## Gross Fixed Capital Formation and Other Key Variables (cr17216) ## Source details **Canonical URL:** [Gross Fixed Capital Formation and Other Key Variables (cr17216)](https://www.imf.org/-/media/files/publications/cr/2017/cr17216.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2017/cr17216.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2017/cr17216.pdf.json) --- ### Investment decline: magnitude, drivers, and model - Real investment fell by around 30 percent between the beginning of 2014 and the beginning of 2017. - Contributing factors to the investment decline: - deterioration in Brazil’s medium-term growth prospects; - rising real interest rates; - falling terms of trade; - rising uncertainty related to economic policy; - rising levels of corporate leverage; and - lower cash flow. - Some normalizing factors that may support recovery: - central bank has begun an easing cycle; - terms of trade stabilized and improved in early 2016. - Aggregate empirical model (medium-term growth expectations, joint estimation with quarterly real investment growth): - Growth expectations (3-years-ahead) modeled as function of ∆y_t, ∆p_t, ∆tot_t, ∆r_t, ∆q_t, ∆ulc_t, plus autonomous residual η_t. - Investment growth driven by same variables, η_t, lags of corporate leverage L_t, and economic policy uncertainty EPU_t. - Variables and transforms (selected): - g_t: Real GDP Growth Expectations (3-years ahead), BCB, Level, % - i_t: Real Gross Fixed Capital Formation, IBGE, Level, log - L_t: Corporate Leverage (corporate debt to GDP), IMF, Level, %GDP - EPU_t: Economic Policy Uncertainty, Haver, Level, log - Key estimation results (preferred specification model 3): - Adjusted R-squared around 0.7 for quarterly investment growth. - Investment increases with higher η_t and higher terms of trade. - Investment decreases with higher real interest rates, higher unit labor costs, higher regulated prices, higher leverage, and higher policy uncertainty. - Decomposition of investment fall since 2014 (cumulative, demeaned): - Autonomous deterioration in medium-term outlook (η_t): reduced investment by around 10 percent since beginning of 2014. - Heightened policy uncertainty: reduced investment by around 10 percent since beginning of 2014. - Other contributors: rise in costs (regulated prices and unit labor costs), falling terms of trade, higher interest rates, rising leverage (notably in 2015). ### Prospects and assessment - Factors supporting recovery: - expected significant fall in real interest rates over the coming year due to central bank easing; - stabilization and improvement in terms of trade since early 2016. - Constraints that are likely to mute recovery: - prolonged recession damaged long-term growth prospects and expected returns to investment; - elevated corporate leverage reducing demand for and supply of investment funding; - ambitious fiscal reform agenda with implementation challenges contributing to policy uncertainty. - Overall assessment: turnaround in investment likely to be subdued given still-high corporate leverage and continued policy uncertainty. *International Monetary Fund — Chapter: “Gross Fixed Capital Formation and Other Key Variables”* --- ### Leverage, Cash Flow, and Firm-Level Investment ### Firm-level model, data, and definitions - Baseline specification: firm i’s net investment scaled by beginning-of-period capital explained by lagged LEV, contemporaneous ΔDebt, ΔSales, Tobin’s Q, interest coverage ratio, lagged political uncertainty, firm fixed effects, time effects, and idiosyncratic error. - Expectations: - Higher leverage → negative association with investment. - Change in debt → positive association with capital expenditures. - Lower interest coverage → associated with lower investment. - Data and sample: - Source: Capital IQ firm-level balance sheets and income statements. - Coverage: over 4,000 Brazilian firms spanning 1995 to 2016; data sparse and concentrated in 2010–2016. - Winsorization cutoffs applied (selected): - Investment-to-capital ratios: 250 and -50. - Sales growth and debt growth ratios: 20 and -20. - Cash flow ratios: 10 and -10. - Tobin’s Q: 50 and 0. - Leverage ratios: 100 and 0. - Variable definitions (selected): - Investment ratio: Capital expenditure within the year over capital stock at the beginning of the year. - Leverage ratio: Total debt net of cash+cash equivalents over total assets-cash and cash equivalents. - Cash flow ratio: Net income+depreciation over capital stock at the beginning of the year. - Change in debt ratio: Change in total debt over capital stock at the beginning of the year. - Tobin’s Q: (Market capitalization-total equity+total assets) over total assets. - Interest coverage ratio: EBITDA over interest expense. - Uncertainty: Change in Economic Policy Uncertainty (Baker, Bloom, Davis). ### Main estimation results (pooled regressions, 1995–2016) - General findings: - Investment increases with Tobin’s Q, sales growth, cash flows, and debt flows. - Investment decreases with higher leverage and higher political uncertainty. - Example magnitude: a 10 percentage point rise in a large firm’s leverage is associated with a 1.1‒1.4 percentage point fall in the investment-to-capital ratio. - Selected coefficient estimates (Leverage, lag; Cash Flow ratio; Change in debt ratio; Change in sales ratio; Tobin’s Q; Uncertainty): - Leverage, lag: coefficients include -0.116*** (0.022), -0.120*** (0.023), -0.115*** (0.028), -0.110*** (0.021), -0.139*** (0.019), -0.116*** (0.022), -0.112*** (0.021). - Cash Flow ratio: 0.031*** (0.005); 0.029*** (0.005); 0.022*** (0.005); 0.034** (0.015); 0.049*** (0.015); 0.049*** (0.015). - Change in debt ratio: 0.016*** (0.002); 0.011*** (0.003); 0.007 (0.005); 0.008 (0.005); 0.008* (0.005). - Change in sales ratio: 0.010*** (0.003); 0.006 (0.006); 0.003 (0.007); 0.003 (0.007). - Tobin’s Q: 0.005*** (0.002); 0.005*** (0.002); 0.004*** (0.002). - Interest coverage ratio: 0.001 (0.001); 0.001 (0.001). - Uncertainty, diff, lag: -0.001 ** (0.000). - Sample sizes and fit (selected): - Number of observations: 10,763; 10,378; 10,144; 9,805; 2,392; 2,311; 2,303. - Number of firms: 3,286; 3,151; 3,052; 2,930; 297; 291; 291. - R2 values: 0.01; 0.03; 0.03; 0.03; 0.04; 0.05; 0.05. ### Robustness and sectoral heterogeneity - Robustness: alternative leverage definitions (net debt/equity; net debt/EBITDA) yield significant negative leverage coefficients (e.g., -0.003*** (0.001); -0.001** (0.000)); cash flow and change in debt remain positive and significant in many specifications. - Sectoral results (Leverage, lag significant across most sectors; exceptions: health and real estate): - Consumer Discretionary: -0.142*** (0.047) - Consumer Staples: -0.230*** (0.033) - Energy: -0.336*** (0.069) - Healthcare: 0.072 (0.120) — not significant - Industrials: -0.119*** (0.036) - Real Estate: -0.062 (0.042) — not significant - Telecommunication: -0.369*** (0.135) - Utilities: -0.182*** (0.050) - Cash Flow ratio significant and positive in Energy (0.094*** (0.025)), Telecommunication (0.099*** (0.035)), Consumer Staples (0.069*** (0.020)). - Change in debt ratio significant positive in Energy (0.044** (0.022)); Industrials (0.019*** (0.006)); Telecommunication (0.101*** (0.038)). - Political uncertainty (diff, lag) shows significant negative effects in Healthcare (-0.001*** (0.008)), Industrials (-0.001*** (0.000)), Real Estate (-0.001*** (0.001)), Utilities (-0.000*** (0.000)). ### Aggregate interpretation - Drivers of the investment decline since 2014: - Rising costs; falling profitability and expected profitability; higher corporate leverage; rise in policy uncertainty. - Empirical evidence highlights policy uncertainty as a significant contributor to investment decline. - Short-term outlook: - Stabilization of regulated-price inflation, terms of trade, and real interest rates should improve investment growth and expectations. - But high corporate leverage and policy uncertainty, plus reform implementation challenges (notably pension reform), may sustain subdued investment recovery. *Source: IMF staff estimates and chapter text in cr17216 — “Leverage, cash flow, and changes in debt capture the relevance of each firm’s financial”* --- ### Brazil’s Doing Business Position, Trade Policy, and External Competitiveness ### World Bank Doing Business (DB) ranking and key indicators - In 2017, Brazil ranked 123rd out of 190 countries. - In 2010, Brazil ranked 129th in a sample of 183 countries. - Brazil’s Distance to Frontier (DTF) would need to move from 56 to 65 percent to approach the fitted line relating DTF to per capita GDP in 2015. - Key weaknesses (selected indicators and statistics): - Starting a business: an estimated 11 procedures (down from 14 in 2010) and about 80 hours. - Paying taxes: 2038 hours a year to pay taxes in Brazil (fell from 2600 in 2010); share of total taxes and contributions in pre-tax profits slightly below 70 percent. - Trading across borders: Brazil occupies rank 149; more than 5 days for export customs clearance and inspections; more than 15 days to clear imports. - Getting credit: rank 101. - Insolvency: recovery rates below 16 percent; time to conclude insolvency averages 4 years. - Political/institutional indicators: ICRG corruption score 2 out of 6; bureaucracy quality score 2 out of 4. ### Recent reforms captured by DB criteria and announced micro measures - Examples of reforms: - Starting a business: 2016 online portal for business licenses in Rio de Janeiro; Redesim to integrate registries. - Paying taxes: repeal of tax on check transactions in 2011; eSocial to unify 13 obligations. - Trading across borders: SISCOMEX Portal and electronic data interchange upgrades; target reductions in export days from 13 to 8 and import days from 17 to 10 via Single Foreign Trade Portal. - Getting credit and insolvency: centralized market for electronic receivables; bankruptcy law improvements; strengthening fiduciary alienation auction processes. - Government package: 47 actions linked to MDIC; 24 linked to foreign trade. ### External competitiveness, tariffs, and trade policy findings - Export structure: - Herfindahl concentration index in line with EM median in 2014–15. - Domestic content of exports persistently higher than peers, indicating weight of commodities and lower integration into global value chains. - Export quality below frontier average. - Tariffs and protection: - Import tariffs declined since early 1990s to below 10 percent, but Brazil’s tariff regime remains more protectionist than LAC and upper middle income averages. - Higher tariffs on goods and raw materials, especially on capital goods. - Quantified simulation result: - If Brazil halves its average tariffs on capital goods (about 10 percent in 2015), it would increase investment by about 10 percent over the medium-term. - Halving tariffs on capital goods would raise investment-to-GDP by about 2 percentage points. - Equivalent to an increase in investment of about 15 percent over three years assuming a real GDP growth of 2 percent on average. - Evidence on NTMs and FDI: - NTMs used extensively; Brazil second only to Indonesia in local content requirements since the global financial crisis (OECD, 2014). - Restrictions to inward FDI close to peers; relative advantage diminished recently. - Frequent use of anti-dumping after 2008 contributed to eroding competitiveness. ### Policy implications and recommended measures - Reduce trade protection by: - Lowering tariffs, including on capital goods. - Removing non-tariff barriers. - Scaling back local content requirements, including on public procurement. - Complementary policies: - Enhance integration into global value chains. - Improve product and labor market regulation and the foreign investment environment. - Support human capital, tertiary education, skills upgrading, and R&D to improve export quality. *Source: cr17216 — “Brazil’s position in the World Bank DB ranking is disappointing, but has improved”; “Brazil’s exports are diversified”* --- ### Progress in Trade Agreements and Reforms to Boost Competitiveness ### Trade agreements and agenda - Mercosur-based network expanded to Cuba, Guyana, and Saint Kitts and Nevis; diversification sought with Pacific basin countries (Peru, Chile, Colombia). - Government intends to expand agreements with Mexico; negotiations with EU resumed (EU accounts for 20 percent of Mercosur trade). - Bilateral agenda with the U.S. includes implementation and expansion of Regulatory Convergence and Trade Facilitation agreements already signed. ### Recommended reforms to improve external competitiveness - Strengthen competition by streamlining product market regulation and reducing entry regulations. - Improve technical capacity and planning for infrastructure concessions; more detailed tender packages prior to tender calls. - Consolidate indirect taxes at state and federal levels; work towards a value-added tax with a broad base, full refunds for input, and zero-rating of exports. - Pursue Doing Business reforms while sequencing to consider cyclical economic impacts (tariff reductions may raise short-term unemployment and lower consumption). *International Monetary Fund — Chapter: "Progress in expanding and diversifying bilateral, regional and multilateral trade."