## 1braea2020001

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### PREFACE — Mission and engagements
- A Fiscal Affairs Department (FAD) mission visited Brasília and the states of Goiás and São Paulo, Brazil, from February 10-21, 2020, to provide technical cooperation on options for subnational fiscal rules.
- Mission leadership and team: led by Paulo Medas; Roberto Perrelli (FAD); Fernando González (external expert); Daniel Cunha (economist from the IMF’s local office) provided research support.
- Meetings with federal authorities, Courts of Accounts, state and municipal officials, and the Independent Fiscal Institution (IFI) outlined fiscal and legal framework issues and implementation challenges.
- Footnote: “This report was prepared based on a mission before the COVID-19 pandemic. The analysis does not cover some of the additional deterioration of the fiscal situation in many SNGs. The proposals are directed to structural reforms for the future and the report does not discuss possible exceptional, temporary, and targeted measures, for example grants from the federal government, to help address the pandemic.”

### Executive summary — context and core conclusions
- Findings:
  - Subnational governments (SNGs) account for a large share of public expenditures, including public investment; their fiscal problems can hamper the economic recovery and the public finances of the federal government.
  - In recent years, many states and municipalities have been struggling with high debt or severe liquidity pressures; some have defaulted on part of their debt and are running payment arrears (wages and suppliers).
  - The federal government has provided a substantial package of financial support through debt service relief.
- Core policy objective: enhance the subnational fiscal framework by promoting appropriate incentives, imposing credible hard-budget constraints, and reducing expectation of future bailouts by the federal government.

### Key historical and structural points
- Development of framework:
  - Since the late 1990s–early 2000s, Brazil developed a complex framework of administrative controls and fiscal rules to promote fiscal transparency, constrain excessive borrowing by SNGs, and promote public investment.
  - The framework had positive initial effects but gradually unraveled and did not eliminate the expectation of bailouts.
- Problems identified:
  - Debt of most states was significantly reduced; however, largest states remained vulnerable due to loosening administrative controls that allowed excessive borrowing.
  - Complex framework allowed some states and municipalities to run arrears even with relatively low debt levels.
  - Public expenditures are highly volatile and procyclical, reflecting weaknesses in rule design, widespread revenue earmarking, and mandatory spending.
  - Lack of consistent accounting standards and poor data quality impede monitoring; weaknesses in internal and external controls enabled creative accounting and extrabudgetary spending and arrears.
  - Significant legal uncertainty over application of the Fiscal Responsibility Law (FRL) because courts have been granting temporary injunctions that prevent enforcement of sanctions for several years.
- Exact historical/statistical points preserved verbatim:
  - The 1988 Constitution increased SNG roles; their share of total taxes rose from 25 in 1980 to around 35 percent more recently.
  - About 23 percent of GDP in spending is equivalent to more than one-half of total public spending.
  - Brazilian states: taxes provide nearly one-half of their revenue.

### Recommended directions for reform (core elements)
- Greater fiscal transparency.
- Rely to a greater degree (but not exclusively) on market discipline.
- Improved design of fiscal rules.
- Grant greater flexibility to SNGs (how to spend and when to borrow) conditional on abiding by fiscal rules.
- Reduce the number of sanctions and make them more gradual to improve effectiveness.
- Strengthen legal tools to address highly indebted governments and eliminate ad hoc bailouts.
- Complement with broader reforms to address structural challenges such as budgetary rigidities.

### Strengthening controls, reporting, and oversight
- Recommendations:
  - Enhance the quality of fiscal reporting and external auditing to ensure SNGs abide by the FRL.
  - Promote harmonization of accounting and adequate reporting; create a technical Fiscal Management Council to develop common standards for all levels of government and verify compliance.
  - Improve internal controls to ensure integrity of data and budgetary procedures.
  - Advance reforms to strengthen governance of the Courts of Accounts and promote harmonization in interpretation of the FRL.
  - Mandate the independent fiscal institution or a new independent body to monitor fiscal policy and compliance with fiscal rules at the subnational level.
  - Develop a strategy to reduce, and effectively prevent in the future, the large stock of spending arrears.

### Market access and the Fiscal Recovery Regime (FRR)
- Rationale:
  - Allowing SNGs more freedom to access debt markets, without federal guarantees, would instill greater market discipline and complement fiscal rules.
  - Current reliance on federal guarantees and public banks, together with repeated bailouts, distort incentives and give states with worse fiscal records lower borrowing costs.
- Core FRR proposals:
  - Make an enhanced Fiscal Recovery Regime (Regime de Recuperação Fiscal, FRR) the sole legal mechanism to address highly indebted states or large municipalities in exchange for fiscal adjustment.
  - Elements: gradual debt relief conditional on FRR conditionality; gradual sanctions; explicit goals to bring debt and debt service to sustainable levels; extend FRR to include private creditors; consider judicial oversight of the FRR (possibly by the Federal Supreme Court); create an SNG-owned fund as a lender of last resort to manage strategic default risk.
- Federal measures cited:
  - In 2014, federal government conceded retroactive debt relief estimated near R$ 100 billion (1½ percent of GDP).
  - In 2016, federal government reduced SNGs’ debt service payments for 24 months while extending repayment schedule by 20 years, estimated to have reduced SNGs’ debt service by R$ 50 billion; in exchange states were required to adopt a spending cap for two years with mixed evidence of compliance.

### Fiscal-rule design recommendations
- Debt and spending rules:
  - Existing debt limits appear too high; recommend lower safe debt limits consistent with SNGs’ capacity to service debt.
  - Introduce subnational spending caps on the growth of total primary expenditures to reduce volatility and procyclicality.
  - Replace or supplement the existing personnel spending limit, which has led to creative accounting, is procyclical, and has not prevented a rise in subnational current expenditures.
  - For municipalities, consider a balanced budget rule and the introduction of rainy-day funds.
- Selected exact legal and numeric limits from the framework (preserved verbatim):
  - Golden rule — Constitution: Credit operations (includes financial revenues) cannot exceed capital expenditures (includes amortizations).
  - Limit on personnel expenses — Fiscal Responsibility Law (FRL): personnel expenses as share of net current revenues (RCL) — 60%.
  - Debt ceiling — FRL, Senate resolution: Net debt as share of RCL — States: 200%; municipalities: 120%.
  - Debt service ceiling — Senate resolution: Annual debt service as share of RCL — 11.5%.
  - Spending limit (two years) — Law 156/2016: Limit on expenditures growth — zero real growth.
  - Administrative controls include annual limit for federal guarantees (Senate), limit on banks' credit (Resolution by National Monetary Council), limit on external credit (COFIEX), and limits set in debt refinancing contracts (PAFs) under Laws 9496/97, 8727/94 and 156/16, and MP 2185/2001.

