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FAQs: The Spending Cap (PEC 241)

October 10, 2016

The spending cap is crucial to the rebalance in public accounts and the return to economic growth

In October, the Lower House will vote on the structural reform that introduces a fiscal spending cap (PEC 241). The following report summarizes some of the most frequently asked questions about the bill, which would limit any increase in real terms  in primary federal government expenditures for at least the next 10 years.

1. What is the spending cap?

The spending cap is a proposed constitutional amendment (PEC 241) stipulating that each year the federal government’s total primary expenditure cannot rise more than cumulative inflation during the 12 months from June of the preceding year, and this stipulation will continue for up to 20 years.

2. Why is the spending cap needed?

Public spending has been increasing constantly and has outpaced economic growth for the last 20 years. The problem is that there is unlikely to be an increase in revenues to support this fast rise in spending at any time in the near future. There is no room for further tax increases. Structural improvements, such as the increase in formal employment, and favorable economic shocks, such as a boom in commodity prices, are unlikely to occur again. Without reforms and with 90% of federal public expenditure classified as mandatory, the structural fiscal problem will continue. Consequently, Brazil could stagnate over the next several years and continue to face what are, by international standards, very high interest rates.

The spending cap is a key reform intended to balance public accounts and create a path for a return to economic growth. The bill, if approved by Congress, could reverse the deterioration in public accounts and the vicious circle of unsustainable public debt and economic stagnation, which has had negative consequences for society in terms of inflation, unemployment and income. Compared with an adjustment based on tax increases, an adjustment in government spending will have significant implications for the equilibrium of the overall economy, especially in terms of faster growth and lower interest rates.

3. Is it prudent to expect a swift recovery in revenues once the economy begins to grow again?

No. Any return to growth is fundamentally dependent on the approval of fiscal reforms. The factors that drove revenues up ahead of GDP growth over the past 20 years will not likely be repeated. First, there is no room for further tax increases. Second, the composition of economic growth will not favor Brazil’s tax revenue base. Seventy percent of federal taxes are linked to family consumption and incomes. Over the past 20 years, an increase in formalization in the labor market and rising commodity prices helped these drivers grow faster than GDP. Now, however, the economic recovery cannot rely on these improvements (see “Macro Vision: Why is Brazil set to Grow 4% in 2018?”). Initially, the recovery is being explained by an inventory cycle. Subsequently, investment will rebound as companies deleverage and interest rates fall, but this is not a significant driver of increased tax revenues. It is only later – and if the fiscal reforms are approved, generating greater confidence and lower interest rates – that family consumption and the labor market will improve.

4. What will spending growth be indexed to?

Primary federal expenditure growth will be limited to 12-month cumulative inflation as measured by the IPCA from June of the preceding year. On an exceptional basis, 2017 expenditure will rise 7.2%, which is the government’s forecast for cumulative twelve-month inflation in December 2016.

5. How long will the spending cap remain in effect?

The spending cap could remain in place for up to 20 years. From 2025, the cap’s ninth year, the president will be allowed to submit a supplementary bill to Congress (once for every term of office, proposing changes to the rule that ties primary spending growth to the previous years’ inflation).

6. Which areas of the federal government are subject to the spending cap?

The bill sets individual ceilings for each state power (Executive, Legislative and Judiciary, including the public prosecutor and public defenders) and for each agency within each branch (for example, the Senate and Lower House, which are part of the Legislative).

7. Does the spending cap also apply to primary expenditures at the state and municipal level? 

No. The proposal for negotiating state debt with the federal government, which is still moving through the Senate, requires adoption of a two-year spending cap (through 2018). The government has said that it will submit a constitutional amendment bill extending the spending cap to the states for a period compatible with the federal government, at the appropriate time.

8. What will the rule be for minimum constitutional spending on health and education? 

The current rules tie minimum spending on health and education to a percentage of revenues and will remain in effect until 2017. Additionally, for health, the convergence to 15% of current net revenues (from 13.2% in 2016 and set forth in current legislation for 2020) will be brought forward, offsetting the negative effect that the drop in revenues has had on minimum health spending. From 2018 onwards, minimum health and education spending limits will be based on previous year’s inflation figures, in line with the spending cap mechanism.

9. Will the spending cap cut funding for health and education?

No. The spending cap states that minimum spending on health and education will remain constant in real terms from 2018. We would point out that the bill sets a minimum threshold and not a ceiling for this expenditure. If the reforms are fully implemented, this would create the conditions needed for a Brazilian economic recovery that would allow for increased spending in areas that are a priority for the general public, without compromising Brazil’s fiscal sustainability.

