Public Economics Seventh Edition

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Public Economics Seventh edition
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Publisher: Janine Loedolff
Editor: Language Mechanics
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Table of Contents
Cover
HalfTitle Page
Title Page
Copyright
Contents
Contributors
Preface
PART 1 Perspectives on the role of government in the economy
The public sector in the economy

1.1 Introduction
1.2 Legacy of the past
1.3 Fiscal challenges
1.4 The study field of public economics
1.5 The public sector in South Africa
1.5.1 Composition of the public sector
1.5.2 Size of the public sector
1.5.3 The relationship between the public and the private sectors
Key concepts
Summary
Multiple-choice questions
Short-answer questions
Essay questions
Benchmark model of the economy: Positive and normative approaches

2.1 Basic assumptions of the benchmark model
2.2 The benchmark model and allocative efficiency
2.2.1 Condition 1
2.2.2 Condition 2
2.2.3 Condition 3
2.3 Efficiency and economic growth
2.4 Market failure: An overview
2.4.1 Lack of information
2.4.2 Friction and lags in adjustments
2.4.3 Incomplete markets
2.4.4 Non-competitive markets
2.4.5 Macroeconomic instability
2.4.6 Distribution of income
2.4.7 Further notes on market failures
2.5 Enter the public sector: General approaches
2.5.1 Allocative function
2.5.2 Distributive function
2.5.3 Stabilisation function
2.6 Direct versus indirect government intervention
2.7 Note on government failure
Key concepts
Summary
Essay questions
Public goods and externalities

3.1 Private goods and the benchmark model
3.2 Pure public goods: Definition
3.3 The market for public goods
3.4 Who should supply public goods?
3.5 Mixed and merit goods
3.6 Externalities
3.6.1 Negative production externality
3.6.2 Positive consumption externality
3.6.3 Concluding note
3.7 Possible solutions to the externality problem
3.7.1 Pigouvian taxes and subsidies
3.7.2 Direct regulation
3.7.3 Creation of regulated markets
3.7.4 Support for alternative markets
3.7.5 Legal solution: Property rights
3.8 Global public and merit goods
Key concepts
Summary
Essay questions
Allocative efficiency, imperfect competition and regulation

4.1 The social costs of statutory monopolies
4.2 Natural monopolies
4.2.1 Characteristics and effects
4.2.2 An overview of policy options
4.3 Competitive restructuring
4.4 Privatisation
4.5 Regulation
4.5.1 Rate-of-return regulation
4.5.2 Price-cap regulation
4.5.3 Sliding-scale regulation
4.5.4 Regulation in developing countries
Key concepts
Summary
Essay questions
Equity and social welfare

5.1 Introduction
5.2 Nozick’s entitlement theory
5.3 Other Pareto criteria
5.4 Bergson criterion
5.5 Efficiency considerations
Key concepts
Summary
Self-assessment exercises
Essay question
Public choice theory

6.1 Introduction
6.2 The unanimity rule and the Rawlsian experiment
6.3 Majority voting and the median voter
6.4 The impossibility theorem
6.5 Majority voting and preference intensities
6.6 Optimal voting rules
6.7 Government failure
6.7.1 Politicians
6.7.2 Bureaucratic failure
6.7.3 Rent-seeking and corruption
6.8 Concluding note
Key concepts
Summary
Essay questions
PART 2 Public expenditure
Public expenditure and growth

7.1 The constitutional framework
7.1.1 The Constitution and public goods
7.1.2 Constitutional entitlements
7.2 The size, growth and composition of public expenditure
7.2.1 Size and growth of public expenditure
7.2.2 The changing economic composition of public expenditure
7.2.3 Functional shifts in public expenditure
7.3 Comparisons with other countries
7.4 Reasons for the growth of government: Macro models
7.4.1 Wagner and the stages-of-development approach
7.4.2 Peacock and Wiseman’s displacement effect
7.4.3 The Meltzer-Richard hypothesis
7.5 Micro models of expenditure growth
7.5.1 Baumol’s unbalanced productivity growth
7.5.2 Brown and Jackson’s microeconomic model
7.5.3 Role of politicians, bureaucrats and interest groups
7.6 Government and the economy: Long-term effects
Key concepts
Summary
Essay questions
Government intervention to reduce inequality and poverty

8.1 Inequality and poverty in SADC countries
8.2 The budget, redistribution and poverty alleviation
8.2.1 Changing the distribution of primary income
8.2.2 Changing the distribution of secondary income
8.2.3 Broad considerations for the design and assessment of policies
8.3 Targeting of government spending programmes
8.3.1 The benefits and limits of targeting
8.3.2 The costs of targeting
8.3.3 The effectiveness of targeting
8.4 Fiscal incidence
Key concepts
Summary
Essay questions
Social insurance and social assistance

9.1 The two components of income security systems
9.2 Social insurance
9.2.1 The income protection role of insurance
9.2.2 The rationale for social insurance
9.3 Social assistance
9.3.1 The choice between cash and in-kind transfers
9.3.2 Conditional cash transfer programmes
9.4 Incentive effects of income protection systems
9.5 The South African income security system
9.5.1 Coverage
9.5.2 Scope and adequacy
9.5.3 The effectiveness of South Africa’s social assistance programmes
Key concepts
Summary
Essay questions
Social services
10.1 Arguments for government intervention in education and healthcare
10.1.1 Education
10.1.2 Healthcare
10.2 The case for in-kind subsidies
10.3 Social service delivery
10.4 Service delivery in education in South Africa
10.4.1 Resources and outputs in the South African basic education system
10.4.2 Educational outcomes in South Africa
10.4.3 Service delivery issues in basic education in South Africa
10.5 Service delivery in healthcare in South Africa
10.5.1 The South African health system
10.5.2 Levels, growth and composition of government spending on health in South Africa
10.5.3 Access and quality of health services
Key concepts
Summary
Essay questions
PART 3 Taxation
Introduction to taxation and tax equity

11.1 Sources of finance
11.2 Definition and classification of taxes
11.2.1 Tax base and rates of taxation
11.2.2 General and selective taxes
11.2.3 Specific and ad valorem taxes
11.2.4 Direct and indirect taxes
11.3 Properties of a ‘good’ tax
11.4 Taxation and equity: Concepts of fairness
11.4.1 Benefit principle
11.4.2 Ability-to-pay principle
11.5 Tax incidence: Partial equilibrium analysis
11.5.1 Concepts of incidence
11.5.2 Partial equilibrium analysis of tax incidence
11.6 General equilibrium analysis of tax incidence
11.6.1 A selective tax on commodities
11.6.2 A general tax on commodities
11.7 Tax incidence and tax equity revisited
Key concepts
Summary
Essay questions
Tax efficiency, administrative efficiency and flexibility

12.1 Excess burden of taxation: Indifference curve analysis
12.1.1 Lump-sum taxes and general taxes
12.1.2 Selective taxes
12.1.3 Tax neutrality
12.2 Excess burden: Consumer surplus approach
12.2.1 The magnitude of excess burden
12.2.2 Price elasticities
12.2.3 The tax rate
12.3 Administrative efficiency
12.4 Flexibility
Key concepts
Summary
Essay questions
Personal income taxation

13.1 The comprehensive income tax base
13.1.1 International taxation of income: The residence principle versus the source principle
13.2 The personal income tax base
13.2.1 Exclusions
13.2.2 Exemptions
13.2.3 Deductions
13.2.4 Rebates
13.3 The personal income tax rate structure: Progressiveness in personal income taxation
13.4 Economic effects of personal income tax
13.4.1 Economic efficiency
13.4.2 Equity
13.4.3 Administrative efficiency and tax revenue
13.4.4 Flexibility
Key concepts
Summary
Essay questions
Company income tax, capital gains tax and income tax reform
14.1 Why company taxation?

14.2 The company tax structure
14.2.1 The company income tax base
14.2.2 Types of company tax
14.2.3 Taxation of small and medium-sized enterprises
14.3 The economic effects of company tax
14.3.2 Company taxation and investment
14.3.3 Fairness
14.4 Capital gains tax
14.5 Income tax reform
14.5.1 The flat rate income tax
14.5.2 The dual income tax
Key concepts
Summary
Essay questions
Taxation of wealth
15.1 Wealth and types of wealth taxes
15.2 Why tax wealth?
15.2.1 Equity considerations
15.2.2 Efficiency considerations
15.2.3 Revenue and administrative considerations
15.3 Property taxation
15.3.1 The tax base
15.3.2 Tax rates
15.3.3 Assessment
15.3.4 Equity effects
15.3.5 Efficiency effects
15.3.6 The unpopularity of property taxation
15.4 Capital transfer taxes
15.4.1 Economic effects of capital transfer taxes
15.4.2 Capital transfer taxation in South Africa
Key concepts
Summary
Essay questions
Taxes on goods and services, and tax reform
16.1 Types of indirect taxes

16.2 Indirect taxes: A general critical assessment
16.3 Value-added tax
16.3.1 The economic effects of VAT
16.4 Personal consumption tax
16.4.1 The rationale for a personal consumption tax
16.4.2 The disadvantages of a personal consumption tax
16.5 Tax reform: International experience
16.5.1 Patterns of taxation in industrialised and developing countries
16.5.2 International tax reform
16.5.3 Globalisation and tax reform
16.5.4 International tax competition and tax harmonisation
16.6 Tax reform in South Africa
Key concepts
Summary
Essay questions
PART 4 Fiscal policy
Public debt and debt management

17.1 The concept of public debt
17.2 Public debt sustainability
17.3 Size and composition of the public debt
17.4 Theory of public debt
17.4.1 Introduction
17.4.2 Internal versus external debt and the burden on future generations
17.4.3 Inter-temporal burden
17.5 Should the government tax or borrow?
17.5.1 Allocation (efficiency)
17.5.2 Distribution (equity)
17.5.3 Macroeconomic stability
17.5.4 Summary of views on the impact of debt
17.6 Public debt management
17.6.1 Introduction
17.6.2 Bonds and the cost of borrowing
17.6.3 Foreign borrowing
17.6.4 Public debt management objectives I and II: Minimisation of state debt cost versus
macroeconomic stabilisation
17.6.5 Public debt management objective III: Development of domestic financial markets
17.6.6 Public debt management objectives IV: Financial credibility
17.6.7 Contingent liabilities
Key concepts
Summary
Essay questions
Fiscal policy
18.1 Introduction
18.2 The nature of fiscal policy
18.2.1 Definition
18.2.2 Fiscal policy and the budget constraint
18.2.3 Goals of fiscal policy
18.2.4 Instruments of fiscal policy
18.2.5 The fiscal authorities in South Africa
18.3 The macroeconomic role of fiscal policy
18.3.1 The Keynesian approach
18.3.2 Shortcomings of anti-cyclical fiscal policy
18.3.3 The structural approach to fiscal policy
18.3.4 Renewed interest in active fiscal policy
18.4 A brief reflection on the fiscal consequences of the Great Recession
18.5 Fiscal policymaking frameworks
18.5.1 Rules versus discretion in fiscal policy
18.5.2 Fiscal policymaking frameworks and fiscal outcomes
18.5.3 Concluding comment
18.6 Fiscal policy in South Africa
18.6.1 Macroeconomic aspects of fiscal policy in South Africa
18.6.2 The fiscal policymaking framework in South Africa
18.7 Fiscal reforms in sub-Saharan Africa
Key concepts
Summary
Essay questions
PART 5 Inter-governmental fiscal relations
Fiscal federalism
19.1 The economic rationale for fiscal decentralisation
19.1.1 The Tiebout model
19.1.2 Public choice perspective on fiscal federalism
19.1.3 Other reasons for fiscal decentralisation
19.2 Reasons for fiscal centralisation
19.3 Taxing and spending at sub-national level: The assignment issue
19.3.2 Distribution function
19.3.3 Allocation function
19.3.4 Tax assignment
19.4 Tax competition versus tax harmonisation
19.5 Borrowing powers and debt management at sub-national level
19.6 Inter-governmental grants
19.6.1 Unconditional non-matching grants
19.6.2 Conditional non-matching grants
19.6.3 Conditional matching grants (open-ended)
19.6.4 Conditional matching grants (closed-ended)
19.6.5 The rationale for inter-governmental grants
19.7 Inter-governmental issues in South Africa
19.7.1 Constitutional issues
19.7.2 Inter-governmental transfers and the Financial and Fiscal Commission (FFC)
19.7.3 Provincial financing issues
19.7.4 Urban economics
Key concepts
Summary
Essay questions
References
Answers to multiple-choice questions
Index
Contributors
Tania Ajam is Associate Professor in Public Policy, Finance and Economics at the School of Public
Leadership at Stellenbosch University. She is a public policy analyst and an economist with broad
experience in the design, analysis and implementation of fiscal policy, intergovernmental fiscal relations
and government-wide monitoring and evaluation systems. She has served on the board of the South
African Reserve Bank, the Financial and Fiscal Commission and on the Davis Tax Review Committee.
She was appointed to the President’s Economic Advisory Council in 2019.
Estian Calitz is Emeritus Professor and a former Executive Director: Finance and Dean of Economic and
Management Sciences at the University of Stellenbosch. During South Africa’s period of political
transition, he was the Director of Finance of the national government (1993–1996). He is a former
president of the Economic Society of South Africa.
Theo van der Merwe is Professor of Economics at the University of South Africa. He was chair of the
Department of Economics for more than seven years. He presently teaches Public Economics at
postgraduate level. His research interests include social security issues and the economics of language.
Krige Siebrits is a Senior Lecturer in the Department of Economics at the University of Stellenbosch. His
research interests include Public Economics and Institutional Economics.
Tjaart Steenekamp is retired Professor of Economics at the University of South Africa where he taught
Public Economics. His research interest includes the economics of taxation.
Ada Jansen is an Associate Professor in Economics at Stellenbosch University. She has a PhD in
Economics from Stellenbosch University, and lectures Public Economics to undergraduate and
postgraduate students. Her main research area is Public Finance, with a specialisation in taxation.
Ian Stuart is the acting head of the Budget Office at the National Treasury of South Africa. The division
is responsible for running the budget process, and preparing all budget documents. Before this, he headed
the Treasury’s fiscal policy unit. Ian is also a member of the IMF’s technical advisory panel on public
finance management, and a research fellow of the Stellenbosch University economics department. He
holds a MCom Economics from Stellenbosch University.
Philip Black was Extraordinary Professor of Economics at the University of Stellenbosch, a past President
of the Economic Society of South Africa and a previous Managing Editor of the South African Journal of
Economics. He taught Microeconomics and Public Economics at post-graduate level.
Preface
Public Economics provides a comprehensive introduction to the study of public economics within a South
African and a southern African context. In this book, theory is explained with reference to southern African
institutions, practices and examples. The aim of the book is to equip the student with basic analytical skills
and to demonstrate the application of these skills to practical issues.
Our emphasis is on developing the student’s understanding of the theoretical issues pertaining to the role
of government in a mixed economy as reflected in expenditure on government functions and the financing
of such spending by means of various taxes and loans. The conceptual framework for the book is that of a
medium-sized, open developing economy, exposed to the forces of democratisation and globalisation.
Many textbooks offer public economics as a study in applied microeconomics. Although this book largely
follows the same approach, it also discusses the macro- and microeconomic dimensions of fiscal policy.
In this seventh edition, we retain the approach followed in previous editions by including several cross-
references to and examples from countries making up the southern African region. In view of the
interrelatedness of the economies of southern African countries as well as cultural and historical links
between these countries, students from neighbouring countries should therefore also find the contents of the
book accessible and relevant. We hope that the book will impart to southern African students greater
appreciation for the broader economic environment in which they operate.
As the book deals with constantly evolving policy and analytical issues, we have used the latest relevant
figures and information provided in recent issues of the Quarterly Bulletin of the South African Reserve
Bank and the 2019/20 Budget of the South African Government to update the material in this edition.
This edition retains several pedagogical features, including the following:
• Important concepts that are specific to the discipline are reviewed and explicitly defined in the text. For
easy reference, these concepts are marked in bold where they are first mentioned. At the end of each
chapter they are listed as important concepts, with the relevant page number in parenthesis.
• A brief summary appears at the end of each chapter.
• Examples of multiple-choice questions are included at the end of each chapter. The correct option or
options for these questions can be found just before the Index at the end of the book.
• Each chapter also contains separate lists of examples of short-answer questions and essay questions.
Key changes
Part 1 provides perspectives on the role of government in the economy. The most important changes in
this edition are highlighted below.
• Various sections of Chapter 2 were partly or entirely rewritten, notably Sections 2.4.1, 2.4.4 and 2.5.1. In
addition, Figures 2.1 and 2.2 were replaced. Chapter 2 is now co-authored by Ada Jansen.
• Chapter 3 reflects substantial editorial revision. Section 3.4 now provides an important perspective on the
production of public goods and examples of such goods.
• Chapter 4 is now entitled ‘Allocative efficiency, imperfect competition and regulation’. The material on
competition policy in the sixth edition has been replaced by three new sections on competitive
restructuring, privatisation, and regulation. The chapter also contains two new boxes. Box 4.1 discusses
the experience of the South African electricity utility Eskom, which is experiencing serious financial
difficulties. Box 4.2 provides a schematic illustration of the determination of electricity tariffs in South
Africa. Figure 4.3 replaces the one in the sixth edition. This chapter is now co-authored by Estian
Calitz.
• In Chapter 5, Figure 5.5 has been changed to show the outward shift of the production possibilities curve
(PPC).
• In Chapter 6, Section 6.4 on the impossibility theorem was substantially rewritten and a new Figure 6.1
was added. Parts of Section 6.7.3 have also been rewritten to provide more clarity on rent-seeking and
Figure 6.4 is new. This chapter is now co-authored by Estian Calitz.
Part 2, which addresses public expenditure, has also seen some major changes.
• Feedback indicated that lecturers generally did not include the chapter on cost-benefit analysis in the sixth
edition in their curricula. Hence, this chapter is omitted from the seventh edition. This change made it
possible to discuss other topics in more depth.
• Chapter 7 (on public expenditure and growth) was updated and slightly revised.
• Chapter 8 is now the first of three chapters on governments’ role in the reduction of poverty and
inequality. It retains material from Chapters 8 and 9 of the sixth edition, but the sections on targeting
(Section 8.3) and fiscal incidence (Section 8.4) were rewritten and expanded. Krige Siebrits wrote this
chapter.
• Chapter 9, also written by Krige Siebrits, remains focused on the social insurance and social assistance
components of social security systems. The material in the sixth edition on the characteristics and
effects of income security programmes in South Africa were retained and updated. This chapter also
contains new material on the income protection role of insurance (Section 9.2.1), the economic
rationale for social insurance programmes (Section 9.2.2), and the incentive effects of means tests
(Section 9.4). The sections on the pros and cons of cash and in-kind transfers (Section 9.3.1),
conditional cash transfer programmes (Section 9.3.2) and the incentive effects of income protection
systems (Section 9.4) were revised and expanded. Section 9.3.2 now includes Box 9.1, which provides
an overview of Tanzania’s Community-Based Conditional Cash Transfer Programme.
• Chapter 10 represents an expansion of the discussion of service delivery in education and health in
Chapter 8 of the sixth edition. The material on the delivery of social services in South Africa (Section
8.4 in the sixth edition) has been revised and updated. This chapter now also contains a new discussion
of the economic arguments for government intervention in the markets for education and healthcare.
Krige Siebrits wrote this chapter.
Part 3, which focuses on taxation, has also been updated and now incorporates the recommendations by the
Davis Tax Committee, inter alia. All the tax chapters are now co-authored by Ada Jansen. The most salient
changes in Part 3 are outlined below.
• Behavioural economics is growing in importance in public economics and elsewhere. Hence, Chapter 12
now contains a box (Box 12.1) that provides insights from behavioural economics into the causes of tax
evasion.
• Previous editions of this book discussed personal and corporate income tax in the same chapter. This
edition splits these two topics into separate chapters. Chapter 13 explores personal income tax, while
the new Chapter 14 is titled ‘Company income tax, capital gains tax and income tax reform’.
• Wealth tax is now discussed in Chapter 15, while Chapter 16 deals with taxes on goods and services as
well as tax reform in South Africa and further afield.
Part 4 covers fiscal policy and public debt.

• The sequence of chapters in this part of the book was changed: the discussion of public debt (Chapter 17)
now precedes that of fiscal policy (chapter 18). This change made it possible to incorporate views on
public debt more clearly and fruitfully in the discussion of fiscal sustainability in Chapter 18. Ian Stuart
now co-authors Chapter 17.
• In the sixth edition, there was some duplication in the material about fiscal activism in the chapters on
fiscal policy and public debt. This has now been largely eliminated.
• A subsection on the public choice view in the public debt chapter of the sixth edition was moved to
become Section 18.3.2.2 in the fiscal policy chapter of this edition. The numbering of the subsequent
subsections of Section 18.3.2 changed accordingly.
• Section 18.4, which was Section 16.4 in the sixth edition, now has the title ‘A brief reflection on the fiscal
consequences of the Great Recession’”. This section was shortened and the somewhat complicated
Figure 16.4 in the sixth edition was omitted. A new Box 18.3 discusses fiscal consolidation approaches
and the expansionary fiscal contraction hypothesis.
• Section 16.5 in the sixth edition was rewritten as Section 18.5 to present the rules-versus-discretion debate
in the wider context of fiscal policymaking frameworks and to incorporate empirical findings about the
connections between such frameworks and fiscal outcomes.
Part 5, which focuses on inter-governmental fiscal relations (Chapter 19), has not undergone major
changes, but has been updated.
This edition of Public Economics is once again the product of a long process of discussions and
deliberations among the authors, as well as discussions with colleagues and students who have used the
earlier editions. We are grateful to them. A special word of thanks is due to our colleagues at Oxford
University Press Southern Africa, Janine Loedolff (Publisher), Nicola van Rhyn (Senior Project Manager),
and Liezl Roux (Development Editor) for their strategic contributions, technical proficiency and, above all,
patience! We also thank Language Mechanics for careful and professional language editing of the
manuscript. Krige Siebrits has replaced the late Philip Black as co-editor of the book.
Plan and outline of the book

We have three objectives with this book:
• To provide students with an opportunity to study public economics with reference to South African and
southern African institutions and practices
• To teach public economics as a field of study characterised by the dynamic interaction and tension
between macro- and microeconomic considerations
• To explain public economics with reference to the enormous challenges posed by economic and political
reforms in the region and the growing integration of individual countries into the global and regional
economies.
The book is divided into five main parts.

Part 1 outlines theoretical perspectives on the role of government in the economy. Chapter 1 begins
with an introduction to the study field of public economics and a discussion of the nature of the public
sector in South Africa. It includes a discussion of the political and institutional context within which the
public sector functions as well as a brief overview of the major views on the role of government in the
economy. Chapter 2 explains the rationale for the role of government in the economy in terms of market
failure and distinguishes between the allocative, distributive and stabilisation roles of government. The next
two chapters examine the different dimensions of the government’s allocative role, focusing on public
goods, externalities and natural monopolies. Chapter 3 provides more detailed discussions of two important
sources of market failure, namely public goods and externalities. These two types of market failures reflect
the incompleteness of many real-world markets. In addition to theoretical perspectives on public goods and
externalities, this chapter also outlines policy implications and options. These include the regional and
global dimensions of some public goods and the international spillover effects of some externalities.
Chapter 4 outlines the economic effects of monopolies and discusses policy interventions to rectify one
manifestation of this phenomenon, namely electricity supply. It highlights the social costs of imperfect
competition by contrasting outcomes under perfectly competitive and monopoly conditions and discusses
the nature and economic effects of natural monopolies. Both the traditional policy approach and the more
recent ‘new model’ approach towards decreasing-cost industries are explained. The discussion of the new
model covers its three elements (competitive restructuring, privatisation and regulation). Inequality as a
type of market failure is the focus of Chapter 5, which also examines the criteria for government
intervention. Experimental evidence that questions the validity of the self-interest hypothesis is also
discussed. Chapter 6 discusses the institutions and mechanisms of public (or social) choice, and examines
their efficiency and equity properties. It also explains the phenomenon of government failure.
Part 2 deals with public expenditure. Chapter 7 outlines theories of government expenditure growth
and comments on their explanatory value for South Africa. It also considers the long-run economic effects
of changes in government expenditure. This chapter includes a discussion of the role of infrastructure
investment in lowering production costs and ‘crowding in’ private investment. The important topics of
poverty and inequality in South Africa are discussed in Chapter 8. This chapter also discusses broad
conceptual and programme-design aspects of the redistributive and poverty-reducing roles of government,
targeting of government spending programmes, and fiscal incidence analysis. Chapter 9 focuses on social
insurance and social assistance. It provides an overview of the economic theory of insurance and explains
the need for government intervention to overcome the inability of private markets to provide insurance
against the effects of certain income losses. In addition, it discusses the choice between providing such
assistance as cash or goods and services, the pros and cons of adding conditions to cash transfer
programmes, and the incentive problems associated with income security programmes. The chapter
concludes with comments on various aspects of the South African income security system. Chapter 10
emphasises the importance of the effective provision of social services. It deals with the market failures that
justify government involvement in the provision of education and healthcare; the case for in-kind subsidies
(which are important policy instruments in the provision of social services), and effectiveness in the
provision of social services. The chapter also discusses aspects of public provision of education and
healthcare in South Africa.
A major part of this book is devoted to taxation (Part 3). In Chapter 11, the focus is on the principles of
taxation (the properties of a good tax, equity and tax incidence). Tax efficiency and the excess burden of a
tax, administrative efficiency and tax flexibility are the main topics of Chapter 12. This chapter also
includes a discussion of tax evasion and measures to reduce it. The next four chapters analyse different
types of taxes, with the emphasis placed on theory as well as the South African and southern African
experiences. Chapter 13 covers personal income tax (PIT). The impact of PIT on work effort and private
savings is analysed. Chapter 14 now focusses exclusively on company income tax, capital gains tax and
income tax reform. It explores the economic effects of company tax and explains two recent income tax
reforms, namely the flat tax and the dual tax. The taxation of wealth (including a more detailed treatment of
property taxation) is the subject of Chapter 15. Chapter 16 focuses on taxes on goods and services,
including the personal consumption tax. This chapter concludes with a section on international tax reform
and tax reforms in South Africa since the late 1960s.
Two seemingly opposing forces have strongly influenced debates about fiscal policy and the economic
role of government in South Africa. On the one hand, there are heavy demands on the fiscus to deal with
poverty, unemployment and the high degree of inequality. On the other hand, the imperative to maintain
macroeconomic stability and simultaneously promote sustained economic growth within a very competitive
global economy imposes severe constraints on the fiscus. This debate is captured in Part 4 (public debt
and fiscal policy). Chapter 17 (public debt and debt management) and Chapter 18 (fiscal policy) are
particularly pertinent to the second objective of this book, that is, to highlight the dynamic interaction and
tension between macro- and microeconomic considerations in public economics. Chapter 17 deals with
theories of public debt and includes several sections on public debt management. Chapter 18 includes a
discussion of the evolution of views on the macroeconomic role of fiscal policy, focusing on the distinction
between the Keynesian and the structural approaches, and the choice between discretionary and rules-based
fiscal regimes. The chapter also provides an overview of the fiscal policy experiences of South Africa and
other countries in the southern African region.
The last part of the book (Part 5) deals with inter-governmental fiscal relations. In the sole chapter of
this part (Chapter 19), the theoretical issues pertaining to fiscal federalism are discussed. The structure of
government as embodied in the Constitution of South Africa and the implications for inter-governmental
fiscal relations in South Africa receive specific attention.
How to use this book

As lecturers with experience at both residential and distance-learning universities, we (the authors of this
book) share a great deal of research and practical experience in different aspects of public economics and
fiscal policy. Hence, we designed this book with the following different kinds of students in mind:
• Students at distance-learning universities who will have a fairly self-contained text that the lecturer can
supplement with further explanations and tutorial exercises
• Residential students who will be able to study on their own, leaving lecturers time to analyse and debate
topical issues, discuss the self-assessment exercises and explain the more difficult material
• Postgraduate students who are completing a course in public economics for the first time and need to do
self-study in order to digest more advanced material
• Postgraduate working students who did not complete an undergraduate course in public economics, but
who need to acquire this knowledge for non-degree purposes in order to advance their careers.
The material contained in this book may be more than can be digested in a semester course at undergraduate
level. If public economics is presented as a theoretical course in applied microeconomics, the focus could
be on Parts 1, 2, 3 and 5. If the course designer requires a good mix of applied microeconomic and
macroeconomic theory as well as practice in public economics, Part 4 is a must. A short course in public
finance could include Parts 1, 2, 3, 4 and 5, but the volume could be reduced by excluding Chapters 4, 13,
14, 15, 16 (Sections 16.4–16.6). The material can therefore be adapted to suit specific types of courses.
Our educational approach is fairly straightforward. We explain public economics to students with a
basic understanding of macroeconomics and microeconomics at the undergraduate level. We make
extensive use of diagrams and some basic algebra. Each chapter begins with an introduction and a number
of study objectives. The student should use these objectives to maintain his or her focus on what is essential
in the chapter. We highlight important concepts in bold in the text and list them (together with page
references) at the end of each chapter. Each chapter also contains a summary, as well as examples of
multiple-choice questions and lists of short-answer questions and essay questions that the student can
answer to test his or her understanding of the material. A comprehensive literature list containing consulted
sources is included at the end of the book.
Throughout the book, we have tried to present factual information about public economics in southern
Africa in relation to theory and international experience, rather than as separate and dull descriptions of
statistical trends and superficial features. We trust that this will enhance the relevance of both empirical
observation and theoretical understanding.
Estian Calitz
Tjaart Steenekamp
Krige Siebrits
The public sector in the economy
Estian Calitz
The aim of this chapter is to demarcate the study field of public economics with reference to key issues and
fiscal challenges facing the South African economy and the Southern African region in general. The role of
government is fairly similar across the region, and in the sections and chapters that follow, we describe the
nature of the South African public sector against the backdrop of the theory of public economics and
contemporary views on the role of government in the economy. We also consider the interaction between
the public, household, and formal and informal private (business) sectors of the economy.
Once you have studied this chapter, you should be able to:
give a brief overview of different views of the role of government in the economy
list key issues confronting Southern African governments regarding their role in the economy
distinguish between the main institutional categories of the public sector
discuss the salient features of and trends in the size and composition of the South African public sector
discuss various aspects of the relationship between the public sector and the rest of the economy.
1.1 Introduction
In economics, we study the way in which society chooses to allocate its resources in order to satisfy a
multitude of needs and wants. As these resources are both scarce and have alternative uses, it is necessary
for society to prioritise its needs and ensure that they are met in a declining order of importance. The
income or budget constraint necessitates these choices. In the process, needs are converted into effective
demand, and resources are allocated and used accordingly. We are therefore interested in the allocation of
resources and the distribution of the benefits derived from resource use.
In public economics, we study the impact of the public (government) sector on resource allocation and
distribution. In a mixed economy, the balance between the supply of and the demand for resources is
pursued through either the market system or the political system. In the market system, prices are the
equilibrating mechanism in the interplay between supply and demand, which, in turn, are determined by
factors such as the preferences and income of consumers, the costs of production factors and the prevailing
technology. Needs that cannot be or are not satisfied via the market system are channelled through the
political process. The equilibrating mechanism between supply and demand in a political system based on
democratic principles is the ballot box, and the ‘price’ is the tax that people pay.
Most Southern African countries have a parliamentary democracy with an executive president elected
by parliament. In South Africa, a constitutional change requires a two-thirds parliamentary majority (or a
75% majority in respect of articles pertaining to the supremacy of the Constitution and the rule of law).
Key features of the Constitution of the South African democratic state, as established on 27 April 1994, are
the Constitutional Court, the Bill of Human Rights and the Human Rights Commission. Other important
features of the country’s democracy and of good governance are an independent judiciary, an independent
Auditor-General reporting to parliament and an independent central bank (the South African Reserve
Bank). The seat of parliament is in Cape Town (the provincial capital of the Western Cape), the Appeal
Court is located in Bloemfontein (the capital of the Free State province) and the Constitutional Court is in
Johannesburg (the mining and industrial ‘capital’ of the country and the capital of the Gauteng province).
There are three tiers of government:
• The executive (the national public service) functions at the national level and is situated in Pretoria.
• At provincial level, there are nine provincial governments.
• At local government level, there are 278 municipalities.
We will discuss the financial interaction between the different tiers of government in Chapter 19.
A large portion of Southern Africa’s total resource use is channelled through the political process.
Resource use in the public sector differs from profit-driven resource use in the private sector, which is
nonetheless indirectly influenced by the nature of the political environment and the functioning of the
political system, including a variety of economic policies and regulatory measures. The efficiency and
equity with which resources are allocated in the public sector as well as the impact of political decisions on
private economic behaviour are therefore of paramount importance to the economic performance of a
country. This point is best illustrated by South Africa’s recent economic history and the major rethink
internationally of the appropriate role of government in market-based economies.
1.2 Legacy of the past

During the ten to fifteen years prior to the constitutional change and the first few years of the new state, the
South African economy performed poorly. Real economic growth did not keep up with population growth:
in 1994, real per capita gross domestic product (GDP) was 16% below its previous peak (recorded in
1981). It was only in 2006 (25 years later) that the 1981 level was surpassed. Broadly defined, about one
third of the labour force was unemployed and South Africa had one of the most uneven distributions of
income ever measured internationally.
At the time of the constitutional change, poverty was indeed – and still is today – the most
discomforting feature of the South African economic landscape. The lack of job opportunities among
millions of previously disenfranchised citizens of the new South Africa is partly the result of statutory and
other regulatory measures that inhibited occupational and geographical labour mobility in the past. More
recently, the job losses due to the international financial crisis of 2007–2009 aggravated the unemployment
problem in South Africa. Furthermore, the allocation of government resources on a per capita basis has
historically been much skewed, resulting in many of the poor having only limited access to basic social
services. A large proportion of the population has had experience of undernourishment, inadequate housing
and poor education, and has only had limited access to basic public services such as primary healthcare.
Generally speaking, millions of people were and still are ill-equipped to participate meaningfully in the
modern (formal) sector of the economy. Under these circumstances, the need for appropriate policies is
evidently urgent. Faced with the high expectations of the citizenry, fiscal measures that promote economic
growth and improve people’s ability to participate gainfully in the market economy constitute important
policy instruments in the hands of the government.
Government’s share in the economy increased steadily in the period between 1960 and 1990 (see Table
1.1 on page 13, which contains different financial indicators of the size of government). When the first full
democratic elections took place in 1994, many experts felt that the total tax burden, the national budget
deficit (or borrowing needs) and the public debt were too high to achieve sustainable economic growth and
development. Concerns for government finances at the time included the increasing arrears and leakage in
tax collection at the national level as well as the tendency for government expenditure to exceed budgeted
figures regularly. The growth of the government’s current expenditure was such that it crowded out public
investment; that is, ever-decreasing funds were available for government investment in social and physical
infrastructure such as schools, hospitals and roads.
The growth in public employment, which constitutes the main component of current government
expenditure, was a source of alarm. Between 1990 and 1999, for example, the number of employment
opportunities in the general government sector (that is, excluding public sector business enterprises and
corporations) was on average 16% higher than in the previous ten years. Between 1989 and 1999, job
opportunities in the formal private sector dropped by 19%. These were hardly the characteristics of a
thriving economy.
1.3 Fiscal challenges

During the three or four decades before and up to the 2007 international financial crisis, a strong consensus
emerged that the efficient management of developed and developing economies required smaller rather
than bigger budget deficits as well as lower rather than higher levels of public debt. There was also general
agreement that fiscal prudence required a thorough revision of the basic functions for which government
should be responsible in order to contain the growth of government expenditure in a way that also ensures
effective support for the real needy in society. Along with the international shift towards market-based
economies that followed the demise of communism and the command economies of Eastern Europe during
the late 1980s and early 1990s, key ingredients of economic restructuring included the privatisation of
various activities hitherto undertaken by the state, a total revision of the role and functions of the state, and
a concomitant reprioritisation of government expenditure. It is important to note that the emphasis was on
how the public sector could be restructured to free up more resources for the development function of
government and to target the destitute effectively, without jeopardising macroeconomic stability or
increasing the share of government in the economy (preferably even reducing it).
The case for a smaller and more efficient government was the result of a growing dissatisfaction with
the effectiveness of government. Contributing factors included the failure of the command economies of
Eastern Europe, the increasing unaffordability of the welfare state in Western Europe, the poor economic
performance of (especially) developing countries with increasingly ineffective and ballooning
governments, the negative impact on economic freedom and initiative of excessive and poorly functioning
government regulations, the alarmingly high prevalence of corruption and rent-seeking activities, the poor
service delivery of government agencies in developing countries, which corresponded with an inability to
attract and/or retain expertise, and – generally – the failure of governments to generate wealth in cases
where they wanted to engage in or prescribe on production activities better left to the private sector. All of
these also went hand in hand with calls on the private sector to assume its role in an efficient and fair
manner.
Countries seldom have the opportunity to thoroughly revamp all their institutions and policies at once.
However, this has been one of the main features of the South African experience since the 1990s and it
occurred against the backdrop of the above-mentioned changing views on the role of government in the
economy. Similar institutional changes are also taking place or have been effected in Angola, Namibia,
Mozambique, Zambia and many other African countries. The restructuring of the public sector in South
Africa after 1994 affected all groups in society, including the way in which business is conducted in the
domestic private sector as well as the nature of the country’s trade and investment relations with the rest of
the world.
It also affected the nature of public goods and services to be provided by the different tiers of
government. In addition, it affected and changed the individuals and groups of individuals who benefit
from public goods and services as well as the way in which the tax or financing burden is distributed
among individuals and firms.
It changed the way in which consultation takes place between politicians and the electorate, and
between politicians and various sectional interest groups in society, be it interest groups in business,
organised labour or civil society.
Finally, it affected the basis on which employees are appointed and managed in the public sector as well
as the nature of interaction between politicians and bureaucrats, and between bureaucrats and the clients of
government.
What has been remarkable about the development of fiscal policy in South Africa since 1994 is the
ability of the government to strike a good balance between the dictates of the market (requiring fiscal
prudence) and the fiscal pressures for redistribution, poverty reduction and socio-economic development.
Unfortunately, some of the good policy decisions were undermined by poor service delivery, resource
waste and the increasing occurrence of rent-seeking activities, fraudulent behaviour and nepotism. We will
return to some of these themes in later chapters of the book.
The international financial crisis of 2007 and beyond was a serious wake-up call. Confidence in
mainstream (consensus) views on the respective roles of government and the private sector in the mixed
economy were shaken. The sub-prime financial crisis in the United States resulted in the bankruptcy of
huge and prominent financial institutions, thus posing a systemic risk to its financial system. The
subsequent financial contagion rapidly spread far and wide. The ensuing economic recession, which
became known as the Great Recession, was the biggest since the Great Depression. It jeopardised the
solvency of companies in the real and financial sectors of developed economies all over the industrial
world, and resulted in bailout and rescue plans by governments of unprecedented proportions. More than
that, the fiscal sustainability of entire countries (such as Greece, Spain and Ireland) was threatened and
required multilateral rescues. The recession in developed countries had a major adverse effect on
developing countries such as South Africa, although the impact was generally less severe than in the
industrial world.
The Great Recession gave rise to a major review of the appropriate role of government in the economy
and the required nature of economic policies. The cost of bailouts of financial institutions and fiscal
measures to counter the recessionary impact led to dramatic increases in the ratio to GDP of budget deficits
and public debt in many industrial countries. Countries that had joined the European Union in terms of the
Maastricht prescriptions of a budget deficit–GDP ratio of no more than 3% and a debt–GDP ratio of no
more than 60% quickly found themselves in huge transgression of these fiscal criteria. For example, in
2010, the United Kingdom recorded a budget deficit–GDP ratio of 11,4% and a general government debt–
GDP ratio of 79,4%.1 Proponents of fiscal activism argue that their views had been vindicated: contra-
cyclical fiscal policy is justified and financial markets need more regulation. But the huge deficits and debt
levels clearly threatened fiscal sustainability, and the appropriate way towards sustainability was and still is
heavily debated.
Subsequent to the establishment of full democracy in 1994, the South African government carved out a
particularly good fiscal track record, at least at the macro level. In tandem with monetary policy,
macroeconomic stability and fiscal sustainability were achieved up to the time of the 2007–2009
international financial crisis. Although not spectacular by international standards, the economy had
recorded sixteen consecutive years of positive economic growth, averaging about 3,5% per year. The
economic upswing that started in September 1999 and ended after 99 months in November 2007 was the
longest by far since World War II. After introducing inflation targeting in 2002, the monetary authorities
succeeded in containing inflation within the target range of 3% to 6% or bringing it back into the target
range fairly quickly. The country’s performance with regard to economic growth, job creation and the
combating of poverty improved on the performance during the fifteen years before the constitutional
change, but still fell far short of the country’s economic needs. Moreover, the Great Recession was a major
setback, causing about one million job losses. Many of the fiscal reforms that have formed part of the
economic policy package since 1994 are highlighted in this book, often with reference to theoretical issues.
Attention is also given to new challenges to fiscal policy on account of the increase in unemployment that
accompanied the economic downswing that has taken place since November 2007 and the continued high
incidence of poverty and economic inequality.
1.4 The study field of public economics

Public economics is the study of the nature, principles and economic consequences of expenditure, taxation
and financing, and the regulatory actions undertaken in the non-profit-making government sector of the
economy.
In order to understand this definition, we first note that economic policy entails the application by
government institutions of measures (instruments) that are designed to influence economic behaviour in
order to achieve certain outcomes. Besides various macroeconomic goals, such as economic growth,
balance-of-payments stability or income redistribution, many sectoral and microeconomic goals are also
pursued, with the ultimate objective of improving the material well-being of people.
Turning now to the elements of our definition of public economics, note firstly that the main areas of
decision-making are expenditure, taxation, financing and regulation. These elements are also called the
instruments of fiscal policy. In public economics, we study the nature and impact of these instruments.
The first three instruments (expenditure, taxation and financing) entail the procurement by the state of
private funds (at the cost of either private expenditure or saving) and the spending of these funds. In
economic terms, the use of these instruments constitutes the direct mobilisation and allocation of scarce
resources. Examples include the spending of tax income on primary healthcare and the borrowing of funds
to build an irrigation dam or a highway.
Regulation, by contrast, entails enacting a law or administratively proclaiming an enforceable
instruction that leads to a different allocation of private resources from that which would apply in the
absence of such government intervention. The allocation of resources is now influenced indirectly.
Examples are the regulation by government that forces the manufacturers of motor vehicles to install
platinum catalysts in the exhaust pipes of vehicles to reduce the emission of carbon monoxide and the
regulations that prescribe the behaviour of natural monopolies such as electricity supply.
Different types of expenditure, taxation, government borrowing and government debt can be
distinguished. In taxation, for example, we distinguish between taxes on income, wealth, and goods and
services. The various categories of taxation or expenditure have different economic consequences. For
instance, a tax on wealth (for example, a property tax) will affect different people in society from those
who would be affected by a value-added tax on red meat. In other words, the distributional effects differ.
The choice of a particular tax therefore depends on how the government wants to change the distribution of
income or wealth in the economy, or on how an efficient allocation of resources can be pursued.
Economists have developed several important fiscal criteria on which economic decisions in the public
sector are or should be based and that may be applied when recommendations on taxes or expenditure
allocations are formulated. These governing criteria are derived from the two concepts of efficiency and
equity, which are paramount and distinguishing features of economics.
The study of the nature and economic consequences of decisions falls in the realm of positive
economics, posing questions such as the following: If I take step a (for example, raising income tax), what
will happen to b (for example, the supply of labour in the economy)? The development of criteria, on the
other hand, has to do with normative economics, focusing on what ought to be. For example, if I want d
(for instance, a more even distribution of income), what should step c be (in other words, what type and
level of taxation should be introduced)?
Public economics enters the realm of normative economics when we consider diverse questions such as
the rationale for government involvement in the economy and how political decisions should be taken (in
other words, what kind of voting system should be used) to ensure efficiency and equity in the allocation of
resources.
Generally, two broad views of the role of government in the economy are encountered.
1. The individualistic view of government (sometimes also called the mechanistic view) recognises the
supremacy of the individual and his or her freedom of choice. The main point of departure and the test
for whether or not government intervention is called for is the maximisation of individual welfare.
Government action is seen as a reflection of individual preferences and government institutions have no
role independent of these preferences. The role of government is limited to correcting for market
failure, a topic that we explore in various chapters of Part 1. This view is closely associated with the
proponents of the free-market economy and gained widespread international support towards the end of
the twentieth century, notably after the collapse of the command economies of Eastern Europe. The
international financial crisis referred to above embodied elements of market failure, as well as of
government failure that we also explore.
2. The public interest or collectivist view of the role of the state is sometimes also referred to as the
organic view. Collective choice and preferences are thought to exist independently of individual
preferences and the goals of society as a separate organism differ from the goals of the constituent
individuals. Instead of individual welfare, it is social welfare or the national interest that should be
maximised. The benefit to the individual, consequently, is derived from the benefits accorded to or
achieved by the group.
From a policy perspective, the individualistic approach focuses relatively more on the efficiency of resource
allocation and economic growth, whereas the collectivist approach is relatively more concerned with
combating poverty and equity issues, notably the distribution of income as justification for government
intervention. In practice, government policies often reflect a combination of the two approaches.
One is indeed likely to find a combination of policies emanating from both views in the model of the
developmental state, a term coined in 1982 by Chalmers Johnson, an American political scientist. The
ANC government propagates this model, although many features of South African society arguably do not
fit this mould (see Burger, 2014). Leftwich (1995: 401) describes developmental states as those states
whose politics have concentrated sufficient power, autonomy and capacity at the centre to shape, pursue
and encourage the achievement of explicit development objectives, whether by establishing and promoting
conditions and the direction of economic growth or by organising it directly, or a varying combination of
both. The developmental state has been characterised as embodying inter alia a determined development
elite, a powerful, competent and insulated economic bureaucracy, a weak and subordinate civil society and
the effective management of non-state economic interests (Leftwich, 1995: 405–420). The focus appears to
be more on the way in which political and economic control is obtained and exercised, and seems to allow
for much variety as regards the nature and principles of the economy and economic policy. Selective
government intervention that distorts relative prices rather than a neoclassical minimisation of price
distortions by government has nonetheless been identified as a feature of the successful developmental
state (Grabowski, 1994: 413). Countries regarded as examples of the developmental state2 as well as their
economic policies are too diverse to allow for the defining of a common economic policy of success. As
always, many other factors besides economic policies determine economic success.
Returning to the elements of our definition of public economics, the term ‘non-profit-making’ signifies
the absence of profit maximisation as the leading motive, or one of the leading motives, in decision-making
on the mobilisation and allocation of resources. The absence of the profit motive means that other criteria
for decision-making have to be employed. We will see that the nature of public goods is such that their
supply does not allow for decentralised price determination in a competitive market economy. Note that the
government is not the only non-profit-making sector in the economy. Many welfare, church and service
organisations exist as non-profit organisations. These institutions are often referred to as non-
governmental organisations (NGOs). When they receive the status of public benefit organisations under
tax law in South Africa, donors to these entities are entitled to special tax benefits and the entities
themselves also enjoy special tax treatment.
Does our definition of public economics include a study of public corporations (alternatively referred
to as public enterprises or state-owned companies) that operate in the hybrid area between the
government and the private sector, such as Eskom in South Africa? If these entities were driven strictly by
the profit motive, they would not fit our definition. However, as long as political appointees serve on or
control the boards of these entities, as long as they render certain socio-economic services on behalf of the
government and rely on government financial support, and/or as long as they behave in a monopolistic
manner, they are not pure private institutions. In countries that have embarked on privatisation, such as
South Africa, public enterprises often find themselves in transition between being a public entity and a
private company. Consequently, it is not easy to pinpoint their exact position on the spectrum between
public and private entities, and the criteria in terms of which to study their behaviour are not that clear. In
our study of public economics, we do not include a separate section on these kinds of activities. We do,
however, analyse aspects of their functioning when we discuss topics such as externalities, imperfect
competition, user charges, privatisation, public-private partnerships and macroeconomic stabilisation.
1.5 The public sector in South Africa
From our discussion in the previous section, it is clear that a wide range of diverse activities is studied in
public economics. In order to structure our thoughts, we will now examine the composition and size of the
public sector in South Africa, which is fairly typical of public sectors elsewhere in Africa, before we
briefly review the relationship between the public and private sectors.
1.5.1 Composition of the public sector

What are the constituent institutional components of the public sector? We present them in Figure 1.1 as a
set of rectangles within rectangles. The South African Constitution specifies three levels or spheres of
government. The central (or national) government (see the inner rectangle in Figure 1.1) consists of all
the national government departments. When the various extra-budgetary institutions are added (such as
the National Research Foundation, the National Health Laboratory Service and the Urban Transport Fund,
a number of government business enterprises that sell most of their output of goods and services to
government institutions or departments at regulated prices, social security funds and universities), we refer
to the combination as the consolidated national government. (Note that in the national accounts, the
universities are in fact classified as part of the public sector.) The aforementioned entities have access to
funds that are additional to budgetary allocations, such as user charges, levies and other non-tax income.
Figure 1.1 The composition of the public sector
As pointed out earlier, the second and third tiers of government in South Africa constitute nine provincial
governments and 278 local authorities (or municipalities) respectively; these are shown in the second
rectangle in Figure 1.1. Together with the consolidated central government, the general departments of
provinces and local authorities and certain business enterprises such as the trade departments (for
electricity, water, transport and so on) of local governments are constituent components of the general
government. For the most part, general government thus represents the non-profit activities of the public
sector. The allocation of resources is determined by political considerations, and is financed through the
tax system and user charges (or loans that have to be repaid out of taxes at a later stage).
The next category of public entities (see the outermost rectangle in Figure 1.1) consists of financial and
non-financial public enterprises (also referred to as state-owned enterprises or companies) such as Eskom,
PetroSA, the South African Broadcasting Corporation (SABC), Telkom, Transnet, the Land Bank and the
Public Investment Corporation. These activities are managed much more along business lines and, in the
case of corporations such as Eskom and Telkom, decisions are often taken on the same basis as in the
private sector. For as long as these corporations are subject to government control, either in the form of
shareholding or the appointment of directors, they are classified as part of the public sector. Conversely,
should any public sector activity or body (or a part of it) be privatised, it will thereafter be reclassified as
part of the private sector.
To summarise: We refer to the three tiers of government (in other words, the general services and
certain business enterprises of national, provincial and local government) as the general government, and to
the combination of general government and public corporations as the public sector.
1.5.2 Size of the public sector

The size of the public sector differs according to the indicator used. If we are interested in the size of the
burden that the government imposes on current taxpayers, we may use the total tax income of the general
government as an indicator and express it as a percentage of the gross domestic product (or national
income). By this criterion, the government’s average share in the South African economy during the period
2008–2017 was 25,4%. We know, however, that government expenditure is not only financed through tax
revenue, but also by means of non-tax income (such as dividend and property income, mining leases and
administrative fees) as well as borrowing (loans). We will thus obtain a more accurate picture by looking at
government expenditure. We can identify two aggregate indicators.
The first of these aggregate indicators is the total amount of resource use by government (in other words,
the final demand by or the exhaustive expenditure of government) in any year. From Table 1.1, we note
that the total resource use by the public sector (that is, consumption and investment spending of national,
provincial and local government as well as of public enterprises, valued at market prices) increased from
an average of 20,2% of the gross domestic product over the period 1960–1969 to an average of 27,5%
during the 1980s. It then decreased to an average of 23,3% during 2000–2007, that is, before the
international financial crisis impacted on South Africa. It then rose sharply to average 27,4% for the period
2008–2017. Even this is not the complete picture.
Not all government expenditure is in the form of final demand for goods and services (that is,
exhaustive expenditure). The government also makes transfer payments (subsidies, current transfers and
interest on public debt) to targeted beneficiaries or entities outside the public sector. These are called non-
exhaustive government expenditure. The government mobilises the resources, but they are used by the
recipients, who exercise the final demand in accordance with their preferences. (Note that the national
government also makes transfer payments to provinces and local governments, as discussed in Chapter 19.
These are regarded as internal flows within the public sector and are not counted as payments from the
government sector to other sectors of the economy.) If we add interest payments and transfers to the
household, business and foreign sector, we can obtain an accurate picture of the extent of resource
mobilisation by the government, our second aggregate indicator of the size of government. During 2008–
2017, the South African public sector was instrumental in mobilising 39,8% of the national resources, a
significant increase on the average ratio of 34,5% of the preceding eight years. This figure is also higher
than the average figures for all of the other previous periods shown in Table 1.1. The highest resource
mobilisation for any year since 1960 was in 2015, namely 41,0%.
Table 1.1 Average size of the South African public sector by different indicators, selected periods (current prices; % of
GDP)
Notes: a In order to link data before and after 1994, data before 1994 were downscaled by an adjustmet factor of
.899537403 so as to remove FISIM (Financial Intermediation Services Indirectly Measured) from series
before 1994. The factor represents the ratio between two sets of figures for 1994–1996, namely interest
inclusive and exclusive of FISIM.
b Include social benefits to households and production subsidies as well as miscellaneous transfers and transfers
to international organisations; for latter two, average ratio to GDP between 1994 and 2009 used as estimate
for data before 1994. Data before and after 1994 for the subcomponents were not strictly comparable and
assumptions were made in order to ensure reasonable comparability of the aggregate. No seperable data for
capital transfers before 1995 were available but the amounts from 1995 onwards were relatively small.
Source: SARB (various years) Quarterly bulletin (various issues); SARB (various years) Electronic data
As a result of the diverse nature of government activities and the corresponding differences in the
factors that determine the allocation and distribution processes in the public sector, we are not only
interested in the aggregate size of the public sector, but also in its constituent components. Note in
particular the opposite trends of general government consumption expenditure and public investment as
well as the rising share of transfer payments. Interest on public debt as a percentage of GDP increased
substantially up to the second half of the 1990s and again since 2014. Commensurate with government’s
priority to ameliorate the consequences of poverty, transfer payments to households, as a percentage of
GDP, likewise rose significantly during the past twenty years. All of the above trends are recurrent themes
in this book (see, for example, Chapters 7–10).
1.5.3 The relationship between the public and the private sectors
What is the relationship between the public sector and the rest of the economy? A number of important
aspects of this relationship may be identified with reference to the familiar circular flow of income,
expenditure, and goods and services (see Figure 1.2).
• Government is a supplier of public goods and services. Households and businesses pay for these goods
and services through taxes (and user charges). Government then uses this revenue to acquire factors of
production as well as to purchase private goods and services (as intermediate inputs), all of which are
used in order to produce public goods and services. Government departments, of course, use outputs of
other departments and state-owned enterprises as intermediate inputs as well. Government activities are
relatively labour-intensive and, as a result, compensation of employees constitute the largest input cost
(averaging 54,9% of consolidated general government output during 1995–2017).3
Figure 1.2 The government in the circular flow of income, expenditure, and goods and services
• The size of government in the mixed economy is such that its purchases of goods and services exert
important influences on the economy. At the sectoral level, for instance, government spending is often
decisive for the construction and engineering sectors. Privatisation entails goods or services formerly
supplied by government as part of the flow of public goods and services to be sold or transferred to and
redefined as goods and services supplied by private firms. In the case of public-private partnerships
(PPPs), the private sector produces and often delivers the goods and services, but government
determines (through the PPP contract) the quantity and quality of the goods and services. Often private
investment cannot be undertaken unless the necessary public infrastructure (for example, roads and
electricity networks) is in place. At the macroeconomic level, changes in the aggregate level and
composition of government expenditure are important factors in determining economic stability and
growth. Excessive expenditure growth can, for example, be inflationary or may crowd out private
investment, thus retarding economic growth.
• The way in which government finances its expenditure also has important economic consequences. The
kind of taxes used and the rates levied influence the after-tax distribution of income and thus the well-
being (welfare) of individuals as well as the decisions by private businesses regarding the allocation of
resources in the private sector. The tax system can promote or obstruct efficiency and equity.
• If there is a budget imbalance (surplus or deficit), the government exercises an influence on the balance
between saving (S) and investment (I) or on the balance of payments (in other words, the balance
between exports (X) and imports (M)). This is shown in Figure 1.3. In national accounting terms, a
budget imbalance (that is, G ≠ T) is reflected in either an imbalance between private investments (I)
and savings (S), that is, S ≠ I (internal imbalance) or an imbalance between imports (M) and exports
(X), that is, M ≠ X (external or balance-of-payments disequilibrium), or both.
• If there is a budget deficit, for example, tax revenue (T) is less than government expenditure (G), or T < G,
the government has to borrow money. The size of its deficit and the way in which it is financed is very
important for macroeconomic stability, depending on one’s view of the impact of budget deficits on the
economy. Government borrowing occurs via the financial markets and represents a use of either
domestic (Sd) or foreign savings (Sf), as shown in Figure 1.3. (In Figure 1.3, T, S and M represent
leakages from the income-expenditure circular flow, while G, I and X are additions to or injections into
the circular flow.) Part of the savings may find their way into financing government investment, which
is included in government expenditure (G). In the case of a budget surplus, the government
supplements the supply of savings in the economy.
• While the government can influence the course of the economy, it is also extensively affected by what
happens in the economy. In an economic recession, for instance, government revenue falls, or grows at
a slower rate. This may impair its ability to provide public services, especially if its debt or budget
deficit is already relatively high. Government also bears the brunt of its own decisions via their adverse
effect on the economy, such as when high budget deficits result in higher interest rates, thereby
increasing the government’s interest bill.
Figure 1.3 The impact of a budget imbalance on the financial sector in the context of the circular flow of income and
expenditure
Key concepts
• budget imbalance (surplus or deficit) (page 15)
• central (or national) government (page 11)
• consolidated national government (page 11)
• developmental state (page 9)
• exhaustive expenditure (page 12)
• extra-budgetary institutions (page 11)
• general government (page 11)
• individualistic (or mechanistic) view of government (page 9)
• instruments of fiscal policy (page 8)
• local authorities (or municipalities) (page 11)
• non-exhaustive government expenditure (page 12)
• non-governmental organisations (NGOs) (page 10)
• non-profit-making (page 10)
• privatisation (page 15)
• provincial government (page 11)
• public corporations (page 10)
• public economics (page 8)
• public enterprises (page 10)
• public infrastructure (page 15)
• public interest or collectivist view of government (page 9)
• public-private partnerships (PPPs) (page 15)
• public sector (page 11)
• regulation (page 8)
• resource mobilisation (by the public sector) (page 12)
• resource use (by the public sector) (page 12)
• state-owned enterprises or companies (page 11)
• transfer payments (page 12)
SUMMARY
• In public economics, we study the impact of the public (government) sector on resource allocation and
distribution. This requires a mechanism whereby demand for and supply of public goods and services
can be equated in the non-market sector of the economy. In a political system based on democratic
principles, this is the ballot box and the ‘price’ is the tax that people pay.
• Resource use in the public sector differs from profit-driven resource use in the private sector, which is
nonetheless indirectly influenced by the nature of the political environment and the functioning of the
political system, including a variety of economic policies and regulatory measures. The efficiency and
equity with which resources are allocated in the public sector as well as the impact of political
decisions on private economic behaviour are of paramount importance to the economic performance of
a country.
• Since 27 April 1994, the new South African Constitution has provided for important features of
democracy and good governance, such as an independent judiciary, a Constitutional Court, a Bill of
Human Rights, a Human Rights Commission, an independent Auditor-General reporting to parliament
and an independent central bank (the South African Reserve Bank).
• Fiscal measures that promote economic growth and improve people’s ability to participate gainfully in the
market economy constitute important policy instruments in the hands of the government.
• In 1994, there were concerns about fiscal sustainability because of increasing arrears and leakage in tax
collection at the national level, the tendency for government expenditure to exceed budgeted figures
regularly, and high and rising public debt. The growth of the government’s current expenditure was
such that it crowded out public investment: ever-decreasing funds, as a percentage of GDP, were made
available for government investment in social and physical infrastructure such as schools, hospitals and
roads.
• During the three or four decades before and up to the 2007–2009 international financial crisis, a wide
consensus developed about fiscal prudence and the restructuring of the public sector (inter alia through
privatisation and deregulation) to free up more resources for the development function of government
and to target the destitute effectively, without jeopardising macroeconomic stability. The case for
smaller and more efficient government was the result of a growing dissatisfaction with the
effectiveness of government in developed and developing countries.
• Against the backdrop of international events and shifting views on the role of government in the economy,
the constitutional change in 1994 provided South Africa with the unique opportunity to restructure or
revamp all of its institutions and policies thoroughly. The new government generally achieved a good
balance between the dictates of the market (requiring fiscal prudence) and the fiscal pressures for
redistribution, poverty reduction and socio-economic development. Unfortunately, in later years some
of the good policy decisions were undermined by poor service delivery and resource waste as well as
increasing occurrences of rent-seeking activities, fraudulent behaviour and nepotism.
• The international financial crisis of 2007–2009 and beyond was a serious wake-up call. Confidence in
mainstream (consensus) views on the respective roles of government and the private sector in the
mixed economy was shaken. The recession in developed countries had a major adverse effect on
developing countries such as South Africa and other countries on the African continent, although the
impact was generally less severe than in the industrial world.
• Since 1994, the South African government has carved out a particularly good fiscal track record, at least at
the macro level. The economic upswing that started in September 1999 and ended after 99 months in
November 2007 was the longest by far since World War II. The Great Recession was a major setback,
causing about one million job losses.
• Public economics is the study of the nature, principles and economic consequences of expenditure,
taxation, financing and the regulatory actions undertaken by the non-profit-making government sector
of the economy.
• Three approaches to the role of government in the economy can be distinguished: the individualistic,
collectivist and developmental state views. The ANC government propagates the latter model, although
it can be argued that many features of South African society do not fit this mould.
• The ‘public sector’ consists of the following:
- Central (or national) government (in other words, all of the national government departments) and
various extra-budgetary institutions, which together are known as the consolidated national
government
- Provincial and local government institutions, which, together with national government, constitute
general government
- Public corporations, also called public or state-owned enterprises (or companies).
• There are different indicators of the size of the public sector and its share in the economy, for example, tax
revenue, resource use (or exhaustive expenditure) and resource mobilisation (that is, resource use plus
transfer payments), all of which are normally expressed as a ratio of gross domestic product (GDP).
• The relationship between the public sector and the rest of the economy can be analysed with reference to
the four-sector circular flow of income, expenditure, and goods and services. While the government
can influence the course of the economy, it is also extensively affected by what happens in the
economy.
• In the macroeconomic identity, the budget balance equals the sum of the balance between domestic
savings and investment (S + I) and the balance between imports and exports (M + X).
MULTIPLE-CHOICE QUESTIONS
1.1 Which of the following statements applies or apply to the individualistic view of government?
a. The main point of departure is the maximisation of individual welfare.
b. Government institutions have no role independent of individual preferences.
c. The role of government is limited to correcting for market failure.
d. This view is also referred to as the mechanistic view of the role of government.
1.2 Which of the following statements is or are wrong?
a. The individualistic view of government best describes the role of government in South Africa.
b. The collectivist view of government best describes the role of government in South Africa.
c. The developmental state view of government best describes the role of government in South Africa.
d. The developmental state view is a special variant of the individualistic view of the role of
government.
1.3 Complete the sentence that follows by choosing the correct alternative from the options below.
When the government has a budget deficit, …
a. the country exports more than it imports
b. private savings exceed private investments.
c. the budgets of local governments as a group are in surplus.
d. the economy will show either an internal or an external imbalance, or both.
1.4 General government …
a. consists of all the general departments of the government.
b. refers to the activities of national, provincial and local government.
c. refers to the general divisions of public corporations.
d. authorities in South Africa undertake no capital expenditure.
1.5 Which of the following statements about the public sector in South Africa is or are correct?
a. After 1994, the biggest increase in the general government tax burden on average occurred between
2000 and 2007.
b. The share of public sector resource mobilisation has increased consistently from its average during
1995–1999.
c. The growth of the government’s current expenditure was such that it crowded out public investment
from time to time.
d. The ratio of current expenditure to GDP provides the best measure of the relative size of
government in the economy.
SHORT-ANSWER QUESTIONS
1.1 Distinguish between the following:
a. positive and normative economics
b. general government and public sector
c. resource use and resource mobilisation.
1.2 Explain the difference between the individualistic and the public interest view of government.
1.3 What are the features of the developmental state?
1.4 List the components of exhaustive government expenditure.
ESSAY QUESTIONS
1.1 Briefly review the salient changes in the size and composition of the South African public sector during
the past few decades. Which of the changes, in your opinion, is or are incompatible with the
requirements of a thriving economy?
1.2 Give an outline of the various dimensions of the relationship between the public sector and the rest of
the economy.
1 By comparison, South Africa’s national government debt–GDP ratio of 34,7% in 2010 was relatively low (see Section 17.3 of
Chapter 17 for further discussion). Even if sub-national government debt is added, the figure remains comparatively low.
2 For example, Singapore, Botswana, Malaysia, South Korea, Indonesia and, more recently, China.
3 During and after the international financial crisis the trend was strongly upwards, that is, from 50,9% in 2007 to 57,1% in 2017.
Benchmark model of the economy: Positive and
normative approaches
Philip Black and Ada Jansen
This part of the book starts with a brief review of the neoclassical theory of general equilibrium, which has
become something of a benchmark model over the years. It is a benchmark model precisely because it does
not presume to provide an accurate description of the real world. Rather, it should be seen as a frame of
reference or a starting point in the sense that it describes a stable economy in which all resources are
optimally utilised. As such, it may help us to understand and appreciate real-world problems better. As
shall become apparent in the chapters that follow, the model can in fact accommodate a large variety of
alternative assumptions. This built-in flexibility enables it to yield alternative predictions that bring us
closer to the real world.
Section 2.1 of this chapter provides a brief description of the basic assumptions of our benchmark
model, while Sections 2.2 and 2.3 discuss its equilibrium properties. These three sections thus provide a
vision of how the world ought to work and as such represent a good example of what some commentators
refer to as ‘normative’ economics. Section 2.4 begins to enter the domain of ‘positive’ economics by
comparing the benchmark model with the real world. This is done by introducing the concept of market
failure, a generic term describing broad categories of human behaviour that deviate from the ideal
assumptions of the benchmark model. Sections 2.5 and 2.6 briefly deal with the role of the public sector in
coming to grips with these market failures and related real-world problems (Chapters 3–6 will deal with
these issues in more detail). The chapter concludes with Section 2.7, which comments on government
failure.
identify the critical assumptions of the two-sector model
define what is meant by a Pareto-optimal allocation of resources
articulate the three conditions for a general equilibrium
distinguish between allocative efficiency, X-efficiency and ‘dynamic’ efficiency (or economic growth)
discuss the broad categories of market failure
explain the allocative, distributive and stabilisation functions of government
distinguish between direct and indirect forms of government intervention.
2.1 Basic assumptions of the benchmark model
The benchmark model is based on a host of patently unrealistic assumptions that are set out in Box 2.1. It
assumes that the individual consumer or producer is fully informed about the economy, unaffected by the
actions of other consumers or producers, completely mobile in the occupational and spatial sense of the
word, and always striving to maximise his or her own utility or profit within perfectly competitive markets.
Any exogenous disturbance will merely set in motion a series of more or less instantaneous adjustments
that will automatically return the system to a stable equilibrium. Indeed, there would be few economic
problems to speak of in such a blissful state, and little need to write this chapter and many of the
subsequent ones.
Box 2.1 Assumptions of the two-sector model
• There are two individuals, A and B, who are the suppliers of two factors of production, the producers of two
commodities and the consumers of both of these commodities all at the same time. Each individual is initially
endowed with fixed quantities of the two factors, capital (K) and labour (L), and uses these endowments to
produce two commodities, X and Y. Each individual consumes both commodities.
• There are no external effects associated with consumption and both individuals have fixed tastes, as reflected in the
existence of smooth and ‘well-behaved’ individual indifference curves. These curves (which show combinations
of goods that yield the same levels of utility) are convex with respect to the origin, cannot intersect and exhibit
diminishing marginal rates of substitution.
• The two production processes are both characterised by unlimited factor substitutability, diminishing marginal
productivities and constant returns to scale. The latter assumption rules out internal (dis)economies of scale, while
there are also no external costs or benefits in production. These assumptions together ensure the existence of
smooth and ‘well-behaved’ isoquants (recall that an isoquant is a curve that shows combinations of inputs that
yield the same level of output).
• As consumers, A and B maximise utility, and as producers, they maximise profit. Both are perfectly informed about
their respective environments, and are perfectly mobile in the occupational and spatial sense of the word.
• The commodity and factor markets are all perfectly competitive, which implies that each market behaves ‘as if’
there were a large number of individual demanders and suppliers involved, none of whom can influence price.
• These assumptions together ensure the existence, uniqueness and stability of a general equilibrium.
One does not have to be an economist to realise that real-world economies do not behave in the way in
which the neoclassical model predicts. Perhaps the only real market that comes close to this is an auction,
where suppliers and demanders all come together to reveal their preferences to an independent and
knowledgeable auctioneer who establishes the equilibrium price before any trading takes place. In the
neoclassical model, we simply assume the existence of this knowledgeable and omnipresent auctioneer –
also called the ‘Walrasian auctioneer’– and give him or her the task of establishing equilibrium prices in
all markets, more or less simultaneously.
Before delving into the model itself in Sections 2.2 and 2.3 below, it is worth noting that a theory does
not necessarily stand or fall by its assumptions. To be sure, assumptions are important if one wanted to
explain and predict some real-world phenomenon, as are the functional relations used to make predictions
and test the validity of the theory. But if one’s aim is merely to develop a normative theory – such as a
benchmark model of resource allocation – it is hardly appropriate to judge it only in terms of the realism of
its assumptions.
2.2 The benchmark model and allocative efficiency

Economic efficiency is conventionally defined in terms of both allocative efficiency and technical
efficiency (or X-efficiency), and can also refer to a country’s ability to achieve economic growth. This
section focuses on allocative efficiency (Section 2.3 discusses X-efficiency and economic growth).
Allocative efficiency refers to a situation in which the limited resources of a country are allocated in
accordance with the wishes of its consumers. An allocatively efficient economy produces an ‘optimal mix’
of commodities. Under conditions of perfect competition, the mix of outputs will be optimal if consumers
maximise utility in response to prices that reflect the true costs of production. It is therefore evident that
allocative efficiency involves an interaction between the consumption activities of individual consumers
and the production activities of producers. In an economy with no public sector and no consumption or
production externalities, allocative efficiency in the general equilibrium context requires the simultaneous
concurrence of three familiar conditions. Brief discussions of these conditions follow.
2.2.1 Condition 1
The first condition is Pareto optimality in consumption. Consider a two-person, two-commodity
exchange economy in which the total supply of the two commodities is fixed. The two consumers (A and
B) each has an initial allocation of the two goods (X and Y), and exchange these commodities as long as it
is mutually beneficial for them to do so. The rate at which they are willing to exchange one good for the
other is given by the marginal rate of substitution of good X for good Y (MRSxy). As long as the MRSxy
differs between A and B, there is room for beneficial exchange and trade continues. Once the two
individuals have exhausted all mutually beneficial exchange opportunities, the MRSxy will be the same for
both. This implies that a Pareto efficient allocation has been reached. A movement from the initial
allocation to this efficient allocation is called a Pareto improvement (the exchange has increased the utility
of at least one of the consumers, without decreasing the utility of anyone). Economic efficiency in
consumption occurs if no interpersonal reallocation of commodities can increase the utility of either of the
two consumers, A or B, without thereby decreasing the utility of the other. All efficient allocations occur
where MRSAxy = MRSBxy. The exchange contract curve is obtained by connecting all these allocations.
Figure 2.1 uses the familiar Edgeworth-Bowley box diagram to illustrate the condition of efficiency in
consumption. The fixed total supplies of the two commodities give the dimensions of the box: either of the
two vertical axes, 0A J or 0BK, gives the total amount of commodity Y, while either of the horizontal axes,
0AK or 0B J, gives the total amount of commodity X. Individual A’s indifference curve map originates in the
southwestern corner, 0A, and that of individual B in the northeastern corner, 0B. Only three out of the large
number of indifference curves are shown for each of the two individuals, that is, UA1, UA2 and UA3 for
individual A, and UB1, UB2 and UB3 for individual B. Starting from an initial allocation at point P (where the
indifference curves UA2 and UB1 intersect), consumers exchange commodities (given that their MRSxy are
not the same). When they reach point T, all beneficial exchange opportunities have been exhausted. The
efficient allocations in this exchange economy are the points where the indifference curves of the two
individuals are tangent, for example, points S, T and R. The exchange contract curve in Figure 2.1, 0A0B,
can be derived by repeating this exercise many times from different initial allocations.
In a competitive market setting, each individual will maximise utility subject to his or her own budget
constraint. This implies choosing the commodity mix for which the MRS equals the corresponding
commodity price ratio. That is:
for all consumers in the market. This condition holds under perfect competition as all consumers are price
takers and face the same prices.
2.2.2 Condition 2
We now relax the assumption of fixed output supplies and make production activities variable. This brings
us to the second condition for allocative efficiency: Pareto optimality in production. This means that it
should not be possible to increase the output of any commodity without decreasing the output of at least
one other commodity. Put differently, in a non-optimal situation, it is always possible to increase the
output of one commodity without thereby decreasing the output of other commodities.
The model assumes that each of the production sectors commence with an initial amount of the (fixed)
factors of production in the economy, labour and capital. The initial allocation of inputs between sectors X
and Y may not be the most efficient option. A reallocation of the inputs L and K can benefit both sectors
and move the economy from an inefficient allocation to a Pareto efficient allocation, as shown in Figure
2.2. A move from point C (the initial allocation) to point E is a Pareto improvement, as it increases the
output of Y while maintaining the output of X. If such gains are no longer possible, a Pareto efficient
production point has been reached. Figure 2.2 illustrates this. The fixed total supplies of the two factors of
production determine the dimensions of the box: either of the two vertical axes, 0xV or 0yW, gives the total
supply of capital, while either of the two horizontal axes, 0xW or 0yV, gives the total supply of labour.
Figure 2.1 Efficiency in exchange
The isoquant map of Sector X (that is, its production function) originates in the southwestern corner, 0x,
and that of sector Y in the northeastern corner, 0y. Only three out of a large number of isoquants are shown
for each of the two sectors, that is, X1, X2 and X3 for sector X, and Y1, Y2 and Y3 for sector Y. The next step
is to find all of the points where the two sectors’ respective isoquants are tangent, for example, points E, F
and G. At such points of tangency of the isoquants, the rates at which one input is substituted for another to
produce constant output levels (the marginal rate of technical substitution, MRTSlk) are the same. The two
sectors use inputs efficiently at such production points, in the sense that it is not possible to reallocate
inputs between sectors to increase the output of one sector, without thereby decreasing the output of the
other sector.
If this exercise is repeated many times, the contract curve for production is derived, shown as 0x0y in
Figure 2.2. Note that each point on the contract curve represents a Pareto-optimal allocation of the two
resources, K and L, between the two sectors, X and Y: at point E (or F or G), it is not possible for either
sector to increase its output without the other sector having to cut back its own output. This is clearly not
true of a point such as C where either of the two sectors can increase its output without causing a reduction
in the output of the other. Point C is not on the contract curve; as discussed in Section 2.3, it represents an
X-inefficient outcome.
In terms of the familiar two-sector model, this condition requires that each of the two sectors should
maximise output subject to its own cost constraint. Hence, for each sector the MRTSlk = where the
latter is the market-determined equilibrium input price ratio. The assumption of perfect competition
ensures that the two sectors operate at the same point on the contract curve (for example, E, F or G in
Figure 2.2), and that the economy finds itself at a point on the production possibility curve (PPC). The
latter is simply the flip side of the above contract curve: it brings together all of the output combinations
along the contract curve within a more conventional diagram and is shown in Figure 2.3. There the PPC is
depicted as the curve MN, on which the points E, F and G represent the same output combinations as their
equivalents on the contract curve in Figure 2.2.
Figure 2.2 Efficiency in production
The slope (or rate of change) of the PPC in Figure 2.3 is given by and is known as the marginal rate of
product transformation of X for Y, or MRPTxy. The latter, in turn, equals the corresponding marginal cost
ratio, which is easily proved with the aid of Figure 2.3.
Consider a small movement from point F to point h in Figure 2.3 such that the resources gained by
sector X equal the resources lost by sector Y. With factor prices assumed unchanged, this means that the
increase in the total cost of sector X will equal the decrease in the total cost of sector Y, that is, ∆TCx =
∆TCy. Now, since
or
therefore
Figure 2.3 Production possibility curve
MCx is the marginal cost of production in sector X. Since under perfect competition each sector will ensure
that its own marginal cost equals the corresponding market price, that is, MCx = Px and MCy = Py, the
following holds:
This is given by the slope of a tangent drawn to a point on the PPC, for example, the slope of line tt’ at
point F in Figure 2.3.
The second condition thus implies a point on the PPC at which it is impossible to increase the output of
either of the two sectors without thereby decreasing that of the other. Under perfect competition, price will
equal marginal cost in each sector, so that the MRPT, which equals the marginal cost ratio for the two
sectors, also equals the corresponding price ratio.
2.2.3 Condition 3
The third condition for allocative efficiency requires that producers and consumers achieve equilibrium
simultaneously. Given that the slope of the PPC (that is, MRPTxy) equals the corresponding ratio of
marginal costs, and thus also the corresponding equilibrium price ratio, the third condition can be
written as follows:
This indicates equality between the (marginal) rate at which each consumer is willing to substitute one
commodity for the other and the rate at which it is technically possible to do so. Put differently, the
economy is producing the combination of commodities X and Y at minimum cost and in compliance with
the preferences of the consumers. If MRPT does not equal MRS, it is possible to alter production and
consumption to achieve a Pareto improvement. This can be illustrated as follows. If the but
the MRPTxy = it means that consumer A is willing to sacrifice 2 units of X for 1 unit of Y, while at this
production point 2 units of Y will be gained if 2 units of X are sacrificed. A Pareto improvement is possible
if more of Y is produced.
Simultaneous compliance with these three conditions will ensure production of the optimal output mix,
which is shown by the parallel lines tt’ at point F and vv’ at point F’ in Figure 2.4. The slope of the line tt’
equals the MRPTxy and the corresponding marginal cost ratio, while the slope of vv’ equals the marginal
rates of substitution for the two consumers. Points F and F’ in Figure 2.4 are thus consistent with Equation
2.6 above: they represent the third or top-level condition, and hence also the first and second conditions for
a general equilibrium.
Point F is a Pareto-optimal top-level equilibrium in the sense that it is not possible to increase the output
of either of the two sectors or the utility of either of the two consumers without thereby reducing that of the
other.
Note that at this point of production (F), total output is X2 and Y2. These quantities determine the
dimensions of the Edgeworth Box in Figure 2.4. However, the precise location of the top-level point on the
PPC will depend on the underlying assumptions of the model, particularly the initial distribution of
resources between the two individuals, A and B. If one of the two individuals owns most of the initial
capital and labour resources, and has a particularly strong relative preference for commodity Y, it stands to
reason that our model will generate a top-level equilibrium lying on the PPC and close to the y-axis in
Figure 2.4 (and Figure 2.3). Chapter 5 revisits this important issue.
Figure 2.4 Consumption and overall equilibria

2.3 Efficiency and economic growth
Technical efficiency or X-efficiency refers to a situation in which the maximum possible output is
obtained from a given set of resources (put differently, a situation of technically efficient production). This
necessarily implies a position on the PPC, such as points C0 and S in Figure 2.5.
Points inside the PPC, such as R, indicate the presence of X-inefficiency. X-inefficiency (sometimes
also termed organisational slack) can be caused by a number of factors ranging from a lack of motivation
by production agents to a lack of information about market conditions, incomplete knowledge of
production functions, and incomplete specification of labour contracts.
Figure 2.5 X-inefficiency and economic growth

Clearly, X-efficiency alone is an insufficient measure of economic efficiency since technically efficient
production of goods as such does not necessarily reflect the needs of consumers. In common sense terms,
it is pointless to produce goods efficiently if people would rather consume some other combinations of
those same goods. Put differently, X-efficiency ensures that society is on its PPC, but cannot determine
where society should be on this curve. As shown in Section 2.2.3 above, the latter point is given by the
top-level equilibrium, and represents an economy that is X-efficient as well as allocatively efficient.
It is also possible to define economic efficiency in dynamic terms. Dynamic efficiency has to do with
increases in the quantity and/or productivity of the factors of production (that is, with economic growth).
The sources of growth are conventionally defined to include savings, investment in the form of both
physical and human capital formation, technological inventions and innovations, and increases in the
availability of labour with different skills. From a general equilibrium perspective, the net effect of
sustained economic growth can be shown in Figure 2.5 as an outward shift in the PPC, for example, from
M0N0 to M1N1, and by a concomitant change in the competitive equilibrium, for example, from point C0 to
C1.
2.4 Market failure: An overview

The perfectly competitive model is nothing more than a theoretical nicety, a normative ideal against which
real-world conditions can be judged. This section briefly distinguishes between several instances of
market failure. The most important of these are discussed in more detail in the remaining chapters of Part
1.
2.4.1 Lack of information

Producers and consumers sometimes lack information that is essential for making rational decisions.
Producers may be unaware of the existence of certain resources they require or of the latest technologies
available in their own lines of business. Similarly, consumers may be ignorant of potentially harmful
properties of some goods and services they consume or unaware that certain goods are available at lower
prices than what they are currently paying (Bohm, 1978). Information problems also arise in labour
markets: unemployed workers are often unaware of job vacancies, while employers are often unaware of
available job seekers who can fill their vacancies. In addition, many transactions are characterised by
asymmetric information, that is, situations in which either the buyer or the seller has more or better
information than the other party has about the terms and implications of the exchange.
Information-related problems of this nature feature prominently in the rest of this book. Regulatory
authorities are often ignorant about the pricing of local and global public goods or the size of and solutions
to externality problems (Chapter 3). Governments are also unsure about the most efficient way of
regulating natural monopolies (Chapter 4), dealing with poverty, inequality and service delivery (Chapters
5, 8, 9 and 10), avoiding or minimising principal–agent problems between and among politicians,
bureaucrats and voters (Chapters 6, 7 and 19), and about the economic impact of various taxes (Chapters
11–16). In fiscal policy-making, the possibility of unforeseen GDP changes means that governments can
never be sure if actual tax revenue will reach the budgeted level (Chapter 18) and neither do they know
precisely what the cost of their debt will be in the future (Chapter 17).
Very few individuals and institutions have all the information they need when they have to take
decisions that would affect their own well-being. Even if consumers, producers and job seekers were
prepared to pay for the required information, this would not always help. It would clearly be impossible for
them to calculate costs of this nature without knowing exactly what information they will obtain. But if
they knew the latter, there would be no need to acquire the information in the first place, let alone calculate
the cost of acquiring it. They thus have no choice but to accept their lack of information as a binding
constraint.
This raises the question whether governments in free societies should bear the responsibility of
providing individual citizens with information for private decision-making. Governments sometimes do
perform this function. In South Africa, for example, virtually all consumer goods must be cleared by the
South African Bureau of Standards. They must also have labels displaying their weight, mass, volume and,
more recently, their ingredients, including chemical additives. These standards have become increasingly
important for many African countries, partly because of the minimum standards imposed by regions and
countries with which they are trading. On balance, however, profit-driven private institutions tend to
acquire and disseminate information more efficiently than government agencies do.
2.4.2 Friction and lags in adjustments

Most markets do not adjust very rapidly to changes in supply and demand. While this may partly be the
result of a lack of information, it is also true that resources are not very mobile at the best of times, that is,
even when the necessary information is at hand. This has given rise to the development of search markets
in which agents spend time and resources searching for information and, in the process, incur so-called
friction costs. Labour may take time to move from one job to another or from one place to another, while
physical capital can only move from one location to another at very irregular intervals. It takes time for an
entrepreneur to move out of textile production into computer software production or for a civil engineer to
become retrained as an electrical engineer, even when they are fully aware of the new opportunities
available in the market place. Acquiring and adapting the latest technologies may also take both time and
money, especially when the requisite skills are not readily available. The discussion of the effectiveness of
fiscal policy in Chapter 18 will revisit the issue of the effects of lags.
2.4.3 Incomplete markets

Markets are often incomplete in the sense that they cannot meet the demand for certain public goods (such
as street lighting, defence or neighbourhood security). Neither do they fully account for the external costs
and benefits associated with individual actions. When a company pollutes the air or river water, damaging
the health of consumers using that air or water, it is not usually held responsible for its actions, and neither
are the consumers compensated for the additional health expenses that they might incur. Chapter 3
discusses these issues in more detail.
2.4.4 Non-competitive markets

Non-competitive markets are the rule rather than the exception. Monopoly often results from government
intervention in markets, using policy instruments such as licenses and regulations. Such monopolies are
called artificial or statutory monopolies. Statutory monopolies cause social costs (a loss in consumer
surplus). These social costs can be reduced by deregulating the industry, that is, by removing the artificial
barriers to entry imposed by government. The natural monopoly is another market failure associated with
non-competitive markets. This market form results from industries exhibiting decreasing average costs
over the entire production range for which there is market demand. Public utilities such as bulk water
providers and rail transport are examples of natural monopolies. If these industries were to produce at the
perfectly competitive market equilibrium, they would be making losses. Government therefore has an
important role to play in ensuring that production and pricing are at a point that is close to the social
optimum level. Chapter 4 considers these issues in more detail.
2.4.5 Macroeconomic instability

At the macroeconomic level, markets may be slow to react to sudden exogenous shocks to the system. Left
to themselves, markets may take too long to adjust to changing external conditions and it is often necessary
for domestic policy-makers to take appropriate actions aimed at stabilising their currencies. The important
role now played by monetary and exchange rate policies can be viewed as an attempt on the part of
governments to deal with the problem of market failure at the macroeconomic level.
A more recent example of a serious exogenous shock is the 2007–2009 global financial crisis, which
has even been compared with the 1929 Great Depression. Swift and appropriate actions were required
from policy-makers the world over to mitigate its effects. It was prompted by a liquidity shortage in the
American banking system, and has led to the downfall of large financial institutions such as Lehman
Brothers, bailouts of banks by domestic governments and downswings in stock markets throughout the
world. The effects of the crisis were more severe in developed countries than in the developing world, with
the International Monetary Fund (IMF) and the European Union (EU) having to bail out several countries
whose public debt burdens had become unmanageably large (including Ireland, Greece and Portugal). This
issue is taken up again in Chapters 17 and 18.
2.4.6 Distribution of income

Perhaps the most important shortcoming of the neoclassical model of general equilibrium is its neutrality in
respect of the distributions of wealth and income and the related poverty problem. The model operates like
a ‘black box’: what you get out of it is what you put into it. For all practical purposes, the distributional
outcome – as reflected by the precise top-level equilibrium on the PPC – is determined by the initial
distribution of capital and labour between the two individuals. If the initial distribution is highly unequal,
then so too will be the final distribution. We take up this issue again in Chapter 5 and spell out some of the
relevant policy implications in the discussions of poverty and redistribution-related issues in Chapters 8, 9
and 10.
2.4.7 Further notes on market failures

These examples of market failure are but a small sample of the many things that can go wrong in a modern
capitalist economy. It is clear that real-world economies are not very efficient in the conventional
economic sense of the word. They do not, and probably never will, achieve a Pareto-optimal allocation of
resources. Neither will they produce an equitable distribution of income on their own, or even a
distribution that is acceptable to the broad community or its representative government.
But this does not mean that any other form of economic organisation, such as a socialist or centrally
planned economy, will be any better at allocating scarce resources in accordance with the true wishes of
the community. There is now enough evidence to suggest that countries that have abided by the principles
of the market have generally grown more rapidly and have spread the benefits of that growth more
effectively than countries that have opted for overly interventionist or centrally planned systems. Indeed,
not all economists have bought into the notion of market failure; as Box 2.2 shows, they have viewed the
phenomena outlined in this section as manifestations of the normal adjustments made by free agents in the
face of changing circumstances. The key issue here is whether these adjustments are being made in
response to negative or positive externalities imposed by others and whether they can be made in good
time with little or no cost to the broader society, or, conversely, whether government intervention can
speed up the process and close some of the gaps discussed above without undermining economic
efficiency.
What cannot be denied is that the public sectors of most market-based economies have played a
significant role in creating wealth for their growing populations. In these economies, the public sector has
been charged with the task of providing certain public goods (such as defence and law and order), dealing
with the problem of externalities, protecting consumer interests through health and other standards,
regulating natural monopolies, and preventing abusive behaviour by monopolies and oligopolies. The
sections and chapters that follow will deal with these issues.
Box 2.2 Market failure: Alternative view
The Austrian school believes in the superiority of a free-market system in which government’s role is limited to that
of protecting the freedom of individuals and communities. To Austrian economists, the notion of market failure, as
conventionally defined, is something of a misnomer.
According to them, it should rather be viewed as an aspect of the dynamic process by which markets continually
adjust to changing tastes and technologies, with individuals and enterprises constantly searching for and filtering
information in an attempt to stay or get ahead of their rivals. Free and competitive markets operate in an evolutionary
fashion, with only the fittest surviving, and with the only ‘failure’ being the ‘creative destruction’ of firms that are
unable to produce at minimum cost, or create or imitate new technologies (for example, Schumpeter, 1987; Nelson
& Winter, 1982). Other economists would argue that market participants can and often do overcome the problem of
imperfect information themselves. We have already referred to the creation of ‘search markets’ in which employers
and job seekers spend time and money to acquire information they need to secure their occupational well-being.
Another example is the payment of efficiency wages by employers in order to save on monitoring costs and, in the
process, avoid an otherwise serious principal–agent problem (Stiglitz, 1984). Yet another example is credit rationing
on the part of banks when demand exceeds supply at the prevailing interest rate. There is also a view that too little is
known generally about the nature and extent of market failures, and that governments have less of an incentive to fill
informational gaps of this nature than the private sector (Cowen & Crampton, 2011).
2.5 Enter the public sector: General approaches

Section 2.4 showed that various kinds of market failure could render the benchmark model of perfect
competition unworkable in the real world. These failures provide a prima facie case for government
intervention. In this section, we focus briefly on the broad approaches that governments can follow to deal
with failures of this nature.
Economists conventionally distinguish between three broad functions of government: the allocative,
distributive and stabilisation functions.
2.5.1 Allocative function

The allocative function of government refers to the role of government in allocating scarce resources to
competing uses in the economy and stems from the distorting effects of market failure on the allocation of
resources in an economy. Market failures caused by incomplete and non-competitive markets are
particularly important sources of allocative distortions. Chapter 3 discusses incomplete markets in more
detail, but we will briefly point out the main manifestations of incomplete markets here.
There are two manifestations of incomplete markets. The first one involves characteristics of some
goods and services that prevent efficient supply by competitive markets. Market failures of this nature can
take various forms. In the case of pure public goods (such as national defence and street lighting), potential
consumers have a strong incentive not to reveal their demand. This makes it impossible to determine a
price, or to force users to pay for the benefits they derive from using the good or service. As a result,
competitive markets cannot supply pure public goods at all, even though they are in great demand. A
second class of goods and services, known as mixed goods, has some public-good characteristics.
Consumers would either not reveal their demand for such goods and services or producers would find it
impossible to enforce payment of the price. Mixed goods can be supplied by competitive markets, but
neither the quantity supplied nor the price resulting from market provision would be optimal. Examples of
these goods are subscription television services and certain healthcare services.
A second manifestation of incomplete markets is the existence of externalities. The activities of
individual consumers and producers often affect other parties. Failure to account for these external effects
tends to create divergence between actual market prices and quantities and their socially optimal
equivalents. Externalities can be either negative, as in the case of air or river pollution, or positive. An
example of a positive externality is the ‘additional’ benefits that society derives from education, such as
having a more literate voter population and a lower crime rate. These benefits are additional to the private
benefits accruing to individuals in the form of higher earnings.
Chapter 4 explains that non-competitive markets may take two forms. ‘Artificial’ monopolies operate in
markets where perfect competition is technically feasible, but prevented by legal restrictions imposed by
government or professional bodies. By contrast, ‘natural’ monopolies emerge in industries characterised by
large capital outlays that give rise to economies of scale over the entire range of their output. Only one
firm can operate effectively in a market of this nature. Examples include the electricity transmission
industry and the local loop in the telecommunications sector. In both forms of non-competitive markets,
firms maximise their profits by supplying less than the optimal quantity of the good or service at too high a
price.
Governments have various instruments at their disposal for correcting the allocative distortions arising
from incomplete and non-competitive markets. Section 2.6 refers to some of these instruments, while
Chapters 3 and 4 discuss them in more detail.
2.5.2 Distributive function

Section 2.4 pointed out that the neoclassical general equilibrium model is decidedly agnostic when it comes
to the distribution of wealth or income in a society. It yields a distributional outcome that is largely
determined by the initial distribution of labour and capital between the market participants – in fact, a
Pareto-optimal allocation exists for each possible distribution. Hence, the model is useful for determining
the Pareto-optimal allocation of resources for a given income distribution, but is silent on the fairness of
the outcome.
The distributions of income and wealth generated by markets are often highly unequal. The ubiquity of
the distributive function of government (that is, the use of combinations of taxes, transfer payments and
subsidies to alter distributional outcomes) suggests that no society regards the market-determined
distribution of income as being fair or just. Some commentators have even suggested that a redistribution
could improve the general well-being of society even if it carried a cost in terms of lower levels of
productivity or slower economic growth. While much disagreement remains about appropriate criteria for
evaluating policies to redistribute income or wealth, the vast majority of economists now agree that the
distributive function is a key aspect of the role of government in a modern capitalist economy. Chapters 5,
8, 9 and 10 investigate aspects of this function in more detail.
The stabilisation function of government has to do with its macroeconomic objectives, which include an
acceptable rate of economic growth, full employment, price stability, and a sound and manageable balance
of payments (see Chapter 18). An inability on the part of competitive markets to achieve these outcomes
would represent market failure on a grand scale, and often induces governments to implement corrective
monetary, exchange-rate and fiscal policies. While a detailed analysis of macroeconomic issues falls
outside the scope of this book, Chapters 17 and 18 discuss key aspects of fiscal policy. The purpose of this
subsection is to provide a brief overview of the stabilisation role of government.
The notion that governments have an important stabilisation function is associated mainly with the
Keynesian school of macroeconomic thought. The Keynesian approach to stabilisation rests on three
premises:
1 The market economy is inherently unstable.
2 Macroeconomic instability is a form of market failure that is extremely costly to an economy.
3 Governments are able to stabilise the economy by means of appropriate macroeconomic policies.
Hence, Keynesians propose active counter-cyclical policies to stabilise economic activity. Their proposed
measures mainly work on the demand side of the economy. In times of recession, governments should
reduce taxes, increase their expenditure and boost credit expansion in order to raise aggregate demand and
stimulate economic activity. Conversely, inflationary overheating of the economy should be addressed by
higher taxes and lower levels of state spending and credit expansion, thus moderating aggregate demand.
This Keynesian view of the stabilisation function of government is not without its critics. Economists
from the New Classical school of thought in macroeconomics argue that Keynesian economics is not
properly grounded in microeconomic principles and that its adherents fail to realise that rational agents
may anticipate the actions of government and act upon them even before they are executed or have their
intended effects. New Classical economists believe that the market economy is self-adjusting and that
government intervention worsens rather than improves matters. The implication of the first belief is that
stabilisation policies are unnecessary in market economies. The second belief implies that attempts by
governments to stabilise economic activity will invariably fail, irrespective of whether such interventions
are warranted.
In response to these criticisms, the so-called Neo-Keynesian school of thought has tried to revive
Keynesian theory by providing it with credible microeconomic foundations. Neo-Keynesian economists
argue that many rigidities characterising the modern economy are perfectly consistent with rational
economic behaviour and that some of them, such as wage and price contracts, can prevent the economy
from responding or adjusting rapidly to exogenous shocks. These theories provide some justification for
demand-management policies, although Neo-Keynesians do acknowledge the practical difficulties
confronting policy-makers, such as policy lags and shifting expectations.
2.6 Direct versus indirect government intervention

Another way of approaching the role of government in the economy is to look at the nature of government
interventions. Viewed very broadly, it is useful to distinguish between direct and indirect forms of
intervention.
Direct government intervention refers to the actual participation of government in the economy. It
includes the government’s constitutional right to tax individuals and companies, to borrow on the financial
markets and to execute its budgeted spending programmes. As far as the latter programmes are concerned,
governments intervene directly when they respond to a market failure by producing or supplying a good or
service (such as national defence, waste disposal or electricity) or by financing production undertaken by
the private sector on a contract basis (such as school textbooks and much of the state’s infrastructure).
Indirect government intervention refers to the regulatory function of government. Regulation entails
enacting a law or proclaiming a legally binding rule that gives rise to market outcomes that are different
from those that would have been obtained in the absence of the regulation. Examples abound. In South
Africa, they include the labour laws that are aimed at improving the working conditions of labour, the anti-
tobacco law through which it is hoped to curb tobacco smoking, the competition policy, which is aimed at
preventing abusive behaviour on the part of monopolies, and several environmental control measures.
Indirect taxes and subsidies, which change market outcomes, also constitute indirect fiscal measures.
The distinction between direct and indirect interventions can make an important difference to our
estimates of the size of the public sector and its effects on the economy. Conventional indicators of the size
of the public sector, which are based on the total tax burden, government expenditures and the budget
deficit or surplus, provide a reasonably accurate picture of the size and extent of direct government
intervention in the economy (or of the ‘resource use’ by government, as explained in Chapter 1). The
problem is that regulatory interventions, whose total effect on the private sector may well be as important
as that of direct measures, are not explicitly captured in the national or government accounts. Conventional
measures of the size of the public sector, such as those used in Chapter 1 and in Chapter 7, may well
underestimate the overall effect of public-sector activity on an economy. However, as yet there is no
suitable quantitative indicator that fully accounts for the impact of government regulations on the
economy.
2.7 Note on government failure

It is important to realise that governments, like markets, can also fail. Those involved in the business of
government – politicians, bureaucrats and public employees – are ordinary human beings like the rest of
us. They often pursue their own self-interest rather than the public interest, and the protected nature of
their business dampens their incentive to be X-efficient. They make mistakes, wittingly or unwittingly, and
some are even corrupt (as are the citizens and corporate executives who offer them bribes and other
inducements to abuse public resources).
In Chapter 6, we argue that ‘government failure’, like market failure, is nothing sinister or
extraordinary. It is a perfectly natural outcome of the factors influencing the behaviour of politicians and
government officials. Like their counterparts in the private sector, they are utility maximisers: politicians
want to maximise votes, virtually at all costs, while bureaucrats often strive to maximise the size of their
departmental budgets, or ‘empires’. The net effect is usually an excess supply of public goods and services
or a government that is bigger than its ‘optimal’ size.
It is therefore important – indeed imperative – for the tax-paying public as well as students of public
economics to know how efficiently their government is performing its various functions. However, in
order to make this judgment, it is not only necessary to know why governments intervene in the economy
in the first place (which is the focus of the rest of Part 1), but also what it is that governments are supposed
to do. This is the focus of the remaining parts of this book. Only then will we be able to make an informed
judgment about the role of government in our economy.
Key concepts
• allocative efficiency (page 22)
• allocative function of government (page 31)
• asymmetric information (page 28)
• direct government intervention (page 34)
• distributive function of government (page 32)
• dynamic efficiency (page 27)
• indirect government intervention (page 34)
• market failure (page 28)
• Pareto optimality in consumption (page 22)
• Pareto optimality in production (page 23)
• Pareto-optimal top-level equilibrium (page 26)
• regulation (page 34)
• stabilisation function of government (page 33)
• technical efficiency or X-efficiency (page 27)
SUMMARY
• Over the years, the neoclassical theory of general equilibrium has become something of a benchmark
model or a frame of reference that can be used for analysing real-world problems.
• As such, the model is based on a set of ideal but unrealistic assumptions (for example, fully informed
agents, no externalities and perfectly competitive markets) that are necessary to generate a hypothetical
economy in which all resources are fully utilised to the satisfaction of all of the agents involved.
• The equilibrium properties are essentially threefold. First, each producer achieves a constrained optimum,
determined by his or her own resources and competitive factor prices. Second, each consumer
maximises utility subject to his or her own budget constraints and the market-determined competitive
commodity prices. The third condition follows from the first two sets of equilibria occurring
simultaneously, thus establishing a Pareto-optimal ‘top-level’ equilibrium.
• The latter equilibrium represents a fully employed economy that is X-efficient in the sense of producing
the maximum output with its given resources. It is also allocatively efficient in the sense of producing
the optimal or most desired mix of commodities.
• With this model as the backdrop, the many market failures that characterise the real world are highlighted.
These include a lack of information on the part of job seekers and employers in the labour market as
well as producers and consumers who are often unaware of the inherent qualities or ‘standards’ of the
goods that they produce, export and consume.
• Markets are often incomplete in the sense that they cannot meet the demand for certain public goods, for
example, street lighting and national defence, on their own. Neither do they fully account for the
external costs and benefits associated with individual actions, such as air and water pollution or the
free dissemination of useful information.
• Commodity markets are often dominated by monopolies and oligopolies capable of abusing their power,
while labour markets are in turn constrained by minimum wages imposed by trade unions, by
governments and by large corporations themselves. These ‘failures’ all undermine allocative
efficiency.
• An important shortcoming of the above model is the fact that it is entirely neutral about the distribution of
wealth and the related problem of poverty. It operates like a ‘black box’: what you get out of it is what
you put into it. The distributional outcome – as reflected by the precise top-level equilibrium on the
PPC – is determined largely by the initial distribution of capital and labour between the individuals.
• From a macroeconomic perspective, markets may take too long to adjust to changing external conditions
and it is often necessary for domestic policy-makers to take appropriate actions. The important role
now played by monetary and exchange rate policies can be viewed as an attempt on the part of
governments to deal with the problem of market failure at the macroeconomic level.
• Government intervention thus usually plays an allocative, distributive or stabilising role in the economy.
The nature of this intervention may be ‘direct’ in the sense of supplying public goods or ‘indirect’ in
the form of regulating the private sector.
2.1 Which of the following statements is/are correct? The theoretical notion of a ‘general equilibrium’
implies equality between …
a. the marginal rates of technical substitution (MRTS) among producers.
b. the marginal rates of substitution (MRS) among consumers.
c. the MRTS and the MRS.
d. the MRS and the marginal rate of product transformation (MRPT).
2.2 Which of the following statements is/are correct? Technical or X-efficiency refers to an economy
operating at …
a. any point along its contract curve for production.
b. any point on its production possibility curve (PPC).
c. a point on or below its PPC.
d. its top-level equilibrium on the PPC.
2.3 Which of the following statements is/are correct? In the general equilibrium model, allocative
efficiency represents …
a. any point along the contract curve for consumption.
b. any point on the PPC.
c. a point on the PPC where MRS = MRPT.
d. a situation where each consumer achieves maximum utility simultaneously.
2.1 Briefly distinguish between technical or X-efficiency and allocative efficiency.
2.2 In what sense can a lack of information be viewed as a market failure?
2.3 Distinguish between the allocative and the distributive functions of government.
2.4 Should governments have a stabilisation function?
2.5 Briefly explain the meaning and implications of government failure.
ESSAY QUESTIONS
2.1 Outline the conditions for a top-level general equilibrium and explain why they represent a Pareto-
optimal allocation of resources.
2.2 Distinguish between allocative efficiency, X-efficiency and economic growth (‘dynamic’ efficiency),
and briefly consider their relevance to Southern Africa.
2.3 Explain the meaning of market failure and provide a few pertinent examples.
2.4 Should governments necessarily intervene to correct so-called market failures?
Public goods and externalities
Philip Black and Krige Siebrits
Chapter 2 introduced a benchmark model that explains the allocation of scarce resources in a perfectly
competitive economy. The exposition emphasised that this model is not a realistic description of the real
world; instead, it is a normative standard against which the performance of real-world markets can be
judged. Against this backdrop, Section 2.4 of Chapter 2 introduced the notion of market failure, that is, the
inability of real-world markets to achieve the efficient outcomes of the benchmark model.
This chapter provides more detailed discussions of two important sources of market failure, namely
public goods and externalities. These two types of market failures reflect the incompleteness of many real-
world markets. On their own, free markets cannot meet the demand for pure public goods or fully account
for the external costs and benefits associated with individual actions. Hence, these market failures provide
a rationale for complementary government actions to improve the allocation of resources. In addition to
theoretical perspectives on public goods and externalities, this chapter also outlines policy implications and
options. These include the regional and global dimensions of some public goods and the international
spillover effects of some externalities.
distinguish between private, public, mixed and merit goods
use supply and demand analysis to derive the conditions for the optimal allocation of private and public goods
explain why competitive markets fail to provide public and mixed goods efficiently
explain the distinction between the financing and the production of public goods and services
explain the concept of an externality
identify the main types of externalities
use supply and demand analysis to explain the effects of positive and negative externalities
discuss policy options to correct for externalities
discuss cap-and-trade programmes
provide examples and discuss the policy implications of global or regional public goods.
3.1 Private goods and the benchmark model

