88640 JUNE 2014 • Number 147 Another Attempt to Reform Brazil’s Intergovernmental Financing Arrangements: Preliminary Results and Future Prospects Rafael Barroso and Jorge Thompson Araujo Since the mid-1990s, Brazil has struggled, with limited success, to reform its intergovernmental financing arrangements. Every four years, the electoral cycle brings promises of much needed reforms. Recently, Brazil had an unusual window of opportunity to promote such reforms, brought about not by another electoral cycle, but by Supreme Court rulings and changes to its oil exploration regime. This note takes stock of the proposed and realized reforms and simulates their impact for state governments in Brazil. In contrast to most Latin American countries, the extent of Key Issues in Brazil’s Subnational Fiscal revenue decentralization in Brazil is comparable to Organisa- Framework tion for Economic Co-operation and Development (OECD) The main deficiencies of the Brazilian fiscal federalism frame- levels. However, Brazil’s subnational finances are fraught with work manifest in different forms. They can take the form of: complexity, inefficiency, and intrafederative conflicts, leading a “fiscal war” 1 among states in the federation; ample heteroge- to several reform attempts over the years that have been in- neity in terms of vertical imbalances at the subnational level; complete or unsuccessful. Inefficiencies include an overly and the tensions in establishing limits to and controls on sub- complex state-level value-added tax (VAT) that favors a “race national borrowing. to the bottom” in the granting of tax incentives by states; a rigid intergovernmental transfer system; and political pres- Indirect taxation sures to revisit the subnational borrowing framework that has ICMS poses myriad problems. While it retains VAT-like fea- helped support the country’s fiscal sustainability prospects. tures, the ICMS differs from similar arrangements in other Such weaknesses have constrained the country’s long-term countries in that its revenues are collected and administered growth prospects. by state governments. The legislative framework is set by a External factors are forcing changes in the current subna- federal law, but states can issue local regulations within the tional fiscal framework. Recent Supreme Court (STF) rulings broad federal rules. While states have autonomy to set inter- affected both intergovernmental transfers and ICMS (Imposto nal rates, the Senate is responsible for setting interstate tax sobre Circulação de Mercadorias e Seviços, VAT), prompting rates. The ICMS operates under a mixed origin-destination Congress and states to respond. The debate on the new oil ex- system in which the interstate tax rate is used to split the rev- ploration regime also impelled the legislative branch to change enues of interstate transactions between the producing (ori- the oil royalties–sharing scheme. Finally, states and munici- gin) state and the consuming (destination) state. palities have been lobbying continuously for a renegotiation The sizable differences in the interstate tax rates provide of the terms of their debt to the federal government. ample space for poorer states to implement tax incentives to 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise attract investors, fueling the so-called fiscal war. These fiscal tional Treasury Secretariat . However, some subnational gov- incentives are irregularly awarded tax breaks aimed at per- ernments (SNGs) are still facing high debt and debt service suading firms to choose to operate in the grantor state—with- burdens, putting pressure on their budgets and creating re- out the approval of the collegiate body, the National Council siduals to be refinanced after the 30-year period. In addition, of Fiscal Policy, as required by law. Because of the mixed ori- the volatility of the price index and the lower benchmark in- gin-destination principle, tax incentives given by the produc- terest rate (SELIC) underscore the need to adjust the terms of ing state have to be honored by the consuming state, therefore the refinanced debt, since the subsidy represented by the dif- diminishing its revenues. As a result, the spatial allocation of ference between the SELIC rate and the interest rates paid by resources is distorted, the competitiveness of richer states is the SNG has narrowed, or even turned negative. reduced, and the ICMS revenues from manufacturing (the most affected sector) are diminished. The Proposed Reforms Intergovernmental transfers During 2013, proposals to reform five areas—ICMS, FPE, The States’ Participation Fund (FPE, Fundo de Participação dos CFEM, oil royalties, and debt—of the subnational framework Estados)—the main revenue-sharing unconditional transfer were discussed simultaneously. from the federal government to the states—has also been at The federal government submitted a proposal to Con- the center of the subnational fiscal policy debate. The FPE op- gress to reform the ICMS in December 2012. The corner- erates through fixed coefficients, adopted in 1989, which stone of the proposal was the gradual unification of the ICMS were only supposed to be temporary, as law 62/1989 envis- interstate tax rate from 7 percent and 12 percent to 4 percent aged their replacement by new variable coefficients through in all transactions, except for goods originating from the another