaries.

---

### Macroeconomic spillover scenarios (IMF FSGM + reduced-form model)
- Methodology:
  - Spillovers estimated using WHDMOD module of IMF’s FSGM; results fed into reduced-form Nicaraguan model for fiscal and reserve impacts.
  - Two scenarios considered separately.

- Scenario 1: Trade shock (NAFTA and CAFTA-DR MFN tariffs)
  - Output and demand:
    - Real GDP growth would fall by 2.3 percentage points below baseline, recovering in medium term.
    - Private consumption projected to deviate by 3.2 percent of GDP over 5 years.
    - Inflation would decline up to 1.5 percentage points.
  - External sector and reserves:
    - Imports and exports decline by about 1 percent of GDP; CA deficit stable short term around 8.7 percent of GDP.
    - Medium-term CA deficit increases from 8.6 to 9.4 percent of GDP (0.8 percentage points above baseline).
    - Gross international reserves in months of imports decline from 3.4 to 3.0 by 2022.
  - Fiscal and public debt:
    - Overall deficit would reach 3 percent of GDP in 2018, due to a reduction in fiscal revenue of 1.3 percent of GDP.
    - Total public debt increases from 39 percent of GDP to 43 percent in medium term.
  - Model caveats:
    - FSGM yields a 5 percent reduction in total investment; impact may be underestimated as FSGM assumes no decrease in U.S. FDI.
  - Alternative: exchange rate flexibility as shock absorber:
    - Immediate impact on GDP reduced by 1.7 percentage points to 0.6 percentage points below baseline.
    - Real interest rates reverse from +1 percentage point to -0.4 percentage points vs baseline.
    - Domestic prices rebound by 1.2 percentage points.
    - Private consumption decline limited to 1.2 percent of GDP vs 3.2 percent in peg scenario.
    - CPS debt stock decreases from 42.8 to 39.3 percent of GDP due to higher revenue and lower debt service.

- Scenario 2: Migration and remittances shock (deportation; remittances decline)
  - Aggregate effects:
    - GDP decreases by 0.3 percent over medium term vs baseline.
  - Private consumption and inflation:
    - Private consumption reduced by 1.4 percent of GDP.
    - Inflation down by 0.2 percentage points in medium term.
  - External sector:
    - Imports decline by 0.6 percent of GDP short term; CA deficit reduces by 0.2 percent of GDP short term; CA deficit increases to 9 percent of GDP by 2022 (0.4 percent below baseline).
  - Fiscal and public debt:
    - CPS balance and total debt worsen by 0.2 percent and 0.8 percent of GDP respectively due to lower tax income (0.4 percent of GDP).
  - Alternative remittance-cost scenario (two percent fee on remittances):
    - Macro impact about half of Scenario 2.
    - Staff estimates remittances fall by about 8.9 percent for a two percent fee added to existing 4.9 percent transfer-cost component (elasticity -0.22).
    - Equivalent to 0.4 percent of GDP, slightly less than half the size of Scenario 2.

---

*Source: cr17174 (IMF staff analysis and calculations in the original document).*

### References .............................................................................................................

### cr17174 - References

### System overview and structure
- Nicaragua’s social security system (INSS) provides pension, disability and healthcare benefits and is managed by the Nicaraguan Institute of Social Security (Instituto Nicaragüense de Seguridad Social or INSS).
- The pension system (IVM: Invalidez, Vejez y Muerte) is a defined benefit, pay-as-you-go system providing pension, disability and survivor benefits.
- Additional INSS programs: health insurance (Enfermedad-Maternidad), occupational risks (Riesgos Profesionales or RP), and disability and survivor benefits for victims of the civil war (Víctimas de la Guerra or VG).
- Beneficiaries of occupational risks and civil war-related disability and survivor benefits typically shift to receiving an IVM pension once they reach age 60.
- As of end-2016, the INSS had about 857,000 active contributors.
- There are two other social security systems in Nicaragua (military; police, firefighters, and prison employees) that are not included in public sector accounts and for which no published data are available.

### Financing, contributions, and benefit rules
- Benefits are financed by mandatory employer and employee contributions, and interest revenue from the INSS reserve fund.
- Contributors can choose between Régimen de IVM-RP (pension and occupational risks) or Régimen Integral (includes health); self-employed workers may contribute voluntarily under Régimen Facultativo (Integral or IVM).
- Pension eligibility: age 60 and at least 750 weeks (about 15 years) of contributions (not necessarily continuous). Special retirement age of 55 for teachers and miners.
- Benefits determined by formula based on average salary and weeks of contributions; two formulas apply: one for base salary less than two minimum wages (covers about 70 percent of all pensioners) and another for base salary above this level. The minimum starting pension cannot be lower than the minimum wage. Pensioners receive a thirteenth payment in December.
- Healthcare: members require three months of continuous contributions to receive healthcare benefits. Children covered up to age 12; female spouses/partners covered for maternity benefits. INSS pays providers a fixed per capita amount and pre-negotiated tariffs for specific events.

### Contribution rates (Table 1)
- Regimen Integral (Percent of pensionable salary):
  - Employer: Health insurance 6; Pension (IVM) 10; Workplace-related disability 1.5; War victims 1.5; TOTAL - Regimen Integral 19.6
  - Employee: Health insurance 2.25; Pension (IVM) 4; Workplace-related disability 1.5; War victims 1.5; TOTAL - Regimen Integral 5.25
  - Govt: Health insurance 0.25; Pension (IVM) 4; Workplace-related disability (—); War victims (—); TOTAL - Regimen Integral 8.5
  - TOTAL (Employer+Employee+Govt) - Regimen Integral 25.5
- Regimen Facultativo Integral TOTAL 18.25 (employer/employee columns merged as shown)
- Regimen Facultativo IVM TOTAL 10

### Recent financial trends and balances (Table 2)
- INSS Revenue and Expenditure, 2012-16 (Percent of GDP):
  - Revenue: 2012 4.8; 2013 5.1; 2014 5.3; 2015 5.5; 2016 5.9
  - Old-age pensions (IVM) revenue: 2012 2.2; 2013 2.4; 2014 2.6; 2015 2.9; 2016 3.1
  - Healthcare revenue: 2012 1.6; 2013 1.7; 2014 1.7; 2015 1.7; 2016 1.8
  - RP revenue: 2012 0.3; 2013 0.3; 2014 0.3; 2015 0.3; 2016 0.3
  - War victims revenue: 2012 0.3; 2013 0.3; 2014 0.3; 2015 0.3; 2016 0.3
  - Other revenue 1/: 2012 0.4; 2013 0.4; 2014 0.3; 2015 0.3; 2016 0.3
  - Expenditure: 2012 4.7; 2013 5.2; 2014 5.5; 2015 5.8; 2016 6.3
  - Old-age pensions (IVM) expenditure: 2012 2.1; 2013 2.3; 2014 2.5; 2015 2.7; 2016 3.0
  - Healthcare expenditure: 2012 1.5; 2013 1.6; 2014 1.6; 2015 1.8; 2016 1.8
  - RP expenditure: 2012 0.1; 2013 0.1; 2014 0.1; 2015 0.1; 2016 0.1
  - War victims expenditure: 2012 0.3; 2013 0.3; 2014 0.3; 2015 0.2; 2016 0.2
  - Other 2/ expenditure: 2012 0.1; 2013 0.2; 2014 0.2; 2015 0.1; 2016 0.2
  - Administrative 3/: 2012 0.6; 2013 0.7; 2014 0.8; 2015 0.8; 2016 0.9
  - Balance: 2012 0.2; 2013 -0.1; 2014 -0.3; 2015 -0.3; 2016 -0.4
  - Notes: 1/ Includes investment income from the reserve fund. 2/ Includes subsidies for funerals, marriages, infant formula, and for maintenance of children, as well as for days missed from work due to accidents, illness or maternity. 3/ Including expenditure on wages, goods and services, and capital expenditure.

