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DE RUEHSO #1005/01 3551730
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P 211730Z DEC 07
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TO RUEHC/SECSTATE WASHDC PRIORITY 7780
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RUEHRG/AMCONSUL RECIFE 3939
RUEHRI/AMCONSUL RIO DE JANEIRO 8509
RUEHBU/AMEMBASSY BUENOS AIRES 3001
RUEHAC/AMEMBASSY ASUNCION 3247
RUEHMN/AMEMBASSY MONTEVIDEO 2561
RUEHSG/AMEMBASSY SANTIAGO 2258
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RUEATRS/DEPT OF TREASURY WASHDC
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RUEHRC/USDA FAS WASHDC 0709

UNCLAS SECTION 01 OF 04 SAO PAULO 001005 
 
SIPDIS 
 
SIPDIS 
SENSITIVE 
 
STATE FOR WHA/BSC, WHA/EPSC 
STATE PASS USTR FOR KATE DUCKWORTH 
STATE PASS FED BOARD OF GOVERNORS FOR ROBITAILLE 
STATE PASS EXIMBANK 
STATE PASS OPIC FOR DEMROSE, NRIVERA, CMERVENNE 
NSC FOR TOMASULO 
TREASURY FOR JHOEK 
USDOC FOR 4332/ITA/MAC/WH/OLAC 
USDOC ALSO FOR 3134/USFCS 
 
E.O. 12958: N/A 
TAGS: EFIN EINV ECON PGOV BR
SUBJECT: CPMF DEFEAT WILL NOT BREAK LULA'S BANK 
 
REF:  Sao Paulo 768 
 
¶1.  (U) Summary: The Lula Administration suffered a serious setback 
on December 12 when the opposition defeated the extension of a 
financial transactions tax (CPMF) that brought in more than R$40 
billion (approximately USD 22.5 billion) into the government 
coffers.  Despite the revenue loss, most financial analysts are 
hopeful that the Brazilian government will maintain the primary 
fiscal surplus of 3.8 percent of GDP in 2008.  Contacts tell us that 
healthy economic growth should result in additional tax revenue and 
make up part of the shortfall.  In addition, the GOB could use a mix 
of tax hikes, cuts in discretionary spending, and cuts of transfers 
to state governments to cover the revenue lost due to the 
discontinuation of CPMF.  A failure to maintain the primary fiscal 
surplus, however, could put off an upgrade to an investment grade 
sovereign credit rating, according to Moody's, but other financial 
institutions such as Banco Itau are less pessimistic.  The economic 
impact for consumers will be difficult to gauge; however, the Sao 
Paulo business community is hopeful that the defeat will open the 
door for fiscal reform including a tax reform that simplifies 
Brazil's tax system.  The full economic impact ultimately rests on 
the GOB's reaction and how it plans to recover from the political 
defeat and the loss of this significant source of government 
revenues.  End Summary. 
 
CPMF Defeated 
------------- 
 
¶2.  (U) On December 12 in a move that surprised most analysts, the 
opposition parties in the Senate defeated President Lula's efforts 
at renewing the Provisional Contribution on Financial Movements 
(CPMF) tax that expires December 31.  Lula's coalition was four 
votes shy of the needed 60 percent majority for the constitutional 
amendment to extend the CPMF.  Even though earlier this year, 
Finance Minister Guido Mantega indicated that extension of the CPMF 
was a top priority and in September, the Lower House approved an 
extension through 2011, President Lula was unable to convince enough 
opposition Senators to break with their party and vote to continue 
the tax.  Seven members of the coalition also did not support the 
measure.  The defeat is a significant political setback for the Lula 
Administration, who put in countless hours and resources over the 
last six months, and will cost the government of Brazil (GOB) more 
than R$40 billion in annual tax revenues.  [Note: Brasilia will 
report the political ramifications of the CPMF defeat septel.  End 
Note.] 
 
¶3.  (U) President Lula has publicly reassured the financial 
community that his Administration will maintain the primary surplus 
and promised to carefully evaluate all possible solutions before 
making any decisions. According to press reports on December 20, an 
initial package of options for consideration from the government's 
economic team (including the Ministers of Planning and Finance) to 
cover the R$40 billion shortfall would include recovering R$12 
through tax increases, R$18 billion through public expenditure cuts, 
and finding the extra R$10 billion by revising the figure for 
estimated tax collections.  The December 19 Senate passage of the 
DRU renewal (a constitutional amendment permitting the government to 
reallocate up to 20 percent of the (heavily earmarked) budget) until 
2011 was crucial in any strategy to cut expenses and protect social 
programs.  To secure passage, the government had to commit to the 
opposition that it would discuss proposed cutbacks with the 
opposition and that it would not submit the failed CPMF package 
as-is again for a vote.  Economic Ministries are now tasked to 
analyze possible budget cut proposal in January with a view toward 
discussion and budget vote in February. 
 
