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Viewing cable 06BRASILIA2490, BRAZIL'S FISCAL GORDIAN KNOT
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| Reference ID | Created | Released | Classification | Origin |
|---|---|---|---|---|
| 06BRASILIA2490 | 2006-11-27 16:14 | 2011-07-11 00:00 | UNCLASSIFIED//FOR OFFICIAL USE ONLY | Embassy Brasilia |
VZCZCXRO9280
PP RUEHRG
DE RUEHBR #2490/01 3311614
ZNR UUUUU ZZH
P 271614Z NOV 06
FM AMEMBASSY BRASILIA
TO RUEHC/SECSTATE WASHDC PRIORITY 7491
INFO RUEHRG/AMCONSUL RECIFE 5928
RUEHRI/AMCONSUL RIO DE JANEIRO 3418
RUEHSO/AMCONSUL SAO PAULO 8710
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RHEHNSC/NSC WASHDC
RUEHBU/AMEMBASSY BUENOS AIRES 4435
RUEHCV/AMEMBASSY CARACAS 3525
RUEHLP/AMEMBASSY LA PAZ 5019
RUEHAC/AMEMBASSY ASUNCION 5807
RUEHMN/AMEMBASSY MONTEVIDEO 6610
RUEHSG/AMEMBASSY SANTIAGO 5942
RUEHQT/AMEMBASSY QUITO 2056
RUEHPE/AMEMBASSY LIMA 3269
RUEHBO/AMEMBASSY BOGOTA 4020
RHEBAAA/DOE WASHDC
RUCPDO/USDOC WASHDC
UNCLAS SECTION 01 OF 04 BRASILIA 002490
SIPDIS
SENSITIVE
SIPDIS
NSC FOR FEARS
TREASURY FOR OASIA - J.HOEK
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
STATE PASS USAID FOR LAC
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/SHUPKA
DOE FOR SLADISLAW
E.O. 12958: N/A
TAGS: ECON EFIN PGOV PREL BR
SUBJECT: BRAZIL'S FISCAL GORDIAN KNOT
REF: A) BRASILIA 0790 B) BRASILIA 1151
This cable is Sensitive But Unclassified, please protect
accordingly.
¶1. (SBU) Summary: Fresh from its reelection victory, the Lula
Administration has begun to consider the elements of a plan to try
to cut through its fiscal Gordian knot: a rigid budgetary system
rife with constitutional earmarks and revenue sharing requirements,
a large debt service burden, high and complex taxes, a burgeoning
social security deficit, galloping current expenditures growth and
tax cut one-upmanship among the states. Dealing with the fiscal
Gordian knot is a sine qua non for reducing the GoB's high borrowing
requirement, which crowds out private investment and increases
prevailing interest rates, thus dampening the level of sustainable
growth. The end-2007 expiration of a temporary measure
de-earmarking 20% of federal revenues from the constitutional
revenue-sharing and earmarking provisions (known as the DRU),
without which the federal government would be unable to meet all of
its spending obligations, requires that the GoB address many of
these fiscal issues within the next year. Moreover, business and
the middle class are clamoring for reductions in the tax burden,
which exceeds 38% of GDP, and increases in public investment. There
nevertheless appears to be a lack of ambition in the measures
recently mooted by the finance ministry. While details are sketchy,
in its broad outlines the Finance Ministry is proposing: a) some
reform of the social security system; b) to extend and perhaps
expand the DRU de-earmarking provisions; c) to extend but reduce the
CPMF financial transactions tax; d) to make unspecified cuts in
current expenditures and improve tax collection; e) to provide for
Reais 15 Billion (USD 7.1 billion) in low income housing subsidies
drawn from a payroll-tax financed fund; and f) to reduce taxes by
Reais 12 billion/year (USD 5.7 billion) for certain targeted
sectors, including construction, capital investment, and
infrastructure investment funds. Most of these ideas must still be
vetted within the Administration. End summary.
The Fiscal Gordian Knot
-----------------------
¶2. (U) Brazil has a high tax burden for a developing country, over
38% of GDP at the federal, state and municipal level. Moreover, the
tax system's complexity makes compliance onerous and reduces the
efficiency of the economy. Up to 1994, use of the "inflation tax"
meant Brazil did not face a hard budget constraint; many debts could
be inflated away. Tax collection in 1994 amounted to about 26% of
GDP. Former President Cardoso's 1994 inflation-killing Real Plan
made the budget constraint a real one, but the rigidities of the
1988 constitution, which earmarks revenues for certain uses and
requires the federal government to share tax revenue with states and
municipalities, made it difficult to cut federal expenditures. Debt
levels began to increase sharply as governments (especially states
and municipalities) borrowed heavily, often from state-owned banks,
to meet spending demands. This led to a debt payments crisis at the
sub-national level in 1998/99.
