Brazil An Agenda for Tax Reform - World Bank...R&eport No. 8147-BR Brazil An Agenda for Tax Reform (In Three Volumes) Volume If: Assessment of the Brazilian Indirect Taxes February

R&eport No. 8147-BR

BrazilAn Agenda for Tax Reform(In Three Volumes) Volume If: Assessment of the Brazilian Indirect TaxesFebruary 28,1990

Country Operations DivisionBrazil DepartmentLatin America and the Caribbean Region

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CURRENCY EQUIVALENTS

Currency Unit * New Cruzado

NCz$1.00 - US$0.04414 (February 13, 1990)US$1.00 - Cs$22.66 (February 13, 1990)

FISCAL YEAR

January 1 - December 31

BRAZIL

VOLUME II - ASSESSMENT OF THE BRAZILIAN INDIRECT TAXES

Table of Contents

Page No.

CHAPTER I - INTRODUCTION AND OVERVIEW . . . . . . . . . . . . . . 1

PART 1

CHAPTER II - BRAZILIAN INDIRECT TAXES BETWEEN 1970 AND 1988 . . 4

I. EVOLUTION IN THE COMPOSITION OF INDIRECT TAX REVENUE . . . . 4II. A DESCRIPTION OF THE MAJOR INDIRECT TAXES . . . . . . . . . 6

A. MAJOR INDIRECT TAXES IN BRAZIL . . . . . . . . . . . . 6

1. Value-Adaed Taxes: the IPI and the ICM . . . . . 6

a. Taxation of Value Added in Brazil . . . . . . 6b. Description of the IPI . . . . . . . . . . . . 9c. Description of the ICM . . . . . . . . . . . .

2. Excise Taxes in Brazil: the Specific Taxesand Others . . . . . . . . . . . . . . . . . 14

a. The Specific Taxes . . . . . . . . . . . . . . 14b. Description of the Specific Tax

on Electricity (IUEE) . . . . . . . . . . . 15c. Description of the Specific Tax on Fuels

and Lubricants (IUCL) . . . . . . . . . . . 15d. Description of the Specific Tax on

Minerals (IUM) . . . . . . . . . . . . . . 16e. Other Excise Taxes and Customs Duties . . . . 17

Description of the Tax on CommunicationServices. 17

Description of the Tax on Transport . . . . 17Description of the Tax on Services (ISS) . 17Descrj.ption of the Tax on FinancialTransactions (IOF) . . . . . . . . . . . . 18

3. Social Contributions as Indirect Taxes:FINSOCIAL and PIS/PASEP . . . . . . . . . . . . 19

a. Description of FINSOCIAL . . . . . . . . . . 19b. Description of PISIPASEP . . . . . . . . . . . 20

This document has a restrictd distribution and may be used by recipients only in the perfomanceof their official duties. Its contents may not otherwise be disclosed without World Bank authofization.

(VOL.II/cont'd) Table of Contents

Page No.

CHAPTER III - ASSESSMENT OF THE BRAZILIAN DOMESTIC INDIRECT TAXES 21

A. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . 21

B. EFFICIENCY IMPLICATIONS OF TAX EXEMPTIONS . . . . . 21

1. Conceptual Issues Arising from an ImperfectDesign of the VATs . . . . . . . . . . . . 22

2. Relevance of the Results for the Assessmentof the IPI and the ICM . . . . . . . . . . . . 23

3. Illustrating the Efficiency Issues . . . . . . . 24

C. A METHOD TO MEASURE INTERSECTORAL DISTORTIONS DUE TOINDIRECT TAXES .... . . . .. . . . . . . .... 25

D. ASSESSMENT OF THE DOMESTIC INDIRECT TAXES . . . . . . . 27

1. The IPI .... . . . . . . . .... . . . .. . . 27z. The ICM .... . . . . . . . .. . . . . . . . . 313. The Specific Taxes and Other Excises . . . . . . 354. The Tax on Services (ISS) . . . . . . . . . . . . 365. Social Coritributions . . . . . . . . . . . . . . 366. Sumuina uD the Individual Effects of

Indirect Taxes . . . . . . . 377. Sectoral Effects of Taxes . . . . . . . . . . . . 388. Inter-Actions Between Taxes and Aggregate

Tax Burden . . . . . ... ......... . 40

E. WHY DID INDIRECT TAX REVENUE DECLINE IN BRAZIL? . . . 4v

F. SUMMARIZING THE ISSUES TO BE ADDRESSED BY A REFORMOF INDIRECT TAXES . . . . . . 42

1. Too Little Revenue . . . . . . . . . . . . . . . 422. Inefficiencies . . . . . . . . . . . . . . . . . 433. Inequities .... . . . . . . . . . . . . . . . 434. Complexity . . . . . . . . . . .. .... . . . . 44

CHAPTER IV - POLICY IMPLICATIONS AND PROPOSALS FOR REFORMS . . . 45

A. INTRODUCTION . . . ........ . . . . . . . . 45B. THE REFORM AGENDA ................ .. . 45

(VOL.II/cont'd) Table of Contents

Pa&e No.

1. Short-Run . . . . . . . . . . . . . . . . . . . . 462. Medium-Term.. . 473. Long-Run . . . . . . . . . . . . . . . . . . . 47

C. ASSESSING THE CHANGES INDUCED BY THE NEW CONSTITUTION . 47

D. SPECIFIC REFORM PROPOSALS . . . . . . . . . . . . . . . 51

1. Quantifying the Effects of the Reforms . . . . . 532. Reform 1 . . . . . . . . . . . . . . . . . . . . 543. Reform 2 . . . . . . . . . . .. .544. Reform 3 . . . . . . . . . . . . . . . . . . 555. Reform 4 ......... 556. Reform 5 . ................. 557. Reform 6.. . . . . ...... 558. Reform 7 . . . . . . . . . . . . . .. 569. Transitional Issues Raised by Reforms 6 and 7 5610. Summing the Lessons from the Simulations of

the Effects of the Reform ..... . 57

PART II

CHAPTER V - REVENUE IMPLICATIONS OF BRAZIL'S PROTECTION POLICIES 58

A. INTRODUCTION .... . . . . . . .......... . 58

1. On the Potential Revenue from Import Taxes . . . 582. On the July 1988 Tariff Reform ... . . . . . . 593. dn the Effective Import Tax Rates . . . . . .. . 59

B. RECENT IMPORT TAX REVENUE PERFORMANCE. .. .. . . 59C. THE PRE-REFORM IMPORT TAX SYSTEM . . . . . . . . . . . 60D. THE POST-REFORMIMPORT TAX SYSTEM . . . . . . . . . . . 64

1. The Reform . . ... . . . . . . . 642. Assessing the Revenue Effects of the Reform . . . 68

a. Possible Working Hypothesis . . . . . . . . 68b. Revenue Effect on the Reform Assuming

Constant Import Consumption . . . . . . . . 68c. Revenue Effect of the Reform Assuming

Capital-Goods and ALADI Imports Increase . 71

E. OTHER MEDIUM- AND LONG-TERM FISCAL EFFECTS OF THE REFORM 72

(VOL.IlIcont'd) Table of Contents

Page No.

Tables:

Table 1: EVOLUTION OF THE COMPOSITION OF TAX REVENUES (1 OF GDP) 5Table 2s ICM REVENUE PER SECTOR IN MAJOR STATES (1987) . . . . 13Table 3s TREATMENT OF AGRICULTURAL EXPORTS: ORANGES AND PRODUCTS 34Table 4: AVERAGE DIRECT AND INDIRECT IMPACT OF TAXES ON PRICES 38Table 5: TOTAL IMPACT OF TAXES ON PRICES PER ACTIVITY IN 1988 . 39Table 6: REAL REVENUE AS A PERCENTAGE OF POTENTIAL REVENUE

FOR VARIOUS COMBINATIONS OF COLLECTION LAGSAND INFLATION . . . . . . . . . . . . . . . . . . . 42

Table 7: COMPARING TAX EFFECTS BEFORE AND AFTER THE NEWCONSTITUTION . . . . . . . . . . . . . . . . . . . . 49

Table 8s SECTORAL IMPACT OF INDIRECT TAXES ON PRICES UNDER THECURRENT AND POST-CONSTITUTION TAX SYSTEMS . . . . . 50

Table 9: COMPARING REVENUE AND DEADWEIGHT LOSS OF REFORMS . . . 53Table lO: IMPORT TAX RATES . ......... .. ....... 61Table llt POTENTIAL TAX REVENUE FROM IMPORTS . . . . . 63Table 12s THE TARIFF REFORM: LEGAL TARIFF RATES . . . . . . . . 65Table 13: THE TARIFF PEFORM: EFFECT OF FISCAL INCENTIVES ON

LEGAL TARZFF RATES .. FRAT S.... . . . . . .. 66-67Table 14: THE TARIFF REFORM: CHANGE IN IMPORT TAX REVENUE . . . 70Table 15: 1985-TARIFF RATES .... . . . . . ... **..... 73Tahle 16t PIPO'RT STRLT YJ. . . . . . . . . . . . . . . . . . . . 73

Appendices

Appendix I: BUOYANCY OF THE MAJOR BRAZILIAN TAXES . . . . . . . 74-76Appendix IIs STATUTORY vs. EFFECTIVE TAX RATES: A SIMPLE MODEL . 77-81Appendix IIIs A MATHEMATICAL PRESENTATION OF THE ANALYTICAL

FRAMEWORK . . . .... . ... ... .... . 82-87Appendix IV: CONSTRUCTION OF THE TAX VECTORS . . . .88-90

Appendix V: THE TARIFF REEORM . . . . . . . . . . . . . . . . . 91-93Appendix VI: THE INDUSTRIAL POLICY REFORM . . . . . . . . . . . 94-99Appendix VII: RESULTS BEFORE THE NErW CONSTITUTION - THE STRUCTURE

OF INDIRECT TAXES IN BRAZIL . . . . . . . . . . 100-105

OTHER VOLUMES

SUMMARY AND CONCLUSIONS - Volume I (for detailed contentssee Attachment I) .*... . . . . . . ...... . . . . . . 106

ASSESSMENT OF THE BRAZILIAN DIRECT TAXES - Volume III (for detailedcontents see Attacbment ) . .......... . . . . .107

ASSESSMENT OF THE BRAZILIAN INDIRECT TAXES

CRAPTER I - INTRODUCTION AND OVERVIEW

1. Obiectives. This volume assesses the major Brazilian domestic indirecttaxes and the revenue implications of Brazilian import protection policiL3. Itis complemented by a full assessment of direct taxation, provided in ansccompanying volume. The specific objectives of this volume ares

(a) to assess the major domestic taxes in terms of the intersectoraldistortions they cause individually and as a set:

(b) to examine and assess the likely allocative and revenue effects ofthe decisions on domestic indirect tax matters that have beenincluded in the new Constitution;

(c) to analyze the reasons for the significapt decrease in real taxrevenues observed in Brazil sihce the mid-1970s (almost 4? of GDP)and to examine potential sources of revenue gains consistent withthe directions for tax reform of tLe new Constitution; and

(d) to identify the direction in which tax policy should davelop tomaintain a consistency between the short-term objective of cuttingthe public deficit and the longer-run objective of restoring growthin the economy through an increased zole of the private sector.

2. Coverage. The volume is in two main parts. The first part emphasizesthe efficiency and revenue implications of the major indirect taxes on domestictransactions: the value-added tax on industrial products (IPI), the va'lue-addedconsumption tax (ICM), financial transactions (IOF), transport, services (ISS)7as well as contributions to PISIPASEP. The report also discusses theimplications of the integration of the specific taxes on fuels (IUCL),electricity (IUEE). minerals (IUM), communications (IUC) into the base of the ICMas a result of decision on tax matters included in the New Constitution.

3. The import tax is dealt with separately in the second part of thisvolume. The emphasis is placed on the revenue effects of the instrument choicesof the current protection policy. It identifies the potential revenue that couldbe collected from the implicit taxes resulting from the extensive use ofnon-tariff barriers in Brazil,and the restrictions imposed by the foreignexchange allocation mechanism.

4. Methodology. The quantification of the distortions and of the revenueeffects of possible reforms is based on a calculation of effective tax rates forfinal goods. The rates are defined as the tax element in the price of that good,accounting for taxes on inputs which arise through the production process. Theeffective rates for the current tax system are calculated using the 1980input-output matrix. Even though the current production structure is not fully

comparable, the results provide a useful illustration, and even quantitativeapproximation, of the importance of some of the conceptual issues raised by thereport. 1/

5. Key Problems. Brazilian indirect taxes raise two main types of issues:

(a) most of the decline in tax revenue observed since the mid-seventiesis due to indirect taxes. Indirect tax revenues dropped by almost7 percentage points between 1970 and 1988. This is especiallypuzzling given that the decline in real revenue has taken place inspite of high nominal tax rates.

(b) the design of the major indirect taxes presents major structuraldeficiencies. 21 First, Brazil's indirect taxes are unusuallycomplex. This complex system increases both the incentives and theopportunities for evading taxes. There are also serious financialcosts involved in complying with such a complex tax system.Second, the indirect taxes are major sources of intersectoraldistorttons. The Brazilian VATs are not really levied only onvalue added but also on some of the inputs of the sectors subjectto the VATs. This characteristic transforms the VATs intocascading sales taxes, and increases the effective tax rates onmany goods and services.

6. Reform Goals. The main proposals presented at the end of the first partof this volume aim essentially at increasing revenue and reducing tax drivenintersectoral distortions through a simplification of the major current domestictaxes. Hore specifically, tne volume suggests a reform of Uhe major indirecttaxes with the following objectives:

1. Increase revenues from domestic taxes and the import tax;2. Increase the transparency of indirect taxes;3. Transform the IP1 and ICM as far as possible from cascading sales

taxes to true value-added taxes;4. Reduce tax administration costs, and increase tax revenues by

simplifying and improving tax administration.

7. Recommendations. The policy recommendations outlined below are directedtoward these goals. A combination of all measures suggested should increaserevenue from indirect taxes by 22 of GDP in the short term, and by probably 32 inthe longer run as the allocation of resources improves, imports are liberalizedand growth recovers. These increases can be achieved without difficulty, while

1/ The results are also imperfect to the extent that they do not account forsubsidies which could have been built in as negative taxes, but for which no datawas available. For a full discussion of subsidy policies in Brazil, see Brazil -Public Expenditures Subsidy Policies and Budgetary Reform, World Bank Report No.738-BR, June 12, 1989.

2/ Ideally, indirect taxes should be simple, with a minimum administration andcompliance cost and with few evasion and avoidance opportunities; they should notdistort the allocation of resources across sectors and should be equitable.

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administrative costs, and tax avoidance are reduced, and the transparency andfairness of the system are improved. The specific measures suggested are listedbelow.

8. Plan. The Volume is organized as follcws. Part I covers the domesticindirect taxes and includes three chapters. Chapter II provides an overview ofthe evolution of the revenue yielded by the major indirect taxes and in theircomposition between 1970 and 1988. The Chapter aleo includes a description ofthese tases -- illustrating their unusual complexity -- and highlights the basicfeatures of their design that need to be assessed from a revenue, efficiency andequity point of view. The description includes all the major taxes that existedbefore the implementation, in 1989, of the major changes resulting from the newConstitution regarding the major indirect taxes. The major changes brought bythe new Constitution are briefly semmarized in the discussion of each tax.Chapter III assesses the Brazilian domestic indirect taxes both before and afterthe implementation of the tax component of the new Constitution. The Chapterfocuses on the efficiency and revenue issuAes raised by the current tax system.However, it also raises some equity issues that would have to be addressed by anyreform. Chapter IV provides some recommendations for a reform of the Braziliandomestic indirect taxes aiming at reducing the sources od distortions and evasionand at increasing revenue.

9. Part II appraises the revenue implications of Brazil's protectionpolicies. The major purpose of the chapter is to illustrate the opportunity costin terms of lost tax revenue of relying on non-tariff barriers rather thantariffs. The efficiency issues are not dealt with here since they are fullydiscussed in a recant Bank report. 3/

31 Trade Policy in Brazil - The Case for Reform, World Bank, Report No. 7765-BR,May 1989.

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PART I

CHAPTER II - BRAZILIAN INDIRECT TAXES BETWEEN 1970 AND 1986

10. This chapter has three major objectives. The first is to highlight theimportance of the decline in indirect tax revenue from a macroeconomicperspective. This is the purpose of Section I. The second objective is topresent the basic features of the main indirect taxes. This is one of thepurposes of Section II. In addition, Section II serves a third objective. Itillustrates the unusually high degree of complexity of the Brazilian indirecttaxes by providing some details on the major rules governing each one the taxes.Hany of these characteristics raise issues addressed in Chapter III.

I. EVOLUTION IN THE COMPOSITION OF INDIRECT TAX REVENUE 4/

11. The evolution of the principal sources of revenue in Brazil issummarized in Table 1. Total tax revenue as a share of GDP decreased by about 61between 1970 and 1988. During that period, the tax burdec increased and peakedin the mid 1970s, before starting the current downward trend. This trend hasbeen only occasionally interrupted by increases in the tax-to-GDP ratioreflecting a temporarily good economic performance or a temporary halt ininflation, as in 1986. Between 1970 and 1988, direct taxes became the majorsource of government revenue, contrarv to the trend in many countries. 5/Furthermore, the decline in aggregate revenue since 1970 is fully explained bytne decline in indirect taxes revenues, which dropped from 16.8Z of GDP in 1970to 10.2Z in 1988. During the same period, the revenue from direct taxesincreased from 9.22 of GDP to 9.7Z -- with a peak at 11.82 in 1985. But this wasnot sufficient to offset the loss of revenues from indirect taxes. Finally, theimportance of the inflation tax as a source of revenue is not directly reflectedin the table but should not be ignored. The inflation tax has been an importantrevenue source -- around 32 of GDP on average in the last few years -- thatsubstituted for re-rnue losses imposed by costly regional and sectoral fiscalincentives. 6/

12. Indirect Taxes. Between 1970 and 1988, revenue from indirect taxesdeclined, the victim of generous fiscal incentives policies (such as those forZons Franca de Manaus, or sectoral incentives such as those given to steel

4/ The data base was obtained from Afonso, J. R.: "Carga Tributaria no Brasil -Uma Discussao Metodol6gica,O Himeo, Rio, 1987, and Afonso, J. R. *A CargaTributaria Bruta - Estimativa para 1987.' Informe Tecnico INPES, No. 05/88,May 1988.

5/ The long-run analysis of the changes in the composition of the taxrevenues is constrained by the limited knowledge of changes in the ratestructures of the various taxes over time.

61 A fuller discussion of this issue is provided in Brazil - An Assessment ofthe Current Macroeconomic Situation, World Bank, Report No. 7540-BR,December 1988.

industry), and decreases in legal tax rates, inflation erosion, and tax evasion.The 6.4 percentage points decline in the revenue from indirect taxes is composedof 2.2 percentage points in IPI revenue, 2 percentage points in ICM revenue, 1.3percentage pointe in the revenue from specific taxes -- which include the taxeson fuels (IUCL), electricity (IUEB), minerals (IUM), and communications (IUC) --and 0.3 percentage points in trade taxes revenue, reflecting tariff revenuedecreases due to various import substitution policies and to the use ofnon-tariff barriers to reduce imports. The overall decline was only partiallyoffset by the creation of IOF and FINSOCIAL (both these taxes function partiallyas indirect taxes).

Table 1: EVOLUTION OF THE COMPOSITION OF TAX REVENUES(I of GDP)

1970 1975 1980 1984 1988

Indirect Taxes 16.82 13.91 13.52 10.22 10.22of which:

FEDERAL TAXESIPI 4.42 3.52 2.1S 1.72 1.82Specific taxes 1.72 1.22 0.72 0.42 0.621OF - 0.42 0.92 0.52 0.32Trade taxes 0.72 1.02 1.22 0.61 0.42

STATF TAXRSof whichs ICM 6.92 5.52 5.02 5.0X 4.62

MUNICIPAL TAXESof which: ISS 0.22 0.32 0.32 0.32 0.3Z

SOCIAL CONTRIBUTIONSof whichs FINSOCIAL - - - 0.62 0.7Z

Social contrib.(*) 5.72 7.82 7.32 6.32 5.12incl. PIS/PASEP - 1.12 1.02 0.82 0.62

Memo Item:Direct Taxes 9.22 11.32 11.22 11.82 9.72Total Tax Revenue 26.02 26.22 24.72 21.42 19.92

Source: IBGE, National Income Accounts of Brazil, May 1989

Note: (*) this line includes all social contributions, inclutding those working asdirect taxes since no disaggregation was available. This explains whythe sum of the components may be larger than the total.

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II. A DESCRIPTION OF THE MAJOR INDIRECT TAXES 71

A. MAJOR INDIRECT TAXES IN BRAZIL

13. The following discussion only deals with the indirect taxes that raisedrevenues larger than 0.1? of GDP in 1987. Some of these sources are taxes oncommodities -- excise, value-added, or cascading sales taxes. Some are not taxesas such, but are levied in a similar way, such as the contribution to the SocialInvestment Fund (FINSOCIAL) and PIS/PASEP, a social contribution created in 1982.These contributions function as cascading sales taxes. 8/

14. The major indirect taxes analyzed here are the taxes on industrialproducts (IPI), the circulation of goods (ICM), imports (II) -- which for ease ofpresentation are limited to the pure import tax and the tax for improvement ofharbors -- services (ISS), financial transactions (IOF), transport (IT), mining(IUM), fuels (IUCL), electricity (IUEE), and communications services (ISC). TheISS is a municipal tax and the ICM is a state tax; all the other taxes andcontributions are federal.

15. The IPI and the ICM are in principle value-added taxes. All the othertaxes and contributions function either as excise taxes or sales turnover taxes.Many of these taxes no longer exist in 1989 and are now integrated with a newICM. Their description and their assessment is relevant to the extent that theyallow the appraisal of the major costs and benefits -- from a tax policy point ofview -- of the reforms brought to tie tax system by the new Constitution. Adetailed description for each of these taxes and contributions is provided in theremainder of this chapter. The description summarizes for each one the relevantchanges due to the new Constitution.

1. Value-Added Taxes: the IPI and the ICM

a. Taxation of Value Added in Brazil

16. Relevant Features. A value-added tax (VAT) is a multiple-stage taxfalling on the value added by a firm at each stage of production. Since the sumof value added at each stage of production is equal to the value of sales at thefinal stage of production, the VAT turns out to be the fiscal equivalent to asales tax imposed at the final stage of production. However, all VATs are notsimilar, and differences in design have some important efficiency Implications.Hence, identification of the major characteristics of the Brazilian value-addedtaxes is important. The features to be discua A here are (i) the function ofthe tax and its macroeconomic base -- production or consumption; (ii) the ratestructure -- single vs. multiple rates; (iii) the way in which the tax iscalculated; (iv) the types of credits allowed; (v) the difference betweenexempting an input and taxing it at a zero rate; (vi) border adjustment for

7/ The report is based on a detailed analysis of the 1987 law for all taxes butalso accounts for the major changes observed in 1988 and 1989 -- the latter as areault of the implementation of the new Constitution.

8/ In some cases FINSOCIAL and PIS/PASEP work as a markup on the income tax.Those cases are not dealt with here.

international and interstate trade -- use of the destination or the originprinciple; and (vii) the extent of double taxation due to overlapping of the taxbases. Coiments on the rate structure of each tax will be included in thediscussion of individual taxes.

17. Taxing Production or Consumption. 9/ A production-based VAT would taxfactor incomes -- wages and salaries, and capital income (dividends, interest,and retained profits). A consumption-based VAT, on the othe- hand, taxes onlythe value added arising from the sale of consumer goods and services, and firmsare allowed to deduct their purchases of investment goods. In other words, aconsumption-based VAT does not tax capital goods.

18. Both the IPI and the ICM were created during the tax reform of the early19609 and replaced sales turnover taxes. The basic law defined the base for bothVAT as production or equivalent income, meaning that capital goods are includedin their bases. However, in the actual law, neither the IPI, nor the ICM were toinclude all production or consumption in their bases. The tax base of thespecific taxes is explicitly excluded from the base of both the ICM and the IPI.Currently, both are hybrid taxes, combining in different degrees production andconsumption-based taxes characteristics. Over time -- since 1969 -- some capitalgoods of Brazilian origin came to be exempted from the IPI, moving that taxcloser to a consumption-based tax. The ICM has moved in the same direction, butat a much slower pace. For instance, agricultural niachinery and equipment havebeen exempted since 1969, as, since 1971, have a long list of equipment andmachinery for the industrial sector intended for the Northern and Northeasternregions.

19. A Single Rate or Multiple Tax Rates? The most common form of VATinvolves multiple rates. The allowance for multiple rates provides someflexibility for policy-makers to differen iate, for example, between'necessities" and "luxury" items. In most countries there are three ratess thestandard rate, the rate for necessities, and the rate for luxury items. Thedecision to have multiple rates is not problem-free. In addition to distortingconsumer and producer decisions, ,t also increases administrative costs -- theinformation required to assess tax liability -- and leave room for both taxavoidance and tax-driven decisions. :^/ When multiple rates are allowed, thegovernment is often heavily pressured by interest groups lobbying forpreferential tax treatments.

20. In Brazil, both VATs permit multiple rates, but multiplicity servesdifferent purposes at the state and federal levels (see below for details). Oneof the most obvious features of the federal VAT, the IPI, is its extremecomplexity. It is used to alter sectoral and regional investment decisions, andfor export promotion and import substitution. On the other hand, until 1989, thestates' VAT was much simpler. In a given state, a single rate was used for all

91 For a very structured discussion of the issues underlying the design of aVAT, see J. Mintz, 'Issues Arising From the Design of the BTT,' in Broadway, R.W.and J.M. Mintz, Policy Forum on the Business Transfer Tax, John Deutsch InstitutePolicy Forum Series, No. 12, 1986.

10/ For an exhaustive discussion of the issues raised by multiple rates see,Tait, A. A., Value Added Tax: International Practice and Problems, IMF, 1988.

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intra-state transactions and rates were only differentiated for trade betweennorthern and southern regions or for exports. Since 1989, the ICM has a morecomplex structure (see below on the New Constitution).

21. Calculating Tax Liability. Both the IPI and the ICM are calculatedaccorling to the invoice -- or credit -- method. Each firm is taxed on its grossreceipts from sales, with credits allowed against that liability for all taxespaid by its suppliers and invoiced on its purchases. This method results in atax liability equal to that arrived at by applying the tax rate directly to thevalued added.

22. Financial Credit vs. Physical Credit. The Brazilian tax lawdistinguishes between two types of credits. The financial r edit is granted forall merchandise entering the factory, while the physical cr .it -- credito flsico-- is only granted for those goods actually incorporated into the product thatwill eventually be sold by the factory. Both the IPI and the ICM use thephysical credit approach. In other words, purchased items which are not used aspart of the actual production process are considered to be consumption items andhence do not entitle the factory to credits. Such purchases include importantinvestments such as furniture and office equipment.

23. Exempting vs. Zero Rating. A confusing but critically important aspectof any VAT is the difference-between zero-rating and exempting. Industries whichare exempted from VAT do not pay any direct VAT on their production. However,they are also not reimbursed for the VAT built into the cost of their inputs.The exempLion approach essentially transforms the buyer into a final purchaser.Indeed, buyers of an exempted product would not have to pay any tax directly.However, they would pay, indirectly, any taxes imposed on the inputs in his/herpurchases. The taxes are included in the final price of their purchase. Ineffect, the effective tax rate on their purchase is determined by the tax contentof its inputs. Under zero-rating, in contrast, the firm receives credits fortaxes paid on its inputs. In that case, the effective tax rate is zero. InBrazil, zero-rating is almost never used, even when listed in the law, becausecredits are seldom effectively allowed, except in a few cases such as the ze:o-rating of exports, or transactions with the M'naus Duty Free Zone (ZFM) that aresubject to the IPI.

24. Origin vs. Destination Base. Another important aspect of a VAT is thechoice between the origin-based and destination-based principles for the bordertax adjustment (BTA) allowed for international and interstate transactions. Withthe origin basis, the VAT is levied on the production of the taxing jurisdiction,regardless of the location of consumption or use. This means that exports arepart of the tax base, but imports are not. Under the destination-based approach,the VAT base is total consumption of residents of the taxing jurisdiction.Hence, exports are excluded and imports are included. In sum, the origin-basedprinciple transforms the VAT into a tax on production while the destination-basedprinciple turns it into a tax on consumption.

25. Under a VAT collected according to the credit method, border adjustmentsare required to keep the VAT neutral with respect to international trade. TheVAT collected before the export stage should be rebated on exports, and VATshould be collected on imports to maintain equity between the use of domestic and

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foreign inputs. In other words, neutrality under a VAT collected according tothe credit method can most simply be obtained through application of thedestination-based principle. 11/ However, neither the IPI nor the ICM fullyfollows the destination principle (as is shown below).

26. Double Taxation. By design, the bases of the two VATs partly overlap.This a clear problem of double taxation, since essentially all industrial sectorsare subject to both the IPI and the ICM. But the problem goes further. The IPIbase includes both the industrial value added are also the ICM levied on thatindustrial value-added, except in the case of imports. For imports, the oppositehappens: the ICM base includes the IPI. This means that the effective rates ofboth the IPI and the ICM are much larger than the legal rates, and they arecertainly not uniform, as the ICM should be according to the law.

b. Description of the IPI

27. Tax Base. The IPI is a federal tax levied on the transmission ofindustrial products in a non-cumulative way. It also applies to transactionsbetween establishments of a given taxpayer. The tax base was meant to consist ofindustrial valued added defined in gross terms -- sales minus purchases ofintermediate inputs only, keeping capital goods outside the creditable base.Only physical credits are granted as a rule. Taxes paid on the purchases oftransport material and office equipment do not generate tax credits.

28. Agriculture, cattle raising, minerals, retail and wholesale trade, andnotably, services are excluded from the IPI. This was meant to reflect thenature of the activity -- non-industrial -- and the fact that several of theactivities fell under various specific taxes. The next chapter will show that rthese arrangements gave rise to serious unwanted economic effects. The IPIdesign has not been affected by the New Constitution.