### Coverage and recent changes (Table 3 and narrative)
- Coverage indicators (2006 and 2016):
  - Share of labor force contributing to INSS (active coverage) 1/: 2006 19; 2016 32
  - Share of population 60+ with INSS old age/survivor pension (passive coverage): 2006 17; 2016 32
  - Share of INSS pensioners receiving a reduced pension: 2006 0; 2016 33
  - Share of working-age population receiving a disability pension: 2006 1; 2016 1
  - Share of INSS members with health insurance: 2006 n.a.; 2016 83
  - Note: 1/ Total labor force, including informal sector.
- Coverage is relatively low but has shown strong gains; about 80 percent of businesses operate informally in Nicaragua (COSEP, 2015).
- The Reserve Fund (RF) aimed at independent and informal sector workers has grown rapidly from a low base.
- Share of population receiving an INSS pension expanded partly due to the introduction of the reduced pension in 2013.
- Social norms (elderly living with children) have mitigated old-age pension needs historically, but demographics and norms are likely to change, increasing priority for a wider social safety net for the elderly.

### 2013 pension reform and immediate impacts
- Key elements of the 2013 reform:
  - Increase in the contribution rate for employers from 7 to 10 percent, implemented between 2014 and 2017.
  - Increase in the maximum monthly pensionable salary to C$72,000 (US$2,774), with annual adjustments in line with growth of the average wage.
  - Minimum pensions to be adjusted in line with average wage growth, rather than with the minimum wage; link between minimum starting pension and minimum wage maintained.
  - Benefit formula for people earning at least twice the minimum wage made somewhat less generous; indexation changed to 5 percent annually (in line with the rate of crawl of the exchange rate against the U.S. dollar).
  - Agreement with the state to pay a debt to INSS through an annual payment of US$10 million over 50 years (obligation of US$500 million arose from non-payment by the central government of the 0.25 percent contribution required on the total wage bill).
- INSS estimates that savings from the reform were about 1 percent of GDP in 2016, with about four-fifths coming from an increase in contributions (higher rate and increase in maximum pensionable salary).
- The 0.25 percent contribution to INSS continues not to be included in the government budget despite the agreement to settle the outstanding debt at end-2013.

### Introduction and impact of the reduced pension (pensión reducida)
- The pensión reducida introduced in 2013 covers participants with 250-750 weeks of contributions (insufficient for a full pension).
- Reduced pension amounts are related to number of contribution weeks, are fixed in law, and are not indexed to the exchange rate, inflation, or wages.
- The average monthly reduced pension in 2016 amounted to about $83, or 27 percent of the average wage.
- As of March 2017, 46,071 pensioners (out of a total of 236,565) were receiving the reduced pension.
- The estimated cost of the reduced pension in 2016 was about 0.36 percent of GDP.
- Savings from the 2013 reform began to be eroded immediately as the partial pension benefit was introduced.

### Other INSS programs and trends
- RP (Riesgos Profesionales) provides coverage for about 15,000 people at end-2016.
- War Victims program (funded by a 1.5 percent employer contribution) currently covers about 32,000 people.
- “Special pensions” granted to people who have not contributed (currently about 2,000 people) are financed by both IVM and RP.
- War victims and special pensions have declined as a percentage of total INSS pensioners and total pension payments since the 1990s.

*cr17174 - References*

### 9.      The investment policy of the INSS has resulted in a reduction of financial income and a

### 9.      The investment policy of the INSS has resulted in a reduction of financial income and a

### Investment policy and reserve fund status
- INSS ran surpluses from 2007-2012 and invested largely in financial assets, largely government securities.
- Reserve fund assets:
  - Increased from US$392 million in 2007 to US$592 million in 2012.
  - Declined to US$410 million (3.1 percent of GDP) at end-2016.
- Reserve fund composition (end-2016 figures shown):
  - $36.3m, Bank accounts
  - $74.5m, Government bonds
  - $149.5m, Private equity investments (mainly medical)
  - $141.3m, Loans to institutions (mainly construction-related)
  - $8.1m, Other
- Liquid assets and liquidity risk:
  - Liquid assets amounted to about $91m at end-2016, or 22 percent of the total (taking into account that not all classes of government bonds are liquid).
  - INSS has used reserve funds to purchase real assets (including medical facilities) and to finance mortgage loans at subsidized rates through the banking system.
  - The share of liquid assets in the reserve fund has been reduced significantly, leaving INSS with only a small portion of reserves that are liquid and can be used to cover deficits.
- INSS has run a deficit since 2013 and has financed deficits from the reserve fund; the social security system is projected to have exhausted its liquid reserves by 2019.

### Pension adequacy, incentives, and distributional features
- Gross replacement rate and pension levels:
  - The gross replacement rate for an average income earner was estimated at 97 percent by OECD/IDB/World Bank (2014).
  - The average old age pension in 2016 was about 80 percent of the average wage.
- Pensioner distribution (end-2016):
  - 42 percent of pensioners were receiving a minimum pension.
  - 33 percent a reduced pension.
  - 26 percent a pension higher than the minimum pension.
- Minimum pension distortions and NPV analysis:
  - Minimum wage earners contributing 15 or 20 years receive no difference in pensions because the minimum starting pension cannot be less than the minimum wage.
  - Those earning an average wage contribute significantly more than minimum wage earners, yet their pensions will be very close in value.
  - NPV calculations assume an average life expectancy after retirement of 15 years and a retirement date of end-2016, reflecting lower historical contribution rates (IVM contribution rates were as low as 5.5 percent up to 2001).

### Revenues, expenditures, and recent trends
- Contribution and spending trends:
  - Contributions increased from 2.4 percent of GDP in 2013 to 3.1 percent of GDP in 2016.
  - Total pension spending rose from 1.4 percent of GDP in 2006 to 3.0 percent of GDP in 2016.
  - Major drivers of pension spending increases: increases in the minimum wage (to which the minimum pension was indexed), particularly in 2008 and 2009; a doubling of the number of ordinary pensioners; introduction and take-up of the reduced pension (about 0.4 percent of GDP in 2016).
- Projected trends:
  - INSS projections for 2017-2020 used for short-term revenue/expenditure; beyond 2020 staff model based on Clements et al (2013).
  - By 2040, IVM pension system expenditure projected to reach 5.9 percent of GDP.
  - IVM contributions projected to grow rapidly until 2020 and then stabilize at around 3.4 percent of GDP from 2020 onwards.
- Healthcare and administrative costs:
  - Number of insured approximately doubled since 2006; healthcare expenditure increased almost six-fold and exceeded contributions since 2015.
  - INSS attempts to contain healthcare cost growth included negotiating tariffs and using the reserve fund to purchase stakes in health service providers and generic drug manufacturers.
  - Health care expenditure per capita in the INSS system fell by 3 percent in 2016.
  - Administrative expenditures rose from 0.3 percent of GDP in 2006 to 0.9 percent of GDP in 2016.
  - Personnel expenditure rose from 0.2 percent of GDP in 2006 to 0.5 percent of GDP in 2016.
  - INSS had 4,090 staff on the payroll at end-2016, 65 percent of which earned a monthly salary of C$20,001 or more.
  - Average economy-wide monthly salary in 2016 was C$9,386; average salary in the central government was C$10,131.
  - INSS staff benefit from a “doble aguinaldo”—two extra months of salary every year.
  - Medium-term INSS projections imply a 14 percent reduction in administrative expenditure in nominal terms in 2017 with planned cuts to personnel and capital expenditure.
- Other programs:
  - War victims program projected to decline from 0.2 percent of GDP currently to 0.01 percent of GDP by 2040.
  - Occupational risks program projected to remain at 0.1 percent of GDP over the long term.

### Demographics and regional context
- Demographic changes:
  - Fertility rates declined from five children per woman in 1990 to 2.3 in 2015.
  - Life expectancy rose from 62 years in 1990 to 75 years in 2015.
  - Currently 5 percent of the population is over 64; expected to rise to 12 percent by 2040.
  - Old age dependency ratio expected to increase from 7.8 percent to 17.8 percent by 2040.
  - Working age population will continue to expand well beyond the next 20 years, but population aging will increase pressure on INSS finances.
  - Caveat: specific demographic information on the INSS population was not available; INSS population may be more advanced in aging than the general population.
- Regional comparisons:
  - Public pension expenditure as a percentage of GDP is highest in Nicaragua among Central American countries.
  - Nicaragua stands out for relatively high contribution rates, replacement rates, and pension expenditure.
  - All countries in the region, except Nicaragua, have introduced a social pension typically targeted to the most vulnerable.

