Territorial Inequalities and Fiscal Federalism in Brazil: An Incomplete Path Toward Equalization

Abstract

Territorial socioeconomic inequalities are the main diversities to be accommodated in the Brazilian federation. They have been a major influence in the design of a transfer system that reduces intergovernmental inequalities in per capita revenue, especially in the case of municipalities in which the Gini coefficient from own revenue has been reduced by half (from 0.5 to 0.24). Grants are mandatory and regulated by the Constitution and laws that establish stable formula-based distribution criteria. Therefore, they assure a significant and steady amount of resources to subnational governments and are protected from short-term political bargaining. However, some important transfers do not have redistributive objectives and increase inequalities. Also, the equalization funds’ distribution criteria present inefficiencies that favor small states and municipalities regardless of their socioeconomic development level. We argue that this historical and political process produced a system that accommodates diverse fiscal capacities by significantly reducing inequalities arising from own revenues. However, its efficiency can be questioned. Moreover, since democratization, the few and marginal advances in this redistributive federative agenda highlight how difficult it is to articulate territorial interests in broad coalitions able to approve redistributive fiscal reforms.

Introduction

The concentration of industrial and financial economic activities in the South and Southeast, especially in São Paulo, in contrast to the underdevelopment of agriculture and extractivists activities in the Northeast and North, consolidated strong structural economic and social inequalities between Brazil’s regions¹ (Cano, 1977). Although there are ethnic and religious heterogeneities in Brazil, several studies highlight the importance of regional inequalities in the construction and evolution of federal institutions. Conflicts between poor and rich regions are identified as the main force that shaped the design of Brazilian political and fiscal institutions. (Arretche, 2010, 2012, 2013, 2020). These institutions, built to benefit poor regions’ states and municipalities, also intensified the division of interests between states’ representatives in the Congress regarding the fiscal structure and the distribution of transfers, which increased the obstacles to horizontal cooperation in fiscal matters (Prado, 2020). It is also argued that this diversity of interests between industrialized and rural regions and the history of domination of the central government by the rich and densely populated states, especially São Paulo and Minas Gerais (MG), influenced a constitutional deal that over-represented sparsely populated states (agricultural states of the periphery) in both legislative chambers. This institutional setting would have enabled the rich and big to coalesce with small and poor states in order to benefit them disproportionately and block more substantial inter-regional redistribution. Therefore, although the original federal pact created political institutions to protect small and peripheral jurisdictions, these are now (ab)used by the rich states to prevent further redistribution (Rodden, 2009). Some also affirm that states created² in the poor regions of the North and Midwest during the military regime (1964–1985) and in the following years, during the constitutional assembly (1987–1988), joined forces with the states in the Northeast to build and preserve a transfer system that involved the redistribution of revenues from rich to poor states (Diaz-Cayeros, 2006). Although there are differences in these arguments, they all share the common idea that territorial cleavages related to structural and economic inequalities have been a major driver of intergovernmental relations and have influenced the overall design of fiscal federalism in Brazil.

In the current chapter, we share this understanding and start from this premise that territorial socioeconomic inequalities are the main diversities to be accommodated in the Brazilian federation. One of the most promising ways to evaluate to what extent this is accomplished is to understand if the fiscal constitution contributes to ensure adequate financing to support similar levels of provision of public goods and services through all Brazilian territories, regardless of their level of income or development. Therefore, the rest of the text will focus on intergovernmental fiscal relations. Following this introduction, Sect. 1 will present a panorama of regional inequalities in Brazil to emphasize its relevance and dynamics over the last decades. Section 2 shows how regional and territorial elements were imprinted in the fiscal constitution to politically accommodate differences in revenue collection due to economic inequalities. The objective is to present in detail how regional imbalances effectively influenced the design of some of the most important sources of subnational governments financing. Section 3 investigates to what extent the transfer system helps to reduce intergovernmental revenue disparities. Findings indicate that although significant attempts and institutional devices were created to tackle inequalities, the pattern of territorial redistribution of revenues shows that demands for more significant reforms to improve equalization are necessary. However, the complex structure of interests resulting from the institutional legacy and the uneven development of regions in the last decades reduces the likelihood of successful redistribution coalition formation.

Territorial and Regional Inequalities: The Main Diversity of the Brazilian Federation

To provide a clear understanding of the relevance and magnitude of territorial and regional inequalities in Brazil, we start by presenting some historical data. The goal is to situate the state of inequalities at the time of the construction of the main features of Brazilian fiscal federalism and its evolution until recently. We try to show that the spatial configuration of disparities that influenced taxes and transfer design during the 1960s and 1980s has changed over time, and that this influenced a transformation in regional interests and reduced the likelihood of formation of successful inter-regional redistributive coalitions. First, Fig. 1 presents the current territorial configuration of Brazil: divided into 26 states and the capital, Distrito Federal. These states are grouped into five different regions: South, Southeast, Midwest, North, and Northeast.

