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MONICA DE BOLLE: Brazil needs to tackle its fiscal deficits and unsustainable debt trajectory. And with the Amazon River basin facing unprecedented peril from development and climate change, Brazil has an opportunity to address these problems and possibly become an ambassador for green policies to the rest of the world. Can Brazil meet these challenges and also deal with its fiscal imbalances?
You're listening to an episode of Policy for the Planet, a podcast exploring the global response to the climate crisis. I'm your host Monica de Bolle, a senior fellow at the Peterson Institute for International Economics.
To help us dive in deeper, I'm joined by Cornelius Fleischhacher.
CORNELIUS FLEISCHHAKER: I'm a senior economist working on economic policies and public finance for the World Bank in Brasilia covering Brazil.
MONICA DE BOLLE: Cornelius and his team at the World Bank have researched better ways that Brazil could connect green policies with fiscal policies, which they've presented in a new report titled, "Double Dividend Policies to Achieve Fiscal and Environmental Sustainability: A Public Finance Review for Brazil".
So Cornelius, welcome to the show. It's a pleasure to have you, especially to talk about this issue. I mean, it has to do with Brazil, my home country where you're living now, and it has to do with fiscal policy and the environment. So the World Bank launched this very interesting report very recently, only a couple of months ago, I think it was, on precisely fiscal policy and how we should be looking at fiscal policy so that it aligns with the country's, let's say, environmental objectives. And this particular report on Brazil has a lot of interesting, I think, stories that go with it. So I would first like to ask you to please talk about the report in terms of like the overview, how fiscal policy in Brazil can be better aligned with its environmental goals, and also what are the main messages.
CORNELIUS FLEISCHHAKER: Sure, no, thank you very much, Monica. It's a pleasure to be on the podcast. So the report is what we call in the World Bank a public finance review, right? So it looks at the public finances of a country as a whole, revenues, expenditures, other interesting aspects. But in this report for Brazil, we would try to do something slightly different in the sense that we looked at the public finance or the fiscal challenges of the country, which are quite significant.
Brazil is at serious need of fiscal adjustment. It's what's in the news here in Brazil almost every week. But Brazil of course also has very important environmental ambitions. Brazil is very fundamental when it comes to the question of climate change, of protecting the climate, especially through the Amazon rainforest. But also given that Brazil has a role as one of the main food producers in the world.
It's very significant in anything that has to do with agricultural emissions. So our idea for the report was to kind of connect the two, because typically the way people think of this, they think of one or the other, they don't think them together. So that's what we're trying to do here. And the main point that the report tries to make is that Brazil's fiscal adjustment, which is important and needs to happen, could benefit a lot from this environmental lens. There is a certain...quite a lot of scope for environmental fiscal policy that could improve the fiscal balance, while at the same time helping Brazil also achieve those environmental objectives, including the NDCs under the Paris Agreement, the deforestation objectives, etc. On the other hand, you can also sort of turn it around and look at the other side of the coin, is that, know, Brazil has these environmental ambitions. They will need policies to achieve them.
And the fiscal policy toolbox is a very important set of tools to use in that, right? You know, that includes taxes, different ways of doing carbon pricing. But also how does the government currently spend money? What does it do to incentivize climate or environmentally friendly ways of production in the agricultural sector or in other sectors? And do the policies that are currently being implemented and that money is being spent on, do they actually encourage that or could they do better?
MONICA DE BOLLE: Excellent. So diving a little bit into the specifics of the report and some of the issues that you touch upon. And as you said so well, know, fiscal touches the environment and the environment touches fiscal policy because stuff that you do on environmental policy may have fiscal implications and fiscal policy can be designed to attain environmental objectives. So running through kind of the list of things or some of the things that you raise in the report, you talk a lot about the carbon market system, which Brazil is just kind of beginning to have, doesn't quite have yet.
Can you say something about how it aligns with the recommendations in the report, this carbon market system that's currently in the works? And what would the likely impact of proposed taxes that you highlight in the report on diesel and fertilizers have?
