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Federal Republic
of Brazil
fernando rezende
The Federal Republic of Brazil covers 8.5 million square kilometres –
about half the total area of South America. Its 184 million inhabitants
are unequally dispersed among twenty-six states and the federal district,
or 5,558 municipalities (see Table 1 for basic data). Most of the population
is located in the six southern states, where the demographic density
reaches sixty inhabitants per square kilometre. Although the centre-west
and the Amazon regions represent more than 60 percent of the territory,
they account for only 15 percent of the population. Population density is
also high in the nine poor northeast states on the coast, where nearly
18 percent of the population resides within a perimeter of 1.5 million
square kilometres
Africans brought in during the slavery era and a large inflow of migrants
from every corner of the world, especially in the late nineteenth and early
twentieth centuries, contributed to the multiple faces that characterize
Brazil’s population nowadays. Despite this, intermarriage and cultural
assimilation has produced a quite homogeneous society. Everyone speaks
Portuguese, the official language, and cultural values do not differ to a
significant extent.
The demographic concentration mirrors the concentration of economic
activity. The six southern states account jointly for three-fourths of
the gross domestic product (gdp), which reached about us$800 billion
in 2005 (1,580 billion in purchasing power parity dollars), placing Brazil
among the leading countries in the world in terms of economic size. The
country’s modern agribusiness and growing modern service economy
contribute to a better balanced composition of domestic output. Recent
data (2004) point to an economic structure akin to those of modern
industrial countries, with the dominance of services (about half of gdp)
and a sizable manufacturing sector (about one-fourth of gdp). A still
Federal Republic of Brazil 75
important agriculture sector (10 percent of gdp) reflects the recent expansion
of highly productive farms that emerged from the incorporation
of modern technologies into rural areas.
From a regional standpoint, due to a bias in regional representation in the
National Parliament in favour of the less developed north, northeast, and
centre-west regions, economic size does not translate directly into political influence
on national policies. These regions have sparsely populated states,
which are entitled to a minimum of eight representatives in the Lower
House, while the highly populated states in the south have a maximum of seventy
representatives. Thus, the less populous states exert a strong influence
on decision making pertaining to issues related to fiscal and intergovernmental
relations.1 The political imbalance in the representation of the states in the
Lower House is reinforced by the equal representation in the Federal Senate
(three per state). Although this is a common federal feature, the extended
role of the Senate in the Brazilian Federation – all legislation, not only that directly
related to federal issues, has to pass through both legislative houses before
being sanctioned by the president – creates additional difficulties.2
Imbalances in political representation result from the dominance of the
regional issue in the formation and consolidation of the Brazilian Federation.
The federal regime put into place by the first republican Constitution
in 1891 empowered the states with a substantial degree of autonomy and
sowed the seeds for the autonomy of local government. Since then, subnational
autonomy and regional balance have become intertwined issues,
and a proper balance between them has been seen as essential in maintaining
internal cohesion in an economically and socially unequal society.3
Table 1
Basic information
Official name: Federative Republic of Brazil
Population: 184 million inhabitants
Area (square kilometres): 8.5 million square kilometres
gdp per capita in us: $ 4,323 (2005)
Constitution: 1988, Republican
Orders of government: Three
Constitutional status of local government: independent units of the federation
Official language: Portuguese
Number and types of constituent units: 26 states, the Federal District,
and 5,558 municipalities
Population, area, and per capita gdp in us$ of the largest constituent unit:
São Paulo – 38.7 million inhabitants; 248,200 square kilometres; gdp pc = us$4,163
Population, area, and per capita gdp in us$ of the smallest constituent unit:
Roraima – 357,300 inhabitants; 224,300 square kilometres; gdp pc = us$1,529
76 Fernando Rezende
Inequality is, therefore, one of the main features of the country. Parts of
the south and the southeast – particularly the state of São Paulo – present
indicators of economic development akin to those of modern industrial
countries: a high level of per capita income, a high degree of urbanization,
diversification in industrial production, and satisfactory social conditions.
At the same time, large portions of the country – especially in the north
and northeast – still show the classic signs of underdevelopment: low per
capita income, poor sanitary conditions, and widespread poverty. It is
worth noting, however, that the incidence of poverty is not associated with
regional imbalances in economic development. This is because the developed
regions have attracted and retained a large number of people below
the poverty line.
With the exception of intermittent periods of authoritarian rule, democracy
evolved over time and achieved high standards after the mid-1980s. A
multi-party system allows for a fairly diversified composition with respect to
the distribution of political power in the federation. Despite this, governability
is achieved by means of coalitions that, in national politics, contribute
to increasing the weight of small political parties beyond what is
indicated by their actual size. The practice of forming coalitions has contributed
to the stability of the Brazilian democracy, which recently passed
two important tests: (1) the impeachment of the president who was elected
in 1989 and (2) the 2003 hand-over of the federal government to the first
leftist president to be elected in the entire republican period.
A stable democratic regime and sound institutional arrangements have
contributed to helping the Brazilian economy muddle through the turbulence
generated by the sequence of external financial crises that have
hit emerging economies worldwide since the mid-1990s. Yet the macroeconomic
policies the country adopted to attenuate the impact of this
turbulence severely hampered economic growth, which showed a meager
2.4 percent annual average rate of increase between 1995 and 2004.
These policies also impinged upon the subnational autonomy envisaged
by the 1988 Constitution.
Being a creature of the transition from authoritarianism to democracy,
the 1988 Constitution reacted to two strong forces: (1) the demand for
greater autonomy for subnational governments and (2) calls from organized
pressure groups for more and better access to state-sponsored social
protection. In so doing, it installed a dual fiscal regime. On one hand, the
states and municipalities acquired greater power to tax and a greater share
of traditional federal revenues; on the other hand, a distinct set of compulsory
levies – the so-called social contributions – was assigned to the federal
government to finance pensions and free access to health care and social
services for every Brazilian citizen regardless of previous contribution to
Federal Republic of Brazil 77
the social security system. Because the extended social rights depended on
the federal government’s ability to raise enough money to meet a steep
rise in social spending, in addition to large surpluses in the public accounts
to keep inflation at bay, recourse to social contributions fed a process that
reversed the fiscal decentralization intended by the 1988 Constitution.
