## 1criea2023001

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### Major findings on the Costa Rica fiscal rule
- The fiscal rule entered into force in 2020 and:
  - Sets ceilings on nominal expenditure growth for current and total expenditures linked to past nominal GDP growth and debt levels.
  - Is explicitly identified in Law 9635, is transparent, relatively simple, and allows flexibility in crises through an escape clause.
  - Bolstered fiscal discipline and guided fiscal policy in the budget, contributing to fiscal adjustment in 2021-22 and delivering a lower public debt relative to Fund program targets.
- Limitations revealed during implementation:
  - Uniform application at the entity level across a wide range of public institutions created distortions or excessively tight constraints for some entities.
  - Verification of compliance led to unintended tightening in 2021-2022 from under-execution of the budget during the pandemic.
- Near-term pressures:
  - Debt exceeded 60 percent of GDP in 2020 and GDP contracted in 2020, tightening ceilings and implying an expenditure cut in real terms amid high inflation.
  - Government under pressure to accommodate spending needs in response to the cost-of-living crisis.

### Coverage, exclusions, and statistical principles
- Proposed amendments and executive actions:
  - Executive decree revised compliance verification in July 2022 to avoid unintended tightening from under-execution.
  - Amendments to Law 9635 propose to (i) exclude certain entities (e.g., decentralized institutions, public corporations) and (ii) exclude items such as capital expenditure or interest payments.
- Quantified implications of proposed exclusions:
  - Coverage would fall from about 60 percent to 45 percent of total expenditures in the NFPS under some proposals.
  - In the national budget of the central government, coverage could reduce from 93 to 65 percent under some proposals.
  - Excluding capital expenditure or interest payments would weaken the link between the fiscal rule and debt dynamics and may create incentives for creative accounting.
- Recommended statistical approach:
  - Institutional coverage should be the general government as defined in the Government Finance Statistics Manual (GFSM).
  - Entities under government control and classified as a non-market producer should be included.
  - Entities outside GFSM criteria should be monitored by STAP using risk-based indicators (debt ratio, revenue to cost ratio, degree of central government transfers).
  - Including CCSS and local governments is not feasible at present; MOF should monitor them under a risk-based approach and Legislative Assembly should consider inclusion over time.

### Verification and budget mechanics
- Recommended change to ex-post compliance verification:
  - Verify ex-post compliance by comparing the final outturn (accrual basis) at year-end with the initial budget of the previous fiscal year adjusted by an estimate of externally funded expenditure, rather than comparing to the final budget.
  - Ex ante and in-year compliance verification at budget level would remain the same with addition of the estimate of externally funded expenditure.
- Budgeting recommendations to address contingencies and fragmentation:
  - Create a general contingency reserve in the budget (e.g., a separate budget line) subject to aggregate expenditure ceilings to cover court rulings and other contingencies.
  - Include the best annual estimate of externally funded expenditure in an annex to budget documents provided to the Legislative Assembly.

### Parameters and operation of the current fiscal rule
- Rule parameters (as defined in the LSPF):
  - Debt to GDP < 30% or current expenditure of central government ≤ 17% of GDP: Growth in current expenditures ≤ 100% of average nominal GDP growth (previous four years).
  - 30% ≤ Debt to GDP < 45%: Growth in current expenditures ≤ 85% of average nominal GDP growth (previous four years).
  - 45% ≤ Debt to GDP < 60%: Growth in current expenditures ≤ 75% of average nominal GDP growth (previous four years).
  - Debt to GDP ≥ 60%: Growth capital and current expenditures ≤ 65% of average nominal GDP growth (previous four years).
- Decree 41641-H (Art. 2) indicates the ceiling applies to the National Budget of the central government as a whole and individually to decentralized public bodies.
- Escape clause:
  - Activated in March 2020 for two years via national emergency; emergency spending totaled 295 billion colons (or 0.8 percent of GDP) in 2020 and 137 billion colons (or 0.4 percent of GDP) in 2021.
  - Escape clause activation criteria: national emergency or economic recession/GDP growth projected below 1 percent; suspension up to two years and a three-year transition in recession case.
  - In periods of extraordinary favorable growth (real GDP growth over 6 percent for two years) MOF can raise current expenditure growth parameter up to 85 percent.

### Selected ceilings on expenditure growth (Percent)
- Table of ceilings, 2020–2023:
  - 2020: Current Expenditure 4.67; Total expenditure Not-applicable
  - 2021: Current Expenditure 4.13; Total expenditure Not-applicable
  - 2022: Current Expenditure 1.96; Total expenditure 1.96
  - 2023: Current Expenditure 2.56; Total expenditure 2.56

### Implementation issues, strengths, and outcomes
- Strengths:
  - Rule is explicit in law, relatively simple, transparent, widely recognized, and helped contain expenditure growth.
  - Before the rule (2012–2019), current expenditure grew faster than nominal GDP by about 2-3 percentage points on average.
- Outcomes and compliance:
  - Central government complied with the expenditure rule in 2020 excluding emergency spending under the escape clause (CGR 2022).
  - CGR reported 12 institutions out of 154 did not comply in 2020; 22 institutions did not comply in 2021.
  - Executed current expenditure for the central government grew by 5.9 percent in 2021, above the 4.2 percent ceiling.
  - Non-compliant entities excluding the central government increased from less than 1 percent in 2020 to nearly 5 percent in 2021.
- Challenges:
  - Pandemic under-execution reduced expenditure base and constrained some entities from 2021 onwards, prompting requests to exclude spending or entities.
  - NFPS fragmentation (central government, local governments (82), social security (CCSS), decentralized institutions (43), public corporations (30)) and entity-level ceilings limited reallocation and service delivery.
  - Absence of a medium-term debt anchor makes it difficult to assess adequacy of expenditure-rule parameters.
  - Limited independent fiscal oversight: CGR focused on auditing compliance but mandate does not cover macroeconomic assumptions in MTFF; fiscal council lacks resources and capacity.

### Proposals to amend coverage and their assessed impact
- Government Bill Nº 23330 (submitted September 2022) proposes to exclude:
  - All public corporations that carry out commercial activity in a competitive market (except part of current transfers from CG).
  - Non-state public entities except those receiving transfers from the central government.
  - Also proposes exclusions of capital expenditure, interest expenditure, externally-financed projects, court rulings, and contractual obligations of airport concessions.
- Quantified impacts:
  - Proposed entity exclusions would reduce coverage from 60 percent to 44 percent of NFPS expenditures (final outturn 2021).
  - Proposed item exclusions represent about 35 percent of the central government total expenditure or 17 percent of total NFPS expenditures.
- Risks:
  - Coverage reduction undermines credibility and debt sustainability objectives.
  - Exclusions can permit scaling up excluded activities without breaching expenditure growth limits and create reclassification incentives.

### GFSM-based classification and monitoring recommendations
- GFSM 2014 classification criteria:
  - Government control: indicators include ownership/control of board, appointment/removal of key officers, contractual provisions, high degree of financing by government, government assuming risk exposures; a single indicator can suffice.
  - Nonmarket producer: sales (excluding taxes and transfers) less than half of production cost over sustained multiyear period is a reference; substantial transfers or guarantees can make a corporation behave as nonmarket.
- Recommendations:
  - Classify decentralized institutions and public corporations per GFSM to determine inclusion.
  - Include controlled nonmarket producers in the fiscal rule; exclude market producers but monitor them.
  - For excluded public corporations, enhance monitoring using IMF tools (FRAT and SOE health check), expand reporting (operations, cashflow, balance sheets), approval for new borrowings, audits, and clear performance indicators.
  - Tighten debt authorization framework; MoF to scrutinize new borrowing, implement alert systems, thresholds, and prudent financial conditions.

### Expenditure items proposed for exclusion — assessment
- Proposed exclusions include capital expenditures, interest expenditure, externally-financed projects, court rulings, and airport concession contractual obligations.
- Assessment:
  - Excluding capital expenditure can lead to distortions, reduced transparency, creative accounting, and implementation challenges for multi-year projects.
  - Excluding externally-financed projects may encourage further reliance on external financing; these projects account for one-fifth of capital expenditure of the national budget of CG.
  - Excluding interest could loosen primary expenditure limits modestly in near term by up to 0.4 percent of GDP under authorities’ projection.
  - Contingent liabilities from court rulings and contractual obligations should not be excluded; recommended instead to keep a contingency reserve in the budget.
- Preferred verification approach:
  - Compare final outturn relative to initial budget of the previous year plus an estimate of externally-financed expenditure; include list of projects and estimated externally financed expenditure in budget documents.

