COSTA RICA SCD Update COSTA RICA SCD UPDATE June 2023 1 CONTENTS Abbreviations and acronyms 5 Acknowledgments 6 Executive summary 7 Challenge 1. Fuel Broadbased Growth 10 1.1 Outward-oriented growth and the dual nature of the economy 11 1.2 Extending the dividends of the outward-looking growth model beyond the external sector 14 Challenge 2. Address the skills mismatch and enhance inclusion in opportunities 23 2.1 Costa Rica’s outward-driven growth is not leading to a reduction poverty or inequality 24 2.2 Achieving broadbased improvements in livelihoods 29 Challenge 3: Leverage environmental leadership to build a climate-smart economy 34 3.1 While Costa Rica has assumed a leadership role on environmental issues, there are challenges 35 3.2 Deepening the mitigation and adaptation agenda 37 Cross-cutting challenge: Adjust institutions to support quality public service delivery 43 High-Level Outcomes 45 Annex 47 Annex A. The Process of Preparing the SCD Update 48 Annex B. Key Developments since the 2015 SCD 50 Table B.1. Macrofiscal Growth 51 Table B.2. Poverty, Inequality, and (Labor Market) Inclusion 52 Table B.3. Climate Change Adaptation and Mitigation 53 Table B.4. Institutional Reform and Priorities 53 COSTA RICA SCD Update Annex C. Data and Evidence Gaps 54 Annex D. Demographic Trends 55 Annex E. Micro, Small, and Medium Enterprises 56 Annex F. Democracy and the Social Compact 59 References 62 ABBREVIATIONS AND ACRONYMS BEE Business Enabling Environment BCCR Banco Central de Costa Rica, Central Bank of Costa Rica DRM disaster risk management ENAHO Encuesta Nacional de Hogares, National Household Survey FDI foreign direct investment GDP gross domestic product GHG greenhouse gas IEA International Energy Agency IFRS International Financial Reporting Standards Mideplan Ministerio de Planificación Nacional y Política Económica, Ministry of National Planning and Economic Policy MSMEs micro, small, and medium enterprises MtCO2e metric tons of carbon dioxide equivalent NDP National Decarbonization Plan PFM Public Financial Management OECD Organisation for Economic Co-operation and Development SCD Systematic Country Diagnostic SDG Sustainable Development Goal SOE state-owned enterprise UNHCR The United Nations Refugee Agency WWBI Worldwide Bureaucracy Indicators 5 COSTA RICA SCD Update ACKNOWLEDGMENTS The Costa Rica Systematic Country Diagnostic (SCD) Update was prepared by a World Bank team led by Jacobus Joost De Hoop (Sr. Economist) and Barbara Cunha (Sr. Country Economist) and including Agustin Arakaki (Research Analyst), Abigail Baca (Sr. Disaster Risk Management Specialist), Sebastian Bedoya (Research Analyst), Rafael Ben (Energy Specialist), Magdalena Bendini (Sr. Education Economist), Eleonora Cavagnero (Sr. Economist), Natalia Campora (Research Analyst), Daniel Alvaro Diez (Associate Investment Officer), Phillipe Eric Dardel (Sr. Natural Resources Management Specialist, co-TTL), Laura Di Giorgio (Senior Economist), Vincenzo di Maro (Sr. Economist), Alejandro Espinosa-Wang (Sr. Private Sector Specialist), Barbara Farinelli (Agriculture Economist), Pamela Gunio (Program Assistant), Jose Eduardo Gutierrez (Senior Public Sector Specialist), Kjetil Hansen (Sr. Public Sector Specialist), Aylin Isik-Dikmelik (Sr. Economist), Peter Johansen (Sr. Energy Specialist), Adriane Landwehr (Program Assistant), Faruk Liriano (Financial Sector Specialist), Maria Elena Garcia Mora (Sr. Social Development Specialist), Suhas Parandekar (Sr. Economist), Miguel Pereira Mendes (Economist), Li Qu (Transport Specialist), Francesca Recanatini (Lead Economist), Mia Rodriguez (Country Officer), Luz Stella Rodríguez (Social Protection Specialist), Erin Shannon Hylton (Water Analyst), Alejandro Solanot (Sr. Financial Management Specialist), Julieta Trias (Economist), Nicholas Timothy Smith (Financial Sector Specialist), David E. Yuravlivker (Consultant), and Melissa Zumaeta Aurazo (Consultant). The peer reviewers were Stefano Curto (Senior Economist), Ana Maria Oviedo (Senior Economist), and Diji Chandrasekharan Behr (Lead Environmental Economist). The team gratefully acknowledges the guidance provided by Carlos Felipe Jaramillo (Regional Vice President), Michel Kerf (Country Director), Manuel Reyes-Retana (Director, CASDR), Robert R. Taliercio (Regional Director), Doerte Doemeland (Practice Manager), Carlos Rodríguez-Castelán (Practice Manager), Joelle Dehasse (Manager, Operations), Pedro L. Rodríguez (Lead Economist), David Treguer (Program Leader), Marina Bassi (Program Leader), David Vilar (Program Leader), and Carine Clert (Country Manager). 6 EXECUTIVE SUMMARY This note provides an update on the World Bank’s 2015 Systematic Country Diagnostic (SCD) of Costa Rica. The SCD is a core analytical product of the World Bank and a key input underlying the World Bank partnership framework with client countries. This SCD Update is based on consultations with counterparts in Costa Rica and with World Bank sectoral leads and on data analysis and a literature review. The update examines the main development challenges in the country, and it describes high- level outcomes that, if achieved, will contribute sustainably to reducing poverty and promoting shared prosperity. Annex A provides background on the process of preparing this SCD Update. Annex B offers a schematic overview of key developments since the publication of the original SCD, developments that underly the narrative of the update. Annex C outlines some of the data and evidence gaps that the team encountered while drafting the SCD Update. In many ways, Costa Rica is a success story and a regional, if not a global model. The country has been democratically led since the early 1950s and has experienced decades of political stability. Good governance and an outward-oriented growth strategy have resulted in steady economic growth. The Costa Rican government’s social compact has contributed to improvements in the delivery of social services and to progress. The environmental accomplishments of the country are also significant. Costa Rica is the only tropical country in the world that has significantly expanded the natural forest cover in recent decades, which enabled it to firmly establish its green trademark. However, as described in the World Bank’s 2015 SCD, “despite these impressive achievements, there are a number of emerging challenges that will need to be addressed to maintain the country’s successful development path” (Oviedo et al. 2015, 135). For this reason, the 2015 SCD was entitled “From Good to Better.” This SCD Update, which focuses on developments since 2015, maintains that assessment. Costa Rica’s economic model has sustained growth in recent years, but has also intensified disparities. The government’s outward-looking development strategy has contributed to diversification and sophistication in exports and increasing the country’s resilience to external shocks. Although Costa Rica was heavily affected by COVID-19, it weathered the shock better than many other countries in the region. Gross domestic product (GDP) contracted by about 4.3 percent in 2020, but growth rebounded to nearly 8 percent the following year. However, the government’s development strategy has failed to lift the domestic-oriented segment of the economy. Indeed, it intensified the duality of the economy, which was identified in the 2015 SCD and which has limited the country’s long-term growth potential. Growth has been driven mainly by the productivity gains associated with the dynamic external sector. Factor accumulation has slowed as increasing fiscal imbalances have discouraged investment, while skill mismatches have affected labor prospects. Solid growth did not translate into lower poverty and inquality. While net job creation slowed in 2014–19, it also shifted away from low-skill jobs and favored medium- and high-skill jobs, particularly in personal, social, and communication services and manufacturing. Job creation has been mostly driven by the private sector. Productivity growth has been led by growth in services and, to a lesser degree, shifts to industrial employment, reflecting an ongoing structural transformation toward higher value sectors. Around 45 percent of employment, however, remains informal and concentrated in elementary 7 COSTA RICA SCD Update occupations with low productivity. The implications are reflected in poverty and inequality statistics. Economic growth did not translate into lower poverty and inequality; poverty and inequality indicators were essentially flat in the years before the pandemic, when the national poverty rate was about 24 percent, and the Gini coefficient was around 0.500. In line with the dual nature of Costa Rica’s growth, poverty rates are higher in the periphery and among less well educated workers. Labor income among these workers appears to be deteriorating, in contrast with that of medium- and high-skill workers. The impacts of the COVID-19 pandemic continue to reverberate. The pandemic affected the employment and livelihoods of the poorest and most vulnerable the most. Labor market and poverty indicators are still recovering. The pandemic resulted in education deficits induced by school closures, particularly among vulnerable groups, complicating school-to-work transitions. If left unaddressed, these education deficits could permanently hamper the prospects of a generation. The role of the external sector became even more prominent, led by the manufacture of medical instruments, information technology development aimed at foreign markets, and professional services. Fiscal consolidation efforts were complicated, and public debt peaked at 68 percent of GDP, thereby reducing the fiscal space for public investment. These challenges were compounded by high imported inflation and rising interest rates, which exerted an impact on the livelihoods of the poorest and also simultaneously reduced the fiscal space. The government and stakeholders must face the challenge of continuing to advance reforms in support of long-term growth and welfare gains, also beyond the external sector. Costa Rica is a small open economy, which appropriately relies on the external sector as an engine of long-term growth. However, the conditions for the domestic-oriented sector to thrive need to be created, and, to the extent possible, commercial links must be established with the dynamic export sector. This entails extending the favorable conditions created to attract foreign investment in the economy. The business environment must be improved, and the regulatory distortions that disproportionally burden domestic enterprises and reduce competition must be addressed. Closing the large infrastructure gap that increases production costs and hampers access to jobs and markets, especially in rural areas, is critical. Enhanced access to finance is required among firms and households to tap into the latent potential of the economy. Continued commitment to balanced fiscal consolidation and public sector efficiency is crucial to reducing the distortions in the economy, curbing the crowding out of private investment by the public sector, and creating the fiscal space needed for investment, including green investment, redistribution, and the response to future shocks. Improving human resource management and state- owned enterprise (SOE) governance are key inputs in this process. Broadbased growth must go hand in hand with social reform to improve livelihoods for all. The reform will have to enhance labor market inclusion. This includes improved skill acquisition to match the demands of the labor market, which would also support the continued transformation of the country’s production structure to promote knowledge-intensive and high–value added sectors. It would likewise facilitate the transition of youth from school to work. Strengthened skill acquisition will have to be complemented by strengthened technical learning to address the unsatisfied demand for technical workers, enhance the skills of migrant workers, and offer permanent education services to meet the evolving skill requirements. Enhanced labor market inclusion would entail removing barriers to the participation of women in the labor market, particularly through a redistribution of the burden of care. And it would entail addressing the barriers to growth among small entrepreneurs, including access 8 to finance and training and a reduction in red tape. The reforms need to encompass a (more) progressive fiscal system and the provision of adequate social assistance targeted on those who cannot work. A better understanding of the policies needed to include historically disadvantaged groups is urgent required. Reforms should be implemented in health care and social protection. In the health sector, the reforms must respond to new challenges, including population aging, unhealthy lifestyles, air pollution, and the increasing burden of chronic noncommunicable disease. In social assistance, reforms should pursue improvements in targeting. Because the relevant budgets are financed through earmarked taxes on wages, allocations for social expenditure are procyclical, and this currently complicates the response to crises. Costa Rica’s leadership in environmental sustainability offers opportunities for the continued development of a climate-smart economy. The country’s green trademark has generated major economic dividends aligned with the outward-looking model. Reforestation efforts have contributed to a successful eco-tourism industry and helped attract multinational corporations with sustainable investments, thereby reinforcing foreign direct investment (FDI). To maintain Costa Rica’s position as a climate leader, the government and stakeholders have committed to ambitious decarbonization goals. The challenge now is to pivot from a focus on forest expansion to a balance between the forest and sustainable activities and to efforts to reduce greenhouse gas (GHG) emissions. Achieving these goals will require significant investment and potential broader social and economic adjustment, but the anticipated benefits may be large. While fiscal constraints limit public investment in the near term, there are opportunities to tap into private resources through green financing initiatives. Simultaneously, continued adaptation is needed to protect citizens, businesses, and infrastructure from the growing exposure to climate disasters. The formalization and implementation of a comprehensive disaster risk finance policy framework are desirable, and so is the development of institutional and regulatory tools for sustainable and risk informed land use. Addressing institutional gaps in water resource management is another goal in the endeavor to foster resilient and sustainable development. Institutional reform is a cross-sector priority for underpinning green, broadbased growth and improved livelihoods. One target of reform is to lessen fragmentation and enhance coordination in the public sector. An example is the need to reduce the proliferation of public (often autonomous) institutions that were created to make the government apparatus more agile, but resulted in diminished coordination, transparency, and accountability. A greater focus in public investment management on efficiency and outcomes would generate broad benefits and is crucial to raising the quality of public services. 9 CHALLENGE 1. FUEL BROADBASED GROWTH 1.1 OUTWARD-ORIENTED GROWTH AND THE DUAL NATURE OF THE ECONOMY Costa Rica’s growth has become increasingly driven by external forces since 2015. An outward- oriented growth model, investment in human capital, political stability, and good governance allowed Costa Rica to double its income per capita in the last two decades, outperforming most regional peers. GDP growth has weakened marginally since the 2015 SCD (Oviedo et al. 2015), but has remained above regional and global trends and continued to support a slow convergence with US per capita income until 2019. The drivers of growth have changed in recent years, explaining part of the weakening. External demand has become more prominent (figure 1). The net goods exports have added to the expanding role of net service exports. Domestic demand, particularly investment, lost steam in 2014–19 as fiscal constraints limited public investment and raised uncertainty among private investors. While economic activity continued to transition from agriculture toward services, the participation of manufacturing rose slightly, helped by a more sophisticated export sector. On the accounting side, factor accumulation declined consistently in overall importance for growth. In addition to subdued investment, labor growth stalled because of the slower expansion of the working-age population and stagnant participation and employment rates (see, respectively, annex D and challenge 2). Human capital made a stable, but relatively small contribution, in line with education challenges (see challenge 2). Average total factor productivity gained importance as a driver of growth, as Costa Rica consolidated the outward- looking model that promoted FDI. Productivity growth was driven primarily by gains in services and, to a lesser degree, by shifts to industrial production and employment, reflecting the continued structural transformation toward higher-value sectors (Ulku and Zaourak 2021). The role of the external sector became even more prominent post-pandemic. Companies under special regimes boosted production substantially more than the rest of the economy in 2020–22, led by medical instrument manufacturing, professional services, and information technology development aimed mainly at foreign markets. These dynamics helped compensate for the lower tourism and fewer transport activities during the pandemic. This dynamic is consistent with Costa Rica’s outward-looking development strategy. Late in the twentieth and early in the twenty-first century, the country was successful in attracting substantial FDI, including from high-technology companies, and experienced high trade volumes. Growth in the external sector was driven by deliberate policy choices, such as unilateral tariff reduction, the expansion of free trade agreements, and the creation of free trade zones through a combination of tax incentives and nontax benefits, such as targeted training, infrastructure, and streamlined government processes.1 This strategy also benefited from Costa Rica’s environmental efforts and green trademark, facilitating the attraction of sustainable investment and boosting the country’s tourism. Between 2016 and 2019, FDI equaled roughly 4.5 percent of GDP, on average, well below the high rates observed earlier in the century, but still a force in the economy.2 The participation of FDI in manufacturing increased, particularly in special economic zones. Trade as a share of GDP fluctuated between 62 percent and 70 percent during the period. Even if trade now represents a smaller share of economic activity, the complexity diversification of exports has risen steadily.3 1 The significant trade agreements of which Costa Rica is a signatory include the Dominican Republic–Central America– United States Free Trade Agreement, the Pacific Alliance (with Chile, Colombia, Mexico, and Peru); the European Union Central American Association Agreement; and the Comprehensive and Progressive Agreement for Trans-Pacific Partnership. 2 The number of companies operating under the free trade zone regime rose from 331 in 2015 to 394 in 2019. By 2019, compa- nies in free trade zones generated (directly or indirectly) employment for over 187,000 workers and 8.4 percent of GDP. The average salary in free trade zones was 1.2 times the average salary in the country’s private sector. 