Is Costa Rica facing a free-trade zone dilemma?

An uncharacteristic element of uncertainty crept into the annual free-zone conference organised by Azofras in San José, which brings together the main players of Costa Rica’s successful free-trade zone (FTZ) programme. President Carlos Alvarado had opened the event by reassuring the audience of his commitment to preserving benefits for companies operating under a FTZ regime. A few hours later, news spread that the National Assembly had rejected an amendment that would have prevented the introduction of VAT for FTZ companies. 

As discontent among the audience mounted, trade minister Dyalá Jiménez Figueres appeared on stage to wrap up proceedings and make a last-minute effort to extend further reassurance to the industry. “It’s going to be a transition, not a change in your status,” she said.

Fiscal crisis 

Mr Alvarado’s government is dealing with a severe fiscal crisis that is forcing ministries across the board to seek greater revenue while cutting back on public expenditure. Foreign investors operating under the national FTZ regime, which offers full tax exemption for eight years, are now being asked to contribute to revenues. 

Yet the government has to tread a fine line, as the success of the FTZ programme traces back, among other things, to its legal stability. This enabled companies to draft investment plans for the mid to long term with a good degree of predictability. 

Industry leaders warn that if things change, overall trust in the programme might be weakened, although the government seems to consider it a risk worth taking in the current climate.

“A fiscal and financial crisis leading to overall instability in the country’s economy is the worst thing that can happen for FTZs and the economy as a whole,” says Ms Jiménez, who prior to joining the government in mid-2018 worked as a lawyer on international arbitration issues. “We are spending much effort in pursuing a fiscal consolidation that starts with this fiscal reform bill and will be followed by other measures to produce changes in the country’s public policy. But we are not going to alter the FTZ regime per se.”

Sounding the alarm

International observers, such as the IMF, the World Bank and credit rating agencies, have been sounding alarm bells on Costa Rica’s fiscal deficit and growing debt for months, warning Mr Alvarado, who surprisingly clinched the presidency in early 2018 elections, that they pose a serious threat to the country’s growth potential and status in the financial markets.

The government is aiming to reduce the fiscal deficit from the current 6.2% of GDP to 3% by the end of the president’s mandate in 2021, to maintain access to international markets and keep attracting investors into the country. An initial major fiscal reform is now being discussed in the National Assembly. 

One of its objectives is to convert an existing sales tax into a more comprehensive VAT. The new VAT would extend to companies operating under an FTZ regime, which has so far been exempt from sales taxes, at least for the supply of those goods and services used to produce goods bound for the local market, or needed for the firm’s day-by-day operations.

Losing their fizz

“The country’s fiscal situation is complicated,” says Erik Rojas, who handles operations for Coca-Cola in Costa Rica (the US drinks behemoth is moving its local concentrate plant to a new facility in the western location of Liberia operating under a FTZ regime – see article on page 14). 

“There are sectors such as ours that have contributed much already, and we continue to contribute. But we also believe that the public sector has to contribute more, cutting costs and streamlining organisational efficiency. It doesn’t work only by increasing revenues. It also works by cutting costs,” he adds. 

“Operationally, it’s not going to be too much of a burden, but it may become a worry if it leads to more consistent changes, such as the introduction of a corporate rate tax for FTZ companies.”

Introduced in 1990, Costa Rica’s FTZ programme has proved a major catalyst for investment and development in goods and services exports. National exports promotion agency Procomer estimated in 2015 that each dollar in incentives offered to FTZ companies generated a return of $6.20 for the country, while the percentage of goods and services sourced locally has doubled to about 40% in the past decade. Besides, local authorities were able to increase the level of value produced within FTZs. 

A wider field

Goods manufacturing evolved from textile and other low value-added production into the current panorama. This is dominated partly by the country’s flourishing clusters for medical devices, its single largest source of exports – in the whole of Latin America, only Mexico exports more medical devices.

In services, typical BPO operations have been partly replaced by more sophisticated shared services centres and even R&D operations. US chip-maker Intel led the way in opening up an R&D centre when it moved its local manufacturing capacity out of the country.

“Our companies don’t take investment decisions looking at the short term, they look at the long term,” says Timothy Scott Hall, public affairs manager at Intel. “We need that legal certainty that allows us to behave predictably in the places where we are. Eventually, the decision boils down to a country where they change the conditions, or another dozen of countries all competing for the same investment because they know [of the] positive economic and social impact [it will have]. It’s a rational decision for the long run, and we wouldn’t expect to experience conditional changes along the way.”

Threat of unrest

The Costa Rican government already faces strikes as parts of the cicil society protest against its fiscal reform. While FTZ operators and companies are unlikely to take to the streets, they continue to work behind the scenes in the National Assembly to fight off the introduction of VAT. 

Costa Rica has been able to reinvent itself several times in the past few decades, making the transition from agriculture exporter to hosting basic operations first, then more elaborate goods and services. The authorities have shown skill in conceiving then executing this transformation, and now Mr Alvarado has to replicate their past successes by striking a delicate balance between the needs of the national purse and the expectations of both the public and businesses, including those operating in FTZs.