Brazil’s tax reform push a step in the right direction - Capital Economics
Latin America Economics

Brazil’s tax reform push a step in the right direction

Latin America Economics Update
Written by William Jackson

The push by Brazil’s government to change the tax system provides a welcome sign that the government’s reform agenda is still progressing, despite the political infighting caused by the handling of the coronavirus crisis. If implemented, the main benefits would accrue over the longer-term by improving potential GDP growth. More immediately, it would probably help to lower longer-term bond yields.

  • The push by Brazil’s government to change the tax system provides a welcome sign that the government’s reform agenda is still progressing, despite the political infighting caused by the handling of the coronavirus crisis. If implemented, the main benefits would accrue over the longer-term by improving potential GDP growth. More immediately, it would probably help to lower longer-term bond yields.
  • Economy Minister Paulo Guedes handed part of the government’s proposal on tax reform to congress yesterday, causing a minor stir. Tax reform had been high up on the government’s agenda last autumn, but interest then seemed to wane, even before the coronavirus crisis started.
  • Yesterday’s move seems to suggest that the government is trying to re-invigorate the reform agenda. That’s particularly encouraging in light of the various political crises that have engulfed the Bolsonaro government in recent months and the president’s re-alignment in congress, allying with more centrist politicians. And the news may explain why the real outperformed other EM currencies yesterday.
  • Mr. Guedes’ proposal envisages replacing two existing taxes used for social contributions (PIS and Cofins) with a VAT rate (called CBS) that would be set at 12%. He will, reportedly, present additional measures to congress that will reform income tax and an excise tax (IPI). These proposals will need to be discussed in congress and merged with two existing tax reform bills (one in each house of congress).
  • There are still major hurdles to passing tax reform. And we don’t know what shape the bill would eventually take. But we shouldn’t underestimate the potential benefits.
  • Most analysis indicate that tax reforms in Brazil would raise revenues. Reports suggest that Mr. Guedes’ request for a CBS tax rate of 12% is motivated by the need to raise funds to pay for the Renda Brasil, which wraps up existing social benefits with the emergency aid provided during this crisis. And the IMF estimated in its Article IV report last year that simplifying the system by reducing tax exemptions could raise government revenues by around 2% of GDP.
  • The rise in revenues would probably materialise over many years and it wouldn’t prevent the need for further consolidation measures in the next few years to stabilise the debt ratio. But it would still help to improve the country’s fiscal health. (For more, see here.)
  • Just as importantly, tax reform should help to lift Brazil’s potential growth rate, boosting longer-term prospects. The country’s tax system is notoriously complex. The World Bank estimates that Brazilian firms spend about 10 times longer complying with and paying taxes than companies in other Latin American countries do. The large costs that companies currently incur to comply with the tax regime deter investment, and cutting these costs should lift productivity.
  • It is difficult to quantify the scope for productivity gains, but research from the Brazilian Fiscal Citizenship Centre estimated that the introduction of a VAT could raise potential GDP growth by 0.5%-pts over the next decade. This seems plausible to us.
  • What’s more, tax reform is a necessary condition for trade liberalisation. Some of the current taxes (such as the IPI) are essentially tariffs on imported goods. In previous research, we’ve identified that significant reductions in tariff barriers are associated with a subsequent rise in productivity growth of an average of 0.75%-pt over the following five years. (See our Update.)
  • In the more immediate future, progress on tax reform might help to reduce sovereign bond yields, particularly at the long end of the curve (where yields have remained high, despite a sharp fall in short-term rates). In turn, that would result in looser financial conditions which might provide some support to domestic demand to offset the impact of forthcoming fiscal austerity.

William Jackson, Chief Emerging Markets Economist, william.jackson@capitaleconomics.com