### Reform options, simulations, and feasibility
- Limitations of coverage expansion:
  - Authorities assume an almost 6 percentage point increase in labor force coverage between end-2016 and 2020; coverage assumed to stabilize at about 37 percent of the labor force after 2020.
  - Simulation indicates coverage would need to increase to about 90 percent of the labor force by 2040 to close the gap with additional contributors alone.
  - Analysis notes that additional contributors may worsen INSS finances long run because benefits tend to exceed the value of contributions.
- Individual reform scenarios simulated (Figure 5):
  - Scenario 1: a gradual increase in the retirement age to 63 by 2025.
  - Scenario 2: keeping pensions fixed in dollar terms (index all pensions to ER only).
  - Scenario 3: increasing contributions by 1 percent in 2020 and a further 1 percent in 2021 (total increase of 2%).
  - Scenario 4: reducing average benefits by 20 percent.
  - On their own, none of these individual reforms achieves full sustainability over the next 20 years; combinations could achieve sustainability.
- Case for raising retirement age:
  - Average life expectancy is now 13 years higher than in 1990 while retirement age has not changed.
  - Increasing retirement age raises the number of contributors and reduces the number of beneficiaries; increases can be gradual and may retain option of retirement at 60 with a penalty.
  - Important caveats: gains in life expectancy likely unequally distributed; miners and some agricultural workers have shorter lifespans and currently have retirement age of 55; teachers currently have retirement age of 55 and consideration could be given to increasing their retirement age to at least 60.
- Contribution rate constraints:
  - There appears to be little scope to increase contribution rates further.
  - Overall contribution rate to INSS is 25¼ percent of wages.
  - Higher employer contributions were a key part of the previous reform and further increases are likely politically difficult and could disincentivize formalization.

*Sources: INSS and IMF staff calculations.*

### 25.      A reduction in pension costs could be achieved by bringing benefits more in line with

### 25.      A reduction in pension costs could be achieved by bringing benefits more in line with

### Pension cost reduction and benefit structure
- Average replacement rates could be brought down to levels closer to the OECD average of 53 percent through an overhaul of the formula.
- Reducing benefits may lower coverage if fewer workers and employers choose to contribute.
- The most recent reform made Nicaragua’s pension system more progressive: higher income earners now have a lower replacement rate relative to those earning below two minimum wages. Policy implication: avoid increasing this gap to prevent disincentives for higher income earners to contribute.
- Recommendation: channel social support to low income earners through an expansion of non-contributory pensions.

### Indexation mechanism reform
- The 2013 reform delinked annual pension increases from the minimum wage.
- Staff calculations: the average IVM pension (excluding the reduced pension) has increased by about 9 percent annually since the reform, less than earlier years and less than the increase in the minimum wage in the industrial sector (11 percent annually), but well above inflation, which averaged 4.5 percent over the same period.
- Modeled change: delink the minimum starting pension from the minimum wage, and index all pensions to the depreciation of the exchange rate against the dollar (currently 5 percent annually for a portion of pensions) or past-year inflation, whichever is lower.

### Shifting certain expenditures to the budget
- Proposal: finance non-contributive pensions (war victims and special pensions) from tax revenue rather than employer and employee contributions; INSS could continue payments but be financed by budgetary allocations.
- Fiscal effect: contributions previously paid for war victims could be reallocated into IVM contributions (war victims’ contributions equal 1.5 percent of the wage bill in the modeling assumptions).

### Illustrative reform packages and simulation results (IVM balance to 2040)
- All reforms assumed implemented over 2020-2025; some (indexation changes) immediately, others phased over 5 years.
- Reforms exclude other programs and administrative expenditures.
- Reforms are indicative; a full actuarial analysis is recommended.

- Reform package 1:
  - Index all pensions to US$ exchange rate; increase retirement age to 63 by 2025; reduce average benefits by 20%.
  - IVM system balance (% of GDP): 2020: 0.8; 2025: 1.5; 2030: 1.2; 2035: 1.1; 2040: 0.7
  - Savings relative to baseline (% of GDP): 2020: 0.9; 2025: 2.0; 2030: 2.4; 2035: 2.7; 2040: 3.1

- Reform package 2:
  - Index all pensions to inflation (inflation assumed 7 percent p.a. over the long term); reduce average benefits by 30%; contributions for war victims shifted to IVM.
  - IVM system balance (% of GDP): 2020: 0.8; 2025: 1.5; 2030: 1.4; 2035: 1.0; 2040: 0.6
  - Savings relative to baseline (% of GDP): 2020: 1.0; 2025: 2.1; 2030: 2.4; 2035: 2.7; 2040: 3.0

- Reform package 3:
  - Index all pensions to inflation; increase retirement age to 65 by 2025; contributions for war victims shifted to IVM.
  - IVM system balance (% of GDP): 2020: 0.9; 2025: 1.4; 2030: 1.2; 2035: 0.8; 2040: 0.3
  - Savings relative to baseline (% of GDP): 2020: 1.0; 2025: 2.0; 2030: 2.2; 2035: 2.4; 2040: 2.7

- Reform package 4:
  - Index all pensions to US$ exchange rate; reduce average benefits by 20%; increase contribution rate by 2%.
  - IVM system balance (% of GDP): 2020: 0.8; 2025: 1.4; 2030: 1.1; 2035: 0.8; 2040: 0.3
  - Savings relative to baseline (% of GDP): 2020: 1.0; 2025: 2.0; 2030: 2.1; 2035: 2.4; 2040: 2.7

- Note: Table 5 and Figure 6 in the source illustrate these scenarios; all numeric values above are preserved exactly as presented.

### Defined contribution and mixed systems
- A full shift to a defined contribution system is not appropriate now due to:
  - Problematic experiences in Latin America: low real rates of return and low contribution densities yielding inadequate pensions.
  - Unmanageable transition costs of closing the current system.
- Historical note: a defined contribution scheme was legislated in the early 2000s in Nicaragua but never introduced, partly due to transition cost concerns.
- Alternative: after reforming the defined benefit system, consider a mixed system with a defined benefit component for lower salaries and a defined contribution component for higher incomes, financed by additional contributions and phased in slowly.

### Reduced pension distortions and options
- The reduced pension has a much larger beneficiary pool than originally foreseen, contributing to rapid INSS financial deterioration.
- Beneficiaries’ contributions have an NPV substantially below the benefits they receive (even though benefits are not indexed), implying cross-subsidies from other contributors.
- Policy options:
  - Re-scale reduced pension benefits to match the NPV of actual contributions, including associated health benefits.
  - Close the reduced pension to new beneficiaries and replace it with a non-contributory pension targeted to families below the poverty line.

### Targeted non-contributory pension example
- Example design: a pension of $24 per month (equivalent to 15 percent of the minimum wage or about 1.1 percent of GDP per capita) benefiting one-quarter of the population 65+ would cost about 0.2 percent of GDP.

### Administrative reforms and operational efficiency
- Administrative costs are high and sizable in Nicaragua’s INSS; these are not included in the reform scenarios except for planned cuts starting in 2017.
- Baseline assumption: administrative costs decline from 0.9 percent of GDP observed in 2016, stabilizing after 2020 at around 0.6 percent of GDP.
- Efficiency measures with potential savings:
  - Outsource pension payments to banks and non-bank financial institutions to reduce staff, equipment and maintenance expenditures.
  - Sell a large part of the branch network to generate additional income.
- INSS payroll observations:
  - 2016 average annual salary of an INSS employee: C$417,000 ($14,570), which is 3.2 times the average salary in the central government.
  - Historical ratio: in 2007 the same ratio was 1.9.
  - Bringing the ratio back to 2007 levels would save about 0.2 percentage points of GDP, equivalent to reducing the average pension benefit by five percent or a 0.75 percent increase in the contribution rate.