bill. While the FPE remains broadly redistributive, Manaus free zone and the interstate natural gas trade. The ra- the continuing use of fixed coefficients overlooks significant tionale was to end the original cause of the fiscal war, which changes in regional development during the past two decades. was the differential in tax rates between regions for the inter- In particular, the current calibration does not take into ac- state trade. To persuade the states to cease the fiscal war, the count the fact that the Center-West Region and some north- federal government proposed the institution of two special eastern states have significantly developed over the past de- funds. The aim of these funds was to compensate reform los- cades, suggesting that their respective coefficients may be ers and allow states to implement policies for regional devel- biased upward. opment and to attract businesses. While a new law on the FPE had not been voted on in The Senate, however, amended the government propos- Congress until recently, the old FPE sharing criteria were al. The amended version did not keep the gradual unification ruled unconstitutional by the STF on February 24, 2010. The of the ICMS interstate tax rate and created several exceptions, STF then required that new rules be put in place by end June resulting in a more complex tax regime. For instance, prod- of 2013. ucts originating from the North, North-East and Center-West Oil and mining royalties comprise another type of trans- regions, plus the state of Espírito Santo, would pay a tax rate fer to states that is undergoing reform. The distribution of of 7 percent. In addition, goods from the Manaus free zone resources from petroleum—especially royalties—also suffers and the other 12 free trade zones in the north of Brazil would from significant asymmetry, but of a different kind: high con- keep the 12 percent rate. Lastly, the old interstate tax rate of centration in producing states. As for the mining royalties 12 and 7 percent would still apply to natural gas. (CFEM), the recent commodity boom and the large amount The Senate proposal reduced, but did not eliminate, the of oil royalties collected opened the government’s eyes to the fiscal war since the interstate tax rate magnitude and regional need to reform outdated mining regulations and to increase differentials were maintained, although lower. On the other currently low revenues from mining royalties. hand, the maintenance of a tax rate differential for wholesale Subnational debt and retail still allowed for the so-called “fiscal invoice tour.”2 Subnational debt distress in the late 1980s and 1990s led to Moreover, it increased the size of the tax rate differential in three rounds of renegotiations between states and the federal the case of the free zones, boosting the incentive for the fiscal government to restore subnational debt sustainability. The war. Finally, it increased the compliance cost of the tax, due to first two rounds occurred in 1989 and 1993. The last and greater exceptions in tax rates. largest renegotiation for states took place from 1997 to 1999, The proposed reforms on intergovernmental transfer leading to the restructuring of nearly 12 percent of the na- framework were a mix of parliamentary and SNG initiatives, tional debt stock. This restructuring was the most compre- responding both to Supreme Court decisions and incentives hensive, including subnational bonds, and was conditioned to obtain more resources. Twenty-two reform proposals for upon states’ compliance with medium-term fiscal adjustment the FPE were presented to Congress, but the one approved es- and structural reform programs agreed upon with the Na- tablished that, until 2015, the old FPE shares will remain un- 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise changed. From 2016 onward, each state will receive the same tive to the beginning of the contract, but only for those SNGs value as per the previous year, adjusted for inflation (IPCA), whose accrued interest was higher than the accumulated plus 75 percent of Brazil’s GDP growth rate. If the total SELIC for the same period. amount of the FPE envelope is higher than the sum of the ad- The Outcome of the Reforms justed FPE values, then the surplus would be distributed in direct proportion to the share of population of each state and Out of the five reforms discussed, only one—FPE—was imple- in inverse proportion to their per capita household income. mented. Senate amendments to the government proposal cre- The population shares have a lower bound of 1.2 percent and ated a stalemate in the ICMS reform. The changes in the sub- an upper bound of 7 percent, benefiting the least populated national debt terms were approved in Congress, but stalled in states. the Senate due to the retroactivity clause introduced. In turn, while the current proposal to change the distri- Regarding the oil royalties, the presidential vetoes were bution of oil royalties has been under discussion for a few overturned by Congress, and the MP expired. After that, the years, it remains mired in controversy. Initially, when the gov- state of Rio de Janeiro appealed to the Supreme Court to de- ernment proposed a change in the oil exploration regime in clare both the law and the MP unconstitutional. Currently, 2009, its intention was not to change the distribution rule. the changes are suspended