Assessment and recommendations

Risks related to political developments are substantial

Risks to these projections include a failure to implement planned reforms, such as the much-needed fiscal adjustment. If the new expenditure rule is not adhered to, unsustainable fiscal dynamics could reduce confidence and trigger a return to recession. In particular, a successful implementation of the pension reform, without which the expenditure rule cannot be met in the medium term, will be a litmus test for the ability of the authorities to implement further structural reforms. Higher volatility on financial markets related to a normalisation of US monetary policy could also present risks for Brazil, although bouts of volatility have been well managed by the Central Bank in the past. Reserves and the strong FDI component of inflows would cushion related exchange rate risks.

In the banking sector, capitalisation exceeds regulatory requirements mitigating solvency risks (Figure 6). Stress test results point to an ability to withstand substantial shocks to growth or risk premiums (BCB, 2017; IMF, 2017a). In some sense, the severe downturn has acted like a real-world stress test for financial institutions, which have anticipated the recession by tightening credit standards and increasing fee income, and have remained solid. However, non-performing loans have risen and around a third of firms have interest obligations exceeding their earnings. Under adverse scenarios, this share could rise to 40%, corresponding to around 15% of total outstanding corporate debt (IMF, 2017a). On the household side, financial education has a role to play for prudent borrowing decisions and the resulting asset quality, as well as for fostering financial inclusion (Banco Central do Brasil, 2015, OECD, 2015h).

Figure 6. Financial markets contain risks, but these appear manageable

1. Unweighted average of 24 OECD countries with available data.

2. Unweighted average of 30 OECD countries with available data.

Source: CEIC, Central Bank.

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The flexible exchange acts as a shock absorber, but in interaction with unhedged foreign-currency debt it can create risks. The corporate sector, whose debt amounts to around 43% of GDP, is exposed to exchange rate risk as unhedged corporate liabilities of non-exporting firms in foreign currency amount to around 9% of GDP (BCB, 2017). By contrast, external debt is not a vulnerability for the public sector, with only 3.6% of public debt denominated in foreign currency and 12.7% of domestic public debt securities held by non-residents. Economy-wide external debt has risen over the past 5 years but is lower than in most emerging market economies (Figure 7). The total amount of external debt to be rolled over within 12 months amounts to 40% of currency reserves.

Figure 7. External debt has risen but currency reserves are high

1. The external debt definition used here includes intercompany lending and domestic fixed income securities held by non-residents.

Source: CEIC, Central Bank

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Enhancing the efficiency of public expenditures, including tax expenditures

Brazil spent over 15% of GDP on social benefits in 2016, corresponding to 35% of total public sector expenditure (Figure 14). Social benefits are responsible for more than half of the increase in primary expenditures and continue to outpace GDP growth. Several of these programmes are crucial for more inclusive growth but much can be done to raise the social returns through better targeting towards those most in need of support. In some cases, this will require reconsidering acquired rights to reduce the inequalities across generations, recognising that the state has made promises that cannot be upheld for future generations.

Figure 14. Main functional areas of public expenditure

In percent of total public sector spending, 2016

Note: A significant part of the 4.5% of GDP that Brazil spends on private sector development programmes are not visible in this breakdown as they take the form of tax expenditures. Part of the cost of past transfers from the National Treasury to public banks that allowed an expansion of subsidised lending operations show up as interest payments in public accounts, as the National Treasury issued additional debt to finance these transfers.

Source: OECD calculations based on National Treasury data.

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A large and rising share of social benefits is paid to households that are not poor, which reduces their impact on inequality and poverty. Already, poverty is highest among children and youths (Figure 15). Limiting future increases in social benefits that mostly reach the middle class could help to increase social transfers with a strong inequality-reducing impact and a strong targeting towards children and youths, like the conditional cash transfer programme Bolsa Família. The attached conditionalities regarding school attendance and medical check-ups also help to reduce inequalities with respect to education and health, which in turn strengthens productivity.

Figure 15. Poverty is relatively high for young people

Source: OECD Income Distribution Database (IDD).

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Brazil’s constitution defines that many social benefits cannot be lower than the minimum wage, but the current level of the minimum wage is almost 7 times as much as the poverty line (Figure 16). In fact, it is even above the median income as more than 56% of Brazilians have incomes below the minimum wage. The minimum wage has increased rapidly over the years, and its real value is now 80% higher than 15 years ago while GDP per capita increased by only 23%. Maintaining the minimum wage as a floor for many social benefits will likely lead to a continuation of rapid increases, with the result that an ever larger share of benefits will be paid to those with above-median incomes and not to the poor.