### Other reforms: healthcare efficiency and governance
- Further healthcare efficiency gains could reduce expenditures without cutting benefits; a thorough investigation is needed.
- Modernize reserve management and improve governance:
  - Current social security law does not regulate INSS’s investment fund.
  - Reserves should typically be invested in low-risk assets (e.g., government bonds), but recent investments have departed from this practice.
  - Lack of disclosure on reserve investments and no constraints on shifting reserves between regimes (e.g., IVM and healthcare) reduce transparency and can create perceptions of unfairness.
- Recommendation: conduct a deep actuarial, economic and operational analysis to design a comprehensive reform program and act quickly to avoid a costly bailout.

### Technical annex highlights (formulae and key assumptions)
- Old Age Pension calculation essentials:
  - Monthly Remuneration Base (RBM): average pensionable salary over the past “n” weeks.
  - Excess Contribution Weeks Factor (FSCE) = (Weeks of Contributions – 150)/52.
  - If RBM ≤ two times the minimum wage:
    - Base pension = RBM * (0.45+0.01591*FSCE)
    - Base pension limited to 100 percent of RBM; family benefits: 15 percent for spouse and 10 percent for each child <21.
  - If RBM > two times the minimum wage:
    - Base pension = RBM * (0.37 + 0.01150*FSCE)
    - Base pension limited to 80 percent of RBM; same family benefits; sum of base pension and family benefits cannot exceed 100 percent of RB; base pension under formula 2 cannot be less than formula 1.
  - Total pension including family benefits cannot exceed US$1,500 monthly.
- Reduced pension current monthly amounts by weeks of contributions:
  - 250-349 weeks: C$ 1,910
  - 350-449 weeks: C$ 2,356
  - 450-549 weeks: C$ 2,884
  - 550-649 weeks: C$ 3,290
  - 650-749 weeks: C$ 3,656
- Pension identity components used in the model: old-age dependency ratio, elderly coverage ratio, replacement rate, inverse employment ratio, labor share of GDP; PE/GDP denotes pension spending to GDP.
- Key modeling assumptions (selected, 2017-2040 averages and specific year figures preserved):
  - Inflation assumed 7 percent p.a. over the long term (for scenarios referencing inflation).
  - Contribution rate (percent of wages): 1/2/12/24/24/24/24/24 (as shown in the source table).
  - Wage growth (percent) historical average (2012-2016): 7.1; 2017: 3.4; 2018: 10.4; 2019: 7.3; 2020: 6.3; Average 2021-2040: 7.5
  - Labor force growth, annual (percent): 3/2.3/2.1/2.0/1.9/1.9/1.4 (as shown in the source table).
  - Labor force covered by INSS (percent): 2/7.3/32.5/33.7/35.5/37.3/37.3 (as shown).
  - Population over 60 receiving an INSS pension (percent): 2/6.5/33.4/33.4/38.8/35.2/36.4/39.6 (as shown).
  - Average pension (in percent of GDP per worker): 2/46.9/43.0/43.2/42.2/40.7/40.8 (as shown).

*Source: IMF staff analysis and calculations as presented in the original document.*

### 2. The impact of climate change on the global economy is expected to intensify over the

### 2. The impact of climate change on the global economy is expected to intensify over the coming decades

### Projected warming and global economic impacts
- Mean projected warming in the absence of mitigation is expected to reach about 3 to 4 degrees Celsius (°C) by 2100.
- Tol (reviewing 21 studies) estimated increases in temperature between 1 and 5.4 °C (typical estimations by the year 2100).
- Estimated impacts on GDP growth from reviewed studies range between -11.5 and 2.3 percentage points.
- Although there is considerable variation across studies, the average impact from a 3°C increase in temperature is projected at about -2 percent of global GDP by 2100.
- Other risks associated with warming include changes in precipitation patterns, sea level rises, more intense and frequent extreme weather, destruction of the marine food chain from ocean acidification, and changes in ocean circulation.

### Differential country impacts and sensitivity factors
- Countries’ productivity reacts differently to climate change depending on initial temperature:
  - Cold countries (annual average temperature below 13°C) tend to see productivity increases as temperature rises.
  - Countries with average temperature above 13°C see productivity declines with global warming.
- Specific empirical estimates:
  - For a country with average initial temperature of about 25°C (such as Nicaragua), the marginal impact of increasing average temperature by 1 °C is a reduction of about 1 percent in productivity growth (Burke, Hsiang and Miguel, 2015).
  - Dell, Jones and Olken (2012): in poor countries, a one-degree rise in temperature in a given period reduces economic growth by about 1.3 percentage points on average; effectively no effect on rich countries.
  - Dell, Jones and Olken (2012) also estimate that for poor countries a one-degree rise in temperature is associated with 2.66 percentage points lower growth in agricultural output, and 2.04 percentage points lower growth in industrial output.

### Nicaragua: exposure, vulnerabilities, and projected impacts
- Historical and projected temperature:
  - Average temperature in Nicaragua has already increased by about 1°C since 1950.
  - Further increases and related changes are expected to impact GDP growth negatively, mainly by reducing agricultural output; rising sea level and affecting coastal areas; degrading the environment and deteriorating health.
- Greenhouse gas emissions and mitigation capacity:
  - Nicaragua’s greenhouse gas emission amounted to 14.3 metric tons of CO2 equivalent in 2013, accounting for 0.03 percent of the world total.
  - Nicaragua has limited possibilities to mitigate climate change given its very low carbon footprint.
- Structural and sectoral vulnerabilities:
  - Agriculture, livestock and fishing contributed 14 percent of Nicaragua’s GDP as of end-2016, 8.4 percent of formal employment, and most informal employment.
  - Exports of agricultural products account for about 30 percent of total exports of goods.
  - As of 2014, 29.6 percent of the Nicaraguan population lived under the national poverty line.
  - Approximately 70 percent of housing constructions do not provide sufficient security against disasters (UNISDR and CEPREDENAC, 2015).
  - The insurance industry is underdeveloped, with total assets of less than 2½ percent of GDP; insurance products against disasters are very limited.
- Disaster exposure and historical impacts:
  - There were 78 disaster events in Nicaragua during 1900-2016 (frequency of 0.7 disasters per year).
  - During 1950-2014, each event on average had a reported economic cost of 2.2 percent of GDP and affected 1.5 percent of the population per event.
  - Nicaragua is the fourth country in the world by number of disasters (Global Climate Risk Index 1996-2015) and ranks 158 out of 173 countries in World Risk Index.
- Country-specific projected costs (estimates drawn from global findings and country attributes):
  - Assuming a linear path of climate change and a negative impact on productivity growth of 1 percent per 1 °C of warming, this would translate into an annual productivity loss of 0.04 percentage points lower compared with the scenario with no climate change.
  - Applying Dell, Jones and Olken (2012), a 1 °C increase in average temperature would reduce Nicaragua’s GDP growth by 1.3 percent; thus the negative impact on Nicaragua’s GDP growth would be 0.05 percentage points per year compared with the scenario with no climate change.
  - Climate change is projected to reduce annual agriculture output by 0.1 percentage points compared with a scenario without climate change.

### Regional disaster trends and Nicaragua’s position
- Global and regional trends:
  - Climate-related disasters have increased steadily during the last 4 decades worldwide and in Latin America and the Caribbean in particular.
  - Climatic disasters increased by 326 percent during 1970-2010, driven mainly by storms (which increased by 453 percent).
  - Storms in Central America and the Caribbean increased fivefold; other climate disasters increased by over 400 percent and 300 percent, respectively.
- CAPDR region exposure:
  - CAPDR countries (Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama and Dominican Republic) are disproportionately exposed to disasters: during 1950-2014 there were 478 disaster events in the CAPDR region.
  - While the region’s land and population is less than one percent of the world’s total, the number of disasters accounts for over 5 percent of total events in the world during this period.
  - Nicaragua ranks third in CAPDR by number of disaster events occurred during 1950-2016 (after Guatemala and Honduras) and ranks first in the region in terms of average economic cost.

