The anaconda tightens its grip
The Regional Development Fund attached to the tax reform bill deepens Brazil's old model of extracting rents from society towards regional bureaucratic stands
Last week, the Senate approved the constitutional amendment for tax reform, which consolidates five indirect taxes—ISS, ICMS, PIS/Cofins, and IPI—into a shared tax between municipalities, states, and the Union, as well as a selective tax on items which display relatively low demand price elasticity, such as beverages and tobacco.
The new tax is divided into two: CBS (Contribution on Goods and Services), directed to the Union, and IBS (Tax on Goods and Services), shared between municipalities and states. As the taxable event, the tax base, and the tax regimes will be the same, they will function as a single tax, with an estimated rate of around 27.5%, making it the highest in the world in its category.
Proponents of this reform argue that the new system is superior to the current one, as it replaces a tangled web of cumulative taxes, where businesses pay taxes on taxes already paid by their suppliers, often without having the possibility of deducting or converting into tax credits the taxes collected under these circumstances. The new system would eliminate these distortions and presumably lead to productivity gains capable of raising the potential GDP growth rate, as well as contributing to reducing the country's enormous tax litigation standout, estimated at about 75% of GDP*.
The inefficiency of the current tax system, as well as the need to reform it, is undisputed. However, the reservations generally made about the system about to be approved do not go much beyond enumerating the multiple exceptions to the main regime that were foreseen, which makes the full rate higher for the few sectors that will be subject to it. The list of sectors beyond those most obvious to be contemplated with a lower rate or a special regime, such as health, education, and urban transport, grew enormously during the bill's progress through Congress, and includes activities as diverse as bars and restaurants, amusement parks, hospitality, financial services, football teams' SATs, sanitation, highway concessions, airlines, professional services of doctors, lawyers, accountants, and many others.
A central aspect of the issue, relatively little discussed in available analyses, is the cost imposed on the Union (taxpayer) as a counterpart for the approval of the reform.
In the current system, states have wide autonomy over the management of the ICMS, whose rate can be reduced or increased, within certain limits, as they wish to attract or inhibit a certain economic activity in their jurisdictions. Many analysts pejoratively call this legitimate federative mechanism a “tax war”, since it leads to some erosion of states’ tax collection as they engage in competition for hosting good businesses.
In the new system, states (and municipalities) will lose all their fiscal autonomy. States will only be able to define the general rate of the IBS for products consumed in their territory, with no differentiation allowed by sectors - which completely precludes its use as a tool for fiscal or economic policy.
To compensate for the incentives granted by the states, in recent years, the approved reform established the Fund for Compensation of Fiscal and Financial Incentives, which will be constituted by federal (taxpayer) resources, to be transferred to the states from 2025 to 2032. The total amount to be transferred over 8 years will reach R$ 160 billion, in 2023 values.
So far, one might argue, be it - we would be talking about a temporary average transfer of 0.2% of the GDP per year to the states, aimed at honoring previously assumed commitments. From then on, the productivity gains resulting from the reform and touted by its enthusiasts should, presumably, be more than enough to compensate for the extinction of the states' fiscal autonomy, making additional mechanisms of regional subsidies, in principle, unnecessary.
But the text approved in the senate went much further. It established the Regional Development Fund (RDF), which will also be constituted by taxpayer’s money, and whose contributed amounts will be increasing, starting in 2029 with R$ 8 billion, and reaching R$ 60 billion (in 2023 values) from 2043 onwards, or 0.6% of Brazil’s GDP.
Seventy percent of the RDF will be distributed to the states according to the same rule that distributes the resources of the FPE - Fund for the Participation of States - which directs 21.5% of the Union's collection from IR (income tax) and IPI (tax on industrialized products) to the states. The distribution of the FPE follows a formula that contemplates the distribution of its resources disproportionately, with the states of the North and Northeast regions being privileged in this sharing - especially, the poorer and less populous states of these regions. In 2022, the FPE distributed 78% of its R$ 180 billion to states in the North and Northeast regions.
It is true that the current system of fiscal federalism generates distortions. After all, when a state offers, for example, a reduction in ICMS to a car manufacturer to set up in the state, the company fully appropriates this benefit - as it issues the sales invoice of its cars at the full ICMS rate. However, the nature of these agreements is competitive and involves trade-offs. The governor needs to evaluate the exemption period of the benefit and weigh, among other aspects, the economic gains from the jobs generated by the company with the associated cost of foregone revenues. In addition, in the present situation, there are no taxpayer’s money involved.
