Devolution s Contribution to Economic Development: The Case of Brazil

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1 CEIDIR s Review Number 9, 2009 Devolution s Contribution to Economic Development: The Case of Brazil Maria Chotreva MSc Development Studies 09, LSE European Marketing Executive, Autonomy, U.K. maria.chotreva@autonomy.com Abstract This paper explores the link between devolution and development by analyzing the ways in which devolution has contributed to and impeded economic development in one of the most decentralized democracies in the developing world. The extent to which devolution has contributed to economic development in Brazil has been influenced, in part, by the specific complementary policies implemented for mitigating its perverse effects on equity and efficiency. I. Introduction: a brief overview of the devolutionary trend In the past 30 years, governments of both developed and developing countries have embarked on a trend of devolution (Rodriguez-Pose and Gill 2004), most commonly defined as an extensive form of decentralization involving the transfer of authority and resources to subnational tiers of government (Rodriguez-Pose and Bwire 1998). In a devolved system, the central government transfers authority for decisionmaking, finance, management and service delivery to quasi-autonomous units of local government that elect their own councils, raise their own revenues, and have independent authority to make investment decisions (Litvack et al. 1998). As prominent as the devolutionary trend itself is the change in rationale behind it. Traditionally advanced on cultural, ethnic, and religious grounds, in the late 20 th century devolution has increasingly been promoted as a means to achieving sustainable economic development (Rodriguez-Pose and Gill 2005). Despite being used as a rationale, however, the link between devolution and development is rarely examined as explicitly as it should be (Morgan 2002). This essay aims to explore this link, by analyzing prominent ways in which devolution has contributed to and impeded economic development in the case of Brazil. Section II will briefly explore the recent devolutionary trend in Brazil. Section III will then focus specifically on devolution s positive contribution to economic development in Brazil through its facilitation of the pursuit of local economic development strategies. Sections IV and V will investigate two possible negative consequences of the devolutionary trend: increased territorial inequity and increased inefficiency through inter-territorial competition. The analysis reveals that Brazil s policy and institutional framework has helped in mitigating the potential negative effects of Ceidir 2009

2 Maria Chotreva CEIDIR s Review, No.9, 2009 devolution on territorial inequity, yet exacerbating these effects on inter-territorial competition. Thus, the essay s main conclusion is that the extent to which devolution has contributed to economic development in Brazil has depended, in part, on the specific complementary policies implemented for mitigating its perverse effects on equity and efficiency. II. Brazil: a shining example of the devolutionary trend Brazil has a long history of federalism going back to the nineteenth century, when a federal republic was established in Since then, devolutionary trends in Brazil have largely followed political cycles, with authoritarian spells favouring a greater centralization of power and democratization being closely associated with devolution (Rodriguez-Pose and Arbix 2001). Thus, the return to democracy with the Constitution of 1988 following a military regime marked a great increase in the political influence and fiscal autonomy of state and municipal governments (Rodriguez-Pose and Gill 2004). The trend was accompanied by a high growth in the share of federal tax transfers to subnational governments, which climbed from 18 percent to 44 percent from 1980 to 1990 (Serra and Afonso 1999, p. 5). Thus, today Brazil is one of the most decentralized democracies in the developing world, with subnational governments accounting for about half of public expenditure (Dillinger and Webb 1999, p. 1). The country consists of 26 states plus the Federal District of Brasilia, which are represented in the Chamber of Deputies based on population and in the Senate on an equal basis of three senators per state. Brazilian states are responsible for a wide and expanding range of taxation, expenditure and investment functions, and are the only known subnational units along with Canadian provinces to administer their own value-added tax, called the ICMS (Rodden 2003). The following plot rudimentarily indicates a slightly negative relationship between Brazil s devolutionary trend and economic growth (Figure 1). However, due to the large number of factors affecting both of these variables, no conclusions can be drawn from this simple representation without a more in depth case-study analysis of the different ways in which devolution has affected economic development in Brazil, to which this essay now turns. 2

3 Growth of per capita GDP (%) Devolution s Contribution to Economic Development: The Case of Brazil Revista CEIDIR, No.9, 2009 Figure 1: Devolution and Economic Growth in Brazil Subnational share of total government expenditure (%) Sources: Growth of GDP per capita (%) from The Penn World Table Version 6.2; subnational share of total government expenditure (%) from IMF Government Finance Statistics (own representation). III. Devolution and local economic development policies in Brazil One of the most prominent contributions of devolution to economic growth, as argued by its advocates, is through policy innovation. Namely, a certain degree of autonomy for investment and expenditure decisions allows subnational units to pursue policies for economic development tailored to their own local needs and endowments (Gil et al. 2004). Having this freedom, and being responsible for their own welfare, the regions are more likely to embark on creative attempts to raise their own revenues (Rodriguez-Pose and Gill 2005) and supply public goods and services (Thiessen 2003). Devolution is thus expected to make public expenditure more efficient (Martinez-Vasquez and McNab 2005), create opportunities for local regimes to mobilize around sustainable development (Benneworth and Roberts 2002) and contribute to a better coordination between various local actors (e.g. local government, businesses and civil society). Most importantly, devolution is expected to provide each territory the autonomy to pursue a development strategy tailored to its own economic potential and competitive advantage (Martinez-Vasquez and McNab 2003a), thus contributing to greater national economic development. In Brazil, the pursuit of economic development strategies at the local level did indeed coincide with the country s recent devolutionary trend. Subnational governments participation in the promotion of local economic development has 3

