40739 March 2007 · Number 104 A regular series of notes highlighting recent lessons emerging from the operational and analytical program of the World Bank`s Latin America and Caribbean Region. BRAZIL Improving Fiscal Circumstances for Growth* Ethan Weisman and Fernando Blanco INTRODUCTION Moreover, other policy decisions, such as minimum Why has Brazil not been able to grow faster for an wage increases, have aggravated increased current extended period of time? Long-run real economic spending. Rising minimum wages increase spending under growth for Brazil seems stuck around 2-3 percent per mandatory programs, especially social security. year (2.4 for the period 1980-2004), in contrast with other middle-income countries (e.g. China (9.8%), India Given the fiscal target and constraints on current (5.8%), and Chile (5.1%)). Although Brazil experienced spending, the most important part of the fiscal rapid annual average economic growth during the adjustment in recent years has been the increase late 1960s and 1970s (8.5 percent), domestic and in tax revenue, reaching about 38 percent of GDP international events led to much weaker growth in the in 2005. High taxation provides disincentives to decades that followed.1 investment, and encourages tax evasion and informal sector growth, which in turn leads the authorities to Fiscal circumstances in Brazil are a key constraint to search for additional tax revenue on a narrower set of faster and more robust economic growth. In part, this formal activities. Thus, there is a vicious cycle of ever is due to accumulated public sector deficits in earlier increasing mandated spending with increased taxation periods that are represented in Brazil's persistently high to meet the fiscal target. However, further tax increases net public sector debt (currently would be difficult to implement and enforce. about 50 percent of GDP). During the 1980s and mid-1990s high debt Budget rigidity, especially revenue earmarking, was associated with debt crises and restricts policy action to resolve the fiscal hyperinflation. Several attempts to conundrum. Revenue earmarking is linked to control inflation failed, until the transfers to sub-national governments, social 1994 Real Plan. Moreover, to inhibit sector spending, and specific taxes to cover the the accumulation of debt, and to social security deficit. The federal government is promote economic confidence in required under the 1988 Constitution to share 47 capital markets, two successive percent of its tax revenue (personal and corporate administrations have pursued primary fiscal surplus income taxes, and taxes on industrial products) with targets (4.25 percent of GDP in 2006). However, the lower levels of government. These transfers represent quality of fiscal adjustment has been poor. about 5 percent of GDP. Social sector spending is mandated as a share of current revenue. Legally mandated spending has increased rapidly, and without significant reform this type of spending Total public investment since 1998 has dropped by is projected to become explosive. An important part of more than 2 percent of GDP2. Private investment this mandatory spending is tied to the 1988 Constitution. has also been falling during this period. The drop in Less than 20 percent of the budget is discretionary. investment was caused by fiscal constraints and high * - This note is based on the World Bank Report (2007) Brazil: Improving Fiscal Circumstances for Growth (BR-36595). interest rates (caused in turn by the high level of public debt and rigid. Pension spending covers: 1) social security and associated risks, weak regulatory environments, and for all public sector workers (RPPS); 2) social public sector distortions in the domestic financial market). security for private sector workers (RGPS, the largest segment of the Brazilian pension system), and 3) a Spending levels are high relative to the quality of private complementary pension system. Brazil is an public services, pointing to weaknesses in expenditure international outlier in almost every class of social management. These weaknesses adversely affect public security spending (old age, survivor, disability, and investment and spending on public services. Thus, sick pay), due to extremely generous benefits. For increasing public investment alone will not accelerate example, survivor pension benefits represent 3.3 economic growth; measures are also required to address percent of GDP, which is over three times as large as expenditure management shortcomings. OECD countries that have older populations and higher incomes. FIVE STYLIZED FACTS Pension reforms have had limited impacts. The 1. BRAZIL'S SpENDINg IS LARgE AND INCREASINg December 2003 reform reduced somewhat the RPPS pension deficit, in part due to increases in the average Brazil has the largest public sector of any other middle age of pensioners and slower growth in new pensioners. income country. General government spending exceeds It also instituted contributions on retirement benefits, 40 percent of GDP and tax revenue was about 38 percent increased the minimum age for retirement, and of GDP in 2005 (an increase of over 10 percentage equalized the benefits of public servants to the general points since the 1990s). This is comparable to sizeable RGPS system (but only for new entrants, so the effect welfare states in northern Europe, such as Finland. When has been delayed). On the other hand, administrative combined with non-financial public