Wholesale versus Within Institution Change Pacting Governance Reform in Brazil for Fiscal Responsibility and Tax

Wholesale versus Within Institution Change: Pacting Governance Reform inBrazil for Fiscal Responsibility and Tax Aaron Schneider 13th of September, 2004 “Politics is a strong and slow bo

Wholesale versus Within Institution Change: Pacting Governance Reform in

Brazil for Fiscal Responsibility and Tax

Aaron Schneider

13th of September, 2004

“Politics is a strong and slow boring of hard boards.”

Max Weber (1946 [1921])

Institutions and Pacts

Despite significant attention to institutions in causal and comparative historical study,few have paid sufficient attention to the nature of change in institutions Most often,studies focus on divergent paths charted by different institutions (Moore 1966;Skocpol 1992) or the critical junctures at which institutions breakdown and arereplaced (Collier and Collier 1991) Comparative study of institutions, therefore, hasoften highlighted national level differences in the ways several cases respond tosimilar challenges This has produced important insights, and many institutionalanalyses operate on the basis of a ‘punctuated equilibrium’ model in which moments

of upheaval are followed by new institutions that provide long periods of stability andsustain themselves through feedback mechanisms, self-enforcement, and positive sumgames (Mahoney 2000; Pierson 2000; Reuschemeyer and Mahoney 2003)

As a result of these analyses, some working definitions of institutions have becomewidely accepted For most, institutions are the ‘rules of the game’ that bound theinteractions of various actors (North 1989) In part, institutions influence thepreferences and relative power of actors, especially by defining the pay-offs todifferent strategies of interaction and limiting the strategic options available.Institutions can be more or less formal, and, more importantly for the currentexploration, more or less resistant to change

Institutions cease organizing routine behaviour if players routinely break rules, prefernot to play, or otherwise operate outside the boundaries of institutions Functioninginstitutions require the agreement of relevant players These players have to form anagreement, a pact, in support of the institutions The task of forming pacts is difficult,

but it is what creates and supports institutions In these pacts, potentially competingplayers agree to rules of engagement

To understand institutions, therefore, is to understand the process and difficulty ofgetting multiple and competing actors to agree to a given set of rules To know whythese pacts are created is to understand how institutions emerge and change Varioustheories have attempted a theory for how institutions change One approach is therational choice approach that sees pacts emerging when all actors rationally accept aset of rules as an efficient solution to problems Institutions are thus equilibriumsolutions They emerge when all actors recognise that certain rules of interactionwould be to all of their benefit Institutional creation and change, in this view, is aconsensual process that takes actors from less efficient to more efficient equilibriumsolutions (North 1990; Bates, Avner, Levi, Rosenthal 1998) For example, in 1789,when the American states were faced with a collapsing Articles of Confederation, theycame together and designed a Constitution that provided a new set of federal rules toprovide a unified national market and enhanced national security (Weingast 1995)

Slightly different than rational choice approaches, historical institutionalistsemphasise the legacies and limitations (sometimes less than efficient) that priorinstitutions and historical events leave Actors do not choose the most efficientsolutions to problems; rather, they choose institutions from a set of optionsconstrained by prior choices As a result, moving from one institution to another is apath dependent trajectory in which early decisions affect later events (March andOlsen 1984) The pattern of institutional change may or may not improve efficiency,and it may not occur even when it would be in the interest of all actors In theexample of the early American federation, historical institutionalists stress some of theefficiency-reducing aberrations in the new Constitution that reflected politicalcontingency or residues from earlier institutions For example, the electoral collegeremained in the Constitution as a legacy of the Articles of Confederation, and has notchanged for 200 years (Elazar 1991)

What both rational choice and historical approaches share is the notion thatinstitutions rest on durable pacts Actors may conflict; but, when they enter pacts, theyagree to play by formal and informal rules that govern interaction In rational choice

approaches, the pact is chosen because it is efficient In historical institutionalapproaches, the pact is related to the contingent decisions of actors within priorinstitutions Both approaches understand institutions underlined by pacts Tounderstand change in institutions is to understand the dynamic of various actorspacting, un-pacting, and re-pacting

The key dimensions of pacts are the actors included and their relative powers andinterests Pacts can be broad or narrow They can be symmetrical among relativeequals or assymetrical among unequal players They can reflect the interests of poorpeople, rich people, workers, industrialists, agriculturalists or others The case of USfederalism is once again instructive A pact had to be formed between Southern slavestates and Northern non-slave states Their relative powers and interests wererelatively balanced at first and were reflected in the original Constitution Over thenext 100 years, the relative power of Northern states expanded as they industrialised,and the federation expanded Westward far beyond the original 13 colonies Theplayers, interests, and relative powers changed, and old institutions were decaying Anew pact had to be forged, and it took a civil war to negotiate (Moore 1966: 111-158)

Change in Institutions

Here, we are primarily concerned with two patterns of change in institutions, withininstitution change and whole-sale institutional change Within institution changesoccur within the boundaries of existing institutions This kind of change can lead tosignificant consequences, but it does not fundamentally alter the rules of the game andthere is no reforming of basic pacts The existing actors simply adjust at the margins

In other words, the actors included and their interests and relative powers do notchange Though major policy changes can occur, within institution change does notsignificantly alter the institutions themselves and does not signify the formation of anew pact (Thelen 2003) For example, in the original US federalism, a change in tariffrates was not a particularly momentous institutional change, though it may havereflected the growing power of Northern states and it certainly had large impacts

