metadata: authors: 0: author: Reis,Jose Guilherme
1: author: Iootty De Paiva Dias,Mariana
2: author: Signoret,Jose E.
3: author: Goodwin,Tanja K.
4: author: Martinez Licetti,Martha
5: author: Duhaut,Alice
6: author: Lall,Somik V.
count: Brazil
docna: 0: docna: Trade Liberalization and Integration of
            Domestic Output Markets in Brazil
docty: Policy Research Working Paper
subtopic: International Trade and Trade Rules,Food & Beverage Industry,General Manufacturing,Plastics & Rubber Industry,Business Cycles and Stabilization Policies,Textiles, Apparel & Leather Industry,Pulp & Paper Industry,Construction Industry,Common Carriers Industry,Labor Markets,Health and Sanitation,Competition Policy,Competitiveness and Competition Policy
teratopic: Industry,Social Protections and Labor,International Economics and Trade,Health, Nutrition and Population,Macroeconomics and Economic Growth,Private Sector Development
abstracts: cdata!: This paper describes how different
            policy distortions have been impeding better integration of
            Brazil's external and internal product markets and
            discusses how these distortions have prevented domestic
            firms from benefiting from multiple sources of efficiency
            gains. The paper first focuses on the costs of barriers to
            global integration, followed by an overview of policy
            induced stringencies hampering domestic integration. Drawing
            from general and partial equilibrium analyses, the paper
            also provides evidence of potential impacts of removing some
            of those distortions and discusses policy options to promote
            better allocation of resources across the economy. The main
            conclusion of the paper is that Brazil could gain
            significantly from opening to foreign trade. Yet, for Brazil
            to take full advantage of the opportunities that external
            integration offers, domestic markets also need to function
            better, so it is key to ensure that the removal of external
            barriers to integration is coordinated with the removal of
            internal distortions to domestic market integration.
geo_reg_key: 119228,517191
repnme: repnme: Trade Liberalization and Integration of
            Domestic Output Markets in Brazil
display_title: Trade Liberalization and Integration
            of Domestic Output Markets in Brazil
listing_relative_url: /research/2018/10/30468290/trade-liberalization-integration-domestic-output-markets-brazil
topicv3: Sanitary and Phytosanitary Standards
            m1326217 1053,Manufacturing Sectors m1326521 1281,Trade m1326924 698,Competition Policy m1326982 406,Labor Productivity m1504060 2756
publishtoextweb_dt: 2018-10-03T00:00:00Z
historic_topic: Industry,Social Protections and Labor,International Economics and Trade,Health, Nutrition and Population,Macroeconomics and Economic Growth,Private Sector Development
no_of_pages: 47
author_keys: 0: author_key: 691054
1: author_key: 1051061
2: author_key: 606241
3: author_key: 1159640
4: author_key: 1014522
5: author_key: 1436493
6: author_key: 124534
model_extractions: WPS8600 Policy Research Working Paper 8600 Trade Liberalization and Integration of Domestic Output Markets in Brazil _Jose Guilherme Reis Mariana Iootty Jose Signoret Tanja Goodwin Martha Licetti Alice Duhaut Somik Lall_ Macroeconomics, Trade and Investment Global Practice October 2018
Policy Research Working Paper 8600

# **Abstract**

This paper describes how different policy distortions have been impeding better integration of Brazil’s external and internal product markets and discusses how these distortions have prevented domestic firms from benefiting from multiple sources of efficiency gains. The paper first focuses on the costs of barriers to global integration, followed by an overview of policy induced stringencies hampering domestic integration. Drawing from general and partial equilibrium analyses, the paper also provides evidence of potential impacts of removing some of those distortions and discusses policy options to promote better allocation of resources across the economy. The main conclusion of the paper is that Brazil could gain significantly from opening to foreign trade. Yet, for Brazil to take full advantage of the opportunities that external integration offers, domestic markets also need to function better, so it is key to ensure that the removal of external barriers to integration is coordinated with the removal of internal distortions to domestic market integration.

This paper is a product of the Macroeconomics, Trade and Investment Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/research. The authors may be contacted at miootty@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Trade Liberalization and Integration of Domestic Output Markets in Brazil**<sup>**1**</sup>

Jose Guilherme Reis, Mariana Iootty, Jose Signoret, Tanja Goodwin, Martha Licetti, Alice Duhaut and Somik Lall JEL codes: F13, F15, D24 Keywords: productivity, trade liberalization, market integration

> 1 This paper was prepared as a background paper for the “Jobs and Growth: Brazil’s Productivity Agenda” report, which was launched in June 2018.
# **_1. Introduction_**

Opening to trade can boost productivity growth through numerous channels. The literature identifies two main groups of mechanisms through which trade can affect productivity: i) those that induce changes _within firms_ and hence impact firm level productivity; and ii) mechanisms that trigger _intra-industry reallocation_ of resources towards more productive firms, thereby increasing aggregate productivity. Improvements in firm level productivity caused by within firm changes can be triggered by exposure to competition stemming from output tariff reduction (the so-called import competition channel) and are associated with (observable) actions, for example, as investment in new technologies, increase in R&D, and entry in export markets.<sup>2</sup> Within firm improvements in productivity can be also triggered by reduction of input tariffs - which allows firms to access better quality, higher variety and lower priced inputs (the so-called input channel) - or by reallocation of firm product mix towards more profitable products.<sup>3</sup> Trade liberalization can affect aggregate productivity as well, as trade shocks are expected to reshuffle market shares towards more efficient firms,<sup>4</sup> in this case, the magnitude of this reallocation process depends on how dispersed productivity was prior to trade liberalization shocks.

Empirical evidence for Brazil has shown that the unilateral trade liberalization episode of the late 1980s - early 1990s has brought positive payoffs to productivity. Using sector level data for the 1985/97 period, Rossi Jr and Cavalcanti Ferreira (1999) show that a 10 percent reduction of import tariffs is associated with an increase in labor productivity growth of 0.88 percent per year and of TFP growth by 3.3 percent per year at the sectoral level. Muendler (2004) uses firm level data for the manufacturing industry in the 1986-1998 period to analyze how the reduction of inward trade barriers between 1990 and 1993 affected productivity and finds evidence that foreign competition pressures firms to raise productivity markedly, whereas the use of foreign inputs plays a minor role for productivity change. Schor (2004) runs a firm level analysis also for manufacturing industry and for the same period and finds evidence that along with higher competition pressure exerted by output tariff reduction, new access to better inputs also contributes to enhance productivity after trade liberalization. Lisboa, Menezes Filho and Schor (2010) use 1988-1998 data and confirm that the trade liberalization episode that took place in Brazil in the late 1980s and early 1990s brought positive impacts for productivity in the manufacturing industry and that the main driver of productivity growth was the reduction of input tariffs.

Productivity dividends accruing from trade liberalization can be maximized when domestic markets are integrated in a way that resources are allocated to their most efficient uses. Easing barriers to trade is expected to trigger an intensive reallocation and churning process where resources are expected to move to more productive uses, within and between firms, sectors and regions, therefore boosting productivity growth. In this context, resource reallocation can be dampened by policy interventions. For example, Restuccia and Rogerson (2017) provide a

> 2 See for instance Bustos (2011) and Aw, Roberts and Xu (2011) as examples of studies covering this type of effect. 3 See Fernandes (2007), Topalova and Khandelwal (2011), and Halpern, Koren and Szeidl (2015) as examples of studies assessing the relevance of the input channel, while Bernard, Redding and Schott (2010) provide empirical evidence for the within-firm reallocation process.

