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Deep dive: Why budget 2021 is ‘too optimistic’

Home Business Management Finance & Investment Deep dive: Why budget 2021 is ‘too optimistic’

Is Budget 2021 too optimistic about the prospects for medium-term fiscal consolidation? JP Geldenhuys, Lecturer: Department of Economics and Finance, University of the Free State believes the answer is yes.

THIS year’s Budget Speech by Minister of Finance, Tito Mboweni, struck a much more optimistic, hopeful tone – in keeping with President Cyril Ramaphosa’s State of the Nation address (SONA) two weeks earlier – than the Supplementary Budget, presented in June last year, and the Medium-Term Budget Policy Statement, presented in October.

This optimism was seemingly fuelled by a relatively strong global economic recovery, higher-than-expected tax receipts, due in part to higher commodity prices, the start of the South African Coronavirus vaccination drive, as well as the subsiding of the second wave of the virus. In his speech, the minister even outlined four reasons why he was hopeful for the future.

But the optimistic tone struck by the minister belies significant uncertainties regarding the pace of economic recovery, the ability of the government to curtail non-interest expenditure growth, and South Africa’s ability to avoid possible third and fourth waves of Coronavirus infections, sickness and deaths.

While the minister and National Treasury acknowledged that much work needs to be done, and that there are significant medium-term risks to the fiscal outlook, I believe these risks are being underplayed, and that the Budget’s expenditure and revenue projections seem to represent best-case scenarios, contingent on many things falling into place perfectly.

Budget ‘highlights’

Before turning to my reasons for being pessimistic about the fiscal outlook and the prospects for fiscal consolidation, let’s briefly consider some ‘highlights’ from Budget 2021.

The headline figures are that total government spending is projected to exceed R2 trillion in each year from fiscal year 2021/22 to 2023/24, ranging between 35% and 38% of GDP, while government revenue is projected to range between 28% and 29% of GDP over the same period.

Reassuringly for the fight against the Coronavirus, R10 billion has been set aside over the next two years to acquire and distribute vaccines.

For fiscal year 2021/22, the largest expenditure items, according to the functional classification of government expenditure, are basic education, health, social protection and community development, with spending allocated to these functions ranging between R219 and R272 billion.

The compensation of government employees constitutes about 32% of consolidated government expenditure, while interest payments make up almost 14% of government expenditure.

Given these revenue and spending estimates, the 2020/21 budget deficit is estimated to be about 14% of GDP, while National Treasury projects that this deficit will decrease to 9.3% in 2021/22 and to 6.3% in 2023/24. The primary deficit – the difference between non-interest government expenditure and government revenue – is projected to decrease from 7.5% in 2020/21 to 4% in 2021/22, before turning to a surplus in 2025/26.

With low growth and high long-run interest rates, debt-ratio dynamics dictate that primary surpluses are required to stabilise the government debt-to-GDP ratio. Given that we are projected to keep running primary deficits until 2025/26, gross government debt is expected to increase from 80.3% of GDP in 2020/21 to 87.3% of GDP in 2023/24. Fortunately, the deficit and debt projections have improved markedly since the Medium-Term Budget Policy Statement was presented in October.

The 2021 Budget contained good news for taxpayers: planned tax increases amounting to R40 billion were withdrawn, and income tax brackets were adjusted upwards by 5%, amounting to real tax relief. Furthermore, the corporate income tax rate will be lowered by 1 percentage point, to 27%, from 1 April 2022. But there was also some bad news for taxpayers, as excise taxes on tobacco products and alcoholic beverages were increased by 8% on average, while the fuel levy and carbon tax were also increased.

While income taxpayers received mostly good news, the news for grant recipients and government employees is mostly bad. The old-age, disability and care-dependency grants will only increase by R30 per month to R1890, while the child support grant will only increase by R10 to R460. These represent increases of 1.6 and 2.2%, respectively.

Given that National Treasury is projecting that the CPI inflation rate will average about 4% over fiscal year 2021/2022, these represent real decreases of about 2.4 and 1.8 percentage points. Since income from grants represents the most important source of income for many South African households, this will very likely mean a real decrease in household income for many households.

While grant recipients bear some of the brunt of government’s expenditure-focused fiscal consolidation programme, government employees will bear most of the brunt. Following the Labour Appeals Court’s judgement in December 2020 that the three-year wage and salary agreement between government and government employees was not binding, because National Treasury’s permission had not been obtained, the 2021 Budget Review makes provision for growth in the government’s wage bill of only 1.2% per year over the period 2021/22 to 2023/24.

As Burger and Calitz explain, wage bill growth depends on wage growth and employment growth: specifically, if wages grow by 4% – more or less the average rate of inflation expected over the next three years employment must decrease by 2.8% to ensure that the wage bill grows by only 1.2%. Negative employment growth could be achieved via natural attrition, early retirement, voluntary or involuntary severance, as well as freezes on promotions and the filling of vacancies.

