The increased attention on the Budget is largely because of the threat to South Africa’s credit rating as we are still in a global downgrading cycle and have experienced a rapid build-up in debt and decline in growth.
According to Dave Mohr, Chief Investment Strategist and Izak Odendaal, Investment Strategist for Old Mutual Multi-Managers, tax revenues collapsed as the recession hit in 2009. In his first stint as Finance Minister, Pravin Gordhan increased expenditure to help stimulate the struggling economy by borrowing and turning the modest budget surplus into a sizeable deficit (this was text-book countercyclical fiscal policy).
Since then, tax revenue and spending have grown roughly at the same pace. However, to close the deficit and reduce debt, tax revenue has to grow faster than spending. Economic growth declined and from 2012 onwards forecasts had to be revised down year after year. The tax revenue assumption in the Budget is based on the growth forecast, but the initial growth estimate has been too high every year since 2012.
This meant disappointing tax revenue (especially from companies) and that “fiscal consolidation”, the process of cutting the deficit and stabilising debt, had to be postponed further and further into the future. The alternative – to aggressively increase taxes and cut spending – risked tipping the economy into recession, worsening the debt and deficit ratio in a vicious cycle.
According to the Davis Tax Committee (DTC), the current ratio of 26% is above the peak of the boom years and higher than the average of OECD countries (excluding social security taxes). A further increase to 27% is projected, but it is debatable whether this ratio can rise much further without killing the metaphorical golden goose. This means that either economic growth needs to accelerate to increase tax revenue at a stable ratio or spending as a percentage of GDP needs to moderate.
The decline in company taxes had to be made up largely by personal income tax (PIT), which has been surprisingly robust growing faster than nominal GDP over the past few years. This was supported by wage settlements consistently in excess of inflation while asset price increases also helped (and a 1% increase in the tax rate in 2015).
According to the DTC, the richest 10% of the population (who earn 63% of income) contributes 86% of PIT, and the buoyancy of PIT suggests this segment have done well despite tough times elsewhere. But there are also limits to how much this segment can be squeezed further, as it already funds a third of government spending through PIT and contributes to value-added tax and municipal coffers (not included in the Budget).
Value-Added Tax (VAT) collections tend to rise and fall with the economic cycle but is very stable compared to company tax. Growth in VAT slowed down to close to zero in the middle of last year. However, it has rebounded to 7% by December as the economy improved.
On the spending side of the equation, there is no shortage of competing demands, with calls for free tertiary education still top of mind. Treasury has a reputation for discipline in spending growth (not always matched elsewhere in Government). It is expected that the expenditure ceiling which has done.
The most immediate risk is the public sector salary agreement that expires at the end of the coming fiscal year. The proposed nuclear build programme remains a source of uncertainty, but it is unlikely that the Budget will make provision for it.
Unfortunately, fixed investment, rather than salaries, typically bears the brunt of attempts to control spending. Government fixed investment has increased by almost a third in real terms over the past five years, but its share of GDP barely increased from 2.9% to 3.4%.
Therefore, the deficit reduction as proposed in the 2016 Medium Term Budget – with the budget deficit declining from 3.1% in the current fiscal year to 2.5% over the subsequent two years – is likely to remain on track. What are the implications?
For the economy:
In the short term, fiscal consolidation – higher taxes and slower growth in government spending – is a drag on economic growth, but should not derail the recovery. Longer term, the South African economy needs policy certainty and restructuring of the major state-owned enterprises to ensure that they no longer put strain on the fiscus or hampers economic activity and other growth enhancing reforms. The Budget could give updates on this, but big policy changes seem unlikely before the ruling party’s elective conference at the end of the year.
Tax increases are expected to come from a variety of sources but ultimately involves the taxman sticking his fingers deeper into consumers’ pockets. This will place some pressure on household spending, but declining inflation should offset the negative impact on real disposable income to an extent.
A “good” budget is necessary but not by itself sufficient for securing South Africa’s investment grade rating. Political stability and faster economic growth will also be required. But Wednesday’s Budget is likely to be the first step in maintaining current ratings. Either way, a commitment to fiscal discipline is positive for bonds as it caps the new and therefore supports prices.
Fiscal consolidation tends to put downward pressure on inflation, making it more likely that the Reserve Bank will consider interest rate cuts, a further positive for domestic bonds.
The company tax rate is expected to remain unchanged, which means that there is no impact on after-tax profits. Small increases in dividend withholding tax or capital gains tax are possible, which will make equities relatively less attractive for local but not foreign investors. Since the R28 billion tax increase was already announced in October last year, it is likely to already be discounted in the share prices of domestically-focussed companies.
Sugar and carbon taxes – which will impact a few specific listed companies – are still being debated and the timing of implementation is uncertain. Global market developments are more likely to drive the JSE than the outcome of the Budget Speech.
For the rand:
The rand has appreciated sharply over the past year despite global and local political uncertainty and the risk of ratings downgrades. Commodity prices, sentiment towards emerging markets and expectations for US interest rate increases will more than likely continue to be the primary drivers of the rand. The Budget is unlikely to change this.