SWP-61 2

Financing State and Local Government in BrazilRecent Trends and Issues

Dennis J. MaharWilliam R. Dillinger

WOiRLD BANK STAFF WORKING PAPERSNumber 612

HJ925. M241983c.2

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WORLD BANK STAFF WORKING PAPERSNumber 612

Financing State and Local Government in BrazilRecent Trends and Issues

Dennis J. MaharWilliam R. Dillinger

p,lJG I 98I

The World BankWashington, D.C., U.S.A.

Copyright © 1983The International Bank for Reconstructionand Development / THE WORLD BANK1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

First printing September 1983All rights reservedManufactured in the United States of America

This is a working document published informally by the World Bank. Topresent the results of research with the least possible delay, the typescript hasnot been prepared in accordance with the procedures appropriate to formalprinted texts, and the World Bank accepts no responsibility for errors. Thepublication is supplied at a token charge to defray part of the cost ofmanufacture and distribution.

The views and interpretations in this document are those of the author(s) andshould not be attributed to the World Bank, to its affiliated organizations, or toany individual acting on their behalf. Any maps used have been preparedsolely for the convenience of the readers; the denominations used and theboundaries shown do not imply, on the part of the World Bank and its affiliates,any judgment on the legal status of any territory or any endorsement oracceptance of such boundaries.

The full range of World Bank publications is described in the Catalog of WorldBank Publications; the continuing research program of the Bank is outlined inWorld Bank Research Program: Abstracts of Current Studies. Both booklets areupdated annually; the most recent edition of each is available without chargefrom the Publications Distribution Unit of the Bank in Washington or from theEuropean Office of the Bank, 66, avenue d'Iena, 75116 Paris, France.

Dennis J. Mahar is a senior economist in the Latin America and CaribbeanRegional Office and William R. Dillinger an urban economist in the UrbanDevelopment Department, both at the Wozld Bank.

Library of Congress Cataloging in Publication Data

Mahar, Dennis J.Financing state and local government in Brazil.

(World Bank staff working papers ; no. 612)Bibliography: p.1. Intergovernmental fiscal relations-Brazil.

I. Dillinger, WilliLam R., 1951- . II. Title.III. Series.HJ925.M275 1983 336.1'85'0981 83-17074ISBN 0-8213-0255-8

TABLE OF CONTENTS

Page No.

GLOSSARY OF ACRONYMS vCURRENCY EQUIVALENTS viiiMAP follows text

I. INTRODUCTION ............................ I

II. HISTORICAL BACIKGROUND TO 1968 ..................... 2

Dual Federa:Lism: 1889-1930 .......................... 2Decentralized Unitary Government: 1930-45 ........... 2Cooperative Federalism: 1946-64 ..................... 3The Fiscal Reforms of 1965-67 ........................ 4

III. CURRENT INSTITUTIONAL FRAMEWORK ......................... 5

Administrative Structure ............................. 5State and Local Revenue Sources ............ 6State and Local Functional Responsibilities ..... 13

IV. CORRESPONDENCE OF REVENUES AND EXPENDITURES:THE QUESTION OF VERTICAL BALANCE ..... ................ 16

The "Conventional Wisdom" .. ............................ 16Saving and Investment ....................... ......... 17Deficit Financing .................................. 17Principal Causes of the States' Fiscal Problems 19Problems of Municipal Resourc-e Mobilization ............ 25

V. SPATIAL VARIATIONS IN REVENUES AND EXPENDITURES:THE QUESTION OF HORIZONTAL BALANCE .................... 29

Regional Economic Disparities ....................... 29Revenues, Expenditures and Public Service Indicators 30Sources of Variation in State Revenues . ........ 33Sources of Variation in Municipal Revenues 38Revenue Sharing ............................................ . 40Regional Distributon of Direct Federal Expenditures ... 43

VI. SUMMARY AND CONCLUSIONS ........................... 45

Vertical Balance ... .... .. ................................. 46Horizontal Balance .. .. ............................. ... 48Final Considerations ........ . ......... ...... 50

REFERENCES . ............................................. 53

LIST OF TABLES

Table Page

Number Number

1 Structure of the Public Sector, 1975 ................. 72 State and Municipal Revenues by Source, 1978....... 93 Summary of Principal Revenue-sharing Mechanisms

(1 1-81........................ 11-

4 Public Expenditures by Function and Level ofGovernment, 1975. ...................... ....... .... 15

5 Selected Indicators of State and MunicipalFinances, 1968-80......... ............. oo*.. ........... 18

6 Structure of State Debt at Year End, 1977-81 ....... 197 Buoyancy of Revenues by Level of Government,

1968-80**..*... ....................... e .o .9..... 20

8 Annual Growth Rates of State Revenues and-Expenditures and GDP, 1968/69-1979/80 ............. 21

9 Impact of CIATA on Municipal Revenues, 1976-78..... 27

10 Hypothetical Impact of Doubled Property Tax Efforton Municipal Current Revenues.... .......... 28

11 State and Municipal Revenues and Public ServiceIndicators by Region, mid-1970s ............... 31

12 State and Municipal Expenditures on Educationand Health by Region, 1975 ....................... 32

13 Gross Regional Product and ICM Revenues, 1970 ...... 3314 Sectoral Composition of ICM Revenues and Taxable

Gross State Product, 1970- oo.... .................. 3615 Regional Pattern of State Revenue Sources, 1978 .... 37

16 Municipal Taxes: Concentration of Base and Yieldin Large Cities, 1975 ...... .... .... ... ......... ... 38

17 Regional Pattern of Municipal Revenue Sources,1975............... 39

18 Impact of Revenue Sharing on Regional Disparities,mid-1970s ................... * ..**O**...... O... ...... 41

19 Non-capital Municlpios: Average Population andRevenues, mid-1970s ........rt u .......b............. 42

20 Federal Direct Expenditures by Region, 1975 ............................45

GLOSSARY OF ACRONYMS

BNH Banco Nacional de Habitas,ao(National Housing Bank)

CIATA Convanios de Incentivos ao AperfeicoamentoTLcnico-Administrativo das Municipalidades(Agreements on Incentives for theTechnical-Administrative Improvement ofMunicipalities)

CIBRAZEM Companhia Brasileira de Armazenagem(Brazilian Storage Company)

CMN Conselho Monetario Nacional(National Monetary Council)

DNAEE Departamento Nacional de Aguas e Energia Eletrica(National Department of Water and Electric Energy)

DNER Departamento Nacional de Estradas de Rodagem(National Highways Department)

DNPM Departamento Nacional de Producao Mineral(National Department of Mineral Production)

ELETROBRAS Centrais El'etricas Brasileiras S. A.(Brazilian Electric Company)

EMBRATER Empresa de Assist8ncia Tgcnica e Extensn'o Rural(Federal Technical Assistance and Rural ExtensionCompany)

FAS Fundo de Assistencia Social(Social Development Fund)

FDTU Fundo de Desenvolvimento dos Transportes Urbanos(Urban Transport Development Fund)

FE Fundo Especial(Special Fund)

FFDF Fundo Federal do Desenvolvimento Ferroviario(Federal Railroad Development Fund)

FGTS Fundo de Garantia do Tempo de Servigo(Time of Service Guarantee Fund)

FGV Fundacao Getulio Vargas(GetAlio Vargas Foundation)

FND Fundo Nacional de Desenvolvimento(National Development Fund)

FNDU Fundo Nacional de Apoio ao Desenvolvimento Urbano(National Urban Development Fund)

FNM Fundo Nacional de Minerac,o(National Mining Fund)

FPE Fundo de Participaqa1o dos Estados, DF e Territorios(States, Federal District and Federal TerritoriesParticipation Fund)

FPM Fundo de Participa'ao dos Municfpios(Municipal Participation Fund)

FRN Fundo Rodoviario Nacional(National Road Fund)

GRP Gross Regional Product

GSP Gross State Product

IBAM Instituto Brasileiro de Amininistra,cao Municipal(Brazilian Institute of Municipal Administration)

ICM Imposto sobre Circulac,ao de Mercadorias(Value-added tax)

INCRA Instituto Nacional de Coloniza,cao e Reforma Agraria(National Institute for Colonization and AgrarianReform)

IPI Imposto sobre Productos Industrializados(Manufacturers' sales tax)

IPTU Imposto Predial e TerriLorial UrbanO(Urban property tax)

IR Imposto sobre a Renda e Proventos de Qualquer Natureza(Income tax)

ISS Imposto sobre Servigos(Tax on services)

ITBI Imposto de Transmissao(Property transfer tax)

ITR Imposto Territorial Rural(Rural property tax)

IUCL Imposto dnico sobre Lubricantes e Combustiveis Liquidose Gasosos(Fuels tax)

IUEE Imposto dnico sobre a Energia Elltrica(Electricity tax)

IUM Imposto dnico sobre Minerais(Minerals Tax)

IVC Imposto sobre Vendas e Consignacoes(Turnover tax)

PASEP Programa de Formacao do Patrimonio de Servidor Pdblico(Public Employees Financial Reserve Fund)

PIS Programa de Integragao Social(Social Integration Program)

PME Programa de Mobilizagao Energetico(Energy Mobilization Program)

SAREM Secretaria de Articulags'o com os Estados e Munic6pios(Secretariat for Coordination with the Stal.es andMunicipalities, Federal Planning Secretar:Lat)

SE Salario Educassao(Ed,ucation Salary tax)

SEF Sec:retaria de Economia e Finangas(Secretariat for Economics and Finance, Ministry ofFinance)

SEPLAN Secretaria de Planejamento(Federal Planning Secretariat)

TELEBRAS TeJLecomunicago8es Brasileiras, S. A.(Brazilian Telephone Company)

TRU Taxa Rodoviaria Unica(Vehicle Registration Tax)

CURRENCY EQUIVALENTS

Yearly Average of Cruzeiros/US$

1968 3.40 1975 8.131969 4.07 1976 10.671970 4.59 1977 14.141971 5.29 1978 18.081972 5.93 1979 26.821973 6.13 1980 52.811974 6.79 1981 93.34

1982 178.89

Source: Central Bank Bulletins

ABSTRACT

Brazil's system of intergovernmental fiscal relations has, with someninor exceptions, remained unchanged for almost two decades. Economic, socialand political conditions :in the country, however, have undergone profoundtransformations during the same period. This paper investigates whether themechanisms, established during the 1960s, for financing state and localgovernments are still.adequate in the environment of the 1980s. The mainconclusion is that they are not, and that certain fiscal adjustments arecalled for in order to bring resource availability at the subnational levelmore into line with functional responsibilities. Given the extreme intra- andinterregional economic disparities prevailing in Brazil, special attention isgiven to the fiscal problems of governments in poorer regions.

ACKNOWLEDGMENTS

This report is based on the findings of a World Bank mission whichvisited Brazil in 1981. It consisted of Dennis J. Mahar, (mission leader),William Dillinger (urban economist), and Woo Sik Kee (fiscal economilst).Mr. Jacques Cellier (transport economist) participated in a followup missionin June 1982. In Washington, additional research and statisticELl supportwere provided by Joan Ahern (research assistant).

,An earlier version of this paper was presented at a seminar heldin Brasilia during February 1983. The authors gratefully acknowledge theuseful comments provided by Brazilian colleagues, in particular Jose TeofiloOliveira, Fernando Rezende, Ricardo Varsano, Osmundo Rebou9as, Ibrahim Eris,and Celsius Lodder.

I. INTRODUCTION

During the period from 1965 to 1967, Brazil enacted a comprehen-sive set of fiscal reforms affecting all levels of government. Theprincipal aims of these reforms were to increase domestic resource mobil-ization, eliminate fiscally-induced distortions in the production anddistribution processes, promote capital formation and economic growth, andreduce interregional disparities in the financial capacities of state andlocal governments.l/ ToD these ends, new taxes were created and othersabolished; the tax administration apparatus was improved; the rights tocollect specific taxes were reallocated among the federal, stat:e and localgovernments; and an expanded, and more regionally redistributive, system ofintergovernmental revenue-sharing was put in place.

Since the mid-1960s, frequent changes have been introduced to thefiscal system, most related to tax rates and the criteria for revenue-sharing. To a large extent, however, the main features of the originalfiscal reforms have remLained intact. But Brazil is not the same country itwas in the mid-1960s -- between 1970 and 1980, for example, th,e real GD)Pmore than doubled, the proportion of the population living in urban areasrose from 55% to 68%, and a gradual political opening (abertura) wasinitiated -- and many have voiced the opinion that the fiscal system hasfailed to adapt to the new economic, demographic and political realities.

One importani: line of thought holds that the public sector hasbecome "overly central:Lzed" during the past 15 years, and that the time hascome to increase the flscal roles and autonomy of the state and localgovernments. 2 / This poLnt of view has been expressed repeatedly inacademic circles and in pronouncements by politicians. Moreover, fiscaldecentralization is included as one of the objectives of Brazil's ThirdNational Development Plan (1980-85).3/ The question of whether theBrazilian public sector is indeed "overly centralized", however, is fraughtwith definitional uncertainties and is, at any rate, only partiallyeconomic in nature. This study takes the present system ofintergovernmental fiscal relations as given and evaluates the recentperformance of state and local finances.

Methodologically, attention is focused on the extent to which theintergovernmental fiscal system has achieved and maintained verticalbalance (the balance between resource availability and functional respon-sibilities at each of the various levels of government) and horizontal

1 R. Varsano, "O Sistema Tributario de 1967: Adequado ao Brasil de 80?",Pesquisa e Plane'jamento Econ8mico, XI, 1 (1981), 208-21.

2/ This is distinct from the argument that the Brazilian public sector asa whole has becolne overextended (estatizacao), an issue which is notaddressed in the present report.

3/ Brasil, Presidencia da Republica, Secretaria de Planejamento,III Plano Nacional de Desenvolvimento, 1980-85 (Brasflia, September1980), pp. 47 and 84.

balance (the balance between resources and responsibilities at given levelsof government in different parts of the country). The report will alsoexplore ways and means through which the roles of the states and munici-palities as revenue-raisers and providers of public services might beenhanced in the future. Before undertaking these tasks, however, it isuseful to discuss briefly the historical background and current institu-tional framework of Brazil's intergovernmental fiscal system.

II. HISTORICAL BACKGROUND TO 1968

The nature of the fiscal relationships among the various levelsof government in Brazil has evolved continually over the years, roughlyparalleling changes in social, political and economic conditions. Fordiscussion purposes, this historical evolution may be conveniently dividedinto four more or less distinct phases: 1889-1930, 1930-45, 1946-64, and1965-67. 4/

Dual Federalism: 1889-1930

Between 1889 and 1930, the period of Brazilian history known asthe "First Republic" or "Old Republic", most public functions were assumedinitially by the central government. This was undoubtedly a result of thecentralized political structure prevailing under the Empire (1822-89) andthe fact that Brazil became a federation by disaggregation rather than by

aggregation as occurred, for example, in the U. S.. As the central govern-ment proved to be weak in relation to the states, power soon decentral-ized. This transformation was closely related to the rapid growth of agri-cultural and industrial activity in southeast Brazil,which generated bothnew revenues and demands for public services, and was reflected in theConstitution of 1891, which reserved all residual powers to the states.

The states, principally Sao Paulo, Minas Gerais and Rio Grande doSul, took advantage of their political autonomy and increasing revenues byassuming such non-traditional responsibilities as coffee stabilization and

the promotion of immigration, and by embarking upon ambitious public worksprograms. This is reflected in the fiscal data of the period which showthe states' share of total public expenditures rising from 36% to 46%between 1907 and 1930. A distinguishing characteristic of this era was theexistence of "dual federalism", a system in which the federal and stategovernments operated quite independently of each other in the planning,financing and execution of public functions.

Decentralized Unitary Government: 1930-45

In the 1930-45 period, government as a whole assumed new respon-sibilities, and the fundamental federal relationships were irrevocablyaltered. More specifically, the "dual federalism" of the First Republic

4/ Details on the historical evolution of intergovernmental fiscalrelations in Brazil may be found in: D. J. Mahar, "Federalismo Fiscalno Brasil: A Experiencia Historica", Revista ABOP, II, 2 (1976),29-82.

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was replaced by a centra:Lized system sharing few characteristics with"classical" federalism.

Two national Constitutions were promulgated during the period --one in 1934 and the other in 1937. The first of these documents,influenced by Germany's Weimar Constitution of 1919, had an economic andsocial content that stood in sharp contrast to the purely political contentof its predecessor. Although it assigned a greater role to the centralgovernment, the 1934 Constitution also clearly defined mumicipal. autonomy.Municpipos (units of government somewhat resembling North Americancounties were granted exclusive revenue sources for the first time andwere expected to become viable members of the federal system. Elowever, theConstitution of 1934 was short-lived and replaced by a distinctlycentralist Constitution in 1937.

Building on the legal basis provided by the Constitul:ions of1934 and 1937, and reacting to the impacts of the Great Depression andrising economic nationalism, the central government, which prior to 1930had performed only minimal functions, considerably expanded its range ofactivities (especially in the areas of commodity controls, education andlabor) at the expense of the previously-powerful states. In addition, itentered fields which hadt never before involved any level of government.These new areas of government activity, often administered through extra-budgetary institutes and enterprises, included a greatly expanded socialsecurity system and the establishment of public enterprises in the steel,energy and capital goodEi sectors.