### Drivers of high disaster frequency and geographic patterns
- Geological and geomorphological drivers:
  - Nicaragua is located between the Cocos and Caribbean tectonic plates where seismic activities are frequent.
  - There are 25 volcanoes in Nicaragua, five considered active and two additional had eruptive activities in the last 200 years.
  - INETER reports 37 percent (about 65 municipalities) of the 153 municipalities present some level of earthquake risks; of these, 47 percent are classified as high risk.
  - Seismic activities concentrate on the Pacific region, concentrating 75 percent of the population and about 90 percent of the economic activity.
- Floods, landslides, and storms:
  - Risk of floods and landslides is higher in the central region (mountainous areas and high precipitation).
  - Storms occur mainly in the Atlantic region; storms impacted a larger proportion of the population than floods according to historical data.

### Quantitative analysis of disasters: methods and key empirical findings
- Methodological challenges:
  - Disaster impacts may not be adequately captured by available data (calendar reporting vs. varying event durations).
  - Other factors could affect observed macroeconomic impacts; econometric techniques are combined with intuitive methodologies to control for exogenous variables.
  - Limited country observations often prevent meaningful country-by-country econometric studies.
  - Different disaster types (floods, storms, earthquakes, droughts) may have different impact patterns and should be treated separately.
- Event-study findings:
  - For CAPDR countries, the most severe disaster events decelerate GDP growth by about 2 percentage points in the event year.
  - GDP growth tends to accelerate by about 3.1 percent the following year, possibly due to reconstruction efforts.
  - Among the four types of events with higher incidence in the region, storms seem to have the largest impact and strongest recovery.
  - Event studies do not control for other growth determinants; causality cannot be established without econometric analysis.
- VAR empirical results (pooled 18-country CAPDR/Caribbean model):
  - A vector auto-regression model with exogenous shocks controlling for domestic and external conditions was used to estimate dynamic effects of earthquakes, floods, storms and droughts.
  - Impulse response functions show immediate negative impacts on output growth:
    - Floods: immediate negative impact of 0.8 percentage points on output growth.
    - Earthquakes: immediate negative impact of 1.9 percentage points on output growth.
    - Storms: immediate negative impact (magnitude between floods and earthquakes as per model results).
  - Although growth tends to recover in about three years, the damage to the output level is permanent.
  - Results on droughts are inconclusive and seem to follow differing intra-regional dynamics.

### Policy-relevant implications and fiscal considerations (as discussed)
- Adaptation and fiscal burden:
  - The need to implement adaptation measures will weigh on the budget.
  - Limited available resources and low adaptive capacity may increase the cost of climate change for Nicaragua.
- Risk financing and insurance:
  - Shallow financial markets and an underdeveloped insurance industry (total assets of less than 2½ percent of GDP) significantly limit the capacity for risk transfer and post-disaster relief and reconstruction financing.
- Structural resilience:
  - Structural factors such as poverty, inadequate building standards and insufficient enforcement exacerbate disaster impacts and constrain resilience-building.

*Source: cr17174 - 2. The impact of climate change on the global economy is expected to intensify over the*

### 19. Floods and droughts have a greater impact on

### 19. Floods and droughts have a greater impact on growth in CAPDR, compared with Caribbean countries.

### Key findings on macroeconomic impact of disasters
- Floods and droughts have a greater impact on growth in CAPDR compared with Caribbean countries. Results for CAPDR countries indicate that floods have slightly greater negative impact than when the model is run for the pool of CAPDR and Caribbean countries.
- Droughts: an immediate negative deviation from the GDP growth baseline of 1.2 percentage points, which recovers in about 3 years.
- Earthquakes (CAPDR): cause the largest contemporaneous impact on revenue—about 5 percent of GDP in the event year—while also showing the strongest recovery ratio.
- Exports: storms, droughts and floods reduce the growth of export-to-GDP ratio by a range of 11 to 24 percentage points 1 to 2 years after the event; exports tend to recover only after 2 to 4 years after the event.
- Agriculture: droughts, storms and floods reduce the growth of share of agriculture products in total primary commodity exports by 15 percent to 51 percent in the event year; the impact of earthquakes appears less significant.

### CAPDR vs Nicaragua — quantitative comparative estimates
- GDP growth (decline, pp) — CAPDR vs Nicaragua:
  - Storm: CAPDR 0.85; NIC 1.74
  - Flood: CAPDR 1.01; NIC 0.61
  - Overall: CAPDR 0.93; NIC 1.18
- Revenue to GDP growth (decline, pp) — CAPDR vs Nicaragua:
  - Storm: CAPDR 0.52; NIC 2.5
  - Flood: CAPDR 2.04; NIC 8.68
  - Overall: CAPDR 1.28; NIC 5.59
- Table 8 (Fund staff estimations on events and revenue impact):
  - Number of Events in Model: Storm 89; Flood 5; Earthquake 4
  - Probability: Storm 0.12; Flood 0.14; Earthquake 0.08; Drought 0.06
  - Impact on revenue as % of GDP: Storm -0.16; Flood -0.39; Earthquake -0.09; Drought -0.11

### Fiscal preparedness and disaster-financing capacity (Nicaragua)
- IDD (Disaster Deficit Index) evolution (IDB, 2015): values indicate Nicaragua lacks fiscal capacity for extreme events and that the gap has grown over time.
  - IDD50 (largest event in last 50 years within next 10 years): 2000 1.17; 2005 1.29; 2010 2.49; 2012 2.74
  - IDD100: 2000 2.52; 2005 2.75; 2010 4.84; 2012 5.22
  - IDD500: 2000 4.02; 2005 4.24; 2010 6.07; 2012 6.30
- Interpretation: an IDD greater than 1 indicates insufficient economic capacity to deal with disasters of that scale. If a disaster of a severity equal to the largest that occurred in the last 50 years had struck Nicaragua in 2012, the country would have necessitated 2.74 times the available fiscal space to cope with the fiscal impact.
- Revenue loss due to severe disasters (average estimated impact on revenue) ranges from 0.1 to 0.4 percent of GDP; floods pose the largest fiscal risk due to higher frequency and larger average revenue impact.
- Nicaragua’s National Disaster Fund (NDF) 2016 allocation: 40 million córdobas (about US$1.4 million) — fully spent in 2016 with no remnant for following years.
- Nicaragua’s CCRIF engagement:
  - Annual premium: US$3.5 million (paid by the World Bank).
  - Catastrophe insurance payouts in 2016: US$1.6 million.
- Contingent financing:
  - IDB contingent credit: up to US$156 million available if a disaster of certain magnitude strikes.
  - World Bank: would frontload all resources available in the pipeline in the event.

### Sectoral and structural notes
- Timing and lags:
  - The lagged impact on exports is partly explained by timing of events (May to October hurricane/rain season), harvest season (October to March for main agricultural exports), and processing times for export products.
  - Earthquake impacts on exports are contemporaneous, likely due to direct effects on export processing facilities and transport infrastructure.
- Renewable energy and mitigation:
  - Power generation in 2015 (GWh): Thermal 268,959.4; Hydroelectrical 2,946.5; Gas Turbine 20.1; Geothermal 67,815.0; Wind 86,519.1; Solar 20.05.
  - Memorandum items: Clean energy share of total 50.6; Energy from petroleum 49.9; National Interconnected System 4,531,100.
  - Nicaragua has increased clean primary energy share from 30 percent in 2006 to over 50 percent; an ongoing plan aims to increase renewable contribution to over 90 percent by 2020.

