South Africa’s new government on a tightrope

South Africa’s Government of National Unity (GNU) is in a difficult position. It must fix the country’s fiscal crisis but cannot raise taxes or cut spending substantially.

This was revealed in the Centre for Development and Enterprise’s (CDE) latest report in its AGENDA 2024 series, which sets out several catalytic actions to reverse South Africa’s decline.

The third report in the series, ACTION THREE: Fix the Fiscal Crisis, emphasises the importance of addressing the country’s fiscal crisis to avoid catastrophic outcomes.

“Years of large structural gaps between government’s revenues and its spending have wiped out the fiscal progress achieved in the first 15 years of democracy, and the country is now in a much worse position than at the start of the democratic era,” the CDE said.

South Africa’s debt-to-GDP ratio declined from 50% in 1994 to 24% in 2008 but has now risen to 74%.

The organisation said, “Resolving this requires a combination of higher revenues, spending cuts, and economic growth.” 

“This is exceedingly difficult because raising taxes or cutting spending tends to slow growth, at least in the short term.”

South Africa’s fiscal deficit results from years of government spending outpacing revenue. Therefore, the best way to address it is to increase revenue and cut spending. However, the CDE report revealed this is far easier said than done.

One of the simplest ways for a government to increase revenue is by increasing taxes. However, the GNU does not have this option.

According to the CDE report, there is limited potential for raising more taxes in South Africa and doing so would weaken growth.

This is a general finding in macroeconomic research and reflects recent domestic experience, where increases in tax rates have tended to produce less revenue than expected.

“This is partly because the fiscus is already taking in as large a share of GDP as has ever been the case, resulting in few remaining low-hanging fruit for the revenue authorities to pluck,” the report explained.

South Africa’s tax base is already overburdened, with a very small number of South Africans paying a very large portion of total personal income tax.

National Treasury’s individuals and taxable income for the 2024/25 financial year showed South Africa has 7.4 million personal income taxpayers. Therefore, only 12% of South Africa’s population pays personal income tax. 

However, it gets worse. The data further showed that only 862,000 people pay 58.7% of all personal income tax.

That means South Africa relies on only 1.4% of its population – less than 1 million people – to provide most of the money for education, healthcare, security, and social grants.

Therefore, the South African Revenue Service has been on a compliance crusade over recent years, attempting to increase revenue by increasing compliance rather than relying on higher taxes.

The report said some improvement in enforcement could generate additional revenues. However, there is every reason to think that higher taxes will induce behavioural responses, making tax collection less efficient and equitable. 

This has already occurred – recent research shows that introducing a new maximum personal income tax band resulted in high-income earners finding ways to reduce their overall tax burden, including by choosing to work less hard. 

“The result of imposing higher taxes will likely be a decline in the progressive nature of the tax system as high-income taxpayers are better able to structure their incomes in the most tax-efficient ways,” the report explained. 

“The result is the opposite of what advocates of higher taxes imagine will happen.”

The government could also address the fiscal crisis by cutting spending, but according to the CDE report, this is also easier said than done.

“While much of the government’s spending is unproductive and inefficient, and too much is misdirected or stolen, there are no easy ways to cut spending significantly,” it said. 

“The vast bulk of non-interest spending is on healthcare, education, social security, and criminal justice.” 

“To the extent that this spend is wasteful and inefficient, the appropriate policy response is to seek to improve the quality of spending, not to cut it.”

It said that, even where there are programmes and activities which might plausibly be cut, there are plenty of areas where increased spending – assuming it is efficiently done – would be welcome. 

This is particularly the case if the funds can be directed at growth-enhancing investment. 

Public infrastructure, for example, is deteriorating, and targeted investment in roads, sanitation, water and electrification would pay for itself if those projects were well-managed.

“Significant cuts to aggregate spending are implausible at this point, though spending growth must be kept below the rate of nominal GDP growth,” the report said. 

It advised the new government to resist more forcefully the inexorable rise in public sector remuneration and seek to tie increases to increased productivity.

“Progress on this was made in 2020 and 2021, but agreements reached with unions more recently have allowed a degree of backsliding,” it said. 

“Once addressed, more spending can be directed at infrastructure and capital spending.”