Acknowledgements The team is co-led by Roland Clarke (Program Leader), and Emmanuel Skoufias (Lead Economist). We would like to thank the members of the Brazil Systematic Country Diagnostic (SCD) core team: Magnus Lindelow (Program Leader), Pedro Olinto (Program Leader), Gregor Wolf (Program Leader), Paul Kriss (Program Leader), Paul Procee (Program Leader), Mark Dutz (Lead Economist), Antonio Nucifora (Lead Economist), Boris Utria (Country Operations Advisor), Candyce Rocha (Senior Communications Officer), Hector Gomez Ang (Country Manager), and Eduardo Wallentin (Senior Manager). The core team worked under the strategic guidance of two Country Directors (Deborah Wetzel and Martin Raiser) for which we are most grateful. The task team leaders (TTLs) and the core team have relied extensively on the knowledge and inputs provided by colleagues from the Brazil Country Team from all the different Global Practices (GPs) and the International Finance Corporation (IFC) and we are all truly thankful for the help and support provided. The table below identifies the team members from the various GPs, who contributed their time, knowledge, and experience on Brazil for the preparation of this SCD: The World Bank Team Members Group Team Agriculture Diego Arias, Fatima Amazonas Climate Change Christophe de Gouvello Barbara Bruns, Rita Almeida, Michael Drabble, Leandro Costa, André Education Loureiro Energy and Extractives Christophe de Gouvello Environment and Natural Ernesto Sánchez Triana, Klas Sander, Bernadete Lange, Adriana Resources Moreira Heinz Rudolph, Mark Dutz, Leyla Castillo, Bujana Perolli, Shanthi Finance and Markets Divakaran, Ceyla Pazarbasioglu Gender Miriam Muller, Renata Mayer Gukovas, Aude-Sophie Rodella Lorena Viñuela, Laura Zoratto, Etel Patricia Bereslawski, Miguel- Governance Santiago da Silva Oliveira Health Nutrition, and Tania Dmytraczenko, Ezaú Pontes, Magnus Lindelow Population IFC Luciana Marchesini, Miguel Angel Rebolledo Dellepiane Jobs Joana Silva, Rafael Prado Proença, Rita Almeida Macroeconomics and Antonio Nucifora, Rafael Barroso, Edith Kikoni, Fabio Bittar, Cornelius Fiscal Management Fleischhaker MIGA Dan Biller, Jorge Rivas The World Bank Team Members Group Team Emmanuel Skoufias, Aude-Sophie Rodella, Martha Viveros, Renata Poverty and Equity Mayer Gukovas, Ali Sharman, Thiago Scot Social Protection and Maria Concepcion Steta Gandara, Claudia Baddini, Anna Fruttero, Labor Renata Mayer Gukovas Mark Dutz, Thomas Kenyon, Paulo Correa, Martha Licetti, Tanja Goodwin, Jean François Arvis, Julie Barbet-Gros, Daria Taglioni, Tom Trade and Farole, Erik van der Marel, Laura Dachner, Roberto Echandi, Doyle Competitiveness Gallegos, the WDR 2016 team, Pluvia Zuniga, Priyam Saraf, Marialisa Motta Georges Bianco Darido, Shomik Mehndiratta, Eric Lancelot, Bianca Transport and ICT Bianchi Alves, Satoshi Ogita, Gregoir Gauthier, Alexandre Takahashi Josef Lloyd Leitmann, Emanuela Monteiro, Catalina Marulanda, Social, Urban, Rural and Andres Villaveces, Alberto Coelho Gomes Costa, Frederico Pedroso, Resilience Nancy Lozano Gracia Water Martin Gambrill, Thadeu Abicalil, Erwin de Nys The team is also very grateful to Flavia Nahmias and Mônica Porcidonio, for preparing the document, the bibliography and the logistics of the SCD. In addition, the following people have provided substantive inputs and guidance: Augusto de la Torre (Chief Economist) and peer reviewers: Indermit Gil (Director, DECDP), Bert Hofman (Country Director, EACCF), and Ana L. Revenga (Senior Director, GPVDR). IBRD Regional Vice President: Jorge Familiar Country Director: Martin Raiser Task Managers: Roland Clarke and Emmanuel Skoufias IFC Vice President: Snezana Stoiljkovic Regional Director: Irene Arias Task Managers: Eduardo Wallentin and Luciana Marchesini MIGA Vice President: Karin Finkelston Director: Ravi Vish Manager: Dan Biller Executive Summary Retaking the Path to Inclusion, Growth and Sustainability RETAKING THE PATH TO INCLUSION, GROWTH AND SUSTAINABILTY 1. Brazil is a vast country and its development prospects matter globally. A continental power, Brazil is the fifth largest country on earth (in both land area and population). It covers a vast territory containing the world’s largest rainforest (the Amazon) substantial freshwater resources, valuable agricultural land, and multiple minerals, metals and other natural capital. Its size gives it systemic importance from the environmental point of view as the lung of the earth and also has important consequences for the structure of the economy and political institutions. As with most large economies, it is relatively closed. This tendency has been strengthened by a historical focus on the domestic market as the driver of development. Another implication of Brazil’s size is a relatively high degree of decentralization in a federative structure, which increased further with the return to democracy in the mid-1980s. 2. Brazil’s prospects have attracted particular interest also because it historically was and remains today one of the world’s most unequal societies. Dating back to the original allocation of land during colonial times and more recently to the distribution of economic opportunities and access to basic social services, deep and persistent inequalities have characterized Brazil’s development path. The country’s size and historically high inequality have given debates about inclusive development paths particular resonance both in Brazil and well beyond the country’s borders. A continuously rising state footprint following re- democratization and strong ‘welfarist’ tradition in public policy have been consequences of policy makers’ efforts to address Brazil’s legacy of sharp socioeconomic inequalities. 