Abstract
This Selected Economic Issues paper examines economic developments in South Africa during 1993–94. After a cumulative fall of 3.5 percent between 1989 and 1992, GDP at market prices grew by 1.1 percent in 1993. The major contribution to growth came from the turnaround in the inventory cycle, with positive investment in inventories recorded for the first time since 1989. Private consumption expenditure remained subdued in 1993, rising by only 0.5 percent; by contrast, public consumption grew by 1.8 percent in 1993.
V. Effective Tax Rates on Labor and Capital
1. Introduction
The Government’s medium-term fiscal plans envisage a more or less constant central government tax take of about 24 percent of GDP for the period 1994/95 to 1998/99; this stance reflects concerns that South Africa’s tax burden may already be high by international standards. 1/ While there is broad political agreement to refrain from permanent increases in the overall tax burden, there is much less consensus on the desirable thrust of reform to achieve the appropriate balance and structure of taxation. In this context, the balance and structure of taxes on labor and capital have come under particularly close scrutiny. 2/ The present tax system is widely held to favor capital-intensive over labor-intensive production activities and to provide for low effective tax rates on capital, despite relatively high statutory tax rates. Furthermore, it has been argued that the burden of labor taxation falls overwhelmingly on persons earning annual incomes of R 20,000-80,000, and that the system of capital income taxation tilts the playing field in favor of particular investment projects through special incentives. 3/
This chapter analyzes effective average and marginal tax rates on labor and capital with the aim of providing empirical evidence on relative tax burdens and, in particular, on the variation of effective marginal tax rates on labor and capital. Section 2 briefly explains the concepts. Section 3 provides a historical analysis of average effective tax rates on labor and capital, based on macroeconomic data, while Sections 4 and 5 examine marginal effective tax rates on labor and capital, using microeconomic data.
Effective average tax rates on labor have risen sharply since the early 1970s, whereas effective average tax rates on capital have varied considerably over time albeit around a relatively stable mean. Until the early 1990s, the average tax burden on capital exceeded the average tax burden on labor by a significant margin. To the extent that any of the incidence of the increase in labor taxation has been on capital, the rising relative tax burden of labor is likely to have favored more capital-intensive production activities and may have contributed to the sharp rise in unemployment described in Chapter III. Nevertheless, recent studies showing that the efficiency costs of capital taxes by far exceed the efficiency costs of labor taxes would caution against increasing the present tax burden on capital income. 1/
The analysis of marginal effective tax rates on labor and capital under the present tax code indicates a wide dispersion of tax rates. In particular, marginal effective tax rates on labor increase sharply at relatively low annual remuneration levels between R 20,000 and R 50,000. Marginal effective tax rates on capital are sensitive to inflation, the type of investment project (equipment or structures), the mode of financing investment projects (debt, new shares, retained earnings), and the tax status of the provider of investment funds (private households, tax-exempt institutions). The chapter concludes that tax reform should focus on mitigating the distortions caused by the wide variation of marginal effective tax rates on labor and, in particular, on capital.
2. Effective tax rates: Concepts
Taxes on labor and capital drive wedges between pre- and post-tax prices of labor and capital. The effective tax rate on a factor service is defined as the ratio of the tax wedge to the before-tax price of the factor service. 2/ As regards labor services, wedges between the pre-tax wage relevant mainly to labor demand decisions and the post-tax wage relevant chiefly to labor supply decisions may be caused by direct taxes on labor (mainly social security contributions), individual income taxes, and consumption taxes. While social security contributions and individual income taxes represent direct deductions from the pre-tax wage, consumption taxes diminish the value of a given pre-tax wage by reducing the purchasing power of labor earnings. Tax wedges on capital services measure the difference between the pre-tax return of an investment and the post-tax return accruing to the investor. Capital tax wedges reflect statutory tax rates on capital income and other provisions of the income tax code, in particular provisions for depreciation allowances and for inflation accounting or the lack thereof. In practice, there can be a wide variety of average and marginal effective tax rates related, for example, to the progressivity of income tax schedules and the personal characteristics of taxpayers.
This study of allocational distortions originating in the South African tax system is limited in scope. Three potential extensions of the analysis are notable: first, the measurement of excess burdens--losses of economic welfare above and beyond the government’s tax take; second, the estimation of labor and capital price wedges introduced by budgetary transfers, subsidy programs including export promotion schemes, and regulations; and third, estimates of who ultimately bears the burden of taxes, i.e., tax incidence.
There are two basic approaches to the calculation of effective tax rates on labor and capital. Traditionally estimates of effective average and marginal tax rates have been based on a combination of information on statutory tax rates, provisions of tax codes, and, in the case of effective tax rates on capital, assumptions on economic behavior. However, the complexity of tax codes may make the construction of realistic effective tax rates difficult, and the relevance of an estimated effective tax rate based on the circumstances of a particular individual may be limited at the level of aggregate macroeconomic variables. Alternatively, effective average tax rates may be calculated using actual tax payments and data on tax bases from the national accounts. 1/ This approach does not require detailed information on the operation of the tax system and is particularly suitable for tracking changes in tax wedges over longer periods of time. On the other hand, macroeconomic data may not be informative on marginal effective tax rates (if taxes are not proportional) and may pose difficult measurement problems. For example, estimated tax rates may reflect tax evasion or mismeasurements of labor and capital income in the national accounts.
