Johannesburg - This year’s Budget Speech will attract a
great deal of attention. In the Trevor Manual years, the Budget was a fairly
dull and technocratic affair focused on numbers, such as the extent of tax
relief (which was possible in those boom times) and not politics. There was no
doubt that Manual had the support of his colleagues in the Cabinet.
Furthermore, South Africa’s credit ratings were improving, partly as a result
of better fiscal management and also because of a global upgrading cycle on the
back of strong growth. The increased attention on the Budget is largely because
of the threat to South Africa’s credit rating as we are still in a global
downgrading cycle and have experienced a rapid build-up in debt and decline in
growth.
The current dilemma
Chart 1 below illustrates how we got to our current
predicament. In 2009, tax revenues collapsed as the recession hit. In his first
stint as Finance Minister, Pravin Gordhan increased expenditure to help
stimulate the struggling economy by borrowing and turning the modest budget
surplus into a sizeable deficit (this was text-book countercyclical fiscal
policy). Since then, tax revenue and spending have grown roughly at the same
pace. However, to close the deficit and reduce debt, tax revenue has to grow
faster than spending. Economic growth declined and from 2012 onwards forecasts
had to be revised down year after year. The tax revenue assumption in the
Budget is based on the growth forecast, but the initial growth estimate has
been too high every year since 2012. This meant disappointing tax revenue (especially
from companies) and that “fiscal consolidation”, the process of cutting the
deficit and stabilising debt, had to be postponed further and further into the
future. The alternative - to aggressively increase taxes and cut spending -
risked tipping the economy into recession, worsening the debt and deficit ratio
in a vicious cycle.
Chart 1: Tax revenue, expenditure and budget balance as
percentage of GDP
Source: SA Reserve Bank
Tax trends
Chart 1 also shows that taxes have increased as a
percentage of gross domestic product (GDP) over the past few years as GDP
growth declined. According to the Davis Tax Committee (DTC), the current ratio
of 26 percent is above the peak of the boom years and higher than the average
of OECD countries (excluding social security taxes). A further increase to 27 percent
is projected, but it is debatable whether this ratio can rise much further
without killing the metaphorical golden goose. This means that either economic
growth needs to accelerate to increase tax revenue at a stable ratio or
spending as a percentage of GDP needs to moderate.
Read also: #Budget2017: DA presents own tax proposals
Chart 2 shows important trends in terms of the three main
tax items. Company taxes surged to 30 percent a share of total tax revenue at
the peak of the commodity cycle, but fell to around 20 percent (or from 8
percent to 5 percent of GDP). This is the cost of weak growth. Company tax
collections could show some improvement as mining profits rebound.
Chart 2: The three main tax items
Source: SA Reserve Bank
The decline in company taxes had to be made up largely by
personal income tax (PIT), which has been surprisingly robust growing faster
than nominal GDP over the past few years. This was supported by wage
settlements consistently in excess of inflation while asset price increases
also helped (and a 1 percent increase in the tax rate in 2015). According to
the DTC, the richest 10 percent of the population (who earn 63 percent of
income) contributes 86 percent of PIT, and the buoyancy of PIT suggests this
segment have done well despite tough times elsewhere. But there are also limits
to how much this segment can be squeezed further, as it already funds a third
of government spending through PIT and contributes to value-added tax and
municipal coffers (not included in the Budget). Value-Added Tax (VAT)
collections tend to rise and fall with the economic cycle but is very stable
compared to company tax. Growth in VAT slowed down to close to zero in the
middle of last year. However, it has rebounded to 7 percent by December as the
economy improved.
The R28 billion question
The Finance Minister is expected to stick to the fiscal
consolidation plans as set out in the October Medium Term Budget, but doing so
will require R28 billion extra in tax revenue relative to the February 2016
baseline for the coming fiscal year. How he plans to fill this R28 billion gap
is probably the key item to watch in this year’s Budget, since there is no
luxury of much faster growth.
