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
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RUEHCV/AMEMBASSY CARACAS 3525
RUEHLP/AMEMBASSY LA PAZ 5019
RUEHAC/AMEMBASSY ASUNCION 5807
RUEHMN/AMEMBASSY MONTEVIDEO 6610
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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