The budget balancing act

The Jacob Zuma administration has backed SA into a fiscal crisis and if the status quo is allowed to continue the country will be in debt distress within a few years.

Finance minister Malusi Gigaba shocked the nation with this revelation when he laid all SA’s fiscal cards on the table in the October medium-term budget last year.

The rand nose-dived in response, S&P Global Ratings immediately junked SA’s local-currency rating and Moody’s put the country on a three-month review for a downgrade — a period that ends just after the 2018 national budget is presented on February 21.

So it’s no exaggeration to say that the upcoming budget is where the buck finally stops.

"This year’s budget speech is expected to be a real show stopper — a watershed year for tax hikes given the projected budget deficit of around 4.5%," says Deloitte managing partner Nazrien Kader. "Gigaba has a tough job on his hands as he will have to negotiate multiple, sometimes conflicting, priorities."

For the past five years, successive finance ministers have been tightening the screws on taxpayers and government spending while trying to plug revenue shortfalls with savings, reprioritisation and running down the contingency reserve.

But these measures have taken SA only so far. Chasing deficit and debt targets was never going to be sufficient to ensure SA’s long-term fiscal sustainability in the absence of economic growth.

Now, after five years of slowing economic activity, treasury has emptied its box of fiscal tricks. Politically hard but essential budget choices are all that remain, like hiking Vat, freezing public sector wages, merging ministries, delaying the rollout of free higher education and national health insurance (NHI), selling noncore assets and shelving the country’s nuclear ambitions. The budget should do all this and more.

"Despite years of fiscal consolidation through tax increases and expenditure cuts, SA’s budget deficit remains wide and the debt ratio continues to increase, while the net worth of government [fixed assets less liabilities] has declined," says Sanlam Investments economist Arthur Kamp. "It’s not working."

Gigaba’s central problem is that the R50bn revenue shortfall estimated for the current fiscal year — which will grow to a projected R209bn cumulative shortfall over the next three years — is so large that draconian adjustments to taxes and expenditure are now required.

Just sticking to the fiscal trajectory outlined by former finance minister Pravin Gordhan, which aimed to get gross debt to stabilise at about 52% of GDP, will now require tax hikes or spending cuts equivalent to 0.8% of GDP — about R40bn in 2018/2019 rands.

To achieve this Gigaba would, for instance, need to raise the Vat rate and the personal income tax rate by one percentage point each this year.

Raising taxes is hard to do when growth is flat-lining and taxpayers are already heavily burdened. At 26.2% of GDP, SA’s tax ratio is at its highest in six years and among the top 10 in the world, according to Deloitte.

The problem is that SA’s effective personal income tax burden has risen sharply in recent years and all personal tax rates were already upped by one percentage point two years ago. At an estimated 17% last year, the ratio of personal tax on income and wealth relative to personal disposable income is at its highest level yet (see graph).

Cutting expenditure is not much easier given the cost pressures created by vast unmet social needs. And both moves (hiking taxes and cutting expenditure) could be self-defeating if they further curb growth and employment, causing tax revenue to shrink.

Economists agree that the state’s wage bill is the most important place to cut back. Citibank economist Gina Schoeman calculates that if the unit cost growth per state employee had been 6% in 2016/2017 rather than 7.5%, state expenditure would have been R7bn lower.

"What’s more, [cutting the wage bill] would be a massive show of political will given that the ANC and Cosatu have typically been close allies," she says.

Gigaba’s task is to try to raise business and consumer confidence in order to boost growth and investment while simultaneously announcing severe tax hikes and spending cuts. The term he’s likely to use to explain this juggling act is "growth-friendly fiscal consolidation".

With confidence in tatters prior to Cyril Ramaphosa’s election as ANC president

in December, this would have been impossible. At least now Gigaba has a fighting chance — provided he has the requisite political backing.

If he is able to take a pitchfork to the smelly state-owned enterprise (SOE) stable by refusing to dispense further bailouts and government guarantees while insisting on improved governance, financial management and operational performance, it will be clear that such backing has been forthcoming.

In October, in the absence of political buy-in, Gigaba had to deliver a half-baked mini-budget that suggested that SA had abandoned the cherished goal of stabilising its debt ratio.

The truth was more nuanced. Though the goal was still sacrosanct to treasury, Gigaba had discovered that, with the ANC election looming, no politician was willing to expend the political capital to endorse unpopular reforms, such as broad-based personal income tax increases.

At the time, the tough decisions were deferred to a smaller fiscal committee under some of the more responsive ministers, including Ramaphosa.

Its job was to identify by this month those programmes, including big capital projects, which could be culled or delayed. It would also identify state assets that could be sold and opportunities for private sector equity participation in SOEs.

But it is still far from clear whether the government has the appetite to take these politically tough decisions.

"While the election of Ramaphosa... has unleashed some cautious euphoria among the business community, the political dynamics remain problematic," says Investec’s Nazmeera Moola.

"Therefore the willingness and ability of the current government to take hard decisions is questionable. And without hard decisions, it is doubtful that the finance minister can do enough to stabilise the debt ratios over the medium term."

This is because SA’s fiscal problems are simply too large to be solved by routine expenditure cuts, tax hikes or reprioritisation. The situation requires that big policy decisions be made at the centre to reduce the size of government and its role in the economy. Government spending has been growing steadily and is now estimated at 33% of GDP, up from 23% in 2005.

Scaling back government is clearly beyond the scope of treasury to secure. It requires that Ramaphosa assert his authority as the new head of the ANC. As such, the budget will reveal the extent to which he is calling the shots in government — or not.

