Targeted Legal Reforms in Latin America: Integrating Foreign Investment with Positive Distributional Effects

By Jean Vilbert

Bogota, Colombia. Photo by Social Income on Unsplash

Introduction 

Even before the COVID-19 pandemic hit in early 2020, Latin American countries were already navigating a second “Lost Decade,” fighting against economic stagnation, social unrest, and political turmoil.[1] COVID-19 seriously aggravated the scenario, destabilizing the already faltering economic activity and plunging governments into unprecedented public debt highs. Now, the region needs urgent reforms to boost growth and avoid widespread impoverishment.[2]

Foreign investment could be a solution for Latin America’s immediate needs. If governments with little fiscal space remaining and debilitated domestic markets do not have the potential to restart the economies at the necessary pace, capital inflows could help. Money from abroad can bolster consumption, facilitating job creation and the implementation of critical projects of infrastructure. The problem is that developing countries often try to entice investors via lenient labor, environmental, and social legislations or exorbitant financial advantages.[3] Such an approach has created a historical dichotomy between foreign capital on one side, and labor—along with the vulnerable segments of society—on the other. The welfare gains accrue among the rich, while the poor may experience welfare losses.

With the challenges imposed by the COVID-19 pandemic, regulatory activity has increased in the region, with governments trying to spark growth by dropping barriers to economic integration.[4] This article explores how Latin American governments can harness the current regulatory dynamism to attract quality foreign direct investment (FDI). Three priority areas for reform crystalize out of this exploration: tax code simplification, reductions in administrative barriers to cross-border business and judicial reform. 


Why foreign investment is necessary to Latin America

Economists traditionally identify four factors needed to produce goods and services and generate wealth: land, labor, entrepreneurship, and capital. Development demands capital, and countries usually cannot rely solely on domestic investment. Buildings, factories, machines, roads, ports, pipelines, and power grids are expensive, making access to international capital a key determinant for economic growth in developing countries.[5] For example, after three years, 1 percent of GDP spending on infrastructure could expand the economy by 2.5 percent in Brazil, 1.8 percent in Argentina, and 1.3 percent in Mexico.[6] However, underinvestment has been a pervasive problem in the region: in 2019, the Latin American infrastructure investment gap—the difference between what is needed and what is spent—was estimated at 2.5 percent of regional GDP, or $150 billion a year.[7]

While some of that required capital can come from institutions like the World Bank, the International Monetary Fund (IMF), or the BRICS’ (Brazil, Russia, China, India, and South Africa) New Development Bank, if growth is to be sustained over time, the bulk of investment must come in the form of the private inflow. Beginning in the 1980s, public participation has shrunk from about 85 percent to 50 percent, even in sectors historically dominated by public investment. Today, public and private investments shoulder roughly equal shares.[8] Between 1982 and 2002, the IMF invested around $448.79 billion in Latin America, in the heyday of the fund’s activity in the continent; and between 1990 and 2013, the private sector invested $680 billion.[9] International organizations can be helpful to raise initial outlay, the capital required to finance projects that can lay the basis for future growth, yet persistent development calls for continuous and dynamic investment. This is where investors, attracted by opportunities for profit, come into play.  

The COVID-19 pandemic adds an element of urgency to this equation: what was necessary may have become even more critical. Since 2021, the world has entered a period of unsynchronized growth, with economies that are able to operate under the pandemic framework moving forward while others risk long-lasting stagnation, led by emerging markets in Asia and Latin America.[10] To  overcome this situation, Latin American nations need solutions to quickly rebuild their economies, fight chronic levels of unemployment, and wrestle with inflation and slow growth.[11] With no support from international capital, the task may be impossible. 

However, in times of uncertainty, when an exogenous push is needed the most, endemic regional characteristics (which will be discussed later) make external help fade. From 2019 to 2020, foreign direct investment plunged by 45 percent in Latin America (see Figure 1), the sharpest decline among developing regions.[12] Brazil and Mexico, the biggest destinations for international capital in the region, saw their influx sink to historical lows. They received $45 billion less in 2020 than they did in 2019. Bolivia and Suriname experienced outflows of capital and only Uruguay showed substantial gains in the period ($793 million), still small relative to the aggregated regional losses. 

