Cablegate: Brazil's 2004 Budget Blues

This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 08 BRASILIA 001098

SIPDIS

SENSITIVE

NSC FOR DEMPSEY
TREASURY FOR OASIA - SEGAL
STATE FOR EB/IFD/OMA - O'REILLY AND WHA/EPSC
STATE PASS FED BOARD OF GOVERNORS FOR ROBITAILLE
USDA FOR FAS/FAA/TERPSTRA
USDOC FOR 4332/ITA/WH/OLAC
USDOC FOR 3134/USFCS/OIO/WH

E.O. 12958: N/A
TAGS: ECON EFIN PGOV EINV SOCI PREL BR
SUBJECT: BRAZIL'S 2004 BUDGET BLUES

REF: A) Brasilia 936
B) Brasilia 291
C) Sao Paulo 557
D) Brasilia 661
E) Brasilia 873
F) Brasilia 644
G) Brasilia 1048

This cable is Sensitive but Unclassified, please protect
accordingly.

SUMMARY AND COMMENT
-------------------

1. (U) A high debt-service burden and extensive earmarking
leave Brazil's federal government with little room for
maneuver in its Reals 413 billion (USD 137 billion) 2004
budget as it tries to pursue its social-policy goals while
addressing public concerns over security, unemployment and
growth. In 2003, overall public-sector interest outlays of
9.48% of GDP turned the GoB's hard-won primary surplus of
4.32% of GDP into a nominal deficit of 5.16%. This year
there is some relief on the interest front, as the return of
financial-market confidence has reduced rates on Brazilian
debt. The GoB estimates interest outlays of about 7.4% of
GDP in 2004. Given the GoB's resolute pursuit of a 4.25% of
GDP primary surplus, that would cause the projected nominal
deficit to fall to about 3.15% of GDP. Discretionary
expenditures (program funds and investment outlays) amount
to about 13% of all federal outlays, including interest
payments and mandated transfers to states and
municipalities. The transfers reduce the revenue available
to the federal government by 15-16%.

2. (U) The GoB's commitment to an austere fiscal policy,
even as economic growth remains feeble, has made it the
target of sustained criticism. Pressure is building,
through a series of strikes and work slowdowns and landless-
movement squatter invasions, for larger-than-budgeted public-
sector wage increases and additional money for resettlement
efforts (refs C and E). Official data shows that, by some
measures, President Lula's Workers' Party government spent
less on social programs in its first year than its
predecessor did the year before.

3. (SBU) Despite these pressures, we see no danger of a
change in the GoB's commitment to its primary-surplus goal
this year: Lula has made defense of his team's economic
policy a constant feature in his public appearances. Two
April 15 actions reinforced this commitment: the Senate
budget committee endorsed the multi-year budget plan, and,
separately, Lula sent Congress the 2005 Budget Guidelines
Bill, both of which set a 4.25% primary-surplus target for
2005. We do expect the GoB to tinker around the edges of
the budget in this municipal-election year, including by
accelerating the expenditure of some higher-than-projected
tax collections from the first quarter of 2004 and finding
even more "savings" by cutting expenditures from program
budgets. But we believe these adjustments will always be
made with the overriding primary surplus goal in sight. END
SUMMARY AND COMMENT.

Table I
Public Sector Primary Surplus Breakdown
(Percent of GDP)

2003 2004

Federal Government 4.17% 4.18%
Social Security -1.74% -1.73%
State Governments 1.89% 1.80%
----------------- ---- ----
Public Sector
Primary Surplus 4.32% 4.25%

- Public Sector
Interest Payments/1 9.48% 7.4%
----------------- ---- ----
Nominal Deficit 5.16 3.15
Sources: Central Bank, Ministries of Planning and Budget,
Finance
/1 Note: Central Bank Chairman Meirelles in public comments
April 29 estimated that 2004 interest outlays could be as
low as 7.15% of GDP.