Fig. 1

(Source Elaborated by the authors)

Map of Brazilian states grouped by regions

Socioeconomic inequalities have many dimensions but due to limitations of data availability and the focus on intergovernmental fiscal relations, in this introduction, we concentrate on income and the Human Development Index (HDI), which synthesizes income, education, and health indicators. Since there is a lack of socioeconomic data for the 1960s, we use the poverty and HDI indicators from 1970 to show the state of spatial inequalities when the tax reform of the mid 1960s implemented the main pillars of the current subnational fiscal structure. At the time, the states of the Southeast –especially São Paulo (SP) and Rio de Janeiro (RJ)—and the South, mainly Rio Grande do Sul (RS)—were clearly more developed than the rest of the country (Fig. 2).

Fig. 2

Map of percentage of poor and HDI for each state (1970) (Note Elaborated by the authors with data from IPEADATA. The states of Mato Grosso do Sul (MS), Amapá (AP), Rondônia (RO), Roraima (RR), and Tocantins (TO) did not exist this year, missing data were manually imputed)

The territorial distribution of poverty³ in Brazil changed considerably over time. While in the 1970s, only two states, São Paulo (SP) and Rio de Janeiro (RJ), in the Southeast region had less than 45% of the population extremely poor, in the 1980s and 1990s, this path extended to other states, especially in the South, such as Rio Grande do Sul (RS), Santa Catarina (SC) e Paraná (PR). The Human Development Index (HDI), which considers a broader range of living capabilities such as education, mirrors this behavior: if lower poverty levels and better living capabilities were highly concentrated in fewer rich states, later more states would be able to reach equivalent levels. Despite those relevant changes, one particular region remains the poorest and with the lowest HDI throughout time, the Northeast (NE). Using data from the decades of 1980 and 1990, the following Figs. 3 and 4 display this trajectory.

Fig. 3

(Source Elaborated by the authors with data from IPEADATA. The states of Amapá (AP), Roraima (RR), Rondônia (RO), and Tocantins (TO) did not exist this year, missing data were manually imputed)

Map of percentage of poor and HDI for each state (1980)

Fig. 4

(Source Elaborated by the authors with data from IPEADATA)

Map of percentage of poor and HDI for each state (1991)

Brazil is among the most unequal countries in the world: the Gini coefficient on average from 2010 to 2017 was 0.51 and the country held the 9th position for the most unequal in the world, also held the 79th position in the HDI in 2017 (PNUD, 2018). Furthermore, a clear income cleavage between North and South of Brazil remains. As the South and Midwest concentrate the highest per capita incomes over time, regions in the North and Northeast remain at the lowest levels. Other studies show an equivalent inequality path for education performance, despite incremental declines (Arretche, 2016). In this case, Brazil has experienced a significant improvement in providing primary education in the last 30 years, however, the smallest percentage still concentrates in the Northeast. Figure 5 displays regional differences according to income, education, and infant mortality in 2021.

Fig. 5

(Source Elaborated by the authors with data from IPEADATA and PNUD)

Map of Per capita income, percentage of people over 25 who completed elementary school and infant mortality by state (2021)

In sum, territorial and regional inequalities were and still are the main diversity to be accommodated in the Brazilian federation. The maps of socioeconomic indicators show that they were relevant in the second half of the twentieth century, when the structure of Brazilian fiscal federalism was built. At the time of the tax reform that created the foundations of the current tax system, the North and Northeast were the poorest regions and the Midwest had similar socioeconomic indicators. Therefore, they were treated differently by the intergovernmental fiscal institutions created in the 1960s. During the next decades, the rapid growth experienced by the Midwest, especially the states of Mato Grosso (MT) and Mato Grosso do Sul (MS), approximated their socioeconomic indicators to those of the rich regions. This transformation and the interests about the transfer system created by institutional legacies have changed the political economy of fiscal federalism and equalization in Brazil. Some states that used to have interests aligned with the poor regions, but now have a dual concern: to benefit from own tax and transfer rules. These and the interests of small states from the North, such as Amapá (AP), Roraima (RR), and Acre (AC), that benefited disproportionately from transfers, have complicated the possibility of coalition formation to improve equalization.

Did Territorial Inequalities Influence the Fiscal Constitution Design?

As pointed out in the previous section, territorial inequalities are historically significant. Regional imbalances were important factors to policy formulation by bureaucrats and to consolidate political cleavages over fiscal legislation. This section explores how this socioeconomic diversity has influenced the design and institutional evolution of Brazil’s main subnational taxes and transfers: (i) the Tax on the Circulation of Goods and Services (ICMS); (ii) the States’ Participation Fund (FPE); (iii) the Municipalities’ Participation Fund (FPM); and (iv) the Fund for the Development of Basic Education (Fundeb). These are the major sources of revenue for states and municipalities: in 2021, ICMS and FPE accounted for 9% of the national GDP and were the two main states’ revenues. In the same year, considering municipalities’ revenues, the local share of ICMS and FPM represented their main sources with values around 3% of the GDP. More important, these are cases in which regional inequalities were clearly addressed by fiscal legislation and also good examples of the political conflicts that hinder further redistribution. To illustrate this, we describe the main institutional features that addressed territorial inequalities since the last structural tax reform in Brazil in the 1960s.

