Brazil’s Bolsonaro Must Adopt Strict Fiscal Rules

This article appeared on Forbes.com on November 14, 2018.
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Jair Bolsonaro won a presidential run-off last month in Brazil. He will take office on January 1, 2019. A key member of Bolsonaro's government, which he plans to slim down from its current bloated size, is Paulo Guedes. He is slated to lead a newly created Ministry of the Economy. Guedes is a Chicago-trained (Ph.D.) who embraces liberalism in the Continental free-market sense. Whether the Bolsonaro-Guedes team will be able to clone the free-market reforms of Chile's Chicago Boys of the Pinochet era remains to be seen.

Indeed, I am reminded of conversations I had with my good friend, the late Roberto Campos. Roberto resides in the pantheon of great Brazilian liberals. And, when it came to the political economy in Brazil, he had vast experience and knew the score. After all, he was a member of the Brazilian delegation to the Bretton Woods Conference in 1944, served as an ambassador to both the U.S. and the Court of St. James, and was the minister of planning in the Castelo Branco government. Roberto was also a member of the Brazilian Congress, a body which he invited me to address on the topics of currency reform and privatization in October 1993. And here is what the sagacious Campos had to say about liberalism and Brazil: "Admitting to liberalism explicitly is as outlandish in a country with dirigiste culture as having sex in public."

To successfully implement liberal, market-oriented reforms, confidence, and credibility are of primary importance. As Keynes argued in The General Theory: "The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention."

Most economists have completely ignored this passage in The General Theory, because confidence is difficult to define and insert in any formal model. Economists find it difficult to quantify and measure. Keynes admitted as much. Perhaps this explains the failure of economists to consider confidence seriously. Yet, it is clearly unsatisfactory to confine analysis only to definable and quantifiable magnitudes and to ignore an important determinant of behavior simply because it cannot be encapsulated in any neat definition or be measured by government statisticians.

Unlike Keynes, I suspect that there is much to be said a priori about the state of confidence. For example, it seems likely that confidence is determined by the general credibility of government policy. And, the best way to establish credibility is with a confidence shock that is delivered by solving a so-called insurmountable, endemic problem.

Brazil has many endemic problems to choose from. That's why it holds down the ignominious 144th rank out of the 162 countries in the Fraser Institute's Economic Freedom of the World 2018 report. But, it is Brazil's bloated government and budget that are in the critical care unit and in need of immediate attention. Indeed, the Fraser Institute's report ranks Brazil's "size of the government" with a dismal rank of 138 out of 162 countries. In contrast, Chile ranks 15th in terms of the size of government.

So, to deliver a confidence shock, the Bolsonaro government must establish:

1. Fiscal order and transparency. Brazil lacks the fiscal institutions to guarantee that budget deficits and government spending can be controlled. To put its fiscal house in order, Brazil's government should begin to publish a national set of accounts which includes a balance sheet of its assets and liabilities and an accrual-based annual operating statement of income and expenses. These final statements should meet International Accounting Standards and should be subject to an independent audit.

Just what is an accrual-based operating statement? At present, accounts in Brazil are kept on a crude cash basis. Revenues and expenditures are recorded when cash is received or paid out. With accrual accounting, spending and revenues are recorded when they are incurred, regardless of when the money actually changes hands. Accrual accounting gives a much more accurate picture of the realities and avoids many financial tricks that politicians can play with cash accounting. For example, under cash accounting, politicians can promise pensions for future retirees, but since no money is paid until people retire, there are no budgeted costs under cash accounting until the pensions are paid. With accrual accounting, the promises to pay future pensions would appear in the government's accounts when the obligations for future payment are made. Consequently, under accrual accounting, the government cannot distort the magnitude of its spending obligations.

Do any countries use accrual accounting for their public accounts? Yes. For instance, New Zealand started to use it in 1989. As a result, New Zealand presents a far more transparent and honest picture of government operations than do most other governments. This has allowed New Zealand to make more informed decisions and control the state much better.

To reduce corruption in Brazil, there is no better medicine than the transparency which would accompany a New Zealand-type of fiscal accounts.

2. Supermajority voting must also be established for important fiscal decisions. Many countries require supermajority voting for important decisions. Such a voting rule protects the "minority" from the potential tyranny of a simple "majority." A supermajority voting rule is particularly important for the protection of minorities in countries, like Brazil, where the democratic process is not circumscribed by a firm rule of law.

Fiscal decisions are important. The arithmetic of the budget shows us that two new fiscal rules would be sufficient to control the scope and scale of the government and protect minority interests. Total outlays minus total receipts equals the deficit, which in turn equals the increase in the total outstanding debt. Rules that limit any two of these variables would limit the other variables. Which two variables should be limited?

Before I answer that question, I should remark that the goal of reducing Brazil's total public debt to something less than 50% of GDP during Bolsonaro's first term is desirable and that it should be vigorously pursued by his administration.

The easiest way to answer the question about which two variables should be limited by supermajority voting rules is to sketch an amendment to the Brazilian constitution:

Section 1. The total Brazilian debt may increase only by approval of two-thirds of the members of the Congress.

Section 2. Any bill to levy a new tax or increase the rate or base of an existing tax shall become law only by approval of two-thirds of the members of the Congress.

Section 3. The above two sections of this amendment shall be suspended in any fiscal year during which a declaration of war is in effect.

3. The tax system must be simplified and tax rates must be lowered. Brazil's tax system is too complicated and tax rates are too high. In consequence, economic incentives are distorted, and the formal economy is unnecessarily burdened. Not surprisingly, corruption is widespread and the gray economy flourishes.

If Bolsonaro is to be successful, he must quickly establish credibility with a confidence shock. There is only one way to do so in Brazil and that's to attack the Brazil's fiscal mess with the adoption of new fiscal rules.

Steve H. Hanke

Steve Hanke is a professor of applied economics at The Johns Hopkins University and senior fellow at the Cato Institute.