¶3. (U) To resolve the debt crisis the federal government assumed the
state/municipal debt but put the states and municipalities on a very
short fiscal leash, the terms of which were enshrined in the Fiscal
Responsibility Law (LRF), which sets limits on state indebtedness,
payroll expenditures, etc. and requires state/municipal payments to
the federal government for the debt it assumed on their behalf. The
state-owned banks were, for the most part, privatized or liquidated.
The cleanup of state-level finances was expensive for the federal
government. Its gross public sector debt grew from 42.4% of GDP in
1997 to an estimated 72.1% in 2006. Currently the great majority of
this debt is financed domestically and is of short tenor. Although
BRASILIA 00002490 002 OF 004
improving, currently the average maturity of the GoB's domestic
bonds is about 30 months and about 37.8% of this debt matures within
the next twelve months. Refinancing these bonds sucks up
significant amounts of domestic capital and crowds out private
investment. It also is one the primary reasons that Brazil has high
real interest rates, currently about 9.6% (based on expected
inflation over the next year).
¶4. (U) Meanwhile, in order to meet burgeoning federal debt service
obligations and other spending demands, the federal government
introduced in 1998/1999 the DRU to exempt 20% of revenues from
earmarks and revenue sharing, as well as a series of new taxes
(which it labeled "contributions" in order to avoid the
constitutional requirement that tax revenue be shared with the
states) over the same period. These contributions helped raise the
tax burden by almost 12% of GDP over the last decade to about 38%
today. Although these new taxes were effective in raising federal
income, they were implemented on a somewhat ad hoc basis, with more
consideration given to enforceability and revenue generating
potential than to the complexity and economic inefficiencies they
would create. Thus Brazil taxes production very heavily -
frequently at the source -and taxes (almost) any bank transaction,
because such levies are easy to enforce.
¶5. (U) Shortly after taking office, the Lula Administration
undertook partial tax reform to make two social "contributions"
assessed on company revenues (the PIS and COFINS) more VAT-like and
remove their cascading application. It increased the rates for both
in order to compensate for the reduced tax base. Due to political
considerations, however, it was forced to abandon an effort to
reform the state-level VAT system (ICMS), one of the main sources of
complexity in the system due to the differing legislation and rates
from state to state. It also has introduced as series of targeted
tax breaks, for example exempting certain exporters' purchases of
capital investments from taxation. Another change reduced taxation
for long term investments in bonds, including government paper.
Other measures benefited the construction and real estate sectors.
What is Being Proposed?
-----------------------
¶6. (SBU) Although there is consensus in most policy circles that
Brazil needs fiscal reform, including mention in the OECD's most
recent report on Brazil, the end-2007 expiration of the DRU (and the
financial transactions tax CPMF) will bring the issue to sharper
political focus. This may prove a useful excuse for the GoB to seek
to undo some of the budgetary rigidities created by the 1988
constitution. Its earmarking provisions and revenue sharing
formulas, coupled with debt service and the wage and pension bill
(i.e. covering the social security system deficit) means that over
90% of federal expenditures are non-discretionary. Allowing the DRU
to expire would push this percentage close to 100%, an untenable
situation for the GoB. At a minimum the Lula Administration will
have to seek to renew the 20% exemption contained in the DRU. Some
commentators have suggested it will push for an expansion to 35% but
ultimately will have to settle for renewal at the 20% level and will
pay a high political cost to woo sufficient congressional votes to
do so. Expansion of the DRU at a higher level, however unlikely,
would allow greater flexibility for re-directing spending to
priorities such as public investment to alleviate infrastructure
bottlenecks.
¶7. (SBU) The burgeoning social security deficit also is a strong
candidate for the most urgent reform for 2007. The deficit in the
private sector social security system (INSS) has doubled from 1% to
2% of GDP and from 6% to 12% of federal expenditures over the last
BRASILIA 00002490 003 OF 004
four years. Left unchecked, it will absorb increasing portions of
the federal budget (ref B). Press reporting indicates that the GoB
is considering a package of management reform measures and the
introduction of a minimum retirement age (currently men who have
contributed to the system for 35 years and women who have done so
for 30 years can retire without regard to their age). The GoB has
discussed grandfathering under existing rules those who already have
met the minimum service requirements but have not yet retired.
While these are useful initiatives, they leave untouched what most
experts have told us is the biggest problem, which is the link
between the minimum wage and minimum pension level. De-linking the
two, however, would require a constitutional amendment.
