What is Limiting Brazil's Productivity-Enhancing Policies?

Even with the taming of inflation since 1994 and clearly more responsible macroeconomic policy since 1999—as well as a recent prolonged period of high prices of its main commodities—productivity and economic growth have remained depressed, with Brazil frequently below the Latin American average. Even with very positive expectations of 7 percent GDP growth for this year, there are still concerns about its sustainability. This puzzling inconsistency between Brazil's potential and actual performance has prompted several analysts in the vast economic literature on the impediments to growth in Brazil to attempt to explain the main constraints that are holding the country back, leading to the common jest that "Brazil is the country of the future, and always will be."

Although these studies start out with more or less the same puzzle, the final answer as to what is the key binding constraint for economic growth in Brazil is not always the same, as could be expected. Even though each author stresses a different constraint as the most important, the stories are not radically different; a common set of policy areas emerges from the literature as the problematic issues that would have to be addressed for the country's growth potential to be realized. What does not emerge from this literature, however, is an analysis of the political economy determinants of the policy choices that have led to these constraints and impeded the reforms that would tackle or ameliorate them.

If a given policy is found to be particularly constraining and yet the opportunity to improve growth and social welfare by changing the policy is systematically forgone, we need to discern which aspects of the country's political institutions drive that outcome. For example, rather than simply recognizing that poor infrastructure is an important constraint to economic growth and productivity, the analysis should focus on why the political choices arose and persist that led to this state of affairs and even now impede the obvious solution of investing more in infrastructure. The puzzling choice of the systematic lack of investment in infrastructure, for example, becomes clear once one understands that Brazilian presidents, although constitutionally and politically very strong, are constrained in their efforts to achieve fiscal discipline by a massively hardwired budget (over 90 percent) that mandates expenditures. In addition, a president has to exchange macroeconomic stability for geographically oriented policies with members of his coalition in Congress, which also decreases resources for investments. The only instruments available to presidents to achieve fiscal targets are taxation (by far the highest in Latin America), borrowing (also stretched to the limit), and the compression of remaining expenditures, such as investment in infrastructure.

The essence of the argument is that political institutions in Brazil generate a series of policies with desirable characteristics in terms of productivity and economic growth while at the same time imposing severe constraints that hinder those same aspirations. Although political institutions provide the president with the incentives and the instruments to pursue monetary stability and fiscal discipline—necessary conditions for improvements in productivity and sustainable economic growth—they simultaneously raise the costs of achieving those very objectives. By insulating several expenditures from the president's discretion, political institutions force the use of other policy options, such as high taxation levels and cuts in unprotected expenditures, which puts a drag on productivity and growth. This results in an environment that possesses many essential elements for sustainable economic growth, but where several accompanying distortions conspire against its realization. The upshot is that although improvements in productivity and growth have materialized in the past decade, the pace has been slow, gradual and incremental.

The role of checks and balances and of interest groups in this process follows the same pattern of promoting virtuous policies while simultaneously creating obstacles for their full realization. Checks and balances, such as the judiciary and the media, are crucial in dissuading the president from deviating from policies that would create an environment conducive to productivity and growth. These very same checks protect entitlements and expenditures, thus forcing the government to seek forms of financing, such as increased taxation, which have negative impacts on productivity and growth. Similarly, the fragmentation of several major interest groups has diluted the potential negative impact of their demands on the government's expenditures. Yet at the same time, it is the interest of several other groups, enshrined in hardwired budgetary legislation, which creates the protected expenditures that force the government to use productivity-reducing policy choices to secure monetary and fiscal stability, for example by neglecting infrastructure investment.

Although the government has maintained fiscal discipline, managing to reverse the trend in public debt and bringing it down to more manageable levels, it was reached at the cost of an ever-increasing tax burden and the suppression of several important expenditures considering them as residual, in particular those related to infrastructure. Analyses shows that the drop in infrastructure investment as a percentage of GDP in the last decade has tracked the growing fiscal effort by the government, suggesting that infrastructure investment is in fact crowded out by the state's need to finance those other expenditures, which are not similarly compressible.

It is important to acknowledge, however, that the decline in public investment in infrastructure is a common trend in most Latin American countries, with an average decline of about 2.27 percent in the last decade. In some cases, notably in Chile and Colombia, this decline was caught up by a massive private investment compensating for the lack of public investments. Although private financing of infrastructure exists in Brazil, it has been very low (about 1 percent of GDP) and has never reached the scale of Chile and Colombia, 5.7 and 2.6 percent of GDP respectively.

Why has Brazil faced so many difficulties to attract private investments in infrastructure? According to the World Bank (2007), "regardless of the indicator used, data show that returns on infrastructure concessions in Brazil have not been sufficient to compensate for the opportunity costs of capital." Low investment returns in infrastructure are closely related to relatively high and risky opportunity costs for business in Brazil. Faced with the risk of administrative expropriation by future governments, private investors have been discouraged from financing infrastructure projects.

Because country risk has reduced since 2008, when Brazil was able to convince several credit ratings agencies to raise Brazilian debt to investment grade, the country can obtain significant gains. However, there are still concerns about the governance conditions of the regulatory environment of Brazilian regulators. There is evidence, for instance, that the government has systematically impounding agencies' budgets, which has tremendously threatened their autonomy and capacity to operate (Correa et al. 2006). Also, there has been excessive government interference on contract renegotiations revising tariffs and investment plans, which might be an indication of poorly designed concession contracts and the weakness of an independent regulator.

Therefore, if the problem is an overburdened state, which has to tax, borrow and trim down other investments to maintain entitlements and other commitments, then which expenditures have such a constraining effect on the economy? Although there are several expenditures in this category, the one that stands out high above all others is outlays for social security and pensions. Practically one-third of the federal budget is devoted to these expenditures, whereas expenditures in investments were less than 6 percent in 2003. Pensions in Brazil since the 1988 constitution have been notably generous, especially in the civil service. A new group of non-contributing rural pensions was added, contributing to systematic deficits. With about 11.7 percent of GDP, Brazil has one of the highest social security expenditures in the world, especially considering that the Brazilian population is much younger than that of most countries with similar levels of expenditure.

The equilibrium that emerges from these opposing forces is one in which economic growth and improvements in productivity are realized but at a pace and scope that are limited by the constraints created by political institutions. This is in many respects a remarkable outcome given the history of the Brazilian economy in the past several decades. Although elements that conspire against growth and productivity have always thrived, the necessary conditions for the virtuous aspects of the policymaking process to materialize are extremely demanding. The approach suggested here thus emphasizes those aspects of the political institutions and policymaking processes that have led to this net-positive equilibrium, though we temper this assessment with the recognition of the many distortions that mitigate what is actually achieved.

>References
Alston, L., M. Melo, B. Mueller, and C. Pereira (2010). "The Political Economy of Productivity in Brazil," IDB Working Paper Series No. IDB-WP-104

Correa, P., C. Pereira, B. Mueller, and M. Marcus (2006). "Regulatory Governance in Infrastructure Governance," the World Bank

The World Bank (2007). "How to Revitalize Infrastructure Investments in Brazil: Public Policies for better Private Participation," Report No. 36624-BR, page 52

The World Bank (2008). "The Growth Report: Strategies for Sustained Growth and Inclusive Development," Washington, DC: Commission on Growth and Development.

[1]Private investment in Brazil has been also smaller than other East Asian countries such as Thailand and Philippines

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