LULA'S TAX REFORM PASSES: WHAT IT LEAVES TO BE

UNCLAS SECTION 01 OF 05 BRASILIA 003953

SIPDIS

NSC FOR DEMPSEY
TREASURY FOR SSEGAL
PLS PASS FED BOARD OF GOVERNORS FOR WILSON, ROBATAILLE
USDA FOR U/S PENN, FAS/FAA/ITP/TERPSTRA
USDOC FOR 4322/ITA/IEP/WH/OLAC-SC

E.O. 12958: N/A
TAGS: ECON EFIN PGOV EINV SOCI BR
SUBJECT: LULA'S TAX REFORM PASSES: WHAT IT LEAVES TO BE
DONE

REF: (A) Brasilia 3910, (B) Brasilia 3734,
(C) Brasilia 3682, (D) Brasilia 3684


1. LULA'S TAX-REFORM BILL PASSED ITS SECOND SENATE VOTE ON
DECEMBER 17 BY 64 VOTES TO FIVE AND WILL BECOME LAW WHEN
PUBLISHED IN THE OFFICIAL GAZETTE ON DECEMBER 22. HAVING
ALREADY GAINED PASSAGE OF HIS PENSION REFORM BILL LAST WEEK
(REF A),LULA HAS THUS ACHIEVED HIS TOP TWIN LEGISLATIVE
PRIORITY FOR HIS FIRST YEAR IN OFFICE, AND CAN CLAIM IN THIS
AREA TO HAVE OUTSTRIPPED HIS PREDECESSOR'S LEGISLATIVE
RESULTS IN FHC'S WHOLE SECOND TERM (THOUGH LULA IS UNLIKELY
TO POINT OUT THAT THE PT WAS THE MAIN ROADBLOCK TO REFORM
THROUGHOUT THAT PERIOD.)


2. THE TAX BILL'S CONTENTS, HOWEVER, HAVE BEEN VASTLY
TRUNCATED SINCE LULA PRESENTED ITS INITIAL VERSION LAST
MARCH IN EYE-CATCHING STYLE, PERSONALLY LEADING TO THE
CONGRESS BUILDING A PARADE OF BRAZIL'S GOVERNORS IN WHAT WAS
MEANT TO SHOW THE LATTER'S SOLIDARITY WITH LULA'S REFORM
AIMS. AS DESCRIBED IN REF B, THE GOVERNORS SOON DIVIDED AND
FELL AWAY, FORCING LULA'S TEAM TO RECOGNIZE THAT ITS
ORIGINAL DESIGN WOULD NOT PASS. THE GOB SETTLED FOR A RUMP
BILL THAT ASSURED IT OF THE TWO CORE MEASURES WHOSE PASSAGE
BY JANUARY 1, 2004 WAS VITAL FOR THE GOB BUDGET: EXTENSION
OF THE CPMF (FINANCIAL-SERVICES `CONTRIBUTION' TAX) AT ITS
PRESENT 0.38% RATE, AND OF THE DRU (GOB AUTHORITY TO DE-LINK
20% OF TAX REVENUES FROM CONSTITUTIONALLY-MANDATED
EARMARKS.) ALL THE MAJOR CHANGES CONCEIVED TO FOSTER TAX
TRANSPARENCY, BETTER CONDITIONS FOR PRIVATE-SECTOR
PRODUCTION, AND -- ESPECIALLY -- AN END TO THE CHAOTIC, ZERO-
SUM "FISCAL WAR" WAGED BETWEEN BRAZIL'S STATES ON THE BASIS
OF THEIR AUTHORITY TO SET INDIVIDUAL RATES FOR THE MAIN ICMS
TAX, WERE STRIPPED OUT TO FACE AN UNCERTAIN FUTURE.


3. As passed, the tax "reform" law (i) extends the DRU and
the CPMF for four years, (ii) creates a Regional Development
Fund with resources of Reals 2.2 billion to disburse in
2004, (iii) provides for the transfer to state and city
governments of 25% of the federal government's revenues from
the Cide (fuel) tax (which currently total approximately 12
billion Reals p.a.) and levies the Cide on imports of
petroleum and its derivatives, formerly exempt, (iv) adds
Reals one billion to the Municipal Participation Fund, (v)
bans the extension by Brazilian state governments of special
fiscal incentives from the date of the law's effect, but
apparently leaves ultimate determination of the issue to a
complementary law, (vi) provides for another complementary
law to define eventual reduction in the CPMF rate down to
0.08%, subject to a "trigger" of favorable fiscal
circumstances, (vii) raises to Reals 6.5 billion the total
GoB fund to compensate state budgets for revenue losses
incurred due to the federal "Kandir Law," which exempts
exports from the ICMS tax.


4. Related tax-reform items outside the approved bill:

-- The GoB apparently still hopes to finalize the reform of
Brazil's "cascading" Cofins (social-contribution) tax before
the end of this year. The Cofins issue was separated out
from Lula's main tax bill into a presidential Provisional
Measure (MP) just last month. All legislators agree the end
of Cofins' "cumulativity" is essential, but the broad non-
GoB view is that the MP's proposed hike in the one-time
Cofins rate to 7.6% from its present 3% would intolerably
increase Brazil's overall tax burden. Among other things,
the MP would start to levy Cofins on import.

