# **1. Introduction**

A large body of empirical literature has provided evidence that pro-cyclical fiscal policies are highly prevalent in developing countries, demonstrating that fiscal policy tends to expand in periods of economic growth (“good times”) and contract during recessions or slowdowns (“bad times”).<sup>1</sup> The empirical literature on budget cyclicality has generally focused more on assessing the degree of pro-cyclicality in federal (central government) revenues and expenditures and less on budget cyclicality at the sub-national level in multi-tiered systems.<sup>2</sup> Sub-national governments often rely on narrow and sensitive revenue streams, have limited access to credit markets, and may be subject to the manipulation of intergovernmental transfers, all of which combine to make sub-national fiscal policy inherently and systematically pro-cyclical. If spending by sub-national governments is pro-cyclical, the need to offset this spending pattern imposes an additional burden on fiscal policy at the federal level. Moreover, pro-cyclical actions by the federal government could affect the cyclical behavior of sub-national jurisdictions through intergovernmental transfers, amplifying rather than mitigating the pro-cyclicality of sub-national fiscal policy.<sup>3</sup> According to a recent World Bank study (World Bank, 2008b), the international evidence shows that budget rigidities the tendency to adopt a pro-cyclical stance, especially during “good times”, have been a main source of the deficit bias of fiscal policy in both industrial and developing countries.

In the recent experience of emerging markets crises, Argentina and Brazil constitute two cases in which sub-national governments worsened the overall fiscal situation. In the Argentine case, the fiscal behavior of the provinces was an important element in the overall fiscal deterioration leading to the 2001 crisis. In the Brazilian case, the default of the state of Minas Gerais in 1999 prompted the devaluation of the Brazilian Real in 1999. Although the empirical literature on the Argentine case is extensive, the Brazilian case has been relatively less studied. This paper examines how sub-national fiscal revenues and expenditures are linked to the business cycle in Brazil by addressing the following questions: Are the Brazilian states’ expenditures pro-cyclical, even after the introduction of the Fiscal Responsibility Law? If so, what explains the degree of pro-cyclicality across Brazilian states? And do intergovernmental transfers stabilize or destabilize state finances?

These questions are addressed using both a time-series and a cross-section dimension at the Brazilian state level for the period 1991-2006, which will allow us to assess the degree of state budget pro-cyclicality while taking into account state characteristics, as

> 1See Gavin and Perotti (1997), Braun (2001), Lane (2003), Kaminsky, Reinhart, and Vegh (2004), Gupta, Clements, Akitoby, and Inchauste (2004), and Ilzetki and Vegh (2008).

> 2 Some exceptions are Wibbels and Rodden (2006), Sturzenegger and Werneck (2006) and Rocha and Giuberti (2006).

> 3 Conversely, the procyclical behavior of subnational governments could also exacerbate the procyclicality of fiscal policy at the federal level through “voracity effects” and the use of bailouts and discretionary transfers (Sturzenegger and Werneck, 2006); i.e., competing demands for intergovernmental transfers by multiple states could have a reciprocal impact on the federal government, exacerbating its procyclicality while constraining its ability to save resources for countercyclical discretionary spending during economic downturns. However, this issue is not analyzed in the study.

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