Cooperative Federalism: 1946-64

At the end of World War II, Brazil gained a new government, anew Constitution and new ways of dealing with intergovernmntal fiscalproblems. An important aspect of the Constitution of 1946 was its emphasison revitalizing local government. Direct contacts between the federalgovernment and the munit:pios were formalized in response to widespread"municipalist" sentimenit in the Constituent Assembly. The newConstitution, however, did not provide "equal partnership" for localgovernment. It aimed only at curbing encroachments of the states withinthe sphere of the munictpios. Nevertheless, the elaborate revenue-sharingschemes utilized after 1948 theoretically provided local government withthe resources necessary to realize the political autonomy guaranteed by theConstitution.

The revenue-sharing mechanisms established in the late 1940swere quite complex and involved all three levels of government., Mostimportantly, the municipios were to receive shares of the federal incometax, excise tax and "sole taxes" (impostos utnicos) on fuels, electricenergy and minerals; 30% of all state taxes collected in a munlcipio whichexceeded the total own-source revenues of that municipio; and 40% of therevenues from any new federal or state taxes.

If only the shares from the federal income and excise taxes hadbeen duly transferred to the local governments, they would have, by theearly 1960s, raised munricipal revenues by over 70%. However, the actualimpact of these provisions was greatly reduced by an "equal-shares per

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municfpio" distribution formula (which led to a proliferation of localgovernments), inflation, and nonpayment of quotas by the federal govern-ment. During 1962-64, for example, less than 10% of the authorized federalshares were actually disbursed to the municipios. 5/ Thus, the expansionof government activity at the local level foreshadowed in the 1946Constitution never materialized and, as of 1964, the municipal share oftotal public sector revenues stood at the same level (7.5%) as it did in1950.

The Fiscal Reforms of 1965-67

The present revenue structures of the state and local governmentswere largely defined by the fiscal reforms of 1965-67. The principalimpetus for these reforms was the need to reduce the large public sectordeficits of the mid-1960s and the inflationary pressures caused by them.There was at the time also a general perception that the revenue-sharingschemes established in the 1940s were not having the salutary effects onmunicipal finances originally envisaged. The government brought to powerin 1964 took immediate steps to deal with these problems. A general reformof the fiscal system was outlined in Constitutional Amendment 18 (December1965), detailed in Law 5172 (October 1966) and included virtually intact inthe Constitution of 1967. The main effects of the reforms were to redefinethe tax bases available to each level of government, concentrate controlover tax bases and rates at the federal level and vastly expand the impor-tance of federal transfers in the revenues of the state and municipalgovernments.

Before the reforms, the main source of state government revenueswas a turnover-type sales tax (IVC). Tax rates and assessment practicesvaried according to the policies of each state government. The states also

collected export, property transfer and stamp taxes as well as fixed sharesof the federal "sole taxes". The yields of state taxes, other than theIVC, were relatively low. Delays and cancellations in the distribution ofshares of the federal taxes also limited their importance.

Prior to 1967, local governments relied on two principal taxes:a tax on urban property and a tax on industrial production and professionalservices. The latter lacked a clearly-defined base (i.e., "movimentoeconomico"), and was often imposed as a surcharge on the IVC, particularlyin poorer states. Yields of the urban property tax were limited by thedifficulties of reassessing local real estate values during a period ofhigh inflation. Municipal governments also collected stamp and licensetaxes, and taxes on entertainment, all with relatively low yields. Likethe states, the municipios were entitled to fixed shares of the federal"sole taxes". They were also to benefit from shares of the federal incomeand excise taxes, though, as pointed out previously, the implementation of

this scheme was flawed.

5/ D. J. Mahar, "The Failures of Revenue Sharing in Brazil and SomeRecent Developments", Bulletin for International Fiscal Documentation,XXV, 3 (1971), 71-80.

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The fiscal reforms abolished all state taxes except for therelatively minor property transfer tax. In place of the IVC, the reformlegislation substituted a value-added tax (ICM). By establishing the ICM,the reformers sought to eliminate the economic distortions and wi.despreadevasion fostered by the turnover tax. All municipal taxes were likewiseabolished with the exception of the urban property tax. To replace the taxon industry and professions, and the other miscellaneous local taxes, thenew fiscal legislation authorized municipios to impose a tax on services,and to share in the collections of the ICM. An additional feature of thereforms was to give the federal government exclusive authority to establishany new taxes,that is, taxes not explicitly contemplated in the reformlegislation.

The reforms sought to compensate the state and local governmentsfor the restriction of their own-source tax bases by expanding the systemof intergovernmental transfers. The mechanism for sharing federal incomeand excise taxes was revised and expanded to include the states. Theprincipal aims of the new system were to augment the revenues of stategovernments in poorer regions and to channel increased federal funds tomuniclpios with limited tax bases and administrative capacities. Thenature of the post-1967 revenue-sharing schemes, as well as the other majorcomponents of the state and local revenue bases (taxes and creditoperations), are described in greater detail in the following section.

III. CURRENT INSTITUTIONAL FRAMEWORK

Administrative Structure

At present, the Brazilian public sector is comprised of a federal(central) government, three federal territories, 23 states and about 4,000local governments (municipios). In addition, a large number of decentral-ized semiautonomous agencies (e.g., autarquias, fundac'es) and publicenterprises (.e.g., empresas pu'blicas, sociedades de economia mista)operate at the federal,state and local levels. This "parastatal sector"had its origins in the 1930s (see para. 10) and has since expandedrapidly. 6/

The data presented in Table 1 illustrate some of the basic fiscalinterrelationships among the federal, state and municipal governments. Twocharacteristics are ev-Ldent. First, the federal government clearlydominates the system, accounting for over 70% of both revenues and expendi-tures. Second, the states and municlpios are more important as providersof public services, particularly investments, than they are as revenue-raisers. This is explained by the existence of various intergovernmentalrevenue-sharing and grant schemes. A third characteristic of the Brazilianfiscal system, obscured by the level of aggregation in Table 1, is the

6/ For an historical, account of this development, see: T.J. Trebat,Brazil's State-Owmed Enterprises: A Case Study of the State asEntrepreneur (Cambridge: Cambridge University Press, 1983).

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extensive fragmentation of spending authority between the federal govern-

ment, states and municfpios and their respective decentralizedagencies. 7/ This administrative feature has interfered with the ability

of budget authorities at all levels of government to control the size and

sectoral allocation of public expenditures.

The relative importance of the federal government is undoubtedly

far greater than implied in Table 1. This is because the data shown are

from the "fiscal budget", and hence exclude public enterprises and the

so-called "monetary budget" (orcamento monetario). 8/ (The latter refers

to the revenues and expenditures of the Banco Centr:L and Banco do Brasil

which include a large volume of essentially fiscal operations). Public

enterprises (though not "monetary budgets") also exist at the state and

municipal levels, but fragmentary data suggest that they are less important

relative to the respective "fiscal budgets" than at the federal level.

Moreover, many subnational public enterprises (including many of those

operating in the energy, telecommunications and agricultural sectors) are

subsidiaries of federal holding companies (e.g., Eletrobras, Telebras,

EMBRATER, CIBRAZEM, etc.) and subject to varying degrees of central

control.

While given units of government are essentially treated as equals

under Brazilian Constitutional law, the states and municlpios constitute a

highly heterogeneous lot. This heterogeneity stems, inter alia, from the

particular pattern of the country's settlement and from wide spatial

variations in natural resource bases and economic structures. Thus, one

finds states as different as Sto Paulo (densely populated and highly

industrialized, with a per capita income almost twice the national

average), Alagoas (densely populated and agrarian, with a per capita income

perhaps half that of the nation) and Mato Grosso (a sparsely-populated,relatively poor frontier area, with incipient agricultural and industrial

development taking place); and municlpios as dissimilar as Vicosa, Rio

Grande do Norte (population 1,150) and S o Paulo (population 8.5 million).

These spatial differences clearly suggest caution when generalizing from

fiscal data aggregated to the national level.

State and Local Revenue Sources

State taxes. Taxes account for about 60% of total state revenues

(see Table 2). Though the states are permitted to tax transfers of real

property (ITBI), for all intents and purposes the only meaningful tax

available at this level is the ICM. In recent years, ICM collections have

comprised about 95% of the states' total tax revenues.

7/ In 1975, for example, state decentralized agencies accounted for about

34% of expenditures at the state level, but only 8% of the revenues.

8/ The full dimensions of the federal public sector are quantified in:Carlos von Doellinger, "Estatizacao, Financas Publicas e suasImplicacoes", Camara de Estudos e Debates Econ8micos e Sociais -CEDES, Relatorio de Pesquisa No. 1 (December 1981).

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Table 1

Structure of the Public Sector, 1975 a/

(Cr.$ millions)

Federal State Municipal All Governments

1. Current Revenues 202,699.7 70,735.4 b/ 9,767.5 283,202.6(X) (71.6) (25.0) (3.4) (100.0)

2. Capital Revenues c/ 2,275..8 653.4 220.1 3,149.3(%) (72.3) (20.7) (7.0) (100.0)

3. Total Revenues (1) + (2) 204,975.5 71,388.8 9,987.6 286,351.9(X) (71.6) (24.9) (3.5) (100.0)

4. Current Expenditures 162,420.1 55,082.9 6,210.1 223,713.1(%) (72.6) (24.6) (2.8) (100.0)

5. Capital Expenditures d/ 27,734.9 26,305.1 6,142.7 60,182.7(%) (46.1) (43.7) (10.2) (100.0)

6. Total Expenditures(4) + (5) 190,155.0 81,388.0 12,352.8 283,895.8

(%) (67.0) (28.7) (4.4) (100.0)

7. Current Surplus/Deficit(1) - (4) 40,279.5 15,652.5 3,624.8 59,489.5

8. Total Surplus/Deficit(3) - (6) 14,820.5 -9,999.2 -2,365.2 -2,456.1

a/ Data include decentralized agencies, but exclude public enterprises;intergovernmental transfers have been deducted to avoid double-counting.

b/ All of ICM collections attributed to states.c/ Net of borrowing.d/ Excludes debt amortization.

Source : Instituto Brasileiro de Geografia e Estatlstica (IBGE), unpublished.

The states' freedom to levy the ICM is restricted by the federalgovernment's authority to determine the tax base and rates. In its presentform, the ICM is not a true tax on global value-added because of the widerange of exemptions from the tax base. Among the more important of theseexemptions are certain essential foodstuffs (e.g., milk, eggs, freshvegetables), manufactured exports, industrial machinery and equipment,agricultural inputs, fuels, minerals and services. From time to time, thefederal government has also granted additional exemptions to promotepriority objectives of national economic policy. At present, the ICM taxrate is set at a uniform 16% for all intrastate transactions. (In thepast, rates had been set higher in the relatively poor North and Northeastto help compensate for the lower state tax bases in these regions). Therates are lower on interstate transactions (11% on sales originating in theNorth, Northeast and Center-West and 9% on sales originating in theSoutheast and South), which are taxed according to the origin of sales.

Municipal taxes. The Brazilian Constitution limits municipios totwo tax bases: urban property and "services of any type". The urbanproperty tax (IPTU) applies to land and buildings in areas of eachmunicfpio defined according to federal guidelines as "urban." To beclassified as urban for fiscal purposes, a lot must be served by at leasttwo services constructed or maintained by the municipal government (amongthem sidewalks, water supply, sewers, street lighting, a primary school, orhealth post). While this definition exempts much of the tax base of ruralmuniclpios, it is in practice a fairly generous definition of an urbanarea. Unlike state taxes, property tax rates are federally unrestricted.A recent Supreme Court decision has upheld the power of municipal govern-ments to "correct" the assessed value of all urban property for inflation,up to a ceiling established by the treasury bond index (ORTN), without anyassessment based on actual field data.

The service tax (ISS) is similarly limited to a federally-defined base. Types of services liable to the tax are specified by federallegislation. The legal base of the ISS is the gross value of the serviceperformed, but in the case of some self-employed professionals federalcourts have approved the power of municipal governments to assess the taxon a "per worker" basis in the interest of administrative convenience.Under this system, each municipio is permitted to set a reference value fortax purposes; a given worker's tax bill is equal to this reference value,or some fixed fraction thereof. Unlike the property tax, the maximum ratesof the service tax are set by the federal government.

Table 2

State and Municipal Revenues by Source, 1978 a/

S T A T E S M U N I C I P I O S

Cr$ 106 % Cr$ 106 X

Exclusive Sources 173,884.2 67.8 Exclusive Sources 22,992.1 48.5

Value-Added Tax(ICM) b/ 151,865.0 59.2 Service Tax (ISS) 7,768.6 16.4

Transfer Tax (ITBI) 4,099.7 1.6 Property Tax (IPTU) 7,834.5 16.5Non-Tax C/ 17;919.5 7.0 Non-Tax c/ 7,389.0 15.6

Transfers 50,367.2 19.6 Transfers 18,804.2 39.7

Participation Fund(FPE + FE) 15,769.2 6.1 Federal: Participation Fund (FPM) 1,233.4 2.6

Fuels Tax (IULC) 7,562.5 2.9 Fuels Tax (IULC) 597.4 1.3Electricity Tax (IUEE) 4,158.8 1.6 Electricity Tax (IUEE) 60.5 0.1Vehicle Registration Vehicle RegistrationTax (TRU) 3,324.6 1.3 Tax (TRU) 222.0 0.5Ed. Salary Tax (SE) d/ 4,647.6 1.8 Grants e/ 1,713.6 3.6Grants e/ 9,469.3 3.7 Others t/ 810.9 1.7Others f/ 5,435.2 2.1

Credit Operations 32,218.7 12.6 State: Value-Added Tax 13,725.7 29.0(ICM) Grants e/ 446.7 0.9

TOTAL REVENUES 256,470.0 100.0 Credit Operations 5,569.3 11.8

TOTAL REVENUES 47,365.6 100.0

a/ Central budgets only; municipal data refer to state capitals only.b/ .State share (80%).c/ Includes fees, property income, asset sales, "miscellaneous" and taxes (ISS, IPTU) collected in

the Federal District.di Includes share transferred through the National Educational Development Fund (FNDE).e/ Transfers not linked to specific taxes.f/ Includes transfers from decentralized agencies and public enterprises; shares from minerals tax

(IUM) and "miscellaneous".

Source : IBGE, Estatlsticas Economicas do Governo Estadual e Municipal, 1978 (Rio de Janeiro,1980).

- 10 -

Federal revenue sharing. Intergovernmental transfers constituteimportant sources of revenue for some of the poorer states and for the

majority of local governments (see Table 2). The present revenue-sharing

system contemplates flows of funds between the federal government and thestates, the federal government and the municlpios, and the states and the

municlpios. As shown in Table 3, a variety of federal taxes are currently

shared with the states and municfpios. 9/ The most important of these are

the income tax (IR), manufacturers' sales tax (IPI), the "sole taxes" on

fuels and electric energy (IUCL and IUEE, respectively), the automobileregistration tax (TRU) and the education salary tax (SE). In 1981, these

six taxes accounted for about 80% of total federal tax revenues.

Shares from the IR and IPI are transferred to the state and local

governments through "Participation Funds" (Fundos de Participacao - FPs).

Overall responsibility for the FPs rests with the Secretaria de Articulacao

cor os Estados e Munictpios (SAREM) of the Federal Planning Secretariat(SEPLAN), an agency which also provides technical assistance to state and

local governments. The percentages of the IR and IPI to be deposited in

the FPs have varied considerably over the years. The figure for 1982 is

23% (see Table 3) and is scheduled to rise to 24% in 1984. At present,there are three FPs: 10.5% of each tax goes to the State Fund (FPE), a like

amount goes to the Municipal Fund (FPM), and 2% is deposited in a "Special

Fund" (FE). The latter is reserved for the northern and northeasternstates and for Esplrito Santo, Goias, Mato Grosso and Santa Catarina.

The criteria employed for determining individual shares from the

FPs are broadly based on the concept of "need". That is, a given state or

municfpio's land area, population and per capita income are all taken into

account (see Table 3). There are two exceptions to this rule: (i)municlpios other than state capitals (entitled to 90% of the FPM) receive

their shares based on population alone; and (ii) the FE is distributedaccording to criteria determined annually by SEPLAN. In order to enhance

further the regionally redistributive impact of the FPs, a special reserve

fund for states in the relatively poor North and Northeast was establishedin 1975. This reserve is constituted through 20% shares of the FPs and is

received by the beneficiaries as an addition to their normal FP and FE

quotas.

Originally, shares from the FPs were to be transferred to thestates and municipios with a number of "strings attached". During most of

the 1970s, both levels of government were required to earmark 30-50% of

their shares for expenditures on certain functions (education, health and

sanitation, agriculture and the formation of "development funds").Moreover, at least half of the total proceeds were to be allocated to

capital expenditures. In order to help ensure that this earmarking would

be carried out, spending plans were to be submitted for federal government

approval prior to the release of individual shares.

9/ It should be noted that funds transferred through institutionalizedtax-sharing schemes do not account for all intergovernmentaltransfers.. As shown in Table 2, some funds are transferred as ad hocgrants and/or emanate from the decentralized sector.

