South Africa can generate more tax revenue by lowering taxes, which will create additional wealth and stimulate the economy.
It may sound counter-intuitive that more tax revenue can be collected through lower taxes, but it has been proven to work in many cases.
A good tax system requires the efficient and cost-effective collection of money to fund the state’s endeavours. It should also be viewed as equal by the citizens and be non-distortive.
There are different tax systems which aim for equality, including:
- Poll tax – Every citizen pays the same tax, independent of income. This tax system was used in South Africa many years ago.
- Proportional tax – Each individual pays a fixed rate on their income. In Mauritius, for example, all individuals and businesses pay 15% of their income, regardless of how much they make.
- Progressive tax – Individuals are taxed higher when they earn more money. The theory is that high-income earners can afford to pay more.
South Africa has a progressive tax system with one of the highest rates in the upper-income tax brackets (45%).
The government has been increasing taxes for many years and even introduced new taxes like a dividends tax.
It may seem that increasing taxes is an easy way for the government to collect more money, but the reality is that higher taxes may lead to lower revenue collection.
The Laffer curve
The Laffer curve shows the relationship between tax rates and the amount of tax revenue collected by governments.
The Laffer curve theory is built upon two extremes.
- If the tax rate is 0%, tax revenue would be 0.
- If the tax rate is 100%, no one will work, and the tax revenue would also be 0.
If the tax rate is incrementally decreased from 100% to 0%, the tax revenue will increase to an optimal point where tax revenue is maximised. It would then decrease to 0 as the tax rate becomes too low to generate tax revenue effectively.
The goal of the government would be to reach the optimal tax rate to generate the highest tax revenue – the revenue maximising point.
When the tax rate is raised beyond this point, individuals have greater incentives to do tax planning and arrange their finances in such a way as to pay as little tax as possible.
As the tax rate continues to increase, productivity would deteriorate as individuals would prefer to stay at lower tax brackets as the reward for hard work would be too low to pursue.
Renowned US economist Thomas Sowell supports the Laffer curve theory and explains it in one of his books, “Trickle down theory and tax cuts for the rich”.
When tax rates are high, the government could generate even greater tax revenue when tax rates are lowered.
This premise is based on the belief that individuals would change their behaviour in response to changes in the tax rate.
He highlighted four examples of where this occurred in the USA – 1920s treasury secretary Andrew Mellon, president John F. Kennedy, president Ronald Raegan, and President George W. Bush cut tax rates with positive results.
In each instance, GDP growth and tax revenue increased. Wealthy individuals not only paid more income taxes, but they also paid more on all other taxes.
Lower tax rates can also create additional wealth and stimulate the economy.
When businesses pay less tax, more funds are available to expand operations and employ more labour, leading to a greater tax base and higher tax revenue.
When individuals pay less tax, they have greater disposable income leading to more spending and greater output within an economy.
Although it may be difficult to determine the optimal tax rate to generate the highest tax revenue, employee and business behaviour and the movement of money could give clues on whether tax policies are efficient.
In the past decade, South Africa has seen many high-net-worth individuals leaving South Africa.
Many large South African businesses have also left South Africa and based themselves in more tax-friendly jurisdictions like Mauritius and The Isle of Man.
Rich South Africans and businesses employ tax practitioners to arrange their finances around paying as little taxes as possible.
These are not all related to the tax rate, but it is one of the main reasons for this behaviour, just as Sowell identified.
Reckless government spending and low trust in the government also affect the optimal tax rate on the Laffer curve.
Good governance makes citizens feel more comfortable in paying their taxes, which is absent in South Africa.
South African economist Dawie Roodt highlighted that the government is corrupt and highly inefficient, which adds to individuals wanting to pay as little tax as possible.
Based on South Africa’s attitude toward taxes and the flight of wealthy individuals and businesses, it is likely that South Africa’s tax rate is on the wrong side of the Laffer curve.
If tax rates were lowered, it may generate additional tax revenue and assist with economic growth.