1
Report No: ACS5885
.
Federative Republic of Brazil
BR Intergovernmental Finance (DLW)
IMPACT AND IMPLICATIONS OF RECENT AND POTENTIAL CHANGES TO BRAZIL’S
SUBNATIONAL FISCAL FRAMEWORK
. September 27th, 2013
. LCSPE
LATIN AMERICA AND CARIBBEAN
.
2
Standard Disclaimer:
.
This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries.
.
Copyright Statement:
.
The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development/ The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly.
For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://www.copyright.com/.
All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail [email protected].
3
BRAZIL INTERGOVERNMENTAL FINANCES NLTA (P132347)
IMPACT AND IMPLICATIONS OF RECENT AND POTENTIAL CHANGES TO BRAZIL’S SUBNATIONAL FISCAL FRAMEWORK1
A SYNTHESIS REPORT
1 This synthesis report was prepared Rafael Chelles Barroso and Jorge Thompson Araujo, on the basis of backgrounds papers prepared by a team of consultants: José Roberto Afonso (coordinator), Kleber Castro, Julia Morais and Celia Carvalho for ICMS; Fabiana Rocha (coordinator), Ana Giuberti, Enlinson Mattos, Ricardo Politi, Fernando Postali e Eric Brasil for intergovernmental transfers; and Mônica Mora for subnational debt. Teresa Ter-Minassian (former Director, Fiscal Affairs Department, IMF) and Lili Liu (Lead Economist, ECSPE, World Bank) kindly peer reviewed this report.
4
ABBREVATIONS AND ACRONYMS
API American Petroleum Institute Instituto de Petróleo Americano BNB Northeast Bank Banco do Nordeste do Brasil BNDES National Bank for Social and Economic
Development Banco Nacional de Desenvolvimento Econômico e Social
CAE Economics Affair Commission Comissão de Assuntos Econômicos CFEM Mining royalties Contribuição Financeira pela Exploração
de Recursos Minerais CMN National Monetary Council Conselho Monetário Nacional COFINS Social Security Financing Contribution Contribuição para Financiamento da
Seguridade Social CONFAZ National Council of Fiscal Policy Conselho Nacional de Política Fazendária FCR Revenue Compensation Fund Fundo de Compensação de Receitas FDR Regional Development Fund Fundo de Desenvolvimento Regional FPE State Participation Fund Fundo de Participação dos Estados FPM Municipal Participation Fund Fundo de Participação dos Municípios FUNDEB Fund for Maintenance, Development of
Basic Education and Valuation of Educational Personnel
Fundo de Manutenção e Desenvolvimento da Educação Básica e de Valorização dos Profissionais da Educação
GDP Gross Domestic Product Produto Interno Bruto ICMS Tax on Goods Circulation, Communication
and Inter-municipal and Inter-state Transportation Services
Imposto sobre Operações Relativas à Circulação de Mercadorias e Serviços de Transporte Intermunicipal e Interestadual e de Comunicação
IGP-DI General Price Index Índice Geral de Preços – Disponibilidade Interna
IPCA Broad Consumer Price Index Índice de Preços ao Consumidor Amplo IPVA Motor Vehicle Property Tax Imposto sobre Propriedade de Veículos
Automotores IR Income Tax Imposto de Renda ISS Tax over Services Imposto sobre Serviços LRF Fiscal Responsibility Law Lei de Responsabilidade Fiscal MCTI Ministry of Science, Technology and
Innovation Ministério da Ciência, Tecnologia e Inovação
MDIC Ministries of Trade, Commerce and Industry
Ministério do Desenvolvimento, Indústria e Comércio
MP Executive Order Medida Provisória NCR Net Current Revenues Receita Corrente Líquida NRR Net Real Revenues Receita Líquida Real OECD Organization for Economic Cooperation
and Development Organização para Cooperação Econômica e Desenvolvimento
PIS Social Integration Program Programa de Integração Social PPB Basic Productive Process Processo Produtivo Básico SELIC Benchmark Interest Rate Serviço Especial de Liquidação e Custódia SIMPLES Unified Tax Regime for Small and
Medium Entrerprises Regime Especial Unificado de Arrecadação de Tributos e Contribuições devidos pelas Microempresas e Empresas de Pequeno Porte
SME Small and Medium Enterprise Pequenas e Médias Empresas
5
SNG Subnational Government Governos Subnacionais STF Supreme Court Supremo Tribunal Federal STN National Treasury Secretariat Secretaria do Tesouro Nacional TJLP Long-Term Interest Rate Taxa de Juros de Longo Prazo VAT Value Added Tax Imposto sobre Valor Adicionado WEO World Economic Outlook Panorama Econômico Mundial
6
TABLE OF CONTENTS I. Introduction............................................................................................................................. 7
II. Brazil’s Subnational Fiscal Framework: A Brief Overview of the Key Issues ...................... 8
A. The ICMS....................................................................................................................... 10
B. Intergovernmental Transfers: FPE and Royalties .......................................................... 13
C. Subnational Debt ............................................................................................................ 15
III. Reforming the Subnational Fiscal Framework .................................................................. 19
A. The Case for Coordinated Reform ................................................................................. 19
B. The Realpolitik of subnational reforms.......................................................................... 20
i. Currently proposed changes to ICMS framework......................................................... 21
ii. Currently proposed changes to intergovernmental transfers’ framework .................. 24
iii. Currently proposed changes to subnational borrowing framework............................ 26
iv. Most probable reform scenario................................................................................... 27
v. Key issues left unaddressed by current reform proposals .......................................... 29
IV. The Expected Fiscal Impact of Alternative Reform Scenarios.......................................... 31
A. Results and discussion of simulations of changes to intergovernmental transfers ........ 31
B. Results and discussion of simulations of changes to ICMS regime............................... 38
C. Results and discussion of simulations of changes to subnational borrowing framework 41
D. The net result: Potential gainers and losers.................................................................... 43
V. Conclusions: Whither Brazil’s Subnational Fiscal Framework? .......................................... 48
VI. References.......................................................................................................................... 51
7
I. Introduction
1. Brazil’s subnational fiscal framework has remained a source of unabated controversy despite its relative stability over the past decade. The current fiscal framework for Brazilian subnational governments (SNG) was largely put in place with the promulgation of the present Federal Constitution in 1988, the subnational debt renegotiation law in 1997 and with the approval of the Fiscal Responsibility Law (Lei de Responsabilidade Fiscal – LRF) in 2000.
2. In contrast to most Latin American countries, the extent of revenue decentralization in Brazil is comparable to OECD levels.2 The intergovernmental fiscal system in Brazil features greater reliance of subnational governments – especially states – on own-revenues, than in other LAC countries. States’ own-revenues account for about 9 percent of GDP, as opposed to about 0.8 percent for LAC as whole, excluding Argentina and Brazil.3 Municipalities, on the other hand, rely more on transfers, and their own revenues account for about 2 percent of GDP.
3. However, Brazil’s subnational finances are fraught with complexity, inefficiency, and intra-federative conflicts, leading to several reform attempts over the years. Those include an overly complex state-level VAT that favors a “race to the bottom” in the granting of tax incentives by states; a rigid intergovernmental transfers system; and political pressures to revisit the subnational borrowing framework that has helped sustain the country’s fiscal sustainability prospects.4 While calls for reform have been frequent, particularly with respect to subnational taxes and intergovernmental transfers, only relatively minor changes to the subnational fiscal framework have taken place.
2 Ter-Minassian, T. (2012b). “More than Revenue: Main Challenges for Taxation in Latin America and the Caribbean”. Inter-American Development Bank Policy Brief IDB-PB-175. 3 Corbacho, A.; V.F. Cibils; and E. Lora (eds). (2013). Recaudar no Basta. Los Impuestos como Instrumento de Desarrollo. Washington, D.C.: Inter-American Development Bank 4 The detailed workings of Brazil’s subnational fiscal framework are discussed in Section II of this report.
Box 1 – Structure of States’ revenues in Brazil
Brazilian states – the mid-tier government level in Brazil – can collect three taxes: a Value Added Tax (VAT), known as ICMS (Imposto sobre Operações Relativas à Circulação de Mercadorias e Serviços de Transporte Intermunicipal e Interestadual e de Comunicação), the motor vehicle property tax (IPVA), and a tax on inheritance and donations. The main transfer benefiting states is the States’ Participation Fund or FPE (Fundo de Participação dos Estados), but they also receive transfers earmarked to health, education and social protection. In addition, states also collect revenues from other miscellaneous sources such as rents, fees, social contributions for the civil servant’s pensions, tax arrears, and private sector payments for concessions. In 2011, these three taxes accounted for 64 percent of state revenues, while transfers accounted for 17 percent of the consolidated current revenues for all states.
Source: BRASIL (2012). Transfers excluding FUNDEB
8
4. Such subnational finance weaknesses – especially those related to ICMS – have been a deterrent to the country’s long-term growth prospects. The importance of ICMS reform to unleash Brazil’s growth potential is reinforced by the macroeconomic outlook, in which the current environment of historically low interest rates is not expected to endure much longer. In addition, the external environment is hitting headwinds, particularly as China’s annual growth rate is anticipated to softly land from a 10 percent threshold to a 6 percent level, putting downward pressure on commodity prices. Since it would be harder for Brazil to sustain growth based on commodity exports going forward, behind-the-border reforms aimed at increasing the country’s cost-competitiveness become even more pressing.
5. External factors are forcing changes in the current subnational fiscal framework. Recent Supreme Court (Supremo Tribunal Federal – STF) rulings affected both intergovernmental transfers and ICMS, prompting Congress and states to respond. The debate on the new oil exploration regime has also prompted the legislative to change the oil royalties sharing scheme. Finally, states and certain municipalities have continuously lobbied for a renegotiation of the terms of the debt they owe to the Federal Government.
6. The objective of this study is to evaluate the nature and impact of recent and expected changes to Brazil’s subnational fiscal framework in light of these debates. More specifically, this work has focused on recent and proposed changes to (i) the ICMS; (ii) the FPE as well as the transfers from oil and mining (CFEM5) royalties; and (iii) the subnational debt and borrowing framework. These three broad areas are precisely the ones that are the center of the current debate on Brazil’s subnational fiscal framework. In order to achieve the proposed objective, three background papers were commissioned, each covering one of the issues outlined above.6 The main value-added of this study is an examination – and an attempt at a quantification – of the impacts of the changes underway in these three dimensions of Brazil’s intergovernmental fiscal framework.
7. The remainder of this synthesis report is organized as follows. Section II provides a brief overview of how Brazil’s subnational fiscal framework currently works. Section III describes the ongoing efforts to reform Brazil’s subnational fiscal framework and points to the advantages of a more coordinated approach over a piecemeal one. Section IV discusses the expected fiscal impact on subnational governments of the most likely reform scenarios. Section V concludes.
II. Brazil’s Subnational Fiscal Framework: A Brief Overview of the Key Issues
8. Although the 1988 Constitution is a decentralization landmark in Brazil, decentralization measures have been taking place since mid-1970. For instance, the share of central government taxes shared through FPE was increased almost yearly from 1975 to 1987, going from 5 percent to 14 percent of the income tax (Imposto de Renda – IR) and industrialized 5 Contribuição Financeira pela Exploração de Recursos Minerais, which is also usually referred as mining royalties. 6 The Bank produced a report in 2008 (World Bank [2008]. Brazil: Topics in Fiscal Federalism) which covered a similar spectrum of issues. Not only does the present study update the results of this previous work, but it also has a sharper focus on the presumed impacts of recent and expected changes to Brazil’s fiscal federalism framework.
9
products tax (Imposto Sobre Produtos Industrializados – IPI). In 1988, the constitution extinguished five selective federal taxes, incorporating them to the ICMS tax base. Decentralization was not a decision from the central government within a well-thought national decentralization plan, but rather a political movement associated with the return of democracy and the end of the military regime. Decentralization was thus associated with re-democratization and devolution of power to subnational governments.
9. This process was accompanied by an increasing participation of subnationals in total tax revenues and public spending, as well as by larger federal transfers to states and municipalities. In particular, the decentralization process also led to a marked “municipalization”, whereby municipalities were made members of the federation on par with the states in the framework of the 1988 Constitution.7 The current revenue sharing framework is clearly tilted towards providing municipalities with a revenue share that far exceeds their tax collections, as shown in Figure 1.
Figure 1 - Tax collection vs. Tax Revenue Sharing by Levels of Government, 20128
10. Notwithstanding the enhanced autonomy of subnational governments since the late 1980s, significant distortions remain. Greater autonomy did not address major regional inequalities, nor did it address the large degree of heterogeneity across subnationals in terms of fiscal capacity. Furthermore, the debate between decentralization of the power to tax and decentralization of the resources from taxation was solved in favor of the latter: Municipalities, in particular, have preferred to augment their participation in federal revenues than to increase their own-revenue sources.9 Another by-product of this process was that the decentralization of
7 As Giambiagi and Além put it, “an important peculiarity of the Brazilian case is its municipalist tendency”. (p. 326). 8 From Afonso, J.R. (2013b). Presentation made at the discussion Forum on “Toward Science of Delivery: Fiscal Federalism and Sub-Sovereign Finance”, Washington, D.C., World Bank, May 28, 2013. 9 See F. Rezende (1995). “Federalismo Fiscal no Brasil”. Revista de Economia Política, Vol. 15, No. 3 (59), July-September.
10
revenues was not accompanied by a clear decentralization of the responsibilities for public service provision, matching the resources needed with revenue sources.10
11. These “structural” issues with the Brazilian fiscal federalism framework manifest in different forms under each modality of intergovernmental fiscal relation. They can take the form of “fiscal war” 11 among states in the Federation; ample heterogeneity in terms of vertical imbalances at the subnational level; and the tensions in establishing limits to and controls on subnational borrowing in view of a legacy of subnational debt bail-outs. These particular manifestations, among others, will be briefly discussed in the following subsections.