Figure 1: Foreign direct investment flows in Latin America: percent change 2019-2020 (Source: Author’s calculation with data from UNCTAD).[13]

To be sure, there are important voices in academia according to which, in the absence of complementary policies to curb its adverse effects, foreign investment can create a transfer of surplus value out of Latin America (predatory capital).[14] This is true in some instances and will be addressed in the next section of this article. In terms of continuing development, Latin America must find ways to attract quality foreign investment, whose consequences are expected to: (a) augment the skill-base of the host economy; (b) contribute to the generation of value-added jobs; (c) facilitate the transfer of technology and knowledge; (d) open access to markets while improving the competitiveness of domestic firms. All this should be achieved by operating with social and environmental responsibility.[15] To obtain this type of investment, it matters which mechanisms countries use to attract investors.

How (and what type of) foreign capital is attracted matters
The logics of public and private investment are different: while the former seeks directly to improve social welfare, the latter does it indirectly. This does not mean that private investors have no social concerns, but the main driver of private investment, especially foreign, is profit. Hence, developing countries will not be able to convince investors to risk their capital by showing them the social gains of a certain project or business model—investors need to see profitability. On the other hand, part of the role of governments is to ensure that private profits are not obtained by imposing social losses. Integrating these two logics such that they can coexist and thrive is the challenge in attracting foreign investment with positive socio-economic effects in the host country.

The modern history of Latin America is filled with examples of governments that failed in this endeavor. In the 2000s, Peru took steps to become a dominant destination for foreign investment. Yet, spending concentrated in urban areas, excessive external debt, and ineffective use of its abundant natural resources hampered the country’s attractiveness.[16] Peru may be the best illustration but it is not alone: the 2019 crisis in Chile seems to confirm the hypothesis that uneven distribution of returns from investments has effects as far-reaching as political instability.[17] 

The eagerness to redistribute social benefits, disregarding institutions, is similarly harmful. Using anti-imperialist rhetoric and promising to tackle social inequities, Hugo Chaves reached power in Venezuela in 1999. His election launched the movement known as “Pink Tide,” the rise of populism that mushroomed to Argentina (Cristina Kirchner), Brazil (Lula da Silva), Bolivia (Evo Morales), and Ecuador (Rafael Correa).[18] The socioeconomic results were mixed at best. Despite improvements in equality, these countries impoverished over time.[19] Bolivia, Ecuador, and especially Venezuela embarked on different levels of isolationism amidst authoritarian drifts.[20]

In the light of these experiences, if international capital is critical to development, it is also well known that foreign investment does not always equal social progress—especially when uneven distributional outcomes across social groups exist.[21] The mechanisms that lead to such failures are less understood though. This article argues that the missing link lies in the means that countries adopt to attract investors. Countries can basically offer: (a) moderate profits under a fair business climate and relative safety; or (b) exorbitant profits under a taxing environment and high risks. An endemic problem in Latin America is that the second package has been commonly presented as a substitute for the first—lacking a favorable business climate, secure rights, and responsive judicial systems, countries in the region remain attractive as long as they offer opportunities for exorbitant profits. 

The World Bank’s report “Doing Business 2020” ranks the best places in the world to do business, and no Latin American economy ranks among the top fifty—Chile has the highest ranking in the region with a rank of fifty-nine.[22] One of the dimensions the index considers is the strength of legal rights. By splitting Latin American countries into two groups according to the strength of their legal rights, it is possible to see that real interest rates in countries with weak legal systems present, on average, wider range and higher variance  (Figure 2a). Rates in countries with weak legal systems can be as low as -16.54 percent and as high as 41.71 percent, while in countries with a strong legal system they range from -0.85 percent to 22.07 percent. The standard deviation is 9.01 percent for countries with weak legal systems and only 4.43 percent for countries with strong legal systems.

