IN 1967 THE BRAZILIAN STATES abolished the heterogeneous turnover taxes that they had levied for 30 years and replaced them with a unified sales tax of the value-added type. The reform was designed to overcome the defects of turnover taxation and to secure a greater degree of tax coordination among the states of the Federation.


IN 1967 THE BRAZILIAN STATES abolished the heterogeneous turnover taxes that they had levied for 30 years and replaced them with a unified sales tax of the value-added type. The reform was designed to overcome the defects of turnover taxation and to secure a greater degree of tax coordination among the states of the Federation.

IN 1967 THE BRAZILIAN STATES abolished the heterogeneous turnover taxes that they had levied for 30 years and replaced them with a unified sales tax of the value-added type. The reform was designed to overcome the defects of turnover taxation and to secure a greater degree of tax coordination among the states of the Federation.

The transformation of the state turnover levies into value-added taxes (VAT) was part of a comprehensive tax reform effort in the 1960s that sought to improve and modernize the entire Brazilian tax structure. Over the years, the antiquated and inelastic tax system had constituted an increasingly less efficient and more burdensome instrument of government finance. One of the major objectives of the tax reform was to remove some of the economic distortions that were magnifying the pressure of the tax system on the economy out of all proportion to actual yields.

At the state level, the emphasis was on eliminating the distortions in the allocation of economic resources caused by the turnover taxes. In the search for an alternative form of sales taxation, the choice fell upon a value-added measure, rather than a single-stage tax. There were several reasons for this choice. It reflected, to a large extent, the appeal of the VAT as neutral with respect to methods of production. The case for adopting the value-added method of collection, which spreads the tax over the various stages of production and distribution, was reinforced by the expectation that serious enforcement difficulties would arise if a single-stage tax were to be used to raise the large amount of revenue required by the state governments. Another important factor was the implicit decision to achieve an interstate allocation of the tax base governed essentially by criteria of origin rather than of destination, as would have been true, for instance, if a retail sales tax had been chosen. The current trend toward centralization of power in the hands of the Federal Government simultaneously played a part in the selection of a measure that would require a high degree of interstate coordination and leave only limited scope for independent state policies.

The Brazilian experience is of interest both as a case study of the VAT in a developing country and as an illustration of the problems posed by interstate tax coordination in the special setting of a federation characterized by huge regional disparities. The purpose of this study is to describe, analyze, and evaluate the Brazilian tax against the background provided by these broader issues.

I. The Brazilian Revenue Structure

The Brazilian fiscal structure is that of a federated country with a strong central government, important but strictly defined powers at the state level, and, historically, a marginal role for local governments. There are 22 states, in addition to four federal territories and the Federal District, Brasília (the capital). The local authorities are the municipalities, approximately 4,000 in number, which vary enormously in area, population, and income levels. The states themselves are at very uneven levels of development. Some of the larger southern states are highly industrialized (especially São Paulo), and parts of the far south and west are at an intermediate stage of development with a fairly prosperous agricultural base; the economies of most of the northern and northeastern states, on the other hand, are still largely underdeveloped and are based on primary production for export markets.

There are a marked concentration of powers and responsibilities at the federal level, which is favored by the Constitution in the allocation of sources of revenue, and severe restrictions on the use of taxing powers by subordinate jurisdictions. State expenditure programs are highly uneven, owing to variations in the fiscal capacity of the different regions. Until recently, at the municipal level the situation was generally one of total penury. The system of intergovernmental transfers of revenue, inaugurated in 1967, has helped to restore a measure of balance by providing substantial revenues for the municipalities, as well as effecting a certain amount of redistribution in favor of the less developed states.

In the period 1966-68, the percentage breakdown of tax receipts by level of government was as follows:1

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About 50 per cent of the total tax revenue (excluding social security contributions) is collected by the Federal Government and roughly 46 per cent by the states. The municipalities have almost no tax revenue of their own.

At the federal level, the major taxes as a percentage of the total were as follows:2

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Mostly stamp taxes, abolished after 1966.

The manufacturers’ sales tax is the most important federal levy, accounting for about half of federal tax receipts. Originally, it was a heterogeneous collection of special excises, but it gradually evolved into a broad VAT on manfacturers’ sales, with credit-offsets for tax paid on purchases of materials and supplies. Credit is also allowed for tax paid on purchases of most industrial machinery and equipment, although there is no credit for other forms of investment, such as building installations, office equipment, and transport equipment (other than specialized equipment for the internal handling of materials). Imported machinery is exempt. Exports are exempt, and full refunds are granted for prior tax paid on inputs used in the manufacture of exported products. The tax rate varies from 3 per cent on some industrial materials to 75 per cent on alcoholic beverages and 366 per cent on cigarettes, but most products are taxed at rates ranging from 4 per cent to 15 per cent.

The income tax plays a somewhat lesser role and rests about equally on corporate and personal incomes. Other sources of federal tax revenue include customs duties and replacement taxes levied, to the exclusion of any other, on the production of hydrocarbons, electricity, and minerals. The three replacement taxes are earmarked for highway, electrification, and mineral resource development programs; they are shared among all three levels of government for these specific purposes. In addition, 12 per cent of the total revenue from the federal income tax and manufacturers’ sales tax goes into a general tax-sharing fund, which is redistributed to the state and municipal governments, essentially as a function of population and in inverse relation to per capita income levels. The contribution from this fund, which is relatively insignificant in the more developed southern states, constitutes a major source of revenue for state and municipal governments in the low-income regions.

The Constitution limits the states to the new tax on value added and a minor tax on the transfer of real property. Both taxes are regulated by the Federal Government, which sets ceilings on their rates. In the period 1966-68, the composition of state tax receipts, as a percentage of the total, was as follows:3

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Turnover taxes in 1966.

Mostly stamp taxes, abolished in 1966.

The streamlining of state tax systems effected in 1967 merely provided official recognition of the fact that the states, for all practical purposes and for a long time, had depended almost entirely on the turnover tax. It was the only levy of sufficient scope and flexibility available to the states, and the only one that could resist the erosion of inflation. By 1966 it had already accounted for 89 per cent of total state tax receipts. After its transformation into a VAT in 1967, the proportion rose to about 94 per cent.

As for the municipalities, they were stripped in 1967 of almost all their traditional sources of tax revenue, which had in any case been very limited and extremely inelastic. They were left with a relatively minor tax on urban real property4 and a new tax on services, with federal rate ceilings. The service tax, although potentially productive in urban areas, is not expected to provide revenues of any magnitude in the poorer, rural localities. For most municipal governments, there is an almost complete lack of locally raised funds and virtually total dependence on revenue transfers from the states and the Federal Government.

Beginning in 1967, the state governments were required to return 20 per cent of their VAT receipts to the municipal governments. This transfer, unlike that from the Federal Government, does not aim at equalization. It consists simply of returning the revenue to its point of collection. It is, however, also automatic and instantaneous, and, owing to the high yield of the VAT, it has provided the municipalities with a substantial source of tax revenue that is both reliable and far more generous than all former municipal levies put together.

II. The State Tax Reform

Before the turnover tax came into general use at the state level late in the 1930s, state tax systems in Brazil varied widely and completely ignored constitutional directives on tax competence and prohibitions. The export tax, which had been assigned to the states in Brazil’s first Constitution, was applied indiscriminately to interstate sales and foreign exports. It was responsible for about half of the state revenues in the early part of the twentieth century and was almost the sole source of revenue in some of the northern and northeastern states. In other regions, the states devised means of levying import duties under another name, or otherwise taxing consumption, which had been reserved for the Federal Government. Taxes on interstate imports were in use almost everywhere. The Constitution of 1934 explicitly prohibited taxes on interstate commerce and placed a 10 per cent ceiling on export taxes. The states, in compensation, were allowed to levy a turnover tax on merchandise sales, which quickly became the cornerstone of state finance throughout the country.

The turnover tax

An imperial stamp tax on commercial invoices was the nineteenth century form of the levy that later became a general sales tax of the turnover type. As a turnover tax, it was first levied in 1924 by the Federal Government, at rates of 0.02-0.03 per cent, still in the form of a stamp affixed to invoices. In those early days, the purpose of the tax was not to raise revenue but essentially to promote the use of invoices as commercial paper in the money market. However, in 1934 the tax was transferred to the jurisdiction of the state governments, and its purpose was altered drastically. From the beginning, it played a significant role in state finance, its contribution to total tax revenue rising from about 30 per cent in 1937 to 65 per cent or more in the immediate postwar years and to more than 80 per cent in the 1960s. Except for steeply higher rates in later years, in the 1930s it had the form that it would retain for the next 30 years until its transformation into a value-added levy.

The state turnover tax was a general tax on gross receipts from sales of goods by manufacturers, merchants, and farmers (excluding direct sales by small farmers). It was normally levied at a uniform rate on all transactions, although in the last years of its existence in a number of states it tended to be replaced in some sectors by single-stage taxes assessed at a correspondingly higher rate. As a turnover tax it had the disadvantage of encouraging vertical integration, as well as imposing an erratic total tax on final products, depending on the number of times the item changed hands before reaching the consumer and on how early in the cycle it received the greatest part of its final value.

The resulting distortions were inconsequential as long as the tax rates were low. But the rates rose swiftly, as the states made increasing demands on the levy to meet their needs for revenue. From a range of 0.3 per cent to 0.5 per cent late in the 1930s, the tax rate rose to 1.25 per cent by 1940 in virtually all the states. By 1950 the rates were mostly about 2.5 per cent, and in 1966, on the eve of its abolition, the turnover tax was levied at an average rate of about 5.8 per cent, not counting the numerous supplements charged in a large number of states to provide additional resources earmarked for special economic and social programs. There was substantial interstate variation in the tax rate. In 1966 the range was from 1.25 per cent to 10.0 per cent,5 although most of the states had base rates between 4 per cent and 7 per cent (excluding supplements).

The tax was subject to very little federal regulation. Its nature and scope were defined by the Constitution, which also prohibited its discriminatory use in interstate commerce. The states were otherwise entirely free to set their rates, modalities, and exemptions. They could, and did, adjust the tax rate to their needs, with the less developed states generally making up for their narrow tax base by levying the tax at rates somewhat above the nation-wide average. Many states, on the other hand, also used exemption from the tax as an incentive to attract industry within their borders.

The issue of jurisdictional rules for interstate trade was never really settled, and it gave rise to unending controversies. In 1938 the Federal Government stepped in to regulate the case of transfers between affiliated firms in different states, attributing the exclusive tax rights to the state of origin. However, in 1963 this position was partially reversed by a new federal decision that provided for the revenue from the tax on agricultural products involved in interstate transfers to continue to go to the state of origin, while that from the tax on industrial goods should be shared by the states of origin and destination on a 50-50 basis. This immediately triggered a sharp debate on the definition of agricultural and industrial products, which dissolved with the creation of the VAT in January 1967.

Introduction of the VAT

The state tax reform was prepared in 1965, along with a general reform of the entire Brazilian tax system. The broad outlines of the reform were embodied in a constitutional amendment, which was swiftly approved by the Congress. By December 1, 1965, the abolition of the state turnover tax had been decided in principle, although the details of the new VAT had not yet been worked out. The states were strongly opposed to the change and for a time held on to the hope that it would not be implemented, or at least that it would come into effect gradually over a period of years. These hopes were dashed a year later with the passing of a new national tax code prescribing, along with other reforms, the shift to a state VAT with effect from January 1, 1967.