* --- ### Pension Reform Illustrative Distributional Effects ### Purpose, methodology, and illustrative worker types - Objective: illustrate distributional effects of proposed pension reform using four illustrative worker types and Mincer wage profiles; PDV of net transfers computed using a 1 percent real discount factor. - Four illustrative types and key outcomes: - Urban (private) skilled worker: - Before: retire on average at age 56 after 35 years of contribution. - After reform (steady state post 20-year transition): assumed work for 45 years and retire at age 65. - Net lifetime income higher after reform; survivor’s pension reduced (sole survivor gets 60 percent of original benefit under new rule). - Urban (private) unskilled worker (incomplete contribution history): - Before: contribute for 15 years. - After: contribution time increases to 25 years. - Negative but small effect on lifetime income; benefit level lower due to calculation over entire contribution history. - Rural worker: - Median rural income less than minimum wage; reform does not change retirement age for these workers; gross lifetime income unaffected; net income small impact due to contribution requirement up to 5 percent of the minimum wage for at least 15 years. - Public sector worker: - Median public worker retires at age 60 before reform; after reform works another 5 years. - Gross lifetime income decreases; net lifetime income change more pronounced due to longer contributions at higher overall rate. - PDV of net transfers declines after reform for all four illustrative types; larger reductions for public-sector and private skilled workers. - Fiscal and equity effects: reform generates fiscal savings and reduces inequities favoring higher-wage groups (public employees). ### Selected pension parameter changes (before vs after) - RGPS — Retirement by Contribution Time: - Before: eligibility sum age+contribution ≥ 85/95 for women/men or minimum 30/35 years contribution; benefit = average of 80% highest salaries or s*f. - After: Retirement by Contribution Time extinguished. - RGPS — Retirement by Age: - Before: minimum age 60/65 for women/men and minimum 15 years contribution; benefit = s*(70% + 1% per year of contribution). - After: Eligibility minimum age 62/65 for women/men and minimum 25 years contribution; benefit = s'*(70%x + 1.5%y1 + 2.0%y2 + 2.5%y3) with s' mean of all salaries since 1994; benefit cannot be higher than s; contribution rates unchanged (employee = 8% to 11%; employer = 20%). - RPPS — Basic Retirement (public): - Before: eligibility 55/60 and 30/35 years contribution; benefit 80% of highest salaries; contribution employee = 11%; employer = 22%. - After: eligibility 62/65 and 25 years contribution (minimum age for teachers 60); benefit formula mirrors RGPS after reform; contribution rates unchanged. *Sources: PNAD; and IMF staff calculations.* --- ### Inequality, Cost-of-Living Adjustment, and Redistribution ### Spatial price adjustment and inequality trends (Box: Cost of Living Adjust) - Rental prices used to construct spatial price adjustment index for sub-regions and states for 2004–2015 using Azzoni and Almeida (2016) parameter. - Empirical correlations reported: - y = 0.9789x - 0.0108, R² = 0.9886 - y = 0.5557x - 0.0118, R² = 0.7245 - Price dispersion example: metro areas diverging from national average between -19 percent and +14 percent. ### Inequality levels, trends, and 2015–2016 risks - Gini indices and state dispersion: - Brazil official Gini index for all income sources: 0.497 in 2014 → 0.491 in 2015. - Gini for labor income: 0.490 in 2014 → 0.485 in 2015. - Gini for household income: 0.494 in 2014 → 0.493 in 2015. - Standard deviation of state Gini coefficients: 0.035 → 0.033. - 2015: employed population drop; real gross household earnings contracted across all professions for first time in 11 years; inequality fell slightly because higher-income brackets were more affected. - 2016: recession continuation, job destruction, and high inflation likely reversed equality gains. - World Bank (2017) estimates: poor in Brazil likely increase by 2.5‒3.6 million by 2017; Gini index increase from 0.51 to 0.52‒0.54. ### Macro-policies and distributional drivers - Factors contributing to declining inequality (2004–14): rapid labor formalization, higher real wages, transfers (notably Bolsa Família). - Bolsa Família: - Coverage: from about 6.5 million households in 2004 to over 14 million in 2014 (56 million people). - Budget appropriations: about 0.3 percent of GDP to 0.6 percent of GDP over 2004–2014. - World Bank (2017) estimate: 58 percent of decline in extreme poverty over 2004–14 due to Bolsa Família. - Tax system and progressivity: - Ratio of direct to indirect taxes at general government level: 45 percent in 2016. - Average worker pays: 15 percent of gross income in income taxes, 3 percent in asset taxes, and 24 percent in consumption taxes (Amaral and others, 2016). - Consumption tax burden: workers up to R$3,000/month pay 24 percent of gross income in consumption taxes; those making more than 10,000 pay 17 percent. - Personal income taxes found progressive and redistributive when corporate dividend taxation is considered (Lustig et al., 2014). ### Implicit education subsidies and equity - Public universities tuition-free but skewed to wealthier students: - Nearly half of public university students belong to households in the top income quartile; only 9 percent from bottom quartile. - Between 2000 and 2014 public university students increased from 0.89 million to 1.96 million. - Funding a higher education student costs about four times a secondary education student in Brazil (OECD average 150 percent). - Policy recommendations: - Preserve equality gains while pursuing fiscal sustainability by moderating civil servants’ wage growth; using direct, needs-based instruments (Bolsa Família); redirecting resources from universal tertiary subsidies towards early childhood, primary and secondary schooling and need-based university support; relying more on direct taxation and less on indirect taxes; ensuring minimum wage policy balances remuneration and employment effects. *Sources: PNAD; and IMF staff calculations.* --- ### Monetary Policy Transmission, Inflation, and Interest Rates ### Empirical evidence and VAR results - Data: monthly 2003–2016; baseline VAR with six variables (headline inflation, SELIC, output gap, 12-month-ahead inflation expectations, commodity prices, REER); sectoral VARs for non-regulated, regulated, services, tradable, non-tradable inflation. - Cross-correlations: - Higher inflation leads to higher interest rates. - Higher interest rates lead to lower inflation. - Peak correlation around 6 months. - Structural VARs: - A 100 basis point cut in policy rate tends to increase inflation over time; peak impact around 9 months. - Sectoral heterogeneity in responses; identification uncertainty examined via orderings (720 possible orderings; 69 unique inflation responses; 1,000 parameterizations → 69,000 estimates per VAR). ### Policy interpretation and model simulations - Robust evidence supports the conventional view: higher rates reduce inflation in the short term; lowering policy rates is not a reliable way to reduce inflation. - New Keynesian simulations and disinflation episodes indicate: - Lower long-run inflation target reduces nominal interest rate and inflation in long run. - If expectations are partially backward-looking, transition to lower target requires lower output in short term; real interest rate must rise to reduce demand. - More credible monetary policy reduces transition costs. - Policy recommendations: - Enhance monetary policy transparency and credibility (anchor expectations). - Improve transmission by reducing distortions in the financial sector (e.g., reduce gap between TJLP and SELIC or link TJLP to SELIC or market rates). - National Monetary Council narrowed target range from 4.5 percent +/- 2 percent to 4.5 percent +/- 1.5 percent from 2017. *Prepared by Troy Matheson (WHD); sources: IMF staff estimates and Appendix II content.* --- ### Fiscal Consolidation and Real Interest Rates in Emerging Markets ### Main empirical findings (local projections, 2001−15 panel) - Fiscal consolidation episodes identified via CAPB improvements (OECD 2009 method). - Episode counts: - Total sample (73 countries): 232 fiscal consolidation episodes. - EM sample: 35 episodes, average consolidation 1.8 percent of GDP per year. - No fiscal consolidation episodes recorded for Brazil during 2001−15. - Effects on interest rates given a fiscal consolidation episode: - One percentage point improvement in change of CAPB associated with ≈100 basis points decrease in the real policy rate (significant about 6 months). - One percentage point improvement associated with ≈70 basis points decrease in the real 10-year government bond yield (significant initially for first couple months). - Interaction with high outstanding debt (>60 percent of GDP): - Given consolidation, one percentage point improvement reduces real policy rate by almost 200 basis points. - Real 10-year yield response remains around 70 basis points but significant mainly during the first year. - Fiscal-adjustment reversals: - Reversals occur on average after the second year; most EMs experience reversals by the fourth year, explaining short-lived effects. - Robustness: - Results qualitatively robust to alternative consolidation definitions and EM-only samples. - Policy implications: - Fiscal consolidations have beneficial but moderate and short-lived effects on real rates; maintaining consolidation is key. - Brazil’s 20-year public spending ceiling and reform agenda could reduce rates if maintained and accompanied by financial sector efficiency improvements. *Source: IMF staff estimates and analysis as presented in the chapter.* --- ### Productivity Challenge, Resource Misallocation, and Tax Policy ### Productivity and resource misallocation - Brazil’s productivity growth 2001–2013: 1.6 percent a year. - Comparative rates: China 9.6 percent; Russia 3.5 percent (Ceratti, 2016). - Resource misallocation findings: - Wide dispersion in revenue productivity across firms within industries. - Potential TFP gains: moving Brazil to the 90th percentile of allocation efficiency could increase TFP by 57.3 percent (RAE comparisons). - Reducing misallocation over 20 years could raise annual real GDP growth by 2.29 percent during the transition path. ### Tax-system distortions and estimated quantitative gains - Tax disparity across asset types: - Eliminating most tax disparity to the 90th percentile would raise resource allocation efficiency by 12.3 percentage points and increase annual GDP by 0.58 percentage points. - These gains are four times larger than potential gains for emerging economies median and three times larger than Latin American median. - Corporate debt bias: - Reducing corporate debt bias to the 10th percentile (raising allocation efficiency to the 90th percentile) would raise resource allocation efficiency by 5.56 percentage points and increase annual GDP growth by 0.27 percentage points. - Gains are 40 percent higher than Latin American average and almost three times larger than Emerging countries average. - Tax informality: - Reducing tax informality to best performers can increase productivity by 2.58 percentage points and annual GDP by 0.12 percentage points. - Addressing tax-related distortions could bridge about half of the productivity gap relative to leading countries. - Policy implications: - Upgrade tax design and administration to reduce tax disparity across assets, correct corporate debt bias, and reduce informality. - Complement tax reforms with product, labor, and financial sector reforms to reduce resource misallocation and boost productivity. *Source: IMF chapter excerpts and Fiscal Monitor–based analyses in cr17216.* *Italic: Source: IMF staff estimates and chapter material in cr17216 (cr17216.pdf).* ### 1. Gross Fixed Capital Formation and Other Key Variables _____________________________ 6 ### 1. Gross Fixed Capital Formation and Other Key Variables ### Introduction - Real investment fell by around 30 percent between the beginning of 2014 and the beginning of 2017. - The investment decline followed a post-global-financial-crisis recovery that was supported by rising terms of trade, low interest rates, expanding consumption, and optimism about growth prospects. - Factors contributing to the decline include: - deterioration in Brazil’s medium-term growth prospects; - rising real interest rates; - falling terms of trade; - rising uncertainty related to economic policy; - rising levels of corporate leverage; and - lower cash flow. - Some dampening factors have begun to normalize (e.g., the central bank has begun an easing cycle and terms of trade stabilized and improved in early 2016), which should help reduce funding costs and increase profitability. However, still-high corporate leverage and continued policy uncertainty imply a subdued investment turnaround. ### Aggregate Empirical Analysis: Model and Specification - Medium-term growth expectations (3-years-ahead) are modeled as a function of: - annual real GDP growth (∆y_t), - annual regulated-price (IPCA) inflation (∆p_t), - annual changes in the terms of trade (∆tot_t), - the real interest rate (∆r_t), - annual growth in equity prices (∆q_t), and - unit labor costs (∆ulc_t), with an autonomous residual term η_t capturing reassessment of medium-term growth beyond contemporaneous conditions. (Equation (1) in text.) - Quarterly real investment growth is jointly estimated with the growth-expectations equation and is driven by: - the same variables as growth expectations, - the estimated residual from the growth-expectations equation (η_t), - lags of corporate leverage (corporate debt to GDP, L_t), and - an index of economic policy uncertainty (EPU_t). - Variables, sources, and transforms (as presented): - g_t: Real GDP Growth Expectations (3-years ahead), BCB, Level, % - i_t: Real Gross Fixed Capital Formation, IBGE, Level, log - y_t: Real GDP, IBGE, Level, log - p_t: Regulated Prices, IPCA, IBGE, Level, log - tot_t: Terms of Trade, Haver, Level, log - r_t: Real Interest Rate (Selic - 12-month-ahead inflation expectations), BCB, Level, log - q_t: Equity Price Index, Haver, Level, log - ulc_t: Unit Labor Costs, R$, BCB, Level, log - L_t: Corporate Leverage (corporate debt to GDP), IMF, Level, %GDP - EPU_t: Economic Policy