-- The ICMS issue is being sent back to the lower Chamber,
effectively for debate on it to be re-opened there, but with
no voting schedule stipulated (and debate next year, as
noted by the December 18 `Estado de Sao Paulo,' would take
place in the full friction of a local-election year, to
which its content would be extraordinarily sensitive.)
-- Finance Minister Palocci has reasserted GoB proposals to
reduce the IPI (Industrial Production tax) on capital goods,
and to levy social-security and perhaps other taxes not on a
company's total payroll but on its gross revenues. Debate
on these and other production-friendly GoB tax-reform aims
remains in an early stage.


5. The above outcome marks what is meant to be just the
first of three phases in Lula's GoB's overall tax-reform
plan. In the next stage, Brazil's National Counsel of
Financial Policy (CONFAZ, consisting of individual state
Secretaries of Finance from all Brazil's states) in 2004 is

SIPDIS
to agree and oversee (with Senate ratification) the
reduction of Brazil's chaotically multitudinous ICMS rates
(reportedly 44) to just five national ones, by product. In
the third and final stage, the ICMS, IPI (federal Industrial
Production tax) and ISS (Municipal Services tax) are
supposed to be combined into a single national VAT. Hardly
by chance, this last and most transformational change is to
be tackled not before 2007, i.e., after Lula's presumptive
reelection campaign.


6. Financial daily `Valor Economico' on December 15
reviewed where the watering-down of the GoB's tax bill has
left things. The `Valor' article featured a detailed list
of future constitutional amendments, complementary laws,
decrees or regulations which the GoB will need to obtain in
order to implement even the changes contained in the present
reform, let alone its ambitious further hopes. Following is
Embassy's unofficial translation of the useful `Valor'
article in question, which appeared shortly before the tax
reform's final passage. Main text is in para 7; the list of
further legislation required, in para 8.


7. (Begin Text)

HEADLINE: PASSAGE OF THE REFORM DOES NOT GUARANTEE CHANGE IN
THE TAX MODEL

The goal of the Lula administration was to finish the
debate concerning tax and pension reform by the end of
this year, but the passage of the essential part of the
two proposals that should occur on the 19th doesn't
guarantee a change in concept of the tax model. "Tax
reform is a process. Passage (in the Senate) will only
kindle this process", said the government's leader of the
Senate, Aloizio Mercadante (PT-SP). Most of the
structural changes proposed in the Senate -- that could
lead to tax simplification, the end of the fiscal war, and
reduction of the tax burden -- depend on new legislation.

The estimate is that the second round of voting in the
Senate will be finished on the 18th. In separate votes
during in the first round, the senators defeated in floor
votes the amendment proposed by the bill's sponsor, Romero
Juca (PMDB-RR) who proposed the delinking (DRE) of 10% of
state and municipal revenues in the social-program part of
their budget.

After conclusion of voting in the second round, Congress
will immediately resume work in 2004 discussing at least
two constitutional amendment proposals (about the gradual
reduction of the CPMF, and the incidence of Cide and
Cofins taxes) and another Provisional Measure that will
address the tax exoneration of companies' payrolls,
replacing part of the social security contributions
collected on salaries by payments based on total turnover,
in a non-cumulative manner.

In addition, after publication of the whole reform, whose
date will depend on the political will of the deputies and
will require a new political agreement, Congress will have
to analyze at least six proposed complementary laws. The
government's expectation is that at least two bills can be
transacted starting in the second half of 2004. Judging
by the text of the tax reform approved in the Senate, two
projects would need to be voted on in Congress by December
31, 2004: one that specifies the rules for unifying the
five new ICMS rates and also exoneration of the `basic
basket', agricultural inputs and minimum consumption of
energy; and one which presents rules for a new industrial
policy for the country, in order to offset the end of
fiscal incentives.

If reform takes a long time to conclude, its efficacy will
also be long-term, in the opinion of Finance Minister
Antonio Palocci. "Tax policy doesn't belong to the
government, nor the opposition. It is a policy for 40, 50
years, and it's for Brazil," emphasized the minister,
after complimenting the senators last Friday for their
drawn-out negotiations and for their having voted for the
reform in the first round.

Palocci used his typical good humor and optimism to
comment on the need for broad political effort by the
Chamber to conclude, in fact, the voting for the reform.
"We have to think like Mineiros: everything will turn out
well. If it's not well done, it's not finished."

The Minister said that the economic team is still
calculating the financial impact of the reform. According
to the government technical experts involved in the
negotiations, the biggest probable amount to be released
in 2004, which is one billion Reals for the
Municipalities' Participation Fund and 2.2 billion Reals
for the Regional Development Fund, will come from an
increase in IPI collections, since the mechanism for
cumulative compensation from Cofins will no longer exist.

