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A slowly worsening chronic fiscal crisis

- Michael Sachs

National Treasury’s strategy to overcome South Africa’s chronic fiscal crisis rests on highly uncertain political and economic foundations.

South Africa’s National Treasury has done an excellent job in the 2021 medium term budget policy statement of balancing the fiscal and political pressures forced on it by economic stagnation and the incoherence of government policy. Capital markets cheered for two reasons. First the revenue numbers were substantially better than those presented in the February 2021 budget. This created potential fiscal space of about R132 billion in the current year, and R64 and R59 billion in the next two years respectively.

Second, Finance Minister Enoch Godongwana resisted political pressure for substantial commitments to permanent increases in spending. About R60 billion (or 1% of GDP) was added to the spending ceiling in 2021 and R30 billion over each of the next two years, less than half the value of the revenue improvement. Treasury also erred on the side of caution in projecting economic growth and tax buoyancy, which leaves substantial room for higher revenue and a lower deficit. Tax buoyancy is a measure of relationship between total tax revenue collections and economic growth.

The increased spending is dominated by three items: wage increases for public servants, the extension of the social relief of distress grant, and President Cyril Ramaphosa’s public works programme. While Treasury presented each of these as temporary, in all likelihood they amount to permanent increases in spending. Instead of conceding this reality in advance, the fiscal framework builds in large buffers of unallocated funds.

By holding back part of the spending increase in reserve, Treasury deftly provided space for the political leadership to make choices and confront real trade-offs while simultaneously clarifying Treasury’s own view of the fiscal constraints within which this debate should take place.

Cabinet caught in the headlights

An improved fiscal outlook that accommodates spending pressures is encouraging but there are two caveats. First, the chronic position of the country’s public finances continues to worsen. This can be seen in several metrics. Growth remains far below interest rates and GDP per capita is expected to continue stagnating. Debt service costs are crowding out social spending.

Money owed by provincial governments to suppliers (largely for essential medical goods) is rising at a rapid rate. Most municipalities are in financial distress, with uncollected revenues reaching R232 billion. The fiscal crisis of local government feeds into the bankruptcy of public utilities, and the latter shows no sign of abating.

As long as Cabinet appears caught in the headlights, unable to offer a programme to overcome the grave operational and financial crises in the provision of municipal services, electricity, water, road construction, and passenger rail, declarations that “there will be no bailouts” are posturing. The ongoing destruction of value must be reflected somewhere in the national balance sheet, even if it is not recognised in the budget.

Second, Treasury’s strategy to overcome this chronic fiscal crisis rests on highly uncertain political and economic foundations. The strategy proposed is a deep shock to public expenditure executed over the next two years –- 2022 to 2023. In real terms, core spending is set to contract by 4% each year. This amounts to reduction in real spending per capita of more than 10%.

The 2021 medium term budget policy statement tells us that following this short, sharp, shock to government consumption, the period of fiscal consolidation will be concluded. Having achieved a primary surplus, the national debt will stabilise, and expenditure increases will resume along a prudent path.

Credibility of the fiscal framework

This strategy depends on a large reduction in the real incomes of public servants and a fall in public employment. But the plan to hold down pay improvements this year has not worked out. Public servants negotiated an effective increase in average pay of more than 5%. This is in line with inflation. Also, headcount numbers have surged during the COVID-19 crisis, especially in the health sector.

The idea that public servants will accept the budgeted wage increases of 1.5% in 2022 and 2023 might be a good negotiating tactic but weakens the credibility of the fiscal framework.

This year South Africa is recovering from the COVID-19 shock and its economy is buoyed by a commodity boom. Public spending has also grown, albeit at a very low rate, providing some support to aggregate demand. Over the next two years, by contrast, Treasury is proposing a large negative fiscal impulse. In their forecast, a recovery in investment and sustained household demand will offset this fiscal contraction, resulting in a expansion in domestic expenditure.

But if these offsetting forces disappoint the proposed fiscal shock may be pro cyclical, slowing growth and raising unemployment. This would be the case if for instance the recovery in capital formation fails or global developments (such as deceleration in China and a tightening of global monetary policy) prove more adverse than currently assumed.

It’s true that a debt crisis and associated high interest rates dampen South African growth and point to the need for fiscal consolidation. But it is also true that a large and sustained consolidation – that is reducing government deficits and debt accumulation – will impede the recovery.

The consolidation as proposed in the medium term budget policy statement will also have problematic consequences for the supply side and long term growth. These depend on effective provision of basic education, criminal justice and healthcare. The deeper and more intense the contraction in spending, the more it will permanently scar these services. Public service reform is sorely needed to improve value for money, and it may well be argued that more spending won’t generate better social outcomes if the public service remains inefficient. But this says nothing about the impact of reduced spending.

The last ten years of gnawing expenditure cuts show that those with organised interests in the distribution of rent through the budget – public sector unions, business interests, and the political class – are quite capable of defending their share of the pie and passing the real costs of expenditure constraint on to the voiceless or unorganised. The temptation to engage in false economies, temporary measures, and unsustainable spending reductions will be huge over the next two years.

In theory, we might plan for a consolidation that is “growth friendly” for the economy and which limits the permanent damage of austerity on public services. But neither Treasury nor any other component of government have suggested such a programme. It would probably be prudent therefore to assume that it does not exist. The budget instrument that Treasury wields is blunt, the capacity of public administrators to manage the blow is weaker than ever, and unintended consequences will be widespread and debilitating.

The finance minister is proposing a decisive course correction in the fiscal accounts, followed by a steady path of expenditure prudence. In the context South Africa faces, it makes sense for Treasury to advance this clean and bright solution. It will help to negotiate the difficult choices government faces in the next two years. These choices include matters on which President Ramaphosa continues to hedge his bets for obvious political reasons – the public-sector wage agreement, the permanent extension of basic income support to working-age adults, and the resolution of the operational and financial crisis of public utilities.

The outcome is likely to be somewhere between Treasury’s negotiating position and imperatives that will define political choices. These choices will emerge as various factions jostle for supremacy in the 2022 ANC elective conference and the 2024 general elections. The most likely outlook remains a continuation along the current path of economic stagnation and slow worsening of South Africa’s chronic fiscal crisis.

__ A version of this article, The MTBPS clears some fiscal space but it is still a path through a swamp, was first published by Econ3x3.__The Conversation

Michael Sachs, Adjunct Professor, University of the Witwatersrand. This article is republished from The Conversation under a Creative Commons license. Read the original article.