Bailouts and Perverse Incentives in the Brazilian States

Brazil is the most decentralized country in the developing world. It has a long history of federalism and decentralization, and has become considerably more decentralized over the last two decades. By 1995, state and local governments together accounted for nearly 60 percent of public consumption (Ter-Minassian, 1997: 438). In comparison with other developing countries, the Brazilian states also raise a good deal of revenue themselves. In 1995, tax revenues collected by the subnational governments accounted for nearly 38 percent of total tax revenues (ibid.). Unfortunately Brazil has experienced few of the benefits of decentralization in recent years, and has been overwhelmed by some of its costs. Brazil’s recent experience with fiscal and political decentralization has posed serious challenges for macroeconomic management. Above all, Brazil has been forced to deal with one of the most serious and persistent subnational debt problems in the world. Brazil has experienced three major state-level debt crises between the late 1980s and the present, and unresolved debt problems in several key states threaten to precipitate further crises. In each of the crisis episodes thus far, the states-already facing precarious fiscal situations with high levels of spending on personnel and dangerous levels of borrowing-were pushed into debt servicing crises by unexpected exogenous shocks. In each case their first