### Fiscal outcomes and debt distress (evidence)
- Observed outcomes:
  - Several states, including the largest ones, have faced significant debt distress despite the FRL.
  - States that entered or applied to enter the FRR and stopped paying debt service to the federal government: AP, GO, MG, RJ, RS.
  - States that defaulted on debt guaranteed by the federal government: AP, GO, MG, RJ, and RN; the federal government paid creditors but could not recover counter-guarantees.
  - Some states saw debt decline significantly to less than 100 percent of revenue.
- RAPs and liquidity:
  - Many states accumulated significant Restos a Pagar (RAPs), including states with lower debt.
  - More than 1,100 municipalities ended 2019 with more RAPs than cash.
  - Liquidity defined as total (or free) cash minus short-term liabilities.
  - For states, RAPs rose to an estimated 1½ percent of GDP in 2019.
  - Minas Gerais: average financing through RAPs equivalent to one-third of its net current revenues in recent years.
- Personnel spending and breaches:
  - All but three states breached the intermediate limit of 54 percent of net current revenue (NCR); some breached the 60 percent limit in 2018, based on National Treasury data.
  - About one-half of all municipalities had personnel expenditures that exceeded the intermediary limit or the 60 percent limit in 2018, according to Firjan (2019).
  - In the state of São Paulo, about one-half of the municipalities breached the rule limiting RAPs accumulation in the last year of mandates to the level of available cash.
- Volatility and procyclicality:
  - Expenditure real growth (in constant prices) tends to be unstable in several states.
  - Elasticity of expenditure growth relative to annual current revenue tends to be high.
  - Example: over the past 10 years, expenditure growth in Rio de Janeiro and Espírito Santo has been, on average, very low (or negative) but with large fluctuations.

### Explanatory factors for weak outcomes
- Economic factor: deep recession in 2015–16 affected all levels of government.
- Structural factor: rising pensions and subnational social security (SS) pressures contributed to fiscal deterioration.
  - Aggregate subnational pension deficit: reached 1.4 percent of GDP in 2017.
  - Projected to increase to 2.9 percent of GDP by 2030 absent pension reform.
- Design and implementation weaknesses:
  - FRL limits tied to net current revenues (highly volatile) promote procyclicality; widespread earmarking exacerbates volatility.
  - Federal bailouts and loosening administrative controls allowed excessive borrowing.
  - Lack of consistent accounting standards and varying data quality hinder monitoring.
  - Weak internal and external controls enabled creative accounting and arrears.
  - Significant legal uncertainty from courts granting injunctions that prevent enforcement of sanctions.

### Strengthening reporting, accounting standards, and oversight (details)
- Current status:
  - FRL established reporting obligations and accounting standards, but compliance varies.
  - STN issues Manual of Applied Accounting for the Public Sector (MACSP) and a standard chart of accounts (CoA), updated yearly to converge to IPSAS and GFSM 2014; compliance mandatory but application varies.
  - Full development of the matriz de saldos contábeis would be significant progress.
- Institutional options:
  - Create a new Fiscal Management Council (FMC) to enhance compliance; council design and enforcement authority are key challenges.
  - Mandate IFI or create state-level fiscal councils to monitor accounts; suggested IFI monitoring frequency: states and large cities annually; other cities less regularly (e.g., random sample each year).

### Strengthening system of controls and Courts of Accounts (SCAs)
- Observations:
  - Internal controls weak; FMIS sometimes fails to properly register commitment, liquidation, and payment stages enabling off-budget spending and inconsistent TSA statements.
  - 33 Courts of Accounts exist with varying practices; perceptions that some allowed creative accounting or interpretations that contributed to excessive deficits and debt.
  - When SCAs detect problems, follow-up actions or enforcement are often lacking; Courts sometimes issue injunctions to suspend rejection of accounts.
  - Sanctions for irregularities can include fines up to 30 percent of the wage of the respective authority and disqualification from holding public office from five to eight years.

### Governance of the Courts of Accounts and judicial injunctions
- Proposed governance changes:
  - SCAs composition change: from seven judges with five politically appointed and two technical, to a proposal where four judges chosen for professional background and three for political considerations.
  - Congressional proposal: grant Federal Court of Accounts (TCU), in consultation with SCAs, authority to settle different interpretations of the FRL with binding power.
  - Adopt a common procedural code and centralize information from different courts.
- Judicial injunctions (liminares) issues:
  - Court injunctions, including STF, can last many years and create judicial uncertainty that undermines enforcement of FRL.
  - Courts tend to side with states against the Union in majority of cases, often citing protection of basic public services or procedural issues.
  - Recent injunctions allowed at least four highly indebted states (Goiás, Minas Gerais, Rio de Janeiro, and Rio Grande do Sul) and Amapá to suspend debt service payments and/or prevent execution of collaterals.

### Sanctions, remedial measures, and incentives
- Recommended approach:
  - Emphasize progressive measures across three phases: preventive, corrective, coercive, with progressively harder consequences.
  - Corrective measures can be non-punitive if entities adopt specified corrective steps (e.g., adjustment program).
  - Introduce positive incentives to support compliance; reduce complexity and increase flexibility in the framework.
  - Review current sanctions to improve effectiveness and add more gradual sanctions and remedial actions.

### Rising expenditure arrears (RAPs) and strategy to clear and prevent arrears
- Scale and effects:
  - RAPs used as proxy for payment arrears; for states, RAPs estimated at 1½ percent of GDP in 2019.
  - Accumulation of arrears can disguise true deficits, harm supplier firms, and raise future fiscal costs.
  - No effective framework to contain RAPs except limits in election years under FRL.
- Clearance strategy steps:
  - Take stock of arrears: establish centrally maintained database of validated outstanding payments showing discharge and additions.
  - Prioritization criteria: socioeconomic impact, vintage, cost (interest/penalties), risk (legal action, disruption of essential services), currency and creditors.
  - Repayment modalities: cash payments (possibly with discount); rescheduled payments with predefined calendar and interest rate; earmarked loans; securitization of arrears via promissory notes discountable by commercial banks; marketable treasury bills or bonds directly to creditors.
- Preventive measures:
  - Clarify legal framework to ban or discourage RAPs (define payments in arrears and specify days after which penalty interest applies).
  - Strengthen transparency: require detailed publication of stock of arrears with vintage and creditor type.
  - Consider progressive corrective measures for late-payments and good-practice codes and regular supplier contact.
- Note on DEA use:
  - Use of despesas de exercicios anteriores (DEA) is increasing to mask deficits and arrears; DEA should be used only in exceptional cases.

### Box 3 — Deeper Reform to Increase Flexibility and Fiscal Responsibility (highlights)
- Key facts:
  - About 90 percent of the states’ outstanding debt involves the federal government—either direct lending through federally owned banks or via federal guarantees.
  - Four states have consolidated debt above 200 percent of net current revenues (NCR), accounting for approximately 75 percent of all states’ consolidated debt.
  - The four highly indebted states: Minas Gerais, Rio de Janeiro, Rio Grande do Sul, and São Paulo. Three smaller states with somewhat high debt-to-revenues ratio: Alagoas, Goiás, and Santa Catarina. Together these seven states account for more than 80 percent of total subnational debt outstanding.
  - Present FRL debt limit: net consolidated debt of 200 percent of NCR.
  - Historical debt service averages:
    - Cross-States Average 1997-2014: 14 percent (debt service as percent of net current revenues).
    - Cross-States Average 2015-2017: 7 percent (debt service as percent of net current revenues).
  - Average implied interest rate on net debt has been more than 6 percent for most states in recent years.
- Simulations and stress tests:
  - Debt levels above 150 percent of revenues generally associated with debt service higher than states have been able to manage.
  - Example: SNG with debt-to-net-revenues ratio of 90 percent and average residual maturity of 20 years, debt service will range around 10 and 15 percent of net revenues.
  - Stress test scenarios for Pernambuco and Santa Catarina:
    - Scenario 1: one-standard deviation downward shock on the annual rate of growth of revenues for one year.
    - Scenario 2: one-standard deviation downward shock on the annual rate of growth of revenues for two years.
    - Scenario 3: one-standard deviation upward shock for one year.
  - Under Scenario 2, Pernambuco’s debt-to-revenue ratio could jump by close to 50 percentage points in the space of a few years (assuming no policy response).
- Policy recommendations:
  - Grant SNGs more freedom to access debt markets without federal guarantees, complemented by fiscal rules.
  - Make enhanced FRR the sole mechanism for debt relief; include private creditors and clear priorities for collaterals.
  - Suggested safe debt ceiling: around 100–120 percent of NCR compatible with an affordable debt service and buffer for adverse shocks.
  - Calibration: set debt ceiling as share of multi-year average of net current revenue (for example, five to 10 years) to reduce volatility.
  - Introduce intermediate thresholds requiring adjustment plans; allow less restrictive prohibitions on new borrowing and transfers while a state approves an adjustment program.
  - Municipalities: consider significantly reducing debt limits or shift to a balanced budget rule; encourage “rainy day funds.”

