The tax conundrum – governments collect more tax at lower rates

SA’s 2007 budget speech was arguably not particularly encouraging for the majority of tax-paying citizens. In the build-up to his speech the Minister of Finance mentioned a number of recommendations and opinions sent to him directly by the public through the ingenious mail service known as ‘tips for Trevor’. The tips generally cover a broad spectrum of tax recommendations from the public advising Mr Manuel on how to deal with certain tax issues. The majority of taxpayers hoped for same thing – less tax. The budget contained the usual accommodations for bracket creep but the tax burden in SA remains high.

The treasury faces the task of improving the system to maximise revenues and reduce costs. Numerous proposals and recommendations have been made as to how to make the tax system more efficient but what has generally been overlooked, whether intentionally or not, is the simple solution to tax – a proportional rate or flat tax system. Milton Friedman proposed the flat tax system in the early 1960’s. The appeal to Friedman of the flat tax was based on the idea that individuals respond to incentives and that they take steps to further their interests. Friedman argued that highly progressive taxes induce taxpayers to find and exploit tax loopholes, so that legally, and at times illegally, taxpayers reduce their tax payments by hiding income or converting income into other forms.

The flat tax allows governments to gather maximum tax revenue at tax rates that avoid negative behaviour by providing taxpayers with what they judge to be an acceptable reward for their extra effort and risk-taking. Higher tax rates reduce the incentives of entrepreneurs to risk their capital and sacrifice their time and energy to earn higher incomes. They interfere with the ability of individuals to pursue their goals and result in lower after-tax incomes for workers and therefore smaller disposable incomes. Less disposable income means less saving; less saving means less capital formation; less capital formation means lower labour productivity, and lower labour productivity means lower real wages.

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 allowances for deductions 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. By comparison, other middle-income countries have relatively low top marginal rates. Consider the following examples: Botswana (25%), Brazil (28%), Malaysia (28%), Mauritius (25%), Namibia (35%) and Uruguay (0%). A decade ago there were 10 different tax brackets in South Africa, which has since been rationalised to six, so we could argue that we have been moving towards a flat rate system. Indeed, the major impetus behind the rationalisation is that it is easier to administer fewer brackets. One bracket would obviously be the simplest of all.

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. At a low tax rate higher-income taxpayers may pay not only more tax but also a higher proportion of the total. When the UK cut its tax rates in the 1980s, the top 10% of earners, who had contributed 32% of income tax before the cuts, contributed 45% afterwards.

Recognising the 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 in 2004/2005 was 6.9% compared to South Africa’s average growth rate of 4.7%. These countries also enjoyed higher rates of gross capital formation as a percentage of GDP with an average of 24% in 2004/2005 compared to SA’s average of 17.5%.

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. Higher tax collections and higher economic growth rates could be achieved by doing more of the same.

Author: Jasson Urbach is an economist with the Free Market Foundation. 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 Free Market Foundation.

FMF Feature Article / 11 April 2007 - Policy Bulletin / 29 September 2009