How deep the hole

By Chris Hart, Chief Strategist at Investment Solutions and Lesiba Mothata, Chief Economist at Investment Solutions.

The 2015 budget is well intentioned; however, the likelihood of achieving the desired result is doubtful. South African government finances are clearly under pressure. Fiscal flexibility has been declining over the past six years. The previous budget tabled by then Minister of Finance Pravin Gordhan showed signs of financial distress. The distress has increased since then, reflecting the difficulties faced by current Minister of Finance Nhlanhla Nene.

The decline in fiscal flexibility has been self-induced. The public-sector wage bill has been one of the factors but included in that has been the rise in the burden of government, reflected as a percentage of GDP. As expenditures have been rising at a pace faster than economic growth and inflation, slow economic growth has led to a lag in tax receipts. A vicious cycle of a rising government burden has constrained economic growth, retarding the tax receipts, which has consequently reduced fiscal flexibility. Last year’s budget perpetuated this decline, as did the one before.

Slow economic growth will perpetuate and compound the social problems of poverty and unemployment despite the stated opposite intention. The divergence between word (intention) and deed (what is actually done) is wider than ever.

In short: slow economic growth has resulted in the perpetuation of problems such as poverty and unemployment. The country needs higher growth and the most effective way to effect this is to reduce the burden of government. Tax cuts promote growth. Tax increases constrain growth. This budget raises taxes and the burden of government. In essence, it is an anti-growth budget. Past budgets have had a similar effect, but not as damagingly as this one.

Not well understood is that economic growth requires investment. Even less well understood is that the resource that funds investment is savings. There are no other avenues to bring new economic capacity into existence than investment, and there are no other avenues to resource investment than savings. The crux of South Africa’s low-growth problem is a low level of investment, compounded by inadequate savings. The low savings rate lies at the heart of our high unemployment rate. As already mentioned, this is not well understood in South Africa, where intentions and actions are widely diverse. It is against these realities that the budget is evaluated.

On the tax-receipt aspect, are taxes extracted from income generation or capital formation? Taxes that target capital formation (savings) have the same economic effect as eating seeds and then wondering why harvests are not produced. And then the economic value chains need to be considered. Taxes that target the start of the value chain constrain economic growth more than taxes that target the end of it.

Government expenditure can also retard growth. Expenditure efficiency is an important starting point. Inefficient expenditure lowers the economic multipliers. And the expenditure tilt is also important. If the tilt is towards consumption rather than investment, the economic growth potential is lowered.

On the tax-receipts side, both income and capital are targeted. The income burden is already extremely high, especially when considering the expenditure aspect is aggressively redistributive. This is understandable against the historic backdrop of an apartheid legacy. However, this means the after-tax effect leaves the bulk of the tax base still having to make provision for education, health and security. This makes for an extremely high tax burden, especially in an emerging-market context — one of the highest tax burdens in the world (in both emerging and developed economies) — on an extremely narrow tax base. The direct income tax burden is a major factor in retarding the ability of South Africans to save. The low savings rate is the primary cause of low long-run growth potential despite South Africa being a high-potential country. Yet far greater economic damage is done through taxes that target capital formation and investment viability. These include capital gains tax, property transfer duty, death duties, taxes on dividends and taxes on interest earned. Two years ago, capital gains taxes were raised. This year, it is property transfer duties. The introduction of dividend taxes was another tax increase in previous budgets. In other words, we continue to eat our seeds. The problem is that the tax experts regard these taxes as very “useful” to help minimise the distortive effect of taxes, completely disregarding their economically destructive nature. Against the South African context of capital deficiency and massive unemployment, this is surely (from an economic perspective) the distortion that requires maximisation. The behavioural distortion needed is that saving and investment should not be taxed and the burden shifted to consumption. This has the added advantage of giving tax relief to the start of the economic value chains while extracting taxes from the end of them — essentially, allowing value to be created before being diminished through taxes. The structure of the tax take remains anti-growth and this year’s budget has accentuated this effect.

Unfortunately, on the expenditure side, the anti-growth theme is compounded. Government expenditure is notoriously ineffective. Despite devoting a high proportion of expenditure to education, for example, the outcomes reflect that much of the expenditure is wasted. More money will not fix problems in education. This requires performance-management systems and managerial expertise. More money is essentially rewarding poor performance. The same applies to health, policing and other areas of government struggling with poor service-delivery outcomes. A simple example is the state of government hospitals. Until the money allocated to cleaning hospitals is properly accounted for, more money will not get them clean. The apparent one-for-the-price-of-two procurement strategy of the state lowers the economic multipliers of that expenditure. Corruption and waste raise the tax burden and rewarding this with more money compounds the problem. These inefficiently consumed resources have consequently been denied to the tax base, which could have deployed them in activities with higher multipliers, especially investment.

The expenditure burden is also projected to increase as a percentage of GDP. This is a rise in the effective tax burden over time. The deficit is merely a deferred tax and it crowds out the capital markets. But of greater concern is that the expenditure burden is forecast to rise at a higher rate than projected economic growth and projected inflation. The expenditure proposals do not indicate that the collective thinking has yet focused on the fiscal hole South Africa is in. While the budget talks about fiscal consolidation, the actual proposals still reflect a growth in expenditure above the economic ability to meet the burden. Fiscal consolidation is highly dependent on higher tax receipts and on higher growth. The biggest risk is that neither materialises.