### Contingent liabilities, reserves, and verification nuances
- Contingent liabilities:
  - Quantified medium-term contingent liabilities were about 9 percent of GDP as of mid-2022.
  - Example: two court rulings may incur expense to the central government of 0.4 percent of GDP if lost.
- Contingency reserve:
  - Some countries maintain a reserve of about 2-3 percent of annual government expenditures for contingencies.
- Verification methodological notes:
  - July 2022 Executive Decree N° 43589-H changed ex-post compliance reference to final budget relative to initial budget of previous year; this raises transparency and legal sanctionability concerns.
  - Preferred ex-post: use final outturn (execution) vs initial budget (T-1) adjusted for externally-financed expenditure estimate.
- Selected compliance measurement figures (percent):
  - Rule: current spending 4.7 (2020); 4.1 (2021); 2.0 (2022)
  - Ex-ante verification (initial (T) vs initial (T-1)) current spending 4.4 (2020); 2.1 (2021); 2.1 (2022)
  - New ex-post verification (final w/ ext. fin. (T) vs initial (T-1)) current spending 4.5 (2020); 5.2 (2021); 3.1 (2022)
  - Old ex-post verification (executed (T) vs executed (T-1)) current spending 0.7 (2020); 7.4 (2021); n.a.

### Debt anchor and medium-term framework
- Rationale:
  - A medium-term debt anchor (stock variable) should supplement the expenditure rule to ensure fiscal sustainability.
  - Operational limits (expenditure rules) should link to the debt anchor so adherence yields a high likelihood of achieving the anchor.
- Empirical practice:
  - As of 2021, 85 countries have a debt ceiling; more than 80 percent of those also constrain the budget balance.
- Calibrated estimates for Costa Rica:
  - Proposed debt limit range: about 65 to 70 percent of GDP.
  - Prudent gross debt anchor estimate for CG: between 35 and 50 percent of GDP if policymakers accept a 10 percent probability of breaching a 65-70 percent limit over the medium term.
- Table 7 sensitivity highlights (selected):
  - Baseline: Debt limit 70; Risk tolerance 5.0; Contingent liabilities 9.3; Debt anchor 45.3; p10-p90 range at year 5 13.8
  - Higher risk tolerance: Debt limit 70; Risk tolerance 10.0; Contingent liabilities 9.3; Debt anchor 49.8; p10-p90 range at year 5 14.1
  - Lower debt limit: Debt limit 65; Risk tolerance 5.0; Contingent liabilities 9.3; Debt anchor 35.4; p10-p90 range at year 5 13.9
  - No contingent liabilities: Debt limit 70; Risk tolerance 10.0; Contingent liabilities 0.0; Debt anchor 61.5; p10-p90 range at year 5 13.0
  - Note: Assumes a maximum primary balance of 2.5 percent. Contingent liabilities estimated by national authorities. Simulation assumes 1.5 percent of contingent liabilities materialize every year, cumulating to 9.3 percent of GDP over 6 years.
- Projections under existing expenditure rule (2024-2035 average and debt in 2035, percent of GDP):
  - Baseline: Current expenditure growth 4.5; Debt in 2035 52.5
  - Higher NGDP growth (+1ppt): Current expenditure growth 5.2; Debt in 2035 39.6
  - Higher interest rate (+1ppt): Current expenditure growth 4.3; Debt in 2035 56.7
  - Higher revenue (+1 pct of GDP): Current expenditure growth 4.7; Debt in 2035 36.3
  - Reference: current expenditure growth ceiling in 2022 was 1.96 percent of GDP.
- Policy implication:
  - Complying with expenditure rule expected to put debt on a path reaching about 50 percent of GDP by 2035, requiring a reduction in total expenditure of 3 percentage points of GDP over 15 years.

### MTFF, fiscal risks, and institutional capacity
- MTFF features:
  - Includes analysis of macro and specific fiscal risks (public corporations, pensions, natural disasters, court rulings, local governments, PPPs, financial sector, public debt); most analysis is qualitative with some quantified risks.
  - MTFF expanded to NFPS in 2022, partially reducing fragmentation.
  - MTFF publication months: April and August each year.
  - MTFF projection model consolidates central and local governments, CCSS, decentralized institutions, and public corporations to NFPS.
- MTFF limitations and data issues:
  - Exclusions and demands for exemptions complicate MTFF projections and reduce transparency.
  - MTFF reports on central government debt only; expanding DSA to NFPS was recommended but not met.
  - DGCP lacks detailed data on NFPS debt holders, terms, interest rates, and currency denomination, affecting consolidated interest-rate calculations.
  - July 2022 decree affects comparability between MTFF and initial budget due to exclusion of externally-financed projects (around 20 percent of central government capital expenditure in 2021).
- Institutional capacity and fiscal council:
  - Fiscal Council established in 2019 but not operational; composition and resignations noted; members work ad-honorem.
  - Council mandate includes evaluating macro-fiscal developments, MTFF projections, fiscal risk management, and commenting on MTFF and budget projections.
  - Recommendations: make Fiscal Council operational with its own budget line, staff, communication channel, and timely information sharing by MOF.
  - MOF should create a Macro Fiscal Unit (MFU) with sufficient personnel and resources to prepare MTFF and projections.

### Key short- and medium-term recommendations (selected)
- Short-term (ST) recommendations (indicative completion by end-March 2023):
  - MOF to develop verifiable and objective GFSM-based criteria to identify public entities to include in the fiscal rule and seek Legislative Assembly approval.
  - Amend Bill 23330 to indicate exclusions must be based on GFSM criteria specified by MOF.
  - Present an assessment on legal changes needed to empower MOF/STAP to make expenditure limits applicable to the overall central government (GFSM) at the aggregate level.
  - Amend Bill 23330 to avoid references excluding capital expenditure, court rulings, and interest expenses from the expenditure rule; create a general contingency reserve line in the budget.
  - Amend the executive decree to compare expenditure growth between final outturn (accrual basis) and the initial budget of the previous fiscal year (adjusted by an estimate of externally funded expenditure).
- Medium-term (MT) recommendations (indicative implementation over the next 2-3 years):
  - Include best annual estimate of externally funded expenditure in an annex to budget documents.
  - Modify the escape clause provision (Decree N° 41641-H Article 25; Article 16 of the LSPF) in Bill 23330 so the maximum transition period applies when the escape clause is activated in either emergency or recession.
  - Amend the Law to introduce a medium-term debt anchor in the fiscal rule with periodic review (e.g., every 5 years) and calibrate expenditure-rule limits to ensure consistency with the anchor.
  - Integrate the debt anchor in the MTFF and amend the law to strengthen fiscal oversight with an operational and independent fiscal council.
  - Minimize use of extrabudgetary entities (EBE) and integrate them into the national budget where feasible; at minimum apply expenditure ceiling to aggregate of national budget and decentralized institutions.
  - Develop enhanced monitoring and tighter debt authorization for entities outside the fiscal rule; require MOF approval for new material borrowings and sovereign guarantees.

### Progress against prior technical assistance (2020–22) — selected entries
- Improve fiscal strategy (debt anchor): Deadline 2020; Preliminary assessment: Not met.
- Contingency reserve in budget and MTFF: Deadline 2021; Preliminary assessment: Not met.
- Prepare MTFF for NFPS in April and update CG in August: Deadline 2021 and 2022; Preliminary assessment: Done 2021 and 2022.
- Develop fiscal projection capacities and databases: Deadline 2021 and 2022; Preliminary assessment: In progress.
- Expand DSA from CG to NFPS: Deadline 2022; Preliminary assessment: Not met.
- Establish Macro Fiscal Unit with resources: Deadline 2022; Preliminary assessment: Not met.
- Regulate MTFF preparation process and information flows: Deadline 2021; Preliminary assessment: Not met.
- Develop macroeconomic projection capacities and analyze sensitivity of fiscal projections to macro shocks: Deadline 2023; Preliminary assessment: In progress (ICD 2022-2023 technical assistance).

