Little tax room to manoeuvre as Covid-19 pandemic triggers bleaker contraction

Source: National Treasury Supplementary Budget Review 2020, p30

By Tania Ajam, Dennis Davis, Deborah Tickle and Ingrid Woolard

19 Jul 2020

South Africa’s growth outlook for 2020/2021 was bleak even before the Covid-19 pandemic. Now, with the contraction triggered by the pandemic, there is expected to be, at least, a 7.2% contraction in the South African economy, with widespread losses of jobs and livelihoods, food insecurity and business insolvencies – and a shrinking tax base.

The special Covid-19 adjustment budget painted a bleak picture of an already unsustainable fiscal trajectory, rapidly deteriorating further into crisis. Consolidated spending – which includes national and provincial departments, social security funds and public entities – will soar to R2.04-trillion, largely due to additional funding of R145-billion allocated for government’s Covid-19 response.

Simultaneously, a tax collapse of R304.1-billion (which includes R26-billion of Covid-19 tax relief), has decimated revenues. As a result, the consolidated deficit for 2021 is anticipated to double from 6.8% of GDP to 15.7% and the debt-to-GDP ratio which, in February 2020, was envisaged to rise to 65.6% of GDP will accelerate to 81.8% of GDP.

The government intends to borrow $7-billion (roughly R117-billion), from international finance institutions such as the International Monetary Fund (IMF) and New Development Bank to help finance the Covid-19 response. National Treasury will also draw down its sterilisation deposits held at the Reserve Bank to finance spending, which it has seldom had to resort to before.

In the Supplementary Budget Review, National Treasury has warned that failing to take action will plunge the country into a sovereign debt crisis. When several of its investors refused to refinance its debt in the wake of the downgrade, despite government guarantees, the Land Bank defaulted on its debt in April 2020. Other state-owned entities (SOEs) could also collapse, triggering government guarantees and loan covenants. This would not only include those SOEs where mismanagement and State Capture had been rife, but also traditionally well-functioning entities which have reduced revenues due to lockdown, such as the Airports Company and Sanral.

Cabinet has committed to actively stabilising the debt spiral at 87.4% of GDP in 2023/24 through targeting the achievement of a primary surplus by 2020 (i.e. ensuring that tax revenue will exceed non-interest government spending), instead of allowing it to ratchet up to 140% of GDP (as illustrated in the diagram below).

Debt outlook scenarios

Source: National Treasury Supplementary Budget Review 2020, p30

This would entail spending and revenue adjustments of about R250-billion over the next two years, the details of which have been deferred to the Medium Term Budget Policy Statement (MTBPS) in October 2020. The supplementary Covid-19 budget does, however, provide an initial estimate of tax increases of R5-billion in 2021/22, R10-billion in 2022/23, R10-billion in 2023/24 and R15-billion in 2024/25, financed mainly through the increase in tax revenues that should accompany the revival of the economy and better tax collection (through combating aggressive tax planning, especially through transfer pricing, reducing VAT and import valuation-related fraud and employing third-party data to enforce compliance).

Given the fragility of the economy and the need to avoid procyclical fiscal policy, this would – in principle – be preferable. Indeed, based on the initial work of the Davis Tax Committee and SARS, improved auditing of taxpayers and hence compliance may produce significantly more revenue than indicated. Much additional work clearly still needs to be undertaken to ensure the collection of this larger amount.

However, tax increases may be unavoidable, given that rationalisation of the hundreds of SOEs is unlikely to yield positive financial results in the shorter short term, the need to address chronic governance dysfunction and inefficient operational models. This initiative, and attempts to constrain the government and SOE wage bills, would also encounter significant political opposition. Moreover, increasing unemployment, hunger and pandemic-related hardship will intensify calls for greater social relief.

Given this dire state of the fiscus, progressive tax increases should not be ruled out. Wealth taxes are currently not administratively feasible in the short term given SARS capacity. VAT could raise some revenue, but would be regressive and is therefore not advisable. Nonetheless, the estimates are instructive and sobering – a 2% increase in the VAT rate would only generate about R40-billion in additional revenue.

The government could consider instituting a temporary (three-year) solidarity levy on personal income tax. The proceeds would be a small amount of revenue, but would signal that the costs of the pandemic are not just borne by the poor and middle class, and would be administratively feasible. This is an approach which has been followed by other countries and is less likely to have the negative impact on tax morality or the economy if it is levied on those who have sustained their earning over the pandemic period.

If there were a 1% increase in the marginal personal income tax rate to 46% for income earners above R1.5-million and a 2% increase for those above R2-million, this would only generate about R2-billion. A 1% increase in tax rates across all tax brackets (excluding the bottom bracket), and an increase in the rate for taxpayers above R1.5-million to 47% and a new top bracket with a marginal rate of 50% for incomes above R2-million would still only bring in another R15-billion.

In short, such increases would add much-needed legitimacy to the system, but would hardly be a panacea for the overall problem of the revenue shortfall.

The DTC Estate Duty Report indicated that little estate duty is collected on smaller estates due to enforcement issues. It was thus recommended that estate duty be levied only on larger estates (those above R15-million, currently R3.5-million), certain exemptions be removed and the removal of assets from estates, for example, using trusts, be counteracted. Following that report, good progress has been made on increasing the taxes attached to the transfer of assets into trusts and the estate duty rate has been increased to 25% (from 20%) for estates exceeding R30-million.

This rate is nevertheless considerably lower than in, for example, the US (a sliding scale between 18 and 40%) and the UK (40%) which both levy taxes at death, but on larger estates. However, as they view the estate taxes as covering the increase in the values of assets held, these other countries do not levy capital gains tax at the date of death, as we do in South Africa. Nonetheless, it is high time that estate duty collection be improved in a country with such stark inequality.

It is clear that the tax room to manoeuvre is modest, relative to the scale of the challenge, which suggests that the bulk of the adjustment has to be borne on the expenditure side of the Budget, while pro-growth policies are simultaneously implemented.

The October 2020 MTBPS and Budget 2021 will have to chart a treacherous passage between the proverbial “rock” of the need to preserve lives and livelihoods, and the economy while cushioning the hardship imposed by the lockdown on the most vulnerable, and the “hard place” of fiscal crisis.

What is clear is that hard expenditure prioritisation choices can no longer be deferred, and the default position of doing nothing which has characterised too many successive Budgets, is no longer an option. The MTBPS can has been kicked down the fiscal road and Budget 2021 is the cul-de-sac. The revenue side of the Budget can no longer constitute the solution. DM

The authors are members of the Davis Tax Committee.

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