This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 05 BRASILIA 003953 
 
SIPDIS 
 
NSC FOR DEMPSEY 
TREASURY FOR SSEGAL 
PLS PASS FED BOARD OF GOVERNORS FOR WILSON, ROBATAILLE 
USDA FOR U/S PENN, FAS/FAA/ITP/TERPSTRA 
USDOC FOR 4322/ITA/IEP/WH/OLAC-SC 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PGOV EINV SOCI BR
SUBJECT:  LULA'S TAX REFORM PASSES:  WHAT IT LEAVES TO BE 
DONE 
 
REF: (A) Brasilia 3910, (B) Brasilia 3734, 
     (C) Brasilia 3682, (D) Brasilia 3684 
 
¶1.  LULA'S TAX-REFORM BILL PASSED ITS SECOND SENATE VOTE ON 
DECEMBER 17 BY 64 VOTES TO FIVE AND WILL BECOME LAW WHEN 
PUBLISHED IN THE OFFICIAL GAZETTE ON DECEMBER 22.  HAVING 
ALREADY GAINED PASSAGE OF HIS PENSION REFORM BILL LAST WEEK 
(REF A), LULA HAS THUS ACHIEVED HIS TOP TWIN LEGISLATIVE 
PRIORITY FOR HIS FIRST YEAR IN OFFICE, AND CAN CLAIM IN THIS 
AREA TO HAVE OUTSTRIPPED HIS PREDECESSOR'S LEGISLATIVE 
RESULTS IN FHC'S WHOLE SECOND TERM (THOUGH LULA IS UNLIKELY 
TO POINT OUT THAT THE PT WAS THE MAIN ROADBLOCK TO REFORM 
THROUGHOUT THAT PERIOD.) 
 
¶2.  THE TAX BILL'S CONTENTS, HOWEVER, HAVE BEEN VASTLY 
TRUNCATED SINCE LULA PRESENTED ITS INITIAL VERSION LAST 
MARCH IN EYE-CATCHING STYLE, PERSONALLY LEADING TO THE 
CONGRESS BUILDING A PARADE OF BRAZIL'S GOVERNORS IN WHAT WAS 
MEANT TO SHOW THE LATTER'S SOLIDARITY WITH LULA'S REFORM 
AIMS.  AS DESCRIBED IN REF B, THE GOVERNORS SOON DIVIDED AND 
FELL AWAY, FORCING LULA'S TEAM TO RECOGNIZE THAT ITS 
ORIGINAL DESIGN WOULD NOT PASS.  THE GOB SETTLED FOR A RUMP 
BILL THAT ASSURED IT OF THE TWO CORE MEASURES WHOSE PASSAGE 
BY JANUARY 1, 2004 WAS VITAL FOR THE GOB BUDGET:  EXTENSION 
OF THE CPMF (FINANCIAL-SERVICES `CONTRIBUTION' TAX) AT ITS 
PRESENT 0.38% RATE, AND OF THE DRU (GOB AUTHORITY TO DE-LINK 
20% OF TAX REVENUES FROM CONSTITUTIONALLY-MANDATED 
EARMARKS.)  ALL THE MAJOR CHANGES CONCEIVED TO FOSTER TAX 
TRANSPARENCY, BETTER CONDITIONS FOR PRIVATE-SECTOR 
PRODUCTION, AND -- ESPECIALLY -- AN END TO THE CHAOTIC, ZERO- 
SUM "FISCAL WAR" WAGED BETWEEN BRAZIL'S STATES ON THE BASIS 
OF THEIR AUTHORITY TO SET INDIVIDUAL RATES FOR THE MAIN ICMS 
TAX, WERE STRIPPED OUT TO FACE AN UNCERTAIN FUTURE. 
 