The expenditure aspect of the budget remains ensconced in redistribution and welfare provision. There is again an increase in grants, which provide much needed and necessary poverty alleviation. The economic effect is to shift resources towards consumption. However, poverty reduction is very different, as this requires resources to be shifted to investment. Once again, a divergence between intention and action. Without growth, poverty, inequality and unemployment will be perpetuated. Economic growth is essential – a necessary aspect of resolving these problems.

Fiscal sustainability remains compromised. Four expenditure bombs threaten to bring on a solvency crisis. The public-sector wage bill is the first one, which this budget seeks to contain at current levels rather than take determined measures to reduce it. The second is national health insurance. The indications are that this is very much on track. Funding proposals are not known and yet implementation requires a step change in tax increases on an already exhausted tax base. Parastatal funding is the third expenditure bomb that received a plaster in this budget. Selling off “non-core” assets will not plug the hole and this still hangs over the tax base. The fourth is nuclear, a clearly unaffordable commitment for South Africa. These four expenditure bombs shatter any illusion of fiscal consolidation if not contained or cancelled. They push the fiscus well into an unsustainable position and will lead to a solvency crisis.

A globally disturbing trend around government finances is the increasing sense of entitlement governments have to the fruits of their people’s labour. This is led by insolvent countries within the OECD such as France and Italy, where welfare commitments have long exceeded the capacity of their tax bases to bear them. South Africa appears no different. Tax-base erosion, avoidance and evasion are only problems in countries with unbearably high tax burdens. This state of affairs arises from political establishments promising welfare benefits that suck in the middle classes to generate electoral support. The welfare commitments go far beyond just providing a safety net for the most vulnerable. This sense of entitlement is essentially a manifestation of systemically corrupt thinking by the political establishments, even if corruption is not transactionally evident. South Africa would do much better economically if the strategy were to provide a haven from that form of financial repression rather than emulate it. If South Africa were to reposition itself as a haven from high taxes and consequently attract investment, the challenges facing the country would diminish. Unfortunately, tax policy is being conducted very introspectively and is drastically reducing the country’s competitiveness. Global investors are spoiled for choice, something not lost on South African investors. When the progressive nature of tax policy becomes overly aggressive, it has the effect of narrowing the tax base even further, and eventually damage-control reforms will be required. Unfortunately, this will only happen once the damage has been done.

The tax-receipt challenge facing government is showing strong signs of tax-base exhaustion. Households are already in deficit and the country as a whole struggles with a triple deficit that screams out for resolution where economic growth is essential. Yet tax receipts fell short of last year’s projections and will fall short again if economic growth does not materialise. Higher tax rates will compound the household deficit. Yet treasury officials are indicating that further tax increases are on the cards and acknowledge that national health insurance will require a step change in the tax burden. Government finances are in the process of being introduced to the Laffer Curve. This is the effect where rising tax rates start to result in falling tax receipts. The tax increases still in the pipeline will take South Africa into that world where the hole just gets bigger and the immediate “needs” of government make reforms all the more difficult. This occurs when governments start to serve themselves at the expense of their people and their tax base. Tax regimes become increasingly draconian and economic stagnation increasingly problematic. The overly progressive nature of the tax take and aggressive redistributive nature of expenditure means the top and middle end of the tax base gets a very poor deal from government. The country is becoming uncompetitive at a time when there is a desperate shortage of skills required to generate value-adding economic activity. Furthermore, a great proportion of essential talent is devoted to meet complex regulatory requirements instead of focusing on value generation.

Investment capital always seeks out opportunity, never need. This was a budget that focused on need and upside was curtailed. The tax system is already highly progressive and aggressively redistributive. The message was that investors and the so-called “rich” are not welcome. A bad deal for the top-end taxpayer. A new South African export.

Conclusion:

This has been the most anti-growth budget over the past 20 years. The progressive tax burden will prove retrogressive as the top end of the tax base may well contract over the next few years. South Africa’s top talent and capital providers have been further disincentivised to help generate the urgently needed economic growth. The country is digging its own hole and perpetuating its own problems. This is not due to the lack of good intentions but rather the lack of understanding that the country’s problems will be better resolved through a higher savings rate, translated into higher investment levels, which will then expand the economic capacity to be better able to absorb the massive army of unemployed. Until these core issues are understood and acted on, the economy will blunder on. South African tax policy has neglected to consider its global competitiveness and may well be later forced to reform under less advantageous conditions. Intentions diverge from actions.

Prediction:

All things being equal, this budget will serve to lower the economic growth outcome over the next year. Consequently, the tax take will again fall short of projections and fiscal flexibility will again decline. The budget deficit will be higher than projected through the effect of disappointing tax receipts and expenditure overruns. Unemployment will rise and the stagflation condition will deepen. The budget compounds self-inflicted mistakes and the vicious cycle the economy finds itself in. At some stage within the next 18 months, the credit-rating agencies will again be seeking to downgrade the sovereign credit rating. Capital formation will languish and the macroeconomic mismatch between the savings rate and investment rate will grow. Consequently, the triple deficits (current account, budget and household) will not be resolved and the vulnerability to macroeconomic instability will increase.

 



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