Chapter 2 gave no information about the goods produced and consumed in the benchmark model. It simply
labelled these goods ‘X ’ and ‘Y ’ and proceeded to derive the conditions under which they would be
produced and consumed in a Pareto-efficient manner. We now have to consider the question whether the
nature of X and Y has any bearing on the outcome of that analysis. Can we substitute any actual commodity
or service for X and Y, and still achieve allocative efficiency? As suggested in Section 2.4 of Chapter 2, the
answer to this question is ‘no.’ Competitive markets cannot supply all commodities and services
efficiently.
The requirement for efficient production under competitive conditions is that consumers reveal their
preferences (or demand) for goods and services. By doing so, they signal to producers what types and
quantities of goods they prefer. Producers use these signals to decide what and how much to produce.
Furthermore, competition among producers ensures that they produce at minimum cost. Provided that
consumer preferences are revealed fully, the market performs like a huge auction that achieves the third or
top-level condition for allocative efficiency: simultaneous achievement of equilibrium by producers and
consumers (see Chapter 2, Section 2.2, for a discussion of allocative efficiency).
Conversely, competitive markets will fail if there are no satisfactory mechanisms by means of which
consumers can reveal their preferences. Whether mechanisms of this nature exist depends on the nature or
characteristics of goods and services. They certainly exist in the case of private goods, which have the
following two characteristics:
• Rivalry in consumption: Private goods are wholly divisible among individuals.This means that one
person’s consumption of the good reduces its availability to other potential consumers. For example, if
Thandi wears a particular dress, it is not possible for Christine to wear it simultaneously. Similarly, the
consumption of an apple by Christine reduces the quantity of apples Thandi can consume by one.
• Excludability: The consumption of a private good can be restricted to particular persons, typically those
who pay the indicated or negotiated price. Once private goods have been paid for, ownership (or the
assignment of property rights) is certain and uniquely determined. For example, if Thabo pays for a
drink in a restaurant, he gains the sole right to consume that drink and has legally excluded Charles
from enjoying it.
Hence, the benefits of consuming private goods are restricted to individuals who reveal their preferences for
these goods. The rivalry and excludability of private goods force potential consumers to reveal their
preferences, which sets in motion the competitive processes that result in allocative efficiency.
Figure 3.1, which depicts the market for takeaway coffees, illustrates these points. DB and DJ are the
individual demand curves for the two consumers, Bongani and Joan (recall from Box 2.1 that the basic
benchmark model has only two individuals and two goods). Each demand curve depicts the quantities of
takeaway coffees that the respective consumer would demand at different prices. The market demand curve
– given by DB + J – is simply the horizontal sum of the individual quantities demanded at each price. Market
equilibrium occurs at point E, where market demand equals market supply. This equilibrium yields a single
equilibrium price at point P. Joan and Bongani cannot affect the equilibrium price they pay for takeaway
coffees and are therefore price-takers. The equilibrium output of takeaway coffees is 0Q, with the
quantities demanded by Joan and Bongani given by 0J and 0B respectively. Although 0J and 0B add up to
0Q, the quantities demanded by the two persons are not necessarily equal. The respective quantities
demanded at the equilibrium price may differ depending on the tastes, incomes and other characteristics of
the two consumers. Hence, they are quantity-adjusters, in the sense that each one determines the quantity
that he or she demands, given the equilibrium price.
Figure 3.1 Equilibrium of a private good

The takeaway coffee example highlights two important characteristics of private goods:
• Marginal utility equals marginal cost for each consumer. Recall that the area underneath the demand curve
gives the total utility derived from the consumption of takeaway coffees (that is, the sum of the
marginal utilities derived from the consumption of each takeaway coffee), while the area under the
supply curve gives the sum of the marginal costs of producing each takeaway coffee. Therefore, at the
equilibrium price 0P, the marginal utilities of Bongani and Joan (BF and JG respectively) both equal
the marginal cost QE. This is the condition for the efficient supply of a private good.
• The price of a private good equals its marginal cost. As is evident from Figure 3.1, this is the efficient
pricing rule for private goods.
3.2 Pure public goods: Definition

The fact that private goods have two defining characteristics implies that there are three classes of ‘non-
private’ goods. Two of these (namely non-rival, excludable goods and rival, non-excludable goods) are
known as mixed goods. Section 3.5 focuses on such goods. The remainder of this section discusses goods
that exhibit neither of the two characteristics of private goods (in other words, goods that are neither rival
nor excludable). Such goods are called pure public goods or pure social goods.
Pure public goods such as street lighting and national defence are indivisible – that is, they cannot be
divided into saleable units – and are therefore non-rival in consumption. For a given level of production of
a public good, one person’s consumption does not reduce the quantity available for consumption by
another person.1
If Thandi uses a street light to guide her during her walk to a postbox, Roger can use that same street
light to establish whether he has found the street in which a distant relative of his lives. Similarly, the
protection provided by the national defence force to the inhabitants of one city does not reduce the
‘quantity’ of protection available to the inhabitants of other cities or towns.
Non-rivalry in consumption has two important implications. Firstly, the fact that one person’s
consumption does not reduce the quantity available to other consumers implies that the marginal cost (in
other words, the cost of admitting an additional user) is zero. The second implication follows from the first:
it would be Pareto-inefficient to exclude anyone from consuming a non-rival good, even if it was feasible
to do so. The reason is straightforward: allowing Ibrahim to use the street light referred to earlier will
clearly make him better off than before, but will not detract from the utility that Thandi and Roger derive
from that same street light. Section 3.3 returns to these implications.
Apart from being non-rival in consumption, pure public goods are also non-excludable, that is, it is
impossible to exclude persons from consuming these goods.2 Put differently, it is not possible to assign
specific property rights to public goods or to enforce them. Again consider national defence and street
lighting as examples. The inhabitants of one province in a country cannot be excluded from protective
services provided by the SANDF (South African National Defence Force). Neither can anyone strolling
along a seafront promenade be excluded from sharing in the benefits of street lights.
The two criteria for pure public good status are quite stringent. In practice, it would seem that there are
very few goods that qualify as pure public goods. For example, the protection offered by an army becomes
less effective as more people or larger areas have to be protected. Hence, it is debatable whether national
defence is fully non-rival at all levels of provision.
Similarly, very few goods are non-excludable in the true or ‘technical’ sense of the term. New
technologies are constantly expanding the scope for applying the exclusion principle to more goods.
Consider lighthouses, which used to be one of economists’ favourite examples of non-excludable public
goods. However, the service offered by a lighthouse is navigational assistance, rather than a mere beam of
light. Nowadays, it is technologically feasible and cost-effective to provide this service in the form of an
electronic signal made available only to those willing to pay for it.
Non-excludability on cost grounds is perhaps more common. It would clearly be very costly to place
police officers at all street lights and expect them to chase away all those who are unwilling to pay for the
benefits received. It is possible, however, that technologies may yet be developed that make such exclusion
viable in financial terms.
Much like the model of perfect competition, the pure public good case is an important analytical
benchmark despite its limited applicability to real-life situations. In the context of this chapter, it serves as
a useful introduction to the sections that follow.
3.3 The market for public goods

This section focuses on the market for pure public goods from a partial equilibrium perspective. More
specifically, it analyses the public good equivalent of the private good case discussed in Section 3.1. The
implications of the divergent characteristics of public and private goods will become apparent when the
results depicted in Figure 3.2 are compared with those shown in Figure 3.1.
Figure 3.2 Equilibrium of a pure public good

Assume that Bongani and Joan live in the same apartment block. Figure 3.2 depicts the market for street
lights in Joan and Bongani’s street. Also assume that they are the only ‘consumers’ of the light. Curves DJ
and DB in the figure give their respective demands for street lighting. Note that these are so-called ‘pseudo
demand curves’ because they can be drawn only if consumers accurately reveal the quantities that they
demand at different prices. As was indicated in Section 3.1, however, revelation of preferences occurs only
with private goods. This point and its implications are discussed further below, but assume for the moment
that Bongani and Joan do reveal their preferences for street lighting accurately. Given this assumption, the
individual demand curves and the total supply curve S are drawn similar to those in Figure 3.1.
The fundamental difference between the public and private good cases is the manner of deriving the
market demand curve. In Figure 3.1, the market demand for takeaway coffees was derived by adding the
demand curves of Joan and Bongani horizontally. Yet, in the case of a public good, which is indivisible,
horizontal summation of the quantities demanded by each consumer at each price is clearly inappropriate.
The non-excludability of street lighting implies that the full quantity supplied is available to both Bongani
and Joan. This implies that the consumers of pure public goods are quantity-takers. Hence, the market
demand for a pure public good (D ) is derived by adding the demand schedules vertically. In effect, this
B+J
means adding the marginal utilities they derive from different quantities of street lighting (or, put
differently, the prices they are willing to pay for it), not the quantities they demand at different prices.
The equilibrium position is defined in the usual manner at the point of intersection between the market
demand curve and the total supply curve. This occurs at point E. The equilibrium output 0Q is available to
both consumers. Price 0PB + J represents the total amount that the two consumers together would be willing
to pay for the equilibrium quantity of street lighting, 0Q. In the example of Figure 3.2, Bongani is willing
to pay a price or equivalent tax of 0PB (which equals his marginal utility), while Joan is willing to pay a
price or tax of 0PJ (which equals her marginal utility). Hence, Bongani and Joan are price-adjusters who
can adjust their willingness to pay for street lighting.
Lindahl (1958) developed a similar model in which each user paid a different price per unit of the
public good based on his or her tax share (or Lindahl price). Through an auctioneer-driven competitive
process, equilibrium is achieved when all users agree to their respective tax shares and the associated
quantity of the public good, for example, 0PB, 0PJ and 0Q in Figure 3.2.
The rules for the efficient allocation and pricing of public goods also differ from those for private
goods. Keep in mind that the areas under the demand and supply curves in Figure 3.2 show the sum of
marginal utilities and the sum of the marginal costs respectively. The equilibrium position implies that the
condition for the efficient provision of a public good is equality between the marginal cost and the sum of
the marginal utilities of the individual consumers. This condition makes it possible to derive the efficient
pricing rule for public goods: the sum of the individual prices should equal the marginal cost. If good X in
the two-sector model of Chapter 2 is the public good, then the equilibrium for sector X can be stated as
follows:
where the two terms on the right represent the marginal utilities that Bongani and Joan derive from
consuming good X.
The other conditions for a general equilibrium remain the same as shown in Chapter 2. It is important,
however, to reiterate that the equilibrium shown in Figure 3.2 is basically a ‘pseudo’ one, because real-
world consumers of pure public goods will not reveal their true preferences.
Table 3.1 summarises the discussion so far by contrasting key characteristics of public and private
goods.
Table 3.1 A comparison of key characteristics of public and private goods
Public goods Private goods
Property rights Non-excludable Excludable
Consumption Non-rival Rival
Vertical addition of
Aggregate demand curve Horizontal addition of individual demand curves
individual demand curves
The sum of marginal

Partial equilibrium condition utilities equals marginal Marginal utility of each consumer equals marginal cost
for optimum provision cost (MUi = MC, with i the individual consumer)
(∑MUi = MC)
The sum of individual prices

Efficient pricing rule equals marginal cost Price equals marginal cost (P = MC)
(∑P = MC)
Source: Adapted from Freeman, A.M. 1983. Intermediate microeconomic analysis. New York: Harper, p. 482.
3.4 Who should supply public goods?
Why do private markets fail to supply goods and services characterised by non-rivalry and non-
excludability? Section 3.2 already touched on the effects of non-rivalry when it stated that the marginal cost
of admitting additional users of non-rival goods is zero. Hence, the condition for efficient pricing by
competitive markets (P = MC) requires the price to be zero as well. It is clear that profit-maximising
producers cannot apply the efficient pricing rule to non-rival goods, because they would be unable to cover
the costs of providing the good or service if they charge a price of zero.
In principle, the alternative of setting a cost-covering price equal to the sum of the individual prices
would enable a competitive market to supply the good. However, such provision would be inefficient. Any
price other than zero exceeds the zero marginal cost of admitting additional users of a non-rival good and
consequently reduces its consumption. Such exclusion is Pareto-inefficient, because doing away with it
would increase the welfare of previously excluded consumers without reducing the welfare of those who
already enjoy access to the good. In summary, it is impossible to determine an equilibrium market price for
a non-rival good.
The non-excludability characteristic of public goods and services creates incentives for ‘free-riding,’
that is, misrepresentation or full-scale hiding of preferences by consumers who believe that it may be
possible to enjoy the benefits of the good without having to pay for it. Recall the example of street lighting.
Being rational individuals, Bongani and Joan know that they cannot be excluded from enjoying the benefits
once street lighting is provided. Hence, both of them have an incentive to understate the intensity of their
preferences for street lighting in the hope that the other will reveal his or her demand and pay for the
service. If they respond to this incentive, they become free riders. If Bongani reveals his preference for
street lights while Joan attempts to ‘free ride,’ a competitive market will undersupply street lighting at the
level where Bongani’s marginal utility equals the marginal cost of provision; this is represented by point B
in Figure 3.2. In the extreme case where both Joan and Bongani attempt to ‘free ride,’ no street lighting
would be provided at all: their true preferences would then not be revealed. Box 3.1 discusses experimental
evidence about the extent of free-riding.
Box 3.1 Do people ‘free ride’? Experimental evidence
The notion of free-riding has recently been brought into question. Economists have conducted several experiments
among students to test one of the basic tenets of neoclassical economics, namely the ‘selfishness axiom’ or, in the
present context, the temptation to free ride (see Kagel & Roth, 1995). In the so-called public goods game (PGG), for
example, the experimenter gives each participant or player an initial endowment – not known to others – in the form
of real money or a token that may or may not differ in value. Each player is then asked to make an unspecified and
entirely voluntary contribution to a public fund to be used to the benefit of all. The players also know that once all
contributions have been made, the experimenter will augment the public fund (for example, by 50%), and then share
it out equally among all of the players.
The dominant strategy in this game would be free-riding (that is, zero contributions to the public fund). Yet the vast
majority of PGG players actually contribute, on average, between 40 and 60% of their endowments. Although
responses tend to vary markedly and some players contribute nothing, free-riding is definitely not a dominant
strategy. In an experiment among secondary school learners in Cape Town with a highly unequal distribution of
endowments, Hofmeyr, Burns and Visser (2007) found that low and high endowment players contribute roughly the
same fraction of their endowments to the public fund. This result emerged after ten rounds of the game, during which
time players could adjust their contributions to what they considered to be a ‘fair share’. This and most other studies
show that reciprocity and a sense of fairness do feature in the utility functions of individuals.
Government provision of public goods and services can improve on the inefficient outcomes of the market.
However, it cannot ensure an optimal provision of public goods. Compared to the market, the government
has the advantage of coercive powers that can be used to enforce payment for public goods. Yet the
government is no more able than the market to get consumers to reveal their demand for these goods.
Hence, it cannot determine efficient prices either. Figure 3.2 can be used to illustrate these points. Assume
the government wishes to apply the efficient pricing rule for public goods, P = MC. To do so, however, it
would have to know the demand curves of the two consumers so that it can charge each consumer a price
that is equivalent to his or her marginal valuation of the benefits of street lighting. In this case, the
government would have to charge Bongani 0PB and Joan 0PJ to recover the full marginal cost (0PB + J) of
providing street lighting (0Q). Optimal provision of a public good thus requires the application of price
discrimination, that is, the practice of charging different consumers different prices.
In practice, however, the government does not have the required knowledge about the preferences of
individuals to enable it to apply perfect price discrimination. This is the reason why governments typically
cover the costs of supplying public goods by collecting a ‘tax price’ from consumers. The mandatory
nature of tax payments eliminates the ‘free rider’ option and gives taxpayers a direct stake in revealing
their preferences for public goods. Once Bongani and Joan have been forced to surrender a part of their
hard-earned salaries to the government, they clearly have an incentive to participate in decisions on the use
of their tax contributions, for example, by insisting on proper funding of the defence force or the provision
of street lighting in their neighbourhood. As will be pointed out more fully in Chapter 6, such participation
could take the form of voting in a referendum on tax and expenditure measures or voting for political
parties in democratic elections.
The actual production of public goods need not necessarily be undertaken by government – it could be
on a contract basis by the private sector. It follows that the critical difference between public and private
goods lies in the financing of these goods. When mention is made of public goods, it essentially refers to
the need for public or collective financing (as opposed to private financing via the private financial sector).
It might even be argued that all public goods could be produced by the private sector as long as the public
sector undertakes the financing. Many economists would argue that such a system would be more efficient
than one in which the government, which is not subject to the profit and loss discipline of the market,
produces public goods.
There are many examples of goods and services that are produced by the private sector but financed by
the public sector: school textbooks, medicines, roads, dams and the like. In addition, governments often use
private goods and services to meet public demands, with the labour of public sector employees being the
only significant value that is added in the ‘production processes’. Examples include the equipment used by
the military to produce national defence systems, the equipment and buildings used by diplomats in
overseas embassies, and the electronic equipment used by administrators in the public sector. It is clear that
a substantial part of government activity is in a sense already ‘privatised.’ The much-debated issue of
further privatisation largely involves the service component and the very important financing issue.
To be sure, government financing presents problems of its own. Other chapters of this book will discuss
some of the efficiency implications of using taxes and debt to finance government spending.
3.5 Mixed and merit goods

As the name suggests, mixed goods possess characteristics of both private and public goods. These goods
and services are common in the real world and raise several vital questions about the economic role of
government. Two classes of mixed goods and services can be distinguished.
• Non-rival, excludable mixed goods and services. Consider a highway running through a remote rural area
(for example, the part of the N10 highway between Britstown and Prieska in the Northern Cape
province in South Africa). The exclusion principle can be applied by installing a toll gate, as has
already been done on the N1 highway between Johannesburg and Bloemfontein and the N3 highway
between Johannesburg and Durban. On an average day, however, access to the N10 is non-rival as
users do not compete for road space. The public good characteristic of non-rivalry in access prevents
competitive markets from providing roads of this nature efficiently. As discussed in the case of pure
public goods, the problem is the impossibility of determining a competitive price. The competitive
solution of setting the price equal to marginal cost is inappropriate since the marginal cost of access to
the road is zero, while charging a cost-covering price will cause Pareto-inefficient exclusion. This class
of mixed goods is also known as ‘club goods’: as is the case with sports and other clubs, the benefits
associated with their use tend to be non-rival up to a point. As the number of users grows, however,
congestion eventually sets in and consumption becomes rival. Other examples are private parks, Wi-Fi
networks and subscription television channels.
• Rival, non-excludable mixed goods and services. On weekdays, main thoroughfares in the downtown
areas of large cities in Southern Africa are good examples of the class of mixed goods characterised by
rivalry in consumption and non-excludability. Rivalry in the form of competition for the scarce road
space is fierce and the marginal cost of road usage increases as congestion increases. In theory, it
becomes possible to determine an efficient price at the level of the marginal cost. It is very difficult to
apply the exclusion principle, though – attempts to levy toll charges at the entrances and exits to the
central business districts of Johannesburg and other large cities would cause very costly congestion
effects. In this case, market failure arises from the non-excludability characteristic of the mixed good.
This characteristic also explains why rival, non-excludable mixed goods are sometimes called
‘common pool resources’. Fish stocks in international waters and open grazing fields are also
examples of this type of mixed goods.
The excludability of mixed goods is influenced strongly by technology. As was pointed out in Section 3.2,
technological innovation has changed the status of navigational aids from a pure public good (the
lighthouse) to a non-rival but excludable mixed good (electronic information signals). In the same way,
sensors that measure traffic volumes, detect licence plate numbers and bill road users effectively change
congested urban roads from rival but non-excludable mixed goods into private goods. This technology
underpins the e-toll system to fund the Gauteng Freeway Improvement Project (GFIP) in South Africa. The
implementation of the e-toll system has been thwarted by legal challenges and widespread non-payment,
though.
It remains an open question whether mixed goods should be supplied by the public or the private sector.
In many countries in Southern Africa and further afield, mixed goods such as education and healthcare
services are provided by both sectors. Such countries have public and private hospitals, for example, and
wholly owned government schools as well as privately owned schools and training colleges. Likewise,
universities in most countries obtain revenue from government in the form of subsidies, but also charge
students registration and tuition fees. This split can be viewed as an attempt to share the costs of university
education in accordance with its public and private good components.
Various market-failure-related considerations affect the extent to which governments become involved
in the provision of mixed goods. For one thing, persons who buy or receive non-excludable mixed goods
such as education and healthcare services often confer external benefits on others. Markets underprovide
and underprice goods and services that confer positive externalities, and one of the arguments for public
provision of mixed goods and services is that it can overcome such market failures. Section 3.6 discusses
this issue in more detail. A second consideration affects infrastructure services that are excludable and
exhibit non-rivalry in consumption until congestion sets in (such as rail transport and electricity supply).
Only one firm can operate efficiently in markets for such services. Hence, public provision can be justified
as a means to prevent the allocative and X-inefficiency associated with supply by monopoly firms. Chapter
4 returns to this issue. Section 3.6 and Chapter 4 will show that public provision is not the only option for
addressing these two types of market failure, though.
In the case of some mixed and even private goods, it is possible to apply the exclusion principle, but the
goods in question are regarded as so meritorious that they are often provided via the national budget.
Examples of these merit goods are education and healthcare services. Similar considerations underpin
certain regulations, such as laws that make schooling and the use of seatbelts in cars mandatory and ones
that prohibit harmful practices (for example, comprehensive bans on smoking or on the use of certain
drugs). Merit good arguments for regulations often reflect the belief that individuals are unable to act in
their own best interest. There is an undeniable element of paternalism to such arguments that makes them
quite controversial, particularly among those who fear that special interest groups would attempt to use the
government to further their own views of how people should behave.
3.6
Externalities
Externalities, or external effects, can be positive or negative. Positive externalities occur when the actions
of a producer or consumer confer a benefit on another party free of charge. In the same way, negative
externalities occur when such actions impose a cost on the other party for which he or she is not
compensated. External effects can be technological or pecuniary in nature. Technological externalities
occur when external effects directly affect the level of production or consumption of the other party. By
contrast, external effects that change the demand and supply conditions, and hence the market prices facing
the other party, are known as pecuniary externalities. In both cases the beneficiaries get windfalls by not
having to pay for benefits, while the prejudiced parties get no compensation at all.
It can be argued that pecuniary externalities do not have net effects on society. The gist of this argument
is that such external effects merely transfer resources from one owner to another, and that markets adjust
efficiently to the changes in demand and supply conditions. Consider an area in which crime is becoming
rampant and house prices are falling rapidly. Current owners and sellers will be disadvantaged, but buyers
will have the benefit of lower house prices. There is therefore little or no net loss to society, only a
redistribution from one group to another. Nonetheless, it remains true that house buyers enjoy a windfall
while house sellers – the losers – get no compensation.
External effects drive wedges between the private (or monetary) costs and benefits and the social costs
and benefits of everyday market transactions. The social costs of a transaction are simply the sum of the
private costs and the external costs; likewise, the social benefits are the sum of the private benefits and the
external benefits. The section that follows focuses on the respective marginal equivalents.
Externalities can originate on the supply side or the demand side of the market. It is possible to
distinguish between four broad categories.
The productive activities of a producer can have one of the following effects on the supply side of a
market:
• A negative external effect on other producers or consumers, in which case the marginal external cost
(MEC) > 0 and the marginal social cost (MSC) > the marginal private cost (MPC)
• A positive external effect, in which case MEC , 0 and MPC > MSC.
Likewise, the consumption activities of a consumer can have one of the following effects on the demand
side of a market:
• A positive external effect on other consumers or producers, in which case the marginal external benefit
(MEB) > 0 and the marginal social benefit (MSB) > the marginal private benefit (MPB)
• A negative external effect, in which case MEB , 0 and MPB > MSB.
Demand and supply curves can be used to analyse the effects of externalities and the scope for remedial
government intervention. While each of the four types of externalities can be analysed in this way, this
chapter focuses on two cases: a negative production externality and a positive consumption externality.
3.6.1 Negative production externality

Assume that a coal-fired power station pollutes the air and the water used by nearby livestock and crop
farmers. This example of a negative production externality can be analysed with the aid of Figure 3.3.
The diagram shows the normal private demand curve (DP 5 MSB) and the private supply or marginal
cost curve (SP 5 MPC) for the electricity generated by the power station. Recall that these curves represent
the consumers’ benefits from using electricity and the supplier’s cost of providing it, respectively. In a
typical market situation, equilibrium would occur at point E0, with 0Q0 electricity supplied at a unit price of
0P0.
From the perspective of the community as a whole, the costs incurred by the supplier do not reflect the
full cost of providing the electricity. The external costs of pollution to nearby farmers are ignored, yet they
are in fact part and parcel of the full or social cost of providing electricity. The ‘social’ supply curve
labelled SS = MSC in Figure 3.3 reflects these external costs. This curve shows that the negative
externality raises the social costs of providing electricity above the private costs of the supplier. By
producing 0Q0 units of electricity, the supplier incurs a marginal private cost equal to Q0E0 and a marginal
external cost of E0F, which together make up the marginal social cost of Q0F. At the private equilibrium
point E0, total private costs equal 0Q0E0K and total external costs are KE0F.
If the externalities were taken into account, the ‘social’ equilibrium would be at point E1, where social
supply (or MSC) equals demand (assumed to equal MSB). At point E1, only 0Q1 units of electricity are
supplied at a unit price of 0P1.
Two points are worth emphasising here. Firstly, 0Q1 represents a lower quantity of output than 0Q0,
whereas P1 is a higher price than P0. Thus, from a social point of view, the presence of a negative
production externality in a competitive market causes inefficiency in the form of overprovision and
underpricing of the good in question. Secondly, the movement from point E0 to point E1 did not eliminate
the externality. It merely reduced it from KE0F to its optimal level, KJE1. The latter is an optimal level
because the farming community is prepared to accept this negative externality from electricity generation
in exchange for the value that it adds to their personal comfort and farming activities.The opposite case of
a positive production externality implies the presence of negative external costs, that is, a situation in
which the social supply curve (MSC) lies below and to the right of the private supply curve (MPC). A good
example is the classic case of a bee farmer’s bees pollinating the apple blossoms on an adjacent farm.
Figure 3.3 External cost and Pigouvian tax
3.6.2 Positive consumption externality

The market for education provides an example of a positive consumption externality. In Figure 3.4, the
curve S represents the social supply of educational services, that is, the marginal social cost of providing
education. Curve DP depicts the private demand for education, which reflects marginal private benefits in
the form of skills accumulation, expected higher earnings and the sheer enjoyment to be had from being
more knowledgeable. The market equilibrium occurs at point E0, with 0Q0 education being supplied at a
‘unit price’ of 0P0.
In this case, the externality originates on the demand or consumption side of the market. The benefits of
education are not restricted to the individual recipient. Society as a whole also derives considerable
benefits from the effects of education. The educated individual may, for example, disseminate valuable
information to other producers and consumers free of charge, thus enabling them to become more
productive or happier citizens. Higher education levels also go hand in hand with lower birth rates and
lower crime rates, which relieve the pressure on government, and hence on taxpayers, to provide additional
healthcare facilities and policing. Hence, the marginal social benefits from additional education exceed the
marginal private benefits.3 This is shown in Figure 3.4 by the social demand or MSB curve DS, which lies
to the right of and above curve DP.
Figure 3.4 External benefit and Pigouvian subsidy
The equilibrium position thus moves from point E0 to point E1 when the external benefits from
education are taken into account. This movement raises the price from 0P0 to 0H and increases the quantity
from 0Q0 to 0Q1. Competitive markets clearly underprovide and underprice goods and services with
external benefits.
The opposite case of a negative consumption externality implies the existence of negative external
benefits, with the social demand curve (MSB) lying below and to the left of the private demand curve
(MPB). For example, someone who plays hard rock music at high volume into the early hours of the
morning would impose a negative externality on a next-door neighbour who prefers classical music.
3.6.3 Concluding note

External effects – whether negative or positive – on individual consumers and producers are common.
Some externalities even affect the natural environment via their effects on biodiversity. Air and water
pollution and the provision of education are textbook cases because of their undeniable importance. But
there are many other examples, including the external costs associated with the consumption of tobacco
products and alcoholic beverages. Box 3.2 gives a summary of the estimated size and composition of
alcohol-related externalities.
Box 3.2 Size and composition of alcohol externality
Alcohol consumption by private individuals can impose various external costs on society at large. These costs are
usually divided into three broad categories. The first type of cost refers to ‘direct’ expenditures on policing,
healthcare and repairs to deal with consequences of alcohol abuse such as fatal and non-fatal traffic accidents,
person-to-person assault, damage to property and ‘avoidable’ illnesses (for example, liver and cardiovascular
disease). The second category refers to ‘indirect’ labour and productivity costs, which result from output losses
caused by alcohol-related premature deaths, injuries, illness and workplace absenteeism. It is customary to refer to
the two cost categories of direct and indirect costs as financial tangible costs, because they can be measured in
monetary terms if the requisite data are available.
The third category is non-financial intangible welfare costs. These costs include emotional pain, depression and
feelings of regret that come about as a result of alcohol-related harm. These non-financial costs can be estimated
even though they do not have a monetary value. This can be done by finding out, through appropriate surveys, how
much the affected individuals and institutions would be prepared to pay to avoid these costs.
Many attempts have been made to estimate the first two cost categories mentioned above. In a recent overview of
international studies, the weighted average tangible external cost of alcohol consumption was found to be 1,58% of
GDP per year, with individual estimates ranging between 1% and 2% of GDP (Mohapatra, Patra, Papova, Duhig &
Rohm, 2010).
Similarly, Parry (2009) estimated the tangible external cost of alcohol consumption in South Africa at 1,5% of
GDP. There have been very few attempts to estimate the intangible costs of alcohol abuse, but a recent study
estimated that intangible costs in the EU came to more than double the tangible costs (Anderson & Baumberg, 2006).
If this was true of other countries, including South Africa, the total size of the alcohol externality may be as high as
3% of GDP.
3.7 Possible solutions to the externality problem

What can governments do about the allocative inefficiencies caused by externalities? Several policy
interventions exist, including Pigouvian taxes and subsidies, direct government regulation, the creation of
regulated markets, support of alternative markets, and the establishment of appropriate property rights.
3.7.1 Pigouvian taxes and subsidies

One possible solution involves the introduction of Pigouvian taxes and subsidies, named after the famous
British economist A.C. Pigou. The aim of such taxes and subsidies is to internalise externalities, that is, to
force parties to include the external effects of their actions in their own cost and benefit calculations.4
The effect of a Pigouvian tax can be explained by revisiting the negative production externality illustrated
in Figure 3.3. Recall that a negative production externality leads to an overprovision and underpricing of
the good in question. By levying a Pigouvian tax on the party whose actions cause the externality, the
government can increase the producer’s marginal private cost to the level of the marginal social cost. In the
case of air and water pollution caused by the generation of electricity, this would be achieved by levying an
ad valorem tax on the price charged by the coal-fired power station, that is, a percentage tax equal to the
value of the externality. In unit terms, the tax would equal E0F at price Q0F (5 0G) and JE1 at price Q1E1 (5
0P1). Hence, it would shift the private supply curve SP to SS 5 MSC. However, since supply exceeds
demand at point F, the new equilibrium will be at point E1, where MSC equals MSB. To be efficient, this
tax must equal the marginal external cost measured at the new social equilibrium. At Q1, the marginal
external cost is the vertical difference between MPC and MSC, in other words, JE1. At point E1, the tax per
unit of output is JE1 and the (internalised) externality equals KJE1, which is its optimal size. The net effect
of the policy is that a large portion of the original externality – given by the area JE0FE1 – has been
eliminated.
Instead of levying a Pigouvian tax on each unit of output, it could be levied on each unit of the
externality itself. This is commonly known as an emission fee or a congestion tax. If a unit tax of this
nature exceeded the unit cost of reducing the polluted emissions, the polluting firm could reduce output or
it could use pollution-free inputs and new technologies in order to reduce its emissions. It would do so until
the marginal cost of these reductions equalled the unit tax. Cities like Singapore and London have been
imposing congestion taxes on vehicles entering highly congested urban areas, especially during rush hours,
for a number of years.5
Likewise, Figure 3.4 can be revisited to illustrate the use of a Pigouvian subsidy to correct a positive
consumption externality. If the government subsidises education by E0F (or GE1) per unit, again on an ad
valorem basis, it will bring the marginal private benefit in line with the marginal social benefit by shifting
private demand DP to DS 5 MSB. At point F, the price inclusive of the subsidy is high enough to induce a
positive supply response. At the new equilibrium point E1, where the marginal social benefit equals
marginal social cost, the price paid by consumers will be Q1G (50P1), the subsidy per unit will be GE1 (5
P1H) and the supplier will receive Q1E1 (5 0H). The subsidy must equal the marginal external benefit at the
optimal output level Q1 to produce the optimal result. The final equilibrium represents a more efficient
outcome in which more educational services are provided at a lower unit price.
Pigouvian taxes and subsidies are widely used in the real world. Nonetheless, they are subject to the
same informational constraints as most of the other regulatory options discussed below. The Pigouvian
options unrealistically assume that the authorities are perfectly informed about the size of the external
effects and, hence, about the slopes and shapes of the respective demand and supply curves. Moreover, it is
assumed that it is costless to obtain this information.
In the case of tobacco and alcohol products (the so-called ‘sin’ goods), the Pigouvian tax becomes a
crude measure in the sense that it may not in fact achieve its objective of reducing consumption and, with
it, the attendant externalities. It may even produce perverse results. This point is discussed further in Box
3.3, and in chapters 12 and 13.
Box 3.3 Perverse effects of Pigouvian taxes
It is generally accepted that consumption of tobacco and alcohol products – the perennial ‘sin’ goods – inflicts huge
externalities on the broader community. Tobacco smoking is a major cause of heart and lung-related illnesses that
require expensive medical treatment, mostly paid for by the tax-paying public. The South African government, in
line with many other countries, has therefore introduced a range of control measures aimed at reducing tobacco
smoking and the attendant externalities. The most important of these measures are excise tax hikes. These are
supplemented by stipulations of the Tobacco Products Control Amendment Act of 1999, including the prohibition of
smoking at work and other public places; comprehensive bans on tobacco advertising, promotion and sponsorships;
and restrictions on the tar and nicotine content of tobacco products.
One of the unintended effects of tax hikes on tobacco products is an increase in smuggling or the substitution of
illicit and cheaper products, often imported, for the legally taxed local equivalents. This has happened in Canada, the
United States, England, Belgium and many other countries. Tobacco smuggling has a long history in South Africa,
owing partly to the size and extent of informal trading networks within the country, and also because cheaper
substitutes are readily available in neighbouring countries. It is estimated that the illicit (and unrecorded) market
comprises between 40 and 50% of the total tobacco market in South Africa (Lemboe, 2010).
The potentially perverse nature of the problem is straightforward. To the extent that tax hikes do boost smuggling
activity, the government may in fact fail to achieve its objective of reducing tobacco consumption. International
evidence also shows that smuggled cigarettes are typically of a lower quality than their legal counterparts, thus
potentially resulting in a larger negative externality per cigarette than before the tax hike. Hence, the net effect of the
tax hike may be an increase in the overall size of the externality rather than a reduction.
A similar substitution effect also applies to tax hikes on alcohol consumption. Official figures usually fail to
capture a significant portion of the alcohol market. This unrecorded market comprises trading in privately produced
and imported alcoholic beverages, often at prices lower than those in the recorded market. The World Health
Organization estimates that unrecorded consumption makes up 27% of the global market in alcoholic beverages,
while it is estimated that unrecorded consumption in South Africa constitutes 26,3% of the total market (Econex,
2010). As is the case with tobacco consumption, evidence shows that home-brewed sorghum beer, which is highly
toxic and unhealthy, is being substituted on a large scale for legal alcohol in response to excise tax increases. To the
extent that this happens, the excise tax is unlikely to fulfil its mission of reducing alcohol-related harms to an
acceptable level and may even have the perverse effect of adding to it.
Tax hikes on tobacco and alcohol consumption may also have unintended adverse effects on the distribution of
income within households, especially poor households. This may happen when tax hikes raise the amount spent on
tobacco and alcohol products relative to other goods making up the household budget. Such changes in the
composition of household budgets have negative effects on non-drinking and non-smoking members of households.
The male heads of many patriarchal households are often egotistical and heavy users of tobacco and alcohol
products. These men, who control their households’ budgets, tend to maintain their consumption of such products in
the face of excise tax increases, often at the expense of other important household goods and services such as food,
healthcare and education (Black & Mohamed, 2006). In such cases, the tax hikes cause other members of households
to be worse off than before. As mentioned before, household heads may also respond to tax hikes by diverting
tobacco and alcohol spending to poor-quality substitutes that may compromise their health status. In either case, the
tax hikes may have the perverse effect of actually enlarging the negative externalities experienced within households
and in communities more generally.
3.7.2 Direct regulation

The option of direct regulation is particularly relevant to cases of negative production and consumption
externalities caused by air and water pollution, sub-standard food and other consumer goods, alcohol
abuse, tobacco smoking, hard drugs, gambling and prostitution. Direct regulation includes restricting the
quantities of ‘harmful’ goods and services that are produced or consumed, and is often used as a
supplement to Pigouvian taxes.
In addition to coal-fired electricity plants, there are many industries polluting the air and water,
including oil refineries, smelters, and producers of textiles and chemicals. The direct option – also known
as command-and-control regulation – entails informing each polluting industry that it must reduce
pollution to a certain level or face legal sanction. In the example used in Figure 3.3, the power station
would be ordered to reduce its output from 0Q0 to the socially optimal level 0Q1. Proponents of this option
assume that the government is sufficiently well-informed to determine the output level 0Q1. As is the case
with Pigouvian cases, it is very difficult to get such information in real-world conditions. Furthermore,
regulation of this nature is not efficient in industries consisting of differently sized firms, since it requires
each firm to reduce its output by equal absolute amounts or proportions. Such reductions, however, may
force firms to violate the efficiency criterion of producing at the point where marginal social cost equals
marginal social benefit. The reason is that these costs and benefits may vary significantly between firms
within the same industry, so that the application of a blanket rule would result in some of them producing
too much and others producing too little.
The regulatory role of the state stretches far and wide. Most countries have bureaux of standards whose
task it is to ensure that all goods and services adhere to certain minimum standards. One of the aims of
such standards is to address an externality problem: consumption of sub-standard food may cause illnesses
that require treatment paid for by the general public, while a defective automobile may cause accidents that
could harm the owner-driver as well as other innocent persons. Similar arguments also apply to a host of
measures regulating industries such as telecommunications, tobacco products, alcoholic beverages,
gambling and prostitution.
In many of these cases, more direct or regulatory measures are superior for controlling externalities to
Pigouvian taxes (or subsidies). In the case of tobacco and alcohol consumption, for example, reference has
been made already to the need for limiting trading hours, and imposing age and space restrictions. There is
also the problem of smuggling, or the substitution of lower quality and cheaper surrogates for taxed legal
goods. It may therefore be worth allocating public resources to combating smuggling before Pigouvian
taxes are used in an attempt to reduce legal consumption. Similarly, the external costs of drunk driving
seem to constitute a significant portion of the total external costs caused by excessive alcohol consumption.
Here too, it would seem that higher penalties and more road blocks would be better means of addressing
the problem than excise tax hikes would be, provided that sufficient law enforcement capacity exists.
3.7.3 Creation of regulated markets

A third possible solution to the externality problem is an incentive-based option generally referred to as the
cap-and-trade programme. It originated in the context of the pollution problem and consists of the
creation of a market in which the government would issue or sell legal permits giving owners the right to
pollute. The first step would be for government to establish the overall quantity of pollutants that it
considers to be an efficient level – for example, the area KJE1 in Figure 3.3 – and then to issue a limited
number of individual permits to firms in polluting industries. Permit holders are free to sell their permits or
buy additional ones and will do so by comparing the price of the permit with the marginal cost of reducing
their emissions, for example, by shifting to cleaner technologies. If the permit price exceeds the marginal
cost of pollution reduction, permits will be sold and the proceeds can be used to help fund the costs
involved in reducing pollution. Those who buy permits can increase their emission of pollutants and
possibly contribute to a more concentrated distribution of a fixed total quantity of emissions. If new
technologies or other factors lower the cost of reducing pollution, however, more permits will be offered
for sale at lower prices until few or no takers remain. Given the fixed (and theoretically optimal) total
supply of permits, a declining price is a sure sign that the quantity of emissions is also decreasing.
The market-creation approach also assumes that the government possesses perfect knowledge about the
sources of pollution and the level of pollution commensurate with the efficient level of output. In fact,
some pollutants (such as the emission of sulphur dioxide from power plants) can be measured and
monitored. On balance, the evidence suggests that cap-and-trade programmes are cost-effective and
environmentally effective alternatives to command-and-control regulation. To be effective, however, such
programmes should be well designed to prevent excessive volatility in permit prices and other potential
problems.6
3.7.4 Support of alternative markets

Given the pollution problem discussed above, a case can be made for governments to support the
development of alternative energy markets that are pollution-free. The case would be similar to that made
in respect of a Pigouvian tax aimed at reducing the negative externality caused by a coal-fired power
station to its optimal level (Figure 3.3). The aim would be to encourage polluters to reduce the quantity of
coal-generated electricity by switching to these alternative sources of energy.
The alternatives to coal-generated energy include nuclear power, natural (including shoal) gas, hydro-
generated energy, solar heating and wind turbines. These all have the advantage of emitting little or no
carbon dioxide, methane and other greenhouse gases. Furthermore, all of them except for nuclear and
natural gas can be installed and developed at relatively low cost and in good time. Wind turbines, solar
panels and, to a lesser extent, shoal gas fracking, are all divisible and excludable, and can thus be viewed
as private rather than public goods.
The number of wind and solar-powered energy plants has grown very rapidly worldwide, with China’s
investment in wind energy currently exceeding its investments in fossil-fuel generation. The South African
Wind Energy Association (2019) reported that independent producers of wind power had 900 wind
turbines in operation in March 2019. These turbines had a combined installed capacity of 2 078 MW
connected to the national grid. But the problem – or rather challenge – is that there are many more
prospective suppliers of renewable energies who all need the permission of government, in the form of
highly priced licences, to start up or even expand their businesses. While licensing fees of this nature are
important, depending as they do on acceptable environmental impact studies, they also need to take into
account the urgent need to reduce greenhouse gas emissions.
3.7.5 Legal solution: Property rights

Yet another approach to solving the externality problem derives from the view that regulation as well as
Pigouvian taxes and subsidies are costly to administer and, in any case, are not likely to achieve their
purpose. The Nobel Laureate Ronald Coase argued that the divergence between marginal private cost and
marginal social cost arises as a result of insufficiently defined property rights over the use of resources.
Broadly defined, property rights represent the legal specification of who owns what goods, including the
rights and obligations attendant upon this ownership. Hence, this approach rests on the view that the
problem of externalities boils down to disputes over the ownership of resources.
Consider an example. Does the owner of a flat have the right to paint her front door a garish pink when
it not only offends her neighbour every time he passes it to reach the door of his own flat, but may also
reduce the value of his apartment? Or, returning to an earlier example, do the producers of electricity
possess the right to discharge pollutants into the atmosphere? Do farmers possess rights to unpolluted air
and water? If property rights are well-defined, they can be exchanged on a voluntary basis by means of
straightforward market transactions. If Prudence had the right to paint the outside of her front door any
colour she wished, then Bongani could offer to pay her a certain amount not to paint it pink. Likewise, if
farmers on the Mpumalanga Highveld had a right to clean air and water, nearby power stations could buy
that right from them by offering to compensate them for the damage caused. The externality problem can
thus be resolved without the need for potentially unsuccessful government intervention.
The Coase theorem holds that market incentives will generate a mutually beneficial exchange of
property rights through which externalities can be fully internalised, provided that property rights are well-
defined and enforceable, and transaction costs are negligible. Transaction costs are the costs of the
exchange process. They comprise the resources used when economic agents attempt to identify and contact
one another (identification costs), negotiate contracts (negotiation costs), and verify and enforce the terms
of contracts (enforcement costs). These transaction costs, together with the costs of enforcing property
rights, may well be lower than the costs of regulation and taxing or subsidising goods and services. In the
Coasian approach, the government’s role in respect of externalities mainly consists of the maintenance of a
judicial system to define and enforce property rights and a market system to lower transaction costs.
The Coase theorem is crucially predicated on the twin assumptions of well-defined and enforceable
property rights and zero or negligible transaction costs. As suggested above, the quality of the judicial
system largely determines the definition and enforcement of property rights. If transaction costs are non-
trivial, however, they may prevent parties from exchanging their property rights and internalising the
externality in the process. In general, the higher the transaction costs, the lower the degree of
internalisation of externalities will be and the greater the resultant divergence between marginal private
cost and marginal social cost will be. Transaction costs are bound to be high when large numbers of people
are involved, such as the many persons experiencing respiratory illnesses from inhaling the polluted air of
industrial areas. It may be too costly for them to take the necessary steps to have their right to clean air
legally enforced.
3.8 Global public and merit goods

Neighbouring countries often agree to take joint responsibility for and share the burden of providing certain
cross-border public, mixed and merit goods. These are called global or regional public and merit goods.
Agreements of this nature can apply to global or regional defence systems and cross-border road and rail
networks, or to measures aimed at addressing externality problems and other forms of market failure.
One country’s national defence system may confer benefits on neighbouring countries free of charge,
unless they enter into an agreement that forces each country to contribute pro rata to the cost of the service.
In fact there may be an important economies-of-scale argument here: providing an effective defence
system or a subsidised electricity network at minimum unit cost may require high levels of production
capable of serving several countries at the same time. It is also pointless to construct a road or railway line
that stops at the border separating two countries that trade with each other. Countries making up the
European Union (EU) all derive huge benefits from being connected by road and railway networks;
likewise, the road linking Gauteng Province in South Africa with Maputo in Mozambique clearly benefits
holiday-makers and transport companies as well as importers and exporters in both countries.
In all of these cases, it is important to know who the beneficiaries are, how they are spread across
different countries and how payment – in the form of taxes and user charges – should be divided among the
beneficiaries. This point can be illustrated by referring back to Figure 3.2 and replacing the two individuals
(Bongani and Joan) with two countries (for example, South Africa and Mozambique). The optimal price-
discriminating solution again occurs when each country pays a price equal to its marginal value of the
service, that is, PJ and PB, where the subscripts now refer to the two countries. We already know that a
pricing strategy of this nature is not a feasible solution, partly owing to a lack of knowledge about
preferences and the attendant problem of free-riding. The only alternative is a ‘tax price’ paid by each
country, presumably based on some pre-determined formula. This clearly calls for a formal bilateral
agreement or a multilateral agreement if more than two countries are involved. An agreement of this kind
would normally form part of a more broadly based regional trade agreement, such as those associated with
the Southern African Customs Union (SACU), the Southern African Development Community (SADC),
the Common Market for Eastern and Southern Africa (COMESA) and the Economic Community of West
African States (ECOWAS).
Similar arguments apply to externalities: air and water pollution may impose negative external effects
on producers and consumers in neighbouring countries. Ideally, these producers and consumers should
have a say in resolving the problem, including the task of defining property rights and determining
compensation in terms of the Coase theorem. A truly global example is the emission of carbon dioxide into
the atmosphere, which happens virtually everywhere in the world where automobiles are used and fossil
fuels are burnt. Box 3.4 shows that these emissions can give rise to dramatic climate changes in different
parts of the world, with adverse effects for producers and consumers that may put the well-being of future
generations at risk. Solving this problem evidently calls for a binding international agreement that aims to
reduce CO2 emissions on a global scale. The Kyoto Protocol and subsequent protocols were steps in that
direction.
Box 3.4 Global warming
Much of our natural energy comes from the sun in the form of shortwave radiation that warms the earth and its
inhabitants. When some of this energy is again released into the atmosphere in the form of long-wave radiation, the
result is a delicate temperature range that is life-giving and makes the earth inhabitable. The incoming short waves
are capable of penetrating man-made greenhouse gases such as carbon dioxide, ozone, methane and other industrial
gases, but the outgoing long waves are not, and are absorbed by the same greenhouse gases. If the emission of these
gases reaches and surpasses a critical level, as many commentators are claiming, the result is an enhanced
greenhouse effect that raises average global temperatures, changes precipitation levels and may give rise to extreme
weather patterns (Stowell, 2005). The earth’s atmosphere can be considered a free resource and a global public good
in the sense that it is largely non-excludable, thus benefiting either all or most inhabitants on earth or, in the case of a
greenhouse effect, harming many innocent individuals, countries and regions. Excessive carbon dioxide emissions in
one region may have negative spillover effects in many other regions (without any compensation changing hands).
Conversely, steps taken to reduce emissions in one country may benefit many others. These are examples of global
externalities that call for appropriate forms of intervention by a supranational or global institution, as discussed in the
accompanying text.
Yet another example is the so-called brain drain. When, for instance, a Namibian citizen, schooled and
trained in that country, accepts a job offer in Germany, the latter country may benefit greatly in that it
obtains human capital free of charge, but paid for by Namibian taxpayers. Such positive spillover effects
happen on a large scale in many parts of the world and can be viewed as a manifestation of an individual’s
right to choose his or her place of work. Over time, the net effect may be small for various reasons:
Namibia may also benefit from human capital created in Germany, the brain drain may be reversed when
the Namibian citizen returns home as a more experienced and productive worker or the brain drain can
contribute to the development of global networks that encourage international trade and capital flows
between the countries concerned.
A final comment refers to the earlier discussion of market failures other than ‘missing markets’. Within
a sovereign country, an appropriate competition policy authority can prevent or minimise abuse of market
power by monopoly firms. Similarly, the problem of ignorance about the harmful properties of certain
goods and services can be addressed by means of a bureau of standards through which minimum standards
can be legally enforced. Likewise, a national government can apply tax and other measures to internalise
positive or negative externalities within its geographical borders. In the case of regional and global public
goods, however, there is no single government with jurisdiction over the entire set of activities.
International cooperation in the form of agreements, treaties and different forms of integration then
becomes a requirement for addressing the ‘problem’ of public goods. One possibility is a mutual agreement
whereby the public institutions of one country are also allowed to exercise their authority in neighbouring
countries. Arguably, this will ensure that they operate more efficiently (in other words, at lower unit cost).
Due cognisance should be taken of relevant differences between the countries, however, because one size
does not necessarily fit all.
Alternatively, new regional or global institutions may be formed. For example, exogenous shocks at the
macroeconomic level usually have a similar negative contagion effect on economically integrated
countries, such as those of the SADC, and may call for a regionally coordinated approach to the conduct of
macroeconomic policy. In the case of the European Union, the extent of economic integration has actually
reached the advanced state of using a single monetary system.
Going beyond the regional dimension, many countries stand to benefit from a world that is becoming
more integrated by the day in terms of economics, culture and geopolitics. At the same time, however,
these countries are also becoming more vulnerable to a range of negative spillover effects emanating from
exogenous financial shocks, technology-driven climatic changes, ethnically driven regional conflicts,
international terrorism and a host of contagious diseases. In the absence of a world government, it is
therefore imperative that global institutions such as the International Monetary Fund (IMF), the World
Bank (WB), the World Trade Organization (WTO), the World Health Organization (WHO), the Food and
Agricultural Organization (FAO) and the United Nations (UN) take the necessary steps to eliminate or at
least minimise the incidence and extent of negative spillovers of this nature.
One of the major obstacles has been the reluctance of industrialised and high-polluting countries to
accept the need for a Coasian-type redistribution of resources (in other words, limiting their own levels of
carbon emissions while compensating poor and low-polluting countries at the same time). However, at a
UN conference involving 193 countries in Cancun in 2010, industrialised countries accepted the proposal
to reduce greenhouse gas emissions by between 25 and 40% of 1990 levels within the next ten years, while
also agreeing to create a Green Climate Fund aimed at helping developing countries to cope with the
effects of global warming.
The relevant greenhouses gases (GHGs) are carbon dioxide, methane, nitrous oxide, sulphur
hexafluoride and two groups of gases (hydrofluorocarbons and perfluorocarbons) produced by them, all of
which are measurable by known techniques. Furthermore, both the UN conference and the (latest) Kyoto
Protocol actively support the use of clean and green forms of renewable energy that can easily be replaced
and repeated. This specifically refers to the use of solar energy, wind energy, biomass energy and
geothermal energy. Finally, it is also worth noting that although nuclear power has a waste disposal
problem and is vulnerable to earthquakes, it does not pollute the air or water, while natural gas causes less
pollution than coal-fired electricity plants.
Key concepts
• cap-and-trade programme (page 56)
• club goods (page 47)
• Coase theorem (page 57)
• command-and-control regulation (page 55)
• common pool resources (page 47)
• direct regulation (page 55)
• emission fee (or congestion tax) (page 53)
• excludability (page 39)
• externalities (page 48)
• free-riding (free rider) (page 44)
• global or regional public and merit goods (page 58)
• merit goods (page 48)
• mixed goods (page 46)
• negative externality (page 49)
• non-excludable (page 41)
• non-rivalry in consumption (page 41)
• pecuniary externality (page 48)
• Pigouvian subsidy (page 53)
• Pigouvian tax (page 53)
• positive externality (page 48)
• private goods (page 39)
• property rights (page 57)
• pure public goods (page 41)
• regulatory measures (page 55)
• rivalry in consumption (page 39)
• technological externality (page 48)
• transaction costs (page 57)
SUMMARY
• This chapter discusses two important sources of market failure, namely public goods and externalities.
Both reflect the incompleteness of markets. On their own, free markets cannot meet the demand for
public goods or fully account for the external costs and benefits associated with individual actions.
Hence, these market failures provide a rationale for complementary government actions aimed at
improving the allocation of resources.
• In contrast to private goods, pure public goods such as street lighting and national defence are indivisible
– that is, they cannot be divided into saleable units – and are therefore non-rival in consumption. For a
given level of production of a public good, one person’s consumption does not reduce the quantity
available for consumption by another. This implies that the marginal cost of the good is zero.
• Public goods are also non-excludable, that is, it is impossible to exclude individuals from consuming these
goods. In contrast to private goods, this implies that the market demand for public goods is derived by
adding the individual demand schedules vertically (as opposed to horizontally). This effectively means
adding the individuals’ marginal utilities or the prices they are willing to pay for different quantities of
the good, not the quantities they demand at different prices.
• Given differences in individuals’ demand for a public good, government would ideally like to charge each
consumer a price that is equivalent to his or her marginal valuation of the benefits of the good. This
would enable the government to recover the full cost of providing the service. Hence, the optimal
provision of a public good requires the application of price discrimination, that is, the practice of
charging different consumers different prices.
• In practice, however, the government does not have the required knowledge about people’s preferences to
enable it to apply perfect price discrimination. This is the reason why governments typically recover
the costs of supplying public goods by collecting a so-called tax price from consumers.
• Mixed goods have characteristics of private goods and public goods. Examples include toll roads,
subscription television channels and healthcare services. Many mixed goods are provided by the private
sector and the public sector. Universities, for example, get their income partly from government and
partly from students in the form of registration fees. This split can be viewed as an attempt to share the
costs of university education in accordance with the public and private good aspects of the service.
• The external costs and benefits associated with individual actions are also examples of incomplete
markets. Such externalities can be positive or negative. They are positive when the actions of an
individual producer or consumer confer a benefit on another party free of charge, and negative when
those actions impose a cost on the other party for which he or she is not compensated.
• These external impacts can be of a technological or a pecuniary nature. They are technological when they
have a direct effect on the production or consumption levels of the other party, and pecuniary when
they change the demand and supply conditions, and hence the market prices, facing the other party. In
either case, however, the beneficiary gets a windfall by not having to pay for the benefit, while the
prejudiced party gets no compensation at all.
• External effects drive a wedge between the private (or monetary) costs and benefits and the social costs
and benefits associated with everyday market transactions. Marginal social cost (MSC) is simply the
sum of the corresponding marginal private cost (MPC) and the marginal external cost (MEC). In the
same way, marginal social benefit (MSB) is the sum of the corresponding marginal private benefit
(MPB) and the marginal external benefit (MEB).
• In the case of a coal-driven electricity plant polluting the air, the MSC will exceed the MPC of supplying
that electricity. This implies an oversupply and underpricing of electricity. Similarly, the MSB of
education will exceed the MPB when students share their knowledge of public economics free of
charge with ‘third’ parties. The result will be an undersupply and underpricing of education.
• One possible solution to externality problems is the use of so-called Pigouvian taxes and subsidies, by
means of which externalities can be internalised by forcing parties to include the external effects of
their actions in their cost and benefit calculations. Yet to do this effectively, governments would need
to know the size of the externality to begin with. Fiscal intervention of this nature may also have
unintended effects. Alcohol taxes discriminate against moderate drinkers, for example, and tobacco
taxes give rise to higher levels of smuggling.
• Apart from using direct measures such as licences, penalties, and age and spatial restrictions to address
pollution problems, governments could also regulate markets by adopting cap-and-trade policies
according to which it would issue legal permits that give private owners the right to pollute. These
permits would be sold if the price exceeded the marginal cost of reducing pollution. If new
technologies make the latter cheaper, more permits will be sold at lower prices until there are few or no
takers left. As before, this option requires that government knows the optimal size of pollution to begin
with.
• Another way to reduce greenhouse emissions is to support the development of alternative energies that are
pollution-free, including nuclear power, hydro-powered energy, solar heating and wind turbines.
• The externality problem can be viewed as the result of insufficiently defined property rights over the use
of resources. It can be argued that affected parties can simply exchange property rights in order to
internalise an externality, provided that property rights are well-defined and enforceable, and
transaction costs are negligible.
• Both public goods (for example, national defence) and externalities (for example, pollution) have spillover
effects on neighbouring countries and beyond. Global warming caused by carbon emissions is a prime
example. In the absence of a world government, global effects of this nature clearly require
international cooperation on a bilateral and a multilateral basis.
3.1 Which of the following are characteristics of pure public goods?
a. Consumption is non-rival.
b. Consumption is non-excludable.
c. The aggregate demand curve is obtained by horizontal addition of the individual demand curves.
d. All of the above options are correct.
3.2 Which of the following factors explain why private markets fail to supply pure public goods?
a. It is impossible to determine an equilibrium price for providing pure public goods via private
markets.
b. Private firms lack the technological know-how to provide pure public goods.
c. It is impossible to exclude those who are unwilling to pay for using pure public goods.
3.3 When you share your knowledge of public economics with a friend, you would be conferring a positive
externality if …
a. the marginal social benefit (MSB) exceeds your own marginal private benefit (MPB).
b. the marginal social benefit (MSB) equals the marginal social cost (MSC).
c. the marginal external benefit is positive.
3.4 When a pecuniary externality causes a decrease in the price of an asset being traded, …
a. the seller is made worse off.
b. the buyer secures a windfall gain.
c. there is little or no net effect on the well-being of society.
3.1 Explain the meaning of the terms ‘mixed goods’ and ‘merit goods’. Who should supply these goods?
3.2 Explain the concept of externality and distinguish between the different types of externality.
3.3 Critically discuss the cap-and-trade approach to addressing the externality problem.
3.4 Discuss the phenomenon of global or regional public goods.
ESSAY QUESTIONS
3.1 Explain the difference between a private and a pure public good. How do their respective equilibria
differ?
3.2 Explain why markets cannot supply pure public goods, and outline the implications of this reality for
the production and financing of such goods.
3.3 Should Pigouvian taxes be used to internalise the negative external effects of tobacco and alcohol
consumption?
3.4 Discuss Coase’s theorem and consider its usefulness as a means of solving the externality problem.
1 It may be somewhat misleading to use the word ‘consumption’ in the context of pure public goods. Goods of this nature are not
really consumed; instead, they generate a stream of benefits that can be enjoyed by all.
2 In his path-breaking analysis, Samuelson (1954 and 1955) defined public goods in terms of non-rivalry in consumption only. Non-
rivalry is indeed a sufficient condition for public good status, because it makes exclusion inefficient even when it is feasible.
Some textbooks follow Samuelson by defining public goods in terms of non-rivalry only, but this book follows the more
conventional approach of using non-rivalry as well as non-excludability as criteria for public good status.
3 These benefits may be subject to a form of decreasing returns. Most empirical estimates of the returns to education indicate that
the excess of the social benefit over the private benefit decreases as education becomes more advanced (Todaro & Smith, 2015:
388–391).
4 Internalisation of externalities could also be viewed as a means of conferring property rights on the individuals involved in order to
account for the divergence between private and social costs and benefits. See Section 3.7.5.
5 For a discussion of congestion charges in these cities, see Santos (2005).
6 For a recent discussion of the effectiveness of cap-and-trade programmes, see Schmalensee and Stavins (2017).
Allocative efficiency, imperfect competition and
regulation
Philip Black and Estian Calitz
Chapter 2 identifies a number of market failures that establish a rationale for government intervention to
promote allocative efficiency, equity and macroeconomic stability. These include imperfect competition,
which is called ‘non-competitive markets’ in Section 2.4.4. The most common manifestation of imperfect
competition is market domination by monopolies and oligopolies. This chapter outlines the economic
effects of monopolies and discusses policy interventions to rectify one manifestation of this phenomenon,
namely electricity supply.
It is customary to distinguish between statutory monopolies and natural monopolies. A statutory
monopoly (also known as an ‘artificial monopoly’) operates in a market where competition is technically
feasible, but prevented by legal restrictions imposed by the government or a professional body or by entry-
limiting behaviour on the part of the incumbent firm itself (for example, exerting control over critical
suppliers or temporarily setting price below its profit-maximising level). By contrast, a natural monopoly
operates in a market where technical factors prevent competition. While this chapter focuses on natural
monopolies, the discussion of general effects of imperfect competition in Section 4.1 also refers to statutory
monopolies.
The chapter consists of five sections. Section 4.1 highlights the social costs of imperfect competition by
contrasting outcomes under perfectly competitive and monopoly conditions. The two parts of Section 4.2
discuss natural monopolies, which are also known as ‘decreasing cost industries’. Section 4.2.1 outlines the
nature and economic effects of this type of imperfect competition, while Section 4.2.2 outlines traditional
policy approaches towards decreasing-cost industries and the more recent approach known as the ‘new
model’. The last three sections contain more information about the three elements of the new model,
namely competitive restructuring (Section 4.3), privatisation (Section 4.4) and regulation (Section 4.5).
discuss the social costs of statutory monopolies
outline the characteristic features of natural monopolies
outline and contrast traditional policy approaches towards natural monopolies and the more recent new model
explain competitive restructuring or unbundling of vertically integrated state monopolies with appropriate examples
discuss the economic rationale for and effects of the privatisation of state monopolies in developing countries
discuss the characteristics and effects of the best-known forms of economic regulation
discuss the most important obstacles to effective economic regulation in developing countries.
4.1 The social costs of statutory monopolies 1
Figure 4.1 illustrates the familiar distinction between perfect competition and monopoly. Here we assume
that the demand function, D, and marginal cost, MC, are the same for the two market forms. There is one
difference, though: under perfect competition, MC represents the sum of the marginal cost curves of the
individual firms making up the market, whereas under monopoly, it represents the marginal cost of the
monopolist only.
The perfectly competitive equilibrium occurs at point E in Figure 4.1 where supply equals demand and
0Qc of the good is produced at a price of 0Pc . Under monopoly, equilibrium occurs at point F where MC =
MR. The market here produces a smaller quantity, 0Qm , at a higher price, 0Pm , than it does under perfect
competition.
The loss in consumer surplus under monopoly is the area given by PmGEPc, part of which – PmGHPc – is a
straight transfer from consumers to the producer, with the remaining triangle, GEH, being the net welfare
(or ‘deadweight’) loss. Although the usual assumption is that the value represented by the rectangle
labelled HEQcQm is transferred to other sectors in the economy, this is evidently easier said than done. The
resources contributing to this value, for example, labour and capital equipment, may remain unemployed
for long periods in a real-world economy with frictions and time lags, at least until they find alternative
employment. The value thus lost represents yet another social cost of monopoly.
Figure 4.1 Monopoly versus perfect competition
The two-sector model discussed in Chapter 2 can also illustrate the difference highlighted in Figure 4.1.
The implications of monopoly for this model are straightforward. Recall from Equation 2.5 in Chapter 2
that the marginal rate of product transformation (MRPT) equals the marginal cost and price ratios for the
two commodities, that is:
Assume Y is a monopolist and X a perfectly competitive industry. This implies that Py > MCy, while Px =
MCx . It follows that:
The above equations indicate that the second, and by inference, the third or ‘top-level’ condition for a
Pareto optimum has been violated. This is illustrated at point M0 in Figure 4.2 by the difference between
the slope of the production possibility curve, R0T0 (indicated by tt), and the slope of the commodity price
line, PMPM. The effect of introducing a monopoly here is to lower the output of good Y and raise its relative
price, as is evident from a comparison of the monopoly equilibrium at point M0 and the competitive
equilibrium at point C. The difference between the equilibria at points M0 and C in Figure 4.2 reflects the
degree of allocative inefficiency arising from the presence of a monopoly in one of the two sectors. In
other words, the economy as a whole produces too little of good Y relative to good X at point M0. Hence, a
reallocation of resources to increase the production of good Y relative to that of good X and to move the
economy to point C would be welfare-enhancing.
Figure 4.2 Efficiency implications of monopoly
Moreover, a monopoly may have an additional cost resulting from X-inefficiency.2 It may be the case
that monopolists do not utilise their existing resources as efficiently as firms operating under the constant
pressure of competitive markets. With no threat of entry, the monopolistic firm may lack the incentive to
maintain a high level of labour productivity or to spend sufficient time and effort searching for and
acquiring the necessary information. Such a situation would imply an equilibrium lying inside the
production possibility curve, for example at M1 in Figure 4.2. Consequently, the social costs of a monopoly
may result from both allocative inefficiency and X-inefficiency.
On the other hand, some economists argue that monopolistic firms are in a better position to achieve
technological advancement than their perfectly competitive counterparts. The typical monopolist may
have an incentive and the means to initiate or imitate cost-saving technical inventions and innovations. If
the monopolistic firm is to satisfy its shareholders, it will have to make a healthy profit that can then be
used for research and development purposes to improve productivity within the firm. In Figure 4.2, the
effect of technological progress will be to shift the production possibility curve from R0T0 to R1T1 and the
monopoly equilibrium from M0 to M2. In this case, technological progress has enabled the economy to
move beyond its original production possibility frontier.
This brings us to the important issue of deregulation, that is, attempts on the part of the authorities to
promote competition by removing certain barriers to entry. Such barriers can take various forms, including
prohibitive licensing fees, property taxes, restrictive labour laws and inappropriate health standards. The
analysis in this section suggests that the removal of barriers to entry will improve allocative efficiency and
X-efficiency in the relevant industry. This will move the equilibrium closer to point C in Figure 4.2 (for
example, to M3). However, it may also entail a cost in terms of the decreased profits made by competitive
firms and their resultant inability to initiate and carry out technical inventions and innovations. The
economic case for deregulation will therefore depend on whether the gains in allocative and X-efficiency
are sufficient to offset the slower pace of technological advancement among competitive firms.
4.2 Natural monopolies

4.2.1 Characteristics and effects
An industry is a natural monopoly if it is characterised by large capital outlays that give rise to economies of
scale over the entire range of its output. The minimum average cost of production may thus occur at a level
of output sufficient to supply the whole market, which means that only one firm can operate effectively in
such a market. The best-known examples of this type of industry are public utilities involved in the
provision of electricity, water, rail and road transport, and postal services.
Increasing returns to scale means that the long-term average cost (AC) of the firm decreases as output
increases. Its marginal cost (MC) curve will therefore lie below the AC curve over the entire output range.
This is illustrated by the curves labelled AC and MC in Figure 4.3. In a perfectly competitive market, each
firm will set marginal cost equal to the market price (for example, at point E in Figure 4.3 where Pe = MC).
With increasing returns to scale, however, the industry will make a unit loss equal to ES so that individual
firms will eventually close down until a natural monopoly emerges.
If the natural monopoly is not controlled by the government, it will maximise profit at point M where its
marginal cost equals marginal revenue. At point M, the equilibrium price, 0Pm, exceeds the socially
efficient price, 0Pe, while the corresponding level of output, 0Qm, is smaller than the Pareto-optimal level,
0Qe. The profit-maximising behaviour of the monopolist may therefore results in too little output being
produced at too high a price, which would give rise to a concomitant loss of welfare. This welfare loss is
the difference in consumer surplus between the two equilibria. Under monopoly, consumer surplus equals
the area AFPm, which is evidently much smaller than the consumer surplus under the hypothetical
competitive solution, given by the area AEPe in Figure 4.3. Note that the existence of a natural monopoly
has nothing to do with whether the activity is undertaken by the government or the private sector. As will
become apparent in Section 4.4.2, the ownership issue has to do with the way in which the allocative and
equity implications of a natural monopoly are managed, but does not take the monopoly element away.
Figure 4.3 Decreasing cost industry

4.2.2 An overview of policy options
The question that arises is whether something should be done about the above-mentioned loss of welfare.
There is no simple answer to this question, but the government does have several options at its disposal.
These all depend on whether the natural monopoly provides goods or services that are important inputs for
many other sectors and industries in the economy (electricity and water supply are obvious examples).
Externalities are involved if this is the case. The terminology explained in Section 3.6 of Chapter 3 implies
that D and MC in Figure 4.3 represent marginal social benefits (MSB) and marginal social costs (MSC),
respectively. Production at point M then clearly implies that MSB > MSC. The only way to create and
confer pecuniary externalities on other industries is then to expand production and lower the price, for
example, to 0Qe and 0Pe . The lower price therefore signifies the internalisation of the social benefit.
One option is for government to establish or take ownership of the natural monopoly itself, as has
happened in many countries during the previous century. It could then apply marginal cost pricing at point
E in Figure 4.3 and cover the resultant loss by means of a unit subsidy equal to ES. But the required subsidy
would have to be paid for by government, and hence by the tax-paying public. If the government
introduced (say) a new or higher indirect tax for this purpose, it will drive a wedge between marginal cost
and marginal revenue elsewhere in the economy. Such a tax wedge will cause a loss in welfare in the form
of an excess burden. Alternatively, the government can borrow money to pay for the subsidy. This,
however, could put pressure on interest rates and crowd out private spending in the rest of the economy.
Recall that point M0 in Figure 4.2 represented the equilibrium of a private natural monopoly. The
equilibrium of a nationalised natural monopoly would lie closer to point C (the perfectly competitive
equilibrium). However, it will be inside the PPC, for example, at a point such as Ms, because of the
distorting effect of the required tax and a possible crowding out effect. Thus, while nationalising a natural
monopoly may have an allocative advantage vis-à-vis the private option, it also has a distorting effect on
the rest of the economy.
Government-owned monopolies are also less X-efficient than private monopolies and have less of an
incentive to initiate and implement cost-saving innovations than their profit-driven private counterparts.
After all, a privatised monopoly has little choice but to remain profitable and satisfy its shareholders if it is
to avoid the threat of a possible takeover. The nationalised monopoly, by contrast, is under no such threat
and can always rely on the seemingly endless resources of the state.
Nationalised natural monopolies failed in the vast majority of developing countries.3 It proved difficult
to implement the solution outlined above (a combination of marginal-cost pricing and unit subsidies) in
environments with much scope for government failure and weak incentives for X-efficiency. To boost their
popularity, many governments created unproductive jobs in state-owned monopolies and forced these
organisations to charge prices that did not cover their marginal costs. Compensatory subsidies drained
national budgets, yet in most cases were inadequate to cover the resulting unit losses. Widespread non-
payment by customers further compounded the financial problems of most government-owned monopolies.
The resulting revenue shortages prevented monopolies from investing enough to maintain facilities and
equipment, let alone expand service provision to growing populations. X-inefficiency took the two forms of
low labour productivity and poor service quality. This reflected the reality that many managers were
political appointees who lacked skills to resolve such problems; others exploited information asymmetries
to maximise their budgets as predicted by models of bureaucratic failure (see Section 6.7.2 of Chapter 6).
Box 4.1 shows that many of these problems manifested recently in the South African electricity supply firm
Eskom.
Box 4.1. The Eskom experience4
Eskom is the dominant supplier of electricity in South Africa: in 2008, it generated 96% of South Africa’s electricity,
with the remainder coming from municipalities (1%) and independent power producers and other entities (3%)
(Department of Minerals and Energy, 2008: 8). During the 1970s and 1980s, it established itself as a prominent name
in the South African capital market when its bonds were priced better than those of the government. This reflected
Eskom’s sound finances and effective bond management strategy at the time. Yet in the past two decades Eskom has
experienced a number of problems. These included (in no particular order):
• Load shedding
The first two decades of this century brought periodic load shedding,5 which has had major implications for
economic activity. Various factors caused these interruptions in the supply of electricity, such as insufficient
production capacity, poor maintenance of existing production plants (including the nuclear power station at
Koeberg in the Western Cape), and periodic shortages of coal.
• Reversal of tariff trends
Between 2007 and 2016 average electricity tariffs increased by 374% in nominal terms, that is, by 16,8% per
annum. The corresponding real increases were 186% and 10,4%, respectively. This reversed the trend from 1997 to
2007, when average electricity tariffs decreased by 21,6% in nominal terms (that is, by 62,2% in real terms). The
average annual decreases in this period were 2,4% in nominal terms and 9,4% in real terms. The timing and size of
Eskom’s investments in electricity supply capacity as well as changes to the tariff-setting methodology caused this
large change in tariff adjustments.
• Municipal arrears
Municipalities are wholesale suppliers of Eskom electricity. The municipal levy on household consumption of
energy, which is added to the Eskom levy, is a significant source of revenue for local governments. Eskom’s debt
problems have been worsened by the huge outstanding bills of cash-strapped municipalities. Eskom’s rising
municipal arrears reflect a form of moral hazard by municipalities that operate as if their debt is explicitly or
implicitly guaranteed by the national government or provincial governments.
• Corporate governance issues: irregular expenditure related to circumventing tender procedures
Business Day (2017) reported that Eskom headed the list of government departments and agencies that sought
permission to deviate from normal government procurement procedures in 2016–2017.6 In fact, Eskom’s requests
accounted for R31,3 billion of the R37 billion worth of deviations requested in 2016–2017.7
• Nuclear energy
Some years ago, the South African Department of Energy entered into negotiations with Russia to commission
additional nuclear energy plants. Technical and financial experts soon questioned the cost efficiency of such plants,
especially when compared to alternative sources such as wind and solar energy. The process eventually came to a
halt when the Western Cape High Court declared a secret 2014 co-operation agreement between the South African
government and the Russian state nuclear energy corporation Rosatom unlawful. In February 2018 (then) Deputy
President Ramaphosa said that South Africa did not have the money to build nuclear power stations (Quartz Africa,
2018).
• Downgrade of Eskom’s credit rating
During the 1990s decisions to expand Eskom’s generation capacity were delayed. This was in part a response to the
over-expansion of capacity during the 1970s and 1980s, when unrealistically high economic growth projections
informed future planning. But it also reflected that the government’s attempts to reduce the size of the public sector
focused on reducing public investment, rather than government consumption. The outcome was considerable strain
on Eskom’s existing capacity as it struggled to ‘keep the lights on’ even if it meant liquidity problems that caused
it to struggle to service debts as well as postponement of much-needed maintenance of plants. These concerns
contributed to the downgrading of Eskom’s credit rating by Standard and Poor and Moody’s in 2016. Moody’s
(quoted in Eskom, 2018) justified its downgrade of Eskom in January 2018 as follows: ‘Despite a number of
improvements at the company in relation to its corporate governance and liquidity, there is limited visibility at this
juncture as to Eskom’s plans for placing its longer term business and financial position on a sustainable footing.’
• Resistance by Eskom to modern methods of managing peaks and troughs and allowing access to the network from
other suppliers
Eskom’s control of access to the transmission network has enabled it to operate as a monopoly in the production of
electricity as well. Such control of market entry and exit has shielded Eskom from competitive forces that would
have yielded allocative efficiency gains in activities where natural monopoly conditions do not apply. Efficiency is
better promoted if electricity consumers are allowed to sell unused electricity back into the network during low
consumption periods for use during peak hours, for example, and if producers are allowed to sell wind and solar
energy into the network as a structural increase in the supply of electricity.
• Adopting a new process of price regulation
The period of low and declining real electricity tariffs ended around 2006/07. The Electricity Regulation Act of
2006 made the National Energy Regulator (NERSA) responsible for tariff determination, and the South African
Government adopted the Electricity Pricing Policy (EPP) in 2008. The EPP stated that electricity tariffs should
ensure the financial sustainability of the electricity supply industry and added that ‘… the industry has the potential
to generate strong cash flows to sustain a financially viable industry and the need for direct state support and
subsidies should, apart from funding social objectives, be minimal’ (Department of Minerals and Energy, 2008:
15). This means that electricity tariffs should be set at levels that allow Eskom to recover the costs of supplying
electricity and to achieve a fair rate of return on its asset base. This emphasis on cost-reflective pricing has
advantages, but also carry risks (see Box 4.2).
• Corporate governance
In a significant and unprecedented step on 19 January 2018, more than 200 senior Eskom managers submitted a
letter to then Deputy President Cyril Ramaphosa that expressed concern over the lack of ‘decisive and bold actions
against allegations of fraud, corruption and maladministration’ (Fin24, 2018). The signatories requested
Ramaphosa to ensure that a credible board is appointed with an ‘exemplary track record in large complex
organisations’ to rebuild trust in the parastatal. The memorandum stated that lenders, investors and ratings agencies
required this. The signatories also wanted the Eskom Executive Management team to be reconstituted with a new
group CEO and CFO who will be ‘well received by investors and citizens of this country’. Soon after this the
Government replaced Eskom’s Board (Sunday Times, 2018).
Comprehensive financing programme
A major outstanding matter is that Eskom has not released a comprehensive long-term plan that integrates operational
and investment expenditure with a comprehensive financing plan. The latter should include all financial sources:
electricity tariffs (indicating cross-subsidisation or financing from government), loans (from government and bond
markets) and equity (from government, if the only shareholder, and/or from private investors, if applicable). The
quoted justification for Moody’s most recent downgrade of Eskom confirms the importance of dealing with this
matter.
The serious need for reforms were acknowledged when the Finance Minister confirmed the State President’s
earlier announcement in his 2019 State of the Nation Address that Eskom will be subdivided into three independent
subdivisions, namely for the generation, transmission and distribution of electricity. This is bound to set the
electricity market ‘on a new trajectory, and allow for more competition, transparency and a focused funding model’
(Minister of Finance, 2019: 9). The Government was not going to take over Eskom debt, but budgetary funds to the
tune of R23 billion per annum in support of the reconfiguration of Eskom were announced. This was followed up by
further conditional financial support.
It is partly for these reasons that the traditional model of using state-owned monopolies to provide services
in decreasing-cost industries has fallen out of favour in various industrial and developing countries. Many
countries have switched, either partially or fully, to the so-called new model for the governance of such
industries. This model has three elements: (1) restructuring (or unbundling) of state-owned monopolies, (2)
privatisation of the components of these entities in which competition is possible, and (3) regulation of the
privatised components. The three purposes of such reforms in decreasing-cost industries have been to
improve allocative efficiency and X-efficiency, improve service delivery, and reduce the financial burdens
these entities impose on governments and taxpayers. The next three sections of this chapter provide more
detailed discussions of the three elements of the new model and their effects. While confirming that this
model has had positive effects in many countries, these sections will also identify some risks as well as
requirements for success.
4.3 Competitive restructuring 8
Competitive restructuring, which is also known as ‘unbundling’, is at the heart of the new model for the
governance of decreasing-cost industries (natural monopolies). The state-owned monopoly model
assumes that all activities in decreasing-cost industries are affected by decreasing average costs, which
preclude profitable operation by more than one firm. The belief that there is no scope for competition led to
the establishment of state-owned monopolies to handle all activities in decreasing-cost industries.
More recently, economists and policymakers realised that most of the activities in decreasing-cost
industries are not natural monopolies. The electricity supply industry, for example, has four elements:
generation (production of electricity in power plants), transmission (long-distance transportation of
electricity at high voltage), distribution (transportation of electricity to end-users over shorter distances and
at lower voltages), and supply (selling of electricity to end-users). Only transmission and distribution are
true natural monopolies, because construction of the networks (‘grids’) that transport electricity requires
huge capital investments that give rise to decreasing average costs over large output ranges. Competition is
feasible in the other two elements of the industry: power plants can compete in generation, for example,
and retailers in supply. Similar distinctions exist in other decreasing-cost industries. The so-called local
loop (the networks that carry analog and digital signals from service providers to customers) is the natural
monopoly element in the telecommunications industry, while competition is possible in long-distance
telephony, mobile telephony, and various value-added services (live streaming, mobile money services,
mobile advertising, et cetera). Similarly, the tracks, signals and other fixed facilities are the natural
monopoly elements in the railways industry, while the operation and maintenance of trains are potentially
competitive ones.
As suggested by the term ‘competitive restructuring’, unbundling involves separation of the potentially
competitive and natural monopoly components of government-owned monopolies in decreasing-cost
industries and the introduction of competition in the former. Privatisation of the potentially competitive
components is a key aspect of such reform processes. Governments usually retain the natural monopoly
components of the entities, but can establish regulatory authorities to oversee pricing and the quality of
service provision.
Competitive restructuring is a step towards reaping the allocative and X-efficiency benefits of
competitive markets (as was pointed out in Section 4.1, industries in which firms compete should produce
more and sell outputs at lower prices than monopolistic ones do, ceteris paribus). These benefits should not
be assumed, however, especially in smaller developing countries in Southern Africa and elsewhere where
markets may be too small for effective competition. Hence, the long-run effects of unbundling depend
significantly on the degree of effective competition in the restructured industries and the government’s
ability to regulate the conduct of market participants. The next two sections discuss aspects of these issues.
4.4 Privatisation
Section 1.5.3 of Chapter 1 described privatisation as transferral of the production of goods and services
from the public sector to the private sector. It can take various forms. The most comprehensive form of
privatisation is when the government transfers all aspects of a particular activity – for example, the
planning, design, construction, financing and maintenance of a road – to a private firm. No government
involvement whatsoever remains in such cases, apart perhaps from enforcement of certain regulatory
standards. Partial forms of privatisation, which involve sharing of roles, responsibilities and risks between
public and private sector entities, can take various forms. These go under the general rubric of public-
private partnerships (see also Section 1.5.3 of Chapter 1).
In education, for example, teaching and the construction of buildings and other infrastructure may be
privatised, while curricula and standards remain government responsibilities. Medical services may be fully
privatised, while the government remains partially responsible for financing to ensure that the most
vulnerable in society have access to proper healthcare. Some countries have used another quasi-
privatisation possibility known as the BOOT (build, own, operate and transfer) model for toll roads, among
other things. This model entails privatisation of construction, financing and maintenance for a specified
period, after which ownership of the asset reverts back to government with maintenance sometimes allotted
by tender to a private company. Public utilities present another variation on the theme. As we have seen, in
the case of electricity, generation and supply can be privatised, while transmission and distribution (the real
natural monopoly elements) may remain government responsibilities. This section discusses the purposes
and effects of privatisation of former state-owned monopolies in decreasing-cost industries in more detail.
Financial considerations have often featured strongly in decisions to privatise state-owned monopolies:
many governments have been keen to rid themselves of loss-making entities and to earn revenue from the
transactions. However, the efficiency considerations discussed in Sections 4.1 and 4.2.2 have been at least
as important. Private firms, whether in competitive or non-competitive industries, have to remain profitable
to survive; hence, they are likely to be more X-efficient than government-owned monopolies subsidised
from the national budget. But a change from public to private ownership as such will not necessarily bring
allocative efficiency gains. Such benefits will realise only when the privatised firm experiences competition
— the spur for innovation, effective use of resources, high-quality service delivery, et cetera. This suggests
that the economic effects of privatisation may well depend on contextual factors such as the size of the
market, the openness of the economy and the competition policy framework and its application.
Equity considerations invariably also come into play in privatisation decisions.9 Budget constraints often
force newly privatised firms to reduce bloated workforces and to raise previously subsidised prices to cover
their costs. These steps raise difficult questions. The reality is that decreasing-cost industries expend
resources to provide services to consumers, and have to recover these costs to remain viable. The equity
question is whether these costs should be borne in full by the users of the services or subsidised (i.e. shared
with taxpayers). The issue becomes even more complex when consideration is given to factors such as
distinctions between richer and poorer users of services, the opportunity costs of subsidies and the
economic effects of the taxes raised to finance them. The costs of job losses in privatised entities should be
weighed against the cost-raising effects of retaining unproductive workers, which will be reflected in the
prices charged to other firms and to consumers (and possibly also the subsidies needed to keep entities
afloat). Be that as it may, its immediate costs have made privatisation an extremely controversial policy in
many countries, despite the likelihood of larger longer-run efficiency benefits such as expanded and more
sustainable service provision and more efficient use of the funds used to subsidise loss-making entities.
South Africa has been no exception. A few privatisation transactions have occurred, including the listing
of Iscor on the Johannesburg Securities Exchange (JSE) in 1989 and the partial sale of Telkom to two
international companies in 1997. However, strong opposition rooted in equity considerations and the
preference for state-led economic development among socialists and adherents to developmental-state
thinking brought an end to such transactions. More recently, opportunists harnessed the opposition against
privatisation as a convenient veil to maintain opportunities in the public enterprises for rent-seeking, state
capture, nepotism and outright fraud.
Although hampered by various methodological problems, econometric and case studies of the effects of
privatisation have yielded several important findings.10 These studies have compared the pre- and post-
privatisation performance of specific firms and industries or the performance of state- and privately owned
entities in specific sectors of different countries. Various aspects of the performance of firms and industries
have been studied, including profitability, operational efficiency, capital investment, employment, prices
and dividends.
Several of these sectoral and firm-level studies have suggested that privatisation often leads to increased
production and improvements in productive efficiency, prices and service delivery. As was suggested
earlier, however, the extent of the benefits has depended markedly on the scope for competition after
privatisation of state-owned monopolies and on governments’ capacity to regulate the industries in
question. Other elements of the general business environment (such as the depth and liquidity of capital
markets, the quality of the legal system and competition policy, and the number of qualified managers)
have apparently also affected the success of privatisation attempts. These findings suggest that investment
in regulatory capabilities and the establishment of sound business environments in which competition can
flourish are prerequisites for obtaining major efficiency benefits from privatisation in Southern Africa and
elsewhere.
The equity effects of privatisation have been mixed. Successful privatisation accompanied by effective
competition and regulation have often had positive equity effects, including improved access to services for
the poor, lower prices and, in the longer run, expanded employment. In other cases, combinations of
inequitable divestment methods (e.g. selling of state-owned entities to rich individuals at favourable
prices), sharp price increases and large-scale job losses have caused adverse distributional effects. The
evidence has suggested, however, that targeted subsidies can do much to lessen the effects of price
increases on poor consumers.
4.5 Regulation 11
Sections 4.3 and 4.4 referred to the important role of regulation in the new model for the governance of
decreasing-cost industries. The term ‘economic regulation’ refers to rules that are made and enforced by
government agencies to control entry and prices in particular sectors of the economy. Regulatory
authorities are independent agencies that operate in specific sectors in accordance with enabling legislation.
Two well-known South African examples are ICASA (the Independent Communications Authority of
South Africa) and NERSA (the National Energy Regulator of South Africa), which regulate the
telecommunications and energy sectors, respectively.
In decreasing-cost industries, the aim of regulation is to complement competitive restructuring and
privatisation by preventing privatised firms in weakly competitive sectors from imposing costs of allocative
inefficiency on the rest of the economy. Put differently, the aim of regulation is to limit privatised natural
monopolies to reasonable rather than maximum (abnormal) profits, partly for efficiency reasons and partly
to protect the interests of consumers and producers using the relevant product or service. In terms of Figure
4.3, such a regulated equilibrium would lie somewhere between the two extremes of marginal cost pricing
and profit-maximising monopoly pricing.
The remainder of this section outlines three models for regulating the prices of privatised natural
monopolies, namely rate of return regulation, price-cap regulation and sliding-scale regulation, and
comments on regulation in developing countries. Box 4.2, which summarises the process for determining
Eskom’s electricity tariffs, complements this subsection.
4.5.1 Rate-of-return regulation

The aim of rate-of-return regulation, which is also known as profit regulation, is to provide a regulated
firm with a degree of certainty about profit outcomes. Hence, this form of regulation derives a price for a
good or service from efficient levels of capital and operating costs and a satisfactory rate of return on the
firm’s asset base. We illustrate this approach with reference to Figure 4.4, which is an extension of Figure
4.3. The additions are shown in bold print and thicker lines.
Figure 4.4 Pricing under rate-of-return regulation

Given a regulated firm’s supply and demand curves, the regulator determines the regulated firm’s
capital and operating costs as the area THQr0 and deems that a total profit of PrGHT (i.e. a profit per unit of
GH) represents a satisfactory rate of return on its asset base. Hence, the required revenue of the firm is the
sum of the areas PrGHT and THQr0, that is, area PrGQr0. This implies a price Pr at production level Qr. Note
that the price will vary depending on the rate of return allowed by the regulator; in principle, it can assume
any value between the monopoly price Pm and the perfectly competitive price Pe. The same applies to the
corresponding production level.
This type of regulation is intended to serve various ends, namely the financial integrity of regulated
firms, their ability to attract new capital and adequate compensation for new investment. At the same time,
the firms are expected to provide goods and services on a non-discriminatory basis and charge just and
reasonable prices. In practice, however, regulators may well be wary of letting firms go bankrupt, and may
try to prevent this by setting the allowed rates of return too high. This may well incentivise production
inefficiency, because it encourages the adoption of capital intensive production technologies by effectively
subsidising capital. On the other hand, such technologies may contribute to dynamic efficiencies if they
embody innovations. Information asymmetries have also undermined many attempts to apply rate-of-return
regulation. Note that the sizes of firms’ asset bases directly influence the satisfactory rates of return allowed
by regulators. This creates incentives for cost-padding, for example, unnecessary capital expenditures that
expand asset bases and enable firms to claim that they need higher profits to achieve the allowed rates of
return. Regulators seldom have enough information about firms’ operating and capital costs to prevent such
inefficient use of resources.
4.5.2 Price-cap regulation

As suggested by the name, price-cap regulation caps the prices charged by regulated firms. In the case of
the regulated firm depicted in Figure 4.3, for example, a regulator applying this type of regulation would
simply cap the allowed price at Pr. (Recall that a regulator who applies rate-of-return regulation would
derive the allowed price from the revenues the firm requires to cover its costs and achieve a satisfactory
rate of return on its asset base.) The major advantage of this type of regulation is that it creates incentives
for firms to cut costs and boost their profits. In the United Kingdom, where this method is used extensively,
regulators apply the following formula to implement price-cap regulation:
where P denotes the regulated price, RPI the retail price index and X the rate of productivity growth of the
production factors used by the firm. If the inflation rate is 5% per annum and the rate of productivity
growth 3% per annum, for example, regulated firms would be allowed to increase their prices by no more
than 2% per annum. Note the built-in incentive for increased efficiency: a firm’s profits will increase
automatically if it achieves a higher rate of productivity growth than provided for in the price-cap formula.
Price-cap regulation therefore partly mimics conditions in perfectly competitive markets where firms are
price-takers and aim to maximise their profits.
These attractive features of price-cap regulation should be weighed against two potential drawbacks.
The first is that it can be as administratively burdensome as rate-of-return regulation, because regulators
must model the finances and economic environments of regulated firms in considerable detail. The
information needed to make forecasts of future trends in demand, productivity and input costs, among other
things, is hard to come by. A second potential problem is that it requires close monitoring of the operations
of regulated firms that lack strong competitors, because the cost-cutting encouraged by this form of
regulation may take the form of reductions in the quality of service provision. Many regulatory agencies do
not have the capacity to undertake such monitoring.
4.5.3 Sliding-scale regulation

Sliding-scale regulation combines elements of rate-of-return regulation and price-cap regulation. The basis
of this form of regulation is a price cap that creates the efficiency incentives outlined above. This price cap
is reduced as soon as the profits of the regulated firm rise above a pre-determined level. The effect of this
adjustment is to share the additional profits resulting from the efficiency gains of the firm between the
producer and consumers. The price-adjustment mechanism therefore dampens but does not eliminate the
efficiency incentives of the firm; at the same time, it prevents excessive profit-making at the expense of
consumers. Unsurprisingly, however, the information requirements for successful sliding-slide regulation
are no less formidable than those of rate-of-return regulation and price-cap regulation.
4.5.4 Regulation in developing countries

The efficiency gains associated with effective regulation imply an outward shift in the PPC similar to that
shown in Figure 4.2, where the unregulated monopoly equilibrium occurs at point M2 or M3. The fact that
any form of regulation entails additional administrative costs means that the regulated equilibrium will
occur closer to point C but inside the (new) PPC, for example, at a point such as M3. Regulation can thus
strike a neat compromise between the need for economic growth (as reflected in the shift of the PPC) and
the need for a higher level of allocative efficiency than under the unregulated scenario.
A growing number of developing countries, including South Africa, have been introducing regulatory
mechanisms to reap such efficiency gains. This section has highlighted the potential as well as the
complexity of effective regulation of decreasing-cost industries. Box 4.2, which outlines the variant of rate-
of-return regulation used to determine Eskom’s electricity tariffs, provides more examples of the
information problems faced by regulators.12 Political economy factors often compound such problems.
Apart from those hinted at in Box 4.1 in Section 4.2.2, such factors include the phenomenon of regulatory
capture: regulatory agencies created to promote the public interest sometimes come to advance the
commercial or political interests of regulated firms instead. This can be the result of effective lobbying by
firms (which usually stand to gain much from influencing regulators), the opportunities that firms may have
to reward sympathetic officials from regulatory authorities with lucrative job opportunities, or outright
bribery.
Box 4.2 The determination of electricity tariffs in South Africa

Decision process in terms of the electricity pricing policy
Source: Amra (2013).
The above outline of the process illustrates how various factors can derail attempts to pursue efficiency and equity in a
balanced manner. These include the following (the numbers in parenthesis refer to the numbered blocks of the pricing
decision process):
• Scope to misrepresent the value of assets (2) to artificially generate the desired amount of revenue (4) – this becomes
particularly likely if external auditors are not alert to irregular, unauthorised or even fraudulent expenditure.
• Scope to manipulate expenditure items (3) to artificially generate the desired amount of revenue (4) – this becomes
• Scope to manipulate the cost of human resources (12) by maintaining unproductive employees, to make it possible to
apply for a higher amount of allowable revenue (4) – this becomes particularly likely if external auditors are not
alert to irregular, unauthorised or even fraudulent expenditure, and if excessive wage demands by labour unions
can be additional disruptive forces.
• Scope to inflate or state lower sales figures to present a desired average revenue ratio (13) – this becomes
• Scope for NERSA to approve revenues (6) that are biased towards efficiency (at the expense of equity
considerations) or equity (at the expense of allocative or X-efficiency).
These considerations underscore that effective regulation always requires clear and transparent policy
frameworks, adequate technical capacity, and political support. The expertise required for effective
regulation at the sectoral level is likely to be a significant constraint in many developing countries, and
policymakers should keep this in mind when taking decisions about the feasibility of the various models of
regulation.
Key concepts
• competitive restructuring (page 73)
• deregulation (page 68)
• economic regulation (page 76)
• increasing returns to scale (page 68)
• natural monopoly (page 65)
• new model for the governance of decreasing-cost industries (page 73)
• price-cap regulation (page 78)
• privatisation (page 74)
• profit regulation (page 77)
• rate-of-return regulation (page 77)
• regulatory capture (page 79)
• sliding-scale regulation (page 79)
• statutory monopoly (page 65)
• X-inefficiency (page 67)
SUMMARY
• Perfect competition and the monopoly case are extreme market types. Monopoly often results from
governments intervening in the market using policy instruments such as licenses and regulations. We
therefore refer to these monopolies as artificial or statutory monopolies. Statutory monopolies cause
social costs (a loss in consumer surplus). These social costs can be reduced by deregulating the
industry, that is, by removing the artificial barriers to entry imposed by government.
• The natural monopoly is another market failure caused by imperfect competition. This is a market form
that results from industries exhibiting decreasing average costs over the entire production range for
which there is market demand. Public utilities such as energy supply, bulk water providers and rail
transport are examples of natural monopolies. If these industries were to produce at the perfectly
competitive market equilibrium, they would be making losses. Government therefore has an important
role to play in ensuring that production and pricing are at a point that is close to the social optimum
level.
• Governments traditionally took ownership of natural monopoly industries. In theory, a combination of
marginal-cost pricing and unit subsidies by a government-owned natural monopoly should yield better
outcomes than a private monopoly would achieve, albeit with distorting effects on the rest of the
economy and increased X-inefficiency. In practice, however, nationalised natural monopolies failed in
the vast majority of developing countries.
• A growing number of countries have switched to the so-called new model for the governance of
decreasing-cost industries. This model has three elements: competitive restructuring (or unbundling) of
state-owned monopolies, privatisation of the components of these entities in which competition is
possible, and regulation of the privatised components.
• The new model holds considerable promise, but also brings risks. Moreover, the effectiveness of
competitive restructuring and privatisation depends significantly on the degree of effective competition
in the restructured industries and governments’ ability to regulate the conduct of market participants.
These are non-trivial requirements.
• Rate-of-return regulation, price-cap regulation and sliding-scale regulation are three well-known models
of economic regulation that have been applied to privatised components of decreasing-cost industries.
Each of these models has advantages and disadvantages. Clear and transparent policy frameworks,
adequate technical capacity and political support are necessary to apply them to good effect.
4.1 An artificial or statutory monopoly …
a. is a form of government failure.
b. is the result of inefficiencies in the market and government policies.
c. causes social costs that can be reduced by deregulating the industry.
d. only results in allocative inefficiency.
4.2 A natural monopoly …
a. is characterised by decreasing returns to scale.
b. is characterised by large capital outlays.
c. implies that average costs lie below marginal costs over the entire output range for which there is
demand.
d. should be deregulated to ensure a social optimum level of production.
4.3 The new model for the governance of decreasing-cost industries …
a. argues that competition is possible in some parts of these industries.
b. implies that the local-loop component of the telecommunications industry can be privatised.
c. includes regulation of privatised components of decreasing-cost industries.
d. offers a simple framework for improving the performance of decreasing-cost industries.
4.1 Distinguish between artificial and natural monopolies.
4.2 What is meant by competitive restructuring of vertically integrated natural monopolies?
4.3 Explain the nature and causes of regulatory capture.
ESSAY QUESTIONS
4.1 Illustrate the effect on general equilibrium of introducing a monopoly into the two-sector model. What
are the efficiency implications?
4.2 Outline the two main sets of policy options for governing decreasing-cost industries.
4.3 Discuss the theoretical and empirical cases for and against privatisation of decreasing-cost industries.
4.4 Compare the aims, advantages and disadvantages of the three best-known models of economic
regulation.
1 This and the next section are partly based on Black and Dollery (1992: 10–16).
2 Section 2.3 of Chapter 2 explains the notion of X-efficiency.
3 This paragraph draws on Kessides (2005: 82–83).
4 Information in this Box is mostly sourced from the Parliamentary Budget Office (2017).
5 The term ‘load shedding’ refers to planned and controlled interruptions in the supply of power when power station capacity is
insufficient to supply the demand from all customers.
6 A forensic investigation report by Fundudzi for and released by National Treasury (2018c) indicated that Eskom did not advertise a
competitive bid to supply Majuba Power Station with coal and allowed the supplier to make an offer outside the competitive
bidding process. The process that was followed was allowed by Eskom’s 2008 Medium-Term Procurement Mandate, but
Tegeta, to whom the tender was allotted, did not comply with all the requirements of the mandate.
7 This is not a new phenomenon. In 1979, the demand for electricity increased in South Africa and the so-called reserve margin (the
available electricity supply capacity over and above that needed to meet normal peak demand) dropped. The urgency of the
situation led to the decision to by-pass the prescribed tender processes, and the construction of two new power stations
(Lethabo and Tutuka) were expedited by ordering turbines and boilers from existing suppliers. See Steyn (2006: 15).
8 This section draws heavily on Kessides (2005: 83–85, 85–86).
9 Chapter 5 discusses some well-known criteria for assessing the welfare effects of policy measures.
10 The following review draws on the findings of Estrin and Pelletier (2018), Kessides (2005), and Parker and Kirkpatrick (2005a).
While more recent studies have overcome some of the methodological pitfalls identified by Parker and Kirkpatrick (2005a:
526), it remains prudent to avoid strong general conclusions about the economic effects of privatisation and never to
underestimate the value of case-by-case analysis and interpretation.
11 This section draws on Den Hertog (2010: 38–40), Parker and Kirkpatrick (2005b), and Parker (2002a: 501–503).
12 This section has discussed models for regulating the prices charged by private monopolies. Eskom, however, is a regulated public
enterprise. Any reforms to the regulatory regime that may accompany the application of the new model in the South African
electricity supply industry may well have profound effects on Eskom’s managerial model and organisational incentives.
Equity and social welfare
Philip Black & Krige Siebrits
In Chapter 2, we noted that one of the most important shortcomings of the neoclassical model of general
equilibrium is its neutrality in respect of the distributional issue. The fair distribution of wealth or income
within a community can be viewed as a potential market failure. In Section 2.4.6, we refer to the ‘black
box’ nature of our benchmark model of general equilibrium, or the fact that its predictions are basically
determined by the initial assumptions on which it is based. The same applies to the distributional issue: the
model predicts a particular distributional outcome that is a mirror image of the distribution assumed
initially. If the initial distribution is deemed unacceptable, so too will be the final distribution.
distinguish between the Pareto and Bergson criteria for a welfare improvement
discuss Nozick’s entitlement theory and its relevance to the recent history of South Africa
explain how a redistribution of income can be justified in terms of the theory of externalities
distinguish between the cardinal and ordinal social welfare functions
discuss the efficiency implications of policies aimed at redistributing income from rich to poor people.
5.1 Introduction
In terms of the two-sector model illustrated in Figure 5.1, all points along the PPC are Pareto-efficient as
defined in earlier chapters. Each of these points also corresponds to a particular distribution of income
between the individuals participating in the economy. This means that the distribution at point S is different
from that at point C. In particular, one individual is in a better position relative to the other at point S than
he or she is at point C.
Two important implications arising from our familiar two-sector model are relevant here:
• A competitive economy producing the output mix given by point C will not necessarily also yield the
most preferred distribution of income; the latter may, for example, occur at point S.
• A policy-induced movement along the PPC, for example, from point C to point S, will necessarily change
the distribution of income and thus place one individual in a worse position compared to the other.
Economists normally distinguish between two criteria when assessing the welfare effects of public policy:
the Pareto criterion and the so-called Bergson criterion. The Pareto criterion implies that a policy-induced
change is justified only if it improves the well-being of at least one person without harming any other. The
Bergson criterion is much broader and allows for a welfare improvement even if one or more individuals
are harmed in the process. In this chapter we shall consider both criteria: Section 5.2 focuses on Robert
Nozick’s (1974) well-known entitlement theory, which provides a Pareto-based justification for a
redistributive policy aimed at redressing past injustices; Section 5.3 examines several other Pareto criteria
and does so in terms of the familiar theory of externalities; Section 5.4 considers the Bergson criterion and
introduces what is conventionally referred to as ‘welfare economics’; and finally, Section 5.5 looks at some
of the efficiency implications of policies aimed at redistributing income from rich to poor people.
Figure 5.1 Potential top-level equilibria
5.2 Nozick’s entitlement theory

The Pareto criterion is commonly associated with the libertarian approach to public policy, according to
which individual freedom is viewed as the primary goal of the community. This is usually defined in terms
of the maximisation of ‘negative freedom’, or protection of the right not to be coerced by others (Hayek,
1960; Nozick, 1974). The libertarian school thus advocates a laissez faire system in which the role of
government is reduced to that of a caretaker charged with the responsibility of protecting individual
freedom. Libertarians are in principle opposed to distributional policies that infringe upon the freedom of
individuals.
There is, however, an important exception to the libertarian rule that derives from Robert Nozick’s
(1974) entitlement theory. Nozick distinguished between three ‘principles of justice’ in which he sets out
the conditions for a just distribution. The first two principles can be defined as follows:
• Principle 1: Justice in acquisition, which states that individuals are entitled to acquire things that do not
belong to others or do not place others in a worse position than before. Such ‘things’ refer to property
and capital goods only – not to labour income, which Nozick regards as an inalienable individual right.
• Principle 2: Justice in transfer, according to which material things can be transferred from one individual
to another on a voluntary basis, for example, in the form of gifts, grants, and bequests, or through
voluntary exchange.
In terms of these principles ‘… a distribution is just if it arises from a prior just distribution by just means’
(Nozick, 1974: 58). Violating either of the first two principles gives rise to Nozick’s third principle of
justice:
• Principle 3: Rectification of injustice in holdings, in terms of which a redistribution of wealth is
potentially justified only if one or both of the first two principles have been violated.
Nozick’s third principle provides his only justification for a policy aimed at redistributing resources
between individuals. But it is evidently easier said than done. Nozick (1974: 67) himself recognises the
practical difficulties involved when he asks: ‘… how far back should one go in wiping clean the historical
slate of injustice?’ This question is clearly relevant to many peace initiatives and conflict resolutions
undertaken in many parts of Africa and, in particular, to South Africa’s recent past. Nozick’s principles
presumably formed one of the cornerstones of the investigations undertaken by the Truth and
Reconciliation Commission (TRC) in South Africa. The TRC limited its focus to the apartheid era, in
particular to the period between 1 March 1960 and 5 December 1993 during which the National Party was
in power, though it did recognise the many historical precedents set by earlier regimes. Some of the
functions of the TRC are outlined in Box 5.1.
Box 5.1 Rectification in South Africa
The overriding objective of the Truth and Reconciliation Commission was to develop a human rights culture in the
country and to bring about national unity and reconciliation. The Commission was divided into three committees
whose primary functions can be summarised as follows:
• The Committee on Human Rights Violations was responsible for identifying victims of ‘gross human rights
violations’ committed during the period 1 March 1960 to 5 December 1993. The committee assessed the nature
and magnitude of those violations, and referred legally prepared reports on the victims to the Committee on
Reparations and Rehabilitation. During its deliberations the former committee also identified alleged perpetrators,
as well as persons already being prosecuted or found guilty in a court of law, and submitted reports on them to the
Committee on Amnesty.
• The Committee on Amnesty considered applications from persons who had committed human rights violations and
based its decision on whether these were committed for political reasons, rather than for personal gain or any other
reason. The Committee also looked at the nature and the degree of seriousness of violations before reaching a
decision. Those who were granted amnesty could not be held liable for damages and could not be criminally
charged in a court of law, while those who were unsuccessful were liable for prosecution.
• The Committee on Reparations and Rehabilitation had to submit proposals to the Cabinet for reparations in the form
of monetary payments to individual victims, as well as ‘community rehabilitation programmes’ aimed at providing
a range of basic services to communities that had suffered under apartheid. The TRC Act required Parliament to
establish a President’s fund from which payments were to be made.
After consulting across a broad spectrum of the community, and adopting a strict legalistic approach to its
deliberations and findings, the TRC concluded that an amount of R2,8 billion was needed to pay reparations to
apartheid-era victims. The Department of Land Affairs had been involved in a process of investigating and legally
processing a number of land claims arising from past violations of individual and communal property rights (another
legacy of the Group Areas Act and human resettlement programmes implemented during the apartheid era). In
addition, several politicians, including former president Nelson Mandela, appealed to the private sector to make
voluntary contributions to the government’s own job creation fund – aimed at ‘achieving racial reconciliation in
South Africa’.
According to Nozick, proper rectification requires a thorough analysis of the historical events that gave rise
to the violation of his first two principles. It also calls for an accurate assessment of the distributional
pattern that would have emerged in the absence of the violation. While both tasks are needed to determine
the extent of rectification, neither can be said to be straightforward. Both require a wealth of historical data,
much of which will be largely hypothetical and based on anecdotal evidence, and neither is likely to
produce outcomes that are free of human prejudice.
On the other hand, Nozick’s third principle is restricted to a redistribution of improper holdings of fixed
property and capital only – not of labour income. The latter reflects a person’s innate endowments and
cannot therefore be taken from him or her, either for equity or efficiency reasons. While this restriction is
perhaps highly contentious, it does at least simplify the practical application of Nozick’s rectification
principle.
The Pareto flavour of Nozick’s rectification principle is straightforward: if Tom enriched himself at
Thandi’s expense and did so against her will, the principle demands that Tom should give back to Thandi
what rightfully belonged to her so that both parties would be in the same position as they would have been
in the absence of the injustice.
5.3 Other Pareto criteria