¶4.  (U) When Finance Minister Mantega initially speculated publicly 
that taxes would have to be raised, President Lula publicly 
contradicted him, saying taxes would not rise in 2008. Speculation 
has been rife in the business and press communities that Mantega 
 
SAO PAULO 00001005  002 OF 004 
 
 
will take the fall for CPMF's extension failure and could step down 
and be replaced from rumored candidates ranging from Central Bank 
President Meirelles to Fernando Pimentel, mayor of Belo Horizonte. 
[Note: A CAMEX contact of the Embassy in Brasilia said yesterday, 
however, that Lula complimented Mantega at a cabinet meeting 
December 20 and Mantega is now wreathed in smiles, appearing 
confident he will keep his job.  End Note.] 
 
 
CPMF Explanation 
---------------- 
 
¶5.  (U) The CPMF tax is applied to financial transactions including 
bank withdrawals, debits, transfers, and checks.  Originally 
approved in 1996 for a two year period to finance public health care 
spending, the CPMF has been re-authorized three times (1999, 2002, 
2003). The CPMF rate is 0.38 percent per transaction, is not popular 
with the business community, and serves as a disincentive to 
participation in the financial system.  However, it importance to 
the government's budget has increased over time as Brazil relies on 
this revenue to help fund Bolsa Familia and health system costs. 
Brazilian tax officials have reported the CPMF strengthened overall 
tax compliance by helping to identify firms and individuals in the 
informal economy that previously avoided paying taxes. 
 
Filling the Gap 
--------------- 
 
¶6.  (SBU) Despite initial negative reactions, financial analysts 
appear mostly agreed that the government should be able to maintain 
a primary fiscal surplus, but perhaps not the current 3.8 percent of 
GDP target.  Merrill Lynch Economic Research analyst Virgilio Castro 
Cunha told Econoff the government should comfortably beat the 
primary surplus target this year and would likely meet it again in 
2008 even without the CPMF revenues.  Tomas Malaga, head of Banco 
Itau's Economic Research Department, told Econoffs that even at a 
smaller primary surplus Brazil should continue bringing down 
Brazil's net debt.  Furthermore, Ministry of Finance economists 
emphasized to the U.S. Treasury Attache that the GOB has enough 
funds and that the GOB would collect enough additional tax revenues 
to "get by" without adjusting the primary surplus. 
 
¶7.  (SBU) Private sector financial analysts have predicted that the 
Brazilian government will likely undertake multiple measures to 
cover the lost revenues, including a mixture of tax adjustments, 
expenditure cuts, and lower transfers to other government bodies. 
The most likely candidate is the IOF which has a smaller tax base 
and could recover about 0.25 percent of GDP (about R$10 billion) in 
lost tax revenues.  [Note: The IOF is a tax levied on credit 
concessions, insurance products, foreign exchange transactions and 
other similar transactions.  Under the Fernando Henrique Cardoso 
administration in 1999, the GOB increased the IOF as a provisionary 
measure while CPMF was suspended for a few months.  End Note.] 
According to Banco Itau's Malaga, even though raising the IOF tax 
would be a popular choice in Congress because its impacts are by and 
large felt by wealthier Brazilians and the GOB can increase this tax 
by decree, it ultimately could create distortions in the economy as 
great at the CPMF tax did.  Malaga told Econoffs that the other 
likely tax is CSLL, which would require a simple majority approval 
by Congress.  ABN Amro estimated these two taxes could increase 
revenues by about R$16 billion in 2008. 
 
¶8.  (SBU) Both Malaga and Cunha told Econoffs they expect some 
expenditure cuts in 2008 as well.  Malaga was enthusiastic about 
President Lula's recent remarks suggesting his Administration would 
carefully weigh the next steps but would maintain the primary 
surplus target.  Malaga opined that the GOB would ideally use this 
defeat to hold back its expenditures.  ABN Amro estimated in its 
financial publication that the GOB could cut some of its 
discretionary outlays by as much as R$16 billion, including scraping 
 
SAO PAULO 00001005  003 OF 004 
 
 
plans to increase investment and raise public sector salaries in 
¶2008.  The GOB may also limit transfers to state governments for 
social programs and to political parties for upcoming municipal 
elections, according to these analysts. 
 
¶9.  (SBU) The GOB could potentially resort to a series of other 
means to cover the remainder of the revenue gap including possibly 
reintroducing another tax similar to CPMF in 2008.  Malaga reasoned 
that additional tax revenues from higher economic growth would 
mitigate some of the revenue shortage.  Merrill Lynch's Cunha told 
Econoff that the GOB will receive more than R$65 billion in 
additional tax revenues this year due to stronger than expected GDP 
growth, and likely even more in 2008.  ABN Amro suggested the 
government could also reduce investments for its state-owned 
enterprises, including Petrobras.  Furthermore, Cunha underscored 
the GOB's inability to execute its 2007 investment budget and 
expected it would have the same difficulties in 2008. 
 
