THE CONTROVERSY BETWEEN THE CENTRAL BANK AND THE FEDERAL REVENUE ON THE CPMF

The Brazilian Central Bank issued two reports analyzing the economic impact of the CPMF.¹⁴⁸ It took a clear position against levying the CPMF on transactions performed in the financial and capital markets.

It should be remembered that just before the announcement of the timid tax reform of 2001 the president of the Central Bank, Armínio Fraga, stated that the government had at last decided to exempt such transactions from the incidence of the CPMF. The exemption was not immediately granted, as the Central Bank had expected, and this may have motivated publication of the two papers as a means of putting pressure on economic authorities to allow the planned exemption,¹⁴⁹ which was finally enacted only in 2004.

In general, the allegations of the Central Bank pointed in two directions. First, the drop in transactions performed in the Brazilian stock market was attributed to the effects of the CPMF. Secondly, it was stressed that the turnover tax was having strong effects on interest rates, thus explaining their high levels.

Actually, since the very beginning of the debate over the Single Tax on Bank Transactions, attention had been drawn to the inadequacy of applying such tax on the financial and capital markets. A financial investment is strictly an operation that involves renting money, or capital. Thus for the same reason that the CPMF is not imposed on the value of real property each time a lease contract is renewed (it is imposed only on the flow of rents, and not on the stock of real estate capital), it must also not be levied on the value of the principal in a financial transaction each time a contract is due, or an investment is reissued, or rolled over.¹⁵⁰

When the Government introduced the Provisional Tax on Bank Transactions (IPMF) in 1993-1994, which was followed by the CPMF in 1997, it did not exempt transactions in the financial and capital markets, although it was full aware that the cumulativeness of the IPMF/CPMF impacted these markets, especially the structure

148 [ALBUQUERQUE, 2001]; see also, [KOYAMA and NAKANE, 2001].

149 Actually, the stock market exemption was effectively implemented only as a by-product of the publication of the conclusions of the Special Committee on Extending the CPMF, in October 2001.

150 José Alexandre Scheinkman, unlike those who see cumulative taxes as the cause of stagnation in financial and capital markets, shows that the major tax cause of capital market atrophy was found in

“tax structures with high marginal tax rates and little enforcement, which encourages illegal practices and accounts, and introduces disadvantages to publicly-held companies, which naturally have greater difficulty in maintaining parallel accounting.” [SCHEINKMAN].

of interest rates.

Albuquerque, the author of one of the Central Bank’s papers, lists various reasons for criticizing the bank debit tax. He addresses the CPMF as a bad tax, which shows “significant deficiencies as a revenue instrument”, among them its impact on interest rates “in a manner disproportional to other taxes” and which, as a consequence, increased government expenditures in servicing the public debt. In addition, he mentions other criticisms to the bank transaction tax, like the disincentive to using banking services, the illiquidity in the financial markets, which diminishes the incentives for increased use of credit, and its high dead-weight losses.

Notwithstanding the imprecision of some of these claims, the paper presents an incomplete and biased analysis of the problem, in addition to having methodological weaknesses, as pointed out in a paper by the Federal Revenue.¹⁵¹

According to it, the validity of the conclusions of the Central Bank’s paper depends on some unlikely and unrealistic assumptions, such as the existence of perfect competition and of a completely specified production function. Furthermore, there are flaws in the specifications of the econometric model (such as not including relevant variables) and the possibility of a strong correlation in the residues of the selected variables, which might indicate a problem of spurious relations.

Technicalities aside, the Central Bank paper attempts to demonstrate that imposing the CPMF on financial markets leads to serious problems, whereas the Federal Revenue’s rebuttal has largely minimized the impact of such alleged effects.

Arguments such as the inducement to excessive verticalization in the production process,¹⁵² the risk of bank disintermediation, and the lack of progressiveness and selectiveness of the CPMF, are issues which have already been thoroughly discussed during the 1990s, and which could be safely discarded as being devoid of practical interest. None of these risks has been empirically observed during the life of the CPMF.

Therefore, we shall concentrate on evaluating the validity of two more relevant criticisms, which are: the impact of the CPMF on interest rates, and the possible erosion of its base of incidence as nominal rate increases.