> 4 See Melitz (2003) and Melitz and Ottaviano (2008) for a theoretical and empirical investigation on this aspect, and Pavcnik (2002) for empirical evidence on the productivity dividends coming from the reallocation effects caused by trade liberalization in Chile.

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compelling review of how policy interventions (or lack thereof) can distort resource allocation; three main policy causes can be listed: statutory provisions that vary with firm characteristics,<sup>5</sup> discretionary provisions favoring specific firms<sup>6</sup> and market frictions.<sup>7</sup> Against this backdrop, this paper aims at shedding light on the potential gains from trade liberalization in Brazil while discussing the (policy induced) stringencies that have been limiting domestic integration and distorting markets. The paper is organized in five sections besides this introduction. Section 2 shows how closed to trade the Brazilian economy is and highlights the key policy interventions that lie behind these results. Section 3 presents the potential gains accruing from trade liberalization and points to opportunities to boost productivity through trade integration. Section 4 sheds light on domestic market integration and discusses the (policy created) stringencies that have been affecting resource allocation in Brazil; three main areas are highlighted: infrastructure, use of distortive and ineffective business support policies and product market regulation and competition law enforcement. Section 5 shows the potential productivity benefits accruing from stronger competition. Section 6 concludes.

# **_2. How closed to trade is the Brazilian economy and which policies lie behind this result?_**

Openness to trade in Brazil is limited. Trade openness (measured as trade of goods and services over GDP) in Brazil, considering the level of per capita income, is below the predicted line, with no signs of improvement (Figures 1 and 2). In 2017, the ratio of exports plus imports over GDP was 24.11 percent relative to the world average of 56.1 percent. Although larger economies do tend to be more dependent on their domestic markets and export less, Brazil is the least open country and significantly below its benchmarked openness based on different econometric specifications and even after controlling for country size and distance to main partners (Lederman et al, 2014).

<!-- Start of picture text --> Figure 1: Trade to GDP: 2000-2011(%) Figure 2: Trade to GDP: 2012-2017 (%)<br><!-- End of picture text --> <!-- Start of picture text --> Brazil<br>Brazil<br>3 3.5 Log GDP per capita (PPP adjusted -avg 2012-17)4 4.5 5<br>3 3.5Log GDP per capita (PPP adjusted -avg 2000-11)4 4.5 5<br>Source: World Bank staff elaboration using WDI data Source: World Bank staff elaboration using WDI data<br>400 400<br>300 300<br>200<br>200<br>Trade to GDP(%)avg2012-17<br>Trade to GDP(%)avg2000-11<br>100<br>100<br>0<br>0<br><!-- End of picture text -->

> 5 For example, provisions of the tax code that vary with firm size; employment protection measures; product market regulation limiting size or market access; and tariffs applied to specific categories of goods.

> 6 Discretionary provisions made by the government or other entities (such as banks) that favor or penalize specific firms; for instance, subsidies, tax breaks, low interest loans granted to specific firms.

> 7 For example. monopoly power, market frictions, and enforcement of property rights.

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Consistent with a limited trade openness, Brazil’s participation in global value chains (GVCs) is low and is relatively stronger on the seller (forward) side than on the buyer (backward) side. GVCs represent a new path for trade, whereby a country does not need the capability to produce an entire export good but instead contributes a segment of its production process. The latest OECDWTO TiVA data for 2011 suggest that Brazil’s participation in GVC is reduced when compared to international peers and is relatively stronger on the seller (forward) side than on the buyer (backward) side.<sup>8</sup>

**Figure 3. Participation in GVC Brazil vs comparator countries, 2011 (value added as share of domestic and foreign gross exports)**

<!-- Start of picture text --> 50<br>45<br>40<br>35<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>Forward Backward<br><!-- End of picture text --> Source: World Bank staff elaboration using OECD TiVA data The limited openness to trade reflects the use of protectionist trade policies. This includes high tariff barriers to import. Brazil’s average (trade-weighted) tariff rate was 8.3 percent in 2015, the highest rate in comparison to other emerging and advanced economies (Figure 4).<sup>9</sup> Overall, apart from the trade liberalization episode of the early 1990s, when tariffs fell from extremely high levels of 90 percent to 20 percent in wearing apparel, and except for small occasional amendments – such as the inclusion of tariff hikes in 1995 to account for the Mercosur list of exceptions, the generalized tariff increase in 1997 and the temporary rise (for 100 products) in 2012 - the import tariff structure in Brazil has not seen major changes since 2004 (Figure 5).

> 8 The first measure captures the foreign value-added content embodied in Brazil’s gross exports, while the second one is measured as domestic value added embodied in the third-party country’s gross exports.

> 9 This number considers bilateral preferences. The simple average MFM tariff rate was 13.5 for Brazil in 2016.

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<!-- Start of picture text --> 10<br>10+<br>| E E U f I @ M naisiaea<br>—Medaana<br>s s gs se oe S & °<br>a > SS Sh<br>ny ce Ss 7<br>s<br>©<br>o-<br><!-- End of picture text -->
**Figure 6. NTM coverage: Brazil vs other countries, 2015 (%)**

<!-- Start of picture text --> 100.0 89.0<br>80.0<br>66.4 64.6<br>61.1<br>60.0 47.5<br>40.0<br>25.8 22.6<br>20.0<br>5.9<br>0.0<br>Sanitary and Technical Quantity Price<br>phytosanitary barriers controls controls<br>Brazil Other<br><!-- End of picture text --> Source: World Bank staff elaboration using UNCTAD TRAINS data and UN COMTRADE data Note: coverage ratios capture how much trade is subject to a NTM measure. It does not reflect the level of NTM restrictiveness, just the incidence. It doesn’t include local content requirement.

**Figure 7.  Services trade restrictiveness index, Brazil relative to LAC average**

<!-- Start of picture text --> 70<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>Brazil LAC average<br>Source: World Bank staff elaboration using World Bank STRI<br>dataset<br><!-- End of picture text --> Note: higher values mean more restrictive regimes.

Among NTMs, Brazil is imposing local content requirements (LCRs) to an increasing number of products. For instance, in 2012, the Brazilian authorities issued regulations related to the industrial and trade regime for the automotive sector. The use of local content requirements was also prevalent in the oil and gas sectors, a tendency reversed in the more recent licensing rounds. A recent analysis conducted by Stone, Messent and Flaig (2015) maps the use of LCR measures applied between 2008 and April 2014 in several countries around the world. Results show that, in this period, Brazil was second only to Indonesia in the number of LCRs used, with 17 LCRs in force.<sup>11</sup> Trade in services, a key enabler of GVC integration and productivity growth, is hampered by policy and regulatory barriers as well as by a distortive tax structure. The internationalization of production and subsequently trading in the GVC also requires attention to the role of services. Next to the fact that many services are used as inputs into the production of GVC goods, they are also essential in the smooth operation of the GVC to connect different production sides across borders. A clear example is logistics services. The latest OECD-WTO TiVA data for 2011 show that the value added of the service sector (both from domestic and foreign sources) contained in Brazil’s gross exports (49 percent) is above the average of Latin American and the Caribbean (LAC) peers (42.3 percent) but below the OECD average (54 percent). In addition, only one-tenth of the total services content of exports originates from foreign providers. This limited contribution is somehow influenced by substantial policy barriers in the service sector. On average, Brazil has more restrictions to trade in services than the average in the LAC region, according to the World

> 11  Overall, the use of LCR tends to undermine export competitiveness over the long run and lead to suboptimal resource allocation that further affect productivity, since the price hike associated with the change from cheaper foreign suppliers to more expensive domestic suppliers leads to substitution away from these now more expensive, though more efficient, goods and services in the rest of the economy. Estimations presented also by Stone, Messent and Flaig (2015) show that the use of LCRs has caused a decline in global imports and total exports in every region. The estimated permanent reduction in total exports from Brazil due to these measures amounts to 0.65 percent.

