just add to the structural fiscal problems that limit the state ability to invest and to provide good quality public services. The fiscal problem is therefore impeding the investment the state would need to make to provide water regulation services. It also is cause to the lack of the resources demanded to carry out or bring the private sector to promote the investments needed to expand irrigation in the state. The main water resource problem is the concentration in time and space of high rainfall, which leads to pervasive episodes of alternate flooding and severe droughts. In the last decade, drought episodes were recorded in five years. In 2011 drought affected 1.8 million people, with the majority of the State being affected by the declaration of a drought emergency through March 2012. Potential for irrigation to mitigate problems related to droughts is high. The geography of the State is favorable for the implementation of irrigation programs: rivers with high volume, irregular but high rainfall and adequate soil for mechanized crops. In fact, irrigation has been practiced in the State for more than 30 years and has led Rio Grande do Sul to be the main rice producer in Brazil. However the irrigation potential has not been tapped, due to: lack of hydro-meteorological and piezometric information, as well as on water quality; poor coverage of waste water treatment causing water pollution; ineffective systems for granting water resource rights leading to growing conflict between users and multiple uses of water resources. On the fiscal front, Rio Grande do Sul has been constrained by high debt, low ability to mobilize revenues and a high demand for public expenditure. As a result, the state faces decaying public services and is unable to invest. The investment ratio in the state is the lowest among all Brazilian states since own revenues are used almost entirely to pay for current expenditures and its high debt levels prevents it from borrowing widely. The low ability to mobilize revenue is explained by relatively high exports (exempt from tax under federal law), lower ICMS (Imposto sobre Circulação de Mercadorias e Serviços) tax rates than other states, especially in high revenue generating sectors and the extensive use of tax incentives. On the expenditure side, the higher demand is explained by higher1 budget earmarks, high debt level and aging population.

- II. Proposed Objective(s)

The purpose of this proposed operation is to strengthen fiscal management to increase fiscal space and support government's effort to make progress towards sustainable irrigation and integrated water resources management. In order to do that, the loan will help the state devise and put in practice policies and tools to manage water supply and demand. The policies supported by the proposed operation are fully in line with the Multi-year Plan (PPA). The Program Development Objective (PDO) of this operation is to strengthen fiscal management to increase fiscal space and to support government's effort to make progress towards integrated water resources management. The PDO is fully aligned with the Government's strategic objectives . Specifically, this proposed operation will contribute indirectly to three other government's objectives, which are: to raise the rate of growth of employment, income and investment; to promote regional development and to improve life quality and eradicate extreme poverty. The expected result from this operation is an increase in fiscal space which would be used to increase public investment and to improve service delivery especially in the water and irrigation sectors. This increase in fiscal space would be obtained through an improvement in tax collection efficiency, expenditure savings without cutting back government services provision and better management of contingent liabilities. These measures would benefit all state citizens, but in particular those that are more dependent on government services. From the water resources management pillar the expected results are a reduction in the impact of drought episodes on agricultural production. This will be sought through expansion of irrigated agriculture and integrated water resources management. The direct beneficiaries of this pillar would be small and medium farmers who have not been able to afford irrigated agriculture tools.