Figure 16. Different benefits reach people at different income levels

Note: The blue line represents the income distribution of Brazil (or point density function). Higher values mean that more people have incomes of the corresponding level on the horizontal axis. The green line is the cumulative distribution function, showing how many people have incomes equal or lower than the corresponding income level on the horizontal axis. The 2015 minimum wage of 788 BRL, for example, corresponds to the 56^th income percentile, meaning that 56% of Brazilians had incomes of BRL 788 or less in 2015.

Source: OECD calculations based on 2015 Pesquisa Nacional por Amostra de Domicílios, IBGE.

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A comprehensive social security reform has become the most urgent element of fiscal adjustment, and is also an opportunity to make growth more inclusive through better targeting of benefits. Brazil’s pension system costs almost 12% of GDP, which is high given Brazil’s young population (Figure 17). Pension expenditures have been largely responsible for the decline in the primary balance. All pension benefits are subject to the minimum wage floor, resulting in high replacement rates, in particular for low-wage earners. Aligning Brazil’s pension rules with those practiced in OECD countries would imply a minimum pension lower than the minimum wage, with eligibility to some prorated pensions for shorter periods. Indexing pension benefits to the consumer price index for low-income households would preserve the purchasing power of pensioners while improving the sustainability of the pension system. Sustainability would also be helped by establishing a formal minimum retirement age as current effective retirement ages of 56 years for men and 53 for women are far below the OECD average effective retirement age of 66 years for men and women (OECD 2015b). Without reform, pension expenditure will more than double, rendering the system clearly unsustainable (OECD, 2017a; IFI, 2017a). Moreover, the highly regressive subsidy element of the pension system with 82% of funds spent on the richest 60% would rise further (World Bank, 2017).

Figure 17. Pension reform is urgent

1. Accumulated over 12 months in BRL million.

2. Net replacement rates for a male full-career worker having entered the labour market in 2016.

Source: National Treasury, OECD Pensions at a Glance 2017.

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A pension reform bill has been submitted to Congress, and, if passed without significant amendments, would improve pension sustainability. Still, delinking the minimum pension from the minimum wage will become inevitable in the future. Moreover, aligning more generous pension provisions for civil servants with that of private employees would be another source of potential savings. Consideration should also be given to prorate the minimum contribution period of 25 years for those with fewer years of contributions to avoid difficulties for poorly educated workers migrating between formal and informal employment, as years spent in informal employment do not give rise to pension rights.

Beyond contributory pensions, different social assistance programmes could be coordinated better or merged to eliminate overlaps and duplication of benefits. Brazil spends around 0.7% of GDP on non-contributory pensions for disabled people and the elderly without pension contributions. With no means-testing, only 30% of this benefit reaches the bottom 40% of the income distribution, with the remainder accruing to the more affluent (World Bank, 2017).

The only truly progressive social expenditure is the 0.5% of GDP spent on the well-targeted conditional cash transfer programme Bolsa Família, which also helps families to move out of poverty over time by conditioning transfers on children’s’ school attendance and basic health check-ups. 83% of benefit outlays reach the bottom 40% of the income distribution. The maximum benefit for a whole family is less than a third of one minimum wage. These benefits have been subject to discretionary increases broadly following prices, but a planned adjustment for 2017 was suspended until 2018.

Bolsa Família is the only transfer where incremental spending would really reach the poor. It is also a key instrument to protect the most vulnerable, including women, Afrodescendants and people of indigenous origin, many of which still suffer discrimination, despite recent progress made (World Bank, 2016). A package of reforms that would sever the link between minimum benefit levels and the federal minimum wage while shifting at least some of the savings to Bolsa Família could have led to 63% faster declines in inequality over recent years (Arnold and Bueno, 2018). In the same vein, tax revenues lost with some consumption tax exemptions, such as basic food, would be more effectively spent on Bolsa Familia.

Labour market benefits have a strong focus on passive income support measures for the 64% of workers that are in the formal sector. With around 36% of employment currently informal, the existing unemployment protection schemes fail to reach the most vulnerable group of workers (IBGE, 2017).

Formal sector unemployment insurance consists of two parallel schemes, Seguro Desemprego and the individual unemployment accounts called FGTS. These two programmes have a joint fiscal cost of around 1% of GDP when considering government top-ups of withdrawals as expenditure. They could be merged gradually as they essentially serve the same purpose and the current mandatory employer contribution to FGTS of 8% of salaries raises the cost of formal employment. In the transition, account balances, whose remuneration has traditionally fallen short of inflation, should be remunerated at market rates to reduce the currently strong incentives for frequent job turnover, often involving self-induced layoffs by arrangement with the employer. Merging the two unemployment insurance schemes Seguro Desemprego and FGTS would allow savings that could finance extending the maximum coverage period of Seguro Desemprego. At currently 3-5 months, this period is short relative to an OECD average of 16 months.

