Lifting the lid on a VAT increase

21 February 2018 - Gilad Isaacs

2018 Budget Speech: A unilateral increase on the least progressive tax component – VAT – will harm the poor and lower-income earners.

The rumoured VAT hike as part of the 2018 Budget Speech poses the risk of eroding the spending power of poor and lower-income households, exacerbating poverty and increasing inequality. 

VAT is a regressive tax 

Value added tax (VAT) – charged on most goods and services at a rate of 14% – is levied irrespective of how much somebody earns, making it a regressive tax. In fact, taxes on goods (VAT plus excise duty) hit the poor hardest. The lowest earning 10% spend 13.8% of their disposable income on these taxes compared to 12.6% of the highest earning 10%. 

The Davis Tax Committee admits that raising the VAT rate would increase inequality. It would also make basic goods more expensive and necessitate a proportional increase in social grants and wages in order to maintain the buying power of the poor and workers. At the same time, the statistical model used by the National Treasury to support a VAT increase rests on highly improbable assumptions. 

While VAT is successful if considered solely from the perspective of revenue-raising, and ignoring its potential negative impact on the poor, where other options are available taxes that hit the poor hardest, make the consumption of basic goods more expensive, and increase inequality should not be entertained. 

South Africa’s tax structure 

Overall, taxation in South Africa is mildly progressive, meaning the wealthier pay a higher share of overall taxes. However, given the extreme levels of inequality in South Africa the system is not progressive enough. Further, taxes paid by households are less progressive than in comparative developing countries. 

As shown in Table 1, the share of revenue from personal income tax (PIT) fell from 43% in 1999 to 30% in 2007. This is despite strong growth in the number of PIT taxpayers and significant wage growth amongst higher-income earners. It is largely due to falling PIT rates and strong corporate profits, and the consistently high share of VAT. The significant decrease in the tax rate for the highest earners is shown in Table 2 – their tax rate fell from 45% in 1990 to 41% in 2016 (in the two decades prior to democracy it averaged 51%). Importantly, a SARS study shows that the share of tax paid by those earning above R1million has fallen between 2006 and 2015, and fallen more than their share of overall taxable income, meaning their relative contribution has declined. 

The share of corporate income tax (CIT) in the overall tax mix rose prior to 2007/8 (Table 1) on the back of strong corporate profits, and better tax collection, and fell subsequently with slower economic growth. While corporate profits boomed, the CIT rate was decreased from 50% in 1990 to 28% in 2016/17 (Table 2). According to the World Bank’s Doing Business Index South Africa’s effective corporate tax rate (“total tax and contribution rate”) is well below emerging market peers and the fifth lowest in Africa. 

VAT has contributed 24% - 27% of tax revenue and been held constant at 14% since 1993.

Table 1: Share of overall tax revenue for select forms of tax

Table 2: Tax rates

Despite wealth inequality in South Africa being extreme – the top 10% of South Africans hold at least 90-95% of its wealth, while the top 1% holds 50% or more of its wealth – taxation on wealth, or income from wealth held, is low. This includes direct taxation on assets (such as property), income from holding assets (such as capital gains) and inheritance. 

Capital gains tax (CGT), for example, raised only R17 billion in 2016/17, a mere 1.5% of tax revenue. Because not all capital gains are taxed, in 2017, individuals only paid a rate of 16% on capital gains, and companies 22%. Tax on inheritance – estate duty – is levied at only 20% and raises revenue worth 0.05% of GDP compared with the OECD average of 0.2%.

South Africa has no annual “net wealth tax” that would tax the total value of wealth held in a given year. 

Considering that large amounts of wealth were accumulated under apartheid, that this wealth is passed between generations, and that black earners have less assets to begin with and must support a higher number of dependents, these low taxes on wealth are indefensible and perpetuate inequality. 

Tax administration and tax evasion and avoidance 

The ability of SARS to raise the requisite revenue has been undermined by state capture. Tax expert, Judge Dennis Davis, notes the “erosion of the integrity of SARS” while previous SARS managers point to a loss of expertise. Specialist units pursuing tax evasion have been gutted while there is indication that companies and individuals associated with state captured are not tax compliant. 

At the same time capital flight and tax evasion and avoidance are endemic although the exact cost is difficult to pinpoint; various estimates suggest that it runs into many billions of rand. One estimate calculates that illicit financial flows from South Africa constitute between 5-9% of all trade, little tax will be paid on such funds.

What should happen to VAT?

Instead of uniformly raising VAT:

1. The list of zero-rated items (products upon which VAT is not charged) should be increased targeting goods bought by the poor such as: bread, poultry, flour, candles, soap, basic medicines, pay-as-you-go airtime and education-related goods. While this will also benefit higher-income earners the share of disposable income spent on these goods by the poor is higher. Even taking into account the benefit to wealthier households and the potential capture of some gains by retailers, this will have positive distributional outcomes (and generally no less so than other pro-poor government policies excepting social grants which are highly redistributive). It will also assist in ensuring basic needs of poorer households are met.
2. A higher VAT rate (for example, 20%) should be levied on luxury goods. These include goods bought only by the rich, for example, yachts, as well as upper segments of other goods markets, for example, fancy cars, expensive fridges, and so on. The selection of items should not place goods that poorer households save for beyond their reach. Given the existing tax administration systems this can be feasibly implemented. Further, given that a higher share of luxury items are imported, this should not unduly dampen domestic demand and could modestly assist in closely the balance of payments.

These changes could be made in a tax neutral manner.

Alternatives to a VAT increase

The revenue gap could be closed through:

1. Repairing the administrative capacity of SARS, including its ability to tackle tax avoidance and evasion by corporates and the wealthy. This requires a change in executive management and various administrative measures, as well as governance reforms aimed at greater independence.
2. Raising personal income tax, particularly on the highest earners. For example, in 2015, an effective tax rate of 40% on those earning between R500,000 and R1 million and 45% on those earning above R1 million would have raised additional revenue of R5.4 billion and R5.3 billion respectively (although some seepage is likely to occur).
3. Increasing corporate income tax. In 2015, effective tax rates of 30%, 32% and 35% would have raised an additional R13 billion, R26 billion and R45 billion respectively (although this is likely to be somewhat less due to avoidance and/or a fall in taxable profit).
4. Instituting an annual net wealth tax. International comparisons suggest this could raise anywhere between R22 billion and R154 billion, although this degree of uncertainty as a result of a lack of adequate data.
5. Instituting a land tax, particularly on unused land, and increasingly property taxes, particularly on non-residents and those owning multiple homes.
6. Increasing other taxes on property or income from property such as capital gains tax, estate duty and securities transaction tax. For example, levying capital gains tax in line with a top marginal tax bracket of 45% could raise at additional R4 billion.

Conclusion

In a country plagued with high levels of poverty and inequality every instrument must be brought to bear on solving these challenges, the tax system is one tool. A detailed process of engagement with all social partners should be undertaken to find an appropriate means of raising the required revenue.

A unilateral increase on the least progressive tax component – VAT – will harm the poor and lower-income earners.

Dr Gilad Isaacs is the Director of the Corporate Strategy and Industrial Development (CSID) Research Programme in the School of Economic and Business Sciences at Wits University.