Fiscally sound social inclusion: what, if any, lesson may EMU learn from the Brazilian experience of fiscal and political centralization? (by Carlos Pereira)

Fiscally Sound Social Inclusion:

What, if any, may EMU learn from the Brazilian experience of fiscal and political Centralization?

Carlos PereiraVisiting Scholar, Hertie School of GovernanceProfessor, Getulio Vargas Foundation – FGV

Mini-Conference and Lecture on “Fiscal Federalism within the EMU”European University Institute, San Domenico di Fiesoli, FlorenceDecember 12, 2016

Fiscal Rules at Glance (IMF)

Out of 207 countries, only 14 (6%) adopted Real Expenditure Rules: Australia, Belgium, Croatia, Denmark, Finland, France, Netherland, Hungry, Island, Israel, Kosovo, Mexico, Peru, and Poland

Balanced budget Debt limits Other expenditure rules Real expenditure rules Revenue rules0

10

20

30

40

50

60

70

80

90

79

67

40

14

7

Real Expenditure Rules• Brazil is about to adopt a very tough real expenditure rule.

– Constitution amendment (biding) – 20 years debt ceiling based on the inflation of the previous year

• The 14 countries that have also adopted real expenditure rules applied different methodologies and control mechanisms:– Take into account economic cycles– It is combined with other rules such as debt rules– The nature of expenditure (current expenses versus investment)

varies – Adapting exit valves – Smaller periods than 20 years– Not in the Constitution, which makes it more susceptible for

adjustments and adaptations

Why adopting such a tough expenditure constrain?

• Severe diseases require bitter remedies!• Serious lack of credibility

– Executive derives utility from fiscal stability and inflation control because of credibility gains in international markets.

• History books– Do the right thing while you are unpopular (about 8%)– Short time-horizon (No-reelection incentives)

• Impeachment of the president for fiscal crimes– It provided incentives for the new political elite to

overshooting fiscal reforms to justify their actions

How can a country (or a region that decides to work together) reaches an inter-temporal equilibrium?

GovernabilityDecisiveness

RepresentationAccountability

Equilibrium is the ability political and economic players achieve cooperation inter-temporally.

In the case of Brazil, it took more than one hundred years…

Old Republic (1889-1930)

Federal Government

Governors and regional

parties

• Strengthening of Federalism• Domination and

opportunistic behavior of elites and regional oligarchies

• Política dos Governadores• Fragmentation via state

political parties• Problems of governability

and lack of inclusion of elites not contemplated

Era Vargas: centralization (1930-1937 and 1937-1946)

National Executive

End of Federalism

• End of oligarchy federalism by Vargas

• The autonomy of the states was weakened and the end of the monopoly of the state parties

• Electoral Justice in 1932 and Proportional Representation in 1935

• Estado Novo: more centralization

• State flags were burned• Congress lost powers and

prerogatives

Decentralized Democracy: (1946-1964)

Weakened Executive

Fragmentation of Congress

• Constitutionally weak president• No Decree Power• No Urgency Power• No Budgetary Powers

• Proportional Representation: Multiparty and fragmentation

• Reestablishment of federalism• Minority Governments• Many governability problems

Military Regime (1964-1985)

Strong National Executive

Weak Congress

and Governors

• Re-centralization of the decision-making process– Decree Power– Urgency– Budget power and discretion

• Marginal role of parties and Congress

• Two-party system• Governors regain some powers at

the end of military regime with elections

New Constitution in 1988: New Equilibrium!

Strong Executive(No Gridlock)

Strong Checks & Balance

• Maintenance of strong executive• Maintenance of Proportional

Representation: Multiparty and Fragmentation

• Political Re-centralization and weakening of governors

• Coalition governments and and institutionalization of gains-from-trade mechanisms

– Cabinet, public jobs– Budget

• Institutionalization of a web of accountability• Independent Judiciary• Independent Public Prosecutors• Independent Federal Police• Independent Audit Institutions: TCU/CGU• Independent Regulatory Agencies• Investigatory and Independent Media