Figure 2b highlights time trends among countries with data for the whole period of 2013–2019. The widely oscillating rates in countries with weak legal systems (Brazil, Bolivia, Uruguay, and Argentina) suggest extreme uncertainty under economic instability. Nations with strong legal systems (Costa Rica, Peru, Colombia, and Mexico), even when employing higher interest rates, do this in a more consistent and predictable way—smoother lines under bounded uncertainty—which is conducive to producing confidence.

Figure 2a: Real interest rates by year and legal system type (Source: Author’s calculations with data from the World Bank).

Figure 2b: Real interest rates (2013-2019) by levels of strength of the legal system (Source: Author’s calculations with data from the World Bank).[23]

As shown in figure 2b, real interest rates in Argentina went from -11.60 percent in 2014 to 10.82 percent in 2019, while in Brazil they spiked to 40 percent by 2017. Wide fluctuations in interest rates expose the economy to speculation—transactions whose sole motivation is to make a profit from changes in market conditions.[24] The problem with speculation is that “while investment is assumed to be output-promoting, loanable funds that are geared to speculative varieties may only increase money supply but not output.”[25] This type of investment is highly volatile, subject to capital flights—rapid outflow during economic downturns. Estimates indicate that more than one-third of the total foreign investment in developing countries leaves as capital flight.[26]

Foreign investment driven by interest rates may also displace domestic investment generally referred to as crowding-out effect.[27] Without corrective policies, the net effect of the inflows can be highly uneven across different layers of society, with benefits accruing in the hands of big national companies and foreign investors, while workers and domestic small entrepreneurs see their share of the national wealth shrink even if the whole market grows.[28] The practical outcomes of this type of foreign investment are predatory, because they might redistribute wealth from the bottom to the top, within, and across borders.

To make matters worse, instead of working to make their legal systems stronger, some governments do the opposite: they try to entice international investment by disproportionately directing benefits to certain sectors, easing environmental and labor standards, and handing in their natural resources or the most promising sectors of the economy to foreign investors at low prices. For instance, Brazil’s government is often accused to have privatized Vale, one of the most valuable mining companies in the world, at a fraction of its actual value.[29] And since 2020, the Brazilian executive power has published hundreds of decrees, executive orders, and other ordinances on environmental issues, many of which bypass Congress to lessen legal restrictions.[30] Some scholars believe that market pressures can “erode the capacity of governments and the willingness of decision-makers to approach key environmental problems that result from trade and investment activities.”[31] From a Marxist perspective, Henry Veltmeyer calls such dynamics “extractive imperialism.”[32] This may be an exaggeration, but there is little doubt that, in such cases, the net social effect of foreign investment in the host economy will be ambiguous at best.

Therefore, it should not come as a surprise that some scholars believe that foreign investment is not an adequate instrument to drive economic growth in Latin America.[33] However, this interpretation’s mistake lies in taking the effect as though it were the cause: foreign investment is not the deterministic cause of social undesirable outcomes in itself. The problem is how investors are attracted and what type of investment they bring. When international capital flows due to the attractiveness of innovative businesses and the potential for sustainable growth, empirical results confirm that foreign investment in Latin America is positively correlated not only to growth and economic stability but a healthy institutional and political environment.[34] Thus, when recovering from a deep economic crisis and planning the future, few things could be more important for Latin American nations than to create a structure in which foreign capital can play a constructive role.

Structural barriers: barking up the wrong tree
Most countries in Latin America are aware that they need to improve their international reputation in the political-economic arena to position themselves for an investment-led recovery. This may have led twenty-one of the thirty-two Latin American and Caribbean states to pass at least one regulatory reform attempting to improve their business climate since 2019.[35] They mostly addressed hurdles to starting a business, lifted impediments to international trade, and implemented mechanisms to enforce contracts. These reforms are welcome and will likely bring positive outcomes, yet governments are still missing the point. Among the less addressed areas is paying taxes (see Figure 3), exactly the domain in which Latin America continues to underperform and where regulations overburden some entrepreneurs and drain resources from productive investments.[36]