Policies aimed at redistributing income from rich to poor people can be justified on Pareto grounds in terms
of the theory of externalities, that is, the externality argument for redistribution, as discussed earlier in
Chapter 3. In communities characterised by a high degree of inequality it is possible that the poor may
impose certain negative externalities on the rich. High levels of crime and violence often go hand in hand
with widespread poverty, and these may undermine the quality of life of the rich. Likewise, a lack of
sanitation and other health-promoting services among the poor may give rise to a variety of contagious
diseases that may ultimately threaten the health status of the rich.
Under these conditions, rich people may be prepared to transfer part of their income to the poor in an
attempt to reduce poverty and minimise its negative external effects. However, no single rich person can do
so alone and it is partly for this reason that the distribution of income is often viewed as a public good: all
or most rich people stand to benefit from a reduction in poverty, and hence in the level of crime and
violence or in the incidence of disease, but individuals acting on their own cannot bring about such
changes. Poverty relief thus calls for appropriate government action aimed at bringing down the negative
external effects of poverty to an optimal level. Government policy could take the form of direct transfer
payments to the poor, or it could be used to provide basic services or strengthen the security system, in
which case both poor and rich people stand to benefit from a healthier and more secure environment.
A related justification for redistribution derives from the so-called insurance motive. Individuals may
view their tax payments as a relatively inexpensive means of insuring themselves against a possible future
loss of income or ill-health. On becoming unemployed, for example, they may qualify for support from a
state-run unemployment insurance fund. If they should become ill, they could likewise avail themselves of
health services provided by the state. These individuals may view tax payments as a superior or cheaper
alternative to taking out private insurance.
In all these cases there is no charity involved, but rather a quid pro quo principle: rich people give up
part of their income for distribution among the poor because they expect to derive commensurate material
benefits from such actions.
By contrast, a redistribution of income can be justified on Pareto grounds if one or more individuals are
assumed to be altruistic, that is, both concerned and generous (Hochman & Rodgers, 1969). Such
individuals could experience a net increase in utility from a policy that taxes their own income and
redistributes it in favour of another (non-altruistic) individual. In terms of our two-sector model, a
movement along the PPC would then improve the welfare of both individuals.
It is important to note that the notion of altruism implies the existence of external effects in
consumption. Reverting back to our earlier examples in Chapters 2 and 3, if individual a is an altruist but b
is not, we can write a’s utility function (Ua) as follows:
where the first derivatives are all positive. Equation [5.1] simply states that a derives utility not only from
her own income, Ma, but also from individual b’s level of utility [Ub(Mb)] – presumably up to some
maximum level. Individual b derives utility only from his own income, Mb.
Simplifying Equation [5.1] by setting
we can state the condition for a ‘Pareto-efficient’ redistribution of income from our altruist, a, to the non-
altruist, b. Mathematically it implies that:
Therefore, the increase in a’s utility resulting from b’s higher income (g’(Mb) > 0) must exceed the decrease
in a’s utility resulting from the drop in her own income (0 > g’(Ma)). In other words, the fact that b is in a
better position gives rise to a net increase in a’s utility.
There are presumably many real-world examples of Pareto-efficient redistributions. When people
contribute towards charitable organisations, or give money to beggars, they presumably do so because it
makes them feel better – this is why we view altruism as a Pareto-based justification for redistribution.
Such transactions are, of course, voluntary while redistribution via the fiscal process is not. Nonetheless, it
can be suggested that some taxpayers do derive utility from that part of their taxes earmarked for the relief
of poverty and the care of old and disabled people (see Box 5.2).
Box 5.2 Experimental games
In the field of behavioural economics, we have witnessed the results of a large number of experimental games aimed
at testing the ‘self-interest hypothesis’ that lies at the root of many of our standard economic models. These games
include the so-called ultimatum game, the gift exchange game, the trust game and, as we saw in Chapter 3, the public
goods game.
In the ultimatum game, for example, the experimenter gives an amount of money to a so-called proposer with the
instruction of sharing it with a responder. If the proposer gives some portion to the responder who then rejects it, both
players get nothing; but if the responder accepts it, the proposal stands. Now, in terms of the self-interest hypothesis,
the smallest possible amount would be offered and accepted. And yet in many such games played across the world
most proposers offer in excess of 20 per cent of the original amount, while the probability of rejection falls
dramatically with the size of the offer. The conclusion here is that both players have a sense of ‘fairness’. Other
experimental games show that people are generally altruistic, or have social (as opposed to only individual)
preferences, and also have an ‘aversion’ to inequality (e.g. Bowles, 2004). From a public economics perspective, one
implication of these experimental findings is that people would be willing to give part of their income to the fiscus if
it will, directly or indirectly, benefit the poor.
5.4 Bergson criterion

In terms of the Bergson criterion, a redistribution of income can be justified on welfare grounds even if it
places one or more individuals in a worse position. The Bergson criterion is best explained in terms of the
familiar social welfare function, according to which a community’s welfare is defined in terms of the
utilities of all the individuals making up that community.
We can distinguish between two such welfare functions. The first is the so-called ‘cardinal’ or additive
welfare function:
where W represents the level of community welfare, and Ua and Ub are individual utilities. According to
Equation [5.4], community welfare equals the sum of individual utilities – these are assumed to be
measurable on the same scale.
The additive welfare function does illustrate the Bergson criterion very neatly: it allows for the Pareto
criterion insofar as W will increase if either Ua or Ub increases, or if both Ua and Ub increase at the same
time. It also allows for a welfare improvement consequent upon a decrease in either Ua or Ub – W will
increase so long as the increase in Ua (or Ub) exceeds the decrease in Ub (or Ua). In addition, if a poor
person, say individual a, derives greater additional utility from an extra R10 than does his or her rich
counterpart, individual b, then the stage is set for a welfare-improving redistributive policy: taking R10
away from b and giving it to a will raise Ua by more than it will reduce Ub . This conclusion assumes that
an individual’s marginal utility from income diminishes as his or her income increases.
Equation [5.4] represents a very restrictive welfare function. Apart from the measurability issue, it
assumes that individual utility functions are identical and depend only on their incomes. It is also highly
debatable whether increases in income engender smaller increases in utility at higher levels of income.
It is partly for these reasons that economists prefer the more generalised welfare function:
This function is ordinal in nature and does away with the assumption of measurability. By letting W take on
different (constant) values, it is possible to derive a set of social or community indifference curves, such as
those labelled W1, W2, and W3 in Figure 5.2. These functions have the same properties as individual
indifference curves: they are convex with respect to the origin, cannot intersect, and exhibit diminishing
marginal rates of substitution.
Figure 5.2 also shows a utility possibility frontier (also known – rather grandly – as the ‘grand utility
possibility frontier’) that is directly derived from the familiar PPC. The utility possibility frontier, QR,
gives the utility combinations associated with all the top-level equilibrium points along a conventional
PPC. In the example of Figure 5.2 the community prefers the combination at point H – the welfare
maximum – to any other point along the frontier.
Figure 5.2 Utility possibility curve and welfare maximum
This analysis crucially depends on two closely related assumptions. Firstly, the community is assumed
to be able to choose between different points along the utility possibility frontier, for example, point H as
opposed to point G; the question of how a community makes such choices has given rise to a vast literature
– referred to as public choice theory – and we shall return to this issue in the next chapter. Secondly, when
choosing a particular point on the frontier, the community is making an explicit value judgement about the
relative worthiness of the two individuals a and b. This is illustrated in Figure 5.3 where two alternative
sets of welfare functions are shown, one labelled W1, W2, …, and the other W1’, W2’, … . The similarly
numbered subscripts indicate the same level of social welfare. It is clear that the former function embodies
a relatively strong preference for individual a, generating a top-level equilibrium at point I; whereas the
function W1’, W2’, …, embodies a strong relative preference for individual b. Individual a is in a better
position at point I than at point J, while the opposite is true of individual b, and yet the two social
indifference curves, W2 and W2’, represent the same level of welfare.
It is but a small step to show that the difference between the two welfare functions in Figure 5.3 also
implies a difference in the community’s assessment of the worthiness of the two sectors, X and Y. All we
need to assume is that the individuals have different tastes. Thus, if individual a has a strong relative
preference for good X, and individual b has a strong relative preference for good Y, then it follows that the
function labelled W1, W2, … indicates, by implication, that the community has a strong relative preference
for sector X. Similarly, the function W1’, W2’, … would indicate a strong relative preference for sector Y.
Figure 5.3 Alternative welfare functions
Consider the following two individual utility functions:
Given that X = Xa + Xb and Y = Ya + Yb , application of the ‘function-of-a-function’ rule to Equation [5.5]

provides the following:
where V indicates a different functional relationship from our earlier function. Equation [5.8a] simply states
that the welfare of society depends on the production levels of the two commodities X and Y. Equation
[5.8a] is a very general version of the welfare function (defined in terms of individual commodities) and it
can be specified in many ways. However, most of these specifications will embody the above value
judgement, that is, that the community has to make a judgement about the relative worthiness of the two
sectors and, by implication, of the two individuals as well.
The commodity-based welfare function is shown in Figure 5.4 where we assume that the top-level
competitive equilibrium occurs at point C. But this does not coincide with the welfare maximum at point S:
the community prefers point S to point C, thus establishing a prima facie case for appropriate state
intervention to move the economy to point S.
This analysis has shown that a top-level competitive equilibrium is only a necessary condition for a
social welfare maximum, not a sufficient condition – this is indicated by the difference between points S
and C in Figure 5.4. Two questions therefore arise:
Figure 5.4 A competitive equilibrium versus welfare maximum
• What kinds of policy could be used to bring about an inter-sectoral or inter-personal redistribution of
income, that is, a movement from point C to point S?
• What are the implications for economic efficiency of such policies?
As far as the first question is concerned, government has several options at its disposal: it can tax sector Y
and subsidise sector X, or it can tax one individual and subsidise the other; it can also redirect its own
spending towards one sector or individual. These options will be discussed in greater detail in subsequent
sections of this book. Note, however, that a movement from C to S entails an improvement in social
welfare even though Ub may be reduced on account of the reduced supply of good Y. This is the difference
between the Bergson welfare function and the Pareto criterion discussed earlier.
In the meantime we turn our focus to the second question raised above.
5.5 Efficiency considerations

It would be surprising if a redistributive policy comprising a suitable tax-subsidy mix had no effect on
efficiency levels in the economy. As we shall see in subsequent chapters, most taxes and subsidies do have
distortional effects on markets, and the real question is whether the perceived benefits from such policies
justify these distortions.
We shall briefly introduce two such distortions here. The first is the possible effect that individual taxes
and subsidies might have on the willingness to work. Specifically, does a new or higher tax or subsidy
cause people to work longer or fewer hours per day or per month? And similarly, does a higher tax or
subsidy cause people to work more or less productively, that is, produce more or fewer units of output per
hour? In other words, can one expect an increase or decrease in the supply of labour or in its productivity –
or, in terms of our two-sector model, an optimal or sub-optimal top-level equilibrium?
The evidence on this issue – referred to as ‘income and substitution effects’ or the ‘(dis)incentive effect’
– is anything but conclusive. What it does show is that, above a certain level, increased taxes tend to have a
small negative effect on the willingness to work. This is illustrated in Figure 5.5 where the initial
competitive equilibrium again occurs at point C0 on the PPC labelled M0N0, representing an initial welfare
level of W1. Now, a policy aimed at redistributing resources from sector Y to sector X (for example by
taxing sector Y and/or subsidising sector X) will move the economy in the direction of point S – the policy
target. However, if the policy does have a small disincentive effect, labour productivity may fall below its
potential and the economy may end up at a sub-optimal allocation lying inside the PPC – for example point
F in Figure 5.5.
Although point F is inferior to point S, it nevertheless represents a higher level of welfare than the
original allocation at point C0 – W2 as opposed to W1. A stronger disincentive effect would have a bigger
negative impact on labour productivity and hence on the level of social welfare. Thus, the policy could
move the economy to a point such as E on the social indifference curve W0, which is clearly inferior to the
original allocation at point C0.
The second possibility referred to above concerns the dynamic consequences of a distribution policy
aimed at taxing the rich and subsidising the poor. The imposition of a new or higher tax (on sector Y or on
individual b) may limit savings and investment and hence economic growth and, in the limit, keep the
economy on its existing PPC, for example, at point S in Figure 5.5, representing the higher welfare level
W3 (compared to the original allocation at point C0). In the absence of such a policy, however, the economy
may experience positive economic growth over time – indicated by the outward shift of the PPC from
M0N0 to M1N1 and the concomitant change in the competitive equilibrium from point C0 to point C1. The
latter change – though not achieving a welfare maximum – nevertheless represents an improvement in the
level of social welfare from W1 to W4 and is evidently superior to the static policy-induced movement to
point S.
Figure 5.5 Disincentive and savings effects of redistribution

On the whole, the above analysis indicates that there are many good reasons why societies might want
to achieve a more equitable distribution of income. But whatever the justification might be, it is clearly
important that the expected benefits of a policy of redistribution should be carefully weighed against the
possible negative effects it might have on labour supply and on savings and investment, and hence on
economic growth in the long term. We will return to this theme in subsequent chapters.
Key concepts
• additive welfare function (page 89)
• altruism (page 87)
• Bergson criterion (page 84)
• entitlement theory (page 85)
• externality argument for redistribution (page 87)
• insurance motive (page 87)
• justice in acquisition (page 85)
• Pareto criterion (page 84)
• rectification of injustice (page 85)
• redistribution (page 87)
• social indifference curves (page 90)
• social welfare function (page 88)
• Truth and Reconciliation Commission (page 85)
• willingness to work (page 92)
SUMMARY
• Economists normally distinguish between two criteria when assessing the welfare effects of public policy:
the Pareto criterion and the so-called Bergson criterion. The Pareto criterion implies that a policy-
induced change is justified only if it improves the well-being of at least one person without harming any
other. The Bergson criterion is much broader and allows for a welfare improvement even if one or
more individuals are harmed in the process.
• Robert Nozick’s entitlement theory distinguishes between the principles of justice in acquisition and
justice in transfer, arguing that ‘a distribution is just if it arises from a prior just distribution by just
means’ (Nozick, 1974: 58). Violating either of the first two principles gives rise to Nozick’s third
principle (that is, justice in rectification), in terms of which a redistribution of wealth is potentially
justified only if one or both of the first two principles have been violated.
• Nozick (1974: 67) himself recognises the practical difficulties involved when he asks, ‘… how far back
should one go in wiping clean the historical slate of injustice?’ This question is clearly relevant to
various peace initiatives and conflict resolutions undertaken in many parts of Africa, and, in particular,
to South Africa’s recent past. Nozick’s principles of justice in effect formed one of the cornerstones of
the investigations undertaken by the Truth and Reconciliation Commission (TRC) in South Africa. The
TRC limited its focus to the apartheid era, in particular to the period between 1 March 1960 and 5
December 1993, during which the National Party was in power, although it did also recognise the many
historical precedents set by earlier regimes.
• Policies aimed at redistributing income from rich people to poor people can be justified on Pareto grounds
in terms of the theory of externalities. High levels of crime and violence often go hand in hand with
widespread poverty, which may undermine the quality of life of the rich. Likewise, a lack of sanitation
and other health-promoting services among the poor may give rise to a variety of contagious diseases
that may ultimately threaten the health status of the rich.
• Under these conditions, rich people may be prepared to transfer part of their income to the poor in an
attempt to reduce poverty and minimise its negative external effects. However, no single rich person
can do so alone and it is partly for this reason that the distribution of income is often viewed as a public
good: all or most rich people stand to benefit from a reduction in poverty, and hence in the level of
crime and violence or in the incidence of disease, but individuals acting on their own cannot bring
about changes of this nature.
• The Bergson criterion can be explained in terms of the familiar social welfare function, which represents
the relative preferences of a group or community of individuals and which, inter alia, reflects the
optimal or most preferred distribution of income. This welfare maximum also coincides with a
particular point lying on the production possibility curve (PPC), but may well be different from the
toplevel equilibrium derived in Chapter 2. When choosing this point on the PPC, the community is
making an explicit value judgement about the relative worthiness of the two (groups of) individuals, a
and b.
• In terms of the two-sector model of general equilibrium, the government can tax the rich (for example,
individual b) and subsidise the poor (individual a) or it can tax luxury goods consumed mostly by the
rich (for example, sector Y) and subsidise basic consumer goods (sector X). It could also redirect its
own spending towards one sector or individual.
• A policy comprising a tax-subsidy mix of this nature may have distortional effects on markets. The real
question is whether the perceived benefits from policies such as this justify these distortions. In terms
of the effect on the willingness to work, for example, does a new or higher tax or subsidy cause people
to work more or fewer hours per day or per month? Similarly, does a higher tax or subsidy cause
people to work more or less productively, that is, to produce more or fewer units of output per hour?
• In addition, the imposition of a new or higher tax (on sector Y or on individual b) may limit savings and
investment, and hence also economic growth.
• It is clearly important that the expected benefits of a policy of redistribution be weighed carefully against
the possible negative effects that it might have on labour supply as well as on savings and investment,
and hence on economic growth in the long term.
5.1 A policy-induced movement along the production possibility frontier can be justified in terms of …
a. the Pareto criterion.
b. the Bergson criterion.
c. the Pareto and Bergson criteria.
5.2 The Bergson criterion implies that a policy-induced change can be justified if …
a. the well-being of at least one individual is increased without anyone else being harmed.
b. the well-being of at least one individual is improved and that of another is diminished.
c. individual benefits exceed individual losses.
5.3 Robert Nozick’s entitlement theory is based on the following principle or principles of justice:
a. Justice in acquisition
b. Justice in transfer
c. Rectification of an injustice
5.4 Taxing the rich and subsidising the poor could have the effect of …
a. an increase or a decrease in labour supply, depending on the magnitude of the tax or subsidy.
b. an increase or a decrease in labour supply, irrespective of the magnitude of the tax or subsidy.
c. an increase or a decrease in labour productivity.
d. an increase or a decrease in savings and investment.
SELF-ASSESSMENT EXERCISES
5.1 Distinguish between the so-called Pareto and Bergson criteria for a redistribution of income between
rich and poor people.
5.2 Explain why altruistic behaviour could provide a Pareto-based justification for a policy of income
redistribution.
5.3 Distinguish between the ‘additive’ and ‘ordinal’ (or Bergson) social welfare functions.
ESSAY QUESTION
5.1 Discuss the proposition that Pareto optimality is a necessary but not a sufficient condition for a welfare
maximum.
5.2 Discuss Nozick’s entitlement theory and briefly consider its relevance for South Africa.
5.3 Discuss the efficiency implications of an inter-sectoral (or interpersonal) policy of income
redistribution.
Public choice theory
Philip Black and Estian Calitz
In the previous chapters, we looked at a range of so-called market failures and highlighted the point that
private markets cannot, on their own, supply public goods or make allowance for external costs and
benefits. Similarly, although it is conceptually possible to regulate imperfectly competitive markets or to
evaluate the desirability of various income distributions by means of the Pareto and Bergson normative
criteria, we have not as yet addressed the question of how a community can practically express its
collective preferences on these matters. In this chapter, we focus on the way in which communities make
public choices.
discuss the Rawlsian theory of justice and comment on its relevance to recent political developments in South
Africa
explain the median voter theory, and indicate its potential strengths and weaknesses
discuss the meaning and importance of Kenneth Arrow’s impossibility theorem
consider whether logrolling (or vote trading) is an efficient means of improving the outcomes of a majority voting
system
explain the theory of optimal voting rules and consider the question of whether it does indeed provide an optimal
rule for majority voting
discuss the maximising behaviour of politicians and bureaucrats, and consider the implications of this behaviour
for majority voting
explain the origins and consequences of rent-seeking.
6.1 Introduction
Many public issues are discussed and resolved in the political marketplace, where the quantities of public
goods and services and the levels of taxes and subsidies are decided. The decisions are usually made by
elected politicians on behalf of the voting population. In this chapter, we look at the way in which these
public decisions are made from a strict economic perspective. We investigate the mechanisms – or social
choice rules – by which individual preferences are transformed into social or public preferences and ask
whether these will ensure that governments act in accordance with the wishes of the people they represent.
The most straightforward method of effecting a transformation of this nature lies in simply imposing the
ethical views of some dictator or central politburo on society, and then adjusting economic policy
accordingly. Viewed historically, however, dictatorial rule has often led to abusive behaviour and clearly
does not represent a desirable social choice rule. Most countries today prefer some method of collective
decision-making based on, and legitimised by, mass participation on the part of their citizenry. Indeed, the
characteristic social choice rule employed in most democracies is majority rule, whereby citizens elect
representatives who must act within certain constitutional parameters.
Thus, in the absence of dictatorial rule, the range of social choice rules varies between the unanimity
rule, in terms of which a proposal requires 100% support before being accepted, and the ordinary
majority-voting rule, for which 50%-plus-one-vote is required. In this chapter, we first consider the
unanimity rule (Section 6.2), focusing specifically on John Rawls’s well-known theory of justice (1971),
partly because of its relevance to the dramatic shift towards a full democracy in South Africa. This is
followed by a discussion of the ordinary majority-voting rule as expressed in the median voter hypothesis
in Section 6.3. Sections 6.4 and 6.5 look at some of the problems associated with majority voting, focusing
specifically on its inability to allow for differences in the intensities of individual preferences. Section 6.6
deals with an important variation on the ordinary majority-voting rule, that is, Buchanan and Tullock’s
(1962) notion of optimal voting rules. In Section 6.7, we shift our attention to positive public choice theory,
and consider the behaviour of politicians, bureaucrats and private interest groups within a typical
representative democracy. Section 6.8 concludes.
6.2 The unanimity rule and the Rawlsian experiment

The unanimity-voting rule means that each member or representative group within a community must
support a proposal before it becomes the collective decision. The unanimity rule is the only voting rule that
will lead to a Pareto-optimal outcome and, since it requires that collective decisions be in the interest of all
parties, it can be viewed as a positive sum game.
A good, if somewhat unusual, example of the unanimity principle is provided by John Rawls, or the
Rawlsian theory of justice (Rawls, 1971). The theory is essentially a normative one setting out the
conditions under which ‘free and rational’ persons will choose certain principles of justice that govern the
‘basic structure of society’. These principles determine the fundamental rights and duties of individuals,
and regulate the institutional framework within which allocative decisions are made on a collective and
unanimous basis. The ‘social contract’ that ultimately emerges is described by Rawls as a case of ‘justice in
fairness’.
What sets the Rawlsian theory apart from others is its focus on the process by which individuals reach
unanimity over the principles of justice. He thus asks his readers to imagine a situation in which the
contracting parties, representing the whole community, all step through a ‘veil of ignorance’ and enter a
hypothetical ‘original position’, which is a position that is reached through intensive personal discourse
during which all barriers are broken down, and each party is able to rid itself of all prejudices and prior
knowledge. In the original position, each party is wholly unaware of its ‘place in society’ and has no
knowledge of the probability distribution of expected outcomes, let alone its current well-being. They all
stand as equals on the same playing field. It is important to emphasise that Rawls only asks his reader to
imagine an original position of this nature, not actually to create it!
What is important for our purpose is that each party in the original position is assumed to be equally
risk-averse. All parties would thus support a risk-minimising social welfare function that effectively insures
them against the worst possible outcome. A welfare function of this nature could take the following form:
indicating that social welfare depends on the lower of the two individual utilities. Thus, if Ua < Ub, then
welfare reduces to W = Ua. This implies that in order for W to increase, there must be an increase in Ua.
The latter condition does not preclude an increase in Ub; it is perfectly in order for Ub to increase as long as
Ua increases as well. The Rawlsian welfare function is therefore perfectly consistent with a Pareto-based
policy benefiting both parties.
From a Rawlsian perspective, Equation [6.1] implies that all parties in the original position will adopt a
so-called maximin strategy, which gives priority to the party potentially finding itself in the worst-off
position or with the minimum utility. This will provide them with a measure of protection in case they end
up being that party. All parties will therefore choose and unanimously approve a political constitution
embodying the Rawlsian welfare function, and, by implication, also an institutional system and a set of
policies aimed at allocating and distributing resources in accordance with that function. Public policy
should thus be aimed at benefitting the poorest of the poor at all times, irrespective of whether it harms or
benefits other parties. The conclusion is a good example of the Bergson criterion for a welfare
improvement, according to which a redistribution of income is justified on welfare grounds – that is, if
social or additive welfare is enhanced – even if it places one or more individuals in a worse position (see
the discussion in Chapter 5).
It hardly seems prudent to suggest that negotiations for a new constitution and democratic dispensation
in South Africa, Namibia, Mozambique and several other African countries even approximated a Rawlsian
original position. None of the negotiating parties can be said to have been completely impartial, while the
underlying principle would appear to have been one of compromise rather than unanimity. Nonetheless, the
growing concern for the poor and historically disadvantaged in South Africa, as reflected in several
empowerment charters and the redistributive nature of recent budgets (see for example Chapter 7), does
seem to come close to acceptance of a Rawlsian welfare function, that is, one that affords priority status to
the disadvantaged members of the community.
The unanimity rule is not without its shortcomings. Reaching a unanimous decision may take a very
long time, partly because of the divergent nature of individual preferences and the number of issues
involved. Consider, for instance, the drawn-out nature of the (‘Kempton Park’) negotiations that preceded
the drafting of a new constitution in South Africa. The point here is that the costs of reaching consensus
may be inordinately high. It is important that cognisance be taken of the opportunity costs associated with
the unanimity rule. The time spent lobbying and influencing individuals and groups of individuals could
arguably be spent more productively elsewhere in the economy. We return to this issue in Section 6.6.
Viewed more practically, the unanimity rule could give rise to strategic actions on the part of certain
individuals or groups who might want to enter into bargaining contracts with other parties in order to
secure special benefits. Under these conditions, parties may be persuaded to engage in logrolling (or vote
trading) by forfeiting something that they want in exchange for something about which they feel
particularly strongly. We shall return to the issue of logrolling in Section 6.5, but suffice it to say here that
the outcome of a process of this nature is hardly likely to be Pareto-efficient.
A final objection to unanimity rule is that it gives minorities the right of veto; in the extreme case, the
last unpersuaded voter has the decisive vote. Exercising a veto right of this nature will clearly render the
unanimity rule obsolete as it will lead to a situation in which effectively a small minority rules.
6.3 Majority voting and the median voter

The most common social choice rule is the ordinary majority rule (or majority voting). Every individual
is given one vote and the issue, policy or party receiving the most votes wins the day. Under a direct
democracy (direct democratic dispensation) where each voter reveals his or her preferences directly via
a referendum, the majority-voting rule requires that a proposal receives 50%-plus-one-vote support before
it can be imposed on the community. If South Africa had a direct democracy and the public were asked in a
referendum to vote for or against an increase in the rate of value-added tax (VAT), the rate would not be
increased if (say) 12 500 001 voters out of a total of 25 million voted against the increase.
In a representative democracy, individual voters elect representatives who make decisions on their
behalf. A representative democracy is generally less costly to administer than a direct democracy and it is
largely for this reason that the former is most widely used in the world today. However, some countries (for
example, Switzerland) combine the two systems, utilising the direct method when important national
decisions have to be made.
Voters’ interests in a representative democracy are represented by several influential actors, including
elected politicians, bureaucrats, and private and public interest groups. The role of politicians is paramount
and one can reasonably ask: What are they in the ‘market’ for? What do they want to maximise? According
to Anthony Downs (1957), politicians act like any other utility-maximising consumer or profit-maximising
entrepreneur; the only difference is that they are in the business of maximising the number of votes they
collect in an election. In an ideal world, the vote-maximising behaviour of politicians is an important
means of transforming individual preferences into a logically consistent set of social preferences.
What is required to maximise votes in a representative democracy? In order to answer this question, we
must examine the median voter theorem. We begin our explanation of this theorem by defining the
median voter as the voter whose set of preferences divides the voting community exactly into two. Let’s
assume we have a community of five people: Ndlovo, Mary, Thandi, Johan and Ibrahim. We assume
furthermore that we know their precise preferences concerning the size of the national health budget. Table
6.1 sets out the budgets for which each of them will vote.
Table 6.1 Voter preference for size of health budget
Voter Amount (R million)
Ndlovo 50
Mary 200
Thandi 400
Johan 600
Ibrahim 800
Let us adopt a step-by-step approach towards discovering the majority decision on the size of the budget,
beginning with a zero budget. Assuming that there are no extreme preferences (see below), all five voters
will prefer a R50 million budget instead of a zero budget. A movement from R50 million to R200 million
will win the support of everyone except Ndlovo; that is, everyone except Ndlovo prefers a budget larger
than R50 million. A movement from R200 million to R400 million will be approved by Thandi, Johan and
Ibrahim, while only two voters will support an increase from R400 million to R600 million, and so on.
It is clear from Table 6.1 that three of the five options will enjoy majority support: all five voters (or
100%) will support a budget of R50 million, four voters (80%) will support a budget of R200 million and
three voters (60%) will support a budget of R400 million. But which is the optimal one? Which one will
make our voting population happiest or cause the least harm?
The answer is provided by the median voter theorem: the best option is that of Thandi’s – our median
voter – whose preference divides the voters exactly into two. The reason is that both Johan and Ibrahim
would prefer Thandi’s option to that of Ndlovo and Mary; Ndlovo and Mary will likewise have a relative
preference for Thandi’s option vis-à-vis those of Johan and Ibrahim. It follows that our larger-budget
supporters, Johan and Ibrahim, will rather give their support to a politician campaigning for the median
voter’s choice than to a politician promoting any other potential majority choice.
We can now formulate the median voter theorem: under a majority voting system in which preferences
are not extreme, it is the median voter’s preferred option that will win the day, since that is the option that
will produce a minimum welfare loss for the whole group.
The median voter model provides a simplified explanation of the rational behaviour of politicians under
ideal conditions. The model assumes that politicians interact with voters to determine their relative
preferences. By doing so, they are able to identify the median voter, act upon his or her preferences and
fulfil the wishes of the majority at minimum cost in the process.
Of course, the real world of politics is a bit different from what the median voter theory would have us
believe. Not all politicians are vote maximisers responding passively to individuals’ demands. Some might
pursue the public interest rather than vote-maximising strategies, while others may appeal to voters because
of their vision and personality, rather than any tangible benefits that they might promise. The model also
presumes that the median voter can be identified. This is not easy, especially since different political issues
may have different median voters. The model furthermore assumes that voters are rational and that
everyone will vote. Politicians and voters are often far from being perfectly informed, which renders
rational choice unlikely, if not impossible. We return to this issue in Section 6.7.
On the whole, the majority-voting rule – although not Pareto-efficient – does have two important
advantages vis-à-vis the unanimity rule:
• Reaching majority approval takes much less time and is therefore less costly than achieving unanimous
support. A parliamentary majority vote would normally be regarded as sufficient to approve the
national budget, but a two-thirds majority is needed to change the constitution. The latter entails a more
expensive and time-consuming decision-making process and requires much more effort to achieve,
especially in a multiparty democracy with strong opposition.
• Under majority rule, it is much less likely that a minority will be able to prevent the majority from getting
their proposals accepted; on the other hand, majority rule can be criticised for its winner-takes-all
consequences, and for its potential to ignore minority interests and enable the majority to tyrannise
minorities.
6.4 The impossibility theorem

A potentially serious shortcoming of the majority-voting rule is the fact that it can lead to results that are
logically inconsistent. Before we explain this, we note that an optimal result under majority voting
implicitly assumes that the choice of a public good is subject to declining marginal benefits, similar to
private goods. This implies that individuals are consistent in their choice of alternative public choices,
which we refer to as exhibiting single-peaked preferences. We demonstrate this with the aid of Figure 6.1,
which is based on Hyman (1999: 178–181). The important point is that the marginal benefit for a voter
decreases as the quantity of the public good increases. This is shown in Figure 6.1(a). Each higher output
level consistently generates less additional benefit, as shown by the negatively sloped line MB. This rules
out a multi-peak preference line such as MB*. The horizontal line t represents the taxpayer’s constant
amount of tax per unit of public good. The difference between MB and t shows the net benefit for each
amount of public good. At quantity Q* the difference is zero, which means that no extra net benefit accrues
when the extra amount of public good reaches Q*. Beyond Q* net benefit is negative. In Figure 6.1(b) we
show the total net benefit. The bell-shaped curve reaches its maximum level (i.e. total net benefit) at Q*,
after which it starts to decline because the tax payment exceeds the benefit. Only when all voters have
similar single-peaked preferences, will majority rule generate an efficient supply of public goods. This is
one of the important prerequisites of the Arrow theorem, discussed next.
Nobel Laureate, Kenneth Arrow (1951) proved that, unless majority rule meets with certain conditions,
it will not lead to consistent outcomes. This became known as Arrow’s impossibility theorem. Arrow
proved that it is not always possible to derive a logically consistent set of social preferences from a
corresponding set of individual preferences on the basis of an ethically acceptable (or democratic) social
choice rule. He came to the conclusion that there is not a single voting rule – not even majority voting –
that would meet all of the minimum ethical conditions that he set for an acceptable social choice rule.
Arrow’s theory crucially depends on these ethical conditions, which can be summarised as follows:
• The first is the rationality assumption, according to which individuals and the community must either
prefer one option (X) to another (Y) or be indifferent between the two; this assumption is formulated as
follows:
Figure 6.1 Declining marginal benefit of a pure public good, reflecting single-peaked preferences.
X > or Y > X or X = Y
where the symbols > and = stand for, respectively, ‘prefer to’ and ‘indifferent between’. The community
must also adhere to the familiar transitivity condition, that is:
If X > Y and Y > Z, then X > Z
which means that if X is preferred to Y and Y is preferred to Z, then X must be preferred to Z. This result is
exactly what single-peaked preferences achieve, as explained in Figure 6.1.
• Next is the independence of irrelevant alternatives, which implies that if the choice is between two
options, X and Y, then the effect of Z is irrelevant.
• The Pareto principle has to apply, that is, if voter a prefers X to Y and voter b is indifferent between the
two options, then the (two-person) community must prefer X to Y; or in algebraic terms:
If (X >Y)a and (X =Y)b then X >Y
• There has to be an unrestricted domain, that is, it should be possible for all eligible voters to vote.
• Finally, non-dictatorship should apply.
Although these conditions seem very reasonable indeed, it is important to note that Arrow’s theorem is
especially relevant to voters who have widely divergent preferences or who choose extreme alternatives.
We can illustrate a case of this nature by considering three voters, Brenda, Christelle and Abdullah. Each of
them has to choose between three alternative budgets, that is, a large budget (denoted by L), a moderate
budget (M) and a small budget (S). Let the individual preferences be as follows:
Brenda: L > M > S

Christelle: M > S > L
Abdullah: S > L > M
It is clear from this example that if alternative budgets are voted for in pairs, a majority of the voters (in
other words, Brenda and Abdullah) would prefer L to M. Another majority (in other words, Brenda and
Christelle) would prefer M to S. (It is appropriate at this point to pause in order to mention, with reference
to Figure 6.1(a), that decreasing marginal utility should be interpreted here in the sense that utility falls
consistently in the case of each voter as he/she moves away from the first choice, rather than visualising a
linear array of public good outputs on the horizontal axis from small to large.) To return to our example:
according to the transitivity condition, therefore, a majority should prefer L to S. Yet this is not the case: a
majority (in other words, Christelle and Abdullah) actually prefer S to L. Hence we have a logically
inconsistent or intransitive outcome.
The reason for this outcome is straightforward. Abdullah has extreme preferences: he prefers a small
budget to a large one, but also prefers the large one to a moderate one. Line MB* in Figure 6.1(a) actually
portrays this. When given the choice between any two budgets, a voter of this nature does not consistently
prefer a larger budget to a smaller budget or vice versa. Abdullah’s preferences may for example stem from
the following.1 Let’s say the above budget is for public schooling, which is financed by taxes. Abdullah has
the possibility of enrolling his daughter in a private school at a substantial cost, while still having to pay
taxes to finance the budget for public schooling. If the budget for public schools (denoted here as S) is
substantially lower than the cost of a private school, he would prefer S to L. In a choice between M (a
medium-sized budget) and L, however, he may prefer L if that could result in a quality of schooling that
may cause him to enrol his daughter in the public school, possibly still at a somewhat lower rate than the
cost of private schooling.
It is not that decisions cannot be taken by means of majority voting, but that decision-making has less
credibility under circumstances such as outlined above and optimal resource allocation is unlikely. In a
system of majority voting where voting often occurs in a pair-wise fashion,2 the presence of extreme
preferences3 can have a number of consequences. The first is that there may be a new winner every time
the sequence of voting is changed. Consequently, it is impossible to get a consistent winner. While the
preferences of voters may individually be consistent or rational, their combined preferences or the
community’s preferences (as reflected in their voting) will not be consistent if the group of voters includes
people with extreme preferences. The phenomenon is referred to as the voting paradox. This kind of
voting can continue indefinitely, in a phenomenon called cycling.
Furthermore, if the organisers of the election have prior knowledge of the existence of these extreme
preferences, it is possible to organise the sequence of voting in such a way that a desired result is obtained.
This is known as agenda manipulation. Any result that can be changed if the order of voting is changed is
not consistent and is not a true reflection of voters’ preferences. Such a result therefore cannot claim to
represent a choice for an optimal allocation of resources.
What is the practical relevance of all this? In a strict sense, Arrow’s theory implies that the majority-
voting rule does not necessarily produce outcomes that enjoy the support of the majority, which is
something of a contradiction in terms. All is not lost, however. The theory only proves that logical
inconsistency is a possible outcome. In the above example of three voters choosing between three
alternatives, for instance, the probability of a logical inconsistency arising is only 6% (Frey, 1978: Chapter
2). As one increases the number of voters and the number of alternatives, this probability rises only very
gradually, reaching about 31% when the number of voters becomes very large and the number of
alternatives reaches six. It is thus tempting to conclude that perhaps too much is made of the impossibility
theorem.
Nonetheless, the problem of inconsistency is compounded by the fact that majority voting does not
allow for differences in the intensity of individual preferences and by the attendant problem of logrolling,
as we shall see in the next section.
6.5 Majority voting and preference intensities
Another major shortcoming of the majority-voting rule is the fact that it cannot account for differences in
the intensity of voters’ preferences or at least it cannot do so in a cost-effective way. Under these
conditions, it is quite possible that a small majority may have a relatively weak preference for a particular
candidate, whom they nevertheless vote into power. If a large minority opposes the same candidate very
strongly, it is possible that, in net welfare terms, the community as a whole will be in a worse position:
given an additive welfare function (implying measurability of individual utilities), the cumulative decreases
in individual utilities will exceed the cumulative increases.
Under majority voting, there are two ways in which preference intensities can be accommodated. The
first is to ask people to vote in the form of intensity units. Instead of a straight yes-no vote, each voter can,
for example, be given a total of 100 points that he or she can allocate between competing candidates. In this
way, the ordering of preferences is weighted and the weights can be taken into account in the voting
procedure. It is thus possible that a candidate who would have come last under a straight yes-no system
fares better under the weighted system. But weighting is a normative procedure: Thandi’s 80% may mean
something completely different from Johan’s 80%. Weighting is also difficult to implement and
administratively very costly, and it must be asked whether the additional benefits from introducing a
procedure of this nature are worth the additional costs.
Another – some would say better – way of accounting for preferences under a majority-voting rule is
through logrolling or vote trading. Logrolling may occur between and among minority parties and the
majority party. For example, an intense minority may trade its support for an issue enjoying strong support
among the majority in exchange for majority support of the minority issue. Alternatively, the same
exchange can be based on amendments being made to the issues involved. In practical terms, the latter
exchange would only be feasible if the minority had a particularly strong preference for the minority issue
and the majority did not feel too strongly about it. It would also not help if the minority took a minority
view on each and every issue: if the majority could never count on a minority’s vote on any issue, there
would be no point in trading votes. Nonetheless, to the extent that logrolling enables a better expression of
consumer preferences in respect of public goods, it may increase the social welfare of society.
Logrolling can also take the form of an exchange of votes between different minority groups. These
groups could gang up against the majority by supporting each other’s causes. Suppose two minority parties
in parliament each have a bill that it will never get approved on its own. By voting for each other’s bill,
they could get both bills passed if the majority party had less than 50% of the votes in parliament. Vote
trading may be beneficial if it leads to the approval of economically viable projects that, together, may
otherwise not have seen the light of day. It could, however, equally lead to the adoption of non-viable
projects or to projects that do not meet with the approval of the majority. While vote trading on the part of
minorities does reveal the intensity of individual preferences, it can either increase or decrease the ability of
a majority voting system to reflect the wishes of the majority accurately.
6.6 Optimal voting rules

Is there anything in between an ordinary majority-voting rule (50%-plus-one-vote) and a 100% unanimity
rule? Is there anything more efficient than ordinary majority voting? The answer can be found in the theory
of optimal voting rules, as propounded by James Buchanan and Gordon Tullock (1962).
Their main hypothesis is that the optimal voting majority varies in accordance with the particular public
issue in question and that these optimal majorities depend on the costs involved in the act of voting. Voters
are faced with two kinds of costs: external costs and decision-making costs.
External costs arise when a community takes a decision that goes against the interest of an individual
voter or group. In other words, the greater the number of people not supporting a public decision, the
higher the external costs will be, or the higher the degree of unhappiness among the voting public will be.
The expected external cost will be highest when public decisions are made by one person – a dictator –
since these decisions will potentially ignore and undermine the interests of all other voters. By contrast,
under a unanimity voting system, where public decisions require 100% support, the external cost can be
expected to be zero. In other words, the closer one comes to unanimity, the smaller the risk of harming
minorities. External costs are inherent in all decision-making rules except the unanimity rule. In Figure 6.2,
which depicts majority size as a function of cost, the external cost curve falls from top left to bottom right.
Decision-making costs refer to the costs involved in persuading voters to support a particular public
issue. The smaller the community of voters, the easier it will be to reach a majority or unanimous decision
and the lower the decision-making costs will be. As unanimity is approached, however, it becomes
increasingly difficult and costly to harness the support necessary to pass a new law or resolution. The
reason is that it takes time and (often) extra resources to debate with and convince more decision-makers to
support a proposal, especially if there are many members of opposition parties whose votes will have to be
obtained. One also finds that the opportunities to act as a free rider increase as the size increases of the
group whose consent is sought. Thus, as the size of the required support base increases, it becomes
increasingly expensive to induce individuals to reveal their preferences accurately. In Figure 6.2, the
decision-making cost curve rises from left to right as the number of individuals required for a collective
decision increases.
Figure 6.2 Optimal majority and the cost of democratic decision-making
We assume that voters take both types of costs into consideration when casting their votes. However,
since these costs will vary with the particular issue in question, the optimal – that is, cost-minimising –
voting rule will vary likewise. If the two kinds of costs are summed vertically, we obtain a total cost curve,
as shown in Figure 6.2. The lowest point on the total cost curve, coinciding with the percentage given by
M*, determines the optimal majority for the particular public issue in question. There is likely to be a
different set of cost curves for each issue on which a vote has to be cast.
The characteristics of the optimal majority point are as follows:
• the higher the external cost (curve), ceteris paribus, the greater M* becomes
• the higher the decision-making cost, ceteris paribus, the lower M* will be.
The shape of the curves will differ according to the type of activity that is to be decided on and the optimal
majority need not be an ordinary majority (in other words, 50%-plus-one-vote).
A factor that influences both decision-making and external costs is the degree of homogeneity among
the voting community. In a homogeneous community, it is probably easier to achieve a majority outcome
or unanimity since individual tastes are relatively similar and, consequently, decision and external costs are
relatively low. One implication is that a community characterised by sharp differences among individual
citizens and groups may not be able to afford the high decision-making costs involved in near-unanimity
rules for collective choice. However, the potentially adverse consequences – or high external costs – for
minority individuals and groups may be the very factor that will prompt these individuals to press for
costly near-unanimity rules.
The above analysis can be used to determine voting rules for different kinds of collective actions. All of
these actions need not be organised under the same voting rule. Voters, for example, will choose a voting
rule with a high majority requirement for collective actions that incur high external costs (or a major loss of
utility) for them. Conversely, there are collective actions that incur low external costs, which means that a
lower majority-voting rule will probably suffice. However, one should bear in mind that individuals and
groups will normally not deem it in their interests to support a voting rule that may promote the interests of
other groups. The customary rule when important issues such as amendments to a constitution are
concerned is that more than just an ordinary majority is required before these can be executed. Changes to
the Bill of Rights in the South African Constitution, for example, require a two-thirds majority in the
National Assembly.
6.7 Government failure

A necessary condition for the success of both direct and indirect (or regulatory) intervention by government
is the presence of an adequate and efficient institutional framework. Important institutions include the
legislative authority (for example, parliament), the judiciary, law enforcement, tax collection or revenue
services and regulatory bodies. These institutions should ideally ensure that agents comply with the rule of
law, and honour their contractual and regulatory commitments. A sufficient condition for success refers to
the value system of the community, including behavioural norms and customs, which should ideally
entrench high levels of trust between and among consumers, producers and government institutions (North,
1991).
Both of these conditions should ultimately ensure that government performs its functions in a
transparent, accountable and consistent manner (Parker, 2002a). But experience shows that such utopian
outcomes are rare, especially in developing countries (Kahn, 2006), owing to what economists refer to as
government failure. As we show below, governments fail because of the ‘rational’ behaviour of
politicians and bureaucrats, and also because of the influence that special interest groups have over
government.
6.7.1 Politicians
As mentioned in Section 6.3, politicians can be viewed as entrepreneurs who engage in vote-maximising
strategies in order to secure and retain political office. It is important to consider the implications for
resource allocation resulting from behaviour of this nature. The likely consequences can be more readily
determined given two further characteristics of the majority-voting rule:
• Voters are rationally ignorant of much of what politicians stand for, since they usually do not have a
sufficient incentive to acquire all of the information necessary to determine the desirability of all of the
relevant public issues.
• Politicians are elected on the basis of a package of policies and therefore do not have to please a majority
of voters on each separate policy issue.
These characteristics can give rise to implicit logrolling, favouring special interest legislation. We can
illustrate this proposition by means of a hypothetical example, as shown in Table 6.2.
Imagine a politician standing for election for a political party with diverse interests. The politician
explicitly supports three special-interest programmes: the relocation of the South African parliament to
Pretoria, a rugby development programme and a subsidised loan scheme for students. Each of these special
interest programmes is likely to attract strong support from a particular group within the voting population.
Civil servants will strongly support the relocation of parliament, rugby lovers will likewise support the
proposed development programme and students will lend strong support to the proposed subsidy scheme.
But none of the programmes is likely to benefit a majority of the voters. The subsidy scheme, for example,
will not benefit civil servants or rugby lovers directly, or at least not attract their strong support; when
faced with a choice between the three programmes, they may have a relatively weak opposition to the
proposed subsidy. Civil servants and rugby lovers may therefore rationally decide to remain ignorant about
the full cost of the subsidy scheme.
Meanwhile, the politician in question who supports all three programmes has an incentive to make the
benefits of these policies clear to the three unrelated recipient interest groups in order to form a coalition
through implicit logrolling. He or she knows that the strong preference that civil servants have for
relocating parliament to Pretoria probably outweighs their mild opposition to the student loan scheme and
the rugby development programme: they would rather have all three programmes than none. And the
politician can make sure of this by disguising or understating the cost of each of the programmes to the
electorate as a whole, that is, by creating fiscal illusion. Table 6.2 illustrates the nature of this implicit
logrolling.
Table 6.2 Coalition-forming and implicit logrolling
Policy Strongly favoured by Weakly opposed by
Civil servants Rest of electorate

Relocation of parliament
(33,3%) (66,7%)
Rugby lovers Rest of electorate

Rugby development
(33,3%) (66,7%)
Students Rest of electorate

Student loan scheme
(33,3%) (66,7%)
It is evident that the politician supporting all three minority programmes will defeat an opponent who
opposes them, or who supports only one or two of them, by mobilising the strong preferences of civil
servants, rugby lovers and students by means of implicit logrolling.
Two important consequences for resource allocation flow from this example:
• We can anticipate a preponderance of special interest legislation producing a variety of relatively
unpopular public goods. This is particularly likely if special interest groups with rather obscure or
idiosyncratic programmes – which will on their own and despite very intensive preferences of a small
minority probably never gain a majority vote – need to be courted.
• We can expect an aggregate oversupply of public goods in society.
It is clear that vote-maximising behaviour on the part of politicians can lead to outcomes that are not in
accordance with the wishes of the majority of voters. Some writers, most notably Buchanan and Tullock
(1962), argue that this phenomenon is a consequence of constitutional failure and can only be dealt with by
constitutional reform, for example, by limiting the proportion of scarce resources expended on public
goods to some fixed percentage of national income and specifying the distribution of these resources
between alternative kinds of public goods. This represents a form of fiscal rule that will be discussed in
more detail in Chapter 18.
6.7.2 Bureaucratic failure

A second source of government failure stems from the maximising behaviour of government employees or
so-called bureaucrats. In essence, bureaucratic failure results from rational responses on the part of
utility-maximising civil servants to the incentives presented to them by politicians and the institutional
structures within which they operate.
Thomas Borcherding (1977: xi) notes that:
Individuals in the bureaucracy, like the rest of us, do react to different incentive schemes; they do have
various preferences, and have the capacity, will and desire to fulfil these preferences. They prefer more
rather than less income, power, prestige, pleasant surroundings and congenial employees.
The rational behaviour of bureaucrats can be analysed in terms of the demand for and supply of public
goods. The demand for public goods in a representative democracy is generated by the decisions of vote-
maximising politicians, while the supply of public goods is usually the responsibility of the state
bureaucracy. Unlike private firms, however, bureaucracies do not maximise profit. Instead, they receive
annual lump sum payments from the legislature based on estimates – prepared by bureaucrats – of the costs
of providing specified (and usually monopolised) public goods. Consequently, bureaucracies do not face
any market test. William Niskanen (1971) argued persuasively that since higher salaries, more power,
greater prestige and other favourable attributes are positively related to bureau size and hence to bureau
budgets, bureaucrats have an incentive to maximise their budgets.
Figure 6.3 Bureaucratic failure
The resultant bias towards the excess provision of public goods is illustrated in Figure 6.3. Part (a) of the
figure shows the total social cost (TSC) and total social benefit (TSB) curves for a public good. The usual
marginal principles apply here: total cost rises at an increasing rate as output expands (owing to the
principle of diminishing marginal productivity), while total benefits increase at a decreasing rate as output
expands. The rates of change of these curves, or their slopes, determine the shapes of the corresponding
marginal curves shown in Figure 6.3(b).
The socially optimal level of output of the public good is given by 0Q0, where marginal social benefit
(MSB) equals marginal social cost (MSC) (in Figure 6.2(b)) or where the difference between TSB and TSC
is maximised (in Figure 6.2(a)). But a budget-maximising bureaucrat would attempt to justify output 0Q1 >
0Q0, where TSB equals TSC and where MSC exceeds MSB by the distance FG. The result is that the total
value to consumers increases from 0AEQ0 to 0AFQ1 (in the (b) part) or by the area Q0EFQ1, while total
cost increases from 0BEQ0 to 0BGQ1 or by the larger area Q0EGQ1. The increase in total cost thus exceeds
the increase in total benefits by the area EGF, which is the net welfare loss to society.
Moreover, given the absence of a profit motive, bureaucrats may supply public goods inefficiently, for
example, by using more than the required inputs to produce a given level of output. The resultant
inefficiency (or welfare loss) thus stems from an excessive use of inputs rather than from excessive
production by the bureau.
In essence, the problem of bureaucratic failure is simply an example of a principal–agent problem. In
the public sector, bureaucrats act as agents for their principals, the tax-paying public, who are in turn
represented by elected politicians. Since each individual bureaucrat benefits directly from a large budget,
he or she has a strong preference for a high level of expenditure. Individual taxpayers, on the other hand,
generally benefit only marginally from that expenditure and therefore remain rationally ignorant about it.
Owing to the size and divergent nature of the tax-paying public, there is little individual taxpayers can do
to lobby against higher levels of state spending or in favour of lower taxes. Thus, there is a poor correlation
between the objectives of agents and the objectives of principals. Put differently, bureaucrats have a greater
incentive to increase spending than taxpayers have to reduce taxes. It follows that one should expect
spending levels on public goods to exceed their corresponding optimal levels.
Although Niskanen’s model of bureaucratic failure provides a plausible explanation for excessive state
intervention in the economy, it can be questioned on several grounds. Is it realistic to assume that
politicians and the tax-paying public are entirely at the mercy of bureaucrats? Budgetary procedures have
become more transparent everywhere, including South Africa and other African countries, while the
salaries and perks of senior public servants are not usually linked to the size of their budgets. A recent trend
has been to determine remuneration in relation to the extent to which pre-set performance goals are met. In
a democratic environment, buttressed by strong institutions, it seems unlikely that bureaucrats will be
allowed to get away with practices that run against the public interest, at least not for long. It is therefore
difficult to confirm or deny the alleged empire-building motives and actions of bureaucrats.
6.7.3 Rent-seeking and corruption

As discussed in Chapter 2, one of the important tasks of a government bureaucracy is to sub-contract, by
tender, the provision of (public) goods and services, legally approved by the legislative authority, or to
limit – through regulation – the production of certain goods and services deemed not to be in the public
interest. Both forms of intervention can give rise to rent-seeking behaviour on the part of special interest
groups in the private sector. This is a type of behaviour whereby interest groups attempt to capture or
compete for the artificial rent created by government through interventions in the market and is perfectly
legal, although it often adds to social waste attributable to the rent created by government (Buchanan,
Tollison & Tullock, 1980).
The concept of economic rent is usually defined as that part of the reward accruing to resource owners
over and above the payment that the resource would receive in any alternative employment. For example, if
government yields to pressures from domestic producers to place a tariff on imports when competitive
market prices apply, producers get a benefit (extra ‘rent’) at the expense of importers and domestic
consumers who have to pay higher prices for imported products. Rent is similar to monopoly profit: it
cannot be competed away. In a perfectly competitive world, however, market forces would ensure the
dissipation of rent in a manner that produces socially desirable outcomes. The existence of positive rent in
a competitive market will attract resources in the same way as the existence of (potential) profits, and
consequently result in the erosion of this rent through an efficient reallocation of resources. However, once
we adjust the mechanisms through which this process occurs, the consequence of rent-seeking behaviour
can be harmful to society at large.
The theory of rent-seeking deals with the origins of, and competition for, artificially created rent. The
latter usually results from government-protected monopoly power. Numerous examples abound in
Southern Africa, ranging from quantitative restrictions on licences for hawkers, liquor outlets and taxi
drivers, to qualitative restrictions on purveyors of food and on people wishing to enter occupations such as
real estate sales, IT repairs, legal services and alternative medicine.
The consequences of rent-seeking under competitive conditions may be illustrated by means of a simple
diagrammatic example (see Figure 6.4)
Figure 6.4 shows a typical competitive market characterised by constant returns to scale, shown by the
supply curve S0 and a normal demand curve that yields an equilibrium price 0P0 and quantity 0Q0. The
demand curve is also the average revenue curve. In the absence of government intervention, it would not be
easy for any number of producers to enforce a higher price than where the demand curve intersects the
supply curve, that is, where average revenue (AR) = price (P0). This is at point E0. The reason is that it
would always be possible for any supplier to thwart attempts by other suppliers to extract extra economic
rent by asking a higher price than P0. How can state intervention favour some suppliers? One way is for the
state to limit the supply of the product, which will result in a regulated higher price. Assume that the state
intervenes to limit output to 0Q1. As a result, the price of the good rises to 0P1, causing a loss of consumer
surplus equal to area P0E0E1P1. According to conventional economic theory, the area P0AE1P1 denotes a
socially costless wealth transfer from consumers to producers, while AE0E1 indicates the deadweight
welfare loss to society. However, this may understate the net loss to society, as we explain below.
Under our present assumptions, the area P0AE1P1 is available to potential suppliers to capture in an
attempt to boost their profits. They would thus be prepared to incur additional costs – by lobbying
government, for example – in an effort to capture a share of this total rent. Two possibilities exist here.
If participating suppliers – taxi drivers, for instance – undertook the lobbying function themselves and
the additional costs were internal to them, then the suppliers could, like a cartel, share the higher profits
among themselves. But given the lobbying-induced exhaustion of P0AE1P1, the social cost of state
intervention will equal both areas P0AE1P1 (or the social waste from rent-seeking) and AE0E1 (the
deadweight loss). The point is that the taxi drivers will have transferred part of their own resources away
from productive activities in favour of non-productive rent-seeking activities. Similar arguments may also
apply to real estate agents, powerful stakeholders in the fishing industry and many other profit-seeking
special interest groups.
Figure 6.4 Rent-seeking

Rent-seeking in the form of lobbying, as explained above, while wasteful, would not necessarily be
against the law and would thus not count as a criminal activity. But the borderline between rent-seeking
and corruption is quite thin, if not blurred. No wonder corruption has been depicted as a special branch of
rent-seeking and described in a rather vague manner as occurring ‘when competition for preferential
treatment is restricted to a few insiders and when rent-seeking expenses are valuable to the recipient’
(Lambsdorff, 2002: 120).
Irrespective, therefore, of who is doing the lobbying – suppliers or concerned citizens – the creation of
rents by government, albeit legal, does establish a potential for corrupt behaviour on the part of
bureaucrats. It is not beyond rent-seekers to offer bribes and kickbacks in an attempt to achieve their
objectives more rapidly. If these offers were accepted by bureaucrats, they would be guilty of committing
corruption, which is, of course, illegal. They would do so only if there were a net benefit in it for them, in
other words, if the expected gain (of the bribe) exceeded the expected cost of being detected and punished.
The fact that corruption is widely practised in many developing countries (Kahn, 2006; Merriman, 2003)
would seem to point to an inadequate legal system that arguably constitutes the critical core of the
institutional framework referred to above.
6.8 Concluding note

In broad terms, then, the application of the microeconomic paradigm of rational maximisation provides
further insight into the social costs attendant upon policy intervention by the state. The inefficiencies
introduced into the market economy by vote-maximising politicians and budget-maximising bureaucrats
generally take the form of an oversupply of public goods. Bureaucrats also have the responsibility of
creating rents aimed at increasing or reducing the provision of certain goods and services, especially if
these actions are deemed to be in the public interest. But these very actions often induce wasteful rent-
seeking on the part of special interest groups in the private sector, and may also be the source of high levels
of corruption if bureaucrats accept bribes and kickbacks offered by rent-seekers. A necessary condition for
avoiding or minimising government failure seems to be an institutional system that includes a judiciary
capable of applying the rule of law to both public and private citizens. However, this may not be sufficient:
individuals and groups also need to have a natural predilection to behave in an honest and trustworthy
manner.
Key concepts
• agenda manipulation (page 105)
• bureaucratic failure (page 110)
• corruption (page 113)
• cycling (page 105)
• decision-making costs (page 106)
• direct democracy (direct democratic dispensation) (page 100)
• economic rent (page 112)
• external costs (page 114)
• government failure (page 108)
• implicit logrolling (page 108)
• impossibility theorem (page 102)
• institutional framework (page 108)
• logrolling or vote trading (page 108)
• majority rule or majority voting (page 100)
• majority-voting rule (page 98)
• median voter theorem (page 100)
• optimal voting rules (page 106)
• preference intensities (page 105)
• principal–agent problem (page 111)
• Rawlsian theory of justice (page 98)
• Rawlsian welfare function (page 99)
• rent-seeking (page 112)
• representative democracy (page 100)
• unanimity rule (page 98)
• voting paradox (page 105)
SUMMARY
• Decisions regarding the levels of taxes and other economic policies are made in the political market by
elected politicians. The social choice rules by which governments make decisions range from the
dictatorial rule, where one person’s preferences determine outcomes, to the unanimity rule, where
100% support from the electorate is required before a decision is carried.
• The unanimity rule finds expression in the Rawlsian theory of justice, which requires communities to
make decisions behind a ‘veil of ignorance’ and to enter a hypothetical ‘original position’. From the
Rawlsian perspective, all parties would unanimously approve a political constitution where priority is
given to the person potentially finding him- or herself in the worst position. The so-called maximin
strategy protects each person in case he or she ends up being in that position. One objection to the
unanimity rule is that it effectively gives minorities veto power.
• The most common voting rule is the simple majority rule, which requires the support of 50%-plus-one-
vote in order for a decision to be accepted. In a representative democracy, where voters elect
representatives to make decisions on their behalf, the preferences of the median voter (or group of
voters) may determine voting outcomes. Although the simple majority-voting rule may have
advantages in comparison to the unanimity rule, it also has shortcomings. According to Arrow’s
impossibility theorem, it can lead to logically inconsistent results and it does not account for differences
in the intensities of voters’ preferences.
• Buchanan and Tullock (1962) proposed an optimal voting rule theory that can be applied to different kinds
of collective decisions. The optimal majority is determined by two kinds of costs: external costs (that
decreases as percentage of votes required increases) and decision-making costs (that increases as the
percentage of votes required increases). Where the sum of these costs is a minimum, the optimal voting
percentage is obtained.
• The perfectly competitive market system fails in a number of respects and consequently requires some
form of government intervention to correct for these failures. Likewise, in the political market,
government fails to provide adequate and efficient institutions as well as public goods and services.
Government failure is ascribed to the rational behaviour of politicians, bureaucrats and special interest
groups. Politicians seek to maximise votes and do not necessarily promote the interest of voters.
Bureaucrats try to maximise their budgets, often leading to inefficient levels of public goods provision.
Special interest groups seek to maximise their own interests and engage in rent-seeking, which again
leads to social waste. Rent-seeking often results in corrupt behaviour on the part of bureaucrats and
rent-seekers.
6.1 The simple majority voting rule …
a. requires 50% of the votes for a decision to carry.
b. implies that voters take decisions behind a veil of ignorance.
c. is a less costly voting rule than the unanimity rule for reaching majority approval.
d. is logically inconsistent when voter preferences are extreme.
6.2 According to Niskanen’s bureaucratic failure module …
a. bureaucrats maximise profits when supplying public goods.
b. bureaucrats’ salaries, bonuses, prestige and power are linked to the size of their departmental
budgets.
c. bureaucrats determine the quantity of public goods by setting total social costs equal to total social
benefits.
d. bureaucrats maximise their budgets by setting marginal social benefits equal to marginal social
costs.
6.3 Government may fail to be efficient because …
a. taxpayers generally avoid paying taxes to finance high government expenditures.
b. bureaucrats have more of an incentive to increase government spending than taxpayers have to
lobby for reduced taxes.
c. politicians tend to exploit the ignorance of voters.
d. bureaucrats try to use only a few inputs to obtain the maximum level of services.
6.4 Refer to Figure 6.4. Which of these statements is correct?
a. As a result of rent-seeking, the consumer surplus increases to BP0E0.
b. Rent-seeking behaviour will result in the price decreasing to P0.
c. Rent-seeking results in spending on non-productive activities (for example, bribes), causing the
consumer surplus to increase from BP1E1 to BP0E0.
d. The deadweight welfare loss caused by rent-seeking is equal to the area E1E0A.
6.1 Describe the unanimity voting rule, and compare its advantages and shortcomings.
6.2 Distinguish between a direct democracy and a representative democracy.
6.3 Define the following concepts:
a. Vote trading
b. Median voter
c. The voting paradox
d. Rent-seeking
6.4 In what way could the behaviour of bureaucrats cause government failure?
ESSAY QUESTIONS
6.1 Discuss the Rawlsian theory of justice and briefly comment on its relevance to the political economy of
South Africa.
6.2 Outline the median voter theorem and explain its importance to the successful application of a majority
voting system.
6.3 Do you agree with the contention that majority rule does not necessarily produce outcomes
representative of the majority view? Discuss with reference to the impossibility theorem and the
phenomenon of vote trading.
6.4 Discuss the theory of optimal voting rules and briefly comment on its relevance to the social choice rule
of majority voting.
6.5 Explain how the maximising behaviour of politicians could contribute to an oversupply of public goods.
6.6 Explain the meaning of the term ‘rent-seeking’ and show how it could undermine efficiency in the
economy.
1 The idea of this example comes from Hyman (1999: 179–180).

2 Suppose there are three candidates for a position. Pair-wise voting entails that the first vote is between the first two candidates. The
one who wins is then paired with the other candidate in the second election. If the third candidate wins the second election, a
third election will be required between the winner of the second election and the loser of the first election to determine the
ultimate winner.
3 In the example of extreme preferences given above, the result is quite confusing if the voter is asked to vote in a pair-wise manner.
If the first vote is between large and small, small wins. In small versus moderate, moderate wins. In the final vote between
moderate and large, large now beats the candidate that conquered its own superior.
Public expenditure and growth
Philip Black, Krige Siebrits and Theo van der Merwe
Part 1 of this book explained in theoretical terms why governments should mobilise and spend scarce
resources in a typical market-oriented economy. In this chapter, we turn to real-world aspects of
government expenditure in South Africa. We want to find answers to the following pertinent questions:
What does the Constitution have to say about government expenditure? How much money is spent
annually by government entities? What forms does this spending take and what services are provided?
How has the composition of government expenditure changed over time and how do these trends compare
with trends in other countries? Why has government expenditure grown so much over time? And, most
importantly, how does government expenditure affect the economy over the medium to long term?
As indicated in Chapter 1, these questions are particularly topical in view of the economic challenges
facing South Africa and the global context within which they have to be addressed. The levels of
government expenditure, revenue and the deficit before borrowing also influence the decisions of rating
agencies and investors, especially when they consider the economic outlook of a country. In this chapter,
we first look at the growth of government expenditure and at the changes in its composition, both in South
Africa and elsewhere in the world, before we discuss some of the theories explaining these changes. In the
last section, we turn our attention to the long-term effects of government activity on the economy.
comment on the implications that the Constitution has for government expenditure in South Africa
discuss salient trends in the size, growth and composition of government expenditure in South Africa
identify the main similarities and differences between government expenditure patterns in South Africa and other
countries
compare and contrast two or more of the theories that explain the growth of the government sector and indicate
whether they have any relevance for South Africa
consider the long-term effects of government spending in terms of new growth theory
discuss the role of infrastructure investment in the economy.
7.1 The constitutional framework

The Constitution is the supreme law of the Republic of South Africa and provides important guidelines on
how South Africans should conduct themselves in the political and economic spheres. Hence, its
provisions for taxation and government expenditure are the basic paradigm within which the government
formulates its budgetary policies. This highlights why state capture and corruption are such serious issues,
since it jeopardises and contradicts the intentions of the constitution when individuals and certain
groupings misuse state funds to their own personal advantages, at the expense of those individuals who are
targeted in the Constitution to receive government services.
7.1.1 The Constitution and public goods

The South African Constitution contains many provisions that affect the extent and composition of
government expenditure directly or indirectly. At a very general level, these provisions depend on how the
government sector and its primary functions are defined in the Constitution. Government functions are
derived from, and structured according to, the constitutional distinction between the legislative, executive
and judicial branches of government; the national, provincial and local levels of government; the security
services and certain constitutional entitlements (see Section 7.1.2) and statutory bodies such as the Public
Protector, the Human Rights Commission, the Auditor-General and the Independent Electoral
Commission. By granting powers and assigning functions to institutions of this nature, the Constitution
implicitly charges government with the task of maintaining them and providing for the necessary public
funding. Failing to do so would indeed be unconstitutional. It is therefore very important that the
constitution be respected and protected by South Africans and that it should not be changed at any whim.
In addition, the government of the day is constitutionally obliged to provide or extend the provision of
specified basic goods and services. The clearest examples of these provisions are found in the Bill of
Rights, which entrenches the right of each citizen to adequate housing, healthcare, food, water, social
security and education. However, Section 26(2) of the Constitution of the Republic of South Africa, No.
108 of 1996, does recognise the need for adequate resources in this regard: ‘… the state should take
reasonable legislative and other measures, within its available resources, to achieve the progressive
realisation of this right’ (italics added).
It is worth noting that these rights generally pertain to mixed and merit goods, rather than only to pure
public goods (see Chapter 3), which partly confirms our earlier point that pure public goods are extremely
rare in practice. It is also indicative of modern thinking about the relative importance of the public sector
in promoting sustained economic growth. We return to this point in Section 7.6 of this chapter.
7.1.2 Constitutional entitlements

The rights to certain goods and services conferred by the Constitution could be regarded as constitutional
entitlements. What are the practical implications of these entitlements for the way in which government
manages its own budget? As we have pointed out, the wording of these entitlements in the Constitution
does acknowledge that government is subject to budgetary constraints, but many economists feel uneasy
about the vagueness of phrases such as ‘reasonable measures’ and ‘within its available resources’. They
are of the opinion that this wording may provide government with too much discretionary power and may
lead to excessive expenditure, which could threaten the macroeconomic sustainability of fiscal policy.
Experts in human rights law also differ in their opinions on how enforceable these rights are in practice.
To what extent is it realistic to keep the government of a developing country like South Africa responsible
for the provision of housing, social security and other basic services to all of its citizens? Which of these
rights should be accorded priority when trade-offs become necessary?
From time to time, the Constitutional Court has to respond to some of these very difficult questions. In
an early case of this nature, the Court ruled in November 1997 that a South African kidney patient was not
entitled to receive expensive treatment at the state’s expense. Two constitutional principles were involved
in this case: the right to live and the right to have access to healthcare services. One of the grounds for the
ruling was that the latter right is subject to the ‘availability of resources’. In a number of subsequent cases,
the Constitutional Court also refrained from granting individual claims and rather took the view that the
government should adopt a comprehensive plan that provides in a reasonable manner for the progressive
realisation of the rights in the Constitution.
From a fiscal point of view, a strong case can be made for a ruling that the government’s obligations to
its citizens should be extended to also include future generations. This means that any current attempt at
fulfilling these obligations should take full account of the impact it is likely to have on the future growth of
GDP, and hence on the growth of government revenue, since the latter is clearly a necessary condition for
maintaining the supply of public services over time. At the same time, however, it can be argued that the
future growth of GDP depends on the current provision of services such as education and healthcare. The
matter is therefore far from simple. A steady and consistent supply of these services whereby backlogs and
future demands are met within reasonable timeframes may help to resolve the conflict between
constitutional entitlements and macroeconomic affordability. In this regard, medium-term expenditure
frameworks may fulfil an important role, as we shall see in Chapter 18.
7.2The size, growth and composition of public

expenditure
In Chapter 1, we provided some indication of the size of the public sector in South Africa. Table 1.1
showed that the public sector has expanded considerably during the past few decades. In this Section, we
take a closer look at trends in general government expenditure since 1992. As we explained in Section
1.5.1 of Chapter 1, general government expenditure includes the outlays of the national government,
provincial governments, local authorities and extra-budgetary institutions, but excludes the spending of
public corporations such as Eskom, Telkom and Transnet.
7.2.1 Size and growth of public expenditure

In this section, we provide data for two measures of general government expenditure: the total amount of
resources used and the total amount of resources mobilised (the concepts of resource use and resource
mobilisation are explained in Section 1.5.2 of Chapter 1).1
We first look at the size and growth of general government resource use at constant 2016 prices.2 This
measure suggests that general government expenditure grew significantly in South Africa after 1990: real
resource use increased from R376,4 billion in 1992 to R1273 billion in 2017. On average, real resource
use therefore grew at a relatively high rate of 5% per annum. Table 1.1 in Chapter 1 indicates that resource
mobilisation by the public sector (which includes public corporations) have increased sharply from an
average of 24,1% of GDP for the period 1960–1969 to an average of 39,8% for the period 2008–2017.
How did this pattern of growth affect the size of the general government sector relative to that of the
South African economy as a whole? Figure 7.1 answers this question by showing general government
resource use and resource mobilisation as percentages of the gross domestic product (GDP) at current
market prices from 1992 to 2017. Over the period as a whole, general government expenditure clearly
grew significantly in relative terms: resource use increased from 21,1% of GDP to 27,4% and resource
mobilisation grew from 28,2% to 36,8%. It is also evident from the figure that the share of general
government expenditure has decreased for a rather brief period in the mid-1990s and again in the early
2000s, due to fiscal restraint and the relatively good economic growth experienced during these periods.
The graph also indicates that government spending is increasing steadily as a share of GDP, which of
course implies that the share of the private sector of the economy is shrinking.
To summarise: general government expenditure grew significantly in South Africa from 1992 to 2017,
both in real terms and as a percentage of GDP. Thus, in 2017, the general government sector was
responsible for a markedly higher portion of aggregate expenditure in South Africa than was the case in
1992. In Sections 7.4 and 7.5 of this chapter, we outline various theories that try to explain why
government spending grows in absolute terms and/or relative to the rest of the economy. Chapter 18
explains why the growth rate of general government spending slowed so markedly in South Africa until
2001, before accelerating to growth rates last seen before the start of the democratic dispensation.
Figure 7.1 The size and growth of general government expenditure in South Africa
Source: Calculated from South African Reserve Bank, Quarterly Bulletin (various issues). Pretoria: South African
Reserve Bank [Online]. Available: https://www.resbank.co.za/Publications/QuarterlyBulletins/Pages/.
Significant changes in the composition of general government expenditure accompanied these trends in
its size and growth. We now provide a synopsis of these changes.
7.2.2 The changing economic composition of public expenditure

Table 7.1 summarises trends in the economic classification of government expenditure, which
distinguishes between the current and capital components of total outlays. The various expenditure
categories are expressed as percentages of total general government expenditure and of GDP in the fiscal
years 1994, 2006 and 2017.3
In 2017, cash payments for operating activities (formerly known as current expenditure) accounted for
92,8% of general government spending in South Africa and purchases of non-financial assets (outlays for
the acquisition of fixed capital assets, land, stock and intangible assets, which was formerly known as
investment) for the remaining 7,2%. In descending order, the largest categories of cash payments for
operating activities were compensation of employees (the government’s wage bill), purchases of goods
and services (for example, stationery, computers, vehicles and maintenance of capital assets), social
benefits paid (mainly welfare payments such as old-age pensions or child-support grants), interest on
public debt and other payments.
Table 7.1 shows that cash payments for operating activities (in other words, current outlays) increased
slightly from 92,2% of total cash payments in 1994 to 92,8% in 2017. Over the same period, purchases of
non-financial assets (in other words, capital spending) decreased from 7,8% of total cash payments to
7,2%. This represented a continuation of a long-term trend in the expenditure of the public sector
highlighted in Chapter 1 of this book: From Table 1.1 it can be deduced that current expenditure by the
public sector (the sum of consumption expenditure and transfer payments) increased from an average of
14,5% of GDP in the period 1960–1969 to an average of 32,6% for the period 2008–2017, while
investment fell rather sharply from an average of 9,6% of GDP in the period 1960–1969 to 7,2% in the
period 2008–2017. The economic effects of government investment depend not only on its extent but also
on its nature: in the long run, the construction of power stations and roads, for example, is clearly more
important for the promotion of economic growth than the construction of new buildings for government
departments. Nonetheless, most economists believe that the decline in general government spending on
economic and social infrastructure has hindered economic growth in South Africa. Despite the fact that the
purchases of non-financial assets by the general government have decreased from 7,8% of total cash
payments in 1994 to 7,2% in 2017, its share of GDP has increased marginally from 2,4% of GDP to 2,6%.
Investment by government is therefore still very important even though it may not be addressing the most
important needs of the economy sufficiently.
Table 7.1 The economic composition of general government expenditure in South Africa, 1994–2017a
Notes: a Government finance statistics data, fiscal years ending 31 March
b Figures may not add up owing to rounding.
Reserve Bank. [Online]. Available: https://www.resbank.co.za/Publications/QuarterlyBulletins/Pages/QuarterlyBulletins-
Home.aspx [Accessed 16 July, 2018].
From 1994 to 2017, total cash payments of the general government increased its share of GDP from 31,4%
to 36,8%. This was as a result of an increase in the share of GDP of all economic categories of government
spending, with the exception of interest on public debt and other payments. The decrease in interest on
public debt can be attributed to fiscal prudence up to the Global Financial Crisis of 2008 and to relatively
low interest rates in the latter period.4 Hence, it could be argued that government has been losing its grip
on fiscal discipline since 2007. From a fiscal policy perspective economic stimulation was required during
the crisis, but unfortunately no return to previous levels of government expenditure occurred afterwards
(see Section 7.4.2 for an explanation of this phenomenon). The increases in the deficit before borrowing
during and after the crisis are responsible for the rise of the share of interest on public debt from 2,9% of
GDP in 2006 to 3,4% in 2017. This increase follows on the decrease from 4,6% in 1994 to 2,9% in 2006.
The GDP share of compensation of government employees has also increased from 10,6% in 1994 to
13,1% in 2017, indicating a sharp rise in the pay packages of civil servants accompanied by an increase in
employment by government, while many of the other sectors of the economy were shedding employment
opportunities. Efforts to restrain the growth of the wage bill at times led to conflict between the
government and public sector labour unions. The reality that total general government cash payments
increased by 5,4 percentage points of GDP for the period under consideration meant that the increases in
the total spending shares of the other expenditure components (purchases of goods and services, subsidies
and social benefits) also represented growth relative to the size of the economy as a whole.
Table 7.2 The functional composition of general government expenditure in South Africa, 1994–2016a
Notes: a Government finance statistics data, fiscal years ending 31 March
b Figures may not add up owing to rounding.

Home.aspx [Accessed 18 July 2018].
7.2.3 Functional shifts in public expenditure

The functional classification of government expenditure refers to the amounts spent on the different
goods and services provided by government. Table 7.2 contains data on the functional composition of
general government spending in the fiscal years 1994, 2005 and 2016 expressed as percentages of the total
and GDP.5
In 2016, social services accounted for 50,6% of total general government expenditure in South Africa,
making it by far the largest functional category. Social services expenditure includes spending on
education, health, social protection, housing and community services, and recreation, culture and religion.
The second and third largest functional categories were general public services (interest payments and
other public debt transactions as well as the outlays of departments such as the Presidency, Foreign
Affairs, Public Works, and Cooperative Governance and Traditional Affairs, including transfers from the
central government to local authorities) and protection services (which consists of government spending
on defence, policing, correctional services and the justice system). The other expenditure category,
economic services, encompasses the outlays of government departments that oversee and assist various
sectors of the economy (such as agriculture, mining, manufacturing and transport) as well as those that are
charged with cross-sectoral issues such as labour and technology. Table 7.2 also shows that environmental
protection is becoming more important, although spending on this function remains at a low level.
After the 1994 elections South Africa experienced relatively good economic growth and government
also followed a policy of fiscal restraint, but this good fortune changed after the Global Financial Crisis of
2008 that required fiscal stimulus. The situation was exacerbated by the corruption, state capture and
patronage of the Zuma administration that led to great economic uncertainty and the firing of the minister
of finance, Mr Nhlanhla Nene. The mining charter, land expropriation without compensation, and the
possible change of the Constitution, are also not contributing towards certainty and an environment
conducive for economic growth. The economic situation is aggravated by international uncertainty
(possible trade wars) and Brexit. It is therefore not surprising that South Africa experienced a deterioration
in economic growth and relatively sharp rises in the share of some functions of government expenditure
expressed as percentages of GDP. Expenditure on social services has for example increased from 14,8% of
GDP in 1994 to 17,6% in 2016.
The increase in the share of education spending-to-GDP ratio raises concerns of whether South
Africans are receiving value for their money in the light of the large number of learners leaving school
early and the limited mathematical and language competencies of some school leavers. Education is the
largest expenditure item of social services with a share of 6,6% of GDP in 2016. Additional pressure will
also be added to this expenditure item due to government’s commitment to provide free tertiary education
to needy individuals from 2018. Social protection, which consists mainly of social assistance (grants) is
the second largest expenditure item within social services and in 2016 its share of GDP was 4,7%.
According to the National Treasury (2018a: 61) the number of beneficiaries will reach 18,1 million in the
2020/21 fiscal year. This implies that more or less one out of every three South Africans will be receiving
grants.
From 2005 to 2016, the other functional categories of government experienced a decrease in their GDP
shares. The net results of these developments have been that general government spending is now
markedly more oriented towards the delivery of social services and public order and safety.
Simultaneously, the priority given to defence against external threats has clearly declined. Low economic
growth levels put the ability of government to generate revenue under pressure and add additional pressure
on government to decrease expenditure. The authorities also need to turn their attention to serious
initiatives aimed at improving the efficiency and effectiveness of government programmes.
The links between trends in the economic and functional compositions of total outlays are now
apparent. There is a close relationship between rates of growth in labour-intensive and supplies-intensive
functions, such as public order and safety and education, and rates of growth in the government wage bill.
Similarly, the extent of growth in transfers to households is closely associated with the importance
assigned to social protection services. Changes in the government spending shares of subsidies and
purchases of non-financial assets are major determinants of rates of growth in outlays on economic
services.
7.3 Comparisons with other countries

For much of the twentieth century, increases in per capita incomes were accompanied by absolute and
relative growth in government spending. One time-series study (Tanzi & Schuknecht, 1995) found that
general government expenditure in the industrialised countries increased from levels of 10% of GDP or
less in 1870 to between 45% and 50% of GDP in 1994. Government spending also increased markedly in
most developing countries in the 1960s, 1970s and 1980s (Lindauer & Velenchik, 1992). We discuss some
of the theoretical explanations for this growth in government expenditure in the next two sections.
By contrast, the last quarter of the twentieth century was characterised by a fundamental
reconsideration of the economic role of government. Various factors gave rise to this development,
including the collapse of the controlled economies of the former Soviet Union, Central and Eastern
Europe, and parts of the developing world (notably sub-Saharan Africa). Mounting evidence has suggested
that the expansion of the public sector beyond a certain point is more likely to contribute to
macroeconomic problems, as well as the erosion of economic incentives and personal freedoms, than to
meaningful improvement in the values of indicators of social and economic progress. Halting or reversing
the expansion of the public sector became a policy objective in many countries, and empirical studies (for
example, Fan and Rao, 2003; Tanzi, 2005) show that government spending did in fact decrease as a
percentage of GDP in several of them. From the Global Financial Crisis of 2008 onwards, many
governments launched fiscal stimulus packages to counteract the effects of severe economic downturns on
production, demand and employment. Most of these packages included public spending programmes that
raised government expenditure-to-GDP ratios. It remains to be seen if these increases will be reversed as
planned (the intention usually was that stimulus packages should be of a temporary nature) or provide
more longer-lasting boosts to public spending levels via the displacement effect discussed in Section 7.4.2.
Such an outcome could even turn out to be a recent manifestation of the ratchet effect that caused
Keynesian fiscal activism to lose its appeal during the second half of the previous century (see Chapter 18,
Section 18.3.2).
Van der Berg (1991) summarised the international cross-section evidence on the composition of
government expenditure at different levels of development as follows:
• In low-income countries, the bulk of government spending is typically directed at capital investment in
the infrastructure, stimulation of industrial development through export subsidies and other incentives,
and the establishment of primary education and healthcare systems.
• Middle-income countries give priority to education, healthcare, and research and development, and
usually also start to develop a social security system.
• High-income countries are characterised by huge increases in the share of transfer payments (especially
social security-related ones), which are typically compensated for by reduced public investment.
Economic development is thus associated with a shift in the economic composition of government
expenditure from capital expenditure to consumption spending, including transfer payments. The
functional counterpart of this trend is a shift from protection and economic services to social services (see
the discussion in Section 7.4.1). In an authoritative study on the issue, Saunders and Klau (1985: 16)
reached the following conclusion:
The structure of government expenditure has thus shifted away from the provision of more traditional
collective goods (defence, public administration and economic services) towards those associated with
the growth of the welfare state (education, health and income maintenance), which provide benefits on
an individual rather than collective basis and where redistributive objectives are more dominant.
The longer-run pattern of change in government outlays in South Africa broadly corresponds with these
international trends. As indicated, South Africa has also experienced a shift from capital expenditure and
economic services towards consumption spending and social services. These compositional trends have
obvious distributional effects, but recent advances in the theory of economic growth suggest that
government spending on education and health also brings efficiency gains in the form of higher levels of
human capital (see Section 7.6).
However, there are some interesting peculiarities to the evolution of government spending in South
Africa. These include the following:6
• The shift in the economic composition of expenditure from capital to current outlays has left South Africa
with a relatively high level of government consumption spending. In 2016, the ratio of general
government .consumption to GDP was 20,8% in South Africa compared to the world average of 17%,
and the net investment in nonfinancial assets by the general government in South Africa accounted for
0,9% of GDP compared to a world average of 1,3%.
• As far as the functional composition of expenditure is concerned, public spending on education is also
relatively high in South Africa. In 2016, public spending on education in South Africa amounted to
6,6% of GDP. The ratio exceeded the world average in 2014 of 4,9% of GDP. South Africa’s level of
public spending on healthcare in 2015 (8,2% of GDP) was below the world average of 9,9%. It must
be kept in mind, however, that in high-income countries public spending on healthcare is significantly
higher than in middle-income countries such as South Africa. It is also notable that South Africa is
spending a relatively small portion of its national income on defence. In 2016, this spending amounted
to 1% of GDP, which was significantly lower than the average of 2,2% for all countries.
Hence, international comparisons tentatively suggest that the scope for further reallocation of resources
from capital to current spending and from protection and economic services to social services in South
Africa is limited. Before further increases in social spending are considered, the interest on the public debt
will have to be reduced and the crime situation be brought under control. However, it is questionable
whether South Africa needs to invest even larger portions of its national income in social services.
Government spending on these items is already relatively high by international standards, and the real
challenge for the future is for government to utilise its existing expenditure more efficiently than before
and to eliminate corruption and state capture. Future increases in expenditure could perhaps more
appropriately be achieved through additional revenues obtained from sustained real growth in per capita
income, as illustrated in Box 7.1.
Box 7.1 Why economic growth is crucial for expanding service delivery
The relative effects on per capita government expenditure of sustained economic growth can be illustrated with the
aid of an example. Let us compare public spending on education in South Africa and Japan (the data are from World
Bank, 2018b). In 2014, the ratios of public expenditure on education to GDP were 6,0% for South Africa and 3,6%
for Japan. South Africa’s GDP per capita was US$6 161 and that of Japan was US$38 109. In Japan, the public
sector therefore expended US$1 372 per person on education, compared to South Africa’s US$370. To achieve the
same level of public spending on education in per capita terms, South Africa would have been required to spend
almost 22% of its national income on education. Since the situation is much the same for other government functions
such as healthcare, social security and many other services, it is clear that South Africa (and other developing
countries) cannot reach the same per capita levels of government spending by simply increasing the portion of
national income devoted to spending of this nature.
That would require extremely high tax rates or unsustainable levels of borrowing. To achieve higher levels of
government spending in per capita terms, it is clearly more important to raise per capita income than to increase the
share of national income devoted to government social spending. Note, however, that per capita expenditure only
measures educational outputs. Unfortunately, education outcomes in South Africa lag behind those of some other
African countries with lower levels of per capita expenditure on education (see Section 10.4.2 in Chapter 10).
7.4 Reasons for the growth of government: Macro

models
In Chapter 1, we pointed out that there are different ways of measuring the size of the government; one is
to express government expenditure as a percentage of gross domestic product. From the information
provided for South Africa at the beginning of this chapter, it appears that the share of government in terms
of both use and mobilisation of national resources had steadily increased over the period under
consideration, with relatively short periods of decrease in the mid 1990s and early 2000s.
South Africa is not unique in this regard. Both industrial and developing countries have experienced an
increase in the share of government in the economy, and various theories have been developed in an
attempt to explain this global phenomenon. Before we discuss these theories, two important qualifications
should be made. Firstly, government expenditure growth is not necessarily the same as a growing share of
government in the economy. Some of the theories (for example, that of Brown and Jackson, which is
discussed in Section 7.5.2) provide an explanation for the phenomenon of expenditure growth, irrespective
of whether it is accompanied by an increasing share. Most of the theories under discussion, however, deal
with the issue of an expanding government sector relative to the rest of the economy.
Secondly, it is important to distinguish between the empirical issue of expenditure growth and the
reasons for it, on the one hand, and the normative question of what the appropriate size of government
should be. The question of whether government is too big or too small is clearly a complex if not
ambiguous one: the answer is bound to vary among different countries and cultures, and, for any given
country, is also likely to vary over time, as the sections below explain. Following Brown and Jackson
(1990: 120), we distinguish between macro models of government expenditure growth, which tend to
explain the broad patterns of government expenditure with regard to aggregate variables such as GDP
(Section 7.4), and micro models of government expenditure growth, which focus on the decision-
making behaviour of public individuals and institutions (Section 7.5).
7.4.1 Wagner and the stages-of-development approach

Both Adolph Wagner (1883) and the subsequent stages-of-development model, developed by Musgrave
(1969) and Rostow (1971), explain how government expenditure tends to increase when a country
develops from a subsistence or traditional economy to an industrialised economy. Wagner emphasised the
need for government to create and maintain internal and external law and order during the first or early
stages of development, and also to set in place the critical legal and administrative institutions necessary to
cut the costs of doing business. According to the stages-of-development approach, it is also important for
government to get investment going in the first place. During the first stage, the formal sector of the
economy is still relatively small and, as a result, government may have to participate actively by providing
the basic infrastructure (for example, roads, railways and harbours) necessary to create an environment
conducive to economic development. The implication of the first stage for government expenditure is that
capital expenditures will feature prominently.
During the middle stages of development, government will continue to supply investment goods while
private investment will also start to take off, partly as a result of the positive pecuniary external effects of
government investment undertaken during the first stage (see Section 7.6). However, the development of
the private sector may cause certain market failures, including externalities, monopoly pricing and high-
density living conditions associated with growing urbanisation, that government would have to address,
thereby giving rise to further increases in government expenditure. Chapters 2, 3 and 4 discussed such
market failures.
In the last stage of development, capital expenditure by government, expressed as a percentage of GDP,
usually decreases because most of the necessary infrastructure is already in place. At this stage, however,
expenditure on education, health, welfare programmes and social security will tend to increase owing to
the high income elasticity of demand for expenditures of this nature. The result is a continuous increase in
the share of government in the economy.
During the early stages of South Africa’s industrialisation, the government (through public enterprises
and corporations) was heavily involved in major capital projects such as railways, harbours, roads and
public works, as well as in (state-owned) enterprise activities such as the creation of Sasol and Iscor, both
of which were subsequently privatised. The growth in public investment expenditure between the 1930s
and 1960s, for example, corresponds with the first and middle stages discussed above. The subsequent
decline in public investment is not, however, an indication that South Africa had entered the last stage of
development: it is perhaps better understood in terms of Peacock and Wiseman’s displacement effect or in
terms of Meltzer and Richard’s hypothesis (see the next two sections). Note that many rural areas in the
country can hardly be said to have entered the first stage of development in the sense that public
investment has scarcely begun in these areas.
7.4.2 Peacock and Wiseman’s displacement effect

Peacock and Wiseman (1967) used a political theory to explain the influence of political events on public
expenditure. They acknowledged a point made by Wagner, that is, that ‘… government expenditure
depends broadly on revenues raised by taxation’ (Peacock & Wiseman, 1967: 26). Governments would
therefore be in a position to continue increasing their own expenditures and expanding their role in the
economy, provided their economies continued to grow through industrialisation. On the other hand,
individuals may not be prepared to continue paying higher taxes in order to finance this increased
expenditure. In a democracy, government has to respect the wishes of the majority (50% of voters plus
one). Under normal circumstances, government expenditure would therefore only increase when it is
strictly necessary and it can be expected that governments would take the possible resistance of taxpayers
against higher tax rates into account.
However, social upheavals or disturbances may change the established conceptions of the public.
Examples of upheavals of this nature are the two world wars, the Great Depression of the 1930s and the
recent Global Financial Crisis. National and international crises of this magnitude may cause a rapid
increase in government expenditure, since they may convince taxpayers that higher taxes are necessary to
prevent a disaster. Peacock and Wiseman called this phenomenon the displacement effect, as certain
government expenditures (for example, war-related expenses) displace private expenditures as well as
other government expenditures (such as non-war-related expenses).
After a crisis had subsided, government expenditure could be expected to return to its pre-crisis level.
According to Peacock and Wiseman (1967: 27), however, this was unlikely and government expenditure
could even remain at the new post-crisis level, the reason being that taxpayers would become accustomed
to the higher levels of taxation and expenditure and accept them as a part of life.
The displacement effect described by Peacock and Wiseman may help to explain the growth in
government expenditure in South Africa. The previous political dispensation in South Africa resulted in a
massive military build-up and incursions into neighbouring countries amidst widespread social unrest
inside the country, especially post-1976. These crises triggered rapid increases in expenditures on
protection services (defence and police) and also on social services. Expenditure on protection services at
one stage (1983) reached almost 20% of the national budget. Also, the share in total expenditure of
education started to increase as a result of the unrest in schools in 1976. It is, therefore, possible to argue
that both social upheaval and the conflict situation on the borders contributed to the growth in government
expenditure in South Africa during the period up to 1994. However, one may also argue that displacement
pressures in South Africa were dampened by a redirecting of government expenditure (for example, from
economic services to social services). Lusinyan and Thornton (2007) concluded that there is some
evidence that the displacement effect did in fact occur in South Africa in the period following 1960.
7.4.3 The Meltzer-Richard hypothesis

Redistributive policies may have an important impact on the growth of government expenditure. Meltzer
and Richard (1981) developed a general equilibrium model in which majority voting determines the
magnitude of income distribution and, as a result, also the share of government expenditure in the
economy. According to this model, the most important reason for the increase in government expenditure
is an extension of the franchise, which brings about a change in the median (or the decisive) voter (see the
discussion of the median voter theorem in Chapter 6).
Meltzer and Richard (1981: 43) argued that the median voter plays an important role in determining the
size of the government sector in a democracy. For example, if all voters were ordered from left to right
according to their income, with the individual with the lowest income on the far left-hand side and the
individual with the highest income on the far right-hand side, the median voter would be the one right in
the middle. Therefore, if there were, for example, only five voters in a country, with incomes of R3 000,
R4 000, R6 000, R15 000 and R25 000 per annum, the median voter would be the individual with an
income of R6 000. The median voter is important because in a two-party democracy, he or she will
determine which party will win the election. Both parties therefore try to gain the support of the median
voter and will need the support of three individuals (including the median voter) for this purpose.
According to the model of Meltzer and Richard, there will be pressure for redistributing income if the
income of the median voter lies below the average income. Redistribution would benefit the median voter
and he or she will therefore vote for the party that proposes a programme of redistribution. In our example,
the income of the median voter (R6 000) lies below the average income (R10 600). To gain the support of
the median voter (and the majority), parties will emphasise redistributive policies that could result in
higher taxes and higher expenditure on social services. The median voter effectively determines the tax
level.
However, Meltzer and Richard’s model (1981: 916) does not allow for unlimited redistribution because
they assume that voters are aware of the disincentive effects associated with high taxes and redistribution.
The rational median voter will thus choose the tax rate that maximises his or her utility, while taking into
account the possible impact on the economic behaviour of other individuals (in other words, their
decisions to work, consume and invest). If the median voter chooses a relatively high tax rate, other
individuals may decide to work less (consume more leisure), with the result that the economic pie may
become smaller. Following this, the fiscal scope for redistribution may also become smaller.
The hypothesis would suggest that the extension of suffrage (which accompanied democratisation in
South Africa) should have resulted in a major increase in the share of government expenditure in the South
African economy. But this did not happen, despite the fact that the election of 1994 resulted in the
appearance of a new median voter with an income well below the average income. It may be argued, of
course, that the median voter model does not apply to South Africa or that a substantial degree of
redistribution had already occurred earlier in an attempt to counter social upheaval (as already explained).
Expenditure on social services increased between 1994 and 2016 from 45,3% to 50,6% of total general
government expenditure and from 14.8% to 17,6% of GDP (Table 7.2), while defence expenditure
declined dramatically both prior to and after the 1994 elections. Also, the overall fiscal restraint imposed
by the need for macroeconomic stability forced the government to meet many of its distributional goals by
means of a reallocation of social spending. The picture, however, changed during the Zuma administration
due to low economic growth rates and rising employment by government and rampant corruption and state
capture.
7.5 Micro models of expenditure growth

Having discussed macro models of government expenditure growth, we now turn our attention to micro
models of government expenditure growth. The focus here is on how the decision-making behaviour of
public individuals and institutions may impact on increasing the share of government in the economy.
7.5.1 Baumol’s unbalanced productivity growth

Government expenditure may also increase disproportionately owing to an increase in the prices of inputs
used by the public sector relative to those employed in the private sector. This phenomenon has drawn the
interest of William Baumol (1967), who developed a microeconomic model of unbalanced productivity
growth to explain the growth in government expenditure. He divides the economy into two broad sectors:
a progressive sector and a non-progressive sector. The progressive sector is characterised by
technologically progressive activities, such as innovation, capital formation and economies of scale, which
all contribute to a rise in the level of output. An important feature of this sector is a cumulative increase in
the productivity of employees that justifies increases in wages and salaries. The inherent characteristics of
the non-progressive sector, on the other hand, only permit sporadic changes in productivity.
The technological structure of a sector will therefore determine the increase in the productivity of
labour inputs used. In the progressive sector, labour is only one of the inputs in the production process,
while in the non-progressive sector labour is often the end product. Baumol (1967: 416) illustrates this
difference with the aid of several examples. Consumers are usually not interested in the labour used to
produce an air conditioner, as they only care about the end product, that is, cold air. However, the labour
input is of great concern when one has purchased a ticket to attend a one-hour concert of a Beethoven
string quartet. Any effort to increase the overall productivity of the concert to below four human hours (for
example, by doubling the tempo of the music) may upset listeners and detract from the end product (that
is, the concert). In this case, there is clearly a limit to productivity increases, which is greatly determined
by the labour-intensive nature of the service.
The non-progressive sector usually consists of services that also constitute a large component of the
public sector. In this sector, labour plays an important role, for example, in respect of functions such as
education and public order and safety, where a certain teacher–learner ratio or a certain number of law-
enforcement officers per thousand of the population is usually the aim. According to Baumol (1967),
technological changes do not have such an important effect on productivity in the non-progressive sector
as they do in the progressive sector. It could be counterproductive, for example, to try to increase
productivity in health services by halving the time individuals spend in an operating theatre or hospital. As
a result, there are only sporadic improvements in productivity in the non-progressive sector compared to
relatively rapid increases in the progressive sector.
Baumol (1967) argues further that there cannot be too big a difference in the wages and salaries
between the two sectors, otherwise employees would be leaving the non-progressive sector to join the
progressive sector. This raises the relative costs of the non-progressive sector because salary increases are
not accompanied by the same increases in productivity as in the progressive sector. Baumol (1967: 426)
thus came to the conclusion that ‘the costs of even a constant level of activity on the part of government
can be expected to grow constantly higher’. Furthermore, if production in the non-progressive sector has to
be maintained relative to that in the progressive sector, it will imply that a larger share of the labour force
will have to be employed in the former sector, which could have negative effects on economic growth.
One point of critique, however, is that Baumol may have underestimated the opportunities for
technological advancement in the public sector, for example, through the computerisation of certain
services.
As we saw in Table 7.1, a large share of government expenditure in South Africa goes towards the
remuneration of employees. Education, health services and policing, to mention but a few, all require
labour inputs as an end in itself. The structure of government expenditure thus corresponds well with
Baumol’s (1967) notion of unbalanced productivity growth. However, the Baumol (1967) hypothesis has
not been tested empirically in South Africa or in other African countries; no firm conclusions can therefore
be drawn about its relevance to government expenditure growth on the African continent. Unfortunately,
for South Africa, government has become the main creator of employment, with the result that
productivity in the government sector deteriorated and added additional pressure on government
expenditure.
7.5.2 Brown and Jackson’s microeconomic model

The purpose of microeconomic models of growth in government expenditure is to study the factors
influencing the demand and supply of public goods and services. Brown and Jackson (1990: 127) have
developed a microeconomic model to derive the levels of publicly provided goods and services by, inter
alia, taking determinants of demand such as the preferences, the income and the tax rate of the median
voter into account, as well as the costs of the goods and services in question. Since the scope of this book
does not permit a detailed description of this model, we will only discuss briefly some of the factors that
may have an influence on the demand and supply of these goods, and hence on the level of government
expenditure.
It often happens that government expenditure increases without a corresponding change in the level or
perceived quality of service. Although this state of affairs can be viewed as a sign of inefficiency, Brown
and Jackson (1990: 137) argue that there may be other forces at work. It may in fact be the result of
changes in the service environment. For example, an increase in the level of crime, as we have witnessed
in South Africa, calls for increased policing and additional funding merely to counter this increase and
ensure that the same level of security as before is maintained. If a sufficient increase in expenditure did not
occur, the service could be regarded as deteriorating and the service environment became worse.
Changes in the size and density of the population and its age structure may also have an influence on
the service environment. Population growth may lead to an increase in the demand for publicly provided
goods and services. As far as pure public goods such as defence are concerned, we have seen that the
marginal social cost of one additional consumer is by definition zero. However, governments do not only
provide pure public goods, but also mixed and merit goods such as education and health services. In such
instances, increases in the population will lead either to higher levels of expenditure or to a drop in
standards (see Chapter 10). On the other hand, population growth may also imply a decrease in the unit
cost of these services because the payment for these services should be shared by more individuals
(taxpayers); in other words, economies of scale may occur. If the relative price of services decreases, it
may be an incentive for government to supply more of those services. However, population growth and
human migration may also lead to changes in the density of the population, which may cause congestion
and add to the costs of government. The fight against HIV/Aids, malaria and tuberculosis should also put
pressure on government expenditure.
Another factor that may influence the level of government expenditure is the quality of goods
demanded by the median voter. To define quality is not always easy. According to Brown and Jackson
(1990: 139), however, a good or service is of superior quality if it requires more inputs in its production
process than a good requiring fewer of those inputs, ceteris paribus. For example, a hospital that has 500
patients and 100 nurses should provide a service of superior quality to a hospital with 500 patients and 50
nurses. Increases in quality may therefore put further pressure on government expenditure if the additional
costs cannot be recovered from the users.
In a nutshell, it would seem that the micro model of Brown and Jackson (1990) has identified and
combined important and relevant factors that may influence the supply and demand of publicly provided
goods and services. Their model provides a useful point of departure for anyone interested in modelling
government expenditure in African countries and identifying the explanatory variables that will determine
future trends in government expenditure.
7.5.3 Role of politicians, bureaucrats and interest groups

We have already discussed the role played by individual agents and interest groups (see Section 6.7 of
Chapter 6) in influencing government decisions and government expenditure. Politicians, bureaucrats and
other interest groups are often powerful enough to pressure policy in a direction that is detrimental to the
social welfare of the broader community. Their behaviour may result in a higher than optimal level of
government expenditure, thereby contributing to the growth of government’s share in the economy at the
expense of the private sector.
Apart from engaging in various forms of vote trading, as discussed in Chapter 6, there are many other
ways in which the vote-maximising behaviour of politicians can bring about an increase in government
expenditure. They may grant wage and salary increases to state employees in order to win the support of
what is often a numerically significant and powerful constituency. From a macroeconomic point of view,
the ruling party may be tempted to introduce populist policies by relaxing fiscal and monetary policies in
an attempt to stimulate the economy before an election. A relaxation of this nature may well please voters
who stand to secure short-term gains in the form of lower interest rates, lower taxes and better job
prospects, and they may well respond by lending their support to the ruling party. However, populist
macroeconomic policies are not sustainable in the long term, giving rise to inflationary pressures and
balance of payments problems, and ultimately necessitating even tighter monetary and fiscal policies than
the measures that were in place prior to the election.
We also saw in Chapter 6 that bureaucrats tend to maximise the size of their departmental budgets,
partly to help build their own personal empires, and that they are able to convince politicians of their
actions as they are better informed about the activities of their own departments. The net result is a
bureaucracy that is larger than the optimal size. In South Africa, we have seen how the so-called
homelands policy of the past and the increase in the number of provinces after the 1994 election have
contributed to a duplication of government activities that has put additional pressure on government
expenditure.
Individuals with shared interests are often able to organise themselves into powerful interest groups,
and put pressure on government to implement programmes and pass legislation that will meet their own
parochial interests. South African farmers have formed an important lobbying group in the past that has
benefited greatly from agricultural subsidies and other forms of support. The same is true of labour unions
and organised business, and the government may well be tempted to grant them special favours, such as
tax allowances, that will erode the revenue base of government. The persistent recurrence of actions of this
nature can also contribute to the growth of government expenditure in the economy.
7.6 Government and the economy: Long-term effects

