9 Municipal finance and local state performance in the crisis: the experience of Brazil and Mexico

Abstract

The record of subnational public finance during the 1980s and 1990s in Brazil and Mexico is well known: long periods of disequilibria caused by excessive debt accumulation at the state and municipal level, sometimes exacerbated by sharp currency depreciations but more often because of distorted incentives from central government implicit bailout guarantees, resulting in a series of fiscal crises and calling into question state performance at all levels of government in managing subnational fiscal policy. During the 1990s, however, piecemeal decentralization reforms were being pursued by fiscal policy makers, introducing new rules and regulations, including quantitative targets and market-based reforms, which laid the groundwork for putting subnational finances on a better footing during the 2000s. The politics of these reforms and the subnational fiscal stability achieved during the regional growth cycle of the previous decade have diverted attention away from the relationship between local public finance and external economic volatility.1 Given the nature of the transmission of the recent global economic crisis and the continuing deficit of global economic regulation, this seems to be a particularly salient field of inquiry. Recent literature on fiscal federalism, the so-called second generation, provides a basis for developing a loose analytical framework in which the Latin American experience of the previous decade can be considered. This literature extends the early normative models of fiscal frameworks constructed on assumptions of economic efficiency and willingness of public sector agents to identify market failures in the provision of collective goods, emphasizing the political, institutional and historical context in which the assignment of fiscal responsibilities occurs (Weingast 2009; Oates 2005). This approach is particularly suitable in the case of Latin America, not just because there is evidence of political patronage in the distribution of intergovernmental transfers (Timmons and Broid 2010), but because, in more general terms, fiscal decentralization has occurred during a period in which the state has made a clear reentrance in the areas of economic and social policy. Institutions, it would appear, are back in the picture – subnational included. Because this chapter is concerned with analyzing the operational resiliency of urban public finance during and after the recession in Brazil and Mexico, it is important to begin with an accurate model of the subnational features of the fiscal federal systems as they existed in the region at the onset of the global financial crisis in 2008. For the purpose of our analysis, we can divide the municipal finance system into two inter-related tracks: politico-institutional and economic. Fiscal autonomy at the subnational level entails a certain accounting identity: local governments raise revenues from assigned tax bases, receive intergovernmental transfers, make expenditures and incur debt. However, the rules, both constitutional and budgetary (de jure), that define the accounting identity and norms of practice (de facto) that guide the fiscal behavior of subnational governments are determined by the nature and quality of political governance(Tommasi et al. 2001).2 The evolution of these rules and norms determines the effective distribution of spending assignments and revenue authority at the local level. The structure and distribution of fiscal responsibilities delineates the sensitivities of local governments to fluctuating economic conditions. Following a period of repeated fiscal crises in the 1990s, many with origins in excessive debt accumulation at the subnational level, the politico-institutional environment in which subnational governments manage their budgets in Latin America has been reshaped by the adoption of fiscal responsibility laws and subnational fiscal rules but also by continued dependence, with some reforms, on financial market regulations (Webb 2004). In principle, a number of benefits are derived from the implementation of fiscal responsibility legislation. It is argued that rules-based regulation makes subnational budgetary institutions more transparent, smoothing government expenditures over voting cycles, minimizing central government exposure to excessive subnational debt, and ensuring the sustainability of local service provision. In short, the intended effect is coordinated fiscal discipline across subnational government units. In practice, the efficacy of fiscal responsibility legislation is dependent, in part, on design, but also on implementation. That is, even though rules-based legislation to maintain fiscal balance at the subnational level might exist, if effective enforcement mechanisms are not in place, national governments face considerable levels of moral hazard from subnational governments operating under soft budget constraints (Ter-Minassian 2007).3