A tip for Pravin: SA should adopt a flat tax

With less than a month to go to Finance Minister Pravin Gordhan’s inaugural budget speech, many South Africans and potential foreign investors will no doubt be wondering how he plans to balance the national accounts. With the vast majority of South Africans still suffering in the aftermath of the economic recession and interest rates predicted to rise in the second half of 2010, additional disposable income will be a welcome respite. Taxpayers will no doubt be hoping for the same thing – some additional disposable income through paying less tax.

Unfortunately, when one considers our budget deficit of R184bn (or 7.6 per cent of GDP) it is unlikely that there will be any significant tax relief. In fact, I bet my bottom rand that all the usual ‘soft taxes’ such as alcohol, cigarettes, and petrol, etc, will be targeted for increases. Of course this list is not exhaustive. Indeed, the government plans to introduce a new “exhaust tax”, which is ironic because no doubt most taxpayers are exhausted by all these taxes.

Now, more than ever, the Treasury must focus on making the tax collection system more efficient. Numerous proposals and recommendations have been made as to how to improve the tax system and SARS has already succeeded in making more people tax compliant. But what has generally been overlooked, whether intentionally or not, is the simple solution to tax – a proportional rate or flat tax system.

The late economist, Milton Friedman, proposed the flat tax system in the early 1960’s. What appealed to Friedman about the flat tax was the idea that individuals respond to incentives and take steps to further their interests. He argued that highly progressive taxes induce taxpayers to find and exploit tax loopholes, so that taxpayers reduce their tax payments legally and even at times illegally, by hiding or converting income into other forms.

The flat tax allows governments to gather maximum tax revenue at rates that provide taxpayers with what they judge to be an acceptable reward for their effort and risk-taking. Higher tax rates reduce the incentives for entrepreneurs to risk their capital and sacrifice their time and energy to earn higher incomes. Higher tax rates result in lower after-tax incomes for workers and therefore interfere with the ability of individuals to pursue their goals. Less disposable income means less saving which is critical for investment, especially in fixed assets such as buildings, machinery, equipment etc, commonly referred to as gross fixed capital formation.

Investments in these assets are essential for increasing wealth and jobs in the future. The ratio of gross fixed capital formation to GDP currently stands at about 23 per cent, 2 per cent below the targeted 25 per cent. When domestic savings are lacking the country needs to rely on foreign capital inflows, which are notoriously volatile. Ideally, SA should increase its domestic savings rate to free up capital for investment in these productive assets and to boost growth. According to the Reserve Bank’s latest quarterly bulletin SA’s domestic savings rate stood at about a mere 16 per cent of GDP in 3Q 2009.

A proportional or flat tax, as opposed to a progressive tax system, is one in which the ratio of tax to taxable income is the same at all levels of income. It replaces the various tax bands that feature in a progressive tax regime with a single rate. A ‘true’ flat tax makes no provision for exemptions and provides no special dispensation for low-income earners. However, for both compassionate and practical reasons there is no merit whatsoever in taxing the poor. The compassionate reasons are obvious while the practical reason is that below a certain level of income the costs of collecting taxes from the poor will exceed the amount collected. Low-income earners should therefore be exempt from paying tax on personal income.

South Africa, at 40%, has one of the highest marginal tax rates of all middle-income countries, and, by comparison, other middle-income countries have relatively low top marginal rates. Consider the following examples: Botswana (25%), Brazil (27.5%), Malaysia (28%), Mauritius (15%) and Uruguay (25%). A decade ago there were ten different tax brackets in South Africa. This has since been rationalised to six, so we could argue that we have been moving towards a flat rate system. The major impetus behind the rationalisation is that it is easier to administer fewer brackets. One bracket would obviously be the simplest of all.

Consider what happened with corporate income tax (CIT) when the rate was lowered. Nominal CIT revenue increased from R55.7bn in 2003 to R140.1bn in 2008, a cumulative percentage increase of 151.4% or 20.2% per year. This dramatic increase in tax revenue came off the back of a reduction in the headline CIT rate from 35% in 1995 to 30% in 2000, 29% in 2006 and 28% in 2009. Thus, CIT revenues increased while the headline CIT rate decreased. Granted much of the increase in CIT revenues was due to higher economic growth and higher commodity prices but a significant factor has been the improved tax administration and tax compliance. Indeed, higher tax compliance and the expansion of economic activity contribute to a broadening of the tax base. This explains one of the most paradoxical features of flat tax: the fact that it rapidly brings in more revenue at a lower rate because the lower rate is charged on more income.

Recognising this apparent paradox, a number of countries have recently introduced a flat tax in order to stimulate economic growth. They include Estonia, Iceland, Lithuania, Latvia, Russia, Serbia, Ukraine, Slovakia, Georgia, Romania and Macedonia. Average economic growth for these countries over the period 1998 to 2008 was 5.06% compared to SA’s average growth rate of 3.62% (only Serbia and Macedonia had lower average growth rates over the period). These countries also enjoyed higher rates of gross capital formation as a percentage of GDP with an average of 24.15% over the period 1998-2008 compared to SA’s average of 17.94% (only Serbia had a lower average rate of investment over the period). Moreover, average GDP per capita (PPP adjusted) was $11,887 over the period for the sample of flat tax countries, compared to SA’s average of $7,640 (only Macedonia and Ukraine had lower averages).

The ANC government has already demonstrated that a reduction in the level and variation of tax rates achieves better returns. They have achieved this by collecting higher taxes through some rationalisation and by cutting the rates established by the previous regime. This helped to change a shrinking economy into a growing economy. Even higher tax collections and economic growth rates could be achieved by doing more of the same.

Author: Jasson Urbach is an economist with the Free Market Foundation and a director of Africa Fighting Malaria. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation.