Report No. 19217-BR Brazil Poverty Reduction, Growth, and Fiscal Stability in the State of Ceara" A State Economic Memorandum (In Two Volumes) Volume 1: Policy Report August 21, 2000 Brazil Country Management Unit PREM Sector Management Unit Latin America and the Caribbean Region Document of the World Bank CURRENCY EXCHANGE RATES (R$US$) Currency Unit - Real (R$) December 1995: R$0.97/US$ December 1996: R$1.04/US$ December 1997: R$1.12/US$ December 1998: R$1.21/US$ December 1999: R$1.78/US$ July 2000: R$1.80/US$ WEIGHTS AND MEASURES The Metric System is used throughout the report. FISCAL YEAR January 1 to December 31 Vice President LCR: David de Ferranti Director LCC5C: Gobind T. Nankani Director LCSPR: Ernesto May Lead Economist: Suman Bery Task Manager: Joachim von Amsberg ABBREVIATIONS AND ACRONYMS BEC Cear6 State Bank (Banco do Estado do Ceard) BID Interamerican Development Bank (Banco Interamericano de Des- envolvimento) BNB Northeast Regional Development Bank (Banco do Nordeste do Brasil) BNDES National Development Bank (Banco Nacional de Desenvolvimento Econ6mico e Social) EMATERCE State Technical Assistance and Rural Extension Agency (Empre- sa de Assistdncia T6cnica e Extenscio Rural do Ceard) EMBRATUR Brazilian Tourism Company (Empresa Brasileira de Turismo), EPZ Export Processing Zone (Zona de Processamento das Exporta- g6es) ETENE Technical Office of the BNB for Economic Studies of the Northeast (Escrit6rio T6cnico de Estudos Econ6micos de Nordeste) FDI Industrial Development Fund (Fundo de Desenvolvimento Indus- trial) FGV Getulio Vargas Foundation (Fundagio Getulio Vargas) FIEC Industry Federation of Ceard (Federagio das Ind0strias do Estado do Ceard) IBGE Brazilian Institute of Geography and Statistics (Instituto Brasileiro de Geografia e Estatistica) ICMS Value Added Tax (Imposto de Circulaglo de Mercadorias e Servi- 9os) IFC International Finance Corporation IPEA Institute of Applied Economic Research (Instituto de Pesquisa Econ6mica Aplicada) IPLANCE Planning Institute of Ceari (Fundag5o Instituto de Planejamento do Ceard) LSMSIPPV Living Standards Measurement Study (Pesquisa das Padr6es da Vida) PME Monthly Employment Survey (Pesquisa Mensal de Emprego) PNAD National Household Survey (Pesquisa Nacional por Amostra dos Domicilios) PRODETUR Tourism Development Program (Programa para o Desenvolvi- mento de Turismo) SDE State Secretariat for Economic Development (Secretaria de Des- envolvimento Econ6mico) SDR State Secretariat for Rural Development (Secretaria de Desenvol- vimento Rural) SEBRAE/CE Support Service for Small and Medium Enterprises (Servigo de Apoio ds Micro e Pequenas Empresas) SEFAZ State Secretariat of Finance (Secretaria da Fazenda) SEPLAN State Secretariat of Planning and Coordination (Secretaria do Planejamento e Coordenagbo) SETUR State Secretariat for Tourism (Secretaria de Turismo) SUDENE Northeast Development Agency (Superintenddncia para o Desen- volvimento do Nordeste)  Brazil: Poverty Reduction, Growth, and Fiscal Stability in the State of Ceara Policy Report Table of contents FO R EW OR D .................................................................................................................................. 6 SUMMARY OF MAIN FINDINGS AND RECOMMENDATIONS ................................................7 1. O V ERV IEW ............................................................................................................................. 17 Introduction ................................................... 7 Basic State Characteristics........................................18 2. ECONOMIC DEVELOPMENT POLICY AND PERFORMANCE ......... .........19 Growth Policies.................... ...................... .....1.9 Overall Growth Performance .......................................20 Industry ......................................................23 Tourism ......................................................26 Agriculture....................................................28 3. SOCIAL DEVELOPMENT POLICY AND PERFORMANCE ...........................................31 The Poverty Trend and Profile......... ............................31 Social Policies ........................................ .........35 4. FISCAL POLICY AND PERFORMANCE ......................................................................... 39 Revenues .................................................... 39 Expenditure Analysis by Economic Category ............................41 Allocation of Expenditure.........................................45 5. A RENEWAL OF THE POLICY STRATEGY ..............................46 Strategy Evaluation.............................................46 Growth and Poverty Reduction Prospects .......................46 Policy Options and Choices.........................................48 Investing in Education and Infrastructure..............................50 Improving Markets and Developing the Private Sector .....................53 Strengthening Global Linkages ................................ ..... 55 De-emphasizing industrial Policy ....................................57 Deepening the Reform of Water Resource Management..........................58 Maintaining Good Governance and Fiscal Balance...... ................. 60 Providing Services and Assets for the Poor. ........................ .....61 Strengthening the Social Safety Net ............................ ......61 6. SUMMARY MATRIX OF POLICY RECOMMENDATIONS ................ .....62 Brazil at a Glance................ ............................... 6.6 Map IBRD No. 31039 TABLES TABLE 1: LINKAGES BETWEEN POLICY OBJECTIVES AND INSTRUMENTS 16 TABLE 2: SECTORAL COMPOSITION OF THE CEARENSE ECONOMY (% SHARES) 21 TABLE 3: GROWTH RATE COMPARISONS FOR NORTHEASTERN STATES, 1985-96 21 TABLE 4: CEARA: TOURISM ESTIMATES AND PROJECTIONS, 1997-2001 26 TABLE 5: HOUSEHOLD PER CAPITA INCOME SHARES BY DECILE 32 TABLE 6: CEARA POVERTY PROFILE 34 TABLE 7: ACCESS TO BASIC SERVICES OVER TIME 38 TABLE 8: TRENDS IN CURRENT REVENUES 39 TABLE 9: TRENDS IN ICMS AND GDP 40 TABLE 10: LOSSES ARISING FROM LEI KANDIR 40 TABLE 11: SECTORAL COMPOSITION OF ICMS RECEIPTS 40 TABLE 12: DISBURSEMENTS AND RECEIPTS OF INDUSTRIAL TAX INCENTIVES 41 TABLE 13: TRENDS IN NUMBER OF PERSONNEL 42 TABLE 14: TRENDS IN DEBT STOCK 42 TABLE 15: TRENDS IN CURRENT AND CAPITAL EXPENDITURES 43 TABLE 16: OBJECTS OF MAJOR CAPITAL SPENDING, 1997 43 TABLE 17: ACTUAL AND PROJECTED FISCAL INDICATORS 44 TABLE 18: GROWTH AND POVERTY REDUCTION SCNEARIOS 47 FIGURES FIGURE 1: SECTORAL CONTRIBUTIONS TO GDP GROWTH 1990-96 22 FIGURE 2: SECTORAL CONTRIBUTIONS TO NEW EMPLOYMENT 1990-96 22 FIGURE 3: POVERTY RATES OVER TIME 31 FIGURE 4: SPATIAL DISTRIBUTION OF THE POOR, PNAD 1996 33 FIGURE 5: POVERTY RATES BY EDUCATION LEVEL, PNAD 1996 34 FIGURE 6: POVERTY RATES BY OCCUPATIONAL SECTOR, PNAD 1996 35 FIGURE 7: THE POOR BY EMPLOYMENT STATUS, PNAD 1996 35 FIGURE 8: CAPITAL SPENDING PROJECTION 44 FIGURE 9: SPENDING BY SECTOR 1997 45 BOXES BOX 1: THE MENU OF POLICIES TO PROMOTE LABOR DEMANDING GROWTH 19 BOX 2: REGIONAL CONVERGENCE POLICIES 20 BOX 3: CLUSTER BASED GROWTH STRATEGIES 54 BOX 4: REGIONAL INVESTMENT INCENTIVES 55 BOX 5: EXPERIENCE WITH EXPORT PROCESSING ZONES 56 Annexes (in Volume II) 1. The Economy: Improving Competitiveness 2. The Land: Reviving the Rural Economy 3. The People: Reducing Poverty 4. The State: Managing Fiscal Stability 5. Statistical Annex FOREWORD This report is based on the findings of a mission to Cearc in July 1998 and is restricted mostly to information and data available at that time. The report was prepared by a World Bank team comprised of Joachim von Amsberg (Task Manager), William Tyler (Growth), Alberto Valdes (Rural), Francisco Ferreira (Poverty) and William Dillinger (Fis- cal). Specific analysis and assistance was provided by Marcelo Neri, Louise Keely, Radha Seshagiri, Detlev Puetz, Guilherme Bastos, Fabio Rolim, Julia Conter Ribeiro, Yana Chagas, and Leo Feler. The report was produced under the supervision of Gobind T. Nankani, Director, Suman Bery, Lead Economist, as well as Eliana Cardoso and Geoffrey Shepherd, Lead Specialists. Ant6nio Rocha Magalh5es provided valuable guidance and advice to the team throughout the process. The peer reviewers for this task were Zmarak Shalizi, Shyam Khemani, and Judith Tendler (MIT). It would not have been possible to produce this report without the close collaboration of the Government of the State of Cear6 under the leadership of M6nica Clark Cavalcante, Secretary of Planning. The State Government's counterpart team consisted of Alberto Teixeira (IPLANCE), Jos& Nelson Bessa Maia (Government Adviser), Adriano Sarquis (BNB), and FlAvio Ataliba (UFC). The work further benefited from the advice and col- laboration of Osmundo Rebougas (BNB), Carlos Azzoni (USP), and Jair Amaral (UFC). The participation of the Governor, several State Secretaries, many other Government officials, as well as other individuals and institutions during the preparation of this report and during seminars in October 1998 and June 1999 is gratefully acknowledged. De- spite the extensive collaboration with the State Government, this report and the views expressed in it remain the sole responsibility of the World Bank. This report consists of two volumes. Volume I is the Policy Report which is directed at policy makers and a general audience interested in the main messages of the report. The Policy Report contains a summary of the most important policy recommendations without providing full analytical support. Volume II is the Technical Report which pro- vides the analytical backup to the Policy Report and contains a detailed statistical An- nex.  Cear6 State Economic Memorandum Page 7 SUMMARY OF MAIN FINDINGS AND RECOMMENDATIONS Northeast region, while its population Overview has grown at the national rate. Per cap- ita GDP in 1996 was UIS$1,917 com- I. Over the last decade, Cear6 has pared to a Northeastern average of emerged among the states of the poor US$2,170 and a national average of Northeast region of Brazil as a model of US$4,421. Favored by incentive pro- good economic and fiscal performance grams of different government entities, and good governance. This model and industry has assumed an increasingly its underlying policies have attracted important role in the States economy. much attention. This report reviews the Nevertheless, industry's role as a'gen- set of policies that the State Govern- erator of employment remains limited. ment has chosen in order to promote Within the service sector, major struc- economic development, poverty reduc- tural changes have occurred, resulting tion, and fiscal stability in Cear6 and as- in an impetus away from more tradi- sesses the resulting performance. By tional services toward tourism as one of pulling together the lessons and experi- the main emerging growth sectors. The ences of Cear, this report attempts to agricultural sector, subject to droughts document some of the progress, the and the near eradication of its main successes, and the remaining chal- product (cotton) due to pests, has been lenges facing the State. stagnant over the past decade. Agricul- ture's share of the economy has de- 1l. Cear6 has applied a policy mix cined to 5.7%, which is exceptionally consisting of a combination of: (a) good low for Cear6's level of income. Cear6's governance and modernization of the products serve mostly a Northeastern state with a focus on sound fiscal man- and domestic rather than an interna- agement; (b) significant industrial pro- tional market. motion in particular through fiscal incen- tive programs; and (c) increasing public IV. Over the past 20 years, poverty investment in areas such as transport in Cearb has been reduced very sig- infrastructure, water resources and edu- nificantly, yet it remains severe and cation. There is an additional emerging deep. Recent analysis by Rocha (1998) emphasis on improving the working of shows that the rate of extreme poverty the micro-economy, for example, has been reduced by half from 1985 to through collaboration with the private 1996 and by a third from 1993 to 1996. sector in the formation of industrial Other studies confirm that poverty rates clusters. Cear has focused relatively in CearA have been reduced somewhat little on fostering international trade link- faster than in the Northeast and in Brazil ages. Also, there has been less focus as a whole. Nevertheless, using a pov- on the promotion of agricultural devel- erty line of approximately R$65 per opment and the modern service sector. month per capita (adjusted for differ- Overall, Ceari has quite consciously ences in the cost of living and higher created the image of a modernizing than the poverty line used by Rocha), state that is open and attractive to in- the State's headcount poverty rate is still dustry. 49% compared to 23% in Brazil, 9% in the Southeast, and 48% in the North- Ill. With annual GDP growth aver- east overall. Poverty rates are lowest in aging 5.8% from 1970 to 1997, Ceari the Municipality of Fortaleza (20%), fol- has grown faster overall than the lowed by cities above 100,000 in popu- Brazilian average and faster than the lation (31%), the Periphery of the For- Page 8 Cear6 State Economic Memorandum taleza Metropolitan Area (42%), medium Performance and Strategic Choices cities (48%), small cities (51%) and fi- nally rural areas (77%). 56% of all poor VI. Dramatic changes have occurred live in rural areas, 17% live in small in the national and international eco- towns up to 20,000, 10% inhabit me- nomic environment during the last dec- dium and large cities, and 19% reside in ade. In particular, Brazil has moved from the Fortaleza Metropolitan Area. Poverty a state-dominated closed economy and is strongly correlated with low education a long period of instability to a more sta- levels, non-migration, agricultural activ- ble and increasingly open but still vul- ity, and unemployment, informal em- nerable economy driven by the private ployment, and self-employment. Other sector. Against this background, this re- welfare indicators, such as infant mor- port attempts to determine whether cur- tality, also show the large scale of social rent policies will be appropriate to en- progress that has already occurred in sure superior performance in the future Ceard. However, these indicators still or whether policy adjustments are suggest that many more improvements needed. The report focuses on the must transpire before Cear6 reaches a analysis of key policy issues related to standard of living equal to the national poverty reduction, growth, and fiscal average. stability but does not attempt a compre- hensive assessment of state policies in V. Justifiably, Ceari has acquired all areas. This report explores and rec- the reputation of a State that is fiscally ommends appropriate adjustments to sound and well-governed by Brazilian state policies in areas where additional standards. This reputation has become reforms are within the powers of the an asset for the State, well worth pre- State and could help sustain and further serving, and a major attraction to firms improve Cear Vs performance. Selective selecting a location for their investment suggestions for relevant reforms at the within the Northeast. While many states federal level are also made. must now focus their energies on post- poned fiscal adjustment, Ceari can af- VII. Ceani's combination of good ford to focus on positive challenges governance and sound fiscal manage- such as the needed improvements in ment, industrial promotion, and in- educational attainments. Presently, per- creasing public investment has overall sonnel costs consume 60% of net cur- been successful. These programs have rent revenues of Cear6. The stock of generated significant growth in industry debt is relatively small by Brazilian stan- and have led to a significant reduction of dards (102% of net current revenues), poverty. However, poverty remains deep and largely long-term and low-interest. and severe by any standard. This report Nevertheless, fiscal constraint is be- addresses the question of whether a coming increasingly important consid- different set of policies could have led to ering that the State's primary balance, higher growth and more reduction in which was only -1% of net current reve- poverty or whether there simply is so nues in 1995, deteriorated to -10% in much poverty that more time and more 1996 and -16% in 1997. In particular, of the same policies are needed to fur- capital spending appears to be unsus- ther reduce poverty rates. tainable at current levels. An assess- ment of the potentially very large liabili- VIII. This report suggests multiple ex- ties of the State's pension system is on- planations for the large amount of pov- going. erty remaining. First, poverty in the Northeast of Brazil is indeed so deep that sustained growth over a longer pe- riod of time will be needed to bring Cearg State Economic Memorandum Page 9 about further drastic reductions in pov- an increasingly competitive economic erty. Second, a long-standing history of environment. For the future, there is inward-looking economic policies at all promise for a stronger external orienta- levels of Government in Brazil has led to tion of the economy. However, industrial patterns of growth with lower labor in- growth alone will only lead to the ab- tensity than one would expect in an sorption of a limited number of poor, and economy with as much available labor a strategy that equally encourages as Brazil. Economic reforms in recent growth in industry, services such as years have introduced drastic changes tourism, and agriculture, is more likely to to Government policies. With time and have larger poverty reducing effects. the consolidation of these changes, the Fortunately, it is likely that tourism will patterns of growth are likely to change play a major role in leading CearA's as well. Third, there have been some growth. Also, agrculture holds some distortions and some biases against la- promise for growth in high-value prod- bor-intensive growth in the current policy ucts and as a supplier for important mix of the State. This includes distor- downstream growth sectors. Improve- tions created by the system of industrial ments in the functioning of the factor incentives. Without these distortions, the markets, in particular reliable access to poverty outcome could have been water, are critical for the growth of mod- somewhat improved but probably not er agriculture. Growth in all modern dramatically better. sectors will depend on improved workforce education. IX. CearA can continue to develop economically on its main assets: (a) a Xl. The large reservoir of the rural climate favorable to tourism and irri- poor and extremely low labor productiv- gated agriculture; (b) a large labor force ity in agriculture (which continues to at wages comparatively low by Brazilian provide 43% of all employment) are at standards; (c) a Government with a the root of CearA's overall poverty reputation for fiscal responsibility and problem. In order to enable the poor to effective administration; and (d) a stra- benefit from the economic opportunities tegic location with respect to markets in arising from growth and to increase the Europe and North America combined effect of growth on poverty reduction, with an improving transportation infra- investments in human capital and the structure. At the same time, develop- physical assets of the poor are critical. ment remains constrained by: (a) low The specific strategy must be tailored to productivity and the relatively low edu- different groups among the poor. Some cation level of the labor force; (b) the of the rural poor can be stabilized in the large share of the population located in traditional agricultural areas through a the backward and stagnant Serfto, combination of land reform along with where access to water is a major limita- other mechanisms to capitalize small tion; (c) the overall high cost of doing farmers. Some of the rural poor will be business in Brazil (Custo Brasil; and (d) absorbed by modern agriculture. Many very limited fiscal headroom. of the rural poor will gradually migrate to urban areas if labor intensive growth in X. Broad-based, labor-intensive industry and services generates the growth remains the most important needed employment and if better edu- strategy for reducing poverty, increasing cation for the rural population supports the overall standard of living, and re- the necessary mobility. Finally, some of ducing fiscal strain. Overall, manufac- the rural poor will be unable to acquire turing, particularly light manufacturing the skills needed to make use of the op- (e.g., shoes, apparel, and agro-industry) portunities in the more modern sectors is expected to continue its expansion in Page 10 Cear; State Economic Memorandum of the economy. They will depend on strengthen the existing policy focus on improvements in the social safety net. industry development, including the ex- ertion of an extra effort to attract heavy XII. Simple simulations are used to industry such as metal and petrochemi- illustrate the impact of different growth cal industries. Such an industrial strat- scenarios on poverty over the next 10 egy might be successful in influencing and 20 years. If Cear4s economy grew the location decisions of important in- by 6% per year, somewhat higher than dustries. However, this strategy would the 4.9% of the 1990-96 period, poverty divert fiscal resources and state man- rates would fall quite rapidly from 49% agement attention away from growth to 33% and 21% in 10 and 20 years re- opportunities in other sectors for which spectively. The 21% poverty level is Cear6 has a more obvious comparative slightly below the level of poverty in all advantage, including agroindustry, high- of Brazil today. The absolute number of value agriculture, and tourism. This poor would also fall significantly in this strategy would be unlikely to lead to the scenario. However, if growth plummeted massive absorption of labor from low to 3% (the countrywide rate of the 1990- productivity sectors, and would probably 96 period), poverty rates would fall to not result in more rapid poverty reduc- only 43% and 37% after 10 and 20 tion. An industry-only strategy is likely to years, respectively. The absolute num- cement or even worsen income me- ber of poor would remain virtually un- qualities in the State. In summary, an changed, making such growth perform- excessive focus on industrial develop- ance unacceptable. ment would lead to performance below potential. XIII. The key question is how CearA's Government can use a sharpened mix XV. Another alternative strategy of the policy instruments available at the would focus on massive public invest- state level to sustain higher than coun- ment, principally on education, and pro- try-average growth over the next decade ductive infrastructure such as roads, and to accelerate the reduction of pov- ports, electricity, and water resources. erty. The report's assessment suggests There is a strong justification for such a that nothing is fundamentally wrong with strategy in the findings of this report, in current state policies and no radical re- particular regarding the expansion of versal in strategy is indicated. However, education. The major problem of this some policy adjustments, the removal of strategy is its fiscal implication. A critical remaining distortions, and a rebalancing element of Cear&s success has been its of the policy mix could bring about im- reputation of fiscal and administrative provements in the policy outcome, in soundness. Given the limited headroom particular with respect to poverty reduc- for public investment, not even consid- tion. Hypothetical alternatives for rebal- ering potential pension liabilities, a mas- ancing the policy mix are presented in sive expansion of public investment the following paragraphs in the form of would undermine the critical success four stylized strategies: an industry factor of fiscal soundness. The funda- strategy, a public investment strategy, a mental difference from East Asian welfare strategy, and, finally, a quality- countries that have successfully pur- of-spending strategy. The quality-of- sued such a public investment strategy spending strategy is the approach rec- is the fiscal situation. The difference in ommended by this report. fiscal situations does not permit a mas- sive public investment strategy to be XIV. Before describing the preferred applied in Ceard. strategy, it is useful to analyze the alter- natives. The first alternative would be to Cearc State Economic Memorandum Page 11 XVI. A third option, built on the belief XVIII. The proposed quality-of- that the fruits of past growth in CearA spending strategy would focus on poli- need to be distributed to the poor more cies with large positive spillover effects rapidly, would be an explicit welfare (principally education but also infra- strategy. This strategy would imply a structure). The strategy would put less shift from growth policies toward the emphasis on industrial development creation of a tighter social safety net and through incentive programs, but more improved services and assets for the emphasis on private sector development poor. Again, the main risk of such a through an evolution of water resource strategy is fiscal instability. Ceard simply management policies and private-public does not have the fiscal room for signifi- partnerships. The State would continue cant increases in public spending with- to improve its policies of providing serv- out either compromising its reputation ices and assets for the poor* and for fiscal soundness or sacrificing strengthening the social safety net. Fi- spending in areas as important as public nally, a concerted effort for the review investment in education and infrastruc- and restructuring of public spending and ture. Moreover, the main problem of so- the management of the public sector cial spending in Brazil is its low quality in pension liabilities should provide more terms of efficiency as well as targeting. focus on the priorities identified in this This means that efforts to improve the report. quality of spending are likely to be more effective for improving social outcomes Recommendations than an outright expansion in social spending. XIX. Improving educational out- comes should become the top priority XVII. The problems with the above for the State. Education is the one area strategies highlight the difficult fiscal that can make a critical difference both trade-offs Ceari is facing in attempting for poverty reduction and for growth in to balance the need for additional higher value-added activities, especially spending that is likely to enhance in the service, tourism, and modern ag- growth performance, such as invest- riculture sectors. Innovative work has ments in education and infrastructure, recently been undertaken by the State in with the maintenance of fiscal stability the educational sector. Cear6 should and reputation. Cear's problems also make every effort to further increase the involve balancing short-term social im- efficiency of educational spending and provements through a better social to focus spending on those specific ar- safety net with services for the poor that eas that yield the highest return in terms provide more sustainable long-term of educational outcomes and achieve- poverty improvements such better edu- ments, and ultimately poverty reduction cation and higher growth. Facing these and growth. However, even once all fiscal trade-offs, the key for better per- potential efficiency gains have been formance is a strategy focused on the captured, the State will likely have to quality of public spending, in terms of concentrate a larger share of its spend- further improvements in spending effi- ing in the area of education. The sug- ciency, poverty targeting of social gestions for the educational sector are: spending, and more concentrated spending on policy priorities. This qual- (a) Improve quality of primary schools ity-of-spending strategy is proposed in and teachers to increase comple- this report. It is a difficult strategy that is tion rates and improve student comprised of a multitude of tedious achievements. smaller tasks, but one that appears most appropriate in the current situation. Page 12 Ceard State Economic Memorandum (b) Specifically, for adults in rural ar- XXI. Public-private partnerships can eas, increase efforts for literacy and play a critical and positive role in more basic education. active and systematic investment pro- motion. The private-public partnership (c) Increase the coverage and improve approach requires the private sector to the quality of preschool education. move toward articulation with the Gov- ernment through industry associations (d) To accommodate an increasing flow or other collective representations. The of primary school graduates, in- recommendations for public-private crease coverage with secondary partnerships are: education guided by labor market demands. (a) Identify and remove remaining bu- reaucratic barriers and distortions to (e) Improve state-municipal coordina- private sector development ("Custo tion and incentives for service pro- Brasil") through public-private col- vision, in particular in areas with laboration. parallel state and municipal school systems. (b) Work toward federal changes for lower payroll taxes and more flexi- (f) Provide incentives for school atten- ble labor regulation, in particular for dance and achievements through rural employment. support payments for poor families (Bolsa Escola). (c) Actively pursue, in partnership with the private sector, the development (g) In the interim, facilitate the in- of business clusters in tourism, fruit migration of individuals with bottle- production, and the software indus- neck skills to Ceari. try. XX. In terms of private sector de- (d) Develop sectoral growth strategies velopment, Cear6 has an interesting jointly with the private sector while and successful history of public-private staying away from the use of distor- partnerships for the provision of serv- tionary policy instruments to pro- ices, consensus building, and resolution mote specific firms, industries, or of conflicts. The more worrisome aspect activities. is that the frequent calls for public- private collaboration are often driven by (e) Intensify and professionalize state the still widespread interventions and investment promotion, separate distortions that complicate business ac- from the granting of fiscal incentives tivities in Brazil. In this environment, and not limited to industry or do- new ventures still depend on the align- mestic firms. ment of public actions, including the provision of subsidized credit by official XXII. Stronger international linkages banks, fiscal incentives granted by the and international trade could bring State, and administrative support to more investment to Cearc and foster the overcome bureaucratic obstacles. The incentives for modernization that typi- danger is that the concept of public- cally accompany international open- private partnership can be misused to ness. Most macroeconomic factors in- direct Government incentives at specific fluencing trade are outside the realm of activities rather than as an approach to state policy making, and these factors identify and remove remaining distor- are improving, in particular after the tions in the economy or coordinate the 1999 devaluation. Some specific meas- provision of genuinely public services. ures are within the powers of the State. Cear6 State Economic Memorandum Page 13 These proposed measures for encour- (c) In the interim, undertake adjust- aging stronger international linkages ments to industrial incentives to be and trade are: more neutral with respect to sector and location (avoiding the current (a) Influence national policies to reduce bias against the formation of indus- barriers to increased global link- trial clusters). Incentives should not ages, for example in the area of be targeted at industrial sectors with cashew nut trade, internet trade, no apparent comparative advantage and coastal shipping. and should be more directed at la- bor-intensive projects. (b) Consider policies to attract export- oriented investments, including the XXIV. Cear6 has become a national possibility of installing (preferably leader in the development of an i6stitu- without committing public expendi- tional and legal framework for efficient tures) an Export Processing Zone in water resource management. Given the port of Pec6m. the importance of water to the State (in- cluding municipal and industrial users, XXIII. The State's industrial incentive but also tourism, all of which depend on policies are moderately expensive and, reliable water supply) and the high together with other mostly federal in- hopes placed on irrigated agriculture, dustrial policies, have introduced some the State should continue and deepen distortions in the economic development its reforms in this area. While invest- of the State. These policies have con- ment in water resource management is tributed to growth in the State. This important, net public spending for water growth, however, has in some cases for commercial agriculture could be lim- been achieved through inefficient and ted first through full cost recovery and unsustainable investments. The policies through increased private investment. have attracted relatively capital intensive Public activity should continue to shift investments and thus have resulted in toward the creation of the legal and in- limited employment and poverty reduc- stitutional conditions for private invest- tion effects. Given the competition with ments (water rights, in particular), and neighboring states, it will be difficult to the management of true externalities unilaterally reduce the expenditures as- such as pollution problems. Commer- sociated with industrial incentives. How- cial, irrigated agriculture can contribute ever, the incentives could be restruc- to poverty reduction through seasonal tured so that they are more incentive- and permanent employment but de- neutral, and possibly more employment pends on flexible factor markets, in- intensive. The suggestions for altering cluding labor, land, and water. The rec- the industrial incentive policies are: ommendations for water resource man- agement are: (a) Pursue negotiations with other states and the Federal Government (a) Advance rapidly in the implementa- to remove industrial incentive pro- tion of the new institutional frame- grams. work for water resource manage- ment, including: (i) river basin level (b) Consider broader reforms of the water user associations; (ii) full cost incentive system, for example recovery; and (iii) water market de- through reduced payroll taxes for all velopment. types of employment instead of the industry-targeted ICMS exemptions. (b) Encourage private investments to- ward reliable supplies in particular through water market development. Page 14 Cear6 State Economic Memorandum (c) For public investments in water re- (e) Expand Projeto S5o Jos6 and Re- source projects, require rigorous ex- forma Agr6fia Sofidclia while im- ante economic analysis and clear proving support to community asso- justification of the public sector role. ciations for the formation of social capital and prioritization of invest- XXV. Cear6 has implemented excel- ments. lent programs to capitalize and serve its poorer citizens, including programs (f) Continue support for municipal supporting community-based health housing and urban upgrading pro- services, urbanization, land reform, and grams with an emphasis on income- rural poverty alleviation. These pro- generating impacts. grams are oriented toward strengthen- ing the assets of the poor, thus also re- (g) Reduce the size of average loans in ducing their vulnerability to different micro-credit programs to improve types of shocks. Many programs have targeting. been successful due to a strong element of active community participation that (h) Support institutional capacity for can be further expanded. The programs management of urban problems at are critical for poverty reduction; they the municipal level. should be continued and expanded where possible since the unmet needs XXVI. While emergency employment continue to be large. While these pro- programs have been successful at buff- grams do not have a significant direct ering the worst effects of periodic growth effect, their overall costs are droughts, the overall social safety net moderate and commensurate with the in Cear6-as in the rest of Brazil-re- poverty reduction objectives pursued. mains incomplete, in particular for those The suggestions for programs that working outside of the formal sector. capitalize and serve the poor are: The recommendations for improving the social safety net are: (a) In health, continue the shift of spending toward cost-effective ba- (a) Integrate emergency employment sic care, ambulatory care, and pre- during droughts, at a possibly re- vention, with a particular emphasis duced wage rate, with a broader on female and child health care. employment guarantee program which would provide basic protec- (b) Improve health policy coordination tion also for the urban population between the Federal Government, and in non-drought years. This pro- the State, and municipalities, and gram could be implemented based improve accountability for service on community initiative. Such in- delivery at all levels. plementation was successfully ac- complished in the Projeto Sjo Jos6. (c) Support municipalities' health-care management capacity and encour- (b) Strengthen the basic overall social age municipal consortia, health rri- safety net through a Bolsa Escola cro-regions, and integrated service program of transfer payments to provider networks. poor families linked to their chil- dren's school attendance. (d) Concentrate government rural sup- port services (extension, technical XXVII. Cear6 is spreading its expendi- assistance, and credit) on small and tures very thinly. Core public spending landless farmers. (basic education, infrastructure, and se- curity) accounts for only one-third of the Cearc State Economic Memorandum Page 15 State budget. While there appear to be (c) Create a small technical office for no obvious examples of large "white prioritization of investment projects elephants," the rest of the budget is across sectors based on cost- spread over a large number of minor benefit analysis. activities, some of only secondary im- portance. This report proposes the fol- XXVIII.The policy actions suggested lowing measures for improving State above are clearly intertwined and mutu- expenditures: ally reinforcing. The linkages are sum- marized in Table 1. The main policy ob- (a) Undertake a comprehensive public jectives (growth, poverty reduction, and sector expenditure review to identify fiscal balance) are shown in columns, spending that can be reallocated to and the main reforms recommended in high priority areas such as educa- this report are shown in the rows 6f the tion. table. Each cell of the table presents the effects of the suggested policy reforms (b) Take measures toward reducing on the objectives, with the direction and future pension liabilities: (i) rigor- magnitude of the effects presented ously tighten eligibility qualifications qualitatively. While there are clearly for state pensions; (ii) introduce trade-offs related to fiscal considera- pension contributions by retirees; tions, most of the suggested policy re- (iii) support consideration of reforms forms contribute to several of the main to reduce statutory pension-to- policy objectives, and should help con- salary ratios, introduce age limits for tribute further to CearNs economic and benefits, and end all special bene- social development and its well de- fits and regimes; and (iv) take full served reputation for good economic advantage of any reduction in re- management. tirement benefits permitted by the ongoing federal pension reforms. Page 16 Ceard State Economic Memorandum Table 1: Linkages Between Policy Objectives and Instruments Policy Objectives Contributions of Growth Poverty Reduction Fiscal Balance Policy Instruments to Objectives Links Between Reputation for fiscal Labor-intensive Growth leads to in- Policy Objectives soundness and growth is the most creased revenues good governance important contribu- and alleviates fiscal attracts investment. tor to poverty re- constraints. duction. Reform and expand + + education Better education of Better education Additional well- the workforce re- means better op- focused spending moves key growth portunities for in- for education obstacle. come and employ- needed. ment Reform industrial + incentives Reform of distor- Current incentive + tionary incentive system biases Current incentives system. against labor inten- are modestly ex- sive investments, pensive. Deregulate and + 0 promote private (indirect through sector development growth) through private- public partnerships Develop water mar- + kets and dynamic (mostly indirect agriculture through growth) More cost recovery, and private instead of public spending Strengthen assets 0 0 of the poor (health, (growth effect insig- (continue current urban, rural, land nificant) spending) reform) Strengthen social 0 + safety net Additional spending necessary to build up a basic social safety net Review and focus- + 0 ing of public expen- (indirect through ditures and broaden perceived fiscal tax base (tourism) soundness that at- tracts investment) CearA State Economic Memorandum Page 17 economic growth, poverty reduction, 1. Overview and fiscal sustainability. This first sec- tion provides an overview and briefly Introduction discusses the basic endowment of the State. The subsequent three sections 1. Over the last decade, Cear6 has discuss current policies and perform- emerged among the states of the poor ance for each of the three dimensions of Northeast region of Brazil as one of the public policy: economic growth, poverty models of good economic and fiscal reduction, and fiscal sustainability. The performance and good governance. final chapter presents an agenda of ad- This model and its underlying policies justments to the current strategy of the have attracted a lot of attention. This State. report reviews the set of policies that the State Government has chosen in order 4. the aenat emrges t the end to promote economic development, oith report foc ote following poverty reduction, and fiscal stability in pol rer wc r is Cear6 and assesses the resulting per- formance. The report attempts to pull ( p together the lessons of the experience provio ofuamor s of the State of Ceart and document some of its progress, successes, and (b) reform of industrial incentive pro- remaining challenges. grams; 2. Dramatic changes have occurred in the national and international economic c on ofia metorientedpfo- environment during the last decade.in private-public partnerships; Brazil, in particular, has moved from a state-dominated closed economy and a (d) expansion of the reforms in water long period of instability to a more stable resource management; and increasingly open but still vulner- able economy driven by the private (e) continuation of innovative provision sector. Against this background, of services and assets to the poor this report attempts to determine (urban and rural services, land re- whether current policies will be appro- priate to ensure superior performance in the future or whether policy adjustments (f) strengthening of the basic social are necessary. The report explores and recommends appropriate adjustments to state policies in areas where additional (g) thorough revision of the efficiency reforms are within the powers of the and targeting of public expendi- State and could help sustain and further tures. improve the performance of Cearc. 3. Plices f te Stte f Car6are 5. The focus of this policy report is on 3. Policies of the State of Ceard are telnae ewe tt oiis directed at bringing together the basic poliojtes an oveleo assets with which the State is endowed pent ote ate Therpr highlgt in a way that brings about the most pro- ment ates and thgldeots gress toward the objectives of poverty te owt rtye t and reduction and growth while maintaining fiscal stblthe poe ofdtheireport fiscal stability. This report analyzes poli- is tat a e o rfrne fort cies of the State with respect to three iscssion of e fsecor te fundamental dimensions of public policy: ATisu rsts os Anc fhorg eah ofdteqthre dimension of Page 18 Ceari State Economic Memorandum sectoral policies, however, is clearly be- riculture, 14.2% industry and 42.7% yond the scope of this report. The An- services.' nexes contain a more detailed discus- sion of sector policies specific to the ar- 8. In 1996, Cear6 had 6.8 million in- eas of growth, rural development, pov- habitants (4.3% of Brazil's total) of which erty reduction, and fiscal stability. 65% lived in urban areas (compared to 64% in the Northeast and 79% in Bra- Basiczil), After Bahia and Pernambuco, Cear Basi Stae Caracerisicsis the third most populous State in the 6. The State of CearA occupies Northeast. Cear6's annual population 146,348 km2 or 1.7% of Brazil's territory. growth rate of 1.4% (1990-96) is equal The geographical regions of the State to the country's average. 2.5 million include the coastal zone (litorao, coastal people (37%) live in the Metropolitan mountain ranges (serra), the large semi- Area of Fortaleza. 760,000 people arid interior (sert5o), and the main river (11%) live in cities above 20,000 in valleys (Jaguaribe and Cariri). Cear population. 1.1 million people (16%) live has a long coastline with attractive in small towns with less than 20,000 in beaches for tourism development. The population, and 2.4 million people (35%) humid areas of Cear6 are located in a live in the rural areas. Internal migration few fertile highlands. Soil types of me-abso- dimfe lw fertilhad.ily tpe s o f mnte lute decline in the rural population since dium and low fertility are found in the te17s semi-arid and coastal areas. Land is abundant, but most of it is located in the 9. Using an extreme (or food-only) semi-arid area where access to water is fundamental for more intensive land povty le oapproxiatel r per use. Cearc is the only state in Brazil mon pe ct as for dif without permanent rivers.Cear's population is living in poverty is limited and has a high salt content. Unreliable rainfall makes the Sert5o vul- (as cometo 23% f Bralo . nerable to periodic droughts. The cli- fort rotn are of in Paulo). mate creates ideal conditions for year- povty raea lowes in t nc - round tourism, and as long as water s plt fFraea(0/)adices roun toris, ad aslon aswatr s With declining city size. Clearly, poverty available, a year-round agricultural in Cear6 is intimately linked to the rural growing season. growig seson.economy. Residents working in rural 7. Since the turn of the century, the occupations or those closely related to Northeast has been the poorest region them (as in small towns), and immi- of Brazil. Regional disparities were ex- grants from rural areas (as in the pe- acerbated as the Southeast and South riphery of Fortaleza or other larger cit- industrialized. The Northeast region has ies) experience the highest rate of pov- been subjected to periodic .droughts, erty, supporting the claim that poverty in economic isolation and continuing Ceari is related to the rural economy. backwardness. In 1996, the size of Cear6's economy (GDP) was R$17.1 billion, or 2.2% of Brazil's total. In 1996, per capita GDP was US$1,917 com- pared to a Northeastern average of The analysis in this report is based on a cor- US$2,170 and a national average of bination of data sources deemed most reliable at US$4,421. In 1997, Cear6's GDP was the time of writing this report. The latest figures for 1996 GDP are taken from IPEA. Other data composed of 5.7% agriculture, 27.4% sources suggest somewhat different numbers but industry, and 66.9% services. The dis- do not qualitatively change the conclusions tribution of employment was 43.2% ag- reached in this report. Cear6 State Economic Memorandum Page 19 Box 1: The Menu of Policies to Promote Labor Demanding Growth The different policy strategies that can be implemented by governments for pursuing labor- demanding growth can be divided into the following groups: * Macroeconomic stability creating necessary (but not sufficient) conditions for attracting private investment. * Public investment in education and infrastructure, two areas that generate positive exter- nal effects. * Improvements to the functioning of markets through the removal of distortions (liberaliz- ing labor markets and reducing non-wage labor costs, capital market reforms, and pri- vatizing public services). * Active policies for microeconomic improvements (strengthening of competition in key sectors, dissemination of information, support for entrepreneurship, and formation of clusters of related industries) * Good governance to attract private investment (efficient and modern public administra- tion, stability of policies, fiscal soundness) * Industrial policy (public investment in production, fiscal incentives, and directed credit) * Global linkages (trade liberalization, export promotion) Different countries and regions have pursued very different mixes of policies from these groups of strategies. Most East-Asian countries have successfully combined macroeconomic stability, mas- sive public investment in education and infrastructure, and global linkages. Chile's, equally suc- cessful economic reform program has focused on the removal of distortions and international trade. In contrast, Brazil's policies have until recently focused more on industrial policies, and to a lesser extent on infrastructure investments. Similar to some other Latin American countries, im- port-substituting industrial policies have produced a less labor-intensive pattern of growth. than a decline in agricultural volati lity.2 2. Economic Development Growth has occurred in most of the re- Policy and Performance gion, and the previously observed in- crease in regional disparities has been Growth Policies at least partially reversed. 