The new tax was named impôsto sôbre circulação de mercadorias, or tax on the circulation of goods (commonly referred to by its Brazilian initials, ICM). The report of the Tax Reform Commission6 had stressed the evils of turnover taxation and had prescribed the value-added method of collection, essentially, as the means for correcting the resulting distortions. The innovation was meant to be simply an improvement over the turnover method of collection, not a new type of levy in any fundamental sense. It remained basically a sales tax, and it was still intended that it be fully shifted forward to the purchaser at each successive transaction.

To characterize it broadly, the ICM is a general sales tax, levied on goods only and collected fractionally at each stage of production and distribution, including retail, with credit-offsets for tax paid at earlier stages. The tax in each state is levied at a uniform rate on all commodities, with few exemptions. It has a common structure in all the states of the Brazilian Federation; the Federal Government prescribes most of its basic features, including the nature and scope of the tax and the exemptions, and sets ceilings on the rate. The credit-offset for tax paid at earlier stages is granted in each state whether or not the prior tax payments were made in the same or another state.

The states’ major objections to the reform rested on two basic apprehensions—about their revenue prospects under the new tax, and about the possibility of loss of the high degree of fiscal independence that they had enjoyed under the turnover tax. The first fear, as it turned out, was totally unfounded. The second was not.

From the first year, 1967, the ICM has proved to be extremely productive. The rate of 15 per cent at which the basic rate ceiling was set initially was more than two and a half times as high as the average turnover tax rate. Revenue from the tax rose, on average, by 54 per cent over that in 1966; this amounted to a real increase of about 17 per cent, considering a price increase of approximately 30 per cent in 1967. Municipal governments also shared in these high revenues in an unprecedented manner.

Interstate coordination

The problem of interstate coordination, although not peculiar to the ICM, comes into sharper focus under the ICM than under the previous tax regime. It arises in connection with the use of most forms of taxation by independent political jurisdictions operating in open economies that are part of a broader geographic framework. To be consistent with the efficient allocation of resources among the different countries or states, the levying of sales taxes by independent jurisdictions requires the specification of an appropriate principle of border tax adjustment. The taxing jurisdiction may elect to apply the sales levy either on the basis of origin (the tax is levied on all domestic production, regardless of where the goods are to be used), or on the basis of destination (each jurisdiction levies a tax on all the goods used within its borders, regardless of where they are produced).

Implementing the destination principle requires the application of a compensatory tax on imported goods and a tax rebate on exports. With the origin principle, on the other hand, exports must be taxed and imports exempted, but this is achieved automatically by taxing domestic production and does not require special tax adjustments on interjurisdictional transactions. For this reason, the origin principle is the more appropriate one to apply to interstate trade in a federated country, where explicit border tax adjustments are ruled out.

Applying the origin principle, however, has important implications for state tax autonomy and for the interstate pattern of distribution of revenue. With interstate sales taxed on the basis of origin, allocational efficiency requires a substantial degree of uniformity in the structure and rate of sales taxes levied in the different states. If tax rates are unequal, producers in low-tax states have a comparative advantage over those in high-tax states, and this may offset, in whole or in part, the true underlying comparative cost situation and may distort production patterns within the integrated market.7 In addition to requiring interstate tax uniformity, a levy based on origin automatically assigns the bulk of the total tax base to the states with the most productive base, creating serious difficulties for the less developed states, which are net importers from the rest of the Federation and which could raise more revenue with a tax based on destination.

As long as the Brazilian state sales taxes were of the turnover type, there was little pressure for uniformity among the states, which had some leeway to adjust tax structures and rates to their individual revenue needs and policy objectives. With a turnover tax, the impact of interstate tax differentials on the allocation of resources among the different states is blunted by the cumulative nature of the levy, and the resulting inefficiencies in the resource allocation process are obscured by the inefficiencies attributable to the cumulative feature itself. With a VAT, on the other hand, the distortions of competition induced by interstate tax differences at once become more serious and readily apparent. The problem of interstate imbalance associated with a distribution of tax revenue based on origin also becomes more acute.

Anticipating these difficulties, the Tax Reform Commission, when it devised the ICM, prescribed the adoption of a federal rate ceiling on out-of-state transactions (interstate and foreign) coupled with the freedom for individual states to set their internal rates at higher levels. As a result, interstate exports are taxed somewhat more lightly in the state of origin than are internal sales. The state of destination then collects the difference between the tax paid in the state of origin at the (lower) interstate rate, for which it is required to allow full credit, and the amount due at the next stage according to its own (higher) internal tax rate. This allows to importing states a revenue supplement on goods coming from other states.

The Commission had hoped in this fashion (1) to guarantee a sufficient degree of tax uniformity among the states without encroaching more than necessary on state autonomy and (2) to ensure an adequate share of total revenue to those states that are net importers from the others (and are, in general, the poorer states in the Federation). In connection with the “crucial and acute problem of jurisdictional rules for interstate transactions,” the Commission report expounded:

… To eliminate once and for all this obstacle to the integration of the tax system, the Commission proposes the only measure that, albeit daring, seems effective in our view: the setting of a ceiling on the tax rate for interstate sales, defined to include all transactions involving goods destined to be sent out of state. This solution eliminates the existing imbalance in tax capacity of the producing and consuming states, while at the same time it preserves, or restores, the political, juridical, and financial autonomy of both groups of states. …8

In retrospect, the Commission appears to have been somewhat over-optimistic in its evaluation of the prospects for both continued state autonomy and a balanced distribution of revenue under the proposed system. The actual difference between out-of-state and internal tax rates turned out to be too small to permit more than a marginal weighting of the interstate distribution of revenue in favor of the state of destination. At the same time, substantially greater restrictions than the Commission had contemplated came to be placed on state autonomy. The ICM, in fact, was designed from the outset to be applied in an almost completely uniform manner throughout the Brazilian Federation. The freedom of action of the state lawmakers in drawing up the original statutes was circumscribed by a set of constitutional directives and federal norms that left little scope for interstate variation.

The states, however, have persistently sought to stretch their margin of autonomy. Subsequent alterations inevitably brought a growing degree of interstate differentiation as the individual states started to apply, administer, interpret, and amend the basic scheme to fit the realities of their particular economic and political situations. Many of the interstate differentials led to dislocation of production and trade patterns and provoked acrimonious interstate conflicts. A formal mechanism for interstate coordination was provided for resolving differences and elaborating common policies on a regional basis. In the first years, interstate agreements did indeed succeed in settling a number of issues. But on the more controversial questions, the mechanism for interstate consultation often breaks down, and individual states proceed pragmatically on their own until the Federal Government steps in to resolve the dispute and to impose a compromise solution on a uniform basis.

Alternatives to the ICM

In view of the difficulties with the ICM, it may be asked why preference was not given to some alternative to an origin-based value-added levy as the cornerstone of Brazilian state finance. The choice, however, was dictated largely by the basic decision to continue relying, at the state level, on a general sales tax measure. Because of the magnitude of the states’ revenue requirements, the value-added technique presented itself as the only solution for enforcing a general sales tax with a base broad enough for this purpose.

Therefore, single-stage tax alternatives were never really seriously considered. Among them, a retail sales tax would have been a logical choice to reach approximately the same base. Such a tax, however, was out of the question, owing to the difficulties of administration and enforcement in the retail trade sector, composed essentially of a large number of small enterprises. It is unlikely, moreover, that Brazil, or almost any other country, could have found it possible to assess a 15-20 per cent tax on retail sales alone.9

It is also highly unlikely that the large industrial states in the South, which are net exporters to the rest of Brazil, would have accepted an interstate allocation of the tax base resting entirely on destination, as would be true with a retail sales tax. On the other hand, the other single-stage tax alternatives at the manufacturers’ or wholesale level would have been inadmissible, not only because of the higher rates that would have been required but also because the extreme concentration of industrial production in a few states would have left all the others without any tax base to speak of. Apart from the consideration of greater allocational efficiency that argues in favor of a broader-based levy, the locational constraint made it mandatory that any general state sales tax should be based on agriculture and trade as well as on industry and should extend to the retail level.10

Under these circumstances, probably the only real alternative to the ICM was a continuation of the existing system of turnover taxation, although in time the turnover tax in most states would probably have split into a heterogeneous collection of single-stage replacement taxes, and it would have been extremely difficult to coordinate these taxes on a nation-wide basis. The VAT had the considerable advantage, from the point of view of the federal policymakers, of offering the best prospects for harmonizing and unifying state tax systems in a federal framework. In this context, and in view of the current tendency in Brazil to downgrade state autonomy in favor of strong central government powers, the implicit bias of the VAT in favor of a high degree of compulsory state tax uniformity was a plus factor rather than a drawback. The interstate allocation of revenues provided by the selected tax measure also coincided largely with the goals imposed by the existing political balance of power among the different regions.

III. Technical Features of the State VAT

Value-added taxation

The VAT is now in effect in eight countries in Europe, and is about to be adopted by several more. At the time of the Brazilian reform in 1967 there was little experience with this form of tax outside of France, which had pioneered its use. In developing countries it had not yet been tried except, in a few instances, as a method for collecting sales taxes levied at the manufacturers’ level. However, following the Brazilian reform, a VAT was adopted in Uruguay and Ecuador, and several other Latin American countries are now considering it. In Brazil, the Federal Government has been using the value-added method since 1959 for the manufacturers’ sales tax. But the range and complexity of the problems facing the tax planners and administrators is increased manyfold when the tax is extended to other sectors of the economy, as is true with the new state tax. In addition, there is as yet no precedent for the use of the VAT by subordinate governmental units in an integrated market without fiscal frontiers.11

The VAT has occasionally been proposed as a business levy, designed to implement some form of the benefit principle of taxation as it applies either directly to business firms or indirectly to individuals viewed as members of producing units rather than as consumers.12 In practice, however, the VAT has almost always been intended as an indirect levy designed to tax personal consumption expenditure. It is generally viewed as the latest in a series of successive improvements that have marked the history of consumption and sales taxation, and as an alternative to the retail sales tax.13

An important merit of the VAT is its neutrality with respect to the allocation of resources in the economy. Unlike the turnover tax, which is applied repeatedly to the full value of a product every time the item changes hands in the process of production and distribution, the VAT is assessed at each stage on only the increment in value acquired by the product since the last taxable transaction. This means that at the end of the chain, the total amount of tax paid on a given commodity is only a function of the rate of tax and of the final price of the commodity, independently of the number of stages through which it has passed. What has been collected, in fractional payments, is equivalent to a single-stage tax on the value of the final product. There is no artificial incentive to vertical integration, and no discrimination against products embodying value added at an early stage versus commodities that receive the largest part of their value in the last stages of the production and marketing chain. In its consumption variant, the tax also makes no difference between capital-intensive and labor-intensive processes, so that businesses are free to select the form of organization, combination of factors, and methods of production on grounds of efficiency rather than with a view to minimizing the impact of taxation on their costs.14

The treatment of investment goods varies with the type of VAT employed. The gross product variant makes no allowance whatsoever for investment; its conceptual base is the gross domestic product. The income variant permits the deduction of annual depreciation to allow for the fact that a firm’s capital equipment gets used up in the production process; the conceptual base of the income variant is net national income. Finally, the consumption variant exempts the full value of investment goods at once—at the time of purchase. In this form, the VAT reaches only consumption expenditure, and, if it is carried through the retail level, its base is identical to that of a retail sales tax on consumer goods and services.