3. Average effective tax rates based on macroeconomic data
The construction of average effective tax rates on labor and capital and the sources for the data series used in the construction are described in Appendix II. Table 17 reports effective tax rates on labor and capital in South Africa averaged over the period 1971-93 and selected subperiods. Chart 19 plots the estimates. The average effective tax rate on labor combines information on labor and consumption tax collections and wage remuneration and consumption data from the national accounts to estimate the average tax burden on labor services. Estimates of the average effective tax rate on capital were constructed both for total capital income and for corporate income. Total capital income as measured in the national accounts is a heterogenous aggregate, which includes corporate profits, interest income, rent incomes, and income from self-employment. Estimates of the average effective tax rate on corporate capital income may therefore provide useful additional information on the capital income tax system.
South Africa: Effective Average Tax Rates Based on Macroeconomic Data
Period 1965-88. Derived from estimates reported in Mendoza, Razin, and Tesar (1993), Tables 2 and 3, p. 94.
South Africa: Effective Average Tax Rates Based on Macroeconomic Data
| Time range | Effective average tax rates | |||
|---|---|---|---|---|
| Labor | Capital | Corporate capital | ||
| 1971-93 | 19.2 | 29.0 | 27.6 | |
| 1971-80 | 13.9 | 28.3 | 25.8 | |
| 1980-90 | 21.5 | 30.7 | 28.3 | |
| 1990-93 | 26.7 | 26.3 | 31.5 | |
| Memorandum items: 1/ | ||||
| United States | 28.9 | 43.0 | … | |
| Japan | 24.6 | 33.0 | … | |
| Germany | 45.1 | 25.0 | … | |
| United Kingdom | 35.8 | 56.0 | … | |
Period 1965-88. Derived from estimates reported in Mendoza, Razin, and Tesar (1993), Tables 2 and 3, p. 94.
South Africa: Effective Average Tax Rates Based on Macroeconomic Data
| Time range | Effective average tax rates | |||
|---|---|---|---|---|
| Labor | Capital | Corporate capital | ||
| 1971-93 | 19.2 | 29.0 | 27.6 | |
| 1971-80 | 13.9 | 28.3 | 25.8 | |
| 1980-90 | 21.5 | 30.7 | 28.3 | |
| 1990-93 | 26.7 | 26.3 | 31.5 | |
| Memorandum items: 1/ | ||||
| United States | 28.9 | 43.0 | … | |
| Japan | 24.6 | 33.0 | … | |
| Germany | 45.1 | 25.0 | … | |
| United Kingdom | 35.8 | 56.0 | … | |
Period 1965-88. Derived from estimates reported in Mendoza, Razin, and Tesar (1993), Tables 2 and 3, p. 94.
SOUTH AFRICA Average Effective Tax Rates, 1971–93
(In percent)
Citation: IMF Staff Country Reports 1995, 021; 10.5089/9781451840919.002.A005
Source: Staff estimates.The plots in Chart 19 show that average effective tax rates on labor have trended sharply upwards since the early 1970s, although the effective tax burden on labor appears to have stabilized between 1988 and 1993. Chart 20 plots the average effective tax rate on labor and two of its components, the average effective tax rates on labor remuneration and on consumption. The series in Chart 20 suggest that both components of the average effective tax rate on labor have contributed to the significant rise in the tax burden on labor. Evidence on average effective tax rates for other countries is available for selected industrial countries. Estimates for the United States, Japan, Germany, and the United Kingdom, reported as memorandum items in Table 17, suggest that the average tax burden on labor in South Africa is high, in particular in view of the fact that the level of average effective tax rates on labor in most countries reflects substantial social security contributions. 1/ By contrast, in South Africa social security contributions are small and only payable for workers below certain wage remuneration levels. Most typical social insurance services--including health care, accident, and retirement benefits--are provided through private sector schemes (see description of social safety net in Chapter IV). To illustrate, adding up premium contributions to private and official pension funds in 1993/94, total pension contributions amounted to about 6½ percent of GDP. Using the hypothetical assumption that all pension insurance schemes would be converted into state-run social security schemes, this amount would add about 10 percentage points to the estimates of the effective tax rates on labor in Table 17, resulting in average tax burdens on labor that are comparable to levels observed for industrial countries. 2/
SOUTH AFRICA Average Effective Tax Rate on Labor, 1971–93
(In percent)
Citation: IMF Staff Country Reports 1995, 021; 10.5089/9781451840919.002.A005
Source: Staff estimates.Average effective tax rates on capital income and corporate income varied considerably over time and usually exceeded the average effective tax rate on labor by a significant margin (Chart 19). However, more recently, there has been a significant decline in the average effective tax rate on capital, which is likely to reflect a range of factors: the deep recession; the sharp fall of tax collections on mining profits; the discretionary cuts in the rate on corporate tax (including surcharge) from 57.5 percent in 1988/89 to 40 percent in 1993/94, which were only partly compensated by the introduction of a Secondary Tax on Companies (STC) on distributed dividends; and tax concessions provided through Section 37e of the Income Tax Act. 3/ On the other hand, since the mid-1980s a number of special capital tax incentives have been removed or reduced, including investment allowances, accelerated depreciation, building investment allowances. Given this range of factors and the observation that large short-run variations in the average effective tax rate are not unusual, it is not clear whether the recent decline in the average effective tax rate on capital signals a permanent lowering of the tax burden or a temporary lowering that will be partly or fully reversed as the economy recovers.
