It’s time for Finance Minister Pravin Gordhan to again walk a tightrope as he tries to balance the country’s books. On the one hand, he will be under pressure from those on the left to substantially increase government spending on social welfare. On the other, there will be those hoping for prudent macroeconomic fiscal policy.
Let us rewind the clock back to October last year. When he presented the Medium Term Budget Policy Statement (MTBPS), Mr Gordhan read out from the MTBPS “South Africa’s present economic growth trajectory cannot meet the country’s employment needs. Faster growth is required over an extended period of time to significantly increase labour absorption, reduce high unemployment and achieve a more equitable distribution of income”.
In the MTBPS he also made known that “While social grants provide an important safety net for about a quarter of the population, South Africa’s long-term prosperity depends on more people being drawn into work. The private sector accounts for 75 per cent of all economic activity and a slightly higher share of employment, and will remain the primary driver for job creation. The public sector plays a complementary role in this process”. Based on the above, one can infer that the government is well aware of the role of growth in alleviating unemployment and poverty in the economy and that the private sector is the primary driver of economic growth.
So how do you encourage the private sector? Well, one basic fact of economics is that people respond to incentives. The top marginal tax rate in South Africa (SA) is 40 per cent, one of the highest in developing countries, which have relatively low top marginal rates, eg, Argentina (35%), Botswana (25%), Brazil (28%), India (30%), Malaysia (28%), Mauritius (15%), Russia (13%) and Uruguay (25%).
In SA, this means that for the individuals who fall into the top marginal tax bracket, up to 40% of their annual income goes towards financing the state’s activities and supporting the poor, the sick and the needy. Typically, these individuals are the ones who fund new investment in the economy, which creates those essential new jobs we are so badly in need of. The tax bill of these individuals equals approximately five months’ earnings. What kind of incentive is it for these people who are necessary for our economy to have to spend the first five months of the year working to support somebody else? Only after May do they begin earning an income that supports themselves and their families.
Also, the more we restrict the amount these people can invest in the economy, the less the investment will be and fewer jobs will be created. Without investments to fund and establish new ventures, the smaller the economy will be, and the inevitable result overall will be less tax revenue. Considering SA’s high rate of poverty and unemployment, some may well ask how will the government support the 13-million odd individuals currently benefiting from the fruits of others’ labours, without increasing tax rates? It is time for the government to recognise that the best way to improve conditions for the poor is not by taxing those who produce wealth and redistributing the proceeds. Government should pursue policies that promote economic growth and expand the entire tax base, and stop preventing people from working.
High tax rates lessen the incentives for entrepreneurs to risk their capital and sacrifice their time and energy to earn higher incomes. Higher tax rates result in lower after-tax incomes for ordinary workers, preventing them from pursuing their personal goals. Less disposable income in the hands of ordinary citizens means less saving which is critical for the economy as a whole. Investment, especially in fixed assets such as buildings, machinery, equipment etc, commonly referred to as gross fixed capital formation, is essential for increasing wealth and jobs in the future.
The ratio of gross fixed capital formation to GDP currently stands at about 23 per cent, 2 per cent below the targeted 25 per cent. When domestic savings are lacking, a country has to rely on foreign capital inflows, which are notoriously volatile. Ideally, SA should increase its domestic savings rate to free up capital for investment in productive assets and to boost growth. But SA’s domestic savings rate stood at approximately 16 per cent of GDP in 2010. By comparison, according to the World Bank, the average gross domestic savings rate for upper middle-income countries is 24 per cent. SA must therefore increase its domestic savings levels. One way to do this is to lower the tax rate to encourage savings.
In the current economic climate, government, like business, should focus on its core activities. Government’s core functions include ensuring that there is sufficient policing, the courts are impartial and efficient, and the rule of law is respected and enforced. Security of property rights is also essential for economic growth. When individuals know that their land and possessions are secure and protected, they have an added economic incentive to go out and earn a living.
Taxing productive individuals and companies to redistribute wealth reduces the incentives to produce goods and services and retards growth. History has demonstrated that it is economic growth that is the key to reducing poverty and expanding opportunities for the unemployed, and not the simple redistribution of wealth. The 2011 budget speech will reveal whether government is brave enough to choose economic growth as its main priority.
Author: Jasson Urbach is an economist with the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author's and are not necessarily shared by the members of the Foundation.
FMF Feature Article / 22 February 2011