6
Bank Services Trade Restrictiveness Index (STRI),<sup>12</sup> with the most restrictive scores in financial and professional services, which are critical inputs across all industries for productivity growth and competitiveness (Figure 7).<sup>13</sup> In addition to restrictive policies and regulations, there is also a distortive tax system for trading services in Brazil: the tax burden on service imports in Brazil compares unfavorably to other countries, which contributes to hamper the absorption of imported technology (Figure 8).<sup>14</sup> <!-- Start of picture text --> Figure 8. Tax burden on service imports: Figure 9. Logistic Performance Index (2016)<br>Brazil vs selected peer countries (%) [very low” (1) to very high” (5)]<br>60.0 5.0<br>50.0<br>4.0<br>40.0<br>3.0<br>30.0<br>2.0<br>20.0<br>10.0 1.0<br>0.0<br>0.0<br>Source: CNI (2017) Source: W orld Bank staff elaboration using World Bank LPI<br>dataset<br>Saudi Arabia South Africa China Germany UK Netherlands South Korea Italia Japan EUA India Mexico Brazil Spain Argentina France<br><!-- End of picture text --> Brazil also faces challenges in trade logistics and trade facilitation. To compete in the global economy, traders require seamless supply chains, including efficient border management and clearance processes, as well as the development of efficient logistics services and improvements in both the hard and soft international logistics infrastructure. The score of overall logistics competence (and quality) in Brazil – as captured by the Logistics Performance Index (LPI) in 2016 – is below Mexico, Turkey, India, China and South Africa (Figure 9). Brazil’s overall integration in GVCs is low compared to international peers in part because of relatively lengthy and costly procedures to import and export.<sup>15</sup> Indeed, firms’ integration to GVCs critically depends on their

> 12 The World Bank STRI data set focuses on policies and regulations that discriminate against foreign services or foreign service providers, as well as certain key aspects of the overall regulatory environment that have a significant impact on trade in services.

13 These results are also valid when using OECD STRI; the latest numbers from 2017 show that Brazil scores worse than Mexico, Chile and Colombia for accounting, architecture, engineering and legal services and for commercial banking and insurance. For telecoms and retail, the value of the Brazil STRI index is zero.

14 The overall tax burden on services is heavier than in other sectors: while the average tax burden on the production and consumption of goods and services is 19.4 percent, it is much higher in the services segments most critical to other sectors of the economy: the tax toll exceeds 23 percent in transport and business services, 27 percent in IT services and over 30 percent in utilities (OECD, 2016). This tends to be particularly burdensome for firms that operate in supply chain organizations as they are not allowed to claim full credit for indirect taxes paid on services inputs in lieu of the "physical credit" principle in ICMS and they cannot claim credit for inputs in ISS.

> 15 This forces firms to adopt costly hedging strategies and complicates their ability to engage in just-in-time production or react quickly to demand shifts. Evidence suggests that inventory-holding costs can vary from 15 percent of the cost of goods per year to as much as 50 percent (Clark et al., 2016). Similarly, each day in transit is equivalent to an advalorem tariff ranging between 0.6 percent and 2.3 percent; and trade in components is extremely time-sensitive

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capacity to provide good quality products delivered on time to buyers further up in the value chain. Yet, unpredictability in customs clearance times due to physical inspection, or delays at border posts generated by excessive cargo handling in response to controls by multiple border agencies, increase uncertainty in delivery times. Despite the recent introduction of the “ _Portal Único de Comercio Exterior_ ” - an electronic data interchange system that has reduced the time for documentary compliance for both exporting and importing<sup>16</sup> - and the recent cooperation agreements between Customs and other border control agencies (as well as with third countries’ agencies<sup>17</sup> ), Brazil still fares poorly in terms of monetary costs of border and documentary compliance when compared to a range of peers (Figure 10).

**Figure 10. Cost to export and import: border compliance in USD (2018)**

<!-- Start of picture text --> 1400<br>1200<br>1000<br>800<br>600<br>400<br>200<br>0<br>Argentina Indonesia Turkey India South Africa China Brazil<br>Cost to export: Border compliance (USD) Cost to import: Border compliance (USD)<br><!-- End of picture text --> Source: data from Doing Business database (2018) The use of those protectionist trade policies, particularly in tariff and NTMS, was not conducive to improve export competitiveness. On the contrary, import protection ends up acting as a direct tax on exports, making them less, not more competitive. The so-called Lerner Symmetry theorem states that an import tariff can have the same effects as an export tax—so reducing import protection is expected also to boost exports. The idea is that an increase in import tariffs appreciates the home real exchange rate as the domestic policy rate and the international interest rate differential increases. The terms of trade appreciation, in turn, induces a positive effect on consumption but a drag on real net exports (Linde and Pescatori 2017). The connection of imports (Hummels and Schauer, 2013). Customs delays also reduce exports value and export market diversification (Volpe Martincus, Carballo and Graziano, 2015).

> 16 Organized as a joint effort between more than 20 agencies and the private sector, Portal Unico promotes the simplification, streamlining and cost reduction of trade-related procedures and formalities with the support of risk management, automation and information technology tools. The initiative aims to eliminate redundant formalities and document requirements, to optimize the performance of the agencies which intervene in trade, and to reduce by 40 percent the average time to export and to import. According to the 2018 Doing Business report, the average time to comply with documentary export obligations fell from 18 to 12 hours between 2016 and 2017, a reduction of a third. The average time on the import side decreased from 120 to 48 hours, a reduction of 60 percent. Brazil improved by 10 positions in the “Trading across borders” indicator.

> 17 Recent examples include the cooperation between Mercosur and the Pacific Alliance countries to enable the exchange of electronic trade documents. Certificates of origin, originally in paper, are already being replaced by digital documents with Argentina, Chile and Uruguay. Brazil is also working to exchange electronic phytosanitary certificates with the United States.

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<!-- Start of picture text --> 5 20%. | |<br>$5P3? 15%<br>Be - ——e- =<br>ao = ~en .<br>a S%<br>=<br>:= oy ie ih| |<br>=7.we2S “10%-5%<br>e<br>=<br>& -15%<br>~ 2006qi = 2007q1 «9 2008q1 «= 2009q1 0 2010q1 = 2011q1 96 2012q1 9 2013q1 9 2014qi = 2015qi = 2016q1 a<br>Change in Brazil's Export Market Share —_ —_<br><!-- End of picture text -->
# **_3. Potential gains accruing from trade liberalization and opportunities to boost productivity through trade integration_**

