CPMF DEFEAT WILL NOT BREAK LULA'S BANK

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

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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

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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.

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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.

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