A. The ICMS
12. ICMS is a VAT-like tax, but it differs from similar taxes in other countries since its revenues are collected and administered by state governments. The ICMS legislative framework is set by a federal law, but states have ability to issue local regulations within the broad federal rules, including issues such as internal tax rates and bases as well as collection regimes. Its tax base includes only transaction in goods, not services except for communication and transport services. Exported goods as well as books, magazines and newspapers are exempt. Small and Medium Enterprises (SME) are subject to a special tax regime, called SIMPLES, in which the tax due is calculated and paid as a share of the SMEs’ gross revenues. In addition, tax credits are generated only from inputs used in the actual productive process, excluding for instance administrative costs. Credits from capital good acquisitions can only be claimed on 1/48 monthly basis12.
13. Responsibility for setting ICMS rates is shared between the states and the Federal Senate, leading to a multiplicity of rates. While states have autonomy to set internal ICMS rates, the Senate is responsible for setting interstate tax rates. The ICMS operates under a mixed origin-destination system in which the interstate tax rate is used to split the revenues in interstate transactions between the producing (origin) state and the consuming (destination) state. The interstate tax rate is 12 percent for the origin state if the good is sent to a state in the Southern or Southeastern regions and also if the trade is carried out within states in the same region. However, it is set at 7 percent for the origin state if the good is sent to a state in the Northern, Northeastern and Center-Western regions. The destination state collects the difference between the internal tax rate and the interstate one13, while the origin state collects the full interstate rate. For instance, if a good is sent from São Paulo to Pernambuco and this good is taxed at 18 percent, then the state of São Paulo will receive revenues worth of the 7 percent tax rate and Pernambuco will get the remaining 11 percent. Exceptions to the general rule occur in air transportation in which the interstate tax rate is set at 4 percent, communication in which the
10 Mendes, M., R.B. Miranda and F. B. Cosio (2008). “Transferências Intergovernamentais no Brasil: Diagnóstico e Proposta de Reforma. Consultoria Legislativa do Senado Federal, Textos para Discussão, No. 40, April. 11 The “fiscal war” is defined as “the competition among states of the federation for the installation of enterprises in their territories”. See Afonso (2013a), background paper. See also Varsano, R. (1997). “A Guerra Fiscal do ICMS: Quem Ganha e Quem Perde”. Texto para Discussão No. 500, Instituto de Pesquisa Econômica Aplicada (IPEA). 12 For example, if a company purchases a new machinery for its factory with a price of 48 million, the company would only be able to use 1 million per month as tax credit from this acquisition to reduce its tax payments. 13 By law, states are prohibited to set internal rates lower than the interstate rate.
11
origin state receives all the revenues and in energy, oil and fuels in which the destination state gets all the ICMS revenues.14
14. The ICMS is the main revenue source of the Brazilian fiscal system and thus the largest subnational own-revenue source, but its relative importance has declined.15 Originally established in 1968 as ICM16, a subnational value-added tax levied on goods, this tax collected at its inception 7.28 percent of GDP or 31 percent of the overall tax burden in the country. As a share of GDP, the ICMS remained fairly stable at around 7 percent, but its share of the overall tax burden had declined to about 19 percent as of 2012 (Figure 2). This has happened despite the increased ICMS tax base and tax rates, reflecting a loss of “productivity” of the ICMS and a more rapid increase in the overall tax burden17, especially in non-shared federal taxes such a (Programa de Integração Social – PIS) and (Contribuição para Financiamento da Seguridade Social – COFINS).
Figure 2 - Evolution of the ICMS (% of GDP and as a share of overall tax burden)
15. As a result of the numerous distortions introduced over time, the ICMS lost many of the advantages associated with a well-designed VAT. These distortions include:18 the high flexibility of states to set norms and tax rates, leading to excessive dispersion of effective tax rates; the introduction of special tax collection regimes taxing revenues, abandoning the value-added principle, an accumulation of ICMS credits that are not honored by the states, the mixed origin-destination principle adopted for ICMS taxation of interstate transactions; and the concentration of ICMS revenues on sectors with high “fiscal productivity”, that is, which can generate large revenues with less tax collection effort. As a result, according to Rezende (2012), the ICMS today is characterized by (i) significant economic inefficiency; (ii) unfair tax burden
14. See Friedmann, R. (2011). “O que é a Guerra Fiscal”, site “Brasil Economia e Governo” (). See also Varsano, R. (1997). “A Guerra Fiscal do ICMS: Quem Ganha e Quem Perde”. Texto para Discussão No. 500, Instituto de Pesquisa Econômica Aplicada (IPEA). 15 J.R. Afonso (2013a), background paper for this study. 16 Originally levied only on goods, until the broadening of its base as a result of the 1988 Constitution. 17 In 1968, the overall tax burden was around 23 percent of GDP while recent figures for 2011 show a tax burden of 36 percent of GDP. 18 See e.g. T. Ter-Minassian (2012a). “Reform Priorities for Subnational Revenues in Brazil”. Inter-American Development Bank Policy Brief IDB-PB-157.
12
sharing among sectors; (iii) lack of transparency with respect to the tax burden; and (iv) federative conflicts.19
16. Partly, the shortcomings of the ICMS reflect the so-called “principle of convenience”, or policymakers’ preference for tax regimes that make tax collection easier.20 A clear symptom has been the increasing participation – at least until the mid-2000s – of “blue chip” segments such as fuels, petroleum products, electricity and communications in ICMS revenues, and the decreasing participation of the manufacturing sector. For example, while ICMS revenues from the manufacturing sector fell from 38 percent in 1997 to 28 percent of the total in 201121, the share of ICMS revenues from the “blue chips” rose from 26 percent to 36 percent during the same period. 22
17. The sizable differences in the origin-related interstate tax rates provide ample space for poorer states to implement tax incentives to attract investors, fueling the so-called “fiscal war.” These fiscal incentives are irregularly awarded tax breaks for firms to choose to operate in the conceding state – without the approval of the collegiate body the National Council of Fiscal Policy (Conselho Nacional de Política Fazendária – CONFAZ), as required by law. Because of the mixed origin-destination principle, tax incentives given by the producing state have to be honored by the consuming state, diminishing therefore its revenues. The fact that such incentives are uncoordinated at the central level, the enforcement of the rules to grant tax breaks is poor and the absence of a regional development strategy are conducive to the current “race-to-the-bottom” situation. As a result, spatial allocation of resources is distorted23, competitiveness of richer states is reduced, and ICMS revenues from manufacturing (the most affected sector) are diminished. The efforts to attract manufacturing companies are known as the first wave of the fiscal war, which was later extended to retail and wholesale companies (second wave of the fiscal war). More recently, Brazil experienced the third wave of the fiscal war with tax incentives being granted to imported goods.
18. Most analysts have called for a comprehensive reform of the ICMS, although political realities have favored a piecemeal approach. Several attempts at reforming the ICMS have been made over the past couple of decades, and are summarized in the ICMS background paper prepared for this study. Some of the main elements of the typical ICMS reform proposal include the creation of a “unified” ICMS underpinned by a single national legislative framework, as well as the adoption of the principle of destination in interstate transactions.24 However, as noted by Rezende (2012), “(…) changes to the ICMS confront two severe constraints: the prevailing climate of lack of trust and antagonism as well as resistance by the states to let go of the
19 F. Rezende (2012). “O ICMS: Gênese, mutações, atualidade e caminhos para recuperação”. Inter-American Development Bank Policy Brief IDB-DP-231. 20 In Portuguese, “princípio da comodidade”. See Rezende (2012), p. 11. 21 Another factor for the decline in industrial sector share in ICMS revenue is the diminishing role of that sector in the national economy. 22 From Afonso (2013a), background paper. 23 Misallocation at the microeconomic level occurs insofar as “the allocation of resources is based on tax costs, and not on relative prices of the production factors, creating unfair advantages for the firms benefitting from fiscal incentives.” In J.M. Arroyo, J.P. Jiménez, and C. Mussi (2012). “Revenue Sharing: The Case of Brazil’s ICMS”. Serie Macroeconomía del Desarollo, United Nations ECLAC, Economic Development Division, June, p. 12. 24 See Giambiagi and Além, op. cit., p. 273.
13
possibility of adopting tax policies that contribute to their development”.25 This issue will be taken up again in more detail in section III.
B. Intergovernmental Transfers: FPE and Royalties
19. FPE is the main revenue sharing-related unconditional transfer from the federal government to the states. It totaled about R$64 billion in 2011 or 1.5 percent of GDP. The FPE is funded by 21.5 percent of the total revenue collections from two federal taxes, the Income Tax and the Tax on Industrialized Products. . The FPE has a regional redistributive goal. The amount received by each state thus depends on the federal tax collection and on each state’s coefficient, which were stipulated in 1989, and have remained fixed since then. These coefficients were defined on ad hoc manner, loosely inspired by the rules prevailing before 1989. Furthermore, the FPE coefficients are calibrated so as that three regions – North, Northeast, and Center-West – receive 85 percent of the FPE resources, with the remaining 15 percent being allocated to the richer South and Southeast regions.
20. The coefficients adopted in 1989 were supposed to be only temporary, as Law 62/1989 envisaged their replacement by new coefficients through a new law to be enacted in 1992. This new law was never brought to vote in Congress and the fixed coefficients remain in place. The current FPE sharing criteria were ruled unconstitutional by the STF on February 24, 2010, based on the view that they “do not meet the constitutional principle of promoting social and economic balance between the states and therefore compromised the federative pact.”26 New rules were then asked to be put in place by end June of 2013.
21. While the FPE remains broadly redistributive, the use of fixed coefficients overlooks significant changes in regional development in the past two decades. As shown in Figure 3, the negative correlation between states’ share in FPE resources and their per capita GDP indicates that a redistributive mechanism is operating. At the same time, the current calibration does not take into account the fact that the Center-West region and some northeastern states underwent considerable development over the past decades, on the back of the agribusiness boom and regional manufacturing diffusion. Therefore, those states are likely over-represented in the sharing of FPE resources. It has also been argued that the FPE “over-finances” its four main beneficiaries: the states of Roraima, Amapá, Acre and Tocantins.27 Figure 4 ranks states in accordance with the share of FPE resources in total revenues.28 This share exceeds 50 percent in these four cases. From a redistributive need perspective, these states have Human Development Indices which are relatively high for the amount of FPE transfers they receive.29
22. Calls for FPE reform have also focused on two key additional features of the fund: Pro-cyclicality and limited accountability. Given that FPE transfers are based on fixed
25 Rezende (2012), p. 56. 26 Accioli, op.cit., p. 22. 27 Mendes et al, op. cit. 28 From Rocha, op. cit., background paper for this study. 29 Mendes et al, op. cit.. While the HDI is not a FPE sharing criterion, it is nevertheless a plausible proxy for relative needs. Ter-Minassian (2012a) also notes that “the six largest recipients of FPE transfers (mostly in the sparsely populated northern region) are not among the poorest in terms of either per capita GDP or revenues before the transfers; rather they lie in the middle of the distribution.”(p. 15).
14
percentages of IR and IPI revenues, they are by nature pro-cyclical. Although it is not advocated here that FPE should act as a stabilizing mechanism, its current design may reinforce a pro-cyclical characteristic of state’s own revenues, in an environment which rainy days funds are not common. Preliminary research, however, showed that there is no difference in FPE and current expenditure volatility.30 The unconditional nature of FPE transfers also limits states’ accountability in the use of these resources, thus adversely affecting incentives for efficient public expenditure management and fiscal responsibility. In particular, unconditional access to FPE grant resources may increase the states’ incentives to use surplus resources in projects with lower rates of return.31
Figure 3 - Correlation Between States’ FPE Shares and Per Capita GDP
Figure 4 - Share of FPE in Total Revenues by State (%) –1990-2011 Average
30. See Box 2 in Rocha, op. cit., background paper for this study. 31 Mendes et al, op. cit.
15
23. Another type of transfer to states undergoing reform is the oil and mining royalties. Until recently, two taxes were imposed on oil production: royalties and the so-called special participation. The royalties rate varies from 5 to 10 percent on gross production value, although the upper bound is by far the most prevalent rate in practice. The special participation has a progressive rate up to 40 percent, but is charged over net production value and only on highly productive or profitable oil fields. Revenues from royalties and special participation are shared with states and municipalities. The sharing scheme depends on the location of the field, but in most cases producing states are entitled to 26.25 percent of the royalties and 40 percent of the special participation. Non-producing states receive collectively only 1.75 percent of the royalties collected. Mining royalties rate are set to 2 or 3 percent on the most common mining products in Brazil, but are levied over net production value. Producing states receive 23 percent of the revenue, while producing municipalities get 65 percent.
24. The distribution of resources from petroleum – especially royalties – also suffers from significant asymmetry, but of a different kind: high concentration in producing states. The states of Rio de Janeiro and Espírito Santo – and its producing and affected municipalities – have received the lion’s share of petroleum royalties. On average, the state of Rio de Janeiro has received about 80 percent of the petroleum royalties envelope in the period between 1999 and 2012. When examined from the point of view of beneficiary municipalities, those in the state of Rio de Janeiro have accounted on average for 73 percent of the total in the same period.
C. Subnational Debt
25. The current subnational borrowing framework is formed by three mutually reinforcing rules. The first is the debt renegotiation law, which was established in 1997 for the states and 1999 for the municipalities. The second piece is the LRF, which was established in 2000 and is complemented by two main Federal Senate Resolutions, which were put in effect in
16
2001. The third piece is the resolution from the National Monetary Council (CMN, Conselho Monetário Nacional), which has put a cap on overall lending from the banking sector to public sector institutions. The main borrowing rules are comprised or referenced in these regulations, which are so intertwined that they cannot be analyzed in isolation.
