Cut VAT, not income tax

There is a fundamental contradiction in the government’s economic approach. It has adopted a counter-cyclical fiscal policy with an eye to stimulating growth and development through increased spending and investment. State spending is directed in key areas to boost employment and relieve poverty.

Simultaneously — at a time of economic downturn — it has chosen to give R4-billion in tax cuts to the relatively well off. The two policies clash.

The People’s Budget Campaign (PBC) — comprising unions, churches and NGOs — has proposals that, if implemented, could boost the state’s counter-cyclical measures while reducing the tax burden on the poor.

Over the past few years the government has chosen to maintain taxation as a percentage of gross domestic product — the tax:GDP ratio — at about 26%. This is much lower than comparable middle-income countries.

Several studies point to space for a higher tax:GDP ratio, and argue that current levels of taxation are in fact 7,8% lower than in comparable economies. They conclude that the tax:GDP ratio can be increased substantially over time by reining in tax cuts, closing loopholes in the taxation system and moderate increases in taxes. The PBC proposes increasing the tax:GDP ratio to about 29%.

This would make more revenue available for social spending. Through spending in education, health and public works, the poor can participate in the economy. In turn, they would contribute to taxes and uplift themselves.

The irony of recent years is that greater social spending could have occurred through the robust collection efforts of the revenue service. The revenue service not only reached its collection targets, it reeled in much, much more.

But instead of ploughing the money back into social services, the Treasury undertook massive tax cuts amounting to almost R75-billion on personal income tax alone. This was money that was essentially wiped off social spending.

The government has argued that the tax cuts will spur savings and investments. Yet the ripple effect of increased savings and investment has not materialised to the levels envisaged in the mid-1990s. Both remain well below the rates for comparable emerging economies.

The net result is that investment capital is not growing at the rate needed to support the government’s development goals, including the maintenance and extension of economic infrastructure and the provision of services to the poor. This is surely not in the interests of the private sector.

The tax cuts have a wider negative effect, however — one must have a job and earn more than R32 000 a year to begin enjoying the benefits. This means that the 30% of economically active people who are unemployed do not benefit from tax cuts, nor do the seven million recipients of social grants. Essentially, this is a tax cut for the relatively well-off.

The PBC has proposed a tax cut that will help the poor. Instead of a cut in personal income tax rates, they argue for a decrease in the value added tax (VAT) rate of 1%, from 14% to 13%.

This would boost the after-tax incomes of the poor and unemployed in particular. At current levels, a household earning R140 000 a year pays only 7% of its income in VAT.

By contrast, a poor household with an annual income of R18 000 spends 10% of its income on VAT. It is thus regressive tax, weighing more heavily on the poor.

To make the VAT system even more progressive, the PBC proposes the introduction of multiple VAT rates, entailing the introduction of a variable rate for different types of purchases.

For instance, buying a staple food could be zero-rated, while a VAT rate of 19% could be levied on jewellery purchases of more than R50 000. In essence, the proposals involve a combination of extended zero-rating on basic necessities, increased VAT on luxury goods and a 1% cut on other goods.

The net effect would be to reduce the amount of money that the poor pay on VAT. This would increase their disposable income for food and other basic goods, and ease their struggle to educate their children or participate in small-scale economic activity.

A 1% reduction in the general VAT rate would decrease tax revenue by R8-billion, which could be offset by higher VAT on luxuries and leaving income tax levels at their current rate.

In addition, the revenue loss would be significantly lower than that caused by historic cuts on personal income tax. The crisp issue is that the developmental impact of reducing VAT would be far greater than the further cuts personal income tax or company taxes.

The raising of the tax:GDP ratio and the introduction of variable VAT rates could lay the basis for sustained and more robust increases in social spending and integrating the poor into the economy.

If the government presses on with a strategy of cutting personal income tax, South Africa will be financing a higher deficit partially through tax breaks to the relatively well-off.

Ebrahim-Khalil Hassen is a senior researcher at the National Labour and Economic Development Institute

This article first appeared in the Mail and Guardian.