Table 3

SunLry of ?rincipal Revenue-Sharing Mechanisms

(As of Januar 1, 1982)

Total Division (X)Shared Taesa a/ Collections, 1981 Distribution

r(C T bfiio States Municipios Criteria Earmarking

1. Income Tax (IR) 965.3 12.50 b/ 10.50 Land area (52); PASEP (2%); educationpopulation and inverse sector (20X) (municipios2. Manufacturers' Sales Tax (IPI) 613.5 12.50 b/ 10.50 of state per capita only)income (95Z). c/

3. Fuels '"ax (IULC) 60.1 30.72 8.00 Land area (202); Transport sector (1002); inpopulation (402); accordance with Nationalconsumption (402). d/ Highway Plan.

i. Vehicli Registration Tax (TRU) 61.2 45.00 - Origin basis; municipal Programa dequotas at discretion of Mobilirco Energetico

etaten. ~ ~~~~ -, PME(3X) Programastates. .Z65Especial de ViasExpressas - PROGRES(28.5X) roadimprovements (35.52).

S. Interstate and IntermanicipalHighway Transport Tax (ISTR) 19.8 20.00 - Origin (502); length of Transport sector (1002); for

highway network (302); road maintenance,population (202). rehabilitation and

improvements, traffic safety,and construction of passengerand cargo terminals.

i. Electlicity Tax (IUEE) 60.6 50.00 10.00 Land area (202); Investment in energy sectorpopulation (602); (1002).production (22) andconsumption (152) ofelectric energy; areainundated byhydroelectric projects(32).

Minerils Tax (IUM) 18.1 70.00 20.00 Origin basis. In direct or indirect benefitof mining sector (states);priority to education, socialassistance, roads andelectric energy (municipios).

1. Education Salary Tax (SE) 62.6 66.67 - Origin basis. Basic education (1002).

1. Rural Land Tax (ITR) 14.0 (eat) - 80.00 Origin basis. None.

O.Valu.-Added Tax (ICM) 1,209.2 80.00 20.00 Origin (752); at None.discretion of states(25X).

I.Prop4!rty Transfer Tax (ITBI) lO.(, e/ 50.00 50.00 Origin basis. None.

a/T'Taxes 1-9 are federal; 10 and 11 are state,,b/ Lwo percent allocated to "Special Fund" (FYI).c/ 3hares to non-state capitals (90X of municipal quota) distributed on basis of

)opulation only.d/ Refers to imported fuels.e/ 1980 data.

- 12 -

In response to criticism that the earmarking provisions and

burdensome bureaucratic procedures were interfering with state and localpolitical autonomy and the efficient allocation of public resources, the*strings" on shares from the FPs were substantially eliminated during

1979-81. 10/ The only earmarking that remains are the provisions that 2%of the FPEiand FPM be deducted for the Public Employees' Financial ReserveFund (PASEP), and that 20% of the FPM be devoted to education. Priorfederal approval of budgets is no longer required, and shares are trans-ferred automatically to the recipient governments by the Bank of Brazil asthe taxes are collected.

The manner in which the other major federal taxes (i.e., IULC,IUEE, TRU and SE) are shared with the states and municipios differs concep-

tually from that of the Participation Funds. One difference is that thedistribution criteria for these taxes do not explicitly promote the reduc-tion of interregional disparities. 11/ In fact, the relative weights

given to such factors as population, production, consumption and motorvehicle ownership (see Table 3) suggests that the benefits from these

revenue-sharing mechanisms would tend to be concentrated in the denselypopulated and highly industrialized Southeast. Another difference is thatthe transfers from the "sole taxes", TRU and the SE are fully earmarked to

the transport, (IUCL, TRU) energy (IUEE) or education (SE) sectors.

State revenue sharing. State taxes shared with the municfpios

include the value-added tax (ICM) and, starting in 1981, the propertytransfer tax (ITBI). Shares of the ICM constitute the single most impor-tant source of revenue for many local governments. Through the 1965-67reforms, a mechanism was established whereby the states would collect theICM and distribute 20% of the proceeds to the municfpios on an origin

basis, gross of state exemptions. Such shares are transferredautomatically to the recipient governments and are not subject toearmarking. However, owing to the particular sectoral incidence of theICM, the main beneficiaries of this tax-sharing mechanism tend to be themore industrialized municfpios. 12/ This peculiarity has had somenegative distributional consequences in a spatial sense, which has prompted

the passage of new legislation permitting the states to transfer up to 25%

of the municipal share according to discretional criteria.

10/ For an early critique of the earmarking provisions, see: A. Barbozade Araujo, M.H.T. Taques Horta and C.M. Considera, Transferencias deImpostos aos Estados e Municipios (Rio de Janeiro: IPEA/INPES, 1973).

11/ It should be noted, however, that the federal share of the educationsalary tax (33%) is transferred back to the states on need-basedcriteria through the National Educational Development Fund (FNDE).

12/ For a discussion of the sectoral incidence of the ICM, see:F. A. Rezende da Silva and M. da Concei'ao Silva, 0 Sistema Tributarioe as Desigualdades Regionais: Uma Analise da Recente ControvdrsiaSobre o ICM (Rio de Janeiro: IPEA/INPES, 1974), Ch. IV.

- 13 -

Credit operations. In recent years, credit has become increas-ingly important as a source of state and municipal revenues. The sourcesof this credit have taken many forms, including bond placements and loansloans from official and commercial (domestic and foreign) banks. Thoughexpressly forbidden by 1kw, it would appear that "arrearages" have alsobeen increasingly used as a means of financing state and local government.

The general rules governing the domestic indebtedness of thestates and municfpios are contained in two resolutions of the FederalSenate Resolution 62 of October 28, 1975 and Resolution 93 of October 11,1976. 13/ The first of these resolutions sets limits on both total andannualfindebtedness. The basic rules are: (i) the total debt outstandingin any given year may not exceed 70% of a given state or municlpio's totalrevenues (adjusted for inflation) of the previous fiscal year; (ii) theamount of debt contracted in any year may not exceed 20% of the totalrevenues of that year; and (iii) debt service (interest plus amortization)in any year may not exceed 15% of the total revenues (adjusted for infla-tion) of the previous fLscal year. For purposes of establishing theselimits, credit operations are excluded from the concept of "total state ormunicipal revenues". Funds obtained under the rules of Resolution 62 areknown as "intralimit" credit.

Resolution 93 broadens the rules established under Resolution 62by freeing certain credit operations from pre-set limits. Such operations,known as "extralimit" credit, apply only to funds obtained from theNational Urban Development Fund (FNDU), the Social Development Fund (FAS)and the National Housing Bank (BNH). However, states and municfpios seek-ing credit from these sources must obtain the approval of SEPLAN, theNational Monetary Council (CMN) and the Federal Senate. Prior approval bySEPLAN and the Senate Ls also required in the case of all foreign borrow-ing, even when a given state or municlpio is below its legal debtlimit. 14/

State and Local Functional Responsibilities

In contrast to the strict separation of revenue sources, the lawis vague when it comes to allocating functional responsibilitLes to thestates and municfpios. Legally, the states are permitted to engage in anyactivity not explicitly or implicitly forbidden to them by the FederalConstitution. Since few functions are assigned to any level of governmenton an exclusive basis., this has theoretically given the states considerable

13/ These rules apply to state and municipal governments proper and totheir decentralized agencies (autarquias. .or fundagoes), but not topublic enterprisies. This is said to be an important loophole.

14/ Through a ruling by the Central Bank (Circular 648 of August 5, 1981),the states and municdpios may circumvent prior Senate approval offoreign credit cperations by sub-borrowing in local currency fromloans obtained abroad by financial intermediaries (generally state orregional development banks) under the provisions of Resolution 63 (ofAugust 21, 1967). These types of operations, however, still requirethe approval of SEPLAN.

- 14 -

freedom. The Constitution is at its vaguest when referring to the func-tions of the munic4pios, which are held responsible only for the organiza-tion of "local public services".

In practice, the lack of a strict delineation of functions has

led to a situation in which a wide range of public services are provided by

more than one level of government. This is clearly illustrated inTable 4. The federal government quite logically maintains a virtualmonopoly over national defense and foreign affairs, but almost all otherservices are jointly provided to some extent. However, certain levels ofgovernment have tended to specialize in specific functional areas. At the

state and local levels, this specialization is most clearly observed in

some of the social services. In 1975, for example, the states andmunicfpios combined accounted for significant portions of public spending(after transfers) in the following social sectors: housing and urbanservices (99%), education (74% overall, and 98% at the primary level) andhealth and sanitation (47%). The state-municipal share of total publicexpenditures in the same year was about 33%.

The data in Table 4 also give some idea of the de facto division

of responsibilities between the state and local governments. In broadterms (keeping in mind that the level of aggregation masks important inter-regional differences in the spending patterns), states tend to be rela-tively more involved in the "economic services" (agriculture, energy,industry and commerce) than are the nunicipios. The opposite appears to be

true in the case of the "social services". However, it may be observedthat the relative importance of local government in providing socialservices is attributable almost solely to their intensive activity in thearea of housing and urban services. Education, on the other hand, ismainly a state function, although the municdpios do play an important role

in providing education services at the primary level. T5/ In 1975, about

70% of total municipal expenditures on education were alTocated to theprimary system.

15/ The Education Reform Law (Law 5692 of August 11, 1971) holds that

education services are provided "most satisfactorily by localadministrations" and calls for the progressive transferral of thisfunction to the municipios. Although practices vary from state tostate, rural primary education is usually the responsibility of themunicfpios, and urban primary education the responsibility of thestates. See: Instituto Brasileiro de AdministraSa4o Municipal (IBAM),Pesquisa Sobre as Relacoes Intergovernamentais: 0 Estado e oMunicfpio (Rio de Janeiro, 1974), pp. 246-47.

Table 4

Public Expenditures by Function and Level of Government, 1975 *

Federal State Municipal -All GovernmentsFunctional Categories Cr.$106 % Cr.$106 % Cr.$100 % Cr.$100 X

GENERAL GOVERNMENT 45,748.7 63.4 23,931.5 33.2 2,487.8 3.4 72,168.0 100.0

Administration 32,121.7 62.8 16,541.2 32.A 2-461.5 4.8 51,124.8 100.0Defense & Foreign Affairs 9,432.8 100.0 - - - - 9OO..Police 4,194.2 36.1 7,390.3 63.7 26.3 0.2 11,610.8 100.0

ECONOMIC SERVICES 43,644.1 65.8 20,159.1 30.4 2,533.5 3.8 66,336.7 100.0

Agriculture & Natural Resources 6,650.8 73.4 2,407.2 26.6 1.9 0.0 9,059.8 100.0Energy 3,281.3 43.3 4,293.9 56.7 3.7 0.9 7,578.9 100.0Transport & Communications 20,639.2 59.6 11,601.3 33.5 2,368.0 6.8 34,608.5 100.0Industry & Commerce 13,072.8 86.4 1,896.8 12.5 159.9 1.1 15,129.5 100.0

SOCIAL SERVICES 101,513.3 69.4 37,257.4 25.5 7,331.5 5.0 14,102.2 100.0

Education 6,541.0 26.2 16,913.1 67.8 1,475.6 5.9 24,929.7 100.0Housing & Urban Services 81.2 1.4 1,868.2 33.3 3,669.1 65.3 5,618.5 100.0Health & Sanitation 10,746.1 53.0 8,177.5 40.3 1,306.5 6.7 20,284.1 100.0Labor & Welfare 84,145.0 88.3 10,298.6 10.8 826.3 0.9 95,269.9 100.0

TOTAL 190,155.0 67.0 81,388.0 28.7 12,352.8 4.3 283,895.8 100.0

* Data include decentralized agencies, intergovernmental transfers have been deducted.

Source: IBGE (unpublished)

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IV. CORRESPONDENCE OF REVENUES AND EXPENDITURES:THE QUESTION OF VERTICAL BALANCE

In order to maintain the fiscal stability of a federation, it is

necessary that there be broad correspondence between resource availability

and functional responsibilities (whether de jure or de facto) at each levelof government in the system. This ideal balance may be achieved at a givenpoint in time, but in most federations it has proven difficult to maintainin the long run. Various hypotheses have been put forward to explain thisphenomenon. Some authors attribute vertical imbalances simply to poorfiscal management. The majority view, however, is that such imbalances are

inherent to federations. Proponents of the latter argument hold that the

most productive modern taxes (especially those on income and value-added)are collected efficiently only at the national level, while optimal scalein the provision of most public services is reached at the subnationallevel. There is, thus, a tendency for subnational governments to bechronically underfinanced.

When vertical imbalances become evident, adjustments in theintergovernmental fiscal system are called for--on the revenue side, expen-diture side, or both. Solutions have varied from country to country,ranging from the establishment of revenue sharing and grant mechanisms, toshifts from one level of government to another of authority over specific

taxes or spending functions. The purpose of the present section is todiscuss the extent to which vertical balance has been achieved and main-tained in Brazil, and to assess the efficacy of the present adjustmentmechanisms. Owing to data limitations, the quantitative analysis of morerecent years is mainly confined to the states.

The "Conventional Wisdom"

It is commonly asserted in Brazil that state and local financeshave deteriorated significantly in recent years. 16/ Through the 1965-67fiscal reforms, it is argued, the federal government assumed control overthe most elastic revenue sources, leaving the rest to the states andmunicfpios. The principal effect has been for the subnational governmentsto become less and less capable of covering expenditures with their ownrevenue sources. This has led to increasing deficits and more frequent

recodrse to outside sources of funds such as revenue-sharing, grants and

borrowing. The latter tendency has been interpreted by some as evidence of

an increasing fiscal (and by implication, political) dependence of thestates and municfpios on the federal government. In order to assess the

validity of the scenario sketched above, several basic fiscal indicatorswere calculated for the period 1968-80. These include calculations ofcurrent account saving ratios, investment rates and the extent to whichstate and local governments have engaged in deficit financing.

16/ See, for example, "Reflexos da Reforma Tributaria de 1966 nasFinangas Estaduais," Revista de Finangas Publicas, XXXVIII, 336(1978), 47-80; and "Reflexos da Reforma Tributaria de 1966 nasFinan9as Municipais ", Revista de FinanEas Pdblicas, XXXIX, 337(1979), 43-60.

- 17 -

Saving and Investment

The saving and investment indicators presented in Table 5 show adeteriorating trend over the 1968-80 period. During the first seven yearsof the series, the states were able to cover current expenditures and toinvest on the basis of t:heir own revenues from taxes and fees, but thisproved impossible after 1974. If intergovernmental transfers are added tothe states' own current revenues, positive saving rates may be observed inall years of the series (see Table 5, column I [D]). However, during thepost-1974 period, these rates behave erratically and are, on the average,lower than those prevailing in 1968-74. The growing dependence on outsidefinancial assistance is illustrated by the ratio of federal transfers tototal state revenues (net of borrowing), which rose from 14% in 1968-69 to22% in 1979-80.

Generally declining saving rates have quite clearly reduced thestates' capacity to invest. Capital expenditures as a proportion of totalexpenditures, which rose from 26.8% in 1968 to 37.6% in 1974, subsequentlyfell to 30.6% in 1980 (see Table 5, column II). Moreover, of the invest-ment spending which did occur, only a part was financed through currentsaving. The rest was covered by miscellaneous capital receipts (e.g.,property sales, rents and participation in industrial enterprises), arrear-ages and, most importantly, by borrowing.

Deficit Financing

The growing imbalance between state revenues and expenditures hasled to an increasing reLiance on deficit financing. Deficits in relationto total expenditures appear to have worsened at the state level (and locallevel as well) starting in 1974 (see Table 5, column III). The relativesize of the states' deficit peaked in 1977 but has since remained at highlevels by historical standards (see Table 5, column III). In aLbsoluteterms, the cumulative deficit of the states amounted to Cr.$868 billion(1980 prices), or US$16.4 billion equivalent at the average officialexchange rate. About 70% of this total was realized after 1974.

During the 1968-80 period, approximately 95% of the states'deficits (Cr.$819 billion in 1980 prices) were covered by credit operationsof various types. (It must be assumed that the remainder was financedthrough arrearages). Among the factors facilitating borrowing of thismagnitude were the introduction of indexed debt instruments in themid-1960s; the establis'hment and subsequent growth of compulsory savingsfunds such as PASEP, the Social Integration Program (PIS), and the Time ofService Guarantee Fund (FGTS); the passage in 1976 of Senate Resolution 93,which freed certain credit operations from pre-set limits (see page 13);and the availability of a multitude of official, frequently subsidized,credit lines for financing activities in water supply and sanit:ation, urbantransport, housing, social services, pre-investment studies, and soforth. 17/

17/ The nature and terms of these credit lines are convenientlysummarized in two publications of the Ministry of Finance: Fontes deFinanciamentos aos Estados (Brasilia, November 1980) and Fontes deFinanciamentos aos Municipios (Brasflia, September 1980).