Two overlapping employment subsidy programmes with a joint cost of 0.2% of GDP and no proven effects on formalisation, Abono Salarial and Salário Família, could be reconsidered as they reach only workers with above-median incomes given that the legal floor for this benefit is the federal minimum wage (Figure 16).

The fact that the most vulnerable segment of workers is not covered by labour market programmes as a result of informality limits their effectiveness as a broad-based insurance or support mechanism. Acknowledging that informality is a complex issue and will only recede over time, a stronger focus towards general income support schemes that protect workers would provide more effective insurance against income losses than benefits tied to a history of formal employment. This may strengthen the case for raising benefit levels in conditional cash transfer schemes, most notably Bolsa Família.

At the same time, further efforts to reduce informality will be key for more inclusive growth going forward. Informal employment offers not only lower job quality, but is also generally less productive (OECD, 2016e). Where informality affects entire firms, as it often does, it precludes access to financial services, credit, and public procurement opportunities. Brazil can build on substantial progress in reducing informality, including programmes to reduce the administrative and tax burdens for micro and small enterprises to join the formal sector (World Bank, 2016; Silva et al., 2015; ILO, 2014). The recent labour market reform may also strengthen the incentives for formal job creation as restrictive regulation on formal labour markets has been identified as one factor behind informality (Estevão and de Carvalho Filho, 2012). Further improvements in the ease of registering a business may also improve incentives for firms and their workers to become formal, while enforcement efforts also have a role to play.

Public health expenditures of 4.4% of GDP finance Brazil’s unified public health system that provides public health services to the population since 1989. In comparison to other countries, the efficiency of health expenditure in Brazil appears to be low. International comparisons based on data envelopment analysis indicate Brazil could gain more than 5 years of health-adjusted life expectancy, a commonly used health indicator, through efficiency improvements, while maintaining current per-capita health expenditures (Figure 18; Chapter 2 of the 2015 OECD Economic Survey of Brazil). Significant savings could result from better coordination across different levels of government and care complexity, improving performance monitoring and strengthening incentives. Since 1990, Brazil has seen one of the strongest declines in child mortality in Latin America (World Bank, 2016). However, indigenous communities suffer from significantly worse health conditions, including higher child mortality rates, suggesting the need for a better focus on vulnerable and disadvantaged groups. Developing a more explicit definition of what is covered by the public healthcare system and what is not would allow a better focus of existing resources on the most important kinds of treatment and those most in need. This would include putting an end to the current practice of relatively well-educated and better-off patients suing the state to cover their drug expenses with no regard to their cost-effectiveness, which exacerbates inequalities. A tax deductibility of private health plan contributions paid by 25% of Brazilians and their employers has regressive effects and could be phased out, saving 0.3% of GDP (Castro, 2014).

Figure 18. Potential gains from greater spending efficiency on health

In years of health-adjusted life expectancy

Source: OECD calculations based on World Bank and WHO data.

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Brazil’s public sector spends 5.4% of GDP on education, above the OECD average and other Latin America Countries (Figure 19). However, while Colombia, Mexico and Uruguay spend less per student than Brazil does, they perform better in the OECD PISA tests, suggesting scope for raising spending efficiency (OECD, 2015f). Shifting spending from tertiary to the pre-primary, primary and secondary levels of education would simultaneously raise progressivity and efficiency. Free public tertiary education tends to benefit students from high-income families as graduates of private secondary schools tend to score better on admission exams. By contrast, early childhood education significantly decreases the likelihood of disadvantaged student dropping out from the education system later on (OECD, 2016p). When allocating scarce spaces in early childhood education, preference should be given to low-income households and single mothers, as this would allow more women to participate in the labour market. Only 15% of poor families with children below 3 years have access to child-care, compared to 40% of the more affluent families (World Bank, 2016). Although it has been narrowing in recent years, there is still a substantial gap in educational attainments between whites and Afrodescendants (World Bank, 2016).

Figure 19. High expenditures in education coincide with weak outcomes

Source: OECD Education at a Glance 2017; OECD PISA 2015 Results (Volume I): Excellence and Equity in Education.

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The public sector wage bill of 13.1% is high in international comparison (Figure 20). Following through on current plans to align entry-level salaries for civil servants with private sector pay has significant potential for saving as 39% of civil servant will retire within 10 years (World Bank, 2017). The efficiency of public administration could also be improved by further limiting the scope for political appointments, including in regulatory agencies and public enterprises. The executive’s right of political appointments is regularly passed on to parliamentarians to reward specific voting behaviour. Empirical research suggests that political appointments are associated with lower agency capacity, thus diminishing spending efficiency, and also the bureaucracy's ability to effectively combat corruption (Bersch et al., 2017). Especially in public enterprises, where technical or management experience is paramount, the rationale for political appointments is weak. The new SOE law of 2016 has effectively put some limits on political appointments in SOEs by defining minimum technical requirements for candidates.

