Fiscal sustainability a serious challenge

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The global credit crunch has severely impacted public finances around the globe and governments need to implement credible strategies to deal with the deterioration in their fiscal positions. While the nascent recovery in the global economy certainly does require further nurturing by governments, countries do need to produce credible plans to ensure government financial positions are sustainable – and S A is no exception.

Government “short-sightedness” and the “common pool problem”

One option is to employ fiscal rules – official public fiscal commitments – to enforce the attainment of narrower budget deficits thereby curbing rising debt levels and debt servicing costs. Fiscal rules are already used in numerous countries around the globe, although some countries changed or suspended rules as the global crisis unfolded.

Fiscal rules require bucket loads of political will. The IMF Fiscal Affairs Department notes fiscal rules are useful in that they aim to correct distorted incentives faced by policymakers. Distortions arise from “governments’ short-sightedness” and the “common pool problem” (Cottarelli, 2009, p.14). The former refers to fiscal decisions that reflect electoral positioning, rather than sustainability considerations. The latter I interpret as the use of public resources to enhance special interests at the exclusion of others.

Of course, fiscal rules need to be flexible enough to cope with adverse shocks like the one we have just experienced. Equally, when faced with pressing needs, governments may be tempted to plunder available resources with little regard for preserving fiscal sustainability for the benefit of future generations.

No room for further slippage

SA does not have a concrete fiscal rule, although government’s Growth Employment and Redistribution (GEAR) plan, introduced in 1996, did initially refer to a reduction in the budget deficit to 3% of GDP over time. Rather, government’s commitment to sound fiscal policy has been reflected in the Medium-Term Budget Policy Statements (MTBPS) and Medium-Term Expenditure Framework (MTEF) introduced in December 1997 – a “soft” fiscal rule whereby the Treasury commits to maintaining a sustainable fiscal position.

Over the past decade, the National Treasury persistently beat targets for the budget and debt levels published in the MTBPS. But, the necessary fiscal response to last year’s globally induced recession changed all of that. An estimated consolidated National Budget deficit for 2010/11 of about 8% of GDP has placed SA on a markedly different fiscal path to the one reflected in the Budget Review published just one year ago.

According to the MTBPS, the structural budget balance (cyclically adjusted budget balance) is expected at 5.7% of GDP in 2009/10. This is a concern and to a large extent reflects permanent expenditure increases. Further, the structural budget deficit is expected to remain in excess of 4% of GDP over the medium term expenditure period. This implies debt servicing costs will probably not stabilise over the medium-term. Indeed, State debt cost is expected to increase by an average 18.1% a year from 2010/11 to 2012/13 – effectively reversing the past decade’s favourable trend that saw lower debt servicing costs freeing up resources for expenditure elsewhere.

MTEF modest expenditure projections

Graph 1

In line with the 2009 MTEF, this week’s Budget will need to reflect a restraint in expenditure growth and, possibly, an increase in the tax burden. There is no room for further slippage. The MTEF projects an average annual increase in total consolidated expenditure of 7.8% over the next three years – little more than 1.5%a year in real terms. That is a remarkable shift from recent years and there will be lingering doubts about whether this can be achieved – especially since the introduction of National Health Insurance is waiting in the wings. But, it is all we can afford because under the existing framework government’s debt ratio is likely to rise to close to 50% of GDP by 2012/13 – i.e. back to its mid-1990s level when Manuel first took over the fiscal reins.

Tax revenue and GDP growth

Graph 2

It is hoped better-than-expected real GDP growth in the years ahead will create some leeway. However, potential economic growth is no longer likely to be 4.5% to 5% as it was leading up to the financial crisis. Given real GDP growth of say 3.5% to 4% during the unfolding upswing and GDP inflation of, say, 6%, nominal GDP growth of about 10% is probably the best we can expect. But, the MTBPS projects revenue growth in excess of this at 13.1%, 12.1% and 10.5% over the next three fiscal years respectively. Initially, as economic recovery gains traction in 2010 and 2011, revenue may advance faster than GDP in current prices. Ultimately, though, revenue elasticity is close to 1. Moreover, the tax burden is already high as a share of GDP. This suggests limited scope for meaningful upside surprises to revenue growth.

State of the Nation Address right on the money

It is unlikely government will give reassurance in the form of hard and fast fiscal or expenditure rules. However, the National Budget should not deviate much from the 2009 MTBPS, as was evident in President Jacob Zuma’s State of the Nation Address delivered last week, which did not deviate from the numbers included in the current MTEF.

Since it is not likely that government’s finances will stabilise during the medium term, i.e. over the next three fiscal years, financial market participants will still want to see a firm commitment that government will reduce the budget deficit beyond the medium term. That, of course, will depend on whether the unfolding economic upswing endures beyond the next three years!

Apart from a commitment to ensuring long-run fiscal sustainability, the MTBPS and the State of the Nation Address gave no hint of any deviation from either the path of continued financial account liberalisation or the commitment to low inflation. Indeed, the MTBPS clearly commits to these policies.

The Treasury places a great deal of emphasis – perhaps too much – on the need for a competitive realexchange rate. But, it sees low inflation as an important condition to achieve a competitive real exchange rate. This suggests continued support for the inflation-targeting mechanism, with a bias towards maintaining an inflation rate that is not far from SA’s trading partners.

