The Pros and Cons of Brazil’s Controversial Constitutional Amendment

A proposed constitutional amendment that would limit public spending growth, one of the Temer government’s key initiatives, is making waves in Brazil. Some have cheered it, stating that getting Brazil’s finances in order is crucial for the country’s economic recovery. Others however, worry that this extreme measure will ultimately harm the country’s poorest citizens. So who’s right?

 

Brazil is recovering from an unprecedented political crisis and the worst economic downturn in a century. The combination of these two events has wreaked havoc on the country’s finances, creating a ballooning debt crisis that has relieved Brazil of its investment grade and relegated it back to junk status as international lenders fear the possibility of a Brazilian default. In response to this, the government of vice-president turned president Michel Temer has proposed a rather extreme new initiative, a constitutional amendment that would cap government spending for the next 20 years.

Investors are cheering the proposal while opponents decry it as “the end of the world.” The reaction has been predictably hysterical in a country that has been polarized by political trauma in recent years. Given the extreme nature of the proposal itself, as well as the inflammatory rhetoric of both its proponents and detractors, it can be difficult to know what to make of the whole thing. 

What exactly is being proposed?

Proposed Constitutional Amendment 241, known in Brazil as the “Ceiling Amendment,” seeks to limit growth in public spending by tying it to the inflation rate, starting in 2017, for a period of 20 years. The limits will be defined based on the 2016 budget and will come into effect in 2017 (the 2016 values will be adjusted by the expected inflation rate of 7.2% to define the 2017 values). The same will be done each year for the next 20 years. It is certainly an extreme measure and an unprecedented step that has never been tried before in Brazil or anywhere else in the world. So is it crazy enough to work, or just plain crazy?

First, a bit of context

Brazil is currently experiencing a terrible recession, one of the worst in its history. Although the economic crisis was triggered by decreasing commodities prices, it was exacerbated by profligate government spending, which caused a doubly painful combination of decreasing GDP and rising inflation, the dreaded stagflation.

To understand why a measure as drastic as the ceiling amendment was proposed to cut spending, it is important to understand the Brazilian context. Brazil is a country that has experienced repeated cycles of boom and bust and has a quite recent history of hyperinflation (in the 1990s, inflation rates reached into the thousands). Of course, the elevated inflation experienced of late is in the double-digits, nothing like in the 1990s, but it is nevertheless something to which Brazilians are particularly sensitive.

The cause of the current increase in inflation is clear: the steady growth of Brazil’s public expenses over the past decade, under the rule of the leftist Workers’ Party. This has been exacerbated by the dramatic decline in revenues as a result of the recession in the past few years, which caused the government to take out ever more debt to finance its ballooning expenses. The difference between how much the government spends and how much it brings in is worrying and unsustainable. As the situation worsened, the international credit ratings agencies downgraded Brazil’s debt to junk status, thereby greatly increasing the interest rates charged on new loans. This has made the debt crisis even worse as Brazil has to spend an ever-increasing amount of borrowed money to cover just the interest expenses on what it already owes.

In such a scenario, the only ways to keep things from spiraling out of control even further are either to raise revenues (i.e., raise taxes), or limit expenses. Since raising taxes during a recession is generally a bad idea, the proposed constitutional amendment proposes to do the latter. Considering the recent growth in spending, and its negative side effects, this is a reasonable and rather logical solution to the problem.

But isn’t austerity bad?

Opponents to the amendment cry “austerity,” making the also logical argument that cutting back on government spending during a recession, when people are most likely to need government services, will only make the crisis worse, keeping the economy from growing or causing it to contract even more. Proponents of this point of view point to the pain inflicted by austerity measures throughout the world in the wake of the recent global economic crisis, starting with the mortgage meltdown in the US in 2008 and continuing over the next few years to the European sovereign debt crises.

There are two problems with this criticism. Although it is certainly true that austerity measures, as recently applied in Europe, have often done more harm than good, the comparison between Europe and Brazil is not valid. Not all economic crises are the same, and different types of economic crises call for different remedies, as explained in this article from The Economist. Austerity was not a good move for European countries because interest rates were already low there. However, Brazil is in a totally different situation. In a high-inflation environment like Brazil’s, reining in the very thing that caused said high inflation, excess government spending, is an obvious and necessary step.

