BRIEF August 23, 2018

Public Policy Notes - Towards a fair adjustment and inclusive growth

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This package of policy notes is addressed to Brazilian society and specifically to the Presidential candidates and their teams of economic advisors in the 2018 election. It provides the World Bank’s diagnosis of Brazil’s main economic and social development challenges and charts a possible course to address them. Read the overview here

1. Fiscal Sustainability2. Tax System │ 3. Intergovernmental Fiscal Issues │ 4. Pensions Reform │ 5. State Reform │ 6. Boosting Productivity │ 7. Credit Markets 8. Infrastructure 9. Education │ 10. Transport & Logistics │ 11. Labor Markets12. Crime and Violence Prevention 13. Health │ 14. Climate Change and Nationally Determined Contribution │ 15. Water Resource Management │ References

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1. Fiscal Sustainability

PresentationPublic Policy Note 

Brazil is on an unsustainable fiscal path. Faster growth and lower interest rates would make the adjustment slightly easier, but do not remove the need to reduce the level of primary spending.  The constitutional spending rule (“teto”) adopted in 2016 will stabilize debt by 2026, but requires a reduction of 5% of GDP in primary spending over 8 years, or a quarter of the federal budget, which is very challenging.  While focusing the adjustment on primary spending is well justified, some revenue measures – in particular the elimination of the myriad of tax exemptions and loopholes - could contribute to reduce deficits at zero or low costs to growth. The teto could also be strengthened by adding additional automatic corrective measures and excluding investment from the spending ceiling.  Any refinement to the teto, however, should be subject to maintaining the same fiscal adjustment path and corresponding debt target, and should happen only after a substantial package of spending reductions has been secured. 

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2. Tax System

PresentationPublic Policy Note

Although Brazil does well in mobilizing revenues, the tax system generates significant economic distortions and has very high compliance costs. Apart from the negative impact on Brazil’s business competitiveness, multiple, overlapping turnover taxes and widespread exemptions distort firm’s input decisions and move the economy away from productive efficiency. Moreover, the tax system does not contribute to reducing income inequalities as in many OECD countries, because it relies mainly on indirect taxes, while the incomes of high earners are partly untaxed.  Finally, the system has encouraged tax competition amongst states, which has resulted in a loss of revenues and significant distortions.  A comprehensive reform would include replacing all turnover taxes by a federal VAT, making the personal income tax more progressive by adjusting rates and reducing loopholes, and simplifying/automatizing filing requirements to cut compliance costs.

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3. Intergovernmental Fiscal Issues

PresentationPublic Policy Note

Brazil’s subnational governments are in a fiscal crisis: if nothing is done, between 10 and 17 States are expected to be bankrupt (up from the current 3) by 2021, depending on economic prospects. Current primary spending took up on average 93% of states’ revenues in 2017. The deficits of the state pension systems (RPPS), which currently account for about 15% of revenues on average, may double in the next decade as many pre-2003 civil servants retire on generous benefits. To deal with this looming crisis, state governments will require federal help – both through legislation and fresh resources. To restore sustainability of state government finances, fiscal rigidities resulting from spending mandates on health and education and generous payroll and pension commitments need to be reduced. In order to prevent a systemic crisis, the Federal Government should provide not just debt relief but also near-term liquidity to those states that are willing to undergo structural adjustments.

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4. Pensions Reform

Presentation

Brazil is still a young country but spends on social security like an old country. Brazil also spends more on pensions than it can afford and the system is highly unsustainable. A reform proposal under discussion in Congress would help halve the projected deficits in general public pension system and make it fairer. The proposal also introduces some reforms to civil service pensions, which however fall far short of redressing the major imbalances in both the federal and state level systems available to civil servants. These imbalances, due to the generous treatment afforded to pre-2003 entrants into the civil service and special regimes available to teachers and the military, are expected to bring several states to the brink of bankruptcy in the next few years. Further reforms of civil servant pensions, including increased contributions, faster transition to the rules of the general system, and a review of acquired rights and special regimes, are thus vital to complement the proposals made by the current administration. The social security system also includes non-contributory benefits to rural workers and elderly without a sufficient formal contribution history. These benefits and the high replacement rates for workers earning little more than one minimum wage will continue to require significant transfers from tax payers to the elderly. These could be reviewed as part of an overall rationalization of social transfers to improve overall targeting, avoid overlaps and encourage activation.

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5. State Reform

Presentation

The size of Brazil’s federal government has grown by around 10 percentage points of GDP since the mid-1980s, reflecting the expectations of Brazil’s citizens of the role of the state in improving people’s livelihoods. However, Brazil’s state has fallen short of these expectations. While it spends more relative to GDP than any emerging market peers, it underperforms in the delivery of quality services in health, education, public security, and infrastructure. The sources of state failures are manifold and include an excessive number of rules; rigid budgets and limited budget credibility; fragmentation of service delivery; poor planning, monitoring and evaluation of projects and policies; human resource management practices that do not create positive performance incentives; judicialization of policy decisions; and growing risk aversion in the bureaucracy. Possible entry points for a reform of the state include a revision of the budget process (including the reduction of rigidities), strengthening state capacity for planning, monitoring and evaluation, consolidation and integration of service delivery, and a reform of the civil service. The scope for public-private partnerships in service delivery is high, but will require better and more independent regulation to deliver improved outcomes.