While the evidence from macroeconomic data indicates that the average effective tax rate on capital income has been fairly stable over the last 20 years, it also clearly suggests that the average tax burden on labor has risen significantly, and may now exceed the average tax burden on capital. Part of the perception that the South African tax system favors capital as a production factor may therefore be more reflective of the sharp relative rise in the tax burden on labor rather than a policy-induced lowering of the tax burden on capital. At least from the point of view of economic efficiency, the appropriate mix of taxes on labor and capital should depend on the relative efficiency costs of labor and capital taxes. In this regard, several studies of excess burdens caused by taxes have concluded that the efficiency cost of capital income taxation by far exceeds the efficiency cost of labor taxation. 1/ The conclusions of these studies--coupled with the evidence from this section that average effective tax rates on labor and capital are presently at roughly similar levels--would appear to militate against a policy of significant rebalancing of labor and capital tax burdens.
4. Effective tax rates on labor
In 1993, the average effective tax rate on labor based on macroeconomic data amounted to about 26 percent. However, this average tax rate may mask considerable variation in average effective labor tax rates across different wage remuneration levels. This section provides estimates of marginal effective labor tax rates at different wage income levels based on micro information about the tax system. In addition, it also reports estimates of average effective tax rates on labor at different income levels.
Table 18 shows calculations of average and marginal tax rates on labor at four annual wage remuneration levels (R 10,000, R 20,000, R 50,000, and R 100,000), reflecting the tax code applicable in fiscal year 1994/95. Specifically, unemployment insurance is levied at 2.0 percent of the insured’s earnings but applies only to workers with an annual income of R 63,648 or less. Additionally, Regional Service Councils levy a payroll tax of about 0.3 percent. The calculation of marginal and average individual income tax rates is based on income tax relief parameters for a married worker with two children. Finally, average and marginal tax rates on consumption are assumed to be equal and not to differ across remuneration levels. The effective consumption tax rate estimate of 17.6 percent corresponds to the average effective tax rate on consumption expenditure in 1993. 1/
South Africa: Marginal and Average Effective Tax Rates on Labor at Different Remuneration Levels Based on 1994/95 Tax Code
Regional Services Council services levy (average).
Married taxpayer with two children.
Sum of the five tax rates divided by 1 plus the consumption tax rate. For explanation of methodology, see Appendix I.
South Africa: Marginal and Average Effective Tax Rates on Labor at Different Remuneration Levels Based on 1994/95 Tax Code
| Annual pre-tax remuneration | ||||||||
|---|---|---|---|---|---|---|---|---|
| R 10,000 | R 20,000 | R 50,000 | R 100,000 | |||||
| Marginal rate | Average rate | Marginal rate | Average rate | Marginal rate | Average rate | Marginal rate | Average rate | |
| Unemployment insurance | 2.0 | 2.0 | 2.0 | 2.0 | 2.0 | 2.0 | -- | -- |
| Payroll tax 1/ | 0.3 | 0.3 | 0.3 | 0.3 | 0.3 | 0.3 | 0.3 | 0.3 |
| Individual income tax 2/ | -- | -- | 21.0 | 6.4 | 41.0 | 19.6 | 43.0 | 30.9 |
| Surcharge on income tax | -- | -- | -- | -- | 3.3 | 3.3 | 3.3 | 3.3 |
| Consumption taxes | 17.6 | 17.6 | 17.6 | 17.6 | 17.6 | 17.6 | 17.6 | 17.6 |
| Effective tax rate on labor 3/ | 16.9 | 16.9 | 34.8 | 22.4 | 54.6 | 36.4 | 54.6 | 44.3 |
Regional Services Council services levy (average).
Married taxpayer with two children.
Sum of the five tax rates divided by 1 plus the consumption tax rate. For explanation of methodology, see Appendix I.
South Africa: Marginal and Average Effective Tax Rates on Labor at Different Remuneration Levels Based on 1994/95 Tax Code
| Annual pre-tax remuneration | ||||||||
|---|---|---|---|---|---|---|---|---|
| R 10,000 | R 20,000 | R 50,000 | R 100,000 | |||||
| Marginal rate | Average rate | Marginal rate | Average rate | Marginal rate | Average rate | Marginal rate | Average rate | |
| Unemployment insurance | 2.0 | 2.0 | 2.0 | 2.0 | 2.0 | 2.0 | -- | -- |
| Payroll tax 1/ | 0.3 | 0.3 | 0.3 | 0.3 | 0.3 | 0.3 | 0.3 | 0.3 |
| Individual income tax 2/ | -- | -- | 21.0 | 6.4 | 41.0 | 19.6 | 43.0 | 30.9 |
| Surcharge on income tax | -- | -- | -- | -- | 3.3 | 3.3 | 3.3 | 3.3 |
| Consumption taxes | 17.6 | 17.6 | 17.6 | 17.6 | 17.6 | 17.6 | 17.6 | 17.6 |
| Effective tax rate on labor 3/ | 16.9 | 16.9 | 34.8 | 22.4 | 54.6 | 36.4 | 54.6 | 44.3 |
Regional Services Council services levy (average).
