1. Introduction Governments raise taxes for public
1. Introduction Governments raise taxes for public expenditure, ranging from social security to national defense, education, and infrastructure like highways or airports. The question is what kinds of taxes are raised and what sorts of effects they have. In particular, the difference between income taxes and consumption taxes is important.
The South African government expects a revenue shortfall of R48.2 billion in 2017/18. This is slightly lower than the R50.8 billion projected in the 2017 MTBPS, but substantially higher than the R30.7 billion revenue gap in 2016/17. The government proposes a combination of expenditure cuts and revenue increases to make up for the Shortfall.
Increasing taxes in a low-growth context, when many South Africans are struggling to make ends meet, is not desirable. But the fiscal position is substantially weaker than it was at the time of the 2008 financial crisis, when South Africa had a gross debt-to-GDP ratio that was just above 26 per cent. That ratio now stands at 53.
3 per cent. A failure to act now would lead to more drastic spending cuts and tax increases in future.2. BackgroundGlobally, economic growth and trading activity are forecast to improve gradually over the short-to medium-term. There has been difficult operating conditions persisting in the domestic economy and Shorter term outlook for the economy remains largely unsatisfactory with subdued household spending holding back the economy’s growth. Lower interest rates provide some relief to strapped households.
With the domestic drivers of growth currently under strain, the South African economy will most likely have to rely on exports for a positive performance. Weak business sentiment will likely adversely affect private sector fixed investment. With South African economy shedding 113 000 jobs in the second quarter of 2017 and the unemployment rate remaining at 27.
7% South Africa needs broad-based economic transformation that creates jobs and business opportunities, reduces inequality and boosts income growth for all citizens.Figure 1: Tax revenue instability in countries with VAT or notSource: Ebeke and Ehrhart (2008)According to Figure 1, preliminary evidence shows that the average levels of tax instability in countries without the value-added tax are significantly larger than in countries that adopted VAT.2.1. How long has VAT been 14%The South African government proposes to raise VAT by one percentage point, from 14 per cent to 15 per cent, effective 1 April 2018. The increase is necessary to meet new spending commitments and prevent further erosion of the public finances.
VAT was last adjusted in 1993, and is lower than the global and African averages.3. Define VATThe value added tax or VAT, as it has come to be known, is a method of taxing, by installments or in stages, final consumer spending in the economy. The method consists of levying a tax on value added to a product or service at each stage of the production and distribution process. VAT is defined by the Ministry of Finance as a tax on sale of a commodity at every point in a series of sales by the registered dealers with the provision of credit of input tax paid at the previous point of purchases thereon. Such credit would be available regardless of whether the goods are sold to another dealer or to a customer. Similar to a retail sales tax, a VAT applies to goods and services sold to consumers, and therefore is a tax on consumption.
However, unlike a retail sales tax, which is collected once on final sales to consumers, a VAT is imposed and collected at every stage in the production and distribution chain. Overall compliance and administrative costs, however, would be higher under an add-on VAT since it represents a new revenue source.3.1. Pros and Cons of VAT increase in SA economyThe VAT proposal recognizes limits on the medium-term revenue-raising potential of other major tax instruments, given recent increases in those categories. VAT is an efficient, certain source of revenue provided that its design is kept simple. Increasing the VAT rate by one percentage point is estimated to have the least detrimental effects on economic growth and employment over the medium term.
The zero-rating of basic food items mitigates the effect of the increase on poor households. The key advantages of the VAT are that they are neutral, transparent and certain, promote self-policing and revenue stability, minimize discretion and they are simple.On the other hand a persistent criticism of VAT from many economists has been that it tends to be regressive since the proportion of income spent on consumption is larger for the poor than for the rich. This weakness inheres in all forms of consumption tax such as the current sales taxes. The regressivity would, however, appear to be less significant if taxes on consumption are compared with those on income over a lifetime, rather than annually. Besides VAT is inflationary and favors the capital intensive firms.4.
How will the increase boost the SA economyThe VAT rate has finally been increased, with effect from 1 April 2018, from 14% to 15%. This increase is expected to generate additional R22.9 billion revenue over the 12 month period. The previous increase was from 10% to 14% on 7 April 1993.4.1.