CORNELIUS FLEISCHHAKER: Sure, So the carbon market is very important and it's something that happened at the very end of last year and maybe didn't get quite as much attention as it should have deserved, which said Brazil actually passed legislation to create a emissions trading scheme, a regulated carbon market, which of course the European Union has had for quite some time, other countries have it.
But for Brazil as a major emerging market economy, as a top 10 admitter, that is a very important step in the right direction when comes to carbon pricing. Now, the way that this carbon market work is similar to other carbon markets that it comes into effect very gradually and it only covers certain types of emissions. In the case of Brazil, which is not so different, I think, from many other existing carbon markets, it basically covers individual emitters, so factories, firms, power plants that have very significant level of emissions at the individual level.
So that basically means that there is parts of the economy that will be covered, like electricity generation from fossil fuels, like cement or steel or fertilizer factories. And these over time will fall under the market and they will have to either reduce emissions or purchase certificates.
So we did a modeling exercise where we tried to model the effect of this policy and a bunch of other policies that the Brazilian government has proposed or started to implement. And we find that the carbon market in itself, we would expect to reduce emissions by about a quarter from now till 2050. So that's quite significant. But of course, it's only a quarter and the ambition that Brazil has is to get to net zero, right?
Of course, the shortcoming of the carbon market in some sense is that it does only cover certain sectors, which in the case of Brazil are only a small or about a third or so of the total emissions. It doesn't cover the agriculture sector in the sense of covering the emissions. It does allow for participation of the agricultural sector in offsets. So in principle, agricultural producers that capture carbon through growing trees or even for example in coffee plantations, could sell these offsets to the carbon market and that could become a new income stream and of course would provide incentives for them to capture as much carbon as possible.
But the emissions from the agriculture sector, which are very significant in the case of Brazil, are not being covered. Which is not unique to Brazil. Most carbon markets that exist don't cover the emissions coming from the cattle sector for example or from rice fields. It's in line with other countries, but it's more important in some sense in Brazil, given that Brazil's emission profile is more tilted towards that. There's some other areas that are not covered and one of them is the road fuel sector. And that's our starting point in some sense for some of these other specific policies is to look at, what are the emissions that the carbon market is not going to be able to reach?
And there, there's a lot related to agriculture and there's also the road fuel sector. So for road fuels, mostly gasoline and diesel, there's a more complicated story about ethanol here as well. But for gasoline and diesel, the obvious alternative is to just tax the fuel, right? You can perfectly combine a carbon market that covers some emissions with a carbon tax on other specific emissions. And so diesel and gasoline would be the obvious case here.
What's important is that it's not just about the carbon. These fuels, especially diesel, is also a major source of other negative externalities, specifically air pollution externalities. What we estimate is the optimal rate of taxation based on the externalities from carbon as well as air pollution. What it would imply is significantly higher tax for diesel, which also has to do with the fact that currently gasoline is taxed significantly more than diesel. Whereas if you look at the externalities, it actually should be the other way around. So that's the story on diesel.
MONICA DE BOLLE: Yeah, and including, sorry to interrupt, but including because the way by which a lot of agriculture is transported across Brazil is by trucks and trucks use diesel, right? So not gasoline. So that is where you really do want this to apply.
CORNELIUS FLEISCHHAKER: Right. Yeah.
No, but it's also sort of where we get a lot of pushback, right? The idea that, well, know, Brazil runs on diesel, right? There's not a lot of trains in Brazil. There's not a lot of big rivers to bring out the agricultural produce like the, know, Mississippi, Missouri River in the United States, for example. know, trucks, the economy runs on trucking, right? And that's true and that's the challenge. And, you know, we admit that. And that also means that if you would implement a diesel tax, it would have significant impact on the prices of everything that's transported, which is most goods essentially. But that doesn't mean that you should just not do anything and continue the diesel addiction, if you will. Part of the reason why Brazil is so dependent on trucking and diesel is because it's been underpriced, which makes it harder for alternative modes of transportation to compete. Of course, there's other challenges with those too. Setting up a freight train system if you don't have one is not an easy thing to do.
MONICA DE BOLLE: Yeah, it's not exactly something you do overnight.
