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OPINION July 10, 2020

The challenge of maintaining medium-term fiscal adjustment in the context of COVID-19

The COVID-19 pandemic presents a major challenge for the fiscal consolidation process in Brazil. The fiscal framework was already weak before the crisis. Brazil’s public finances face a number of structural challenges, including low levels of economic growth, with resulting lim­ited growth in tax revenues; continued rise in mandatory pension and personnel expenses; and an already high public debt. The economic recession expected in 2020 and the increase in public debt caused by COVID-19 response measures make fiscal adjustment even more difficult from 2021 onwards.

In order to address the crisis in the health sec­tor and minimize the effects on the income of the most vulnerable families due to lower eco­nomic activity, the federal government has put forward a package of fiscal measures that add up to about 7.3% of GDP.

For subnation­al governments, the federal government has pledged to keep state and municipal transfers (FPE and FPM, respectively) at the same levels as in 2019. In addition, it has approved trans­fers to finance expenditures related to the health crisis. Another aid package for states and municipalities (worth R$60 billion, or 0.9 percent of GDP) is intended to partially offset local tax revenue losses (ICMS and ISS), and finance expenses related to COVID-19.

Of this total, R$50 billion can be freely used by each subnational entity to finance its expenditure needs in the face of reduced tax revenues. The remainder is earmarked for health care and so­cial assistance. In addition, the package also suspends the payment of subnational entities’ debts with the federal government, and gives them permission to renegotiate their debts with other creditors.

Ideally, states will not grant wage raises to their public servants, to maintain flexibility in their budgets, and to fo­cus their resources on priority areas (for exam­ple, critical health care workers). However, this point is yet to be defined.

Considering all the measures that have already been approved, Brazil’s primary deficit in 2020 is estimated to exceed 8% of GDP, an increase of almost 7 percentage points com­pared to 2019, and 6,7 percentage points above pre-COVID-19 estimates.

In a downside sce­nario, Brazil’s primary deficit could reach 10% of GDP. A smaller GDP growth and large primary deficit in 2020, and a potential in­crease in borrowing costs due to greater un­certainty, will strongly impact the trajectory of Brazil’s public debt.

The country’s public-debt-to-GDP ratio is expected to increase from 75,8% in 2019 to 91.5% in 2020, and stabilize at 101.6% in 2028. In the down­side scenario, debt would reach stability only in the next decade, at 119.6% of GDP in 2032. However, the short-term debt scenario may turn out to be even more dire, if sizable contingent liabilities materialize. These include the debts of subnational governments and public utilities (electric, water, transport), many of which were in a weak financial position even before the crisis.

Although it is too early for a precise assessment of the fiscal vulnerabilities resulting from COVID-19, it is already clear that the public sector will need to reinforce fiscal consolida­tion efforts from 2021 onwards. The promotion of fiscal consolidation depends on the implementation of a structural reform agenda to control mandatory public spending and accelerate economic growth. For this, Brazil should stick to the following principles.

  1. Ensuring that fiscal measures to address the crisis are indeed temporary.
  2. Reaffirming the federal spending cap rule as a fiscal anchor in Brazil, which limits public spending and guides the fiscal consolidation process. In order to comply with the ceiling rule, the government will need (i) to increase the flexibility of its public bud­get so as to better control and reallocate expenses according to needs. A first step would be the approval of the three proposed constitutional amendments (PECs) currently in Congress (known as Emergency PEC, Public Funds PEC and Federative Pact PEC). In addition, (ii) administrative reforms are required to reduce the federal administration’s recurring expenses.
  3. Reducing the federal government’s contingent liabilities through the appropriate sharing of fiscal risks among federal, state and municipal governments. This re­quires (i) the creation of a framework that may reduce moral hazards in intergovern­mental fiscal relationships, but also (ii) the acceleration of fiscal reforms in subnational governments so as to limit their structural expenditure growth (for example, com­pleting the pension reforms in states and municipalities).
  4. Resuming progress on the long-term economic growth agenda, which includes mea­sures to improve the business environment, lower the cost of production, and in­crease Brazil’s insertion in global value chains through greater openness to trade. Reforming Brazil’s tax system to enable a more efficient allocation of production factors and foster greater trade liberalization takes a high priority.

The uncertainties surrounding the impacts of COVID-19 are still high. If the crisis were to be prolonged or if new waves of infection occur, further stoppage of economic activity may be­come necessary, deepening the recession, and delaying the recovery. This could require the extension of temporary measures adopted by the government, further increasing Brazil’s fis­cal deficit, and forcing an even stronger fiscal adjustment in the aftermath.

Therefore, rein­forcing Brazil’s commitment to the resumption of economic and fiscal reforms would help to secure investor confidence and gain access to cheaper sources of financing, which would, in turn, accelerate the economic recovery once the health crisis has been overcome.

This article was written in collaboration with Rafael Ornelas, economist and Fabiano Colbano, senior economist of the World Bank in Brazil.