26. Subnational debt distress in the late 1980s and 1990s led to three rounds of renegotiations between states and the Federal Government to restore subnational debt sustainability.32 The first two rounds took place in 1989 and 1993, but were not successful in addressing the problem, for two main reasons: (i) they did not refinance the majority of debt outstanding - for example, subnational bonds were not included; and (ii) they did not deal with the structural causes of the debt crisis, namely, the underlying fiscal imbalances in subnational governments. In addition, the then prevailing high inflation environment made it easier for states to hide their imbalances by postponing payments.
27. The largest renegotiation for states took place from 1997 to 1999, leading to the restructuring of nearly R$200 billion, or about 12 percent of the national stock of debt. The restructuring was the most comprehensive one, including subnational bonds, and was conditioned upon states’ compliance with medium-term fiscal adjustment and structural reform programs agreed upon with the National Treasury Secretariat (Secretaria do Tesouro Nacional, STN). This process was of critical importance for subnational debt sustainability as the Federal Government was (and continues to be) the main holder of subnational debt. Box 2 describes the main features of such programs. Furthermore, a subsequent restructuring round, on similar grounds, was concluded for municipalities in 2001. As a result, subnational debt declined significantly between 2001 and 2012, as shown in Figure 5.
Figure 5 - Net Subnational Debt as a Share of GDP (%)
32 For a fuller history of the changes to Brazil’s subnational debt framework, see Mora, M. (2002). “Federalismo e Dívida Estadual no Brasil”. Texto para Discussão 866, Instituto de Pesquisa Econômica Aplicada (IPEA), Brasília, as well as Mora, M. (2013), background paper prepared for this study.
17
Box 2 - Main Features of Debt Restructuring Programs Agreed between States and the Federal
Government
• Addressing the structural causes of fiscal imbalances in subnational government, through the institution of binding rolling three-year fiscal plans with targets and supervision from STN:
– The fiscal plans consisted of fiscal and state reforms, monitored by six indicators which included targets on variables such as (a) debt-to-revenues ratio; (b) public sector wage bill; and (c) primary fiscal balance.
– In addition, state owned banks were extinct, privatized or capitalized.
• Subsidized refinancing to subnational governments debt, including bonds:
– Refinancing was done with a 30-year maturity, with fixed real interest rates of 6%, 7.5% or 9% p.a., depending on, respectively, whether 20%, 10% or no part of the initial debt stock was amortized up to end of 2000. The debt was indexed to the general price index (IGP-DI) and a debt service ceiling was established.
– The debt service ceiling was set at 12 to 15 % of Net Real Revenues (NRR). Every time debt service exceeds this limit, the difference – called “the residual” – is capitalized together with the debt principal. If SNG still holds a residual after 30 years, it will be refinanced for 10 years in the same conditions, but without any debt service ceiling.
– The subsidy was represented by the freeze in debt amounts between the cut-off date and the contract signature and between the interest rate paid by the government on its debt proxied by SELIC33 and the debt cost charged to subnational governments.
– During several years, SELIC was set much higher than the debt cost to SNGs, however, the declining trend of the SELIC itself meant that the interest rate subsidy has declined over the years, as shown in the chart below.
33 Selic stands for Special Settlement and Custody System, and represents the benchmark interest rate. See Manoel, A.; S. Garson, and M. Mora (2013). “Brazil: The Subnational Debt Restructuring of the 1990s – Origins, Conditions, and Results”. In Canuto, O. and L. Liu (eds.) Until Debt Do Us Part: Subnational Debt, Insolvency, and Markets. Washington, D.C.: World Bank.
18
Figure 6 - Comparison between Selic and SNG rates, accumulated basis (base year: 1995)34
28. Following the restructuring process, Brazil’s subnational borrowing framework was enshrined in the 2000 Fiscal Responsibility Law. The LRF helped institutionalize fiscal discipline at all levels of government, through a series of novel features, including: (i) the incorporation of hard budget constraints into a single unifying framework; (ii) the ban on further debt refinancing operations between different levels of government to avoid moral hazard; (iii) the introduction of more stringent requirements on fiscal targets in the preparation of the Budget Guidelines Law. It is also complemented by a Fiscal Crimes Law applicable to cases of non-compliance with the FRL. The third piece of the subnational fiscal framework is a resolution from the National Monetary Council which set limits for outstanding loans from the banking sector to the public sector. Brazil’s reformed subnational borrowing framework includes a number of additional important features, namely: (i) the use of administrative rather than market-based mechanisms for control of subnational indebtedness; (ii) the absence of competitive domestic capital markets for subnational debt, combined with the prevalence of public banks in credit operations to subnationals; and (iii) the ban on subnational issuance of bonds until 2020.
29. A new cycle of subnational borrowing started in 2008, in line with the renewed emphasis on infrastructure investments as a driver of growth and later as part of the Government’s response to the global crisis.35 This new cycle was enabled by the post-crisis creation of a new financing line by the National Bank for Social and Economic Development (BNDES) for subnationals36; increasing subnational lending by major public banks Banco do Brasil and Caixa Econômica; and greater reliance on multilateral sources for infrastructure financing at the state and municipal levels. Furthermore, with the goal of expanding subnational investment financing capacity, STN has also raised borrowing limits for states through the PAF 34 Reproduced from Mendes (2012a). 35 See Mora, M. (2013), background paper to this study. 36 Canuto, O. and L. Liu (2010). “Subnational Debt Finance and the Global Financial Crisis”. Economic Premise, The World Bank, No. 13, May.
19
annual revision cycles37. From January, 2008 to April of 2013, credit to public sector grew on average 3 per cent per month while total credit expanded at 1.5 percent on the same basis. This expansion was concentrated in state-owned banks, since credit to public sector from privately-owned domestic banks contracted, while credit to public sector from foreign-owned banks remained stable.
30. Subnational solvency is again in the spotlight as the interest subsidy is plummeting and the debt service cap together with the evolution of macro conditions has led to significant accumulation of unpaid “residual” by major subnational governments.38 First, significant and consecutive declines in the Selic benchmark rate all but erased the interest subsidy. Second, the accumulation of the “residual” has put in question the ability of some states - Rio Grande do Sul, Minas Gerais, São Paulo and Alagoas – and the Municipality of São Paulo to be able to fully repay their debts to the Federal Government within the agreed timeframe. Both factors have contributed to the ongoing pressure by some subnationals to renegotiate the terms of their debt with the Federal Government. Sections III and IV will look in more detail into the current debates on reforming Brazil’s subnational borrowing.
III. Reforming the Subnational Fiscal Framework A. The Case for Coordinated Reform
31. Given the deep-rooted issues with Brazil’s fiscal federalism framework, there have been calls for fundamental reform. For example, drawing on the notion that Brazil’s subnational fiscal framework is outdated, Rezende (2009) proposes a “new model of fiscal federalism” that includes modernizing the tax system, revamping intergovernmental transfers, and developing a new strategy for greater regional and federative equality. Other authors such as Miranda, Mendes & Cosio (2008) proposed comprehensive changes to the transfer system while Werneck (2008) looks at comprehensive tax reforms.
32. If ever implemented, such fundamental reform would include a major revamping of the ICMS as one of its key components. A shift to greater federal responsibility in the ICMS collection process has been a central idea.39 In one formulation, the ICMS would be replaced by a national VAT, with well-defined rules for the sharing of revenues with the states. Another formulation envisaged the adoption of a dual VAT, whereby its base would be shared between the Federal Government and the states. In this version, the Federal Government and the States would separately administer their respective shares of the tax base. A dual VAT is often viewed as a superior alternative to a national VAT in the Brazilian case, in order to preserve states’ fiscal autonomy and political accountability.40
33. While many analysts agree that a “new model of fiscal federalism” would be politically infeasible, the debate has focused on a coordinated- if less ambitious – set of reforms. In this reasoning, Brazil’s subnational fiscal issues would be addressed in a multi-
37 The limits foreseen in the Senate resolutions remained unchanged. 38 See Mora, M. (2013), background paper to this study, as well as Mendes, M. (2012a). “Por Que Renegociar a Dívida Estadual e Municipal?”. site “Brasil Economia e Governo” (www.brasil-economia-governo.org.br) 39 Rezende, F. (2012), op. cit. 40 See Ter-Minassian (2012), op. cit., p. 28.
20
pronged fashion, through politically-acceptable changes to the ICMS to end the fiscal war; to the FPE and royalties sharing rules, to address fairness concerns and satisfy the STF ruling; and to the subnational borrowing framework, to allay concerns about states’ debt sustainability prospects.41
34. In a coordinated reform process, the synergies among the different components of Brazil’s subnational fiscal framework could set the stage for “cross compensations” among states. For example, revenue losses in some states due to changes to the ICMS could be compensated for by gains stemming from adjustments to the FPE sharing criteria.42 These potential synergies also motivated the Federal Senate’s Commission of Experts to propose to simultaneously tackle changes to ICMS tax rates in interstate transactions, FPE sharing criteria and the indexation rules for subnational debt to the Federal Government.43 In addition, the STF rulings on the FPE and on the ICMS fiscal benefits could be seen as opening a “window of opportunity” for coordinated subnational fiscal reforms. 44
35. However, political resistance to even limited reforms has proven to be formidable. The greatest obstacle seems to be reaching a consensus on ways to addressing net gainers and losers from different reform proposals.45 Furthermore, reform proposals often confront deep-rooted federative issues, as in the case of royalties sharing rules. The realpolitik of subnational fiscal reforms will be discussed in more detail in subsection III.B.
B. The Realpolitik of subnational reforms
36. Brazil is a federative country with some important peculiarities, starting with the role of municipalities. Besides the central level of government and the 27 states, the 5,570 municipalities are considered members of the federation. Unlike in the US in which they are creature of the states and are regulated by the states, in Brazil they do not have any hierarchical relation with state governments. Thus, municipalities are an important political actor and can strongly oppose projects that can harm their interests. This is one explanation as to why attempts to incorporate the tax over services (Imposto sobre Serviços – ISS) under the ICMS tax base have failed.
37. These peculiarities are reflected in the Municipalities’ share of intergovernmental fiscal transfers, as well as in the weight of the ICMS for states’ revenues. As previously noted, the federal government accounts for the bulk of revenue collection, while states collect one quarter of the revenues. Municipalities in turn collect only 5.7 percent of the total revenues. However, the municipalities are the biggest winner of the transfer system in place ending up with 18 percent of the total resources available. States, on the other hand, end up with a neutral position from the standpoint of intergovernmental transfers: Incoming transfers roughly equals 41 As noted by Ter-Minassian: “A comprehensive and simultaneous approach to the reforms would promote their mutual consistency and facilitate trade-offs that might increase their political viability”. Op. cit., p. 33. 42 See e.g. Rezende, F. (2012), op. cit, p. 57. 43 See Partial Report by the Federal Senate’s Commission of Experts, October 2012. 44 See Ter-Minassian (2012), op. cit., p. 3. 45 For example, none of the various FPE reform proposals being discussed in Congress as of early 2012 were found to be able to garner enough consensus to ensure approval. See Rocha, C.A.A. (2012). “Rateio do FPE: Avaliação de Impacto e de Viabilidade Legislativa das Novas Propostas”. Núcleo de Estudos e Pesquisas do Senado, Texto para Discussão No. 111, Março.
21
out states’ transfers to municipalities – states account for 25.5 percent of the revenues collected while keeping 24.4 percent of the available resources after accounting for transfers. This balance just reinforces the importance of ICMS for the states, especially for the most developed ones which receive less transfers proportionately speaking. The relevance of ICMS hence makes any reform attempt more difficult since states do not have other sources of funds of similar magnitude.
38. Furthermore, smaller states tend to be overrepresented in Congress. This is a result of the 1988 Constitution, which has defined a minimum of 8 representatives for each state and a ceiling of 70 representatives. Thus, in principle, one representative in São Paulo represents nearly 600,000 inhabitants while a representative in Roraima represents around 60,000 people. In addition, representatives are not elected by district, but rather by the whole state population. Lastly, states are represented on equal standing at the Senate – 3 senators for each state.
39. These features of Brazil’s fiscal federalism provide the politico-institutional context in which the country operates and in which the reforms are being attempted. The federal government has submitted reform proposals for ICMS and subnational debt, while the proposals to change intergovernmental transfers were originated from the legislative or by the subnational governments. The following three subsections describe the proposed reforms, while the last two subsections discuss the most likely reform outcome and the key issues left unaddressed.
i. Currently proposed changes to ICMS framework
40. The Federal Government has submitted to Congress a proposal to reform ICMS. The cornerstone of the proposal is the gradual unification of the ICMS interstate tax rate from 7 percent and 12 percent to 4 percent in all transactions, except from goods originated from the Manaus Free Zone and interstate natural gas trade46 (See Figure 8). The rationale is to end the original cause of the fiscal war which is the differential in tax rates between regions for the interstate trade. This was already implemented for ICMS over imported goods47, and would be implemented in four years according to the original government proposal. However, due to pressures by the affected states, the unification period was extended to 12 years.
Figure 7 – ICMS Current Interstate Tax Rate Scheme48
Figure 8 – ICMS Interstate Tax Rate Unification Schedule Proposed by the Federal Government
46 The initial government proposal was even bolder since it aimed to unify all interstate transactions into the 4% rate. In addition, to the rates showed in Figure 8. The other exceptions to the general rule which are air transport and electrical energy, oil and fuels, which have interstate tax rate of 4% and zero respectively would be maintained. Also, there are some exceptions defined by agreement at CONFAZ such as capital goods, which have an interstate tax rate of 8.8% and 5.14%. 47 Federal Senate Resolution 13/2012 became effective in January 1st, 2013. 48 The advanced states group comprises all states in the South and Southeast region, except for Espírito Santo. The emerging states group comprises the remaining states. Intraregional refers to interstate transactions done inside each group.
