Brazil: Approval of Tax Reform leads to Rating Improvement
The Brazilian Congress has approved the Tax Reform. The new system will replace three federal taxes with a Value Added Tax (VAT) and unify two subnational taxes under another VAT, creating a dual VAT system. In Brazil, most taxes are based on the overall value of products and services, resulting in multiple taxes on transformed products throughout their value chain. In this new system, the tax will only be applied to the value added, making the system more efficient.
The new tax system will be implemented gradually, commencing in 2027 for the federal VAT and 2033 for the subnational VAT. The tax rate will be determined in the coming years, and due to Brazil's need for revenue, it is expected to be one of the highest VAT rates globally, potentially reaching 28%. The system will maintain differentiated rates for certain services and products, similar to the current tax system, but aims to simplify it, potentially leading to long-term productivity gains.
In response to this approval, S&P has surprisingly increased Brazil's long-term rating from B to BB, still two degrees below investment grade. The reasons for this upgrade include multiple structural reforms approved in recent years, such as the Labour Reform, the two Fiscal Rules, the BCB Independency Bill, and the Tax Reforms. The Rating Agency also acknowledges the deterioration in the fiscal situation, likely leading to a rise in government debt in the coming years. However, the government is expected to finance this debt through domestic emissions.
Additionally, the independence of the BCB in the face of strong political pressure to lower interest rates was highlighted, along with a strong external position and a shortening current account deficit. These factors are seen as capable of compensating for the challenging fiscal situation. Given the current outlook, S&P improving Brazil's rating further is challenging to foresee. One potential avenue could be the approval of an Administrative Reform capable of reducing government expenditures or a sudden improvement in government revenues to offset expenditure increases. Achieving investment grade remains a distant goal, but other rating agencies could follow S&P's lead and improve Brazil's rating.