3 Primary products, including bananas and pineapples, are a large component of the export mix. 11 COSTA RICA SCD Update FIGURE 1. DRIVERS OF GDP GROWTH Growth Decomposition - Demand Growth Decomposition - Accounting 80 80 70 6,0 4,5 70 4 5,0 4,0 4 60 60 3,5 3 50 4,0 50 3,0 3 40 3,0 2,5 40 2 2,0 2,0 2 30 30 1,5 1, 1,0 20 20 1,0 1, 0,0 0,5 0 10 10 -1,0 0,0 0 0 0 2009-2014 2014-2019 -2,0 2008 2009 2010 2011 2005 2006 2007 2012 2013 2014 2015 2016 2017 2018 2019 2020 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2009-14 2014-19 Capital Stock Human Capital per Labor Agriculture Manufacturing Services Agriculture Manufacturing Services services) Consumption Investment Net exports (services) Labor Total Factor Productivity Government spending Net exports (goods) GDP GDP: Sector Composition 80 70 4,5 4,0 60 3,5 50 3,0 40 2,5 2,0 30 1,5 20 1,0 0,5 10 0,0 0 2009-2014 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 09-14 2014-19 Capital Stock Human Capital pe Agriculture Manufacturing Services n Investment Net exports (services) Labor Total Factor Prod spending Net exports (goods) GDP Sources: World Bank calculations; data of the Central Bank; data of PWT (Penn World Table) (database version 10.0), Groningen Growth and Development Centre, Faculty of Economics and Business, University of Groningen, Groningen, the Netherlands, https://www.rug.nl/ggdc/productivity/pwt/. This dynamic also reflects the effects of a challenging macroeconomic environment on the domestic economy. Costa Rica’s fiscal position continued to deteriorate as the fiscal balance rose gradually from 5.5 percent of GDP in 2014 to 6.7 percent in 2019 led by growing current expenditure (especially on personnel) and interest payments, at the expense of public investment. The government enacted key fiscal reforms (see below) that stabilized the public debt in the medium run, but implementation did not begin until early 2020, shortly before the pandemic hit and delayed progress. The fiscal situation depressed the already structurally low national savings and investment.4 4 Despite healthy growth rates, Costa Rica exhibits the lowest national savings and investment rates among structural peers. There is an important knowledge gap in understanding how relatively healthy growth rates have existed alongside relative- ly low investment and domestic savings rates. 12 The latter dropped by an average of 1.5 percentage points of GDP between 2009–14 and 2015–19 not only because of lower public investment, but also because of the crowding out of private investment by government financing, which reduced domestic liquidity, deepened the country’s perceived risk in international capital markets, and raised the cost of financing throughout the economy. Fiscal consolidation came back on track in 2021. This generated a decline in public debt in 2022 from a peak of 68 percent of GDP. Continuing with an orderly fiscal consolidation that balances social and economic objectives is critical to achieving inclusive growth. While Costa Rica’s outward-looking strategy has supported growth, the dividends have benefited only part of the economy. The export sector is exposed to international competition, attracts international finance and expertise, recruits talented and highly educated Costa Ricans, and has recorded high output and productivity growth. Domestic firms that are able to establish links with the export sector also benefit from productivity spillovers (Sandoval et al. 2018). However, the majority of domestic firms do not enjoy appropriate conditions and capabilities for such integration. They tend to be micro, small, and medium enterprises (MSMEs), which are dedicated to the local market and face a business climate with substantial obstacles.5 This hinders investment, jobs, and knowledge spillovers and encourages informality and declines in aggregate productivity (Monge-González and Torres- Carballo 2015). The contribution of formal MSMEs to GDP declined by approximately 3 percentage points in 2015–19. World Bank enterprise surveys help illustrate the duality of the Costa Rican economy.6 While domestic-owned firms identify access to financing and unfair competition from informal firms as primary obstacles to business development, foreign-owned firms consider the lack of adequately educated workers as the main challenge. The 2017–18 World Economic Forum Executive Opinion Survey provides a similar picture (Schwab 2017). Costa Rican firms report bureaucratic inefficiency, infrastructure gaps, taxes, access to finance, and restrictive regulations as the main constraints on doing business. In line with the rest of the region, it is likely that Costa Rican firms are also being held back by a lack of the managerial knowledge and capabilities needed for the scale and sophistication demanded in the export sector.7 Analytical work is required to map and quantify this gap. Going forward, Costa Rica faces the challenge of fueling long-term growth beyond the external sector. As a small economy, Costa Rica should rely on the external sector to continue tapping into foreign investment and trade as engines of long-term growth, especially because nearshoring is creating new opportunities. However, some aspects of the current growth model might profit from rethinking and be adjusted to maximize the benefits to the economy as whole, creating the conditions for the domestic-oriented sector to thrive and, to the extent possible, establishing commercial links with the economy’s dynamic export sector. This would entail extending the favorable conditions for attracting foreign investment, especially the nontax benefits, to the economy at large, addressing the burdensome regulatory framework that disproportionally affects local firms, as well as the high cost borne by firms because of financing and infrastructure gaps (OECD 2020b). Fostering widespread growth also requires staying on a balanced and steady path toward fiscal sustainability. 5 Small and medium enterprises account for approximately 97.5 percent of formal firms, but only 1.6 percent of all these enterprises are involved in export (see annex C). 6 Enterprise Surveys (dashboard), World Bank, Washington, DC, https://www.enterprisesurveys.org/en/enterprisesurveys. 7 WMS (World Management Survey) (dashboard), London School of Economics, London, http://worldmanagementsurvey.org/. 13 COSTA RICA SCD Update Developing highly skilled talent is key to transforming the production structure to promote knowledge-intensive, high value added sectors by attracting a large, stable inflow of FDI and modernizing the domestic economy. Firms are struggling to find highly qualified technicians and tertiary graduates, especially in scientific fields, leaving many formal jobs vacant. In the services sector, one job offer in three is for technicians, and one in four is for professionals with tertiary education (Maravalle and González Pandiella 2023). In the industrial sector, around a third of firms report that technicians are the most difficult workers to recruit (Maravalle and González Pandiella 2023). Digital skills and a good knowledge of a foreign language, especially English, should be enhanced at any level of education, but especially at an early age. These skills and the completion of secondary education are becoming essential for formal jobs, but are undersupplied in Costa Rica. The skills mismatches that hinder broadbased growth must be resolved (see challenge 2). 1.2 EXTENDING THE DIVIDENDS OF THE OUTWARD-LOOKING GROWTH MODEL BEYOND THE EXTERNAL SECTOR Enhancing the business environment beyond the external sector Business regulations in Costa Rica are among the most burdensome among advanced and emerging peer economies. The regulations and costs associated with starting and, to a lesser extent, closing a business stand out. According to the latest indicators of product market regulation, markets are subject to more stringent regulations in Costa Rica than in any other country of the Organisation for Economic Co-operation and Development (OECD), including Latin American peers.8 Other rankings of regulatory stance convey a similar picture.9 The large barriers to business entry in Costa Rica derive from a combination of lengthy and costly licensing, permit systems, and administrative burdens. Opening a firm in Costa Rica typically requires the completion of 10 procedures and a time lapse of 23 days. The cost is equivalent to approximately 10 percent of the country’s per capita income, about three times the average across OECD countries. The business liquidation process in Costa Rica takes twice as long as inmain peer countries and enables an average recovery from proceedings that is significantly less favorable than in Colombia or Mexico. These barriers, which disproportionally affect MSMEs, limit the creation of new firms and the destruction of unproductive ones. This hampers competition, creates rents, and lowers the share of wages in value added. The resulting higher prices goods reduce consumer purchasing power, which disproportionally affects low-income households. 8 Indicators of Product Market Regulation (dashboard), Organisation for Economic Co-operation and Development, Paris, http://www.oecd.org/eco/growth/indicatorsofproductmarketregulationhomepage.htm. 9 According to the Global Competitiveness Index, Costa Rica ranks 125 (out of 137 countries) with respect to the burden of government regulations (Schwab 2017). Meanwhile, the country slipped in the last doing business exercises, ranking lower than Chile and Mexico. See BEE (Business Enabling Environment): Doing Business Legacy (dashboard), World Bank, Wash- ington, DC, https://www.worldbank.org/en/programs/business-enabling-environment/doing-business-legacy. 14 State controls are particularly restrictive in Costa Rica, and high payroll taxes lead to labor market distortions and discourage formal job creation (OECD 2018). SOEs are active in a range of sectors and activities as monopolies or playing a dominant role. These enterprises are frequently subject to conditions and regulations that are different than those governing their private peers, with implications for the quality and cost of services. This occurs in key sectors, such as electricity, transport, banking, insurance, and petroleum products. In most cases, there is room to improve governance and efficiency in services delivery (see challenge 4). Tax revenues are low in Costa Rica compared with most OECD peers. Despite ongoing efforts to improve tax administration, tax evasion, the narrow tax base, and too numerous tax exemptions still limit revenue mobilization. However, Costa Rica stands out for its tax mix, which relies on social security contributions for about a third of revenue. Payroll charges account for 37 percent of the wage bill. Employers pay 72 percent of these charges, more than among OECD peers. The high costs discourage formal job creation, thereby hurting the labor market and promoting informality (see challenge 2). The OECD accession process helped advance reforms that increased business dynamism and competitiveness in Costa Rica. As a part of the OECD accession process, legislation adopted by Congress improved the insolvency regime (Law 21.436/2021), the regulation of competition (Law 9736/2019), and corporate governance (Law 9392/2016). The success of the reforms will depend heavily on the effective implementation of the new laws through a sound regulatory framework that covers institutional design, adequate human and budgetary resources, and procedural reform. Without proper implementation, high operating costs will continue to affect the ability of firms to accumulate knowledge capital. For example, if a firm faces an unlevel playing field in a complex business environment, investments in innovation, upgrades, or expansions will receive low returns and become much less attractive. Closing infrastructure and connectivity gaps Growth continues to be hampered by logistical challenges because of low-quality infrastructure. While the quality of transport infrastructure has improved in the last decade, Costa Rica still ranks below peer countries (figure 2). Despite efforts to modernize port infrastructure, road and railroad quality has stagnated. In contrast, electricity supply performs relatively well (see below). While there is room for efficiency gains in the sector, it is not considered a top obstacle to economic activity. 15 COSTA RICA SCD Update 4,8 4,9 5,0 4,5 4,3 4,0 3,6 3,5 3,5 3,1 3,0 2,5 2,0 1,5 FIGURE 2. QUALITY OF INFRASTRUCTURE 1,0 0,5 0,0 Costa Rica Latin America Central America Aspirational OECD Aspirational in and the including the in LAC countries Europe* a. Quality of overall infrastructure, 1–7 b. Infrastructure Caribbean Dominican Republictype: value and ranking 4,8 4,9 5,0 7,0 4,5 4,3 5,9 6,0 4,0 3,6 3,5 3,5 5,0 4,5 3,1 3,0 4,0 3,4 2,5 3,1 3,0 2,6 2,0 1,8 1,5 2,0 1,0 1,0 0,5 0,0 0,0 Costa Rica Latin America Central America Aspirational OECD Aspirational in Air (64th) Electricity Overall (110th) Port (98th) Railroad Roads (123th) and the including the in LAC countries Europe* supply (37th) (95th) Caribbean Dominican Republic Source: Schwab 2019. 7,0 5,9 6,0 5,0 4,5 Gaps in hard and soft transport infrastructure have boosted costs and undermined 4,0 3,4 competitiveness. 3,1 The quality of roads and railroads has stagnated, leading to congestion, rising costs 3,0 2,6 of doing business, and burdens in the 1,8 access to jobs, services, and markets. The road network extends 2,0 for 44,316 kilometers, and the road density is the highest in Central America, at 0.87 kilometers per 1,0 0,0 square kilometer of land area. However, 73 percent of the road network is unpaved10. Around 44 percent of the Air (64th) roads paved Overall Electricity are rated (110th) as poor. Port (98th) Only Railroad 22 Roads percent are in good or very good condition. The coverage (123th) supply (37th) (95th) of the road network is especially poor in rural areas, where the access of the population to cities is low. The leading causes are insufficient investments, ineffective planning, and inefficient short-term input-based contractual models that hinder the maintenance of existing assets. This is exacerbated by the fragmented institutional arrangements and overlapping bureaucracies involved in the provision of transport infrastructure and services. Nine SOEs currently share responsibility for transport. Nonetheless, transport infrastructure investment is below what is needed for maintenance and sustainable growth, averaging 1.1 percent of GDP during 2011–17, compared with the 2.4 percent required by the National Transport Plan. Logistics gaps, including sub-utilization of trucks, limited storage infrastructure, and inefficient border crossing infrastructure, adds to transport costs. Seaport quality has improved significantly during the last decade with the completion of the first phase of the new port of Moín in Limon Province through a successful public-private partnership in early 2019. The new port can service larger vessels. Future expansions will enable the handling of the new Panamax ship class able to transit the expanded Panama Canal. A new terminal is expected to reduce the costs of fresh exports through larger reefer terminals and to promote the overall competitiveness of Costa Rica in global markets. Meanwhile, other ports, such as Caldera, continue to operate overcapacity. 10 Around 67 percent of the National Road Network (7,815 km) and 19 percent of the Cantonal Road Network (36,495 km) are paved, leading an average rate of 27 percent, lower than structural peers (Costa Rica INFRASAP, World Bank, 2023) 16 High-speed internet connectivity is now widely available, but disparities in access remain. Internet connectivity underpins economic activities in critical sectors, such as personal and business services, technology industries, commerce, and tourism. It is also critical to maintaining activities during crisis periods, as observed during the pandemic. Internet coverage is relatively high. 4G covers about 90 percent of the country, and 3G coverage is almost universal. The deployment of 5G technologies in Costa Rica has been delayed because of the COVID-19 pandemic, and the use of these bands still needs to be assigned.11 Rising internet access has been a key explanatory factor of the decline in multidimensional poverty in recent years (World Bank 2022b). Nonetheless, socioeconomic and geographical divides persist. About 16.7 percent of households do not use the internet. The gap is particularly significant in remote areas and in rural areas. Moreover, a large share of households, especially in rural areas, rely on mobile devices to access the internet, and this limits the speed capacity of their connection (INEC 2021). Addressing digital connectivity disparities would contribute to diverse development priorities, including the labor market demand for digital skills, access to remote learning during shocks, the labor market inclusion of select workers, and service delivery in the health sector (see challenge 2). It can also contribute to a climate-smart transition and support emergency response systems in the face of climate events (see challenge 3). While the performance of Costa Rica is in line with peers on e-business, there are opportunities to enhance e-government indicators and thereby support institutional development in the country. Governance shortcomings, limited funding, and low private participation are key bottlenecks in infrastructure development. Public investment in infrastructure has been structurally low and has been declining since 2015 because of fiscal constraints. However, beyond increasing resources, there is room to improve spending efficiency and attract more private investment. International public investment efficiency indexes rate Costa Rica below the Latin America and Caribbean average. The public investment system has limited institutional coverage and relies on outdated methodologies. Expanding its reach, modernizing processes, and strengthening project formulation and evaluation may foster efficiency. Public-private partnerships face gaps related to complex regulation and weak institutional capacity. Challenges include regulatory overlaps, weak delivery capacity, lack of clarity in roles and processes, and misconception of the roles and objectives of the public-private partnership model. Untapped private resources could be mobilized by improving the enabling environment and developing the correct financial instruments. Eliminating distortions that affect access to finance Despite recent improvements, access to financing remains an obstacle for firms and households. Financial inclusion allows firms to fund investments and helps households smooth consumption and invest in human capital. Limited, costly financing has affected domestic firms’ demand and supply. Except for Chile, according to the World Bank’s financial inclusion indicator, 11 Efforts have been undertaken to improve the cybersecurity framework, but the government’s new cybersecurity strategy still needs to be implemented, coordination needs to be enhanced across sectors. Fixed broadband penetration among households in Costa Rica is above the Latin America and Caribbean average (60.1 percent versus 48.0 percent), but below the OECD average (95.1 percent). Likewise, internet speeds are lower in Costa Ricans than in developed countries. 