_Italic: IMF Fiscal Affairs Department mission findings and recommendations (Costa Rica fiscal rules, 2022–2023)._

### 1. Selected Country Examples of Exclusions from Expenditure Rules _____________________________ 28

### 1. Selected Country Examples of Exclusions from Expenditure Rules

### Major findings on the Costa Rica fiscal rule
- The fiscal rule that came into force in 2020:
  - Sets ceilings on nominal expenditure growth for current and total expenditures linked to past nominal GDP growth and debt levels.
  - Is explicitly identified in the Law 9635, is transparent, relatively simple, and allows flexibility in crises through an escape clause.
  - Has bolstered fiscal discipline and served Costa Rica well, guiding fiscal policy in the budget and coalescing public opinion on fiscal discipline.
- The rule was instrumental to fiscal adjustment in 2021-22 and contributed to expenditures being restrained, helping deliver a lower public debt relative to Fund program targets.
- Limitations revealed during implementation:
  - Uniform application of the rule at the entity level for a wide range of public institutions (outside the national budget of the central government) created distortions or excessively tight constraints for some entities.
  - Verification of compliance led to unintended tightening in 2021-2022 from under-execution of the budget during the pandemic.
- The expenditure limits have become more binding amid rising debt and high inflation in the near term:
  - Debt exceeded 60 percent of GDP and GDP contracted in 2020, making ceilings on nominal expenditure growth tighter and implying an expenditure cut in real terms amid high inflation.
  - Government under pressure to accommodate spending needs in response to the cost-of-living crisis.

### Coverage, exclusions, and statistical principles
- Proposed amendments and executive actions noted:
  - An executive decree revised the method to verify compliance in July 2022 to avoid unintended tightening from under-execution of the budget in some entities.
  - Various amendments to Law 9635 propose to (i) exclude certain entities (such as some decentralized institutions or public corporations) from the rule; and (ii) exclude expenditure items such as capital expenditure or interest payments.
- Implications of proposed exclusions:
  - Proposed amendments would further reduce the coverage of the rules from about 60 percent to 45 percent of total expenditures in the nonfinancial public sector (NFPS).
  - In the national budget of the central government, coverage would reduce from 93 to 65 percent under some proposals.
  - Excluding capital expenditure or interest payments would weaken the link between the fiscal rule and debt dynamics and may create incentives for creative accounting.
- Recommended statistical approach to coverage:
  - Institutional coverage of the fiscal rule should be the general government, as defined in the Government Finance Statistics Manual (GFSM).
  - Entities that are under government control and classified as a non-market producer should be included in the fiscal rule.
  - Entities falling outside GFSM criteria should be monitored according to a risk-based set of indicators agreed by STAP, such as debt ratio, revenue to cost ratio, or degree of central government transfers to the entity.
  - Including the social security (CCSS) and local governments is not feasible at present, but MOF should monitor them under a risk-based approach; over time the Legislative Assembly should consider including these entities in the fiscal rule.

### Verification and budget mechanics
- Recommended change to compliance verification:
  - Ex-post compliance should be verified based on the fiscal outturn relative to the initial budget of the previous year (adjusted with the best estimate of external financing) rather than comparing to the final budget (to avoid unintended effects from an under-executed budget).
  - Specifically: compare the final outturn (accrual basis) at the end of a fiscal year with the initial budget of the previous fiscal year adjusted by an estimate of externally funded expenditure.
  - Ex ante and in-year compliance verification at budget level would remain the same, adding the estimate of externally funded expenditure.
- Budgeting recommendations to address contingencies and fragmentation:
  - Create a general contingency reserve in the budget (e.g., a separate budget line) that could cover expenditure from court rulings, among others, subject to aggregate expenditure ceilings.
  - Include the best annual estimate of externally funded expenditure in an annex to budget documents provided to the Legislative Assembly to reduce budget fragmentation and support a comprehensive capital budget.

### Debt anchor and medium-term framework
- Need for an explicit medium-term debt anchor:
  - Introducing an explicit debt anchor would supplement the expenditure rule in upholding debt sustainability.
  - Best practice is to maintain a debt level that provides a prudent safety buffer while keeping debt below its limit.
- Recommended calibration and timing:
  - A risk-based approach to determine the debt anchor should consider macroeconomic shocks, debt composition, and development needs.
  - The analysis suggests it would be appropriate to aim for a medium-term debt anchor of about 40-50 percent of GDP.
  - This anchor is lower than the elevated level at present but considered credible to achieve by the mid-2030s with sustained fiscal efforts.
- Integration with MTFF:
  - Integrate the debt anchor in the Medium-Term Fiscal Framework (MTFF); the MTFF should lay out the expenditure growth rate consistent with the expenditure rule and reaching the anchor over the medium term.
  - Significant progress was made in developing the MTFF, introduced in 2021 to provide transparent communication of the fiscal strategy and forward guidance to the budget process.

### Institutional and oversight recommendations
- Aggregate-level assessment and ministerial powers:
  - Compliance with the fiscal rule should be assessed at the aggregate level, at least for the central government statistical concept (including extrabudgetary entities).
  - MOF and STAP should be empowered by law to allocate resources across decentralized institutions (extrabudgetary entities) and the national budget among competing needs; the rule should be assessed for the overall central government instead of by individual entities.
- Fiscal council and oversight:
  - Strengthen fiscal oversight by amending the law to establish an operational and independent fiscal council.
  - Monitoring compliance requires broader assessment of macro-fiscal projections in the MTFF and debt sustainability beyond verifying that fiscal outturns comply with expenditure ceilings.
  - Allocate resources commensurate to the fiscal council’s mandate so it can fulfill responsibilities.

### Key short- and medium-term recommendations (selected)
- Short-term (ST) recommendations (indicative completion by end-March 2023):
  - MOF should develop verifiable and objective criteria (based on GFSM) to identify public entities to include in the fiscal rule and seek Legislative Assembly approval.
  - Amend Bill 23330 to indicate exclusions must be based on GFSM criteria specified by MOF.
  - Present an assessment on legal changes needed to empower MOF/STAP to make expenditure limits applicable to the overall central government (GFSM) at the aggregate level.
  - Amend Bill 23330 to avoid references excluding capital expenditure, court rulings, and interest expenses from the expenditure rule; create a general contingency reserve line in the budget.
  - Amend the executive decree to compare expenditure growth between final outturn (accrual basis) and the initial budget of the previous fiscal year (adjusted by an estimate of externally funded expenditure).
- Medium-term (MT) recommendations (indicative implementation over the next 2-3 years):
  - Include best annual estimate of externally funded expenditure in an annex to budget documents.
  - Modify the escape clause provision (Decree N° 41641-H Article 25; Article 16 of the LSPF) in Bill 23330 so the maximum transition period applies when the escape clause is activated in either emergency or recession.
  - Amend the Law to introduce a medium-term debt anchor in the fiscal rule with periodic review (e.g., every 5 years) and calibrate expenditure rule limits to ensure consistency with the anchor.
  - Integrate the debt anchor in the MTFF and amend the law to strengthen fiscal oversight with an operational and independent fiscal council.

_Italic: IMF Fiscal Affairs Department mission findings and recommendations (Costa Rica fiscal rules, 2022–2023)._

### 3.      Costa Rica’s fiscal rule continues to play a pivotal role in anchoring debt sustainability,

### 3.      Costa Rica’s fiscal rule continues to play a pivotal role in anchoring debt sustainability

### The Current Fiscal Rule
- The 2018 Law to Strengthen Public Finance (LSPF) introduced a fiscal rule that sets limits on expenditure growth. The fiscal rule entered into force in 2020.
- The rule sets a ceiling on current expenditure growth (and total expenditure growth if debt exceeds 60 percent of GDP) for the central government and most entities in the Non-Financial Public Sector (NFPS).
- Growth on current expenditures is a function of the average nominal GDP growth over the previous four years, adjusted by a parameter that depends on the government debt-to-GDP ratio.
- Because central government debt rose above 60 percent of GDP in 2020, the rule specifies that growth in current and capital expenditures cannot exceed 65 percent of the average nominal GDP growth of the previous 4 years.
- The expenditure rule supplements the pre-existing ‘golden rule’ (current expenditure cannot be financed by government debt), which has not been complied with since 2009.

- Parameters of the existing fiscal rules on expenditure growth (as defined in the LSPF):
  - Debt to GDP < 30% or current expenditure of central government ≤ 17% of GDP
    - Growth in current expenditures ≤ 100% of average nominal GDP growth over the previous four years.
  - 30% ≤ Debt to GDP < 45%
    - Growth in current expenditures ≤ 85% of average nominal GDP growth over the previous four years.
  - 45% ≤ Debt to GDP < 60%
    - Growth in current expenditures ≤ 75% of average nominal GDP growth over the previous four years.
  - Debt to GDP ≥ 60%
    - Growth capital and current expenditures ≤ 65% of average nominal GDP growth over the previous four years.

