Budget will test Gordhan’s mettle

This is a budget that is going to test Finance Minister Pravin Gordhan’s mettle. In the current financial year, expenditure is on track to rise by about 20%. Inflation over the same period was probably up by about 7%, translating into a real expenditure increase of 13%. This is massive by any standards and was a sorely necessary stimulus for the economy given the global crisis.

Of course, this can’t continue. In the Medium-Term Budget Policy Statement (MTBPS), Gordhan provided for an 8% increase in spending. Against the backdrop of inflation that may end up at 5% for the year, this translates into a mere 3% in genuine additional spending – a cold turkey experience for Government! The big question is whether the Minister will hold to an expenditure envelope that is in line with the MTBPS.

The Minister faces a range of expenditure pressures, not the least of which is the legacy of last year’s unusually high public sector wage settlement. He will also have to look seriously at the health budget to see to what extent he could meet public sector health needs without having to resort to a dedicated tax like the National Health Insurance immediately.

Tax proposals and revenue

The challenge on the revenue side is going to be equally big. Revenue for the current year will turn out to be some 6% less than the previous year. It is safe to assume that there will be a recovery of sorts, given that the economy is improving. The question that will focus the minds of the National Treasury is how strong it will be. It is Government’s stated aim to grow revenue faster than expenditure this year, so as to bring the deficit down. According to the mini budget, the intention is to raise revenue by 14%.

VAT, which is one of the ‘big 3’ taxes, was down some 6% in the current year and will undoubtedly rise from the present level, but judging from the state of the still struggling and over-indebted consumer, it is probably going to be a moderate recovery in VAT. We believe Treasury would be lucky if we saw 10% growth in VAT receipts.

The big unknown is company tax, which was the major disappointment for the current year. It fell by 17% on the back of JSE earnings that were down 22% over the corresponding period. Earnings in the new financial year could be up in the region of 30%, which could easily lift company tax by 20%, even allowing for some collection lags. National Treasury will probably err on the conservative side by budgeting for a somewhat lower recovery in company tax.

So if VAT grows slightly slower than the overall target and company tax slightly faster, then the remaining tax among the ‘big 3’ – personal income tax – will probably have to grow broadly in line with the overall revenue target. This means there will be pressure on personal income tax. The one positive for the Minister is in the motor vehicle allowances. As he told us this time last year, this tax loophole, which is one of the only remaining deductions left in the personal income tax code, will be tightened substantially. This will undoubtedly help on the personal income tax collection side. As a result, Gordhan will be able to make some of the usual inflation-related adjustments to provide for fiscal drag. This will help the Minister to put a more positive spin on personal income tax adjustments. Either way, the result is that we are all going to pay a little bit more tax relative to our income.

Deficit for the current year

So where will the Minister close the book for the current financial year? We believe he will be slightly further in the red than set out in the revised budget, to the tune of about R3 billion. This will be an unexpectedly good outcome, as it implies a deficit of 7.5%. The market is expecting a deficit of 8% for the current year.

Nevertheless, it is sobering to compare this outcome to what was planned when the previous year’s budget was drafted around this time. Then the National Treasury budgeted for a deficit of about R96 billion. Now we are looking at a deficit of R183 billion, which just illustrates how unexpectedly fast the economy deteriorated.

This meant that the borrowing requirement will end up at about double the budgeted R62 billion, causing indigestion in the bond market and putting pressure on long-term interest rates.

Deficit and funding

According to the MTBPS, Government is targeting a reduction in the deficit from around 7.5%, when this year ends, to just over 6%. If Gordhan sticks to this target, it will be an excellent outcome. The big challenge globally is for governments to begin to address the damage done to the state of government finances by the global crisis. Countries which fail to do this, as the Greek example clearly illustrates, will be severely punished by the capital markets.

We are reasonably confident that our Minister of Finance is going to prove his mettle by pushing the deficit in the right direction.

Even so, a deficit of 6% means that there is still a real funding challenge out there in the coming year. In the current year, Treasury was able to shield the pressure on long-term funding to some extent by drawing more heavily on short-term funding. This is not an option that will be available in the coming year. The overall capital funding requirement is not going to come down, even if the deficit improves.

Inflation targeting

The much-awaited announcement on inflation-targeting is causing some jitters in the market. We think that the Minister will amend the mandate of the Reserve Bank to incorporate growth and employment objectives. This will come as a relief, since growth has been the elephant in the room at every single MPC meeting for the last ten years.

If it becomes an explicit objective, it will further clarify the monetary policy framework, as it will then be unambiguously clear that interest rate decisions have to strike a balance between competing objectives. This may mean that short-term interest rates end up fractionally lower on average and long-term interest rates a little bit higher than might have been the case otherwise. Minor consequences at best, given all the heat this debate has generated.

A more drastic revision to the framework would provoke a strong reaction from the market. Long-term rates will shoot up as it would be clear to lenders of government that the Zuma administration has little intention of containing inflationary pressures. This would lead to a sharp decline in the value of all long-term assets with concomitant negative implications for long-term investment and growth