Brazil in Transition: Beliefs, Leadership and Institutional Change, 1964-2014

1960 1964 1974 1985 1994 2003

Ant i-Aut hor itar ianism

Aver sion to Infl at ion

Mil itar y Coup

Star tOpening

Redemo-c r at i-zat ion

RealPl an

FHC Lul aTanc r edo /Sar ney

Co l l orIt amar

GeiselCast el oBr anco Cost a

E Sil va

Medic i F iguei-r edoJ ango

60.7% 24.6% 98.3%

1050.6%

10.1%

Popul ism Aut hor it ar ian Rul e Democr acyWit hout Checks

& Bal ancesRul e-o f -Law

NewConst i-t ut ion

5.72%8.89%

4.03%2.81% 3.12% 4.81%

F iscalr espon-abil it y

Bel iefs

Infl ation

GDP

Pol iticalOutcome

---++-

-----+

+++Approval

Events

Timel ine

President

F r an-chise

Devel opment ism

Fiscal Responsibility Law – FRL • In the year of 2000, Brazil implemented a hard-budget constraint

legislation – the FRL.• Along with its companion law, the Fiscal Crimes Law, the FRL is the

culmination of a relatively successful set of measures to constrain fiscal behavior and control the state governments indebtedness.

• The FRL also bars the federal government from financing sub-national governments. This is meant to eliminate the possibility of bailouts as well as any changes in the financial clauses of the existing debt-restructuring agreement.

• The FRL illustrates the kinds of policy outcomes that reflect the national executive’s ability to implement its policy preferences in the political game.

• There is no question about the positive effect of the FRL with regard to the states’ fiscal situation, which improved considerably since the enactment of the FRL in 2000.

Brazilian States’ Fiscal Accounts (1993-2010)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

Fiscal Responsibility Law (2000)

F• President

• Mandatory Top-down (the federal government has the exclusive prerogative of setting debt parameters and expenditures ceilings)

R• Governors

• Control the state governments’ indebtedness (Audit Courts)

L

• Mayors• Sets parameters for all levels of government (Audit Courts)

• provides ex ante and ex post controls on both borrowers and lenders

Renegotiation of States’ Debts and Privatization of State Banks

• The view that governors in Brazil wield vast powers is inaccurate

• The President was able to impose his fiscal preferences – The President enjoys agenda powers and other legislative

prerogatives to implement its agenda. – He controlled resources – such as loans from federal banks and

treasury’s advances - that were used in exchange for fiscal reforms, including privatization of state banks and utilities.

– He was also helped by the reelection, which strengthened not only the President vis-à-vis governors but also helped extend the time horizons of governors; (19 governors ran for reelection), thus introducing some element of self-enforcement in the fiscal game.

– Financial vulnerability state governors faced – High electoral competition

Tax Revenue %GDP

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

Consolidated Public Sector Central Government States Municipalities

Tax Burden in Latin America19

90

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

0

5

10

15

20

25

30

35

40Argentina

BoliviaBrazil

Chile

ColombiaCosta Rica

EcuadorEl Salvador

GuatemalaHonduras

MexicoNicaragua

PanamaParaguay

PeruD. Republican

Uruguay

VenezuelaAverage

Source: CEPAL

Net Debt %GDP

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

Net Debt of Public Sector Federal Government Central BankStates Municipalities States Companies

Primary Surplus, % of GDP

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Consolidated Public Sector Federal Government + Centra Bankl Regional GovernmentsStates Municiplities

Why has this equilibrium been out of track?

1. The discovery of pre-salt oil reserves in 20062. The boom for Brazilian commodities 3. The global financial crisis of 2008

Those shocks, which were unexpected exogenous events with high consequences, have

momentarily relaxed the constraints imposed by the fiscal imperative.

Dilma Rousseff’s Administration

• New economic matrix• Creative accounting• The FRL prohibits the union to finance states and

municipalities. – However, it does not veto the authorization for states

and municipalities do contract new debts up to 60% of their revenue, which has allowed new indebtedness.

– From 2013 to 2014, the National Treasure has endorsed about R$ 50 billion of new debts at the state level.