due to an injunction issued by the However, Congress amended the law to redistribute all royal- Supreme Court in response to an appeal from oil-producing ties—old and new contracts, concession and production-shar- states. ing regime—accruing to SNGs according to the FPE and FPM Lastly, even though the government has not withdrawn coefficients. Under this amendment, the federal government its proposal to change the landmark mining regulation, this would compensate the losing states with its share of the royal- proposal is no longer a priority for the government. ties. These changes were vetoed by the president and the orig- inal rules set in 1997 were maintained. In 2012, Congress Conclusion approved another law (12.734/12) that set the royalty rate at What if all five reforms had been implemented? The follow- 15 percent for the oil-sharing regime, instead of the current 5 ing simulation demonstrates the estimated net results for to 10 percent rate, but no special participation payment was each state, and was conducted under the following scenario: foreseen. The law also changed the royalty and special partici- FPE as approved by Congress, royalties paid as foreseen by the pation distribution in favor of nonproducing states in both new (albeit suspended) legislation, tax rates doubled for new and old contracts. These changes were again vetoed by CFEM, ICMS reformed as in the Senate proposal, and debt the president, and an Executive Order (MP) established new price index and interest rates reduced with no retroactivity. royalty distribution rules for contracts signed after December Figure 1 displays the estimated loss for each state in 2020 as a 3, 2012. share of NRR. Lastly, the federal government sent to Congress a draft law The main winners are non-oil-producing small states to institute a new landmark regulation regarding mining activi- that have a moderate debt level and low GDP and household ties. Specifically, the government’s proposal envisages a change income per capita, and as such they are benefitting from the in the tax base from net revenues to gross revenues for mining FPE change as well. This is the case for Piauí, Amapá, Alagoas, royalties. The tax rates would be set by decree for each ore, re- Acre, and Maranhão. These five states presented not only the specting the maximum tax rate of 4 percent. The revenue-shar- largest gains, but all benefitted by the proposed changes. For ing scheme between government levels was maintained. example, Amapá would see its transfers boosted by 16 per- The debate on subnational debt focused primarily on cent of NRR in 2020, and its ICMS revenues increase by 2.2 changes to the indexation rules and concerns about debt sus- percent. The change in debt rules would represent a gain of tainability. The centerpiece of the federal government’s pro- less than 0.1 percent due to its low debt level. The main los- posal was a change in the interest rates accruing to the renego- ers, on the other hand, are large oil-producing states, such as tiated debt of the states and municipalities. Currently, SNGs Rio de Janeiro and Espírito Santo, and states strongly engaged pay interest rates of 6 percent, 7.5 percent, or 9 percent on top in the ICMS fiscal war. of the adjustment by the General Price Index (IGP-DI). The The main drivers of the results are the changes in royal- proposal aimed to reduce this interest rate from January 2013 ties and ICMS. This is because the changes in FPE are very onward to 4 percent on top of IPCA or simple SELIC interest gradual—the total amount of mining royalties collected is very rate accrual, whichever is lower. However, it did not change the small, and because the debt for the most indebted states will debt service ceiling, which varies from jurisdictions, ranging represent mostly a long-term gain, rather than budget savings from 12–15 percent of net real revenues (NRR). in the short term. On the other hand, ICMS is the largest tax The Senate committees modified the proposal to make in Brazil in terms of revenue generation: oil royalties distrib- the changes in the indexation clauses and interest rate retroac- uted in 2012 amounted to 3.6 percent of GDP. 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 1. Estimated Net Results in 2020 20 10 percent of NRR 0 Acre Alagoas Amapá Amazonas Bahia Ceará Distrito Federal Espírito Santo Maranhão Minas Gerais Pará Paraíba Paraná Pernambuco Rio Grande do Norte Rio Grande do Sul Rondônia Roraima Sergipe Tocantins Piauí Mato Grosso São Paulo -10 Rio de Janeiro Goiás Santa Catarina Mato Grosso do Sul -20 -30 -40 Source: Authors’ calculations. Regarding the new royalties rules, the losers and winners counting for 37 percent of the total loss in 2020. However, from this possible change are clear. The major losers would be states that have developed their industrial sectors, largely the two largest oil-producing states in Brazil, namely Rio de thanks to tax benefits granted in the 1980s and 1990s, and Janeiro and Espírito Santo. Rio de Janeiro, the largest produc- that have become net exporters in recent years, such as Bahia er, would lose revenues worth of 18.8 percent of its NRR in and Góias, would also lose revenues. Bahia would lose 2.3 per- 2020. Espírito Santo would suffer a loss of 11.5 percent of cent of its NRR, while Góias would lose 13.8 of its NRR. NRR. The major winners in the royalties redistribution