29. Principles Underlying the IPI. The IPI was originally meant to be basedon two major principles: (i) it was supposed to be selective, allowing differentrates, and a concentration on certain products, and (ii) it was supposed to benon-cascading. The tax rates were supposed to reflect two concerns: the degreeof processing of commodities, as the IPI was to tax the last stages of productionmore heavily than inputs and production processes, and equity, as tax rates wereto reflect the degree of necessity of the goods produced. Essential necessitieswere to be taxed less.

30. Exemptions, Zero Rating, and Tax Reductions. The major exemptions ortax reductions are granted for: (i) some specific imports, (ii) all exports,(iii) the output of firmts installed in the ZFM and approved by the properauthority, and (iv) a large number of specific products or projects listed in theregulation governing the IPI. About 60 products are taxed at zero rate orexempted from the IPI. They include many food items, pharmaceutical products,fertilizers, skins and leathers, and shoes.

31. For imports, the most important exemptions apply via drawback regimes.The new industrial policy implemented in July 1988 also adds a large number ofnew exemptions. These include reductions of 802 in the import tax and in the IPI

ill The origin principle could also lead to neutrality but in a much morecumbersome way.

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levied on machinery and equipment, which become part of the inobile assets ofindustrial enterprises if included sectoral programs approved by the CDI. Thenew industrial policy grants the same reduction to inputs imported to producehigh technology and specific capital goods. Inputs imported by the firmssponsored by the BEFIEX program also benefit from IPI reduction of up to a thirdof the net value of their exports of industrial products.

32. All industrial exports are exempted from the IPI, and they also benefitfrom a credit for taxes paid on the inputs used. In the ZFM all approvedindustrial production exported from the Zone is exempted from the IPI. Importsby the ZFM are also exempted if consumed locally or used as an input in approvedprojects. A large number of sectoral or regional fiscal incentives entitle theirbeneficiaries to exemptions or credits for IPI paid. They include some firms inthe steel industry which benefit from a tax credit, of up to 952 of the IPI paid.Other incentives such as SUDAM and SUDENE benefit from similar reductions. Moredetails on these incentives are provided in an Appendix to Volume III.

33. The IPI and International Trade. The IPI almost respects thedestination principle. Exports of goods included in its base -- industrialproducts -- are zero rated, and imports of similar products are in principletaxed. However, when an item is exempted from the import tax, it is alsoexempted from the IPI. In cases where the imports are made under a drawbackregime (the import is used as an input for an export and is, therefore, exempted)or in cases where the imports are used as inputs in the production of anindustrial good (the tax not collected on entry is collected when the finaloutput leaves the factory), the exemption does not imply a violation of thedestination principle. In all othe. cases (capital goods and final consumptionimports), the exemptions are equivalent to a subsidy for imports and discriminateagainst the domestic production of similar goods.

34. Tax Rates. The variance of the IPI legal rates across products is veryhigh, but shows little concern for selectivity. The rates are now very high onsome final consumption items -- such as cigarettes (365X), beverages (beer at200?, wine at 20?), automobiles (from 402 to 5OX), perfumes (772) -- andcomparatively low on some intermediate inputs -- such as chemical inputs (8?to 10?), metallurgy (42 to 16?), electrical machinery and equipment (4? to 18?),paper (4Z to 15Z) and non-metallic minerals (4 to 10?).

35. Implementation of the Tax Law. The tax is no longer as general as itwas at its conception, given IPI regulation exceptions, and special treatment forspecific products. The law has become very complex. The current version of theIPI regulation includes 21 sections, which 98 chapters. Each chapter covers 10to 20 products. Implementation is difficult and costly. Furthermore, the delaysauthorized by the Treasury in paying the tax vary between 15 and 60 days, whichis significant when inflation averages 10? and 20? per month. 12/

36. Tax Revenue. The contraction of the IPI has caused yield to erode overtime, from 4.4? of GDP in 1970 to 1.8? of GDP in 1988. It now represents about25? of total federal tax revenues. Most of the revenue is generated by thetobacco industry (222 of total IPI revenue in 1987), transport equipment (20.5Z),beverages (17?), metallurgy and mechanical industries (9.2?) and chemicalproducts (5.8?). Three states are responsible for 75Z of the total: Minas

12/ These delays have been drastically reduced as of October 1988.

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Gerais, Rio de Janeiro, and SAO Paulo. At the time of its creation, the IPI wasa fairly general tax levied on industrial production. Tax rates weredifferentiated for equity purposes, and zero rating or exemption was utilized fora large number of commodities that were considered essential, such as food andclothing. Over time similar treatment was extended to intermediate inputs. Inthe end, the IPI's yield was provided by very few sectors. Abou' 60Z of itsrevenue comes from the tobacco, automobile, and beverage industries.

c. Description of the ICM

37. Tax Base. Until the promulgation of the new Constitution in 1989, theICM was a value-added state tax levied on the sales of goods at all stages of theproduction process. It excluded services and those goods taxed by the specifictaxes (fuels, electricity, minerals, transport, and communications). It includedretail trade, agriculture, and the cattle raising sectors. As a rule, no creditswere allowed for taxes paid on purchases of capital goods. Finally, all exportswere subject to the ICM, except for industrial exports. The treatment of exportswas however complex and non- standard under the ICM (see below). The tax wasunder the jurisdiction of the National Congress. The tax was subject to adramatic change as a result of the New Constitution. The major changes are awidening of the base to include the sectors covered by some of the specific taxesdiscussed below and an adjustment to the rate structure. The design of tthe ICMwas however hardly altered. The details of the changes are summarized andassessed in Chapter IV, section C.

38. Exemptions, Zero Rating and Tax Reductions. The ICM allows for a numberof non-standard situations, including exemptions, reductions in the base,reductions in the rates, and special arrangements for tax credits. Exemptionsand tax reductions can be granted by the states' governments. Most alterationsto the law need to be cleared with the Council of Fiscal Policy (CONFAZ) whosemembers are representatives of each state. The approval of benefits must beunanimous, and their cancellation requires the agreement of 80? of the members.

39. In addition to the exclusions from the base discussed above -- servicesand activities taxed through specific taxes until 1989 -- there were a number ofother major exemptions:

(a) under federal law, imports of goods to produce machinery andequipment for the domestic market can be exempted under veryconstraining rules;

(b) imports exempted from the import tax are exempted from the ICM, asare imports under the drawback regime, and the production offertilizers, insecticides, and similar products intended for theagricultural sector;

(c) under CONFAZ agreements, some specific products such as vegetables,eggs and domestic fish are also exempt; most notable among theother exemptions granted by CONFAZ are those for the sale ofagricultural equipment to the North-Eastern states, Para, Amapa andRondonia;

(d) some exports of agricultural items also benefit from the exemption,including specific vegetables and fruits; and

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(e) micro and small businesses which are exempted for administrativereasons--the administration cost would be too high.

Of these, only the last three remain under the current regime.

40. The Treatment of Agriculture. Agriculture pays ICM on internaltransactions (except for transactions with the Northeast which represent lessthan 102 of overall volume). Agriculture's purchases of inputs and capital goodsare also taxed as a rule, but do not generally generate tax credits. 13/ Majorexceptions to this rule include insecticides, fertilizers, and seeds, which allbenefit from true zero rating. Tax rates on perishable food (vegetables, etc.)change from state to state, and reflect special exemptions granted to states onintrastate transaction. Corn is also treated spe-ially, paying the tax when usedfor the production of flour for human consumption, but does not pay it when usedfor animal consumption.

41. Among the major agricultural exports (coffee, soybeans, meats (poultryand beef), silk, vegetables, fruits, and fruit juices) only coffee and soy paythe tax. There is a list of exempted fruits, but essentially all fruits areincluded, except for pineapples. Heat is not taxed unless it is frozen and ishence similar to an industrial product.

42. The ICM and International Trade. The destination principle is appliedvery loosely to the ICM. With respect to imports the situation is similar tothat of the IPI. Exemptions from the import tax could be extended to become anexemption the ICM liability. The new Constitution has however modified this rul-eby impeding Federal Government exemptions for state and local government revenuesources. With respect to exports, primary and intermediate goods are taxed at afixed rate determined by the Senate, except when conventions agreed upon by allstates determine exemptions or reductions in rates. Many agricultural exports --all vegetable and fruits except pineapples -- have in the end been exempted.

43. Only industrial products were exempted in the early years of the tax.The exporters of industrial products get full credits for taxes paid on theirinputs. This causes firms to accumulate excess credits which they cannot use,since they are not paid in cash by the federal or state governments. Very rarelydo the states actually reimburse e'porters for the excess credits accumulated.In other words, the credits are essentially non-refundable, and the ICM is defacto equivalent to an export tax. In addition, the tax-exempt industrialexports are defined, and cover goods like frozen meat or fruit juice. But ofthese goods, only those whose primary-input content does not exceed 502 getcredit for taxes paid on inputs. This gives rise to intricate distortions, to bediscussed in the next chapter.

13/ In fact, in principle, they receive credits but they are difficult toimplement because it is hard to identify the value of the tax built in the costsof inputs. This results form to problems. The first is that many farmers do nohave a detailed accounting allowing them to keep track of their inputs costs. Thesecond is that the nature of the production process in that sector is such thatthere are long lags between the time an input is purchased and the time at whichthe output is available for sale. Given the current inflation level, it would beunusually complex to keep a record of the correct value of the credit.

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44. The ICM and Interstate Trade. Since tax rates are not uniform forinterstate trade, an adjustment is necessary for transactions among states. Theborder adjustment for interstate trade nearly follows the origin principle. Ifthe tax is paid by the "exporter" and if the rate is equal to the rate applied oninternal transacticzs, the revenue remains in the "exporting" state. If the rateon interstate transactions is less than that imposed on domestic transactions,the revenue is allocated accordingly between the exporting and importing states.If the rate is higher, the revenue goes to the importing state.

45. Originally, the rates for both types of transaction were equal. By theend of the 1960s, however, taxes on intrastate trade were increased relative totaxes on interstate trade. The rules governing the border adjustments impliedthat the exporting states were keeping the full revenue on the interstatetransactions. This benefits the southern states which are the largest producersin the country. Part of the problem is due to the fact that the ICM is both aproduction- and consumption-based tax.

46. Trade with the ZFM is also given special treatment. Exports of domesticindustrial goods to the ZFM are zero rated, so "exporters" benefit from fullcredits for the taxes paid on the inputs used in producing the exported output,as in the case of international exports.

47. Tax Rates. Until 1989, there are five rates: 17Z for intrastatetransactions and for final consumption, 121 for interstate transactions, exceptfor shipments from the South and Southeast (excluding Espirito Santo) to theNorth, North-East, Center-West, and Espirito Santo, which are taxed at 92.Exports are taxed at 13S. A true zero rate -- a tax rate of 02 with creditsgiven for taxes on inputs -- applies in certain cases discussed earlier(industrial exports, some agricultural inputs). Since the tax rates are imposedon prices inclusive of the taxes, the actual rates applying to the producerprices are 20.482, 13.642, and 9.891 respectively for the three non-zero rates.One of the major changes brought by the New Constitution is greater freedom tothe states to set those rates. Early in 1989, the states decided however toessentially stick to the old rate structure. The only difference will be thattheir will be a 12Z rate form basic necessities, and a 252 for luxuries inaddition to the 17S rate. Most sectors will remain subject to 172.

Table 2: ICM REVENUE PER SECTOR IN MAJOR STATES (1987)

2 of ICM Sectoral Contribution (2)Revenue in -----------------------------Brazil Primary Secondary Tertiary

Slo Paulo 39.92 0.42 78.5Z 21.12Minas Gerais 9.72 13.6Z 48.52 37.92Rio de Janeiro 9.3Z 0.22 60.7S 39.12Rio Grande do Sul 7.32 12.32 n.a. n.a.Parana 5.12 24.82 38.6Z 32.82Pernambuco 2.92 17.52 37.3Z 46.22Ceara 1.52 6.92 35.82 57.32

TOTAL 75.7Z

Sources Data provided by the Ministry of Finance

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48. Implementation of the Tax Law. The ICM is simpler than the IPI. Itsmajor complexity stems from the fact that it is a state tax which is regulatedpart by the states and the Congress. This has turned the ICM into a heterogenoustax. It has some characteristics of both a product-based and consumption-basedtax. The criteria for border adjustments for interstate trade are such that itis difficult to assess their value in terms of equity or efficiency.

49. Tax Revenue. The tax is one of Brazil's most important sources ofrevenue, producing close to 5Z of GDP. Table 3 shows the revenue generated in afew important states. Over 752 of ICM revenue in 1987 was collected in onlyseven states, almost 60 2 in only three (Sao Paulo, Minas and Rio).

50. The actual yield of the tax is however well below its potential, in viewof the current tax rate. Since the true nominal rate is 20.482 and the base isfairly large -- essentially GDP minus those sectors covered by the specific taxes-- its yield could be significantly higher. The legal exclusion from its actualbase of a large share of its theoretical base, the negative impact of inflationon real revenues, and widespread tax evasion explain the difference betweenpotential and actual revenues, as discussed in Chapter III.

2. Excise Taxes in Brazil: the Specific Taxes and Others

51. In addition to the VAT discussed above, the Brazilian tax systemincluded until 1988 a large number of excise taxes and customs duties.Individually, they did not yield a significant share of revenue but they played -- and still play for those taxes that remain (see next paragraph) -- an importantrole as potential or actual sources of distortions in the price system. Theyinclude the specific taxes -- the taxes on minerals (IUM), electricity (IUEE),and fuels and lubricants (IUCL) -- the taxes on communication services (IC),services (ISS), financial transactions (ICF), transport services, and trade. 14/

a. The Specific Taxes

52. The original specific taxes were created to finance the development ofsectors considered to be of major national interest. They were intended asseparate taxes to protect the bases of two cascading taxes existing at the time:a consumption tax levied by the Federal Government and a sales turnover taxlevied by the states. The creation of the specific taxes was justified to theextent that it prevented double taxation of the protected sectors. However, withthe fiscal reform of the 1960s, the consumption and the sales turnover taxes werereplaced by the IPI and the ICM. Since they were VATs, the ICM and the IPI wouldnot fall on inputs such as electricity, minerals, or fuels. Had these inputsbeen included in the IPI and ICM bases, they would have been creditable. Inother words, the creation of the IPI and the ICM made the original specific taxessuperfluous, but they still remain part of the tax system.

14/ Only the import tax is somewhat significant. The export tax is essentiallylevied on cocoa products and yields only about O.1? of GDP.

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53. The new Constitution abolished most of the taxes on specific sectors andincluded their base in the ICM base. Among the taxes describeJ below, only theISS, FINSOCIAL and PIS-PASEP survived the New Constitution in their originalform. The description of the others is however relevant to assess the effects oftheir inclusion in the ICM.

b. Description of the Specific Tax on Electricity (IUEE)

54. Tax Base. The IUEE was levied on the production, imports, anddistribution or consumption of electrical energy. The tax base was the officialprice as defined (and frequently revised) by the 'Departamento Nacional de Aguase Energia ElUtrica' (DNAEE) at the Ministry of Mines and Energy. The tax appliedonly once on any of the three types of transactions. In practice, the tax waslevied at the consumption stage on residcntial, industrial, and commercial users.

55. Credit Policy. The IUEE could not be credited against other taxes.

56. Exemptions. There were no significant exemptions. The main exemptionswere churches, political parties, educational institutions, and all public andsocial assistance institutions.

57. Tax Rates. The tax rates were differentiated by user. The tariff(sales price) of electricity were fixed legally (as of June 17, 1988 at4,272.42 Cz$). The tax rates were then applied on that tariff. The rates wereSO? for residential users, 16Z for industrial consumers consuming less than 2000kwh a month, and 60Z for commercial users. Industrial consumption greater than200OKW a month was not subject to the IUEE. Those consumers were howeverrequired to pay a compulsory loan to ELETROBRAS, usually equivalent to 10? of theofficial price of electricity, 32.5Z in a few cases.

58. Tax Revenue. For 1985-88, the tax represented 0.2Z of GDP.

c. Description of the Specific Tax on Fuels and Lubricants (IUCL)

59. Tax Base. The IUCL was levied on the production, importation,circulation, distribution, or consumption of lubricants and fuels of any origin.The tax was paid by the producers, distributors, importers, or consumers of theproducts. It was calculated by applying the tax rate defined by law to the salesprices of the product as defined by the National Oil Council.

60. Credit Policy. The IUCL could not be credited against other taxes.

61. Exem tions. Some important products were exempted. They included rawoil, gasoline and kerosene for airplanes, rock oil for petroleum conditioning andfor fertilizers, fuels for the agricultural and cattle raising sectors, fuels forBrazilian fishing boats, gasoline and kerosene for the petro-chemical industry,and sugarcane alcohol to be added to gasoline.

62. Tax Rates. The tax was applied on the sales price as determined by theNational Oil Council. The rates were ad-valorem whatever the origin of theproduct taxed, and were differentiated by product. They varied from 0? to 29?.Gasoline for cars is taxed at 10, diesel at 52, and petrochemicals derived frompetroleum not incorporcted in the final product at 0.3Z, for example. The taxwas applied to more than 20 categories of products.

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63. Compulsory loans were calculated as a sales tax (28X of the price of theproduct) levied on gasoline and alcohol. The loan applied between July 1986 andend-December 1989, and should be reimbursed three years after payment in sharesof the National Development Fund. Discrepancies between our calculations of the'effective' price based on the law and effective price statistics will be d:. tothe omission of this 'tax" and some other minor addition to the price of fuelswhich represent revenues for the Government.

64. Tax Revenue. The IUCL raised on average between 0.1X and 0.2? of GDP.

d. Description of the SRecific Tax on Minerals (IUM)

65. Tax Base. The IUM was levied on the extraction, processing, transfer,export, distribution, or consumption (within the mining site) of minerals andfossil substances originating in Brazil. The departure of the minerals from themine was the source of the tax obligation. Residuals were excluded from the taxbase. Small-scale producers (prospectors) who cannot be controlled by ReceitaFederal are subject to a different regime. Their production was also taxed, butthe tax is paid by the buyer. Under the new Constitution, minerals are alsoincluded in the base of the IC!4.

66. Credit Policy. The IUM was subject to a peculiar tax credit policyrelated to the distribution of tax revenue between the various levels ofgovernment. The credits granted were perfectly integrated with the VATs andavoid the taxation of inputs: 10? of the tax can be credited against the IPI, 902against the ICM. This is explained by the fact that the tax was collected by theFederal Government, but 902 of its yield was distributed to the states andmunicipalities: 702 went to the state of extraction, 20? to the municipality ofextraction. Collection of the tax costs the Federal Government more than its 10?share of the revenue.

67. Exemptions. The major exemptions included extraction for sampling andsurveying, for use in the construction of transport infrastructure, and for useas inputs as raw materials in the production of inputs for agriculture andmicro-enterprises.

68. The IUM and International Trade. The IUM is the only Brazilian tax thatobeyed fully the origin principle for border adjustment. Imports were exemptedand exports are taxed -- although at reduced rates. No credit were allowed forthe IUM paid on exports.

69. Tax Rates. The tax rates were differentiated by type of mineral anddestination. The tax applied to the value of the minerals. For domesticactivities, precious metals, precious stones, processed semi-precious stones, andcarbons were taxed at 12 and other minerals at 15?. For exports, preciousmetals, precious stones, processed semi-precious stones, and carbons were taxedat 12, iron and manganese at 7.5X, and other minerals at 4?.

70. Tax Revenue. The annual revenue from the IUM was about 0.1? of GDP.

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e. Other Excise Taxes and Customs Duties

Description of the Tax on Communication Services

71. Tax Base. The tax on communication servicbes was levied on the deliveryof communication services. In fact, it was essentially a tax on use of thetelephone, telegrams, and telexes. The tax was based on the value of theservice. Like the ICM the tax rates are quoted inclasive of the tax. Under thenew Constitution, the tax will be included in the tax base of the ICM and itsyield will hence be transferred from the union to the Federal Government to thestates.

72. Credit Policy. The tax could not be creoited against other taxes.

73. Exemptions. Television, radio broadcasting, and local telephone callsfrom public telephones were exempt.

74. Tax Rates. Rates were differentiated by type of service. For 1988,most domestic telephone services are taxed at 20Z. Domestic telegrams were taxedat 02. Most other domestic telegraphic services -- such as telexes -- were taxedat 23.07x. Most international services were taxed at 13.042, with the exceptionof telexes which were taxed at 4.762. All maritime communications were taxedat 9.092.

75. Tax Revenue. The tax yielded on average 0.12 of GDP.

Description of the Tax on Transport

76. Tax Base. The tax base was the price charged for the road transport ofpersons or goods from one municipality or state to another. Under the newConstitution, the tax will be included in the tax base of the ICM and its yieldwill hence be transferred to the states.

77. Exemptions. The list of exemptions was long. The most important werethose for international transport, transport of printed documents, transport byvehicles belonging to the public sector, transport of fuels, lubricants, andminerals, merchandises transported to the ZPM (provided that the good is eligiblefor incentives granted to exports', transport to an establishment of an exportingenterprise or to another establishment of the same enterprise, transport ofcultural and scientific equipment for educational purposes, and transport ofagricultural items from the producer to the first distributor. intra-municipaltransport was taxed by the services tax (ISS).

78. Tax Rates. There was a single tax rate of 52.

79. Tax Revenue. The tax yielded a revenue equivalent to 0.12 of GDP,drawing about 702 from taxation of freight transport and 302 from the taxation ofpassenger transport.

Description of the Tax on Services (ISS)

80. Tax Base. Municipalities tax industrial, commercial, and professionalservices not included in a federal tax base. This excludes communication andtransportation. It also excludes public construction, publications, hotels (but

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only on their activities as 'host"), tourism agencies, schools, culturalactivities, and sports federations and their members. Most banking activitiesare also excluded. A credit i allowed for other services paid.

81. The ISS is theoretically calculated on the full value of the services.In practice, the tax is levied on an assumed price level for services rendered.These asstmed price levels are indicated in official lists published by themunicipalities. No lower puice is allowed, unless specif'id by the law. Thetaxpayers are classified into: independent professionals nd firms.Professionals include activities such as doctors, nurses, lawyers, economist,interpreters, translators, engineers. The list is fairl; comprehensive. Firmsinclude about 90Z of all activities described as services bv IBGE. Constructionis one of the most significant sectors, and rental is also ubject to the ISS.There is also a fairly comprehensive list of firms' services. When a firm hasmixed activities, only the service activity is taxed. Note that when the serviceis identical to the sale of the merchandise (such a3 in distribution activities,or supermarkets) only the ICM applies.

82. Exemptions. Every municipality has a different list of exemptions.However, few of these are significant.

83. Tax Rates. The tax rates for the ISS vary from municipality tomunicipality, and by type of service. The rates vary between 1Z and 10X, butmost services are taxed at 5Z. For services requiring few qualifications, therates are the lowest. The practice is however somewhat more subtle in the caseof independent professionals, where the value of the services is determined byeach municipality and the tax is actually levied as a poll tax.

84. Tax Revenue. The ISS yields a revenue equivalent to 0.31 of GDP.

Description of the Tax on Financial Transactions (IOF?)

85. The full name of the tax explains its actual coverage: it is the tax oncredit, foreign exchange, insurance, and titles and securities transactions. Thetax is made up of several components. Only the parts dealing with credit andforeign exchange transactions, and the 1OF levied on insurance premiums, functionas indirect taxes. The IOF on foreign e-change is essentially a customs duty,while the remainder are taxes en services. All components are income or transfertaxes in concept. However, the IO on foreign exchange transactions wascancelled as part of the tariff reform, as of July 1, 1989.

86. Tax Base. The IOF is levied on four different types of transactions.The base and rates are specified in each case by law. When the IOF is levied oncredit, the taxed transaction is the value of lending to a borrower. The tax oninsurance transactions is levied on the premium received. For exchangetransactions, the tax is levied on the value of the purchase of currency to payfor imports. Finally, the issuing value, the transmission value, or the paymentof transactions on titles and securities are also subject to the IOF.

87. Exemptions. There are numerous exemptions. For the IOF on foreignexchange, they include imports under drawback regime, imports of fertilizers,imports of seeds, and fruits for sowing, imports of machinery and equipment to beused by radio and TV stations, and imports of crude oil. For the IOF on credit,

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the major exemptions are salary advaaces, loans granted by legal entities withterms of at least 90 days or with unspecified terms, and a long list of veryspecific cases.

88. Tax Rates. For credit transactions, the rates are defined according tothe terms of the credit or the type of transaction. Advances to depositors aretaxed at 1.52. Discount operations for terms of less than one year are taxed at0.00412 daily (adding up to 1.52 if the term is 365 days) while for terms of oneyear or longer, the annual rate is 1.52 annually. For mortgages, the rates are0.0052 for less than one year and 1.82 for over one year, also using theadding-up rule. For other types of transactions, the ratee are 0.0041 daily forloans of less than one year and 1.5Z annually for more than one year.

89. The rates are differentiated for foreign exchange transactions. 15/Transactions due to imports of goods and services are taxed at 252. Fortransactions by the ZFM, the rate is 10Z. Imports included in the ALC/ALADIagreements are taxed at 122 if they are part of the tariff concession, 152otherwise. Imports of microelectronic products to be used by nationalenterprises are taxed at the following rates: manufactured inputs 252,semi-finished products 502, final products 752. Insurance premiums are taxed at2Z for life insurance and 42 for goods and valuables.

90. Tax Revenue. The IOF yields about 0.52 of GDP. However, the largestsource of revenue is the tax on foreign exchange transactions which represents0.32 of GDP. This source of revenue no longer exists.

3. Social Contributions as Indirect Taxes. FINSOCIAL and PIS/PASEP

91. Social contributions can be divided into three main categories: wealthfunds -- giving an entitlement to the workers because of their involvement in theproduction process and financed compulsorily by the employers; social welfarebenefits -- related to contributions which finance guaranteed benefits such associal security; and social funds -- which include contributions identified withtaxes to finance social expenditures. In the third category, some contributionsfunction as direct taxes, some as indirect taxes. This section provides a briefdescription of the major social contributions functioning as indirect taxes:FINSOCIAL, and the Social Integration Program (PIS) and the Public Employees'Financial Reserve Fund (PASEP).

a. Description of FIMSOCIAL (Social Investment Fund)

92. Background. FItISOCIAL is paid by virtually all sectors. Created in1982, the tax is levied on goods as an indirect tax, and on services as a markupon income tax liability. Its official purpose is to fund social relief programsfor food and lodging, health, education, and protection for small farmers. Infact. the Treasury retains receipts for months, while applications for thefunding go through the bureaucratic maze, after which the funds are deliveredhaving lost up to 702 of their real value, a portion de facto retained bythe Treasury.

15/ This part of the tax no longer exists; it was abolished on July 1, 1988.

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93. Tax Base and Rates. The tax is raised according to one of two generalformulae. Enterprises selling goods (or mixed goods and services) pay 0.62 ofgross sales net of IPI and IC4 (as of 1988; 0.52 until the end of 1987).Enterprises selling services pay 52 of the income tax due (before incentives).The tax applies to all sectors of the economy.

94. Exemptions and Other Tax Reductions. The major exemptions are formicro-enterprises, cooperatives, ITAIPU, and exports. Some sectors also enjoynon-standard treatment. In the tobacco industry, the producer pays 0.62 on salesplus 0.62 on the value of the sales at retail, made possible by the fact that thepr'ce is set by the Government, and necessary given that retailers are toodifficult to tax -- and would in fact be erempt as micro-enterprises. 16/

95. Tax Revenue. Total revenue cannot be desaggregated between the tax ongoods and the tax on services. Total revenue represents about 0.62 of GDP.

b. Description of PISIPASEP

96. Background. The P1S was established in 1970 with several objectives.It was to integrate employees into the life and development of the enterprise,encourage private assets holdings, stimulate savings, improve incomedistribution, and facilitate the accumulation of resources for investment. It isessentially a forced savings program for the private sector. The PASEP is theequivalent program for the public sector.

97. Tax Base and Tax Rates. The tax is raised according to two generalformulae. The first, common to all firms, is 52 of the gross amount due forincome taxes. The second element is differentiated by type of economic activity.For firms selling goods, the tax is 0.752 of gtoss sales. For firms providingfinancial and insurance services, it is a 5Z markup on the income tax due. ForPASEP, the public sector contributes a share of current revenue: 0.2U forgovernments, 0.82 for public enterprises.

98. Tax Revenue. PIS-PASEP contributions have represented about 0.5?of GDP over the last three years.

16/ Here the cascading nature of the tax is made explicit. The same applies tooil products.

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CHAPTER III - ASSESSMENT OF THE BRAZILIAN DOMESTIC INDIRECT TAXES

A. INTRODUCTION

99. This chapter has four main objectives:

(a) to show that the plethora of exemptions and special rulescharacterizing the Brazilian value-added taxes transforms them intocascading sales taxes; this implies that an assessment of theeffects of different indirect taxes on the price of a commodityshould take into account the taxes which fall on the inputs intothat commodity as well as the taxes which fall on the commodityitself; 17/

(b) to show how the total effects of the Brazilian domestic indirecttaxes on prices across sectors can be tracked through a system ofsimultaneous equations provided by the 1980 input-output matrix;

(c) to analyze the efficiency and equity effects of the distortionsidentified through the computation of the effective tax rates;

Cd) to explain the erosion in real indirect tax revenue. 18/

100. The chapter is organized as follows. Section B describes the efficiencyimplications of the transformation of the Brazilian VATs into cascading saletaxes due to the use of exemption rather than zero rating. Section C presentsthe methodology used to assess the full impact of indirect taxes on prices.Section D provides an assessment of each one of the domestic indirect taxes. Thediscussion covers the issues raised by their design and as well as theintersectoral distortions they create -- the effective tax rate for each tax iscomputed for a 43-sector disaggregation of the economy. Section E explains themajor reasons for the decline in indirect tax revenue. Section F sums up themajor issues that need to be addressed by a reform of the domestic indirecttaxes.