The constitution of the RDF follows a completely different logic. By creating a mechanism for transferring taxpayer resources - additional to those already existing - to certain states, the amendment approved by the senate blatantly reveals the legislative intention to intensify and even perpetuate the machine for transferring resources from the states of the South, Southeast, and Midwest - towards the North and Northeast - which was installed in Brazil by the Constitution of 1988. The magna carta created the FPE and the FPM; the minimum values of federal spending on health and education - which imply more transfers, once the nature of these expenses is markedly regional - in addition to several other mechanisms that encourage the growth of public spending, associated with the huge list of "rights" that the constitution "guaranteed" to the population.
The FDR funds - which, from 2043 onwards, will represent an additional constitutional transfer to the states of about 30% of the current value of FPE - can be used by the states as they see fit. There are no trade-offs, in the sense that there is no need to weigh the cost/benefit relationship between the drop in revenue and the economic gains associated with companies coming to the state. These are resources that, literally, from the perspective of the ruling elites and - in Raymundo Faoro's** definition - the bureaucratic stand of each state - fall from the sky, and can be allocated in ways that maximize the interests of these groups. But will this mechanism exist forever? Yes, it will. But then will these states “need’ these transfers forever? Will they never be on the same level of development as the rest of the country, thus unable to do without these resources? This is irrelevant. The logic of appropriation and transfer of resources in Brazil is not related to 'necessity' or any argument of economic efficiency, but to a pure mechanism of extracting rents from less organized and proportionally less politically represented groups towards others.
Objectively, the fiscal compensation fund (which expires in 2032) would address the incentives already taken, and from then on the states could stand on their own. However, the reform, without the FDR add-on, simply would not be approved. Will the Southern, Southeastern, and Central-Western states be left without tools for fiscal policy and management? The governors of these states did not like it? That's their problem. The Northern and Northeastern states will have more taxpayer resources, and that's the only logic that matters. Not coincidentally, the fact that this reform did not advance during the previous government was largely due to the presence of a finance minister who respected taxpayers' resources, having refused, while in office, to support any transfer in the style of those determined by the constitutional amendment about to be enacted.
The increase in the regional estate's voracity over public resources is also not a coincidence. Comprising 16 out of a total of 27 states, which account for only 21% of the GDP and 36% of the country's population, the Northern and Northeastern regions control the majority of seats in the Senate, which was enough to ensure the introduction of other absurdities in the present reform, such as the Fund for Economic Sustainability and Diversification of the State of Amazonas, also to be constituted with taxpayers’ resources, in the context of preserving tax incentives for the Manaus Tax Free Zone (ZFM). The approved text commands the collection of a tax (CIDE) that every product sold in the country, which has a similar 'produced' in the ZFM, will be subject to. No, you did not read it wrong. That's exactly it. The approved tax reform bill dictates that, should you buy a bicycle or motorcycle, for example, that happens not to be assembled in the ZFM, you will pay this tax when purchasing the product. The alleged purpose of the tax is to maintain the 'competitiveness' of the Manaus industrial hub.
It should be mentioned that the states will not be completely prevented from creating new taxes. The approved text allows for the creation of a new state tax on primary or semi-processed products - in practice, on agriculture, mining, and oil. A new front for the expansion of the tax burden.
The current reform deepens and consolidates the “federative pact” that governs Brazil today, which also traces its origins to the 1988 Constitution. Its governance works more or less as follows: The Supreme Federal Court (STF), endowed by the constitution with the authority to judge the political elite, holds it under control, having acquired the right to interfere in matters of the other power branches and disregard any law as it pleases - as long as it does not imprison any senator, which seems to be the only scenario that might lead to the impeachment of one of its ministers. The Senate, controlled by 16 states representing 21% of the country's GDP - thanks also to the Constitution of 1988, which created the states of Roraima, Amapá, and Tocantins - has become a mechanism for transferring resources from the south-central to the north and northeast states, especially to the most backward and less populated corners of these regions. Meanwhile, the executive power increases federal expenditures relentlessly, and to enable this practice, extorts as much taxes as possible from individuals and companies, securing the support of deputies for this levy through budgetary allocations and/or government job positions for their protegés.
Feel the squeeze of the anaconda? Fasten your seatbelt, take a deep breath and save some breath, as the tax reform bill anticipates the submission, within 90 days, of the income tax reform. On the agenda, the imposition of income tax on dividends, the end of JCP - a lower corporate income tax bracket - and other measures that taxpayers will surely adore.
Disclaimer: The financial market operates with a short-term focus. As long as the country is growing and the exchange rate is well-behaved, long-term structural negatives such as those highlighted in this text tend to have a low impact on financial assets.
* Insper Report on Tax Litigation, 2020.
** Raymundo Faoro, the author of the magnificent work “Os Donos do Poder”, is Brazil’s greatest interpreter.