Over time, equality, autonomy, efficiency, and growth objectives collided.
Increasing reliance on federally collected social contributions eroded subnational
autonomy. It also worked against promoting efficiency and accountability
in public policies through decentralization as earmarked grants from
the federal government, supported by revenues from such contributions, became
necessary to finance the provision of social services by state and local
governments. At the same time, vertical and horizontal imbalances increased
in so far as the basis of equalization funds lost importance over time. In addition,
inefficient social contributions created further obstacles to economic
growth. Therefore, an overhaul of the Brazilian fiscal federalism system is
desperately needed.
structure of government and d i v ision
of f i s c a l powers
Brazil is a three-tier federation. According to the 1988 Constitution,
states and municipalities are independent units of the Brazilian Federation.
Both have independent taxing powers and share with the federal
government responsibilities for public services and development policies.
A growing direct relationship between the federal and local governments
is a source of intergovernmental conflicts and increasing complexity in
fiscal relations.
The formal assignment of expenditure responsibilities follows the subsidiary
principle. Thus, the Constitution assigns the provision of basic urban
and social services (urban roads, water supply and sewerage, public transportation,
streetlights, primary education, and basic health and social assistance
services) primarily to local governments. These local governments count on
technical and financial assistance from the federal and state governments to
carry out these responsibilities (see Table 2). Following the usual pattern,
the federal government is solely responsible for the armed forces, foreign
relations, international trade, and monetary control.4
In practice, however, due to high economic and social inequalities, most
of the responsibilities are shared in the federation. Responsibility for law
and order is mainly in the states’ hands, but organized crime, drug trafficking,
weapons smuggling, money laundering, and other illegal activities are
in the federal jurisdiction. In the social area, with the exception of social
protection for private-sector workers (pensions and related benefits),
78 Fernando Rezende
which is the sole responsibility of the federal government, provision of
basic education, health care, and other social services is split among states
and local governments on a more or less equal basis (see Table 3). The
federal government intervenes directly in higher education and in more
sophisticated health services.
The absence of a clear definition of the functions to be performed by
each order of government is a major source of continuing conflicts. On the
tax side, conflicts come up whenever measures adopted by the federal government
reduce revenues from the income and manufacturing taxes that
form the basis of the present revenue-sharing system. Conflicts also arise
when federally sponsored legislation interferes with subnational tax autonomy,
for example by granting exemptions from the state value-added tax
(vat) for exports. In such cases, demand for financial compensation becomes
a permanent focus of conflict because the compensation has to be
negotiated annually during the regular budgetary process. On the expenditure
side, changes in rules governing federal financial aid to social programs
carried out by the subnational governments are also a source of
intermittent conflict.
Table 2
Legislative responsibility and actual provision of services by different orders of government
Legislative responsibility
(de jure) Public service
Actual allocation of function
(de facto)
Federal Defence Federal
Federal/state Law & order Federal/state
Federal/state Basic Education State/local
Federal/state Higher education Federal/state
Federal Health State/local
Federal Social assistance Local
Local Water and sewerage State/local
State Police State
Federal Environmental protection Federal/state
Local Street cleaning and lighting Local
Local Public transportation Local
Local Urban infrastructure Local
Local Waste collection Local
State Fire Protection State
Federal Republic of Brazil 79
Table 3
Direct expenditures by function and level of government (percent)
Function Federal (%) State (%) Municipal (%) Total (%) % of gdp
Defence 99.8 – 0.2 100.0 0.9
Debt servicing 85.4 12.0 2.6 100.0 10.4
General administration 46.1 28.9 25.0 100.0 5.3
Law and order 26.2 71.5 2.4 100.0 3.2
Economic services1 53.7 33.9 12.4 100.0 3.3
Social services 51.9 25.3 22.8 100.0 23.6
Health 26.5 33.6 39.8 100.0 3.8
Education 15.6 49.8 34.6 100.0 5.3
Old age 85.5 11.3 3.3 100.0 10.7
Other social services 32.6 22.6 44.8 100.0 3.7
Subsidies2 … … … … …
Total 58.0 26.1 15.9 100.0 46.7
Local Public Services 13.6 43.3 43.0 100.0 10.1
Primary and secondary
education3
1.7 43.5 54.9 100.0 3.2
Health 26.5 33.6 39.8 100.0 3.8
Housing and community
amenities4
3.9 14.3 81.9 100.0 1.2
Environmental protection5 14.6 42.8 42.5 100.0 0.3
Police services 10.1 87.1 2.8 100.0 1.6
Notes
The functional classification of expense basically follows the imf/gfs 2001 methodology.
1. Includes general economic and commercial affairs, agriculture, forestry, fishing and hunting, fuel and
energy, transport, communications, R&D, and economic affairs.
2. Amounts related to subsidies are not broken down.
3. Amounts were estimated to exclude outlays other than for primary and preschool and secondary
education.
4. Includes housing development, expenditures related to urbanism – street paving and lighting, waste
collection, traffic and other urban services.
5. Includes waste water management, water supply, and sewerage.
80 Fernando Rezende
Conflicts among the states and their municipalities are also noteworthy.
The 1988 Constitution granted state legislators the authority to set the criteria
for dividing one-fourth of the proceedings of the state vat that belongs
to the municipalities. Quite often, such changes prove contentious
because they may be seen to favour political allies or to create losses for
some municipalities.
A council of the states’ finance ministers was created in the 1970s and
was the sole attempt to provide an institution that would be in charge of
mediating conflicts. The federal finance minister presided over the council,
which worked properly during the authoritarian regimes for obvious
reasons. After redemocratization, the federal government could no longer
impose rules that had to be obeyed by all, and the council, albeit still formally
in existence, was deprived of any power to harmonize states’ tax policies.
The council lost credibility and became unable to enforce legislation
prohibiting special tax concessions by any state without the unanimous approval
of all twenty-six states and the federal district.
A long tradition of applying symmetric arrangements to asymmetric situations
makes it difficult to avoid conflicts or to find proper solutions. In the
fairly heterogeneous Brazilian Federation, symmetric arrangements cannot
lead to a proper equilibrium among subnational government units.