- Decree 41641-H (Art. 2) indicates the ceiling applies to the National Budget of the central government as a whole and individually to decentralized public bodies in the NFPS; in practice each entity would be subject to the same annual expenditure growth ceiling, though LSPF did not explicitly indicate entity-level application.

- Ex-ante and ex-post compliance:
  - LSPF (Art. 19) requires initial budgets and modifications to comply with the fiscal rule; growth in current expenditure in the initial budget of year t or in-year modifications could not exceed the predetermined growth ceiling relative to the initial budget of year t-1.
  - Ex-post compliance is defined in terms of outturn expenditure (Art. 21 LSPF “liquidación”).
  - Compliance is monitored quarterly and annually by the General Directorate of the National Budget (DGPN) and the Technical Secretariat of the Budgetary Authority (STAP); annual compliance report submitted to the Comptroller Office (CGR), which prepares its own report for the Legislative Assembly (LA).
  - July 2022 revision: basis of ex-post compliance was revised to comparing the growth rate of expenditure in the final budget relative to the initial budget of the previous year (Executive Decree N° 43589-H).

- Escape clause activation:
  - The escape clause was activated in March 2020 for two years by declaring a national emergency (confirmed by the National Emergency Commission (CNE)); expenditure of the central government and 16 other decentralized institutions were not subject to the expenditure ceiling.
  - Emergency spending totaled 295 billion colons (or 0.8 percent of GDP) in 2020 and another 137 billion colons in 2021 (or 0.4 percent of GDP).

### Coverage, Exclusions, and Implementation Issues
- The existing expenditure rule covers a subset of expenditures in the NFPS, where the central government accounts for less than half of total expenditures.
- Major NFPS entities and local governments excluded from the fiscal rule (selected entries and 2021 shares where provided):
  - Social Security (CCSS): All expenditure (pensions by Law, health spending at a later stage, not in the LSPF) — Year of exclusion: 2018 — Share NFPS total expenditures, 2021 (percent): 20.5
  - Public corporation carrying out commercial activities in a competitive market and has debt less than 50 percent of assets: Expenditure related to commercial activities in a competitive market setting — Year of exclusion: 2018 — Share NFPS total expenditures, 2021 (percent): 3.4
  - National Oil Company (RECOPE): Oil import spending — Year of exclusion: 2018 — Share NFPS total expenditures, 2021 (percent): 8.0
  - Municipalities and district councils: Transfers from the CG are not excluded — Year of exclusion: 2020 — Share NFPS total expenditures, 2021 (percent): 3.1
  - Fund for Social Development and Family Allowances (FODESAF): All expenditure — Year of exclusion: 2022 — Share NFPS total expenditures, 2021 (percent): 3.5
  - (Other listed institutions excluded in various years; some entries show “-” for 2021 share or note projected expenditure in 2022.)

- Table of ceilings on expenditure growth under fiscal rules, 2020–2023 (Percent):
  - 2020: Current Expenditure 4.67; Total expenditure Not-applicable
  - 2021: Current Expenditure 4.13; Total expenditure Not-applicable
  - 2022: Current Expenditure 1.96; Total expenditure 1.96
  - 2023: Current Expenditure 2.56; Total expenditure 2.56
  - Note: Escape clause was activated during the COVID-19 pandemic in 2020-21. Government debt exceeded 60 percent of GDP in 2020.

### Strengths and Positive Effects
- Desirable features:
  - Objectives of the rule are explicitly identified in the LSPF, which sets clear criteria to assess functioning of the rule.
  - The expenditure rule is relatively simple and transparent; ceilings on expenditure growth are communicated and widely recognized in budget preparation and implementation.
  - The rule envisages nominal current expenditure growing less than nominal GDP, helping mitigate expenditure pressures that lead to excessive deficits.
- Outcomes:
  - Before the rule (2012–2019), current expenditure grew faster than nominal GDP by about 2-3 percentage points on average.
  - The expenditure rule facilitated fiscal discipline and helped contain expenditure growth, contributing to improvement of fiscal balances in 2021-22.
  - Compliance: central government complied with the expenditure rule in 2020 excluding emergency spending under the escape clause (CGR 2022).
  - CGR reported only 12 institutions out of 154 did not comply with the fiscal rule in 2020; 22 institutions did not comply in 2021.
  - Executed current expenditure for the central government grew by 5.9 percent in 2021, above the 4.2 percent ceiling.
  - In terms of executed current expenditure, non-compliant entities excluding the central government increased from less than 1 percent in 2020 to nearly 5 percent in 2021.

### Challenges, Limitations, and Risks
- Pandemic stress-test:
  - Over 80 percent of countries with fiscal rules activated escape clauses or suspended rules during the pandemic; about half of countries with fiscal rules have had deficits or debt exceeding limits of their fiscal rules.
  - The escape clause allowed the government to put in place an additional spending of 1.2 percent of GDP in 2020-21 to respond to the pandemic.
  - The government did not invoke the recession provision of the escape clause, implying return to the expenditure ceiling starting in 2022 rather than a 3-year transition period.
- Tighter limits coming near term:
  - Because the rule uses a 4-year average of nominal GDP growth (years T-5 to T-2), the 2020 growth slowdown affects ceilings from 2022 to 2025.
  - Rise in government debt-to-GDP above 60 percent lowered the debt-linked adjusting factor from 85 percent in 2018 to 65 percent starting in 2022 and extended application to total expenditures.
  - These changes imply expenditure growth ceilings would diminish from about 6 percent before the pandemic to less than 4 percent in the coming 2-3 years; ceilings would be higher from 2026 onwards as the 2020 decline drops out of the averaging window.
- Inflation and real expenditure:
  - High unanticipated inflation affects public finances by reducing real expenditure in the short term and lowering debt-to-GDP via higher nominal GDP.
  - In 2022, growth in real expenditure is projected to be negative, at the lower part of the distribution across emerging market economies, while real growth in social benefits will remain positive (even if deflated with CPI inflation).
- Specific implementation limitations identified during early implementation:
  - Unintended effects from under-execution of budgets: pandemic-induced under-execution reduced the expenditure base, constraining some entities with smaller expenditure ceilings and limiting normal operations from 2021 onwards; reduced base imposed unintended tightening and prompted legislative requests to exclude spending or entities.
  - Budget fragmentation: NFPS fragmentation (central government, local governments (82), social security (CCSS), other decentralized institutions (43), and public corporations (30)) and application of ceilings at individual entity level limited spending reallocation and made compliance challenging for some basic services (e.g., 911 emergency service); verification did not provide for compensation among entities.
  - Lack of a medium-term debt anchor: absence of a specific reference to debt in LSPF makes it difficult to assess whether expenditure rule parameters are adequate for fiscal sustainability. Counterfactual analysis indicates that if existing expenditure rules had been in place since 2013 they would have led to only a small reduction of current spending and debt-to-GDP relative to actual levels, with debt continuing to rise as a share of GDP—because nominal GDP growth was strong and debt low in the reference period, implying loose ceilings.
  - Limited independent fiscal oversight: CGR has focused on auditing whether expenditures grew within prescribed limits but its mandate does not cover broader assessment of macroeconomic assumptions in the MTFF or debt sustainability; existing fiscal council lacks sufficient resources and capacity for such oversight.

### Policy Intentions and Ongoing Reforms
- Authorities:
  - Approved an executive decree in July 2022 and submitted a bill to the Legislative Assembly to address operational constraints in the implementation of fiscal rules and allow for additional spending.
  - Are considering, with technical support from the Fund, reforms to the fiscal rule.
- Technical advice aims:
  - Help authorities determine an appropriate institutional coverage of the fiscal rule.
  - Facilitate a better reallocation of resources given budget fragmentation, while maintaining broad coverage of the rules and their essential role in reducing debt.

*Source: IMF staff compilation from “3. Costa Rica’s fiscal rule continues to play a pivotal role in anchoring debt sustainability,” chapter text and tables.*

### 16.      It is understandable that some implementation challenges emerged as the rule just

### 1criea2023001 - 16.      It is understandable that some implementation challenges emerged as the rule just

### Immediate implementation challenges
- The fiscal rule came into force in 2020, coinciding with the pandemic, creating implementation challenges.
- As the expenditure ceiling tightens in the near term, legislative and executive proposals seek to exclude certain entities or spending items from the fiscal rule.
- Some proposed changes would be permanent and are not well suited to resolve near-term constraints.
- Since the fiscal rule was put in place:
  - The decree regulating the LSPF has undergone 7 revisions.
  - 11 entities were excluded by law.

