Boosting Productivity: Taxes and Resource Misallocation in Brazil1
A. The Productivity Challenge in Brazil
1. Once Brazil recovers from its recent economic crisis, raising productivity will remain a top priority challenge. Brazil has struggled for several decades to generate strong and sustained productivity growth, the key driver of living standards over the long term. Brazil’s productivity grew by only 1.6 percent a year between 2001 and 2013 (Figure 1). By comparison, China and Russia, also considered emerging economies, saw their productivity rates rise by 9.6 and 3.5 percent, respectively (Ceratti, 2016).
Figure 1.Labor Productivity Growth in Selected Countries
Source: World Bank
2. Brazil’s productivity malaise can be explained by multiple factors, including significant resource misallocation. At the macroeconomic level, weak productivity growth can be explained by multiple factors, such as a high cost of finance and doing business, a poor state of the country’s physical infrastructure, limits to competition resulting from domestic regulation, trade barriers, and inadequate skills of the labor force (World Bank, 2016). At the microeconomic level, lack of total factor productivity growth reflects weak productivity performance by individual firms, which is typically related to the poor use of existing resources (labor and capital) within the country.
3. Reducing resource misallocation is a multidimensional task which requires upgrading the tax system. Resource misallocation is often the result of many poorly designed economic policies and market failures that prevent the expansion of efficient firms and promote the survival of inefficient ones. Reducing misallocation therefore requires the use of multiple policy levers, including structural (financial, labor, and product market) reforms which have proved successful in improving resource allocation efficiency.2 This appendix makes the case that upgrading the tax system in Brazil is also key to boosting productivity by reducing distortions that prevent resources from going to where they are most productive.
B. Resource Misallocation in Brazil
4. Resource misallocation reflects a poor distribution of resources across firms, reducing the total output that can be obtained from existing capital and labor. Resource misallocation is apparent in the dispersion in revenue productivity levels across firms, even within narrowly defined industries that produce similar goods. When dispersion is wide, reallocating resources from firms with low revenue productivity to firms with high revenue productivity increases output, simply by using the same resources differently. For example, imagine a situation in Brazil with two firms within the same industry that have identical technologies but face different tax treatments. This could happen if an inefficient small firm benefits from the tax exemptions under the SIMPLES tax regime, which is available to companies below a certain revenue threshold. In that case, the larger efficient company, using the economies of scale generated by its more efficient use of resources, would be fully taxed. In this scenario, aggregate output would be higher if capital were reallocated toward the more efficient firm, resulting in more investment in higher return projects. However, some resources would remain employed in inefficient firms that could afford to undertake investments in projects with lower pre-tax returns and survive thanks to lower taxation.
5. Brazil suffers from significant resource misallocation, as captured by high dispersion of revenue productivities across firms. Borrowing the data and the methodology from the IMF’s Fiscal Monitor (IMF, 2017), Figure 2 illustrates the dispersion in firm-level revenue productivities in Brazil and the top performing country in the sample.3 The figure shows that dispersion in the more efficient country is much narrower than that observed in Brazil. Consequently, Brazil would be able to reap substantial gains if it were able to move resources from those firms with lower productivity (on the left tail of the distribution) to those with higher revenue productivity (those in the right tail).
Figure 2.Brazil: Distribution of Firm-Level Revenue Productivities 1/
Source: Fund staff estimates.
1/ Data from the Fiscal Monitor (April 2017). The figure shows the distribution for firms in the manufacturing sector for each country. Top performer is defined as a country at the 90th percentile of the cross-country distribution of the aggregate resource allocation efficiency index for manufacturing.
