#Budget2018: Why hiking VAT might not be such a bad idea

PUBLISHED: Tue, 20 Feb 2018 19:26:39 GMT

By Nazmeera Moola, co-Head of Fixed Income, Investec Asset Management

After the euphoria of South Africa’s President Ramaphosa’s SONA, the 2018 Budget speech due tomorrow will bring South Africa down to earth with a bit of a bump.  The President said that hard choices will be needed – but making hard choices in five days is a big ask!

After spending a week immersed in the details of the budget, I’ve come to a few conclusions:

  1. A higher growth trajectory solves most ills.  South Africa’s growth forecasts were moved dramatically lower between the February 2017 Budget and the October 2017 MTBPS.  This was due to the sluggish growth outlook and weak revenue collection.  With some real chance of structural reforms after the change in president, it looks possible that growth moves back to 2.5% in 2020 and 3% in 2021.  This is still below the Treasury’s forecasts from February 2017, but will be enough to stabilise the growth outlook.
  2. Around R45bn of tax hikes and spending cuts are needed in the fiscal year that starts 1 April 2018 to stabilise the South African fiscal outlook.  With free tertiary education weighing on the fiscus, it will be difficult to achieve the R31bn in expenditure cuts that were planned.  At most R15bn is likely.  Therefore, tax hikes of around R30bn are needed.  Last year, personal income taxes (PIT) bore the brunt of the adjustment, with very little offset provided for inflation in the tax brackets.  As a result, households earning from R350 000/annum saw a decline in real wages due to limited tax relief for inflation.  While that maneuver can be repeated this year, it is woefully inefficient – and did not raise nearly the amount of expected revenue in 2017.
  3. A far better option is to hike VAT by at least 1%. Tax increases are always an emotive subject.  Value Added Tax or VAT is particularly so.  The main argument against an increase in the VAT rate is that this tax is regressive.  A regressive tax is one where the proportion of an individual’s income expended on that tax falls as they progress up the income scale.  The reasoning is that since lower income earners spend a greater proportion of their income on goods and services and save less, they also spend a higher share of their wages on VAT than lower income earners.

While this is true in developed markets, in South Africa, the situation is a bit more nuanced.  A February 2015 study by Ingrid Woolard and a few colleagues published in the World Bank paper titled The distributional impact of fiscal policy in South Africa, shows that VAT in South Africa would be regressive in the absence of the zero-rated food items.

The authors found that VAT is broadly neutral in South Africa.  This means that households across the income brackets pay roughly the same proportion of their income on VAT.  The conclusion is that VAT does not make inequality better or worse in South Africa.

With the inclusion of zero-rated goods, VAT becomes slightly progressive.  This means that higher income earners pay a slightly higher proportion of their income on VAT when zero-rated goods are taken into consideration than lower income earners.    This can be expanded by further increasing the zero rated items.

Moreover, work by the Davis Tax Committee found that a hike in VAT has the smallest negative impact on overall growth and job creation – relative to measures required to raise the same amount of revenue from corporate and/or personal income tax hikes.

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