10. Will the new rule for minimum constitutional spending reduce actual expenditure on health and education? 

No. If the deteriorating fiscal situation is not reversed, then the economy will remain unbalanced and it may actually stagnate for the next several years. And, if the economy does not grow, under current rules minimum health and education expenditure will be lower. For example, the current rule for health spending would generate a minimum cumulative expenditure, discounting inflation, of around BRL 500 billion over the next five years, but adjusting the current expenditure for inflation from 2017 and in line with the spending cap rule, the actual expenditure would be closer to BRL 525 billion.

11. Is there any spending that will be excluded from the cap?

Yes.

First, we note that the ceiling only applies to primary expenditure, therefore it does not include expenditures such as interest on the public debt. This is because interest rates are outside government control and are simply a consequence of past government decisions. The ceiling also does not apply to other financial expenditures, such as the FIES.

Second, primary expenditure excludes nonrecurring expenditures, such as capitalization of state-owned companies and funding of elections and referendums.

Third, the ceiling does not apply to constitutional transfers of tax revenues from the federal government to the states and municipalities or revenues which, despite belonging to the federal government, are collected by the states and municipalities. We note that these revenues include the resources provided by the federal government via the state fund to maintain and develop basic education (Fundeb), which is an important education-financing mechanism in Brazil.

So, every year the spending cap will apply to primary federal expenditure, discounting these exceptions, which will be added together annually, totaling overall primary federal expenditure. The exclusions do not undermine the objective of the spending cap; they are mainly linked with regional government autonomy from the federal government.

12. What corrections can be implemented if the government cannot adhere to the spending cap?

Importantly, corrective measures are applied automatically from the following year if any of the individual thresholds are exceeded, until the expenditures fall back within their respective limits.

First, the federal government is barred from creating any mandatory expenditure and from taking any steps that would increase a mandatory expenditure beyond the inflation rate (for example, real-term minimum wage adjustment policies).

Second, in regard to spending on personnel, the federal government is barred from (i) increasing public servant compensation or benefits, (ii) creating or modifying careers or positions that would result in an increase in expenditure and (iii) from hiring additional staff or holding hiring exams, except as required to fill open positions.

Third, the government is also barred from granting or increasing tax benefits and from increasing expenditures on subsidies.

13. What happens to these corrective measures, once implemented, if the government continues to breach the spending cap? 

The corrective measures are applied until expenditure falls below the threshold.

14. How soon will the federal government start posting surpluses again? 

In around four years (2020). This timeframe reflects the fact that revenues are unlikely to outpace GDP for the next several years. Unlike the past 20 years, when tax increases, structural changes (such as increasing labor market formality) and economic trends (such as rising commodity prices) helped to boost tax revenues, this economic recovery will not be especially tax intensive. Brazilian taxation is concentrated on labor and income, and these factors will take some time to respond to the upturn in economic activity.

15. When will Social Security reform become a critical factor for implementation of the ceiling? 

2019. Today, Social Security outflows represent approximately 40% of primary federal expenditure and 8% of GDP. Without reforms, the number of beneficiaries will rise around 4% annually because the population is aging and mean retirement ages are low, compared with other countries. Additionally, around two-thirds of benefits will again see real-term increases because they are linked to the minimum wage. As a result, year after year this expenditure will rise in real terms, making it more necessary to make cuts to the rest of the budget. Hence, the spending cap can only be fully implemented alongside reforms setting a minimum retirement age of 65 years, which the government has signaled it intends to do, and adopting increases limited to maintaining the real value of benefits.

16. If the spending cap is approved and implemented, by which year will the public debt stabilize, and at what level?

Public debt would likely stabilize when the economy reaches equilibrium by 2023, the cap’s seventh year, at around 80% of GDP (see “Macrovision: Spending ceiling could stabilize public debt below 80% of GDP”). Before that, even with these reforms, primary results will remain in negative territory for several years, and public debt stabilization will also depend on faster economic growth and lower interest rates.  We note that 80% of GDP is quite a high level compared with other emerging market countries. This reinforces the need to apply the spending cap for an even longer period of time so that the level of public debt declines.

17. What happens if Congress rejects the spending cap bill?

Without PEC 241 or other offsetting measures, public debt will remain in an unsustainable path, and it will probably not stabilize as we move ahead. This would entail an adjustment via a swift increase in inflation or the adoption of other initiatives that would have a big, negative impact on the population, as occurred in Greece where a debt crisis has caused the economy to shrink by about 32% since 2008. Among the offsetting measures we have discussed, we would probably see an increase in taxes representing at least four percentage points of GDP, which would make it exceedingly difficult for any economic recovery to gain traction.


 


 



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