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### Viewing cable 06BRASILIA790, BRAZIL AT A FISCAL INFLECTION POINT?

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
06BRASILIA790 | 2006-04-24 19:00 | 2011-07-11 00:00 | UNCLASSIFIED//FOR OFFICIAL USE ONLY | Embassy Brasilia

`

    VZCZCXRO3062
    PP RUEHRG
    DE RUEHBR #0790/01 1141900
    ZNR UUUUU ZZH
    P 241900Z APR 06
    FM AMEMBASSY BRASILIA
    TO RUEHC/SECSTATE WASHDC PRIORITY 5193
    INFO RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY
    RUEHRG/AMCONSUL RECIFE 4650
    RUEHSO/AMCONSUL SAO PAULO 6810
    RUEHRI/AMCONSUL RIO DE JANEIRO 1930
    RUEHBU/AMEMBASSY BUENOS AIRES 3954
    RUEHSG/AMEMBASSY SANTIAGO 5449
    RUEHAC/AMEMBASSY ASUNCION 5371
    RUEHMN/AMEMBASSY MONTEVIDEO 6191
    RUEHME/AMEMBASSY MEXICO 1961
    RUEHCV/AMEMBASSY CARACAS 3211
    RUEHBO/AMEMBASSY BOGOTA 3711
    RUEHQT/AMEMBASSY QUITO 1789
    RUEHLP/AMEMBASSY LA PAZ 4522
    RUEHPE/AMEMBASSY LIMA 2955
    RUCPDO/USDOC WASHDC
    RHEHNSC/NSC WASHDC

` `

    UNCLAS SECTION 01 OF 04 BRASILIA 000790

    SIPDIS

    SENSITIVE
    SIPDIS

    NSC FOR CRONIN
    TREASURY FOR OASIA - DAS LEE, FPARODI
    STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
    USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
    USDOC FOR 3134/ITA/USCS/OIO/WH/RD/SHUPKA
    STATE PASS USAID FOR LAC

    E.O. 12958: N/A
    TAGS: ECON EFIN PGOV PREL BR
    SUBJECT: BRAZIL AT A FISCAL INFLECTION POINT?

    REF: A) BRASILIA 665  B) BRASILIA 608

    ¶1. (SBU) Summary: The Lula administration heretofore has compiled an
    impressive record of fiscal rectitude, routinely posting primary
    budget surpluses well beyond its formal 4.25 percent of GDP target.
    This performance has allowed the GoB to reduce its net-debt-to-GDP
    ratio (from 57.2% in 2003 to about 51.6% at end 2005).  While these
    results have been commendable, the GoB achieved them primarily
    through higher tax revenues, which grew due to tax reforms in 2003
    and income tax growth based on the strong profitability of certain
    economic sectors in 2004/2005.  Though Lula reduced real
    expenditures in his first year in office, revenue growth since then
    has meant that expenditure growth has been much less constrained in
    subsequent years.  Revenue growth may now have reached an inflection
    point, with March 2006 revenues falling ever so slightly (0.04%) in
    real terms from March 2005 levels.  Newly appointed Finance Minister
    Guido Mantega publicly reiterated on April 19 that the Gob would
    sequester whatever expenditures it must in order to meet its 4.25%
    of GDP primary surplus target.  However, if stagnant revenue trends
    continue, this will exacerbate the political battles surrounding
    fiscal policy in Brazil, and will likely become one of the key
    points of debate in this presidential election year.  Fiscal and tax
    reform will thus become an urgent issue for the new administration
    in January 2007.  End Summary.

    Revenue Growth Down
    -------------------

    ¶2. (U) GoB federal tax revenues in the first quarter of 2006 grew
    much more slowly (1.7% in real terms) than in the two previous
    years, while March revenues were down 0.04% from March 2005 levels.
    The GoB's obligatory expenditures (e.g. government payroll, social
    security, earmarked health expenditures), however, are expected to
    continue to grow apace.  Revenues administered by Receita Federal
    (Brazil's IRS equivalent - this measure of revenues excludes payroll
    taxes that are paid directly to the Social Security system) likely
    will fall from 17.2% of GDP in 2005 to 16.8% of GDP this year, while
    obligatory expenditures climb from 15.5% of GDP to 17.1% (obligatory
    expenditures include payroll, earmarked health expenditures, social
    assistance, government employee pensions and social security
    expenses).  Overall, it accounts for about 90% of central government
    expenditures).  Broader data for the central government as a whole
    (i.e. including the social security system but excluding states and
    municipalities) shows that in the first two months of 2006, revenues
    as a percent of GDP were essentially unchanged (26.28% of GDP in
    2006, vs. 26.25% of GDP in 2005) while expenditures grew from 17.84%
    of GDP to 19.05% of GDP in the same period.