In the preceding sections, we looked at the growth of the public sector in the economy and discussed some
of the reasons for this growth. We saw that there are various theories explaining the secular growth of
government in virtually all economies across the world. We now shift our focus to the economic effects –
rather than the causes – of government activity and deal mostly with the long-term effects that changes in
government expenditure can have on the economy.
The short-term impact of government activity on the economy depends on the value of the spending
multiplier (that is, the effect of the change in expenditure on the GDP) and on how government spending is
financed on an annual basis (for example, taxes or borrowing). These issues are discussed further in
Chapters 17 and 18.
The long-term role of government can be viewed within the context of the growing body of literature
known as endogenous or new growth theory (NGT) (Romer, 1986). Adherents to this school have all
called attention to the contribution that government can make towards stimulating and reinforcing
sustained economic growth. Several kinds of public investment and expenditure programmes are reputed
to confer significant positive externalities (of both a pecuniary and a technological kind) on private
producers and consumers, and it is to these programmes that policy-makers should turn in their quest to
promote economic growth and development.
The origin of NGT can be traced to a general dissatisfaction with the classical and neoclassical theories
of growth, according to which savings and private fixed investment or additions to the physical capital
stock play a pivotal role in fostering economic growth. According to NGT, however, this is an
oversimplification of what is really a very complex process. This school of thought adopts a much broader
definition of the concept of capital and focuses attention on the role played by each of the components of
capital in the growth process.
In addition to privately owned physical capital (for example, factories, equipment, office buildings and
luxury homes), capital also includes the following three components:
• The existing economic or physical infrastructure (for example, roads, rail, street lighting, sewage systems,
water and electricity)
• Accumulated human capital acquired through education, training and healthcare, in other words, social
infrastructure
• The stock of technical expertise acquired through learning-by-doing and research and development
(R&D).
The main thrust of NGT is that additions to any of the components of capital may yield increasing returns
because they create externalities that benefit a range of sectors and industries in the economy. Investment
in the physical infrastructure creates (pecuniary) externalities by lowering production costs and boosting
returns in the private sector. Likewise, recipients of education may transfer their skills free of charge to
third parties, healthier citizens will be more productive and limit the spread of disease, new users of
electricity will boost the demand for electrical appliances and so on. Each of the components of capital can
be influenced by government through appropriate policy intervention. The case for intervention of this
nature is again based on market failure. Since the marginal private benefits from investments in the
economic infrastructure, human capital and R&D are lower than the corresponding marginal social
benefits, free markets will underprovide these services. NGT thus provides a strong justification for
government intervention in these areas, as it will create favourable conditions for private investment and
economic growth. Investment in a country’s economic infrastructure usually boosts the productivities of a
range of inputs used by existing private enterprises (see Aschauer, 1989). It may do so by lowering
transport and communication costs, thus cutting down on travel time, reducing the time and costs involved
in negotiations, and facilitating the discovery of new input and output markets. It may also ‘crowd in’ new
private investment, including foreign direct investment (FDI), in the sense of new firms starting up or
existing firms expanding their operations. The point here is that it is the new or improved infrastructure
that triggers both the (mostly pecuniary) externalities and the new private investment, neither of which
would have happened in the absence of infrastructure investment.
From a macroeconomic perspective, the role played by government capital investment can be briefly
illustrated with the aid of a Solow-type aggregate production function. For example, let aggregate supply,
where Kp and Kg represent the levels of capital owned by the private and public sectors respectively, e is a
measure of labour productivity and N is the quantity of labour (with eN being Solow’s ‘effective’ labour).
While an increase in Kg will directly boost Y in Equation [7.1], it may also either crowd in new private
capital investment or, if the addition to Kg is financed by means of borrowing, putting upward pressure on
interest rates, crowd out some private investment (see Chapter 17). In addition, an increase in Kg (for
example, in the form of new school buildings or healthcare facilities) may boost labour productivity, e. We
may therefore extend Equation [7.1] as follows:
where the relationship, Kp (Kg), is either positive or negative, depending on whether there is a net
crowding-in or crowding-out effect, and where the first derivative of e (Kg) is positive.
Infrastructure investment is usually financed by means of borrowing on the open market, but it is
generally accepted that investments of this nature are more likely to have a net crowding-in effect than a
crowding-out effect. The reason is that government borrowing usually constitutes a small portion of total
borrowing, so that it is unlikely to have much of an effect on interest rates, either directly or indirectly. But
even if it did cause a rise in the interest rate, private investors would not necessarily be deterred by it. To
them, other things, including a country’s infrastructure, are often more important when it comes to making
important decisions about their own investments.
Empirically, too, several recent studies have produced evidence confirming this proposition. Although
government spending as a whole tends to have a negative impact on economic growth – partly because it
consists mostly of recurrent consumption expenditure – most studies show that public infrastructure
investments do have a positive impact on factor productivities in the private sector. In its World
Development Report 1994, for example, the World Bank (1994: 14) summarised the results of these
studies and concluded that ‘… the role of infrastructure in growth is substantial, significant and frequently
greater than that of investment in other forms of capital’.
Much the same can be said of public investment in education, training and healthcare. When these
spending categories are suitably disaggregated, one finds significant differences between the constituent
components of each category. Vocational training often produces higher returns than poor-quality formal
schooling, and so too do good quality primary and secondary education in relation to certain categories of
tertiary education. Other categories of tertiary education, in turn, provide the specialised skills that are
necessary for sustained economic growth (Bhorat, 2004).
These findings are clearly important in helping governments to prioritise their spending programmes,
especially in view of the important redistributive role that programmes of this nature play today. We will
return to this theme in the next chapter. The prioritisation of state expenditures, based on efficiency
criteria, can help governments to do two things: achieve a more equitable distribution of income and create
the conditions for sustainable economic growth over the long term.
Key concepts
• displacement effect (page 131)
• economic classification of government expenditure (page 123)
• endogenous or new growth theory (page 136)
• functional classification of government expenditure (page 125)
• functional composition (page 125)
• general government expenditure (page 121)
• macro models of government expenditure growth (page 130)
• micro models of government expenditure growth (page 130)
• service environment (page 135)
• stages-of-development model (page 130)
• unbalanced productivity growth (page 133)
SUMMARY
• The South African Constitution explicitly charges government with the task of maintaining critical
government institutions, including national, provincial and local governments, and providing them
with the necessary public funding. Failing to do so would in fact be unconstitutional.
• In addition, the government of the day is constitutionally obliged to provide or extend the provision of
specified basic goods and services. The clearest examples of these provisions are found in the Bill of
Rights, which entrenches the right of each citizen to adequate housing, healthcare, food, water, social
security and education. However, Section 26(2) of the Constitution does recognise the need for
adequate resources by stating explicitly, ‘… the state should take reasonable legislative and other
measures, within its available resources, to achieve the progressive realisation of this right’ (italics
added).
• General government expenditure grew in South Africa from 1960 to 2017, both in real terms and as a
percentage of GDP. Thus, in 2017, the general government sector comprised some 27,4% of GDP in
terms of resource use and 36,8% in terms of resource mobilisation.
• In terms of the economic classification, cash payments for operating activities (formerly known as current
expenditure) accounted for 92,8% of general government spending in 2017 in South Africa, while
purchases of non-financial assets (outlays for the acquisition of fixed capital assets, land, stock and
intangible assets, formerly known as investment) accounted for the remaining 7,2%. The largest
categories of total cash payments were the government’s wage bill, purchases of other goods and
services (for example, stationery, computers, vehicles and maintenance of capital assets), and social
benefits paid.
• In terms of its functional composition, government spending on public order and safety, education, health,
social protection, housing and community amenities, and transport all increased during this period as
percentages of both total general government expenditure and of GDP.
• The long-run pattern of change in government outlays in South Africa broadly corresponds with
international trends, with South Africa also having experienced a shift from capital expenditure and
economic services towards consumption spending and social services.
• It is questionable whether South Africa needs to invest even larger portions of its national income in
publicly financed education and healthcare. Government spending on these items is already relatively
high by international standards, and the real challenge for the future is for government to utilise its
existing education and health budgets more efficiently than before. Future increases in these budgets
could perhaps be achieved more appropriately through additional revenues obtained from sustained
real growth in per capita income.
• Growth in the government sector does not necessarily imply an increase in the share of government in the
economy. If government expenditure increases at the same rate as the (real) GDP, no change in its
relative share will occur. However, if government expenditure increases at a higher rate than GDP, its
share in the economy will increase.
• Macro models explain the growth of government expenditure in the economy by taking aggregate
variables such as the GDP into account. According to these models, the development process goes
through several stages and will cause an increase in the share of government in the economy. Social
upheaval (such as war and social unrest) may cause instability and may require an appropriate response
by government, which may lead to a potentially permanent increase in the share of government in the
economy. Furthermore, democratic processes may also play a role, especially in a society with high
levels of inequality. Voters may elect a party to parliament with the specific aim of addressing these
inequities.
• Micro models explaining the growth of government expenditure focus mainly on productivity differences,
factors influencing the demand and supply of public goods and services, and the decision-making
behaviour of public individuals and institutions. Differences in productivity growth between the
private and public sectors may cause an increase in government expenditure owing to the need to pay
higher wages and salaries in an attempt to retain employees who have scarce skills in the government
sector. Increased demand for policing, HIV/Aids treatment and education, for example, may place
additional pressure on government expenditure. Politicians, bureaucrats and special interest groups
often pursue their own interests at the expense of the national interest, resulting in higher levels of
government expenditure.
• In terms of endogenous growth theory, public investment in the economic and social infrastructure may
yield increasing returns because it creates positive externalities that benefit a range of private sectors
and industries in the economy. It may also crowd in new private investment, including foreign direct
investment (FDI), in the sense of new firms starting up or existing firms expanding their operations.
7.1 Which of the following statements is or are correct?
a. Resource-use measures of the size of government expenditure are always larger than resource-
mobilisation measures.
b. In the economic classification of government spending, purchases of goods and services is a
component of purchases of non-financial assets.
c. The functional classification distinguishes between the current and the capital elements of
d. None of the above.
a. General government spending has grown without interruption as a percentage of GDP in South
Africa from 1992 to 2017.
b. Long-term trends suggest that general government spending on infrastructure remains relatively
low in South Africa.
c. International comparisons suggest that South Africa still has considerable scope for increasing
social spending as a percentage of GDP.
d. All of the above.
a. Growth in government expenditure does not necessarily imply an increase in the share of
government in the economy.
b. According to the stages of development model, urbanisation will not put additional pressure on
c. The increase in the share of government in the economy of South Africa can be attributed only to
the displacement effect, which is caused by social upheaval.
d. All of the above.
a. The median voter will always favour the redistribution of income.
b.Government expenditure increases because government tends to use too much new technology.
c.Politicians, bureaucrats and interest groups are always inclined to put the national interest before
their own self-interest.
d. None of the above.
7.5 To promote GDP growth, governments should invest in:
a. the economic infrastructure
b. human capital
c. research and development (R & D)
7.1 What guidelines does the South African Constitution give in respect of the role of government in the
economy?
7.2 Explain the displacement effect in Peacock and Wiseman’s model of government expenditure growth.
7.3 Explain how unbalanced productivity growth may affect government expenditure and briefly comment
on its relevance to South Africa.
7.4 Distinguish between the notions of ‘crowding in’ and ‘crowding out’ (of private investment).
ESSAY QUESTIONS
7.1 Discuss trends in the size, growth and composition of government spending in South Africa since 1994.
7.2 Distinguish between the various macro and micro models of public sector growth.
7.3 Explain the median voter hypothesis of Meltzer and Richard, and indicate whether it can explain the
growth of government expenditure in South Africa.
7.4 Consider the implications of new growth theory for the role of government in the economy.
1 The data were obtained from the electronic database of the South African Reserve Bank (available online at
http://www.resbank.co.za/Publications/QuarterlyBulletins/Pages/QBOnlinestatsquery.aspx).
2 Data at constant 2016 prices are not available for the resource mobilisation measure.
3 In South Africa, fiscal years run from 1 April to 31 March. The fiscal year 2009 therefore represents the period from 1 April 2008
to 31 March 2009.
4 Legislation decrees that the government should service the public debt before undertaking other expenditures.
5 .Data for the fiscal years before 2005 were compiled by Statistics South Africa on the basis of the 1986 version of the
Government Finance Statistics (GFS) Manual, whereas data for later years reflect the conventions of the 2001 version. Hence,
the two parts of the series are not strictly comparable and caution should be exercised when interpreting the information in
Table 7.2. Note also that the total expenditure–GDP ratios in Tables 7.1 and 7.2 differ. According to the South African
Reserve Bank, the main cause of the discrepancy is the exclusion from the functional classification of general government
expenditure of data on the trading accounts of local governments.
6 This section reports World Bank data for South Africa, which may differ from the South African statistics used elsewhere in this
chapter.
Government intervention to reduce inequality and
poverty
Krige Siebrits
Sections in earlier chapters of this book introduced equity-related arguments for government intervention to
reduce inequality and poverty. Chapter 2 (Section 2.4.6) argued that highly unequal distributions of income
and wealth and the related problem of high levels of poverty are examples of market failure that establish
prima facie cases for policy intervention. Section 2.5.2 confirmed the real-world relevance of this argument
by stating that the income distributions generated by markets tend to exhibit considerable inequality. These
theoretical and practical considerations underpin governments’ distributive function. As was also pointed
out in Section 2.5.2, this function is important to governments, all of whom attempt to change the
distributions of income and wealth and to reduce poverty. Apart from discussing criteria for assessing the
welfare effects of policies to make economic outcomes more equitable, Chapter 5 commented on the
efficiency implications of such interventions. Section 5.5 showed that redistributive measures might harm
the long-term growth potential of economies by distorting markets. However, such efficiency-equity trade-
offs are sometimes avoidable. Well-designed redistributive measures can enhance human capital
development and boost investment by reducing the instability associated with distributional conflict.
Redistributive and anti-poverty policies that achieve these ends make the allocation of resources more
efficient and contribute to higher rates of economic growth.
This chapter, as well as the next two chapters, develop these arguments further by discussing practical
aspects of the role of government in addressing inequality and poverty. The present chapter discusses broad
conceptual and programme-design aspects of the redistributive and poverty-reducing roles of government.1
The next two chapters will examine specific elements of these roles, namely income security (Chapter 9)
and the provision of social services (Chapter 10). All three chapters focus mainly on government spending
programmes. We also pay some attention to tax issues, however, because the revenue and expenditure sides
of the budget are deeply intertwined aspects of governments’ endeavours to reduce inequality and poverty.
Part 3 of this book discusses some of the tax-related issues raised in these three chapters in more detail.
The structure of this chapter is as follows. Section 8.1 introduces important measures of inequality and
poverty and uses these to provide information about the extent of these phenomena in South Africa and
other Southern African Development Community (SADC) countries. Against this backdrop, Section 8.2
explains how governments can use fiscal policy instruments to change the primary and secondary
distributions of income. Section 8.3 discusses an important aspect of the design of policies to reduce
inequality and poverty, namely targeting mechanisms that channel the benefits of public programmes to
those in greatest need. The chapter concludes with Section 8.4, which explains the concept of ‘fiscal
incidence’ and illustrates the usefulness of incidence studies for gauging the efficacy of policies to reduce
inequality and poverty.
distinguish between primary and secondary income and discuss policy approaches to change the primary and
secondary distributions of income
discuss broad considerations in the design of government interventions to reduce inequality and poverty
define targeting and distinguish the most common mechanisms to target the benefits of government expenditure
programmes
define the concept of ‘fiscal incidence’ and explain how it is used to assess the effectiveness of policy interventions
to reduce inequality and poverty.
8.1 Inequality and poverty in SADC countries

Poverty and inequality are very important policy issues in Southern Africa. Table 8.1 contains measures of
the severity of these problems in the SADC member states.2
The most widely used indicators of the extent of poverty are poverty rates (also known as poverty
headcount ratios). A poverty rate simply shows the percentage of the population of an area whose incomes
are below the poverty line. The international poverty line of $3.20 per person per day used by the World
Bank in the 2018 edition of the World Development Indicators database is the basis of the poverty rates in
Table 8.1. The second column in the table shows that poverty is widespread in all SADC countries except
Mauritius and Seychelles (with only 3,2% and 2,5% respectively of the population living in poverty in
these countries). South Africa’s poverty rate of 37,6% is relatively high for a middle-income country.
Countries that have levels of per capita income similar to that of South Africa tend to have markedly lower
poverty rates. For example, the most recent poverty rates for Brazil, Colombia and Indonesia at the time of
writing were 8,0%, 11,8% and 30,9%, respectively.
The Gini coefficient is a well-known summary measure of the distribution of income. It is derived from
the Lorenz curve, which shows the cumulative income shares of cumulative fractions of a population.
Figure 8.1 shows a Lorenz curve based on the income distribution data for South Africa in the July 2018
version of the World Bank’s World Development Indicators. The income shares of the five quintiles are as
follows: first (poorest) quintile – 2,4%, second quintile – 4,8%, third quintile – 8,2%, fourth quintile –
16,5%, and fifth (richest) quintile – 68,2%. This implies that 7,2% of total income accrued to the poorest
40% of the population, 15,4% to the poorest 60%, and 31,9% to the poorest 80%. The dark line in Figure
8.1 is a Lorenz curve based on these cumulative income shares. The Gini coefficient is a measure of the
extent to which an actual income distribution, such as the one summarised by the Lorenz curve in Figure
8.1, deviates from a perfectly equal distribution. The dashed line in Figure 8.1 depicts such an equal
distribution: Exactly 20% of total income accrues to each of the quintiles. To calculate the Gini coefficient,
the area A (that is, the area between the dashed reference line of perfect equality and the Lorenz curve) is
divided by the area A + B (that is, the entire triangular area beneath the reference line of perfect equality).
The resulting coefficient can range from zero (perfect equality, which implies that the Lorenz curve
coincides with the reference line) to one (perfect inequality, which implies that all income accrues to one
member of the population). In practice, Gini coefficients tend to range from 0,20 to 0,70.
Table 8.1 Measures of poverty and inequality in SADC countries

Source: World Bank (2018b).
Hence, it is clear from the data in Table 8.1 that several Southern African countries have exceptionally
high levels of income inequality. South Africa’s Gini coefficient of 0,630 is the highest among the 163
countries for which the World Bank published figures in June 2018. The reality that only 2,4% of income
accrued to the poorest 20% of South Africans in 2014 while fully 68,2% accrued to the richest 20%
confirms the extreme skewness of the distribution of income. Namibia, Botswana, Zambia, Lesotho,
Mozambique and Eswatini also have very high Gini coefficients. In these countries, too, the gaps between
the income shares of the poorest 20% and the richest 20% of the populations are very large.
A discussion of the reasons for the high levels of income inequality and poverty in South Africa and
most other SADC countries falls outside the scope of this book. The remainder of this chapter focuses on
another important question raised by the data in Table 8.1: What can governments do to reduce poverty and
extreme inequality in the distribution of income? To this end, it discusses policy approaches and tools for
assessing their effectiveness.
Figure 8.1 The Lorenz curve and the calculation of the Gini coefficient
Source: Based on data for South Africa in World Bank (2018b).
8.2 The budget, redistribution and poverty alleviation

Taxes, government expenditure programmes and regulation are important policy instruments for reducing
poverty and changing the distribution of income. In the short run, the national budget is the most important
direct mechanism available to any government to influence the distribution of private earnings. In the
longer run, the fiscal system also has important indirect effects: government spending and taxes influence
economic growth rates and investment in human and physical capital, which are major determinants of the
distribution of earnings from assets and labour market activity.
The distinction between primary income and secondary income can be used to outline the scope for
using fiscal policy instruments for these purposes. The primary income or personal income of an
individual, household or group is the actual value of income received in cash or in kind. It includes the
value of subsistence production activities such as subsistence agriculture. The secondary income of the
individual, household or group is obtained by subtracting direct taxes paid from primary income (which
leaves disposable income) and adding the value of government services consumed. Hence,
where Ys represents secondary income, Yp represents primary income, Td represents direct taxes and G
represents government expenditure.3
Sections 8.2.1 and 8.2.2 provide overviews of two policy approaches aimed at changing the distributions
of primary income and secondary income, respectively. The two approaches can be used separately or at
the same time. Poverty reduction is invariably also an important objective of both approaches. Section 8.2.3
introduces some key issues policymakers should take into account when they design and assess the effects
of measures to reduce inequality and poverty, including the risk of unintended consequences caused by
behavioural responses to such policies. The discussions of redistributive public spending programmes in
Chapters 9 and 10 as well as those of taxes in Chapters 11 to 15 provide more detail on these issues.
8.2.1 Changing the distribution of primary income

The first approach relies on interventions to make the primary distribution of income less unequal. Put
differently, the aim of this approach is to establish rules and incentives that generate more equitable market
outcomes. Governments often use regulations for this purpose. Possibly the best-known examples are
minimum wage regulations, two aims of which are to establish floors for the remuneration of lower-paid
workers and to reduce pay gaps between these workers and higher-paid ones. Several Southern African
countries have minimum wage regulations for particular or for all sectors of their economies, including
Botswana, Mozambique, South Africa, Zambia and Zimbabwe. Governments can also use public spending
programmes and tax measures to influence the distribution of primary incomes. Given that job creation is a
powerful remedy against poverty and a first step towards reducing inequality, governments can pay wage
subsidies to firms to encourage them to hire unemployed members of the labour force. A similar reduction
in the cost of employing labour can be obtained by granting tax incentives to firms that hire jobless persons.
South Africa’s Employment Tax Incentive, which reduces the employees’ tax payable by firms that hire
young and less experienced persons, is an example of such a measure.
8.2.2 Changing the distribution of secondary income

The aim of the second approach is to influence the secondary distribution of income. Hence, it involves the
use of fiscal instruments ex post to reduce disparities in the primary distribution of income generated by
market forces.
Government expenditure programmes are the backbone of this approach. Such programmes can take the
form of cash transfers, in-kind transfers and the provision of social services. Cash and in-kind transfers
directly increase recipients’ command over resources, while effective provision of social services raises the
living standards of recipients and improves their ability to access income-generating opportunities.4 A few
examples of cash transfers programmes in SADC countries are the Social Cash Transfer Programme in
Malawi, the Child Support Grants and Grants for Older Persons in South Africa, the Basic Social Subsidy
programme in Mozambique, and the Harmonised Social Cash Transfer Programme in Zimbabwe. In-kind
transfer programmes include the Food for Education Programme in Tanzania, the Food Security Pack in
Zambia, and the school feeding schemes in Angola, Botswana, Lesotho and Namibia. Like their
counterparts elsewhere, the governments of Southern African countries also provide social services such as
education, health care and social welfare services.
Governments can also reduce inequality by imposing taxes on the incomes and assets of the rich. Of
course, taking from the rich in itself does not reduce poverty– taxes contribute to poverty reduction only to
the extent that the proceeds are used to finance transfer payments and social service provision to the poor.5
This confirms that the redistributive and poverty-reducing effects of the revenue and spending sides of
budgets should be assessed jointly. Section 8.4 also emphasises this point.
8.2.3 Broad considerations for the design and assessment of policies

This subsection outlines two interrelated sets of considerations policymakers should be mindful of when
designing policies to reduce inequality and poverty: first, whether the policies will achieve their aims and,
second, how the policies might influence the behaviour of intended beneficiaries. These considerations can
also be used to formulate criteria for assessing the effects of such policies.
One key factor that determines the effectiveness of government spending programmes to reduce poverty
and inequality is whether such programmes reach the intended beneficiaries. In practical terms, this means
that benefits of transfer and social service programmes should be provided to the largest possible fraction
of the poor and that benefit leakage to the affluent should be avoided. This requires appropriate targeting
mechanisms (the topic of Section 8.3) and sufficient administrative capacity within the government agency
responsible for policy implementation. When it comes to taxes aimed at reducing disparities in income and
wealth, the equivalent effectiveness issue is the extent to which tax burdens are borne by the affluent. This
issue matters because those responsible for paying certain taxes may succeed via legal or illegal means to
shift the actual burdens to others (firms, for example, can sometimes pass on tax burdens to other firms,
their workers or customers). Taxes imposed on wealthy individuals or highly profitable firms fail to
achieve redistributive purposes if these taxpayers succeed in shifting burdens to less affluent individuals.
Chapter 11 provides a detailed discussion of this issue, which is known as the incidence of taxes.
The usefulness of the benefits to recipients also influences the effectiveness of poverty-focused public
spending programmes. The forms such benefits take – cash, goods or social services – and how recipients
use them are relevant considerations.6 For example, Section 9.3.1 comments on the validity of the argument
that in-kind transfers and social services programmes are preferable to cash transfers because poor people
might use cash to purchase luxuries and ‘sin goods’ (such as tobacco products and alcoholic beverages).
Another important issue is that the utility recipients derive from publicly provided social services depends
heavily on the quality of such services. The link between the quality and the poverty-reducing potential of
government spending on education and healthcare is a major theme in Chapter 10.
A more general effectiveness-related issue is whether the impact of government spending programmes
extends beyond short-term poverty relief to the promotion of sustainable livelihoods. In the past, many cash
transfer programmes enabled beneficiaries to meet essential consumption needs, but failed to prevent the
transmission of poverty from generation to generation. Hence, a growing number of countries have adopted
conditional cash transfer programmes, which link eligibility for cash transfers to the performance of actions
such as regular school attendance by children and visits to clinics for health check-ups (the Community-
Based Conditional Cash Transfer Programme in Tanzania is a Southern African example). The purpose of
the conditions is to break inter-generational poverty cycles by building the human capital of children in
poor households. Section 9.3.2 comments on the effectiveness of conditional cash transfer programmes.
Policies to reduce inequality and poverty can influence the behaviour of beneficiaries and taxpayers in
ways that distort the allocation of resources and counteract intended effects. For example, firms might react
to the wage subsidy mentioned in Section 8.2.1 by replacing existing workers with subsidised ones. The
outcome would be that the subsidy fails to create new jobs and only benefits firms by reducing their labour
costs. This subsection has already referred to two other examples: Recipients might squander cash
transfers, and the rich and highly profitable firms may shift the burdens of some taxes to less affluent
individuals. The problem of moral hazard is at the heart of many actual or perceived behavioural distortions
associated with government spending programmes to fight poverty. Moral hazard occurs when individuals
and families do not provide for their own needs or do not protect themselves against negative income
shocks because they have access to government assistance in times of need. Section 9.2.2 contains a more
detailed discussion of the nature and effects of moral hazard problems. In addition, attempts by individuals
and firms to avoid or reduce the burdens of taxes imposed to finance transfer payments and social service
provision can give rise to various forms of inefficiency. Distortion of time allocations for work and leisure
is a well-known example of this. Chapter 12 discusses the efficiency effects of behavioral responses to
various taxes.
8.3 Targeting of government spending programmes

Targeting is the practice of using mechanisms to identify those in greatest need and to channel the benefits
of government spending programmes to them. Three broad categories of targeting mechanisms exist:
1 Means testing. This involves using levels of income or wealth to distinguish poor individuals who are
eligible for government assistance from more affluent ones who are not. Means tests determine
eligibility for the benefits of the three largest cash transfer programmes in South Africa (the Grant for
Older Persons, the Child Support Grant and the Disability Grant) and the Child Maintenance Grant in
Namibia, among others.
2 Indicator targeting. Means testing is sometimes complicated by measurement problems and can create
perverse incentives (for instance, individuals might forgo or hide labour-market earnings to pass
means tests and qualify for cash transfers). In such circumstances, government might use indicator
targeting instead. This involves basing eligibility for benefits on one or more indicators that are highly
correlated with income yet easier to measure. Such indicators might include ownership of land or
other assets, levels of education, age, and areas of residence. Southern African examples of the use of
indicator targeting mechanisms are programmes to assist vulnerable groups such as children
(including the school feeding schemes listed in Section 8.2.2, the National Orphan Care Programme in
Botswana, and the Basic Education Assistance Module in Zimbabwe), individuals with disabilities
(including the Basic Invalidity Pension in Mauritius and the Disability Grant in Namibia) and the
elderly (including the Old-Age Pension in Botswana and Eswatini’s Old-Age Grant).7
3 Self-targeting. Self-targeted programmes have requirements or offer benefits that are unattractive to the
affluent. Thus, the wages offered by public works programmes might be set too low to attract workers
who hold other jobs, and in-kind transfer programmes might provide foodstuffs or other goods that are
consumed only or mainly by the poor. This targeting mechanism underpins the Ipelegeng Public
Works Programme in Botswana, among others. Effective self-targeting has a clear advantage over
other targeting mechanisms: It is unnecessary to spend resources to identify intended recipients,
because aspects of the design of the programme prevent benefit leakage to affluent individuals.
8.3.1 The benefits and limits of targeting

The major benefits of effective targeting are budgetary savings and strengthening of the poverty-reducing
effects of government expenditure programmes. Figure 8.2, which compares the effects and budgetary
costs of targeted and universal (non-targeted) cash transfer programmes, illustrates these benefits.
The pre-transfer incomes of the inhabitants of a country are arranged from the smallest (Ymin) to the
largest (Ymax) along the horizontal axes of panels A and B in Figure 8.2. The vertical axes of the two panels
show the post-transfer incomes of these individuals, arranged in the same way. The two horizontal lines
labelled z represent the country’s poverty line: All individuals who earn less than z are poor, while those
who earn more are not. Hence, the triangles Yminaz depict the country’s poverty gap, that is, the amount of
money needed to raise the incomes of all poor individuals to the poverty line and eliminate poverty.
We first focus on Panel A, which compares the effects of universal and perfectly targeted cash transfer
programmes. The line Ymin ad represents the initial income levels of the country’s inhabitants. Assume the
government introduces a cash transfer programme that disburses an equal amount T (equal to c – Ymin) to
everyone. This non-targeted transfer causes a parallel upward shift of the incomes line from Yminad to cbe.
The programme clearly reduces poverty: It lifts all individuals whose pre-transfer earnings ranged between
Y1 and Y2 out of poverty. However, the reality that the transfers are too small to lift individuals whose pre-
transfer earnings ranged between Ymin and Y1 out of poverty means that it fails to eradicate the problem
completely. Hence, the poverty gap does not disappear; instead, it merely shrinks from Ymin az to cbz.
Figure 8.2 The benefits and limits of targeting

Source: Adapted from Hoddinott (2007: 91).
Universal cash transfer programmes also produce substantial benefit leakage. Panel A in Figure 8.2
shows the two types of leakages associated with such schemes. First, everyone who was lifted from poverty
except those whose pre-transfer incomes were exactly Y1 received more than what was required to raise
their incomes to z. Second, the beneficiaries of the programme included all non-poor individuals (that is,
everyone whose pre-transfer incomes exceeded Y2). Benefit leakage tends to be the main reason why the
benefits provided by some universal transfer programmes are inadequate to eliminate poverty gaps.
A perfectly targeted cash transfer programme would yield markedly better outcomes. Such a programme
would provide everyone whose initial income was less than Y2 with a transfer that exactly equals his or her
individual poverty gap (that is, the difference between z and the person’s pre-transfer income). The result
would be the complete eradication of absolute poverty and, by implication, elimination of the poverty gap.
Moreover, no benefit leakage would occur. Put differently, perfect targeting avoids two important errors of
targeting mechanisms. These are type 1 errors (or errors of exclusion, which occur when the targeting
mechanism excludes poor people whom the programme was supposed to benefit) and type 2 errors (or
errors of inclusion, which occur when the targeting mechanism fails to exclude rich people who were not
supposed to be among the beneficiaries).
It is likely to be very difficult or expensive to determine individual poverty gaps and to manage systems
of differentiated transfers. Hence, countries tend to use less sophisticated targeting mechanisms. Panel B in
Figure 8.2 uses the example of a simple means tested transfer programme to show that such mechanisms
still yield better outcomes than non-targeted programmes do. This programme provides a cash transfer T
(equal to c – Ymin) to all poor individuals (that is, those whose pre-transfer incomes are less than Y2). Hence,
it avoids type 2 targeting errors by excluding everyone whose pre-transfer incomes exceed the poverty line.
For a given programme budget, a means tested programme that excludes the affluent makes a larger
transfer to each poor person possible than a universal programme would. This is shown by the difference
between the extent of c – Ymin in Panel A and Panel B. The size of the programme budget would determine
whether poverty is eradicated or merely reduced. The means-tested transfer in Panel B does not eradicate
absolute poverty, and the result of this type 1 error is a small poverty gap cbz. Panel B also illustrates a
major drawback of this targeting mechanism: Individuals who formerly earned between Y1 and Y2 receive
more than what is required to raise their post-transfer incomes to z. Hence, the programme raises their
incomes above those of some others who are ineligible for government assistance because their pre-transfer
incomes exceed Y2. This change in the distribution of income seems unfair. In addition, it creates perverse
incentives, as these non-qualifying individuals are now able to increase their incomes by working less and
becoming eligible for transfers.
8.3.2 The costs of targeting

The benefits of targeting should be weighed against its costs. Such costs can be classified into three types:
1 Administrative costs. The costs of identifying, reaching and monitoring the target population can be
substantial: Grosh (1994: 36–37) found that such costs make targeted transfers in Latin American
countries 3–8% more expensive than universal ones are. Hence, trade-offs exist between curtailing
administrative costs and avoiding the costs of poor targeting. Strictly speaking, the administrative
costs of targeted transfer programmes should include compliance costs for participants, including
those associated with interviews and documents to prove eligibility.
2 Incentive costs. Targeting can have positive incentive effects. To name but one example: A food subsidy
programme targeted at parents whose children attend school may raise school enrolment. Negative
incentive effects (that is, incentive costs) are more common, however. Distortions of the consumption-
saving and work-leisure choices are cases in point. Means testing might reduce incentives to save for
retirement, for instance, while generous unemployment benefits might discourage job search.8 Non-
productive use of time and other resources that arises from moral hazard problems is another important
category of negative incentive costs associated with some targeting mechanisms. Examples of this
include the problem of so-called ‘rotten parents’ who may not provide adequately for their children if
they know that the state will do so by means of school feeding programmes or transfer programmes.
3 Stigma costs. The stigma costs of targeting refer to the loss of self-esteem sometimes fostered among
participants by the negative attitudes of non-participants and officials. The desire to avoid
stigmatisation of poor children is the reason why some school-feeding programmes are universal
instead of targeted. By contrast, the reality that eligibility for the grant for older persons is almost
universal in many parts of South Africa means that there is hardly any stigma associated with being a
recipient.
8.3.3 The effectiveness of targeting

How effective is targeting in practice? A study of 86 targeted transfer programmes introduced in middle-
and low-income countries between 1985 and 2003 (Coady, Grosh & Hoddinott, 2004) find that such
programmes generally, but not always, channel more benefits to the poor than equivalent universal ones do.
The criterion used by the authors is the benefit ratio, which is the share of programme benefits transferred
to a certain segment of the population divided by that segment’s share of the total population. Consider the
poorest 40% of the population (the segment used by Coady et al., 2004) as an example. A universal transfer
programme would yield a benefit ratio of one, because it would provide the same benefits to everyone (for
example, the poorest 40% of the population would receive exactly 40% of the benefits). By contrast, a
targeted programme with a benefit ratio of more than one provides more than 40% of the programme
resources to the poorest 40% of the population. In such cases, the targeting mechanism enhances the
redistributive effect of the programme.
Fully 61 (or 70%) of the 86 programmes studied by Coady et al. (2004) had benefit ratios higher than
one. In fact, the ratios of 45 of the programmes were at least 1,25. Hence, the targeting mechanisms
effected significant redistribution in more than half of the sample of programmes. Another four
programmes had ratios of exactly one – this means that these transfer schemes were not more effective than
non-targeted ones would have been at channelling benefits to the poor. However, the reality that 21 (almost
one quarter) of the programme had benefit ratios smaller than one, confirms that targeting does not always
work well. It should also be kept in mind when interpreting these findings that benefit ratios ignore the
targeting costs discussed in Section 8.3.2.
One of the reasons for the disparate outcomes is the variation in the effectiveness of the categories of
targeting mechanisms. The authors found that the benefit ratio of the median programme with means
testing or some other form of individual targeting was 1,50, while those for the median programmes with
indicator targeting and self-targeting were 1,32 and only 1,10, respectively. Effective targeting depends in
part on choosing appropriate mechanisms and good enforcement of programme rules.
8.4 Fiscal incidence

Evaluation is an essential element of successful policymaking and policy implementation. Fiscal incidence
analysis, which draws on information from household surveys and administrative datasets to identify the
beneficiaries and the bearers of the tax burdens and other sources of financing of government expenditure
programmes, is a useful tool for evaluating the effectiveness of policies to reduce inequality and poverty.
Well-executed incidence studies assist policymakers to establish whether policy measures reach intended
beneficiaries and achieve their redistributive goals.
It is possible to study the incidence of government expenditure programmes and that of taxes separately.
However, a clear picture of the redistributive effects of policies requires comprehensive fiscal incidence
studies, which estimate the net result of the incidence of spending benefits and tax burdens. Such analyses
can be done for specific programmes (for example, government spending on education) or for the fiscal
system as a whole. Identification of beneficiaries and bearers of fiscal burdens is normally done for income
groups such as deciles or quintiles. In some countries, however, historical or present-day factors make other
forms of fiscal incidence analysis important. In South Africa, for instance, the distorting effects of
apartheid on the distribution of benefits of government expenditure programmes have motivated many
race-group-based fiscal incidence analyses.9
Figure 8.3 Income concepts in fiscal incidence analysis
The remainder of this section presents a conceptual framework developed by the Commitment to Equity
Institute at Tulane University and selected findings of studies for South Africa and Namibia to illustrate
key principles and the value of fiscal incidence analyses.10 It should be stated at the outset that various
methods exist for undertaking such studies. These methods all have advantages and disadvantages. We will
return to some of the weaknesses of the method illustrated here after presenting the conceptual framework
and findings.
Figure 8.3 summarises the conceptual framework of the Commitment to Equity Institute’s fiscal
incidence studies. The starting points for such analyses are market incomes of individuals, which consist
of salaries and wages, income from capital (such as dividend income), private transfers (such as private
pensions and remittances) and contributory pensions (pension scheme benefits funded from compulsory
contributions by employers and workers). Market incomes are the real-world equivalent of the concept of
primary income in Section 8.2. Net market incomes are market incomes less personal income tax
payments and employee contributions to old-age pension schemes. Adding direct transfers (such as cash
transfers) and near-cash transfers (such as free school textbooks and school feeding scheme meals) to net
market incomes yields disposable incomes. Post-fiscal incomes are calculated by subtracting value-added
tax, excise tax and other indirect tax payments from disposable incomes and then adding indirect subsidies
on foodstuffs, energy and other goods and services. The final major income concept is final incomes,
which consist of post-fiscal incomes plus in-kind transfers (government-provided education and health
services).11 Final incomes are similar to secondary income, which was introduced in Section 8.2.
Table 8.2 Findings of fiscal incidence analyses for South Africa (2010/11) and Namibia (2009/10)
Note: a In 2010/11, the lower bound poverty line for South Africa was R443 per person per month. In 2009/10, the lower
bound poverty line for Namibia was N$277,54 per person per month.
Sources: Inchauste et al. (2015: 31); World Bank and Namibia Statistics Agency (2017: 52).
Researchers often present the results of fiscal incidence studies as Gini coefficients and poverty rates for
the income concepts in Figure 8.3. Table 8.2 shows results of fiscal incidence studies for South Africa and
Namibia (Inchauste, Lustig, Maboshe, Purfield & Woolard, 2015; World Bank and Namibia Statistics
Agency, 2017) in this format. Note that the poverty rates are based on national poverty lines. Hence, they
are not comparable.
The Gini coefficients for the final incomes of both countries (0,596 for South Africa and 0,429 for
Namibia) are markedly smaller than the ones for market incomes (0,771 for South Africa and 0,635 for
Namibia), which implies that fiscal measures make their income distributions significantly less unequal.
Hence, the data confirm the redistributive potential of fiscal systems. Yet the South African data also
emphasise the limits of fiscal redistribution: The Gini coefficient for final incomes of 0,596 remains
exceptionally high despite the strong redistributive effects of the fiscal system.12 Fiscal redistribution might
not suffice to obtain a fair distribution of final incomes if the distribution of market incomes is extremely
skewed.
Redistributive fiscal systems usually also reduce the incidence of poverty. This is true for both
countries: The poverty rates in South Africa are 46,2% for market incomes and 39,6% for post-fiscal
incomes, while those for Namibia are 22,2% for market incomes and 16,7% for post-fiscal incomes. Note
that poverty rates are not provided for final incomes. Fiscal incidence studies exclude the monetary value of
education and health services when calculating the poverty-reducing effects of fiscal systems because
households ‘are unlikely to be willing to pay as much as the government spends on these services and as a
result do not view these services as part of their income’ (Inchauste et al., 2015: 29).
Fiscal incidence studies usually also provide information about the contributions to redistribution and
poverty reduction of the various components of fiscal systems. The findings of Inchauste et al. (2015: 15–
28) and the World Bank and Namibia Statistics Agency (2017: 30–49) yield the following conclusions for
South Africa and Namibia. Both countries have progressive income tax systems that reduce income
inequality by levying higher tax rates on the richer strata of their populations.13 Indirect taxes are somewhat
regressive in South Africa and distribution-neutral in Namibia. The main reason why these taxes are not as
regressive as might be expected is that both countries zero-rate various items consumed mainly by the
poor.14 The net result is that the tax systems of both countries are slightly progressive. Especially the
indirect taxes increase poverty, though. Hence, the data for South Africa and Namibia confirm the
statement in Section 8.2.2 that tax systems often reduce income inequality, but do not contribute directly to
poverty alleviation.
Both countries maintain large cash transfer programmes (mainly pensions for the elderly, child grants
and disability grants). South Africa’s programmes are better targeted, however, and have stronger
moderating effects on income inequality and poverty (see World Bank and Namibia Statistics Agency,
2017: 38–40). Indirect subsidies – free water, electricity, sanitation and refuse removal services in South
Africa and water and housing subsidies in Namibia – and publicly provided education and health services
augment these effects. These outcomes underscore another important statement in Section 8.2.2: Well-
targeted cash and in-kind transfers can markedly reduce inequality and, in the case of the former, poverty as
well.
Table 8.3 illustrates another way of presenting results of fiscal incidence analyses. For each of the
income concepts, it shows average per capita income levels for the deciles of the income distribution of
South Africa.
The market income column in Table 8.3 is a stark reminder of the extreme nature of income inequality
in South Africa. Recall from Figure 8.3 that personal income tax payments and employee contributions to
pension schemes constitute the difference between market incomes and net market incomes. Hence, the per
capita income figures in the net market income column confirm the progressivity of direct taxes in South
Africa by showing that the burden of personal income taxes rests heavily on the three richest deciles. By
contrast, it transpires from the disposable income column that individuals in the poorer deciles benefit
markedly more (in relative and absolute terms) from cash transfers than individuals in the richest deciles.
The post-fiscal incomes column shows the effects of indirect taxes. Such taxes reduce absolute incomes in
all deciles.
Table 8.3 Average per capita incomes by market income deciles in South Africa (Rands, 2010/11)
Note: The disposable income figures exclude the value of free basic services (water, electricity, refuse removal and
sanitation).
Source: Inchauste et al. (2015: 30).
Various issues should be kept in mind when interpreting the results of fiscal incidence studies of this nature.
These include the following:
• Data and other problems usually restrict the scope of such studies to parts of fiscal systems. For example,
the South African study discussed in this section analysed the incidence of 64,5% of general
government revenue and 43% of general government expenditure. The results of many such studies
might have been quite different if it had been possible to include additional parts of fiscal systems.
• The reliability of the findings depends markedly on the quality of the household and other surveys that
generate the core data for fiscal incidence analyses.
• Most fiscal incidence analyses do not incorporate the effects of taxes and government spending benefits on
the behaviour of beneficiaries and non-beneficiaries. In trying to identify the effects of fiscal systems
on inequality and poverty, such analyses compare the secondary and primary incomes of individuals (or
households) and assume that the primary incomes would have been the same if the government did not
levy taxes and did not provide any spending benefits. In reality, howver, fiscal systems are likely to
affect the labour supply, consumption and saving behaviour of individuals and households. Incidence
analyses that do not incorporate behavioural effects of taxes and benefits can significantly under- or
overestimate the influence of fiscal systems on inequality and poverty.
• Fiscal incidence analyses typically measure the amounts of money governments spend on individuals or
households in various income groups. These amounts are not necessarily reliable indicators of the
actual benefits of the recipients; the services provided by governments may be of poor quality, for
instance. This is a major issue in fiscal incidence analysis in South Africa, where public education and
healthcare spending is high by international standards and well targeted (see Section 7.3), yet highly
inefficient in terms of outcomes. Chapter 10 returns to this important issue.
Key concepts
• benefit ratio (page 152)
• disposable incomes (page 153)
• errors of exclusion (type 1 targeting errors) (page 150)
• errors of inclusion (type 2 targeting errors) (page 150)
• final incomes (page 154)
• fiscal incidence analysis (page 152)
• indicator targeting (page 148)
• market incomes (page 153)
• means testing (page 148)
• net market incomes (page 153)
• post-fiscal incomes (page 154)
• primary income (page 145)
• secondary income (page 145)
• self-targeting (page 149)
• targeting (page 148)
SUMMARY
• Indicators such as poverty rates, Gini coefficients and income shares show that poverty and inequality are
severe problems in most SADC countries.
• Taxes, government expenditure programmes and regulations are important policy instruments for reducing
poverty and changing the distribution of income. These instruments can be used to change the
distribution of primary income, the distribution of secondary income, or both. Governments should be
mindful of two sets of issues when designing policies for these purposes: whether policies will achieve
their aims (which has to do with whether policies reach the intended beneficiaries, how useful the
benefits are to them, and what the developmental effects of policy measures are), and the ways in which
policies might change the behaviour of the intended beneficiaries.
• Targeting is the practice of using various mechanisms (such as means testing, indicator targeting and self-
targeting) to identify those in greatest need and to channel the benefits of government spending
programmes to them. The poverty-reducing effects of public spending programmes can be enhanced
markedly if appropriate targeting mechanisms are chosen and if the programme rules are enforced
properly. Targeting can bring administrative, incentive and stigma costs, though. Hence, decisions
whether to use targeting should always be based on comparisons of benefits and costs.
• Fiscal incidence analysis is a useful tool for evaluating the effectiveness of policies to reduce inequality
and poverty. Such analyses use information from household surveys and administrative datasets to
identify the beneficiaries and the bearers of the tax burdens and other sources of financing of public
spending. Clear pictures of the redistributive effects of policies require comprehensive fiscal incidence
studies, which estimate the net result of the incidence of spending benefits and tax burdens. Fiscal
incidence studies tend to have various shortcomings, however, and these should be kept in mind when
results are interpreted and used for policymaking purposes.
8.1 Which of the following statements is/are correct?
a. Income from subsistence agriculture is included in primary incomes.
b. Secondary incomes include benefits from government expenditure programmes.
c. Regulations are the only policy measures that can be used to make the primary distribution of
income less unequal.
d. Cash transfer programmes are examples of policy measures to make the secondary distribution of
income less unequal.
a. Not all targeting mechanisms require substantial expenditures to identify intended beneficiaries.
b. Universal cash transfer programmes produce substantial benefit leakage.
c. Targeting mechanisms cannot have positive incentive effects.
d. Targeting hardly ever fails.
a. Fiscal incidence analysis ignores the distributional effects of taxes.
b. Disposable incomes reflect the redistributive and poverty-reducing effects of cash transfers, among
other things.
c. Fiscal incidence studies usually do not provide poverty rates for final incomes.
d. Final incomes do not include the redistributive and poverty-reducing effects of indirect subsidies.
8.4 Which of the following statements is not true?
a. Fiscal incidence studies show that the fiscal systems of South Africa and Namibia reduce income
inequality.
b. Incidence studies confirm that South Africa and Namibia have progressive income tax systems.
c. Most fiscal incidence analyses ignore the behavioural effects of taxes and government expenditure
programmes.
d. One of the strengths of fiscal incidence analysis is its ability to measure the actual benefits of
government expenditure programmes.
9.1 Explain the difference between primary incomes and secondary incomes.
9.2 Distinguish between three broad categories of targeting mechanisms.
9.3 Explain the difference between disposable incomes and post-fiscal incomes.
ESSAY QUESTIONS
9.1 Use the distinction between primary incomes and secondary incomes to identify two broad approaches
to changing the distribution of income, and briefly discuss two sets of issues that government should
keep in mind when implementing either of these approaches.
9.2 Use a graphical analysis to demonstrate the advantages of targeted cash transfer programmes over
universal ones.
9.3 Explain why potential benefits and costs should be taken into account when policymakers decide
whether to use targeting mechanisms.
9.4 Discuss the purpose and most common shortcomings of fiscal incidence studies.
9.5 Fiscal incidence studies for Country A and Country B yield the following information:
a. What do these statistics reveal about the overall effects of the two fiscal systems on inequality and
poverty?
b. Briefly state the most likely effects of direct taxes, indirect taxes, cash transfers, indirect subsidies
and in-kind transfers on income inequality and poverty.
c. Use these propositions to suggest possible explanations for the figures in the table.
Findings of fiscal incidence analyses for Country A and Country B

1 Some sections in this chapter refer to specific social protection programmes in Southern African countries. We drew on Cirillo and
Tebaldi (2016) for information about such programmes.
2 At the time of writing this chapter, the figures in Table 8.1 were the most recent ones in the World Bank’s World Development
Indicators database.
3 Strictly speaking, social transfers form part of primary incomes (Yp). If included in Yp, such transfers should be omitted from
government spending (G) to prevent double counting.
4 Government expenditure on social services (for example, education and healthcare) forms part of general government consumption
in Table 1.1 in Chapter 1. Hence, it is included in the resource use measure of the size of the public sector. By contrast, cash
and in-kind transfers are included in the resource mobilisation measure under the heading ‘Subsidies, grants and other transfer
payments’.
5 Section 11.4.1 discusses the pitfalls of dedicated or earmarked taxation, among other things. To avoid these pitfalls, decisions
about the allocation of tax revenues for the financing of programmes to reduce inequality and poverty should be integrated into
the government’s expenditure prioritisation process.
6 The second of these issues is linked closely to the effects of such programmes on the recipients’ behaviour, to which we return
below.
7 Indicator targeting is sometimes combined with means testing. In South Africa, for example, eligibility for the benefits of most
cash transfer programmes depends on personal characteristics (such as disability and age) as well as income or wealth.
8 Chapter 9 discusses these incentive distortions in more detail.
9 Van der Berg (2014) provides a brief review of such analyses that shows the highly unequal distribution of government
expenditure benefits in the apartheid era and the large resource shifts towards blacks that started in the mid-1970s and were
completed after the political transition in 1994.
10 For more detail on the conceptual framework and studies of other countries, see the website of the Commitment to Equity
Institute at http://commitmentoequity.org/.
11 Strictly speaking, final incomes should exclude user fees and co-payments for government services (for example, healthcare).
However, the fiscal incidence studies for South Africa and Namibia discussed below do not provide information about such
fees and payments.
12 Inchauste et al. (2015: 31) compare fiscal redistribution in twelve middle-income developing countries (Armenia, Bolivia, Brazil,
Costa Rica, El Salvador, Ethiopia, Guatemala, Indonesia, Mexico, Peru, South Africa and Uruguay). South Africa’s fiscal
system reduces its Gini coefficient more than those of the other countries do. Yet because of South Africa’s exceptionally
unequal distribution of market incomes, its Gini coefficient for final incomes remains the highest.
13 The tax rate structures of personal income tax systems are progressive if the average tax rate increases as income increases – see
Section 12.2.2.
14 Indirect taxes are levied on commodities and market transactions (see Section 12.2.4). Poorer individuals typically consume larger
percentages of their incomes and save smaller percentages than richer individuals do. The reality that consumption falls as a
percentage of incomes as incomes increase means that taxes on the consumption of commodities tend to be regressive – average
tax rates tend to fall as incomes increase.
Social insurance and social assistance
Krige Siebrits
The International Social Security Association (2018) defines social security as ‘… any programme of social
protection established by legislation, or any other mandatory arrangement, that provides individuals with a
degree of income security when faced with the contingencies of old age, survivorship, incapacity,
disability, unemployment or rearing children. It may also offer access to curative or preventive medical
care.’ This chapter discusses the income security-related components of social security systems, which are
core elements of governments’ efforts to reduce poverty and income inequality. Such arrangements serve
two purposes. The first is to protect individuals who normally earn enough to support themselves against
income losses or fluctuations that would put their welfare at risk, for example, those caused by bouts of
illness or unemployment. The other purpose of such arrangements is to support individuals who cannot earn
enough to meet their basic consumption needs, for example, children in poor households, disabled persons
who cannot work, and elderly persons without enough savings. This chapter focuses on income-
augmentation programmes financed or administered by governments. However, the exposition also gives
some attention to private arrangements with similar purposes, which are closely interlinked with public
ones.
This chapter consists of five sections. Section 9.1 distinguishes between the two types of arrangements
that make up the income security-related components of social security systems, namely social insurance
programmes and social assistance programmes. Section 9.2 discusses social insurance programmes in more
detail. It provides an overview of the economic theory of insurance and explains the need for government
intervention to overcome the inability of private markets to provide insurance against the effects of certain
income losses. The topic of Section 9.3 is social assistance programmes. This section discusses the choice
between providing such assistance as cash or goods and services, as well as the pros and cons of adding
conditions to cash transfer programmes. Section 9.4 reviews the incentive problems associated with income
security programmes. In closing, Section 9.5 outlines and comments of various aspects of the South African
income security system.
distinguish between social insurance programmes and social assistance programmes
use aspects of the economic theory of insurance to explain the need for social insurance systems
discuss the choice between cash and in-kind transfer programmes
discuss the nature and effectiveness of conditional cash transfer programmes
discuss the incentive problems associated with social insurance and social assistance programmes
outline and discuss the South African income security system.
9.1 The two components of income security systems
As was pointed out earlier, the income security-related parts of public social security systems have two
components, namely social insurance programmes and social assistance programmes. Social insurance
programmes are funded from mandatory contributions by workers and employers. These contributions,
which are known as social security taxes, are examples of payroll taxes (see Section 9.2). Only those who
have made such contributions may access the benefits of social insurance programmes when affected by
income losses or fluctuations. Social assistance programmes, on the other hand, are cash transfer
programmes funded from general tax revenues. Consequently, eligibility for social assistance is not
restricted to those who have contributed to dedicated funds from which benefits are paid.1 The cash transfer
programmes referred to in Section 8.2.2 are examples of social assistance schemes.
Social insurance schemes have long been the core elements of income security systems in European
welfare states. Such schemes initially were established for industrial workers and were extended to other
groups over time. Social assistance schemes have played a residual role in these systems by protecting
members of vulnerable groups who do not qualify for social insurance benefits. Insurance-dominated
systems have sufficed in these countries, because the vast majority of working-age individuals have formal
sector jobs that enable them to access benefits linked to payment of social security taxes. The income
security systems of most developing economies are still evolving. On balance, the unemployment rates and
informal sector participation rates in these countries have been higher than those of the advanced
economies. This has limited governments’ scope to use social insurance arrangements linked to formal
sector jobs as income protection mechanisms. Although many developing economies have been expanding
the social insurance components of their income security systems, most have remained more reliant on
social assistance programmes than advanced economies have been. The extent and growth of formal sector
employment have not been the only determinants of the weights of these two parts of countries’ income
security systems. Factors ranging from the availability of fiscal resources to ideological preferences,
distributions of political power and even accidents of history have all shaped the structures of such systems.
While the remainder of this chapter focuses on social insurance and social assistance programmes, some
sections also refer to two private income security mechanisms that interact with the equivalent public ones.
The first of these is occupational insurance. In some countries that lack payroll tax-funded social
insurance programmes, legislation or collective bargaining agreements make it mandatory for private sector
workers to belong to their employers’ pension or provident funds. Such workers receive retirement benefits
from the returns on the contributions they and their employers make to these funds. The second type of
private income protection arrangements referred to in this chapter is inter- and intra-household transfers
(for example, remittances from migrant workers). These arrangements are known as informal, traditional
or indigenous income security systems. Section 9.5.2 refers to the interplay between public and private
income security arrangements in South Africa.
9.2 Social insurance

The first part of this section briefly outlines the income protection role of insurance. This is followed by an
overview of the economic arguments for social insurance schemes. The roots of these arguments are equity-
and efficiency-related market failures.
9.2.1 The income protection role of insurance

Assume an individual has to choose between two consumption bundles. The first option is to consume R300
000 in each of the next two years, while the second is to consume R400 000 in the first and R200 000 in the
second year. Which option would the individual choose? Recall the principle of diminishing marginal
utility, which maintains that the marginal utility of consumption decreases as the level of consumption
increases. One of the implications of this principle is that the above-average level of consumption in the
first year of the second option would not increase the utility of the individual as much as the below-average
level of consumption in the second year would reduce it. It follows that the individual is likely to derive
more utility from the first option than from the second even though the values of the two consumption
bundles are the same. Put differently, the principle of diminishing marginal utility implies that individuals
would derive more utility from a smooth path of consumption than from a variable one of the same total
magnitude, ceteris paribus.
The conclusion that individuals prefer to avoid fluctuations in incomes and consumption levels also
holds in real-world conditions of uncertain outcomes. To be sure, some individuals may be able to sustain
their levels of consumption when they experience unexpected income losses by drawing down their own
savings, borrowing from banks or moneylenders, and obtaining assistance from charitable organisations,
friends or family members. These options may be not be available to all individuals, however, or may be
inadequate if the income losses are large or permanent. Insurance against income losses caused by
retirement, illness, work-related injuries and periods of unemployment can be an alternative form of income
protection. This would involve making payments known as ‘insurance premiums’ to insurers who, in turn,
pay amounts of money when the insured suffer income losses caused by events covered by the insurance
contracts. Hence, insurance amounts to consumption smoothing: individuals reduce their consumption in
times of plenty to finance premiums that would enable them to sustain their levels of consumption by
means of payouts in times of economic hardship.
9.2.2 The rationale for social insurance

In well-developed market economies, private firms provide insurance against various risks, including losses
of possessions caused by theft and natural disasters. Individuals can also obtain retirement insurance from
private firms (Section 9.1 pointed out that this is known as occupational insurance). The question therefore
arises whether there is economic justification for government intervention in the form of social insurance
systems. This subsection outlines the efficiency- and equity-related market failures in private insurance
markets that justify such intervention.
Efficiency arguments for social insurance are based on market imperfections that prevent insurers from
determining actuarially fair premiums for cover against some forms of income losses. An actuarially fair
premium equals the expected loss of the insured. If, for example, there is a one per cent probability that a
worker who earns R300 000 per annum will become unemployed in the next year, the expected income loss
is R3 000 (1% of R300 000). Hence, the actuarially fair unemployment insurance premium will be R3 000
per annum. In general terms, this can be written as follows:
where ∏ represents the actuarially fair insurance premium, p represents the probability of the loss and L
represents the potential size of the loss (see Barr, 1989: 62).2
To determine actuarially fair premiums, insurance providers must either know or be able to make
reliable estimates of p and L for individual clients. Probabilities of and income losses associated with
retirement are readily available or estimable, which explains why private firms offer retirement insurance in
South Africa and elsewhere in Southern Africa. The information needed to determine actuarially fair
premiums is not available for all causes of income losses, though. Workers’ probabilities of suffering
unemployment, for example, are determined by many complex factors, including technological change,
changes in the sectoral composition of economies, and characteristics such as skills, work experience and
personal motivation. The probabilities of career-interrupting or -terminating injuries at work also vary from
person to person because of differences in the nature of jobs, workers’ attitudes to safety issues and the
extent to which firms adhere to workplace safety laws, among other things. While insurance providers can
sometimes use historical data about injuries and unemployment rates in specific occupations or sectors to
estimate probabilities of income losses, unexpected technological change and other factors can severely
reduce the reliability of such estimates. The effects of information problems that prevent determination of
actuarially fair premiums are that private firms either do not provide cover against the income losses in
question at all or restrict cover to low-risk market segments (for example, workers in occupations that are
least likely to be affected by unemployment or work-related injuries). These outcomes are examples of the
effects of violations of the full information assumption of the benchmark model in Section 2.1.
Section 2.4.1 distinguished between situations in which both parties to a transaction lack information
and instances of asymmetric information (recall that information asymmetries occur when one party to a
transaction has more or better information than the other does).3 Both situations cause market failure. Two
types of information asymmetries have particularly pernicious effects in insurance markets, though:
• Adverse selection. Equation 9.1 implies that the determination of actuarially fair premiums is hampered
when workers can hide information about factors influencing their probabilities of suffering losses from
insurance providers (p). The term ‘adverse selection’ describes situations in which persons who face
high probabilities of suffering losses – and are therefore keener than others to insure themselves against
such events – can hide their high-risk status from insurers. Adverse selection is common in markets for
unemployment and work-related injury insurance: insurers often cannot access all the information
possessed by workers about generic risk factors in specific jobs or sectors as well as relevant personal
characteristics (for example, the effort levels of individual workers and the extent to which they adhere
to safety regulations). The only option available to insurers who cannot distinguish between low- and
high-risk clients is to charge everyone the same premium based on the average risk. However, this
would mean that workers with high probabilities of suffering income losses would face inefficiently
low prices for insurance and in all likelihood would buy more than the optimal quantities. By contrast,
low-risk workers would have to pay inefficiently high prices and would be likely to buy too little
insurance. These distorted prices and quantities would represent allocative inefficiency. Low-risk
workers may even stop buying any insurance if they deem the premiums excessive. Such ‘opting-out’
would make insurance provision by private firms impossible, because insurers would lose money if they
only serve high-risk workers whose premiums are lower than their expected losses.
• Moral hazard. Another implication of Equation 9.1 is that insurers cannot determine actuarially fair
premiums if insured parties have scope to behave in ways that increase the size of an insured loss (L)
and the probability of its occurrence (p). Moral hazard exists when insured parties can affect the
liabilities of insurers via such behaviour without the knowledge of the latter. Moral hazard is a distinct
possibility in markets for insurance against income losses. Some insured workers may undertake actions
that increase p. Persons with comprehensive unemployment insurance may be more inclined to work in
sectors with volatile employment levels, for example, and may be less motivated to perform to the best
of their abilities to avoid becoming redundant than those who lack such cover. In addition, full
insurance may affect some workers’ resolve to avoid work-related injuries.4 Actions that increase L are
also possible: compared to those without cover, insured persons may put less effort into job search
activities after becoming unemployed or into rehabilitation programmes after injuries at work. Moral
hazard would have the same effects that adverse selection has: insurance provision would be inefficient
(usually when insured parties increase L) or not provided at all (usually when potential clients can
increase p to such an extent that profitable provision would be impossible).
Note that adverse selection and moral hazard are market failures caused by information asymmetries at
different stages of insurance transactions. Adverse selection (which is also known as the problem of hidden
characteristics) arises before insurance contracts are signed when potential clients hide information about
their probabilities of suffering losses from insurers. By contrast, moral hazard occurs after the signing of an
insurance contract when clients engage in hidden actions that affect the size of the loss or the likelihood of
its occurrence from insurance companies. Hence, it is sometimes called the problem of hidden actions.
Government intervention in the form of social insurance systems can overcome some efficiency-related
insurance market failures. Most notably, such systems provide solutions to the adverse selection problems
that prevent private firms from providing any insurance against some causes of income losses or restrict
provision to low-risk clients. Governments can force all high-risk and low-risk workers as well as their
employers to join social insurance schemes. This makes it possible to provide insurance against income
losses caused by unemployment and work-related injuries to all workers in the formal sectors of economies
(Section 9.5 refers to examples of such schemes in South Africa). Social insurance schemes that cover
entire economies may also have other efficiency-related benefits. For one thing, there may be economies of
scale in the administration of insurance schemes (this argument assumes that such economies are not
outweighed by X-inefficiency or other forms of government failure). In addition, it may be the case that
individuals would not insure themselves adequately against some risks of income losses if governments do
not force them to do so. This argument, which clearly has a paternalistic bent, implies that social insurance
is an example of the class of goods described in Section 3.5 as ‘merit goods’.
Social insurance schemes remain prone to other efficiency-related market failures, though. The payroll
taxes that fund social insurance schemes can be linked to the earnings of individual workers (L in Equation
9.1). It is impossible to link such taxes to individual-specific loss probabilities (p in Equation 9.1), though,
because governments cannot obtain more information than private insurance providers can about relevant
risk factors. The reality that these adverse selection problems cannot be overcome implies that social
insurance systems exhibit inefficiencies very similar to those that undermine private provision of insurance
against the same causes of income losses: individual risk profiles do not determine the ‘tax price’ paid nor
the degree of cover provided to each worker. Moreover, moral hazard problems caused by information
asymmetries are as common in social insurance programmes as in private insurance markets (see also
Section 9.4).
The efficiency-related arguments for social insurance systems are significantly strengthened by equity
considerations. The basis of the equity argument for social insurance is that individuals without adequate
access to savings, borrowing opportunities or informal income protection systems cannot maintain their
consumption levels when they suffer income losses. Negative income shocks often push such individuals
and their dependents into poverty, and dispersed income losses – such as those caused by deep recessions –
can exacerbate income inequality. Some of these individuals (for example, workers who earn small or
irregular incomes in the informal sector) cannot afford any insurance against income losses. Governments
can use non-contributory social assistance programmes to enable these individuals to meet their basic
consumption needs when they suffer negative income shocks (see Section 9.3). Social insurance schemes
financed by payroll taxes protect individuals who have formal-sector jobs but lack the means to afford full
insurance, that is, insurance that fully compensates them for income losses. Mandatory social insurance
programmes that collect payroll taxes from all workers (including those with high earnings) can mobilise
enough funds to bring lower-income individuals closer to the full insurance or consumption-smoothing
outcomes than private insurance products can.
Income losses caused by unemployment and work-related injuries have featured prominently in the
summary of the efficiency justification for social insurance schemes in this section. Equity considerations
closely related to those raised in the previous paragraph underpin the case for social insurance against a
third cause of income losses, namely retirement. Private firms offer occupational insurance, but their
annuity products do not necessarily provide full insurance to persons who earned low incomes during their
working lives, especially if they live long after retiring and if unexpectedly high rates of inflation erode the
values of their retirement savings. In fact, the retirement incomes of some individuals with occupational
insurance may be insufficient to enable them to meet their basic consumption needs.5 Compared to the
products offered by private firms, mandatory social insurance programmes funded from payroll taxes on all
workers can provide former workers who earned low incomes with more generous retirement benefits.
As was pointed out in Section 5.3, the income redistribution inherent to social insurance systems can be
justified on Pareto grounds. It is also fully compatible with the externality argument for Pareto-efficient
redistribution outlined in that section.
9.3 Social assistance

Section 9.1 stated that the social assistance parts of income protection systems disburse cash transfers to
needy individuals on a non-contributory basis. Such schemes are very important anti-poverty instruments,
both as complements to contributory social insurance systems and in their own right. Moreover, social
assistance programmes can be strongly redistributive if financed from progressive taxes (a tax is
progressive if the average tax rate increases as consumption, income or wealth increases – see Section
11.2.1). Sections 9.3.2 and 9.5 will show that empirical evidence confirms the poverty-reducing and
redistributive effects of social assistance.
Social assistance programmes were traditionally justified with reference to livelihood protection
effects, that is, effects on poorer individuals’ ability to maintain minimum standards of living, even when
they lose other income sources. Debates on social assistance now also focus on livelihood promotion
effects, which have to do with sustainable poverty reduction via improvements in living standards over
time. Livelihood promotion effects become possible when social assistance programmes promote
investment in education, healthcare, nutrition, social networks, and income-generating assets. Apart from
strengthening the well-established equity arguments, the possibility of such effects adds an important
efficiency argument to the case for social assistance: investments in education, healthcare and nutrition can
boost economic growth (the dynamic efficiency of economies – see Section 2.3) by making the labour force
more productive.
To be sure, the possibility of livelihood protection and livelihood promotion effects depends strongly on
how recipients use social assistance money. Two sets of risks come to mind. The first and most obvious is
that the recipients may squander the money on luxuries and so-called ‘sin consumption’ (expenditure on
gambling, harmful drugs, alcoholic beverages, tobacco products, et cetera). Alternatively, they may use all
the money for consumption smoothing purposes (livelihood protection) instead of investing some of it to
obtain livelihood promotion benefits. Hence, the question arises whether it is possible to design social
assistance programmes in ways that enhance their benefits and reduce such risks. The remainder of this
section discusses two design issues that may affect the effectiveness of social assistance programmes.
These are the choice between providing the benefits in the form of cash or goods and services (Section
9.3.1) and the effects of adding behavioural conditions to cash transfer programmes (Section 9.3.2).
9.3.1 The choice between cash and in-kind transfers

Social assistance programmes can provide cash or in-kind transfers to beneficiaries. In-kind transfers can
take two forms: direct provision of goods and services to targeted groups, or subsidisation of the prices of
market goods and services. Direct provision of some goods and services (such as foodstuffs and housing)
can serve the same purpose as cash transfers, namely to enable poor persons and households to meet basic
consumption needs.
The core theoretical argument for cash transfers is that recipients who are allowed to choose how to use
social assistance benefits can attain higher levels of utility than those who are given goods and services
selected by government officials. Figure 9.1 illustrates this choice-related argument. It uses standard tools
for analysing consumer choices, namely budget lines and indifference curves. A budget line shows
combinations of two goods or services that a consumer can afford given prices and his or her income. Its
slope is the negative of the price ratio of the goods or services. An indifference curve depicts combinations
of two goods or services that yield the same level of utility to a consumer. The marginal rate of substitution
between the two goods or services gives the slope of an indifference curve. The horizontal axis in Figure
9.1 shows quantities of food consumed per month, while the vertical axis shows quantities of other goods
and services consumed per month.
Figure 9.1 The choice-related argument for the superiority of cash transfers over in-kind transfers
Source: Adapted from Rosen and Gayer (2014: 265).
The initial equilibrium in Figure 9.1 is at E1, where the consumer’s budget line, AB, is tangent to
indifference curve I1. At E1, the consumer’s monthly consumption of food amounts to 0QF1 and that of
other goods and services to 0QO1. Assume that the government introduces a new social assistance
programme that provides a food parcel valued at 0QF2 to low-income individuals. The consumer satisfies
the income means test that determines eligibility for this benefit. The in-kind benefit enables the individual
to consume more; hence, it is equivalent to an income increase and can be depicted by an outward shift of
the budget line. The individual’s cash income, however, remains the same. At the prevailing prices, this
level of cash income does not allow spending in excess of 0QO2 on other goods and services (the Y-
intercept of the budget line depicts how much the consumer can afford if he or she uses all cash income to
purchase other goods and services). Hence, line ACD represents the budget constraint after the introduction
of the food parcel scheme. The individual is now at E2, where the values of the monthly consumption
bundles of food and of other goods and services are 0QF2 and 0QO2, respectively.
Note that the in-kind transfer has increased the individual’s consumption bundles of food and of other
goods and services, and that the indifference curve associated with E2, namely I2, represents a higher utility
level than that associated with the initial equilibrium E1, namely I1. Yet, unlike an equivalent cash transfer,
the in-kind transfer does not enable the beneficiary to select combinations of food and other goods and
services along the hypothetical line segment EC. The preferred combination of this individual (monthly
consumption bundles of food and of other goods and services of 0QF3 and 0QO3, respectively, which would
have yielded a utility level shown by indifference curve I3) lies on this line segment. Indifference curve I3
lies above indifference curve I2, which implies that the individual would have attained a higher level of
utility if he or she had been given cash instead of the food parcel. The reality that many in-kind transfer
programmes are likely to yield such sub-optimal outcomes underpins the choice-related argument for the
superiority of cash transfers.
This argument is not always decisive, though. Various counterarguments emphasise potential benefits of
in-kind transfers. For one thing, such transfers can reduce the costs of targeting by serving as self-targeting
mechanisms (see Section 8.3). As an alternative to costly means testing, governments can provide staple
foods consumed mainly by the poor (such as maize meal) at subsidised prices to anyone who wishes to
purchase it. The reality that very few affluent consumers buy such products makes this a low-cost way to
achieve some of the benefits of targeting discussed in Section 8.3.1. It should be kept in mind, however,
that interventions of this nature invariably distort prices and market outcomes. A second counterargument is
that policymakers may find it easier to mobilise funding for in-kind transfer programmes, because public
support for programmes providing essential goods and services is often stronger than for cash transfer
schemes. Finally, Section 10.2 will outline the powerful case for in-kind provision of goods and services
with positive external benefits (recall from Section 3.6 that the marginal social benefits of such goods and
services exceed their marginal private benefits because benefits accrue to non-users as well).
Some proponents of in-kind transfers also use an argument that follows from the significant influence of
recipients’ use of benefits on the effectiveness of social assistance schemes. It states that in-kind transfer
programmes are more likely to achieve social assistance goals than cash transfer programmes are, because
at least some recipients of cash transfers will squander the money on luxuries or ‘sin goods’. A survey of 30
studies on African, Asian and Latin America countries (Evans & Popova, 2017) reported that the evidence
for this argument was weak.6 These studies found that cash transfers were generally not spent on alcoholic
beverages and tobacco products; if anything, most participating households reduced their consumption of
‘sin goods’ after the introduction of the transfers. Two factors possibly caused this response: most of these
programmes were targeted at women (who generally are more likely than men are to spend cash benefits on
the needs of children) and accompanied by strong social messaging that discouraged misuse.
It is in any case not true that governments can prevent all misuse of social assistance benefits by only
providing in-kind transfers. Social assistance recipients with a strong preference for luxuries and ‘sin
goods’ can sometimes sell in-kind benefits – such as foodstuffs – to get cash, and attempts to prevent this
can significantly increase the administrative costs of in-kind transfers. Moreover, Figure 9.1 suggested that
the problem would not necessarily be solved by preventing sales of in-kind benefits. Recall that the
introduction of food parcels increased the consumption bundles of food as well as other goods and services
even though the recipient did not resell any foodstuffs. The reason why the recipient could afford larger
quantities of other goods and services after the introduction of food parcels was that the income he or she
previously spent on food was freed up for other uses. These other uses may or may not have included
purchases of luxuries and ‘sin goods’.
On balance, the case for using cash transfer programmes as income protection mechanisms is strong. It
rests on the theoretical argument about the utility benefits to recipients, the lack of compelling evidence of
large-scale squandering of cash transfers, and the reality that in-kind programmes are not fail-safe
mechanisms to prevent misuse of social assistance benefits. More generally, it is important that choices
between cash and in-kind transfer programmes should be informed by rigorous empirical analysis of data
on the use and effects of both types of transfers in specific contexts.
9.3.2 Conditional cash transfer programmes

The introduction to this section emphasised that cash transfer programmes are very important instruments
for reducing poverty in developing countries. Governments traditionally used cash transfers for livelihood
protection purposes, and relied on other policy instruments (including education, healthcare and asset-
redistribution programmes) for livelihood promotion effects. As stated in Section 8.2.3, several developing
countries have recently introduced conditional cash transfer programmes (CCT programmes), which are
cash transfer programme with livelihood protection as well as livelihood promotion goals.
The twin aim of CCT programmes is to combat current poverty (by providing income support that
enables consumption smoothing) and future poverty (by encouraging human capital accumulation to break
inter-generational poverty cycles). To achieve this aim, CCT programmes provide cash transfers to
households that meet certain requirements. The most common purpose of the conditions is to increase the
human capital of children. Mexico’s ‘Prospera’ programme, for example, provides cash transfers and food
supplements to households if the children attend school regularly and if all family members attend health
workshops and make regular visits to health centres. The Community-Based Conditional Cash Transfer
Programme in Tanzania, which is discussed in more detail in Box 9.1, has similar conditions. Several other
developing countries – including Brazil, Colombia, Jamaica, Nicaragua and the Philippines – also have
CCT programmes.
The aims of CCT programmes make perfect sense. Basic economic theory, however, postulates that all
attempts by policymakers to force rational individuals to change their behaviour distort their decisions and
reduce their utility. (This is a variant of the choice-related argument for cash transfers in Section 9.3.1.)
Hence, an important question arises: are conditions appropriate measures to enhance the ability of cash
transfer programmes to achieve livelihood promotion effects? Economists have identified two sets of
considerations that justify behavioural conditions:7
• Efficiency-related market failures. The marginal social benefits of parents’ investment in the education and
healthcare of their children may exceed the marginal private costs: such investment can increase
communities’ stocks of knowledge and skills and prevent the spread of disease (cf. Section 3.6.2).
Parents, however, may not consider these external benefits when they take decisions about investing in
the health and education of their children. CCT programmes can overcome such externalities by
increasing investment in the human capital of children to socially optimal levels. Policymakers can also
use such programmes when mismatches between the preferences of parents and the interests of children
result in inefficiently low levels of investment in education. Some parents underinvest in the education
of their children simply because they prioritise own consumption needs, but economic motives often
come into play as well. In households that depend on subsistence agriculture, for example, the short-
term benefits to parents of using their children as labourers may outweigh the longer-term benefits of
sending them to school. In such cases, cash grants tied to school enrolment and attendance can enhance
efficiency and welfare.
• Equity-related targeting considerations. Conditions can be useful targeting mechanisms for cash transfer
programmes when means testing is not feasible. The requirement to visit public health facilities on a
regular basis, for example, would impose high opportunity costs on richer people who usually use
private health facilities. Hence, these conditions could make transfers more redistributive by tilting the
cost-benefit calculation of higher-income groups against participation. Policymakers should keep in
mind, however, that households without school-age children cannot benefit from programmes with
school attendance and child health conditions. In addition, poor households may conclude that the costs
of participation exceed the benefits and opt out of cash transfer programmes if the conditions seem too
onerous to them. In such cases, potential equity and efficiency gains are foregone.
On balance, empirical studies of CCT programmes have found positive effects on household consumption,
reductions in child labour and, in some cases, increases in saving and investment (see, for example, Box
9.1). Studies also show that conditions boost school enrolment and the use of health facilities. However, the
effects on education and health outcomes depend on the quality of the services provided by governments.
While most unconditional cash transfer programmes yield similar benefits, the few direct comparisons of
the effects of the two types of cash transfer programmes have suggested that conditions usually strengthen
the benefits.8
Box 9.1 Tanzania’s Community-Based Conditional Cash Transfer Programme9
The Government of Tanzania established the Tanzania Social Action Fund (TASAF) in 2000 as a major community-
driven development initiative. The Community-Based Conditional Cash Transfer Programme, which is one of the
components of TASAF, was introduced as a pilot programme in three particularly poor districts in 2010. The
Programme disbursed cash to poor households if the members satisfied three conditions: children up to the age of five
had to visit a health clinic six times per annum, children aged seven to fifteen had to be enrolled in school and achieve
attendance rates of at least 80%, and elderly people had to visit a health clinic once a year. One of the notable features
of this programme was that communities elected representatives who helped to select participating households and
monitored their compliance with the conditions. This feature reflected the community-driven orientation of TASAF.
The pilot phase of the conditional cash transfer programme was designed with scientific assessment of its effects
in mind. It provided the conditional benefits to households in 40 randomly selected villages in the three districts, and
researchers then compared education, healthcare and other outcomes in those villages to those in the 40 other villages
where households did not receive cash transfers. An assessment published in 2014 (Evans et al., 2014) showed that
the conditional cash transfers had clear positive effects. Compared to their peers in households that did not receive the
conditional transfers, the members of participating households were markedly healthier and had higher primary
school attendance and completion rates. The beneficial effects on school completion rates were especially large for
girls. Analysis of spending patterns indicated that the participating households mainly used the cash transfers to buy
health insurance, shoes for children and livestock (especially chickens). The poorest households also sharply
increased their non-bank savings.
Concern that the involvement of community members in the selection and monitoring of participating households
would have jeopardised the cohesion of communities proved unfounded. On the contrary, households that received
conditional transfers were more likely than others to have attended community meetings, participated in community
projects and expressed trust in other community members.
These positive outcomes led to the creation of a much larger safety net programme known as the Productive Social
Safety Net (PSSN). This intervention, which was introduced in 2013 to support the poorest 15% of Tanzanians,
combines conditional cash transfers with labour-intensive public works programmes and other livelihood
enhancement initiatives to support sustainable income-generation activities among poor households.
It is too soon to say if long-term livelihood promotion benefits will complement the promising short- to
medium-term effects of CCT programmes. However, the effects of such programmes on human capital
accumulation are likely to be negligible in countries where school attendance among poor children is very
high already or where schools and hospitals cannot provide high-quality education and healthcare services.
9.4 Incentive effects of income protection systems

Thus far, this chapter has identified various benefits of income protection systems. However, many income
protection programmes also create disincentives or perverse incentives. Thomas Schelling (1985: 6–7), the
joint winner of the Alfred Nobel Memorial Prize in Economic Sciences in 2005, explained this as follows:
Policy issues are preponderantly concerned with helping, in compensatory fashion, the unfortunate and
the disadvantaged. An unsympathetic way to restate this is that a preponderance of government policies
have the purpose of rewarding people who get into difficulty. There is no getting away from it. Almost
any compensatory programme directed toward a condition over which people have any kind of control
… reduces the incentive to stay out of that condition and detracts from the urgency of getting out of it. It
is a rare ameliorative programme that has no visible way, by its influence on behavior, to affect the
likelihood or the duration or the severity of the circumstances it is intended to ameliorate. And most
commonly – not always but most commonly – the effect on behavior is undesired and in the wrong
direction. To keep the issue in perspective we can observe that private insurance … can have the same
adverse influence on behavior.
Section 9.2.2 discussed a well-known example of such incentive problems, namely moral hazard in social
insurance schemes. This section provides two other examples and briefly comments on the implications of
such problems for income protection systems.
The first example is the possibility that income transfers – such as universal income grants financed
from general tax revenue –may create a disincentive to work. Figure 9.2 explains the effect of such
transfers on the work effort of an economically active person who is also subject to income tax. The
horizontal axis of the figure shows the 24 hours available to the person per day, and the vertical axis his
daily income. Line AX is vertical, because the time endowment of 24 hours per day is fixed at all income
levels. He can use this time endowment for work or other activities (here labelled ‘leisure’). The person’s
income is determined by his allocation of the time endowment between work and leisure. If we assume that
the person does not earn non-wage income,10 we can write the relationship between his income and
allocation of the time endowment between work and leisure as follows:
Figure 9.2 The effect of an income transfer on work effort
where I is the daily income of the person, w his hourly wage, and L the number of hours per day he devotes
to leisure. If the hourly wage is R100, for example, the individual will earn R500 per day if he works five
hours and uses the remaining 19 hours for leisure. A longer working day of eight hours (which implies 16
hours of leisure) will yield a bigger income of R800 per day. The budget constraint BA depicts such
relationships between the person’s income levels and allocations of the time endowment. Its slope is the
hourly wage w, which also represents the opportunity cost of leisure. The indifference curves in Figure 9.2
(I0, I1 and I2) depict the person’s preferences for work and leisure. Initially, the individual is in equilibrium
at E0, where the budget constraint BA is tangent to indifference curve I0. At E0, he works AC hours and
devotes 0C hours to leisure. This allocation of the time endowment yields income level 0D.
Assume the government now introduces a universal income grant, that is, a cash transfer to all citizens
of the country irrespective of age or economic status. Its value is BG per person per day. Hence, the budget
constraint shifts parallel to the right to GF. Note that the grant provides the individual with an income of
AF (which is equal to BG) when he devotes no time to work. This income floor is augmented by wage
income as he works more hours from A towards the origin along the horizontal axis. The new equilibrium is
at E1 on the new budget constraint GF and the higher indifference curve I1. Despite working fewer hours
and devoting more time to leisure than before the introduction of the transfer – the number of hours worked
decreased from AC to AH – the individual now has a higher income (0J > 0D) and a higher level of welfare.
These changes reflect the income effect of the cash transfer.
Next, the government imposes an income tax to finance the universal income grant programme. Unlike
the cash transfer, this policy change has an income effect as well as a substitution effect. The tax changes
the slope of the budget constraint, because it reduces the hourly wage w received by workers. Recall that
such a reduction also implies a drop in the opportunity cost of an additional hour of leisure. Hence, the
budget constraint swivels inwards from GF to KF. The reduction in the relative price of leisure induces an
increase in the number of hours of leisure, which is the substitution effect. The income effect of this tax-
induced wage change increases the hours worked.
The final equilibrium is at E2 on indifference curve I2, where the individual works even fewer hours per
day than before the introduction of the tax (AL, as opposed to AH). Reductions in the levels of income (0M
< 0J) and welfare now accompany the reduction in work effort.
Theoretical analysis therefore suggests that income tax-financed cash transfers can reduce the incentive
to work in two ways: the income effect of the cash transfer (shown by HC) as well as the net impact of the
income and substitution effects of the income tax (shown by LH) are negative.
A second example of disincentive effects associated with social assistance transfers are the ‘poverty
traps’ caused by some means tests. Thus, persons’ incentives to save for retirement during their working
lives are weakened by means tests that base eligibility for and the value of old-age pension on their non-
pension incomes. Such means tests also discourage them from working after they reach the legal retirement
age.
Figure 9.3 illustrates these effects of some means tests for a hypothetical old-age pension scheme. Line
AEFG shows the monthly incomes of elderly persons from all sources other than social assistance
pensions.11 The pension scheme works as follows. Elderly persons whose non-pension incomes range from
zero to R2 400 per month receive the full social assistance pension of R1 600 per month. This implies that
the total income of an elderly person without non-pension income is R1 600 per month, while that of an
elderly person with non-pension income of R2 400 per month is R4 000 per month. Segment BC of line
BCDEFG depicts the pension-inclusive total incomes associated with non-pension incomes in this interval.
For non-pension incomes ranging from R2 401 to R3 600, the value of the pension drops by R1 for every
additional rand of non-pension income the elderly person has.12 Hence, the pension-inclusive total incomes
of all elderly persons with non-pension incomes in this range are R4 000 per month, as shown by the
horizontal segment CD of line BCDEFG. The income threshold of the means test that determines eligibility
for old-age pensions is a monthly income of R3 600 per month; furthermore, the minimum pension paid to
an eligible elderly person is R400 per month. This implies that an elderly person with non-pension income
of R3 600 per month would have a pension-inclusive total income of R4 000 per month. Someone with
non-pension income of R3 601, however, would not be eligible for a pension. The near-vertical segment
DE of line BCDEFG depicts the ‘drop-off’ in total incomes when the pension falls away. The two lines
share the segment EFG, because the incomes of elderly persons who earn R3 601 per month or more from
other sources are not augmented by social assistance pensions.
Figure 9.3 Disincentive effects of means tests for old-age pensions

Source: Adapted from Van der Berg (2001a: 129).
The following example illustrates the disincentive effects of the sliding-scale benefit values and the
income threshold of the means test. Assume that a worker saves enough to have a non-pension income of
R2 401 per month after retirement. When deciding whether to increase her retirement savings, she has to
consider two things. First, the implication of the ‘drop-off’ associated with the income threshold is that the
pension-inclusive total incomes of retired persons with monthly non-pension incomes from R3 601 to
R3 999 (segment EF of line BCDEFG) would be less than those of their peers with monthly non-pension
incomes from R2 400 to R3 600 (segment CD of line BCDEFG).13 Second, the sliding-scale benefit values
mean that a retired person with non-pension income of R3 600 per month would be no better off than one
with a non-pension income of R2 401: both would have a pension-inclusive total income of R4 000 per
month. Hence, she will not be better off in retirement, and may even be worse off, unless she can increase
her retirement savings sufficiently to generate a non-pension income of at least R4 001 per month. She may
well regard such a large increase as infeasible and refrain from saving more. Persons who reach the legal
retirement age but have the option to remain in paid employment would face similar disincentive effects.
To be sure, only persons with prospective or actual non-pension incomes in the relevant income
intervals would be affected by these disincentives. Moreover, such effects can be mitigated by appropriate
reforms. For example, the sliding scale benefit system can be changed so that the value of the pension
decreases by only 50 cents for every additional rand of non-pension income the beneficiary has, while the
extent of the income drop at the income threshold can be moderated by reducing the minimum pension
paid. Such reforms may reduce the effectiveness of means tests as targeting mechanisms, however, or limit
the number of poor households assisted with a given programme budget. Such trade-offs are common in the
design of social assistance programmes.
In the statement quoted earlier, Thomas Schelling pointed out that many of the disincentive effects of
income protection programmes are inherent to such schemes. Some, however, are effects of design errors.
To avoid such errors, policymakers should anticipate possible incentive effects of targeting mechanisms,
conditions, and benefit levels and keep these in mind when they design income protection programmes.
Once such programmes are in place, policymakers should strive to obtain reliable empirical information
about incentive effects of specific design features and, where feasible, change those that distort behaviour.
9.5 The South African income security system

This section has three parts. Section 9.5.1 discusses the coverage of the South African income security
system in the three major life stages of individuals and families (childhood, working age, and old age),
Section 9.5.2 comments on the scope and adequacy of the system, and Section 9.5.3 reviews empirical
research on the effectiveness of its social assistance components.
Recall from the introduction to this chapter that income security-related programmes are components of
social security systems. Figure 9.4 contextualises the following discussion of South Africa’s income
security programmes by summarising its full social security system. The figure shows the three formal parts
of the system and the elements of each, as well as their types of financing mechanisms and sources of
funding:14
• Social insurance programmes. South Africa has three types of social insurance programmes that provide
income support or compensation for defined-risk events. These are the Unemployment Insurance Fund;
the Compensation Funds, which assist workers who sustain work-related injuries or diseases; and the
Road Accident Fund, which provides compensates to victims of road accidents caused by wrongful or
negligent driving. The Unemployment Insurance Fund and the Compensation Funds are financed by
payroll taxes levied on workers and employers. The Road Accident Fund receives a portion of the fuel
levy on sales of petrol and diesel, which is paid by road users.
• Social assistance programmes. The social assistance component of South Africa’s social security system
consists of seven cash transfer programmes: child-support grants, care-dependency grants, foster-care
grants, disability grants, old-age pensions, war veteran’s grants, and grants-in-aid. Apart from the
foster-care grants, these cash transfer programmes are all means tested. Some also have health status-
based eligibility criteria. General tax revenues fund the various cash transfer programmes. This means
that all taxpayers – workers and firms, but also recipients of cash grants whose purchases of goods and
services are subject to value-added tax and excise taxes (cf. Sections 16.1 and 16.3) – contribute to the
financing of these programmes.
• Occupational insurance programmes. Section 9.1 stated that the occupational insurance programmes in
South Africa are examples of private income security arrangements. Binding industrial-council and
other agreements between employers and employees have made it mandatory for most workers in the
formal sectors of the South African economy to join medical aid schemes and their employer’s pension
fund or provident fund. Hence, the term ‘occupational insurance’ refers to contributory retirement and
health insurance tied to workers’ conditions of employment. Legislation merely enables employers and
employees to enter into such agreements, and government involvement is limited to regulation to
protect contributors to provident funds, pension funds and medical aid schemes.
The remainder of this section discusses the income security-related components of this system in more
detail. The discussion covers all the programmes listed in Figure 9.4 except medical aid schemes (as was
stated in the introduction to this chapter, medical insurance is not an income security programme), the Road
Accident Fund (which is not primarily focused on poverty alleviation or income redistribution), and grant-
in-aid (which is provided to recipients of old-age pensions, war veteran’s grants and disability grants who
require full-time care because they suffer from physical or mental disabilities).15
Figure 9.4 The South African social security system

Source: Adapted from Woolard and Leibbrandt (2010: 3).
9.5.1 Coverage
This subsection discusses the components of the South African income security system listed in Figure 9.4
in more detail.16 The discussion revolves around coverage in the three major life stages of individuals and
families, namely childhood, working age, and old age.
9.5.1.1 Childhood
South Africa has three grant programmes to assist children in poor families. The child- support grant, which
replaced the child maintenance grant in April 1998, is the largest of the three. The South African Social
Security Agency (SASSA) pays these grants to the primary caregivers of children aged 18 years or
younger. In the 2017/18 financial year, the child-support grant amounted to R380 per month and reached
12 269 084 children. The means test stipulated that single and married caregivers must have earned less
than R45 600 and R91 200 per annum, respectively, to have been eligible for child-support grants.
Care-dependency grants are paid to the parents or caregivers of children between the ages of one and 18
years who suffer from severe physical and mental disability and are in permanent home care. (Disabled
persons between the ages of eighteen and the retirement age receive state disability grants, while those over
the retirement age are eligible for old-age pensions). The parents or caregivers of 147 467 care-dependent
children received such grants in the 2017/18 fiscal year. At the time, the value of the grant was R1 600 per
month. The income thresholds that determined eligibility for the grant were R192 200 per annum for single
and R384 000 per annum for married parents or caregivers.
Children deemed by the courts to be in need of care are placed in the custody of foster parents. The aim
of foster-care grants is to reimburse these parents for the cost of caring for children who are not their own.
Hence, the grants are not means-tested and fall away if the foster parents formally adopt the children. In the
2017/18 fiscal year, SASSA disbursed 416 016 foster-care grants of R920 per month.
9.5.1.2 Working age
The Unemployment Insurance Fund (UIF), which is administered by the Department of Labour, provides
unemployment benefits to qualifying workers. Employees and employers each contribute 1% of employees’
earnings up to a maximum of R124,78 per month to the UIF and the proceeds are used to pay benefits to
contributors or their dependents in instances of unemployment, illness, death, maternity and adoption of a
child. Access to UIF benefits is limited to one day for every six completed working days, up to a maximum
of 365 days per period of four years. Furthermore, the benefits vary from 60% of the earnings of low-
income earners to 38% of the earnings of higher-income earners. The net asset value of the UIF has been
increasing steadily in recent years: in the 2017/18 financial year, for example, its total assets and total
liabilities were R160,1 billion and R13,4 billion, respectively (National Treasury, 2019a: 96). In that year,
the UIF collected contributions of R18,7 billion and earned R9,5 billion in investment revenue, while its
benefit payments totalled R9,2 billion (Unemployment Insurance Fund, 2018: 15).
It is well known that unemployment is exceptionally high in South Africa. In the four quarters that made
up the 2017/18 fiscal year, the narrowly defined numbers of unemployed persons of working age ranged
between 5,9 million and 6,2 million (Statistics South Africa, 2019b: Table 2).17 The reality that the UIF
received only 679 988 claims for unemployment benefits in that year (Unemployment Insurance Fund,
2018: 23) confirmed that the system plays an important but limited role as far as providing relief to
unemployed persons and their dependents are concerned. Two aspects of the rules of the UIF limit its
ability to assist the unemployed. The first is that many unemployed persons have never worked in the
formal sectors of the economy. Because such persons have never contributed to the UIF, they are not
eligible for unemployment benefits. In addition, many persons of working age remain unemployed for long
periods and exhaust their time-limited benefits before they find new jobs.
The Compensation Funds provide income benefits and medical care to workers who are injured on the
job, funding for the rehabilitation of disabled workers and survivor benefits to the families of victims of
work-related fatalities. The main Compensation Fund, which is administered by the Department of Labour,
covers workers in sectors other than mining and construction, while the Department of Health administers
the Mines and Works Compensation Fund, which provides benefits to victims of work-related lung diseases
in the mining sector. Private firms licensed by the Compensation Commissioner administer two other
funds: the Rand Mutual Association for workers in the mining industry and the Federated Employers’
Mutual Assurance for workers in the building industry. In 2017/18, the main Compensation Fund received
contributions to the tune of R7,3 billion and interest and dividend income of R4,2 billion, while it disbursed
benefits amounting to R3,6 billion (Compensation Fund, 2018: 10,77). The Fund then had assets of R67,3
billion and liabilities of R34,3 billion (National Treasury, 2019a: 96).
Disability grants are available to people who are disabled in circumstances other than road accidents and
work-related accidents. Disabled persons between the ages of eighteen and the retirement age who do not
receive other state grants and who are not cared for in state institutions are eligible for such grants
(disability grants are converted to old-age pensions when recipients reach the retirement age). Strict
medical criteria determine eligibility: the disability should be permanent and sufficiently severe to prevent
the affected person from working. Hence, the purpose of the grant is to compensate disabled persons for
loss of income. In the 2017/18 fiscal year, the disability grant amounted to R1 600 per month. SASSA
disbursed such grants to 1 061 866 persons with disabilities. The means test stated that eligibility was
restricted to single persons whose annual incomes and assets did not exceed R73 800 and R1 056 000,
respectively, and married persons whose incomes and assets did not exceed R147 600 and R2 112 000,
respectively. Persons with disabilities who passed the means test did not necessarily receive the full grant
amount of R1 600 per month, though. Disability grants were paid on a sliding scale: the more income from
other sources disabled persons had, the smaller the grants they received.
9.5.1.3 Old age

South Africa has a sophisticated retirement fund market that provides coverage to some 60% of employees
in the formal sectors of the economy.18 This coverage rate as well as the ratio of pension fund assets to
GDP are comparatively high by international standards. This shows the extent to which membership of an
occupational fund is accepted as an obligatory condition of employment despite the quasi-voluntary nature
of the system.19
Coverage rates vary markedly across income categories, though: while most middle- and high-income
earners are well covered – partly because generous income tax incentives exist for retirement saving –
many lower-income earners do not belong to retirement, pension or provident funds. Moreover, the
retirement incomes of large numbers of pension and provident fund members are inadequate: only some
10% of retired South Africans can maintain the levels of consumption they enjoyed while they were
working. Various factors contribute to this state of affairs, including the low earnings of many workers, low
preservation rates (many employees withdraw all their retirement savings when they change jobs) and the
eroding effects on benefits of the high fees structure of the South African retirement industry. Hence,
lower-income South Africans (including many formal sector workers) depend on social pensions in old age.
Persons aged 60 and above who pass the means test receive old age pensions. In the 2017/18 fiscal year,
the old-age pension (which is also known as the grant for older persons) amounted to R1 600 per month for
elderly persons between the ages of 60 and 75 and to R1 620 per month for those above the age of 75. In
that year, SASSA disbursed 3 423 337 old age pensions. The means test for single persons limited
eligibility to those whose incomes and assets did not exceed R73 800 and R1 056 000, respectively, and
married persons whose incomes and assets did not exceed R147 600 and R2 112 000, respectively. As was
the case with disability grants, old age pensions were paid on a sliding scale: elderly persons with more
income from other sources received smaller grants than those who did not.
South Africans who fought in the Second World War or the Korean War are eligible for war veteran’s
grants. In 2017/18, SASSA disbursed 134 such grants, which amounted to R1 620 per month. The war
veteran’s grant had the same means test and sliding scale payment system as the old-age pension.
9.5.2 Scope and adequacy

On balance, South Africa has a relatively advanced social security system for a middle-income country.
When assessing the scope of the income security components of this system, it should be kept in mind that
international comparisons of social security expenditures underestimate its size. As was pointed out earlier,
many countries levy payroll taxes on employers and employees to finance social insurance benefits. Such
taxes and benefits are reflected in the social security components of governments’ accounts. In South
Africa, the occupational insurance contributions of private-sector employers and employees do not flow
through the coffers of the state; hence, neither these contributions nor the benefits they finance show up in
the accounts of the public sector.
In 2017, the South African retirement fund industry consisted of 5 158 funds with 16 945 651 members
and assets of R4,3 trillion (Financial Services Board, 2018: 17, 18).20 In that year, it mobilised R238,5
billion in contributions and disbursed benefits amounting to R314,6 billion to its members (Financial
Services Board, 2018: 20–21). By comparison, the South African government expended only R150,3
billion on social grants in the 2017/18 fiscal year. As was pointed out in Section 9.5.1, however, the size
and sophistication of the industry belies the reality that many South Africans lack adequate retirement
provision. Hence, National Treasury has embarked upon a wide-ranging retirement reform process. The
goals of this initiative are to raise the level of savings in South Africa (including savings for retirement),
increase transparency in the retirement savings industry and improve the overall efficiency of the retirement
system. To ensure that the intended reforms achieve these goals, National Treasury has been engaging with
various stakeholders and has undertaken research on aspects of the retirement system in South Africa.
Table 9.1 Numbers of social grants (1996/97–2017/18)

Sources: South African Social Security Agency (2009: 20); South African Social Security Agency (2018: 21).
Many of the intended reforms will affect only the regulation of the private retirement insurance industry.
Some of these reforms, however, are likely to have direct or indirect implications for social pensions and,
hence, the public finances more generally. One of the major proposals has been to introduce mandation or
auto-enrolment. The intention of this proposal has been to make retirement provision mandatory – that is, to
convert the occupational insurance system to a social insurance system – though there are still questions
about the implications of such a step for low-income and vulnerable workers. Measures to preserve the
retirement insurance benefits of workers when they change jobs are also under consideration.
The social assistance component of the South African social security system is particularly large by
international standards. Table 9.1 shows that the number of social grants disbursed by SASSA increased
from 2 408 742 in 1997 to 17 509 995 in 2018. Almost one-third of the South African population now
receive a social assistance grant, which is a remarkably high figure for a middle-income country. Although
all of the grant types except the war veteran’s grant experienced significant growth in numbers of recipients
during the past two decades, the major driver of growth in the system as a whole has been the introduction
and subsequent expansion of the coverage of the child-support grant.21 Fully 70% of all grants disbursed in
2017/18 were child-support grants, while 19,6% were old-age pensions and 6,0% disability grants. Because
it is the smallest in money terms, however, the child-support grant does not dominate government spending
on social assistance programmes. In 2017/18, for example, 42,7% (R64,1 billion) of social assistance
spending took the form of old-age pensions, 37,1% (R55,8 billion) of child-support grants, and 13,9%
(R20,9 billion) of disability grants (National Treasury, 2019b: 351).
Government expenditure on social grants increased in nominal terms from R16,0 billion in 1997/98 to
the already mentioned figure of R150,3 billion in 2017/18. Figure 9.5 shows that such expenditure
increased markedly as percentages of total general government spending and of GDP from 2000 to 2005 –
largely because of the expansion of the coverage of the child-support grant – but stabilised thereafter. In
2017/18, spending on grants amounted to 8,2% of general government expenditure and 3,2% of GDP. The
social grant system should remain financially feasible if the number of grants grows in line with the
population (which implies that new grants programmes should not be introduced and that the scope of
existing ones should not be expanded) and the rand values of the various grants remain constant in real
terms.
Historical factors explain the evolution as well as the scope of the South African social security system.
The initial spur for the creation of this system was the desire to create an embryonic welfare state for whites
during the apartheid period. Following a pattern common to modern economies, the authorities first
introduced social insurance schemes and established regulatory frameworks for occupational insurance.
Means-tested social assistance for the poor and vulnerable (for example, the elderly and the disabled)
complemented these schemes. Social assistance benefits were eventually extended to other population
groups, albeit initially at much lower values. The government adopted the general principle of moving
towards parity in social spending programmes in the late 1970s, and social grants levels reached equality
even before the political transition from apartheid.
This process gave South Africa a relatively advanced social security system for a semi-industrialised
country, but also tied its scope to the needs of apartheid-era whites. Preferential access to education and job
reservation measures meant that most whites had employment security. Hence, they were adequately
protected by a system that combined occupational insurance with targeted social assistance programmes
and insurance against short spells of unemployment. Even in the apartheid era, however, this system did not
meet the needs of the other South African population groups. For one thing, many members of these groups
lacked access to occupational insurance. In addition, these groups generally were more exposed to
unemployment than whites were. The inadequacy of the unemployment insurance component of the income
protection system was severely exacerbated by the sharp increase in structural unemployment from the
mid-1970s onwards.
Van der Berg (1997) used needs and coverage by existing programmes as criteria to judge the adequacy
of the South African income protection system for four income classes. The affluent (largely the richest
quintile of the population in per capita income terms) generally have high levels of education that provide
relative job security. Members of this income class usually have occupational and private retirement
insurance, as well as cover against cyclical unemployment through the UIF system. Members of the stable
urban working class (quintile 4 of the population in per capita income terms) also have relatively high
levels of education and skills. They rely more on occupational insurance than on social assistance transfers,
although some receive old-age pensions after retiring. Their main income protection concern is the risk of
relatively long unemployment spells. Persons in the insecure formal sector (quintile 3 of the population in
terms of per capita incomes) have relatively low levels of education and limited skills. Some members of
this income class experience upward social mobility, but face significant risks of losing their jobs. Hence,
they are inadequately protected against unemployment. In addition, limited access to occupational
insurance leaves them reliant on social assistance benefits. Members of the fourth group, the outsiders
(quintiles 1 and 2 of the population in terms of per capita incomes), generally have low levels of education
and skills, and high dependency burdens (in other words, relatively large numbers of non-working
dependents). Unemployment is rife among members of this group. Furthermore, workers in these quintiles
often have insecure jobs that pay low wages. Elements of the social assistance system (such as old-age
pensions and child-support grants) are crucial sources of income for these workers. Viewed from the
perspective of the outsiders, however, the absence of a separate grant for the unemployed is a serious gap in
the social assistance system.
Figure 9.5 Government spending on social grants in South Africa (1997/98–2017/18)

In summary, the South African social security system contains large gaps despite its unusual breadth
compared to the social security systems of other developing countries. Severe structural unemployment
limits the adequacy of the country’s social assistance programmes and its social security system as a whole.
Unemployment not only limits individuals’ access to occupational insurance schemes, but also exacerbates
the unmet social security needs of poor households.
Table 9.2 Income sources of five types of South African households (2008–2017)
Source: Zizzamia, Schotte and Leibbrandt (2019: 25).
The effectiveness of South Africa’s social assistance

9.5.3
programmes
This subsection focuses on three aspects of the effectiveness of South Africa’s social assistance
programmes: the effects of these programmes on the welfare of poor households, the labour market, and
population growth.
9.5.3.1 Social grants and the welfare of poor households

