Macro economic commentary – January 2018

Author: Ntsekhe Moiloa

The consensus in markets around the world is that 2018 is going to be a solid year of economic growth, however, financial markets may be close to a downturn either at some point in 2018 or in 2019. Valuations in financial markets appear to many commentators to be full or extended, relying perhaps on relatively recent developments like tax reform in the US to give some justification to current levels. Interest rates have already started to rise, placing some of the tax underpin in valuations at risk.

US 2-year yields rose about 25 basis points during January, while 5-year yields rose more than 30 basis points, and US 10-year Treasury yields rose from about 2.45 percent at the start of January to close at about 2.7 percent at the end, a rise of 25 basis points. The longer-dated 30-year yields rose only about 13 basis points, pointing to an overall bear flattening of the US Treasury curve. The yield curve is not yet inverted – a situation that usually points to recession – but rising yields are likely to make it harder to continue making a case for equities.

South African equities also enjoyed a respectable return in the 12 months to the end of January, yet unlike the United States it is not interest rate policy that will worry investors.

Investors in South Africa have spent January digesting the many events of December and thinking about the shape of things to come this year. The global economy is looking healthy, but South Africa’s economy is still in uninspiring shape. The South African political drama cycle was unscientifically expected to have peaked in December but public interest in politics has shifted from national spheres to local and provincial spheres where politicians are being blamed for shortcomings in the provision of bulk services such as water. The drought affecting agriculture and human settlements – mostly in the Western parts of the country – has dominated public discussions this January. Crop yields are expected to be much lower this season than last season, though we do not expect food inflation to be material. With the strain that drought is bringing to large parts of the country amidst a slow economy, many investors had expected the South African Reserve Bank to lower interest rates when the Monetary Policy Committee met just after mid-month. The SARB ultimately did not change its policy stance, and eyes shifted once again to the political landscape where President Jacob Zuma was widely expected to be replaced in government. Speculation about Zuma’s demise as well as general US dollar weakness, helped to bring the South African currency below 12 rand to the dollar after an initial strong move in December when Cyril Ramaphosa won the presidency of the African National Congress.

In isolation, the stronger rand, firmer bond market and a stock market that is not far from its historic highs, seem to suggest that South Africa is on a safe path. The tone of analyst calls on companies suggests that South Africa has entered a period in which consumer strength is recovering. This may well be the case, but we still expect the local economy to remain weaker than necessary to lift output substantially and to generate sufficient tax revenues to plug sizeable holes in the fiscus. The governing ANC has difficult decisions to make ahead of the 2019 national election, and we hope that they point to a focused and fiscally responsible path for government. The ANC’s task will not be easy.

What has become a regular threat of a government shutdown in the United States, is a timely reminder for South Africans of the importance of an independent and functional public administration. It has become lore that cadre deployment (whether by the ANC or by the DA where it governs) aligns delivery with the mandate a party receives at the polls. Conveniently overlooked are the misalignments that can happen between civil servants and communities. These misalignments can arise even in the absence of corruption. Recall that party hierarchies may inadvertently promote a reluctance to speak truth to power, especially among party colleagues. The reluctance to interrogate one another may lead to sub-optimal outcomes for the communities that these servants of the people are tasked to look after. This situation has essentially become the ANC’s headache after the feisty support of cadre deployment under President Thabo Mbeki.

Not only does the ANC need to strengthen the capability and resolve of those whom it has deployed in government, it has to perform this delicate surgery while government’s cherished tax pile is under threat from forces near and far; near forces being a lethargic economy and far forces being geopolitical competition for corporate investments.

In the aftermath of the Great Financial Crisis, governments around the world sought ways of raising revenues and closing down opportunities for tax leakage. For countries with a redistributive agenda, the attraction of higher revenues was a boon. Many of the tax augmenting efforts continue afoot in the form of initiatives to counter Base Erosion and Profit Shifting and to implement Common Reporting Standards. However, there are signs that a new tax dynamic is emerging. In the years after 2008, disillusionment with globalism has set in, leading to the rise of populist policies and nationalist governments in key parts of the world. Important examples include Brexit in the United Kingdom, and Donald Trump’s election in the United States.

In the wake of the Brexit vote questions began to be asked about how the UK would sustain itself outside the care of the greater European project. One of the early suggestions was the pursuit of a lower tax policy. This was not looked upon kindly by neighbours as it could trigger an arms race in tax policy that could potentially hollow out the finances of countries involved. Not long after the Brexit vote, the American electorate voted a populist and nationalist Donald Trump into office. One of the supposed successes of the Trump administration has been to push through tax reform which appears most beneficial to the wealthy and to corporations. In apparent response, the Swiss finance minister is preparing the ground for a vote on a corporate tax reform in the third-quarter of this year, arguing that Switzerland has a reputation for tax friendliness to uphold and that the US tax reform has placed the country under pressure to sweeten its appeal.

Should the boulder of tax advantage for corporations gain momentum around the world, it will not be long before South Africa has to consider its strategic move. With public finances in a parlous state and National Treasury looking for revenue raising opportunities, South Africa is on the back foot in this comparative tax cycle.

In May last year, Melisso Boschi and Stefano d’Addona published a paper on tax elasticities in select European countries. The aim of their paper was to understand how elasticities for the major categories of tax change through business cycles. The real-world application is to assist European governments in developing cyclically-adjusted budget balances in line with European Union policy, yet for the rest of the world they offer a window into which categories of tax revenue are most at risk to changes in the underlying performance of economies. The Boschi and d’Addona paper suggests that short-run corporate income tax elasticity is larger for periods of weak economic performance than for boom periods. The implication is that even as underlying economic performance recovers, tax revenue tends to recover more slowly. It should be a sobering thought for politicians who are prone to using the public purse to fund populist ideas while their economies are weak, cyclically and structurally.

The Medium-Term Budget Policy Statement delivered in October 2017 painted a bleak picture of the state of the fiscus and the likely trajectory of South African government debt. There was nary a kind word uttered in the wake of its delivery. We come to February with trepidation for what the main Budget proposes. Since the 1996/97 tax year tax revenue has gently crept up from 22.6 percent of GDP to 26 percent of GDP in the 2016/17 tax year. The OECD average is around 35 percent, including countries like the UK and Switzerland which are close to that average. In that sense South Africa’s overall tax burden is quite light. What the overall number masks, however, is a competitive disadvantage that South Africa has in the corporate landscape. The average OECD receipts from corporate income and gains is only 9 percent, slightly below Israel’s average of nearly 10 percent. In South Africa the number is closer to 16 percent, a level quite similar to Australia’s 15 percent. Yet, even in a high-tax Scandinavian country like Denmark, taxes on corporate profits amount to less than 6 percent of government receipts; and there are no capital gains applied against corporates. In Germany we find that receipts from corporates account for just north of 5 percent. The unfolding picture is that individuals bear the bulk of the tax burden in advanced economies. One must consider the possibility that a tax structure that relies less heavily on corporates compels governments to be more aggressive on investment and on job creation. Not only do higher levels of employment promote social stability, but for advanced economies the income and consumption taxes therefrom are crucial to supporting state balance sheets.