### Proposals to amend coverage and exclude entities (government and parliamentary initiatives)
- Government Bill Nº 23330 (submitted September 2022) proposes to exclude:
  - i) all public corporations (PC) that carry out commercial activity in a competitive market, even those with high debt, except for the part of the current transfers from the central government;
  - ii) non-state public entities except for those receiving transfers from the central government.
- The bill also proposes to exclude various types of expenditure items (see Section III.B).
- Legislative Assembly: Twenty draft bills pending discussion propose entity-specific exclusions or other amendments.
- Rationale cited by proponents:
  - Expenditure limits have constrained critical spending and investment, especially for entities that under-executed budgets due to lockdowns.
  - Some entities run a surplus and have adequate resources to invest but cannot do so because fiscal rules are applied at the individual entity level.
- Example of ad-hoc modification: National Tourism Institute (ICT) — base reference variable was modified when applying ceilings on expenditure growth to allow increased actual spending while still complying with the rule.

### Assessment of entity-exclusion proposals and risks
- Proposed exclusions in Bill Nº 23330 lack common criteria and would significantly reduce coverage:
  - Coverage would fall from 60 percent to 44 percent of total NFPS expenditures (using final outturn data in 2021).
  - The fiscal rule would cover only two-thirds of central government spending under these exclusions.
- Comparators:
  - Paraguay and Peru: fiscal rules coverage has reached more than 90 percent of total government expenditures.
- Risks:
  - Excluding entities and expenditure items can undermine credibility and the objective of debt sustainability.
  - Exclusions permit scaling up spending in excluded activities without breaching expenditure growth limits, creating pressure to approve budgets at the limit.
- Recommendation:
  - Identify coverage and perimeters of the fiscal rules and establish a sound framework with objective criteria to determine which entities should be included.

### GFSM-based criteria for classifying general government activity
- IMF Government Finance Statistics Manual (GFSM 2014) indicates two broad criteria to classify an entity as part of government:
  - Government control:
    - Defined as the ability to determine general policy or program of an entity.
    - Indicators include: ownership or rights to control the board or appoint/remove key officers; contractual provisions for government to determine policy; high degree of financing by government; government assumes risk exposures for the entity.
    - A single indicator can suffice; in some cases multiple indicators considered together determine control.
  - Nonmarket producer:
    - Provides output for free or at prices that are not economically significant.
    - Reference: an entity is generally a nonmarket producer if its sales (excluding taxes and transfers) is less than half of the production cost over a sustained multiyear period (this value is a reference and case-by-case judgement is needed).
    - Corporations receiving substantial government transfers or guarantees may behave as nonmarket producers despite sales covering costs.
- Recommendation:
  - Government should classify all decentralized institutions and public corporations according to GFSM principles to determine inclusion in the fiscal rules.
  - Entities not controlled by government (e.g., some professional associations currently classified as non-state public entities) should be excluded.
  - Controlled nonmarket producers should be included; market producers (public corporations) should be excluded from the fiscal rule but monitored.

### Monitoring and debt authorization for entities outside the fiscal rule
- For public corporations excluded from fiscal rules, enhanced monitoring is needed to manage fiscal risks:
  - Use IMF tools: Fiscal Risks Assessment Toolkit (FRAT) and SOE health check.
  - Expand reporting on operations, cashflow statements, and balance sheets to monitor financial viability and government exposures.
  - Public corporations should be subject to approval for new material borrowings, audits, and clear performance indicators.
  - Fiscal risk statements should incorporate public corporations using a risk-based approach; high-risk entities require enhanced control explicit in regulations.
- Current debt authorization framework:
  - Law 7010: only the MoF has borrowing capacity at the central government.
  - Annual budget approves domestic bonds issuance; each new loan requires Legislative Assembly approval (external loans by qualified majority; internal loans by simple majority).
  - Sovereign guarantees for public entities follow same process.
  - Autonomous entities (Universities, local governments, social security, public banks) do not need approval except for sovereign guarantees.
- Recommendation:
  - Tighter debt authorization to scrutinize financial and debt-servicing conditions, loan terms, and final MoF approval.
  - Implement alert systems, thresholds, and prudent financial conditions as in other countries (Mexico, Spain).

### Applying expenditure ceilings and treatment of decentralized entities
- Applying expenditure growth ceilings individually to each decentralized institution:
  - Creates rigidity and compliance challenges.
- Recommendation:
  - Minimize use of extrabudgetary entities (EBE) and integrate them into the national budget where feasible.
  - At minimum, apply the expenditure ceiling to the aggregate of the national budget and decentralized institutions to allow flexibility and compensating adjustments across entities (Annex 1).
  - Empower STAP by law to approve and monitor compensating activity per fiscal policy guidelines and priorities.

### Medium-term inclusion of local governments and CCSS
- Statistical principles classify local governments and social security (CCSS) as part of general government; thus:
  - Ideally include local governments and CCSS in the fiscal rule over the medium term.
- Interim measures if immediate inclusion is not feasible:
  - CGR and Ministry of Finance should implement enhanced monitoring and control to avoid fiscal slippages, including:
    - Reflecting these entities in the fiscal risk report.
    - Publishing regular long-term projections for health and pension spending.
    - Requiring monthly or quarterly financial information.
    - Requiring authorization when they incur new debt.
    - Enhancing information exchange.
  - Incentives to encourage prudent public finances (e.g., balanced budget principles for local governments).
- Design consideration:
  - If included, do not apply a uniform individual-entity expenditure limit; allow built-in flexibility while respecting the overall expenditure envelope.

### Proposed exclusion of expenditure items (Bill Nº 23330) and assessment
- Government Bill Nº 23330 proposes to exclude from the fiscal rule:
  - Capital expenditures (regardless of the debt level).
  - Interest expenditure (only for the central government).
  - Externally-financed projects (existing projects with financing rolling over (revalidaciones) and new international grants and loans).
  - Court rulings pending a final judgement.
  - Contractual obligations of the airport concessions.
- Quantified impact:
  - These items represent about 35 percent of the total expenditure of the central government.
  - Or 17 percent of total NFPS expenditures.
- Assessment:
  - Excluding these items narrows the fiscal rule’s coverage and undermines the principle that well-designed fiscal rules should cover main fiscal aggregates affecting fiscal policy and debt sustainability (Eyraud and others 2018).
  - Exclusions reduce transparency and make monitoring harder; full compliance would not guarantee reduced debt vulnerabilities because excluded activities can pose significant fiscal risks.
  - Exclusions reduce the counter-cyclical property of the expenditure rule during adverse shocks.
- International experience:
  - Many countries exclude certain expenditure items to safeguard priority spending or investment, but experience is mixed; exclusions often generate implementation challenges and incentives for reclassification of expenditure.
- Mitigating factor in Costa Rica:
  - Law 9635 includes certification from entities on capital expenditure classification and control from STAP and DGPN, which can mitigate creative reclassification risks.

*Source: Chapter/section content from the provided IMF PDF content unit.*

### 35.      The proposed exclusions in Costa Rica create limited spending space but present

### 1criea2023001 - 35.      The proposed exclusions in Costa Rica create limited spending space but present

### Key findings
- Excluding certain expenditure items from the fiscal rule could create limited additional policy space to spend but presents significant risks to fiscal discipline and expenditure control.
- Capital expenditures were always under-executed relative to the budget amount in recent years; it is therefore unclear whether the key binding constraint on aggregate public investment is the fiscal rule or unintended under-execution.
- Excluding interest payments might loosen the primary expenditure limit modestly in the near term by up to 0.4 percent of GDP under the authorities’ projection, but the additional space could be offset in the future depending on the macroeconomic outlook.
- The authorities identified two court rulings that may incur an expense to the central government of (0.4 percent of GDP) if the government loses the legal cases.
- Externally-financed projects account for one-fifth of capital expenditure of the national budget of central government.