Social grants have become an increasingly important source of household income in South Africa. One of
the many surveys that have confirmed this has been Statistics South Africa’s annual General Household
Survey: the portion of surveyed households that reported income from one or more grants increased from
27,5% in 2002 to 44,6% in 2017 (Statistics South Africa, 2002b: 67; 2017: 170). In fact, 20,1% of
households reported that grants were their main sources of income in 2017, compared to 18,1% in 2002
(Statistics South Africa 2002b: 65; 2017: 54). Another survey, the National Income Dynamics Study
(NIDS), has shown that grant income is particularly important for poorer households. This is evident from
Table 9.2, which is based on one of the findings of a study that pooled all the data from the first five waves
of NIDS.22 The table shows the income sources of five types of households in South Africa: the chronic
poor, the transient poor, the vulnerable, the middle class and the elite. The dominant income sources of the
financially secure middle class and elite households were salaries and other forms of labour-related
remuneration.
Elite households also obtain considerable income from their investments. By contrast, vulnerable and
poor households obtain significantly smaller fractions of their incomes from paid employment. These
households rely more heavily on social grants and, to a much lesser extent, on remittances from other
households. Grants constituted 50,2% of the incomes of chronically poor households, and labour income
only 41,0%.
The fiscal incidence study for 2010/11 discussed in Section 8.4 provided evidence of the extent to which
social grants augment the incomes of poor households in South Africa (cf. Table 9.3).23 It also made it
possible to draw preliminary conclusions about the effects of the grants on poverty and income inequality.
Table 9.3 Average per capita incomes by market income deciles in South Africa (2010/11)
Note: Section 8.4 defined the concepts ‘net market income’ and ‘disposable income’. The disposable income figures
exclude the value of free basic services (water, electricity, refuse removal and sanitation).
Sources: Inchauste et al. (2015: 30).
It is clear that South Africa’s social grants are well targeted at poor households: in 2010/11, the value of
cash transfers decreased from an average of R2 163 in the poorest decile and R2 262 in the second decile to
only R283 in the richest decile. In the poorest and second deciles, the respective average values of the cash
transfers received by each person was almost eleven times and slightly more than three times the average
net market incomes. On average, the value of such transfers also exceeded the net market income of
persons in the third decile, and amounted to 70% of the average net market income of persons in the fourth
decile and 35% of the average net market income of persons in the fifth decile. These figures show that
social grants are vital mechanisms for augmenting the incomes of poor households in South Africa and for
protecting them against negative shocks to their other income sources.
Several studies have confirmed that the grants markedly reduce poverty and income inequality. The
World Bank (2018a: 72–73), for example, estimated that social assistance transfers reduced the poverty rate
by 8%, the poverty gap by 32%, and the Gini coefficient by 10,5% in 2014/15.24 These were large
reductions compared to those achieved by the social assistance programmes of other countries. Exercises of
this nature compare the actual incidence of poverty and income inequality to the incidence that would have
been obtained if social assistance programmes had not existed. The results are indicative only, because they
are sensitive to the choice of a poverty line and rest on the assumption that the existence or non-existence of
social assistance programmes does not influence aspects of the behaviour of beneficiaries, such as their
labour supply and household formation decisions. It should also be noted that the last two columns of Table
9.3 confirm an important conclusion in Section 8.4: the gaps between the incomes of rich and poor South
Africans remain extremely large even after the moderating effects of social grants have been taken into
account.
Providing well-targeted cash transfers to the poor is at best a necessary condition for reducing poverty.
The actual impact of these transfers depends crucially on how poor people use the money. In this regard,
Section 9.3 identified two threats to the poverty-mitigating potential of cash transfers: beneficiaries may
squander the money on luxuries and so-called sin goods, or use all of it for livelihood protection purposes
that do not generate sustainable improvements in living standards. South Africa’s social grants programmes
are currently not structured as livelihood-promoting interventions, as the intended beneficiaries (children,
the disabled and the elderly) are not economically active persons. However, the grants could contribute to
the future productivity of children in poor households if the income is invested in their sustenance and
education. Several studies have explored the impact of grant income on the spending patterns of recipient
households in South Africa, with particular emphasis on the nutrition and school attendance of children.
Many households pool income from grants and other sources (e.g. remittances and labour market
activity) to finance consumption spending. Hence, it is often difficult to establish which goods and services
households buy with grant income. No evidence of large-scale squandering of grant money has emerged,
however; studies have found that households’ use of grant money does not differ greatly from their use of
other incomes. Hence, social grants mainly boost the food spending of beneficiaries (Van der Berg &
Siebrits, 2010: 22). Research has highlighted the nutritional benefits to children of increases in food
spending associated with receipt of child-support grants and social pensions (cf. Coetzee, 2013; Woolard &
Leibbrandt, 2010: 19–23). Studies using height-for-age ratios as indicators of nutritional inputs in early
childhood found that child-support grants improved the nutritional inputs of children in KwaZulu-Natal.
Furthermore, each grant received by a household markedly reduces the probability that any child in that
household goes hungry. With regard to old-age pensions, it appears that the gender of the recipient
influences the nutrition and health-status effects of social grants. For example, the weight-for-height ratios
of girls living in households with female pension recipients increased after the large increases in social
pensions during the late 1980s and early 1990s, while no increases were discernible for boys or girls living
in households with male pension recipients.
Evidence also suggests that income from grants encourages school attendance among recipients of child-
support grants and children who live with recipients of old-age pensions. However, these positive effects
were small owing to the already high school enrolment and attendance rates in South Africa. This also
suggests that the benefits of adding school attendance conditions to the child-support grant are likely to be
small (cf. Leibbrandt & Woolard, 2010: 26).
9.5.3.2 Labour market effects of social grants

As was indicated earlier, the vehicle for the provision of unemployment benefits to able-bodied South
Africans is the Unemployment Insurance Fund, which is a contribution-based social insurance institution.
The only members of the working-age population who qualify for social grants are persons with disabilities
who also pass the means test. This does not mean that the South African social assistance system does not
affect labour-market participation. However, such labour market effects of social grants do not arise mainly
because of the mechanism emphasised in Section 9.4, namely distortion of the relative prices of work and
leisure. In fact, survey responses indicate that poor South Africans generally prefer wage income to the
currently available grants (cf. Van der Berg & Siebrits, 2010: 23). Instead, the grant system seems to
influence the supply of labour through direct and induced effects on retirement decisions, household
formation and job search activities.
Direct effects have to do with the incentives faced by the actual recipients of grants. The means tests that
determine eligibility for the old-age pension and the disability grant have income thresholds that have
‘drop-off’ effects such as those discussed in Section 9.4; furthermore, the values of the grants disbursed to
eligible elderly and disabled persons are reduced on a sliding-scale basis in accordance with their incomes
from other sources. Empirical studies have confirmed that these characteristics reduce the work incentives
of disabled and elderly persons (Ranchhod, 2006; Mutasa, 2010). Such disincentive effects are worsened by
the very high unemployment rate in South Africa and by other labour-market disadvantages confronting
elderly and disabled South Africans, many of whom have limited skills and reside in rural areas where job
opportunities are scarce. An additional factor that affects people with disabilities is that the available job
opportunities tend to be temporary and badly paid. The resulting small differential between the disability
grant and available market wage means that there is little incentive for many disabled persons to take up
paid work.
Empirical studies have also explored the indirect or induced labour-market effects of elements of the
South African social assistance system on persons other than the actual recipients. The social pension has
become a major source of support for unemployed South Africans of working age, especially in rural areas.
Unemployed youths and younger adults often delay forming new households, or return to their parents or
relatives to share in the pension income of the elderly. This is an example of interaction between public and
private income security systems (cf. Section 9.1). This attachment to households with pension recipients
apparently affects labour-market participation in two ways (cf. Leibbrandt, Lilenstein, Shenker & Woolard,
2013: 8–10). Some individuals stop looking for work when they join these households, often because they
are located in rural areas where job opportunities are scarce. On the other hand, there is evidence that
access to pension income may stimulate labour-market participation by enabling some household members
to search for jobs away from home. Positive effects of this nature appear to be particularly strong for
women.
The available evidence indicates that receipt of child-support grants has boosted caregivers’ labour-force
participation, but has not affected their search behaviour or actual employment (Williams, 2007). This is
not unexpected, as the small value of the child-support grant makes major labour-supply effects unlikely.
9.5.3.3 Fertility
Public discourse has shown concern about the possibility that child-support grants have been encouraging
needy women (especially teenagers) to have more children. The incidence of teenage pregnancy did
increase markedly during the mid-1990s, but then levelled off around the turn of the millennium (cf. Van
der Berg & Siebrits, 2010: 25). Hence, it does not appear as if the introduction of the child-support grant in
1998 had a strong impact on teenage pregnancy. Moreover, the increase in teenage pregnancy was not
especially pronounced among those in the lower income groups who are eligible for means-tested child-
support grants.
Incentives matter at the margin; hence, the availability of the grant may have tilted the cost-benefit
calculations of some in favour of having more children. In all likelihood, however, a small grant of this
nature would not have been decisive in the reproductive decisions of many people. The introduction of the
child-support grant probably at most slightly slowed the ongoing decline in the fertility rate compared to
what would have happened otherwise.
Key concepts
• actuarially fair premium (page 162)
• adverse selection (page 163)
• asymmetric information (page 163)
• conditional cash transfer programmes (page 169)
• consumption smoothing (page 162)
• diminishing marginal utility (page 162)
• full insurance (page 165)
• informal (traditional or indigenous) income security systems (page 161)
• livelihood promotion effects (page 166)
• livelihood protection effects (page 166)
• moral hazard (page 164)
• occupational insurance (page 161)
• social assistance programmes (page 161)
• social insurance programmes (page 161)
• social security (page 160)
• universal income grant (page 173)
SUMMARY
• Social security systems consist of programmes that provide protection against various contingencies,
including income losses causes by unemployment, disability, illness, work-related injuries and old age.
Such systems consist of social insurance programmes funded from mandatory contributions by workers
and employers and social assistance programmes funded from general tax revenues. Social insurance
programmes are usually complemented by private income security mechanisms such as occupational
insurance and informal income security schemes.
• Insurance-based income protection systems enable consumption smoothing. Efficiency- and equity-related
market failures in private insurance markets provide the economic rationale for government
intervention in the form of social insurance systems. The efficiency-related market failures have to do
with problems of hidden characteristics (adverse selection) and hidden actions (moral hazard). Well-
functioning social insurance schemes can overcome some, albeit not all, such effects of information
asymmetries in private insurance markets. Equity considerations strengthen the efficiency-related case
for social insurance systems. The income redistribution effected by social insurance systems can be
justified on Pareto grounds.
• The traditional economic justification for social assistance programmes based on livelihood protection
effects (poorer individuals’ ability to maintain minimum standards of living) are now complemented by
livelihood promotion effects (sustainable poverty reduction via improvements in living standards over
time).
• The justification for using cash transfer programmes as income protection mechanisms rests on the utility
benefits to recipients, the lack of compelling evidence of large-scale squandering of cash transfers, and
the limited ability of in-kind programmes to prevent misuse of social assistance benefits. Although
powerful, these considerations are not necessarily decisive: valid targeting, political economy and
externality-based arguments exist for in-kind transfer programmes.
• Conditional cash transfer schemes provide cash transfers to households that meet certain requirements.
The aims of such programmes are to combat current poverty (by providing income support that enables
consumption smoothing) and future poverty (by encouraging human capital accumulation to break
inter-generational poverty cycles). Efficiency- and equity-related market failures (such as externalities
and targeting considerations) justify the use of conditions to change the behaviour of recipients.
Empirical studies of conditional cash transfer programmes have found positive effects on household
consumption, reductions in child labour and, in some cases, increases in saving and investment.
Conditions also boost school enrolment and the use of health facilities, but their effects on education
and health outcomes depend on the quality of the services provided by governments.
• Income protection systems have various benefits, but many also create disincentives or perverse
incentives. Income transfers financed from general tax revenues, for example, may create a disincentive
to work. In the same way, means tests that base eligibility for and the value of old-age pension on non-
pension incomes weaken persons’ incentives to save for retirement during their working lives. Such
means tests also discourage them from working after they reach the legal retirement age. While some of
the disincentive effects of income protection programmes are inherent to such schemes, others are
preventable effects of design errors.
• South Africa has a well-developed income security system that consists of a few social insurance schemes
and an unusually large suite of social assistance programmes. Almost one-third of the South African
population now receive a social assistance grant. Despite its unusual breadth compared to the social
security systems of other developing countries, the South African social security system contains major
gaps: severe structural unemployment limits the adequacy of the country’s social assistance
programmes and its social security system as a whole. Unemployment limits access to occupational
insurance schemes and exacerbates the unmet social security needs of poor households.
• Empirical studies show that social assistance grants improve the welfare of poor households in South
Africa. Apart from markedly raising the incomes of such households, grants also seem to improve the
nutrition, health outcomes and school attendance of children. Direct effects have to do with the
incentives faced by the actual recipients of grants. Researchers have found that the means tests for and
sliding-scale values of the old-age pension and the disability grant reduce the work incentives of
disabled and elderly persons. Grants also have significant household formation effects. In a clear
example of interaction between public and private income security systems, the social pension has
become a major source of support for unemployed South Africans of working age, especially in rural
areas. Some working-age individuals stop looking for work when they join households to share in the
pension income of the elderly. In other cases, however, access to pension income seems to boost labour-
market participation by enabling some household members to search for jobs away from home.
a. Social insurance programmes are financed from payroll taxes.
b. Social assistance programmes are financed from mandatory contributions by workers and firms.
c. Occupational insurance are financed from general tax revenues.
d. Informal social security systems include transfers between and within households.
a. An actuarially fair insurance premium equals the potential size of the loss.
b. Adverse selection is also known as the problem of hidden characteristics.
c. Moral hazard arises after the signing of insurance contracts.
d. The income redistribution inherent to social insurance programmes can be justified on Pareto
efficiency grounds.
a. Livelihood protection effects have to do with consumption smoothing.
b. Price subsidies are examples of in-kind transfers.
c. The benefits of in-kind transfer programmes can be used to finance purchases of ‘sin goods’.
d. Conditions can improve the targeting of social assistance programmes.
9.4 Which of the following statements is not true?
a. South Africa’s Unemployment Insurance Fund is an example of an occupational insurance scheme.
b. Comparisons with industrial countries underestimate the size of South Africa’s social security
system.
c. The child-support grant is South Africa’s most expensive social assistance programme.
d. The means test for South Africa’s old age pension reduces elderly persons’ incentive to work.
9.1 Distinguish between social insurance programmes and social assistance programmes.
9.2 Discuss the economic rationale for conditional cash transfer programmes.
9.3 Explain why some types of means tests reduce the incentive to work.
ESSAY QUESTIONS
9.1 Outline the economic rationale for social insurance systems.
9.2 ‘Theoretical considerations and empirical evidence suggest that social assistance benefits should always
be provided in the form of goods and services.’ Do you agree with this statement? Explain your
answer.
9.3 Explain why income tax-financed cash transfer programmes can reduce the incentive to work.
9.4 Discuss the welfare and labour market effects of South Africa’s social assistance programmes.
1 As was explained in Section 8.3, however, means testing and other targeting mechanisms may restrict access to the benefits of
social assistance programmes.
2 Equation 9.1 ignores transaction costs (that is, the administrative costs and normal profits of the insurance company). Hence, a
more realistic representation of an actual insurance premium is ∏ = pL + T, in which all transaction costs are included in T.
3 Uncertainty about the effects that artificial intelligence technologies may have on many existing jobs is a contemporary example of
an information problem affecting both parties to insurance transactions (that is, workers and potential providers of
unemployment insurance). Such uncertainty complicates the estimation of unemployment probabilities by potential insurers as
well as the career prospects of prospective and existing workers.
4 To be sure, rational insured persons will not engage in such behaviour unless the perceived benefits exceed the perceived costs.
Some insured office workers may spend too much time at their desks and ignore the risk of back problems, and some
professional athletes may ignore the risk of injuries caused by overtraining. Insurance cover is unlikely to cause life-threatening
behaviour, though.
5 Section 9.5 shows that this is a significant problem in South Africa.
6 Section 9.5 summarises evidence from South African studies.
7 Das, Do and Özler (2005: 64–66, 69–71) discuss these considerations in more detail.
8 Bastagli, Hagen-Zanker, Harman, Barca, Sturge, Schmidt and Pellerano (2016) provide a comprehensive review of the effects of
conditional and unconditional cash transfer programmes.
9 The source of the information in this box is Evans, Hausladen, Kosec and Reese (2014: 1–8).
10 Non-wage income includes investment income (e.g. interest and dividend income) and private transfers (e.g. remittances and
gifts).
11 These sources would include salaries and wages, interest and dividend income, and annuities bought with accumulated savings.
12 Sliding-scale benefit values is a feature of many social assistance programmes, including the old-age pension and disability grant
programmes in South Africa (cf. Section 9.5.1.2. and Section 9.5.1.3). The purpose of restricting the amounts paid in this way is
to assist more poor persons with a given programme budget.
13 This effect of an income threshold is a well-known example of the incentives costs of targeting mechanisms (cf. Section 8.3.2).
14 Recall from Section 9.1 that informal income security systems, which are also known as traditional or indigenous income security
systems, consist of transfers between and among households.
15 In 2017/18, the monthly value of grant in aid was R380. It was provided to 192 091 persons.
16 This subsection reports features of the social grants system in the 2017/18 fiscal year. The rand values of the various grants are
from National Treasury (2018a: 62) and the means tests from the South African Social Security Agency (2017: 7). The South
African Social Security Agency (2018: 21) is the source of the numbers of and expenditures on the various grants. The Minister
of Finance announced in his Budget Speech on 20 February 2019 that the monthly values of the various grant will be as follows
from 1 April 2019: state old age grant – R1 780 (under 75 years of age) or R1 800 (over 75 years of age), war veteran’s grans –
R1 800, disability grant – R1 780, foster-care grant – R1 000, care-dependency grant – R1 780, and child-support grant – R425
(National Treasury, 2019a: 57).
17 For statistical purposes, only persons of working age who are actively seeking employment are classified as unemployed. In
reality, however, many unemployed persons in South Africa have given up trying to find jobs. A more complete estimate of the
extent of joblessness can be obtained by adding these so-called ‘discouraged work seekers’ to official unemployment numbers.
In the four quarters of the 2017/18 fiscal year, this broader measure of unemployment ranged from 8,4 million work seekers to
8,8 million (Statistics South Africa, 2019b: Table 2).
18 The following overview of retirement savings in South Africa draws heavily on National Treasury (2014b: 6–9).
19 Employers are not required by law to make retirement provision for their workers. If employers choose to set up retirement
schemes, however, employees must join as a condition of employment (National Treasury, 2014b: 6).
20 The membership figure is inflated by double counting, because some individuals belong to more than one fund.
21 Eligibility was limited to children younger than seven when the child-support grant was introduced in 1998. It was extended in
steps to children under the ages of nine (2003), eleven (2004), fourteen (2005), fifteen (2008) and eighteen (2012).
22 The aim of NIDS has been to track and improve understanding of trends in poverty in South Africa. To this end, it has been
surveying the same nationally representative sample of more than 28 000 individuals in 7 300 households every two years since
2008.
23 Whereas the information in Table 9.2 is for households, that in Table 9.3 is for individuals.
24 Section 8.1 defined poverty rates and Gini coefficients, while Section 8.3.1 defined poverty gaps. The effects estimated by the
World Bank were based on three poverty lines for 2015 determined by Statistics South Africa: a food poverty line of R441 per
person per month, a lower bound poverty line of R647 per person per month, and an upper bound poverty line of R992 per
person per month (World Bank, 2018a: 8–9).
Social services
Krige Siebrits
The Government Finance Statistics system of the International Monetary Fund, which is the best-known
system for classifying government expenditure, distinguishes five functional categories of social services.1
These are education; health; social protection; housing and community amenities; and recreation, culture
and religion.2 Section 8.2.2 pointed out that effective provision of social services raises the living standards
of beneficiaries and improves their ability to access income-generating opportunities. Hence, governments
rely heavily on social services to reduce poverty and disparities in the primary distributions of income
generated by market forces.
This chapter discusses public provision of education and healthcare services. These social services are
particularly important for economic development (cf. Todaro & Smith, 2015: 382). On the one hand,
education and healthcare services are vital inputs in the aggregate production functions of developing
economies – recall the discussion of the connection between social infrastructure and long-run economic
growth in Section 7.6. On the other hand, contemporary development economists emphasise that outcomes
of effective provision of social services, such as knowledge and long and healthy lives, are also ends or
objectives of economic development. Yet the link between the extent of government spending on education
and healthcare and developmental outcomes in these areas is often tenuous. Hence, this chapter emphasises
the importance of effectiveness in the delivery of social services.
The remainder of the chapter consists of five sections. Section 10.1 discusses the market failures that
justify government involvement in the provision of education and healthcare. The case for in-kind
subsidies, which are important policy instruments in the provision of social services, is outlined in Section
10.2. Section 10.3 discusses effectiveness in the provision of social services and introduces the notion of
the ‘service delivery chain’. The last two sections of the chapter discuss aspects of public provision of
social services in South Africa. Section 10.4 focuses on education and Section 10.5 on healthcare.
discuss the market failure-based arguments for government involvement in the provision of education
discuss the market failure-based arguments for government involvement in the provision of healthcare
explain the excess burden of a subsidy
show that an in-kind subsidy can be welfare-enhancing if the consumption of the good or service in question yields
positive externalities
explain the importance of the ‘service delivery chain’ in the provision of social services
discuss public provision of education in South Africa
discuss public provision of healthcare in South Africa.
10.1Arguments for government intervention in
education and healthcare
Section 3.5 categorised education and healthcare as mixed services. Mixed goods and services exhibit
characteristics of private and public goods and services, and can be supplied by the public sector or the
private sector. As was also pointed out in Section 3.5, this explains the co-existence of public and private
schools and hospitals in Southern African countries and further afield. The reality that private firms can
profitably supply education and healthcare services raises the question whether economic justification
exists for public provision or financing. Put differently: are education and healthcare markets prone to
market failures? This section shows that these markets are characterised by various market failures that
establish prima facie cases for government intervention.
10.1.1 Education
Externalities, information problems and capital market failures cause allocative inefficiency in education
markets. Equity considerations further strengthen the case for government intervention in such markets.
As was pointed out in Section 3.5, individuals are unlikely to take external benefits to other persons into
consideration when deciding how much they should spend on education services. These external benefits
include free dissemination of valuable information and the reduced pressure on government expenditure
caused by the decreases in birth rates and crime levels that usually accompany improvements in education
levels. Section 3.6.2 argued that failure to consider these benefits would cause market failure in the form of
underprovision and underpricing of education services. It also demonstrated how policymakers could use
Pigouvian subsidies to internalise such positive externalities and increase allocative efficiency.
Imperfect information also gives rise to allocative inefficiency in education markets. According to
human capital theory, spending on education and training by individuals represents investments in human
capital (i.e. characteristics that determine workers’ productivity such as knowledge and skills). In deciding
whether to make such investments, individuals and households have to estimate and compare private
benefits and costs. Although education brings social, psychological and other benefits as well, human
capital theory focuses on its financial benefits, that is, additional earnings flowing from access to higher-
paying jobs. Education also has two types of costs: direct costs such as fees, books, computers, and
accommodation and transport expenses; and indirect or opportunity costs in the form of earnings foregone
while studying. Figure 10.1 is a stylised representation of two possible outcomes of such cost-benefit
decisions.
Panel A (the figure on the left) shows the costs and earnings of persons who receive no schooling, start
working at the age of six and retire at 62. Such persons avoid the direct and opportunity costs of education
and have relatively long careers in paid employment. Yet their starting wages are likely to be relatively low
and their earnings grow relatively slowly because progression to higher-paying jobs often depends on
academic qualifications. The persons whose costs and benefits are depicted in Panel B (the figure on the
right) go to school at the age of six and enter into paid employment at the age of 22 after obtaining tertiary-
level academic qualifications. They incur the direct and indirect costs listed above while studying, and have
fewer years in paid employment than their counterparts who joined the labour force at younger ages.
However, they are rewarded with relatively higher starting wages and relatively steeper earnings growth.
Figure 10.1 The private costs and benefits of investing in education

Source: Adapted from Connolly and Munro (1999: 387).
The cost-benefit calculations that underpin choices among these and other education and career paths
are complex, and some young people, parents and guardians may lack the information needed for optimal
investments in education. This information problem is the basis of the merit good argument for government
intervention in education markets outlined in Section 3.5. In addition, economic and other factors may tilt
the incentives of some persons or households against human capital accumulation (recall the example in
Section 9.3.2 of parents who may gain more in the short run from using their children as workers than from
sending them to school). To counter the effects of such information problems and distorted incentives,
governments combine education subsidies with regulations that ban child labour and specify minimum
ages at which children may leave schools.
Because the costs of education and training must be defrayed before the monetary benefits are reaped,
households with limited savings have to borrow to finance human capital accumulation. Capital markets,
however, often fail to provide adequate education financing: unlike physical assets such as buildings and
land that can be repossessed and sold by banks, human capital cannot serve as collateral to secure loans.
Such barriers to human capital accumulation distort the allocation of resources and further bolster the case
for government intervention in education markets.
The equity argument for public provision or financing of education follows from the strong influence of
human capital on labour market earnings and the distribution of personal incomes. In all countries, labour
market earnings are much bigger portions of personal incomes than transfers from governments are, and,
hence, more important determinants of income inequality. Leibbrandt, Woolard, Finn and Argent (2010:
23), for example, found that inequality in wage incomes explained between 85% and 90% of the total
inequality in household incomes in South Africa in 1993, 2000 and 2008. Hence, attempts to improve
highly skewed distributions of income are doomed to fail unless they empower the poor to obtain jobs and
earn higher salaries and wages. Education systems can be powerful mechanisms for enabling poor persons
to obtain well-paying jobs. If high direct and indirect costs prevent poor people from accessing education
and training programmes, however, education systems perpetuate, instead of reduce, poverty and
inequality. The capital market failures referred to earlier tend to exacerbate this problem, because richer
persons and households are more likely than poorer ones to have assets that can be offered as collateral to
obtain bank loans. These considerations imply that subsidies and other measures that enable poor persons
to accumulate human capital should be cornerstones of governments’ efforts to reduce income inequality.
10.1.2 Healthcare
Externalities and imperfect information cause allocative inefficiency in unregulated healthcare markets.
Moreover, richer persons are served more effectively by such markets than poorer ones are. These market
failures are the elements of a powerful case for government intervention in healthcare markets.
Healthcare services that prevent the emergence or spreading of contagious diseases confer positive
external benefits to parties other than those receiving treatment. This implies that the marginal social
benefits of such services exceed their marginal private benefits. Section 3.6.2 explained that unregulated
markets underprovide and underprice goods and services that exhibit positive consumption externalities
and illustrated the efficiency-enhancing potential of Pigouvian subsidies. Section 10.2 returns to the case
for and policy implications of such subsidies in healthcare markets.
Specific features of healthcare services make unregulated healthcare markets prone to severe
information problems. Healthcare per se has little value for consumers, who spend money on such services
to obtain something else that matters to them, namely good health. Put differently, healthcare services are
inputs into good health. The relationship between good health and spending on healthcare services is
complex, though, because health outcomes also depend on other inputs such as nutrition, lifestyle choices
and the physical and human environments. Individuals typically have limited information about the specific
factors that determine their health outcomes, the efficacy of treatments, and the knowledge and skills of
providers of healthcare services. Hence, governments regulate the training, accreditation and activities of
medical practitioners to protect consumers of healthcare services.
The nature of the demand for healthcare services also causes information problems. Unpredictable
illnesses and injuries are major sources of the demand for such services, and the costs of treating many
health problems can be very high. Recall from Section 9.2.1 that insurance products enable individuals to
maintain their levels of consumption when they are affected by unexpected income losses. Large medical
bills caused by unexpected illnesses and injuries affect the finances of households in much the same way
that negative income shocks do. Private firms can and do offer healthcare expenditure insurance in the form
of medical aid schemes. However, markets for such insurance are prone to both forms of information-
related market failures discussed in Section 9.2.2, namely adverse selection and moral hazard.
Section 9.2.2 explained that adverse selection arises when persons whose exposure to certain risks
makes them particularly likely to seek insurance cover can hide their high-risk status from insurers. It also
pointed out that adverse selection causes allocative inefficiency: firms that cannot distinguish between
high-risk and low-risk clients charge everyone the same premium based on the average risk, and such
mispricing of insurance cover distorts the quantities purchased. In some circumstances – for example, when
low-risk individuals deem the premiums based on average risk excessive and do not buy cover – adverse
selection can make insurance provision impossible by preventing sufficient pooling of high and low risks.
Such inefficiency seems highly likely in markets providing healthcare expenditure insurance, because
persons who already face or are at risk of facing large medical expenses are more likely to seek cover than
those who do not, ceteris paribus. In reality, firms providing medical aid substantially reduce the
prevalence of adverse selection by subjecting prospective clients to various forms of screening such as
medical tests and scrutiny of personal and family health records. Screening enhances efficiency, because it
enables medical aid schemes to charge risk-related premiums. However, it also enables them to increase
their profits by limiting healthcare expenditure cover to low-risk individuals, either by charging high-risk
persons unaffordable premiums or by refusing to insure them. Such practices raise important equity
questions, especially if the poor are heavily affected by the risk factors that determine access to and the
price of medical aid. This would be the case, for example, if these risk factors were linked to inadequate
diets and poor living conditions.
Recall from Section 9.2.2 that moral hazard occurs when insured persons can raise the liabilities of the
insurer without the knowledge of the latter by increasing the size of the insured loss or the probability of its
occurrence. Behaviour with both types of effects causes allocative inefficiency, and actions that increase
the likelihood of the occurrence of the loss can even make insurance provision impossible.
Moral hazard is a serious problem in markets for healthcare expenditure insurance. Some fully insured
persons may well take less care to avoid lifestyle-related ailments (for example, those linked to smoking
and unhealthy eating habits) than they would have if they had to pay the full price of medical care. Such
behaviour is the equivalent of actions in other insurance markets that increase the probability of losses to
the insurer. The equivalent of actions that increase the size of the insured loss is also a major issue in
healthcare expenditure insurance markets. This is the so-called third-party payment problem: the reality
that a third party (the medical aid scheme) carries the costs strengthens the incentives of insured persons to
consume healthcare services and that of service providers to supply them. Figure 10.2 shows that the likely
outcome of such incentives is inefficiently large consumption and supply of healthcare services.
The downward-sloping demand curve Dm in Figure 10.2 depicts the marginal benefit of healthcare
services to consumers. In the same way, the upward-sloping supply curve Sm shows the marginal cost of
producing such services. In the absence of medical aid schemes providing healthcare expenditure
insurance, the market would be in equilibrium at a, where the price would be P0 and the quantity consumed
Q0. The total expenditure on healthcare services would be given by the rectangle P0aQ00 (that is, the
product of P0 and Q0).
A person with healthcare expenditure insurance pays premiums to a medical aid scheme, but is not
required to pay service providers in full when receiving treatment or buying medicines. This means that an
insured person does not pay the full marginal cost when using healthcare services. However, medical aid
schemes often require clients to make small payments known as co-payments to providers of medical
services.3 Figure 10.2 illustrates the third-party payment problem in the context of medical aid schemes
with co-payments. Hence, the introduction of medical aid reduces the out-of-pocket cost to consumers of
healthcare services from P0 to P1.4 While a markedly larger quantity of healthcare services is now
consumed – Q1 exceeds Q0 – out-of-pocket spending by consumers on such services is less than before (the
area P1bQ10 is smaller than the area P0aQ00). The reason for the drop in out-of-pocket spending by
consumers is that medical aid reduces the price they pay to providers of healthcare services.
Figure 10.2 The third-party payment problem in the market for healthcare expenditure insurance
Source: Adapted from Hyman (2010: 369).
The effects of the third-party payment problem are not necessarily limited to the demand side of the
market for healthcare services. Figure 10.2 shows that the supply side may be affected as well. If the
supply curve has the usual positive slope, the price of healthcare services has to increase to induce
providers of healthcare service to meet the increase in the quantities demanded by consumers. Thus, the
slope of the supply curve depicted in Figure 10.2 implies that a price of P2 is necessary to elicit the
provision of Q1 units of healthcare services. In this case, total expenditure on healthcare services increases
from P0aQ00 to P2cQ10. The portions of these payments made by consumers of healthcare services and
medical aid schemes are P1bQ10 and P2cbP1, respectively. Note that the marginal cost of providing
healthcare services exceeds their marginal benefits along the segment Q0Q1 on the horizontal axis. Hence,
the triangle abc represents the allocative inefficiency caused by the third-party payment problem.
Section 9.2.2 pointed out that social insurance schemes can overcome some adverse selection problems
in insurance markets, as well as their negative equity effects. In principle, government-run national health
insurance schemes with compulsory membership can yield similar risk-pooling benefits and achieve
equitable coverage of all income groups. The case for such schemes is bolstered further by the merit good
argument introduced in Section 3.5, which rests on externality considerations and the (paternalistic) belief
that some persons would not buy enough healthcare expenditure insurance to ensure access to adequate
medical care for themselves and their families.
National health insurance schemes are costly and administratively complex, however, and sufficient
financing sources and managerial skills are prerequisites for their viability and effective functioning. Most
developing countries lack the payroll tax bases and skills needed to operate such systems. In fact, there is
growing concern in several high-income countries with well-established systems of this nature about the
longer-term fiscal implications of rapid growth in healthcare spending.5 While population ageing and other
factors have also been at play, this development has confirmed an important conclusion in Section 9.2.2:
moral hazard may well be as common in social insurance schemes as in private insurance markets, because
organisations in the public sector are unlikely to be more successful than private firms are at overcoming
the underlying information-related market failures.
Supplier-induced demand – the tendency of service providers to encourage patients to buy more
healthcare services than they need – has been one of the information-related causes of the worldwide
growth in healthcare expenditure. As was pointed out earlier, third-party payment systems weaken the
incentives of healthcare service providers to economise on the use of resources. Such systems do not
encourage price competition; instead, they incentivise providers of healthcare services to compete on the
real or perceived quality of care. Such competition often revolves around investments in appealing facilities
and the latest diagnostic technologies, as well as cost-raising treatment strategies involving expensive tests,
procedures and medicines. Insured patients’ limited knowledge of health conditions and treatment options
as well as the reality that medical aid schemes foot their bills weaken their incentives to resist supplier-
induced demand.
Public healthcare systems that offer free care at the point of use and are funded from general tax
revenues – such as the British National Health Service – are alternatives to national health insurance
schemes. In principle, such systems can provide healthcare services to all income groups irrespective of
ability to pay. Fixed allocations from the national budget provide control over aggregate healthcare
expenditure, but the enforcement of budget constraints usually involves rationing in the form of waiting
periods for treatment. Like national health insurance schemes, such systems are very complex to run and
require considerable administrative capacity.
10.2 The case for in-kind subsidies

Recall from Section 8.2.2 that government expenditure programmes to change the secondary distribution of
income can take the form of cash transfers, in-kind transfers and the provision of social services. Many
governments levy only nominal fees for at least some education and healthcare services, or provide such
services free of charge. The term ‘in-kind subsidies’ is used to describe social service provision on such
terms. The question arises whether there is economic justification for such in-kind subsidies. One reason
why this is a pertinent question is that the costs of subsidies often exceed their benefits. In such cases,
subsidies give rise to economic inefficiency in the form of excess burdens. Figure 10.3 uses the concept of
consumer surplus to illustrate the excess burden of a subsidy.
Figure 10.3 depicts the market for Good X. The initial equilibrium is at E0, where the demand curve and
the supply curve intersect. The government now introduces a subsidy to reduce the price consumers pay for
Good X. We assume that the cost of producing the good is constant and that the full benefit of the subsidy
is passed on to consumers. The new equilibrium at E1 implies that the subsidy decreased the price from P0
to P1 and boosted the quantity demanded from Q0 to Q1. Recall that the demand curve is a marginal benefit
curve. It follows that the subsidy increased the consumer surplus (the difference between the benefit a
consumer derives from a good and service and the price he or she pays for it) from the area aP0E0 to the
area aP1E1. Thus, the area P0E0E1P1 depicts the total benefit of the subsidy to consumers. It has two
components: area P0E0cP1 represents the benefit from paying a lower price for the original quantity and
area E0E1c the benefit from the additional units of Good X purchased because the subsidy made it more
affordable.
It is important to ascertain the cost of achieving this increase in the consumer surplus. The budgetary
cost of the subsidy is its unit cost (the difference between P0 and P1) multiplied by the Q1 units consumed,
that is, the area P0bE1P1. Hence, the fiscal cost of the subsidy (area P0bE1P1) exceeds its benefit to
consumers (area P0E0E1P1) by the area E0bE1. This welfare loss, which is known as the deadweight loss or
excess burden of the subsidy, arises because in-kind subsidies restrict the choice set of consumers. It
follows that the above demonstration of the excess burdens of in-kind subsidies complements the choice-
based argument for cash transfers outlined in Section 9.3.1.
Figure 10.3 The excess burden of a subsidy
These arguments, however, do not mean that in-kind subsidies are never justifiable in economic terms.
Section 3.7.1 and Section 9.3.1 pointed out that a case can be made for subsidising goods or services that
exhibit positive externalities.6 In fact, Section 3.7.1 used education – one of the social services discussed in
this chapter – as an example to illustrate that subsidies can promote allocative efficiency by bringing the
marginal private benefits of consumption in line with the marginal social benefits. Healthcare services also
exhibit external effects. Tuberculosis (TB) treatment is a good example. Individuals with TB who fail to
seek treatment or fail to complete the required treatment regime do not only jeopardise their own health;
the contagious nature of the disease means that such behaviour also poses health risks for others. Moreover,
failure to comply fully with the suggested treatment regime has been linked to multidrug resistant TB. This
represents another public health externality, because treatment of this type of TB is more expensive than
that of other strains.
The implication of the positive external benefits is that the social benefits of TB treatment compliance
exceed the private benefits. Figure 10.4 illustrates the potential benefits of subsidising such treatment. The
figure shows the marginal private benefit (MPB) of treatment to a consumer, the marginal external benefit
(MEB) and the marginal social benefit (MSB) to the community as a whole. Note that the MSB curve is
obtained by vertical summation of the MPB curve and the MEB curve. The marginal cost (MC) is assumed
constant and equal to the competitive market price (P0).
From a social point of view, optimal consumption of TB treatment by the individual consumer is Q1
(this is the level of consumption associated with E1, where the marginal social benefit MSB equals the
marginal cost MC). The individual will not consider the external benefits of his or her consumption of TB
treatment, though. Instead, he or she will consume at E0, where the marginal private benefit MPB equals
the marginal cost MC. The resulting quantity consumed (Q0) will be sub-optimal. However, an in-kind
subsidy that reduces the cost to the consumer from P0 to P1 would encourage socially optimal consumption.
The shaded area P0E1E2P1 indicates the size of the required subsidy. In sum: in the presence of a good- or
service-specific externality, a subsidy for that good or service could induce socially optimal consumption
via its effect on the price.
Would an unconditional cash transfer enhance allocative efficiency to the same extent as an in-kind
subsidy would? One reason why an unconditional cash transfer might not do so is that its consumption-
boosting effects would not necessarily be restricted to goods and services valued by society. Recall, for
example, that South African households’ use of grant money does not differ markedly from their use of
other incomes (cf. Section 9.5.3.1). This implies that the introduction of an unconditional cash transfer
aimed at improving the health of members of such households would increase their expenditure on
healthcare. Yet households would only use a portion of the cash transfer for this purpose, and would spend
more on the other goods and services in their consumption baskets as well. These goods and services can
range from necessities such as food and transport to ‘sin goods’ such as alcoholic beverages and tobacco
products. Hence, an in-kind subsidy is likely to give rise to a larger increase in the consumption of a good
or service with positive externalities than an unconditional cash transfer with the same monetary value
would.
Figure 10.4 Subsidisation and the external benefits of tuberculosis treatment
10.3 Social service delivery

Section 7.2.3 pointed out that government expenditure on education and healthcare is relatively high in
South Africa by international standards, and fiscal incidence studies (e.g. Van der Berg & Moses, 2012;
Inchauste et al., 2015) have found that these spending programmes are well targeted at the poor.7 It is well
established, however, that the returns to South Africa’s investments in the public education and healthcare
systems have been disappointing. As Van der Berg and Moses (2012: 137) put it: ‘Social spending has
often not produced the desired social outcomes’. This section uses the notion of the ‘service delivery chain’
to identify some of the factors that influence social service delivery in South Africa and other Southern
African countries. While these ideas are used in this chapter to comment on the effectiveness of public
education and healthcare systems, they can be applied to other social spending programmes as well.
Service delivery has short-term and long-term effects on citizens’ lives. Access to and the quality of
services such as education, healthcare, housing and sanitation are important aspects of persons’ quality of
life. Moreover, it also creates future possibilities and opportunities, primarily but not exclusively via its
influence on the labour market prospects of individuals.
The World Bank (2004c) described the process of service delivery as a chain consisting of relationships
between three sets of role players: policymakers, service providers (for example, teachers and doctors), and
citizens. Problems affecting any of the links of such chains undermine service delivery. In primary
schooling for example, outcomes would be compromised if policymakers fail to provide teachers with
sufficient resources, if high rates of teacher absenteeism prevent full coverage of the curriculum in schools,
or if learners do not use the textbooks provided to them. The various reasons why links in service delivery
chains break down range from corruption to weak accountability mechanisms and weaknesses in the
capacities to budget, disburse allocated funds, and monitor programme implementation. Hence, it should
not be assumed that more government spending on social services would always lead to better social
outcomes. Pay hikes for teachers and medical staff are cases in point: such injections of money into the
education and healthcare sectors do not automatically lead to better service delivery and improvements in
outcomes.
The distinction between outputs and outcomes is also important. Outputs are deliverables that are
usually easy to observe, count and verify (for example, the number of children enrolled in school or the
proportion of a population that has access to potable water). Such deliverables tend to intermediary aims
that are necessary but not sufficient conditions for meeting the ultimate goals of programmes. Outcomes,
on the other hand, are deliverables that are more difficult to observe, count and verify, but are linked to the
ultimate goals of programmes. Examples of outcomes are whether children enrolled in school are learning
at the expected pace and according to set standards or whether the water provided to communities is
actually clean and safe. The distinction between outputs and outcomes does not matter much when it comes
to services that are simple to administer, such as vaccinations or grants. In education and healthcare,
however, outputs often contribute very little to the effectiveness or success of programmes. In such cases,
assessments of effectiveness should focus almost entirely on outcomes.
Sections 10.4 and 10.5 discuss social service delivery issues in South Africa by outlining weak links in
the delivery chains of public education and healthcare services. These services are well worth focusing on,
because they absorb large portions of the national budget. Furthermore, the introduction to this chapter
emphasised their importance for economic development.
10.4 Service delivery in education in South Africa

Section 7.2.3 pointed out that education expenditure is the largest item in the functional classification of
government spending in South Africa,8 while Section 7.3 showed that the country’s education spending-to-
GDP ratio is high by international standards. As was mentioned in Section 10.3, however, the economic
returns to this large investment in public education are poor. The weak relationship between resources and
results in the South African education sector confirms the importance of effectiveness in the provision of
social services.
South Africa has a large and diversified public education system with four components: pre-primary
education (a reception year known as ‘Grade R’), basic education (primary and secondary schooling),
higher education (universities), and technical and vocational education and training provided by TVET
(technical and vocational education and training) colleges and SETAs (sectoral education and training
authorities). This section focuses on public basic education; as such, it does not discuss other components
of the public education system or the significant and growing private basic education sector.
10.4.1 Resources and outputs in the South African basic education

system
The South African education system was highly fragmented during the apartheid era, when segregated
facilities and administrative structures existed for each race group. In addition, the allocation of funding for
schools, teachers and learning materials was extremely inequitable. While facilities and structures serving
whites were well resourced, those of other race groups were severely underfunded. Such discrimination in
the allocation of resources contributed to large racial disparities in educational attainment (that is, years of
schooling completed) and outcomes.9
The transition to democracy in South Africa was accompanied by a fundamental restructuring of the
basic education sector: an integrated system administered by a national and nine provincial departments of
education replaced the fragmented apartheid structures. This process was accompanied by large shifts in
the allocation of resources. Within a short space of time, the government largely eliminated disparities in
public spending per learner between race groups and income groups by equalising learner–teacher ratios
and teacher pay scales, and by reducing allocations to schools that formerly served only white children
while increasing those to schools that formerly served only children of colour.10 It should be pointed out
that these reforms did not fully eliminate differences in resources among schools in richer and poorer areas.
The infrastructure (buildings and other facilities) of many schools remains inadequate, and schools in
richer communities that charge fees still have lower learner–teacher ratios because they employ and pay
additional teachers. Nonetheless, the post-apartheid shift in resources in basic education was a remarkable
achievement.
Apart from changing the distribution of resources among schools, the government markedly increased
the volume of resources set aside for basic education. This is evident from Figure 10.5, which depicts
general government expenditure on basic education and its two components (pre-primary and primary
education, and secondary education) in the fiscal years from 1994 to 2016. The figure contains real
amounts, that is, actual expenditure deflated with the consumer price index.
Expressed in 2016 prices, total general expenditure on basic education increased from R98,3 billion in
the 1996 fiscal year to R165,1 billion in the 2017 fiscal year, that is, at an average annual growth rate of
2,5% per annum. Growth in expenditure on pre-primary and primary education as well as secondary
education underpinned this trend (the average annual growth rates in expenditure on both components of
basic education were also 2,5%). It is clear from Figure 10.5 that basic education expenditure grew rapidly
from 2008 to 2013. From 2014 onwards, the deterioration in the overall fiscal situation forced the fiscal
authorities to limit the growth in most functional categories of expenditure. The restraining effect of this
development on basic education spending was compounded by the need to increase allocations to higher
education after the introduction of fee-free tertiary education at the beginning of 2018. It should be kept in
mind when interpreting these figures that the population of school-going age also grew markedly in this
period. In fact, Spaull (2019: 6) argued that spending per learner decreased in real terms from 2010 to
2017. Nevertheless, the combined effect of the resource allocation shift and the growth in government
expenditure on basic education was a significant increase in the resources available to schools serving
poorer learners in South Africa.
Figure 10.5 General government expenditure on basic education in South Africa in real terms, 1996–2017
Source: Calculated from South African Reserve Bank, Quarterly Bulletin (various issues). Pretoria: South African Reserve
Bank. [Online]. Available: https://www.resbank.co.za/Publications/QuarterlyBulletins/Pages/QuarterlyBulletins-
Home.aspx [Accessed 14 June 2019].
These shifts and increases in resources were accompanied by further improvements in access to
education, as indicated by enrolments and grade survival rates. For all practical purposes, South Africa now
has universal access to primary and lower secondary schooling. Household surveys show that 98,9% of
South African children aged between seven and fifteen years were attending some form of educational
institution in 2016 and that 66% of children in this age group were in schools that did not charge any fees
(Department of Basic Education, 2018: 6, 12). By international standards, the extent of access to primary
and secondary schooling in South Africa is above average, especially in the African context. However,
many learners drop out of school in Grades 10 and 11 before the external matric examination. Thus, only
85,1% of 16 to 18-year-olds were in school in 2016 (Department of Basic Education, 2018: 6). While this
figure exceeded the 82,6% recorded in 2002, South Africa’s rates of graduation from upper secondary
school continue to lag behind those of peer countries (Gustafsson, 2011: 2). This also explains why
comparatively few young people in South Africa reach and complete post-school education. Fewer than
10% of youths in South Africa attain fifteen years of education (completion of a three-year degree, for
example), compared with at least 15% in Columbia and Peru, and 24% in the Philippines and Egypt
(Gustafsson, 2011: 14).
10.4.2 Educational outcomes in South Africa

The question arises how educational outcomes changed amidst these improvements in the availability of
resources to schools as well as the outputs of the basic education sector.11 Unfortunately, outcomes have
remained disappointing. The performance of South African learners in cross-national assessments of
educational achievement has provided particularly compelling evidence of poor learning outcomes that lag
behind those of most developing countries (see Van der Berg, Burger, Burger, De Vos, Du Rand,
Gustafsson, Moses, Shepherd, Spaull, Taylor, Van Broekhuizen & Von Fintel, 2011: 2–3). In fact, the
results of such assessments have indicated that the performance of the country’s education sector lags
behind that of some markedly poorer African countries with smaller economies, lower government
expenditure on education per capita and more severe poverty burdens. Box 10.1 discusses the findings of
such cross-national assessments in more detail.
Box 10.1 What do South African learners know relative to learners from other countries?
Cross-national assessments, which consist of tests written by a representative sample of students in each country,
make it possible to compare the knowledge of South African learners with that of learners in other countries on the
continent and further afield. The three major cross-national assessments are the Progress in International Reading and
Literacy Study (PIRLS – Grade 4 and 5), the Trends in International Mathematics and Science Study (TIMSS –
Grade 8 and 9) and the Southern and Eastern Africa Consortium for Monitoring Educational Quality (SACMEQ –
Grade 6). This box summarises the performance of South African learners in each of them.
• PIRLS. The 49 countries that participated in the 2016 round of PIRLS included South Africa, several OECD
countries and other middle-income countries such as Azerbaijan, Bulgaria, Egypt, Georgia, Iran, Kazakhstan,
Morocco and the Russian Federation. The South African students fared worse than their peers from all the other
countries: fully 78% of them failed to achieve the Low International Benchmark that indicates minimal
competence in reading (Mullis, Martin, Foy & Hooper, 2017: 58). Trong (2010: 2) explained the practical value of
this benchmark: ‘Learners who were not able to demonstrate even the basic reading skills of the Low International
Benchmark by the fourth grade were considered at serious risk of not learning how to read.’ The portions of
learners from some other countries that failed to achieve the Low International Benchmark were as follows: Egypt
(69%), Morocco (64%), Iran (35%), Georgia (14%) and Bulgaria (5%). The governments of some countries with
significantly better results than those of South Africa spend markedly less per primary school learner. In Bulgaria,
for example, such spending amounted to US$1 363 per learner in 2017 in purchasing power parity terms, which
was 40% lower than South Africa’s spending level of US2 281 per learner.12
• SACMEQ. South Africa’s performance relative to poorer African countries has confirmed that the availability of
additional financial resources does not guarantee better outcomes. Van der Berg et al. (2011: 4) concluded after
studying the SACMEQ 2000 and SACMEQ 2007 data that ‘South Africa performed slightly below the average of
the other participating African countries in Grade 6 mathematics and reading, despite benefiting from better access
to resources, more qualified teachers and lower pupil-to-teacher ratios’. The relative performance of South African
in SAQMEC 2013 was somewhat better yet far from satisfactory. In that year, the average reading score of South
African learners (558) equalled the average of all the learners from the 14 participating countries, while the
average mathematics score of South African learners (587) only marginally exceeded the average of all
participating learners (584) (Portfolio Committee on Basic Education, 2016: 2). It is disconcerting, for example,
that South African Grade 6 learners performed significantly worse than their Kenyan peers, whose average reading
and mathematics scores were 601 and 651, respectively. This is in spite of the fact that in 2015, public current
expenditure per pupil in purchasing power parity terms was more than seven times higher in South Africa (US$2
271) than it was in Kenya (US$307).13
• TIMSS: South Africa participated in the TIMSS studies in 1995, 1999, 2003, 2011 and 2015. Hence, these studies of
competence in mathematics and science allow the most extensive comparison of the performance of South African
learners since the political transition.
The TIMSS studies showed that there was no improvement in Grade 8 mathematics or science achievement
between 1995 and 2003. Thus, it was decided that the international Grade 8 tests were too difficult for South
African Grade 8 students. Grade 8 and Grade 9 students wrote the Grade 8 test in 2003, but only Grade 9 students
wrote the Grade 8 test in 2011. A comparison of the performance of Grade 9 students in 2003 and 2015 shows that
there was an improvement in mathematics and science performance amounting to approximately two grade levels
of learning (Reddy, Visser, Winnaar, Arends, Juan, Prinsloo & Isdale, 2010: 6). When interpreting this trend, one
should keep in mind that South Africa started from an exceedingly low base in 2003 and that the level of
performance remains poor even after the improvement. Thirty-nine countries participated in TIMMS 2015. In that
year (that is, after the improvement), the average mathematics score of the participating South African learners was
the second lowest after that of Saudi Arabia, while none of the other countries had a lower science score (Reddy et
al., 2010: 3).
Although South Africa has achieved relatively high levels of educational attainment (including near-
universal access to primary and lower secondary schooling), the cross-national assessment results
summarised in Box 10.1 suggest that very little learning is taking place in as many as 80% of schools. The
roughly 20% of schools that perform well in such assessments are fee-paying and independent ones that
predominantly serve richer communities and households. Various surveys have also indicated that the
majority of South African learners perform poorly in key learning areas such as Reading, Mathematics and
Science; furthermore, the results of the Department of Education’s Systemic Evaluations have shown that
most children fail to achieve the standards required by the curriculum (Van der Berg et al., 2011: 2–3). In
sum, the large pro-poor shift of resources since the transition has been accompanied by improvements in
educational outputs, but similar improvements in educational outcomes have not been forthcoming.
10.4.3 Service delivery issues in basic education in South Africa

It is now widely accepted that the ability of a country to educate its youth cannot be measured by access to
schooling or enrolment rates alone, but rather by its ability to impart to students the skills, abilities,
knowledge, cultural understandings and values that are necessary to function as full members of their
society, their polity and their economy. This more appropriate definition of success suggests that the South
African basic education system performs extremely poorly, especially when one considers the substantial
amount of resources that is allocated to this enterprise. Section 10.3 pointed out that failures to turn
additional resources into improved outcomes often reflect problems in the service delivery chain that links
policymakers, social service providers and citizens. A growing body of research has suggested that the
South African basic education system exhibits several problems of this nature. Van der Berg and Hofmeyr
(2018: 14–19), for example, discussed four binding constraints that hinder the ability of other interventions
(such as the provision of more resources) to improve educational outcomes:
• Weaknesses in provincial education departments. The bulk of basic education spending in South Africa is
undertaken at the provincial level of government.14 Hence, the lack of capacity in most provincial
education departments is a major constraint in the basic education sector. Its manifestations include
poor fulfilment of critical administrative functions (such as the management of learning materials and
other non-personnel resources) and inadequate monitoring of and support to schools and teachers.
• The undue influence of labour unions. Most teachers belong to labour unions. The power of some unions
extends well beyond issues related to teacher pay and working conditions to include aspects of
education policymaking and implementation. Some strong teacher unions have even distorted post-
provisioning processes to secure nepotistic appointments for their members, and have thwarted several
attempted policy reforms to increase accountability in the basic education sector.
• The weak content knowledge and pedagogical skills of teachers. While most South African teachers are
adequately qualified, many lack the content knowledge to teach the subjects for which they have been
appointed.15 This is indicative of shortcomings in the pre-service and in-service training of teachers.
One of the outcomes of many teachers’ poor content knowledge is that they cannot accurately judge the
performance of their learners. The quality of teachers and teaching are particularly important aspects of
the relationship between resources and outcomes in schooling. Basic education is a labour-intensive
activity16; hence, large portions of increases in government expenditure on education usually take the
form of salaries and other benefits paid to teachers. Such expenditure increases will not improve
educational outcomes unless they attract better teachers to the public education sector or motivate
existing ones to work harder and more effectively. In South Africa, the main driver of the rapid growth
in basic education spending from 2008 to 2013 was improvements to the pay scales of teachers. These
improvements had three aims: to increase the reward to teaching experience, to restore the position of
teachers relative to other civil servants, and to ensure that the teaching profession attracted appropriate
individuals. The adoption of the new pay scales did not lead to immediate improvements in educational
outcomes, and it remains to be seen whether benefits will realise in the longer-term.
• Wasted learning time. Much learning time is wasted in South African schools.17 This reflects a variety of
reasons, including teacher absenteeism, poor time management, and the lack of a culture of teaching
and learning. A study by the Human Sciences Research Council (Reddy, Prinsloo, Neshitangani,
Moletsane, Juan & Janse van Rensburg, 2010: 84) confirmed that wasted learning time markedly
reduces children’s opportunity to learn in many South African schools.
It is notable that several of these service delivery problems are related to a lack of accountability, that is, the
reality that there are few, if any, consequences for non-performance in the basic education sector.
Education is one of the most important elements of social policy. Hence, it should be a priority function
in the national budget, as is the case in South Africa. However, outcomes do not necessarily improve when
more resources are made available for social service provision, especially when capacity and accountability
are lacking. This disconnect between increased resources and improved outcomes characterises various
areas of government activity in South Africa. It is especially problematic in education, however: compared
to social assistance, which uses taxes and social grants to redistribute a small portion of current total
income, education has much greater potential to influence the mechanisms that determine the distribution
of income via its effects on labour market earnings.
10.5 Service delivery in healthcare in South Africa

The health status of a country’s population is a critical input into an economy’s growth; furthermore, it
plays a major role in preventing poverty and in ensuring quality of life for the population. Hence, it is
important to ensure that government expenditure on health contributes to good health outcomes.
10.5.1 The South African health system

The South African health system has large public and private components. In 2014, total health expenditure
in South Africa amounted to 9,0% of GDP, of which 49% (4,4% of GDP) flowed through the public and
51% (4,6% of GDP) through the private sector (National Treasury, 2015a: 53). Although their aggregate
spending levels are quite similar, the proportions of the South African population served by the private and
public components of the health system differ markedly (Statistics South Africa, 2019: 26). The 2018
General Household Survey showed that 16% of South Africans had medical scheme cover and relied on
private sector healthcare. The remaining 84% of the population lacked medical scheme cover and mainly
used public healthcare services. It follows that expenditure in the private healthcare sector is markedly
higher on a per capita basis than that in the public healthcare sector. However, Box 10.2 shows that
attempts are underway to extend health coverage to all South Africans by means of a national health
insurance system.
More than 90% of South Africa’s health budget is allocated to the national Department of Health and
the nine provincial departments of health, predominantly to fund a non-contributory public health system.18
The national Department of Health receives only a small portion (some 5%) of the total public healthcare
budget. The bulk of this budget (85% or more) is allocated to the provincial departments of health, which
are the most important providers of healthcare services in the public system.19 This section focuses on total
public health expenditure, which includes all funds set aside for this purpose in the national budget,
whether to the national or provincial departments of health or to other departments or institutions.
Box 10.2 Towards universal health coverage in South Africa
A growing international movement supports the establishment of universal health coverage systems. Definitions of
universal health coverage vary across countries and contexts; in its simplest form, however, it means ‘providing all
people with access to needed health services of sufficient quality to be effective without their use imposing financial
hardship’ (Moreno-Serra & Smith, 2012: 917). One of the principles of this movement is that individual countries
should consider their own income constraints when deciding which health services to include in such systems. One of
the outcomes of the Rio+20 United Nations Conference on Sustainable Development in Rio de Janeiro (Brazil) in
June 2012 was a call to action that clearly articulated some of the envisaged benefits of universal health coverage,
namely enhancement of health, social cohesion, and sustainable human and economic development (see Evans,
Marten and Etienne, 2012: 864).
Apart from the obvious health and socio-economic benefits of better access to health services, empirical evidence
shows a strong association between better health status and growth and development. The 2001 Commission on
Macroeconomics and Health, for example, found that an increase of 10% in life expectancy at birth is associated with
increases of 0,3% to 0,4% in annual economic growth (World Health Organization, 2001: 24).
South Africa has embarked on a deliberate process to achieve universal health coverage. The aim of this process is
to pool all government health spending in a single insurance scheme by establishing a National Health Insurance
(NHI) system. In an important step in this process, the Government gazetted the NHI White Paper in June 2017. In
addition, the Department of Health released a draft NHI bill. It invited relevant stakeholders to make submissions on
areas of concerns in the bill and produced a revised draft bill, but it has not been released yet. The most likely sources
of funding for an NHI system will be general taxes and compulsory contributions by all formally employed South
Africans whose earnings exceed a certain threshold. The scheme will contract both public and private healthcare
providers to deliver healthcare services to the citizens of South Africa.
Increased health expenditure via an NHI system may lead to better health outcomes for all South Africans. Yet
cross-country evidence indicates that higher government spending on health does not necessarily lead to better health
outcomes (see Gupta, Verhoeven & Tiongson, 1999). When considering the potential effects of health spending,
policymakers often ignore the possibility that users might not respond to policy changes in the ways they envisage.
The incentives that govern the behaviour of health system staff and other actors in the public sector may also
undermine health outcomes. Filmer, Hammer and Pritchett (2000: 201) put it as follows: ‘Often, health service
failures result from a systemic mismatch between the traditional civil service incentive structure and the tasks
required in the health sector.’
The aims of this section are to present data on current public health expenditure levels, describe how these
have changed over time and discuss the problems that arise in efforts to use public funds to improve health
outcomes for the poor. Hence, the section refers to levels of health service access, the quality of health
services provided and the efficiency of the public health system. Although an awareness of private health
expenditure is important for understanding the larger South African health-financing context and the
inequity in expenditure between the public and private sectors, the public sector provides the bulk of the
health services consumed by poor South Africans. Hence, the remainder of this section focuses on the
public-sector component of the health system.
Public health expenditure in South Africa takes place in the context of a heavy disease burden. The
health system is confronted with a so-called ‘quadruple burden of disease’ that consists of communicable
diseases (for example, tuberculosis and HIV/Aids), a growing burden of non-communicable diseases (for
example, diabetes and cardiovascular disease), injuries (many of which are effects of high levels of
interpersonal violence), and maternal and child health problems. Studies of the South African health system
(for example, Van den Heever, 2012: 2–3) consistently conclude that South Africa produces worse health
outcomes than many low-income countries despite its status as an upper middle-income country. Thus,
despite the positive effects of the widespread availability of antiretroviral therapy (ART), South Africa
remains amongst the 30 countries in the world with the worst TB burdens (World Health Organization,
2018: 25). In similar vein, South Africa was the country with the highest number of new HIV cases in the
world in 2017 (World Health Organization, 2019). The heavy disease burden necessitates high levels of
public health expenditure, but also weakens the effectiveness of such spending.
Levels, growth and composition of government spending on

10.5.2
health in South Africa
Health is the third largest functional category of government spending after education and social protection
(see Table 7.2). Figure 10.6 shows that general government expenditure on health increased in real terms
from R54,1 billion in fiscal year 1993 to R182,2 billion in fiscal year 2017.20 This represented an
impressive average annual rate of growth of 5,2%. It is also clear from Figure 10.6 that the real rate of
growth in health spending outstripped the rate of growth in the South African population over this period.
Hence, the real level of general government health expenditure increased in per capita terms from R1 430
in fiscal year 1993 to R3 206 in fiscal year 2017.
Figure 10.6 General government expenditure on health in South Africa in real terms, 1996–2017
Sources: Calculated from South African Reserve Bank, Quarterly Bulletin (various issues). Pretoria: South African
Home.aspx [Accessed 14 June 2019]; and Statistics South Africa, Mid-year population estimates (various issues).
Statistical Release P0302. Pretoria: Statistics South Africa. [Online]. Available: http://www.statssa.gov.za/?
page_id=1866&PPN=P0302&SCH=7362 [Accessed 14 June 2019].
The increase in spending depicted in Figure 10.6 was the result of deliberate efforts by the government,
albeit of varying intensity, to expand healthcare expenditure, equalise it across race groups, and make it
more pro-poor. The emphasis on making public healthcare expenditure more pro-poor was reinforced by
allocation shifts between provinces and expenditure categories.
Real government expenditure on health grew relatively slowly during the second half of the 1990s,
when the availability of funds was limited by difficult macroeconomic conditions and a strong focus on
fiscal consolidation guided by the Growth, Employment and Redistribution (GEAR) strategy (see Section
18.6.1). In fact, such spending even decreased in aggregate and per capita terms in 1999. Aggregate
spending grew in every fiscal year from 2003 to 2017, however, while per capita spending increased in
each of these fiscal years except 2014 and 2017. The real growth rates of both aggregates were particularly
rapid from fiscal year 2004 until fiscal year 2013. Table 7.2 showed that this period of growth also brought
a significant increase in the ratio of general government health spending to GDP: following a slight
decrease from 2,9% in fiscal year 1994 to 2,7% in fiscal year 2005, this ratio rebounded to 4,0% in fiscal
year 2016. However, real public health expenditure lost some of its upward momentum from 2014 onwards
because of the poor growth performance of the South African economy and the deteriorating fiscal
position. The decreases in the per capita values of real public health expenditure in 2014 and 2017
underscored this development.
Fiscal shifts towards primary healthcare activities have occurred during the post-apartheid period.21 The
Government introduced free primary care for mothers and young children in 1994 and abolished the
remaining user fees on primary care in 1996. Free primary care has been available to the entire population
since then. The effect of this policy shift has been to raise government expenditure on primary care from
20% of its spending on hospitals in 2000 to 30% in 2007 (Burger, Bredenkamp, Grobler & Van der Berg,
2012: 682). This was achieved by simultaneously increasing the share of the budget allocated to primary
healthcare and decreasing the share allocated to hospitals.
Another important trend in public health expenditure in South Africa during the new millennium has
been marked increases in the salaries, wages and other benefits of workers in the health sector.22 The real
wage bill of the public health sector more than doubled between the 2006 fiscal year and the 2015 fiscal
year (Blecher, Davén, Kollipara, Maharaji, Mansvelder & Gaarekwe, 2017: 29). At first, this trend was
driven by increases in salaries and wages as well as growth in the number of staff employed in the public
health sector (the purpose of the hiring of additional workers was to rectify perceived understaffing,
especially compared to other developing countries). From the 2007 fiscal year onwards, the main driver
was the incremental implementation of the Occupation Specific Dispensation (OSD) – a new remuneration
structure for health workers that gave rise to substantially higher salaries.
10.5.3 Access and quality of health services

The distinction between access and quality is more complex in health than in education. School enrolment
rates can be used as indicators of access in education, while the learning outcomes of students can serve as
proxies for quality. In healthcare, utilisation rates and interactions with the health system (for example,
visits to clinics) are useful measures of access. It is very difficult to measure quality, though. Nonetheless,
these concepts remain relevant for assessment of the outcomes of increased healthcare expenditure and
shifts in expenditure allocation in the post-apartheid period.
Did access to public healthcare services improve in the post-1994 period and, if so, how? Did some
groups receive better access or more benefits than others did? The following evidence exists on four
dimensions of healthcare access:
• Overall utilisation of healthcare. The total number of visits to primary healthcare facilities increased from
82 million in fiscal year 2001 to 129 million in fiscal year 2013 before dropping to 126 million in fiscal
year 2016 (Blecher et al., 2011: 39; Blecher et al., 2017: 34). On average, South Africans without
healthcare expenditure insurance paid 2.8 visits to such facilities in fiscal year 2016.
• Pro-poor access. Not only did expenditure on primary healthcare increase substantially in the post-
apartheid period, there is also evidence that it became more pro-poor. In other words, the share of the
benefits of public health spending received by the poorest began to exceed their share of the population.
By 2008, 30% of government expenditure on clinics accrued to the poorest 20% of the population,
while 50% of such expenditure accrued to the poorest 40% (Burger et al., 2012: 689). The distribution
of the benefits of changes in expenditure on public hospitals also exhibited a pro-poor pattern, albeit a
slightly weaker one.
• Affordability. An analysis of household survey data on self-reported payments to healthcare providers by
Burger et al. (2012: 692) revealed a large decrease in payments to public clinics and hospitals between
1993 and 2008. This largely reflected the effects of the introduction of free services. It is also worth
noting that the incidence of catastrophic health expenditures amongst South African households has
been very low in the post-apartheid period (Burger et al., 2012: 693).23
• Physical proximity. Since 1994, the government has markedly expanded the health infrastructure network,
especially the number of clinics. As a result, the proportion of the population that report travel times of
more than 30 minutes to the nearest clinic decreased significantly between 1993 and 2008 (Burger et
al., 2012: 695). Respondents in household surveys now rarely mention the physical distance to public
healthcare facilities as a barrier to accessing healthcare. However, the high public transport costs
associated with accessing such facilities are still frequently cited as an obstacle (see, for example,
Goudge, Gilson, Russel, Gumede & Mills, 2009). These costs are particularly onerous for people
suffering from chronic diseases such as TB and HIV, who require frequent visits to healthcare facilities.
As was pointed out earlier, it is difficult to capture the quality of healthcare services in aggregate measures.
Hence, we provide evidence on the experiences of health system users, which can be seen as tentative
indications of quality problems in healthcare. An analysis of data from the General Household Surveys
from 2002 to 2008 by Burger et al. (2012: 697) identified waiting times, insufficient staff and the rudeness
of staff as the main complaints about public healthcare facilities. Another study found that the major
supply-side constraints experienced by chronically ill patients were the unavailability of drugs, weak or
inadequate clinical services at clinics that necessitated referrals of patients to other facilities, and a lack of
ambulances to transport patients (Goudge et al., 2009). Earlier analyses of changes in the demand for
specific categories of health services in South Africa (for example, Grobler & Stuart, 2007) have found
public healthcare to be an inferior good for which the demand decreases as incomes increase.24
South Africa’s consistent under-performance in critical health areas (for example, maternal and child
health, HIV/Aids and TB) relative to peer countries cannot be explained away by insufficient funding for
the public sector, especially in view of the growth trend in public healthcare expenditure discussed in
Section 10.5.2. In 2015, fully 120 of the other 182 countries for which data were available had lower rates
of maternal deaths than South Africa had (World Health Organization, 2018: 24); furthermore, South
Africa was one of only twelve countries in which the child mortality rate was higher in 2008 than it was in
1990 (Chopra, Daviaud, Pattinson, Fonn & Lawn, 2009: 835). These and other unsatisfactory health
outcomes point towards the presence of inefficiency or, more specifically, X-inefficiency, in the public
health system.25 While this issue has not yet been explored in detail in the South African context, there
exists some evidence that points towards the presence of X-inefficiency in the public health sector once the
burden of disease and available resources have been controlled for.
Christian and Crisp (2012) provided several examples of a lack of leadership and decision-making
power in the public health system that are likely to lead to X-inefficiency. In addition, the reality that some
public health districts with scant resources outperform other better resourced ones (see Engelbrecht &
Crisp, 2010: 201) probably reflects differences in levels of X-efficiency. Evidence from South Africa also
suggested that levels of efficiency may differ between the public and private sectors: for example, client
perceptions indicated that a sample of low-cost private sector clinics provided higher-quality services at
similar cost to public sector clinics (Palmer, Mills, Wadee, Gilson & Schneider, 2003).
South Africa’s public and total health expenditure levels compare relatively well with those of its upper-
middle income country peers, but the impact of public expenditure is undermined by the heavy disease
burden. The period from 2004 to 2014 was marked by consistent absolute and relative increases in real
public health expenditure, in part because of the anticipated implementation of a national health insurance
system. Rates of growth in public health expenditure have slowed from 2014 onwards, however, because of
poor economic growth and the deterioration in the fiscal situation. In all likelihood, the effects of X-
inefficiency in the system have been exacerbated by lack of capacity and accountability. While appropriate
levels of health expenditure are important for achieving a healthy population, they should not be valued for
their own sake. The outcomes that should be sought are a healthy population and its attendant benefits,
which include increased labour-market participation, a reduction in poverty, and more rapid economic
growth and development.
Key concepts
• catastrophic health expenditures (page 17)
• consumer surplus (page 4)
• co-payment (page 5)
• deadweight loss, or excess burden (page 7)
• human capital (page 2)
• in-kind subsidies (page 5)
• outcomes (page 9)
• outputs (page 9)
• supplier-induced demand (page 6)
• third-party payment problem (page 4)
• universal health coverage (page 14)
SUMMARY
• Education and healthcare services are particularly important for economic development, both as inputs in
the aggregate production function and as ends. Effective service delivery is very important, however,
because the link between the extent of government spending and developmental outcomes in these
areas is often tenuous.
• Education and healthcare are mixed services that can be supplied by the public sector or the private sector.
The existence of market failures underpins strong cases for government intervention in education and
healthcare markets. The case for government intervention in education markets rests on externality
considerations, information problems, capital market failures and equity concerns. Externalities and
imperfect information cause allocative inefficiency in healthcare markets. Equity considerations further
strengthen the case for government intervention in such markets.
• In-kind subsidies often cause excess burdens, because they restrict the choice sets of consumers. However,
such subsidies can be efficiency- and welfare-enhancing when good- or service-specific positive
consumption externalities exist.
• The process of delivering social and other services can be seen as a chain consisting of relationships
between three sets of role-players: policymakers, service providers and citizens. The reality that links
service delivery chains can break down because of weaknesses in capacity or accountability, among
other things, means that more government spending on social services does not always lead to better
social outcomes. It also emphasises the salience of the distinction between outputs (readily observable
and measurable deliverables that are necessary but not sufficient conditions for meeting the ultimate
objectives of programmes) and outcomes (deliverables that are more difficult to observe and measure
but linked to the ultimate goals of programmes).
• By international standards, government expenditure on education and health is relatively high in South
Africa. Furthermore, there has been significant growth in public spending on both sets of services since
1994, accompanied by effective policy reforms that made such spending more pro-poor. Yet the
outcomes of government spending on education and healthcare services have remained disappointing:
various indicators show that these outcomes fall short of those of other middle-income countries and
even those of some low-income countries subject to much tighter resource constraints. Service delivery
problems linked to weak accountability mechanisms and X-inefficiency are major causes of these
disconnects between resources and outcomes. These problems severely undermine the considerable
developmental potential of government expenditure on education and health.
a. Human capital theory considers the financial and other benefits of education.
b. Capital markets often fail to provide adequate education financing.
c. Private firms cannot provide healthcare expenditure insurance.
d. Supplier-induced demand is a major problem in markets for healthcare expenditure insurance.
a. In-kind subsidies cannot increase the social welfare, because they generate excess burdens.
b. In-kind subsidies cause excess burdens because they restrict the choice sets of consumers.
c. Social outcomes do not always improve when governments spend more on social service provision.
d. Outputs are easier to observe and measure than outcomes are.
a. Not all differences between the resources of schools in richer and poorer areas of South Africa have
been eliminated.
b. According to some researchers, real government expenditure on education per learner decreased in
South Africa from 2010 to 2017.
c. Measures of educational attainment are good proxies for educational outcomes.
d. The large pro-poor shift in resources since the end of apartheid has been accompanied by
improvements in educational outcomes, but not by improvements in educational outputs.
a. Resources are equitably distributed between the public and private components of the South African
health system.
b. For a middle-income country, South Africa has a very high disease burden.
c. Real government health expenditure increased in per capita terms from fiscal year 2003 to fiscal
year 2013.
d. In South Africa, public healthcare is a normal good.
10.1 Explain the importance of education and healthcare services for economic development.
10.2 Briefly explain the nature and effects of the third-party payment problem in markets for healthcare
expenditure insurance.
10.3 Explain the distinction between outputs and outcomes in social service delivery.
10.4 Briefly discuss four binding constraints in the South African basic education sector.
ESSAY QUESTIONS
10.1 Summarise the case for government intervention in education markets.
10.2 Summarise the case for government intervention in markets for healthcare expenditure insurance.
10.3 ‘Governments should always avoid in-kind subsidies, because they cause allocative inefficiency in the
form of excess burdens.’ Do you agree with this statement? Explain your answer.
10.4 Discuss the nature and manifestations of the service delivery problem in the basic education sector in
South Africa.
10.5 Discuss developments in access to and the quality of public healthcare in South Africa since 1994.
1 Recall that the discussion of trends in the functional composition of government expenditure in South Africa in Section 7.2.3 used
the Government Finance Statistics (GFS) system categories.
2 The income security programmes discussed in Chapter 9 are the main elements of the social protection category of social services.
3 The purpose of such payments is to discourage persons with medical aid from seeking unnecessary or excessively expensive
medical care.
4 The out-of-pocket cost would have been zero if co-payments were not required.
5 Chernew and Newhouse (2011) provided a useful overview of the extent and causes of growth in healthcare expenditure in
developed and developing countries.
6 Recall from Section 3.6 that goods and services exhibit positive externalities when the marginal social benefits of consumption
exceed the marginal private benefits because external benefits accrue to non-users.
7 The only exception is government expenditure on higher education, which mainly benefits members of higher income groups (Van
der Berg & Moses, 2012: 130–131; Inchauste et al., 2015: 24–25). The main reason for this is that many children from low-
income households attend poorly functioning schools that prevent them from accessing opportunities for tertiary education.
8 Recall from Table 7.2 that expenditure on education by the general government amounted to R285,2 billion in the 2016 fiscal year.
This constituted 18,8% of total general government expenditure and 6,6% of GDP.
9 Educational attainment gaps began to narrow from the 1960s onwards as the school enrolment and completion rates of all race
groups increased markedly (Van der Berg & Hofmeyr, 2018: 10).
10 Fiscal incidence studies – which were introduced in Section 8.4 – have confirmed the extent of this shift in resources (see, for
example, Inchauste et al., 2015). Van der Berg (2006) and Gustafsson and Patel (2006), among others, discussed the nature and
effects of this shift in more detail.
11 Recall the distinction between outputs and outcomes explained in Section 10.3.
12 The amounts per learner were published by UNESCO (2019: 281, 287).
13 13 The amounts per learner were published by UNESCO (2017: 402).
14 In the 2016 fiscal year, for example, provinces were responsible for 70,4% of total general government expenditure on education
(Statistics South Africa, 2017: Table 2). The national Department of Basic Education has policymaking and monitoring
mandates.
15 To name but one example: fully 79% of the Grade 6 mathematics teachers tested in SACMEQ 2007 had a content knowledge
below Grade 6/7, that is, below the level they were teaching (Venkatakrishnan & Spaull, 2014: 14).
16 Salaries and wages accounted for 87,1% of general government expenditure on basic education in fiscal year 2017 (Statistics
South Africa, 2018a: 22, 26).
17 In 2008 and 2009, for example, the National School Effectiveness Study (NSES) showed that only 24% of Grade 4 and 5
mathematics topics were actually covered in a nationally representative sample of schools (Taylor & Reddi, 2013: 193).
18 The remainder of the national health budget is allocated to various other government departments (including Education, Defence,
and Correctional Services) and to extra-budgetary institutions such as the Compensation Fund and the Road Accident Fund. As
was pointed out in Section 9.5, the Compensation Fund and the Road Accident Fund are social insurance elements of the South
African social security system.
19 Three sources determine the total funds receivable by the provincial departments of health: the provincial equitable share,
conditional grants and provincial own revenue. The provincial equitable share is the major funding source of the provinces. The
allocation of this pool of funds among the provinces is based on an equitable share formula that incorporates factors such as
their population sizes and poverty rates. Section 19.7.2.2 discusses the provincial equitable share in more detail. Conditional
grants are typically allocated on a national priority basis, for example, to combat HIV/Aids or to revitalise infrastructure. Such
funds are allocated by the National Department of Health and are disbursed to provinces with lists of conditions. The
allocations could be frozen or withdrawn if the provinces fail to meet these conditions. Provincial own revenue are funds
generated by the provincial departments of health. These typically form very small shares of total provincial revenues.
20 All amounts in this paragraph are expressed in February 2016 prices. The consumer price index was used to deflate the nominal
amounts.
21 Many definitions of primary healthcare exist. In South Africa, the budget of the Department of Health contains a programme
entitled ‘Primary health care services’ that manages the district health system and deals with environmental health issues,
communicable and non-communicable disease control, general health promotion and improvement of nutrition. The shift in
fiscal resources discussed here coincided with a policy shift to increase the focus on these aspects of the public health system at
the expense of that on hospital-based curative services, among other things.
22 Salaries and wages form the bulk of the health budget: in the 2017 fiscal year, for example, this component accounted for 61,4%
of general government expenditure on health and the next biggest component – purchases of goods and services – for 29,8%
(Statistics South Africa, 2018a: 22, 26).
23 Catastrophic health expenditure refers to health expenditure in excess of a pre-defined income threshold that may have an
impoverishing effect on households. Various thresholds have been proposed. Two widely used ones are healthcare expenditure
that exceeds 10% of total household expenditure and healthcare expenditure that exceeds 40% of total household non-food
expenditure.
24 Large numbers of South Africans without medical scheme coverage first seek care at private facilities when they are ill. Even
among the poorest quintile of households, about 20% access private healthcare services (Burger et al., 2012: 682).
25 Christian and Crisp (2012: 726) defined X-efficiency as ‘an open-ended concept which describes the effectiveness with which a
set of inputs can produce outputs’. While it is closely related to the concept of technical efficiency, it differs from that concept
in that the source of inefficiency is explicitly identified as ‘intrinsic to the nature of human behaviour’, for example, aspects of
management and decision-making in organisations (Christian & Crisp, 2012: 727). Section 2.3 also explained the notion of X-
efficiency.
Introduction to taxation and tax equity
Tjaart Steenekamp and Ada Jansen
In Parts 1 and 2, we explained the role and functions of government as well as the nature and patterns of
government expenditure. The need and demand for public goods and services would appear to be varied
and extensive. However, like all other demands (wants) and needs, the demand for public goods and
services is also constrained by limited resources on the supply side. Furthermore, like all other goods and
services, the supply and distribution of public goods and services must be financed. John Coleman aptly
remarked, ‘The point to remember is that what the government gives, it must first take away’ (quoted in
Mohr, Fourie & associates, 2008: 339). This chapter focuses on taxation as a source of finance for public
expenditures. Different sources of finance are identified in Section 11.1. In the section that follows, tax
bases are identified and a distinction is made between different types of taxes, such as general taxes, ad
valorem taxes and direct taxes. Criteria for analysing taxes are proposed in Section 11.3, after which the
equity criterion is described and discussed in depth in Section 11.4 as well as the rest of the chapter. When
the fairness of a tax is considered, the effects of tax shifting are paramount. In Sections 11.5, 11.6 and 11.7,
the incidence of taxes is discussed using both a partial equilibrium and a general equilibrium analysis.
list alternative sources of government revenue
define a tax and describe the structure of tax rates
distinguish between general and selective taxes, specific and ad valorem taxes, and direct and indirect taxes
list the properties of a ‘good’ tax
explain what is meant by an equitable tax
distinguish between the statutory and the economic burden of a tax
analyse the shifting of a tax and its impact on tax incidence using both a partial and a general equilibrium
framework.
11.1 Sources of finance

The dominant source of finance for public expenditure is taxation. In 2017/18, tax revenue constituted
approximately 78,5% of total cash receipts from operating activities of the consolidated general
government (South African Reserve Bank, 2018: S-73). Government expenditure may also be financed
from alternative sources. In addition to taxation, there are four other important sources of finance: user
charges, administrative fees, borrowing and inflation taxation.
User charges (also referred to as benefit taxes) are prices charged for the delivery of certain public
goods and services. The role that these charges play in the allocation and distribution of resources is
analogous to the role of prices in the market mechanism. The important difference is that user charges are
set in the political market. User charges can only be levied if exclusion is possible (see Section 3.4 of
Chapter 3). In other words, it should be possible to exclude those who do not pay for the consumption of
the public good or service in question. Examples of user charges include toll roads, public swimming pools,
ambulance services and university education (see Section 11.4.1 for a further discussion of benefit taxes).
Administrative fees are similar to user charges, but differ in the sense that the service (or benefit)
received in return for the fee is defined rather broadly and imprecisely. Fees of this nature include business
licences, television licences, diamond export rights, fishing licences and motor vehicle licences. The
dreaded parking ticket and speeding fine can also be added to the list. Administrative fees and fines are
insignificant sources of revenue.
Government can borrow from its own citizens and from abroad. Borrowing is often used to finance
capital expenditure. Borrowed funds must be repaid at some point and can therefore amount to deferred
taxes. Because lenders have to be adequately compensated by way of interest payment for current
consumption forgone, it is imperative that borrowed money be spent on productive activities. Sometimes
government uses borrowed funds to finance current consumption, a practice that cannot easily be defended
on economic grounds (see Section 17.2 of Chapter 17).
Government-induced inflation can also be regarded as a source of revenue. If public expenditure is
financed in such a way that increases in the money supply occur, this financing may eventually raise the
price level. Inflation changes the real value of public debt. If government borrows R2 000 from a taxpayer
(for example, if government imposes a loan levy on all taxpayers with incomes in excess of R100 000) and
inflation is 10%, then in a year’s time, the real value of the loan is only R1 800 (R2 000 2 [ 2 000]).
If the value of the loan is not linked to a price index, the real value of government debt decreases. In this
case, it may also be said that government finances its expenditure with an inflation tax.
11.2 Definition and classification of taxes

In 1789, Benjamin Franklin wrote: ‘In this world, nothing can be said to be certain, except death and taxes’
(Cohen & Cohen, 1960). What, then, is so abhorrent about taxes? Taxes are transfers of resources from
persons or economic units to government and are compulsory (or legally enforceable). There is not
necessarily a direct connection between the resources transferred to government and the goods and services
that it supplies. In fact, government can compel one group of individuals to make payments that are used to
finance activities to the benefit of another group. Taxes are compulsory owing to the free-rider problem. As
no one would pay taxes voluntarily, people have to be compelled to do so. The fact that government has
legally been granted the power to tax, distinguishes government’s confiscation of resources through
taxation from other involuntary transfers of resources (for example, theft).
However, government does not have unlimited powers as far as taxation is concerned. The Constitution
of the Republic of South Africa (1996) provides for money bills, that is, bills that provide government with
the legal right to appropriate amounts of money or to impose taxes, levies or duties. All money bills must
be considered in accordance with the procedure established by Section 75 of the Constitution and an act of
parliament must provide for a procedure to amend money bills before parliament. Since the National
Assembly must pass this type of bill, it implies that, in addition to procedural limits, the imposition of taxes
and changes to taxes are subject to the checks and balances of parliament. In a representative democracy,
parliamentarians must take cognisance of the preferences of voters as well as those of other parties (for
example, vested interests) that may influence fiscal decisions. The influence of interest groups in this
process is considered to be particularly important (see Chapter 6) and may even explain why the fear that
‘the numerous poor will out-vote the rich and middle classes, and tax away much of their wealth’ is more
apparent than real (Becker, 1985).
Taxes can be classified in many ways. The classification used in South Africa is the one that conforms
to the International Monetary Fund’s Government Finance Statistics Manual, of which the latest version
was published in 2014. Tax revenue is grouped into six categories, each of which is then sub-divided
further. The main tax categories in respect of central government (with the approximate percentage
contribution to total tax revenue net of South African Customs Union payments1 for 2018/19 in brackets)
are as follows (National Treasury, 2019a: 195):
• Taxes on income and profits (60,0%)
• Taxes on payroll and workforce (1,4%)
• Taxes on property (1,3%)
• Domestic taxes on goods and services (36,7%)
• Taxes on international trade and transactions (4,5%)
• Stamp duties and fees (0,0%).
Income taxes clearly constituted the most important category of taxes in 2018/19. Taxes on the income of
individuals contributed 66,2% towards the total taxes on income and profits, while tax on the income of
corporations contributed 29,1%. In order to do a proper analysis, we will classify taxes according to tax
base in the next section. We will then distinguish between general and selective taxes (Section 11.2.2),
specific and ad valorem taxes (Section 11.2.3), and direct and indirect taxes (Section 11.2.4).
11.2.1 Tax base and rates of taxation

Taxes can generally be imposed on three tax bases: income, wealth and consumption (sales or transactions).
A tax on people can be added to these three bases. A lump-sum tax per head (or poll tax) is an example of
a tax on people. Tax bases can also be viewed in terms of their flow and stock characteristics. Flows are
associated with a time dimension and are measured over a period. Income and consumption are flow
concepts since both are measured over a period of time (normally a tax year). Stocks have no time
dimension and are measured at a particular point in time, for example, wealth. Which of the three potential
tax bases is the best is a much-debated issue. Most countries have hybrid systems, exploiting three (or four)
bases simultaneously. Tax systems differ according to historical and political circumstances as well as the
stage of economic development of the country. This aspect is discussed in Section 16.5 of Chapter 16.
Once the tax base has been identified, the tax rate structure can be set. The tax rate structure describes
the relationship between the tax rate and the tax base. The tax rate refers to the amount of tax levied per
unit of the tax base. Three variants can be distinguished: proportional, progressive and regressive taxes.
The rate structure can be described in at least two ways. One way is to compare the average tax rate (the
total rand amount of taxes collected divided by the rand value of the taxable base) to the size or value of the
tax base. Therefore, when the average tax rate remains constant with respect to variations in the tax base,
the tax is proportional (see Box 11.1). When the average tax rate increases as the tax base increases, the
tax is progressive. If the average tax rate decreases as the tax base increases, the tax is regressive.
The rate structure can also be described by focusing on the ratio of taxes paid to income. All taxes are
then evaluated in terms of the income base as a common denominator for purposes of comparison between
different taxpayers, even though, in practice, the tax may be imposed on a different base. In this way, the
distributional consequences of taxes can be determined. Taxes that generate the same proportion of income
as income rises are proportional (for example, corporate income tax). A tax with a proportional rate
structure (e.g. 20% of taxable income) is also called a flat-rate tax. Taxes that take an increasing proportion
of income as income increases are progressive taxes (for example, personal income tax). If a tax generates
a decreasing proportion of income as income increases, it is a regressive tax (for example, a value-added
tax without any zero ratings). See Box 11.1.
Box 11.1 Proportional, progressive and regressive taxes
Consider a tax on the consumption base. Suppose a tax of 15% is imposed on the consumption of all essential
expenditure items. Suppose furthermore that there are two households: the Peterson household with a monthly
income of R1 500 and the Chetty household with a monthly income of R250 000. Is this tax progressive, proportional
or regressive? According to a report by the Bureau of Market Research (Bureau of Market Research, 2017) on
Household Income and Expenditure Trends and Patterns, 2013–2017, the low-income group (monthly income of less
than R1 750) spends approximately 70,0% of its income on essential items, whereas the high-income group (monthly
income in excess of R204 000 per month) spends about 36,0% of its income on essential items (Bureau of Market
Research, 2017). The Petersons thus spend approximately R1 050 on essential items per month and the Chettys spend
R90 000 (almost eighty six times more than the amount of the Petersons). A 15% tax on essential items will therefore
cost the Petersons R158 per month in taxes, while the Chettys will pay R13 500. In absolute terms, the Chettys thus
contribute more in tax on food products to the South African Revenue Services (SARS) than the Petersons. When we
divide the tax collected (R158 or R13 500) by the rand value of the taxable sales or transactions base (R1 050 or R90
000), the average tax rate is the same . Our first conclusion
would therefore be that the tax is proportional since the average tax rate does not vary with the size of the tax base,
namely consumption. However, if we evaluate the tax in terms of the income base, as is commonly done, the picture
looks rather different. The Petersons have to pay over almost 11,0% of their income ( 3 100) to SARS, but in the
case of the Chettys, it is less than 6,0% of their income .Thus the tax structure is regressive with
respect to income, but proportional with respect to the sales (or transactions) base.
11.2.2 General and selective taxes

Taxes can be classified as general or selective taxes. A general tax (also called a broad-based tax) is one
that taxes the entire tax base and allows for no exemptions. A value-added tax (VAT) without any
exemptions or zero-ratings is a general tax on consumption. Similarly, an income tax that taxes all sources
of income (including capital income) without any tax deductions is a general tax. Selective taxes (also
called narrow-based taxes) are imposed on one or a few products, or only wage income (for example,
excluding interest income). The whole tax base is therefore not taxed. An excise tax on cigarettes is another
example of a selective tax. The importance of the distinction between general and selective taxes lies in the
fact that under certain assumptions,2 general taxes are similar to head or lump-sum taxes, which leave
relative prices unchanged. In other words, the behaviour of economic role-players is assumed to be
unaffected by these taxes. In contrast, selective taxes distort relative prices by driving a wedge between the
before-tax price and the after-tax price of a commodity. This violates the Pareto-efficiency condition of
optimal welfare in the sense that one person’s welfare is increased at the cost of another person. This aspect
will again receive attention when we consider the efficiency of different taxes in Section 12.1 of Chapter
12.
11.2.3 Specific and ad valorem taxes

Taxes can also be specified according to the size or the value of the tax base. The size of the tax base can be
measured in terms of weight, quantities or units. When a fixed amount is imposed per unit of the product,
the tax is called a unit tax or specific tax. Examples of specific taxes in South Africa in 2019/20 are excise
duties on the following products: sparkling wine (R13,55 per litre), beer made from malt (R1,74 per
average 340 ml can) and cigarettes (R16,66 per twenty cigarettes).
Taxes imposed on the value of products are called ad valorem taxes. Such a tax is usually levied as a
rate (that is, a percentage) of the excisable value (or price) of a commodity. VAT and excise duties are
examples of ad valorem taxes. Ad valorem taxes (sometimes called ad valorem duties) are often imposed
on luxury goods. Ad valorem excise duties were introduced in 1969 for revenue purposes and were levied
on certain locally manufactured goods with a corresponding ad valorem customs duty (at the same rate)
levied on imported goods of the same kind. For example, in South Africa, commodities such as sun
protection products with a sun protection factor of less than fifteen, perfumes and toilet waters, golf balls,
video cameras for non-commercial application and cellphones are taxed at rates varying between 7% and
9% of the price. Motor vehicles are taxed using a graduated formula that distinguishes between vehicle type
and weight, and translates into a higher excise duty on high-priced (luxury) cars.
11.2.4 Direct and indirect taxes
Yet another distinction can be made between direct and indirect taxes. Direct taxes are imposed directly on
individuals and companies (for example, personal income tax and company tax). Indirect taxes are imposed
on commodities (for example, excise taxes and VAT). This distinction fundamentally revolves around the
issue of tax incidence (that is, the question of who really pays the tax). Tax incidence is a complex issue
and is analysed in Section 11.5. For the moment, it suffices to say that we simply cannot tell with certainty
in advance who is going to bear the burden.
From the perspective of tax shifting, direct taxes are defined as taxes that cannot be shifted readily.
They are collected from individuals, households or firms and allow for the possibility of adjusting the tax
according to the personal circumstances of the taxpayer (for example, the marital status, gender, size of
household or wealth status). These taxpayers are the intended bearers of the tax burden and it is assumed
that they pay the tax over to SARS. Nowadays, personal income tax is mostly deducted from employees’
salaries and paid over by employers. Nonetheless, the employer does not have complete information on
non-salary income (for example, donations, interest, rent or capital gains), and the individual is therefore
still responsible for the completeness and correctness of the tax assessment.
Indirect taxes are taxes that are imposed on commodities or market transactions and are likely to be
shifted. Examples are excise duties and fuel levies. It is also more difficult to adjust the tax rate to the
personal circumstances of the consumer. In the case of indirect taxes, it is often possible to shift the burden
of the tax to someone else. VAT is collected from merchants who, in turn, can pass on the tax to consumers
by way of a price increase. The consumer then indirectly bears the burden.
Although there are differences of opinion on the exact distinction between direct and indirect taxes, this
classification is widely used. The relative importance of direct versus indirect taxes is much debated,
internationally as well as in South Africa. In 1975/76, the ratio of direct to indirect taxes was 2,7, that is, for
each rand in indirect taxes collected, R2,70 was collected in direct taxes. In 2018/19, this ratio was 1,5,
which shows a clear shift in the direction of indirect taxes. These trends will be discussed in Section 16.5 of
Chapter 16 when the topic of tax reform is considered. The merits and demerits of indirect taxes will
receive attention in Chapter 16.
11.3 Properties of a ‘good’ tax

Tax systems evolve from time to time as new taxes are introduced and others are amended. The question is
whether these changes are good or bad. To evaluate these changes, we can use a list of criteria, some of
which date back to the maxims of taxation proposed by Adam Smith in 1776. A ‘good’ tax system must
first of all generate sufficient revenue to finance budgeted government expenditure. The other more
important criteria or properties of a ‘good’ tax system can be classified under four headings:
• Equity: Taxes should promote an equitable (or ‘fair’) distribution of income. Cognisance has to be taken
of the fact that the burden of taxes can be shifted. To determine fairness, the incidence of taxes,
therefore, has to be examined. These topics are covered in Section 11.5.
• Economic efficiency: All taxes impose a burden and most taxes affect the behaviour of taxpayers (in other
words, they cause an excess burden). Taxes should be designed in such a way that their distorting
effects on the choices made by taxpayers are minimised. This aspect is discussed in Section 12.1 of
Chapter 12.
• Administrative efficiency: Taxes are levied to yield sufficient revenue, but in order to be efficient,
administration and compliance costs have to be kept low. This calls for tax simplicity and certainty.
This topic is discussed in Section 12.3 of Chapter 12.
• Flexibility: As economic circumstances change, taxes and tax rates need to adjust. Taxes should therefore
be flexible enough to facilitate macroeconomic stability and economic development. This aspect is
discussed in Section 12.4 of Chapter 12.
11.4 Taxation and equity: Concepts of fairness
One of the most important judgements in tax analysis is whether or not the distributional impact of a tax is
equitable or fair. However, fairness is a subjective concept and, like beauty, it lies in the eye of the
beholder. Although fairness is a value-laden concept, economists can help to make informed value
judgements. In his first maxim of taxation, Adam Smith (1776), as quoted in Musgrave and Musgrave
(1989: 219), stated:
The subjects of every state ought to contribute towards the support of the government, as nearly as
possible, in proportion to their respective abilities; that is, in proportion to the revenue which they
respectively enjoy under the protection of the state.
This statement contains a tax equity principle that is still used in theory and practice to evaluate the fairness
of the impact (or incidence) of taxes, that is, the ability-to-pay principle. Another principle is based on
benefits received. We will first consider the benefit principle.
11.4.1 Benefit principle

The benefit principle stipulates that the tax burden of government expenditure be apportioned to taxpayers
in accordance with the benefits each receives. Consider the example of a bridge: the more an individual
uses the bridge, the more he or she will have to pay for this benefit. If the bridge is financed out of general
revenues instead of through a benefit tax (for example, a toll) levied on people using the bridge, those who
do not use the bridge will be in a worse position. It seems unfair to expect non-users also to pay for the
construction and maintenance of the bridge. Here we have an example of forced carrying: while free-
riding refers to someone failing to carry a proper tax burden, forced carrying refers to someone being made
to carry a heavier-than proper burden. It can also be argued that tax morality will be undermined if
taxpayers do not benefit from a tax system and that a democratic society will become intolerant of this type
of system in the long run.
A major advantage of the benefit principle is that it links the expenditure side of the government’s
budget to the revenue side. In this way, it serves to discipline or regulate government expenditure. A further
benefit is that the allocative procedures of market behaviour are approximated. Individuals can adjust their
consumption of services until price is equal to the marginal cost. In a voluntary exchange model, if the
price is higher than the marginal cost, society places a higher value on an additional unit of the service than
the resources required to provide the additional unit. In terms of Pareto-optimality conditions, society’s
welfare can then be improved by allocating more resources to the provision of the service, that is, at least
one person’s position can be improved without causing anyone else to be in a worse position. Benefit taxes
assume the role of prices and can therefore ensure that resources are efficiently allocated.
Unfortunately, the scope for applying the benefit principle to government funding is rather limited.
Governments generally provide goods and services that are public in nature. In other words, the benefits are
generally non-excludable (see Chapter 3). For example, how would one apportion the benefits of protection
(for example, policing) to different beneficiaries? There is no straightforward answer. Some people would
argue that the rich benefit most because they have so much to lose and that they therefore have to
contribute more. Others would argue that the poor are the most vulnerable (in other words, most in need of
protection) and that they thus have to pay more.
Another shortcoming of benefit taxes is that it takes the existing distribution of income and wealth for
granted. The effective demand for public goods and services is often determined by this distribution. If the
distribution is skewed towards the rich, the provision of public services might therefore be tailored largely
to their needs. The benefit approach can ideally only handle a tax-expenditure process that has no
redistributive objectives (that is, where redistribution is not a significant justification for the service being
provided). It cannot handle a tax-expenditure programme designed for redistributive purposes (for example,
taxes levied to finance transfer payments or expenditure programmes designed to benefit the poor rather
than the rich) or where it is administratively not feasible to exempt poor people from paying for the benefits
of a particular service (for example, a toll road). It would, for instance, be somewhat ridiculous if
pensioners had to bear the current taxes required to finance the transfers to themselves. The benefit
principle can therefore undermine redistributive objectives of government and result in conflicting
outcomes.
Benefit taxes (often referred to as user charges) are nevertheless levied in some cases, for example, tolls
for roads and bridges, admission charges to museums and parks, license fees, and (to a certain extent)
university tuition fees and school fees. Note that in the case of user charges, the link between the financing
of the use of the service and the benefit is reasonably direct.
The benefit approach may therefore be rationalised on the grounds of equity and efficiency. However, a
frequent criticism against user charges is that they may contradict the equity objective by preventing the
poor from using government-supplied services. For example, it is argued that education and publicly
supplied cultural and recreational facilities such as art galleries, museums and parks, often referred to as
merit goods, should be made available free of charge to all people, that is, financed from general revenue.
This will enable people who are unable to pay for the use of these facilities to enjoy them. A problem with
this approach is that the implicit subsidy that is involved when general financing is applied accrues to both
the rich and the poor. If the services are heavily used by the rich, the subsidy to the rich may be substantial.
To the extent that the poor contribute to general revenue, a part of the cost of the subsidy is borne by the
poor. In certain circumstances, general fund financing could even redistribute income from the poor to the
rich. This dilemma may be resolved by imposing a charge for the use of facilities, but offering special
reductions to targeted groups such as children, the elderly and so on.
Sometimes services are financed in such a way that the link is more indirect. This occurs when charges
are assigned (or dedicated) to special funds or accounts for financing services that are indirectly related to
the source of the funds. In these cases, the taxes are called earmarked taxes. Examples of earmarked taxes
are levies on the sale of fuel, social security taxes (for example, unemployment insurance contributions)
and skills development levies. Fuel levies at provincial level have been proposed in some provinces (for
example, the Western Cape) and are intended for maintenance of transport infrastructure. At the time of
writing, fuel levies consisted of a general levy of R3,52 per litre (in respect of 93 unleaded octane petrol),
the Road Accident Fund (RAF) levy of R1,98 per litre, a customs and excise levy of 4,0 cents per litre, and
a carbon tax of 9,0 cents per litre (effective from June 2019). Only the RAF has the character of an
earmarked tax since a portion of the general fuel levy finances general government expenditure and accrues
to the National Revenue Fund. Government decided to do this on the recommendation of the Katz
Commission (1995) that a portion of the general fuel levy should be allocated to the National Road Agency
for road construction and maintenance. The Skills Development Act (No. 97 of 1998) as amended (2003)
provides for a levy of 1% of payrolls aimed at, for example, developing the skills of the South African
workforce, improving productivity in the workplace, promoting self-employment, and increasing the levels
of investment in education and training in the labour market.
The shortcomings of the benefit principle generally apply to earmarked taxes as well. In addition,
earmarked taxes affect the procedural fairness of the budgetary process. Since earmarked funds have
assured sources of revenue, these funds need not compete with other departments for finance. In the case of
earmarked funds, accountability and the responsibility for efficient resource allocation are also shifted to
the managers of these funds. Earmarked taxes also complicate fiscal policy aimed at achieving
macroeconomic objectives. The Katz Commission (1995: 24) therefore recommended against a
proliferation of earmarked taxes (especially in respect of general tax revenue such as VAT, where the link
between benefits and costs is extremely vague).
11.4.2 Ability-to-pay principle

As already mentioned, the benefit principle cannot be applied to the financing of public goods and services
that are non-excludable. Public expenditures are predominantly of this type. Total cost of public
expenditure therefore has to be apportioned according to the ability of people to pay. In contrast with the
benefit principle, the application of the ability-to-pay principle implies that the tax problem is viewed
independently from the expenditure aspect.
The ability-to-pay principle calls for people with equal capacity to pay the same amount of tax
(horizontal equity) and for people with greater capacity to pay more (vertical equity). Horizontal equity
requires similar treatment of people in similar economic circumstances for tax purposes, while vertical
equity requires that individuals in different economic circumstances be treated differently.
The implementation of a tax system based on ability to pay requires public consensus on an appropriate
definition (in other words, measure, indicator, criterion or basis) of ability to pay. It also calls for consensus
on the rate structure. Income is generally regarded as one such measure or criterion. Other possible
measures include consumption, wealth and utility. Much of the discussion concerning the appropriate
measure or base is theoretical, but, in practice, income is commonly used.
However, income is by no means a perfect measure of a person’s ability to pay. Income measures
outcomes and does not necessarily reflect ability or capacity. Consider, for example, two people, Ms
Moleketi and Ms Pienaar, with similar economic circumstances and the same capacity to earn income. The
economic circumstances referred to here include gender, race, religion, marital status, level of education,
disability, number of dependants and so on. Ms Moleketi, however, is much more hardworking and works
ten hours a day at a rate of R50 per hour, compared to the five hours that Ms Pienaar works for the same
hourly pay. Ms Moleketi therefore earns R500 per day compared to Ms Pienaar’s R250. Using income as
the yardstick of ability to pay implies that Ms Moleketi has a greater ability to pay and that she should
therefore make a greater tax sacrifice. Is this fair? In this case, is the wage rate, instead of total wage
income, not a more appropriate measure of ability? Not surprisingly, the inclusion or exclusion of the
various possible determinants of economic circumstances in the search for an appropriate base for ability to
pay has been hotly debated.3
The appropriate measurement of horizontal and vertical equity is not only a complicated issue, but also
requires subjective evaluations. Economics alone cannot provide unambiguous answers to the measurement
of ability and the final decision therefore has to be taken via the political process.
Once the appropriate measure of ability to pay has been established, fairness suggests that people with
the same ability should pay the same amount of tax and people with different abilities should pay different
amounts. Suppose income is used to measure ability to pay. This still leaves the question of how to
determine the taxes payable by people with different incomes. For example, if person A’s income is double
that of person B, should person A pay exactly twice as much tax as person B? This relates to vertical equity
and is a rate structure issue. Various concepts involving sacrifice have been developed in an attempt to deal
with the problem of vertical equity.4
Suffice it to say that most countries try to deal with vertical equity by applying the progressive tax rule
to income (in other words, by taxing an increasing proportion of income as income increases). But this does
not solve the dilemma. To determine whether a tax is truly progressive, proportional or regressive, one
needs to know who really pays the tax. In other words, the impact of a tax on the distribution of income has
to be investigated. This is what tax incidence is all about.
11.5 Tax incidence: Partial equilibrium analysis

We noted that in order to understand whether a tax is fair or not, we need to know the ultimate incidence of
the tax. We first investigate the meaning of tax incidence and the shifting of the tax burden. Thereafter, the
impact of tax shifting on the tax burden is analysed using partial equilibrium analysis as well as a general
equilibrium framework.
11.5.1 Concepts of incidence

All taxes reduce the real disposable income of taxpayers. All taxes therefore involve a burden. At the outset,
it should be noted that only people bear the burden. Companies, for example, cannot bear the tax burden.
Only people (for example, shareholders, workers, landlords and consumers) bear the burden of taxation.
Exactly who ultimately bears the burden is a matter for theoretical discourse and empirical evidence. To
deal with this question, we first have to distinguish between the statutory (or legal) incidence of a tax and
its economic (or effective) incidence.
The statutory incidence refers to the legal liability to pay the tax over to the revenue authorities.
Economists are not really interested in who is legally obliged to make the tax payment to SARS. Since
taxes affect economic behaviour, economists are more concerned with who ultimately bears the tax burden,
that is, the economic incidence of the tax. For example, customs and excise taxes are levied on cigarettes.
At the time of writing, an importer of cigarettes had to pay a customs duty of R16,66 per twenty cigarettes
to SARS. However, the importer can shift the actual burden forward to retailers who, in turn, can pass on
the tax to the consumers (the smokers) in the form of higher prices. The tax burden can also be shifted
backward if, for example, the importer cuts back on staff or lowers real wages. In addition to tax shifting,
the tax can be avoided by cutting back on the taxed activity, that is, by reducing imports of cigarettes. What
we notice here is that the economic incidence issue is fundamentally about how taxes affect prices
(including wages).
Tax incidence studies may apply either a balanced-budget incidence methodology or a differential-
incidence methodology. According to the balanced-budget incidence approach, the overall distributional
effect of a tax and the spending financed by the tax is considered. Income taxes lower real disposable
income. At the same time, however, the income tax revenue is spent on education and other public services
that raise real disposable income (at least for those with school-going children). The advantage of the
balanced-budget incidence approach is that it relates the cost of spending programmes to those who pay for
it. The disadvantage is that, in reality, government uses a number of different taxes to finance expenditure.
Tax revenue is pooled in the national revenue account. Linking a particular expenditure item to a tax source
is almost impossible.
Since not all taxes are earmarked for a particular expenditure programme, the differential-tax incidence
approach comes in handy. The differential-tax incidence methodology considers the distributional impact
as one tax is substituted for another, holding total revenue and expenditure constant. The benchmark tax
often used for purposes of comparison is a lump-sum tax (for example, head tax), which does not affect
relative prices and hence economic behaviour. For example, suppose government replaced a lump sum tax
on all redheads with an excise tax on beer drinkers that yielded the same tax revenue. Assuming that
redheads were not beer drinkers, they would gain and beer drinkers would lose. Furthermore, the owners of
breweries and their employees would be affected by the tax. By comparing the total impact of the tax
change on the incomes of beer drinkers to those of redheads, we are engaging in differential-tax incidence
analysis.
Ultimately, the economic incidence of a tax depends on how the economy reacts to a tax change. The
response of the economy can be determined by tracing the effect of the tax on prices. Taxes change the
relative prices of goods and services. For example, if a R2,00 dairy levy on butter increases the price of
butter from R20,50 to R22,50 per 500 g while other prices remain unchanged, the relative price of butter
also increases. If it is assumed that the initial change in the price of butter does not have significant
repercussions on prices in other markets, tax incidence can be analysed in terms of a partial equilibrium
framework. In other words, we can then study the effect of the tax in a single market in isolation. In partial
equilibrium analysis, price and quantity in each market are determined by demand and supply, with the
assumption that other prices remain unchanged (in other words, the ceteris paribus assumption is used).
However, when a tax is imposed on one good, it usually means that the prices of other goods change as
well. For example, a levy on butter will affect the price of margarine, a substitute. After the imposition of
the levy, butter will be relatively more expensive and margarine will be relatively cheaper than before.
Consumers will therefore tend to substitute margarine for butter and the increased demand for margarine
will probably lead to a rise in the (absolute) price of margarine. This will leave margarine consumers with
less real disposable income than before. Once the secondary effects of a tax are taken into account, tax
incidence is studied in a general equilibrium framework.
Both partial and general equilibrium analyses can be used in incidence studies. Partial equilibrium
studies are less complex since all of the ramifications of a tax change are not considered. This form of
analysis is ideally suited to studying taxes levied on goods and services that are characterised by low
degrees of substitutability or complementarity. Where the secondary effects are considered to be small,
uncertain or spread thinly over a number of other markets, economists would argue that these can be
ignored and that the conclusions based on partial equilibrium analysis will not differ significantly from
those based on general equilibrium analysis. The general equilibrium framework, however, is more suitable
for studying the incidence of a general sales tax that is levied on a broad base or a levy on an important
product (such as fuel) that has important ramifications for the economy. Since general equilibrium analysis
considers relative price changes in more than one market, it is conceptually superior to partial equilibrium
analysis.
11.5.2 Partial equilibrium analysis of tax incidence

