WASHINGTON, DC –These are the best of times for Brazil. The country has emerged as Latin America’s clear leader and a key global player. Its economy was among the first to rebound strongly from the recent financial crisis, and has since maintained impressive growth. Poverty has been drastically reduced, and income inequality is declining, as the middle class swells. And, thanks to the discovery of vast offshore oil reserves, Brazil not only has become energy-sufficient, but is poised to become a major oil exporter.
Yet, despite all the good news, Brazilians should be worried, because the good times will last only if Brazil addresses a host of mounting economic-policy challenges. Some concern short-term issues; most are of a medium-term nature.
In the short term, it is essential to prevent economic overheating: annual real GDP growth exceeded 10% in 2010, owing to expansionary fiscal and monetary policies and favorable terms of trade. Ensuring that domestic demand decelerates to a more sustainable pace is necessary to moderate the upward pressure on prices that threatens the credibility of the inflation-targeting monetary-policy framework – indeed, in April, the 12-month consumer inflation rate breached the upper limit of the central bank’s tolerance band. Likewise, Brazil must cool its overheated labor market and stem the deterioration in the external balance (which has swung from a small surplus to a deficit of more than 2% of GDP over the last three years, despite a large gain in the terms of trade).
Moderating domestic demand requires, first and foremost, fiscal tightening, because further increases in interest rates, which are already relatively high, would only fuel further capital inflows and put even more upward pressure on the real, which is already over-valued. The authorities have taken initial steps to tighten fiscal policy by announcing significant cuts in the approved budget, but it is estimated that even then, central-government spending will rise by about 4% in real terms in 2011 from its historically high level in 2010. The authorities are complementing moderate fiscal tightening with macro-prudential credit-restraining measures and an array of (mostly tax-based) capital controls.
In the longer term, Brazil faces a range of fiscal-reform challenges. Addressing them successfully would allow the country to generate the savings needed to meet its huge looming public-investment requirements: expansion of productive infrastructure (roads, ports, and airports) in order to remove severe bottlenecks to faster non-inflationary growth; unprecedentedly large planned investment in oil exploration and electricity generation; and forthcoming international sporting events (the World Cup and the Olympic Games) that Brazil will host in the next few years.
Brazil also needs budgetary space to accommodate needed investment in social infrastructure, especially sanitation and basic health-care facilities, in order to reduce the incidence of infectious diseases. It also needs to fund well-targeted programs to reduce poverty further and ensure universal access to basic education; to improve secondary education, with a view to improving the technical skills of the labor force; and to support efficient research and innovation.
Finally, Brazil’s policymakers should aim to remove, or at least significantly reduce, existing tax obstacles to efficiency and competitiveness.
So, what fiscal reforms are needed to meet these objectives?
First, Brazil should adopt a medium-term fiscal framework that targets a gradually declining path for public debt, including a commitment to adjusting the target for the primary budget surplus accordingly. Systematic calculation and publication of cyclically adjusted fiscal indicators would help maintain discipline by promoting accountability, as would other improvements in transparency, especially regarding quasi-fiscal operations and the contingent liabilities of the government and public enterprises. The creation of an independent fiscal council to vet official budgetary projections would also help in meeting fiscal targets.
On the revenue front, Brazil should replace the current state-level value-added tax (VAT), which is riddled with major distortions, and the federal cascading turnover taxes with a modern dual (federal and state) consumption-type VAT, with a common base and a very small number of rates. It should also gradually reduce the plethora of payroll levies that currently add about 50% on average to labor costs, hindering competitiveness and creating a significant incentive to informal employment.
On the expenditure side, Brazil needs a new round of pension reform – clearly a priority, given the rapid aging of the population. Reforms will need to include both increases in the retirement age and changes in benefits, especially the de-linking of the minimum pension from the minimum wage. In addition, a range of civil-service reforms are needed to improve flexibility and increase productivity, while health and education programs require greater cost effectiveness.
In short, despite rosy appearances, Brazil clearly faces a complex and, in some respects, daunting agenda, which newly elected President Dilma Roussef cannot be expected to accomplish within her current mandate. But, it is important that the government make a determined start by picking some “quick wins” to gain credibility with Brazilians and global markets alike.
Brazil is currently benefiting from a favorable external environment, strong international credibility, and unprecedented prosperity for ever-larger segments of the population. But this window of opportunity must not be wasted if Brazil is to consolidate and build upon its current successes.