A VAT that applies only through the manufacturing or the wholesale stage does not offer the advantage of noninterference with market processes to the same extent as one that covers all sectors of the economy, including retailing and services. As long as some sectors remain outside the scope of the tax, some distortions may result from the incentives remaining to business firms to integrate forward or backward, and from some double taxation of value added at an early stage. The European taxes, for this reason, are all extended to retail sales and cover most services.15

Specific product exemptions and differentiated tax rates also pose serious problems under the value-added method of taxation. According to the system that is most widely used, the tax due by a business firm is computed by applying the relevant tax rate to total sales during a given period, and deducting from the resulting figure the amount of tax paid by the firm on its purchases of intermediary products and capital equipment (for the consumption variant). The amount of tax paid on value added at earlier stages is shown compulsorily on invoices to permit this procedure.16 Therefore, a continuous chain of tax credits accumulates as a product moves through the production and distribution processes up to the finished stage and into the hands of the final consumer. Apart from adding administrative complications, an exemption at any point along the cycle (except at the very beginning or at the ultimate stage) normally results in a break in the tax-credit chain, which leads to a loss of neutrality, and introduces an element of double taxation to the extent that the exempt product re-enters the taxable sector at the next stage.

In principle, therefore, a VAT should be universal, extending to the retail stage and to virtually all sectors of the economy, including services, with as few exemptions as possible. Only with a comprehensive and uniform coverage is it possible to obtain the full benefit of a truly neutral tax and to minimize the administrative complexity of the VAT.

General characteristics of the Brazilian system

The Brazilian state VAT falls short of the ideal comprehensive model in many respects. While it extends to the retail stage, the levy is significantly less universal in coverage than the VAT that has been adopted in Western European countries. Services are excluded from its scope, along with a number of special sectors, such as construction and electric power. The ICM also until now has made a more limited application of the investment and export exemptions that are characteristic of the European levies. The rate of tax, on the other hand, is the same for all commodities, and exemptions are few; this has kept down the level of administrative complexity. On the whole, the tax follows a relatively simple design, ignoring some of the technical refinements that have been incorporated in the VAT systems of the more developed countries. More often than not, the complications that have arisen in implementing the tax are attributable to its interjurisdictional nature, rather than to the value-added technique of collection, per se.

Although the Brazilian VAT is only six years old, many of its technical aspects have already undergone a certain amount of change. The outlines of the federally designed framework, to which the state statutes must conform, are pragmatically filled in and modified on the basis of experience. The passage of time has brought growing pressures for uniformity in applying the tax in the different states. The Federal Government has further increased its control over state policy and has multiplied the number of its initiatives and interventions to step up standardization and to resolve interstate conflicts.

From the beginning, interstate differentiation has been most noticeable in two major areas: the treatment of agriculture and the tax regime for foreign exports. A third area of differentiation involves the extension by individual states of special concessions to attract new industries. Federal government efforts have been aimed at narrowing differences in these areas, as well as ensuring the uniform treatment of investment spending, standardizing collection and administration, and keeping down the tax rate level.

Nature and scope of the tax

The ICM has the broadest base of all Brazilian taxes. Taxable activities include the production and marketing of virtually all tangible goods. The tax also applies, as a rule, to imports.17 It extends through all phases of distribution, including retail sales. Public enterprises engaged in the production and sale of goods are generally within its scope. Agricultural production is specifically included, in principle, although certain foodstuffs are exempt. In a number of states, the tax is not levied on sales by farmers of unprocessed agricultural products but rather is collected from manufacturers and merchants who buy these products for processing and marketing. Aside from this special handling of the agricultural sector, the tax is usually levied at each sale or transfer along the production/distribution cycle. It is defined by the statutes as a tax on the economic “circulation” of goods, assessed, essentially, on the increments of value that goods acquire as they move through the various stages of the economic process, from primary products to manufactured goods to commodities in the hands of consumers.

The specific points at which the tax becomes due, along this continuous process, are defined by the statutes to include most transactions in the nature of sales or transfers (regardless of actual physical movement of goods) and to exclude most physical transfers without real economic significance. The taxable event is the sale or transfer of the goods, with passing of title to another owner. There are no provisions to tax self-deliveries.18 Transfers between affiliated enterprises, on the other hand, are taxable events, as the tax status of a transaction is independent of legal relationships between the establishments involved. This feature, in particular, distinguishes the ICM sharply from the earlier turnover tax, which was to a considerable extent avoided by large firms through vertical integration of the production process and the establishment of sales subsidiaries.19

The scope of the ICM ensures almost complete coverage of primary and secondary sector activities and part of the tertiary (wholesale and retail trade). It applies to all types of business engaged in the production and trade of goods, regardless of size, legal status, or other such characteristics. Thus, it applies to farmers and cattlemen (with the qualification made earlier) and to virtually all other primary producers (except mining firms).

It is levied on manufacturers large and small, big corporations, and family firms, excluding only artisans who work at home without hired help. And it is collected from all persons engaged in trade of any sort, from wholesale merchants and retailers to itinerant salesmen and corner shopkeepers or owners of stalls in outdoor markets.20 The sale of food and beverages for consumption in bars and restaurants is also taxable.



While it is quite broad and general in its coverage of goods, the ICM does not cover services, except insofar as they are an integral part of the production or distribution of the goods in question (and thus are automatically taxed upon the sale of the goods themselves). This is true for wholesaling and retailing as well as for all other services purchased by business firms from service enterprises in the course of their operations.

Services as such are reached by a separate tax levied by municipal governments. The service tax is imposed on the gross receipts of service enterprises in virtually every field, including professional services, entertainment, leasing of goods, letting of rooms in hotels and pensions, and personal and business services of all types. The area of incidence of the municipal service tax is strictly regulated by the Federal Government, which specifies the services taxed and sets ceilings for the rates that may be charged.21 This solution was chosen by the Tax Reform Commission in order to give municipal governments at least one potentially productive source of independent tax revenue. Taxation of the service sector had traditionally been the province of these governments, which were already including service establishments in the scope of the old municipal business-license tax that was abolished by the tax reform.

The failure to integrate the taxation of services with the ICM leads to a certain amount of distortion in the economy. Since there is no credit under the ICM for the tax paid on service inputs of business firms, these inputs are in fact taxed twice. At the same time, the service tax rate is substantially lower than that of the ICM, which implies a substantial tax bias in favor of consumer outlays on personal services as against consumer goods.22 The service tax, on the other hand, is cumulative in nature. Its effective impact on the final purchase price is therefore likely to be erratic, with a built-in bias toward such vertical integration in the service sector as this type of activity will allow.

The municipal service tax applies to local transportation, but the right to tax all other transportation and communications services has been reserved for the Federal Government, which has made only marginal use of it so far. Neither the ICM nor the service tax applies to insurance companies and financial intermediaries. These institutions are subject instead to a special tax levied by the Federal Government on outstanding loan balances and premium payments, at rates ranging from 0.3 per cent to 2.0 per cent.23


The service tax is also applied to the construction industry, which was removed from the scope of the ICM almost immediately after the ICM went into effect for fear of the repercussions it might have on the cost of residential building at a time when the Federal Government was launching an all-out attack on the housing problem. For construction, the service tax is not based on gross receipts, however, but on value added. In computing the tax base, a deduction is allowed for purchases of raw materials and supplies, which have already borne the ICM, and for the cost of services rendered by building subcontractors, which have already borne the service tax. As a result, no double taxation is involved either in the coexistence of the ICM and the service tax, or in the successive applications of the service tax itself, and the total value embodied in new buildings is uniquely allocated, at each stage, to the relevant tax. The sale of real property, however, is not subject to the ICM, so that business purchasers are not able to claim any credit against the tax that they owe on their own business activities.24

Other exclusions

Aside from construction and services, the ICM is not levied in three other important areas: mining and quarrying, the refining and sale of liquid and gas fuels, and the production and distribution of electrical energy. Federal replacement taxes are levied at the production stage on the output of each of these three sectors, to the exclusion of any other tax. The federal minerals tax, however, may now be applied by mineral-processing firms as a credit-offset against their liability under both the federal sales tax on manufacturers and the state ICM.25 This has largely removed the double taxation of mineral and raw material inputs that prevailed initially under the ICM. The treatment of electric power still leads to a certain amount of double taxation for agricultural, industrial, and commercial users; the same is true of fuels used by ICM taxpayers in their productive activities. It was planned originally to leave sales of motor fuel within the scope of the ICM, with the tax to be collected by the states only at the retail level. The idea, however, was abandoned out of concern for the potential impact that the measure would have on transportation costs.

Tax rates and exemptions

Exemptions and rate levels are governed by regional interstate agreements and are subject to tight federal controls. The tax rate in each state is essentially uniform for all commodities but is slightly higher for internal transactions than for out-of-state sales. There are few exemptions, and preferential treatment in the form of explicit rate differentiation is nonexistent. In a few cases, the effective rate of tax is reduced through special credits or percentage deductions from the tax base. Another indirect means of varying the tax rate is by the use of official price schedules that put taxable value above or below the true market value. This occurs in some states in the taxation of primary products.

Tax rate

Domestic transactions. The federal rate ceiling for out-of-state sales was set initially at 15 per cent. Originally, the only statutory requirement for internal sales in each state was that the rate be uniform for all the states. In practice, however, each of three major geographical zones (North, Northeast, and Center-South) set their internal rates only slightly above the out-of-state rate, and within 1 percentage point of one another (18 per cent in the Northeast and 17 per cent elsewhere). Since then, the internal rates have also been brought under complete control by the Federal Government, which has now lowered the ceilings for both internal and out-of-state rates. By 1974 the rate on out-of-state sales is scheduled to drop to 13 per cent, while the internal rates go down to 16 per cent in the Northeast and to 15 per cent elsewhere. As the tax itself is included in the tax base, the effective rates will be 15 per cent on out-of-state sales, and 19 per cent and 17.6 per cent, respectively, on internal sales in the Northeast and elsewhere.

The dual rate system has the advantage of representing a compromise between origin and destination rules in interstate trade. Although each state is allowed to tax all value added that originates within its borders, the internal/interstate rate differential constitutes, in effect, the equivalent of a partial system of compensatory import taxes and export rebates on interstate trade, without requiring actual border tax adjustments. However, because the rate differentials are small, the application of this hybrid geographic principle to interstate transactions does not in fact differ substantially from a system based strictly on origin, under which each state would apply the same tax rate to both internal and out-of-state sales. The less developed northeastern states, which are characterized by an import deficit in their trade with the rest of the country, should net a little more revenue to the extent that the supplementary tax collected on interstate imports exceeds the revenue lost because of the partial rebates granted on shipments to the rest of Brazil. But this is considerably less than they would be receiving under a normal system based on destination.