Figure 20. Compensation of general government employees

In % of GDP, 2015

Source: Government Finance Statistics, IMF.

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Programmes specifically geared at parts of the industrial sector cost an annual 4.5% of GDP, most of which in the less transparent form of tax expenditures, but also subsidies. Rigorous evaluations of these policies are rare but existing evidence has failed to find significant benefits for productivity or investment (World Bank, 2017).

At 1.2% of GDP, the targeted tax regime for small and medium enterprises Simples Nacional combines a lighter tax burden with a simplified calculation of tax liabilities based on turnover. This encourages firms to stay small and reduces the possibilities to achieve productivity gains by sourcing intermediate inputs from potentially more efficient external providers (Caprettini, 2015; OECD, 2009b). For very small firms, the easier compliance may outweigh these considerations, especially considering that youth and women are overrepresented in informal micro- and small enterprises, either as workers or entrepreneurs (ILO, 2014). However, with a high participation ceiling of USD 1.5 million in turnover per year, the regime is currently used by 74% of Brazilian firms. Evidence that the scheme has been successful in fostering firm formality is limited to micro-enterprises in the retail sector (Piza, 2016; Monteiro and Assunção, 2012). In the context of a broader tax reform that would simplify the general tax system, lowering the participation ceiling of Simples Nacional would allow to narrow the scope of application of the targeted tax regime to firms where formalisation gains are more likely and the resulting distortions of the organisation of the value chain matter less. Such a reform would bring substantial productivity benefits for businesses and foster inclusiveness. At significantly lower fiscal cost, the Microempreendedor Individual programme, with a ceiling of USD 20 000 in turnover, has contributed to lower informality among low-income entrepreneurs, especially women (OECD, 2012c).

Special tax benefits have also been given to domestically-produced electronics and vehicles and to promote technological upgrading, often adding to trade protection. Some of these measures have recently been found in breach with WTO rules (WTO, 2017). In most cases, they have raised prices for consumers and increased income for producers, but there is no solid evidence of positive longer-run effects. In addition, large-scale tax benefits for producers in the Manaus Free Trade Zone, located in the state of Amazonas, and a few other special zones cost around 0.4% of GDP per year. Submitting these special regimes to systematic evaluations could allow identifying scope for fiscal savings.

State-owned enterprises (SOEs) play a sizeable role in Brazil. There are 141 SOEs in Brazil, with revenues on the order of 5% of GDP (OECD, 2015b; OECD, 2012a). The authorities have passed a new SOE law as a first step to harmonise and improve governance in 2016 and announced a package of privatisations of state-owned enterprises in 2017, including the electricity generator Electrobrás, oilfields, energy transmission lines, highways and several airports. While privatisations generate one-off revenues that can help improve fiscal accounts in the short term, the principal reason for undertaking them should be to improve governance mechanisms and raise efficiency. In Brazil, management positions in state-owned enterprises have often been political appointments, which tends to affect management quality and governance, and at the state level, political parties have maintained strong influence over local SOEs. This suggests scope for efficiency gains from private operation. The OECD Guidelines on Corporate Governance of State-Owned Enterprises (OECD, 2015b) can be a powerful tool to address governance challenges usually faced by state-owned enterprises attributable to political interference, lack of incentives to improve performance and complex institutional arrangements.

Estimates suggest that these proposals to raise spending efficiency could generate annual fiscal savings of up to 7.9% of GDP (Table 4).

Improving the fiscal framework

Brazil has made substantial progress on its fiscal framework, including the new expenditure rule and the recently established fiscal council (IFI), which has been publishing high-quality monthly reports, including fiscal projections and scenarios. Its establishment has been a recommendation in previous OECD Economic Surveys or Brazil (Table 5). Fiscal transparency has also made progress (IMF, 2017b). Further improvements could include systematic periodic policy impact evaluations for major expenditure items. Moreover, the widespread practice of budget appropriations by parliamentarians for projects in their constituency could be reduced and made more transparent, as empirical evidence suggests links between these appropriations and corruption (Azevedo and Colaço, 2010). Without systematic audits, these budgets are essentially used for coalition building, as evidenced by their sharp increases ahead of key parliamentary votes.

Enhancing the options for investment financing

Access to finance and high costs of credit have been a key impediment to investment. Dominated by the public development bank BNDES, long-term corporate credit markets may not be allocating scarce available funds effectively, as even long-term investments are overwhelmingly flowing into short-term, mostly overnight instruments. A competitive private credit market is likely to lead to better outcomes and the conditions for its development are now better than ever as BNDES lending rates will converge with market rates and returns on safe government bonds have declined.

At the extreme long end of the credit market, 53% of outstanding infrastructure loans are extended by BNDES, whose resources will be insufficient to meet future infrastructure needs. Drawing in more private funding requires relying on a wider variety of financial products to suit different kinds of investors such as international banks, sovereign wealth funds, foreign pension funds and multilateral development banks.

The focus of BNDES could evolve from being the principal source of infrastructure finance in Brazil to serving as a catalyst for mobilising private, including foreign financing. Co-financing requirements for investment loans are one way to engage private lenders. For large infrastructure loans, BNDES could arrange syndicated loans among several banks. BNDES could also lead the creation of structured financial instruments, tranches of which could be purchased by a wider range of institutional investors, including those that are limited to investment grade assets. Mimicking the practices of multilateral lenders, BNDES itself could invest in subordinate or mezzanine debt with loss absorption capacity to reduce the risk profile for other investors, or provide guarantees against certain types of risk to complement incomplete insurance markets. A shift of focus from lending to these kinds of instruments, some of which have already been used by BNDES in the past, would make more effective use of BNDES’ balance sheet, which could in turn be substantially reduced to leave more space for private lenders. At the same time, BNDES could shift its lending towards specific areas that the private sector is struggling to cover and where market failures are particularly prevalent, for example the financing of small start-ups and innovation projects. In most OECD countries that have public development banks, their focus is on such specific areas.

BNDES could also take a leading role in the transition towards the project financing model, which limits creditor recourse to the assets and cash-flows of the project, capping the downside for equity investors. Currently, most BNDES loans require collateral from the sponsor companies, thus narrowing the range of equity investors to all but the largest industrial companies, utilities or construction firms. As many large construction firms have been weakened by corruption scandals, diversifying the equity investor base to include investment funds or pension funds has become more urgent.

Improving the business climate to enhance investment returns

Beyond difficulties in accessing finance, Brazil’s low investment reflects an unfavourable business climate that raises costs and curtails returns on investment. Reforms in several areas could lead a long way to improve this and provide a much-needed boost to investment in Brazil.

One key element of this is a fragmented consumption tax system that raises the cost of capital by failing to refund input tax paid on fixed assets and makes Brazil the country with the highest tax compliance costs (Figure 23). Brazil’s 6 consumption taxes are levied in part by the federal government and in part by the states, each of whom applies its own tax code, tax base and tax rates. Companies wishing to offer goods and services nationwide are required to comply with all states’ tax rules (CNI, 2014). Tax credits for intermediate inputs accrue only if they are embodied in the final good sold which results in extensive use of tax accountants and frequent lawsuits over disputes.

One solution would be to consolidate the different consumption taxes into one value-added tax with simple rules, following the recent example of India and as recommended in the 2015 OECD Economic Survey of Brazil (OECD, 2017c, OECD, 2015g). The federal government could lead the way by consolidating its own consumption taxes into a single value added tax with a broad base, full refund for input VAT paid and zero-rating for exports. Once such a tax was established, state-level taxes could be integrated into this system as state-specific surcharges on the same tax base. This could be done in a gradual manner and would not preclude different states from applying different rates as long as the tax base is uniform and the destination principle is applied consistently for interstate commerce. A temporary compensation via the federal government of some states that are likely to face revenue losses from moving to the destination principle may help to allow these states to adjust gradually and would make it easier to reach a consensus, as has been done in India (OECD, 2017d).

Figure 23. Hours required to prepare taxes

For a benchmark manufacturing company, 2017

Source: World Bank (2017).

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Many industries are characterised by low levels of competition, which tends to foster rigid industry structures in which strong performers find it more difficult to grow at the expense of low-productivity firms. This has trapped resources in low-productivity firms with fewer investment opportunities and curtailed incentives for innovation and technological upgrading (Pinheiro, 2013; IEDI, 2011; IEDI, 2014; World Bank, 2018).

Both domestic barriers to entry and a lack of foreign competition have contributed to this. Brazil has scope to reduce administrative burdens and streamline licensing procedures for new businesses, to make sure its regulations do not unnecessarily hinder competition (Figure 24). Portugal, for example, has made positive experiences with applying a silence-is-consent rule in areas without major safety or environmental concerns. More generally, the OECD’s Competition Assessment Toolkit (OECD, 2010a) can provide guidance not only for identifying but also for revising policies that unduly restrict competition. Empirical results suggest that high administrative burdens are linked to lower firm productivity (Arnold and Flach, 2018).