Symmetry is reflected in equal powers being granted by the Constitution to
every state or municipality whatever its size, region, and economic and social
characteristics. Well-developed industrialized states and frontier states
have to abide by the same rules with regard to administrative organization,
tax powers, and expenditure responsibilities. The same goes for large metropolitan
cities and small rural municipalities, where differences are even
greater. Both have similar organizational structures, a directly elected legislative
body, and direct access to federal funds.
Although subnational governments enjoy a great degree of constitutional
autonomy, the amplitude of the legislative power of the federal
government, in fiscal and regulatory matters, has curtailed the decisionmaking
power of the former. By means of complementary laws to the Constitution,
the federal government defines the framework within which
states and local governments can set norms for imposing and collecting
their own taxes. Federal legislation also establishes detailed provisions concerning
the elaboration and execution of subnational budgets. With regard
to regulation, the detailed rules of the federal laws leave almost no
room for the states in areas such as public utilities, environmental protection,
and the exploration and exploitation of natural resources.
In fact, local governments have more autonomy than do the states in so
far as the former are entitled to regulate the use of municipal land and
the provision of urban services, impose user charges, and define norms
for collecting property taxes. In general, local governments also have a
Federal Republic of Brazil 81
reasonable degree of autonomy over their budget because, on average,
about 40 percent of their revenues come from general-purpose grants.
Through earmarked grants and control of the subnational debt, the federal
government has increased its influence on subnational policies. Coupled
with hard budgetary constraints that were put in place to sustain
macroeconomic stability, the degree of freedom of state governors to allocate
budgetary resources has been curtailed significantly. The situation is
somewhat better at the local level, the large metropolitan cities aside, because
the criteria applied to divide the municipal share of federal taxes is
biased towards smaller municipalities and penalizes the states’ capital cities.
The state capitals generate one-third of gdp and house one-fourth of
the population but get only 10 percent of this pie.
Conversely, subnational governments can interfere in national policies
only by means of their representatives’ actions in the national Congress.
That happens when proposals for federal regulation on the use of natural
resources, the provision of public services, or the exercise of tax powers by
state and local governments affect state and local government interests.
However, due to the fragmentation of political parties and the nature of
the electoral process, representatives from the states in the Lower House
and the Senate do not always act in accordance with the wishes of state governors,
weakening subnational influence on national politics.
f i s c al federalism
and macroeconomic management
The success of a monetary stabilization plan adopted in 1994 to close an
era of high inflation had important consequences for federal finance. For
decades, inflation made it easy to curb budgetary deficits as tax revenues
were fully indexed and most expenditure items were not. Thus, through
postponing payments and adjusting nominal salaries and pensions only
once a year, fiscal disequilibria were easily corrected.
A stable currency brought structural imbalances to light. Expenditure
on personnel and social security benefits showed the real effect of a paternalistic
approach to past policies concerning employment and pensions
across the federation. At the same time, a tight monetary policy to protect
the Brazilian economy from external shocks raised the amount of money
required to service the public debt.
In the beginning of this new era, price stability was anchored to the overvaluation
of the new currency – the real. But the successive external financial
crises that hit emerging economies in the second half of the 1990s –
Mexico (1995), Southeast Asia (1997), and Russia (1998) – forced the
Brazilian government to abandon its policy to control the exchange rate
in 1999 and, instead, to let the national currency float. Thus, monetary
82 Fernando Rezende
stability came to depend on responsible management of the fiscal accounts,
and fiscal discipline took the place of the exchange rate as the
anchor for averting inflation.
The new inflation targeting regime, adopted in 2000, relies on properly
functioning monetary and fiscal policies. The National Monetary Council
formed by the finance and planning ministers and the president of the
Central Bank not only set targets for the inflation rate for two years in a
row but also set the interval within which the actual result could differ
from the desired outcome. The Central Bank is in charge of bringing inflation
as close to the mark as possible, making use of the interest rate to adjust
expectations and force convergence towards the target. To that end,
the Central Bank has enjoyed a fairly large degree of autonomy, although
it does not have formal independence from the national government.
In the fairly decentralized Brazilian Federation, the enforcement of fiscal
discipline required important institutional changes. The Fiscal Responsibility
Law (frl), inspired by the highly praised New Zealand experience,
was enacted in 2000. This law enforces fiscal discipline at the federal, state,
and local government levels through the imposition of objective and clear
rules for administering revenue and expenditure policies, the public debt,
and government assets. It emphasizes transparency in the public administrator’s
use of the resources extracted from taxation. Among the norms set
by the frl, the following are worth noting:
1 Limits on spending for personnel. Remuneration of public employees
shall not exceed 50 percent of net current revenues at the federal level
and 60 percent at the subnational level.
2 Indebtedness limits. Outstanding debts cannot exceed two times current
revenues for the states and 1.2 times for local governments. With regard
to debt service, annual payments cannot surpass 11.5 percent of current
revenues in both cases. In addition, resources from new loans cannot
exceed 16 percent of current revenues in any fiscal year.
3 Provision for recurrent expenditures. Public authorities cannot take
actions that create future expenses lasting more than two years without
identifying a source of financing or a compensating cut in other
expenses.
4 Special provision for electoral years. The law prohibits outgoing governors
and mayors (in their last year in office) from using tax revenues to
provide short-term loans, increase wages, or contract new public servants.
Failure to fulfill obligations imposed by the frl leads to several administrative
penalties, to which personal incriminations included in an additional
law may be added. More serious misbehaviours may be punished
with the loss of the mandate, ineligibility for employment in the public
Federal Republic of Brazil 83
service, fines, and imprisonment. It is worth emphasizing that all levels of
government, federal included, have to abide by the conditions established
in the frl.
To make it possible for states and large municipalities to adhere to the
new rules concerning the public debt, previous debts with the federal government
were refinanced on favourable terms for a period of thirty-five
years. However, unlike previous bailouts, the beneficiaries of such renegotiations
were prohibited from issuing new bonds and were required to
transfer between 11 percent and 13 percent of their current revenues to
the federal treasury on a monthly basis for the duration of these contracts.