17 COSTA RICA SCD Update Costa Rica has outpaced Latin American structural peers in account ownership rates.12 Nonetheless, the recent improvements have not been sufficient to raise the country to the levels of financial inclusion generally prevailing in the OECD. Additionally, access rates to financing are lower among women, the poorest 40 percent of the welfare distribution (the bottom 40), and rural residents. While most firms have bank accounts, only 40 percent of small firms have access to credit lines or loans (against 72 percent of medium firms and 80 percent of large firms). Moreover, the collateral requirements are almost two times greater for small firms. Compared with regional peers, small and medium enterprises in Costa Rica pay higher excess interest on loans relative to large firms (OECD 2020b). Costa Rica fares better than most of its Latin American peers in the use of mobile or internet banking, internet-based purchases, and digital payments. However, intermediation margins are high, and financial technology start-ups in Costa Rica lag their Latin American peers in operating outside traditional segments of provision and in targeting financially excluded populations. The banking sector is resilient, but sectoral distortions limit efficiency and overall performance. The banking system is concentrated, and the State plays a prominent role in the provision of financial services. While the five largest banks hold 79 percent of the banking system’s assets, the four state-owned banks hold 47 percent of credit provider assets, one of Latin America’s largest public ownership shares. Distortions and regulatory asymmetries make the playing field uneven between public and private banks. Public entities have a legal mandate to deposit national currency funds with state-owned banks, which enjoy explicit government liability guarantees. Additionally, private banks must invest 17 percent of their deposits in a fund used by state-owned banks to provide credit in priority segments. Costa Rican financial institutions rank below corresponding institutions in upper-middle-income countries and OECD countries with respect to financial efficiency because of relatively high net interest margins, high overhead costs, and low profitability.13 Credits in foreign currencies represent more than a third of the total credit in the private sector (BCCR 2020). The deteriorating fiscal situation has been the key vulnerability. The exposure of state-owned banks to the public sector, including in loans and securities, represented 14 percent of the total assets of the banks at the end of August 2020, compared with 7.1 percent in private banks. The lack of local capital markets is a source of untapped economic potential. Barriers, such as high government debt, that crowd out the demand for private issuers limit domestic capital market development. In Costa Rica, there is an ecosystem of nonbank financial institutions, including cooperatives, with specific focus areas. Domestic banks are the main providers of long-term credit to commercial clients and for infrastructure projects. Firms do not go to the domestic bond market for financing. Some do seek financing on foreign capital markets. Domestic pension funds deploy their capital abroad because of a lack of domestic investment opportunities. All these factors create an asset-liability maturity mismatch. Capital markets are well-regulated overall, but market development is limited. Insurance penetration is low and has not increased since the 1970s, despite the opening of the sector to private participation in 2008. Because of insufficient insurance coverage, households and small firms struggle if they are hit by shocks. 12 See Global Findex (Global Financial Inclusion Database), World Bank, Washington, DC, https://globalfindex.worldbank. org/#data_sec_focus. 13 The Financial Institutions Efficiency Index calculated by the International Monetary Fund comprises indicators on net in- terest income, lending-deposit spread, noninterest income to total income, overhead cost to total assets, return on assets, and return on equity. See Financial Development Index Database (dashboard), International Monetary Fund, Washington, DC, https://data.imf.org/?sk=f8032e80-b36c-43b1-ac26-493c5b1cd33b. 18 Pursuing growth- and inclusion-friendly fiscal consolidation Costa Rica faced extended periods of persistent fiscal deficits and rising public debt. The public deficit remained above 5 percent of GDP between 2010 and 2021. Fiscal imbalances, which were aggravated by the impacts of the pandemic, caused an explosive growth of public debt, from less than 25 percent of GDP in 2008 to a peak of 68 percent in 2021. The large deficits were a consequence of a sharp increase in public spending in response to the global financial crisis within the context of a lack of initiatives to improve revenue collection (Orviedo et al. 2015). The deficits were aggravated by the rising interest bill. By design, crisis response consisted mostly of permanent measures involving an increase in public sector wages and employment (see challenge 3). Interest rates remained contained at around 2 percent of GDP until 2012. However, the risk perceptions associated with the rising debt stock, combined with tightening international and domestic financing conditions, lifted interest payments to close to 5 percent of GDP, narrowing the fiscal space. In this environment, higher expenditures did not translate into improved public services or in substantial redistribution (see challenge 2). Indeed, the evidence suggests that higher public spending contributed to widening income inequality rather than reducing income inequality (González Pandiella and Gabriel 2017). Ambitious reforms initiated in 2018 have placed the public debt on a declining path. However, careful implementation and complementary efforts are needed to ensure fiscal sustainability and widespread economic gains. At the end of 2018, the government enacted a major fiscal reform, which replaced the sales tax with a value added tax with a broader base, increased personal income taxes, and harmonized the treatment of capital income across tax bases (figure 3). These steps improved revenue mobilization. On the expenditure side, the reform included measures to contain the wage bill, together with a fiscal rule that capped the nominal growth of public spending by amounts that are inversely proportional to the country’s public debt ratio. At the onset of the pandemic in 2020, the government appropriately activated the escape clause in the new fiscal rule, but, since 2021, the government has followed additional spending containment measures, while pursuing the recently approved Public Employment Law, the Public Procurement Law, and debt management reform to help reduce the burden of public debt servicing.14 Ensuring the continuity and careful implementation of these reforms is expected to bring the public debt below 60 percent by 2025 and help restore credibility in the macroeconomic framework of the economy. However, continued improvements in the efficiency in the delivery of social services (see challenge 2) will have to be balanced against the revenue mobilization model by reducing exemptions, widening the tax base, reducing the burden on labor, and expanding the space for priority investment, including climate change–related investment, to turn the government into an engine of inclusive and green growth.. 14 Reform efforts to date and strong results in 2022 are already contributing to investor confidence. They have led to an up- grade in the Fitch rating of Costa Rica (to BB- stable) and in the S&P (long-term foreign to B+ stable). 19 COSTA RICA SCD Update FIGURE 3. PUBLIC DEBT PATH: NO REFORM (SCD 2015) VERSUS REFORM SCENARIOS Trajectory w/o reforms 2018 reform + Spending measures 2018 reform (Fiscal Rule, VAT, IT and BEPS) 2018 Reform + Additional spending measures + Public Employment and Procurement Reforms 105 95 87 85 83 75 75 65 61 55 45 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Source: World Bank calculations. There has made some progress in consolidating the public sector wage bill, but effective implementation of recently approved legislation will be critical to move towards more transparent, sustainable and performance-oriented public employment. At around 15 percent, the public sector employment rate is one of the largest in the Latin America and Caribbean region.15 The fiscal impact of this comparatively large workforce is increased by the fact that salaries and wages are significantly higher in the public sector than in the private sector.16 Following the approval of the 2018 reforms, the government introduced a range of short-term measures to contain the growth in the public wage bill and enable the implementation of the fiscal rule, while it worked on building consensus around a broad public employment reform. This included (1) the suspension of the general increase to the base salary of central government staff, (2) the enactment of a hiring freeze, (3) the elimination of the annual bonus for the public sector, (4) the strict enforcement of the statutory retirement age, and (5) the creation of eligibility rules for annual bonuses. The wage bill declined from 7.4 percent of GDP in 2014 to 6.6 percent in 2022. A New Law of Public Employment was approved in March 2022.17 It allows for the reduction of the public employment wage bill through the standardization of various 15 WWBI (Worldwide Bureaucracy Indicators) (database), World Bank, Washington, DC, https://datacatalog.worldbank.org/ search/dataset/0038132/Worldwide-Bureaucracy-Indicators. 16 Costa Rica public sector employees enjoyed a compensation premium of 74 percent over their private sector counterparts in 2017. 17 The New Law was submitted twice to the constitutional court for review and validation. The approved reform is considered fully consistent with the constitution. 20 subregimes of labor relations and wages across the government and the decentralized public sector.18 It thus simplifies the current compensation system through a transition to a single-spine salary system, with a ceiling on the top salaries. The goal is to evolve toward a more transparent and sustainable performance-based compensation system. However, the outcome will depend on an effective and comprehensive implementation of the law, starting in 2023. Progress has also been made in addressing challenges in the procurement system. Procurement practices added to the country’s fiscal burden prior to the pandemic. Better practices in public procurement might have delivered significant efficiency gains. In 2016–17, the government conducted a strategic sourcing analysis of public procurement and concluded that the introduction of tailored strategies to boost the efficiency of public procurement could have saved 15 percent–21 percent in costs. The government has since enacted a new Procurement Law that addresses many of the changes recommended in the analysis. It streamlines procurement processes, makes contracting mechanisms transparent, and promotes efficiency in public spending. It establishes a unified digital system for all contractual activity involving the use of public funds, eliminates separate contracting regimes so the entire state apparatus uses the same parameters, constrains noncompetitive practices, and encourages the use of umbrella contracts to improve efficiency. Improving SOE governance to enhance private sector growth Because of the numerous SOEs, Costa Rica has one of the largest public sectors in Latin America and the Caribbean. At the level of the central government, 28 SOEs play a dominant role in critical sectors, such as electricity, transport infrastructure, banking, insurance, and petroleum products. This translates into substantial government control over the economy, frequently accompanied by restrictions or asymmetric conditions that affect other participants. This restricts competition, leading to operational and allocation inefficiencies that reduce productivity and may also increase prices (Hsieh and Klenow 2009). Even liberalized sectors, such as telecommunication and insurance, retain a dominant incumbent SOE. The Instituto Costarricense de Electricidad, the electricity company, dominates the electricity sector. It provides all transmission services and is responsible for 44 percent of the distribution (see challenge 3). The share of private sector generation is limited to 30 percent, which means that private firms compete for the market rather than in the market, that is, to enter the market, they must win tendering contracts from the Instituto Costarricense de Electricidad. Barriers to foreign participation in the sector—35 percent of the capital of the generating firms must be domestic— reduces competition and keeps prices relatively high. Concerns about the lack of a level playing field and the call to tap into the growth potential of the private sector have not been addressed. SOEs often enjoy government-granted revenue streams. Thus, public banks have the advantage over private banks of a total government deposit guarantee. The banking sector is highly concentrated. Three public banks control around 60 percent of total assets, while the rest is controlled by nine foreign private banks and two domestic private banks. 18 An exception is made for those SOEs that are competing with the private sector, workers in universities, the judicial system, the Congress, the social security institute, the National Insurance Institute, and municipalities. These exceptions stem from the rights recognized in Costa Rica’s Constitution. Whether the exceptions apply to the institutions themselves or only to certain job categories within the institutions is a matter of current debate. 21 COSTA RICA SCD Update Several distortions and regulatory asymmetries fragment the market and reduce competition. Key asymmetries include the legal obligation imposed on public nonbank institutions to deposit their cash in public banks and the requirement that public banks must contribute to many state funds. A good strategy in all sectors might involve defining and reporting the costs associated with meeting public policy objectives for each SOE, while improving the conditions for private partnerships. This would allow the economy to benefit from a balanced regulatory environment and good governance and provide fiscally sustainable and more efficient public services. Better SOE governance is crucial to enhancing the redistributive power of tax policy, market competition, and overall growth. Progress has been made in SOE governance, but challenges lie ahead. Since entering the OECD, the country has addressed many governance issues, primarily relative to listed companies (OECD 2022). These include modernizing the framework for the treatment of insolvent companies, respect for shareholder rights, the disclosure of shareholder agreements, and reducing weaknesses in the legal framework. But the full implementation of international accounting standards, establishing SOE performance indicators, strengthening the functioning and remuneration of boards, pursuing public procurement reform to limit the use of exceptions for direct public procurement among public entities, or making clear the separation between commercial and policy goals are still significant barriers.19 SOE reform is an essential part of a pro-growth reform agenda. Phasing out asymmetric regulations would boost competition and have an positive economy-wide impact by facilitating access by firms and households to financial services at lower cost. Reforms to crowd in the private sector could focus on optimizing the government’s role in important markets and strengthening business regulation with government shareholding. Making effective the separation of monopolistic activities (such as the operation of the transmission network) from activities that can be subject to competition (such as generation and retail supply) can generate considerable benefits in innovation and lower prices (IEA 2019). The government should also consider relaxing the restrictions and caps on private sector participation. 19 See IFRS Accounting Standards Navigator (dashboard), International Financial Reporting Standards Foundation, London, https://www.ifrs.org/issued-standards/list-of-standards/. 22 CHALLENGE 2. ADDRESS THE SKILLS MISMATCH AND ENHANCE INCLUSION IN OPPORTUNITIES 23 COSTA RICA SCD Update 2.1 COSTA RICA’S OUTWARD-DRIVEN GROWTH IS NOT LEADING TO A REDUCTION POVERTY OR INEQUALITY Poverty rates in Costa Rica continue to be among the lowest in the region. Yet, economic growth is no longer translating into reduced poverty or narrowing income inequality. The Costa Rican government’s social compact has historically played a key role in the delivery of services and social progress. Poverty rates continue to be low compared to other countries in the region. The assets of the poor are still growing, as reflected in improving multidimensional poverty indicators. Progress is notable, for instance, in secondary-school attainment, social assistance, and internet access. Yet, even combined with healthy economic growth, these advances do not translate into a decline in income poverty (figure 4). In the decade prior to the onset of COVID-19, incomes among the bottom 40 percent of the income distribution and, consequently, poverty rates were about as high at the start of the pandemic as they had been a decade earlier.20 This means that Costa Rica is a striking exception in a region with falling poverty and inequality rates. The pandemic accentuated the income inequality in the country because the declines in income were even more pronounced at the bottom of the income distribution than at the top. The poverty rate (national definition) rose from nearly 24 percent in 2019 to 30 percent in 2020. With the subsequent economic recovery, the poverty rate fell to 25.5 percent in 2022, but remained above the pre-pandemic level. The recent high levels of inflation have exerted new upward pressure on poverty rates.21 20 The poverty rates referred to here are measured in accordance with Costa Rica’s national definition, which is more ambitious than the international poverty line used by the World Bank for upper-middle-income countries. 21 The composition of Costa Rica’s poor has changed in some respects relative to 2015. Because the population is aging, the elderly have come to represent a growing share of the poor. The working poor are increasingly self-employed, in contrast with the share of the self-employed among all workers, which is roughly stable. However, in many other ways, the profiles of the poor have remained similar. The bulk of the poor have low educational attainment (a little over 95 percent have completed at best secondary school); households with children are still nearly twice as likely to be poor; women continue to exhibit higher poverty rates than men, particularly at childbearing and childrearing ages among the women; and poverty rates are still markedly higher (at about 70 percent) among households with unemployed heads. 24 FIGURE 4. GDP GROWTH HAS NOT TRANSLATED INTO DECLINING POVERTY OR INEQUALITY 35 30,0 7 30 24,2 24,6 23,9 25,5 6 25 5 20 4 15 3 GDP per capita growth (%) 10 2 Poverty rate (%) 5 1 0 0 -5 -1 -10 -2 -15 -3 -20 -4 -25 -5 -30 -6 -35 -7 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 GDP per capita growth rate Overall poverty Extreme poverty Source: World Bank calculations based on data of ENAHO (Encuesta Nacional de Hogares, National Household Survey) (dashboard), National Institute of Statistics and Census, San José, Costa Rica, https://inec.cr/estadisticas-fuentes/encuestas/encuesta-nacional- hogares; WDI (World Development Indicators) (dashboard), World Bank, Washington, DC, https://datatopics.worldbank.org/world- development-indicators/. The government’s outward-focused growth strategy does not favor less well educated workers and residents in remote areas. The government’s externally focused growth strategy has supported the expanding participation of higher value added sectors in job creation, such as electronics, medical devices, and information technology services (see the 2015 SCD, Oviedo et al. 2015). As net job creation slowed in 2014–19, it began shifting away from low-skill jobs (especially agriculture) in favor of medium- and high-skill jobs, particularly in personal, social, and communication services and manufacturing (figure 5). Job creation became mostly driven by large firms in the private sector. Accordingly, the labor market situation of less well educated workers has not improved since 2015, despite economic growth. Less well educated workers were less likely to be in the labor force at the end of 2022 than in 2015, though the unemployment rate among these workers remained unchanged. Because higher value added growth is concentrated in the central valley, labor market opportunities outside the San José greater metropolitan area continue to lag. Labor force participation rates are about 4 percentage points lower in rural areas; the underemployment rate is about 4 percentage points higher; and there is a gap of about 12 percent in the formality rate. Indeed, poverty rates are structurally lower in urban areas and in the central valley. Research suggests that poverty rates are especially high in cantons along the borders with Nicaragua and Panama and that regional disparities have been rising. Perhaps paradoxically, because of rising urbanization, the poor are now predominantly located in urban areas. 