Brazil unveils broader income tax exemption plan as Lula seeks to regain popularity

By Marcela Ayres

BRASILIA (Reuters) -Brazil's government on Tuesday unveiled a long-promised plan to exempt individuals earning up to 5,000 reais ($881.27) per month from income tax, with the revenue gap set to be covered by new levies on high earners and profits and dividends sent abroad.

The proposal, initially announced late last year when it triggered a negative market reaction over fiscal concerns, was one of President Luiz Inacio Lula da Silva's key campaign promises, and is now seen as crucial for the president to regain popularity amid declining approval ratings.

The initiative is the strongest in a series of measures announced in less than a month by the leftist administration to boost disposable income for Brazil's middle class, including a new system for releasing payroll-deducted credit for formal workers and relaxed rules for disbursements from workers' severance fund FGTS.

When asked if these efforts were at odds with the central bank's push to cool the economy and control inflation through its aggressive rate-hike cycle, Economic Policy Secretary Guilherme Mello said it is difficult to determine whether a single measure would generate inflationary pressure.

"Improvements in income distribution can boost growth potential without inflationary pressures," he added at a press conference on Tuesday.

The Lula administration has consistently stated that the proposal to raise income tax exemptions would be fiscally neutral, with the president himself underscoring it at an event on Tuesday where he also said the move seeks to promote tax justice. 

The measure must be approved by Congress this year to take effect in 2026, when Brazil will hold presidential elections. But its path forward remains unclear.

The heads of the Senate and the lower house released statements saying lawmakers would swiftly analyze the bill. House Speaker Hugo Motta, however, stressed that lawmakers would likely amend the text, which contradicts the interests of wealthy individuals and companies with great lobbying power in Congress.

"Changes will certainly aim to improve the proposal," Motta said at the event where the measure was announced.

As first reported by Reuters on Monday, the bill includes a 10% withholding tax on profits and dividends remitted overseas, whether to individuals or legal entities. 

According to a presentation released by the government, the measure would increase revenues by 8.9 billion reais a year.  

Tax Revenue Secretary Robinson Barreirinhas told reporters that the measure should not hurt investors, as most countries allow taxpayers to offset taxes paid in Brazil against their local liabilities.

Dividend remittances are currently exempt from income tax in Latin America's largest economy.

"We are bringing to Brazil a portion that would otherwise be paid in the taxpayer's home country," said Barreirinhas.

Government officials also noted that foreign investors could be fully reimbursed for the tax paid in the year following the withholding if the company distributing the dividends meets its income tax obligations by paying the standard 34% corporate rate.

The distribution of profits through "interest on equity" (JCP) payments, a common instrument in Brazil, will not be subject to the 10% withholding tax, they added.

A government source, speaking on condition of anonymity, said the plan to tax dividends sent abroad could lead companies to remit more dollars this year before the measure takes effect, but "the volume would not be significant enough to impact" the foreign exchange market.

The Brazilian real reversed early session losses to close up nearly 0.2% against the U.S. dollar on Tuesday, the strongest since late October, in a sign that investors did not immediately react to the measure's announcement.

WEALTHIEST TO PAY MORE

To compensate for the tax exemption for Brazil's middle class, the government also aims to introduce a minimum effective tax on high-income Brazilians, which will apply to annual earnings above 600,000 reais. 

This compensation mechanism had been announced late last year.

The proposed tax rate would rise gradually, capping at 10% for gross income exceeding 1.2 million reais per year, and is estimated to increase revenues by 25.22 billion reais a year.

Currently, individuals earning up to two minimum wages are exempt from income tax.  The government stressed on Tuesday it plans to raise this threshold from 2,824 reais per month to 3,036 reais this year to reflect a recent adjustment to the federal minimum wage.

While Finance Minister Fernando Haddad said that the bill is "balanced" in fiscal terms, the government's presentation detailed that the impact of tax exemptions will amount to 25.84 billion reais next year, less than the total revenue gains officials expect. That means the proposal could provide a boost to public finances.

However, Finance Ministry Executive Secretary Dario Durigan denied that this was the bill's purpose, stating that it includes room for negotiation in Congress.

($1 = 5.6736 reais)

(Reporting by Marcela Ayres with additional reporting by Lisandra Paraguassu; Editing by Gabriel Araujo, Alexandra Hudson and Marguerita Choy)