VZCZCXRO7767
PP RUEHRG
DE RUEHBR #0452/01 0751356
ZNR UUUUU ZZH
P 161356Z MAR 07
FM AMEMBASSY BRASILIA
TO RUEHC/SECSTATE WASHDC PRIORITY 8352
INFO RUEHRG/AMCONSUL RECIFE 6353
RUEHRI/AMCONSUL RIO DE JANEIRO 4001
RUEHSO/AMCONSUL SAO PAULO 9400
RUEHMN/AMEMBASSY MONTEVIDEO 6785
RUEHBU/AMEMBASSY BUENOS AIRES 4635
RUEHAC/AMEMBASSY ASUNCION 5982
RUEHSG/AMEMBASSY SANTIAGO 6130
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/USDOC WASHDC

UNCLAS SECTION 01 OF 02 BRASILIA 000452 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE PASS USTR FOR CRONIN 
STATE PASS FEDERAL RESERVE BOARD FOR P.ROBITAILLE 
TREASURY FOR OASIA - J.HOEK 
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: LULA'S MEETING WITH GOVERNORS PRODUCES LITTLE ON 
TAX REFORM AND STATE DEBTS 
 
REF: A) BRASILIA 0149  B) 06 BRASILIA 2562 
 
¶1. (SBU) Summary:  President Lula held a meeting with the governors 
of Brazil's 26 states and the federal district on March 6, in part 
to lay the foundation for cooperation with the governors on some of 
the sensitive fiscal federalism issues that, in an ideal world, Lula 
would address over the course of his second term.  Lula put on the 
table a proposal for unification of the 27 individual state value 
added taxes (known as the ICMS) and three federal VATs into a 
harmonized VAT system with a federal and a state component.  The 
governors also obtained a promise that the federal government would 
allow them to refinance the states' debts to the federal government 
were they able to obtain better terms from the private sector. 
Fiscal expert Raul Velloso, in a March 7 meeting with Econoff, 
assessed that states would have difficulty obtaining better terms 
from private banks.  Velloso, who has links to the opposition PSDB 
party, suggested that Lula put the VAT reform proposal on the table 
primarily to appease private sector pressure for tax reform, and 
that the proposal was likely doomed given the opposing interests of 
state governments.  Lula's bottom line for congressional action this 
year, according to Velloso, would be the renewal of the federal 
financial transactions tax (CPMF) and of the fiscally-critical 
de-earmarking measure (DRU) which exempts 20% of federal revenues 
from constitutional earmarks.  End Summary. 
 
Refinance Now! 
-------------- 
 
¶2. (U) President Lula held a meeting with Brazil's 27 governors (26 
states and the federal district) in Brasilia on March 7.  Many of 
the major topics of discussion were economic.  The governors asked 
for federal flexibility on the terms of payment of state debts to 
the federal government.  These debts were the product of a 
state-level payments crisis of the late 1990's, when the federal 
government assumed payment obligations on all state-level debts to 
third parties.  In exchange, the states assumed obligations to repay 
the federal government, albeit on relatively generous terms, with 
debt rescheduled over as much as 30 years and payments capped as a 
percentage of state revenues.  The terms of these debt contracts 
became part of the fiscal responsibility law, passage of which was 
spurred by the payments crisis. 
 
¶3. (SBU) Some states reportedly have had offers from private banks 
to refinance some of the debts to the federal government on better 
terms, thus reducing their debt service burden and allowing for 
greater spending on other priorities.  The Lula Administration, 
after a review of the fiscal responsibility law, agreed that the 
states could do so as long as the refinancing was from private 
sources, rather than government banks.  Velloso related to Econoff 
that the PT governor of Velloso's native northeastern state of Piaui 
had told him that some foreign banks had approached the state 
government with a proposal to refinance its debt to the federal 
government.  Velloso said he warned the governor to be cautious, 
since he doubted any bank could offer better terms than what the 
state already had. (Currently the state debts to the federal 
government have maturities as long as 30 years and an interest rate, 
which while variable, is competitive to that on the federal 
government's own debt.)  Velloso assessed that the Lula's 
flexibility on state debt refinancing would likely mean little in 
practice as the states would not find better terms than those 
already extended by the federal government. 
 
¶4. (U) The governors also obtained from Lula a promise to study 
other ideas that might help the states financially.  According to 
published reports, these included: 1) allowing states to sell their 
uncollected debts to collection agencies; 2) new criteria for the 
use of the education fund; 3) exempting investments in sanitation 
from the federal PIS and COFINS taxes; and, 4) a pledge to 
facilitate the flow of funding for law enforcement and security 
related spending. 
 
Tax Reform Proposal - Simply Political Maneuvering? 
--------------------------------------------- ------ 
 
¶5. (SBU) Lula put on the table at the governors meeting a general 
 
BRASILIA 00000452  002 OF 002 
 
 
proposal for consolidation and simplification of the various state 
VATs and three federal VATs.  The state-level VATs (ICMS, in its 
Portuguese acronym) have different legislative bases in each of the 
27 states.  Tax rates on the same products vary from state.  The 
ICMS also is an origin tax.  The federal government has three VATs, 
the PIS and COFINS, both of which are "social contributions" and a 
VAT on manufactured products (the IPI).  Lula proposed harmonizing 
the legislation and the rates for the state level VATs and unifying 
the PIS, COFINS and IPI into a single federal VAT.  The state VATs 
would become destination taxes, rather than origin taxes.  Velloso 
stated that, although the proposal included few details, the idea of 
harmonizing and unifying the VATs made sense in principle. 
 
¶6. (SBU) Velloso nevertheless believed that Lula put forward the 
proposal primarily as a political maneuver.  There were too many 
obstacles to reform, Velloso said, both in terms of lost state 
revenues to the political costs of increased transparency in the 
taxation system, as consumers in Brazil currently have little idea 
of how much tax is included the price of their purchases.  Velloso 
said this tax reform proposal would make this much more transparent 
and likely lead to greater pressure for tax reductions, which 
neither the states nor the federal government really wanted. 
Velloso assessed that the reform proposal would ultimately fail 
absent a tremendous investment of political capital by Lula.  But, 
having been seen to address private sector calls for tax reform by 
pressing the states for an (ultimately doomed) effort at reform of 
the ICMS system, Lula would be better positioned politically to 
obtain his congressional priorities for the year, which were renewal 
of the financial transactions tax (CPMF) and of the de-earmarking 
measure (DRU).  The DRU, which expires at the end of 2007, exempts 
20% of federal revenues from constitutional earmarks and 
revenue-sharing requirements.  Without its renewal, the federal 
government would not be able to meet all of its spending 
obligations. 
 
¶7. (SBU) Comment:  Velloso probably understates the extent of Lula's 
economic agenda with Congress.  In addition to renewal of the CPMF 
and the DRU, which is the absolute minimum necessary to keep the GoB 
fiscally afloat, Lula likely intends to press for congressional 
approval of the principal elements of his so-called 
growth-acceleration package, the PAC.  The problem is that the PAC 
is primarily a fiscal stimulus package, rather than the 
comprehensive reform agenda that Brazil needs in order to unlock its 
potential for sustaining higher GDP growth rates.  Unfortunately, 
Velloso is no doubt correct that Lula won't invest the political 
capital necessary to obtain approval of his own proposal for reform 
of the state ICMS taxes and federal VATs.  But it is a positive sign 
that he felt the need to put it on the table at all.  There is still 
pressure for reform, however unlikely it is to succeed in the near 
term. 
 
WILLIAMSON