Investment Grade Requires Fiscal Discipline 
------------------------------------------- 
 
¶10.  (SBU) Luiz Tess, Moody's Brazil Representative Director, told 
Econoff that maintaining fiscal discipline continues to be the most 
important determinant of whether Brazil receives an investment grade 
sovereign credit rating.  He noted that the GOB's failure to secure 
CPMF renewal doesn't hurt automatically Brazil's chances for an 
upgrade, but it does create more uncertainty and puts more pressure 
on the government to keep its fiscal targets in-line.  [Note:  This 
position has not changed demonstrably from Econoff's meetings with 
Moody's in September (reftel).  End Note.]  Banco Itau's Mauricio 
Oreng, on the other hand, does not expect a change in the primary 
surplus target and has not altered his prediction for a sovereign 
credit rating in 2008. 
 
Household-level Impacts of No CPMF 
---------------------------------- 
 
¶11.  (SBU) Because many Brazilians do not participate in the formal 
financial system (two-thirds of Brazilians do not have bank 
accounts), the impact of not paying the CPMF tax may not be 
dramatically felt at the individual household level.  However, 
Malaga pointed to a potential indirect increase in demand as 
consumers have more money to spend.  [Note: The Brazilian Institute 
of Tax Planning (IBPT) estimated the average Brazilian paid R$172 in 
2006 in CPMF.  End Note.]  The CPMF has a cascading effect across 
the entire value chain of a final good's production.  The 
influential Brazilian magazine Veja in a report in September 
calculated that the total CPMF tax was approximately two percent of 
the total price of finished products, after aggregating across all 
steps of the production process. Planning Ministry officials have 
noted that CPMF revenues represent 1.5 percent of Brazilian GDP. At 
the margin, however, Cunha said it would be hard to define the 
direct and indirect impacts without CPMF because the Brazilian 
economy has been outperforming expectations. 
 
¶12.  (U) Financial institutions and businesses that bore the 
admittedly light administrative burden of collecting CPMF should 
feel some relief.  On average, tax compliance in Brazil for 
companies requires 2600 hours per year--the largest figure in the 
world and eight times more than is required in the U.S. 
 
¶13.  (U) Despite CPMF's explicit goal to help improve healthcare, 
the revenues were collected into the central Treasury where they 
were redistributed.  Many of the tax's critics note the revenues do 
not actually contribute directly to healthcare.  For instance, as 
reported by Veja, even with CPMF revenues in hand, the Ministry of 
Health failed to meet its four healthcare goals. In reviewing areas 
for potential budget cuts, protecting the health sector is a stated 
opposition priority and a political necessity for the Lula 
government. 
 
SAO PAULO 00001005  004 OF 004 
 
 
 
Tax Reform Impact 
----------------- 
 
¶14.  (SBU) Both Malaga and Cunha noted the defeat could prompt the 
Lula government to broach some form of tax reform in 2008, a welcome 
sign in a country where the tax burden is 35 percent of GDP.  Cunha 
noted the defeat might give the GOB enough room to come to the 
negotiating table.  Vice-President of the Sao Paulo Federation of 
Industries (FIESP), Saturnino Sergio da Silva, told Econoffs the 
defeat opens the door to discuss other pending business for the 
country, including tax reform and infrastructure development.  The 
federal government's buy-in to any tax reform negotiation with state 
and municipal governments is essential because federal taxes 
comprise three-quarters of total tax revenues, he said.  On the 
other hand, other analysts in Brasilia have speculated that failure 
of the CPMF will lead to indefinite delay in the government tabling 
the tax reform package it reportedly already has ready (originally 
intending to table it once CPMF was passed) and to lack of 
willingness to consider tax reform measures that would further lower 
short-term revenue collections even if they encourage longer-term 
growth. 
 
Comment 
------- 
 
¶15.  (SBU) The defeat of the CPMF renewal leaves the GOB fumbling 
for answers, while the business community cautiously awaits the 
GOB's response.  Lula invested significant political time and 
capital to extend the CPMF.  The controversial vote came at a time 
where the Brazilian economy is seeing tax revenues growing, economic 
growth picking up, lower inflation, and falling (though still high) 
interest rates.  These factors mitigate to some extent the loss of 
this CPMF revenue. 
 
¶16.  (SBU) The economic impact and financial sector's reaction 
ultimately hinge on the Brazilian government's reaction.  However, 
as Brazil heads into the holiday season, we are unlikely to see any 
real movement in tackling this issue until after Carnival in 
early-February when business returns to normal in Brazil.  If the 
GOB did decide to tinker with the primary surplus target, as 
currently appears unlikely, it could face serious consequences 
including a possible sovereign credit downgrade, an interest rate 
hike, and a retreat in international capital flows.  However, given 
what appears so far to be a pragmatic approach to dealing with this 
issue both politically and economically, post believes the economic 
impact of the loss of the CPMF tax is likely to be minimal.  End 
Comment. 
 
¶17.  This cable was cleared by the Treasury Attache in Sao Paulo and 
the Embassy in Brasilia. 
 
WHITE