- 18 -

Table 5

Selected Indicators of State (S) and Municipal (M) Finances, 1968-80

(%)

II. Investment III. DeficitI. Current Saving Ratio Ratio Ratio

Year (a) (b)

S M S M S M S M

1968 4.5 -147.5 17.2 33.6 26.8 44.7 -4.0 -5.9

1969 0.7 -147.7 12.7 27.7 29.1 41.1 -8.5 -7.1

1970 1.4 -135.5 16.4 30.5 30.2 41.0 -8.0 -2.1

1971 2.8 -137.3 15.8 28.1 29.4 40.0 -5.3 -1.1

1972 2.4 -145.7 14.7 25.3 32.4 39.3 -9.6 -7.4

1973 6.4 -143.6 19.5 26.0 34.7 37.7 -7.9 -5.3

1974 7.2 -134.8 20.4 28.7 37.6 44.7 -10.8 -13.4

1975 -5.0 -126.3 13.7 29.9 36.3 46.2 -16.6 -14.3

1976 -9.7 n.a. 8.9 n.a. 34.7 n.a. -17.1 n.a.

1977 -2.5 n.a. 17.1 n.a. 35.6 n.a. -9.2 n.a.

1978 -6.0 n.a. 13.7 n.a. 34.5 n.a. -13.3 n.a.

1979 -14.6 n.a. 7.8 n.a. 29.0 n.a. -12.8 n.a.

1980 -5.8 n.a. 15.2 n.a. 30.6 n.a. -9.9 n.a.

Definitions:

Current SavingRatio (a) = Own current revenues less current expenditures

divided by own current revenues.(b) = Total current revenues less current expenditures

divided by current revenues.Investment Ratio = Capital expenditures divided by total expenditures.Deficit Ratio = Total revenues (excluding credit) less total

expenditures divided by total expenditures.

Note: Data exclude decentralized agencies and public enterprises.Only state share of ICM (80%) included in state "own currentrevenues "*.

Source : Raw data provided by MinistArio da Fazenda, Secretaria deEconomia e Financas (MF/SEF).

- 19 -

As of October 1931, the states' (excluding decentralized agenciesand public enterprises) total medium and long-term debt outstanding stoodat Cr.$952.5 billion (US$8.3 billion equivalent). The evolution cf thisdebt since December 1977 is shown in Table 6. It may be observed thatstate indebtedness increased by about 10% per year in constant pricesduring the period, a rate considerably above the 3% annual rate of increasein state revenues (net of borrowing). Though this would imply a risingcebt service ratio, it is not possible, on the basis of the available data,t.o judge conclusively whether future service payments will seriously impairthe states' capacity to meet other expenditure commitments. In addition toprojections of state revertues, such an analysis would require detailedinformation on the terms of the debt outstanding (average maturities and:nterest rates) and the nature of the projects for which the debt was:Lncurred (e.g., whether these projects are self-financing, give rise tosiignificant recurrent cost:s).

Table 6

Structure of State Debt at Year End, 1977-81 a/(Percent)

Components 1977 1978 1979 1980 1981(Oct.)

Foreign 28.2 24.4 33.3 33.0 29.1

Domestic 71.8 75.6 66.7 67.0 70.9of which:

"Intralimit" b/ (73.1) (68.1) (67.7) (66.3) (64.8)"Extralimit" c/ (26.9) (31.9) (33.3) (33.7) (35.2)

Total 100.0 100.0 100.0 100.0 100.0

(Cr.$ billions, Dec. 1980 prices) 361.1 425.7 542.9 465.4 533.6

a/ Excludes decentralized agencies and public enterprises.b/ Contracted under rules of Senate Resolution 62 (1975).c/ Contracted under rules of Senate Resolution 93 (1976).

Source : Banco Central

Principal Causes of the States' Fiscal Problems

Macroeconomic conditions. Owing to their dependence on taxesrelated to production, sales and income (e.g., ICM, ISS, shares from theIPI and IR), the revenue structures of both the states and munidcpios aresensitive to changes in macroeconomic conditions. "Buoyancy coefficients"calculated for the 1968-30 period (1968-75 in the case of the localgovernments) are near unity (see Table 7 below). That is, for each

- 20 -

percentage-point change in GDP, state and local revenues changed by close

to a like amount. 18/

Table 7

Buoyancy of Revenues by Level of Government, 1968-80 a/(Coefficients)

Level of Tax TotalGovernment Revenues Revenues b/

Federal 0.97 0.95

State 0.92 0.95

Municipal c/ 1.08 0.98

a/ Estimated on the basis of simple double logarithmic functions relating

revenues to GDP.b/ Excludes borrowing.c/ Data are for 1968-75 period.

Source: Raw data from MF/SEF.

As shown in Table 8, national economic growth rates were consid-

erably higher in the 1968/69-1973/74 period than in the latter part of the

1970s. Not surprisingly, this led to a reduction in the annual growth of

state revenues from an average of 9.8% in the late 1960s and early 1970s to

5.5% in the latter half of the decade. The states responded to this short-

fall in revenues by sharply curtailing total expenditures. However, the

data indicate that the states were far more successful at cutting invest-

ments than current expenditures (see Table 8).

Investment expenditures are, by their nature, easier to postpone

than current expenditures. But the two are frequently related. That is,

public investments made in one period give rise to associated recurrentcosts (e.g., salaries, maintenance) in a subsequent period. It may be

hypothesized, therefore, that the states' inability to cut current expendi-

tures in the latter part of the 1970s was related to the recurrent costs

gen&rated by the high rates of investment observed earlier in the decade.

Though highly aggregated, the data in Table 8 generally support this hypo-

18/ The calculations presented in Table 7 suggest that the "conventionalwisdom" regarding the intergovernmental division of tax sources is

essentially correct ( page 16)--since 1968, federal taxes have beenmore buoyant with respect to GDP than those allocated to the states.Municipal taxes tended to be highly buoyant during the 1968-75 period,

but owing to a lack of data for recent years, a direct comparison withthe federal coefficient could not be made.

- 21 -

thesis. The available data do not permit a linkage of operating costs tospecific types of investtaents. However, it seems reasonable to assume thatthe burden of recurrent 0ost financing has been mst severe in statesemphasizing the social sectors, as investments in this area (e.g.,education and health) are normally characterized by highrecurrent-to-investment cost ratios, and low levels of cost recovery. 19,

Table 8

Annual Growth Rates of State Revenues and Expenditures

and GDP, 1968/69 - 1979/80 a/

(%)

1968/69- 1968/69- 1973/74-1979/80 1973/74 1979/80

Total Revenues b/ 7.4 9.8 5.5ICM Revenues 6.9 9.1 5.0

Total Expenditures 8.0 10.5 5.9Current Expenditures 7.7 7.8 7.6

- Operating Costs (custeio) 7.3 6.3 8.1- Transfers C/ 8.5 10.3 7.0

Capital Expenditures 8.6 16.3 2.5

GDP 8.8 11.3 6.8

a/ Adjusted with GDP implicit deflator; data exclude decentralizedagencies and public enterprises.

b/ Excludes borrowing.c/ Excludes transfer of ICM share (20%) to municlpios.

Source : Fiscal data are from MF/SEF; GDP data are from Getulio VargasFoundation (published in Conjuntura Economica)

In this respect, it is interesting to cite the case of Parana'where, in the face of declining rates of revenue growth, chronic deficitsand recourse to borrowing have been largely avoided by a deliberate policyof concentrating investments in physical infrastructure (mainly transportand energy) so as to minimize subsequent pressures on current expendi-tures. 20/ It is difficult to see, however, how this policy could have

19/ This issue is further explored in F.A. Rezende da Silva, "OFinanciamento da Polltica Social," Pesquisa e Planejamento Economico,X, 1 (1980), 12:3-46.

20/ See Fundagao IPARDES, "Participa,a`o do Setor Pu'blico na EconomiaParanaense", Relatorio de Pesquisa No. 1 (Curitiba, January 1980).

22 -

been emulated by many other states, especially the poorer ones. In

contrast to the poorer states, Parana has maintained a low dependence onfederal transfers (7.8% of total revenues in 1978 versus about 20% for all

states), which has given the state considerable freedom to determine its

own sectoral allocation of investment expenditures, coupled with a very low

rate of population growth (0.96% p.a. in 1970-80 versus 2.48% p.a. for

Brazil as a whole), which has restrained the demand for social services.

Legislative changes. The erosion of the ICM base through a

series of legislative reforms has compounded the adverse effect on state

and local finances. 21/ One of these reforms was the decision of the

federal government tColower gradually the rate of the ICM. Starting in1970, the rate on intrastate transactions was reduced by 0.5% per year from

17% in the Center-South (18% in the North/Northeast) to 14% in 1976 (15% in

the North/Northeast). It stayed at these levels until 1980 when the rate

was raised by one percentage point. In 1982, the ICM rate on intrastate

transactions was set at a uniform 16% for all regions.

Another source of tax base erosion has been the intensive use of

the 1CM for purposes of stimulating exports and for subsidizing certain

projects of "national interest". Incentives of the first type were

established during the late 1960s and early 1970s. Until 1979, they were

comprised of three elements: direct exemption, indirect exemption and a

subsidy. 22/ Direct exemptions from the ICM for manufactured exports were

provided for in the 1967 Constitution, but these were limited to the final

stage of production. Starting in 1971, however, exporting firms were

permitted a direct exemption, plus a credit (which could be applied to the

firms' other ICM liabilities) equal to the ICM paid at previous stages of

production. In the same year, the incentive mechanism was further expanded

to include a subsidy element (the so-called credito-pr^mio) in the form of

an additional ICM credit expressed as a percentage of the firm's FOB export

value. 23/ The subsidy to projects of "national interest" was established

in 19757. In essence, it provides that inputs to projects deemed high

priority by the federal government are exempt from the ICM. During recent

years, such projects have been concentrated in the telecommunications,power and steel sectors.

21/ Some legislative changes passed during the 1970s directly benefitted

the states and munic:pios. The portions of the IR and IPI to be

deposited in the Participation Funds, for example, increased from 12%

to 20% between 1970 and 1979, and the earmarking of shares from these

funds was virtually eliminated in the latter part of the period (see

pages 10-12).

22/ W.G. Tyler, Manufactured Export Expansion and Industrialization in

Brazil (J.C. B. Mohr: Tubingen, 1976), pp. 210-12.

231 Until 1977, the states were expected to bear the full fiscal burden

of the cr6dito-premio. In 1977, the federal government absorbed 50%

of the burden, and in the following year the ICM credito-premio was

abolished.

- 23 -

A quantification of ICM revenues foregone as a result of legis-Lative changes is difficult because of data limitations and methodological,roblems. However, such an exercise was carried out for Sao Paulo (whichaccounts for about 45% of total ICM collections) by the state's FinanceSecretariat. 24/ Accord:Lng to these calculations, about Cr$ 761 billionin 1980 prices TUS$14.4 billion) were lost through ICM rate changes andvarious exemptions during the 1972-80 period. This is equivalent to about37% of the total ICM revenues effectively collected in Sao Paulo. Therevenue losses via exemptions (Cr$513 billion) were found to be consider-ably more important than those accounted for by changes in the IM rate(Cr$248 billion).

Though declines in the ICM rates mDst likely resulted in realrevenue losses for the states, the purported shortfall caused by exportincentives and the exemptions given to inputs to priority projects isprobably exaggerated. First, the Sao Paulo study implicitly assumes thatall tax-exempt products would have been exported even in the absence of thefiscal incentives. This is a dubious assumption. Second, the study doesnot take into account the multiplier effects of increased production(either for export or for use in priority projects) which induce economicactivity and hence help raise the tax base in other segments of theeconomy. These same criticisms also apply to the argument that reductionsin the income tax and IP'E awarded to exporting firms have adverselyaffected state and local finances by reducing the funds available forredistribution through the Participation Funds.

Administrative aspects. Another aspect of the current fiscalproblems of the states, closely linked to macroeconomic conditions andlegislative changes, is the process of budgetary fragmentation. 25/ Thecentral argument here is that the responsibility for investment E-s becomeincreasingly assumed by state-level decentralized agencies and publicenterprises, leading to a loss of control over expenditures by the statefinance secretariats. The growing relative importance of the decentralizedsector is attributed to the decline in the states' capacity to financeinvestments from their own-source revenues, and the consequent need tosecure resources through federally-controlled grants and credit lines.Rather than pass these funds to the state budgets, the federal governmenthas preferred to channe]. them to state-level decentralized agencies orenterprises (state road departments-DERs, power companies, housingcompanies-COHABs, rural extension companies-EMATERs, collective transportcompanies, etc.) with counterparts at the national level (DNER,

24/ A.C. Pastore, "Avaliac,o Critica da Reforma Tributaria de 1965,"Revista de Financas Publicas, XLI, 348 (1981), 4-32.

25/ This issue is mDre fully explored in: F.A. Rezende da Silva,"Autonomia Polftica e Depende^ncia Financeira: Uma Analise dasTransforma,es Recentes nas Relap"es Intergovernamentais e seusReflexos sobre a Situa,co Financeira dos Estados", Pesquisa ePlanejamento Econc,mico, XII, 2 (1982), 489-540.

- 24 -

ELETROBRAS, BNH, EMBRATER, EBTU, respectively). 26/ Through this process,

effective control over investment decisions in many sectors has passed from

the states to the federal government.

What are the major implications of the administrative transforma-

tions described above? First, they have significantly modified the tradi-

tional concept of planning at the state level. Ideally, planning requires

reasonably accurate projections of available investment funds, and a selec-

tion of various investment options based on their respective economic rates

of return. In constrast, the present system revolves around negotiations

for federal funds--negotiations in which the states, because of their

precarious fiscal situations, find themselves in inferior bargaining posi-

tions. The amount of investment funds to be available, therefore, has

become difficult to predict, and specific sectors or projects to benefit

from these funds are more apt to reflect national priorities than those of

the states.

Second, the loss of control by the states over investment deci-

sions has reduced their control over recurrent costs. In agreeing toaccept federal funds for investments, the states assume responsibility for

the subsequent operation and maintenance of the resulting projects. Since

the operational revenues of many decentralized agencies do not cover their

expenditures, this implies increasing levels of intragovernmental trans-

fers, not only to cover these agencies' operating and maintenance costs,

but to service their debt as well. 27/ This, in turn, sets the stage for a

further deterioration of the states' central budgets on current account,

and the continuation of the present dependence on the federal government

for new investment funds.

26/ The data indicate that, while the growth of investment expenditures

made through the state budgets declined abruptly after 1974 (see

Table 8), the opposite occurred with respect to the state decentral-

ized agencies. Investment expenditures of the latter grew at 2.9%

p.a. in the 1970-75 period, accelerating to 19.8% p.a. during

1975-78. Ibid. p.77.

27/ The summary fiscal accounts of state-level decentralized agencies

(fundacoes and autarquias) for 1978 are as follows (millions of 1978

cruzeiros):

(a) Total Non-Debt Revenues Cr$ 97,123.4

(b) (operational revenues) (30,302.3)(c) (state budget transfers) (58,494.7)(d) (other transfers) ( 8,326.4)

(e) Total Expenditures 106,454.7

(f) Operational Deficit (b)-(e) - 76,152.4

(g) Net Deficit (a)-(e) - 9,331.3

- 25 -

Problems of Municipal Resource Mobilization

Municipal governments are financially the weakest of Brazil'sthree levels of government, accounting for only about 4% of public sectortax collections. However, municipal own-source tax revenues grew rapidlyduring the years of the: Brazilian economic "miracle". Property taxrevenues averaged 17% real growth per year between 1968 and 1975; servicetax revenues grew by 28% annually. Relative to growth in GDP, the buoyancyof tax revenues was above unity, as shown in Table 7. (Data on revenuegrowth during the subsequent economic downturn are not available).

Despite the Lmpressive gains of the 1968-75 period (albeitreflecting to some extent the low bases upon which the revenue growth rateswere calculated), Brazil's relative dependence on property taxation isstill the lowest of any country in Latin America (comparable data on thetaxation of services are not available). As of the late 1970s, only 0.13%of total public revenues came from this source. This may be compared withthe analogous ratios for Argentina (2.25%), Chile (2.49%), Mexico (0.89%)and Peru (5.58%). 28/ Brazil, with a per capita GDP of US$1,160 in 1975,collected just US$5.00 per capita in property taxes from its urban popula-tion. Excluding the country's seven largest municipios, which dominatelocal tax collections, property tax revenues averaged US$2.70 per urbanresident.

There are three potential barriers to further increases inproperty taxation: (i) federal legal restrictions, (ii) municipaladministrative capacit:y, and (iii) political pressures. The case forfederal restrictions as a major constraint on the yield of the property taxis weak. Though the exemption of rural property reduces the tax baseaccessible to rural municipios, there are few other controls on thetaxation of property ( page 8). 29/ The cause of the low yield of theproperty tax lies more in'-the inability or unwillingness of municipalgovernments to exploit the tax bases at hand.

Tax administration. The low yield of the property tax is, to alarge extent, attributable to poor tax administration. Property cadastresoften fail to include recent subdivisions, building improvements or newconstruction, and land and building assessments are frequentLy years outof date. (Municfpios as large as Campinas--with a population of 660,000--make no systematic attempt to update their property cadastres; relyinginstead upon requests for building permits or subdivision approvals totrigger a reassessment.) Uncollected tax bills also reduce the effectiverevenues from the property tax. In Campinas, the value of unpaid property

28/ International Monetary Fund, Government Finance Statistics Yearbook,VI (1982).

