Drastic measures to save a desperate situation
03 March 2014
Posted by: Author: Yasmeen Suliman
Author: Yasmeen Suliman (KPMG)
Reduce tax rates to grow the economy and increase tax collections, says Yasmeen Suliman, director corporate tax at KPMG, who believes that a move like this could be the legacy that Pravin Gordhan leaves behind in his 2014 budget speech.
"With an economy facing languishing growth and dangerously high unemployment levels, it is unlikely that sufficient sustainable jobs will be created to reduce unemployment levels significantly", says Suliman. "A depressed economy means lower tax collections, and with a ballooning government deficit, the Treasury is under pressure to collect more revenue to fund expenditure."
Suliman labels our situation as desperate, and believes that desperate times call for drastic measures. "How about cutting tax rates to increase economic growth and tax collections?" she asks.
"With the need to raise more revenue to fund a growing deficit, it seems counter-intuitive to reduce taxes to increase tax collections." However, it has been proved that there is a graphical relationship between tax rates and tax collections, says Suliman referring to what is known as the Laffer Curve.
According to the Laffer Curve, as tax rates increase so do tax collections, but only to a certain point, after which as tax rates increase, tax collections actually decline. "So when a country is on the declining part of the Curve, a tax rate cut will actually boost tax collections.
"This theory has been shown to work in practice in the USA in the previous century. After a short decline in tax collections, tax collections actually started to increase in the medium to long term following a cut in tax rates."
It has also been shown in overseas examples that a tax cut had a positive impact on economic growth and unemployment levels, which explains why tax collections increased over the medium to long term – even though tax rates had reduced, there was a larger base to collect taxes from.
"It has also been postulated that governments should not set tax rates at the revenue maximising point, but rather should set tax rates at a point below the revenue maximising point, which would maximise economic growth instead," says Suliman. "Higher economic growth presumably would lead to higher tax collections in the long term due to a growth in the underlying tax base."
This theory was supported by South African research at the University of Pretoria in 2008, which showed that our tax rates are too high to support growth. Around this period tax collections as a percentage of GDP was 26%-28%, whereas the optimal growth maximising tax ratio was estimated to be 21.94%.
"Undoubtedly, a reduction in tax rates would result in a short term decrease in collections. However, this could be offset in the medium term by increased levels of savings and investment, leading to higher economic growth and lower unemployment." Suliman believes that there would be less incentive to engage in tax arbitrage activities, tax evasion and aggressive avoidance schemes. Which could mean higher tax collections in the medium to long-term?
"If internationally there is evidence that reducing tax rates may impact positively on growth and unemployment, and then this option should certainly not be ignored."
Speculation is rife that 26 February 2014 will see Pravin Gordhan reading his last budget speech as the Minister of Finance.
This article first appeared on mondaq.com.