Brazil confronts a fiscal crossroads

Brazil managed a big reduction in the budget deficit of the central government in 2024. Last year, the country reported a primary deficit of BRL 45 billion (USD 7.9 billion) which is equivalent to 0.36 per cent of the country’s GDP. While Brazil shaved off a significant 81.7 per cent from the BRL 228 billion (USD 40 billion) fiscal gap recorded in 2023 as seen in Graph 1, market economists remain cautious about the state of public finances for the year ahead, especially with the recent decline in President Luiz Inácio Lula da Silva’s popularity.

To provide context, one must look at Brazil’s broader macroeconomic situation and the recent policies the Finance Ministry has been pushing for approval in Congress. A less popular Lula would mean slimmer chances of getting his priority measures passed, and that includes further cuts in public spending to keep the budget balanced. 

The government began easing its fiscal rules at the end of last year, initially aiming for a zero primary deficit in 2024 and a 0.5 per cent budget surplus in 2025 which has increased market concerns. The central government later opted to target a neutral budget balance for 2025 following a narrow 0.25 per cent gap the previous year. However, estimates show that the consolidated public sector deficit may hit 0.60 per cent of GDP for the year, and one of the key challenges is the inflexibility of most budgetary items. A decade ago, 85 per cent of state expenses were mandatory, mainly to cover debt payments. Today, that figure has risen to 93 per cent to exceed total revenue collections.

Reduced spending cuts

Lula’s government approved a package of spending cuts at the end of 2024 to firm up its commitment to fiscal prudence. However, Congress diluted the already-insufficient measure to curb public expenditures, which included a cap on increases in real minimum wages, limitations on “super salaries” or salaries paid to public officials exceeding those enjoyed by Supreme Federal Court ministers, and tightened the qualifications for social benefits. The initial savings forecast from these changes was around BRL 70 billion (USD 12.3 billion) by 2026, but has dropped to BRL 50 billion (USD 8.7 billion) following the policy adjustments.

As the Brazilian government hopes to deliver on its promise of fiscal responsibility, it is also attempting to recover Lula’s lost popularity. According to a March 2025 survey conducted by PoderData, disapproval towards the federal government rose by two percentage points from January to March, reaching its highest level since the start of Lula’s third term. Public approval has been on a decline since May 2024, and this has only been exacerbated by persistently high inflation particularly for food, a weakening Brazilian real, a widening fiscal deficit, and an upward interest rate trend. Brazil’s key rate stands at 14.25 per cent, a 110-year high meant to tame domestic price hikes and in response to the US Federal Reserve’s pause in its easing cycle.

Unabated inflation

The IPCA inflation index reached 5.48 per cent in March, exceeding the upper tolerance limit of 4.5 per cent. This has been a recurring story from 2021-2023, as depicted in Graph 2. Brazil’s central bank continued to raise interest rates to usher inflation back to target, with a full percentage point increase unleashed in its 19 March policy meeting. The Selic rate is now at its highest level since 2016, and further increases are expected in upcoming meetings to temper further price adjustments.

This high interest rate environment creates good opportunities for investors seeking profitable alternatives tied to the benchmark rate. The elevated Selic rate makes Brazilian fixed-income products more attractive as they offer solid returns. Higher interest rates translate into greater profitability for this asset class. Conservative investors can still find security in bonds due to high interest rates and the persistent rising inflation scenario. Given the uncertainties in the global economy, Treasury Inflation-Protected Securities can help hedge against inflation risks globally.

Banking on tax reform

To regain public support, the federal government recently proposed new income tax brackets that would see more Brazilians paying less to no taxes. The plan includes exemptions for monthly incomes of up to BRL 5,000 (USD 877), along with partial tax discounts for incomes between BRL 5,500 (USD 964) and BRL 7,000 (USD 1,228). The expected revenue loss from this measure is BRL 27 billion (USD 476 million), which would easily revert the country into budget deficit mode.

To offset this gaping revenue shortfall, the proposal introduces a progressive tax equivalent to 10 per cent on monthly incomes above BRL 50,000 (USD 8,777) and capped at BRL 100,000 (USD 17,543). Additionally, the government has proposed taxing profits and dividends exceeding BRL 50,000 per month at a progressive annual rate of up to 10 per cent. Currently, these income sources are tax-free across all brackets.

Some sectors, such as electricity and sanitation services, have already begun planning to distribute profits to shareholders ahead of schedule to avoid the new tax before its planned implementation in 2026. Under the new tax regime, foreign investors will also be taxed, which could reduce the attractiveness of Brazilian companies for international investors. The proposal has been submitted to the National Congress, where it will be debated and likely modified before approval.

Brazil needs to strike a delicate balance between populist income tax reductions and higher duties on capital gains to achieve its goal of a balanced budget without unnecessarily turning investors away from the economy. We see attempts towards better fiscal responsibility as encouraging for it allows Brazil to allot resources where needed – and in the process, fuel economic growth.

This original article has been produced in-house for Lundgreen’s Investor Insights by on-the-ground contributors of the region. The insight provided is informed with accurate data from reliable sources and has gone through various processes to ensure that the information upholds the integrity and values of the Lundgreen’s brand.