New Economic Matrix(Primary Government Expenditure, GDP)

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20160%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

13.0

14.0

15.0

16.0

17.0

18.0

19.0

20.0

21.0

4.9 5.3 5.4 5.5 5.7 5.9 6.2 6.4 6.7 6.9 6.8 6.4 6.7 6.6 6.4 6.6 6.7 6.9 7.4 8.3

4.5 4.7 4.5 4.6 4.9 4.94.6 4.5 4.3 4.4 4.3 4.2 4.6

4.34.1 3.9 3.9 3.9 4.0

4.2

0.9 0.8 1.1 0.9 0.9 0.91.3 1.4 1.8 1.9 2.1 1.8 2.0

2.12.1 2.1 2.4 2.7 3.9

3.3

3.6 4.0 3.6 3.7 4.1 4.13.0 3.3 3.5 3.6 3.7 3.7 4.0

5.2 4.1 4.3 4.3 4.7 4.3 4.1

14.0

14.814.6

14.8

15.615.9

15.1

15.6

16.416.8 16.9

16.2

17.3

18.1

16.716.9

17.3

18.3

19.6

20.1

Social Security Benefits Personel Others Discretionary spenditure Spenditure

Source: IBRE/FGV

New Economic Matrix(Income Transfers, % of GDP)

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20164.0

5.0

6.0

7.0

8.0

9.0

10.0

11.0

5.4

5.8 5.8 5.96.2

6.4

7.07.3

7.78.0 8.0

7.6

8.17.9 7.8

8.08.2

8.68.9

10.1

Social Security Benefits Pension and Unemplyment insuranceBPC Income Transfers

Source: IBRE/FGV

Very high primary deficit in four consecutive years(Primary New of the consolidated public sector)

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

-0.9

0.0

2.93.2 3.2 3.2 3.2

3.7 3.8

3.2 3.2 3.3

1.9

2.52.9

2.1

1.4

-0.8 -1.1

-2.4-2.5

Central Government (Recurrent) Not Recurrent Regional GovernmentsState Companies Cnsolidated Public Sector

Source: IBRE/FGV

Even with the real expenditure rule, the primary net would be positive in 2020 only

20132014

20152016

20172018

20192020

20212022

20232024

20252026

15.0

16.0

17.0

18.0

19.0

20.0

21.0

E v o l u ti o n o f R e v e n u e s a m d p r i m a r y S p e n d i t u r e o f t h e C e n t r a l G o v e r n m e n t , % o f G D P

Net Revenue Spenditure (PEC 241/2016)

Source: IBRE/FGV

Expectation post-impeachment(Consumers and Business Confidence)

Sep-05Jan-06

May-06

Sep-06Jan-07

May-07

Sep-07Jan-08

May-08

Sep-08Jan-09

May-09

Sep-09Jan-10

May-10

Sep-10Jan-11

May-11

Sep-11Jan-12

May-12

Sep-12Jan-13

May-13

Sep-13Jan-14

May-14

Sep-14Jan-15

May-15

Sep-15Jan-16

May-16

Sep-1660

70

80

90

100

110

120

Consumers Confidence versus Business Confidence

CCI BCI

Source: IBRE/FGV

Expectation post-impeachment(GDP)

2016.I 2016.II 2016.III 2016.IV 2017.I 2017.II 2017.III 2017.IV

-5.4%

-3.6%

-2.9%

-2.2%

-1.2%

0.0%

0.9%

1.4%

Source: IBRE/FGV

Expectation post-impeachment (Inflation)

2015 2016 2017 20180.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%10.7%

6.6%

5.1%4.7%

10.7%

6.6%

5.5%5.1%

Actual Inflation (IPCA) Pessimistic Inflation (IPCA)

Scenario Exchange rate 2017

Actual R$ 3,25 / US$Optimist R$ 2,85 / US$

Source: IBRE/FGV

Expectation post-impeachment(Interest Rate)

2015 2016 2017 20180.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%14.1% 13.8%

11.0% 10.5%

14.2% 13.8%

11.3% 11.3%

Interest Rate (Selic)

Interest Rate (Actual) Pessimistic Interest Rate

Source: IBRE/FGV

Conclusion

• Conditions for fiscal reforms to succeed in the Brazilian federalism1. Centralization of the political game

• The Union has to have the agenda setting-power• Control of discretionary gains-from-trade mechanisms

2. Reform initiatives have to to be self-enforcing• Politicians in the different levels of the government

have to identify