¶3.  As passed, the tax "reform" law (i) extends the DRU and 
the CPMF for four years, (ii) creates a Regional Development 
Fund with resources of Reals 2.2 billion to disburse in 
2004, (iii) provides for the transfer to state and city 
governments of 25% of the federal government's revenues from 
the Cide (fuel) tax (which currently total approximately 12 
billion Reals p.a.) and levies the Cide on imports of 
petroleum and its derivatives, formerly exempt, (iv) adds 
Reals one billion to the Municipal Participation Fund, (v) 
bans the extension by Brazilian state governments of special 
fiscal incentives from the date of the law's effect, but 
apparently leaves ultimate determination of the issue to a 
complementary law, (vi) provides for another complementary 
law to define eventual reduction in the CPMF rate down to 
0.08%, subject to a "trigger" of favorable fiscal 
circumstances, (vii) raises to Reals 6.5 billion the total 
GoB fund to compensate state budgets for revenue losses 
incurred due to the federal "Kandir Law," which exempts 
exports from the ICMS tax. 
 
¶4.  Related tax-reform items outside the approved bill: 
 
-- The GoB apparently still hopes to finalize the reform of 
Brazil's "cascading" Cofins (social-contribution) tax before 
the end of this year.  The Cofins issue was separated out 
from Lula's main tax bill into a presidential Provisional 
Measure (MP) just last month.  All legislators agree the end 
of Cofins' "cumulativity" is essential, but the broad non- 
GoB view is that the MP's proposed hike in the one-time 
Cofins rate to 7.6% from its present 3% would intolerably 
increase Brazil's overall tax burden.  Among other things, 
the MP would start to levy Cofins on import. 
 
-- The ICMS issue is being sent back to the lower Chamber, 
effectively for debate on it to be re-opened there, but with 
no voting schedule stipulated (and debate next year, as 
noted by the December 18 `Estado de Sao Paulo,' would take 
place in the full friction of a local-election year, to 
which its content would be extraordinarily sensitive.) 
-- Finance Minister Palocci has reasserted GoB proposals to 
reduce the IPI (Industrial Production tax) on capital goods, 
and to levy social-security and perhaps other taxes not on a 
company's total payroll but on its gross revenues.  Debate 
on these and other production-friendly GoB tax-reform aims 
remains in an early stage. 
 
¶5.  The above outcome marks what is meant to be just the 
first of three phases in Lula's GoB's overall tax-reform 
plan.  In the next stage, Brazil's National Counsel of 
Financial Policy (CONFAZ, consisting of individual state 
Secretaries of Finance from all Brazil's states) in 2004 is 
 
SIPDIS 
to agree and oversee (with Senate ratification) the 
reduction of Brazil's chaotically multitudinous ICMS rates 
(reportedly 44) to just five national ones, by product.  In 
the third and final stage, the ICMS, IPI (federal Industrial 
Production tax) and ISS (Municipal Services tax) are 
supposed to be combined into a single national VAT.  Hardly 
by chance, this last and most transformational change is to 
be tackled not before 2007, i.e., after Lula's presumptive 
reelection campaign. 
 
¶6.  Financial daily `Valor Economico' on December 15 
reviewed where the watering-down of the GoB's tax bill has 
left things.  The `Valor' article featured a detailed list 
of future constitutional amendments, complementary laws, 
decrees or regulations which the GoB will need to obtain in 
order to implement even the changes contained in the present 
reform, let alone its ambitious further hopes.  Following is 
Embassy's unofficial translation of the useful `Valor' 
article in question, which appeared shortly before the tax 
reform's final passage.  Main text is in para 7; the list of 
further legislation required, in para 8. 
 
¶7.  (Begin Text) 
 
HEADLINE: PASSAGE OF THE REFORM DOES NOT GUARANTEE CHANGE IN 
THE TAX MODEL 
 
The goal of the Lula administration was to finish the 
debate concerning tax and pension reform by the end of 
this year, but the passage of the essential part of the 
two proposals that should occur on the 19th doesn't 
guarantee a change in concept of the tax model.  "Tax 
reform is a process.  Passage (in the Senate) will only 
kindle this process", said the government's leader of the 
Senate, Aloizio Mercadante (PT-SP).  Most of the 
structural changes proposed in the Senate -- that could 
lead to tax simplification, the end of the fiscal war, and 
reduction of the tax burden -- depend on new legislation. 
 
