Scenarios for Different R&D Tax Bills

            While the coalition will push for the R&D tax bill proposal that grants companies maximum fiscal incentives, there is a possibility that modifications will be needed in order to get the bill ratified by the government. Resistance to the proposal will likely be aimed at the preferential incentives given to the transportation industry.  There may be pressure to limit the approved preferential tax credit to the base level for all other companies: 15%. Therefore, we need to examine the following scenarios for the R&D tax bill:

·       Scenario 1:  50% for all 5 years (2002-2006);

·       Scenario 2:  50% for the 1^st year, with reducing levels up to 2006, when the base level of 15% is applied;

·       Scenario 3:  30% for the first 4 years (2002-2005), and the base rate level of 15% for 2006; and

·       Scenario 4:  No preferential level is given, so the base level rate of 15% is applied for the 5 years (2002-2006).

The following tables show calculations of how much resources can be saved at the different scenarios by Embraer:

Scenario 1

Scenario 2

Scenario 3

Scenario 4

             As can be seen from the tables above, Embraer stands to save between US$ 196.5 million (Scenario 4- Least Favorable) to US$ 655 million (Scenario 1- Most Favorable). 

The Tax Credit bill will expire 31 December 2005.  Upon expiration, the bill could be renewed for another four years, but only at the cross-section level of 15%. The Ministry of Finance will make the decision after evaluating the effectiveness of the bill during the initial 5 years. 

Overall Result From Changes to Subsidies 

The Canadian government provides several subsidies to its aerospace industry. Those benefiting Bombardier are: 

·       Canada Account

·       Technology Partnerships Canada

·       Invest Canada

·       Province of Quebec

·       Export Development Corporation (EDC) 

The DSB Panel ruled that Canada Account and Technology Partnerships Canada had to be changed, and the Canadian government complied. The EDC, Invest Canada and Province of Quebec are still under investigation in the WTO/DSB, and are suspected of needing changes.  Presently, these support mechanisms allow the company to export to risky markets while taking less risk when using Canada Account. Thus, there exists the need for Embraer to find an alternative way to compensate for this handicap, which will be the proposed R&D tax credit.  The adaptations would result in a reduction in support to Bombardier in its research efforts to develop new products or acquire new technology. However, after the changes are implemented, the stricter conditions on loans will negatively impact Bombardier. 

            It is estimated that if the EDC, Industry Canada, and Province Quebec subsidies were to be restructured according to WTO rules, Bombardier would experience a drop in subsidies of roughly US$ 200 million annually.[1]  Meanwhile, the burden to Embraer from using Proex III would be small because of the implementation of the R&D bill, amounting to a net loss of around US$ 40 million. Therefore, Embraer should gain an overall advantage over Bombardier, while both companies will be performing on a ‘level playing field’. 

            Embraer would be better off with either Proex III or IV and Bombardier not having access to their existing illegal subsidies.  The final price of Embraer jets would be around US $ 1 million cheaper than its rival’s jets. Therefore, Brazil needs to reach an agreement with Canada to restructure its illegal subsidies according to WTO rules, while agreeing to do likewise with Proex. The Government can even argue that it is willing to add the exposure fee to Proex (turning it into Proex IV), as requested by the Canadians, and Embraer will still be competitively better off. 

Economic Analysis 

            Although the new conditions to be placed on Proex would inflict a noticeable commercial impact on Embraer, the overall damage is more significant. Embraer’s symbolic stature: the the country’s largest exporter and competing internationally in a high-tech sector, means that there is more at stake to the Government, the Brazilian people, and the reputation of Brazilian products abroad. The Government wants to ensure the well being of Embraer because several departments and politicians have revered it in public speeches. Many Brazilians are aware of Embraer, and admire the company because of its success story of moving from a State-owned firm to the lead exporter in the nation. Indeed, various business journals have written about Embraer’s case as a success story. In fact, a campaign called “Made in Brazil” in which Brazilian products are promoted abroad has used the aircraft producer as a leading indicator of the quality level of Brazilian products.