Married taxpayer with two children.
Sum of the five tax rates divided by 1 plus the consumption tax rate. For explanation of methodology, see Appendix I.
At the lowest annual remuneration level reported in Table 18 (R 10,000), average and marginal effective tax rates on labor coincide at about 17 percent, reflecting the complete exemption of remuneration from individual income tax. 2/ The marginal effective tax rates on labor increases substantially at higher remuneration levels. For example, the marginal tax rate more than doubles, from about 17 percent to about 35 percent, as remuneration levels increases from R 10,000 to R 20,000. At annual remuneration of R 100,000, the marginal effective tax rates is 55 percent, or more than three times the level at R 10,000. Average effective tax rates on labor increase more moderately than marginal rates at low remuneration levels but they edge up sharply as taxpayers move to higher income tax brackets.
The evidence on effective tax rates on labor suggests two noteworthy conclusions. First, at wage remuneration levels typical for low-income workers, tax wedges are almost exclusively due to consumption taxes. Second, marginal effective tax rates on labor reach a maximum at a relatively low remuneration level and thereafter remain constant.
5. Effective marginal tax rates on capital
This section analyzes variations in marginal tax rates on domestic capital investments, employing the approach developed by King and Fullerton (1984). The King-Fullerton approach draws on data on statutory capital income tax rates and on the provisions of the income tax code to estimate the wedge between the required pre-tax rate of return needed to make the project a worthwhile investment and the post-tax rate of return accruing to investors providing funds for the project. Table 19 sets out key capital income tax parameters based on FY 1994/95 tax laws. Nonmining companies are taxed at a statutory rate of 35 percent plus a temporary surcharge of 5 percent; the latter is scheduled to be phased out at the end of FY 1994/95 and is therefore unlikely to affect long-term investment decisions. The value of distributed dividends is subject to a 25 percent withholding tax (Secondary Tax on Companies). 3/ Dividends are exempted from individual income tax. Interest income is fully taxed but a special annual tax credit of R 2,000 on interest income applies. For the purpose of the effective marginal tax rate calculations, it is assumed that the private household providing the funds to finance the marginal investment project is subject to the top marginal income tax rate of 43 percent. Alternative calculations will assume that the provider of funds is a tax-exempt institution. There is effectively no capital gains tax in South Africa.
South Africa: Capital Income Tax Parameters Based on Tax Code as of FY 1994/95
Secondary Tax on Companies (STC).
South Africa: Capital Income Tax Parameters Based on Tax Code as of FY 1994/95
| Corporate tax rate (nonmining companies) | 35 percent | |
| Temporary surcharge on corporate tax rate | 5 percent | |
| Withholding tax on distributed dividends 1/ | 25 percent | |
| Withholding tax on dividends to nonresidents | 15 percent | |
| Personal income tax rates: | ||
| Dividends | -- | |
| Interest income | 43 percent | |
| Surcharge on interest income | 3.3 percent | |
| Capital gains | -- | |
| Asset lifetimes for tax purposes: | ||
| Machinery and equipment | 5 years | |
| Structures | 20 years | |
| Depreciation methods: | ||
| Machinery and equipment | Straight line | |
| Structures | Straight line | |
| Inventory valuation method | FIFO | |
| Investment allowance | -- | |
| Investment tax credit | -- | |
| Rates of economic depreciation | ||
| Machinery and equipment | 12.5 percent | |
| Structures | 2 percent | |
Secondary Tax on Companies (STC).
South Africa: Capital Income Tax Parameters Based on Tax Code as of FY 1994/95
| Corporate tax rate (nonmining companies) | 35 percent | |
| Temporary surcharge on corporate tax rate | 5 percent | |
| Withholding tax on distributed dividends 1/ | 25 percent | |
| Withholding tax on dividends to nonresidents | 15 percent | |
| Personal income tax rates: | ||
| Dividends | -- | |
| Interest income | 43 percent | |
| Surcharge on interest income | 3.3 percent | |
| Capital gains | -- | |
| Asset lifetimes for tax purposes: | ||
| Machinery and equipment | 5 years | |
| Structures | 20 years | |
| Depreciation methods: | ||
| Machinery and equipment | Straight line | |
| Structures | Straight line | |
| Inventory valuation method | FIFO | |
| Investment allowance | -- | |
| Investment tax credit | -- | |
| Rates of economic depreciation | ||
| Machinery and equipment | 12.5 percent | |
| Structures | 2 percent | |
Secondary Tax on Companies (STC).
Depreciation allowances for tax purposes are calculated according to the straight line method, assuming asset lifetimes of 5 years for machinery and equipment and 20 years for structures. 1/ The rates of economic depreciation quoted in Table 19, 12.5 percent for machinery and equipment and 2 percent for structures, are based on estimates used by the South African Reserve Bank to construct capital stock estimates. The valuation of inventories uses the first-in, first-out (FIFO) accounting principle. There are currently no investment allowances or investment tax credits available to investors.
A brief description of the King-Fullerton approach to the calculation of marginal effective tax rates capital is provided in Appendix III. Table 20 displays marginal effective tax wedges and marginal effective tax rates for investment projects financed by savings of private households. The marginal effective tax wedge measures the difference (in percentage points) between the required real pre-tax rate of return and the real post-tax rate, whereas the marginal effective tax rate expresses the tax wedge as a percent of the required real pre-tax rate of return. Both indicators are reported because the marginal effective tax rates may be difficult to interpret if the required real pre-tax rate of return is small. 2/
South Africa: Marginal Effective Tax Rates on Capital Based on 1994/95 Tax Code 1/
Based on real interest rate of 4 percent.
