1.1 WORK PROGRAMME OF THE COMMISSION
1.1.1 Having been appointed on 22 June 1994, the Commission completed its first Interim Report ("the first Report") on 18 November 1994. This report was presented to the Minister of Finance on 18 November 1994.
1.1.2 In its introduction to the first Report the Commission explained the approach it had adopted to its task as well as the Commission's vision regarding tax reform in South Africa. As it was mandated to do in its terms of reference, the Commission dealt in the first Report substantively with those aspects which in its view were required to be addressed in the 1995/96 Budget.
1.1.3 At the request of the Minister of Finance the 1994 Report was submitted to the Parliamentary Joint Standing Committee on Finance for consideration and, more particularly, for evaluation of the public response to the recommendations contained in the Report.
1.1.4 The evolution which is occurring in the approach to and administration of South Africa's exchange control regulations necessitated the preparation by the Commission of a second report. This Second Interim Report was issued by the Commission on 28 June 1995. It dealt with thin capitalisation and transfer pricing rules. These issues had already been identified in Chapter 14 of the first Report in which the Commission recommended the introduction of transfer pricing rules to protect the tax system against abuse as well as to prepare the system for any further relaxation of exchange controls.
1.1.5 This Report, being the Commission's third interim report, deals with a variety of matters, including:
1.1.6 There are various other matters which could not be dealt with in this Report due to time constraints. There are still other matters which the Commission has considered it appropriate to defer until the restructuring of the tax administration along the lines recommended by the Commission in its first Report commences. It is not realistic to consider certain changes to the system and structure of taxation in South Africa in the absence of an efficient tax administration.
1.2 CHANGES IN THE MEMBERSHIP OF THE COMMISSION
1.2.1 On the completion of the first Report, Professor P J Mohr resigned as a member of the Commission. This was occasioned by pressure of his work-load. He made an invaluable contribution to the Commission in the preparation of the Report, which is gratefully acknowledged.
1.2.2 Professor Lieb Loots and Ms Nomhle Gcabashe were appointed as members of the Commission on 10 August 1995.
1.3 ROLE OF THE JOINT STANDING COMMITTEE ON FINANCE
1.3.1 As is set out in paragraph 1.1.3 above, the Joint Standing Committee on Finance was given the task of evaluating the public reaction to the first Report.
1.3.2 The Committee invited submissions from the public and held numerous public hearings to discuss the first Report. The Commission was also afforded the opportunity to be present at these hearings and to elaborate on the reasoning that resulted in the recommendations contained in the first Report.
1.3.3 On 14 February 1995 the Joint Standing Committee on Finance issued a Report containing its views on the recommendations made by the Commission in its first Report. As a result of the views of the Committee, the Minister requested the Commission to reconsider certain matters. This has been largely done in this Report.
1.3.4 The role played by the Joint Standing Committee as set out above proved to be invaluable. The Commission records its appreciation to the Committee for its contribution and the manner in which it undertook this task.
1.4.1 A large part of the Commission's first Report was devoted to the extent and nature of the deficiencies in the existing administration of the Inland Revenue and Customs and Excise branches of the Department of Finance.
1.4.2 Certain recommendations were made by the Commission to remedy the problems identified and the Commission stressed the urgency surrounding the implementation of these recommendations.
1.4.3 The Commission is gratified by the strong support given to these recommendations and by the thorough and urgent attention given by the Government, and, more particularly, the Minister, towards the implementation of these recommendations.
1.4.4 The Commission again stresses the importance in the tax reform process on which the Government has embarked of significantly enhancing tax administration in South Africa. In fact, so serious is the matter, that the Commission finds itself inhibited in its ongoing ability to make recommendations for reforming South Africa's tax system in the absence of enhanced tax administration. Substantial improvement in South Africa's tax administration is required if a meaningful tax reform programme in South Africa is to be given effect.
1.4.5 The Commission therefore places on record its support for the decision taken by Government to restructure the Inland Revenue and Customs and Excise administrations.
1.5 FINANCIAL AND FISCAL COMMISSION
1.5.1 The appointment of the Financial and Fiscal Commission ("the FFC") in terms of section 198 of the Interim Constitution is an important event in fiscal relationships in South Africa.