### Advantages of an expenditure growth ceiling versus a personnel cap
- Advantages listed:
  - Expenditure growth ceiling controls total primary expenditures while allowing flexibility in spending composition.
  - More stable than personnel limit tied to volatile yearly revenue; better tool to avoid excessive spending growth during booms or cuts in downturns.
  - Less subject to creative accounting than personnel limit or the golden rule, though high transparency and monitoring remain crucial.
  - Provides flexibility but requires addressing budgetary rigidities for lasting effectiveness.
- Economic simulations (Pernambuco 2001–16):
  - Two scenarios compared:
    - Spending cap scenario: primary expenditures growth constant at 5 percent annually from 2010 onward (similar to Pernambuco’s average over 2001–09).
    - Primary rule scenario: primary-to-revenues ratio constant at 3 percent from 2010 onward (similar to Pernambuco’s average over previous six years).
  - Finding: expenditure ceiling delivers a more stable expenditure path; debt falls in strong years and rises when revenue falls, conditional on keeping debt at safe levels.
- Escape clauses:
  - Rules should include escape clauses for severe economic downturns, natural catastrophes (example: Brumadinho dam disaster in Minas Gerais in 2019), pandemics (example: COVID-19 in 2020), or other national emergencies.
  - Design principles: precise definition of exogenous shocks, specify return-to-compliance timing, ensure limited and necessary use to preserve credibility.

### Annex I — System of Intergovernmental Transfers (high-level elements)
- Main transfers: States and Federal District Participation Fund (FPE); Municipalities Participation Fund (FPM); FUNDEB; Royalties; Transfers under the National Health System (SUS); Manufactured Products Tax Relative to Exports (Lei Kandir).
- FPE evolution rules since 2016:
  - Amount received by each state in the same period in 2015 corrected by inflation and 75 percent of Gross Domestic Product change determine distribution.
  - If reference value (based on the 2015 level) is less than amount of the resources (21.5 percent of IR and IPI), the reference value is transferred based on coefficients defined in Supplementary Law nº 62/1989; the rest depends on coefficients annually defined by the Brazilian Federal Court of Accounts (TCU).
- FUNDEB:
  - Resources come from 20 percent of specified sources (including FPE, FPM, ITCMD, ICMS, IPVA, ITR, IPI, and transfers foreseen in Supplementary Law nº 87/1996); federal government supplements with 10 percent of the total amount.
  - Every state and the federal district has its own fund (27 accounting funds).
  - Distribution among municipalities based on numbers of students enrolled in infant education and in elementary and high school education.
  - At least 60 percent of FUNDEB expenses must be applied to improve teachers’ salaries.
- Transfers related to health care depend on demographics and health network characteristics.
- Transfers from states to municipalities include 25 percent of ICMS and 50 percent of IPVA.

### Annex II — Spain’s strategy to control spending arrears (high-level elements and figures)
- Context and scale:
  - Aggregate commercial public debt rose from 57.1 billion euros (5.3 percent of GDP) to 87.3 billion euros (8.1 percent of GDP) between 2007 and 2011.
  - In 2011, SNGs, autonomous communities, and local entities accounted for 75 percent of the total arrears.
- Two types of measures:
  - Temporary measures to clear arrears: extraordinary funding mechanisms such as Payments to Suppliers Fund and Autonomous Communities Liquidity Fund.
    - Payment to Suppliers Fund mobilized around €)30 billion from the central government to suppliers of SNGs.
    - Total in loans from extraordinary funds well above €)250 billion as of today.
    - Governments required to sign 10-year loans with central government, including conditionality and monitoring via adjustment plans.
  - Structural measures to avoid future arrears: transparency and monitoring using average payment periods (APP).
    - APP constructed with common methodology by law and monitored and published monthly by central government.
    - Basic Stability Organic Law establishes sanctions similar to those applying to fiscal rules; if APP exceeds limits, preventive, corrective and coercive measures apply progressively, with central government ultimately able to block regular transfers and pay suppliers directly, deducting amounts from transfers.

### Annex III — Spanish regions’ progressive return to financial markets (high-level elements)
- Extraordinary loan system (2012) mobilized total amount of €)277 billion.
- Financial conditions improved: most municipalities in surplus and markets willing to lend again.
- July 5, 2018 agreement:
  - Rules for progressive return independent of authorization regimes for bond issuance, foreign currency instruments, and noncompliance with fiscal rules.
  - Eligibility required prior compliance with fiscal targets, low average payment to suppliers, and minimal investment grade credit rating.
  - Eligible regions required to present three-year Multiannual Debt Plan for feasibility assessment by Ministry of Finance and Treasury.
- Transition considerations:
  - Return to markets likely gradual given short average debt maturity and accumulated amortizations.
  - Consider temporary transition fund with fixed end date (for example, three to five years); after period, region should obtain funds only from markets.
  - Extraordinary mechanisms remain last-resort with strong conditionality and punitive interests.

*Source — PREFACE, EXECUTIVE SUMMARY, and selected chapters, 1braea2020001*

### PREFACE _________________________________________________________________________________________ 6

PREFACE

### Mission and engagements
- A Fiscal Affairs Department (FAD) mission visited Brasília and the states of Goiás and São Paulo, Brazil, from February 10-21, 2020, to provide technical cooperation on options for subnational fiscal rules.
- The mission was led by Paulo Medas and comprised Roberto Perrelli (both FAD) and Fernando González (external expert). Daniel Cunha (economist from the IMF’s local office) provided research support to the mission.
- The mission met with National Treasury Secretary Mansueto de Almeida Junior; José Franco de Morais (Under-Secretary of Public Debt); Pedro Jucá Maciel (Under-Secretary of Fiscal Policy Strategic Planning); Marco de Hollanda Cavalcanti (Under-Secretary for Fiscal Policy, Ministry of Economy); Izabel Nogueira de Andrade (General Secretary for the Judiciary of the Advocacia Geral da União); Felipe Salto (Executive-Director of the Independent Fiscal Institution); Leonardo de Araújo Ferraz (National Council of Internal Control); Carlos Eduardo Girão de Arruda (General Comptroller of the State of Mato Grosso do Sul); Gustavo de Queiroz Chaves (Deputy Federal Secretary of Internal Control); Weder de Oliveira (Minister-substitute of the Federal Court of Accounts); Renato Rainha (Vice President of ATRICON); and Federal Senator Marcio Bittar.
- State and regional meetings included Governor Ronaldo Caiado and officials in Goiás; Tomás Bruginski de Paula, Roberto Yamazaki, Emilia Ticami, Paulo Massaru and State Court of Accounts team in São Paulo; Gustavo Barbosa (Secretary of Finance, Minas Gerais) and Andrea Senko (Chief of Staff); Aldemir Freire (Secretary of Planning and Budget, Rio Grande do Norte); and Marco Alves (Secretary of Finance, Roraima).
- The mission acknowledges support from the Under-Secretary of Intergovernmental Relations staff: Acauã Brochado, Gabriela Guerra de Queiroz, Paulo Monteiro Gomes, Cecilia de Souza Salviano, Carlos Reis, and Thiago Dominoni.