In addition, the proposed ceiling will not take effect until next year, giving Brazil a bit more time to recover (indeed, the Brazilian economy is expected to grow between 0.5% and 1.3% in 2017), so technically the spending limits will not take effect until after the recession has ended and the economic recovery has started. In addition, the amendment does not propose slashing spending, but rather aims to keep it at the same level over time.

Critics point out that as the population grows, with the same amount of money being spread over more people, the amount spent per person will effectively decrease. This is true, but in a country plagued by an inefficient bureaucracy and rampant corruption, it is logical to assume that a good amount of public expenditure is currently being wasted. If that waste is cut, there is probably room for the amount actually getting to citizens to stay the same or even grow despite the limits. In any case, considering that the level of expense has been growing every year and is already quite elevated, there is no option other than for it to decrease. This approach, which keeps spending stable over time, rather than implementing radical cuts, is a way to make small real decreases gradually, over a long period of time, without causing any shocks.

Won’t this decreased spending negatively impact development?

Although a case can be made for deficit spending (taking out loans to finance development), even those who support this approach must recognize that there are limits. Brazil has already lost its investment grade and is very significantly burdened by interest due on previous loans. The more it borrows to finance its deficit, the more it spends on interest, and the greater the chances that it will default on its debt. This cannot continue indefinitely. This is the position of Finance Minister Henrique Meirelles, who recently stated that Brazil “has already passed the threshold in which additional government spending acted as a stimulus to the economy. Instead, increased spending has pushed up interest rates and driven down consumer confidence.”

The ceiling amendment is a radical but logical response to this scenario. It is not so much about cutting government spending per se, but rather about rebalancing the system after years of short-sighted profligacy that was completely unsustainable in the long-term, as explained by economist Mansueto Almeida, an official in the Finance Ministry of Michel Temer. 

A brief reminder that the ceiling amendment was originally the PT’s idea

In a place where hyperinflation generated by government spending sprees has been a relatively recent phenomenon, placing limits on how much the government can spend is a logical and reasonable solution. In fact, it is such a logical and reasonable solution that the Brazilian left once suggested it. Just 10 years ago, before the Workers’ Party (PT) of deposed president Dilma Rousseff and her predecessor, Luiz Inacio Lula da Silva, started calling the amendment “the end of the world”, they actually proposed something very similar.

Eleven years ago, Antonio Palocci, the finance minister under Lula, also wanted to pass a “fiscal adjustment plan” that would place limits on public spending growth. Although his proposal was not identical (it stipulated a shorter time frame, 10 years, and tied spending growth to GDP, rather than inflation) the underlying principle was the same: government spending cannot continue to grow indefinitely without severely negative consequences for the country’s economy, and something needs to be done to keep it under control.

Palocci’s position was essentially the same as that of the Temer administration: The government should absolutely provide a social safety net, but can only do so at a reasonable expense that is sustainable in the long term. The underlying principle is the need to keep the government’s accounts balanced, without a huge discrepancy between income and expenses, as has been the case in recent years. Unfortunately, the proposal was killed by the President’s Chief of Staff at the time, none other than Dilma Rousseff (she thought it was “rudimentary”).

Rousseff continued to pursue spending increases after she became president (arguably illegally – her “fiscal pedaling” and spending decrees are what got her impeached for breaking Brazil’s Fiscal Responsibility Law), in large part exacerbating a budding recession to create perhaps the worst economic downturn in Brazilian history. And yet, as recently as February of this year, even her own Finance Minister Nelson Barbosa argued in favor of limiting government spending. One Federal Deputy from the Brazilian Workers’ Party (PTdoB), Silvio Costa, who has been widely criticized by the left for voting in favor of the amendment in the lower house of Congress, had this to say about it “Palocci defended this. The Dilma government wanted this. I can’t defend one thing when she is in office and something else when she is out.”

Given the PT’s past support for similar measures, their current criticisms smack of unprincipled obstructionism of the sort that will oppose anything Temer says just to hurt him, even if what he is saying is right. It is reminiscent of the approach of the Republicans in the US Congress in opposing anything Barack Obama proposed, even if they agreed with it. The PT would be well-advised to remember that the obstructionist Republicans failed to keep Obama from being reelected and are now reaping the fruits of what they sowed with their belligerent and unqualified demagogue presidential candidate, Donald Trump. This is because blind obstructionism is not a viable long-term political strategy. It only alienates reasonable people, allowing cynical opportunists to take charge, and creates more problems in the long-run.