22
41. The gradual unification of the interstate tax rate would solve the problem going forward, yet it would not in itself resolve the issue of past tax incentives. These incentives are in jeopardy due to judicial decisions. In order to resolve this problem, the Federal Government proposal aims to validate all tax incentives granted in the past, with their future effect being phased out. The past unpaid taxes would also be forgiven. This would be achieved with the replacement of the unanimous approval requirement for all states for tax incentives by a softer rule requiring simultaneously the approval of 3/5 of all states and 1/3 of the states in each region.
42. Lastly, in order to persuade the states to cease the fiscal war, the Federal Government proposed the institution of two special funds. The aim of these funds would be to compensate reform losers and to allow states to implement regional development and business attraction policies
43. The first fund – the Revenue Compensation Fund (FCR – Fundo de Compensação de Receitas) - would financially compensate the states for the losses incurred with the reduction in the interstate tax rate. The amount of the losses would be calculated every year in the month of June by the federal government revenue service (Secretaria da Receita Federal do Brasil – SRFB) based on the electronic fiscal invoice national database of the previous year. Thus compensations paid in any given year would be based on the losses occurred in the two previous years. Payments would be made monthly during 20 years. The government estimate total losses in the first year to be R$ 2.1 billion (or 0.05 percent of GDP) and the total loss over the transitioning years to amount to R$ 63.5 billion. However, the cap for this transfer was set much higher at R$ 8 billion in the draft law proposal.
44. The second fund – the Regional Development Fund (FDR – Fundo de Desenvolvimento Regional) - aims to provide a flexible tool for state governments to promote regional development. It is also expected to last for 20 years. The FDR would be constituted by federal budgetary resources and proceeds from federal debt issuance. Budget resources would amount to R$ 74 billion starting with R$ 1 billion yearly and reaching R$ 4 billion in year 4 remaining constant until the end of the fund, while the debt issuance part is expected to sum up to R$ 148 billion, starting with R$ 2 billion in the first year and growing to R$ 8 billion yearly from year 4 onwards. Thus, the total fund size would amount to R$ 222 billion.
23
45. The fund’s resources would be used to finance new business ventures in the states territories and infrastructure projects as well as subsidies for private companies or infrastructure users. In the first case, resources would come from the debt issuance proceeds. The use of these resources would be regulated by the CMN and operationalized by a federal financial institution such as BNDES or the Northeast Bank (BNB). The cost of the debt to the fund would be the long-term interest rate (TJLP). In case the final cost to private borrowers is lower than TJLP, the subsidy would have to be covered by the budgetary resources in the fund.
46. The FDR resources would be distributed among states according to their share of population to the total of all states and in inverse relation to GDP per capita (see Table 1). In addition, the states would be divided in two groups, being the first one formed by states with per capita GDP above the national average and the second one with the remaining states. The resource partition between these two groups would be done in accordance to the inverse of each state’s GDP per capita. The implementation of both funds is conditioned on the unification of the interstate tax rate as laid out in the government proposal sent to Congress, the submission of information on tax incentives to the Federal Government and the renouncement of any new tax incentives in disagreement with the legislation. The state of Maranhão would receive the largest share of the FDR (6.7 percent), while the Federal District would receive the smallest share (0.9 percent), according to calculations made by the Ministry of Finance.
47. Lastly, a concurrent change in the ICMS on distant sales (electronic commerce and catalogue sales for example) is being discussed at Congress. Currently, the ICMS paid on such transactions is sent entirely to the originating state, thus not being divided between origin and destination states according to the interstate tax rate rule. For instance, if a fridge is produced in São Paulo and purchased by a resident of Recife, then the states of São Paulo would get 7% and Pernambuco would receive 11%. However, if the same fridge is purchased by a inhabitant of Recife through the internet from a website whose warehouse is located in São Paulo, then the state of São Paulo would receive 18%, or the total ICMS paid in this transaction. This has become an issue of greater concern due to the increase in e-commerce transactions, posing a risk of revenue loss to poorer states, since the majority of the e-commerce companies’ warehouses are located in the south and southeastern part of the country, where consumption value is higher.
Table 1 – Regional Development Fund (FDR) Distribution Quotas49
49 The shares sum up to 100.1% due to rounding.
24
Source: Ministry of Finance
ii. Currently proposed changes to intergovernmental transfers’ framework
48. Unlike with the ICMS and the subnational debt, the Federal Government abstained from proposing reforms in the intergovernmental transfer framework. Thus, the proposed reforms in this area are a mix of legislative and subnational government initiatives, responding both to Supreme Court decisions and incentives to obtain more resources.
49. Congress has approved and the President has sanctioned the reform proposal for the FPE. The proposal establishes that until 2015 the current FPE shares will remain unchanged. From 2016 onward, each state will receive the same value as per the previous year adjusted for inflation (IPCA) plus 75 percent of Brazil’s GDP growth rate. If the total amount of the FPE envelope is higher than the sum of the adjusted FPE values, then the surplus would be distributed in direct proportion to the share of population of each state and in inverse proportion to their per capita household income. The population shares have a lower bound of 1.2 percent and an upper bound of 7 percent, benefiting the least populated states such as Roraima, which is the least populated state with 0.24 percent of the national population. A provision to limit the effects of tax breaks given by the federal government on FPE was included, but was vetoed by the President. The veto was then maintained by Congress. 50. Figure 9 shows in a simplified way the steps needed to calculate the FPE coefficients according to new rules.
Figure 9 – Revised procedure to calculate FPE coefficients under the new proposed rule
25
51. In turn, while the current proposal to change the distribution of oil royalties has been under discussion for a few years, it remains mired in controversy. Initially, the Government’s intention was not to change the royalties distribution rule when it proposed a change in the oil exploration regime in 2009. However, Congress amended the law to include a provision to redistribute all royalties: old and new contracts, concession and production sharing regime, accruing to states and municipalities, according to the FPE and FPM coefficients. Under this amendment, the Federal Government would compensate the losing states with its share of the royalties. These changes were vetoed by the President and the original rules set in 1997 were maintained. In 2012, Congress approved another law (Lei 12.734/12) that set the royalties rate at 15 percent for the oil sharing regime instead of the current 5 to 10 percent rate, but no special participation payment is foreseen and also changed the royalties and special participation distribution in favor of non-producing states in both new and old contracts. These changes in the royalties distribution were again vetoed by the President, and an Executive Order (Medida Provisória – MP) was put in place to establish new royalties distribution rules for contracts signed after December 3, 2012. The presidential vetoes, however, were overturned by Congress and the MP expired. After that, the state of Rio de Janeiro appealed to the Supreme Court to declare both the law and the MP unconstitutional. Currently, the changes are suspended due to an
26
injunction given by the Supreme Court to the appeal sponsored by the oil-producing states of Rio de Janeiro, São Paulo and Espírito Santo.
52. Controversy is fueled mostly by the distributional implications for producing and non-producing subnationals. Regarding the royalties distribution, the law envisages that producing municipalities will have their share reduced gradually to 15 percent in the first year up to 4 percent in the eighth year and beyond. Taking into account the royalties rate, the share of oil revenue accruing to the producing municipalities would be reduced from 2.625 percent to 0.6 percent in 2020. For the producing states, the share of oil royalties was fixed at a steady 20 percent. For the non-producing states and municipalities, the royalties share was set at 21 percent for the first year of the new law, increasing to 27 percent until 2020. These royalties are to be distributed among states and municipalities following the same rules as the FPE and FPM. In addition, producing states cannot receive royalties through both the FPE rule and for being a producer. Lastly, the amount of royalties received by each producing municipality is capped at the 2011 level or an amount equal to twice the FPM.
53. Lastly, the Federal Government has sent to Congress a draft law to institute a new regulatory landmark on mining activities in Brazil. In relation to the mining royalties, or CFEM, the Government’s proposal envisages a change in the tax base from net revenues to a concept of gross revenues, in which only taxes paid on sales, can be deducted from the gross sales revenues. The tax rates will be set by decree for each mining product, respecting the maximum tax rate of 4 percent. The revenue sharing scheme between government levels was maintained.
iii. Currently proposed changes to subnational borrowing framework
54. The current debate on subnational debt has focused primarily on changes to the indexation rules and concerns about debt sustainability for some subnationals. The prevailing view is that the IGP-DI should be replaced by the more stable IPCA (the broad consumer price index), accompanied by a reduction in the “real” interest rate.50 However, this change in itself may not necessarily guarantee a return to debt sustainability in the most affected subnationals51. This has led to proposals to change indexation rules retroactively to the year that debt contracts were negotiated. Such scenario looks rather implausible, since it would probably be considered as a breach of the LRF and some subnationals would become creditors, instead of debtors, of the Federal Government, and the Treasury’s net debt would increase considerably.52
55. The centerpiece of the Federal Government’s proposal is a change in the interest rates accrued to the renegotiated debt of the states and municipalities. Currently, subnational governments pay interest rates of 6 percent, 7.5 percent or 9 percent on top of the adjustment by the General Price Index (IGP-DI, Índice Geral de Preços – Disponibilidade Interna).
56. This proposal aims to reduce this interest rate from January 2013 onwards to 4 percent on top of IPCA or simple SELIC interest rate accrual, whichever is lower. 50 See Mora, M. (2013), background paper to this study, as well as Mendes, M. (2012b). “Como Renegociar a Dívida Estadual e Municipal?”. Site “Brasil Economia e Governo” (www.brasil-economia-governo.org.br). 51 Mendes, M. (2012a), op. cit. 52 Mendes, M. (2012b), op. cit. A version of this scenario is simulated in subsection IV.C.
27
However, it does not change the debt service ceiling, which varies from jurisdictions, going from 12 percent to 15 percent of Net Real Revenues.
iv. Most probable reform scenario
57. Of the three reforms discussed above the FPE reform is the only one completed. Agreement was facilitated due to the fact that the proposed new FPE sharing rule will start producing effects only in 2016 and in a very gradual manner, thus drastically reducing opposition to the reform. Nonetheless, the first law approved by Senate was overturned by the lower House on June 12. Consequently, a new proposal was drafted by Senate changing the floors and caps on the population and income representative factors to benefit small states and the transition became even more gradual than the initial Senate proposal, since 75 percent of the GDP growth, rather than 50 percent is to be applied on previous year FPE in order to calculate the amount of the FPE shared by the former fixed coefficients. This proposal was approved by Senate on the June 18 and by the House of Representatives on June 26 and again by the Senate on the same day, since some amendments were introduced by the Lower House.
58. The Federal Senate has amended the Government proposal on the unification of the ICMS interstate tax rate, creating a stalemate. An amended version was approved at the Economics Affair Commission (CAE – Comissão de Assuntos Econômicos) and is now pending a vote at the Senate. 53
59. The amended version of the proposal did not keep the gradual unification of the ICMS interstate tax rate and has created several exceptions, resulting in a more complex tax regime. For instance, products originating from the North, Northeast and Center-West regions plus the state of Espírito Santo would pay a tax rate of 7 percent. In addition, goods from the Manaus free zone and other 12 free trade zones in the North of Brazil would keep the 12 percent rate54. Lastly, the old interstate tax rate of 12 and 7 percent would still apply to natural gas, both imported and produced in Brazil. The Senate amended proposal also conditioned the change in ICMS tax rate to the creation of the compensatory funds in a complementary law, rather than an ordinary one. The complementary law requires approval from the absolute majority of congressmen, while a simple majority suffices to approve an ordinary law55. In addition, ordinary laws can be changed by the Executive through Executive Orders, which take effect immediately and are voted by Congress only after it is already in place. Thus, the rationale
53 The ICMS reform is embodied in three pieces of legislation. The interstate tax rate is dealt in a Federal Senate Resolution, while the change in procedures to validate past tax incentives is foreseen in a complementary law. The changes to the subnational debt interest rates are included in the same complementary draft law. Lastly, the compensation and developmental funds are dealt in a Provisional Measure, which is an ordinary law proposal sent by the Federal Government to Congress that produces immediate effects. It is valid for 60 days and renewable for another 60 days. Beyond that, if Congress does not approve it, the law loses its effect. 54 Goods produced in these areas would have to follow the so called Basic Productive Process (Processo Produtivo Básico – PPB), which is established by the Ministries of Trade, Commerce and Industry (MDIC) and Science, Technology and Innovation (MCTI), adding another layer of complexity. 55 In numbers, an ordinary law can be approved by 129 votes out of 513 representatives, provided 257 representatives are present. A complementary law requires approval by 257 representatives. In the Senate, which is composed of 81 senators, 21 votes are needed to approve an ordinary law, with a quorum of 41 senators, which is the same number needed to approve a complementary law.
28
for having the funds in a complementary law is to ensure its longevity, by preventing the Federal Government from changing the funds through a MP.
60. The ICMS reform approved at CAE reduces, but does not eliminate the room for the fiscal war since the interstate tax rate magnitude and regional differentials are reduced. On the other hand, the maintenance of a tax rate differential for wholesale and retail still allows for the so-called “fiscal invoice tour”56. Moreover, it increases the size of the tax rate differential in the case of the free zones, boosting the incentive for the fiscal war. Finally, it has increased the compliance cost of the tax, due to greater exceptions in tax rates.
61. In contrast, the Senate amendments did not change the essence of the Federal Government’s proposal on the compensation and development funds. Overall, the Senate changes aimed at strengthening the guarantee for the fund resources and give transparency and participation to the states on the revenue loss calculation process. Two changes, however, indicate a departure from the original government proposal. The first one increases the share of budgetary resources in the FDR fund from 25 to 50 percent, maintaining the total value of the fund unchanged. The second one creates four free trade zones that would benefit from the privileged status granted to the existing eight ones.