1.5.2 There is a necessity for a significant interaction between the FFC and the Commission. In recognition of this fact the Commission responded to the FFC's invitation to make representations with regard to the report released by the FFC entitled Framework Document For Intergovernmental Fiscal Relations In South Africa.
1.5.3 The FFC and the Commission share the objective of ensuring, inter alia, that:
1.5.4 Co-ordination of the total fiscal programme at all levels of Government is therefore an essential ingredient of South Africa's ongoing tax reform efforts.
1.6 HOLISTIC APPROACH TO TAX REFORM
1.6.1 In the first Report the Commission emphasised that sensible long term reform of the South African tax system required an holistic evaluation of the tax system. Short-term ad hoc adjustments which are not part of a well crafted structure designed to take account of South Africa's specific needs are unlikely to produce an optimum system.
1.6.2 In its first Report the Commission indicated that it would undertake such an holistic revision of the tax system. This holistic evaluation would include an endeavour to determine an appropriate balance between the various taxes that contribute to all revenue collected by Government, including capital taxes, income tax, both individual and corporate, and various indirect taxes.
1.6.3 In embarking upon such a process, it is appropriate to bear in mind the important difference between tax reform and tax design. Tax reform takes place within the context of an existing tax system and takes account of the fact that the existing tax system must respond to the needs of specific circumstances and events.
1.6.4 This constraint was aptly described in the Report of the Margo Commission, as follows:
The problem is compounded by the fact that the current proposals must be made within the framework of an existing tax structure. Reformers do not have the benefit of a tabula rasa, upon which property rights with respect to the community's scarce resources have not as yet been imprinted. The difference is important because optimisation under the constraint of existing property rights leads to results different from those obtained in a situation unencumbered by such restrictions. Therefore the selection of a tax base in a process of reform need not necessarily correspond to the selection that would have been made under different circumstances.
1.6.5 By reason of these factors it became necessary for the Commission to define an approach to its task, and in particular to the question of the extent to which the Commission should deviate from existing taxes and recommend new taxes.
1.6.6 The Commission has determined that the justification for imposing a new tax must reside in one or more of the following factors:
1.6.7 The Commission is also conscious that cognizance should be taken of the social and economic behavioural impact which would result from any proposed tax.
1.7 DEDICATED TAXES AND USER CHARGES
1.7.1 The Commission has noted that in recent times a variety of proposals have been made for the assignment of the right to impose selective taxes to finance specific needs of particular government departments or functions.
1.7.2 In the context of the Commission's concerns regarding the overall coherence of the tax system and the dangers of a proliferation of taxes in South Africa, it has been deemed necessary to investigate the advantages and disadvantages of dedicated taxes and the imposition of user charges.
1.7.3 The Commission's findings on this vital issue are set out in Chapter 3 of this Report.
1.8.1 The Governor of the Reserve Bank, in his commendable battle against inflation, has recently suggested that only real interest, which is the interest yield after adjusting for inflation, should be taxed.
1.8.2 The Commission has considered this suggestion and, although it has sympathy for this view, considers that inflation cannot be addressed only in parts of the tax system. If inflation is to be addressed at all in the tax system, then the remedy must be effected throughout the system, including, in particular, in respect of rates of depreciation, trading stock and other allowances affected by price trends.
1.9 THE INTERNATIONAL DIMENSION OF TAXATION
1.9.1 The international dimension of taxation is becoming more important as foreign trade and foreign investment are increasing in significance in the South African economy.
1.9.2 The negotiation and conclusion of double tax agreements with South Africa's trading partners are continuing at a satisfactory pace. This is an important aspect of the international tax environment.
1.9.3 The Commission continues to accord attention to the international dimension of taxation in recognition of its importance to the South African economy.
1.10.1 The Commission has, in Chapter 2, embarked upon the holistic evaluation of the tax system as foreshadowed in its first Report.