By contrast, the abolition of slavery in the mid-1800s implied an entirely new set ofinstitutions and required a new pact among social actors Such changes resulted in thecreation of new institutions and the wholesale elimination of old ones New rules of

the game were established This represented the formation of entirely new pacts inwhich old actors and interests were eclipsed and new ones entered the scene Withininstitution changes differ in degree from wholesale institution changes Wholesalechanges are bigger Wholesale institutional changes are also different in kind.Wholesale institutional change replace one set of institutions with another set Thisrequires replacement of one social pact with another.1

The triggers of wholesale institutional change are both external and internal.Exogenously driven economic crisis or world events can drive institutional ruptures.Also, Machiavellian manoeuvres within old institutions can lead to endogenousshifting of actor preferences and powers This does not mean that change willnecessarily occur The obstacles to wholesale change follow from the fact thatwholesale change implies a new pact in which there are new actors, with greatlyaltered interests and relative powers, and new potential strategies of interaction Suchpacts are extremely difficult, and even grave crisis and skilful political artci

It should be noted that change is especially difficult to trace when it occurs gradually.Minor adjustments by actors; small shifts in their relative powers; and gradualalterations in their interests can be barely perceptible A new pact can be emergingeven though little seems to be happening Observers can rarely tell if incrementaladjustments are building up to a wholesale change or if they will remain within theboundaries of old institutions

If such marginal and incremental shifts eventually build up until a threshold is passed,they produce an entirely new pact and generate whole-sale institutional change Atthis threshold, new actors and interests emerge, and a new pact is formed, oldinstitutions fall away, and new rules of the game are established Recognizing thatincremental changes are occurring is often difficult; the changes only become visiblewhen the threshold is passed (Pierson 2003) Still, it would be a mistake to recogniseonly the threshold Each of the marginal shifts is also important

1 It is certainly possible for a new tariff to imply a new social pact and a new set of institutions The dividing line is never clear Tariff increases that are large enough imply institutional shake-ups in which rules of the game change and new social pacts are required Differences in degree that are large enough eventually amount to differences in kind.

Gradual shifts in pacts do not always lead to wholesale institutional change In somecontexts of gradual change, actors make adjustments but no institutional threshold ispassed This is a case of within institution change It can be extremely important, butunlike whole-sale institutional change, it does not lead to the creation of new rules ofthe game nor symbolise a new pact

Two Patterns of Change in Brazilian Institutions

The current study examines two patterns of gradual change In one case, changes were

so slow-moving that few noticed they were occurring, and they did not lead to theeclipse of old arrangements in a significant way Actors adjusted at the margins to fitchanging circumstances but left intact the basic rules of the game In short, no new

pact was formed, and only within institution change occurred

In another case, gradual and cumulative changes built to a crescendo in which a

wholesale institutional reorientation occurred Because this occurred gradually, the

direction of change became apparent only when the minor shifts cumulated over timeand ultimately passed a threshold The threshold marked the construction of a newpact and eclipse of old institutions

These two patterns orient the current study of governance reform in Brazil.Institutions inherited from the military regime and the transition to democracy wereimperfectly suited to the challenges of the 1990s, especially the challenges of fiscaladjustment Still, institutions were resilient and difficult to change, and adjustmentoccurred marginally and gradually In one case, tax reform, these adjustments builtwithin old institutional arrangements but did not replace them No new pact wasformed In the other case, the Fiscal Responsibility Law, the adjustments builtpressure that ultimately led to the elimination of old institutions, the forging of a newpact, and the construction of new institutions

Tax reform Tax reform was a slow and gradual change that did not rest on a new

pact nor did it lead to entirely new rules of the game Institutional legacies of themilitary regime and the transition to democracy remained rigid and relatively difficult

to change The actors involved, their interests, and their relative powers did notsignificantly change No new pacts around tax were formed Interestingly, minor

adjustments within inherited institutions and at their margins did allow significantpolicy changes in the tax system to occur There was a major expansion of taxrevenues that brought Brazil to developed country levels of tax and introduced anumber of extremely modern tax practices In the context of fiscal adjustment andmarket liberalization, such changes were a major priority and represented importantachievements

On the other hand, government was unwilling or unable to renegotiate the actorsincluded in a pact around tax and tax institutions remained largely intact Expandedrevenues were possible only through tightening the screws on those handles thatgovernment could easily access through its inherited institutions, and these handleswere not always the most appropriate to a modern, growing economy The result wasthat the increase in the tax burden occurred in a way that was inefficient andinequitable In short, tax reform might have been more successful had a new pactaround tax been possible, but nevertheless, tax changes have been a case of(moderately) successful governance reform within the boundaries of old institutions

Federalism Reform The second reform, the Fiscal Responsibility Law, was also

gradual, but it reflected the tipping point of a cumulative process that eventuallybreached a threshold in Brazilian federalism Reform fundamentally renegotiated theactors, interests, and relative powers expressed in the federal arrangement While theFiscal Responsibility Law marked an important threshold in the construction of a newfederal pact, it was not an unprecedented, watershed event that many portrayed.Rather, it was the culmination of a series of minor shifts that altered the institutionalterrain in which actors operated These repeated interactions largely did the hard work

of weakening certain actors, strengthening others, altering preferences, eroding priorinstitutions, and setting the architecture of a new federalism A particular historicalmoment, marked by external economic crisis, made it possible to pass the threshold inwhich new institutions were constructed in the Fiscal Responsibility Law

It is important to note the cumulative nature of the reforms leading to the FiscalResponsibility Law Like the tax reform, this was a governance reform thatcontributed to meeting the fiscal adjustment challenge in Brazil What sets the FiscalResponsibility Law apart is the fact that it culminated in a whole-sale change in

institutions There were a series of incremental changes that occurred within oldinstitutions, just as there had been for tax The difference was that these incrementalchanges over time were building to a critical mass that would result in a wholesalechange in Brazilian federalism It was possible to create a new pact among relevantactors, and as a result, wholesale institutional change was possible Both tax reformand the fiscal responsibility law were success stories, but only one represents asuccess enshrined in a wholesale change in institutional arrangements.

