VZCZCXRO3062
PP RUEHRG
DE RUEHBR #0790/01 1141900
ZNR UUUUU ZZH
P 241900Z APR 06
FM AMEMBASSY BRASILIA
TO RUEHC/SECSTATE WASHDC PRIORITY 5193
INFO RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY
RUEHRG/AMCONSUL RECIFE 4650
RUEHSO/AMCONSUL SAO PAULO 6810
RUEHRI/AMCONSUL RIO DE JANEIRO 1930
RUEHBU/AMEMBASSY BUENOS AIRES 3954
RUEHSG/AMEMBASSY SANTIAGO 5449
RUEHAC/AMEMBASSY ASUNCION 5371
RUEHMN/AMEMBASSY MONTEVIDEO 6191
RUEHME/AMEMBASSY MEXICO 1961
RUEHCV/AMEMBASSY CARACAS 3211
RUEHBO/AMEMBASSY BOGOTA 3711
RUEHQT/AMEMBASSY QUITO 1789
RUEHLP/AMEMBASSY LA PAZ 4522
RUEHPE/AMEMBASSY LIMA 2955
RUCPDO/USDOC WASHDC
RHEHNSC/NSC WASHDC

UNCLAS SECTION 01 OF 04 BRASILIA 000790 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
NSC FOR CRONIN 
TREASURY FOR OASIA - DAS LEE, FPARODI 
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE 
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D 
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/SHUPKA 
STATE PASS USAID FOR LAC 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PGOV PREL BR
SUBJECT: BRAZIL AT A FISCAL INFLECTION POINT? 
 
REF: A) BRASILIA 665  B) BRASILIA 608 
 
¶1. (SBU) Summary: The Lula administration heretofore has compiled an 
impressive record of fiscal rectitude, routinely posting primary 
budget surpluses well beyond its formal 4.25 percent of GDP target. 
This performance has allowed the GoB to reduce its net-debt-to-GDP 
ratio (from 57.2% in 2003 to about 51.6% at end 2005).  While these 
results have been commendable, the GoB achieved them primarily 
through higher tax revenues, which grew due to tax reforms in 2003 
and income tax growth based on the strong profitability of certain 
economic sectors in 2004/2005.  Though Lula reduced real 
expenditures in his first year in office, revenue growth since then 
has meant that expenditure growth has been much less constrained in 
subsequent years.  Revenue growth may now have reached an inflection 
point, with March 2006 revenues falling ever so slightly (0.04%) in 
real terms from March 2005 levels.  Newly appointed Finance Minister 
Guido Mantega publicly reiterated on April 19 that the Gob would 
sequester whatever expenditures it must in order to meet its 4.25% 
of GDP primary surplus target.  However, if stagnant revenue trends 
continue, this will exacerbate the political battles surrounding 
fiscal policy in Brazil, and will likely become one of the key 
points of debate in this presidential election year.  Fiscal and tax 
reform will thus become an urgent issue for the new administration 
in January 2007.  End Summary. 
 
Revenue Growth Down 
------------------- 
 
¶2. (U) GoB federal tax revenues in the first quarter of 2006 grew 
much more slowly (1.7% in real terms) than in the two previous 
years, while March revenues were down 0.04% from March 2005 levels. 
The GoB's obligatory expenditures (e.g. government payroll, social 
security, earmarked health expenditures), however, are expected to 
continue to grow apace.  Revenues administered by Receita Federal 
(Brazil's IRS equivalent - this measure of revenues excludes payroll 
taxes that are paid directly to the Social Security system) likely 
will fall from 17.2% of GDP in 2005 to 16.8% of GDP this year, while 
obligatory expenditures climb from 15.5% of GDP to 17.1% (obligatory 
expenditures include payroll, earmarked health expenditures, social 
assistance, government employee pensions and social security 
expenses).  Overall, it accounts for about 90% of central government 
expenditures).  Broader data for the central government as a whole 
(i.e. including the social security system but excluding states and 
municipalities) shows that in the first two months of 2006, revenues 
as a percent of GDP were essentially unchanged (26.28% of GDP in 
2006, vs. 26.25% of GDP in 2005) while expenditures grew from 17.84% 
of GDP to 19.05% of GDP in the same period. 
 
