Brazil’s Lula First Six Months: Wins, Losses, and Missed Opportunities in Economic Policy

Brazil’s Lula First Six Months: Wins, Losses, and Missed Opportunities in Economic Policy

July 25, 2023, Covington Alert

Executive Summary:

• President Lula da Silva and Minister of Finance Fernando Haddad secured two major economic policy wins in the first six months with votes in Congress on the new fiscal framework and a historic tax reform. Decisions by the National Monetary Council reaffirmed their commitment to inflation control.
• The administration has been less successful in securing tax revenue increase. Several of its proposed measures were not approved by Congress while others resulted in more spending or increased tax losses.
• Missed policy opportunities include a lack of proposals on spending cuts as well as a lack of clarity on the administration’s trade and investment policy.
• In the second half of the year, the administration will likely focus on approving pending legislation, as well as proposing further microeconomic reforms.

Economic Policy Priorities

Since the beginning of his administration, President Lula da Silva and his Minister of Finance and heir apparent, Fernando Haddad, had established a goal to reignite economic growth and job creation with a particular focus on promoting gender equality, social inclusion, and environmental sustainability.

To achieve this goal, Minister Haddad outlined an economic policy focused on three main objectives:

1. The establishment of a new fiscal framework to stabilize public debt and create an incentive for the Central Bank to reduce the benchmark interest rate (SELIC), set at 13.75% since August 2022;
2. The increase of tax revenue through the elimination of tax loopholes, reduction of tax-related subsidies, decrease of federal government losses in tax disputes, and increase of tax enforcement; and
3. The approval, by the National Congress, of a major tax reform to simplify the Brazilian tax system at the federal, state, and local levels.

After its first six months, the administration has secured more wins than faced losses in its economic policy, with a few notable missed opportunities.

Policy Wins

The first major win of the administration was the proposal of the new fiscal framework (detailed in this blog post). This was triggered by a constitutional provision the outgoing Congress approved in late 2022, when then president-elect Lula negotiated fiscal spending for 2023 beyond the existing spending cap rule. In exchange, Lula agreed to present a proposal for a new fiscal policy mechanism.

The new fiscal framework bill was introduced in the House of Deputies on April 18, and approved, with amendments, on May 23. The administration needed 257 votes out of 513, and secured 372, in a demonstration of the strength of its alliance with the Speaker of the House. The Senate approved it, with additional amendments, on June 21. The administration needed 41 votes out of 81, and secured 57. A final vote is pending in the House.

The second major win of the administration was the approval, by the House, of a historic tax reform to implement a value-added tax (VAT) system in Brazil (detailed in this blog post). Reform of the tax system requires a constitutional amendment, so the administration needed 308 votes in two rounds. It secured 382 in the first round and 375 in the second. The Senate must now approve the reform and is expected to introduce amendments.

While none of the legislative measures reached the final milestone in the congressional approval process, it is very likely that the new fiscal framework will be approved by the House after Congress returns in August. The tax reform, however, will face more debate and, likely, significant amendments in the Senate. Nonetheless, the positive prospect substantially changed the perception of market players, reflected in an increased approval rate of the administration and its economic policy.

A final important win were the decisions of the National Monetary Council -- whose members are the ministers of Finance, and Planning and Budget, as well as the president of the Central Bank -- to keep the inflation targets for 2023, 2024 and 2025; to establish the target for 2026 at 3.00%, continuing the trend of the previous years; and to convert the targeting mechanism from the current calendar-year target to an ongoing target. All these decisions resonated positively with market players, reinforcing their perception of an administration committed to inflation control despite the many months of criticism of the president of the Central Bank by both President Lula and his allies.

Policy Losses

The administration has been less successful on the revenue increase strategy of its three-track approach to economic policy.

In January, President Lula issued two provisional measures (MP) with the goal of reducing private sector accumulation of tax credits as well as federal government losses in tax disputes at the administrative level. A MP is a temporary legislation issued by the Brazilian President that can change existing federal law but needs to be approved or rejected by Congress within 180 days. If Congress does not act, the MP expires.

Of the first ten MPs issued by President Lula, including the two focused on tax revenue, only two were converted into federal law. The other eight expired, including the ones focused on revenue increase. The president issued an additional MP in April to increase the taxation of Brazilian investment in offshore companies. This MP is still valid but might face the same destiny of the other two.

These developments are a symptom of the challenges the administration faces in Congress to approve measures of this nature.

One of these losses was partially reverted as the administration introduced a bill to reduce federal government losses in tax disputes at the administrative level that was approved by the House on July 7. The Senate must now vote on the bill.

Nonetheless, President Lula also issued MPs authorizing further spending on social programs and providing additional, limited tax incentives for fuels and vehicles. These MPs go against the goal of Minister Haddad to control spending and reduce tax revenue losses.

Finally, the administration suffered a significant policy loss when it tried to revert a recently-approved new legal framework for the waste and water management sector. The framework was voted by Congress during the Bolsonaro administration and opened up the sector to private investment, but President Lula tried to increase state-owned enterprises (SOEs) participation in it through an administrative act. Congress threatened to suspend the act, forcing the President to reissue it rolling back its SOEs provision.

Missed Policy Opportunities

The single, most important missed opportunity by the administration is the fact that no substantial proposal on spending cuts was presented. Since taking office, President Lula and his advisors have been reestablishing a number of flagship social programs and adopting measures that increase spending, such as salary hikes to civil servants and an increase in the minimum wage beyond the inflation level.

The new fiscal framework, as introduced in Congress by the administration, did not foresee any relevant spending control measure. A few of them were added through House amendments, but the main criticism of the framework continues to be its overreliance on revenue increase rather than on spending cuts.

Without significant improvement in fiscal policy on the spending side, Central Bank changes of SELIC will remain less effective in bringing inflation to its target in the long term.

Another notable absence in the first six months is the lack of a clear, well-defined trade and investment policy for Brazil. The administration is engaged in concluding the European Union-Mercosul free trade agreement, and advancing the trade facilitation agenda inherited from the Bolsonaro administration. There is still uncertainty on the administration’s policy on the trade agreements program and other aspects of trade and investment policy -- in particular, the goals toward Brazil’s key trade partners.

Next Steps

In the second half of 2023, the administration will likely focus its efforts on approving pending legislative measures, foremost among them the new fiscal framework and the tax reform.

Once approved, it is likely that it will move in two parallel directions. First, it might introduce in Congress an income tax reform, continuing its push to simplify and make the tax system more progressive. Second, it might move to microeconomic reform, looking for areas where an improved legal or regulatory framework can attract private sector investment. One potential area mentioned by Minister Haddad is the modernization of the existing public-private partnerships framework.

In parallel to the administration’s efforts, Congress will likely move on with its own microeconomic reform agenda, as it has done in the past two legislatures. During the first half of the year, it approved a new transfer price law, bringing Brazil closer to the Organization for Economic Co-operation and Development (OECD) standard. Other microeconomic reforms of this nature can be expected.

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