VZCZCXRO9014
PP RUEHRG
DE RUEHSO #0012/01 0101618
ZNR UUUUU ZZH
P 101618Z JAN 08 ZFF6
FM AMCONSUL SAO PAULO
TO RUCPDOC/DEPT OF COMMERCE WASHINGTON DC PRIORITY
RUEHC/SECSTATE WASHDC PRIORITY 7810
INFO RUEHAC/AMEMBASSY ASUNCION PRIORITY 3260
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UNCLAS SECTION 01 OF 05 SAO PAULO 000012 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
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 
UDSOC ALSO FOR 3134/USFCS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PREL BR
SUBJECT: LULA'S PLAN TO RECOVER CPMF REVENUES AS EXPECTED 
BUT NOT WITHOUT OPPOSITION 
 
REF: A. SAO PAULO 1005 
     ¶B. SAO PAULO 0832 
 
 ¶1.  (SBU) SUMMARY: The Brazilian government announced on 
January 2 three ways for compensating for lost revenues after 
losing the battle to renew the Provisional Financial 
Transactions Tax (CPMF) in December.  As expected, the GOB 
announced a mix of tax hikes and potential cuts in government 
spending to cover the shortfall from the lost CPMF revenue 
(R$40 billion or approximately USD 23 billion at the current 
exchange rate).  While the tax hikes have been announced in 
the form of increases to another financial transactions tax, 
the IOF (Financial Operations Tax), and increases in the CSLL 
(Corporate Profits Tax), the GOB is holding off on defining 
cuts in spending until February when Congress reviews the 
2008 budget.  The tax hikes are not expected to hurt Brazil's 
prospects for strong economic growth in 2008, but might hit 
some consumers harder than others and has the potential to 
slow the exploding growth in credit.  The political 
opposition is attacking the Lula Administration for 
backtracking on its December promise not to raise taxes by 
specifically calling into question the constitutionality of 
the two tax hikes and by threatening to stop negotiating 
comprehensive tax reform.  One potentially positive impact of 
the increase in the IOF tax is a likely slowing of credit 
growth, which would alleviate some of the Brazilian Central 
Bank's fears of growing inflation.  As for spending cuts, 
Post is not convinced the GOB will follow-through on all the 
spending cuts, nor would these cuts be necessary.  The 
forecast for robust economic growth in 2008 will likely mean 
higher tax receipts.  In addition, it appears that the GOB 
has underestimated the additional revenues it will receive 
from increasing the IOF tax.  END SUMMARY. 
 
¶2.  (U) On January 2, Finance Minister Guido Mantega and 
Planning Minister Paulo Bernardo announced three measures 
aimed to partly compensate for the revenue losses from the 
end of the Provisional Financial Transactions tax (CPMF) in 
December (Ref A).  The R$30 billion package is in line with 
market expectations, and includes R$20 billion in spending 
cuts and R$10 billion in tax hikes on two taxes, the 
Financial Operations Tax (IOF) and the Tax on Corporate Net 
Profits (CSLL).  (Note:  Technically speaking, the spending 
cuts the GOB plans to make are reductions in expenditure 
growth; the GOB's overall spending is still expected to be 
higher in 2008 than 2007.  Other economic contacts indicate 
that these taxes will generate significantly more than R$10 
billion.  End Note.)  As an explanation for raising the IOF 
tax, Mantega stated that increases in the IOF would slow down 
the rate of credit growth and provide a small hedge against 
inflation.  (Note:  The overall credit market in Brazil grew 
by some 25 percent in 2007 and individual credit grew by more 
than 32 percent.  End Note.)  Concerning cuts to government 
spending, Minister Mantega again reaffirmed that the GOB will 
not make cuts to Bolsa Familia and to the Program for Growth 
Acceleration (PAC) without specifying which programs would 
receive spending cuts. 
 
IOF-Financial Operations Tax Increased 
-------------------------------------- 
 
¶3.  (U) The GOB issued a decree effective January 4 to 
increase the IOF which is a tax on a variety of financial 
transactions including credit, foreign exchange, and 
insurance and stock purchases.  The decree increases the IOF 
by a fixed 0.38 percent on all financial operations 
 
SAO PAULO 00000012  002.2 OF 005 
 
 
previously taxed under the CPMF (currency exchange operations 
for exports, foreign exchange from service revenues, goods 
and services and spending abroad using credit cards).  In 
addition to the 0.38 percent, the GOB doubled the rate 
applied to personal credit transactions to approximately 
three percent per year or 0.0082 percent calculated on a 
daily basis.  Originally the IOF accounted for about 1.3 
percent of federal revenues (approximately R$8 billion).  The 
IOF is not applied to foreign portfolio investments; however, 
repatriation of profits by Brazilian firms abroad is subject 
to IOF, as well as foreign direct investment in Brazil. 
Personal mortgages continue exempt from IOF, but mortgages 
for investment properties are subject to the three percent 
plus 0.38 percent surcharge. 
 