CORNELIUS FLEISCHHAKER: Right, right, right. But I think getting those prices right is important to level the playing field or even tilt it in the way that it should be tilted, which is towards the more clean, environmental-friendly and human health-friendly alternatives. And we also show that while there is a price impact from these taxes, and that does result in income loss for households, that's only if you look at it in isolation, right?
Because what would happen is the government would collect these taxes on fuels and then it would have this revenue to either spend or reduce other revenue sources. So one way to keep this whole thing neutral, which is actually in line with what Brazil has done on consumption taxes more generally, is to say, look, we're going to collect more tax on gasoline and diesel, but the revenue we're raising we're going to use to lower Brazil's very high general consumption taxes.
Brazil may well have the highest or one of the highest VATs in the near future. And that would basically mean families would be paying more on fuel, they would be paying more through the channel of transported goods, but they would be paying less on everything that has a VAT, which is pretty much everything they consume. And that would also sort of provide the right incentive to ultimately produce, sorry, consume less gasoline and diesel.
MONICA DE BOLLE: Yeah, that's a very good point. Moving into the specific recommendations and issues regarding the agricultural sector, which as you underscored and you all underscore in the report repeatedly, is very important. Because as you said, Brazil is a food producing country. It produces a bunch of other commodities as well, but a lot of food, a lot of grains, meat, you name it. So can you talk a bit about the proposals for this — one I really like the tax on rural property — and what would it likely achieve and what might be some of the obstacles to implementing it?
CORNELIUS FLEISCHHAKER: Sure, no, this is also one of my favorite parts of the report. Brazil has a property tax on rural land. It exempts the smallholders, the agrarian settlements, all the small family farmers. But in principle, taxes anyone who owns large pieces of land. It was set up in a way that it was supposed to be progressive. So the bigger the property, the more you pay. And it was meant to encourage productive use of land.
So in principle, if you use your land productively, you pay less than if you don't use it productively. Which of course it was set up at the time when the environmental concerns were not as much in the foreground. And it was more about, well, you have to develop the country, we have to spread productive agriculture through the interior of Brazil. But the problem is that the tax just doesn't... doesn't work. Brazil collects about 3 billion reais, so that's well under a billion dollars per year, on all the rural properties all over Brazil, which is, for example, significantly less than the urban property tax of the city of Rio de Janeiro. It's a fraction of the urban property tax of São Paulo, right? Which shows you there's something off. So the average tax per hectare paid is just over a dollar.
So the estimated effective tax rate is 0.03 % of the value of that land. So that doesn't change any incentives and it also doesn't raise any revenue for the government. So the government collects the tax, the people who are paid pay minimal tax. There's a minimum tax actually of 10 reais, so that's about $2. And many property owners pay just that, colloquially they call it the 10 reais tax.
So the whole thing is not very useful as it currently is. But what we try to show in the report is that it could be much more useful, right? Because taxing land and taxing the specific use of land could actually provide incentives on how people use the land. And we have to remember that most of Brazil's emissions are tied to land, right? The biggest two sources of emissions and varies from year to year, what is first, what is second, is land use change, which is essentially deforestation, expansion of land into the forest. And the second one is the agricultural livestock sector. And typically what happens is that when land is recently deforested, the first thing that happens is cattle ranching. So clearly this is a tool that could be much more effective. So what we did is we worked with researchers at the University of São Paulo.
And we did an extensive geospatial general equilibrium modeling where we run a couple scenarios where we make specific changes to the tax. All of them result in raising the tax. All of them result in collecting at least double, triple the revenue that is currently raised, which is still not very much. But of course, they do provide these different incentives and that has significant impact in the model on how land is being used.
So for example, one interesting parameter is that to be considered productive and therefore have a lower tax rate, if you're doing cattle ranching, you have to reach a certain stocking rate, a certain rate of animals per hectare. These rates in the current system are completely outdated, they're extremely low. So in most of Brazil, they vary by region, but in most of Brazil, if you put one cow per hectare, that's considered productive, you pay very little tax. Now clearly that's not productive use of land, right?