3. Until the late-1990s, little progress was made in reducing income inequalities in Brazil, but in the past decade Brazil’s socioeconomic progress has been remarkable and internationally noted. From 2003, the country has become recognized for its success in reducing poverty and inequality and its ability to create jobs. Innovative and effective policies to reduce poverty and ensure the inclusion of previously excluded groups have lifted millions of people out of poverty. Nevertheless, even today, in Brazil 5 percent of the population receives 30 percent of the income generated (together with Colombia the highest proportion for any country in Latin America). 4. Brazil has also been assuming global responsibilities. It has been successful in pursuing economic prosperity while protecting its unique natural patrimony. Brazil has become one of the most important emerging new donors, with extensive engagements particularly in Sub- Saharan Africa, and a leading player in international climate negotiations. Brazil’s development path over the past decade has shown that growth with shared prosperity, but balanced with respect for the environment, is possible. Brazilians are rightly proud of these internationally recognized achievements. i EXECUTIVE SUMMARY 5. However, the mood in Brazil has recently turned pessimistic. The shifts in the global economy following the world recession of 2008-2009, rising economic imbalances as the post- crisis stimulus was maintained too long, and in particular the end of the commodity super- cycle after 2011, have severely impacted Brazilian growth prospects, and, in 2015, the country entered recession. Falling government revenues accompanied by increasing expenditure pressures have led to a significant fiscal deficit, denting investor confidence. Administered price increases and one of the largest depreciations among emerging market currencies have driven up inflation, forcing the Central Bank to raise interest rates. 6. The bleak short-term economic outlook raises the risk that social and environmental achievements may not be sustained. Rising unemployment is likely to put pressure on lower- income households, rising inflation is eating into the real value of social transfers, while fiscal pressures accentuate spending trade-offs in the public sector. Economic difficulties also have the potential to sharpen conflicts over land and other natural resources, putting Brazil’s environmental achievements at risk. They may provoke an increase in urban crime and violence with negative social as well as economic consequences. 7. More fundamentally, the changed economic circumstances have exposed shortcomings in Brazil’s development model, epitomized by the struggle to achieve a sustainable fiscal policy. This report argues that the desire for a more inclusive state, after the return to democracy, led to a bias in favor of a large and increasing role for the public sector. Fiscal policy has been constrained by hardwired spending commitments and its sustainability risks being undermined by a burgeoning social security system, which provides substantial benefits to the non-poor. These commitments were affordable during a period of extraordinarily high commodity prices and relatively strong consumption-driven growth. They look unsustainable in the light of the recent shift in Brazil’s terms of trade and the country’s weak underlying growth potential, reflected in the poor track record of productivity growth and lagging performance on a range of indicators of external competitiveness. 8. Against this background, some Brazilians are now asking whether the gains of the past decade might have been an illusion, created by the commodity boom, but unsustainable in today’s less forgiving international environment. The answer provided in this Systematic Country Diagnostic (SCD) is a qualified ‘no’. There is no reason why the recent socioeconomic gains should be reversed; indeed, they might well be extended with the right policies. This will however require substantial shifts in Brazil’s growth model and its fiscal policies, as well as reforms and adjustments in successful policy dimensions such as, for instance, environmental and agricultural policies or social assistance programs. Brazil’s recent history contains several episodes of crises that gave rise to important economic and institutional reforms, which ii RETAKING THE PATH TO INCLUSION, GROWTH AND SUSTAINABILTY alleviated previously binding constraints to further economic and social progress. It also contains several examples of creative policy design overcoming implementation bottlenecks, often through the careful collection of evidence and rigorous monitoring and evaluation (M&E). Another reason to be optimistic is that Brazil’s policy makers today operate in an environment of much stronger accountability because of the increasing role of independent control institutions, the growing strength of non-government actors and the rising aspirations and expectations of the new middle class. 