Budget Outline
--------------

4. (U) Brazil's federal government collects 23% to 24% of
GDP at the federal level. About two-thirds of this (16.23%
of GDP) is projected in 2004 to come from taxes and
"contributions," the largest of which are personal and
corporate income taxes (5.1% of GDP), COFINS (a payroll
contribution whose revenues, at 4.3% of GDP, are earmarked
for social-security expenditures) and the CPMF, a financial
transactions "contribution" (1.5% of GDP). The remaining
one-third is made up of private sector social-security
contributions (at 5.48% of GDP) and of other income (2.25%
of GDP, including dividends from parastatals, fees,
royalties, and worker unemployment insurance fund payments.
"Importation Taxes," i.e., tariffs, are projected at Reals
9.2 billion or 0.54% of GDP for 2004).

5. (U) A constitutional revenue-sharing scheme mandates the
transfer of 47% of all personal and corporate income taxes
and 57% of the federal Industrial Production Tax (the "IPI")
to states and municipalities. In recent years these
transfers have reduced overall federal income by about 15%-
16%. They have also given the federal government an
incentive to create a series of "contributions," which,
unlike "taxes," are exempt from the constitutionally-
mandated transfer arrangements. After transfers, net
federal income (including social security contributions)
currently fluctuates around 20% of GDP. Brazil's total tax
burden, once state and municipal taxes (notably the ICMS)
are added in, was over 36% of GDP in 2003.

Table II
Federal Income
Billions of Reals (Nominal)

2002 2003 2004 2004
Executed Executed Law After
Sequestration

Total Income 324.02 359.98 413.47 407.14
- % of GDP 24.1% 23.8% 24.9% 24.5%

- of which taxes 224.27 247.18 279.92 274.90
- other income 27.29 31.01 39.72 38.12
- Worker Guarantee
Fund Income 1.92 1.67 1.57 1.57

Social Security
Contributions 71.03 80.12 92.58 92.82

Transfers to States
and Municipalities 52.28 56.86 64.27 61.50
- % of GDP 3.88% 3.75% 3.87% 3.70%

Net Federal Income 271.74 303.13 349.19 345.64
- % of GDP 20.19% 20.00% 21.00% 20.79%

Source: Ministry of Planning and Budget
6. (U) To meet their primary-surplus goals, GoBs of recent
years have limited non-debt-interest federal expenditures to
between 17% and 18% of GDP. The Lula government cut such
expenditures in its first year, 2003, to 17.53% of GDP from
17.83% of GDP in 2002. It projects a rise to 18.3% of GDP
in 2004 (Tables I - III). Almost 87% of federal spending,
including federal-level interest payments and transfers to
the states and municipalities, is earmarked or otherwise not
discretionary, i.e. committed to salaries and benefits.
Salaries and benefits (including pensions for government
employees) have swallowed as much as 30.85% of non-interest
expenditures in recent years.

7. (U) Constitutional and legislative earmarking leaves the
federal government insufficient money to make interest
payments on the debt and for required program expenditures
and investment. In addition to the mandatory transfers to
states, income from many taxes is earmarked. Revenues from
"contributions," which are taxes in all but name, are 100%
earmarked. Income from the CPMF, for example, which hits
financial transactions, legally is required to be spent for
Social Security, the Combat Against Poverty Fund, and health
programs. The solution to this budgetary Gordian knot was a
legislative/budgetary artifice, the so-called "DRU," that de-
links 20% of federal tax and contribution receipts (after
the required transfers to states) from the earmark
calculation. This gives the GoB some margin to cover
interest payments, wages and benefits and have a little
money left over for discretionary expenditures. To obtain
original passage of the measure in the early 1990s, it was
made nominally temporary; in December 2003 Lula's GoB
achieved its latest extension, this time through 2007.

8. (U) After making wage and benefit payments, social
security payments and other obligatory expenditures (and
having netted out interest payments and transfers to the
states) the GoB is left with between 20% and 22% of its
expenditures to allocate at its discretion among ministries
to cover program expenses (utilities, travel costs, etc) and
investment (everything from computer upgrades at ministries
to selected infrastructure projects - see Table III).
(Note: Discretionary expenditures are about 13% of federal
outlays if interest payments and transfers to states are
included in the calculation.) It is this discretionary
portion of the budget which invariably is sequestered to
meet primary-surplus goals. There are limits on how much
the GoB can try to save on these program expenses; the
savings effort last year at times left some ministries
struggling to pay their electricity bills. In early 2003,
Lula's then-incoming GoB cut these discretionary
expenditures by over Reals 4 billion in nominal terms from
2002, primarily by cutting investment outlays (see Table
III).