### Executive summary — context and core conclusions
- The fiscal challenges of Brazil’s states and municipalities can have a significant impact on the economy and the provision of core public services.
- Subnational governments (SNGs) account for a large share of public expenditures, including public investment; their fiscal problems can hamper the economic recovery and the public finances of the federal government.
- In recent years, many states and municipalities have been struggling with high debt or severe liquidity pressures; some have defaulted on part of their debt and are running payment arrears (wages and suppliers). The federal government has provided a substantial package of financial support through debt service relief.

### Key historical and structural points
- The fiscal responsibility legislation was intended to prevent harmful outcomes, but its effectiveness has been diminished over time.
- Since the late 1990s–early 2000s, Brazil developed a complex framework of administrative controls and fiscal rules to promote fiscal transparency, constrain excessive borrowing by SNGs, and promote public investment.
- The reforms had some positive effects initially, but the framework gradually unraveled and did not eliminate the expectation of bailouts by the federal government.
- Problems that emerged:
  - The debt of most states was significantly reduced; however, this was not the case in the largest states, which became increasingly vulnerable to economic shocks. This partly reflected the loosening of administrative controls that allowed excessive borrowing.
  - The complex framework has led some states and municipalities to run arrears even if their debt levels were relatively low.
  - Public expenditures have been highly volatile and procyclical, reflecting weaknesses in rule design, widespread revenue earmarking, and mandatory spending.
  - Lack of consistent accounting standards and poor data quality make it difficult to monitor fiscal rules and risks; weaknesses in internal and external controls have facilitated creative accounting and extrabudgetary spending and arrears.
  - Significant legal uncertainty has arisen over application of the Fiscal Responsibility Law (FRL) because courts have been granting temporary injunctions that prevent enforcement of sanctions for several years.

- Footnote: “This report was prepared based on a mission before the COVID-19 pandemic. The analysis does not cover some of the additional deterioration of the fiscal situation in many SNGs. The proposals are directed to structural reforms for the future and the report does not discuss possible exceptional, temporary, and targeted measures, for example grants from the federal government, to help address the pandemic.”

### Recommended directions for reform
- Objective: enhance the subnational fiscal framework by promoting appropriate incentives, imposing credible hard-budget constraints, and reducing expectation of future bailouts by the federal government.
- Core elements proposed:
  - Greater fiscal transparency.
  - Rely to a greater degree (but not exclusively) on market discipline.
  - Improved design of fiscal rules.
  - Grant greater flexibility to SNGs (how to spend and when to borrow) conditional on abiding by fiscal rules.
  - Reduce the number of sanctions and make them more gradual to improve effectiveness.
  - Strengthen legal tools to address highly indebted governments and eliminate ad hoc bailouts.
  - Complement with broader reforms to address structural challenges such as budgetary rigidities.

### Strengthening controls, reporting, and oversight
- Enhance the quality of fiscal reporting and external auditing to ensure SNGs abide by the FRL.
- Promote harmonization of accounting and adequate reporting; create a technical Fiscal Management Council to develop common standards for all levels of government and verify compliance.
- Improve internal controls to ensure integrity of data and budgetary procedures.
- Advance reforms to strengthen governance of the Courts of Accounts and promote harmonization in interpretation of the FRL.
- Mandate the independent fiscal institution or a new independent body to monitor fiscal policy and compliance with fiscal rules at the subnational level.
- Develop a strategy to reduce, and effectively prevent in the future, the large stock of spending arrears.

### Market access and the Fiscal Recovery Regime
- Allowing SNGs more freedom to access debt markets, without federal guarantees, would instill greater market discipline and complement fiscal rules.
- Current reliance on federal guarantees and public banks, together with repeated bailouts, distort incentives and give states with worse fiscal records lower borrowing costs.
- Propose an enhanced Fiscal Recovery Regime (Regime de Recuperação Fiscal, FRR) as the sole legal mechanism to address cases of highly indebted states or large municipalities in exchange for fiscal adjustment.
- To reduce legal uncertainty, programs under the FRR could be overseen by the judicial system, possibly the Federal Supreme Court.

### Fiscal-rule design recommendations
- Existing debt limits appear too high; states tend to suffer fiscal crises even at lower debt levels. Recommend lower safe debt limits consistent with SNGs’ capacity to service debt.
- Introduce subnational spending caps on the growth of total primary expenditures to reduce volatility and procyclicality.
- Replace or supplement the existing personnel spending limit, which has led to creative accounting, is procyclical, and has not prevented a rise in subnational current expenditures.
- For municipalities, consider a balanced budget rule and the introduction of rainy-day funds.

### Selected exact legal and numeric limits from the framework (preserved verbatim)
- The 1988 Constitution increased SNG roles; their share of total taxes rose from 25 in 1980 to around 35 percent more recently.
- About 23 percent of GDP in spending is equivalent to more than one-half of total public spending.
- Overall, Brazilian states have considerable revenue autonomy, as taxes provide nearly one-half of their revenue.
- Fiscal rules and administrative controls (legal basis and limits, preserved exactly as in Table 1):
  - Golden rule — Constitution: Credit operations (includes financial revenues) cannot exceed capital expenditures (includes amortizations).
  - Limit on personnel expenses — Fiscal Responsibility Law (FRL): personnel expenses as share of net current revenues (RCL) — 60%.
  - Debt ceiling — FRL, Senate resolution: Net debt as share of RCL — States: 200%; municipalities: 120%.
  - Debt service ceiling — Senate resolution: Annual debt service as share of RCL — 11.5%.
  - Spending limit (two years) — Law 156/2016: Limit on expenditures growth — zero real growth.
  - Administrative controls include annual limit for federal guarantees (Senate), limit on banks' credit (Resolution by National Monetary Council), limit on external credit (COFIEX), and limits set in debt refinancing contracts (PAFs) under Laws 9496/97, 8727/94 and 156/16, and MP 2185/2001.

_Italic: Source — PREFACE and EXECUTIVE SUMMARY, 1braea2020001_

### 6.      The new rule-based framework had mixed success in bringing subnational debt to

### 6.      The new rule-based framework had mixed success in bringing subnational debt to more sustainable levels

### Fiscal outcomes and debt distress
- In several states, including the largest ones, debt remained high throughout the period after the introduction of the FRL and some are now facing significant debt distress.
- Several states entered, or applied to enter, the FRR and have already stopped paying their debt service to the federal government: AP, GO, MG, RJ, RS.
- Several states defaulted on debt guaranteed by the federal government: AP, GO, MG, RJ, and RN; the federal government promptly paid creditors but could not recover the counter-guarantees from the defaulting states.
- Some states saw debt decline significantly to less than 100 percent of revenue (referenced as Figure 3 in source).