29/ Municipal governments are entitled to an 80% share of the federalgraduated tax on rural property (imposto territorial rural - ITR).However, the prLmary function of this tax is to promote more intensivecultivation of Idle or underutilized land, not to raise revenue. Thepotential contribution of the ITR to local finances is thereforelimited.

- 26 -

tax bills exceeds the annual revenues of the tax. Revenues are also keptlow for political reasons (pp. 27-28).Nominal tax rates are typically 1%on land, and 0.5% on buildings. The ratio of assessed value to marketvalue is often deliberately kept low (if it is known at all), resulting ineffective rates of taxation of a few tenths of a percent.

In an effort to improve municipal tax administration, the federalFinance Ministry in 1974 established Project CIATA (Convenio de Incentivoao Aperfei,oamento Tecnico-Administrativo das Municipalidades), a jointfederal-state-municipal program of technical assistance. The programfocuses on smaller municipalities, selected by mutual agreement of thestate and municipal governments, and consists of five components:

(i) revision of the municipal tax code (based on modellegislation prepared by the federal government);

(ii) creation or revision of the municipal property cadastre toinclude all land and buildings subject to propertytaxation, and identify lots served with public lighting,garbage collection or other municipal services subject touser charges;

(iii) creation or revision of the municipal economic cadastre,identifying business as subject to service taxation andmunicipal licensing fees (optional);

(iv) property assessment based upon locally derived land andbuilding value assessment factors; and

(v) processing of cadastre and assessment actions, preparationof bills, processing of tax returns and fines for latepayments.

The first four components are funded largely by grants from the federalFinance Ministry. Data processing, billing, supervision and collection ofdebt--as well as subsequent maintenance of the cadastre--are the financialresponsibility of municipal, and in some cases, state governments. Staff-ing typically consists of a team of federal technicians, with counterpartsfrom the municipal government involved for purposes of training.

CIATA has had an immediate and dramatic effect on municipalrevenues. As shown in Table 9, revenues from the urban property tax andrelated surcharges averaged a real increase of over 100% in municfpiostaking part in the program between 1976 and 1978. Though comprehensivedata on the impact of CIATA are not available, there is general agreementamong Brazilian sources that the program's principal product is a morecomprehensive and accurate property cadastre and a mDre efficient billingsystem. The effective taxation of property owners who previously evadedthe IPTU through unrecorded building improvements or increases in landvalues, or by administrative errors in billing, is the principal source ofrevenue growth attributable to CIATA.

CIATA does not induce an increase in nominal tax rates. Yieldsper capita, therefore, remain relatively low after CIATA assistance. As

- 27 -

ahown in Table 9, revenues per urban resident averaged only US$3.32 amongaunic1pios having received CIATA assistance in 1978. Relative to theyield of the tax, the cost of CIATA assistance is high. CIATA officialsestimate that revisions of property cadastres cost about US$11.00 per unitcadastred. The impact of the technical assistance is also reportedlyshort-lived. Federal officials report they are already returning tomunicfpios covered in the mid-70s to repeat the entire process. In Paranl,where the state now pays for processing costs, local officials reportedthey would not be able tc sustain the present level of tax administrationif state aid were withdrawn.

Table 9

Impact of CIATA on Municipal Revenues, 1976-78

-----Year of Program…-----1976 1977 19713

Yield in preceding year (US$000) 376.00 522.00 1,107.00Yield per capita (US$) 0.95 0.87 1.53Yield in year of program (US$000) 749.00 1,234.00 2,397.00Yield per capita (US$) 1.89 2.08 3.32Percent increase in yield 98.9% 139.0% 117.0%Municipios in program (no.) 21 21 35

Notes: Yield includes only property tax and related surcharges. Dataare for municfpios listed in Minist£rio da Fazenda, "ProjetoCIATA" (mimeo). Per capita figures are calculated from 1980urban population. Cruzeiros converted by average officialexchange rates.

Given the low nominal rates that prevail even after ClATA, andthe rapid decay in its effect, the cost effectiveness of the program isquestionable. Data are not available to permit an accurate calculation ofthe rate of return for the program as a whole. Using the existing data onaverage cost per unit and average increase in yields, it is difficult toarrive at a positive internal rate of return for the program with anyreasonable assumptions regarding duration of impact and costs and yieldswithout CIATA, even counting all increases in municipal revenues as netsocial benefits.

Political constraints. The above discussion suggests thattechnical assistance alone is not a solution to the low yield of municipaltaxes. Political constraints discourage municipal tax effort, even whentechnical problems are resolved. Three factors put the municfp i at adisadvantage in the competition for public resources:

(i) The imayor and city council are directly elected officialsand are the most accessible targets for complaints overhigh taxation. State governors (until November 1982) andthe president have been appointed or indirectly elected,in contrast, and are politically more isolat:ed from thetaxpayers.

- 28 -

(ii) The property tax is a direct tax in a country with atradition of indirect taxation. Two thirds of federaltaxes, and 98% of state taxes are indirect; part of theirincidence being passed from the point of collection on toconsumers in the form of higher prices. To the extentconsumers remain unaware of the source of higher prices,indirect taxation is a politically innocuous source ofrevenues. The municipal services tax is also an indirecttax, which partly accounts for its rapid growth. Theproperty tax, as a direct tax (except when passed on bylandlords and businesses in the form of higher rents orproduct prices), is a conspicuous exception to theBrazilian tax system and is therefore politicallydifficult to impose.

(iii) Because of municipal dependence on transfers, an increasein tax effort has little impact on the ability ofmunicipal governments to provide services. Property taxesaccount for only 11% of non-debt revenues of all Brazilianmunicfpios, and only 7% of the revenues of municipios withpopulations of under one million. As none of the transferformulas reward tax effort, a doubling of property taxeffort would increase municipal current revenues by only11% (Table 10). Excluding municfpios with over a millioninhabitants, a doubling of local tax effort, with itspolitical costs, would only increase the funds availableby 7%.

Table 10

Hypothetical Impact of Doubled Property Tax Efforton Municipal Current Revenues(millions of 1975 cruzeiros)

All Large SmallerMunicipios Municfpios a/ Municfpios

Property tax revenues b/ 5,265.0 3,191.4 2,073.6Service tax revenues 2,597.1 1,792.2 804.9Charges 1,814.1 724.6 1,089.5All other local current revenue 2,580.2 819.0 1,760.9Transfers 14,358.0 4,319.5 10,038.8

Total 26,614.4 10,846.7 15,767.7

Percent increase c/ 11% 17% 7%

a/ Seven municfpios with populations over 1 million in 1975.b/ Represents twice the amount actually collected in 1975.c/ Increase of hypothetical total current revenues over actual revenues.

- 29 -

V. SPATIAI VARIATIONS IN REVENUES AND EXPENDITURES:TEE QUESTION OF HORIZONTAL BALANCE

Regional variations in the correspondence between revenue basesand expenditure requirements exist in all federal systems. Wealthy taxbases are often concentrated in industrial areas, while expenditurerequirements can be higher in rural areas where the population isdispersed, and where greater backlogs exist in the provision of physicaland social infrastructure. Ideally, interregional flows of labor andcapital would eliminate regional disparities. However, the persistence ofsuch disparities in most parts of the world testifies to the inadequacy ofthese flows as a short- or medium-term solution to the problem. Mostfederal systems are, therefore, forced to use intergovernmental transfersas a means to assure an adequate level of public services in poor regions.

The problem of horizontal balance is particularly iraportant inBrazil, owing to the scale of economic disparities. The revenue bases ofstate governments vary widely between the country's major economicregions. The revenue bases of municipal governments vary not only amongeconomic regions, but between industrial and rural areas of each state.This section examines two issues of horizontal balance: (i) the impact ofpublic policy in reducing regional disparities in state and local taxcollections; and (ii) the effectiveness of federal intergovernmentaltransfers in reducing spatial disparities in total resources available tostate and local governments.

Regional Economic Disparities 30/

Regional economic disparities are wide in Brazil. TheSoutheast's highly urbanized, industrialized economic base dominates therest of the country. With 60% of the national population, the Southeastaccounts for over 80% of Brazil's GNP. Gross regional product (GRP) percapita is more than twice the national average. Sixty percent of south-easterners live in cities of over 20,000 and nearly 40% live in metropo-litan agglomerations of over a million. The labor force in engaged primar-ily in services (43%) and manufacturing, construction and utilities (28%).

Northeast B3razil, in contrast, is predominantly rural, agricul-tural, and poor. Two-thirds of the population live in rural areas or intowns with less than 20,000 inhabitants. Fifty-five percent of the laborforce is engaged in agriculture, and only 16% in manufacturing, construc-tion, and utilities. Labor productivity is low in all sectors of theeconomy, but particularly in agriculture, where it is less than a third ofthat of the Southeast. Per capita gross regional product (1970 US$138) iswell under half the national average.

30/ For purposes of the present analysis, Brazil is divided into threeregions: "Southeast" (comprised of Minas Gerais, Espfrito Santo, Riode Janeiro, Sa'o Paulo, Paranl, Santa Catarina and Rio Grande do Sul);"Northeast" (Maranhao, Piaui, Cearl, Rio Grande do Norte, Paralba,Pernambuco, Alagoas, Sergipe and Bahia); and "Frontier" (Rond8nia,Acre, Amazonas, Roraima, Pare, Amapd, Mato Grosso and Goias). See

- 30 -

The interior of Brazil -- the Frontier -- is sparsely populated.Like the Northeast, the Frontier is predominantly rural and agricultural.Roughly one-third of the population live in towns of over 20,000; a figurewhich falls to 25% with the exclusion of Brasflia. Two-thirds of the laborforce is engaged in agriculture, and only 10% in manufacturing, construc-tion and utilities. Population pressures are much less severe in theFrontier than in the Northeast, however, and per capita indicators ofeconomic activity are generally higher. Gross regional product per capitais (1970 US$221); well below the per capita GRP of the Southeast, but abovethat of the Northeast. Average labor productivity in agriculture andservices also falls between the figures for the Northeast and Southeast,though industrial productivity in the Frontier region is about equal tothat of the Northeast.

Revenues, Expenditures and Public Service Indicators

Wide variations in the economic conditions of different parts ofBrazil are paralleled by disparities in the revenues and expenditures oftheir respective state and local governments. However, the impact ofregional disparities in government finances on the quality of publicservices is difficult to document statistically. The available indicators-- school attendance, infant mortality, levels of access to certainservices -- reflect the ability of residents to exploit public services aswell as the ability of governments to provide them. Particularly infunctions that are financed in part through user charges, low levels of usemay reflect the inability of residents to pay fees, as much as the povertyof their governments. The complex nature of the Brazilian fiscal systemalso limits any simple correlation between state and local finances on theone hand, and public service quality on the other. Nevertheless, a linkbetween the two is evident in Table 11.

The marked regional disparities in per capita revenues are shownat the top of the Table. State governments in the richest region, theSoutheast, take in three times as much per capita as the state governmentsof the poorest region, the Northeast. The disparity in revenues betweenstate capitals and the interior municlpios of each region is equally wide.The southeastern capitals take in 2.8 times the per capita revenues ofnortheastern capitals; and southeastern interior municlpios, over fourtimes the revenues of their northeastern counterparts. Within each region,the per capita revenues of interior municipios are well below the averageof each region's capitals. The poorest class of municfpios is, therefore,the interior municfpios of the Northeast; the richest, the capitalmunicipios of the Southeast. These disparities are reflected to varyingdegrees in the list of public service indicators.

- 31 -

Table 11

State and Municipal Revenues and Public Service Indicators by Region,Hid-1970s

Indicator --------- -Region--------------Southeast Northeast Frontier

Revenues per capita, 1975 Cr$State government Cr$ 1025 Cr$ 312 Cr$ 717Municipal government

Capitals 703 248 244Interior 243 57 84

Percent eligible populatlion,1976, attending:Primary school

Urban 69 57 63Rural 52 27 n.a.

Secondary schoolUrban 20 12 12Rural 3 1 n.a.

Percent qualified primry school

teachers - , 1978Urban 99 93 95Rural 75 31 34

Hospital beds per thousandpopulation, 1976Capitals 9.7 1.3 6.7Interior 3.6 1.2 1.4

Infant mortality, 1978, per thousandMetro and non-metro capitals 70 124 n.a.All other municfpioa; 63 127 n.a.

Percent urban househo'lds, 1978 with:Water network connection

Metro 77 52 85Non-metro 79 57 58

Sewer network connectionMetro 50 20 35Non-metro 49 8 10

ElectricityMetro 95 81. 58Non-metro 90 68 n.a.

Frequent garbage collection b/Metro 62 23 58Non-metro 53 16 n.a.

a/ Defined as having at least primary school degree.b/ Defined as 3 or more times per week.n.a. - not available.

Sources: Revenues per capita: MF/SEF, unpublished computer listings.Education: Ministerio de Educacao e Cultura, Ensino de

Primeira Grau-Sbntese Retrospectiva, 1981.Hospitals: IBGE, Estatisticas da Sadde, 1976.Infant Mortality: IBGE, Anudrio Estatistico, 1980.Householda: IBGE, Metodologia da PNAD, 1981.

-32 -

State and local per capita expenditures on social services areclosely correlated with per capita revenues. The Northeast, with thelowest per capita revenues (and poorest public service indicators) amongthe regions, also lags well behind the rest of Brazil with regard to thevolume of public resources devoted to education and health. As shown inTable 12, per pupil education expenditures and per capita healthexpenditures in this region are only about 45% of the national average, and35% of the Southeast average. Although the cost of providing health andeducation services undoubtedly differs among the regions, it is certainthat most of the variation in expenditure levels represents differences inservice quality, coverage or both. 31/ The federal government, bytargeting its own education and health expenditures on the poorer regions,could help narrow these qualitative and quantitative gaps. The availabledata, however, suggest that the regional distribution of such expenditures,by favoring the Southeast, might have widened them.

Table 12

State and Municipal Expenditures on Educationand Health by Region, 1975 a/

(current Cr$)

b/Education Health-

Region Cr$ Index Cr$ Index(per pupil) (Brazil=100) (per capita) (Brazil=100)

Southeast 1,196.1 126 111.1 133Northeast 418.5 44 37.8 45Frontier 642.0 68 49.7 60

BRAZIL 951.3 100 83.5 100

a/ After intergovernmental transfers.Includes sanitation.

Sources: MF/SEF, Finan,as do Brasil, Vol. XXIII (Brasilia, 1981) forexpenditures; IBGE, Metodologia da Pesquisa Nacional por Amostrade Domicflios na DScada de 1970 (Rio de Janeiro, 1981) forenrollment data; 1975 population estimated from 1970-80 trends.

31/ In 1975, the minimum wage (a crude proxy for regional differences inthe cost of living) prevailing in the Southeast was only 40% higherthan that prevailing in the Northeast.

- 33 -

Sources of Variation in State Revenues

Value-added l:ax (ICM). Economic disparities explain most of thevariation in the per capita yield of the ICM. Table 13 compares ICMrevenues with gross regional products, aggregating the states into threeeconomic regions. (All regional averages are weighted by population). Asthese data show, the states of the Southeast take in over five times asmuch per capita as the states of the Northeast, and roughly four times asmuch as the frontier states. This represents a considerably wider varia-tion than exists in per capita GRP where the ratio among the t:hree regionsis roughly 1-to-3.5-to-2.5. The yield of the ICM is equal to 8% of GRP inthe Southeast, but only 5% of GSP in the Northeast and the Frontier.

Table 13

Gross Regional Product (GRP) and ICM Revenues, 1970(Current Cr$)

RegionSoutheast Northeast Frontier

GRP per capita (Cr.$) 2,218 622 872ICM revenues per capita (Cr.$) 174 33 44ICM revenues as percent of GRP 7.9% 5.3% 5.2%

Note: Table excludes Federal District and Territories. ICM revenuesinclude only state government share, and were adjusted from rawSEF data based on the accounting practices of each state asindicated in the 1975 data.

Sources : Regional Accounts: Fundarlo Getulio Vargas.ICM Revenues: MF/SEF.

Federal policy is a major determinant of ICM yields and should,in principle, explain the disproportionately low yield of the tax in poorerstates. In broad terms, the federal government defines the legal base ofthe ICM as the value added in agriculture, industry and commerce. Thisdefinition works against the states of the poorer regions. In excludingservices and transportation from the definition, the ICM base excludessectors that constitute a relatively large share of the economies of thenortheastern and frontier states. Sectors taxable by the ICM constituteabout 60% of the economy of the Southeast, but only about 54% of theeconomy of the Northeast and 56% of the Frontier economy.