Table III
Federal Expenditures, Primary Surplus
and Social Security Deficit
Billions of Reals (Nominal)

2002 2003 2004 2004
Executed Executed Law After
Sequestration
I. Expenditures 240.00 265.54 307.35 304.22
- % of GDP 17.83% 17.53% 18.48% 18.30%
a) Salaries and Government Benefits, including Pensions
74.04 78.97 83.70 84.71
- % of expenditures 30.85% 29.74% 27.23% 27.84%
- % of GDP 5.50% 5.21% 5.03% 5.09%

b) Private Sector Social Security Benefits
88.03 107.13 122.19 122.05
- % of expenditures 36.68% 40.35% 39.76% 40.12%
- % of GDP 6.54% 7.07% 7.35% 7.34%

c) Other Obligatory Expenditures
21.81 27.37 30.92 32.23
- % of expenditures 9.09% 10.31% 10.06% 10.60%
- % of GDP 1.62% 1.81% 1.86% 1.94%

d) Discretionary Expenditures
56.12 52.06 70.54 65.23
- % of expenditures 23.38% 19.61% 22.95% 21.44%
- % of GDP 4.17% 3.44% 4.24% 3.92%

II. Primary Surplus (without Social Security)
48.74 64.60 71.46 70.64
- % of GDP 3.62% 4.26% 4.30% 4.25%

Social Security Deficit
-17.00 -26.40 -29.62 -29.23
- % of GDP -1.26% -1.74% -1.78% -1.76%

Overall Federal Primary Surplus /1
31.92 38.74 41.85 41.42
- % of GDP 2.37% 2.56% 2.52% 2.49%

1/ State-level savings and earnings from financial
parastatals, not included here, increase the overall public
sector primary surplus (see Table I).

Source: Ministry of Planning and Budget

2004 Expenditure Tensions
-------------------------

9. (U) The Lula administration, under the authority of the
Fiscal Responsibility Law (LRF), started 2004 by freezing
Reals 6.6 billion in expenditures from the 2004 budget law
approved previously by Congress. This was a GoB step to re-
assert revenue realities (Ref B). The Congress had adopted
a series of optimistic revenue assumptions, including real
GDP growth of 4% (versus 3.51% in the administration budget
proposal) to justify the increased spending, most of which
would have gone to finance pork-barrel investment (ref A).
To soften the political impact of its spending freeze, the
GoB said at the time that it would contemplate unfreezing
some expenditures relatively early in the year, should
revenues be higher than it projected.

10. (U) Revenues through March have in fact been running
ahead of projections: Ministry of Finance data show first-
quarter federal revenues at Reals 75.3 billion, up 13.9%
from the same period of 2003. This represents a real
increase of about 7.7% (deflating using the IGP-DI, a broad
inflation index). This resulted in a first-quarter 2004
primary surplus of Reals 20.3 billion, well ahead of the
Reals 14.5 billion target, despite having to offset an
unexpectedly negative income of Reals 2.2 billion from
parastatals (mostly accounted for by Petrobras dividend
payments). By comparison, the first-quarter surplus in 2003
was Reals 22.8 billion, with parastatals contributing Reals
3.2 billion to the positive outcome. This implies a large
positive swing in the federal-level surplus.

Wages and Strikes
-----------------

11. (U) The GoB set aside Reals 1.5 billion in the 2004
budget to accommodate projected wage increases for public-
sector workers ranging from 7.1% to 29.4% (depending on the
job category). Under the threat of a general strike by
government workers (Ref C), the GoB has improved its offer
to the 9.5% to 32.3% range, an action that reportedly would
increase the fiscal impact of the wage settlement by 500
million Reals, for a total fiscal impact of about 2 billion
Reals. This new offer comes after the GoB's announcement of
Reals 1.7 billion for the resettlement of landless movement
(MST) families (ref E), an amount also not accounted for in
the original GoB budget proposal. These increased
expenditures will need to be offset through reduced
investment, greater savings in program expenses, and/or
using some of the greater-than-anticipated revenues from the
first quarter, which the GoB originally planned to hold in
reserve until later in the year (ref B).