Kamp believes that, thanks to the "Cyril dividend", SA could be afforded a "grace period" this year to get its house in order. If so, 2018 could mark the trough in the country’s deteriorating fiscal position.

Ideally, the budget should deliver sufficient tax hikes and spending cuts to avoid any breach of the expenditure ceiling and to allow debt to stabilise below 60% in the next few years.

More specifically, Kamp argues that SA should align the tax structure with the growth objective, address the revenue shortfall partly through an increase in Vat, cut the ratio of consumption to GDP, boost expenditure on human and physical capital, and protect the state’s balance sheet by reducing its liabilities.

"This would make a valuable contribution to the credibility of government’s economic reform plans and bolster confidence further," he says.

It would also reassure investors that SA remains firmly committed to fiscal sustainability and help to shore up the country’s credit rating.

The consensus expectation is that this is roughly what Gigaba will try to do. But while the budget is likely to look passable on paper (aided by the global economic recovery and domestic cyclical upswing under way), economists will be on the lookout for any sleight of hand.

For instance, the budget could give the appearance of fiscal sustainability if it relies on unrealistic GDP growth or tax buoyancy assumptions, or makes big cuts to infrastructure spending rather than to government consumption and the wage bill.

Similarly, if administrative problems in the SA Revenue Service (Sars) continue to undermine tax collection and if government incapacity and corruption are not addressed, SA’s fiscal problems will mount, no matter how nicely the budget columns appear to tally up on February 21.

"The risk is that we are lulled into believing that we have already turned the corner on fiscal policy before we have actually done enough to improve the situation," Kamp warns.

SA Institute of Race Relations economist Gwen Ngwenya agrees: "The challenge will be to rein in exuberance and not to allow improved sentiment to lead to consolidation complacency and an over-estimation of the extent to which improved sentiment will broaden the tax base through job creation or lead to higher private sector wage increases or bonuses."

This year, SA’s top spending priority should be the funding of free higher education (though basic education is as important) followed by water infrastructure and initiatives to stimulate job creation.

Gigaba has said the cost estimates for Zuma’s free higher education plan have been finalised. It will be implemented over eight years in a sustainable manner that avoids any breach of the expenditure ceiling.

Given the R50bn revenue shortfall, the only way to free up the additional funds required will be by cutting elsewhere. Deloitte health-care actuary Ashleigh Theophanides fears that one casualty could be NHI.

She cautions that the R20bn that stood to be raised from cutting medical aid tax benefits, which was going to be ring-fenced to fund NHI, is now unlikely to materialise following treasury’s finding that this measure would hurt low-income earners.

NHI could score from the new sugar tax, which will come into effect on April 1 and is likely to raise several billion a year, but it is still unclear where these funds will be spent.

Hiking Vat remains the closest thing to a silver bullet left at Gigaba’s disposal. A one percentage point rise in the Vat rate would rake in a hefty R15bn-R20bn a year. Treasury had been saving this to finance NHI. It’s now more likely to go towards subsidising university fees and plugging the yawning hole in tax revenue.

There is a mistaken belief among politicians that avoiding a fiscal crisis comes down to a simple choice between hiking the Vat rate or introducing a new wealth tax. In fact, both will be required to prevent SA’s debt from spiralling.

The Davis tax committee is investigating the form a new wealth tax could take. Whatever it concludes, international evidence shows SA would be doing extremely well if it raised more than R6bn annually, as this would be levied on an incredibly narrow base. A huge amount of wealth in SA is also tied up in retirement funds.

The committee is also concerned that a new wealth tax may penalise middle-class savings, and is aware that Sars would need to institute a sophisticated system to administer it.

A more elegant approach might be to jack up estate duty, SA’s existing wealth tax. The tax committee estimates that if its estate duty reforms are implemented, the revenue generated from this tax would rise from R1bn to R5bn a year.

Taken together, implementing the estate duty reforms (R5bn), introducing a new wealth tax (R5bn), a Vat hike (R20bn) and raising R10bn from voluntary disclosures could rake in about R40bn for the fiscus.

Gigaba could also find another R12bn-R15bn by not compensating taxpayers fully for fiscal drag or bracket creep (when inflation-linked wage increases push taxpayers into higher tax brackets).

Schoeman calls for more creative options that would generate more revenue while minimising the pain to taxpayers. She suggests, for instance, the introduction of a 48% upper-income tax bracket for one year only, or a temporary levy on wealthy individuals and corporates with earnings above a set threshold in exchange for the state actually meeting its debt-reduction targets.

She believes the existing tax structure could probably raise R15bn quite easily, but anything more than that could severely dent growth, fuel social unrest and worsen tax compliance.

Clearly, the only sustainable solution is to broaden the tax base.

This means raising the growth rate to generate more income, more profits, more taxpayers and more tax revenue.

Moola estimates that raising the growth trajectory to 2.5% in 2019 and 3% in 2020 would resolve most of the concerns around debt sustainability.

This means that broader economic reform can no longer be delayed. Government should prioritise fixing the education system, raising the competitiveness of the economy and removing obstacles to doing business, especially for small firms.

Ultimately, the budget has to do double duty as a growth strategy. It has to convince the sceptics that concrete, credible steps can and will be taken not only to cut expenditure and discipline delinquent SOEs, departments and municipalities, but also to raise the growth rate.

With Ramaphosa at the helm SA finally has a chance of actually pulling this off.

"Without hard decisions, it is doubtful that the finance minister can do enough to stabilise the debt ratios over the medium term" — Nazmeera Moola

What it means: The budget must kick-start growth and rein in debt if SA is to win back investor confidence