Together with limits set by the Central Bank on the exposure of public and
private banks to public clients, control over subnational government indebtedness
was duly enforced. To ensure enforcement, debt-refinancing
contracts entitled the federal government to sequester state and local government
revenues from federal transfers in the case of failure to comply
with the agreed-upon rules.
The hard budgetary constraints put into place by the Fiscal Responsibility
Law brought control to public finance. Since its inception, the public
sector as a whole has saved a sizable amount of money and reversed the ascending
trajectory of the total public-sector debt-to-gdp ratio. The primary
surplus – that is, the balance between total revenues and non-financial expenditures
– rose steadily between 1999 and 2005, with states and local
governments contributing approximately one-tenth of the overall result.
Thus, after having reached 7.5 percent of gdp in 1998, the public-sector
debt ratio dropped to 2.7 percent in 2004 despite a tight monetary policy
that sustained high interest rates.
Conditions built into subnational government debt contracts became a
good substitute for macroeconomic fiscal coordination. The revenue sequestration
mechanisms adopted, as well as the forced privatization of
state-owned banks, worked as a tool to force fiscal discipline at the subnational
level. Together with the limits set in the frl for personnel spending
and debt financing, previous windows for irresponsible management of
subnational government accounts were duly closed.
As time goes by, incumbent and opposition leaders alike perceive that
the culture of fiscal discipline is an important political asset. Yet, present
concerns point to the consequences of a lengthy period of public spending
restraints on economic growth and income inequality. As public investment
plunged, notably at the federal level, road construction and maintenance
suffered a severe setback, creating an important handicap for
growth in exports of goods. In the social area, difficulties in improving the
quality of education and health services will increase the problems faced by
low-income people in gaining access to better-paid jobs and escaping the
poverty trap.
84 Fernando Rezende
issu e s i n revenue-raising respons i b i l i t ies
The 1988 Constitution is the basis of the current assignment of taxing
powers in the Brazilian Federation (see Table 4). The federal government
is solely responsible for imposing taxes on income (corporate and
personal), foreign trade, and rural property as well as on payroll. The
federal government can also make use of contributions intended to intervene
in the economic domain and of any other potential tax source not
explicitly attributed to the state or local governments by the Constitution
(residual powers).
Federal and state governments have overlapping powers for taxing
goods and services. The former is entitled to taxes on manufacturing
goods and the social contributions earmarked to finance pensions, health,
and social assistance. The states are empowered to levy a vat type of tax on
goods, which is also applied to transportation and telecommunications
services. In addition to taxing general services, local governments are
entitled to tax ownership and sales of urban property and to apply user
charges. An inheritance property tax and a motor vehicle tax are also
under the states’ jurisdiction.
Despite the constitutional separation of tax powers, subnational governments
do not have total autonomy to apply their most important taxes. As
mentioned before, complementary laws to the Constitution set the basic
rules to be followed by states and municipalities with regard to the state
value-added tax (the icms) and the municipal services tax (the iss). These
laws narrow the scope of state and local government legislators with regard
to the definition of the tax basis but do not interfere with rates. Rates of
the states’ vat are only constrained by a constitutional provision that prohibits
internal transactions from being taxed at a rate lower than the smallest
rate applied to interstate sales.
Restrictions imposed on the subnational governments’ ability to implement
their most important taxes do not mean that the tax system is harmonized.
The residual legislative powers of state governments allow for great
differences with regard to the rates applied to each category of goods, ways
to reduce the effective tax burden (reduction in the tax base, for instance),
special regimes for small businesses, criteria adopted for the utilization of
tax credits paid on inputs used to produce exempted export goods, and
preferred tax rates for food and other essential consumption items.
Another source of differences in the tax burden imposed on the same
goods across the federation arose out of demands from less developed
states to apply a reduced rate on goods shipped from the more industrialized
south and southeast states to the north, northeast, and centre-west regions
to allow consumer states to reap part of the revenues from interstate
sales. As a result, a 7 percent rate applies to shipments from the south/
Federal Republic of Brazil 85
Table 4
Tax assignment for various orders of government
F = Federal; S = State; L = Local; R = Regional
Determination
of Shares in revenue (%)
Base Rate
Tax collection
and
administration F S L R1 All orders
Federal
taxes
Import tax – ii F F F 100.0 100.0
Export tax – ie F F F 100.0 100.0
Rural territorial tax – itr F F F 50.0 50.0 100.0
Income tax – ir F F F 53.0 21.5 22.5 3.0 100.0
Tax on manufactured
goods – ipi
F F F 43.0 29.0 25.0 3.0 100.0
Tax on financial operations
– iof
100.0 100.0
Financial operations
dealing with gold –
iof-Ouro
F F F 30.0 70.0 100.0
Other taxes and fees F F F 100.0 100.0
contributions
Social contributions
On sales of goods and
services
F F F 100.0 100.0
On financial transactions
– cpmf
F F F 100.0 100.0
On net profit – csll F F F 100.0 100.0
On payroll –
employee/employer
F F F 100.0 100.0
On payroll earmarked
to primary education
F F F Shared under special legislation2
Other contributions F F F 100.0 100.0
Royalties – oil and
hydroelectric dams
F F F Shared under special legislation3
Contribution on production
and imports
of oil – cide
F F F 71.0 21.8 7.2 100.0
86 Fernando Rezende
Determination
of Shares in revenue (%)
Base Rate
Tax collection
and
administration F S L R1 All orders
State or provincial
taxes
irrf withheld on state
civil servants’ wages4
F F S 100.0 100.0
Motor vehicle property
tax – ipva
S S S 50.0 50.0 100.0
Tax on inheritance
and gifts – itcd
S S S 100.0 100.0
Tax on circulation of
goods and services –
icms
F, S F, S S 75.0 25.0 100.0
contributions
On employees’ wages
earmarked to pensions
S S S 100.0 100.0
Local
taxes
irrf withheld on municipalities’
civil servants’
wages4
F F L 100.0 100.0
Urban land and territorial
tax – iptu
L L L 100.0 100.0
Tax on real estate ownership
transfer – itbi
L L L 100.0 100.0
Tax on services – iss F F, L L 100.0 100.0
Betterment taxes L L L 100.0 100.0
contributions L L L 100.0 100.0
On employees’ wages earmarked
to pensions
L L L 100.0 100.0
Primary sources: Federal Constitution and Federal Revenue Service.