Finally, industrial policies should provide neutral treatment across incumbents and entrants, and across different sectors of activity. Many industrial policies of the past have tended to cement existing industry structures, but the exit of less productive firms releases the resources that more successful firms need to grow to an efficient scale (Andrews et al., 2017). In addition, environmental licensing could be streamlined and made more predictable, without opening the door to wholesale exemptions from licensing.

Figure 24. Regulatory barriers to entrepreneurship are high

Indicator scaled from 0 (least restrictive) to 6 (most restrictive), 2013

Note: LAT includes Argentina, Chile, Colombia and Mexico. Data for Argentina are for 2016.

Source: OECD Product Market Regulation Indicators, 2013, available at www.oecd.org/eco/pmr.

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In infrastructure, reviewing some of the current regulations and practices, particularly in the structuring and preparation of projects before a tender call and at the subnational levels, could raise investment. Due to a lack of technical capacity, some projects have been structured by the same firms (or their subsidiaries) that later submit tenders. This reduces the number of bids received in the tender call, often down to one, and opens the door to anti-competitive behaviour (World Bank, 2016). The capacity for structuring infrastructure projects could be enhanced by providing more training to officials involved in infrastructure structuring. At the same time, the national development bank BNDES has built up substantial technical capacity in structuring projects and particularly state and municipal authorities could make wider use of its expertise.

While Brazil has 20 years of experience using concessions remunerated through user fees, public-private partnerships (PPPs) could serve as an additional tool where user fees are hard to implement. Despite a federal PPP law, there are only few cases so far, mostly involving subnational governments. Unifying policies and processes on how to prioritise, prepare, structure, and conduct bidding for PPPs across jurisdictions could reduce uncertainty and costs for investors (World Bank, 2016). However, in some countries, PPPs have been attractive in the past because the associated future liabilities were not properly recorded in the budget which shows the dangers of using PPPs without an appropriate and transparent accounting framework. As a lesson from these experiences, it is important to incorporate the full budget implications of PPPs over their whole life-cycle into the medium-term budget framework.

A new 2016 investment partnership law has created a new central entity attached directly to the presidency, tasked with selecting and prioritising projects and monitoring their implementation. The coordinating role of this central entity would be similar to the infrastructure planning done for the electricity network. The PPI Secretariat (Secretaria Executiva do Programa de Parcerias de Investimentos) is in line with international best practices and should remain well resourced, both financially and in terms of human resources. Environmental concerns should also be part of infrastructure planning.

The economy is shielded from global opportunities and foreign competition

This situation reflects trade barriers of various forms. Average tariffs levels weighted by imports are almost twice as high as in neighbouring Colombia and more than 8 times higher than in Mexico or Chile (Figure 27). Brazil’s most frequently applied tariff rate is 14%, while around 450 tariff lines are at the maximum of 35%, including textiles, apparel and leather and motor vehicles. Effective protection levels due to the cascading effects of tariffs at different levels of the production chain are 26% on average, but range between 40% and 130% for textiles, apparel, and motor vehicles, in ascending order (Castilho and Miranda, 2017). Brazil is the country with the highest number of tariff lines above 10%. In addition to tariffs, various forms of local content requirements are probably adding to the protection of domestic producers and model simulations suggest that they are at the root of significant reductions in imports and exports (Stone et al, 2015).

The high trade barriers preclude Brazil from many of the benefits of an increasingly integrated global economy. Both consumers and companies purchasing intermediate or capital goods are paying markedly higher prices than in other countries. Trade barriers on capital goods tend to be even higher than average tariffs and this may be a good starting point for tariff reductions as the benefits of lower-cost capital goods would spread across the entire economy. A special tax regime is in place to reduce import tariffs on capital goods, but it is applicable only if no equivalent domestic product exists, and Brazil has a sizeable capital goods industry. Brazilian firms use the least of imported inputs among Latin American and emerging market economies, which contributes to low productivity at the firm level (Brambilla et al., 2016).

Figure 25. Exposure to trade and participation in global value chains are low

Source: OECD Economic Outlook database, OECD, TiVA Nowcast Estimates.

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Figure 26. Brazil has remained on the side lines of global value chains

A map of global value chains

Note: A larger circle reflects an economy that is more connected within global production networks. A line reflects input flows exceeding 2% of total inputs used in the importing or exporting economy.

Source: Criscuolo and Timmins (2017).

Figure 27. Trade barriers are high, especially in capital goods

Source: World Integrated Trade Solution database (WITS).

