New Spending and Debt Cap Plans Require License to Spend Small in 2023

A large increase in government debt in 2023 will make debt control very difficult, with the risk of provoking a vicious circle: more debt, higher interest rates, less economic growth, more debt, etc.

What is big”? An increase in debt due to an increase of more than R$ 80 billion or R$ 90 billion in expenditure in 2023. The transitional government for Lula 3 now foresees an increase in federal spending of almost R$ 200 billion.

This prospect of high debt and high risk of a vicious circle is evident in the first more detailed proposals for a new debt containment plan, a new “fiscal rule”. That is, of projects to replace the current spending ceiling. Created in 2016, the ceiling —limitation inscribed in the Constitution— in theory prohibits the annual increase in federal spending from going beyond the inflation registered in the year prior to the expenditure (it has been pierced since 2019).

In two of these proposals, the underlying idea is a target for the debt/GDP ratio (the size of public debt relative to the size of the economy). This goal would be achieved through an annual limitation of federal government spending that is compatible with the objective, the size of the debt in certain years. That is, a new “roof”, adjustable according to need.

These are the proposals presented by the Secretary of Finance for the state of São Paulo, Felipe Salto, and collaborators (see names at the end of this text), and by economists Armínio Fraga and Marcos Mendes, for example.

Salto says that too hard or too loose an adjustment is not credible and proposes a smooth debt reduction

In the plan by Salto and collaborators, the target for the government’s gross debt is 78% of GDP in 2036 (date of the end of the fiscal regime instituted with the ceiling, in 2016). There is an intermediate goal: the debt in 2026 (end of the Lula government 3) could not grow more than 5 percentage points from 2023. That is, to go from an estimated 79% of GDP in 2023 to up to 84% in 2026. from 2027, the debt would necessarily have to decrease, towards the target of 78% of GDP in 2036.

Each year, the government would be obliged to present, in the budgetary laws, a projection of revenue and expenditure compatible with the trajectory of debt reduction for those targets. This is tax revenues and extraordinary revenues (such as privatizations, for example), spending and the necessary balance (primary surplus) necessary to reduce the debt.

The ceiling would remain. But it would be corrected annually by the change in inflation (as it is now), plus an increment equivalent to half the average GDP growth over the previous five years. Expenses with Bolsa Familia would be permanently off the ceiling.

But, it should be noted, depending on the need to reduce the debt, it would not be possible to spend all the expenditure provided for by the ceiling. In cases of incompatibility of revenue and expenditure with the defined path of the debt, the government would be subject to restrictions on increased expenditures already provided for in the Constitution.

The chart shows the different debt paths, depending on additional spending in 2023 and economic assumptions. Federal revenue grows from 17.5% of GDP in 2023 to 19% in 2026 and stays there. The real interest rate drops from 6% to 3% in 2026 and stays there. The economy grows 1% in 2023 and 2% annually thereafter. Each year, there is a windfall of 0.5% of GDP.

Of course, such indicators can vary. It’s just an exercise that tries not to be too unrealistic. A possibility of variation of these initial hypotheses depends on the initial size of the debt and its growth and on the reaction of the government’s creditors. The greater the initial debt and the extra debt, the higher the interest rate and the lower the growth, for example.

This plan was presented to the vice president-elect, Geraldo Alckmin, who commented on it in passing in some interviews. In the opinion of economists in the private financial sector, the target set by Salto et alli would be too loose.

Salto, the finance secretary from São Paulo and former executive director of the Independent Fiscal Institution, says that it is necessary to have a credible target, neither too tight nor too loose. A tight target, which would require cost cuts and revenue increases of unfeasible size, is also not very credible.

Arminio and Mendes propose faster and tougher adjustment to not let debt get out of control

The plan by Arminio Fraga and Marcos Mendes says that a greater tightening is inevitable, so that the target is credible: enough to avoid interest rate hikes, etc. that cause that vicious circle. Fraga, a founding partner of Gávea Investimentos, was president of the Central Bank under FHC 2. Mendes, a research associate at Insper, was one of the authors of the “roof” project, when in Michel Temer’s government.

