South Africa’s Medium Term Budget Policy Statement (MTBPS), which will be read on Wednesday, 26 October 2016, is unlikely to disappoint in terms of its adherence to a fiscal path which seeks to stabilise government’s debt level close to its current level. A gross loan debt ratio of 50.5% of GDP was recorded at end June 2016. Critically, the Treasury is likely to continue mapping a path to improve the primary budget balance (revenue less non-interest spending) from a deficit of little more than 1% of GDP in 2015/16 (Main Budget framework) to a surplus of around 0.5% of GDP by 2018/19, which is good enough to stabilise the debt ratio at, say, 52% to 53% of GDP within the next three years.
That said, some slippage in the projected fiscal deficit for 2016/17 is possible, given a (hopefully limited) shortfall on revenue collection. Revenue collection has held up remarkably well in recent years, considering the weakness of GDP growth. But, revenue growth cannot exceed GDP growth indefinitely, unless there is a change in the tax structure or the composition of GDP growth.
Available evidence from the history of fiscal consolidation in other countries suggests excessive fiscal imbalances should ideally be addressed through expenditure cuts – notably government consumption rather than capital expenditure. But, given an unemployment rate of around 25%, which limits the extent to which expenditure can be cut, the National Treasury has supplemented expenditure cuts with tax increases to boost revenue growth. Cumulative gross tax raising measures announced since 2015/16 amount to some 1.5% of GDP.
In the fiscal year to August 36.6% of Main Budget revenue had been collected, close to the average level of revenue collected in the opening five months of fiscal years since 1990/91. Hence, revenue collection appears more or less on track. It is not easy to judge the likely revenue outcome for the full fiscal year after just five months, but there are some concerns that have been raised. For example, the outright decline in the net operating surplus (tax base) of business enterprises in 2015 may translate into even weaker corporate tax revenue with a lag. Further, revenue collection in the current fiscal year is being supported by “one-off” non-tax revenue receipts related to financial transactions.
Even though GDP growth is likely to be weak in 3Q16, there is a case to be made growth will lift into 2017, barring external shocks. Indeed, income growth has already lifted. GDP in current prices increased 7.5% year-on-year and 7.3% year-on-year in 1Q16 and 2Q16 respectively. This follows a disappointing outcome of just 5.3% in 2015.
And, judging from gross operating surplus data provided by Statistics South Africa, more recent profits data has improved, which could lift the corporate income tax take further down the line. Concomitantly, gross domestic expenditure (the tax base for VAT receipts) in current prices increased 6.9% year-on-year and 6.1% year-on-year in 1Q16 and 2Q16 respectively. If maintained, this suggests growth in the VAT take should increase from its current depressed level.
In addition, potential revenue receipts from the foreign exchange control amnesty (voluntary disclosure programme) and measures aimed at reducing erosion of the corporate tax base have not been included in revenue projections.
These factors ward off the need for the introduction of extremely harsh measures to hit the fiscal target at this point. The Treasury is aiming for a deficit of 3.6% of GDP on the Main Budget deficit in 2016/17 followed by smaller deficits of 3.3% of GDP and 2.9% of GDP in the following two fiscal years respectively.
Of course, expenditure pressures persist. For example, some relief on education fees is likely to be incorporated in the Budget. For reference, we calculate implementation of a zero university tuition fee (only) structure would boost government spending in the region of R21 billion (0.5% of GDP). It appears as though this will be addressed, although not fully, in the expenditure projections.
Even so, there may even be room to cut current expenditure projections if expected savings from the work of the Chief Procurement Officer are realised. At the very least, we expect the National Treasury to hit its expenditure targets. After all, it has built up a solid track record in this department in recent years.
On balance, we suspect any slippage on the deficit is likely to be contained to around 0.2% to 0.3% of GDP, which implies the threat of additional tax increases still lingers. But, even if there is no slippage, there is still the matter of what taxes will be increased to cover the projected tax increases of R15 billion in both 2017/18 and 2018/19, which were announced in February 2016. Ideally, the aim should be to increase indirect taxes (VAT), as opposed to taxes on income. The latter are a disincentive to work, and to save and invest.
Ultimately, there are a number of options open to the Treasury. The Treasury may, for example, decide not to compensate for fiscal drag (as was the case in the current tax year), implement the “sugar tax” and /or increase capital gains tax or dividends tax. The latter two are taxes on wealth and income earned from wealth. But, wealth is accumulated savings and therefore taxes such as dividends tax or tax on interest income lower the returns on savings. This is not ideal considering South Africa’s inadequate gross domestic savings ratio of 16.5% of GDP.
In any event, the point is the MTBPS, on balance, should once again reflect the intent of the National Treasury to place South Africa’s fiscal policy on a sustainable path as it adjusts expenditure projections and tax regime to ensure the primary budget deficit returns to a surplus. The projected stabilisation of the debt ratio will, nonetheless, remain dependent on the ability of the economy to lift growth. After all, real GDP growth remains well short of the level required, considering the current level of real long-term interest rates.
The question, of course, is whether the Budget will be sufficient to stave off the risk of a credit rating downgrade. In June this year Standard and Poor’s (S&P) credit rating agency affirmed South Africa’s long-term foreign currency bond rating at BBB- (one notch above junk status) and its long-term local currency bond rating at BBB+ (three notches above junk status), while maintaining its negative outlook on the rating. The latter is an indication the agency expects to downgrade the rating in the absence of South Africa adopting measures to ensure a decisive shift towards long-term fiscal sustainability. S&P is expected to review the country’s rating in December 2016, although there is nothing to prevent it from concluding the review earlier.
Since ratings are, at least in part, based on opinion, the appropriate rating is not easy to determine. At the moment we believe current fiscal, real economy and external accounts data warrant the current S&P rating. However, in South Africa’s case economic policy uncertainty lingers. Also, the underperformance of state-owned companies and the possibility that additional central government guarantees may need to be extended is likely to be a source of concern for ratings agencies. The appropriate guideline is that net government debt plus guarantees should not exceed 60% of GDP. Currently, the figure is around 55% of GDP – uncomfortably high. It is these uncertainties that keep the likelihood of a sovereign debt rating downgrade high.
But at least it could be argued such an outcome is largely “in the price” as the credit default swap (CDS) market is pricing in such an event with South Africa trading in line with Brazil and Turkey (both rated two notches below South Africa). In the end, though, how financial markets react to a downgrade, if it occurs, depends on the policy response. An inadequate policy response that fails to signal a return in the fiscal accounts to long-term sustainability or does not anchor inflation expectations (and the inflation outlook) would invite the anticipation of further downgrades.
Arthur Kamp, Economist at Sanlam Investments