10. Ceari's recent strategy has to be 11. For the last decade, the State of seen in the context of the broader gov- Cear6 has gradually undergone an im- ernment efforts over the past forty years portant and profound transformation. to reduce Brazil's regional income dis- parities and reduce income volatility in the Northeast. These efforts have fo- turned its attention toward putting the cused largely on two separate strate- state's finances on a sound fiscal basis, gies: (a) drought alleviation (for exam- modernizing the State administration gies: (a)f eerorcntrcinad and focusing the state's interventions on pIe, relief, reservoir construction and, agricultural irrigation) and (b) industriali- the provision of such public goods as zation (for example, public enterprise education, health, sanitation, and infra- investments and credit and fiscal incen- structure, and on the establishment of a tives for private sector investment). The conducive environment for private sec- volatility of the Northeastern economy has indeed been significantly reduced, mostly however due to a secular decline See World Bank, 1998, "Public Expenditures for in the importance of agriculture rather Poverty Alleviation in Northeastern Brazil," Re- port No. 18700-BR. Page 20 Ceari State Economic Memorandum Box 2: Regional Convergence Policies Traditional growth theory suggests that in a country with low barriers to the mobility of goods and factors, there should be a trend toward convergence in per capita income across regions. How- ever, the empirical evidence on convergence in developing countries is mixed, and income dis- parities between regions in many countries are surprisingly stubborn. Even internal migration contributes only slightly to convergence. Relying on market forces alone to remove subnational inequality is not sufficient, yet long experience with regional policy in industrial countries suggests that there is no easy way to mitigate the differences: * There is little evidence that large public infrastructure investments in subnational re- gions can be successfully used to create growth poles. * There is also not much evidence that strategic investments in a leading sector or in- dustry will do the trick. * The effect of investment incentives remains controversial. * The currently popular approach of bringing together the private sector and other actors to develop an informal marketplace encouraging appropriate clusters of economic ac- tivities offers considerable promise. Source: Peter Fallon, 1998, World Bank PREM Notes Number 6, "Can backward subnational regions catch up with ad- vanced ones?" tor development.3 In some areas, Cear6 private sector in the formation of indus- has led the way toward reforms later trial clusters. Ceari has focused rela- undertaken elsewhere in Brazil. Subse- tively little on international trade link- quently, the role of the state has under- ages. Also, there has been less focus gone an important redefinition. The reli- on active promotion of agricultural de- ance on market mechanisms and the velopment and the service sector. Mac- private sector has been increased, and roeconomic stability falls essentially out- the scope of government interventions side the State's mandate and depends in the economy has been reduced. principally on actions by the Federal Government. 12. Selecting a policy mix from the menu of available economic development Overall Growth Performance strategies (see Box 1 and Box 2), Ceari has focused on a combination of: (a) 13. The modernization strategy of the good governance and modernization of State has paid off in the form of higher the state with a focus on sound fiscal rates of growth for Cear6 than for management; (b) significant industrial neighboring states and for the country promotion in particular through fiscal as a whole (see Table 3). In addition, incentive programs; and (c) increasing despite continuing poverty, the overall public investment in areas such as image of the State and its government transport infrastructure, water re- has become one of modernization and sources, and education. There is an progress. Relative economic success emerging emphasis on improving the has been mutually reinforcing with politi- working of the micro-economy, for ex- cal stability and good governance, char- ample, through collaboration with the acterized by a sequence of different 3 A statement of the Ceari's Government's strategy is contained in Governo do Estado do Cear6, Plano de Desenvolvimento Sustentive, 1995-1998 (Fortaleza, 1995). Cear. State Economic Memorandum Page 21 Table 3: Growth Rate Comparisons for Northeastern States, 1985-96 GDP "I" (R$ bin) Annual Growth Rates (in %) 1996 1985-90 1990-96 1985-96 Brazil 778.82 1.8 3.0 2.5 Northeast 109.37 2.2 2.8 2.5 Cear6 17.13 3.4 4.9 4.2 Maranhao 10.12 8.9 3.6 6.0 Rio Grande do Norte 7.35 6.7 4.8 5.6 Pernambuco 18.38 4.5 1.8 3.0 Bahia 33.52 2.5 2.4 2.4 Notes: 1) GDP growth comparisons, using constant prices of 1996. 2) Revised data. Sources: Brazil: IBGE/DECNA; Northeastern states: SUDENE/DPO/DCR; Ceari: IPLANCE/DEP/DEAC. State Governments that have pursued that 6% in 1997. Despite this de- consistent economic policies.4 cine, agriculture continues to be the provider of 43% of total employ- 14. Over the past thirty years, Cear's ment. Agriculture also provides the economy has undergone a dramatic inputs to the more dynamic agroin- transformation. Growth has been ac- dustry sector. companied by sectoral changes and continuing urbanization. Table 2 shows (b) In aggregate terms, the industrial the changes in the sectoral composition sector has emerged as CearA's of state GDP and employment and illus- leading growth sector, but its per- trates Cear6's major growth dilemma. formance as a generator of em- Agriculture has decreased in its relative ployment has been disappointing. importance, but employment growth in Cear6's most important manufac- the more dynamic sectors of the econ- turing industries are food producers, omy has not been enough to transfer a textiles, apparel, and shoes. In sufficient number of workers out of low 1996, these industries together ac- income, subsistence, and drought prone counted for over 56% of the state's agriculture. manufacturing output. In the case of textiles, trade liberalization in the (a) The contribution of agriculture to early 1990s has produced a com- total output has continued a secular petitive shock at the national scale decline, decreasing from nearly after rapid growth during the 1980s. 16% of state GDP in 1970 to less In Cear , textile output has contin- Table 2: Sectoral Composition of the Cearense Economy (% shares) Years Agriculture Industay Services A. State GOP 1970 15.8 18.6 65.7 1980 9.4 25.4 65.1 1986 8.3 25.1 66.6 1997 5.7 27.4 66.9 B. Employment 1970 68.4 10.4 21.2 1980 54.3 14.4 31.4 1986 44.0 16.7 39.3 1996 43.2 14.2 42.7 Source: IPLANCE t See also: Tendler, Judith, 1997, "Good Govern- ance in the Tropics," John Hopkins University Press. Page 22 Cearc State Economic Memorandum Figure 1: Sectoral Contributions to GDP Growth Figure 2: Sectoral Contributions to New 1990-96 Employment 1990-96 Others Ofto, 14%13 Rentals and Real Estate Commrercial Seneas c24%ueo 24%% 3%n,rna Soerw,b%ucftn Hotels and Restaurants Food a 4% Transport 4% Commerce D-rm1 Sal, 6% 13% Public Adnnistration Constiction Professional Educafonj 9% C.maV ued to grow (5.7% annually) while growing faster but from a much smaller employment has been reduced. base than services (see Figure 1). For employment, the situation is even less (c) The share of the service sector in encouraging. Most employment has State GDP has remained roughly been generated in the stagnant agricul- stable; however, the composition of ture sector with extremely low labor pro- the service sector has changed re- ductivity,5 commerce, and services. In- markably. There has been a shift dustry does not even appear among the away from more traditional services main sectors in terms of employment and an increasing emphasis on the generation (see Figure 2).6 services that characterize a modern economy. Communications, com- 16. Exports have not been important in merce, financial services, and pri- leading Ceari's growth. The markets for vate educational services have CearA's goods and services have been grown dramatically over the past national, rather than international. Mer- thirty years. In particular, a major chandise exports currently represent impetus has come from the devel- only about 2% of the State's GDP, and opment of tourism, which is evolv- this share has not grown appreciably. ing as a major growth sector. Em- ployment in the service sector has The high share of agriculture in new employ- also grown fairly robustly, at rates ment is misleading as 1990 was a particularly exceeding those for manufacturing bad and 1996 a particularly good agricultural employment. year. 6 Figure 1 uses subnational accounts data from 15. A more detailed look at the sources the revised lBGE methodology. Since similar of growth and employment from 1990- employment data is not available, Figure 2 is 96 suggests a cautious assessment of based on the previous IPLANCE data (see Table industrial14 of the Statistical Annex). The comparison of indutril deeloment Th larest both sources of subnational accounts data re- contributors to growth have been rent- veals significant differences in the composition of als, construction, and services, rather the service and construction sectors. However, than industrial subsectors which are the small contribution of industry to growth fol- lows from both data sources. Cear6 State Economic Memorandum Page 23 Moreover, Ceari's exports totaling US$ been successful in capturing some of 353 million in 1997 represent less than this investment-both from existing 0.85% of Brazil's total exports (and this firms and from newly established firms. share has decreased over recent years). There has also been a major change in 19. Investment in the State of Cear6 has the composition of the State's exports. been favored by the image of a state By 1996 57% of exports were manu- with fiscal responsibility, modern political facturing products, as opposed to 20% leadership, and efficient public admini- in 1985. While cashew nuts are the sin- stration. Public sector reforms initiated gle most important export product, in 1987 have centered on fiscal adjust- shoes, textiles, and apparel have be- ment and a redefined role of the state. come important export categories as The State's leadership has expressed a well. The major markets for Cearc's ex- commitment to improving the economic ports have been NAFTA (58% in 1997) infrastructure, as witnessed in the highly and MERCOSUL (18%), with the US visible airport project, the new seaport and Argentina constituting the largest being built at Pecdm, and investments in two single country markets. roads. Faced with a choice to locate in Cear6 or elsewhere in the Northeast, a 17. In summary, Cear6 has shown supe- number of interviewed firms choosing rior growth performance. However, Cear6 emphasized the importance of Cear6's overall impressive growth per- good and honest state government and formance is accompanied by three rela- fiscal responsibility. tive weaknesses in actual outcomes compared to what would have been ex- 20. A second major attraction stems pected given the basic endowment of from wage levels in Ceari that are much the State. First, growth has not been lower than those in the Southeast and successful in absorbing a sufficiently South. Indeed, Cear6's wage levels are large number of workers into high pro- potentially internationally competitive in ductivity sectors. Second, modern agri- a wide range of light manufacturing culture has not been able to establish products. In a typical firm, total labor itself in a way that would make a signifi- costs (including payroll taxes and other cant contribution to the State's econ- costs) for an unskilled entry-level worker omy. Third, there has been very little in Ceari are R$263 per month versus international export despite the State's R$560 per month in S&o Paulo. This geographical advantages. difference implies that a firm whose la- bor costs represent 20% of total produc- Industry tion costs would experience a competi- tive edge of up to 10% at the lower 18. With some exceptions, it has only wage costs. Unskilled labor productivity been since the early 1970s that a sig- in Ceard is considered as high as in the nificant industrial sector has emerged in Southeast and South, although some Ceara, in line with a decentralization of greater initial supervision and training industry from the South and Southeast may be necessary. Moreover, the pres- of the country to the Northeast. Much of sures either for unionization of the labor this decentralization has taken the form force or from unions are considered to of existing firms based in the South and be less than in the Southeast and Southeast establishing branch facilities South. in the Northeast. In addition, some mi- gration has also taken place through the 2.Dsieteoealcagsi h roation o fatres frome therouhth- role of the state in Brazil, there are still relocation of factories from the South-regulations that dis- east and South to the Northeast. Par- tort incentives and hinder business ac- ticularly in more recent years, Cearoe has Page 24 Cearc State Economic Memorandum tivities. These distortions include the to the balance. Formally, the program is effective rationing of long-term capital set up as a financial incentive, thereby through official banks, various industrial complying with a national prohibition on incentive programs, and trade restric- fiscal incentives. tions. Consistent with lagging liberaliza- tion, businesses still look to the Gov- 24. In the three and a half year period ernment as a provider of subsidies and from January 1995 to June 1998, total as a protector from external competitors. investments of R$3.3 billion were ap- Therefore, it needs to be recognized proved under the incentive program. that industrial growth in Cear6-as The comparison with total private sector elsewhere in Brazil-has been occurring investment in Cearc of R$l.8 billion in in a still somewhat protected and dis- 1996 suggests that a very significant torted environment. proportion of private investment is cov- ered by the incentives. Every major 22. There are a number of programs manufacturing industry is represented. and incentives directed at the industrial The most notable concentrations in development of the Northeast. The fed- terms of the number of firms and the eral income tax incentive involves an employment generated are in apparel, exemption for a period of ten years shoes, and food products. The largest from payment of 75% of the net operat- single investment, totaling some R$800 ing results for firms either making or ex- million, is destined for a very capital in- panding their investments in the North- tensive steel plant currently being de- east. Special credit programs also veloped in the new port of Pec6m. benefit the Northeast. For SUDENE- approved projects, subsidized financing 25. There are two major economic ef- is provided through FINOR for up to fects of the ICMS-based financial/fiscal 40% of the total investment. In addition, incentives: (i) their fiscal costs; and (ii) BNDES and BNB have been channeling the distortions they introduce in the de- increasing amounts of loans at favorable cision making of investors. The net dis- terms to the Northeast. bursements (gross disbursements mi- nus repayments by the beneficiary 23. Cear's industrial policies have fo- firms) for 1997 were R$83.2 million or cused on creating incentives for indus- 4.2% of the States net current revenue trial investments, primarily through tax or 0.44% of GDP. These estimates of holidays and generous provision of land fiscal cost presume that the firms would and infrastructure. The major state in- have located in Cear6 even without the centive for investment is a refund of the incentives and thus represent an upper- value added tax (ICMS) following new bound estimate. While these fiscal costs investments or capital equipment mod- are significant, the distortions introduced ernization. The incentives increase with by the incentive system may be more distance from Fortaleza, with the objec- important from an economic point of tive of encouraging regional decentrali- view. Some of the distortions created by zation. There is significant discretion in the incentive system are implicit in the the award of incentives. The maximum nature of the incentive system itself. incentive permissible is an effective tax Others are a sometimes unintended re- deferral of the payable ICMS extending suit of the particular way in which the up to a period of 15 years, with a grace system is administered; period of five years. Typically, there is forgiveness of 50% of the principal (a) As a result of market protection and amount of the deferred tax and an inter- incentive programs, some invest- est rate of TJLP (Taxa de Juros de ments are undertaken that are vi- Longo Prazo, currently at 11%) applied able only as long as they benefit Cear6 State Economic Memorandum Page 25 from the incentive programs and likely reflects the aggregate impact can produce for a protected national of different incentive programs (in- market. While systematic data is not cluding subsidized credit pro- available, there is evidence of plant gramS7) rather than Cea4s tax in- closures after the expiration of in- centives in particular. Other reasons centives in Ceari as well as in other could include the concentration on states that offer similar incentive larger firms and an attempt to at- programs. tract more prestigious investments in less labor intensive sectors. (b) The incentive system does not ap- ply to activities that are not subject (e) Tax holidays are available for a to the ICMS (but typically other determined period of time to any forms of taxation), such as agricul- firm that undertakes new invest- ture, tourism, and exports. Incen- ments to establish or expand pro- tives may thus bias overall invest- duction. The program changes in- ments toward the industrial sector. centives for the renewal of capital stock in a way that is not necessar- (c) Even though the rules of the incen- ily efficient. On the one hand, it tives do not exclude small firms, in- places the established production vestments actually supported are capacity of existing firms at a com- mostly large investments by large petitive disadvantage vis-A-vis new firms. Of the total of 369 projects, entrants. On the other hand, it can only 67 envisaged investments of lead to the deferral of modernization less than R$500,000. In practice, and expansion investments if firms small firms are effectively left out of want to exploit the full potential in- the incentive system. The reason is centives granted on previous in- likely the high transactions cost on vestments. both sides, which only large firms seem willing or able to accept. In line with its decentralization ob- jectives, the Government d iscour- (d) Employment generation is a de- ages the granting of incentives to clared objective of the program. more than one firm in the same Nevertheless, the approved projects sector in a given geographical area. demonstrate very high capital to la- This policy works against the for- bor ratios. While the planned capital mation of business clusters despite intensity varies considerably across parallel policy initiatives to promote sectors, the average investment the formation of clusters. costs per job are high at R$45,000 (R$33,600 if metal and chemical in- 26. While manufacturing has indeed dustries are excluded). Even in the grown considerably in Cearc, imited more labor intensive sectors (ap- evidence points toward rather low levels parel and shoes) the cost per job of efficiency, productivity, and economic (R$15,000 and R$12,000, respec- performance for Northeastern industries tively) may be considered high. By in general. The protected domestic mar- way of comparison, one large re- ket has afforded higher profit margins cently established hotel operator (a for domestic sales than for exports. With sector without such incentives) indi- further trade liberalization, Cear6's in- cated for his project an investment cost per job of around R$8,000. In 7 Capital-intensity is even higher in some gov- agriculture, the investment cost per ement credit programs. Under FINOR, for ex- job created can be as low as ample, investment costs per job created are R$98,600 for the Northeast and R$59,500 for inlCears. Page 26 Cear6 State Economic Memorandum Table 4: Cear: Tourism Estimates and Projections, 1997-2001 1997 1998 1999 2000 2001 Tourist Demand (No. of Tourist Arrivals) Brazilian Residents 914,700 1,216,600 1,520,700 1,900,900 2,281,100 Foreign Tourists 55,300 73,500 91,900 114,900 143,600 Subtotal: 970,000 1,290,100 1,612,600 2,015,800 2,424,700 Total Tourist Spending (in millions of 1996 R$) Brazilian Residents 811.0 1,078.6 1,348.3 1,685.4 2,022.4 Foreign Tourists 44.2 58.8 73.5 91.9 114.9 Subtotal: 855.2 1,137.5 1,421.8 1,777.3 2,137.3 Tourism Spending as % of State GDP: 4.8 6.0 7.1 8.5 9.7 Total (Direct plus Indirect) Effects Production as % of GDP 7.4 9.2 10.9 13.0 14.8 Employment 112,400 148,300 182,300 223,900 264,600 Notes: Estimations made using tourist budget, spending and stay duration estimates from SETUR, SEBRAE, and EMBRATUR. The IPLANCE/USP econometrically estimated input-output model for Ceari was used to estimate the indi- rect effects of tourism spending on state production and employment. dustry has to undergo an adjustment cludes high domestic interest rates and process toward achieving greater levels transactions Costs that are driven up by of international competitiveness. The antiquated administrative and regulatory industrial activities less likely to en- arrangements. The tax environment and counter major difficulties in this process the availability and cost of infrastructure are those that are more labor intensive services also contribute to the Custo and those that are already exporting, for Brasi. One can expect that with the pri- example, the apparel and shoe indus- vatization of many services previously tries. performed by state firms or entities (telecommunications, railway transpor- 27. Within the context of domestic com- tation, port services, and electricity), the petition, industry does not see labor quality of these services will improve quality and productivity at the unskilled and costs will fall. level as a problem. Internationally, how- ever, a preliminary comparison of wage Tourism levels and education levels across countries and regions suggests that 29. In stark contrast to industry, tourism Cear's education levels are too low for in CearA has grown without inducement its labor costs. If Ceari wants to pursue by special incentives. Until recently, a higher value-added growth strategy tourism has played a very small role in that would support current or higher la- boosting State GDP and State employ- bor costs in the context of international ment. Part of the explanation for this low competition, education levels are a criti- involvement of tourism may be that pol- cal constraint. Moreover, many firms are icy-makers in the past considered de- facing real difficulties in recruiting quali- velopment and growth through tourism fied individuals for supervisory and as less attractive than industry in terms technical positions. Frequently firms re- of linkages and image. sort to bringing in staff from the South- east and South, but problems persist in 30. The international market for tourism the form of costs, local resentment, and is experiencing very rapid growth, at a cultural acclimation. rate of over 9% annually over the period 28. Another important constraint for ex- 1 0 wth Hoeer, panding manufacturing output involves r g Brazil's share of the relatively high costs of doing busi- fe fom17 in 1980 to 0.5% i9 tDespite the mediocre performance of Cear. State Economic Memorandum Page 27 Brazil as a whole, Cear4's tourism has nues directly attributed to tourist spend- nevertheless grown substantially. Over ing was R$51 million. the period 1980-97 the number of tour- ists arriving in Cear6 has grown at an 32. In summary, tourism has become annual rate of 6.7%. During the early one of the economy's leading growth 1980s, this growth was considerable, sectors. The prospects for continued although beginning from a low base tourism growth in the foreseeable future then slowing until 1992, and finally tak- are quite promising, and there is ample ing off with annual growth of 10% during room for continued expansion, espe- 1993-1996, and an increase of more cially for international tourism.10 SETUR than 25% in 1997. Of the estimated projections for 1998 show that tourist tourist arrivals, the overwhelming major- arrivals in Cear6 will grow in 1998 by ity (94.3%) were Brazilian residents. Yet 34%. Such growth in itself amourts to international tourism has grown the about a 1.6% increase in the State's fastest (38% in 1997) and has the GDP. A factor not included in these greatest potential for future expansion. projections has been the recent de- regulation of the domestic airline indus- 31. By 1997, tourism revenues were try. This deregulation has resulted in a equal to some 4.8% of State GDP" In- tumbling of domestic airfares, with cluding its indirect effects on State out- roundtrip fares from the Southeast and put and incomes, tourism generated South to Fortaleza falling by as much as 7.4% of State GDP. Direct plus indirect 50%. Subject to more detailed analysis, employment generated by tourism (to- one could expect that the decline in air- taling some 112,000 employees) was fares alone might result in an increase in 3.9% of the State's total employment9 tourist arrivals by 25%. Tourism also generates substantial tax revenues. In Cear, hotel and restaurant 33. Some projections of tourism arrivals services are exempt from the ICMS. and expenditure have been made for (Within the limits set by the national le- illustrative purposes (Table 4) and are gal framework, the Government may considered feasible under good policies wish to consider changes in this status and adequate external conditions. as part of a generalized tax reform for These projections envisage tourism the ICMS. Most countries subject tour- emerging as a leading sector in Ceari's ism and tourists to taxation, and there is economy over the next 5-7 years. By the no prima facie reason that Cear; should year 2004, tourism expenditures could be different.) Nevertheless, tourists pur- account for 20% of State GDP. chase other goods and services that are subject to the ICMS tax. In 1997, a 34. Bringing about the projected growth lower bound estimate of ICMS tax reve- in tourism will involve overcoming a number of problems and constraints. While very appealing, attractive, and Since tourism is not measured directly in the poSes eous potenta, ny of national accounting framework, indirect meas- to international standards: urement techniques have been applied based upon estimating the number of tourist arrivals, the duration of their stays, and their spending habits (a) Maintenance and quality standards, both in composition and amount. These tech- telecommunications, and the com- niques measure tourism revenue and not value puter systems of hotels leave space added and are thus not strictly comparable with for improvement. Water, sewerage, GDP figures 9 The relatively high labor intensity of tourism is masked by the predominance of low productivity 1 ceanYs foreign tourists in 1997 were about agriculture in total employment. 