Fitch: Brazil States Need Expenditure Cuts Despite Tax Rise

NEW YORK--(BUSINESS WIRE)-- A recent report by Tesouro Nacional shows that efforts to modernize Brazil's state and local government tax collection system and a shift in the economy to more formal businesses have led to a rise in tax collections. However, Fitch Ratings believes the larger states could still do more to improve collections and will not see meaningful recovery until expenditures are reined in and their federal debt is restructured.

We believe most of the improvement in state collections is due to a strengthening of state tax collection systems, which were mainly sponsored by the World Bank. Because new higher rates have only recently been implemented, the rise in revenues is likely due to more improved and efficient tax collections. We also believe an increase in the number of formal businesses, which are more likely to pay taxes, has contributed to higher tax revenues.

A larger surge in municipal tax collections is related to the performance of taxes called Imposto Sobre Servicos (ISS). In addition to better collection rates, Brazil's 5,570 municipalities generally offer few tax incentives on ISS. Municipal collections have also expanded due to the growth of the service sector in many local economies and the relatively stronger performance of banking and private medical services.

The states could do more to improve tax revenue by reducing the number of corporate tax incentives. We believe that incentives reduce total tax collections by approximately 30%. Changes to the tax code would also help. The combination of the recession and the relatively high levels of the taxes have made tax reform a higher political priority. The highest tax bracket of Brazil's value added tax rate is 37%.

Raising tax revenue is important for many states. Fitch rates five and expects each to maintain very slim operating margins (even negative in some cases). Expenditures are high, in part, due to rising pension costs and an increase in personnel expenditures. The three largest Brazilian states (Sao Paulo, Rio de Janeiro and Minas Gerais) saw their average personnel expenditures rise by 14.7% per year from 2010 to 2015. We expect that last year's increase in the tax levy on some sectors will not compensate for these rises in pension and headcount costs.

A restructuring of state debt to the federal government is also required before the states can recover. By the end of June the Supreme Court will rule on a plan to lower the interest rate states pay on this debt. The proposed cut would save the states approximately BRL400 billion (USD115 billion) over the entire term of the loans, which amounts to almost 90% of their outstanding debt.

Brazilian states and municipalities have been able to raise their tax collections faster than the federal government over the last five years. From 2010 to 2015, federal tax collections decreased by 1.5% to 21.5% GDP while state collections rose by 1.6% of GDP to 8.8% of GDP. Municipal tax collections jumped 20.1%, reaching a still low 2.3% of GDP.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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View source version on businesswire.com: http://www.businesswire.com/news/home/20160616006344/en/

Fitch Ratings
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Source: Fitch Ratings

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