Exports. Apart from permitting a more balanced distribution of revenue, an important function of the federal ceiling on the out-of-state rate was to ensure the uniform treatment of foreign exports in all the states. This goal has not been achieved, however, as effective rates on exports have begun to differ from the statutory rate. The effective tax rate on exports actually varies from zero to the out-of-state ceiling on rates. The 1967 Constitution exempted exports of manufactures from the ICM, but border adjustments so far have varied considerably from state to state.26 In principle, exports of primary products are taxed at the full rate. In practice, however, a number of states have granted tax concessions to their most important exports of primary products. In the State of São Paulo, all agricultural exports are exempt except coffee. In the remaining states, direct and indirect rate reductions affect a whole range of commodities, including rice, corn, soybeans, tobacco, meat, leather, wool, and cotton.27 On the other hand, there are few rate reductions on agricultural exports in the northeastern states, where the primary product export base still constitutes a large segment of the economy and one of its principal sources of tax revenue.

Exemptions and rate concessions

The ICM provides relatively little scope for independent exemption policies. Exemptions cannot, in fact, be enforced by any one state independently, except on purely internal transactions. With respect to products entering interstate trade, any fiscal favors—unless granted uniformly in the different states—are canceled automatically upon crossing state lines, as the importing state enforces its own rate of tax retroactively, picking up the revenue forgone by the state of origin as a result of the exemption.

Most of the exemptions that do exist under the state VAT have actually been granted by federal decree. They concern, essentially, books, newspapers, and printing paper; a limited number of unprocessed foods; agricultural producer goods; industrial machinery and equipment; and exports of manufactures.

In the Center-South, the difficulties encountered in applying the tax to farmers also led state administrations to exempt farm sales. On the whole, the states otherwise have been reluctant to allow any substantial erosion of the ICM tax base through exemptions, especially in the Northeast. On the other hand, in the less developed regions, state administrations have not hesitated to subsidize industrial development by refunding to business taxpayers a substantial part of the tax paid on their sales, provided that the money is reinvested in local projects.

Essential foodstuffs. The issue of an explicit exemption for foodstuffs did not arise as such under the turnover tax, but many food products in fact escaped taxation, both legally and illegally. The tax burden on the agricultural sector, moreover, was relatively light. With the shift to the VAT, the tax rate was sharply increased, exemptions vanished, and evasion became more difficult. The exemption for essential foodstuffs was therefore introduced under the ICM as a measure of social equity and to lessen the impact of the tax reform on the cost of living.

The concept of essential foodstuffs was never clearly defined, and the exemption is at best a partial one. It was theoretically restricted to retail sales. Strong opposition from the states stood in the way of complete exemption, particularly at the production stages, and prevented extending exemption to a broad range of commodities. The exempt foodstuffs include fresh fruits, vegetables, eggs, and poultry. In the Northeast, milk, sugar, fish, and manioc flour were also added to the list, while in the Center-South an agreement was eventually reached to eliminate the tax on retail sales of meat. The two basic items of the Brazilian diet—rice and beans—are conspicuously absent from the list of exemptions.

The products included in the list of essential foodstuffs are typically the output of the myriad small-scale agricultural enterprises, which present the most difficult tax enforcement problems. For this reason, in the Center-South it was eventually decided to extend the exemption backward from the retail stage to the wholesale and production stages. Special rate concessions and exemptions were also granted for milk and dairy products. A general food exemption, on the other hand, was never under consideration, as it would have been possible in many states only at a considerable sacrifice of revenue.

Farm sales. Before the introduction of the ICM, farmers had usually managed to escape taxation on a very large scale. They were in principle liable for the turnover tax, but “small producers” were constitutionally exempt. Owing to the vagueness of this criterion, and to the difficulties of enforcing the tax on sales by large numbers of small farmers, most agricultural products escaped taxation until they entered regular commercial channels, where the tax could be collected easily from merchants and processors. Many states actually came to develop a set of single-stage taxes, which they applied to their chief agricultural crops at strategic points that could be easily controlled—for example, sugar refineries, cotton mills, and vegetable-oil processing plants. Although the single-stage rates were usually higher than those of the regular turnover taxes, this did not fully compensate for the fact that the tax was levied only once or twice along the production/distribution chain, so that the effective burden was relatively moderate.

As a result, when the ICM was adopted, farmers reacted strongly against the idea of paying 15-18 per cent on the value of their crops. An additional problem is that the state statutes normally require immediate collection of the tax that is due on sales by farmers. In general, the merchandise cannot be moved from the farm unless it is accompanied by documents proving that the tax has been paid. The requirement of prepayment constitutes a further heavy burden on the farm sector. This was quickly recognized, and the state governments devised various techniques for granting the farmers a measure of relief. One of the most widespread is the tendency, whenever possible, to continue collecting the tax at a more convenient time from “substitute taxpayers” in the manufacturing or trade sector. Another practice is that of assessing farm products at substantially less than market value.

On the whole, in many states the substitute-taxpayer approach has provided a solution to the administrative problem of taxing the major crops. An alternative procedure was to exempt farm sales altogether. The revenue lost through exemption is recovered automatically at the processing or marketing stage, except for the portion of the product that is sold directly to the consumer. Exemption was the solution favored in the Center-South. Early in 1968 the states in this region agreed, in principle, on a policy of exemption for farm sales of all unprocessed agricultural products. It was only a year later, however, that it became possible to carry out the exemption. In the first two years of the ICM, the state governments were powerless to act in this area because of the 20 per cent share in revenues that was allocated to the municipalities. This share had to be turned over to each individual municipality, from the actual tax revenue collected in the locality. To exempt farm sales would make it impossible to earmark the 20 per cent quotas exactly in proportion to the agricultural production of each municipality. This impediment was finally removed in December 1968 by federal legislation that dissociated the municipal quota allocations from on-the-spot revenue collections.

After the way was cleared by this measure, farm sales of unprocessed products were exempted in São Paulo and in most of the southern states. In general, the northeastern states continued to collect the tax as before, from the farmer or his substitute taxpayer. The difference, actually, is more one of form than of substance. Whether the farmer is legally exempt from paying the tax or not, it is in any case essentially postponed and collected at a later stage in the same state. Agricultural products for sale outside the state of origin are not exempt, except for the products on the list of essential foodstuffs of the Center-South region.

Agricultural producer goods. The value-added technique of collecting a sales tax poses special problems in the agricultural sector, owing to the fact that most farmers do not keep a record of purchases and thus cannot benefit from a credit for the tax paid on their inputs. Farm sales, when taxed, are assessed mostly on gross value. Even when farm sales are exempt, as in the Center-South, there is still an element of double taxation on the value of agricultural producer goods, if a corresponding tax credit cannot be claimed by the purchaser of farm products. The European VAT systems have generally dealt with this problem by allowing purchasers of farm products some form of credit-offset to compensate for the farmer’s input tax.

Brazil chose instead to exempt agricultural producer goods from the ICM. Fertilizers, seeds, pesticides, veterinary products, animal feed, and other similar items were placed on the exemption list in the southern states from the beginning. No such policy prevailed in the Northeast in the first few years of the ICM. However, at the end of 1969, the Federal Government made the exemption of most such agricultural supplies compulsory throughout the country, and included agricultural machinery and tractors on the list.

The difficulty with the exemption approach is that the problem of the loss of tax credits is pushed back to the manufacturers of agricultural producer goods, unless they in turn can obtain refunds for the prior-stage tax paid on their own inputs. The sale of most of the raw materials used in the fabrication of agricultural producer goods has itself also been made tax free, however, while the import of fertilizers and agricultural machinery is exempt.

Industrial machinery and equipment. These goods were originally taxable under the ICM, and a credit was allowed for tax paid on purchases of equipment. The credit was to be utilized only up to 10 per cent of the tax that otherwise would be due by the purchasing firm in each tax period; the remainder was carried over to subsequent periods. In 1971, however, it was decided to switch to an outright exemption of industrial machinery and equipment. The list of exempt items is identical to the list of equipment that was eligible for credits under the earlier system (and to that of the equipment eligible for similar tax credit under the federal sales tax on manufacturers). It includes most types of industrial machinery directly employed in the production process but excludes office machines and furnishings and transportation equipment other than equipment specialized for the internal handling of materials. After a three-year transition period during which the exemption will be only partial, it will be made fully effective by the allowance of full credit on prior-stage tax paid on the inputs of domestic equipment manufacturers, along with a refund scheme to be applied uniformly in all the states.28

By 1974, sales of domestic industrial equipment will, in effect, be subject to a zero rate. Imported machinery is exempt from the ICM. Construction is in fact exempt on its value added, but construction materials, which make up about two thirds of total building costs, are taxed. Motor vehicles are fully taxed. As a result, about three fourths of total industrial investment will, in effect, be free from the burden of the ICM when the exemption of domestic equipment becomes fully effective. This is comparable to the situation prevailing in agriculture, where purchases of machinery and equipment are exempt. In the trade sector, on the other hand, neither exemptions nor tax credits are available for investment expeditures. The ICM can thus be characterized as only a modified version of the consumption type of VAT, discriminating to some extent against commercial investment and investment in construction facilities.

Exports of manufactures. The complete standardization of border tax adjustments on exports is still a fairly distant goal for both raw materials and manufactures. The variety of rates at which raw material exports are taxed has been described. Manufactured exports are exempt from the ICM by the Brazilian Constitution. The constitutional provision, however, was interpreted originally as applying only to the last stage. To make the exemption fully effective on the entire value of the exported goods, it is necessary to allow the exporter full credit on the prior-stage tax paid on his inputs. In the first years of the ICM only a few states allowed such credits. Even in those states, because of the absence of any provision for refunds, exporters have been unable to take advantage of the credits unless they could set them off against commensurate tax liabilities generated by sales in the domestic market. A complete exemption of manufactured exports (i.e., a zero rate on these exports) is being sought by the Federal Government, which in 1971 negotiated with the states a covenant designed to guarantee in all the states by 1974 the allowance of full credit on prior-stage tax on inputs for exporters of manufactured products. This will not yet ensure uniform treatment of all manufactured exports, as there is still no agreement about the allowance of credit for prior-stage tax on the export of products that embody only a small amount of processing over and above the value of the basic raw materials.29

A related problem is that the constitutional export exemption, however interpreted, extends only to manufactures. As a result, it has been necessary at times to determine precisely at what point a commodity ceases to be a primary product and becomes a manufactured good. This has been a subject of controversy between the states and the Federal Government. The states whose economies are based on primary production for the export market have been anxious to preserve their tax base from the inroad made by export exemptions by promoting a definition of primary products that would include a certain amount of early processing. The Federal Government, on the other hand, has held out for as narrow a definition as possible. The products concerned range the whole gamut of Brazilian primary production, from unrefined brown sugar in the Northeast to roughly worked timber in the South. The tax status of these exports will not be entirely clear until the definitional problems have been settled uniformly in all the states.

Industrial incentives. Before the state tax reform, many states had used exemption from the turnover tax as a device to attract industry. With the adoption of the ICM, the competitive use of state tax exemptions as industrial incentives was, in principle, prohibited by the Federal Government. However, in the northeastern states, a regional policy was devised to achieve the same ends. Through a system of partial tax refunds, industrial taxpayers can benefit indirectly from a substantial rate reduction on their products. The refunds range, in most states where this system prevails, from 40 per cent to 60 per cent of the tax that is due. This tax is formally paid in full (this is important for the purpose of passing on the tax credit to business purchasers). Part of the tax payment, however, is deposited in a special account at the state development bank. The bank uses the funds for short-term operations, usually lending them back to the taxpayer at low interest rates; eventually the funds are turned over to him permanently for investment in approved local projects. The projects in question may or may not involve the expansion of the beneficiary’s own industrial operation, as he is also allowed to invest his accumulated deposits in the purchase of stocks to finance other approved projects. Virtually all northeastern states have adopted such incentive programs. In the Center-South, no comparable uniform regional approach has been defined, but a number of states (e.g., Minas Gérais, Espirito Santo, Rio de Janeiro, and Santa Catarina) have set up similar schemes independently.

