South Africa is a country of vast inequality with huge unmet developmental needs, but squeezing the affluent for more tax is easier said than done and could even be costly and counterproductive.
A new paper, co-authored by Chris Axelson, acting head of tax and financial sector policy at the National Treasury, shows empirically that there is little space to wring more out of South Africa’s highest-income groups by hiking personal income tax (PIT) further.
When this was done in 2017, by abruptly raising the marginal tax rate from 41% to 45% for those with incomes of more than R1.5m, instead of reaping an extra R5.46bn as had been calculated, PIT revenue collection dropped by R6.48bn.
This came as a shock to the authorities. Their thinking was that because South Africa has a broad PIT base definition and the tax change was carefully crafted and implemented, leaving little room for evasion, the revenue would duly come rolling in.
So why didn’t it? According to the Southern Africa Towards Inclusive Economic Development (SA-TIED) working paper, “Taxing Top Incomes in the Emerging World”, taxpayers responded to the tax hike far more energetically than expected, reducing their declared income by about 10%.
This meant that the tax collected on personal incomes above the R1.5m threshold was less than it would have been without the reform — a disastrous outcome for the Treasury.
This has important policy implications given the government’s desire to extend social support from free higher education to free preschool education and, over time, to introduce free universal health care and a more generous basic income grant. To deliver all this fully would require a significant increase in taxation, with higher-income earners viewed as the obvious soft target.
However, the lesson from the SA-TIED paper is that the tax authorities need to tread carefully when they tax the rich, as the efficiency losses can be considerable, even when tax reforms are well designed.
In the 2017 example, the affected taxpayers didn’t emigrate, nor did they respond by cutting their standard working hours or normal monthly earnings. Instead, bonus and incentive payouts sank like a stone, as did nonmonetary fringe benefits (such as the use of cars, laptops, travel and cellphones), all of which make up a significant fraction of top earners’ compensation packages.
Affected taxpayers also significantly cut their reported investment income — behaviours all commonly associated with tax avoidance and evasion.
There is a trade-off between equity and efficiency when taxing the rich in South Africa
— WHAT IT MEANS:
But while some may have used tax planning to reduce their tax burden, this wasn’t the only issue. The real problem was that the tax hike also harmed the economic performance of the companies that employed these tax targets — on average their sales output dropped by close to 5% — suggesting that top employees reduced their work effort.
This has concerning implications in a developing country, especially one with a skills constraint and a low-growth problem like South Africa.
“Our findings suggest that policymakers in the developing world need to carefully balance equity goals against efficiency losses when taxing top income earners in their economies,” the researchers conclude.
Or, as Axelson puts it in a recent article in Business Times: “Our research shows that when you tax the incomes of the rich in lower-income countries like South Africa, this can be counterproductive even when design and implementation are done well.
“We found that while some wealthy individuals may use tax planning to reduce their tax burden, this isn’t the only issue. High income taxes can also negatively impact the performance of companies. These findings highlight the need for tax authorities to carefully analyse the impact of tax reforms and continue to calibrate tax policy.”
Leading economists canvassed by the FM agree with the research’s main finding: that there isn’t much space to raise further revenue by raising the highest PIT rate.
While the total tax-to-GDP ratio has hovered at about 25% of main budget revenue for most of the past 30 years, PIT collection increased from 7.3% to 9.2% of GDP between 2010 and 2020.
The PIT system is also highly progressive in that the richest 10% of households earn 63% of total income, but pay 80% of income tax.
Wits University adjunct professor Michael Sachs, a former head of the Treasury’s budget office, accepts that as a tool PIT may have been maxed out at the top end. However, he doesn’t accept the broader policy implication: that there is no more revenue that can be raised from “the highly inefficient consumption of the elite” without affecting productivity and investment.
Sachs is unequivocal that taxes in South Africa need to go up because it’s “unfair and unworkable” for the full burden of fiscal consolidation to take the form of expenditure cuts, especially since the main burden will fall on the most labour-intensive departments — those employing teachers, nurses and police.
In his view, there is an excessive amount of consumption and rent extraction (mineral rents, monopoly rents, government rents) occurring at the top end of the economy and there are ways other than using PIT for the government to tax some of those rents without reducing productivity or disincentivising entrepreneurship.
At the top of his list would be increasing the VAT rate, but in a tiered way and possibly by including more zero-rated items.
Sanlam Investments chief economist Arthur Kamp agrees that the best option is to favour indirect taxes on goods and services over direct personal and company income taxes.
“Taxes on income and wealth ultimately reduce the incentive to work and invest,” he says. “In turn, this is reflected in weaker economic activity, lower profits and lower performance-related compensation including share incentives, bonuses and commissions, and hence lower tax revenue.
“In an unequal society it is fair that the wealthy pay more tax on their income. At the same time, we should also recognise that wealth is nothing other than accumulated savings — often over a very long time. If a lack of savings to fund investment in South Africa is a problem — which I think it is — then it’s important to take this into account when designing tax policy.”
The counterargument to raising the VAT rate is that politically it would be a nonstarter because it disproportionately affects the poor. It would also be administratively burdensome to introduce different VAT rates for goods and services (tiering), along with further exemptions, and would probably also lead to even more VAT fraud.
Other contenders for tax reform that have been the subject of recent research include replacing the retirement contribution tax deduction with a tax credit and doing away with the medical aid contribution tax credit, since both mainly benefit the relatively well-off.
In a separate SA-TIED working paper, Gemma Wright, the research director of Southern African Social Policy Research Insights, and her co-authors considered extending the top PIT band downwards to include those with taxable incomes of R1m or more, without raising the 45% tax rate.
In addition, they modelled what would happen if South Africa lowered the minimum PIT threshold to R55,000 a year and introduced a new tax band with a 5% tax rate for those earning between R55,001 and R79,000 a year.
They found these changes could raise an additional net R3.9bn and R8.8bn respectively. If this was all ploughed back into social grants, roughly 600,000 people could be raised out of poverty.
The policy focus now has to be on raising growth
— Andrew Donaldson
Another idea being floated is for South Africa to institute a one-off wealth tax. Tax experts believe this would be far preferable to a continuous wealth tax, provided there was complete transparency over what the revenue raised was to be used for and how it was spent.
Andrew Donaldson, a senior research associate of the Southern Africa Labour & Development Research Unit at the University of Cape Town, says the emphasis should be on broadening the tax base and reviewing the available tax handles in the various categories of capital income.
This is not to say that he sees much scope for increasing the national tax burden.
“Over time, we will need to find a way of broadening the municipal tax base, probably through some form of business tax; and when a basic pension plan is introduced and/or a standard basic health plan, then the social security tax base [Unemployment Insurance Fund contributions] will have to be phased up,” he says.
“But these are long-term shifts. I don’t expect a substantial rise in the tax burden in the foreseeable future. The policy focus now has to be on raising growth.”
The bottom line is that South Africa has a well-designed and well-administered PIT system, and while there may be room to raise a bit more revenue through some modest adjustments, there is no more low-hanging fruit to be had.
This means the focus now should be on raising the country’s growth rate and increasing compliance measures to bring illicit activity into the tax net.
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