In the endeavour to rebuild South Africa and plan a post-Covid society, inequality, poverty and unemployment will have to feature prominently. In designing a new South Africa, the architects will need to employ a number of building blocks, including education, tax policy, competition policy, company law, small business legislation and labour relations, to name but a few. Here, I offer some thoughts on one of those building blocks – tax policy.
In designing a tax policy, there will be an immediate realisation that there are a number of objectives which compete with each other and in some cases appear to be mutually exclusive.
In the first instance, it is clear that government will need a huge purse to fund vital purposes. The two obvious sources are borrowings and tax. Excessive borrowings and the consequential unmanageable servicing cost of interest obligations appears to be a non-starter. That leaves tax. Here again, excessive tax burdens – apart from concerns of inequity in an already strained economy – could have a devastating effect on growth and, in addition, could be a detracting factor in attracting foreign investment.
Second, employment is clearly a key objective. A tax system that unduly favours capital over employment will therefore be problematic. But favouring capital could also attract much-needed new investment which, apart from other favourable results, could also create new jobs,
Third, consumption taxes, such as VAT, provide a significant and predictable source of revenue, but are inequitable as they are regressive and operate most harshly on the poor.
Fourth, the use of tax incentives to promote certain significantly needed objectives appears at first blush to be a much-needed mechanism in solving an extremely difficult puzzle. However, conventional wisdom is clear that an over-abundant use of tax incentives doesn’t increase either economic activity or revenue. On the contrary, it simply rechannels activity and in general results in a zero sum game.
At the same time, it creates many distortions and high costs of administration and compliance. In addition, incentives to foreigners generally help the foreign fiscus and do little to encourage investment in South Africa.
Important principles of tax reform
When faced with such seemingly insoluble problems in designing a tax system fit for the purpose of a post-Covid South Africa, there is unfortunately no alchemy or magic. One can do no better than to look to well-established principles of tax design formulated by many people over centuries, which have served societies that have adhered to these wisdoms.
Many of them have been formulated by two well-known experts in their recently published book, “Rebellion, Rascals and Revenue – Tax Follies and Wisdom Through the Ages”. The authors are Michael Keen, deputy director of the fiscal affairs department at the International Monetary Fund, and Joel Stemrod, professor of economics at the University of Michigan. The authors state that “there are eleven lessons that millenia of enduring, arguing and thinking about taxation teach us”. Set out hereunder are some of them.
Incidence of taxation
It is correctly pointed out by the authors that one of the hardest questions to answer about any tax is the question of who really bears it, in the sense of a loss of purchasing power as a consequence.
It must be realised that just because something is called a tax “on” some person or activity does not mean that it actually imposes a real burden on those people or on those who engage in that activity. The point is that the tax burden can and will generally be shifted as prices adjust to reflect the impact of the tax on supply and demand.
Who bears the corporate income tax – workers, shareholders or consumers? This remains opaque. It is vitally important in an unequal society to determine where the real burden of taxes is felt.
Taxes must be fair. Thus, the ability-to-pay principle is important. So too is horizontal equity, i.e different tax treatment for different people must generally be rational and fair. This is not always easy to achieve.
Vertical equity is even more important. This raises the issue in a society as to how the tax burden should be shared between the better-off and the less well-off. This raises a number of issues, both philosophical and economic. It includes incentive to earn and other similar issues. On this topic the authors conclude:
“[It] is important to remember that taxes, even including negative ones in the form of cash benefits, are only one weapon in the policy arsenal for addressing vertical equity, and may not even be the most effective of them. One of the most powerful ways in which governments support the poor – especially in low income countries – is by providing basic education and health care. By enabling such spending, a not-very-progressive tax that raises a lot of revenue, such as the VAT, can do more for the poor than a very progressive one that raises little.”
This thought has been expressed somewhat differently: in an endeavour to achieve redistribution in a society, it is often more important to determine how government spends taxes than how it raises them. The expenditure side of the budget is often more telling than the revenue side.
Finding good proxies
As a starting point, say the authors, for a tax system to be anything but capricious, it has to be based on things that can be measured and verified in a court of law. But the problems occur thereafter. Is a wealth tax fair or effective if it levies tax on assets? In addition, how is the value of the assets measured for these purposes? How is income measured? Or turnover? Does a carbon tax require pencils to be taxed because of the lead?
Tax avoidance and evasion
The authors point out that history shows people’s ingenuity in trying to escape taxation has few limits. They then provide illustrative examples:
“If that means having only nine windows when 10 or more would attract a tax liability, someone is sure to do it. Living in skinny houses when street frontage triggers tax; replacing walls with movable partitions when the latter, but not the former, qualify for an investment tax credit…”
Tax innovativeness either reduces tax revenue or requires the more honest, or less creative, to pay more.