The following sections compare the dynamic process of change in tax and the FiscalResponsibility Law in Brazil The case of gradual reforms that ultimately breached athreshold and produced a new pact is described in the reform of federalism in theFiscal Responsibility Law and its antecedents The case of gradual reforms thatoperated within existing institutions without transcending them is described in thereform of the tax system Both reforms are significant and important governancereforms, but they differ in important ways By comparing them, we can understandthe nature and difficulty of pacting new institutions among multiple and potentiallycompeting actors

The main point to be drawn from this comparison is that governance reform can takemultiple forms, though there are important commonalities The main commonalitybetween these two cases was that governance reform was a gradual and cumulativeprocess The main variation between the two reforms is that one operated withinexisting institutions atop relatively constant pacts while the other passed a thresholdand resulted in the construction of a new pact and new institutions Both withininstitution and wholesale change can lead to important policy results Only wholesaleinstitutional reform involves a fundamentally new pact among actors about the rules

of the game

Prior Pacts and Institutional Arrangements

To understand these two processes of change, it is necessary to establish a referencepoint Basic social pacts and essential institutions were established in the 1988Constitution and the waning years of the military regime that ended in 1985 One ofthe most significant aspects of these pacts and institutions was the significantexpansion they gave to Brazilian subnational government autonomy

Subnational Power Subnational governments have always been important in Brazil’s

federal system, even during the military period (Hagopian 1996) In particular, afterhistoric election defeats in 1974, the military sought to legitimate itself and hold ontopower by decentralising power and resources to state governments Elections forsubnational executive office opened long before the national level Governor powerwas further enhanced when the first elected president died shortly after assumingpower, and his vice-president, José Sarney, rose to power indirectly Sarney thusbegan with a relatively weak hand, and he bargained away additional power duringthe 1988 Constitutional Convention in an effort to secure an extra year on his mandate(Souza 1997)

The 1988 Constitution gave the states residual powers (areas not left to the centralgovernment or municipalities), and imbued states with several policy domains thatincluded tax, spending, and administrative autonomy In particular, governors gainedfurther control over the single most important tax, the ICMS (similar to a subnationalVAT), which accounts for approximately 30% of all revenues Governors could nowset sales tax rates, and they gained control over certain bases that had belonged to thecentral government earlier, such as electricity, fuel, minerals, and telecommunications.The states and municipalities also expanded their portion of shared taxes, which are aproportion of federal income and manufactured goods taxes The proportiontransferred to states grew from 9% each in 1979 to 21.5% (states) and 22.5%(municipalities) in 1988 (Afonso 1995; Afonso and Serra 2002)

What was left unclear by the 1988 Constitution was what was to be done with shiftedrevenues Various functions were either left shared by states and the federal level orgiven to both (Camargo 2001; Shah 1991) The result was that certain aspects ofsubnational outlays greatly increased, partly as a result of pressure to undertake policyareas that the federal government was abdicating (Arretche 2000) Though the centralgovernment retained primary responsibility for transfers to individuals (80% of total)and public debt interest payments (90% of the total), subnational units accounted for68% of active civil servants and other current expenditures and 80% of fixedinvestments (Afonso and Serra 2002)

Especially important to the current discussion, states controlled important banks andpublic enterprises The developmentalist strategies pursued by the military regime hadincluded important government action in banking, production, and distribution.During the 1970s, when the military regime sought to hang onto power by distributingpoles of development to dispersed political allies, many states established both creditand commercial banking interests (there were 35 states banks in 1994), as well asimportant energy companies and other government-owned enterprises As the statesgained greater autonomy, especially after the 1988 Constitution, governors securedfurther control over bank and enterprise directors This control gave access toinfrastructure projects, employment, and credit that were often oriented towardspolitical patronage needs rather than developmental goals State banks offered cheapcredit to the private sector, financed state enterprises and development projects, andmost significantly, purchased bonds issued by state treasuries In effect, each governorcontrolled a bank that could cover state deficits and thus provide a soft budgetconstraint (Dillinger 1995)

The role of subnational units was exaggerated at the national level by the representation of certain territorial units While all federal systems engage in somedegree of malapportionment (deviation from one man-one vote), Brazil represents anextreme case of ‘demos-constraining’ federalism (Stepan 2000) States with smallerpopulations are systematically over-represented by equal representation in the Senate(three senators per state) Though this is not uncommon in upper houses of federalsystems, overrepresentation in the lower house, the Chamber of Representatives,exaggerated malapportionment In the Chamber, representation is proportional topopulation, but a floor on the number of representatives per state and a ceiling onrepresentation for the most populous states leads to an overrepresentation of smallerstates (Samuels and Snyder 2001)

over-The interests of subnational units, especially states, are also exerted through informalgovernor power at the federal level through state representatives In the Chamber ofDeputies, governors influence the deputies from their state This impact is likely to begreater for deputies of the governor’s coalition than opposition parties and vary acrossparties and states and by issue area, but there is evidence that governors acted asoccasional veto players in the Chamber (Abrucio 1998)

