Brazil's Fiscal Puzzle: Trade, Politics, and Tax Reforms

Brazil's tapestry of fiscal reforms carry bright prospects, but macroeconomic storm clouds and thunderous geopolitics may blot out the sun.

From a fiscal and legislative perspective, President Lula recently achieved a major victory. His administration passed a new fiscal framework built on three pillars:

First, achieving fiscal stability to ease inflationary pressure to allow monetary authorities to lower interest rates. The fiscal anchor includes a tolerance range mechanism, similar to Banco Central do Brasil’s - the central bank - inflation target system, which provides flexibility while aiming for fiscal stability​.

The framework also sets an annual primary budget surplus target, aiming to move from -0.5% of GDP in 2023 to 1.0% of GDP by 2026, increasing by 0.5 percentage points each year. This pillar’s effects are more immediate. Its spending limits and targets for a budget surplus have already influenced the government budget. 

Second, boosting tax revenue to sustain the new framework. This is a more gradual process. Some changes, like reducing certain taxes, have already begun in early 2024. A key part, the new Goods and Services Tax (IBS), will be implemented in 2027. The full reform, including potential changes to income and payroll taxes, won't be completely in effect until 2033.

Third, tax reforms to simplify the Brazilian tax system on consumption. This overhaul is expected to be phased in over a transitional period starting in 2026, with full implementation projected by 2033. The overall changes are part of a comprehensive effort to facilitate investment and economic growth by streamlining Brazil's notoriously complicated tax system. 

In the near-term, the fiscal stability measures will have the most tangible impact on the Brazilian economy. Understanding their effects on monetary policy is therefore also crucial to incorporate into the macroeconomic forecast. 

Since the start of 2024, the central bank has held two meetings, and at both it cut interest rates by 50 basis points. Between January and April, the benchmark SELIC rate was reduced from 11.75% to 10.75%, the lowest since March 2022.

In a statement issued by the policy committee, they intend to make reductions "of the same magnitude in their coming meetings”. The next decision will take place on May 7 and 8. There is a tug-of-war between central bank officials carefully avoiding hyper-inflationary scenarios and the dampening effect tighter credit conditions have on economic dynamism.

President Lula has stated that he believes it is “irrational” for rates to be where they are now, and thinks they should be reduced in a more pronounced way. Despite a history of political influence, Brazil’s central bank has undergone a series of reforms and risk-mitigating provisions to maintain its operational autonomy.

The risk of political interference is therefore low. Furthermore, the recent decline in inflation was in line with expectations, and improvements in relative prices, a favorable commodities forecast, and a reduction in services sector inflation could accelerate the disinflation trajectory.

Having said that, from a domestic perspective, core prices within the services sector remain stubborn. In the international context, some officials argue that a more measured pace of rate reductions might be advisable if uncertainties about the future persist. 

As for the macroeconomic outlook, Brazil has experienced an average real GDP growth of 2.5% throughout the last forty years. However, this growth has plateaued in recent years, with a mere 0.6% increase observed over the previous decade.

The country's economic stabilization can be primarily attributed to the return to normalcy in both global and domestic economic environments following widespread corruption scandals and the impact of the COVID-19 pandemic, rather than to any substantial macroeconomic adjustments or structural reforms.

This suggests the country is still vulnerable to geopolitical shocks or macroeconomic convulsions from economic powerhouses like the US and China. The latter’s property market crisis, demographic ailments, and friction with Western allies could continue to weigh on growth. 

A recession in the US and/or a prolonged period of higher-than-expected interest rates would exert similar pressure and narrow the flow of capital into emerging market economies. In both cases - particularly if they occurred simultaneously - it would pressure commodity prices, hurt Brazil’s exports, and lead to a contraction of foreign investment.

Limited FDI would in turn hurt Brazil’s domestic reforms which rely on and are geared towards stimulating outside investment. Such a scenario would be politically damaging for the current administration. 

President Lula aims to transform his successful outcomes in 2023 into electoral triumphs for his Worker's Party before the October elections. Subsequently, an important political event will be the struggle for leadership positions in Congress, where the House and Senate will select their Speaker and President, respectively, in early 2025.

The administration faces a critical choice on whether to intervene in these elections, and the decision will significantly shape Brazil's political landscape. The success of passing more fiscal reforms will therefore be predicated on the stability of the economy, the ability to lower interest rates without reigniting inflation, and legislative alignment.

Exogenous geopolitical shocks and macroeconomic turbulence could derail domestic economic activity in Brazil, potentially leading to legislative friction ahead of key elections.