Raising taxes reduces income and higher debt service costs crowd out important economic and social expenditure, says Duncan Pieterse
There have been several calls for a large fiscal stimulus to support SA’s post-Covid recovery. While this seems reasonable, before SA can embark on a fiscal stimulus we need to answer two questions: can we afford it? And will additional spending raise economic growth?
The available evidence indicates the answer to both questions is, no. Though the recent supplementary budget allows for a substantial temporary increase in debt and spending in response to Covid-19, some have suggested the short-term increase in non-interest expenditure is insufficient. This is misleading, as it ignores the additional tax relief, the drawing down of government’s balance sheet through the temporary employee relief scheme, the introduction of the credit guarantee scheme and the monetary policy response. These measures provide immediate and direct relief to businesses to maintain productive capacity and support vulnerable and low-income households.
Can South Africa afford a fiscal stimulus?
That being said, is a larger and more permanent fiscal stimulus required to support the post-Covid economy? Turning to the first question: can SA afford a fiscal stimulus? To pay for a stimulus, a country can rely on conventional or unconventional methods. Conventional methods include raising taxes or increasing borrowing. Selling assets is another, but it only delivers a one-off boost to revenue, it is complex to execute because government assets are scattered across different entities, and it is unclear how much revenue it will raise.
Unconventional methods include accessing the broader balance sheet of the government by drawing down unemployment insurance fund surpluses, accessing reserves held by the central bank or allowing workers to access their pension fund savings.
Let’s consider the conventional methods first. Raising taxes to pay for a fiscal stimulus will not work because tax increases reduce current income for firms and households and thereby constrain aggregate demand and investment. Large tax increases over the past six years have been less and less effective, and there are no obvious gaps in the tax system that could generate sufficient increases in revenue. Paper evidence indicates there is little scope for raising marginal rates on high-income earners further without decreasing revenue collected. We also know tax multipliers are large and negative, which means tax increases could result in a further contraction in economic growth.
What about more borrowing? As the gap between revenue and spending has widened each year since 2008 higher borrowing has been required. Debt-service costs have been the fastest-growing area of spending: in rand terms we spend as much on servicing debt as we do on social development. There are signs that our lenders are concerned that we cannot pay back the money we have borrowed. Since the beginning of the year the rand has depreciated by 16.5% against the US dollar, the risk premium has increased from 3.2% to 5.3%, and the cost of insuring SA’s debt against default has increased from 1.6% to 3.1%. Without a fiscal adjustment, these developments point to a sovereign debt crisis for SA.