1. Amount channelled into a regional development fund.
2. Two-thirds goes to the states on a derivation basis. States and municipalities can have access to the other
one-third on a project basis.
3. Royalties: states and municipalities receive compensation for the exploration of petroleum, gas,
hydroelectricity, and other mineral resources inside their territory or in the adjacent maritime platform.
4. Income tax withheld on the earnings of state and local government public servants.
Table 4
Tax assignment for various orders of government
F = Federal; S = State; L = Local; R = Regional (Continued)
Federal Republic of Brazil 87
southeast to the north/northeast/centre-west regions, whereas a 12 percent
rate applies to interstate sales flowing in the opposite direction. The
same 12 percent rate applies to interregional transactions. This mixed origindestination
principle caused distortions in resource allocation and provided
a strong incentive for tax evasion. It also led to the main weapon
used in the so-called fiscal war in which Brazilian states have been engaged
in order to attract investments and new industries to their jurisdictions.5
With respect to the municipal tax on services, a recent constitutional
amendment exempted exports from this tax and allowed for the imposition
of a ceiling and a floor on rates by way of a complementary law whose
purpose was to avoid great variation and to curb harmful competition in
metropolitan areas.6 However, other less visible means for providing fiscal
benefits, such as reducing the tax base and providing better terms for payment,
may compensate for that.
Fiscal competition among the states in Brazil gained new impetus in the
mid-1990s in a bid to attract a new wave of foreign direct investment in the
Brazilian automotive sector away from the São Paulo metropolitan region.
Due to the mixed origin-destination principle applied to the state vat,
neighbouring states could shift the burden of the fiscal incentives offered to
foreign investors to the state of São Paulo, which houses the most important
consumer market. In what came to be known as a fiscal war, southern states
(mainly Parana, Rio de Janeiro, and Rio Grande do Sul) succeeded in luring
investors to locate new plants in their territories. They did this by providing
additional benefits, such as infrastructure and training programs for the labour
force, to the more usual tax concessions. In one case only, the federal
government intervened to move the location of an automotive plant to the
northern state of Bahia. Several studies pointed to the irrationality of a fiscal
war for attracting investment. However, politicians and public administrators
thought it was a good response to the absence of a federal policy to discourage
even greater concentration in the already highly concentrated manufacturing
activities in a few locations in the country.7
Of course conflicts arose out of the fiscal war, making it very difficult to
implement any proposal for harmonizing the tax system and propelling
tax administrators to cooperate. Cooperation is also hampered by conflicts
related to the taxation of natural resources – oil in particular. For oil, as
well as for electricity generation, the 1988 Constitution adopted a destination
principle for the states’ vat so that producer states would not reap all
the revenues from these important tax bases. However, as revenues from
oil and electricity came to represent a sizable portion of the taxes collected
by the state treasuries, producer states claimed that this exception to the
general rule did a lot of harm to their finances. In recent years, states have
recognized the cost of this fiscal war and are currently engaged in serious
negotiations in an attempt to bring an end to wasteful tax competition.
88 Fernando Rezende
f i s c al equity and efficiency concerns and
intergovernmental f i s c al transfers
Despite the tax powers assigned to states and local governments by the Constitution,
data on tax collections by each order of the federation show a remarkable
degree of vertical imbalance. The federal government obtains a
little less than 70 percent of all the money extracted from businesses and
households through various taxes. The states collect about 25 percent of
total tax revenues, and local governments account for the rest.
Three distinct regimes attempt to address the vertical disequilibria: (1) a
conventional revenue sharing system, (2) separate rules concerning the
share of state and local governments in revenues from specific taxes, and
(3) conditional transfers.
The pillar of the revenue-sharing system is the participation of states and
local governments in sharing the proceeds of federal income and manufacturing
taxes. According to the 1988 Constitution, 21.5 percent of federal
revenues from these taxes goes to the states and 22.5 percent to the municipalities.
At the same time as the Constitution more than doubled the
share of federal taxes going to states and municipalities, it asked for a revision
of the apportionment formula. But implementing this provision became
impossible due to conflicts that arose over attempts to carry out the
revision. Consequently, quotas for each state and municipality were frozen
on the basis of the coefficients prevailing at the time the Constitution was
promulgated, and the previous practice of making adjustments in light of
updated income and population estimates was abandoned.8
Another important component of the revenue-sharing system is the
25 percent share of local governments in their states’ vat collections.
Three-fourths of the municipal share is distributed according to the value
added in each local jurisdiction; the rest follows rules set by the respective
state legislators. Municipalities with a strong economic base benefit from
the first criteria, whereas the formulas adopted by the states tend to favour
political allies and are subject to frequent changes. Local governments also
get 50 percent of revenues from the rural property tax collected by the federal
government and from the motor vehicle tax applied by the states.
States and local governments are entitled to keep revenues from the
income taxes withheld from their own employees, to receive 100 percent
of the proceeds from the federal tax on financial operations in gold
(30 percent for the states and 70 percent for the municipalities), to
participate in a compulsory levy on the wage bill (earmarked for basic
education), to share in federal revenues from a compulsory levy on oil
imports, and to receive compensation for exempting exports from the
states’ vat. These other sources of subnational revenues are not important
in global terms.9
Federal Republic of Brazil 89
Table 5
Vertical fiscal gaps, 20031
Percentage of gdp
Level Total revenue collected2
Total revenue available,
including net transfers for
that level of government Expenditures3
National 28.8 23.3 31.7
Subnational 13.3 18.7 21.1
State/provincial 10.6 11.3 13.5
Local 2.7 7.4 7.6
All orders 42.1 42.1 52.8
Percentage of total
Level Total revenue collected2
Total revenue available,
including net transfers for
that level of government Expenditures3
National 68.4 55.4 60.1
Subnational 31.6 44.6 39.9
State/provincial 25.3 26.9 25.6
Local 6.4 17.7 14.4
All orders 100.0 100.0 100.0
us$ millions
Level Total revenue collected2
Total revenue available,
including net transfers for
that level of government Expenditures3
National 145,777.8 118,239.0 160,667.9
Subnational 67,462.1 95,000.9 106,823.7
State/provincial 53,878.2 57,312.3 68,376.9
Local 13,583.9 37,688.5 38,446.8
All orders 213,239.8 213,239.8 267,491.6
Primary source: National Treasury Secretariat, Federal Finance Minister.