3% of those visiting the Dominican Republic. Page 28 Cear6 State Economic Memorandum and energy infrastructure are over- gated rice, and cultivated pastures); and burdened, especially in the outlying the South (dryer areas, with extensive coastal areas, and constitute a high grazing system, and more humid areas, priority given that international with beans, maize, cotton, sugar cane, tourism flows can be quite sensitive and rice). As elsewhere in the Northeast to health concerns. Bottlenecks in of Brazil, agriculture is characterized by the highway network exist or will limited input use and slow rates of tech- emerge shortly. nology adoption. (b) There are serious human resource 36. Overall, the agricultural sector has constraints in both managing and been stagnant over the last decade. Ag- staffing tourism facilities. Catering riculture's share of Cear6's economy to international tourists requires has declined to 5.7%, which is excep- openness, basic education, and tionally low for the level of development language abilities. Ceari's educa- of the State. The annual rate of growth tion system is presently producing in agricultural GDP has declined dra- few individuals with the requisite matically, from 8% in the 1981-86 period skills, and operators and firms ac- to about 1 to 1.3% between 1987 and tive in the tourism industry complain 1997. In spite of this very low growth, about the scarcity of trained and sectoral employment remained high at qualified personnel. around 43% of the workforce, which suggests a widening of the income gap (c) Another constraint is the partly un- between agricultural and non- favorable image that Brazil has agricultural workers. Low labor produc- abroad as a country beset by prob- tivity in agriculture explains the large lems of poverty, crime, and health difference between agriculture's share in hazards. These concerns require a employment and GDP and is also at the continued emphasis on improving root of widespread and deep rural pov- the public sector services in police erty. Through migration, rural poverty and health and a concerted public also contributes to urban poverty. relations effort. 37. A sharp deceleration of the State's (d) Finally, the State needs to ensure agricultural economy has taken place due diligence with respect to the since the late 1980s, both in terms of possible negative environmental, agricultural GDP growth rate, crop area, social, and cultural consequences and cattle inventories. The sharp decline of some forms of tourism. in total farmed area between 1985 and 1995-96 is striking. According to the Ag- Agriculture ricultural Census figures for Ceari, be- tween 1985 and 1995-96, the area un- 35. Until the early 1980s, agriculture der crops (annual and permanent) fell was predominantly dependent on cotton by 42.4%, while total farmed area fell by and livestock. Nowadays, agriculture is 18.6%. The most dramatic change in the more diversified. The predominant pro- cropping pattern since 1985 has been duction systems vary among the main the near extinction of cotton (from subregions, namely the Northeast coast 757,000 hectares to 17,000 hectares), (cashew, coconut, and livestock); the which is attributed to the impact of the North (beef, milk, cotton, poultry, and cotton weevil, a fall in world prices, and some food crops); the Sert6es (cotton, the effect of changes in the labor code. extensive grazing system, maize, The dramatic decline in cotton is per- beans, and cassava); the region around haps the major underlying factor for the the Jaguaribe River (annual cotton, irri- overall sector decline. However, the Cear6 State Economic Memorandum Page 29 planted area of beans, maize, and cas- less than 1.0% each to the agricultural sava has also declined. The exception is GDP cashew, which has increased from 163,000 to 280,000 planted hectares 40. In general, crop yields for major and some increase in coconut and ba- products in Cear6 are relatively low, nana cultivation. The situation for live- particularly those of food and subsis- stock shows a less pronounced but still tence crops cultivated in non-irrigated very significant declining trend in stock areas. Also, the utilization of fertilizer numbers. The stock of cattle, goats, and (chemical and organic) is amazingly low, sheep fell by 3.8%, 19.4%, and 1.8%, even on larger farms. Only 6.7% of all respectively. Pork inventories dropped farms apply any chemical fertilizer and 15.9%. Poultry is the exception, with an only 9% apply any organic fertilizer. increase of 16.7%. These application rates are somewhat higher in larger farms. The analysis 38. Other contributing factors to the suggests a situation of low profitability in sector's decline include falling real pro- intensifying production. Partly, this is ducer prices for most farm products probably the effect of the decline in real since 1993-94. Real farm producer producer farm prices and the high-real prices for crops increased by 15% in interest rates prevailing in Brazil. Low 1993-94 compared to 1990-91, but the fertilizer use could also be linked to wa- index was 25% lower in 1996-97 than in ter constraints. Soil fertility is not par- 1990-91. Real prices for livestock prod- ticularly low (especially when the crop ucts declined throughout the period. For rotation includes legumes such as tradable products, which represent the beans), but shortage of water and the majority of farm products, there are high risk of droughts would make higher three factors contributing to the decline fertilizer use unprofitable. As a matter of in the agricultural sector, namely the fact, mineral fertilizer and crop protec- appreciation of the exchange rate, lower tion use are highest in meso-regions border prices, and lower levels of pro- with more irrigation, such as Jaguaribe, tection (in particular, related to the Centro-Sul, and Fortaleza. opening of the economy under Merco- sul). For non-traded goods, the lack of 41. Water resource management and overall economic growth during 1985-95 irrigation development figure promi- is also a major contributing factor for the nently in the rural development strategy agricultural decline. of Cear6. The objectives are to improve the efficiency of Cearci's integrated wa- 39. In terms of contribution to agricul- ter resource management system and to tural GDP, poultry is by far the subsec- expand the irrigated areas. These ob- tor that contributed the most, accounting jectives can potentially contribute to sig- for 19.5% of agricultural GDP, followed nificant growth of the sector. Also, irri- by beef and milk (10.0% and 10.4% re- gation increases farming intensity and spectively), beans (10.8%), maize contributes to agricultural growth. In (7.4%), and eggs adding another 5.4%. most cases, irrigation can also increase All fruits together contributed almost agricultural labor demand and thus re- 11% to agricultural GDP. Cotton, sugar- duce rural poverty. cane and cassava reduced their partici- pation, now representing 1.6%, 4.8%, 42. In 1995-96 approximately 8.5% of and 5.2%, respectively. One should also farms used some form of irrigation. observe that goat and sheep herding, 23.8% of the irrigated land was culti- activities that are frequently mentioned vated on farms of less than 10 hectares, as a potential for growth, still contribute 30.1 % on farms between 10 and 100 hectares, and the rest on farms above Page 30 Cear6 State Economic Memorandum 100 hectares. In 1994, Cear6 had about of operation, not necessarily ownership) 51,700 hectares under irrigation. The decreased from 34 to 26 hectares be- goal of the responsible Secretariat is to tween 1985 and 1995-96, and the share reach a total of approximately 100,000 of farms with less than 10 hectares in- hectares by the end of 1999. Investment creased from 49% in 1970 to 72% in projects under construction will incorpo- 1995-96. In absolute numbers, 245,000 rate about 25,000 hectares under irriga- farms in the State have less than 10 tion, so as to reach a total of 75,000 hectares, out of a total of 340,000 farms, hectares. As one would expect, produc- and more than one-third of all farms tivity on irrigated areas is significantly have less than 2 hectares (121,000 higher than on non-irrigated land. Higher farms). As a reference, an area of 30-50 yields with irrigation are particularly ap- hectares is typically considered a viable parent for rice (4.18 versus. 1.39 tons farm size for a single-family farm in the per hectares) beans, and coconuts, al- Sert5o. though not for maize. 45. As more farms are subdivided, one 43. Unfortunately, no rigorous ex-post observes a trend from owner-operated economic evaluations of irrigation farms to farms operated by tenants and schemes in the State were available for occupants. Tenants and occupants in- review. Studies in other countries show creased their share from 34.5% of all that the actual economic returns to in- farms in 1970 to approximately 50% in vestments in large-scale irrigation 1995-96. Overall, one would expect that schemes are often much lower than an- this high share of tenants and occupants ticipated by ex-ante evaluations." An would result in lower farm productivity indication of potentially substantial levels, relative to titled and properly misallocation of water resources is the registered farm units, on the premise surprisingly high share of the irrigated that tenure insecurity (i) reduces the area cultivated with low-value food farmers' investment in assets attached crops. Approximately 60% of the irri- to the land (small scale irrigation, soil gated area is grown with beans, rice, conservation, orchards, etc.), (ii) re- and sugar (24.4%, 18.6% and 17.0%, duces the supply of credit due to lack of respectively), while less than 5% of the collateral, and (iii) inhibits the entry of area is grown with higher value products more productive farmers and the exit of such as fruits, tomatoes, and cotton. the less productive farmers. Evidence suggests that the economic returns to food crops such as beans, 46. Cearc's 250,000 minifundicrios maize, and rice under irrigation in the (classified as those with less than 10 large-scale irrigation areas are low, and hectares) produced 40% of the main are likely to remain low. Inadequate crops and 25% of the livestock while pricing for water comprises a strong occupying only 7% of the farmed area. factor explaining the use of water in A large fraction of the small farms pro- lower value crops.12 duce under very unfavorable natural conditions of low soil fertility and low 44. A trend of increased farm fragmen- rainfall. For most crops, yields are tation has been observed since the somewhat higher in small farms even 1970s. The average farm size (by size though the share of owner-operators is low. In this situation, both land reform "Jones, William (1995), "The World Bank and and improved tenure security would Irrigation" OED report. likely contribute significantly to raising 12 Dinar, Ariel and Subramanian, A. (1997), rincos pob la ins "Water Pricing Experiences- an international ex- perience", World Bank Technical Paper# 386. the low share of farms (4%) with access Cear. State Economic Memorandum Page 31 Figure 3: Poverty Rates over Time 1.3 - - -- 1.2 0.8- Ily 0.7-8 4 0.7 T,0C,Q h T C O C11- (7)~ Source: IPEA, IBGE/PNAD --*-Ceari -4 -Northeast - a -Brazil to extension services in 1995-96. The existence of such a large number of very small farms poses a major budget- 48. Independent of data source and ary, administrative, and technical chal- methodology, poverty in Ceari has lenge for the Government. been significantly reduced over the last two decades. This is an important 3.achievement. Notwithstanding the rela- 3. ScialDeveopmet Poicy tively low employment intensity of in- and Performance dustrial investments in CearA, growth 47. The effort exerted to reduce poverty has had a decisive impact on reducing and improve living standards in Cear6 is poverty. Rocha (1998) reports that striing Vaiou leelsof ov- Cear6i's rate of extreme poverty has clearly striking. Various levels of gov-5 13 ernment and several agents in civil so- Usin aouh higher pov rate, P ciety participate in the attempt to miti- data a on PNAD sows tat PEv gate poverty in CearA. Nevertheless, the amount of poverty remaining presents a erty in CearA has declined faster than reason why further efforts and more effi- poverty in the Northeast overall (see cacious social policy must be developed g ) I y to aid the large number of CearA's poor. higher than in the Northeast overall, but This section first presents a profile of the poor in Ceard and then discusses cur- 13 This statement is based on analysis by Sonia rent Government social policies and Rocha (1998) who uses a significantly lower pov- their possible impact on the poverty re- erty line (for 1996 R$26.46 for Fortaleza) than the duction. one used elsewhere in this report. Page 32 Ceara State Economic Memorandum Table 5: Household Per Capita Income Shares by Decile Tenth 1985 1990 1996 1 0.8 1.3 0.6 2 1.6 2.6 2.2 3 2.2 3.3 3.1 4 2.8 4.3 3.8 5 3.6 5.2 4.9 6 4.6 5.7 6.1 7 6.0 7.4 7.8 8 8.6 9.2 9.5 9 14.8 14.7 14.8 10 55.1 46.4 47.1 Source: Rocha, (1998), Table 14. this gap has since been closed. As 50. Table 5 presents the evolution of Cearc's poverty trend has broadly fol- income distribution in Cearc between lowed the national poverty rate, most of 1985 and 1996 by means of income the variation in poverty over time is likely shares accruing to each population related to national macroeconomic per- decile in the state. Between 1985 and formance. Most notable is the large re- 1990, there was an unambiguous im- duction in poverty immediately after provement in the distribution of incomes, economic stabilization in 1994. Other with shares for the bottom eight deciles studies also confirm that the reduction of rising at the expense of the top two poverty in CearA has been somewhat deciles. Growth between 1990 and faster than in other major states of the 1996, on the other hand, seems to have Northeast and in Brazil as a whole,14 been unequalizing. In fact, while the top suggesting a somewhat better policy decile did not recover its 1985 share, performance of the State of Ceari. the shares of the bottom five deciles fell between 1990 and 1996, while those of 49. Despite the undoubtedly overall each decile 6 through 10 increased. It is positive trend, some caution is in order. worthy to note that while the income First, intertemporal poverty analysis in share of wealthiest decile did decline periods of significant macroeconomic since 1985, it still remained substantially instability (before 1994) is inherently un- high, at approximately 50% of the over- reliable. Second, poverty reduction has all income share. Whatever poverty re- been much slower in rural than in urban duction took place over this period, then, areas. Finally, the reduction in poverty was due to growth rather than to pro- incidence was achieved largely through gressive redistribution. In fact, the loss increases in the incomes of those clos- in income shares for the poorest deciles est to the poverty line, with a simultane- is clearly consistent with the finding that ous increase in the average distance the depth of poverty seems to have in- between the incomes of the poor and creased substantially over this period, the poverty line. There appears to re- despite a decline in incidence. main a "core" of poverty, which is pre- dominantly rural, mostly associated with 51. The following analysis is based on a very low levels of schooling, and which poverty line of approximately R$65 per is less responsive to economic growth month per capita in prices of the S5o per se, requiring instead a stronger Paulo Metropolitan Area.15 The poverty component of direct intervention. _______________________15 Incomes in Cear6 are inflated to account for 14 See Dorte Verner, 2000, "The Dynamics of the difference in price indices between the S5o Poverty and its Determinants; the Case of Per- Paulo Metropolitan Area and the Fortaleza Met- nambuco and the Northeast of Brazil," World ropolitan Area, non-metropolitan urban areas, Bank,smimeo. and rural areas in the Northeast, respectively. Cear6 State Economic Memorandum Page 33 line used in this report was derived from a rigor- ous methodology. The main purpose of the use of a poverty line is to Metropolitan Core permit consistent com- 12% parisons across time, Metropolitan space, and different Periphery population groups, and no particular normative sig- Large Urban nificance should be given to the specific poverty line Medium Urban chosen. Rural 4o 54% 52. Using the chosen poverty line, 49% of Small Urban CearA's population is 17% considered poor (com- pared to 23% for Brazil or 3% for the S5o Paulo Metropolitan Area). An- other measure of poverty in Ceard is the income ropolitan area of Fortaleza. Both of gap of R$1.3 billion, which is the amount these areas are closely linked to the ru- theoretically necessary in any given ral economy. Residents working in rural year to lift the income of all poor up to occupations or those closely related to the poverty line (assuming that transfers them (as in small towns), and immi- are costless and can be perfectly tar- grants from rural areas (as in the pe- geted). This amount represents 7.3% of riphery of Fortaleza) experience the State GDP or 53% of State Government highest rate of poverty, supporting the spending in 1996. For comparison, the claim that poverty in Cear6 is related to national income gap constitutes 2.2% of the rural economy If efforts to reduce Brazil's GDP. poverty were to be spatially targeted, rural areas should clearly receive the 53. The main characteristics of CearA's bulk of resources, with urban spending poor are summarized in Table 6. Their concentrating on small towns and on the location is shown in Figure 4. Poverty metropolitan area of Fortaleza. rates are lowest in the Municipality of Fortaleza (20%), followed by cities 54. The two most important determi- above 100,000 population (31%), the nants of poverty are education and the Periphery of the Fortaleza Metropolitan occupational sector of the household Area (42%), medium cities (48%), small head. The education profile in Figure 5 cities (51%) and rural areas (77%). 56% shows how strikingly the poverty ici- of all poor live in rural areas, 17% reside dence declines with the education of the in small towns up to 20,000 in popula- household head, from over two-thirds for tion, 10% live in medium and large cit- those with one year of schooling or less, ies, and 19% live in the Fortaleza Met- to less than 1% for those with more than ropolitan Area. Clearly, poverty in Cear6 twelve years (with some time spent at a remains a rural phenomenon. In the ur- college or university). 84% of the poor ban areas, a large number of poor are live in households where the household concentrated in small towns with less head has less than four years of educa- than 20,000 inhabitants and in the met- tion. Page 34 Ceari State Economic Memorandum Table 6: CearA Poverty Profile CEARA BRAZIL Characteristics of Headcount Contribution to Headcount Contribution to the Sub-Groups Poverty Rate Poverty Poverty Rate Poverty Household or Household Head (%) (%) (%) (%) Total 49.25 100.00 22.59 100.00 Zone Metropolitan Core 20.06 11.65 7.47 5.83 Metropolitan Periphery 41.86 7.36 10.07 5.41 Large Urban 30.87 2.70 10.22 8.55 Medium Urban 47.68 6.66 17.58 12.21 Small Urban 51.14 17.02 30.82 20.49 Rural 76.51 54.60 52.03 47.52 Water Canalized 27.26 28.64 13.04 47.08 Not Canalized 72.86 71.36 65.19 52.68 Other/Not Specified 0.00 0.00 35.46 0.24 Years of Schooling Less than 1 Year 66.90 56.27 46.22 44.71 1 to 4 Years 60.17 28.42 32.95 29.22 4 to 8 Years 34.61 12.64 15.78 21.03 8 to12 Years 9.35 2.64 5.44 4.95 More than 12 Years 0.46 0.03 0.30 0.10 Working Class Inactive 39.40 14.75 18.71 14.65 Unemployed 71.86 3.08 45.81 5.62 Formal Employees 28.30 6.99 10.96 11.30 Informal Employees 66.91 20.53 36.60 21.55 Self-Employed 58.12 45.40 30.66 36.63 Employer 26.73 2.43 4.95 1.04 Public Servant 19.77 2.31 10.66 4.12 Unpaid 64.42 4.50 46.89 4.97 Other/Not Specified 30.78 0.03 65.55 0.13 Sector of Activity Agriculture 78.06 51.17 52.44 45.52 Manufacturing 51.31 9.09 15.80 8.49 Construction 37.63 5.77 18.48 6.58 Services 27.17 14.31 11.22 15.64 Public Sector 18.21 1.82 9.62 3.50 Other/Not Specified 42.73 17.83 22.38 20.28 Source: Neri, PNAD 1996 - IBGE 55. Figure 6 displays poverty rates in scattered across the interior of the state different occupational sectors. As ex- (of which cashew-nut factories are the pected, those directly in- volved in agriculture are Figure 5: Poverty Rates by Education Level, PNAD 1996 overwhelmingly poor (78%). Public servants experience the lowest poverty rate, with only 80 18% in poverty, followed by workers employed in 60.17 the services sector, with a 60 27% poverty incidence. g Construction, a sector with a predominantly un- skilled urban labor force, ' 30 has an associated poverty 20 rate of 38%. Manufactur- [3 ing, which comprises not 10 M 0.46 only modern industry in and around Fortaleza, but 0-1Years Ito4Years 4to8Years 8to12Years >12Years also the mostly backward, Years of Schooling low-productivity food- processing enterprises _________________ __________ Cear6 State Economic Memorandum Page 35 prime example), has a prielyxamp) hih p t iFigure 6: Poverty Rates by Occupational Sector, PNAD 1996 relatively high poverty in- cidence of 51%. 56. In regard to the labor force status of the popu- 08.06 lation (see Figure 7), it is 87. noteworthy that only 12% of all household heads 60 describe themselves as 5 formal employees, com- 37.63 pared to 54% who are 27.17 counted as informally or 18.21 self-employed (sem car- teira and conta pr6pria, respectively). Only 2% 0L report being unemployed. secto Among the poor, high in- formality is even more pronounced with 66% of the poor working infor- mally or being self- employed. Unemployment Figure 7: The Poor by Employment Status, PNAD 1996 is at a remarkably low rate of 3% among the poor. Unpaid Puli Srvnt 4% (While technically defined, 2% unemployment is low; the Employer 15% complaint about the ab- 2% -Unemployed sence of stable well- 3% paying jobs remains Formal Emploees widespread.) 