9. Brazil thus finds itself at an important juncture and, to a certain extent, the policy course set today will determine whether the country can sustain the gains of the past and return to a path of solid, inclusive and environmentally sustainable growth. This SCD offers a contribution to the debate about Brazil’s future development. It abstains from formulating specific policy recommendations and rather focuses on highlighting the way in which Brazil’s development challenges and opportunities are closely interlinked. The causal chains identified by the analysis lead to a set of broad priorities, which can serve as background for discussion of concrete reform plans and policies, as well as their feasibility in a complex and fluid political environment. The remainder of this overview first presents the main causal chains traced in this SCD and explains the structure of the report, before providing a chapter-by-chapter summary of the main argument. The determinants of poverty reduction and shared prosperity—the narrative of this SCD 10. The basic argument of this SCD is that Brazil needs to adjust its fiscal policy and its growth model if the country is to sustain the socioeconomic gains made over the past decade. The story of Brazil’s recent achievements is fundamentally a story of buoyant labor markets, declining wage inequality and progressive social policies, all supported by the boom in commodity prices that began around the turn of the millennium. It coincided with the successful macroeconomic stabilization Brazil achieved in the late 1990s, thus allowing the country to take full advantage of high commodity prices and abundant international liquidity. The improvement in the terms of trade facilitated rapid consumption growth without jeopardizing external balances. This in turn swelled public coffers thanks to a tax system built largely around indirect, consumption-linked taxes, and financed a substantial expansion in social transfers and improvements in access to a range of public services. Consumption-based growth and real exchange rate appreciation favored the domestic services industry, which accounted for the bulk of new employment creation disproportionately benefiting less-skilled workers. Rising formalization, improved social safety nets, and large increases in the minimum wage combined to push up the relative earnings of the less skilled and thus contributed to iii EXECUTIVE SUMMARY falling earnings inequality. Abundant liquidity facilitated access to credit, including among households, thus further reinforcing the consumption-based growth dynamics. 11. By late 2015, the factors that drove socioeconomic progress in the past decade had mostly gone into reverse. International commodity prices have trended down since late 2012, with oil prices recently following suit, global liquidity conditions have tightened since May 2013 and December 2015 saw the first US Federal Funds Rate increase since 2006. Brazil, as most emerging markets, faces a much bleaker international outlook than at most times since the early 2000s. Strong fiscal and financial buffers allowed the country to react to the 2008-2009 global recession with countercyclical fiscal and monetary policies, but in the light of headwinds from the commodity and financial markets and weak underlying growth potential, such measures have failed to stem the gradual deceleration of Brazil’s economy since 2012 to face outright recession in 2015. Indeed, the maintenance of countercyclical policies in the light of the declining growth potential created growing macroeconomic imbalances during 2013 and 2014. As a result, the authorities were forced to correct policy; monetary policy tightened in 2013 and a difficult fiscal adjustment is now under way. 12. With the changed economic outlook, two fundamental weaknesses of Brazil’s economy have come to the fore. First, Brazil has struggled for several decades to generate strong and sustained productivity growth. This weakness is reflected, for instance, in the gradual decline of Brazil’s manufacturing capacity, the small share of high technology products in its own export basket, the bias in employment creation toward relatively low productivity services such as catering and home care, and consequently in the low rate of aggregate growth in gross domestic product (GDP) per worker and in total factor productivity. It is also mirrored in the wide dispersion of productivity levels across firms within industries, suggestive of substantial allocative inefficiencies. The underlying causes of Brazil’s productivity malaise are complex. They include a high cost of finance and doing business, the poor state of the country’s physical infrastructure, limits to competition resulting from domestic regulation as well as relatively high tariff and non-tariff barriers against exports, and muted incentives for innovation, including technology adaptation, due to a myriad of distortive or ineffective government interventions. Another structural constraint to higher productivity growth may lie with the inadequate skills of the labor force, despite the very substantial progress Brazil has made in providing greater access to education. 