Tax racket: who's afraid of a hundred million Chinese factory hands? Not Brazil.

Nestled in quiet green hills in the countryside, Flextronics' Sorocaba plant has 1,500 employees. Wearing white coats, hairnets and special shoes to prevent static electricity from damaging equipment, assembly-line workers walk amid a buzz of whirling machines. A contract manufacturer, Flextronics makes products globally for brands as varied as computer giant Microsoft, Germany's Siemens and copier company Xerox in the United States.

Robot hands snap parts together at lightning speed, like wading birds snapping up minnows in a marsh. Workstations fill a room so big that it seems that androids instead of cellular telephones will emerge at the end.

It's a long drive from bustling Sao Paulo, and quite a stretch of the imagination these days. Why would any company stay in South America when a chance to manufacture for pennies can be had in China? Chinese factory workers earn less than US$1 per hour, and by 2009 will earn just $2 an hour, according to the Boston Consulting Group, less than what Brazilian workers make today. There are 800 million Chinese in the countryside--more than four times the total population of Brazil. If even some of them leave the fields for factory work, low-level salaries around the globe will remain depressed for decades to come.

The answer: Brazilian import taxes make it too expensive to leave. During the 1990s, Chile and Malaysia were heaped with international scorn for protecting domestic capital markets by restricting the movement of investment money. (Both were later vindicated.) Brazil, since the late 1950s, has done the same in high tech industries, restricting--in effect--the movement of its labor through punitive taxes on imports.

Even as Brazil works to open markets to its soybeans and sugar, it holds the door shut on electronics.

Many products made outside, even in cheap Asian product mills, just can't be sold competitively inside the country, manufacturers say. And that has some shaking their heads. A $1,000 computer sold in the United States costs $1,300 in Brazil once taxes are added, says Terry Kahler, computer maker Dell's vice president for Latin America. While the government may collect hefty tax revenues from those import duties, he says, it is missing out on other revenue sources. Flextronics estimates that taxes add between 15% and 20% to a product's cost.

Meanwhile, gray market computers--assembled from parts and outside the tax system--account for as many as half of the 3 million hard drives sold in the country and perhaps another 50% of notebooks sold in Brazil, Kahler says. More than 70% of the desktop market is contraband, he estimates. Legal manufacturers, he says, are the only ones paying taxes at all. "The government has set up an environment where those who profit are those who sell contraband," Kahler says.

In part to serve an important market, and in part to beat the taxes, Dell manufactures servers and desktop computers in Brazil, at Eldorado do Sul near Porto Alegre in the state of Rio Grande do Su]. "We are really not asking [Brazil] not to collect money; we want them to collect more by collecting taxes in the right place" Kahler says.

Those tax policies drive decisions good and bad. PalmOne, the U.S. maker of the handheld computer devices, manufactures two of its products in Brazil to get around the hefty import tariffs. Doing so, says Carlos DeVries, company director and general manager for Latin America at PalmOne, makes his company competitive. Manufacturing outside of Brazil could nearly double the eventual cost of the product inside the country, compared to the U.S. retail price.

Facing such wide difference in prices, foreign tech companies are finding it difficult to grow in Brazil unless they are making products there. "We wanted to expand the customer [base] and the only way to do it was to reduce the street price," DeVries says.

For HP, labor costs were lower in China, but the company finds producing in Brazil cuts the time it takes to get its product to the market. HP can more quickly address the needs of its clients by having manufacturing facilities in Brazil, and it can better meet warranty issues or local technology demands by having its products made in the country, says Dario Llorente, Latin America commercial portables product marketing manager for HP's personal systems group. "We are reaching price points that we couldn't in the past," he says.

Being in Brazil means that Flextronics can offer logistics, refurbishing and distribution services across the country, cutting customers' costs by as much as 20% by producing in-country, says Antonio Federico, business development director at the plant in Sorocaba. Cost savings can even break 30% if parts are made with local supplies, Federico adds.

