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