Daily Bulletin

  • Written by The Conversation
imageThe poor and the middle class will be the hardest hit if the South African government increases the value-added tax.Shutterstock

There are strong hints that the South Africa government will raise the value-added tax (VAT) rate rather than increase income tax rates following the release of an interim report on VAT by a committee led by an eminent judge.

The reason an increase in the VAT rate is being contemplated is because the government wants more money to cover its ever increasing expenditure. Well, that is not new. More than 100 years ago Adolph Wagner predicted that this will always be the case. This view has become known as Wagner’s Law. The question thus becomes, once again, how to raise this additional income.

The South African government should weigh its decision carefully. It has been understood since the beginning of time that indirect taxes fall most heavily on those who are unable to bear this additional burden. Any increase in VAT will fall heaviest on the poor and middle class. The poor cannot even afford food and the middle class barely earn enough to pay income tax and will be paying double tax.

Understanding the canons of taxation

Decisions about tax should not be made by looking solely at the present. The past should also be looked at. The further back one looks the clearer the present problem becomes and hence so does the solution.

For several centuries there has been two forms of taxes, which John Stuart Mill in 1848 called direct and indirect taxes. Today these are income tax and VAT – the Two Ugly Sisters of taxation.

The question is: which to increase? The answer is not as difficult as it may appear at a first sight if David Ricardo’s factual observation is recalled: that taxes fall either on income or capital, in other words savings.

If taxes fall on savings the tax system will not survive too long, ending as soon as savings have been exhausted, and with that ending the economy. Taxes can only fall on income. All forms of taxation are therefore forms of income tax, all attempting to extract some part of the taxpayers' income using different mechanisms.

The point of departure is to understand the fundamental principles on which tax is to be levied, as applied to taxing income. These principles were set out a long time ago by Adam Smith as the canons of taxation. Later they were more clearly explained by Mill.

Oddly, it was only recently that Smith’s first canon was restated in modern accounting terms. The fundamental basis of income tax is simple and if imposed in terms of the rule of law requires a single law applicable to all taxpayers. This is what Smith’s first canon achieves. The cost of the necessities of life is subtracted from the taxpayer’s gross income to arrive at taxable income.

Tax is imposed on the taxable income. This fundamental principle was applied from the introduction of income tax in 1799 in Britain until the Peoples’ Budget in the early 1900s when the marginal tax system was introduced. The marginal tax system opened the way for a class war since tax could thereafter be differentiated.

The introduction of Income Tax in 1799 introduced a direct tax on all income. This should have meant that all other forms of taxation become redundant since all income was taxed. Their continued existence amounted to double taxation. In theory indirect taxes, or consumption taxes as they were then called at the time, should have been abolished. But they were not.

The poor shouldn’t be taxed

At current levels all those who earn less than the amount needed to cover the necessities of life, which in 2006 I estimated to be R120,000 per annum for a single person, should be exempt from all taxes. The reason for this is given by Jeremy Bentham and quoted with approval by Mill.

The mode of adjusting these inequalities of pressure, which seems to be the most equitable, is that recommended by Bentham, of leaving a certain minimum of income, sufficient to provide for the necessities-of-life, untaxed.

There should thus not be any VAT on the poor at all. The only rationale for the existence of VAT would be that everybody should bear some of the burden of taxation but in this case VAT should not be a significant revenue source. To the extent that VAT exists it is to fulfil the purpose of being the income tax of the poor.

If, for example, someone earns the minimum R120,000 a year and VAT is levied at 10%, that person would pay R12,000 per annum. That person then does not earn enough to cover the necessities of life. The VAT is paid at the expense of purchasing food, clothing, and shelter.

Income tax should then start at R120,000 per year at the same rate of 10%. So a person who earns, say R150,000 a year, would pay the same R12,000 via the VAT system and an additional R300 in income tax – a total of R12,300 per annum.

In all probability that person would be paying R15 000 in VAT and R300 in income tax, producing a a total of R15,300. The additional R3000 is the double taxation paid by the middle class because of VAT.

The tax burden on the lower income earners because of VAT is infinite. Tax burden is the ratio of tax paid to the taxable income. Since, in this case, the taxable income is zero the ratio is infinite, the tax burden is infinite.

The Davis Committee Report raises equity considerations of VAT and concludes “VAT is broadly neutral”. This view is easily dismissed as it has been throughout history where it has always been understood the burden of indirect taxes falls more heavily on smaller than larger incomes.

To avoid the type of misunderstandings set-out in the report, the history of taxation is important. The error of the statement is easily demonstrated. The tax burden is the ratio of tax paid to taxable income. In the example above the tax burden of the person earning R150,000 is clearly heavier when VAT is part of the equation.

Dire consequences

imageFrench Revolution: the government just didn’t get it.Sutterstock

There is a very good chance that if VAT is increased, civil unrest will break out as happened in Zimbabwe when VAT was increased to pay for the War Veterans Pensions. For Zimbabwe, it was downhill from there onwards.

The tax burden cannot continue to rise indefinitely as indicated by Wagner. The time must come where government expenditure is reduced in preference to increasing taxes. Now is the time to understand this and react accordingly.

Failing this, South Africa will be in the same position France was just before the French Revolution. The peasants were paying 80% of their income in tax and just before the revolution the government of the day was considering ways to increase the tax burden even more. The government just did not get it.

Robert Vivian does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.

Authors: The Conversation

Read more http://theconversation.com/south-africa-needs-to-raise-taxes-why-a-vat-increase-would-be-a-bad-idea-44871

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