In this section, we analyse the incidence effect of taxes within a partial equilibrium framework. The ability
to shift the tax burden under partial equilibrium conditions depends on a number of factors, but we will
consider only two: market structure and price elasticity.
Two types of taxes are considered: a unit tax (in other words, a fixed amount per unit of a good or
service sold; see Section 11.2.3) and an ad valorem tax. We start by assuming that there is perfect
competition and that the tax is levied on an increasing-cost industry (in other words, the supply curve
slopes upward).
11.5.2.1 Incidence of a unit tax

In Figure 11.1(a), D0 is the demand curve and S0 is the supply curve for bread. The before-tax equilibrium
price is P0 and the equilibrium quantity is Q0. Suppose that an excise tax (a unit tax) of t per unit is imposed
on bread. The excise tax is a fixed amount per unit of the product. If the tax is collected from the seller (in
other words, the statutory burden is on the seller), it means that the minimum price at which firms will
supply the equilibrium quantity, Q0, is P0 1 t. Since the sellers are interested in the after-tax price, they will
try to recover the full tax amount at any given quantity. They will charge a higher price (the original price 1
the tax) at each output level. The supply curve therefore shifts up vertically by the tax amount to S1 (5 S0 1
t). Note that because it is a unit tax, S1 is parallel to S0. The new market equilibrium is at point A with price
Pm and quantity Q1. The market price, which is the price paid by buyers of bread, increases from P0 to Pm.
Sellers receive the after-tax price, Ps (that is, Pm 2 t).
What is the total tax revenue that accrues to government? The formula for total revenue is price
multiplied by quantity. Total tax revenue is the tax per unit t (5 PmPs 5 AC) multiplied by the number of
units sold, 0Q1 (5 PsC). Geometrically, the total revenue is represented by the rectangle PmACPs. The
important question now is: Who pays what part of the total tax amount? The answer to this question will
tell us what the economic incidence of a unit tax on consumption is.
Before the imposition of the tax, consumers paid a price P0 for the product. After the tax, they pay Pm.
Note that the price that buyers have to pay did not increase by the full amount of the tax (Pm minus P0 is
less than t or AB is less than AC). The total tax amount paid by consumers is equal to the rectangle PmABP0.
What about the sellers? The before-tax price received was P0. The after-tax price received by sellers is Ps,
which is less than P0. Producers therefore also pay part of the tax. The total tax amount paid by sellers is
equal to the rectangle P0BCPs. From this analysis, it is clear that the total tax burden is split between buyers
and sellers; that is, the tax incidence falls on both. Uninformed observers generally assume that sellers
simply pass on the total tax burden to consumers. Partial equilibrium analysis shows that this need not be
the case.
Would the result be any different had the statutory burden been on buyers (that is, the consumers)? The
answer is no. To show this, one must remember that the demand curve in our example indicates the
maximum price that consumers are willing to pay for each different quantity of bread. In Figure 11.1(b),
the before-tax equilibrium price is P0 and the equilibrium quantity is Q0. At the equilibrium quantity Q0, the
consumer is only willing to pay P0. If a tax of t [equal to the size of the tax in Figure 11.1(a)] is now
collected from the buyer instead of the seller for quantity Q0, the buyer will still only be willing to pay P0.
The price paid to the seller, however, will be reduced by the tax amount (P0 – t) that is paid over to SARS
by the buyer. This will hold for each point on the demand curve. In this case, therefore, the effective
demand curve (in other words, as perceived by the seller) shifts downward by the tax amount. The new
demand curve is D1 (5 D0 2 t). Since a unit tax of t is imposed, D1 is parallel to D0. The after-tax
equilibrium is at point C with price Ps and quantity Q1. While the original demand curve, D0, shows what
price buyers are willing to pay for each quantity, the demand curve D1 shows the price received by sellers
(that is, the after-tax price) for each quantity. Thus for quantity Q1, buyers are willing to pay Pm and sellers
receive Ps (5 Pm – t). The result is exactly the same as the result obtained when the tax was levied on
sellers: the tax incidence is on both buyers and sellers, and their burdens are exactly the same. The side of
the market on which the tax is imposed does not impact on the distribution of the tax burdens. What matters
is the tax wedge, which is the tax-induced difference between the price paid by the buyer and the price
received by the seller.
Figure 11.1 Incidence of a unit tax on consumption imposed on the supply side or the demand side
11.5.2.2 Incidence of an ad valorem tax

An ad valorem tax is levied as a percentage of the price of a good or service (see Section 11.2.3). We now
examine the imposition of an ad valorem tax, collected from the producers of DVD players, for example,
with the aid of Figure 11.2.
Figure 11.2 Incidence of an ad valorem tax

The most important difference between the analysis of an ad valorem tax and a unit tax is that the after-
tax supply curve swivels in the case of an ad valorem tax (compared to the parallel shift in the case of a unit
tax). Because the tax is proportional, the higher the price, the greater the amount of tax to be paid over by
producers (or the higher the after-tax price paid by consumers) will be. For example, at a price of R1 000
per DVD player and an ad valorem rate of 20%, the absolute amount of tax is R200 (5 3 1000) If the
price is R2 000, the absolute amount of tax is R400.5
Thus, when an after-tax supply curve such as S1 in Figure 11.2 is constructed, the vertical distance
between S1 and S0 (the before-tax supply curve) at a relatively high price such as Ph (5 DE) should be
greater than at a low price such as Pl (5 FG). The rest of the incidence analysis of an ad valorem tax is
similar to that of a unit tax. In Figure 11.2, the total tax burden of buyers is the rectangle PmABP0 and the
total tax burden of sellers is P0 BCPs. The ad valorem tax rate, expressed as the ratio of tax to the gross
price paid by the buyer, equals
11.5.2.3 Incidence and pure monopoly

Until now, we have investigated tax incidence under conditions of perfect competition. Pure monopoly is
another extreme form of market structure. It is often taken for granted that a monopolist, being a price-
maker, can always shift taxes forward in full. Under certain circumstances (for example, where a
monopolist is not maximising profit), this may indeed be the case; however, the conclusion does not
necessarily apply. Let’s consider the tax-shifting capacity of a profit-maximising monopolist.
A monopolist maximises profits where marginal cost (MC) equals marginal revenue (MR). In Figure
11.3, the before-tax equilibrium of the pure monopolist is at quantity Q0 and price P0. The before-tax profit
is the area P0 ABC. Assume that a unit tax on output is now imposed on the monopolist.
Figure 11.3 Incidence of a tax on a pure monopoly

A unit tax on the output of the monopolist will raise the average cost (AC) and the marginal cost of the
firm. The reason why both AC and MC increase is that the tax is levied on each unit produced and is
therefore viewed by the firm as a variable cost. In Figure 11.3, the average cost curve shifts from AC0 to
AC1 and the marginal cost curve from MC0 to MC1. Profits are now maximised at an output of Q1 and at
price P1. If you compare the before-tax equilibrium to the after-tax equilibrium, you will notice the
following:
• The after-tax price is higher and the quantity is lower than before the imposition of the tax, but the price
did not increase by the same amount as the tax. The increase in the price from P0 to P1 indicates the
extent of forward shifting.
• The after-tax profit (the rectangle P1FDE) is less than the before-tax profit (the rectangle P0ABC). The
pure monopolist therefore does not shift the tax burden fully.
Monopolists can also be taxed (at least in theory) on their economic profits. Economic profit (or excess
profit) is the difference between total revenue and total costs (in other words, both explicit and implicit
costs). Implicit costs include the opportunity costs of self-owned resources (that is, normal profit). The cost
curves in Figure 11.3 represent economic costs. In other words, if average revenue exceeds average cost,
economic (or excess) profits are earned. In Figure 11.3, the pure monopolist’s before-tax profit (area
P0ABC) is considered to be economic profit. A tax at a rate of t per cent on the monopolist’s profit of
P0ABC will simply reduce its economic profit by the tax amount. Neither the average nor the marginal cost
curves will be affected. The monopolist will maximise after-tax profit at the same before-tax level of output
and price. The tax is therefore borne fully by the owners of the firm. In these circumstances, the profits tax
cannot be shifted.6
11.5.2.4 Incidence and price elasticities of demand and supply

As mentioned at the beginning of Section 11.5.2, tax incidence is affected by market structure (for example,
perfect competition or pure monopoly) and price elasticities. When a tax is imposed, both the quantity
demanded and the quantity supplied at equilibrium decrease. The magnitude of the decrease depends on the
elasticity of demand and supply. Likewise, the impact on the tax burden and the relative tax shares of
buyers and sellers also depend on the price elasticities.
The importance of price elasticities in tax incidence analysis can be illustrated with the aid of diagrams.
We will first consider the effect of demand elasticities and then the effect of supply elasticities.
Figure 11.4 shows two demand curves, D0 and D1, and a supply curve, S0, all intersecting at X. The
before-tax equilibrium price (P0) is the same, irrespective of the demand curve used. The intersection of the
demand curves enables us to compare elasticity at this point. The demand curve D1 is more inelastic at any
price than the demand curve D0, that is, quantity demanded is less responsive (or sensitive) to price changes
in the case of D1. Suppose the taxed good is cigarettes. If a unit tax (t) is now imposed on the importer or
seller, the effective supply curve shifts upwards and to the left from S0 to S1 (where S1 5 S0 1 t). Let us
consider the relatively inelastic demand curve D1 first.
If the demand for cigarettes is represented by D1, the price charged to buyers increases from P0 to P1.
The price received by the seller (or importer) decreases from P0 to P2. The proportional price change for the
buyers therefore exceeds that of the sellers. The tax burden (P1CFP2) is divided between the portion borne
by the buyers (the area P1CDP0) and the portion borne by the sellers (the area P0DFP2). In the case of the
more elastic demand curve D0, the proportional price changes for buyers and sellers are approximately the
same in this example. The total tax burden of P3ABP4 is then divided between the buyers (the area P3AEP0)
and the sellers (the area P0EBP4). Thus, the more price inelastic the demand for a product is, the greater the
relative portion of the tax borne by buyers, ceteris paribus (sometimes referred to as the inverse elasticity
rule). Conversely, the more price elastic the demand for the product is, the greater the relative portion of
the tax borne by the sellers.
Figure 11.4 Tax incidence and price elasticity of demand
Remember that the flip-side of the tax burden for consumers and producers is government’s tax revenue.
Comparing demand curve D1 to D0, it is evident that the more price inelastic the demand curve is, the
greater the total tax revenue government collects is (P1CFP2 compared to P3ABP4).
We can also show that, ceteris paribus, the more price inelastic the supply of a product is, the greater the
relative portion of the tax borne by the sellers is. In Figure 11.5, we have two supply curves, S0 and S1,
intersecting a demand curve D0 at point X. The supply curve S1 is relatively more inelastic than the supply
curve S0. To simplify the analysis, suppose that the unit tax (t) on cigarettes is now imposed on buyers (in
other words, the statutory burden is on smokers). This means that the effective (after-tax) demand curve
shifts downwards to the left from D0 to D1 (where D1 5 D0 – t). Let us first analyse the shifting of the tax
burden in the case of price-inelastic supply S1. The new equilibrium quantity is Q1. The after-tax price paid
by smokers increases from P0 to P2, whereas the after-tax price received by sellers decreases from P0 to P1.
The proportional price change for sellers is greater than for buyers. Put differently, the share of sellers in
the total tax burden P2ACP1 is P0BCP1, which is greater than the share of buyers (that is, P2ABP0). By
contrast, in the case of the elastic supply curve S0, we notice that the proportional change in the after-tax
price of sellers is less than that of buyers. The new equilibrium quantity is Q2. The buyers pay a price (P4)
per unit and the sellers receive a price (P3) per unit. The portion of the total tax burden P4DFP3 borne by
the sellers (that is, P0EFP3) in the case of the elastic supply curve is less than the burden of the buyers (that
is, P4DEP0).
Figure 11.5 Tax incidence and price elasticity of supply
From our discussion of price elasticity so far, we can generalise by stating that the more inelastic the
demand and the more elastic the supply are, the easier it is to shift the burden of a tax forward through a
higher selling price. This conclusion is illustrated in Figures 11.4 and 11.5. By rotating the demand curve
D0 and the supply curve S0 around X in each case, we note that the buyer’s portion of the burden increases
as the demand curve becomes steeper (in other words, more inelastic) and the supply curve becomes flatter
(in other words, more elastic). In addition to the examples provided here, the extreme possibilities of
perfectly (in)elastic demand and perfectly (in)elastic supply also exist; however, we will not consider these
possibilities here.
Applying the theoretical discussion of tax incidence to, for example, taxing tobacco and alcohol
consumption as well as sugar sweetened beverages (SSBs) (so-called sin products) reveals some interesting
policy perspectives and dilemmas. There is some empirical evidence that the price elasticity of cigarette
demand ranges between –0,5 and –0,7 in South Africa (see Boshoff, 2008: 128–129). Consumption is thus
relatively price inelastic (it is less than 1 in absolute value) and the quantity demanded is not that
responsive to price (tax) changes (see demand curve D1 in Figure 11.4). A 10% increase in the price of
cigarettes will lead to a reduction in quantity demanded of only 5%. In South Africa a health promotion
levy, which taxes sugary beverages, was implemented from 1 April 2018. In support of the beneficial
effects of such a tax, a South African study used a price elasticity of –1,299 to show that a 10% increase in
the price of SSBs would reduce consumption by 13% and thus impact significantly on health outcomes
(e.g. obesity) (Manyema, Veerman, Chola, Tugendhaft, Sartorius, Labadarios & Hofman, 2014: 4).
Expectations regarding how high (or higher) excises on sin products will reduce consumption should not be
too optimistic. There are also other factors that impact on consumption, such as income (higher disposable
income leads to higher consumption) and people’s health awareness. Policy interventions such as
advertising, labelling and physician counselling improve people’s awareness of health risks and reduce
consumption. Higher cigarette prices also impact on the number of smokers who substitute illegal for legal
cigarettes. Similarly, higher taxes on SSBs may lead to higher consumption of substitutable sweetened
drinks such as coffee, tea and hot chocolate. Thus lower official consumption figures may not reflect the
full picture. To the extent that the calculation did not control for other factors, the price-elasticity
coefficients noted above may thus be overestimating the reduction in the number of smokers and obese
persons caused by higher excises.
Another interesting consideration when analysing excise taxes (sin taxes) imposed on sugar sweetened
beverages, cigarette and alcohol products is how these taxes may affect the welfare of, in particular, those
earning low incomes. In 2014/15 poor households spent approximately 1,5% of their total annual
expenditure on mineral waters, soft drinks, fruit and vegetable juices whereas the upper expenditure group
spent only 0,3% (StatsSA, 2017c: 111). The tax is clearly regressive from this perspective since the poor
spend a higher proportion of their expenditure on these goods.
We have noticed that the incidence of an excise on cigarette consumption is mainly on consumers (the
area P1CDP0 in Figure 11.4). This tax burden is distributed unevenly across households and categories of
users (for example, moderate drinkers versus abusers). Studies for the United States and the United
Kingdom have found that these taxes tend to be regressive. The tobacco and alcohol spending of the poor
as a percentage of total income is much higher than that of the rich. According to the Bureau of Market
Research (BMR), poor households in South Africa in 2017 spent 7,8% of total expenditure on alcoholic
beverages and tobacco, compared to 2,5% by the richest households (Bureau of Market Research, 2017).
Indirect taxes (excises) on these products will therefore be shared approximately in this proportion,
implying that taxes on sin products are regressive. Black (2008: 607–611) and Econex (2010: 7–38) also
argue eloquently that an excise tax on alcohol is a blunt instrument in addressing the negative external
effects of abusive (heavy) drinking. The Econex study (2010: 19) shows that the vast majority of
(moderate) drinkers pay 87% of the tax, yet contribute perhaps 20% to the externality. A better option
would be to target heavy drinkers directly by enforcing stiff penalties for drunken driving as well as
abusive and intrusive behaviour (see Section 3.7 of Chapter 3).
There is evidence that low- and middle income groups are more sensitive to price increases in tobacco
and alcohol goods than the high-income group. And if – as argued in Chapter 3 – many low-income
household budgets are controlled by males who are also addicted to nicotine and alcohol, an increase in
excise taxes may have perverse effects (see Black & Mohamed, 2006: 131–136 and Econex, 2010: 36–38).
Money may be diverted from the household budget to maintain the user’s level of addiction. He or she may
also substitute lower-quality sin goods (for example, cigarette butts and low-quality wine in foil bags or
home-brewed beer concoctions, which may be damaging to health) for high-quality ones. The negative
externality is actually aggravated. The potential for policy conflict is apparent; applying the inverse
elasticity rule (see Chapter 16, Section 16.2) to tobacco and alcohol consumption implies that tax revenue
objectives must be traded-off against reducing negative externalities, and ensuring that the burden is shared
fairly between the rich and poor, and abusers and non-abusers alike.
11.6 General equilibrium analysis of tax incidence

In Section 11.5, we distinguished between partial equilibrium analysis and general equilibrium analysis.
Partial equilibrium analysis examines a single market in isolation (in other words, on the basis of the ceteris
paribus assumption) and ignores the secondary effects of a price change. When the secondary effects of a
tax are taken into account, we are studying tax incidence within a general equilibrium framework.
Because general equilibrium analysis considers what happens in all markets simultaneously, modelling
tax incidence becomes rather complex. To make it more manageable, certain assumptions have to be
made.7
Assume that only two products are produced in the economy: shoes and reed baskets. There are two
factors of production, labour and capital, which are perfectly mobile between sectors. Both factors of
production are fixed in supply (in other words, the supply curves are vertical). Shoes are produced using a
capital–intensive technique (in other words, the capital–labour ratio is high), whereas reed baskets are
produced using a labour-intensive method (in other words, the capital–labour ratio is low). We will analyse
and compare the incidence of a tax on one product (that is, a selective tax) and the incidence of a tax on
both products (that is, a general tax). In Chapter 15, we will discuss a selective tax on one factor of
production (for example, land).
11.6.1 A selective tax on commodities

Suppose that a tax is imposed on shoes. The price of shoes increases relative to that of reed baskets.
Remember that the after-tax price does not necessarily increase by the full amount of the tax (in Figure
11.1, the tax was equal to AC, but the price increase was only AB). The price increase has two effects: one
is on the consumption (uses) side; the other is on the factors of production (sources) side.
On the uses side, the price increase of shoes (which is, of course, also a relative price increase) causes
consumers to demand fewer shoes (illustrated by a movement along the demand curve for shoes) and
demand more reed baskets. When the demand for reed baskets increases (illustrated by a shift of the
demand curve to the right), the price of reed baskets increases, ceteris paribus. The tax thus causes an
increase in the price of both products; that is, the tax burden (and incidence) is spread to the consumers
(and producers) of the non-taxed product as well.
On the sources side, the fact that the tax on shoes results in fewer shoes being demanded implies that
fewer shoes will need to be produced. When fewer shoes are produced, some of the capital and labour used
in the production process become redundant. But since shoes are produced using capital-intensive
technology, relatively more capital than labour is released into the market. The redundant labour and capital
must now find employment in the sector manufacturing reed baskets. Since the reed basket sector is a
labour-intensive sector (and technology is assumed to remain unchanged), all of the redundant capital
cannot be absorbed into the sector. The additional capital can only be absorbed if the capital–labour ratio
increases. But with capital in excess supply, its relative price will decrease, so that both sectors will end up
using more capital-intensive production techniques. Thus, in addition to the rise in the relative price of the
non-taxed commodity (reed baskets), a tax on shoes also causes the relative price of capital (that is, the
return on capital) to decrease. The burden of the tax is therefore also spread to the owners of the factor of
production used most intensively in the production of the taxed commodity.
11.6.2 A general tax on commodities

If a tax is imposed on shoes and reed baskets simultaneously at the same rate, the tax is a general one as
opposed to a selective tax. The general tax is equivalent to a tax on income (for example, a tax on capital
and labour at the same rate). The tax will be borne in proportion to the consumption (or income) of each
member of the economy. A general tax on commodities leaves relative prices unchanged (including the
relative price of leisure).8
11.7 Tax incidence and tax equity revisited

When we introduced the topic of tax shifting and tax incidence, we stated that most taxes alter the
distribution of income. To make inferences about the equity of a tax, it must be ascertained whether the tax
alters the distribution in a progressive, proportional or regressive way.
In Sections 11.5 and 11.6 we examined the question of who bears what part of the tax burden in the case
of consumption taxes in particular. If the economic burden of the tax is on buyers and the expenditure on
this good or service increases as individuals move up the income scale (in other words, if the demand is
relatively income elastic), the tax is progressive. Luxuries tend to fall into this category of goods and
services since individuals tend to spend more on luxuries as their income increases. In contrast, expenditure
on necessities tends to fall as total income rises (in other words, low-income earners spend proportionally
more on these goods and services than high-income earners). A tax on necessities that is shifted to buyers is
therefore regressive. A value-added tax or a general sales tax levied on a broad base will be regressive. The
reason is that consumption as a percentage of income decreases as individuals move up the income ladder.
High-income earners tend to save proportionally more, leaving them with a proportionally lower tax burden
than low-income earners (since saving is exempt from the tax).
When the tax is shifted to the seller, it also has distributional implications. If the seller has to bear the
tax, his or her real factor income (wage, rent, interest or profit) is reduced. Whether the tax is progressive or
regressive now depends on the factor income shares of the ‘sellers’ and their relative positions on the
income ladder. If the tax is shifted to unskilled workers who find themselves at the bottom end of the
income scale, the tax could be said to be regressive. On the other hand, if the tax is shifted to highly skilled
workers earning high incomes, the tax will be progressive.
To determine the final impact of a consumption tax on distribution, the effect on buyers and sellers
should be considered simultaneously. According to Musgrave and Musgrave (1989: 254), there is no
systematic relation between the distribution in consumption of a good and the distribution of the factor
income that the production of a good generates. They conclude that in the absence of evidence to the
contrary, the distribution of the tax burden is dominated by what happens to consumption (in other words,
the extent of tax shifting to buyers) since the initial impact is on the uses side.
The incidence of alternative taxes will be addressed when they are examined in later chapters. In
addition to the impact of individual taxes on distribution, we would also like to know the overall impact of
taxes on income distribution. This is a daunting task since we need to know the incidence of each tax
beforehand (see Box 11.2). Based on plausible assumptions about the shifting of different taxes, empirical
studies have found the tax structure of countries to be progressive for the low-income and high-income
groups, and regressive for the intermediate income groups.9 Similar results have been obtained for South
Africa.10
It seems that not much redistribution is taking place through the fiscal system from the tax side. This
conclusion has persuaded many economists to argue that if the objective is to improve the position of poor
people, it is best to pursue the objective through the expenditure side of the national budget rather than
through the tax system (see Section 16.5 of Chapter 16).
Box 11.2 Incidence of a tax on crayfish
There is some evidence that government has shifted its attitude regarding the taxation of luxury goods, as is evident
from the extension of excise duties to aircraft, helicopters, motorboats and sailboats in recent times (see National
Treasury, 2012: 58). In a very unequal society such as ours, a populist approach would be to stretch the tax net on
luxury goods even further. However, actions of this nature may have unintended consequences if the incidence
effects of taxes are not properly traced out. Determining the distributional impact requires a great deal of information
and data on the income and expenditure patterns of socio-economic groups. For most indirect taxes, the tax incidence
is also likely to remain uncertain. Usually researchers and policy-makers assume that excise taxes are shifted 100%
forward to consumers, but this is not the full story. Let us take a glance at a possible chain of events when a
hypothetical ad valorem excise duty is imposed on crayfish processing establishments (suppliers). This would, of
course, be in addition to the application fees, permit fees, licence fees and other fees that crayfish harvesting and
processing already attract. Crayfish (also known as West Coast Rock lobster) is usually served as an expensive dish at
seafood restaurants. A reasonable assumption for income and price elasticity of demand for crayfish would be that
they are greater than one (in other words, demand is fairly elastic). Since this delicacy is a luxury good, individuals
would be able to adjust their consumption quite easily as the (tax) price changes. Consumers will nevertheless have to
pay a higher price, while the suppliers will receive a lower after-tax price. From a vertical equity perspective the
higher price paid by consumers would be considered fair. After all, these consumers are mostly in the higher-income
groups. From the consumption side and based on income and expenditure patterns, the tax would thus be progressive.
However, owing to the relatively elastic demand for crayfish, suppliers will pay the larger share of the tax. How will
suppliers respond to the lower after-tax price and the decline in the quantity demanded? Owners of crayfish
processing facilities will surely take a knock (their return on capital decreases) in the short term. In the long run, they
will attempt to shift the burden to their employees by reducing employment numbers, offering lower wage increases
and/or paying lower prices to crayfish permit holders. These factors of production are mostly unskilled or semi-
skilled, earn low average wages and have been historically marginalised; the fish permit holders (or their employees)
are engaged in labour-intensive harvesting techniques and use their resources to ensure food and livelihood security
(see Department of Agriculture, Forestry & Fisheries, 2012; Mather, Britz, Hecht & Sauer, 2003). Some of the
retrenched workers may also try to find employment in other industries. Depending on the factor intensities in the
other industries, the job seekers may force wages down in these industries. As a result, all labourers will bear part of
the burden. It is thus conceivable that on the production side, the excise tax on crayfish will be regressive. The net
redistributional impact can only be established using quantitative analysis, but the chain of events shows the
complexity of designing equitable taxes.
Key concepts
• ability-to-pay principle (page 227)
• administrative fees (page 222)
• ad valorem tax (page 225)
• balanced-budget incidence approach (page 231)
• benefit principle (page 227)
• differential-tax incidence (page 231)
• direct tax (page 226)
• earmarked tax (page 229)
• economic incidence (page 231)
• forced carrying (page 227)
• general equilibrium framework (page 232)
• general tax or broad-based tax (page 225)
• horizontal equity (page 229)
• indirect tax (page 226)
• inflation tax (page 222)
• inverse elasticity rule (page 237)
• lump-sum tax or poll tax (page 223)
• partial equilibrium framework (page 232)
• progressive tax (page 224)
• proportional tax (page 224)
• regressive tax (page 224)
• selective tax or narrow-based tax (page 225)
• specific tax (page 225)
• statutory incidence (page 231)
• tax base (page 223)
• taxes (page 222)
• tax rate (page 224)
• tax rate structure (page 224)
• tax wedge (page 234)
• unit tax (page 225)
• user charges or benefit taxes (page 222)
• vertical equity (page 229)
SUMMARY
• The most important source of government revenue is taxation. In addition to taxation, there are user
charges (for example, tolls), administrative fees (for example, motor vehicle licences), borrowing and
inflation taxation.
• There are four tax bases on which taxes can be imposed: income (for example, personal income tax and
company tax), wealth (for example, tax on estates and gifts), consumption (for example, value-added
tax) and persons (for example, poll tax or lump-sum tax). The different bases can be taxed at different
rates. Depending on the relationship between the change in the average tax rate and the change in the
tax base, the tax structure can be described as regressive, progressive or proportional. Taxes can further
be classified as general or selective, unit or ad valorem and direct or indirect taxes.
• The properties of a ‘good’ tax are as follows: taxes must be fair (equitable) and non-distorting
(economically efficient), must yield sufficient revenue with low compliance cost (administrative
efficiency) and must adjust to economic circumstances (flexible).
• Taxes are equitable when they meet either the benefit principle of fairness or the ability-to-pay principle of
fairness, or both. The ability-to-pay principle requires that persons with the same capacity (or income)
be treated similarly (horizontal ability) and those with greater capacities should be pay more (vertical
ability).
• Since tax burdens can be shifted (forwards and backwards), the fairness of a tax can only be determined
once the economic incidence of the tax is known. Tax incidence is studied using partial or general
equilibrium analysis.
• Using a partial equilibrium framework, it can be shown that the incidence is determined by the type of tax
(unit tax or ad valorem tax), price elasticity and market structure. A unit tax would cause the after-tax
demand or supply curve to shift parallel to the original demand or supply curve, whereas an ad valorem
tax would cause the demand or supply curve to swivel. Under certain circumstances, a monopolist may
not be able to shift a tax in full. The extent to which consumers (buyers) and producers (sellers) share
the tax burden is dependent on the price elasticity of demand and supply. The more price elastic
demand is, the greater the share of producers; the more price inelastic supply is, the greater the relative
share of producers.
• General equilibrium analysis considers how taxes are shifted when relative prices change and impact on
both the consumption (uses) side of the market and the production (factor source) side of the market. A
selective tax causes a burden not only for the consumers of the taxed good, but also for the consumers
of nontaxed goods. In addition, the factors of production used most intensively in the production of the
taxed good also bear the burden of the tax.
11.1 A 14% tax on the price of cigarettes …
a. is a unit tax.
b. is a direct tax because it taxes the smoker directly.
c. would cause the after-tax supply curve of cigarettes to shift parallel to the original curve.
d. would result in the tax burden being borne mostly by the smokers themselves.
11.2 Which one of the following statements is correct?
a. National Defence should be funded using benefit taxes.
b. An excise tax of R50 is payable on DVD players priced at R500. The excise tax increases to R120
when the value of DVDs is R1 000. The tax rate structure is therefore progressive.
c. Mr Average earns R5 000 a month and Ms Hasarrived earns R100 000 a month. Each of them
purchases a digital camera valued at R1 000 and pays an import tax of R200. The tax rate
structure is therefore proportional.
d. A tax on luxury goods would be fair from a horizontal equity point of view.
11.3 Consider Figure 11.4. Which one of the following statements is correct?
a. When demand is relatively inelastic, the tax burden can easily be shifted to producers.
b. If the demand curve is D1, the total tax burden is P1CXFP2.
c. If the demand curve is D0, the tax share of the supplier is P0EBP4.
d. Because the tax was imposed on sellers, the demand curve shifted to the left.
e. If the demand curve is D0, the total tax revenue of government is obtained by multiplying the tax per
unit by the tax base, that is, P2P3 3 0Q2.
11.4 Assume our economy produces only two goods: wine and BMWs. Wine is produced using labour-
intensive technology and BMWs are produced using capital-intensive technology. An excise tax is
imposed on BMWs. Which of the following statements is or are correct?
a. The most appropriate analytical framework to use is partial equilibrium analysis.
b. The price of wine will increase.
c. More capital than labour will become redundant.
d. The incidence of the tax will be mainly on capital.
e. If an income tax had been imposed on labour and capital at the same rate, no tax shifting would have
occurred.
11.1 Distinguish between taxes and other sources of government revenue.
11.2 A R1 000 tax payable by all adults could be viewed as both a proportional tax and a regressive tax. Do
you agree? Explain.
11.3 Indicate whether the following taxes or levies are general or selective, specific or ad valorem, direct or
indirect. Explain your answer in each case.
• Personal income tax
• A 10% tax on DVD players
• Value-added tax
• R1,02 per litre levy on fuel
• A levy of R200 on all economics students.
11.4 ‘When taxes are evaluated, we need only be concerned with fairness.’ Do you agree? Discuss.
ESSAY QUESTIONS
11.1 Explain what is meant by tax equity. Discuss critically how applicable these fairness principles are to
financing toll roads.
11.2 By using the partial equilibrium framework, explain who bears the burden of an ad valorem tax levied
on buyers (in other words, consumers) if there is perfect competition and demand is relatively
inelastic.
11.3 ‘It is a misconception that a monopolist can simply pass on the burden of a tax on its product to
consumers.’ Discuss this statement.
11.4 The Minister of Finance wishes to reduce inequality and alcohol abuse by significantly increasing the
excise tax on spirits since it has a high price elasticity (e 5 21,5) and income elasticity (e . 1) of
demand. Using partial and general equilibrium analysis, advise the Minister on the revenue and equity
implications. What alternatives are there to raising the excise tax?
1 The reason for calculating this on a net basis is that South Africa collects trade-related taxes on behalf of the Southern African
Customs Union and thereafter pays over to the other member countries (Botswana, Lesotho, Eswatini and Namibia) their
formula-driven shares of the common customs union pool.
2 The most important assumptions are that the supplies of work effort and of savings remain unchanged (in other words, are
unaffected by the tax).
3 For a comprehensive debate on whether the individual or the household should be the taxable unit as well as the constitutional
implications of discrimination on the basis of gender and marital status in the South African tax system, see Margo Commission
(1987: 106–154) and Katz Commission (1994: 67–84).
4 For a discussion on using the sacrifice of utility as measure for determining ability to pay, see Musgrave (1959: 90–115).
5 The ad valorem tax can be levied as a percentage of the gross price (in other words, the price received by sellers). A 20% tax on
the gross price is equivalent to a 25% tax on the net price. If the buyer pays 20% on R1, the seller receives R0,80 (the net
price). The tax is R0,20. Twenty cents as a percentage of the gross price is 20% (5 3 100). As a ratio of the net price, it is
25% (5 3 100).
6 This conclusion holds only if the firm is maximising profit prior to the introduction of the tax on economic profits. In the case of
unrealised profits or non-profit maximising behaviour, tax shifting is possible.
7 This approach to tax incidence theory was pioneered by Harberger (1962). For a discussion of the extensions to and limitations of
the simplified model we are considering, consult Boadway and Wildasin (1984: 368–374).
8 This assumes that leisure can be taxed. The tax therefore cannot be shifted and consumers have to bear the entire burden.
9 For references, see Boadway and Wildasin (1984: 384–385).
10 See McGrath, Janisch and Horner (1997). In the same study, the authors calculated the tax share of the high-income group to be
75,7% of the total tax burden, compared to the tax share of the low-income group of 2,8%.
Tax efficiency, administrative efficiency and
flexibility
In Chapter 11, we identified a number of properties of a ‘good’ tax and considered the equity criterion in
some detail. Most taxes affect relative prices and consequently also the economic choices of participants in
economic activity. This chapter focuses on the impact of taxes on efficiency in the allocation of resources.
Because tax efficiency is handicapped by the fact that people do not like paying taxes, the issue of tax
compliance will be discussed. Since tax systems are continuously being adjusted in response to changing
economic and political influences, issues surrounding tax reform will be highlighted.
We begin this chapter (in Section 12.1) with an explanation of what the excess burden of a tax is, using
budget lines and indifference curves. The measurement of excess burden is discussed in Section 12.2 by
applying the consumer surplus approach. Once the impact of taxes on economic efficiency has been
analysed, we focus on the two remaining criteria for analysing taxes: administrative efficiency (Section
12.3) and tax flexibility (Section 12.4).
explain what is meant by tax efficiency
compare the excess burden of different taxes using indifference curves
determine the magnitude of excess burden using the consumer surplus concept
explain the meaning of administrative efficiency and how it can be achieved
show what is meant by tax evasion and how to reduce it
define tax flexibility.
12.1Excess burden of taxation: Indifference curve

analysis
All taxes place a burden on consumers, workers or producers. In addition to this direct burden, most taxes
cause a burden that is greater than what is necessary to generate a certain amount of tax revenue. This
additional burden is called the excess burden, welfare cost or deadweight loss of a tax. It measures the loss
in benefits (well-being) to consumers and producers that results when prices are distorted by a tax, and then
prevents the market for the taxed good from reaching equilibrium at the most efficient level. An example
will help to illustrate this concept.
We know from Chapter 2 that for a given set of relative prices, perfectly competitive markets will
allocate resources in a Pareto-efficient way. This means that the marginal rate of substitution (MRS) of,
say, (x) for (y) will be equal to the marginal rate of transformation (MRT) of x for y (MRSxy = MRTxy = ).
Furthermore, given this set of relative prices, we know that the consumption of x and y yields a certain
amount of consumer satisfaction (or a certain level of welfare). Suppose that a tax (t) is now levied on x.
The price of x becomes (1 + t)Px. Suppose also that the tax is such that the consumption of x becomes zero.
This is an extreme example of excess burden. If this is the case, no tax revenue will be forthcoming and
there will thus be no direct tax burden. However, there must be some burden since consumers can now
only enjoy y. Because the relative price ratio changed consumers reallocated their resources
(in other words, their after-tax income) towards y. The expenditure pattern moved away from what was
previously regarded as optimal and desired, and consumers therefore experience a welfare loss (or loss in
utility), even though there is no direct tax burden. On the production side, production of good x must be
discontinued and the resources used to produce it must be reallocated to producing more of good y. In
practice, workers will probably have to be reskilled and some may even lose their jobs if the technology
used in the production of y is less labour-intensive. In addition, machinery used in the production of x may
have to be moved to a different location and reprogrammed to produce more of y. These additional costs
are (deadweight) losses that result from the tax-induced price distortion.
Another example that is often cited to illustrate the effect of taxes on the behaviour of taxpayers is the
so-called window tax that was levied in England between 1695 and 1851. The tax was levied in proportion
to the number of windows in a house. It was obviously levied in order to generate revenue, but because the
wealthy, who had the largest houses, paid the most, it can be viewed as a form of wealth tax. However,
people do not like to pay taxes and some owners simply avoided the tax by bricking up some of their
windows. The loss in daylight that they had to endure (that is, the excess burden of the tax) has led some
people to believe that this is the origin of the phrase ‘daylight robbery’!
The theory of excess burden of different taxes can be explained using two approaches: the indifference
curve approach and the consumer surplus approach. The consumer surplus approach is useful for
measuring the excess burden and is discussed in Section 12.2. Here we focus on the indifference curve
approach, which is useful for comparing the price-distorting effects of different taxes. We first look at the
impact of tax-induced changes in relative prices on the welfare of a particular consumer. We then
distinguish between the impact of a general tax and that of a selective tax. For comparison purposes, we
use a lump-sum tax as our general or benchmark tax. We therefore evaluate the excess burden of a
selective tax by comparing its impact on welfare with that of a lump-sum tax.
12.1.1 Lump-sum taxes and general taxes

A lump-sum tax is a fixed amount of tax that an individual would pay in, for instance, a year, and is
independent of his or her income, wealth or consumption. Lump-sum taxes do not distort relative prices
and therefore do not affect people’s choices. For example, a person will not be able to avoid paying a
lump-sum tax by working shorter hours or by reducing his or her consumption of a particular commodity.
Put differently, a lump-sum tax does not cause a substitution effect. It reduces the taxpayer’s disposable
income and thus has an income effect only. Because relative prices are not distorted, lump-sum taxes have
no excess burden. A head tax, levied on each member of society or on all breadwinners, is an example of a
lump-sum tax.
Lump-sum taxes have one major disadvantage. Since the tax as a percentage of income (in other words,
the average tax rate) decreases as income increases, lump-sum taxes are regressive. They therefore leave
the after-tax distribution of income more unequal than the before-tax distribution. For most policy-makers,
the price tag of this trade-off between equity and efficiency is simply too high. The perceived unfairness of
the poll tax (a prime example of a lump-sum tax), introduced by the Thatcher government in Britain in
1990, is widely regarded as one of the factors that led to Thatcher’s downfall later that year.
A head tax is not an unfamiliar tax in Africa. An early version of a head tax in South Africa can be
found in the Glen Gray Act (No. 25 of 1894). This tax generated insignificant tax revenue (R9 million, or
approximately 0,1% of total tax revenue in 1978/79) and was abolished in 1978/79, the year in which
general sales tax (GST) was introduced.
The effects of a lump-sum tax are illustrated in Figure 12.1. Good X is measured horizontally and Y is
measured vertically. The before-tax budget line is AB. The consumer is initially in equilibrium at point E0,
where the indifference curve U0 is tangent to (in other words, it touches) the budget line. A lump-sum tax is
introduced that lowers the income of the consumer and causes the budget line to shift from AB to CD. The
lump-sum tax yields revenue equal to AC if measured in terms of Y or DB if measured in terms of X. Note
that the after-tax budget line, CD, is parallel to AB since relative prices are unchanged. The consumer is
now in equilibrium at E1, where fewer of X and fewer of Y are consumed than before.
Note that the consumer is in a worse position after the tax since consumption is on a lower indifference
curve, U1. This is as a result of the normal burden of the tax. The condition for Pareto optimality has not
been disturbed (MRSxy = ) and resources are allocated efficiently at the new after-tax income level. A
lump-sum tax thus causes a normal burden, but it has no excess burden.
In Section 11.2.2 of Chapter 11, a general tax was defined as one that taxes the entire tax base and
allows for no exemptions. If a general tax is imposed at the same rate on Y and X, and it is assumed that
these are the only products produced in the economy (and leisure is ignored), the budget line in Figure 12.1
shifts from AB to CD. Equilibrium is again at E1. Tax revenue equals AC. A general tax does not distort
relative prices. This means that the aftertax price ratio is the same as the before-tax price ratio .
The condition for a Pareto-efficient allocation of resources in the economy is therefore not distorted [MRSxy
= MRTxy = ].
General taxes resemble lump-sum taxes and do not have excess burdens. These taxes have the added
advantage that, from a practical point of view, general taxes at uniform rates are easy to administer.
However, as in the case of lump-sum taxes, the disadvantage of a general tax is that it ignores distributional
implications. We will also note later (Section 12.2.2) that a general indirect tax contradicts the inverse
elasticity rule of allocative efficiency.
Figure 12.1 The excess burden of a tax using indifference curves

12.1.2 Selective taxes
In contrast to a lump-sum tax, a selective tax is one that taxes only a part of the general tax base. Suppose a
selective tax is now imposed on X. To analyse its welfare implications, we compare the impact of the
selective tax to that of a lump-sum tax that generates the same tax revenue (that is, AC) in Figure 12.1. We
know that a selective tax on X will increase the price of X and leave the price of Y unchanged. If the
consumer spends his or her entire budget on X, fewer of X can be obtained after the tax than before the tax.
If the consumer spends his or her entire budget on Y, the same amount of Y can still be purchased (because
the price of Y has remained unchanged). The budget line showing combinations of Y and X will, therefore,
swivel inward (or pivot around point A). To obtain the after-tax budget line, which yields the same tax
revenue as the lump-sum tax, we must find an equilibrium point that is also on budget line CD. A budget
line therefore has to be drawn through A in such a way that it is tangent to an indifference curve at its point
of intersection with CD. In Figure 12.1, budget line AF is a budget line of this nature.
A selective tax on X that yields the same revenue as the lump-sum tax (that is, E2G = AC) will cause the
budget line AB to pivot (or swivel) to AF. Equilibrium is at E2 on indifference curve U2. This is an
important observation. Compared to the lump-sum tax, consumer welfare is lower (indifference curve U2 is
lower than U1). The difference in welfare indicates the welfare cost or excess burden of a selective tax.
Selective taxes distort relative prices and cause an excess burden. In terms of Pareto optimality, the
equilibrium condition for consumers is now where the marginal rate of substitution of X for Y (MRSxy) is
equal to the after-tax price ratio [ ]. Assuming that producers shift the full burden of the tax to
consumers, the equilibrium condition for producers is where the marginal rate of transformation of X for Y
(MRTxy) is equal to the before-tax price ratio ( ). The price ratios for consumers and producers thus differ
and, as relative prices are distorted by the selective tax, resources are allocated inefficiently in the economy
(MRSxy ≠ MRTxy).
12.1.3 Tax neutrality

Economic efficiency is considered to be one of the properties of a ‘good’ tax. Efficient taxes are taxes that
minimise the distorting effect on the choices of decision-makers. In other words, taxes are considered
efficient when the excess burden is as small as possible. This brings us to the concept of tax neutrality.
The tax neutrality concept must be understood in its traditional, narrow context and also in its wider,
modern context. The traditional, narrow neutrality concept is mainly concerned with allocation, the idea
being that taxes should not prevent consumers from maximising utility or producers from maximising
profit; in other words, taxes should be neutral. The tax should have little or no impact on economic
decisions about what to buy, how much to invest or save and how many hours to work. This view of
neutrality rests on the assumption that resources in the economy are allocated optimally, and that non-
neutral taxes would result in a reallocation and therefore a non-optimal allocation. A broader view of tax
efficiency, however, also takes account of market imperfections.1
In reality, the market economy is imperfect (meaning that it is inefficient and inequitable), and
optimality is the exception rather than the rule. Hence non-neutral taxes may be beneficial or harmful,
depending on whether they steer the economy in the direction of optimality or away from optimality. These
two possibilities are called the positive non-neutral effect and the negative non-neutral effect
respectively.
A selective tax is clearly non-neutral as it disturbs relative prices. Economic choices are affected and,
according to the traditional view, selective taxes are therefore inefficient. According to the modern
approach, however, a selective tax can move the economy in the direction of optimality, which amounts to
positive non-neutral action. In contrast, a general tax such as a head tax is a neutral tax and does not
influence allocation decisions. From the modern perspective, a general tax may well perpetuate existing
distortions in the economy or perpetuate a socially unacceptable income distribution, which implies that
tax non-neutralities can sometimes improve allocative efficiency. Examples include levying taxes to
correct for negative externalities and taxing sumptuary consumption (for example, excises on cigarettes
and liquor).
The term ‘optimal taxation’ is derived from efforts to design tax systems to improve efficiency
(minimise excess burden) and to achieve a more socially equitable distribution of income (maximise social
welfare). In the sections that follow, we will touch upon some of the tax optimisation rules to minimise
excess burden (for example, the inverse elasticity rule; see Section 12.2.2). Related to the theory of optimal
taxation is the theory of second best. We saw in Chapter 2 and subsequent chapters that the market
sometimes fails owing to certain inefficiencies (or distortions). The theory of second best is concerned with
designing government policy (and therefore tax systems) in situations where some inefficiencies cannot be
removed. More accurately, the theory of second best states that whenever there are distortions in several
markets, removing one may not necessarily improve matters. In fact, it may introduce other distortions and,
in general, may result in a lower level of welfare for consumers (see Lipsey & Chrystal, 1995: 414–415).
12.2 Excess burden: Consumer surplus approach

We have made some progress in comparing different taxes in terms of their excess burdens. Selective taxes
cause an excess burden, whereas general taxes do not. Using the indifference curve approach, we have
shown that, compared to a selective tax, the same tax revenue can be obtained by levying a general tax or a
lump-sum tax, which leaves the consumer better off. We now wish to measure the change in consumer
welfare and investigate the factors that determine the magnitude of the excess burden.
12.2.1 The magnitude of excess burden

In this section, we follow the consumer surplus approach in order to measure the excess burden of a tax.
To enable measurement, we employ a partial equilibrium framework and focus on the burden of a unit tax
on a particular commodity or output of an industry. Suppose the commodity is grams of butter. We can
simplify the example by assuming that supply is produced under constant-cost conditions (in other words,
the supply curve is horizontal). Furthermore, we use standard demand curves. Although it is theoretically
more correct to use compensated demand curves2 to calculate the excess burden, we use standard demand
curves. Ignoring this subtlety will not affect our analysis significantly.
In Figure 12.2, the demand curve for butter is shown as D0 and the supply curve is S0. The equilibrium
price is Pb and the equilibrium quantity is Q0. We now have to introduce the consumer surplus. You will
recall that the demand curve indicates what consumers are willing to pay for different quantities. However,
once the market price is determined, it applies to all consumers. The difference between what different
consumers are willing to pay for a good and what they actually pay is the consumer surplus. This is
represented by the area under the demand curve and above the price line. The consumer surplus measures
the rand value of consumer welfare at different quantities.3 In Figure 12.2, the consumer surplus is ACE.
Suppose a selective tax (t) is levied on the producers of butter that increases the price of butter to (1 +
t)Pb. The supply curve S0 shifts upwards and parallel to S1. The equilibrium quantity of butter decreases
from Q0 to Q1 and the consumer surplus is reduced from ACE to ABF. The loss in consumer surplus is the
trapezoid FBCE. But this is not the total welfare cost (or loss) to the consumer. The tax revenue is the tax
per unit (tPb) multiplied by the quantity of butter purchased (Q1) (in symbols, FE × 0Q1 = FBDE). The tax
on butter therefore yields revenue equal to the area FBDE. If government, which after all spends the tax
revenue, were to return this amount of tax to consumers as a lump sum, the consumers would be worse off
by the triangle BCD (that is, FBCE – FBDE). The triangle is the welfare loss or excess burden of the
selective tax on butter. In other words, the tax causes a reallocation of resources (less butter and more other
goods are produced than without the tax). The triangle measures the welfare loss caused by this
misallocation of resources.4
Figure 12.2 The magnitude of the excess burden of a tax on a constant-cost industry
The size of the triangle (that is, the excess burden) is determined by the price elasticities of demand and
supply, as well as the tax rate. These determinants are discussed below.
The magnitude of the excess burden can be measured using simple algebra. We know that the formula
for the area of a triangle is one-half the base multiplied by the height. In Figure 12.2, the excess burden can
therefore be expressed as
where Eb is the excess burden (area BCD), tP is the ad valorem tax (= BD) and ΔQ is the decrease in
quantity demanded (= DC). This formula can be refined by also considering two other determinants of the
excess burden: price elasticities and the tax rate.
12.2.2 Price elasticities

Price elasticity of demand indicates how sensitive the demanded quantity is to a price change, while price
elasticity of supply indicates the same sensitivity in respect of the supplied quantity. If demand is inelastic,
buyers will tend not to adjust their quantities demanded by much if the price changes. In other words, they
are insensitive to price changes. If demand is elastic, buyers will tend to adjust their quantities demanded
significantly if the price changes. In other words, they are sensitive to price changes.
What is the impact of price elasticity of demand on excess burden? Figure 12.3 is almost the same as
Figure 12.2. The only difference is that in Figure 12.3, we compare the impact of a selective tax on butter
for two cases of demand. In one case, the demand curve (D1) is relatively inelastic. In the other case, the
demand curve (D0) is relatively elastic. The before-tax quantity (Q0) and the price (Pb) are the same in both
cases. A selective tax (t) causes the supply curve to shift upwards from S0 to S1. In the case of demand
curve D0, the equilibrium quantity decreases to Q1. With demand curve D1, the equilibrium quantity
decreases to Q2, indicating that the quantity demanded is less sensitive to the imposition of the tax than in
the case of D0. Comparing excess burdens, we notice that for demand curve D0, the excess burden is BCD
(the same as in Figure 12.2) and for demand curve D1, the excess burden is GCH. This illustrates that the
welfare cost of a given tax is less where the demand for a good is relatively inelastic. In other words, the
more elastic the demand is, the greater the excess burden (or welfare cost).
Figure 12.3 also illustrates how price elasticities impact on the amount of tax revenue that can be
collected from a tax. Consider first the relatively elastic demand curve D0. The tax revenue is the tax per
unit (tPb) multiplied by the quantity of butter purchased (Q1) (in other words, FE × 0Q1 = FBDE). With the
more inelastic demand curve D1, the tax revenue is clearly much greater (in other words, FE × 0Q2 =
FGHE). From a revenue perspective, it would make perfect sense for tax authorities to levy taxes on
commodities for which demand is relatively inelastic. The implications are that it is more efficient from an
economic efficiency point of view (that is, low excess burden) and tax revenue perspective (that is, high
tax revenue) to levy taxes on price-inelastic commodities than on price-elastic commodities. Commodity
taxes should thus be high on inelastic goods and services, and low on goods and services with high demand
elasticities. This tax rule, commonly referred to as the inverse elasticity rule, is attributed to Frank
Ramsey (1927). A further implication of this tax rule is that uniform tax rates are not necessarily efficient,
since the higher the price elasticity of demand of good X relative to that of good Y is, the lower the tax rate
on X should be relative to that on Y.
Applying the Ramsey rule to the design of taxes leads to interesting results. Luxury goods and services
typically have high price elasticities since the possibilities for product substitution are greater. Consumer
products with high elasticity coefficients include marijuana (–1,50), transatlantic travel (–1,30), restaurant
meals (–2,27), lamb and mutton (–2,65), and motor vehicles (–1,20). Necessities have lower elasticity
coefficients, for example, food (–0,21), bread (–0,15), petrol (–0,60) and medical services (–0,18) (see
Nicholson & Snyder, 2010: 131; McConnell & Brue, 2005: 363 for a list of price and income elasticities
for the United States). The price elasticity of demand for necessities tends to be low compared to luxury
goods. In Section 11.5.2 of Chapter 11, we noticed that the price elasticity of cigarette demand ranges
between –0,5 and –0,7 in South Africa. A non-smoker would hardly consider cigarettes necessities, but this
would not surprise a smoker. The low coefficients are inter alia indicative of the addictive nature of
nicotine. The elasticity tax rule implies that a high tax rate on, for example, bread or insulin, would be
efficient (the excess burden is small and the tax revenue would be high). However, distributional
implications are ignored in arriving at these conclusions. Expenditure on bread constitutes a major
proportion of the income of poor people. The tax is therefore regressive and inequitable. Diabetics depend
on insulin to keep them alive and would probably pay anything to obtain it. Few would disagree that it
would be very unfair to apply optimal taxation rules to this product. Tax design often calls for a trade-off
between equity and efficiency.
Figure 12.3 The effect of demand elasticity on excess burden

The effect of elasticity on the magnitude of the excess burden can be expressed in mathematical terms.
In Equation [12.1], the term ΔQ depends on the price elasticity of demand (ε), which is defined as follows:
which can be expressed as
The change in price caused by the tax (ΔP) is equal to the value of the selective tax (that is, tP). The
right side of Equation [12.3] can therefore be rewritten as . By substituting this expression for ΔQ
in Equation [12.1], we obtain the following:
Equation [12.4] tells us three things. Firstly, the value of ε indicates the importance of price elasticities of
demand. If the value is low (demand is price inelastic), it means that the excess burden will be small, and
vice versa. Secondly, PQ is the amount spent on butter before the tax. In our equation, it means that the
higher this original amount spent is, the greater the excess burden. Finally, we notice that the excess burden
is a function of the tax rate. We focus on this finding in the next section.
Figure 12.4 The effect of tax rates on excess burden
12.2.3 The tax rate

The magnitude of the excess burden also depends on the tax rate. As the tax rate increases, the excess
burden increases by a multiple of the tax rate.
In Figure 12.4, the initial equilibrium is at price Pb and quantity Q0. The commodity, butter, is produced
under constant-cost conditions. If a selective tax of t2 is levied on butter, the after-tax price is (1 + t2)Pb and
the equilibrium quantity decreases to Q2. The excess burden is the triangle ACH. The tax revenue is the
area GAHE. Suppose that the tax rate is halved to t1. The new equilibrium price is (1 + t1)Pb and the
equilibrium quantity is Q1. Tax revenue is now equal to the area FBDE. The excess burden is now the
triangle BCD. We notice that although the tax rate was halved, tax revenue did not halve. More
importantly, the excess burden fell by about three-quarters. This can easily be confirmed geometrically by
decomposing the triangle ACH into four smaller triangles of equal size: ABK, KBH, BDH and BCD.
We can conclude that low tax rates on a large number of commodities will produce smaller excess
burdens (and more tax revenue) than high tax rates on a few commodities that yield the same total revenue.
This analysis therefore suggests that broad-based taxes such as VAT and income taxes are more efficient
than narrow-based selective taxes.
Excess burdens are real and, according to some estimates, quite significant (see below). Knowing the
excess burdens of different taxes is useful in designing taxes. If, for example, an ad valorem tax of 30% is
levied on a good of which the price elasticity of demand is equal to one and total expenditure on the good
is R200 million, it can be shown (using Equation [12.4]) that the excess burden will be R9 million (that is,
15% of the tax revenue). Put differently, if the excess burden is expressed per rand of tax revenue, the
efficiency–loss ratio of the tax can be calculated (in other words, excess burden ÷ tax revenue). Given tax
revenue of R60 million from the ad valorem tax, the efficiency–loss ratio is 0,15. This means that for each
rand raised in taxes, the deadweight loss (excess burden) is 15 cents. By comparing the efficiency–loss
ratios of different taxes, tax designers can attempt to minimise the total excess burden of the tax system.
Overall economic efficiency can be improved by reducing taxes on goods and services with high
efficiency–loss ratios, and increasing taxes on goods and services with low efficiency–loss ratios.
Excess burden calculations are subject to theoretical and empirical limitations. When excess burdens are
estimated, compensated demand and supply curves should be used. Using standard demand and supply
curves overestimates the excess burden. The problems associated with attempts to make the concept
operational are illustrated by its absence in public budgets. The excess burden costs of taxes are not
recorded as expenditure items in public budgets. Given an uncompensated demand elasticity of –0,75 for
alcohol and assuming constant costs, Econex (2010: 11) estimates the total current value for the excess
burden to be R881,0 million (figures for 2009). Of this amount, 87,26%, or R769,0 million, is carried by
moderate drinkers. The estimated excess burden for alcohol may be lower or higher, depending on the size
of the income effect and the possible loss in producer surplus if increasing costs are assumed (the supply
curve is upward sloping). For the United States, it was estimated that for each $1,00 of tax revenue raised
in the personal income tax system in 1994, the additional loss in net benefits (excess burden or deadweight
loss) was $1,65 (Feldstein, 1997). The loss is attributed to the impact of the tax-induced distortion on
labour participation rates and hours as well as the effect on investment in education, occupational choice,
effort, location, more attractive fringe benefits, nicer working conditions and all of the other aspects of
behaviour that affect the short-run and long-run productivity and income of the individual.
12.3 Administrative efficiency

The excess burden is not the only cost of a tax. Taxes have to be administered and this generates costs. In
2016/17, the estimated expenditure by the South African Revenue Service (SARS) amounted to R10 795
million, which was approximately 0,89% of total tax revenue collected (South African Revenue Service,
2018: 53). In addition to administration costs borne by government and, ultimately, taxpayers, individual
taxpayers incur costs (called compliance costs) in order to meet their tax obligations. These include the
cost of time spent filling in tax returns as well as the cost of employing tax specialists (accountants and
lawyers). When taxes are designed, these costs must also be considered. There is some evidence that the
compliance costs are significantly greater than the administrative costs incurred by government. For
example, Slemrod and Sorum (1984) estimated compliance cost in the United States at between 5 and 7%
of revenue collected from income taxes. In New Zealand, Sandford and Hasseldine (1992) estimated
compliance costs at approximately 2,5% of GDP.
Administrative efficiency entails minimising both administration costs and compliance costs. Two
phenomena are related to these costs: tax avoidance and tax evasion. Tax avoidance is perfectly legal and
includes the actions by taxpayers to take advantage of special provisions (tax loopholes) in the tax code so
that their tax liability is reduced. Although tax avoidance is legal, it is wasteful in the sense that taxpayers
make choices on the basis of tax considerations rather than economic considerations, that is, it entails high
opportunity costs. Avoidance practices often arise from errors or loosely drafted tax legislation. Exploiting
these loopholes through careful tax planning is therefore not in the ‘spirit of the law’. An example is where
a business is split up into smaller units to take advantage of the graduated company tax rate for small
businesses.
Tax evasion is illegal and consists of actions that contravene tax laws. The most common forms of
evasion are not registering as a taxpayer, underreporting of income and claiming more deductions than
warranted. Tax evasion is quite prevalent in the informal sector (also called the unrecorded sector) and is
characterised by cash transactions that are difficult to trace.
To get a clearer understanding of the actions that can be taken to reduce tax cheating, we need to know
the extent of tax evasion, the reasons why taxpayers engage in evasion practices and what the optimal level
of tax evasion is from the perspective of the cheating taxpayer.
In some countries, tax evasion is said to have become a national pastime. South Africa is not untouched
by taxpayers’ attempts to reduce their tax burden. The extent of tax evasion can be measured by
considering the tax gap, which is the difference between the tax liability declared to tax authorities (the
actual revenue collected) and the tax base calculated from other sources (the expected tax revenue in
accordance with tax legislation). Knowing the size of the tax gap is important as a performance measure
for the revenue authorities, and helps them to identify problems with tax legislation, national statistics and
what the impact of the informal sector is on tax revenue. Various attempts have been made by countries to
estimate the gap for different taxes and the total tax gap, but it remains a difficult task to quantify the gap
accurately (see McManus & Warren, 2006: 77–79 for examples of tax gap studies). The Margo
Commission (1987: 406) and the Katz Commission (1994: 62) refer to tax gap studies that indicate that the
gap is in the order of 10% for developed countries and an average of 33% for developing countries. The
Katz Commission (1994: 66) guesstimated the tax gap in South Africa to be around 20% of actual
collections. If this figure is accurate, it would have amounted to approximately R232 billion in lost tax
revenue in 2017/18. In 2015 the International Monetary Fund estimated the value added tax (VAT) tax gap
for South Africa, a task commissioned by the Davis Tax Committee5. The main findings revealed a
compliance gap ranging between 5% and 10% of potential VAT revenues for the period 2007 to 2012
(IMF, 2015a: 5).6 The VAT policy gap was estimated to be low compared to international standards, due to
an efficient VAT policy structure (IMF, 2015a: 6). Another indicator of tax evasion and avoidance is the
difference between persons who have chosen to register for personal income tax purposes and the number
of persons employed (that is, the potential tax base). In 2017, there were approximately 22,4 million
employed and unemployed workers, but only 4,9 million were assessed as individual taxpayers. We return
to this aspect in Chapter 13 when we look at the personal income tax base.
Various factors contribute to the tax gap, including tax illiteracy, cultural attitudes, the level of tax
morality and deficient tax legislation. Oberholzer (2008) studied the differing perceptions about taxation
that result from people’s cultural, political and social backgrounds. All of the respondents in his study were
of the opinion that waste and corruption in government were high, and almost 80% felt that taxes were
used by government for meaningless purposes. This of course affects taxpayers’ willingness to pay taxes
(that is, their tax morality). At local government level, similar problems apply. Fjeldstad (2004) argues
that an explanation for non-payment is that non-compliance is caused by poverty (in other words, an
inability to pay) and the existence of a so-called culture of entitlement. In addition, the paper argues that
non-payment is related to whether or not citizens trust the local government to act in their interest. Trust
has three dimensions: the local authority will use tax revenues to provide the expected services; the
authorities will apply fair procedures in collecting tax; and other citizens will pay their share. In other
words, taxpayers want value for their money and taxes must be fair from a horizontal and vertical equity
point of view. Suffice to say there are psychological reasons and economic reasons for tax evasion (see
Gcabo & Robinson, 2007). In this section we focus primarily on the economic reasoning behind tax
evasion and what the optimal level of tax evasion is.
Neoclassical economic theory considers decision-makers as rational beings who attempt to maximise
their expected income and utility. Note that deciding how much to evade implies that the taxpayer has
already made up his or her mind about the morality of tax evasion (that is, the taxpayer acts illegally). We
can then employ an ordinary demand-and-supply framework to answer the ‘how much’ question. Tax
evasion generates benefits and costs. If we assume a progressive income tax structure, the marginal
benefits from evading an extra rand’s income decline as evasion increases. The individual faces lower tax
brackets and thus lower taxes. For example, if the marginal tax rate is 35%, the tax liability for the extra
rand not reported is reduced by R0,35. This is the marginal benefit received by the taxpayer. If more tax is
evaded, the marginal tax rate may be reduced to, say, 18% (because taxable income becomes less),
translating into a tax liability of only R0,18 for the extra rand evaded. Of course, when no taxable income
is reported, the marginal tax rate becomes zero. We can plot this relationship in Figure 12.5(a) as a
downward-sloping marginal benefit (MB) curve. A marginal benefit curve can also be interpreted as a
demand curve for underreported income (D0).
When evading taxes, the taxpayer runs the risk of being caught and penalised. Marginal costs of
evasion, therefore, increase as evasion increases. This can be plotted as a marginal cost (MC) curve or a
supply curve for underreported income that increases from left to right (S0). To complete the picture, we
consider both the marginal benefits and the marginal costs of evasion in Figure 12.5(a). Equilibrium (E0) is
where MC = MB. At this point, the optimal level of underreported income is Q0.
Figure 12.5 Optimal tax evasion and policy options
To reduce the level of underreporting taxes, the revenue authorities have two clear policy options:
increase the marginal cost for underreporting and/or decrease the marginal benefits that taxpayers derive
from tax cheating. The marginal cost can be increased by higher penalties if a taxpayer is caught cheating
and by increasing the probability of getting caught. Both would have the effect of shifting the supply curve
in Figure 12.5(b) from S0 to S1. The new equilibrium is at E1, thereby reducing underreported income from
Q0 to Q1. The revenue authorities, however, cannot monitor all taxpayers at all times. In their enforcement
programme, they encourage compliance by randomly auditing taxpayers. The audit coverage ratio of the
South African Revenue Service (SARS) has consistently exceeded the target set. It amounted to 14,47% of
taxpayers in 2017/18 (South African Revenue Service, 2018: 68), which compares very favourably with
that of other countries. Although economic theory predicts that increased sanctions against underreporting
of income or non-payment of service charges should lead to better compliance, this may not necessarily
always be the result. Experience from local authorities in South Africa shows that the more severe the
sanctions observed are, the greater the resistance to paying tax is. Fjeldstad (2004: 552) ascribes this
‘perverse’ relationship to reciprocity considerations: ‘the proposition that the authorities’ unresponsive,
disrespectful and unfair treatment of ratepayers fosters disrespect for and resistance against local
authorities and the service providing agencies …’. A softer approach was followed by SARS at one stage
when it encouraged taxpayers who had failed to meet their obligations to make a disclosure of their sins in
return for a waiving of penalties or additional tax (National Treasury, 2005a: 97). But to ensure fairness in
the tax system and to improve budget revenue, the revenue authorities subsequently revised penalties,
requiring higher penalties on the higher taxable evaders (National Treasury, 2009a: 39). Penalties for
income tax evasion can be up to double the amount evaded (that is, 200%).
The alternative to combating tax evasion through penalties is to decrease marginal tax rates in an effort
to lower the benefits from underreporting tax. Lower marginal tax rates would cause the demand curve in
Figure 12.5(b) to shift from D0 to D1. Equilibrium is at E2 and the amount of income underreported also
decreases from Q0 to Q1. There is some evidence that lower marginal tax rates may positively affect
underreporting. In a study measuring the effect of tax rates on tax evasion on Chinese imports, Fisman and
Wei (2004) found that the evasion gap is highly correlated with tax rates and that much more tax revenue is
lost in respect of products with higher tax rates.
Of course, by applying both compliance options (higher penalties and lower marginal tax rates)
simultaneously, equilibrium E3 can be reached in Figure 12.5(b), resulting in underreporting decreasing
from Q0 to Q3.
Thus, in addition to taxes having to be designed to minimise the excess burden, administration costs and
compliance costs, good tax administration requires that tax evasion and avoidance be kept to a minimum.
When taxes are evaluated according to the criterion of administrative efficiency, a number of issues should
consequently be considered.
• The golden rule in tax design is simplification. Simple tax laws are easy to understand and comply with.
Incentives for tax delinquency should also be minimised. For example, high marginal rates should be
avoided and the poor should not be taxed. Penalties for tax evasion should be high and actively
enforced. High penalties and a high probability of being detected increase the marginal cost of
cheating.
• An important consideration is the community’s level of literacy. For example, income taxes require high
levels of skill, whereas a head tax is fairly easy to understand.
• A further consideration is the efficiency and expertise of the tax administration. The importance of this
was recognised in the first Interim Report of the Katz Commission (1994). Considerable attention was
devoted to tax administration in this report and it was made clear that the South African system
required major structural changes. At that time, the Commission estimated that at least R5 billion in
additional revenue could be netted through administrative reform. The figure turned out to be much
higher in reality.
• To improve tax collection, taxes should be withheld at source. Most taxpayers are subject to the pay-as-
you-earn (PAYE) system, according to which tax is withheld at the source (for example, by the
employer) and paid over directly to the tax authorities. (Note that PAYE is a tax collection system and
not a particular kind of tax.) Under the PAYE system, government receives its revenue before the
employee can lay his or her hands on it. Moreover, there is a regular flow of revenue, which, in turn,
reduces the lag in the operation of the tax multiplier and makes stabilisation policy more effective. On
the other hand, the PAYE system significantly increases the compliance costs borne by companies and
other institutions in the private sector on behalf of taxpayers. Clearly, a trade-off between
administrative and compliance costs is required.
• A further consideration is the tax morality of the community. Taxpayers’ willingness to part with their
hard-earned money is linked to perceptions about the vertical and horizontal equity of taxes as well as
the way in which the tax revenue is spent. If taxpayers feel that the tax system is inequitable and that
government is spending their tax money wastefully (or not in their interest), the willingness to pay tax
will be undermined. Government’s proposal to publish the names and particulars of persons who have
been convicted of tax law offences in the Government Gazette ranks as a measure to improve tax
compliance and tax morality (see Box 12.1 for some further insights from behavioural economics).
• Administrative efficiency is also affected by the political will to enforce tax laws.
• For taxes to be administratively efficient, they should be certain and transparent. The tax to be paid should
be certain (predictable) to ensure rational decision making on the part of both taxpayers and the
government. Both the tax collector and the taxpayer should thus be given as little discretion as possible.
There should also be no uncertainty about who bears the tax burden. Personal income tax satisfies this
requirement, but there is still too much uncertainty in respect of company tax as to who actually bears
the burden. Indirect taxes are also characterised by obscurity as to who carries the tax burden, as we
saw when tax shifting and tax incidence of tobacco and alcohol products were explained (see Section
11.5.2 of Chapter 11).
• Transparency means that the government should not take advantage of people’s ignorance. Transparency
also means that the government has a responsibility to subject tax decisions to the political decision-
making process; in other words, tax decisions should be embodied in legislation and be actively
debated. Taxation through inflation is an example of a tax on income that is not legislated for explicitly
(see Chapter 13, Section 13.4.4).
Box 12.1 Insights from behavioural economics in explaining tax evasion
The standard deterrence model has been criticised for not predicting tax evasion well. In the model the focus is on
financial incentives (such as penalties) to explain tax evasion. New insights have been drawn from behavioural
economics, which is described as a mix of economics and psychology that allows opportunities to augment existing
theories on behaviour, and to develop better models thereof on the empirical side (Thaler, 2016: 1577). These
theories provide reasons why taxpayers may be more or less compliant than predicted by the standard deterrence
model. Below are some examples:
• In contrast to the assumption of the neoclassical approach, individuals may face limits in their ability to compute,
that is, they may exhibit bounded rationality (Alm, 2012: 62). Given this, the complexity of the tax system may
affect compliance behaviour if individuals make mistakes in their tax computations (Leicester et al., 2012: 83).
• It is also possible that the compliance decision is influenced by individuals’ perceptions of the probabilities they
face under tax compliance. For example, taxpayers may overestimate the probability of being audited by the tax
authorities, which increases tax compliance, since their subjective weight of the probability (of an audit) exceeds
that which is implied by its objective level (Alm, 2012: 63).
• Individuals may react more to losses (from penalties in the tax system) than to gains from successfully evading
taxes, and therefore evade less than what the standard model would predict (Leicester et al., 2012: 84).
• Taxpayers’ decisions to comply may depend on the actions of others, reflecting social norms. For example, if some
taxpayers are dishonest and evade taxes, such behaviour can reduce the perceived cost of non-compliance for
others. In the same vein, if others are honest and compliant, the moral cost of evasion may be high and it can result
in increased compliance (Leicester et al., 2012: 85).
12.4 Flexibility
Economic activity is characterised by recurrent recessions and booms, that is, cyclical changes. Moreover,
structural changes occur in the economy as well. Taxes should be flexible enough to provide for changing
economic conditions. Taxes can influence economic activity from both the supply side and the demand
side.
On the supply side, economic growth can be influenced by changing the incentive to work and spend
(or save). For example, if the price elasticity of the supply of female labour is greater (in other words,
labour supply is more sensitive) than that of males, female labour should be taxed at a lower marginal rate
(according to the inverse elasticity rule). This should, theoretically, induce more females to enter the labour
market or to increase their work effort. Hence the supply of labour can be influenced. This topic is
discussed in more detail in Chapter 13.
In macroeconomics, the use of demand-side measures to smooth out business cycles is a standard topic
of discussion. This is known as stabilisation policy. A distinction is made between automatic and
discretionary stabilisers. The timing of discretionary fiscal action is decisive. The problem of timing,
however, is not too serious in the case of automatic stabilisers. Automatic stabilisers are characterised by
built-in flexibility. An example of an automatic stabiliser is a progressive income tax system. When the
economy is entering a recession, for example, the average income tax rate will automatically begin to
decrease. As individuals’ incomes decline, they are automatically assessed at lower rates. In this way, they
are left with relatively more disposable income than they would have had otherwise. By the same token,
tax revenue for the government declines more rapidly than the national income. In Chapters 13 and 16, we
will note that inflation has largely rendered tax policy’s role in automatic stabilisation ineffective.
Key concepts
• administrative efficiency (page 258)
• compliance costs (page 258)
• consumer surplus approach (page 252)
• efficiency–loss ratio (page 257)
• excess burden (page 248)
• indifference curve approach (page 248)
• inverse elasticity rule (page 254)
• lump-sum tax (page 249)
• optimal taxation (page 251)
• positive and negative non-neutral effect (page 251)
• selective tax (page 250)
• tax avoidance (page 258)
• tax evasion (page 258)
• tax gap (page 258)
• tax morality (page 259)
• tax neutrality (page 251)
• theory of second best (page 252)
SUMMARY
• All taxes (except lump-sum taxes) tend to distort relative prices and generate a welfare loss to producers
and consumers. This is called the deadweight loss or excess burden. This loss is in addition to the
normal burden of a tax. The excess burden can be illustrated with the aid of indifference curves and can
also be measured using the consumer surplus approach.
• The excess burden (or efficiency cost of taxation) is determined by price elasticities, the size of the tax
base and the tax rate.
• From an efficiency and tax revenue perspective, it can be argued that it is better to levy taxes on price-
inelastic commodities than on price-elastic commodities. This tax rule is sometimes referred to as the
inverse elasticity rule or Ramsey rule. It can also be concluded that it is more efficient to levy low tax
rates on a large number of commodities (in other words, a broad base) rather than high rates on a few
commodities.
• To ensure that taxes are administratively efficient, administration costs and compliance costs must be
minimised. Related to these costs are the practices of tax avoidance and tax evasion. Tax evasion is
illegal, but can be reduced by imposing penalties in order to increase the marginal cost of
underreporting. Alternatively, marginal tax rates can be lowered, which would decrease the benefits
from underreporting.
• Good taxes must be flexible enough to adapt to changing economic conditions. Progressive personal
income taxes are characterised by built-in flexibility.
12.1 The size of the excess burden …
a. can be measured using indifference curves.
b. is indicated as the difference between the consumer surplus before a tax and after a tax.
c. increases with the square of the tax rate.
d. decreases as price elasticities of demand increase.
e. doubles when the tax rate doubles.
12.2 Consider Figure 12.1. Which one of the following statements is correct?
a. When a selective tax is levied on good x, the relative price ratio changes from
b. The after-tax budget line pivots when a selective tax is levied.
c. The after-tax budget line shifts parallel when a selective tax is levied.
d. The selective tax on good x generates tax revenue equal to Q2E2.
e. The excess burden of a selective tax is indicated by the difference between U0 and U2.
12.3 The more price elastic the demand of the taxed good is, …
a. the greater the excess burden will be.
b. the greater the tax revenue will be.
c. the more likely it is that the good is a necessity.
d. the higher the tax rate should be, according to Ramsay’s rule.
a. When businesses underreport their profits, they are avoiding tax, which is perfectly legitimate.
b. The marginal costs of underreporting can be decreased by naming and shaming tax dodgers.
c. Lower marginal tax rates reduce the benefits from underreporting.
d. Perceptions about high levels of corruption and the inequity of the tax system may lead to tax
revolts.
e. A head tax has built-in flexibility, which makes it a good tax.
12.1 What are the main determinants of the excess burden of a tax?
12.2 Briefly discuss administrative efficiency as a property of a ‘good’ tax.
12.3 Use examples to explain what tax flexibility means.
ESSAY QUESTIONS
12.1 Explain why a lump-sum tax is used to compare the excess burden of different taxes.
12.2 ‘A tax on cigarettes is inefficient since it is non-neutral.’ Do you agree? Explain your answer by using
indifference curves.
12.3 Assuming that government needs to raise a certain amount of tax revenue from two goods with
different price elasticities of demand, what would your advice be to government if the excess burden
had to be minimised? How would your answer differ if other tax criteria had to be considered as well?
12.4 ‘Marginal tax rates should be reduced for high-income taxpayers to increase tax compliance.’ Discuss
this statement by making use of a diagram.
1 In addition, the modern approach to neutrality applies a balanced-budget framework. According to this approach, the concept of
fiscal neutrality relates to both the revenue side and the expenditure side of the budget, in the sense that tax changes are not to
disturb the revenue-expenditure balance.
2 A compensated demand curve shows the change in quantity demanded when price changes and the individual is compensated to
remain on the same indifference curve, thus reflecting the substitution effect of a price change (see Rosen & Gayer, 2014: 331).
3 Assuming that the marginal utility of income is constant, the demand curve can be interpreted as measuring marginal utility. The
area under the demand curve (in other words, the sum of the marginal utilities) represents the total utility (welfare) of
consumers. The difference between the total utility and the actual cost of the benefits (the market price) is the consumer surplus
(Mohr, Fourie & Associates, 2008: 129).
4 In the case of an increasing-cost industry (in other words, where the supply curve is positively sloped), the excess burden is the
area between the original demand curve and the supply curve, and is restricted by the after-tax equilibrium quantity. The excess
burden triangle therefore contains some consumer and producer surplus.
5 The Davis Tax Committee was constituted in 2013 by the Finance Minister at the time, Mr Pravin Gordhan, to review the tax
system and its contribution to inclusive growth, employment and fiscal sustainability.
6 Note the IMF’s tax gap analysis encapsulates a broader definition of the tax gap, which considers the impact of non-compliance
and the effects of the tax policy framework on revenues (see IMF, 2013: 11).
Personal income taxation
In Chapters 11 and 12, the properties of a ‘good’ tax were identified and explained. We are now ready to
apply these criteria to the analysis of specific taxes. In this chapter, we focus on income taxation with the
aim of describing and analysing personal income tax in terms of the tax criteria developed in Chapters 11
and 12.
We begin by defining the income tax base in the first section. We include the international taxation of
income. In the three sections that follow, we consider personal income tax. We begin this discussion by
defining concepts such as exclusions, exemptions, deductions and rebates (Section 13.2). In Section 13.3,
we address the important feature of progressiveness in personal income taxation. This is followed (in
Section 13.4) by an analysis of the economic effects of personal income tax using the tax criteria we
identified in Chapters 11 and 12.
Once you have studied this chapter, you should be able to

define the comprehensive income tax base
discuss the international principles of taxing income
discuss the reasons why the personal income tax base differs from the comprehensive income tax base
explain what a progressive personal income tax is and how progressiveness is achieved
discuss the economic effects of personal income tax.
13.1 The comprehensive income tax base

When we introduced the tax base in Chapter 11, we distinguished between three bases: income, wealth and
consumption. In this chapter, we will focus on personal income. We first need to know what income is.
We are all familiar with a budget (for example, our own personal budget), which has an expenditure (or
uses) side and a revenue (or sources) side. Income can be defined from both the sources side and the uses
side of the budget. From the uses side, income is the monetary value of consumption plus any change in
the net worth over a year. Net worth (or the net value of assets) is obtained by subtracting liabilities from
assets (see Chapter 15). Put differently, income is the net increase in the power to consume in a particular
period (for example, a year). It can be expressed as follows: Y = C + S where Y is income, C is
consumption and S is saving (or the change in net worth).
From the sources side of the budget, anything that makes consumption possible (in other words,
anything that is available to finance consumption) is considered as income. Income thus includes salaries,
wages, interest, capital gains, rent, profits, royalties, dividends, gifts, employer contributions to pension
funds, unemployment benefits and income in kind. This definition of the comprehensive income tax base
is referred to as the Haig-Simons definition, named after two early twentieth-century economists who
advocated its use. Haig and Simons believed that this definition of income most accurately reflects the
ability to pay (one of the criteria of fairness) or purchasing power.
For administrative and other reasons, governments tax some of the sources of income separately. In
South Africa and most other countries, income received by individuals is subject to personal income tax.
The income of incorporated businesses (in other words, profits) is subject to company tax. In some
countries, net capital gains from increases in the value of assets are subject to capital gains tax. Personal
income tax is discussed in this chapter; company tax and capital gains tax are discussed in Chapter 14.
Gifts, which can also be treated as additions to wealth, are discussed in Chapter 15.
Another dimension of the comprehensive definition of income is that income is recorded as it accrues
and not only when it is realised. For example, if an asset increases in value during the course of the year,
the capital gain is an addition to net worth. The asset need not be sold (that is, realised) for the increased
value to be regarded as income. The reason is that an increase in the value of an asset represents an
increase in the owner’s purchasing power (that is, ability to pay). In practice, the accrual principle causes
considerable administrative complications (for example, valuation problems) and it may also result in cash
flow problems for those who have to pay tax on accrued amounts not actually received in cash.
International taxation of income: The residence principle

13.1.1
versus the source principle
Income is generated within countries, but also across national borders. In recent years, the economies of
countries have become increasingly internationalised. This has impacted on a tax jurisdiction’s ability to
tax individuals and companies. In an integrated and open economy, the returns of factors of production (for
example, salaries, dividends, profits, royalties and interest) flow much more freely within a country and
across national borders. When rates of return differ between countries as a result of taxation, these tax-
induced differentials can be exploited by capital and highly skilled individuals, causing distortions within
countries and across countries. Over the years, tax authorities have dealt with the international taxation of
income using two general principles: the residence of taxpayer principle and the source of income
principle.
The residence principle (or worldwide basis principle) is based on the view that the country of
residence of the person or business that receives the income determines the tax liability and collects the tax.
Thus, a person residing in South Africa would be liable for taxes on his or her total (worldwide) income in
South Africa if a residence system was applied. For example, if the person earns R300 000 from a source
in South Africa and R120 000 from a source in Zimbabwe, the combined income of R420 000 is taxable in
South Africa. For a legal person (for example, a company), residence is determined by where the business
is registered or has a permanent presence. Only income that can be allocated to the activities of the
business (at home and abroad) would be taxable.
According to the source of income principle, income is taxed by the country where the income is
generated. Using the example above, only the R300 000 that originated in South Africa would be taxable in
South Africa if the source principle was applied. In practice, most countries apply a combination of both
systems. This hybrid form of taxing cross-border flows of income could result in double taxation of income
of this nature. If South Africa applies the residence principle and Zimbabwe uses the source principle, then,
in our example above, a person residing in South Africa would be taxed on his or her worldwide income of
R420 000 in South Africa. In addition, the Zimbabwean tax authorities would tax the person on the
R120 000 generated in Zimbabwe. To eliminate or reduce the extent of double taxation, countries using the
worldwide basis unilaterally grant tax relief in the form of an income deduction for the income earned in
the source country or a tax credit for the tax paid in the source country. Alternatively, countries enter into
bilateral tax treaties or attempt to harmonise the tax treatment of cross-border income.
On a multilateral basis, however, it is difficult to harmonise tax systems as countries perceive the net
benefits of each system differently. The debate on the merits of each system is extensive and not clear-cut
at all (see Faria, 1995: 216–221; Tanzi, 1995: 65–89 and Katz Commission, 1997b). The issues that
developing countries have to consider include the following:
• The source basis resembles the benefit principle of taxation. The entity generating the income benefits
from public expenditures, for example, uses public roads and schools, and should therefore be taxable.
This is not a very convincing argument since a resident who earns foreign-sourced income also benefits
to some extent from public roads and schools in the home country. The residence basis, on the other
hand, approximates the ability-to-pay principle and enables countries to tax the worldwide income of
residents on a progressive scale. Countries with low levels of foreign income (for example, dividends,
interest and royalties) would have to consider using the source basis on grounds of administrative
expediency. On the other hand, where income from investments abroad is considerable, the residence
basis has to be considered on revenue grounds.
• From a tax neutrality point of view, a tax system (for example, tax rates) should not influence locational
decisions of businesses. From the perspective of a capital-importing country, a source-based system
would have the advantage of being neutral with regard to capital imports since it does not discriminate
between domestic investment and foreign investment, regardless of where the capital originates.
Developing countries tend to be capital importers. On the other hand, from a capital-exporting
perspective, a residence-based system would be neutral with regard to capital exports. The only
concern to an investor would be the tax rate in his or her country of residence.
In South Africa, the taxation of income was based on the source principle of international taxation in the
past. As a result of the increasing globalisation of the economy and the relaxation of exchange controls, a
residence-based income tax system was introduced as of 1 January 2001. It was argued that by doing this,
the South African income tax base would be broadened, opportunities for tax arbitrage would be limited
and the tax system would be brought in line with accepted norms for taxing international transactions
(Department of Finance, 2000: 84).
This move was contrary to the recommendations of the Katz Commission (1997b). In its Fifth Interim
Report, the Katz Commission (1997b) distinguished between active income (income derived from
operational activities, such as manufacturing and rendering services) and passive income (income derived
from investment, such as interest and royalties). The Commission recommended that active income be
taxed on the source basis and passive income on the worldwide basis. It argued that taxing active income
on a worldwide basis and at the relatively high domestic effective tax rates would encourage South African
multinational companies to relocate to low tax jurisdictions. Changing the tax system to a worldwide basis
would also be administratively complex. The Commission argued that taxing passive income on a
worldwide basis would be necessary to protect the tax base. Passive capital is very mobile when exchange
controls are limited.
There remain differences of opinion on the relative merits of the change to a worldwide (or residence)
basis in South Africa. The application of the residence principle may enhance equity by taxing the off-
shore income of South African residents. After all, these amounts increase taxpayers’ ability to pay and
allow for progressive rates of taxation in the vertical equity sense of the word. On revenue grounds, it is
also sound to protect the system from undue losses as exchange controls are relaxed. Foreign-employed
income (for a South African resident working more than 183 days a year, for a private-sector company)
was exempt from tax until 2017. The current legislation now only allows exemption if the income earned is
taxed in the foreign destination (National Treasury, 2017a: 138). However, converting to the worldwide
basis involves many administrative problems, including problems of definition (for example, when is an
establishment resident) and requires the (re)negotiation of various double taxation agreements. The
possible impact on net foreign investment is unpredictable at this early stage.
13.2 The personal income tax base

Total (comprehensive) income is the starting point in calculating personal income tax. Once exclusions
such as unrealised capital gains have been subtracted, gross income is obtained. In South Africa, gross
income consists of all receipts and accruals (for example, wages and salaries, rents, royalties, dividends,
capital gains and interest) of South African residents, irrespective of where in the world it was earned.
Exempt income (for example, interest) is deducted from gross income and the resulting amount constitutes
net income. Taxable income is obtained by deducting all of the amounts allowed as deductions (for
example, medical expenses) from net income. Normal tax is calculated at the applicable rate on taxable
income.
The comprehensive definition of income is much broader than the definition of taxable income in South
African tax law. The reason is that government provides tax expenditures, sometimes referred to as tax
loopholes. Tax expenditures include exclusions, exemptions, deductions and tax rebates (or credits) that
all affect the size of the tax base. It has been estimated that tax expenditures to the amount of R106,8
billion were provided to personal income taxpayers in 2016/17 (National Treasury, 2019a: 121). This
revenue forgone represents about 25,2% of the income tax revenue collected from persons in 2016/17. The
calculation of personal income tax liability in South Africa is shown in Box 13.1.
Box 13.1 Calculating personal income tax liability
TOTAL (COMPREHENSIVE) INCOME

minus exclusions (for example, imputed rent and unrealised capital gains)
GROSS (CASH) INCOME
minus exemptions (for example, tax-free portion of interest)
NET INCOME
minus deductions (for example, contributions to retirement funds)
TAXABLE INCOME
Tax according to tables
GROSS TAX LIABILITY
minus rebates (for example, primary rebate and rebate for age 65 and over)
NET TAX LIABILITY
13.2.1 Exclusions
Income tax is generally levied on cash income. Some forms of non-cash income, such as in-kind receipts,
are excluded from the tax base. A tax exclusion can be illustrated as follows: the salary of a person who is
employed as a cook or a child minder is taxable, but if a housewife or mother performs the same functions,
the value (or opportunity cost) of her services is not taxed. If a homeowner lets his or her house, the rent
received is taxable. If, on the other hand, the owner lives in the house, the rent forgone is an opportunity
cost (in other words, imputed rent) that ought to be taxable in terms of the comprehensive definition of
income, but it is excluded from tax.
In the past, companies could also offer generous fringe benefits (for example, motor vehicle allowances,
subsidised meals, low interest loans and housing subsidies) that were not taxed to employees. Nowadays,
most fringe benefits are taxable, but the real value of these benefits is not always taxed in full. For
example, in the case of (higher education) bursaries for relatives of employees, R60 000 per year is tax-free
for employees earning up to R600 000 per year. The taxation of fringe benefits is sometimes also difficult
to administer. For example, it is often difficult to distinguish between personal use and business use (for
example, the use of a company cell phone or company stationery for private use). Finally, non-cash
transactions such as barter arrangements are also difficult to detect and frequently go untaxed (for example,
a dentist filling a plumber’s tooth in exchange for the plumber clearing a drain at the dentist’s residence).
13.2.2 Exemptions
A second category of tax expenditures is exempt income (or exemptions). Tax exemptions refer to income
that is exempt from payment of income tax. As a method of providing tax relief to the poor and the aged,
an amount of income is tax exempt. In 2019/20, the exempt amount for persons below the age of 65 was
R79 000 and for those over the age of 65, the implied exempt amount was R122 300. A further implied
threshold applies to those aged 75 years and older (R136 750). In practice, the exempt amount is
determined by tax rebates allowed on the amount of tax that is due (see the discussion on rebates in Section
13.2.4). The first R23 800 of interest income received by a natural person under the age of 65 from a South
African source is also exempt from income tax in South Africa. In March 2015 the government introduced
tax-free savings accounts, which allows an investor to save up to a maximum of R33 000 per annum1 (up
to a lifetime limit of R500 000). Interest on these accounts is tax exempt.
13.2.3 Deductions
In addition to the exempt categories of income, certain expenditures may be deducted from net income for
tax purposes. There are various tax deductions (or allowances) that serve different purposes. Some
deductions, such as those in respect of pension fund contributions and contributions to retirement annuity
funds, are intended to serve as incentives for taxpayers to provide for their old age, at which time their
pension may be taxed according to the applicable tax rate. This is particularly important in a country like
South Africa, which does not have a comprehensive social security network. Until a few years ago
deductions were also allowed (within limits) for contributions to medical aid funds and medical
expenditures. It is important to note that a tax deduction of a given amount is worth more to a person with a
high marginal tax rate than a low marginal tax rate. It is for this reason that the monthly deduction for
medical contributions and expenses was converted into tax credits from 1 March 2012 (see rebates below).
Another category of deductions is in respect of expenditures incurred with the purpose of producing
income (for example, travelling and motoring expenses or allowances, or rental income on a second
residence).
13.2.4 Rebates
A further tax expenditure, which affects the government revenue from income tax, is tax rebates (or tax
credits). Tax rebates involve the subtraction of a specified amount from the amount of tax to be paid (that
is, the taxable liability). In contrast to a tax deduction of a specified amount, a tax rebate is a lump-sum
benefit and is independent of the taxpayer’s marginal tax rate. Rebates are primarily aimed at providing tax
relief to the poor and middle-income groups, and to provide for differences in taxpayers’ personal
circumstances. Because it is a lump-sum benefit, its value falls as taxable income increases, thus enhancing
tax progressivity and vertical equity. In 2019/20, our personal income tax system provided for a primary
rebate of R14 220, while persons aged 65 and over (the secondary rebate) were allowed an additional
R7 794, and persons aged 75 and over (the third rebate) had a further R2 601 deducted from their tax
liability. What does this mean? The primary rebate determines the de facto tax-exempt income (see
exemptions in Section 13.2.2). When the primary rebate of R14 220 is deducted from the gross tax liability
of a person earning a taxable income of R79 000, the net liability is zero. The income level at which the
effective tax rate is zero is referred to as the minimum tax threshold. Any taxable income above this
amount would incur a tax liability. It should be obvious that rebates benefit the poor more than the rich.
For example, a rebate of R14 220 is percentage wise worth more to a person with a taxable income of
R100 000 than to a person with a taxable income of R500 000. Without the rebate, a person earning
R100 000 would have had to pay tax of R18 000. With the rebate, the tax liability falls to R3 780. The
benefit is 79% of the unadjusted tax liability. For the person earning a taxable income of R500 000, the
benefit (calculated in the same way) is only 11,1%. In addition to the above rebates, medical tax credits are
allowed as a rebate against taxes payable. Standard medical scheme contributions can be rebated with a tax
credit of R310 per month for each of the first two beneficiaries, and R209 for the remaining beneficiaries.
Qualifying (other) medical expenses can, within limits, also be converted to tax credits. More generous
conversions are applicable to taxpayers over 65 years of age as well as persons with disabilities. These
taxpayers often have high medical expenses over which they have no discretion that can significantly affect
their ability to pay. Equity is thus ensured since the relief does not increase with higher income levels.
13.3The personal income tax rate structure:

Progressiveness in personal income taxation
In the case of personal income tax, most observers agree that the ability-to-pay principle should apply. This
principle generally takes taxpayers’ income as a yardstick. However, it is not so simple to determine
taxable income and to combine it with the tax rate in such a way that fairness is achieved. For example, one
of the most prominent features of personal income tax is that the structure can be adapted to the personal
circumstances of the taxpayer, but adaptations of this nature complicate the rate structure.
Ability to pay (and thus the rate structure) is affected by the filing status (or unit of taxation) of the
taxpayer, that is, whether he or she is single, married or has children. If two people live together, their
living costs (per person) should be lower than when they live apart (for example, because they share certain
things). Their combined ability to pay should therefore be greater than it would have been if they had lived
apart and they could, therefore, be taxed at a higher rate (on their combined income). But the issue is not
quite so simple. For example, a married couple with both partners working can be at a disadvantage
compared to a couple where there is only one breadwinner. In the case where both spouses work, families
may have to purchase a number of services that would normally be rendered at no additional cost by a non-
working spouse (for example, cleaning services and child care). If imputed income is not taxed, the two-
breadwinner couple should be taxed at a lower rate.
There is a further complication when children are included in the relationship. Having children involves
costs and affects the disposable income of the parents. Some would argue that these costs are non-
discretionary (for example, where contraception is ruled out owing to religious beliefs) and that tax
deductions or rebates for children should be allowed. Others argue that children are a matter of choice, and
that there is no reason why special provision should be made for expenses involving children and not for
other expenses that are incurred by choice, such as private overseas trips. The particular view taken on
these issues also depends on the values of society in respect of the family. Should mothers be encouraged
to return to work or should the income tax system discriminate against women to promote a stable family
life? Whether or not the personal income tax structure should be used for social engineering purposes is a
much-debated issue. It should be obvious that all kinds of cultural, religious and moral factors can enter the
picture. This brief discussion shows that an individual’s tax rate and tax liability do not necessarily depend
solely on his or her income. In practical terms it also should be clear that there will be limits to any
country’s ability to have its tax system cater for all equity-related matters.
Until the mid-1990s, the tax unit in South Africa was the married couple. Married and single people
were taxed using different schedules. The choice of unit was scrutinised carefully by the Margo
Commission (1987). It was argued that joint taxation of spouses amounted to a marriage penalty for
income-earning wives. This type of taxation discouraged people from marrying, discouraged married
women from entering the labour market and affected the status of married women as individuals. The
Margo Commission (1987: 151) successfully recommended that the individual replace the couple as the
unit. In the current personal income tax system in South Africa, the individual is now the unit of taxation.
The Katz Commission also considered the issues of discrimination on the basis of marital status, gender,
age, ethnic or social origin, religion and so on. Their perspective was mainly a constitutional one. The Katz
Commission (1994: 73) recommended that all provisions in the Income Tax Act that were based on gender
and marital discrimination violated the Constitution and should therefore be eliminated. The Katz
Commission (1994: 73) also recommended that child rebates no longer be granted, but that discrimination
on the basis of age remains for the time being. These recommendations were introduced in 1995.
Whether the unit of taxation is the family, a married couple or the individual, the principle that people
should pay tax according to their ability to pay still holds. In Chapter 11, it was said that a tax system based
on ability to pay requires consensus on how ability is to be measured as well as on the rate structure. In the
case of vertical equity, the question is what the respective tax liabilities of rich and poor taxpayers should
be. For this purpose, each taxpayer’s sacrifice of utility as a result of taxation has to be evaluated. Most
countries apply the equal marginal sacrifice principle. According to this principle, the income tax rate
should increase progressively as taxable income increases (in other words, the richer the person, the higher
his or her tax rate should be). The aim is to achieve a more equitable distribution of after-tax income.
Table 13.1 Personal income tax rates in South Africa, 2019/20
Source: National Treasury (2019a: 41).
What is meant by progressivity and how can it be achieved? In Chapter 11, it was explained that the
progressivity of the rate structure can be determined by looking at the average tax rate. When the average
tax rate (that is, the total amount of taxes payable divided by the value of the taxable base) increases as
taxable income increases, the tax is progressive. Progressivity can be obtained by using a combination of
income exemptions (or tax rebates) and by taxing blocks or brackets of income at different rates. A higher
tax rate is specified for each higher income bracket, but the higher rate is applicable only to that part of the
taxable amount that falls into the relevant bracket. These graduated rates are called marginal tax rates
since they represent the change in taxes (in other words, the marginal or extra tax amount) paid with
respect to a change in income (that is, the marginal or extra income).
Table 13.1 shows the tax rates for individuals for 2019/20. The first column shows the taxable income
brackets. The second column shows the basic amount of tax paid for each bracket. The basic amount in the
schedule is simply the sum of the marginal tax amounts of the preceding brackets and is specified to
simplify tax calculations. Thus a person with taxable income of R220 000 pays R35 253 on the top
‘marginal’ income in the first bracket (R195 850 3 18%) plus an extra R6 279 on the ‘marginal’ income in
the second bracket ([R220 000 – R195 851] = R24 149 × 26%), which add up to R41 532. Note that this
amount is not the effective tax liability. The primary rebate of R14 220 has to be subtracted from this
amount, which leaves a tax liability of R27 312. This converts to an average tax rate (or effective tax rate)
of 12,4% on taxable income. If we repeat this exercise for an income of R1 500 001, an
average tax rate of approximately 34,5% of taxable income is obtained. Since the average tax rate increases
as income increases, the tax structure is progressive. The importance of the distinction between marginal
and average rates will again be emphasised when the economic impact of personal income taxes is
discussed in the next section. A much more simplified personal income tax rate structure applies in some
other countries. Take Lesotho, for example. On the first M61 080 (one rand equals one Lesotho maloti), a
rate of 20% is applied. (A tax credit of M7 260 may be deducted.) Income in excess of M61 080 is taxed at
30%. This structure almost resembles a flat rate tax (see below). In Botswana, individuals with an income
of more than P36 000 are liable for personal income tax. Five brackets are used. At the threshold income
level of P36 000 (one rand equalled 0,74 Botswana pula in December 2018), a rate of 5% applies. This rate
increases to a maximum of 25% for incomes over P144 000. Eswatini (previously known as Swaziland)
taxes persons other than companies using four brackets, with the highest rate of 33% being levied on
taxable income exceeding SZL200 000 (one rand equalled one Swazi lilangeni in December 2018). A
rebate of SZL8 200 is allowed, which means that no tax is payable below an annual taxable salary of
SZL41 000 per annum. The Namibian tax schedule provides for seven tax bands, with income above
N$1 500 000 being taxed at 37%. Income below N$50 000 is taxed at a nil rate (one rand equalled one
Namibian dollar in December 2018). Using GDP per capita as a yardstick, the top personal income tax rate
in Namibia takes effect at approximately 20 times the GDP per capita level. By comparison, in Botswana,
the top rate becomes effective at approximately 2 times GDP per capita, albeit at a lower rate.
13.4 Economic effects of personal income tax

In Chapters 11 and 12, we laid the foundations for analysing different taxes. You will recall that we
identified four properties of a ‘good’ tax: economic efficiency, equity, administrative efficiency and
flexibility. These properties or criteria will now be applied to personal income tax.

