Enhancing sustainable fiscal policy in South Africa

Abstract

In this study, fiscal sustainability is defined consistent with the government intertemporal budget constraint framework which is related to the solvency of the government. Fiscal sustainability analysis in this context, therefore, considers the revenue side of the budget as well as the expenditure obligations. On the revenue side, the study highlights that fiscal authorities in South Africa continue to rely on income, profit and wealth taxes as they account for a larger share of government revenue compared to indirect taxes. However, immediately prior to the first democratic South Africa, there was a substantial shift from company taxes to personal taxes; a trend that has continued onto 2010. Analyses in this study show that the structure of the main taxes of South Africa compares less favourably to other emerging economies, and the worldwide averages. For instance, even though fiscal authorities have reduced the CIT rate from a high 50% to 28%, this rate is still higher when compared to other upper middle income economies and the rest of the world‟s average. The country compares no better either when the PIT rate is considered but its VAT rate compares favourably to that of the economies mentioned. Since the new era, in particular between 2000 and 2010, fiscal authorities in South Africa focussed on the reduction and stabilisation of marginal tax rates for the major taxes as well minimising the complexity in tax administration by reducing the number of tax brackets. Despite such effort, the wedge between the statutory rates and the realised average tax rates for the three main taxes is a concern regarding the protection of the revenue base. With regards to budget allocations, this study shows that collectively, expenditure on the social sector accounts for slightly below half of government consumption expenditure; specifically, however, there was a reduction in the proportional allocation to Education whilst at the same time the proportional allocations to Social Protection, Public Order and Safety and Social Grants increased. Defence expenditure was high pre-1994 and immediately after the first democratic election, but declined in the later years of the democratic South Africa. In general, the policy of fiscal prudence after 1994 resulted in a substantial decline in debt service cost, whilst the real growth rate of the economy increased considerably. Nevertheless, the former still exceeded the latter for most part of the period between 1994 and 2010. Having reduced its debt burden over the past decades, the South African government again finds itself facing a problem of rising debt due to an increase in the fiscal deficit. On the basis of this background, this study addresses four broad questions, namely: (i) was the fiscal stance taken in the past, sufficient to attain fiscal sustainability in South Africa? (ii) How did fiscal policy in the past adjust to budget imbalances and to what extent did that affect fiscal sustainability? (iii) Which are the optimal ways to v protect the revenue base; and (iv) How does the current fiscal dispensation (i.e. composition of expenditure and tax) affect the economy and inter alia fiscal sustainability? Different econometric techniques, namely: the Smooth Transition Error Correction model; the Logistic quadratic model; the Currency Demand model and the Bayesian Structural Vector Auto Regression Model are applied in the analyses. The findings of this study suggest that fiscal policy over the sample period has been sustainable but likely to be adjusted more quickly when the budget deficit exceeds 4.02% of GDP. However, the stabilisation policies by fiscal authorities are fairly neutral at deficit levels below the estimated threshold; that is, at deficit levels of 4.02% of GDP and below. The fiscal reaction speed of the South African government (i.e. increasing the tax burden) to lower the large deficit levels towards a band of tolerable values, indicate that they are indeed concerned about solvency. Thus, on the basis of this historical fiscal stance, it can be expected that fiscal policy will remain sustainable in the medium-term; and that the government‟s projection to reduce the fiscal deficit from a high 5.3% of GDP in 2010 to 3.0% in 2015 is plausible. In South Africa the main fiscal challenge, therefore, is to find ways through which the recent gains in fiscal solvency are not at the expense of the future revenue base. Consequently, the next objective in this study is to analyse one important element of protecting the revenue base, namely, possible leakages from it. In this regard, shadow economic activity is being investigated. This study finds that on average, the size of the South African shadow economy is 22.18% of GDP with estimated revenue evaded at about 7% of GDP. Further analysis shows that there is a strong positive relationship between the tax burden and shadow income but that this relationship is not symmetric. In South Africa, businesses and individuals are likely to react quicker when