By Arthur Kamp, Economist at Sanlam Investments
Government’s budget deficit and debt level numbers do not, in isolation, reveal whether its fiscal consolidation effort is gaining traction or not. That is not to say these ratios are unimportant. Successful fiscal consolidations inevitably need improved budget balances to stabilise the debt ratio and place fiscal policy back on a sustainable path.
However, fiscal consolidation that constrains spending by reducing capital expenditure relative to government consumption, or allows the build-up of large off-balance sheet liabilities, ultimately risks failure. The former implies the government is borrowing to fund consumption spending. The latter implies the true (weak) fiscal position of the state is only revealed in the long run.
Government’s ability to cut expenditure relative to GDP is especially important
In this regard the National Treasury has performed admirably in containing expenditure growth in the first nine months of fiscal year 2018/19. Indeed, Main Budget expenditure advanced by 4.6% year-on-year over the first three quarters of the fiscal year. This compares favourably with an initial budget of 7.1% (February 2018), later revised to 7.7% in the 2018 MTBPS. Admittedly, government spending can be “lumpy”, and expenditure could lift in the last three months of the fiscal year. Even so, we expect significant savings over the full fiscal year.
But, looking ahead, considering contingent liability risks listed by the National Treasury in the 2018 MTBPS, the government is likely to need those savings. To start, the Treasury warned provinces have some R25 billion in unpaid bills. Further, the Treasury noted 113 local governments adopted unfunded budgets in 2018/19, compared with 83 municipalities in 2017/18. Local governments are expected to fund most of their expenditure from own revenue, but they do receive an allocation from government. The problem is local government arrears amounted to an estimated R23.4 billion in 2017/18.
In addition, legal claims for medical negligence are a substantial contingent liability for provincial health departments. These claims amount to R80 billion. It is unlikely all claims will be successful. Still, pay-outs amounted to R1.5 billion in 2017/18, while the 2018 MTBPS indicated they are likely to exceed R2 billion in 2018/19.
Also, the implementation of National Health Insurance will require material resources in the years ahead, while potential upward revisions to future population estimates, if realised, would need to be included in government spending projections when the medium-term expenditure framework is announced in October 2019.
Moreover, the Treasury projects total worker compensation, which accounts for 35% of government’s total consolidated expense bill, will remain high.
Meanwhile, revenue collection continues to underperform
Despite increases in taxes on personal income, goods, dividends and capital gains the Treasury notes the revenue shortfall increased from R7.4 billion in 2014/15 to R49 billion in 2017/18.
For 2018/19 a total revenue shortfall of more than R30bn is expected compared with the initial budget read in February 2018.
It’s concerning that tax buoyancy continues to surprise on the low side
Tax buoyancy (the rate at which government taxes increase relative to the increase in GDP) continues to surprise on the low side despite tax increases, including the VAT rate hike in 2018. The latter was a veritable tax bonanza for the state, but this was counteracted by weaker than expected income tax collection on companies and individuals. The government also had to deal with a substantial backlog in VAT refunds.
In February 2018, the Treasury expected a tax buoyancy ratio of 1.51 for 2018/19. This was subsequently revised lower to 1.21 in the October 2018 MTBPS and is likely to be lowered further.
At least, given savings on expenditure, National Treasury is expected to match or even improve on its projected Main budget deficit of 4.3% of GDP for 2018/19 printed in the 2018 MTBPS. Also, budget deficit projections for the next three years are unlikely to be alarming.
What is happening to the public sector’s net worth?
However, the above estimates do not reflect the unfolding deteriorating trend in the public sector’s net worth as it accumulates more debt, while its current expenses increase relative to its purchase of fixed assets.
In aggregate, non-financial state-owned companies’ cash payments for operating expenses have continued to trend upwards, relative to the flat trend for capital expenditure. Accordingly, total public sector infrastructure spending has declined from more than 8% of GDP in 2009/10 to close to 5% of GDP in 2018/19.
To be clear, a large share of state-owned company debt still funds capital expenditure. But, as the Treasury notes in the 2018 MTBPS, an increasing portion of debt is going towards funding operational expenditure and interest payments.
This is a problem for the government, which, according to the Treasury, had a guarantee portfolio of R670 billion when the MTBPS was read in October last year, with Eskom accounting for roughly half of this amount. At end June 2018, R334.2 billion of these guarantees had been taken up.
With crippling debt of its own, government can ill afford to bail out Eskom
The risks associated with these trends are being realised as the Treasury prepares to announce how it intends supporting Eskom’s balance sheet in Budget 2019, even though it has limited space to do so. Indeed, the central government’s own gross loan debt ratio continues to increase persistently with upward revisions the norm in recent years. The 2018 MTBPS mapped a path to a debt ratio of close to 58.5% of GDP by March 2022, while its debt service costs increase from 3.6% of GDP in 2018/19 to 3.9% of GDP in 2021/22.
Looking ahead, a true fiscal consolidation will require the promotion of capital expenditure relative to consumption (which needs to be cut) and the implementation of the reform measures announced in the 2019 State of the Nation Address, such as:
- Strengthening the capacity of the state, notably in implementing infrastructure projects
- Restructuring state-owned companies, notably Eskom
- Improving governance and financial management at state-owned companies
- Being amenable to equity partnerships and selling non-core assets where necessary
South Africa is moving beyond the crossroads. The decisions taken in 2019, starting with this week’s Budget, will provide important clues as to which path we have picked. At the very least, government support for state-owned companies must be accompanied by a credible plan for the turnaround of these entities.
The point is, a fiscal adjustment needs not only an improving trend in government budget deficits. It must also address the deteriorating trend in the public sector’s net worth.