Policy simulations, obtained from a customized CGE model, point to substantial gains from trade liberalization in Brazil. A customized CGE model for Brazil is applied to assess the impacts of trade liberalization reforms on exports, imports, GDP and output.<sup>19</sup> Three hypothetical liberalization scenarios are modeled (Figure 13). In the first scenario, called “coordinated trade reforms within Mercosur”, each Mercosur member unilaterally reduces tariffs by 50 percent with respect to non-Mercosur countries, NTMs are streamlined among the Mercosur parties<sup>20</sup> and export taxes are eliminated among the parties. In the second scenario, a reciprocal preferential trade agreement between Mercosur and the EU is modeled where the average tariff applied by Brazil to EU products would fall from 10.7 to 3.2 percent in a 10-year time-horizon, while the average tariff in the EU for Brazilian products would fall from about 2.5 percent to close to 1 percent, NTM tariff equivalents are reduced by 15 percent and export taxes are eliminated among Mercosur and EU countries. The third scenario comprehends a preferential trade agreement between Mercosur and the Pacific Alliance, where Mercosur countries and Pacific Alliance members gradually reduce tariffs over 10 years,<sup>21,22</sup> NTM tariff equivalents are reduced by 15 percent and export taxes are eliminated among the parties.<sup>23</sup> 19 The model used is the LINKAGE model, which is a dynamic, multi-sector, multi-region model with economy-wide coverage for each region. For each economy, the model also tracks the inter-linkages between sectors through inputoutput transactions, as well as various sources of final demand including private and government consumption, imports, exports, and investment. The database used is the Global Trade Analysis Project (GTAP) which was modified to update the data and identify subsectors of interest for Brazil. Starting from the GTAP database 9.2, the base year of 2011 was updated to 2015 and the input-output structures for Brazil were updated to reflect the latest official tables from IBGE. The sectoral dimension in GTAP was expanded to include several new sectors of interest in Mercosur countries. These include sectors such as beef, soybean, soybean products, wine, footwear, furniture, home appliances, and auto parts that are part of more aggregate GTAP sectors.

> 20 Resulting in a reduction of 15 percent in the tariff equivalents for goods and services.

> 21 It is worth highlighting there will be already free trade between Mercosur and the Pacific Alliance by 2019.

22 In this case, the trade-weighted average tariff applied by Brazil to products from the countries in the Pacific Alliance would fall from 1.3 to 0.3 percent. The average tariff faced by Brazil in the Pacific Alliance would fall from 2.9 percent to 0.8 percent.

23 For the Mercosur-Pacific Alliance scenario, NTM tariff equivalents are reduced by 15 percent and export taxes are eliminated among the parties. Moreover, a bilateral market access is assumed so that existing liberalization among partners remain. Existing tariff barriers with Pacific Alliance countries have been lowered by previous bilateral or Mercosur agreements under the ALADI framework, especially with respect to Chile and Peru. Most tariff liberalization in this scenario would be with respect to Mexico and to a lesser extent Colombia. Liberalization with the Pacific Alliance is assumed to take place both more quickly and more comprehensively. No products are excluded from liberalization and all tariffs are either removed or partially reduced for the most sensitive products.

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**<u>Figure 13. CGE trade liberalization scenarios</u>**

||“Community reforms” at<br>Mercosur|Mercosur-EU|Mercosur- Pacific Alliance|
|---|---|---|---|
|Tariffs|Tariffs in all Mercosur countries<br>reduced by 50 percent|Bilateral tariffs: in Mercosur from 10.5<br>to 3.1percent; in the EU from 2.5 to<br>0.7percent|<br>Bilateral tariffs: in Mercosur from 1.3 to<br>0.3 percent; in the PA from 2.6 to<br>0.6percent|
|NTMs|Reduced by 15 percent intra-<br>Mercosur; export controls<br>eliminated|Reduced by 15 percent among parties;<br>export controls eliminated|Reduced by 15 percent among parties;<br>export controls eliminated|

The largest economywide gains would come from coordinated trade reforms within Mercosur. The second largest economywide gains would come a reciprocal preferential trade agreement between Mercosur and the EU. Coordinated trade reforms within Mercosur would boost exports and imports by 7.5 and 6.6 percent, respectively, while real GDP would experience a 0.93 percent increase (above baseline projections in 2030). The effects on output would be different across sectors. Figure 15 shows the output percentage deviations from the baseline in 2030. The largest negative effects are seen for manufacturing (-0.8 percent), led by retrenchments of the textiles and apparel sector (-$2.37 billion) and vehicles (-$2.17 billion). All other broad sectors would expand relative to the baseline as resources shift to other activities. On a dollar basis, the services sector expands the most (by $16.6 billion), followed by natural resources and energy products ($10.3 billion), and agriculture ($8.1 billion). The second largest economywide gains would come from a reciprocal preferential trade agreement between Mercosur and the EU. Exports and imports would increase by 5.5 and 4.9 percent, respectively, while GDP would experience a 0.58 percent increase (above baseline projections in 2030). All big sectoral aggregates would experience positive output variations (above baseline projections in 2030): manufacturing would experience the highest expansion (2.2 percent), led mainly by expansion of the footwear sector.

**Figure 14. Economy wide effects - deviations Figure 15. Sectoral output deviations from the from the baseline, 2030 (%) baseline, 2030 (%)**

<!-- Start of picture text --> 4.0 3.4<br>3.5<br>Mercosur-Pacific Alliance 3.0 2.2<br>0.41 2.5<br>2.0<br>1.5<br>1.0<br>Mercosur-EU 0.5<br>0.58 0.0<br>-0.5<br>-1.0 ‐0.8<br>Coordinated trade reforms<br>Coordinated trade Mercosur-EU Mercosur-Pacific<br>within Mercosur 0.93 reforms within Alliance<br>Mercosur<br>0.00 2.00 4.00 6.00 8.00<br>Agri. And food Manufacturing<br>Imports Exports Real GDP NR and energy Services<br>Source: World Bank staff elaboration using GTAP-Linkage Source: World Bank staff elaboration using GTAP-Linkage<br>model model<br><!-- End of picture text --> 11
While the CGE results presented here are conservative estimates, their magnitude is aligned with other recent reform simulations estimated for Brazil. While the model is dynamic in the sense that capital stock can change over time, it does not include other dynamic factors such as productivity increases from endogenous growth effects via technological spillovers, “learning by doing,” and inflows of foreign technology and efficiency-seeking FDI induced by liberalization. Nevertheless, the magnitude of the results is aligned with recent empirical evidence on the potential benefits from furthering trade liberalization on Brazil. For instance, results from IMF (2017) suggest that halving tariffs on capital goods in Brazil would increase the investment-toGDP ratio by about two percentage points. Araujo and Flaig (2016) use a CGE model and show that if Brazil reduces its import tariffs to OECD minimum level, eliminates all local content requirements and reduces export tariffs to zero, aggregate output would grow by 1.7 percent.

At the firm level, higher participation in GVCs is expected to bring productivity dividends to firms. The literature on productivity effects from GVC participation points to three main transmission channels. First, through specialization in tasks. Growth of GVCs has led to increasing specialization in specific activities within value chains. Firms then can reap productivity gains by specializing in those core tasks for which they are most efficient and offshoring less efficient parts of the production process abroad (Grossman and Rossi-Hansberg, 2008). Second, through access to a larger variety and quality of intermediate inputs; as previously highlighted, there is vast empirical evidence in the literature showing the effects of importing inputs in productivity growth (see Halpern, Koren and Szeidl (2015), for instance). Third, through knowledge spillovers from multinational enterprises. To the extent that these firms tend to demand more and/or better-quality inputs from local suppliers and may also share knowledge-technology and encourage the adoption of new practices, sales of GVC-linked local intermediates to international buyers is expected to spur productivity by increasing demand for more and/or better inputs and by providing assistance to local suppliers (Taglioni and Winkler, 2016).<sup>24</sup> The existence of productivity spillovers from structural integration in GVCs for Brazilian manufacturing firms is confirmed by recent empirical analysis. Using a cross-section of around 12,700 domestic manufacturing firms in 22 low- and middle-income countries from the World Bank’s Enterprise Surveys, Winkler (2017) explores the association between GVC integration and labor productivity for Brazil and the full sample (see Annex 1 for a brief methodological presentation). Results suggest that Brazilian manufacturing firms operating in industries with a high structural integration into GVCs, namely which equals or exceeds the 75th percentile across all 22 countries in the sample for that industry, show significantly higher labor productivity levels than those firms that operate in industries with lower GVC integration. Their difference in productivity is stronger for GVC integration as a seller (+11.2 percent on average) compared to GVC integration as a buyer (+8.5 percent on average) in the Brazil sample, holding all other variables constant. By comparison, the findings suggest that GVC integration as a seller at the industry level is correlated with a smaller labor productivity surplus (+3.8 percent on average) in the sample of 22 countries and is non-existent for high GVC integration as a buyer.