Unlike the turnover tax exemptions, which were usually granted only to new or “pioneer” industries, the ICM incentives have generally been made available to all industrial firms that apply, although the percentage of tax refunded is usually lower for established industries than for those that introduce new lines of activity into the state. The operation of these incentive programs on a substantial scale might amount, within a few years, to a general reduction in the tax rate on local industry in the less developed regions of Brazil.

The mechanisms employed are similar to the pioneering systems for promoting the investment of private funds under the federal income-tax incentive schemes for the development of the northeastern and Amazon regions.30 From the point of view of the state treasury, the ICM tax refund system is roughly equivalent to earmarking a portion of tax revenue for subsidies to industrial investment undertaken within the framework of a regional development program. Viewed more broadly, the ICM incentives represent effective protection for the products of local industry against the competition of industrial goods from the more developed states. Products from out of state are placed at a disadvantage, since their manufacturers receive no comparable investment subsidy.

The incentive schemes will provide the large manufacturing firms from the Center-South region with an additional inducement to step up the establishment of plants in the Northeast to supply the local markets. This evolution already receives considerable stimulus from the Federal Government’s own income-tax incentive plan for the development of the region. The Federal Government has nevertheless condemned the state tax concessions because of the waste involved in interstate competition. Late in 1968 the states that wished to do so were authorized to provide for denial of credits on purchases from another state. This measure is designed to cancel the benefits of these schemes on sales outside the borders of the subsidizing state. Its implementation, however, is likely to be a rather delicate matter, and only the states that do not themselves operate an industrial incentive scheme are likely to make use of such a tax-credit denial.

Determination of tax liability and administration

The ICM is collected from producers and merchants. Each taxpayer determines his liability by computing the total tax that is due on his sales during a given period and subtracts from this amount the tax paid on eligible purchases made during the same period. For this purpose, the tax paid on purchases is required to be quoted separately on all invoices except those of final sales to consumers. Excess credits in one period are carried over to the next period. There are generally no provisions for refunds, except for the prior-stage tax paid on their inputs by exporters of manufactured goods and by manufacturers of industrial equipment, since these are the only two situations in which a complete exemption (i.e., an effective zero rate) is intended.

Taxable price

In principle, the tax that is due on sales is computed on the basis of the actual sale price. A special set of pricing rules prevails in interstate transactions between affiliated firms, while official price schedules are often used as the basis for assessment of primary products.

The taxable price includes all accessory charges except transportation and insurance costs. These costs are expressly excluded from the tax base under all circumstances in interstate and export sales and usually in internal sales as well, provided that they are stated separately. Indirect taxes in general and the ICM itself are included in the tax base. An exception is made for the federal sales tax on manufacturers, which is not included in the taxable value of factory sales. But the tax on imports includes all customs charges and fees, including the compensating import tax imposed within the framework of the federal levy on manufacturers. Only unconditional discounts and rebates can usually be deducted from the sale price.

Tax is due on the final sale price and takes into account increases and decreases attributable to adjustments to the initial contract price. This is important in the commerce of primary products with fluctuating market prices; it also has implications for the interstate allocation of revenues in transactions involving more than one state, since agricultural commodities are frequently shipped to out-of-state markets and the tax is collected before the actual price of the final sale is known.

Considerations of the interstate allocation of revenues are likewise responsible for regulating assessment values in transactions between affiliated firms in different states. In general, the state of origin must levy its tax on a base equal to the f.o.b. factory or wholesale price at which the vendor customarily sells to third parties. On commodities destined for resale at a fixed retail price in another state, the tax base of the state of origin may not exceed 75 per cent of the fixed retail price.

A number of states assess primary products on the basis of special schedules of taxable prices. Although, in principle, a tool of administrative convenience and a useful weapon against fraud on such transactions, these schedules are rarely flexible enough to permit correct valuation, and they are quickly out of date in relation to market trends. Fixed prices, however, are often used as a device to grant effective reductions in the tax burden on selected primary products. Differential prices for internal and interstate sales have also served on occasion to overtax raw material and cattle exports to neighboring states, a practice that is sternly condemned but difficult to stop; this policy enables a state to appropriate part of the tax base of another state and to encourage the processing of its primary products within its own borders.

Tax credits

Purchases eligible for tax credits normally include all items of current expenditure that are subject to the ICM. No distinction is made between physical ingredients and auxiliary materials used in the manufacture and packaging of the taxpayer’s product. Capital expenditures are not involved, now that both industrial and agricultural equipment have been made tax exempt.

Service inputs are also excluded, as are purchases of fuels and electrical energy, which are not subject to the ICM.31 The same is true for exempt inputs, with a few special exceptions. Also, the ICM taxpayer is usually not entitled to credit on materials used in the manufacture of exempt products. The only exception to this rule applies to manufactured exports and industrial equipment.

Exempt inputs. No tax credits are allowed on purchases of materials on which no tax was paid, such as exempt agricultural products and purchases made in suspension of tax. A few exceptions to this rule occur, however, where it is deemed desirable to exempt a raw material through the processing stage, instead of allowing the automatic cancellation of the exemption in subsequent transactions. In such circumstances, the purchaser is authorized to take a fictitious credit corresponding to the tax that would have been paid in the absence of exemption. For instance, purchasers of jute and jute manufactures, which are exempt, were allowed to take such a credit when computing tax liability on their own final product sales. The same privilege was granted to dairy-product processors for milk purchases, in states where milk pays a reduced or zero rate. Owing to the small number of instances in which it is desired to carry through to later stages any exemptions given at an earlier stage, there has been little need for this kind of device.

Exports. As already explained, until recently most state governments have not recognized tax credits acquired under the ICM on materials used in fabricating exempt manufactured exports. This is a situation that the Federal Government sought for several years to modify, until finally, in 1971, all the states agreed that within three years they would grant exporters of manufactures the right to use fully the tax credits accruing to their inputs against the tax liability arising from their sales in the domestic market. It was also agreed that if domestic sales are lacking or are inadequate to absorb the credits, these credits may be transferred to suppliers; failing this, the excess credits are to be refunded.32

The compulsory allowance of a prior-stage tax-credit offset applies only to exported products that have undergone a substantial amount of processing. For other exports, the states are still free to deny the credits if they wish, and state policies vary widely. While credit for tax paid on raw materials incorporated in manufactured exports is always granted in São Paulo, in most other states such credits are disallowed unless processing accounts for at least a doubling of the value of the original primary product. If this requirement is not met, the state revenue loss attendant on the export exemption may thus be limited to the tax on the value added to the original raw material by manufacturing.

The denial of credits on exports that have undergone only a small amount of processing is most prevalent in the northeastern states. The criterion of doubling the value was introduced precisely to satisfy the demands from those states where most manufactured exports are only one or two steps away from the raw stage. However, the failure of some of the southern states to follow the same rule tends to distort the pattern of competition in the processing industries involved. The tax advantage to the southern manufacturers is such that the northeastern states risk finding themselves reduced to the role of raw material suppliers. Therefore, in the long run, in order to save their processing industries it is likely that they will be forced to grant full export rebates on their semimanufactures whenever the physical transfer of the processing to a competing state looms as a real threat.33 In general, the simultaneous use of origin principle in interstate trade and of destination rules in foreign trade tends to distort the flow of trade between the different states, and between them and the rest of the world, unless the rates of border tax adjustments on foreign transactions are the same in all the member states. Even if some interstate variation in tax rates can be tolerated within the Federation, it is important to ensure the standardization of compensatory import taxes and export rebates.

The contradiction inherent in the simultaneous application of the origin principle to interstate trade and the destination principle to foreign transactions leads to an additional difficulty in applying tax credits on exports. Whenever an exported product is manufactured in one state from raw materials acquired in another, the granting of full export rebate implies, in substance, that the state that does the actual exporting, apart from waiving its tax claim on value added within its borders, must refund the tax on the raw materials even though the tax was in fact collected by another state. In practice, this has not been a major problem so far, but it is likely to become more important when the export refund scheme is made fully effective in all the states. It may then become necessary to set up a mechanism for interstate compensation in order to divide the financial burden of export rebates, in such a situation, among the different states involved.

Industrial equipment. As mentioned, the exemption now granted to sales of industrial machinery and equipment is to be made fully effective by allowing a prior-stage tax-credit offset and by refunding to equipment manufacturers in the same way as to exporters of manufactures. The exemption of equipment goods is, in principle, substantially equivalent to charging tax on the sale of these goods and subsequently allowing the purchaser a credit-offset for tax paid. In practice, the resulting tax relief for industrial investment is greater, since the exemption makes the relief effective at an earlier stage in the production process. This is particularly true in Brazil because of the potentially protracted period over which the earlier investment credit was compulsorily prorated, owing to the 10 per cent ceiling set for its use in any one tax period.

Collection of tax

The ICM is due at regular intervals, usually every 10 or 15 days or every month, depending on the state and type of business. The delays allowed for settling the tax liability were originally very short. In the southern states, tax deadlines have been extended at times to accommodate industries whose supply of working capital was particularly limited. This has been a common practice of tax administration at the federal government level as well, in periods of tight money or lagging consumer demand. Recently, the Federal Government persuaded state tax administrations to extend considerably the normal delays allowed by statute for the payment of the ICM by manufacturers and tradesmen, in order to bring them into line with the delays allowed under the federal sales tax on manufacturers and to ease the cash situation of businessmen.

Annual or semiannual tax returns are usually required to furnish the information necessary for cross-checking of the larger transactions between business suppliers and purchasers. Out-of-state sales are listed separately, and tax administrators must be sent copies of invoices. Every taxpayer is required to keep detailed records. Unless he is assessed under some form of estimate procedure, the taxpayer must keep on an up-to-date basis a daily record of sales, purchases, and inventories and must make them available to tax inspectors on request. The inventory information is used in spot checks seeking to uncover potential fraud.

Although a VAT is capable of being administered and controlled entirely on the basis of accounting information, the Brazilian states still resort to a substantial amount of physical checks of merchandise, both in the business establishments and at checkpoints along transit routes. The practice of controlling the physical movements of goods is mostly a holdover from the attitude that prevailed under the turnover tax and, even more, from the days when the states levied taxes on interstate exports and imports. It is likely, however, that this form of control will be gradually phased out with the modernization of state tax administrations.

On the whole, except for listing out-of-state sales separately, the bookkeeping requirements do not appear unusually burdensome on the medium-sized and large taxpayers, who would maintain the same kind of information for their own purposes. The major problem would seem to be that posed to multistate businesses by the varying regulations issued in the different states. Beginning in 1972, this problem is apparently being solved by adopting a uniform system of reporting the sales tax, including a uniform set of bookkeeping requirements, forms, and procedures for collecting the ICM in all the states. The same norms, moreover, are also being adopted by the federal tax administration for the manufacturers’ sales tax. This should greatly simplify taxpayer compliance and provide as well a substantial amount of useful economic information on a broadly comparable basis.