The different types of people that are affected by VAT increase in SAThe new rate of 15% is still relatively low in comparison to African and European countries, and is now equivalent to the New Zealand VAT rate. The Minister indicated that the regressive nature of the increased rate would be alleviated by increased social grants and the existing zero-rated basic foodstuffs. The changes in VAT will largely impact on individual consumers as well as on private and public firms and the government.4.
2. The Impact of VAT increase in SAImpact of VAT regarding who bears the burden of tax largely depends on the elasticities of demand and supply of the goods and services. The VAT proposal will increase the cost of living for all households. However, the zero-rating of basic food items and paraffin will reduce the impact on the poor, who will receive further assistance through an above-inflation increase in social grants. The wealthiest 30 per cent of households contribute 85 per cent of VAT revenue.
While government has explored implementing a luxury VAT to make the tax more progressive, this option is not being proposed. Reducing inequality is crucially important, but the VAT system is not the best instrument for achieving redistributive goals. Even though the zero-rated items are mostly well targeted, there are a few food items, such as fruit, where higher-income households reap most of the benefits. Multiple VAT rate structures may also lead to legal uncertainty. Recently, for example, there has been uncertainty around zero-rating brown bread. The 19 zero-rated food items are only meant to cover basic food items.
As of 1 April 2018, government proposes to amend the VAT Act (1991) to reflect the original policy intent – that only brown bread and whole wheat brown bread will be zero-rated. Some have also observed that VATs abroad have generally grown over time, possibly enabling or even leading to an increase in the size and scope of government; that is, a VAT may be a “money machine.” One prominent study finds empirical evidence that more efficient tax systems contribute to an expansion of government7 and another lends some credence to the idea that reliance on the VAT leads to increased government spending.8 Even if a VAT were initially small, it might later expand to finance an expansion in the size of government, although such an expansion might be limited by the current fiscal imbalances in the United States. The increase in VAT will drive inflation higher and affect the average consumer’s pocket. The first trend is that aggregate consumption and economic growth increases or decreases just before the rise or reduction of the VAT rate. The second trend is that they decrease or increase relatively dramatically as soon as the rise or reduction is implemented.
The third trend is that after the dramatic decrease or increase they increase or decrease gradually.4.2.1. General Inflation The possible impact of a VAT on the level of retail prices is an issue heavily debated when a country considers a VAT. The VAT can be expected to lower real incomes by an amount roughly equal to the size of the tax.
Economic theory suggests there are two ways for this to occur. First, real incomes could fall through a decline in nominal wages and other factor payments without any change in the price level. Alternatively, real incomes could fall through a one-time increase in the price level while nominal wages and other factor payments are held fixed or unaffected by the tax. In either case, the real incomes of households would fall by the amount of the tax.Figure 2: Impact of VAT on Aggregate Demand and Aggregate SupplySource: AuthorFor firms VAT will be an incentive to increase supply hence the aggregate supply curve will move from AS2 to AS3 and for consumers VAT presents a price increase hence a cause for reduction in demand from AD2 to AD1 which will result in decrease in quantity demanded and increase in general price levels.4.2.
2. Price Impacts Adoption of a new VAT or rate changes in an existing VAT will have an impact on both the level of consumer prices and the relative prices of goods and services (unless the VAT is fully comprehensive at a uniform rate). 4.
2.3. Short-Run Shifts in Consumer Spending The adoption of a VAT can be expected to have significant short-run impacts on the timing of consumer spending. The enactment of a VAT in Australia again provides an illustration of the short-run shifts in consumption with a substantial shift of consumer spending exhibited from the quarter after VAT implementation in July 2000 to the quarter preceding its implementation. It took 18 months for total retail sales to return to the pre-VAT level.4.
2.4. Government Spending Although VATs have often been adopted as a replacement for existing sales, excise or turnover taxes, there is evidence that VAT rate increases have resulted in increases in the ratio of government revenue-to-GDP over time. Henry Aaron’s summary of the impacts of early European VAT adoptions for twelve countries concludes that taxes as a percentage of GDP increased significantly after the VAT was adopted. While an increasing ratio of VAT revenue to GDP over time is not necessarily correlated with increases in the ratio of government spending to GDP, critics of the VAT have argued that an indirect and thus less visible VAT may support higher levels of government spending compared to the use of more visible, direct taxes, such as the income tax. A VAT increase is a shock to the economy which will in the short-to-medium term lead to an inward shift of the PPF and in the long run may result in an outward shift.4.