### Policy recommendations and measures
- Adaptation measures (implemented and recommended):
  - Strengthen technical institutions (INETER) to develop knowledge base, hazard and vulnerability mapping, and early warning systems; World Bank estimate: every U.S. dollar invested in early warning systems yields US$4 in reduced losses.
  - Strengthen agricultural resilience: diversify products, extend irrigation, improve crop resilience; new Agricultural and Livestock Insurance by INISER to protect producers against climatic and biological hazards.
  - Continue reforestation and deforestation-prevention plans (World Bank-assisted): aim to reduce CO2 emissions by 11 metric tons in 20 years; partial financing from Green Climate Fund (GCF).
  - Increase access to international donor financing for mitigation measures for lower income countries.
- Mitigation and institutional measures:
  - Maintain and strengthen National System for Disaster Management and Prevention (SINAPRED) and the National Plan for Human Development’s integration of prevention, mitigation and disaster relief; enhance local implementation and citizen awareness/training.
  - Improve enforcement of building codes and appropriate zoning rules to ensure structures can withstand disasters.
  - Continue and expand use of catastrophe risk insurance (CCRIF) and contingent credit lines with multilateral partners.
- Macroeconomic and fiscal policy actions:
  - Integrate CCDs’ risk into fiscal risk annual reports and medium-term budgetary framework: identify, quantify, and communicate disaster and climate fiscal risks to the legislature and public.
  - Public investment in resilient infrastructure and incentives for private sector investment in CCD risk mitigation; align spending with fiscal space, debt sustainability, and absorption capacity.
  - Strengthen social safety nets to help households in poverty cope with disaster impacts.
  - Build disaster-specific fiscal buffers: authorities should gradually build up a disasters-specific fiscal buffer of at least the average revenue cost of natural disasters plus the estimated impact on expenditure; fiscal effort to create additional fiscal space should be spread over a sufficient timespan and reviewed at least annually in the medium-term budget framework.
  - Adopt broadly counter-cyclical fiscal policy to create contingent buffers in non-disaster years that can be deployed when disasters occur.

*Source: Fund staff estimation; IDB (2015); World Bank (2016); chapter content.*

### 37. Energy prices should be allowed to reflect the full range of environmental impacts.

### 37. Energy prices should be allowed to reflect the full range of environmental impacts.

### Energy pricing and subsidies
- Recommendation: Allow energy prices to reflect the full range of environmental impacts to support an environmentally friendly development strategy and improve revenue.
- Findings:
  - Nicaragua contributes little to the global greenhouse gases, but appropriate pricing policy can help the country embark on a more environmental-friendly development strategy and improve revenue.
  - Electricity subsidies are estimated at 0.6 of GDP in 2016, and financed by both public and private resources.
  - Subsidies are also provided to public transportation through reduced price for diesel and the VAT preferences.
  - These subsidies are costly and inefficient—most of these subsidies are received by the households in the higher welfare quintiles.
- Policy implication: Reduce subsidies to electricity and public transportation to improve fiscal efficiency and environmental outcomes.

### Monetary, financial, and exchange rate policies to address climate and disaster risk
- Strengthening financial regulation and supervision:
  - Recommendation: Further strengthen the financial regulatory and supervisory framework to increase resilience of financial institutions to climate change and climate- and catastrophe-related disasters (CCDs).
  - Measures suggested:
    - Fully integrate CCDs’ risks into the risk analysis and management system of financial institutions.
    - Increase bank capital buffers and technical reserves for the insurance industry, taking into account exposure to CCD in provisioning policies.
    - Develop a reinsurance market that reduces the cost of catastrophic insurance.
- Financial market development and inclusion:
  - Finding: Underdeveloped financial markets may delay or prevent efficient reallocation of risks and financial resources.
  - Recommendations:
    - Strengthen the legal and institutional basis of financial markets.
    - Improve financial literacy and financial inclusion.
    - Promote financial deepening to transfer risks to entities most capable of bearing them.
    - Increase access to financing and insurance for households and businesses to mitigate financial stress.
- Exchange rate framework and reserves:
  - Finding: Under the current exchange rate framework, the optimal level of gross international reserves would be above conventional metrics.
  - Rationale:
    - Given the high exposure to CCDs, and the increase in foreign currency demand associated to events, the central bank may have to conduct substantial foreign exchange interventions to maintain exchange rate stability within the crawling peg framework.
  - Recommendation:
    - Maintain a higher level of reserves to help prevent disorderly foreign exchange market developments.
    - Eventually consider introducing some flexibility to allow the exchange rate to absorb external shocks and reduce the macroeconomic cost of CCDs.

### Role of the IMF
- Activities:
  - The IMF assists in building resilience to CCDs through policy advice, capacity building, and financing.
  - This paper is part of several pilots to better integrate the assessment on CCDs’ risk within IMF’s surveillance.
  - The Fiscal Affairs Department delivers technical assistance and training in topics related to climate change, particularly carbon taxation.
  - The IMF’s Rapid Credit Facility (RCF) and Rapid Finance Instrument (RFI) provide prompt assistance to countries with emergency balance of payments needs.
- Recent change to emergency financing:
  - The Fund increased the annual access limits under the RCF and RFI from 37.5 percent of the quota to 60 percent of the quota.

### Methodological approach to estimating macroeconomic impact of disasters (Annex I — key points)
- Overall approach:
  - Methodology follows Acevedo (2014), estimating the macroeconomic impact of natural disasters in Nicaragua within the Central American and Caribbean context using a fixed effects unbalanced panel VAR with exogenous variables (VARX).
- Data and sources:
  - Complemented Penn World Tables (v 9.0) with IMF World Economic Outlook (2016) and World Bank World Development Indicators (WDI).
  - Disaster event data source: Emergency Disaster Database (EM-DAT).
  - Panel dataset includes series for 18 countries over the period 1950-2016.
- Variable treatment:
  - All variables are calculated as growth rates to ensure stationarity.
  - Severe disasters defined as events which affect more than 0.1 percent of total population; severity dummy equals 1 if threshold met.
  - Threshold for earthquakes set at 0.01 percent with a full weight on individuals affected.
- Estimation methods and diagnostics:
  - Because of lagged dependent variables and potential bias, estimates obtained using the Generalized Method of Moments (GMM) proposed by Arellano and Bover (1995).
  - Stability condition and lag-selection tests indicate the VAR model satisfies stability criteria.
  - Optimal lag order selected: first order panel VAR based on MBIC, MAIC and MQIC.
  - Impulse-response analysis uses dynamic multiplier functions to derive responses of real GDP, export-to-GDP ratio, revenue-to-GDP ratio and agriculture share of exports to shocks from storm, flood, earthquake and drought; 95 percent confidence intervals reported using Monte Carlo simulation.
- Key data points preserved from the dataset description and diagnostics:
  - Panel: 18 countries over 1950-2016.
  - Severity threshold for severe disasters: affect more than 0.1 percent of total population (earthquake threshold 0.01 percent).
  - VAR lag selection favored first order panel VAR.
  - Unit-root and stability tests reported (e.g., Im-Pesaran-Shin statistics provided in Table 5 indicate rejection of unit root for series included).
  - Table summaries indicate presence and frequency of disaster types across CAPDR and Caribbean countries (Nicaragua: 8954 listed under Table 3).

### Context on trade, FDI, and free trade zones (excerpts relevant to policy)
- Findings:
  - Exports represent about 95 percent of GDP (2016).
  - Net inflows of FDI have averaged nearly US$ 800 million annually over the past five years.
  - Export Tax Free Zones (FZ) introduced in 1991; user firms of FZ are exempt of CIT for 10 years, renewable for a second term; after they benefit from an exemption of 60 percent. Service and interest payments to foreign residents are also exempt.
  - Maquila-type exports outside FZ enjoy a CIT credit available for up to 1.5 percent of the value of exports, and VAT and tariff exemptions for temporary imports.
  - The FZ employed over 110,000 workers in 2016, representing two thirds of total manufacturing employment in Nicaragua.
- Policy concern:
  - A growth strategy driven preeminently by tax exempt sectors may dampen the state’s capacity to mobilize revenues for development in the long-run.
  - Globalization and presence of multinational corporations expose Nicaragua to BEPS risks, particularly through manipulation of transfer pricing (TP) in cross-border transactions and between domestic firms and FZ entities.
  - Transfer pricing manipulation can shift profits into FZs or understate tax expenditures associated with FZs; it may also lead transnational enterprises to undervalue exports even if profits are not taxed in Nicaragua.

*International Monetary Fund. Nicaragua: Coping with Climate and Disaster Risks — Chapter excerpt.*

### 4.      Nicaragua has strengthened somewhat its international taxation framework, especially

### 4.      Nicaragua has strengthened somewhat its international taxation framework, especially

### Overview of recent TP legal developments
- TP legislation was adopted in 2012, allowing four years before it became effective, so that taxpayers and tax authorities could prepare for it. (Ley de Concertación Tributaria (LCT), diciembre 17, 2012. (Ley No. 822). Arts. 93-106.)
- The entry into force was postponed till June 30, 2017. (Ley No.922, December 17, 2015.)
- As of the report, operational capacity of the administration to implement TP rules remained uncertain.