 
   Federal Fiscal Snapshot 
    Percent of GDP 
 
Revenues       2002     2003    2004    2005    2006 /1 
--------      ----     ----    ----    ----    ---- 
 
Administered 
Revenues (tax)     16.3%   15.6%    16.2%   17.2%   16.8% 
 
+ Social 
Security Income     5.3%    5.2%     5.3%    5.6%    5.6% 
 
+ Other Income      2.5%    2.4%     3.1%    3.1%    2.6% 
 
- Transfers to 
 States/Cities      3.9%    3.8%     3.7%    4.5%    4.1% 
-------------- 
Equals Net Central 
Govt. Revenues     20.2%   19.3%    20.4%   20.1%   20.6% 
 
BRASILIA 00000790  002 OF 004 
 
 
 
 
Expenditures 
------------ 
 
Total 
Expenditures       18.0%   17.2%    17.8%   19.1%   18.4% 
 
Obligatory 
Expenditures       15.6%   15.8%    15.4%   15.5%   17.1% 
 
- of which Social 
Security            6.4%    6.9%    7.1%    7.58%   7.93% 
 
- of which Fed 
Payroll and 
Benefits            5.6%    5.1%    5.1%    4.85%   4.92% 
 
--------------- 
Federal Gov. 
Primary Surplus/2   2.4%    2.5%    3.0%     2.9%    2.3% 
 
 
/1 - Predicted 2006 values 
/2 - Does not include state, municipal and parastatal company 
contribution to the public sector primary surplus 
-Sources: Planning Ministry, Finance Ministry, Raul Velloso 
 
 
¶3. (SBU) A well-known private sector budget consultant, Raul 
Velloso, noted to Econoff in an April 13 conversation that the drop 
in revenue growth and increasing obligatory expenditures mean the 
GoB's discretionary expenditures (currently about 10% of total 
expenditures, including investments, operating expenses such as fuel 
for vehicles, communications, etc.) would be dramatically squeezed 
this year.  He thought that the GoB would have a hard time meeting 
the 4.25% of GDP primary surplus target.  Indeed, GoB data shows the 
central government primary surplus (excluding states and 
parastatals, which contribute towards the overall public sector 
primary surplus) dropped from 3.59% of GDP in the first two months 
of 2005 to 2.33% of GDP in 2006.  This is partly to be expected, 
according to Velloso, since in an election year the GoB typically 
concentrates expenditures prior to the election-law-mandated June 30 
cut-off on new investments.  The problem, Velloso argued, was that 
falling revenue growth meant revenues would not cover the continued 
growth in obligatory expenditures (fed, among other factors, by 
Lula's minimum wage increase, which impacts both Central Government 
and social security accounts).  Velloso feared that the GoB would 
not be able to make up the difference in the second half of the 
year. 
 
¶4. (SBU) Velloso - who it must be noted has strong ties to the 
opposition PSDB - explained that previous years' strong revenue 
growth was due to a series of one-off events.  These included the 
revamping of the PIS and COFINS taxes in 2003 to make them more 
VAT-like.  Accordingly, the effect of this reform, which increased 
the effective rates of these taxes, diminished after 2004.  2005 saw 
strong profitability in the commodity-based sectors of the Brazilian 
economy, which significantly boosted income tax revenues paid by 
firms such as mining giant CVRD.  These effects were unlikely to be 
repeated, Velloso argued.  Moreover, in the second half of 2005 the 
GoB implemented legislation granting targeted tax breaks for capital 
investments, the effects of which were now becoming perceptible. 
For example, from March 2005 to March 2006 revenues generated by the 
IPI, a federal VAT on manufactured products, fell 7.65 percent. 
 
Mantega: "Anyone Betting Against Us Will Lose Money" 
--------------------------------------------- ------- 
 
BRASILIA 00000790  003 OF 004 
 
 
 
¶5. (U) Newly appointed Finance Minister Guido Mantega has used 
recent public appearances to reiterate forcefully that the GoB will 
fulfill its 4.25% of GDP primary surplus target.  Testifying along 
with Planning Minister Paulo Bernardo at the April 18 presentation 
of the 2007 Budget Directives Law (i.e., the LDO, a multi-year 
budget framework document) to Congress, Mantega insisted the GoB 
would meet the target this year.  The LDO, moreover, maintains the 
4.25% primary surplus target unchanged for 2007, 2008 and 2009.   In 
an April 19 interview with daily Estado de Sao Paulo, Mantega blamed 
the lower primary surplus for the first months of 2006 not on 
reduced revenue growth, but rather on the election year-related need 
to spend in the first half of the year, as well as unusually high 
carry-over spending from the end of 2005.  Mantega pledged the GoB 
would sequester whatever expenditures necessary from the 
just-approved 2006 budget to meet the 4.25% of GDP target.  He 
dismissed the idea of the GoB attempting to over-perform the target, 
however, as it had repeatedly done under his predecessor, Antonio 
Palocci. 
 
