Friday, January 18, 2008

Fiscal or Monetary Dominance in Brazil 2008?

We know that fiscal deficits may or may not lead to high inflation depending on whether there is ‘fiscal dominance’ or ‘monetary dominance’. If there is ‘fiscal dominance,’ fiscal deficits will eventually force the central bank to monetize the deficit, i.e. to increase seigniorage and use the inflation tax to finance an exogenous fiscal deficit path. If there is ‘monetary dominance,’ a credible central bank commitment not to monetize the deficits and forces the fiscal authority to adjust its budget policy (cut spending or raise taxes) to satisfy its inter-temporal budget constraint.

The recent debate about Brazil’s fiscal package suggests that the government chose to raise taxes as a way to offset the losses from the CPMF. Indeed, since 1999 Brazil has been living under an inflation targeting regime. For such a regime to be successful the country cannot maintain fiscal dominance; instead, fiscal authorities should produce persistent primary surpluses to avoid an increase in debt or inflation. In this moment, the key aspect is to preserve the primary surplus, an indicator of solvency for investors.

One might then infer that Brazil’s significant primary surpluses have eliminated the problem of ‘fiscal dominance.’ Unfortunately, investors’ expectations on Brazilian fiscal solvency are not yet clear. The literature on the theme suggests that fiscally dominated governments, like Brazil, may have to produce a primary surplus greater than the one predicted by the markets, as a way to enhance the country’s credibility and solvency.

As correctly explained by Eliana Cardoso, the fiscal package is not a fiscal reform but mainly tries to replace the loss of one tax (CPMF) by raising another (IOF) as a way to preserve a high primary surplus. In a near future, the country will indeed have to choose between cutting expenses or decreasing its primary surplus. This is so because the amount of taxes that the average Brazilian citizen pays (around 36% of the GDP) is too high given the lack of public services available. In turn, it remains to be seen if Brazil will indeed eliminate the fiscal dominance stigma that the country has been carrying over the years.

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