The Senate was a particularly important site in which governors exerted influence.Senators are frequently ex-governors, and they paid special attention to regionaldemands with an eye on running for future office as governor (or even mayor) afterleaving the Senate In addition, there is an informal practice in which Senatorsapprove requests to benefit colleagues’ states, expecting the same treatment whenissues affecting their own state emerge

Weak Discipline Parties might have served to discipline these pressures from

subnational governments, but Brazilian parties have been characterized as extremelyfragmented and inchoate (Mainwaring 1999; Mainwaring and Scully 1995;Mainwaring and Shugart 1997; Haggard 1995; Ames 1995, Ames 2002) Anextremely permissive electoral system sets low thresholds for participation withautomatic free access to the mass media Coalitions in multi-member, proportionalelections are allowed and ballots are open-list Further, party members are free toswitch their allegiance up to a year before elections These rules weaken parties asinstitutions, and strengthen the power of governors in influencing electoral outcomes.Some have argued that governor “coattails” are important to state and federal deputies(Samuels 2003)

Organised interests might have provided an alternative source of discipline to thefragmenting qualities of Brazilian politics, but interests have also been characterised

as pulverised and unable to exert influence (Schneider 1991: chapter 6) The Braziliantradition of organising interests in vertical corporatist associations tied to the statelimited autonomous capacity for negotiation and weakened the utility of social sectors

as counterparts in forging broad pacts (Schmitter 1974) In addition, the liberalisation

of the 1990s further fragmented weak social interests, and few could provide thedisciplining oversight that might have been necessary to forge a new social pact

Potential Countervailing Institutions Despite these factors, several aspects of the

Brazilian political system create countervailing tendencies Inside the Congress, partyleaders play an important role assigning members to committees, influencing thelegislative agenda, and impose discipline on party members for certain votes (Alston,Mueller, Melo and Pereira 2004)

The most important institutional mechanisms to impose discipline on the party systemoperate through a powerful president Presidents have had little difficulty buildinggoverning coalitions in Congress, and only one president failed to build such acoalition on reaching office (Collor, who was later impeached) (Figueiredo andLimongi 1999; Meneguello 1998)

Additional mechanisms that strengthen presidents and impose discipline include vetopower, budget power, power to influence the legislative agenda, and especially decreepower inherited from the military regime (Cheibub, Figueiredo, Limongi 2002;Figueiredo and Limongi 1999) Decrees are provisional and, until 2001, could be re-issued indefinitely Unless Congress acted upon them within 30 days, they went to thetop of the agenda In addition, presidents could leap their legislative priorities to thefront of the agenda by issuing emergency legislation Hundreds of emergencylegislation were issued and a similar number of decrees that Congress simply allowed

to continue (Pereira, Renno and Power 2001; Pereira and Mueller 2002)

This changed in 2001, when Constitutional Amendment 32 altered the use ofprovisional decrees They can no longer be renewed, except by the vote of Congress,and only one renewal is now possible The result has been to limit decrees somewhat,but they now almost entirely clog the legislative agenda and give the president evenmore control over the order of business, as no other legislation can be passed untilthey have been resolved

Presidents also exert influence through the use of the veto (including line item veto)and exclusive power to initiate legislation in the area of budgeting as well aslimitations on the kind and amount of legislative amendments (Giacamoni 1997).Amendments are governed by formal and informal rules which allow presidents todecide if and when funds will be released The result is that many amendments aremere symbolic efforts, while moments of parliamentary support-building are preceded

by the release of numerous projects

In sum, several aspects of the Brazilian federal system were solidified in 1988 Infiscal terms, subnational units greatly benefited at the expense of the central

government States and municipalities expanded their resources and autonomy, andstates in particular gained control over enterprises and state banks At the federallevel, the entities that might have overseen state behaviour were particularly unsuited

to the task Congress, particularly the Senate, was heavily influenced by governorsand state interests Parties were little help in moderating the behaviour of subnationalunits, as electoral and institutional rules weakened parties as institutions Interestgroups were equally unsuited, as they were weak and tended to organize vertically tosecure benefits from the state instead of horizontally to forge new social pacts onmajor issues

To achieve the largest possible governance change, a new pact would have to beformed around a set of institutional rules of the game The wise use of existingcountervailing institutions would allow marginal and subtle repositioning amongsupporters and opponents of reform during the 1990s These shifts were sufficient toallow wholesale change in federalism but only within institution change in tax It isuseful to understand both the similarities and the difference in these patterns ofchange

Wholesale Institutional Change – A New Federal Pact around Fiscal

Responsibility

“In the last few years, Brazil has achieved a high degree of fiscal transparency,together with major improvements in the management of public finances Thecornerstone of these achievements has been the enactment in May 2000 of the FiscalResponsibility Law which sets out for all levels of government fiscal rules designed toensure medium-term fiscal sustainability, and strict transparency requirements tounderpin the effectiveness and credibility of such rules” (IMF 2001: 1)

The current project suggests that the Fiscal Responsibility Law of 2000 was animportant event that can only be understood as the culmination of a repeated series ofinteractions among the central government, executive branch, Congress, andsubnational units, especially states Few who looked at Brazil in 1988 might havesuspected that the federal order would be completely changed in a little over a decade.The actors and institutions that favoured retaining a chaotic federal system of

powerful states seemed unlikely to change, and the few actors that wished to establish

a degree of fiscal coordination were weak Over the course of the 1990s, a series ofinteractions adjusted actor positions, relative powers, and choices and they adjustedtheir strategies Ultimately, the pact and institutions that sustained the previousfederalism arrangement progressively weakened The Fiscal Responsibility Lawrepresents a new set of rules of the game supported by a renegotiated pact amongfederal and state players