62. Finally, the amended proposal also kept the original provisions regarding the validation of past tax incentives unchanged. It included a mandate for past tax incentives to be approved by state legislative and to be disclosed at the official Gazette. The main change was the creation of a provision to safeguard the existing tax incentives until their expiration or 2033, whichever comes first.
63. An impasse has also been reached in the subnational debt discussion in Congress as an element of retroactivity was introduced in the amended version. Major changes were made with respect to the proposed Complementary Law regarding the renegotiated debt conditions. The proposed new interest rate and index (IPCA plus 4 percent capped at SELIC) were maintained. However the Federal Government would in addition give a 40 to 45 percent discount in the amount owed by the subnational government. This discount would promote a similar effect to the retroactivity of the new debt conditions. In addition, the Federal Government would refinance the outstanding amount in 25 years and municipalities with population larger than one million inhabitants would be allowed to sign fiscal adjustment plans with the Federal Government and contract loans if the agreed targets are fulfilled in a similar manner as the states. In exchange, the fiscal space created would have to be spent in public investments or PPP payments and there would be no more debt service ceilings.
64. In light of the changes proposed by the Senate, the Federal Government is debating whether it is worth to go ahead with or abandon the reforms. Despite the changes promoted by Congress, none of them are permanent yet since they need at least one more vote to be put
56 The “fiscal invoice tour” (passeio de nota fiscal) refers to a situation in which companies send only the fiscal invoice and not the actual goods to a state where the interstate tax rate is 12 percent. In this state, the company normally has a tax incentive wherein it pays only 3 percent, but receives tax credit worth of 12 percent. The company then sells the product back to its original state, where the good is claiming a tax credit of 12 percent against a tax debit of 6 percent (the difference between the interstate and the state tax rate), ending up with a net tax credit of 3 percent.
29
into effect. Moreover, the President also holds a line veto power over them after approval by Congress. In addition, the MP 599 that changes the interest rate on the subnational debt has expired on June 6th57.The recent wave of protests also blurred the picture, since reform of the intergovernmental arrangements was not included in the five “pacts” proposed by the Federal Government. Nonetheless, these reforms were included in the priority list of the Senate, whose President vowed to put them to vote shortly.
v. Key issues left unaddressed by current reform proposals
65. Even though the government intention was never to promote the intergovernmental reforms in a “big bang” approach, some key issues were left unaddressed. Such issues include the difficulties faced by companies to claim their tax credits and some loopholes in the subnational debt framework. The issues discussed here do not necessary represent the changes that would yield the largest benefits to the economy, but rather those that would yield positive benefits while at the same time not representing great disruptions to the current state of affairs.
66. The three main ICMS-related unaddressed issues are: (i) the difficulty of export companies to realize the benefits of their tax exemption; (ii) the taxation of investment; and (iii) restrictions to tax credits. These issues, if addressed, would not require introducing new provisions in the ICMS, but rather deal with existing provisions that are not working properly.58
• Export exemptions. Exported goods are exempt from ICMS since 1988 for manufactured goods and since 1996 for primary products. However, due to the value added nature of ICMS this has meant that exporting companies have accumulated tax credits, gained from the purchase of inputs that cannot be compensated and should thus be returned in cash to these firms. Since these returns would represent an actual cash outflow for the states and also because the compensations from the Federal Government has fallen short of the actual losses, states have not honored fully and timely the credits accumulated by exporting companies. Thus, in fact exports continue to be taxed by ICMS. More importantly, now the taxation on export companies can vary depending on the share of the production exported and also on the company location. With the implementation of the national electronic fiscal invoice, the Federal Government can now know the amount of credits accumulated by these companies. This would allow the Government to try a new approach in which it can better control the use of the compensatory resources sent to the states.
• Taxation of investment. The acquisition of capital goods by companies is taxed by ICMS and the credit can only be recovered in 48 months, with no inflation or interest rate adjustment, thus increasing the cost of investment in Brazil. An immediate compensation of credits would not cause a permanent revenue loss for the states, but rather a change in their revenue flow which could be compensated by the Federal Government. Although it can be claimed
57 According to the Brazilian constitution, Provisional Measures are valid only for 120 days, period in which it has to be voted by both the House of Representatives and the Senate in order to become an ordinary law and takes effect permanently. 58 In this sense, the curtailment of the state governments’ power to issue regulations on ICMS in favor of the creation of a single national rule (which would simplify tax compliance), as well as the merger of the ISS and ICMS tax base, are not dealt with here because they would deviate from the piecemeal approach sought by the Government.
30
that promoting investment should be as much in the interest of the state as of the Federal Government, the current low investment rate of the Brazilian economy, which is a bottleneck for sustainable higher long-term growth, make a compelling case for the Federal Government to at least share the cost temporarily.
• Tax credit restrictions. Relatedly, ICMS rules restrict tax credits to the inputs employed in the industrialization process. Thus, companies have to separate their inputs between those used for administrative purposes such as the company headquarters, making compliance burdensome and giving a lot of discretion to the tax administration authority59. The provision to allow for all inputs to generate credits to the ICMS taxpayer is foreseen in the legislation since 1996 to be implemented in 2007, which was postponed to 2011 and later postponed to 2020, reflecting both the unwillingness of the states to give up on revenues and its inability to adjust its expenditures to lower revenues. Thus, any financial help from the Federal Government would help the states prepare for the transition and avoid new delays in implementation.
67. Lastly, one issue relating to the phasing out of the fiscal war is being overlooked in the ongoing reform debate in Congress. The prevailing idea as can be seen by the Congress amendments is to preserve the current tax incentives. However, the mere maintenance of these tax incentives would create a wedge in the tax treatment between incumbent companies and new entrants and even among old facilities and new facilities from existing companies, since the new ones would not have the tax incentives that the old ones enjoy. This issue will have to be dealt by CONFAZ since it has a potential to halt economic growth in the near future. A possible solution discussed at CONFAZ would be to allow new entrants to receive the same tax incentives as incumbents during the same period of time.
68. The FPE and royalties reforms underway do not envisage a major overhaul of the intergovernmental transfers’ framework scheme. Key issues left unaddressed thus include the framework’s fragmentation, its excessive devolving characteristic and insufficient transparency, as pointed out by Ter-Minassian, (2012). The economic literature on this theme seems to lean towards the position that equalizing transfers, either by fiscal capacity or expenditure needs, are preferable than devolving or simple parametric rules60, 61. Ter-Minassian (2012) also showed that a distribution formula based on actual revenues would be more equalizing than the proposed parametric ones. Nonetheless, there is some consensus in the literature on Brazil in that the informational requirements needed for such transfers to work are not met presently. Thus, it
59 For instance, in order to obtain tax credit for the energy used in its factory plants, a company has to hire an independent engineer to produce a technical report quantifying the share of the energy consumed by the company in its industrialization process. 60 See Shah A. (2006). “A Practicioner’s Guide to Intergovernmental Fiscal Transfers”. Policy Research Working Paper 4039, World Bank, Washington, DC.; and Wilson L.S, (2007). “Macro Formulas for Equalization”, In Intergovernmental Fiscal Transfers: Principles and Practice, edited by Robin Boadway and Anwar Shah, chapter 8. Washington, DC: World Bank 61 Equalizing transfers aim at reducing the disparity between jurisdictions in the amount of available resources to fund public services, in which case they are named as fiscal capacity equalization or in bridging the gap between the available resources and the expenditures needs of each jurisdiction. Devolving transfers simply channels the resources to the jurisdiction in which they were collected, in this sense they reinforce the inequality between jurisdictions. Lastly, the division of transfers between jurisdictions can be made based on revenues and expenditures calculations or based in parameters, thus called parametric formula, such as population and income.
31
would seem wise to put in place a plan to generate the information needed for calculate and implement these equalization transfers in the future.
69. The current subnational debt and fiscal framework was pivotal in the reduction of the subnational indebtedness, helping the country to produce positive primary balances and supporting macroeconomic stabilization. Moreover, it proved to be flexible enough to accommodate an increase in the amount of debt contracted by subnational governments in response to its sounder fiscal situation and the need to boost growth by addressing the infrastructure gaps in Brazil.
70. However, a broader approach to subnational debt reform would have helped secure resources to finance investment while safeguarding fiscal and debt sustainability. This is particularly relevant in light of the increase in subnational demand for loans vis-à-vis the limited resources from multilateral lenders and the increased exposure to public sector borrowers in the public banks. Such reforms would not have required major changes in laws, but mainly in resolutions and decrees as well as increasing transparency and some capacity building at the subnational level coordinated by the Federal Government.
IV. The Expected Fiscal Impact of Alternative Reform Scenarios62 A. Results and discussion of simulations of changes to intergovernmental
transfers
71. This section presents the results of the simulation of the changes being promoted at the intergovernmental transfers in Brazil, namely FPE, royalties and CFEM63. The simulations were carried out for an eight year period since they tend to be implemented in a gradual pace and as such major changes are not expected from one year to another. Regarding the uncertainty of the changes, since most of them are still under discussion, we opt to simulate the changes with the highest likelihood of being effected at the moment in which this report was being produced. In addition, depending on the transfer more than one possibility was simulated and will be presented. The simulations then are consolidated to obtain a net result of the changes being promoted. Lastly, some scenarios are constructed for this final net result based on different reform assumptions.
72. The first result from the reform simulations to be presented is on FPE. Although the FPE reform has been concluded, we opted to maintain two simulations and consolidate them with the other concurrent changes in the subnational fiscal framework in order to assess a different approach to FPE reforms. The first one reflects the proposal approved in Congress, and recently converted into law (Lei Complementar 143/2013). The second proposal is a revenue equalization one proposed by (Mendes, 2011). Both proposals are also compared against the baseline case which is the fixed FPE coefficients in place today. In addition, a third proposal laid
62 The scenarios discussed in this section focus on the static distribution of gains and losses and, as a result, do not provide an estimate of secondary effects from the simulated changes (e.g., on how they could affect incentives or behavior of economic agents). 63 Royalties are grouped here under the transfers group, for a mere analytical purpose following the lines of (Ter-Minassian, 2012). It should not be seen as an endorsement to any specific revenue classification of the royalties.
32
out in Ter-Minassian (2012c) was also simulated, but was not consolidated with the other changes.
73. The reform approved in Congress maintains the current FPE shares until 2015 and gradually introduces some parametric formulas starting in 2016. The parametric formula will, however, be applied only to the amount of the FPE exceeding the previous year amount in real terms, plus 75 percent of GDP growth. Therefore, in the long run, the FPE coefficients will converge to the ones dictated by the parametric formula, which takes into account population and per capita household income64. However, the convergence will be very slow. It is estimated that the full convergence would take between 300 and 400 years, depending on the scenario adopted. The approved version differs from previous ones, since it envisages a slower transition, and more rigid upper and lower bounds on the components of the formula to benefit less populated and low income states. In addition, the approved law does not call for a new rule after 2018.
74. The new coefficients set by the parametric formula, after the transition is completed, will spread the loss among more states and in a more equal manner, while the gain is concentrated in fewer states. That is there are no big losers among loosing states, but there are some states that stand out between the winners. This can be seen by looking at the descriptive statistics. The number of states that will have their coefficient reduced is 15, while 12 states will have their share increased. Among the losing states, the average loss represents a reduction of 10.5 percent in their coefficient, with a standard deviation of 0.06. The same figures for the winning states show an average gain of 22.7 percent in their coefficient and a standard deviation of 0.36.
75. The largest increase in absolute terms would be in the State of Amazonas, while São Paulo would have the largest increase in relative terms. Amazonas share will go from 2.79% to 4.25% - a 52.5 percent increase in relative terms. The state of São Paulo, would show a 67 percent increase, going from a 1% coefficient to 1.67%. On the losing side, Bahia would be the state with the largest reduction in absolute terms – reduction of 0.98 percentage points, going from 9.40% to 8.42%. The largest reduction in proportional terms would be the state of Roraima (25.7 percent), which will see its share be reduced from 2.48% to 1.84%.
76. The changes, however, would not be very drastic, because the transition rule put in place is extremely gradual. For example, in 2020 the state that would have lost the most – Bahia - will have seen its FPE share reduced by 0.14 percentage points, i.e. its FPE share would have been reduced from 9.40% to 9.25%. On the other hand, the state that would have gained the most – Amazonas – will see its share goes from 2.79% to 3.01%. That’s to say that in 5 years less than 15 percent of the convergence would have been made. This helps to explain why states and legislators have agreed to this proposal.
77. The impact of the changes also depends on the relevance of FPE to the state’s total revenues. That is to say the impact of the change will be bigger the larger is the proportion of FPE in the state’s revenues, all other things equal. Thus, São Paulo which is the largest gainer in relative terms would have seen its Net Real Revenue increase by a mere 0.1% due to the change 64 The introduction of the per capita household income instead of the more traditional GDP per capita criteria does not change much the ranking among states. The biggest change is felt by Amazonas which displays the 10th largest GDP per capita, but ranks only in 19th place in terms of per capita household income.
33
in FPE in 2020. On the other hand, Roraima would have seen its NRR decrease by 3.1 percent in 2020. Table 2 shows the estimated impact in terms of NRR for each state in 2020 under the two proposals.
78. In regional terms, the Senate proposal would not represent a major change even after the transition is completed. Currently, 85 percent of the FPE must be transferred to states in the North, Northeast and Center-West. This share will be reduced slightly to 82.9 percent. The Southeast region is the only one that will see its share increased overall, going from 8.48 percent to 10.78 percent of total resources.
