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Nicaragua: Selected Issues Summary

Core Content

This document provides an in-depth analysis of key challenges and reform options for Nicaragua's social security system, the impact of climate change and disasters on the macroeconomy, and the special case of transfer pricing in commodities and free trade zones. It is based on data and projections up to June 2017.

Social Security System: Pathways to Sustainability

Overview

Nicaragua's social security system, managed by the Instituto Nicaragüense de Seguridad Social (INSS), includes pension, healthcare, and occupational risks programs. The pension system, known as IVM, is a defined benefit, pay-as-you-go system.

Current Challenges

• Financial Sustainability: The system is projected to exhaust its liquid reserves by 2019.
• Contributions and Expenditures: While contributions have increased, expenditures have grown faster, particularly in pensions and healthcare.
• Demographic Pressures: The population is aging, with life expectancy rising and fertility rates falling, increasing the old-age dependency ratio.
• Low Coverage: About 80% of businesses operate informally, leading to low active coverage of the social security system.

Key Statistics

• Contribution Rates: Increased from 10% (employer) and 13.5% (total) in 2013 to 10% (employer) and 13.5% (total) in 2016.
• Pension Expenditure: Rose from 1.4% of GDP in 2006 to 3.0% in 2016.
• Old Age Dependency Ratio: Expected to increase from 7.8% to 17.8% by 2040.
• Reserve Fund: Assets fell from US$592 million in 2012 to US$410 million in 2016, with declining revenue and increasing reliance on reserves.

Reform Options

• Retirement Age Increase: Gradually raising the retirement age to 63 by 2025 could help improve sustainability.
• Fixed Pensions in Dollar Terms: Keeping pensions fixed in dollar terms could reduce the burden on the system.
• Contribution Rate Increases: A 1% increase in 2020 and another 1% in 2021 could help close the gap.
• Benefit Reduction: Reducing average benefits by 20% is another potential reform.
• Combination of Measures: A mix of the above reforms may be necessary to achieve long-term sustainability.

Macroeconomic Impact of Climate Change and Disasters

Overview

Climate change and natural disasters pose significant risks to Nicaragua's macroeconomic stability. The country is vulnerable due to its geographic location and economic structure.

Key Findings

• Climate Change Impact: The global economic impact of climate change is estimated to be significant, with rising temperatures affecting productivity.
• Natural Disasters: Nicaragua experiences a high number of natural disaster events, which have a substantial impact on GDP and fiscal revenue.
• Fiscal Preparedness: The country's fiscal system is not well-prepared for disaster-related shocks, and the impact of these events can be severe.
• Policy Response: The document suggests the need for improved fiscal preparedness and resilience, including better disaster risk management and climate adaptation strategies.

Supporting Data

• Natural Disaster Events: Increased significantly from 1970 to 2016.
• Economic Impact: Disasters have a notable effect on GDP, exports, and fiscal revenue.
• Exchange Rate Impact: Exchange rate flexibility can mitigate some of the negative impacts of trade shocks.

Transfer Pricing and Free Trade Zones

Overview

Nicaragua's transfer pricing policies and the role of free trade zones (FTZs) are examined, with a focus on their impact on tax revenue and economic activity.

Key Issues

• Commodities and Transfer Pricing: The system for transfer pricing in commodities is underdeveloped and needs improvement to ensure fair taxation.
• Free Trade Zones: These zones are a special case due to their tax exemptions and the potential for abuse in transfer pricing.
• Tax Expenditures: The FTZs contribute to a significant portion of tax expenditures, which may need to be reformed to improve revenue collection.

Recommendations

• Improved Transfer Pricing Regulations: To ensure that companies operating in FTZs do not exploit loopholes to avoid taxes.
• Enhanced Oversight: To monitor and regulate transfer pricing more effectively, especially in the context of FTZs.
• Revenue Enhancement: By reforming tax expenditures, the government could improve its revenue base and reduce the fiscal burden.

Conclusion

The social security system in Nicaragua faces significant financial and demographic challenges, with the pension system being particularly unsustainable. The country is also vulnerable to climate change and natural disasters, which can have severe macroeconomic consequences. Transfer pricing in commodities and FTZs presents a unique challenge for fiscal sustainability. The document outlines various reform options and emphasizes the need for a combination of measures to ensure long-term financial stability.