13. Stronger productivity growth alone will not generate inclusive growth. The hallmark of Brazil’s progress in shared prosperity over the past decade was the extent to which economic growth was reflected in fast job creation and declining earnings inequality. While improvements in the business and regulatory environment and greater public and private iv RETAKING THE PATH TO INCLUSION, GROWTH AND SUSTAINABILTY investment will clearly be critical to relaunch economic growth, how this growth translates into the creation of a sufficient number of good jobs for Brazil’s bottom 40 percent (B40) will be equally important. This SCD consequently pays significant attention to the dynamics of Brazil’s labor markets and to the opportunities available to the B40 and the assets at their disposal to avail of such opportunities. Without a return to growth and the adoption of a more sustainable, less commodity and less consumption-dependent growth model, improvements in living standards for the B40 will remain elusive. However, while growth is a necessary condition for shared prosperity, it is not sufficient. Policies that enhance economic opportunities, build human capital and resilience, and recognize the assets of the poor (including their claim over natural resources and land rights) deserve particular attention. 14. The second weakness in Brazil’s economic model is related to the sustainability of public spending commitments in the light of the economy’s underlying growth potential. Brazil’s public sector has continuously grown since the introduction of democracy in the mid-1980s. Fundamentally, this is related with spending commitments that were enshrined in Brazil’s 1988 Constitution and with the nature of the country’s fragmented politics, where access to government funds is a key incentive for building and sustaining political coalitions. The large claim of Brazil’s public sector on the country’s limited domestic savings has traditionally been a source of both macroeconomic instability, which Brazil finally overcame with the Plano Real and the fiscal adjustment of 1999, and a relatively high cost of capital, which remains a problem until today. In light of buoyant revenue performance, fiscal constraints lost some of their salience during the first decade of the 2000s but the substantial expansion of public spending after 2008 and the collapse in revenues since the sharp economic downturn in 2014–2015 have exposed Brazil’s underlying budget rigidities. Without fiscal adjustment, it seems, the country may be stuck with weak investor confidence, high interest rates in the light of concerns over macroeconomic imbalances, and as a result little impetus for a return to investment-driven growth. At the same time, the necessary fiscal adjustment is fraught with important distributional consequences, which may affect Brazil’s future prospects for continued inclusive economic development. 15. Addressing fiscal trade-offs will be critical for the ability of the public sector to redistribute resources (income and services) to the poor, within a sustainable fiscal and macroeconomic framework. The analysis in this SCD highlights that some of the largest public expenditure items in the social sphere benefit mostly the better-off, public pensions being an obvious example. In other areas, including health care or general education, there is ample scope for greater efficiency. Many budget subsidies to various economic sectors may even be harmful, by distorting competition, or may be wasted in poorly planned and executed investment projects. By reforming social security, reducing waste, abolishing inefficient subsidies, and reallocating resources to v EXECUTIVE SUMMARY those services mostly benefiting the B40, the necessary fiscal adjustment can be made consistent with further social progress. In this regard, particular attention should be placed on safeguarding and even expanding programs and services that protect the most vulnerable, such as women, Afrodescendants, and indigenous peoples, many of whom still suffer discrimination and are particularly subject to violence and insecurity, despite considerable government efforts in recent years, which have begun to bear fruit. 16. Beyond the structural conditions for future job creation and the quality of Brazil’s inevitable fiscal adjustment, the prospects of the B40 are also intrinsically linked with the country’s vast natural assets and its leadership in the global environmental agenda. Many of the poor and vulnerable depend on the natural environment for their livelihoods, such as small- scale agricultural producers, as indigenous communities whose lifestyles are dependent on the preservation of Brazil’s natural habitats, as well as urban dwellers exposed to pollution, water scarcity or power shortages, and the risks of natural disasters. The high population density and large numbers of poor in urban areas characterize the vulnerability to natural hazards in the country, largely driven by the suboptimal land use and planning that characterizes Brazilian cities. With much fewer means to protect or insure themselves against environmental risks, the poor and B40 are particularly affected by the degree to which government policy and regulation manages to balance the needs of economic development with the objective of environmental sustainability. This SCD shows that there is significant scope to reduce the burden of existing regulation and improve their environmental impact, for instance in the management of land and water resources. Indeed, Brazil has the opportunity to position itself as a leader in exploring green growth paths for emerging markets through innovative policy design. This has the potential to create new economic opportunities for the B40 and greatly increase their resilience against climate-related and other natural shocks. 