Interestingly, though the current situation represents a significant institutional shift,there are obvious ways in which a retrogression or at least watering down could occur

In particular, though the actors that might favour rolling back the federal arrangementare currently weak, the institutions that have been established to sustain the currentarrangement have identifiable points of vulnerability

For the designers and supporters of the law, it marked a sea-change in the nature ofBrazilian federalism Attitudes among the Brazilian political elite now frown uponrepeated crises and bailouts This signalled more than obedience to legal prohibitions,

of which there were many, but rather a change in cultural behaviour that recognisedthe spirit of the law Such a change was only possible through a pacting process thatcould generate the consensus to make the new practices feasible.2

The current analysis views the Fiscal Responsibility Law as the tipping point orculmination to a series of cumulative, gradual changes that crystallized a change infederal institutions The starting point to the federal pact could be traced back throughgenerations of Brazilian federalism, and reference will be made to historical legacies

of prior eras For the current analysis, the most marked round of interactions beganwith the legacies of the 1988 Constitution

Starting Positions – 1988 Constitution The most important of these legacies was

the relative power of subnational units Governors wielded constitutional power,controlled significant resources, and manipulated state enterprises and banks withserious macroeconomic implications Governors exerted pressure at the national level

2 Selene Nunes, one of the architects of the legislation, has made this extremely clear in personal communication and in several of her published evaluations (Nunes 2003, 2004).

through state delegations in Congress and the Senate, and the Senate as an institutionheld important powers versus the executive in the area of subnational debt TheConstitution gave the Senate authority to set limits on debt, establish debt serviceceilings, and approve credit requests by individual states Though the Central Bankprovided an evaluation, it was the Senate that held ultimate authority Collegial rulesand influence exerted by powerful Senate presidents meant that Senators from statesseeking credit were frequently assigned to the committee charged with evaluating therequests for credit from their own states As one would expect, it was extremely rarethat such requests would be denied.

The fiscal scenario of the federal system was extremely precarious Many of the stateshad made their own situations even more difficult by locking themselves into majorspending initiatives This had begun in the early 1990s in part to cover reductions infederal investments Worse, most states had engaged in a rapid expansion of publicemployment during the late 1980s and early 1990s as disconnected municipal, state,and presidential electoral cycles meant seven elections in ten years (1985, 1986, 1988,

1989, 1990, 1992 and 1994) The fiscal impact of the hiring binges was compounded

by the 1988 Constitution, which changed all public employees to regulated labourcontracts that included complicated demission and generous pensions Pensions werealso extended to rural workers, and many states found themselves carrying some ofthis burden as well Several found themselves with over 90% of their budgetdedicated to public sector personnel (Varsano 2002)

The states turned to the temporary stop-gaps to finance their expansion They indexedtaxes to inflation while delaying and failing to index many expenditures They alsofloated financial assets through state banks that essentially allowed governors to giveloans to themselves (Giambiagi and Além 1999) At least for a time, they could coversome of these fiscal illusions with the increasing transfers coming from the federalgovernment, but states repeatedly turned to the central bank for bailouts, which theywere summarily granted

First Movement – The Real Plan The first salvo in the realignment of federalism

could be marked by the Real Plan of 1994 It was a successful monetary stabilisationeffort, though the fiscal adjustment that might have sustained the effort was not

immediately clear The federal government made a clear effort to secure its own fiscalstability, and in so doing, it greatly undermined the practices, many of them dubious,that subnational units had used to sustain themselves The federal government raisedinterest rates by 60% in three years to help sustain the value of the currency, greatlylimiting state ability to float financial assets (Alston, Melo, Mueller, Pereira 2004).The inflation tax disappeared, and the Real Plan coincided with an agreement bywhich the central government by retained 20% of all revenues that were meant to beshared revenues (Giambiagi and Alem 1999)

To some observers, the Real Plan was principally a transparency shock that exposedthe financial use state governments had made of inflation In the words of oneobserver, “When they ended inflation, there was greater clarity on the skeletons.Malan put it best when he said ‘In Brazil, the past is more unpredictable than thefuture’” (Interview with Legislative Aide)

The most immediate implication of this transparency shock was a rapid deterioration

of state accounts The state governments were forced to depend even moresignificantly on transfers from the central government and new credit operations,often from fragile state banks Subnational debt increased 85% from 1990 to 1996 andincreased as a portion of total national debt (Mora 2002)

In sum, the fiscal implications of the Real Plan of 1994 can be understood as animportant adjustment within the federal institutions of the 1988 Constitution Themain actors involved, central government and subnational governments, may not havebeen conscious of the (not-so) subtle adjustments stabilisation would imply, but theReal Plan marked an important shift In particular, the way in which stabilisation wasachieved spelled fiscal crisis for the state governments On one hand, the unexpectedend to inflation intensified their fiscal insecurity and made them extremely dependent

on the federal government On the other hand, the sudden end to inflation and itsunexpected character legitimated many of their demands for debt workouts

Shifting Power and Institutions - State Debt Workouts The debt workouts

negotiated by the states and the federal government both indicate the gradual shift inactor power and were a cause of that shift Crisis and workout occurred in 1989, 1993,

and post 1994 At each moment, individual states or several states simultaneouslycould not meet their debt obligations (Pereira 1999).