the tax burden changes fall outside the band of -3.64% to +2.13% of GDP but remains neutral as long as they are within this band. The implication of this finding is that, any attempt by the fiscal authorities to increase the tax burden to levels above the estimated threshold of 2.13% in order to close the budget deficit might trigger a significant response from the shadow economy thereby reducing the tax base and further worsening the fiscal deficit. Next, the analysis shows that an increase in total government spending has a “crowding–in” effect as real GDP per capita and real private investment respond positively. When government expenditure is disaggregated into consumption and capital expenditure per capita, the analysis shows that a one standard deviation positive shock in government consumption expenditure per capita increases real GDP per capita with a multiplier effect of 0.22, which is higher than the growth multiplier effect (0.16) of government investment expenditure per capita. In addition, the effect of the total tax burden on the GDP and private investment is negative and persistent in the long-term (i.e. after 4 years). The net effect of fiscal policy, therefore, is that it is growth enhancing in the short and medium-terms leading to fiscal sustainability (since r < g) but in the long-term, the growth promoting effects of increased public intervention is offset by the growth inhibiting effects of increased taxes; hence, a threat to long-term fiscal sustainability. vii The composition of the tax regime has a substantial influence on growth; whilst taxes on income and wealth reduce growth, indirect taxes have a positive effect on growth in the short and medium term. On the basis of the above findings the following suggestions are proposed: Firstly, the nature of fiscal policy in South Africa over the post-1994 period has shown to be successful from a fiscal sustainability perspective and should therefore be continued. However, the fact that government only seem to be pro-active in the case when the budget deficit exceeds the 4% margin and actually seem to be fairly neutral at deficit levels below this ratio should be noted. By implementing drastic tax increases in such a scenario could be detrimental to the growth of the revenue base. Conversely, tax relief at lower levels of the margin outlined, and even in times of surpluses could be growth enhancing and should be implemented actively. Secondly, the 2012 medium-term budget document requesting for additional taxes to boost revenue might lead to further growth in the shadow economy, as the projected tax burden increase recommended is above the estimated threshold of 2.13% in this study. Such a reaction from shadow income poses a threat to long-term fiscal sustainability. Thirdly, in their attempt to expand and secure the revenue base fiscal authorities in South Africa should consider further adjustments to the composition of the revenue base. The continuous reliance of the government on direct taxes is shown in this analysis to affect growth adversely, which could destabilise the fiscal gains already achieved. The results of this analysis, therefore, support the international trend towards a shift to indirect taxes from direct taxes. Fourthly, expenditure priorities have to be carefully considered. Fiscal authorities should guard against populist spending patterns and prioritise those expenditures that result in capacity building and enhancing growth and employment. In this regard, the declining trend in expenditure on education and health has to be reversed. A priori, only by focussing its expenditures coupled with enhanced efficiency within such “productive” areas, would government be able to contribute towards enhancing growth which in turn is essential for long-term fiscal sustainability. Thus, the analyses in this study show that in the short- and medium-term, there is no serious threat to fiscal sustainability in South Africa but long-term fiscal sustainability remains a challenge. To enhance long-term fiscal sustainability would require continuous adjustment of policies including the speed of policy adjustment, the stabilisation of the tax burden but with a redirection of focus from direct to indirect taxes; the protection of the revenue base, in particular a reduction in the existing level of tax revenue evaded and the reprioritisation of government expenditures. A broader social and political context of fiscal sustainability has, however, not been included in this study. In a middle income country like South Africa where the role of government is politically and socially important and controversial, future research could explore how the quest to enhance fiscal consolidation can affect political and social stability which may in turn endanger the sustainability of fiscal policy. On the other hand quantifying the fiscal implications of expected developments such as demographic changes, development in health cost and public pension liabilities, could initiate future research on this topic should more relevant data becomes available.