A forfait system is employed in most states to relieve small taxpayers of most of the bookkeeping burdens, as well as to facilitate administration and to reduce fraud. The system is usually applied automatically to all retail business with sales of less than a specified amount. Under the ICM, there is no exemption whatever for even the smallest businesses. Most of the enterprises assessed by estimate are stores with very small turnovers. Typically, the firms covered by the forfait procedure account for 10 per cent or less of total revenue from the ICM in a state, although they may amount to as much as 40 per cent or 50 per cent of the number of registered taxpayers.

All taxpayers except farmers that sell only to registered taxpayers are required to register. The elaboration of up-to-date tax rolls represented a gigantic task for state tax administrations in the initial period, and many states were still operating with the old turnover tax rolls more than two years after the tax reform. In those early years, really fundamental changes in methods of tax administration and control were still mostly in the planning stage. A few of the large states were beginning to experiment with electronic data processing and to elaborate systematic control schemes based on standard value-added coefficients by type of activity. But until the new unified tax reporting system is fully implemented, statistics on revenues collected by size and type of business will remain too fragmentary to provide an adequate picture of the actual base of the ICM.

IV. Economic Base of the Tax and Its Sectoral Allocation

Although there are as yet no comprehensive ICM revenue data by sector, it is possible to obtain some idea of the size and sectoral composition of the tax base through an analysis of available income and output data. On the whole, the information available suggests that despite its somewhat restricted coverage the ICM still succeeds in reaching a substantial part of the economy’s total product. Furthermore, the boundaries between the taxable and exempt sectors are such that exemptions and exclusions from the scope of the tax do not interfere (by breaking the tax-credit chain along the path of products from primary production stage to final utilization) to any significant extent with the proper functioning of the value-added technique of tax collection. As a result, the degree of double taxation associated with the operation of the tax appears to be small.

Because of the areas that it excludes, however (especially the service sector), the ICM departs to a substantial extent from the pure value-added principle in allocating the tax among branches of economic activity and among individual firms. The industrial sector, in particular, in its capacity as user of inputs from the nontaxable sector, bears a far heavier initial tax load than the rest of the economy in relation to its own value added.

Effective scope of the tax

The definition of the ICM tax base in terms of economic magnitudes and sectors is easily derived from the statutes. As has been indicated, essentially, the levy was designed to tax value added in agriculture, manufacturing, and trade activities. Excluded, in principle, from the scope of the tax are mining activities, the production and sale of liquid fuels, the public utilities (including electricity), construction, and services in general (including banking, finance, transportation, and communications).

Table 1 shows the relative contribution of these various branches of the economy to domestic income in 1959 and 1966. Agriculture, manufacturing (excluding fuels), and trade accounted for about 55 per cent of total income in 1966. Mining, petroleum refining, public utilities, and construction contributed approximately 5 per cent. About 40 per cent of income was generated in the service sector (including about 10 per cent in wages and salaries paid by the Government). The share of agriculture, manufacturing, and trade in the total was depressed slightly in 1966 in relation to other recent years and to 1959, owing to bad harvests and the prolonged industrial stagnation from which Brazil was only beginning to emerge in 1966.

Table 1.

Brazil: Domestic Income by Sector of Activity, 1959 and 1966

(In per cent)

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Source: “Brazilian National Accounts—New Estimates,” Conjuntura Económica, Vol. XXIII (October 1969), pp. 53-93 (in Portuguese). The data refer to net domestic product at factor cost.

The net product of the petroleum-refining industry was estimated on the basis of the share of petroleum derivatives in total production of the chemical industry. The product of the manufacturing sector was adjusted to exclude petroleum refining.

The scope of the ICM, however, extends beyond the income generated in the three sectors in which it is levied. The exclusion of other sectors from the tax actually succeeds in eroding the effective base of the levy only to the extent that the output of the exempt sectors either goes directly to satisfy final demand or is used as input by other exempt activities. If the output of the excluded sectors receives further processing or in any way serves as input for one of the sectors that is within the scope of the tax, its value will be included automatically in the tax base of the purchaser of the input, owing to the fact that it will carry no tax credit. This is true, for instance, of the fuel and electricity consumed by agriculture, industry, and trade. Services, similarly, are implicitly taxed to the extent that they are rendered to other producers and their value is incorporated in taxable outputs. Input/output information suggests that the amount of intermediate production by sectors outside the scope of the ICM that is effectively brought into the tax base in the form of nondeductible inputs is considerable—approximately 15-20 per cent of the value added by the agriculture, manufacturing, and trade sectors as such.

It is not just the value added by the exempt activity that is thus captured in the tax base (as the exempt items re-enter the taxable sphere in subsequent stages of production) but the entire value of the exempt goods or services, including the cost of any intermediary inputs that were used in their fabrication. If those, in turn, were purchased from the taxable sector of the economy, they had already been taxed once. In Brazil, however, the degree of double taxation that is likely to result from this phenomenon (as distinct from the indirect inclusion in the tax base of nondeductible inputs described in the preceding paragraph) should be minimal. The main reason for this lies in the nature of the activities that are not covered by the tax. The major areas of exclusion—mining, electrical energy, construction, services—involve production processes that imply only a limited degree of interrelationship with the taxable sector with respect either to intermediary input use, or to output destination, or both, thus limiting the extent of the re-entry phenomenon that causes double taxation. Apart from these basic exclusions, the flow of inputs back and forth from the taxable to the exempt sphere of the economy in the chain of production is not likely to be substantial, owing to the limited use that has been made of specific product exemptions at intermediate stages.

Estimate of the tax base by sector

The effective ICM tax base in agriculture, manufacturing, and trade is estimated here on the basis of data for 1966. Exemptions and other factors tending to reduce the base are taken into account, insofar as possible, along with the inclusion of nondeductible inputs from non-taxable sectors that tend, on the contrary, to increase the base in relation to the value added in the taxed sector.

On the basis of the estimates detailed later, it appears that the effective base of a tax designed like the ICM succeeds in reaching roughly 60 per cent of the net domestic product of the Brazilian economy. The apportionment of the tax among firms and sectors can differ significantly from the corresponding value added, owing to the failure of the tax to encompass all sectors of activity. From a global point of view, the non-deductibility of certain inputs from the tax base simply means that the value embodied in these inputs is taxed to the purchaser rather than to the seller of these items; but for the individual business firms the result is that the base of the tax includes not only wages, profits, depreciation, rents, and interest but also a series of intermediary inputs, including minerals, fuels, electricity, professional and business services, advertising, and transportation costs.

The foregoing factor introduces an erratic element in the allocation of the tax among taxpayers. The burden imposed on a given activity or enterprise is no longer apportioned as a function of just the value added by that activity, but varies with the extent to which it uses inputs purchased outside the taxable sphere. The size of the effective tax base in relation to value added can therefore be expected to differ widely among the various sectors of economic activity. While the manufacturing sector, in particular, generates less than one fourth of net domestic income and accounts for only about 40 per cent of the value added by agriculture, industry, and trade taken together, it is shown in our estimates as supplying most of the revenue from the ICM. This is due to the fact that a substantial amount of value added in other sectors is effectively taxed through industry, while exemptions are almost nonexistent.

The agricultural tax base, on the other hand, although in principle encompassing the entire value of agricultural production, is in fact likely to be considerably narrower, even disregarding the exemption for farm sales that is granted in some states.

In retail and wholesale trade, for which no sectoral data are available, the tax base has been assumed to be equal to the net product of the sector as shown in the national income accounts.

Agricultural tax base

In general, the ICM tax base in agriculture is the gross value of output. Although most intermediary inputs were granted exemptions, this does not prevent the costs incurred in purchasing them from entering into the taxable price of the final product. The exemption of agricultural producer goods was decreed essentially to prevent them from being double taxed, in view of the failure of farmers to keep the accounting records required by the tax-credit method.

Several factors, however, are responsible for a substantial shrinkage of the effective tax base in relation to the gross value of the agricultural product. The most obvious are the amount of direct consumption of farm products by the sector itself and the exemption of essential foodstuffs. Beyond these two, some allowance must be made for the relative ease of tax evasion in this area and the undervaluation practices, which, as seen earlier, are often the expression of official policy toward the sector.

The exemption of essential foodstuffs is by far the most significant. The main products covered—milk, eggs, and fresh fruits and vegetables—accounted for more than 25 per cent of the value of agricultural production in 1966. The value of direct consumption of farm products is more difficult to quantify. In a sample study carried out in seven states a few years ago, this variable was found by the Getúlio Vargas Foundation to cluster around 10 per cent of gross output.34 Finally, undervaluation and evasion, for which there are no estimates, are assumed here to reduce the agricultural tax base by about 20 per cent.35

On the basis of the data for 1966, these assumptions yield the following estimate of the effective agricultural tax base:

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Inasmuch as the output of the agricultural sector is destined largely to some form of industrial processing, the exemption of farm sales that is granted in the Center-South states is not likely to reduce overall revenue very much, although it will shift the revenue from the agricultural to the industrial component of the tax base. In the states where this development takes place, it will further accentuate the concentration of revenue in the manufacturing sector. Disregarding this factor, the agricultural tax base can be estimated at about 44 per cent of the gross value of agricultural output.

Industrial tax base

An estimate of the ICM tax base in manufacturing can be derived directly from the industrial statistics available for 1966. The cost of materials and supplies, which is listed separately, corresponds closely to the definition of deductible inputs used for the ICM. Thus, a good approximation of the taxable value of manufacturing output can be obtained by subtracting this component from the gross value of manufacturing production. This basic aggregate need be adjusted only slightly to take into account the effect of specific exemptions and export rebates.

Unadjusted tax base. According to industrial statistics for 1966, the ICM manufacturing tax base—before special exemptions and rebates—exceeded the net value added of the sector by roughly two thirds. The estimate of the unadjusted tax base in manufacturing is as follows:36

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Total labor costs (including fringe benefits) plus residual net return to capital after deduction of all current expenses from the gross value of output.

Apart from depreciation charges and indirect taxes, the main factor in the discrepancy between taxable value added and net value added is the nondeductibility of service inputs. In effect, the information available on the various components of total manufacturing cost permits us to establish the breakdown of the difference between the two (Table 2).

Table 2.

Brazil: Difference Between the Estimated ICM Tax Base and the Net Value Added in Manufacturing, 1966

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Source: Fundação Instituto Brasileiro de Estatística (IBGE), Produção Industrial, 1966 (RIO DE JANEIRO, 1969).

On the basis of the information available on depreciation accounts of manufacturing firms, from one fourth to one third of the unclassified “other current expenses” in Table 2 may be attributable to depreciation charges. The remainder represents the cost of all current inputs not registered separately as labor, materials, fuels, electricity, or industrial service costs. It includes, essentially, miscellaneous overhead costs and business and professional services (including freight).

Adjustments for exemptions. Few adjustments need be made to the foregoing estimate of the aggregate manufacturing tax base to allow for the impact of exemptions and exclusions on the probable effective tax base. The exclusion of petroleum refining should reduce the taxable value added by about Cr$600 million. Mineral inputs, which are only partially deductible for ICM purposes, can be estimated to increase the tax base by a little more than 1 per cent of the gross value of manufacturing output, roughly Cr$400 million for 1966. The exemption of books, newspapers, and printing paper should lower the overall manufacturing tax base for 1966 by approximately Cr$350 million.