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6. Boosting Productivity

Presentation

Brazil’s per capita income today is no higher relative to the United States than 30 years ago. The main reason for this lack of convergence is that Brazil has not experienced any productivity growth over this period, unlike the majority of emerging market peers. As Brazil’s population starts to age and its labor force starts to decline, boosting productivity will be key to maintain and expand Brazilians’ standard of living. Three policy priorities stand out. First, Brazil should open up its economy to international trade, reaping the benefits of cheaper imports, access to technology, and greater competition. Second, Brazil should reduce the costs of doing business, so that Brazilian companies can compete globally on equal terms. And third, Brazil could greatly facilitate the necessary adjustment of its productive sector through better coordinated policies to support innovation and technology adoption.

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7. Credit Markets

PresentationPublic Policy Note

Historically macro-instability has undermined the development of free market finance beyond short term finance, and thus motivated policy makers to develop extensive interventions for longer term finance through directed lending. Private financial intermediation is mostly short term in nature and costly, with very high spreads making Brazil an international outlier, and with higher net interest margins than in peer countries. Overhead costs and loan loss provisioning are the main components of net interest margins, but the high and varying interest rates in some segments of the credit markets raise questions whether the credit markets are functioning well. The extensive directed credit is associated with significant fiscal costs, has implications for monetary policy, and there is evidence that it disrupts the efficiency in the free credit market. Directed credit, generally provided at regulated interest rates, makes up half of total credit and amounts to about a quarter of GDP. Subsidies embedded in directed credit peaked at 2.1 percent of GDP in 2015, but have since declined.  Recent reforms, most notably the TLP reform, address the pricing of directed credit reducing the embedded subsidies. In addition, financial infrastructure gaps in the credit reporting, and insolvency and collateral regimes have also presented challenges for an effective functioning of the credit markets, resulting in higher costs for the banking sector. In order to address credit market inefficiencies, reform directions include:

  • evaluating and promoting competitive conduct in the financial sector;
  • reviewing and optimizing public interventions; and
  • undertaking financial infrastructure reforms in the credit reporting, secured transactions, and insolvency and collateral execution frameworks.

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8. Infrastructure

Presentation

Brazil has been investing around 2% of GDP in infrastructure, much less than similar countries around the world, and not even sufficient to cover depreciation. Increasing focus should be given to improving the quality and sustainability of infrastructure. Given tight budgets at all levels of government, private sector financing is an attractive alternative to cover the gap. To realize its potential, governments need to develop a predictable and robust pipeline of infrastructure investments based on transparent selection and prioritization criteria. Together with the development banks, governments have to build capacity for project structuring and finance based on cash flows and risks. New instruments could provide credit enhancement to attract private sector financing, with support from state owned banks. However, private investors will deliver efficient results only if regulation becomes more transparent, stable and political interference and judicial uncertainty is reduced.

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9. Education

Presentation

Brazil spends more on education than the average OECD country and much more than many middle-income countries. Nonetheless, education outcomes remain poor. If Brazil is to achieve better education outcomes it should turn attention away from levels of spending and towards (i) increases in enrollment in and the quality of Early Childhood Education (ECE); (ii) updating curricula particularly at secondary level; (iii) revamping pre-service teacher training, teacher selection and in-service support to improve the quality of teaching; (iv) improving school and education level governance to make it more performance oriented and reduce political interference; (v) revisiting budget rigidities (‘vinculação’) and redesigning  equalization transfers to create incentives for performance improvements and reduce spatial and income inequalities.

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10. Transport & Logistics

Presentation

Brazil has had a limited expansion of its road and rail networks in recent years. To attract new investments and improve services in roads, railways and waterways, the authorities should consider:

  • Strengthening the planning function;
  • Improving the regulatory frameworks; and
  • Integrating policy across transport modalities and responsible agencies.

Efficiency gains from improved inter-modal coordination could amount to 0.7% of GDP annually, more than double current public investments in the sector. Improved planning, regulation and integration would also allow additional objectives such as low carbon transport and road safety to be reflected in the policy agenda.

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11. Labor Markets

Presentation

Labor institutions in Brazil create perverse incentives that encourage excessive turnover. The reform of the labor code has addressed some of these incentives, but more reforms are needed. Labor programs are expensive and focus on income support with little attention to re-skilling. Youth disengagement is a growing problem in a rapidly ageing society. Recommendations for further labor market reforms focus on realigning the minimum wage with productivity to reduce entry barriers for youth into the formal labor market, reforming labor market programs to support activation with a focus on youth and the long-term unemployed, and build capacity for job activation programs at state level.