Tax on the Circulation of Goods and Services (ICMS)

In late 1963, a Tax Reform Commission was established by the Ministry of Finance and ordered a series of academic studies to support the modernization of the tax system. In March 1964, a coup ended this democratic period and gave rise to a military authoritarian regime that lasted until the eighties. Commission reports affirm that this reduced political and institutional obstacles, and allowed for a structural tax reform to be approved in Brazil between 1965 and 1967 (EC 18/65; Lei 5.172/66; and Constitution, 1967). Its main objectives were to: (i) increase tax collection to balance central government budgets; (ii) centralize revenue and decision-making over public finances; and (iii) eliminate cumulative taxes on sales (Varsano, 1996).

The tax on the circulation of goods (ICM) is the Brazilian version of VAT and was created by the 1965–1967 reform to replace the cumulative tax on sales and reduce incidence on interstate transactions. It was innovative for the time and one of the main pillars of tax collection modernization. It was attributed to state governments with limited autonomy: rates should be uniform by product and the maximum rate for interstate transactions would be set by the Senate at 15%. The tax was levied on the state of the origin of the transactions mainly due to the technical challenges faced at the time to monitor and enforce collection on the destination of transactions.

Within a context of significant regional economic and social heterogeneity, as shown in the introduction of this chapter, the taxation on the origin of the production reinforced inequalities. The South and Southeast states concentrated economic production and were net exporters to the rest of Brazil. Therefore, they had a larger tax base than agricultural states of the North and Northeast. In this context, conflicts over the tax soon began and several rate changes were made to accommodate regional interests. The main one was over interstate tax rates and started in 1980 when the Senate differentiated rates for transactions originating in the two richest and poorest regions. A coalition of less developed states—from the North and Northeast plus Espírito Santo, the poorest state from the Southeast—was decisive to continuously increase this difference until 1989, when the rate for transactions originating from the poor was set to 12% and for operations starting in rich states to 7%. The main idea was that the higher rate to poor regions could partially balance the per capita tax collection between rich and poor regions (Rezende, 2012).

Today’s major transfer to municipalities is the local share of 25% of the Tax on the Circulation of Goods and Services, 1.8% of GDP in 2021, and it was also created in the 1965–1967 reform. At first, it did not have any equalization goals: the distribution was made according only to the value added in each jurisdiction. This tended to reinforce inequalities and benefit disproportionately small and medium cities with industrial plants. Recognizing the distortions, in 1980, national legislators allowed each state to distribute up to a quarter of the ICMS share to its municipalities according to own legislation. The original proposition suggested a uniform rule distributing one-third of the ICMS share according to the area and population. The Parliamentary Commission that made changes to the original project argued that the formula was not effective to deal with regional peculiarities and agreed to leave up to one-quarter of the ICMS share to be distributed according to law established in each state.⁴ Since then, several states used this autonomy and adopted economic, educational, and ecological variables to this part of the ICMS share transfer. The state of Paraná (PR), for example, in the South, introduced seven extra criteria to the distribution, including the value of agricultural production (8% of the resources), the number of inhabitants in rural areas (6%), and the existence of environmental conservation zones in the city (5%). The state of Ceará, in the Northeast, started adopting educational indicators to the distribution of part of the ICMS share in 1996, when the education spending in the local government budget became an important element of the criteria. In 2007, a reform changed the formula and established performance indicators, such as student approval rates and standardized test results to create incentives for better educational results. This new law also included health and environmental indicators (infant mortality and good management practices in the sector, respectively). Inspired by the case of the state of Ceará (CE), the Constitutional Amendment that created the new Fund for the Development of Basic Education in the National Congress, to be presented below, set an obligatory 10% of the ICMS share to be distributed to municipalities according to educational results. Now, up to 25% of the ICMS share may be distributed according to each state’s decision and until 35% may have a more equitable distribution than the one determined by the value added in each jurisdiction.

The democratic Constitution of 1988 added some essential services (such as energy, fuel, and telecom) to the tax base and changed the name to tax on the circulation of goods and services (ICMS). Although there was a proposal to give states autonomy over the tax rate and introduce the destination in tax collection, only the first measure was approved. The last one faced intense federal conflicts, not only between poor and rich states but also due to the special situation of the Midwest states: they used to form the coalition of poor states but due to its economic growth, their socioeconomic and fiscal indicators became closer to the ones of rich regions. These decisions helped to raise distortions and intensify federative conflicts. Now, the autonomy to set internal rates created the possibility for the states to engage in a complex “fiscal war” to attract private investments that has many features of a typical race to the bottom in states’ revenues (and municipalities, due to their 25% share of the IMCS) (Rezende, 2012).

Municipalities’ Participation Fund (FPM)

Constitutional tax sharing mechanisms with local governments in Brazil began in the late 1940s, when the democratic Constitution of 1946 set the share of 10% of the income tax to municipalities, except state capitals. Each municipality should allocate at least 50% of these resources to public policies in rural areas. Later, in 1961, a constitutional amendment included capitals and added the share of 15% of the federal consumption tax. The exclusion of state capitals at first, and the maintenance of the minimum of 50% to public policies focused on rural areas show that the diagnosis at the time was that inequalities between urban (industrialized) and rural areas resulted in reduced fiscal capacity to provide the basic public goods and services and, therefore, should be tackled with fiscal transfers.

