THE JOB of a finance minister is never easy. It requires balancing constant demands for increased spending with the requirement to collect taxes in a manner that does not compromise economic growth. Reconciling these is especially difficult during economic downturns, when the calls for increased spending are loudest and the ability to increase tax receipts is weakest.
Budget deficits usually rise during downturns. This is because profits and salary increases are generally lower when the economy is weak, so the taxes paid by companies and individuals grow slowly. Consumer spending and receipts from value-added tax also come under pressure. At the same time, government spending on unemployment benefits rises. So budget deficits increase because of the widening gap between government spending and income.
In contrast, when the economy is growing fast, profits, employment, wages and consumer spending all grow. So tax collections rise, payments of unemployment benefits fall and the budget deficit usually shrinks.
This pattern of peaks and troughs helps stabilise levels of economic activity. Increased deficits alleviate some of the pain of economic downturns and falling deficits reduce the risk of overheating. But there is a limit to which countercyclical fiscal policy can help. This is because the government must borrow to fund the deficits that, if prolonged, cause government debt to rise quickly. Soon it reaches levels where savers no longer want to buy all the bonds that must be sold to fund debt. And the interest on borrowings grows, leaving less for other essential spending.
This is why last week’s medium-term budget policy statement seeks to reduce the budget deficit, though predicted economic growth has slowed to 1.4% this year. Finance Minister Nhlanhla Nene has outlined a plan to curb state spending and raise taxes. This aims to slow the growth of government debt and the interest repayments thereon. He hopes to persuade global credit rating agencies not to further downgrade SA’s creditworthiness.
Achieving his goals will be difficult because SA’s large budget deficits since 2008 were the result of rising government spending rather than falling tax revenue. Our budgetary problems are therefore structural and long term, not cyclical and short term.
The rise in government debt in recent years was accompanied by a ballooning of borrowing by parastatals such as Eskom. Nene warned that the government no longer has capacity to support their borrowing requirements.
Government tax revenue is unchanged as a share of GDP from where it was in 2007, when the economy had been growing rapidly for several years and global commodity prices and mining taxes were at record highs. Tax revenue has remained strong because companies have successfully protected profit margins even though the economy is weak. Moreover, wages continue to grow faster than inflation. This means that income tax paid by individuals and VAT have grown quite strongly, despite the economic downturn. Tax receipts will therefore probably not pick up easily when the economy recovers. So Nene has warned of unspecified tax increases in next year’s budget.
Our large deficits since 2007 were caused mainly by large increases in government spending, which now amounts to more than 30% of GDP, up from less than 26% in 2007. Most of this increase is unrelated to the economic downturn. A prime cause is the increased number of government employees. Such spending will not automatically fall when the economy grows. It makes the goal of curbing spending difficult. Keeping growth in the wage bill to the budgeted 6.6% a year over the next three years will be crucial to meeting spending and deficit targets.
Few believe that unions will easily accept an increase only slightly above inflation, so the credibility of the government’s projections will soon be tested.
The rise in government debt in recent years was accompanied by a ballooning of borrowing by parastatals such as Eskom. Nene warned that the government no longer has capacity to support their borrowing requirements. It will sell some nonstrategic assets to help fund Eskom and will, belatedly, seek greater private sector involvement in infrastructure investment.
This change will help address weaknesses that have been obvious ever since the government started increasing infrastructure spending in 2006. The first weakness was the lack of implementation capacity, which has led to delays in delivering needed infrastructure. Second, huge cost overruns have simply been passed on to users. More private investor involvement should help address these failings, while relieving the government of a funding burden it can no longer afford.
Nene knows what is now needed, but delivering what he has promised will not be easy. He will face strong ideological resistance within the government and pressure from unions for larger wage increases. Investors and the credit rating agencies will be watching developments closely. There is very little room for slippage.