The estimate is that the second round of voting in the 
Senate will be finished on the 18th.  In separate votes 
during in the first round, the senators defeated in floor 
votes the amendment proposed by the bill's sponsor, Romero 
Juca (PMDB-RR) who proposed the delinking (DRE) of 10% of 
state and municipal revenues in the social-program part of 
their budget. 
 
After conclusion of voting in the second round, Congress 
will immediately resume work in 2004 discussing at least 
two constitutional amendment proposals (about the gradual 
reduction of the CPMF, and the incidence of Cide and 
Cofins taxes) and another Provisional Measure that will 
address the tax exoneration of companies' payrolls, 
replacing part of the social security contributions 
collected on salaries by payments based on total turnover, 
in a non-cumulative manner. 
 
In addition, after publication of the whole reform, whose 
date will depend on the political will of the deputies and 
will require a new political agreement, Congress will have 
to analyze at least six proposed complementary laws.  The 
government's expectation is that at least two bills can be 
transacted starting in the second half of 2004.  Judging 
by the text of the tax reform approved in the Senate, two 
projects would need to be voted on in Congress by December 
31, 2004: one that specifies the rules for unifying the 
five new ICMS rates and also exoneration of the `basic 
basket', agricultural inputs and minimum consumption of 
energy; and one which presents rules for a new industrial 
policy for the country, in order to offset the end of 
fiscal incentives. 
 
If reform takes a long time to conclude, its efficacy will 
also be long-term, in the opinion of Finance Minister 
Antonio Palocci.  "Tax policy doesn't belong to the 
government, nor the opposition.  It is a policy for 40, 50 
years, and it's for Brazil," emphasized the minister, 
after complimenting the senators last Friday for their 
drawn-out negotiations and for their having voted for the 
reform in the first round. 
 
Palocci used his typical good humor and optimism to 
comment on the need for broad political effort by the 
Chamber to conclude, in fact, the voting for the reform. 
"We have to think like Mineiros:  everything will turn out 
well.  If it's not well done, it's not finished." 
 
The Minister said that the economic team is still 
calculating the financial impact of the reform.  According 
to the government technical experts involved in the 
negotiations, the biggest probable amount to be released 
in 2004, which is one billion Reals for the 
Municipalities' Participation Fund and 2.2 billion Reals 
for the Regional Development Fund, will come from an 
increase in IPI collections, since the mechanism for 
cumulative compensation from Cofins will no longer exist. 
 
For Palocci, the proposal voted on in the Senate "balances 
the budgets of federative entities, doesn't increase the 
tax burden and creates a set of significant benefits." 
The minister recognizes, however, that tax reduction will 
only occur long-term.  "Brazil should seek a long-term 
reduction of the tax burden, and this should be done 
responsibly, that is looking at commitments and the 
country's economic balance", he affirmed.  This mechanism 
of gradual tax reduction, emphasized Palocci, will have to 
be discussed as part of a new proposed constitutional 
amendment, which could be presented today (December 15) by 
Senator Tasso Jereissati (PSDB-CE), but would only be 
voted on next year. 
 
The minister also recognized that the unification of ICMS 
rates -- which will have to be discussed anew in the 
Chamber - does not materially affect the Federal 
Government.  "The ICMS question, though it does not affect 
us, does greatly affect the economy," he justified. 
 
Another polemical issue that will only be discussed at the 
end of Lula's mandate is creation of an IVA (Value Added 
Tax).  That will also require a constitutional amendment, 
and as it is a most controversial subject, there is no 
political guarantee that the lawmakers will approve this 
constitutional amendment and introduce the new tax. 
 
(End Embassy Translation of Main Text) 
 
 
¶8.  (Start Embassy Translation of Inset Headlined:  REFORM 
UNDER CONSTRUCTION/Tax changes that depend on new laws) 
 
New Proposals for Constitutional Amendments (PEC in 
Portuguese acronym) 
 
-- CPMF:  a new PEC will be presented today (December 15), 
drawn up by Senator Tasso Jereissati (PSDB-CE) that will 
change the constitutional regulation, fixing the maximum 
(0.38%) and minimum (0.08%) rate of the contribution and 
determining that as of 2005 it can fall, gradually, 
according to macroeconomic conditions.  Criteria for 
reduction of the CPMF rate and of the tax burden will have 
to be defined in a complementary law. 
 