¶4.  (U) Under the decree, corporations pay IOF on more 
financial transactions including 0.38 percent on operations 
involving the export of goods and services and the import of 
services.  Furthermore, the government created a specific tax 
rate for imported products that the GOB suspects have an 
unfair advantage in the domestic market, such as textiles, 
machine parts, and apparel, among others.  The GOB also 
expanded the breadth of financial transactions covered by the 
IOF (adding an additional fixed 0.38 percentage point 
increase to the 1.5 percent levied) on corporate credit 
transactions to include the Brazilian development bank 
(BNDES) loans, financing for machinery and equipment, loans 
for rural exporters and rural producers, and on government 
transfers and financing of employment generation programs. 
 
Corporate Profits Tax Increased 
------------------------------- 
 
¶5.  (SBU) The GOB also notified Congress of a provisional 
measure to increase the CSLL from nine percent to 15 percent 
for financial institutions, which the GOB estimates would 
bring in an additional R$2 billion.  Minister Mantega said 
that GOB chose financial institutions (including investment 
banks, finance companies, mortgage associations, credit card 
companies, leasing companies, stock markets, and insurance 
and capitalization companies) over other industries because 
the banking sector is the most profitable sector in Brazil. 
The GOB must wait 90 days to begin collecting the additional 
tax, and Congress has 120 days to vote on the bill. 
Vice-President of Economic Research at Itau Corretora 
Mauricio Oreng told Econoff that Brazilian banks should be 
able to absorb the additional tax because the banking 
industry was extremely profitable in 2007.  Several economic 
interlocutors, however, say that banks would likely pass on 
the increase to consumers rather than lower their profits. 
 
Effect on Companies and the Economy 
----------------------------------- 
 
¶6.  (SBU) Overall, economic interlocutors told Econoff that 
they don't believe the tax hike will have a significant 
negative impact on economic growth.  Oreng said he expects 
GDP growth above five percent unless the Brazilian Central 
Bank raises interest rates, which he sees as a growing 
possibility due to creeping inflation.  Although the IOF 
increases are designed to replace the previous CPMF tax, many 
industries are still better off than under CPMF, according to 
local financial analysts.  Industries with long production 
chains felt the largest impact under the CPMF tax (Ref A) 
because of its cascading effect on all stages of production. 
The IOF, on the other hand, is less of a drain on the 
 
SAO PAULO 00000012  003.2 OF 005 
 
 
competitiveness of these industries because the tax is 
applied to a smaller base of transactions. 
 
¶7.  (SBU) Individuals, however, are likely to feel the IOF 
hit their wallets more heavily than CPMF did.  Credit card 
interest rates will be three percentage points higher and if 
banks are able to pass on the CSLL to consumers, they will 
likely pay more for banking services.  The President of the 
Sao Paulo Federation of Industries (FIESP) Paulo Skaf told 
Econ-Pol Chief that the additional three percentage points 
would hit the working class hardest because they use the 
Brazilian equivalent of a pay advance called the "cheque 
especial" that carries higher interest rates (Ref B).  He 
expects half of the estimated R$15 billion the GOB collects 
this year from IOF would come from the working class. 
 
Industry Reaction 
----------------- 
 
¶8.  (SBU) Industry largely disapproved of the GOB's measures. 
 Skaf said that the measures are unnecessary and that the GOB 
should have used the opportunity of strong economic growth to 
stimulate credit.  He opined that the Senate's rejection of 
CPMF reflected the "voice of the people" and that FIESP's 
efforts to end CPMF were based on the expectation that the 
GOB would not need additional revenue to cover the loss due 
to higher economic growth.  When Econ-Pol Chief pointed out 
Minister Mantega's points regarding the need to raise the IOF 
to combat slowly rising inflation, Skaf stated that Mantega's 
position had little basis in reality and was merely his 
attempt to give an explanation to an unnecessary tax hike. 
 
¶9.  (U) Other industry interlocutors offered various opinions 
of the GOB response to the loss of the CPMF.  Armando 
Monteiro, President of the Brazilian National Confederation 
of Industries, told O Globo television that he expects the 
tax hikes to mean higher interest rates and bank spreads; 
however, he approved of the GOB's announcement to cut 
expenditures.  The senior advisor for the Commercial 
Association of Sao Paulo Sergio Leopoldo told Econ Specialist 
that the GOB should stimulate consumption to boost revenues, 
rather than dampen credit.  He believes consumers will suffer 
the brunt of the hikes.  The Economic Director for the 
Federation of Commerce (Fecomercio) Fernanda Rosa told Econ 
Specialist that Fecomercio estimated a two percent reduction 
in retail and service sales revenues and she said that the 
IOF increase punishes those who need financing for 
consumption. 
 