At the beginning of the structural tax reform of the 1960s, the 10% share of the income tax was maintained and a 10% share of the new tax on industrialized goods was added (as the old consumption tax was extinguished). This was called the Municipal Participation Fund (FPM), distributed to local governments according to population only, especially due to the problems involved in obtaining income information at the time. It also benefited small municipalities by the establishment of minimums and maximums coefficients.

The FPM was incorporated by the 1967 Constitution. In the same year, it was clear that the distribution rules penalized large cities by setting a maximum share of the fund below their population share. For that reason, a presidency act set a share of 10% destined to state capitals and 90% to an “interior” cities fund. The capitals’ participation was distributed according to the population, the inverse of the average state income and its area (the same criteria as the States Participation Fund, which will be addressed below). With this rule, it incorporated equalizing criteria to reduce the gap between poor and rich state capitals’ per capita revenues.

In 1968, following the rise of military power and authoritarianism, the Fund’s share in the two federal taxes was reduced by half. This situation only began to reverse in 1975, when a series of constitutional amendments raised the subnational share on the Income tax (IR) and the Tax on Industrialized Goods (IPI) progressively to 17% in 1985.

A FPM “reserve” was created in 1981 to reduce the underfunding of large cities that were not capitals with 3.6% from the “interior’s” share (86.4%). As mentioned, the distribution criteria tended to favor small municipalities with more revenues per capita by setting a minimum coefficient. So, this reserve fund implemented the same criteria as the capitals’ share.

The 1988 democratic Constitution added social contributions to finance the growth of the welfare-state and decentralized funds and competences to states and especially municipalities. It implemented a centralization of taxation and policy decision-making as well as a decentralization of policymaking (Arretche, 2010). It established a progressive rise to 22.5% in municipalities share in the IR and IPI. Three more amendments (2007, 2014, 2021) added 1% each to the FPM, resulting in 25.5% of the two federal taxes.⁵

The Constitution also determined a complementary law to regulate the FPM distribution criteria with the “objective to promote the socioeconomic balance between states and between municipalities” (art. 161). Several laws (six from 1989 to 2001) extended the validity of the main aspects of the distribution criteria until today. In 1990, the only significant change fixed the coefficients of each state in the major part of the fund (interior, with 86.4% of the fund) to prevent the creation of new municipalities that could influence the distribution of funds between states. Therefore, the population criteria was restricted to the distribution between cities of the same state and the fixation of limits in the population size influence in coefficients benefited sparsely populated municipalities regardless of their level of income or social demands.

States’ Participation Funds

The 1965–1967 reform created the States’ Participation Funds with 10% of the same taxes that sustained FPM, such as the income tax (IR) and the tax on industrialized goods (IPI). FPE distribution was made by a formula: 5% area and 95% according to an index based on the population size and the inverse of the per capita income, which favored small and poor states by implementing minimum and maximum index. FPE was also incorporated by the 1967 Constitution (in article 26) and had its share on IR and IPI reduced by half in 1968. This share, however, started to rise progressively from 5% in 1975 to 17% in 1985.

In 1975, poor states of the North and Northeast successfully pressured the central government to allocate a part of the fund exclusively to them. In the first two years, the share was set to 10% and would rise to 20% afterward. The distribution followed the same general criteria (income, population, and area) and 80% of the rest of the fund was distributed between all the states, including the ones from Northeast and North (Prado, 2020).

The 1988 Constitution established a progressive rise to 21.5% in the income tax and tax on industrialized products for the fund. It also determined the reform of FPE’s distribution criteria, but negotiations did not succeed. The conflict between rich and poor regions was at the center of the disputes and the last succeeded in the following year. The complementary law 62/1989 changed the reserve of the fund, destining 85% to the states in the North, Northeast, and added the ones in the Midwest, the three less developed regions in the country. In addition, this law froze each state’s coefficients in the fund, which were particularly opposed by states that didn’t agree with the static FPE distribution and appealed to the Supreme Court. The resulting distribution created situations that favored mainly small states of the North with significantly higher FPE per capita revenue. It is also important to highlight that in 1988, the Midwest joined the coalition with the North and Northeast but was already going through a structural change that led the region to be the fastest growing economy of the country for several decades. This would put the region in a special position in the revenue distribution structure since their governments generally present high tax and transfer influx.

After several years and laws approved to postpone the validity of these same fixed coefficients, in 2010, the Supreme Court judged some states’ claims and declared unconstitutional the articles of the LC 62/1989 that imposed an 85% share of the fund to the states of the North, Northeast, and Midwest and froze states’ coefficients. Legislation approved in Congress in 2013 to resolve the issue, namely the complementary law n.143/2013, only introduced marginal changes, and a period of transition of 30 years. All states would receive that same real amount as in 2015 plus 75% of GDP growth. Only the residual of the fund is distributed according to a new criterion based on population and the inverse of the per capita household income. Therefore, the new criteria apply to a small share of the fund which will increase very slowly, and may reach 30% by the end of 2050.