> 24 It is worth stressing however that the knowledge spillovers from international buyers and FDI in general tend to accrue asymmetrically, benefitting firms with sufficient absorptive capacity. In this regard, the capacity of a country or a firm to absorb, adapt, and reap the full benefits of knowledge produced at the frontier depends on strategic investments in R&D, organizational know-how, and other forms of knowledge-based capital. (OECD, 2015) provides a theoretical and empirical discussion on the role of technology diffusion as a channel to boost productivity growth.

12
Integrating to GVC represents a challenge to countries that are far from trade hubs. However, there are also some opportunities. OECD (2015) suggests that location is one of the main nonpolicy determinants of GVC participation: evidence suggests that because GVC activity is organized around large manufacturing hubs, the larger the distance to the main manufacturing hubs in Europe, North America and Asia, the lower is the backward (buyer) engagement. On the other hand, while there is a premium to locating close to “headquarter” economies, there are also opportunities for GVC integration for countries located far from large manufacturing hubs; a recent empirical analysis conducted by Cheng et al. (2015) on the determinants of GVC participation suggests that physical distance (weighted by economy size) is negatively associated with trade in GVCs only for low-tech manufacturing sectors. Moreover, production networks serving European or U.S. markets do not need to be the only geographical focus of countries that want to integrate into GVCs. With growing markets in the Americas, a regional network of production might be increasingly sustainable.

Increasing the number and depth of preferential trade agreements (PTAs) offers an important channel to increase participation in GVCs. Given the increasing unbundling of export goods production, PTAs have become the main vehicle to bring in new disciplines (such as competition policy, intellectual property, investment, etc.) that allow factories to connect across borders in a seamless way. The frequency and depth of PTAs have been increasing substantially: data presented in Hollweg and Rocha (2017) show that the number of agreements notified to WTO have increased from about 70 in 1990 to close to 300 presently in force. The same data set<sup>25</sup> shows that more recent PTAs cover more policy areas than earlier PTAs: agreements signed before 1991 included on average 9 provisions whereas agreements signed between 2005 and 2015 included on average 15 provisions; more than 50 percent of agreements include deeper provisions such as anti-dumping and countervailing measures, rules on competition, movement of capital and intellectual property rights. Evidence presented by Hollweg and Rocha (2017) also suggests that GVC-related trade – proxied by trade in parts and components - is higher on average for countries that have signed deeper agreements (Figure 16), where depth of an agreement is the number of legally enforceable provisions.

> 25 The World Bank data set on PTAs content; see Annex 3 for further details.

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these three cases, Brazil ranks in the bottom third of the Doing Business 2018 ranking (176th, 170th and 131th, respectively). With regards to operational costs, the performance is even worse for paying taxes, where Brazil occupies the 184th position out of 190 countries (Figure 20).

# **<u>Figure 20. Doing Business in Brazil: rank and distance to frontier</u>**

|**Topics**|**DB 2018 Rank**|**DB 2017 Distance**<br>**to Frontier (%**<br>**points)**|**Change in**<br>**Distance to**<br>**Frontier 2018-**<br>**2017 (% points)**|
|---|---|---|---|
|Overall|125|56.45|0.38|
|Starting a Business|176|65.05|0.01|
|Dealing with Construction Permits|170|49.83|0.04|
|Getting Electricity|45|82.46|1.23|
|Registering Property|131|52.6|0.02|
|Getting Credit|105|45|..|
|Protecting Minority Investors|43|63.33|..|
|Paying Taxes|184|32.97|..|
|Trading across Borders|139|59.78|4.21|
|Enforcing Contracts|47|66|..|
|Resolving Insolvency|80|47.46|1.69|

Source: World Bank Doing Business 2018 dataset.

Note: An economy’s distance to frontier score is indicated on a scale from 0 to 100, where 0 represents the worst performance and 100 the frontier

## **Box 1. Tax structure and resource allocation in Brazil**

Aggregate productivity performance at country level is particularly impaired by a complex tax structure that hampers resource allocation across sectors and states. As highlighted by Apy (2017), the Brazilian tax structure with regards to goods and services is extremely complex, with four main taxes (ICMS, IPI, ISS and PIS-Cofins) that have distinct incidence coverage (cumulative, non-cumulative and mixed). More importantly, individual products are subject to different regimes depending on the industry, the way the production process is structured (vertical integration versus fragmentation) and the locality where the production process takes place. Thus, relative prices are distorted with impacts on resource allocation and productivity.

As a result, firms are often induced to integrate their activities in a vertical way, even when the production of goods and services would be cheaper if outsourced. Second, the fact that ICMS is cumulative – as it follows the origin principle and has restrictions on input tax credits – impairs exports of goods and services. Third, tax wars and regional tax breaks lead to regional capital misallocation. More specifically, Brazilian states (and also municipalities) have been engaging over the years in tax competition, known as “fiscal war.” Benefiting from full administrative autonomy in setting their ICMS rates, states have used the ICMS as an industrial policy instrument by granting tax exemptions to attract investment, not only in manufacturing but also services (distribution centers). Therefore, firms are often encouraged to locate their activities in regions/states where taxes are lower, even if the production is less efficient.

16
# **_Inadequate state of physical infrastructure_**

Second, the inadequate state of physical infrastructure, another key component of Custo Brasil, constrains connectivity while hindering the increase of economies of scale, which is a crucial feature needed to reap the benefits of trade integration and to boost productivity growth. In principle, increasing the efficiency in overall public infrastructure is expected to raise productivity directly through higher infrastructure capital (measured as capital intensity) which makes private capital more productive. Recent analysis conducted by IMF (2015) - for a panel of 17 advanced economies during the 1985-2013 period - provided evidence that an increase in public investment equivalent to 1 percent of GDP is associated to an increase of labor productivity of 0.5 percent over the medium term, although primary through higher physical capital intensity. The impacts are higher the more efficient is the public spending system. In Brazil, the average rates of investment in overall infrastructure have been decreasing in the past decades, falling from an average of 5.42 percent over GDP in the 1970s and 1980s to an average of 2.15 percent in 2011-16 (Frischtak and Mourao, 2017). This sinking investment trend, explained by a reduction in public investment that was not counterbalanced by private sector investment,<sup>31</sup> brought negative impacts in terms of infrastructure adequacy: Brazil scores lower than its main export competitors on qualitative indicators of infrastructure adequacy, both in terms of overall infrastructure and transport infrastructure (Figures 21 and 22). Moreover, the strong preference for road transport over other modes combined with low percentage of paved roads<sup>32</sup> increases logistics costs. There is also evidence that inadequacy of transport infrastructure is associated with market segmentation in Brazil: evidence presented by Garcia-Escribano, Goes and Karpowicz (2015) shows a positive correlation between slower price convergence across major metropolitan areas and longer commuting times between cities in Brazil. All these factors together contribute to hamper domestic market integration, which then prevents increasing economies of scale, a crucial feature to reap the benefits of trade openness.