Funding this gap will be challenging in its own right,
but also comes against the backdrop of a broader discussion of where the burden
should fall, given the concentration of wealth and widespread poverty. The
easiest way to close the revenue shortfall is through VAT. A 1 percent VAT rate
increase could raise around R20 billion extra. South Africa’s VAT rate of 14
percent is below global standards and has not changed since 1993. However,
since rich and poor alike pay VAT, it is not seen as politically feasible to
implement an increase at this stage (although it is likely at some point in the
future). In contrast, some form of “wealth” tax would be politically popular
(and symbolically important given the extreme income and wealth inequality) and
is likely at some point in the future. However, it would not raise significant
amounts of additional revenue. For instance, increasing the marginal tax rate
by 3 percentage points to 44 percent on taxable incomes above R1 million per
year (130 000 taxpayers according to SARS’ 2016 Tax Statistics publication)
would increase revenue by roughly R7 billion, assuming no changes in the
behaviour of taxpayers.
Read also: #Budget2017: Eyes on solution to R28bn shortfall
According to the DTC, estate duty collections have
declined in real terms and relative to other taxes and play a small part in the
overall tax take compared to other jurisdictions. If the share of estate duties
in overall tax revenue increases from around 0.17 percent to approximately 0.5 percent,
where the UK currently is, an additional R4 billion could be raised.
Since the wealthy has larger estates, this would be progressive, but the DTC
also noted that difficulties in compliance and administration associated with
collecting these taxes might make more aggressive targets unrealistic.
Another approach would be a tax on wealth (assets) as
proposed by French economist Thomas Piketty in a 2015 lecture in Soweto. We
have limited detail on household assets - as the DTC noted, the asset
declaration associated with such a tax would yield valuable information on who
owns what - but the Reserve Bank’s estimate of household net wealth for 2015
was R9 384 billion, including property and financial assets and excluding debt.
Assuming the distribution of wealth is narrower than that of income with the
richest 10 percent accounting for 80 – 90 percent of the total, an annual tax
of 0.1 percent on net wealth could yield around R7 billion, but with
considerable challenges in administration and compliance. For instance, it
would place great strain on the cash flows of these taxpayers, whose wealth
might be in illiquid assets. There are very few examples of such taxes in the
world, but then South Africa is unusually unequal. It is also clear that the narrow
tax base means wealth taxes will not be a game changer in terms of government
funding.
The South African company tax rate of 28 percent is
already higher than the OECD average of 24 percent. The election of Donald
Trump and Brexit is expected to result in downward pressure on corporate tax,
not just in the US and UK, but also with knock-on effects elsewhere. However,
effective company tax rates are always lower as companies engage in various
activities to reduce their tax bill (including transfer pricing and base erosion)
and Government also offers a number of tax incentives. Emphasis is therefore
likely to be on closing any loopholes, and possibly redirecting some of the
incentives or subsidies (for instance, the World Bank recently proposed
reducing the effective tax burden of manufacturers, which is higher than for
mining firms). So changes in company tax rates are unlikely, but since
corporate tax revenue is highly sensitive to economic growth, corporate tax
revenues are likely to improve.
A combination of sources
Therefore, the Finance Minister is likely to turn to a
combination of sources, instead of a big change. A 1 percent increase in the
marginal income tax rate for the 3 million taxpayers with a taxable income of
more than R150 000 per year could raise approximately R10 billion rand.
Limiting fiscal drag relief could add another R5 billion. The contentious sugar
tax (a 20 percent tax on sweetened beverages) could earn a further R5 billion
according to Treasury. A 30 cents increase in the fuel levy from the current
level of R2.85 per litre – the same increase as last year - could raise an
additional R6 billion. However, financial troubles at the Road Accident Fund
could necessitate an increase in the RAF levy, limiting the scope for a fuel
levy increase. The voluntary disclosure programme related to offshore
investments is expected to net as much as R15 billion over time, but not
necessarily in the coming fiscal year.