The higher proportion of taxable sectors in the economy of theSoutheast is partly compensated for by a quirk in Brazil's t:ax system.Brazil uses the "credit" method to calculate ICM liabilities. That is, afirm's ICM bill is equal to the tax rate applied to the total value ofsales, minus a credit equal to the ICM paid by suppliers on inputspurchased by the firm. This method is equivalent to the traditional sub-traction method (tax rate applied to the difference between sales receiptsand input costs), as long as all inputs are taxed at the same rate. If an

- 34 -

input is tax exempt, however, the firm has fewer credits to apply to itstax liability. In this way, a part of the value of sectors legally exemptfrom the ICM are captured by overtaxation of other sectors, but not all ofthe exempted tax base is fully recovered. Services provided to finaldemand, rather than as inputs to agriculture, industry, or commerce remainexempt. Silva and Silva's study of the ICM estimated the taxablevalue-added in industry and commerce to be about 20X higher than the true-value added in these sectors, however suggesting that a large share ofexempted value-added is recaptured. 3_/

The federally-decreed ICM tax rates also fail to explain thedisproportionately low yields in the Northeast and Frontier. The scheduleof ICM rates now applies uniformly to all states, although in earlierperiods slightly higher rates were applied in poorer regions. The rateschedule is, however, differentiated according to the destination of salesin a way that increases the revenues of Northeast and Frontier states.Current ICM legislation requires that sales across state lines be taxed atrates substantially below the rate for intrastate sales. This reduces theICM paid by exporting firms to their respective state governments forinterstate sales. By the same token, it reduces the amount importing firmscan credit to their gross ICM liability. As Sao Paulo is usually the onlynet exporter of ICM-taxable goods, it is the government of this state whichbears the loss in potential revenues from the lower tax rate applied tointerstate trade. The Northeast and Frontier regions, as well as netimporting states in the Southeast, experience proportionate gains.

Given data constraints, it is not possible to calculate thedegree to which the differential taxation of interstate trade inflates thetax base of states that are net importers. The size of the trade deficitsin the Northeast and Frontier regions, and the substantial difference inrates (interstate rates in the poorer regions are now 45% higher than ratesfor interstate sales originating in the Southeast), suggests that thecontribution of differential taxation to the revenues of governments inpoorer regions is substantial. 33/ Nevertheless, it has been estimatedthat between 1969 and 1974 the Wortheastern states had their ICMcollections reduced by 20% because of the essentially origin-basedcriterion for assessing this tax. 34/

Problems of tax administration appear to explain best the dispro-portionately low yield of the ICM in the Northeast and Frontier. Thepredominance of sectors that are inherently difficult to tax, and the"slippery" nature of the northeastern and frontier economies in general,limit the effective tax base of poorer states. Silva and Silva, describeit) in effect, as a tax on industrial production and the distribution ofindustrial products. Though the legal tax base extends to agriculturalproducts and their distribution, agricultural value-added has provedextremely difficult to tax. The low taxation of agriculture is partly dueto federally-required exemptions that carry through to final demand. Milk,eggs, and fresh fruits and vegetables, for

32/ Silva and Silva, op. cit., Ch. IV.

33/ In 1978, the Northeast ran a deficit of Cr$55 billion on taxable tradeof Cr$131 billion with the Southeast; the Frontier's deficit with theSoutheast totalled Cr$28 billion out of a total Cr$94 billion.

34/ C.A. Longo, "Controvgrsias sobre o ICM no Comercio Interstadual:Uma Resenha", Pesquisa e Planejamento Economico, XI, 1 (1981), p. 246.

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example, are all exempt 1rom the ICM at all stages of production anddistribution. The share of farmers' crops consumed on farm are also, defacto, exempt. The small scale and often non-mon_=t 4zed nature of Brazilianagriculture also makes il: subject to evasion.

The relatively low yield of ICM taxation of agri( ilture isillustrated in Table 14. The table compares the percentage oi 1CMcollected from agriculture, industry, and commerce with the share of eachsector in gross state product (GSP). (In calculating shares of gross stateproduct, sectors not subject to the ICM are excluded). In four of the fivestates for which data are available, the share of ICM collections from theagricultural sector are below agriculture's share of taxable GSP. In SaoPaulo -- the extreme case -- agriculture represents 8% of the GSP, but only0.1% of ICM revenues. More typically, agriculture's share of D2M revenuesis only half its share cf taxable GSP. The difficulty of taxing agricul-ture is particularly onerous to the northeastern and frontier states. Inthe Southeast, agriculture is a relatively small proportion of the taxablebase. In the poorer states, however, it represents roughly 40% of the taxbase eligible for ICM taxation. The loss from untaxed agriculture thusfalls disproportionately on the poorer states.

Industry, on the other hand, is more readily taxed and, with theexception of Mato Grosso, is consistently overrepresented in ICM revenues.The share of industry in ICM revenues is roughly 5% higher than its shareof gross state product in the Northeast, and 15% higher than its share ofstate product in the Southeast. Commerce, similarly, is overrepresented inthe ICM revenues of most states, excluding Mato Grosso and Sawo Paulo.

The tax collection problems of the Northeast and Frontier may beinstitutional as well as sectoral. Silva and Silva's analysis suggeststhat the yield of ICM per cruzeiro of value-added is lower in Lndustry andcommerce as well as agriculture in the Northeast and Frontier, compared tothe Southeast. They attribute the lower yield in the poor reg:lons partlyto the nature of taxpaying units there: the higher proportion of subsis-tence farmers, small-scale manufacturers, informal street vendors, and soforth. They also attribute variations in the ratio of ICM collections toindustrial value-added to varying degrees of industrial tax exemptions,though it is unclear which region sacrifices more of its industrial taxbase to exemptions.

In summary, :it is clear that the relatively low per capita yieldof the ICM in poorer regions is primarily a reflection of the low produc-tivity of their economLes. Federal restriction of the tax base to agricul-ture, industry and commerce appears to be only slightly detrimental to thepoorer regions, and they are able to recover some of the exempted tax baseas a result of the way tax liabilities are calculated. Federal policiesregarding the taxation of interstate trade explicitly favor the governmentsof poorer regions. Thus, the available data supports the conclusion thatthe inability of state governments to raise ICM revenues at least propor-tionate to their gross state output is primarily due to problems of taxadministration.

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Table 14

Sectoral Gopositimgof IOI 1W ners and Table Gross State Product, ((GP) 1970

(percent of each sector in IM aid taxable GSP)

State

Ariculture Industry GQmmrceIRl GSP ICI/GSP ICQI GSP ICH,/GSP I(M GSP IaI/GSP

NbrtbeastParafba 18.3 43 0.4 36.2 24 1.5 45.5 33 1.4Pernambuc 17.6 23 0.8 40.7 39 1.0 41.6 38 1.1

SoutaastMinas Gerais 13.6 26 0.5 50.4 43 1.2 36.0 31 1.2S;o Paulo 0.1 8 0.0 80.3 68 1.2 19.2 24 0.8

FrmntierMito Grosso 63.5 53 1.2 8.7 16 0.5 27.8 31 0.9

NDte: 1CM revenues in P crnanb3 and Paraiba exclude 12.6% and 5.0%, respectiwely, classified as"other". Gross state product (GSP) ewcludes public uti]ities and civil constructicn and istherefore consistent with the legally defined I1M industrial tax hae. Commerce, as defined ingross state product, excludes sales of merchaidise In bars, restaurants, and similarservice-type locations, where sals of anDrchandise are subject to IQC taxation. Iba share ofmerce, as defined for ICM purposes, is therefore larger in gross state product than

Indicated in the table.

Source: 1CM Revenmes: SIlva and Silva (1974).State product: FIzuoda Getulio Vargas, Contas kclonais, 1974.

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Property transfer tax (ITBI). The federal Constitution permitsthe states only one tax base other than the ICM--a tax on the transfer ofreal property (ITBI). The legal tax base of the ITBI includes both thesale of property and ithe transfer of property at death. Maximum tax ratesare fixed by federal law. As shown in Tables 2 and 15, revenues from theITBI are a relatively minor component of state receipts. Low rates partlyexplain the tax's low yield. The maximum rates range from 0.5% to 2.0% ofmarket value according to the type of property transferred. Spatial varia-tions in per capita ITBI revenues are highly correlated with variations inICM revenues per capita (r = 0.80 in 1980), reinforcing the concentrationof state tax revenues in the Southeast.

Other state revenue sources. The federal Constitut:ion alsopermits state governuLents to charge fees for licenses and permits and forservices performed by the state. In order to prevent states from usingthis power to raise revenues for general expenditures, federal legislationrequires that the charge not exceed the cost of the function performed.Per capita revenues from licenses and service charges are highly correlatedwith per capita ICM revenues (r = 0.83 in 1980). In contrast, the yieldsfrom rentals or sales; of state property, fines and penalties, and dividendson state-owned stock,, vary erratically from year to year, and from state tostate. However, the lack of correlation with ICM revenues does not (atleast in 1980) imply that this revenue source counteracts the overallconcentration of public revenues in the Southeast. Aggregated by region,the yield of "miscellaneous revenues" is still significantly higher in theSoutheast than in the poorer regions of Brazil (see Table 15).

Table 15

Regional Pattern of State Revenue Sources, 1978

(current Cr$ per capita)

Source -------------Region…------------Northeast Southeast Frontier

Value-added tax (ICM) 475 1,853 601Transfer tax (ITBI) 10 49 30Charges and Misc. 65 202 75

Subtotal: local sources 550 2,104 706

Transfers 453 366 613

Borrowing 106 389 131

TOTAL 1,110 2,858 1,449

Notes: Table excludes Federal District and territories. ICM figureexcludes nmunicipal share.

Source: IBGE, Estatfsticas Economicas do Governo Estadual eMunicipal, 1978 (Rio de Janeiro, 1980).

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Borrowing. Federal legislation regulates the borrowing of state

governments (see page 13). The legislative controls over borrow-

ing, in principle, exaggerate regional disparities in revenues, though it

is not clear that the controls have that effect in practice. In linking

borrowing to tax revenues, the formula allows a considerably higher

absolute level of borrowing in the relatively wealthy southeastern states

than in the northeastern or frontier states. Though the restrictions of

Resolution 62 can be circumvented, there remains a fairly high correlation

between per capita borrowing and total per capita revenues. The value of

borrowing varies from year to year. Taking a five-year average (adjusted

for inflation), revenues from official borrowing account for about 11% of

state revenues in the Southeast and Northeast, and about 7% of the revenues

of the frontier states. The correlation between per capita revenues from

borrowing and per capita non-debt revenues is 0.80.

Sources of Variation in Municipal Revenues

Regional disparities in per capita tax collections are wider at

the municipal level of government than at the state level. In 1975,

property and service tax collections in the Southeast were seven times

higher than in the Northeast, and ten times higher than in the municfpios

of the Frontier region. Disparities in municipal tax collections are also

substantial within regions. Large cities dominate local tax collections

throughout Brazil. As shown in Table 16, the munfcipio of Sa'o Paulo, with

7% of Brazil's population, collects almost 40% of all municipal taxes. The

seven municfpios with populations of one million or more together collect

nearly two-thirds of all local taxes, though they account for less than 20%

of national population. The tax collections of smaller municApios are thus

almost insignificant, particularly in poorer regions. The average yield of

local taxes in the Frontier region in 1975 was Cr$8.1 (US$1) per capita.

In the Northeast, excluding the major cities of Fortaleza, Recife, and

Salvador, the average yield of local taxes was the equivalent of US$0.41

per capita.

Table 16

Municipal Taxes: Concentration of Base and Yield in Large Cities, 1975

Percent of National Total

ManufacturingValue Property Service Total

Municipio Added Population Tax Tax Municipal(IPTU) (ISS) Taxes

Sao Paulo 24% 7% 39% 38% 39%

Rio de-Janeiro 8 5 12 19 15

Other municipiosof over onemillion a/ 4 6 10 12 11

Total 36 18 61 69 65

a/ Fortaleza, Recife, Salvador, Belo Horizonte, Porto Alegre.

Sources: Tax Revenues: MF/SEF, unpublished computer listings;

IBGE, Estatisticas Econ8micas do Governo Estadual

e Municipal, 1979Value added: IBGE, Pesquisa Industrial, 1980

Population: IBGE, Sinopse Preliminar do Censo Demografico,

1981 (1975 population estimated based on 1970-80

growth rate).

- 39 -

Unlike states, mnunicipal governments have the authority to settax rates. Variations in revenues therefore reflect political factors, thestrength of the local tax base, and local administrative capacity. Thereare no precise indicators of the property and service tax bases of eachmunicfpio, and it is therefore difficult to separate the effect of taxbases from other factors in explaining regional variations in tax yield.Using formal sector manufacturing value added as a rough index suggeststhat tax base variations are not the sole explanation for varying yields inlocal taxes. As shown in Table 16, the large cities' share of t;ax collec-tions far exceeds their share of manufacturing value added. The sevenmunicipios with populations over one million account for 36% of manufactur-ing value-added, but 65% of tax collections.

There is some evidence that the legal, administrative andpolitical constraints on local tax collections (see pages 25-27 ) applymost stringently to smaller municlpios, particularly in poorer, ruralregions. The federal restriction of the IPTU to urban areas clearlyconstrains the tax base of rural areas more than that of urban municfpios.Administrative capacity :is also more limited in poorer regions. Moreover,political factors appear to have greater impact in smaller municfpios.Brazilian sources frequently cite the day-to-day contact between a mayorand his constituents as a major obstacle to increased tax effort in smalltowns. The federal revenue-sharing system also confers larger amounts, percapita, on smaller municpios, reducing the incentive for increa,sed taxeffort.

Given present low levels of municipal revenue effort, spatialvariations in local tax yields are not the major source of variation inmunicipal revenues. Taxes account for only 20% of local current: revenues.As shown in Table 17, revenues from charges for municipal services,licenses, and miscellaneous sources nearly equal tax collections in eachregion. The principal source of variation is not local revenues, but thedistribution formulas of intergovernmental transfers. The effect oftransfers on spatial variation in revenues is discussed in the Eollowingparagraphs.

Table 17

Regional Pattern of Municipal Revenue Sources, 1975(Current Cr$ per capita)

Source RegionNortheast Southeast Frontier

Property Tax (IPTU) 4.5 41.1 4.6Service Tax (ISS) 6.5 39.7 3.5Charges and Misc. 8.8 56.0 14.8

Subtotal: local sources 19.8 136.8 22.9

Transfers 59.4 _198.8 69.1

Borrowing 3.9 49.3 11.1Unclassified 1.1 9.7 4.5

Total 84.3 394.6 107.6

Note: Table excludes Federal District and territories.Sources: MF/SEF, unpublished computer listings;

Finangas Publicas (Jan, Feb, March 1981).

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Revenue Sharing

Revenue sharing is a major component of the Brazilian system ofintergovernmental fiscal relations. The federal government shares therevenues from 12 of its taxes with state and municipal governments, andrequires the states to share fixed proportions of their tax revenues withtheir respective municdpios. The revenue-sharing system is primarily aimedat closing the "vertical gap". The federal government, having monopolizedmost tax bases, permits state and local governments a share of the revenuescollected in their respective jurisdictions. Eight of the shared taxes arethus distributed largely or entirely on the basis of origin. Two others,the fuels (IUCL) and energy taxes (IUEE), are distributed according topopulation and consumption, mixing origin and need criteria. Only theParticipation Funds, financed from the income and manufacturers' salestaxes, use "need" as a primary distribution criterion.

The impact of shared taxes and non-formula intergovernmentaltransfers on regional disparities in current revenues is shown inTable 18. At the state level, the redistributive effect of the Participa-tion Funds is partly counteracted by origin-based shared revenues, as wellas by non-formula grants. The net effect of federal intergovernmentaltransfers is a substantial increase in total state revenues (about 30%),but a fairly modest decrease in regional revenue disparities. With theaddition of transfers, state revenues per capita in the Southeast drop from139% to 128% of the national average, and levels in the Northeast andFrontier regions rise correspondingly.

Consistent data on federal and state transfers to the municfpiosare not available. The figures in Table 18, based on aggregate datasupplied by the Finance Ministry, show virtually no net regional redistrib-ution via federal transfers (combining Participation Funds, origin basedtransfers and non-formula transfers). Federally-mandated transfers of theICM clearly favor municfpios in the Southeast. The net effect of federaland state transfers to local governments is a slight narrowing of regionaldisparities. Including transfers in municipal revenues reduces municipalrevenues in the Southeast from 153% to 141% of the national average, withcorresponding increases in the Northeast and Frontier region.

The question of how much the transfer system should attempt toreduce regional disparities is largely a political one, outside the scopeof the present report. however, two technical aspects of the system oftransfers require comment. The first, already discussed, is the need todesign transfer formulas to reward, rather than discourage, the reci-pients' own tax effort. The second concerns the targeting of transfers.In two respects, the present system of transfers mistargets its recipients-- these cases are discussed below.