7% 57. Income-based poverty Self-Employed, measures obviously cap- 46% Informal ture only a part of depri- 21mpoye vation. However, Cear6l's deep poverty is also pres- ent in other measures. The average Cearense is__________________________ born with a life expec- tancy significantly lower than the aver- Social Policies age Brazilian. Adult literacy is also lower in Ceari than elsewhere in the country, 58. Much is being done by the State and with barely half of the State's adults able other institutions to reduce poverty and to read and write (in 1991), as com- improve the quality of life for the poor. pared to 80% in the entire country. Policies to reduce poverty can be clas- Here, there is a significant difference sified into the areas of: (a) growth, em- even with respect to the Northeastern ployment, and increased demand for average, of almost ten percentage labor (discussed elsewhere in this re- points, port); (b) increases in the provision of services and assets to the poor (human and physical capital formation and better Page 36 Ceari State Economic Memorandum services); and (c) protection of the poor 61. In the area of Health, Cear6 has de- from income volatility and basic support servedly won international recognition for the hard-core poor. State policies for its success with the Programa de have primarily relied on the positive ef- Agentes Comunitirios de SaOde. The fect of economic growth. At the same program relies on local residents as time, the State has pursued innovative community health agents, selected on approaches toward improved education, the basis of their ability to provide ad- health, and service provision to the vice and leadership in basic health pre- poor. In fact, the State has pioneered vention and child care. Presently, there several important innovations in the fight are approximately 8,700 community against poverty that are now being used health agents across the State, and elsewhere in the country. CearJ has every municipality is covered. The State been moving cautiously toward the has now moved to a second-phase pro- creation of a social safety net, in fear gram, Programa de SaOde da Familia. that more decisive action might create a This program links ten community health heavy fiscal drag and possibly undesir- agents to one qualified physician and able incentive effects. one nurse, in order to provide a higher level of care. Each team of ten agents, 59. Human capital in the form of skills, one physician, and one nurse is ex- education, and health is the main asset pected to cover one thousand families of the poor. Education enhances human (or roughly 5,000 people). Of the 1,000 capital, which in turn generates the in- teams required across the State, 347 come that helps individuals escape from were in place as of July 1998. poverty. The Education Secretariat, along with various other State and mu- 62. In the 1980s, infant mortality rates nicipal agencies, has developed a series fell approximately 40% throughout Bra- of programs to address the acute edu- zil, with Ceara showing slightly better cational need of the poor in Cear6. improvements than the Northeast over- These programs attempt to improve *he all but remaining at a very high level of quality of teachers and teaching, pre- about 90 deaths per one thousand born vent and reduce school evasion and in 1991. Since 1991, rates have been repetition, and provide vocational train- reduced further, which could have been ing. the result of successful improvements in basic health care. Studies also show a 60. Some programs have had remark- somewhat larger improvement in areas able outcomes. For example, training covered by the Community Health Agent initiatives as well as reforms in hiring Program. However, the remaining high and appointing school directors have incidence of infant mortality and cor- contributed to an improvement in the municable diseases suggests that a low levels of schooling of teachers. As a large challenge remains for further in- result, the proportion of teachers in proving basic health and extending wa- Cear;'s public schools (excluding For- ter and sanitation services, which have taleza) with less than complete secon- been shown to be very strongly related dary schooling fell from 55.7% in 1996 to health outcomes in the Northeast. to 26.6% in 1998. The State has been widely successful in increasing enroll- 63. Assets of the Rural Poor. One of the ment rates for primary education. How- underlying causes of poverty in the ever, despite progress, educational at- Northeast is the relatively inferior re- tainments, educational quality, and en- rollment in higher levels of schooling, 16 See World Bank, 1998, Public Expenditures vocational, and adult education remain for Poverty Alleviation in Northeastern Brazil," at unsatisfactory levels. Report No. 18700-BR. Ceara State Economic Memorandum Page 37 source base in several regions. The 65. Cear6 is undertaking a number of drought of 1993, which affected nearly programs directed at strengthening the three-fourths or approximately 12 million physical assets and basic services pro- people of the Northeast, was particularly vided to the poor. In rural areas, the devastating in Cear6, where agricultural main programs are the Programa de output declined by 47.2%. Another se- Combate a Pobreza Rural ("Projeto Sdo vere drought hit the region in 1998. For Jos6), which provides investment small farmers without modern technol- grants for small farmers; the Programa ogy and without adequate working da Reforma Agrcria Solidiria, or capital, drought years lead to low quality "C6dula da Terra", a market-based land crops with minimal income-generating reform pilot program; the Programa de capacity. For the landless wage work- Apoio e Fortalecimento da Agricultura ers, drought eliminates their principal Familiar (PRONAF), a federal program source of income and employment. that provides subsidized credit for small Many of these vulnerable family groups farmers; and Pro-Renda and Proger, migrate either temporarily or perma- smaller programs supporting employ- nently to urban centers in the interior or ment and income-generating activities to the capital. Additional complicating through grants and subsidized credit. factors include: (i) a land tenure struc- ture characterized by large extensive 66. An important aspect of the rural de- farming that coexist with a very large velopment program is the heavy reli- number of small semi-subsistence ance on community associations in both farms; and (ii) extremely low levels of the Projeto S5o Jos6 and the Reforma schooling of the rural population, re- Agr6ria Solid6ria. Under the Reforma ducing their employability in non- Agrcria Solid6ria, land reform is under- agricultural economic sectors. taken by community associations of lan- dless farmers or minifundi6rios who ne- 64. The bulk of the rural labor force in gotiate the purchase of land and receive agriculture is self-employed, 80% work credit for the land as well as grant fi- on their own farms, 3.9% work as per- nancing for complementary community manent laborers, and 13.6% are tempo- investments. This program is new, and it rary laborers. Between 1985 and 1995- is too early to assess its final impact. 96, the total number of rural laborers in However, the first results in terms of im- Ceari (including non-paid family mem- plementation speed, cost reduction over bers, permanent and temporary hired administrative land reform, and ex- labor, and sharecroppers) decreased pected farm viability are impressive. The slightly from 1.3 to 1.2 million. Rural project is proceeding well, and the newly household income analysis (based on established farms appear to be eco- data for all of the rural Northeast) con- nomically viable, once basic capital firms that absolute poverty and indi- goods and some infrastructure (rural gence levels in rural areas of the North- electrification and small scale irrigation) east, including Ceari, are extremely are made available. high. The analysis also suggests that the poorest are often not the landless 67. Assets of the Urban Poor. In urban workers but minifundicrios (farmers who areas, the main complaints of poor own less land than necessary for sub- communities include: (a) lack of em- sistence) who are typically less mobile ployment opportunities; (b) inadequate than hired workers and usually have housing; (c) insufficient provision of less access to public services such as secondary education and vocational electricity, education, and health care. training; (d) inadequate access to credit for micro-entrepreneurs. A recent World Bank study has reaffirmed the critical Page 38 Cear6 State Economic Memorandum Table 7: Access to Basic Services Over Time State of Ceart - % Share of Population in Households with adequate... Year Access to Water Electricity Connection Garbage Collection 1985 67.4 50.5 25.2 1990 66.4 65.5 38.0 1993 99.7 69.1 46.8 1995 99.6 71.3 48.4 1996 97.9 73.9 47.6 Source: Rocha, (1998), Tables 5, 7 and 8. importance of water and sanitation els remain significantly lower for the services, in particular for the health of poor than for the general population. the poorer population.17 The State's ur- 71 % of Ceari's poor do not have piped ban development project (PROURB), water (compared to 48% of the entire with World Bank financing, supports im- population). 43% do not have electricity provements in urban infrastructure with (compared to 26% of the entire popula- a focus on poor neighborhoods. Another tion). program designed to deal specifically with housing is the State's Programa de 69. The final element of the poverty re- Mutir5es Habitacionais, which could duction strategy is the social safety net. potentially be expanded. In this pro- The purpose of the social safety net is to gram, Cear6 provides construction ma- provide basic support to those structur- terial (and sometimes the regularization ally unable to earn sufficient income (the of urban land titles) while the communi- elderly and disabled, in particular) and ties supply the labor to construct popular to protect the broader population from housing. Due to the higher quality of the negative income shocks that would oth- final housing stock and better supervi- erwise cause deprivation. Shocks can sion by beneficiaries of the procurement be based on idiosyncratic risk, which is of construction materials, beneficiaries largely uncorrelated across individuals typically prefer this system to more con- (like the risk of illness or disability), or on ventional ready-made housing pro- aggregate risk, which is positively cor- grams. related across individuals (like the risk of low yields due to drought). 68. Over the last 10-15 years, there has been continuous and significant im- 70. At present, Ceari provides some provement in indicators of access to coverage against idiosyncratic risks, services, such as water, sewage, elec- mostly through federally funded pro- tricity, and garbage collection (see Table grams. These programs include: (a) 7). The rise in electricity connection Brazil's federal public health system (the rates has been steady over time and Sistema Onico de SaOde), which is free has clearly made substantial inroads of charge and (in principle) available on into rural areas that were previously demand; (b) the Social Assistance Law largely untouched by the power grid. (Lei Orginica de Assist6ncia Social, Sewage services (not included in the LOAS), which mandates benefits for table) also have improved but remain at poor families with elderly or disabled unacceptably low levels. Despite ad- members; (c) the rural pension system, vances in service provision, access lev- which provides for minimum retirement _____________________pensions for workers involved in agri- 17World Bank, 1998, Public Expenditures for cultural activities; and (d) the unem- Poverty Alleviation in Northeast Brazil, Report ployment insurance system, which is No. 18700-BR. tied to formal employment and thus has limited reach in Cear where only 18% CearA State Economic Memorandum Page 39 of household heads are formally em- ployed. The very significant importance of pensions for poverty reduction is Million Current Reais 1995 1996 1997 Current Revenues 1744 2180 2202 highlighted by Rocha (1998) who shows Tax Revenues 985 1227 1302 that Cearc's poverty rate would be ap- lOVS 951 1184 1242 proximately 50% higher in the absence Cur Tanes 65 7 8 of pension benefits. FPE 567 641 719 IRF 51 53 55 71. Aggregate risk is largely climatic. In Satiro educag6o 10 15 14 Contractual Transfers 21 71 41 Cear, as elsewhere in the Northeast, Other Transfers 10 20 15 the main program aimed at mitigating Return to Investments 57 18 16 the effects of droughts, such as the one le Trnertous 26 3 48 which affected crops throughout the re- palities gion in 1998, is a public work scheme NetCurrentRevenues 1475 1860 1854 (Frentes de Trabalho) set up during (NCR) drought periods. The program is jointly funded by federal and state govern- to -10% in 1996 and -16% in 1997. Also, ments. Local councils, which include capital spending cannot be sustained at government representatives as well as current levels. members of community associations, organize work programs and approve beneficiaries. Demand for these jobs Revenues typically exceeds supply, so that quan- tity rationing is in place. Each worker 73. Taxes. The state's principal revenue receives a monthly wage of R$90. Addi- source is a value added tax (ICMS), tional support in drought periods is pro- which is administered by the State Gov- vided through emergency food and wa- ement, subject to regulations imposed ter deliveries and emergency farm credit by the federal senate and by agreement at special terms. of the council of state finance secretar ats. In general, the ICMS is imposed on the gross value of sales, less a credit for 4. Fiscal Policy and Perform- ICMS paid by the suppliers of inputs. anceFor some products, where the imposi- ance tion of the tax at the retail level would be 72. Justifiably, Cear5 has acquired the difficult, the full tax on the imputed retail reputation of a jurisdiction that is fiscally price is imposed at the manufacturing sound by Brazilian, though not neces- stage. Certain services are exempted sarily international standards. Personnel from the tax by federal law, including costs consume only 60% of net current hotels, banks, and the liberal profes- revenues. The stock of debt is small by sions. The Senate sets the maximum Brazilian standards (102% of net current tax rate on interstate transactions (now revenues), and largely long-term and 12% for states of the Northeast and low-interest. Nevertheless, fiscal con- Center-west and 7% for states in the straint is becoming increasingly impor- South and Southeast. Rates on intra- tant considering that the State's primary state sales are set at the discretion of balance,8 which was only -1% of net the individual states, subject only to a current revenues in 1995, deteriorated minimum fixed by the Senate. In CearA, the rate on intrastate transactions is now ____________________25% for telecommunications, electric The primary balance equals net current reve- energy, and fuels, and 17% for most nues minus current expenditures (net of transfers other products and services. to municipalities and interest payments) and mi- nus capital expenditures (net of amortization). Page 40 Ceard State Economic Memorandum Table 9: Trends in ICMS and GDP ticularly steep in sectors affected by rising con- Million Cur- 1994 1995 1996 1997 1998 sumer interest rates (re- rent Reais ICMS 508 951 1,184 1,242 1,344 ceipts from eletrodom6sti- State GDP 7,969 14,003 17,290 19,586 20,809 cos and purchases of ICMS/GDP 6.4% 6.8% 6.9% 6.3% 6.5% automobiles both fell ISource: Iplance 28%.) Overall, receipts from wholesale and retail 74. Over the course of the last five trade fell 7.6% while receipts from in- years, the ratio of ICMS to GDP rose dustry fell 9% (Table 11). Assuming that with price stabilization in 1994 and the recent stagnation in ICIS revenues peaked in 1996. In 1997, revenues fell was due to recession, the State could in relative terms, and recovered only expect resumption in revenue growth partially in 1998 (see Table 9). The fall once the economy recovers. The recent in ICMS in 1997 was largely due to a experience nevertheless demonstrates one-time change in federal policy the ICMS's vulnerability to changes in through the "Lei Kandir' (L.C. 87/96). federal policy and trends in the econ- Effective September 1996, this law omy. Prospects for increases in the granted an ICMS exemption on exports ICMS will also depend on the sectoral and permitted firms to claim a tax credit composition of economic growth. The for purchases of capital equipment. impact of growing tourism will be Taken together, total losses due to the blunted by the exemption of hotels from Lei Kandir are estimated at R$115.1 the ICMS base. million (Table 10). Without Lei Kandirs negative impact, ICMS revenues would 76. Fiscal impact of industrial incentives. have increased by 6% in real terms. In the short term, Ceal- is also losing This corresponds to the rate of growth in revenues through the financial incen- the economy, and suggests that at least tives granted to industrial firms. In the in 1997, losses were entirely policy- State accounts, ICMS revenues from induced. industry are reported gross of tax incen- tives. The incentives are instead re- 75. By October 1997, the Lei Kandir's ported as an expenditure of the indus- impact on the growth rate of ICMS trial development fund. Comparing should have dissipated. However, ICMS these expenditures to gross revenues revenues failed to recover completely. gives an idea of their impact. In 1996, This failure appears to be due to the re- the cost of tax incentives under PROVIN cession induced by the Government's (the largest incentive program) totaled response to the Asian Economic Crisis. R$102.2 million, against ICMS receipts Declines in ICMVS revenues were par- of R$25.1 million. In 1997, incentives Table 11D: Losses Arising from Lei Kandir Table 11: Sectoral omposition of ICMS Receipts R$mn % 1st semester 1998 14MS Sector % receipts Real growth Export Tax Credits 44.6 3.6% 9897* ICMS on Exports 30.8 2.5% Manufacturing 32 -8.9 Transfers of Credits 13.7 1.1% Retail and wholesale commerce 32 -7.6 Investment Credits 47.6 3.8% Electric energy 11 +48.6 Electricity Tax Credit 23.0 1.9% Telecommunications 9 14.7 Total 115.11 9.0% Fuels 8 -2.9 Transport 2 -14.6 Other 6 Total 100% 0.0 oreflects expansion of base and increase in rate **1st semester 1998/1 " semester 1997 Cear6 State Economic Memorandum Page 41 Table 12: Disbursements and Receipts of Industrial Tax Incentives Million Cur- PROVIN PROVIN PROAPE PDCI Disbur- Total Net Incentives as rent Reais Disbursement Accrued Re- Disbursement sement Disbursement % NCR ceipts 1996 102.2 25.1 0.3 77.4 4.2% 1997 110.6 32.7 4.2 1.1 83.2 4.5% rose to R$110.6 million, with receipts of includes a mechanism for compensating R$32.7 million. The net negative cash states for their tax losses as the result of flow in 1997 was equal to 6.7% of gross the ICMS exemptions granted by the ICMS receipts, or 4.5% of net current law. Under the law, if real ICMS reve- revenues (see Table 12). Although up to nues in any twelve month period are not half of the principal will be eventually at least 3% (increased to 5% in 1997) recovered through repayments, the pro- above their levels during the period July gram represents a significant cost in 1995 -through June 1996, the Federal cash flow terms as long as it continues. Government is required to compensate (Note that in 1996, the State securitized the State for the difference. In CearA's the PROVIN tax receivables and sold case, this formula failed to produce any them for R$103 million. While this in- compensation in 1997, produced only a creased cash flow in 1996, it has re- small compensation in the first semester duced repayments in subsequent of 1998, and will produce further com- years.) pensation if Ceard's ICMS taxes fail to grow again. 77. Transfers. The other major compo- nent of State recurrent revenue is Expenditure Analysis by Economic transfers. These are mostly automatic, based on fixed shares of specific taxes. The largest is the Fundo de Participaglo 79. Personnel expenditures. Personnel dos Estados. This consists of a fixed is the largest single category of spend- share of the Federal Government's two ing in Cear6. However, the current level principal non-social security taxes: the -- 60% of net current revenues -- is still income tax and industrial products tax. low by Brazilian standards. The wage As specified in the 1988 Constitution, bill has been contained through a policy the Federal Government is required to of virtually no growth in the number of transfer 21.5% of the revenues of the active staff and tight control over sala- two taxes to states. Of this amount, 85% ries. As shown in Table 13, the number is distributed to the states of the North, of personnel paid from treasury reve- Northeast and Center-West regions, nues has been falling19. The number of with the remainder going to the states of personnel paid from treasury revenues the South and Southeast. Within each declined dramatically in the first se- group of states, 95% of the funds are mester of 1998, with the closure of four distributed on the basis of population state enterprises, the sale of COELCE, and per capita income (with poorer and staff reductions at EMATERCE and states receiving proportionately more). SEPROCE. The total reduction in staff The remaining 5% is distributed on the was 3,785. The State intends to hire a basis of geographic area. In the ab- roughly equivalent number of staff, of sence of changes, Ceard's receipts which 3,500 would be professors; 1,000 would grow at the rate of receipts of the police and 100 would be prison guards. two federal taxes. in 19 This includes staff in direct administration and indirect administration, but excludes staff of self- transfers lies in the Lel Kandir, which financing state enterprises. Page 42 Ceari State Economic Memorandum Table 13: Trends in Number of Personnel 6/30/1996 6/30/1997 6/30/1998 Executive Branch No of ativos 101760 99576 *96331 No of inativos 14261 14767 16536 Total 116021 114343 112867 Avg wage 8372 9984 **9666 Other Branches No of ativos 5358 No of inativos 1023 Total 119248 *of which 3,304 afastado ** based on May 1998 payroll Once these are hired, personnel levels sonnel bill of approximately 11%. This are expected to stabilize at around compares with 33% in the city of Rio de 100,000 active staff. Janeiro and nearly 40% in Rio Grande do Sul. Cear6's retirement spending is 80. Salary policy has been tight since a ominous and suggests that such major increase in December of 1994. spending has not yet reached the equi- The December 1994 increase was in- librium implicit in the current structure of troduced as an overall adjustment in the retirement benefits. Judging from the salary structure, aimed primarily at de- comparators, this equilibrium is reached compressing salaries. Increases were when the number of retirees equals at given within each grade based on years least half the number of active staff. of service. Since that time, there has Cear5 is far from these proportions. At been a 25% increase for military police present, the number of retirees equals (effective April 1995) and a 19% in- only 17% of active staff, or 21% of ac- crease for professors (effective, July tive staff if a temporary category of re- 1996). The remaining staff has received cent retirees is included. no increase. The current administration has granted a general increase of 82. Debt service. Cear4ls debt stock is 4.75% to be effective in August 1998. relatively small, inexpensive, and long The employees of the State have made term. As of December 31, 1997, the an important and significant contribution overall stock of contractual and bond to the overall fiscal adjustment process, debt was equal to 102% of net current especially since cumulative inflation revenues (see Table 14). The majority from January 1995 to June 1998 totaled of debt consists of rescheduled debt 45% while salaries remained relatively owed to the Federal Government. This unchanged. includes foreign debt refinanced by the Federal Government under Law 7976 81. The key personnel issue confronting (1989) and debt to federal financial in- the State involves its pension obliga- termediaries rescheduled under Law tions. Under the Federal Constitution, Table 14: Trends in Debt Stock Cear6 is required to concede expensive retirement benefits to its staff. Staff Debt stock as of (Mil E094 E095 E096 E097 members can retire after 35 years of Domecirret Rea1s) service (five years less for women, and Tltulos 50 78 100 0 another five years less for teachers of contractual debt 898 1163 1222 1560 7976 na Na 641 657 either sex). Retirement benefits are Brady bonds na Na 56 64 based on 100% of exit salary and are 8727 na Na 370 375 indexed to changes in the salary of the 9496 114 other domestic na Na 155 350 position formerly occupied by the re- External debt 217 251 336 330 tiree. At present, payments to retirees Total 1165 1492 1658 1890 appear to take a small share of the per- as percent NCR 1 Ro 101 89% 102% Cear6 State Economic Memorandum Page 43 Table 15: Trends in Current and Capital Expenditures Million Current Reais 1995 1996 1997 Current Expenditures 1548 1974 2060 Salaries and Social Contributions 1075 1142 Interest and Fees, Domestic Debt 80 91 101 Interest and Fees, External Debt 15 16 18 Other Current Expenditures 1006 799 plus capitalized interest 200 101 less transfer to municipios 269 320 348 =net current expenditures 1279 1854 1813 Capital Expenditures 408 394 678 Investments 313 291 463 Amortization, Domestic Debt 42 99 208 Amortization, External Debt 53 4 7 =net capital expenditures 408 394 678 8727 (1993). These refinanced debts debt is expected to rise in the near fu- bear long-term maturities (30 years) and ture. The State, for example, intends to relatively low interest rates (averaging borrow to finance the costs of privatizing 6.2% in real terms). Also in this category the state bank. (Newspaper estimates is debt arising from the recent refinanc- put the cost of privatizing BEC at $700 ing of the State's bonds, under Law million, although the State anticipates a 9496. All the rescheduled and refi- considerably smaller figure.) At the ex- nanced debts are subject to a debt tent that Cear6 borrows to maintain its service ceiling. If debt service on the present level of investment spending, loans totals over 11.5% of net current the level of debt is also likely to rise. revenues, the State is permitted to defer the excess, capitalizing it into Table 16: Objects of Major Capital Spending, 1997 the outstanding stock and servicing ite when debt service drops below the DER road construction Mlioneang 70 11.5% threshold. At present, Ceara Water and sanitation 49.4 is near the threshold, but has not Port construction (PECEM) 39.7 Airport 32.0 surpassed it. In addition to its refi Judicial power building program 34.0 nanced debt, the State has $306 School construction 13.3 million in long-term (10-25 year), low Note: cost data on from SEPLAN and include expenditures interest (5.5%-6.6%) debt owed to financed own-source revenues of autarchies and foundations. the Caixa Econ6mica and the Banco 84. Capital spending. The State has do Nordeste, and R$41 million in slightly maintained a high level of capital shorter term (6-7 year) more expensive spending over the past several years. (12%) debt owed to BNDES. External As shown in Table 15, investment debt totals R$ 330 million and consists spending has averaged R$355 million of debt to the DB and the World Bank. over the last three years. In 1995 and s1996, two-thirds of this investment Se the te s spending was financed out of current long and the interest rates are low .20 The contribution of current Ceard's debts constitute a relatively savings.dcie n197 srcit aving d6 beclinedMjo Cint99alSdin eipts small burden. Nominal interest pay- from the sale of stock in COELCE be- ments in 1997 totaled R$ 120 million, came available. In 1998, the State will Together with interest charges in the have ample resources from the sale of form of indexation, interest payments the remaining shares in COELCE to fi- totaled about 12% of net current reve- nues. Amortization costs, net of the3 transfer of state bonds to the treasury, 0 For purposes of this calculation, interest em- Juici bedded in indexation is excluded from current totaledosboutta$89 million.ANhenstonclodeexpenditures. Page 44 Cear6 State Economic Memorandum Table 17: Actual and Projected Fiscal Indicators Actual Projected 1995 1996 1997 1998 1999 2000 Growth of Revenues 7% -6% 3% 3% 3% Credit Operations/NCR 7% 6% 8% 13% 5% 5% Asset Sale/NCR 0% 0% 8% 31% 0% 0% Current Surplus/NCR 13% 11% 8% 7% 6% 7% Capital Spending/NCR 21% 16% 25% 26% 10% 10% Total Debt