The workouts arranged for the different states shifted over time They were widelycriticised by most observers for softening the budget constraints facing states andencouraging future defaults (Dillinger 1997) What was less obvious was that eachframework was building central government capacity to hold states to account

The first major state debt crisis can be traced to before 1989, when oil price shocksand interest rate increases led to national defaults on international debt The totalrenegotiated was approximately US$11 billion Debts were rescheduled for 20 yearswith a 5 year grace period and interest rates equal to the original contract States wereexpected to undertake privatization to cut expenses and pay down some of the debt

The second crisis occurred prior to 1993, when most of the debt was owed to federalinstitutions, especially the federal housing and savings bank The federal governmentabsorbed approximately US$40 billion of state debt, again rescheduling for 20 years,this time at lower than market rates

The third crisis occurred post-1994 when states mostly owed debts to their own statebanks and to private banks on short-term state bonds and loans in anticipation ofrevenues (AROs) A new framework for debt workouts was established in 1997, law

9496, which set the framework for workouts for the largest portion of state debt, statebonds These bonds had been issued at high interest rates on short-term, evenovernight, markets, and states eventually defaulted The bonds were the largestcomponent of the post-Real debt crisis, and they were owed principally by the largeststates and municipalities These governments had the most privileged access to themarket, but their unpayable state bonds reached over R$30 billion (Goldfajn andGuardia 2003)

The framework was followed by agreements with 24 states for US$82 billion with 30year repayment schedules and low fixed interest rates The ceiling on debt service wasalso set somewhat generously, not to pass 15% of current revenues (Rezenda andAfonso 2002: 16) The law also established ceilings for personnel, and targets for

growth in revenues, and privatization (Guimarães 2004) Failure to meet conditionscould be punished with retention of state constitutional transfers It was a measure that

“gave the government a stronger mandate to withhold transfers from states that failed

to meet their agreements” (Webb 2004: 7)

Shifting Actor Positions – Federal/State The process of debt restructuring during

the 1990s appeared to many observers as a never-ending cycle States would defaultand the centre would bail them out by absorbing debts and extending the timeline forpayment The basic pattern of these crises was that the federal government assumedthe payment of subnational debts, states paid back (some of) the costs at privilegedinterest rates, and states were presented with conditionalities for structural adjustment.Restructuring without eliminating old debt or seriously undertaking fiscal adjustmentmeant that another debt crisis would loom after a few years The repeated crises andbail-outs suggest, at first glance, that the federal government was simply providing asoft-budget constraint to states that increased moral hazard problems and led themrepeatedly to fail, and the central government was unwilling to change the incentives(Dillinger 1997; Perry and Webb 1999; Rodden and Litvack 2001; Ter-Minassian1997)

In fact, what had occurred by the end of the 1990s was a basic weakening of stategovernment power to secure new credit from the central government What was notvisible was the subtle repositioning of the different levels of government andredefinition of the rules of the game over the course of each negotiation For example,

in the early bail-outs, the federal government negotiated with states en masse, largelysetting the same conditions for all states and negotiating partly through the Senate.After 1994, the president and ministry of finance sought to split the states bynegotiating with each governor individually Though restructuring agreements passed

in bunches in the Senate, the conditions varied slightly across states and the timing ofthe agreements differed according to when they were agreed by each governor Inparticular, the large states were targeted early, strengthening the central government’shand in later negotiations with smaller states (Webb 2004)

One indication of this were the terms of the workouts They were linked to fiscaladjustment programmes in which states were required to secure a downpayment on

debt equal to 20% of the total In general, funds for this downpayment were to comefrom privatisation, and the federal government pressured states to privatise the mostcommon underwriter of debt, their state banks In relatively few years, almost all statebanks were made purely developmental banks or eliminated entirely To this end, thepresident had used decree power in 1996 to establish a fund (PROES) whicheventually spent R$62 billion to eliminate the bad debts of state banks and preparethem for sale, absorption by the centre, or extinction (Lopreato 2002) The totalobtained through state level privatisations reached US$34.7 billion

An additional indication that the relative power of centre and states had shiftedoccurred in 1999 In January of that year, the new governor of Minas Gerais defaulted

on the debt service agreement signed by his predecessor Publicly, there was norenegotiation of debt service contracts, and the president retained federal transfers ofshared taxes from the Minas government Meanwhile, in private, the presidentmanoeuvred patronage and debt negotiations to ensure that other states would notdefault also A few opposition governors threatened default, but they returned tohonouring their debt service payments with much less fanfare The hardline stancetaken by the president was partly possible because all the states were vulnerablefollowing the Real Plan Further, repeated bailouts and workouts had weakened theirbargaining positions

More important, the hard line taken with Minas was no coincidence The governor ofMinas, Itamar Franco, had been president from 1993-1994 and was a political rival topresident Fernando Henrique Cardoso The Minas default was Itamar’s calculatedmove to test the resolve of president and opposition Unfortunately for Itamar, he hadnot calculated the political winds particularly well Though a few other oppositiongovernors threatened defaults of their own, they soon defected and resumedpayments, and other governors failed to support the move for en masse renegotiation(Samuels 2003: 554)

The president had numerous political tools in his arsenal to coopt reluctant governors

In 1998, the Kandir Law had exempted exports from the sales tax collected by states.The loss in revenue led to complaints by governors, and they pressed to receivecompensation Shortly after Itamar’s gamble, the president agreed to a compensation

fund for the Kandir Law For the numerous states that were net exporters, especiallythe poorer states with agriculturally based economies, this compensation promisedpotential benefits Such compensation had been one of Itamar’s demands, but thepresident passed the legislation through decree and then left the negotiation overamounts to be haggled later, leaving exporting states somewhat dependent oncontinued goodwill.