External Debt 

            In order to be able to speculate what possible legislative solutions are feasible, we need to understand the significance of Brazil’s external debt, and how it affects the government’s budget. The external debt places a huge weight on the Government bodies’ ability to finance budgeted activities because the government spends significant amounts to service its foreign debt. As a result, the Ministry of Science and Technology has not been able to implement its R&D promotion programs as stated in its policies. Indeed, the government finds itself obliged to cut back on social policy investments, such as health and education, in order to meet its financial obligations of foreign debt. 

            Over the last decade, the foreign debt has been an enormous concern in Brazilian politics because it has accounted for 40% - 50% of GDP.  Furthermore, a large portion of the Ministry of Finance’s revenues goes to servicing the debt, while attempting to reduce it.  The government’s main strategy to tackle this problem has been to improve the trade balance through increased exports in order to collect hard foreign currency to reduce the external debt. This is why the Brazilian Government designed PROEX in 1991.  PROEX provides more favorable lending conditions to foreign buyers, thereby encouraging higher exports of Brazilian goods and services.  It can therefore be seen as a tool to tilt the trade balance in Brazil’s favor by encouraging exports. 

Effect of Restricting Proex 

            Exporters using the Proex Equalization program would have their final prices raised. As stated above, Embraer jets will end up costing about US$ 1 million more per jet for the customer. The actual selling price remains the same, but the amount owed by the customer after accounting for interest rate charges will be higher than with the previous Proex (version I). The impact will be small to other exporters using Proex because most of the exports involve lower value products. 

            Brazil will export about 8 jets less per year, amounting to US$ 144 million; while importing US$ 100 million less, since there will be no need for the foreign aircraft parts. The end result is a negative impact on Brazil’s trade balance of US$ 44 million. There should be no effect on productivity because Embraer is already working at almost full capacity. Similarly, the impact should be too small to affect wages of the employees. Consumers, i.e. the airlines, will be less well off because of the increase in price of the aircrafts.

Effect of Granting R&D Tax Credits 

            In the short-run, the R&D tax credit should allow for some fall in prices by most companies. Embraer will use the kept income taxes to lower the final price to its customers. In the long-run, the tax incentive should lead to higher exports because of the reduced transportation costs resulting from the R&D tax law. Also, the increase in R&D spending should lead to better products through innovation, thereby favoring customer welfare. Production and productivity levels should increase in the long-run.

The IT Sector 

            To better comprehend the economic benefits from adopting a R&D tax credit, we can look at the implications of the IT Law to the Brazilian IT companies. The Ministry of Science and Technology carried out a study that evaluates the impact of the IT Law 8.248/91 on the Brazilian IT industry.[2] Among the study’s findings are the following:

FACTS:

·       R&D investments increased during the period of 1993 to 1998 from R$ 299 million to R$ 742 million. Averaging 22% growth per annum.

·       Out of 1,591 applications for the tax incentives, 1,121 were accepted, i.e. 70% approval rate; and 107 were accepted for the Income Tax exemption, i.e. 9% of requests.

·       From 272 companies, 94 used Income Tax incentive, i.e. 34%.

·       During 1994-1998, intra-firm R&D expenditures increased from R$ 224 to R$342 million, amounting to an annual increase of 11% in spending.

·       About a quarter of expenditures went to joint public research programs.

·       There is a concentration of R&D investment: 90% by 30 companies.

·       The IT Law attracted Multi-National Corporations (MNCs) to establish in Brazil to produce goods that were being imported up to that point.

·       Overall, there was an increase in revenues by the companies of 52% between 1994 and 1996.

OPINIONS:

·       All companies interviewed considered the tax incentives, both IPI and Income Tax exemption, to be very important for their competitiveness and their technological development;

·       84% changed their technology policy in terms of amplifying their local production and developing new product lines, increasing their R&D expenditures, and amplifying their investments in training of technicians and engineers; and,

·       95% found that R&D activities were considered a determining factor in their firm’s competitiveness.

