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Should Brazil Dance to the Tune of a Fiscal Band?



Brazil's government, much of which is already under investigation for widespread, endemic corruption, is trying to pull another fast one on its taxpayers and creditors.

As talk of a need for fiscal adjustment fails to translate into action, officials have been shifting the public discussion away from fixing the country's fiscal problems by introducing novel—and ill-advised—ideas for fiscal management. The latest proposal is the revival of an issue that placed former finance minister Joaquim Levy and the current minister, Nelson Barbosa, in a head-on collision shortly before Levy left office in late 2015: the elimination of Brazil's fiscal target and its replacement by a "fiscal band"—a moving range for the primary balance as a share of GDP.

Under the new proposal, a primary balance target would be set every year, but rather than offsetting spending with fresh savings to meet the target in the event of revenue shortfalls, it is the target that would be reduced to accommodate the reduction in tax collections. If this sounds fishy, it's because it is.

To avoid the (correct) perception that the government is repudiating the need for fiscal adjustment by creating smoke screens that damage proper evaluation of the fiscal stance, Barbosa's proposal envisages the adoption of a ceiling on public expenditures. Hence, if revenues fall short of the level compatible with the target it would be lowered, but expenditure cuts would automatically kick in to bring the primary balance back to its previously established levels over time. If this sounds overly complex, it's because it is.

Although any potential spending cuts have not yet been fully specified, the government is contemplating suspending adjustments to public sector wages, as well as reducing constitutionally-mandated spending on health and education. Therein lies the crux of the political trick: The suggested expenditure triggers would need to be approved by Congress, not to mention accepted by public civil servants.

Given President Dilma Rousseff's lack of political support, growing popular discontent with her government, and Brazil's political dysfunction, it is highly unlikely that Barbosa's expenditure ceiling would be approved. The fiscal band would also require changes to Brazil's fiscal responsibility law, which might also fail to pass in Congress. However, if the band passes but the ceiling does not, the stage would be set for a substantial deterioration in fiscal management and weakening of fiscal institutions. This would further damage market perceptions regarding the government's fiscal intentions, possibly leading to further ratings downgrades and a widening of risk premia. As the figure below shows, credit risk measured by Brazil's 5-year credit default swaps has been rising steadily since mid-2014 exactly because of poor fiscal management.

Even if the proposal were to pass in full, i.e. if both the fiscal band and the expenditure ceiling and triggers won congressional approval, the wasted political capital is ill-advised on more than just political grounds. Currently, Brazil's fiscal regime is, at least on paper, fully transparent: A target is set, and if it is missed policies need to be adjusted. The government's proposal, at best, would achieve the same result in convoluted fashion. At worst, it would make the conduct of fiscal policy opaque by raising a number of questions.

Namely, how would markets, investors, and ratings agencies be able to adequately assess debt dynamics if fiscal targets were subject to constant revisions? Why wouldn't expenditure ceilings and triggers for expenditure cuts, especially in their proposed form—cutting mandated health and education spending—not ignite substantial popular backlash, ultimately damaging any chance for a coherent medium-term adjustment the country so desperately needs?

As the economic and political crisis in Brazil deepens, the government appears to be shifting the debate towards further policy confusion and disarray, rather than trying to address problems with what meager political capital it still has. Unfortunately, such a turn of events does not bode well for Brazil's chances of a recovery in 2017.

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