¶6. (U) Background Note: Budget fulfillment is not mandatory in 
Brazil.  Indeed, in an acrimonious annual exercise, the 
administration is required to walk back whatever unrealistic 
revenue, GDP growth, interest rate or exchange rate assumptions that 
the Congress inserts in the budget law and sequester corresponding 
expenditures in order to ensure the primary surplus target is 
fulfilled.  With the April 18 approval of the 2006 budget, the GoB 
within the next weeks should issue a decree identifying budgeted 
expenditures that must be sequestered.  In prior years, public 
investment spending has accounted for the great majority of spending 
targeted for sequestration.  Sequestered expenditures can be 
liberated later if revenues exceed the administration's 
expectations.  End Note. 
 
¶7. (SBU) Separately, Mantega and Bernardo highlighted an LDO 
provision that calls for current expenditures to be cut by 0.1% of 
GDP per year over the next three years (down from the budgeted 2006 
level of 17.71% of GDP).  The GoB hopes to achieve this through a 
requirement, which would take effect immediately upon the LDO's 
approval, that all recurring spending commitments (such as new 
hiring) must receive prior authorization from both the finance and 
planning ministries.  Hiring discipline has been a problem for the 
Lula administration.  March 2006 data showed that the Lula 
administration had created a total of 37,543 new federal jobs, 2,268 
of which are to be filled through presidential appointment.  This in 
part reflects Lula's reversal of policy of the previous two 
governments to outsource jobs wherever possible and reduce the 
public payroll via attrition.  A little less than a quarter of the 
new federal jobs were created to staff new regulatory agencies. 
 
Market Views 
------------ 
 
¶8. (SBU) Most analysts believe the GoB will meet the 4.25% of GDP 
target.  The chief economists of several Brazilian and foreign banks 
told visiting Treasury A/S Clay Lowery on April 4 that they expect 
the GoB to do so.  Separately, Banco Itau Executive Director (and 
former Central Bank director) Sergio Werlang told the press that 
while he believes the GoB will meet the target for the calendar 
year, it is likely that the rolling twelve-month primary surplus 
will dip below 4.25% of GDP at some point this year.  Markets, he 
said, will take that as a bad sign, and it would perhaps slow 
Brazil's march towards an investment grade credit rating.  Gustavo 
Loyola, who recently left his job as a Central Bank director for the 
private sector, chastised market participants for fixating on the 
primary surplus, which he argued should not have become an end in 
itself, but rather was simply an anchor for policies aimed at 
reducing the debt-to-GDP ratio.  Not enough attention was being 
 
BRASILIA 00000790  004 OF 004 
 
 
paid, he said, to reducing the nominal deficit or to the quality of 
expenditure. 
 
¶9. (SBU) Loyola's point on the quality of expenditure is an 
oft-repeated one.  The rigid structure of the GoB budget, with 
constitutionally mandated transfers to states and municipalities, 
along with earmarked expenditures on items such as health and a 
large social security deficit (about 2% of GDP in 2005) financed out 
of general revenues, mean that investments and operating 
expenditures must bear the brunt of fiscal adjustment.  The GoB 
anticipates, for example, that federal discretionary expenditures 
including investments will fall from 3.29% of GDP in 2005 to 2.82% 
in 2006.  In its first years, the Lula administration advanced 
measures that could make up for the shortfall in public investment 
spending and ameliorate the public infrastructure deficit, notably 
the Public Private Partnerships (PPP) legislation which was passed 
in December 2004.  Despite the fanfare that greeted its passage, 
implementation has been slow and the GoB has yet to put out for 
tender any PPP projects.  The private sector is increasingly 
concerned about the infrastructure gap, predicting that Brazil may 
well face energy shortages in the medium term (2008/2009) due, in 
part, to the GoB's problematic overhaul of the energy sector 
regulatory framework in 2004/2005. 
 
¶10. (SBU) Comment: The falling growth in revenues, if it proves a 
more durable trend, stands to exacerbate the always lively and 
sometimes acrimonious fiscal policy debate.  As several contacts 
have observed to us, the first step to cutting through Brazil's 
budgetary Gordian knot is to bring current expenditures under 
control, which has been problematic for the Lula administration. 
The 2007 LDO contains some useful measures aimed at doing so, but 
with the Lula administration continuing to beat off corruption 
scandals even as it tries to prepare for the October 2006 elections, 
there is little hope that it will make hard decisions on longer-term 
expenditure constraint.  Instead, it will likely just muddle through 
the remainder of the year, trying to placate both the markets and 
its political constituencies.  The GoB has both the tools and the 
political will to meet the primary surplus target (as we expect it 
ultimately will), but the fiscal dynamics involved mean it will 
occur at further cost to the quality of public expenditure.  Fiscal 
and tax reform, therefore, will need to be at the top of new 
administration's agenda come January 2007. 
 
LINEHAN