corporations, the size reforms to the RGPS system in 1998 had more limited of the public sector represents about half of the economy. impacts. They introduced changes in the formula (the fator previdenciario) to reduce incentives for early The bulk of public sector spending is devoted to retirement, increased revenues (through recertification primary current spending (roughly 33 percent of GDP) efforts) and reduced the number of sickness benefits and is increasing3. Social security schemes alone (that took effect recently). However, both the average represent roughly 12½ percent of GDP. Sub-national retirement age (54 for men and 51 for women) and government spending on social services also has been average length of service remain low. RGPS expenditure expanding; this spending devolved to state and municipal and deficits continue to increase; so further parametric governments under the 1988 Constitution. Pressures reforms are needed. to increase social security and social spending are mounting, due in part to the aging population. 3. EFFECTS OF pUBLIC INVESTMENT AND CONSUMpTION ON gROWTH Off balance sheet transactions also have contributed to increasing the size of the public sector. Contingent The present level and composition of public spending liabilities include pending judicial decisions. The are not conducive to long-term economic growth. discovery and recognition of liabilities not previously Econometric analysis of per capita GDP growth over recorded (so called "skeletons") increased the stock of 1950-2000 shows: public debt substantially (with estimates ranging from · Public (and private) investment increases growth; 12-19 percentage points of GDP). The larger debt stock · Government subsidies increase private capital accu- has increased debt servicing payments. Tax expenditures mulation (and thus growth), but this effect dampens also contribute to fiscal pressures; the federal government over time as debt accumulates. tax expenditure was 2.5 percent of GDP in 2004. · The tax burden reduces capital accumulation (and thus growth). 2. SOCIAL SECURITY SpENDINg REpRESENTS A MAJOR · Government consumption, social security, and social CHALLENgE assistance transfers all reduce growth (the latter in the long run because more financing translates into Social security spending is mandated through the higher taxes). 1988 Constitution, which made the system generous 2 · March 2007 · Number 104 Over time, the composition of public spending has allocations set in multi-year plans, annual budgets, and shifted to larger shares of government consumption, amounts of investment effectively executed. Since 1996, social security, and social assistance and away from the government's primary instrument for expenditure public investment and targeted capital subsidies. planning has been its Multi-year Plan (PPA, Plano Additional taxation needed to finance the enlarged public Pluriannual), which does not contain a medium-term sector (along with inefficient expenditure composition) fiscal framework. The Budgetary Guidelines Law has dampened growth. (LDO) defines revenue, expenditure, and balances in a three-year rolling framework, but the LDO targets are Simulations show that Brazil would benefit from not well linked to the PPA, nor do they integrate the higher public investment within a tight fiscal constraint impacts of policy decisions, such as increases in the (however, increasing taxation or borrowing to pay for minimum wage. Moreover, Congress makes changes such investment would limit long-run growth prospects). when the budget proposal gets finalized in the Annual Given the low level of public investment, a reallocation Budget Law (LOA). In addition, a reversal of priorities from social security to spending on infrastructure would results from reductions to the budget and restrictions likely have sizeable growth effects. On the other hand, on the release of funds ("contingenciamento") during increasing public debt to finance transfers would decrease execution. growth. Moreover, increasing public debt to finance education expenditure would increase growth in the short As a result, the quality of spending is poor relative to run, but the debt accumulation would slow growth in the the amount of spending. For example, health indicators long run. are well below the average for middle-high income countries, even though per capita health spending is 4. THE BUDgET IS INFLEXIBLE above average. Moreover, the execution of spending is A major challenge is the excessive rigidity arising from not well monitored and evaluated for outputs or results. legally mandated expenditure and extensive revenue earmarking. There are essentially three broad sources of FOUR RECOMMENDATIONS budget rigidity: (i) earmarking of tax revenue, (the most important are Constitutionally mandated spending on 1. REDUCE THE SIZE OF THE pUBLIC SECTOR (AND CONTROL social protection, health and education, and transfers to EXpLOSIVE SpENDINg) states and municipalities); (ii) social contributions, which To address the fiscal conundrum nondiscretionary are used to cover part of the social security deficit; and expenditures need to be controlled and the rising trend (iii) non-discretionary expenditure that includes legal or reversed. Changes to legal mandates are required to Constitutional obligations for interest payments, wages restrain the growth of the public sector and to reduce and salaries, entitlements (such as social security), and its size. This will require