B. EFFICIENCY IMPLICATIONS OF TAX EXEMPTIONS 19/

101. The Brazilian VATs are rife w.2h exemptions and special rules for thetax treatment of inputs. In fact, exem3Žiov- from the VLTS are granted de facto,in three types of situations:

171 The resulting total tax element in the price of the commodity is called theeffective tax.

181 Recent law changes have succeeded in reducing the significant revenue lossesdue to the Tanzi effect as discussed later.

191 The comments hereafter provide an intuitive discussion of the issue. A morerigorous proof is provided in Appendix II.

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(a) when the law explicitly exempts a sector, as a fiscal incentive;and

(b) when a sector is zero-rated, in Brazil, it is often equivalent to asimple exemptions because credit accumulated are seldom paid incash -- except for the ZFM and exports, see paragraph 23.

This Section shows that the widespread use of exemptions has two majorimplications. First it results in intersectoral distortions. Second, it narrowsthe base on which tax rates apply and reduces effective tax revenue co.lections.This second implication is discussed in detail at the end of the chapter.

1. Conceptual Issues Arising from an Imperfect Design of the VATs

102. Exemptions as a Source of Distortions. As explained earlier, underzero rating, the firm receives credits for all taxes paid on its inputs. Incontrast, industries which are exempted from VAT do not pay direct VAT on theirproduction but they are also not reimbursed for the taxes built into the cost oftheir inputs. Hence, while an exempted producer of machinery would not have topay any taxes directly, he would pay a VAT on purchases of parts for his/hermachine and those tax payments would not be credited in any way. In general, theexempted producer of machinery will built into his/her price the tax borne on hisinputs. The taxes levied on his/her inputs become part of the cost to theconsumer of his/her machinery.

103. Effects of a Break in the Tax Credit Chain. The major consequences ofthe failure to provide a full credit for tPnes paid on inputs as a result of theuse of exemptions rather than zero rating are as follows: 20/

(a) the VAT imposed ona a final commodity is, in fact, also imposed onthe value added of the exempted inputs used by the industry byvirtue of the exemption from the VAT granted to that input;

(b) the VAT is also levied on the inputs subject to excise taxes and tothose excise taxes themselves; and

(c) the inputs subject to a VAT rate lower than the VAT rate levied onthe final commodity will be taxed at a rate equivalent to thedifference between the two VATs.

104. Implications of Exemptions for Effective Tax Rates. These result implythat the effective tax rates imposed by indirect taxes are higher than the legaltax rates. Taxes levied on the receipts of a firm do not fully correct for taxespaid on the purchase of inputs, which is sufficient to transform the VATs intocascading sales taxes. The current VAT results in a bias against the use ofinputs in the production of exempted inputs, and a bias against the use ofexempted inputs themselves. In other words, exempting inputs hurts the sectorproducing them. In addition, the VATs are also levied on taxes paid at earlierstages, adding to the double taxation problem and to the resulting non-neutralitywith respect to the use of inputs. An important corollary of these observationsis that these distortions can have positive revenue effects for the government.

20/ These results are derived rigorously in Appendix II.

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105. International Competitiveness Implications. The previous discussionraises an additional issue with respect to international trade. Since theeffective tax rate on the final commodity produced is higher than the legal taxrate, domestic goods can loose competitiveness compared with imports. Assumethat there is no import tax on the imported commodity, and that the coststructure of foreign producers is the same as that of the Brazilian producers.Assume also that when entering Brazil, that final commodity is only subject tothe VAT. In that case, the legal tax rate for the imported commodity will alsobe equal to the effective tax rate. This represents a comparative disadvantagefor domestic production not recognized in most calculations of effectiveprotection.

2. Relevance of the Results for the Assessment of the IPI and the ICM

106. The above conclusions are very significant for the IPI and the ICM. TheIPI provides a number of illustrations of the issues raised above. It contains along list of exemptions ard zero rates for intermediate inputs and capital goods.If the additional effective tax levied on the industries consuming thoseintermediate inputs and capital goods was shifted backward, the value added bythe exempted industries would be burdened unexpectedly, and possibly against law-makers' intentions. It seems reasonable to assume that the exemptions weregranted in the first place to stimulate the production and consumption of thoseinputs that benefit from them. Similar conclusions apply to the ICM, but theextent of the damage is more limited due to the tax's simpler structure.

107. Change in the regulation of the excise taxes levied on specific sectorsor activities can also have some important revenue and efficiency implication.Most of these taxes have their bases currently excluded from the bases of the IPIor the ICM. The mere exclusion of the bases of the specific taxes from the baseof the IPT and the ICM is sufficient to transform the two VATs into salesturnover taxes. There are only two ways out of this problem. The first wouldrequire more encompassing VAT bases and the suppression of most excise taxes.The second would require a fuller system of credits allowed against taxes paid oninputs. Both solutions give rise to dilemmas. The first option improvesefficiency at the cost of revenue. The second ignores the conflict ofjurisdiction that would emerge from a full credit policy among Brazil's threelevels of government. It would also be complicated by the very loose applicationof the destination principle in the implementation of the VAT. For example, aproducer in Rio de Janeiro purchasing taxed inputs in Minas Gerais would claimcredits on taxes due in Rio for taxes paid in Minas Gerais by its suppliersof inputs.

108. Revenue Effects of the Price Distortions. By generating indirectrevenue through the taxes built into exempted inputs, the distortions increasethe tax revenue generated by the VATs. Hence, an additional important resultfollows from the above models suppression of the distortions could lead to adecline in tax revenue. If tax rates remain the same, the inclusion of the baseof the excise taxes in the VAT base and/or the suppression of the long list ofexemptions for inputs would reduce distortions in relative prices at the cost ofa lower revenue level for the government. For example, the replacement ofexemptions by zero would lead to lower revenue by restoring the credit chain fortaxes paid on inputs.

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3. Illustrating the Efficiency Issues

109. Assume that the leather industry purchases inputs for a value of Cz$10.It transforms these to sell at Cz$17, with a value added of Cz$7. The buyer ofthat leather is the shoe making industry which benefits from an exemption of theIPI on its purchases of leather. The shoe industry also purchases other inputsat a cost of Cz$23. The two industries producing inputs are assumed to pay notaxes on their own inputs. The shoemaker pays an IPI of 102 on inputs notexempted. The value added of the shoe industry is Cz$40 which means that itsgross sales revenue is Cz$80.

110. The Base Case. To assess the distortionary and revenue impact of theactual tax treatment of manufactured leather products, it is useful to have adescription of what a non-distorted tax rule would be. In this base case, allinputs as well as shoes are taxed at 102. Inputs are taxed through specificsales taxes, output is taxed on its value-added. Full credit is given for taxespaid on inputs. The effective tax rate paid by the shoe sector is equal to thelegal (nominal) tax rate. So is the effective tax rate paid by consumers. TheIPI would be a true value added yielding Cz$4 -- 102 of the value added of theshoemaker. Total tax revenue would also have included the revenue due to the taxpaid on inputs which amount to an additional Cz$4.

111. Effect of Exemptions on Effective Tax Rates. Because the use of leather(input 1) as an input is exempted, the net tax paid by the shoe industry is: 21/

10? .(80 - 23) = 5.7

An additional tax of Cz$ 1.7 is paid by the shoe industry on its leather inputs.This corresponds for the leather industry to a 24.31 tax on its value-added --1.7/7. If the shoe industry was a price taker (accepting the forward shifting ofthe tax without adjustment), the average effective tax rate on its output wouldbe 14.3Z (5.7/40) and not 102 as intended by the law. A tax wedge of 4.3Z on theshoe industry is imposed by exempting it from paying the tax on its leatherinputs.

112. Direct and Indirect Impact of the Tax on Prices and Value-added. Thetax wedge calculated alone represents an implicit additional tax levied on shoes(it will also be referred to later as the indirect tax effect on the price). Itis due to the exemptions, exclusions from the base, and all the other distortionsin the prices introduced by the tax system. The implicit tax rate calculated inthis way assumes that all the indirect effects are shifted forward to the finalbuyers of the production of the sector under scrutiny. The direct effect on theprice of the tax is determined by the legal or nominal tax rate for a givensector. To sum up, in our example, the direct effect of the tax on the price ofshoes is 10?, the indirect effect is 4.3?.

113. Limitations of the Simple Framework. The preceding equations providesimple and strong results for a quick assessment of the degree of distortionimposed on any commodity by the tax system. Little information is requireds the

21/ The revenue (Ti) from a VAT on a firm producing commodity i is calculated bysubtracting the taxes paid on inputs (t*Ci) from the taxes paid on the grosssales revenue of fhe firm (t*Si)t Ti - to(Si) - te(Ci.)

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tax rates on the commodity of interest and the exemptions in place, and someknowledge of the composition of gross output for the sector, assessed at thelevel of disaggregation provided by the input-output matrix.

114. The results include implicit assumptions about the behavior of buyersand sellers with respect to prices. The price taker behavior assumed may be toostrong an assumption for many sectors in Brazil. A more precise result wouldrequire knowledge of the price elasticities for each sector. Also, if theproducers of the final good are not price takers in the inputs markets, theexemptions and rate differentials analyzed above would affect the price of thatfinal good as well as its value added in the form of a specific tax on thoseinputs. In fact, the exact measure of the effects -- in terms of distortions andrevenue -- of the taxation of all final commodities would require knowledge ofthe alternative uses of the exempted commodities and of the inputs taxed at lowerrates. A full assessment would account for the general equilibrium effectstracked through the input-output matrix. This is the objective of the secondmodel, to be discussed below.

C. A METHOD TO MEASURE INTERSECTORAL DISTORTIONS DUE TO INDIRECT TAXES

115. While the previous section provided an intuitive explanation of theissues raised by deficiencies, this section presents a framework allowing theidentification and quantification of the impact on final prices of theinteraction of the various taxes. Since the more exempt goods there are, themore likely it is that value added is taxed at different unintended rates, thecalculation of the effect of taxation on prices in a multi-commodity worldrequires general equilibrium modelling of the effects of taxes via inputs. Thesimplest intersectoral model for which data is available in Brazil is theinput-output model. The interactions of the various taxes with the productionstructure are recognized explicitly. 221 The effects of the various taxesdiscussed in the previous chapter will be considered separately as well asjointly.

116. The Model. The framework used is based on standard input-outputanalysis and has been applied to the discussion of tax policy issues for severalother countries. 23/ The input-output model used here is a -- fixed-coefficient -

- general equilibrium model reflecting the structure of the economy in 1980. Itassumes, like the first model, competitive markets and constant returns to scale.Producer prices are equal to average costs, which depend on the returns tofactors and on the prices on inputs. Input prices enter the price equation as aweighted average of the prices of all inputs used. The weights are the

22/ However, the role of the import taxes is ignored in this version of themodel. This implies that the tax load computed for each sector is likely to beunderestimated since most sectors use imported input subject to imports taxes,directly, through tariffs or indirectly through NTBs. In fact, the tax loadcomputed is the domestic tax load.

23/ The theory was spelled out in series of papers by Ahmad and Stern whoapplied it to India and Pakistan between 1981 and 1987. The following discussionis based on their contribution to the theory. A mathematical description of themodel used for Brazil is provided in Appendix III.

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input-output technical coefficients which give the inputs required to produce aunit of the final output. If there were no indirect taxes, the producer priceswould be equal to consumer prices. The introduction of indirect taxes in themodel drives a wedge between the two prices for a given commodity. Because ofthe assumption of full forward shifting of the tax burden, the consumer price islarger then the producer price by precisely the amount of the indirect taxes paidby the sector producing the final commodity.

117. Essentially, the model calculates the effective tax rates for eachsector in a way similar to that discussed in the previous section for a one inputand output case, but it does of course approximate the interactions andcomplexities of the real world more fully. In particular, the model addressesboth the cases where taxes on inputs are creditable and those where they are notbecause of their exclusion from the base or exemptions granted to their users.In both cases, the production equilibrium is reached when the producer price isequal to the average cost of production, but the difference lies in thedetermination of the average cost. When producers benefit from full credits, theaverage cost is a function of factor remuneration and a weighted average of inputprices -- where the weights are the shares of the inputs in the total costs ofthe consuming sector -- without any tax element being built into the input price.On the other hand, when taxes on inputs are not fully creditable, the averagecost depends on the same vector of factor remuneration but with a weightedaverage of input prices including a tax element.

118. Input price vectors are then derived as follows. To incorporate theBrazilian tax system explicitly into the model, a vector of tax rates for eachtax is identified. The influence of those taxes on in-put prices is theirweighted average, and the weights form a matrix summarizing the relevant featuresof the Brazilian tax system. For each sector of the economy, for each inputrequired by that sector, and for each existing tax, the matrix indicates whetherthe sector gets a credit for taxes paid on inputs when it pays a tax on thepurchase of an input. When the tax is creditable, the weight is shown to beequal to the share of the creditable input in the production cost of theconsuming sector. Each tax vector required an adjustment discussed inAppendix IV.

119. The total effect of each tax on the price and on the burden each sectorwill be decomposed into its two components. The first is the direct tax effect,determined by the legal or nominal tax rate for a given sector. The secondeffect is the indirect tax effect, representing the fully shifted forwardimplicit tax burden due to the exemptions, exclusions from the base, and allother price distortions introduced by the very complex regulation of the IPI.For each one of the taxes discussed below, the direct and indirect effects aremeasured in terms of both their effects on prices and their burden on value-added. The burden on each sector is defined as the tax paid directly andindirectly by each sector as a proportion of its value-added.

120. Interpreting the Results of the Model. Comparison of the total effecton prices with the direct tax effect is not only a measure of the distortion inprices: the results can also be used to assess the intersectoral differences infinal prices due to any given tAx. Even if a few sectors contribute most of therevenue for a tax, the effective tax rates and the implicit tax burden on allsectors could be more widely dispersed. Note that a large spread of tax rates isnot necessari!y inefficient from an optimal taxation point of view, but theactual dispersion of tax rates across sectors does not seem to reflect efficiency

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considerations anymore than it reflects equity considerations. An additionalissue, not well addressed by our method, hap to do with a comparison ofinterregional effects of the distortions irAtroduced by the tax. The revenueimplications of the distortions can also be assessed from the results obtained.Finally, note that the indirect effect is a good indicator of the incentiveprovided to industry to integrate vertically. Vertical integration, if complete,would avoid the implicit tax burden imposed by those indirect effects.

121. Limitations of the Model. The model ignores the role of some importantvariables. First, subsidies are ignored since the analysis concentrates on theeffects of indirect taxes. Second, factor reward issues are assumed away. Aslong as our only interest is in the determination of changes in prices due tointersectoral relations, the determination of wages can be assumed out of theproblem by treating them exogenously. Any effect of tax changes on wages --whether direct or through feedbacks -- would be additional to those consideredhere. Thirrd, there is the effect on prices via the capital stock. Returns tocapital are also treated exogenously in the model. This last omission restrictsthe usefulness of the model for long-run analysis. The period of analysis usedis. however, assumed to be long enough for the effect of taxes on input andoutput prices to have worked themselves through the input-output process.Finally, use of the 1980 input-output matrix rather than a more recent picture ofthe structure of the economy imposes an additional constraint on interpretationof the results.

D. ASSESSHENT OF THE DOMESTIC INDIRECT TAXES

122. In this section, each tax is assessed individually. The analysisincludes identification of the fundamental issues raised by the tax law as itexists or as it will exist once the tax changes mandated by the new Constitutionhave been fully implemented. It also includes a numerical illustration ofdistortions in the price system introduced by each tax. The numerical discussionis based on a disaggregation of the effective tax rate for the 43 sectors of the1980 input-output matrix. The variance of these effective tax rates is alsocomputed as an indicator of the level of distortion.

1. The IPI

123. Evolution of the IPI. Originally, the IPI was partially based on aselectivity principle. The tax rates were supposed to reflect the degree ofprocessing of commodities by taxing the last stages of production and thenecessity of the goods produced taxing more essential needs at lower rates. Thetax base was intended to be the gross value added (sales minus purchases ofinputs) of the industrial sector, thus excluding agriculture, cattle raising,minerals, retail trade, and services. These exclusions were justified by thenature of the activity if it were not industrial -- or by the inclusion of thesector or activity into the base of a specific tax, such as those imposed on formirerals and service".

124. Over time, a long list of exemptions was added to the list ofexclusions, justified by the desire to stimulate the production of exemptedsectors and the consumption of exempted inputs. Eventually, the oversized listof full or partial exemptions and exclusions from the tax base turned the IPIinto a complex tax with a rate structure as long and detailed as the tariff

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structure. The list of exemptions includes regional incentives, such as the ZPH(which will be discussed fully in the section dealing with fiscal incentives),sectoral incentives such as those covering the steel industry, and productincentives such as those for some machinery and equipment. Exports ofmanufactured products are also exempted from the IPI.

125. The tax is now opaque and its administration has become very costly. Forinstance, the tax is levied on a firm and not on a corporation, which means thatthe movement of merchandise from one establishment to another of the same firm istaxable and includes a credit for tax paid.

126. Issues Raised by the IPI. Generally, the IPI's effective tax rates areonly marginally determined by the legal rates. This results its intersectoral andinterregional distortions, sometimes -- with policy objectives -- as in the caseof regional incentives, to stimulate regional growth, but more often unintended.In addition, the actual base of the IPI has been reduced to four sectors --tobacco, automobile, beverages and weapons. This is largely explained by theexistence of a regional incentives for the ZFM with exemptions for all industrialproduction from the IPI except for those four sectors.

127. The major economic effects of the IPI are derived from the simpleanalytical framework introduced earlier. They can be summarized as follows:

(a) the exemption of a sector providing inputs (such as intermediateinputs and capital goods) to taxed industries hurts that sector,whether the exemption is granted to try to benefit the sector or toreduce collection costs because of any specific characteristic ofthe sector that makes the fiscal monitoring of the operationsdifficult for taxpayers or the Treasury:

(b) the exemption of a sector that provides inputs for a sectorproducing necessities results in higher effective tax rates onthose necessities, even though they were intended to benefit frompreferential treatment;

(c) the inclusion in the tax base of a sector which was formerly exemptmay reduce revenues;

(d) in the presence of exemptions, the earlier stages of production aretaxed more heavily, despite objectives to the corntrary;

(e) since the IPI is also levied on the taxes levied on inputs used inproduction by sectors exempted from the IPI -- essentially thetaxes on transport, services, electricity, minerals, and fuels --the effective tax rates on products such as services, transport,minerals, fuels, electricity, and any other product exempted orexcluded from the IPI differs widely by user; the tax burden willdepend on the relative share of taxed and exempted inputs and onwhether the consumer is final or not, and will result in a fairlyarbitrary and random set of effective tax rates; 24/

24/ The five previous consequences introduce a bias against the use of inputs inthe production of goods and service exempted.

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(f) the final allocation of the tax incidence between producer andconsumer cannot be determined within this framework and needs to beanalyzed independently; the assumption that the full incidencefalls on the consumer or on the producer may not be realistic; and

(g) the effective tax structure is very likely to affect the pattern ofinternational transactions of some products since the effective taxrate on a given domestic good may be heavier than the import taximposed on an imported substitute; in addition, even if exportedmanufactured goods are exempted, their effective tax burden can besignificant for some sectors.

128. The IPI and the Use of Inputs. The most obvious conclusion to be drawnfrom the simple model presented above is that the IPI provided a negativeincentive for the use of exempted inputs. The IPI ends up being levied on thevalue added of all inputs, as well as on any specific tax levied on those inputs.In general, it is an incentive against industrialization. Furthermore, it alsoprovides an incentive to use imported inputs.

129. The IPI and International Trade. Imports, when taxed, are taxed at thesame rates as domestic products. However, the mechanism described earlier alsoimplies a distortion in favor of imports and discrimination against domesticproduction if the sector or a large portion of its inputs are exempted from theIPI. The intensity of distortion is best illustrated by a comparison betweennominal and effective tax rates by sector. Imports are taxed at the nominal rateand domestic production is taxed at the effective rate. In practice, however,the importance of this distortion due the design of the Brazilians VATs is minor,since imports are subject to quantitative restrictions and otuer forms of non-tariff barriers.

130. In principle, exports of industrial products are exempted from the IPIand bedefit from credits for taxes paid on inputs. However, once again, theseexports are not always fully exempted from indirect taxes. The larger the shareof exempted Inputs in the production of an export, the larger the implicit taxeffect that it faces. Exports of unprocessed agricultural products are not taxedby the IPI, but do not benefit from credits for taxes paid on their inputs. Thistreatment discriminates against sectors using industrial inputs.

131. The Treatment of Capital Goods. The new industrial policy proposes thesuppression of the credit granted for the purchase of national capital goods andits replacement by an exemption for the production of such goods (with theappropriate credits) and the imports of those sectors. The definition of capitalgoods is, however, restrictive, and only includes machinery and equipment,excluding structures, vehicles, and office equipment. In fact, the proposaleliminates the discrimination against imported capital goods, while leavingdomestic capital goods relatively unchanged. The result is a reduction in theIPI base, bringing it closer to a consumption-based VAT. The change alsoeliminates the current distortion against imports of capital goods. But itleaves domestic production at a comparative disadvantage, given the implicit taxburden due to the non-creditable taxation of some of its exempted inputs.

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132. Distortionary Effect cf the ZFM. In addition to the conception of thetax discussed above, a dramatic distortion in the IPI is induced by the ZFH, animportant regional incentive. 25/ The tax benefits granted to the ZFMessentially turn it into a foreign country within Brazil. For tax reasons, mostindustrial activities have a very strong incentive to locate in the ZFM with theexception of four industries -- tobacco, automobiles, beverages, and weapons andammunition -- which do not benefit from the IPI exemption even in the ZFM.Furthermore, the ZFM enjoys an additional advantage compared to a foreigncountry, since imports from the ZFM by other Brazilian states are exempt. As aresult, all production of televisions, viees, motorcycles, sound equipment, allthe high-value, luxury commodities -- precisely the goods that should form thebase of the IPI -- are produced in Manaus. The four excluded sectors generateabout 70? of the IPI revenue in the country. In other words, the existence ofthe ZFM in its present form results in a weak and narrow IPI.

133. Direct and Indirect Impact of the IPI on rrices and Value-Added. Usingthe methodology discussed earlier, the total effect of the IPI on prices and ontax burdens by sector has been decomposed into the direct and indirect taxeffects. These effects are measured in terms of both their effects on prices andtheir burden on value-added.

134. The direct and indirect effects of the IPI on prices were computed forthe 43 sectors of the 1980 input/output matrix but aggregated -- weighing byvalue-added -- into 16 sectors for the presentation. The average direct andindirect tax effect of the IPI on prices and on value added, and the standarddeviation of those effects, were also computed. 261 A summary of the results isprovided in Tables 4 and 5 below.

135. In 1988, the average total -- direct plus indirect -- impact of the IPIon prices was 8.7Z. The dispersion across sectors was high and reflected thehigh tax rate levied on tobacco, perfumes, alcoholic beverages and automobiles --the standard deviation drops from 13 to 6.5 when these 4 sectors are not includedin the average.

136. The average direct impact of the IPI on prices was 5.5Z. The dispersionwas high also but lower than for the total effect -- a standard deviation of 11 -- proving that the indirect effect adds to the dispersion. The legal rates rangefrom 0? for manw activities, combining those not considered as industrialproduction and those exempted, to over 330? for the tobacco industry. The veryhigh tax rates levied on the production of alcoholic beverages. Perfumes andtobaccos may be justified by the relative inelasticity of their demand withrespect to prices. The same is true but to a lesser extent for the production ofcars, paper, plastics, electrical equipment and steel products.

137. The average indirect impact of the IPI on prices is 3.2? -- about 60? onthe legal tax rate -- with a standard deviation of 2.7. All sectors, without anyexemption, are burdened by an indirect effect brought about by the imperfections

25/ A full description of the ZFM is provided below.

26/ The details of those results and of all the simulations discussed in thisreport are included in a separate statistical volume that can be obtained uponrequest.

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of the tax crediting mechanisms. For no sector is the indirect impact 02, and itranges between 0.072 (for communication equipment) and 5.96Z for housing and foodservices.

138. The size of the indirect tax effect is greater for industrial sectors.Agricultural activities are subject to less than average implicit taxationthrough the indirect effect. The sectors hurt most by exemptions in the middleof the production chains and by the implicit tax included in the costs of theirinputs are oil refineries, rubber, drugs and plastics.

2. The ICM

139. High Potential Revenue - Low Effective Revenue. Real ICM revenues havedeclined over time, from 6.92 of GDP in 1970, to 4.72 in 1987. This yield ishigh by Brazilian standards but very low in comparison to its potential, giventhat (i) the tax is levied on a very wide base (the sales of goods and servicesat all stages of the production process, except for services, transport,electricity consumption, minerals, fuels, and communications), and (ii) most ofthe transactions are taxed at a 172 inclusive rate (20.482 effective rate).Given the nominal tax rate and the actual yields, the effective base of the ICMin 1987 is only 22.9? of GDP.

140. The same issues are raised by ICM and IPI exemptions, except that theintensity of the former is more limited. In short, the exclusion fLom the ICMbase of the sectors subject to the specific taxes hurts those sectors when theyare used as inputs in the production of goods subject to the ICM. They impose aneffective indirect tax burden unaccounted for by the ICM tax law, becausespecific taxes paid on inputs cannot be claimed as credits against the ICM taxliability. As a result and as discussed earlier, the effective tax rates on theproducts taxed by the specific taxes, such as services, transport, minerals,fuels and electricity differ widely by the user. The tax burden will depend onthe relative share of taxed inputs and on whether the consumer is final or not,and will result in a fairly arbitrary and random set of effective tax rates.

141. Effective ICM tax rates are not dispersed across sector3 as widely asIPI rates except for those sectors with a significant share of exempted inputs intotal inputs. The exclusions from the base and exemptions are not as dramatic asin the case of the IPI, but there are still some significant exclusions, notablyactivities subject to the tax on services (ISS) or any of the specific taxes (onminerals, transport, fuels, electricity consumption, and communications) wherethe exclusion of some inputs from the ICM base breaks the chain of credits fortaxes paid on inputs and makes the ICM more of a cascading sales tax than a VATfor some sectors.

142. The important sectors most affected by the price distortions are likelyto be transport and construction, since they are subject to specific taxes whiletheir inputs are subject to tho ICM. In addition, the sectors which use theservices of these sectors intensively are themselves affected by the heavyimplicit burden imposed on those sectors which is probably shifted onto consumersto a large extent. From a revenue point of view, the relatively high tax burdenimposed on those sectors may, however, not be excessive, given the fairly lowdemand elasticity with respect to prices of these sectors.

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143. The New Constitution. The new Constitution incorporates transport,minerals, electr'city consumption, fuels, and communications in the ICM base. Itthus enhances efficiency since it suppresses the exemption frtm the ICM grantedto those sectors and restores the chain of tax credit. However, when the ICMrate is lower than the rate originally imposed by the sector specific tax, thishas been achieved at the cost of revenue loss. A quantification of the revenueand efficiency implications of the new Constitution is provided in Chapter IV.

144. However, not all sectors will be in better shape. The ISS remains inplace, which means that all services subject to that tax will remain in adisadvantaged position. In particular, the construction sector will still behurt by the ICM.

145. Finally, the new Constitution rejects the principle of origin, andasserts that the rate structure will be decided, in part, by each stateindividually, while Congress imposes the rates to be levied on interstatetransactions and exports. But the new Constitution also restricts the rates tobe decided by the states, as they cannot fall below those imposed on interstatetransactions.

146. Some form of tax competition between states may still result from thenew rules. It could take the form of discounts on tax rates to attract investorsor consumers, but the form of competition would be constrained by the lower boundimposed oy the Congress. However, non-rate competition is also possible, asstates could compete on the delays allowed for payment of the tax liability tostate governments. With high average inflation rates, an additional delay of onemonth could represent substantial gains for the taxpayer. Some recentdiscussions between states (within CONFAZ, an interstate forum legislating on ICMmatters within the Ministry of Finance) seem to indicate that no violent taxcompetition is likely and that tax rates will, at a minimum, be maintained andare likely to be raised for the new portion of the base and for some luxuryitems. Initial information suggests that states have agreed to maintain the 172rate as the standard for most commoditles. For luxury items, however, rates willbe increased to 25Z. The only problem so far is that there does not seem to beunanimity as to how to define luxury goods. In addition, in some states such asSBO Paulo, a third rate of 122 will be levied on some products, mainly energy andminerals which were formerly subject to specific taxes.

147. The Treatment of Capital Goods. An important issue raised by the ICM isthe absence of credits for taxes built into the price of capital goods. 27/ Witha large number of exemptions -- mostly for agricultural equipment -- t',e ICM baseapproximates GNP, which is equivalent to the sum of wages, capital income(including rents), and the amortization of capital goods. From an economicefficiency point of view, this choice of a base introduces an importantdistortion against capital, taxing both its income and its consumption during theproduction process. This favors the use of other inputs and discriminatesagainst capital goods with shorter life spans. On the other hand, while a movefrom a production-based ICM to a consumption-based tax would restore efficiency,it would also produce a lower volume of revenue. The new base would be narrower.

271 However, this tax becomes a cost to be depreciated against the corporateincome tax during the economic life of the asset.

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148. The Treatment of Agriculture. The ICM treats agriculture uniquely. Theproblem comes from the fact that agriculture is considered the first link in theproduction chain. Producers pay taxes (ICM as well as others) as part of theirinputs costs, but cannot claim any credits for them against their ICM liability.The magnitude of this distortion is however reduced by the zero-rating granted tothe production of fertilizers, seeds, and insecticides.

149. In general, the tax treatment of agriculture is damaging. Its output istaxed at effective rates greater than those levied on the other economicactivities, to the extent that it uses taxed inputs for which it receives nofiscal credit. The treatment of industrial machinery and equipment is especiallysignificant discriminating against agricultural producers in relation to otherproducers. An additional distortion is created by the differential treatment ofagricultural producers by region: the absence of credits for taxes paid on inputsis true only in parts of the country. Agricultur2l producers in the North,Northeast, and Center West regions benefit from true zero-rating, and therebyreceive preferential tax treatment.