are Lastly, the states of Santa Catarina, Mato Grosso do Sul and small and less-developed states such as Acre, Amapá, and Ro- Espírito Santo, which appear to be the main losers, with losses raima. Acre would see an increase in revenue of 12.5 percent of 15, 20.6 and 21 percent of NRR, have their losses overesti- of NRR. mated due to the limitations of the methodology, as explained However, there is a caveat regarding the methodology above. Therefore, even though they are losers due to the pro- used for the ICMS simulation exercises that influences the posed ICMS changes, it is hard to sustain that they would be way the results are interpreted. The methodology uses the the major losers. electronic fiscal invoice database, which has limitations im- On the winning side, there are the less-developed and posed by the data. The two main limitations are: (i) it does not net-importer states such as Maranhão, Rio Grande do Norte, capture the changes in ICMS revenues brought about by the and Piauí. These three states would enjoy a revenue gain Senate resolution that unified the interstate tax rate on im- worth of 8.3, 8, and 7.3 percent, respectively, of their NRR in ported goods, since it became effective only in 2013,3 and 2020. They do not have relevant industrial production, espe- therefore it does not accurately reflect the current scenario; cially for products sold outside their boundaries, and most of and (ii) it does not distinguish between taxes that were effec- the goods consumed come from factories outside the state. tively collected from those that were just registered and not In contrast to the changes in the FPE and ICMS, the paid due to fiscal war benefits. This is paramount because it proposed changes in the debt would benefit all states—at the tends to overestimate the loss of the most active states in the expense of the federal government. However, for some fiscal war. Therefore, these estimates must be read as the max- states, the reduction in interest would represent an immedi- imum estimated gain or loss to the state, and not as a mid- ate relief to their cash flow, while for others the gain would point. be in long-run debt sustainability, since they would still pay The main losers, as expected, would be the net-exporting a debt service that is lower than the actual installment due states. São Paulo would have a loss of 2.6 percent of NRR in to the debt service cap foreseen in the debt renegotiation 2014, increasing to a loss of 4.5 percent in 2020. It also would contract. Four states—Minas Gerais, Rio de Janeiro, Rio show the largest loss in absolute terms: R$8.3 billion, ac- Grande do Sul, and São Paulo—are in this situation. Thus, 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise for these states, the reduction in interest rate would trans- Adviser at the Office of Regional Vice President for Latin Ameri- late in accelerated amortization and smaller residuals at the can and the Caribbean of the World Bank. end of the contract. Notes The proposed changes do not cancel each other out in the majority of states. That is, the losses stemming from one re- 1. The “fiscal war” is defined as “the competition among states form are not fully compensated by the gains coming from of the federation for the installation of enterprises in their ter- other reforms—there is no endogenous compensation or zero- ritories through the granting of tax exemptions or benefits.” sum game. Therefore, to avoid losses that could jeopardize fis- 2. The “fiscal invoice tour” (passeio de nota fiscal) refers to a cal sustainability at the subnational level, an external source or situation in which companies send only the fiscal invoice and funding, probably the federal government, would need to step not the actual goods to a state where the interstate tax rate is in to soften the losses and make the reform viable. 12 percent. In this state, the company normally has a tax in- However, a few changes in the reforms would increase centive wherein it pays only 3 percent, but receives a tax cred- the space for internal compensation and reduce the need for it worth of 12 percent. The company then sells the product external resources from the federal government. The royalty back to its original state, where the good is claiming a tax redistribution imposes considerable losses on the two largest credit of 12 percent against a tax debit of 6 percent (the differ- oil-producing states. A more balanced rule would help, espe- ence between the interstate and the state tax rate), ending up cially since the slow transition rule of the FPE reduces the re- with a net tax credit of 3 percent. quirements of windfall gains from royalties to compensate for 3. For instance, the Rio de Janeiro Secretariat of Finance re- those losses. Lastly, a refinement in the ICMS methodology ported an increase of 38 percent on the value of the goods would reduce the uncertainty of estimates and thus make imported through its ports in the first two months of 2013. states more willing to commit to the reform. Reference About the Authors World Bank. 2013. Impact and Implications of Recent and Potential Rafael Barroso is an Economist at the Macro and Fiscal Manage- Changes to Brazil’s Subnational Fiscal Framework. Report No: ment Global Practice, and Jorge Thompson Araujo is an Economic ACS5885, Washington, DC. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise