PROGRAM INFORMATION DOCUMENT (PID) CONCEPT STAGE November 19, 2017 Report No.: 122008 Operation Name Brazil Fiscal Sustainability and Business Environment Development Policy Financing Region LATIN AMERICA AND CARIBBEAN Country Brazil Sector General public administration sector (50%); Public administration- industry and trade (50%) Operation ID P165533 Lending Instrument Development Policy Financing Borrower(s) Federative Republic of Brazil Implementing Agency Secretary for Productivity and Promotion of Competition of the Ministry of Finance Date PID Prepared November 19, 2017 Estimated Date of Appraisal January 20, 2018 Estimated Date of Board March 7, 2018 Approval Corporate Review Decision Following the corporate review, the decision was taken to proceed with the preparation of the operation. Key development issues and rationale for Bank involvement The proposed Development Policy Financing (DPF) supports Brazil’s efforts to strengthen fiscal sustainability and improve the business environment to cope with the worst economic crisis over the last decades, which has regional implications. In 2015-2016 Brazil suffered its worst economic downturn in decades in terms of GDP decline, with adverse impact on the social and political landscape. It exacerbated fiscal imbalances that were compounded by a drop of domestic and external demand and lagging productivity growth. Moreover, Brazil’s recession has had negative regional implications, particularly among major trading partners in South America1. Brazil accounts for 35 percent of Latin America and the Caribbean (LAC) GDP and or 55 percent of South America’s GDP. Brazil imports from other South American countries fell by close to 40 percent during the recession. given its large population, a significant amount of LAC’s poor people live in Brazil In response, the Brazilian authorities are starting to deal with fiscal consolidation under a new fiscal framework (the expenditure rule) and pushing for the implementation of critical fiscal reforms, including pensions. Stabilizing public finances over the medium term and resuming increases in employment and output will only be possible with increased investment and productivity. Thus, the authorities are also implementing a program of structural reforms to reduce bureaucratic costs, regulatory barriers and other distortions to competition and investment. 1 In 2016, Brazil was the first export destination for Argentina (15.6 percent of total exports), Uruguay (17.2 percent of total exports), Paraguay (35.4 percent of total exports), and Bolivia (28.1 percent of total exports in 2015), among others. To respond to Brazil’s deep economic recession, the authorities have been undertaking fiscal and monetary policy measures. While external factors contributed to the downturn since 2014, growing fiscal imbalances, pre-existing structural bottlenecks, corruption scandals, and domestic political uncertainty led to a loss of investor and consumer confidence. In this context, GDP growth declined from an average of 3.5 percent per year between 2006 and 2014 to a contraction of 7.4 percent between 2015 and 2016. During 2015, external balances responded positively to the depreciation of the exchange rate, which was the first line of defense to adjust the economy. But the exchange rate depreciation was passed through to inflation and limited the space of the monetary authorities, which had to hike the policy rate to stabilize prices. At the same time, initial steps to reduce fiscal imbalances were taken but more than offset by declining revenues. Fiscal consolidation efforts were intensified with the adoption of a new fiscal rule and the design of a far-reaching pension reform proposal. The fiscal reforms, together with falling inflation, allowed the authorities to loosen monetary policies since late 2016, and the economy has been gradually recovering. Rising unemployment and falling real wages during the recession have partially eroded previous progress in poverty reduction. Growth in employment and labor income allowed for a large reduction in the share of Brazilians living below the extreme poverty line from the 1990s until 2014. However, since the beginning of the recession, 3.6 million formal jobs were lost in 2015 and 2016 and unemployment increased from an average rate of 6.8 percent in 2014 to a peak of 13.7 percent in early 2017. Since the second quarter of 2017 unemployment has decreased, reaching 12.8 percent in July, in part due to seasonal factors as well as increased job creation. As a result of the recession, poverty increased sharply in 2015, reaching 8.7 percent at the national poverty line compared to 7.4 percent in 2013. In PPP terms, using the recently updated line for middle income countries of 5.5 US$/day, poverty stood at 23.5 percent in 2016 compared to 22.1 percent in 2015. This has implications for regional poor numbers as, given Brazil’s large population, around one-third of LAC’s poor live in Brazil. The Gini remained almost constant at 0.515 in 2014 and 2015, following years of steady reduction. The operation is well-aligned with the objectives of the World Bank Group’s Brazil Country Partnership Framework (CPF) for FY2018-2023. In response to the identified need for fiscal adjustment, the new CPF proposes a reorientation of lending and advisory services and analytics to support the federal government in addressing structural constraints, notably those related to fiscal issues and the business environment. This operation supports two of the three focus areas of the CPF: (i) fiscal consolidation and government effectiveness; and (ii) private sector investment and productivity growth. Proposed Objective(s) The fiscal sustainability and business environment DPF aims to support Brazil’s efforts to help support fiscal sustainability and to enable economic recovery. The proposed DPF supports the Brazilian authorities’ growth strategy by addressing key constraints. The Program Development Objectives (PDOs) of the operation are to (i) support a framework for fiscal consolidation and (ii) improve the business environment. These reforms are likely to raise investor confidence, reduce entry, exit, operating and expansion costs for the private sector, and help foster a faster and sustained recovery. The proposed DPF is structured as a two-tranche operation (with a first tranche for US$200 million and the second for US$300 million). Preliminary Description The DPF has two pillars: (i) supporting a framework for fiscal consolidation and (ii) improving the business environment. The approval of the spending ceiling