150. The Treatment of Exports. Industrial exports are completely exempted(with credits for taxes on inputs), but inputs pay taxes at the moment ofpurchase since a priori it is not known whether the output will be exported orsold domestically. There is also a problem with tax rebates, since exportersmaintain enormous credits for taxes paid on inputs, but are paid no cash by theTreasury. Exporters of shoes are typical; to avoid the accumulation of unusedexcess credit without cash reimbursements, shoe exporters are allowed to use thecree ts to purchase specific local goods. This boils down to some sort ofearuarking of credits, when credits are used, or to an export tax when they arenot. In addition, exporting states not only do not obtain tax revenue, they mustalso give a credit for taxes paid in another state.

151. The vague definition of industrial products is a related problem. Thedefinition is important for primary products with some degree of transformation.If they are considered industrial products, they will be exempted. If not, theywill have to pay the ICM. This has led to some confusion as to how muchprocessing an agricultural product needs in order to qualify as an industrialproduct. After considerable debate, the Supreme Court ruled that if the price ofthe agricultural input represents over 50Z of the price of the exportedcommodity, then the exported commodity is not considered to be industrial and thetax is due. This ruling was expected to promote exports with a larger share ofdomestic value-added.

152. The ruling did not, however, meet its objective. It merelydiscriminates against agricultural production that is less processed. Inaddition, it could result in the promotion of exports of less rather than moreprocessed exports if the credits obtained by the exporter of the agriculturalproduct more than compensate for the ICM (13Z). In comparison, on exporter ofindustrial products would have benefited from the ICM exemption on exports, butwould have received no credits on inputs.

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153. The treatment of oranges and orange products provides a usefulillustration of this somewhat confusing issue, summarized in Table 3. Exports oforange juice do not obtain the credit because the cost of oranges represents over502 of the cost of the juice. Local sales do benefit from the credit. Theexample shows that the initial intent and logic of the Supreme Court, which wasto stimulate the exports of products with higher value added, ends up beingundermined by the tax policy. If the cost of oranges represents up to 13/17 ofthe cost of juice (comparing the export and domestic tax rate), the producers oforange juice will have an incentive to sell domestically, to switc! to theproduction of jam, or to use intermediate inputs (oranges) and other factors(labor and capital) in such a way that oranges represent less than 502 of thetotal production cost -- which boils down to a waste of resources. If theproducer does otherwise, orange juice ends up paying more taxes than oranges.

Table 3: TREATMENT OF AGRICULTURAL EXPORTS:ORANGES AND PRODUCTS

INPUTS TAX PRODUCTION SALE USES TAX

1. Fertilizer, 0? => 1. Exports jamSeeds, (WC) (0 with credit) 0? (WC)Insecticides -> Oranges(with credit) 3> 2. Exports juice 0? (PC)

(02 no credit)2. Other agric. 172

(no credit) (NC) => 3. Exports oranges 13? (WC)(13? with credit)

3. Non-agricul. 17X(with credit) (WC) > 4. Domestic sales 17? ('C)

of oranges,jam/juice(17? with credit)

Note: WC - with credit; NC - without credit for taxes on inputs

154. Direct and Indirect Impact of the ICM on Prices and Value-Added. Thedistortions built into the IGM can be illustrated quantitatively. Just as in thecase of the IPI. the major distortions are due to tne exemptions and theexclusions from the base. The average direct impact on prices is 15?, with astandard deviation of 8.8. The average indirect effect on prices is 3?, with astandard deviation of 1.4. The sum of the two effects on prices is 18? and thestandard deviatio.a is 10. The sectors most affected by the indirect effect areagain in industry. The less affected are in services.

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3. The Specific Taxes and Other Excises

155. The specific taxes and all the other excise taxes are levied on specificoutputs or services. They were created to protect sectors of special nationalinterest from the cascading sales taxes that existed at the time of theircreation. These specific taxes became a significant source of price distortionwhen the sales cascading taxes were themselves transformed into the IPI andthe ICM.

156. The Issue. Most of the sectors subject to the specific taxes can betaxed twice or three timest once by the specific taxes, once by the ICM, and insome cases by the IPI also. This is explained as follows. All the sectorssubject to the specific taxes (electricity, minerals, fuels, transport,communications) are important inputs for many sectors subject to the ICM and theIPI. All these specific taxes are embodied in the price of these inputs. Butmost of these specific taxes are not creditable against the IPI or ICM liability.The only exemption is the IUM (tax on minerals), of which 902 can be creditedagainst the ICM and 102 against the IPI. Hence, the price distortion caused bythe exclusion of minerals from the base of both VATs is less significant. Forall the other excises and specific taxes, the formal exclusion of their base fromthe ICM and IPI bases does not mean that they are not also subject to them. Onthe cc.trary, it is precisely because of that exclusion that the output of theelectricity, fuels, transport, and communications sectors is subject to both thespecific tax and the IPI and/or the ICM, when the sector using them as an inputis subject to either or both of the latter.

157. An important corollary of this distortion is that all the Brazilianproducers of these inputs lose competitiveness withi. the domestic market. Theimplicit tax burden imposes a price wedge between foreign and domestic pricesmissed when considering only the legal tax rates and the tariff structure. Theexact desincentive is even harder to assess, since the preferred protectioninstrument in Brazil is quantitative restriction, which also imposes an implicittax burden. In sum, for comparable production costs, a domestic supplier of aninput subject to the specific taxes and excluded from the VAT bases will be lesscompetitive than any foreign supplier, as long as the total level of protection(through tariff or quantitative restrictions) is not high enough to offset theprice wedge imposed directly and indirectly by domestic taxes.

158. Changes Built Into the New Constitution. The new Constitution mergesthe taxes on minerals, electricity, transport, and on communication services withthe ICM, which improves efficiency. It maintains, at the municipal level alone,the tax on fuels with a reduced base. All the sectors presently taxed throughspecific taxes will no longer be subject to double taxation, at least from theICM. They will remain taxed indirectly by the IPI when they are used as inputsof exempted industries, as long as they are not included in the IPI base. Theefficiency gains are not freet there will be a loss in revenue, since they implylower effective tax rates on the sectors newly included in the ICM. Thisnegative effect on revenue is likely to be offset by increases in nominal taxrates. In addition, reductions in collection lags are likely to ensure that realrevenue increases from a reduction of the Tanzi effect. Not however, that the

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integration of the ICM and of the specific taxes still represents a significantreduction in revenue for the Federal Government since the ICM is purely a statetax and no revenue sharing is involved.

159. Direct and Indirect Impact on Prices. As explained in Appendix II, allthe specific and excise taxes have been aggregated into a single tax vector, soas to apply the methodology discussed earlier. This simplification does notalter the results. Nor should it hide any distortion, since most of the taxesare sector specific and do not cumulate on a given sector. The nominal tax ratescan be tracked through the direct tax effects.

160. The average total price effect of the specific taxes was 2.7 with astandard deviation of 8.3. The average indirect effect on prices of the specificand excise taxes is 0.8X, with a standard deviation of 1.6. The direct effect is1.82, with a deviation of 6.8. These figures are quite low, but reflect the factthat many sectors are not directly affected by the specific and excise taxes.Only 5 sectors out of 42 are directly subject to any of the specific or excisetaxes. Proportionally (looking at the ratio of indirect to direct effects), thedistortions introduced by the specific taxes are much more significant than thoseidentified for the IPI or the ICM. The highest indirect price effects wereobserved for communications, electricity and transports.

4. The Tax on Services (ISS)

161. The conclusion drawn from the analysis of the specific taxes can bereiterated here. The ISS is just one more tax on inputs for many activities. Italso results in double taxation and loss of competitiveness for those activitiesincluded in its base when they are used as inputs by producers subject to the ICMand IPI, vis-&-vis substitutes not subject to the ISS. The tax is built into theprice of these inputs, but it is not creditable against the IPI or ICM liability.

162. No sector is significantly affected by the indirect effect of the ISS onprices. The average indirect price effect is 0.35Z, with a standard deviation of0.484. The total is 0.92 with a standard deviation of 2. The sectors mostaffected by the price distortions are the industrial sector in general and retailtrade. The low average reflects the fact that only 5 of 42 categories oiactivities are subject to the 5S ISS tax.

5. Social Contributions

163. Two of the social contributions are levied as indirect taxes. Inconcept, the social contributions are quite general -- everybody pays them,including agriculture. However, not all sectors pay them as an indirect tax.Essentially, service industries pay them as an income tax while other activitiespay them as indirect taxes. When paid as an indirect tax, the legal rate is thesame for all sectors, but the effective rates are bound to be different becausethe contributions are levied as cascading sales taxes on the receipts of a firm,with no allowance for taxes paid on any input. Hence, they lead to arbitraryrelative price distortions, and provide an incentive for the vertical integrationof economic activity.

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164. The average direct price effect is 1.01Z with a standard deviation of0.6. The average indirect effect on prices is 1.82 with a same standarddeviation of 0.9. The total effect is 2.92 with a deviation of 1.4. For thistax, the indirect effect is much larger than the direct tax effect. The indirecttax effect is mostly hurting the industrial sector. If the major users ofagricultural output are indirectly taxed more highly than the average sector, theagricultural sector is only subject to low levels of indirect price effects--1.3.Services benefit from the same relatively favorable treatment, with the exceptionagain of the construction and transport sectors.

6. Summing up the Individual Effects of Indirect Taxes

165. The effects on prices of each taxes can be consolidated. 281 Theaverages are computed by weighing the tax rate levied on a sector -- whetherdirect, indirect or total -- by the value added of the sector. Hence the weightsdo not generally reflect the base since tax is levied on the whole value added ofthe economy. The results are summarized in Table 4. It indicates that onaverage the total tax rate -- accounting for all taxes -- imposed on value addedin Brazil is around 202. Note that this does not really translate into equivalentrevenue effect. Evasion and long collection lags -- in the presence of an highinflation -- for most indirect taxes can reduce significantly the real revenueyield as discussed in Section E.

166. The dispersion around that mean is large -- over 18. For every tax,that dispersion of tax rates increased as a result of the indirect effects. Asimilar computation for the legal tax rates suggests than the direct effect, isonly 13.32 on average. The difference of almost 72 is due to the implicittaxation of inputs due to imperfections in the design of Brazil's indirect taxsystem. In fact this indirect effect adds, on average, 502 to the legal taxrate. Finally, Table 4 highlights that the major sources of distortions are dueto the design of the social contributions and the IPI. The ICM is not problem-free, but has an indirect effect relatively small in comparison to its directeffect.

28/ Recall that the results assume that all taxes are shifted forward throughproduction costs to the last consumer of any given product, and reflect the 1987legal tax structure.

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Table 4: AVERAGE DIRECT AND INDIRECT IMPACT OF TAXES ON PRICES

INDIRECT EFFECT INDIRECTTOTAL TOTAL DUE THE IMPLICIT AS 2 OF

TAX EFFECT OF TAX (Z) EFFECT OF TAX TAXATION OF INPUTS DIR. EFFECT

IPI 2.042 4.26S 2.22Z 108.82(11.032) (13.043)

ICM 7.602 9.54Z 1.942 25.52(8.861) (10.121)

SPECIFIC TAXES 1.542 2.412 0.872 56.52(6.843) (8.397)

ISS 1.522 2.162 0.64? 42.12(1.603) (2.024)

SOCIAL CONTRIB. 0.562 1.742 1.182 210.7Z(0.572) (1.428)

TOTAL 13.302 20.112 6.812 51.22(14.983) (18.190)

Note: (*) Below each average, the standard deviation is in parenthesis

7. Sectoral Effects of Taxes

167. To summarize the sectoral impacts of the taxes, the total tax burden iscalculated for a 15-sector disaggregation of the economy, which isolates themajor sectoral issues raised by the tax system. The results are summarized inTable 5.

168. The table shows that the most heavily taxed sector is "OtherIndustries." That residual category includes the production of alcoholicbeverages and tobacco which is subject to a very high nominal IPI rate levied onthat sector, and to a relatively high social contributions burden. Theelectricity sector is the next highest taxed, followed by chemicals, autos,electronics and all the major sectors producing capital goods. The heavytaxation of capital goods indicates that the indirect tax system has a severeanti-growth bias. The agricultural and mineral sectors as well as most servicesare taxed below average.

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Table 5: TOTAL IMPACT OF TAXES ON PRICES PER ACTIVITY IN 1988

SECTOR IPI ICM SOC.CON. ISS SPECIF. TOTALS z Z 2 2 Z

Agri./Livest./Fisheries 1.43 22.32 2.70 0.09 0.85 27.39Minerals/Oil Extraction 1.43 17.88 2.34 0.19 4.55 26.41Metals, Non-Metal & Steel 10.27 24.47 3.69 0.19 0.51 39.14Machinery & Equipment 9.86 24.42 3.46 0.22 0.39 38.36Automotive & Electronics 13.38 24.45 3.76 0.22 0.38 42.19Timber & Paper 11.22 24.72 3.35 0.24 0.43 39.95Chemistry & Derivatives 18.25 25.26 4.28 0.26 0.52 48.58Textile, Clothing & Shoes 3.39 24.19 3.82 0.21 0.37 31.98Food Supply 2.37 23.79 3.74 0.18 0.32 30.39Other Industry 78.94 24.21 2.95 0.22 0.31 106.64Electricity 1.24 0.82 0.47 0.15 49.74 52.41Construction 2.96 1.51 0.94 6.94 0.45 12.82Commercial Services 3.36 1.84 1.18 0.22 11.26 17.86Transport & Communic. 2.21 2.16 1.20 0.17 7.12 12.86Other Services 0.68 0.61 0.53 3.51 0.30 5.63

(1) Average 8.70 18.06 2.88 0.93 2.68 33.26(2) Weighted Average 4.26 9.54 1.74 2.16 2.41 20.11(3) Standard Deviation 13.04 10.12 1.43 2.02 8.40 18.19

169. All in all, at the aggregate level, the industrial sector is often moreheavily taxed than average through the indirect effect on prices. Agricultureand almost all services are subject to an indirect effect below average. Onlytransport and electricity carry an implicit burden somewhat above average.Paradoxically, this results from the large number of exemptions benefiting theindustrial sector and aimed at promoting industrial development. The importanceof the indirect effect illustrates tne counter-effectiveness of these measuresin Brazil.

170. To sum up, the quantitative analysis confirms the intuitive analysis ofthe distortions built into the 1988 Brazilian tax system provided by the simpleanalytical framework discussed above. The coexistence of two VATs (the IPI andthe ICM) with specific input taxes ended up imposing a large unintended burden onthe activities subject to those specific taxes. In addition to inducinginefficiencies in the allocation of resources among sectors, the distortionsreduced the competitiveness of domestic inputs. Despite protection throughtariff and non-tariff barriers, foreign inputs do not therefore necessarily carryas high a total tax burden as domestic substitutes. The importance of theseeffects varied significantly across sectors, according to production structure.

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8. Inter-Actions Between Taxes and Aggregate Tax Burden

171. Given their diversity, the indirect tax instruments existing in Brazilare also expected to interact to a certain extent. Most obviously, there areinteractions between the IPI and the ICM. In principle, the indirect taxes areincluded in the bases of the VAT. 29/ The ICM is included in the base of the IPIup to the last stage of production where the IPI is levied. The IPI is lastlevied on the suppliers of the retailers. Since the ICM is levied on all valueadded (except that subject to the specific taxes), it is also levied on allindirect taxes included in the value-added. At the other extreme, the IPI isincluded in the base of the ICM at the retail level. All the other indirecttaxes -- except the social contributions functioning as such -- are included inthe sales receipts, which are in turn included in the bases of the ICM and theIPI. Imperfection in the integration of the various indirect taxes leads todouble taxation. This issue is however uneasy to address without a dramaticsimplification for the current system.

E. WHY DID INDIRECT TAX REVENUE DECLINE IN BRAZIL?

172. The previous chapter illustrated that real indirect tax revenue hasdeclined significantly since the mid-seventies. lhis reflects a combination offactors. First, the acceleration of inflation, combined with long collection wasa major factor in the erosion of the real value on indirect tax revenue. Secondfiscal incentives are as important a source of revenue losses as they are asource of distortions. Third, the increased complexity of the tax system hasmultiplied the opportunities for tax evasion and avoidance. And finally, the IPIand the ICM "macroeconomic base" has shrunk. Specifically, exports and serviceshave been two key elements in the engine of economic growth over the past decade.However, these exports pays little taxes and services are subject to the ISS onlywhich is characterized by a much lower statutory tax rate then both the IPI andthe ICM. While it is difficult to quantify the revenue loss due to the last twosources of decline, some gross estimates can be provided for the first twosources.

173. Revenue Implications of Fiscal Incentives. Fiscal incentives grantedagainst indirect taxes in Brazil take various formss tax holidays, reduced taxrates, tax credits and total or partial exclusions from the tax base of any giventax. 30/ Except for the case of rates reductions, all the other incentives areequivalent to exemptions. If by now the efficiency implications of theseincentives have been clearly identified, the assessment of their actual revenueeffects remains an issue. A first approximation of their revenue effects isprovided by a budget for fiscal incentives that was first prepared for 1989 asmandated by the new Constitution.

29/ The base is defined as the selling price minus the (social) cost. Theresidual is equivalent to the distribution of returns to factors plus the tax.

30/ A detailed description of all the major incentives programs is provided inAppendix II, in Volume III.

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174. The budget applies only to federal taxes and hence does not cover theICM or the tax on services. However, for indirect taxes, the issue of incentivepis mostly an issue with respect to the IPI, which is a federal tax and is dealtwith by the 1989 budget. For 1989, there were 24 different fiscal incentiveprograms granted against the IPI -- most where intended to promote regions (6) orsectors (15) -- which resulted in a total revenue loss equivalent to 0.432 of GDPor almost 62 of projected federal revenue for 1989. This figure represents alower bound since estimates of revenue loss were not possible for all fiscalincentive programs.

175. The Effects of Inflation on Tax Revenue. The results presented so farindicate that the potential revenues are fairly significant. The average taxrate computed as a weighted average of the total effective tax rates -- where theweights represent the share of each sector in total value added -- is around 20X.This represents about double the level of actual revenue collections presented inthe national accounts for the last few years. Several factors explain thedifferences. Part of the explanation has to do with the methodology which is notable to model all the effects of the tax law -- in particular all the effects ofthe fiscal incentives -- and may lead to an overestimate of the effects of thecurrent tax system. Also some of the difference between the potential taxrevenue figure computed with the model and actual collections could be explainedby tax evasion.

176. The issue is clearly not new and reforms implemented in the firstsemester of 1989 in Brazil will go a long way in minimizing the revenue loss dueto long collection lags with two digits monthly inflation. The followingdiscussion is only to quantify the potential revenue effects of measures aimingat decreasing inflation or at reducing collection lags if inflation persists.

177. According to recent tax law changes implemented for the IPI, the taxliability is due on the 9th day following the fortnight during which the taxabletransaction took place. Assume that the typical transaction takes place at theend of the first week. Nine days later, the tax payer is required to convert thetax liability in BTNs to make sure the real value of the tax liability remainsconstant. In other words, on average, the government will suffer a 15 dayscollection lag. For monthly inflation rates varying from 102 to 302, thisrepresents real revenue losses between 152 and 52 which is significantly lowerthan the 192 to 512 that would prevail with an average of 60 days dela,s. Delaysreductions have been implemented for the ICM and for many of the smaller taxes.However, many sectors still benefit from delays of over a month.

178. To account for the importance of collection lags, the model required analteration. A discount factor had to be applied to each tax vector. Thediscount factor is the monthly rate of inflation, multiplied by the effectivecollection lag. For instance, assuming that inflation is 202 a month and thatcollection lags are 60 days (2 months), the tax vector was multiplied by thefollowing discount factors (1-.20)*(l-.20). This reduces tax revenue by 362

179. Table 6 provides a summary of the potential effects of variouscombinations of collection lags and monthly inflation rates from a revenue pointof view. The Table provides the discount factor to be applied to the theoreticalrevenue for nine different combinations. Actual revenue collections are obtained

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by multiplying potential revenue as computed by the model used up to now by thefigure in Table 6 corresponding to the relevant combination of collection lagsand inflation. For instance in 1988, monthly inflation averaged to about 201 andeffective collection lags averaged to 60 days -- it was actually more in manycases. This means that tax revenue were only 642 of the potential revenue thatcould result if inflation was 0 or if there were no collection lags, without anychanges in the tax system. 31/ Measures aiming at cutting effective collectionlags to about 15 days pr less such as those implemented in 1989, if implementedfor all taxes, could significantly reduce the real revenue loss due to inflation.

Table 6: REAL REVENUE AS A PERCENTAGE OF POTENTIAL REVENUEFOR VARIOUS COMBINATIONS OF COLLECTION LAGS AND INFLATION

Monthly Inflation Level

10 202 30X 40Z 502Collection Lags

60 days 0.81 0.64 0.49 0.36 0.25

30 days 0.90 0.80 0.70 0.60 0.50

15 days 0.95 0.89 0.84 0.77 0.71

F. SUMMARIZING THE ISSUES TO BE ADDRESSED BY A REFORM OF INDIRECT TAXES

180. The traditional tax policy principles of revenue, efficiency, equity andsimplicity can be used to sum up the core problems in the Brazilian indirect taxsystem that need to be addressed by a reform. This list of issues represents themajor items to be addressed by a reform of the Brazilian indirect taxes.

1. Too Little Revenue

181. The key sources of the decline in revenue from domestic indirect taxesthat should be addressed by a reform are:

(a) the narrowing of the base due to the multiplicity of exclusion, andexemptions granted through fiscal incentives which ease tax evasionand avoidance and due to changes in the production structure of theeconomy away from highly taxed activities into activities exemptedsuch as exports or lightly taxed such as services; and

31/ Since actual revenues are only 502 of potential revenues and long collectionlags only explained only explains 362, the model and tax evasion could be blamedfor the remaining 142.

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(b) the erosion of real tax revenue due to long collection lags in anhigh inflation environment.

2. Inefficiencies

182. The Brazilian VATs function as cascading sales taxes because of acombination of two factors: (i) the existence of non-creditable excise taxes onsome of the major inputs in the production process, and (ii) the generalizedsectoral exemptions which interrupt the chain of credits for taxes paid oninputs. As a result, the value added, when exempted, ends up being effectivelytaxed in an indirect way, and this indirect taxation increases directly with theratio of inputs to value added in the exempted industry. This introduces a biasagainst the ase of inputs in the production of goods and service exempted. Also,the dispersion of tax rates is much larger than suggested by legal rates, andboth inter- and intra-sectoral distortions are unintendedly significant.

183. The imperfect integration of the various taxes, the wide dispersion oftax rates and the multiplicity of fiscal incentive available result, inparticular in the following distortions:

(a) the current system provides not tax credit on certain keyagricultural inputs and taxes many agricultural inputs;

(b) services benefit very strongly from their general exclusion fromthe VATs and the low rate of ISS. This implies a strong bias towardthe production of services; and

gc) the taxation of capital goods through the VATs reduces Brazil'sgrowth capacity by reducing the incentive to invest. 32/

184. In aJdition, indirect taxes lead to regional imbalances. Along with theenormous tax break to businesses operating within the ZFH, which introduces animportant potential, though not perhaps actual, regional bias, there are moregeneral, though, less significant regional biases due to fiscal incentives.

3. Inequities

185. The tax system was designed to protect the poor, a principle reflectedin the original conception of the IPI. However, the chapter showed that suchexemptions can be ineffective or counterproductive, since no protection isafforded against the hidden tax effect -- dtue to the taxation of inputs -- whichthe poor still have to lay. For instance, essential goods for the poor such asfood are taxed at much lower rates. However, unless the entire sector ofagriculture is subject to true zero rating, then the farmers will pass on the

32/ This is discussed fully in Volume III where estimates of effective tax rateson capital in Brazil are presented.

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taxes paid on their inpuits into the final price of their productions and theconsumers will end up paying a higher effective tax rate than the low nominal taxrate initially intended. 331

4. Complexity

186. The Brazilian system was shown to be very complex. This complexityIncreases both the incentives and the opportunities to evade taxes. While harddata is elusive, the large disparity between potential and actual tax revenuesuggests that tax evasion is substantial in Brazil. In addition, many of theissues raise about as a direct consequence of the complexity problem.

33/ A fuller study of tax incidence would be desirable to provide a fullassessment of the equity issue.

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CHAPTER IV - POLICY IMPLICATIONS AND PROPOSALS FOR REFORMS

A. INTRODUCTION

187. The empirical part of the previous chapter illustrated the importance ofthe distortions built into the tax system in terms of efficiency, revenue, andloss of international competitiveness in domestic markets for sectors producinginputs excluded from the VAT bases. As discussed earlier, the implicit taxburden is generally large enough in many sectors for it to be worth highlightingthe danger of relying on legal tax rates as indicators of the extent to which anyproduct is actually taxed. Recognition of the relative and absolute importanceof implicit taxes has to be part of the analysis of any reform of the Braziliantax system given the considerable divergence between legal and effective taxrates. The results -- and the methodology -- presented earlier provide insightswhich allow the identification of desirable directions for reforms from bothefficiency and revenue perspectives.

188. This chapter is divided into three major parts. The first provides abrief inventory of the issues to be addressed in any reform of indirect taxationin Brazil. The second assesses the revenue and efficiency effects of the newConstitution and shows that the reforms implemented in that context were a firststep in the desirable direction. The third includes a number of suggestionsintended to reduce inter- and intra-sectoral distortions while maintaining orraising the level of revenues allowed by the current system.

B. THE REFORM AGENDA

189. The three main objectives of a reform of indirect taxes in Brazilshould be tot

(a) raise revenue;

(b) reduce undesired distortions due to implicit taxation; and

(c) simplify tax administration.

Actually a radical simplification of the tax system -- the third objective --would take the Brazilian Treasury a long way toward the successful completion ofthe first two objectives. In addition, a better design of indirect taxes wouldalso suppress the sources of inequity mentioned in the previous chapter.

190. To be more specific, the agenda for a reform of indirect taxes in Brazilshould include the recommendations listed below if Brazil's indirect taxes are toraise more revenue, introduce fewer distortions and achieve its equityobjectives. The recommendations are separated according to the speed at whichthey could be implemented:

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1. Short-Run

191. Two major measures are desirable in the short-run. The first one aimsessentially at a recovery of revenue. It is a generalization of the measuresincluded in the Provisional Measure 68 aiming at reducing revenue losses due tocollection lags.

192. The second measure is a set of changes in the design of the taxes thatwould succeed in reducing administration and compliance costs and improve revenueat a lower efficiency cost. The changes would not yet succeed in correcting allthe issues raised in the previous chapter but would represent a significant firststep in the desirable direction. They would include the following measurest

(a) widening the bases of the IPI to include all industrial activitiescurrently excluded and grant true zero rating to agricultural andservices inputs into industrial production;

(b) eliminate all current exemptions, mostly granted through fiscalincentives, within the broad tax base;

(c) allow full credit for all inputs into production;

(d) simplify tax on exports and imports, by zero-rating all exports andimposing the full rate of VAT on all imports;

(e) implement a flat rate for the IPI on all industries; the currentrates levied on tobacco, weapons, perfumes and alcoholic beveragescould be maintained; the reform should also try to reduce thedispersion of tax rates across sectors; tL3 new rate structureshould be set to reflect the choice to maintain or increase IPIrevenue;

(f) adoption of a more general credit policy for taxes paid on inputs,in the case of both the IPI and the ICM, than the current policy,which only allows credits for those inputs incorporated directlyinto the production process; many inputs do not qualify but arestill required inputs for that activity; in particular, the ICMbias against agriculture could be eliminated by (i) allowingenterprises in that sector to claim credits for all taxes builtinto its inputs, as is currently the case for fertilizers, seeds,and insecticides and (ii) exempting all agricultural exports fromICM and IPI while allowing credits for taxes paid on inputs;

(g) recognition that in light of the Constitutional right of the ZonaFranca de Manaus to exist until 2007 -- and the resultingimpossibility of avoiding the IPI exemptions of sales by Manaus --alternative solutions need to be identified to control thedistortions in resource allocation decisions that have followed.These would include reduction of the tax rates levied on itemscurrently produced in Manaus to levels that did not justify theadditional transport cost imposed by the location of production farfrom the major consumption centers, thus reducing the incentive toproduce in the ZFM mainly for tax reasons.

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2. Medium-Term

193. In the medium term, two additional reforms should be considered. First,the PIS/PASEP and FINSOCIAL contributions, which are levied as cascading salestaxes, could be replaced by a surtax on the IPI which could yield an equivalentor higher revenue. This would eliminate the intersectoral distortions imposed bythese social contributions.

194. Second, the two VATs could be transformed into true consumption-basedtaxes. Currently, both taxes impose an effective burden on capital goods.Consumption-based VATS would provide a stronger incentive for investment byexcluding capital goods, and hence promote growth. The measure is presented as amedium term measure because an immediate exclusion of capital goods from the taxbase could shrink the base to such an extent that the offsetting increase in taxrates required to maintain revenue constant would lead to prohibitively highrates on those products remaining in the base. But once a more stable overalltax system is established with more reliable sources of revenue -- includingimprovements in direct taxes -- the exclusion of capital goods from the baseshould be a priority. In the mean time, those capital goois already exemptedshould be zero-rated instead.

3. Long-Run

195. In the longer run, the full integration of the two VATs or theircombination into a single tax would be recommended. This does not seem feasiblein the short-run. The changes proposed are instead intended to allow Braziliantaxes to yield a revenue closer to their potential while reducing the effects ofthe distortions that they impose on the economic structure.

C. ASSESSING THE CHANGES INDUCED BY THE NEW CO"STITUTION 341

196. The Reform As A First Step Towards Less Distortions. The tax componentof the new Constitution introduces some important changes for indirect taxes. Itessentially eliminates all the specific taxes by integrating them into the baseof the ICM. Hence, the new ICM has a wider base. The rate structure is verysimilar however. The states, which now can set their own rates, have decided tomaintain the standard rate at 172 but allow a 122 rate for necessities and a 252for luxuries. The major items included in the necessities are food and otheragricultural items. For luxuries, the major items are those already highly taxedby the IPI. Those include tobacco, alcoholic beverages, weapons and ammunitionfor most states. Some states will also levy a 252 on cars and sports vehicles.Not all states will implement the rate differentiation to its full extent. Manywill stick to the standard rate of 17X. Since the disaggregation level of the

341 These simulations were made before the recent decision by most states tomaintain the standard ICM rate at 172 but to add a few rates for internaltransactions. A rate of 252 will be levied on luxury items. There is noagreement yet across states as to what should be considered a luxury item. Autoswere originally included in the list, but the latest information suggests thatsome states have rejected the idea. In addition, a rate of 122 is likely to belevied on energy and minerals.