The claim that the CPMF has caused a significant increase in real interest rates can be rebutted quite easily, even though, coeteris paribus the CPMF does effectively lead to a higher cost of money. In other words, the criticism may be qualitatively true, but a quantitative evaluation demonstrates that this is a problem of minor importance.

The Central Bank model presupposes, without plausible justification, a totally inelastic demand for credit, which obviously magnifies the CPMF’s impact on interest rates. Based on that, the Central Bank paper asserts that the CPMF

151 [SECRETARIA DA RECEITA FEDERAL, 2001(a)]

152 On this, see [CINTRA and ZOTTMAN, 2002].

“contributes to the increase in the public deficit”. In other words, what it implies is that revenue from the CPMF is less than the increase in the public debt service that it may have caused. With CPMF revenue estimated at approximately R$ 19 billion in 2001, and accepting the exaggerated assumption that 40% of net public debt (approximately R$ 240 billion) is indexed to the Selic rate (rate of interest paid on government bills), the paper leads to the conclusion that the CPMF must have caused an increase of at least eight percentage points in nominal interest rates.

This is a gross exaggeration, as the Central Bank itself claims that the CPMF has had a 2.7% impact on Selic rates, 3.3% on consumer credit, and 5.9% on the interest rate charged on overdrawn bank account balances. Actually, the greatest impact on interest rates in Brazil does not stem from the CPMF, but rather from the banking spreads.

Several of the Central Bank’s papers claim that the influence of taxes on banking spreads is very modest, and that more important than taxes are the rates of interest demanded by savers, the operational costs of banks, and their profit margins.

Even if we grant that interest rates demanded by savers are influenced by the CPMF, it cannot be denied that high interest rates in Brazil are more likely explained by the microeconomics of the Brazilian banking system, with its notorious concentration, its cartel-style organized trade associations, its high operational costs, and its high profit rates.

According to the Federal Revenue paper, to claim that the CPMF is responsible for Brazil’s high interest rates “is to jump to conclusions. The CPMF impacts interest rates in the same way as other taxes long imposed on bank transactions (such as the IOF, a tax on credit), countless fees charged on transactions and many other cost and profit items related to financial intermediation activities. Before reaching a conclusion... one must determine the true components of the banking spread (30.4 percentage points in January 2009), of which more than half is accounted for as banks’ gross profits, net of indirect taxes). However, it is well known that these factors are not the most relevant in determining Brazil’s interest rates. Interest rates represent, in synthesis, the market’s overall assessment of Brazil’s creditworthiness...” Thus, it can be seen that blaming the CPMF for the high costs of capital in Brazil is more likely a good excuse for justifying the banking sector’s high profitability.

Furthermore, an impartial analysis of an eventual increase in interest rates caused by the CPMF should consider the countervailing effect the CPMF may have had in reducing banking costs by replacing traditional paper-driven declaratory taxes, which are known to have much higher compliance and administrative costs.

In spite of the fact that the author of the Central Bank paper has not based his conclusions on reliable empirical data, and that he may be reaching conclusions that are highly speculative in their quantitative results, the fact is that a bank transaction tax does indeed tend to raise interest rates. And though this effect may not be very significant, and therefore should not be held responsible for the budgetary problems

faced by Brazil’s public sector, the CPMF should not be imposed on the financial and capital markets, as I have been insistently pointing out since the earliest discussions about the Single Tax proposal, in the beginning of the 1990s.

This recommendation is not based on the CPMF’s quantitative impact on interest rates, but rather on a conceptual necessity. In this regard, the Central Bank paper’s arguments are well-founded, although for the wrong reasons. Nevertheless, it lays solid ground for not imposing the CPMF on the financial and capital markets.

It must be noticed, however, that the Single Tax proposal,¹⁵³ which provides for the non-incidence of the CPMF on financial and capital markets, does not create any privilege whatsoever for them. Such transactions are taxed, albeit with a special procedure. In other words, we advocate the non-incidence of the turnover tax on such transactions, but, in exchange, we call for a non-cumulative procedure that taxes net earnings of financial investment portfolios, regardless of the number of intermediary transactions carried out, at rates equal to the average rate of the current tax system.

