Tax Reform is ‘beautiful’, says Citi – 07/14/2023 – Market

The Tax Reform approved by the Chamber in the first semester was the big news for the Brazilian economy this year, says Leonardo Porto, chief economist at Citi in Brazil. “It is a beautiful reform that could be the great flagship of this government from the point of view of improving fundamentals.”

The approval comes at a time when the scenario was already clearing up, according to Porto. The framework, according to him, if it is not as austere as the spending ceiling, neither can it be considered irresponsible from a fiscal point of view.

Citi’s chief economist calculates that around 30% to 40% of the exchange rate appreciation in recent months is due to the reduction of uncertainties in the domestic scenario, with the remainder of the appreciation of the real coming from a more benign global environment than expected. at the end of 2022.

The chief economist also praised the BC’s performance in conducting monetary policy and foresees a first cut of 0.25 percentage points in the Selic rate in August, with the basic interest rate at 11.75% in December, reaching 9% in mid 2024.

What assessment did Mr. about the economic agenda of the Lula government in the first semester? Every time there is a new government, it is natural that the level of uncertainty is higher, especially a government that was not re-elected.

There is a whole exchange of ministries, a knowledge of who the ministers are, [dúvidas sobre] the willingness and ability of the president to materialize his desire in reforms, a lot of noise.

With this government it was no different, it started with a lot of noise, that the inflation target was going to change, that it could move towards a framework from the fiscally irresponsible point of view… And what we saw is that many of these noises did not materialize .

The National Monetary Council ratified not changing the target until 2025 and maintaining it at 3% for 2026. The fiscal framework is evidently more fragile, or less austere than the expenditure ceiling was, because it allows for an increase in expenditure in real terms, but it is far from being a fiscal framework that can be considered irresponsible from a fiscal point of view.

The framework still depends on a number of relevant things, such as raising extraordinary revenues to reach the established primary surplus target. But the spending trajectory is not as unsustainable as many feared.

And more recently we had the approval of the Tax Reform in the Chamber. The vote on the Tax Reform was surprising, that was the big surprise, because I don’t think it was on the radar, at least mine, that this was going to happen in the first half.

It is a beautiful reform that could be the great flagship of this government from the point of view of improving fundamentals. It is a reform that addresses the structural problems of the extremely complex tax system. In other words, it is a reform that simplifies the system in several dimensions.

Of course, there are exceptions within the new reform that were put in place, but even with these dilutions that were made in the Chamber, it represents a very important step and a very big improvement in relation to the current system.

What implications does this improvement bring to companies? Under the current system, companies need a brutal allocation of resources, a number of lawyers, accountants to be able to comply with the rules, which makes companies heavy. It’s as if they had a lot of friction to be able to transform the input into a product.

The Tax Reform is like an oil that will allow the machine to move more fluidly, making the company lighter, more efficient, more competitive.

At the same time, the complexity of the current tax system leads to a series of disputes, different interpretations of the legislation, legal insecurities that hinder the investment decisions of companies that we can potentially improve in a medium and long term perspective.

There is also the dimension of capital allocation. There is evidence that the current tax system overly punishes companies that are capital intensive, which, in general, are the most productive ones. As you change this system and make these distortions lighter, you tend to allocate capital to those sectors that are more productive. In other words, it also improves the perspective of medium and long-term growth.

This is a flagship renovation and a unique opportunity. It was the great positive news in this first semester from the point of view of us doing our homework.

Does the economic agenda in Brasília and the deceleration of inflation allow the BC (Central Bank) to start cutting interest rates in August? I think so, our scenario is an initial cut of 0.25 percentage points in August, accelerates to 0.50 points in September and November, then to 0.75 points in the December meeting and closes the year at 11 75% . And it continues to fall over the next year until it reaches a level of 9%.

What is your assessment of the conduct of monetary policy by the BC? I think the Central Bank should be praised for the work it has been doing. It is an extremely technical job, of discipline and tenacity, from the point of view of bringing this inflation down and having it rise [os juros] even in an extremely tight and polarized election, prevailing the technical decisions of the Central Bank. And now, for the first time in the August meeting, we think that the space will technically appear so that we can cut this interest rate.

What are the necessary macroeconomic conditions that we must have in August so that the BC can start cutting the Selic rate? We are seeing this process of appreciation of the real against the dollar since March, from R$5.30 to R$4.80, in an environment where the price of commodities is going from stable to falling. This is completely unusual in Brazil, usually when commodities are falling, the exchange rate depreciates, but what we are seeing is an exchange rate appreciating along with falling commodities, it is a very strong deflationary component, it is no wonder that we are seeing the price of commodities in reais falling horribly. This helps with consumer inflation, especially in terms of food, just look at what happened to the IPCA. As the President of the Central Bank says [Roberto Campos Neto], it’s a matter of the antibiotic taking effect. It’s taking effect.

Has the advance in the economic agenda been reflected in appreciation in asset prices? Some investors who believed that risks could materialize depressed asset prices to a certain extent. When this does not materialize, it tends to improve [os preços no mercado]which are around 30% to 40% of the appreciation of the exchange rate, which appreciated due to domestic factors.

And what about the rest of the appreciation of the real? We had a global environment where willingness to take risks was better than imagined. An important part, around 60 70% of the appreciation of the real since mid-March, when it was at R$5.30 to today at R$4.80, came from global events.

It was a better global environment than imagined at the beginning of the year, especially from April onwards, when the risk of a banking crisis was being reduced. There was great uncertainty about how much monetary tightening in the United States could trigger a new financial crisis like what happened in 2008, and what we saw was that it was contained. Today the global financial system is much more resilient.

X-ray | Leonardo Porto, 47

Chief Economist at Citi Brasil, Leonardo Porto leads the bank’s economic research department in the country and has been part of the institution’s Global/Latin America research team since August 2008. Before joining Citi, he was coordinator of the team of economists at Citi Brasil. macroeconomic consultancy AC Pastore & Associados, in addition to having worked in the economic research department at Bradesco. He has a doctorate and a master’s degree in economic theory from FEA / USP and a bachelor’s degree in economics from PUC-MG.