Economists argue that public spending increased without limit in Brazil from 1997 to the late 2010s, also because of institutions and political conflicts in the country. In order to avoid an endless growth of debt, it was necessary to increase government revenue (from the tax burden), even if the indebtedness was mitigated by primary surpluses in this century, until 2013. The tax burden cannot grow without limit; social and political tolerance with tax increases would be minimal since 2007 (end of CPMF) and excessive taxes cause economic inefficiencies.

There could be a fiscal adjustment through additional revenue through “the revocation of tax benefits in special regimes and the increase in capital taxation, especially in special tax regimes, such as Simple and Presumed Profit. In both cases there is great difficulty policy to repeal legislation that has well-organized and mobilized winners in defense of their privileges”, write Fraga and Mendes.

Rules such as primary surpluses and the ceiling were demoralized or became unfeasible due to the lack of other changes (in social security, assistance, public servants, undue tax exemptions, for example).

Fraga and Mendes propose a rule to limit the increase in expenditure compatible with reducing the public debt to a desirable and viable level, which they assume will be 65% of GDP in 2032. Every three years, there would be revenue projections for three years ahead, a compatible expenditure is then defined and adjusted so that it reaches, on average for the period, a primary surplus sufficient to limit debt growth (the surplus would be a result, not a target). The “ceiling”, in short, would be readjusted every three years.

Fraga and Mendes carried out a debt projection exercise depending on the additional expenditure foreseen for 2023. With a “license to spend” (“waiver”) of R$ 220 billion, the debt will reach close to 92% of GDP in 2023. With a “waiver” of BRL 80 billion, close to 79% of GDP.

The economic and revenue assumptions are the same in both scenarios. That is, depending only on the extra expense in 2023, the perspective is very different. It could get even worse. Even in the “least worst” scenario, the debt would rise until 2027 (to 83.4% of GDP), with which the interest rate would tend to be higher and growth lower. That is, even the most optimistic scenario does not hold, they argue.

Fraga says that he gives “a lot of weight” to 2026: there would have to be limitations in order to show debt control by that year and, thus, reduce the risk of a vicious circle.

However, “as there is rigidity in expenses, and it is not possible to make an abrupt fiscal adjustment, we can only try to minimize the loss in 2023 and start 2024 under a new and credible fiscal rule”, write Fraga and Mendes.

Instead of making the adjustment (necessary primary surplus) on the revenue side, as occurred in the Real until the first decade of the century, expenditure would be limited (although additional revenue may be necessary).

In each year, moreover, expenditure was often capped in an improvised way, in order to reach the surplus target (by means of more or less arbitrary and inefficient “contingencies” from the budgetary and economic point of view).

In the event of a recession, tax revenue falls. In the Fraga-Mendes proposal, the expense would be fixed for a period. There could then be a smaller deficit or surplus (thus helping to attenuate the economic downturn: it would be “anti-cyclical”). But there would have to be compensation in later years.

In the exercise of Fraga and Mendes, the “waiver” for 2023 is R$ 90 billion, as has been said. The 2023 debt is 80.8% of GDP. Federal government revenue grows from 17.5% of GDP to 19.2% of GDP in 2025 (thanks to the cancellation of tax exemptions) and so on. The longer the 2023 waiver, the greater the effort needed: the greater the constraint on spending ahead, the greater the need to increase revenue (more taxes, more privatization).

The real interest rate starts at 5% per annum, drops to 3.5% in 2027 and to 3% in 2030 (the “credible” fiscal rule helps to lower the interest rate, it is supposed). GDP grows 0.7% in 2023 and 2% thereafter. “GDP inflation” is considered to be 0.5 percentage points beyond the IPCA (which helps to “inflate” GDP and, everything else constant, to reduce the relative size of debt). Each year, an additional 0.5% of GDP is obtained in privatization revenues.

A debt of 80.4% of GDP in 2026 would require zero expenditure growth between 2024 and 2026, on average and in real terms (and absolute: in reais). Expenditure, relative to GDP, would fall continuously, from 19% to close to 16% of GDP in 2032, with gross debt reaching 65% of GDP.

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Final note: Salto, São Paulo State Finance Secretary, prepared his proposal with the head of his advisory office, Josué Pellegrini, and with Eduardo Walmsley Carneiro, Fernando Facury Scaff, Cristiane Coelho, José Roberto Afonso, Guilherme Tinoco.