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1980 input-output matrix does not allow to differentiate adequately in the ratestructure, all the results presented below for the effective tax rates after theimplementation of the New Constitution will assume an ICM rate of 17S.

197. Some important cascading effects will remain. They will be due to theISS and a tax on retail sales of fuels -- which represents only a part of theformer IUCL. In addition, the new Constitution does not include any changes inthe design of the IPI, FINSOCIAL and PIS/PASEP and these taxes were shown tocarry a very high indirect tax burden. Table 7 summarizes the major changes.

198. Assessing the Reform. The reform is clearly a conceptual improvement interms of efficiency. However, in relation to the reform agenda discussed above,its positive features only go part of the way in improving the system. On theone hand, it will allow taxes paid on inputs currently subject to the specifictaxes to be claimed as credits against ICM liability. This will reduce a majorsource of distortion by restoring the chains of credits for taxes paid on inputsand hence reduce the indirect effect from 6.842 to 5.682 as reflected in Table 7below. Note also that the overall dispersion of the tax rates declined as well.On the other hand, for many sectors formerly subject to a specific tax, theinclusion into the ICM also implies a higher legal tax rate and hence a higherdirect tax effect, as reflected in the increase in the direct effect for the ICMfrom 7.602 to 10.64X shown in Table 7. On average, the decline in the indirecttax effect will not be sufficient to offset the increase due to the direct effectand the total tax effect will end up being larger than under the 1988 tax system.It will been shown below that increases in effective tax rates are concentratedin very few sectors. All the other sectors benefit form a tax cut due to thereduction in the indirect tax effects.

199. Sectoral Effects of the Reform. Table 8 estimates the sectoral effectsof the changes induced by the new Constitution. The effect is a decline in theaverage price for most sectors, even if the aggregate effect on prices ispositive. The net increase is explained by a few sectors, especially transportand communications, and minerals. In most case, the reduction obtained by theothers are minor, except for electricity.

200. Despite these important changes, numerous significant distortionsremain. First, as IPI statutory rates are not part of the reform, no significantdecline is expected from current inter-sectoral differences in marginal IPI taxrates. The base remains narrow since the allocative distortions imposed by theZFM have not been reduced. Also, the ±CM treatment of agriculture is notimproved. Neither VAT is clcser to becoming a true consumption-based tax, andtheir credit mechanisms still discriminates against inputs not incorporated intothe final output during the production process.

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Table 7: COMPARING TAX EFFECTS BEFORE AND AFTERTHE NEW CONSTITUTION

BEFORE AFTER

WEIGHTED STANDARD 'WEIGHTED STANDARDAVERAGE DEVIATION AVERAGE DEVIATION

IPIDirect Effect 2.04 11.032 2.04 11.032Total Effect 4.26 13.043 4.26 13.043

ICMDirect Effect 7.60 8.861 10.64 7.561Total Effect 9.54 10.121 12.28 8.381

SOCIAL CONTRIBUTIONSDire-.c Effect 0.56 0.572 0.56 0.572Total Effect 1.74 1.428 1.74 1.428

ISSDirect Effect 1.52 1.603 1.52 1.603Total Effect 2.16 2.024 2.16 2.024

SPECIFIC TAXESDirect Effect 1.54 6.843 n.a. n.a.Total Effect 2.41 8.397 n.a. n.a.

TOTAL(1) Direct Effect 13.27 14.983 14.76 14.168(2) Total Effect 20.11 18.190 20.44 17.237(2) - (1) (Indirect

Effect) 6.84 5.68

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Table 8: SECTORAL IMPACT OF INDIRECT TAXES ON PRICESUNDER THE CURRENT AND POST-CONSTITUTION TAX SYSTEMS

SECTOR 1988 TOTAL DIFFERENCESYSTEM POST-CONSTITUTION

Z X

Agriculture/Livest./Fisheries 27.39 25.98 -1.41Minerals/Oil Extraction 26.40 27.13 0.73Metals, Non-Metal and Steel 39.14 37.33 -1.81Machinery & Equipment 38.36 36.92 -1.44Automotive & Electronics 42.19 40.80 -1.39Timber & Paper 39.95 38.39 -1.56Chemicals & Derivatives 48.58 46.84 -1.74Textile, Clothing & Shoes 31.98 30.67 -1.31Food Supply 30.39 29.14 -1.25Other Industry 106.64 105.52 -1.12Electricity 52.41 25.42 -26.99Construction 12.86 26.34 13.48Commercial Services 12.82 12.11 -0.71Transport and communications 17.86 28.17 10.31Other services 5.63 5.24 -0.39

(1) Average 33.26 32.09 -1.17(2) Weighted Average 20.11 20.45 0.34(3) Standard Deviation for (2) 18.19 17.24(4) Revenue (1988-100) 100 102 2

201. Revenue Effects of the Reform. The reform is does not lead to a revenueloss. The net revenue effect of the reform is the result of two offsettingeffects. First, the increase in the direct tax effect -- reflecting higherstatutory rates -- will increase revenue. Second, the reduction in the indirecteffects -- due to a smoother credit chain across sectors -- decreases revenues --assuming a flat 17? for the ICM. A simulation of the new Constitution changes

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using the framework discussed earlier, indicates that the reform would lead to arevenue increase of about 22 over the 1988 revenue from indirect taxes. Thisrevenue increase is however an upper bound rather than a point estimate. 35/

D. SPECIFIC REFORM PROPOSALS

202. This section describes a set of alternative reforms packages proposingimprovements in the Brazilian tax system which build upon the reforms alreadyincluded in the new Constitution. There are two types of reforms. The firsttype should be implemented immediately for an immediate recovery of revenues.The second type is a set of reform alternatives. They are all different but areconsistent. They could be viewed as a succession of reforms that could beconsidered by the Brazilian authorities. The figures resulting from thesimulations of these various alternative are, of course, purely illustrative.However, they provide a useful illustration of the potential welfare cost andrevenue effects of all the major changes in the design of the major Brazilianindirect taxes that could be considered. They all aim at increasing simplicityof administration and at improving efficiency, some in addition, aim atincreasing revenue.

203. Minimize Collection Lags. In the short run, as stated earlier, Brazilshould minimize the collection lags for all its indirect taxes. Table 6 of theearlier chapter illustrated the very large real revenue gains that could resultfrom that measure. A minimization of collection lags could very rapidly resultin an increase in real revenue of at least 12 of GDP at current inflation levels.36/ Note that if inflation were stabilized at low levels, there would be no needfor this measure.

35/ This results from the methodology adopted. The level of aggregation of the1980 input-output matrix (43 sectors) does not allow a precise modeling of thetax credit status of a given sector. Assume for instance that a single sector inthe 1980 input output matrix actually includes several activities identifiedseparately in the IPI law. If the rate for one activity is 0 and the rate forthe other is 102, assuming each activity represents 502 of the total, the averagetax rate will be 5Z. But it was mentioned earlier that, in Brazil, a zero rateis actually equivalent to an exemption and no credits are allowed. However, thecomputations presented here assume that a full credit mechanism exist for asector taxed at 52 and this is quite different from the actual tax treatment. Asa result, indirect effects will be underestimated. The more actual exemptionsare omitted by the framework, the more the revenue will be underestimated. Thissystem before the Constitution was certainly more subject to that bias than thenew Constitution system which restores many credit mechanisms. As a result, thecomputations of the revenue increase likely to result from the new Constitutionand from all the reform proposals presented here provide an upper bound ratherthan a point estimate.

36/ Alternatively, a reduction of inflation combined with a reduction incollection lags would also contribute to a reduction in the real revenue erosionobserved since the mid-seventies.

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204. Reforms Addressing the Structural Deficiencies. The reform proposalsaiming more specifically at reducing sources of distortions through alterationsin the design of the current taxes are the following.

Reform l: Replace the current IPI rate structure by an almost flat ratestructure; all sectors would be subject to a standard 102 rate except forperfumes, tobacco, weapons and alcoholic beverages that would keep theircurrent rates.

Reform 2: Implement Reform 1, but in addition, ensure that the IPI is atrue value-added taxes, in the sense that all sectors excluded from its base(agriculture and services) are treated as zero rated rather than as exemptedsectors; this reform would lead to a revenue loss due to the loss of the currenthigh indirect tax effect.

Reform 3: Essentially, the same as Reform 2, except that the standardIPI rate would be computed to ensure revenue neutrality.

Reform 4: Essentially the same as Reform 3, except that the standardIPI rate would be computed to increase revenue by 302 to return it to its lateseventies level.

Reform 5: Essentially the same as Reform 3 for the IPI; in addition,sector excluded from the ICM base (services) would be treated as zero ratedrather than exempted; the ICM rate would have to be adjusted to offset therevenue loss due to the suppression of the indirect effect and to maintainrevenue neutrality.

Reform 6: Replacement of all current domestic taxes by a single basevalue-added tax with a flat rate except for perfumes, tobacco, weapons andalcoholic bevezages that would keep their cnirrent rates; the new VAT rate wouldbe computed to ensure revenue neutrality;

Reform 7: Essentially the same as 6, except that the rate would be thesame set at the level of the top personal income rate (25Z) to improve theintegration between direct and indirect taxes.

205. The first four reforms could be implemented in the very short run by thefederal government. They do not require any major changes in the overallindirect tax system. They only aim at improving the design of the existing taxesto reduce distortions while increasing revenue by 12 to 22 of GDP. The fifth onewould have to be debated among the states -- within CONFAZ -- since it involvesthe ICM, and its implementation, if considered desirable by the states, wouldprobably take some more time. Reform 6 and 7, in spite of being the mostdesirable from an efficiency, equity, administrative and revenue point of view,can only be considered for the longer run. Their inclusion in this documentessentially aims at illustrating are the potential benefits from a completeredesign of Brazil's indirect tax system. They show that the current revenuecould be achieved at a much lower efficiency cost.

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1. Quantifying the Effects of the Reforms

206. To ease the comparison of the various reforms proposed, Table 9 presentsthe revenue effect and the deadweight loss in each case. 37/ The results arepresented in index form, normalized for the tax system before the implementationof the New Constitution. In other words, revenue and the deadweight loss areequal to 100 for the 1988 tax system. If the figure computed for the tax systemprevailing under any of the reforms proposed is below 100, it means in one casethat revenue is lower and in the other case, that efficiency costs are lower.

207. Table 9 also provides an index illustrating the change in efficiencycost per unit of revenue collected. The index is provided to ease the ranking ofthe reforms and is also normalized for the tax system before the new Constitutionwhen an increase in 12 of revenue would result in a 12 increase in efficiencycost. When this ratio is smaller than 100, the reform proposal reduces theefficiency cost of increasing revenue. The opposite holds when the ratio isgreater than 100. This ratio is however a weak measure. First, typically,concepts of deadweight losses applied to taxation do not account for the benefitsof tax simplification. But more importantly, the deadweight loss used here islikely to systematically underestimate the efficiency gains of a reform.

Table 9s COMPARING REVENUE AND DEADWEIGHT LOSS OF REFORMS(1988 tax system - 100)

REFORMSNew

Constit. 1 2 3 4 5 6 7

(1) Deadwei ghtLoss 97.7 111.9 86.2 97.7 189.3 99.8 64.6 91.8

(2) Revenue 101.6 108.6 94.7 100 129.3 100 100 124.3

(3) (1)/(2) 96.2 103.0 91.0 97.7 146.4 99.8 64.6 73.8

208. The deadweight loss computations are presented for purely illustrativepurposes. Exact measures would require a general equilibrium model. Theframework used here has no behavioral equations and hence does not allow themeasurement of the costs and benefits resulting from the reallocation ofresources in the economy. The computation of the deadweight losses used here is

37/ A 43-sector disaggregation of the effects of the reforms proposals isavailable in a statistical volume available upon request.

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based on the simple application of the original 'Harberger TriangleO.38/ Theexact formula shows that the deadweight loss is a function of the volume of thecommodity consumed, of the compensated price elasticity of demand for thecommodity and of the square of the tax rate. The deadweight loss is computed foreach commodity bundle produced by each of the 43 sectors of the economy and thenadded up to obtain the total welfare loss for the economy as a whole. 39/ Thechange in the deadweight loss resulting from a reform proposal is thenillustrated by the ratio of the deadweight loss computed as just described forthe effective rate structure prevailing under the reformed tax system, over thedeadweight loss computed for the tax system before the changes in theConstitution.

2. Reform 1

209. The first reform would ease administration and compliance and increaserevenue by imposing a flat 102 rate on all sectors in the IPI base, except forthe perfumes, tobacco, alcoholic beverages and weapons which would keep the samerate- as today. Such a reform would also include a simplification of the currentset of indirect tax laws, through the elimination of all exemptions. This muchsimpl-; IPI which reduces opportunities for tax evasion would however increasethe e¼adweight loss. This is because currently, many sectors in the base of theIPI - e subject to a total tax rate below 102 even when accounting for theimpl!it tax burden due to the taxation of the inputs.

210. The reform also assumes that with respect to foreign trade, all exportsare exempted with full credit for taxes built into inputs. All imports are&iesumed to be taxed without exception.

211. The existence of the Zona Franca de Manaus does not represent asignificant problem for this proposal. This is explained by the low tax rateproposed (10%), one sufficiently low that it is unlikely to promote production inManaus for tax reasons alone. Manaus is not really a significant problem for theIPI since it produces less than 52 of industrial production in Brazil.

3. Reform 2

212. In addition to the items built into Reform 1, Reform 2 proposes toreduce the importance of indirect effects due to the taxation of :.!pvts. If thefederal government decided to implement true zero rating for agriculture andservices and to all sectors currently paying a rate of zero within the IPI base,large efficiency gains could be achieved. However, as shown by Table 9, revenuewould decline by over 5Z. While the reform would reduce the efficiency cost per

38/ Harberger, A. C., Taxation and Welfare, The University of ChicagoPress, 1974.

39/ Implicitly this assumes that the typical consumer has a directly additiveutility function (see Atkinson, A. B. & Stiglitz, J. E., "The Structure ofIndirect Taxation and Economic Efficiency," Journal of Public Economics, April1972, pp.97-119); the computations also assume that the demand elasticity is thesame under both tax systems and since ratios are used to compare the efficiencycosts of the system, it is never require to estimate it since it cancels out.

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unit of revenue, its total effect would be undesirable since in the short runBrazil cannot afford to lose revenue. A better reform would alter the IPI rateto ensure that revenue is neutral. That would be the purpose of Reform 3.

4. Reform 3

213. To transform tne IPI into a true VAT and suppress the very high indirecteffects due to the IPI, Reform 2 would be sufficient. But to maintain revenuesto its 1988 level, once all the indirect effects from the IPI are cancelled bythe design of an appropriate credit mechanlsm, the legal IPI rate needs to beincreased. According to the model, the standard should be set at 15.12 -- asalways, maintaining the high rates on the 4 usual sectors.

5. Reform 4

214. Since Brazil needs to recover tax revenue, the next reform proposalsimulates the effect of a roughly 302 revenue increase -- actually 29.22. -- toreturn to the high revenue from indirect taxes of the late seventies. Thisreform would be undesirable. It shows a very high efficiency cost per unit ofrevenue. This is because deadweight losses are a function of the square of thetax rate and the IPI rate would have to be increased to almost 422 -- with theappropriate credit mechanisms -- to achieve the 301 increase in revenue fromindirect taxes.

6. Reform 5

215. This reform proposal includes Reform 3 and would also recommend thetransformation of the ICM along the line recommended in Reform 2 for the IPI.The goal would be to eliminate the indirect effects by granting appropriatecredits to all sectors excluded from the base. Both the IPI and the ICM rateswould be set to achieve revenue neutrality for each tax individually. Hence, theIPI rate would be 152 and the ICM rate would be 242. The deadweight loss of themeasure would be the same as under the system prevailing before the newConstitution but the administration of the IPI would be simpler and less roomwould exist for evasion.

7. Reform 6

216. This reform is probably unrealistic in the short-run. The Braziliandecentralization mechanism is partially based on a large degree of independencewith respect to tax policies. This proposal is not acceptable as long asdecentralization in that form remains Brazil's preference.

217. But much of the report was intended to illustrate that the multiplicityof taxes and their overlapping leads to large efficiency losses and highadministration costs. In the long run, Brazil could consider the replacement ofall indirect taxes by a s4ngle VAT. The revenue would clearly have to bedistributed between states, municipalities and federal governments. It could bedone without changing the resources available by any given municipality or statein the Union by designing the appropriate revenue sharing formula. A new VATwith 20? as standard rate and the current high rates on the main four sectorswould maintain revenue at its current level. Such a reform would however,represent a dramatic increase in efficiency. The welfare cost of a unit of

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revenue under such a system would be 35Z less than under the system prevailingbefore the new Constitution or 33X less than under the current tax system. Andthese are probably lower bound estimates since the benefits of the reallocationof resources are not picked up by the above results.

218. The proposal also implies the suppression of most fiscal incentiveprograms and the suppression the social contributions functioning as cascadingsales. In this last case, since the unique VAT proposed is revenue neutral, aportion of tax collection could be transferred to the financing of socialexpenditures.

8. Reform 7

219. The last reform proposal simply aims at illustrating the revenue effectsof a better integration of indirect and direct taxes. Under the currentBrazilian tax system, the top rate under the personal income tax is 25X. Sinceincome is (almost) equivalent to the sum of value added, an appropriateintegration would require that the single VAT of reform 6 be characterized by aflat 25Z rate. The reform would result in a 25Z increase in revenue. If wouldalso provide a tax system that is more efficient than all others except for thetax system proposed in reform 6.

9. Transitional Issues Raised by Reforms 6 and 7

220. The switch to a single VAT included in the last two reform proposalsraises some transitional administrative issues that should not be underestimated.This section proposes a transition path that could be followed to switch from thecurrent multi-tax environment to a single tax environment providing the verysignificant efficiency gains illustrated by the simulations of Reforms 6 and 7.

22±. The current two VATs could be modified in such a way that each one endsup being a duplicate of the ideal single VAT. This means that the base of bothcurrent VATs would be increased to include all sectors currently not covered. Infact, their base would become the same. For the ICM this means the inclusion ofservices in its base and for the IPI it means the inclusion of agriculture andservices. The ISS would then become redundant. The tax rates for the newfederal and state tax would have to be set to meet any revenue target eachgovernment may have at the time. Also, a revenue sharing mechanism would have tobe designed to ensure the desired distribution of revenue across governmentlevels. In the long run, once the transitional hardships have been overcome andrevenue sharing arrangements have been agreed upon, the two taxes couldbe merged.

222. Note that during the transition period, zero rating would only have toapply to exports. This in turn could lead to excess credits being accumulatedfor taxes paid on inputs. This excess credit would have to be reimbursed to thetax payers to avoid the transformation of zero-rating into an exemption ofexports. The administration of the excess credit should not be an issue since alltax payers would have an incentive to provide the Treasury with the appropriateinformation in order to maintain its tax rate at the statutory level and to avoidpaying undue taxes on inputs.

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223. A problem that could arise is that specific states or local governmentsmay be unable to reimburse the exce6s credits for the tax they would manage (theexpanded ICM). To avoid the potential efficiency costs, these credits could beabsorbed during the transition by the federal government. In turn, the 'expandedIPI" rate would have to be increased somewhat to maintain revenue constant at thefederal level.

10. Sumning the Lessons from the Simulations of the Effectsof the Reform

224. The results provided in Table 9 highlight the major lessons that can belearned. Reforms 1 to 4 suggest that the Agenda for a reform of the indirecttaxes should include, besides the cut in collection lags, the following items inthe short run:

(a) widen of the IPI to include all industrial activities currentlyexcluded;

(b) allow full credit for all taxes paid on inputs into production,including capital goods; this means, for the IPI, granting granttrue zero rating to agricultural and services inputs intoindustrial production, and for the ICM, granting true zero ratingon services inputs; and also, in both cases, grant true zerorating for exports;

(c) eliminate all current exemptions, mostly granted through fiscalincentives, within the broad tax base; and

(d) implement a flat rate for the IPI except for the four highly taxedindustries whose rate would not change; set the new IPI rate tomaintain or increase revenue -- within certain limits -- at alower efficiency cost.

225. The simulations show the revenue and efficiency gains that can beachieved. They also illustrate their limitations. First, reform 1 to 3 showthat significant efficiency gains can obtained from a simplification of the IPIrate structure and from the replacement of all exemptions by true zero-rating.Reform 2 shows however, that the restoration of all credits for taxes paid oninputs can lead to revenue losses. Reform 3 shows that this revenue loss can beavoided by setting the new IPI rate at an appropriate level. Reform 4 showshowever that there is a limit that to the revenue gains from the IPI reform. Bysetting the new rate too high, a reform could result in an increase in thedeadweight losses per unit of revenue.

226. Reform 6 and 7 illustrate clearly the long-term gains that could begained from a complete redesign of the current Brazilian indirect taxes. Theefficiency costs per unit of revenue could clearly be much lower than they arenow, with a single value-added tax replace all domestic indirect taxes. Revenuecould be increased and at the same time, growth would be promote through anincreased role of the private sector. Potential revenue could be increased by24.32 with a reduction in the welfare cost of about 8Z.

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PART II

CHAPTER V - REVENUE IMPLICATIONS OF BRAZIL'S PROTECTION POLICIES

A. INTRODUCTION

227. This chapter has two objectives:

(a) quantification of the implicit tax revenue loss due to theBrazilian Government's preference for non-tariff barriers as ameans of protection; 40/

(b) assessment of the revenue effects of the July 1988 import tariffreform.

228. The chapter proceeds as follows: Section B discusses the recentperformance of the import tax. Sections C and D describe the import tax systemin Brazil before and after the July 1988 reform respectively. Section D alsoprovides an estimate for the revenue impact of the tariff reform. In AppendicesIV and V, the new tariff and industrial policies are briefly described.

229. The main conclusions of the chapter are as follows:

1. On the Potential Revenue from Import Taxes

Import taxes are not an important potential source of revenue in Brazilfor two major reasons: 41/

(a) tariffs are not the most important protection instrument;non-tariff barriers (NTBs) are more widely used but do not yieldany tax revenue; and

(b) the current protection structure supports an import substitutionstrategy, which, as expecte'i, eroded significantly the tax basefor the import tax. Ccusequently, even if NTBs were to bereplaced by tariffs, the revenue from the import tax would not beincreased very significantly because the volume of imports isitself relatively low. At best, the revenue from the import taxand the IPI could only be doubled to 1Z of GDP.

40/ The distorting impact of Brazil's commercial policies has been discussed in'Trade Policy in Brazil -- The Case for Reform," World Bank Report No. 7765-BR,May 31, 1989 and will not be dealt with here.

41/ In addition to these two reasons which are well documented, a third one iscurrently being assessed by the Bank: the efficiency of customs services.

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2. On the July 1988 Tariff Reform

(c) the actual impact of the reform is hard to assesst its revenueeffects are combined with those of the recession which affecteddemand for imports; an attempt to isolate the effects of thereform suggests that the likely impact of the tariff reform was arevenue loss of 0.2-0.42 of GDP (in terms of 1985 data)s thelargest loss is due to the cancellation of the IOF, whichrepresented 0.32 of GDP; the tariff reform seems to simplifyimport procedures and to make them more transparent but nocollection-cost reduction is expected in the short-run;

(d) the medium-term outcome of the tariff reform is uncertain, andwill depend on the short-run outcome. If the policy change isviewed as temporary, this may create a speculative accumulation ofdurable goods and consequent loss of reserves and reversal of thepolicy;

(e) import taxes on consumer goods are higher than on intermediate andcapital goods; in addition, there are rate differences acrossindustries; and

(f) before the tariff reform there was no problem in harmonizing taxesbetween domestic goods and equivalent imports because the law ofsimilar banned the latter. If equivalent imports are allowed,then harmonization of taxes will be necessary.

3. On the Effective Import Tax Rates

(a) the comparison of the implicit import tax rates and of theeffective tax rates due to domestic taxes illustratesinconsistencies between the domestic tax policies and theprotection policies.

B. RECENT IMPORT TAX REVENUE PERFORMANCE

230. Brazil intensified its post-var import substitution policy by means oftariffs and, more importantly, non-tariff barriers (NTBs) as a consequence ofbalance of payments difficulties created by the first oil shock in 1973. Animmediate fiscal consequence of the policy was a declin: An import tax revenuedue to erosion of the tax base -- i.e., the value of imports -- which was notcompensated by higher tariff rates. In addition, the preference for NTBs asprotective devices led to the creation of economic rents instead of tax zevenue.

231. Because of the close interactions among the various sources of taxrevenues in Brazil, it is also important to recognize the yield of the domestictaxes levied on imports. Imports are subject to the IPI, the ICM, and the HarborImprovement tax (TMP) (the TMP yields negligible revenues). Before the July 1988tariff reform, importers also paid a tax on the purchase of foreign exchange(the IOF).

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232. All in all, in recent years, total trade taxes represented around 51 oftotal annual federal revenue, or 0.52 of GDP. On average, all revenues fromimports have amounted to an average of 0.82 of GDP eince 1982. Import taxrevenue alone accounted for 0.4Z of GDP. IPJ levied on imports yields 0.11 ofGDP, and IOF yielded 0.3-0.5Z of GDP. These figures indicate that imports arenot a significant tax base in Brazil. Because of NTB and a smaller taxablebase, relative to other LDCs, Brazil's import taxes provide a small percentage oftax revenue.

C. THE PRE-REFORM IMPORT TAX SYSTEM

233. Legal, Actual, and Implicit Tax Rates. Legal tariff rates in Brazilhave little economic meaning. Special import regimes through which importers aretax exempt or allowed to pay a lower tax have substantially reduced the tax onsome imports. These programs are of long standing (from the late 1960s at least)and are the result of international agreements, or a means of directing brnefitsand incentives to specific sectors. The legal and actual (in the sense ofrealized average rates) rates for the whole economy are 22.11 (36.61 excludin;oil and wheat) and 5.8Z (10.C6 excluding oil and wheat), 42/ respectively.Despite low actual tariff rates, implicit tax rates are high as a result of NTBs.These barriers take the form of foreign exchange allocation, explicitquantitative restrictions, a list of banned imports, deferred foreign paymentconditions, or bureaucratic requirements.

234. Table 10 shows implicit, legal, and actual import tax rates for 23industries. 43/ The implicit and actual rates are defined as followst

(a) implicit tax rates have been calculated from direct comparisons ofinternational and domestic prices. The latter is the ex-factoryprice which does not include domestic indirect taxes. A negativeimplicit tax rate indicates that the domestic price is lower thanthe international price, and that the product or sector isimplicitly subsidized. This situation arises when there aredomestic price controls (i.e., agriculture, food products), orwhen import barriers are so high that no imports are allowed -- atypical case is the tobacco industry; and

(b) the actual tariff rate is defined as tax revenue collected dividedby the taxable import base.

42/ 1985 data. The legal (theoretical) rate is calculated on the basis of theinformation contained in the law whereas the actual (or realized qverage) rate isequal to actual paid import-tax revenue/base. Data "Comercio Exterior doBrasil," CIEF, MF, p.749).

431 Braga, Santiago, and Ferro (1987) do not report legal and actual tariffsrates for 1985; nevertheless, the import protection system in Brazil in 1985 wasmuch the same as that in 1984; therefore, for comparative purposes 1984 tax ratesare a approximation for 1985.

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Table 10s IMPORT TAX RATES al (Z)

Number Actualof average

Sectors Implicity b/ Legal tax

IBGE Classification 1985 1984 1984of Sectors ----------------- -----

3 Primary Agriculture c/ 6 - 23.2 57.3 22.65 Mining 4 - 6.2 16.7 18.9

Manufacturing 90 18.0 90.0 19.1

10 Non-metallic minerals 6 12.0 98.7 29.511 Metallurgy 11 26.6 72.8 12.712 Machinery 7 11.8 62.1 17.213 Electrical equipment dl 8 47.0 100.4 11.214 Transport. equipment 6 12.4 115.9 2.915 Lumber and wood 2 20.9 101.1 0.316 Furniture 2 46.0 169.9 3.517 Paper 3 18.6 82.2 39.418 Rubber 2 45.6 101.7 14.519 Leather and furs 1 33.6 135.2 8.920 Chemicals 10 22.9 34.2 11.521 Pharmaceutical prod. 1 99.5 42.2 25.822 Perfumery 1 23.4 184.4 5.623 Plastics 2 114.8 164.3 25.224 Textiles 5 65.1 161.6 6.625 Apparel 2 111.7 192.2 1.126 Food products 15 - 5.8 84.2 16.927 Beverages 2 3.0 183.3 78.828 Tobacco 1 - 70.7 204.7 168.829 Printing and publishing 2 - 0.9 71.1 1.130 Miscellaneous 1 75.6 136.5 33.3

Source: Braga, H. C., Santiago, G. M. C. and Ferro L. C. M., OProteg8o Efetivano Brasil: Uma Estimativa a Partir da ComparagAo de Pre9os,' Fundagao de Estudosdo Comercio Exterior, FUNCEX, Manuscript, 1987, Table 4.1.

Notes:a/ Weighted by production at international prices.b/ Implicit rate- p/p*c, f-1, where p-domestic price, p*cm CIF price and

p*f- FOB price. Implicit tax rates are exclusive of domestic indirect taxes.c/ Including forestry and fishing, agriculture, and livestock and poultry.d/ Including communication equipment.