Shifting Actor Positions – Executive/Legislative In addition to the shift in

federal-subnational relations, another important shift in actor position occurred in theexecutive-senate relationship during the 1990s According to the 1988 Constitution,principal responsibility for setting state debt limits, debt service caps, and approval ofnew loans fell to the Senate In particular, the Economic Affairs Committee evaluated,and generally approved, subnational requests for new debt and debt service levels.Frequently, members of this committee used their power to support allies in stategovernment or to promote their own elections to executive positions in the states insubsequent years In 1997, evidence emerged that the Senate, with grudging CentralBank approval, had been approving state and municipal bonds issued to coversubnational court obligations These bonds were issued with inflated values, andworse, they were marketed through a series of poorly regulated brokerage houses atlarge discounts As the bonds exchanged hands, the gains realized from the discountswere skimmed off and laundered, some even finding their way into campaign coffers.The scandal barely scraped the important politicians involved, but it was enough toforce the Senate to recognise its own culpability in creating a moral hazard ofrepeated state fiscal crisis

Senate Law 78 in 1998 greatly restrained Senate tendencies and power to favourstates in debt negotiations It handed first-mover power to the Ministry of Finance inevaluating requests for subnational debt Instead of exerting political pressure tosecure positive evaluations, Senators now largely accept the positive or negativeevaluation of creditworthiness provided by the Ministry of Finance (Webb 2004) Thenew law prohibited loans to states holding primary deficits, reduced admissible levels

of debt, and set a trajectory for gradual reduction of debt/revenues ratios (Rezendeand Afonso 2002: 16)

Shifting Actor Positions - Local Preferences An additional shift was evident in

shifting preferences of state leaders themselves (Cortez Reis, mimeo) Part of the shiftwas driven by the revised electoral cycle established in 1998 In his first term,Cardoso had spent political capital (and some dubious patronage) to secure anamendment to the constitution that would allow reelection in 1998 The 1998elections were framed by the potential of currency instability, and Cardoso was ridingthe popularity and legitimacy of having defeated inflation in the Real Plan He wonreelection, and on his coattails were elected several governors In total, of the 27governors, 21 were members of Cardoso’s party or governing coalition Even therogue governor Itamar mentioned above was from the allied Brazilian DemocraticMovement Party More important, the most important state, São Paulo, was governed

by a close Cardoso ally who shared his concern with fiscal discipline The result wasthat most governors owed at least part of their political success to Cardoso, and many

of them agreed with his strategy of fiscal adjustment

In essence, as they entered in 1999 they were looking for an excuse to implement thetypes of personnel cuts and privatizations the central government was pressing Thedebt agreements and the Camata Law gave these new governors some cover to softenthe political impact of having to impose cuts

The Tipping Point - Fiscal Shock The 1998 elections were framed by a series of

final shocks that tilted the balance in favour of a wholesale change to federalinstitutions Just prior to the elections, the Russian currency crisis shook worldmarkets Shortly thereafter, the Asian financial crisis suggested the possibility thatnumerous middle income and emerging market economies could also be hit Brazilwas high on many lists for a crisis, partly because it had already weathered no fewerthan seven crises since the mid-80s, but also because the Real Plan had fixed acurrency band that most observers knew to be overvalued Cardoso negotiated anagreement with the IMF to get Brazil past the elections, and agreed to 51 conditions

of financial and structural adjustment (few were met) Even with the inflow of credit,Brazil was in a fragile situation, and the Minas default sparked a speculative crashthat saw the currency fall by a third of its value

The crash was significant for several reasons, not least the disappearance of billions inBrazilian reserves and the apparent mismanagement of the liberalisation of theexchange rate Brazilians, especially those close to the president in the federalgovernment, stressed the need to send firm signals to external creditors that thestabilisation regime would not be threatened

Wholesale Change in Institutions - Fiscal Responsibility Law In some ways, the

Fiscal Responsibility Law aggregated measures that were already on the books indifferent forms, repackaged them, and presented them to international markets as asignal of commitment to hard budget constraints (Tavares 1999) There is evidencehowever, that an extra push was needed in 1999 Though rules had been on the books

in the past, it would not be the first time they had been flouted One of the terms ofthe Fiscal Responsibility Law, the limit on personnel expenses, offers a good example.Attempts to control personnel expenses had a relatively long history In 1995, theCamata law set a ceiling of personnel expenses equal to 50% of current net revenueand scheduled a time-table for states and municipalities to eventually comply with theceiling The federal government quickly moved to obey, but many states were slow tobring their payroll into line As a result, the law was reformed several times beforebeing written into the debt service agreements post-1997 with a cap set at 60% of netcurrent revenues

Even for governors that wanted to obey the limits, however, they frequently wereunable to oppose pressures from inside their own governments After meeting withmost of the governors, Justice Minister Nelson Jobim had explained, “The biggestproblem is that the state executives lost control over their legislative and judicialbranches The proposal reasserts their control, creates salary ceilings, and for thisreason, it has the support of the governors” (Folha de São Paolo, 1/11/95) To makecivil service reform viable, states were encouraged to use privatization receipts tocapitalise pension funds that could then be used to finance voluntary retirementschemes in which employees were offered preferential pension packages With theFiscal Responsibility Law backing up the debt workouts and the Camata Law,governors were finally bringing their personnel costs in line after 1999 There was arapid decline of personnel expenses from 65% of state revenues in 1999 to 54% by

2002 (Alston, Mueller, Melo and Pereira 2004: 73)