Fund for the Development of Basic Education (Fundeb)

The 1988 Constitution followed the Brazilian institutional legacy and maintained two central aspects of education policy: (i) shared competences between central, state, and local governments; and (ii) a minimum spending on education for subnational governments, equivalent to 25% of each state or municipality net revenue. These rules tended to reinforce territorial inequalities, by linking spending directly with revenue collection capacity and not clearly defining each level of government responsibilities. Not only did this result in differences in spending per capita but also influenced the emergence of a regional pattern of division of responsibilities between subnational levels of government. This diagnosis is clear in the formulation of the central government’s proposal that led to the approval of a Constitutional Amendment in 1996:

...the distribution of resources is not compatible with the effective responsibilities in school maintenance. Given the different collection capacities and the fact that constitutional transfers from the Union to States and Municipalities, and from States to Municipalities, do not follow criteria that take into account specific needs, whether in education or in any other area, it results that different subnational governments present substantial differences in their capacity to invest in education.

One of the most striking disparities is the fact that, precisely in the poorest regions of the country, municipalities are responsible for most of the provision of compulsory primary education. In more developed regions, however, State Governments provide most of the assistance. In both situations, however, the volume of resources available in each sphere of government, despite the constitutional binding of a significant part of its revenues (art. 212, CF), is clearly insufficient to ensure minimally acceptable quality education (Brazil, 1995).

To reduce these inequalities, the constitutional amendment n. 14/1996 defined competences more clearly and established the Fund for the Development of Fundamental Education (Fundef), beginning in 1998 and lasting until 2006. Fundeb comprised 27 funds (26 for each state and its municipalities, and one for the country’s capital, Distrito Federal (DF)), financed by 15% of major state’s taxes and grants and of the local Municipalities’ Participation Fund (FPM). These resources were then redistributed, within the scope of each state, according to the number of students of each jurisdiction (including state and local governments) and weighted by the location (urban or rural) and the level of study (early childhood, primary and secondary education). It was also established that a central government complementation would be provided to the state funds that did not achieve a minimum per capita value (measured as the value of the state funds’ revenues divided by the number of students in the state). The complementation is set as the value that closes the gap between the per capita value of the state fund and the national minimum. However, since the federal budget for this complementation was significantly limited, not all state funds below this minimum received those resources. Besides, the complementation was destined primarily to the state funds with the lowest per capita revenues, not to the local governments with smallest fiscal capacity. Under this criterion, poor municipalities from states that achieved the minimum were not contemplated, while rich cities from states in which the funds were below the national standard would benefit from federal resources.

With the end of Fundef in 2006, the constitutional amendment n. 53/2006 transformed it into the Fund for the Development of Basic Education to last until 2020. The main improvements in relation to the previous fund were: (i) strengthening the fund by adding other revenues and increasing its share to 20%; (ii) setting the federal complementation to 10% of the fund’s resources; (iii) broadening the coverage to early childhood and secondary education; and (iv) setting a minimum salary for teachers.

In 2020, a new constitutional amendment (n. 108/2020) turned the Fundeb into a permanent fund, increased the federal complementation progressively to 23% until 2026, and changed the distribution criteria to improve the redistributive impact. The new Fundeb sets new resources exclusively to municipalities that do not achieve the minimum values per capita after the federal complementation to state funds mentioned above.

The three constitutional amendments of Fundef/Fundeb, in 1996, 2006, and 2020, are good examples of the political economy of territorial redistribution of fiscal resources in Brazil. The reduction of territorial inequalities was an important objective of these reforms and was achieved through the distribution of additional resources to poor municipalities. The federal complementation also played a role in reducing inter-regional disparities and has been recently improved to increase its redistributive impact. On the other hand, the disaggregation of 27 funds that mainly obtain resources within the borders of each state and redistribute them accordingly to this territorial arrangement is evidence of the political challenges to promote more substantial inter-regional redistribution. This again shows the importance of territorial inequalities in the design of the transfer fund and highlights the key role of the central government in promoting a more equitable distribution of resources.

In sum, major transfer funds and subnational taxes include important elements that refer explicitly to territorial inequalities and, therefore, that the Brazilian fiscal federalism has tried to accommodate them. In the Tax on the Circulation of Goods and Services (ICMS), the rate for interstate transactions was differentiated to increase tax collection in poor regions. State legislatures were permitted to autonomously set the distribution criteria for 25% of the local governments’ quota, which allowed the introduction of socioeconomic criteria in some states. In the Municipalities’ Participation Fund, initial attempts to reduce inequalities focused on the differentiation of urban and rural areas, and small and large cities. To reduce these distortions, national legislators set apart a percentage of the funds to state capitals (10%) and another one to large cities (3.6%) based on a more equalizing criteria that also considered the inverse of the average per capita income of each state. In the States’ Participation Fund, the original distribution criteria considered were population and the inverse of the per capita income, and in the late 1980s, a significant share was set exclusively to the states of the North, Northeast, and Midwest. In the Fund for the Development of Basic Education, the redistribution is made by demand criteria, i.e., by formulas guided directly by social needs in the territory (the number of students, in this case), and was intended to reduce territorial inequalities linked to historical economic and institutional legacies. The central government complementation to the fund has more inter-regional equalization purposes and, although it is only 10% of the fund, national legislation approved recently will increase its share to 23% and its redistributive impact by implementing marginal but important improvements in the distribution criteria.