And we know that if Brazil has a lot of cattle on a lot of land, so if you could manage to concentrate the cattle a little bit more, that would free up a lot of land and would therefore reduce the demand for additional land. Because that's sort of where the link to deforestation comes in, right? Deforestation in Brazil is very complicated. There's a lot of reasons why it happens. But one of the main ones clearly is demand for additional marginal land, which again, tends to first go into cattle ranching and then maybe eventually into more intensive uses. So clearly if you give the incentive to use less input land, that will reduce the overall demand for land and should reduce the pressure on the forest, right?
So that's the basic rationale of this report and the modeling shows it very clearly. There's a lot of options you can do with the different tax parameters, the stocking rate, the progressivity with the size of the property, how to deal with reserves or protected land within a property. There's a lot of little factors that we all can play through in the model. But I think the bottom line is that making land more expensive as an input, should lead producers to use less of it and that is highly desirable. And another thing we observe is that, know, obviously taxing land, is a tax, so it does have some effect on production in a general equilibrium model like it always will. But since land is, you know, it's a non-produced factor, the supply of land is essentially given even though it's not fully static in a case like Brazil where there is this land expansion.
It means that taxing this factor with the very low elasticity is going to be more efficient, it's going to create less economic distortions than taxing something else like agricultural outputs or consumption or income from activities. So that's sort of the big story here.
MONICA DE BOLLE: So just to clarify, the low elasticity part you're referring to is the relative insensibility of demand, demand for land to price changes. So in other words, if you say something is inelastic or has low elasticity, you're basically saying, okay, if the price for this one thing, in this case, land, increases by a bit, this is not going to have a significant impact on the demand because people will need land to produce what they want to produce. So just as a clarification.
CORNELIUS FLEISCHHAKER: Yeah, well, yeah, but there's an even more simpler side to it, which is the elasticity of supply, right? Generally speaking, just because there is a higher price of land doesn't mean there is more land, right? Nobody produces land from scratch, right? Which is very different from capital, which is capital goods are produced, savings are created, right?
Yeah, so there's this whole theory of Georgian taxation that kind of goes back to that, right? So the idea is that when land becomes more expensive, people will find ways to use other factors more intensively, which could be labor or in the case of agriculture, it will mostly be capital and technology. And that will allow them to produce the same or more using less land.
MONICA DE BOLLE: Yeah. And so I love this specific the way by which you discuss in the report this issue on the taxes on rural property. And I like it because it illustrates, not only does it illustrate a really interesting aspect of what's going on in Brazil specifically, but it also underscores how once you're looking into fiscal environment, how they touch each other and how policies in one affect policies in the other realm, how they're connected. You can see it through these examples like the case of Brazil in the rural property taxes. You can see very clearly how those incentives would play out if you just did this to the tax, raise it a bit or fiddled with it a bit and designed it in a way as to achieve the goals you want to achieve. So I like that discussion very much. And I also was looking at the fact that when we take the agricultural sector in Brazil, as we both know, it is a very highly subsidized sector. The government provides a lot of subsidies to agriculture in Brazil, has always done so. And it also provides a lot of tax breaks. So it's a sector that ends up getting a lot of fiscal incentives, which are not necessarily aligned with any environmental goals whatsoever. So can you say something about that?
CORNELIUS FLEISCHHAKER: Sure, no. And you're absolutely right. So when we start a public finance review, one of the first things we typically do is we look at the budget allocations, And so for the federal union budget in Brazil, there's about 1% of primary spending that goes to environmental issues and about 1% that goes to agriculture, which at first glance, it seems like very little, right? Because it's true that Brazil actually spends little in terms of primary direct spending on things like agricultural extension.
Also, there's not the kind of producer subsidies or land sparing subsidies like you would see in the EU, for example. But what you do have a lot is there's two main tools of agricultural policy in Brazil. One is subsidized credit, which in part is explicitly subsidized through the federal treasury, providing subsidies to the banks that then provide subsidized credit to farmers. There's another part which is not explicitly subsidized from the budget, but it's a cross-subsidy where banks are required to land to the rural sector at subsidized rates and make up for that by charging the non-rural sector higher interest rates, which is one of the drivers, arguably, of the general high interest rate environment in Brazil.
