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How to respond to this onslaught is a tricky matter. One way would be to approach the MTBPS exactly as in the past to demonstrate continuity and not to elevate the absurd to mainstream thinking. But will the absurd necessarily go away?

It seems clear that the expenditure ceiling introduced to keep the fiscal numbers on the right track is under pressure, partly because of legitimate claims to additional allocations of funds, such as the widely recognised need to increase the subsidy to higher education institutions, but partly also because of the limit it poses to possibilities for patronage and rent-seeking. Not to mention the apparent frustration for some members of government of being restricted by the limits on available resources and the consequent need for prioritisation and trade-offs.

It may therefore be preferable not to approach the MTBPS in a business-as-usual manner, merely focusing on updating the numbers, adding another year to the medium-term fiscal framework, and preparing the ground for the 2017 National Budget. Perhaps the current political climate requires the MTBPS to be used as an opportunity to (once again!) set out the principles guiding fiscal policy and the restrictions within which the public finances need to be conducted. The point needs to be brought home that the National Treasury is not acting wilfully by demanding fiscal discipline from the entire government, but that it is applying sound financial principles in response to hard reality.

As indicated above, the expenditure ceiling can be regarded as the focal point of the budget. One question in particular that therefore needs to be addressed is the limits to total government expenditure, which boils down to the sustainable level of the tax burden and government debt.

Although this question does not have a simple answer, a starting point would be to compare government expenditure in South Africa with international experience, bearing in mind that the size of government is ultimately a political decision. According to the IMF, general government expenditure will amount to 34% of Gross Domestic Product (GDP) in 2016, compared with the average of 31% for the G20 emerging group of countries.

 
 

The accompanying figure compares government expenditure in South Africa to that in a number of individual emerging-market economies.

The current level of government expenditure as a percentage of GDP does not stand out as being low compared with that of other BRICS members or peer emerging-market economies. Brazil is the exception, but it has a fairly comprehensive contributory social insurance system which South Africa does not have (social contributions account for 25% of government revenue in Brazil compared with 2% in South Africa). According to the World Bank, the comparable numbers for operating expenses for South Africa and Brazil in 2013 were 34,8% and 24,4% of GDP respectively.

A basic principle to bear in mind is that the relationship between economic growth and the size of government shows a negative correlation between the two variables, in other words an increase in the size of government beyond a certain threshold (necessary for the execution of core functions) is associated with a lower growth rate. This effect is strengthened if the increase in expenditure is mainly due to higher government consumption expenditure and transfer payments (as has been the case in South Africa).

Of particular importance to South Africa is that an increase in government expenditure in an environment of weak or compromised institutions has been found to be especially negative for growth. Increased government expenditure when patronage and rent-seeking are rife will undermine efficiency in the use of resources. It is ironic that while capital expenditure presents the most lucrative opportunities for rent-seeking, this is precisely the type of expenditure of which South Africa needs more!

Any increase in the size of government from current levels should therefore be critically evaluated and should be tolerated only if it will unequivocally enhance the growth potential of the economy. The current expenditure rule is aimed at keeping government expenditure as a percentage of GDP approximately fixed over the medium-term expenditure framework. As the National Treasury has repeatedly emphasised, any increase in expenditure will have to go hand in hand with an increase in taxes.

The question then becomes what tax burden is sustainable, taking into account not only the total burden but also its distribution.

International comparisons show that general government revenue is set to amount to 30% of GDP for South Africa in 2016 compared with an average of 27% for the G20 emerging economies and 20% for upper middle-income countries. Once again the number for South Africa is already high in an international context, leaving no obvious room for increasing the tax burden.

South Africa furthermore collects the bulk of taxes at the level of central government, unlike some other countries. For example, in Brazil’s case less than half of tax revenue is collected at the central level (15% of GDP). National government thus has much more direct control over the allocation of government revenue and expenditure in South Africa.

The maximum sustainable tax burden is constrained by a narrow tax base (which is inter alia a reflection of the high level of inequality in the distribution of income).

Increasing tax revenue meaningfully would therefore require substantial increases in tax rates, resulting in the accompanying disincentive effects being more pronounced. Consequently any increase in government revenue to support higher expenditure will have to wait for the expansion of the tax base, for example by the introduction of new taxes or clamping down on tax evasion. The work of the Davies Committee on tax policy is a crucial input into this debate and awaits the government’s response.

From time to time suggestions have been made for some form of earmarked tax to finance specific expenditure without having to go through the normal budgetary process where it has to compete with other priorities for the available (scarce) resources. To date the National Treasury has been able to resist these requests but the question of earmarked taxes may be raised again, for example in connection with the need to increase the government subsidy to universities. It would therefore be appropriate to reiterate the principles regarding the acceptability or not of such taxes.

Apart from increasing taxes, the only other way to finance higher government expenditure would be through increased borrowing, which immediately raises the issue of what a sustainable level of public debt would be. Any decision to increase government debt will of course fly in the face of the National Treasury’s goal of stabilising the debt level as part of its campaign to avoid a sovereign rating downgrade. It would also clash with the need to reduce government debt in order to regain fiscal space to be able to counter future unfavourable economic developments.

South Africa’s current national debt level, excluding contingent liabilities such as those arising from guarantees to state-owned enterprises, nevertheless still compares favourably with those of other emerging-market economies (see figure below). The budget deficit, or more specifically government’s borrowing requirement, which determines to a large extent the pace at which the public debt increases, is also under control at 3,8% of GDP for 2016 compared with 4,4% for the G20 emerging economies as projected by the IMF.

 
 

Debt sustainability depends on a host of factors, including the level of economic growth, interest rates, the affordability of the interest burden, how much of the debt is denominated in foreign currencies, the percentage of total debt held by foreign investors, the strength of the domestic investor base, as well as what borrowings are used for.

South Africa’s poor growth prospects, together with the expected rise in interest rates globally as US monetary policy is normalised, pose a particular threat to the sustainability of current debt levels. If economic growth is lower than the interest rate on new government debt, as it is at the moment, it implies upward pressure on the debt-GDP ratio.

From a political as well as a financial perspective, debt sustainability also depends on the affordability of debt-servicing costs. These costs are already taking up more than 11% of total expenditure (double the average for upper middle-income countries) and are set to increase further, acting as an additional constraint on discretionary spending.

The question is for how long new claims on expenditure can continue to be accommodated by the reprioritising of existing expenditure. Once the limit is reached, and that cannot be too far off, the pressure will be on to adjust the expenditure ceiling. The way to avoid that is of course to grow the economy.

South Africa may yet come to regret that it did not introduce a fiscal council that would have provided independent oversight of government finances when the going was easy. To try to do so now will probably be futile as the necessary political support for such an initiative is unlikely to be forthcoming.

¹All statistics are from the April 2016 IMF Fiscal Monitor and World Bank World Development Indicators 2016 for the sake of comparability.
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