       Federal Fiscal Snapshot
        Percent of GDP

    Revenues       2002     2003    2004    2005    2006 /1
    --------      ----     ----    ----    ----    ----

    Administered
    Revenues (tax)     16.3%   15.6%    16.2%   17.2%   16.8%

    + Social
    Security Income     5.3%    5.2%     5.3%    5.6%    5.6%

    + Other Income      2.5%    2.4%     3.1%    3.1%    2.6%

    - Transfers to
     States/Cities      3.9%    3.8%     3.7%    4.5%    4.1%
    --------------
    Equals Net Central
    Govt. Revenues     20.2%   19.3%    20.4%   20.1%   20.6%

    BRASILIA 00000790  002 OF 004

    Expenditures
    ------------

    Total
    Expenditures       18.0%   17.2%    17.8%   19.1%   18.4%

    Obligatory
    Expenditures       15.6%   15.8%    15.4%   15.5%   17.1%

    - of which Social
    Security            6.4%    6.9%    7.1%    7.58%   7.93%

    - of which Fed
    Payroll and
    Benefits            5.6%    5.1%    5.1%    4.85%   4.92%

    ---------------
    Federal Gov.
    Primary Surplus/2   2.4%    2.5%    3.0%     2.9%    2.3%

    /1 - Predicted 2006 values
    /2 - Does not include state, municipal and parastatal company
    contribution to the public sector primary surplus
    -Sources: Planning Ministry, Finance Ministry, Raul Velloso

    ¶3. (SBU) A well-known private sector budget consultant, Raul
    Velloso, noted to Econoff in an April 13 conversation that the drop
    in revenue growth and increasing obligatory expenditures mean the
    GoB's discretionary expenditures (currently about 10% of total
    expenditures, including investments, operating expenses such as fuel
    for vehicles, communications, etc.) would be dramatically squeezed
    this year.  He thought that the GoB would have a hard time meeting
    the 4.25% of GDP primary surplus target.  Indeed, GoB data shows the
    central government primary surplus (excluding states and
    parastatals, which contribute towards the overall public sector
    primary surplus) dropped from 3.59% of GDP in the first two months
    of 2005 to 2.33% of GDP in 2006.  This is partly to be expected,
    according to Velloso, since in an election year the GoB typically
    concentrates expenditures prior to the election-law-mandated June 30
    cut-off on new investments.  The problem, Velloso argued, was that
    falling revenue growth meant revenues would not cover the continued
    growth in obligatory expenditures (fed, among other factors, by
    Lula's minimum wage increase, which impacts both Central Government
    and social security accounts).  Velloso feared that the GoB would
    not be able to make up the difference in the second half of the
    year.

    ¶4. (SBU) Velloso - who it must be noted has strong ties to the
    opposition PSDB - explained that previous years' strong revenue
    growth was due to a series of one-off events.  These included the
    revamping of the PIS and COFINS taxes in 2003 to make them more
    VAT-like.  Accordingly, the effect of this reform, which increased
    the effective rates of these taxes, diminished after 2004.  2005 saw
    strong profitability in the commodity-based sectors of the Brazilian
    economy, which significantly boosted income tax revenues paid by
    firms such as mining giant CVRD.  These effects were unlikely to be
    repeated, Velloso argued.  Moreover, in the second half of 2005 the
    GoB implemented legislation granting targeted tax breaks for capital
    investments, the effects of which were now becoming perceptible.
    For example, from March 2005 to March 2006 revenues generated by the
    IPI, a federal VAT on manufactured products, fell 7.65 percent.

    Mantega: "Anyone Betting Against Us Will Lose Money"
    --------------------------------------------- -------

    BRASILIA 00000790  003 OF 004

    ¶5. (U) Newly appointed Finance Minister Guido Mantega has used
    recent public appearances to reiterate forcefully that the GoB will
    fulfill its 4.25% of GDP primary surplus target.  Testifying along
    with Planning Minister Paulo Bernardo at the April 18 presentation
    of the 2007 Budget Directives Law (i.e., the LDO, a multi-year
    budget framework document) to Congress, Mantega insisted the GoB
    would meet the target this year.  The LDO, moreover, maintains the
    4.25% primary surplus target unchanged for 2007, 2008 and 2009.   In
    an April 19 interview with daily Estado de Sao Paulo, Mantega blamed
    the lower primary surplus for the first months of 2006 not on
    reduced revenue growth, but rather on the election year-related need
    to spend in the first half of the year, as well as unusually high
    carry-over spending from the end of 2005.  Mantega pledged the GoB
    would sequester whatever expenditures necessary from the
    just-approved 2006 budget to meet the 4.25% of GDP target.  He
    dismissed the idea of the GoB attempting to over-perform the target,
    however, as it had repeatedly done under his predecessor, Antonio
    Palocci.