17. The reforms required to preserve Brazil’s socioeconomic achievements and return the country to a sustainable growth path are challenging. Brazil rightly looks back at its recent progress in social inclusion with pride. Some in the country see a direct association with an expansive public sector and fear that regulatory reforms and spending cuts may unwind many of these gains. The analysis of this SCD points in a different direction. Brazil’s political institutions have required compromises that have swelled government commitments even at the cost of significant inefficiencies. In times of tight fiscal constraints, it may be time to review some of these compromises and generate a new consensus in favor of a more efficient, while still inclusive, economic and social model. Brazil’s own history suggests that a new policy consensus has emerged at times of crisis and allowed the country to overcome past institutional constraints to better public sector governance. In the late 1990s, repeated bouts of high inflation finally convinced the political class to establish a new set of institutions – vi RETAKING THE PATH TO INCLUSION, GROWTH AND SUSTAINABILTY the macroeconomic tripod and the fiscal responsibility law – that guaranteed macroeconomic stability for the next 15 years. Likewise today, poor macroeconomic prospects, the decreasing public tolerance of the ‘old ways’ of political deal making, as well as growing pressure for improvements in the quality of services may create incentives for policy makers to align behind a coherent economic strategy and overcome the vested interests that have blocked reform to date. Brazil’s political establishment has already demonstrated leadership and vision in declaring ambitious climate objectives – a national consensus seems to be forming in favor of a future green growth model. All this is reason to be optimistic. 18. The structure of the SCD follows the argument in the previous paragraphs. Chapter 1 summarizes Brazil’s achievements in reducing poverty and boosting incomes of the B40, drawing up a profile of the poor and vulnerable, their main assets, access to markets and public services and susceptibility to various economic risks, as well as the effectiveness of government transfers. Chapter 2 looks at Brazil’s political institutions to get at the root of the country’s fiscal challenges. Chapter 3 examines the consequences of these fiscal challenges for macroeconomic management and traces the evolution of Brazil’s macroeconomic policy framework since the days of high inflation in the late 1980s. Chapter 4 deals with the structural reforms needed to raise the level and types of private investment required to increase productivity growth and competitiveness, with a particular focus on the role of infrastructure. Chapter 5 reviews the scope for efficiency enhancing and socially progressive reallocations of government expenditures. It also analyzes why some vertical government policies, such as the Programa Bolsa Família (PBF) conditional cash transfer (CCT) program, have been so successful, while others—in infrastructure, or in the area of education—have had a more mixed record. Chapter 6 looks at the challenges for improved environmental and natural resource management, and outlines the contours of a future green growth strategy for Brazil. Chapter 7 concludes the SCD and draws out the main constraints to Brazil’s development. In the remainder of this overview, we summarize the responses to the key questions in each chapter. Who are the poor and bottom 40 percent in Brazil and how did they fare? 19. Between 2001 and 2013, 24.6 million Brazilians have escaped poverty, although Brazil remains one of the most unequal countries in the world. The reduction in poverty is an achievement of regional significance, representing almost 50 percent of the reduction in poverty in the whole Latin American and Caribbean (LAC) region (Figure 1). Brazil also experienced a rapid decline in inequality over the past decade, with the Gini coefficient of household incomes falling from 0.59 to 0.53. To a large extent, it was due to a policy of social inclusion in the context of a booming economy, fueled by favorable external conditions. Brazil’s achievements were also of historical significance, in that it was the first time in the history of Brazil that a sustained vii EXECUTIVE SUMMARY reduction in poverty and inequality had been achieved. Nevertheless, even after the reduction in poverty and inequality, Brazil remains one of the most unequal countries in the world, with a Gini coefficient higher than in most countries except Colombia and Honduras in Latin America and Caribbean and a few countries in sub-Saharan Africa. Figure 1: Progress in Poverty and Inequality Reduction in Brazil Gini Coefficient Extreme Poverty Rate (