and improved coordination between fiscal and monetary policies enable a gradual enhancement of the macroeconomic policy mix with positive impact on inflation and interest rates. The implementation of a medium term fiscal consolidation requires compliance with the fiscal framework established by the spending ceiling, which in turn will help strengthen Brazil’s macroeconomic conditions and foster investment. The structural microeconomic reforms aim to improve the business environment by reducing bureaucratic costs, regulatory barriers and other policy distortions to competition, and thereby reduce the policy and regulatory risks for private investment. Parallel implementation of reforms in the two pillars is expected to raise investor confidence, and boost investment, productivity growth and jobs creation over the medium term. The government has embarked on a long-term fiscal consolidation process anchored by a constitutional expenditure rule and underpinned by fiscal reforms. The main macroeconomic challenge remains the large structural fiscal imbalance, with cyclical revenues that have declined during the recession, and rigid spending driven by constitutionally-guaranteed social commitments, in particular generous pension benefits. To establish a clear framework and path for fiscal consolidation, the authorities adopted a constitutional amendment to maintain public expenditure growth in line with inflation growth. Moreover, the authorities are committed to a medium-term plan of tax and expenditure policy reforms to underpin the fiscal path established. As first step on these reforms on the expenditure side, the authorities are pursuing a pension reform, which is the main structural driver of spending rigidities and primary deficits in the budget. On the revenues side, the authorities are eliminating payroll tax exemptions (desoneração da folha) that were eroding the tax base, without having any positive impact on employment. Below the line, reforms have been implemented to reduce interest rate subsidies undertaken through state development banks. The reforms and their momentum will need to be sustained to meet the ambitious consolidation path envisaged by the fiscal rule over the medium term. These measures, together with a gradually improving balance in the fiscal and monetary policy mix, are also supporting a reduction of interest payments, which not only have an impact on investment and output, but contribute to reduce the overall fiscal deficit. To support and accelerate the economic recovery, the authorities are implementing a program of structural microeconomic reforms geared to boost investment, productivity and jobs growth over the medium term. Brazil’s main microeconomic challenge is to generate strong productivity growth to sustain the creation of more and better jobs over time. Regulatory barriers, bureaucratic costs and inappropriate regulations and policies have limited investment and formal firm creation while protecting inefficient firms from competition, hindering their restructuring or exit. Overcoming regulatory and policy distortions would increase investment and facilitate reallocation of resources from less to more productive uses, which would in turn fuel the output, export and jobs growth of more productive firms. The government is implementing a series of reforms to improve the business environment. First, it has simplified the process to register a company and file taxes, which will ease constraints to firm entry and growth. Second, it is making changes to the insolvency framework, which are expected to facilitate firms’ exit in a more orderly way and with a higher recovery rate. Third and most importantly, the government has reduced financial distortions by adopting the TLP, thereby improving the allocation of scarce finance to projects with higher returns on investment. Fourth, to reduce Brazil’s high trade costs and promote participation in Global Value Chains (GVC) and exports, the government is expanding the services provided by the Authorized Economic Operator (AEO) Program, an inter-agency cooperation program that streamlines border control processes, avoiding duplication of requirements and strengthening risk management. Finally, the government has adopted a new labor law, which provides greater flexibility for contractual agreements between employers and workers, facilitating job creation in the formal economy as Brazil’s more productive firms expand in local and global product markets. The two pillars of reform supported by this DPF are mutually reinforcing. Ensuring fiscal sustainability is critical to raise investor and consumer confidence and to continue to reduce financing costs in the economy. Improving fiscal deficits and debt dynamics require a boost to private sector demand, which in turn can be fostered by lifting a number of structural bottlenecks and rigidities in product and factor markets that hamper competition and an efficient allocation of resources in the economy. Part of the short-term economic costs of the needed fiscal consolidation process would be mitigated through reforms that encourage firm entry and raise potential output. As structural reforms pick up, more productive and growing firms and a higher number of formal workers will expand the tax base, helping to accelerate fiscal consolidation. Poverty and Social Impacts and Environment Aspects The prior actions supported by this operation are not likely to have significant poverty, social, distributional or environmental effects. While significant poverty, social and distributional effects are not likely for most of the prior actions, a more detailed poverty and social impact analysis will be presented for those related to pension and labor market reform. As for environmental effects, any such effects related to the prior actions would be of an indirect nature, and are not likely to be significant. Tentative financing Source: ($m.) Borrower 0.00 International Bank for Reconstruction and Development 500.00 Total 500.00 Contact point World Bank Contact: Rafael Muñoz/Mark Andrew Dutz/Antonio Nucifora Title: Program Leader/Lead Economist/Lead Economist Tel: +55 (61) 3329-1077/(202) 473-0275/(202) 473-1402 Fax: Email: rmunozmoreno@worldbank.org/mdutz@worldbank.org/anucifora@worldbank.org Borrower Contact: João Manoel Pinho de Mello Title: Secretary for Productivity and Promotion of Competition of the Ministry of Finance Email: joao.pinho_de_mello@fazenda.gov.br For more information contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-4500 Fax: (202) 522-1500 Web: http://www.worldbank.org/infoshop