Figure 3: Legal reforms in Latin America (2019) addressing business (Source: Author’s calculations with data from the World Bank).[37]

According to the World Bank, Latin America has the most cumbersome tax compliance processes in the world. The Bank compares various groupings: in high-income OECD economies, it takes 159 hours a year for a small company to pay its taxes, following all applicable regulation, while a similar company in Brazil spends over 1,500 hours to comply with its fiscal obligations.[38] Scaling the problem, foreign investors need to be offered inflated margins of profit to make up for that difference, let alone the risk-premium due to the complexity of filing processes. Moreover, a substantial part of the capital inflow that could help the host country build infrastructure and invest in critical sectors ends up diverted to (almost monopolistic) law and accountancy firms.

The problem is enormous. The literature has shown that “a 10 percent reduction in tax complexity is comparable to a one percentage point reduction in effective corporate tax rates.”[39] This means that the proposition that a country needs to slash corporate taxes to attract investments is misleading with highly regressive consequences. The rich end up paying lower taxes than the poor in proportion to their income and wealth. Extorsive tax rates are certainly inimical to investment, but when taxes are levied within reason, through an efficient and fair procedure, governments do not need to rely upon regressive policies to attract capital.

When answering which structural reform is needed, more than analyzing aggregate numerical data, it is valuable to consider what actual decision-makers think. Biglaiser and Staats surveyed investors and found that risks associated with property-rights protection, adherence to rule of law, and an effective judiciary system weigh more heavily in investors’ assessments.[40] The result confirms previous research suggesting that, more than economic policies, institutions are the determining factor for investment, which signals that reforms in the legal system could enhance foreign investors’ interest.[41]


The solution: targeted legal reforms

A path to attract quality foreign investment for the people of Latin America—and not against the people of the host countries—is to strengthen the legal framework: both the law and the judiciary need to secure the rule of law and fair economic relations in a world driven by interactions between nations.[42] Beyond the classical advice for the protection of property rights, targeted legal reforms can address sensitive (and underestimated) points that would allow foreign investment to be a fundamental tool for Latin America’s development.[43]

The first and maybe the most crucial step is tax simplification. The literature has revealed a significant link between tax corruption and tax complexity, such that simpler tax systems are correlated with lower levels of corruption.[44] The simplification can come, for example, in the form of consolidation of taxes in a single tax code, the elimination of itemized deductions, and the reduction of formalities. Simplified fiscal regulations also mean less room for rent-seeking and inefficiencies. Efficient systems are expected to collect more taxes, controlling for similar rates, and improve public revenues. All this together creates a web to capture foreign investment.

The next measure is to reduce transaction costs: excessive bureaucracy, restrictive investment codes, administrative barriers to cross-border business, repressive and inefficient bank and financial systems have long created locational disadvantages for Latin American countries such as Brazil and Mexico.[45] Albeit being the main recipients of international investment in the continent, these two countries score high in the OECD FDI Regulatory Restrictiveness Index: Brazil scores above the OECD average and Mexico above the non-OECD average.[46] In terms of trade facilitation, no Latin American country reach the OECD benchmark for best practices (18.226 points). Chile is the closest (17.21) and Venezuela lags far behind (7.853).[47]

It is important to notice that besides inhibiting foreign capital, environments inimical to business may create dysfunctional bubbles, where foreign companies that find a way to transpose the barriers operate with little competition. Empirical evidence confirms that markets with entry regulation costs above certain levels push foreign capital to crowd out domestic investment.[48] Reforms toward simplification of procedures, as well as migration from paper to electronic platforms, save time, money, confer more transparency to processes, and allow small investors and businesses to operate. There are ongoing initiatives toward these goals: Brazil has led the efforts that in December 2021 culminated in a World Trade Organization (WTO) Joint Statement on Investment Facilitation for Development, which intends to “improve the investment and business climate, and make it easier for investors in all sectors of the economy to invest, conduct their day-to-day business and expand their operations.”[49] Negotiations are still under way but a multilateral action co-sponsored by 112 WTO members is an important step.