To What Extent Does the Transfer System Reduce Intergovernmental Revenue Inequalities?

After exploring, in detail, the mechanisms created in the fiscal constitution to accommodate territorial inequalities, we now turn our efforts to examine to what extent these rules were successful in reducing horizontal gaps. Brazil has a broad set of taxes and transfers with different objectives, some aim to reduce vertical gaps and others focus on horizontal equalization. Previous studies show the importance of fiscal transfers to reduce inequalities, particularly those originated from shared federal taxes (Arretche, 2010, 2016). In this section, we aim to develop this assessment further on in three ways. First, the effects that transfer revenue have on tackling horizontal inequality in aggregate terms for states and municipalities in the fiscal year of 2021 are discussed. Second, the resulting spatial patterns of revenue distribution are presented through maps and showing the distribution of per capita revenues according to the level of income and socioeconomic development of the jurisdictions to understand their progressive or regressive character. Finally, the analysis of the main sources of transfers is disaggregated, to investigate their heterogeneity and their role in the distribution of fiscal resources.

Previous findings that the aggregate intergovernmental transfer system does reduce disparities are confirmed. By disaggregating the main revenue items, it is possible to add that the redistributive impact of each type of transfer is significantly different and that although the total effect is expressive, it is significantly limited due to: (i) inefficient distribution criteria of equalization funds that favor small states and municipalities; and (ii) the existence of high own tax collection disparities and relevant inequality inducing devolutive transfers, that share part of the upper level tax revenue with the territory where its economic basis occurred.

In 2021, on average, most state resources consisted of own tax. For municipalities, the scenario is reversed, and transfer revenues account for most of their total revenue. This indicates that in relative terms, municipalities depend more on transfers (especially the ICMS share and FPM) for public provision than states. It also means that the impact of transfers on the final distribution of per capita revenues is higher in the case of local governments than at the state level.

Measuring the inequality of per capita revenues by source, higher levels of Gini coefficient are perceived among states (0.224) and municipalities (0.504) considering only their own tax revenues. When we add transfers, there is a decrease in the Gini coefficient reaching the values of 0.175 and 0.237 for states and municipalities, respectively. This is the same Gini coefficient for the total per capita revenues of states and municipalities, meaning transfer revenues have a fundamental role in tackling inequality of resources in aggregated terms, especially among municipalities.

The highest per capita own revenues are concentrated in the South, Southeast, and Midwest regions. This matches with the data from Fig. 5, which shows these regions as the richest ones in terms of per capita income. In contrast, transfers to states are lower in the Center-South than in the North-Northeast, which indicates that there is not only an aggregate but also a regional/spatial reduction of inequalities. However, it is also clear by Fig. 6 that three states in the North region, Acre, Roraima, and Amapá, receive significantly higher per capita transfers than other poor states. This result is clear in the total revenue map, which also highlights that the states from the Midwest and small states from the North present the highest per capita fiscal capacity. In the first case, high own revenue adds to the fact that they receive similar per capita transfers than poorer states from the Northeast; in the second case, it shows that states in the North previously mentioned receive such high per capita transfers, which leaves them among the highest per capita total revenues.

Fig. 6

(Source Elaborated by the authors with data from STN (National Treasury Secretariat). Per capita revenue in current R$)

Map of states per capita revenue by source, 2021

This is a direct consequence of two main features of the States’ Participation Fund distribution criteria: (i) privileged states from the North, Northeast, and Midwest (the three poorer regions at the time) with 85% of the funds; and (ii) established minimum shares that benefited sparsely populated states. Evidence indicates that transfers to states are benefiting disproportionately some poor and less populated states and are not sufficient to tackle regional inequalities in the historically more populated and poorer states of the Northeast. The graphs below present the relation between per capita FPE revenues and the level of territorial development (using proxies such as per capita GDP and the Human Development Index). The dots dimensions are proportional to each state population, which is evidence that the negative relation that indicates progressivity is also characterized by benefiting disproportionately less populated states (Fig. 7).

Fig. 7

(Source Elaborated by the authors with data from STN)

States per capita FPE revenue according to per capita GDP and HDI, 2021

As mentioned before, transfers represent a more significant percentage of municipalities’ total revenues in comparison to states’.⁶ They also play an important role in diminishing inequality as measured by the Gini coefficient: it goes from 0.504 to 0.237, which means that it decreases by half. When own tax revenues and total revenues are territorially distributed, the cleavage between North-Northeast and the Center-South can also be observed (presented in Fig. 8). On the other hand, it is interesting to notice that transfers are mainly benefiting municipalities in the Midwest, a region that previously was part of the poor but currently has the highest per capita income and own tax collection levels.

The distribution of per capita revenues according to the jurisdictions’ per capita GDP and HDI shows a positive correlation between these variables instead of a negative one that would be expected in an inequality-reducing scenario. There are obvious limitations with the use of a simple linear regression to assess the progressivity degree of transfers to local governments. However, the dispersion plots clearly highlight that there is not a negative relation and that municipalities with similar levels of GDP and HDI receive significantly different amounts of transfers per citizen (Figs. 9 and 10).

