Reform of tax policy should incorporate a shift in the tax mix from income taxes to taxes on consumption

Charles de Wet, PwC, Head of Indirect Tax, Africa.

A reform of South Africa’s tax system should incorporate a shift in the tax mix from income taxes to taxes on consumption in the form of Value-Added Tax (VAT). Any such realignment of the tax mix, however, should be done on a revenue neutral basis after providing support for poor households to alleviate their increased tax burden resulting from increases in VAT. There is scope for such a tax shift to be carried out by way of an increase in the VAT rate and broadening of the VAT base accompanied by decreases in both the companies and personal income tax rates.

This comes in the wake of Finance Minister Nhlanhla Nene’s recent Medium Term Budget Policy statement that changes are set to be made to tax policy in the 2015 Budget. The details of the proposed changes will be announced by the Minister of Finance on 25 February 2015 when he tables the Budget in Parliament.

The Medium Term Budget Policy Statement states that –

“The proposals will enhance the progressive character of the fiscal system, improve tax efficiency and realise a structural improvement in revenue. The short-and long-term implications for economic growth and job creation will be a key consideration.”

The contribution of VAT to total tax revenue has been fairly consistent over the years, ranging from 23% in 1999/00 to 28% in 2004/5. However, in 2009/10 VAT revenues fell significantly to 6% of GDP in the wake of the global financial crisis, but has been steadily recovering since then and has largely returned to previous levels at around 7% of GDP.

The financial crisis has made governments worldwide consider the composition of their tax revenues. The International Monetary Fund (IMF), the Organisation of Economic Cooperation and Development (OECD) and the European Commission all promote a shift from direct to indirect taxes to promote economic growth. Consumption taxes such as VAT (or Goods and Services Tax or GST in some countries) are increasing in prominence and VAT now exists in more than 150 countries, with other jurisdictions planning to introduce VAT regimes over the coming months.

VAT cannot be considered in isolation and must be considered in the context of corporate income tax and personal income tax. Currently, South Africa has a high reliance on tax revenues from personal and corporate income tax revenues – 34% and 20%, respectively. The World Bank indicators for 2012 ranked South Africa as having the 10th highest tax: GDP ratio (excluding most social security contributions) at 26.5% of GDP. This is significantly higher than the world average of 14.5% and the Africa average of 14.4%.

Presently, South Africa’s standard rate of VAT is 14%. A recent study by PwC of the VAT systems of 28 African countries,‘Helping you navigate Africa’s VAT landscape – Overview of VAT in Africa, 2014)’ indicates that the average standard rate of VAT across those countries is 16.2%. The average standard rate of VAT in the European Union is 21.5%. In 2013 the average rate for OECD countries was 18.9%. South Africa has the lowest contribution to tax revenues from consumption taxes and the highest from personal and corporate income taxes of the BRICS countries. Accordingly, a comparison of headline VAT rates shows that South Africa’s VAT rate is low by international standards.

Progressively shifting taxes from income to consumption taxes could prove to be beneficial for a number of reasons: Firstly, it would make South Africa more attractive as an investment (domestic and foreign) destination. Secondly, it would promote savings by increasing the cost of consumption and decreasing taxes on savings.

Thirdly, a reduction in consumption will have positive implications for South Africa’s current account deficit. Fourthly, a shift from corporate taxes to consumption taxes will also result in a more stable fiscal environment due to a lower reliance on more volatile company profits. Finally, lower income tax rates could also result in efficiency gains and reduced tax avoidance for those taxes.

However, a shift in the tax mix from taxes on income to VAT presents a number of challenges that will have to be addressed. Some of these include: The different goals of the tax system will need to be weighed up and trade-offs may be required. Any reform of VAT that seeks to address the VAT rate requires political factors to be addressed. Primarily these relate to the regressive nature of VAT and the perception that a shift from income taxes to VAT will result in greater income and wealth inequality. To this end, the tax system as a whole needs to be considered, together with social security benefits, rather than focusing on individual elements.

Studies carried out by the OECD indicate that broadening the VAT base is the best way of increasing VAT revenues as part of a tax shifting exercise as it improves efficiency and reduces administration and compliance costs, while more targeted relief for poor households can be provided through direct transfers (social security) rather than through the tax system. South Africa’s VAT system is already fairly broad-based. Studies also indicate that much of the benefit of zero-rating is not passed on to consumers, but is retained by suppliers. For these and other reasons, we hold the view that a reform of the tax mix in South Africa should commence with broadening of the tax base by the elimination of most of the zero-rated supplies, with the exception of exports.

By our estimation, the withdrawal of the basic foods zero-rate could raise an additional R18 to R20 billion in VAT revenues and the withdrawal of the zero-rate for fuel could raise a similar amount of tax. It is, however, true that fuel is subject to the fuel levy and adding VAT on top of this should be given careful consideration. An increase in the VAT rate to 15% would raise a further R18 billion in tax revenues.

However, in order to make tax mix reform socially palatable, any increase in the level of taxation associated with VAT would need to be considered in conjunction with a comprehensive reform of South Africa’s social assistance system in order to relieve the burden on poor households. For example, to maintain the purchasing power of the existing social security grants for a withdrawal of the basic foods zero-rate would cost approximately R3.5 billion, assuming that the full cost of the VAT is passed on to consumers. Reform would, however, likely have to go further than this by extending social assistance to the unemployed as envisaged in the National Development Plan.