Sharp reduction in taxes will put governors under pressure

06/28/2022

The reduction of sales tax ICMS on fuel, electricity, communications and public transportation, in effect since Friday, and the analysis by the Federal Supreme Court (STF) on how to calculate taxes levied on fuels will cause a loss of R$105 billion to R$136 billion for states and municipalities, nearly 10% of all revenues from the state tax. The abrupt reduction in revenues will put governors under pressure, especially from 2023 on. Experts and politicians see a limited menu of options for them to balance it out.

The idea of compensating for the loss of revenues by increasing ICMS rates on other goods and services, or the rates of state taxes like IPVA (on vehicles) and ITCDM (on inheritance), is seen as insufficient and politically difficult. An alternative, from the revenue point of view, is to lift tax benefits granted to certain companies and industries.

Another solution is to force the ICMS tax reform, to adjust the new tax in a way to recover these losses. Some people believe, on the other hand, that the result will be pressure for more transfers from the federal government and public services deterioration. The tax collection today is on the rise because of inflation, but this same inflation will begin to pressure spending soon for salary and contract adjustments.

The decision adopted by Congress and signed into law by President Jair Bolsonaro (Liberal Party, PL) to curb inflation has trampled states and municipalities. The governors were divided between those who criticized the bill, saying it would not solve the high power and fuel prices, and those allied to the president, who praised the measure. There was concern on all sides that resistance to the tax cut would be used to attack them in October, given the proximity to the election campaigns.

Among lawmakers leading the bill, the discourse behind the scenes is that there will not be a substantial drop in revenue this year, because of inflation and the measure that will force the federal government to compensate for a loss of more than 5% in revenue compared to 2021, a rule that will be in force only by December. Starting in January, they say, the new governors and the president-elect will be able to evaluate the scenario and adopt the necessary measures.

States see gigantic losses ahead. The National Confederation of Municipalities (CNM) estimates that the cut in ICMS will take R$85 billion in revenue per year from states and municipalities. They also say that the decision of Supreme Court’s Justice André Mendonça, who ruled that the calculation of taxes levied on fuels must be based on the average of the last five years, will increase losses by more R$20 billion. The National Committee of Finance Secretaries of the States (Comsefaz) presented larger numbers Tuesday to the STF – they foresee revenue losses of R$136 billion.

A source in the treasury department of one of the largest states in the country told Valor last week that there are still no discussions among governors about what to do. They were waiting for the unfolding of all the actions to be taken by the government and the decision on possible lawsuits. He corroborated, however, the view that the deficit is high and will require measures, either spending cuts or tax increases, probably announced only in November, after the election. The impact on the coffers will also differ for each state, because it depends on the rate currently applied to items with a reduced rate under the new law, so the solutions in each location may also be different.

Ítalo Franca — Foto: Divulgação

Santander’s economist Ítalo Franca points out that regional governments (state governments and municipalities) reported last year the largest surplus since official records began, with a positive balance of R$97.7 billion between revenues and expenses, but that the new law will hinder this result.

He had projected a surplus of R$70 billion this year. With the ICMS reduction, he reduced the figure to R$25 billion. For 2023, when the impact of the new law will reach the entire year’s collection, there would be a deficit, also considering the increase in expenses such as salaries and constitutional floors for spending in health and education. “This would bring problems for the state accounts. It will be a very hard adjustment.”

Rodrigo Spada, head of the State Tax Auditors Associations (Febrafite), points out that some states do see a temporary relief for cyclical reasons, while others in fiscal recovery regime as Rio de Janeiro, Goiás and Minas Gerais. “And any loss is permanent,” he recalled.

In Mr. Spada’s opinion, the governors will have difficulty in compensating for the loss in ICMS with increases in IPVA and ITCMD because they are direct taxes, with the bill going to the richest taxpayers, with the greatest mobilization capacity.

“The most likely is the increase of the ICMS itself on other fronts. The taxpayer does not know how much he pays because it is embedded in the price of the goods. Businesspeople are the ones who collect the tax, but the buyer bears the burden,” he said. This solution, he highlighted, would harm mainly the poorest people.