### Transfer Pricing on Commodities — importance and vulnerability
- Applying the arm’s length principle for related party transactions is the standard to avoid profit shifting through TP; methods established by OECD guidelines include the Comparable Uncontrolled Price (CUP) method.
- At first sight, the CUP method could be most useful for benchmarking commodity TP because commodities:
  - Are more homogenous relative to other goods;
  - Are traded in very efficient and well organized international markets; and
  - Have normally a daily, publicly quoted price.
- However, related parties often price commodity exports following other methods that may easily erode the tax base of the producer country.
- Nicaragua’s exports originating outside the FZ are mostly commodities. The top five commodities (meat, coffee, gold, sugar and oil seeds) represent around 60 percent of Nicaragua’s total non-FZ export (Table 1).
- Another US$397 million worth of commodity exports originate in the FZ (2016).

### Tax planning schemes affecting commodity pricing (findings)
- Common scheme: locate a related intermediary in a low tax jurisdiction alleged to provide a trading service; intermediary pays a low price to the producer affiliate and resells at spot prices to the final customer, keeping the difference as payment for a purported service. Goods shipped directly to the customer; intermediary often only issues contracts.
- Variant: retroactive contracts selecting dates when the spot price was lowest within a period (backdating), with trade routed through a related intermediary in a low tax jurisdiction that resells at the current spot price.
- Another practice: taxpayers avoid reference to internationally quoted prices and instead use profit-based valuation methods (profit methods) where CUP may not be applied.
- Risk: profit-based methods may misplace taxation rights on sizeable economic rents because differences in production advantages across producers mean imputing an average profit margin can be misleading.

### Protecting the tax base — international practices and concerns
- Many Latin American countries have limited taxpayer discretion in pricing controlled commodity transactions; examples:
  - Argentina: exports of primary goods sold to a related party which is a conduit entity must be valued according to quoted prices in international markets at the date of shipment (the “Sixth Method”).
  - Uruguay: allows CUP with adjustments for insurance and shipping costs and accepts internal comparables and contemporaneous contract registration with tax authorities.
  - Mexico: prioritizes the use of CUP, as defined by OECD (with reasonable adjustments), in all transfer pricing cases.
- Nicaragua has no regulation specific to TP on commodities; this absence is a concern and should be reviewed given the importance of commodities in foreign trade and the need for relatively simple TP rules.

### Design considerations for a balanced commodity TP regime
- Most Appropriate Method
  - Taxpayers should not cursorily reject the CUP method; without regulation prioritizing CUP for controlled commodity transactions, taxpayers will typically favor profit methods.
  - The OECD noted that “... the CUP method would generally be an appropriate transfer pricing method for commodity transactions between associated enterprises...” (OECD (2015b), p. 53).
  - Nicaragua could examine and cautiously adopt elements from other countries’ experiences to be more ambitious than OECD consensus.
- Adjustments
  - Even when CUP is applied, physical and other differences may require adjustments to the quoted market price.
  - For a small tax authority with scarce resources, limiting adjustments could be practical: for example, allow adjustments for shipping and insurance costs and quality differences, and possibly set a small range around the market price for other differences.
  - Allowing no adjustments is too strict; allowing only some adjustments or conditional adjustments may be arbitrary or difficult to manage.
- Contract Dates
  - Backdating and date selection can undermine CUP. Logical anti-abuse measures include anchoring valuation to:
    - The date of shipment; or
    - The average price for several days before or after shipment.
  - Uruguay and some countries allow contemporaneous registration of contracts so contract date can be accepted; permitting contract dates according to non-defined “industry practices” undermines anti-avoidance purpose.
  - Allowing only the shipping date may be more restrictive than necessary, but is a clear anti-abuse reference.
- Conduit Traders
  - Applying anti-abuse measures only when the foreign customer is deemed a paper conduit may be too narrow because:
    - It is hard for tax authorities to verify the taxpayer’s facts even if the burden of proof is on the taxpayer.
    - Entities with real business functions (e.g., refiners) may still shift profits away from related producing affiliates for tax reasons.
  - Recommendation: a simpler, less strict, but more general rule could be more appropriate for Nicaragua rather than narrowly targeting apparent shell companies.

### Box 1 (summary of regional approaches)
- Argentina: “Sixth Method” (introduced in 2003) — strict CUP at date of shipment for exports to related conduit entities; limited adjustments; exemptions if intermediary demonstrates real trader status.
- Uruguay: CUP with adjustments for insurance and shipping costs; internal comparables accepted; contemporaneous contract registration allowed.
- Brazil: since 2013 only permits CUP for commodities; tax authority may determine recognized commodity exchanges; freight and insurance costs and an average market premium can be considered; a “divergence” margin of 3 percent is permitted.
- Mexico: prioritizes CUP as defined by OECD (with reasonable adjustments) in all TP cases.
- Ecuador: repealed its ‘Sixth Method’ to adopt the OECD approach allowing case-by-case selection of the most appropriate method.

### The additional problem with Free Zones (FZs)
- Some agro-industrial products are exported from FZs, free from CIT.
- FZs in Nicaragua attract foreign businesses through tax exemptions; the most important activity in the FZ is a sizeable and labor intensive manufacture (apparel and auto harnesses/electrical equipment) representing nearly half of Nicaragua’s total foreign trade.
- Risks:
  - Purchases of primary goods into the FZ could transfer domestic corporate profits into the Zone through TP abuse.
  - Simple manufacturing functions performed in the FZ (e.g., packaging) could concentrate a large share of profits in the FZ, effectively extending tax exemptions beyond the Zone.
  - Current tax legislation requires that transactions with related parties in the FZ be priced at arm’s length, but in the absence of detailed commodity-specific regulations, it can be easy to plan around them.
- Policy implication: CIT exemptions for modern primary export sectors that may enjoy considerable economic rents are harder to justify and require protection from TP manipulation to preserve revenue.

_International Monetary Fund staff report excerpt (section 4)._

### 19.      The problem can be compounded with high value-added agro-industrial activities.

### 19.      The problem can be compounded with high value-added agro-industrial activities.

### Transfer pricing, intangibles, and location-specific reputation
- Transforming primary products into manufacturing goods may require very specific know-how; international markets may associate that know-how closely with certain jurisdictions and sometimes legally protect it as a denomination of origin, or as registered international brands.
- Such intangibles can represent significant economic rents for taxpayers and can be registered anywhere, making them a very mobile asset.
- When an intangible is driven by a distinct locational reputation (examples in text: a Mexican tequila, a Cuban cigar, a Colombian coffee) the actual activity cannot migrate without losing its reputational value.
- Countries often have protections against tax consequences from legal migration of brands or other intangibles, including a deemed capital gains tax upon exit.
- Transfer pricing (TP) can require that transfer of the intangible be treated (for tax purposes) as a deemed sale valued at arm’s length and consistent with royalties paid thereafter.
- Risk highlighted: In a territorial tax system such as Nicaragua’s, migrating a brand abroad (so that it is held by a foreign subsidiary) would generate deductible royalty payments for the Nicaraguan user while the corresponding earnings would be considered foreign source income and remain untaxed.

### Transfer pricing and free zones (FZ)
- Accepted TP practice: the tested party (the party that must demonstrate arm’s-length operations) is typically the party carrying out the simpler functions in the transaction.
- For an affiliate in the FZ performing packaging or reselling of a primary product, that affiliate could be the tested party and be rewarded with a relatively low profit margin, leaving the full residual profit in the domestic commodity-producing affiliate.

