How to fix the fiscus
To achieve fiscal sustainability, SA must engineer a sustainable economic recovery — something which remains elusive
The recent weakness in economic growth, if it persists, threatens to cause some fiscal slippage this fiscal year, which could set in motion further tax hikes. But the real problems await further down the line should SA fail to stage a meaningful economic recovery over the next few years.
There is a misapprehension that the 2018 budget, which hiked VAT, snatched SA from the jaws of a debt trap and put the country on a sustainable fiscal path. While it certainly did the former, the fiscal risks have not gone away and SA’s long-term fiscal sustainability is far from secured.
Earlier in the year, pervasive optimism over the improving growth and political outlook raised the expectation that SA could look forward to positive credit-rating dynamics taking hold. Realism has since set in.
The concern is that downward pressure on SA’s credit ratings will again start to build due to disappointing growth, high unemployment and the country’s weak fiscal position, says Matrix Fund Managers macro strategist Carmen Nel.
"We should not dismiss the risk that SA will ultimately lose its investment-grade status entirely unless some hard and dramatic policy decisions are taken."
The first step must be to acknowledge that the consolidation package the 2018 budget delivered is far from ideal: productive capital expenditure has been cut, rather than the ballooning wage bill; taxes have been hiked, which will likely depress demand; and total expenditure will be allowed to keep growing faster than inflation over the medium term.
To achieve fiscal sustainability the government needs to reduce consumption expenditure and get the growth rate up — two things it is manifestly failing at.
With just two months’ data of the 2018/ 2019 fiscal year available it’s too early to say whether SA’s fiscal consolidation plan is on track, but there are some worrying signs.
Main budget revenue growth is largely on target at about 10.5% for April and May, but expenditure is growing at about 12%, well ahead of the National Treasury’s target of about 7%.
Nominal GDP growth is more worrying, coming in at only 6.2% in the first quarter compared with the Treasury’s forecast for a 6.9% increase for the year as a whole.
There is also a question mark over whether tax buoyancy will pick up to 1,5 (for every 1% rise in GDP, tax revenue rises by 1,5%) as budgeted for, given that it has been running at around 1 for the past year.
Sanlam Investment Management economist Arthur Kamp estimates that if nominal GDP growth remains at this pace for the rest of the tax year, the main budget revenue shortfall will be about 0.2% of GDP, or R9.5bn (assuming the expenditure target is met). He is not overly concerned, given that there is an R8bn contingency reserve for the year and such a small revenue shortfall should not alter the debt ratio significantly. A small bit of fiscal slippage is also unlikely to provoke immediate opprobrium from the ratings agencies.
But SA does need GDP growth to lift significantly into next year, and keep climbing.
The Treasury is budgeting for real GDP to rise from 1.5% in 2018 to 1.8% in 2019 and 2.1% in 2020. While this is in line with the prevailing consensus, it’s a shaky consensus. The inability of a proper upswing to take hold six months into the year is starting to make economists nervous.
Economic activity surged in the second half of last year thanks to firming commodity prices and the knock-on effect into higher consumer spending. But instead of rising confidence fuelling a recovery in fixed investment, employment and credit extension, the second leg of the recovery is completely missing.
While the possibility remains that fixed investment could take off on the back of President Cyril Ramaphosa’s investment drive, business confidence is faltering and private sector credit extension at 5,6% year on year is still too low to suggest a pick-up in growth is imminent.
But even assuming real GDP growth rises to 2% over the medium term, long-term fiscal sustainability will remain elusive unless SA has a continued business cycle upswing and real interest rates remain low.
Both are unrealistic assumptions given that the global recovery is becoming long in the tooth and that monetary policy is normalising in the US and Europe after a decade of ultra-low interest rates.
For some time, the government’s financing costs have exceeded GDP growth in both nominal and real terms. The real interest rate on SA’s existing debt is manageable for now at about 1.5%. But the real interest rate on long-term, noninflation-linked new debt at 3%-plus is too high even if SA grows at 2%.
In short, if growth does not recover sustainably above 2% over the longer term, SA will be in an increasingly difficult fiscal position and under renewed ratings-agency pressure.
Given SA’s low growth rate in relation to its financing costs, the International Monetary Fund considers 50% of GDP a prudent debt level for SA. This is roughly where SA’s net debt ratio is now.
However, SA’s gross public-sector debt ratio rises to 70% of GDP once the debt of state-owned enterprises (SOEs) is included, according to S&P Global Ratings estimates.
There was some disappointment in May when S&P kept SA’s foreign currency rating two notches into junk status at BB, but it explained that SA’s rating is constrained by its weak economic growth, large fiscal debt burden and sizeable contingent liabilities.
Despite acknowledging that SA was taking steps to reduce the deficit, S&P noted that the Treasury’s own estimates are for debt to continue rising over the medium term.
S&P also expressed concern that SA’s public finances faced risks from a higher public-sector wage agreement than budgeted for (a fear that has since been realised) as well as the possible need to provide unbudgeted support to SOEs with weak balance sheets.
Given that the government’s financing costs continue to exceed GDP growth, and the country has run a persistent primary deficit (the budget deficit when interest costs are excluded), there is little hope of stabilising the debt ratio over the next few years, let alone reversing it, says Nel. "If we add to that the potential for certain contingent liabilities to materialise and rising demands for free tertiary education and the implementation of National Health Insurance, then the debt ratio is at risk of becoming explosive," he says.
Ian Stuart, the acting head of the Treasury’s budget office, concedes that the higher-than-expected wage settlement and lower-than-projected economic growth have both increased the possibility of fiscal slippage in the 2018/ 2019 fiscal year.
However, he points out that there are no plans to raise departments’ compensation ceilings to accommodate the rise in the wage bill created by the R30bn settlement overrun.
"How the wage agreement feeds through to the deficit will depend on how departments act to absorb the costs and on the effect of the interventions announced by the department of public service & administration (early retirement and employee-initiated severance packages)," he explains.
"These interventions could add to spending pressures over the short term, but could also assist in reducing wage pressures over the medium term."
If some fiscal slippage occurs in 2018/2019, the immediate concern is that the government will resort to a fresh round of tax hikes in the 2019 budget to bring the fiscal consolidation plan back on track.
Stuart declines to be drawn on whether there is room to raise the three main taxes next year — corporate income tax, personal income tax and VAT — without dampening economic activity further.
He cites the guidance provided by the Davis Tax Committee that personal and corporate income tax increases are likely to have a greater negative impact on growth but that VAT increases have greater distributional concerns.
So far, the extra VAT revenue collected since the April 1 hike is in line with the Treasury’s expectations, according to Stuart. The rate adjustment does not seem to be having a substantially negative effect on consumption.
Several economists believe that SA is at, or close to, the turning point in the Laffer curve — that point where further increases in taxes lead to a decrease in tax revenue because the tax burden begins to depress economic activity.
But Stuart doesn’t believe that SA is at, or past, the peak of the Laffer curve. Of course, this doesn’t mean that further tax increases wouldn’t have a dampening effect on growth, he points out, just that they wouldn’t necessarily lead to a decrease in tax revenue for the state.