Economic growth forecasts presented may be too optimistic

I now turn to why I am sceptical about the fiscal outlook and prospects for fiscal consolidation presented in the 2021 Budget. First, the economic growth forecasts presented in the Budget may be too optimistic, given South Africa’s slow economic growth and poor economic performance from 2009 onwards, as well as significant risks to the projected economic recovery, which may have been underemphasised in the baseline growth forecasts.

As Goldstein and Hausmann point out, the South African economy went into the COVID-19 pandemic in dire straits: economic growth has been low since the 2009 recession. In fact, according to the South African Reserve Bank, the South African economy has been in a downswing since 2013 – the longest recorded downswing since the end of the Second World War.

Following an estimated contraction of 7.2% in 2020, National Treasury is projecting that real GDP growth will be 3.3% in 2021, followed by 2.2% and 1.6% in 2022 and 2023, respectively. While economic forecasting is a fraught endeavour at the best of times, and while some form of recovery is to be expected following last year’s extraordinary circumstances, these forecasts seem optimistic, especially if we bear in mind that the IMF is projecting real GDP growth of 2.8% and 1.4% for 2021 and 2022, respectively.

Another reason to be concerned about National Treasury’s projections is that the growth rates being projected for 2021, 2022 and 2023 will be the highest annual GDP growth rates recorded since 2011, 2012 and 2017, respectively.

Furthermore, National Treasury’s baseline projections seem to underestimate significant risks to future GDP growth. The Budget Review does present a pessimistic economic scenario in which additional COVID-19 waves necessitate further non-pharmaceutical interventions that curb economic activity.

I find it interesting that no additional COVID-19 wave is modelled in the baseline GDP projection, seeing that the Minister of Health, as well as some of the government’s advisors on the COVID-19 Ministerial Advisory Committee, have until fairly recently warned that South Africa may face a third or even fourth COVID-19 wave, even with vaccines being available.

Furthermore, the Budget Review states that South Africans can only expect significant improvements to Eskom’s electricity generation performance by September of this year. If electricity production remains constrained for most of this year, it remains doubtful that high growth will be achieved this year, given that unreliable electricity supplies will constrain economic activity.

Finally, the baseline growth projections assume that very difficult upcoming wage negotiations with public sector unions will be successful, and that no prolonged industrial action will result if Treasury implements its wage bill proposals, which seems unlikely.

Unanticipated expenditures

My second reason for being sceptical about the fiscal outlook is that unanticipated expenditures, which cannot be covered by the increased contingency reserve, may substantially increase government spending, thereby increasing the budget deficit and the debt-to-GDP ratio.

Sources of these unanticipated increases may include further relief to South Africans if the economic recovery stalls, or if it is underwhelming; further bail-outs of state-owned companies, and higher-than-projected increases in the wage bill if wage negotiations between government and public sector unions break down.

Many South Africans will continue to experience economic hardship over the medium term: even if National Treasury’s growth forecasts are met, it will take until 2023 for real GDP to return to its pre-pandemic level. And the day before the Budget Speech, Statistics South Africa announced that the official unemployment rate increased to 32.5% in the fourth quarter of 2020, while the expanded unemployment rate, which includes discouraged workers, decreased slightly to 42.6%.

The increased poverty that will accompany employment losses if sluggish economic growth persists will lead to calls for government to provide much needed relief, such as a further extension of the special COVID-19 Social Relief of Distress Grant beyond April 2021, as announced in the SONA.

The Budget Review also provides data about the sheer extent of government’s financial assistance and loan guarantees provided to state-owned companies and other public institutions, due to poor financial performance at these entities over the past several years.

While National Treasury states that government will no longer grant guarantees to public institutions that can’t afford to repay, it remains to be seen if many of these institutions will be able to turn around their financial performance to the extent that is required for them to no longer approach government for financial assistance and loan guarantees – chapter 8 of the Budget Review paints a very distressing picture of the financial position of public sector institutions.

While reference is made to an announcement in the SONA address that there will be a revision of the mandates of state-owned enterprises as part of a rationalisation process, and also to the progress being made regarding the restructuring of Eskom, there is very little specific information about how National Treasury believes that the financial positions of these institutions will improve over the medium term.

It might therefore be high time for government to finally accept the need to either shutter or sell equity stakes in at least some of its state-owned companies.

The public sector wage bill has grown very fast for more than a decade – Intellidex estimates that real compensation in the public sector increased by almost 70% between 2006 and 2018. Furthermore, National Treasury and Intellidex have shown that the compensation of South African government employees is high compared to many countries, along various dimensions.

