Itaú BBA - Brazilian states in crisis: diagnosis and solutions

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Brazilian states in crisis: diagnosis and solutions

December 16, 2016

The solution for the structural crisis is by controlling spending.

The financial crisis in the Brazilian states is structural and was caused by growing expenses, uncoordinated and badly planned tax breaks and institutional breakdown. Additionally, in 2012-2014, the federal government encouraged states with lower creditworthiness to take on more debt, intensifying the imbalance in state expenses, particularly on personnel. In our view, the solution for the states is to establish a spending cap similar to the one approved for the federal government. If the cap is fully implemented without exclusions, states would go back to posting sustainable primary surpluses within five years. For the more critical cases, such as Rio de Janeiro, Rio Grande do Sul and Minas Gerais, additional adjustment measures are needed, as proposed by Brasília in the Fiscal Recovery Regime, in order to reduce short-term cash problems and their increasing debt levels in the medium term, while the spending cap gradually solves the fiscal imbalance.

The crisis in the states is structural. Since 2000, the states’ primary expenditure expanded 5% in real terms, on average. In only three of the past 15 years has spending fallen in real terms. This path was enabled by fast growth in tax revenues, led by robust economic expansion, high commodity prices, tax hikes and structural changes such as the expansion of the service industry. Additionally, with the first signs of economic deterioration and a still-comfortable fiscal situation, states went on to grant tax breaks more frequently and without coordination, aiming to attract investments. The result was a “fiscal war” without winners. With more incentives and tax breaks and the slide in economic growth, the pace of tax revenue growth cooled down. Hence, with limited room and appetite for spending cuts and despite tax hikes, the primary balance of states started to deteriorate (see chart). 

Personnel expenses are the core of the imbalance in state expenses. Payments to pensioners, inactive and active state public-sector employees account for 60% of states’ primary expenses, and expanded briskly in recent years. After remaining stable at around 4.8% of GDP in 2002-2011, personnel expenses reached 5.6% of GDP in 2016. One of the main reasons for this surge was payments to inactive public–sector employees (see chart), which increased on average by 20% a year in real terms from 2012 until 2016, rising from 1.6% to 2.2% of GDP during this period. In Rio de Janeiro, for instance, personnel expenses widened from 3.6% to 4.9% of the state’s GDP, as payments to inactive personnel climbed from 0.9% of state GDP in 2012 to 1.7% in 2016. An ageing population, a low retirement age and the equalization of payment adjustments between active and inactive personnel are behind the imbalance.

However, states exacerbated the problem, evading some of the provisions of the Fiscal Responsibility Act (LRF). As enforcement of LRF limits fell to the states themselves, States' Accounts Courts excluded from official accounting components of personnel expenses (for example: expenses related to aid, outsourced workers and inactive personnel) as a way to artificially, and misleadingly, comply with limits. As control mechanisms were weakened, states granted generous payment adjustments to public servants, while not formally breaching the LRF. In 2015, at last half of the states reported personnel expenses with significant differences from the ideal concept set by the National Treasury (see chart). As the economy contracted and tax revenues fell, this policy became clearly unsustainable and wage payments were delayed in eight out of 27 Brazilian states in 2016. It is reasonable to think that the outlook for debt renegotiation between the states and the Union, which materialized in 2015, encouraged greater fiscal laxity among subnational entities, given that it created expectations of a lower need to produce primary surpluses.

When put together, growing expenses, falling tax revenues and the institutional disarray led to higher debt levels among states. In 2012-2014, the federal government backed loans for states with lower creditworthiness (see chart), creating room to increase permanent expenses such as personnel outlays.

As the Union faced more stringent fiscal constraints and it became impossible for some States to issue new debt, they were forced into disorderly adjustment. Without cash, states are using tax hikes, investment cuts, debt amnesty programs and anticipating receivables (such as withdrawals on judicial deposits) to deal with the drop in recurring revenues caused by the decline in economic activity.

Nevertheless, in the most critical cases, such as Rio de Janeiro, Rio Grande do Sul and Minas Gerais, the forced adjustment is insufficient and harmful to the economic recovery. As of 2016, states have about 44 billion reais in debt from previous budgets (the so-called “restos a pagar”). Lower incomes and more uncertainty about when people will get paid put the brakes on the rebound in activity.  

In our view, the broad solution to the states’ problem is a spending cap similar to the one for the federal government. The cap must not have exclusions and must be applied to all states, so that the impact is not watered down. A universal cap forces a higher-quality adjustment, focused on structural reforms instead of investment cuts. Hence, states can gradually recover fiscal balance as the economy resumes growth.  

To ensure the cap remains feasible in the years ahead, state pension systems must be reformed. Without a reform, personnel expenses, which represent 60% of total primary expenses by states in 2016, would climb to 70% in 2022 and 80% in 2025. The pension reform recently proposed by the federal government includes state public –sector employees and eliminates special pension regimes for civilians (such as teachers). Population ageing and a low retirement age were the main reasons for the imbalance in expenses for inactive personnel and are addressed by the proposal. On the other hand, the end of equalized adjustments for active and inactive (retired, pensioned-off) personnel, a higher social security contribution rate by public-sector employees and pensions for state military personnel are not in the proposal, and will be addressed by state legislators. 

According to our calculations, if the cap is implemented without exclusions, states would post sustainable primary surpluses within five years (see chart). One way to implement the cap would be through the complementary law proposal for renegotiation of state debt with the Union (PLC 54/16), currently waiting for approval by the Lower House . Approval by the National Congress would prevent a prolonged and uncertain process of deliberation in each state’s legislative body.

For states where the situation is more critical, additional measures are needed, as the government proposes in the Fiscal Recovery Regime. The regime is voluntary and will last no more than three years, requiring approval by the state legislative body. Rio de Janeiro, Rio Grande do Sul and Minas Gerais will likely be the first states to adopt the regime. The main actions are the suspension of debt payments to the Union while the regime is in place, privatization of state-owned enterprises, a higher rate of pension contribution by public servants, reduction of tax incentives and the prohibition of measures that imply higher mandatory expenses and/or forgoing revenues. 

Further measures could reduce the short-term cash problem and the additional increase in debt levels in the medium term. In Rio de Janeiro, for instance, if no additional measures are considered, even with a spending cap, consolidated debt would climb from 200% of revenues in 2016 to 230% in 2018 — or from 15% of the estimated GDP for the state to 18%. If this outlook is maintained, the state will continue to deal with delayed payments of suppliers, wages and pensions, hindering the economic recovery.


Pedro Schneider



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