4 Maria Chotreva CEIDIR s Review, No.9, 2009 surged dramatically over the last decade. A survey reveals that by 2001, 35 percent of the country s municipalities had implemented some type of fiscal incentive program and 52 percent had implemented some type of employment or income generation program (Biderman and Barberia 2005, p. 6). Most importantly, studies have shown that this new trend of the growing presence of decentralized development initiatives can largely be attributed to Brazil being one of the countries to give the most autonomy to municipal governments (Biderman and Barberia 2005, emphasis added). Rodriguez-Pose et al. (2001) illustrates this trend of Brazilian municipalities increasing involvement in local economic development with the case of the ABC region in the Sao Paolo metropolitan area, where economic crisis and restructuring have led to inter-municipal cooperation and the creation of a local economic development council, involving civil society, the public sector, local businesses and trade unions. The authors acknowledge that this initiative has in part been driven by greater municipal autonomy, giving local governments the capacity to take a more pro-active stance in implementing innovative initiatives for endogenous development. Thus, in the context of empowering local development strategies, devolution has, arguably, made a positive contribution to economic development in Brazil. Yet, working against this positive contribution are potential perverse effects of the devolutionary trend, whose manifestations have been differentially mitigated or exacerbated through the country s policy environment. IV. Devolution, inter-territorial competition and efficiency concerns in Brazil On the negative side, through the contraction of the central government s role in attracting and allocating industry (Rodriguez-Pose and Gill 2004) and the delegation to regions of the responsibility for their own revenue generation and economic development, devolution can push subnational territories to competition for the attraction of foreign direct investment (FDI). In a belief that FDI will spur innovative capacity and have a stimulating effect on the local economy (Vazquez-Barquero 1999), subnational territories could increasingly engage in competition for the attraction of firms. However, as FDI has become more footloose and less constrained by traditional location factors in recent decades (Cheshire and Gordon 1998), this competition is likely to take the form a race-to-the-bottom in general incentives (tax breaks, grants, donations of land, etc.) offered by each region. Such strategies can have a clearly detrimental effect on economic development. Firstly, the incentives offered to firms will put a strain on fiscal budgets 4

5 Devolution s Contribution to Economic Development: The Case of Brazil Revista CEIDIR, No.9, 2009 and may cause regional governments to underprovide for public services and basic infrastructure (Serra and Afonso 1999). Secondly, when regions sell themselves out based on generic incentives, instead of building upon what already exists in the local economy, the possibility of a synergy between the attracted firms and local economic activity is greatly diminished (Biderman and Barberia 2005). Thirdly, engaging in raceto-the-bottom causes most of the value of such incentives to accrue to the investors themselves, who are able to exploit their monopsonistic power at the regions expense (Cheshire and Gordon 1998). Most importantly, the incentives offered represent a deadweight loss and source of inefficiency to the nation as a whole, as they are aimed at affecting the location decisions for firms that had the intention to locate within the country in the first place (Rodriguez-Pose and Gill 2005). In Brazil, the manifestation of this detrimental effect of devolution has been borne out in the form of a guerra fiscal between different states for the attraction of FDI, notably in the automobile industry. Between 1995 and 1999, car manufacturers invested over US $12 billion in Brazil (Rodriguez-Pose and Arbix 2001, p. 134). Far from being growth-enhancing, however, this investment spurred a fierce and wasteful rivalry between Brazilian states in trying to influence companies' location decisions. In exchange for locating within a region, firms were increasingly offered tax breaks, favourable loan agreements, donations of land, grants, etc. The car companies encouraged such competition and played Brazilian states off against each other in order to achieve the best possible deal. The final outcome of these bidding wars was pure waste, since any possible increase in local welfare was neutralized by the costs of attracting FDI, which would have located in Brazil any case, leading, in the long-run, towards greater dependency, greater instability, greater disparities and probably greater poverty (Rodriguez-Pose and Arbix 2001, p. 152). Arguably, the detrimental effect of devolution on inter-territorial competition has been induced, or at least exacerbated, by inadequate policy decisions and institutional framework. Firstly, incentives and subsidies as a means of attracting companies were encouraged under the New Automotive Regime a federal government initiative for fostering FDI in the automobile sector (Rodriguez-Pose and Arbix 2001). Further, this practice was made possible by state governments right to levy their own value-added taxes (Biderman and Barberia 2005). Most importantly, when the bidding wars got out of hand, the federal government failed to set up an adequate institution for the regulation of financial incentives offered by the competing regions. Ideally, such an institution would discriminate against FDI attracting policies which are diversionary (i.e. attract investment away from other regions) and promote those that are capacity-enhancing (Cheshire and Gordon 1998). The National Fiscal 5