Small population as an indicator of weak tax base. The share ofthe federal Participation Fund distributed to state governments, and themunicipal governments of state capitals, is distributed according topopulation and the inverse of per capita state income. The share ofnon-capital municlpios is distributed only on the basis of population. Inall cases, population is measured according to a formula that gives greaterper capita weight to less populous municpios. Thus, Espfrito Santo, with

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Table 18

Impact of Revenue Sharing on Regional Disparities, Mid-1970s(Current Cr$)

RegionRevenue Source Northeast Southeast Frontier

State Government:

Cr$ per capita, 1978Participation Fund 273 50 251Origin-based transfers* 106 225 237Non-formula transfers 73 91 125

Total 452 366 613

Local revenues 550 2,104 706Total non-debt revenues 1,002 2,470 1,319

As % of national averageTransfers 109 88 147Local revenues 37 139 47Total non-debt revenues 52 128 69

Municipal Government:

Cr$ per capita, 1975Federal formula transfers 29 33 31Federal other transfers 4 10 7State transfers 27 155 31

Total 60 198 69

Local revenues 20 137 23Total non-debt revenues 80 335 92

As % of national averageTransfers 42 139 48Local revenues 22 153 26Total non-debt revenues 34 141 39

* Includes TRU, XUM, ITR, SE and federal tax on incomes of stateemployees withlield at source.

Sources: IBGE, Estatfsticas Economicas do Governo Estadual eMunicipal, 1978 (Rio de Janeiro, 1980); MF/SEF, unpublishedcomputer listings.

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a population of 1.6 million in 1970, received 2.5 times as much per capitaas Minas Gerais, with a population of 11.6 million and an approximatelyequal income level. Under the present distribution formula, a non-capitalmunicfpio of 10,000 would receive twice as much per capita as a non-capitalmunicipio of 100,000.

The distribution criteria of the Participation Funds wereapparently intended to assist state and local governments whose revenuesfrom local sources were low owing to weak tax bases and poor administrativecapacities. This intent is explicit in the inclusion of state income percapita in the distribution formulas of the FPE, FE, and the capitals shareof the FPM. However, the success of population as a tax capacity indicatoris questionable. At the state level, the per capita tax and charge reve-nues of governments are positively correlated with their population (r =0.60) only when income per capita is ignored. Regressing per capita taxand charge revenues on state income per capita and state population rendersthe influence of population not significantly different from zero. Incomeper capita is, in contrast, significant (at a 0.01 level of significance)with, or without the inclusion of population. As an indicator of taxcapacity at the state level, the use of population is at best redundant andappears to over-compensate less populous states.

The problem at the municipio level is more complicated, sincethere are no indicators of the tax capacity of each of Brazil's approxim-ately 4,000 municfpios. The earlier discussion of local taxation lendssome support to the present distribution formula. Very large municipiosappear to be far more successful in collecting taxes than the average ofall municfpios. Nevertheless, population alone is a poor indicator of taxyield, and probably, of tax capacity. Though detailed municipal revenuesby region and size class are not available, the regional averages shownbelow in Table 19 indicate that regional variations in municipio populationsize are relatively small, compared to regional variations in local reve-nues from taxes and charges. The FPM transfer formula, intending tocompensate municfpios with weak administrative capacities, succeeds inconcentrating revenues at the lower end of the population scale, but failsto compensate for regional variations in tax capacity within a givensize-class.

Table 19

Non-Capital Municipios: Average Population and Revenues,Mid-1970s(Current Cr$)

Southeast Northeast Frontier

Average population 24,590 20,303 18,106

Average tax and charge revenues, 186 22 41per capita, 1975

Average FPM per capita, 1978 Cr$ 124 Cr$ 150 Cr$ 146

Sources: MF/SEF, unpublished computer listings; Revista de FinancasPublicas, XLI, 345 (Jan-March 1981); IBGE, EstatfsticasEcon8micas do Governo Estadual e Municipal, 1978 (Rio de Janeiro,1980).

- 43 -

"Value-added" collections as an indicator of origin. The secondtechnical issue concerns the federally-mandated transfer of revenues fromjtates to municfpios. Federal law requires that states return 20% of theirICM revenues to municipal governments; 75% on the basis of origin, and 25%at the discretion of the state government. Regionally, the result is aconcentration of resourcei; in the Southeast, as noted earlier. At the sub-regional level, the result is a concentration of funds in industrialareas. The concentration is most apparent in metropolitan regions, whereindustrial municipios, with relatively large tax bases, coexist with"dormitory suburbs", with relatively small tax bases. Owing to thejurisdictional segregation of tax bases and population, wide variations inper capita ICM transfers occur. In metropolitan Sao Paulo, for example,the industrial city of Sio Bernardo received ICM transfers equal to US$147per capita in 1975, while the "dormitory suburb" of Francisco Moratereceived the equivalent of US$0.61 per capita. 36,

The intent of using origin as a distribution criteriorL is toreturn a share of taxes collected to the local jurisdiction where they arepaid. Because the ICM is an indirect tax, its incidence is partly shiftedforward from the point of collection to the point of consumption. Theorigin of the tax may, therefore, correspond more to the geographic patternof consumption of taxable goods than to the pattern of value-added. Atransfer system based on actual origin--approximated by population--wouldmore uniformly distribute the ICM transfer without doing violence to itsintended distribution objectives.

Regional Distribution of Direct Federal Expenditures

A recent study of the spatial distribution of the federal budgetsuggests that the pattern of the federal government's own revenues andexpenditures leads to aL transfer of resources from the Southeast to thepoorer regions. 37/ In 1975, according to this study, the southeasternstates contributeT 32% more to federal revenues than they received infederal expenditures. The Northeast, in contrast, received 70% more infederal expenditures than it paid in federal taxes, and the Frontier nearlythree times as much. The study concluded that regional redistributionimplicit in the federa1l budget far outweighs the effect of official systemof intergovernmental transfers.

There are a number of conceptual problems with this type ofanalysis, particularly as it applies to Brazil. On the revenue side, thefederal government relies heavily on indirect taxes where incidence is tovarying degrees shifted across state boundaries through interstate trade.Revenues collected in the Southeast may, therefore, be paid in part byconsumers in poorer regions, reducing the magnitude of the apparenttransfer. On the expenditure side, there are problems in treating federal

36/ In 1975, transfers were distributed entirely on the basis of origin.The disparity would be less under the distribution formula adopted bySao Paulo in 1981 which takes population into account.

37/ C.A. Longo and A.E. Muller, "Impacto Regional das Finanpas Federais",in Proceedings of the IX Encontro Nacional de Economia, Olinda(Pernambuco), Deicember 8-11, 1981; Vol. 4, pp. 1663-83.

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expenditures as equivalent to transfers to state or local governments.Owing to externalities, the benefits of a given federal expenditure are notalways limited to the region in which the expenditure occurs. Federalexpenditures on "public goods", for example, benefit the nation as a whole,though the expenditures may be concentrated in certain regions. Expendi-tures on general administration and national defense are obvious cases inpoint.

Certain federal expenditures can be considered comparable tofederal intergovernmental transfers, however, to the extent that theyreplace or supplement the expenditures of state or local governments. Thisapproach is particularly appropriate to Brazil. Because the division offunctional responsibilities between levels of government is vague, federaldirect expenditures often take the place of what would be intergovernmentalgrants under a wmre rigid division of functions.

The most recent regionalization of federal expenditures, byfunction, is only for 1975. Table 20, below, shows federal per capitaexpenditures on selected functions. The table excludes federalexpenditures on general administration, defense, social security,agriculture, energy, industry, and foreign relations, which togetheraccount for 78% of federal expenditures. Federal expenditures in theFederal District (Brasilia) are also excluded. Owing to the level ofaggregation, it was not possible to separate official intergovernmentaltransfers from the functional categories. The total of selected sectorsmay therefore include state and municipal shares of some taxes, most likelythe fuels tax (IUCL) and the motor vehicle registration tax (TRU).

On a per capita basis, federal expenditures in the selected func-tional areas clearly favor the Southeast. The federal government.spendsroughly Cr$500 per capita on the selected functions in this region,compared to Cr$310 in the Frontier and Cr$163 in the Northeast. The biastoward the Southeast is particularly great in transportation and healthexpenditures. The value of federal expenditures on the selected functionsis more than twice the value of official transfers (assuming no doublecounting). The Southeast bias in direct expenditures is therefore suffi-cient offset the bias of official transfers toward poorer regions. Combin-ing federal expenditures on the selected functions and official transfers(and ignoring any double-counting) the federal government spends Cr$640 percapita in the Southeast, nearly twice what it spends in the Northeast, and20% more than its expenditures per capita in the Frontier states.

- 45 -

Table 20

Federal Direct Expenditures by Region, 1975(Current Cr$ per capita)

RegionFunction Frontier Northeast Southeast

Transportation Cr$ 164 Cr$ 53 Cr$ 327Education 61 55 65Housing and Urban Services 2 0 0Health 84 55 116Total (selected functions) 310 163 510Official transfers 239 153 134Total (direct expenditures plus

official transfers) 549 317 634

Source : Fundacao Getdlio Vargas/Centro de Estudos Fiscais, Regionalizacaodas Transagcces do Setor Publico - 1975 (Rio de Janeiro, 1980).

VI. SUMMARY AND CONCLUSIONS

State and Local governments already play important roles in theprovision of essential services such as education, health, housing, andurban development. Since the demand for these types of services tends tobe highly elastic wii:h respect to GDP, one would expect that pressures onthe financial resources of the states and municfpios will continue toincrease rapidly in the future. 38/ This tendency should be reinforced,moreover, by the gradual political opening now underway.

Will the states and municipios be able to meet future demands forexpanded services? rhe experience of the past decade raises doubts in thisrespect. The basic conclusion of the present report is that means need tobe devised to increase the level of resources available to the states andmunicipios generally, and to subnational governments of poor regions inparticular. In order to achieve this objective, both vertical and hori-zontal fiscal adjustments are indicated. but these adjustments need notentail a comprehensive reform encompassing the creation of new taxes, nor asignificant increase, in the national tax burden. 39/ A series of measuresaimed at improving the efficiency and equity of t1ie system as it now existswould be sufficient.. A recapitulation of the findings of the presentreport concerning the fiscal situation of the states and munidpios, aswell as some suggestions as to how this situation might be iraproved,follows.

38/ Calculations of historical income-elasticity coefficients for variouspublic expenditure categories are presented in: D. J. Mahar andF. A. Rezende da Silva, "The Growth and Pattern of Public Expenditurein Brazil, 1920-1969", Public Finance Quarterly, III, 4 (October1975), 380-99.

39/ During the 1972-76 period, Brazil had the second highest (after Iran)tax effort index among a sample of 47 developing countries. See:A.A. Tait, W.L.M. Gratz and B.J. Eichengreen, "InternationalComparisons of Taxation for Developing Countries, 1972-76", IMF StaffPapers, 26, 1 (March 1979), 130.

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Vertical Balance

Principal findings. Over the past decade, state finances havebeen characterized by declining saving and investment ratios, chronicbudgetary deficits and increasing levels of indebtedness. Though thefiscal data for the municipios are fragmentary after 1975, it is likely,given the strong links between state and local finances (particularly withrespect to intergovernmental transfers of the ICM), that local financeshave behaved similarly. The causes of this financial deterioration arevaried. The most important, however, is probably the slower growth ofeconomic activity observed after the "oil shock" of 1973-74. One effect ofthis slowdown was a substantial reduction in the rate of public revenuegrowth. In response, many states sharply curtailed their spending forinvestment programs, at least those financed through central statebudgets. Current expenditures, in contrast, could not be cut back to thesame extent owing to commitments to finance general administrative costs,and the operation and the maintenance of investments made in previousyears.

Though the subnational governments could not have foreseen theshortfall in their revenues, certain legal and administrative factors haveexacerbated their financial situations and interfered with their ability toadjust to the new economic environment. Foremost among these factors arethe federally-mandated controls over the rates and/or bases of someimportant state and local taxes. The ICM, in particular, has been increas-ingly utilized as an instrument of national economic policy, as evidencedby periodic changes in the tax rate and the exemptions given to manufac-tured exports, inputs to projects of "national priority", and so forth.This has contributed to the instability of ICM revenues and the erosion ofstate and local tax bases.

With little latitude for adjusting their own sources of revenuesto demands on the expenditure side, the state and local governments have,by necessity, become more dependent on the federal government for financialassistance. In recent years, this assistance has increasingly taken theform of transfers and special credit lines to help finance the investmentsof state-level decentralized agencies. This process has reduced thecontrol of state finance secretariats over investment decisions, therebyinterfering with medium and long-term planning and efforts to containrecurrent costs. The situation described above contrasts sharply with thepositive steps taken in 1979-81 to eliminate the earmarking of shares fromthe Participation Funds.

Recommendations. The Government is cognizant of the general needto strengthen state and local finances and has included this among theobjectives of the third National Development Plan. This is a laudablegoal, which should be pursued vigorously. Given its high revenue-raisingpotential, a good place to start would be enactment of legislation toreform the ICM. Here the principal objective should be to broaden the baseof this tax by eliminating most of the present exemptions. 40/

40/ To avoid possible negative effects on the balance-of-payments, itwould be preferable not to abolish the present exemption for manufac-tured exports. Instead, federal compensation to the states for all,or part of, the revenue loss caused by this provision should beconsidered.

- 47 -

By including such items as fuels, industrial equipment, agricul-tural inputs, and servicefs in the ICM base, both state and municLpal reve-nues would be greatly increased. If services were to be included in theICM base, it would be advisable to abolish the municipal ISS. Though thiswould undoubtedly cause local own-source revenues to fall, some importantbenefits could be achieved. For example, existing conflicts between thestates and municipios over the taxation of certain bases (e.g., publishingand food services) would be eliminated. Also, there would undoubtedly beefficiency gains in the collection process. The munictpios could becompensated for the loss of the ISS through adjustments in the state-to-local tax-sharing system.

In addition to broadening the states' tax base, steps should betaken to improve the-control of the state governments over the activitiesof their decentralized agencies and enterprises. The recognition of theneed for such coordination in urban areas has led to the creation ofmetropolitan planning agencies, which in some cases have been successful inintegrating the efforts of a large number of state and municipal. entitieswithin their areas of influence. A similar process could take place at thestate level, with guidelines being drawn up to ensure appropriate balancebetween the sectorial investment plans of the various decentralizedagencies. The states should also insist on improvements in pricing and ongreater efficiency to reduce the need to support the agencies from statebudgets.

At the municipal level, efforts to improve the productivity ofthe IPTU should be continued. As the experience of CIATA has shown,considerable revenues are foregone because of poor administrative prac-tices. However, in order for property taxation to increase significantlyin importance as a source of municipal revenue, the traditional reluctanceof locally-elected officials to tax their own constituents must be over-come. This change of mentality could, in principle, be promoted by linkingfederal and state transfers to local tax effort. In practice, this is notan easy task.

The simplest way to reward tax effort is the matching grant.Under this system, the amount transferred would be based upon the amount ofcounterpart funds raised by a given municipio; the transfer would be set ata fixed fraction of the amount raised. However, matching grants onlyreward tax effort when per capita tax bases are roughly equal among theeligible governments. Otherwise, a municipio with a rich tax base and alow tax effort could raise as much, or more, money as a poor municipalitywith a high tax effort. Given the extreme diversity in wealth amongBrazil's local governments, matching grants alone would not provide anacceptable vehicle for intergovernmental transfers.

In the Brazilian context, tax effort would have to be measureddirectly. Two approaches may be suggested. The first is the directmeasurement of the tax base itself, i.e., the assessed value of property ineach jurisdiction. This approach requires a uniform definition of the taxbase in each jurisdiction, and some assurance that no jurisdiction isunderestimating its base. Either direct assessment or regular auditing bya higher level of govercnment is therefore required. The second approach isto use indicators. A large number of possible indicators are now generatedannually by the transfer system itself. State governments monitor value

- 48 -

added and the value of property transactions by municipio. The federal

government collects statistics on electric energy and fuel consumption, and

motor vehicle registrations. Data are also available decenially from the

demographic census, and quinquenially from the sectorial censuses

(industry, commerce, services), allowing periodic verifications of the

reliability of selected indicators. While no single indicator will

perfectly reflect spatial variations in property and service tax bases, the

available data would permit a reasonable approximation. Despite the

obvious administrative problems, a change in the incentives embodied in the

system of intergovernmental transfers is required if locally-administered

taxes are to make a major contribution to public sector revenues in

Brazil. Technical asssistance, while necessary, is not sufficient to

ensure the exploitation of the large revenue potential of the property tax.

Benefit taxation (recovering the costs of public works from the

direct beneficiaries) is another underexploited source of local revenue.

This is mainly because legislation specifying the means for calculating

individual charges has never been enacted. Some municipal governments

recover the costs of street paving, sidewalks, gutters and similar works by

charging their costs directly to owners of abutting property according to

the front footage of each lot. This practice has been halted in some

cases, however, owing to uncertainties over whether municipal governments

have the legal authority to charge property owners for public works

performed without their consent. The law must be clarified on this point

before the full potential of benefit taxation can be realized.

Horizontal Balance

Principal findings. Wide disparities exist in the financial

situation of states and munictpios in Brazil, and these are reflected in

the quality (as measured by per capita expenditures) of publicly-supplied

services in different parts of the country. Varying economic conditions

largely explain the extent of the disparities. The impact of local govern-

ment policy is small, as federal policies discourage or prohibit local

differences in own-source revenues. The federal government's variousrevenue-sharing programs work at cross purposes and have only a small net

equalizing effect, at least interregionally.

Though state and municipal autonomy is limited, problems of tax

administration exacerbate the poverty of governments in poorer regions.

