Tax framework: learn how to interpret the new rule – 01/04/2023 – Ana Paula Vescovi

The Ministries of Finance and Planning released the general lines of the proposal for a new fiscal rule, to be sent to Congress in the coming weeks. The immediate reaction of the markets was positive: the yield curve yielded around 0.2 percentage points, the Stock Exchange rose by almost 2%, and the exchange rate appreciated.

Some choices became more apparent in the form of fiscal adjustment to be handled by the government. It will be more dependent on the search for new sources of income, more gradual, more flexible and less predictable.

The most complete scenario with economic parameters must be disclosed with the fiscal law project or in the scope of the PLDO (Budget Guidelines Law Project). So far, with the set of data we have available, there are difficulties in building the bridge between the component elements of the fiscal rule and the commitment to the primary result targets, including the tolerance bands.
Let’s go to the comments, by parts.

First, the rule indicates a band for real primary expenditure growth of between 0.6% and 2.5% per year. In other words, it is a much more flexible rule than the spending ceiling, which dictated stability in real primary spending. In this case, there is no reading of the induction of structural reforms in Brazilian public spending, which is extremely rigid, nor the need to make choices in the face of tighter fiscal space.

To give you an idea, social security expenses
—which represent 44% of total primary expenditures, after the reform—tend to grow at around 2.5% a year above inflation. Health and education expenses will start to grow at the same rate as net current revenues, with the return of the proportional criterion in force before the ceiling (health expenses correspond to 15% of net current revenues, and education expenses to 18%). In this case, we expect a one-off increase of BRL 30 billion in the health budget, which today is below the amount in force in the previous rule.

The same happens with parliamentary amendments. This set represents 35% of current revenues. Fundeb, the new nursing floor and part of the precatories will remain outside the expense limitation, the latter item accumulating unpaid balances.

Proposals for the gradual recovery of real values ​​of the minimum wage and real wages of civil servants, in turn, should put pressure on expenses with personnel payroll, pensions and retirement benefits, and social assistance benefits. Here we are talking about a universe of 70% of total primary expenditure.

On the side of discretionary expenses, which are budgeted at 9% of the total, there has already been a substantial increase in the base in 2023, which may facilitate the execution of minimum public investment commitments. But here, again, we still don’t have numbers to elucidate the size of the commitment.

Thus, the task of fulfilling the limit of 2.5% of real growth will not be so trivial in view of commitments already assumed. And there is yet another limit to be met: the expenditure within a year, even within the range, cannot exceed 70% of the change in primary recurring net revenue in the last 12 months.

Therefore, even if linked expenditures such as health, education and parliamentary amendments grow as a proportion of current revenue and other mandatory expenditures have their own dynamics, total primary expenditures should grow less. That is: there is a commitment to allocate 30% of the increase in revenue to debt reduction.

However, despite the difficult containment of expenditure growth, commitments to targets for the primary result as a proportion of GDP (deficit of -0.5% in 2023, 0% in 2024, surplus of 0.5% in 2025 and 1% in 2026) are extremely bold, even with tolerance bands of 0.25 percentage points.

Starting from the deficit of 1% of GDP estimated in the most recent bimonthly evaluation report of the National Treasury, this would be a fiscal adjustment of around 2% of GDP, similar to that carried out during the validity of the expenditure ceiling regime. The size of the effort surprised market agents and was probably something that caused the optimism portrayed in the improvement in asset prices.

For the expenditure rule to lead to such results, it will be necessary to grow revenues far beyond what is indicated by the statistical models that relate them to GDP. Especially if we consider that the economy will undergo a contractionary cycle between 2023 and 2024, growing most likely below potential GDP.

In addition, there is a forecast for a drop in the extraordinary level of income from dividends and asset sales. Thus, it is understood that the government will have to look for new sources of permanent income between 1.2% and 2.3% of GDP to meet the stipulated result targets. This would be something close to twice the total gross income, since about half is shared with subnational entities and funds.

If, due to the aforementioned restrictions, the targets are not met, the punishment will be to reduce the expenditure forecast for the following year to 50% of the previous year’s revenue growth. But, in our view, there is still no rule that prevents the non-compliance from being repeated, triggering the same penalty and, possibly, new non-compliance. And so on.

On the other hand, if the primary result exceeds the ceiling of the band, then the surplus can be used for capital expenditures.

Using the government’s own economic parameters, we calculate that the average primary expenditure growth between 2024 and 2027 tends to be around 2.2% per year. Values ​​that tend not to stabilize expenditure as a proportion of GDP in this period. Which once again reinforces the hypothesis of a necessary and relevant increase in revenues so that the primary result targets are met.

If this increase in revenues does not occur, given that this is a factor over which the government has no control, then we will see public debt growing persistently and outside of a stabilization trajectory. This becomes a key element for achieving the goals, and without a credible solution to this equation, the optimism of the markets may not be sustained.