Service/NCR*) 13% 11% 18% 12% 14% 13% Primary Balance/NCR -1% -10% -16% -30% 4% 4% Overall Balance/NCR Na -15% -23% -37% -4% -3% Cash Flow/NCR -4% -3% -5% 8% 0% 1% * excluding capitalization nance capital spending. Once this is ex- amount required to maintain the level of hausted, the Cear4s ability to maintain debt service below 15% of net current its recent levels of capital spending is revenues (the traditional ceiling imposed questionable. by the federal Senate) assuming a 6% interest rate and 20 years to maturity on 85. In order to provide an estimate of the new debt. Sale of the remaining shares level of capital spending that Ceard is in BEC is assumed to raise R$ 600 mil- likely able to maintain, a model of the lion in 1998, net of funds allocated to State's fiscal situation was prepared. capitalize the proposed pension fund. Cash flow is forced to Figure 8: Capital Spending Projection zero, meaning that total 30% receipts are required to -match total expenditures. Under these assumptions and constraints, the level ne dtS of capital spending that the State can sustain E 0% --- would equal approxi- l -10% '19i5 19 mately 10% of net current revenues, considerably Sta % fbelow scale of capital aspending achieved in S-30% 1995-1 997 (see Figure 8). U) -40% . .86. While some of the as- Fig 8:bCapialance S apipending sumptions underlying the - Prmar baanc - apial peningmode! may not be accu- rate, it is clear that the The model allows the impact of the ma- scope for financing a jor determinants of fiscal performance large capital program by borrowing is (revenues, personnel spending, debt limited. With debt service already at service, capital spending, new borrow- 12% of revenues (excluding interest ing and asset sales) to be tested simul- capitalized through indexation), debt taneously. The results shown in Table service takes a considerable share of 17 assume 3% real growth in revenues, the State's resources. Unless Cear can 3% real growth in personnel spending, identify investments that have an eco- and no borrowing in 1998 (other than nomic rate of return considerably higher the $350 million required to finance the than its cost of funds and are likely to recapitalization of BEC). The level of generate a proportionate increase in tax borrowing in 1999 and 2000 is set at the Cear6 State Economic Memorandum Page 45 Figure 9: Spending by Sector 1997 Security 7% University Education r 2% Basic Education Health Urban Development Industrial Incentives 6- % 5%/ Rural Development 2% Debt Service * Social Funds 14% .5% Highways, Ports, Airports Other 7% 12% Finance, Other Branches Administration 9% 8% revenues, investment spending may accounts for only R$383 million, or 15% have to be curtailed. of total State expenditure. Much of this amount appears to be spent on admin- Allocation of Expenditureoverhead. Only R$186 million Alloatin o Expndiureor 7% of total expenditure is devoted to 87. ne ay f adresingtheStae's paying the salaries of primary school 87. One way of addressing the State's 2 overall resource constraint is to increase teachers. Spending on security is the return on its existing expenditures. small, compared to the states of the An analysis of the State's expenditures South, although this may be due to the show that there do not appear to be any relatively low level of crime in Cearc. egregious examples of "white elephants" Spending on health accounts for 8% of or inappropriate subsidies in Cear. The 21 The chart is based on a breakdown of actual State spent R$463 million on capital 1997 expenditures by budgetary entity, project works in 1997. Slightly over half this and activity. It includes al expenditures financed amount is accounted for by the five ac- from the treasury and from the own-source reve- tivities shown in Table 16. Subsidies to nues of funds, foundations, and autarchies. It State enterprises are a relatively small excludes expenditures financed from the own- proportion of the 1997 expenditures, source revenues of state enterprises. Spending on retired staff is included in the allocation to totaling R$74 million. The State is in the each budgetary entity. Spending on constitution- process of selling the largest potential ally-mandated transfers to municipalities is ex- claimant on treasury subsidies, the cluded. State bank, and has closed the State 22To an extent, this may be explained by the development company (transferring its important role of municipics in primary education. industrial park program to the Secretar- At present, the state primary schools account for iat of Industry and Commerce). only 36% of the 1,499,570 students enrolled in public primary schools. It is not clear (as of this writing) where responsibility for children not en- 88. One noteworthy characteristic of the rolled in school lies, or which level of government pattern of State expenditure is the small is responsible for upgrading the many one-room proportion of spending on what might be schoolhouses in the interior. This issue will be consdere theStae's ore unctonsexamined in detail during the preparation of a consideredproposed World Bank financed education project As shown in Figure 9, basic education in cearp. Page 46 Ceari State Economic Memorandum the total, including SUS financed and more of the same policies are spending. Spending on infrastructure- needed to further reduce poverty rates. (highways, ports and airports) accounted for 7% of the total net 91.This report suggests multiple rea- spending (although this proportion may sons for the limited absorption of labor be atypically large, due to the availability through past growth. First, poverty in the of revenues from the sale of shares in Northeast of Brazil is indeed so deep COELCE). Together, this core accounts that more growth over a longer period of for only one-third of expenditures. Given time will be needed to bring about fur- the tendency of governments ther drastic reductions in poverty. Sec- everywhere to create new programs ond, a long-standing history of inward without extinguishing old ones that have looking economic policies at all levels of outlived there usefulness, the State government in Brazil has led to a geowth Government may find it useful to pattern with less than efficient levels of evaluate its overall spending program, labor intensity. Economic reforms in re- with an eye to eliminating extraneous cent years have introduced drastic activities and focusing more of its changes. With time and the consolida- spending on core functions. tion of these changes, the patterns of growth are likely to change as well. 89. Not reflected in these numbers are Third, there have been some distortions significant steps that the State has taken and some biases against labor-intensive after 1997 to increase the concentralion growth in the current policy mix of of spending on priority areas, particu- Ceari. Without these distortions, the larly education. The share of education poverty outcome could have been spending has been increasing since somewhat, but probably not dramati- 1997 as the result of the creation of rew cally, better. programs for adult literacy and the crea- tion of FUNDEF, a fund for ensuring Growth and Poverty Reduction Pros- minimum spending on basic education using earmarked tax revenues. 92. Cearci will continue to build its eco- nomic development on its main assets: 5. A Renewal of the Policy (a) a climate favorable to tourism and Strategy irrigated agriculture; (b) a large labor force at wages low by Brazilian stan- Strategy Evaluation dards; (c) a Government with a reputa- tion for fiscal responsibility and effective 90. Ceari's policy mix of good govern- administration; (d) a strategic location ance and sound fiscal management, in- with respect to markets in Europe and dustrial promotion, and increasing public North America combined with an im- investment has overall been very suc- proving transport infrastructure; and (e) cessful. This policy mix has generated ample available land that can be made significant growth in industry and has more productive through investment in led to a reduction of poverty. However, water resources. This factor combina- poverty remains deep and severe by tion suggests that the State would have any standard. An important question a comparative advantage in labor- addressed here is whether a different intensive light industries and agroindus- set of policies could have led to growth tries, irrigated higher-value agriculture, with the generation of more employment and tourism. At the same time, devel- and absorption of more of the large pool opment remains constrained by: (a) low of remaining poor or whether there sim- productivity and education levels; (b) a ply is so much poverty that more time large share of the population located in Cear6 State Economic Memorandum Page 47 Table 18: Growth and Poverty Reduction Scnearios Actual 6% Real GNP Growth 3% Real GNP Growth 1996 10 Years 20 Years 10 Years 20 Years Per Capita GNP R$1,707 R$2,559 RS4,012 R$1,969 R$2,308 Poverty Rate 49% 33% 21% 43% 37% Total Population 6.8 million 7.7 million 8.9 million 7.7 million 8.9 million Total Poor 3.4 million 2.6 million 1.9 million 3.3 million 3.3 million the backward and stagnant Sertco, reduction, investments in human capital where limited access to water is a major and physical assets of the poor are criti- limitation; (c) the overall high cost of cal. Finally, and within the limits posed doing business in Brazil (Custo Brasil); to the actions that can be taken by a and (d) very limited fiscal headroom. single State, a tightened and well tar- geted social safety can help further re- 93. Overall, manufacturing, particularly duce the number of poor at a moderate light manufacturing (for example, shoes, cost. apparel, and agro-industry) is expected to continue its expansion in an increas- 95. To illustrate the impact of different ingly competitive economic environ- growth scenarios on poverty, Table 18 ment. In addition, a major role seems summarizes the results of a simple destined for tourism in leading Cear's simulation of growth and subsequent growth. Agriculture holds some promise reduction of poverty over the next 10 for growth in high value products and and 20 years based on a constant provides inputs to important growth population growth rate of 1.4%*23 if sectors. However, agriculture by itself is Cear§'s economy grew by 6% per year, unlikely to play a key role in the State's somewhat higher than the 4.9% of the economic expansion. There is promise 1990-96 period, poverty rates would fall for a stronger external orientation of the quite rapidly from 49% to 33% and 21% economy in the future. in 10 and 20 years respectively. The 21% poverty rate is slightly below the 94. The key contribution toward poverty level of poverty in all of Brazil today. The reduction in Cear6 has to be labor- absolute number of poor would also fall intensive broad-based growth. Industrial significantly in this scenario. The real growth will continue to make an impor- possibility of such a drastic poverty re- tant contribution to overall growth. In- duction through growth is underlined by dustrial growth alone, however, will only the experience of East Asian countries lead to the absorption of a relatively lim- over the last 20 years or Chile, which ited number of poor, compared to the achieved a reduction of the number of scale of the remaining poverty in Ceart. poor by 40 to 60% between 1987 and Even the removal of distortions against 1994 alone. If growth in CearA plum- labor-intensive growth is not likely to meted to 3%, the countrywide rate of the change the fact that industrial growth 1990-96 period, poverty rates would fall alone will only absorb a relatively limited to only 43% and 37% after 10 and 20 number of poor. A strategy that equally years respectively. The absolute num- encourages growth in industry, services, ber of poor would remain virtually un- such as tourism, and agriculture, is more likely to have larger poverty- reducing effects. In order to enable the 23The poverty estimates in this simulation are poor to benefit from the economic op- based on a growth elasticity of the poverty rate of portunities arising from growth and in- -1, a value in the middle of the range of reason- crease the effect of growth on poverty able estimates of this elasticity in recent studies for Brazil. Page 48 Cearc State Economic Memorandum changed, making such growth perform- projects or market-based land reform) ance unacceptable. increase labor productivity and incomes and reduce migration pressures. Physi- 96. A rural development strategy should cal investments can be efficient even aim at the efficient growth of a competi- though they do not contribute signifi- tive and flexible farming sector (not nec- cantly to growth of the overall economy essarily very fast growth induced by because of their small scale. subsidies) and at rural areas attractive for non-farm activities and employment. 98. Overall, a substantial reduction of There is a small and growing dynamic labor in agriculture in the semi-arid ar- modern agricultural sector, producing eas seems inevitable and even desir- fruits and other higher value products on able, considering the high incidence of irrigated lands. Production under irriga- poverty, the very large absolute number tion is generally capital-intensive, and of very small farms, and the relatively subject to high price variability. Produc- low agricultural growth potential in non- tion of fruit and other goods for exports irrigated areas. This reduction in agri- can be profitable but risky. The agricul- cultural labor will occur through migra- tural sector requires constant reorienta- tion and absorption into urban areas and tion towards new products and different other sectors of the economy. More varieties, and thus depends on well- training and educational opportunities developed, flexible factor markets (land, for the rural poor appear to be the most water, labor, finance, and technology) to critical policy variable for the reduction facilitate adjustment in irrigated areas. of rural poverty. Education allows the Policies have to be directed at improving rural poor to compete for the higher the flexibility of these factor markets. paying jobs in the growing sectors of the While significant potential certainly ex- economy, either in commercial agricul- ists, this modern farming sector is still ture or outside of rural areas, and raises too small to adequately gauge its future the productivity of those who stay. Fi- role in CearA's economy. Growth in nally, there is a group of rural poor that modern commercial agriculture in suit- will not be able to benefit from opportu- able irrigated areas can provide sub- nities in commercial agriculture, from stantial seasonal employment for a sub- small-scale intensification, or from mi- set of current small farmers. The irri- gration. Members of this group are typi- gated areas also promise new opportu- cally older, often widows as heads of nities for part-time farming and rural households, and farmers in poorly en- non-farm employment. dowed areas. This group is trapped in extreme poverty with no viable future in 97. The traditional agricultural areas (in agriculture and is faced with consider- particular the Serto) will not be the able barriers to finding off-farm employ- source of significant growth of the ment. For this group, a social safety net State's economy. However, a policy of is critical to assuring a basic decent liv- abandoning these areas would be a ing standard. mistake. First, the large numbers of of- ten very poorly educated people living in Policy Options and Choies these areas have little medium-term prospects in other sectors of the econ- 99. The key question is how Cearis omy. Second, productive investments Government can use a resharpened mix can significantly improve the living con- of the policy instruments available at the ditions of the population in these areas. state level to sustain superior growth Physical investments and services for (6% per year) over the next decade and poor farmers (for example, through the accelerate the reduction of poverty. The intensification of small-scale irrigation previous assessment suggests that Cear6 State Economic Memorandum Page 49 nothing is fundamentally wrong with cur- tion and productive infrastructure such rent State policies and no radical rever- as roads, ports, electricity, and water sal in strategy is indicated. However, resources. There is strong justification some significant adjustments, the re- for such a strategy in the findings of this moval of remaining distortions, and a report, in particular regarding the ex- rebalancing of the policy mix can bring pansion of education. The major and about significant improvements in the very important problem with this strategy policy outcome, in particular with re- is its fiscal implication. A critical element spect to poverty reduction. The hypo- of Cear6s success has been its reputa- thetical options for rebalancing the pol- tion for fiscal and administrative sound- icy mix are presented in the following ness. Given the limited headroom for paragraphs in the form of stylized sce- public investment, not even considering narios. the pension risks, a massive expansion of public investment would undermine 100. One hypothetical option is to this critical success factor. The funda- strengthen the already existing focus of mental difference between Cear4 and the State on an industrial strategy. This several East Asian countries, which could include a deepened effort to at- have successfully pursued such a public tract industry, including heavy industry investment strategy, is precisely the fis- such as metals and petrochemicals, cal situation. through both fiscal incentives and lob- bying. Such an industrial strategy might 102. A third hypothetical alternative be able to achieve some successes in would be an explicit welfare strategy. terms of industrial location choices. This strategy would be based on the be- However, this strategy has two main lief that the fruits of past growth in Cearc shortcomings. First, this strategy would need to be distributed to the poor more divert fiscal resources and State man- rapidly and would emphasize the crea- agement attention away from growth tion of a tighter social safety net and im- opportunities in other sectors for which proved services and access to assets CearA has an obvious comparative ad- for the poor at the expense of growth vantage, including agroindustry, high oriented policies. Again, the main risk of value agriculture, and tourism. More im- such a strategy is its fiscal implications. portantly, such an industrial strategy Cear6 simply does not have the fiscal would neglect rural development and is room for significant increases in public unlikely to lead to the massive absorp- spending without either compromising tion of labor that is needed to advance its reputation for fiscal soundness or rapidly with the reduction of poverty. An sacrificing spending in areas as impor- industry-only strategy is likely to cement tant as education and infrastructure. or even worsen income inequalities in Moreover, the main problem of social the State. A limitation to or excessive spending in Brazil is its low quality in focus on industrial development would terms of efficiency as well as targeting. lead to performance below potential. This means that efforts to improve the Nevertheless, the dismissal of this strat- quality of spending are likely to be more egy in no way implies that the State effective for improving social outcomes should not continue to welcome invest- than an outright expansion of social ments in industry. spending. 101. A hypothetical alternative to an 103. The problems of the above dis- industrial strategy would be to focus cussed industry, public investment, and further on the emerging public invest- welfare strategies emphasize the diffi- ment strategy, highlighting principally cult fiscal trade-offs the State is facing. investments and expansions in educa- These trade-offs involve balancing the Page 50 Ceari State Economic Memorandum need for additional spending that is from the steering of the economy likely to enhance growth performance, toward certain sectors, an ap- such as investments in education and proach that is likely to fail, and a infrastructure, with fiscal stability and move toward more sectorally- reputation. The trade-offs also involve neutral growth policies encom- balancing short-term social improve- passing rural development, ments through a better social safety net tourism, as well as industry and and services for the poor with more other sectors. sustainable long-term improvements through better education and higher (e) Further reforms toward efficient growth. and fiscally sustainable water re- source management through 104. Facing the fiscal trade-offs, the cost recovery and development key for better performance is a strategy of water markets focused on the quality of public spend- ing in terms of higher spending effi- (f) A continuing emphasis on fiscal ciency, poverty targeting of social stability including the proactive spending, and concentration of spend- management of the pension risk ing on policy priorities. The quality-of- and a thorough public expendi- spending strategy is the policy option ture review. proposed by this report. This strategy is difficult precisely because it is com- (g) Continuation of and further im- posed of a multitude of tedious smaller provements in the provision of tasks, but overall, this strategy appears services and assets to the poor, most adequate in the current situation. building on successful models of The quality-of-spending strategy in- active community participation. cludes the following elements, each of which is discussed in more detail in the (h) Measures to strengthen the so- subsequent sections: cial safety net. (a) A stronger focus on the provision Investing in Education and Infrastruc- of services with positive exter- ture nalities, in particular education (refocusing public funding on this 105. The provision of goods with area), and infrastructure (mostly strong positive externalities, in particular through the mobilization of pri- education and infrastructure, needs to vate financing). lie at the heart of the State Govern- (b) Public-private partnerships in thethis identification and removal of re- educatonifor rolao isre- maining distortions, development edctofrCa4 pputinsr- of markets, and improved com- peatedly highlighted. Ultimately, the de- petitiveness n imroved corn- velopm ent prospects of the State are petiiveessin ectrs n wich tied to its human resource base. The Cearg has a comparative ad- absence of higher education levels is vantage. already a binding constraint in tourism (c) A stronger effort to attract inter-technical and supervisory (castronger inefotmet atac iente staff levels of industry and modern agri- nationalinest culture. With the continuing opening of export markets.the Brazilian economy, better education (d)outcomes are going to be of critical im- (d)al A nreduce t emhisnidus- portance at all levels if Cear wants to attain international codpetitiveness. Cear6 State Economic Memorandum Page 51 106. While the number of school va- (b) A strong focus should be given to cancies in Cear6 is now roughly suffi- primary education and basic literacy cient to meet the demand for primary for adults in rural areas. Local schooling, problems of high repetition teachers could act as 'agents', initi- rates, school evasion, the quality of ating a drive of teacher training, to teachers and teaching, low student raise the quality and attractiveness achievement, and the spatial distribution of schooling. This adult education of schools remain serious. Additional should have implications both for problems that need to be addressed are the effectiveness of the absorption low quality and low enrollment at the of new agricultural technologies and preschool and secondary levels, as well for the scale of off-farm employment as weak coordination of the actions at in rural areas. the state and municipal level. Further reforms in the education sector should (c) There is increasing recognition of address remaining weaknesses on the the critical role of early childhood supply side but also create incentives education for future student for higher schooling demand from fami- achievements. Current coverage lies with children in the workforce. and quality is low, and increasing efforts in this area can be expected 107. The State should make every to have a very high payoff. effort to increase the efficiency of edu- cational spending and focus spending (d) The State should continue to up- on those specific areas that yield the grade secondary schools, and ex- highest return in terms of educational pand teacher-training initiatives to outcomes and achievements. However, provide the level of general knowl- once all potential efficiency gains have edge and teaching skills required been captured, the State will likely have for the effective functioning of sec- to concentrate a larger share of its ondary schools. The demand for spending in the area of education. Pol- better post-primary schooling is icy recommendations include the fol- driven by the perceived pre- lowing :24 requisites for the higher-quality jobs in manufacturing and parts of the (a) As primary enrollment rates have service sector, such as the growing increased, further efforts are now tourism industry. Secondary school needed to enhance the quality of curricula should be adjusted to primary education and reduce drop- meet labor market demands. out rates, repetition, and age-grade distortion. These efforts include (e) The parallel operation of state and training for and selection of teach- municipal school systems without ers, the promotion of school