<!-- Start of picture text --> Figure 21. Quality of overall infrastructure, rank Figure 22. Quality of road infrastructure,<br>(2016-17) rank (2016-17)<br>1 = best; 144 = worst 1 = best; 144 = worst<br>140 122 123 140 121 123<br>120 120 108<br>95<br>100 87 100<br>80 64 65 80<br>59 54<br>60 60 41<br>35 34<br>40 23 40 26<br>13 14<br>20 20<br>0 0<br><!-- End of picture text --> 31 In addition, public infrastructure spending efficiency in Brazil, and Latin America in general, has been hampered by several factors, as listed by Fay et al. (2017), such as: weak planning, project appraisal and preparation capacity; overly rigid or myopic budgeting; difficulties with budget execution; inefficient procurement system; unclear project sustainability (caused by an imbalance between capital and current spending); uncompetitive construction industry. 32 Almost 60 percent of cargo in Brazil flows through highways of which only 14 percent is paved.

17
Source: World Economic Forum 2016-17 Report Source: World Economic Forum 2016-17 Report

# **_Excessive (and ineffective) use of business support programs_**

Third, several business support programs seem to be inefficient in reaching their objectives and appear to undermine creative destruction. At the micro level, evaluations of specific business support programs suggest a broad lack of impact on productivity. For instance, Lazzarini et al. (2014) analyze BNDES direct activity through loans and equity funding and find evidence that BNDES mostly financed large and profitable firms, lowering their financial expenses, but with no effect on their investments and performance in the period 2002-2009. Also, size-based policies – such as Simples, the largest tax exemption program in place in Brazil – have shown no impact on key economic performance indicators. For instance, Piza (2016) finds that Simples was not effective in increasing formalization rates of small firms. More recently, Corseuil and Moura (2017) show that the same program did not have any impact on firm performance within manufacturing industry: the impacts on wages, employment and value added were all statistically null. In addition, Lei de Informática and Lei do Bem<sup>33</sup> disproportionately benefited a small number of large firms and are not able to cover, by design, young firms that are likely to be more productive. Moreover, a recent assessment of various Brazilian programs of firm support — including productive finance, business consulting, value chain, export promotion, and innovation support – presented by Pires and Russel (2017) suggests there were few positive results on productivity or other indicators; in most cases either no impact was found or regression results were inconclusive. Overall, the evidence suggests that through these non-competitively allocated incentives, Brazil has created an unlevel playing field that has favored the profitability of less efficient firms, both small as well as larger and older firms – thereby preventing more efficient firms from expanding, and likely deterring potentially more productive firms from entering these markets (Dutz et al., 2017).

## **Box 2. Inovar Auto: Key features and impact**

Inovar-Auto was created in April 2012. Its official objective was to promote R&D, improve the quality of domestically produced cars (energy efficiency was a target within this framework) and to promote investment and domestic production.

The incentives provided under the program followed a two-pronged approach. First, it increased a tax levied on industrialized products (IPI) by 30 percent for all light-duty vehicles (LDVs) and light commercial vehicles. Second, it defined a set of requirements for automakers to qualify for up to 30 percent discount in the IPU as follows:

- Meet a corporate average vehicle efficiency target (precisely to improve the average efficiency for new LDVs by about 12 percent from 2012 levels by 2017)

- Conduct a minimum number of manufacturing and engineering activities in Brazil for at least 80 percent of produced LDV and light commercial vehicles,<sup>34</sup> and

33 Lei do Bem is an R&D tax subsidy program instituted in 2007 with the objective of expanding incentives for investments in R&D; it authorizes companies that invest in R&D and meet certain requirements to claim tax incentives automatically for certain types of spending.

34 For cars and light commercial vehicles these manufacturing stages are: Stamping; welding; anticorrosive treatment and painting; plastic injection; motor manufacturing; gearbox and suspension systems assembly; steering and suspension systems assembly; electrical systems assembly; axle and brake systems assembly; monoblock manufacturing or chassis assembly; final assembly, review and testing; and own laboratory infrastructure for product 18
|<br>Choose at least 2 out of 3 pre-requisites to qualify for the program – (1) investment in R&D, (2) investment<br>in engineering, industrial technology, and supplier capacitation, and (3) participation in the Vehicle<br>Labeling Scheme.|
|---|
|In other words, IPI taxes would remain unchanged for those manufacturers that meet the requirements, which in<br>principle incentivizes investments in vehicle efficiency, national production, R&D, and automotive technology.<br>The program was limited to vehicles manufactured between 2013 and 2017, after which IPI rates return to pre-2013<br>levels.|
|While the official objective of the program was to increase the sector’s competitiveness, its real motivation seems<br>to have been to protect domestic producers from losing market share to imports. By not including instruments to<br>promote exports (even a t the regional level), and not boosting the sustained development of suppliers’ capabilities,<br>the program neglected the benefits of a more outward expansion approach while inflicting a longer period for<br>technological catching up, as there was limited space to import inputs of better quality and higher variety.|
|In fact, according to Sturgeon et al (2017), although Inovar-Auto may have shifted demand from imports to<br>domestic production in the short-term, it did not alter the competitiveness of the industry enough to allow Brazilian<br>production to grow through exports or through cost and price reductions in the domestic market. Despite the absence<br>of a counterfactual, the authors present evidence suggesting lack of impact on most economic outcomes, such as:<br>employment, wages, production and productivity. In addition, the authors show that while Inovar-Auto improved<br>the trade balance through a reduction of imports, it did not increase the industry participation in global value chains<br>(via increased bi-lateral trade in intermediates and knowledge-intensive services) and has not increased scale-<br>efficiency, since automakers overinvested in different plants.|
|In August 2017, a dispute panel at the World Trade Organization (WTO) recommended that Brazil withdraw Inovar<br>Auto, supporting complaints of unfair competition by the European Union and Japan. The program was then closed.<br>In July 2018, a new incentive program, Rota 2030, was launched; this program includes among other incentives a<br>federal government grant of up to 1.5 billion reais (US$382mn) in tax credit for every year automotive companies<br>jointly invest at least 5 billion reais on research and development.|

At the regional level, development policies aiming at redistributing economic activity in less flourishing areas have been showing mixed impacts on local productivity growth and might be dampening economic agglomeration effects. Duhaut and Lall (2018) apply a propensity score method combined with a difference-in-differences estimator to assess how credit provided under the regional Constitutional Financing Funds as well as loans provided by BNDES under the Regional Dynamization Policy (the PDR) impact local productivity growth between 2008 and 2014 (see Annex 4 for a methodological presentation). When pooling all minimally comparable areas across all population densities, results suggest that receiving credits from both the Constitutional Funds and the BNDES is linked to a 12 percent higher productivity index in 2014 compared to areas that received Constitutional Funds only. This suggests that regional development programs in Brazil may generate higher productivity dividends if better coordinated.

development and testing. For trucks these manufacturing stages are: Stamping; welding; anticorrosive treatment and painting; plastic injection; motor manufacturing; gearbox and suspension systems assembly; steering and suspension systems assembly; electrical systems assembly; axle and brake systems assembly; monoblock manufacturing or chassis assembly; final assembly, review and testing; final assembly of cabins or bodies, with installation of items, including acoustic and thermal, lining and finishing; production of bodies predominantly through single pieces stamped regionally; and own laboratory infrastructure for product development and testing. For chassis with an engine the manufacturing stages are: welding; anticorrosive treatment and painting; plastic injection; motor manufacturing; gearbox and suspension systems assembly; steering and suspension systems assembly; electrical systems assembly; axle and brake systems assembly; monoblock manufacturing or chassis assembly; final assembly, review and testing; production of bodies; and own laboratory infrastructure for product development and testing.

