Brazil’s tax issues are a direct consequence of very high government expenditure on social programs and a deep “underground economy” creating large amounts of non-taxed “black money.” This problem began when Brazil drastically increased its taxes in the early 2000’s to help propel the economy and pay for infrastructure projects as seen in Figure X (Corporate Tax Rate % History). The drastic revenue increase has resulted in social programs that now depend on a very high rate of tax revenue which has become difficult to sustain and is burdensome on corporations at twenty-five percent of profits.Most experts do not believe that the tax system in Brazil can be significantly reformed, as it will require difficult decisions related to social policies that political parties will be unwilling to make, and the uncertainty of tax policy can be summarized by the positions of the two leading candidates. One intends to cut taxes to make investment more attractive and grow the tax base, while the other plans to increase tax revenue further by taxing things such as dividends. A recent poll predicts a likely win for conservative political candidates, however the recent success of populist rhetoric will ensure that most tax reform measures will be mild and unimpactful. Lisa Schineller, primary credit analyst at S&P Global states – “Whoever wins, it’s going to be a question of what their political mandate is and how much political capital they have. 7”
All-in-all, Brazil’s tax rates add up to a very uncompetitive thirty-four percent, compared to countries like Mexico, which has lowered tax rates to twenty-eight percent. (Table 1), while Figure X shows the tax revenue as a percent of GDP, where Brazilian tax policies are so high, that they are only comparable to the socialist/communist Russian Federation among countries in “BRIC.” However, current world-wide trade issues present a unique opportunity for Brazil to create a competitive tax. Regardless, the only clear path to a more competitive tax system is one where Brazil grows its economy enough to move people out of the “black” untaxed zone, into the taxed zone. This can happen only if growth in the economy continues to accelerate, and employment levels rise. , Brazil should reform its tax policy to facilitate an increase in consumption through policies that lead towards increased consumer household incomes.
Global Trade Wars and Tariffs
Brazil has for long followed an isolationist policy that prevents imports by keeping tariffs high. Tariffs average twelve percent 5 and comparable to Venezuela’s, considered the most protectionist government in South America. Figure x provides an overview of the Tariff rates across various categories and Figure y provides a comparison of Tariffs with other BRIC countries. Brazil follows the model of most developing countries, keeping trade barriers high, in an attempt to protect its own industries. Although, in the end, tariffs are just another consumption tax for the consumers. When one combines the high income and corporate tax structure in Brazil , with high trade barriers, it results in a negative climate for accelerated GDP growth, as seen in Figure x.
Brazil’s primary trade pact, is MERCOSUR. “Mercosur (also known as Mercosul or Ñemby Ñemuha) is a South American trade bloc established by the Treaty of Asunción in 1991 and Protocol of Ouro Preto in 1994. Its full members are Argentina, Brazil, Paraguay and Uruguay. 10” Brazil has made several attempts to extend this trade pact to all countries on the American continent, which including taking a leadership role in the early 2000’s, boldly attempting to create a free trade zone across the Americas (FTAA). This failed, and Brazil was did not benefit from the advantages of free trade with other global economies.
The Unique Opportunity for Brazil
In 2004, Cunha, Alexadra et.al 11 conducted a study of three experiments on the impact of tariffs, trade pacts and tax policies on the Brazilian economy, that remain relevant and applicable to Brazil’s current situation. The experiments are summarized as:
Experiment 1 – MERCOSUR remains the only trade pact for Brazil, and there are no changes to Brazil’s existing trade agreements.
Experiment 2 – Brazil negotiates and gains access to a trade free zone which includes the US, a plausible scenario where the US considers trade deals with Brazil given its attitude towards NAFTA and Mexico.
Experiment 3 – Brazil negotiates and gains access to a trade free zone which includes the US AND makes changes to their tax policy, which may occur as a result of the impending election and the current leader’s 12 intention to cut taxes.
Results of the experiment can be found in EXHIBIT X. Note: This is not a study conducted by our team but a direct reproduction of study by Cunha, Alexadra et.al 11.
The authors conclude that if the US increases tariffs, or if Brazil were to negotiate further trade deals, that these actions would have significantly smaller impact on the Brazilian economy than a “unilateral” tax policy change. In their experiment, tax reductions had a more significant impact on welfare gains and resulted in significant increase in private investments.
In summary, as Cunha, Alexadra et.al suggest, Brazil should reform its tax laws to remain competitive. With the impending election, corporations will be looking for “early mover” opportunities to leverage this likely scenario. Companies should explore leveraging growth in Brazil as a risk mitigation strategy around possible sourcing shocks resulting from trade wars between the US, China and Mexico. As the world waits and watches while Brazil’s political drama plays-out, companies and investors are paying close attention, trying to make heads or tails of the opportunity to bet on Brazil.