The other big policy element in Brazil is the tax expenditures. So it's not budgetary expenditure, but basically the government gives tax breaks on agricultural inputs, like fertilizer or chemicals, herbicides, pesticides, etc. As well as agricultural production. Some of it is under the food exemption and consumption tax, which has an agricultural aspect as well as sort more of a social nutritional aspect. But also on other outputs of the agricultural sector. Also on the income tax, the agricultural sector ends up paying very little because of the way that these firms are structured and their tax treatment.
So there's a lot of implicit expenditure through the tax code there as well. And yes, so the thing is that neither of these main policies, right, neither the subsidized credit nor the tax expenditures are currently very much aligned with environmental and climate objectives.
It's not that there is nothing in that direction. There are specific credit lines that are, for example, for low carbon agriculture, for doing things like integrated pastures and forests which reduce emissions in the cattle sector. But it's a very small part. At most, it's something like 4% of the overall volume of agricultural directed credit. And on the tax subsidy side, it's even worse.
There's pretty much nothing we can identify that is targeting environmental objectives. And there are some things that are actually running counter. So for example, when you give a tax break to fertilizers, which is a very carbon intensive product, you're really subsidizing emissions. You're subsidizing environmental pollution. So clearly that goes in the wrong direction. And it's also a bit contradictory, which was happening at the same time on the carbon market, right? So on the one hand, you're pricing the emissions from fertilizer in the carbon market. But on the other hand, you're giving tax breaks on general taxes, right? So that's just not very consistent.
MONICA DE BOLLE: Yeah. Yeah. So, but we do know that it is a hard sell this one because these policies have been in place for so long that you can just see the resistance from, you know, the agribusiness folks and the farmers, the big farmers and so on to any kind of change in those policies. But I fully agree with you. This is very necessary if you want to really be serious about these environmental goals and the ways by which fiscal policy can help them or hamper them as you very well put. The other thing that I liked a lot in the report is that you talk about the idea of green government transfers. Can you explain that?
CORNELIUS FLEISCHHAKER: Sure, sure. It's a bit of a nerdy public finance topic, but I think it's very interesting, right? So when you have multiple levels of government, so in Brazil we have federal, state and municipal, they typically transfer monies to each other, right? And typically the higher levels of government collect the most taxes, but the lower levels do a lot of spending on say health and education, so they need to get transfers from the higher levels to be able to finance that.
And so that's what's happening in Brazil. The federal government transfers significant amounts of money to the states and the municipalities and the states also transfer to the municipalities. Now, there is a big question of what should these transfers be based on? How should they be allocated? What should give a given state or municipality the right to receive a certain amount of transfer? And typically it's things like population or if it's your mark to education, how many students you have in school and those often make sense.
But there's another way of thinking about it, which is, can we tie these transfers to results to provide an incentive to those lower level governments to achieve desired results that contribute to national or higher level objectives, right? And Brazil actually has some interesting experience on that, especially when it comes to the state to municipal level. So there's two that are interesting, one that is environmental and one that's not environmental. The environmental one is something that's been around since the early 90s, where some states have started to earmark a small part of the transfer to municipalities to specific environmental characteristics. So within that little envelope, those municipalities that have the most protected areas will get a little bit extra, or those that do well in treating the wastewater or the trash.
And that's been around for a long time. Currently 18 states have it. The state of Amazonas and we worked with them to create it so that'll start next year. But it's all quite small in terms of the amounts of money being transferred and the criteria vary from state to state. So it's hard to say how effective that actually is. The best evidence I've seen that it can be effective, for example, in small municipalities in big states where there's a lot of revenue to be transferred. So for example, the state of Sao Paulo.
If you're a small municipality that preserves Atlantic forests in Sao Paulo, that little tiny fraction of a percentage of the Sao Paulo VAT that you get due to that is actually a lot of money for you. So then it probably makes a difference. Now there's another example which has very good evaluations, which is the results-based transfer on education. So this is something that was started in the state of Serra also quite a while ago.