### Account payables (Restos a Pagar, RAPs) and liquidity pressures
- Many states accumulated significant RAPs, including states with lower debt in recent years.
- More than 1,100 municipalities ended 2019 with more RAPs than cash, indicating severe liquidity constraints.
- Liquidity is defined as total (or free) cash minus short-term liabilities.
- Several state capitals present high levels of RAPs (as a share of revenues).

### Breaches of FRL limits and personnel spending
- All but three states breached the intermediate limit of 54 percent of net current revenue (NCR); some breached the 60 percent limit in 2018, based on National Treasury data.
- About one-half of all municipalities had personnel expenditures that exceeded the intermediary limit or the 60 percent limit in 2018, according to Firjan (2019).
- In the state of São Paulo, about one-half of the municipalities breached the rule limiting RAPs accumulation in the last year of mandates to the level of available cash.

### Volatility and procyclicality of subnational spending
- The framework permitted volatile and procyclical spending at the subnational level.
- Expenditure real growth (in constant prices) tends to be unstable in several states (referenced as Figure 6).
- The elasticity of expenditure growth relative to annual current revenue tends to be high (referenced as Figure 7).
- Example: over the past 10 years, expenditure growth in Rio de Janeiro and Espírito Santo has been, on average, very low (or negative) but with large fluctuations reflecting oil price shocks and, for Rio, high indebtedness.

### Explanatory factors for weak outcomes
- Economic factors: Brazil experienced a deep recession in 2015–16 that affected all levels of government.
- Structural factors: rising pensions contributed to fiscal deterioration.
- Design and implementation weaknesses:
  - The FRL framework tends to promote procyclical behavior because many limits and rules are calculated as a share of net current revenues, which are highly volatile; widespread revenue earmarking exacerbates this.
  - History of federal bailouts and loosening administrative controls that allowed excessive borrowing.
  - Difficulty monitoring fiscal rules due to lack of consistent accounting standards and, in some cases, poor data quality.
  - Weak internal and external controls enabled creative accounting, extrabudgetary spending, and payment arrears that circumvent the rules.
  - Significant legal uncertainty from courts granting injunctions that prevent enforcement of sanctions; when a state defaults on federally guaranteed debt, the Union has not been able to collect on counter guarantees.

### Need for complementary reforms (preview)
- The report signals that reforming the rules-based framework requires strengthening budgetary systems, increasing transparency, reinforcing controls, and reducing structural rigidities; a reform that fails to address these PFM and governance shortcomings is unlikely to succeed.

### Strengthening reporting, accounting standards, and oversight
- The FRL established reporting obligations and accounting standards, but these have not been followed consistently; fiscal data are reported inconsistently and quality varies across states and municipalities.
- Differences in accounting methodology impede assessment of compliance and comparability across SNGs; examples include personnel expenses sometimes excluding costs of pensions of civil servants’ dependents despite FRL guidance.
- The Fiscal Management Council (FMC) envisaged in the FRL has been delayed; the STN has assumed a role by issuing the Manual of Applied Accounting for the Public Sector (MACSP) and a standard chart of accounts (CoA), updated yearly to converge to IPSAS and GFSM 2014. Compliance with MACSP is mandatory, but application varies among states and municipalities.
- Full development of the matriz de saldos contábeis (a comprehensive consistent database for all levels of government) would be significant progress.
- Creation of a new FMC (under consideration by Congress) could enhance compliance; challenges include council composition and whether it should have authority to verify compliance across levels of government.
- An independent fiscal council could monitor SNG fiscal accounts and compliance; the Independent Fiscal Institution (IFI) could assume the role for states and large cities if its independence and resources are strengthened by law. Alternative: create state-level fiscal councils, ensuring independence and capacity.
- Suggested monitoring frequency: IFI monitor states and large cities annually; monitor other cities less regularly (for example, a random sample each year).

### Strengthening system of controls and Courts of Accounts (SCAs)
- Internal controls are weak across many subnational entities; commitment, liquidation, and payment stages are sometimes not properly registered in FMIS, enabling spending outside budgets, inconsistent TSA statements, cancellation of RAPs to meet end-year targets while debt persists, and constitutional transfers to municipalities in arrears.
- Audits by state and local Courts of Accounts (SCAs) vary significantly in interpreting and enforcing the FRL; there are 33 Courts of Accounts (including those of the state, four for municipalities, one for the city of São Paulo, and one for the city of Rio de Janeiro).
- Perceptions exist that some SCAs have allowed creative accounting or interpretations that contributed to excessive deficits and debt, partly motivated by reluctance to trigger sanctions affecting all branches of government.
- Examples of divergent practices include differences between National Treasury and state methodologies for measuring personnel spending (Figure 8).
- When SCAs detect problems, follow-up actions or enforcement of sanctions are often lacking; options include approve, approve with reservations, or reject accounts, but subsequent legislative follow-up is frequently absent. Courts sometimes issue injunctions to suspend rejection of accounts.
- For irregularities outside general accounts, Courts can apply sanctions including fines of up to 30 percent of the wage of the respective authority and disqualification from holding public office from five to eight years.

*Source: IMF staff analysis as presented in the provided content unit.*

### 21.      Several reforms to strengthen the governance of the Courts of Accounts and

### 1braea2020001 - 21.      Several reforms to strengthen the governance of the Courts of Accounts and

### Governance of the Courts of Accounts and proposed reforms
- The SCAs consists of seven judges; five are politically appointed, and two are chosen based on professional background or technical expertise.
- A proposal envisages changing composition so that four judges would be chosen based on relevant professional background, and three would be chosen based on political considerations.
- Another congressional proposal would grant the Federal Court of Accounts (TCU), in consultation with the SCAs, authority to settle different interpretations of the FRL, with binding power for all courts.
- Other initiatives include adopting a common procedural code for the Courts of Accounts and centralizing information from different courts.
- There are regular reviewers of the Courts of Accounts, but these reviews are not published unless the individual SCA agrees to do so.
- INTOSAI notes it is critical to ensure the independence and professionalism of the audit institution.

### Judicial injunctions (liminares) and the fiscal responsibility framework
- Courts’ injunctions, including those by the Federal Supreme Court (STF), can take years to be decided and grant temporary injunctions that, in practice, can last many years with significant financial consequences for the Union and subnational governments.
- Effects include impacts on debt owed to the federal government, guarantees, and transfers between levels of government, creating judicial uncertainty and incentives to escape sanctions through injunctions.
- Courts tend to side with states against the Union in the majority of cases, often on the basis of defending provision of basic public services or procedural issues (e.g., lack of right of defense when a guarantee is to be executed by the Union).
- Sanctions are usually not progressive and involve severe consequences when infringements occur, which may partly explain courts’ reluctance to enforce the FRL and apply sanctions.
- In recent years, at least four highly indebted states (Goiás, Minas Gerais, Rio de Janeiro, and Rio Grande do Sul) and one less indebted state (Amapá) obtained injunctions from the Supreme Court to suspend debt service payments and/or prevent execution of collaterals on debt guarantees.

### Sanctions, remedial measures, and incentives
- The report argues for emphasis on progressive measures across three phases:
  - preventive measures (applied at the risk of infringement),
  - corrective measures (verification of noncompliance),
  - coercive measures (persistence of noncompliance), with progressively harder consequences.
- Corrective measures may not necessarily entail sanctions; legislation could specify steps necessary to correct deviations from debt or expenditure limits and allow avoidance of sanctions if steps are taken (e.g., adjustment program).
- Positive incentives could support compliance; current framework emphasizes sanctions but provides limited incentives for cooperation and compliance.
- Consideration to reduce complexity and increase flexibility in the framework; reform proposals would eliminate the need for some administrative controls and procedures.