From Chapter 12, we know that when the economic efficiency of any tax is considered, economists try to
establish whether or not the tax has an excess burden. You will recall that the excess burden is a burden in
addition to the normal burden of a tax that reduces the taxpayer’s welfare (in other words, leaves the
taxpayer on a lower indifference curve). To determine whether an income tax has an excess burden, we
will first consider a general tax on income and then a selective tax on labour income. Since personal
income tax is levied on interest income as well, we will also consider the economic efficiency of this
practice separately.
13.4.1.1 General tax on income

The impact of a general tax (a tax that is levied on the entire tax base) was analysed in Chapter 12. We
concluded that a tax of this nature has no excess burden since relative prices are not distorted. An example
of this kind of tax is a head tax. If the entire income base (personal income and company income) is taxed
and leisure is ignored (or it is assumed that leisure can be taxed at the same rate as income), an income tax
is also a general tax. The effect of this type of tax was illustrated using Figure 12.1. The tax on income will
simply shift the after-tax budget line (CD) parallel and downwards to the origin. Relative prices remain
unchanged and there is no excess burden. The tax has a normal burden only, which is illustrated by
consumption occurring on a lower indifference curve (U1) than before. An income tax that taxes the entire
tax base (excluding leisure) is therefore an efficient tax. Unfortunately, leisure cannot be ignored and
neither can leisure be taxed that easily.
13.4.1.2 Selective tax on labour income

Once we include leisure in our analysis, it can be shown that a personal income tax does have an excess
burden. Workers have a choice between income and leisure. Since leisure cannot be taxed easily, a tax on
income only is in fact a selective tax. If income (or the goods that can be purchased with that income) and
leisure are viewed as two commodities, we can argue that an income tax distorts the relative prices of
income and leisure. People may decide to work more or less as a result of the tax (in other words, the
supply of labour is affected). The net result will depend on the relative strengths of the income and the
substitution effects of the price change. We focus on these two effects below and show that it is the
substitution effect that has an adverse impact on the incentive to work. We also show that the substitution
effect is determined by the marginal income tax rate. We start by examining how the supply of labour is
determined using budget lines and indifference curves.
Figure 13.1 The supply of labour and an income tax on personal income
Assume that a person, Peter, has eighteen hours a day (his time endowment), which can be used for two
activities: work and leisure. In Figure 13.1, the daily time endowment is measured on the horizontal axis as
the distance 0L. Note that on this axis, we measure two things. From left to right (in other words, from
point 0 to point L), we measure the number of hours spent on leisure activities. From right to left (that is,
from point L to point 0), we measure the number of hours worked. For example, if LQ1 hours are spent
working, it means that 0Q1 hours are available for leisure.
Suppose Peter earns a wage of R10 per hour. If he uses his entire daily time endowment (eighteen
hours) to work, he can earn an income of R180 per day. Peter’s income (or the goods that can be purchased
with that income) is plotted on the vertical axis. If the full-time endowment is used to earn income, one
combination of income and leisure or work is obtained (in other words, point Y). If, instead, he wastes all
his time doing nothing, zero income is earned and we have another combination of income and
leisure/work that we can plot (that is, point L). We can continue in this way and trace out the different
combinations of income and leisure or work for each number of hours worked. This is shown as line YL,
that is, Peter’s budget line. The two ‘goods’ in this case are income and leisure. By adding indifference
curves (which indicate Peter’s preferences or tastes), we can determine the combination of income and
leisure or work most preferred by Peter. Suppose that the highest indifference curve that Peter can attain is
U0. He is then in equilibrium at E0, where 0Q0 hours are spent on leisure and LQ0 hours are used or
supplied for work.
Suppose a proportional tax or flat rate tax (for example, 14%) is now levied on income only. A
proportional tax lowers the after-tax wage. This means that Peter’s income (his after-tax wage multiplied
by the number of hours worked) is now less at each number of hours worked. The after-tax budget line
pivots (or swivels) from YL to BL. The after-tax equilibrium is at E1, where indifference curve U1 is tangent
to the new budget line, BL. Peter’s welfare has declined as indicated by the fact that he finds himself on a
lower indifference curve. At the new equilibrium, Peter has a tax liability of E1G (in other words, the
difference between his before-tax income and his after-tax income earned by working LQ1 hours). The
quantity of labour supplied has increased from LQ0 to LQ1 hours per day. This, however, need not always
be the case. The movement from E0 to E1 is the result of the combined effect of the income effect and the
substitution effect of the tax change. Whether the number of labour hours supplied increases or decreases
will depend on which effect is stronger.2
What is the income effect? The tax reduces Peter’s after-tax income. Peter is worse off as a result of the
tax and he will tend to work more to offset partly this loss in income. Put differently, Peter has a lower
after-tax income and can therefore not afford the same amount of leisure than before. Less leisure means
more hours of work. The income effect will therefore cause the quantity of labour supplied to increase.
What about the substitution effect? To understand the substitution effect, it is important to note that
leisure has a price. The price of one hour of leisure is the hourly wage sacrificed by not working. Thus, the
opportunity cost of leisure is the wage foregone. Since the introduction of an income tax reduces the after-
tax wage, the opportunity cost of leisure decreases; that is, leisure becomes cheaper. In other words,
consuming leisure involves a smaller sacrifice in income than before the introduction of the tax. Because
leisure is now relatively cheaper, it is substituted for work. The substitution effect increases leisure, which
means that it reduces the quantity of labour supplied.
The income and substitution effects can also be explained using Figure 13.1. After the introduction of
the proportional tax, equilibrium changes from E0 to the new equilibrium at E1. The movement from E0 to
E1 can be decomposed into the income effect and the substitution effect. If the individual were
(hypothetically) compensated with an amount just enough to make him as well off as before the tax, the
budget line BL would shift parallel outwards to HJ, which is tangent to indifference curve U0 at E2. The
movement from E2 to E1 is, therefore, the income effect of the tax. The income effect shows that the
individual increases his work effort in response to the imposition of the proportional tax. The movement
from E0 to E2 depicts the substitution effect, which is a consequence of the change in the relative price of
labour alone. The movement shows how the individual substitutes more leisure for less work if a
proportional tax on labour is imposed or increased.
As stated earlier, the income and the substitution effects combine to determine whether a person will
work more or less. If the income effect dominates, the after-tax quantity of labour supplied will increase. In
contrast, if the substitution effect dominates, the number of hours worked will decrease and the quantity of
leisure will increase. On the basis of this analysis alone, it is impossible to say what the outcome will be.
Empirical evidence, however, suggests that the labour-supply elasticities for prime age men (men aged
between about twenty and sixty years old) are generally close to zero (see Brown & Jackson, 1990: 449).
This means that the supply curve is almost vertical or, put differently, that the quantity of labour supplied is
very insensitive to changes in the net (after-tax) wage. On the other hand, the estimated elasticities are
generally positive and high for married women. In their case, the quantity of labour supplied is thus quite
sensitive to changes in the net (after-tax) wage. For example, there is evidence in the United Kingdom that
the hours men work are not very responsive to changes in work incentives; however, participation by those
with low levels of income is responsive. In contrast, the hours of work and the participation of women with
young children are quite sensitive. The income of men with high levels of education is responsive to tax,
but in the sense that they shift their income to non-taxable forms (see Meghir & Phillips, 2010: 204 and
252).
The analysis used for a proportional tax can be repeated for a progressive tax on income. One difference
would be the shape of the after-tax budget line. In the case of a progressive tax, the budget lines will be
kinked or curved (see Rosen & Gayer, 2010: 418). This does not change the conclusion with regard to the
impact of the tax on the supply of labour fundamentally, but there is one important difference between
progressive and proportional taxes: for a proportional tax, the average tax rate is equal to the marginal tax
rate, but for a progressive income tax, the marginal tax rate is greater than the average tax rate. This means
that the adverse incentive effects owing to the substitution effect are likely to be more important for a
progressive tax than for a proportional tax (see Box 13.2).
Box 13.2 Marginal tax rates and the substitution effect
In the case of a proportional tax, every taxpayer faces the same marginal tax rate, but in the case of a progressive tax,
the marginal tax rate varies with income (for example, in Table 13.1, the marginal tax rate exceeds the average rate
for each income tax bracket). What does this mean?
The size of the income effect is determined by the average tax rate, whereas the size of the substitution effect is
determined by the marginal tax rate.
The average tax rate indicates how much of his or her income the taxpayer sacrifices to the revenue authorities for
his or her total work effort. To recover some of the income lost as a result of tax, the taxpayer will work more. You
will recall that this is the income effect of the tax change. The income effect is therefore related to how much tax is
paid and, for a given income, this is determined by the average tax rate. The marginal tax rate, on the other hand,
indicates the additional income an individual sacrifices to the revenue authorities for additional work effort (in other
words, changes in work effort) and is therefore related to the substitution effect. The higher the marginal tax rate, the
more of the additional income a taxpayer must sacrifice. As the marginal tax rate increases, the incentive to substitute
leisure for income becomes greater. It is therefore the size of the marginal tax rate that determines the incentive to
work (the substitution effect).
Figure 13.2 The excess burden of a proportional tax on personal income
We know at this stage that a tax that selectively taxes income (and not leisure as well) has income and
substitution effects that together may cause the quantity of labour supplied to increase or decrease. We also
know that the taxpayer’s welfare is reduced by the tax (as illustrated by the movement to a lower
indifference curve). However, we still have to determine the economic efficiency of the tax, that is,
whether or not it has an excess burden. To arrive at an answer, we have to compare the results of the
proportional tax to a lump-sum tax of equal revenue. Remember that a lump-sum tax does not distort the
relative prices of leisure or work and income, and therefore has no excess burden. The impact of the
personal income tax on economic efficiency (the excess burden) is explained in Figure 13.2. This figure is
similar to Figure 13.1, except that the income and substitution effects are not illustrated.
If a lump-sum tax (for example, head tax) is introduced to raise the same tax revenue as the proportional
tax in Figure 13.1 and Figure 13.2 (in other words, E1G at Q1 hours), the after-tax budget line shifts parallel
to the original budget line (YL) to DF, which intersects BL at point E1. Peter will now be in equilibrium at
E2, where the highest indifference curve, U2, is tangent to the (new) budget line. Peter is working LQ2
hours a day, which is more than the LQ1 hours worked under the proportional tax. Peter’s welfare is also
higher under the lump-sum tax than under the equal-yield proportional income tax, as illustrated by the
attainment of a higher indifference curve (U2) than before (U1). The difference between U2 and U1 can be
ascribed to the excess burden of a proportional income tax that selectively taxes income. Note that
compared to lump-sum taxes, selective income taxes lower the incentive to work, even though they may
lead to increased work effort (labour supply increases from LQ0 without any tax to LQ1 with the tax). A
lump-sum tax of equal revenue yield thus results in an even greater quantity of labour being supplied (the
quantity of labour supplied increases from LQ0 to LQ2). We can therefore conclude that income taxes are
economically inefficient, the reason being that relative prices are distorted by the tax.
Our conclusion that income taxes are distortional rests on the premise that it is difficult or impossible to
tax leisure. If it were possible to tax both labour and leisure hours, we would have had a tax that generates
no excess burden. One option put forward, which became known as the Corlett-Hague rule, was to tax
goods and services complementary to leisure (Corlett & Hague, 1953). Consumers use certain goods, such
as golf clubs, DVDs, television sets and romance novels, along with leisure time. On their own, these
goods have little value. They only become useful if used in combination with leisure time. Therefore, if
you cannot tax leisure explicitly, the policy solution would be to tax goods complementary to leisure at a
rate that would reduce demand for leisure indirectly. In this way, the excess burden of the income tax
system could possibly be reduced.
From this analysis, it follows that taxing women who are not the main breadwinners at lower marginal
tax rates than men may, for example, increase the supply of labour. This would induce more women to
enter the labour market. This option is not available, however, since the South African Constitution does
not permit discrimination on the basis of gender or marriage.
Based in part on the theoretical arguments that lower marginal tax rates will increase work effort and
improve tax compliance (the incentive to cheat is lower if tax rates are lower), there has been a worldwide
trend towards lower marginal tax rates (see Section 15.5.2 of Chapter 15). South Africa has followed suit.
In the early 1970s, the maximum marginal tax rate was 72%, compared to the present rate of 45%.3
13.4.1.3 Selective tax on interest income

Personal income tax not only impacts on the supply of labour, but also affects private savings if interest
income is taxed. South African households have a poor savings record. Savings as a percentage of
disposable income of households declined from 2,6% in 1998 to 0,3% in 2017 and was in negative territory
for the period 2006 to 2016. Because taxation may affect savings behaviour, governments attempt to
encourage individuals to save more. In South Africa, domestic interest income is exempted up to a certain
threshold, depending on the age of the individual (above or below 65 years). Contributions to retirement
annuities, pension and provident funds are also tax deductible up to certain levels to provide incentives for
individuals to save for their retirement. A comprehensive framework for social security and retirement
reform was proposed in 2007. This framework provides consistent tax incentives for mandatory
contributions and supplementary voluntary contributions. To analyse the impact of taxation on savings, we
will show that the supply of savings is a function of lifetime income, the interest rate and the preferences
(tastes) of individuals. We then introduce a tax on interest income and show that because the tax changes
the opportunity cost (or ‘price’) of present consumption, it has income and substitution effects. The supply
of individual savings may increase or decrease.
We know that income (Y) is equal to the sum of consumption (C) and saving (S). Less saving implies
more consumption. We can understand the impact of a tax on a person’s savings choices by analysing
consumption in two periods: the present and the future. In deciding how much to save, the individual will
have to consider his or her lifetime income, that is, the income that is now received and what is expected
to be earned in the future. Because individuals prefer present consumption to future consumption, our
individual (let’s call her Grace) would require some form of compensation for postponing consumption to
the future. The compensation for giving up one rand of present consumption (that is, saving) can be seen as
the interest that can be earned on her savings. Put differently, the opportunity cost of one rand of present
consumption is (1 + r) rand in the future, where r is the interest rate. If Grace has R2 000 available now
and the interest rate is 10%, she would be able to postpone her consumption of this amount (the principal)
in return for future consumption of R2 200, that is, (R2 000 + [0,10]2 000). This can also be analysed
graphically.
Figure 13.3 Effect of an income tax on savings
In Figure 13.3, present consumption is measured on the horizontal axis and future consumption on the
vertical axis. Suppose Grace has an initial endowment of present income (Y0) and future income (Y1). If she
neither saves nor borrows, this income and consumption bundle would correspond to point E0 (the
endowment point). She now decides to save S. This can be shown as a movement to the left of E0, and a
reduction in present consumption equal to the distance Y0C0. In the next period, Grace will be able to enjoy
increased consumption equal to (1 + r)S. This represents a movement to a point above and to the left of E0,
such as D, entailing an increase in future consumption equal to the distance Y1C1. But Grace can also
decide to borrow; that is, her present consumption exceeds her present income, leaving her with less future
consumption. In Figure 13.3, the net effect is represented as point F, a movement to the right and below the
initial endowment point E0. By linking points D and F through E0 and by considering all of the other
possible values of savings and borrowing, the lifetime budget constraint AB is derived. This budget line
shows the different combinations of consumption over the two time periods and has a slope of –(1 + r). But
which combination will Grace choose? Each person has a set of indifference curves. Each curve gives
those combinations of present and future consumption that leaves the person indifferent, that is, at the same
level of utility. Whatever the person’s preference, each person will attempt to maximise utility subject to
his or her lifetime budget constraint. If Grace prefers to consume less today in return for more in the future,
a point such as D can be attained, where her indifference curve U0 is tangent to the lifetime budget line AB.
She prefers present consumption equal to 0C0 and future consumption of 0C1.
Let us now consider the effect of a proportional tax, at rate t, on interest income. We will not analyse
the case of the borrower who has to pay interest and who may, in some cases, deduct interest payments
from income tax. Deductible interest payments are permissible in countries such as the United States.
Some taxpayers in South Africa may also claim part of the interest payments on their housing bonds as a
personal income tax deduction. The tax reduction on interest payments on housing bonds is the exception
and we will focus on the more important practice where interest income (in other words, the return on
savings) is taxed.
A tax at a rate of t reduces the rate of interest received to (1 – t)r. The opportunity cost of present
consumption changes to [1 + (1 – t)r] compared to the before-tax opportunity cost of (1 + r). How does this
affect the budget line? First of all, the after-tax budget line must include the initial endowment (Y0, Y1),
since the individual may still opt neither to save nor to borrow at that income. If Grace decides to save (in
other words, move above and to the left of point E0 in Figure 13.3), she will be able to increase future
consumption by less than before. The new life-time budget line becomes the flatter segment GE0. Put
differently, the slope of the budget line now has an absolute value of –(1 + [1 – t] r). The cost of borrowing
is not affected by the tax on interest income. Therefore, to the right of point E0, the individual can still
consume combinations on segment E0A of the budget line. The after-tax lifetime budget constraint becomes
AE0G and is kinked at point E0. Again, the question is: Which combination of present and future
consumption will Grace choose after the tax on interest?
Before the tax, Grace consumed at D where indifference curve U0 touches the lifetime budget line AB.
After the tax consumption is at E0*, where the lower indifference curve U1 is tangent to the after-tax budget
line AE0G. Present consumption is now at 0C0* and future consumption is equal to 0C1*. The important
observation is that saving has declined from Y0C0 to Y0C0*. But depending on her taste for future and
present consumption (the shape of the indifference curves), the outcome could have been different. Saving
could have increased. The net result is ambiguous. Why?
The tax has changed the relative ‘price’ of present consumption, and a price change has a substitution
effect and an income effect. Let us consider the substitution effect first. Since the opportunity cost of
present consumption has decreased (the product has become ‘cheaper’), Grace would increase present
consumption. This implies that savings is reduced, resulting in less future consumption. The income effect
can be explained by noting that the reduction in the interest rate received caused after-tax income in the
future to become less. The only way in which Grace could maintain her consumption level in the future is
to reduce present consumption. The income effect implies more saving. One could also understand the
income effect by considering that many people aim at reaching a certain retirement goal or that they are
target savers. If the return on their savings declines, they have to compensate by saving more (reducing
present consumption). To summarise: the substitution effect causes saving to decrease; the income effect
causes saving to increase. If the substitution effect dominates, the net result would be lower saving. If the
income effect dominates, the net result would be increased saving. The end result is therefore theoretically
ambiguous and remains a matter for empirical research.
We have established that an income tax levied on interest income causes the relative price of present
consumption in terms of future consumption to change. The impact on the supply of savings remains
uncertain. How is economic efficiency affected? To determine whether the tax on interest income has an
excess burden, we could repeat the procedure we employed when we analysed a selective tax on labour
income. We simply contrast the effect of the interest income tax with a lump-sum tax of equal revenue. A
lump-sum tax does not have an effect on the consumption choices of the individual in the two periods (in
other words, the relative price ratio between present and future consumption remains unchanged). We can
conclude that an income tax on interest income is economically inefficient since it causes the individual to
substitute between present and future consumption (an excess burden is created). The magnitude of the
burden may also be compounded when different forms of savings are taxed differently, thereby changing
the rates of return on savings vehicles. This would imply a further distortion of relative prices.
Empirical results of the effect of taxation on saving are inconclusive. Some economists estimated a low
interest elasticity of supply of savings, whereas others came to different conclusions. The consensus
opinion is that the rate of return effects on saving is at best small (Jappelli & Pistaferri, 2002). The
evidence on whether taxation may have an impact on pension savings is also not clear. People do not
necessarily increase their net savings; they shift their savings in response to tax incentives (Gale & Scholz,
1994). The Katz Commission (1994) came to similar conclusions, noting that the impact of non-tax factors
is much more important and that it is only the composition of savings that is affected by personal income
tax. In this regard, by stimulating personal saving, the loss in revenue for government could result in an
increased budget deficit (in other words, greater government dissaving). Promoting savings through
mandatory contributions to pension funds also crowds out voluntary savings. However, there may be other
reasons for introducing compulsory savings programmes, including equity reasons. Low-income earners
below the income tax threshold have no tax incentive to save, while high-income earners have the
resources and financial information needed to exploit tax incentives. To leave saving for retirement entirely
in the hands of individuals could lead to free-riding behaviour, which could cause a burden for future
generations. The reform of the social security system was addressed in Chapter 9.
13.4.2 Equity
As mentioned, personal income taxation lends itself to the application of the ability-to-pay principle.
Through a system of exemptions, deductions, tax rebates and marginal tax rates, the rate structure can be
made to conform to society’s notion of fairness. However, before we can make final conclusions in respect
of tax equity, we need to know who ultimately bears the burden of the tax. If the tax can be shifted quite
easily, the achievement of equity objectives could be compromised.
Even though the statutory burden of the tax is on the individual, it may be possible for individuals to
shift the burden. The critical issue is how sensitive the supply of labour is to price and tax changes. As
already noted, the net effect on work effort will be determined by the relative strengths of the income and
substitution effects. Empirical evidence points to an insensitive or inelastic supply of labour for men (in
other words, the supply curve is almost vertical). If the supply curve is relatively inelastic, the burden is on
the supplier, that is, the employee in this case (see Chapter 11, Figure 11.5). If the supply curve is less
inelastic, the employer and the employee will share the burden. This scenario is possible in the case of
married women and high-income professionals who are internationally mobile. Thus governments should
take due cognisance of tax shifting possibilities when personal income taxes are levied with a view to
changing the income distribution. Intentions and actual policy outcomes do not necessarily point in the
same direction. The unintended consequences of attempts at changing the distribution of income using
populist approaches are considered in Box 13.3.
Box 13.3 Taxing the rich4
The debate on taxing the rich was invigorated by a New York Times article in which billionaire investor Warren
Buffett alleged that the super-rich do not pay enough taxes (The Guardian, 2011). United States president Barack
Obama was also calling for ‘millionaires and billionaires’ to ‘pay their fair share’ and the new French president was
arguing for a 75% tax rate on household incomes above $1,3 million (Economist, 2012a, 2012b). In the United
Kingdom, it was announced in 2008 that a 45% tax on incomes above £150 000 would take effect in 2011, but this
rate was increased to 50% and the date was brought forward to April 2010 (Brewer, Browne & Johnson, 2012: 181).
South Africa is characterised by large income and taxable income inequality. In 2010, the taxable income share of
the top 10% was 47% and that of the top 1% of taxpayers was approximately 18% (see Steenekamp, 2012: 3;
Alvaredo & Atkinson, 2010: 14). In line with international trends, marginal tax rates applicable to the rich were
similarly reduced in South Africa in steps from a high of 75,5% in 1948 to the current level of 45%. Using a micro-
simulation model, Van Heerden and Schoeman (2010: 13) confirm that taxpayers at the higher end of the income tax
scale have benefited relatively more from tax reforms in recent years.
It is obvious that the rich are important to economic development, for that is where the concentration of money is
as well as wealth, net savings and talent. A progressive income tax system taxes success, and may discourage
entrepreneurial entry and innovation. The very rich receive relatively more compensation in the form of cash,
bonuses, share options and capital income than other income groups, which makes them more responsive to demand
conditions and the business cycle. It also enables them to shift the form in which they receive income in the short
run. The hours of work of high-income taxpayers are sometimes assumed to be more responsive to high marginal tax
rates. High tax rates may furthermore encourage evasion and emigration. Because of the economic importance of the
rich, it is imperative to study how sensitive their behaviour is to changes in income, and what the implications are for
public policy and taxation in particular. All the mentioned behavioural responses are important because they impact
on tax revenue and economic efficiency (the deadweight loss). In principle, the elasticity of taxable income (ETI)
can capture all of these responses.
The ETI concept is central in the analysis to estimate the impact of changes in marginal tax rates. It measures the
responsiveness of top reported incomes (as a share of all reported incomes) with respect to the net of tax rate.5 The
higher the elasticity coefficient, the more responsive tax earnings are to the net of tax rate. If government increases
the tax rate by a small amount, it will have two effects on tax revenue: a mechanical effect and a behavioural effect.
The mechanical effect causes tax revenue to increase when the higher tax rate increases, whereas the behavioural
effect causes a reduction in tax revenue. The behavioural response is also equal to the marginal excess burden
(deadweight loss) created by the tax increase.
Using published tax data by income group contained in Tax Statistics 2011, it was determined that the
approximate top 1% of taxpayers (approximately 100 000 taxpayers) in 2010 earned taxable income starting at R750
000. Because tax policy results are so sensitive to different estimates of the ETI, the results for an ETI of 0,20, 0,40
and a much higher ETI of 0,80 were used to investigate the revenue and efficiency implications of a marginal tax
increase for the top 1%.6 Using these coefficients, it was estimated that a 10% increase in the top marginal tax rate
(an increase from 40% to 44%) would result in taxable income ranging from a gain of approximately R2 billion to
losses of R340 million. Although these results are tentative, they show that taxing the rich at higher rates may not
produce the revenue windfall expected. The marginal excess burden increases from R0,39 to R3,16, depending on the
ETI and the effective marginal tax rate (society is worse off by this amount for each extra rand of tax revenue raised).
Using a micro-simulation model, Van Heerden (2013) also concludes that from an efficiency perspective, increases
in marginal tax rates will be detrimental to the economy. Kemp (2017: 31) estimates the elasticity of taxable income
in South Africa at approximately 0,3 (using bracket creep in the absence of large tax reforms), and for gross income
the estimate is smaller at around 0,2. He also finds that higher income groups are more behaviourally responsive (i.e.
the elasticity estimate for the top 10% of income earners is 0,37). He concludes that profound increases (such as the
increase of the maximum marginal rate to 45%) could dampen anticipated revenue gains. Empirical evidence on
progressivity and the impact of taxation in particular on redistribution in South Africa since 1994 is also not very
encouraging (see Nyamongo & Schoeman, 2007; Van der Berg, 2009; StatsSA, 2008).
13.4.3 Administrative efficiency and tax revenue

In the discussion of administrative efficiency in Chapter 12, a number of references were made to income
tax (Section 12.3). We will highlight some of the issues here. Income taxes are complex, and
administrative efficiency requires relatively sophisticated taxpayers and administrators. In countries where
these requirements are generally lacking, the income tax code should be as simple as possible. To simplify
tax administration and ease the compliance burden for some taxpayers, SARS introduced an electronic
filing facility for individuals.
Personal income tax is the largest source of government revenue. In 2017/18, it contributed 39,7% of
total tax revenue collections. It must, however, be recognised that the tax base is rather small. For the 2017
tax year, there were 20,0 million individuals registered as taxpayers, but approximately 32% of them were
expected to submit tax returns and only 4,9 million were assessed (National Treasury and South African
Revenue Services, 2018: 30). This must be compared to a labour force of approximately 22,4 million
employed and unemployed workers in the first quarter of 2017 (StatsSA, 2018b: 1). Thus although the
labour force is indicative of the potential income tax base, many of the total number of potential taxpayers
are not liable for income tax owing to the tax threshold and tax rebates. The tax base can be increased by
lowering tax rebates or lowering the minimum tax threshold. This would cause hardship for the poorer
taxpayers and increase tax administration. Alternatively, efforts could be made to capture people outside
the tax net, such as those in the informal sector and other groups that are difficult to tax. These groups
could be taxed using presumptive taxes. Presumptive taxation involves the use of certain indicators (for
example, ownership of certain assets, personal servants, average profit margins or average gross turnover)
to determine tax liability. We will return to this concept when we discuss the company tax on small
businesses in Chapter 14 (Section 14.3.2).
Another method that has been proposed to increase tax revenue (or maintain the same level of tax
revenue) is to reduce tax rates. This recommendation is based on the alleged tax-rate–tax-revenue
relationship that has become known as the Laffer curve, named after the economist Arthur B. Laffer, who
popularised the idea (see Laffer, 2004). The logic of his argument is that higher tax rates will not
necessarily produce more tax revenue, since the tax base will shrink as taxpayers reduce their work effort
in response to the higher rates. Fundamentally, the debate is again about how sensitive labour supply is to
tax changes. Without discussing this issue again, it should be recognised that the higher the tax rate is, the
more likely it is that the substitution effect will dominate. For example, if income is taxed at increasingly
higher marginal rates and ultimately at 100%, work effort will not only decline, but a person will
eventually not be prepared to do any additional work whatsoever. Tax revenue is the product of the tax rate
and the tax base, where the tax base depends on work effort (the number of hours worked). At low tax
rates, an increase in the tax rate will tend to increase tax revenues (at low rates, people will still work more;
in other words, the income effect dominates). However, this will only continue up to a point, beyond which
further tax rate increases will reduce tax revenues (people will eventually reduce their work effort; in other
words, the substitution effect will dominate).
The Laffer curve is illustrated in Figure 13.4. Total tax revenue is plotted on the vertical axis and the tax
rate on the horizontal axis. If the tax rate is at A, government can still increase tax revenue by raising the
rate. Once the tax rate is at B, however, a further increase in the rate will cause tax revenue to decline (for
example, from R3 to R2). The supporters of the Laffer hypothesis use the mechanism to show that if the tax
rate is at C, the authorities should lower the rate since this will result in higher tax revenue, as illustrated by
a movement from R2 to R3. The critical question, of course, is to determine where countries are on the
curve. The proponents argue that some countries may well be beyond point B. The debate can only be
settled empirically, but it does appear that labour supply elasticities are such that it is unlikely that rate
reductions would be fully counteracted by increased work effort.
Figure 13.4 The Laffer curve

13.4.4 Flexibility
In Section 12.4 of Chapter 12, it was pointed out that one of the ‘good’ characteristics of a personal income
tax is its built-in flexibility to counter cyclical economic behaviour. Personal income tax is thus considered
to be an automatic stabiliser. On the negative side, inflation has serious implications for a progressive
personal income tax, to the extent that it has rendered the automatic stabilising effect meaningless (see
Chapter 18). Inflation erodes the value of tax thresholds and deductions, and leads to bracket creep; this is
a process whereby a person is pushed into a higher income tax bracket as his or her nominal income
increases (irrespective of what happens to the person’s real income). This could be beneficial to
government (it raises more and more revenue without the legislative process needed to increase tax rates),
but if tax brackets and the value of tax preferences are left uncorrected, all taxpayers could, in the extreme,
end up paying the maximum marginal tax rate. This disguised way of increasing the tax burden is, of
course, not conducive to transparency, an important requirement of a good tax system. Sometimes the
phenomenon of bracket creep is erroneously referred to as ‘fiscal drag’. The latter concept really refers to
the dampening effect on the economy of the higher tax revenues (caused by bracket creep); that is, rising
tax revenues automatically push the government’s budget into a surplus, creating a restrictive fiscal policy.
This could have very adverse implications if substantial inflation occurs in recessionary times (when a
deficit on the budget would be more appropriate in Keynesian terms) unless tax brackets are adjusted for
inflation.
To understand the phenomenon of bracket creep, it is essential to distinguish between nominal income
and real income. Real income refers to the purchasing power of income (in other words, income after
adjustment for inflation), whereas nominal income is the actual monetary value or rand (or home-
currency) value of income.
The personal income tax schedule taxes a person on his or her nominal income. In inflationary times,
employers often compensate workers for the decline in purchasing power by increasing their wages or
salaries. If the rate of increase is equal to the inflation rate, workers’ nominal income increases, but their
real income stays the same. However, if the personal income tax schedule is not corrected for inflation,
individuals are pushed into higher tax brackets with higher marginal tax rates because their nominal
incomes have increased. Consider the numerical example below using the tax schedule in Table 13.1.
Suppose that Ms Shope received an income of R180 000 in 2018/19. Now assume that the general price
level increases by 10% in 2019/20 and that Ms Shope’s employer raises her salary by 10%. In real terms,
her income stays the same, but in nominal terms, her income increases to R198 000. We can calculate Ms
Shope’s tax liability in 2018/19 and 2019/20, assuming that the tax schedule in Table 13.1 remains
unchanged (inclusive of the tax rebate). In 2018/19, her tax liability (based on her income of R180 000)
was R18 180 (remember to take the primary rebate of R14 220 into account). In 2019/20, her nominal
income of R198 000 pushed her into the higher (R195 851 and more) tax bracket and the last R2 150 of her
income is taxed at a marginal tax rate of 26%. In 2019/20, her tax liability increases by 18,8% to R21 592,
much more than the inflation rate of 10% with which her salary increases. Ms Shope therefore pays R3 412
more tax, even though her real income has not increased. Her average tax rate increased from 10,1%
to . This increase in her average tax rate (while her real pre-tax income
remains unchanged) is what bracket creep is all about. If left unchecked, bracket creep undermines vertical
equity. Even poor taxpayers will be drawn into the tax net and will eventually be taxed at ever higher
marginal tax rates.
The tax authorities can temper or eliminate the effects of bracket creep by linking the rate structure to a
price index (in other words, by raising the income brackets each year in line with the increase in the
general price level). Alternatively, government can adjust the brackets and rebates on an ad hoc basis. This
has been the preferred method of the South African tax authorities. Following the recommendation of the
Margo Commission (1987: 81), government has also reduced the number of tax brackets to slow down the
inflationary creep to increasingly higher marginal rates. For example, in 1991/92, the income tax schedule
for married couples provided for fifteen brackets compared to the seven brackets in 2019/20.
Key concepts
• bracket creep (page 287)
• comprehensive income tax base (page 267)
• Corlett-Hague rule (page 280)
• elasticity of taxable income (page 285)
• fiscal drag (page 288)
• income effect (page 277)
• Laffer curve (page 286)
• lifetime budget constraint (page 282)
• lifetime income (page 281)
• marginal tax rates (page 273)
• minimum tax threshold (page 272)
• nominal income (page 288)
• presumptive taxation (page 286)
• real income (page 288)
• residence principle or worldwide basis principle (page 268)
• source of income principle (page 268)
• substitution effect (page 277)
• tax deductions (page 271)
• tax exclusions (page 270)
• tax exemptions (page 271)
• tax expenditures (page 270)
• tax rebates (page 271)
• unit of taxation (page 272)
SUMMARY
• Income is anything that is available to finance consumption and falls within the definition of the
comprehensive income tax base, also known as the Haig-Simons definition of income. Three important
forms of income are personal income, company income and capital gains. For administrative and other
reasons, these forms of income are taxed separately.
• In calculating personal income tax, gross income is first determined. It consists of all receipts and accruals
of South African residents irrespective of where in the world the income was earned. Taxable income is
obtained after tax expenditures (that is, exemptions and deductions) have been provided for. The gross
tax liability is calculated using tax tables. Once rebates (for example, primary tax rebate) and credits
(for example, medical tax credit) have been deducted, the net tax liability is obtained.
• A tax on income distorts relative prices and therefore impacts on the choice that workers have between
work and leisure. A tax on labour income has an income effect and a substitution effect. Depending on
the relative strengths of these effects, it will result in work effort increasing or decreasing. Empirical
evidence suggests that the supply of working-age men is not sensitive to tax changes, whereas that of
married women is.
• Individuals have a choice between current and future consumption (savings). A tax on interest income will
have an income effect and a substitution effect. The substitution effect causes saving to decrease; the
income effect causes saving to increase. The empirical evidence on whether taxation may have an
impact on savings is inconclusive, but the consensus opinion is that the effect is small.
• Because a tax on personal income or interest income is a selective tax, it distorts relative prices. By
comparing the effect of the selective tax to a lump-sum tax of equal revenue, we can show that a tax on
labour income or interest income has an excess burden. The personal income tax is therefore
allocatively inefficient from this perspective.
• Personal income taxation is suited to address equity concerns of society. Through a system of exemptions,
deductions, tax rebates and marginal tax rates, the rate structure can be made to conform to the ability-
to-pay principle. But because some groups of income tax payers (mobile professionals and married
women) can shift their tax burden, the equity outcome of high tax rates may not necessarily be as
intended.
13.1 In South Africa, gross tax liability …
a. exceeds comprehensive income.
b. minus the medical tax credit equals net tax liability.
c. is calculated by applying personal income tax tables to taxable income.
d. equals taxable income.
13.2 Personal income tax …
a. has a substitution effect when leisure can be taxed at the same rate.
b. levied at progressive marginal tax rates decreases the substitution effect.
c. increases the opportunity cost of leisure.
d. generally decreases work effort according to available empirical evidence.
e. causes labour supply to increase when the income effect dominates.
13.3 Personal income tax has an excess burden …
a. because leisure and income are taxed at the same rate.
b. since there is a choice between current consumption and saving.
c. that can be illustrated as the difference between U0 and U1 in Figure 13.2.
d. but can be reduced by taxing goods and services, which are substitutes for leisure.
e. meaning that the tax is not only inefficient, but also inequitable.
13.4 A selective tax on interest income …
a. only causes an income effect.
b. increases the slope of the after-tax budget line, for the segment to the left of the endowment point
(assuming that future consumption is measured on the vertical axis).
c. increases the opportunity cost of present consumption.
d. has no excess burden.
e. decreases the opportunity cost of present consumption.
13.1 Define and explain the comprehensive income tax base.
13.2 Differentiate between the following concepts:
• Gross, net and taxable income
• Nominal and real income
• Accrued and realised income
• Average tax rate and marginal tax rate
• Tax exclusions, tax deductions and tax credits.
13.3 Why are policy-makers so concerned about the impact of inflation on personal income tax?
ESSAY QUESTIONS
13.1 Critically evaluate the introduction of a worldwide basis of taxation in South Africa.
13.2 Explain the rationale behind the progressive nature of individual income tax structures.
13.3 With the aid of a graph, explain the likely effects of an increase in individual income tax on the supply
of labour.
13.4 ‘Personal savings in developing countries are at low levels. By exempting interest income from
taxation, governments can stimulate higher levels of savings.’ Do you agree? Make use of a diagram
and empirical findings in your discussion.
13.5 Discuss the economic effects of personal income tax by referring to economic efficiency, equity,
administrative efficiency and flexibility.
13.6 Discuss the relevance of the so-called Laffer effect.
1 In 2015 the maximum annual tax-free amount was R30 000. It increased to R33 000 as of 1 March 2017.
2 The decision to work less or more is also affected by noneconomic factors (for example, the status of work in a society as well as
the need to avoid boredom and to get out of the home environment). We concentrate only on the economic effects.
3 Since the 1970s the top marginal income tax rate decreased to 40%, but it was subsequently rasied to 41% in 2015/16, and then to
45% in 2017/18 (for equity and revenue purposes).
4 This section is based on Steenekamp (2012).
5 For a comprehensive description of the ETI concept and the model framework for analysing behavioural responses, see Saez
(2004: 11–15), Saez, Slemrod & Giertz (2012: 5–10) and Giertz (2009: 115–117).
6 Van Heerden (2013: 78) estimated the ETI for the high-income taxable group to be 0,79.
Company income tax, capital gains tax and income
tax reform
In Chapter 13 we applied the properties of a ‘good’ tax as identified and explained in Chapters 11 and 12 to
personal income tax. In this chapter we continue our application of these properties to other income taxes,
namely company income tax and capital gains tax.
We begin by attempting to answer the question of why companies are taxed in the first section. In
Section 14.2, we discuss the structure and calculation of company tax. Section 14.3 analyses the economic
effect of company tax. In Section 14.4 we turn our attention to the taxation of capital gains. We conclude
this chapter with a section on income tax reforms that have implications for both individual and company
income tax and that include the topical issues of the flat rate tax and dual income tax.
Once you have studied this chapter, you should be able to

Explain why companies are taxed separately
Define the company tax base
Describe the classical and fully integrated company tax systems
Describe company tax in South Africa
Explain the efficiency of company tax
Discuss the importance of company tax in the investment decision
Discuss the merits and disadvantages of tax incentives for investment
Explain the equity implications of company tax
Discuss the arguments for and against capital gains taxation
Explain a flat rate income tax
Explain the dual income tax.
14.1 Why company taxation?

Owing to certain unique properties of company income, most countries tax this source of tax separately.
These are the main reasons for taxing companies:
• From a legal point of view, companies are separate entities (legal persons). They function as institutions
with their own identity and are independent from their shareholders, who are taxed in their own right.
• Companies receive benefits from government and should be taxed for these privileges according to the
benefit principle. The benefits include companies’ limited legal liability to shareholders, the creation of
an orderly environment by government, which is necessary for conducting business, the use of
infrastructure and so on.
• If companies are not taxed, it is possible for shareholders to limit their personal income tax liability by
retaining profits in the company. This increases the capital value of the shareholders’ investment in the
company. If capital gains are also not taxed, the integrity of the whole system of income taxation is
jeopardised. Tax avoidance by individuals is therefore limited by taxing company profits. Since it is
generally members of the higher-income group who are shareholders in companies, taxing this income
is fair from an ability-to-pay perspective.
• By taxing the excess profits of imperfectly competitive firms (for example, monopolies and oligopolies),
market failures are addressed. Even though this may contradict the tax neutrality arguments against tax
expenditures, the government may attempt to achieve other economic policy objectives, such as
promoting foreign and local investment and achieving regional development aims, by manipulating
company tax rates and providing tax incentives (for example, liberal depreciation allowances, training
allowances and tax credits).
• Company taxation is administratively simple and generates significant revenue as a separate tax,
particularly in developing countries (see the discussion of tax reform in Section 16.6).
• By taxing companies, revenue is derived that would otherwise accrue to foreign investors and their home
governments. Foreign investors are usually taxed on their investment income at company tax rates in
their home countries, that is, according to the residence basis of taxation discussed in Chapter 13. For
example, when South Africa (the host country) levies company tax, the profits repatriated to the home
country (for example, the United States) will also be taxed at prevailing American company tax rates.
To avoid double taxation, countries usually enter into double taxation agreements, whereby the home
country credits taxpayers with taxes paid on business income in the host country. In other words, only
the difference between the home country tax liability and the host country liability is payable in the
home country. This amounts to a sharing of company tax revenue between the home and source
countries, thus deviating by mutual agreement from the residence basis of taxation.
Company tax is a significant but declining source of tax revenue. In 1975/76, income tax on companies
amounted to R1 969 million, or about 41% of total tax revenue (net collections) in South Africa.
In 2018/19, company tax came to R218 436 million, or about 17,4% of total tax revenue (excluding
Southern African Customs Union (SACU) payments). There are various reasons for this decline, one of
which concerns the nature of economic development. As a country develops economically, the
consumption tax base broadens and the personal income tax base also becomes more important. Another
set of possible reasons includes factors that reduce company profit margins, such as rising wage costs,
import costs and debt finance charges. Tax exemptions, tax evasion and tax avoidance are further possible
causes, since they lead to effective tax rates that turn out to be much lower than the nominal or statutory
rates. Moreover, the company tax is a relatively unstable source of government revenue, in the sense that
changing domestic and global economic conditions cause volatility in the contribution of company income
tax to total tax revenue as profits track upswings and contractions in economic activity. The company tax
rate was also reduced from 50% in the 1980s to the current 28%.
Although the contribution of company tax revenue shows a declining trend, South Africa uses company
taxation very intensively compared to other low- and middle-income economies. When countries are
ranked according to their company income tax efforts, South Africa ranks second out of 27 countries
studied (Steenekamp, 2007).
Mining and quarrying in South Africa has for many years been an important contributor to income tax
revenue, but its role has changed significantly over the last decades. Provisional tax payments by the
mining and quarrying sector vary greatly because of global changes in commodity prices, the rand
exchange rate and other reasons. In 1975/76, income tax revenue from mining companies was 10,8% of
total tax revenue (excluding SACU payments). In that same period, tax revenue from gold mining was
approximately 10% of total tax revenue, but it declined to only 0,1% in 1998/99 (the last year in which
revenue from gold mining companies was reported separately from other companies). Gold and other
mining companies contributed approximately 1,2% to total tax revenue in 1998/99. In 2017/18, tax
payments by this sector remained low at only 1,9% to tax revenue collections (R21,9 billion) (National
Treasury & South African Revenue Service, 2018: 170).
14.2 The company tax structure

Before company tax can be analysed, it is necessary to discuss the company tax structure. This can be done
by describing the tax base and by distinguishing between different types of company tax as well as
different sizes of enterprises.
14.2.1 The company income tax base

Businesses can be classified as incorporated or unincorporated. Incorporated businesses or companies
include private and public companies, state-owned companies and non-profit companies. Unincorporated
businesses include sole proprietorships and partnerships. In South Africa, mining companies are also
distinguished from non-mining companies. The nature of business differs so much between these two
categories that they are taxed differently. The South African government introduced a mineral and
petroleum royalty regime in 2010/11. The mineral royalty generated R7,6 billion in 2017/18. The taxing of
mining enterprises is still receiving the attention of government. The terms of reference for the South
African Tax Review Committee (the Davis Tax Committee (DTC)), appointed in 2013, specifically
required the Committee to review whether the royalty regime is sufficiently robust and to assess the
appropriateness of the current mining tax regime. The DTC (2016a) released a final report on hard-rock
mining. Below are some of their recommendations on the mining tax system and the royalty regime.1
• Retain the mineral royalty regime as its design balances responsiveness to fluctuating economic
circumstances (obtaining rents when mining companies earn high profits and ensuring minimum
revenues for the fiscus during downturns). Some aspects of the regime, though, require attention (see
DTC (2016a)).
• Move towards an alignment of the current mining tax system with that of the other taxpaying sectors, and
retain the royalty regime in response to the non-renewable nature of mineral resources.
• The existing capital allowance that makes provision for the upfront expensing of capital expenditure
should be replaced by an accelerated depreciation allowance similar to that of the manufacturing sector
(40/20/20/20 basis). This will also allow for the removal of ring fences (which was put in place to
prevent deductions of future capital expenditure against the tax base of other mines, or non-mining
income).
• Existing gold mines should continue to be taxed according to the gold mining formula. The motivation for
this recommendation is the possible loss in employment if the formula is not retained for these mining
companies.
• The mining industry has experienced profound changes over the past two decades, with a resultant
environment conducive to smaller companies making a meaningful contribution in the industry. Given
that their involvement is often based on a contract mining business model, it is recommended that an
appropriate template contract be designed to guide such contract mining arrangements.
• In the rest of this chapter, we focus on the taxation of non-mining companies only.
Taxable income is defined as total receipts (or revenue) of the company minus certain allowable expenses
(or costs). Expenses comprise costs incurred to run the business. Examples include any labour costs
incurred, interest payments or materials bought. The definition seems simple enough, but a number of
issues in respect of expenses complicate company taxation. These are the two most important
complications:
• Interest payments can sometimes be deducted from taxable income, but dividends cannot. This has
implications for company finance. Companies have three basic sources of finance: share capital,
borrowing (debt financing) and retained earnings. In the case of borrowing, the company can write off
the cost of the loans (interest) against income for tax purposes. When share capital is used in South
Africa, the cost of shares (dividends) cannot be written off against income. Therefore, there is a built-in
bias against the use of share capital as a source of financing. In other words, the tax system encourages
the use of loan finance, but excessive use of loans increases indebtedness and may lead to bankruptcy.
• Companies are allowed to deduct depreciation on assets when taxable income is calculated. The rationale
for a depreciation allowance is that assets (for example, machinery) lose some of their value each year
and wear out over their lifetime; this constitutes a cost of production. But it is difficult to determine the
true rate of depreciation precisely (that is, economic depreciation). Sometimes the allowance exceeds
economic depreciation. From time to time, governments also allow companies to depreciate assets at an
accelerated rate. This is sometimes used, for example, as an incentive to attract foreign investors or
stimulate investment in selected industries. Practices of this nature have the effect of reducing the
effective company tax rate below the statutory tax rate (see Section 14.3.2.1). Assets are also classified
into different categories and depreciation allowances differ accordingly. For example, 5% per annum is
allowed on commercial buildings (in other words, a write-off period of twenty years), but 40% of the
cost of manufacturing machinery will be deducted in the first year and 20% of the cost for the
subsequent three years.
In 2004, a special depreciation allowance for investment undertaken for construction or refurbishment of
buildings in underutilised designated urban areas was introduced. Taxpayers refurbishing a building within
this type of zone receive a 20% straight-line depreciation allowance over a five-year period. If a new
commercial or residential building is constructed within a zone of this nature, taxpayers receive an eleven-
year write-off period with a 20% write-off in the first year and 8% thereafter. The incentive is aimed at
encouraging investment in areas with high population-carrying capacity and central business districts. This
depreciation allowance applies to sixteen municipalities, including areas such as Johannesburg, Cape
Town, Polokwane, Sol Plaatje Metropolitan (Kimberley) and Nelson Mandela Metro-politan (Port
Elizabeth).
The problem with differentiated depreciation rates is that this practice tends to open up tax arbitrage
opportunities. Investors, for example, will invest in assets that they can write off quickly or immediately
for tax purposes, but that actually depreciate much slower or even appreciate over time. The tax authorities
usually only become aware of these ‘tax shelters’ after a while, and it then takes some time to eliminate the
loopholes. In South Africa, investments in forests, ships, motion pictures and aircraft were, and still are,
examples of this type of tax shelter. Needless to say, these tax-driven schemes are not models of efficient
resource allocation (see Section 14.3.2.3 on tax incentives).
14.2.2 Types of company tax

There are two extreme types of company tax. At one extreme, companies are regarded as entities separate
from their shareholders and both are taxed on the same income source (referred to as the classical system
or partnership approach). Company income is thus taxed twice, first as company tax, and then also as
personal income when distributed as dividends. This is commonly known as double taxation of dividends.
At the other extreme, the company is simply seen as a conduit for all company income to the shareholders.
All company income (retained as well as distributed) is taxed in full in the hands of the shareholders at
their marginal income tax rates. The company tax then only serves as a withholding tax, which is credited
in full at shareholder level. This type of company taxation is referred to as the full integration system.
Prior to 1990, South Africa had a modified classical company tax system incorporating a tax on
company income and a tax on dividends, with a certain portion of dividends being excluded from taxation
in the hands of the shareholders. On the recommendation of the Margo Commission (1987: 204), the
double taxation of dividends was discontinued in 1990, when dividends became tax-exempt in the hands of
resident individuals and close corporations. The company tax system was modified again in 1993 in an
effort to reduce the company tax rate without undue revenue loss to the fiscus, and to encourage companies
to finance themselves. A dual tax rate was introduced, that is, a basic rate and a secondary rate. Non-
mining companies are taxed at a fixed percentage on their taxable income. This is the basic tax on
companies. Company tax is therefore a proportional tax. The basic company tax rate was lowered from
48% to 40% in 1993 and to 30% in 1999. In 2005, the rate was further reduced to 29% and again in 2008 to
28%. The basic rate applies to all retained profits, that is, profits that are used to finance company
investment or build company reserves, and that are therefore not paid out as dividends to shareholders. In
addition to the basic rate, a secondary tax on companies (STC) was introduced in 1993. STC was levied
on all profits distributed to the company’s shareholders (in other words, dividends). STC was levied at
company level and paid by companies. The rate was originally set at 15% in 1993, but it was raised to 25%
in 1994, reduced to 12,5% in 1996 and reduced again to 10% in 2007. Both rates had to be considered in
order to determine the company tax rate.
The Katz Commission (1994: 175–177 and 226–227) thoroughly investigated the advantages and
shortcomings of STC. The Commission concluded that STC had served its purpose and that ‘it has become
desirable to consider better ways to achieve its objectives’. Starting in 2007, STC was phased out and
replaced with a dividend tax, which became effective on 1 April 2012. The tax rate is set at 20%.2 It
applies to all distributions and is administratively enforced as a withholding tax at company level; legally it
is not a tax on companies. The withholding tax only applies to dividends paid to individuals and non-
resident shareholders (dividends to all South African tax resident companies are exempted). No deductions
may be claimed against the dividends received and these dividends are not included in the shareholder’s
taxable income.
Company tax rates differ somewhat between the BLSN countries. In Botswana, resident companies pay
company tax at 22%. Where a business falls within the definition of ‘manufacturing’, it is entitled to a
reduced corporate tax of 15%. This relief is conditional on the approval by the Minister of Finance on
consideration of, for example, the number of citizens employed, training, replacement of non-resident
employees with skilled citizens and citizen management participation. The Kingdom of Lesotho taxes non-
manufacturing companies at a rate of 25%. Income derived from manufacturing activity sold within the
common SACU market is taxed at a rate of 10%. Manufacturing companies selling outside the SACU
market attract no company tax. In Namibia, corporate income is taxed at 32%. Special rebates may be
granted to approved manufacturing companies. Taxable income (after the special deductions) derived from
manufacturing is taxed at 18% for a total period of ten years. A tax-free regime applies in Namibian export-
processing zones (EPZs). All companies generating income in Eswatini (Swaziland) are taxed at a flat rate
of 27,5%.
14.2.3 Taxation of small and medium-sized enterprises

It is generally recognised that small and medium-sized enterprises are important for economic growth and
creating job opportunities in the economy. It is also recognised, however, that the tax system severely
affects these types of businesses insofar as tax compliance is concerned3. In addition, small businesses are
highly dependent on working capital provided by the owners. When their profits are taxed, owners often
have to use short-term debt, which increases their risk exposure. Various options can be pursued to assist
small enterprises through the tax system, including taxing these businesses on their cash flow, taxing
enterprises at differentiated rates (for example, a progressive corporate rate structure) and using tax
incentives (for example, tax holidays or accelerated depreciation allowances) (see Steenekamp, 1996).
The real and financial cash-flow tax base equals [sales + borrowing + interest received] − [real
purchases + interest payments + debt repayment]. The main advantages of a cash-flow tax (Mintz & Seade,
1991: 177–190; Shome & Shutte, 1993; Sunley, 1989) are as follows:
• The definition of the tax base is simple as the tax does away with problems of defining depreciation,
measuring capital gains, costing inventories and accounting for inflation.
• The tax is neutral with respect to the use of capital. Immediate expensing implies that the tax does not
discriminate between debt and equity.
The cash-flow tax has a number of shortcomings, however:

• During the transition from an accrual to a cash-flow system, the tax creates windfall tax revenue gains or
losses, depending on whether government allows or denies companies depreciation on earlier
investment.
• Full and immediate expensing seems to reduce the tax base compared to the accrual income tax base.
However, this conclusion is disputed by some, who argue that it has to be considered that the corporate
income tax base is also eroded through all kinds of tax expenditures.
• The incentive for base shifting is high (the tax base can be shifted from a high-tax entity to a low-tax
entity). This could be done by purchasing inputs from the low-tax entity at inflated prices, by low-rate
leasing and expensing by a high-tax party to a low-tax party, and by the sale of expensed assets at
understated prices to the low-tax entity. Monitoring these practices is difficult and increases the
administrative burden.
• The cash-flow tax raises serious problems in international taxation, as it may not be creditable in home
countries.
• Since no country has implemented the tax as yet, administrative problems are difficult to predict.
The Katz Commission (1994: 157–158) considered cash-flow accounting and recommended that it be
introduced as an option for small enterprises. The South African government accepted this
recommendation in principle and considered implementing cash-flow taxation in a particular sub-sector of
the economy, namely the micro and small business sector. Limiting cash-flow taxation to a sub-sector has
the advantage of improving its cash flow and capital requirements. Although the theoretical case for a cash-
flow tax system is quite strong, one serious problem concerns the international consequences. On the
negative side, cash-flow taxation increases the incentive for tax evasion and avoidance. The application of
this form of taxation to a sub-sector of the economy will probably add to opportunities for tax arbitrage.
In 2000, the South African government opted for a graduated tax rate structure and generous
depreciation allowances for small business corporations. The tax rate structure is set out in Table 14.1.
Small businesses may write off investment in manufacturing assets in full in the tax year in which the
assets are brought into use. An accelerated allowance for machinery, plant, implements, utensils, articles,
aircraft or ships (other than plant or machinery used in a manufacturing or similar process) acquired by
small business corporations can be depreciated at 50% of the cost of the asset in the tax year during which
it was first brought into use, 30% in the second year and 20% in the third year (a 50/30/20 rate structure
over a three-year period). At the time of writing, these benefits were limited to businesses with an annual
turnover of less than R20 million. Businesses in which more than 20% of gross income consists
collectively of investment income are excluded. As a means of reducing compliance cost, small businesses
with a payroll of less than R500 000 are also not required to pay the skills development levy. These tax
reliefs are thus mainly intended for manufacturing businesses, and are aimed at promoting job creation and
improving the cash flow of small businesses. Small businesses engaged in the provision of personal
services qualify for relief as long as they maintain at least four full-time employees for core activities.
To further reduce compliance costs (income tax and VAT paperwork) for very small businesses, the
government proposed a simplified tax regime in 2008. The regime is a turnover-based presumptive tax
system. Businesses with a turnover of less than R1 million per year will have the option to elect this form
of tax. Tax liability is calculated using a graduated tax rate structure based not on taxable income, but on
turnover (sales) (see Table 14.2). In addition, these micro businesses are not required to register for VAT4.
Table 14.1 Graduated tax rate structure for small business corporations
INCOME TAX: SMALL BUSINESS CORPORATIONS

Financial years ending on any date between 1 April 2019 and 31 March 2020
Taxable income (R) Rate of tax (R)
0–79 000 0% of taxable income
79 001–365 000 7% of taxable income above 79 000
365 001–550 000 20 020 + 21% of taxable income above 365 000
550 001 and above 58 870 + 28% of taxable income above 550 000
Source: South African Revenue Services (SARS). 2019. Budget 2019 Tax Guide. [Online]. Available:
http://www.treasury.gov.za/documents/national%20budget/2019/sars/Budget%202019%20Tax%20Guide.pdf [Accessed
4March 2019].
The use of presumptive taxes is widespread globally. This approach uses criteria such as turnover, sales,
employment, assets or size of the firm to determine tax liability administratively. It is intended to capture a
minimum tax amount from hard-to-tax groups of taxpayers such as those operating in the informal (or
unrecorded) sector. The aim is eventually to draw these taxpayers into the regular tax net once they have
reached a certain maximum threshold (for example, R1 000 000 of turnover in Table 14.2). Above this
limit, firms do not qualify for presumptive tax status and must migrate to the regular company tax
structure.
Presumptive taxation has some advantages, including simplification. It not only reduces compliance
cost for the business, but makes it easy for the revenue authorities to administer. They can use readily
available data to benchmark and verify tax liability, and it also releases them from spending too much time
on large numbers of small tax entities, freeing them to concentrate on the ‘big fish’. On the negative side,
presumptive taxes may cause inefficiencies in the tax system as firms try to take advantage of the regime
by restructuring their activities to qualify for presumptive tax status. Alternatively, if the maximum
threshold is set too high (resulting in a tax liability that is low compared to the regular tax liability), firms
will attempt to remain in the presumptive tax net. This may compromise horizontal fairness in the company
tax system.
Table 14.2 Presumptive turnover tax for micro businesses
Turnover tax for micro businesses

Financial years ending on any date between 1 April 2019 and 31 March 2020
Taxable turnover (R) Rate of Tax (R)
0–335 000 0% of taxable turnover
335 001–500 000 1% of taxable turnover above 335 000
500 001–750 000 1 650 + 2% of taxable turnover above 500 000
750 001 and above 6 650 + 3% of taxable turnover above 750 000
Source: South African Revenue Services (SARS). 2019. Budget 2019 Tax Guide. [Online]. Available:
http://www.treasury.gov.za/documents/national%20budget/2019/sars/Budget%202019%20Tax%20Guide.pdf [Accessed 4
March 2019].
As part of its mandate, the DTC investigated the tax system of the small and medium size business
sector. In 2014 the DTC released a first interim report on small and medium enterprises, and this was
followed by the final report in April 2016 – see DTC (2016c). Three focal issues were the turnover tax
system for micro businesses, the small business corporation tax system (in particular the graduated tax
structure and other incentives), and the VAT registration threshold for small businesses. Below is a brief
synopsis of these issues, as reported in the final report of the DTC (2016c):
• The turnover tax thresholds were adjusted in the 2015/16 Budget (which were part of the
recommendations in the DTC’s first interim report). This was done to encourage small business
participation in the economy and form part of the tax system (National Treasury, 2015c: 49). In its final
report, the DTC proposed retaining the current turnover tax package. Furthermore, taxpayers should be
given the option to exit the system on an annual basis. The National Treasury and SARS should also
explore measures that would require micro businesses to register for tax before allowing them to use
electronic payment facilities.
• The DTC found that the small business corporation (SBC) tax incentive system was not effective. A large
proportion of the benefits of the system accrued to service-related businesses (such as financial,
medical, and veterinary services), who were not the intended beneficiaries. Furthermore, since the
turnover tax system is in place, the SBC tax system does not have to account for small businesses with
a turnover of less than R1 million. The DTC proposed the following options for consideration: retain
the current system with its accompanying problems; remove service-related small businesses from the
SBC definition; consider extending the SBC system with a compliance rebate system to all tax
compliant SBCs; and finally, remove the SBC incentives and direct more targeted interventions through
the office of the Department of Trade and Industry, or the recently formed Department of Small
Business Development.5
• The DTC received submissions suggesting that the compulsory VAT registration threshold should be
increased. In response, the DTC indicated there was no justification for increasing this threshold, as it
aligns favourably with international standards.
14.3 The economic effects of company tax

Company tax impacts on economic efficiency, the decision to invest and the fairness of the tax system.
These topics will be the focus of the next subsections.

In analysing the economic efficiency of company tax, we again have to consider the excess burden of the
tax. Does company tax cause an excess burden? In other words, are relative prices (or returns) distorted,
resulting in resources not being optimally allocated? The answer depends on whether company tax is seen
as a tax on excess profits (or economic profits) or as a selective tax on capital.
If company tax is regarded as a tax on economic profits only, then company tax has no excess burden.
The economic profits of firms are simply reduced by the tax and firms still maximise profits. The tax does
not cause any other changes in behaviour (in other words, marginal costs are unchanged) and relative prices
are not affected. However, companies are taxed on their accounting profits (that is, economic profit plus
normal profit).6 In the short term, normal profits are a fixed cost. Therefore, marginal costs, which change
only when variable costs change, are not altered by the tax. However, in the long term, there are no fixed
inputs (all become variable) and taxing normal profits as part of accounting profits may then affect
marginal cost. Thus, in the long term, a tax on accounting profits may cause a change in the behaviour of
owners and prices, which could result in an excess burden.
The return on capital of shareholders invested in companies (in other words, dividends) is a non-
deductible expense. Company tax can therefore be regarded as a tax on capital. However, all forms of
capital are not taxed at the same effective rate. In South Africa, incorporated businesses (for example,
public companies) are taxed at a rate of 28%. Non-incorporated businesses (for example, sole
proprietorships) are taxed at marginal personal income tax rates, which vary between 18 and 45%. Small
business corporations are taxed at graduated rates that vary between 0 and 28%. The important point about
differential taxes on capital is that if companies are taxed at different rates, the net (after-tax) returns differ
from sector to sector. Capital will then move from the sectors with lower net (after-tax) returns to sectors
where a higher net (after-tax) return can be obtained. In theory this process will continue until net returns
are equal in all of the sectors. This migration of capital is purely in response to tax-induced differences in
returns and not because capital can be used more productively elsewhere. Resources are therefore
misallocated and an excess burden results. In the United States, this loss in welfare has been estimated at
between 12% and 24% of total tax revenue (see Shoven, 1976: 1261–1283; Jorgenson & Yun, 2001: 302).
14.3.2 Company taxation and investment

When decisions are made to invest in a country, investors consider taxes. However, non-tax factors and tax
incentives are just as important.
14.3.2.1 The decision to invest
Another issue concerning the economic efficiency of company taxation is its impact on local and foreign
fixed investment. The company tax structure can lower or raise the user cost of capital. The user cost of
capital includes, firstly, the opportunity cost of holding an asset in a company. By investing capital in a
company instead of, for example, saving it, an opportunity cost is incurred (in other words, the interest
forgone). Secondly, the user cost of capital includes depreciation costs. Capital invested in, for example,
machines, decreases in value. Finally, the user cost of capital is affected by company tax. The returns on
share capital (realised profits and dividends) are taxed and constitute a cost to the investor. By lowering
nominal company tax rates, providing depreciation allowances or giving tax incentives (for example, tax
holidays and tax rebates), the user cost of capital can thus be lowered and vice versa.
In 2014, the DTC commissioned the World Bank to update a 2006 sectoral study7 on the effectiveness
of investment incentives by determining the marginal effective tax rate (METR) of capital investment.
The METR is a summative measure8 that captures the impact of the tax system on the marginal investment
of a profit-maximising firm, and it determines the scale of the investment project (World Bank, 2015: 8). In
the case of company tax, we can determine the METR on income from physical capital by determining the
impact of the tax system on the user cost of capital. Hence, the METR is simply the difference between the
before-tax and after-tax rate of return on a marginal investment, divided by the before-tax rate of return
(Fullerton, 1999: 270). The effective tax rate typically considers the statutory tax rate, and any tax
incentives related to the investment (such as investment tax credit, accelerate depreciation allowances, and
investment allowances). There are two main approaches to determine the METR, namely, the forward-
looking approach and the backward-looking approach (see Sørensen, 2004: 4). The former applies the
parameters of the current tax legislation and determines what the expected tax burden will be on a
hypothetical investment. The latter uses (historical) data on capital taxes paid, and compares it to before-tax
capital income estimates.
The main findings of the World Bank study revealed that the METR on capital is lower than the
statutory company tax rate (of 28% at the time of the study) for almost all sectors investigated. This implies
that tax incentives (see Section 14.3.2.3 below) have a significant effect on the tax burden of the marginal
investment (World Bank: 2015: 9). In particular, the METR for the manufacturing sector was 19,6% (using
a neutral debt-equity scenario, i.e. a ratio of 0,5). Interestingly, even for sectors where there are no specific
tax incentives, the allowance of deducting interest payments from taxable income has reduced their METR.
Hence, where fixed assets were financed through debt, the METR was lowered considerably (World Bank,
2015: 10).
The question in developing countries is whether taxes impact on foreign direct investment (FDI); that is,
can developing countries attract new capital to meet various economic, social and political objectives?
Empirical studies on the impact of taxes on FDI in developed countries generally conclude that taxes have
a strong effect. Limited evidence for developing countries also shows some impact of tax rates on location
decisions of investors (see Zee, Stotsky & Ley, 2002: 1509–1510; Keen & Mansour, 2009: 22; Norregaard
& Kahn, 2007: 18–19). Using dynamic panel data econometrics, Klemm and Van Parys (2010) find
evidence that lower company income tax (CIT) rates and longer tax holidays are effective in promoting
foreign direct investment in Latin America and the Caribbean, but not in Africa. This is a surprising result.
It means that investment incentives are ineffective in Africa and simply lead to a loss of revenues. This
ineffectiveness of tax incentives is presumably attributed to a generally poor investment climate in Africa,
thus indicating that non-tax factors are important considerations when investors make locational decisions.
Based on the evidence brought before the Katz Commission (1994: 213), the Commission observed that
‘while tax is an important investment consideration, it ranks well down the list of priorities unless it poses a
specific and actual inhibition’. However, corporate taxation might be a major policy issue for the following
reasons:
• A punitive corporate tax regime constrains investment, while a liberal regime could result in an
unnecessary loss of revenue to the treasury, thus allowing foreign treasuries to capture bonus revenue.
• An unfavourable corporate tax regime might lead to other forms of profit-taking (for example, repatriation
of profits through transfer pricing and setting up branches instead of subsidiaries). The willingness of
multinational enterprises (MNEs) and others to lower their effective tax rates through transfer pricing
indicates their sensitivity to tax rates. Globalisation has opened opportunities for MNEs to minimise
their tax burden, which impacts on tax equity (see Organisation for Economic Co-operation and
Development, 2013).
• When non-tax factors are approximately the same in countries competing for investment, taxation
becomes all-important, as is evident from the intense tax competition in the East Asian region.
14.3.2.2 Non-tax factors

One should guard against overemphasising the impact of the company tax structure and rates on the
decision to invest. Overall, it appears that there is much more empirical evidence indicating that the effect
of taxes is minor compared to the impact of other factors that affect investment decisions (see Norregaard
& Kahn, 2007: 18; Zee, Stotsky & Ley, 2002: 1509–1510). The following non-tax factors are important to
investors:
• Business opportunities: Investors look for market opportunities to maximise profits, for example, by
increasing market size or vertically integrating their production processes across national borders.
Portfolio investors look for speculative profits (such as those offered by exchange rate differentials) or
are interested in spreading risk.
• Political stability and good governance: Political instability disrupts investors’ calculations of the expected
rate of return on their investment. Conditions in badly governed countries impact negatively on the
business environment.
• Economic stability: This includes price and exchange rate stability as well as fiscal stability (in other
words, a sustainable fiscal deficit).
• Labour stability: Rigidities in the labour market can result in labour costs becoming internationally
uncompetitive. Work ethic is important for certain types of investors. For a business person interested
in manufacturing goods that use labour-intensive technology (for example, clothing), a reliable
workforce is essential.
• Security and respect for property rights: Investors are sensitive to policy in respect of nationalisation and
privatisation, and to the honouring of international commitments such as double taxation agreements
and debt repayment obligations.
• Transportation costs and communication infrastructure: In principle, it is always desirable to manufacture
goods as close as possible to the market or markets that they serve. Poor communication infrastructure
can raise the cost of doing business.
14.3.2.3 Tax incentives

Tax incentives (for example, tax holidays, capital allowances, incentives for research and development, and
deductions for training expenses) are used in many developing countries in an effort to attract investment to
particular regions, sectors and industries. They are used for specific purposes such as export promotion,
employment creation, local participation, local sourcing of materials, improved infrastructure, the
promotion of technological transfers, skills development and the development of geographical regions.
The reasons for and arguments in favour of the use of tax incentives (see Zee, Stotsky & Ley 2002:
1499–1501; Boadway & Shah, 1995; Chia & Whalley, 1995) are as follows:
• In the case of market failures (for example, positive externalities), incentives may correct these. To reduce
congestion and pollution in urban areas, tax incentives could be used to promote economic activity in
rural areas. Similarly, projects that use new technology or require much research and development
(R&D) input can be targeted.
• Incentives are regarded as a means of offsetting the effects of regulations and controls in developing
countries, such as exchange control and licensing restrictions. Incentives compensate for these
distortions.
• Likewise, labour market distortions may be corrected by using investment incentives as a second-best
policy. In this way, employment can be created.
• Capital markets are often imperfect in respect of small firms. By targeting these firms selectively,
incentives can be used to overcome these constraints.
• Temporary investment incentives may be effective devices for assisting infant industries.
• To the extent that they are effective in encouraging investment, incentives generate external benefits for
the economy over and above those accruing to the investor, for example, innovation and training.
• Tax incentives can be used to signal to investors that a country is open for business. They announce to
investors that government has certain priorities and that investors will be compensated for their
commitment. Countries remain vulnerable to competitive incentives by other countries, whereby the
signalled benefits of incentives are neutralised. Niche markets can also be promoted through income tax
incentives.
Various analysts have questioned the use of incentives to promote investment and other objectives. The
arguments raised against incentives (Zee, Stotsky & Ley, 2002: 1501–1502; Easson, 1992: 387–439; Shah,
1995; World Bank, 1991) include the following:
• Incentives complicate tax administration and increase administration costs.
• Tax concessions erode the revenue base and necessitate higher tax rates. In some cases, profitable
investments would have taken place without the tax incentive. The incentives then become a free gift
from the government to the investor or even the treasury of the investor’s home country if the latter
uses the residence principle.
• Incentive schemes are often the result of pressure group action rather than an analysis of the economy as a
whole, thus favouring certain sectors over others (socially unproductive rent-seeking). If the incentive
is not aimed at correcting a market failure, it may actually create distortions and economic costs
(inefficiencies).
• Tax incentives result in an uneven tax burden among taxpayers, thus violating horizon equity.
• Tax incentives are less likely to succeed in attracting foreign investment than a general reduction in
corporate income tax.
• Investment incentives often lead to windfall gains in respect of investments that would have taken place
anyway. They have little impact on new investment.
• If there are obstacles to investment (for example, untrained labour), it is better to address these problems
directly instead of using tax incentives, since such incentives simply add further distortions to the
economy.
In developing countries, tax incentives for investment are now much more widely used than in the 1980s.
Low-income countries use incentives more extensively than do middle-income countries. It appears that tax
holidays are very popular. At the same time, the use of free zones (for example, export processing zones,
free trade zones and economic development zones) has increased to attract footloose industries9 (see Keen
& Mansour, 2009: 20). The number of countries in Sub-Saharan Africa with free zones has increased from
17 in 2005, to 27 in 2014 (James, 2016: 159). Research by Klemm and Van Parys (2010) confirms that
countries in Africa, Latin America and the Caribbean compete for FDI by lowering company income tax
rates and offering tax holidays. There is no evidence of spatial interaction (competition) using investment
allowances and tax credits.
The popularity of tax holidays runs counter to best practice tax advice. Tax holidays exempt (for a
period) investment projects from company income tax (CIT) or offer a rate lower than the regular rate. The
advantage of tax holidays and preferential CIT rates is ease of administration. The disadvantages are many:
these incentives favour investors expecting high profits and who would have undertaken the investment
without the incentive, it encourages shifting of profits from non-exempt to exempt firms, it attracts short-
run projects rather than sustainable ones and the revenue losses are not transparent. Some forms of
incentives, for example, investment allowances or tax credits and accelerated depreciation, are preferred to
tax holidays (see Zee, Stotsky & Ley, 2002: 1504–1505). These incentives (for example, shorter write-off
periods for investment costs) provide for investment in plant and equipment, thereby raising capital
intensity, however. They are more targeted and transparent in addressing, for example, human resource
training needs and cash-flow problems associated with new investments, and are also less prone to abuse
than tax holidays. To ensure that incentives achieve their beneficial outcomes, well-designed incentives
must follow three basic rules (Bird 2008: 9):
• Keep them simple.
• Keep records on who receives them and what the costs are in revenue sacrificed.
• Evaluate the numbers at regular intervals to check the results.
To this should be added that all new tax incentives should be accompanied by a legislative sunset clause,
whereby the incentive automatically expires unless re-legislated following a proper assessment of their net
benefits.
The Katz Commission (1994: 204) thoroughly reviewed tax incentives in South Africa and concluded
that ‘… the range of incentives should be narrowed as far as possible and that those which exist should all
be justified in terms of the objectives in the Reconstruction and Development Programme.’ This, however,
is a very vague guideline. The Commission also endorsed the principle that tax incentives be subject to
thorough cost-benefit analysis. Incentives can be economically justified mainly where markets fail (for
example, when investments generate positive externalities). When granted, incentives of this nature should
be transparent and discretion should be minimised.
For some years, South Africa has used a range of incentives to encourage foreign and domestic
investment. Investment support is provided by the Department of Trade and Industry, and consists of an
extensive grant system. Tax incentives (see Box 14.1) are also provided to promote investment. They
consist of accelerated depreciation allowances, graduated tax rates for small businesses (see Section
14.2.3), and incentives for capital expenditure on research and development (R&D). As indicated earlier,
the World Bank (2015) determined the METR for several economic sectors in South Africa, and they
concluded that most sectors benefited from a reduced effective tax rate because of the tax incentives. In
particular, the effective tax rate for the mining sector was calculated at -1.2% (weighted average across
minerals), and a significant factor for this result is the full expensing in the year of purchase of capital
expenditure (an incentive that the DTC has recommended should be adjusted – see Section 14.2.1). In the
late 1990s, South Africa also experimented with a tax holiday scheme for certain companies, but it applied
only until September 1999. Much emphasis is now placed on grants and depreciation allowances. This
augers well for transparency and better targeting of projects.
In the 2019 Budget Review, a statement concerning tax expenditures was provided in an effort to
quantify revenues forgone as a result of tax incentives. It was estimated that incentives amounting to
approximately R10,0 billion were provided to the corporate sector in 2016/17 (National Treasury, 2019a:
121). Compared to the approximate R204 billion tax revenue collected from companies in the same year,
the revenue forgone owing to tax incentives is insignificant. Nevertheless, with expenditures now
quantified, analysts will be able to attempt a proper cost-benefit analysis of tax incentives. One such
attempt is the second study completed by the World Bank (2016), in which the analyst first investigated
whether tax incentives reduce the cost of capital, and whether the reduced cost of capital resulted in
additional investments. Using individual firm data for the period 2006 to 2012, the study determined that
although tax incentives reduced the cost of capital to between 3% and 6,5% for all sectors, investment
increased (by R2,1 billion each year over this period) in only the following sectors: manufacturing, trade
and services, agriculture, and construction (World Bank, 2016: 6). However, revenue foregone (due to tax
incentives) amounted to approximately R4,5 billion per year over the seven-year period (World Bank,
2016: 7).
Additional employment opportunities to the tune of 340 000 were created, but the costs thereof were
relatively expensive (on average an additional job cost around R116 000 in terms of revenue foregone).
Two subsequent studies followed in 2017 and 2018 in which the World Bank analysed the efficiency of
specific tax incentives (research and development and incentives for small business corporations and
property investment). The DTC (2018a: 51–53) reported these results: in the case of the research and
development incentive, firms who received the incentive increased their research and development
spending, compared to those who did not receive it. The results showed that the additional investment in
research and development (approximately R13 billion) outweighed the revenue foregone of around R7
billion (between 2008 and 2015). On the tax incentives for the small business corporation sector (i.e.
graduated rate structure, and investment incentives), the DTC (2018a: 53) reported the World Bank study’s
finding that an additional job created by the incentives in this sector cost the government on average lost
revenue to the tune of around R120 000.
Box 14.1 Grants and tax incentives for investment
A generous system of taxable and non-taxable cash grants is provided by the Department of Trade and Industry to
promote new investment in South Africa. Programmes benefiting from this grant system include:
• The Clothing and Textile Competitiveness Improvement Programme
• The Automotive Investment Scheme
• Manufacturing Competitiveness Enhancement Programme
• Black Industrialists Scheme
• Critical Infrastructure Programme
• Sector-Specific Assistance Scheme
• The South African Film and Television Production Incentives
• Special Economic Zones.
Tax incentives to support investment are provided in terms of the Income Tax Act, No. 58 of 1962, and include
accelerated depreciation allowances, graduated tax rates for small businesses, and incentives for research and
development (R&D) capital expenditure. Accelerated depreciation allowances permit investors to use a 40/20/20/20
regime for manufacturing assets (plant and machinery). Investments in renewable energy and biofuels production as
well as capital expenditure on R&D can be depreciated over a three-year period on a 50/30/20 basis. Furthermore, an
accelerated depreciation regime applies to buildings within Special Economic Zones. The special allowance makes
provision for a 10% per annum depreciation over ten years.
Other tax incentives include the following:
• A tonnage tax regime for South African shipping companies according to which companies are taxed not on their
business income, but on the size of the ship, thus lowering the effective tax rate.
• Investments in energy-efficient equipment get an additional tax allowance of up to 15%.
• The government’s industrial policy strategy provides for investment and training allowances for large manufacturing
projects. It is designed to support Greenfield investments (in other words, new industrial projects that utilise only
new and unused manufacturing assets) as well as Brownfield investments (that is, expansions or upgrades of
existing industrial projects). A points system is used to determine qualifying status (criteria include improved
energy efficiency, skills development, innovation, business linkages, location in Special Economic Zone, and
SMME procurement). Between 35 and 55% of the cost of fixed capital investment and employee training is
deductible from taxable income.
• Expenditure in respect of scientific and technological research and development can be deducted at a rate of 150%
of expenditure.
• Special economic zones exist where a 15% company tax rate applies together with an employment incentive
allowing tax deductions for workers earning less than R6 500 per month.
14.3.3 Fairness
When we considered tax incidence in Chapter 11, we explicitly stated that only people could bear the
burden of a tax. In the case of companies, the people in question are shareholders, workers and consumers.
We will now analyse the incidence of company tax on each of these groups.
In Section 14.3.1, we noted that when companies are taxed at different rates, capital will move from
high-taxed sectors to low-taxed sectors so that a higher net return can be obtained. Theoretically, this
process will continue until net (after-tax) returns are equal in all of the sectors. All owners of capital
therefore bear the burden of the tax, not only the capital owners in the taxed sector. The real controversy
regarding the incidence of company tax is whether capital owners bear the full tax burden. Empirical
studies indicate that capital bears almost the entire burden, but it is still worth examining how the tax can
theoretically be shifted to other groups.
When the net (after-tax) return of taxed businesses declines, firms will attempt to recover the tax by
increasing their prices to consumers. The extent to which the taxed businesses can shift the tax will, of
course, depend on the price elasticities of demand and supply of the goods and services produced by these
businesses (see Chapter 11).
How can the company tax be shifted to workers? Just as firms may attempt to pass on the tax burden to
consumers in the form of higher prices, so they may try to shift the burden to workers in the form of lower
wages or lower levels of employment. Some observers argue, for example, that company tax affects
savings and investment over time. Since capital is internationally mobile, a tax on capital will cause capital
to move to lower tax jurisdictions. This lowers the amount of capital available per worker in the country
where capital is taxed and causes the marginal physical product of labour (MPPL or labour productivity) to
fall. A decline in labour productivity may lead to a decrease in wages or lower employment. Thus labour
may bear a part of the company tax burden. Details about how company tax can be shifted to labour fall
beyond the scope of this chapter. However, the incidence of company tax on consumers and labour remains
controversial.
Ultimately, equity (or fairness) depends on who the owners of capital are. Capital is usually owned by
the higher-income group. If the burden of company tax falls mainly on capital owners, vertical equity is
served.10 Horizontal equity depends on the type of company tax system in operation and will not be
discussed here. The fully integrated income tax system (Section 14.2.2) appears to serve both horizontal
and vertical equity objectives best, but this type of tax system is unfortunately administratively complex.
14.4 Capital gains tax

Capital gains can be defined as increases in the net value of assets over a period of time (for example, an
accounting period or fiscal year). According to the Haig-Simons definition of comprehensive income,
anything that makes consumption possible without diminishing wealth at the beginning of a fiscal year is
considered to be income. Capital gains are, accordingly, often classified as a form of income and are taxed
as such. Capital gains can be taxed as they accrue (an unrealised gain) or when they are realised. An
unrealised capital gain occurs when an asset increases in value in a given fiscal year and the asset is not
sold, for example, an increase in the rand value of a Krugerrand when the rand depreciates against the
dollar. A capital gain is realised when an asset has increased in value and is sold for cash.
Capital gains tax is currently levied in a number of developed countries, such as Canada, the United
States, the United Kingdom, Australia and Japan, as well as in some developing countries, including
Argentina, Brazil, India, Nigeria and Zimbabwe. In South Africa, capital gains were generally not taxable
in the past. Where assets were kept as an investment and then sold, the yield on realisation of the asset was
regarded as a receipt of a capital nature: one asset (capital) was simply converted into another (cash) and
the yield was therefore not taxable. But where assets were sold in the course of normal business (that is, to
make a profit), this profit was regarded as income and taxed as such. In many cases, the courts had to rule
on the application of this principle, which caused a great deal of uncertainty about the taxability or
otherwise of capital gains. On 1 October 2001, South Africa implemented a capital gains tax (CGT).
Capital gains tax comes into play when there is a change in the ownership of an asset, that is, when it is
sold, given away, scrapped, swapped, lost or destroyed. It is thus a ‘realisation’ or transaction-based tax
and, when capital gains are realised or deemed to be realised, these gains form part of the income tax base.
The capital gain (or loss) is determined as the difference between the realised proceeds from the sale of the
asset and the total base cost of the asset. The base cost of an affected capital asset includes the original
acquisition costs and related transaction costs (for example, legal fees and brokerage), the costs of any
improvements and VAT.
Capital losses may only be deducted against capital gains. There is no such thing as a negative CGT.
Capital losses incurred on assets not used for business purposes cannot be subtracted from realised gains
for tax purposes. These include assets used for personal consumption, such as sailboats, second vehicles
and aircraft.
The first R40 000 of net capital gains of a natural person during a tax year is excluded from CGT.
Although capital gains in excess of R40 000 are included in taxable income, some relief is granted to
individuals and other legal persons. In the case of an individual, only 40% of the net capital gain (the
inclusion rate) is included in taxable income. A company has to include 80% of its net capital gain. This
means that the effective capital gains tax rate in respect of individuals varies between 0% and 18%,
depending on the marginal tax rate, and for companies it is 22,4%. The effective capital gains tax rate for
small businesses ranges from 0% to 22,4%.
Any individual or legal person (for example, a company, close corporation or trust) resident in South
Africa is liable for CGT in respect of the disposal or deemed disposal of capital assets held both inside and
outside the country. Where an individual or legal person is not resident, a liability will only arise in the
event of the disposal of immovable property inside South Africa or the sale of the assets of a local branch,
permanent establishment, fixed base or agency through which a trade, profession or vocation is being
carried out.
Capital assets liable for CGT are property of any kind, whether movable or immovable, tangible or
intangible, and include land, mineral rights, office blocks, plant and machinery, motor vehicles, boats,
caravans, trademarks, goodwill, shares, bonds and Krugerrands. Some assets, such as trading stock and
mining assets qualifying for income tax deductions as capital expenditure, are exempted from CGT. In the
case of individuals, principal owner-occupied residences (gain/loss of less than R2 million), private motor
vehicles and personal belongings (for example, clothing, stamps, works of art, antiques, medallions,
foreign exchange and coins not minted in gold or silver), are exempted from CGT. Small business assets
(businesses with a market value of assets of less than R10 million) realised by individuals over 55 who use
the proceeds for retirement purposes are also exempted from CGT, provided that the assets had been held
for at least five years. This provision is limited to a once-off exemption of R1,8 million per taxpayer.
In order to safeguard the reinvestment of profits, a capital gains tax liability may in certain cases be
deferred until a subsequent CGT event. Deferral (rollover) relief applies to asset disposals such as certain
transfers of property to establish or reorganise a business, transfers of property from a deceased estate,
donations of property and transfers between spouses.
The Franzsen Commission (1968) already recommended the introduction of a separate capital gains tax
50 years ago and more than 30 years before it was established. The Commission regarded profits arising
from the sale of shares and fixed property (with the exception of property that the person liable for tax uses
for residential purposes) as the principal components of the capital gains tax base. Two subsequent tax
commissions held contradictory views. The Margo Commission (1987) opposed a capital gains tax
primarily because of the administrative problems involved. The Katz Commission (1995: 49), in its Third
Interim Report, also recommended that ‘… by reason of the lack of capacity on the part of the tax
administration, there should not be capital gains tax in South Africa at this stage’. The low revenue
potential of this tax reinforced the Katz Commission’s conclusion. Capital gains are not really taxed for the
sake of the revenue they yield, but rather for other reasons. At the time of introduction, it was estimated
that CGT could raise about 1% of total tax revenue a year directly (in other words, around R5 to R6
billion). In 2017/18, capital gains tax raised R17,6 billion (1,5 % of total tax revenue), of which companies
paid R7,6 billion and individuals paid approximately R10,0 billion (National Treasury & SARS, 2018:
274).
The most important reasons for capital gains taxation are as follows:
• To protect the integrity of the personal and corporate income tax base. If capital gains are not taxed,
taxpayers have an incentive to convert income into capital gains in order to avoid taxation. Consider the
example of a sole proprietor who reinvests his or her profit instead of taking it as a salary (which is
taxed at marginal income tax rates). The reinvested income increases the value of the business. When
the business is eventually sold, the benefits are reaped in the form of long-term capital gains (regarded
as non-taxable capital income in the absence of capital gains taxation).
• To ensure horizontal equity. A capital gain represents an increase in economic power, and it increases the
individual’s ability to earn income and to be taxed. Consider two persons with the same net additions to
wealth (income plus net assets) Person A’s net additions consist of salary income and capital gains;
person B’s net additions consist of salary income only. Both have the same horizontal ability to pay in
terms of the comprehensive definition of income (that is, the Haig-Simons definition). If capital gains
are not taxed, person B is taxed unfairly on his or her income.
• To ensure vertical equity. Capital gains accrue mostly to higher-income tax-payers. If they are not taxed
on these gains, the vertical ability-to-pay principle is jeopardised.
• To improve economic efficiency. If investments are chosen on the basis of tax considerations, the
allocation of investment funds is distorted and an excess burden results.
There are also several arguments against capital gains tax, of which the most important include the
following:
• Capital gains taxation is subject to numerous administrative problems. Assets have to be valued, and there
is a need for accurate and up-to-date deeds registers in the case of, for example, works of art and real
property. The valuation problem is more acute in a situation where an accrual base is used (that is,
where unrealised capital gains are also taxed). The problem of valuation is less severe when a
realisation base is used (in other words, when the selling price is compared to the purchase price when
the asset is sold and tax payment is only due when the asset is sold).
• If nominal profits (instead of real profits) are taxed, equity is at risk. Inflation causes imaginary capital
gains (that is, increases in the nominal value of assets) and it may be unfair to tax someone just because
inflation has increased the nominal value of an asset. Nominal capital gains should therefore be deflated
by an appropriate price index. The choice of a suitable index is a further complication.
• Capital gains are usually once-off events. Taxpayers tend to lock in rather than realise investments in
order to avoid the tax. This lock-in effect can affect investment negatively. Concessions are therefore
usually made either in the form of lower personal income tax rates on capital gains or by not taxing
capital gains once a certain period has elapsed. To compensate for the effects of inflation and the lock-
in effect, the South African tax authorities opted for low effective capital gains rates.
14.5 Income tax reform

In the previous chapter and preceding sections of this chapter, attention was devoted respectively to
personal income taxation and company taxation within the broad framework of a comprehensive income
tax system (the Haig-Simons definition of income). This tax base includes labour and capital income, and
ideally applies the same rate structure to all forms of income. In practice, tax systems are far removed from
the intended comprehensive income tax. Capital income and labour income are taxed at different rates, and
some forms of income are not taxed. Certain activities are encouraged using tax incentives, deductions and
credits, all leading to a smaller tax base. Because of the international mobility of capital and, to some
extent, labour, countries try to outcompete their rivals using the tax system. But distortions are created that
impact on the work effort as well as saving choices (that is, tax efficiency). The comprehensive income tax
does not deal adequately with irregular income earned over the lifetime of the taxpayer and results in
excessive progressivity in this case. Tax systems also include taxes other than income taxes, such as
consumption taxes (for example, VAT and excises) and wealth taxes (for example, inheritance tax). This
mix of taxes has different distributional effects, and spoils both horizontal and vertical equity. The problem
becomes even bigger considering the administrative complexity and compliance issues resulting from the
comprehensive income tax system. In addition to the tax preferences and expenditures, the integration of
the personal income tax and company income tax adds to the administrative difficulties. What are the
alternatives? In this section, we consider two reform options that have received attention in recent times:
the flat rate income tax and the dual income tax.
14.5.1 The flat rate income tax

The flat rate income tax option is mainly a response to the administrative complexity of the comprehensive
progressive income tax and the inefficiencies created by taxing labour income and capital income at
different rates (see Barreix & Roca, 2007: 127). Two broad variants of the flat rate income tax can be
considered. The system proposed by Hall and Rabushka (1983 and 1995) received particular interest in the
United States. Their proposal provides for a combination of a cash-flow tax on business income (with full
allowance for capital expenditure, but not labour expenditure) and a tax on labour income (with a non-
taxable personal exemption) at a single (low) flat rate. In principle, it is none other than an origin-based
VAT collected by the subtraction method and supplemented by a (non-refundable) tax credit against labour
income (see Chapter 16 for a description and discussion of the destination-based VAT system). This
design, therefore, taxes consumption, but has some progressivity built in (the personal income tax
exemption). This system has not been implemented in this form anywhere.
The second variant has been adopted in a number of Eastern European countries (including Russia) and
has attracted much attention. It deviates from the Hall-Rabushka form in that only labour income is taxed at
a single positive rate (with some income allowance based on the taxpayer’s circumstances). Sometimes
company income is also taxed at the same rate, but not necessarily. Therefore, when we refer to a flat rate
income tax, we mean a single low rate on personal income (see Keen, Kim & Varsano, 2008: 714 for a
comprehensive discussion and analysis of the flat rate income tax).
Supporters of the flat rate tax base their arguments on various advantages (see Keen et al., 2008: 712–
751; Browning & Browning, 1994: 378–379; Boskin, 1996):
• A flat rate tax is simple to administer, and complexity is reduced by the elimination of all kinds of
exemptions and exceptions. Tax liability can be determined on a single-page tax return where all forms
of income are entered, and then multiplied by the tax rate. Tax compliance should improve because of
the lower marginal tax rate. Improved compliance may also lead to higher tax revenue (see the Laffer
curve analysis in Section 13.4.3).
• To get some perspective on the size of the tax rate required to maintain tax revenues, it should be
considered that in 2017, current taxes on income and wealth of households in South Africa were R465
800 million (South African Reserve Bank, 2018b: S-134). This amount was raised with average tax
rates ranging from zero % to in excess of 34,7% (taxpayers with taxable income of R1 500 001 in
2017/18). If the gross balance of primary income of households as defined in the national accounts is
used as the tax base (R3 061 637 million), the same amount of tax could have been obtained by levying
a tax of approximately 15,2% on all income (with zero personal income exemptions).
• Lower marginal tax rates increase productivity and the incentive to work.
• Horizontal equity is promoted since different special provisions are not available to people with the same
taxable income.
• Bracket creep (explained in Section 13.4.4) during inflation is eliminated.
• A political economy argument favours the adoption of a flat rate. The public choice school would reason
that a single low tax rate will limit the amount of tax revenue government can extract from voters. The
size of a government pursuing its own interest and wasting resources is consequently restricted. It
should be noted that there are other ways of constraining government, such as fiscal rules (see Section
18.5).
One disadvantage of the flat rate tax regime is that the built-in flexibility of income taxation is reduced if
the aggregate marginal tax rate falls; although this will be less the higher the basic allowance
accompanying the flat tax is. Another problem is that capital income and labour income are in most cases
still taxed at different rates, resulting in tax arbitrage and competition between different countries. The
most important shortcoming of the flat rate tax proposal (and probably its nemesis) lies in its redistributive
impact. The tax burden will be redistributed. The burden of the high-income group will be reduced, while
the burden of the low-income group will increase (although some adjustments may be possible to
counteract these effects). Its impact on the tax burden of the low-income and even the middle-income
group can, therefore, be curtailed by applying the tax rate to all income above a minimum income. It would
thus introduce a degree of progressivity in the tax structure.
Another serious equity problem with the flat rate tax is the treatment of taxpayers with income around
the threshold. For example, if a flat rate of, say, 14% were levied on incomes equal to or in excess of R30
000, a taxpayer with an income of R30 001 would be taxed at an inordinately high rate of 14%, whereas a
person with an income of R29 999 would have no tax liability.
The distributional and work incentive effects of the flat rate tax are not obvious and Keen et al. (2008:
722–732 and 741) show they are somewhat complex. The reason is that the progressivity (or lack of equity)
of the flat rate tax must be compared to that of the system it replaces. In addition, the tax revenue yield and
implications for compliance must be considered. Empirical evidence and the practice in flat rate income tax
countries of allowing for a personal income tax allowance show that the equity impact is not
unambiguously adverse for the low-income group. The impact on work incentives is also not clear-cut and
there is no evidence that high-income taxpayers improve their work effort significantly. Complexity is
somewhat reduced and the potential for arbitrage is lessened, but this is not necessarily owing to the rate
structure itself; it is the result of fewer exemptions and special treatments. Finally, the sustainability of the
flat rate tax movement is unclear: the low (or lower) rate imposes constraints on revenue and the
framework does not provide adequately for internationally mobile capital income (see Keen et al., 2008:
742).
14.5.2 The dual income tax

Another alternative to the progressive comprehensive income tax system is the dual income tax system
(DIT). Variants of the DIT were introduced in the 1990s in the Nordic countries and this system is now
also being suggested as an option for developing countries.11 The potential for introducing the dual income
tax in developing countries is discussed in great detail in Bird and Zolt (2010).
In contrast to the comprehensive income tax system, which includes all income minus the costs to
acquire and maintain that income in the tax base, the dual income tax is a ‘schedular’ tax system. This
means that different types of income are taxed separately and at different rates. The DIT has the following
characteristics:
• Personal capital income is taxed separately from labour income and is levied at a flat or single rate. Under
a pure dual tax system, the single proportional rate is set equal to the lowest income tax rate (the first
income tax bracket) on personal (wage) income. Personal capital income includes interest, dividends,
capital gains, rental income, royalties, imputed rent on owner-occupied housing, accrued returns on
pension savings and profits from personal businesses (small enterprises). Profits from small enterprises
is the aggregate return on capital invested and labour provided by the owners of sole proprietorships,
closely held companies and partnerships. An important element of the DIT is the taxation of capital
income on a broad basis and at a low flat rate to ensure uniformity and neutrality in capital income
taxation.
• Labour income (wages, salaries and transfers from government) or non-capital income is subject to a
progressive rate structure. It provides for tax deductions and exemptions to achieve equity objectives.
Overall, the taxation of labour income is therefore at higher rates than the taxation on capital income.
• Company income (incorporated businesses) is taxed at the same rate that applies to personal capital
income. In a pure system, the company income tax is fully integrated with the personal income tax to
eliminate double taxation. This can, for example, be achieved using the imputation method, whereby
shareholders receive credit for company tax paid. The company tax thus becomes a simple withholding
tax at source (see Section 14.2.2).
The DIT system was implemented in Sweden, Norway, Denmark and Finland in the early nineties, and a
number of other industrialised countries have subsequently adopted forms of the dual income tax system.
Uruguay is one of the few developing countries that have moved to a dual income tax system. The reasons
in favour of the DIT were specific to Nordic countries at that time, but still have relevance. These are listed
below. In addition, there are convincing economic and administrative considerations.
Firstly, the Nordic countries were feeling the impact of globalisation and the international mobility of
some forms of capital (for example, portfolio investment). Because of their comparatively high tax rates,
investors were moving their capital to lower tax jurisdictions. High inflation also meant that effective tax
rates on capital were high, which led to arbitrage actions. High-income taxpayers could exploit tax
preferences for capital investment using, for example, interest rate deductions to lower their earned income.
This eroded the labour income tax base. Because of high unemployment, political support was mobilised
by decision-makers who were in favour of a dual tax arguing that lower tax burdens on capital would
increase economic activity and thus reduce unemployment. A dual tax left marginal tax rates on labour
income untouched, which would not have been possible to achieve from an equity point of view. The
combination of a lower flat tax rate on capital income and a progressive tax on labour income was therefore
considered to be a pragmatic way of dealing with problems of capital flight, tax arbitrage activities and
inflation.
Secondly, the economic argument for lower tax rates on capital income and progressive rates on labour
income needs to be considered (see Boadway, 2005: 913–922). The basic efficiency argument is that the
more elastic the source of income is, the more appropriate a lower tax rate would be. Capital income has
the characteristics of being more elastic than labour income. In addition, it is mobile and is used for riskier
investments. High capital income tax rates, therefore, will lead to evasion and discourage investment. Other
efficiency arguments claim that investment generates externalities that should be encouraged by having
lower tax rates on savings. The broadening of the capital income tax base and the imposition of a low flat
rate reduce the distortions associated with the differential treatment of different sources of income (for
example, avoidance through tax planning, shifting of assets or selecting a business form on tax grounds).
Levying a single (proportional) tax on people who choose to save reduces discrimination against
savings. Taxing capital income (for example, interest) at progressive rates (as under a comprehensive
income tax system) can cause horizontal inequities because some individuals use savings to smooth their
income over their life cycle. An individual who saves for a rainy day or retirement will end up paying a
higher lifetime tax bill than a person with similar earnings who does not save. Taxing labour income at a
progressive rate is easier to justify than a corresponding tax on capital income.
Taxing labour income causes some distortions as it affects the choice between labour supply or effort
and leisure. The variability of labour income is, however, more predictable (for example, seasonable work)
and the impact can be determined based on knowledge of the worker profile and the income distribution.
The responsiveness to progressive taxation of individuals to work and how much to work is reasonably
well known (see Section 13.4.1). The personal income tax system can be designed to compensate for
individuals who experience income variability thatis beyond control. In addition, a social security network
can play a supporting role (see Boadway, 2005: 917).12 In short, progressiveness of the tax system as a
whole is important, but not all taxes need to be progressive. It can be argued that the most efficient way to
achieve progressiveness is to tax labour income using a progressive rate schedule, a provision that
continues to characterise a dual tax system. The DIT thus provides the flexibility that developing countries
need in order to meet the international competition for capital and to maintain the progressiveness
generated by the personal income tax system. However, personal income tax rate schedules have become
flatter globally, which means that the advantage of flexibility of the DIT is somewhat dissipated (see Bird
& Zolt, 2010: 201).
Thirdly, from an administrative perspective, the dual income tax system has the advantage that capital
taxes are rationalised by treating all income from capital uniformly. The base is broadened, and the
accompanying removal of tax preferences and exclusions simplifies the personal and company tax system,
in addition to reducing tax compliance costs.
Although much can be said in favour of the dual income tax system, it also has a number of
disadvantages. One of the most important is that the DIT requires the splitting of income of active owners
of small firms into a capital and labour component. This administrative challenge is the Achilles heel of the
system (see Sørensen, 2007: 566; Sørensen 2005: 780–781). As noted above, profits from small enterprises
are the aggregate return on capital invested and labour provided by the owners of sole proprietorships,
closely held companies and partnerships. If capital income is to be taxed at a different rate from labour
income, profits must be split into the two components. If it is left to the owners to decide, arbitrage
opportunities arise or are sought; that is, attempts are made to reduce the tax liability. For example, if the
tax rate on capital income is lower than the marginal tax rate of the taxpayer, the owner will attempt to
have profits declared as capital income (for example, dividends) or capital gains on shares. The problem
becomes even more acute if the small enterprise makes losses: is the loss to be treated as labour income or
capital income? In the Nordic countries, income-splitting rules are applied. This is done by imputing a
rate of return to business assets (classified as capital income) and treating the residual profits as labour
income. The imputed rate of return provides for a ‘normal’ return on capital (for example, the interest rate
on government bonds) as well as a risk premium to compensate investors for their exposure to risk and a
pure (excess) profit part (referred to as rent). One problem related to income splitting is the practice by
entrepreneurs of including low-yielding assets such as motor cars and real estate (used for private
consumption) in the asset base. In effect, this increases the part of the business profit imputed as capital
income (the asset base to which the imputed return is applied increases) and is thus taxed at the lower
capital income tax rate. The income-splitting mechanism for self-employed and other small entrepreneurs,
closely held companies and small companies remains imperfect, and requires all kinds of special tax rules
and anti-avoidance measures (see Sørensen, 2005: 777–801), thus increasing the cost of tax administration.
A second disadvantage of the dual income tax system is the unresponsiveness of the company tax rate to
international competition. Remember that the company tax rate is set equal to the capital income tax rate,
which is pitched at the lowest personal income tax bracket. If this rate is higher than global rates,
investments and profits may be shifted between jurisdictions. International mobility of capital requires a
large degree of cooperation between financial institutions and governments to police these movements. In
developing countries, the alternatives for a company rate equal to the lowest income tax bracket would be
to set the company tax rate either higher or lower than the personal income tax rate for income from
capital. The choice would depend on whether the business is, for example, in resource extraction, which
generates location-specific excess profits. In this case, the company tax could be higher. On the other hand,
if small firms are to be encouraged to incorporate or formalise their activities (developing countries often
have a large informal sector), the rate must be set lower. In the latter case, incentives are unfortunately
again created for small entrepreneurs to reduce their tax liability (see Bird & Zolt, 2010: 203–204).
Thirdly, from a vertical equity perspective, lower tax rates on capital may be viewed as unfair since
capital income is earned mainly by the rich. Boadway (2005: 915–916 and 924) argues that this is a flawed
argument, since capital income must eventually be consumed and will then be taxed using the consumption
tax system. On the other hand, the negative vertical equity effect can be mitigated by higher personal
income tax rates on the labour income of the well-to-do and by taxing the inheritances of the rich.
Measuring capital income remains a problem. Included are accrued returns on human capital
investment, imputed returns on consumer durables (for example, owner-occupied housing), the return on
investment in small businesses and accrued capital gains. If capital income is taxed at a low uniform rate
but excludes these hard-to-measure incomes, there are still opportunities for avoidance and evasion, since
returns between assets are distorted.
In designing tax systems, it is almost inevitable that governments will be faced with policy conflicts and
goal choices. Tax fairness, efficiency, neutrality and administrative simplicity cannot always be achieved
simultaneously, and must sometimes be traded off. The dual income tax system appears to sacrifice
neutrality; income from capital is taxed differently from income from labour. Vertical equity is sacrificed
for horizontal equity, but is preserved for tax on labour income. Efficiency gains can be achieved by taxing
all capital at the same low rate. Countries face different policy objectives, depending on their economic and
political considerations.
Key concepts
• basic tax on companies (page 296)
• capital gains (page 308)
• classical system or partnership approach (page 296)
• dividend tax (page 297)
• dual income tax (page 314)
• flat rate income tax (page 312)
• full integration system (page 296)
• income-splitting rules (page 316)
• labour income (page 314)
• marginal effective tax rate (page 302)
• personal capital income (page 314)
• secondary tax on companies (STC) (page 297)
• tax holidays (page 305)
• tax incentives (page 304)
• user cost of capital (page 302)
SUMMARY
• The company income tax base is simply total revenue minus certain allowable expenses. Interest costs are
deductible, but not dividends, which biases financing of companies through loans instead of share
capital. Companies may also deduct depreciation. Special depreciation allowances often differ from the
true (economic) rate and lead to arbitrage opportunities.
• A modified classical company tax system is used in South Africa. It means that the company is taxed as a
separate unit on its profits. The profits distributed (dividends) are taxed again in the form of a dividend-
withholding tax. The dividend tax is paid by the company to SARS, but the individual shareholder
retains the ultimate responsibility for the tax liability.
• The basic tax on companies is 28%. Small and medium-sized businesses are taxed at a graduated tax rate.
Micro businesses have the option of being taxed on their presumed income (based on turnover).
Because companies are taxed at different rates, the after-tax returns differ from sector to sector. The
tax-induced distortion implies that the tax causes an excess burden (allocative inefficiency).
• Company tax raises the user cost of capital and is thus a cost to the investor. Developing countries have
attempted to reduce the user cost by lowering tax rates and providing other incentives, such as tax
holidays and generous depreciation allowances, to attract foreign direct investment (FDI). Reasons for
and against tax incentives abound, but they remain popular with the governments of developing
countries.
• Capital gains tax is classified as a form of income tax. If capital gains are not taxed, taxpayers have an
incentive to convert income into capital gains in order to avoid taxation. In South Africa, capital gain
(or loss) is determined as the difference between the realised proceeds from the sale of the asset and the
total base cost of the asset. Only 40% of the net gain is taxed at the individual’s marginal tax rate.
• Globally, income tax systems do not conform to the ideals of a comprehensive income tax system and are
not always fair, efficient or easy to administer. There are two major tax reform alternatives: the flat rate
income tax and the dual income tax. The flat rate income tax provides for a single low rate on income
with a non-taxable personal exemption. This alternative is administratively simple, but the equity
implications and impact on work effort are not that clear. The dual income tax taxes labour income at a
progressive rate and capital income at a low flat rate. The progressive rate on labour income is based on
equity grounds, whereas the lower rate on capital is based on efficiency grounds (promoting savings
and investment).
14.1 Company income tax …
a. is based on turnover for all companies in South Africa.
b. rates are differentiated depending on the size of companies.
c. can be reduced by financing new ventures using share capital instead of borrowed capital.
d. is levied at a fixed rate to which a tax on dividends is added.
14.2 Which of the following statements regarding the economic effects of company tax is or are correct?
a. If all forms of businesses were taxed at the same proportional tax rate, it would be an efficient tax.
b. A company tax rate below 30% would attract investors to a country such as the Central African
Republic.
c. Industries are likely to be attracted to regions with a surplus supply of labour by providing a tax
credit for youth employment.
d. The incidence of the company tax is likely to be borne by shareholders in full.
14.3 A capital gains tax …
a. conforms to all of the requirements of the comprehensive definition of an income tax.
b. is levied at the top marginal income tax rate.
c. is intended to reduce personal income tax avoidance.
d. is levied primarily for revenue purposes.
14.1 Why is company income taxed separately from other forms of income? Explain.
14.2 Why are the economic consequences of company tax regarded as controversial?
14.3 Explain the arguments for the integration of the individual and the company income taxes.
ESSAY QUESTIONS
14.1 The combined effect of income tax on companies and individuals implies the double taxation of
dividends. Explain the efficiency and equity aspects of this interaction.
14.2 If special provision is made in income tax law for small business or the agricultural sector, it means
that the tax is not neutral. What is your opinion on this issue?
14.3 How will income tax on companies affect the decision of an entrepreneur to invest?
14.4 ‘Tax incentives are not effective instruments for attracting investment.’ Do you agree? Discuss.
14.5 Analyse the following statement: ‘Capital gains tax is an inappropriate form of taxation for South
Africa.’
14.6 What is a flat rate tax and what are the reasons for the interest in this type of tax?
14.7 Compare a progressive comprehensive income tax to a dual income tax. Is either of these two taxes
appropriate for a developing economy? Why or why not?
1 See DTC (2016a) for a discussion of these recommendations and DTC (2016b) for the report on the oil and gas sector.
2 In 2017 the dividend tax rate increased from 15% to 20%, to ensure alignment with the increase in the top marginal income tax rate
to prevent arbitrage opportunities (National Treasury, 2017a: 39).
3 Rankin (2006: 11) investigated the regulatory environment of SMMEs in South Africa, and on the basis of the survey data
analysed, he found that smaller firms were more likely to mention tax regulation as a constraint.
4 The DTC (2014: 32), in their first interim report on small and medium enterprises, indicated that 50% of VAT vendors registered
had a turnover below R1 million, even though compulsory registration was not required.
5 The Department of Small Business Development was established in May 2014 (DTC, 2016c: 5).
6 See Mohr & associates (2015: 146–148) for an explanation of these profit concepts.
7 See World Bank (2006).
8 Another important measure is the average effective tax rate (AETR), which determines the average tax burden on an investment
(World Bank, 2015: 8). The AETR applies when firms earn a return above normal profit on an investment, and it is important
for locational decisions (i.e. where to invest).
9 Footloose industries tend to have few constraints in deciding its location. They have high value-to-weight ratios, are highly mobile
and locate where the availability of inputs leads to the lowest overall manufacturing costs. See Decker & Crompton (1993: 69)
and Salvatore (1998: 175).
10 It should, however, be recognised that there are people with low incomes (for example, pensioners) who derive their income
mainly from capital. This could affect our equity conclusion with regard to company taxation.
11 For a comprehensive analysis of the dual income tax system, see Boadway (2005: 910–927), Sørensen (2005: 777–801), Sørensen
(2007: 557–602), and Sørensen and Johnson (2010: 179–235).
12 Also see Boadway, Chamberlain and Emmerson (2010: 760–770) for a brief outline of the welfarist, equality-of-opportunity and
paternalism criteria for evaluating a tax system.
Taxation of wealth
In Chapter 11, we noted that taxes could be imposed on four bases: income, wealth, people and
consumption. In this chapter, we consider the wealth base. Wealth is the product of accumulated savings,
assets that have gained in value and the free gifts of nature. Richard Bird (1992: 134) argues that the
existing distribution of wealth in a country is ‘… largely the outcome of historical accident, as condoned by
the state and frozen in law. The result of this pattern of distribution of initial wealth is that many of those
successful in life stand not on their own feet but on the shoulders of their fathers.’ Wealth holdings
therefore contain an element of personal effort (self-accumulated wealth) and an element of luck (inherited
wealth). These characteristics make wealth taxation a much-debated topic and also an emotive one,
especially in countries with vast inequalities of wealth. The aim of this chapter is to analyse the economic
impact of the personal net wealth tax, property taxes and capital transfer taxes. We begin this chapter by
distinguishing between different types of wealth (Section 15.1). In Section 15.2, we investigate the reasons
why wealth is taxed. The taxation of real property, which is an important type of wealth, is studied in
Section 15.3. The chapter concludes with a discussion of capital transfer taxes such as estate duty and gift
taxes.
define the wealth tax base
explain the merits and shortcomings of taxing personal net wealth
define the property tax base
describe property tax rating and assessment
explain the effect of property tax on equity using the benefit principle
analyse property tax incidence using partial and general equilibrium analysis
discuss the efficiency effects of a property tax
define a capital transfer tax
discuss the economic effects of capital transfer taxes.
15.1 Wealth and types of wealth taxes

Income and consumption are flow concepts since both are measured over a period of time. Income consists
of wages, rental income from property, interest on savings, dividends on shares and so on. In contrast to
income, wealth is a stock concept that is measured at a particular point in time.
Wealth is the value of accumulated savings, investment, gifts and inheritances. If a person does not
save or receive inheritances or gifts, he or she will never accumulate wealth. A person’s wealth consists of
the net monetary value of assets owned. Another and technically more correct definition is that personal
wealth is the present value of a person’s expected real income. Personal wealth includes tangible things
such as houses, durable goods (for example, motor cars, jewellery and valuable paintings) and land. In
addition, individuals hold financial assets such as cash, deposits in bank accounts, shares in businesses and
government bonds. These are all assets that can be traded in the market. We can also identify other items,
such as insurance policies and pension rights, although these types of assets are difficult to trade in the
market and to value. Human capital acquired through investment in education and training should also be
included as (intangible) forms of personal wealth, although valuing human capital is obviously difficult. A
person’s wealth must also take account of any liabilities, since assets are often acquired through incurring
debt. By subtracting liabilities from assets, we obtain the net value of assets (in other words, personal
wealth), which is also called net personal worth.
The wealth tax base is not restricted to personal wealth; company wealth should also be considered.
Company wealth includes different forms of capital such as fixed capital (premises, plant and machinery),
floating capital (raw materials and inventories) and financial capital (stocks and shares, cash and bank
deposits). It is not difficult to see why the term ‘capital’ is often used synonymously with company wealth.
To these assets, we should, in principle at least, add intangibles such as goodwill, brand name and market
power and intellectual property rights. As in the case of human capital, it is difficult to value these assets.
To arrive at net company wealth, we must subtract liabilities from the gross value of assets.
The taxation of the wealth base has a long history dating back to a form of property tax that was
introduced in ancient Rome. The most important types of wealth taxes today include:
• Annual wealth taxes (for example, on persons and/or companies)
• Property tax (for example, tax on land and improvements)
• Capital transfer tax (for example, tax on estates and gifts).
15.2 Why tax wealth?