79. The second exercise simulated a revenue equalization mechanism. In this exercise, a parametric formula proposed by Mendes (2011) that takes into consideration the per capita Net Current Revenues (NCR) excluding FPE revenues is employed. Since it is an equalizing mechanism, states share would be defined based on the inverse of their per capita NCR. In 2012, the state with the highest per capita NCR was the Federal District with R$ 5,065.21 and the lowest per capita NCR was registered in the state of Maranhão – R$ 677.72. It is important to note that since this is not an absolute equalization, every state, would receive some transfer.
80. The revenue equalization proposal would yield more gainers than losers. In addition, the average gain and the average loss would be higher than in the first proposal, evidencing a greater change to the current coefficients in the equalizing proposal. For example, Bahia and Pernambuco, the major losers would have their FPE coefficient reduced by 45.3 and 37.7 percent respectively. On the other hand, the main winners in absolute terms would be Alagoas (from 4.16% to 7.07%) and Piauí (from 4.31% to 5.98%). However, the largest gains in relative terms would accrue to São Paulo and Santa Catarina, whose coefficients would grow 100 and 95.3 percent respectively. Once again, since these two states are not heavily reliant on FPE the change would represent an increase of 0.7 and 6.3 percent in their NRR. The biggest increase in overall revenues would occur in Alagoas (38.9 percent).
81. Regionally, an increase is seen in the share of FPE in the South, Southeast and Center-West regions and a decline in the other two. Overall, the three poorest regions would receive 82.8 percent of the FPE instead of the 85 they receive today as mandated by law. Interestingly also is to see that the interests within regions are not aligned. For example, the Northeast has at the same time the two states with the largest losses and gains. That means that opposed to conventional wisdom, if this proposal would be taken to a vote northeastern states would not tend to vote together.
82. The third simulation is also focused on a revenue equalization model. It was proposed by (Ter-Minassian, 2013c) and instead of the NCR, it takes the per capita NRR, excluding the FPE revenues as well. This proposal takes as a reference value 105 percent of the per capita NRR of the Federal District, the higher in the country. It then distributes 2/3 of FPE according to the maximum redistribution criteria and 1/3 according to the maximum coverage criteria. It also foresees a transition mechanism in which the nominal value of last year FPE is guaranteed to all states. The main winners of such approach, after the transition is completed, would be the states of Bahia, Ceará and Maranhão, while the biggest losers would be Tocantins and Sergipe.
34
Table 2 – FPE current proposed coefficients65 and impact of changes
83. Simulating royalties payments is more difficult than FPE. Firstly because the rules are being questioned at the highest court. Therefore, we opted to simulate only the rule embodied in Law 12.734/12. We take as the baseline the royalties’ distribution set by the previous oil law (Law 9.790/97) ,
65 The coefficients presented under the Law 143 row are the ones that will prevail after the transition rule.
35
84. In addition, forecasting the oil royalties values is a complex exercise due to the variables involved. A detailed projection needs inputs not only on oil production, oil price and exchange rate, but also on the distribution of this production by oil field and state, location (onshore or offshore), production distribution between oil and gas and the oil price for each oil well, which depends on their API (American Petroleum Institute) degree. Thus, as a first approximation the simulations show the results of the new legal regime holding constant all of these variables and assuming oil production to grow in line with government plans and GDP growth, inflation and exchange rate to grow according to Bank projections.
85. The new royalties sharing rule, set forth by Law 12.734/12, if maintained, will generate a major redistribution of these resources in favor of non-producing states and municipalities. Currently, producing states and municipalities receive respectively 26.3 percent and 35 percent of the royalties66. In addition, states and municipalities receive 40 and 10 percent of the special participation fee, which is an additional form of government take that is charged only over high production and high profit oil wells. Non-producing states and municipalities receive only 8.8 percent of the royalties, in the so-called special fund divided according to the FPE and FPM rules, and no revenue from the special participation fee.
86. In the oil-sharing regime, there will be no special participation fee, but the royalties rate was increased from 10 percent to 15 percent of the gross oil revenue. The share of non-producing states and municipalities was augmented to 49 percent, while producing states share was reduced to 22 percent and the municipalities to 7 percent. In addition, the new law also changed the royalties’ distribution rules for existing and new oil fields in the concession regime, favoring once again non-producing states and municipalities, which share will increase to 54 percent in royalties and 30 percent in the special participation fee. The criteria to distribute the resources among non-producing states and municipalities remained the FPE and FPM, which reinforces the effect of the changes in the FPE.
87. Two other significant changes were introduced. The first one determines that subnational governments cannot receive royalties both as producer and from the special fund, having to choose between these two alternatives. If the state gives up its share as producer, the amount is redistributed to all states receiving royalties from the special fund. If the state retains its producer quota, the renounced special fund share is redistributed to all states, except the renouncing state. This rule not only turns the decision into a dynamic wherein one state decision affects other states decisions, but also makes forecasting rather problematic. The second change applies only to municipalities and determines that the total government take received by a municipality cannot exceed twice the value of the FPM.
88. The application of the new royalties distribution rules is currently suspended. Due to the major loss inflicted to the producing states and municipalities not only on the prospective oil fields, but also on the producing ones, three states filed injunction claims at the Supreme Court against the changes. The court has not decided on the merit of the changes, but has suspended its effect due to the devastating effects it would cause in some subnational government’s finances. Therefore, the prevailing rules for royalties and special participation fee are still the ones from
66 The shares differ between the first and the second half of the royalties rate. Thus, the number presented is the average.
36
the original law (Law 9.478/97). The Federal Government has tried to change the royalties sharing rules for oil exploration contracts signed after December 3rd, 2012 through the Executive Order – MP 592/2012, but this MP expired on May, 12th 2013.
89. Despite the uncertainty regarding the new rules, the losers and winners from this possible change are clear. The major losers would be the two largest oil producing states in Brazil, namely Rio de Janeiro and Espírito Santo. These two states accounted in 2012 for 89.4 percent of oil production in Brazil. Rio de Janeiro, the largest producer, would lose in 2020 revenues worth of R$ 12.3 billion or 18.8 percent of its NRR, with little variation in both scenarios. By the same token, Espírito Santo would suffer a loss of R$ 2.2 billion, which is equivalent to 11.5 percent of NRR, again with little difference between scenarios 1 and 267. Only two other states would lose resources: Amazonas and Rio Grande do Norte. However, their loss would be small. The first one would lose 1.1 and 1.7 percent of its NRR in scenario 1 and scenario 2 respectively, while the second state would face a loss only under scenario 1 and of small magnitude – 1.7 percent of NRR.
90. The major winners on the royalties redistribution are small and less developed states such as Acre, Amapá and Roraima. Acre would see an increase of revenue of 12.5 percent of NRR under scenario 1 and 15.9 percent of NRR under scenario 2. Amapá’s revenues would increase by 15 and 10.7 percent of NRR under scenarios 1 and 2 respectively and the same figures for Roraima would be 9.8 and 16.4 percent. These states share some characteristics that have benefitted them in the policy change scenario. They currently do not produce any oil or gas, they have low GDP and household income per capita and as such they are being benefited by the FPE change as well.
91. The other producing states such as Bahia, Ceará, Sergipe and São Paulo would not incur losses. These would happen due to their small oil production and by the fact that they have a large FPE coefficient. São Paulo is a sui generis case. In the portrayed scenario, it would benefit from the changes because its current production is very low and also due to the projected increase in its FPE quota in both scenarios, despite its absolute small value. However, the state of São Paulo is probably the subnational jurisdiction with the highest perspective of oil production increase since a large share of the new discoveries was found in its territory. Lastly, there are few differences between scenario 1 and 2, since the only change is in the mechanism to devise the FPE quotas.
67 Please refer to Table 3 for explanation on the differences between scenario 1 and 2.
37
Figure 10 – Estimated royalties revenues losses by state in 2020 (% of NRR)
92. The last change in transfers under analysis is the change in mining royalties (CFEM). The draft law submitted to Congress will change not only the CFEM rate, but will replace the whole legal framework governing mining exploration in Brazil. For instance, mining rights will be auctioned and only companies will be able to participate. The winning company will have to commit to minimum investment amounts and the new regulatory framework will be enforced by a regulatory agency to be created. The CFEM maximum rate was set at 4 percent, however the specific rate for each mineral will be set by the Executive power by decree. Lastly, the CFEM base was changed from net to gross revenues. The revenue sharing rules was kept unchanged, however nothing forbids the Congress to try to change these rules as it was done with the oil royalties.
93. Once again, simulating the effect of the changes on the CFEM revenues is an uncertain exercise. The uncertainty is reinforced by the fact that the new tax rates were not disclosed and can be changed easily in the future due to the fact that an Executive Power decree does not require legislative approval. In order to forecast the revenues from CFEM, it was assumed that mining production will grow in line with government plans and that the average effective tax rate will double due to a combined effect of higher tax rates and the change in the base from net revenues to gross revenues.
94. Due to the small aggregate collection of the mining royalties, only the two major mining states would be relevantly affected by changes in CFEM. Minas Gerais would see an increase of R$ 392 million in 2014 up to R$ 536 million in 2020, while Pará would see an increase ranging from R$ 379 million to R$ 510 million in the same period. By 2020, these gains would represent an increase of 0.8 percent of NRR in Minas Gerais and 2.4 percent in Pará.
38
B. Results and discussion of simulations of changes to ICMS regime
95. This section presents the simulations for the changes in ICMS under two scenarios. The first is the final government proposal as submitted to Congress and the second is based on the latest version approved by the Senate Committee, which kept the interstate rate differential between Brazilian states and created some exceptions to the general rule. Additionally, the effect of the change in ICMS on distance sales transactions (e-commerce, catalogue sales, etc) is not included in the simulations for both scenarios.
96. The methodology for the simulation exercises uses the electronic fiscal invoice database as a starting point. The database is supplemented with data on transport services, rural production and administrative supplies68 purchases provided by each state. The database was checked for consistency by the states and distorting figures were eliminated resulting in a more refined database than the one used by Khair (2011). In addition, the database is also more recent since the aforementioned work used data from June, 2010 to May, 2011, while this study draws upon invoices from the year 2011.
97. Despite the advantages of having a national and refined database, the methodology has some limitations imposed by the data69. First of all, it does not capture the changes in ICMS revenues brought about the Senate Resolution that unified the interstate tax rate on imported goods, since it became effective only in 201370. Therefore, it does not reflect so accurately the current scenario. Secondly, it does not distinguish taxes that were effectively collected from those that were just registered and not paid due to fiscal war benefits. This occurs because most of these benefits are given not as a reduction in the tax rate, but as a presumed tax credit. This is paramount since it tends to overestimate the loss of the most active states in the fiscal war. It is also important since under the government proposal these losses would not be compensated. Additionally, it is not possible to differentiate the origin of the goods traded in the case of the Manaus Free Zone and other Free Trade Areas, as well as trade in natural gas. Therefore some simplifying assumptions had to be made in order to simulate the exceptions foreseen in the proposals. For example, all goods originating from Amazonas are supposed to come from the Manaus Free Zone and the trade on natural gas was simulated through a tax rate reduction. This last assumption tends to overestimate the loss to the state of Mato Grosso do Sul (MS) since the pipeline through which natural gas is imported from Bolivia enters Brazil via MS. Another important caveat is that the ICMS reform is not a zero-sum game, i.e. the amount of losses not necessarily equals the amount of the gains since not all tax debts in one jurisdiction translates into credits in another jurisdiction. Additional distortions may also arise from the complementary data provided by the states on transport services, agricultural production and administrative supplies purchases. Lastly, the estimates are done based on the interstate trade structure prevailing in 2011. Thus an implied assumption is that this structure will not be changed until 2020. The values obtained were adjusted according to the expected inflation and GDP growth, assuming tax elasticity equal to 1, since they were in 2011 values.
68 “material de uso e consumo” 69 The Ministry of Finance has signaled that for the 2012 database some improvements will be made, which will mitigate, at least partially the limitation in the current database. 70 For instance, the Rio de Janeiro Secretariat of Finance reported an increase of 38 percent on the value of the goods imported through its ports in the first two months of 2013.
39
98. In the first scenario71, the aggregate loss due to the unification of the interstate tax rate amounts to R$ 5 billion in the first year, growing up to R$ 22.7 billion after the transition is complete. 19 states would win ICMS revenues, while eight would lose revenues. The average gain in 2020 would be equal to 4 percent of NRR, while the average loss would be 10.4 percent of the NRR, evidencing the concentration of the losses. It is important to note that this is a static exercise and thus not take into account dynamic gains that would accrue from tax evasion schemes (backed by fiscal war incentives) that would be no longer profitable in this new scenario. Thus, states most affected by the fiscal war, usually the most developed ones, would probably have larger benefits than the ones estimated here.
99. The main losers as expected would be the net exporting states. São Paulo would have a loss of 2.6 percent of NRR in 2014, increasing to a loss of 4.5 percent in 2020. It also would show the largest loss in absolute terms: R$ 8.3 billion, accounting for 37 percent of the total loss in 2020. However, some states that have developed its industrial sector, largely to tax benefits granted in the 1980s and 1990s, that have become net exporters in recent years such as Bahia and Góias would also lose revenues. The first state would lose 2.3 percent of its NRR, while the second one would lose 13.8 of NRR. Lastly, the states of Santa Catarina, Mato Grosso do Sul and Espírito Santo, which appears as the main losers, with losses of 15, 20.6 and 21 percent of NRR, have their losses overestimated due to the limitations of the methodology explained above. Therefore, even though they are losers due to the proposed ICMS changes, it is hard to sustain that they would be the major losers.