RESULTING R&D ACTIVITIES:

·       An improvement in planning and following up on medium to long-term R&D activities;

·       Improvement in cooperation with public research and technical institutes;

·       Modernization of production lines; and,

·       Creation of new product-lines.

The improvement in production performance by the firms was achieved through:

·       Optimization of production processes;

·       Increased production efficiency;

·       Reduction in product development cycle;

·       Implementation of quality verification systems;

·       Better up-stream integration with the company’s suppliers;

·       Development of new technologies; and

·       Reduction in faulty outputs, thereby reducing aggregate costs.

The report concluded that among the external benefits experienced was the increase in revenues by the companies and in turn the higher volume of taxes paid to the government. 

Accounting for Taxes Foregone  

By granting tax credits to companies investing in R&D, the government (Ministry of Finance) will forego collecting some of their income taxes. While the nature of the R&D tax bill will imply granting greater amounts of tax credits to companies than the IT Law did, it is not too much greater: 

·       The transportation industry is 1.5 times the size of the IT sector, which would imply that greater tax credits would have to be given, but the industry invests, on average, less than half of what the IT sector does. So, the tax credit volume given to the transportation industry will be over half of what is given to the IT sector.

·       The rest of the industries in Brazil spend relatively little in R&D, meaning that only small volumes of tax credits would have to given to the companies. The only industries that spend much on R&D are the pharmaceutical, chemical, petroleum (which is exempt from this proposed bill), and engineering industries. Studies show that the IT sector’s R&D expenditures represents 26% of all R&D spent in Brazil. So, considering that the proposed tax credit for the other industries will be:

= 15% / 50%= 30%

We can estimate that the tax credit volume towards the other industries will be:

= ((1/0.26) * IT volume) * 30%

= 1.2 * IT volume

  So, the volume of tax credits expected for the R&D tax bill will be:

= 0.5 * IT volume [transportation industry] + 1.2 * IT volume [other industries]

= 1.7 * IT volume

So, the R&D tax bill will grant less than twice the amount of tax credits currently offered by the IT Law to the IT sector. Estimates vary for what the IT Law grants annually from between US$ 280 million[3] and US$ 470 million.[4] Therefore, we can expect the R&D tax bill to be granting an annual amount of tax credits between US$ 500 million and US$ 800 million. 

Compensating for Foregone Taxes  

            To make up for the uncollected corporate taxes, the government can use the Proex resources that were freed-up from redesigning the financing subsidy, i.e. Proex III.  The changes to Proex reduced its budget allocation from US$ 2.7 billion in 1997 to US$ 820 million for 2000,[5] and US$ 1.1 billion for 2001, resulting in over US$ 1.6 billion being liberated. The government should be persuaded that a portion of these US$ 1.6 billion be directed towards accounting for the taxes foregone by the R&D tax bill, which should amount to less than half of this value. 

Additionally, even though there will be a deficit in taxes collected by the government in the short-run, the medium to long-term outcomes will more than compensate for this because: 

·       The reduction in costs in the transportation sector will lead to greater commercial transactions and exports. In turn, more taxes will be paid to the government, as well as causing a positive tilt on the national trade balance;

·       There will be an increase in production by the parts suppliers of the transportation industry, which will lead to greater tax payments to the Ministry of Finance; and,

·       The overall increase in R&D investments by the various industries of Brazil will lead to the economic advantages outlined above (see IT Law) with additional spillover effects due to the broader reach of the bill to numerous industries. 