Uncertainty, Haver, Level, log ### Aggregate Empirical Analysis: Key Estimation Results and Implications - Three variants of the model were estimated using Seemingly Unrelated Regressions; the preferred specification (model 3) fits quarterly investment growth well given series volatility (adjusted R-squared is around 0.7). - Signs of estimated coefficients in the investment equation (intuitive interpretation): - Investment increases with: - higher autonomous growth expectations for the future (η_t); - higher terms of trade. - Investment decreases with: - higher real interest rates; - higher unit labor costs; - higher regulated prices; - higher leverage; and - higher policy uncertainty. - Decomposition of the drop in investment since 2014 (Figure 2, cumulative quarter-on-quarter growth since 2014Q1, demeaned variables): - The most significant drags on investment since beginning of 2014 were: - deterioration in the autonomous part of the medium-term outlook for growth (η_t), reducing investment by around 10 percent since beginning of 2014; - heightened policy uncertainty, reducing investment by around 10 percent since beginning of 2014. - Other contributors to the fall in investment include: - a rise in costs (chiefly a sharp increase in regulated prices, such as energy prices, and unit labor costs); - falling terms of trade (impacting prospects for commodity exporters); - higher interest rates; - rising leverage, which contributed especially during 2015 when it rose fast. - The text indicates other factors and an “Other factors” residual in the decomposition (see Figure 2). ### Firm-Level Analysis - A panel regression of firm-level investment-to-capital ratios was estimated to study micro drivers of investment, following approaches in Magud and Sosa (2015) and Li and others (2015). - The firm-level model distinguishes: - Fundamentals (marginal productivity drivers): - change in sales (proxying demand and expected future growth); - Tobin’s Q (expected marginal return on investment). - Financial factors (financing constraints): - leverage; - cash flow; - change in debt; - debt repayment capacity. - Political uncertainty is included as an additional control variable at the firm level because it is less likely to be endogenous to firm-level variables than macro variables (interest rates, GDP, terms of trade). ### Prospects for Investment Recovery - Factors expected to support recovery: - easing cycle by the central bank and an expected significant fall in real interest rates over the coming year; - stabilization and improvement in terms of trade from early 2016. - Constraints likely to mute recovery: - prolonged recession has damaged Brazil’s long-term growth prospects, lowering expected returns to investment; - elevated corporate leverage reduces both demand for and supply of investment funding; - ambitious fiscal reform agenda with implementation challenges has contributed to heightened policy uncertainty, which can deter firm investment decisions. - Overall assessment: while some headwinds have begun to normalize, still-high corporate leverage and continued economic policy uncertainty suggest the turnaround in investment is likely to be subdued. *International Monetary Fund — Chapter: “Gross Fixed Capital Formation and Other Key Variables”* ### 9. Leverage, cash flow, and changes in debt capture the relevance of each firm’s financial ### 9. Leverage, cash flow, and changes in debt capture the relevance of each firm’s financial ### Model specification and interpretation - Baseline model relates firm i’s net investment in period t (ܫ ௜௧ ) scaled by beginning-of-period capital stock (ܭ ௜௧ିଵ ) to: - LEV ௜௧ (firm leverage; enters with a lag), - ܶܤܧܦΔ ௜௧ (change in total debt; contemporaneous), - ܵܧܮܣܵΔ ௜௧ (change in total sales; contemporaneous), - ܳ_ܰܫܤܱܶ ௜௧ (average Tobin’s Q, proxy for marginal Q), - ܴܥܫ ௜௧ (interest coverage ratio, proxy for debt repayment capacity; contemporaneous), - ܴܧܥܷܰ ௧ (index of political uncertainty; lagged), - firm fixed effects (ߥ ௜ ) and time effects (ߣ ௧ ), - idiosyncratic error (ߝ ௜௧ ). - Expectations: - Higher leverage → negatively associated with investment. - Change in debt (debt flow) → positively associated with capital expenditures. - Tighter debt repayment capacity (lower interest coverage) → associated with lower investment. - Lag structure: leverage enters with a lag; cash flow, debt growth, and interest coverage enter contemporaneously (as in Magud and Sosa (2015) and Li and others (2015)). ### Data, sample, and variable construction - Data source: firm-level balance sheets and income statements from Capital IQ. - Sample coverage: over 4,000 Brazilian firms spanning 1995 to 2016; data sparse and concentrated in 2010–2016. - Winsorization / outlier constraints: - Investment-to-capital ratios: cutoff values 250 and -50. - Sales growth ratios and debt growth ratios: 20 and -20. - Cash flow ratios: 10 and -10. - Tobin’s Q: 50 and 0. - Leverage ratios: 100 and 0. - Variable definitions (selected): - Investment ratio: Capital expenditure within the year over the capital stock at the beginning of the year (net property, plant and equipment+depreciation and amortization-investment within the year). - Leverage ratio: Total debt net of cash+cash equivalents over total assets-cash and cash equivalents. - Cash flow ratio: Net income+depreciation over the capital stock at the beginning of the year. - Change in debt ratio: Change in total debt over the capital stock at the beginning of the year. - Change in sales ratio: Change in revenues over the capital stock at the beginning of the year. - Tobin's Q: Market capitalization-total equity+total assets over total assets. - Interest coverage ratio: EBITDA over interest expense. - Uncertainty: Change in Economic Policy Uncertainty by Scott Baker, Nicholas Bloom and Steven J. Davis. ### Main firm-level estimation results (baseline and variations) - General findings summarized from Table 2 and text: - Investment increases with higher expected future profitability (proxied by Tobin’s Q and sales growth), cash flows, and debt flows. - Investment decreases with higher leverage and higher political uncertainty. - Example magnitude: a 10 percentage point rise in a large firm’s leverage is associated with a 1.1‒1.4 percentage point fall in the investment-to-capital ratio. - Selected coefficient estimates from pooled regressions (Dependent variable: Investment to capital ratio; estimation period 1995–2016; firm fixed effects and time effects included): - Leverage, lag: coefficients reported across specifications: - -0.116*** (std. err. (0.022)) - -0.120*** (0.023) - -0.115*** (0.028) - -0.110*** (0.021) - -0.139*** (0.019) - -0.116*** (0.022) - -0.112*** (0.021) - Cash Flow ratio: - 0.031*** (0.005) - 0.029*** (0.005) - 0.022*** (0.005) - 0.034** (0.015) - 0.049*** (0.015) - 0.049*** (0.015) - Change in debt ratio: - 0.016*** (0.002) - 0.011*** (0.003) - 0.007 (0.005) - 0.008 (0.005) - 0.008* (0.005) - Change in sales ratio: - 0.010*** (0.003) - 0.006 (0.006) - 0.003 (0.007) - 0.003 (0.007) - Tobin's Q: - 0.005*** (0.002) - 0.005*** (0.002) - 0.004*** (0.002) - Interest coverage ratio: - 0.001 (0.001) - 0.001 (0.001) - Uncertainty, diff, lag: - -0.001 ** (0.000) - Sample sizes and fit (selected): - Number of observations: 10,763; 10,378; 10,144; 9,805; 2,392; 2,311; 2,303. - Number of firms: 3,286; 3,151; 3,052; 2,930; 297; 291; 291. - R2 values: 0.01; 0.03; 0.03; 0.03; 0.04; 0.05; 0.05. - Robustness checks (Table 2, alternative leverage/cash definitions and GMM): - Leverage (net debt/equity) coefficient in one robustness: -0.003*** (0.001) with Number of observations 9,144 and Number of firms 2,833; R2 0.03. - Leverage (net debt/EBITDA): -0.001** (0.000) with Number of observations 11,391 and Number of firms 3,357; R2 0.04. - Cash Flow ratio in robustness specifications: 0.028*** (0.007); 0.034*** (0.005); 0.021** (0.005); 0.025 (0.016); 0.049*** (0.014). - Change in debt ratio robustly positive and significant in many specifications: e.g., 0.014*** (0.003); 0.015*** (0.002); 0.009*** (0.002). ### Sectoral heterogeneity (Table 3) - Leverage is statistically significant across most sectors; exceptions: health and real estate sectors. - Notable sectoral coefficients (Leverage, lag): - Consumer Discretionary: -0.142*** (0.047) - Consumer Staples: -0.230*** (0.033) - Energy: -0.336*** (0.069) - Healthcare: 0.072 (0.120) — not significant - Industrials: -0.119*** (0.036) - Real Estate: -0.062 (0.042) — not significant - Telecommunication: -0.369*** (0.135) - Utilities: -0.182*** (0.050) - Cash Flow ratio displays mixed signs across sectors; significant positive cash-flow coefficients in Energy (0.094*** (0.025)), Telecommunication (0.099*** (0.035)), Consumer Staples (0.069*** (0.020)). - Change in debt ratio is significantly positive in some sectors (Energy: 0.044** (0.022); Industrials: 0.019*** (0.006); Telecommunication: 0.101*** (0.038)). - Uncertainty, diff, lag shows significant negative effects in Healthcare (-0.001*** (0.008)), Industrials (-0.001*** (0.000)), Real Estate (-0.001*** (0.001)), Utilities (-0.000*** (0.000)). ### Aggregate interpretation and drivers of the investment decline - Factors contributing to the decline in investment since 2014: - Rising costs. - Falling profitability—and expected profitability. - Higher levels of corporate leverage. - A rise in policy uncertainty. - Empirical evidence suggests policy uncertainty has played a significant role in the decline in investment. - Quantified example: a 10 percentage point rise in leverage → associated with a 1.1‒1.4 percentage point fall in investment-to-capital ratio for a large firm. ### Short-term outlook and persistent headwinds - Factors pointing to stronger short-term investment: - Stabilization of regulated-price inflation, terms of trade, and real interest rates should improve investment growth and expectations. - Recent policy actions noted: large increases in fuel and electricity tariffs in 2015 are not expected to be repeated; the central bank began an easing cycle expected to continue over the remainder of 2017; terms of trade have improved markedly since early 2016. - Remaining headwinds to a full recovery of investment: - High levels of corporate leverage remain elevated historically and relative to regional peers despite recent stabilization. - Policy uncertainty and low medium-term growth expectations could prevent a full recovery. - Implementation challenges related to the government’s reform agenda—most notably pension reform—and the prospect of rising government debt could sustain high policy uncertainty and weigh on investment decisions. ### Appendix highlights (selected) - Economic Policy Uncertainty (EPU) index for Brazil: - Constructed from Folha de São Paulo text archives from 1991 onwards using terms in Portuguese for uncertainty, economy, and policy-relevant terms. - Raw counts scaled by total articles per month and multiplicatively rescaled to a mean of 100 from January 1991 to December 2011. - Estimating medium-term growth expectations: - Uses Central Bank of Brazil consensus survey forecasts regressed on a polynomial of the forecast horizon to produce continuous time series for growth expectations; reported regressions produce high goodness-of-fit (R² values reported as 0.98–0.99 for sample dates shown). - Aggregate model results and joint estimates reported with significance levels and robust standard errors; many investment determinants show statistically significant effects at conventional levels. *Source: IMF staff estimates and chapter text in cr17216 - 9. Leverage, cash flow, and changes in debt capture the relevance of each firm’s financial* ### 1. Brazil’s position in the World Bank DB ranking is disappointing, but has improved ### 1. Brazil’s position in the World Bank DB ranking is disappointing, but has improved ### Global ranking and trends - In 2017, Brazil ranked 123rd in a total of 190 states on which data were collected. - In 2010, Brazil occupied rank 129 in a sample of 183 countries. - Between 2015 and 2016, 137 economies worldwide implemented 283 business regulatory reforms. This represents an increase of more than 20 percent compared to the previous year (Doing Business report, 2017). - Brazil’s DTF (Distance to Frontier) has been overall stable with some improvement in recent years, notably in insolvency procedures, contract enforcement, and minority investor protection. - To approach the fitted line relating DTF to per capita GDP in 2015, Brazil’s index would have to move from the current 56 to 65 percent. Kazakhstan’s largest one-year DTF increase was still less than 5 percentage points. ### Key weaknesses across Ease of Doing Business indicators - Starting a business - An estimated 11 procedures (down from 14 in 2010) and about 80 hours are necessary to start a business. - Starting a business is easier than in 2010 but remains more complicated than elsewhere in the region. - Paying taxes - It takes 2038 hours a year for a firm to pay taxes in Brazil (fell from 2600 in 2010). - The share of total taxes and contributions in pre-tax profits is estimated at slightly below 70 percent. - Tax-system features cited: fragmented and inefficient indirect tax system; tax credits for intermediate inputs allowed only when embodied in the final good sold; burden of proof on taxpayers; extensive use of tax accountants and frequent lawsuits. - Trading across borders - Brazil occupies rank 149 in this indicator. - Border compliance and import/export costs are among the highest in the world. - It takes more than 5 days to acquire customs clearance and inspections for exporting from Brazil, and more than 15 days to clear imports. - Getting credit - Brazil occupies rank 101 in this indicator. - Credit bureau coverage per adult is high, but the credit registry can be strengthened and legal rights need