12. (U) Refs A and G reports on Lula's oft-delayed decision,
originally expected April 15, on the size of this year's
increase in the minimum wage. Explaining the delay, Lula
told reporters that he needed to weigh carefully the social
implications of the size of the minimum-wage increase
against the need to invest to facilitate future economic
growth, implying that the latter would have to be reduced to
offset higher-than-planned wage expenditures. Despite
substantial pressure for a significant increase, in the
event Lula raised the minimum wage by 1.2% in real terms
(Reals 20), to Reals 260. When coupled with a parallel
increase in a social assistance payment, the 20-Reals
increase should add Reals 677.7 million in expenditures
beyond those envisioned in the 2004 budget document during
the remainder of this calendar year. This remains well
within the budgetary cushion that higher-than-anticipated
revenues have won the GoB.

Investments
-----------

13. (U) The easiest target of cuts have been discretionary
investment expenditures. When it first came into office in
January 2003, the Lula administration cut investment
expenditures in nominal terms from the Reals 10.9 billion in
the last year of the FHC administration to Reals 6.957
billion in 2003 (an even more substantial cut in real
terms). And, while the Congress budgeted investment
expenditures at Reals 12.9 billion for 2004, the GoB's
freezing of expenditures cut that by almost Reals 6 billion.
Through March 2004, only Reals 54.8 million in investments
had been executed, Reals 47.4 million of which was by the
Air Force. This inability to finance substantial
investment, particularly infrastructure investment, at the
federal level increases the importance of Brazil's effort to
attract investment to infrastructure projects through Public
Private Partnerships (PPPs - Ref F).

Table IV
Federal Budget By Function
Billions of Reals
2002 2003 2004
Executed Executed Law

Pensions (public & private)
123.22 145.48 160.71
- % of Expenditures 51.3% 55.4% 52.4%

Sanitation 0.097 0.06 0.19
- % of Expenditures 0.04% 0.02% 0.06%

Health 25.43 27.17 33.10
- % of Expenditures 10.6% 10.4% 10.8%

Public Security 2.20 2.41 2.72
- % of Expenditures 0.92% 0.92% 0.89%

Education 13.22 14.22 13.85
- % of Expenditures 5.5% 5.4% 4.5%

Defense 12.62 11.57 11.95
- % of Expenditures 5.3% 4.4% 3.9%

Social Programs 6.51 8.42 13.17
- % of Expenditures 2.7% 3.2% 4.3%

Source: Ministry of Planning and Budget

Social Programs
---------------

14. (U) Lula's PT government has come in for considerable
criticism over the low level of spending on social programs.
There is some official data to indicate that Lula spent less
on social programs in the first year of his administration
than his predecessor Fernando Henrique Cardoso (FHC) did in
2002, his last. There was a decrease in nominal terms of
the budget of the Social Assistance Ministry, which fell
from Reals 1.2 billion in 2002 to Reals 1.0 billion in 2003.
The GoB, however, claims an increase in social expenditures,
from Reals 6.5 billion to Reals 8.4 billion, based on more
inclusive measures of social-assistance programs scattered
through many ministries. By this measure, social spending
increased 18% in real terms as well as increasing as a
percent of GoB expenditures (to 3.2% from 2.7% in 2002).
The Congress budgeted a much larger increase, to Reals 13.2
billion for 2004, representing 4.2% of expenditure, in part
as financing for a new secretariat to manage hunger
alleviation programs, including the Bolsa Familia program
(Table IV).

Public Security
---------------

15. (U) Polling data have consistently shown that the poor
public-security situation is the area of greatest public
dissatisfaction with the GoB's record. While the state
governments carry the main responsibility for public
security and much of the expenditure burden, the perception
of governmental inaction taints all levels of government.
Federal public security expenditures have in fact increased
slightly in real terms since the last year of the Cardoso
government, and are budgeted to do so again in 2004.
However, public-security spending still accounts for less
than 1% of the federal budget and stands to decline slightly
as a percent of expenditures inn the 2004 budget (Table IV).
Industrial Policy
-----------------