Fig. 8

(Source Elaborated by the authors with data from STN)

Map of municipalities per capita revenue, 2021

Fig. 9

(Source Elaborated by the authors with data from STN and IBGE)

Municipalities per capita revenue according to per capita GDP, 2021

Fig. 10

(Source Elaborated by the authors with data from STN and PNUD)

Municipalities per capita revenue according to HDI, 2021

It is important to bear in mind that some transfers are designed to diminish vertical fiscal gaps and others are more focused on horizontal equalization. In the following map, transfers are differentiated between the share of the Tax on the Circulation of Goods and Services (ICMS) and the Municipalities’ Participation Fund (FPM), which respectively fit into these two classifications, and are the most important sources of municipalities’ total revenues. Figure 11 shows that the cities with the highest per capita ICMS share concentrate in the Midwest, South, and Southeast regions, but also include municipalities from the North. The Northeast remains the net loser of this group of transfers. The FPM does not show a clear spatial pattern of distribution but highlights a less territorially concentrated scenario and some cities from the Northeast with higher revenues, in a sharp contrast with the ICMS share map. Besides, it can be noticed that a large number of municipalities from the South and the Midwest regions are in green in both maps, which means they are among the top 50% in terms of per capita revenue in the two major local revenues.

Fig. 11

(Source Elaborated by the authors with data from STN)

Map of municipalities per capita transfers, 2021

The dispersion plots presented below help to evaluate the impact of these transfers in accommodating socioeconomic inequalities. Besides the expected positive relation between the per capita value of the share of the Tax on the Circulation of Goods and Services (ICMS) and both GDP and HDI (Fig. 12), the graphs present evidence of a significant inefficiency in the equalization impact of the Municipalities’ Participation Fund (FPM). Although the regression line indicates only a slight positive relation, the most striking result is in the FPM graph (Fig. 13), which shows the existence of major revenue inequalities between territories with the same level of development.

Fig. 12

Municipalities per capita ICMS share transfers according to per capita GDP and HDI, 2021 (Source Elaborated by the authors with data from STN, IBGE, and PNUD)

Fig. 13

(Source Elaborated by the authors with data from STN, IBGE, and PNUD)

Municipalities per capita FPM transfers according to per capita GDP and HDI, 2021

Education transfers are mainly composed of the Fund for the Development of Basic Education, which collects and distributes resources within each state and its municipalities. The data displayed in the following graphs (Figs. 14 and 15) indicate that municipalities with low per capita income and from poor regions benefit relatively more from these transfers. The negative relation between net per capita education transfers and income or development index indicates a higher level of progressiveness than other presented. In fact, the boxplots present the highest values for municipalities from the poorest state of Brazil, Maranhão, and show almost all states from the Northeast and North with higher per capita transfers than rich states’ local governments. However, it is important to stress that this is not a result of inter-regional redistribution, since it is fundamentally a fund shared within each state and its municipalities. The regional pattern displayed in the boxplot graphs reflects the historical patterns of division of responsibilities between subnational levels of government in education described in the previous section. In poor regions, municipalities had to assume more responsibilities and had less fiscal capacity. Therefore, the distribution criteria guided by demand indicators (number of students in each jurisdiction, predominantly) contributed to accommodate this historical territorial diversity and significantly reduce territorial inequalities in basic education financing. The central government complements (with 10% of the funds’ annual flow) the resources for those state funds that do not achieve the minimum value per student and therefore plays a residual but important inter-regional redistributive role.

Fig. 14

(Source Elaborated by the authors with data from STN)

Boxplots of per capita education transfers to municipalities grouped by states

Fig. 15

(Source Elaborated by the authors with data from STN, IBGE, and PNUD)

Municipalities per capita education transfers according to per capita GDP and HDI, 2021

In short, looking at the territorial distribution of revenues, one can conclude that transfers were capable of accommodating inequalities in fiscal capacity to provide public goods and services. In general terms, the transfer system does reduce intergovernmental fiscal inequalities. This is especially true in the case of municipalities, in which inequality originates by own revenue and is reduced by half when measured by the Gini index. On the other hand, going beyond the aggregate analysis, it is possible to realize the limitations of this redistributive impact, considering that (i) own revenue promotes high territorial inequality; (ii) some important transfers do not have redistributive objectives; and (iii) there are inefficiencies in the equalization funds’ distribution criteria. As a result, transfers tend to favor small states and municipalities regardless of their socioeconomic development level. Among state governments, revenues from the Tax on the Circulation of Goods and Services (ICMS) tend to replicate the inequality cleavage between poor and rich jurisdictions, while the States’ Participation Fund seems to benefit mostly less populated states from the North. The Municipalities’ Participation Fund (FPM), in turn, reduces inequalities but does not clearly benefit the poorest cities or regions. Education transfers, namely the Fundeb, show more progressivity and have a remarkable influence in the accommodation of historical territorial inequalities that are not only a result of economic inequalities but also of diverse regional institutional legacies. On the other hand, the inter-regional redistribution impact of Fundeb is limited to the central government complement, since Fundeb operates with 27 separate funds for each state and its municipalities, as mentioned in Sect. 2.