25 COSTA RICA SCD Update FIGURE 5. EMPLOYMENT GROWTH, BY SECTOR AND SKILL LEVEL 3,0 3,0 3,0 3,0 2,5 2,5 2,5 2,5 2,0 2,0 2,0 2,0 1,5 1,5 1,5 1,5 1,0 1,0 1,0 1,0 0,5 0,5 0,5 0,5 0,0 0,0 0,0 0,0 -0,5 -0,5 -0,5 -0,5 2010-2014 2010-2014 2015-2019 2015-2019 2010-2014 2010-2014 2015-2019 2015-2019 Agriculture Agriculture Manufacturing Manufacturing ConstructionCommerce Construction Commerce High skill High skill Medium Medium Low skill Low skill skill skill Financial Professional Financial Professional Personal Personal Sources: INEC 2021; data of ECE (Encuesta Continua de Empleo, Continuous Employment Survey) (dashboard), National Institute of Statistics and Census, San José, Costa Rica, https://inec.cr/estadisticas-fuentes/encuestas/encuesta-continua-empleo. A sizable share of the workforce continues to operate in the informal sector, which offers limited economic opportunities. Although perhaps less so than in other Central American countries, a substantial portion of employment—slightly less than 45 percent—is in the informal sector and concentrated in elementary, low-productivity occupations. About 74 percent of the working poor are in informal employment, and 39 percent are self-employed (up from 35 percent in 2015). The majority of microentrepreneurs indicate that they are running their businesses out of need. Annex E, which presents evidence based on a survey of informal microentrepreneurs, shows that the challenges experienced by informal microentrepreneurs mirror those in the broader economy as detailed in challenge 1. These microentrepreneurs consider the lack of access to finance, training, and formal procedures and supports as the main obstacles to the growth of their businesses. The data suggest that the profitability of informal microenterprises and the obstacles to growth they experience have not improved in recent years. Women’s limited access to the labor market contributes to poverty and inequality. There is a strong dichotomy in labor market outcomes among women and men. This situation has not meaningfully changed in the last decade. For instance, even if the female labor force participation rate has inched upward, so has the female unemployment rate, leaving the employment rate among women effectively unchanged, at about 40.5 percent (figure 6). The female labor force participation rate is low in Costa Rica relative to other countries in the region, even those countries with comparable GDP per capita. Caregiving obligations are a critical stumbling block to female labor force participation. There is a clear gradient by educational attainment. Less well educated women are markedly more likely to be out of the labor force because of household obligations (World Bank 2022b). 26 Participation rate 100 80 60 40 Non-poor workers Employment rate 20 0 FIGURE 6. DICHOTOMIES IN LABOR MARKET OUTCOMES, BY EDUCATIONAL ATTAINMENT Formality rate Full-time worker rate AND SEX Comp prim Comp sec Comp sup Labor market indicators, by level of education. 2021 Labor market indicators, by gender. 2021 Participation rate Participation rate 100 100 80 80 60 60 40 40 Non-poor workers Employment rate Non-poor workers Employment rate 20 20 0 0 Formality rate Full-time worker rate Formality rate Full-time worker rate Comp prim Comp sec Comp sup Male Female Sources: World Bank 2022b; data of ENAHO (Encuesta Nacional de Hogares, National Household Survey) (dashboard), National Institute of Statistics and Census, San José, Costa Rica, https://inec.cr/estadisticas-fuentes/encuestas/encuesta-nacional-hogares. Participation rate 100 The Covid-19 crisis exacerbated 80 disparities in the labor market. Labor market indicators showed modest deterioration in 60the final years of the decade before COVID-19. Unemployment, for instance, trended upward, from 7.5 Non-poor workers 40 percent in 2017 to 9.2 percent Employment rate in 2019. The onset of COVID-19 had a dramatic 20 impact on the labor market. 0 The unemployment rate grew to 17.4 percent in 2020 as labor markets rapidly contracted. It subsequently dropped to 8.4 percent in 2022 as the economy rebounded, but continued to be above the pre-pandemic rate. Job losses during COVID-19 were disproportionately large among youth, women, and the low skilled, who were more likely to be employed in the sectors most by therate affectedFormality pandemic. Male This, combined Female Full-time worker rate with a deterioration in education outcomes because of the pandemic (see below), meant that new entrants to the labor market face an uphill battle. They must compete with more experienced workers for limited jobs. Indeed, the share of youth not in education, employment, or training rose from 17 percent in 2020 (pre-pandemic) to 25 percent in 2021, reversing some of the gains of the previous decade. Difficulties in the social integration of migrants and refugees put upward pressure on poverty and inequality. As the political situation in neighboring Nicaragua deteriorated, a new wave of migration from Nicaragua to Costa Rica began in 2018 in addition to the normal seasonal and circular migration. The wave stopped briefly during the COVID-19 pandemic, but then continued in 2021. Costa Rica recorded 250,000 pending asylum cases by the end of 2022 and over 80,000 recorded transiting migrants as of March 30, 2023, mostly from Nicaragua and República Bolivariana de Venezuela (UNHCR 2023).22 Unprecedented numbers of migrants put substantial pressure on the country’s registration and regularization system, as well as housing, health care, social protection, 22 See also Informes Estadísticos Anuales (dashboard), Dirección General de Migración y Extranjería (General Direc- torate of Migration and Aliens), San José, Costa Rica, https://www.migracion.go.cr/Paginas/Centro%20de%20Docu- mentaci%C3%B3n/Estad%C3%ADsticas.aspx. 27 COSTA RICA SCD Update and education services. The extent of transit and irregular migration in the country has made drawing an accurate picture of the phenomenon daunting, including the socioeconomic status of the migrants. The social and labor market integration of the migrants is clearly an immense task. Thus, even though the labor force participation and employment rates among migrants are more than 10 percentage points higher than the corresponding rates among Costa Rica nationals, Nicaraguan migrants are 10 percentage points more likely to be poor.23 Addressing this problem will require a complex policy effort involving regularization, education initiatives, and a reduction in the barriers to integration in society and in the labor market (Mora 2021; Solís Bastos and Hernández Murillo 2022). Ongoing national efforts include the launch of the 2023–27 National Integration Plan for Migrants and Refugees, the mandatory Protocol to Support Migrants during Emergency Crisis, the preparation of national migration policies and strategies, and concessional resource mobilization to cover targeted investments. The fiscal system is being used to offset declines in labor incomes driven by the issues outlined above, but it is not sufficiently progressive to realize reductions in poverty and inequality. In recent years, incomes from labor have declined substantially in the lower part of the income distribution. In the bottom quintile, for instance, income from labor represented over 70 percent of household income in 2010 (according to calculations based on data of the National Household Survey). By 2021, income from labor represented only about 55 percent of household income (figure 7). Nonetheless, because expanded social assistance payments offset the fall in labor incomes, total household incomes at the bottom of the distribution remained stable. However, despite this positive outcome, the fiscal system is not especially progressive. Commitment to Equity analysis—examining the role of taxes, transfers, and social programs in addressing poverty and inequality—concludes that education and health expenditure have a relatively strong redistributive impact in Costa Rica. Fiscal redistribution through taxes and transfers, however, is comparatively limited. Taxes and transfers reduce income inequality (the Gini coefficient) by only a few Gini points. In fact, income inequality among all OECD countries is highest in Costa Rica both before and after accounting for taxes and transfers. 23 Non-Nicaraguan migrants are a small minority of the population, tend to be relatively more highly educated, and generally exhibit lower poverty rates. 28 100% 80% 60% 40% 20% 0% FIGURE 7. THE CONTRIBUTION OF LABOR TO HOUSEHOLD1 INCOME 2 DIMINISHED 3 AMONG 4 THE 5 BOTTOM INCOME QUINTILES Labor Pensions Pub. transfers Priv. transfers Capital + Other a.2010 b. 2021 100% 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% 1 2 3 4 5 1 2 3 4 5 Labor Pensions Pub. transfers Priv. transfers Capital + Other Labor Pensions Pub. transfers Priv. transfers Capital + Other Source: World Bank calculations based on 2010 and 2021 data of ENAHO (Encuesta Nacional de Hogares, National Household 100% Survey) (dashboard), National Institute of Statistics and Census, San José, Costa Rica, https://inec.cr/estadisticas-fuentes/encuestas/ encuesta-nacional-hogares. 80% 60% 40% There is an economic case for addressing disparities in poverty and inequality. Countries with 20% lower income inequality tend to grow more quickly over longer periods relative to those with widening 0% inequality (Berg et al. 2018). Inequality may have long-run detrimental effects through uneven human capital 1 accumulation, 2 fertility 3 rates, 4and the social 5 and political environment. Demographic change adds to the Labor importance Pensions of confronting Pub. transfers Priv. transfers the disparities. Capital + Other Costa Rica’s population growth continues to slow, and the population is aging (see annex D), which will begin to put downward pressure on economic growth and enhance the significance of labor market inclusion. 2.2 ACHIEVING BROADBASED IMPROVEMENTS IN LIVELIHOODS Strengthening education quality, relevance, and inclusion Continued improvements in education are crucial to link future workers with the demand for skilled labor and enhance labor market inclusion. Overall educational attainment has improved. However, the supply of skilled labor remains limited as the share of working age population with no more than 8 years of education is still significant, at 45 percent. Advances in learning in school substantially lag advances in educational attainment (World Bank 2020). Moreover, there are signs that skills acquired in formal education do not match the skills demanded in the labor market. Youth participate in the labor market at less than two-thirds the rate of adults (45 percent versus 78 percent). 29 COSTA RICA SCD Update In addition, informality and low salaries are predominant among youth. In Costa Rica, as in other Central American countries, higher educational attainment does not always translate into higher earnings (especially among men), as reflected in a declining skill-wage premium (figure 8). Efforts to improve educational attainment thus need to be complemented with a focus on the relevance of skills acquired to access the labor market. This is particularly important since the changing world of work (in part associated with the transition toward a climate-smart economy) means increased demand for advanced skills (such as problem solving, adaptability, digital skills, and so on, in addition to foundational skills in literacy and numeracy). FIGURE 8. SKILL WAGE PREMIUM a. Skill wage premium, by gender b. Distribution of job positions according to minimum education required, %, 2018 70 60 0 2 4 6 8 10 12 14 16 18 20 3-year bachelor's degree 50 Full secondary education 40 4-year bachelor's degree Full primary education 30 Partial secondary education Mid-technician (full secondary vocational education) 20 Partial university education 10 Non-formal technical education with the full secondary education Pregraduate degree 0 Partial primary education 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Postgraduate degree Skill wage premium-women 95% CI Skill wage premium-men No schooling Non-formal technical education with full primary education Source: World Bank (forthcoming) based on Costa Rica 2020 (Encuesta Continua de Empleo). Note: Skill wage premium was estimated using controls, such as age, gender, employment type, education, etc. The results for 2020, represents the drastic shift in employment due to COVID-19 shock; capturing only the workers that could still work (mix of essential Source: INEC, National Survey of Job Positions in the workers+ those that could work from home). Services Sector 2018, based on OECD (2023). In addition, there is a need to address a deterioration in education outcomes driven by the pandemic, to avoid a generation with permanently lower education attainment. Deficits in learning outcomes—referred to by some as an education crisis—have only worsened during the pandemic, exacerbating inequities in education outcomes (CORNARE and PEN 2021). Even pre- pandemic, learning outcomes among poor students lagged those of their wealthier peers. During the pandemic, certain student groups were especially affected, including students with special needs, students who attend schools relying on open learning modalities, those from indigenous backgrounds, girls, preschool-age children, and students with little or no connectivity. A gap in digital infrastructure hampers crucial digital skill acquisition of students in rural areas and the periphery and affected their remote learning during the pandemic. In addition, it is likely that learning outcomes for children who attend public schools will lag behind those of children attending private schools, where continuity has been more consistent during the pandemic. 30 Enhancing labor market inclusion of women and less-educated workers Active labor market policy and a focus on workforce development can complement more fundamental, but longer-term improvements in the education sector. This involves strengthened technical and practical learning by continuing the process of modernizing the main technical training agency, the National Institute of Learning (Instituto Nacional de Aprendizaje) (see also Ferreyra et al. 2021). Strengthening this institution could generate broad payoffs and contribute by (1) addressing unsatisfied demand for technical workers, (2) enhancing the skills of migrant workers from neighboring countries, and (3) offering permanent education services to match adult workers with evolving skill requirements. To accomplish this, the government and stakeholders may draw on the existing system of active labor market policies, training, and technical and vocational education and training to connect youth and women more closely to the labor market through integrated interventions that address supply and demand issues, such as wage subsidies, combined with training and complementary measures, including childcare subsidies and vouchers. An encompassing approach to informality and the productivity of micro- and small enterprises is needed. This will require the reform of labor regulations, including taxation, hiring and firing, and social security contributions (see also OECD 2023). These policies could be complementary to new job opportunities in an increasingly decarbonizing country by reskilling workers away from brown jobs toward a green economy (see challenge 3). Enhancing labor market outcomes among women would contribute to gender equality and address some of the longer-term challenges the country faces. A more equal division of caregiving tasks will become a more pressing priority as Costa Rica’s population ages. Moreover, it will help offset the disproportionate impacts of climate change on women, while positioning women to reap the opportunities offered by the transition to a climate-smart economy (Deininger et al. 2023). Women’s access to the labor market can be improved through enhanced access to quality alternative childcare in the medium term and a concerted effort to change social norms around caregiving duties in the longer term. Addressing gender gaps in careers in science, technology, engineering, and mathematics and in labor market transitions would also contribute to more equal labor market outcomes.24 There is likewise room for greater legal equality. According to UN Women, “83.3% of legal frameworks that promote, enforce, and monitor gender equality under the SDG [Sustainable Development Goal] indicator, with a focus on violence against women, are in place.”25 According to the World Bank, Costa Rica could improve “when it comes to laws affecting women’s pay, laws affecting women’s work after having children, and constraints on women starting and running a business” (World Bank 2022a, 1). 24 Only one graduate in three is a woman in science, technology, engineering, and mathematics, and the share of youth not in education, employment, or training is about 6 percentage points higher among women. 25 Costa Rica (dashboard), UN Women (United Nations Entity for Gender Equality and the Empowerment of Women), New York, https://data.unwomen.org/country/costa-rica. 31 COSTA RICA SCD Update Increasing health sector capacity to address new challenges Costa Rica’s health indicators continue to compare favorably to those of other countries with similar per capita income. Already impressive health indicators continued to improve since the publication of the previous SCD (Oviedo et al. 2015). Costa Rica’s strong performance in health indicators is generally attributed to decades of investment in public health, preventive measures, health promotion, the innovative use of integrated comprehensive care teams at the community level, and comparatively low socioeconomic gradients in health outcomes (that is, relatively equitable performance of the health care sector) (Gawande 2021; Rosero-Bixby and Dow 2016; VanderZanden et al. 2021). Nonetheless, the sustainability of Costa Rica’s health system was already under pressure and this situation was aggravated by the COVID-19 pandemic. Population aging, unhealthy lifestyles, high rates of obesity, air pollution, and an increase in the burden of noncommunicable chronic diseases is leading to increasing pressure on the system.26 Noncommunicable diseases now make up the top 7 leading causes of death.27 Moreover, despite increasing health coverage, demand continues to outstrip supply leading to long waiting lists. As in other countries, the COVID-19 pandemic added significant pressure. Data- and evidence-driven health finance reform may help address these challenges. It should comprise (1) a payment model for people without insurance and for people under special programs; (2) payment systems in primary health care and higher level of care; (3) in- depth analysis of cost drivers; (4) an independent health technology assessment mechanism for the introduction of new drugs, treatments, and equipment. Providing adequate social assistance for those excluded from the labor market For those who cannot access the labor market, there is a continued need for timely, reliable, and adaptive social assistance. Social transfers represent an increasingly crucial share of the income of households in the bottom of the income distribution. Of the main social assistance programs, Costa Rica’s noncontributory pensions make an especially important contribution to poverty reduction. They are well targeted compared with the other main social assistance programs and provide relatively high benefit levels. Yet, even the relatively generous social pension program does not fully prevent poverty among the elderly. The share of the elderly (ages 65+) among the poor increased from 9.3 percent in 2015 to 14.4 percent in 2022, reflecting Costa Rica’s increasingly aging population composition and challenges in reaching the most vulnerable. The challenge for social assistance programs to reduce poverty in households with children is even greater. Although targeted by various social assistance programs, households with children remain over-represented among the poor. 26 Levels of harmful air pollutants and suspended particulate matter concentrations in the greater metropolitan area are above the limits recommended by the World Health Organization and substantially higher than in comparable cities in the region. Nationally, annual health care costs because of air pollution are estimated at US$280 million (Tello Medina and Lakovits 2023). 