The DTC’s work continues, suggesting restructuring the
tax system to get the optimal mix of tax revenues, balancing growth, equity and
efficiency. This might include wealth taxes in the future. A structural
increase in state spending – such as the proposed National Health Insurance –
could lead to a structural increase in tax revenue as a share of GDP. At the
same time, 2 percent faster growth at a static 26 percent tax to GDP ratio
would yield an additional R17 billion. Therefore, faster economic growth is
required to keep Government’s finances on a sustainable path. However, for the
time being, it is a case of getting the most out of existing taxes.
Spending under control
On the spending side of the equation, there is no
shortage of competing demands, with calls for free tertiary education still top
of mind. Treasury has a reputation for discipline in spending growth (not
always matched elsewhere in Government). It is expected that the expenditure
ceiling which has done much to build fiscal credibility will be adhered to.
Charts three and four from the Medium Term Budget Policy Statement (MTBPS) show
that progress has been made in terms of spending discipline as growth in
headcount has moderated and real spending growth slowed sharply.
Chart 3: National and provincial headcount, millions
Chart 4: Actual and planned growth in real non-interest
spending, percent
Source: National Treasury 2016 MTBPS
The most immediate risk is the public sector salary
agreement that expires at the end of the coming fiscal year. The proposed
nuclear build programme remains a source of uncertainty, but it is unlikely that
the Budget will make provision for it.
Unfortunately, fixed investment, rather than salaries,
typically bears the brunt of attempts to control spending. Government fixed
investment has increased by almost a third in real terms over the past five
years, but its share of GDP barely increased from 2.9 percent to 3.4 percent.
Implications
Therefore, the deficit reduction as proposed in the 2016
Medium Term Budget - with the budget deficit declining from 3.1 percent
in the current fiscal year to 2.5 percent over the subsequent two years – is
likely to remain on track. What are the implications?
For the economy:
In the short term, fiscal consolidation – higher taxes
and slower growth in government spending - is a drag on economic growth, but
should not derail the recovery. Longer term, the South African economy needs
policy certainty and restructuring of the major state-owned enterprises to
ensure that they no longer put strain on the fiscus or hampers economic
activity and other growth enhancing reforms. The Budget could give updates on
this, but big policy changes seem unlikely before the ruling party’s elective
conference at the end of the year.
For consumers:
Tax increases are expected to come from a variety of
sources but ultimately involves the taxman sticking his fingers deeper into
consumers’ pockets. This will place some pressure on household spending, but
declining inflation should offset the negative impact on real disposable income
to an extent.
For bonds:
A “good” budget is necessary but not by itself sufficient
for securing South Africa’s investment grade rating. Political stability and
faster economic growth will also be required. But Wednesday’s Budget is likely
to be the first step in maintaining current ratings. Either way, a commitment
to fiscal discipline is positive for bonds as it caps the new and therefore
supports prices. Fiscal consolidation tends to put downward pressure on
inflation, making it more likely that the Reserve Bank will consider interest
rate cuts, a further positive for domestic bonds.
For equities:
The company tax rate is expected to remain unchanged,
which means that there is no impact on after-tax profits. Small increases in
dividend withholding tax or capital gains tax are possible, which will make
equities relatively less attractive for local but not foreign investors. Since
the R28 billion tax increase was already announced in October last year, it is
likely to already be discounted in the share prices of domestically-focussed
companies. Sugar and carbon taxes – which will impact a few specific listed
companies - are still being debated and the timing of implementation is
uncertain. Global market developments are more likely to drive the JSE than the
outcome of the Budget Speech.
For the rand:
The rand has appreciated sharply over the past year
despite global and local political uncertainty and the risk of ratings
downgrades. Commodity prices, sentiment towards emerging markets and
expectations for US interest rate increases will more than likely continue to
be the primary drivers of the rand. The Budget is unlikely to change this.
Dave Mohr is Chief
Investment Strategist and Izak Odendaal is Investment Strategist at Old Mutual
Multi-Managers.