It is therefore not unreasonable for any fiscal consolidation programme to target slower wage bill growth. Many commentators have expressed their satisfaction with the government’s intention of limiting the annual growth of its wage bill to 1.2% per year over the medium term.

While the minister indicated in his speech that the Public Service and Administration Minister is working with public sector unions on securing a multi-year wage settlement, and while the Budget Review states that government will negotiate based on fairness, equity and affordability, we are provided with very little further information about progress in this regard.

This should be cause for concern (or at least tempered optimism), because a failure to curb wage bill growth will result in a failed fiscal consolidation, given how central these curbs are to the proposed fiscal consolidation.

Another point that should be considered is that if growth in the wage bill is curbed by reducing the number of government employees, as alluded to above, it will erode the real value of services like basic education, health, the police service and the defence force, thereby placing even more pressure on the ability of the government to improve service delivery.

The proposed fiscal consolidation programme

My final reason for scepticism is the design of the proposed fiscal consolidation programme. This consolidation programme rests on curtailing growth in government non-interest current expenditure, particularly the wage bill. In general, a fiscal consolidation entails the lowering of the government’s debt ratio by ensuring sufficiently large primary surpluses if interest rates exceed growth rates, which is the case in South Africa. Primary surpluses can be obtained by decreasing spending or increasing taxes or both.

National Treasury took increased income and wealth taxes off the table in this Budget. The reasoning for this decision is compelling: South Africa’s total government revenue-to-GDP ratio is already high compared to our middle-income country peers, marginal tax rates have been increased in the recent past, without substantial increases in tax revenues, while increased taxes could be contractionary.

However, this reasoning ignores that poor economic performance and a concerted effort to hollow out the capacity of SARS to collect taxes goes a long way towards explaining disappointing revenue collection in the years between 2009 and 2018.

Furthermore, while increased taxes could be contractionary, decreased government spending could also be contractionary. Increased taxes need not be contractionary, however: total consumption expenditure may increase if income is transferred from those with high marginal propensities to consume, to those with low marginal propensities to consume.

Specifically, consumption may increase if income is transferred from high-income to low-income South Africans via a tax-and-transfer programme. High-income earners usually have relatively low marginal propensities to consume, while low-income earners usually have higher marginal propensities to consume. This means that low-income earners are more likely to spend a rand of additional income than high-income earners, which could lead to increased consumption overall.

Another reason, not stated, for the preference to achieve consolidation through spending moderation, is that there is evidence that successful fiscal consolidations involve spending cuts, particularly politically unpopular ones like cuts to the wage bill and transfer payments, not tax increases. But more recent work finds that increased taxes could also be associated with successful fiscal consolidations.

We also need to consider how fair it is, during a global pandemic, and at a time when many other countries are strengthening their social safety nets, that South African income taxpayers, who fall within the top 10% of the South African income distribution, get real tax relief, while grant recipients are expected to be satisfied and make do with decreases in the real values of their grants.

While income tax increases would have been extremely unpopular, in particular in the light of revelations of large-scale corruption at the State Capture Commission, the ruling out of even temporary tax increases, the scrapping of the previously proposed tax increases amounting to R40 billion, and the granting of real income tax relief by increasing tax brackets, might prove to be short-sighted and counterproductive.

The success of a fiscal consolidation

The success of a fiscal consolidation also depends on the state of the economy and the size and speed of the proposed adjustment. Successful consolidations, without negative economic consequences, are more likely if an economy is in an upswing, which is most definitely not the case currently for South Africa.

Furthermore, fiscal consolidations could have negative economic effects if the proposed pace of the consolidation is too fast. Burger noted that, following the Supplemental Budget in June of 2020, the primary surpluses that National Treasury intended on running from fiscal year 2021/22 onwards, implied changes to the primary balance that were on par with, and even exceeded, the primary balance adjustments seen under IMF structural adjustment programmes.

He also stated that the size of these adjustments might be counterproductive, as it would lead to contractionary fiscal policy, which may act as a drag on aggregate demand and GDP growth.

While deficit and debt projections improved in the 2021 Budget, it should be noted that the size of the proposed expenditure cuts is comparable to large fiscal adjustments enacted in other countries: a cumulative expenditure reduction of 2.1 percentage points of GDP for South Africa, compared to a worldwide average cumulative expenditure reduction equal to 2.5 percentage points of GDP. The size of this reduction will probably be contractionary, leading to negative consequences for GDP growth.

I fully agree with National Treasury that the need for fiscal consolidation is urgent. I also agree that the growth in South Africa’s government debt-to-GDP ratio should be reined in to ensure fiscal sustainability, so that the country can avoid further credit ratings downgrades and increased borrowing costs. I am merely urging that we should be more realistic and less optimistic about the Budget that was presented on February 24.

Unfortunately, it will take more than five years to undo the effects of the unsustainable fiscal path that the country has been on since 2009.

 

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