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Moreover, providing a boost to competition will foster growth and job creation. Opening up would probably be the most effective way to strengthen competitive pressures in many industries. This would also support Brazil’s export performance which has declined by almost 25% over the past 15 years, while Mexico’s export performance has increased by 25%. Given their poor trade integration in general, Brazilian companies have also shown only scant participation in global value chains. In Latin America, Mexico and Chile exemplify how trade and the integration in global value chains can contribute to economic growth and resilience (OECD, 2017b, OECD, 2015c).

A stronger integration into international trade would support growth and social progress

Raising productivity, which has been largely stagnant over the last 15 years, will require embracing global opportunities more fully. The most evident and immediate effects of lower trade barriers are falling import prices for consumers. Estimates suggest that Brazilian consumers could see their purchasing power increase by 8% without trade barriers (Figure 28). Moreover, these benefits are highly progressive as lower income households spend larger shares of their incomes on tradable goods such as food, home appliances, furniture and clothing. A detailed analysis of reducing trade protection, taking into account differences in the consumption basket across households, suggests that the lowest-income decile could gain as much as 15% in terms of additional purchasing power, compared to 6% for the top decile (Arnold et al., 2018). Lower tariffs would therefore bring particular benefits to poor consumers, including women in their role as family providers (UN-IANWGE, 2011). Lowering tariffs would not result in significant fiscal losses as they currently amount to around 0.5% of GDP and the productivity effects of better integration would likely lead to an expansion of activity and additional tax revenues.

With respect to companies and employment, the effects of lowering trade barriers generally combine medium-term benefits with short-term adjustment costs as it triggers resource allocations between sectors and firms, including job losses in some areas and job creation in others. On one hand, firms –just like consumers– gain improved access to intermediate and capital inputs from imports, but also via the reaction of domestic producers to rising competition. Tariff reductions in the 1990s triggered substantial productivity benefits (Lisboa et al., 2010; World Bank, 2018). A recent study concluded that a 1% reduction in tariffs of inputs would increase productivity by around 2% (Gazzoli and Messa, 2017). Similar effects have been found for other countries (Amiti and Konings, 2007; Grossman and Helpman, 1991).

On the other hand, lower trade barriers intensify the competitive pressures that domestic companies face in their own market. As a result, some low-performing firms will lose market share and may eventually be squeezed out of the market. It is precisely this reallocation process that will allow capital and labour to flow to more productive sectors or firms where new and better-paying jobs can be created (Criscuolo et al., 2014). A significant share of productivity growth in advances economies can be attributed to these reallocation effects (Hsieh and Klenow, 2009). For Brazil, estimates suggest potential productivity gains on the order of 40% (Busso et al, 2013).

Figure 28. The potential consumer benefits from lower trade barriers are highly progressive

Potential gains in purchasing power by deciles of income distribution

Source: Arnold et al. (2018).

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Just as some firms lose domestic market share in the face of stronger integration, others seize newly arising export opportunities, expand and hire new workers. Brazil’s export performance has been weak over the last decade and promoting stronger exports would be a key reason to reduce trade protection (Figure 29). In terms of overall employment, the export effect is likely to dominate, with analytical work suggesting overall employment gains exceeding 1% (Araújo and Flaig, 2017). Moreover, the demand for low-skilled labour would likely rise much more than the return on capital, suggesting that newly arising job opportunities in a more open Brazilian economy would disproportionately help the poor (Harrison et al., 2004). Previous reductions in trade protection were associated with an increase in female employment (Gaddis and Pieters, 2012), in line with international evidence suggesting that women benefit particularly from job opportunities arising in the context of stronger integration (UNCTAD, 2009). Jobs created in exporting firms are also more likely to be formal and to pay better, as Brazilian exporters pay 51% higher wages than non-exporters (Brambilla et al., 2016).

Opening up to the world economy tends to have pro-poor effects in emerging market economies (Artuc et al, 2017; Porto, 2006). However, for some workers, reallocations will involve the need to search for a new job. Brazil has high job turnover rates with a third of manufacturing employees changing jobs within one year (Assunção et al., 2017; DIEESE, 2014). This is partly due to incentives arising from the FGTS unemployment insurance scheme. Hence, more firm turnover in the adjustment period is probably a manageable burden for those who find new employment in the same sector. However, when entire sectors contract and workers have to learn new skills, the adjustment costs may be more substantial. Empirical analysis using exogenous variation in exchange rates to proxy changes in effective trade protection suggests that this would only affect a very limited number of sectors, including clothing and textiles, machinery and metal products, while all other sectors are likely to hold up well to more cost-competitive foreign competitors (Arnold et al., 2018). Model-based simulations by Messa (2017) also point to contractionary effects only for the clothing and leather sectors. For other sectors, the effect is either small or positive.