1.10.2 In Chapter 3, the question of dedicated taxes and user charges is addressed. Chapter 4 concerns taxes on land, Chapter 5 deals with certain regional taxes and Chapters 6 and 7 examine various capital and wealth taxes. In Chapter 8 the Commission reconsiders, in response to the Minister's request to do so, the taxation of pension, provident and retirement funds. This is followed by an evaluation of the taxation of dividends and secondary tax on companies in Chapter 9. Chapters 10 to 14 deal with several technical aspects of taxation. The evaluation of gambling taxes in Chapter 15 is a response to an important specific contemporary problem. The democratisation of ownership of shares in companies has become an important issue of policy in South Africa and the Commission accordingly has considered the tax implication of this matter in Chapter 16 of the Report. Miscellaneous issues are discussed in Chapter 17 and the recommendations contained in this Report are set out in Chapter 18.
1.11.1 The Commission still requires to investigate numerous additional matters which it proposes to address in a further interim report to be published next year. Topics still to be covered include the following:
1.12.1 The Commission has received much support from the Minister of Finance, the Director-General of Finance, the Commissioner for Inland Revenue as well as the Inland Revenue administration. This support is gratefully acknowledged.
1.12.2 Dr Frans le Roux and the Unit for Fiscal Analysis, and in particular Mr Martin Grote, Mr Andrew Donaldson, Mr Ashraf Kariem and Ms Ingrid Woolard, have again provided considerable support to the Commission.
1.12.3 Mr Dave Allwright, the secretary of the Commission, his assistant, Mr Ferdie Schneider, and Mrs Alrina van Lier, have all continued to be of great assistance to the Commission.
1.12.4 Mr Garth Griffin was of great assistance to the Commission in the preparation of Chapter 8 of this Report. His assistance is gratefully acknowledged.
1.12.5 The Commission is also indebted to the people who served on its various sub-committees.
1.12.6 Thanks are due to those whose evidence and submissions to the Commission have greatly facilitated its work. A list of persons from whom written submissions have been received is attached to this Report as Appendix A.
2.1 INTRODUCTION
2.1.1 The appointment of the Commission was an indication that the Government is aware of the need for a more systematic approach to tax reform in South Africa. Since the Report of the Margo Commission a decade ago, much has changed in South Africa and it is opportune that a comprehensive and fundamental, "holistic", view be taken of the tax structure in South Africa. As stated in the introduction to this Report, short-term ad hoc adjustments which are not part of a well crafted structure designed to take account of South Africa's specific needs are unlikely to produce an optimum system.
2.1.2 In its 1994 Interim Report the Commission recorded the need for a fundamental review of the tax system. It referred to the rapidly evolving domestic and international context against which a thorough review of the South African tax system should be undertaken. In that Report the Commission expressed the hope that a close and careful examination of longer term tax reform options would contribute to South Africa's pursuit of better living standards for all in its complex environment. The Commission thus clearly envisaged that a comprehensive and systematic investigation into the tax system would be undertaken.
2.1.3 This is a task which the Commission considers it will be in a position to undertake over the longer term with the benefit of full public participation.
2.1.4 This Chapter constitutes an introduction to the topic and an indication of the guidelines that have informed the recommendations that are made in this Report. The Commission regards it as imperative that there be a broad debate regarding the direction and framework that should guide and shape tax reform over the next decade or more. It would therefore be premature for such a framework to be presented in this Report.
2.2.1 The debate about a comprehensive and systematic framework for tax reform in South Africa should address at least four considerations. These are:
2.2.2 This Chapter sets out some aspects of these issues.
2.3 THE LEVEL OF OVERALL TAXATION IN THE ECONOMY
2.3.1 The services citizens require to be provided through the institutions of Government must be charged one way or another to society's account. In this sense, the "overall tax burden" is no more than an accounting of the price citizens elect to pay for services collectively rendered. Careful tax design and sound fiscal management will ease the burden of this payment, but the aggregate charge is a consequence of expenditure policies.
2.3.2 The corollary of this principle, however, is that public expenditure is unavoidably constrained by financial considerations. As the Minister of Finance put it in his 1995 Budget Speech:
... the overall growth performance of the economy determines the increase in revenue which will accrue to the fiscus each year given the existing tax structure, while the economic growth objective limits the extent to which either an increased tax burden or borrowing can be used to finance additional outlays. Revenue and deficit targets thus dictate the overall government expenditure levels which the economy and the fiscus can sustain.
Against this background, the Minister proposed a tax level of just under 25 per cent of expected GDP for the 1995/96 fiscal year.