Still, the WTO project does not include controversial matters of investment protection and investor-state dispute settlement.[50], So, country-level comprehensive legal and judicial reforms are still critical to ensure efficiency in the enforcement of contracts. Functional judicial systems have a broad impact on the economy, including on the attractiveness to investment. This happens because the speed and fairness of trials improve trust, reduce litigation and other costs, and augment productivity. For sectors relying on relationship-specific investments, judicial efficiency can increase firms’ productivity by 22 percent.[51]  Even though the connection is not always apparent, legal systems that ensure judicial independence from political pressure, grant access to fair trials but avoid judicial congestion, reduce the waiting time for a decision, and deliver satisfactory rulings under a fair law, have solid appeal among international investors.

Improving the justice system’s quality and performance is hard because it imposes a multifaced challenge: courts are framed within diverse political regimes and models of checks and balances, not to mention variances in procedures—civil, criminal, administrative—and structure—general and specialized jurisdictions, appellate and supreme courts.[52] This does not mean that the endeavor is impossible: Colombia recently underwent broad judicial reforms as part of its path towards OECD accession.[53] From the structural perspective, the sweeping changes expanded civil society participation to increase accountability and transparency.[54] Besides an augmented budget, the country invested in alternative mechanisms of dispute resolution and advanced from predominantly written court procedures to an oral system, improving the timeliness of justice services.[55] Colombia’s case shows that more ambitious judicial transformations are feasible under enough political will and motivation.

These are the most uniform reforms Latin American countries can adopt to attract beneficial foreign investment. At first glance, they may seem too simple to guarantee that the distribution of welfare gains will reach the bottom layers of society. However, since these reforms escape the temptation to attract investors via exorbitant profits, preferring to rely on a healthier institutional framework, they entice quality capital. This different type of investment is more stable, presenting less risk of capital flight during a crisis, tends to be less concentrated, and is more likely to align with environmental and social protection. When countries turn to institutional improvements, the difference they see is both in terms of the quantity and quality of the capital being attracted.[56]

Finally, despite its normative approach, the limitations of this piece are evident: it generalizes problems of Latin America as a whole and keeps a range of questions on the table, in particular, which specific local arrangements and context-driven reform options countries could additionally embrace.[57] This work cannot be employed as an extensive list of policies that all governments must follow, but it does call attention to the importance of foreign investment to Latin America and present patterns of how countries can make international capital work for the benefit of their entire populations, particularly of those in need of urgent improvements in standards of living.


Conclusion

Balancing the evidence regarding foreign investment in Latin America, it becomes clear that depending on what measures countries put into play to attract international investors, they receive distinct types of capital which present different socio-economic effects. Thus, what countries should be looking for is quality investment, which is not raised by offers of exorbitant profits, but via political and economic stability and a robust and fair legal system, creating a favorable institutional environment for investors interested in reasonable profits under relative safety.

Through targeted legal reforms intended to reduce transactional costs, simplified tax systems, and enhanced legal systems, Latin America can attract quality investment and create value-added jobs; facilitate transfers of technology, skill-basis, and knowledge; and increase productivity and competitiveness, without disregarding the social and environmental spillover effects. It is certainly an arduous task to raise this kind of investment under the constraints and needs of emergent economies, but it is a challenge that Latin American governments must face. A successful socio-economic recovery post-COVID-19 and a brighter future for Latin America depend on capital attractiveness. It must be the right type of capital, obtained through the right means.

About the Author

Jean Vilbert is a resident fellow at the Latin American, Caribbean and Iberian Studies Program (Lacis) at the University of Wisconsin-Madison. He holds a Master’s in Laws (Fundamental Rights) and served as a judge in Brazil, where he teaches Constitutional Law and Humanities. Currently, he is a MIPA candidate at the La Follette School of Public Affairs and an instructor of Comparative Politics in the UW-Madison Department of Political Science.

Disclaimer: The views and opinions expressed in this paper are those of the author and do not reflect the position of any organization with which the author is associated.

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ArticleYale Journal of International AffairsSouth America, North America, Spring 2022