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Tax Revenues in Brazil Declining Faster Than GDP

February 11, 2016

Tax revenues are a problem because they depend on wages that are slower than GDP to recover.

Brazil’s economic growth has been slowing for the last few years, but only this year it turned into Brazil worst-ever recession. Tax receipts have followed a similar pattern. With the recession worsening, some areas of government are finding it difficult to balance the books at the end of the month. The fiscal issue has become a dramatic problem. What happened?

Unfortunately, nothing very surprising. The end of the commodity cycle and the uncertainty stemming from domestic policy caused the continuous investment decline and GDP slowdown. However, the full effects of the slowdown were not felt until the economic decline reached the job market and started to undermine consumer spending and the service sector, causing the current recession.

There has been ample warning that weak GDP, falling industrial output and shrinking investment would eventually affect jobs and wages. But there was still hope that Brazil had discovered how to decouple the job market from GDP-measured value creation.

The fact that the crisis reached the job market last year has serious repercussions. First, a weaker job market provokes a second phase in the recession. With fewer jobs and lower incomes, real wages fall and drag down consumption. Sales suffer and output shrinks further, causing additional job losses. The vicious circle causes a deeper recession. Second, a weaker job market directly exacerbates Brazil’s fiscal problem.

Clearly, Brazil’s fiscal problem is rooted in cyclical and structural problems involving government expenditure. In recent years, excessive spending and subsidies have transformed a primary surplus of 3%-4% GDP at the start of the decade into a deficit of almost 2% last year. Any attempt to correct the situation faces both political and structural difficulties. A large proportion of government spending is mandatory and difficult to prune in the short term. Also, there are several government benefits (income transfers) that have simply outgrown GDP. The most obvious example is Social Security spending. No other country in the world has an average retirement age of 55. Without a change, Brazil’s primary deficit will worsen 0.3% annually and continue to drive the debt upward. Brazil needs to institute a minimum retirement age to correct this unsustainable trend.

Brazil’s growing public expenditure is a particularly thorny problem, especially as we now face a prolonged period of weaker tax revenues.

Last year, this drop in tax revenues was the biggest issue facing federal, state and municipal governments. Without revenues, administrations at all levels found it increasingly difficult to pay their bills, and sometimes even salaries, or maintain hospitals and other basic services.

The crisis of declining tax revenues is an obvious consequence of Brazil’s worst-ever recession.

However, the fact that the job market has been recently hit during this recession has a double impact on public finances, which may not yet be fully understood. The direct effect is that job and wage losses affect GDP growth, which affects tax revenues.

But there is also an indirect effect. Many analysts are surprised that tax revenues are falling so much faster than GDP (10% compared with a fall in GDP of almost 4%).They appear to think that tax revenues have become much more sensitive to GDP just now, in the middle of the recession. Economists are calculating that elasticity (GDP impact on tax revenues) is well above historic levels. They believe this to be caused by a “structural breakdown” beyond their comprehension.

A recent study by Luka Barbosa (supervised by Gino Olivares at Insper University) shows that there is no structural breakdown in tax revenues. In fact, tax revenues depend to a much greater extent on wages and retail sales than GDP, with the former shrinking much faster than the latter: 43% of tax revenues depend on wages; 30% is linked to sales.

If we look at historical (and more recent) trends, tax revenues are consistently affected by a drop in formal wages and sliding retail sales. Historical (and more recent) elasticity is unitary (for each 1% these items fall, tax revenues also shrink by 1%.)

In sum, a depressed job market and therefore weaker sales have a stronger, but less evident, impact on fiscal accounts, because they have a more potent effect on tax revenues than GDP. It is not surprising that declining tax revenues collapsed and fiscal difficulties grew last year, when national unemployment reached 10%.

The problem ahead is that tax revenues may take longer to recover because they depend on the job market. The first signs of a return to economic growth should come from the goods market, meaning that GDP will recover before unemployment starts to fall. We expect, first, a jobless recovery. 

The investment rebound, when it happens, may be more vigorous than the consumption rebound, which will have to wait for an upswing in the wage bill. 

I believe that the fiscal/political issue is at the root of the crisis: if Brazil does not address the fiscal problem, it will be difficult to solve everything else. Excessive spending and unsustainable growth of mandatory expenditures are the main causes of the fiscal crisis. However, there is also a persistent problem with tax revenues, which depend on the wage bill (and, therefore, sales), whose recovery should be slower than that of GDP. Managing the lack of tax revenues in coming years will prove to be quite a challenge; This is another reason to speed up measures to rein in mandatory expenditures.


 

Ilan Goldfajn is chief economist and partner at Itaú Unibanco.



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