6. In a fully efficient and frictionless equilibrium, Brazil could potentially increase its total factor productivity by nearly 60 percent. If marginal products were equalized within each industry, industry-level TFP would be at an efficient level. The Resource Allocation Efficiency ratio (RAE) is the ratio of actual TFP to this efficient TFP, aggregated across sectors.4Figure 3 plots the Resource Allocation Efficiency (RAE) for all 67 countries in the sample.5 It shows that Brazil is in the bottom third of the distribution. Implementing reforms to help Brazil to transition from its current level of efficiency to the level of the country in the 90th percentile of the distribution (in red) could increase Brazil’s total factor productivity by 57.3 percent. These estimates of TFP gains present a lower bound. While within-industry misallocation accounts for the bulk of cross-country productivity differences, reducing misallocation across broad economic sectors can also spur aggregate productivity and output. Although these numerical estimates should be treated with caution, as they are subject to statistical error like all estimates, they strongly suggest that Brazil could stand to gain much if it could take steps to improve resource allocation and productivity.
Figure 3.Brazil: Cross-Country Resource Allocation Efficiency 1/
7. Potential TFP gains from reducing resource misallocation could lift annual real GDP growth rate by roughly 2 percent of GDP. By comparing the gains in TFP and, consequently, the gains in output that could result from some interventions to reduce specific distortions, it is possible to estimate the GDP growth effects from such interventions. Assuming a transition path of 20 years, reducing resource misallocation (by moving Brazil to the 90th percentile of the distribution of resource allocation efficiency) translates into a higher annual real GDP growth rate of 2.29 percent for Brazil.6 One way to read this estimate is that when one considers the distance in output per capita between Brazil and the group of more developed/productive countries today, a substantial fraction could be made up just by improving the way Brazil uses the resources it already has. Of course, moving resources from one part of the economy to another is a slow process, hence the assumption of a 20-year period for catching up to the higher standard of resource allocation efficiency. In any case, as shown in Figure 4, these gains would be much higher than average gains for emerging market economies or the five largest economies in Latin America (LA5), partially because Brazil starts further behind in terms of allocation efficiency.
Figure 4.Brazil: Growth Impact from Improving Resource Allocation Efficiency 1/
Sources: April 2017 Fiscal Monitor.
1/ The figure shows medians across country groups. Estimates are computed based on the assumption that the other sectors could achieve TFP gains similar to those estimated for the manufacturing sector and that there are no adjustment costs. EMEs = emerging market economies; LIDCs = low-income developing countries; LA5 = Median for Brazil, Chile, Colombia, Mexico, Peru.
C. Upgrading the Tax System to Reduce Resource Misallocation
8. Among other factors, upgrading the tax system is key for reducing resource misallocation and increasing productivity and growth. Several policies may be behind high levels of resource misallocation. For example, Restuccia and Rogerson (2013, 2016) survey the literature and point to legislated provisions that vary by firm characteristics (for example provisions of the tax code that vary with size, tariffs applied to particular goods, employment protection measures, or product market regulations that limit market access); discretionary provisions made by the government that favor specific firms (for example subsidies, selective tax enforcement, or preferential loans); and market imperfections (for example monopoly power or incomplete financial markets). For Brazil, De Vries (2014) shows that taxes, regulation and access to credit create distortions to output and capital that vary by firm size, thus generating resource misallocation. Appy (2017) explains that the tax system in Brazil generates allocative distortions by altering the relative prices of labor and capital, and by inducing a suboptimal allocation of production by sectors and regions.
9. Distortive tax policy and tax administration are among the important factors that policymakers need to bear mind when tackling the productivity challenge in Brazil.11 Below, we examine a selection of tax policies to explore the channels through which they generate resource misallocation in Brazil, and provide some estimates for potential gains, based again on the methodologies outlined in the Fiscal Monitor (IMF, 2017). The analysis includes taxes that discriminate across capital asset types (leading to differentiated treatment of firms as the propensity to use the various asset types as input varies across firms), across firm characteristics such as their sources of financing (debt or equity), and their degree of informality.7
10. When disparities in effective tax rates across asset types push investors toward lower-return, tax-favored projects, resource misallocation increases. One way in which the tax code introduces distortions in the economy is by differential taxation across factors of production. In this situation, firms will choose their factor allocations partly based on tax concerns, displacing productive concerns. Also, firms that are factor-intensive on the privileged factor can afford being less productive and still be competitive due to their tax advantage. A standard method to estimate resource misallocation driven by tax disparity is to compare effective marginal tax rates (EMTRs) across various types of assets.8 The significant variation in EMTRs for various asset types in Brazil and half of the countries shown in the Fiscal Monitor (IMF, 2017) arises from differences between the rates at which the tax code allows businesses to deduct the cost of assets (known as tax depreciation) and the rates at which those assets actually wear out or become obsolete (economic depreciation).
