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November 02, 2007

Increasing Fiscal Transparency -- Brazil's Budgetary Fiscal Risk Report

Posted by Mario Pessoa

Brazil As public financial management (PFM) systems develop and become more complex, the need to identify, quantify, and manage various public finance risks expands. As the need expands, the capacity and instruments to do so expand as well. Brazil's PFM system advanced considerably with the adoption of its Fiscal Responsibility Law (FRL) in 2000, and it has further advanced transparency by publishing a "Budgetary Fiscal Risk" report (BFR) as one of many annexes to its annual budget.

First published in 2002, the BFR report (available here in Portuguese under “Anexo V. Anexo de Riscos Fiscais”) is a requirement of the FRL, which states that 'the federal government must prepare an annual report demonstrating the budget’s main contingent assets and liabilities and their associated risks.' In addition to the annual report, the Brazilian Ministry of Finance must prepare a quarterly report showing the current position of the fiscal risks and present it in the legislature in a public hearing.

Rationale and Concepts

Annual budget are based on estimates of economic performance, which influences the levels of revenues and expenditures. Therefore, the budget is subject to economic uncertainties that are generally referred to as fiscal risks.

The BRL defines two kinds of budgetary risks: (1) overestimation of revenues and (2) underestimation of expenditure. Both are covered in the annual report, which serves as an early warning to the legislature by identifying potential risks and necessary actions if actual economic or fiscal performance differs from projections.

To maintain fiscal balance, the government will reduce the amounts of expenditure in some programs, reallocate authorizations, or use the contingent budget allocation to accommodate the financial restrictions. As a consequence, it is important to understand that these risks represent a threat to achieving the overall fiscal target. Therefore, the fiscal report should evaluate the risks to the fiscal policy by simulating scenarios to demonstrate what the financial consequences would be. 

The BFR includes sections devoted to the various types of risk, including:

Public debt risks -- risks associated with debt service, related to interest and exchange rate fluctuations, and inflation. The impact varies depending on the composition of the public debt (e.g. bonds remunerated by fixed rates, inflation, or exchange rate).  Bond maturity and the level of market confidence (expectations) in the economic policies can also influence the estimates.

The government evaluates the consequences for fiscal policy by simulating various scenarios to demonstrate the impact, calculating what is the increase in expenditure resulting from each one percent of increase in the relevant economic variable. For example, how much the debt will increase for every one percent of increase in inflation or for every one percent of increase in the exchange rate. These simulations can estimate the level of sensitivity of the debt in relation to each economic indicator.

Revenue projection risks -- risk of over-estimation of revenues. According to the Ministry of Finance, the most important macroeconomic indicators influencing tax projections are economic growth, inflation, exchange rate, and interest rate. However, the level of variation depends on the characteristics of the tax. For example, income tax and consumption tax are usually more sensitive to changes in inflation; on the other hand, import tax and VAT are more sensitive to variations in exchange rate.

One method used for measuring impact is to calculate the percentage of decrease in revenue for each percentage of decrease in the relevant economic variable. For example, for every one percent of decrease in inflation, the decrease in revenues related to income tax is estimated; for every one percent of increase in the exchange rate, the decrease in revenues related to import taxes is estimated. These estimates can give a measure of the sensitivity of each kind of tax to each economic indicator.

Expenditure projection risk -- increases in expenditure are associated with the introduction by the legislature of new programs and projects during the budget execution period, or approval of new legislation that results in more expenditure. In particular, legislature is usually sensitive to increasing social benefits such as minimum wage and unemployment benefits, particularly in election periods.

Other sources of risk include granting higher-than-projected wage increases to civil servants, an increase in the gap between private-sector salaries and those in the public sector (leading to pressure to increase wages), an increase in the inflation rate, and internal demand to hire more personnel than initially authorized in the budget.

The calculation method is used to demonstrate how much expenditure will increase for each percentage of increase in the relevant variable. For example, for every one percent of increase in the minimum wage, how much will social benefits increase; for every one percent of increase in the unemployment rate, how much will expenditures on paying the unemployment benefit increase. These simulations can give an idea of the expenditure’s level of sensitivity to each economic indicator.

Contingent Liability Risk -- the risk to public finances (revenues or expenditures) should certain discrete conditions be met. The BFR identifies the main sources of contingent liability:

  • judicial proceedings against the government motivated by controversies over legal provisions regarding price controls of good and services, the use of an economic index to correct the values of long-term contracts, and other situations involving fiscal measures during implementation of economic stabilization plans;
  • judicial proceedings against public enterprises that are financed by the budget, usually related to arrears, judicial proceedings brought by suppliers of goods and services, and employees demanding labor and social security benefits;
  • judicial proceedings related to privatization, concessions, and liquidation of public entities brought by suppliers of goods and services, participants in the bidding process, and employees demanding labor and social security benefits;
  • other liabilities under the responsibility of the Treasury, such as arrears or guarantees;
    judicial proceedings against the Central Bank related to the liquidation of financial and credit institutions; and
  • judicial proceedings brought by taxpayers who do not agree with the amounts charged in relation to taxes, fees, fines, and other tax obligations.

Central Bank Liabilities -- The Fiscal Responsibility Law requires losses from Central Bank operations to be covered by the Treasury. Because the operations of liquidation of financial institutions (public or private) can represent important losses, the Central Bank has to estimate the contingent liabilities of these operations. Because the Central Bank has to make a provision in its financial statement, only those amounts that can represent a loss but are not provisioned are considered to be contingent (The Central Bank has provisions only for contracts with more than a 50 percent chance of non-performance).

Contingent Assets -- As a complement to the contingent liabilities, the government also estimates the values of potential rights and future revenues, particularly in relation to pending judicial proceedings. Because the success of judicial proceedings is uncertain, these amounts are not included in the budget, but can represent an additional source of resources during the year. The main types of contingent assets are: judicial proceedings over taxes and contributions not paid, and financial credit that has not been honored and has already been written off as a loss. Contingent assets do not represent a fiscal risk because they can only increase revenues, so fiscal balance can only be positively affected.

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