Fiscal Discipline and Subnational Borrowing: the Case Study of Brazil

Posted by Mario Pessoa

Decentralization of borrowing authority to local government and fiscal sustainability are two issues in permanent tension in public financial management. On the one hand, it is positive to give local authorities room for raising financial resources in order to finance investment and provision of goods and services to local communities. On the other hand, the lack of institutional capacity, history of defaults, and lack of controls pose to the central government an argument to restrict autonomy. In other words, there is a fear that decentralization can weaken fiscal discipline. Therefore, is it possible to built a safe net in order to prevent problems? Can both objectives be met?

A recent article by C.R. Martell entitled "Fiscal Institutions of Brazilian Municipal Borrowing" (Public Administration and Development 28, 30-41; 2008) examines the effectiveness of Brazilian fiscal institutions (constitution, fiscal responsibility law, and borrowing arrangements) in light of 2001 policy recommendations for strengthening efficiency and fiscal discipline in subnational borrowing by means of fiscal policies that encourage efficiency, discipline, and controls.

In a 2001 article "Fiscal decentralization and borrowing costs: the case of local governments" (Public Finance Review 29(2): 108-138; 2001), De Mello argues that fiscal decentralization should not only prevent fiscal disarray at the local level, but should also preserve central government finances from fiscal imbalances at the local government level. His conclusions is that subnational borrowing costs are greater when local government have a greater reliance on grants and transfers from the central government. To improve this situation he recommends three set of policies:

1. spending and revenues should be aligned at the local level;
2. local government fiscal management should be encourage through the use of stringent constraints on local government indebtedness via fiscal institutions and markets; and
3. the form of decentralized arrangements should be carefully designed (for example, revenue sharing arrangement should encourage local revenue mobilization, institutional arrangements should foster fiscal discipline, and earmarked transfers should be avoided).

Institutional fiscal arrangements in Brazil have favored revenue decentralization after the 1988 constitutional reform (local government revenues has increased from 37 to 45 percent for the states and from 18 to 21 percent for the municipalities).  Greater authority has also been given to local governments to collect taxes. In relation to expenditure, the constitution was less clear, despite implicitly devolving more responsibilities in terms of provision of education and health services to the local governments. Revenue transferred from the central government is highly earmarked, reducing local budget allocationflexibility.

The 2000 fiscal responsibility law, due to a history of accumulation of arrears and poor controls at local level and past bailouts by the central government of local debt, imposed:

1. restrictions in terms of issuing of sovereign bonds by the local authorities,
2. limits on personnel expenditure
3. obligation to produce and publish periodic fiscal reports,
4. sanctions to authorities and governments that do not observe the fiscal law, and
5. other constraints to foster fiscal discipline.

It has also imposed banking sector restrictions on lending money to local governments, limiting significantly their access to the capital market.

Martell found that the Brazilian institution arrangements for municipal borrowing achieve some of de Mello’s recommendations, but some practices and values diverge. The values advocated by de Mello are efficiency, discipline, and controls, however, the values promoted by the actual institutions in Brazil are administrative feasibility, equity, fiscal discipline, rule-based control, protection from political intervention, certainty and some constructs of efficiency.

Finally, one of the main conclusions is that while the constraints imposed by the fiscal arrangements have been very effective at controlling expenditures, the encouragement of long-term discipline is limited to rule-based, not market-based, control. The current institutions penalize fiscal discipline offenders, but do not reward performers. She recommends a reform in the fiscal law in order to leverage fiscal management to reward successful performance by establishing policies that enable local governments access to a broader tax base, greater discretion at setting tax rates, and more extensive borrowing options.