11. Reducing resource misallocation associated to tax disparity in Brazil can increase productivity and growth significantly. The differential taxation between machinery and buildings could be used an indirect measure of the differential taxation between capital-intensive and labor-intensive industries leading to resource misallocation. Brazil suffers from the effects of high tax disparity, meaning that there are higher effective taxes for machines than for buildings. This explains why the country tends to have a lower share of machinery, compared to those countries with lower tax disparity. Eliminating most of the existing tax disparity and bringing Brazil to the level of tax disparity existing at the 90th percentile of the distribution, would raise resource allocation efficiency in Brazil by 12.3 percentage points and increase annual GDP by 0.58 percentage points (Figure 5). This potential improvement would be four times larger than the potential gain for emerging economies and three times the gains for the group of Latin American economies.9
Figure 5.Brazil: GDP Growth Effects from Reducing Tax Disparity 1/
The group of Latin American countries includes Argentina, Belize, Bolivia, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Falkland Islands, French Guiana, Guatemala, Guyana, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Suriname, Uruguay and Venezuela. The group of Emerging countries includes Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, South Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates.
Corporate Debt Bias
12. Giving tax breaks to debt but not to equity financing of risky projects increases resource misallocation. Governments can introduce distortions by privileging some financing methods over others. Corporate debt bias occurs when firms are allowed to deduct interest expenses, but not returns to equity, in calculating corporate tax liability, raising the cost of equity financing compared to debt financing. Many young companies, especially innovative ones and R&D-related startups finance their operations with equity due to the risky nature of their businesses because there are no collateral requirements and shareholders share in upside returns (Stiglitz, 1985; Hall, 2002; Brown and others, 2009). Therefore, corporate debt bias induced by the tax system not only distorts the financing choice, but it can also create resource misallocation by imposing a higher marginal tax on R&D investment compared to other capital spending.
13. Reducing the corporate debt bias can help increase productivity and growth associated to innovative companies. The debt bias can be measured as the EMTR on equity minus the EMTR on debt.10 The results from the Fiscal Monitor (IMF, 2017) show that R&D intensive industries—which are more exposed to debt bias—have lower resource allocation efficiency in countries where debt bias is higher. Using these estimates, we calculate that if Brazil were to reduce its corporate debt bias to the level observed in the 10th percentile of the sample (thus moving the country to the 90th percentile of the distribution of resource allocation efficiency), it could raise its resource allocation by 5.56 percentage points and annual GDP growth in Brazil by 0.27 percentage points (Figure 6). These gains would be 40 percent higher than for the average of Latin American countries and almost three times larger than for the average of Emerging countries.
14. Tax informality is not only a problem for revenue collection but also for productivity. The literature defines informal firms are those that fail to pay the full amount of tax due, recognizing that there are many reasons why a firm or individual might not pay taxes (Kanbur and Keen, 2014). Noncompliance with taxes reduces productivity by interfering with firm entry and exit. Informal firms enjoy a relative cost advantage over their tax compliant competitors through tax evasion and circumvention of regulations. This allows informal firms to stay in business despite their low productivity, increasing their weight in the economy at the expense of more productive firms.
15. Reducing tax informality in Brazil can help increase productivity and growth further. Results from the Fiscal Monitor (IMF, 2017) suggest that, as tax enforcement improves and the prevalence of informality falls among registered firms, less productive firms will exit the market, releasing resources that can then migrate to more productive firms. Reducing tax informality to the level of the best performers can increase productivity in Brazil by 2.58 percentage points and annual GDP by 0.12 percentage points (Figure 7). While significant, these gains would be smaller in Brazil than in the groups of Latin American and Emerging countries, reflecting the improvements that Brazilian tax administration has experienced in the last decades.
