Analysis-Tax slump in outperforming Brazilian economy scrambles reform plans

By Marcela Ayres and Bernardo Caram

BRASILIA (Reuters) – Even as Brazil’s economic growth blew past expectations in the first half of this year, tax revenue has tumbled, underscoring doubts about the central government’s bold new fiscal targets and scrambling plans for an ambitious tax reform.

The contrast between stronger-than-expected growth and disappointing government revenue comes down largely to what is driving Brazil’s recent outperformance. A bumper harvest to start 2023, followed by strong oil and mining output, have the economy on track to grow more than 3% this year, officials said, when most economists had forecast sub-1% growth in January.

However, Brazil’s commodity exporters shoulder a lighter tax burden than retailers and heavy industry, effectively boosting gross domestic product (GDP) more than government revenue, according to Rafaela Vitoria, chief economist at Banco Inter.

“We don’t expect a change in this dynamic. Tax collection in the second half (of 2023) will remain stagnant,” Vitoria said. “The GDP subject to taxation is not expected to rebound, especially in manufacturing and retail.”

Brazil’s Finance Ministry expects much of this year’s surprising growth to come from the relatively undertaxed farm sector, one ministry official confirmed, requesting anonymity to share internal calculations.

With the central government’s revenue through June slipping 5% from a year earlier in real terms, the Finance Ministry widened its estimate for this year’s primary deficit to 145 billion reais, or 1.4% of GDP. Now, the ministry is rushing out emergency measures to boost tax revenue by next year, when new fiscal rules require the government to erase that deficit.

The strategy has unsettled some people in the Finance Ministry, according to two other ministry officials, who see a rush for new revenue undermining a broader push to overhaul the tax code in Latin America’s largest economy. After making headway in Congress to consolidate consumption taxes, Finance Minister Fernando Haddad had pledged to embark on an income tax reform in the second half of this year.

But President Luiz Inacio Lula da Silva has since moved to raise taxes on closed-end investment funds through an executive order and proposed the end of a tax loophole for shareholder payouts, as Reuters first reported in July. Both measures were originally slated for discussion as part of the broader income tax reform in Congress, but have now front-run the debate.

“Given the problem with next year’s target, they’re trying to bring everything forward, at whatever cost,” said one of the Finance Ministry officials, who asked not to be named. “The idea of doing a thoughtful (income tax) reform, like what’s been done for consumption taxes, is going to be tough.”

The other official said an aversion to public spending cuts had forced the scramble to boost revenue immediately.

“The fiscal shortfall and unwillingness to cut expenses has left no other alternative,” the source said.

The Finance Ministry declined to comment.

OIL PRICE IMPACT

Haddad acknowledged last week that budget pressures had forced the government to bring forward measures “that we might have only brought up next year in Congress.”

Although public revenues have regularly undershot private forecasts this year, the weaker collection figures were not entirely unexpected.

The 2022 baseline was boosted by oil auctions and the privatization of power utility Eletrobras, plus big dividends from state oil firm Petrobras and state lenders BNDES and Caixa, which helped to bankroll election-year spending.

Soaring oil prices also boosted the Petrobras dividend and state royalties. Crude prices, however, have cooled this year.

Finally, Brazil’s progress in fighting inflation, which has fallen from 5.8% last year to 3.2% in the 12 months through June 2023, had a perverse effect on public accounts, as the country’s tax collection is structurally tilted toward consumption.

“The 2022 tax collection was heavily influenced by oil prices and inflation,” said Felipe Salto, chief economist at brokerage Warren Rena, flagging the silver lining of lower borrowing costs.

With inflation apparently contained, Brazil’s central bank has started cutting interest rates, which will ease public debt-servicing costs and eventually boost more tax-intensive sectors, such as retail and industry.

In the meantime, the Finance Ministry is focused on short-term revenue fixes and still holding out hope for broader debate on tax reform at the end of this year, a fourth official said on condition of anonymity.

“Obviously, the need to balance the budget requires you to bring forward some measures, but that doesn’t prevent you from having the right structural debate later,” that official said.

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