27 The top 7 leading causes of death are ischemic heart disease, stroke, chronic kidney disease, Alzheimer’s disease, chronic obstructive pulmonary disease, stomach cancer, and cirrhosis. See Costa Rica (dashboard), Institute for Health Metrics and Evaluation, Seattle, https://www.healthdata.org/costa-rica. 32 There is a need to reform the design, delivery, and financing of social assistance. Population aging, extreme hydrometeorological events, and the risk of multiple shocks, will increase the demand for social assistance. This will require sustainable and reliable financing, improved program design, and efficient and agile delivery. As of 2019, more than half the budget for targeted programs, which is allocated through the Fondo de Desarrollo Social y Asignaciones Familiares (Social Development Fund and Family Allowances), and around 14 percent of the budget of the Joint Social Welfare Institute (Instituto Mixto de Ayuda Social) are financed through earmarked taxes on wages. This makes social assistance budgets procyclical and therefore complicates response in times of crisis and limits allocation to other priority areas during boom times. Lessons from the COVID- 19 crisis show that, while an ad hoc response, such as the Bono Proteger, contributed to the mitigation of the effects of the pandemic on poverty, strengthening the adaptiveness of social protection is critical, including the availability of reliable and timely mechanisms to adapt programs as well as sources of funding at the time of shocks. In addition, because of the high number of programs, the system is fragmented, which creates inefficiencies in the allocation of scarce resources and frustration among beneficiaries. A specific focus is needed for groups that are at a structural disadvantage. These include single mothers and households with children more generally, who have structurally higher poverty rates. Social assistance benefits, even if they do reach these households, are insufficiently substantive to pull many of these households out of poverty.28 While the national census provides basic information on ethno- racial minorities and vulnerable groups and various in-depth qualitative and quantitative studies are available, data limitations make it difficult to track consistently the socioeconomic situation of minority groups with comparable estimates across years, including Nicaraguan migrants, Afro-descendants, indigenous populations, and sexual and gender minorities. However, previous analysis suggests that these groups are at a significant disadvantage and should be expected to have higher poverty rates (Cortez, Arzinos, and De la Medina Soto 2021; Freire et al. 2018; World Bank 2015, 2022b). A holistic understanding of the combination of policy efforts is critical to improving the situation of these groups. 28 For additional profiles of the poor in Costa Rica, see World Bank (2022b). 33 COSTA RICA SCD Update CHALLENGE 3. LEVERAGE ENVIRONMENTAL LEADERSHIP TO BUILD A CLIMATE-SMART ECONOMY 34 3.1 WHILE COSTA RICA HAS ASSUMED A LEADERSHIP ROLE ON ENVIRONMENTAL ISSUES, THERE ARE CHALLENGES The government and stakeholders are committed to maintaining the country’s leading role in fighting climate change, which has generated important economic dividends aligned with the outward-looking model. The historical commitment of the government and stakeholders to addressing climate change has positioned Costa Rica as a regional and global leader. The tradition of innovation and success is long in the implementation of transformative policies and the application of carbon pricing instruments. The government pioneered the Payments for Environmental Services Program and participates in the Clean Development Mechanism, including the pilot phase of activities implemented jointly. The payments program, funded by a tax on fuel, has helped the country nearly double the forest cover over the last 30 years and reach 52 percent of the national territory. Costa Rica is the only tropical country in the world to have reversed deforestation and has helped shape conservation incentives. National parks and protected areas comprise 26 percent of land area and contribute to a successful eco-tourism industry, which represents around 44 percent of total services exports or 19 percent of total exports and employs almost 7 percent of workers. Globally, Costa Rica has the 10th highest share of electricity production from renewable resources. Less than 1 percent of the country’s electricity is derived from oil, gas, and coal. The country has been able to attract multinational corporations with sustainable investments, reinforcing FDI. The 2015 SCD outlined numerous challenges to climate change mitigation in Costa Rica and highlighted the need to increase the focus on climate change adaptation, which are still highly relevant. Challenges included the need to pivot from reducing net emissions through forest expansion to reducing actual emissions, a need to bring down pollution, and fiscal pressures posed by the Payments for Environmental Services Program, as well as the need to address vulnerability of the urban population and infrastructure to natural hazards. Costa Rica’s emissions increased rapidly (176 percent) in the last two decades, and are largely generated by transport (43 percent), agriculture (21 percent), and industrial processes and production (9.6 percent). GHG emissions are estimated to increase by 69 percent until 2050 in the absence of additional emissions-reducing reforms. At the same, Costa Rica is still highly vulnerable to natural disasters (ranking 61 in 182 countries in the 2022 ND-GAIN Index).29 Approximately 6.8 percent of its total area is exposed to three or more adverse natural events, largely related to heavy rain and wind. Around 80 percent of Costa Rica’s population reside in areas at high risk of multiple hazards. Infrastructure damage from rains and droughts averaged 0.7 percent of GDP between 1998 and 2018. Damage could rise to 1.6 to 2.5 percent per year over the medium term as extreme hydrometeorological events increase. Costa Rica made significant progress in mapping these challenges, defining objectives, and crafting plans to address them; implementation is now a key area of focus. On the mitigation side, the government has drafted the National Decarbonization Plan (NDP) outlining paths and actions 29 The ND-GAIN index ranks 182 countries using a score that represents a country’s vulnerability to climate change and other global challenges as well as its readiness to improve resilience. See ND-GAIN Country Index (University of Notre Dame Global Adaptation Index) (dashboard), University of Notre Dame, Notre Dame, IN, https://gain.nd.edu/our-work/country-index/. 35 COSTA RICA SCD Update to reach net-zero emissions by 2050.30 The plan includes ambitious goals for emission reductions in strategic sectors. Costa Rica’s strategy to limit vulnerabilities from climate change focuses on (1) building an efficient disaster response system; (2) enforcing building codes, environmental standards, and land use planning regulations (World Bank 2021a); and (3) strengthening the institutional and legal framework. Costa Rica’s National Adaptation Plan includes key milestones for 2022–26 across sectors of the economy. The plan is fully aligned with the national risk management policy (2016–30) and seeks to improve resilience in infrastructure, tourism, and water resource management. Barriers and considerations persist on the path to a successful transition to a climate smart economic model that is consistent with the country’s inclusive growth objectives. This transition will require amplifying the returns associated with lowering emissions, while mitigating adverse impacts. Key elements of Costa Rica’s strategy for reducing emissions include greening transport, ensuring renewable energy production expands in line with demands, integrating forest and agriculture, and mobilizing green financing. A successful transition toward climate smart economy also requires increasing resilience to economic and social impacts of climate related shocks though a holistic disaster risk management (DRM) strategy, as well as the adaptation of vulnerable activities such agriculture. The NDP outlines paths and actions to reach net-zero emissions by 2050, consistent with a 1.5°C pathway.31 It evolved from a single-year target (as in the previous Nationally Determined Contribution) to a multiyear emissions budget of 106.53 million tons of carbon dioxide equivalent (tCO2e) in 2021– 30. Initial estimates suggest that the plan could generate a net economic benefit of around US$54 billion derived from energy savings, reduced congestion, reduced road accidents, improved air and water quality, and the benefits of ecosystem services for tourism, water, and soil health. The plan includes short, medium, and long-term goals related to emissions reductions in strategic sectors. For the transport sector, the NDP focuses on enabling conditions and measures to promote the use of both public and private electric transportation. For the agriculture sector, the NDP promotes programs to help rural communities better manage land resources. For the energy system, the NDP focuses on ensuring that it supports electrification of the economy, enabling Costa Rica to maintain its high share of renewable energy as it meets increasing demand for energy. Continued progress toward decarbonization goals, however, will require large investments and will come with fiscal, economic, and social implications as well as opportunities. The cumulative investment (both private and public) needed to reach the set objective is estimated at around US$31 billion until 2050 (World Bank 2021c). Yet, the fiscal space to scale up public investment is currently limited (see challenge 1). Decarbonization could also lead to economy-wide adjustments, triggering shifts in public revenue sources, and jobs. It may reduce purchasing power and economic opportunities of the poor, requiring policies to accompany these offset negative effects. For instance, the transition to sustainable energy sources could result in job losses in industries that rely on carbon- based production, affecting low-skilled workers who may struggle to find employment in a more climate-friendly economy. It is critical to identify and estimate potential transition costs, map winners 30 Executive Decree no. 41581 of February 2019. The NDP complements the Strategic Plan Costa Rica 2050 and the Territorial Economic Strategy for an Inclusive and Decarbonized Economy 2020–50. 31 Executive Decree no. 41581 of February 2019. 36 and losers from this process, and develop mitigation strategies to address them. At the same time, Costa Rica’s global leadership in decarbonization also creates opportunities, for example allowing the country to position itself as a low carbon exporter and a destination for sustainable investment (which can be supported by efforts to improve the preparedness of its financial sector through the Greening the Financial System Initiative). Indeed, Costa Rica has already attracted multinational corporations with sustainable investments. It is also valuable to quantify the returns associated with these opportunities to inform investment decisions. 3.2 DEEPENING THE MITIGATION AND ADAPTATION AGENDA Supporting an efficient and inclusive transition toward a low-carbon economy Decarbonizing the transport sector is one of the main elements of Costa Rica’s decarbonization strategy. The country’s total carbon dioxide (CO2) emissions were estimated at 10.9 metric tons of CO2 equivalent (MtCO2e) in 2015, of which around 50 percent (5.5 MtCO2e) were from road transport (Blanco Salas et al. 2019). Private passenger cars were the main source of emissions, accounting for 46.6 percent of the road transportation emissions (2.6 MtCO2e). Light duty trucks, buses, and taxis emitted a combined 27.5 percent of road transportation GHG emissions (1.5 MtCO2e). A quick expansion of the fleet of (mostly fossil fuel) private vehicles significantly adds to overall emissions. This expansion is driven by a mix of income growth and shortcomings in public transportation. In the NDP, the government has committed to an ambitious plan of ensuring that 85 percent of its public transport fleet and 95 percent of its light vehicle fleet (private or institutional) will have zero emissions by 2050. Since the country is a frontrunner in renewable energy usage (with roughly 98 percent of electricity coming from renewable sources), decarbonizing the transport sector would mean almost zero GHG emissions throughout the postproduction vehicle life cycle. Costa Rica has put in place a comprehensive strategy to tackle emissions from vehicles, which should be complemented by the continued modernization of the public transportation system. Key milestones implemented in 2018–20 include (1) regulating the construction and operation of the network of electric charging centers; (2) introducing tax benefits for the purchase of electric vehicles; and (3) setting tariffs for charging vehicles. Despite all these efforts, uptake was relatively low (fluctuating around 1 percent of new cars; equivalent to 1,000 vehicles for private/institutional use). To address this challenge, the government is now implementing revisions of the tax incentive scheme, balancing effectiveness and fiscal impact considerations. The scheme will be complemented by a feebate scheme that imposes additional costs on high emission vehicles. In parallel, the government has advanced steps toward the electrification of public transportation. It started piloting three electric buses that were donated in 2021. The government has also started discussions with private concessionaries providing public transport services as part of the renegotiation of their ongoing contracts. Electrification efforts should be complemented by a broad strategy to improve the public transportation system including through integrating networks, reducing travel times, and modernizing information management system. These efforts would also reduce externalities related to road safety, congestion, and air quality. 37 COSTA RICA SCD Update Continuing the expansion of electrification relying on renewable energy sources is critical for significant decarbonization. Costa Rica already generates almost all its electricity from renewable resources. However, a well-functioning and stronger electricity sector is necessary to meet future demand (from the electrification of transport and industrial sectors) at competitive prices. The NDP recognizes the importance of electrification of the economy and highlights the need for consolidating the national electricity system. This entails significant integration of additional variable renewable energy resources, that can help meet demand peaks through improvements in transmission, distribution, storage, and forecasting. There is also a need for strengthening the governance and transparency of the sector to respond to increasing challenges. Having clear rules, simplified procedures, and an appropriate institutional setting is key to achieving these goals. Desirable reforms include the vertical separation of the Instituto Costarricense de Electricidad for more clarity in cost accounting and regulatory accountability, establishing open performance indicators across divisions, transformation of the national energy control center into an independent system operator, and a plan for the engagement of the private sector in variable renewable energy integration. The new draft Law for the Harmonization of the National Electricity Sector (currently in discussion by Congress) and the Law on Distributed Generation (enacted in January 2022) are welcome improvements in the regulatory framework and overall efficiency. New investment in electricity generation will be needed in the medium-term, and as discussed in other infrastructure sectors, financing could become a binding constraint. High reliance on hydro also exposes the system to draughts related to climate change; therefore diversification of renewable sources should be considered as the system expands. Costa Rica is globally recognized for its achievements in the rehabilitation and conservation of forest ecosystems and for its high-value, export-oriented agriculture (that is, bananas, pineapples, coffee, sugarcane, rice, vegetables, and fruit). Over the past 30 years, the country has doubled forest coverage from 26 percent to 52 percent, while agriculture growth continued (representing 40 percent of total exports in 2019) (OECD 2020a). With increases in land area dedicated to forest, competition for agricultural land has become a challenge. Given a clear limit on productive land areas, the emphasis has been on production of high-value agriculture products and better use of grazing pastures (that is, cattle ranching intensification instead of expansion). At the same time, protections to domestic oriented production through border protection (for poultry, pig meat, milk, and sugar) and minimum reference prices for rice, discourage productivity and competitiveness gains. To reconcile the tradeoffs between forest and agricultural expansion, increased production must come from higher yields. This requires more efficient use of inputs, improved labor productivity, reduced food loss and waste, and the adoption of climate-resilient agricultural practices. Raising productivity and continued export success in competitive global markets will require addressing bottlenecks—notably, climate change hazards, infrastructure, innovation, and access to financial services—and maximizing Costa Rica’s comparative advantage in higher-value niche markets. Investments are required both to enhance productivity directly (for example, through irrigation and drainage) and to facilitate access to markets (for instance, through transportation, distribution, cold chain facilities, and so on). Expanding existing financing instruments, such as the Payments for Environmental Services Program, for sustainable agriculture could incentivize low-carbon technologies. Increased productivity and a low-carbon transition will also depend on efficient provision of extension services, notably services that facilitate innovation and improved access to input and output markets. Central to achieving this objective will be the design and implementation of targeted programs 38 to mainstream community supported agriculture solutions, improved private sector engagement, coordination among institutions, and suitable financial flows. As in many countries, policy frameworks, institutional and producer capacity, and financing are significant constraints for a transition to more sustainable agriculture. To optimize land-use outcomes, Costa Rica’s agroenvironmental policy has the potential to serve as an umbrella framework for integrating the NDP with other programs. Collaboration with the private sector and international partners to develop nationally appropriate mitigation actions for coffee production that offer concrete options to expand sustainable agriculture and generate greener jobs provides a good example for other sectors. Coffee production accounts to 9 percent of Costa Rica’s national GHG emissions. To reduce the carbon footprint of the sector and maintain sustainable coffee production, six actions were suggested, as follows: (1) reduce the use of fertilizers, (2) use water and energy in coffee processing more efficiently, (3) promote financial mechanisms to support new agroforestry systems in coffee production, (4) undertake