Average inflation rate of producer prices over 1985-93.
Difference (in percentage points) between required pre-tax rate of return and post-tax rate of return received by investor.
Tax wedge as a percent of required pre-tax rate of return. If the required pre-tax rate of return is small, the size of the effective marginal tax rate may not be informative.
South Africa: Marginal Effective Tax Rates on Capital Based on 1994/95 Tax Code 1/
| Inflation rate (in percent) | |||||
|---|---|---|---|---|---|
| -- | 5 | 14.8 2/ | |||
| A. Effective marginal tax wedges 3/ | |||||
| (In percentage points) | |||||
| Equipment | |||||
| Debt | 0.7 | 1.5 | 2.5 | ||
| New shares | 1.0 | 2.1 | 3.8 | ||
| Retentions | 0.4 | 0.7 | 0.9 | ||
| Structures | |||||
| Debt | 0.8 | 1.3 | 1.4 | ||
| New shares | 1.2 | 2.0 | 2.8 | ||
| Retentions | 0.4 | 0.4 | -0.4 | ||
| B. Effective marginal tax rates 4/ | |||||
| (In percent) | |||||
| Equipment | |||||
| Debt | 26.0 | 86.4 | 323.3 | ||
| New shares | 30.8 | 90.1 | 763.5 | ||
| Retentions | 13.2 | 73.7 | 37.9 | ||
| Structures | |||||
| Debt | 26.8 | 85.0 | 73.2 | ||
| New shares | 33.6 | 89.7 | 586.7 | ||
| Retentions | 15.8 | 64.9 | -10.4 | ||
| Memorandum items: | |||||
| (In percentage points) | |||||
| Tax wedges for projects financed by new share issues at zero STC |
|||||
| Equipment | 0.4 | 0.7 | 0.9 | ||
| Structures | 0.4 | 0.4 | -0.4 | ||
Based on real interest rate of 4 percent.
Average inflation rate of producer prices over 1985-93.
Difference (in percentage points) between required pre-tax rate of return and post-tax rate of return received by investor.
Tax wedge as a percent of required pre-tax rate of return. If the required pre-tax rate of return is small, the size of the effective marginal tax rate may not be informative.
South Africa: Marginal Effective Tax Rates on Capital Based on 1994/95 Tax Code 1/
| Inflation rate (in percent) | |||||
|---|---|---|---|---|---|
| -- | 5 | 14.8 2/ | |||
| A. Effective marginal tax wedges 3/ | |||||
| (In percentage points) | |||||
| Equipment | |||||
| Debt | 0.7 | 1.5 | 2.5 | ||
| New shares | 1.0 | 2.1 | 3.8 | ||
| Retentions | 0.4 | 0.7 | 0.9 | ||
| Structures | |||||
| Debt | 0.8 | 1.3 | 1.4 | ||
| New shares | 1.2 | 2.0 | 2.8 | ||
| Retentions | 0.4 | 0.4 | -0.4 | ||
| B. Effective marginal tax rates 4/ | |||||
| (In percent) | |||||
| Equipment | |||||
| Debt | 26.0 | 86.4 | 323.3 | ||
| New shares | 30.8 | 90.1 | 763.5 | ||
| Retentions | 13.2 | 73.7 | 37.9 | ||
| Structures | |||||
| Debt | 26.8 | 85.0 | 73.2 | ||
| New shares | 33.6 | 89.7 | 586.7 | ||
| Retentions | 15.8 | 64.9 | -10.4 | ||
| Memorandum items: | |||||
| (In percentage points) | |||||
| Tax wedges for projects financed by new share issues at zero STC |
|||||
| Equipment | 0.4 | 0.7 | 0.9 | ||
| Structures | 0.4 | 0.4 | -0.4 | ||
Based on real interest rate of 4 percent.
Average inflation rate of producer prices over 1985-93.
Difference (in percentage points) between required pre-tax rate of return and post-tax rate of return received by investor.
Tax wedge as a percent of required pre-tax rate of return. If the required pre-tax rate of return is small, the size of the effective marginal tax rate may not be informative.
The starting point of the calculations is an arbitrary assumption for the real pre-tax interest rate an investor can earn in the capital market. The results reported in Table 20 are based on a real pre-tax interest rate of 4 percent. Accordingly, in the absence of capital income taxation, a worthwhile marginal investment project would have to yield at least 4 percent (net of economic depreciation). At the same time, the investor in the capital market would receive the full 4 percent real interest rate and there would be a zero tax wedge. Panels A and B in Table 20 show the marginal effective tax wedges and rates, respectively, for investments in equipment and structures at three different inflation rates and based on the assumption that the ultimate provider of funds is subject to the top marginal income tax rate of 43 percent. The results broadly indicate that investments financed by new share issues (assuming the present STC rate of 25 percent) bear the highest marginal tax burden, followed by projects financed by debt, and projects financed by retained earnings. To illustrate tax discrimination introduced by the STC, Table 20 also reports marginal effective tax rates for projects financed by new share issues under an STC rate of zero. The STC increases the required pre-tax rate of return on projects financed by new share issues relative to projects financed by retained earnings because it lowers the post-tax dividend yields on shares. Accordingly, removing the STC would remove the current tax discrimination between projects financed by new shares and retained earnings and equalize effective tax rates across the two sources of finance. 1/
The marginal effective tax burden also varies significantly with inflation. For zero inflation, marginal effective tax rates are close to or below the statutory corporate tax rate of 35 percent, mainly reflecting the fact that depreciation rates for tax purposes are considerably more favorable than economic depreciation rates (Table 19). Positive inflation rates generally raise effective marginal tax wedges, mainly because the household’s real post-tax rate of return from savings declines owing to the taxation of nominal interest returns. However, in the case of structures financed by retained earnings, the required pre-tax rate of return declines by even more than the household’s post-tax rate of return, leading to an effective tax subsidy at higher inflation rates.
