Fitch: Brazilian Tax Incentives Imperil State Budget Planning

Tax incentives are making Brazilian state budgets difficult to manage. They are not transparent and could be as high as 30% of some states' annual revenues. The incentives have also led to lawsuits with sizable settlements. Making these incentives transparent and limiting their scope would reduce this risk, Fitch Ratings says. In our view, if properly applied, more transparent and prudent tax incentives could reduce regional inequalities and promote social inclusion by creating jobs and developing the local industries.

These and other steps are being negotiated by states in discussions around the Conselho Nacional de Politica Fazendaria Agreement 70 (Convenio 70/2014). The agreement is meant to address how to mitigate the losses derived from the so-called "fiscal war" (legal disputes over tax revenue) and to highlight each state's precise amount of incentives granted. Many states have committed to these changes, but not all have. .

Tax disputes between states have become more frequent, and the losses have become significant. In one example, a state grants a tax incentive to an automobile manufacturing company to build and operate a plant in its borders. In this agreement, the company might pay 2% in state taxes, while the actual state tax is 12%. If one of the company's cars is sold in another state, that state applies the full state tax credit of 12%, because the state that granted the tax incentive has not made the actual amount of tax the company paid public. Many of these incentives may be renewed annually and have no expiration date.

We estimate that all the states combined have, at the end of 2014, accumulated losses of approximately USD54 billion due to tax incentives. As the transparency is low and incentives are not properly reflected in the states' budgets, this amount may be underestimated. And approximately 30% of the tax in arrears is likely related to such litigations. For some states, this could be as much as 43% of their annual operating revenues, if they were collected entirely at one time.

In some countries, the value-added tax (VAT) is collected at the national level, mitigating these disputes. Others apply VAT where the product or service is sold. In other countries, states can incentivize companies to work in their borders through the provision of land and negotiating with local banks to provide loans. And states outside Brazil are more selective in offering tax incentives. Many offer them only to companies in the high-tech and environmentally conscious industries.