### Structural imbalances and budgetary rigidities
- High degree of budgetary rigidities compromises implementation of fiscal rules and fiscal sustainability.
- Example states:
  - In the State of São Paulo, discretionary spending accounts for less than 10 percent of total expenditures; in Goiás, it is even less.
- A key source of spending pressure: subnational social security (SS) due to aging population; several states are considering or implementing reforms to contain rising SS deficits.
- The sum of personnel expenses and interest expenses averaged 60 percent of total expenditures across states in 2017.
- Subnational pension systems:
  - Aggregate deficit reached 1.4 percent of GDP in 2017.
  - Projected to increase to 2.9 percent of GDP by 2030 absent pension reform.
- Additional rigidities: constitutional minimum expenditures on health and education, revenue earmarking, indexation rules such as minimum wage growth, and other subnational spending mandates.
- Excessive revenue earmarking and mandatory spending are exacerbated by lack of medium-term fiscal frameworks; SNGs grant large wage increases with little consideration of medium- and long-term impacts and have limited analysis of risks and high yearly revenue volatility.

### Intergovernmental transfers and fiscal capacity
- Transfers to states and municipalities can be the main source of revenue:
  - Transfers represent from 70–90 percent of all revenue for states in the Northern region.
  - For small municipalities, transfers can constitute 90 percent of their resources.
- Identified issues:
  - Many small municipalities have very limited capacity to tax or spend well or to comply with the FRL; debate in Congress on reducing number of very small municipalities.
  - Many transfers are earmarked, contributing to budgetary rigidities and limiting SNGs’ management tools.
  - Federal tax system decisions, including tax incentives, affect transfers received by SNGs.
  - Transfers framework is based on outdated criteria that can distort incentives (e.g., favor small municipalities) and often does not consider revenue capacity or needs of different SNGs.
  - Caution advised on assigning more oil revenue to SNGs given high volatility; SNGs may be less able to manage such volatile resources and risk excessive spending growth during booms and hard adjustments when prices fall.

### Rising expenditure arrears (RAPs) and economic effects
- There is no official definition of payment arrears in Brazil; governments publish data of RAPs used here as proxy.
- For states, RAPs rose to an estimated 1½ percent of GDP in 2019.
- Minas Gerais example: average financing through RAPs has been equivalent to one-third of its net current revenues in recent years.
- States with lower debt-to-revenues ratios have also used RAPs: Amapá, Mato Grosso, Rio Grande do Norte, and Roraima.
- Accumulation of arrears can:
  - disguise true government deficits,
  - reduce economic growth by harming financially firms that supply government,
  - raise future fiscal costs if suppliers increase prices to compensate for payment risk.
- No effective framework to contain RAPs across levels of government except in the last year of government mandates; the FRL only imposes limits on RAPs in election years.
- Clearing arrears practices vary: some states publish timelines/criteria; others use ad hoc approaches (auctions, prioritizing suppliers agreeing to larger discounts, paying part of wage arrears depending on cash flow).
- Mixed external audit action; some Courts of Accounts have sanctioned abuses, other cases lack enforcement.
- Use of despesas de exercicios anteriores (DEA) is increasing to mask deficits and arrears; DEA should be used only in exceptional cases.

### Strategy to clear arrears and prevent future accumulation
- Standard arrears clearance strategy should begin by taking stock of arrears to understand extent, composition, and vintage and to prioritize clearance, including:
  - Establish a centrally maintained database of validated outstanding payments by the state’s Secretariat of Finance showing discharge and subsequent additions.
  - Set prioritization criteria: socioeconomic impact, vintage, cost (interest/penalties), risk (legal action, disruption of essential services, cost escalation), currency and creditors (intra-government debts administratively cleared via annual budget at minimal net cost).
  - Repayment modalities could include: cash payments (possibly with discount); rescheduled payments with predefined calendar and interest rate; earmarked loans; securitization of arrears via promissory notes discountable by commercial banks, marketable treasury bills, or bonds directly to creditors.
- Preventive measures to avoid future RAPs:
  - Clarify legal framework to ban or discourage RAPs (e.g., define payments in arrears and specify number of days after which penalty interests apply).
  - Strengthen transparency requirements: require detailed publication of stock of arrears with vintage and type of creditor.
  - Consider progressive corrective measures for late-payments and good-practice codes and regular supplier contact.

### Recommendations (summary)
- Promote transparency and strengthen system of controls:
  - Promote greater harmonization of accounting and reporting standards; create a Fiscal Management Council to develop common standards for all levels of government and verify compliance.
  - Create an independent fiscal council to assess financial health of SNGs and compliance with fiscal rules; mandate could be given to Senate’s IFI, requiring legal strengthening of its independence, clear mandates, and additional resources.
  - Invest in internal controls to ensure data integrity and budgetary procedures; reinforce integrated financial management system to increase controls prior to payments.
  - Advance reforms to strengthen governance of SCAs and harmonize interpretation of the FRL.
  - Review current sanctions to improve effectiveness and add more gradual sanctions and remedial actions.
- Reduce budget rigidities:
  - Reduce excessive budget rigidities including revenue earmarking, mandatory spending, and indexation to improve fiscal management and compliance with rules.
  - Review transfers system to ensure balance of revenue assignments and spending responsibilities, considering effective cost of public service provision, assumed responsibilities, federal transfers, and whether SNGs use their tax capacity.
- Clearance of arrears:
  - Design and publish a strategy for clearance of arrears including temporary and structural measures; start by taking stock to understand extent, composition, and vintage and prioritize clearance.
  - Consider legal measures to avoid accumulation of future payment arrears (define payments in arrears; specify days after which penalty interests apply).
  - Require detailed publication of stock of arrears with vintage and type of creditor.

### Design of subnational fiscal rules
- The FRL sets limits on debt and personnel expenditures; states that breach limits on debt (levels, services, issuance) or on personnel expenditures are forbidden from further credit operations and prevented from receiving new voluntary federal transfers.
- FRL contributed to a substantial decline in subnational indebtedness during its first decade, reducing stock of public sector debt of states and municipalities from almost 20 percent of GDP in 2002–03 to nearly 10 percent of GDP a decade later.
- Despite considerable debt relief granted by the federal government in recent years, subnational debt has increased by 2 percent of GDP since 2014.
- Given the history of bailouts, fiscal rules are effective only as part of broader reforms: combination of fiscal rules, greater fiscal transparency, and market discipline.
- Under proposed revamped framework:
  - Preconditions include reliable data reflecting fiscal and financial situations of states and local governments.
  - Subnational governments should face hard-budget constraints and not depend on regular bailouts by the Union.
  - Many regulations could be reduced, giving more flexibility to SNGs; governments that abide by fiscal rules could decide when and how to borrow in debt markets without federal guarantees.
  - Participation in debt markets would add incentives for transparency and prudent fiscal/borrowing policies because states with weaker records would face higher borrowing costs.
- Federal measures cited:
  - In 2014, federal government conceded retroactive debt relief estimated near R$ 100 billion (1½ percent of GDP).
  - In 2016, federal government reduced SNGs’ debt service payments for 24 months while extending repayment schedule by 20 years, estimated to have reduced SNGs’ debt service by R$ 50 billion; in exchange states were required to adopt a spending cap for two years with mixed evidence of compliance.