Instead of wholesale rejection, suggestions to improve the amendment

The ceiling amendment is certainly not without its flaws, and it is absolutely correct for there to be a vigorous debate of important issues in a democracy. Therefore, those who oppose the amendment should offer up constructive counter-proposals. Indeed, while the fringes of the extreme left throw a tantrum, more reasonable voices have risen up to debate the faults and merits of the details of the proposal. Their approach is not to disqualify it on principle, but rather to offer suggestions that would fine-tune and improve it.

For example, the economists Monica de Bolle and Felipe Salto have offered up some constructive criticisms. Although they generally agree with the idea of placing a reasonable cap on spending, they argue that “the devil is in the details,” and that, if not done properly, it could end up doing more harm than good. They feel that the terms of the amendment should be modified to make it more efficient and to reduce the possibility of negative unintended consequences.

In an article published this month, they argue that the time-frame for the amendment, 20 years, is simply too long and could create the opposite extreme of the current situation, in which an unbalanced policy of limiting spending too much results in the government having a huge surplus that it is not allowed to touch. This would certainly be problematic anywhere, but it is especially unacceptable in a developing country where millions of people lack access to decent schools, hospitals, roads, or even clean water and sanitation infrastructure. If the economy grows and there is money to spend, then Brazilian society should absolutely be able to benefit from it. A situation in which this is not allowed is positively immoral in a place with as much poverty and inequality as Brazil. The key point, then, is to modify the amendment to ensure balance. Balance in spending and balance in saving. It does no good to swing from one extreme to another.

Former Brazilian president Fernando Henrique Cardoso has made the same observation, calling the amendment “too rigid” and stating that it would have to be reviewed and altered within the next five years or so. Still, despite this criticism, he defended the proposal, stating that Brazil’s “financial situation is so chaotic that something like this must be done to restore credibility”.

The amendment does contain a provision in which alterations could be made starting in 10 years. Responding to these criticisms, Temer himself has stated that the measures could be reviewed and altered in as little as four or five years, if the Brazilian economy recovers and starts growing again during this time.

What if instead of cutting spending, they raise taxes?

Some critics argue that although it is certainly a high priority to get Brazil’s finances back in order, perhaps cutting costs is not the best way to do that. Although opponents of austerity generally agree that raising taxes during a recession is not ideal, they have argued that strategic tax increases on the rich would raise revenues without hurting the poor. Proponents of this idea point specifically to Brazil’s low inheritance and capital gains taxes.

Although this may seem appealing at first glance, this idea, too, is flawed. The previously mentioned taxes may indeed be low compared to international standards, but other taxes are quite high. In fact, Brazil already has among the highest tax burdens in the world. A problem specific to the Brazilian system is that it generates a disproportional amount of revenues from consumption taxes, like VAT and import tariffs, rather than from income taxes. Everybody pays those.

There is no denying that the poor suffer disproportionately from this system and that a significant reform of the absurdly complex and inefficient Brazilian tax code is in order for this and many other reasons. The fact is that the entire Brazilian population is already being taxed beyond the limits of what would be reasonable. A constant refrain in Brazil is “taxes like Scandinavia, infrastructure like Africa.” All of this tax money goes to support a bloated government bureaucracy that fritters away billions through inefficiency and corruption. Raising taxes at this point, to continue to support this system, would be not only bad for the economy but also plainly wrong on principle, sending the wrong message that the government can continue to waste taxpayer funds without reforming itself. The system has to change. Again, it is not about big government versus small government, but rather, about balance. The current system, as it is, taxes people too much, and provides too little in return. The proposed ceiling is (or at least should be) about forcing the government to do less with more, to improve efficiency and reduce corruption.

The ceiling would be for public spending overall, not for specific types of spending. Placing a constraint on the total amount of funds disbursed in this way is an opportunity to cut waste and make sure that money goes only where it is needed. In theory, it will force Congress to prioritize funding for critical areas while slashing spending on unnecessary items. For example, why should the Brazilian government give out tens of billions of dollars in subsidies to multi-billion dollar corporations, as it has routinely done through the Brazilian Development Bank in recent years? That money could certainly be better spent, especially on healthcare and education. This is a chance for Brazilian politicians to live up to their rhetoric, to literally put their money where their mouths are.