The scope for variations of marginal effective tax wedges and rates increases considerably if investment funds are provided by tax-exempt institutions (Table 21). For projects financed by debt, the marginal effective tax rate calculations indicate a significant tax subsidy as interest on debt is deductible as cost at the firm level while the costs of equity can not be deducted. At the same time, tax wedges on projects financed by new share issues widen significantly relative to the calculations without tax exemptions, reflecting the fact that projects financed by new share issues have now to compete with the higher alternative real post-tax returns available to tax-exempt investors through debt instruments.
South Africa: Marginal Effective Tax Rates on Capital if Investment Funds are provided by Tax-Exempt Institutions 1/
Based on real interest rate of 4 percent.
Average inflation rate of producer prices over 1985-93.
Difference (in percentage points) between required pre-tax rate of return and post-tax rate of return received by investor.
Tax wedge as a percent of required pre-tax rate of return. If the required pre-tax rate of return is small, the size of the effective marginal tax rate may not be informative.
South Africa: Marginal Effective Tax Rates on Capital if Investment Funds are provided by Tax-Exempt Institutions 1/
| Inflation rate (in percent) | |||||
|---|---|---|---|---|---|
| -- | 5 | 14.8 2/ | |||
| A. Effective marginal tax wedges 3/ | |||||
| (In percentage points) | |||||
| Equipment | |||||
| Debt | -1.0 | -2.3 | -4.8 | ||
| New shares | 1.9 | 4.1 | 7.8 | ||
| Retentions | 0.7 | 1.4 | 2.5 | ||
| Structures | |||||
| Debt | -0.9 | -2.5 | -5.8 | ||
| New shares | 2.3 | 4.7 | 8.3 | ||
| Retentions | 1.0 | 1.6 | 2.3 | ||
| B. Effective marginal tax rates 4/ | |||||
| (In percent) | |||||
| Equipment | |||||
| Debt | -33.3 | -134.6 | -618.9 | ||
| New shares | 31.7 | 50.4 | 66.1 | ||
| Retentions | 14.1 | 25.6 | 38.0 | ||
| Structures | |||||
| Debt | -28.4 | -157.9 | -312.3 | ||
| New shares | 36.5 | 54.1 | 67.6 | ||
| Retentions | 19.2 | 29.1 | 36.2 | ||
Based on real interest rate of 4 percent.
Average inflation rate of producer prices over 1985-93.
Difference (in percentage points) between required pre-tax rate of return and post-tax rate of return received by investor.
Tax wedge as a percent of required pre-tax rate of return. If the required pre-tax rate of return is small, the size of the effective marginal tax rate may not be informative.
South Africa: Marginal Effective Tax Rates on Capital if Investment Funds are provided by Tax-Exempt Institutions 1/
| Inflation rate (in percent) | |||||
|---|---|---|---|---|---|
| -- | 5 | 14.8 2/ | |||
| A. Effective marginal tax wedges 3/ | |||||
| (In percentage points) | |||||
| Equipment | |||||
| Debt | -1.0 | -2.3 | -4.8 | ||
| New shares | 1.9 | 4.1 | 7.8 | ||
| Retentions | 0.7 | 1.4 | 2.5 | ||
| Structures | |||||
| Debt | -0.9 | -2.5 | -5.8 | ||
| New shares | 2.3 | 4.7 | 8.3 | ||
| Retentions | 1.0 | 1.6 | 2.3 | ||
| B. Effective marginal tax rates 4/ | |||||
| (In percent) | |||||
| Equipment | |||||
| Debt | -33.3 | -134.6 | -618.9 | ||
| New shares | 31.7 | 50.4 | 66.1 | ||
| Retentions | 14.1 | 25.6 | 38.0 | ||
| Structures | |||||
| Debt | -28.4 | -157.9 | -312.3 | ||
| New shares | 36.5 | 54.1 | 67.6 | ||
| Retentions | 19.2 | 29.1 | 36.2 | ||
Based on real interest rate of 4 percent.
Average inflation rate of producer prices over 1985-93.
Difference (in percentage points) between required pre-tax rate of return and post-tax rate of return received by investor.
Tax wedge as a percent of required pre-tax rate of return. If the required pre-tax rate of return is small, the size of the effective marginal tax rate may not be informative.
