Why not flatten South Africa’s tax rates?

Many people are waiting with great anticipation for the Minister of Finance to announce the 2006 budget this week. There will be differing opinions on where the money should be spent but the majority will be hoping for the same thing – less tax! There have been numerous proposals and recommendations but many of the experts have overlooked, whether intentionally or not, the simple solution to tax – what is generally known as a proportional rate or flat tax system.

Higher tax rates reduce the incentives of entrepreneurs to risk their capital and sacrifice their time and energy, interferes with the ability of individuals to pursue their goals, and results in lower after-tax incomes for workers and therefore smaller disposable incomes. Less disposable income means less saving; less saving means less capital formation; less capital formation means lower labour productivity and lower labour productivity means lower real wages.

South Africa, at 40%, has one of the highest marginal tax rates of all middle-income countries. By comparison, other middle-income countries have relatively low top marginal rates. Consider the following examples: Botswana (25 %), Brazil (28%), Malaysia (28%), Mauritius (25%), Namibia (35%) and Uruguay (0%). Not surprisingly, these countries also invested more in gross capital formation as a percentage of their GDP: Botswana (27.5%), Brazil (19.2%), Malaysia (20.6%), Mauritius (22.4%) and Namibia (22.7%) compared with South Africa’s 17.7%.

A proportional or flat rate tax system is one in which the ratio of tax to taxable income is the same at all levels of income. It replaces the various tax bands that feature in a progressive tax regime with a single rate. A ‘true’ flat tax makes no allowances for deductions and provides no special dispensation for low-income earners. However, for both compassionate and practical reasons there is no merit whatsoever in taxing the poor. The compassionate reasons are obvious while the practical reason is that below a certain level of income the costs of collecting taxes from the poor will exceed the amount collected. Low-income earners should therefore be exempt from paying any tax on personal income.

A decade ago there were 10 different tax brackets in South Africa, which has since been rationalised to six, so we could argue that we have been moving towards a flat rate system. Indeed, the major impetus behind the rationalisation is that it is easier to administer fewer brackets and one bracket would obviously be the simplest of all.

Well-known economist Arthur Laffer noted that government revenue is maximised at a rate somewhere between 0% and 100% of income earned by the taxpayer. At the extremes no tax would be collected. At a level above the ‘optimal’ rate it becomes counter-productive to raise tax rates further since people will evade tax or avoid it by not working, saving or investing.

Maximum tax revenue will therefore be achieved at a tax rate that avoids negative behaviour by providing taxpayers with what they judge to be an acceptable reward for extra effort and risk-taking, a rate that can be determined only by trial and error. Both higher tax compliance and the expansion of economic activity contribute to a broadening of the tax base. This explains one of the most paradoxical features of flat tax: the fact that it rapidly brings in more revenue at a lower rate. It does so because the lower rate is charged on more income.

At a low tax rate higher-income taxpayers may not only pay more tax but also a higher proportion of the total. When the UK cut its tax rates in the 1980s, the top 10% of earners, who had contributed 32% of income tax before the cuts, contributed 45% afterwards.

A number of countries have recently introduced a flat tax in order to stimulate economic growth. They include Estonia, which introduced a flat tax on personal and corporate income at a single uniform rate of 26% in 1994. This rate has gradually been reduced and next year the tax will come down to 20%. Other Eastern European countries such as Latvia and Lithuania have had flat taxes of 25% and 33% respectively since the mid-1990s. Slovakia introduced a 19% "true" flat tax on corporate, personal income and value added tax in 2004; the number of new firms registering in Slovakia jumped 12%. Hong Kong, which is by no means a small economy, has had a flat tax since 1948 and in 2004 enjoyed a growth rate of 8%, with a gross capital formation rate of 22%.

What the evidence tells us is that the best way to achieve economic and political objectives is not always obvious. The ANC government has already demonstrated this by collecting higher taxes by cutting the rates established by the previous regime, which also helped to change a shrinking economy into a growing economy. Even higher tax collections and higher economic growth rates can be achieved by doing more of the same.

Author: Jasson Urbach is an economic researcher at 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 Free Market Foundation.

FMF Feature Article/ 14 February 2006
Help FMF promote the rule of law, personal liberty, and economic freedom become an individual member / donor HERE ... become a corporate member / donor HERE