This, however, comes up against two obstacles. To prevent the gasoline tax reduction from being offset by higher taxes on diesel and ethanol, Congress forbid states from raising fuel and energy taxes that were already lower than the standard (17% or 18%). Furthermore, fuels, energy and communications are today the most profitable items of ICMS, representing 50% of the tax collection in some states. These are products that, even with higher prices, the population can’t stop consuming, unlike a new refrigerator or stove.

Deputy Aguinaldo Ribeiro (Progressive Party, PP, of Paraíba), the rapporteur of the tax reform in a mixed congressional committee, believes that, because of these obstacles, there will be greater pressure to vote on the issue in 2023. The tax overhaul was shelved due to political divergences.

“It makes it easier because neither the federal government will be able to compensate the states nor the governors will be able to survive with a cut like this,” he said. For him, the proposal to amend the Constitution (PEC) 45 would have solved the problem by applying a single tax rate for all goods and services, with extra taxation for items that cause “negative externalities.”

Gabriel Leal de Barros, a partner and chief economist at Ryo Asset, also sees a consensus forming on the need to change state taxation. “It will be inescapable. It is a blessing in disguise,” he said. The risk, he points out, is if this is not accompanied by measures on the expenditure side: the administrative reform, the revision of social programs and the definition of the country’s new fiscal anchor.

“Whoever wins [the presidential election], Lula or Bolsonaro, it is clear that the spending cap will be revised and the size of this flexibilization will be proportional to the quality of tax reform,” Mr. Leal said, citing former president Luiz Inácio Lula da Silva, the front-runner in the electoral race. “If the new spending space is too big, instead of doing tax reform that focuses on efficiency, the government will end up doing reform to increase revenue. And if that’s the concern, the chance of raising tax in the wrong place is much higher, which could reduce potential GDP growth even further.”

In the current legislature, the states pressed for the approval of the ICMS reform, with the creation of a Value Added Tax (VAT) that would unite five to nine taxes, but in the end, there were divergences with the federal government about the creation of a fund to compensate for losses, with the opposition of business sectors, such as services and agriculture. In addition, Chamber of Deputies Speaker Arthur Lira (Progressive Party, PP, of Alagoas) opposed the rapporteur.

Paulo Ziulkoski, head of the National Confederation of Municipalities (CNM), said that the tax reform has been discussed for 30 years without progress and that he does not believe it will be approved in the next legislature. The most urgent issue, he stressed, is a reform of the federative pact, to discuss the responsibilities of the federal government, states and municipalities. “We have no leeway to try and reverse this loss,” he said. The cities only have three taxes (property tax IPTU, service tax ISS and real tax transfer ITBI) that, even in the largest municipalities, such as São Paulo, only represent 7% of revenues.

The loss of up to R$13 billion this year and R$26 billion annually as of 2023 due to the ICMS cut will not be compensated with other revenues, but with the precariousness of public services to the population, said Mr. Ziulkoski. “Citizens will be affected. There will be no money for school maintenance, school transportation, distribution of medicine, adequate health care,” he said.

Juliana Damasceno, a senior economist at Tendências Consultoria, pointed out that the states live an atypical situation, with lower spending because of the freezing of wages during the two years of the pandemic, and increased revenue because of inflation, but this combination will take its toll and this may occur sooner if inflation slows down. “An inflation-adjusted tax helps in the short term, but in the medium and long term it hinders on the spending side. Either because the civil servants will press for salary raises, or because contracts will be adjusted,” she said.

As a tax reform is a “very long, exhausting and difficult path,” she believes that states are likely to increase taxes and review tax incentives granted to economic activities, mainly in the scope of the fiscal war. “These governments will be forced to rethink these benefits and study how they can withdraw them,” she said. A study by Febrafite, a federation that gathers state tax inspectors, showed that, in 2020, the tax waiver as a result of these incentives reached R$92 billion, a value close to the deficit now imposed by the federal government. In states like Paraná, Paraíba and Goiás, the amount exceeded 30% of the ICMS revenue.

*By Raphael Di Cunto — Brasília

Source: Valor International