### Implications of proposed exclusions
- Capital expenditures
  - The existing fiscal rule already has a provision to protect capital expenditures: expenditure growth ceilings only apply to current spending when debt is below 60 percent of GDP.
  - Excluding capital expenditures could lead to distortions, less transparency, and incentives for creative accounting and undue classification of expenditure items.
  - Capital expenditures often involve multi-year spending; exclusion can give rise to implementation challenges and efficiency concerns.
- Externally-financed projects
  - At present, the government does not include all capital expenditures in the initial budget because at the time of budget preparation the nature and size of externally-financed projects are uncertain; these projects are included through in-year budget modifications and reflected in the final budget.
  - The government revised the reference (July 2022 decree) to assess compliance with the fiscal rule and intends to exclude externally-financed projects from the fiscal rule; excluding them might encourage further reliance on external financing.
- Interest bill
  - Rationale for exclusion: interest spending represents the cost of previous deficits and is outside direct control of government, so some countries adopt limits on primary spending or primary balance.
  - For countries prioritizing debt reduction, focusing on overall expenditure or balance (including the interest bill) is appropriate as they link directly to debt dynamics.
  - Frequent amendments to rules may undermine credibility and raise borrowing costs.

### Contingent liabilities and reserves
- Contingent liabilities from court rulings and contractual obligations on airport concessions (Juan Santamaría and Daniel Oduber) should not be excluded from the fiscal rule.
- Recommended approach: keep a contingency reserve in the budget to account for court rulings and other contingencies; some countries maintain a reserve of about 2-3 percent of annual government expenditures for such contingencies, and the council of ministers (or the cabinet) approves its use.
- Over the medium term, potential realization of contingencies should be incorporated through better fiscal planning under the MTFF fiscal path.
- Accrued expenditure from contractual obligations should be included as part of overall expenditure when assessing compliance with the fiscal rule for the general government.

### Verification and compliance measurement
- Government modified the methodology for verifying compliance with the fiscal rules in July 2022 (Executive Decree N° 43589-H), changing the reference variable to the final budget of a given fiscal year relative to the initial budget of the previous fiscal year; this implies compliance is assessed based only on budgetary terms rather than final outturn and does not consider externally funded spending.
- Challenges introduced by using final budget as reference:
  - Monitoring final budget becomes less transparent for the public; monitoring budget modifications requires frequent access to SIPP and dedicated websites.
  - Final budget often lacks comprehensive explanatory notes compared with execution data.
  - CGR indicated compliance based on the final budget cannot be subject to legal sanctions because the final budget remains an estimate and not an outturn.
- Preferred approach for ex-post compliance
  - Compare final outturn relative to the initial budget of the previous year while making an estimate of externally-financed expenditure.
  - The execution accounts for all funding sources, including externally-financed projects; option: add the estimated annual execution of externally-financed expenditure to the initial budget so the reference is comparable to final execution.
  - Include list of projects and estimated externally financed expenditure for the next budget year in the budget document (or a supplementary annex).
- Procedural notes
  - Implementing the preferred approach may involve procedural changes in STAP and DGPN because the initial budget only involves domestic financing items while external financing is approved separately.
  - If comparing final outturns with the initial budget is not feasible, a closer analysis on annual execution of externally-financed projects and their implications on government debt is necessary.
- Ex-ante verification
  - Comparison of budgets remains useful to avoid large deviations before final execution (as in Art. 19 LSPF); initial budget base should be adjusted with estimate of annual externally-financed expenditure.
  - First adjustment can apply the effective execution of the previous year to avoid an overestimate.

### Empirical indicators (selected)
- Excluding interest bill in the fiscal rule might loosen the primary expenditure limit modestly in the near term by up to 0.4 percent of GDP under the authorities’ projection.
- Contingency reserve examples: about 2-3 percent of annual government expenditures.
- Escape clause thresholds and parameters (see Escape clause section below).

Selected figures from compliance measurement table (CG spending growth rate, percent)
- Rule: total spending n.a.; n.a.; 2.0 (for 2020, 2021, 2022 respectively)
- Rule: current spending 4.7; 4.1; 2.0 (for 2020, 2021, 2022)
- Ex-ante verification (initial (T) vs initial (T-1)) total spending 5.4; 1.1; 2.0
- Ex-ante verification (initial (T) vs initial (T-1)) current spending 4.4; 2.1; 2.1
- New ex-post verification (final w/ ext. fin. (T) vs initial (T-1)) total spending 11.5; 14.6; 14.4
- New ex-post verification (final w/ ext. fin. (T) vs initial (T-1)) current spending 4.5; 5.2; 3.1
- New ex-post verification (final w/o ext. fin. (T) vs initial (T-1)) total spending -1.7; -4.4; 2.4
- New ex-post verification (final w/o ext. fin. (T) vs initial (T-1)) current spending -1.2; -3.0; 2.5
- Old ex-post verification (executed (T) vs executed (T-1)) total spending -3.3; 9.0; n.a.
- Old ex-post verification (executed (T) vs executed (T-1)) current spending 0.7; 7.4; n.a.

### Escape clause
- The fiscal rule includes an escape clause in the event of a national emergency or sharp economic downturn.
- Activation conditions and parameters:
  - The escape clause can be activated for two years if (i) there is a state of national emergency, which allows emergency spending of at least 0.3 percent of GDP; or (ii) there is an economic recession or if GDP growth is projected to fall below 1 percent.
  - In case (ii), the suspension of the rule is up to two years if previous levels of real GDP are not recovered before, and there is a three-year transition period to return to the rule.
  - In periods of extraordinary favorable economic growth (real GDP growth over 6 percent for two years) the Ministry of Finance can raise the current expenditure growth parameter up to 85 percent.
- Recommendation: a two- to three-year transition appears appropriate when countries exit from national emergencies or recessions; a robust procedure to activate the clause and a narrow set of circumstances remain important.
- Suggested modification: make the maximum transition period apply when the escape clause is activated in either one of the triggering conditions (emergency or recession).

### Policy recommendations (explicit)
- Coverage of the expenditure rule
  - Apply fiscal rule institutional coverage to general government, as defined in Government Finance Statistics Manual (GFSM).
  - Over time, the Legislative Assembly should consider including local governments and the social security (CCSS) in the fiscal rule; in the interim, the Ministry of Finance will closely monitor them under a risk-based approach.
  - MOF should develop verifiable and objective criteria to identify which public entities should be included in the fiscal rule, in accordance with GFSM and other indicators.
  - Amend Bill 23330 to indicate that exclusion of entities from fiscal rules should be based on GFSM criteria specified by MOF (or include those criteria in the law).
  - Entities under government control and nonmarket producers should be considered government entities and included in the fiscal rules; other entities need risk-based monitoring and enhanced debt authorization regulations for outside-central-government borrowing.
  - MoF will present an assessment on legal changes needed to empower the ministry and in particular STAP to make expenditure limits applicable to the overall central government (GFSM) at the aggregate level, including extrabudgetary entities such as Decentralized Institutions, instead of by individual entities.
- Excluding expenditure items
  - Amend Bill 23330 to avoid excluding capital expenditure, court rulings, and interest expenses from the expenditure rules.
  - Create a contingency reserve in the budget (e.g., a separate budget line) that will cover court rulings, among others, subject to the aggregate expenditure ceilings.
- Verification of compliance
  - Clarify the executive decree to include the comparison of expenditure growth between the final outturn at the end of a fiscal year relative to the initial budget of the previous fiscal year plus an estimate of externally funded expenditure; ex ante and in-year verification at budget level remains the same but add the annual estimate of externally funded expenditure.
  - Include the best estimate of annual externally funded expenditure in an annex to budget documents provided to the Legislative Assembly.
- Other provisions
  - Modify the escape clause provision (Decree N° 41641-H Article 25; Article 16 of the LSPF) such that the maximum transition period applies when the escape clause is activated in either one of the triggering conditions (emergency or recession).
- Legislative process
  - To rectify bills already submitted to the Legislative Assembly, propose a modification in line with principles of well-designed fiscal rules as the bill is under review by relevant legislative committees.
  - Further proposals to amend the fiscal rules would benefit from thorough and unified cost-benefit analyses.

*Italic: Source — Authors’ estimates and analysis as presented in the provided chapter text.*

### 47.      The annual ceilings on expenditure growth could be supported by an explicit

### 1criea2023001 - 47.      The annual ceilings on expenditure growth could be supported by an explicit

### Rationale for a medium-term debt anchor
- Well-designed fiscal rules have a medium-term anchor linked to fiscal sustainability and defined in terms of a stock variable (typically, gross debt in percent of GDP).
- Anchoring to a stock variable is appropriate because fiscal sustainability is determined by the government balance sheet and its capacity to meet financing needs and service debt.
- Because the debt stock is not fully under government control, the debt anchor should guide fiscal policy over the medium term, while one (or a few) operational limit(s) should guide near-term fiscal policy and budget preparations.
- Operational limits (for example, expenditure rules or deficit targets) should have a clear link to the debt anchor so that adhering to operational limits over time yields a high likelihood of achieving the debt anchor and maintaining sustainability.
- Operational limits should also contribute to macroeconomic stability over business cycles (for example, via a countercyclical primary balance).

