Executive Summary
- On November 27, Brazil’s Finance Minister Fernando Haddad announced a package of spending cut measures and the outline of an income tax reform. The package was a reaction to market unease over the perceived weakness of the country’s fiscal framework, which built up over the past year.
- The announced spending cuts were poorly received by market players prompting the Brazilian real to reach a record devaluation against the U.S. dollar. They perceived the announcements as lacking spending cut ambition and including future spending through income tax exemption. There is also uncertain congressional support and no fixed timeframe for the approval of these measures.
- Investors might reap short-term gains from the heated economy and low-priced assets in Brazil, but a fiscal framework in peril points to medium-term problems, including high inflation and reduced economic growth.
Analysis
On November 27 and after two months of internal government discussions, Brazil’s Finance Minister Fernando Haddad announced a package of spending cuts in an effort to rescue the country’s fiscal framework. In addition, Haddad announced President Luiz Inácio Lula da Silva’s administration proposal for an income tax reform.
The following day, Haddad and five other ministers provided details on these measures. The package was not well-received by market players, with the Brazilian real reaching a record devaluation against the U.S. dollar.
Brazil’s fiscal framework, proposed by the Lula administration in March 2023 and approved by Congress in August 2023, has been progressively weakened due to the Brazilian federal government’s lax fiscal policy and refusal to address structural spending issues.
Structural Fiscal Problem
In 1994, Brazil implemented one of the most successful monetary stabilization programs among developing countries since the end of the Cold War. The so-called Real Plan ended the country’s multiyear struggle with hyperinflation, and created the opportunity for further economic reforms, growth, and job creation.
With inflation under control, Brazil’s structural fiscal problem came to prominence. Years of hyperinflation created an incentive for uncontrolled spending by federal, state, and local governments, and generated chronic indebtedness.
The first attempt at solving the fiscal problem took place between 1999 and 2010, when different administrations adopted a three-pronged economic policy: primary fiscal surplus, inflation targeting, and floating exchange rate. However, this successful policy was reversed in 2011 and eventually led to a government-induced recession that reduced Brazil’s GDP by 8.1% between 2014 and 2016.
A second attempt was made between 2016 and 2022, with the approval of a spending cap rule that limited spending based on inflation growth. The cap, combined with a return to the economic policy of the 2000s, stabilized Brazil’s economy but became increasingly unpopular due to its perceived fiscal rigidity. Over time, then President Jair Bolsonaro’s administration and Congress approved a number of exceptions to the rule that eventually eroded market players’ trust in this policy.
In 2023, a third attempt was made with the new fiscal framework. Supporters argue that the framework will help Brazil secure future primary fiscal surpluses, control public debt, and allow fiscal stimuli during economic downturns by making sure spending can only grow within a certain range. Critics, however, argue that the framework creates a spending floor, which means that federal government will continue to spend even in a scenario of economic slowdown or recession, thus aggravating chronic indebtedness.
Attempts to Preserve the Framework
Throughout 2023 and 2024, the Lula administration tried to preserve the fiscal framework through the implementation of three sets of measures.
First, by trying to change the framework’s rules, making it easier to achieve fiscal targets and waive specific spending measures. These attempts were seen with distrust by market players.
Second, the administration embarked on an effort to raise revenue by closing tax loopholes, reducing tax subsidies, creating new taxes, and aggressively enforcing tax rules. While partially successful, this strategy seemed to reach its political limit by the second quarter of 2024.
Finally, there were attempts by different federal government agencies to reduce spending by reviewing qualifying criteria for social programs. The goal was to make sure that government databases only included beneficiaries that were clearly in compliance with existing legislation and regulation.
These measures were not enough to significantly reduce government spending and keep market players’ trust in the fiscal framework’s long-term feasibility.
Spending Cut Announcements
Over 2024, pressure built on the Lula administration to address spending because fiscal adjustment solely or largely focused on revenue increase was seen as unrealistic and unsustainable. Therefore, the recent announcements included a package of spending cuts and the outline of an income tax reform.
An income tax reform proposal was due since the approval of a historic consumer tax reform in December 2023. However, it seems the Lula administration decided to announce the outline of this new reform only to sugar-coat the spending cuts.