The calculations of marginal effective tax burdens on capital presented in this section are only illustrative of the wide variation of marginal capital tax rates that may occur under the present capital income tax system. But the findings of this section do bring out the favored tax treatment of investment financed by retained earnings if investment is financed by private households. 2/ This feature of the capital tax structure may explain the absence of a developed market for corporate fixed-interest securities. If the STC is to be abolished and, for example, replaced by an imputation system with full tax credit (such that dividends are deductible against profits for corporate tax purposes), retained earnings would still be tax favored because the top marginal income tax rate exceeds the corporate tax rate. The findings also indicate that debt financing provided by tax-exempt institutions results in substantial tax advantages, in particular at high inflation rates, as it combines the advantage of deductibility of debt interest costs with the advantage of a full interest income-tax exemption for the provider of funds.
It is likely that incorporating further details regarding special tax incentives--for example, for agriculture and mining or specific tax provisions for foreigners or for Section 37e projects--would add to the impression of a highly tilted playing field for capital investments. While some variation in effective capital tax rates may be unavoidable even in a well-designed capital income tax system--in particular at the inflation rates historically observed in South Africa--there appears to be ample scope to reduce the present degree of variation. Key options in this regard include the use of indexation to mitigate the effects of inflation, reconsideration of STC, and reducing the scope for channeling savings to investment projects through tax-exempt institutions.
APPENDIX I Tax Wedges and Effective Tax Rates: Concepts
To define effective tax rates on labor and capital, consider a stylized economy that levies four types of taxes: (i) a direct tax on labor remuneration at effective rate tL; (ii) an individual income tax at effective rate tY; (iii) a tax on profits at effective rate tp; and (iv) a tax on consumption at effective rate tC. Denoting the pre-tax wage by W, the tax wedge on the use of labor (WEDGEL) is defined
The labor tax wedge measures the difference between the pre-tax wage relevant to labor demand decisions and the post-tax wage relevant to labor supply decisions. Expressing the labor tax wedge as a ratio to the pre-tax wage gives “the effective tax rate on labor” (ETRL)
In practice, there is a variety of effective tax rates on labor related, inter alia, to the degree of progressivity/regressivity of labor and consumption taxes and/or to personal characteristics of tax payers.
Denoting the pre-tax return on capital by R, the tax wedge on the use of capital (WEDGEK) is defined
Thus, the capital tax wedge measures the difference between the pre-tax return of an investment and the post-tax return accruing to an investor. Expressing the capital tax wedge as a ratio to the pre-tax return yields “the effective tax rate on capital”
There may be many effective tax rates on capital, reflecting, inter alia, different types of financing (debt, equity, retained earnings), different providers of financing (private households, tax-exempt institutions), and, most importantly in nonindexed income tax systems, the level of inflation.
While taxes on consumption affect the tax wedge on labor, they do not affect the tax wedge on capital income, where capital income is interpreted as the return on postponing consumption from the current to a future period. As regards the labor tax wedge, consumption taxes reduce the value of a given pre-tax wage, assuming that labor income is eventually consumed. But consumption taxes leave the terms of the trade-off between current and future consumption unaffected, at least at the margin, as long as they are imposed at unchanged rates between the two periods.
APPENDIX II Effective Average Tax Rates Based on Macroeconomlc Data
The construction of effective average tax follows the methodology outlined by Mendoza, Razin, and Tesar (1993). The calculations mostly use annual data obtained from the Quarterly Bulletin of the South African Reserve Bank (SARB). The effective average consumption tax rate (tc) is defined
Consumption taxes are measured as the sum of general sales tax/value-added tax (series Y4001) and net revenue from customs duties and excises (series Y4011). The pre-tax value of consumption corresponds to the nominal value of private consumption (series Y6007) minus consumption taxes. The effective average tax rate on labor remunerations (tL+ty) is derived as
Individual income tax on labor is measured as labor income taxes collected through the Pay-As-You-Earn (PAYE) system. The data on PAYE collections were provided by the Fiscal Analysis Unit. Remuneration of employees corresponds to series Y6000. Social security contributions in South Africa are small and have been ignored. The effective average capital income tax rate (tK) is constructed as
Capital income taxes are defined as total income taxes (series Y4000) minus PAYE collections, while net operating surplus is measured by (series Y6001). Finally, the effective average tax rate on corporate capital income (tCORP) is derived as
Corporate taxes are series Y6230 and net corporate income is total income of incorporated enterprises (series Y6225) minus interest payments of incorporated enterprises (series Y6227). The numerators of the effective tax rates (3) and (4) of tK exclude property taxes collected at the local government level and a few small tax items on capital transactions (estate tax, gift and donations tax, marketable securities tax).