D. Conclusions and Policy Recommendations
16. Resource misallocation in Brazil is significant. Resource misallocation arises from distortions that prevent the expansion of efficient firms and promote the survival of inefficient ones. It is apparent in a wide dispersion in productivity levels across firms, even within narrowly defined industries.
17. Brazil can reap substantial TFP gains from reducing resource misallocation. By enabling firms to catch up with the productivity frontier, Brazil can reduce resource misallocation. Using methodologies developed in the Fiscal Monitor, it is possible to estimate that reducing resource misallocation could increase productivity by more than 50 percentage points in Brazil. In other words, the evidence suggests that with existing resources, and simply by improving the way these are used, output could be that much higher. If one could imagine that a reallocation of resources could be implemented gradually over 20 years in such a way that Brazil’s levels of efficiency could catch up with those of leading countries, that would boost annual GDP growth by more than 2 percentage points during this catch-up period. While these estimates are subject to statistical uncertainty, like any estimates of this type, they are suggestive of the scope for improvement that is available to Brazil if it can focus on a productivity-increasing agenda.
18. Resource misallocation can be reduced by upgrading the tax system. Distortions are created by several factors, like poorly designed economic policies and market failures. The tax system is also an important factor. Countries, such as Brazil, can reap TFP gains by upgrading the design of their tax system, to ensure that firms’ decisions are made for business reasons and not tax reasons. Significant gains can also be achieved if Brazil addresses tax treatments that discriminate by asset type, sources of financing, or by firm characteristics such as tax informality. The estimates shown in the preceding sections suggest that by addressing tax-related distortions, Brazil could bridge about half of the gap in productivity relative to leading countries. Again, exact estimates of potential gains need to be taken with caution; but they confirm that there are important benefits for the country that can be reached by pursuing a well-designed, productivity-oriented tax reform.
AppyB.2017 “Tributação e produtividade no Brasil” In Bonelli and others Anatomia da Produtividade no BrasilRio de Janeiro: FGV-IBRE.
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Prepared by Henrique Fialho Barbosa (WHD) and Carlos Mulas-Granados (FAD), based on the IMF’s Fiscal Monitor chapter on the same topic (IMF, 2017).
For selected advanced economies, Dabla-Norris and others (2015) show that TFP gains from improving factor allocation across sectors average about 9 percent.
According to Hsieh and Klenow (2009), “revenue productivity (the product of physical productivity and a firm’s output price) should be equated across firms [in the same industry] in the absence of distortions. To the extent revenue productivity differs across firms, we can use it to recover a measure of firm-level distortions.”
Using a Cobb-Douglas aggregator.
Using firm-level data for 10 advanced economies (from ORBIS database) and 57 developing countries (from World Bank Enterprise Surveys), the Fiscal Monitor (IMF, 2017) calculates resource allocation efficiency for each industry within each country.
We assume a transition period of 20 years to make our results comparable to those calculated for other countries in the world (see IMF, 2017).
Because industry or firm specific tax policy indicators are not readily available for a wide set of countries, like in the Fiscal Monitor (IMF, 2017) most of the analyses in this section rely on a difference-in-differences approach to assess the effect of tax distortions on resource misallocation.
The EMTR on capital income measures the tax burden applied to before-tax capital income realized over an investment’s lifetime, implied by major provisions of the corporate tax code. These major provisions include the statutory federal tax rates, surcharges, local tax rates, depreciation rates and accelerated depreciation, treatment of inventories, and interest deductibility.
Note that underlying data for Brazil used in the Fiscal Monitor (IMF, 2017) is from 2009 as reported by the World Bank Enterprise Survey. This is when still Brazil was still among the best performing emerging markets, a situation which has changed since 2014 due to one of the deepest recessions in its history. Therefore, inefficiencies may be larger now and gains from reducing resource misallocation could be even higher today.
Note that in the case of debt-financed investment, the combination of interest deductions and accelerated depreciation can exceed taxes paid on the associated income, resulting in negative EMTRs.