A tax regime for development

A country’s fiscal regime consists of a set of written rules, customs, and practices that affect public spending, tax collection, and public debt. The fiscal regime is made up of laws, such as fiscal responsibility or spending ceilings; the jurisprudence built around tax issues by the control bodies and the Judiciary; the unwritten incentives and rules that shape how the political world makes budget decisions; fiscal relationships between different levels of government.

The topic is broad and includes both quantitative and qualitative dimensions. In the quantitative approach, dealt with in this article, the main issue is whether the country’s fiscal deficit is sustainable over time. The fundamental basis for a sustainable fiscal regime is intuitive: public spending and public debt as a proportion of GDP cannot grow indefinitely.

In 1999, with the introduction of the macroeconomic tripod (inflation target, floating exchange rate and positive primary result), we had a change in the fiscal regime, complemented by the Fiscal Responsibility Law (approved in 2000), which established targets for the primary result. Given that spending was rigid and growing, the Union’s accounts began to be balanced by increasing the tax burden.

But the discipline imposed by the LRF was short-lived, the victim of accounting tricks, exemptions and subsidies that reduced the tax burden. As the 2014 elections approached, the final collapse of accountability occurred, a deterioration of the federal primary of 4.7% of GDP, from a surplus of 2.2% of GDP in 2011 to a deficit of 2.5% in 2016.

Faced with this situation, in 2016 a spending ceiling was proposed and approved. It was an initiative to induce a change in the country’s fiscal regime through legal/constitutional means. In practice, it was known that the control of expenditure growth would depend on changes in the laws that determine the mandatory growth of expenses, such as Social Security and social assistance, as well as the State payroll.

The perception that the ceiling could induce a consistent fiscal regime contributed to reducing the interest rate that investors require to invest in government bonds, which reduced the federal government’s financial expenditure and helped to slow down debt growth. The strong reduction in interest rates resulting from the sudden stop of the economy, due to Covid 19, also helped to reduce interest rates and financial expenses.

But, over time, the legal, political, juridical and federative components of the fiscal regime, added to the economic and social impacts of Covid-19, began to put pressure on primary expenditure, which grew again in relation to GDP. Subsequent constitutional amendments were approved to raise the ceiling and accommodate additional spending, including the one now under discussion.

The anchor is gone and we will enter 2023 resuming the path of debt unsustainability. A simple arithmetic exercise shows that the primary surplus needed to keep the public debt stable is at 1.5% of GDP, an adjustment of 3% of GDP if the 2023 deficit is 1.5% of GDP. In order to reduce the debt, it would be necessary to expand the adjustment even further, something that we believe is recommendable.

The next governments, as of 2023, will not be able to abandon the fiscal consolidation effort. They will need to design and approve a credible rule that will help change the fiscal regime in its various dimensions (legal, political, juridical and federative).

The idea of ​​a fiscal rule is opposed to the notion of discretion. In fragile fiscal regimes, such as ours, where there is always the temptation to go into debt “just a little longer”, the literature suggests tying one’s own hands, through formal rules, that allow the monitoring of goals and that, in case of breach, impose reputational costs and automatic adjustment mechanisms.

The fiscal rule is intended to define the level and trajectory of expenses and revenues compatible with the sustainability of the public debt (always as a proportion of GDP). It also defines trajectories to converge back to these levels when there is a deviation.

In the case of Brazil, it seems clear that a debt of 77% of GDP with an upward trend is very high. A strong indication is the real interest rates that the federal government pays to finance itself, currently around 6.0%, a point outside any global curve. As a first step, we suggest targeting a debt reduction of 65% in 10 years

We believe that the best way to do this is by means of a rule limiting the growth of spending. The income would be estimated for a time horizon and the expenditure would be limited in order to reach, on average, the primary surplus necessary to bring the debt to the desired level.

The LRF fulfilled the role of fiscal anchor for a while, but the adjustment was made on the revenue side and through contingencies. As a result, the adjustment was procyclical, expenditure growth followed its rise and induced the inefficiencies resulting from the contingency. If there is an effective limitation of expenditure, the Budget could be imposing. This would contribute to a more predictable and efficient management of public resources.

In this model, we would have an automatic stabilizer of economic cycles. In the event of a recession, revenue would fall and, maintaining the level of other expenditures under the fiscal rule, the deficit would increase, preventing a fiscal contraction. It is also worth discussing automatic mechanisms in the social area, such as unemployment insurance, which in Brazil need a good review.

In addition, there would be more room to establish a looser rule for spending growth since, ex-ante, tax benefits were revoked or a decision was made to increase the tax burden. The more ambitious the debt reduction target, and the smaller the effort to reduce tax benefits, the more restrictive the expenditure growth rule would have to be.

An escape clause would allow spending above the ceiling on emergencies. But soon after, the primary surplus needed to stabilize the debt would be recalculated. This reaction function is important and has ample support in economic theory and history.

We are here proposing targets for debt and public spending. It would be a political decision, based on a cost-benefit analysis. The targets will be achieved through multi-year planning in which, periodically, the expenditure limit would be adjusted to the parameters and projections observed for debt and revenue. Therefore, our proposal recovers elements of the two anchors that lasted a short time.

At the moment, the debt is above the desirable level, which requires a substantial correction in the primary balance. The adopted quantitative parameters must induce the immediate beginning of the adjustment, avoiding setting initially loose limits, which do not impose sacrifices on the ruler and the legislators of the moment, leaving the bill to future generations and their rulers.

No rule has the power to forever shield a macroeconomic environment conducive to the sustained and inclusive development of a nation. That said, it is our conviction that the proposed rule would greatly enhance the chances of success of a development strategy for the country.