Brazil’s Weakening Fiscal Framework and its Impact on Businesses

ExecutiveSummary

• President Luiz Inácio Lula da Silva's administration has pursued a vigorous effort to increase revenue as part of Brazil's fiscal framework implementation. At the same time, the administration has avoided spending cuts.
• This strategy seems to be reaching its political limit, creating an incentive for the administration to weaken the fiscal framework approved by Brazil's National Congress last year.
• This sends mixed signals to investors and results in an overburdened monetary policy, which may lead to reduced investment, growth, and job creation in the medium term.

Analysis

On August 30, 2023, President Luiz Inácio Lula da Silva signed into law Brazil's new fiscal framework. The framework was presented by his administration in March last year, and approved by Brazil's National Congress in less than five months. It was the administration's top economic policy priority to stabilize public debt, create an incentive for the Central Bank to reduce the benchmark interest rate, and reignite economic growth and job creation. It was also highly anticipated by market players to assess the administration's commitment to fiscal responsibility.

Framework Mechanics

The framework established a "fiscal anchor" based on an annual primary budget surplus target, beginning with a deficit of 0.5 percent of GDP in 2023 and growing in 0.5 pp increments per year until reaching a surplus of 1.0 percent of GDP in 2026. It is a linear trajectory to put the country's fiscal policy back in a scenario of annual primary budget surpluses (i.e., excluding debt servicing.) These targets were codified in the 2024 annual budget authorization legislation signed into law on December 29, 2023.

However, the framework also pegged spending growth to revenue increase at 70 percent. If the annual target is not achieved, the peg is reduced to 50 percent, but never zeroed. The spending increase has both a "floor" of 0.6 percent and a "ceiling" of 2.5 percent of revenue increase.

In practice, the mechanics of the peg allows the federal government to spend even if it does not achieve the target, and independently of the business cycle stage (i.e., if in expansion or contraction.)

Increasing Revenue

To make the framework mechanics work, the federal government embarked on a vigorous effort to raise revenue by strengthening tax enforcement, closing tax loopholes, reducing tax subsidies, and hiking taxes.

Examples of these measures in the past 18 months include:

• Reimposition of a federal government tie-break vote on administrative tax disputes;
• Enforcement of existing and creation of new cross-border e-commerce taxation;
• Limitations on several types of tax credits;
• Establishment of a temporary export tariff on oil; and
• Creation of new taxes on offshore companies, investment funds, and sports betting and online gaming.

Avoiding Spending Cuts

While the administration pursues its revenue-generating strategy, it has also been avoiding spending cuts. For months, the Speaker of the House has been publicly stating the need for an administrative reform to streamline the federal government's workforce and curb spending, only to see his proposal rejected publicly by cabinet members.

The only small opening to a spending cut discussion came from recent commentary by the ministers of Finance, and Planning and Budget, on the federal government's budget rigidity. Constitutionally-mandated minimum spending targets, combined with the indexation of social security entitlements and social programs to the national minimum wage (that increases every year), are progressively reducing the administration's room to pursue discretionary spending.

In view of growing budget rigidity, these ministers have been pointing to the need for constitutional reform to eliminate social security entitlements and social programs indexation to the national minimum wage. In practice, this would mean that the minimum wage could increase beyond inflation, while benefits would only adjust for it. Nonetheless, President Lula has yet to support this proposal, which increases market players' perception that the administration will only pursue spending cuts as a last resort.

Finally, it is important to mention that, as Brazil approaches local elections in October, Congress has also softened its stance on spending cuts. It has renewed tax subsidies and approved additional spending, either with the support of or against the administration's request.

Weakening the Fiscal Framework

Without any real commitment so far to reduce spending, the administration's push to increase revenue seems to be reaching its political limit. Recent efforts to reduce payroll taxes subsidies, increase the taxation of cross-border e-commerce, and limit debt compensation with tax credits have resulted in increased criticism by members of Congress, business leaders, and voters.

This limit was already clear to the administration since the end of 2023, when President Lula pressured his cabinet and Congress to change the 2024 annual primary budget surplus target of 0.0 percent of GDP to a deficit, an effort later abandoned when the annual budget authorization legislation was approved. However, the administration doubled down on this strategy when it introduced the 2025 annual budget authorization bill.

This bill, currently in debate in Congress, stretches the 2025 annual primary budget surplus target of 0.5 percent of GDP, and the 2026 target of 1.0 percent of GDP, into 0.25 pp increases per year, as follows: 0.0 percent in 2025, 0.25 percent in 2026, 0.50 percent in 2027, and 1.0 percent in 2028. In practice, the administration is proposing to postpone its commitment to reach 1.0 percent of annual primary surplus from 2026 to 2028, two years after President Lula's current term ends.

Finally, a minor, yet symbolic weakening of the fiscal framework already took place when the administration sponsored the inclusion of a non-related amendment in an insurance bill approved by Congress to change a provision in the framework's federal law to anticipate otherwise unavailable spending.

Impact to Businesses

The administration's combined efforts to increase revenue, avoid spending cuts, and weaken its own fiscal framework have the potential to negatively affect businesses.

On one hand, these efforts generate mixed signals to investors because the administration simultaneously voices its commitment to fiscal responsibility, but pursues a strategy that seems to contradict it. A similar contradictory pattern has also emerged when it comes to microeconomic policy, signaling a potential return of State capitalism-type policies in Brazil.

On the other hand, this approach to fiscal policy creates pressure on the Central Bank to rely more heavily on monetary policy to manage the business cycle. This already resulted in the Bank's interruption of the benchmark interest rate reduction cycle at 10.50 percent per year, effectively making it the least ambitious of the last decade in Brazil with an accumulated reduction of 3.25 pp, respectively 0.25 pp and 1.75 pp less than in the previous Bolsonaro and Temer administrations' cycles.

At this point, market players' average GDP growth projection for 2024 is 2.09 percent, compared to 1.51 percent in January. While this projection points to a more positive outcome, the benchmark interest rate average projection increased from 9.00 percent in January to 10.50 percent in June, while annual inflation projection increased from 3.90 percent to 3.98 percent in the same period. In addition, while a 2.00 to 2.50 percent GDP growth would be a good result for the administration, it would also mark a weaker economy when compared to the 2.9 percent growth in 2023.

The combination of mixed signals to investors with an overburdened monetary policy might reduce investment, growth and job creation in the country in the medium-term, despite short-time gains.

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