Political Analysis 

How Politics Work in Brazil 

            Brazil is a presidential and federative republic with considerable decentralized federalism, yet there is an aspect of politics that is different in Brazil when compared to, for instance, the American political system (see Annex A). Brazilian voters often perceive local issues as very important, while paying little attention to the major legislative agendas of deputies or senators.[6] Therefore, legislative members must work differently if they are to secure the support and votes of the citizens. Instead of capitulating on broad ideological positions or national policies, they must look at what issues affect the people in their localities.[7] In order for them to secure votes, they must defer heavily to state-level politicians.[8] Also, according to Anthony Pezzola, “Legislators often pursue policies that cater to specific interest groups, almost exclusively business as most other political interests are poorly organized and lack financial resources, in order to attract campaign contributions.”[9] Federal deputies often have a ‘dobradinha’ (electoral double-up) with local-level candidates, where the former provides funds to the latter, who in turn instructs voters to vote for the federal candidate.[10] This aspect implies that a different approach is needed when attempting to get the legislative body to approve your proposed bill or law amendment. 

Restructuring Proex 

Ministry of Foreign Relations (Itamaraty): 

            The Ministry of Foreign Relations has placed a lot of effort in negotiating the dispute with the Canadians. 

            They want to put an end to this dispute for several reasons: 

·       The lingering situation is creating a bad image on Itamaraty’s abilities to  effectively negotiate;

·       There is a shift of focus to other current trade issues, for example the US soybeans dispute;

·       Itamaraty hopes to prevent the recurrence of Canada’s indirect retaliation through banning Brazilian beef exports due to unfounded allegations that they were contaminated with BSE

·       The Ministry wants to avoid direct retaliation from Canada through the US$1 billion granted by the WTO DSB. 

On the other hand, the Ministry of Foreign Relations is unwilling to make the required changes because it wants the DSB to understand that Proex does not grant any real benefit to Embraer as the DSB concluded in its report WT/DS46/R.  The Minister Celso Lafer, like his predecessor Luiz Felipe Lampreia, has repeatedly stated that he condemns the panel’s ruling as "myopic" and that it does not take into account the context of Brazil's economy. 

            Emphasis will need to be on how the proposal will lead the Canadian government to adapt their subsidies in return. As has been illustrated above that Bombardier receives great benefits from the Canada First program, so both sides would have to make amendments to their subsidy programs, saving face to Itamaraty. 

Embraer has used most of Proex funds. In 1998 it used 90%, in 2000 82%, meaning that only a small portion is available for other exporters. It was only in 1998 that SME's began to take advantage of Proex, so up to that year the budget was not a problem. However, ever since then, SME's have increasingly resorted to Proex, both in loans and interest rate equalization, and the limits of the budget have posed a problem. BNDES requested an increase in budget allocation for Proex so that small businesses can increase their exports.

Canadian Department of Foreign Affairs and International Trade 

            The difficulty that the Canadian trade representatives face is that on the one hand they want to comply with the investigation procedures of the DSB Panel of their subsidies, but on the other, the fact that the subsidies are granted confidentiality in Federal law means that they are constrained. However, Canadian trade representatives will emphasize the need to comply with the DSB procedures to other government agencies, because as a member of the WTO, they are expected to comply with the Agreement. Minister Pierre Pettigrew has been a strong advocate of restructuring the Brazilian export subsidy, while avoiding the criticisms concerning the legality of the Canadian subsidies and stating that Canada will fully comply with the demands of the WTO dispute settlement Panel. Even though previous attempts at reaching bi-lateral agreements on the subsidies issue failed, the representatives have recently announced that they are willing to negotiate the matter further, in hopes of ending the ongoing dispute.  It is the Canadian government’s policy that the export financing terms as specified by the OECD are completely acceptable,[11] and so, if Proex III indeed does satisfy these terms, then the Canadian government cannot argue against Proex III.

BNDES

             The stricter subsidy conditions of Proex would reduce the amount taken by Embraer from the budget. The SME's would then have larger funds for Proex use with its exports. The assumption being that the budget for Proex remains unchanged. However, my proposal includes shifting the funds used previously of Proex I to account for the tax credits granted to Brazilian companies investing in R&D. Therefore, my proposal should free up some more funds to SME's to use Proex, however not significantly.