improvement. - Insolvency - Recovery rates below 16 percent of the value are particularly low. - Time to conclude insolvency processes averages 4 years. - Other observations - Brazil performs relatively better on getting electricity, enforcing contracts, resolving insolvency and protecting minority rights. - Political/institutional constraints identified: low ICRG corruption score (2 out of 6) and low bureaucracy quality score (2 out of 4), with repercussions for the business environment. - Tax rates, tax regulations, corruption and inefficient bureaucracy were identified as the most problematic factors for doing business in Brazil in the 2015 World Economic Forum’s survey. ### Subcomponents and DTF comparisons - The DB database’s Distance to Frontier (DTF) score ranges from 0 to 100, where 0 represents the worst performer and 100 the frontier. - Brazil shows relative improvements in insolvency procedures, contract enforcement, and minority investor protection; regressions in trading across borders. - The largest five countries in the region (LA5, excluding Brazil) are much closer to the frontier than Brazil. ### Recent reforms captured by DB criteria - Starting a business: 2016 online portal for processing business licenses launched in Rio de Janeiro; synchronization improvements between federal and state-level tax authorities occurred between 2009 and 2010. - Paying taxes: repeal of the tax on check transactions in 2011 reduced cost to companies. - Trading across borders: electronic systems (SISCOMEX Portal and other electronic data interchange upgrades) reduced documentary compliance time for imports and exports; last upgrade prior to these reforms was in 2009. - Getting credit: private credit bureaus allowed to collect and share positive information since 2011. - Enforcing contracts: new mediation law with financial incentives and a new code of civil procedure; 2012 electronic filing system at the São Paulo civil district court. - Registering property: 2012 requirement of a new certificate on good standing on labor debts increased due diligence; 2015 increase in property transfer tax in the city of São Paulo. ### Announced micro reform measures (government package) - The package includes 47 actions directly linked to the Ministry of Industry, Foreign Trade and Services (MDIC) or agencies under the ministry; 24 out of 47 measures are linked to foreign trade (digitalization, computerization, standardization). - Starting a business: National Network for Registration Simplification and Leading of Business (Redesim) to integrate cadasters with registries and licensing bodies. - Paying (and collecting) taxes - Aim to simplify procedures for tax refunds and payment of labor and tax obligations via an electronic collection system (eSocial). - eSocial currently applies to taxes and contributions collected from domestic workers and will be extended to unify 13 different obligations. - Electronic invoicing used by states and municipalities and accounting information provided to the Federal Revenue will be simplified and standardized. - Reform of Programa de Integração Social (PIS) to simplify tax base definition and reduce litigation. - Trading across borders - Single Foreign Trade Portal to consolidate required documents including digital certificates of origin, simplify trade processes and customs transit. - Target reductions in days necessary: export from 13 to 8 days; import from 17 to 10 days. - Measures include ending the need to register to access MDIC official statistics online, reviewing accreditation procedures (Inmetro), and standardizing patent and brand registration procedures. - Efforts to cut waiting time for reviewing annual reports of R&D projects granting tax breaks in the Manaus Tax Free Zone. - Labor productivity: Migration Law approved in Congress allows working visas for foreign citizens with higher education diplomas. - Getting credit and insolvency-related measures - Centralized market for electronic credit card and other receivables to be created. - Legislation for fiduciary alienation of immovable property going to auction to be strengthened. - Bankruptcy Law improvements to empower creditors, promote extrajudicial recovery, streamline processes, and strengthen acquirers’ rights. - Other measures - Coordination attempt for settlement of tax and social-security debts of companies. - Renegotiation of large companies’ debts to BNDES under the Investment Support Program (PSI) and renegotiation of small and medium-sized companies’ debts. - Authorization for merchants to charge different prices for cash or card purchases; reduction in repayment period and cost of revolving consumer credit; standardization of forms for commercial establishments. ### External competitiveness - Brazil’s external sector performance has deteriorated in recent years. - Since the global financial crisis, investment, export growth and market efficiency have declined relative to peers. - Contributing factors: high unit labor costs, inadequate infrastructure, elevated tariffs, high rigidities in factor, goods, and financial markets. - Export volumes performance prior to the global financial crisis was strong (upper quartile of major EMs), but post-crisis export volume path converged to the median of major EMs. - REER experienced ample swings in the 2000s — a large depreciation in the first half and appreciation thereafter — in sharp contrast to other EMs and LATAM countries. *Source: cr17216 - 1. Brazil’s position in the World Bank DB ranking is disappointing, but has improved* ### 9. Brazil’s exports are diversified, ### 9. Brazil’s exports are diversified, ### Export structure, concentration, and quality - The Herfindahl concentration index was in line with the EM median in 2014‒15, up from lower levels registered over the past two decades. - The domestic content of Brazil’s exports, based on value added trade data compiled by the OECD and WTO, has been persistently higher than its peers’. - This points to the weight of commodities in Brazilian exports and the country’s lower integration into global value chains. - Brazil’s export quality, compiled by Henn et al. (2015), is well below average implied by the frontier of other major EMs and advanced economies. ### Trade policy, tariffs, and protection - Trade liberalization appears to have stalled after the large tariff reductions in the early 1990s. - Import tariffs in Brazil have declined since the early 1990s to below 10 percent, but Brazil’s tariff regime is currently more protectionist than the average in Latin America and the Caribbean (LAC) and the upper middle income country average. - Disaggregated data indicate goods and other raw materials tariffs are substantially higher than Brazil’s peers’, especially on capital goods. - Historical notes: - Three tariff reduction waves were implemented during 1988 and 1994 (first phase 1998‒89; second phase 1991‒93; third phase 1994). - In November of 1997, the government temporarily raised the tariffs by 3 percentage points. - Weighted-average tariff declined substantially during the 1990s but gradually increased since the global financial crisis. ### Investment, capital stock, and competitiveness - Investment in Brazil has been weaker than in its peers; weak investment relative to peers was persistent. - Slow growth and the aging of the capital stock has constrained marginal productivity of labor, limiting growth potential. - There is some correlation across countries between investment and tariffs on capital goods: higher tariffs on capital goods are associated with lower investment. - IMF (2017) result: - If Brazil halves its average tariffs on capital goods (about 10 percent in 2015), it would increase investment by about 10 percent over the medium-term. - Halving tariffs on capital goods in Brazil would raise its investment-to-GDP by about 2 percentage points. - This is equivalent to an increase in investment of about 15 percent over three years assuming a real GDP growth of 2 percent on average. ### Non-tariff measures (NTMs) and FDI - Non-tariff measures are used extensively in Brazil; quotas and special safeguards are more common in Brazil than in LAC countries on average. - OECD (2014) finds Brazil is second only to Indonesia in the number of local content requirements imposed since the global financial crisis. - Restrictions to inward FDI are close to peers: - Brazil has fewer restrictions on FDI than Asian and European EMs, although its relative advantage appears to have diminished recently. - De Araujo Jr. (2017) noted frequent use of anti-dumping, especially after 2008, has contributed to eroding competitiveness by keeping domestic prices high and reducing competition. ### Evidence from the literature and quantitative simulations - Cross-country and sectoral studies indicate trade liberalization can raise productivity and external competitiveness through competition, scale, and lower input costs, but gains depend on complementary policies and degree of integration. - OECD (2011) simulation (G20 coordinated scenario): - 50 percent MFN tariff reduction and a reduction of non-tariff barriers by 50 percent on an MFN basis. - Estimated impact for Brazil: increase in real GDP by about 7½ percent over the long-run, most of it driven by a decline in non-tariff barriers. - Araujo and Flaig (2016) computable general equilibrium simulation for Brazil: - Reduction of import tariffs (to the OECD minimum level), elimination of local content requirements, and zero taxes levied on exports. - Results show: - Aggregated production level in Brazil would increase by about 1.7 percent, driven by a pick-up in exports. - Deeper integration to global value chains, with substantial growth in some manufacturing sectors and non-ferrous metal exports. - Largest gains in production would stem from zero-tax rates on exports; export gains would come from eliminating tariffs on imports of intermediate goods. - Beaton et al. (2017) and Cerra and Woldenmichael (2017) findings: - The probability of an export surge in Brazil could increase by about 8 percentage points if the degree of globalization in Brazil, measured by the KOF index of globalization, increases from the latest reported level to its frontier implied by per capita income among AMs and major EMs. - Raising participation in global value chains from the current level (slightly below the 10th percentile) to the 25th and 50th percentiles of AMs and major EMs would raise annualized growth by 0.15 percent and 0.3 percent, respectively. - Increasing the number of trade partners in agreements to the 25th and the median of AMs and major EMs would raise annual growth by 0.5 percent and one percent, respectively. - Cerdeiro (2016) simulation of TPP effects in Latin America: - Expanding the TPP to include nine LAC countries (Argentina, Bolivia, Brazil, Colombia, El Salvador, Guatemala, Nicaragua, Paraguay and Uruguay) would raise real income in Brazil by 0.4 percent (simulation assumes full tariff liberalization and a decline in non-tariff barriers to levels of TPP members with less restrictive trade regimes). ### Policy implications and recommended measures - Trade protection should be reduced steadily by: - Lowering tariffs, including on capital goods. - Removing non-tariff barriers. - Scaling back local content requirements, including on public procurement. - Rationale and expected channels: - Lowering barriers increases use of foreign intermediate goods, lowers final goods prices, enhances export competitiveness, benefits households, reduces cost of capital, spurs investment, and supports production expansion. - Complementary structural policies are important to maximize gains: - Enhance integration into global value chains. - Improve domestic product and labor market regulation, and the foreign investment environment. - Support human capital, tertiary education, skills upgrading, and R&D where relevant to export quality improvements. *Source: cr17216 - 9. Brazil’s exports are diversified,* ### 15. Progress in expanding and diversifying bilateral, regional and multilateral trade ### 15. Progress in expanding and diversifying bilateral, regional and multilateral trade ### Trade agreements and integration - Brazil, through Mercosur, developed an extensive network of tariff agreements in the region. - Trade agreements cover goods, services, investment, trade facilitation, technical regulations and government procurement. - The network has been further extended to Cuba, Guyana and Saint Kitts and Nevis. - Diversification of trade agreements, especially with the countries of the Pacific basin (Peru, Chile and Colombia) was also sought. - The government intends to expand trade agreements with Mexico. - Negotiations to conclude the Mercosur agreement with the EU, which accounts for 20 percent of trade of the block, were resumed. - The bilateral agenda with the U.S., including the implementation and expansion of the agreements on Regulatory Convergence and Trade Facilitation, has been already signed. ### Reforms to improve external competitiveness - Reforms in product and labor market regulation are critical for improving external competitiveness. - Recommended measures (as presented): - strengthening competition by streamlining regulation on product markets and implementing planned reductions in entry regulations; - improving the technical capacity and planning for infrastructure concessions and elaborating more detailed tender packages prior to launching tender calls; - consolidating indirect taxes at the state and federal levels and working towards a value-added tax with a broad base, full refunds for input and zero-rating of exports; and, more broadly, - pursuing DB reforms. ### Conclusions and policy considerations - Brazil can boost productivity through reforms aimed at improving the business environment and external competitiveness. - Lowering tariff and non-tariff barriers can enhance trade integration, improve economic efficiency, and boost investment and growth. - Pursuing trade agreements, over and above the Mercosur partnership, bears promises of further global integration of Brazil and stronger growth. - Product and labor market regulation reforms and tax system reforms are important for strengthening channels through which the business environment affects competitiveness and trade. - Implementation caveat: trade measures should consider the cyclical position of the economy. - Tariffs reduction could increase competition forcing some inefficient firms to exit from markets. - Although this would increase productivity over the long run, it could result in higher unemployment and lower consumption in the short-run. - This suggests that reforms should be carefully sequenced, paying attention to their potential contractionary impact on economic activity as the economic transformation unravels (IMF, 2016c). *International Monetary Fund. Chapter: "Progress in expanding and diversifying bilateral, regional and multilateral trade."