-- Cide/Cofins:  a new PEC will also be presented today, 
drawn up by Senator Rodolpho Tourinho (PFL-BA), changing 
the language of Articles 149 and 195 of the Constitution. 
The objective is to make clear that Cide only applies to 
domestic or imported petroleum derivatives.  In addition, 
it specifies that any social contribution (tax) can only 
be applied to imports if it is also charged on domestic 
production. 
 
-- IVA: The tax reform anticipates a Value Added Tax (IVA 
in Portuguese acronym) in 2007.  Since this tax will be 
the fruit of the unification of the ICMS, IPI and ISS 
taxes, various articles of the Constitution will need to 
be modified.  The government is not mentioning any time 
frame for this PEC. 
 
-- Progressive ITBI (transferal/inheritance of goods and 
real estate):  The government wants to take up the debate 
again on a progressive estate tax, but the lawmakers and 
executive need to elaborate another PEC, since the final 
text of the tax reform approved by the Senate defeated the 
progressivity idea and left collection as it is today - 2% 
tax for all transactions.  This new PEC can only be 
presented in 2004. 
 
 
Complementary Law Proposals 
 
-- Exemption of the basic consumer basket, machines and 
agricultural inputs, medicines for human use, minimum 
consumption of electric energy/Unification of ICMS rates: 
after promulgation, the government promised to submit this 
bill in a maximum of 120 days.  The constitutional text 
approved in the Senate requires this law to be promulgated 
by December 31, 2004. 
 
-- Industrial policy: as a form of compensation for the 
end of the fiscal war, the government promises to submit a 
law that will define the concession of credits and federal 
incentives favoring regional development.  Deadline:  120 
days after promulgation of the entire tax reform. 
 
-- Reduction of the Tax Burden:  the "trigger" that links 
tax-rate reduction to the improvement of macroeconomic 
conditions also depends on a complementary law.  The 
government promises that this law will also be submitted 
120 days after promulgation of the whole tax reform. 
 
-- Definition of criteria for re-examining the budget for 
the Export Compensation Fund:  the fund is automatically 
extended into 2004, but the States want to change the 
criteria for the transfer of resources, to consider the 
export balance and type of export, and this will also 
depend on a complementary law.  The date for submitting 
the bill is not specified in the text of the reform. 
 
-- Fiscal Incentives:  The reform says that incentives can 
only be conceded up to the definitive promulgation date of 
the proposed constitutional amendment, and that their 
maximum life is 11 years.  However, the Congress will have 
to approve a complementary law "defining rules in effect 
at the time of concession, that will remain applicable." 
 
-- Regional Development Fund:  The text of the reform 
states that the fund will go into effect immediately after 
final promulgation of the PEC, when the concession of 
fiscal incentives ends.  A complementary law will be 
needed to define criteria for distribution of resources 
from this Fund to the States. 
 
 
Decree/revenue regulations/Provisional Measures (MP in 
Portuguese acronym) 
 
-- Decree by the Treasury Ministry to gradually exempt 
capital goods from the IPI (Industrial Production Tax): 
Minister Palocci has said this will be drafted at the end 
of the month, immediately after promulgation of the first 
phase of reform. 
 
-- Cide MP:  The government promises to edit, probably by 
the end of December, an interim measure defining the 
criteria for transfer of Cide (fuel-tax) revenues to 
states and municipalities. 
 
-- MP to exempt payroll:  the constitutional principle to 
do so is guaranteed in the tax reform, but the government 
has promised to send the MP within 90 days after passage 
of the law establishing the non-cumulative collection of 
Cofins. 
 
-- The national register of taxpayers anticipated to be 
part of the third phase of reform (2007) may be created 
via a normative instruction by the Federal Treasury. 
 
HRINAK