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Increasing the income tax rate may reduce tax collections

19 February 2018
– 5 Minute Read


Increasing the individual tax rates for the 2018 financial year in South Africa may well add to the budget deficit in years to come, rather than providing a sustainable and realistic solution to the current shortfall.

Given the low rate of economic growth and the projected revenue shortfall of ZAR 50.8 billion for the 2017 fiscal year, Government will no doubt be looking (once again) to increase tax revenues in the hope of making some inroads into the ever-increasing budget deficit.  However, from an economic and tax perspective, increasing the individual tax rates, may prove to be a costly mistake in the long run.

The so-called ‘Laffer Curve’, developed by economist Arthur Laffer in the 2003s, shows how tax rate changes impact total tax revenue.  This demonstrates that certain tax rates are prohibitive, actually reducing the overall taxes collected by Government. 

The reduced tax collections can be as a result of various factors, such as reduced business activity, change in the nature of activity to lower-taxed or non-taxed activities, withdrawal from the tax base (for example as a result of emigration), or engaging in legal tax avoidance or illegal tax evasion.   

The size of the ‘unobserved economy’ has a significant impact on the amount of revenue Government can collect. This refers to illicit activities, which generate untaxed and unreported revenue, ranging from the under-declaration of income in tax returns to illegal imports, organised crime and the drug trade. The unobserved economy may also influence the outcome of a higher tax rate through decreased voluntary compliance and increased tax evasion.

Experience shows that, as a general rule, revenue collection may actually decrease in response to an increase in the income tax rate in scenarios where:

  • Slow economic growth and relatively high rates of tax have already placed the existing tax base under financial pressure so that people (and industries) begin to seek ways of minimising their taxable expenditure to maximise available disposable income.
  • Levels of tax morality and the perceived legitimacy and integrity of the government are low, illicit economic channels exist and there is inconsistent or ineffective penalisation of non-compliance with tax reporting obligations.
  • The progressive nature of the tax system (higher tax impact on wealthier individuals) has the potential to amplify the effects of tax rate increases for relatively wealthy taxpayers.

While this is a simplification of the complex factors in the determination of the Laffer Curve for a particular country, it is not difficult to see a number of red flags for the proposed income tax rate increases in the South African context. Arguably, raising the income tax rate in South Africa may decrease revenue collection, as opposed to providing a much-needed boost to flagging revenue collections in the 2017/ 18 fiscal year.

South Africa already has a small, highly condensed tax base (estimates indicate that only 13% of the population currently pays income tax).  South Africans also see a relatively low proportionate return on taxes paid – infrastructure and systems that should typically be funded or subsidised through national revenue, such as safe and reliable public transport and quality education and healthcare, are privately funded by many South African citizens in addition to the tax they pay. 

Since South Africa has a progressive system with a relatively high rate of tax for those in the higher tax brackets, the effects of an increase in the tax rate will be most severe on those who contribute the largest proportionate share of revenue collected.  According to the 2017 Tax Statistics Report published in December 2017, the tax burden on individuals increased from 29.6% of total tax revenue in 2007/ 8, to 37.2% in 2016/ 7.

The existence of significant economic activity outside the legal and tax framework naturally has an impact on revenue collection.  An increased tax rate does nothing to address the billions of Rands worth of untaxed income being generated by illicit enterprises and activities year-on-year.  This gives rise to the perception in the minds of tax-compliant taxpayers that illicit activities and cash flows are not being addressed by the relevant authorities, creating an additional disincentive for South African individuals to register for and pay the correct amount of tax.

As for tax compliance within South Africa, SARS’ Strategic Plan for the 2016/17 to 2020/21 period indicates that voluntary compliance levels are worryingly low. SARS’ research indicates that the perceived legitimacy and morality of the tax system is at risk due to concerns such as political corruption and the challenging economic conditions South Africans are experiencing.

In conclusion, it appears that South Africa is currently in a situation where compliant taxpayers face high tax rates, increasingly challenging economic conditions and little reward for voluntarily paying their taxes.  Conversely, those who evade their tax obligations are unlikely to be caught and punished.   There is a real risk that this is a system in which revenue collections will decrease if the tax rate is increased further.

Article by Julia Moore, associate in our Tax Practice.