audits at mills to determine their carbon footprint, (5) develop strategies to promote differentiated coffee, and (6) conduct feasibility and project design studies for the implementation of low-emission technologies. Lessons from the sustainable management of green assets could be translated to help maximize the potential of Costa Rica’s abundant blue endowment. With a maritime jurisdiction over ten times the size of its land area, Costa Rica is endowed with substantial marine resources with significant potential to contribute to the country’s climate smart and inclusive growth. Done sustainably, offshore commercial fishing has the potential to contribute to output and public revenues, while small scale coastal fishing and marine tourism can generate jobs in the poorest areas of the country. However, fishing output, trade, and employment have persistently declined in this sector, partially because of overexploitation of coastal fisheries. In this context, data informed licensing, better institutional coordination, and improved monitoring capacity are critical to maximize the long-term economic and social returns of Costa Rica marine wealth. Capitalizing on environmental leadership to attract green private financing and sustainable investment Costa Rica has comparative advantages in attracting investment and financing for mitigation, adaptation, and conservation activities. Costa Rica’s Natural capital is estimated at US$14.5 billion or 23 percent of GDP (two-thirds is derived from oceans and one-third from forests), highlighting the potential for the development of blue and green carbon markets. The country has defined clear strategic goals for its climate transition, but lacks the fiscal space for financing them. Moreover, demand constraints limit climate finance mobilization and the development of green capital markets. Pension funds and insurance companies have ample liquidity in local and foreign currency, but invest up to 70 percent of their funds passively in government bonds. Lack of sustainability mandates, higher return incentives, and availability of green finance information limit participation of institutional investors. Foreign participation in the local bond and equity markets is low, reflecting weak investor engagement efforts and onerous frameworks. Commercial and development banks offer green loan products at preferential rates, but corporate and retail clients’ uptake remains limited. Moreover, despite 39 COSTA RICA SCD Update Costa Rica’s high vulnerability to natural disasters, there is no issuance of climate-resilient bonds and insurance penetration (2.3 percent) is below the Latin American average (3.5 percent). Although green finance-related initiatives have been deployed, developments seem to have slowed after early innovations such as the Payments for Environmental Services Program and debt-for-nature swaps. There is a legal framework for the development of a green finance market, including through requirements for the integration of environmental, social, and corporate governance considerations in investment policies. However, harmonization and coordination between authorities (including ministries and government agencies) is still an issue. Several classification systems to determine which activities or assets can be labelled as green are currently in use or under development, leading to fragmentation of standards and definitions. The potential of capitalizing on Costa Rica’s image as a green leader is underutilized, leaving opportunities in international markets untapped. The green bond market (public and private) remains small, with issuance as a share of GDP low compared to peers. Only one green investment fund is registered in the country. The general immaturity of the Costa Rican capital market is an inhibiting factor, with large companies generally not issuing domestically. Compliance with international standards, excessive domestic regulation, overprotection of investors, and costs of independent verifications have been cited as disincentives for green bond issuers to come to the market. While public funding and policies do not necessarily crowd in private funding, evidence shows its influence on incentivizing private sector investments.32 In the short- term, there is thus an opportunity to use public financing (although limited by the current fiscal space) and complementary financing policies to catalyze green/climate private financing. As fiscal constraints ease, public resources can have an increasing role in financing Costa Rica’s climate strategy. Continue strengthening resilience to climate change Costa Rica is highly vulnerable to extreme hydrometeorological conditions, and climate change will only exacerbate this. The risks posed by extreme hydrometeorological events are reflected in growing losses and damage. The National Commission for Risk Prevention and Emergency Response and the Ministry of National Planning and Economic Policy estimate that US$3.4 billion in losses were recorded between 2005 and 2020 in the areas of infrastructure, service interruption, and production because of disasters related to natural hazards, that is, economic losses caused by natural phenomena (figure 9). It also estimated that 77.9 percent of the population and 80.1 percent of GDP are subject to high risk from multiple hazards (World Bank 2019). Poor and vulnerable populations are most at risk due to unplanned urbanization, particularly for the poor concentrated in the Central Region. Women and vulnerable groups continue to experience disproportionate impacts of climate shocks; regional assessments of DRM systems show a persistent gender gap in women’s access to information, training, and resources (Erman et al. 2021). 32 Key policy actions already taken by the authorities to enable deeper green financing include recently enacted Law 10051 to promote financing and investment for sustainable development through the use of thematic public offerings of securities, secondary legislation, and the development of green financing solutions through the Payment for Environmental Services Program. 40 FIGURE 9. DECOMPOSITION OF THE DAMAGE CAUSED BY HYDROMETEOROLOGICAL EVENTS - Damaged hydrometereological events by type and area. 1988-2018. Millon dollars of 2015 4.000 183,9 3.500 3.000 681,8 662,7 2.500 279,5 639,1 2.000 590,3 1.500 3.166,9 1.000 2.029,8 1.818,3 500 0 Type of event Area Sector Heavy rains Droughts Rural Urban Without classification Road infrastructure Agricultural sector Dwellings Others Source: World Bank 2022b based on MIDEPLAN (2019). Transportation infrastructure (roads and bridges, mainly) suffered most of the damage and losses registered after disasters. Data provided by the National Commission for Risk Reduction and Emergency Response shows that impacts in transportation infrastructure accounted for 49 percent of the total damages between 2010 and 2020 (33 percent for roads; 16 percent for bridges), underscoring the need for including adaptation in road asset management. According to the Ministry of National Planning and Economic Policy, total damages in transportation infrastructure are valued at US$1.912 million for 1988 – 2018, mostly triggered by hydrometeorological hazards, indicating the importance of taking into account the best available knowledge on design standards and natural hazard in physical infrastructure investments. The effects of climate change are also transmitted through water and Costa Rica’s water resources are vulnerable to hydrometeorological extremes. The country’s water security is affected by three main factors, which lead to conflicting priorities between hydropower, water supply, irrigation, and the environment: High water contamination, mostly from untreated wastewater, but also due to the intensive use of agrochemicals in commercial agriculture (herbicides, pesticides and fertilizers), solid waste, and industrial effluents. Relatively high temporal variability in rainfall, which compounded with relatively low groundwater and surface water storage capacity, leads to recurrent water shortages, droughts, and floods. Groundwater overexploitation from illegal wells. Illegal water use for irrigation has been rapidly increasing alongside from 0.8 percent to 4.0 percent of cropped areas from 2000 to 2018. Declining aquifers also impact municipalities, which rely on groundwater for 80 percent of their supply. 41 COSTA RICA SCD Update Exploring circular economy principles to help improve water management, and reduce pollution, while preserving water resources and ecosystems is therefore a priority. Facing these hazards, Costa Rica has been at the forefront of embedding climate adaptation considerations into sectoral priorities. In 2018, Costa Rica approved its 2018–30 National Policy for Climate Change Adaptation, which guides actions and programs on climate adaptation and defines the National Disaster Risk Management Policy. The strategy combines risk mitigation through stronger climate considerations in infrastructure project standards and territorial planning, as well as improved instruments to manage residual social, economic, and financial risks. Since then, the country has continued to make progress in governance and action for adaptation, as reflected in the adaptation chapter of the 4th National Communication before the UN Framework Convention on Climate Change, published in December 2021. The government of Costa Rica has a long tradition of public policies for reducing disaster risk and increasing climate resilience. Recent milestones include the country’s 2020 submission of its updated Nationally Determined Contribution to the United Nations Framework Convention on Climate Change, in support of its efforts to increase resilience to climate change. Additionally, the regulatory and institutional framework for DRM was strengthened with the approval of a legal framework that requires all new public investments to follow best DRM practices and include a risk assessment, with a roadmap to mainstream gender and inclusion in the country’s DRM framework, and with the approval of the country’s first disaster management financing strategy. According to the index of governance and public policy in disaster risk management of the Inter-American Development Bank, Costa Rica ranked fourth in the Latin America and Caribbean region with a level of 54.52 percent (good).33 A recent diagnostic implemented by the World Bank shows that Costa Rica ranks the best among seven nearby countries on emergency preparedness and response and early warning systems (0.69 compared with a regional average of 0.51).34 In the last decade, the government has identified key gaps in terms of decentralization of the DRM responsibilities and capacities, which need to be addressed. Despite having a robust DRM system, institutional capacity gaps persist and constrain climate resilience. Costa Rica’s fiscal space to finance disaster response is limited and the country has not formalized and implemented a comprehensive disaster risk finance policy framework. Institutional and regulatory tools for sustainable and risk informed land-use planning and hazard control mechanisms at a local and basin level are not systematically developed and implemented. Moreover, there are institutional gaps in water resource management for resilient, sustainable, and universal access to water and sanitation, as defined in the National Climate Change Adaptation Plan. Priorities include updating the water resources laws, as well as the National Water Resource Policy, and National Plan for Integrated Water Resources Management. 33 Risk Monitor: Costa Rica (dashboard), Inter-American Development Bank, Washington, DC, https://riskmonitor.iadb.org/ en/country?country=cr. 34 The Central American countries, plus Dominican Republic (World Bank 2021b). 42 CROSS-CUTTING CHALLENGE. ADJUST INSTITUTIONS TO SUPPORT QUALITY PUBLIC SERVICE DELIVERY 43 COSTA RICA SCD Update Despite Costa Rica’s good standing relative to the Latin America and Caribbean region, governance continues to be a constraint to sustainable economic and social progress. The 2015 SCD identified a disconnect between the country’s institutions and procedures and the challenges of a new economic and social environment (Oviedo et al. 2015). Perceptions about government effectiveness and regulatory quality deteriorated further in since 2015, despite some progress in terms of the transparency and stakeholder engagement in the reform process (OECD 2021). A vicious circle of low satisfaction with public sector performance and polarization of the political system continued, making it hard to build consensus and mobilize support for reforms. A consequence of this gridlock has been the proliferation of public (and often autonomous) institutions created to address specific problems. Many of these institutions were born out of a desire to make the government apparatus more efficient and agile, but resulted in lower transparency and accountability. These new bodies end up affecting the government’s efficiency and service delivery, thus further reinforcing discontent and polarization. Small consolidation steps have been made in recent year in the context of rebalancing the fiscal accounts, but more is needed to ensure that Costa Rica’s institutions can continue to underpin the country’s social compact and economic goals. As a result, institutional improvements have slowed down. Generally, the quality of Costa Rica’s governance systems, the stability of its checks and balances, and its budget transparency are satisfactory. However, according to the Bertelsmann Stiftung transformation index, which analyzes transformation processes toward democracy and a market economy, overall areas of concern are (1) political and social cohesion, increasing political fragmentation and polarization, and lower political participation, all within a setting of perceived higher corruption, and (2) service delivery and government steering capability (Bertelsmann Stiftung 2022). These areas remained stable or weakened since 2014 at levels below Costa Rica’s peers. The influence of transnational crime is adding to governance and institutional challenges. Although it is difficult to gauge the impact of this development, the issue gained in prominence since the publication of the previous SCD (see annex F). Over the coming years, the government and stakeholders will have to overcome the slowdown in institutional improvements and service delivery. Institutional and governance improvements are critical to address all the three challenges identified by the SCD Update. This report is populated with many examples of how institutional, regulatory, political, and institutional challenges have limited Costa Rica’s inclusive and green growth perspectives. Those include the large regulatory burden affecting business; institutional fragmentation, planning and contractual challenges hampering transport infrastructure; as well as a large and distortive SOE footprint that limits opportunity for private investment under challenge 1. They also refer to the fragmentation of social institutions and programs, with overlapping mandates and coverage gaps that limited effectiveness of social protection and education quality under challenge 2. They include issues such as implementation and resource mobilization capacity, as well as political consensus needed to advance the implementation of Costa Rica’s ambitious climate change related goals described under challenges 3. 44 HIGH-LEVEL OUTCOMES. 45 COSTA RICA SCD Update This concluding section presents three high-level outcomes—outcomes that are central to improving the lives of the poorest and most vulnerable—and one key cross-cutting theme of institutional strengthening (figure 10). The high-level outcomes will serve as a critical input for the new country partnership framework to be prepared by the World Bank and the government of Costa Rica in the coming year. In the preparation of the high-level outcomes and the underlying priorities, the SCD team applied four criteria. The high-level outcomes need to (1) contribute directly to the twin goals of reducing poverty and promoting shared prosperity, (2) be anchored in the narrative and evidence presented in this SCD Update, (3) be achievable in the medium term, and (4) tie into with the broader development priorities identified in the government of Costa Rica’s national development and investment plan (Mideplan 2022). FIGURE 10. OVERVIEW OF HIGH-LEVEL OUTCOMES AND ASSOCIATED PRIORITIES Eliminating extreme poverty and boosting shared prosperity Fuel broadbased growth Address skills mismatch Leverage environmental Challenges and enhance inclusion in leadership to build a opportunities climate smart economy Increase the creation of Improve household income Amplify the returns to HLOs quality jobs, especially for generating capacity and greening growth disadvantaged populations resilience to shocks • Enhancing business • Strengthening education • Supporting an efficient and environment also beyond quality, relevance, and inclusive transition towards the external sector inclusion a low-carbon economy • Closing infrastructure and • Enhancing labor market • Capitalizing on connectivity gaps inclusion of women and environmental leadership less-educated workers to attract green private • Eliminating distortions that Policy financing and sustainable affect access to finance • Increasing health sector Priorities investment capacity to address new • Pursuing a growth and challenges • Continue strengthening inclusion friendly fiscal resilience to climate change consolidation • Providing adequate social assistance for those • Improving SOE governance excluded from the labor to enhance private sector market growth Cross-cutting Adjust institutional setting to support quality public service delivery The high-level outcomes were prepared in an iterative process. The team drafted the high-level outcomes building on the priorities framework of the original SCD (see annex A), the consultations with sector experts in the World Bank and government counterparts, and the analysis presented in this document. The team received and incorporated feedback on a first and second draft of the high-level outcomes from a wide range of World Bank sector experts at internal review meetings. 46 ANNEX. 47 COSTA RICA SCD Update ANNEX A. THE PROCESS OF PREPARING THE SCD UPDATE This note presents a second-generation Systematic Country Diagnostic (SCD) Update for Costa Rica, as per the IBRD / IFC / MIGA / IDA Guidance. The update is based on the criteria that (1) the preceding SCD was a comprehensive SCD; (2) the broad development narrative for the country as outlined in the previous SCD is still valid; and (3) the preceding SCD was based on adequate data and analytical evidence. The 2015 SCD identified three core development challenges (see figure A.1) related to (1) inclusion and concerns about rising inequality, (2) the economic model which results in uneven growth, and (3) sustainability of Costa Rica’s broader development model. These same challenges remain relevant today and are reflected in this SCD Update. Although the development challenges presented in the 2015 SCD remain relevant, some changes in the period since 2015 are core to the narrative presented in this SCD Update. Notably, growth and job creation is increasingly driven by externally focused, higher value added segments of the economy. This growth, from which a substantial part of the population did not benefit, puts further upward pressure on already high inequality. COVID-19 led to a setback in education outcomes, disrupting the last years of school for some students and hence their transition to the labor market. Fiscal imbalances amplified in 2015–19 and were further aggravated by the pandemic. Structural improvements to the fiscal framework and sound implementation of fiscal reforms can set the country on a sustainable path, but in the near-term limited fiscal space will pose challenges for growth and redistribution. Costa Rica strengthened its green trademark by committing to an ambitious decarbonization agenda, while gradually improving its preparedness to deal with increasingly severe climate shocks. And finally, a vicious and self-reinforcing cycle of low satisfaction with public institutions and polarization of Costa Rica’s political system has intensified. 