The exemption for manufactured exports is more difficult to quantify, especially in view of the lack of uniformity in state policies that has prevailed until now with respect to rebates for the tax paid on inputs of raw materials. According to industrial statistics for 1966, direct exports by manufacturers amounted to Cr$710 million. Even with allowance for additional shipments through exporting firms, the uncertainty as to rebates suggests a maximum of Cr$ 1,000 million as the value of the overall exemption for manufactured exports. The tax credit for domestic purchases of industrial machinery and equipment that was in effect until the switch to an exemption system in 1971 may have cut into the effective tax base by half this amount, at the most. Industrial purchases of new machinery and equipment from domestic manufacturers amounted to only Cr$500 million in 1966.

These estimates suggest that the combined effect of the specific exemptions and investment tax credits might reduce the aggregate manufacturing tax base by no more than Cr$2,000 million at 1966 levels, probably by substantially less. As shown next, the remaining base still represents an excess of about 50 per cent above the net value added by the sector:

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Tax base in wholesale and retail trade

There is virtually no information on cost structures in the wholesale and retail trade sectors. The input/output data for 1959 suggest that nondeductible inputs may amount to roughly one fourth of the net product of the sector. On the other hand, one must allow for the fact that on balance a sizable segment of retail trade is likely to be underassessed according to the estimating procedures generally used. Opportunities for evasion and fraud are also great in this sector.

It is impossible to say whether or not the de facto underassessment of the commercial sector succeeds in offsetting the nondeductible input burden. This is the assumption made here. The tax base in wholesale and retail trade is therefore estimated to be equal to the net value added by the sector, as it appears in the national income accounts.

Intersectoral breakdown

On the basis of the data for 1966, the estimated sectoral breakdown of the effective tax base in agriculture, industry, and trade is summed up as follows:

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This suggests that by far the greatest amount of revenue from the ICM is likely to be collected from the manufacturing sector, which accounts for an estimated 60 per cent of the total tax base. The remainder is divided almost equally between the agricultural and commercial sectors.

This breakdown offers a marked contrast to the percentage distribution of net domestic product generated in the same three sectors. It is also quite different from the breakdown that might be expected to prevail under a general gross receipts tax covering the same sectors. In percentages, the three distributions compare as follows:

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In agriculture, 44 per cent of gross value of agricultural production; in manufacturing, gross value of output; in wholesale and retail trade, gross sales were estimated at five times the net domestic product. (This is the relationship that prevailed in 1959, according to the commercial census taken in that year.)

The move from gross receipts to a value-added basis naturally gives the greatest relief to the commercial sector, which formerly accounted for the largest amount of tax collections in relation to its net product. The relative impact on agriculture and industry, on the other hand, is increased.

While agriculture generates about the same percentage of the net domestic product as manufacturing, it accounts for the smallest share of the tax base under both alternative tax measures. A large proportion of total output in this sector is bound to escape taxation altogether. The relative impact on agriculture is nevertheless increased under the value-added measure as a result of the higher statutory rate that must prevail in order to secure approximate equivalence in the overall revenue yields of the two taxes.

The manufacturing sector remains the most important source of revenue under either tax measure, but its role as the principal tax source is further enhanced by the VAT, especially in relation to its own contribution to the net national product.

Although it is difficult to evaluate its significance in terms of final incidence of the tax, one cannot overlook the effect of the adoption of the ICM on the intersectoral redistribution of the initial impact of the tax. While the tax was imposed with the intention that it should be fully shifted forward, it is unlikely that all sectors are equal in their ability to pass on increased tax costs to purchasers. In particular, some of the difficulties that have arisen in the farm sector upon changing from the turnover tax to the VAT may have been related to an inability of agricultural producers to resist pressures from commercial intermediaries to shift the tax back to them.37

V. Interstate Allocation of Revenues

The extreme inequality of state and local fiscal capacities in different parts of the Federation poses one of the major problems of Brazilian public finance. This inequality is even more acute than the basic regional economic imbalance from which it stems. In 1966, for instance, the five southeastern states, with slightly more than 40 per cent of the country’s population, accounted for nearly two thirds of domestic income and for more than 70 per cent of state turnover tax collections. On the other hand, in the Northeast (with 30 per cent of the population), income was less than 15 per cent of the nation-wide total and state tax receipts did not reach 10 per cent of the total levied in the country as a whole (Table 3).

Table 3.

Brazil: Regional Distribution of Population, Income, and State Turnover Tax Receipts, 1966

(In per cent)

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Sources: Population: Fundação Instituto Brasileiro de Estatística (IBGE); income: Fundação Getulio Vargas, Brazilian National Accounts; turnover tax receipts: State Treasury balance sheets.

Regional groupings of the states and territories are as follows:

The transformation of the state turnover taxes into value-added levies has not substantially altered the regional picture. The ICM has proved a highly reliable source of funds in the more developed states, but in the poorer regions the ICM, like its predecessor, the turnover tax, has been incapable of producing revenues adequate to the needs, or even commensurate with the income base, of these regions. It has tended, if anything, to accentuate even further the imbalance that prevails in favor of the industrialized states to the detriment of those that constitute the chief markets for their manufactures. Because the origin principle is used, the capacity of the poorer states to raise revenues comes up against the absolute limitations that stem from their narrow production bases. In addition, the uneven sectoral impact of the ICM compounds the differences in state income structures, so that the percentage of value added that is effectively reached by the levy varies substantially from state to state, and only the more developed regions actually find themselves in a position to tax a substantial portion of the value added within their borders. While in the more prosperous southeastern states the tax does reach about 70 per cent of total income, only 40-50 per cent of the income originating in the other regions is likely to be effectively taxed by the ICM.

In comparison with the turnover tax, the adoption of the ICM seems to have brought little change in the interstate allocation of revenue, except for that which could be attributed to the realignment of individual state tax rates in accordance with the ceilings set for each region. This can be seen in Table 4, which compares the geographic pattern of actual receipts under the turnover tax in 1966 with the pattern that prevailed under the VAT in 1967. The regional percentages were barely altered between the two years, and the shares of the individual states were mostly unaffected, except where the turnover tax rates for 1966 had been significantly above or below the nation-wide average of 5.8 per cent.38

Table 4.

Brazil: State Sales Tax Rates and Revenue by State, 1966 and 1967

(In per cent)

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Sources: State Treasury balance sheets, and Ministry of Finance, Conselho Técnico de Economia e Finanças.

The share of the Northeast appears to have gone up slightly. Closer analysis reveals, however, that the small increase in the percentage of that region is due entirely to the rate disparity of 3 percentage points with the Center-South that prevailed during 1967. Without it, the northeastern share would actually have gone down to about 8 per cent of the nation-wide total. After correction for interstate rate differentials, it becomes readily apparent that on a regional basis the chief alteration that followed upon the change from the turnover tax to the VAT was a reduction in the already low share of the total revenue going to the northeastern states. On this adjusted basis, the share of the southeastern region is virtually unchanged at 70.5 per cent, although there is a certain amount of reordering of individual state shares within the region, and in particular an increase in that of São Paulo from 47.7 per cent to 49.3 per cent.

The State of São Paulo is by far the largest producer of manufactures in Brazil. On the other hand, there appears to have been a marked decline in the revenue share of several of the states that constitute important markets for manufactures, both in the Southeast (Guanabara and Rio de Janeiro) and in the Northeast (specially the State of Pernambuco). It is difficult, in the absence of adequate interstate trade statistics, to interpret the exact significance of these shifts in revenue. But they do tend to suggest a greater bias than under the turnover tax in the interstate allocation of revenues in favor of the highly industrialized areas and to the disadvantage of both the primary producing states and those that are, because of their relatively high population or income levels, important customers of the country’s highly concentrated manufacturing industries.

VI. Summary and Conclusion

Although it is still too early to attempt more than a preliminary evaluation of the new Brazilian state VAT, a number of broad conclusions have emerged from the present study.

The first of these is that the ICM is a productive levy and a significant improvement upon the former turnover taxes. It may be characterized as a general sales tax of the value-added type, levied by the states of the Brazilian Federation according to a modified origin principle. Applied to goods only, and calculated by the tax-credit method, it extends up to and includes the retailing stage. With respect to the principles of taxation that it seeks to implement, it may be regarded as an indirect form of personal taxation on consumer expenditure that is used as a substitute for a retail sales tax, although it also applies to certain types of investment. Because of the value-added method of collection, it has been possible to set relatively high rates and to raise substantially more revenue than could be raised with a retail sales tax.

Despite its failure to include some important sectors of activity—in particular, the service sector—the ICM is a uniform, broad-based levy that succeeds in reaching, directly or indirectly, a considerable part of the value added in the Brazilian economy, apparently involving a minimal amount of double taxation. Exemptions have been kept as few as possible, and they do not seem to interfere significantly with the value-added technique of collection. The administration of the tax does not appear unusually burdensome, and will be simplified by the forthcoming adoption of a unified federal/state sales tax reporting system. In the transition from the turnover tax to the VAT, the greatest administrative difficulties were associated less with the intrinsic complexity of the tax law than with the initial trial-and-error approach adopted by the Federal Government in the exercise of its regulatory power over the state tax statutes.

In allocating the tax base among individual firms and sectors, the ICM may depart significantly from the value-added principle because of the nondeductibility of inputs from sectors that are excluded from the scope of the tax. The industrial sector, in its capacity as user of inputs from nontaxable activities, bears a far heavier tax impact than the rest of the economy in relation to its own value added, and the tax loads on different industries vary widely. In contrast with the turnover levy, under which the commercial sector was responsible for collecting a substantial portion of the total tax, the move to the VAT has led to a much greater concentration of tax payments at the manufacturing stage. Manufacturing accounts for an estimated 60 per cent or more of the total ICM tax base, although it generates less than one fourth of the net domestic product.

It is difficult to evaluate the significance of the intersectoral redistribution of the initial impact of the tax in terms of final incidence. If full forward shifting can be assumed, the incidence of the ICM approximates that of a uniform retail sales tax that exempts a limited number of unprocessed foodstuffs. It is not likely to be more regressive than the incidence of the earlier turnover taxes, considering the bias of the turnover tax against goods that embody value added at an early stage, which presumably account for a large part of the consumption outlays of low-income households.39 In less developed economies, an exemption of unprocessed food probably goes a long way toward alleviating the regressive impact of a general sales tax. Although the exemption under the ICM does not extend to all the basic food staples, it can be assumed to be effective over a fairly wide range of unprocessed foods that are produced for local consumption in rural areas. While it may be argued that this discriminates against the urban poor who must buy their food through regular commercial channels, the resulting inequality may be offset by the far wider range of free government services available to the urban population. The failure of the ICM to encompass the service sector, on the other hand, undoubtedly intensifies its regressive impact.

The Brazilian experience does suggest that the VAT technique can be adapted with no great difficulty to conditions in some developing countries. However, the states’ previous experience with the turnover tax was undoubtedly an important factor in smoothing the transition. The Brazilian situation, in this respect, is somewhat comparable to that of a number of European countries, where the VAT was also adopted in substitution for general taxes on turnover. The administration of a VAT could be expected initially to pose a more difficult problem in developing countries that have no previous experience in operating a broad-based sales tax.

