Lula da Silva (commonly known as Lula), from the Workers' Party (PT, Portuguese acronym) and former president of Brazil between 2003-2010, was elected president for a four-year term with 50.9% of the vote in a very tight electoral run-off against Liberal Party incumbent Jair Bolsonaro. Electoral turnout reached 79.4% and with a relatively calm election day, Brazil extended its democratic track record, which it regained in 1985.

Lula campaigned on promises to reimplement or expand some of the social programs created during the PT governments between 2003 and 2016 and to extend the role of the public sector in the economy while tackling inflation. During the campaign, the elected president and his economic advisors provided few details on how they would implement the government agenda over the next term. Regardless, in our opinion, a U-turn in economic policy direction is highly unlikely. Brazil's key credit strengths and vulnerabilities are structural, somewhat limiting both the upside and the downside to the sovereign credit rating (BB-/Stable/B). They include Brazil's weak fiscal position and institutional complexities; considering the country's very detailed constitution and an extensive political process to reform it will likely result in very gradual policy implementation over the next four years.

Frequently Asked Questions

What are Lula's top economic priorities in the new administration?

The elected president's campaign was very ambiguous about his economic agenda and how to implement it. Over the course of the campaign, Lula refused to indicate whom he might appoint to key economic policy posts, instead focusing on achievements of his past terms and attacking the economic policy of subsequent governments.

Key campaign promises included concepts like larger individual income tax exemptions, a higher minimum wage, sustaining "Auxilio Brasil at R$600 (which would likely be renamed back to "Bolsa Familia"), more social housing, universal internet access, and fighting inflation and hunger, as well as creating new ministries.

Lula spoke against Brazil's 2016 labor reform, the central government spending ceiling, and the privatization process promoted by the Bolsonaro administration. Overall, the PT favors government and government-related entities taking a greater role in promoting economic development.

Will Lula have the political capacity to implement his government agenda?

In our opinion, Lula's political capacity will be limited. Congress remains a key anchor for the status quo in Brazil, even more so than at any time in the recent past. The PT couldn't significantly expand its representation at the legislative elections and will hold only 16% of the house seats and 12% of the Senate. Including left-leaning parties, representation increases to 32% of the house and a less than a fifth of the Senate, far from simple or qualified majorities to pass government-proposed legislation.

Lula could still enjoy support from the political center on a case-by-case basis, following political negotiations and proposal moderations, increasing the likelihood of a simple majority in Congress and allowing the government to pass budgets and complementary legislation, and to ratify presidential vetoes.

That said, constitutional amendments in Brazil require two votes in each house of Congress with a three-fifths qualified majority. Most significant items in Brazil's current political debate, including tax reform, revisions of the fiscal rule, public servants' careers, and labor code, among others, would imply changes to the constitution. Right to center-right party representatives hold enough votes to block any constitutional reform proposal, requiring further moderation for reform proposals to advance.

Overall, we continue to expect very gradual policy implementation, translating into a persistently weak fiscal situation and low economic growth--key rating weaknesses--over the next government term.

Can Brazil's fiscal policy become very expansive without compromising creditworthiness?

It's unlikely. After withdrawal of fiscal support in 2020-2021, coupled with a tremendous effort to freeze salaries and reduce the payroll, the Bolsonaro government was successful at creating some fiscal flexibility and improving fiscal accounts. However, high inflation, which in the last year facilitated fiscal consolidation, would translate into less capacity to withstand spending pressures, especially on salaries; furthermore, higher interest rates over the forecast period will sustain high general government deficits, which we expect will average 6% of GDP during 2022-2024 (chart 1).

Chart 1

With gross general government debt and net general government debt trending toward 90% and 70% of GDP, respectively, by 2025, greater spending not sustained by structural revenues, which are already high in Brazil, will likely increase financing needs and debt levels, further exposing the country to rollover risk and higher debt cost, therefore adding downward pressure on the sovereign rating.

What does S&P Global Ratings expect from government promises to revoke Brazil's spending ceiling?

An important note is that any spending above the ceiling or changes to the rule will require the approval of a qualified majority in Congress. Unilaterally breaching the ceiling is a constitutional offense and a reason for presidential impeachment. Over the past years, Congress has gradually increased its influence on the national budget and incremental spending could benefit congressional representatives. That said, given the country's very weak fiscal profile, we still believe a greater share of congressional representatives understand the risk of a fiscal de-anchoring scenario.

Lula has publicly stated his intention to end Brazil's spending ceiling due to its restrictive nature. Embedded in the constitution, the spending ceiling caps central government primary spending to the previous year's primary spending level adjusted by inflation. In theory, if the economy grows in real terms--and tax revenues rise in line with economic growth--primary and nominal results would improve, resulting in declining debt levels. Since its implementation in 2017, the rule has translated into net general government debt stability in terms of GDP. In particular, it forced a meaningful fiscal adjustment following a very significant countercyclical expansion in 2020.