Spending Cuts in February? 
-------------------------- 
 
¶10. (SBU) The big uncertainty of the GOB's package of 
measures to fill the CPMF gap is spending cuts.  The bright 
spot in the GOB's announcements in December after its failed 
attempt to extend the CPMF (Ref A) was the GOB's announcement 
that it would cut expenditure growth for the first time since 
¶2003.  The GOB again pledged in its package announced January 
2 to cut R$20 billion across the legislative, executive, and 
judicial branches, but held off announcing specific cuts 
until February when Congress reconvenes and begins its review 
of the 2008 budget.  For the most part, financial analysts 
are optimistic but remain unconvinced until the GOB releases 
more details.  Nilson Teixeira, Managing Director for 
Emerging Markets Research at Credit Suisse, expects the GOB's 
will not meet the spending reduction mark, which they 
 
SAO PAULO 00000012  004.2 OF 005 
 
 
estimate at 0.7 percent of GDP, which could force the GOB to 
reduce the primary fiscal surplus.  However, if the economy 
grows as expected, the GOB should maintain its primary 
surplus target.  According to Bear Stearns Economist Emy 
Shayo, she expects that the spending cuts will come in the 
form of lower wage hikes for civil servants and lower levels 
of investment spending.  Oreng agreed that a likely option 
would be a freeze on public sector salary increases initially 
announced in 2007.  End Comment.) 
 
¶11.  (SBU) Expected robust economic growth in 2008 may 
protect the GOB from needing to make significant spending 
cuts.  Economic growth of five percent or more in 2008 would 
have covered the lost tax revenues from the CPMF, according 
to economic interlocutors.  Skaf told Econ-Pol Chief that 
FIESP deemed a tax hike unnecessary because FIESP estimated a 
12 percent increase in tax collection based on the projected 
economic growth of five percent, which easily would have 
covered the R$40 billion gap.  Oreng told Econoff that Itau 
estimated an additional R$40 billion in tax collection from 
these two measures based on economic growth of five percent 
and far exceeds the GOB's estimate of R$10 billion. 
Likewise, Teixeira told Econoff that Credit Suisse believes 
that the government should collect more tax revenues under 
the two measures than estimated. 
 
Legal Challenges Ahead? 
----------------------- 
 
¶12.  (U) The GOB's two tax measures may face legal challenges 
under the Brazilian Constitution.  Opposition congressmen 
have initiated an inquiry into the GOB's decree and 
specialists including Mailson da Nobrega, former Finance 
Minister, say the IOF was not designed nor constitutionally 
mandated to be a revenue generating mechanism, as the GOB's 
decree explicitly intends it to be used.  Under the 
Constitution of 1988, the IOF is restricted to credit and 
exchange regulation for use in inflation or balance of 
payments crises.  Local press criticized the increase of the 
CSLL for similar legal irregularities.  In addition, a 
Constitutional Amendment from 2003 prohibits the GOB from 
using provisional measures to assign differentiated tax 
rates.  Press reports indicate that some law firms are 
encouraging their financial institution clients to fight the 
increase to the CSLL as discriminatory against their 
industry.  Oreng, for his part, told Econoff that he doesn't 
expect the financial sector to submit claims and assumes they 
will pass on the additional tax to consumers. 
 
¶13.  (SBU) COMMENT: The IOF and CSLL tax increases are likely 
to dampen the rapid rate of credit growth in Brazil, but are 
unlikely to change the prospects for continued credit 
expansion this year on the order of 20 percent in Brazil. 
The increase in the cost of credit should help soothe the 
Central Bank's fears that the Brazilian economy is beginning 
to overheat.  From a macroeconomic perspective, the GOB's 
rhetoric to cut spending is a positive sign; however, Post 
remains unconvinced that the GOB  will successful trim 
spending by R$20 billion.  The risk exists, though minimal, 
that the GOB may eat into the primary surplus despite the 
GOB's repeated statements to the contrary.  The primary 
surplus has been the GOB's key policy anchor since 2003 and 
any adjustment would represent a change in policy and would 
have implications for Brazil's fiscal accounts.  Furthermore, 
covering the CPMF revenue gap has distracted the GOB from 
working on ways to tackle the growing inflation problem. 
 
SAO PAULO 00000012  005.2 OF 005 
 
 
Brazil closed out 2007 with inflation nearly two percentage 
points higher than at the end of 2006 and runs the risk that 
the Central Bank will decide to raise interest rates.  The 
political ramifications of the GOB's announcement, however, 
are the most disconcerting.  The Lula Administration 
backtracked on a deal it made with the opposition in order to 
get the de-earmarking measure (DRU) passed in December (Ref 
A).  In doing so, the GOB has likely closed off any remaining 
possibility for working with the opposition to institute a 
comprehensive tax reform, as some analysts hoped following 
the CPMF defeat.  END COMMENT. 
 
¶14.  (U) This cable has been coordinated with the U.S. 
Treasury Attache in Sao Paulo and Embassy Brasilia. 
WHITE