Fiscal Responsibility Legislation And Fiscal Adjustment: The Case Of Brazilian Local Governments

Summary

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This paper discusses trends in fiscal adjustment in Brazil since the 1990s, with particular emphasis on the strengthening of institutions for fiscal policymaking, and its effect on local government finances and their ability to invest in infrastructure building and upgrading. Although fiscal adjustment, which is ongoing, has taken a toll on the government's ability to finance much-needed infrastructure investment, it is not the only culprit. A lack of budget flexibility, against a backdrop of increasing downward rigidities in current spending, also constrains the government's ability to invest. The paper argues that regulatory uncertainty in many sectors, particularly water/sanitation, in which the municipalities play a leading role, has discouraged private sector investment and that the financing of infrastructure building and upgrading goes beyond the municipal level of government. Higher-level jurisdictions are responsible for financing investment in energy and transport infrastructure, for example.

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Fiscal Responsibility Legislation And Fiscal Adjustment: The Case Of Brazilian Local Governments

Luiz de Mello1

1. Introduction

1. Brazil's fiscal adjustment since the floating of the Real in 1999 has been impressive, even under adverse conditions. This has been of paramount importance in the consolidation of macroeconomic stability in the period and to ensure that the dynamics of public indebtedness is sustainable. But fiscal adjustment has taken place on the back of revenue hikes and, to a lesser extent, a compression of public investment, rather than the retrenchment of current outlays. As a result, Brazil's tax-to-GDP ratio is now much higher than that of countries with comparable income levels, being close to the OECD average and nearly twice as high as that of the rest of Latin America. This suggests a quality problem: based on international experience, the composition of fiscal adjustment affects its likelihood of success in the sense of delivering a sustained reduction in indebtedness over time.

2. Against this background, this paper discusses trends in fiscal adjustment in Brazil since the 1990s, with particular emphasis on the strengthening of institutions for fiscal policymaking, as well as its effect on local governments and their ability to invest in infrastructure building and upgrading. The main issues to be highlighted are as follows:

· The strengthening of fiscal institutions has played an important role in instilling fiscal probity at all levels of government. Emblematic of developments in this area is the enactment of the Fiscal Responsibility Law in 2000. Market scrutiny also helps, and policymakers now appear to be responding more forcefully to changes in public indebtedness by delivering the primary budget surpluses needed to service their outstanding debt obligations.

· Fiscal adjustment is on-going and has taken a toll on the government's ability to finance much- needed infrastructure investment. But fiscal retrenchment is not the only culprit for a lack of investment. Regulatory uncertainty in many sectors, particularly water/sanitation, in which the municipalities play a leading role, has also discouraged private sector investment. It also needs to be recognized that the financing of infrastructure building and upgrading goes beyond the municipal level of government. Higher-level jurisdictions are responsible for financing investment in energy and transport infrastructure, for example.

3. The paper is organized as follows. Section 2 reviews broad trends in fiscal adjustment since the early 1990s, focusing on debt sustainability. Section 3 discusses the main provisions of Fiscal Responsibility legislation. Section 4 discusses trends in municipal finances, including investment. Section 5 concludes.

2. Trends in fiscal adjustment: the focus on debt sustainability

4. Brazil's fiscal performance has improved over the years at all levels of government, owing predominantly to the need to contain the rise in public indebtedness (Table 1).2 Currently at about 52 percent of GDP, the consolidated net public debt is not only high but its composition, with relatively short maturities and a high share of securities paying floating interest rates, makes the debt dynamics overly sensitive to changes in market conditions. Exposure to foreign exchange risk has now been reduced considerably through the gradual retirement of foreign exchange-indexed debt since 2003. Continued effort is therefore needed towards fiscal consolidation in countries, such as Brazil, where public indebtedness is perceived as a source of vulnerability. Recent empirical evidence suggests that debt levels above 30-50 percent of GDP may not be sustainable in emerging markets.3

5. Against this background, a few considerations are noteworthy:

· Fiscal stance has responded swiftly to changes in the macroeconomic environment. The consolidated primary surplus -- including the central and sub-national levels of government -- has been raised over time to keep the debt-to-GDP ratio on a sustainable path (Figure 1).4 This has been the case even in periods of economic slowdown, making fiscal stance less counter-cyclical than desirable. Concern about the sustainability of public indebtedness calls for corrective action even in periods of below-potential growth, making fiscal consolidation, rather than short-term demand management, the overriding objective of fiscal policymaking in indebted countries.5 In fact, the OECD experience shows that a pro-cyclical fiscal stance is not uncommon in industrial countries, particularly when retrenchment is implemented to restore fiscal sustainability against a backdrop of high, or rising, indebtednes...

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