* ### 10. The four types are illustrative, and by no means exhaustive. One could construct ### cr17216 - 10. The four types are illustrative, and by no means exhaustive. One could construct ### Purpose and approach - Objective: develop a few examples to provide a sense of some of the distributional effects that can be expected of the reform. - Not intended to span all possibilities or to study “representative” cases in any statistical sense. - Evaluation uses the most recent reform proposal (see Appendix for more detail on the changes in parameters). - Wage profiles estimated via a Mincer regression with “Age” and “Age2” for each of four illustrative types; survey shows significant variations in wages, particularly for public workers. - Present discounted values (PDV) of net transfers computed using a 1 percent real discount factor, in accordance with established OECD methodologies (Queisser and Whitehouse, 2006). ### Key findings — effects by worker type - Urban (private) skilled worker - Before reform: retire on average at age 56 after 35 years of contribution; retirement benefit indexed to inflation till death; spouse receives full benefit for another 12 years on average. - After reform (new steady state, post 20-year transition): minimum retirement age introduced → assumed work for 45 years and retire at age 65. - Consequences: earn wages longer, enjoy retirement benefit for a shorter period, survivor’s pension lower under new rules; net lifetime income (after taxes and contributions) would be higher than before the reform. - Survivor’s pension example: under the new rule, sole survivor would get a pension equal to 60 percent of the original benefit; survivor’s pension can be cumulated with spouse’s own pension up to the amount of two minimum wages. If this limit is exceeded, the survivor can choose which benefit to keep. - Urban (private) unskilled worker (incomplete contribution history) - Current assumption: contribute for 15 years; some 65 percent earn up to two minimum wages (Appendix I, Figure 1). - After reform: contribution time increases to 25 years. - Consequences: postponing retirement has a negative but small effect on overall lifetime income; retirement period remains the same but benefit level lower because it will be calculated over the entire contribution history (not the 80 percent highest wages, as currently); survivor’s pension would also decline. - Rural worker - Survey: median rural worker’s income is less than the minimum wage and about 45 percent of rural workers earn half the minimum wage (Appendix I, Figure 1). - Income increases after retirement to one minimum wage. - Reform: retirement age would not change for these workers → gross lifetime income unaffected. - Net income: reform would have a small impact to the extent they would be required to contribute up to 5 percent of the minimum wage for at least 15 years. - Public sector worker - Assumption: median public worker retires at age 60 under current rules, in line with the average observed for federal civil servants (the group affected by the reform). - After reform: public worker would continue to work for another 5 years. - Consequences: retirement benefit would be lower; net lifetime income change more pronounced because the public worker would contribute to the social security system for a longer period at an overall rate that is higher than in the private sector. - Overall: gross lifetime income of public sector workers would decrease. ### Net transfers, fiscal and equity implications - PDV of net transfers (retirement and survivor benefits minus contributions) declines after the reform for all four illustrative types. - Reduction in PDV is greater for: - Public-sector worker - Private-sector skilled worker - Reform effects: - Will generate fiscal savings. - Will reduce inequities in a social security system that currently benefits disproportionately a small share of the population already enjoying higher wages (the public employees). - PDV computation detail: difference between all retirement and survivor benefits and all contributions paid by or on behalf of the employee; present discounted using a 1 percent real discount factor. ### Pension parameter changes (selected items preserved from Table 1) - RGPS — Retirement by Contribution Time (Before the Reform) - Eligibility: (1) the sum of age and contribution time should be no less than 85/95 for women/men; or (2) minimum of 30/35 years of contribution for women/men. - Benefit value: in (1) is equal to s: the average of the worker's 80% highest salaries; in (2) is equal to s* f, where f is the so‑called “fator previdenciário” (depends on time of contribution, on age and life expectancy at retirement). - RGPS — Retirement by Contribution Time (After the Reform) - Will be extinguished. There will only be retirement by age (see rules below). - RGPS — Retirement by Age (Before the Reform) - Eligibility: minimum age of 60/65 years for women/men and minimum of 15 years of contribution time. - Benefit value: is equal to s*(70% + 1% per year of contribution), where s is the average of the worker's 80% highest salaries. - Contribution rate: employee = 8% to 11%; employer = 20%. - RGPS — Retirement by Age (After the Reform) - Eligibility: Minimum age of 62/65 years for women/men and minimum of 25 years of contribution time. - Benefit value: is equal to s'*(70%x + 1.5%y1 + 2.0%y2 + 2.5%y3), where s' is still to be determined (meanwhile it will be the average of all salaries since 1994); y1 = contributing years within 26 to 30 range; y2 = contributing years within 31 to 35 range; y3 = contributing years after 35 years of contribution. Benefit value cannot be higher than s. - Contribution rate unchanged: employee = 8% to 11%; employer = 20%. - RPPS — Basic Retirement (Before the Reform) - Eligibility: Minimum age of 55/60 years for women/men and minimum of 30/35 years of contribution. - Benefit value: 80% of highest salaries. In 2013 the RPPS salaries were capped for new entrants to a value approximately equal to 6 minimum wages. - Contribution rate: employee = 11%; employer (government) = 22%. - RPPS — Basic Retirement (After the Reform) - Eligibility: Minimum age of 62/65 for women/men and 25 years of contribution time. Minimum age for teachers will be 60 years old. - Benefit value: is equal to s'*(70%x + 1.5%y1 + 2.0%y2 + 2.5%y3), where s' is still to be determined (meanwhile it will be the average of all salaries since 1994). Benefit value cannot be higher than s. - Contribution rate unchanged: employee = 11%; employer (government) = 22%. - Transition rules (selected) - RPPS transition rule (one formulation): Eligibility for the transition rule: (1) minimum age of 55/60 in 2017 for women/men. The minimum age will gradually increase reaching 62/65 years for women/men in 2036/2038; and (2) pay a penalty in terms of time of contribution: the penalty equals to 30% of the contribution time left to achieve 30/35 years of contribution. - Alternative RPPS transition formulation: Eligibility for the transition rule: (1) minimum age of 53/55 in 2017 for women/men. The minimum age will gradually increase reaching 62/65 years for women/men in 2036/2038; and (2) penalty linked to the time of contribution (30% of the contribution time left to achieve 30/35 years of contribution for women/men.) *Sources: PNAD; and IMF staff calculations.* ### Box 1. The Cost of Living Adjust (Concluded) ### Box 1. The Cost of Living Adjust (Concluded) ### Methodology: Spatial price adjustment using rental data - Micro-data for consumer-price level differences is not available for Brazil; rental prices are used as a proxy because most price dispersion generally comes from non-traded goods, especially housing. - Two-step procedure: - For each sub-region s = {1,2,...,7} of each state j = {1,2,...,27} and each year t = {2004,...,2015}, construct a rental spatial price difference index measuring the percent deviation of the per room average rental price from the national average: - p̂_{s,j,t} = (h_{s,j,t} / n_{s,j,t}) / (h_* / n_*) - where h is the average monthly rent price for the cluster s,k, n is the average number of rooms per household for the cluster, and * denotes national averages. - Fit an overall spatial price difference index using the parameter from Azzoni and Almeida (2016), assumed homogeneous across regions: - P̂_{s,j,t} = β · p̂_{s,j,t} (parameter from Azzoni and Almeida (2016) used; less than one denotes compression effect) - Use P̂_{s,j,t} to obtain adjusted household incomes for analysis of income distributions and trends. - Empirical correlations shown: - y = 0.9789x - 0.0108, R² = 0.9886 - y = 0.5557x - 0.0118, R² = 0.7245 - Example evidence: Almeida and Azzoni (2016) showed overall level price differences in Brazilian metro areas can diverge with levels as low as -19 percent and as high as +14 percent from the national average. ### Main findings on inequality levels and trends (2004–2014) - Overall decline in inequality across the period studied, including among regions. - Within-state income distributions vary: in 2014 the Gini of the most unequal state was 18 percent higher than the national Gini, while the least unequal state was almost 20 percent lower than the national Gini. - Standard deviation of state Gini coefficients declined from 0.035 to 0.033. - Between-states inequality decreased as a share of total inequality as incomes grew faster in poorer regions (North, Northeast, Midwest). - Adjusting for spatial price differences compresses nominal differences in incomes and decreases the overall inequality indicator; estimated coefficient shown (less than one) denotes the compression effect. - The authors’ estimated overall Gini coefficients are nearly perfectly correlated with official IBGE estimates. Key numerical indicators: - Brazil official Gini index for all income sources: 0.497 in 2014 → 0.491 in 2015. - Gini for labor income: 0.490 in 2014 → 0.485 in 2015. - Gini for household income: 0.494 in 2014 → 0.493 in 2015. - Standard deviation of state Gini coefficients: 0.035 → 0.033. ### Regional convergence and within-state inequality dynamics - Convergence in average incomes led to a decreasing share of total inequality explained by between-state inequality (supported by GE and Atkinson’s indices). - Inequality within states declined, primarily driven by substantially higher income growth rates for lower-income households in nearly all states. - Declines in within-state inequality were relatively larger in states with higher initial inequality in 2004 (especially after excluding outliers SC and DF). - Convergence is most evident in the lower and upper quantiles of the income distribution, with some catch-up in the middle quantiles. - State median household income relative to the national distribution shifted over time; medians can fall between the 30th and 70th percentile of the national distribution but differences have shrunk since 2004. ### 2015–2016: signs of reversal and distributional risks - 2015: drop in employed population; real gross household earnings contracted across all professions for the first time in 11 years; real income decline touched entire distribution but was more severe in higher income brackets, yielding a slight fall in inequality (see Gini changes above). - 2016: continuation of the recession, job destruction, and high inflation likely dented equality gains. - Preliminary 2016 estimates from FGV Social suggest inequality widened slightly for the first time in 22 years. - World Bank (2017) estimates: - Number of poor in Brazil will likely increase by 2.5‒3.6 million by 2017. - Gini index will increase from 0.51 to 0.52‒0.54. - Among the “new poor”, young, skilled workers in the service sector represent a higher share of those falling below the poverty line due to the crisis. ### Macro-policies and inequality outcomes: empirical evidence - Rapid labor formalization, higher real wages, and transfers boosted living standards of the poor. - Redistributive taxation and social programs played a role in declining inequality. Tax policy - Brazil’s overall tax system relies relatively more on indirect taxes, which are regressive. - Ratio of direct to indirect taxes at general government level: 45 percent in 2016. - According to Amaral and others (2016): the average Brazilian worker pays 15 percent of gross income in income taxes, 3 percent in asset taxes, and 24 percent in consumption taxes. - Consumption tax burden: those making up to R$3,000 per month pay 24 percent of gross income in consumption taxes; those making more than 10,000 pay 17 percent. - Effective personal income tax (PIT) rates (accounting for admissible deductions) do not seem progressive; but when accounting for taxation of dividends at corporate level, the system’s progressivity appears