Otaviano Canuto talks about fixing the Brazilian economy

How to Fix Brazil’s Economy

Brazil is approaching its most consequential election since the end of military rule more than three decades ago. But while the country’s politics are plagued by dysfunction, the election’s outcome will hinge on the next government’s economic reform agenda.

One of Brazil’s most serious economic challenges is anemic productivity growth, which has been undermining the country’s growth potential. With output per employee increasing by just 0.7% per year, on average, since the mid-1990s, more than half of per capita income growth over the last two decades has resulted from an increase in the share of the economically active population. But that engine of income growth will soon stall, owing to rapid population aging.

Weak productivity growth partly reflects a lack of trade openness, which limits Brazilian firms’ access to foreign inputs and technologies, as well as barriers to effective domestic competition. Moreover, weak logistics infrastructure, differentiated state tax regimes, and subsidies to specific firms enable less efficient companies to survive and retain resources, lowering average productivity.

Private sector strengthening

To address this, policymakers must support the private sector by strengthening the adoption and diffusion of advanced technologies, rather than by offering compensation for high internal costs. Moreover, the business environment should be made more favorable for entrepreneurs, including through reform of the complex and imbalanced tax system.

Increased infrastructure investment is also needed, as is reform of financial intermediation, so that financing terms are better aligned with investment projects. And the quality of education and the formation of human capital could benefit from less rigid allocation of public resources and more experience-sharing among states and municipalities, some of which have made progress using measures that could be applied elsewhere.

Brazil also needs significant fiscal adjustment. Even as productivity and economic-growth potential have increased at a snail’s pace, real (inflation-adjusted) public spending has risen sharply. Public expenditure increased from less than 30% of GDP in the 1980s to about 40% in 2017, including 68% growth from 2006 to 2017. And yet public investment (including in infrastructure) has declined, amounting to less than 0.7% of GDP last year.

With tax revenues affected by the decline in GDP in 2015-2016 and the subsequent fragile macroeconomic recovery, the primary budget balance, relative to GDP, deteriorated by more than four percentage points. This caused public debt to rise from 54% of GDP in 2012 to 74% in 2017.

Curbing public spending

To address skyrocketing debt, in 2016, Brazil approved a constitutional amendment imposing a ceiling on public spending for the next 20 years. If the authorities manage to adhere to this rule – or combine spending cuts with tax revenues to obtain an improvement of 0.6% of GDP per year in the public-sector primary balance – the trajectory of public debt could become sustainable again within a decade. The key to success, of course, will be smart spending cuts.

The World Bank, where I am an executive director, has already identified areas where such cuts can be made: social security, public-sector payrolls, and subsidies and tax exemptions. By easing the strain on the public budget, spending cuts in these areas could even create space for other, more productive types of public expenditure.

Crucially, such cuts would have only minimal consequences for poorer Brazilians. In fact, when it comes to tax reform, there are steps that could not only contribute to improving the business environment, but also help to reduce the social inequities embedded in the current system.

In the quest to improve productivity and achieve fiscal rebalancing, Brazil’s leaders must also reform public-sector governance. As it stands, the provision of public services in a wide range of areas – including health, education, violence, infrastructure, transportation and logistics, and the management of water resources – is highly inefficient.

The reasons are wide-ranging. Brazil suffers from an excess of rules, which contribute to budget rigidity; fragmentation of service delivery; poor planning, monitoring, and evaluation of projects and policies; a lack of positive performance incentives for public-sector workers; the judicialization of policymaking; and an increasingly risk-averse bureaucracy.

Brazil thus needs to improve policy consistency, from planning through execution of programs and projects, and focus more on monitoring and evaluating results. Better coordination between the public and private sectors would also improve the capacity of public expenditure to contribute more to improving socioeconomic outcomes.

Brazil’s future hinges on the implementation of smart, gradual, and coherent economic reforms that facilitate productivity growth and put the country on the path toward fiscal sustainability. Whoever wins the upcoming election has a responsibility to address that imperative.

Otaviano Canuto is an executive director at the World Bank.

Copyright: Project Syndicate, 2018.