*Source: IMF staff analysis in the provided content.*

### Box 3. Deeper Reform to Increase Flexibility and Fiscal Responsibility

### Box 3. Deeper Reform to Increase Flexibility and Fiscal Responsibility

### Greater access to debt markets and strengthening market discipline
- About 90 percent of the states’ outstanding debt involves the federal government—either via direct lending through federally owned banks or via federal guarantees.
- Current structure creates incentives for strategic defaults by subnational governments.
- Policy recommendations:
  - Grant SNGs more freedom to access debt markets without federal guarantees to promote market discipline; complement this with fiscal rules so better-disciplined states receive lower borrowing costs.
  - Use increased market access to give SNGs greater flexibility to borrow for investment or to manage negative shocks (for example, temporary declines in tax revenues).
  - Make an enhanced Fiscal Recovery Regime (FRR) the sole mechanism to provide debt relief to SNGs to avoid ad hoc bailouts. Elements to include:
    - Gradual debt relief conditional on meeting FRR conditionality (structural reforms and fiscal targets). Avoid large upfront debt relief that creates incentives to delay fiscal adjustment.
    - A gradual system of sanctions that enables insolvent states to continue fiscal consolidation in the event of limited deviations from original program targets; consider delaying debt relief until compensatory measures are taken.
    - An explicit approach to bring outstanding debt stock and the debt service burden to more sustainable levels, in line with fiscal rules; set explicit goals for the adjustment plan to enhance transparency on costs of insolvency and burden sharing.
    - Extend the FRR to include private creditors: current FRR allows insolvent states to auction arrears but lacks provisions for private creditors and no general obligation for a plan to clear RAPs; a rules-based framework should include private creditors and establish clear priorities for treatment of collaterals.
    - Consider judicial oversight of the FRR (possibly by the Supreme Federal Court) to reduce legal uncertainty and ensure procedural and substantive fairness, especially if debt restructuring is involved.
    - Create an SNG-owned fund as a lender of last resort in cases of financial distress to better manage the risk of strategic default and complement other control mechanisms; the fund would impose conditionality and monitor fiscal adjustment. Federal government commitment to a no-bailout policy is important to ensure FRR and fund credibility.

### Key facts on current subnational indebtedness and debt service
- Four states have consolidated debt above 200 percent of net current revenues (NCR), accounting for approximately 75 percent of all states’ consolidated debt.
- The four highly indebted states are Minas Gerais, Rio de Janeiro, Rio Grande do Sul, and São Paulo. In addition, three smaller states have somewhat high debt-to-revenues ratio: Alagoas, Goiás, and Santa Catarina. Together, these seven states account for more than 80 percent of the total subnational debt outstanding.
- The present debt limit in the FRL is net consolidated debt of 200 percent of NCR.
- Historical debt service:
  - Cross-States Average 1997-2014: 14 percent (debt service as percent of net current revenues).
  - Cross-States Average 2015-2017: 7 percent (debt service as percent of net current revenues).
- Since 2014, average debt service was cut by one-half, reflecting significant debt relief by the federal government and the low interest rate environment.
- Even so, the average implied interest rate on the net debt has been more than 6 percent for most states in recent years.

### Simulations, stress tests, and thresholds
- Simulations show debt levels above 150 percent of revenues will generally be associated with debt service higher than what states have been able to manage.
- Example simulation insights:
  - For an SNG with a debt-to-net-revenues ratio of 90 percent and average residual maturity of 20 years, debt service will range around 10 and 15 percent of net revenues.
  - Debt service burden rises significantly with higher debt stock, shorter maturity, or interest rate increases.
- Stress tests for Pernambuco and Santa Catarina using historical revenue volatility produced three shock scenarios:
  - Scenario 1: one-standard deviation downward shock on the annual rate of growth of revenues for one year.
  - Scenario 2: one-standard deviation downward shock on the annual rate of growth of revenues for two years.
  - Scenario 3: one-standard deviation upward shock for one year.
- Stress test outcome:
  - Under Scenario 2, Pernambuco’s debt-to-revenue ratio could jump by close to 50 percentage points in the space of a few years (assuming no policy response).

### Recommendations for debt ceilings and correction mechanisms
- Suggested safe debt ceiling: around 100–120 percent of NCR would be compatible with an affordable debt service and would create a buffer to manage adverse shocks.
- Calibration notes:
  - The debt ceiling could be set as a share of an average of past years (for example, five to 10 years) net current revenue to reduce indicator volatility.
  - Significantly reducing the debt ceiling to 100–120 percent would require an adjustment plan for only a few states, though the largest ones have debt considerably above the ceiling.
- Automatic correction mechanism proposals:
  - Introduce intermediate thresholds under which a state would need to adopt an adjustment plan (for example, including a primary balance target) to bring debt under control over a prespecified time horizon.
  - While a state is between the intermediary threshold and the limit, prohibitions on new borrowing and transfers could be less restrictive while the state approves an adjustment program.
  - Such adjustment program could be reviewed by an independent fiscal institution.
- States under debt distress should enter the FRR; the FRR should be the only legal mechanism to address highly indebted federative entities that breach debt limits in exchange for a credible fiscal adjustment and, if needed, a debt restructuring strategy that involves all creditors.

### Municipalities: limits and balanced budget option
- The average net debt for non-capitals during 2016-2018 was zero or negative for most states, with exceptions of Bahia and São Paulo.
- Two large state capitals—Rio de Janeiro and São Paulo—had average net debt-to-revenues around 60-80 percent during this period.
- Policy options:
  - Consider significantly reducing the debt limit for municipalities, possibly differentiating between large cities and smaller municipalities.
  - Alternatively, shift to a balanced budget rule for all municipalities, consistent with most municipalities having limited capacity to borrow and overall deficits around zero.
  - Encourage municipalities to create “rainy day funds” to accumulate savings when revenues are higher than expected and finance budgets when revenues fall.

### Options for new quantitative fiscal rules: debt limits and spending limits
- Debt limits:
  - Existing debt limits are not binding for most states and seem too high given past debt distress; the current FRL limit of 200 percent of NCR appears too high as states reaching that level tend to face large and disruptive fiscal adjustments and federal bailouts.
- Spending limits:
  - Introduce a ceiling on expenditure growth for states to reduce high procyclicality of expenditure; subnational revenues are volatile in real terms and often more volatile than real GDP, resulting in volatile expenditure growth.
  - Proposed design:
    - A subnational spending cap applying to growth of total primary current expenditures, similar to the federal rule.
    - Target could be set in the FRL or allow states to set their own limits within broad FRL guidelines.
    - One proposal: set the real growth limit on total primary expenditures based on the trend growth of the state’s current revenues—for example, equal to or less than the average growth of real revenues over the past decade.
    - The quantitative limit could be reviewed and, if necessary, revised every four to five years.
    - For SNGs that rely heavily on commodity revenues, adopt more prudent strategies; revenue windfalls from nonrenewable resources should be saved, implying more conservative expenditure limits to avoid boom-bust cycles.
- Implementation considerations:
  - Given complexity and uneven technical capacity across states and municipalities, municipalities could be expected to adhere to state-specific primary spending cap rules.