Figure 29. Export performance has been weak

Note: Export performance is measured as actual growth in exports relative to the growth of the country’s export market, which represents the potential export growth for a country assuming that its market shares remain unchanged.

Source: OECD Economic Outlook database.

 https://doi.org/10.1787/888933655700

For affected workers, active labour market policies can go a long way to reduce the burden of adjustment. Such policies, whose focus should be on protecting workers rather than on protecting jobs, economic sectors or firms, can help workers move across sectors through training, job search assistance and activation measures (World Bank, 2013; Flanagan and Khor, 2012). While overall spending on active labour market policies is close to the OECD average, the composition of this spending is very much focused on supporting self-employment and employment subsidies (Figure 30). These programmes are often less effective in increasing the future employability of participants (Brown and Koettl, 2015). In the same vein, the effect of employment subsidies tends to be short-lived. Thus, shifting spending towards those schemes that support the acquisition of new skills, such as training, would better support that Brazilians get ready for the new jobs that will be created. Training can help workers to get ready for new jobs in expanding sectors, and even enhance their chances of accessing better paying jobs. Programmes to retrain workers so that they get new skills and ready for new jobs in other sectors are only starting to be deployed, but should become a priority. Parallel to this, a strong social safety net can protect incomes during unemployment spells (see discussion above).

Figure 30. Active labour market policies are not focused on training and labour market services

Source: OECD Public expenditure and participant stocks on LMP database; ILO; and ILO (2016) "What works. Active labour market policies in Latin America and the Caribbean."

 https://doi.org/10.1787/888933655719

Additional policy efforts on training will also help to ensure that the benefits from integration reach youths or women, both of which are characterised by below-average labour market attachment (Figure 31). Active labour market policies with a strong training component can be effective in reducing gender inequalities, as evidence suggests that women tend to benefit more from them (Bergemann and van den Berg, 2007). Brazil’s youth unemployment rate of 27% is high in international comparison, and keeping youths attached to the labour market is essential to avoid scarring effects and social exclusion later in life. Skill acquisition is a key factor determining the impact of trade on the economic opportunities of women and youths (UN-IANWGE, 2011).

Figure 31. Women and youths have lower labour market attachment

Note: Data in Panel A refer to 2015, data in Panel B to 2016.

Source: OECDstat, ILOStat.

 https://doi.org/10.1787/888933655738

Policy options for strengthening integration

Defining a concrete policy agenda for integration requires thinking about the right sequencing and the role of international trade negotiations. On the former, it is tempting to argue that domestic policy reforms to strengthen the competitiveness of Brazilian companies should precede stronger integration. Despite ample scope for improvements, in practice this argument is likely to block any progress in the nearer term. Given the low growth prospects in the absence of structural reforms, Brazil cannot afford to hold its breath for a political consensus on all domestic reform agendas to arise. Instead, a gradual but credible reduction of trade barriers should be announced without further ado, which would still give domestic companies time to adapt. Ongoing efforts to improve the business environment would also help in the transition to a more open economy.

A similar question arises with respect to leveraging trade opening to negotiate better market access with trading partners. Brazil is a member of the MERCOSUL customs union, which has helped to strengthen trade linkages with other members of the trade bloc, in particular Argentina. At the same time, the exchange of goods and services with the rest of the region is weak (IMF, 2017c). Regional integration could be supported by negotiations with other trade blocs and countries in the region such as the Pacific Alliance or Mexico. Besides lowering tariff barriers, which in the case of Brazil are on average significantly lower for vis-à-vis countries in the region than those outside, a convergence of trade rules and regulatory standards could also play a significant role. Finally, weak connectivity among countries due to geographic factors and low investment in infrastructure has been identified as key reasons behind Latin America’s relatively low intra-regional trade integration. This highlights the importance of progress on the quality of transport infrastructure, the efficiency of customs management and the quality of logistic services (IMF, 2017c).

Beyond South America, a tighter integration with large foreign markets would have strong potential to deliver a significant boost in competition and access to intermediate goods. At present, Brazil has bilateral agreements with only about 10% of world GDP, while Peru and Chile have trade agreements covering about 70-80% of world GDP. Negotiations such as those currently underway between Mercosul and the European Union/EFTA are important initiatives in which Brazil should play a leading role, taking advantage of the window of opportunity presented by recent policy efforts in Argentina to foster a greater integration into the global economy.

At the same time, the sometimes glacial pace of trade negotiations suggests to make unilateral advances alongside bilateral negotiations according to a gradual, pre-announced schedule on both tariffs and local content rules, which should be phased out without delay. Many Asian countries pursued a strategy of liberalising unilaterally in addition to regional and bilateral agreements, with tariffs often reduced for the purpose of attracting investment (Baldwin, 2006).