Thus, if a Single Tax with a turnover rate of 3% raises revenue equal to 25% of GDP, the rate applicable to financial portfolio earnings should be the same 25%.

It is important to underscore this characteristic of the Single Tax, because the Federal Revenue, in its paper on the CPMF, strongly criticizes those who support exempting the financial markets, believing the exemption would be granted unaccompanied by specific taxation of that sector. This is obvious disinformation by the paper’s author, who states that such an exemption would “privilege a class of individuals, precisely the most fortunate, to the detriment of the remainder of the population subject to the CPMF.”

As for the fear of the Federal Revenue that the taxation method for financial investments proposed by Single Tax supporters “would demand extremely complex and costly operational control”, it is a surprising statement in view of the conclusions drawn by the critics themselves who, in another section of the paper, demonstrate convincingly that the electronic age and the progress in digital technology are capable of supporting a tax system that is based on electronic impulses, simply, cheaply, and efficiently. In other words, it would not be recommendable to give in on a correct conceptual principle merely because of presumed operational difficulties.¹⁵⁴

The second aspect of the CPMF strongly criticized by the Central Bank has to do with the allegation that as its nominal rate increases, its base of incidence is gradually eroded.

153 See [CINTRA, 1994(b)].

154 We should state that the criticism pointing to a likely loss of revenue caused by exempting the financial markets from the CPMF is based on the absence of compensatory tax mechanisms in PEC No. 378/2001, which was presented by the author, and which called for exemption in the financial markets. The reason is that a countervailing tax, being a special tax on financial income, would require separate legislation and, therefore, was not included in such PEC.

Initially, it is important to admit that any tax suffers from this effect. The higher the tax’s nominal rate, the greater is the stimulus to evade it. It is also expected that the strength of this effect tends to accelerate as the nominal tax rate increases.

Concerning this aspect, cumulative taxes such as the CPMF have some clear advantages. Tax base erosion occurs mainly as a function of marginal tax rates. In the case of value-added taxes, which are imposed on a smaller tax base (value-added at each production phase), the rates required to reach a given level of revenue are higher than those required by a cumulative tax, which is imposed on a broader base (gross value of sales). Furthermore, VATs have equal average and marginal rates, whereas in cumulative taxes the average rate is always higher than the marginal rate.

Having said this, it is easy to conclude that the impact of self-erosion on the tax base may be stronger in VATs than in turnover taxes.

In the case of the CPMF, a measure of the tax base erosion that the Central Bank claims to have taken place in Brazil must be searched in the growth of bank disintermediation, in the drop in bank deposits, and in the concomitant expansion of the use of paper currency, to the detriment of fiduciary and other forms of currency such as checks, credit cards, electronic transfers etc. In other words, for the Central Bank’s allegation to be true, the public must have reduced its use of banking institutions, making increasing use of paper currency.

The data, however, do not support this statement. TABLE 20 shows that, following the fast drop in inflation after the Real Plan in 1994, and with the introduction of bank transaction taxes (which supposedly would have strongly increased preference for paper currency), indicators of preference for paper currency showed significant differences compared to earlier levels, albeit remaining at levels significantly lower than seen in other countries. Cash deposits in the banking system have been increasing in proportion to GDP, and the public’s preference for paper currency has remained practically constant vis-à-vis bank deposits.

Lastly, the evidence used by the Central Bank to argue against the CPMF, based on international experience, is not theoretically comparable to Brazil’s experience.

The conditions for a well-functioning bank transaction tax do not exist in any other economy. Only Brazil satisfies the basic prerequisites conducive to the correct application of a bank transaction tax, as shown in other sections of this text. Thus, other countries’ experience with bank transaction tax are weak indicators of what could happen in Brazil, and which, from a conceptual point of view, turns any comparison into a totally speculative exercise. In other words, the coeteris paribus conditions for a correct comparison of operational efficiency across countries are not present. ¹⁵⁵

155 The author of the Central Bank’s paper also estimated the CPMF’s dead-weight loss, but failed to compare it to the corresponding loss associated with a VAT raising the same revenue.