1. 2003 average exchange rate: us$ 1 = R$ 3.07.
2. Current and capital revenues. Does not include loans.
3. Current and capital expenses. Capital expenses exclude debt refinancing.
90 Fernando Rezende
Royalties from the exploration of natural resources should also be mentioned.
Federal legislation establishes the rules for compensating states
and municipalities for the extraction of oil, mining, and loss of land due to
inundation provoked by hydroelectric dams. Municipal governments are
the main beneficiaries of these royalties. The most important distortions in
the distribution of royalties are found in the extraction of oil in the maritime
plateau in the northern coast of the state of Rio de Janeiro.
With the exception of a constitutional mandate to earmark 25 percent
for basic education, resources channelled to state and local government
coffers under the revenue-sharing system do not carry any provisions concerning
their use. The same applies to the shares of the specific taxes listed
above, with the sole exception of the one earmarked for basic education.
Among the conditional transfers, the most important is the health
transfer system. A recent constitutional amendment established that the
money allocated in the federal budget to finance health spending should
increase in line with gdp growth on the basis of the amount spent in the
previous year.10 There is no fixed amount to be transferred to subnational
governments. One portion is allocated to state and local governments on a
per capita basis to cover basic health care services. Another is distributed
on a service provision basis and so follows the spatial distribution of the
health service network. Financial cooperation in health care is assured by
earmarking 12 percent of state revenues and 15 percent of municipality
revenues for health care spending. On the whole, the federal government
covers about 60 percent of the health care bill. States and municipalities
split the rest on a more or less equal basis. Given the concentration of sophisticated
health care facilities, in larger municipalities resources from
the health transfer system are more important than is the share of federal
government revenues.
The abandonment of the original formula conceived for the revenuesharing
system and the proliferation of other transfers led to the absence
of any criteria guiding the intergovernmental flow of resources in the
federation. The outcome of such a situation is a hazardous process of redistributing
the fiscal pie. On the vertical perspective, the big winners are
the municipalities, who have seen their share of the fiscal pie more than
treble in relation to own revenues (after taking into account all kinds of
intergovernmental money transfers), while the increase for the states has
been only 40 percent. As a result, total disposable revenues are roughly
split in the following manner: 50 percent to the federal government,
30 percent to the states, and 20 percent to the municipalities. Besides
passing on about 30 percent of what it collects to subnational governments,
the federal government has lost discretion over more than half
its available revenues as it increasingly depends on taxes earmarked for
social spending.11
Federal Republic of Brazil 91
Worse still is the outcome regarding the horizontal distribution of fiscal
resources. Of the total amount collected by the states, nearly three-fourths
belongs to the seven states that comprise the south and southeast region.
Among the municipalities, the twenty-six more important metropolitan cities
raise more than 60 percent of total local government own-source revenues.
Moreover, as each specific transfer follows its own logic to distribute
money across the twenty-six states, the federal district, and nearly 5,558 municipalities,
an enormous horizontal disparity arises in the distribution of
fiscal resources across the federation.12
Data on the per capita revenues of the states and municipalities illustrate
the size of these imbalances. Current budgetary per capita revenues can be
as much as twenty to thirty times greater in small municipalities located in
thinly populated regions than they are in the more populous municipalities.
Among states, disparities are less severe but still significant. In this
case, the low population density of the newly created states in the Amazon
and centre-west regions means that the per capita revenues of these states
are more than three times higher than the national average. More densely
populated states in the northeast, with the single exception of Sergipe, are
among those with the lowest per capita revenues.
Inequalities are particularly severe in metropolitan areas, where the outcome
is determined by the manner in which economic activity and population
are distributed geographically. In general, due to their share in state
tax collections, municipalities with an important manufacturing sector and
a small population have per capita budgets several times higher than the
regional average. At the other extreme, municipalities with a very large
population and a fragile economy, usually functioning as a dormitory city,
are severely underfinanced, having per capita budgets well below the
regional average.
One undesirable consequence of expanding transfers to municipalities
without a concomitant revision of the distribution formula was the proliferation
of new units. More than one thousand municipalities were created after
1988 because the distribution formula rewarded districts that decided
to “emancipate” themselves. They were rewarded either because they
housed major industries, in which case they would receive a high quota of
the state icms, or because they had few people, in which case they would
benefit from the apportionment under the Municipal Participation Fund.
The combination of these two factors provided an ideal opportunity for demanding
autonomy because, in the case of secession, the rules at the time
did not require the approval of residents in other parts of the municipality.
Lack of a well-designed institutional arrangement to provide a rationale
for the system and to mediate conflicts of interest is a large handicap for
better functioning intergovernmental fiscal relations. Brazil does not have
a formal fiscal equalization transfer program but, rather, a constitutionally
92 Fernando Rezende
mandated revenue-sharing mechanism that automatically delivers a fixed
proportion of income and federal manufacturing tax revenues, plus other
minor taxes, to states and local governments on the basis of predetermined
fixed rates.13 Coupled with specific purpose grants, the absence of an
equalization thrust in the general-purpose transfers is responsible for a
fairly high degree of horizontal disequilibria in the distribution of fiscal resources
in the Brazilian Federation, and this adds to the difficulties faced
in achieving cooperation in public policies.
f inancing cap ital investment
A very low degree of budgetary flexibility – due to excesses in earmarking revenues
and a large interest and pension bill – led to insignificant levels of public
savings throughout the federation. Data for the public sector as a whole
point to a current account surplus of a meager 2.06 percent of gdp, with the
federal government showing zero savings and the states as a whole only
0.9 percent of gdp. Conversely, the municipalities show healthier figures.
About two-thirds of local governments’ investments are financed by savings.
Municipalities, on average, show a savings ratio of 1.12 percent of gdp.