The Lula administration estimates that the spending cuts announced by Haddad will save approximately BRL 330 billion (USD 55 billion) from 2025 to 2030, with a little less than BRL 72 billion (USD 12 billion) in the last two years of the current administration (2025 and 2026).
The package includes 13 spending cut measures. The bulk of the cuts, representing 48 percent of the estimated total, will be on social programs, including a reduction in the minimum wage growth rate, unemployment benefits, conditional cash transfers, and financial support to people with disabilities and the elderly.
Approximately 25 percent will be achieved through budget and administrative efficiency measures; 13 percent through a reduction in education financing; and nine percent through the trimming of subsidies and regional development funding. A mere four percent will be achieved through a reduction in federal government human resources spending.
Most of the measures can be adopted through federal legislation, but some require constitutional amendments. Federal legislation can be approved by simple or absolute majorities, depending on the nature of the measure, while constitutional amendments require two votes by three-fifths of each congressional chamber.
One draft constitutional amendment and two bills with the implementation details were introduced in Congress over the past week, and additional measures were announced but their contribution to spending reduction was not yet published.
The Administration’s Approach
It is clear that the Lula administration made a decision to place the bulk of the fiscal adjustment burden on private sector workers and retirees through the reduction of social programs, in particular the minimum wage growth rate, while largely preserving the federal government workforce and the military. This is likely the reason why it also decided to outline its income tax reform proposal, which plans to expand the existing tax bracket that allows an exemption waiver. It seems the administration is trying to compensate lower minimum wage growth with future income tax exemption.
A so-called “administrative reform” of federal government human resources has been debated for years. In 2020, the Bolsonaro administration introduced a draft constitutional amendment to implement it, but Congress has not yet voted it. The Lula administration could have announced its willingness to pursue a reform of this nature, which has wide market and private sector support, but opted not do so.
Also notably, the administration refused to include in the package measures that would address one of the key drivers of public debt: constitutionalized spending mandates with minimum spending targets in various public policy areas, in particular healthcare and education. These mandates, combined with social security entitlements, social programs, and government human resources, make Brazil’s federal government budget rigid, and are outpacing discretionary spending. Absent changes to these mandates, the budget will eventually be 100 percent indexed and out of the administration’s control.
Market Reaction
Market players’ reaction to the package was negative. The Brazilian real reached a record devaluation against the U.S. dollar, trading at 6 to 1, and the stock market fell.
On the one hand, many players believe the spending cuts are insufficient to sustain the fiscal framework. They also believe the Lula administration made a mistake by announcing further tax exemptions in a future income tax reform while trying to make its spending cut measures credible.
On the other hand, the administration points to the steady increase in GDP and reduction in unemployment throughout 2024 to make the case that market players are overreacting. However, it omits inflation and interest rates increases. Many market players believe the positive GDP and unemployment numbers were mainly achieved by an unsustainable fiscal spending level. From January to November 2024, market players’ GDP projection grew from 1.59 to 3.17 percent, while inflation and benchmark interest rate projections rose from 3.90 to 4.63 percent and from 9.00 to 11.75 percent, respectively. Currency devaluation projection also grew, from 5.00 to 5.70 reais per dollar.
Impact on Businesses
It is unclear how many of the proposed cuts will be approved by Congress and in which timeframe. It is likely some of them might be either rejected or watered down. There is also no timeframe for the presentation of the income tax reform proposal, and the Lula administration might present additional spending cut measures.
The combination of a perceived lack of spending cut ambition, future spending through income tax exemption, and uncertain congressional support will continue to fuel a perception of lax fiscal policy. This will likely drive increases of the benchmark interest rate by the Central Bank, reinitiated in September with a 0.25 pp hike, followed by an additional 0.50 pp in November.
Investors might reap short-term gains from the heated economy and low-priced assets in Brazil, but a fiscal framework in peril points to medium-term problems, including high inflation and reduced economic growth. Moreover, as the country approaches the 2026 presidential election, the already feeble Lula administration’s commitment to a sound fiscal policy will further weaken as political considerations take the front seat.