100. On the winning side, there are the less developed and net importers states such as Maranhão, Rio Grande do Norte and Piauí. These three states would enjoy a revenue gain worth of 8.3, 8 and 7.3 percent of their NRR in 2020. They do not have relevant industrial production, especially sold outside their boundaries and most of the goods consumed come from factories outside the state. For example, if a good was made in São Paulo and sold in Maranhão, the latter would collect a tax rate of 11 percent, considering a total rate of 18 percent and now will collect a tax rate of 14 percent. The gain would be even larger if the good was made in Bahia, since Maranhão used to collect 6 percent and will collect 14 percent after the transition.
101. The revenue gains however would not be restricted to less developed states, as Minas Gerais and Rio de Janeiro are among the main winners. These two states would enjoy revenue gains equivalent to 5.6 and 10.4 percent of NRR in 2020. Although these states show levels of high development within Brazil, their production is concentrated in items of which revenues accrue to the destination state (energy) or are tax exempt such as exports, thus explaining their net importer status.
102. In terms of regional distribution, losers are concentrated among the emerging states which have a higher interstate tax rate. In fact, the only state with a relevant loss that is from an advanced region and thus receives less ICMS in the distribution is Santa Catarina. This finding is very important since the initial tax reforms discussion in the 1990s always framed the advanced states as the main losers and thus the major hindrances for the reform. However, almost two decades after the beginning of the tax reform discussion the current numbers are
71 The reform simulated in the first scenario is the one submitted by the government to Congress as discussed before (see paragraph 40).
40
showing that the economic geography of Brazil has changed and that the initial reform losers are now winners and that the main losers are now the states that have initiated the fiscal war in the 1980s and 1990s. Once again as in the case of FPE, a clear cut division between regions cannot be made since there are losers and gainers almost within every region.
103. The losses incurred in the second scenario72 are smaller than in the first one. The total losses in 2014 would amount to R$ 2.7 billion escalating up to R$ 20.8 billion in 2020. The number of losing states would also be reduced to 7 and consequently the number of states gaining from the reform would be 20. Pernambuco would be the only state changing from a losing position in scenario 1 (- 0.3 percent of NRR) to a winning position (+ 0.3 percent of NRR). The beneficiaries states would be again Rio de Janeiro, Maranhão and Rio Grande do Norte, while the losing states would remain to be Santa Catarina, Espírito Santo and Mato Grosso do Sul. In fact, the winning and losing states are roughly the same with a few differences in positions.
104. The smaller losses in the second scenario are explained by the maintenance of the interstate rate differential and the inclusion of new exceptions. The difference in 2020 between the two proposals is not large. The main change is with Santa Catarina, whose loss would be reduced by 1.8 percentage points of NRR in the second scenario. This small difference however is misleading since in 2020 the transition in the interstate tax rates would not be completed in both scenarios. By 2020, in scenario 2 there are three more steps to be fulfilled in the transition trajectory while in scenario 1 there is only one. After the transition is completed the larger size of the loss under the first scenario becomes clearer. For example, the loss of the state of Góias is reduced from 25.9 percent of ICMS revenues to 14 percent.
Figure 11 – Impact of ICMS reform under scenario 1 in 2020 (as a % of NRR)
Figure 12 – Impact of ICMS reform under scenario 2 in 2020 (as a % of NRR)
105. Concerning the change in taxation of goods sold through distance sales, six states would lose revenues. The main losers would be Amazonas and Santa Catarina, while in São Paulo gains and losses would even out73. The methodology pitfalls however seems to be at its highest in this simulation. First of all, the database does not differentiate the distance sales 72 The reform simulated in the second scenario is the one embodied in the proposal approved in the first committee of the Senate and is explained in paragraph 59. 73 The states of São Paulo and Rio Grande do Sul have informally acknowledged that according to their internal estimate they would loose revenues.
41
transactions within the transactions to non ICMS taxpayers. Secondly, it does not take into account the ICMS paid through Substituição Tributária in distance sales transaction. This not only reduces the amount of the ICMS revenues that should be redistributed, but also impacts the estimation of the outgoing effective ICMS tax rate which lowers the estimated loss and consequently increases the gains for the whole exercise. Therefore, it was decided not to incorporate such estimation in the consolidation of the intergovernmental finance reforms.
C. Results and discussion of simulations of changes to subnational borrowing framework
106. Regarding debt payments, again two scenarios were simulated. The first one reflects the federal government proposal which is a simple reduction in interest rates to 4 percent and the change in the indexator from IGP-DI to IPCA. As a simplifying hypothesis, it was assumed that IPCA + 4 percent is at least as advantageous as SELIC. The second scenario simulates the changes proposed by the House representative in charge of appraising the Government’s proposal. This proposal not only reduces the interest rate to 4 percent and changes the indexator to IPCA, but also gives a 40 percent discount in the amount of the debt owed and extends the maturity of the outstanding debt to 25 years.
107. The debt simulation incorporated some simplifying assumptions. To start with, only the renegotiated debt under Law 9.496/97 was simulated74. Thus, the reader must be aware that the current debt and debt service are higher. However, in most states this debt represents more than 90 percent of the states’ debt stock. The debt simulation was carried out on annual basis, not on monthly payments as in the original contract. All payments were assumed to have started in 1998, which would leave 15 years until maturity. Revenues are assumed to grow in tandem with inflation and GDP growth. Lastly, IGP-DI variation was assumed to be equal to IPCA.
108. As opposed to the changes in the FPE and ICMS, the proposed changes in the debt will benefit all states but Piauí and Tocantins. The first one has already paid out all its renegotiated debt with the Federal Government, while the second one did not have any debt renegotiated since it had been founded in 1988. This happens because on the debt the redistribution is between federal and subnational level whereas in the former the redistribution occurs between state governments. However, for some states, under scenario 1, the reduction in the interest will represent an immediate relief in their cash flow while for others the gain will be in the long run debt sustainability, since they will still pay a debt service that is lower than the actual installment due to the debt service cap foreseen in the debt renegotiation contract. That is to say that the states that have a debt residual, accumulated due to the rule that caps the debt service to a percentage of the NRR will not experience a relief in their cash flow in the short term. Four states – Minas Gerais, Rio de Janeiro, Rio Grande do Sul and São Paulo – are in this situation. Thus, for these states the reduction in interest rate would translate in accelerated amortization and smaller residuals at the end of the contract. In addition, states with larger debt amounts would have a greater benefit in absolute terms. Lastly, three states – Alagoas, Pará and Minas Gerais – have debt tranches with interest rates at 7.5 percent, thus the proposed reduction
74 Information was obtained from the credit operation cadastre form sent by all states to STN regarding the 2012 data.
42
would almost halve their interest bill. Under scenario 2, all states would have not only a debt sustainability improvement, but also a short term cash flow relief.
109. The interest rate reduction from 6 to 4 percent would save R$ 8.1 billion over the 2013-2020 period for the states under scenario 1. In absolute terms, the main saving would be at the state of Rio de Janeiro with R$ 1.3 billion. According to the simulations, São Paulo, Minas Gerais and Rio Grande do Sul would still generate residual throughout the whole simulation period and would thus not reap any budget saving in the study horizon. On the other hand, Alagoas75 would start having cash flows gains already in 2013 with the change while Rio de Janeiro would face the same situation in 2018.
110. The reduced interest rates and the extended maturity would allow the states to save R$ 182.8 billion over the 2013-2020 period under scenario 2. Saving in year one would vary from 0.2 percent of NRR in the state of Amapá to 8 percent of NRR in the state of Alagoas. The main beneficiaries would be the states with the largest debt in proportional terms which would see their debt service reduced, while still accruing gains on the sustainability front as well. For example, the state of São Paulo in the baseline as well as in the first scenario would have to pay the debt service by the cap: 13 percent of NRR, however under scenario 2 the debt service would almost halve to 6.9 percent of NRR already in 2013.
111. Debt sustainability at the state level would be improved under both proposals, however federal government balance sheet would worsen considerably in the second scenario. Figure 14 shows that despite not reaping any budget gain until 2020, highly indebted states such as São Paulo and Rio Grande do Sul would see a reduction in their debt-to-revenues ratio under scenario 1. The improvement in debt sustainability under scenario 2 is more remarkable as expected. For some states it would represent almost a 50 percent cut in their debt-to-revenues ratio.
Figure 13 – Debt service payments reduction in 2020 (as % of NRR)
Figure 14 – Debt Stock in 2020 in highly indebted states (as % of NRR)
75 The simulation for Alagoas was done under the assumption that the state pays interest rate of 7.5% and committed 15% of its NRR. However, due to an injunction from the Supreme Court, the interest rate was reduced to 6% and the commitment to 11.5%. In this case, Alagoas savings would be reduced from R$ 968.9 million in the first scenario to R$ 657. 4 million, and from R$ 4,239.2 million to R$ 3,927.7 million in the second scenario for the whole period.
43
D. The net result: Potential gainers and losers
112. In order to consolidate all changes in the subnational fiscal framework, two aggregate scenarios were put together in addition to the baseline case (see Table 3). In the first aggregate scenario, which is the most likely one, FPE is redistributed according to the proposal approved by Congress. Royalties are distributed according to the new law, thus also following the new FPE coefficients. The ICMS reform simulated is the original government proposal. In the second aggregate scenario, FPE is distributed in accordance with the revenue equalization proposal by Mendes (2011) without transition and so are the royalties. Finally, ICMS reform takes the shape of the last version approved in Senate which is still provisional. In addition, both scenarios share the same hypothesis for the mining royalties – doubling the tax rate. Lastly, for the debt which the first scenario assumes an interest rate reduction to 4 percent and the change of index to IPCA. The second scenario reflects the interim proposal by the lower chamber of Congress, which includes a discount of 40 percent in the debt stock and a maturity extension of 10 years. The baseline scenario reflects the situation before any reform was implemented.
Table 3 – Outline of the Reform Scenarios
113. A few assumptions had to be made in order to project all scenarios until 2020. Revenues were assumed to grow in line with GDP and inflation. These projections were obtained from the April 2013 World Economic Outlook (WEO). Federal Government projections for oil and mining royalties were used as well as exchange rate projection also from WEO was inputted to calculate royalties revenues. The transfers and debt simulations was carried out by the authors of this paper and its background papers resorting to public sources, while the ICMS simulations due to its complexities were obtained directly from CONFAZ. Lastly, the results are presented in net terms, which means that revenues were summed up and debt payments were subtracted from that amount. Thus, reductions in debt payments are reflected in larger available revenues.
44
114. Looking first only at the consolidated results from the changes in transfers a couple interest conclusions emerge. The first one is that under scenario 1, the net result, specially the losses, are dominated by the results in royalties. Thus, Rio de Janeiro and Espírito Santo are the main losers, despite the gains obtained with the changes in FPE and CFEM. For example, Rio would have a loss of 18.8 percent of NRR in 2020 from royalties, only partially compensated by the 0.2 percent gain in FPE, resulting in a total loss of 18.6 percent of NRR.
115. Rio Grande do Norte is an interesting case. It is a net loser under scenario 1 since it would lose revenue in both FPE reform (-0.4 percent of NRR) and in royalties (-1.7 percent of NRR) since it is an oil producing state. However, its total losses would amount to 2.1 percent of NRR in 2020, which is far from being unmanageable. Under scenario 2, however Rio Grande do Norte turns from a net loser to a net gainer, adding to a total gain of 0,6 percent of NRR in 2020.
116. Under scenario 1, all other states profit from the changes. In this case, eventual losses in FPE are compensated by gains on royalties and vice-versa. This is the case of Bahia and Amazonas. The first one losses 0.5 percent of NRR in 2020 due to the changes in FPE, but gains 2.3 percent of NRR from the royalties reform, The second state faces an opposite situation, in which it losses 1.1 percent of NRR since it is an oil producing state, but gains 1.6 percent of NRR due to the FPE reform.
117. Under scenario 2, not all losses from FPE changes can be compensated by gains in royalties. This happens due to the fact that in this scenario there are no transition rule in the FPE change, In addition, the revenue equalization proposal promotes bigger changes in the coefficients than the approved proposal by Congress, even after transition ends. This is the case for instance of Pernambuco, which would lose 13 percent of NRR from change in FPE and would gain only 5.3 percent of NRR from the royalties reform, ending up with a loss of 7.7 percent of NRR in 2020.
118. In scenario 1, the losses are dominated by the changes in oil royalties and ICMS reform. Thus, the main loser in relative terms would be the state of Espírito Santo, which loses revenues in both royalties and ICMS. In numerical terms, Espírito Santo loses 10.9 percent of NRR due to the transfers’ reform and 21 percent of NRR because of ICMS. The savings from the reduced interest rate on debt would only represent a gain of 0.1 percent of NRR The state loss is attributable to the change in oil royalties distribution since the state is the second largest oil producer in Brazil but also to the change in ICMS, which in some years is more severe than the revenue loss caused by the change in royalties distribution. In addition, the state is facing another loss which was not accounted here which is the unification of the interstate tax rate for imported goods implemented in 2013. The usual caveat of overestimating the ICMS loss also applies here, which may set the actual loss to be lesser than the forecast, however due to the magnitude of the loss and the small gains obtained with FPE as well as with the debt leave the state in a worse-off situation. On the other hand, Rio de Janeiro losses from transfers (-18.6 percent of NRR) is strongly attenuated by a large gain in ICMS (10.4 percent of NRR) and debt payments (1.2 percent of NRR).
119. There is a second cohort of states, whose results are determined by the loss suffered in the ICMS reform. This group is comprised of Santa Catarina, Góias and Mato Grosso do Sul. This last state as an example, would see its transfers gains of 2.2 percent of NRR wiped out by a
45
loss of 20.6 percent of NRR in the ICMS reform. Once again, due to the limitations in the methodology the uncertainty regarding the amount of their loss is bigger than for the other states. Lastly, Santa Catarina is facing a concurrent loss from the reduction in interstate tax rate on imported goods, to end the so-called Ports war, that it is not being taken into account here. .