And education is maybe in some ways easier to study, but it's been shown very clearly that giving an incentive to municipalities to improve their results in primary education has helped the state of Sierra actually be bit of an outlier. It performs significantly better on primary education than all of the surrounding states.
So our idea is to you all, should combine these things and think about environmentally, transfers based on environmental criteria, but that really target results or outcomes that are most significant to the overall national agenda. And so the one that comes to mind first and foremost is the protection of forests, especially the Amazon rainforest. And here, you our idea is that, you should elevate this mechanism to the federal to state level. So the federal government currently transfers a lot of money to the states.
But this is just based on a formula, it doesn't really respond to anything the states do. So our idea is that you could use at least a small share of this and make it dependent on how much forest you have and what is happening with your forest in terms of deforestation increasing or decreasing. And therefore give states an incentive to do what is in their power to actually protect their forest and benefit from having the forest. Because what we've seen in Brazil is that the states that where there's been a lot of deforestation over the decades, economically they've done well. If you think of a state like Mato Grosso, which today produces close to 10 % of the global soy crop, it's a very prosperous place nowadays, and 40 years ago it wasn't because it was mostly forest. So the problem is if other states try to follow the same path, there's not going to be much forest left.
So in a sense it is about providing incentives for states to have an upside to keeping the forest, to reducing deforestation and intergovernmental fiscal transfers could play a role there.
MONICA DE BOLLE: This is such a rich report, Cornelius. We could go on and on and on because you guys have done such a wonderful job with this. it is just so great to kind of peek through it and think about these things and these examples and the ones that you raised. I'm actually sorry that we're ending the episode, but to ask you a final question, how likely do you think that some of the recommendations, some of the measures that you have...stipulated and raised in the report, how likely is it that Brazil adopts them?
CORNELIUS FLEISCHHAKER: Well, think it's, I would say it's a mixed bag in many ways, right? I mean, who would have thought a few years ago that Brazil would have a carbon market in the books now, approved law. So things do happen. I mean, the consumption tax reform that happened is something that, know, Brazil watchers like you have been looking at for decades and, you know, Brazil has been struggling with for long time and now it did happen, right?
Now, of course, some of the things that we propose in the report are hard to swallow in a political sense or could face very entrenched opposition. And that's certainly true for the fuel taxes. We all know around the world how difficult it is to get prices right, as the IMF guys like to say on fuels. Also, of course, the agricultural sector is a sector that has a lot of cloud in Brazil for… for obvious reasons, mean in many ways agriculture has been the driver of growth in Brazil for a few decades now. But I think that the things we're proposing, not that radical, right? We're often talking about incentives at the margin, And we are talking about things that do have benefits for the society as a whole, so I do think there is chances that some of this will be picked up.
And again, there is this synergy between the environmental and the fiscal, right? mean, the Brazil watchers all understand that Brazil will need to do more on the fiscal front, you know, maybe not right now, but definitely, you know, after the election that's just over a year away. So I think there will be fiscal measures coming up. And so I think our hope and our idea, our proposal is that, well, when you do these fiscal adjustment measures, think about what you can do in terms of green fiscal policy. Think about how your fiscal adjustment measures can also have these additional benefits. And maybe that's even going to help you sell them a little bit. I think there is lot of, there's some, for example, the land taxation. It's not just that it would create additional revenue for the government and that it would help with the deforestation challenge and the climate issues. It's also extremely progressive. Because it would be a tax on the largest landowners, which we know are among the largest individuals in Brazil. And they're wealthy because they've done very well in terms of their productivity and they've done a lot to invest and to innovate. But I think it's not that radical to say, if you have this kind of economic wealth and capacity you should be contributing a little bit more.
MONICA DE BOLLE: Well, thank you so much Cornelius. This was a fascinating conversation. Thank you. Thank you very much for coming on this show.
CORNELIUS FLEISCHHAKER: No, thank you. Thank you very much for your interest in the report and it was a pleasure to be here.
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