    ¶6. (U) Background Note: Budget fulfillment is not mandatory in
    Brazil.  Indeed, in an acrimonious annual exercise, the
    administration is required to walk back whatever unrealistic
    revenue, GDP growth, interest rate or exchange rate assumptions that
    the Congress inserts in the budget law and sequester corresponding
    expenditures in order to ensure the primary surplus target is
    fulfilled.  With the April 18 approval of the 2006 budget, the GoB
    within the next weeks should issue a decree identifying budgeted
    expenditures that must be sequestered.  In prior years, public
    investment spending has accounted for the great majority of spending
    targeted for sequestration.  Sequestered expenditures can be
    liberated later if revenues exceed the administration's
    expectations.  End Note.

    ¶7. (SBU) Separately, Mantega and Bernardo highlighted an LDO
    provision that calls for current expenditures to be cut by 0.1% of
    GDP per year over the next three years (down from the budgeted 2006
    level of 17.71% of GDP).  The GoB hopes to achieve this through a
    requirement, which would take effect immediately upon the LDO's
    approval, that all recurring spending commitments (such as new
    hiring) must receive prior authorization from both the finance and
    planning ministries.  Hiring discipline has been a problem for the
    Lula administration.  March 2006 data showed that the Lula
    administration had created a total of 37,543 new federal jobs, 2,268
    of which are to be filled through presidential appointment.  This in
    part reflects Lula's reversal of policy of the previous two
    governments to outsource jobs wherever possible and reduce the
    public payroll via attrition.  A little less than a quarter of the
    new federal jobs were created to staff new regulatory agencies.

    Market Views
    ------------

    ¶8. (SBU) Most analysts believe the GoB will meet the 4.25% of GDP
    target.  The chief economists of several Brazilian and foreign banks
    told visiting Treasury A/S Clay Lowery on April 4 that they expect
    the GoB to do so.  Separately, Banco Itau Executive Director (and
    former Central Bank director) Sergio Werlang told the press that
    while he believes the GoB will meet the target for the calendar
    year, it is likely that the rolling twelve-month primary surplus
    will dip below 4.25% of GDP at some point this year.  Markets, he
    said, will take that as a bad sign, and it would perhaps slow
    Brazil's march towards an investment grade credit rating.  Gustavo
    Loyola, who recently left his job as a Central Bank director for the
    private sector, chastised market participants for fixating on the
    primary surplus, which he argued should not have become an end in
    itself, but rather was simply an anchor for policies aimed at
    reducing the debt-to-GDP ratio.  Not enough attention was being

    BRASILIA 00000790  004 OF 004

    paid, he said, to reducing the nominal deficit or to the quality of
    expenditure.

    ¶9. (SBU) Loyola's point on the quality of expenditure is an
    oft-repeated one.  The rigid structure of the GoB budget, with
    constitutionally mandated transfers to states and municipalities,
    along with earmarked expenditures on items such as health and a
    large social security deficit (about 2% of GDP in 2005) financed out
    of general revenues, mean that investments and operating
    expenditures must bear the brunt of fiscal adjustment.  The GoB
    anticipates, for example, that federal discretionary expenditures
    including investments will fall from 3.29% of GDP in 2005 to 2.82%
    in 2006.  In its first years, the Lula administration advanced
    measures that could make up for the shortfall in public investment
    spending and ameliorate the public infrastructure deficit, notably
    the Public Private Partnerships (PPP) legislation which was passed
    in December 2004.  Despite the fanfare that greeted its passage,
    implementation has been slow and the GoB has yet to put out for
    tender any PPP projects.  The private sector is increasingly
    concerned about the infrastructure gap, predicting that Brazil may
    well face energy shortages in the medium term (2008/2009) due, in
    part, to the GoB's problematic overhaul of the energy sector
    regulatory framework in 2004/2005.

    ¶10. (SBU) Comment: The falling growth in revenues, if it proves a
    more durable trend, stands to exacerbate the always lively and
    sometimes acrimonious fiscal policy debate.  As several contacts
    have observed to us, the first step to cutting through Brazil's
    budgetary Gordian knot is to bring current expenditures under
    control, which has been problematic for the Lula administration.
    The 2007 LDO contains some useful measures aimed at doing so, but
    with the Lula administration continuing to beat off corruption
    scandals even as it tries to prepare for the October 2006 elections,
    there is little hope that it will make hard decisions on longer-term
    expenditure constraint.  Instead, it will likely just muddle through
    the remainder of the year, trying to placate both the markets and
    its political constituencies.  The GoB has both the tools and the
    political will to meet the primary surplus target (as we expect it
    ultimately will), but the fiscal dynamics involved mean it will
    occur at further cost to the quality of public expenditure.  Fiscal
    and tax reform, therefore, will need to be at the top of new
    administration's agenda come January 2007.

    LINEHAN

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