TABLE - INSS DEFICIT
(Percent of GDP)
2002 2003 2004 2005 2006 /1
-------- ---- ---- ---- ---- ----
INSS
Revenues
(payroll tax) 5.3% 5.2% 5.3% 5.6% 5.6%
INSS
Expenditures 6.4% 6.9% 7.1% 7.58% 7.93%
INSS Deficit 1.1% 1.7% 1.8% 1.98% 2.33%
INSS Deficit
as percent of
federal 6.1% 9.8% 10.1% 10.3% 12.7%
expenditures
--------------------------------------------- ---------
/1 - Predicted 2006 values
-Data Source: Planning Ministry
¶8. (SBU) Beyond the financial burden it imposes, Brazil's tax system
is poorly structured, exacerbating the economic inefficiencies it
creates. There is also some movement to address tax reform, which
was one of the seven policy principles that Lula and the centrist
PMDB party announced November 22 would be the basis for negotiating
a congressional coalition. The document calls for tax reform with a
reduction in the tax burden and incentives for investment, and the
implementation of selective tax cuts. Many analysts believe that
the state-level ICMS value added tax system, which is governed by 27
different pieces of legislation across states with widely varying
tax rates on similar items, needs reform the most. It is unclear
that the GoB will have the political wherewithal to tackle this
complex reform after attempts to do so in 2004 and 2005 were
derailed by state governors unwilling to accept potential revenue
losses. Some elements within the GoB have, nevertheless, proposed
facilitating ICMS reform by creating a federal government fund to
aid the poorer states during the transition to a new system.
¶9. (SBU) Continuing his enthusiasm for targeted tax relief for
favored sectors, Finance Minister Mantega on November 23 announced a
set of measures, many of the details of which are still uncertain,
that would extend Reais 12 billion (USD 5.7 billion) in tax breaks
to some sectors. Mantega stated that the GoB would exempt
infrastructure funds (private investment funds to be created to
invest specifically in infrastructure projects) from income taxes.
In addition, construction materials would be exempted from the
federal VAT on industrial products (known as the IPI). Investment
in certain capital equipment also would benefit from an immediate
exemption from the IPI tax and a delayed credit on PIS and COFINS
taxes.
BRASILIA 00002490 004 OF 004
¶10. (SBU) Current expenditures have been rising faster than GDP
growth over the past two years, in part the product of the Lula
Administration's 12% real increase in the minimum wage since 2004.
While the Lula Administration has never missed a primary budget
surplus target and is unlikely to do so, the growth in current
expenditures has reduced the GoB's ability to invest in
infrastructure. Aside from bromides about good management, the GoB
has said very little about how it plans to contain expenses.
Nevertheless, limiting the growth of expenditures to less than the
growth of GDP was one of the seven policy points agreed on between
Lula and PMDB as the basis for negotiations for forming their
congressional coalition.
¶11. (SBU) The Finance Ministry also has proposed creating space for
greater infrastructure investment by expanding the size of its pilot
investment program (PPI), under which certain infrastructure
investments are not counted against its primary surplus target (i.e.
effectively reducing the primary surplus target by this amount).
Under the plan, the PPI would increase from Reais 4.6 billion (USD
2.1 billion or 0.2% of GDP) to Reais 10.6 billion (USD 5 billion or
0.5% of GDP) and the implied primary surplus target would fall to
3.75% of GDP from today's target of 4.25% of GDP (or 4.05% of GDP
with the current level of investments under the PPI included).
However, while the GoB has included the PPI in recent budgets, it
has yet to use this flexibility to drop below the primary surplus
target of 4.25% of GDP -- the primary surplus result was 4.6% of GDP
in 2004, 4.8% of GDP in 2005 and is expected to be about 4.4% of GDP
in 2006.
¶12. (SBU) Comment: There's much ferment in Brasilia policy circles
over fiscal issues right now as the Lula Administration considers
its strategy for dealing with one of its biggest challenges for
¶2007. Although the election has increased Lula's political capital
and the expected formalization of a coalition with the PMDB may help
Lula get some proposals through Congress, we expect modest results
on the big issues, such as social security reform, expansion of the
DRU de-earmarking measure and reform of the state-level value added
tax. On these issues, entrenched interests and/or the need to
obtain Congressional supermajorities to amend the constitution will
facilitate the work of those seeking lowest-common denominator
outcomes. Whether the measures ultimately passed have a big enough
impact to lower the GoB borrowing requirement and redirect capital
in the economy to the private investment necessary to raise
sustainable growth levels remains an open question. End Comment.
SOBEL