Arminio Fraga: Four fiscal adjustments: a good and necessary path

Brazil needs four fiscal adjustments. Each has its role and deserves attention. Before discussing the Brazilian case, it is worth reviewing some concepts, without going into too much detail.

Here, the size of the government (strictly, of the State) is understood as the totality of primary public expenditure, that is, excluding interest. In a democracy, the decision as to the size of government rests with the legislature, in negotiations with the executive. The decision is political and is materialized in the definition of a Budget, built on the basis of an assessment of the costs and benefits of expenditure and collection. In particular, the process must take into account the impacts of each option on the productivity of the economy and on the desired degree of social solidarity, both in the short and long term. Such an assessment is extremely complex and rarely done.

The possibility for the government to borrow and apply resources allows the Budget to operate out of balance, within certain limits. The indebtedness must be such that it does not put pressure on the interest rates the government pays and gives the government some slack to deal with emergencies such as the pandemic that still plagues us.

Fiscal policy must therefore define and achieve four objectives: the size of expenditure, the budget result (the primary balance), spending priorities and the design of the tax system.

Let us now look at the Brazilian case, starting with the size of the government. For comparison purposes, I will use data from the IMF’s latest Fiscal Monitor. To avoid the impact of pandemic spending, which varied greatly by country and are exceptional, I will use data from 2019. Brazil spent 32.4% of GDP, up from the 29.9% average for emerging and middle-income countries ( “EMs”) and below the advanced ones (37.1%), with 47.9% in the euro zone and 33.6% in the US. If we include tax subsidies as an expense, which should be in the Budget, the expense is higher. By regressives, below I advocate their elimination. Other than that, my recommendation is to analyze and discuss the topic.

For consolidated government gross debt (ie, all spheres), I will use data projected to 2022, legacy to the next government. Having reached 98.7% of GDP in 2020, the projected debt for the end of this year is at 91.9%, a figure much higher than the average for MSs (67.4%). The recent decline was due to three non-recurring factors: negative ex-post interest rates in real terms and the effects of the spending ceiling on the federal government’s payroll. With a primary balance close to zero, growth of 2.5% and real interest rates of 5.9% (the current rate on ten-year Treasury bonds), debt will grow again. This is pure arithmetic.

With a high and growing debt, Brazil will find it difficult to finance itself in the event of a new negative surprise or public policy error. It would be possible to temporarily shorten the debt term, to gain time. But without substantive answers, it would just be a source of more risk, a costly waste of time. The recommendation here seems unequivocal to me: the next government needs to set credible multi-annual targets for the primary surplus, capable of bringing down the trajectory of public debt (as a proportion of GDP) in a realistic scenario for growth.

One often hears talk of just stabilizing debt, which would require a primary surplus of around 3% of GDP. In this case, with a GDP growth rate higher than the real interest rate, debt would fall over time. In theory, with a lot of luck and competence, it would be possible. But to rely on this unlikely scenario would be suicidal madness. For a long time, it will be necessary to program a primary surplus of more than 3%.

The current situation is worrying, given that payroll expenditures are held back and public investment is very depressed. Furthermore, demands for higher spending in the social areas suggest growing fiscal pressures as far as the eye can see.

The spending ceiling instituted by constitutional amendment in late 2016 froze spending in real terms and has been the main line of fiscal defense ever since. The ceiling combines two of the fiscal policy decision areas: the eventual achievement of a primary surplus and the reduction of expenditures as a proportion of GDP.

The original proposal had important implications. If GDP had grown by 2.5% per year during the ten-year ceiling, federal spending as a proportion of GDP would have fallen by 22%. It seemed unrealistic to me at the time. Five years are gone, difficult years of low growth. Spending as a proportion of GDP did not fall because GDP did not move and, on top of that, the ceiling was breached. And, the way things are going in Brasília, the risks of more punctures are increasing.

The truth is that, in addition to the blanket being too short, the Budget has been in a rut for a long time and in need of a deep review of priorities. It is high time to face this challenge. On the expenditure side, there is no escaping a State reform and an additional Social Security reform, which at least corrects the gaps in the reform that was approved. A profusion of benefits fanatically defended by their corporations needs to be faced, to free up resources to balance the accounts and allow a necessary increase in social spending and investments.

Finally, collections have been urged for decades to follow the growth of spending to avoid budgetary uncontrolled. The result was a system fraught with distortions and easy prey for diverse interest groups, always high-income. From the equity point of view, the ripe points for correction are the special income taxation regimes (Free Zone, Simple, Presumed Profit and others), which affect doctors, lawyers, artists, journalists and others, and the taxation of the income of the capital. From the point of view of efficiency, there is an urgent need to create a VAT to put an end to the costly chaos in force. This point seems ripe for voting next year.

I conclude by summarizing the four necessary adjustments: in terms of government size, better examining the costs and benefits of public policies; on the macroeconomic side, achieving an adequate and sustainable primary surplus; on the expenditure side, to promote an enormous rearrangement of priorities, and, on the revenue side, to seek efficiency and equity.

Brazil as it is is not going to work. With adjustments in the direction proposed here, it would be possible to reduce uncertainties, extend horizons and grow in an inclusive and sustainable way.