For Palocci, the proposal voted on in the Senate "balances
the budgets of federative entities, doesn't increase the
tax burden and creates a set of significant benefits."
The minister recognizes, however, that tax reduction will
only occur long-term. "Brazil should seek a long-term
reduction of the tax burden, and this should be done
responsibly, that is looking at commitments and the
country's economic balance", he affirmed. This mechanism
of gradual tax reduction, emphasized Palocci, will have to
be discussed as part of a new proposed constitutional
amendment, which could be presented today (December 15) by
Senator Tasso Jereissati (PSDB-CE),but would only be
voted on next year.

The minister also recognized that the unification of ICMS
rates -- which will have to be discussed anew in the
Chamber - does not materially affect the Federal
Government. "The ICMS question, though it does not affect
us, does greatly affect the economy," he justified.

Another polemical issue that will only be discussed at the
end of Lula's mandate is creation of an IVA (Value Added
Tax). That will also require a constitutional amendment,
and as it is a most controversial subject, there is no
political guarantee that the lawmakers will approve this
constitutional amendment and introduce the new tax.

(End Embassy Translation of Main Text)



8. (Start Embassy Translation of Inset Headlined: REFORM
UNDER CONSTRUCTION/Tax changes that depend on new laws)

New Proposals for Constitutional Amendments (PEC in
Portuguese acronym)

-- CPMF: a new PEC will be presented today (December 15),
drawn up by Senator Tasso Jereissati (PSDB-CE) that will
change the constitutional regulation, fixing the maximum
(0.38%) and minimum (0.08%) rate of the contribution and
determining that as of 2005 it can fall, gradually,
according to macroeconomic conditions. Criteria for
reduction of the CPMF rate and of the tax burden will have
to be defined in a complementary law.

-- Cide/Cofins: a new PEC will also be presented today,
drawn up by Senator Rodolpho Tourinho (PFL-BA),changing
the language of Articles 149 and 195 of the Constitution.
The objective is to make clear that Cide only applies to
domestic or imported petroleum derivatives. In addition,
it specifies that any social contribution (tax) can only
be applied to imports if it is also charged on domestic
production.

-- IVA: The tax reform anticipates a Value Added Tax (IVA
in Portuguese acronym) in 2007. Since this tax will be
the fruit of the unification of the ICMS, IPI and ISS
taxes, various articles of the Constitution will need to
be modified. The government is not mentioning any time
frame for this PEC.

-- Progressive ITBI (transferal/inheritance of goods and
real estate): The government wants to take up the debate
again on a progressive estate tax, but the lawmakers and
executive need to elaborate another PEC, since the final
text of the tax reform approved by the Senate defeated the
progressivity idea and left collection as it is today - 2%
tax for all transactions. This new PEC can only be
presented in 2004.


Complementary Law Proposals

-- Exemption of the basic consumer basket, machines and
agricultural inputs, medicines for human use, minimum
consumption of electric energy/Unification of ICMS rates:
after promulgation, the government promised to submit this
bill in a maximum of 120 days. The constitutional text
approved in the Senate requires this law to be promulgated
by December 31, 2004.

-- Industrial policy: as a form of compensation for the
end of the fiscal war, the government promises to submit a
law that will define the concession of credits and federal
incentives favoring regional development. Deadline: 120
days after promulgation of the entire tax reform.

-- Reduction of the Tax Burden: the "trigger" that links
tax-rate reduction to the improvement of macroeconomic
conditions also depends on a complementary law. The
government promises that this law will also be submitted
120 days after promulgation of the whole tax reform.

-- Definition of criteria for re-examining the budget for
the Export Compensation Fund: the fund is automatically
extended into 2004, but the States want to change the
criteria for the transfer of resources, to consider the
export balance and type of export, and this will also
depend on a complementary law. The date for submitting
the bill is not specified in the text of the reform.

-- Fiscal Incentives: The reform says that incentives can
only be conceded up to the definitive promulgation date of
the proposed constitutional amendment, and that their
maximum life is 11 years. However, the Congress will have
to approve a complementary law "defining rules in effect
at the time of concession, that will remain applicable."

-- Regional Development Fund: The text of the reform
states that the fund will go into effect immediately after
final promulgation of the PEC, when the concession of
fiscal incentives ends. A complementary law will be
needed to define criteria for distribution of resources
from this Fund to the States.


Decree/revenue regulations/Provisional Measures (MP in
Portuguese acronym)

-- Decree by the Treasury Ministry to gradually exempt
capital goods from the IPI (Industrial Production Tax):
Minister Palocci has said this will be drafted at the end
of the month, immediately after promulgation of the first
phase of reform.

-- Cide MP: The government promises to edit, probably by
the end of December, an interim measure defining the
criteria for transfer of Cide (fuel-tax) revenues to
states and municipalities.

-- MP to exempt payroll: the constitutional principle to
do so is guaranteed in the tax reform, but the government
has promised to send the MP within 90 days after passage
of the law establishing the non-cumulative collection of
Cofins.

-- The national register of taxpayers anticipated to be
part of the third phase of reform (2007) may be created
via a normative instruction by the Federal Treasury.

HRINAK