### Tax expenditures (TE) from CIT exemption in FZs: estimates and methodology
- Earlier study estimate: TE from the CIT exemption in FZ was 0.24 percent of GDP (2013). (Footnote attribution in source: Cortes Selva (2014).)
  - Caveats: Likely underestimated because calculation used data filed by companies in the FZ (income is exempt and not audited) and assembly plants are often cost centers showing limited profits due to intra-company pricing.
- More recent study (different methodology) estimate: TE for FZ at 0.48 percent of GDP (2014).
  - Method: Rather than relying entirely on profits declared by FZ entities, this method calculates an effective average CIT for the rest of the economy and applies it to gross revenues declared by FZ entities.
  - Limitation: Revenues are also a function of transfer pricing, so estimation error not fully corrected.
- Benchmark assumption noted: assuming an arm’s length return for a typical assembly plant in the American market of 6.5 percent over total cost and expenses (benchmarked by Mexico’s safe harbor rule for maquiladoras), the TE for FZs in Nicaragua would be above 0.4 percent of GDP.
  - Reference in source: Ley del Impuesto sobre la Renta (Mexico), art. 182, II; Mexico’s safe harbor for maquiladoras.

### Policy considerations for FZ tax benefits and TP enforcement
- The potential magnitude of TE (measured at arm’s length) should inform decisions on renewal of CIT benefits in the FZ.
- Proposed transition option instead of the current 60 percent reduction in rate after a (potentially) 20-year tax holiday:
  - Immediately after the initial ten-year term expires, entities in the FZ could transit into a safe harbor determining a minimum taxable profit margin, with which taxpayers would comply with all TP requirements.
  - The full statutory CIT rate should apply to that profit margin.
  - Rationale: Without such a safe harbor, end-of-holiday companies may pay a reduced CIT rate on very little unless Nicaragua enforces complicated TP rules.
  - Benefit: Simplicity and certainty of a TP safe harbor would generate positive tax revenues and is presented as an attractive policy option for Nicaragua’s FZ.

### Concrete TP and tax policy recommendations (from text)
- Develop TP practice concentrated on two key areas: commodities and maquiladoras.
- Measures to induce TP compliance and enforcement for commodity trading:
  - Identify key commodities that should be subject to special treatment.
  - Prioritize CUP as the most appropriate TP method to value those commodities.
  - Extend this priority to all controlled transactions of such commodities.
  - Define a specific (short list) of TP adjustments allowed (examples in text: transport, quality, volume, type of contract).
  - Set reference price on shipping date, or average for short period around that date (example in text: one week), and allow registering contracts so that contract day can be used also.
  - Revert tested party to foreign or FZ-related party to price services they may provide in connection to Nicaraguan commodity exports, especially when relatively simple, routine agro-industrial activities operate in the FZ; pricing them accordingly will place the residual profit in the domestic value chain.
  - Consider an exit tax on a deemed sale when intangible property is transferred to the FZ or abroad.
- Consider adopting a TP Safe Harbor option, defining a minimum arm’s length profit margin, as an exit strategy for companies benefiting from tax holidays in the FZ; the Safe Harbor would apply instead of renewal of tax privileges.

*Italicized source attribution: IMF staff technical discussion in chapter "19. The problem can be compounded with high value-added agro-industrial activities."*

### 11.      Estimates are based in the results obtained from the IMF’s FSGM and the reduced form

### cr17174 - 11.      Estimates are based in the results obtained from the IMF’s FSGM and the reduced form

### Methodology and scenarios
- Estimates are based in the results obtained from the IMF’s FSGM and the reduced form model of the Nicaraguan economy described in Section A.
- Spillovers from potential changes to U.S. policies were estimated through a simulation based on the WHDMOD module of the IMF’s Flexible System of Global Models (FSGM).
- Two scenarios were considered:
  - (1) effective immediately, NAFTA and CAFTA-DR members’ tariffs increase to the most-preferred nation (MFN) tariff of the World Trade Organization.
  - (2) an increase in deportation rate and ensuing reduction of workers’ remittances by about 1 percent of GDP within the next five years.
- Results from each scenario were fed into the reduced form model of the Nicaraguan economy to estimate parameters not directly generated by the FSGM, including consolidated public sector and nonfinancial public sector overall balance and debt, as well as gross international reserves.
- Each shock was assessed separately due to their independent probabilities of materializing.

### Scenario 1 – Macroeconomic implications of a trade shock
- Output and demand:
  - Real GDP growth rate would fall by 2.3 percentage points below the baseline scenario, to recover in the medium-term.
  - Private consumption is projected to deviate from the baseline by 3.2 percent of GDP over a 5-year period.
  - Inflation would decline up to 1.5 percentage points.
- External sector and reserves:
  - Imports and exports decline by about 1 percent of GDP which keeps the CA deficit stable in the short term at around 8.7 percent of GDP.
  - In the medium term, the CA deficit increases gradually from 8.6 to 9.4 percent of GDP, 0.8 percentage points above the baseline.
  - Gross international reserves in months of imports decline from 3.4 to 3.0 by 2022.
- Fiscal and public debt:
  - The overall deficit would reach 3 percent of GDP in 2018, due to a reduction in fiscal revenue of 1.3 percent of GDP.
  - Total public debt increases from 39 percent of GDP to 43 percent in the medium term.
- Model caveats:
  - The FSGM yields a 5 percent reduction in total investment because of the reduction in output growth, which is assumed to affect proportionally all its components, including FDI.
  - The size of the impact on output growth and external sector balance might be underestimated, as the FSGM assumes no accompanying decrease in U.S. FDI to the rise in tariffs’ shock.
- Baseline tariff context:
  - As of December 2016, the average tariff applied by the U.S. to Nicaraguan imports was 0.2 percent. The MFN tariff is 6.2 percent.

### Alternative: exchange rate flexibility as a shock absorber (within Scenario 1)
- Allowing the exchange rate to react would:
  - Reduce the immediate impact on GDP by 1.7 percentage points to a relatively moderate 0.6 percentage points below the baseline.
  - Reverse real interest rates from an increase of 1 percentage point to a reduction of 0.4 percent point, vis-à-vis the baseline scenario.
  - Domestic prices rebound by 1.2 percentage points.
  - Private consumption declines only by 1.2 percent of GDP below the baseline, compared to 3.2 percent of GDP in the peg scenario.
- Fiscal outcome in the medium term under exchange rate flexibility:
  - The CPS debt stock decreases from 42.8 to 39.3 percent of GDP, owing to higher revenue collection and lower debt service.

### Scenario 2 – Macroeconomic implications of a shock on migration and remittances
- Aggregate effects:
  - The impact is smaller than Scenario 1 but still negative for GDP growth, the CPS deficit and public debt sustainability.
  - GDP would decrease by 0.3 percent over the medium term, vis-à-vis the baseline.
- Private consumption and inflation:
  - The impact on remittances would reduce private consumption by 1.4 percent of GDP.
  - Inflation would be pushed down by 0.2 percentage points in the medium term.
- External sector:
  - Imports would decline by 0.6 percent of GDP with respect to the baseline, reducing the CA deficit by 0.2 percent of GDP in the short term.
  - As imports recover gradually and workers’ remittances keep constant at a lower level, the CA deficit would increase to 9 percent of GDP, 0.4 percent below the baseline, by 2022.
- Fiscal and public debt:
  - The CPS balance and total debt would worsen by 0.2 percent and 0.8 percent of GDP, due to lower tax income (0.4 percent of GDP).

### Alternative remittance-cost scenario (fee on remittances)
- If migration policy remains unchanged but a two percent fee is imposed on remittances:
  - The macroeconomic impact is estimated at about half that of Scenario 2.
  - Using a cost-elasticity approach, staff estimates remittances will fall by about 8.9 percent if an additional two percent fee were added to the existing 4.9 percent fee component of money transfer costs, assuming an elasticity of remittances to transaction costs of -0.22.
  - This is equivalent to 0.4 percent of GDP and is slightly less than half the size of the hypothesis under Scenario 2 (which assumed a one percent of GDP decline in remittances).
  - The effect of raising a temporary two percent fee will reverse when the fee is lifted, and part of the macroeconomic impact might be diluted by using alternative and informal channels for international transfers.
- Context and references within source:
  - World Bank “Remittance Prices Worldwide,” February 2017.
  - John David and Halahingano (2005) estimated the cost-elasticity of remittance with respect to the fix cost component is -0.22.
  - In 2006, only 0.4 percent of the transactions were made through online banking, and the figure in 2016 is 5.5 percent.

*IMF staff analysis in cr17174, Section 11.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17174.pdf_