Fiscal policy is a huge problem for South Africa, with stuttering tax collections, and an apparent unwillingness of the government to cut the public sector payroll, says Absa.
The 2020 Budget to be presented on 26 February is key, it said in a Q1 2020 quarterly update published on Monday (20 January). We think the government will once again rely primarily on taxes to try to narrow the deficit, and in particular, we are making the bold call of a 1 percentage point rise in the VAT (value-added tax) rate, it said.
Absa said that South Africa persistent current account deficit leaves South Africa reliant on a continual inflow of foreign capital for financing.
However, JSE-based data on portfolio capital inflows have continued to disappoint, with net sales of R118 billion of equities and R26 billion of South African local currency bonds for a total outflow at R144 billion, just a touch higher than 2018 R142 billion.
In 2020, the possibility of a credit rating downgrade from Moody and the loss of South Africa last remaining investment grade rating raises the probability of further big bond portfolio capital outflows, as South Africa is ejected from the World Government Bond Index.
We also believe the MSCI equity index re-weightings to include China possibly point to further net equity outflows, and fuel levy Absa said that given South Africa ongoing fiscal challenges, it expects the government to lift indirect taxes in an effort to earn more revenues, and this carries implications for the inflation outlook.
In our forecast, we have assumed that the government will raise the general fuel levy by 30 cents\litre. But more importantly, we expect the government to increase the VAT rate by 1 percentage point to 16% in the 2020 Budget.
It said that some 65% of the headline CPI basket is subject to VAT after controlling for zero-rated and exempt items i.e., some food items, rentals, education and public transport. Meanwhile, we find that 71% of core CPI is subject to VAT, although we note that Stats SA does not survey all items of the CPI on a monthly basis. In a full pass-through scenario, the VAT increase would add 0.4pp to headline CPI inflation in 2020 and 0.2pp in 2021.
However, given the recent experience where some retailers absorbed the 2018 VAT increase into their margins, we think pass-through may again be only partial, Absa said. It said that the 2019 Budget announced R10 billion in tax increases for FY20\21 with full details to be unveiled in the 2020 Budget, but we believe given Eskom financial requirements and the urgency of action against South Africa slippery debt dynamics, the 2020 Budget could go somewhat further.
Absa forecasts a mix of smaller tax adjustments for a total take of roughly R35 billion. Our call of a VAT hike is perhaps a bold one, given the likely political fallout, but it is difficult to see what other options the government has, it said. Further increases in personal income tax rates would likely damage the tax base, the financial services firm warned. Over the longer term, the institutional rehabilitation of the South African Revenue Service (SARS) should serve to boost tax buoyancy, but this will take time to entrench.
The government raised VAT by one percentage point to 15% in 2018, for the first time in 25 years. Fiscal position remains precarious noted that the Medium-Term Budget Policy Statement (MTBPS) in October forecast a main budget deficit outcome of 6.2% of GDP in FY19\20, rising to 6.8% of GDP in FY20\21, equivalent to a primary deficit of 2.6% of GDP, including financial support for Eskom amounting to about 1% of GDP.
However, with a real interest rate on government debt that is much higher than the real GDP growth rate, South Africa needs instead to run sizeable primary budget surpluses just to stabilise debt to GDP. We believe the government intends to implement some corrective measures in the 2020 Budget, which will be unveiled on 26 February, but their scale and exact modalities are still up in the air, especially with regard to the relative balance between reliance on expenditure cuts versus tax increases, Absa said. In June last year, the National Treasury called for 5% mandatory cuts in baseline budgets from national and provincial government departments, but such large spending cuts were not embedded into the MTBPS projections, it said.
The National Treasury has warned of the pressing need to curtail spending on public sector compensation, but with employee compensation accounting for 34% of total planned spending in FY19/20, Absa said that the scope for big cuts is limited, given that the government is in the middle of a multi-year pay deal with civil servants, which ends only in March 2021, and it has also promised not to implement any mandatory retrenchments. Other important components of total spending, such as social grants (over 9% of total spending) and the interest bill (11%), also cannot be cut, Absa said, and there is a limit to how much the government capital investment and its transfers to provinces and municipalities can be cut further without negatively impacting service delivery.
Absa noted that the MTBPS already announced cuts of R20.3 billion in transfers to the provinces over the three years commencing in FY20/21, while transfers to local government are to be cut by R20.5 billion, in part to make room for extra funding for Eskom.
Bailout demands from other troubled state-owned companies (SOCs) like South African Airways are likely to continue, it said. Instead, contrary to earlier hints from the National Treasury that there is little economic scope for further tax increases, we believe the fiscal adjustment effort will rely significantly again on the revenue side of the fiscus, Absa said.