### Empirical practice and components of a risk-based debt anchor
- As of 2021, 85 countries adopted fiscal rules that included an explicit ceiling on government debt.
- More than 80 percent of countries with a debt ceiling also have rules imposing constraints on the (nominal or structural) budget balance; among those, almost a third has expenditure ceilings.
- A risk-based approach requires two elements:
  - A (maximum) debt limit: the level debt should not exceed; sensitive to growth and interest rate differentials and the elasticity of interest rates to debt.
  - A safety buffer: maintain debt sufficiently below the limit so that typical adverse shocks do not push debt above the limit and so policymakers retain space to respond.

### Estimating a medium-term debt anchor for Costa Rica
- Proposed debt limit range: about 65 to 70 percent of GDP (slightly below the 70 percent threshold applied to emerging market-access countries in the IMF DSA framework for Market Access Countries).
  - Justification: sovereign spreads and credit risk in Costa Rica have recently surpassed those of the average emerging-market economy for a similar level of government debt; spreads for Costa Rica sovereign bonds have been higher than those of 75 percent of emerging market economies since 2014.
- Historical context: Costa Rica experienced a doubling of debt from 34 to 68 percent of GDP between 2012 and 2021.
- Contingent liabilities: quantified medium-term contingent liabilities were about 9 percent of GDP as of mid-2022 (sample-average comparison noted in source).
- Methodology: calibrate a safety buffer so that the distribution of debt dynamics starting from the debt anchor stays below the maximum debt limit over a 6-year horizon with a high probability (method described in Annex II).

### Quantitative estimates and sensitivity analysis
- Prudent gross debt anchor estimate for Costa Rica’s central government:
  - Between 35 and 50 percent of GDP if policymakers are tolerant of a 10 percent probability that debt may breach the maximum debt limit of 65-70 percent of GDP over the medium term.
- Table 7 (sensitivity analysis of simulated gross debt anchor) — parameters and results:
  - Baseline scenario:
    - Debt limit (percent of GDP): 70
    - Risk tolerance (probability of exceeding limit, percent): 5.0
    - Contingent liabilities (percent of GDP): 9.3
    - Debt anchor (percent of GDP): 45.3
    - p10-p90 range at year 5 (percent of GDP): 13.8
  - Higher risk tolerance:
    - Debt limit (percent of GDP): 70
    - Risk tolerance (probability of exceeding limit, percent): 10.0
    - Contingent liabilities (percent of GDP): 9.3
    - Debt anchor (percent of GDP): 49.8
    - p10-p90 range at year 5 (percent of GDP): 14.1
  - Lower debt limit:
    - Debt limit (percent of GDP): 65
    - Risk tolerance (probability of exceeding limit, percent): 5.0
    - Contingent liabilities (percent of GDP): 9.3
    - Debt anchor (percent of GDP): 35.4
    - p10-p90 range at year 5 (percent of GDP): 13.9
  - No contingent liabilities:
    - Debt limit (percent of GDP): 70
    - Risk tolerance (probability of exceeding limit, percent): 10.0
    - Contingent liabilities (percent of GDP): 0.0
    - Debt anchor (percent of GDP): 61.5
    - p10-p90 range at year 5 (percent of GDP): 13.0
  - Note: Assumes a maximum primary balance of 2.5 percent. The contingent liabilities are estimated by the national authorities. The simulation assumes that about 1.5 percent of contingent liabilities materialize every year, cumulating to 9.3 percent of GDP over 6 years.

### Projections under the existing expenditure rule and sensitivity to shocks (Table 8)
- Baseline: Current expenditure growth, 2024-2035 average, percent = 4.5; Debt in 2035, percent of GDP = 52.5
- Higher NGDP growth (+1ppt): Current expenditure growth = 5.2; Debt in 2035 = 39.6
- Higher interest rate (+1ppt): Current expenditure growth = 4.3; Debt in 2035 = 56.7
- Higher revenue (+1 pct of GDP): Current expenditure growth = 4.7; Debt in 2035 = 36.3
- Reference: current expenditure growth ceiling in 2022 was 1.96 percent of GDP.
- Under the expenditure rule, complying is expected to put debt on a path reaching about 50 percent of GDP by 2035, but this requires a sizeable reduction in total expenditure as a share of GDP by 3 percentage points of GDP over the next 15 years.

### Coverage and data considerations
- The debt anchor can be set to cover central government debt (gross terms), with the aim to include debt incurred by municipalities and local governments when consolidated data become timelier and available.
- Local government debt was modest at 0.2 percent of GDP in 2021 at the aggregate level.
- The central government contributed 85 percent of the consolidated NFPS debt level in 2021.
- The DSA projections extend to 2031; beyond 2031, all macroeconomic variables except for current spending and debt are assumed constant, and current spending path is determined by the fiscal rule.

### Legal and institutional implementation
- Introducing a debt limit and anchor likely requires amendment to the current Fiscal Responsibility Law (Law 9635).
- The debt anchor should be described in the law as contributing to fiscal sustainability (not as a legally binding constraint on near-term fiscal policies).
- The constraining role of debt exceeding the anchor level would be formalized in a correction mechanism.
- Expenditure ceilings remain the operational constraint on near-term fiscal policy; expenditure rule parameters and other non-parametric aspects of the fiscal rule framework would need periodic review (for example, every 5 years) once the debt anchor is in place to ensure consistency with reaching the debt anchor under the MTFF.

### Recommendations (Section C)
- Include a medium-term debt anchor in the current fiscal rule framework.
  - The government, through consultation of stakeholders, would propose a gross debt anchor for the central government consistent with maintaining fiscal sustainability with high probability and to be operationalized through an expenditure rule.
  - The proposal should specify the institutional and economic coverage of the debt anchor.
- Recalibrate expenditure rule limits periodically (every 5 years) after the debt anchor is established in the fiscal rule to ensure consistency with the medium-term debt anchor.

### Strengthening the MTFF to support the rules-based framework
- The MTFF (3-5 year fiscal envelope) must be consistent with fiscal rules to achieve fiscal sustainability; expenditure limits in legislation must align with the MTFF path converging to the medium-term debt anchor.
- To support credibility of the MTFF and fiscal path:
  - Prepare alternative macroeconomic scenarios and sensitivity analysis.
  - Empower independent fiscal councils to assess macroeconomic and fiscal forecasts.
- MTFFs should include fiscal risk assessments at macro and specific-risk levels (public corporations, subnational governments, pension funds).
  - Fiscal risk management stages: identification, mitigation, provision for risks that cannot be mitigated, building fiscal buffers to accommodate residual risks.
- Strengthen the budget process and fiscal transparency:
  - Address fragmented and non-comprehensive budgets, delays in information sharing, and gaps in consolidation.
  - Improve coverage, quality, and timeliness of fiscal reporting (monthly/quarterly statistics, consolidation of general government and NFPS) and include extra‑budgetary activities within central government statistics.
- MTFF should integrate the composition of current spending and investments, presenting the most likely investment scenario as baseline consistent with overall expenditure limits rather than treating public investment as a residual.

*IMF staff report excerpt: 1criea2023001 - 47. The annual ceilings on expenditure growth could be supported by an explicit (Costa Rica fiscal framework analysis).*

### 61.      The MTFF in Costa Rica also includes an analysis of fiscal risks, which is deemed

### The MTFF in Costa Rica

### Analysis of Fiscal Risks
- The MTFF includes an analysis of fiscal risks, considered good practice.
- Risks covered: macroeconomic risks and specific risks (public corporations, pensions, natural disasters, court rulings, local governments, private-public partnerships (PPPs), financial sector and public debt).
- Most analyses are qualitative; some risks are quantified.
- Mitigation measures are included in some cases.

### MTFF Coverage, Consolidation, and Link to Fiscal Rules and Budget
- Expansion of the MTFF to the NFPS in 2022 partly reduced fragmentation between the national budget and rest of the NFPS.
- Fiscal rules and MTFF follow a top-down approach by setting fiscal aggregates to guide budget preparation.
- Costa Rica’s expenditure rule is based on individual entities with a rather bottom-up approach except for the budgetary CG.
- The MTFF provides:
  - A top-down overview of deficit and debt consistent with expenditure ceilings under the fiscal rules.
  - An overall projection with the contribution of subsectors to fiscal objectives.
- The MTFF is the link between the fiscal rules and the annual budget; preparation should guide the budget and projection should reflect envisaged execution.
- The MTFF must be in line with the expenditure rule in the budget and in execution.

