Brazil: Selected Issues

International Monetary Fund. Western Hemisphere Dept.

doi:10.5089/9781475553222.002.A004

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Brazil: Selected Issues

Author: International Monetary Fund. Western Hemisphere Dept.

Publication Date:: 15 Nov 2016

eISBN:: 9781475553222

Language:: English

Keywords:: ISCR; CR; futures intervention; credit; central bank; income; producing state; revenue inefficiency; state GDP; expenditure rigidity; states of Minas Gerais

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Brazil: Selected Issues

Abstract

Brazil: Selected Issues

Stretching the Limits: The Evolution of Subnational Public Finances in Brazil¹

This annex documents the ongoing subnational fiscal crisis in Brazil. It looks at the evolution of subnational public finances since 2003, and provides evidence that while present stresses have a strong cyclical component arising from the recession, in some states current liquidity problems are symptomatic of deeper structural problems jeopardizing medium-term sustainability. In particular, during the past decade personnel costs followed a steep upward trend in many states, and revealed themselves to be unsustainable during the sharp deterioration of growth and revenues in 2015–16. Going forward, the federal governments and subnational entities need to collaborate and undertake a comprehensive reform of personnel and age-related social expenditures, together with a reform of the ICMS tax, to put subnational public finances in order.

A. Overview

1. A fiscal crisis has gripped the lower levels of government in Brazil. The press has been reporting frequently on the difficult liquidity situation of many states, which are being severely affected by the decline in the ICMS, the subnational sales tax, while some states are also facing declining oil royalties. Real revenue growth has been negative in most states since the beginning of 2015, while real personnel expenditures and retirement benefits have continued rising. States have coped with this situation in different ways: 20 states have increased their rates of indirect taxes (ICMS and ITCMD), most have reduced discretionary spending, and some state governments have, reportedly, been postponing payments and expenditures and adopting “securitization” to raise money.²

2. Facing rigid personnel spending obligations, the majority of states have cut their investment expenditures undermining future growth prospects. In 2015, 15 out of 27 states breached the limit of personnel expenditures to current net revenues established by the Fiscal Responsibility Law, the rest were approaching that limit, and 2 states had already exceeded the alert limit for debt (Rio de Janeiro and Minas Gerais).³ Constrained by declining revenues, mandatory spending and the prohibition imposed by the federal government in 2015 to take on new credit loans, states have slashed investment, by more than half compared to the previous period, thus affecting their capacity to contribute to the economic recovery.

B. Structure and Evolution of Subnational Budgets

3. Brazil is one of the most decentralized countries in the world. In Brazil there are 27 states and over 5,500 municipalities, which, after transfers, represent more than 40 percent of total budgetary resources collected in the country (Fardoust and Ravishankar, 2013). In areas such as health and education, the federal government and the states have overlapping responsibilities. In other areas, such as social spending for instance, the responsibility lies at the federal level almost exclusively, while the states administer almost 80 percent of spending on security.

4. In Brazil state governments rely on own revenues more than on federal transfers, while municipalities rely more on transfers from upper levels of government. States’ own revenues include the ICMS, the motor vehicle property tax (IPVA) and a tax on inheritance and donations. The ICMS resembles an origin-based VAT, levied on transaction in goods, communication, and transport services. It is collected and administered by states, who share with the Federal Senate the responsibility of setting norms and rates. This has led over time to excessive dispersion of effective tax rates and the introduction of incentives to attract investors, which has narrowed the tax base and fueled fiscal wars. According to the World Bank (2013), the ICMS is the main revenue source of the Brazilian fiscal system and thus the largest subnational own-revenue source, but its relative importance has declined. Proponents of an ICMS reform seek the unification of the ICMS interstate tax rate and the institution of special funds to compensate “reform losers,” and help states to boost infrastructure investment.⁴