48 FIGURE A.1. SUMMARY OF UPDATES IN THE COSTA RICA SCD FRAMEWORK 2015 SCD SCD Update Growth and economic Fuel broadbased growth model • Enhancing business environment also beyond the external sector Business environment • Closing infrastructure and connectivity gaps • Eliminating distortions that affect access to finance to support quality public service delivery Infrastructure • Pursuing a growth and inclusion friendly fiscal consolidation Governance Adjust institutional setting • Improving SOE governance to enhance private sector growth Inclusion and concerns Address skills mismatch and support those excluded from about rising inequality economic opportunities Education and skills: • Strengthening education quality, relevance, and inclusion adapting to new • Enhancing labor market inclusion of women and less educated workers market opportunities • Increasing health sector capacity to address new challenges • Providing adequate social assistance for those excluded from the labor market Sustainability of the development model Leverage environmental leadership to build a climate smart Fiscal economy • Supporting an efficient and inclusive transition towards a low-carbon economy Social compact • Capitalizing on environmental leadership to attract green private financing and sustainable investment Green trademark • Continue strengthening resilience to climate change Note: Mapping from the 2015 SCD to the development challenges and priorities identified in the SCD Update. Building on the 2015 SCD, the proposed SCD Update is structured around four closely interrelated challenges for Costa Rica. The first is to adjust Costa Rica’s growth model so that, in addition to benefitting the outward-looking segment of the economy, it creates broadbased economic opportunities. The second is to improve livelihoods for all by enhancing skills acquisition, reducing gender gaps in labor market outcomes, addressing informality, and providing adequate social assistance to those who cannot take part in the labor market. The third is to leverage Costa Rica’s global leadership in environmental sustainability and advance its transition toward a climate smart economy. The fourth, which is a cross-cutting challenge, is to upgrade and modernize the institutional framework in line with Costa Rica’s economic, social, and sustainability goals and enhance the quality of government spending to improve public service provision. Figure 1 (above) shows how the organization of the 2015 SCD (left) maps to the structure of the SCD Update (right). The SCD Update is based on the inputs of World Bank sector colleagues, data update and benchmarking exercises, and in-country consultations. World Bank sector colleagues provided inputs on the latest sector developments and identified new emerging challenges the country faces. The SCD team combined these inputs, which are described in the present note, with a benchmarking exercise and in-country consultations with the government and civil society. 49 COSTA RICA SCD Update ANNEX B. KEY DEVELOPMENTS SINCE THE 2015 SCD The previous SCD, written in 2015, identified three key challenges facing Costa Rica: (a) despite economic growth and a solid commitment to its Social Pact, poverty reduction had stalled and inequality had increased; (b) Costa Rica’s GDP per capita did not converge toward high-income countries such as the USA, unlike in countries such as Chile, Panama and Uruguay; and (c) fiscal pressures threatened the sustainability of the Social Pact and the country’s Ecological brand, and prevented badly needed investments in public infrastructure. Each of these challenges still holds true, as validated by both updated data analysis and consultations on the ground, although there have been minor changes. The previous SCD also identified four ‘transversal areas’ to tackle those challenges: (a) strengthening education and capacitation systems; (b) promoting competitiveness and reducing the infrastructure gap; (c) strengthening governance; and (d) taking measures to guarantee the sustainability of the fiscal accounts as well as the Social Pact and the country’s ecological brand. These areas remain relevant and served as a starting point for preparing this report. FIGURE B.1. PRIORITY AREAS, LINKS, AND COMPLEMENTARITIES IDENTIFIED IN THE 2015 SCD Priority Areas, Linkages & Complementarities Inclusion & concerns Growth & about rising inequality Economic Model Education & Skills: Competitiveness Adapting to the changing labor market opportunities Business Infrastructure Governance Climate Sustainability of the Development Model Fiscal Social Compact Green Trademark Source: Oviedo et al. 2015. 50 The tables below give an overview of key findings of the 2015 SCD and the developments since then. The tables are structured in accordance with the challenges for Costa Rica discussed in this note. The left-hand column discusses the conclusion of the 2015 SCD. The right-hand column presents the findings of the team working on the SCD Update. TABLE B.1. MACROFISCAL GROWTH a. 2015 SCD main findings b. Trends since 2015 GDP grew 3.5 percent during 2015–19, but with lower figures in 2018 and Growth: Costa Rica grew 6.7 percent on average during 2003–07 2019. GDP contracted 4.1 percent in 2020 (COVID) but growth rebounded but decreased to 3.5 percent in 2012–14 after the financial crisis to 5.9 percent in 2021-22. Potential GDP growth stayed at 3.4 percent in Potential GDP grew 3.7 percent 2010–14a (below Latin America 2015–19 and is expected to fluctuate around 3 percent in the post-COVID. and the Caribbean and income peers). (above peers pre-COVID, but slightly below after) Convergence: Moderate convergence to US income: GDP per capita Converge continued in 2015-17 but stalled at around 20.8 percent in 2019. increased from 15 percent to 20 percent of the US’s between 1990 (Latin America and Caribbean countries did not converge and some and 2014. (faster than Latin America and the Caribbean, but slower diverged during this period, other peers converged moderately) than aspirational peers) The deficit increased further to reach 6.7 percent of GDP in 2019, as Fiscal: While the central government deficit declined continuously expenditures increased by another 3.1 p.p. of GDP, surpassing the 2 p.p. in 2000-07 (from 3.7 percent of GDP to around 0), it increased from increase in revenues. The implementation of 2018/2019 reforms and 4.3 percent in 2011 to 5.7 percent in 2014. Revenues declined by spending containment is expected to bring the deficit to 4.3 percent of 0.3 p.p. of GDP, while expenditures increased by 1.3 p.p. during this GDP, helped by an additional 0.7 increase in revenues and 1.6 decline in period. expenditures with respect to 2009. Public Debt Sustainability: The central government debt was Debt is higher but sustainable. The debt increased continuously to 56 on an unsustainable path: it increased from 27 percent of GDP in percent in 2019 and 68.2 in 2021, due to the impacts of COVID. However, 2007 to 37.8 percent in 2014 and was projected to reach 63 percent the debt is expected to decline to 67.4 percent in 2022 and follow a in 2009 and continue expanding in the absence of corrective declining path to 52.8 percent in 2030 if approved reforms continue to be measures. implemented. Consumption and trade led growth between 2015–19, while investment Sources of growth: Growth was balanced before the financial crisis, remained stagnant. The balance returned in 2021-22, when both but consumption gained a primary role between 2010–14, while net investment and net trade played a role in the recovery. Services continued to exports became negative. Services was the sector driving growth. be the main sector driving growth. Productivity: TPF growth averaged 0.6 percent in 2000–07 and Total factor productivity growth moderated back to 0.7 percent in 2015–19. increased to 1.8 percent in 2010–14 (factor accumulation fell)b Trade: Trade accounted for 85 percent of GDP in 2000–07 and Trade remained around 64 percent of GDP in 2015–19 but recovered to dropped to about 66 percent in 2010–14.c Similarly, exports (G&S) around 70 percent in 2021–22. Export gradually recovered (32.7 percent declined from 41 percent of GDP in 2000–07 to around 31.7 percent in 2015–19 and 36 percent in 2021–22). Export sophistication and in 2010–14. Export sophistication and diversification increased diversification increased continuously, but the number of destinations continuously. stalled after 2015. FDI: FDI remained around 5.9 percent of GDP in 2000-07 and FDI decreased to around 4.7 in 2015–19, and 2021–22 (above Latin America 2010–14 periods (above peers). and the Caribbean but below inspirational peers in Europe) a. World Bank estimates using MFMod. b. PWT (Penn World Table) (database version 10.0), Groningen Growth and Development Centre, Faculty of Economics and Business, University of Groningen, Groningen, the Netherlands, https://www.rug.nl/ggdc/productivity/pwt/. c. WDI (World Development Indicators) (dashboard), World Bank, Washington, DC, https://datatopics.worldbank.org/world- development-indicators/. 51 COSTA RICA SCD Update TABLE B.2. POVERTY, INEQUALITY, AND (LABOR MARKET) INCLUSION a. 2015 SCD main findings b. Trends since 2015 The poverty rate remained stable before the COVID-19 pandemic, oscillating Poverty: Poverty reduction had stalled. After a declining trend in around 23 percent between 2010 and 2019. In 2020 it shot up to 30 percent due 1990- 2007, the poverty rate increased after the 2008 financial to the COVID-19 shock, and in 2021, it dropped to 26.2 percent, but it was still crisis and remained at 24 percent in 2010–14. higher than in 2019. Extreme poverty followed a similar path. Extreme poverty followed a similar trajectory, but with less variation. Inequality was fairly stable in the years between 2015 and the pandemic. The Inequality: Inequality had increased. The Gini coefficient increased Gini coefficient increased slightly since the start of the pandemic, from 0.514 in from an average of 0.50 in 2000-09 to 0.52 in 2010–14 2019 to 0.524 in 2021 and then dropped to 0.504 in 2022. Unemployment showed an upward trend in the years before the pandemic Labor market: Unemployment increased during the crisis in 2008 (from 7.5 percent in 2017 to 9.2 percent in 2019). It grew to 17.4 percent in 2020 reaching 9 percent in 2014. In particular, weak job creation for due to the shock of Covid, and dropped to 8.4 percent in 2022, as the economy the unskilled. Unemployment reached 22 percent for the lower rebounded. quintile, compared to about 5 percent in El Salvador, Honduras Females, youth, migrants, refugees, asylum seekers, and the less-qualified were and Panama. most affected by the employment reduction during the crisis of COVID. Outward-oriented growth continued to favor high-skilled workers. Their labor market outcomes improved, while those of less-skilled workers deteriorated. Human capital: Outward-oriented growth favored the While education attainment improved, there continued to be a mismatch development of high-value added sectors creating demand for between skills generated in general education and skills demanded by the skilled workers. The education sector could not meet this demand. market. Women and youth were especially excluded from the labor market Youth transition to the labor market continues to be problematic and women have markedly worse labor market outcomes than men Women’s labor market participation: Costa Rican women’s comparatively poor labor market outcomes have long stood Costa Rica continues to be characterized by low female labor force participation, out and contribute to higher poverty rates in women-headed driven at least partly by an unequal division of caregiving tasks. households. Earnings gap: Trend of widening earnings gaps between the rich This trend continued unabated. Labor incomes of the poorest continued to fall. and the poor and between skilled and unskilled workers Earnings of low-skilled workers continued to deteriorate. Redistribution: Taxes and transfers were found to effectively The role of transfers was vital in offsetting falling labor incomes. However, as of redistribute income to compensate for these disparities. 2015, Costa Rica’s taxation structure was still not very progressive Beyond labor market gender gaps: The poor were more likely Poverty rates remain elevated for women. There are further opportunities to to live in female-headed households, and nonpoor women were improve legal equality for women and men and enhance women’s economic twice as likely as poor women to participate in the labor force. security. Data limitations affect the ability to describe changes in the predicament of minority groups. Several new policies and legislative initiatives aim to improve Minority groups: The SCD emphasized lower human capital and the situation of ethnoracial minority groups, but further action is needed. income generation of indigenous groups. It did not discuss afro- Costa Rica is relatively progressive on LGBTQ+ rights compared to regional descendants or gender minorities. peers. It was the first country in Central America to allow same-sex marriage in 2020 52 TABLE B.3. CLIMATE CHANGE ADAPTATION AND MITIGATION a. 2015 SCD Main Findings b. Trends since 2015 Climate change mitigation: Costa Rica strived to be a Costa Rica emphasized its commitment to climate change mitigation by setting a goal of ‘green leader’, through forest conservation, reforestation, zero net emissions by 2050. Achieving this goal (as signaled in the original SCD) still requires and afforestation. However, the SCD signaled challenges, substantial reductions in emissions from transport and agriculture. Costa Rica articulated a as maintaining the green trademark would increasingly national bioeconomy strategy and National Appropriate Mitigation Action (NAMA) for key require a reduction in actual emissions. value chains to enter a ‘productive transformation’ trajectory. Forestry: Costa Rica successfully expanded its forest Reconciling tradeoffs between forest and agricultural expansion requires a focus on higher through public and private engagement and the use yields through more efficient use of inputs, improved labor productivity, and the adoption of economic incentives for conservation. However, the of climate-resilient agricultural practices. It will also require adapting to climate change opportunity costs of forest expansion were increasing hazards and addressing infrastructure gaps. Costa Rica implemented various actions to lower plastic waste and increase the reuse of Pollution: Air pollution, heavy use of pesticides, and plastic. There is no clear evidence that reliance on pesticides was reduced. Despite the challenges in sewage treatment and solid-waste development of multiple policies and plans, key priorities in the water sector remain relevant management stood out. today: water quality, equal access to water and sanitation services, and water storage. In 2022, Costa Rica launched its first National Adaptation Plan, which describes how the Climate change adaptation: Climate change will country can enhance its resilience to climate change. Despite a tradition of public policies increase Costa Rica’s already high exposure to natural for reducing disaster risk, losses due to extreme hydrometeorological events are increasing. hazards. Increasing urbanization and vulnerability of Housing, agricultural production, and especially transport infrastructure are vulnerable to public infrastructure contribute to risk exposure. disasters and extreme weather events. TABLE B.4. INSTITUTIONAL REFORM AND PRIORITIES Governance and institutions: Although Costa Rica’s governance Costa Rica continues to underperform in the areas of labor institutions, legal indicators compare favorably to those of other countries in the region, institutions and business and trade environment relative to its selected the SCD identified challenges in the adaptation of governance and structural peers. Moreover, there are signs of a slowdown in institutional institutions to changing socioeconomic circumstances, and raised the improvements. issue of political gridlock due to spread of power across many actors. Education: Significant concerns about education, considering comparatively There have been significant improvements in educational attainment over recent high spending levels but low education attainment, low quality of education, years. However, education quality continues to lag, which is reflected for instance in and disparities by region and socioeconomic background. PISA scores. School closures during COVID-19 may well have long-term repercussions. Health: “Cracks” in Costa Rica’s successful system had begun to Despite pressures identified in the 2015 SCD, key health outcomes continued to appear, with rising out-of-pocket spending, demographic changes, and improve. Costa Rica’s health care system performed favorably during the pandemic. increasing inefficiencies and inequities However, structural pressures (demographic and fiscal) remain worrisome. Significant progress in the development of a national social assistance registry. Increased reliance of those at the bottom of the income distribution on social Social protection: High coverage, but fragmented and weakly targeted assistance, especially public pensions. Emergency cash transfers helped mitigate social assistance. the impact of COVID-19. However, institutions remain fragmented and there are further chances to harmonize allocation and enhance efficiency. Costa Rica still has one of Latin America and the Caribbean’s largest and most Public sector: Public sector administration not modernized in tandem expensive public sector workforces. To change this, deep-rooted legal and with the economy. Inefficient service delivery and institutional institutional HRM issues will need to be addressed and operational processes complexity. High public sector wage bill. and information systems will need to be improved. There has been progress and Costa Rica’s Public Financial Management (PFM) Public financial and investment management: Earmarked system is reasonably aligned with international good practices. However, there expenditures reduce the agility of budget allocation. Public investment, are opportunities to enhance reliance on uniform accounting practices and especially in infrastructure, at a standstill. Culprits include: “weak financial statements across public institutions and SOEs. Local governments sectoral planning and bureaucratic inefficiencies”. need better tools for local revenue and financial management 53 COSTA RICA SCD Update ANNEX C. DATA AND EVIDENCE GAPS In the past decades, Costa Rica has been able to maintain stable economic growth, while having relatively modest investment rates compared to regional and structural peers, both public and private. It is important to better analyze structural barriers to domestic investment, particularly private, to further unleash Costa Rica’s growth potential. To further support domestic firms it is important to understand the obstacles they face and how they fare with respect to managerial capability. Although this SCD update identifies key barriers faced by domestic firms, a better understanding of the underlying drivers of these barriers is important. For example, why are collateral requirements twice as large for small firms and why is insurance penetration relatively low? In line with the rest of the region35, it is likely that Costa Rican firms are held back by lack of managerial knowledge and capabilities needed for the scale and sophistication demanded by the export sector, but additional analytical work is need to map and quantify this gap. It is critical to consider and enhance understanding of the inclusion of historically marginalized groups. Data limitations make it harder to understand the socioeconomic situation of ethnoracial minorities. Based on past analysis drawing on the 2012 census, it is reasonable to assume that these groups face significant barriers to labor market access. However, designing policy responses to labor market inclusion requires improved data and evidence based on the new census. There are information constraints that hamper additional recommendations related to women’s economic inclusion. The team could draw on limited gender-disaggregated data and evidence on entrepreneurship, for instance. There are also data constraints related to gender-based violence (Maquera Sardon and Galeano 2023). Although there is significant evidence on the importance of enhancing education outcomes, additional analysis would support policy reform. One relates to the returns to education and their impacts on schooling decisions. Another relates to ways to improve accountability in the education sector to enhance outcomes. Continued progress toward decarbonization goals come with fiscal, economic, and social implications as well as opportunities, which should be carefully assessed. It is critical to identify and estimate potential transition costs, map winners and losers from this process, and develop mitigation strategies to address them. These comprise, for instance, the risk of distributional and affordability effects of Costa Rica’s current approach to renewable energy integration within transport and industry, including the ambitious target of 100 percent electrification of rail transport and 70 percent of urban public transport by. At the same time, Costa Rica’s global leadership in decarbonization also creates important opportunities, for example, allowing the country to position itself as a low carbon exporter and a destination for sustainable investment. It is also valuable to quantify returns associate with this opportunities to better inform investment decisions. 