2.3.3 For three further reasons, the question of the overall tax burden cannot be ignored. Firstly, taxpayers' perceptions of what is fair and just can change rapidly, with a negative impact on tax morality. There are indications of a perception in South Africa that taxation is too high. Secondly, a view took hold during the 1980s that too high a level of overall taxation is damaging to economic growth. Thirdly, a belief has apparently taken root that taxation in South Africa is making the country less competitive in international trade and less attractive to direct international investment. These points are made in various submissions to the Commission. There is also a perception that similar conclusions can be drawn from comparisons between South Africa and other countries.
2.3.4 What should be regarded as the appropriate level of taxation will vary from country to country, and from time to time, depending on:
2.3.5 It follows that an international comparison of tax revenue as a percentage of Gross Domestic Product (GDP) is too simplistic to be a foundation on which tax reform should be based. At best, such a comparison can only serve as one of many measures for drawing a profile of a country's tax system. With this in mind, the Commission has attempted to place the South African tax system in international perspective.
2.3.6 The relative size of the public sector tends to be positively related to the per capita income of the country. Hence, the ratio of tax revenue to GDP also tends to increase with per capita income. In 1986 to 1992, tax revenue averaged 30,4 per cent of GDP in the OECD countries, 17,7 per cent in African countries, 14,1 per cent in the non-OECD Asian countries, and 27,3 per cent of GDP in the former socialist economies. The average tax revenue as percentage of GDP for middle income developing countries is 26,7 per cent. South Africa thus has a similar tax to GDP ratio to countries comparable on a per capita income basis.
2.3.7 A factor that militates against reducing the level of taxation as a percentage of GDP in South Africa at present is the substantial gap which exists between government expenditure and revenue which has necessitated borrowing by the national Government in excess of 6 per cent of GDP in each of the past three years. The Commission is conscious of the force of "supply-side" arguments for tax reductions, which give emphasis to the possible disincentive effects of high tax rates on investment and economic growth. However, tax reform cannot be pursued in isolation from stabilisation policy. International evidence favours a cautious approach to supply-side tax reductions, particularly in a context of a substantial fiscal deficit and underlying inflationary pressures.
2.3.8 Appeals for a reduction in the overall tax burden in order to release resources for financing investment are misplaced. It is the aggregate of government expenditure that represents the appropriation of national resources by the fiscus. The available empirical evidence suggests, furthermore, that the links between taxation, capital spending and economic growth are tenuous. The same share of investment in GDP can be associated with various rates of growth, depending on factors such as the international environment, available human resources, macroeconomic stability and the general quality of economic infrastructure. Various ratios of tax to GDP can be associated with either high economic growth or growth-enhancing investment.
2.3.9 The Commission can see no compelling grounds for either increasing or decreasing the tax to GDP ratio in South Africa under current circumstances. On balance, the Government's commitment to the avoidance of permanent increases in the overall tax burden is appropriate and is supported by the Commission.
2.3.10 In so far as it may be desirable for the level of taxation to fall, the Commission supports the view that it is only when the ratio of public spending to GDP has fallen and the public sector borrowing requirement thereby reduced that serious attention should be paid to the supply-side preference for reducing the "tax burden". No such considerations apply, clearly, to changes that are revenue-neutral in the aggregate.
2.3.11 In view of the considerations set out in section 2.1 above, the Commission defers its more detailed evaluation of the structure of the South African tax system to a later report. Two aspects of the direction of South African tax reform are however discussed briefly below.
2.4 THE RELATIONSHIP BETWEEN VAT AND POVERTY RELIEF
2.4.1 In section 1.7 of its first Report, the Commission identified the main dilemma South Africa faces in regard to further VAT reform. Inequality and poverty argue against a greater reliance on VAT, which, in turn, prevents much needed income tax reform. The inhibiting effects of distortionary direct taxes on economic efficiency and growth cannot be addressed without greater reliance on indirect taxation. The Commission points out the important relationship between VAT reform and poverty relief below.
2.4.2 The related question of the relationship between income tax reform and income distribution is addressed in section 2.5 below.
2.4.3 It is not in the tax system that the remedy for poverty is to be found. Even the complete removal of all taxes on the poorest members of society would not add greatly to their wellbeing, because the absolute amounts of tax attributable to very poor households are small. Fiscal correction of poverty must be exercised primarily through the expenditure side of the budget. This view is reflected in the Commission's findings on the VAT in Chapter 9 of the 1994 Interim Report.
