Budget 2018: Beware of focusing on the symptoms

By investment economist Arthur Kamp

Despite years of tax hikes and expenditure cuts, the Budget deficit remains wide and the government’s debt ratio continues to rise. Fiscal consolidation has not worked. Why?

One culprit is the depressed level of GDP growth. The good news is South Africa’s economic downturn seems to have bottomed in the middle of 2017 and the economy is set to grow faster in 2018 and probably next year too – provided global real economic activity is sustained.

The 2017 Medium Term Budget Policy Statement (MTBPS) reflected a consolidated deficit of 3.9% of GDP for the three fiscal years commencing in 2018/19 and an increase in the government’s debt ratio to 60.8% of GDP by 2021/22. However, slightly firmer growth, together with the additional fiscal consolidation “promised” by the National Treasury, should ensure the projected government budget deficit and debt level numbers for the next three years are not as worrying as those reflected in the MTBPS.

If so, Budget 2018 is likely to be applauded. But, we should not focus on debt and budget balance targets alone. These are merely the symptoms of the problem.

Not all debt is bad; the high interest rate is the problem

Viewed in isolation the debt level does not tell us much. We observe South Africa’s current gross loan debt level of just over 50% of GDP is in line with the IMF’s estimate of 49.2% of GDP for the general government debt of the G20 emerging market economies in 2017. So, why is it a concern? The debt level is a problem because of the high real interest rate South Africa pays on its newly issued debt against the background of modest real GDP growth.

Low growth: the root of our problems

Poor growth constrains revenue collection, while ever-increasing interest payments are absorbing a larger and larger share of revenue. As a result, the government must cut its non-interest spending, or increase taxes, to such an extent that its budget balance excluding interest payments returns to a surplus, from an estimated deficit of -1.2 % of GDP in 2017/18.

Many routes to boost growth and lower rates on government debt

To be sure, an unchecked, persistent increase in the debt ratio, reflecting sustained large budget deficits, is bad news. But, we should not judge the merits of Budget 2018 on its budget balance and debt ratio projections alone. Rather, we should assess whether the Budget makes a contribution to the growth objective and lays the groundwork to lower the real interest rate government pays on its debt.

As regards real interest rates, the Reserve Bank is already doing its bit, diligently pursuing its inflation target and, more recently, emphasizing its long-term inflation target is closer to the middle of the inflation target range, rather than the upper end where inflation expectations are seemingly anchored.

The Treasury, meanwhile, should help change expectations of further sovereign debt rating downgrades into expectations of sovereign debt rating upgrades. It can go some way towards achieving this by emphatically shifting government expenditure towards investment in infrastructure and human capital and away from government’s wage bill. This will not only make a contribution to South Africa’s potential growth rate, but will also help protect the state’s balance sheet as borrowing is directed towards the accumulation of capital rather than consumption.  Critically, expenditure on human capital includes health and education, which necessitates sharp cuts to government consumption spending. Failing this, the expenditure burden is likely to prove too much for our economy to cope with.

Another cause of our problems – the rise of contingent liabilities

Focusing too narrowly on the central government’s fiscal targets also draws attention away from the government’s steadily rising contingent liabilities, some of which have become actual liabilities. These include, but are not limited to the financial position of state owned companies (SOCs) requiring capital injections to stay afloat. This is a clear and present danger. Government has guaranteed a large share of SOC debt and will need to present a credible strategy in Budget 2018 as to how it intends improving the situation.  This may include the sale of non-core assets. But selling assets to plug holes is not a long-term solution. Ultimately, the commercialisation of parts of SOCs, including clear demarcation of their commercial and developmental operations and/or the pursuit of partnerships between the public and private sectors should be explored as options.

VAT: hike the tax that supports growth

At the same time, the tax structure should be aligned with South Africa’s growth objective. If so, it could be argued that we should increase taxes on consumption and limit tax increases on savings and the income of employees. This line of reasoning would favour a VAT rate increase. However, acute income inequality in South Africa demands that the tax system should focus on fairness. An increase in the VAT rate is not considered to be fair on lower income earners, because higher income earners spend a smaller portion of their income on consumption than lower income earners. Hence, low income earners pay over a larger share of their income for VAT than higher income earners.  But, VAT need not be as regressive as widely thought if products on which low income earners spend a large share of their income are zero-rated or excluded.

If implemented, these interventions would not make much difference to government’s budget balance and debt level projections in the near term. However, they would plausibly help address key concerns of investors and make a meaningful contribution to lifting South Africa’s potential growth rate, while likely, all else equal, lowering the risk premium on investing in South African assets, which would lower the interest rate on government debt repayments. In so doing, we will directly address the causes of South Africa’s deteriorated fiscal position.

Arthur Kamp
Investment economist

Arthur has been an investment economist at Sanlam since 2005, providing economics input on the domestic and global economy to the asset allocation team. Before Sanlam, Arthur worked as an economics consultant at Eskom from 1990 to 1995 and thereafter spent 10 years working as an economist at stock broking firm Simpson McKie, which was later bought by global investment bank HSBC.