legal changes to break the social assistance benefits. rigidity in social security and to add flexibility in social spending. Measures should focus on: So far government efforts in this realm have · reducing spending on the pension system; concentrated on an ad hoc measure to "de-earmark" · reducing certain subsidies, (e.g. credit through public federal revenue, called DRU (Desvinculação de Receitas financial entities); da União). However, given simultaneous increases in · increasing revenue by selectively applying fees for certain non-discretionary expenditure items (most notably services and eliminating tax expenditures; social security benefits), the DRU has had innocuous · revitalizing the privatization process to add efficiency impacts on budget rigidity and overall spending. and limit quasi-fiscal deficits; · taking into account the full fiscal impacts of further 5. THE BUDgET IS NOT WELL LINKED TO pLANNINg AND increases in the minimum wage, including impacts on EXECUTION OF pUBLIC EXpENDITURE social protection spending; (ideally, spending offsets An expenditure management review highlighted should be contemplated for such increases); and institutional weaknesses in planning, budgeting, · improving the quality of spending through better expenditure execution, and evaluation. In particular, targeting in social assistance programs, health, and there is a lack of congruence between expenditure education. March 2007 · Number 104 · To make these adjustments more persuasive, a certain 4. INCREASE pUBLIC (AND RELATED pRIVATE) SECTOR share of the fiscal saving should be directed to increase INVESTMENT public investment. Part of the fiscal saving should be directed to increase 2. MORE AggRESSIVELY DE-EARMARK REVENUE IN public investment, while keeping the overall tax COMBINATION WITH REDUCED MANDATORY SpENDINg burden and indebtedness under control. Systematic efforts also will be required to strengthen institutional Brazil should more aggressively pursue revenue de- capacities for planning, budgeting, and executing earmarking, but not through DRU. As a first step, public investments. Improving infrastructure ministries' all earmarked funding should be set in terms of reais capabilities to manage these limited resources in real terms (that is indexed to inflation) rather than efficiently and effectively could involve: (i) a medium- as a share of revenue. Unused funds in a given year term infrastructure investment strategy; (ii) a set of should be used for domestic debt reduction, or saved to performance indicators to monitor efficiency and fund additional infrastructure. De-earmarking should effectiveness of the infrastructure portfolio as a whole, accompany reductions in mandatory spending. as well as by sub-sector; and (iii) an organizational reform, including adoption of a human resource 3. IMpROVE pUBLIC SECTOR MANAgEMENT THROUgH policy to enhance the professional quality of the staff STRENgTHENINg pLANNINg, BUDgETINg, EXECUTION, AND working in the infrastructure sector and to streamline EVALUATION the ministries' business processes and organizational structures. Reforms to improve the coherence of planning, budgeting, execution, and evaluation should be Given the fiscal constraints, the private sector will implemented across all levels of the public sector. need to play a more active role. Public-private- Efforts could focus on improving the budget partnerships; solid and reliable contracts (public and cycle and developing a consistent medium-term private); and public sector reforms that strengthen macroeconomic framework consistent with the the regulatory environment are needed. Moreover, budget. getting the size of the public sector under control and continuously working to reduce indebtedness would set The LDO is the most appropriate vehicle to enabling conditions for continued reductions in interest develop a medium-term framework. Even in the rates, leading to more private sector investment. case of successful constitutional reforms to bring greater budget flexibility, there may not be sufficient ******** information to determine where the budget should be cut, preserved, or increased in the absence of a Notes medium-term framework. An institutionalized process 1. See also the World Bank Report (2002) - Brazil: of expenditure reviews for generating micro-level The New Growth Agenda. (BR-22950) information about saving options would be a useful 2. The central government dropped ½ a percent of addition to Brazil's planning and budget process. GDP, over ½ a percent of GDP from sub-national governments, and about 1 percent of GDP from public To strengthen executing agencies, measures should corporations. improve financial management, increase flexibility 3. Interest payments represented approximately 7 regarding human resource management, and percent of GDP per annum during 1995-2004. implement a solid set of monitoring and evaluation systems. Eventually, a medium-term framework About the Authors and the monitoring and evaluation system could Ethan Weisman is the Lead Economist/PREM be developed in a harmonized manner to support Sector Leader with the World Bank's Brazil Country results-based budgeting for the entire general Management Unit. Fernando Blanco is the Brazil Country Economist. government. "en breve" is produced by the Knowledge Team of the Operations Services Department of the Latin America and the Caribbean Region of the World Bank - http://www.worldbank.org/lac 4 · March 2007 · Number 104