Coupled with high indebtedness ratios, the fall in public savings brought
public investment along with it. The average rate of public investment was
around 3 percent of gdp in the early 2000s, down from the already low
4.2 percent registered in the second half of the 1990s, and shows no sign
that it will improve to a significant degree in the short run. Contrasting
with the situation that prevailed in the 1970s, when the public sector accounted
for a sizable part of total gross capital formation in the Brazilian
economy, the state now accounts for less than 20 percent of the annual
rate of capital accumulation in the country.
In theory, lack of savings could be compensated by an increase in borrowing.
The Brazilian Constitution grants autonomy to federal, state, and
local governments with respect to access to the financial market. The only
restriction is the requirement of Senate approval for state and local government
access to money from external sources.
In practice, however, the situation is much different. As mentioned earlier,
the Fiscal Responsibility Law put into place tough limits for the outstanding
debt of states and local governments as well as for the amount of
their current revenues that can be used yearly for debt servicing. Moreover,
Central Bank regulations impose a severe limit on the exposure of
public and private financial institutions to public entities, with the result
that even financially sound subnational public entities cannot get extra
money for financing capital investments. As for the federal government,
although limits demanded by the frl have not yet been put in place, the
already high debt-to-gdp ratio imposes a natural barrier to borrowing.
Federal Republic of Brazil 93
Restrictions on capital financing could be relaxed by reducing the earmarking
of government revenues at all levels and going forward with institutional
reforms to alleviate the pressures that pension systems put on
public budgets. This would allow for the restoration of public savings. Proposals
to deal with this situation have been put forward recently, but politicians
do not look favourably on the very sensitive issue of cutting pensions
or erasing the guarantees to their financing. The proposals also face strong
resistance from labour unions and better organized lobbies.
The low level of public investment generates problems for economic
growth and inequalities in income distribution, and this has led to a search
for alternative means of investment financing. A new federal law, along
with similar laws adopted in some states, has been enacted to open room
for the formation of partnerships between public and private organizations
aimed mainly at gathering resources to finance infrastructure projects.
These new institutional arrangements have not had enough time to show
how much can be expected from them. The still low degree of confidence
in the capabilities of the regulatory agencies and the public bureaucracy’s
lack of familiarity with such arrangements mean that this alternative may
take some time to show its full potential.
Whatever the possibility of exploring alternatives, the need to restore
public investment is compelling. In less developed regions, privatization or
partnerships will not meet the needs of infrastructure modernization. In
metropolitan areas, the absence of public investment means that many lowincome
families do not have access to good basic urban services, and many
newcomers have no access at all. At the same time, health and education infrastructure
deserves more attention, especially from state governments.
f i s cal federalism dimensions
of the public management f ramework
Subnational governments exercise almost complete discretion with respect
to the management of their internal affairs. State and local governments
alike are free to set rules governing the careers of public servants, hire personnel,
set wages and salaries, and establish employee pension systems. In
matters related to their own workforce, they are only constrained by the
constitutional provisions that require candidates to pass exams in order to
obtain permanent positions in the public sector, the federal government
included, and that prohibit public administrators from firing public
servants without justifiable cause. To circumvent the rigours of the rules
concerning public-sector employment, menial jobs – such as security,
cleaning, transportation, and low-level administrative tasks – are contracted
out to private firms selected by special auction procedures. This introduces
some flexibility into areas where it is most needed. The frl has
94 Fernando Rezende
established limits on personnel costs, which have also induced the substitution
of private services for direct public employment.
Health care provides the main example of private agents being actively
engaged in service provision under special agreements. The national
health system joins the financial, managerial, and human resources of the
federal, state, and local governments to give free access to every Brazilian
citizen to basic health care as well as to more complex procedures carried
out at public and private hospitals. The health care model has been extended
to social assistance, and proposals have been floated for adopting a
similar approach in the case of public safety. The health system is the most
important attempt to improve efficiency and efficacy in public management
by means of coordinating policies throughout the federation.
Coordination of public investment and services provision by local governments
is impaired by the inability of state governments to organize production
of urban and social services across the limits of local jurisdictions.
This is particularly important in metropolitan regions and other urban
agglomerations. In so far as the states cannot interfere in municipal autonomy,
they lack the legislative power and administrative capability to
enforce metropolitan policies. In addition, the increasingly direct relationship
between the federal government and the municipalities, with high
amounts of federal funds being channelled directly into the local purse,
undermines the ability of the states to control activities that take place in
their territory. Superimposition of programs and lack of integration and
coordination lead to waste of resources, higher costs, and uneven access to
public services – that is, poor people in less endowed municipalities may
receive fewer benefits than the less poor in financially rich municipalities.
Attempts to achieve coordination by means of a consortium of municipalities
to deal with issues of common interest have proved to be unsatisfactory
because the volatile political alignment of mayors contributes to the instability
of such arrangements.14
Excessive dependence on transfers can be blamed for the non-materialization
of the expected benefits from fiscal decentralization. As transfers become
the major source of revenues for half the states and the majority of
municipalities, efficiency in the use of resources at the subnational level is impaired
and accountability cannot be properly exercised. Less reliance on own
taxes makes individuals less conscious of the consequences of the expenditure
decisions of governors and mayors. And lack of accountability adds to inefficiency
and facilitates misconduct in dealing with the public money.
the way forward
Most of the flaws in Brazil’s fiscal federalism observed in recent years are
the direct result of the dual fiscal regime that was adopted in the 1988
Constitution and of the lack of will to pursue thorough reform thereafter.
Federal Republic of Brazil 95
Coupled with the dominance of macroeconomic issues in the fiscal policies
designed in past decades, this duality led to a reversal of the fiscal
decentralization envisaged at that time. There has been backward movement
in the quality of the tax system, and increasing constraints on the actual
exercise of the fiscal autonomy formally granted to states and local
governments, with deleterious impacts on the efficiency and efficacy of
public policies.
Nonetheless, politicians and policy makers alike do not see reform as a
high priority. Conflicts of interest among developed and less developed
states as well as among large and small municipalities may be one of the
reasons for that. Another is the fear expressed by federal authorities that
any reform proposal could reduce federal revenues and so jeopardize the
sustainability of macroeconomic fiscal targets. In addition to more objective
reasons for immobilization, it seems that politicians as a whole, mainly
those from less developed regions, might be stuck in the view that the
present system works to benefit their constituencies. In fact, everyone fears
that any movement could lead to unexpected results and so could undermine
their particular interests.
