VAT zero-ratings finely balanced
- Imraan Valodia and David Francis
The most likely alternative to VAT the Treasury would have taken would have been further cuts in expenditure - a move that would have cost the poor a lot more.
Since the announcement in the finance minister’s budget speech of the increase in value-added tax (VAT) from 14% to 15%, comment on the effect of the hike has focused on three questions: Is VAT regressive? Will it place an unfair burden on the poor? Can zero-rating be extended to ameliorate the effect on the poor?
The evidence is quite clear. VAT is not regressive; it is very slightly progressive.
The richest decile in SA pays about 12% of its disposable income in VAT, while the poorest decile pays about 9.5%. VAT efficiently raises a large amount of revenue from the wealthy.
For the forthcoming one percentage point increase, revenue will increase by about R22.9bn. SA’s income deciles 1-9 will pay about R9.26bn (43.34%), while decile 10 (the richest) will pay R13.63bn (56.66%). The poorest will pay just more than R1m.
Notwithstanding this evidence, there is still a great deal of concern about what the effect will be on poor households.
The table shows the costs of the VAT increase for the average household in SA. Assuming everything else stays the same, the poorest households, which spend R13,782 a year, will, after the VAT increase to 15%, pay R13,902 to buy the same basket of goods. The poorest people will pay an extra R121 a year in VAT, while the richest households will pay an extra R5,694 in VAT a year. The burden on the very poor will thus be about R10 a month.
The most likely alternative to VAT the Treasury would have taken would have been further cuts in expenditure.
This would have been a very regressive move and would have cost the very poor a lot more than R10 per month.
One way to protect the poor would be to expand the basket of goods that are zero-rated. Since food items are by far the largest component of what low-income households consume, this is the obvious place to look. Households in the poorest decile spend 35% of total household expenses on food, compared to just 6% for the richest decile.
Zero-rating an item is equivalent to the government providing a subsidy to households that consume it. The problem with zero-rating is that while it protects the poor, it also results in a subsidy to rich households that also consume the goods, and results in a reduction in revenue from VAT.
Given that some level of subsidy to the rich is unavoidable, one way to analyse the distributive effects of zero-rating is to use a "benefit ratio rule" of three.
For an item to be zero-rated, the benefit accruing to the poor (deciles 1-7) must be more than three times that accruing to the non-poor (deciles 8-10).
This ignores a number of other important considerations that should be considered, most important the promotion of consumption that may improve health outcomes.
Using this guideline shows that the current zero-rating system is well targeted, with one or two exceptions such as milk, where the rich receive a large subsidy (the benefit ratio for milk is only 0.8). The other zero-rated items are, for the most part, well targeted.
To address inequality, what other items should be zero-rate? If the rule of three is applied, no additional food items are appropriate for zero-rating.
According to the Income and Expenditure Survey, expenditure on "solid fuels", which includes firewood, charcoal, candles and coal, shows a benefit ratio of 3.19 and some items in this category could conceivably be zero-rated after analysis of the practical implications.
If the benefit ratio rule of three is reduced to a benefit ratio rule of two — the benefits accruing to the poor should be at least twice that to the non-poor — there are still no additional food items that should be zero rated.
An item to consider is poultry products, which forms an important part of the basket of goods consumed by low-income households. The average decile 1 household spent R147 in VAT on poultry products a year, compared to R279 for the richest households.
Zero-rating chicken would result in a benefit ratio of 1.82 – reasonably close to two. This is a higher benefit ratio than for milk, fruit and vegetables, which are currently zero-rated.
Zero-rating chicken, however, would result in about R3.2bn in foregone revenue from VAT, and R1.1bn of this accrues to deciles 8-10; essentially a large subsidy for the rich. The poorest three deciles, meanwhile, would benefit from a subsidy of R761m.
SA is very close to the limits of using zero-rating in the VAT system to protect low-income households. Any significant zero-rating will result in a very large consumption subsidy to the non-poor and a significant loss in revenue for the state.
In its first interim report on VAT, the Davis Tax Committee argued that the benefits of zero-rating have been exhausted, and strongly recommended that no additional items be zero rated.
Inequality cannot be examined or addressed with reference only to the revenue side of the budget. The tax system is designed to collect as much tax as efficiently as possible, with the least amount of restrictions and special provisions.
Reducing poverty and growing well-paid employment is far better dealt with on the expenditure side of the budget. This can be done through pro-poor spending and investment on, among others, education, health, transport and social grants.
If this is done properly, then it is clear that the R121 the very poor pay every year is a good policy choice.
Imraan Valodia is the Dean of the Faculty of Commerce, Law and Management, and David Francis is a Researcher in Economics at Wits University. This article was originally published on https://www.businesslive.co.za/bd/.