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Government's debt servicing costs

Should government's budget merely be about listing all the spending requests from different departments and raising the required taxes and loans to meet them?

Or is it is also about having a sense of what is feasible, what the maximum financial resources are the state can extract from the economy without damaging it, and the trade-offs required for their optimal use?

In short, a bottom-up approach to budgeting is not sufficient and must be complemented by a top-down perspective that sets a limit to total spending, as in, e.g., the Netherlands, Sweden and Switzerland, but unfortunately not in South Africa.

As discussed in my commentary on the 2009 Medium Term Budget Policy Statement (see my "Economic Commentary" of 28 October 2009), the hard-won gains of 13 years of fiscal consolidation have been reversed within the space of one year.

The budget deficit, at a projected level of 7,6% of GDP for 2009/10, is back to its pre-consolidation level, and government debt has inexorably been set on the road to returning to its pre-consolidation level of approximately 50% of GDP.

The state therefore finds itself back at square one, except that the current political environment is much less supportive of fiscal conservatism and the fiscal parameters much tighter.

The previous fiscal consolidation effort could rely on some easy gains from the sale of government assets (even if they were limited), squeezing capital expenditure and, in spite of tax rates being reduced, increasing revenue thanks to improved tax compliance.

But all this has now been turned on its head, and none of these measures are currently available.

Although the current global economic climate is very forgiving of deteriorations in public finances, with many countries having resorted to fiscal stimulus to limit the recessionary consequences of the financial crisis, markets are very clear about their demand for credible plans to put the position right once the cycle turns.

The year 2010 is expected to be a year of consolidation, but 2011 must provide evidence of improving fiscal positions. Countries that do not oblige the markets will find themselves being punished through higher long-term interest rates, which will make the effort to improve their fiscal positions just that more demanding.

The coming budget therefore must show a credible commitment to fiscal discipline.

Unfortunately the fiscal space that was created by the decline in government's debt servicing costs from 5,2% of GDP in 1996/97 to 2,4% of GDP in 2008/09 was used to vastly expand the social grant system. 

Because the latter is a permanent addition to government expenditure, the underlying assumption was therefore that the decline in debt servicing costs is irreversible.

But unfortunately it appears that government's debt servicing costs are set to return to 5% of GDP in the next 5 years, depending on long-term interest rates, which will make it much more difficult to contain government expenditure and avoid tax increases.

Government's debt servicing costs

Furthermore, the current president does not share his predecessor's active interest in economic policy, and his style of governing is aimed more at accommodating different views through compromise than taking the country by the scruff of its neck and dragging it to where it should be.

It will therefore not be that easy to shrug off the expected opposition to the belt-tightening demanded by the fiscal position.

On the expenditure side it is expected of the budget to reflect the decisions reached at the ANC's congress in Polokwane in December 2007, with little regard for the drastic change in economic conditions in the meantime and the need to prioritise expenditure in the context of limited resources.

And now this approach is being extended to the revenue side with attempts to usurp the National Treasury's prerogative of determining tax policy.

I am, of course, referring to the proposal (or is it demand?) that the SABC should be financed by a new earmarked tax equal to 1% of income tax.

This idea should be emphatically rejected as it implies that the financing of the SABC is the highest priority and should not be part of the normal budgeting process where it will have to compete with alternative claims on the available resources.

It would create a dangerous precedent, with many more worthy causes that could then also claim the right to be financed in a similar way.

In any case, ear-marked taxes are in principle a bad idea because they undermine the efficient allocation of resources while increasing the tax burden by stealth.

Not even the financing of Eskom's expansion programme has been deemed worthy of such special treatment!

But then the National Treasury should also be careful to avoid this kind of approach. For example, the planned new environmental taxes should not be seen as an opportunity to increase revenue, but rather as having the objective of changing behaviour through the creation of specific incentives and disincentives.

In my opinion there is an urgent need for top-down budgeting to complement the bottom-up approach, viz. the need to systematically determine the maximum sustainable levels of government revenue and expenditure, the deficit, and government debt for the South African economy.
 
In other words, the size of government must be determined first to define the aggregate expenditure ceiling. On the one hand this is an ideological decision, but on the other it is a technical issue that has to take into account the impact of prevailing economic conditions on expected revenue.

It should also reckon with the evidence that big government is often associated with less efficiency, lower growth, and higher inflation.

It is striking that government expenditure in middle-income countries on average amounts to 18% of GDP (compared with more than 30% in South Africa) and that for Asia's high-growth economies it is substantially less.

It is only once these matters have been resolved that Government will know how much resources it will have at its disposal on a sustainable basis and be able to prioritise expenditure accordingly.

A top-down budgeting approach that determines a binding ceiling for government expenditure and sectoral allocations will make the required trade-offs explicit and force Government to deal with them, resulting in greater efficiency in spending.

This is especially important in view of the pressure for additional spending that will be brought about by the new national health insurance and social security systems that are being envisioned.

The second instalment of my pre-budget commentary will focus on an analysis of the budget numbers.