### Expenditure Ceilings and MTFF (Table 10)
- Expenditure growth projections and rules (Percent):
  - Expenditure Rule: Current Expenditure — 2021: 4.13, 2022: 1.96, 2023: 2.56
  - MTFF expenditure growth projection CG — 2021: 5.8, 2022: 1.25, 2023: 2.61
  - MTFF expenditure growth projection NFPS — 2021: Non-applicable, 2022: 5.22, 2023: 4.69
  - Expenditure Rule: Total expenditure — 2021: Non-applicable, 2022: 1.96, 2023: 2.56
  - MTFF expenditure growth projection CG (Total) — 2021: Non-applicable, 2022: 1.96, 2023: 2.56
  - MTFF expenditure growth projection NFPS (Total) — 2021: Non-applicable, 2022: 5.6, 2023: 5.0
- Note: Expenditure growth projections for the CG are actual executed data in 2021 and exclude Covid-19 related expenditure and the excess expenditure over the ceiling of the previous year. For 2022 and 2023 it excludes some items exempted from the rule.

### MTFF Publication Calendar and Data Inputs
- MTFF publication months: April and August each year, reflecting budget preparation and the budget proposal.
- MTFF requires:
  - Final execution data of the previous fiscal year consolidated by STAP in March each year.
  - Decision on the expenditure rule in March.
  - Macroeconomic scenario from the central bank (BCCR).
- The MoF published the MTFF in April in 2021 and 2022 and updated it for the central government in August.

### MTFF Projection Model and Assumptions
- Framework developed with FAD capacity development includes:
  - A fiscal database and projection model for central and local governments, social security (CCSS), rest of decentralized institutions (ID), and public corporations to consolidate to NFPS projections.
  - Model components: baseline scenario, policy measures, final scenario in compliance with the fiscal rule by subsector.
- Assumptions needed because many subsectors are excluded from the fiscal rule:
  - Central government, ID sector (without Social Security) and around 50 percent of the expenditure of public corporations are assumed rule-compliant.
- Rule compliance in the model ensured by adjusting:
  - Public current transfers (CG), private transfers (ID sector), and goods and services expenditure in public corporations.
- National budget transfers play a key role for consolidation among subsectors to ensure compliance with fiscal rules at subsector and consolidated levels.

### Pending Issues Regarding the MTFF
- Exclusions and transparency:
  - Demands for exclusions from the expenditure rule have complicated MTFF projection exercise, reducing transparency.
  - Increasing number of expenditure items and significant entities are excluded from the fiscal rule.
  - Without a medium-term debt anchor, entities not covered by the rule could overspend and contribute to debt buildup.
- Debt coverage limitations:
  - MTFF reports on central government debt only as the rule thresholds apply.
  - It is advisable to expand debt sustainability analysis to cover NFPS debt; published data at MoF include government guaranteed debt.
  - Limitations: DGCP lacks detailed data on public debt holders within the NFPS regarding terms, interest rates, and currency denomination needed to calculate average effective interest rate of consolidated debt.
  - Projection was based on interest rates of central government non-consolidated debt, which could have overestimated interest payments.
- Impact of July 2022 decree:
  - Decree established compliance with the rule at budget level and considers only initial and final budgets for rule compliance, excluding externally-financed projects that account for around 20 percent of central government capital expenditure in 2021.
  - MTFF starting point is execution of last fiscal year and includes all expenditure items irrespective of financing sources.
  - To make MTFF comparable to initial budget, assumptions on external funding and any under-execution should be made explicit.
  - MTFF should comply with fiscal rules and explain deviations and underlying assumptions compared to the budget.
- Institutional capacity constraints:
  - Operation of the macro fiscal unit (MFU) to improve projections and MTFF report remains a challenge.
  - Resource constraints in the MoF limit ability to carry out NFPS medium-term projections.
  - MTFF is prepared by a small group of two stable staff at the Minister’s office without full-time dedication to projections.
  - A MFU led by a directorate in charge of macro-fiscal issues at MoF with sufficient resources would be needed.
- Short-term suggestion:
  - MTFF could explicitly integrate the debt anchor as the final objective guiding the fiscal path, even if the LSPF takes time to introduce the debt anchor.

### Independent Fiscal Council
- Establishment and status:
  - Fiscal Council established in 2019 but not operational.
  - Council composed of five members (initially three); four designated by the Government and the fifth by the Legislative Assembly.
  - Members must be independent professionals with knowledge of macroeconomics and public finance; they work ad-honorem without renumeration.
  - Establishment was one of the loan conditions by Inter-American Development Bank (IADB) in 2021.
  - Current status: Council only has one member, with two resignations in 2021 and two in 2022.
- Mandate:
  - Evaluate macro-fiscal developments, prepare reports evaluating MoF performance on fiscal policy, fiscal rule monitoring, and fiscal risk assessment.
  - Give opinion on fiscal projections in the MTFF and macro projections in the annual budget, including underlying assumptions and methodologies.
  - Give opinion on MoF’s management of fiscal risks and comment on quarterly and annual reports monitoring the fiscal rule.
- Resource constraints and recommendations for operationalization:
  - Council lacks its own staff and communication channel (e.g., designated website).
  - Recommendation: have the Fiscal Council with its own budget line to secure adequate resources commensurate with its mandate.
  - MoF needs to share information timely; regulation should clarify calendar of information sharing and timing of fiscal council inputs and reports.

### Recommendations (as listed)
- Continue to strengthen the MTFF that presents the fiscal path consistent with fiscal rules compliance and aligned to a medium-term debt anchor.
- Reinforce Hacienda Digital project to allow for timely fiscal reporting on consolidated NFPS fiscal accounts and public debt.
- The MOF should present to the Ministry of Planning a proposal to create the Macro Fiscal Unit (MFU) with a directorate and sufficient personnel and resources.
- Amend the law to strengthen independent fiscal oversight with the necessary provisions to make the independent fiscal council operational.

*1criea2023001 - 61.*

### Annex III. Progress of MTFF since the Capacity Development

### Annex III. Progress of MTFF since the Capacity Development Missions in 2020-21

### Main 2020-22 Technical Assistance Mission Recommendations — summary of recommendations, deadlines, and preliminary assessment of progress
- Improve fiscal strategy
  - Recommendation: Address the lack of a debt anchor. Change the legal framework to establish it and define 4-year debt and deficit sustainable paths in the MTFF. Clarify the fiscal rule and its monitoring in terms of budget and execution.
  - Deadline: 2020
  - Preliminary assessment of progress: Not met

- Improve the budgetary process
  - Recommendation: Contingency reserve in the budget and the MTFF for both the CG and other institutions
  - Deadline: 2021
  - Preliminary assessment of progress: Not met

- Prepare the MTFF
  - Recommendation: Prepare the MTFF for the NFPS in April, and update it for the CG in August, focusing on fiscal policy measures, fiscal risk assessment and debt paths.
  - Deadline: 2021 and 2022
  - Preliminary assessment of progress: Done 2021 and 2022
  - Recommendation: Develop fiscal projection capacities, by using and updating the fiscal model and the databases developed with FAD
  - Deadline: 2021 and 2022
  - Preliminary assessment of progress: In progress

  - Recommendation: Expand debt sustainability analysis in 2022 from the CG to the NFPS
  - Deadline: 2022
  - Preliminary assessment of progress: Not met

- Institutional and legal framework
  - Recommendation: Establish a Macro Fiscal Unit as soon as possible, with enough human resources to perform its duties.
  - Deadline: 2022
  - Preliminary assessment of progress: Not met

  - Recommendation: Regulate the process for preparing the MTFF: information flows between institutions and MOF, process of approval by the Council of Ministers, opinion by the Fiscal Council.
  - Deadline: 2021
  - Preliminary assessment of progress: Not met

- Fiscal projections
  - Recommendation: Develop macroeconomic projection capacities and analyze the sensitivity of fiscal projections to macro shocks
  - Deadline: 2023
  - Preliminary assessment of progress: In progress (ICD 2022-2023 technical assistance)

*Fiscal Affairs Department
International Monetary Fund
700 19th Street NW
Washington, DC 20431
USA
http://www.imf.org/capacitydevelopment*

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_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1criea2023001.pdf_