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235. Dispersion of Effective Import Tax Rates. Table 10 shows that legaltariff rates are higher than actual and implicit rates, and that implicit taxrates are, in most sectors, higher than actual rates. The dispersion of taxrates across induetries is significant for some sectors. There are some majordifferences between, for example, the pharmaceutical (21), and plastics (23)industries, and the machinery (12) and electrical equipment (13) industries.According to Table 10, differeneas in actual tariffs for these industries are notas pronounced as the implicit tariffs -- which implies the existence of NTBs.Even when the desire for uniformity of rates is quertioned in terms of efficientresource allocation, the non-uniformity of tax rates allows interest groups tolobby for tax rates of their choice.

236. Inconsistencies Between Domestic and Import Tax Policies. A comparisonof Table 10 with Table 7 (in the previous Chapter) illustrates some interestingcharacteristics. 44/ The legal tax rates are not relevant for this comparison.Only the implicit rate is. The dispersion is clearly very large. Any attempt atreducing the dispersion of effective indirect tax rates in Brazil relying only ona reform of domestic taxes would be incomplete. The dispersion in effectiveimport tax rates would feed in the economy and result in a large volume ofdistortions due to the taxation of inputs since the import tax and the domestictaxes are not integrated.

237. Only in a few cases are comparable sectors taxed in a similar way bydomestic and import taxes. Only for electrical equipment, lumber and wood,rubber, leather and furs are the tax rates somewhat comparable. In all othercase, the implicit import tax rate is either much higher than the effectivedomestic rate or much lower. Most intermediate goods -- non-metallic minerals,metallurgy -- are subject to a much lower import tax thin domestic. The same istrue for machinery, paper perfumes and chemicals. Agriculture and food productsare even subsidized which offsets the effects of any domestic tax component. Forthese two sectors, full import liberalization could lead to significant increasesin imports. In all other cases, conflicts of objectives could already ariseunder the current regime if a producer benefits from an exemption from the majordomestic indirect taxes and is only subject to low import taxes. This situationis currently only possible in the SUDENg or SUDAM regions. In most caseshowever, lower import tax rates do not help since they are added to the domestictaxes. Liberalization could change the situation depending upon thesubstitutability of domestic and imported commodities.

238. Implicit Revenue from NTBs. Non-tariff barriers raise domestic pricesabove international prices, but the government does not collect taxes as aresult. Potential tax revenue from implicit, legal, and actual tax rates forsectors were calculated and are presented in Table 11. 45/ Assuming no changesin the volume of imports, the replacement of NTBs by an equivalent tariff,maintaining the same level of protection, doubles the import tax revenue to 0.8 2

44/ A perfect comparison is impossible. There are some methodologicaldifferences and sectors are not always comparable. The two Table provide howeversome useful insights.

45/ The only significant case, in terms of GDP, with a negative implicit taxrate is food products. This sector is most likely to have price controls. Inthat case the revenue collected is assumed to be the revenue from the actualtariff.

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GDP. 461 This should be taken as a lower bound as a result of the methodologyused to estimate the implicit tariff rates. Nor do they reflect the existence ofa doaestic content requirement. 4t7

239. Because import tax revenue is included in the IPI taxable base, thelatter will also increase when NTBs are replaced by an equivalent tariff. 481IPI revenue in terms of GDP could increase by between ZOZ and 80Z, to around 0.2Zof GDP. Thus, by eliminating NTBs and implementing a tariff that would keep thesame level of protection, the government could double revenue from import taxes(II) and IPI on imports, to 11 GDP.

Table 11: POTENTIAL TAX REVENUE FROM IMPORTS a/

POTENTIAL TAX REVENUE FROM DMPORTS b/USING:

Implicit Legal Actual AverageIBGE Classification Tax Rate Tax Rate Tax Rate

(Z GDP)

3 Primary Agriculture cl 0.0 0.1 0.011 Metallurgy 0.0 0.1 0.012 Machinery 0.0 0.2 0.113 Electrical equipment d/ 0.2 0.4 0.014 Transport. equipment 0.0 0.5 0.016 Furniture 0.0 0.0 0.020 Chemicals 0.2 0.3 0.121 Pharmaceutical prod. 0.1 0.0 0.026 Food products 0.1 0.3 0.127 Beverages 0.0 0.0 0.030 Miscellaneous 0.2 0.3 0.1TOTAL 0.8 2.2 0.4

Notesta/ Duty imports revenue with significant shares in GDP have been listed;b/ Potential Revenue/GDP (Z) = CIF-Imports.taxigdp.tc/ Including forestry and fishing, agriculture, and livestock and poultry.d/ Including communication equipment.

46/ Going from NTBs to equivalent tariffs, it is not necessary to worry aboutelasticities.

47/ A fuller discussion of the limitations of the effective protection figuresused to estimate this revenue effect is presented in Trade Policy In Brazil - TheCase For Reform, World Bank Report No. 7765-BR, May 1989, paragraph 169.

48/ Let R1 - M.t be the revenue from the actual tariff rate, t, where M isimports; and r, - M(l+t)s, the IPI revenue, where s is the IPI rate. Asindicated above, the replacement of NTBs by an equivalent tariff doubles IIrevenue. Taking this into account, the IPI revenue collected, r2, is r2 - r1 +Rls (where r, - M(l+t)s - Ms+Rls. Then for a constant M, r2-rl - R1 s) In recentyears, ri - 0.1 GDP and R1 - 0.4Z GDP. For 0.05 < a < 0.20.

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240. Table 11 also gives the potential revenue from legal tariffs, andindicates that if the legal tax rate is paid, the revenue from the import taxeswould be almost five times higher than actual revenue.

D. THE POST-REFORM IMPORT TAX SYSTEM 491

1. The Reform

241. The Obiective of the July 1988 Tariff Reform. Brazil introduced atariff reform in July 1988. Reportedly, the principal objective of the reform isnot fiscal and the aim is not to liberalize the economy but to increasetransparency in the import system. 50/ Appendix III describes the July 1988tariff policy in some detail. The tariff reform lowered legal tariff rates so asto reduce tariff redundancy 51/ (i.e., the excess of legal rates over implicit oractual rates). Table 12 shows old and new tariff rates 52/ for goods classifiedaccording to their use. The highest rate corresponds to consumer goods;intermediate goods and capital goods are equally taxed after the reform. Theserates were chosen such that the variance of actual tariffs, i.e., legal tariffsminus subsidies, is small. This makes the calculation of potential revenue fromthe new legal tariffs irrelevant.

242. In addition, the tariff reform exempts imports from the IOF and the TMP.It also eliminates fiscal concessions on imports for targeted sectors, i.e.,import regimes. However, this is not evident. The new tariff policy embodiesthc new industrial policy (see Appendix IV) by which the import tax and IPIconcessions remain for specific imports, particularly capital goods for fixedinvestment or technology development. The new tariff policy still dividesimports into a large number of regimes, on those bases. Consequently, regimeswith a high priority will continue to enjoy tariff concessions despite theirbeing eliminated by the tariff reform. This is consistent with the desire ofBrazilian authorities 53/ to keep the cost of government-enterprise imports fromincreasing.

49/ The reform referred to in the title is exclusively the July 1988 reform.More recently, in July/August 1989, Brazil introduced a new set of tariffchanges. These are not included in the current discussions by lack ofinformation.

50/ Camargo Moreira, H., (interview with), "CPA: Uma Proposta Racionalizante,Atenta as Metas do Setor Privado," Revista Brasileira de Comercio Exterior,FUNCEX, 15, Janeiro/Fevereiro, 1988.

51/ "Plano de Medio Prazo Para o Desenvolvimento do Comercio Exterior,"July 1988.

521 These rates differed from those report by CPA due to different aggregationmethods.

53/ Camargo Moreira, op. cit.

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243. Table 13 presents 1985 imports classified by status. Within eachcategory, imports have been classified by use. Column 2 shows shares of regimeimports in total imports, excluding oil and wheat. The table indicates that 69Zof total imports receive some kind of concession, 3Z have OZ tariff rate, andthat the full tariff is paid on 24Z of total imports. 54/

Table 12: THE TARIFF REFORM: LEGAL TARIFF RATES

Old Rates New Rates

Average St.Dev. Average St.Dev.

Consumption goods 68.8 27.7 47.3 21.2Intermediate goods 55.9 22.4 39.7 17.0Capital goods 43.8 27.8 39.8 16.2

Total 60.3 26.2 43.0 19.1

Source: Kume, H. and Patricio, "A Reforma Aduaneira Proposta pela CPA para aFormulagao de uma Politica Tarifaria,' Revista Brasileira de Comercio Exterior,FUNCEX, 15, Janeiro/Fevereiro, 1988 and update in manuscript, July 1988.

244. The tariff reform reduces the number of regimes that enjoy tariffreduction or exemption from 69Z to 56X. The regimes that remain unchanged areindicated by n.c. in Table 16, column 3. The import regimes eliminated (e.g.,Carajas, Constru9Ao Naval (hiEEL), consists mostly of capital goods imports, asindicated in Table 13, column 1, where the capital goods content of each regimeis presented. As discussed above, because of this characteristic, those importswill receive some type of tariff concessions through the new industrial policy(the percentage tax reductiona are given in Appendix IV). The latter reducestariffs by up to 802 on capital and intermediate goods for firms fixed investmentin most cases. Thus, the new tariff reform eliminates incentives and the newindustrial policy reincorporates them. Columns 3 and 4 in Table 16 show changesin tariff rates and the decree law that authorized the new concessions.

245. The tariff reform does not change tax rates for imports with a 0 legaltariff. Imports paying the full legal tariff will pay a lower tax rate after thereform, according to the new rates shown in Table 14.

246. Tax Administration Implications. A reduction in collection costs in theshort run seems unlikely: (a) IOF must be collected on imports bills dated beforeJuly 1, 1988 which have eight years or less import credits; and (b) although theimport procedures have been simplified, the allocation of incentives stillrequires the evaluation of import requests.

54/ There are some minor regimes that have been omitted. They amount about 4?of total imports.

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Table 13. THE TARIFF REFORMsEFFECT OF FISCAL INCENTIVES ON LEGAL TARIFF RATES

Capital-good Share of Legal DecreeImport Share Regime Import Tariff Law a/in Regime in Total RatesImports Imports b

Bef. Aft. cl(1) (2) (3) (4)

A. Regimes WithTariff Concessions

A.1 ExportDrawback 20.0 15.7 n.c. d/ 2BEFIEX 63.7 7.3 n.c. 1Carajas 96.3 0.4 0 0.2t 1Incent. toManuf. Exp. 64.8 0.2 n.c. 1

A.2 Industrial Development

MIC-CDI 51.0 1.4 n.c. 1GEIMI 82.1 0.4 n.c 2Naval Construc. 93.5 1.0 0 0.2t 1Capital GoodsNat. Ind. 68.0 0.3 ?

IMBEL 63.8 0.2 0 0.2t 1

A.3 Regional Development

Manaus 27.1 5.5 n.c. 2SUDAM 24.9 0.0 2 0.lt 2SUDENE 37.5 0.3 2 0.lt 1

A.4 Communications

Movies, Radio, TV 35.5 0.4 0 0.2t 1EMBRATEL 23.3 0.0 ?Paper(Printing & Graph.) n.a5 0.5 n.c. 2

A.5 International Agreements

ALADI 52.0 4.2 n.c. 2?GATT 27.7 2.5 n.c. 2?PEC 2.4 0.6 n.c. 2?Other 11.1 0.1 n.c. 2?

- 67 -

(Table 13 - Cont'd)

Capital-good Share of Legal DecreeImport Share Regime Import Tariff Law a/in Regime in Total RatesImports Imports b/

Bef. Aft. cl(1) (2) (3) (4)

A. 6 Special Areas

Air Navigation 88.7 3.9 0 0.2t 2EMBRAER 74.3 1.7 0 0.2t 1Scientific & Educ.Institutions 72.0 0.8 n.c. 2

Nation, States, DF 65.4 0.5 n.c. 2Seeds & Reprod. 0.0 0.2 ?Items listed by CPA 91.4 0.8 n.c. ISamples WithoutCommercial Value 50.0 0.0 n.c. 2

A. 7 Transport 93.0 0.5 0 0.2t 1

A. 8 Electricity

Electricity 95.3 1.6 0 0.2t 2PETROBRAS 51.6 0.9 0 0.2t 2Nuclear Program 99.5 1.3 0 0.2t 1Coal 70.2 0.0 0 0.2t I

A. 9 Other Regimes 27.0 0.3 ? ?

A.l0 Contingency/CPA ? 15.2 n.c. 2

A.ll Omissions 4.3

A. SUBTOTAL 69.0

B. Zero rating 0.6 2.9 n.c. 2

C. No Benefits 23.0 24.1 ti t* 2(Recolhimento Integral)

TOTAL 100.0

Sources CPA and DL-2433188 and 2434188Note: a/ l DL-2433188, industrial policy regulation & 2: DL-2434/88,

tariff reform regulationb/ Excluding oil and wheat.c/ Haximum reductiond/ n.c.s no change, n.a.s not available

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2. Assessing the Revenue Effects of the Reform

247. The net effect of the reform is difficult to isolate. Clearly, cliangesin actual tax revenue from taxes on imports reflect the overall evolution of theeconomy. The macroeconomic situation was not ideal and an approximation of thereverue effect of the reform requires some assumptions.

a. Possible Working Hypothesis

248. Revenue Impact of the Tariff Reform. Although the principal objectiveof the new tariff policy is not fiscal, the new rates have an effect on the taxrevenue derived from imports. The revenue impact of the tariff reform is nextestimated under two alternative assumptions: (a) constant import consumption, and(b) an increase in capital-good and ALADI imports. The latter is based ongovernment projections for 1988. These two types of imports could Increasebecause all import barriers on them seem to have been lifted, at leasttemporarily.

249. Under either assumption, elimination of the IOF tax is the mostimportant source of revenue loss. But the increase in import tax and IPI ratesdo not seem to compensate for this loss whether or not an increase in importdemand is assumed.

b. Revenue Effect of the Reform Assuming Constant Import Consumption

250. Estimating the Changes in Revenue. Estimates of the change in revenueare made using 1985 data. This is a typical year during which there were nomajor policy changes such as the Cruzado Plan in 1986, and on which there isreadily available information on tax collections on special import regimes. Thediscussion applies only to the import tax. The change in IPI revenues is notcalculated but its effect is discussed. It is shown that if import consumptiondoes not change, the tariff reform will cause a revenue loss of 0.2 - 0.4 X GDP.

251. Assumptions Underlying the Constant Imports Approach. The assumption ofconstant imports is based on the following four major argumentst

(a) The Tariff Reform Reduces the Redundancy of Legal Tariffs. Asmentioned before, the objective of the reform is only to reducetariff redundancy, not to liberalize, 55/ i.e., the excess of thelegal tariff over the implicit tariff. This means that the levelof protection will not change nor will the demand for imports.Implicit is the assumption that NTBs are binding. NTBs have beensomewhat relaxed on capital goods for fixed investment and forsmall importers recently. 56/ However, despite these measures,imports are unlikely to increase for reasons discuss in (2) below;

(b) Temporary Policies. The possibility of intermittent policyreversals is not conducive to an increase in imports. Althoughsome NTBs have been removed, CACEX can reinstate them if

55/ See footnote 9.

56/ Resolution BACEN 1485/88.

- 69 -

necessary, so the overall approach encourages pressure-grouplobbying activities. This has been the case in the electronics,textiles, and chemical industries: a month after the tariff reformwas announced, Resolution 1517 increased tariff rates on importsin textiles, apt rels, and digital equipment. Moreover, theallocation of foreign exchange among importers is based onexpected exports. If a monthly target is in jeopardy, apre-agreed import program may not be honored;

(c) Unclear Rules. There are several examples of unclear rules. (i)Is the IPI exemption regulated by the new industrial policy or byindependent regulations? (ii) Until a month after the announcementof the new tariff and industrial policies, firms did not know howthe new policies would be implemented. The use of discretion alsoamounts to an unclear rule; and

(d) Unstable Macroeconomic Conditions. As long as inflation andpersist, industrialists are very unlikely to invest in importequipment despite incentives to import capital goods which seem tobe free of restrictions.

252. Revenue Effect of the IOF Exemption on Imports. The tariff reformexempts imports from the IOF st:arting July 1, 1988. The IOF collected on importsof goods and services in 1985, 1986, and 1987 amounted each year to 0.3Z GDP.Imports of services represent 102 of total imports and 0.61 of GDP. Therefore,we ignore import of services and assume that all IOF is collected from importedgoods. Thus, the IOF reform causes is a decline in revenue of 0.32 of GDP.

253. How to Calculate the Revenue Effect of Cuts in Fiscal Benefits? Asindicated before, 132 of imports (excluding oil and wheat) were exempted from theimport tax before the reform. They will now pay, in most cases, a minimum of 20Xof the import tax (t) (80 reduction) on intermediate and capital goods.Table 14 shows the effect of the tariff reform on the II revenue from importregimes which were exempted before the reform. Because the reduction is up to902 for some imports, we consider two scenarios: (1) a high-revenue case with thelowest possible tariff reduction; and (2) a low-revenue case with the highestpossible tariff reduction. Within each category the change in tariff rates forcapital and intermediate goods as well as the change in revenue is described.The change in revenue as a percentage of GDP was calculated in the followingway: 57/

DR - (Dtkqk + DtIqI)MS (1)

57/ IA "DI before a variable indicates change, e.g., Dtk means change in tk.

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where tk is the tariff raie on capital goods, tl is the tariff rate onintermediate goods, and qz, i-k,I are the corresponding type of import sharesshown in Table 14, column (1), e.g., naval construction qg - 93.5Z and ql -6.5Z. There is an implicit assumption that there are no consumption goods in theimport regimes involved. HS is the share of the special import regimein GDP. 58/

Table 14: THE TARIFF REFORM: CHANGE IN IMPORT TAX REVENUE

High-Revenue Case Low-Revenue Case

Import Imports/ Change in Change inRegime GDP tariff rate Revenue tariff rate Revenue

(in Z) capital interm. (ZGDP) capital interm. (ZGDP)goods goods goods goods

Z Z 2 Z

Caraj6s 0.01 20 40 0.002 8 8 0.000NUCLEOBRAS 0.04 8 8 0.003 8 8 0.003Naval Contruc. 0.03 8 20 0.006 8 8 0.005Transport 0.02 20 40 0.004 8 8 0.002Electricity 0.05 8 8 0.005 8 8 0.004Air Navigation 0.13 8 8 0.010 8 8 0.010EMBRAER 0.06 8 8 0.005 8 8 0.005Scientific Inst. 0.03 4 4 0.001 4 4 0.001IMBEL 0.01 20 a 0.002 8 8 0.001PETROBRAS 0.03 40 40 0.012 8 8 0.002

Total Changein Revenue 0.050 0.030

Sources:(a) Importst CPA, Chart VII. The latter gives FOB- Imports, these

figures have been increased in 102 FOB- Imports to account fortransport costs;

(b) GDP: FundaqAo Get6lio Vargas;(c) Tariff rate changes: Bank staff estimations based on information

extracted from "Principais Regimes de Tributag8o porMercadoriass, Comercio Exterior do Brasil, Importag8o, 1985 andDecree Laws Nos. 2433 and 2432 described in Appendices I and II.

254. Revenue Effect of Changes in Fiscal Benefits. The highest possiblerevenue could be obtained if, as the government claims, the full new rate is paidon lmports of the eliminated reLmnes. Since the new tariffs for capital and

58/ Given the characteristics of the import regimes, this is a reasonableassumption.

- 71 -

intermediate goods are about the same (i.e., 40?, from the eliminAted importregimes -- which amount to about 0.4? of GDP) the tax could collect around 0.2?GDP in revenue. Thus, the change in import tax revenue from special importregimes as a consequence of the tariff reform iss (a) 0.03Z GDP in thelow-revenue case; (b) 0.05? GDP in the high-revenue case; and (c) 0.20? of GDP inthe high-revenue case. Given the small increases in import tax revenue, theincrease in IPI revenue is negligible in terms of GDP.

255. Revenue from Imports with no Benefits. These imports will enjoy adecrease in the tariff rate as shown in Table 14. The change in the tariff ratefor capital goods, Dtk, is -4Z and for intermediate goods, Dt, is -16Z. In thisimport category, the shares of a particular import in terms of GDP, pi wherei-k,I,c, for capital, intermediate and consumer goods respectively are thefollowing: 591

Capital goods, pk = 0.2 X GDPIntermediate goods, pl 0.6 S GDPConsumer goods, pc = 0.0 Z GDP

256. Therefore, taking into account Table 3 and equation (2) below, we cansee that the change in revenue from imports without benefits is - 0.1 Z GDP.Thus, the total change in tax revenue due to the tariff reform is the folloving:

(a) - 0.35 Z GDP for the low-revenue case;(b) - 0.38 Z GDP for the high-revenue case; andIc) - 0.20 Z GDP for the highest-revenue case.

c. Revenue Effect of the Reform Assuming Capital-Goodsand ALADI Imports Increase

257. Effects on Imports of the Assumption. Assuming no NTIs on capitalgoods, drawbacks, and ALADI imports, official projections indicated that theseimports will increase 23?, 15?, and 15?, respectively, in 1988: 60!

1987 1988 (projected)US$ millions

Capital Goods 3958 4860Drawback 1900 2185ALADI 1400 1610Total Imports (excl. oil) 10904 12600

591 CPA, chart XV.

60! *Plano de IIdio Prazo para o Desenvolvimento do Comfircio Exterior,July 1988.

- 72 -

258. Revenue Effects of the Assumption. Capital goods and ALADI are therelevant imports in terms of revenue since drawback imports remained exemptedfrom the import tax after the reform. The actual tariff paid on capital goods in1985 is 15.0Z as shown in Table 15. Since capital goods will continue to receivetariff concessions and, apparently, all tariff barriers on capital goods havebeen eliminated, the change in revenue, DRek, taking into account the governmentprojections for 1988 capital good imports, Mk, is 134.3 US$ Millions -- computedas a multiplication of the tariff rate on capital goods (152) multiplied by thechange in imports. Similarly, for ALADI imports, using a teziff rate of 52, thezhange in revenue computed was 10.5 US$ millions.

259. As discussed earlier, most of the special regimes that have beeneliminated have a high capital goods content, i.e., 80-1002 in most cases. Theincrease in revenue from the remaining intermediate goods, which will continue tobe affected by NTBs, is then negligible. But the change in revenue fromintermediate goods which do not enjoy benefits is negative and around (0.12 ofGDP in terms of 1985 information we do not have 1987 data to check whether thatfigure still holds). Therefore, a decrease in revenue is expected fromintermediate goods. Thus, about 145.8 US$ millions extra could be collected fromthose imports completely liberalized. However, this amount compensates for only102 of IOF revenue loss which amounted 1030 US$ millions and represented 0.32 ofGDP in 1987. Therefore, under the assumption of an increase in imports, a lossof at least 0.32 GDP could be expected.

E. OTHER MEDIUM AND LONG-TERM FISCAL EFFECTS OF THE REFORM

260. In the medium- and long-run, the outcome of the tariff reform is veryuncertain. Several import incentives will be granted for a fixed period of time,i.e., after the end of 1989, defense and aeronautic industries must pay a 402tariff on intermediate goods. With the reform these industries will pay on thoseimports a tariff of about 82; the same will hold for the shipbuilding industryafter December 31, 1989. If NTBs are binding, the elimination of incentives willbring more revenue; if NTBs are not binding, the outcome will depend on the priceelasticities of the products involved and a more thorough study should be donetaking into account the effect of the tariff change on real exchange rate.However, the medium-run outcome will depend very much on the short-run responseto the reform.

261. The tariff reform does seem to have improved the implementation ofimport policy. The use of discretion in awarding fiscal incentives seems to havebeen reduced with the restructuring of the CDI (see Appendix IV). Instead ofevaluating projects on a case-by-case basis, a commission formed by governmentofficials and private sector representatives will decide whether a firm qualifiesfor incentives according to guidelines determined by the commission based on theneeds of each productive sector.

262. Furthermore, although CPA can alter tariff rates, the tariff reformfixes the maximum reduction allowed. Also, the elimination of the IOF and TMPwill simplify the import procedure. In general, imports, are subject to the same

- 73 -

cumulative tax problems that domestic goods face. However, for drawback imports,the largest share of imports enjoying fiscal incentives, rebates of IPI or II arenot usual. Direct exemption of these taxes is the most common fiscal incentivesused. Before the reform, there were no discrepancies between taxes on domesticand equivalent import goods because the latter were banned through the law ofsimilar. After the reform these imports are allowed, but they cannot enjoyfiscal incentives. In this new situation, taxes on domestic and importequivalent goods will have to be harmonized.

263. Taxes on consumer good imports are higher than on capital orintermediate goods, as indicated in Table 15. This is consistent with thestructure of imports shown in Table 16. The lowest share corresponds to consumergoods. This is also evident in Figure 3 where nominal and effective protectionrates for 21 industries are shown. In industries such as plastics (23), apparel(25), and textiles (24), nominal protection is lower than effective protectionrates, suggesting that taxes on inputs are relatively lower than those onfinal products.

Table 15: 1985-TARIFF RATES

Implicit Actual Legal

(Z)

Capital Goods 29.0 15.0 51.2Intermediate Goods 28.6 12.6 55.4Consumption Goods 32.1 23.8 78.4

Source: GuimarAes, de Carvalho, and D'Authouguia (1987).

Table 16: IMPORT STRUCTURE

1985 1986 1987 1988

(Z)

Capital Goods 19 25 26 29Intermediate Goods 28 36 32 34Consumer Goods 6 14 10 9Oil and derivatives 47 25 32 28

100 ,100 100 100

Scuarces: CACEX

- 74 - APPENI IPage 1 of 3

BUOYANCY OF THE KAJOR BRAZILIAN TAXES

1. The long-run analysis of tax bouyancies in Brazil is constrained by thelimited knowledge of changes in the rate structures of the various taxes overtime. Little can be aid to explain the changes observed in the compositionobserved. Table 1 shows the buoyancy for the major Brazilian taxes. Theconcept of buoyancy is different from the concept of elasticity of a tax system.Buoyancy does not correct for changes in revenues due to discretionary changes inthe tax law. The elasticity concept discounts the effects of these discretionarychanges and only accounts for the automatic charges which represent the changesin revenue that would occur without any change in the tax law.

2. Buoyancy only provides an average measure of the sensitivity of thevarious taxes to their base over a period of 17 years. However, theBrazilian authorities have used taxes very actively as a policy instrument --modifying the rates, increasing exemptions, altering the bases, creatingincentives. In addition, as mentioned earlier, inflation has become asignificant source of revenue to the Federal Government, but has alsointroduced new distortions and sources of erosion of tax revenues in recentyears. Hence, the buoyancies estimated should be interpreted cautiously. Forthe same reasons, calculation of the true elasticities is not possible, since themethod available do not deal well with such frequent changes in the tax system.Essentially, in the Brazilian context, a buoyancy of 1 should be interpreted asImplying that the Government, through a very active tax policy, has managed tokeep revenue growing in the same proportion as its (proxy) a base. The emphasisshould be on 'active tax policyn which implies that the existing design of thetax system is not capable of yielding a stable, expected volume of revenues.Such active policies mostly consist of increases in tax rates, bracket creepingand similar types of easy adjustments to the tax law to increase revenue. If thebuoyancy is larger than 1, the Government's tax activism has managed to increasereal revenues. If it is lower than 1, the constant changes in the tax law havenot been sufficient to maintain the original volume of revenues.

3. For each major tax, the buoyancy of its nominal yield with respectto its nominal base is calculated. Also, since there is some debate about theimportance of inflation as a source of erosion of real revenues in Brazil,the buoyancy of the nominal revenue of each tax with respect to its realbase and with respect to inflation were also estimated. The following multipleregression provide both types of buoyancies for the period 1970 to 1987:

ln (TR it) - a + boln (Bit) + 6 t (1)

ln (TR lt) = a' + b'*ln (bit) + c'"ln (st) + et' (2)

where TRit is the nominal revenuae from tax i in year, t, Bi is a proxy for thenominal base for tax i, bi is a proxy for the tax base in real terms, wt isinflation measured by the rate of change used to calculate the real tax base, and

- 75 - APPINDX IPage 2 of 3

et and et' are error terms. All the coefficients measure buoyancies and areexpected to be positive -- b with respect to the nominal base, b' with respect tothe real base, c' with respect to inflation.

Table 1: EJOYANCIES Of THE MAJOR TAXES(1970 - 1967)

Nminal R"l Price BaeConsant B" e ase Effect R2 01 Selected

Peronml Incne TaxEquotlon 1 -5.046 0.907 .999 1.78 MP

(24.9) (6.6)

Equtlon 2 8.J87 (66.6) -0.478 1.076 .96 2.47 GP(0.65) (1.09) (42.61)

Corporate Incone TaxEquation 1 -51U8 1.086 .994 1.86 GP

(9.56) (20.70)

Equation 2 27.700 -8.051 1.172 .9" 2.56 UOP(2.82) (2.85) (15.84)

VI Equation 1 -1.682 0."6 .990 1.78 Ind.VA(6.27) (87.70)

Equation 2 -1.982 0.411 0.690 .096 2.17 WnM.VA(1.46) (2.46) (5.69)

ICU Equation 1 -2.676 0.099 .999 2.21 Con_ump.(10.39) (22.21)

Equajion 2 -256S .500 1.006 .906 1.96 Con_mp.(8.") (67) (1090.)

stslel ContributionsEqtion 1 -2.689 0.90 .999 2.04 UOP

(5.01) (22.21)

Equation 2 -18.220 1.088 0.962 .69 1.72 UP(0.04) (6.64) (40.6)

Notes t atatlacs are ilven below the coefficients.

4. The results are summarized in Table 1. Most regression have a very highexplanatory power but few provided convincing results. All had to be correctedfor autocorrelation. Due partially to a multicollinearity problem and partiallyto the poor selection of the proxy bases, not all the variables are statisticallysignificant. In the case of the IPI for instance, only four or five industries(Tobacco, transport equipment, beverages, perfumes) yield around 70Z of total taxrevenue, while the proxy base used covers the whole industrial sector.

- 76 - APPENDIX I

Pape 3 of 3

5. The buoyancies of revenues with respect to their nominal bases are close toX for the corporate income tax (CIT) (1.036), the ICM (.99)and socialcontributions (.969). The buoyancy for the IPI (.866) and the personal incometax (PIT) (.907) are below 1. However, none of them are significantly differentfrom 1.

