By Lesiba Mothata, Chief Economist, Investment Solutions
The Davis Tax Committee, established by the National Treasury to look into domestic tax issues, solicited work from the World Bank – work which has preoccupied the imagination of many since its publication a few weeks ago.
The Bank was tasked to investigate the effectiveness and efficiency of investment tax incentives granted to South African firms and it delivered haunting recommendations. Of particular interest was its proposal that South Africa should consider giving tax incentives to companies to revive investment by the private sector. This should be done, the World Bank report opined, with a specific focus on the manufacturing sector, which has seen sharp declines in both investment and contribution to gross domestic product (GDP).
The World Bank report has proved instructive and its focus on private sector investment opportune. Data from the South African Reserve Bank show private capital formation, which accounts for more than 60% of total investment including that from the state and parastatals, has contracted for four consecutive quarters, on a year-on-year basis, since the beginning of 2015 (a compounded decline of almost 20% during that period). At the same time, business confidence has barely recovered from its post-2008 lows. There is a deep and ongoing business investment recession happening in South Africa.
The primary message from the research can be reduced to, inter alia, that South Africa should engage in a decisive policy shift towards lifting business confidence, which would in turn, improve private capital investment. This is to say, the Minister of Finance should consider constructing fiscal policy to improve business confidence and investment.
Since the Brexit vote, Donald Trump’s surprise win as US President and the ongoing electoral battles in Europe based on populist ideologies, there is a preoccupation about the impact of politics on markets and economies. In South Africa one wonders whether the recession in private sector investment and the depressed business confidence cycle is due to partisan politics. This warrants attention – on some level, policy decisions are simply another form of “business decision”, but with potentially farther reaching consequences. Hopefully, in its expression in the 2017/18 national budget, this intersect between politics, economics and investments will result in a positive effect on business confidence.
John Maynard Keynes provided us with perhaps one of the best frameworks to assess this intersect. It’s a framework that could prove useful in detangling the politics/economics knot. Keynes introduced us to a concept that he called “animal spirits”.
Keynes conceded that most economic activity can be explained by the natural function of people motivated by self-interest (for example, taking care of family), which produces efficiencies that maximise output. At the same time, Keynes also showed this does not explain the full workings of an economy. Individuals have motives, not always explained by standard economic rationale, as they pursue their interests. Animal spirits refers to people’s innate animalistic response to external stimuli. The term is used to explain and measure this human behaviour and its effect on economic activity, which tends to exaggerate downturns or upswings.
Animal spirits, from the Keynesian perspective, isn’t simply another word for behavioural finance, whereby individuals have irrational responses to economically rational problems. Rather it refers to one specific behavioural characteristic. This can be defined as “gut instinct”. In other words, “animal spirits” refers to an urge to action that a businessman or investor might have, despite a climate of political or economic uncertainty. Animal spirits refers to a certain dimension of confidence that a businessman or investor has, which compels them to expand or recapitalise or invest.
One interesting aspect of this “animal spirit” of confidence is that it can be stimulated by effective leadership or policy setting. For example, profits may be high, but if businessmen fear a recession then investment is likely to dry up and savings are likely to rise. Effective policy setting would address this reluctance with an expansionary fiscal policy to stimulate economic growth and boost demand.
Indeed, there is a feedback loop between politics and economics, but this is expressed through animal spirits (positively or negatively). If good economic policies are implemented, the effect on the economy can be great as people gain the confidence to invest and engage in value-adding activities – in other words, animal spirits are stimulated for positive action. Similarly, a political situation that thwarts confidence can have adverse impacts on the economy.
South African dimensions of animal spirits
In South Africa, the interplay between politics and economics has become more nuanced than what we typically see offshore. Animal spirits have been significantly thwarted in the domestic economy. Although the post-2008 effect of corporates hoarding cash is a global phenomenon, it is much more pronounced locally. Judging from JP Morgan data on companies making up the MSCI South Africa index (excluding financials), cash balances on firms’ balance sheets surged three-fold between 2007 and 2015. Relative to the overall emerging market MSCI equity index, corporate cash balances increased 2.4 times over the same period. In the developed world, US corporate cash nearly doubled by increasing 1.9 times, while in Europe and the UK it rose 1.7 and 2.1 times respectively.
A similar picture is seen when data from the South African Reserve Bank on non-financial corporations’ cash deposits is analysed.
Cash balances have surged to over R700 billion currently from R334 billion in 2006. This increase has taken place during the longest post-1994 economic downturn in the South African business cycle and a period of heightened political uncertainty. The net effect has been a collapse in business confidence as well as a decline in private sector investment into new capital formation. Animal spirits have been throttled. If private business leaders were optimistic about the future of the economy, there would be a commensurate increase in their investment into new capital (technologies, research and development, machinery, equipment and construction).
Challenging task for fiscal policy
As so eloquently put forward by the World Bank, South Africa’s major challenge is to lift business confidence, which may revive private investment. Although Finance Minister Pravin Gordhan is confronted with the need to raise government revenue (about R28 billion in this fiscal year) and thus taxes are likely go up, efforts need to be made to construct a long-term strategy to boost South Africa’s growth.
Under the current circumstances, it is understandable that high-income earners are likely to pay more tax. Taxes on wealth – such as capital gains, estate duty and donations – could also go up. What needs to be considered is that, at some point in this tax-hiking cycle, the Laffer curve, a depiction of the relationship between taxes and government revenue, suggests additional future income for the fiscus can be eroded. Higher taxes eventually erode the capacity of the economy to generate enough output, which, in turn, will result in diminishing tax collections.
It is not clear whether the ensuing cyclical recovery for the South African economy will generate enough of a positive effect on the depressed business confidence to encourage private capital investment. Although commodity prices have somewhat turned around and terms of trade might improve for South Africa, external policy stimuli is needed to revive business confidence (animal spirits).