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.
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.
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.
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.