based sufficient coordination leads to inef- development strategies, increased ficiencies and inequalities. Current school autonomy, and increased in- efforts for coordination should be volvement of the entire community strengthened. Institutional support in school development as well as for the organization and manage- the installation of acceleration ment of municipal systems is criti- classes, cal. (f) On the demand side, the State 24 A more comprehensive view on recommended could consider the adoption of a reforms of the education system of the Northeast program that would transfer a small overall can be found in World Bank, 1997, Brazil:f A Call for Action, Combating School Failure in the c s f Northeast, Report No. 18358-BR. wage per month) to families below a Page 52 Ceari State Economic Memorandum certain income threshold (such as centrate on improving the quality of life one-quarter minimum wage per in Cear6's main urban centers. capita), conditional on their chil- dren's school enrollment and atten- 110. Ceari is already heavily invest- dance (Bolsa Escola). Good tar- ing in its infrastructure. A recent World geting and enforcement mecha- Bank study on the Northeast of Brazil nisms would be critical in this pro- confirms the importance of comple- gram. While rigorous evaluation of mentary public investment in infrastruc- similar programs elsewhere has ture in order to crowd-in private invest- been limited, indications are that ment. Important bottlenecks persist or these programs are successful in are presently emerging in services such providing a safety net to families in as water, sewerage, and energy for severe hardship, while at the same tourism. These bottlenecks should be time reducing school evasion and carefully reviewed in light of the growth repetition rates among their chil- patterns discussed in this report in order dren. to produce a list of infrastructure in- vestment priorities. At the same time, 108. One issue regarding the effect of Government capacity for financing infra- education on growth is that better edu- structure requirements is heavily con- cation for Cear4's population is likely to strained. Therefore, much of the effort induce some out-migration. Some of the will have to involve private sector par- education provided by the State will thus ticipation in the provision of services. benefit current residents of Cear6 who Efforts in this direction have included the leave the State to make use of opportu- sale of the State electrical company. nities elsewhere. In terms of the welfare Additional private sector participation of the current population of Cear6, this should be sought in sectors such as out-migration is positive. However, the highways, ports, water and sanitation, externalities associated with the educa- and water resources. tion of such migrants would not accrue within the State. This partial leakage 111. Effective private sector participa- suggests a possibly stronger federal role tion in infrastructure provision depends in the financing of education; however, it on an effective regulatory framework. does not undermine the basic argument This framework must balance the need in favor of a top state priority in the edu- to assure adequate financial returns to cational sector. investors with the need to ensure ade- quate service provision and protection 109. Another important question is the for consumers. A transparent regulatory most efficient way of removing skill bot- process and an independent regulatory tlenecks. Currently, investment, growth, agency have shown to be important in- and employment generation in key sec- gredients to such a framework. Cear6 tors are hindered by lack of qualified la- has recently created a regulatory entity bor. While expanded education and for power, transport, and telecommuni- training will address this constraint in the cations that must now build a reputation medium term, the in-migration of indi- for effective regulation. viduals with critical skills from other parts of the country can alleviate the bottleneck in the short term. This in- migration requires that Ceari, and For- taleza present themselves as attractive places to live for individuals with bottle- 25 World Bank, 1998, Public Expenditures for neck skills. The focus on in-migration Poverty Alleviation in Northeast Brazil, Report implies that public policy should con- No. 18700-BR. Cear6 State Economic Memorandum Page 53 Improving Markets and Developing dures could significantly reduce the cost the Private Sector of business as it applies in Cear.26 112. One main obstacle to raising re- 114. Recent literature emphasizes turns to labor and human capital in Bra- that simply freeing markets and remov- zil and Cear6 is the high burden of pay- ing distortions does not necessarily lead roll taxes and the rigidities created by to the dynamic industrial learning proc- labor regulation. Labor market regula- esses that bring about sustained growth tions matter a great deal, in particular to and competitiveness. This view sug- the rural economy. Agricultural employ- gests that government, in partnership ment can be very sensitive to labor con- with the private sector, can play a critical tract legislation that does not permit the facilitating role in the promotion of busi- flexibility of tailoring contracts to the ness clusters. These clusters bring to- characteristics of the firm and the avail- gether a critical mass of related firms able labor in a given season and local- and business activities in a way that fa- ity. Agriculture is constantly confronted cilitates growth of a particular sector and with considerable instability in produc- encourages dynamic improvements in tion and prices and sharp fluctuations in productivity. Cear; and other North- labor demand. Moreover, it is a sector eastern states are currently engaged in characterized by high monitoring costs a process in which governments, out- and highly seasonal patterns of work, side consultants, and the private sector generally under very heterogeneous are jointly identifying and developing conditions, even within the same geo- cluster based opportunities. In Ceari, graphic region. While labor regulation is the focus lies on the development of often not effective in the traditional agri- clusters in tourism, fruits, and the soft- cultural sector, there is evidence that ware industry. It would be unwise for the rigid labor regulation, especially with re- State to exclusively rely on a cluster- spect to seasonal labor, reduces com- based growth strategy. However, the mercial agricultural employment. This approach and its specific applications to issue requires further review and sub- Cearg hold considerable promise and sequent action, principally at the na- should be actively pursued (see Box 3). tional level. 115. Beyond the specific cluster ini- 113. Many small bureaucratic barriers tiative, the State should adopt a greater and market distortions still exist at all emphasis on strengthening public- levels of government. The high fixed private sector partnership arrangements costs of meeting bureaucratic require- and attracting new investments, taking ments for export licenses or other op- greater advantage of private sector or- erational permits are heavier for small- ganizations. As an example for a secto- scale, often informal enterprises than for ral strategy, efforts led by the State larger companies, placing the former at Government at its highest level should a disadvantage and stifling entrepre- go into the development of an integrated neurship. These barriers and distortions state-level strategy for tourism devel- tend to bias economic activities against opment. This state strategy should in- exports and in favor of capital intensity. dude strong private sector participation. These distortions reduce labor demand To proceed with the formulation of such and the returns on the main assets of the poor. Private-public collaboration in 26 See also: World Bank, 1996, The Custo Brasi the identification of these barriers and Since 1990-92, Report No. 15663-BR. distortions, and the Government's will- 27 See, for example, Sanjaya Lail, 1998, Exports ingness to simplify bureaucratic proce- of Manufactures by Developing Countries, Oxford Review of Economic Policy, Vol. 14, No.2. Page 54 Ceari State Economic Memorandum Box 3: Cluster Based Growth Strategies Cluster initiatives focus on improving the interlinkages within and between networks of firms and their supporting institutions. Clusters can increase the productivity of an industry when they cap- ture local externalities of the geographical or sectoral agglomeration of firms. It is the high degree of specialization among suppliers, the extensive interlinkages between firms, and increased col- laboration between the public and private sectors that distinguish and enhance the efficiency of a cluster. The cluster creates a competitive yet cooperative structure in which specialization and information-sharing among supplier networks leads to increased levels of trust, more effective collective action, and ultimately, higher productivity than most individual firms can attain alone. Classic examples of clusters that have evolved without specific intervention are the computer in- dustry in Silicon Valley or Italy's shoe industry. More recently, cluster initiatives have been ac- tively pursued in Arizona, Mexico, New Zealand, South Africa, and El Salvador. In the case of Cearb, the cluster initiative for tourism is focusing on issues like the mobilization of the sector to develop a joint marketing strategy, the development of an action plan for training and human resource development for the sector, the sensitization of financiers to the special characteristics of the sector, and the facilitation of access to financing for sector firms. The joint public-private process is expected to lead to improved private input into economic policy making and public investment decisions. Similar activities comprise the cluster initiatives for fruit and software. Source: World Bank, Informal Note, 1999, Cluster-Based Growth Strategies: Lessons from initiatives Around the World a strategy, a special commission should petuate distortions that should have be formed with technical support in- been removed in the first place. volving international as well as national expertise. The private-public partnership 117. The State could also take a more approach requires that the private sector active role in private sector promotion. move away from bilateral relations be- Currently, there is no separate office or tween individual firms and Government unit that deals with investment promo- toward articulation through industry as- tion. Indeed, the emphasis of current sociations or other collective represen- efforts is on the negotiation of incentives tations. with individual firms from the industrial sector only. Little organized effort is 116. Private-public partnerships can given to actually marketing the State's play a critical role in the definition of de- rather attractive investment environment velopment and sectoral strategies and in and seeking out potential investors. To the identification and removal of bottle- the extent that there are concerted ef- necks for private sector development. forts to attract new ventures and in- The objective of these initiatives should vestment, those efforts have been con- be the facilitation of private-sector-led centrated on the country's Southeast growth and the coordination of private and South. Little has been done to at- sector investment with public sector in- tract foreign direct investment. As a re- frastructure provision. In this context, sult, of all the firms establishing produc- the State should stay away from the tive facilities in Ceark there is not one temptation to use such initiatives to reported case of a foreign firm estab- merely reorient fiscal incentive pro- lishing its first operations in Brazil in grams, public credit lines, and other Cear6. distortionary instruments toward specific sectors or initiatives. If the State capitu- 118. A reorganization of the Eco- lated to these temptations, it would per- nomic Development Secretariat could CearA State Economic Memorandum Page 55 Box 4: Regional Investment Incentives Regional investment incentives have been the main policy tool used in countries actively pursuing a more even pattern of regional development. They are being used in Western Europe but also in China, Ghana, India, South Korea, and Thailand. The use of investment incentives is highly con- troversial, in particular, as the subsidization of capital can create pressures toward inefficiently high capital intensity. The main conclusions from the empirical literature on the effect of invest- ment incentives are: * Regional investment incentives encourage investment, employment, and output with the expected bias toward increased capital intensity. * Incentives do not have a permanent effect unless maintained indefinitely. * Investment incentives generate more jobs if they are directed at smaller firms. * The cost effectiveness of investment incentives is inconclusive. A recent study in Can- ada found that the cost of incentives amounted to twice the wage-bill of the jobs cre- ated. Other studies have found more favorable results. Source: Peter Fallon, 1998, World Bank Policy Note, "Regional Investment Incentives" permit greater professionalization of the ence over policy outcomes at the federal investment promotion function, including level: a separation of investment promotion from any negotiation of the incentives. (a) In the area of trade policies, Cear6 The investment promotion office should is the major state affected by exist- seek outside professional advice and ing export restrictions for unproc- assistance in attracting foreign direct essed cashew nuts. There is evi- investment. A number of functions could dence of significant distortions and be contracted out to the private sector, damage to Cear6's economy in ag- including the preparation of promotion gregate caused by this restriction. materials. Investment promotion activi- Cear6's views would be presumably ties should not concentrate on industry important in having this export re- but should also include other activities, striction lifted. including tourism. (b) Potential Brazilian exporters are Strengtheningprecluded from selling their prod- Stregthnin Gloal inkgesucts internationally over the Inter- 119. Stronger international linkages net. The restrictions mostly involve through foreign investment and tradeto Central Bank thoudbgh fore investment and tae regulations. Changes to these poli- could bring more investment and thecisadrl,tomecoey incentives for modernization that typi- conforthse ti in clds- cally accompany international openness to Ceara. Most macroeconomic factors trial counties, would benefit Cearg's influencing trade are outside the realm Frstuseps in tdre hvel- of state policy making; however, these re bn take t he al factors are improving, in particular after level. the recent devaluation. There are some specific national policies that are nega- (c) Liberalization in the regulatory envi- tively influencing CearA's global link- ages. In these areas, the State's roumenoer asa shping woud ( ea anoh area of Cearl authrites an ossblyexecis inlu-intreate ad mpotncis restrico. Page 56 Cear6 State Economic Memorandum Box 5: Experience with Export Processing Zones Many successful exporting, labor-abundant economies have created Export Processing Zones (EPZs), which are frequently set up to overcome the constraints and obstacles in developing manufacturing that characterize many industrializing economies. EPZs provide several benefits: (1) access to infrastructure can be relatively easily provided; (2) obtaining intermediate inputs at international market prices is assured; (3) dealing with government authorities is facilitated; (4) externalities are generated through "clustering"; and (5) marketing obstacles are sometimes more easily overcome. In addition, EPZs provide confidence for competing in international markets, with the EPZs serving as a stepping stone to more vigorously contesting world markets and dem- onstrating the viability of export activity. In 1996, a total of 73 countries were operating more than 500 EPZs. -Design features differ bUt the main characteristics include exemption from import duties for export production and "one-stop shopping" for government permits. Successful EPZs can generate income and jobs, create an industrial infrastructure, build human capital, and serve as an engine of growth. However, the actual success of EPZs has differed. EPZs have performed well in countries such as Taiwan, Ko- rea, Mexico, Honduras, and Nicaragua. Conditions under which EPZs have performed well in- clude: * The existence of sound macroeconomic and realistic exchange rate policies. * The existence of strong backward linkages, which are more likely to be effective in ar- eas with an already solid industrial base. * Complementarity with other sound instruments for fostering growth. * Integration with an overall reform and liberalization program for which the EPZs serve as models. In cases where EPZs are set up with a large amount of public investment or require excessive investment incentives, they have been very costly and fared less well. Lessons from the experience include that there is no need for overly generous tax incentives, that utilities and other services should not be subsidized, that privately owned and managed EPZs should be encouraged, and that compliance with relevant labor, health, and environmental regu- lations should be ensured. Source: Dorsati Madani, World Bank, PREM Notes No. 11, 1998, "Export Processing Zones" The current legal and regulatory ternational investment promotion, con- environment, entailing enormous certed efforts with the private sector to levels of restriction on private sector reduce bureaucratic obstacles to private activity, has effectively resulted in sector activity, special drawback ar- the demise of Brazil's coastal ship- rangements, and bonded customs ping industry and has impeded the warehouses. development of a cruise line tourism industry. 121. The creation of an Export Proc- essing Zone (EPZ) was contemplated in 120. The completion of the new port the late 1980s but ultimately not pur- of Pec6m presents a critical opportunity sued. The issue remains controversial to increase the international integration today. With the trade liberalization that of Cear6's economy. The State should began in 1990, the advantages and im- consider complementary measures that portance of an EPZ has declined but not would increase the attraction of the port disappeared. Incorporating the changed to private investors, including active in- policy environment and the lessons for Cear6 State Economic Memorandum Page 57 the design of a successful EPZ (see Box than one firm in a given area and sector; 4), the State Government could take the (d) establishing a ceiling on the implicit initiative and reconsider the installation subsidy per job generated; and (e) pro- of a well-designed EPZ at the port of viding transactional assistance for small Pec6m to complement other trade- firms to benefit from the program. related policy instruments. A successful EPZ would help make the port venture a 124. Beyond these marginal changes very visible success. An EPZ could po- to the incentive system, the Government tentially give a new stimulus to industrial may want to consider more substantial development and at the same time help reforms, especially if a national reform the State advance to a level of interna- of the tax system opens the opportunity tional competitiveness that will be re- for a fundamental restructuring of tax quired for success in an increasingly incentives. One possible substitute for open national economy. There is no ICMS-related incentives would be a presumption that State budget funds system of incentives based on the pay- should be used in establishing, financ- roll taxes (the encargos sociais) paid by ing, or administering the EPZs or that employers. The State Government legislation protecting labor rights and the could, for example, offset a share of the environment would not apply in an EPZ. payroll taxes (collected mostly at the national level) for workers receiving up De-emphasizingto two times the minimum wage. This De-ephaszingIndstril Poicysubstitute system would apply uniformly 122. Fiscal incentive programs similar to old and new, large and small firms to the one offered by Ceara are in place and any sector, and would effectively in other Northeastern states. Even reduce currently high payroll taxes that though the economic benefits of these create incentives against the use of la- programs are very controversial (seea reformed program would Box 5) and their removal desirable, their al lor cntcts a oulze unilateral removal by one state may prove to be disadvantageous. Effec- nondiscriminatory, non-discretionary, tively, states find themselves in a typical and fully transparent. Aligned with the "prisoner's dilemma" situation, where all phase-out of the current ICMS incen- states might benefit from the collective tives, the new program could be cali- removal of the programs, but no state brated to be fiscally neutral. Additional alone has an incentive to do so. Priority should therefore be given to negotiating fiscal impact and the competitive effect the phase out of industrial incentives of such a change vis- -vis other states. with other states. 125. Overall, the greater the involve- 123. In view of the distortions gener- ment of public resources in attracting ated by the ICMS-based incentive sys- firms through ICMS-based incentives, tem, some revamping would appear to be desirable in the meantime. In a first sion of infrastructure services, the step, marginal modifications in the way greater should be the care exercised by in which the system is administered can the Government to assure that the sup- be envisaged to reduce some of the ported investments are viable on a sus- distortions. These changes could in- tamable basis and that there will be no clude: (a) substantially reducing the future drain on public resources. The scope for administrative discretion in the risk of nonviable investments is greatest awarding of the incentives; (b) simplify- where there is no apparent comparative ing the process of granting the incen- advantage for CearA, such as in heavy, tives; (c) granting incentives to more capital-intensive industry. Steel, petro- Page 58 Ceard State Economic Memorandum chemicals, and automobile manufactur- nance and operations cost is a generally ing are cases in point. In these exam- accepted principle. While Cear6 has ad- ples, there have been no inherent ad- vanced further than most other states in vantages for Cear6 based on the pres- Brazil, the cost recovery principle has ence of natural resources, the avalabil- not yet been fully implemented. Studies ity of a human resource base, unique show that significant improvements in market access, or other compelling fac- water use efficiency already occur with tors. While some countries have used the introduction of charges at the level subsidies and succeeded in creating of operation and maintenance costs. competitive industries where no com- There are important linkages between parative advantage was initially appar- cost recovery and water user autonomy. ent, many more have failed and wasted In Mexico (as in Chile and Australia), the large amounts of resources in the en- operation of irrigation districts has re- deavor. Moreover, whether the subsi- cently been turned over to farmers. One dies have contributed to these suc- of its consequences is that there has cesses remains controversial. For the been a dramatic increase in cost recov- State Government to actively promote ery, from about 30% to 80%. This expe- heavy industry and manufacturing ac- rience shows the importance of financial tivities is a risky and potentially expen- autonomy and accountability for cost sive strategy. recovery.28 Deepening the Reform of Water Re- 128. In principle, water charges source Management should also include the full capital cost soure Mnageentof water supply even though historically 126. Water is of critical importance to most countries have subsidized the the State, for domestic, industrial, and capital costs for irrigation water. The agricultural use. Since Cearc does not reasons for such subsidies are mainly have interstate rivers, the management political, since most of the arguments of water resources falls squarely within made against capital cost recovery, for the responsibility of the State. Cear6 example with reference to externalities thaecnlgiecosdrbeepa and public good characteristics of water, has recently given considerable empha- sis to the development of an appropriate only apply under very narrow circum- institutional framework that encom- stances. In practice, capital cost passes water resource management at charges for existing users need to be the river basin level, cost recovery, and phased in very carefully and gradually to the development of water markets. With avoid negative distributional conse- its reforms, Cear6 has become a na- quences or political backlash. For new tional, and in some respects interna- projects and new water users, however, tional, leader. Given the importance of charges should include full capital costs water resources to Cear, the State unless subsidies are justified for specifi- stands to gain greatly from the consis- cally identified externalities or market tent, speedy, and forceful implementa- failures. tion of reforms in this area. 129. The final step toward water use 127. The first element of the reforms efficiency is the creation of tradable is the creation of an appropriate legal water rights and water markets. These framework for management of water re- instruments, if well designed and well sources through water-user associations implemented make water users face at the river basin level. The second ele- ment is the implementation of a water 28 See John Briscoe, 1997, "Managing Water as pricing policy more consistent with cost an Economic Good: Rules for Reformers", in recovery. Full cost recovery of mainte- Water Supply, 15(4): 153-172. Cearg State Economic Memorandum Page 59 the opportunity cost of the water they ernization that will bring about improve- are using without punishing current low- ments in water use efficiency and allo- value water users. Secure water rights cation needs to be complemented by are separate from land ownership and investments to increase the reliability of can be legally traded under the guide- supplies and capture economic gains lines established by the legal, regula- from the connection between different tory, and institutional framework. The river basins. Any public investments development of water markets is an im- should be subject to rigorous ex-ante portant objective but requires time, the economic analysis, including analysis to build-up of institutional capacity and demonstrate that the proposed invest- credibility, infrastructure investments, ment would be viable even after the fu- and cultural change. The State should ture introduction of water markets. In- continue to build the conditions that will creasing cost recovery will allow an support water markets. The experience greater share of such investments to be with tradable water rights in Chile, Mex- financed from charges. In addition, the ico, and in some regions of Colorado establishment of water markets can cre- (USA) illustrates the many challenges ate the necessary incentives for private posed to water market development but financing of water resource investments. also shows that this can be a viable and effective approach to water allocation. 