restored. - Lustig and others (2014) find personal income taxes in Brazil are progressive and redistributive and contributed to reducing the Gini of after-tax incomes by 1.9 percent in 2009. Minimum wage and expenditure policies - Minimum wage policy supported upward mobility for lower classes during strong growth periods. - Effect on inequality is ambiguous due to potential offsetting effects on employment and inflation. - Maurizio (2014): increases in the minimum wage led to wage compression, reducing inequality among wage earners; hourly wages for given education levels rose faster among the poor, aided by declining unemployment during strong growth. - In low or negative growth environments, minimum wage growth may affect employment negatively, especially for unskilled workers, potentially increasing before-tax inequality. Public sector wages - Public sector wage increases systematically above private sector wage growth appear to have slowed equality gains. - In 2014, estimated median premium on public sector jobs across comparable professions was about 50 percent up to the secondary education level. - Accumulated change in real earnings per sector (private vs public) shown in figure (PME/IBGE). Bolsa Família and targeted transfers - Bolsa Família coverage increased from about 6.5 million households in 2004 to over 14 million in 2014 (56 million people). - Budgetary appropriations for Bolsa Família increased from about 0.3 percent of GDP to 0.6 percent of GDP over 2004–2014. - World Bank (2017) estimates that 58 percent of the decline in extreme poverty in Brazil over 2004‒14 was due to Bolsa Família transfers. - Soares and others (2006): in 2005 about 80 percent of Bolsa Família budget went to families below the poverty line (half of the minimum wage per capita); program was responsible for 21 percent of decline in the Gini coefficient between 1995 and 2005. ### Box 2 — Returns to Education and Public-Private Wage Gap: approach and findings - Method: Two “Mincer” regressions (Mincer, 1974) relate log wages to years of schooling and experience separately for public and private sectors for each period t = {2004,...,2015}, with more than 50 additional controls (gender dummy, race dummies, occupation dummies, sector dummies, worker’s class dummies, state dummies, etc.). - Regression specification provided for ln(w_{i,t}) including schooling, experience, gender, races, occupations, sectoral activities, worker class, state dummies, and other controls. - Second step: use estimated coefficients to generate fitted values (expected log wages) for ~150,000 workers in sample belonging to private or public sector. - Findings: - Predicted earnings increase with years of schooling for both sectors, but public sector earnings are consistently higher. - Up to the secondary education level, the 25 percent lowest predicted earnings in the public sector are higher than the median earnings in the private sector. - Public sector wage premium is defined as the difference between predicted log wages for public and private sectors. - Evidence of some compression of the premium at higher educational levels, but premium remains high across all years of schooling. - Given observable characteristics, at least 75 percent of workers would benefit today by moving from the private to the public sector in comparable jobs at all education levels. - Estimation details: - Sample size: ~150,000 observations. - Standard errors obtained from a bootstrap simulation with 500 repetitions. *Sources: PNAD microdata; and IMF staff calculations.* ### 18. Even when they don’t worsen income inequality by themselves, implicit education ### 18. Even when they don’t worsen income inequality by themselves, implicit education subsidies use up resources that could be otherwise employed to improve income equality ### Implicit education subsidies and distributional facts - Public universities in Brazil are tuition-free and more accessible to children of wealthier parents who often studied in private primary and secondary schools (World Bank, 2016). - Nearly half of the public university student population in the PNAD sample belongs to households in the top quartile of the income distribution, while only 9 percent of university students comes from families in the bottom quartile. - Between 2000 and 2014 the number of students in public universities more than doubled—from 0.89 million to 1.96 million (Ministry of Education, INEP, 2015). - A student in the 25th percentile of the income distribution has a 2 percent probability of attending a public university while the one in the 99th percentile has more than 30 percent probability of attending it. - Funding a student at the higher education level costs about four times as much as funding a student at the secondary education level in Brazil. This ratio is much higher than the OECD average of 150 percent (OECD, 2014). - About 40 percent of the younger cohorts of the Brazilian population still fails to complete secondary education. ### Empirical analysis: regression framework and main drivers of inequality decline - Data: PNAD microdata aggregated to state-level statistics; complemented with annual Bolsa Família state budgets and federal income tax revenues collected in states. - Method: Two-stage least squares approach with state dummies; first stage regresses incomes of top and bottom quartiles on variables including average income, civil servants’ income, tax revenues, share of formal sector workers, employment, schooling, and per capita Bolsa Família budget; second stage regresses the Gini on predicted values from first stage. - Key findings summarized: - Employment, labor formalization, income growth, Bolsa Família budgets and schooling have contributed to declining inequality. - Increased schooling and labor formalization explain the largest share of the decline in the Gini. - Growth of incomes of civil servants has affected equality negatively. - Income taxes are not a significant determinant of inequality in these estimates. - Decomposition figure (2004–14) shows contributions to Gini changes by region and components (Income, bottom quartile; Income, top quartile; Total). ### Quantitative regression coefficients and marginal effects (2SLS results) - Coefficients from the 2nd Stage Regression - LN of average HH income per capita, bottom quartile (1): -0.186***(1) - LN of average HH income per capita, top quartile (2): 0.198***(2) - constant: -0.057 - Marginal Effects on Gini from the 1st stage specification 1/(1)(2) - LN of average HH income per capita: -0.014****** - LN of Civil Servant HH income per capita: 0.054****** - Share of Civil Servants, pct.: -0.001 - LN of Bolsa Familia exp. per capita: -0.007****** - Share of Formal Workers, pct.: -0.002*** - Employment Rate, pct.: -0.001*** - Avg Schooling Years for Adults, bottom quartile: -0.030*** - Avg Schooling Years for Adults, top quartile: 0.004 - Tax Revenues, pct: 0.003 - Notes: The asterisks denote significance at the first stage in relation to first stage dependent variables (1) or (2). The coefficients shown are the combination of 1st and 2nd stage regression coefficients. ### Data limitations and caveats - PNAD may underreport income at the top tail: income received by the top 1 percent of the income distribution in Brazil may be underreported (Souza, 2013). - If income of the richest segment not captured in PNAD increased over time, the study could overestimate the decline in inequality. - DIRPF (personal income tax returns) adjustments reported by other studies (Medeiros and others, 2015) were not possible here because DIRPF data are not available for the entire period. - The analysis assumes homogeneous and linear estimated parameters across states, which limits extrapolation to the future or to specific states. ### Policy implications and recommendations - Preserve equality gains while pursuing fiscal sustainability by: - Moderating civil servants’ wage growth rather than further increasing spending. - Using direct, needs-based instruments (such as Bolsa Família) to provide benefits. - Redirecting resources from universal, tuition-free tertiary education toward improving early childhood, primary, and secondary schooling, while continuing to support university students based on need. - Relying more on direct taxation and less on indirect taxes. - Ensuring minimum wage policy provides appropriate remuneration for the poor without discouraging formal employment. *Source: PNAD; and IMF staff calculations.* ### Appendix II. Econometric Results and Tables ### Appendix II. Econometric Results and Tables ### Table 2 — Brazil: Drivers of Income Inequality in Brazil’s States from the 2SLS Regression (2004–14) - Dependent variable: LN of average HH income per capita, bottom quartile (1) - LN of average HH income per capita: Coeff. 0.734; Std. Err 0.061; z 12.040; P>|z| 0.000; [95% Conf Interval] 0.614, 0.853 - LN of Civil Servant HH income per capita: Coeff. -0.135; Std. Err 0.040; z -3.380; P>|z| 0.001; [95% Conf Interval] -0.213, -0.057 - Share of Civil Servants, pct.: Coeff. -0.002; Std. Err 0.004; z -0.570; P>|z| 0.569; [95% Conf Interval] -0.010, 0.005 - LN of Bolsa Familia exp. per capita: Coeff. 0.134; Std. Err 0.021; z 6.480; P>|z| 0.000; [95% Conf Interval] 0.093, 0.174 - Share of Formal Workers, pct.: Coeff. 0.002; Std. Err 0.002; z 1.210; P>|z| 0.227; [95% Conf Interval] -0.001, 0.006 - Employment Rate, pct.: Coeff. 0.005; Std. Err 0.003; z 2.060; P>|z| 0.039; [95% Conf Interval] 0.000, 0.011 - Avg Schooling Years for Adults, top quartile: Coeff. 0.156; Std. Err 0.019; z 8.280; P>|z| 0.000; [95% Conf Interval] 0.119, 0.193 - Avg Schooling Years for Adults, bottom quartile: Coeff. -0.007; Std. Err 0.011; z -0.620; P>|z| 0.533; [95% Conf Interval] -0.028, 0.015 - Tax Revenues, pct: Coeff. -0.013; Std. Err 0.009; z -1.450; P>|z| 0.146; [95% Conf Interval] -0.031, 0.005 - Dependent variable: LN of average HH income per capita, top quartile (2) - LN of average HH income per capita: Coeff. 0.618; Std. Err 0.056; z 11.130; P>|z| 0.000; [95% Conf Interval] 0.510, 0.727 - LN of Civil Servant HH income per capita: Coeff. 0.145; Std. Err 0.036; z 3.990; P>|z| 0.000; [95% Conf Interval] 0.074, 0.216 - Share of Civil Servants, pct.: Coeff. -0.005; Std. Err 0.004; z -1.350; P>|z| 0.176; [95% Conf Interval] -0.012, 0.002 - LN of Bolsa Familia exp. per capita: Coeff. 0.090; Std. Err 0.019; z 4.780; P>|z| 0.000; [95% Conf Interval] 0.053, 0.127 - Share of Formal Workers, pct.: Coeff. -0.010; Std. Err 0.002; z -5.890; P>|z| 0.000; [95% Conf Interval] -0.013, -0.006 - Employment Rate, pct.: Coeff. 0.001; Std. Err 0.002; z 0.210; P>|z| 0.832; [95% Conf Interval] -0.004, 0.005 - Avg Schooling Years for Adults, top quartile: Coeff. -0.003; Std. Err 0.017; z -0.200; P>|z| 0.842; [95% Conf Interval] -0.037, 0.030 - Avg Schooling Years for Adults, bottom quartile: Coeff. 0.015; Std. Err 0.010; z 1.490; P>|z| 0.137; [95% Conf Interval] -0.005, 0.034 - Tax Revenues, pct: Coeff. 0.003; Std. Err 0.008; z 0.380; P>|z| 0.707; [95% Conf Interval] -0.013, 0.019 - Notes on estimation: - 1st Stage Least Squares Results. Sources: PNAD; Secretaria da Receita Federal; Previdência Social; and IMF staff calculations. ### Table 3 — Brazil: Logistic Regression: Determinants of Attending Public University, 2014 - Estimation notes: - Sources: PNAD microdata; and IMF staff calculations. - 1/ Coefficients denote the expected marginal response in the dependent variable after a unit change in the independent variable at specific points. - Continuous variables (age and income) calibrated so coefficients denote marginal responses at medians. Categorical variables calibrated to zero; coefficients denote marginal responses from 0 to 1. - Households’ income per capita adjusted for spatial price differences. - Marginal effects on probability of attending public university (selected coefficients and robust standard errors in parentheses): - LN of HH income per capita: 0.025*** (0.001) - Age: 0.022*** (0.001) - Male: 0.001*** (0.000) - Black: -0.004*** (0.001) - Brown: -0.014*** (0.003) - Asian: -0.013*** (0.002) - Native Brazilian: 0.016** (0.007) - North Dummy: -0.024* (0.013) - Northeast Dummy: 0.021*** (0.002) - South Dummy: 0.021*** (0.001) - Midwest Dummy: -0.000 (0.002) - Observations: 40,385 - Pseudo-R2: 0.0716 (column 1) and 0.0953 (column 2) - Significance notation: *** p<0.01, ** p<0.05, * p<0.1 ### Interest Rates and Inflation in Brazil — Summary of Analysis and Results - Main question and context: - Debate between conventional view (higher interest rates reduce inflation) and Neo-Fisherian view (lower nominal rates can lead to lower inflation via the Fisher equation). - Fisher equation (annualized): nominal interest rate = real interest rate + expected inflation. - Empirical strategy: - Baseline VAR estimated using monthly data 2003 to 2016 with six variables: monthly headline inflation, the nominal interest rate (SELIC), the output gap, 12-month-ahead inflation expectations, and monthly percent changes of commodity prices and the real-effective exchange rate. - Five additional VARs include sectoral inflation series: non-regulated-price, regulated-price, service-price, tradable, and non-tradable inflation. - VAR lag lengths selected using the Swartz-Bayesian Inflation Criteria. - Parameter uncertainty captured by bootstrapping; each VAR resampled 1000 times. - Empirical findings: - Cross-correlations: - Higher inflation leads to higher interest rates. - Higher interest rates lead to lower inflation. - Peak correlation between leads and lags of inflation and interest rate around 6 months. - Structural VARs: - Responses of headline inflation to a 100 basis point cut in the policy interest rate indicate that an unexpected cut tends to increase inflation over time. - Peak impact generally occurs around 9 months after the shock. - Results vary by sector; short-term impact within the same month can be ambiguous depending on identification scheme. - Identification uncertainty: Each VAR contains six variables so there are 720 different orderings; 69 of these orderings lead to unique inflation responses. 