APPENDIX III Calculation of Effective Marginal Tax Rates on Capital
The calculation of effective marginal tax rates on capital follows closely King and Fullerton (1984, Chapter 2). Consider a marginal investment project costing R 1. The project is assumed to earn a perpetual real gross return of MRR, which grows at inflation rate π and on which corporate tax at statutory rate δ is levied. The asset is assumed to depreciate at exponential rate τ, yielding a pre-tax net return p defined as p=MRR-δ. The present value of depreciation allowances and other tax incentives is denoted by A. A risk-neutral investor will equate marginal costs (1-A) and benefits of the project
where ρ denotes the discount rate of the project. Thus, given the discount rate, inflation rate, economic depreciation rate, and tax parameters, the project’s pre-tax net return is
An investor can earn a nominal interest rate i by lending in the capital market and interest income is taxed at marginal rate m. The real pre-tax rate of return r in the capital market is r=i-π and the real post-tax return s to an investor is
The marginal effective tax rate on capital is defined as the wedge between pre-tax return on the marginal investment project (p) and the post-tax return to investors in the capital market (s) expressed as a ratio to p
To implement the calculations, the discount rate ρ for different types of financing has to be fixed. For debt financing, the discount rate is given by ρ=i(1-τ), as interest payments on debt are deductible under the corporate tax system. For financing by new share issues, the discount rate is ρ=i(1-m)(1+d), where d is the tax on distributed dividends. Finally, for financing based on retained earnings, the relevant discount rate is ρ=i(1-m). The discount rate on retentions also reflects the fact that South Africa has effectively no capital gains tax.
References
Fourie, F.C.v.N., and Owen, A., “Value-Added Tax and Regressivity in South Africa,” The South African Journal of Economics, Vol. 61 (No. 1, 1993), pp. 281–300.
Jorgenson, D.W. and K.-Y. Yun, “The Excess Burden of Taxation in the US,” in A. Heimler and D. Meulders (eds.), Empirical Approaches to Fiscal Policy Modelling (London: Chapman & Hall, 1993), pp. 9–24.
King, M.A., and D. Fullerton (eds.), The Taxation of Income from Capital (Chicago: University of Chicago Press, 1984).
Lachman, D., and Bercuson, K. (eds.), “Economic Policies for a New South Africa,” Occasional Paper No. 91, (Washington: International Monetary Fund, January 1992).
Lucas Jr., R.E., “Supply-Side Economics: An Analytical Review,” Oxford Economic Papers Vol. 42 (No. 3, 1990), pp. 293–316.
McKee, M.J., Visser, J.J.C., and Saunders, P.G., “Marginal Tax Rates on the Use of Labour and Capital in the OECD Countries,” OECD Economic Outlook (No. 7, Autumn 1986), pp. 45–101.
Mendoza, E.G., Razin, A. and Tesar, L.L., “An International comparison of Tax Systems in Industrial Countries,” Staff Studies for the World Economic Outlook, Chapter V (December 1993), pp. 86–105.
Ministry in the Office of the President, White Paper on Reconstruction and Development (November 1994), Cape Town.
OECD, Taxing Profits in a Global Economy (Paris, 1991).
World Bank, Reducing Poverty in South Africa: Options for Equitable and Sustainable Growth (Washington, D.C.: The World Bank, 1994).
For a comparative analysis of the tax burden and various tax rates in South Africa with those in industrial and in middle-income countries, see Lachman and Bercuson (1992), Chapter VI. The central government tax-GDP ratio excludes social security taxes--which are small in South Africa, however, as many social insurance services are provided through private sector schemes--own tax revenues of provinces, and taxes collected by local governments. The general government tax-GDP ratio in 1993/94 amounted to about 26 percent of GDP.
See, inter alia, White Paper on Reconstruction and Development.” Ministry in the Office of the President, p. 38, 1994, and Reducing Poverty in South Africa: Options for Equitable and Sustainable Growth, p. 3, The World Bank, 1994.
See, inter alia, Lucas (1990) and Jorgenson and Yun (1993).
For a more formal discussion of tax wedges and effective tax rates, see Appendix I. For evidence on effective tax rates in industrial countries, see King and Fullerton (1984), McKee, Visser, and Sanders (1986), OECD (1991), and Mendoza, Razin, and Tesar (1993).
The calculation of effective average tax rates based on macroeconomic data has been proposed by Lucas (1990).
The March 1994 Fiscal Review reports that social security contributions in 1990 for an average of industrial countries amounted to 9 percent of GDP and to 4.1 percent of GDP for an average of middle-income countries.
The average tax rates referred to include both employee and employer social security contributions.
Section 37e tax concessions, which were abolished during 1993/94, provided for accelerated depreciation and deduction of interest for large-scale “mineral-benefication projects” before projects went on stream.
For the U.S. tax system after the Tax Reform Act of 1986, Jorgenson and Yun (1993, p. 20) calculated a marginal excess burden on corporate income of $0.84 per $1 raised in tax revenue, compared with an excess burden of $0.49 per $1 for taxes on labor remuneration.
This assumes a life-cycle perspective from which consumption taxes are in general proportional. In static terms, however, a value-added tax is likely to be regressive with respect to income and evidence provided by Fourie and Owen (1993) indicates that this is indeed the case in South Africa despite the zero-rating of essential foodstuffs.
A married worker with two children is exempted from individual income tax up to an annual income level of R 13,553.
Nonresident shareholders are assessed an additional 15 percent tax withholding tax on dividends.
However, depreciation allowances for agricultural and mining investments are significantly more generous. Agricultural machinery and equipment may be written off at 50 percent, 30 percent, and 20 percent over three years. Mining equipment may be written off fully in the first year, although the depreciation allowances are ring-fenced.
When the required pre-tax rate of return is negative, the absolute value was used as the denominator to calculate the marginal effective tax rate.
Introducing a capital gains tax would introduce a new form of tax discrimination by raising the required pre-tax return on projects financed by retained earnings.
See Chapter II for an analysis of the implications of the capital income tax system for corporate savings behavior in South Africa.
