The Quality of Fiscal Adjustment and the Long-Run Growth Impact of Fiscal Policy in Brazil

This paper describes the main trends of Brazil's fiscal policy during the last decade and analyzes: (1) the ability to raise the primary surplus in response to external shocks, (2) the pro-cyclical nature of fiscal policy, and (3) the long-run impact of government expenditure composition and taxation. The use of the primary balance as a policy tool is analyzed within the Drudi-Prati model, wherein the government uses the primary balance to reveal its commitment to service its debt. We verify that both the debt ratio and the primary balance are determinants of spreads and credit ratings in Brazil. However, the relationship is non-linear: the impact of the primary balance on spreads is amplified as the debt ratio increases. Using an Autoregressive Distributed Lag (ARDL) approach, we analyze the relationship between the primary balance and economic activity, finding a positive correlation in the long run. However, in the short run, fiscal expansions are associated with primary balance reductions and vice-versa during output contractions confirming the procyclical nature of fiscal policy in the short run. The paper uses two approaches, the autoregressive distributed lag (ARDL) and a cointegrating VAR, to analyze the interaction between public expenditure composition and taxation on growth. Similar results are obtained: large elasticities of output with respect to capital stocks, a significant negative impact of taxation on long-run GDP, and a negative impact of government consumption and transfer payments on GDP. These results shed light on the contribution of fiscal policy to disappointing growth performance in Brazil during the past decade