1,000 parameterizations of each reduced-form model are simulated, leading to 69,000 different estimates of the response of inflation to an interest rate for each VAR examined. - Robust evidence supports the conventional view of monetary policy transmission in Brazil (higher rates reduce inflation in the short term). - Modeling and simulations: - Long-run Fisher equation (steady-state nominal interest rate = steady state real interest rate + inflation target) used to inform policy. - Simple New Keynesian model simulations: - Lower inflation target reduces nominal interest rate and inflation in the long run. - If households/firms are partially forward-looking or backward-looking, transition to a lower inflation target requires lower output in the short term; the real interest rate must rise to reduce demand. - In a purely forward-looking model with full central bank credibility, transition is instantaneous and output is unaffected. - Historical disinflation episodes: - Disinflation episodes across countries show slow adjustment of inflation and costly transitions in terms of output, reflecting unanchored inflation expectations and limited monetary policy credibility prior to disinflation. - Evidence from five early inflation-targeting adopters and the Volker disinflation beginning in 1981: nominal interest and inflation rates positively correlated and tended to decline together once inflation targeting was adopted; output gaps generally moved into negative territory. - Policy implications and recommendations: - Evidence strongly favors the conventional view: lowering policy interest rates is not a reliable way to reduce inflation in the short run. - A lower long-run inflation target can achieve lower long-term inflation and lower nominal interest rates but is likely to impose short-term output (and employment) costs if monetary policy credibility is limited. - Costs of disinflation can be mitigated by: - Enhancing monetary policy transparency and credibility. - Improving monetary policy transmission by reducing distortions and improving allocation of resources in the financial sector. - Transition to a lower inflation target is less costly when the central bank has more policy credibility and more anchored inflation expectations prior to the target change. *Prepared by Troy Matheson (WHD); sources: IMF staff estimates and analyses as presented in the Appendix II content unit.* ### 10. There is strong evidence of the conventional view of monetary policy transmission in ### 10. There is strong evidence of the conventional view of monetary policy transmission in ### Evidence on monetary policy transmission in Brazil - Cross correlations show that: - higher inflation leads to higher nominal interest rates; - higher interest rates result in a reduction in inflation. - Since inflation tends to lead the policy interest rate in the sample examined, the central bank appears to have responded to inflation developments, partly as the result of unanticipated demand and supply shocks (such as food and regulated-price shocks, and exchange rate shocks). - Structural VARs suggest that an unexpected cut in the policy interest rate leads to a broad-based rise in inflation across the sectors examined, with the peak impact on inflation occurring around 9 months after a monetary policy shock. - Figure-based results (Fund staff estimates) document cross-correlations and impulse responses by sector (headline, non-tradable, tradable, services, non-regulated, regulated), showing heterogeneous sectoral responses to interest-rate shocks. ### Model-based simulations and disinflation episodes - Model-based simulations and cross-country evidence suggest: - lower inflation and lower nominal interest rates can be achieved over the longer term if the central bank commits to a lower inflation target. - If households and firms base expectations on the past (even partially), the transition to a new lower inflation target comes at the cost of lower output in the short term. - Larger output losses and more prolonged transition periods occur when expectations are more backward looking. - Examination of disinflation episodes across several countries broadly supports findings from model simulations that assume expectations were (at least) partially backward looking prior to disinflation. ### Policy recommendations to achieve lower inflation at lower cost - Enhanced monetary policy transparency and credibility can: - better anchor inflation expectations; - reduce the persistence of inflation; - improve the short-run tradeoff between inflation and output; - mitigate the cost associated with transitioning to a lower inflation target over the medium term. - Suggested improvements to Brazil’s inflation-targeting framework (as discussed in Domit and others (2016)) include: - increasing the autonomy of the central bank; - changing the inflation target from a range that needs to be met at the end of each year to a longer-term point target. - Policy change already implemented: The National Monetary Council narrowed the target range from 4.5 percent +/- 2 percent to 4.5 percent +/- 1.5 percent from 2017. ### Improving monetary policy transmission via financial sector reform - Monetary policy transmission could be made more efficient by reducing distortions and improving resource allocation in the financial sector. - Specific recommendation: reduce the gap between the subsidized interest rate on long-term lending (the TJLP) and the policy interest rate (the SELIC) over time. - Linking the TJLP more tightly with the SELIC or another market-determined interest rate (such as long-term yields on government inflation-linked debt) would enhance transmission of SELIC changes to longer-term interest rates. - This could increase the potency of a given change in the SELIC and contribute to lower interest rate volatility over the business cycle. - Improving efficiency of resource allocation in the financial sector could contribute to a lower long-term real interest rate in Brazil, allowing for lower nominal interest rates for a given inflation target. - Reference: See Minutes of the 205th Meeting of the Monetary Policy Committee (“Copom”) of the Central Bank of Brazil for a discussion. ### Data and empirical robustness (Appendix I) - Data series and transforms (selected): - Headline IPCA IBGE: ∆log(x)*1200 - Non-tradable IPCA IBGE: ∆log(x)*1200 - Tradable IPCA IBGE: ∆log(x)*1200 - Services IPCA IBGE: ∆log(x)*1200 - Non-regulated IPCA IBGE: ∆log(x)*1200 - Regulated IPCA IBGE: ∆log(x)*1200 - Inflation expectations (12-months ahead) BCB: x - Interest rate (SELIC) BCB: x-hptrend(x) - Activity Index (IBC-BR) BCB: log(x)*100-hptrend(log(x))*100 - Commodity Price Index (IC-BR) BCB: ∆log(x)*1200 - Real Effective Exchange Rate (broad) JP Morgan: ∆log(x)*1200 - * ∆ = first difference; hptrend = Hodrick-Prescott Filter - Empirical results highlights: - Figure 1: Range of cross-correlations between the interest and inflation rates (median and 20th and 80th percentiles) by sector (headline, non-regulated, regulated, services, tradable). - Figure 2: Range of inflation responses to 100bps increase in interest rate (median and 20th and 80th percentiles) by sector (headline, non-regulated, regulated, services, tradable, non-tradable). - Source for figures: Fund staff estimates. ### Simple model specification (as presented) - IS curve: The IS curve relates the current level of the output gap, ݕ௧, to the lagged output gap, expectations of the future output gap and the real interest rate (deviation from steady state): - ݕ௧ ܧߜൌ ௧ ݕ௧ାଵ ൅ ሺ ߜ1െ ሻ ݕ௧ିଵ ߪେ ሺ ܴ ௧ ܧେ ௧ ߨ ௧ାଵ ݎെ ∗ ሻ - Phillips curve: Relates current inflation to inflation expectations, past inflation, and the output gap (where 0൑ߙ൑1ሻ: - ߨ ௧ ܧߙൌ ௧ ߨ ௧ାଵ ൅ ሺ ߙ1െ ሻ ߨ ௧ିଵ ݕߛ൅ ௧ - Monetary policy rule: Relates nominal interest rate to the steady state nominal interest rate and the expected deviation of inflation from the inflation target: - ܴ ௧ ܴൌ ∗ ߤ൅ ሺ ܧ ௧ ߨ ௧ାଵ ߨെ ∗ ሻ - where ൐1ߤ to ensure a unique and stable solution, and the long-run Fisher equation is: ܴ ∗ ݎൌ ∗ ߨ൅ ∗ - Parameter values (as stated in the source): - The parameters values are ൌ1ߪ, ߛ ൌ0.05, ߤ ൌ1.5, and ݎ ∗ ൌ6,The parameters in the Phillips and IS curves related to persistence are: ൌ1ߙൌߜ, in the forward-looking model; ߜൌߙ ൌ0.5, in the partially forward-looking model; and ൌ0ߙൌߜ, in the backward-looking model. ### The effect of fiscal consolidation on real interest rates in EMs (Appendix; key findings) - Context: - In 2016, Brazilian authorities introduced reforms to control the budget deficit, including a 20-year public spending ceiling; Brazil was recovering from a recession with output falling by a cumulative 7.5 percent during 2015−16. - Real interest rates have been among the highest in Emerging Market economies (EMs). - Key findings summarized: - There are beneficial, but relatively moderate and short-lived effects of fiscal consolidation on real interest rates in EMs, possibly reflecting difficulties in continuing the adjustment over a long time. - Fiscal policy background for Brazil: - December 2016: constitutional amendment limiting growth in federal noninterest spending to the rate of consumer inflation of the previous year. - Social security reform bill under discussion. - Fiscal condition trajectory: debt-to-GDP ratio increased by about 10 percentage points on average in 2013−15; CAPB has been consistently worsening since 2009. - Identification of fiscal consolidation episodes: - Outcome-based approach using changes in the cyclically adjusted primary balance (CAPB) following OECD (2009) methodology; elasticities of revenues and expenditures with respect to output gap take values of 1 and 0, respectively. - Definition of fiscal adjustment: period of 2 years during which CAPB/GDP improves in each year and the cumulative improvement is at least two percentage points of the actual GDP. - Episode counts and magnitudes: - Total sample (73 countries, 2001−15): 232 fiscal consolidation episodes. - On average, fiscal consolidations amounted to 2.2 percent of GDP per year (sample average). - For the sample of EMs: 35 fiscal consolidation episodes, amounting to a consolidation of 1.8 percent of GDP per year on average. - Alternative stricter definition (3 percentage points improvement) yields only 18 consolidation episodes among EMs. - During 2001−15, no fiscal consolidation episodes were recorded for Brazil (Brazil’s fiscal adjustment occurred in the late 1990s); cyclically adjusted primary balance averaged 2.8 percent of GDP for 2003−13 and turned negative in 2014. - Econometric approach: - Local Projections (LP) method (Jorda, 2005) used to estimate Impulse Response Functions (IRFs) via OLS; baseline specification follows Alesina and Ardagna (2012) and IMF (2010). - Dependent variable ݎ௜,௧ା௛ denotes the real policy rate or the real 10-year government bond yield. - Regression controls include country fixed effects, time fixed effects, and interaction terms allowing differential effects for EMs. - Marginal effect for EMs is calculated as: ݎ߲௜,௧ା௛ ݁݀݋ݏ݅݌ܧ߲ ߩൌ ௛ ܤܲܣܥ∆ ௜,௧ ߠ൅ ௛ ܤܲܣܥ∗∆ܯܧ ௜,௧ *Source: IMF staff estimates and analysis as presented in the chapter.* ### 8. Fiscal consolidation episodes are accompanied by decreases in real rates in EMs. Given ### 8. Fiscal consolidation episodes are accompanied by decreases in real rates in EMs. Given ### Main findings on interest-rate responses - Given a fiscal consolidation episode, a one percentage point improvement in the change of the cyclically adjusted primary balance is associated with approximately 100 basis points decrease in the real policy rate (Figure 3, Panel 1). - The effect on the real policy rate is short lived, but significant for about 6 months during the period of fiscal retrenchment. - Given a fiscal consolidation episode, a one percentage point improvement in the change of the cyclically adjusted primary balance is associated with approximately a 70 basis points decrease in the real 10-year government bond yield (Figure 3, Panel 2). - The response of the real 10-year government bond yield is only significant initially for the first couple of months during the consolidation episode. - Under the expectation hypothesis, the 10-year real rate encompasses the average of the future short rates over the following 10 years and a risk premium; the results suggest fiscal consolidation affects both components, but it cannot be inferred whether the impact on expectations or the risk premium dominates. - The effects on both short-term real policy rates and 10-year real yields do not seem long-lasting, as responses turn insignificantly different from zero as time progresses. ### Fiscal-adjustment reversals - Reversals in fiscal adjustment occur on average after the second year (Figure 4, Panel 1). - Almost all EMs experience reversals in the fiscal adjustment during the fourth year following the consolidation (Figure 4, Panel 2). - Such reversals likely explain why fiscal tightening does not appear to have a long-lasting effect on interest rates. ### Effect of outstanding debt (interaction with high-debt countries) - The specification includes an interaction where the dummy takes a value of one if a country has a gross outstanding debt higher than 60 percent of GDP and zero otherwise. - Controlling for outstanding debt levels, given a fiscal consolidation episode, a one percentage point improvement in the change in the cyclically adjusted primary balance reduces the interest rate by almost 200 basis points (Figure 5, Panel 1). - The response of the real 10-year government bond yield remains around 70 basis points in magnitude, but