Concluding Remarks: Obstacles for the Advancement of an Equalization Agenda

Socioeconomic regional inequalities are the main diversities to be accommodated in the Brazilian federation. They have shaped the design of main subnational sources of revenues and altogether assured a significant and steady number of resources to subnational governments. Fiscal institutions show clear evidence of the attempt to accommodate diversities in fiscal capacities and they do reduce overall inequalities from own tax revenues. Grants are mandatory and regulated by the national Constitution as well as by laws that establish stable sharing criteria based on formulas or fixed coefficients. Therefore, they are protected from short-term political bargaining. On the other hand, some important transfers do not have redistributive objectives and increase inequalities further on. Also, there are important inefficiencies in the equalization funds’ distribution criteria that favor small states and municipalities regardless of their socioeconomic development level.

The reforms that could help to improve fiscal equalization showed little advance in Congress, especially since democratization. The State’s Participation Fund had only marginal changes with a long transition time frame. In the Fund for the Development of Basic Education, the recently adopted reform has been restricted to a gradual and marginal improvement in the distribution criteria of the increased central government complementation to the fund. In the case of the Municipalities’ Participation Fund, the only change was the increase of 3% in its share of federal taxes since the 1988 Constitution and later through constitutional amendments,⁷ but the distribution criteria remain intact. In the Tax on the Circulation of Goods and Services (ICMS), several reform attempts were unsuccessful and resulted in the accumulation of economic and federative distortions.

It is important to highlight the case of the ICMS due to its relevance not only to subnational finance, as this is the main source of own revenue for states, but also to economic efficiency. Since the democratization process, three different proposals aimed to reform the tax: (i) during the constitutional assembly of 1987; (ii) in the first year of the Fernando Henrique Cardoso government, in 1995; (iii) in the second Lula government, in 2008. The main goals were to harmonize and simplify taxation on goods and services. The major changes were the unification of several taxes into one single VAT under national legislation (transferring states’ and municipalities’ autonomy to the central government or a multilevel agency) and the change of the place of collection to the destination of transactions. They were all unsuccessful mainly due to the difficulties of forming coalitions in an issue where benefits are complex and diffused and costs are tangible or, at least, there are strong expectations of losses (Arretche & Gobetti, 2023). Also, an important obstacle to reform is the multidimensionality of the conflicts involved, which overlap disputes between rich and poor states, and among different sectors of the economy (Junqueira, 2015; Orair & Gobetti, 2019; Prado, 2020).

Currently there are two proposals being discussed in Congress. Both try to change the tax incidence to the destination of transactions. As shown in Fig. 16, the reform impact is negatively related to income, that is, losses are concentrated in rich states and gains in poor ones. The map, in turn, shows the territorial character of this conflict, which mainly benefits states from the Northeast and penalizes states that concentrate production in the South and the Southeast.

Fig. 16

(Source Elaborated by the authors with data from Orair and Gobetti (2019) and IBGE)

Estimated reform impact by state (including state and local governments) (in million reais)

The strong effort of the central government to approve this reform and the public willingness of state finance secretaries and congressmen show that this time may be different. Nevertheless, even if this reform is approved and achieves significant inter-regional redistribution, there is still evidence of the relevance of the territorial conflicts in the difficulty to advance this agenda. The decades of failures, the importance of a gradual change mechanism lasting 40 years, and the need for compensation funds to achieve the minimum consensus are strong indications of the political economy obstacles to further fiscal redistribution.

These institutions that consolidated the distribution of subnational revenues were forged through conflicts between rich industrial states in the Southeast and South regions and poor rural states in the North and Northeast. The tax and transfer system has also created interests over the appropriation of resources that influence current states’ preferences to changes in the status quo. It is difficult to imagine states of the North engaging in a coalition to implement a structural reform in the State’s FPE without knowing the result of the negotiation process, for example, if they already receive a higher per capita revenue under the current criteria. The Midwest is also a complex case because it was part of the poor states in the past and treated as such by the FPE. However, the region’s economic growth situated its states at the top of the average own revenue distribution. Now, they benefit from the tax and transfer system as the Midwest region became much less underdeveloped than the past or than the Northeast and North.

The formation of winning coalitions seems to be harder in these cases mainly due to the heterogeneity of territorial interests. The political preferences are complex and are influenced by institutional legacies and economic dynamics that determine the position of each state in the distribution of subnational revenues. Institutions such as a strong Senate, super majorities and, sometimes, the Supreme Court, as well as rules like disproportional representation, create potential further obstacles to territorial fiscal redistribution. The interaction of these intricate interests and intergovernmental relations in a context of political federal institutions designed to prevent the tyranny of the majority reduce the likelihood of successful inter-regional redistributive coalitions in current days.

In sum, these historical political processes have managed to produce a system that accommodates diverse fiscal capacities by significantly reducing inequalities arising from own revenues. On the other hand, its efficiency can be questioned and, since democratization, the few and marginal advances in this redistributive federative agenda highlight how difficult it is to articulate territorial interests in one broad coalition that can approve more effective redistributive fiscal reforms.

Annex

See Table 1.

Table 1 State ranking—Population, GDP, own tax revenue, and transfer revenue (per capita)