Embraer  

            Embraer clearly would oppose the modifications of Proex not only because it negatively impacts it exports, but also because it knows and firmly believes that the program does not provide any benefits that its Canadian counterpart does not already have. The company has constantly provided ample information and data regarding customers’ benefits from Proex , and how Proex does not provide any additional benefit other than ensuring that the loans have the same conditions as those offered to Bombardier’s customers.

Exporters Using Proex 

            Exporters using Proex will continue to pressure the Brazilian government to resist modifying the financing system. Arguments used before were that the WTO does not recognize the purpose of Proex, and how it does not provide them with any advantage. Some organizations are more critical of the WTO and argue that the WTO is damaging developing nations because WTO rules were designed to complement the economic conditions of developed countries. Indeed, this criticism has been reiterated by other groups opposing free trade, such as NGO’s and political parties opposing the president’s decision to open Brazil’s markets without due thought to the consequences associated with it. 

Pushing for Tax Credit for Research and Development 

Embraer  

Embraer would have to look for ways to compensate for the additional costs brought by the restrictions placed on Proex. Although there are possible options for compensating for the additional costs, such as sacrificing profits, these options would not be as effective or reliable as the proposal to have tax credits for R&D. 

Embraer invested US$ 180 million in research and development in 2000. It plans to spend US$ 200 million in 2001 and US$ 1.3 billion overall through 2005. R&D is key to product development in Embraer, and the constant growth in R&D investments since the privatization of the company illustrates the significant role it plays in Embraer’s competitiveness.  A tax credit for R&D would greatly benefit the Brazilian aircraft manufacturer. It would secure a significant amount of savings from the income tax owed to the government, which could be used to ensure that loans with favorable conditions are offered to its customers. 

Ministry of Development, Industry and Commerce (MDIC) 

            The MDIC will be a strong supporter of the R&D tax credit proposal because they will want to implement an incentive for businesses to improve their products and increase their competitiveness. Having played a central role in the passing of the IT Law (No. 8.248/91), there is strong reason to believe that they would be interested in campaigning for this R&D proposal because of its similar nature. 

            The I.T. Law (No. 8.248/91) expired in October of 1999 but was extended on January 11^th 2001 through Law No. 10.176. The extension however, changed the tax incentives to the IT companies so that instead of tax credits, the companies were exempt from paying the IPI tax on products purchased for R&D based on a diminishing schedule. In 2001, 95% of IPI taxes were exempted for these companies, and in 2009, 60%, after which time the law would expire. Considering this, the new proposal should exclude the IT companies in order to avoid providing double the amount of tax incentives, as the other industries will receive. 

            The MDIC will need much lobbying to reform Proex because they designed the system, and have stood firmly behind its legality in international trade. The attractiveness of the R&D tax proposal to the objectives of the Ministry should, however, create sufficient internal support for this strategy. 

Ministry of Science and Technology (MCT) 

            The Ministry of Science and technology would welcome the tax credit proposal because of the expansion of R&D activities by Brazilian companies that would result from this legislation. Considering that MCT helped design and implement the Law on IT (No. 8.248/91), they would similarly play a key role in designing the tax credit proposal for R&D. 

            The Ministry would be very active in arguing for the benefits of tax credits for R&D. Further, they would be able to provide research, such as econometric studies, illustrating the economic impact of providing this incentive to invest in research and development.

Federation of Industries 

            The Federations of Industries in Brazil have constantly been striving to improve the conditions for optimal business performance, which since the early 1990’s has meant the reduction of ‘Brazil Cost’. As explained above, reducing Brazil Cost involves making the conditions for running a company easier and less costly. A tax credit for research and development would fall into this effort, so the Federation of Industries should welcome it. 

