By Marcela Ayres

BRASILIA (Reuters) -Brazil’s government on Thursday detailed spending cuts aimed at achieving more than 70 billion reais ($11.8 billion) in savings over the next two years to support its new fiscal framework, but investors remained anxious, roiling financial markets.

Investors were surprised by an announcement that tax exemptions would rise, and worried that the government was relying on overly optimistic fiscal projections. The Brazilian real ended at its weakest closing level ever at 5.99 per dollar. Interest rate futures rose further and the Bovespa stock index fell some 2%.

Barclays said the highly anticipated measures to curb expenditures were overshadowed by income tax reform plans aimed at easing the burden on the middle-class. It said this limited credibility of the measures and necessitated a firmer response from the central bank.

Uncertainty over the fiscal outlook had already led the central bank to call for structural measures to control spending, accelerating its tightening pace in November with a 50 basis-point hike that brought interest rates to 11.25%.

“We now see the central bank hiking rates by 100 basis points in the next meeting,” said JP Morgan, adding it viewed the government’s fiscal estimates as too optimistic.

Finance Minister Fernando Haddad sought to calm the market following a meltdown on Wednesday over announcement of a proposal to increase the income tax exemption threshold for those earning up to 5,000 reais per month from 2,824 reais.

After weeks of delays, markets had expected the package to focus exclusively on spending cuts, consistent with previous statements by Haddad. Those statements had suggested that the government would wait until next year to propose changes in tax exemptions to fulfill a campaign promise by President Luiz Inacio Lula da Silva.

On Thursday, Haddad told a press conference that the broader income exemptions would carry a 35 billion reais fiscal impact that would be fully neutralized by compensatory measures, taking effect only in 2026 after Congressional approval.

COMPENSATIONS

The government said around half of the compensation would come from setting a higher effective tax rate for the wealthiest.

The proposal would hike the effective income tax rate for those earning more than 600,000 reais per year. The rate would reach 10% for individuals earning over 1 million reais annually.

The current effective tax rate is 4.2% for the top 1% of earners and 1.75% for the top 0.01%, government figures showed.

To cover the remaining fiscal hit, the government would end the income tax exemption for retirees with severe illnesses or who suffered accidents and who earn above 20,000 reais per month, among other measures.

Media reports of a coming increase in the income tax exemption had already soured market sentiment even before the official announcement.

Haddad said the U.S. dollar had been strengthening globally, and that inflation in Brazil is expected to end the year within or very close to the official target range of 1.5% to 4.5%.

“The market needs to read again what the government is doing. They’ve been wrong in terms of growth and deficit (projections),” Haddad said. “Our work is not done. I don’t believe in silver bullets. I’m happy with this year’s results.”

($1 = 5.9377 reais)

(Reporting by Marcela Ayres; Editing by Gabriel Araujo, Angus MacSwan, Bill Berkrot and David Gregorio)

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