5. The states enjoy unconditional transfers from the federal government through the State Participation Fund (FPE) and receive also a share of royalties from oil and mining. The FPE is funded through 21.5 percent of total revenue collections from two federal taxes, the Income Tax (IRPF and IRPJ) and the Tax on Industrialized Products (IPI). The role of this fund was equalizing in nature when the fixed coefficients were calibrated in 1989 to benefit mostly the less developed states in the North, Northeast, and Center-West. Significant changes in regional development in the past two decades made the coefficients obsolete. However, with the approval of a new law in 2013 (no. 143/2013), the equalizing role has resumed. The FPE is now distributed according to two criteria foreseen in the law. The application of each depends on a reference value. This reference value is the amount received by each state in the previous year corrected by inflation and 75 percent of Gross National Product growth. Up to this value, the amount is distributed according to the previous fixed coefficients. What exceeds the reference value is distributed according to a new criterion. This new criterion considers population (50 percent) and inverse of per capita income (50 percent). The distribution of resources from petroleum suffers from a different kind of asymmetry, as some of these transfers are highly concentrated in the producing states of Rio de Janeiro and Espírito Santo (Bevilaqua, 2002; World Bank, 2013). The dependence on transfers from federal government thus varied dramatically from one state to another. Outside of the revenue-sharing framework, funds are transferred to the states through the so-called convenios for the financing of investments, education, and regional development among others. These are negotiated grants funded through the Federal Budget (Rodden, 2003). Overall, transfers from the federal government to subnational entities has remained slightly above 5 percent of GDP during the last decade, but it has declined in recent years (Figure 1).

6. Subnational spending has increased gradually, but its composition has shifted in favor of personnel spending over the years. Subnational expenditures increased to 17.2 percent of GDP in 2015, from 16.5 in 2003 but social transfers and payroll have been an increasing share of public spending, representing 6.3 and 8.4 percent of GDP in 2015 respectively (up from 5.1 and 8.1 in 2003). An important asymmetry is that although states can increase the payroll by hiring and raising salaries when circumstances are favorable, they have limited ability to reduce or even contain personnel costs; and the share of spending on personnel in total revenues increased already following the 1994 real stabilization plan (Rodden, 2003; Bevilaqua, 2002).⁵ Other categories of subnational spending have been less important, with interest payments representing 0.5 and public investment 2 percent of GDP respectively. Subnational total revenues also grew over this period to represent 12.3 percent of GDP in 2015, up from 12 in 2003. Taxes were the major source of public revenues at 9.7 percent of GDP in 2015 (up from 9 in 2003), with social security contributions and other revenues representing only 2.6 percent of GDP (Figure 2). (These trends correspond to the aggregate of all subnational governments, and understates the adverse developments in some states, as will be discussed below).

7. Subnational finances have been deteriorating over the past few years. During 2003–11, state and municipal public finances generated a joint primary surplus of about 0.3–0.5 percent of GDP per year, reversing the deterioration of the 1980s and 1990s. However, some vulnerabilities had been building as cyclical revenue strength fostered real spending growth. The situation started worsening visibly in 2012 and turned alarming with the abrupt real contraction of activity in 2015. Because states rely on revenue sources that are very sensitive to the economic cycle, but face rigid mandatory expenditures, their primary balance became negative both in 2014 and 2015 (Figure 3). Some states had difficulties servicing their debt and even paying their payrolls on time.

8. Looking ahead, given population aging trends and current indexation rules, pensions will be a permanent source of spending pressure absent reforms. As with the federal government, the spending of the states on retirement benefits is growing and becoming increasingly unsustainable in the medium and long term. For example, out of 27 states, only Acre, Amapá, Rondônia, Roraima and Tocantins still registered a financial surplus in their social security systems at the end of 2015. On the other hand, São Paulo registered the largest negative result (-R$14.3 billion), followed by Rio Grande do Sul (-R$8.0 billion) and Minas Gerais (-R$7.1 billion). To attempt balancing the accounts in the future, some states are introducing the complementary social security systems in the mold of the Federal Public Worker Complementary Social Security Foundation (Funpresp).⁶ But more reforms are needed, especially with respect to special retirement plans granted to police officers, physicians and teachers, who can retire very early.

C. Structure and Evolution of Subnational Public Debt

9. Past subnational fiscal crises have resulted in bailouts by the federal government and a tightening of monitoring. Most states were affected by fiscal mismanagement in three notable episodes: in 1989, in 1993 and 1997.⁷ The size of these refinancing operations (through Federal loans) ranged between R$10 and R$90 billion, and in some cases these bailouts spilled over to public banks. All three crisis episodes where characterized by high personnel expenditures and unsustainable borrowing. The conditionality attached to the restructuring in 1997 succeeded in addressing the fiscal imbalances, which remained unresolved during the first two restructuring episodes of 1989 and 1993. The 1997 bailout included elements of debt forgiveness, interest subsidy, restructuring of maturities, and divestiture of state assets (Cordes et al., 2015; Bevilaqua, 2002). Since 2001, the country’s FRL gives the federal government significant control over the states, including the right to regularly supervise debt levels and personnel expenditures. The federal government must approve every new credit line, and guarantees all outstanding debt denominated in U.S. dollars. The FRL introduced a limit on the ratio of subnational net debt to net current revenues (NCR) at 200 percent, and a limit of 11.5 percent on debt service to NCR.⁸