6. The interpretation of the results separating the voluse from the vriceeffects is more complex. A buoyancy superior to 1 means that over time, changesin the law have managed to improve the link between tax collection and thechanges in the base or inflation. A buoyancy less than 1 means that the existingtax law has not managed to maintain the real value of tax collections or thatchanges in the law have eroded the base in Brazil, since fiscal incentives aregranted against essentially all taxes, the buoyancies of most taxes vith respectto their real basee are expected to be below 1.

7. Only social contributions revenue moves in line with its real proxy base.This result is, however, biased upward. Important social contributions have beencreated only recently in their inclusion in the revenue figure explains a goodshare of the high buoyancy of social contributions. Among the other revenues,the CIT's buoyancy with respect to its real base is low, as expected. The taxsystem provides exemption from the CIT in many circumstances -- most notable, forprofits earned on exports. Since exports have, over time, been an increasingsource of growth of the economy, an increase in GDP should be expected todecrease revenue from the CIT.

8. With respect to inflation, if taxes were perfectly indexed and there were nocollection lags, buoyancy would be 1. A buoyancy of less than 1 means thattaxpayers have benefited from an erosion of their real tax liability with theincrease in inflation. A buoyancy of more than 1 means that there has been anincrease in real revenues, due to phenomena such as bracket creep. Between 1970and 1987, ICM revenues appeared to be the only tax revenues that were neutralwith respect to inflation. This result is however no longer relevant since thestates -- the collectors of the ICM -- have recently used collections lags as aform of non-price competition to attract potential investors. This form ofincentive results in a larger erosion of real revenue, as inflation increases.Real CIT and PIT revenues have on average increased by 172 and 7.8S respectively,for each percentage point increase of inflation. This does not mean that realrevenues have always increased with inflation, but that over time, changes in thetax laws have managed to improve inflation accounting for tax purposes. At theother extreme, IPI revenues have been eroded over time by inflation by 10.4Z.

9. Also, as a result of the new Constitution, the states will now be allowed toset their own ICM rates. The trend observed so far indicates that they havereached some agreement intended to limit rate competition. Most will tax luxurygoods at a higher rate (25Z) than other transactions. The other transactionsveill remain taxed at 17?. There is still no clear agreement as to whether thelist of luxury items will be the same in all states.

- 77 -APPENDIX I1Page 1 of 5

STATUTORY vs. EMFFCTIVE TAX RATES: A SIMPLE MODEL

1. The model developed below demonstrates that the failure to maintain asmooth and full chain of credit transforms the VATs into cascading salestaxes. The model also measures the additional tax burden imposed by theabundance of exemptions built into the Brazilian tax system.

1. The Model l/

2. The model deals with a commodity (i) produced through the use of twoinputs. One input is exempt from the VAT but may have paid a VAT on its owninputs. The second input is subject to the VAT when acquired by its consumer.The model determines the effective tax rates on the output of the consumingsector and on each one of its inputs. For simplicity, the VAT is called t andremains anonymous, but it could be the IPI or the ICM since the model'sresults are relevant for both taxes. The model assumes competitive marketswith constant returns to scale, so that prices are equal to average costs andtaxes are fully shifted forward onto consumers.

3. The revenue (Ti) from a VAT on a firm producing commodity i iscalculated by subtracting the taxes paid on inputs (t*Ci) from the taxes paidon the gross sales revenue of the firm (t*Si)s

Ti te(Si) - to(Ci) (1)

4. Now, assume that a firm (i), subject to the VAT, purchases taxedinputs and exempted inputs, the value of its sales (Si) is composed of thecost of its taxed inputs including the values of the tax paid at the time ofpurchase of those inputs (Cie (1 + t) plus the cost of its exempted inputs(Sm) minus the credits obtained on the taxes paid on its inputs:

Si - Ci-(l + t) + Sm + VAi - teCi (2)

1/ This simple analytical framework is adapted from A. Fernandez in:Diagnostico de loo Impuestos Indirectos en Brasils Neutralldad,Incidencia y Posibilidades de Reforma," Mexico, D.F., August 1988.

- 78 - APPENDIX IIPage 2 of 5

5. To identify the importance of breaking the credit chain for taxespaid on inputs, the composition of the sales value of the exempted inputsneeds to be identified. The cost of the exempted input to the firm producingcommodity i can be decomposed into: the costs of its own inputs which includethe tax 2/ paid on those inputs (C~s (1 + t), and the value added of thesector (VA,-):

Sm = Cm(l + t) + VAm

6. Factoring out the tax rate in equation (1) and substituting equations(2) and t3) in equation (1) yields the following informationt

Ti - t(Si - Cj)

= t(Cj'(l + t) + Sm + VAi - t*Ci - Ci)

= t'(Sm + VAj)

- t(CM*(l + t) + VAm + VAi)

which can be rewritten ass

Ti = t*(VAM + VAi) + t*CM + t Cm

7. The assumptiou on the shifting of taxes may be very strong in somecases, as all taxes are assumed to be shifted fully forward, as this is hardlyrealistic for origin-based taxes in an open economy. The only tax that seemsclearly to be an origin-based tax is the tax on minerals. The other taxesfollow, even if imperfectly, the destination principle. For the IUM clearly,and to a lesser extent for the other taxes, the forward shifting assumptionmeans that the results presented below may overestimate their effects on finalprices. In addition, the revenue effects of the inclusion of the IUM in thebase of the ICM as a result of the new Constitution may be somewhat excessive.However, while it is important to identify the potential error, its empiricalimportance is not likely to be overwhelming. Finally, the assumption that allproducts in the 1980 input-output matrix are for final consumption may seemunrealistic. That is, however, a standard assumption when using themethodology, and it is one that would be difficult to avoid without goingthrough extensive manipulation of the matrix.

2/ This tax could be the same VAT levied on the final output, or any one ofthe excise taxes levied on some important inputs in Brazil.

- 79 - APPENDIX IIPage 3 of 5

2. Why the Brazilian VATs are Cascading Sales Taxes

8. Equation (4) illustrates the implications of the widespread use ofexemptions of inputs in the Brazilian VATs. By levying a tax on the consumingindustry i, the government is taxing: (i) the value added of that industry i(VAi); (ii) the value added of the exempted industry (VAn); (iii) the inputsof the exempted industry (Cm); and (iv) in the cases where the exemptedindustry itself uses taxed inputs, the tax levied on the inputs of theexempted industry as shown by the last term of equation (4). This last termwould disappear if the inputs used in the production of the inputs of thefinal output were not taxed.

9. But the full importance of the price distortions built into the VATemerges from a generalization of the previous result. Expression (4) can begeneralized to the case where the exempted industry acquires a combination ofexempted and taxed inputs, and allowance is made for differential rates in thetaxation of inputs. In that case, expression (4) becomes:

Tf = (tfSm - EtieCfi) -

= (tf(VAf + EVAe) + tf-(l + ti) (ECei)e i

+ (tf@(l + ti)*(ECfj) + ECfie(tf - ti) (5)

where i : commodities taxed by the V.ATf s final commodities taxed by the IPIe : exempted commoditiesj : commodities taxed by excise taxesCrm : inputs m used in the production of good r

10. Equation (5) confirms and completes the results obtained from the twoinputs simplification of equation (4). Equation (5) suggests that:

(a) the VAT imposed on a final commodity is also imposed on thevalue added of the exempted inputs used by the industry, byvirtue of the exemption from the VAT granted to that input;

(b) the VAT rate also applies on the inputs subject to excisetaxes and to those excise taxes themselves; and

(c) the inputs subject to a VAT rate lower than the VAT ratelevied on the final commodity will be taxed at a rateequivalent to the difference between the two VATs.

- 80 - APPENDIX I1Page 4 of 5

3. Simple Measures of Effective Tax Rates on Exempted Inputs

11. Tax Rate in Terms of the Value Added by the Exempted Industry.Assuming that the producers of the final good are price takers in the inputsmarkets -- and constant returns to scale in production, the marginal tax ratespaid on the purchase of inputs benefiting from exemptions are equal to theaverage tax rates, and can be measured as a percentage of the value-added.Then, returning to the earlier two-input case, the effective marginal tax rateon the exempted input can be derived from equation (4), which gives the fulltax revenue from the VAT:

Ti - t*(VAm + VAi) + tOCm + t2Cm

By isolating the tax burden on the input, the next expression follows:

Ti TVAi + T*i

wheres TVAi - tOVAi and T i - t*VAM + tICM + t2-

12. TVAi is the direct revenue from the VAT levied on commodity i andthe revenue that would be expected if the Brazilian VATs were true VATs. Tis the indirect revenue due to the existence of an exempted input. 31 Theimpact of the exemptions and rates differentials on the price of that finalgood and on its value added can be measured as a specific tax on those inputs.The marginal rate of that specific tax (t*) is measured by dividing therevenue from the indirect taxation of the exempted input (T*i) by the valueadded built into the exempted input (VAm). The following two expressions arethen derived:

t* t(VAm + Cm + tCm)/VAm (7)

or

t- t + t(Cm + C/VAm) + t2(CmIVAm) (8)

13. Equations (7) and (8) are simply different expressions of theearlier results. However, they allow a more precise measurement of theadditional revenue derived from the indirect element of the tax, in terms ofthe value added of the sector producing the exempted input. The value addedof the exempted input is subject to the same tax rate as that faced by the

31 Remember that the last term of the equation only applies when a tax islevied on the inputs used to produce the inputs to the final output. In theevent that the inputs to the inputs are exempted, that last term -- the VATlevied on the tax on the input to the input -- disappears.

- 81 - APPENDIX II

Page 5 of 5

consuming sector on its own value-added. However, in addition, the sectorproducing the exempted input pays that same tax rate on its use of inputs.The larger the share of input in its value added, the larger the effective taxpaid by the exempted producer of input. The larger the share of inputs in thevalue added, the more expensive is the use of inputs for the producer of thefinal commodity, and the larger the price distortion. This second distortiondisappears only in the case where the production of exempted inputs does notrequire the use of taoed inputs.

14. Tax Rate in Terms of the Price of the Exempted Industry.Alternatively, the impact of the price distortion can be measured in terms ofthe effect on the exempted inputs. Two cases can be distinguished. In thefirst one, the industry producing the exempted inputs pays no taxes on its owninputs. In that case, the marginal tax on the input is equivalent to themarginal tax on the value added of the consuming industry: in the second case,the industry supplying the exempted input consumes taxed inputs. In thatcase, the costs of the inputs to the final commodity are relatively more taxedin terms of the net before tax cost of production --(Sm - t.Cm)-- than otherinputs that would be taxed:

t T*/Sm = t(VAm + Cm)/Sm - t

In the second case, the industry supplying the exempted input consumes taxedinputs. In that case, the costs of the inputs to the final commodity arerelatively more taxed in terms of the net before tax cost of production(Sm - t.Cm) than other inputs that would be taxed:

t** T*/(Smut.Cm - t(VAm + Cm)ISm_tCm + t2"Cm/(Sm_tCm)

t - t + (t2/(l+(VAm/Cm))) (10)

4. An Example: Effective Tax Rate on the Leather Industry

15. Leather and skins are exempted from the IPI. But at the same time,manufactured leather products such as shoes are subject to a 102 IPI. Thismeans that simple leather is actually taxed at a minimum of 1OZ when purchasedby the manufacturers of leather products. But the production of leather islikely to have required the consumption of taxed inputs.

16. The formulas derived earlier allow a precise derivation of theeffective tax rate paid by the leather industry. According to the 1975input-output matrix, the inputs used by the leather (and skins) industryrepresent 142.862 of its value added (or 58.83? of the total cost ofproduction). This means that the effective tax rate on the value added of theleather and skins industry is 24.27Z -- 102 + 102 of 142.861 -- if the inputsof this industry are not taxed and 25.702 -- 24.27Z + ClOZ)2 of 142.862 -- ifthe inputs to this industry are taxed at that same rate.

- 82 - APPENDIX IIIPage 1 of 6

A M&TUDMflCAL PRESIITATION 0F TES ANALYTICAL FRAMNORK

1. This Appendix provides a mathematical presentation of themethodology used to assess the incidence of indirect taxes on relativeprices in Brazil. The effects of indirect taxes on relative prices acrosssectors are tracked through a system of simultaneour equations provided bythe 1975 input-output matrix. The returns to factors are assumed constant.This system of equations is derived from the production equilibriumcondition under perfect competition.

PP1 - C1 (W* , P*p) (1)

where: PP1 - producer price of good i

W* = vector of factor payments

P*p - vector of input prices

Ci - production cost of good i

2. In a world without indirect taxes, the producer price is equal tothe consumer price:

pci - Ppi (2)

where: pci - consumer price of good i

3. 'When indirect taxes are accounted for, two additional elementsmust be factored in. First, the consumer price differs from the producerprice by the amount of the tax:

Pci - PP1 + Ti (3)

where: Ti - indirect taxes levied on good i

Second, for each tax analyzed, two cases need to be considered. Inthe first case, the sector taxed can credit the taxes paid on its purchasesof inputs. In the second case, credits for taxes on inputs are not allowed.This second case also coreesponds to the situation of sectors exempted fromthe tax. No tax is levied on their production but they cannot claim anycredit for taxes paid on their purchases of inputs.

- 83 - APP )IX .Page 2 of 6

4. From the previous considerations, it results that, for sectorsentitled to credits, the production equilibrium can be expressed as t

PPi - Ci (W* , P*p) (4)

while for the sectors not benefiting from credits for taxes paidon inputs, there is an implicit tax burden and the production equilibriumis expressed ast

PP - Ci (W* , P*P + Ti) (5)

5. Differentiating the production equilibrium conditions, thefollowing equations results

A A

pci = P Pi + Ti (6)

PPi - Ej aij PPj (with credits allowed) (7)

PPi Ej aij (PPj + tj) (if no credits allowed) (8)

where ̂ denotes percentage changes

aij - share of input j in the total cost of good i; 3, the numberof activities varies from 1 to N

ti - tax levied on the consumption of good i

6. In matrix notation, the previous system can be rewritten as

A

Pc inPp + t (9)A

Pp A Pp I A1 t (10)

where:

/I all a12 ... al. I

I a2l a2 2 ... a2n1l l

A - | . l

l lI ani an2 ... ann

APPENDIX III IPage 3 of 6

/l 8111 a112 ... alnll a21 al 22 ... 2n1

A1w I IA 1- 1.Al

1- 1Ia nl al2 ... al

where:

alij X 0 if sector i is entitled to a credit for taxes paid on thepurchase of input j

aij= aij if sector i is not entitled to credits for taxes paid onthe purchase of input j

7. The Brazilian tax structure was incorporated explicitly through thedefinition of a vector for each one of the taxes considered. This allowed theidentification of the effects on prices of each one of the taxes individually.As a result, the price vector can be expressed as:

A A

Pp APp + Al tIPI + A2 tICM + A3 tIpPS + A4 tISS + A5 tIE (11)

where t tIPI tICM * tIFFS, tISS and tIE , are the tax vectorsrepresenting the IPI, the ICM, FINSOCIALIPIS/PASEP, the taxon services and the specific taxes (all lumped together);

I ahll ah 12 ... ah.lnl

I ah 2 1 ah 2 2 ... ah2nl

Ah I

a I

I 8N4 ahn2 ... a>

- 85 - APPENDIX IMPage 4 of 6

wheres

ahij - 0 if sector i is entitled to a credit for tax h paid onthe purchase of input j

ahij - aij if sector i is not entitled to credits for the paymentof tax h on the purchase of input j

and,

I th, II th 2 l

th = I * is the vector of tax rates for tax h;each sector, 1 to N, has its own rate specified

l lI th IIth N

8. The details on the definition of the tax vectors for each individualtax is left to Appendix 2. The remainder of the present Appendix will howeverdiscuss some of the tax vectors but only to the extent that their definitionadds elements to the producer price calculated above. For most taxes, a simplelisting of the nominal tax rates was sufficient to create the tax vector. Whenthe product disaggregation of the tax law was larger than that of the input-output matrix, the most representative tax rate or a simple or weighted taxaverage of the relevant sub-sectors were taken as proxies for the relevantinput-output sector. In some cases, however, some particular aspects of thetax law were best modelled using alternative specifications of the tax vector.The two taxes lending themselves to such modelling alternatives are the tax onservices (ISS) and the tax on electricity (IUEE) which is included in the setof specific t%xes (IE).

9. The ISS is the tax of 51 levied on all services, excluding financialservices and those taxed subject to specific taxes. The ISS regulationspecifies that for the providers of services who purchase services themselves,the SI tax should only be levied on the net value of the services provided inthe market. To model this rule, an effective tax rate was calculated for theacquisition of services fo; each one of the sectors both providing andpurchasing services subject to the ISS. These effective tax rates are includedin a separate tax vector. As a result, the model includes two vectors of taxeson services. The first one applies to those services not requiring the uses ofother services as inputs. Tie second one applies to those sectors requiringthe application of that the special regulation. The difference between the twovectors is that in the secoad one, the tax rates on services are weighted bythe share of not value of production in total value of the services acquiredas inputs by those providers of services using other services as inputs. Acorollary of this distinction between tax vectors is that the matrix A4 aboveneeds to be divided to into two componentsa A'4 and A'4. For the first matrix,

- 86 - APPfNDIX IIIPage 5 of 6

only the elements related to sectors both demanding and supplying serviceswill have zero value. For the second matrix, only the elements representingthe rest of the sectors will have a zero value. In mathematical notation, theprevious discussion is represented as:

A4 tISS - A'4 t'ISS + A'4 t'ISS (12)

10. The last modelling difficulty is due to the tax levied on theconsumption of electricity. The use of electricity for cormercial and as apure input in a business activity are taxed at different rates. To isolate thetwo types of users, two tex vectors are defined, t' and ti. In this case, theonly difference between the two tax vectors are the ratess commercial userspay a fiIG tax rate, large industrial users pay 162. The matrix A5 is alsodivid',d into two components: A'5 and A'5. For the first all the elementsconcerning the commercial sectors take a zero value. For the second one, onlythose elements take values different from zero. In mathematical notation, thedistinction is expressed as X

As tIE - A'5 t'IE + A15 t'I (13)

11. Combining (12 and (13) with (11), the general expression used toassess the incidence of indirect taxes on prices is obtaineds

Pp A Pp + Alt 1 p1 + A2tICM + A3tIFFS

+ A'4 t'ISS + A*4 t'ISS + A'S t'IE + A'5 t'IE (14)

12. Solving for P, the following final expression is obtainedt

Ppp Blt 1 p1 + B2 t 1CM + B3tIFFS

+ B'4t'ISS + B"4t'ISS + B'5t'IE + B'5t'IE (15)

where Bl - (I-A)1 A1

B2 - (I-A)- 1 A2

B3 - (I-A)-1 A3

B'4 - (I-A)1 A'4

B'4 - (I-A)-1 A'4

B'S - (I-A)-1 A'5

B"5 - (I-A)-1 A'5

- 87 - APPENDIX III

Page 6 of 6

13. Finally, to obtain the changes in the consumer prices, two lastadjustments were made to the vector defining the spoecific taxes. First, thatvector includes the tax levied on the consumption of electricity. A tax rateof 501 is levied on the residential consumption of electricity, which differsfrom the rates just discussed for business activities. Second, there is a 132export tax on the export of non-industrialized goods. To account for itcorrectly, the tas was weighted by the share of exports in the totalconsumption of these sectors. Once these two adjustments have been made, a newtax -ector for the specific taxes is defined, tIE'''. The expression used tocalcuiate the impact of indirect taxes on the consumer prices is thens

Pc - Pp + tIPI 4 tlCM + tIFFS + t'.'.I (16)

14. Equation (16) is used to obtain the impact on the relative prices ofeach sector of the principal Brazilian indirect taxes. All the resultspresented in the report are derived from the application of this methodology.In addition, the model is flexible enough to allow the simulation of theimpact of possible tax reforms. The simulation simply requires the definitionof alternative tax vectors representing the proposed reforms.

- 88 - ~~wxi88 - ~~~~~APPENDIX IV

Page 1 of 3

CONSTRUCTION OF THE TAX VECTORS

1. This appendix discusses the modelling of the regulation of eachtax in a way consistent with the framework used to assess them. For eachtax, the major assumptions are discussed first. The description of thevector of tax rates applying to all the sectors is given next. When agiven tax includes several types of tax bases, a matching number of taxvectors are defined. Each tax vector is multiplied by its proxy base, asgiven by the input-output matrix, tailored to reflect the true base. Thematrix urltiplying a given tax vector will only have non-zero coefficientsfor the commodities subject to the tax rates given in the tax vector bywhich it is multiplied. The tax yield of a given tax will be given by aweighted average of the tax vectors defined where the weights are given bythe matrices approximating the true base.

2. The IPI. The dispersion of IPI rates and the disaggregation ofthe IPI base are is unusually large for a VAT. This is a source ofdifficulty when approximating the tax bases by the sectors defined in theinput-output matrix. The matrix counts 43 sectors which is significantlylower than the number of commodities identified in the IPI regu.ation.Each sector defined in the matrix is subject to a large number of differentIPI rates. It is thus necessary to calculate an average tax rate or arepresentative tax for each one of the sectors. When no commodity wasclearly outstanding in the matrix sector, a simple average was calculatedto obtain the legal rate to be used in the calculation of the effective taxrate for that sector. In the second case, the rate applying to the mostrepresentative commodity was selected. The final set of rates is given atthe end of this appendix.

3. An additional adjustment was made to the IPI to account for thefact that the margin of commercialization of industrial products at theretail level is not subject to the IPI but is included in the proxy baseused in the calculations. Using the commercialization margin and the finalconsumption value of production given in the input-output matrix, anaverage margin of commercialization of industrial prodtvwtion of 10.322 wascalculated. This allows to calculated the effective IP_ rates as

t'ipi - tiPi(l 4h) (11)

where: t'iPi is the effective tax rate on any commodity

tJ1Pi is the legal tax rate on the same commodity

m is the retail margin.

4. The ICH. Since the ICM rates are inclusive, the relevant taxrates are somewhat higher than the rates quoted in the law. The lawdistinguishes between five rates: 0?, 92, 12?, 13% and 171 aecording torule explained in a previous chapter. When adjusting for the fact thatthe7 are inclusive of the base, the rates become: 02, 9.89Z, ... , 13.642and 20.48Z respectively. In most cases, the 20.482 was used. Theexceptions were extraction of minerals where a rate of 15? was used and

- 89 - APPENDIX IVPage 2 of 3

services which are exempted. The resulting vector is given at the end ofthis appendix. To limit the number of vectors built in the analysis theIOF was built in the ICM vector.

5. The IOF. For sectors producing goods, a rate of 1.352 wasapplied. Those same sectors and the financial services sector (sector 116)pay a tax of 0.6Z.

6. The ISS. A tax of 52 was used in almost all sectors providingservices. Financial services (sector 116 are exempted. However, asexplained in Appendix 1, the taxation of services is subject to a veryspecific fiscal rule. That rule specifies that the providers of servicesthat purchase themselves other services will only pay the tax of 52 on thenet value of the services they are supplying to the market. The modellingof the rule required the calculation of an effective tax rate for thepurchase of services by the sectors that also supply services. As aresult, the model includes two vectors of taxes on services. The first oneapplies to those services not requiring the uses of other services asinputs. The second one applies to those sectors requiring the applicationof the special rule discussed above. The difference between the twovectors is that in the second one, the tax rates on services are weightedLby the share of net value of production in total value of the servicesacquired as inputs by those providers of services using other services asinputs.

7. FINSOCIAL and PIS/PASEP. The social contributions are all lumpedinto one tax vector. The vector includes two parts. The first for oneincludes the 0.75Z rate levied on the gross sales revenue of the firmsselling the products (excluding any type of service). The second one is arat- of 0.62 levied on the total revenue of firms supplying goods and allservices.

8. Specific Taxes. All the other taxes are lumped together in onetax vector building in their individual characteristics. The vectorincludes the tax on .lectricity consumption, the tax on transport, and thecommunications tax. The tax also includes a 132 export tax levied on non-industrial exports.

9. The Tax on Electricity. With a few minor exemptions business useof electricity is taxed at two different rates. There is a different ratefor commercial and industrial use. Two tax vectors were used todistinguish between the two types of uses. The first vector gives a taxrate of 60Z. The second one a tax rate of 162. Private consumers aretaxed at 502.

10. Other Taxes. For the various excise taxes not discussed so far,the procedure followed was the following. For the products derived fromoil refinery, the tax rate of 292 applying to gasoline was used. Forcommunications (sector 155), the rate of 202 applying to domestic phoneservices was used. For the transport sectors, the rate used was 5Z. Thesame rate was also used for construction for those sectors which are not

- 90 - APPENDIX nVPage 3 of 3

exempted. The exemption of the transport tax benefiting the transport ofbooks, minerals and lubrifiers was modelled by using a zero coefficient inthe matrix.

- 91 - APPENDIX VPage 1 of 3

THE TARIFF REFORM

The aim of the new tariff policy is to have a more transparent tazpolicy; and to simplify its administration. The new volicy introducesgeneral changes for all imports as well as specific changes depending onthe type of imports. The general changes are the followings

(a) elimination of IOF and TMP;

(b) reduction of the old legal II; and

(c) concession on the new legal II and the IPI.

1. Table 4 shows the new and old legal II for imports according totheir use and their respective variances. New tariff rates and variancesare smaller. However, the new tariff policy does not liberalize imports. Itonly reduces the tariff redundancy, i.e., excess of legal tariffs overimplicit rates. CPA continues with the power to modifying (not throughconcessions), legal II rates (DL2434/88, art.8); CPA can reduce rates up10O and increase them up to 60X. Capital goods for PETROBRAS could enjoyup to 80Z reduction of I;. The objective of the tariff-rate modification isto adequate legal rates to each productive-sector needs throughnegotiations such that the change is gradual.

2. S3ecific changes are listed below 1 s

A. Exemption or Reduction of II and IPI

(a) scientific institutions;

(b) contingency imports, e.g., food, fertilizers or raw materialsfor their production (DL-3244/57,art.4 and DL-63/66,art.7);

(c) parts and components--nor for resale--for airplanes and ships;

(d) imports under the new ir.dustrial policy (DL2433/88, includesBEFIEX and CIEX). See part B;

(e) drawback imports by DL37/66, art.78,III;

(f) imports in the inform4tica sector under L-7232/84;

(g) imports regulated by: (i) DL 2120/84, art.l,2,b; (ii) DL-2324/87; (I do not know these pieces of regulations);

(h) imports without commercial value;

L In what follows we describe the new legislation affecting the mostimportant group of imports. For instance, we do not include diplomaticmission imports.

- 92 - APPENDIX VPage 2 of 3

These exempt'ons and reductions will be conceded according to thes.espective regulation.

B. Exemption of II and IPI,

(a) imports by the Unigo, Estados, Distrito Federal, Territ6rios,Municipios and their respective Autarquias;

(b) imports by political parties, educational institutions; socialsecurity agencies;

(c) books, journals, newspapers and. graphic papers.

C. 801 Reduction of II and IPI:

(a) national agency imports of airplanes, public-utility airclubimports; those by airtaxis and airsurvey firms;

(b) capital goods-not for resale-for TV and radio companies;

Cc) capital goods for fixed investment in the electric-energysector.

In order to get the IPI reduction, importers must comply with requireLentsfor the II reduction.

D. No Change

(a) Manaus imports;

(b) Amaz:nia Occidental imports;

E. Suppression

The new tariff regulation revokes all other II and IPI exemptionsor reductions of general or special character. Concessions on the followingprograms have been revoked:

I. Development Programs

I.1 Regional Programs1.1.1 Program Grande Carajis (DL 1956/82)

I.2 Sectorial Programs

I.2.1 Energy SectorI.2.1.1 Petr6leo (DLs 1953182;4287/63);1.2.1.2 CarvAo (DL 2110184);I.2.1.3 Alcool (DL 1938182);1.2.1.4 Energia Eletrica (DLs 1450176; 1522177;

1630/78; 1955/82; 2359/87).

-3 -APPENDIX VPage 3 of 3

I.2.2 Industrial SectorI.2.2.1 ConstruVAo e Reparos N&vais (DL 2238185);1.2.2.2 Aeronuutica (DL 770/69);1.2.2.3 Material B4lico (LLs 1869/81; 1946/82);I.2.2.4 Ind6stria com Comprcmisso de Exportaq&o/CIEX (DLs

491/69 e 1428/75);1.2.2.5 Pr6logo S.A. (informhtica, DL 1871/81);1.2.2.6 GrAfica e Editorial (DL 37/66);1.2.2.7 Ind6stria Petroqulmica.

I.2.3 Research and Development Sector (DL 1160/71)1.2.4 Agricultural Sector (DL 37/66);I.2.5 Mining Sector (see Program Grande de CarajAs Petr6leo, e

Carvao).

II. Basic Service Programs

II.1 Transport Hetrovi&rio e Perrovitrio de Passageiros eCarga (DLs 2044/83; 2180.84 e 2247/85);

11.2 Transporte Aereo (DL 37/66);II.3 Aerolevantamento (D' 8 37/66 e 1639/78);11.4 Transporte Maritimo (DL 1856181);.1.5 Ccia-m.icagces (DL 1293/83).

III. Programs in Specific Areas

IIT.1 Abastecimento interno (Lei 3244/57 e DL 63166);111.2 Saude (DLs 491/69; 1389/75; 1482/78; 1622/18; 1726/79);III.3 Arte e esporte (Lei 6251175 e DLs 1436/75; 1797/80).

IV. Other Programs

IV.1 Empreendimentos de reconhecido interesse economico (DL1857/81);

IV.2 Empreendimentos na area industrial ou de servicios basicos(DL 1938/82).