Complex tax rules and ever abundant incentives, allowances and credits compound this problem.
Hidden costs of taxation
The authors make a critically important observation:
“However much revenue tax raises, that number will underestimate the true cost to society that the tax has imposed. This is because taxes generate an additional social cost – ‘excess burden’ – that arises when they alter the decisions that people and businesses would otherwise make.
“These distortions are rarely easy to see as ridiculously long cigarettes or buildings shaped like rockets. They do not require creative schemes. They may simply mean buying less of something (or supplying less of something, such as labour) because it is more heavily taxed. Those reactions are pervasive.
“But we do have a pretty good idea of what taxes perform badly in terms of the excess burden they create, and of how to measure that burden. The key lesson is that the greater the excess burden, the more responsive to taxation is the tax base. An example would be for a firm to finance by borrowing rather than injecting new equity.”
In introducing taxes, care must be taken to avoid excess burden with the consequential societal cost.
Targeting particular behaviour for taxation, such as pollution or road congestion, is acceptable. There are externalities, such as carbon tax, and internalities, such as taxing specific products. Both have a legitimate place in any tax system.
Optimum revenue collection is heavily dependent on tax compliance. How is this achieved? In the first instance, user-friendly tax laws are required even while recognising that tax is complex. User-friendly tax administration is also necessary.
Ultimately, however, tax compliance depends on trust. The relationship between the tax administration and the taxpayer is built on trust. This is achieved in a variety of ways, including fairness, respect for taxpayer rights and equal treatment of all taxpayers.
Impact of technology
The impact of technology is double-edged. On the one hand, it facilitates tax administration such as e-filing and cooperation, including sharing of information, by tax authorities.
On the other hand, it makes for more difficult tax collection; multinationals are able to structure their activities so as to reduce their tax liability to specific geographic areas, including low rate jurisdictions.
The solution to these issues is close co-operation between the South African tax administration with those of other jurisdictions worldwide, and participating with international tax agencies and organisations.
Finally, in this context, there is an ongoing necessity to ensure that the South African tax administration is provided with necessary capacity, including skills and technology.
Tax revolts are rarely just about tax
A word of caution must be expressed for societies where people feel marginalised or disregarded. A potential response by them to this situation is non-compliance.
“When tax blazes across history, it is usually because of some kind of rebellion or resistance. But there is almost always more to these episodes than tax. Tax measures are more often a tipping point, sparking conflict whose deeper source lies in more fundamental disputes over the ways in which a wider range of sovereign powers are allocated or being exercised – the coercive power to tax being almost the definition, and certainly one of the most salient manifestations, of state sovereignty.
“Tax resistance and boycotts are a natural focal point for expressing discontent with government, because they simultaneously deny both the legitimacy and the practical possibility of exercising the most basic coercive power of the state.”
Ways of taxing
Taxes can be raised through a variety of terminology – “fee”, “charge”, “levy”. All of these suggest that taxpayers receive something in return for the taxes they remit.
The precise label of the tax cannot, however, detract from the total fiscal burden of which they are each component parts. It is the cumulative burden that must be considered.
Five concluding observations are appropriate. First, an appropriate tax policy must be determined. As has been demonstrated, the usual formulation of a tax system is that it exists simply to collect revenue in an effective and efficient manner – this is overly simplistic. There are a number of other factors that must be taken into account, such as fairness, horizontal and vertical equity, the ability to pay principle, the misuse of tax incentives, the problems of measuring the base on which to levy tax such as asset valuations, income definition, turnover definition, the use of tax to drive certain desired behaviour such as sugar tax, carbon tax and so forth, determining the incidence of tax – who bears the burden – and the importance of tax neutrality, i.e a uniform tax for all activities, all entities, whatever their form, and all activities wherever they take place without favouring any geography.
Second, tax administration is of vital importance. It has rightly been observed that tax policy and tax administration are inextricably linked. This includes, but is not limited to, efficient tax collection. It also includes the ability to design and administer taxes.
Third, optimum taxes have a low cost of administration and compliance.
Fourth, in the endeavour to achieve redistribution in society, the way that taxes are spent by government – promoting education, healthcare and housing, for example – is often more effective than the way in which taxes are raised.
Finally, the optimum system is, in addition to taking cognisance of the observations set out above, a broad tax base with competitive rates, and an effective and efficient tax administration. Not only does this formulation have merit in itself, but it also contributes to the growth of the economy, thereby increasing the tax base.
Clearly, in the short term, while relief is required for the consequences of the pandemic and the recent unrest, inroads into the principles suggested in this article would be justifiable. DM
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