10. Total gross debt of states and municipalities has declined during the past decade. At end- 2015, nonconsolidated subnational net debt amounted to about 13 percent of GDP, down from over 18 percent of GDP in 2003, of which 78 percent was owed to the federal government. Net debt has been on a similar declining trend as subnational assets, consisting mainly of bank deposits and taxes collected but not transferred, have been constant over time at about 10 percent of subnational gross debt. By virtue of past subnational bailouts, the federal government assumed the majority of subnational debt to national and international creditors and became the subnational governments’ main creditor.⁹ The composition of gross debt is, however, uneven across regions: while the overwhelming majority of debt in the South and Southeastern states is owed to the federal government, Northeastern and Midwestern states also have a large share of bank and external debt (Figure 4).

11. Nearly 90 percent of the debts of states and municipalities is concentrated in just ten entities. The state of São Paulo accounts for over 30 percent of the total subnational debt stock. In addition, the states of Minas Gerais, Rio de Janeiro, and Rio Grande do Sul are large contributors to total debt. Municipal debt is also highly concentrated within the five cities with largest populations. The largest and most populated states are also those with the highest debt burden as a share of state GDP, together with another group including the poorer states of the North and the North-East, such as Acre and Alagoas.

12. As a share of own (local) nominal GDP, the debt of states and municipalities declined until 2010, remained stable from 2011 to 2013, and rose during 2014–15. The largest decline in the debt-to-GDP ratio was registered in the northeastern state of Maranhão, followed by Piaui, Mato Grosso do Sul, Alagoas and Rio Grande do Sul (Figure 5). Since 2014, the subnational debt has, however, started to grow fast, primarily on account of an expansion in bank and external borrowing, induced in part by the slowdown in economic activity. Real growth of debt to domestic banks has been about 3 percent in annual terms over the past three years, but remains contained overall, below 2 percent of GDP in 2015.

13. The share of external debt in total state debt has been growing since 2009, increasing the states’ vulnerability to external shocks. In 2012, the federal government allowed 21 states to borrow an additional R$58 billion (14 percent of outstanding debt with the federal government) to make up for lower transfers caused by the economic slowdown and central government tax cuts. The total net debt of the states in 2015 was equivalent to 14 percent of GDP, 15 percent of which was foreign debt (Figure 6). In some states external debt was used to repay part of the debt owed to the federal government that bore higher interest rates. Yet, some 40 percent of the increase in external debt of states since 2009 was due to the depreciation of the real. Given that the vast majority of subnational governments does not earn revenues in foreign currency, the increase in foreign debt will put further pressure on servicing costs ahead, including for states with comfortable prudential ratios.

14. Adherence to the fiscal rule continued to weaken. Between 2003 and 2015, net debt in percent of net current revenues declined across subnational entities and was below the FRL limit except for Rio Grande do Sul. In 2015, this indicator has shown a worsening trend in all states, and approached fast the prudential limit in the large states of the Southeast region that depend more on own taxes. In 2016, Rio Grande do Sul and Rio de Janeiro had already breached the limit (with a debt above 200 percent of net revenues).

15. The federal government approved in 2016 a short-term plan to restructure state debt. On September 2016, the Ministry of Finance sent to Congress a proposal to extend maturities of regional government debt with the National Treasury for 20 years and with BNDES for 10 years. According to that plan, states would be given a grace period of 6 months during the second half of 2016, and debt-repayment would resume in 2017. The budgetary impact for the federal government would be R$20 billion in 2016, and R$15 billion in 2017 and 2018 respectively. The government’s proposal requires that States wanting to benefit from this debt rescheduling take a series of fiscal adjustment measures and accept to apply a spending cap for 24 months.¹⁰ While this debt rescheduling would alleviate fiscal tensions in most states, it will not be sufficient for those states which are nearly insolvent like Rio de Janeiro. Final legislative approval of the negotiated solution was still pending as of the writing of this document, with delays arising from disagreements over the type of adjustment measures and spending limits that should be required of states; but the grace period in the servicing of debt is being observed.

D. Recent Developments and Immediate Challenges in the Most Indebted Entities

16. The decline in the consolidated primary surplus of subnational entities since 2012 is mainly due to the weak fiscal performance of the 10 largest debtors (D-10).¹¹ Five large entities alone (São Paulo state, the municipality of São Paulo, Rio de Janeiro, Minas Gerais, and Rio Grande do Sul) account for 82 percent of total indebtedness. Together with the states of Paraná, Goiás, Bahia, Pernambuco and Santa Catarina, they constitute 91 percent of total subnational public debt. The average above-the-line primary balance of the ten most indebted states (D-10) has declined from 0.9 percent of GDP in 2008 to -0.15 percent of GDP in 2015 (Figure 8). From 2005, growing primary surpluses were used to repay debt, bringing down interest payments on debt close to zero by 2009. But since 2011, primary surpluses disappeared and indebtedness started to increase again. Interest payments of D-10 surpassed the primary balance, with the overall deficit becoming strongly negative (-0.5 percent of Brazil’s GDP in 2015).

17. The ten largest debtors have been deeply affected by the decline in tax revenue, especially from ICMS.¹² Between 2005 and 2015, ICMS tax collection declined considerably in D-10 states, from 5.4 percent of GDP to 4.6 percent. Part of this decline was due to competition between states to attract investments, and more recently to the impact of the economic crisis (Figure 9). In contrast, current transfers from the federal government declined more slowly over the period, reaching about 1.7 percent of GDP in 2015. Most affected were states like Maranhão that are highly dependent on federal transfers. Other states with greater fiscal autonomy, such as Santa Catarina and Parana, have experienced lower downward pressure. In addition to the decrease in ICMS tax collection and the overall effect of the recession, the state of Rio de Janeiro suffered the fall in royalties associated to the extraordinary retrenchment in activity from Petrobras.

18. Total consolidated primary revenues of D-10 states nonetheless were supported over 2005–15 by other revenue sources, most recently including one-offs. The decline in tax revenues (driven by weak ICMS tax collections) was compatible with stable primary revenues in the ten most indebted states thanks to two additional sources of growing revenues, which almost doubled. First, the increase in other current revenues from 0.75 to 1.6 percent of GDP between 2005 and 2015 was significant, and included revenues from fines, other indemnities and refunds, and judicial deposits in those states that resorted to these unconventional, one-off operations. In addition, the increase in revenues from social (and pension) contributions was also important and grew from 0.5 to 0.8 of GDP during the same period (Figure 10).

19. Widening primary deficits in D-10 States are largely a consequence of the increase in expenditures on employee compensation. A significant part of the primary expenditures of the largest debtors remained stable as a percentage of GDP from 2005 to 2015. The exception was the increase in personnel expenditures that matched the increase in social security contributions. The wage bill declined from 4 percent of GDP in 2005 to 3.7 percent of GDP in 2011. Since 2012, these expenditures experienced a sharp increase, reaching 5.1 percent of GDP in 2015 (Figure 11). In contrast, the evolution of public investment was volatile during the same period.

20. The increase in personnel expenditures in D-10 States was financed indirectly by borrowing. In 2011, the government stimulus policy allowed BNDES to finance certain subnational investment initiatives. Thus, credit transactions went up from 0.13 percent of GDP in 2011 to 0.81 percent of GDP in 2015 (Figure 12). These new resources freed up fiscal space, which was allocated to other current expenditures, in particular on personnel. The rise in personnel expenditures has increased the rigidity of the states’ budgets, worsening prospects for balancing budgets beyond 2015. In 2015, the Ministry of Finance limited strictly new credit operations by regions and municipalities, with the purpose on ending this practice. Subnational entities had to then look for funds elsewhere (e.g. judicial deposits) or accumulate arrears on their wage bill payments.

E. Concluding Thoughts

21. Much as the federal government, during the recession Brazilian subnational entities have been experiencing financial difficulties attributable to the general economic slowdown and budget rigidities. On the side of revenue collections, most states have been adversely affected by the decline in ICMS collection, but disproportionally more so those enjoying greater revenue autonomy. The contraction in revenue has mainly come from the slowdown in growth, possible compliance issues, as well as a decline in commodity prices affecting states highly dependent on these industries. Expenditure rigidities have become more binding in those states and municipalities that have rapidly increased wages and public employment in recent years (Rio Grande do Sul, Santa Catarina, São Paulo City, Bahia and Minas Gerais), planting seeds for a more difficult adjustment ahead. A rising share of external (foreign currency denominated) debt has pushed the interest burden up.