19
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Except for the Simples size-based tax exemptions and the R&D incentives, the remaining incentives have a sectoral focus and thereby generate distortions across sectors and activities. In addition, Simples also provides incentives to smaller firms, which can create threshold effects in preventing formal firm growth. The bulk of the implicit subsidies created by incentives go to firms in trade and services, and manufacturing industries. These differences across sectors erode a level playing field by favoring some firms and sectors over others.

# **_Additional government interventions: Product market regulations and competition law enforcement_**

Reducing cost of doing business and improving the adequacy of infrastructure are not enough to foster competition in markets and ensure domestic market integration. Effective antitrust enforcement and pro-competition regulation are also important. Even when transport and transaction costs are lower, or when costs of paying taxes, getting electricity and dealing with construction permits are reduced, there may be still firms exercising significant market power even in geographically large and integrated markets, for example, if they agree to collude on prices, or if there is a lack of regulation that prevents the abuse of dominance by firms that supply services in segments with features of a natural monopoly. Effective antitrust enforcement and procompetition regulation minimize these risks and are key pillars of a holistic competition policy.<sup>37</sup> In this turn, while this paper discusses specific policies that can enhance healthy market dynamics and competition, it does not include an assessment of Brazil’s competition policy implementation itself.<sup>38</sup> Available data on product market regulation reveal that government interventions in domestic markets have not been conducive to competition. Competition enhances productivity by improving allocative efficiency, enhancing productive efficiency, and boosting innovation. Aghion, Akcigit and Howitt (2014) also provide a compelling framework linking market competition to productivity growth through creative destruction, while Conway et al (2006) and Alesina et al. (2005) trace the positive impact of pro-competition product market regulation on productivity, and Barone and Cingano (2011) find empirical evidence that pro-competition reforms in input sectors benefit productivity of the overall economy. Furthermore, the introduction of anti-cartel policy is also related to higher labor productivity growth. Symeonidis (2008) records a 20 to 30 p.p. lower labor productivity growth in industries with cartels than in industries without cartels. Some government interventions unduly inhibit firm’s ability or incentives to compete. The OECD Product Market Regulation (PMR) indicator measures the degree to which policies or regulatory measures promote or inhibit competition in areas of the product market where competition is viable. PMR data for Brazil in 2013 suggests that policies and regulations in key sectors are less conducive to competition than in comparator countries.

While other BRICS countries have promoted reforms over the last decade, the overall restrictiveness of product market regulation in Brazil remained unchanged between 2008 and 2013. The general degree of restrictiveness of product market regulations in Brazil has not changed since between 2008 and 2013 and compares less favorably to other economies which on average have moved towards a more pro-competitive regulatory framework (Figure 24). In fact, while others

> 37 _Competition policy_ encompasses a set of policies and laws that ensure competition in the marketplace is not restricted in such a way as to reduce economic welfare (Motta, 2004).

> 38 For more details on what competition policy encompasses, see Kitzmueller and Licetti (2012).

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<!-- Start of picture text --> 3.50<br>3.00<br>zou<br>2.00<br>we<br>100<br>O50<br>0.00<br>OECD Chile Mexico South Russia Brasil} Brasil | China India<br>TOP 5 a/ Africa 2008 | 2013<br>@State control wm Barriers to entry and rivalry m Barriers to trade and investment<br><!-- End of picture text -->

<!-- Start of picture text --> 2.0% 01%<br>0.0% —<br>-20%<br>-40%<br>-6.0%<br>-8.0% 71% 73%<br>-10.0% 8.8%<br>waa 3.7%<br>as “13%<br>-16.0%<br>“18.0% “16.7% -17.3%<br>-20.0%<br>Brasil Mexico OECDTop5a/ = India China Chile SouthAfrica Russia<br><!-- End of picture text -->
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While there are regulatory barriers that hinder the efficient allocation of resources across sectors, regions and firms, some critical markets also have inherent features that reduce contestability and facilitate anti-competitive behavior. This is the case for markets such as cement, fuel distribution and LPG. In 2014, Brazil’s Competition Authority CADE sanctioned 6 domestic cement companies that represented 75 percent of the domestic cement market for forming collusive agreements. While local cement sales had doubled in the past decade, prices had increased by around 33 percent. CADE estimates that customers overpaid around US$9 billion over the two decades the cartel existed.<sup>45</sup> A total of 14 cartel agreements have been uncovered by CADE in fuel retail and LPG markets between 2002 and 2015. In one of these, subsequent consumer savings were estimated at over U$ 10 million a year.<sup>46</sup>

# **_5. Potential productivity dividends accruing from stronger competition_**

Boosting competition in product markets is expected to bring positive payoffs for productivity growth in the manufacturing industry. The acceleration of trade integration combined with the removal of policy induced stringencies that hamper resource allocation would reduce distortions to market functioning while boosting competition in product markets. An econometric analysis is conducted to measure the association between productivity growth and competition intensity for Brazil. The analysis draws on the methodology presented at Aghion, Braun and Fedderke (2008) and uses data at CNAE 3-digit level from 2007–2014 Pesquisa Industrial Annual (see Annex 3 for a methodological presentation). The results suggest that higher price cost margins (implying that firms face lower levels of competition intensity) are significantly associated with lower (labor) productivity growth in the following year (see Figure 28).<sup>47</sup> The economic magnitude of the (average) “effect” is non-negligible: a 10 percent decrease from the manufacturing overall mean price cost margin of 0.14 is associated with an increase in productivity growth of 3.4 percent per year. With regards to this average “effect”, two aspects are worth highlighting. First, the productivity dividends reflect overall competition pressure and therefore include both domestic and foreign competition pressure exerted by trade. In fact, the data show that sectors (at 3-digit level) with higher import penetration present lower price cost margins (see Figure 29), which suggests that increasing import penetration can be one effective channel to increase competition pressure.<sup>48</sup> In addition, a recent empirical analysis conducted by Kannebley Jr, Remedio and Oliveira (2017) shows that the recurrent use of protectionist trade interventions proxied by antidumping measures in the past three decades in Brazil has been associated with an increase in markups of firms that operate in protected sectors. Second, as expected, the magnitude of the (lagged) markup coefficient varies substantially across markets: the productivity growth dividend of a 10 percent decrease in average markup by sector varies from 1.43 percent (“Roasting and Milling of Coffee”) to 7.54 percent (“Magnetic and optical media”), as displayed in Figure A3.1 in Annex 3.

> 45 http://www.reuters.com/article/2014/05/29/brazil-cement-antitrust-idUSL1N0OE2IF20140529

> 46 http://www.cade.gov.br/upload/Brazil_Leniencia_Program_Brochure.pdf

> 47 The relationship between price cost margin and productivity is negative on average and did not present a U-shaped format, as the coefficient of the squared PCM term was not statistically significant (see column 2). This result suggests that, on average, higher degrees of competition are continuously expected to increase labor productivity growth, and there are no industries that may present ‘too much competition’.

> 48 Import penetration data were taken from the Confederacao Nacional da Industria website (available at http://www6.sistemaindustria.org.br/gpc/externo/estatisticaAcessoSistemaExterno.faces).

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# **_6. Conclusions and overall policy recommendations_**

As a result of protectionist trade policies, Brazil’s external integration is limited, which has been preventing local firms from benefiting from multiple sources of productivity gains, such as: reaping the benefits from economies of scale accrued from access to larger markets; relaxing technological constraints through access to better-quality and competitively priced inputs, and facing stronger competition (either from import competition or entry of foreign companies), which pushes firms to increase efficiency.