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12. Crime and Violence Prevention

PresentationPublic Policy Note

Despite large expenditures on public security, crime and violence rates in Brazil remain extraordinary high, driven partially by and reinforcing discrimination and social exclusion, in a vicious circle that jeopardize development prospects for the poor. Confronting this epidemic calls for actions that address the socio-economic drivers of crime and violence and improve the governance model of the public security sector. The need is for better and more reliable data, inter-institutional coordination, planning based on evidence, monitoring and evaluation and implementation based on results. Public policy should focus interventions on territories and social groups at higher risk of exposure and victimization. Finally, there is considerable scope to foster greater citizen participation and social accountability and thereby regain valuable social trust.

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13. Health

PresentationPublic Policy Note

Brazil’s spending on healthcare is characterized by significant inefficiencies, which will increasingly represent a binding constraint to improved outcomes, as fiscal constraints and rising health costs due to aging put additional strains on the system. To deal with these inefficiencies and create incentives for better health sector performance, the policy note recommends:

  • System reforms that establish Integrated Health Care Networks;
  • Supply side reforms that expand de coverage of primary health care, rationalize the provision of ambulatory and hospital services, and increases providers’ autonomy;
  • Demand side reforms that strengthen the role of primary care as gate-keeper; and
  • Transactional reforms that increase the linkages between payment and quality of services.

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14. Climate Change and the Nationally Determined Contribution

Presentation

As part of the Paris Accord, Brazil pledged to reduce 1.3GtCO2 emissions by 2030, a 43% reduction compared to 2005. The largest contributor to emissions in Brazil have been land-use changes and deforestation. Brazil made substantial progress in reducing deforestation rates from 2005-2014 but progress has stalled since. Energy emissions are increasing due to increasing reliance on thermoelectric power, a growing motorized vehicle stock and low energy efficiency. There is great potential to improve agriculture and livestock productivity to reduce deforestation and use existing pastures for agriculture expansion. Rural credit should be subject to compliance with forest code limits on deforestation, and incentives should be provided for low-carbon agriculture (ABC) practices. Monitoring and enforcement capacity of federal and state level agencies must be strengthened. Pricing mechanisms should be further developed to induce higher energy efficiency and credit lines should be targeted to support efficiency and expand renewables.

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15. Water Resource Management

Presentation

Brazil has 12% of the world’s fresh water resources, but they are unequally distributed throughout the country and subject to large seasonal fluctuations. Historically, the Northeast has witnessed prolonged drought periods, but in recent years, water scarcity problems have become more common in other regions, too. At the same time, flood and landslides in the rainy season generate about R$2.4 billion (US$575 million) in economic losses every year. About 43% of the people are still not connected to sewage, polluting scarce water resources and adding to vector diseases such as Zika, Chikungunya and Dengue in peri-urban and rural areas. Brazil’s water management system greatly improved since the Water Law was enacted in 1997, but problems of overlapping responsibilities remain. In addition, regional development plans do not consider the scarcity of water resources and monitoring and enforcement capacity of authorities is limited. Finally, pricing mechanisms for bulk water and water services need to be strengthened to signal the economic value of water and encourage a more efficient and sustainable use.

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Planejamento e financiamento de infraestrutura

.PPT │Documento completo│ Documentos de apoio

O Brasil tem investido cerca de 2% do PIB em infraestrutura, muito menos do que países semelhantes em todo o mundo, e nem mesmo suficiente para cobrir a depreciação. Um enfoque crescente deve ser dado para melhorar a qualidade e a sustentabilidade da infraestrutura. Com orçamentos apertados em todos os níveis do governo, o financiamento do setor privado é uma alternativa atraente para cobrir a lacuna. Para realizar seu potencial, os governos precisam desenvolver um pipeline previsível e robusto de investimentos em infraestrutura com base em critérios transparentes de seleção e priorização. Juntamente com os bancos de desenvolvimento, os governos precisam desenvolver capacidade de estruturação e financiamento de projetos com base em fluxos de caixa e riscos. Novos instrumentos poderiam melhorar a qualidade do crédito para atrair financiamento do setor privado, com o apoio de bancos estatais. No entanto, os investidores privados só produzirão resultados eficientes se a regulamentação se tornar mais transparente, estável e a interferência política e a incerteza judicial forem reduzidas.

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Planejamento e financiamento de infraestrutura

.PPT │Documento completo│ Documentos de apoio

O Brasil tem investido cerca de 2% do PIB em infraestrutura, muito menos do que países semelhantes em todo o mundo, e nem mesmo suficiente para cobrir a depreciação. Um enfoque crescente deve ser dado para melhorar a qualidade e a sustentabilidade da infraestrutura. Com orçamentos apertados em todos os níveis do governo, o financiamento do setor privado é uma alternativa atraente para cobrir a lacuna. Para realizar seu potencial, os governos precisam desenvolver um pipeline previsível e robusto de investimentos em infraestrutura com base em critérios transparentes de seleção e priorização. Juntamente com os bancos de desenvolvimento, os governos precisam desenvolver capacidade de estruturação e financiamento de projetos com base em fluxos de caixa e riscos. Novos instrumentos poderiam melhorar a qualidade do crédito para atrair financiamento do setor privado, com o apoio de bancos estatais. No entanto, os investidores privados só produzirão resultados eficientes se a regulamentação se tornar mais transparente, estável e a interferência política e a incerteza judicial forem reduzidas.