*Source: Box 3. Deeper Reform to Increase Flexibility and Fiscal Responsibility (consolidated from the supplied IMF content).*

### 48.      The new rule has several advantages over the existing cap on personnel expenses,

### 1braea2020001 - 48.      The new rule has several advantages over the existing cap on personnel expenses,

### Advantages of an expenditure growth ceiling versus a personnel cap
- The expenditure growth ceiling ensures control of total primary expenditures while giving states the flexibility to manage the composition of their spending.
- The personnel limit is based on its relationship to volatile yearly revenue; the expenditure growth ceiling would be more stable and thus a better tool to avoid excessive spending growth during booms or the need for cuts in economic downturns.
- The expenditure growth rule would be less subject to creative accounting than the existing limit on personnel spending (or the golden rule), though high transparency in reporting and monitoring remains crucial.
- The expenditure growth limit provides more flexibility to manage the budget, but addressing the high degree of budgetary rigidities to ensure the rule is effective over time remains a priority.

### Economic simulations and interaction with debt limits
- Simulations use historical data for the State of Pernambuco for 2001–16 to compare two alternative fiscal rules:
  - Spending cap scenario: assumes primary expenditures growth at a constant annual growth rate of 5 percent from 2010 onward (similar to Pernambuco’s own average over 2001–09).
  - Primary rule (primary target) scenario: replaces the actual primary-to-revenues ratio from 2010 onward with a constant ratio of 3 percent (similar to Pernambuco’s average over the previous six years).
- Findings from the simulations:
  - The expenditure ceiling delivers a more stable expenditure path.
  - Debt falls in years when the economy and revenue are strong and rises when revenue falls, conditional on debt being kept at safe levels to avoid reaching the debt limit.
- Note on calibration and interpretation:
  - Caution is advised regarding linking expenditure growth to the behavior of oil prices; analysis should focus on longer trends and account for the nonrenewable nature of oil resources.

### Escape clauses for exceptional shocks
- Rules should include escape clauses for severe economic downturns, natural catastrophes (example: Brumadinho dam disaster in Minas Gerais in 2019), pandemics (example: COVID-19 in 2020), or other national emergencies.
- Design principles for escape clauses:
  - Be precise on the definition of exogenous shocks that trigger legal deviation from the rules.
  - Specify the expected time for SNGs to return to compliance with the rules.
  - Ensure escape clauses are used only when necessary to address specific shocks and not to accommodate fiscal slippages due to other factors, to preserve credibility and robustness of the fiscal framework.

### Recommendations for the new fiscal framework
- Base the framework on improved fiscal rules, stronger external audits, greater transparency, and increased market discipline.
- Allow SNGs more freedom to access debt markets without federal guarantees to instill greater market discipline, complemented by fiscal rules.
- Enhance the FRR as the only legal mechanism to address cases of highly indebted states in exchange for a credible fiscal adjustment.
- Specific rule design recommendations:
  - Introduce subnational debt limits that ensure fiscal sustainability with high probability under adverse scenarios; consider complementing these with an automatic correction mechanism.
  - Introduce subnational spending caps on the growth of total primary expenditures to reduce volatility and procyclicality of public expenditures.
  - For municipalities, consider introducing a balanced balance rule and rainy day funds.
  - Establish well-defined escape clauses that allow temporary deviations from the rules under extraordinary circumstances and offer a legal path for resuming fiscal sustainability over the medium term.

### Annex I — System of Intergovernmental Transfers (high-level elements)
- Main intergovernmental transfers listed: States and Federal District Participation Fund (FPE); Municipalities Participation Fund (FPM); FUNDEB; Royalties; Transfers under the National Health System (SUS); Manufactured Products Tax Relative to Exports (Lei Kandir).
- FPE evolution rules since 2016:
  - Amount received by each state in the same period in 2015 corrected by inflation and 75 percent of Gross Domestic Product change determine distribution.
  - If the reference value (based on the 2015 level) is less than the amount of the resources (21.5 percent of IR and IPI), the reference value is transferred based on coefficients defined in Supplementary Law nº 62/1989; the rest depends on coefficients annually defined by the Brazilian Federal Court of Accounts (TCU).
- FUNDEB resources come from 20 percent of specified sources (including FPE, FPM, ITCMD, ICMS, IPVA, ITR, IPI, and transfers foreseen in Supplementary Law nº 87/1996); the federal government supplements with 10 percent of the total amount.
- Distribution criteria and earmarking:
  - Every state and the federal district has its own fund (27 accounting funds).
  - Criteria for distribution among municipalities are numbers of students enrolled in infant education and in elementary and high school education.
  - At least 60 percent of FUNDEB expenses must be applied to improve teachers’ salaries.
- Transfers related to health care depend on several factors including demographics and health network characteristics.
- Transfers from states to municipalities include 25 percent of ICMS and 50 percent of IPVA.

### Annex II — Spain’s strategy to control spending arrears (high-level elements and figures)
- Context and scale of the problem:
  - Aggregate commercial public debt rose from 57.1 billion euros (5.3 percent of GDP) to 87.3 billion euros (8.1 percent of GDP) between 2007 and 2011.
  - In 2011, SNGs, autonomous communities, and local entities accounted for 75 percent of the total arrears.
- Two types of measures in the Spanish strategy:
  - Temporary measures to clear the stock of arrears (extraordinary funding mechanisms such as the Payments to Suppliers Fund and the Autonomous Communities Liquidity Fund).
    - The Payment to Suppliers Fund mobilized around €)30 billion from the central government to suppliers of SNGs.
    - The total in loans from the extraordinary funds is well above €)250 billion as of today.
    - Those governments were required to sign 10-year loans with the central government, including conditionality and monitoring via adjustment plans.
  - Structural measures to avoid future arrears (transparency and monitoring using the average payment periods, APP).
    - APP is constructed with a common methodology by law and is monitored and published monthly by the central government.
    - The Basic Stability Organic Law establishes a system of sanctions similar to those applying to fiscal rules for SNGs; if APP exceeds certain limits, preventive, corrective and coercive measures apply progressively, with the central government ultimately able to block regular transfers and pay suppliers directly, deducting amounts from transfers.
- Transparency of APP and public monitoring play a central role in enforcing discipline.

### Annex III — Spanish regions’ progressive return to financial markets
- The central government’s extraordinary loan system (created in 2012) aimed to clear arrears and fund deficit targets; the system mobilized a total amount of €)277 billion.
- Financial conditions improved: most municipalities are in surplus and markets are willing to lend again.
- On July 5, 2018, an agreement established rules for the progressive return of regions to financial markets:
  - The agreement is independent of authorization regimes applicable in cases such as issuance of bonds, use of foreign currency instruments, and noncompliance with fiscal rules.
  - Regions eligible to start the transition had to meet conditions linked to compliance with fiscal targets in previous years, low average payment to suppliers, and a minimal credit rating of investment grade.
  - Eligible regions had to present a three-year Multiannual Debt Plan for feasibility assessment by the Ministry of Finance and the Treasury.
- Transition considerations:
  - The return to markets is likely gradual given short average debt maturity and accumulated amortizations.
  - Consideration of a temporary transition fund with a fixed end date of, for example, three to five years; after this period, the region should obtain funds only from markets.
  - Extraordinary mechanisms would remain as last-resort instruments, linked to strong conditionality and punitive interests.

*Source: IMF staff calculations and narrative from the provided chapter.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1braea2020001.pdf_