In Brazil, from the beginning, the most serious difficulties with the ICM have involved not the use of the value-added technique as such, but rather the problem of tax coordination and allocation of revenue associated with its use at the state level within a federal framework. These problems, in turn, have arisen essentially because of the marked regional economic differences that prevail in the Brazilian Federation.

The ICM has tended to accentuate rather than to alleviate existing fiscal disequilibria. The percentage of value added that is taxed effectively under the ICM varies substantially from state to state, as the uneven sectoral impact of the levy is compounded by differences in state economic structures. Although extremely productive in the more developed and industrialized states, the tax is not capable of producing adequate revenue in the poorer states, which remain highly dependent on federal government funds. The use of origin rules in interstate transactions is responsible for the heavy weighting in the distribution of the tax base in favor of the more developed states. The rate differential on interstate as against internal transactions is too small to introduce a significant destination factor into the formula, and the rigid rate ceilings have deprived the states of any leeway in manipulating even the internal rates so as to adjust revenues better to their needs.

Apart from the revenue aspects, interstate coordination posed serious problems in the first few years. There are strong pressures for uniformity, inasmuch as interstate variations in the tax rates and exemptions tend to disturb competitive equilibrium and lead to the dislocation of production and trade patterns. Yet it has proved difficult to enforce a uniform system in all the states because of the marked regional economic differences. An effective common rate of tax on external transactions, in particular, has not yet been achieved, and border tax adjustments on exports to the outside world still vary widely. Independent state tax concessions for industrial development are another case in point.

The magnitude of the dilemma of interstate coordination is intensified by the lack of alternative sources of state finance that could be manipulated more flexibly on a local or regional basis. Federal revenue transfers were designed, up to a point, to provide such supplementary resources in the states that need them most. It has been suggested that, beyond these equalizing transfers, the Federal Government should provide funds specifically to compensate the individual states that are hurt most directly as a result of compliance with compulsory ICM exemptions and rebates. This action, however, might accentuate to an undesirable point the already high degree of fiscal centralization. It would probably be preferable, in the interest of state autonomy, to de-emphasize to some extent the role of the ICM in the tax structures of the states, and to allow them to make up the difference with some complementary source of revenue that would permit greater flexibility at the state level (e.g., the retail sales tax on motor fuels, which was considered briefly at the time of the tax reform).

The possibility of devising a formula designed to increase the share of the less industrialized states in the interstate allocation of revenues might also be considered. It may be difficult to allow a much greater differential between the interstate and internal tax rates, since the interstate rate has to be high enough in any case to absorb the credit for the tax paid at a prior stage on inputs at the internal rate. But it might be possible to alter the distribution of the proceeds of the tax, perhaps by establishing an equalization fund to redistribute, according to a formula based on destination, a portion of the revenue collected at the point of origin.


Miss Guerard, economist in the Tax Policy Division of the Fiscal Affairs Department, is a graduate of Bryn Mawr College and of Columbia University. This paper is adapted from the author’s unpublished doctoral dissertation, submitted to Columbia University in 1972. The study developed out of the author’s participation in the Brazilian Development Assistance Program of the University of California at Berkeley during 1967-70. The author wishes to acknowledge her indebtedness to Professor Carl S. Shoup for his many helpful comments.


Ministry of Finance, Secretaria da Receita Federal and Conselho Técnico de Economía e Finanças.


Ministry of Finance, Secretaria da Receita Federal.


Ministry of Finance, Conselho Técnico de Economia e Finanças, and State Treasury balance sheets.


In addition, 80 per cent of the proceeds of a rural land tax, levied by the Federal Government, is returned to the municipal governments, but the revenue is quite small.


The higher rate prevailed in the State of Amazonas, where the tax was levied only on the first sale.


Fundação Getúlio Vargas, Comissão de Reforma do Ministério da Fazenda, Reforma Tributária Nacional (Rio de Janeiro, 1966).


In effect, producers in low-tax states enjoy a degree of protection in local markets because of the tax differential, as well as some subsidization of their exports to other states in the Federation.


Reforma Tributaria Nacional (cited in footnote 6), p. 49 (in Portuguese).


In this connection, a recommendation by the Canadian Royal Commission to shift the federal sales tax in Canada from a manufacturers’ to a retail levy, to be combined with the existing provincial retail sales tax, encountered a major obstacle: the fear of public reaction to the 15 to 18 per cent rate that would have been necessary to raise the required amount of revenue. See John F. Due, Indirect Taxation in Developing Economies: The Role and Structure of Customs Duties, Excises, and Sales Taxes (Baltimore, 1970), p. 124.


The argument that conditions in retailing do not permit the use of a retail sales tax does not apply as strongly to a VAT extended through the retail stage, since with the VAT the largest potential for evasion and fraud is the retailer’s margin—the tax on earlier stages having already been collected from the production and wholesale sectors.


The tax harmonization program of the European Economic Community (EEC) calls for the removal of fiscal frontiers and for a move to the origin principle in trade within the Community, but this step has been left for a later stage. Meanwhile, the EEC countries continue to apply the destination principle in their trade with countries both inside and outside the Community.


See Clara K. Sullivan, The Tax on Value Added (Columbia University Press, 1965), Chapters 1 and 4, for an excellent review of this topic and the various theories of business taxation that have been offered in support of this viewpoint.


See, for example, Carl S. Shoup, Public Finance (Chicago, 1969), pp. 250–51; Due, op. cit., pp. 124-25 and passim.


A detailed analysis of the characteristics of the VAT and its three basic variants—the gross product type, the income type, and the consumption type—can be found in Shoup, op. cit., pp. 250-66, and Sullivan, op. cit., Chapters 1 and 5. A succinct examination of its main features also appears in the Richardson Report, Report of the Committee on Turnover Taxation (Cmnd. 2300, London, March 1964).


Until 1968, the French VAT stopped at the wholesale level. Separate taxes were levied on retail sales (by local governments) and on services.


This is the so-called invoice, or tax-credit, method of computation. The other possible methods of computing a VAT are described in the basic reference works by Sullivan and Shoup, cited in footnotes 12 and 13.


The ICM was not charged on imports originally. The value of imports, nevertheless, was automatically included in the importer’s tax base upon resale in the domestic market, so that the exemption was effective only for goods imported directly by the final consumer. Imports have now (in principle) been made subject to the tax, but registered ICM taxpayers may import raw materials and supplies in suspension of tax for further processing. Capital goods are generally exempt (see the section, Industrial machinery and equipment).


Self-deliveries are taxable in all the European VAT systems. In the Brazilian tax, the position is not to tax them, thereby avoiding difficult valuation problems. Credit is denied, of course, on tax paid on purchases of raw materials and other goods set aside for private use, or utilized for purposes not connected directly with an enterprise’s ordinary business.


In transactions between dependent firms, the actual point of collection and accurate valuation do not make any difference to the final total VAT bill. The Brazilian approach to integrated business concerns, however, is motivated by considerations of interstate allocation of revenue. For the valuation rules, see the section, Taxable price.


The Brazilian states, having operated turnover taxes for 30 years, were experienced in the handling of large numbers of small taxpayers. It was not deemed necessary, as a result, to grant an exemption for small enterprises, as was done under the VAT in several European countries. In the retail sector, however, small firms are assessed under a forfait (estimate) system, which was already a feature of the earlier turnover levy (see p. 152).


It is 5 per cent on most services, 10 per cent for entertainment services (Federal Complementary Act No. 34, Art. 9, January 30, 1967).


All the European value-added levies tax services to some extent. In the EEC, it was decided that the member countries would be required to tax at least those services that are likely, as business inputs, to have a significant impact on the price of goods and other services. The inclusion of personal services remains optional and varies from country to country. The list of activities subject to the separate Brazilian service tax is as comprehensive as that of the services included in the scope of the VAT by most European countries. Furthermore, there are no socially minded exemptions: both health and education services are within the scope of the tax.


Financial institutions are normally excluded from the scope of the VAT because of the technical difficulties involved in defining the tax base when the tax-credit method is used.


In the European VAT systems, the treatment of transactions relating to immovable property varies widely. Arrangements are usually made to allow for the transfer of some tax credits to the business purchasers of buildings.


The credit against the minerals tax, which is normally levied at the rate of 7 per cent, is prorated between the ICM and the federal sales tax on manufacturers, with 90 per cent of the payment allowed as credit against the ICM. This corresponds to the percentage of the revenue from the minerals tax that is returned by the Federal Government to the state of origin.


For further discussion of the treatment of manufactured exports, see the sections, Exemptions and rate concessions and Tax credits.


Many of these rate concessions were granted partly because of federal government pressures. The exemption of agricultural exports in São Paulo also had an impact on the policy of neighboring states. The cotton export trade in Paraná, for instance, was faced with a major upheaval after the exemption of cotton exports in São Paulo. Paraná eventually cut its tax on cotton exports by 50 per cent.


See the section, Tax credits.




These schemes provide for a tax credit for approved investments in the northeastern and Amazon areas of up to 25 per cent (formerly, up to 50 per cent) of a firm’s federal corporate income-tax liability.


Credit is allowed, however, for the minerals tax; see the section, Other exclusions.


Interstate Covenant No. 7/71, May 5, 1971. The agreement provides for refunds “in cash or securities.” The prior-stage tax-credit provision is to be put into effect gradually, with only 30 per cent of the prior-stage tax eligible for offsetting against other liabilities or refunds in the first year, 40 per cent in 1972, 70 per cent in 1973, and 100 per cent by 1974.


A case in point is the problem that was faced, in this connection, by the castor-oil industries in the States of Pernambuco and Bahia, which work mostly for the export market. They were denied credit on their purchases of castor beans. The State of São Paulo allowed full credit. As a result, the major firms began to close down their northeastern plants and to concentrate their operations in São Paulo, until Pernambuco took the step of exempting castor beans from the tax and Bahia granted them a rate reduction of 50 per cent. Castor beans were finally declared exempt from the tax throughout the country by an interstate covenant signed in January 1970.


“O Produto Agrícola Segundo Tipos de Pagamento aos Fatores,” Revista do Banco Nacional de Desenvolvimento Económico (1966), pp. 43-59.


Undervaluation through administrative use of a deliberately low price base for agricultural products is likely to be much more significant, in fact, but a great deal of the loss would be recouped at the processing stage.


Fundação Instituto Brasileiro de Estatística (IBGE), Produção Industrial. 1966 (Rio de Janeiro, 1969).


In the agricultural sector, the adoption of the ICM in 1967 coincided with a period of bumper crops, which at least temporarily may have created the supply conditions for some backward shifting of the tax. In real terms, farm prices after taxes fell considerably in 1967.


The substantial increase for the western region is due mostly to the fact that it was decided to provide revenues for the Federal District by allocating to it all the proceeds from the compensating tax on wheat imports (a federal monopoly), regardless of the port of entry. This has provided the major source of income for the capital, exceeding by far what could be levied on value added in the District itself.


This point is made in Shoup, op. cit., p. 217. The argument is that low-income households do not normally buy products in a form or at a location that embodies expensive marketing services. It would seem to have particular validity in less developed countries, where the basic needs of low-income groups are met in a very rudimentary fashion, while the middle and upper classes are becoming accustomed to a standard of living that embodies all the trimmings associated with the distribution system of the developed economies—credit, advertising, etc.

IMF Staff papers: Volume 20 No. 1
Author: International Monetary Fund. Research Dept.