The context in 1999 included the following ingredients that had built up over time:vulnerable states in fiscal crisis, strengthened central government as a result of debtrenegotiations, a Senate chastened by scandal, an emboldened president starting hissecond term, a majority of governors from the president’s coalition, and personnelregulations that moved states towards a reform of their civil service The currencycrash of January 1999 gave the final push in favour of a wholesale change to federalinstitutions Many parts of the law were already written in debt workouts with thefederal government and the Camata Law, but this moment marked a threshold inwhich multiple changes were codified and established in laws requiring a super-majority in Congress to be revoked

The law was presented to Congress in April 1999 after several months of internetconsultations It passed through Special Committee in the Chamber of Deputies inDecember and passed the floor in January of 2000 with only 30 amendments Afterpassing in the Senate, it was signed into law on May 4th Parallel to the FiscalResponsibility Law, though somewhat slower in speed, a Fiscal Crimes Laweventually passed in October and established penalties for public officials that failed

to obey fiscal responsibility These penalties included administrative, financial,political penalties and even prison time for violators of fiscal responsibility Mostobservers agree that the criminal component of the law will largely hit only municipal

or minor officials, but it sends a similarly clear message of the seriousness of fiscalcontrol

The law stipulated that limits would be established on public debt as a percentage ofcurrent receipts for the federal, state and municipal levels The limit for states hasbeen set at 2 times current receipts, municipalities 1.2 times, and discussions areunder way for the federal government If indebtedness levels exceed the ceilings,measures must be taken within 12 months that reduce the excess by at least 25%within the first 4 months Later, the Senate added a provision that states over the limit

by the end of 2002 will have 15 years to adjust at 1/15 each year The law alsostipulates a golden rule for credit operations that they cannot exceed capital expenses

In addition, the law specifically forbids bailouts of one level of government byanother Finally, the law eliminates one of the mechanisms of state finance that had

been most abused prior to the debt workouts, refinancing of loans in anticipation ofreceipts Such anticipations have been forbidden entirely in electoral years (Rodden2003).

The law also established rules for transparency in accounts All levels of governmenthad to publish fiscal targets for receipts, expenses, nominal balance, primary balance,public debt, and estimates of state enterprises, pension systems, and other obligations.These accounting and planning exercises were now codified and regulated according

to standards set by the national treasury and had to be published in the first phase ofthe budget process when Budget Directives Laws were passed The law alsoestablished norms for consolidating and disseminating annual accounts and requiredquarterly reports on fiscal performance published according to a common set ofconcepts and available on the internet (interview with senior officials at the NationalTreasury Secretariat)

The law also prohibits all levels of government from contracting new paymentobligations within the last year of their administrations unless they can demonstratethat the expenses can be fully paid within the term or sufficient cash has been left topay unpaid obligations in the next term

Following the Camata Law, the new law placed limits on personnel expenses as apercentage of revenue for the three levels of government and all branches ofgovernment At the federal level the maximum limit is 50% of current net revenue,while at the state and municipal levels it is 60% There are also ceilings for eachbranch of government The executive branch at the federal level is allowed 37%,legislative 2.5%, and judiciary 6% and Attorney General 6% At the state level thepercentages are 49%, 3%, 6% and 2% and at the municipal level 54% executive and6% for city councils In the case of a level of government or a power failing tomeeting personnel targets, the law stipulates a pattern of transition, and includessanctions for failure to comply that include retention of federal transfers andadministrative penalties All provisions are enforced through both individual andinstitutional sanctions In terms of the latter, if 95% of the maximum limit forpersonnel is exceeded, the granting of new benefits to revenue officers, the creation ofoffices and new admissions and overtime will be suspended, or, if officials fail to

implement, collect and charge levies under their jurisdiction, voluntary transfers totheir jurisdiction will be suspended With regards to personal sanctions, officials may

be removed from office, prevented from occupying public posts, forced to pay finesand serve prison sentences (Afonso and Serra 2002; Tavares 2001)

These personnel limits attracted some civil society and partisan opposition Publicsector workers, sensing a threat, mobilised against the law, and their chief partisanally, the Workers’ Party, articulated their concerns Several factors made this civilsociety and partisan opposition weak, however First, the public sector most able toinfluence Congressional proceedings was at the federal level, and administrativereform there had preceded the Fiscal Responsibility Law and the new law would notimply additional cuts (Interview with Legislative Aide) As a result, federal publicworkers were not easy to mobilise to defend workers at subnational levels, and therewas only limited pressure during Congressional proceedings

The partisan opposition of the Workers’ Party was also relatively ineffective In part,many of the members of the party agreed with basic tenets of fiscal responsibility, andmost of their executives at subnational government (with a few notable exceptions)were already well within limits stipulated by the law There were elements ofopposition to what was branded an ‘IMF-Style’ or ‘externally-driven’ piece oflegislation (Bruno 2002: 111-113), but this opposition was really only lukewarm.Even had they mobilised to oppose the law, Congressional rules gave the executiveand the governing coalition a strong position to push the legislation through Forexample, the reporter of the Special Commission, Pedro Novais, had been chosen asfavourable to the spirit of the law, and he used his position to limit the number ofamendments The members of the Chamber presented 110 amendments, of whichNovais accepted only 30 In addition, the law required only a simple majority, and theparliamentary majority of the governing coalition passed the law easily (386-86)

Several caveats have been inserted in the law Smaller municipalities with fewer than

50 thousand citizens operate under slightly looser accounting requirements Thesemunicipalities represent over 90% of the total number of municipalities In addition,some elements of the personnel regulations were left open to interpretation, and havebeen rescheduled They were initially meant to hit 2000 but they were allowed to slip