120. In the case of São Paulo the driver of the loss is the ICMS reform. Even though in relative terms the state would deal with an overall loss of only around 4.4 percent of its NRR (the sole loss caused by the ICMS would be 4.5 percent of NRR), it would face the largest loss – R$ 8 billion in 2020 – in absolute terms due to the size of its ICMS revenues.
121. The main winners are non-oil producing small, less developed states with a moderate debt level. This is the case of Alagoas. Amapá, Maranhão and Piauí. These four states presented not only the largest gains, but were benefitted by all changes promoted. For example, Amapá would see its transfers augmented by 16.6 percent of NRR in 2020 and its ICMS revenues increased by 2.4 percent. The change in debt rules would represent a gain of less than 0.1 percent due to its low debt level. Alagoas however would reap a 1,5 percent of NRR gain on the debt, to sum up with gains of 11.8 and 3.6 percent of NRR in transfers and ICMS respectively, making up for a 17.1 percent of NRR overall gain in 2020.
122. The second scenario shows changes with higher magnitude and different set of winners and losers. For example, in the first scenario the main winners had gains of 19.3 percent of its NRR at most in 2020, while Alagoas would have increased its resources by 65 percent of its NRR in 2020 and Piauí would do so by 37 percent of NRR in the second scenario. These differences can be attributed to three factors. The first one is that in the second scenario the change in FPE coefficients is more marked and done without a transition rule. The second factor is the ICMS reform that by maintaining the interstate tax rate differential and other exception alleviated the loss for several states and reinforced the revenue position of small northeastern states which have become the main winner in this scenario. The third one is the debt, which is highlighted below.
123. Under scenario 2, there would be a major influence from the changes in debt in the overall net result. This is due to the major haircut, namely, the interest reduction and maturity extension that would be made in the renegotiated debt under this scenario. The best example of this influence is in the state of Rio de Janeiro. The state would accrue a gain of 8.2 percent of NRR, which together with the gains in the ICMS would counterbalance the losses arising from the transfers reforms (-17.4 percent of NRR), leaving the state in a net gainer position with 0.2 percent of NRR. The same would happen to São Paulo, which would see its ICMS loss more than compensated by the change in debt condition leaving the state better off with additional resources worth of 4.8 percent of NRR. Another great beneficiary would be Rio Grande Sul which would go from a bottom 19th position to a top 8th position in terms of net gains.
124. Despite some changes in ranking, the characteristics of the winners and losers are roughly the same under both scenarios. States with the largest gains continue to be small states with low development status, while losing states are the ones who suffer the largest loss on ICMS and royalties.
46
125. As it can be seen by the numbers and figures, the changes do not cancel out each other in the majority of states. That is the losses in one reform are not compensated by the gains in other reforms. Therefore, in order to avoid losses that could jeopardize fiscal sustainability at the subnational level an external source or funding, probably the Federal Government, must be used in order to soften the losses and make the reform viable. That said, a few changes in the reforms would increase the space for internal compensation and reduce the need for external resources. The royalties redistribution imposes considerable losses on the two largest oil producing states. A more balanced rule would help, especially since the slow transition rule of the FPE reduces the requirements of windfall gains from the royalties to compensate them. The proposed changes in the borrowing framework would not provide significant relief in the short term. However, further changes in the framework must take into account not only the existing fiscal responsibility framework but the moral hazard risk of easing conditions for worse performing states. Lastly, the ICMS estimates would still benefit from further refining the database and methodology since the major losers are states that rely heavily on tax incentives, thus impairing the accuracy of the simulated results.
Figure 15 – Net results in 2020 under both scenarios (as % of NRR)
47
Table 4 – Gains and losses in scenario 1 vis-à-vis baseline scenario in 2020
48
Table 5 - Gains and losses in scenario 2 vis-à-vis baseline scenario in 2020
V. Conclusions: Whither Brazil’s Subnational Fiscal Framework?
126. This report reviewed, assessed and simulated the impact on states of possible reforms to Brazil subnational fiscal framework. In so doing, it took into account the political constraints to major changes to the country’s current fiscal federalist structure, while at the same time highlighting the rationale for coordinated – if less ambitious and more pointed – reforms to the ICMS, intergovernmental transfers, and the subnational borrowing framework.
127. The jury is still out as to whether the window of opportunity for subnational fiscal reforms opened by the STF rulings has been missed. The unique chance of moving forward with coordinated, multi-front reforms opened up by the STF decisions on both the FPE and the
49
ICMS seems to be fading away with the stalling of key proposals in Congress. The realpolitik of subnational fiscal reforms – fueled by concerns about the spatial distribution of gains and losses from reforms – seems to have prevailed by now. However, it is still early to dismiss the possibility that an agreement is reached on these reforms, since the status quo is far from being satisfactory either. The discussion on net gainers and losers in this report indicate that the implementation of coordinated reforms can help allay concerns of damaging shifts in the spatial allocation of public resources.
128. Even under a policy of piecemeal reform attempts, a great deal of uncertainty remains with respect to the future of the ICMS reforms currently under discussion.76 Resistance to ICMS reforms reflect a conservative behavior on the part of state-level fiscal policymakers, given the uncertain fiscal impact of ICMS reforms (especially if taken in isolation), their mistrust of the Federal Government’s compensatory schemes, and their preference to increase fiscal space through renegotiation of subnational debts to the Federal Government, particularly among the more developed states. The impasse on ICMS reforms means inter alia that the incentives for the ongoing fiscal war would continue to be in place in the foreseeable future.
129. The proposed parametric changes to the FPE could have a greater chance of being enacted, since they do not fundamentally alter the existing “distributive equilibrium” among states. The redistributive shifts would be rather moderate under the Senate FPE proposal, because there would not be major changes to the coefficients applied to each state and the transition rule put in place is extremely gradual.77 The redistributive shift under the equalization proposals by Mendes (2011) and Ter-Minassian (2012) would be more significant, but there does not seem to be enough political appetite in the Government or Congress to pursue that avenue, even if it is cast within a more “gradualist” approach.
130. In the absence of coordinated reforms, intra-federative conflicts – as exemplified by the controversy over the royalties sharing rules – are likely to go on. The ongoing attempts at legislating reforms to the oil royalties sharing rules has pitted the oil producing states of Rio de Janeiro, São Paulo and Espírito Santo against the rest of the Federation in an intense, bitter political fight. The STF’s decision to put on hold the recently-passed and controversial royalties bill testifies to the intensity of this particular manifestation of Brazil’s intra-federative conflicts.
131. Pressures to “flexibilize” the subnational borrowing framework are on the rise, with a potential adverse impact on subnational fiscal discipline. In response to these pressures, subnational borrowing limits have been increasing even for highly indebted states such as Rio Grande do Sul, Minas Gerais, Rio de Janeiro, and São Paulo. In addition, as discussed, the political class has also sought changes in the terms of subnational debt. This has created doubt among some observers as to the consistency of these changes with the Fiscal Responsibility Law, which prohibits new subnational debt refinancing initiatives.78
76 According to Afonso (2013a), “the only certainty is that nobody has the slightest idea about what may happen to the ICMS”. 77 See Rocha (2013), background paper for this study. 78 In the understanding of the Federal Government, there is no inconsistency between such proposed changes and the Fiscal Responsibility Law. See Mora (2013), op. cit., background paper for this study.
50
132. Yet Brazil’s hard-fought subnational borrowing framework is and should remain an essential component of the fiscal “leg” of the country’s macroeconomic “tripod”.79 In fact, it is a cornerstone of the country’s economic stabilization process. An actual or perceived “flexibilization” could weaken subnational governments’ resolve to continue to operate under a hard budget constraint and could give rise to free riding and moral hazard concerns. In extracting the lessons from past experiences with national-government-led subnational debt restructuring, Canuto and Liu (2013) concluded that “[d]ebt restructuring plans must pay attention to their incentive effects. Rules-based debt restructuring reduces ad-hoc bargaining and adverse incentives; hard budget constraint prevents moral hazard; and burden sharing provides proper incentives and avoids free-riding behavior, while also recognizing the incentive role played by higher levels of government to leverage reform.”80 It is paramount that these lessons continue to guide the debate on Brazil’s subnational fiscal reform going forward.
133. Ultimately, even a policy of piecemeal reforms, although far from ideal, would probably be better than the current stalemate. Maintenance of the status quo has already proven to be highly counterproductive and with potentially deleterious impact on the country’s competitiveness and fiscal sustainability prospects.
79 The other two being the flexible exchange rate arrangement and the inflation targeting mechanism, both of which have also being subject to pressures over the past couple of years. 80 Canuto, O. and L. Liu (2013). “An Overview”. In Canuto and Liu (eds), Until Debt Do Us Part: Subnational Debt, Insolvency, and Markets. Washington, D.C.: World Bank, p. 13.
51
VI. References
Accioli, C. (2012). “How Should the State Participation Fund Be Shared?”, The Brazilian Economy, IBRE-FGV, May.
Afonso (2013a), background paper for this study.
Afonso, J.R. (2013b). Presentation made at the discussion Forum on “Toward Science of Delivery: Fiscal Federalism and Sub-Sovereign Finance”, Washington, D.C., World Bank, May 28, 2013
Arroyo, J.M., J.P. Jiménez, and C. Mussi (2012). “Revenue Sharing: The Case of Brazil’s ICMS”. Serie Macroeconomía del Desarollo, United Nations ECLAC, Economic Development Division, June, p. 12.
BRASIL (2012). Balanço do Setor Público Nacional. Brasília, DF. Ministério da Fazenda.
Canuto, O. and L. Liu (2010). “Subnational Debt Finance and the Global Financial Crisis”. Economic Premise, The World Bank, No. 13, May.
Canuto, O. and L. Liu (2013). “An Overview”. In Canuto and Liu (eds), Until Debt Do Us Part: Subnational Debt, Insolvency, and Markets. Washington, D.C.: World Bank, p. 13.
Corbacho, A.; V.F. Cibils; and E. Lora (eds). (2013). Recaudar no Basta. Los Impuestos como Instrumento de Desarrollo. Washington, D.C.: Inter-American Development Bank.
Friedmann, R. (2011). “O que é a Guerra Fiscal”, site “Brasil Economia e Governo” (www.brasil-economia-governo.org.br).
Giambiagi, F. and A.C. Além (2011). Finanças Públicas. Teoria e Prática no Brasil. Elsevier Editora, 4th edition.
Khair, A. (2011). Avaliação do Impacto de Mudança nas Alíquotas do ICMS nas Transações Interestaduais. Inter-American Development Bank Textos para Debate IDB-DP-212.
Manoel, A.; S. Garson, and M. Mora (2013). “Brazil: The Subnational Debt Restructuring of the 1990s – Origins, Conditions, and Results”. In Canuto, O. and L. Liu (eds.) Until Debt Do Us Part: Subnational Debt, Insolvency, and Markets. Washington, D.C.: World Bank.
Mendes, M. (2012a). “Por Que Renegociar a Dívida Estadual e Municipal?”. site “Brasil Economia e Governo” (www.brasil-economia-governo.org.br).
Mendes, M. (2012b). “Como Renegociar a Dívida Estadual e Municipal?”. site “Brasil Economia e Governo” (www.brasil-economia-governo.org.br).
52
Mendes, M., R.B. Miranda and F. B. Cosio (2008). “Transferências Intergovernamentais no Brasil: Diagnóstico e Proposta de Reforma. Consultoria Legislativa do Senado Federal, Textos para Discussão, No. 40, April.
Mora, M. (2002). “Federalismo e Dívida Estadual no Brasil”. Texto para Discussão 866, Instituto de Pesquisa Econômica Aplicada (IPEA), Brasília.
Mora, M. (2013), background paper prepared for this study.
Rezende, F. (1995). “Federalismo Fiscal no Brasil”. Revista de Economia Política, Vol. 15, No. 3 (59), July-September.
Rezende, F (2009). A Reforma Tributária e a Federação. Rio de Janeiro: Editora FGV.
Rezende (2012). “O ICMS: Gênese, mutações, atualidade e caminhos para recuperação”. Inter-American Development Bank Policy Brief IDB-DP-231.
Rocha, C.A.A. (2012). “Rateio do FPE: Avaliação de Impacto e de Viabilidade Legislativa das Novas Propostas”. Núcleo de Estudos e Pesquisas do Senado, Texto para Discussão No. 111, Março.
Rocha, F. (2013). Background paper for this study.
Shah A. (2006). “A Practicioner’s Guide to Intergovernmental Fiscal Transfers”. Policy Research Working Paper 4039, World Bank, Washington, DC.
Ter-Minassian, T. (2012a). “Reform Priorities for Subnational Revenues in Brazil”. Inter-American Development Bank Policy Brief IDB-PB-157.
Ter-Minassian, T. (2012b). “More than Revenue: Main Challenges for Taxation in Latin America and the Caribbean”. Inter-American Development Bank Policy Brief IDB-PB-175.
Ter-Minassian, T. (2012c). “Reforma do Fundo de Participação dos Estados (FPE)”. Inter-American Development Working Paper IDB-DP-216 .
Varsano, R. (1997). “A Guerra Fiscal do ICMS: Quem Ganha e Quem Perde”. Texto para Discussão No. 500, Instituto de Pesquisa Econômica Aplicada (IPEA).
Werneck, R. (2008). Tax Reforms in Brazil: An Evaluation at the Crossroads. Departamento de Economia PUC-Rio, Texto para Discussão 558.
Wilson L.S, (2007). “Macro Formulas for Equalization”, In Intergovernmental Fiscal Transfers: Principles and Practice, edited by Robin Boadway and Anwar Shah, chapter 8. Washington, DC: World Bank
53
World Bank [2008]. Brazil: Topics in Fiscal Federalism