2.5. Saving and Investment The impact of adopting a VAT on a country’s level of saving and investment is usually discussed in the context of substituting a VAT for another major tax source, such as the corporate and/or personal income taxes or other indirect taxes on consumption.
Economic theory predicts that the substitution of a VAT for income taxes would stimulate saving and investment. Because income taxes tax the return to savings, they favor current consumption over savings used to fund future consumption. An income tax results in a reduction in the level of saving and investing in the economy.4.2.
6. Foreign Trade Balances VATs are constructed as “destination-based” taxes. In other words, the tax is imposed in the country where consumption occurs, not where production occurs. To achieve this result, the VAT is not imposed on export transactions, and any VAT paid on the inputs used to produce the exports are refunded to exporters; imports are subject to full taxation. These border adjustments convert the VAT into a destination-based tax. The impact that adopting a VAT will have on a country’s trade balance (exports minus imports) will depend upon whether the VAT is an add-on tax or a substitute for existing sales (consumption) taxes.
5. How does the VAT increase affect individuals and businesses in SAAnother concern is that a VAT is generally viewed as being borne disproportionately by lowand moderate-income households. The regressivity of a pure flat rate VAT arises because households’ consumption tends to comprise a higher fraction of income for low- and moderate income households than for higher-income households. However, most VAT proposals include policies to address their regressivity. These proposals invariably include some mechanism to offset all or a portion of the VAT paid by low and moderate-income households, and thus requires higher VAT rates to raise a given amount of revenue. Although the low-income policies modeled may eliminate the regressive nature of the VAT on low income households, they still would impose a relatively large tax increase on middle income households.Any discussion of the distributional impact of adopting a VAT must begin with a discussion of the economic incidence of the tax after businesses and consumers have reacted to the imposition of the tax.
If the VAT is designed as a comprehensive, destination-based tax, economists generally believe that the tax will be passed forward in higher prices to consumers. This conclusion assumes that the VAT can be effectively collected on imports of goods and services and removed from exports. As a result, domestic consumers will pay the same price (including the tax) whether they purchase from domestic or foreign suppliers. Given the assumption of forward shifting of the tax, the distribution of the tax by household income levels will be determined by the ratio of taxable sales to income as income increases. Because this ratio generally falls as income increases, the VAT is generally characterized as being “regressive.” To overcome or partly offset this regressivity, countries adopting a VAT can provide tax credits or rebates to lower income households that pay the tax, or adopt multiple-rate VATs that remove or reduce the taxes imposed on specific types of goods and services, often referred to as “necessities,” that make up a larger share of the spending of lower income consumers.
Most existing VAT systems use multiple tax rates (including a zero rate) to reduce the regressivity of the VAT. But the use of multiple rates comes at a significant cost in terms of administrative and compliance costs for both tax agencies and taxpayers and in terms of costly economic distortions. However, if a single-rate VAT is adopted, tax credits or rebates can be used to offset the regressivity of the tax. This is a classic example of the tradeoff between equity and efficiency in tax policy.
6. ConclusionAll in all, VAT has many points in its favor and advantages clearly outweigh the disadvantages. As the EU experience shows, VAT has a special advantage for countries in large economic groupings. It facilitates flow of inter-country or inter-regional trade unhindered by taxes and thereby serves to promote competition and efficiency. The government should be careful regarding the timing of the change in the VAT rate in order to avoid excessive recession or prosperity.On the positive side, any deficit reduction measure, such as an add-on VAT, diverts private saving from government debt to private investment and is successful in reducing the deficit and ultimately the level of debt, reducing interest rates and further increasing private investment. In the case of an add-on VAT, however, these benefits come at the cost of reducing consumption.
The partial nature of VATs under which substantial portions of consumption are excluded from the tax base means that VATs, in practice, can be expected to have large, differential effects. Both the reductions in consumption and jobs are a direct result of using a consumption-based tax to reduce the deficit. Reducing the deficit through an add-on VAT, as compared to a reduction in government transfers, produces results that are more adverse to the economy: GDP falls immediately, jobs are reduced, and consumption falls by a greater extent. This alternative approach for deficit reduction may well have very different distributional effects.ReferencesAaron, Henry, 1981.
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