Postponing structural reforms costs growth – 4/5/2023 – Solange Srour

Fiscal adjustments imply complex choices in face of the possibility of economic and political constraints. In addition to defining its size and pace, the authorities in charge of the process are faced with two questions: what is the most effective combination of tax increases and expenditure cuts in order to achieve a reduction or stabilization of the debt/GDP ratio, and what is the cost in terms of output and job losses associated with the fiscal adjustment?

The general lines of the new fiscal framework make clear the choice for an adjustment that gradually limits spending and depends on the increase in the tax burden. The adjustment is about 2% of GDP in three years, and to stabilize the debt something close to 3.5% of GDP is needed. Although the new framework establishes that expenditure growth is limited to 70% of net revenue and a real expansion of 2.5%, the primary surpluses needed to stabilize the debt/GDP ratio in the medium term demand revenue growth above levels indicated by their correlation with GDP.

Our tax burden is around 32% of GDP (according to the IMF’s Fiscal Monitor), well above the 27% average of emerging countries. Over many years, we increased the burden as a way to offset part of the strong expansion in spending (the other part resulted in debt growth), harming the business environment, discouraging investment and compromising potential growth. On the spending side, international comparisons (data from the World Bank and the OECD) show that we spend a lot, but we spend poorly (mainly on education and social benefits).

Without an in-depth spending review, it will be difficult to meet your proposed cap on growth. The indications –commitments with real readjustments of the minimum wage and the remuneration of civil servants in the coming years, since the administrative reform is out of the picture– go in the opposite direction. Expenditure on education and health will grow at the same rate as net current revenue (rule prior to the expenditure ceiling). As if that were not enough, having 92% of mandatory spending and high budgetary rigidity, linking the growth of total expenses to a proportion of revenue will result in an increase in mandatory and discretionary spending in good times, which are unlikely to be reduced when they need to grow respecting the proposed lower limit (actual growth of 0.6%).

There is ample empirical evidence pointing out that adjustments based on expenditure reduction are the least likely to be reversed and are most likely to promote a permanent reduction in the debt-to-GDP ratio. Furthermore, they are associated with smaller downturns than those based on tax increases. In some cases, they even become expansionist when they include pro-growth policies, such as labor market liberalization and trade opening, based on a strong positive reaction from private investment.

The economic literature also points out that the gradualist choice can be successful depending on its political support base and the government’s credibility in pointing out measures for the adjustment to be finalized over time. Newly elected governments are more likely to support this strategy, but communication must be transparent and there must be strong participation from society. Public debate is critical to finding the right balance in the policy mix and overcoming headwinds that can delay the necessary adjustment.

In this regard, given the tax reform agenda set as a priority by the current government –aimed at improving the efficiency of our system and bringing productivity gains–, it seems to be counterproductive to anticipate collection measures that could be better designed within the reform itself. Not every “jabuti”, such as the differentiated taxation of closed-end funds, can be seen as a measure that merely “closes loopholes”. Many of these funds have illiquid assets, are investment instruments in the real economy and must pay taxes, but on a more staggered basis.

The taxation on the import of consumer goods should be included in the VAT reform, as well as the impasse on the tax benefits granted by the States to companies composing or not the calculation basis of the IRPJ and CSLL. It is expected that the taxation of dividends will be discussed in depth with society, given its relevant impacts on the organization of companies, not seen as a mere “jabuti”.

The spending ceiling gave transparency to the country’s immense fiscal challenge: discussing how to allocate resources efficiently while respecting a budget constraint. The new framework makes this restriction more flexible by increasing the tax burden, which may allow the postponement of essential reforms for greater growth and job creation. Sooner or later, spending reform will have to be part of this new framework.

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