That said, the spending ceiling generally failed to contain mandatory spending growth in detriment of discretionary spending. An overwhelming majority of Brazil's primary spending is mandated by the constitution or other legislation, indexed to inflation, and/or linked to revenue performance. Public sector employees enjoy job stability. Recent pension reform has helped to contain pension spending, but decades of pension system mismanagement has translated into onerous pension costs. Discretionary spending in 2017-2021 averaged 1.7% of GDP, which is about the space the new government will have to implement fiscal policy. Therefore, while limiting the overall risk of increasing the debt level, the spending ceiling also led to an even lower level of discretionary spending or public investment vis-à-vis current spending.

Overall, in a context of relatively weak growth expectations, changes to the fiscal rule will only be sustainable if they can break automatic spending growth inertia. Changes that allow higher spending without credible efforts on fiscal consolidation would most likely weaken Brazil's debt profile and creditworthiness.

What does S&P Global Ratings expect from current political debate to reform the tax code?

For decades, modernizing Brazil's tax code has been on the political agenda and discussed by administrations of different ideological backgrounds, but has failed to materialize. Paying taxes in Brazil is complicated and burdensome, a key component of the infamous "custo Brasil." In addition, Brazil has relatively large government revenues compared with emerging markets (chart 2), which in addition to the "custo Brasil" increases the cost of operating in Brazil and restrains investment.

Chart 2

As currently designed, the tax system gives significant taxation capacities and independence to states and municipalities through indirect taxes. Taxes levied on the origin of goods motivate states to grant hefty tax benefits to attract investors, translating into relatively high levels of forgone revenues.

The lack of consistency among state tax codes evidences weak regional coordination and limits interstate goods production capabilities. Adding to the system complexity, service taxes are a municipal competence. By law, ISS (Portuguese service tax acronym) ranges from 2%-5%, but it implies another 5,568 tax codes (the number of Brazil municipalities) and services being comparably undertaxed vis-à-vis goods.

Two competing revenue-neutral reform proposals before Congress intend to partially solve the tax code complexities. Both initiatives propose to consolidate a number of indirect taxes on consumption of the different levels of governments. The proposals differ on the capacity of states and municipalities to determine the tax rate.

Reforming Brazil's tax code will likely affect states' and municipalities' revenue-generating capacity, which would also require a revision of the intergovernmental revenue-sharing agreement and the creation of compensation mechanisms, which would likely weigh on the central government fiscal accounts over the long term. Both candidates promised to advance tax reform, but it would likely be a lengthy and complex process.

Still, if only by reducing the number of taxes and creating consistency among the numerous tax codes, less-ambitious tax reform would still lead to positive cycles by strengthening (and clarifying) the rule of law, boosting predictability and investment levels in the country, and thereby creating the basis for higher economic growth in the long term.

Can the PT administration repeal some of the microeconomic reforms implemented by the previous government?

Most of the revisions to the regulatory and concession framework were not constitutional amendments, but fully reversing them would require a simple majority in Congress, which the PT will lack. In light of the very weak governmental capacity to invest, we believe the Lula government lacks incentives to fully reverse changes promoted by the Bolsonaro government that have led to higher levels of private sector investment in recent years.

Is Brazil's recent pickup in economic growth sustainable?

Along with most of Latin America, Brazil's poor economic growth performance is a key credit weakness. Despite the country's relatively stable institutional anchors, diverse economic structure, and strong external sector, Brazil's trend growth is estimated at only 1.8% over 2022-2024. In the past 12 months, however, we have revised upward our 2022 growth estimate to 2.5% from 0.8%, reflecting more resilient than expected consumption and investment, and very favorable commodity prices during the first half of 2022. Drivers of consumption and investment include the one-off post-pandemic economic reopening effect but also a marked increase in employment, helping to sustain household disposable income, a broad improvement in Brazil's regulatory and concession framework, and a healthy financial system.

Monetary authorities' efforts to contain inflation will result in more adverse domestic and global financing conditions, resulting in a slowdown in 2023 toward 0.6%. That said, assuming only gradual changes to Brazil's macroeconomic policies and more-favorable financing conditions in 2024 and onward, we would expect Brazil's GDP to grow 2% in 2024-2025. Although very welcome when considering the 2012-2021 average of 0.4%, growth in Brazil will continue to compare poorly with that of most emerging markets in Europe, Middle East, and Africa, and Asia (chart 3).

Chart 3

In addition to higher levels of investment, to unlock stronger economic growth, the new Brazilian government will need to continue to address productivity issues. These include simplification of the tax code, sustain efforts to improve the regulatory framework across levels of government, improve the rule of law, and strengthen education standards of the Brazilian population. Given the structural nature of the problems outlined above, it remains unlikely that we could see a material reform of them in the next four-year term.

Why is it so difficult to reform Brazil's economic model?

As part of its transition from a military to a civil government, in 1988 Brazil approved a constitution that embedded many social rights as a means to promote equality. It was also a key safeguard of a then-newly designed economic and social model, with much prescriptive content that is usually absent in constitutions around the world. Over time, judicial decisions have tended to expand the scope of constitutional rights, with a major impact on economic policies. In addition, much of government spending (and revenue) is legally earmarked for specific purposes by the constitution, reducing budgetary flexibility.

As a result, policies that would require ordinary laws and simple majorities in the legislature in other countries require qualified majorities in Brazil due to its constitutional nature, in the context of congressional fragmentation. This forces Brazilian administrations to spend much of their political capital in passing such laws.