Fiscal Policy Coordination in Brazil: From Fiscal Distress to Fiscal Discipline—A Giant Leap Forward

Tax assignments mandated by the 1988 Constitution in Brazil reduced federal flexibility in the conduct of fiscal policies. The new constitution transferred some productive federal taxes to lower-level jurisdictions and also increased subnational governments’ participation in federal revenuesharing schemes. One of the most productive taxes, the value-added tax on sales, was assigned to states, and the Council of State Finance Ministers (CONFAZ) was set up to play a coordinating role. Federal flexibility in the income tax area, however, remained intact. This gives the federal government some possibility of not only affecting aggregate disposable income, and therefore aggregate demand, but also exerting direct influence over the revenues and fiscal behavior of the lower levels of government, which end up receiving nearly half of the proceeds of this tax. The effectiveness of such a policy tool is an open question and critically depends upon the goodwill of subnational governments.

Consider the case where the federal government decides to implement a discretionary income tax cut. The measure could have a potentially significant effect on the revenues of state and local governments, given their large share in the proceedings of this tax. It is possible that, in order to offset this substantial loss in revenues from federal sources, lower levels of government might choose to either increase the rates and/or bases on the taxes under their jurisdiction or increase their tax effort. Such state and local government responses could potentially undermine the effectiveness of income taxes as a fiscal policy instrument. Thus a greater degree of intergovernmental consultation, cooperation, and coordination would be needed for the success of stabilization policies.

An overall impact of the new fiscal arrangements was to limit federal control over public-sector expenditures in the federation. The success of federal expenditures as a stabilization tool again depends upon subnational government cooperation in harmonizing their expenditure policies with the federal government. Once again, the constitution has put a premium on intergovernmental coordination of fiscal policies. Such a degree of coordination may not be attainable in times of fiscal distress.

A reduction in revenues at the federal government’s disposal and an incomplete transfer of expenditure responsibilities have further constrained the federal government. The primary source of federal revenues is income taxes. These taxes are easier to avoid and evade by taxpayers and therefore are declining in relative importance as a source of revenues. Value-added sales taxes, which are considered a more dynamic source of revenues, have been assigned to the state level. Thus, federal authorities lack access to more productive tax bases to alleviate the public debt problem and to gain more flexibility in the implementation of fiscally based macroeconomic stabilization policies.

According to Shah (1991, 1998) and Bomfim and Shah (1994), this situation could be remedied if a joint federal-state value-added tax (VAT) to be administered by a federal-state council were instituted as a replacement for the federal Industrialized Product Tax (Imposto sobre os Produtos Industrializados, or IPI), the state Merchandise and Service Tax (Imposto sobre Circula^ao de Mercadorias e Presta^oes de Servi^os, or ICMS), and the municipal services tax, whose bases partially overlap. Such a joint tax would help alleviate the current federal fiscal crisis as well as streamline the administration of sales tax. They argued that federal expenditure requirements could be curtailed with federal disengagement from purely local functions and by eliminating federal tax transfers to municipalities. Transfers to the municipalities would be better administered at the state level, as states have better access to data on municipal fiscal capacities and tax effort in their jurisdictions. Some rethinking is in order on the role of negotiated transfers that have traditionally served to advance pork-barrel politics rather than to address national objectives. If these transfers were replaced by performance-oriented conditional block (per capita) federal transfers to achieve national (minimum) standards, both the accountability and coordination in the federation would be enhanced. These rearrangements would provide the federal government with greater flexibility to pursue its macroeconomic policy objectives. Finally, the authors advocated the development of legally binding fiscal rules at all levels of government and a federal-state coordinating council to ensure that these rules are enforced.

There has been significant progress on most of these issues in recent years. For example, negotiated transfers have become insignificant due to the fiscal squeeze experienced by the federal government. The senate has prescribed guidelines (Senate Resolution #69, 1995) for state debt: maximum debt service is not to exceed 16 percent of net revenue or 100 percent of current revenue surplus, whichever is less, and the maximum growth in stock of debt (new borrowing) within a 12-month period must not exceed the level of existing debt service or 27 percent of net revenues, whichever is greater (Dillinger, 1997).

More recently in 1998, pension and civil-service entitlements reform has introduced greater budgetary flexibility for all levels of government. Likewise, after the suboptimal results achieved from letting capital markets discipline subnational borrowings, the Brazilian federal government opted for establishing a fairly constraining set of fiscal responsibility institutions. First, Law 9.696 of September 1997 created the framework for a series of debt-restructuring contracts between December 1997 and June 1998, whereby 20 percent of the debt should be paid with the proceeds of privatization of state assets, while the remaining portion of state and local debt was restructured with maturities up to 30 years at a subsidized interest rate (equal to 6 percent of the annual real rate).

Debt-restructuring contracts had a global reach, as 25 out of 27 states and over 180 municipalities signed debt-restructuring agreements (Goldfajn and Refinetti, 2003; IMF, 2001). The contracts required the subnational governments’ commitments to engage in adjustment programs aimed to reduce the debt-to-net-revenue ratio to less than one over a per- case negotiated period of time. Debt-restructuring contracts also impose stringent penalties for noncompliant states and, in the event of a default, authorize the federal government to withhold fiscal transfers or, if this is not enough, to withdraw the amount due to the states from their bank accounts (Goldfajn and Refinetti, 2003: 18). Debt-restructuring agreements prohibit further credit or restructuring operations involving other levels of government. This helps to eliminate the incentives related to the moral risk implicit in the possibility of governmental bailouts (IMF, 2001).

Building upon Law 6.996/97 and complementary regulations, the Brazilian federal government adopted an LFR in May 2000 and its companion law (10.028/2000), both legally binding for federal, state, and municipal/local governments. The LFR is likely the most significant reform after the 1988 constitution in terms of its impact on the dynamics of federalism in Brazil, as subsequent compromises between states and the federal government have continuously increased the negotiation leverage of the latter, increasing its effectiveness in macroeconomic management.

The LFR establishes ex ante institutions such as thresholds on state debt, deficit, and personnel spending. According to the LFR, states and municipalities must maintain debt stock levels lower than the ceilings determined by the federal senate regulations. If a subnational government exceeds this debt ceiling, the excess amount must be reduced within a one-year period, during which the state or municipality is prohibited from incurring any new debt and becomes ineligible for receiving discretionary transfers (World Bank, 2002a). In terms of personnel management, the LFR defines ceilings on payroll spending, which should not exceed 50 percent of the federal government’s net revenues, nor 60 percent at the subnational level.

The LFR also institutionalized a variety of ex post provisions aimed at the enforcement of its regulations. For governments, violations of personnel or debt ceilings can lead to fines of up to 30 percent of the annual salary of the person responsible, impeachment of mayors or governors, and even prison terms in cases of violation of mandates regarding election years. For capital markets, the LFR declares that financing operations in violation of debt ceilings would not be legally valid, and amounts borrowed should be repaid fully without interest. This provision is aimed at discouraging such lending behavior by financial institutions.

The Brazilian Federation had remarkable success in ensuring fiscal policy coordination and fiscal discipline at all levels in recent years. By June 2005, the LFR had created significant positive impacts on fiscal performance in Brazil. All states and the federal government have complied with the ceiling on personnel expenditures (50 percent of current revenues). On debt, only 5 states out of 27 (inclusive of the federal district) are still above the ceiling of 200 percent of revenues, owing to the 2002 currency devaluation. Also, 92 percent of municipalities have reduced debts below 1.2 times revenue levels, and only a handful of large municipalities have unsustainable debt levels. Primary surplus was achieved by all states by 2004 (Levy, 2005).

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