Medium-to-Large Businesses 

            Companies would certainly welcome the tax credit proposal, especially if they are already engaged in R&D, or if they plan to in the coming years. Even if without plans to invest in R&D activities, the proposal would be an incentive to begin conducting R&D activities. Considering that studies indicate the increasing trend for Brazilian companies to invest in R&D*, they will be very interested in the proposal.

Labor Party and Unions 

            We can expect that the PT party members will not vote harmoniously on the coalition’s proposal. Almost half of the PT voted in favor of extending the IT Law. This is surprising considering that the party’s ideologies run counter to fiscal incentives that benefit capital owners and improve the manufacturing systems at the expense of jobs. However, the support for extending the IT Law may have been a result of some back-door politics of exchanging favors. In order to gain their support for the proposed bill, there should be clauses within the bill that will benefit workers, either through securing jobs or by improving their bargaining position relating to manufacturing processes. An attraction of the proposed bill is that boosting the transportation industries most likely means a greater number of jobs, since these industries tend to be labor intensive.

State Governors 

            Considering that income taxes and IPI taxes are collected at the state level, it would appear that the governors would be concerned by the negative impact that a tax credit would have on their tax revenues. However, with the IT Law there was very little opposition from the governors, mostly due to the political success in implementing the law in 1991, as well as the strength in the arguments advocating for Brazil  to develop its IT sectors or otherwise be left behind in the global economy. Since the adoption of the law, the only opposition has come from Amazonio Mendes (PFL- Amazon) at the time of renewing/extending the law. Mendes was afraid that the law would attract investments away from the Free Trade Zone (FTZ) in Manaus, the capital of his state. Companies also benefit from tax credits in the FTZ of Manaus, as well as several other incentives that lure them there. The governor of the Amazon state therefore felt threatened by the IT law and sanctioned against it. He was in particular opposed to the exclusion of a clause that he had added to the Law which excluded states that had more than 50% of the national IT investments, which was Sao Paulo. Mendes built enough opposition in Congress to require a review of the Law in early January of 2001.[12] On the 11^th of January, however, the President sanctioned the Law without the clause that would have prohibited IT companies in Sao Paulo from receiving tax incentives. Mendes threatened to take the issue to the Supreme Court (Supremo Tribunal Federal), however, he did not go that far. 

            Another sign that the Brazilian governors are not seriously afraid of losing tax money through tax credits granted to companies investing in R&D is the fact that the tax incentives of the new IT Law are based on IPI taxes, not on income tax. The percentage of IPI taxes and income taxes collected at the state level is equal (i.e. 21.5%), yet unlike income tax, another 28.5% is collected by the municipalities. So, if local politicians were concerned about the decrease in tax revenues for their state budgets as a result of the IT Law, they would have opposed the change in the Law that shifted the tax credit to the IPI tax. As explained above, the municipal politicians have a strong influence on the politics in Congress, so it is difficult to argue that the local politicians’ voices were not heard.

Pushing the Canadians to Reform Their Subsidies 

            At the international level, the main challenge will be to move the Canadian government to carry out the changes to their subsidies that benefit Bombardier, and which, according to Embraer , give the Canadian manufacturer unfair advantages. 

            The Ministry of Foreign Affairs will be responsible for influencing the Canadian Department of Foreign Affairs to revise their subsidies. Embraer ’s role will be to help Itamaraty’s arguments, mostly by supplying the information needed to negotiate more effectively with the Canadians. The type of information that Embraer  will need to supply is in respect to its own activities relating to Proex, and any research it finds relating to subsidies Bombardier had or still has access to. 

            Embraer  can also engage internationally on the issue by supporting Canadian interest groups that oppose the government subsidy programs granted to Bombardier. One example is an NGO called ‘Probe International’. They have campaigned over the past 20 years to end some subsidy programs granted by organizations belonging to the Crown Corporation. Particularly, Probe International has focused on the Export Development Corporation (EDC). They claim that the export-financing program is very secretive, and that it funds projects that are environmentally harmful.

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