I do await with great interest, though, the outcome of the National Treasury’s investigation into “the development of asset prices and their impact on inflation” (MTBPS, 2009, p.9).

Concomitantly, the Treasury hints at maintaining a weak exchange rate bias by weakening the nominal exchange rate through foreign exchange purchases. We may argue about the damage this may or may not do, but the good news is the Treasury will seek to further encourage two-way flow in the currency to reduce volatility by continued exchange control liberalisation.

The lesser appreciated benefits of low government debt ratios and inflation

What is most needed from the forthcoming Budget is a commitment to policy continuity. Policies designed and implemented by SA’s National Treasury from the mid-1990s, along with structural reform of the economy, such as  tariff reform, facilitated a 4.5% to 5% a year surge in SA’s growth during the four years leading up to the global economic fallout.

The sharp fall in government’s debt ratio from close to 50% of GDP in 1995/96 to close to 25% in 2008/09, together with a decline in inflation from double to single digits, together lowered the structure of interest rates. Reduced government deficit and debt ratios were also accompanied by a material improvement in SA’s credit ratings, thereby reducing the SA’s sovereign risk premium..  Corporate and individual tax rates were cut meaningfully too.

This virtuous set of circumstances set the scene for a patch of strong private sector investment and GDP growth and low inflation. Unsurprisingly, the equity market rerated. Little wonder financial market participants will be keen to see a Budget in line with the 2009 MTBPS, which emphasises the importance of curbing spending growth to ensure fiscal sustainability and maintaining low inflation.

Incidentally, even though the corporate tax rate was cut, the tax take from corporations rose sharply relative to GDP. The accompanying rise in the share of gross operating surplus to GDP suggests an ever-increasing share of the pie was ending up with capitalists. Not so, after adjusting for net interest and income tax payments the share of capital in GDP has remained relatively constant as share of GDP. Thus corporations contributed greatly to improving government finances over the past ten years; supporting a robust expansion in government expenditure.

Depression level unemployment demands attention – and it will get it

However, these policies are not a sufficient condition in ensuring continued robust, employment-generating growth. The socio-economic stress caused by SA’s depression level unemployment rate compels government to act to reduce it.

Have you ever wondered why investors everywhere prefer productive economies that deliver high growth, low inflation AND low unemployment rates? It’s because sustained high unemployment rates ultimately introduce significant fiscal risk.

Inadequate education and skills development are fundamental reasons for SA’s structural unemployment problem. If SA does not address these issues satisfactorily the distress caused by SA’s unemployment problem will affect every taxpayer. Against this backdrop, we can expect the 2010/11 and subsequent budgets to introduce specific measures and incentives targeted at promoting labour-intensive growth by supporting small scale farmers, introducing wage subsidies and social security contributions and employing matriculants.

These interventions will inevitably increase the tax burden. Indeed, the MTBPS warns that even if growth resumes, revenue growth is likely to fall short of what is required to ensure fiscal sustainability. Thus the tax base will have to be broadened going forward and new taxes may be required.  For example, additional environmental taxes are likely and taxes may have to increase to fund wage subsidies. Industrial policy is likely to target labour intensive GDP growth, possibly supported by special export zones. 

Individuals’ tax burden is set to become more onerous

The MTBPS projects an increase in the ratio of total revenue to GDP from 27.3% in 2009/10 to 29.6% by 2012/13 – and individuals are likely to bear the brunt of the search for more revenue. This is already reflected in National Treasury’s existing revenue projections, which spell out a  material increase in personal tax as a share of total tax revenue over the next three fiscal years.

Specifically, the MTBPS indicates the contribution of individuals’ income tax to gross tax revenue is set to increase to 37.3% by 2012/13 from 34.5% in 2009/10. This reverses a seven year declining trend during which individual income tax fell from more than 40% of tax revenue in 1999/00 to less than 30% in 2006/07, while corporate tax increased from 10% to 24.0% during the same period.

Given an expected marked increase in personal income tax collections, individuals should prepare for either higher tax rates or additional taxes. For example, while the “luxury” ad valorem excise estate duty rate on the sales of new motor cars is expected to be reduced, it looks like an ad valorem “emission” tax rate on motor vehicles is on its way. So you can expect to pay progressively more tax on CO2 emissions that Treasury deems too high.

Rising personal income tax burden

Graph 3

Fiscal sustainability a serious challenge

Overall, there is no more room to boost spending projections and this year’s National Budget is likely to reflect long-term projections that are similar to those contained in the MTEF published late last year. However, government is unlikely to be able to stabilise its finances over the next three years and if government wants to ensure fiscal sustainability in the medium- to long-term, it will have to ensure there are continued improvements in the budget balance beyond 2012/13.

The extent of the expenditure restraint required to ensure long-term fiscal sustainability is likely to leave some lingering doubts about whether fiscal restraint is likely to be achieved over this period. Certainly, there is a growing expectation that the tax burden is likely to increase with the introduction of new taxes to make inroads into SA depression-era unemployment problem.

Ultimately, however, macroeconomic policy must support the private sector as the engine for growth because government alone cannot generate enough growth to ease our unemployment problem. In addition to a continued commitment to low inflation and an open economy, government needs to be mindful that big deficits and rising debt ratios push real interest rates higher – potentially crowding out the private sector.

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