Evidence compiled by this paper suggests there is large scope for further trade reforms in the country. Tariffs are high, use of NTMs and local content requirements is widespread, and the number (and depth) of FTAs Brazil is signatory of is quite restricted. Unilateral tariff reforms could prioritize reducing tariffs on capital goods and intermediates; reducing tariff escalation and establishing more homogeneous levels of protection; and simplifying the tariff structure by reducing the number of tariff levels. Opening to trade goes beyond tariff liberalization. In this regard, tariff liberalization efforts should be combined with a more aggressive strategy of trade agreements, especially with more technologically sophisticated countries with significant GVC integration and learning potential for Brazilian companies (e.g. Canada, EFTA and New Zealand as warm-up for US, EU and Australia). In addition, LCRs in input markets should be removed and the tax structure on services imports should be streamlined. From the trade facilitation front, the recent unified export system with an online platform that has started to function in mid-2017 represents a major improvement; however, there is still space to streamline other initiatives, such as the Authorized Economic Operator Program where ANVISA and the Army could provide a common assessment framework and a single authorization.

Reducing barriers to trade would bring substantial payoffs for Brazil, according to a customized analysis developed for this paper. Estimations from a customized CGE model show that coordinated reforms at the Mercosur level would permanently accelerate overall trade (parts, components and final goods), increasing both exports and imports by 7.5 and 6.6 percent, respectively, by 2030 relative to the baseline. These reforms would also trigger a permanent expansion of economic activity: real GDP would be 0.93 percent higher than the baseline by 2030. In addition, increasing the level of depth of Mercosur would increase Brazil’s GVC-related trade with Mercosur partners: if Mercosur had all 17 legally enforceable provisions currently in force, Brazil exports in parts and components to other Mercosur members would increase 22 percent on average (US$2,287 million).

Reaping the full benefits from further integration to the global economy will depend on how production factors move across firms, sectors and regions. Evidence compiled by this paper suggests that the resource allocation process in Brazil has been hampered by multiple stringencies created by distortive “behind the border” policies. Four key issues were highlighted. First, high costs of doing business tend to impose a higher burden on entry of new firms that could be potentially more efficient than incumbents. Second, lagging transport infrastructure and lack of technology diffusion policies constrain the increase of economies of scale. Third, federal spending on industrial policies has been growing at high speed and several incentive programs seem not only to be inefficient in reaching their objectives but they also appear to undermine creative destruction. Fourth, product market regulations have not been conducive to competition. Boosting competition would bring productivity gains. Estimations presented in the paper show that a 10 26
percent decrease in the average manufacturing price-cost margin, as would likely occur with greater competition, is associated with an increase in labor productivity growth of over 3 percent per year.

Against this backdrop, key policy recommendations to boost trade integration can be outlined:  _Reform of the tariff schedule_ : The new tariff schedule should be designed to give greater rationality to the protection structure. In addition to high import tax rates, there are a number of distortions resulting from both the Brazilian tariff structure and the way it has been managed, resulting in levels of effective protection badly distributed, ad hoc administration of import tariffs, reintroduction of temporary import quotas associated with tariff reductions, and costly proliferation of tariff exemptions. A new protection structure should be designed to provide longterm predictability for producers and investors in Brazil. The trade liberalization schedule should be announced in advance and be implemented gradually over a few years and should focus on simplification of the tariff schedule, limitation in the number of levels of tax rates, a reduction of the cost of imports of intermediate products and capital goods, and a reduction in the effective rates of protection.

- _Reducing or streamlining the application of non-tariff measures_ , involving, inter alia:

a. Remove local content requirements, in particular in input markets. LCRs in input markets deter integration into GVCs, limit the choice of best-global inputs, and thereby depress productivity & competitiveness of user industries.

b. Reduction of the tax burden on exports. Simplifying national tax regimes, reducing ancillary costs in meeting tax requirements, and eliminating tax residues levied on exports with the payment of tax credits due to exporters is essential to give predictability and greater competitiveness to domestic production.

c. Reinforcement of institutions for technical regulation and product certification (e.g., INPI and INMETRO). Participation in global value chains requires property rights guarantees for technology transfer along the chain and ability to comply with standards and technical regulations. It is essential to reduce time limits in obtaining patents and to develop the capacity to participate in the definition of international norms and regulations that affect Brazilian exports.

d. Reduction of services costs. Reforms should start by reducing the high levels of restrictiveness especially in financial and professional services (substantially above the regional average). It would be important to reassess the tax treatment for imports of technical services in Brazil, essential for technology attraction, business consulting, etc. and currently highly taxed (see CNI 2016). Finally, Brazil would benefit from removing barriers to services trade and investment in international trade agreements - it should start with opening restrictions in its main trade agreement, Mercosur – much more restrictive than most trade agreements in the region, and especially comparted to LAC commitments in FTAs with the US.

- _Reinforcement of the Trade Facilitation agenda_ , including:

- a. Accelerate the implementation of the Single Portal for exports and imports:

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- b. Creation of a single payment system for all government fees.

- c. Use of risk-based assessment at the border, including all agencies involved

- d. Authorized Economic Operator

 _Pursue an aggressive strategy for (deeper) trade agreements_ , starting by completing ongoing negotiations Mercosur-European Union, the main market for Brazilian exports, but also including moving forward in negotiations within the Americas, including Mercosur-Pacific Alliance and resuming the idea of a free trade area in the Americas.

Looking forward, there is also large scope for “domestic” reforms aiming at improving the resource allocation process across firms, sectors and regions. First, reducing economywide regulatory costs of doing business would help alleviate the burdens that are disproportionately higher for new entrants. In addition, the tax structure needs to be streamlined at least to harmonize taxes across jurisdictions to boost the efficiency of resource allocation process across states and municipalities. Second, transport infrastructure needs to be streamlined which requires improving infrastructure public spending efficiency. According to World Bank (2017), Brazil, as most Latin American countries, has limited fiscal space to increase public investments, so much of what is needed to increase public spending efficiency (in transport and overall infrastructure) lies outside the infrastructure sector and has to do with broader government issues—from pro-competition reforms in construction services sectors, such as engineering and architecture (to help bring costs down) to budgeting rules that no longer solely focus on controlling cash expenditures. Third, business support programs need to be revisited and properly evaluated to identify which incentives are effectively working as well as those that should be eliminated to avoid prolonging the distortive incentive structure that private sector firms often rely on to survive. Fourth, tackling anticompetitive business practices and removing product market regulation that restricts competition represent key anchors to boost domestic competition. In this sense, trade liberalization also plays a role as import competition represents an additional channel to boost domestic competition.

Finally, it is key to ensure that the removal of external barriers to integration is accompanied and coordinated with the removal of internal distortions. In addition to the progress achieved in trade facilitation and the initial steps to remove local content requirements, the removal of trade barriers can be accelerated by the elimination of regulatory barriers to export and by an in-depth assessment of NTMs; these are measures that are less costly from a fiscal standpoint and are likely to bring positive impacts on trade and possibly on jobs. As a second step, it is recommended to tackle tariff peaks and tariff escalation in the context of the flexibility Mercosur already offers (i.e. unilaterally) while advancing negotiations on new (PTAs. Meanwhile, the removal of internal market distortions will involve the combination of (medium term) policies encompassing the reduction of regulatory costs of doing business, with focus on the elimination of tax distortions across states, reduction of connectivity costs and boosting domestic competition.

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