132. For economic viability, large- scale irrigation schemes typically require 130. Once fully functional, water mar- the production and professional cor- kets will help address the major effi- mercialization of high-value crops, in ciency issue in the allocation of water particular fruits and vegetables. High resources in Cear, as elsewhere: The value products such as fruits, flowers, largest share of water resources is cur- and other products under irrigation rently used in agriculture where returns (partly for export) seem to be economi- are often less than the cost of develop- cally promising. However, these prod- ing additional water supply sources. At ucts are usually capital-intensive and the same time, there is increasing de- subject to high price variability, often mand for water in municipal and indus- requiring constant adjustments in pro- trial uses where benefits typically far ex- duction and fairly sophisticated market- ceed the costs. In this case, efficiency ing. These high value products face a would require that instead of investing in high price risk on capital-intensive ac- additional supplies, the State should re- tivities. To be financially viable, these allocate water from agriculture to mu- projects need to be operated on a com- nicipal and industrial use. Voluntary mercial basis. transactions in functioning water mar- kets would bring about this reallocation 133. An earlier federal policy of allo- of water toward high value uses. The cating half of the irrigated area to small result would be a lower cost of water for farmers who are prohibited from selling municipal and industrial users and full their land has sometimes led to a vi- compensation for those farmers who cious circle of traditional farmers grow- voluntarily sell their water rights. ing low-value crops on expensive irri- gated lands and subsidies on water in 131. During the potentially lengthy order to protect the income of these transition toward the development of farmers.. Such policies and their coun- water markets, inefficiencies in the allo- ter-effects should be avoided through cation of water are likely to remain. the careful selection of beneficiaries ca- These inefficiencies should not stop all pable of adopting the required technolo- investments where additional water gies for high-value production on irri- supply is needed. The institutional mod- gated lands. Appropriate suppoit Page 60 Cear6 State Economic Memorandum should also be offered to smaller farm- sion fund, which would be capitalized ers so that they can undertake commer- with R$ 400 million from the proceeds of cially viable activities. The main contri- the sale of COELCE. New employees bution of irrigation projects to poverty would also be required to contribute to reduction will likely occur through sea- the fund. Judging from rough calcula- sonal and permanent employment and tions, the relief that could be expected through the creation packing and proc- from such a fund is limited. If the fund essing facilities. were able to generate a real return of 10%, this would be sufficient to pay only Maintaining Good Governance and 20% of the State's retirement costs (in Minai aning 1997). These retirement costs are ax- Fiscal Balance pected to rise substantially in the future, 134. The simulations in the fiscal sec- further complicating Ceari's financial tion of this report show that the fiscal options. If the full pension deficit were headroom for the State's important in- paid from this fund, it would be entirely vestment program is disturbingly limited. depleted in only a few years. Moreover, Since public spending cannot be in- studies in Rio Grande do Sul suggest creased, it must become more effective that the level of payroll contributions re- through improvements in the quality of quired to fund retirement benefits for spending and through reallocations to- new employees may be as high as 50%. ward top priority areas. In terms of real- Additional measures are needed to locating spending, it is important to note contain future pension liabilities and that top priorities, such as basic educa- should be incorporated in the discussion tion and those infrastructure services regarding the pension fund:29 where private investment is not feasible, account for a very small share of total eSta suld r or stte spending. The resulting suggestion is that significant gains could be obtained pensions. from a better prioritization of spending. (b) Within existing legal constraints, the On the other hand, there are no obvious examples of hugely wasteful spending. Sttoshou ireesion Therefore, a thorough and detailed pub- con s re treuc ha lic expenditure review would be the thoe reny nt most appropriate instrument to deter- mine the areas from which spending (c) In addition, the State should support could be redirected toward top priorities. reforms to reduce statutory pen- In this context, the Government may sion-to-salary (replacement) ratios, want to consider the creation of a small introduce a minimum age at which but well-placed and technically qualified benefits commence for current unit to analyze, compare across sectors, workers, and end all special bane- and rank proposed public investment projects based on cost-benefit analysis fits adgete Stateuld and related methodologies. Such analy- tions in retirement benefits permit- sis would feed into the development of ted by the ongoing federal pension multi-year investment programs (Plano reforms. Plurianual) 135. The State is well aware of the risk of increasing pension costs and has commissioned a study of its pension li- abilities. To reduce its pension obliga- 29 See World Bank, Brazil: Critical Issues in So- tions, the State intends to create a pen- cial Security, June 2000, Report No. 19641-R. Cearc State Economic Memorandum Page 61 Providing Services and Assets for of various community associations and the Poor by representatives of the municipality. 136. In the area of health, Ceari has 138. With respect to urban areas and advanced, but major challenges remain urban services, the State should con- that are manifest in high infant mortality tinue and possibly expand its current and other health indicators. The State approach to jointly supporting municipal should further pursue the model of projects for housing and urban upgrad- community health agents and its im- ing with the beneficiaries of the project. proved linkages with the formal health In particular, the complete coverage with care system. Overall, and to the extent safe water and the extension of sewage this is within the powers of the State, services should have top priority. The spending should be further shifted to- delivery of urban services depends'criti- ward cost-effective basic health care cally on the capacity of municipalities. and ambulatory and preventive care, The State can play an important role especially in the areas of maternal and through institutional strengthening for child health. Emphasis should be given municipalities, support for municipal fi- to improved coordination of policies and nancial administration, and local land actions across the different levels of use management. The targeting of mi- government. Given the weak capacity of cro-credit schemes operated by many municipalities to assume the re- PROFITEC and by the Proger and Pro- sponsibilities of health care decentrali- Renda programs could be improved by zation, the State should help strengthen reducing financing amounts from the municipal capacity in the management current average of R$3,000. of health care systems and encourage the formation of municipal consortia, Strengthening the Social Safety Net health micro-regions, and integrated service provider networks. 139. Despite implementation prob- lems, the rural emergency employment 137. Overall, current State policies to program has been rather effective in capitalize and support poor farmers are buffering the effect of periodic droughts moving in the right direction; they should on rural incomes. However, each be maintained and possibly extended, drought requires renewed mobilization always ensuring the sharpest possible leading to significant start-up costs, de- focus on the poorest among the poor. lays, and inefficiencies. Also, substantial Government support services (exten- unemployment, underemployment and sion, technical assistance, marketing, inactivity ;n rural areas in non-drought and credit programs) should be strictly periods raise the need for further limited to small farms. The focus on ru- strengthened safety-nets. It would be ral poverty and land reform project im- desirable to integrate emergency em- plementation through community asso- ployment during droughts with a broader ciations should continue. The reliance employment guarantee program that on community organizations, however, would also provide basic protection in requires availability of technical and in- non-drought years. This program could stitutional support. This approach should combine features of the drought emer- be complemented by measures to in- gency employment programs, the rural crease transparency in the project se- poverty alleviation project (S5o Jos6), lection process. In the Projeto Sio Jos6, and employment guarantee programs in progress in this direction has been other countries. The program would achieved through the approval and pri- guarantee a very low wage (for example oritization of subprojects through mu- half a minimum salary) for full-time work nicipal councils composed by members in any community-sponsored program. Page 62 Cear6 State Economic Memorandum The low salary would serve as a self- needs to be considered in program de- selection device, ensuring that the pro- sign, for example through minimum gram would only be used in times of residency requirements and limits to the need and by the people in need. generosity of benefit levels. At the same time, the long-term persistence of great 140. The federal LOAS benefits, as regional income differences and differ- well as the Seguro-Desemprego for ences in social services within Brazil formal sector workers, provide some demonstrates that there are significant protection against income shocks. How- barriers to migration that permit the in- ever, given the importance of informal stallation of some safety net programs employment, informal self-employment, at the sub-national level without the in- and inactivity vis-A-vis formal employ- ducement of mass-migration. It remains ment, the existing safety net coverage important to recognize the limits to the for the informal sector is clearly inade- actions that a state can take alone in quate. Such safety net coverage could this area. be improved through Bolsa-Escola pro- grams that would provide needed funds to families at the very bottom of the in- 6. Summary Matrix of Policy come distribution while offering the Recommendations means and incentives for better child education. 142. The following matrix includes the main areas of Ceard's development 141. Generous state level, social strategy where adjustments are sug- safety-net programs could theoretically gested in this report. The matrix summa- induce immigration from neighboring rizes current policies and performance states, making such safety-net pro- as well as the actual recommendations grams fiscally unsustainable. This risk for policy adjustments. Area Current Policies, Strategies and Policies Performance, and Obstacles Labor Intensive Growth_____ __ Education Policies Moderate policy tEducation policy and Human Re- emphasis; impor- s Improve quality of primary schools source Availability tant improvements and teachers to increase comple- have been tion rates and improve student achieved but edu- achievements cation levels are d Focus on basic education, vocational still low, and lack of training, and adult literacy in rural skilled workers is a areas bottleneck 9 Increase and improve preschool edu- cation m Increase and improve secondary education s Improve state and municipal coordi- nation A Balsa Escola Facilitation of in-migration of bottleneck s aeskills to Cear CearA State Economic Memorandum Page 63 Area Current Policies, Strategies and Policies Performance, and Obstacles Infrastructure In- Significant policy 0 Determine infrastructure investment vestments emphasis; bottle- priorities based on the expected growth necks remain or patterns (for example in tourism) are presently * Encourage broader private sector par- emerging ticipation in infrastructure investments (in ports, highways, water and sanita- tion, and water resources) * Strengthen regulatory framework and build reputation for effective, independ- ent regulation Removal of distor- Limited but now 0 Support federal reforms for lower pay- tions, creation of emerging policy roll taxes and more flexible labor regu- markets, public- emphasis; distor- lation, in particular for rural employment private partnerships tions are not very 0 Identify and remove remaining bureau- bad by international cratic barriers and distortions (Custo standards but a Brasi) through public private collabora- significant agenda tion for reform remains * Actively pursue the development of the currently developing clusters in tourism, fruit, and software, in partnership with the private sector c Develop sectoral growth strategies jointly with the private sector while staying away from the use of distortion- ary policy instruments to promote spe- cific industries or activities * Intensify and professionalize state in- vestment promotion, separate from the granting of fiscal incentives and not limited to industry or domestic firms External linkages Limited emphasis, 0 Influence national policies to reduce and few trade link- barriers to increased global linkages in ages; macrofactors the area of cashew trade, internet determined by fed- trade, and coastal shipping eral policies; some 9 Consider policies to attract export- State measures oriented investments, including the possible to improve possibility of installing (preferably with- microfactors* out committing public expenditures) an Export Processing Zone in the port of Pec6m Industrial policy Significant empha- t Pursue negotiations with other states to sis of past and cur- remove industrial incentive programs rent policies have 0 Undertake immediate adjustments to produced invest- industrial incentives to be more neutral ments but also in- with respect to sector and location and troduced distortions more directed at labor-intensive proj- ects Page 64 Cear6 State Economic Memorandum Area Current Policies, Strategies and Policies Performance, and Obstacles * Consider broader reforms to reduce payroll taxes across the state instead of targeted ICMS exemptions * Avoid fiscal incentives in industry sec- tors with no apparent comparative ad- vantage Deepening of re- Cear6 has as- 0 Rapid implementation of the new insti- forms of water re- sumed national tutional framework source manage- leadership and can 9 River basin level water user associa- ment obtain further gains tions by rapid imple- 9 Full cost recovery mentation of re- e Water market development forms R Investments in reliable supplies * Encourage private investments through water market development * Require rigorous ex-ante economic analysis Governance Significant empha- * Fiscal Balance: See Below sis of past and cur- * Support for municipalities in decentrali- rent policies has zation process produced image of modernizing state Stable macroecon- Mostly federal poli- omy cies improving but risks are remaining Poverty Reduction Labor intensive See above * see above growth Human capital in- See above * see above vestments Physical assets Moderate emphasis * Health and services for the with innovative * Shift spending toward cost-effective poor (social in- policies; health in- basic care, ambulatory care, and vestments) dicators improved prevention, with a particular em- but still dismal phasis on women and child health * Improve the coordination between Federal Government, the State, and municipalities * Support municipalities' health care management capacity and encour- age municipal consortia, health mi- cro-regions, and integrated service provider networks * Rural Poverty Alleviation * Concentrate government support services (extension, technical as- sistance, and credit) on small farm- Ceari State Economic Memorandum Page 65 Area Current Policies, Strategies and Policies Performance, and Obstacles ers * Continue and expand Projeto Sio Jos6 and Reforma Agr6ria SolidAria but improve transparency of project selection and assure support for community associations. * Urban Services * Continue support of municipal hous- ing and urban upgrading prograns * Reduce size of average loans in mi- cro-credit programs * Support institutional capacity for management of urban problems at the municipal level Social safety net Moderate emphasis * Reduce number of people depending on the safety net by inducing growth and social investments (see above) * Strengthen safety net * Create a community based employ- ment guarantee scheme that would absorb drought emergency em- ployment programs * Introduce a Bolsa-Escola type pro- gram Fiscal Balance Fiscal Balance Overall sound fiscal * Undertake a comprehensive public situation but very sector expenditure review to identify limited headroom spending that can be reallocated to for investments high priority areas such as education Contingent Liabili- Serious fiscal risks * Take measures toward reducing future ties through pension pension liabilities: liabilities * Tighten eligibility qualifications for state pensions. * Introduce pension contributions by retirees. * Support consideration of reforms to reduce statutory pension-to-salary ratios, introduce age limits for benefits, and end all special bene- fits and regimes. * Take full advantage of any reductions in retirement benefits permitted by the ongoing federal pension re- forms. Quality of Spending Lack of focus on * Create a small technical office for pri- spending on priori- oritization of investment projects across ties sectors Page 66 Ceard State Economic Memorandum Annex A2: Brazil at a glance Latin Upper. POVERTY and SOCIAL America middle- Brazil & Carib. Income Developmentdlamond* 1998 Population. mid-vear (millions) 165.9 502 588 Life expectancy GNP Per capita (Attes method. US$) 4,570 3.940 4.860 GNP (Atas method. US$ billions) 758.0 1.978 2.862 Average annual growth, 1992-98 Population M%) 1.4 1,6 1.4 Labor force (% 1,7 2.3 2.0 GNP Gross per pn prmary Most recent estimate (latest year available, 1992-98) capita Anrollmant Poverty (% of oonulation below national ooverty lne) 17 . Urban population (% of total population) 80 75 77 Life expectancy at birth (years) 67 70 70 Infant mortality (oar 1,000 five biths) 34 32 27 Child malnutrition (% ofchilden under 5) 6 8 Access to safe water Access to safe water (% of population) 69 75 79 Illiteracy (1% of oopulation ae 15+) 16 13 11 Gross primary enrollment (% ofschool-ase poouldaton) 123 113 108 Brazil Male . . Upper-middle-income group Female -A KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1977 1987 1997 1998 - Economic ratios' GOP (USS billions) 178.2 294.1 8204 750.8 Gross domestic investment/GDP 22.1 22.3 21.3 21.2 Exports of goods and services/GOP 7.3 9.5 7.6 6.9 Trade Gross domestic saving-/GOP 21.4 25.6 18.6 18.8 Gross nationalsavlngs/GDP 19.7 21,8 16.9 16,6 Current accountbalance/GDP 2.9 -05 *4.1 -4.7 Interest payments/GDP 1.2 21 1.2 1.4 Domestic Investment Total debt/GDP 23.9 40.7 23.6 28.2 Savings Total debt service/exports 42.5 41.7 57.4 67,7 Present value of debt/GOP . ., 22.5 Present value of debtlexports . . 277.4 I. Indebtedness 1977-87 198-98 1997 1998 1999.03 (average annual growth) GDP 3.0 24 3.2 0.2 3.0 Brazil GNP per capita 0.5 0.5 1.9 -1.4 1.0 - Upper-middle-income group Exports of goods and services 10.1 4.8 1.1 0.2 6.2 STRUCTURE of the ECONOMY 1977 1987 1997 1998 Growth rates of output and Investment (%) (% of GOP) 12 Agriculture 14.7 10.0 8.1 8.6 Industry 38.6 45.t 35.2 37.5 Manufacturing 29.3 32.C 22.8 24.3 Services 46.7 44.1 56.7 53.9 0 - Private consumption 69.2 62.3 63.2 88.5 es 4 s General novemment consumption 9.4 12.2 18.1 12.7 Imports of goods and services 7.9 6.2 10.2 9.2 G GOP 1977-87 1988-98 1997 1998 Growth rates of exports and Imports (%) (average annual growth) Agriculture 3.5 2.5 1.9 0.5 40 Industry 2.7 1.8 5.5 0.5 Manufacturing 2.3 0.7 3.8 0.5 20 Services 3.2 2.6 3.5 1.2 Private consumption 3.6 5.3 2.4 -3.4 General oovemment consumption 4.0 -1.5 8.0 2.1 Gross domestic investment -1.3 2.1 6.2 0.1 o Imports of goods and services -2.6 13.4 13.9 8.9 - Exports -Imports Gross national product 2.7 2.0 3.3 0.0 Note: 1998 date are preliminary estimates. The diamonds show four key indicators In the country (In bold) compared with Its income-group average. If data are missing, the diamond will be incomplete. Cear6 State Economic Memorandum Page 67 Brazil PRICES and GOVERNMENT FINANCE 1977 1987 1997 1998 Inflation (%) Domestic prices ~0 (% change) Consumer prices .. 228.3 6.9 2.7 2.0oo Implicit GDP deflator 46.2 204.1 7.8 0.0 1,000 Government finance (% of GDP, includes current grants) 0 Current revenue ., 10.4 18.6 21.2 1,000 Current budget balance .. -1.4 -1.8 -4.6 " GDP deflator "O"CPI Overall surplus/deficit .. -2.8 -2.7 -5.7 TRADE (US$ millions) 1977 1987 1997 1998 Export and import levels (US$ milllions) Total exports (fob) .. 26,225 52,990 47,176 oaoo Coffee ,. 2,185 3,094 2,505 Soybeans .. 2,325 5,729 4,580 0,0o Manufactures .. 14,331 32,736 27,601 Total imports (cf) .. 15,053 61,354 53,012 ,0 'Ii- Food .. 500 3,290 2.961 k,l Fuel and energy .. 4,674 3,220 3,903 Capital goods .. 3,958 26,232 25,262 Export orice index (1995=100) .. 78 96 92 9 03 94 95 96 97 98 Imoortorice index (1995=100J .. 81 95 84 Exports 1imports Terms of trade (1995=100) .. 97 101 108 BALANCE of PAYMENTS (US$ millions) 1977 1987 1997 1998 Current account balance to GDP ratio (%) Exports of goods and services 13,003 28,073 56,831 55,479 7 Imports of goods and services 14,646 17,749 74,147 70,517 Resource balance -1,643 10,324 -17.316 -15,038 0 S92 93 94 Net income -3,469 -11,699 -18,331 -21,794 Net current transfers 4 -43 2,216 1,886 se Current account balance -5,108 -1,418 -33,430 -34,946 Financing items (net) 5,629 363 25,629 26,455 Changes in net reserves -521 1,055 7,801 8,491 Memo: Reserves includino nold (US$ millions) 7.256 6.420 51.729 43.366 Conversion rate (DEC. locaVUSS) 5.14E-12 1.43E-8 1.1 1.2 EXTERNAL DEBT and RESOURCE FLOWS 1977 1987 1997 1998 (US$ millions) Composition of total debt, 1998 (US$ millions) Total debt outstanding and disbursed 42,037 119,820 193,663 212,069 IBRD 1,371 9,384 5,743 6,298 5310 IDA 0 0 0 0 49229, . 5264 Total debt service 5,737 11,956 38,091 44,049 12644 IBRD 204 1,555 1,428 1,373 IDA 0 0 0 0 Composition of net resource flows Official grants 5 35 63 80 Official creditors 415 10 -1,820 -2,571 Private creditors 5,708 -690 19,890 -26,999 Foreign direct investment 1,833 1,225 19,652 23,737 Portfolio equity 0 78 5,300 -1,852 133324 World Bank program Commitments 319 1,394 1,104 1,291 A- IBRD E - Bilateral Disbursements 299 915 1,416 1,240 B- IDA D - Other multilateral F - Private Principal repayments 101 867 1,049 995 C - IMF G - Short-term Net flows 198 48 368 245 Interest payments 104 688 380 378 Net transfers 95 -641 -12 -133 Development Economics  -\ - >GUYAN4 - 40 39- VENEZUELA COLOMBIA A(pr, Oceon BRAZIt STATE OF CEARA E AMAZONAS PAR .i ,.,.. l ._ -BAHIA i,' I l 05 1 -I L N I I '-ei (.4----- T LE..- G OG E A N -J- L \7'- - / t1A '. i ~ C E AUA RANFL ÁNMLIMT \ \ - .r . -.. . --t. - _, . I -,E- J.-,- i NDO GRANDE DO NORTE -- » ~ '- *r--- il~6-- -7° IA a . J ''d. d g _..- - . -- -\..- Å~- -- -lillIUAL RAINEALL IN MILLIMETERS -i..: -ES .4 ~ ~-. 0't - tS AND TOWNS a . sæ ,. i .- ,._ li -- -- - - or acceptance ot such I N A-M - i C ' S bovndaries. 4T 40" 34oIue7ý~