- - 94 - A2PrNIIX VIPage 1 of 6

THE INDUSTRIAL POLICY REFORM

1. The new industrial policy aims at the modernization of theproduction sector, and the facilitation of government and private sectornegotiations regarding incentives. According to Brazilian authorities, thereform does not liberalize the economy nor makes it more governmentdependent--except in those activities considered 'essential". In terms oftrade policy, the new industrial strategy was defined as the "fourth waveof Brazilian import substitution": only imports conducive to new technologydevelopment or personnel training will enjoy import duty concessions. It isthe belief of the government that technology developments in Brazil arefalling behind the world trend, and therefore, the country is losingcomparative advantage in its industrial sector. The areas of education,research and development, and technology transfer will be promoted.

2. In the past, incentives were awarded on a case-by-case basiscreating a very inefficient and corrupt administrative system. The newpolicy aims at dismantling the old administrative system and creating amore transparent one. The new industrial policy establishes maximum annualvolumes of incentives concessions which are decreasing over time, po as tobe consistent with fiscal constraints.

3. With the reform, CDI becomes a bureau of 6 ministries: theMinistries of Industry and Commerce, Planning, Science andTechnology, Interior, Fazenda, and Mining and Energy. The national iron,steel and nonferrous metals council, CONSIDER, as also been incorporated toCDI. Until July 1, CDI reviewed and recommended for fiscal concessions,industrial projects only deemed in the national interest, in its new roleCDI will conduct Brazil's new industrial strategy. The executive branch ofCDI is the Secretaria de Desenvolvimento Industrial (SDI) whichintermediates between CDI and concessions applicants. Since July 1, firmsrequesting tax concessions must comply with guidelines i.e., 'programas'set by a commission of government and private sector representatives basedon each production-sector needs.

4. The focus of the reform is on high-technology products andprocesses, defined as those which:

(a) have embodied recent scientific and technological advances;

(b) have a strategic role in increasing the welfare of the economy;

(c) are produced by firms which in order to be competitive mustengage in research and development.

5. The law allows for modifications of the above definition.

- 95 - APPENDIX VIPage 2 of 6

6. The reform establishes some general concessions for all imports aswell as specific concessions depending on the user of Imports. Concessionswill be awarded provided there is no domestic equivalent (i.e., the law ofsimilar holds) or, like in the BEFIEX program, imports are included in alist provided by the Ministry of Commerce and Industry.

7. The general concessions are the followings

(a) IPI exemption on:

a.l capital goods imports for fixed-investment. Firms enjoyingthis type of concessions are the followings

al.l industrial firms;al.2 journalistic and publishing companies;al.3 direct or indirect public administration agencies, or public

services companies in the areas of transport, sanitation,electric and nuclear energy, oil, nining, andtelecomnunications;

al.4 research and technology development centers.a.2 ships except those for recreation.

(b) II and IPI 80Z reduction on:

b.1 intermediate goods for defense and aeronautic industriesuntil 12-31-89; and for shipbuilding until 12-31-92.Jurisdiction1 : Ministry of Industry and Commerce.

b.2 raw materials and intermediate products for themanufacturing (in the country) of capital goods providedthey comply, cumulatively, with:

b2.1. the contracted manufacturing cowpany is the result ofinternational biding, and national firms participate also;

b2.2 goods are for fixed-investment capital for type al.2 andal.3 above;

b2.3 purchase of these goods is financed (long tern2 ) byinternational organizations or foreign government agencies.

Note: Capital goods imported under international biding and financedaccording to b2.3, will enjoy 80? reduction of II.

Jurisdiction: Ministries of Industry and Commerce and thepertaining area Ministry.

(c) II 80Z reduction on capital goods for fixed investment forjournalistic and publishing companies. The specificconcessions will be awarded when complying with theguidelines of the following programs:

1/ By jurisdiction we understand the government agency responsible for theconcession of benefits.

2/ Long term is deflned by CDI.

- 96 - APP3NDIX VIPage 3 of 6

1. Progremas Repecials de Bxportacao (Programa BEFIU);2. Programas Setorials Integrados (PSI); and3. Programas de Desenvolvimento Tecuologico Industrial (PDTI).

1. Programa BEFIEX

Only ftrms with the intention of modernizing their businessfacilities and/or to increasing their share in production in theinternational market can enjoy BEFIXM benefits. The latter will be awardedfor at least five years. Some general requirements must be complied with,i.e.,

(a) firms must be committed to having every year positiveforeign-exchange net balances. If Imports are to be used forfacilities improvement, a negative balance will be permittedthe first year. BEFIEX imports for SUDAN and SUDENE areexempted of the positive foreign-exchange balancerequirement, except for those for the petrochemicalindustry;

(b) imports under Program BEFIEX are not subject to the law of_r - q-:e, herever, they have to he I*n a lis of imports thatwill be worked out between the Ministry of Co_merce andIndustry and representative of the manufacturing industry.

8. Firms under this program will enjoy the following concessionss

(a) exemption of IPI on fixed-investment capital goods (art.17),as indicated in al. above;

(b) exemption or 90Z reduction of II on fixed-investment capitalgoods;

(c) exemption and 502 reduction of II and IPI on raw materials,intermediate products and parts. The value of this type ofimports can not be higher than a third the value ofmanufactured exports of the same period (art7.II);

(d) exemption of AFRMK (Adicional au Frete para la Renovacao daMarinha Mercante) for those under (a) and (b).

Note: although the new industrial policy does not regulate informaticproducts, CDI could give BEFIEX concessions to imports in this industry.

9. In the old policy II and IPI reductions for fixed-investmentcapital goods were within 70 and 902. There has been no change inconcessions for intermediate good imports.


2. PSI

10. Firms, inputs suppliers, related infrastructure services as wellas support activities such as personnel training or technology developmentscan qualified for concession requests. The criteria for the awarding ofconcessions are the followingt

(a) popular consumption goods;or

(b) activities along the production chain which are important inthe determination of industrial prices; or

(c) potential larger share in the world market; or

td) new knowledge on technological developments is a by-productof process involved in the production chain; or

Ce) SUDAM or SUDENE projects.

11. The objective of the PSI is to facilitate government and privatesector negotiations. The departure point is an evaluation of a production-gect^r teeds hy a np-muision of these two groups. Based on the outcome ofthe evaluation a program, i.e.. the PSI is designed. A firm can requestconcessions if it complies with the PSI. In the past, a firm applieddirectly to the entity responsible for the request evaluation, e.g., theComissao de Politica Aduaneira (CPA) for tariff concessions; and theevaluation was done on a case-by-case basis. After July 1, SDI recommends afirm for all type of concessions to CDI. With CDI approval, CPA processesand concedes the exemption or reduction of import taxes. The tariff reform(Decree-Law 2434) makes explicit the reduction percentage of the importand industrialized product taxes. Although CPA can alter tariff rates, thetariff reform fixes the maximum reduction allowed.

12. The PSI should have the following informations

(a)-, a description of the sector activities

(b) an economic and technological prognosis of the production chain;

(c) specific objectives of the Program;

(d) statistical information on:

dl. consumption and production estimates of goods and servicesthat are part of the production chain including expectedimports and exports;


d2. investment needed and its financing; the latter shouldspecify its sources i.e., official, national private orforeign private;

d3. expected fiscal concessions.

13. The PSI also could have the following recosmendations:

(a) to CPA and SRF to adjust II and IPI on s

al. goods which share in the world market can increasecompetitive;

a.2 capital and intermediate goods such that the objective ofthe Programa is carried out.

(b) on future rmeasures on support activities, i.e., research,technological development and training even when thetechnology involved is not industrial t?);

(c) on future meAsures on firm ectivitiee to improveproductivity, product quality and technological training,even when they must comply with PDTI (?);

(d) to the Ministry of Science and Technology regardingactivities in the informatic sector;

(e) on actions regarding environmental pollution;

(f) to the public sector, regarding financial incentives,commercial policy, price policy and investment, to make FSIconsistent with their activities.

14. The following incentives could be awarded to PSI provided CPA orSRP do not modify published legal rates:

(a) IPI exemption on capital goods for fixed investment forfirms listed in

(b) II reduction on capital goods for fixed investment accordingto the following schedule:

bl. 80? for high-technology industries. For SUDAH and SUIDENE,through PSI the reduction is 901. High technologyindustries, SUDAM and SUDENE could be granted concessionsindependently of the elaboration of the PSI. If that is thecase, SUDENE and SIDAM can enjoy a 50Z reduction. Where PSIis not used, the project has to be authorized anyway;

- 99 - ~APPNDIX VIPage 6 of 6

b.2 up to 502 for other type of technologies. For SUDAM andSUDENE the reduction could go up to 901.

(c) II and IPI reduction up to 80 for intermediate goods forhigh-technology sectors; this concessions could be grantedup to 5 years and until December 31. 1993. This concessionwill be granted only through the PSI;

PSI could define industries in the production chain only for BEFIEXconcessions.

3.PDTI

15. The aim of the PDTI is to give incentives to research anddevelopment centers.

16. Through the PDTI the following concessions can be awarded:

(a) IPI exemption;

(b) sOt reduction of II on capital goods for new technologicaldevelopments.

- 100 -

RESULTS BEFORE THE NEW CONSTITUTION (1980) APPEND 1 VIIPage I of

THE STRUCTURE OF INDIRECT TAXES IN BRAZIL

DIRECT EFFECTS

IPI' ICM IFFS lSSl IE3 TOTALAgric.& Livestock 0.000 20.480 1.350 0.000 0.670 22.500Mineral Extraction 0.000 15.000 1.350 0.000 4.230 20.580Oil Extraction 0.000 15.000 1.350 0.000 4.230 20.580Non-Metals 7.330 20.480 1.350 0.000 0.000 29.160Steel 4.850 20.480 1.350 0.000 0.000 26.680Non-Iron Metals 6.170 20.480 1.350 0.000 0.000 28.000Metals 7.280 20.A80 1.350 0.000 0.000 29.110Machinery Production 7.250 20.480 1.350 0.000 0.000 29.080Machinery Repair 6.600 20.480 1.350 0.000 0.000 28.430Electric Materials 6.960 20.480 1.350 0.000 0.000 28.790Electronics 13.910 20.480 1.350 0.000 0.000 35.740Autos 19.480 20.480 1.350 0.000 0.000 41.310Auto Parts 5.380 20.480 1.350 0.000 0.000 27.210Timber & Furniture 3.420 20.480 1.350 0.000 0.000 25.250Paper & Graphics 10.980 20.480 1.350 0.000 0.000 32.810Rubber 10.730 20.480 1.350 0.000 0.000 32.560Chemicals 1.180 20.480 1.350 0.000 0.000 23.010Oil Refining 8.380 20.480 1.350 0.000 0.000 30.210Other Chemicals 8.470 20.480 1.350 0.000 0.000 30.300Pharmac. & Perfumes 24.040 20.480 1.350 0.000 0.000 45.870Plastics 9.620 20.480 1.350 0.000 0.000 31.450Textile 0.000 20.480 1.350 0.000 0.000 21.830Clothing 0.000 20.480 1.350 0.000 0.000 21.830Shoes 3.040 20.480 1.350 0.000 0.000 24.870Coffee Transformation 0.000 20.480 1.350 0.000 0.000 21.830Produce Transform. 0.000 20.4C0 1.350 0.000 0.000 21.830Slaughter 0.000 20.480 1.350 0.000 0.000 21.830Dairy 0.000 20.480 1.350 0.000 0.000 21.830Sugar Transformation 0.000 20.480 1.350 0.000 0.000 21.830Vegetable Oil 3.670 20.480 1.350 0.000 0.000 25.500Food Industry 0.000 20.480 1.350 0.000 0.000 21.830Other Industries 67.310 20.480 1.350 0.000 0.000 89.140Electricity 0.000 0.000 0.000 0.000 41.000 41.000Construction 0.000 0.000 0.000 0.000 4.200 4.200Commercial Services 0.000 0.000 0.000 5.000 0.000 5.000Transport 0.000 0.000 0.000 0.000 5.000 5.000Communications 0.000 0.000 0.000 0.000 20.000 20.000Fin. Institutions 0.000 0.000 0.600 0.000 0.000 0.600Services to Families 0.000 0.000 0.000 5.000 0.000 5.000Services to Employees 0.000 0.000 0.000 5.000 0.000 5.000Rents 0.000 0.000 0.000 5.000 0.000 5.000Public Administration 0.000 0.000 0.000 0.000 0.000 0.000Other Services 0.000 0.000 0.000 5.000 0.000 5.000

Average 5.490 14.986 1.019 0.581 1.845 23.920Weighted Average 2.037 7.604 0.559 1.523 1.545 13.467Standard Deviation 11.032 8.861 0.572 1.603 6.843 14.983

- 101 -

APPNDII VIIPage 2 of i

INDIRECT EFPECTS

IPi ICM IPPS ISSi IE3 TOTALAgric.& Livestock 1.431 1.843 1.349 0.091 0.181 4.895Mineral Extraction 1.330 2.775 0.925 0.187 0.310 5.527Oil Extraction 1.025 3.305 1.209 0.220 0.378 6.937Non-Metals 3.174 3.730 1.565 0.179 0.493 9.141Steel 4.804 4.798 3.393 0.241 0.594 13.830Non-Iron Metals 3.148 3.601 2.370 0.159 0.566 9.843Metals 3.302 3.923 2.517 0.193 0.478 10.413Machinery Production 2.956 4.052 2.376 0.225 0.399 10.007Machinery Repair 2.366 3.646 1.420 0.207 0.392 8.030Electric Materials 3.200 4.065 2.334 0.224 0.400 10.223Electronics 3.275 3.744 1.969 0.Z19 0.293 9.500Autos 5.327 5.010 ..994 0.278 0.451 14.060Auto Parts 2.843 3.614 2.517 0.191 0.388 9.554Timber & Furaiture 2.966 3.675 2.008 0.203 0.388 9.239Paper & Graphics 4.389 4.731 1.987 0.264 0.467 11.838Rubber 7.675 4.821 3.269 0.267 0.495 16.527Chem=cals 2.586 3.358 1.952 0.147 0.536 8.579Oil Refining 13.176 5.768 3.725 0.319 0.652 23.641Other Chemicals 4.671 3.770 2.627 0.191 0.402 11.661Pharmc. & Perfumes 6.731 5.076 2.117 0.296 0.396 14.615Plastics 6.957 4.702 2.745 0.257 0.514 15.175Textile 2.976 3.718 2.636 0.200 0.400 9.930Clothing 2.259 3.710 2.367 0.216 0.331 8.883Shoes 3.240 3.699 2.147 0.212 0.346 9.643Coffee Transformation 1.462 2.705 2.712 0.150 0.232 7.261Produce Transform. 1.642 3.100 2.146 0.172 0.290 7.351Slaughter 1.440 2.680 2.428 0.138 0.254 6.939Dairy 1.816 3.547 2.902 0.191 0.327 8.783Sugar Transformation 1.738 3.285 2.292 0.182 0.332 7.829Vegetable Oil 4.467 3.187 2.670 0.161 0.311 10.795Food Industry 2.052 3.828 2.351 0.207 0.381 8.819Other Industries 11.632 3.732 1.604 0.220 0.312 17.500Electricity 1.243 0.818 0.466 0.145 8.742 11.415Construction 2.208 2.162 1.197 0.172 2.916 8.656Commercial Services 2.964 1.514 0.942 1.944 0.452 7.816Transport 3.883 2.069 1.347 0.226 3.211 10.737Communications 0.744 0.693 0.375 0.209 6.481 8.502Fin. Institutions 0.252 0.215 0.242 0.196 0.208 1.114Services to Families 1.545 1.595 1.040 2.498 0.313 6.990Services to Employees 0.944 0.738 0.345 1.724 0.243 3.994Rents 0.329 0.314 0.173 0.752 0.410 1.978Public Administration 0.785 0.576 0.323 0.265 0.347 2.297Other Services 0.216 0.178 0.116 0.412 0.074 0.996

Average 3.209 3.071 1.865 0.352 0.839 9.336Standard Deviation 2.664 1.441 0.939 0.484 1.621 4.282

- 102 -

APPEDIX VIIPage 3 of 6

TOTAL W ECTS

IPI' ICM IFFS ISSi 113 TOTALAgric.& Livestock 1.431 22.323 2.699 0.091 0.851 27.395Mineral Extraction 1.330 17.775 2.275 0.187 4.540 26.107Oil Extraction 1.825 18.305 2.559 0.220 4.608 27.517Ron-Metal. 10.504 24.210 2.915 0.179 0.493 38.301Steel 9.654 25.278 4.743 0.241 0.594 40.510Non-Iron Metals 9.318 24.081 ? 720 0.159 0.566 37.843Metals 10.582 24.403 1.867 0.193 0.478 39.523Machinery Production 10.206 24.532 3.726 0.225 0.399 39.087Machinery Repair 8.966 24.126 2.770 0.207 0.392 36.460Electric Materials 10.160 24.545 3.684 0.224 0.400 39.013Electronics 17.185 24.224 3.319 0.219 0.293 45.240Autos 24.807 25.490 4.344 0.278 0.451 55.370Auto Parts 8.223 24.094 3.867 0.191 0.388 36.764Timber & Purniture 6.386 24.155 3.358 0.203 0.388 34.489Paper & Graphics 15.369 25.211 3.337 0.264 0.467 44.648Rubber 18.405 25.301 4.619 0.267 0.495 49.007Chemicals 3.766 23.838 3.302 0.147 0.536 31.589Oil Refining 21.556 26.248 5.075 0.319 0.652 53.851Other Chemicals 13.141 24.250 3.977 0.191 0.402 41.961Pharmac. & Perfumes 30.771 25.556 3.467 0.296 0.396 60.485Plastics 16.577 25.182 4.095 0.257 0.514 46.625Textile 2.976 24.198 3.986 0.200 0.400 31.760Clothing 2.259 24.190 3.717 0.216 0.331 30.713Shoes 6.280 24.179 3.497 0.212 0.346 34.513Coffee Transformution 1.462 23.185 4.062 0.150 0.232 29.091Produce Transform. 1.642 23.580 3.496 0.172 0.290 29.181Slaughter 1.440 23.160 3.778 0.138 0.254 28.769Dairy 1.816 24.027 4.252 0.191 0.327 30.613Sugar Transformation 1.738 23.765 3.642 0.182 0.332 29.659Vegetable Oil 8.137 23.667 4.020 0.161 0.311 36.295Food industry 2.052 24.308 3.701 0.207 0.381 30.649Other Industries 78.942 24.212 2.954 0.220 0.312 106.640Slectricity 1.243 0.818 0.466 0.145 49.742 52.415Construction 2.208 2.162 1.197 0.172 7.116 12.856Commercial Services 2.964 1.514 0.942 6.944 0.452 12.816Transport 3.883 2.069 1.347 0.226 8.211 15.737Communicatlons 0.744 0.693 0.375 0.209 26.481 28.502Fin. Institutions 0.252 0.215 0.842 0.196 0.208 1.714Services to Families 1.545 1.595 1.040 7.498 0.313 11.990Services to Zuployees 0.944 0.738 0.345 6.724 0.243 8.994Rents 0.329 0.314 0.173 5.752 0.410 6.978Public Administration 0.785 0.576 0.323 0.265 0.347 2.297Other Services 0.216 0.178 0.116 5.412 0.074 5.996

Average 8.698 18.057 2.883 0.934 2.684 33.257Weighted Average 4.261 9.542 1.743 2.161 2.406 20.113Standard Deviation 13.043 10.121 1.428 2.024 8.397 18.190

- 103 -

RESULTS AFTR THE NEW CONSTITUTION Page 4 of 6

STRUCTURE OF INDIRECT TAXZS IN BRAZIL

DIRECT EFFECTS

IPI' ICM IS ISS1 TOTALAgric.& Livestock 0.000 20.480 1.350 0.000 21.830Mineral Extraction 0.000 20.480 1.350 0,000 21.130Oil Extraction 0.000 20.480 1.350 0.000 21.830Non-Metals 7.330 20.480 1.350 0.000 29.160Steel 4.850 20.480 1.350 0.000 26.680Non-Iron Metals 6.170 20.480 ..350 0.000 28.000Metals 7.280 20.480 1.350 0.000 29.110Machlne.y Production 7.250 20.480 1.350 0.000 29.080Machinery Repait 6.600 20.480 1.350 0.000 28.430Electric Materials 0.960 20.480 1.350 0.000 28.790Electronics 13.910 20.480 1.350 0.000 35.740Autos 19.480 20.480 1.350 0.000 41.310Auto Parts 5.380 20.480 1.350 0.000 27.210Timber & Furniture 3.420 20.480 1.350 0.000 25.230Paper I Graphics 10.980 20.480 1.350 0.000 32.810Rubber 10.730 20.480 1.350 0.000 32.560Chemicals 1.180 20.480 1.350 0.000 23.010Oil Refining 8.380 20.480 1.350 0.000 30.210Other Chemicals 8.470 20.480 1.350 0.000 30.300Pharmac. & Perfumes 24.040 20.480 1.350 0.000 45.870Plastics 9.620 20.480 1.350 0.000 31.450Textile 0.000 20.480 1.350 0.000 21.830Clothing 0.000 20.480 1.350 0.000 21.830Shoes 3.040 20.480 1.350 0.000 24.870Coffee Transformation 0.000 20.480 1.350 0.000 21.830Produce Transform. 0.000 20.48C 1.350 0.000 21.830Slaughter 0.000 20.480 1.350 0.000 21.830Dairy 0.000 20.480 1.350 0.000 21.830Sugar Transformation 0.000 20.480 1.350 0.000 21.830Vegetable Oil 3.670 20.480 1.350 0.000 25.500Food In2ustry 0.000 20.480 1.350 0.000 21.830Other Industries 67.310 20.480 1.350 0.000 89.140Electricity 0.000 20.480 0.000 0.000 20.480Construction 0.000 20.480 0.000 0.000 20.480Commercial Services 0.000 0.000 0.000 5.000 5.000Transport 0.000 20.480 0.000 0.000 20.480Communications 0.000 20.480 0.000 0.000 20.480Fin. Institutions 0.000 0.0GO 0.600 0.000 0.600Services to Families 0.000 0.000 0.000 5.000 5.000Services to Employees 0.000 0.000 0.000 5.000 5.000Rents 0.000 0.000 0.000 5.000 5.000Public Administration 0.000 0.000 0.000 0.000 0.000Other Services 0.000 0.000 0.000 5.000 5.000

Average 5.490 17.146 1.019 0.581 24.236Weighted Average 2.037 tV . 0.559 1.523 14.759Standard Deviation 11.032 i.561 0.572 1.603 14.168

- 104 -

FUNDIX VuPage S of 6

INDIRECT EFFECTS

Pi2 ICM IFFS lSS1 TOTALAgric.& Livestock 1.431 1.281 1.349 0.091 4.52Mineral Extraction 1.330 2.615 0.925 0.187 5.057Oil Extraction 1.825 2.965 1.209 0.220 6.218Non-Metals 3.174 2.375 1.565 0.179 7.292Steel 4.804 3.408 3.393 0.241 11.846Non-Iron k#etals 3.148 2.268 2.370 0.159 7.945Metals 3.302 2.728 2.517 0.193 8.741Machinery Production 2.956 2.997 2.376 0.225 8.554Machinery Repair 2.366 2.607 1.420 0.207 6.599Electric Materials 3.200 3.016 2.334 0.224 8.7?4Electronics 3.275 2.915 1.969 0.219 8.378Autos 5.327 3.688 2.994 0.278 12.288Auto Parts 2.843 2.630 2.517 0.191 8.181Timber & Furniture 2.966 2.615 2.008 0.203 7.792Paper & Graphics 4.389 3.529 1.987 0.264 10.168Rubber 7.675 3.549 3.269 0.267 14.760Chemicals 2.586 2.054 1.952 0.147 6.739Oil Refining 13.176 4.505 3.725 0.319 21.725Otheir cheicals 4.671 2.680 2.627 0.191 10.169Pharmac. & Perfumes 6.731 3.822 2.117 0.296 12.966Plastics 6.957 3.488 2.745 0.257 13.446Textile 2.976 2.726 2.636 0.200 8.538Clothing 2.259 2.857 2.367 0.216 7.699Shoes 3.240 2.734 2.147 0.212 8.332Coffee Transformation 1.462 2.008 2.712 0.150 6.332Produce Transform. 1.642 2.277 2.146 0.172 6.237Slaughter 1.440 1.867 2.428 0.138 5.873Dairy 1.816 2.511 2.902 0.191 7.419Su3ar Transformation 1.7.8 2.333 2.292 0.182 6.546Vegetable Oil 4.467 2.238 2.670 0.161 9.536Food Industry 2.052 2.768 2.351 0.207 7.378Other Industries 11.632 2.924 1.604 0.220 16.379Electricity 1.243 3.089 0.466 0.145 4.943Construction 2,208 2.286 1.197 0.172 5.863Commercial Services 2.964 1.257 0.942 1.944 7.107Transport 3.883 2.908 1.347 0.226 8.365Communications 0.744 2.967 0.375 0.209 4.296vin. Institutions 0.252 0.227 0.242 0.196 0.918Services to Families 1.545 1.208 1.040 2.498 6.290Services to Employees 0.944 0.615 0.345 1.724 3.628Rents 0.329 0.330 0.173 0.752 1.583Public Administration 0.785 0.526 0.323 0.265 1.900Other Services 0.216 0.148 0.116 0.412 0.891

Average 3.209 2.431 1.865 0.352 7.857Standard Deviation 2.664 0.987 0.939 0.484 3.972

- 105 -

APPENIX VIIPage 6 of 6

TOTAL EFFECTS

IPl ICM IFFS ISS1 TOTALAgric.& Livestock 1.431 21.761 2.699 0.091 25.982Mineral Extraction 1.330 23.095 2.275 0.187 26.887Oil Extraction 1.825 23.445 2.559 0.220 28.048Non-Hetals 10.504 22.855 2.915 0.179 36.452Steel 9.654 23.888 4.743 0.241 38.526Non-Iron Metals 9.318 22.748 3.720 0.159 35.945Metals 10.582 23.208 3.867 0.193 37.851Machinery Production 10.206 23.477 3.726 0.225 37.634Machinery Repair 8.966 23.087 2.770 0.207 35.029Electric Materials 10.160 23.496 3.684 0.224 37.564Electronics 17.185 23.395 3.319 0.219 44.118Autos 24.807 24.168 4.344 0.278 53.598Auto Parts 8.223 23.110 3.867 0.191 35.391Timber & Furniture 6.386 23.095 3.358 0.203 33.042Paper & Graphics 15.369 24.009 3.337 0.264 42.978Rubber 18.405 24.029 4.619 0.267 47.320Chemicals 3.766 22.534 3.302 0.147 29.749Oil Refining 21.556 24.985 5.075 0.319 51.935Other Chemicals 13.141 23.160 3.977 0.191 40.469Pharmac. & Perfumes 30.771 24.302 3.467 0.296 58.836Plastics 16.577 23.968 4.095 0.257 44.896Textile 2.976 23.206 3.986 0.200 30.368Clothing 2.259 23.337 3.717 0.216 29.529Shoes 6.280 23.214 3.497 0.212 33.202Coffee Transformation 1.462 22.488 4.062 0.150 28.162Produce Transform. 1.642 ?2.757 3.496 0.172 28.067Slaughter 1.440 22.347 3.778 0.138 27.703Dairy 1.816 22.901 4.252 0.191 29.249Sugar Transformation 1.738 22.813 3.642 0.182 28.376Vegetable Oil 8.137 22.718 4.020 0.161 35.036Food Industry 2.052 23.248 3.701 0.207 29.208Other Induetuies 78.942 23.404 2.954 0.220 105.519Electricity 1.243 23.569 0.466 0.145 25.423Construction 2.208 22.766 1.197 0.172 26.343Commercial Services 2.964 1.257 0.942 6.944 12.107Transport 3.883 23.388 1.347 0.226 28.845Communications 0.744 23.447 0.375 0.209 24.776Fin. Institutions 0.252 0.227 0.842 0.196 1.518Services to Families 1.545 1.208 1.040 7.498 11.290Services to Employees 0.944 0.615 0.345 6.724 8.628Rents 0.329 0.330 0.173 5.752 6.583Public Administration 0.785 0.526 0.323 0.265 1.900Other Services 0.216 0.148 0.116 5.412 5.891

Average 8.698 19.577 2.883 0.934 32.092Weighted Average 4.261 12.280 1.743 2.161 20.445Standard Deviation 13.043 8.381 3.000 2.024 17.237

- 106 - ATTACHMET I

TAX REFORM PROPOSALS - SUMMARY AND CONCLUSIONS

VOLUME I

Table of Contents

ABSTRACTSOCIAL INDICATORSCOUNTRY DATAGLOSSARY OF ABBREVIATIONS AND ACRONYSMSPREFACEEXECUTIVE SUMMARYMATRIX

A. INTRODUCTIONB. INDIRECT TAXESC. DIRECT TAXES

Tables

- 107 - ATTACHMENT II

ASSESSMENT OF THE BRAZILIAN DIRECT TAXES

VOLUME III

Table of Contents

CHAPTER I - INTRODUCTION

CHAPTER II - EVOLUTION AND DESCRIPTION OF THE MAJOR BRAZILIAN DIRECT TAXES

A. EVOLUTION OF DIRECT TAX REVENUE BETWEEN 1975 AND 1988B. DESCRIPTION OF THE MAJOR DIRECT TAXES

CHAPTER III - APPRAISAL OF BRAZIL'S DIRECT TAXES

A. DEFINING BENCHMARKS FOR ASSESSING DIRECT TAXESB. A ME:HODOLOGY TO ASSESS THE TAX-DRIVEN DISTORTIONS IN FACTOR MARKETSC. KEY ISSUES IN THE TAXATION OF PERSONAL INCOMED. KEY ISSUES IN THE TAXATION OF BUSINESS ACTIVITIESE. KEY ISSUES RAISED BY PAYROLL TAXES

CHAPTER IV - REFORM PROPOSALS

A. INTRODUCTIONB. PROPOSALS FOR A REFORM OF THE DIRECT TAXES

TablesGraphsAppendices

AVAILABLE UPON REQUEST

DETAILED RESULTS OF REFORM SIMULATIONS

Documents

Brazil An Agenda for Tax Reform - World Bank...R&eport No. 8147-BR Brazil An Agenda for Tax Reform (In Three Volumes) Volume If: Assessment of the Brazilian Indirect Taxes February