35  WMS (World Management Survey) (dashboard), London School of Economics, London, http://worldmanagementsurvey.org/. 54 Additional evidence is needed to understand and address the challenge of increasing crime connected to drug trafficking and money laundering. Although it is clear that these developments can have a decisive impact on livelihoods, human capital and social cohesion, further analytical work is required to identify the measures that can be taken to address this challenge in different public sector areas and identify measures to reduce the impact of drug trafficking on youth in poor neighborhoods and communities.  ANNEX D. DEMOGRAPHIC TRENDS Costa Rica’s population growth continues to slow and the population is aging. Costa Rica’s population growth is coming to an end. The country’s population quintupled from a little under 1 million in 1950 to over 5 million in 2021. But growth is projected to end around 2050 at a peak of about 5.5 million inhabitants. The population aged zero to 24 is already declining not only as a share of the population but also in absolute terms. The population aged 65 or older, in contrast, is still growing (also in absolute terms) and this trend is expected to persist until about 2075. This trend of population aging will further put the supply of (skilled) labor under strain, thus exacerbating some of the growth and labor market challenges outlined above. It will also have significant implications for demand for health care and social services. However, planning for a greying population is lacking at many levels of government. Costa Rica: Population by broad age groups Population (millions) 4.0 95% prediction interval 3.5 3.0 25-64 2.5 2.0 1.5 0-14 1.0 15-24 0.5 65+ 0.0 1950 1975 2000 2025 2050 2075 2100 Year Source: 2022 United Nations, DESA, Population Division. Licensed under Creative Commons license CC BY 3.0 IGO. United Nations, DESA, Population Division. World Population Prospects 2022. http://population.un.org/wpp/ 55 COSTA RICA SCD Update Costa Rica’s population increasingly lives in urban areas, but urban growth is largely unplanned. An estimated 72 percent of Costa Rica’s population lived in urban areas in 2022 and this share is expected to increase to 90 percent in 2050 (UN DESA 2022). However, the formation of Costa Rica’s urban area continues to be largely unplanned and informal, with most of the municipalities in the country lacking land use plans (Planes Reguladores). As discussed also elsewhere in this document, this unplanned growth increases the exposure of some communities to disaster risks, exacerbates transportation challenges and contributes to the burgeoning of mono-functional and segregated communities. Most municipalities in the country lack the financial resources, technical capacities, and necessary instruments to manage urban growth and plan for sustainable, socially inclusive, and economically vibrant human settlements. Indeed, the National Development Plan 2023–26 recognizes the need to leverage urbanization to promote sustainable growth and reduce inequality. Costa Rica experienced a new wave of migration from Venezuela since 2015 and a spike in Nicaraguan migrants since 2018 (Migration Policy Institute 2021). The new wave of migration has put pressure on the Costa Rican migration system, leaving many migrants and refugees in a state of further vulnerability.36 Nicaraguan migration to Costa Rica had been predominantly low-skilled. However, the new wave of Nicaraguan migration since 2018 includes a significant cohort of individuals with higher education, estimated at 53 percent.37 The increase in Nicaraguan and Venezuelan migration occurred in a context of economic contraction caused by the COVID-19 pandemic, and has resulted in delays for migrants to regularize their status as well as in a reduced capacity of the state to provide services for them. During the pandemic, the government developed a protocol for migrant seasonal workers to keep migration flow in an orderly manner and provide sanitary measures. 38 However, there are many irregular migrants without protection who, due to fear of deportation, may be less likely to access health or might opt not to receive treatment in public hospitals. ANNEX E. MICRO, SMALL, AND MEDIUM ENTERPRISES MSMEs represent a large share of Costa Rica’s formal enterprises, but a relatively modest share of production. A study published by Costa Rica’s Ministry of Economy, Industry and Trade in 2021, examines the situation of formal enterprises in Costa Rica, with a focus on MSMEs.39 It relies primarily on information from Costa Rica’s “Registro de Variables Económicas” (REVEC) and its “Sistema de Información Empresarial Costarricense” (SIEC) for the period from 2015 to 2019. The study shows that MSMEs make up the bulk of Costa Rica’s formal enterprises (in 2019 97.4 or 133,845 out of 137,378 enterprises). However, MSMEs are rarely directly engaged in exporting (1.6 percent of MSMEs v. about a quarter of large enterprises). And, accordingly, MSMEs represent only about a third of Costa Rica’s employment and GDP. 36 Estimates place the number of Venezuelans in Costa Rica at between 29,820 and 40,000 (IOM 2021; OAS 2020). The total number of Nicaraguans by the end of 2020 was 367,984, representing 66 percent of the total migrant population. There are 3,828 Nicaraguans and 1,237 Venezuelans with refugee status in the country, less than 10 percent of applications, which highlights the strain on the Costa Rican migration system (MPI 2021). 37 Fundación Arias, 2019. 38 Protocolo general para la atención de la migración laboral para la época de cosechas en el marco de la alerta por (COVID-19), 2020–21. 39 http://reventazon.meic.go.cr/informacion/estudios/2021/pyme/DIGEPYME-INF-038-2021.pdf. 56 100% 90% 12,1% 12,6% 12,6% 12,5% 12,5% 80% 70% 60% 50% 40% 81,5% 81,0% 80,7% 80,9% 80,8% 30% 20% Although MSMEs remained stable as a share of all formal 10% enterprises, (employment) growth was driven 0% by large firms and the share of MSMEs in GDP and employment 2016 as a result. is declining 2015 2017 2018 2019 Medium Small Micro Share of SMEs. In % of enterprises, 2015-2019 Share of exporting enterprises, by size. In %, 2015-2019 100% 30% 26,3% 90% 12,1% 24,1% 24,7% 24,9% 24,6% 12,6% 12,6% 12,5% 12,5% 25% 80% 70% 20% 60% 50% 15% 40% 81,5% 81,0% 80,7% 80,9% 80,8% 10% 30% 20% 5% 10% 0% 0% 2015 2016 2017 2018 2019 2015 2016 2017 2018 2019 Medium Small Micro SMEs Large Note: SMEs = small and medium enterprises. Source: DIGEPYME 2021. http://reventazon.meic.go.cr/informacion/estudios/2021/pyme/DIGEPYME-INF-038-2021.pdf. 30% 26,3% 24,7% 24,9% 24,6% 24,1% 25% Informal microenterprises far outnumber the formal enterprises. Costa Rica’s Encuesta Nacional 20%de Microempresas de los Hogares (ENAMEH) provides insight into informal microenterprises. The 15%sampling frame for this microenterprise survey is constructed drawing on the national household survey 10% called Encuesta Nacional de Hogares (ENAHO). The ENAMEH comprises information on enterprises that carry out market activities and do not appear in the registries on which the study of Costa Rica’s Ministry 5% of Economy, Industry and Trade is based. According to the ENAMEH, the number of microenterprises has hovered between 350 and 400 thousand, with perhaps a slight upward trend. Although there are some 0% 2015 2016 2017 2018 2019 challenges in comparing information in the Ministry’s study and the ENAMEH, it is thus clear that theLarge SMEs informal microenterprises constitute an important part of Costa Rica’s economy. Profile of microenterprises and entrepreneurs, 2021 46,34% 43,01% 32,94% 25,43% 21,03% 19,80% 17,01% 14,54% 12,82% Females Up to complete primary Incomplete secondary Complete secondary Superior Agriculture Industry Wholesale and trade Services Source: World Bank calculations based on 2021 data of ENAMEH (Encuesta Nacional de Microempresas de los Hogares, National Survey of Households’ Microenterprises) (dashboard), National Institute of Statistics and Census, San José, Costa Rica, https://inec.cr/ estadisticas-fuentes/encuestas/encuesta-nacional-microempresas-los-hogares 57 COSTA RICA SCD Update Informal microenterprises are operated mostly by less well educated men. The share of microenterprises operated out of need is increasing. Most informal microenterprises are run by men 60% 15 percent) of informal microenterprises are run (about two-third). Only a small minority (less than50% by entrepreneurs with superior education. Most of the 40%informal microenterprises work in services (46 percent), followed by industry (21 percent) and wholesale 30% and trade (20 percent). Most informal microentrepreneurs (56 percent in 2021) indicate that they operate their enterprise out of need, rather 20% than opportunity or tradition. And this share has increased sharply in recent years, from 41 percent 10% in 2017, to 46 percent in 2019, and 56 percent in 2021. This is in accordance with the argument that 0% opportunities for low educated (male) workers have not improved 2017 2018 years. 2019 in recent 40 2020 2021 Need Opportunity Tradition Reasons for starting a business. Reasons for starting a business. In % of entrepreneurs, 2017-2021 In % of total entrepreneurs. 2021 60% 55,9% 50% 40% 33,9% 30% 20% 10% 10,2% 0% 2017 2018 2019 2020 2021 Need Opportunity Tradition Need Opportunity Tradition Source: World Bank calculations based on 2017 to 2021 data of ENAMEH Source: World Bank calculations based on 2021 data of ENAMEH (Encuesta Nacional de Microempresas de los Hogares, National Survey of (Encuesta Nacional de Microempresas de los Hogares, National Survey Households’ Microenterprises) (dashboard), National Institute of Statistics of Households’ Microenterprises) (dashboard), National Institute of and Census, San José, Costa Rica, https://inec.cr/estadisticas-fuentes/ Statistics and Census, San José, Costa Rica, https://inec.cr/estadisticas- 55,9%encuestas/encuesta-nacional-microempresas-los-hogares fuentes/encuestas/encuesta-nacional-microempresas-los-hogares 33,9% The challenges faced by informal microentrepreneurs resemble those discussed under challenge 1 where it discusses extending the dividends of growth beyond the external sector. It is common for informal microentrepreneurs 10,2% to mention that they require support to maintain their business Need and make it grow. This share Opportunity was about 65 percent in 2021 (62 percent among male Tradition entrepreneurs and 69 among female entrepreneurs) and relatively stable over time. In line with the arguments outlined in Challenges 1, 2, and 4 of this diagnostic, the top three areas of support required by informal microentrepreneurs are: access to credit, training, and easier procedures. These areas have been fairly stable over time too. Access to credit and training were also mentioned as the two main areas requiring support in 2017. Only ‘easier procedures’ has gained in prominence as an area requiring support; it was mentioned by a little over a third of microentrepreneurs in 2017 and nearly half of entrepreneurs in 2021. 40 While data on profits recorded in the ENAMEH is volatile, it suggests that profits of informal microenterprises have not increased in real terms since 2017. 58 63,4% 2017 2018 2019 2020 2021 of entrepreneurs who state that they Share Type of support needed by entrepreneurs. need support to maintain their business or In % of entrepreneurs, 2021 make it grow. In % of entrepreneurs, 2017-2021 Lending Training 66,7% 64,4% 66,9% 64,6% 63,4% Easier procedures Diversify their own production Partner with other companies Increase the number of workers Change the location of… Investors Join trade unions Care system 2017 2018 2019 2020 2021 Others 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Source: World Bank calculations based on 2017 to 2021 data of ENAMEH Source: World Bank calculations based on 2021 data of ENAMEH (Encuesta (Encuesta Nacional de Microempresas de los Hogares, National Survey of Nacional de Microempresas de los Hogares, National Survey of Households’ Households’ Microenterprises) (dashboard), National Institute of Statistics Microenterprises) (dashboard), National Institute of Statistics and Census, and Census, San José, Costa Rica, https://inec.cr/estadisticas-fuentes/ Lending San José, Costa Rica, https://inec.cr/estadisticas-fuentes/encuestas/encuesta- encuestas/encuesta-nacional-microempresas-los-hogares Training nacional-microempresas-los-hogares Easier procedures Diversify their own production Partner with other companies ANNEX F. DEMOCRACY AND THE SOCIAL COMPACT Increase the number of workers Change the location of… Investors Costa Rica has long stood out as a beacon of political stability in the region. The country last Join trade unions Care system experienced Others severe political violence in the civil war of 1948, which followed heavily disputed elections. After the war, new 0% a 5% constitution 10% 15% 20% 25% was30% adopted, the right to vote became universal, and Costa Rica 35% 40% 45% abolished its army. In the period since, as described by Freedom House, Costa Rica has had “democratic stability, with a multiparty political system and regular rotations of power through credible elections.”41 As an “island of peace” in Central America, the country contributed to peace and stability in the region. 8 Political Rights 7 6 5 4 3 2 1 0 1978 2021 CHL CRI DOM SLV GTM HND NIC PAN URY Source: Freedom house Note: Freedom in the World assigned a country or territory two ratings—one for political rights and one for civil liberties. Each rating of 1 to 7, with 1 representing the greatest degree of freedom and 7 the smallest degree of freedom, corresponded to a specific range of total scores. Countries and territories with a rating of 1 enjoy a wide range of political rights, including free and fair elections. Candidates who are elected actually rule, political parties are competitive, the opposition plays an important role and enjoys real power, and the interests of minority groups are well represented in politics and government. 41 https://freedomhouse.org/country/costa-rica/freedom-world/2021. 59 COSTA RICA SCD Update FIGURE F.2. INDEX OF FRAGILITY, COSTA RICA, EL SALVADOR, GUATEMALA, AND HONDURAS, 2006–22 Worsening 80.0 70.0 Total country score 60.0 50.0 Improving 40.0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: Fragility State Index, 2022 Costa Rica: Blue; El Salvador: Dark red; Guatemala: Pink; Honduras: Yellow The Fragile States Index is based on a conflict assessment framework – known as “CAST” – that was developed by FFP nearly a quarter-century ago for assessing the vulnerability of states to collapse. The CAST framework was originally designed to measure this vulnerability and assess how it might affect projects in the field, and continues to be used widely by policy makers, field practitioners, and local community networks. The methodology uses both qualitative and quantitative indicators, relies on public source data, and produces quantifiable results. Twelve conflict risk indicators are used to measure the condition of a state at any given moment. The indicators provide a snapshot in time that can be measured against other snapshots in a time series to determine whether conditions are improving or worsening. Costa Rica’s current stability can be traced back to its social contract established in the second half of the twentieth century. The Costa Rican economic development model and social contract have their roots in legislation approved after the civil war of 1948. The abolition of the army after the civil war enabled a shift in resources to social programs, including basic social services guaranteed by the state, a universal health system, and free public education for all. The democratic tradition and the social pact have produced economic, social and environmental dividends, including sustained economic growth, improved social indicators and conservation of the environment. The enduring stability of Costa Rica can be seen as social capital, the importance of which is difficult to overestimate. However, Costa Rica’s democratic stability is facing challenges. The two-party political system that lasted for about 50 years after the civil war generally provided working parliamentary majorities. In the past 25 years, the political landscape has become increasingly fragmented, which has undermined the legislative process. Twenty-five parties and candidates participated in the February 6, 2022, presidential and parliamentary elections. And, as can be inferred from the chart below, the number of parties in congress has increased considerably over time. As highlighted in the 2015 SCD, this political fragmentation makes reform processes more lengthy, complicates meaningful reform especially on sensitive issues, and affects overall political delivery. 60 FIGURE F.3. COSTA RICA’S CONGRESS HAS BECOME MORE FRAGMENTED Composition of Congress by political party % of seats (57), 1962-2026 100% 6 6 90% 9 14 7 80% 70% 18 18 6 10 60% 6 50% 19 40% 9 30% 33 29 20% 17 19 10% 0% 1962-1966 1982-1986 2002-2006 2022-2026 Partido Liberación Nacional Partido Republicano Nacional Partido Unión Nacional Coalición Unidad Partido Unidad Social Cristiana Movimiento Libertario Partido Acción Ciudadana Frente Amplio Partido Progreso Social Democrático Partido Nueva República Partido Liberal Progresista Others The disruptive effect of drug trafficking, money laundering and criminal activity is adding to these challenges. Costa Rica is not an exception to the increasing presence of drug trafficking, money laundering and its concomitant criminal activity in the region. The country is part of the international corridor that smuggles drugs from South America to Mexico and the USA, and increasingly so to Europe. Drug smuggling fuels local criminal activity and hampers public safety. According to the Bureau of Judicial Investigation (OIJ), 2022 closed with the highest historical record of homicides, 60 percent of which were related to drug trafficking. OIJ also reported that 75 out of 100 kidnaps were to be attributed to drug gangs, between 2020-22. Drug trafficking directly affects poor communities, but also political and economic institutions. 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