The predominance of small-scale agriculture and "informal" manufacturingand retailing reduces the tax base that can be effectively captured by

state and municipal governments in poorer regions. Federal legislation

does permit governments in poorer regions to impose higher taxes on inter-

state imports. However, this does not compensate for the difficulty

governments in poorer regions have in collecting taxes. Despite federal

policy, the proportion of economic activity effectively taxed is higher in

rich regions than in poor ones.

In addition to regional disparities, there are marked differences

in the per capita revenues of municipal governments of different sizes.

Locally-generated revenues are particularly dominated by larger

municfpios. Brazil's most populous municipios (Sao Paulo and Rio de

Janeiro), for example, collect more than half the locally-administered

taxes collected in the nation. Lack of both administrative capacity and

- 49 -

incentive are explanatory factors. Many small municpios are operatingwith obsolete tax codes and property cadastres, owing to a lacI: ofsufficiently trained staff. At the same time, municipal tax effort isdiscouraged by federal laws granting municfpios fixed shares of federal andstate taxes. A municipio's incentive to raise funds locally is alsodiscouraged by the ambiguous nature of its responsibilities. Directparticipation by the federal or state government is an alternative to localtax effort as a means of financing many public services. Though theevidence is not strong either way, these disincentives to loca:L tax effortappear to be more influential in smaller municlpios than in ma;jor cities.

Wide disparities in per capita revenues also occur among themunicpios of Brazil's metropolitan regions. In this case, the disparityis largely due to federal regulations which permit municipal governments toretain a fixed share of the ICM collected within their boundarLes. As thegrowth of metropolitan areas has been characterized by the segregation ofindustrial plants from residential areas, municlpios with high concentra-tions of industry collect a disproportionate amount of ICM revenues, whilethe municdpios housing their work force collect relatively little.

The federal government distributes shares of 12 of its taxes tothe states and municipios; nine of them according to fixed formulas. Onlytwo, comprising the system of Participation Funds, are distributed accord-ing to explicitly equalizing formulas. Participation Funds are distributedto states and municipios of state capitals largely on the basis of stateper capita income and population. Funds are distributed to interiormunicipios only on the basis of population. In both cases, population isweighted so that less populous municfpios receive higher per capitatransfers. At the stat:e and state capital levels, the weighting of popula-tion appears redundant as an equalizing factor, and penalizes large poorstates and their capitals. The lack of any income indicator in thedistribution formula for non-capital municipios eliminates any element ofregional equalization among the interior municipios.

The remaining shared taxes are distributed according to formulasthat, to varying degrees, contradict the equalizing intent of theParticipation Funds. B3ecause of the higher level of funding in theParticipation Fund, fe,ieral transfers to state governments are, in aggre-gate, higher per capita in poorer regions. Considering state capitals andinterior municipios, together federal transfers to local governments areroughly equal per capita among regions. Intraregionally, the ParticipationFund formula compensates smaller municfpios for their relatively low taxrevenues, though only Dn a small scale. No federal program addresses theproblem of intra-metropolitan disparities, though recent changes in federallegislation allow state governments greater flexibility in distributing ICMrevenues among municfpios.

Recommendations. Brazil's Third National Development Plan callsfor the reduction of regional social and economic disparities. Given thesize of economic variations between regions, complete equalization throughthe public sector would be impossible, short of a radical centralization ofpublic sector expenditures or a massive increase in intergovernmentaltransfers. Neither alternative is compatible with the curreni: politicalpressure for increased state and local autonomy. The problem of theinability of governments in poor regions to provide a level of- services

- 50 -

consistent with Brazil's overall level of development has to be addressedin the long run through instruments designed to encourage factor mobility,e.g., promoting investment in poor regions and encouraging labor migrationto rich regions.

In the short run, the extent of regional disparities in publicservices might be reduced by:

(i) improving state and municipal tax administration, sincegovernments in the poorest areas generally have the worstrecords in this respect (this would need to be accompaniedby measures to ensure that administrative improvements wouldbe maintained);

(ii) targeting state and municipal Participation Funds moreeffectively to jurisdictions with limited tax capacities(particularly the interior municipios of poorer regions);

(iii) introducing an equalization element into the other taxesshared by the federal government (though at a cost to eachprogram's own objectives); and

(iv) increasing direct federal social expenditures in poorerregions.

These four "top-down" measures would be more effective if comple-mented by better performance by the recipient governments in poorerregions. The municipal level particularly has room for improvement.Municipal performance is discouraged by the present system of ambiguousfunctional responsibilities and readily available aid from higher levels ofgovernment, both in the form of transfers and as direct participation. Thedefinition of what functions are appropriate to the municipal level ofgovernment and what revenue sources would be adequate, would require exten-sive study, given the enormous diversity of Brazilian municfpios. Aninvestigation of the present functions and problems of a particular classof municfpios -- particularly rural municfpios and secondary cities inpoorer regions -- would be a good place to start.

Final Considerations

An Interministerial Working Group, comprised of representativesof SEPLAN and the Ministry of Finance, was established in 1982 for thepurpose of proposing a new fiscal reform. One of the major tasks of thisGroup is to identify ways to increase the fiscal autonomy of the states andmunicipios. In this regard, a working assumption of the Group is thatfiscal autonomy can be most effectively promoted through an expansion inthe volume of own-source revenues available to these governments, ratherthan by altering the present system of intergovernmental transfers. Asecond assumption is that any reform of the tax system should be designedto benefit disproportionately subnational governments in the poorer regionsof the country. A final assumption is that the devolution of taxingauthority from the federal to the state and local levels will need to becompensated for by a similar shift in the responsibility for publicservices like education, health and transport.

- 51 -

The Interministerial Working Group has not yet submitted itsforLal fiscal reform proposal for consideration by the national Congress.A preliminary proposal, however, was made public in mid-1982, and its fivemain features may be summarized briefly. l/ First, it was proposed thatthe ICM rate on interstate sales be reduced to zero. This feature would,in effect, change the assessment of the ICM from an origin to a destinationbasis. By chiefly benefitting poorer net importing states, it would helpto redress horizontal fiscal imbalances. Second, it was proposed to expandthe list of essential food items exempted from the ICM. This proposalwould reduce the regresisivity of the tax, although at the expense offurther circumscribing the state and local tax base. Third, it wasproposed that the IPI be abolished and that its present base, with theexception of vehicles, tobacco products and alcoholic beverages, beincorporated into the base of the ICM. This measure would incr,ease totalstate revenues by roughly 15%; the revenue gain to an individual statebeing determined by the3 production or (in the case of production exportedto other states) consumption of taxable goods. Fourth, it was proposedthat the federal income tax burden be increased for upper-income groups.This proposal is mainly intended to compensate the federal government forthe loss of the IPI, w'hile improving the overall progressivity of the taxsystem. However, it would also assist the states and municfpios to theextent that it offset the decline in the volume of resources transferredthrough the FPs caused by the elimination of the IPI. Finally, it wasproposed that a special fund be created to compensate states for revenuelosses due to the exeniption of manufactured exports from the ICM. Thismeasure would have the macroeconomic advantage of motivating states topromote exports. The revenue gains, however, would mainly accrue to thewealthier industrial Etates of the Southeast which, in 1980, accounted forabout 85% of Brazil's total exports.

To some extent, the preliminary proposals of the InterministerialWorking Group paralleL the recommendations of the present report. TheGroup has quite right:Ly concentrated its efforts on reforming the ICM,proposing an expansion in its base (proposal 3) and the formation of a fundto compensate states for revenue losses caused by the exemption ofmanufactured exports (proposal 5). However, the Group's proposals do notaddrcss directly the need for fiscal reform at the municipal level, thedefects of the intergovernmental revenue-sharing system, nor the problemsof fiscal administration. Our analysis has shown that these are all areasdeserving close attention. The proposal to tax interstate sales on adestination basis (proposal 1), for example, while clearly intended tobenefit the poorer states, would only result in additional revenues to theextent that these states possess the administrative capacities to identifyand effectively tax the myriad retail establishments operating within theirborders..

Since the proposals of the Interministerial Working Group arestill preliminary, and not fully detailed, it is difficult to assessquantitatively their net effect on state and local finances. According torepresentatives of the Group, all states would benefit through increasedrevenues, with the relatively largest gains accruing to the poorer states.(The change in the overall fiscal situation of the states, however,would be largely determined by the expenditure implications of transferringcertain functional responsibilities from the federal to subnationallevels). This revenue-enhancing aspect of the proposed fiscal reform

41/ C. Viacava, "Reforma Tributaria," Revista de Finangas Publicas, LXII,351 (1982), 4-7.

- 52 -

package has been generally well received by the states, although individual

states, or regional blocs of states, have expressed dissatisfaction with

the working assumptions of the Interministerial Group or with one or more

of the preliminary proposals. The governments of the northeastern states,

for example, citing their underdeveloped economies and relatively weak

administrative capabilities, appear to favor an expansion of federal-state

transfers more than a devolution of taxing authority. 42/ Similarly, the

government of Minas Gerais has noted that it would gain relatively little

through the proposal to transfer some of the IPI base to the states

(proposal 3), since about 84% of the IPI now collected in Minas is

accounted for by bases (i.e., vehicles, tobacco products and alcoholic

beverages) that would be retained by the federal government. 43/

Finally, the Sao Paulo state government has objected to the proposal to

change the assessment of the ICM on interstate sales from an origin to a

destination basis (proposal 1), arguing that its treasury should be

compensated for the benefits of public services (e.g., education, health,

transport, energy) accruing (through "spillovers") to residents of other

states, as well as for social costs (e.g., congestion and pollution)

associated with the production of exported goods.

The national debate concerning the Interministerial Working

Group's preliminary proposals illustrates well the economic and political

difficulties of designing a fiscal reform for a country characterized by

extreme regional disparities. Because of the direct elections for national

congressional seats and most state and local offices held in November 1982

(which brought the issue of fiscal reform to the forefront), and the

continuing recession in Brazil (which has caused state and local finances

to deteriorate still further), however, there is considerable pressure for

a compromise fiscal reform package to be enacted into law. The major

question mark at this point is whether the federal government will be

willing and able to transfer some of its revenue base to the subnational

governments during a period when, as a part of an austerity program,

it is making a strong effort to reduce its own fiscal deficit. 44/ To

transfer additional responsibilities to the subnational governments,

without making adequate allowance for their financing, of course, would

only make matters worse.

42/ C.M.P. de Albuquerque and J.D. de M. Gomes, "Reforma Tributaria:

Uma Visa'o Consolidada das Propostas Estaduais," Fundasao JP; Analise

e Conjuntura, XIII, 13 (1983), 72-78.

43/ A.K. Gomes and C.M.P. de Albuquerque, "Reforma Tributaria: Aspectos

Economicos da Proposta do Grupo Interministerial", Fundagco JP;

Analise e Conjuntura, XIII, 13 (1983), 79-83.

44/ This dilemma is discussed in P.R. Haddad, Bases Para a Reforma

Tributaria no Brasil (Belo Horizonte, 1982).

- 53 -

REFERENCES

Albuquerque, C. M. Pontes de, andJ. D. de Magalhaes Gomes. "ReformaTributaria: Uma Visao Consolidada dasPropostas Estaduais", Fundaago JP;Analise e Conjuntura, XIII,(1983), 72-78.

Aradjo, A.B. de, M. H. T. Taques Horta, andC. M. Considera. Transferencias de Impostosaos Estados e Municipios. Rio de Janeiro:IPEA./INPES, 1973.

Brasil, Instituto Brasileiro de Geografia eEstELtisticd (IBGE). Estatlsticas Econ8micas doGoverno Estadual e Municipal, 1978. Rio deJaneiro, 1980.

Metodologia da Pesquisa Nacional par Amostra deDomLcilios na D6cada de 1970. Rio de Janeiro,1981.

Brasil. Ministifrio da Fazenda. Secretaria deEconomia e Financas. Fontes de Financiamentoaos Estados. Brasflia, 1980.

Brasil. Ministfrio da Fazenda. Secretaria deEconomia e Finanqas. Fontes de Financiament:osaos Municdpios. Brasflia, 1980.

Brasil. Ministfrio da Fazenda. Secretaria deEconomia e Finantas. Finangas do Brasil, XLII(1.981).

Brasil.. Presid#ncia da Republica. Secretaria dePlmnejamento. III Plano Nacional deDe_senvolvimento, 1980-85. Brasilia, 1980.

DoellLnger, C. von. "Estatizacao, Finanqas Putblicase suas Implicacoes", Camara de Estudos e DebatesEcon6micos e Sociais - CEDES, Relatorio dePesquisa 1 (1981).

Fundagao Getulio Vargas. Centro de Estudos Fisicais.Regionaliza ao das Transap3es do Setor P4blico -1975. Rio de Janeiro, 1980.

Fundagao IPARDES. "Participagavo do Setor P¢blLco naEconomia Paranaense", Relatorio de Pesquisa I(1.980).

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Gomes, A.K., and C.M. Pontes de Albuquerque."Reforma Tributaria: Aspectos Econ6micosda Proposta do Grupo Interministerial",Fundacao JP; Analise e Conjuntura, XIII, (1983),79-83.

Haddad, P.R. Bases para a Reforma Tributaria noBrasil. Belo Horizonte, 1982.

Instituto Brasileiro de Administracao Municipal(IBAM). Pesquisa Sobre as Relacoes Inter-governamentais: 0 Estado e o Municipio. Rio deJaneiro, 1974.

International Monetary Fund. Government FinanceStatistics Yearbook, VI (1982).

Longo, C.A. "Controversias Sobre o ICM no ComercioInterstadual: Uma Resenha, Pesquisa e PlanejamentoEcon8mico, XI, 1 (1981), 229-49.

Longo, C.A., and A.E. Muller. "Impacto Regional dasFinancas Federais", in Proceedings of the IXEncontro Nacional de Economia, Olinda, Pernambuco,Dec. 8-11, 1981; Vol 4, pp. 1663-83.

Mahar, D.J. "Federalismo Fiscal no Brasil:A Experigncia Historica", Revista ABOP, II, 2,(1976), 29-82.

Mahar, D.J. "The Failures of Revenue Sharing inBrazil and Some Recent Developments", Bulletinfor International Fiscal Documentation, XXV, 3(1971), 71-80.

Mahar, D.J., and F.A. Rezende da Silva. "The Growthand Pattern of Public Expenditure in Brazil, 1920-1969", Public Finance Quarterly, III, 4 (1975),380-99.

Pastore, A.C. "Avaliacao Critica da ReformaTributaria de 1965", Revista de Finansas P'blicas,XLI, 348 (1981), 4-32.

Reflexos da Reforma TributSria de 1966 nas FinancasEstaduais", Revista de Finangas Publicas, XXXVIII,336 (1978), 47-80.

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- 55 -

Silva, F.A. Rezende da. Autonomia Polltica eDepend6ncia Financeira: Uma Andlise dasTransformagses Recentes nas Rela8o'esIntergovernamentais e seus Reflexos Sobrea Situaca"o Financeira dos Estados," Pesquisa ePlanelamento Econ8mico, XII, 2 (1982), 489-540.

Silva, F.A. Rezende da. "0 Financiamento da PoliticaSociaL", Pesquisa e Planejamento Econ8mico, X, 1(1980), 123-46.

Silva, F.A. Rezende da and M. da Concei,ao Silva. 0Siste1na Tributario e as Desigualdades Regionais:Uma Analise da Recente Controversia Sobre o ICM.Rio de Janeiro, IPEA/INPES, 1974.

Tait, A.A., W.L.M. Gratz, and B.J. Eichengreen.International Comparisons of Taxation forDeveloping Countries, 1972-76", IMF Staff Papers,XXVI, 1 (1979).

Trebat, T.J. Brazil's State-Owned Enterprises: A CaseStudy of the State as Entrepreneur. CambridgeUniversity Press, 1983.

Tyler, W.G. Manufactured Export Expansion andIndus;trialization in Brazil. J.C.B. Mohr:Tiibingen, 1976.

Varsano, R. "0 Sistema Tributario de 1967: Adequadoao Brasil de 80?", Pesquisa e PlanejamentoEcon;5mico, XI, 1 (1981), 203-27.

Viacava, C. "Reforma Tributaria", Revista de FinansasPdblicas, XLII, 351 (1982), 4-7.

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Rudolf HablutzeiRomo M ButitaEast Asia-Korea, Thailand, theThis background study for World Romeo M. Bautista Philippines, Malaysia, andDevelopment Report 1981 Examines the experiences of twenty- Indonesia-during the last twodiscusses the production strategies two developing countries in adapting decades; focuses on the key factorsand the development policies of the to the generalized floating of the explaining their remarkable economiccapital-surplus oil-exporting world's major currencies since 1973 and social progress; and identifies thecountries. and discusses the implications that main economic issues for the 1980s.World Bank Staff Working Paper No. currency floating has on policymaking World Bank Staff Working Paper No.483Bn AgStaff81. Workin Pages (iNcl g in these countries and indicates direc- 529. 1982. 42 pages.485. August 1981. 55 pages (including tions for further research.statistical tables). World Bank Staff Working Paper Po. ISBN 0-8213-0102-0. $3.00.

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Tax Effort of State Govern- Arne Drud, Wafik Grais, and Social Security Funds in Singapore

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