the effect appears to be significant only during the first year while the fiscal consolidation is still ongoing (Figure 5, Panel 2). ### Robustness checks - Control for real GDP-per-capita: Adding real GDP-per-capita levels does not affect the main results; country and time fixed effects capture cross-country and time variation. - Control for terms of trade: Including the change in the terms of trade as a control yields an insignificant coefficient on terms of trade, suggesting fixed effects capture its variation. - Change definition of fiscal consolidation episodes: Defining an episode as an improvement in the cyclically adjusted balance by 1.5 (instead of 2) percentage points of GDP yields qualitatively same results but of somewhat lower magnitude. - Restricting the sample to EMs only: Excluding the interaction term and using the EM-only sample produces the same sign of effects with somewhat lower magnitudes; the negative relationship between real interest rates and fiscal consolidation episodes holds within the EM sample alone. ### Conclusion and policy recommendations - Fiscal consolidations tend to have beneficial, but relatively moderate and short-lived effects on real interest rates. - Quantitative summary: - The real short-term rate is likely to decrease by approximately 100 basis points in response to a fiscal consolidation episode. - The real bond yield is expected to decrease by about 70 basis points. - The transient nature of effects likely reflects the proclivity of fiscal adjustments to falter and suffer reversions after a period of time. - Policy recommendations: - Efforts to impose fiscal discipline should be accompanied by policies aimed at alleviating the inefficiencies present in the financial sector. - Fiscal policies implemented and those on the agenda are in the right direction to decrease rates and allow for more stable growth in the long-run, but other factors beyond fiscal policy (e.g., financial sector inefficiencies) also contribute to high rates. - Implications for Brazil: - Some positive effects from fiscal consolidation can be expected if consolidation is maintained. - Brazil’s episode of fiscal consolidation will be long, is preannounced, and is accompanied by monetary easing; the main lesson is that gains in interest rates can be expected if fiscal consolidation can be maintained. ### Data and methodology notes - The data span over the period 2001−15; the panel is unbalanced due to availability prior to 2002 with respect to the fiscal variables for some countries. - Potential output was estimated using the HP-filter with a penalizing parameter set to 6.5, which corresponds to yearly data. - The sample of Emerging Market economies (EMs) includes: Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, Korea, Thailand, Turkey. - Key data sources: - Real GDP (total): WEO Database - Real GDP (per capita): WEO Database - Government revenues (general): WEO Database - Government expenditures (general): WEO Database - Government interest payments, staff calculations: WEO Database - Government debt as a percentage of GDP: WEO Database - Policy interest rate: National authorities (Haver), Bloomberg Financial Markets - 10-year government bond yield: Bloomberg Financial Markets - Estimation method: - Local Projection (LP) method following Jorda (2005) is used to trace the response of interest rates at t+h to a fiscal consolidation episode at time t. - To control for serial correlation and cross-sectional dependence, Driscoll-Kraay standard errors are used. *Source: IMF staff estimates.* ### References ### References ### Bibliographic citations - Alesina, Alberto, and Silvia Ardagna, 2012, “The Design of Fiscal Adjustments,” Tax Policy and the Economy, Vol. 27. - Blanchard, Olivier J., 1990, "Suggestions for a New Set of Fiscal Indicators," OECD Economics Department Working Papers No. 79. - Caselli, Francesca G. and Agustin Roitman, 2015, “Non-Linear Exchange Rate Pass-Through in Emerging Markets,” IMF Working Paper No. 16/1 (Washington: International Monetary Fund). - Driscoll, John and Aart Kraay, 1998, “Consistent Covariance Matrix Estimation with Spatially Dependent Panel Data,” The Review of Economics and Statistics, Vol. 80(4), pp. 549-560. - Guajardo, Jaime, Daniel Leigh, and Andrea Pescatori, 2011, “Expansionary Austerity: New International Evidence,” IMF Working Paper No. 11/158 (Washington: International Monetary Fund). - Gupta, Sanjeev, Benedict Clements, Emanuele Baldacci, and Carlos Mulas-Granados, 2002, "Expenditure Composition, Fiscal Adjustment, and Growth in Low-Income Countries," IMF Working Paper No. 02/77 (Washington: International Monetary Fund). - International Monetary Fund, 2010, “Will it Hurt? Macroeconomic Effects of Fiscal Consolidation,” World Economic Outlook, Chapter 3. - Jorda, Oscar, 2005, “Estimation and Inference of Impulse Responses by Local Projections,” American Economic Review, Vol. 95(1), pp. 161−82. - Nakamura, Koji and Tomoyuki Yagi, 2015. “Fiscal Consolidation and Long-term Interest Rates,” Bank of Japan Working Paper, No. 15-E-10. - OECD, 2009, “Computing Cyclically Adjusted Balances and Automatic Stabilizers,” Fiscal Affairs Department. - Romer, Christina and David Romer, 2010, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review, Vol. 100, pp. 763−801. *Prepared references and IMF chapter material from the source document.* ### A. The Productivity Challenge in Brazil - Once Brazil recovers from its recent economic crisis, raising productivity will remain a top priority challenge. - Brazil's productivity grew by only 1.6 percent a year between 2001 and 2013. - Comparative productivity rates: China 9.6 percent; Russia 3.5 percent (Ceratti, 2016). - Macro factors constraining productivity: high cost of finance and doing business, poor physical infrastructure, limits to competition from domestic regulation, trade barriers, and inadequate labor force skills (World Bank, 2016). - Micro factor: weak total factor productivity reflecting poor use of existing resources (labor and capital) within firms. - Policy implication: reducing resource misallocation requires multiple levers, including structural reforms (financial, labor, product market) and upgrading the tax system. ### B. Resource Misallocation in Brazil — Findings and Quantification - Resource misallocation defined: poor distribution of resources across firms reducing total output from existing capital and labor; evidenced by wide dispersion in revenue productivity across firms even within narrowly defined industries. - Example distortion: tax exemptions under the SIMPLES tax regime can favor inefficient small firms over larger efficient firms, preserving low-productivity firms. - Empirical evidence: - Dispersion in firm-level revenue productivities in Brazil is much wider than in the top-performing country in the sample (Figures and Fund staff estimates; data from IMF Fiscal Monitor, April 2017; manufacturing sector). - In a fully efficient, frictionless equilibrium, Brazil could potentially increase its total factor productivity by nearly 60 percent. - Moving Brazil to the level of the country in the 90th percentile of the distribution could increase Brazil’s total factor productivity by 57.3 percent (Resource Allocation Efficiency, RAE, comparisons). - Estimated growth impact: - Assuming a transition path of 20 years, reducing resource misallocation to the 90th percentile translates into a higher annual real GDP growth rate of 2.29 percent for Brazil. - These potential gains would be much higher than average gains for emerging market economies (EMEs) or the five largest economies in Latin America (LA5), in part because Brazil starts further behind in allocation efficiency. - Methodological notes: - RAE is the ratio of actual TFP to efficient TFP, aggregated across sectors (using a Cobb-Douglas aggregator). - Firm-level data sources: ORBIS for 10 advanced economies and World Bank Enterprise Surveys for 57 developing countries (Fiscal Monitor, IMF, 2017). - Estimates are lower bounds and subject to statistical error; within-industry misallocation accounts for the bulk of cross-country productivity differences. ### C. Upgrading the Tax System to Reduce Resource Misallocation — Channels and Estimated Gains - Key channels by which tax policy generates misallocation: - Legislated provisions that vary by firm characteristics (tax code provisions that vary with size), tariffs, employment protection, product market regulations. - Discretionary government provisions favoring specific firms (subsidies, selective tax enforcement, preferential loans). - Market imperfections (monopoly power, incomplete financial markets). - For Brazil specifically, taxes, regulation, and access to credit create distortions varying by firm size; the tax system alters relative prices of labor and capital and induces suboptimal sectoral and regional allocation (De Vries, 2014; Appy, 2017). - Tax disparity (differential taxation across asset types): - Effective marginal tax rates (EMTRs) differ across asset types due to tax depreciation rules versus economic depreciation. - Brazil exhibits high tax disparity: higher effective taxes for machines than for buildings, contributing to a lower share of machinery. - Quantified gains from eliminating most tax disparity (bringing Brazil to the 90th percentile of tax disparity distribution): - Raise resource allocation efficiency in Brazil by 12.3 percentage points. - Increase annual GDP by 0.58 percentage points. - These gains are four times larger than potential gains for emerging economies and three times larger than for Latin American economies (median comparisons). - Data caveat: underlying Brazilian data in the Fiscal Monitor is from 2009 (World Bank Enterprise Survey); inefficiencies may be larger now and gains could be higher. - Corporate debt bias (tax preference for debt over equity): - Corporate debt bias arises when interest is deductible but returns to equity are not, raising the cost of equity financing and disadvantaging R&D-intensive and risky firms that rely on equity. - Measurement: debt bias measured as EMTR on equity minus EMTR on debt (EMTR can be negative for debt-financed investment if deductions and accelerated depreciation exceed taxes on associated income). - Estimated gains from reducing corporate debt bias to the level observed in the 10th percentile of the sample (i.e., moving to the 90th percentile of resource allocation efficiency): - Raise resource allocation efficiency by 5.56 percentage points. - Increase annual GDP growth in Brazil by 0.27 percentage points. - These gains are 40 percent higher than the Latin American average and almost three times larger than the Emerging countries average. - Policy implication: upgrading tax policy and administration (reducing tax disparity across asset types, addressing corporate debt bias, and tackling tax-induced incentives for informality) is key to reducing resource misallocation and boosting productivity and growth in Brazil. *Source: Excerpts and figures from the IMF country chapter material in the supplied document.* ### 14. Tax informality is not only a problem for revenue collection but also for productivity. ### 14. Tax informality is not only a problem for revenue collection but also for productivity. ### Tax informality and firm productivity - The literature defines informal firms as those that fail to pay the full amount of tax due. - Noncompliance with taxes reduces productivity by interfering with firm entry and exit. - Informal firms enjoy a relative cost advantage over tax-compliant competitors through tax evasion and circumvention of regulations, allowing low-productivity firms to remain in business. - The persistence of informal firms increases their weight in the economy at the expense of more productive firms. ### Quantitative estimates of gains from reducing tax informality - Reducing tax informality to the level of the best performers can increase productivity in Brazil by 2.58 percentage points. - The same reduction can increase annual GDP by 0.12 percentage points. - Brazil’s estimated gains from reducing tax informality would be smaller than gains for groups of Latin American and Emerging countries, reflecting improvements in Brazilian tax administration in recent decades. - Using methodologies developed in the Fiscal Monitor, reducing overall resource misallocation could increase productivity by more than 50 percentage points in Brazil. - A hypothetical gradual reallocation of resources implemented over 20 years that allows Brazil’s efficiency to catch up with leading countries would boost annual GDP growth by more than 2 percentage points during the catch-up period. - The estimates are subject to statistical uncertainty but indicate substantial scope for improvement from a productivity-oriented agenda. ### Conclusions and policy recommendations - Resource misallocation in Brazil is significant, reflected in wide dispersion in productivity levels across firms, even within narrowly defined industries. - The tax system is an important contributor to distortions that cause resource misallocation. - Brazil can reap substantial TFP gains by upgrading the design of its tax system so that firms’ decisions are driven by business reasons rather than tax reasons. - Significant gains can be achieved by addressing tax treatments that discriminate by: - asset type; - sources of financing; and - firm characteristics such as tax informality. - Estimates suggest that addressing tax-related distortions could bridge about half of the productivity gap relative to leading countries. - Pursuing a well-designed, productivity-oriented tax reform offers important benefits for Brazil, though exact quantitative estimates should be interpreted with caution. *Source: IMF staff analysis (chapter excerpt).* --- _Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17216.pdf_