2.4.4 The Commission dealt extensively with the relationship between VAT, the zero rating of certain commodities and poverty relief in its above-mentioned first Report. The main recommendations which emerged from this analysis were that the further erosion of the VAT base should not be considered and that renewed priority should be given to targeted poverty relief and development programmes. There is no need to deal with these matters again. The issue discussed below is the relationship between an increase in the VAT standard rate and poverty relief.
2.4.5 The empirical question of the effect on the poor of an increase in the VAT rate, with or without the present zero rating of basic foodstuffs, is not a simple matter. Relevant aspects include a household's propensity to consume, the percentage of disposable income spent on zero rated foodstuffs, the extent to which producers pass on the tax in higher prices, the extent of purchases from the informal sector, and the price elasticities of demand for the various goods consumed by the poor. These are not questions to which definitive answers are available, but there are good grounds in theory and experience for accepting that, particularly in the longer term, a larger share of revenue could be derived from the VAT without significantly increasing the extent or severity of poverty in South Africa.
2.4.6 As the reform of the VAT needs to be considered alongside possible reforms of the personal income tax, there are other empirical questions to consider. Significant numbers of poor households depend on wage income or remittances out of wages. The increasing burden of taxes on labour income, indicated in Chapter 16 of the Commission's 1994 Report, is therefore pertinent. The Commission recognises that tax policy cannot wait for conclusive answers to all relevant questions. The appropriate directions for reform need to be agreed on the basis of available evidence, and the finer details of policy implementation can be determined on the basis of further analysis and experience. The Commission therefore draws attention to the following broad findings.
2.5 THE RELATIONSHIP BETWEEN INCOME TAX AND INCOME DISTRIBUTION
2.5.1 A second critical question regarding the overall tax structure is the relationship between income tax and income distribution. In view of the difficulties of assessing the incidence of the corporate tax and its inappropriateness as an instrument of redistribution, the discussion below is confined to the personal income tax.
2.5.2 Internationally, personal income tax reform has focused in recent decades on reducing the distortionary effects and thus the overall burden of the tax, while continuing to raise a significant share of revenue. Objectives of reform have included:
2.5.3 These aspects of the design of the personal income tax are relevant in the South African context. Certain issues, including possible base broadening measures, were dealt with in the first Interim Report. Other potential reforms have not yet been considered by the Commission and remain to be addressed in a future report. The Commission wishes at this stage to place the relationship between personal income tax reform and income distribution on the agenda for public debate and further investigation.
2.5.4 Continued broadening of the base, with which some progress has been made, holds some potential for greater equity. The beneficiaries of measures which narrow the tax base are by definition taxpayers (and thus the wealthier quintile of South Africans) and wealthier taxpayers are likely to enjoy greater benefits. The effects of particular base broadening measures need to be investigated, however, with regard to revenue, income distribution and other objectives, such as the encouragement of individuals to make provision for retirement.
2.5.5 Further attention needs to be given to the tax schedule. Its steep gradation in the lower brackets and the absence of protection against inflation-induced bracket creep are defects that would long ago have been remedied had the fiscus not relied so heavily on this source.
2.5.6 The Commission notes that the introduction of a surcharge on individual taxpayers has been mooted, possibly to replace RSC levies. At present, individual tax rates are steeply progressive and the imposition of an additional surcharge without some form of bracket or other relief could create further difficulties with fiscal drag. The recommendations of the Financial and Fiscal Commission regarding the introduction of provincial surcharges are consistent with this observation.
2.5.7 The impact of income taxes on horizontal equity is also of interest. Horizontal inequity arises partly as a consequence of differences between taxpayers in their capacity to avoid or evade tax. There is international evidence that this problem is severe in progressive income tax systems. By comparison, broad-based indirect taxes, such as the VAT, raise few questions of horizontal fairness.
2.5.8 Tax reform directed towards price neutrality or particular aspects of social and economic equity has frequently offended excessively against the principle of simplicity. Attempts to extend the income tax base, to include fringe benefits or capital gains, for example, can create unanticipated opportunities for tax avoidance while also distorting choices in undesirable ways.