22. The adjustment in the near future will have to address the structural sources or revenue inefficiencies, and, most importantly, contain the structural growth of spending on wages and pensions. A reform of the ICMS reducing dispersion in tax rates across states, has the potential to unleash greater integration and to lower tax competition, while improving the business environment. While the crisis has not bottomed out, going forward the recovery of revenues will be uneven, with those states betting their future on commodity exports, such as Minas Gerais, needing a greater permanent adjustment than those penalized merely by the cycle (São Paulo). Most importantly, the resolution of the subnational fiscal crisis depends on structural expenditure rationalization that goes beyond the ten largest debtors and affect all states. In order to generate greater space for much needed investment, structural fiscal reforms need to address the pressures from unsustainable personnel and pension costs, which have increased 50 percent on average in the 27 states (up to 70 percent in Rio de Janeiro) between 2009 and 2015 (Figure 13).¹³

References

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Prepared by Izabela Karpowicz and Carlos Mulas-Granados.

Payment deferrals processed have increased by 37 percent between 2015 and 2016. Acknowledged expenditures from previous exercises (known as Despesas de Exercicios Anteriores) have increased 44 percent between 2015 and 2016. For more details, see Vescovi (2016).

The alert limit for personnel expenditures is set at 44 percent of net current revenues (and the maximum at 49 percent). The alert limit for state debt is set at 180 percent of net current revenues (and the maximum at 200 percent). See World Bank (2016) for other indicators of subnational fiscal distress.

The Revenue Compensation Fund (FCR—Fundo de Compensação de Receitas) would compensate the states for the losses incurred with the reduction in the interstate tax rate, while the Regional Development Fund (FDR—Fundo de Desenvolvimento Regional) would receive federal budgetary resources and proceeds from federal debt issuances to be distributed among states according to their share of population in total and the inverse of GDP per capita.

According to the 1988 Constitution, states cannot dismiss civil servants or decrease their wages in nominal terms.

For example, in the case of São Paulo, a complementary social security system for public workers was introduced in 2011 with the aim of guaranteeing financial equilibrium in the long term for the entire state social security system. Similarly, in 2013, Rio de Janeiro launched a complementary social security institution.

The 1989 and 1993 debt crisis were due to growing vertical fiscal imbalances that have reduced subnational fiscal control incentives, and the macroeconomic adjustment, which resulted in a real output contraction and lower inflation.

Net current revenue is equal to current revenue minus transfers to municipalities. The limit on new borrowing is 16 percent of NCR and the limit on concession of guarantees is 22 percent of NCR.

For example, 90.7 percent, or R$199.3 billion (US$52.4 billion) of the state of São Paulo’s debt in 2014 was owed to the federal government (Fitch Ratings).

The proposal, which was negotiated with state governors, was a solution to an unusual episode. In the second quarter of 2016, pressed for cash, 14 states asked the Supreme Court to order the federal government to use simple interest (as opposed to compound interest) in re-calculating states’ liabilities to the central government. The federal government opposed this interpretation of the law (which, applied retroactively, would reduce outstanding states’ debt to the federal government by 90 percent). The Supreme Court gave two months (expiring in September) to all the parties involved to work out an agreement or risk an unfavorable ruling. The 14 states have withdrawn their request for a ruling on simple vs. compound interest.

See Brazil Economics Digest (Credit Suisse, May 19th, 2015).

Almost 60 percent of revenues in the ten major debtor states come from taxes, while the other 40 percent correspond to voluntary or mandatory transfers from the federal government (constitutional mandates), social security contributions, and other current revenues (from service supplies, tax liabilities and tax debt renegotiations). Out of total tax revenues, 75 percent comes from the sales tax ICMS, and the rest from other local taxes. The most important federal transfers are those coming from revenue sharing mechanisms (taxes collected at the federal level, but shared by the three levels of government). Examples of these transfers are funds for education (Fundeb), revenues from oil and mining royalties, and fuel taxes (Cide).

As a share of current revenues, the wage bill exceeded the 46.55 percent limit under the FRL in 15 states in 2015.

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