TABLE 20

Paper currency in circulation, cash deposits and public preference Brazil (1992-2008)

Concerning the alleged ill-effects the CPMF might have caused in Brazil’s stock markets, the Federal Revenue paper satisfactorily demonstrated the lack of a causal nexus between the CPMF and the drop in domestic trade volume. In fact, the creation of ADRs (American Depositary Receipts), which are surrogates for Brazilian stocks used in American stock trading, bears primary responsibility for the migration of such transactions to the U.S. market. The same occurred, as that paper demonstrated, in Argentina, Chile, and Mexico, whose domestic stock trade virtually disappeared (in Mexico, it dropped from US$ 300 million per day to less than US$ 30 million per day), even though there was no cumulative tax on stock market transactions in any of those countries. Actually, capital seeks greater liquidity such as found in US markets. For foreign investors, the use of ADRs reduces the risk associated with fluctuations in the rate of exchange. Thus, in Brazil, there is a clear causal relationship between stock trade migration abroad and the creation of ADRs, but not between migration and the CPMF. However, the Central Bank’s model of analysis ignores this causal nexus.

Summing up, the Central Bank’s paper is superficial, it mistakenly specifies the econometric models, and it omits variables and causal relationships that could significantly change its findings. Furthermore, it points solely to the costs and disadvantages of the CPMF, such as raising interest rates and its negative impact on the financial markets, but completely ignores its virtues, such as the elimination of tax evasion, the lowering of administrative costs to the public sector, and the reduction in corruption that goes hand in hand with non-declaratory, electronic taxes.

The other paper by the Central Bank¹⁵⁶ also shows surprising conceptual and statistical weaknesses. It reveals the clear intention to demonstrate, by means of an illusorily methodological sophistication, something which cannot be easily proven, namely that the CPMF has caused significant financial disintermediation in Brazil.

The previously mentioned paper authored by the Federal Revenue states that,

“the criticism linked to financial disintermediation can easily be refuted, since agents did not stop performing financial transactions as a result of the CPMF and the Brazilian banking system continues to operate normally.”

The Central Bank paper intends to demonstrate the undesirable impacts of the CPMF on financial markets. Thus, it claims that the CPMF erodes its own tax base and that it has been responsible for the reduction in the number of checks used in the economy (remonetarizing the economy); that the CPMF displaced savings deposits in favor of investment funds, and that it increased the banking spread.

The CPMF should not, indeed, be levied on the financial, credit, and capital markets. If the Government had correctly implemented the original Single Tax proposal, it would not have imposed the CPMF on such markets. Nevertheless, it is imperative that we point out the imprecision and technical weaknesses contained in the Central Bank studies, as they attempt to impute faults and distortions to the CPMF without solid empirical foundation. Rather than being scientific, the paper reflects misconceptions and prejudices.

To impute to the CPMF the decline in the number of checks issued is, at best, a gross mistake. Rather, such decline is part of an ongoing trend that occurred even during periods when the CPMF rates remained constant.

According to the Federal Revenue, the paper is misleading “because the model fails to consider the true variables that cause the reduction in the use of checks.” It states that “even the Brazilian System of Payments (an innovative and path breaking real-time and on-line system of transfers of bank reserves) will further stimulate real-time digital transactions, which means that the Central Bank’s policy will also seek to discourage the use of checks as a means of payment, since they are obviously not adapted to the digital economy.” Likewise, banks discourage the use of paper checks, either through charging high service fees, such as for use of checks, or through emphasizing the greater safety and reduced operational costs of electronic transactions. Therefore, the assertion that the CPMF is responsible for the drop in the

According to the Federal Revenue, the paper is misleading “because the model fails to consider the true variables that cause the reduction in the use of checks.” It states that “even the Brazilian System of Payments (an innovative and path breaking real-time and on-line system of transfers of bank reserves) will further stimulate real-time digital transactions, which means that the Central Bank’s policy will also seek to discourage the use of checks as a means of payment, since they are obviously not adapted to the digital economy.” Likewise, banks discourage the use of paper checks, either through charging high service fees, such as for use of checks, or through emphasizing the greater safety and reduced operational costs of electronic transactions. Therefore, the assertion that the CPMF is responsible for the drop in the