In search of fiscal credibility

Over the past few weeks, the short-lived tenure of UK prime minster Liz Truss presented a lesson in how not to conduct responsible fiscal policy. This week should present a much better, but far from perfect, example as South Africa’s finance minister Enoch Godongwana presents the Medium-Term Budget Policy Statement (MTBPS).

Mistrusting Ms Truss
Trust takes time to build but can be destroyed instantly. By recklessly trying to ram through a massive package of tax cuts and increased spending at a time when markets were already jittery, Truss and Kwasi Kwarteng, who was briefly Chancellor of the Exchequer (finance minister), inflicted massive losses on bondholders and almost blew up the private pension system. To regain some credibility, the new Chancellor, Jeremy Hunt, cancelled the planned tax cuts that would have required substantial additional borrowing at a time when the UK already runs a big fiscal deficit (the difference between spending and tax revenue) and has a debt-to-GDP ratio near 100%.

Hunt is reportedly considering going further and wants to cut spending to reduce government’s borrowing requirement. This is controversial among his Conservative Party peers since it would almost guarantee a loss at the next general election. In the end, the only way to begin to undo the reputational and financial damage was for Truss to resign after only 44 days in office, making her the shortest-serving prime minister ever.

It recalls the notion of “Bond Vigilantes” introduced by US economist Ed Yardeni in the early 1980s. At the time he warned that the bond market would impose discipline on the governments that did not manage their fiscal affairs well. If investors dump your bonds, borrowing costs rise, making long-term debt more expensive. This forces the government to cut spending to reduce deficits and prevent its interest burden from exploding, a painful process to regain credibility.

South Africa is also still trying to win back credibility after Nenegate in 2015 and the general fiscal profligacy of the Zuma years. With Nenegate, South Africa’s bond yields derated compared to other emerging market bonds and the gap has not closed yet, speaking to a big risk premium that investors now demand to lend to the South African government. The Bond Vigilantes are forcing action locally too, as National Treasury continues to try to reduce its borrowing requirement in the face of high bond yields.

Tax overrun
That brings us to this week’s MTBPS. The good news is that Minister Godongwana is likely to present a tax revenue overrun compared to the February Budget projections. This is partly because of conservative assumptions in the latter, but also as the economy has delivered decent tax growth. Commodity prices have remained elevated, though they have been declining of late as global growth concerns increase. Fortunately, National Treasury still does not base its planning on a belief that commodity prices will be high forever.

The other reason for better-than-expected tax revenues is that inflation is good for tax growth. Higher inflation raises nominal economic growth, and this in turn tends to raise tax revenue growth. Companies and individuals pay a percentage of the rand amount of their income. If inflation pushes this up, the fiscus benefits. Individuals can also end up being pushed into higher tax brackets when inflation is high, unless relief is granted by adjusting brackets for this so-called fiscal drag.

Since higher inflation pushes up the rand value of total economic activity, the debt and deficit ratios also tend to look a bit better (both are expressed relative to nominal GDP).

However, inflation can also place indirect pressure on the Budget since clamouring for increased social spending and public sector wage increase rises with the cost of living. Food and fuel prices, the most visible and volatile elements of consumer inflation, are particularly high. In September, fuel prices were 34% higher compared to a year ago and food prices 12% higher. Fortunately, fuel inflation is off its high, and this lowered the overall headline inflation rate to 7.5% from 7.6% in August and the recent peak of 7.8% in July. Core inflation, which excludes food and energy and gives us a good view of underlying inflationary pressures, continues to increase gradually but at 4.7% year-on-year is not worryingly high.

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