6 Maria Chotreva CEIDIR s Review, No.9, 2009 Policy Council, which on paper should fulfill such a role, was ineffective as it operated on a unanimity rule, where any state has the right to veto a decision (Rodriguez-Pose and Arbix 2001). In sum, the negative effects of devolution on inter-territorial competition in Brazil have been borne out partly as a result of an inadequate policy and institutional framework, to the detriment of economic development, and in opposition to devolution s positive impact. V. Devolution and spatial disparity concerns in Brazil Through a mechanism similar to that of promoting inter-territorial competition, devolution can often lead to increased inequality between the regions of a country. In a devolved system, spatial equality usually comes second to the main objective of promoting an economic dividend within each region (Agnew 2000). By putting each region in charge of its economic development and exposing it to competitive forces from its neighbours, devolution carries with it implicit fiscal, political and administrative costs, which fall more heavily upon those regions with limited adjustment capacities, resulting in differential rates at which regions can capitalize upon the opportunities it offers and leading to greater development of initially rich and powerful regions to the detriment of poorer areas (Rodriguez-Pose and Gill 2004). In addition, insofar as redistribution to minimize spatial disparities is a role of the central government, the reduction of the latter s power and resources through the devolutionary process can reduce its capacity to correct such disparities and thus increase inter-regional inequality (Prud homme 1995). Further, from a dynamic point of view, devolution can bring about a regressiveness in the allocation of government expenditure, as the empowerment of the states in deciding how transfers are allocated gives a disproportionate negotiating strength to the richer ones, whose degree of influence over the central government is higher, allowing them to secure a disproportionate share (Rodriguez-Pose and Gill 2003). Thus, devolution can reinforce regional inequalities, which may prove detrimental to economic development due to their negative welfare consequences (Cheshire and Gordon 1996, cited in Agnew 2000) and the underutilization of resources, such as infrastructure and labour, in lagging regions (Armstrong and Taylor 2000), for instance. In line with the theoretical predictions above, empirical evidence from various developed and developing countries indicates a clear coincidence of increasing spatial disparities with devolution initiatives. Most surprisingly, however, Brazil is a 6

7 Devolution s Contribution to Economic Development: The Case of Brazil Revista CEIDIR, No.9, 2009 notable exception to this trend, experiencing a 16 percent decline in spatial inequalities between the 1980s and 2000, when devolutionary efforts were on the rise (Rodriguez-Pose and Gill 2004, p. 2098). As in the previous case of inter-territorial competition, Brazil s policy and institutional framework has played a role in affecting the link between devolution and regional disparities. In contrast to the previous case however, the role has been positive, comprising of an effective mitigation of the negative consequences of devolution on spatial disparities. Firstly, the fact that devolutionary trends have not been accompanied by an increase in regional disparities can be attributed to the existence in Brazil of a fairly developed and redistributive fiscal transfer system, which, according to Prud homme (1995) is an important tool for controlling the negative effects of devolution on spatial disparities. The federal government assumes exclusive responsibility for the taxes on personal and corporate income, payroll, wealth, foreign trade, banking, finance and insurance, thus having control over a large revenue pool from which transfers to the state governments can be made (Rodden 2003). These transfers are fixed by formula, which determines a participation coefficient for each state that is based mainly on redistributive criteria, with about 85 percent of total funds being set aside for the poorer regions the North, Northeast, and Centre-West (Rodden 2003, p. 8). Further, because the majority of federal taxes are generated in the south and southeast, the extent of regional redistribution is even greater than this figure would suggest (Dillinger and Webb 1999). Finally, the Brazilian federative system is also designed to generate a significant process of redistribution in terms of political power and congressional representation of the states (Serra and Afonso 1999). In the Federal Senate, where each state is represented by three senators, rich and poor regions enjoy equal representation. This equality in representation is of great importance, as the Brazilian Senate is responsible for analyzing and voting all bills and constitutional amendments that come out of the Chamber of Deputies. In sum, in contrast to the case of inter-territorial competition, the institutional and policy framework of Brazil has contributed to mitigating the perverse effects of devolution on spatial disparities and therefore on economic development. VI. Conclusion: lessons for other developing countries As a logical conclusion to the arguments presented in this essay, it can be asserted that, for the case of Brazil, devolution has affected economic development 7

8 Maria Chotreva CEIDIR s Review, No.9, 2009 through various complex channels, and the extent to which the two factors have been positively related has in part been dependent on institutional-specific policies The experience of Brazil under devolution provides important lessons for other developing countries undergoing similar changes, with regards to accommodating the potential consequences of transferring resources and power to lower tiers of government. As the case of Brazil clarifies the negative consequences of devolution on equity and efficiency could be overcome through policy, yet, if left unmitigated, they can have clearly detrimental consequences for economic development. 8

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