An opportunity to reform the entire system was lost in 1993, when the
federal Constitution opened a window for a complete reform to be carried
out under favourable terms.15 After that, federal authorities opted for a
narrow focus, directed only at minor issues related to taxation, reasoning
that any attempt to pursue a broader reform, including changes in the revenue-
sharing system, could endanger macroeconomic stability. Meanwhile,
successive ad hoc measures have helped to exacerbate distortions and to
increase conflicts in the federation.
A consensus among pundits about the need to go for a thorough reform
of the Brazilian fiscal federalism model is being formed, but public
authorities and politicians are still far from endorsing this view. In the
midst of strong antagonisms, every federal entity fears that a structural reform
could run against its particular interests. To make matters worse,
private business is now very active in the fiscal policy arena and lobbies
against any change that might be prejudicial to its interests. On the positive
side, society at large has a general aversion to further increases in taxation;
this may help to convince political leaders that a complete reform
is long overdue.
These are positive signs, but large challenges must be faced in order to
achieve a broad understanding of proposals for a new fiscal federalism.
A new model will have to be able to reconcile tax harmonization, macroeconomic
fiscal discipline, subnational autonomy, and governments that
are efficient in the use of fiscal resources and accountable to their citizens.
Moreover, the likelihood of an increase in regional disparities in the wake
of higher rates of economic growth is not conducive to a reduction in antagonisms
that block the search for structural changes.
96 Fernando Rezende
Nevertheless, the main impediment to reform is the still uncertain situation
concerning the vulnerability of the Brazilian economy to external
shocks. In the event of an international crisis, macroeconomic pressures
may be conducive to renewed resistance on the part of the federal government
to changing the present system, thus postponing the reconciliation
of Brazil’s fiscal federalism with the challenges of economic globalization
and monetary stability.16
In the meantime, efforts should be made to expose in a clear and understandable
way the present system’s lack of economic and political rationale.
Empirical evidence contained in recent studies has to be translated
into terms that can be easily perceived by regional and local leaders
throughout the federation so that the need for a thorough reform can be
clearly stated and understood.
A forum to discuss the present system and to appraise alternatives to improve
federal cohesion and efficiency in public services provision would be
of much help. To that end, thirteen states have taken an important first
step by creating the Fiscal Forum of the Brazilian States, which has just begun
to explore the main issues involved as a prelude to the preparation of
a package of reform proposals. Such a process could create a window of
opportunity for fundamental reform of the fiscal system in Brazil.
notes
1 On imbalances in political representation, see José Serra and José Roberto Afonso,
“Federalismo Fiscal à Brasileira: Algumas Reflexões,” Revista do bndes (Rio de
Janeiro) 6, 12 (1999): 3–30.
2 This particular aspect led Alfred Stepan to consider Brazil an extreme case of a
democratically constrained federation. See Alfred Stepan, “Toward a New Comparative
Analysis of Democracy and Federalism: Demos Constraining and Demos
Enabling Federations,” mimeo, Coréia do Sul, 1997.
3 On the importance of the regional issue, see Celina Souza, “Constitutional Aspects
of Federalism in Brazil,” in A Global Dialogue on Federalism, vol 1: Constitutional
Origins, Structure and Change in Federal Democracies, ed. John Kincaid and G. Alan
Tarr, 77–102 (Montreal and Kingston: McGill-Queen’s University Press for the
Forum of Federations, 2005).
4 For a detailed account of the division of responsibilities in the Brazilian Federation,
see Marcelo Piancastelli, “The Federal Republic of Brazil,” in A Global Dialogue on
Federalism, vol 2: Distribution of Powers and Responsibility in Federal Countries, ed.
Akhtar Majeed, Ronald L. Watts, and Douglas M. Brown, 67–90 (Montreal and
Kingston: McGill-Queen’s University Press for the Forum of Federations, 2006).
5 See Ricardo Varsano, “Subnational Taxation and Treatment of Interstate Trade in
Brazil: Problems and a Proposed Solution,” abcd-lac Conference, Valdivia, Chile,
1999.
Federal Republic of Brazil 97
6 Constitutional Amendment 37/2002. A top rate of 5 percent was imposed
afterwards.
7 For details on fiscal competition in Brazil, see Ricardo Varsano, “A Guerra Fiscal do
icms: Quem Ganha e quem perde,” ipea Discussion Paper, Brasília, 1997.
8 The shares of each state were established by confaz. A percentage was set for all
municipalities within each state in order to prevent the creation of new municipalities
from having outside effects.
9 For the municipalities as a whole, these other revenue sources represent about
6 percent of total revenues.
10 Constitutional amendment 29/2000.
11 By means of transitory amendments to the Constitution, the federal government
regained discretionary spending power over 20 percent of revenues from contributions
earmarked for social spending.
12 The extent of the fiscal gaps can be seen in Sergio Prado, Waldemar Quadros, and
Carlos Cavalcanti, “Partilha de Recursos na Federação Brasileira,” fundap, São
Paulo, 2003.
13 The 1967 original formula established that the state quotas would be directly related
to population and inversely related to per capita income, whereas the municipal
quotas would grow with population size but at a decreasing rate.
14 See Fernando Rezende and Sol Garson, “Financing Metropolitan Areas in Brazil:
Political, Institutional, Legal Obstacles and Emergence of New Proposals for
Improving Coordination,” Revista de Economia Contemporânea (Rio de Janeiro) 10,
1 (2006): 5–34.
15 The 1988 Constitution called for an entire revision to be carried out five years after
its promulgation under special procedures that included approval by single majority
in a joint parliamentary session.
16 These challenges are the subject of Fernando Rezende and Jose Roberto Afonso,
“The Brazilian Federation, Facts, Challenges and Perspectives,” in Federalism and
Economic Reform: International Perspectives, ed. Jessica Wallack and T.N. Srinivasan,
143–88 (New York, ny: Cambridge University Press, 2006).