By Marcela Ayres

BRASILIA (Reuters) -Brazil’s government on Wednesday proposed to expand income tax exemptions for lower-income Brazilians and increase taxes on those who earn more, while outlining plans to trim public spending in coming years.

Brazilian markets sank ahead of the televised announcement by Finance Minister Fernando Haddad, on reports that the government was introducing the income tax reform instead of focusing exclusively on the long-awaited spending cuts.

The Brazilian real slipped 1.8% on the news to 5.91 per U.S. dollar, its weakest close ever in spot trading. Brazil’s benchmark Bovespa stock index slid 1.7% and long-term interest rates climbed sharply higher.

After markets closed, Fernando Haddad announced what he described as “the biggest income reform in our history,” proposing to raise the tax-free threshold to 5,000 reais ($842) per month from 2,824 reais per month, while making up for the lost revenue with higher taxes on those earning over 50,000 reais.

The bigger tax exemption carries out a campaign promise by leftist President Luiz Inacio Lula da Silva.

Haddad also outlined the key elements of a much-anticipated spending cut package, which are expected to generate savings of 70 billion reais ($11.8 billion) over the next two years.

All the measures still need be formalized and then voted on by Congress. They come after weeks of internal government debate and repeated delays to proposed spending cuts, which the government had initially aimed to announce after municipal elections at the end of October.

Uncertainty over the fiscal measures has been driving volatility in Brazilian markets amid concerns the government has not done enough to meet new budget rules passed last year to rein in the growth of public debt.

“The market was expecting something more concrete, relevant, on spending cuts,” said Lucelia Freitas, a foreign exchange specialist at Manchester Investimentos. “But the announcement on income tax went in the opposite direction.”

Haddad argued that the shifting income tax burden would help Brazil’s middle class without creating a net fiscal impact, adding that the policy was “in line with established international standards.”

A government official, speaking on condition of anonymity, expressed disappointment with the inclusion of the tax exemption in Wednesday’s speech, warning it could overshadow new spending controls and hurt talks in Congress over the fiscal package.

MINIMUM WAGE, MILITARY PENSIONS

Among the measures to control public spending, Haddad said real growth of the minimum wage would stay within the same limits that apply to overall expenditure, reining in the growth of various mandatory expenditures linked to the minimum wage.

He also said that military pensions would now be subject to a minimum retirement age, and public sector salaries would be capped according to a constitutional ceiling.

On another front, he announced restrictions on the annual “wage bonus” benefit, which boosts the income of the poorest formal workers.

Haddad said in case of a primary deficit, the creation, expansion or extension of tax benefits will be prohibited.

Lula, who has openly opposed calls for fiscal austerity, last year approved a new fiscal framework that combines primary budget targets with a cap that limits overall spending growth to up to 2.5% above inflation.

However, with many mandatory expenses – such as social benefits and pensions – rising at a faster pace, the new rules have constrained funding for investments and operational costs.

Many economists have warned that, without reforms to curb mandatory spending, the framework would become unsustainable within a few years.

(Reporting by Marcela Ayres, Victor Borges and Lisandra Paraguassu in Brasilia, Fabricio de Castro in Sao Paulo; Editing by Brad Haynes, Chizu Nomiyama, Alistair Bell, Paul Simao and Sonali Paul)

---