Next week, the House of Deputies of the Brazilian National Congress may vote a potentially historic tax reform, revamping a tax system that has been in place since the 1960s and has increased in complexity, inefficiency, and compliance cost over the years. The reform has been debated for nearly three decades and is widely perceived as key to increase Brazil’s competitiveness by making the tax system simpler, more transparent, and less burdensome for businesses.
By adopting a full-fledged, value-added tax approach, the reform will likely result in a decreased tax burden for companies with longer supply chains, such as manufacturers, while potentially increasing the current tax burden for companies with a shorter supply chain, such as those in the agribusiness and services sectors.
The proposal encompasses two main areas: a complete reform of the taxation of consumption and a partial reform of property taxes. Other aspects of the tax system, in particular taxing of income, payroll, and financial transactions, are not included in the proposal.
Consumption Taxes Changes
In the area of consumption, the reform will merge five federal, state, and municipal taxes into a so-called “dual” value-added tax (VAT), charged both at the national and subnational levels.
At the national level, the VAT will be called Contribution on Goods and Services (CBS) and will be the result of the following three existing taxes, merged:
- Federal tax on manufactured goods (IPI);
- Federal contribution for the financing of Social Security (COFINS); and
- Federal contribution for the financing of the private sector Social Integration Program (PIS).
At the subnational level, the VAT will be called Tax on Goods and Services (IBS) and will be the result of the following two existing taxes, merged:
- State tax on the movement of goods and services (ICMS); and
- Municipal tax on services (ISS).
In addition to the CBS/IBS, the reform will create a new Selective Tax to regulate goods it characterizes as having significant negative health and environmental externalities, such as tobacco, alcohol, and pollutants.
The key results expected with the new system are:
- Simplicity: a reduction in compliance complexity and associated costs through the streamlining of tax-related legislation and regulation;
- Legal certainty: a reduction of tax evasion, currently estimated at USD 100 billion, and tax disputes, at USD 400 billion, by having a simple, easy-to-apply, and transparent VAT system;
- Business competitiveness: an increase in business competitiveness through the elimination of the cumulative effect of the tax-over-tax system and of taxes on exports;
- Government revenue: a solution to the tax base erosion problem by extinguishing the so-called “tax war” between Brazilian states that compete among each other to provide tax incentives to new investment;
- Regional development: a reduction in regional inequality by adopting a “dual” VAT charged at destination instead of origin, combined with the creation of a regional development fund to support less developed states;
- Equality: an increase in economic equality by making the current taxation over property more progressive and by including a CBS/IBS cashback mechanism for individuals, in particular the poor; and
- Growth: an increase in economic growth by adding an estimated USD 240 billion to Brazil’s GDP in 15 years through the reduction of economic distortions and the cost of doing business in the country.
The CBS/IBS will have a single tax level with four main exceptions:
- Specific sectors will have a 50 percent reduction in their tax level, including agribusiness, agrochemicals and fertilizers, cultural and artistic activities, education, healthcare, medical devices, personal care, and public transportation;
- Specific sectors will be exempt (i.e., will have a 100 percent reduction in their tax level), including educational services to the poor, pharmaceuticals, and production by small-hold farmers;
- Special tax regimes for the Amazon (ZFM) and small businesses (Simples Nacional) will continue to exist; and
- Special tax rules will apply to financial services, fuel, and government procurement.
The CBS/IBS will be phased in during an eight-year implementation period between 2026 and 2033. In addition, the transition from the current system of taxes charged at origin to the “dual” VAT charged at destination will take place over 50 years, between 2029 and 2078.
The CBS will be managed by the federal government and the IBS by a new Federative Council with representatives from the Federal District, state, and municipal administrations.
Property Taxes Changes
In the area of property taxes, the reform will:
- Expand the existing tax on motor vehicle ownership (IPVA) to private jets and vessels;
- Make the existing tax on inheritance and donations (ITCMD) progressive and expand its scope to include assets held outside of Brazil; and
- Streamline the process to raise tax on urban property (IPTU) rates.
Political Economy of the Reform
There are two key debates at the center of the tax reform that explain the choices made by the rapporteur of the proposal in the House.
On one hand, there is a debate among private sector groups. In the current tax system, manufacturers are overtaxed while farmers and service providers are undertaxed. As the CBS/IBS tends to benefit companies with a longer supply chain, it is expected that manufacturers will see a reduction in their current tax burden while farmers and service providers will face an increased burden. Agribusiness and services companies tend to favor a separate proposal introduced in the Senate in 2022 called Simplify Now that only focuses on payroll and financial transactions tax reform.
In order to reduce the resistance to the reform from these groups, the rapporteur included exceptions to the CBS/IBS tax level, in particular by offering a 50 percent reduction to agribusiness and key service sectors such as education, healthcare, and public transportation.
On the other hand, there is a debate among states and cities, and between them and the federal government. In the current system, rich states and cities benefit from charging at origin. With the new system, the CBS/IBS will be taxed at destination, providing more revenue for poor states and regions, but potentially creating a tax loss for rich ones. The elimination of the “tax war” will also affect the capacity of poor states to attract investment through tax incentives.
In view of these debates, the rapporteur included in the proposal a long transition period (50 years) to charge the CBS/IBS at destination, the creation of a regional development fund to assist less developed regions, the creation of another fund to compensate companies currently benefiting from “tax war” incentives in order to avoid the relocation of investments away from poor regions, and provisions to expand revenue generated by property taxes to help states and cities that will face tax losses.
In addition, states and cities do not trust merging their existing taxes into a single VAT whose tax enforcement and management would be controlled by the federal government. This is why the rapporteur created a “dual” VAT, charged both at the national (CBS) and subnational (IBS) levels, with the IBS managed by a Federative Council whose membership includes the Federal District, state, and municipal administrations.
Process and Prospects for Approval
To reform the tax system, the National Congress has to amend the Constitution. Therefore, the tax reform proposal takes the form of a draft constitutional amendment (PEC) that requires two 3/5 votes in both the House and the Senate.
President Lula da Silva, the Speaker of the House, and the President of the Senate support the proposal. Although the tax reform is listed as a key priority for the administration, it is largely the result of years of negotiation by congressional leaders and the merging of two existing proposals, PEC No. 45/2019, introduced in the House, and PEC No. 110/2019, introduced in the Senate.
President Lula’s congressional coalition does not seem to have enough votes to pass the new PEC introduced by the rapporteur, so the administration will rely on the Speaker of the House and the President of the Senate to craft a deal with members of Congress and secure the necessary votes—308 in the House and 49 in the Senate.
It is expected that parts of the agribusiness and service sectors, along with some states and cities, will continue to pressure members of Congress to oppose the new PEC. Governors are expected to push for a commitment to provide substantial amount of financial resources to the new regional development fund.
Several aspects of the reform will have to be further implemented by supplementary law (i.e., federal law to detail aspects of the Constitution) and resolution of the Senate. Moreover, the draft requires the administration to submit to Congress an income tax reform proposal within 180 days of approval of this tax reform. It also states that if a future income tax reform increases federal government revenue, the additional revenue might be used to reduce payroll taxes.