16. (U) The GoB's splashy March 31 announcement of amounts
to be spent on its industrial policy caused some market and
media concern that this spending might endanger the GoB's
2004 budget target. The monies involved, however, are
mainly earmarks for sector-specific lending by the Economic
and Social Development Bank (BNDES) and majority state-owned
Banco do Brasil. Out of BNDES' total 2004 lending target of
Reals 15.05 billion for industrial development, the
industrial policy earmarks Reals 3.61 billion for the
software, pharmaceuticals, capital goods and
microelectronics sectors. The money is supposed to be
destined primarily for modernizing plant and equipment in
these capital-intensive sectors (ref D). A further Reals
550 million is slated to come from the 2004 budget to create
research and development incentives, including by increasing
staff at Brazil's Intellectual Property Institute (INPI) to
ensure patent applications are given quicker handling.

Military Expenditures
---------------------

17. (U) Brazil's defense budget (excluding pensions and
benefits) fell in nominal terms from Reals 12.6 billion
(0.94% of GDP or 5.26% of federal expenditures after state
transfers and interest payments are netted out) in 2002 to
Reals 11.6 billion (0.76% of GDP) in 2003, representing
4.41% of expenditures. While Congress subsequently budgeted
defense expenditures to increase to Reals 11.95 billion in
2004, this would still represent a reduction to 3.9% of
federal non-interest expenditures and a fall to 0.72% of
projected GDP.

18. (U) The biggest question mark on military expenditures
is the much-postponed decision on the purchase of new
fighter aircraft to replace Brazil's aging fleet of Mirage
2000's. Many of the financing plans presented by the
competing consortia have a grace period before repayments
begin, so these expenditures may well not figure in this
year's budget even if the GoB were to sign a contract, which
seems most unlikely. On the other hand, payments for Lula's
new Airbus ACJ reportedly are to come out of the Air Force
budget beginning this year. Although the Airbus financing
plan for the $56.7 million plane was not detailed in the
budget document, one media account said that an initial $1
million would be due upon contract signature, followed by a
$15.2 million (about Reals 45.6 million) payment later this
year, out of an Air Force 2004 equipment budget in the 2004
budget law approved by Congress of Reals 213 million.

Social Security Deficits
------------------------

19. (U) Aside from payments on the existing public-debt
stock, the biggest looming threat to GoB budgetary health
comes from the private-sector social security pension system
(INSS). While Lula's public-sector pension reforms last
year should help "staunch the bleeding" in the public-sector
pension system, keeping the deficit in this part of the
system relatively constant at 3% - 3.5% of GDP for the next
several years, the INSS system covering the private sector
is a different story. Contributions into that system are
not keeping pace with benefit payments. The INSS deficit
widened from 1.26% of GDP in 2002 to 1.74% of GDP in 2003
and preliminary reports for 2004 suggest the deficit
continues to widen well beyond the 1.76% of GDP deficit the
GoB projected. Analysts predict that this growing deficit
over the medium run will more than offset the savings
attained in the public-sector pension reform of 2003 (Refs A
and G). An idea of the scale of the issue can be gleaned
from the fact that the INSS (private-sector) pensions are
expected to account for 40% of federal non-interest
expenditures in 2004 (Table II). While these expenditures
are offset in part by contributions, covering the deficit
will consume 9.6% of federal non-interest outlays.

COMMENT
-------

20. (SBU) Lula is personally committed to the primary
surplus goal and gives all the signs of being more than ever
convinced that current tight monetary and fiscal policies
are necessary to set the stage for sustained growth.
Questioned by a recent interviewer whether he is committed
to this year's primary-surplus target of 4.25%, his
exasperation-tinged response was: "It won't change, it won't
change, it won't change!" Nevertheless, the GoB is under
substantial pressure to increase expenditures, and it has
begun to accommodate these demands at the margins. Better-
than-expected revenues in the first quarter make this
possible without vitiating the primary-surplus target, but
the GoB originally had planned to hold any higher-than-
expected revenues in reserve. Should the current positive
revenue trend not be borne out for the full year, the GoB
would have to sequester more program spending. Investment
expenditures likely would suffer even more under that
scenario. All of this reinforces the importance of the GoB
attracting private investments in infrastructure.

HRINAK

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