Brazilian government’s fiscal framework is no anchor

This article originally appeared in The Brazilian Report (April 16, 2023).

After many weeks of delays and speculation, on March 31, Finance Minister Fernando Haddad presented the fiscal framework with which the new government intends to replace the controversial spending cap rule that has been in place, albeit with minor modifications, since the end of 2016. 

The cap rule, as designed, induced fiscal austerity and translated any growth in government revenues into declining public deficits (or rising surpluses), resulting in a declining debt-to-GDP ratio, a dynamic welcomed by investors, rating agencies, and multilateral institutions.

The fiscal framework cannot be accused of lacking ambition. According to the presentation following Mr. Haddad’s speech, the framework “guarantees” that Brazil can have its cake and eat it too, with more public investment, more “poor people back in the budget,” less inflation, lower interest rates, more stability, and a return to the investment grade status lost during the Dilma Rousseff government.

The unpleasant exercise of number crunching renders much less sunny conclusions. The first one is that the government’s numbers for the trajectory of budget balances and debt stock only make sense under rosy macroeconomic premises. 

The Finance Ministry’s economic policy unit forecasts average annual GDP growth of 2.3 percent during the current presidential term, much higher than current market expectations (1.5 percent in the latest weekly Central Bank survey) and the most frequently used estimates for Brazil’s potential growth (between 1 percent and 1.5 percent). 

The last time Brazil achieved that kind of growth was before the 2015-2016 recession, when the country was still under the spell of the massive commodities boom that began in 2003. The government also seems to be expecting a big reduction in the cost of debt, with real long-term interest rates falling from the current 6 percent to around 4 percent. 

Indeed, interest rates are expected to fall, but probably to higher levels than when the country had a bonafide orthodox economic management, a functioning spending cap, and was aggressively reducing earmarked lending at subsidized rates.

Mr. Haddad’s promised path to primary (excluding interest payments) surpluses starting in 2025 also relies on increasing the country’s already high tax burden. It took the government a long time to admit it, but it is now openly looking for new sources of revenue — from sports betting to online retail imports from China — to raise the roughly 1.2 percent of GDP that the government estimates is needed to balance the primary budget as early as next year.

Under more realistic estimates of current tax base growth, economists at private bank Santander calculate that twice as much new tax revenue will be needed to achieve this goal.

Brazil’s Congress has long been adamantly opposed to raising the overall tax burden, for both good and bad reasons. Brazil taxes much more than the average emerging country. 

According to the International Monetary Fund’s Fiscal Monitor, general government revenues averaged 36 percent of GDP in the five years to 2022, in line with advanced economies and well above the 27 percent for G20 emerging markets. But, of course, the country is still underperforming in the provision of essential public goods, and there are far too many lucrative breaks for wealthy individuals and well-connected firms that have been successfully lobbying for the status quo. 

The resulting stalemate is evidently detrimental to growth and inequality reduction, but the much-needed wholesale reform seems to be out of reach for a government with weak support in Congress and a lack of interest in what really needs to be done. 

Government high officials recently demonstrated this by supporting new subsidies for automakers and by ruling out the possibility of bringing the generous income tax regime for “small entrepreneurs” (often doctors and lawyers with millionaire annual incomes) into line with the more draconian one, valid for salaried employees. 

Nobody really knows how revenues will grow (the widely expected tax reform under development claims to be “neutral” in terms of overall collection), but what the fiscal framework truly and clearly assures is that spending will grow above inflation – at least 0.6 percent per year, regardless of revenue performance, and up to 2.5 percent (plus undefined kickers for investment) if the bullish forecasts materialize. 

All in all, the country will at best have a revenue-driven fiscal adjustment if all goes well, or no adjustment at all if growth remains mediocre and attempts to create new taxes fail. In my firm’s estimates, the gross debt-to-GDP ratio will keep growing in the foreseeable future, from 73 percent in 2022 to 86 percent in 2030.

This does not mean that the country will go bankrupt or be forced to monetize debt, but it will certainly continue to show up negatively in cross-country comparisons of fiscal fragility, and the markets will demand interest rates premiums accordingly to keep refinancing the huge debt stock. 

From time to time, bouts of inflation will be needed to avoid a more explosive trajectory – exactly what we saw over the last few years. Strong nominal growth does wonders to improve fiscal ratios, but it is questionable whether it improves general welfare when it comes mostly from inflation rather than from real expansion. 

The Workers’ Party and Lula clearly dream of their golden years, when they could deliver strong GDP growth under low inflation (and a strengthening currency) while boosting government spending by 6 percent over inflation year in, year out. That would take another decade of yearly double-digit growth in China, something that is not safe or reasonable to expect now.

The fiscal framework does provide a structure for economists to analyse how revenues and expenditures are likely to evolve in the next few years, but it will not anchor expectations around a sustainable (i.e., at least stable in the future) debt path. 

Like unanchored ships bobbing with the oceanic tides, Brazil will continue to be perceived as a possible casualty of global dislocations in risk appetite, once again a victim of the lack of strategic vision of its helmsmen.