Skeptics say that they will never do this, and will use the amendment as an opportunity to trim back spending for the poor while keeping the perks for themselves at the same level. That may well happen. A recent article published by Plus 55 summed up this sentiment nicely: "No law has the magical power of turning Brazilian politicians into sensible human beings." Given their dismal track record, it is reasonable to be skeptical that Brazil’s politicians will suddenly begin operating in good faith, trimming back waste and corruption while focusing on making sure the poor are not harmed. The corruption and self-interest at the expense of everyone else is not just going to disappear.

But this is exactly why it is so hard to understand the notion that a better option would be to give these same dishonest politicians even more money. The case of forcing a cap on spending growth is derived from the question: Where does all the money go? How can Brazil, a country with a high tax burden and a huge population, where government spending has been growing, have so little to show for it? The amendment should, in theory, be about belt-tightening, delivering better results with fewer resources. Will it work? Who knows? But, something needs to be done. Something different. It is clear that raising government revenues, just throwing money at the problem, is not going to resolve anything.

Still, there certainly are ways to find revenues without raising taxes, and these should definitely be explored. An obvious place to start would be to crack down on tax evasion, which is a huge problem. It is estimated to cost Brazil almost 300 billion dollars per year, more than enough to cover the current deficit. A recent amnesty program to allow Brazilians to repatriate undeclared funds in exchange for a fine is expected to bring in some 25 billion dollars this year. It’s a start, but there is so much more that could be done in this area. The amount coming back in is but a drop in the bucket of everything that’s out there. Making sure that everyone is paying their fair share is a far better way to help close the budget gap than simply raising taxes. Regulatory authorities should take advantage of the momentum provided by recent anti-corruption investigations to start changing the norm of impunity for tax evaders.

A tough solution to a tough problem

In short, the proposed ceiling amendment is a unique and extreme solution to fit the particular context of Brazil, a country with a history of profligacy-related hyperinflation. Last time hyperinflation reared its ugly head, the Fiscal Responsibility Law was passed to make sure that something like that never happened again. And yet, it was not enough. Dilma Rousseff flouted the Fiscal Responsibility Law for years, ultimately getting herself impeached for it. Unfortunately, by the time her ouster came around, the damage was already done.

That law should have been enough to keep finances from spiraling out of control. Since it wasn’t, stronger measures are needed. Hence this proposal. It may be extreme, but it is a logical conclusion to the past few years.

Criticisms that the amendment alone will not resolve the country’s fiscal crisis are absolutely right, and indeed the government plainly recognizes this. The next item on the agenda after getting the amendment approved (which will require several votes in Congress and is expected to culminate before the end of the year) is tackling Brazil’s pension system, which given Brazil’s aging population is now growing unsustainably as well.

Although the system is underfunded in general, a specific problem is that there is a vast discrepancy between the pensions of private employees versus public servants, with some elite categories of public servants earning often outrageous sums after just a few years of service. Once again, the issue at hand is a rebalancing – the burden of the reform should fall on the party responsible for the problem, in this case, those disproportionately overpaid public sector workers.

The constitutional amendment to limit public spending is therefore just the first step in getting Brazil’s finances in order. It is without a doubt a blunt instrument, and an imperfect one, for a very complex problem. But for now, it seems to be the only solution on the table. Perhaps with some intelligent adjustments, it can be improved and optimized so as to deliver the best results possible. It is not ideal, but it will at least begin to resolve one of the most pressing and urgent problems facing Brazil right now.

It will, of course, have to be complemented with other measures to improve the economy, chief among them the adjustment of the pension system. In the longer term, for Brazil to remain on the path to sustainable development and retake its position as an emerging global power, improvements will have to be made to productivity, which is dismal. This means addressing poor infrastructure, healthcare and education, as well as tackling other bureaucratic problems that limit competitiveness, like the complex tax system and protectionist laws.

Clearly then, fixing public spending is just the first of a long line of highly complex problems that will have to be solved for Brazil’s situation to truly change. We can only hope that Brazil’s leaders will be up to the challenge. Otherwise, in a few years, we will find ourselves here again, scrambling to resolve a crisis that could have been prevented, as has been done so many times over Brazil’s history.