Stable. "Basically, Brazil continues to be a protectionist country--we have a lot of taxes on imports, and the only way to be competitive is to produce in Brazil. Federico says. Due to the sheer size of the country--180 million people--technology companies cannot ignore Brazil. Despite a 1999 devaluation, a string of global financial crises and a presidential election, Flextronics has remained stable, Federico says.

With the economy improving, business is picking up. Flextronics expects revenues for Brazilian operations to grow by 40% during fiscal year 2005 from fiscal year 2004, which ended in March, Federico says, although he declined to specify dollar amounts. Hefty demand for cellular telephones in Brazil is fueling that growth, which is a boost for the company's plant in Sorocaba, which deals with telecommunications products.

Flextronics entered Brazil in 1997, although it isn't the only contract manufacturer to jump on the bandwagon. Korean electronics company Samsung makes its own products in Brazil and manufactures for others, says Wladimir Benegas, the company's director for digital products in Brazil.

Samsung produces mostly mass-market products for the Brazilian market. The company sells 15-inch computer monitors domestically, although it is trying to sell its 17-inch model. The company will also introduce flat-screen television sets in Brazil by the end of 2004, although Samsung says its cheaper products will drive revenue in the future. "Even international companies are focusing on the lower [end] products," Benegas says.

Samsung owns factories in Manaus and in Campinas, where it makes computer monitors for global companies such as HP as well as computer parts for domestic companies such as Itautec and Semp Toshiba. About 80% of the supplies come from South Korea. "Because Brazil is a closed country, to introduce a new product, you need to invest here, to produce here," Benegas says.

Unlike some of its competitors, Samsung has chosen not to outsource. China maybe cheaper; but it's too hard to get products and services quickly. "China is far away from the Latin American market." says Yong Jin Park, president of Samsung Electronics Latinoamerica.

The company expects Brazilian sales to grow 10% in 2004, compared with 2003, Benegas says. Business since 2000 has been stable, although Samsung hopes sales top 30% by 2006, which would take business to pre-2000 levels, he says. Corporations and governments are starting to spend again on information technology, which helps. "It depends on the economy, of course," Benegas says.

Whether to dodge import taxes or to tap the local market, companies are lining up to go to Brazil. Cellular phone maker Sony Ericsson, a partnership of the Japanese consumer-products giant and Swedish telecommunications equipment maker Ericsson, left Brazil a few years as it refocused its business model.

Sony Ericsson has decided to team up again with Flextronics to sell GSM-standard cellular telephones not only in Brazil but to the rest of Latin America from Brazil, says Anderson Teixeira, Sony Ericsson Mobile Communications rice president and head of Latin America. Sony Ericsson expects to make GSM phones a mass-market product, which makes manufacturing in the country the right decision, he says.

"We want to supply all markets [south of Panama] from the factory in Brazil," says Teixeira. "We want to have a factory achieving large volumes to achieve good production costs at economies of scale."

Yet protectionism is a double-edged sword. Companies that do high volumes of inexpensive goods, like cellular phones and monitors, can compete. Makers of higher-end goods have trouble. Managers at Polycom, a U.S. maker of videoconferencing products, say the taxes are a big crimp in their potential output.

"I think that we could probably double our business in one year if we had normal importation fees--by normal I mean commensurate with other Latin American nations," says Polycom General Director James M. Bell. Tariffs, he says, can increase retail prices to 1.6 times the price of goods sold in the United States. Normal tariffs in Latin America range from 1.15 to 1.25 times the U.S. price, he says.

For Polycom, there are no local competitors for the government to protect, says Bell, who says he believes the government should exempt tariffs on products that sell in smaller volumes. As it is, thanks to those costs, Polycom won't be opening a factory in Brazil any time soon. It manufactures in Thailand, China and Israel.

FORREST JONES * SOROCABA, BRAZIL