2.5.9 These are a few of many complex questions regarding income distribution and tax reform. During its holistic investigation of the tax structure, the Commission hopes to see these questions examined and widely discussed.
2.6 EFFICIENCY AND EFFECTIVENESS OF THE TAX SYSTEM
2.6.1 The major objective of the tax system is to raise revenue. This is not, however, the only objective, so that an investigation of the effectiveness of the tax system will have several dimensions. The first Interim Report dealt with the Reconstruction and Development Programme (Chapter 7), small and medium-sized enterprises (Chapter 10), taxation and the non-governmental sector (Chapter 12), tax incentives (Chapter 13) and the impact of the tax system on investment and saving (Chapter 15). This Report returns to these topics at various points and addresses additional aspects of public policy, including the role of taxation in regard to retirement provision (Chapter 8) and the question of employee share ownership (Chapter 16).
2.6.2 The Commission's approach is to deal with the effectiveness of the tax system both in regard to particular objectives or policy questions and in the context of systematic evaluations of specific taxes. A consolidated assessment of the effectiveness of the tax system in all its dimensions would be a considerable intellectual challenge. To have taken on such a challenge would have required the Commission to hold back from the particular projects which are described in this Report.
2.7.1 The Commission does not favour a comprehensive tax reform introduced in one package. A stepwise, or incremental, reform programme is both more practical and more likely to achieve its ends. A clear transition strategy is accordingly of critical importance for successful and sustained reform.
2.7.2 A recent review of taxation in developing countries points to the danger that in attempting to achieve too much in a comprehensive programme, the process of tax reform will ultimately flounder. Comprehensive reform is much more unsettling than partial reform. The theoretical design of an optimal tax system is, moreover, an exercise different from, and rather less awkward, than the reform of any actual tax system. Although the tax system envisaged might be clearly superior to the one that it would replace, a vision which lacks a strategy for transition will not be attained. This strategy must include attention to the likely costs of adjustment and the capacity of the tax administration and other affected parties to accommodate change.
2.7.3 There is also the likelihood that the Government may choose amongst elements in a reform programme, thereby defeating the purpose of a comprehensive initiative. Tax reform is a learning process. Policymakers must stand ready to alter and adjust their policies to suit changing needs and circumstances. In can again be emphasised that tax administration may have to receive attention before some policy changes or other reforms are introduced. The Commission therefore underlines the point already made in the 1994 Interim Report: that a strategy for South African tax reform will be incomplete, if not fatally flawed, if it does not give due weight to improvements in tax administration.
2.7.4 It also needs to be emphasised that because of the recommended phased or incremental approach to the implementation of tax reform, a transition strategy, carefully crafted on the basis of a holistic analysis of the current tax structure and the nature and direction of changes to it, is of the utmost importance. Without it the result may be short term ad hoc meddling which would not contribute to a structure designed to take account of South Africa's specific needs.
2.7.5 There is another sense in which a transition strategy is of importance. Recommended reforms need to be phased in an integrated and coordinated manner, with regard to critical linkages. Certain reforms may be dependent on preceding adaptations or may be more effective if accompanied by other reform measures.
2.7.6 Only continued close scrutiny of the tax reform process and ongoing attention to the problems of policy implementation will ensure that a reform programme remains on track. Progress requires time as well as the commitment of the Government. A clear framework for tax reform can help to generate the vision necessary for a long-term commitment and broad-based support.
2.8.1 The commitment of the Government to avoiding increases in the present ratio of national and provincial tax revenue to GDP of about 25 per cent is supported. [para. 2.3.9]
2.8.2 The question of VAT reform should be further investigated, both with respect to an increase in the standard rate and a narrowing of the set of zero rated items. The scope for appropriate poverty relief to accompany VAT reform should be evaluated. [para. 2.4.6]
2.8.3 The relationship between income tax reform and income distribution should be examined further, including attention to the issues identified in paragraph 2.5.2 above. [para. 2.5.3]
2.8.4 A stepwise, or incremental, approach to tax reform is recommended, rather than a comprehensive tax reform introduced in one package. The development of an explicit transition strategy, including improvements in tax administration, should be undertaken as an important foundation for this incremental approach. [paras. 2.7.1; 2.7.3-4]