The case for a wealth tax is best presented by considering the arguments in favour of an annual wealth tax
on individuals (also called a personal net wealth tax or net worth tax).1 The arguments for a net or gross
assets tax on businesses are somewhat different and will not be addressed here.2
15.2.1 Equity considerations

When we discussed fairness as a criterion of a ‘good’ tax in Chapter 11, two principles emerged: the benefit
principle and the ability-to-pay principle. A wealth tax is often justified in terms of the benefit principle.
Governments provide public services that increase the value of real assets (for example, property).
Governments also provide protection for property (for example, law enforcement and legislation).
Consequently, owners of assets should pay for the benefits (expenditures) of the protection they receive. It
may, however, be difficult to determine the extent of the benefits received. Some properties, for example,
need more protection than others.
As far as the ability-to-pay principle is concerned, monetary income, which may include income arising
from realised or unrealised capital gains, is normally subject to income tax (see Chapter 14). From the
horizontal equity perspective, however, wealth confers an additional ability to pay on the owners of wealth
(over and above the monetary income derived from wealth itself and from work). Consider the example of
a poor person with almost no income and a wealthy person who keeps his or her wealth in the form of
Krugerrands and Persian carpets. Surely, even if the wealthy person has no income, he or she is bound to
have greater taxable capacity on account of the potential income-generating capacity of the assets than the
poor person. Besides, because wealth owners have the ability to realise assets, they have economic security
that enables them to exercise purchasing power (for example, by obtaining loans). Wealth also provides
them with the power to exploit economic opportunities.
From a vertical equity point of view, people with different taxable capacities should be taxed
differently. Wealth is generally distributed very unevenly and it is argued that wealth taxes could reduce
this skewness. The distribution of personal wealth in South Africa is also very uneven. Until very recently,
there have been no reliable estimates of the distribution of wealth (assets) for the whole of South Africa
since 1994. At a regional level, the Gini coefficient (see Section 8.1 of Chapter 8) in respect of the
distribution of wealth in the former Transvaal in 1985 was estimated at 0,67 (Van Heerden, 1996).3 This
distribution, however, was not more skew than in other countries (for example 0,81 for the United States in
1983, 0,68 for the United Kingdom in 1968 and 0,52 for Australia in 1968). What makes South Africa’s
distribution different is its racial dimension. In 1985, whites comprised approximately 36% of the
population of the Transvaal, but owned approximately 91% of the wealth. In 2015, Orthofer (2016) used
two data sources4 to estimate the distribution of wealth in South Africa. Her main findings were that wealth
is more unequally distributed than incomes: ten per cent of the population owns about 90–95% of all
wealth in South Africa. The estimated Gini coefficient is close to unity at 0,95. These results are supported
by the research of Mbewe and Woolard (2016), who conducted a similar analysis5 and found wealth
inequality to be extremely high with an estimated Gini coefficient above 0,90.
According to these equity principles, it seems fair to tax wealth; however, we need to consider the
incidence of a wealth tax as well. Remember that wealth is mostly accumulated savings. A tax on wealth is
therefore largely a tax on savings. The incidence of a wealth tax depends on the price elasticity of the
supply and demand for savings. If the supply is perfectly inelastic, the tax is borne by the owners of capital
(wealth) and, since wealth is concentrated in the hands of the middle- and upper-income groups, the tax is
progressive. If, however, the supply of savings is not perfectly inelastic, the incidence becomes complex,
but it is probable that wealth owners would then be able to pass on some of the tax to consumers and
workers.
15.2.2 Efficiency considerations

Wealth taxes may affect economic efficiency positively or negatively. On the positive side, a net wealth tax
has a smaller disincentive effect on work effort than an income tax. A tax on wealth is levied on past effort,
whereas income tax is levied on current effort. Furthermore, in the absence of a wealth tax, a person may
invest in assets that do not yield income to avoid paying income tax. A wealth tax would counteract this
type of tax avoidance to some extent. A wealth tax might therefore serve as an incentive to wealth holders
to put their assets to productive use. We will address this issue when land taxation is considered in Section
15.3.5.
On the negative side, wealth taxes may affect saving because the tax base (wealth) is mainly
accumulated savings. A tax on saving will also translate into a tax on labour, that is, insofar as the purpose
of work is to save (for future consumption). When the tax becomes a disincentive to work, efficiency is
lost. In addition, although wealth taxes may encourage a more productive use of assets, they may also have
the opposite effect. High yield and efficiency are not necessarily the same. Assets are sometimes invested
in ventures that yield little or no profit over the short term (for example, investments in plantations). A
wealth tax on these assets would cause an undue liability on its owners and ultimately on the community or
economy, especially if taxes have to be paid when wealth increases, even though there is no cash flow.
A discussion of the efficiency of wealth taxes would be incomplete without reference to the excess
burden of taxes of this nature. Wealth taxes reduce the net return on saving (that is, the after-tax interest
rate). Since wealth taxes distort the relative prices of goods that can be consumed presently and goods that
can be consumed in the future, an excess burden results. The size of the excess burden will depend on how
sensitive saving is to changes in interest rates.
15.2.3 Revenue and administrative considerations

Similar to all taxes, wealth taxes can be introduced to generate revenue, although this is not a particularly
important consideration. In fact, in most countries where this type of tax is in force, the net wealth tax
revenue rarely exceeds 1% of total tax revenue.
Wealth taxes do have administrative advantages. The database for these taxes can be used to cross-
check income tax returns. Since the income tax base is often eroded by tax avoidance and evasion schemes,
wealth taxes may complement income tax systems by curtailing these schemes. On the other hand, wealth
taxes also have administrative shortcomings. In the past, wealth was relatively easy to tax since it was held
in very visible forms (for example, immovable property). Nowadays, wealth holdings and their valuation
have become very complex (for example, derivatives such as options and swaps) and are often held in
foreign countries. This calls for a sophisticated and costly tax administration, which deters many countries
from introducing taxes of this nature.
It appears as if the trend is to move away from taxes on wealth. In 1990 twelve Organisation for
Economic Co-operation and Development (OECD) countries levied tax on individual net wealth. This
number dropped to three OECD countries by 2008. After the financial crisis Iceland and Spain re-
introduced net wealth taxes on a temporary basis as fiscal consolidation measures; in 2017 only four
countries (France, Norway, Spain6 and Switzerland) still levied these taxes (DTC, 2018b: 37). Other
developed countries, such as Japan and Ireland, also abandoned the net wealth tax for reasons of equity,
complex administration and impeding economic growth. Colombia introduced a net wealth tax in 1935, but
recently repealed it. In South Africa, the Margo Commission (1987: 310–322) and the Katz Commission
(1995: 50–55) both considered an annual wealth tax, but concluded that this type of tax (including an
inheritance tax) should be avoided owing to the administrative and compliance burdens involved. The Katz
Commission (1995: 50) argued that redistribution is better achieved by other means, particularly through
the expenditure side of the budget. More recently, the Davis Tax Committee (DTC) considered the
feasibility of a recurrent net wealth tax. They recommended that more work be done to ensure a well-
designed tax, one that will raise more revenue than what it would cost to administer the tax (DTC, 2018b:
7). In a survey of the issues on the economics of taxing net wealth in the OECD, Schnellenbach (2012)
concludes that the equity, efficiency and political arguments for taxing wealth are generally quite weak.
There are also hints of a negative effect on economic growth.
15.3 Property taxation

The property tax base can be defined very broadly to include real property (realty) and personal property
(for example, furniture, motor vehicles, shares, bonds and bank deposits). We will focus exclusively on real
property, partly because it is the most common one. A tax of this nature is an impersonal (in rem) tax.
Property tax can be levied at the national level and the provincial government level or local authority
level. In South Africa, it is collected mainly by (urban) local authorities. National government taxes on
property are primarily in the form of transfer duties (payable by the person who acquires a property), and
tax on donations and estates. In this type of case, the tax is levied when immovable property is alienated or
acquired in terms of a donation or an inheritance. However, the property taxes levied by local authorities
are by far the most important form of property tax in South Africa. Property tax is a major source of
revenue for local authorities.
Property tax revenue to the tune of R63,1 billion was generated in 2017/18. Property tax represented
approximately 16,7% of the cash receipts from operating activities of municipalities (South African
Reserve Bank, 2018b: S-72). Important as this source may be for local governments, its relative
insignificance as a national revenue source is illustrated by the fact that it would contribute only about
4,4% to the total tax receipts of the consolidated general government.
15.3.1 The tax base

The real property tax base includes land (farm, residential, commercial and forest land) and capital
invested in improvements (farm buildings, homes, business buildings, fences and so on). The importance of
the distinction between the two tax bases will become clear once we analyse the incidence effects of a
property tax.
In South Africa, all land and improvements in urban areas (from metropolitan local councils to small
local councils) are rateable. In the past, property tax (collected by local authorities) was not levied on rural
land. The Katz Commission (1995 and 1998) considered the possibility of a national tax on agricultural
land, but found that a tax of this nature was not a viable option at the national level of government, either
as a means of raising revenue or as an instrument of a land reform programme. It did, however, support a
rural land tax at local authority level. It also acknowledged that a rural land tax may have certain social
advantages, such as encouraging the economic use of land.
A land tax on farmland was implemented in Namibia in 2004. The purposes of this tax are to fund the
government’s acquisition of agricultural land for resettlement of previously disadvantaged Namibians as
well as to compel absentee landlords to sell unused land to the government.
As far as the urban property tax is concerned, municipalities in South Africa had the option of choosing
between a site value rating (in other words, rating the value of the land only), a flat rating (that is, rating
the value of improvements), or a composite rating or differential rating (in other words, rating both land
and improvements, but at different tax rates). In four provinces, the majority of municipalities used the site
value rating system. Of the remaining five provinces, KwaZulu-Natal opted for composite rating, while
many councils in the other four provinces used flat rating (Franzsen, 1997).
In 2004, the Local Government: Municipal Property Rates Act, 2004 (hereafter the Property Rates Act
2004) was enacted, to be implemented over a four-year period. It empowers the eight metropolitan
municipalities (for example, Tshwane, Johannesburg and Cape Town), 205 local municipalities and 44
district municipalities to levy a rate on all rateable property. Property generally means immovable property
and includes immovable improvements (excluding underground mining structures). Different categories of
rateable properties may be determined, including residential properties, industrial properties, business and
commercial properties, farm properties, smallholdings, and formal and informal settlements.
15.3.2 Tax rates

Property tax is usually levied as a percentage of the taxable assessed value of the property. The assessed
value for tax purposes is often less than the market value of the property. Owing to this difference between
the assessed value and the market value, the nominal tax rate differs from the effective rate (the effective
rate being the tax liability expressed as a percentage of the estimated market value). Tax rates generally
differ between jurisdictions as a result of the selectivity of the property tax. Since the property tax is
considered burdensome to certain categories of taxpayers (for example, elderly homeowners), these
taxpayers usually receive some kind of tax relief.
In the case of the Namibian land tax, a rate of 0,4% is levied on the unimproved site value per hectare
owned by commercial farmers. It increases by 0,25% for each additional Namibian-owned farm. If the land
is owned by foreigners, the rate starts at 1,4% of the site value for the first farm and increases by 0,25% for
each additional property. The proceeds of the tax go into a land reform programme.
In the past, flat (uniform) rates were levied in South Africa, but these rates differed among provinces
and among municipalities within provinces. The taxes were levied annually, but were generally collected in
monthly instalments. A maximum rate was prescribed in some provinces. Before 1994, a number of
categories of properties were exempted from paying property tax (for example, properties used for religious
and educational purposes, hospitals and national theatres). Since 1994, however, almost all exemptions
have been repealed and replaced by a system of grants-in-aid that could not exceed the equivalent rateable
amount. Rebates were granted for certain classes of properties (for example, residential properties) and
categories of ratepayers (for example, the handicapped, pensioners and other ratepayers with annual
incomes below a specified minimum).
In terms of the new Property Rates Act (2004), a rate levied by a municipality must be an amount in
rand based on the market value of the property. The valuation roll remains valid for a period of four years
(which can be extended to five years) in respect of a metropolitan municipality and five years (which can
be extended to seven years) in the case of a local municipality. Differential rates for different categories of
rateable property may be set. The categories may be determined according to the use of the property or
geographical area in which the property is situated. Certain categories of owners, such as pensioners,
owners temporarily without income and indigent owners, may be exempted or may be granted a rebate.
The ratio for residential property to public benefit organisation property (for example, churches and
schools), public service infrastructure property and agricultural property should not exceed 1:0,25. The rate
for non-residential property is the same as that for residential property. The right to levy rates is limited by
a number of provisions. One of these provisions stipulates that the Minister of Finance may set upper limits
on the percentage by which rates may be increased annually. Furthermore, the rate may not:
• materially prejudice national economic interest and economic activities across its boundaries
• be levied on the first R15 000 of the market value of a residential property
• be levied on places of worship (excluding a structure used for educational instruction in which secular or
religious education is the primary instructive medium)
• be levied on property belonging to a land reform beneficiary, or his or her heirs, for a period of ten years.
15.3.3 Assessment
Probably the most controversial part of property taxation is the valuation of property. There are a number of
different approaches to assessing the value of property, such as the capital value of land and improvements,
the site value system, the rental value of premises and the comparable sales method (see Bahl, 1998). The
capital value system attempts to determine the full market value of land and improvements (as a bundle)
on a willing buyer and willing seller basis (in other words, the value they would agree to in an open
market). In practice, the capital value is determined by assessing land independent of improvements. Land
is valued using data based on a judgemental approach, and the expert opinions of professional valuers and
real estate agents are enlisted. Improvements are valued with the aid of schedules of value per square metre
(based on building costs).
The site value system assesses the value of land only. The value of land can be based on sales of
comparable vacant land or estimated by means of a residual method (for example, by determining the
bundled value of the property, and then deducting the value of improvements).
The British tradition is to assess the value of property on the basis of some estimate of the rental value
of the property or the rental income derived from the asset. The sales value of a property tax and the rental
value are supposed to yield equal results.7 However, in developing countries, property markets may not be
adequately developed to generate plausible results, property is often underutilised and an assessment based
on the rental value would thus understate the value of the property. Idle land also generates no net income
and rental value will therefore have to be imputed in such a case.
In South Africa, the general basis of valuation will be the market value of a property, that is, the
amount the property would have realised if sold on the date of valuation in the open market by a willing
seller to a willing buyer (Republic of South Africa, 2004). The market value would be inclusive of the land
value and the value of improvements to the property. In the case of agricultural land, the values of any
annual crops or growing timber that have not yet been harvested are disregarded for valuation purposes.
All rateable property must be valued during a general valuation. Physical inspection of the property to
be valued is optional, and comparative, analytical and other systems or techniques may be used to
determine the value, including aerial photography and computer-assisted mass appraisal systems. The
valuation roll must remain valid in total for not more than four financial years.
The taxing of farm properties could be considered a new category of property that is now rateable by
municipalities. The Property Rates Act (Republic of South Africa, 2004) provides that newly rateable
property had to be phased in over a period of three financial years. When rating properties used for
agricultural purposes, the extent of services provided by the municipality in respect of these properties, the
contribution of agriculture to the local economy, and the impact of agriculture on the social and economic
welfare of farm workers must be considered. These factors confirm that the property tax is not a national
land tax on agriculture.
Using market values instead of use value for property, especially in respect of farm land, is a much-
debated issue. The Katz Commission (1998) was in favour of use value as a valuation base. Use value can
be determined using the income capitalisation method, land resource quality index method and lease value
or rental value method (see Katz Commission [1995: 1–36] for a description of use value methods and their
merits). According to the income capitalisation method, use value is determined by dividing net farm
income by an appropriate capitalisation rate. A major shortcoming of this method is that income is volatile.
The land resource quality index method compiles an index using information on the quality of the land
obtained from farmers, population censuses and the Weather Bureau. Farm land is then assessed on the
quality of the land only. In terms of the rental value method, the value of land is assessed with reference to
the potential market rent that could be obtained for a unit of land. The usefulness of this method depends
on the size of the rental market. If properties in a geographical area are mainly owner-occupied, it is
difficult to determine rental value.
There is a tendency for use values to be lower than market values, since market values are influenced by
non-farm factors such as location and investment value. This discrepancy is most noticeable where farm
land is close to urban concentrations. The market value of farm land is determined under conditions of
supply and demand. If the farm is not actually going to be sold, it is difficult to determine market value
accurately. The comparative sales method then has to be employed. According to this method, the market
value of the property is obtained by comparing it to similar properties that have recently been sold. Another
shortcoming of the market value method is that rates based on the market value could put severe strain on
the cash flow of property owners during periods of property price booms. The proponents of use value
methods argue that these methods are more equitable from an ability-to-pay point of view compared to the
market value method, which would tax wealth. When the capacity of municipalities to appraise farm land
was considered, the Katz Commission (1998: 51) noted that municipal property valuers have more
experience in market valuation methods. In addition, not all rural land is used for agriculture. In the end,
we have to consider that, from an efficiency perspective, market values should reflect the value of the
property when used in its most productive use (or best forgone opportunity). In other words, when valuing
a property, the assessor should consider the best use of the property. If farm land close to an urban area
could best be used for residential purposes, the market value should reflect this condition. It should also be
clear that determining the highest or best use has a subjective element. For this reason, valuation rolls are
normally open for inspection and objections, and there is a right of appeal.
15.3.4 Equity effects

The fairness of a property tax can be analysed by considering the benefit principle of taxation. Further
analysis of its fairness is possible by using a partial equilibrium framework and a general equilibrium
framework to determine its incidence.
15.3.4.1 Benefit principle of taxation

According to the benefit principle of taxation, people should pay tax in relation to the benefits (or cost of
expenditure) of public services received. At the level of local authorities, this rule suggests that owners
should pay for services that raise the value of their properties, such as pavements, tarred roads and street
lighting. A property tax on site value can then be viewed as a comprehensive benefit tax and may be
regarded as a fair tax from this perspective.
Although the link between benefits received and the tax paid is not always clear, empirical studies
indicate that property taxes and the value of local public services are capitalised into house prices (see Box
15.1 for the meaning of the term ‘capitalisation’). The implication is that we can expect property taxes to
depress property values, but that this effect could be countered by the positive effect of public services
financed by these taxes (Rosen & Gayer, 2008: 525–526).
Box 15.1 The capitalisation of a property tax
The capitalisation principle can be illustrated by means of a simple example. Suppose a piece of land in Cape Town
has an expected yield of R10 000 per annum and that the current interest rate (the opportunity cost of capital) is 20%
per annum. The capitalisation value is determined by answering the following question: What amount needs to be
invested to earn this return? This amount can be determined by using the formula for capitalised value. The
capitalised value (CV) is income from the property (R) divided by the interest (i): . Thus, the capitalised
value of the land will be R50 000 . Let a property tax of R1 000 now be levied. This would be equivalent
to a tax on the income from the land at a rate of 10% (R1 000 as a percentage of R10 000 = 10%). The capitalised
value of the land changes to , where t is the tax rate (equal to 10%) or CV R45
000. The value of the Cape Town property has been reduced by R5 000. When the owner wants to sell the property,
he or she will have to absorb the loss since the new buyer will want to obtain a net return (after the R1 000 property
tax) of 20% on the investment (= R9 000).
Property taxes based on land values have until now not been considered as benefit taxes (or user
charges) because benefit taxes are usually linked to specific services (for example, access to a public park
or bus fees for public transport). However, there are taxpayers who are eligible for, but do not use, these
services. Consider the example of a childless couple: although an activity centre in a public park may affect
the value of their property, they derive no further benefit from it. Taxing them at the same (uniform) rate as
other property owners would be unfair. Therefore, it can only be said that property tax is a benefit tax if the
revenue from property tax is spent on infrastructure and activities that genuinely benefit property owners as
a group (individually and collectively).
15.3.4.2 Incidence of a property tax

By now, we know that information on the statutory (or direct) burden of a tax is insufficient to allow us to
arrive at conclusions about the fairness and distributional implications of that tax. We also need to identify
the economic incidence of the tax. The incidence of property tax can be studied using partial equilibrium
analysis and general equilibrium analysis.
Partial equilibrium analysis

When property tax is analysed within a partial equilibrium framework, it is regarded as an excise tax that
falls on land and on the capital invested in improvements.
Figure 15.1 Incidence of an ad valorem property tax on land

• Property tax on land: Since the quantity of land in a country is fixed, the supply of land is in effect
perfectly inelast ic. This means that landowners cannot increase the quantity of land if prices increase.
All they can do is to change the use of land and, to a very limited extent, reclaim parcels of land (for
example, swamp land). In Figure 15.1, the supply curve (S0) is vertical and the demand curve is D0. The
equilibrium rental before tax is P0 and the equilibrium quantity is Q0. Suppose that an ad valorem
property tax (t) is now introduced. The before-tax demand curve D0 swivels downwards to D1, which is
the new effective (after-tax) demand curve (the demand curve as perceived by landowners). The rent
paid by the users of land remains unchanged at P0. However, the rent received by the owners of land is
reduced by the tax to P1. The total tax revenue is equal to the area ABCD and is borne entirely by the
owners of land. Thus, the incidence of a tax on land is on the landowner. Since income from land
ownership increases as income increases, the tax falls relatively more on taxpayers with higher
incomes. This makes a land tax progressive and, from the ability-to-pay point of view, the tax is
therefore fair. The lower rent on the land will cause the price of land to fall in order to account for the
future tax burden; taxes are capitalised into the value of land (see Box 15.1). When subsequent buyers
make property tax payments, these payments should not be seen as a burden in the true sense of the
word, since the payments have already been capitalised into a lower purchase price. In other words, the
incidence of the property tax is only on the initial owner of the land (that is, the owner at the time when
the tax was imposed). Should property taxes be increased, the increase would again be capitalised. The
extra tax burden would fall on whoever owns the property at that time. The determination of the
incidence thus becomes quite complicated, since the identities of the owners at the time when the tax
was imposed or increased must be known.
• Property tax on improvements: In contrast to land, which is fixed in supply, the capital invested in
improvements is elastic in the long run. The argument is that in the long term, investors can find all of
the capital they require at the market price. When market rents are taxed, it is possible for property
owners to shift the burden to the users of property (tenants and, indirectly, consumers and workers).
This is illustrated in Figure 15.2. The supply of capital for improvements is the perfectly elastic curve
S0. The before-tax equilibrium is at Q0 and P0. If an ad valorem property tax is now levied on property,
the effective (after-tax) demand curve becomes D1. This is the demand curve as perceived by property
owners. At the after-tax equilibrium, property owners still receive P0, but the users (for example,
tenants) have to pay P1, which includes the property tax. Note that the after-tax equilibrium quantity of
property supplied is lower. Property owners are therefore able to shift the full tax burden (= ABCD) of a
tax on improvements to users. The distributional implications depend on who the users are. If the users
are lower- to middle-income tenants or owner-occupiers of residential property, the distribution tends to
be regressive. The reason is that housing expenditures decrease with increases in income; that is, low-
income taxpayers spend relatively more on housing than high-income taxpayers. If the users are tenants
of commercial property, the higher after-tax rents will be reflected in higher prices for goods and
services. Since consumption as a whole decreases as income increases, the regressive effect of a tax on
the improvements part of property is again emphasised. However, since these effects disregard dynamic
general equilibrium effects, the question of who bears the burden of the property tax is not fully
resolved.
General equilibrium analysis

In a general equilibrium framework, the full effect of the tax is traced throughout the economy. Viewed
from this perspective, a property tax levied at different rates is equivalent to a selective tax on capital. In
the short term, the tax will be capitalised and the value of property will be lowered. Since land and the
capital invested in improvements are immobile in the short term, the incidence of the tax is on the initial
owners of the assets. The burden is distributed progressively because property is not only heavily
concentrated in the hands of the wealthy (particularly in developing countries), but income from ownership
of property tends to be an increasing proportion of income.
Figure 15.2 Incidence of an ad valorem property tax on improvements

In the long term, the capital invested in improvements is more mobile. Capital then migrates from high
tax rate areas to low tax rate areas. The stock of capital is reduced in the high tax rate area (increasing the
net return on capital in this area), while the stock of capital in the low tax rate area increases (thereby
reducing the net return of capital in this area). Theoretically this process continues until net (that is, after-
tax) rates of return are equal throughout the economy or region. Therefore, even though the tax was
imposed on capital in one area, the burden is shared by capital owners in other tax jurisdictions. The
process does not stop here. When capital moves out of an area in which labour is immobile (often the case
with unskilled labour), the labour in that area must now be combined with the reduced stock of capital in
production. The capital–labour ratio decreases and this adversely affects the productivity of labour, with
the result that real wages decrease. Thus labour also bears part of the burden of the property tax, which
adds another regressive element to the equity equation.
15.3.5 Efficiency effects

Note that the property tax is a selective tax on wealth. Elements of selectivity include the following:
• Only immovable property is taxed.
• The tax base can include land or improvements.
• Tax bases and rates can differ between tax jurisdictions (for example, between urban and rural areas and
between different urban areas and rural areas).
Selective taxes have non-neutral allocation effects. As discussed in Chapter 12, tax non-neutralities can
have positive or negative influences on resource allocation. These are some of the effects of selective
property taxation:
• The industrial and residential locational decisions of entrepreneurs and individuals are influenced by tax
differentials. These differentials cause a reallocation of resources away from jurisdictions with high
property tax rates to those with low property tax rates. This kind of regional competition based on tax
differentials can promote efficiency if, for example, agglomeration benefits8 are created. However, it
can also be very disruptive in areas where labour is not very mobile. A lower capital–labour ratio could
depress already low wages even further or could result in unemployment.
• High property tax rates on improvements may discourage investment in the taxed property and lead to
speculative purchases of low-taxed unimproved land. Large pockets of unimproved land in developed
urban areas are inefficient since infrastructure (such as roads and telephone lines) has to be provided for
the greater area.
• High property tax rates on land may encourage more efficient use of land. A tax on land, for example,
could serve as an incentive to owners of land to develop it to its most profitable use. Badly managed
land or idle land that is taxed may generate no net (after-tax) income. The owner will have to improve
the productivity of the land or sell the land to someone able to do so, or else the owner may go
bankrupt.
• Property taxes on improvements may have perverse effects. As mentioned in Section 12.1, in 1695, a
window tax based on the number of windows in a house was introduced in England. Of course, large
houses tend to have more windows. The tax proved to be very unpopular and many households simply
bricked up their windows to avoid payment; the tax was finally abolished in 1851 (Richardson, 1986).
15.3.6 The unpopularity of property taxation

Property taxation is known to be particularly unpopular (Rosen & Gayer, 2008: 527–528; Skinner, 1991).
Why?
• Property taxation is a tax on unrealised capital income, which may cause solvency and liquidity problems
for some taxpayers.
• The burden of the land part of a property tax is on the owner of the property (when the tax is first
introduced). Since land ownership is mostly concentrated in the hands of a few property owners and
ownership is often coupled with political power, the tax is fiercely resisted.
• The land part of the property tax increases the riskiness of farming, which is already subject to external
risks and seasonal fluctuations in income.
• The administration of property taxes has shortcomings. Properties and the liable taxpayers must be
accurately identified. The taxation of, for example, communal land is problematic. Each parcel of land
must be valued. This process is difficult and sometimes subjective. Since valuation is not done
regularly, there is often outrage when values are updated. Property taxes are generally viewed as
regressive and unfair. In addition, property taxes are highly visible forms of taxation and relatively easy
targets for political action.
15.4 Capital transfer taxes

Capital transfer taxes are taxes on inheritances, estates and gifts. Inheritance tax and estate duties are
called death duties. The estate duty is donor-based. In other words, it is imposed on the estate out of which
the legacy has been made. The liability is determined on the basis of the size of the total estate.
Inheritance tax is donee-based (in other words, it is levied on the receiver of the legacy). The tax liability
is determined by the size of the wealth transfer. Donations (gift) tax is levied on gifts. The reason for this
tax is that estate duties can be avoided if a tax of this nature does not exist. Individuals would simply
transfer wealth before their deaths. The donations tax is levied on the donor and certain exemptions are
usually allowed.
15.4.1 Economic effects of capital transfer taxes

The economic effects of capital transfer taxes can be analysed using the now familiar properties of a ‘good’
tax introduced in Chapter 11.
15.4.1.1 Equity issues

Capital transfer taxes are viewed as important tax instruments in reducing wealth inequalities, particularly
vertical inequalities. Inheritances tend to perpetuate wealth inequalities. In this respect, the inheritance tax
has an advantage over estate duties since it targets the source of inequality. Inheritance tax is also fair to the
extent that it is levied according to the donee’s ability to pay. Taxing the donee may also serve as an
incentive to the donor to spread his or her wealth in order to minimise the tax burden of donees.
To comprehend the impact of death duties on wealth distribution fully, it must be realised that the act of
leaving inheritances in itself can reduce wealth inequalities. Consider the example of a father leaving his
worldly possessions to four low-income earning children with no accumulated wealth. Inter-generational
inequality is reduced in this manner. Therefore, by taxing each child on his or her inheritance, the
promotion of intergenerational equality of wealth is thwarted.
15.4.1.2 Efficiency issues

Capital transfer taxes affect an individual’s choice between current consumption and saving (or future
consumption). If bequests (accumulated savings) are taxed, the individual must give up more current
consumption (in other words, save more) to maintain a given estate size. This is the familiar income effect
of a price change. However, in addition to the income effect, there is also a substitution effect. Capital
transfer taxes increase the opportunity cost of accumulated wealth (that is, savings), causing an increase in
current consumption (that is, lower saving). The final impact of capital transfer taxes therefore depends on
the relative strengths of the two effects, causing the outcome to be uncertain.
15.4.1.3 Administrative issues

Capital transfer taxes are probably easier to administer than an annual wealth tax as the estate is valued once
only. By the same token, estate duties are easier to administer than an inheritance tax. In the case of estate
duties, there is only one tax identity, whereas there could be a number of tax identities under an inheritance
tax. Possibly the most serious problem associated with death taxes is the ability of taxpayers to minimise
tax liability through various forms of generation-skipping devices, such as trusts and interest-free loans.
These devices not only erode the tax base, but are also mainly utilised by wealthy individuals, thereby
perpetuating wealth inequalities. Tax avoidance activities are also unproductive (no new wealth is created).
Other problems with death taxes relate to the hardships they may cause surviving spouses and children.
Special provision has to be made for these categories of donees, which often complicates tax
administration. Many forms of wealth (for example, jewellery) are easy to hide and lend themselves to
evasion under death duties. Transfers made in kind are also difficult to tax under a donations tax. It is no
coincidence, therefore, that capital transfer taxes in the form of death and gift taxes are an insignificant
source of revenue in developing countries. In 2016 these taxes comprised less than 0,1% of total tax
revenues in Africa and Latin American countries (see OECD.Stat. 2019).
15.4.2 Capital transfer taxation in South Africa

Capital transfer taxation in South Africa includes taxes on estates and gifts. A rate of 20% applies to
donations and estates up to R30 million. The rate increases to 25% when the donations and estate exceed
R30 million. A rebate of R100 000 is applicable to donations, and any donations between spouses are
exempt from tax. An abatement of R3,5 million in respect of estate duty applies and may be carried over, in
some instances, to the surviving spouse, with a combined limit of R7,0 million. If the same asset is taxable
due to a second death occurring within 10 years of a preceding death, relief applies on a sliding scale.
Estate duty is not only decreasing in importance, but is also an insignificant source of total tax revenue.
From 1984/85 to 2018/19, estate duty as a percentage of total tax revenue (net of SACU payments)
declined from 0,42% to 0,15%. In 2018/19, approximately R2 435 million was raised in donations tax and
estate duty.
Both the Margo Commission (1987) and the Katz Commission investigated transfer taxes. In its Fourth
Interim Report, the Katz Commission (1997a) confirmed the viewpoint that a donations tax and a system of
estate duty should be retained rather than be replaced by an inheritance tax. It was argued that:
• An inheritance tax is more complicated.
• Estate duty has been in place over many years and is well documented.
• Estate duty has been the subject matter of numerous judicial decisions.
• The administrative systems are geared to the system of estate duty. The Katz Commission (1997a)
recognised that the transfer tax system had deficiencies. It recommended that there should be
provisions to deal with generation-skipping trusts that would tax capital transfers in a trust. It was
suggested that net assets of a trust be valued at intervals of 25 to 30 years (more or less reflecting a
single generation).
More recently, amendments to capital transfer taxation was based on recommendations made by the DTC
(2016d). The proposals the DTC submitted to the Minister of Finance included the additional rate (of 25%)
applicable to donations and estates valued above R30 million, discussed above. In the DTC’s first interim
report on estate duties (DTC, 2015) the following recommendation was accepted: the retirement fund
exemption from estate duties was retained, but additional retirement fund contributions made from 1 March
2015 above the annual income tax allowance are not to be taken into account when the general retirement
abatement is computed for estate duty purposes (DTC, 2016d).
Key concepts
• capitalised value (page 328)
• capital transfer tax (page 333)
• capital value system (page 326)
• composite rating or differential rating (page 325)
• donations (gift) tax (page 333)
• estate duty (page 333)
• flat rating (page 325)
• impersonal (in rem) tax (page 324)
• inheritance tax (page 333)
• market value (page 327)
• net wealth tax or net worth tax (page 321)
• personal property (page 324)
• real property tax base (page 324)
• site value rating (page 325)
• site value system (page 326)
• use value (page 327)
• wealth (page 321)
SUMMARY
• Wealth is a stock concept and includes accumulated assets (tangible and financial). The net value of assets
is obtained by subtracting liabilities from assets. Three types of taxes often levied on wealth are the
personal net wealth tax, property tax and capital transfer tax.
• The taxation of wealth is fair in terms of both the benefit principle and the ability-to- pay principle. A tax
on wealth is a tax on savings. Consequently, the incidence effect is determined by the price elasticity of
demand and supply of savings. If the supply of savings is relatively inelastic, the incidence is mostly on
the owners of capital, who tend to be middle- and upper-income individuals. The tax is therefore
progressive.
• Although wealth taxes may encourage the more productive use of assets, they may also reduce efficiency
when individuals reduce savings and work effort. They also have an excess burden, since relative prices
of goods consumed presently and in the future are distorted.
• Property (realty) tax is an important revenue source for local authorities. In South Africa, property tax is
levied as a rand-based amount on the market value of the property. The market value is inclusive of the
land value and the value of improvements.
• It can be shown using a partial equilibrium framework that the incidence of property tax on land is borne
by the landowner (the tax is progressive). The incidence of property tax on improvements can be
shifted to tenants and tends to be regressive. General equilibrium analysis indicates that a tax on
property will be borne by all capital owners in the long run as well as by labour as the productivity of
labour is adversely affected by a lower capital–labour ratio.
• Property taxes distort relative prices and cause an excess burden. Although the tax may serve as an
incentive to use land more productively, it may also discourage investment in fixed property.
• Capital transfer taxes include death duties (tax on inheritances and estates) and gift taxes (donations).
Taxes of this nature may reduce vertical imbalances, but impact adversely on savings, and tend to be
avoided by taxpayers by using trusts and interest-free loans.
15.1 Wealth is …
a. income from capital gains.
b. gross personal worth.
c. interest on government bonds.
d. net value of assets.
15.2 Which of the following statements in respect of a net wealth tax is or are correct?
a. The tax is fair because the rich benefit more from public services than the poor.
b. The tax is equitable because the rich have greater taxable capacity.
c. Relative prices of savings and other goods are distorted by the tax and an excess burden results.
d. Asset values are easily determined, thus simplifying tax administration.
15.3 The municipal property tax in South Africa …
a. rates land and improvements at different rates.
b. is based on market values of the assets of property owners.
c. may reduce the value of properties when the tax is capitalised.
d. is unfair to land owners because they cannot shift the tax.
15.4 Capital transfer taxes …
a. are paid by the donor when levied as an estate duty.
b. have only an income effect and are therefore efficient taxes.
c. are significant sources of revenue.
d. include donations between spouses.
15.1 Define a net wealth tax.
15.2 Illustrate the tax incidence of a tax on the land part of property. Who bears the burden?
15.3 Distinguish between an estate duty and an inheritance tax.
ESSAY QUESTIONS
15.1 ‘Wealth taxes tend to generate limited revenues for government and should therefore be eliminated.’
Discuss this statement.
15.2 ‘Municipal rates boycotts in South Africa would confirm the notion that a property tax is a benefit tax.’
Discuss.
15.3 ‘Property taxes on land are not only efficient, but are also equitable.’ Do you agree? Discuss.
15.4 Who really pays the property tax on improvements? Explain by using partial and general equilibrium
analysis.
15.5 Discuss the possibility that high property rates in Sandton in Johannesburg can be shifted to other
forms of capital and even to low income earners in Soweto.
15.6 A factory located in Epping, an industrial area near Cape Town, is valued at R1,2 million. The
opportunity cost of capital (or current interest rate) is 14%. Owing to the high incidence of crime, the
Cape Town Metropolitan Council introduces a once-off ‘protection levy’ of R1 200 payable by all
local property owners. Assuming full capitalisation, what will be the impact on the value of the
property in Epping?
15.7 Discuss the economic effects of capital transfer taxes in South Africa.
1 The personal net wealth tax as implemented in a number of developed countries is discussed in detail in Organisation for
Economic Co-operation and Development (OECD) (1988: 30–75).
2 For a discussion of a gross assets tax on businesses, see Sadka and Tanzi (1993: 66–73).
3 The land area largely corresponds to the present-day South African provinces of Gauteng, Mpumalanga, Limpopo and North West
province.
4 The study used the National Income Dynamics Study (NIDS) Wave 2 data conducted in 2010–2011, and an unpublished dataset of
Personal Income Tax records for the 2010/11 tax year (see Orthofer (2016) for more details on the nature of these data sources).
5 Mbewe and Woolard (2016) also used the NIDS Wave 2 data, but included the more recent data from NIDS Wave 4 (2014–2015).
6 Spain has continued to extend the wealth tax since its re-introduction in 2011 (DTC, 2018b: 37).
7 In theory, the discounted stream of net rent payments is equivalent to the capital value of the property.
8 As firms concentrate (or agglomerate) in an area, benefits such as better access to a larger market and larger pools of managerial
talent result.
Taxes on goods and services, and tax reform
In Chapter 11, we identified four major tax bases: income, wealth, people and consumption. We have
already studied taxes on income (Chapters 13 and 14) and wealth (Chapter 15). In this chapter, we examine
taxes on goods and services (in other words, the consumption base). When we introduced tax equity and
efficiency in Chapters 11 and 12, we explained most of these concepts using excise taxes as examples. In
this chapter, we begin by identifying the types of indirect taxes in Section 16.1. The debate on the relative
importance of indirect taxes versus direct taxes is an ongoing one, and the advantages and disadvantages of
indirect taxes are discussed in Section 16.2. Value-added taxes have increased in importance worldwide.
This type of indirect tax is described and its economic effects are analysed in Section 16.3. In Section 16.4,
we consider the personal consumption tax, which has until now only received theoretical attention by tax
analysts. International tax reform is discussed in Section 16.5. The chapter concludes with a brief reference
to tax reform in South Africa.
distinguish between different indirect taxes and indicate their relative importance as sources of revenue
discuss the merits of indirect taxation
describe the consumption-type VAT
explain the economic effects of VAT
describe the personal consumption tax base
discuss the rationale for a personal consumption tax
discuss the shortcomings of a personal consumption tax
distinguish between patterns of taxation in advanced countries and developing countries
identify the direction of international tax reform
compare tax competition with tax harmonisation
contrast international tax reforms with the major tax reforms in South Africa since the late 1960s.
16.1 Types of indirect taxes

Indirect taxes are taxes that are imposed on commodities or market transactions (see Section 11.2.4 of
Chapter 11). The burden of an indirect tax is likely to be shifted. Consider, for example, an excise tax on
locally produced washing machines. Although the statutory burden is on the supplier, the consumer usually
bears the burden indirectly. Indirect taxes can be imposed at different stages of the production process: the
resource (mining or farming) stage, the manufacturing stage, the wholesale stage or the retail stage. If the
tax is collected at one stage only, it is called a single-stage commodity tax. If it is collected at more than
one stage, it is called a multi-stage commodity tax. VAT is an example of a multi-stage tax.
We can distinguish between selective (narrow-based) taxes (for example, specific excise duties) and
general (broad-based) indirect taxes (for example, turnover tax, general sales tax and value-added tax) (see
Section 11.2.2 of Chapter 11). Excise duties are selective taxes levied on certain goods or transactions.
Excise duties can be specific (unit) taxes or ad valorem (percentage of value) taxes (see Section 11.2.3 of
Chapter 11). Excise taxes are collected on both domestically produced and imported goods. When levied
on imported goods, they are generally known as customs duties (or tariffs). The personal consumption tax
(see Section 16.4) is also included under indirect taxes.
From Table 16.1, it is clear that VAT is by far the most important indirect tax source in South Africa
(contributing 70,8% of the revenue from domestic taxes on goods and services), followed by the fuel levy
(16,4%), which is an excise tax. Specific excise duties are levied mainly on alcoholic beverages and
cigarettes (the so-called sin taxes), whereas ad valorem excise duties are levied on a number of luxury
goods. Excises imposed to reduce consumption of certain goods are known as sumptuary taxes (or sin
taxes). Specific excise duties (8,8%) generate much more revenue than ad valorem duties (0,9%). Other
levies included in the total of domestic taxes on goods and service include various environmental levies,
such as the plastic shopping bag levy (twelve cents per bag), a levy on incandescent light bulbs (R8,00 per
bulb), a carbon dioxide (CO2) emissions tax on new motor vehicles, a levy applied to electricity generated
from non-renewable and nuclear energy sources of 5,5c/kWh and the international air passenger departure
tax (R190 per passenger). These levies serve as (negative) incentives to consumers to reduce greenhouse
gas emissions and to improve the environment.
16.2 Indirect taxes: A general critical assessment

Indirect taxes have a number of advantages.
• Indirect taxation is a practical way of raising revenue from people who have small incomes and those who
are not captured by the income tax net. This advantage hinges on the proposition that all citizens should
contribute to some extent to the upkeep of government (in other words, it is based on the benefit
principle).
• Taxes on goods and services are often invisible. Consumers hardly know that they are paying excise taxes,
while the inclusion of VAT in prices is mostly noted only after the goods and services have been paid
for. The advantage of fiscal illusion makes these taxes less susceptible to tax resistance. The downside
is that it does not conform to transparency requirements of good governance.
• The tax liability is largely determined by how much is purchased of the taxed good. In the case of
consumption goods (excluding certain necessities), consumers sometimes have a choice between
different goods and services (in other words, substitution possibilities exist). For example, if an excise
tax is imposed on golf equipment (for example, golf balls), individuals may decide rather to take up
jogging (an untaxed leisure activity). Within certain limits, taxpayers themselves can thus determine
their tax liability. To the extent that the shifting of the tax burden is possible, the tax liability would be
reduced further. In respect of direct taxes (income and company tax), the liability cannot be avoided
that easily and the substitution possibilities are also fewer (for example, in the case of income tax,
breadwinners have to earn an income). Government enforces the tax liability much more strongly in the
case of income tax.
Table 16.1 Main domestic taxes on goods and services

Sources: Budget Review 2019, National Treasury (2019a), Available: http://www.treasury.gov.za [Accessed 6 March
2019]; and SARS (2019), Schedules to the Customs and Excise Act, 1964 (Tariff Book), Available:
http://www.sars.gov.za/Legal/Primary-Legislation/Pages/Schedules-to-the-Customs-and-Excise-Act.aspx [Accessed 7
March 2019].
• Consumption taxes can be used to achieve multiple objectives. Excise taxes can be used to correct market
failures such as externalities. By levying a lower tax on unleaded petrol, environmental objectives are
promoted. High sumptuary taxes on liquor and cigarettes are in part aimed at reducing alcohol abuse
and smoking, and thus help to improve general health levels. Similarly the tax on sugar sweetened
beverages (SSBs) is intended to reduce obesity and related health problems among adults and children.
More broadly, it could be argued that it may be worth levying the highest excises on luxury goods
produced by means of capital-intensive technology and the lowest on necessities produced by labour-
intensive means in developing countries.
• Taxes on goods and services are often levied on the value of the commodity, that is, on an ad valorem
basis (for example, ad valorem excises and VAT). Tax revenue from this source automatically
increases as the price of the commodity increases and is therefore effectively indexed to inflation.
• Indirect taxes are relatively simple to administer. Consumers also have limited scope for evading taxes on
goods and services, and compliance is accordingly easier to enforce.
Analysts have also pointed to a number of disadvantages of indirect taxes.

• According to the ability-to-pay principle, broad-based taxes on goods and services tend to be regressive.
The reason is that consumption declines as a percentage of income as income increases. This
conclusion has led to the exemption or zero-rating of certain basic consumption goods and services
from indirect taxation, in particular where a broad-based VAT applies (see Section 16.3). Even excise
taxes, which are generally levied on sumptuary goods, can be regressive. According to the Bureau of
Market Research (BMR, 2017), poor households in South Africa spent approximately 2,1% of their
expenditure on cigarettes and narcotics, in comparison to the 0,3% spent by the affluent in 2017. Even
if it is assumed that cigarette prices are the same for both income groups (the poor often pay higher
prices since they buy cigarettes at inflated prices in rural areas or townships and in units, for example, a
single cigarette), the tax is regressive. The same conclusion applies to excise taxes on beer and
‘luxuries’ such as skin care, hair and shaving preparations (Steenekamp, 1994; Katz Commission,
1994: 124).
• Indirect excise taxes are selective and lead to inefficiencies. For example, in developing countries, the
opportunity to purchase luxury goods may act as an incentive to work harder and save more. However,
if high rates of indirect taxation are levied, this may result in a substitution effect in favour of leisure,
thereby adversely affecting work effort (see Cnossen, 1990). In addition, high indirect tax rates may
lead to smuggling and black market activities. To counter smuggling, the Swedish government lowered
taxes on cigarettes and tobacco in 1998. A recent study by Ipsos (2018) in South Africa revealed that
approximately three of four cigarettes sold in small and medium businesses (such as spaza shops and
cafes) were sold at prices below the minimum tax due to SARS (which is typically taken to indicate an
illicit cigarette).
• Since indirect taxes can be levied for various purposes, there is often a policy conflict (too many goals and
only one instrument). When we considered economic efficiency as one of the properties of a ‘good’ tax
in Chapter 12, we concluded that, to minimise the excess burden, commodity taxes should be high on
goods and services with an inelastic demand, and low on goods and services with high demand and
supply elasticities. This tax rule was referred to as the inverse elasticity rule. In practice, excise taxes
are imposed on luxuries for equity reasons. The demand for luxury goods, however, tends to be both
price and income elastic. Taxes on these commodities will significantly decrease the quantity
demanded. Application of the inverse elasticity rule means that, from an efficiency point of view, these
goods should bear low tax rates, which is contradictory to the equity requirement. Thus there is a policy
conflict that requires a trade-off between equity and efficiency objectives.
• Indirect taxes may represent an inflationary impulse if wages are raised in response to tax increases. Some
multi-stage commodity taxes also have a cascading effect on prices. If the tax at each stage of
production is based on the gross price up to that stage, including tax levied at earlier stages, tax is in
effect levied on tax. This may encourage vertical integration of production processes and thereby
reduce the degree of competition in the markets concerned.
16.3 Value-added tax
Value-added tax is a multi-stage sales tax levied on the value added at the different stages of production.
Roughly speaking, value added is the difference between sales and purchases of intermediate goods and
services over a certain period (normally a month). If a retailer purchased goods to the value of R150 000
from suppliers in a month and had sales worth R300 000 in that month, the value added by the retailer
would be R150 000. The tax would then be applied to this value. The value added consists of wages, rent,
interest, depreciation and profit. The calculation of value-added tax is illustrated in Box 16.1. South
Africa’s neighbouring countries, Namibia, Botswana, Lesotho and Eswatini (previously known as
Swaziland), have all recently introduced VAT. Their systems are broadly similar to that of South Africa,
but differ in some respects with regard to rates, exemptions, and goods and services that are zero-rated.
VAT comes in many forms. A tax authority wishing to introduce VAT therefore faces a number of
choices. We now discuss these choices and the South African practice in respect of each.1
There are three broad types of VAT: a consumption-type VAT, an income-type VAT and a VAT on
gross product. When South Africa introduced VAT in 1991, the universal practice of a consumption type
VAT was chosen. In a closed economy with no government,
GNP = C + I = W + P + D
where GNP is gross national product, C is consumption, I is gross investment, W is wages, P is net profit
after depreciation and D is depreciation. The consumption VAT base is then
C=W+P+D–I
The regime for international trade can be based on the origin principle (exports taxable, imports zero-rated)
or the destination principle (exports zero-rated, imports taxable). Again, South Africa decided to follow
the popular route of applying the destination principle. This is perceived to be a fair practice (domestic and
imported goods are treated the same) and one that does not affect the competitiveness of exports.
Since destination-based VAT taxes imports but not exports, tax rate differentials between countries are
normally offset at the border. This implies that production takes place in the least-cost location, or put
differently, global allocative efficiency is achieved. The destination principle, therefore, promotes
neutrality in the taxation of internationally traded commodities. Within a customs union or union such as
the European Union (EU), where border controls on trades among members do not exist or are not
effective, the destination principle breaks down. Cross-border shopping is, for example, encouraged if rate
differentials between countries are significant. This has relevance for the SACU (Southern African
Customs Union; see Section 16.5.4) should there be a liberalisation of border controls in this union.
Alternatives to the destination-based VAT include applying the restricted-origin principle to intra-union
trades. This option provides for a clearing house allowing for exports of union members to be taxed at
origin. Importers would be entitled to a tax credit for the VAT paid on imports. Tax-rate harmonisation
could also lessen the impact somewhat. The incentive for cross-border shopping diminishes with the
distance consumers have to travel to buy goods. The overall impact may not be that significant and reduces
the need for rates to be approximately the same.2
Tax liability can be computed using three methods: subtraction, tax credit (or ‘invoice’) or addition. The
tax credit (invoice) method is generally used, also in South Africa. This is the type of VAT illustrated in
Box 16.1.
Two techniques can be used to free goods and sectors from VAT (see Section 16.3.1): outright
exemption (the firm need not file a VAT return and does not, therefore, levy VAT, but it also cannot claim
refunds for any VAT included in the price of purchased goods and services), and zero-rating (the firm files
a return, but pays zero tax on sales and receives a refund in respect of VAT payments made at earlier
stages in the production and distribution chain). South Africa uses both techniques. Education and health
services as well as the services of various non-governmental organisations are exempt. In addition to goods
and services destined for export, a list of basic foodstuffs is zero-rated. This list includes brown bread,
maize meal, samp, mealie rice, dried beans, lentils, pilchards, milk powder, dairy powder blend, rice,
vegetables, fruit, vegetable oil, milk, cultured milk, brown wheat, eggs and edible legumes. After the one
percentage point VAT rate increase (to 15%) in the 2018 budget, the Minister of Finance commissioned a
panel to review the current list of zero-rated items, and to make recommendations on additional items to be
zero-rated. The panel recommended that the following items be considered: white bread, cake flour, bread
flour, sanitary products, nappies, and school uniforms (with the proviso that a uniform be clearly
demarcated)3. The 2019 budget confirmed that three additional items would be added to the zero-rated list:
cake flour, white bread four, and sanitary pads (National Treasury, 2019a: 43).
VAT can be levied at a single rate or at multiple rates (rates in addition to the zero rate). Namibia taxes
most goods and services at a standard rate of 15%. Lesotho levies VAT on most goods and services at a
standard rate of 15%. Alcohol and tobacco products are taxed at a rate of 15%, 8% on electricity, and
telecommunications at 9%. South Africa, Eswatini and Botswana have a single-rate VAT (apart from the
zero rate that is applied for equity reasons – see Section 16.3.1.3). In contrast to the 15% VAT levied in
South Africa and Eswatini, Botswana levies VAT at only 12%.
Box 16.1 Value-added tax: An illustrative example
Consider the transactions of three firms for the month of September. Agent A is an importer of bicycle components
who, for argument’s sake, is assumed to add no further value to the value of imports. Firm B is an assembler of
bicycles and Firm C is a bicycle shop. Agent A imports bicycle components to the amount of R100 000 and sells
them for R100 000 to Firm B, who, after assembling the bicycles, sells them for R150 000 to Firm C. Firm C sells
the bicycles for R300 000 to the cycling public (consumers). The tax trail is shown in the table below.
Table 16.2 The VAT tax trail
VAT is collected at different stages of the production process and, at the end of the distribution channel, the tax is
passed on to the consumer. Assuming for simplicity reasons that consumption is perfectly price inelastic, the
incidence (the burden) of the tax is therefore on consumers, but the sellers make the tax payments to SARS. VAT is
collected by the seller at the point of sale (this is referred to as the output tax). The seller may then deduct taxes paid
on intermediate products (this is referred to as the input tax). For example, Firm B purchases components from
Agent A. Included in the price is input tax of R15 000 (this amount is collected by Agent A and paid over to SARS).
Firm B may deduct the input tax from the VAT of R22 500 (the output tax) payable on his or her selling price. At the
end of the month, the total tax liability of Firm B is R7 500 (or R22 500 minus R15 000 on inputs). Firm C’s tax
liability is R22 500 (R45 000 on the selling price less input tax of R22 500). The total VAT collected is R45 000
(R15 000 from Agent A, R7 500 from Firm B and R22 500 from Firm C). Note that the same result can be obtained
by levying 15% VAT on the value added at each stage of the production process (remember to include the value
added included in imports).
16.3.1 The economic effects of VAT

The economic effects of VAT can be analysed by considering its revenue-generating potential as well as the
familiar and important properties of a ‘good’ tax: efficiency, equity and administrative efficiency.
16.3.1.1 Revenue
Value-added tax (VAT) has a worldwide reputation of being a ‘money machine’ and in developing
countries this has indeed proven to be the case. In South Africa, VAT was introduced in October 1991 at a
rate of 10%, but the rate was increased to 14% in April 1993. The revenue importance of VAT cannot be
contested. In 1992/93, collections amounted to R17,5 billion, or approximately 21,7% of total net tax
revenue. In 2017/18, the budgetary outcome amounted to R298 billion, or 25,7% of total tax revenue (net
of SACU payments). Likewise, Namibia expects 24,3% of the estimated 2018/19 tax revenue (including
customs and excise) in the form of VAT (Republic of Namibia 2018: 3). When countries are ranked
according to their efforts at raising VAT revenue, South Africa ranks 21st out of 27 countries studied
(Steenekamp, 2007). More recently, an IMF study on the South African VAT gap estimated the average C-
efficiency ratio between 2007 and 2013 to be approximately 64% (IMF, 2015: 13). The C-efficiency4 ratio
is calculated by dividing the actual VAT revenue collections by what could be collected if VAT is imposed
on all consumption at a uniform rate without exemptions (Keen, 2012: 427). It is a measure of how
efficiently VAT revenue is collected. In comparative terms, the estimated value of South Africa’s C-
efficiency ratio was the third highest 5 in Sub-Saharan countries over the same period. A further breakdown
of the ratio allows the identification of the policy gap (which gives an estimate of the tax expenditures
associated with VAT), and the compliance gap (which provides an indicator of the efficacy of VAT
collection and enforcement, given the tax base)6. The policy gap estimated was relatively low compared to
international standards, whereas the compliance gap was estimated at between 5% and 10% of potential
VAT revenues (IMF, 2015a: 16).
16.3.1.2 Efficiency and the tax rate

In our discussion of the efficiency effects of general taxes in Chapter 12, we concluded that taxes imposed
on a broad base and at a uniform rate resemble lump-sum taxes and are efficient. In arriving at this
conclusion, we ignored equity considerations. Whether efficiency requires uniform rates is a much debated
issue. The theory of optimal taxation (see Section 12.1.3 of Chapter 12) provides convincing arguments on
efficiency and equity grounds, which refute the notion of uniformity (Newbery & Stern, 1987). The inverse
elasticity rule is one example of this line of thinking (see Section 12.2.2 of Chapter 12).
You will recall that the inverse elasticity rule states that the excess burden of selective taxes can be
minimised by taxing price inelastic goods and services at higher rates, that is, inversely proportional to the
product’s price elasticity of demand. Put more eloquently, the rule states that the excess burden will be
minimised if the proportional reduction in compensated demand that results when a set of selective taxes is
imposed is the same for all goods. When we move away from the one-person assumption of the model and
also include equity considerations, the rule calls for higher taxes on goods with low distributional
characteristics and lower taxes on goods with high distributional characteristics (goods where the share of
the poor in its total consumption is high). The important conclusion from optimal tax theory is that, from
an equity perspective, uniform taxation is not desirable. In other words, to minimise inefficiency, different
tax rates should be applied to different commodities. A case for uniform rates can only be made under
certain strict conditions. One condition is that governments should make optimal lump-sum transfers to
households. In other words, when taxes are designed, one has to consider what government does with the
tax revenue.
Using optimal tax theory in formulating policy is, however, severely restricted by data limitations. For
example, to design separate rates for each commodity requires information on elasticities and patterns of
complements and substitutes that are difficult to come by. It is also doubtful whether the efficiency gain
from designing a great variety of tax rates would outstrip the costs involved in administering a system of
this nature. One solution could be to lump together large categories of commodities and to subject them to
uniform ad valorem taxes. Another option is to achieve the desired equity objectives with a combination of
differentiated or uniform excises on luxuries and a uniform VAT rate. The lumping-together process is,
however, still analytically and empirically problematic. In the end, there appears to be some agreement that
the loss of economic efficiency owing to VAT is likely to be minimised when uniform rates or a few rates
(three or four) are applied to the broadest possible base. Moreover, if a system of income and expenditure
supports for the poor is in place (see Chapters 8 and 9), the case for uniformity in rates is strengthened.
16.3.1.3 Equity
There is no question that a broad-based (comprehensive) VAT with no exemptions or zero-rating is
regressive. To lessen the impact on low-income households, VAT rates can, for example, be restructured
using different tax rates for commodities that are important to poor consumers (Go, Kearney, Robinson &
Thierfelder, 2005). This would again affect the economic efficiency and the administrative complexity of
the system. To find a balance between revenue, equity and efficiency in taxation, for example, pursuing
equity would imply trading off distributional and economic efficiency objectives. As mentioned, tax relief
includes exemption from VAT and zero-rating. Exemption of a good or service from VAT means that the
firm or supplier need not levy VAT on sales, but at the same time, that firm may not claim refunds of the
VAT already collected at earlier stages of the production process. The buyer of the service therefore pays
VAT levied on all but the final stage in the production chain. Because the invoice trail breaks down when a
retailer is exempt from VAT (see also Section 16.3.1.4), there is also no way of knowing or checking –
especially in remote rural areas or even in urban areas with little competition – whether or not the exempt
retailer actually adds a margin to the price that resembles a tax at this final stage of the supply chain. Zero-
rating of a good or service means that the firm charges a zero rate of tax on sales of the commodity and is
also allowed to deduct VAT collected at earlier stages. The buyer of a zero-rated product does not pay any
VAT. None of the stages of production is thus subject to VAT.
A major shortcoming of zero-rating is that the tax base is eroded, perhaps necessitating a higher VAT
rate, given the total revenue that the government requires. For example, the estimated revenue loss due to
zero-rating in South Africa in 1994/95 was R2 600 million. It was calculated that by abolishing zero-rating
on foodstuffs, the standard rate could have been reduced by about 1,25 percentage points without affecting
the yield from VAT. Furthermore, since zero-rated goods and services are consumed by the rich as well,
they also benefit from the zero rate. Affluent households spend substantially more in absolute terms on
zero-rated goods than less affluent households. It was estimated that of the above-mentioned R2 600
million loss in VAT revenue, more than two-thirds of the benefit accrued to households in the top half of
the income distribution (Katz Commission, 1994: 113). Zero-rating may also lead to over taxation of
suppliers who cannot credit VAT collected at earlier stages. In South Africa, this is of particular concern to
unregistered vendors who operate in the informal sector.
Another method of reducing the regressivity of VAT is to levy multiple rates (for example, higher rates
on luxuries). This is similar to the option mentioned earlier of combining uniform VAT rates with
differentiated excises on luxuries (as is the case in Namibia, for example). This option, however, is subject
to various administrative and efficiency complications.
In its First Interim Report, the Katz Commission (1994: 133) recommended that the further erosion of
the VAT base through zero-rating or exemptions should not be considered, and that targeted poverty relief
and development programmes should receive priority. In addition, the Katz Commission (1994: 133)
recommended against higher VAT rates on luxury goods or a multiple VAT rate system. The Commission
argued that a system of this nature would make an insignificant contribution to reducing regressivity,
would have high administration and compliance costs, and would not have much additional revenue
potential. The South African government accepted these recommendations.
In their final report on VAT, the DTC (2018c) evaluated the structural features of VAT in South Africa.
Some of their recommendations to the Minister of Finance were as follows:
• Zero-rating of basic foodstuffs, if considered in isolation, mitigates the regressivity7 of VAT to some
extent. However, this may not be the most efficient policy tool given the gain (in absolute terms) to rich
households. The DTC (2018c) recognised the difficulties of removing zero-rating and acknowledged
that the best scenario would be to retain those items that explicitly benefit poor households, whilst
removing others disproportionately consumed by the rich. They recommended that no additional food
items should be zero-rated.8
• The DTC (2018c) also considered the option of multiple rates (particularly on luxury items). Their key
recommendation was that there is scant evidence that higher rates improve the equity of the VAT
system; rather, it adds further administrative complexities. Furthermore, excise duties are already
imposed on selective (more luxurious) items. Given this, they recommended that multiple rates should
not be considered.
• With reference to exemptions, the DTC (2018c) acknowledged the difficulties associated with the taxation
of the financial sector in the VAT system and in particular where services are not explicitly charged.
South Africa charges VAT on explicit services. When there is no explicit charge for the supply of the
financial service, it renders the service VAT exempt. The problem of VAT cascading consequently
arises. Since the financial institution that supplies the service cannot on-charge the VAT paid on inputs
to produce the service, it becomes a cost to the business that purchases the service as it cannot claim
input tax credit. Various approaches were considered to alleviate VAT cascading and reduce the
incentive of vertical integration, and the DTC recommended that National Treasury and SARS give
urgent consideration to approaches adopted by other countries in addressing this problem.
To reduce the regressive impact of VAT, tax relief could be given to the poor or transfer payments could be
directed at them. Van Oordt (2018) investigated the plausibility of taxing foodstuffs and providing cash
transfers from the additional revenues as more welfare enhancing than the zero-rating policy. He concludes
that under conditions of tax earmarking 9 and an efficient government (that increases the value of social
grants by the total additional tax revenue, i.e. a revenue-neutral policy), zero-rating could be removed.
However, Van Oordt (2018) indicates it is unlikely that both assumptions will hold (i.e. full tax earmarking
and government being perfectly efficient in raising social grants) in a developing country context. Hence,
he recommends that under these circumstances, zero-rating can be considered for food items that are not
disproportionately consumed by affluent households.
16.3.1.4 Administration
The credit-type VAT system has the reputation of being effective against tax evasion. The anti-evasion
features are its self-policing attributes, the possibilities for the cross-checking of invoices and the fact that a
large portion of tax revenue is collected before the retail stage. The self-policing feature reveals itself in the
lack of incentives for sellers and buyers to collude in making underpayments of VAT. Sellers would prefer
to understate the output tax, whereas all buyers who are not final consumers would like to overstate the
input tax since they can reclaim it. Therefore, if the seller does not pay the full VAT, it increases the VAT
liability of the buyer, who will certainly complain about it. Since VAT requires the maintenance of records
of both purchases and sales, the revenue authorities have a basis for cross-checking returns. The benefit
from collecting VAT at the different stages of the production process can be seen from our example in Box
16.1. If the retailer (Firm C) is not a registered VAT vendor and therefore does not charge VAT on sales or
claim an input tax credit, SARS will still collect R22 500 from Firms A and B.
Opportunities for fake claims increase when goods are zero-rated, exempt or taxed at different rates. A
retailer can, for example, understate output tax by understating sales of higher-rated goods. Multiple rates
not only open up avenues for tax evasion, but also complicate administration for the tax authorities and
taxpayers alike.
16.4 Personal consumption tax
In Section 16.3.1 we saw that one of the disadvantages of a value-added tax is its regressivity. An
alternative tax on consumption that can address this shortcoming is the personal consumption tax (or
expenditure tax). The base of the personal consumption tax is income less net saving (saving minus
dissaving). This tax is collected directly from the consumer, similar to the personal income tax, and can be
made progressive by applying a rate schedule and allowing for exemptions on certain consumption items
(for example, medical expenditures). Although it looks simple enough, it is more complicated to design
and implement than income tax or VAT. Nonetheless, there is a large body of support among economists
for a tax of this nature.
16.4.1 The rationale for a personal consumption tax

The proponents of a consumption tax argue that it is more equitable to tax what an individual takes out of
the economic system (as reflected in consumption) than what an individual contributes to society (as
measured by income). From this perspective, it would be considered fair that a millionaire who lives like a
miser ends up with a low current tax liability. This conflicts with the ability-to-pay principle, which views
potential consumption (the power to consume) as the yardstick. The counter-argument is that the
millionaire is simply postponing the tax until he or she consumes the funds accumulated. The tax liability
of the individual must therefore be viewed over a longer period; that is, a lifetime equity perspective is
required.
It is further argued that a personal consumption tax is more efficient than an income tax. This
conclusion rests on two assumptions:
• That income tax affects saving
• That the supply of labour is fixed.
A tax on saving (for example, an income tax) distorts the choice between present and future consumption.
An income tax therefore causes an excess burden, that is, in addition to the burden associated with the
choice between income (work) and leisure. In contrast, a tax on consumption does not create an excess
burden, since saving is not taxed. If the supply of labour (or work effort) is not affected by a tax on
personal consumption, it has no excess burden. If, however, a tax on consumption induces a consumer to
work less (in other words, enjoy more leisure time), it entails an excess burden. Nevertheless, there is some
empirical evidence that a consumption tax is on balance more economic efficient than an income tax.
If consumption is taxed (as leisure is too difficult to tax), the price of consumption goods increases
relative to leisure. It means that one hour of leisure (or labour sacrificed) is now equivalent to less
consumption than before; that is, the opportunity cost (or relative price) of leisure has decreased. Put
differently, a tax on consumption decreases the return to work effort. Leisure hours will increase and work
effort decreases. Therefore, a tax on consumption does cause an excess burden. Since the consumption tax
base is smaller than the income tax base, the tax rate on consumption would have to be higher in order to
yield the same tax revenue. Because the excess burden of a tax increases with the square of the tax rate, the
excess burden of the consumption tax is higher than the equal-yield income tax. This efficiency loss must
be subtracted from the efficiency gain derived from not taxing savings. The net effect must then be
compared to the excess burden caused by an income tax. Whether the excess burden of a personal
consumption tax is less than that of an income tax ultimately depends on empirical evidence. Some studies
show that a consumption tax creates a smaller excess burden than an income tax and this has advanced the
case of the proponents of the personal consumption tax (Rosen & Gayer, 2008: 479).
It is also argued that a consumption tax would be beneficial to developing countries. These countries
have a critical shortage of saving. Since the personal consumption tax is neutral in respect of the choice
between present and future consumption (saving), consumption would be a good tax base. Furthermore,
consumption (like income) tends to be distributed highly unequally in these countries. A progressive
expenditure tax could tap this base effectively and equitably.
The personal consumption tax is usually considered too complex to administer. It is argued, for
example, that to arrive at the taxpayer’s annual consumption, a list would have to be made of all
expenditures, and then added up. This, together with the required record-keeping, would be a mammoth
task. Proponents argue, however, that these problems can be overcome by observing the individual’s cash
flow in qualified bank accounts. In addition, certain problems normally associated with income tax, such as
valuing unrealised capital gains and depreciation, are also avoided when consumption is taxed. Under a
consumption tax, capital gains are taxed when they are realised. Capital purchases are immediately
expensed (written off when purchased), making allowances for depreciation unnecessary.
16.4.2 The disadvantages of a personal consumption tax

The personal consumption tax has not been implemented successfully anywhere in the world. India and Sri
Lanka, for example, experimented with this tax, but abandoned it. The problem areas in designing a
personal consumption tax are administration, treatment of bequests and gifts, and the problems of
transition.
Critics are concerned about the risks of implementing a tax of this nature because we know too little
about the practical administrative problems to be encountered. In contrast, the problems with the current
income tax system are known and can be addressed. Furthermore, proponents of a consumption tax tend to
compare an ideal consumption tax to the current income tax, with all its impurities introduced over years.
This is not really a fair comparison since there is no guarantee that a personal consumption tax would not
follow the same route, and become progressively more impure and complicated.
A personal consumption tax creates a host of specific administration problems. For example, under an
income tax system, taxes are withheld at source for administrative and compliance purposes (for example,
the PAYE system mentioned in Chapter 12). This would be difficult under a consumption tax. How would
an employer estimate the consumption and saving of each employee? A presumptive consumption–income
ratio may have to be applied. As mentioned earlier, extensive record-keeping would also be required in
respect of bank balances, expenditures and assets.
It would be necessary (and difficult) to distinguish between consumption and investment. Consider
expenditures such as housing and education. The purchase of a house, for example, should be regarded as
investment and subtracted from consumption to determine the tax base. Owner-occupied housing,
however, generates a service that should be classified as consumption. An imputed rent value would have
to be determined for this purpose. An alternative would be to exclude housing altogether from the tax base,
but this would erode the tax base. Education also has both an investment and a consumption component.
Another source of base erosion is the consumption of goods and services in kind. The consumption tax
system is not necessarily superior to the income tax system in detecting consumption. Under the cash flow
system, consumption is calculated as a residual (income minus saving). The definitional problems related
to income all still apply and are compounded by problems relating to the definition of saving. Would it not
be simpler to use an income tax system where only income needs to be determined?
Another major problem is the treatment of bequests and gifts. Should bequests and gifts be considered
as consumption by the donor or as income of the donee (that is, the recipient of the donation)? According
to one view, a gift (for example, cash) by a parent to a child is no different from any other form of
expenditure and should be treated as consumption. From another point of view, it is argued that
consumption only occurs when the child spends the cash. Exempting bequests and gifts would solve the
administrative problems, but could lead to large concentrations of wealth. Some form of wealth taxation,
however, could address this problem.
Finally, introducing a personal consumption tax will cause transition problems. One dilemma is the
treatment of savings once the new system comes into effect. Under the income tax system, saving comes
from after-tax income. If an existing asset is now realised or previous saving is spent on consumption
goods, the same base will be taxed again under a consumption tax, which appears to be unfair.
16.5 Tax reform: International experience

The existing tax systems of countries evolved over time. Changes to tax systems are implemented through
ad hoc reforms or comprehensive tax reform programmes. The goals of these reforms are varied and differ
from country to country. The driving force is often a desire for more revenue. In addition, non-revenue
goals, such as redistribution or equity, promotion of growth, tax simplification and a more efficient
allocation of resources, are also pursued.
Tax reform can be triggered by various factors, one of which is political change. A change in
government often implies different voter preferences. For example, if the new constituency is, on average,
composed of relatively more low-income voters (such as in Southern Africa), tax reforms that redistribute
income to them may be forthcoming (see Section 7.4.3 of Chapter 7). Political change may also be
accompanied by ideological shifts (for example, a shift away from centralised planning to a more devolved
or federal-type structure or a market-based system). Developments in tax theory often provide new
analytical insights, and attempts are then made to operationalise these through tax reforms. Some reforms
are undertaken in response to international trends. For example, there is a global trend towards VAT and
lower marginal income tax rates, and in the current integrated world economy, it is difficult for a small
open economy to ignore this trend. Tax reforms have also often resulted from a fiscal crisis (for example,
short-term budget deficits) or a concerted effort to prevent future fiscal crises (for example, chronic deficits
and inflation). Several African countries have recently introduced VAT, partly for these reasons.
16.5.1 Patterns of taxation in industrialised and developing countries

A cross-country comparison of tax systems indicates that there are vast differences in the composition of
taxes between countries. As each country’s tax system has been established over time by many – often
unique – forces, one should be careful of overgeneralising best tax practices and reforms on the basis of
international comparisons alone. Nevertheless, interesting patterns do emerge when countries are grouped
together, for example, according to the level of economic development, as shown in Table 16.3.
Table 16.3 Tax revenue of total government by type, 2016

Note: Total government comprises the following categories: supranational authorities, federal or central government, state
or regional government, local government, and Social Security Funds.
Source: Compiled from the OECD Global Revenue Statistics Database. Available: http://www.oecd.org/tax/tax-
policy/global-revenue-statistics-database.htm [Accessed 6 March 2019].
Table 16.3 contains a comparison of total government taxes for a group of OECD countries (advanced
countries), two regional groups (Africa, and Latin America and the Caribbean) and South Africa. When
total tax revenue as a percentage of GDP is considered, we notice that the tax burden is much higher in the
advanced countries (34,0% of GDP) compared to the other regions. South Africa comes closest to the
OECD countries with a tax–GDP ratio of 28,6%. A number of observations can be made in respect of the
composition of taxes (the percentages are unweighted average shares of tax types to total tax revenue):
• Taxes on income, profits and capital gains constitute one of the predominant sources of revenue in OECD
countries (33,6%), whereas taxes on goods and services (mostly value-added taxes) are the major
sources of revenue in Africa (54,6%) and Latin America and the Caribbean (50,5%).
• In the OECD countries, the average income tax on individuals (23,8%) is much more important than
income tax on companies (9,0%). In contrast, in Latin America and the Caribbean for example, the tax
contribution of companies exceeds that of individuals by 5,7 percentage points.
• Taxes on payroll and workforce as well as property taxes are insignificant tax sources in both advanced
countries and developing countries.
• Trade taxes are insignificant sources of tax revenue in OECD countries (0,5%) compared to developing
countries in Africa (11,6%).
Explaining differences in levels of taxation (the tax burden) and the composition of tax revenue is rather
tricky. A few generalisations will suffice. The high tax burden and reliance on income taxes in advanced
countries can probably be attributed to their level of development. Not only does the level of development
determine the size of the tax base, but it also has an effect on a country’s capacity to administer taxes. In
addition, taxpayers are more sophisticated in advanced countries, enabling tax authorities to levy relatively
complex taxes, thereby broadening the tax base even further. The greater reliance on company tax and
taxes on international trade in developing countries can be explained by the administrative ease with which
a relatively few companies and points of import and export can be targeted.
When South Africa’s tax composition is compared to the tax compositions of the OECD countries and
countries in the other two regions, it is evident that in most respects, the South African pattern is quite
similar to that of the advanced countries. An obvious deviation from most developing countries and some
of the advanced countries included in the sample is the relatively high total tax burden that South Africans
face (28,6% of GDP). It has to be considered that the percentage contributions are averages and the values
for different countries in each group show considerable variation. Another difference between the two
groups of countries is the importance of social security contributions to government revenue. In the past,
these contributions (compulsory social security payments by employees and employers) were included in
the tax revenues of government, but are now treated separately. The social security contributions add up to
approximately 26,2% of GDP for the OECD countries, but merely 8,4% for countries in Africa. In South
Africa, social security contributions constitute only 1,4% of GDP. It should be recognised that social
security contributions are negligible in South Africa, since most individuals provide for old age through
voluntary private retirement schemes. Furthermore, South Africa has a large non-contributory, means-
tested old-age grant system that caters for lower income elderly people in the form of transfers financed by
government tax revenue.
16.5.2 International tax reform

A number of countries have reformed their tax systems in recent years. Given South Africa’s status as an
emerging market developing country, we are particularly (although not exclusively) interested in reforms
undertaken in similar countries. A detailed discussion of tax reform in developing countries falls beyond
the scope of this chapter, however. We will therefore focus on a selection of prominent tax issues in tax
reform debates. The lessons for reform of specific taxes were discussed in the chapters on specific taxes
(see, for example, Section 14.5 of Chapter 14 on income tax reform). In the discussion below, the emphasis
is on the direction of tax reform.10
There has been a reappraisal of the redistributive role of taxes. The importance of using the tax system
for redistributive purposes has been reduced, partly because both vertical and horizontal equity have
proved to be elusive goals. Nonetheless, the contention is that the tax burden on the poor should at least be
reduced or removed altogether. In this way, a levelling-up process can take place. Bird and De Wulf
(quoted in Brown & Jackson, 1990: 175) summarised the position as follows:
Taxes cannot, of course, make poor people rich … If the principal aim of redistributive policy is to level
up – make poor people better off – the main role the tax system has to play is thus the limited and
essentially negative one of not making them poorer.
Consequently, more emphasis has been placed on public expenditure policies as instruments of
redistribution (see Chapters 8 and 9). More attention is also given to efficiency considerations when raising
revenues. This has resulted in a larger role for consumption taxes and less reliance on the principle of
comprehensive income taxation (see Norregaard & Khan, 2007: 5).
Concerted efforts have been made to broaden the base of the tax system. Tax systems in developing
countries are known to be allocatively non-neutral; that is, they cause distortions in the goods and factor
markets. Various reforms have been introduced to reduce the excess burden of taxation in these countries.
The general direction has been towards a broadening of the tax base accompanied by reductions in tax
rates. The concern with base broadening stems from the following:
• The narrower the base is, the higher the rate required to generate a given income.
• The higher the rate is, the greater the incentive for avoiding or evading the tax.
• Resources used for evading taxes are socially unproductive.
• High tax rates cause changes in relative prices that may lead to a reallocation of resources away from
taxed activity.
The objective, therefore, should be lower rates on a broader base. The base-broadening policy debate
focuses on the merits of a broad-based value-added tax, a flat tax on consumption and the reduction or
removal of tax expenditures (for example, tax incentives to promote economic activity).
Major efforts are being made to improve tax administration. Tax simplification, which is one of the
mainstays of better administration, requires a rationalisation of the number of taxes. Taxes that provide
little revenue and have high administrative costs should be done away with. Tax rates should also be
streamlined (for example, there should be fewer personal income tax brackets). There is growing
recognition that less complex taxes are easier to administer and will improve tax compliance. In addition,
steps are being taken to improve information systems and to limit political interference in tax
administration.
Lower tax rates and a movement to more uniform tax rates (for example, less differentiation in VAT
rates) have been a worldwide phenomenon in the last decade. Lower tax rates are aimed at reducing the
disincentive effects of taxation. Examples include lower import tax rates, lower marginal rates of personal
income tax and lower effective company tax rates. Lower tax rates as well as the transnational convergence
of tax bases and rates are also the result of the increased tax competition that accompanies economic
globalisation and the regional integration of countries in geographic proximity.
A popular development in tax reforms is the levying of ‘green’ and ‘carbon’ taxes to address
environmental externalities. These taxes are aimed at reducing pollution and greenhouse gas emissions,
and moderating climate change.
The recent financial and economic crisis caused industrialised and developing countries to review their
tax systems. For most of the last decade, the countries of the EU and others have experienced high
economic growth and a cyclical fiscal dividend. This led to tax rate reductions and a weakening of
automatic stabilisers. An aging population as well as the increasing burden of financing social pensions and
healthcare systems further exposed structural fiscal balances. The crisis in the financial sector added an
additional burden to the fiscus and the extent of bonuses received by executives raised the ire of taxpayers.
Tax reforms, which are intended to meet these challenges, include a tax on financial transactions, shifting
the tax structure towards taxes on property, consumption and environmental taxes, and higher tax rates for
the rich and super rich. Some of these reforms are short term, but it is clear that public finances must be put
on a sustainable path: governments need to finance the cost of the crisis and the increasing future cost of an
aging population. Many of the above-mentioned reforms underpin the findings of tax trends in a very
recent report by the Organisation for Economic Development (OECD, 2017). The report highlights the
following, amongst others: orientation towards economic growth – particularly reductions in corporate
income tax; enhancing fairness, which entailed numerous personal income tax cuts in the range of middle-
and low-income tax payers; and tax measures to deter harmful consumption and behaviours, such as
reforms of excise duties and environmentally-related taxes and increasing popularity of health-related taxes
(e.g. on sugar).
16.5.3 Globalisation and tax reform

Economic globalisation may be defined as the integration of economies throughout the world through
trade, financial flows, the exchange of technology and information, and the movement of people (Ouattara,
1997: 107). It is a process whereby economic interdependence among nations has increased since World
War II and has gained particular momentum since the fall of the command economies in Eastern Europe
towards the end of the 1980s.11 This increasing interdependence has led to increasing competition and is
reflected in cross-border economic integration between politically sovereign countries. In a globalised
economy, the effect of policy measures of one country spill over to other countries.
When the tax systems of the world came into being, it was at a time when economies were by and large
closed economies. Much of the economic activity was highly regulated and controlled, and the tax policies
of other countries could be disregarded. Globalisation has, however, altered the behaviour of economic
actors in ways that required tax redesign. Firstly, cross-border shopping has increased in many regions in
the world, including Southern Africa and Europe. This enables some countries to lower their excise taxes
on high-value and easily transportable commodities to attract foreign consumers. In this way, parts of the
tax base of some countries is in actual fact ‘exported’ to other countries and tax revenue is generated in
neighbouring countries instead. Secondly, transfer pricing has resulted from the expansion of the
multinational firm. Through transfer pricing, profits can be repatriated from high-tax jurisdictions to low-
tax jurisdictions by over-invoicing imports and under-invoicing exports. Multinational enterprises are in the
advantageous position of being able to minimise their global tax liability by shifting profits (through
transfer pricing) from high-tax jurisdictions to low-tax jurisdictions. To entice multinational and other
firms to locate in their countries, tax authorities compete by offering lower tax rates and other tax
incentives. Thirdly, tax evasion and tax avoidance by individuals has become possible on a global scale, as
personal savings have become more mobile. The proliferation of tax-haven areas and even countries as
well as new financial market instruments have made it extremely difficult for tax authorities to monitor the
non-reporting of personal income from savings invested12.
How will globalisation impact on the future of tax systems? In his analysis of the globalisation
phenomenon, Tanzi (1996 and 2004) identified a number of possible trends. Globalisation tends to put
pressure on developing countries to lower the level of taxation. As far as taxes on consumption are
concerned, it is expected that as borders are effectively removed, countries that have high initial tax rates
will be under pressure to reduce their rates in the face of competition. These reductions would in particular
affect excises on luxury products. The opening-up of economies requires that taxes on international trade
be reduced or eliminated. International tax competition leads to reductions in marginal tax rates for
personal income. In as much as taxation is a locational factor, tax competition will tend to drive down
effective company tax rates. In an environment where multinational enterprises dominate, it is even
conceivable that income tax on profits may be replaced by another tax base, such as a tax on net assets or
gross assets. Owing to the mobility of incomes from capital sources (for example, interest and dividends),
these sources could become taxed separately from wage income. This would enable tax authorities either to
exempt these forms of income entirely or to tax them using a separate schedule – see in this regard our
discussion of the dual income tax (Chapter 14, Section 14.5.2). Lastly, taxes on property will probably
increase, as the tax base is reasonably immobile.
The downward pressure on levels of taxation implies that developing countries have to rely increasingly
on reforming personal income taxation and VAT. Personal income tax serves the purpose of raising
revenue and ensuring that equity objectives are reached. Since it is mostly the high-income earners who
benefit most from globalisation, the personal income tax system is ideally suited to capture revenue from
these income groups for redistributive purposes. At the same time, if the tax base is broad enough, tax rates
need not be set that high. Value-added tax should become the most productive source of revenue. Tanzi
(2004) notes that it would be much better to have a low single rate on a broad base to generate sufficient
revenue to deal with poverty and equity issues as well as the pressures of globalisation on spending.
According to Keen and Mansour (2009: 38), most sub-Saharan African countries have been successful in
recovering much of the revenue losses owing to trade liberalisation by implementing VAT systems in the
1990s.
16.5.4 International tax competition and tax harmonisation

Economic integration within some regions and between countries bordering each other has become more
important in recent times. The economies of the European Union (EU) member states now form an
integrated market. The same applies to the economies of bordering countries such as Canada and the
United States, and Mexico and the United States. In Southern Africa, the economies of South Africa,
Botswana, Lesotho, Eswatini and Namibia (the BLSN countries) have been interlinked historically for
many decades. The Southern African Customs Union (SACU) agreement between the BLSN countries
aims to have goods interchanged freely between these countries. The Union provides for a common
external tariff and excise tariff. All customs and excise collected in the common customs area are pooled
and the revenue is shared among members according to a revenue-sharing formula. In the BNLS countries,
revenue from the common revenue pool (customs, excise and additional duties) is by far the most
important source of revenue. In 2017/18, revenue from this source as a percentage of total tax revenue
ranged from approximately 36,0% (Namibia) to 45,4% (Eswatini). The economies of South Africa and
other Southern African countries, such as Zimbabwe, Malawi and Mozambique, as well as other African
countries, are similarly interlinked through their membership of the Southern African Development
Community (SADC). The aim of the SADC is to create a community providing for regional peace and
security, and an integrated regional economy. A number of protocols have been signed promoting
economic cooperation, planning and assistance in areas such as trade, mining, tourism and education. The
SADC also provides the building blocks for the African Union (AU), which has the promotion of
accelerated socio-economic integration of the continent as its vision. The most recent regional integration
development has been the signing by early July 2018 of the African Continental Free Trade Area
(AfCTFA) agreement, by more than 50 African countries. It is aimed at facilitating a single market for
goods and services on the continent.
In a global and regional context each country remains an independent nation state with political
autonomy, but their economies have become much more integrated, historically and by agreement. In this
integrated regional setting, the monetary and exchange rate policies as well as the tax policies of these
countries impact directly on each other. Added to the policy issues are the increased international mobility
of consumers and factors of production, such as capital and labour (for example, professionals). The
increased economic integration, coupled with the mobility of factors of production and consumers, has led
governments to compete for investment capital and the purchasing power of neighbouring consumers by
lowering tax rates. This may be welfare reducing in that public services are underprovided. Others argue
that tax competition is welfare-enhancing.
In this section, we will approach the theory of tax competition (that is, when countries lower their tax
burden relative to competitor countries to attract investment) and the need for tax harmonisation (that is,
when countries make their tax burden identical or effect marginal differences between jurisdictions) from
the international tax perspective. (In other words, we will consider competition between independent
countries.) The theoretical discourse also applies broadly to competition between independent
governmental jurisdictions (or sub-national governments) such as local governments or federal states. The
federal states perspective is provided in Chapter 19. In fact, the theory on tax competition has its roots in
the literature of local public finance (or fiscal federalism).13
One of the earlier contributors to the debate was Oates (1972: 143), who noted that ‘in an attempt to
keep taxes low to attract business investment, local officials may hold spending below those levels for
which marginal benefits equal marginal costs’. Put differently, there is a perception that high taxes on
capital will drive mobile capital out of the country, and even cause a lowering of wages, employment and
land rents. Governments then lower their public expenditure below efficient levels to reduce their
dependence on tax. What is worrisome, of course, is if governments do not adjust expenditure to lower tax
revenues and the prospective investments and their associated future tax revenue do not materialise. In
such cases rising budget deficits and public debt may be the unfortunate result. In addition, tax competition
leads to fiscal externalities or fiscal spill-overs. Some public services generate positive benefits for
neighbouring countries, for example, malaria control efforts. Countries engaging in tax competition would
ignore these positive externalities when setting levels of public expenditure. These externalities also come
in the form of negative costs, for example, tax base externalities, which can be described as the result of a
country lowering the tax rate on mobile capital to increase its welfare. The country gains the capital inflow,
but it is at the expense of another country in that the tax base of the latter is reduced and tax revenues
decline. The same negative fiscal externality can be caused by a reduction in a commodity tax to attract
cross-border shoppers. Other adverse effects of tax competition include weaker environmental standards to
attract investment and reductions in welfare payments by countries trying to make it unattractive for poor
households from other countries to migrate or immigrate to their home countries. Another interesting
negative outcome of tax competition between countries is that it may lead to government failure in the
provision of public goods and services. The argument is that government provides some goods and services
when competitive private markets fail to do so, but when countries compete for the provision of these
goods, governments might fail to provide the necessary public goods and services.
From an efficiency point of view, the potential adverse effects of tax competition suggest a role for tax
rate harmonisation as well as tax base harmonisation. That is, if all countries were to agree to raise their
capital taxes or value-added taxes simultaneously, to set minimum rates or to unify tax bases, they would
all benefit from increased levels of public expenditure. The interaction between countries then pertains to
comparative and competitive advantages, rather than tax-driven opportunities. The welfare-enhancing
effects of tax rate harmonisation can, in simple terms, be illustrated with the aid of Figure 16.1. Assume
two countries with identical demand curves and a world price given by Pw. The high-tax country sets its tax
rate at (th) and the low-tax country sets its rate at (tl). The taxes create an excess burden in each country,
measured by ABC in the high-tax country and ADE in the low-tax country. By harmonising at a common
rate equal, for example, to the average of the two rates, 0,5 (t1 + th), the excess burden is reduced by BCFG
in the high-tax country and increased by GFED in the low-tax country. The net effect is a reduction of the
global welfare loss (excess burden) equal to GHB, implying a potential Pareto improvement14 under
general conditions (for example, assuming that tax revenues can be returned to consumers without
additional distortions being created).
Tax harmonisation may, however, be undesirable, since tax competition may generate benefits that
could offset the efficiency costs of the under-provision of public services.
The Tiebout model is discussed in Chapter 19. Modern formulations of this model argue that tax
competition between local governments or states within a single nation will tend to limit overexpansion of
the government at the local level. A market-like solution to the efficient provision of public goods is
reached as a result of the fact that local governments are closer to the people and therefore more
accountable, and that individuals tend to vote with their feet. This conclusion can be extended to the
between-country situation. It is believed that tax competition is an important argument against tax
harmonisation in unions such as the EU, where labour is fairly mobile over national borders. Furthermore,
when labour mobility and population economies of scale are considered together, the under-provision of
public goods associated with tax competition becomes even less of a problem. From a public choice
perspective, we know that politicians and bureaucrats often attempt to maximise their self-interests and
budgets, and it may thus follow that tax harmonisation benefits government officials. Tax competition may
curtail undesirable attempts at raising budgets.
Figure 16.1 Efficiency gain from harmonising tax rates

The net effect of the positive and negative factors is very difficult to determine. Zodrow (2003)
concludes that the argument for corporate tax rate harmonisation in the EU is not yet compelling.
Economic models of the welfare costs of tax competition also suggest that its costs may not be excessive.
Zodrow recommends that a cautious approach to tax coordination (harmonisation) is appropriate. In
designing or analysing tax regimes, tax autonomy must be traded off against tax efficiency and the
minimisation of tax administration. In this regard, Cnossen (2003) emphasises the importance of
subsidiarity (or jurisdiction). Subsidiarity implies that the power to tax (or tax autonomy) rests with
countries. With reference to the EU experience, Cnossen (2003) is of the opinion that all the proposals for
VAT coordination require greater involvement of a central authority, and thus a reduction in country
autonomy and sovereignty. Ade, Rossouw and Gwatidzo (2017) analysed tax harmonisation in the SADC,
with a specific focus on corporate taxes and VAT. Based on their empirical analysis, they conclude that tax
harmonisation is feasible in the SADC, and that member countries must expand their corporate tax base to
allow for the adoption of a low optimal corporate tax rate. They also recommend that if SADC members
adopt an optimum VAT rate, this can lower the usage of different VAT rates that may be politically driven
(Ade et al., 2017: 12).
16.6 Tax reform in South Africa

The government of South Africa has appointed three commissions and one committee of inquiry reporting
on aspects of the tax structure since the late 1960s: the Franzsen Commission (1968), the Margo
Commission (1987), the Katz Commission (2013 to 2018), and the Davis Tax Committee (from 2013). The
work of these commissions resulted in comprehensive reforms of the South African tax system. In addition
to these comprehensive tax reforms, several major ad hoc tax reforms have also been introduced.
Instrumental in these initiatives were the Standing Commission of Inquiry with regard to Taxation Policy
of the Republic (Standing Tax Commission) and its successor, the Tax Advisory Committee (TAC), which
was an advisory body to the Minister of Finance. Presently the organisational structure of the National
Treasury provides for a Tax Policy Unit, which is responsible for advising the Minister of Finance on tax
policy issues that arise at all three levels of government. In designing tax policy, this unit cooperates with
the South African Revenue Service (SARS), and interacts with the corporate sector and the general tax-
paying public.
In 2013, the Minister of Finance announced the formation of a South African Tax Review Committee
chaired by Judge Dennis Davis. The Davis Committee (DTC) was tasked with inquiring and advising on
the role of the tax system in the promotion of inclusive economic growth, employment creation,
development and fiscal sustainability. The terms of reference of the Committee were comprehensive, and
some of the aspects on their agenda included the following:
• An examination of the overall tax base and tax burden, including the appropriate tax mix between direct
taxes, indirect taxes, provincial and local taxes
• The impact of the tax system on the promotion of small and medium-sized businesses
• A review of the corporate tax system, with special reference to the efficiency of the tax structure, tax
avoidance, tax incentives and effective company income tax rates
• The advisability and effectiveness of VAT dual rates, zero-rating and exemptions
• The progressivity of the tax system and the relevance of estate duty in particular
• The evaluation of proposals to fund the proposed National Health Insurance system.
In the paragraphs below, we highlight some of the main recommendations and reforms proposed by the
different tax inquiries.
The Franzsen Commission (1968) concluded in 1968 that the tax structure at that time was increasingly
inhibiting economic growth. The focus of taxation was shifting from indirect to direct taxes and from direct
taxes on companies to direct taxes on individuals. The Commission therefore believed that structural
changes were required in the form of the following:
• Reduced progression in direct taxes
• A shift towards indirect taxes by broadening the base
• A broadening of the fiscal concept of income by including capital gains
In its first report, the Commission consequently recommended that the maximum marginal income tax rate
on individuals be reduced from 66% to 60%, that selective sales duties on a number of items (to be
collected from manufacturers and importers) be introduced and that capital gains tax of 20% on net realised
gains be introduced. With the exception of the recommendation in respect of capital gains tax, all of the
other proposals were accepted by government and duly implemented.
The next major tax reform occurred in 1978, when sales duties was replaced by a general sales tax
(GST) at a rate of 4%. The sales duties had inherent disadvantages (for example, narrow base and high
rates). The major aim of introducing GST was to broaden the tax base and eliminate tax non-neutralities.
GST was followed by the introduction of Regional Services Council (RSC) levies in 1985. The RSC levies
were implemented in 1987, and consisted of a levy based on the remuneration of employees (0,25%) and a
levy based on the turnover of enterprises (0,10%).
The report of the Margo Commission (1987) was released in 1987. The Commission reported at a time
when inflation was rampant, the business cycle was in an upswing and foreign disinvestment was a
threatening factor. The Commission took the view that tax reform should not be driven by short-term
economic problems, but rather by aspects of the existing tax structure that could hinder economic
development. The Commission’s general approach (1987: par 1.28) was founded in a base-broadening
philosophy:
The ideal, both for direct and indirect imposts, is a broad-base, widely distributed, low-rate, high-yield
tax, conforming to these other requirements (equity, neutrality, simplicity, certainty and so on) as far
as possible.
A tax system of this nature would reduce the ‘brain drain’, encourage immigration, improve standards of
tax morality and compliance, promote entrepreneurship and capital formation, and create job opportunities.
The following major recommendations of the Commission were accepted by government:
• The taxation of fringe benefits
• Lower personal income tax rates with fewer brackets
• Accepting the individual as the unit of taxation and phasing in marriage neutrality, and the equal treatment
of men and women
• The rejection of capital gains tax
• The scrapping of certain tax expenditures and allowances
• The modification of GST and the reduction of the rate; if the recommendation was not accepted, GST
would be replaced by an invoice VAT system
• The imposition of a capital transfer tax to replace estate duty and donations tax.
Between 1987 and 1994, two of the most important tax reforms were the introduction of value-added tax
(VAT) and the lowering of the company tax rate (along with the introduction of the secondary tax on
companies [STC]). VAT was introduced in 1991 to eliminate the distorting effects of tax cascading
inherent in GST and to reduce tax evasion. Initially, the VAT rate was to be 12%, with very few
exemptions and zero rates. After much political lobbying by the trade union movement in particular, VAT
was eventually introduced at 10%, with allowance for a number of zero-rated items. Secondary tax on
companies (STC) was introduced in 1993. This was a tax on distributed profits, levied on firms. The aim
was to encourage firms to reinvest their profits and thereby promote economic development. In a sense,
STC was also an astute way of reintroducing tax on dividends, since government had exempted the
taxation of dividends in 1990.15
In 1994, the first interim report of the Katz Commission (1994) was released. It was supplemented by
another nine reports between 1994 and 1999. The Commission conducted its investigations at a time when
South Africa had just entered a new political and constitutional era. The major thrust of the first and third
interim reports was to improve tax administration and collection, and to reappraise the equity aspects of
certain taxes.
The DTC has completed several tasks and a summary of the work done for the period 2013 to 2018 can
be found in its closing report (DTC, 2018d). In short, this report highlights that the DTC submitted 25
reports to the Minister of Finance, all of which have been published on their website16. The following
topics were covered in these reports (refer to the respective chapters and sections of this book (in
parenthesis below) for some of the recommendations of the DTC):
• Small business (see Section 14.2.3)
• Macro analysis (with concurrent reports on tax incentives – see Section 14.3.2.3)
• Base erosion and profit shifting
• Mining (see Section 14.2.1)
• Value-added tax (see Section 16.3.1)
• Estate duty and CGT implications (see Section 15.4.2)
• Wealth tax (see Section 15.2.3)
• Carbon tax
• Public Benefit Organisations
• Tax administration
• Funding National Health Insurance and Tertiary Education
• Corporate income tax (see Section 14.3.2.3)
We have studied a number of taxes in the previous chapters. Tax reforms that were specific to these taxes
were touched on and analysed. The following relatively important tax reforms were introduced and
proposed between 1994 and 2019:
• The status and independence of the revenue authorities were enhanced by the establishment of the South
African Revenue Service (SARS) as a separate department. Various changes and modernisation
measures were introduced by SARS to improve tax collection as well as to simplify tax administration
and compliance. An electronic filing facility was introduced, improving the quality of returns and
timeliness.
• A single rate structure with six brackets for personal income tax was introduced. To enhance the
progressive nature of the tax, marginal tax rates were increased by one percentage point for all personal
income tax brackets except the lowest.
• All gambling and fee-based financial services were subjected to VAT. Gambling winnings above a
threshold are subject to a final withholding tax.
• Mandatory (tax) contributions to a national social security fund and incentives for additional savings to
promote retirement savings were proposed. Contributions to retirement funds are deductible, but
became capped at an annual maximum.
• Capital gains became taxable.
• The source-of-income base was replaced by a residence-based income tax.
• The company tax rate was lowered for small businesses with turnover below a certain threshold.
Furthermore, a turnover-based presumptive tax system was introduced as an elective system.
• Tax incentives to promote direct investment were introduced, including an accelerated depreciation
allowance for investment in underdeveloped designated urban areas. A company income tax rate of
15% will be authorised in special economic zones.
• Secondary tax on companies (STC) was phased out and replaced with a dividend tax on shareholders. The
dividend tax is enforced through a withholding tax at company level.
• Regional Service Council (RSC) levies and Joint Services Board levies were abolished.
• A mineral and petroleum royalty regime was introduced.
• Various environmental charges and incentives were introduced in response to climate change. A carbon
tax was proposed as an appropriate mechanism to reduce greenhouse gas emissions in South Africa.
• A national health insurance (NHI) scheme is to be phased in over the next few years (see Section 10.5.1 of
Chapter 10). This will have a major funding impact, and suggested options under consideration include
a payroll tax payable by employers, an increase in the VAT rate and a surcharge on individuals’ taxable
income.
• Medical tax deductions were converted into tax credits per beneficiary.
• A youth employment subsidy in the form of a tax credit was introduced.
• The personal income tax rate structure was amended in 2017/18 and a further tax bracket was added to tax
the top income bracket of incomes above R1 500 000 at a marginal tax rate of 45%.
• A health promotion levy was implemented to reduce the consumption of sugar-sweetened beverages.
• The VAT rate was increased from 14% to 15%.
• Three additional food items were added to the zero-rated list.
• Estate duties increased from 20% to 25% for estates greater than R30 million.
• Approval of six special economic zones that will benefit from additional tax incentives was granted.
Key concepts
• base broadening (page 354)
• consumption VAT (page 342)
• customs duties (or tariffs) (page 339)
• destination principle (page 342)
• economic globalisation (page 355)
• excise duties (page 339)
• exemption (page 341)
• input tax (page 344)
• multiple rates (page 343)
• multi-stage commodity tax (page 339)
• output tax (page 344)
• personal consumption tax (or expenditure tax) (page 348)
• restricted-origin principle (page 343)
• single-stage commodity tax (page 339)
• sumptuary taxes (or sin taxes) (page 339)
• tax competition (page 357)
• tax harmonisation (page 357)
• uniform rate (page 345)
• value-added tax (page 342)
• zero-rating (page 341)
SUMMARY
• Indirect taxes are taxes that are imposed on commodities or market transactions. We distinguish between
selective taxes such as excise duties and general taxes (for example, VAT). These taxes are called
indirect taxes since the tax burden is likely to be shifted.
• Indirect taxes have advantages such as being useful in addressing market failures (for example,
externalities) and raising revenue not captured by the income tax net. The liability is to some extent
determined by how much is consumed. The disadvantages are that indirect taxes tend to be regressive
and may cause excess burdens when goods and services are taxed selectively.
• Value-added tax (VAT) is a major revenue source for the revenue authorities. The VAT system in South
Africa and the BLNS countries is of the consumption type and taxes international trade using the
destination principle. The tax credit method is used to determine the liability and only a few services
are exempted. A range of goods is zero-rated, with all other goods being taxed at a single rate.
• The VAT systems used in Southern Africa are considered to be ‘clean’ and efficient systems, given that
there are few exemptions, some goods are zero-rated and there is a uniform tax rate. Fairness is
somewhat sacrificed in that the system taxes the poor disproportionally.
• An alternative to the personal income tax is a consumption (or expenditure) tax regime. The consumption
tax base is defined as the difference between income and savings. Taxing consumption is beneficial
considering that the individual is taxed on what is taken out of the economy, in contrast to an income
tax, which taxes effort and savings. The personal consumption tax has not been implemented
successfully anywhere in the world and faces a host of administrative challenges.
• Tax systems differ between developing countries and advanced countries. Developing countries tend to
rely more on consumption taxes, whereas income taxes are the most important sources in advanced
countries. Tax systems change over time. These changes are often triggered by international tax
reforms, globalisation and the harmonisation of taxes between countries. Some of the important
elements of global tax reform are as follows:
- Income taxes: Lower tax rates, fewer tax brackets and fewer exemptions
- Sales taxes: The introduction of broad-based VAT-type taxes at a single rate
- Tax administration: Simplification of tax codes.
• Tax reform in South Africa was much influenced by government-appointed commissions and committees
of enquiry into the tax system. Important tax reforms since 1994 include the introduction of a capital
gains tax, a mineral and petroleum royalty regime, green taxes and a withholding tax on dividends as
well as lower personal and company income tax rates.
16.1 In South Africa, the tax on cigarettes and tobacco products …
a. contributes more to total tax revenue than the fuel levy.
b. is an ad valorem tax.
c. cannot be shifted.
d. is a sumptuary tax.
16.2 Which of the following statements about a value-added tax is or are correct?
a. Exempted firms may claim an input credit from SARS.
b. Because VAT is levied at each stage of production, tax is levied on tax, causing a cascading effect.
c. There is some consensus that taxing consumption at a uniform rate on a broad base is efficient.
d. Zero-rating certain goods and services is fairer to the poor, but erodes the tax base.
16.3 A personal consumption tax …
a. has no excess burden.
b. taxes savings, but not work effort.
c. would encourage individuals to save.
d. requires taxpayers to report their annual income and savings.
e. Both c. and d. are correct.
16.4 Which of the following statements on tax competition and harmonisation is or are correct?
a. Tax competition between countries or regions is neutral in respect of the impact on public
expenditure levels.
b. Tax harmonisation impacts on tax autonomy.
c. Tax harmonisation reduces tax efficiency in the low tax country, but increases efficiency in the high
tax country.
d. The global excess burden after tax harmonisation increases by BHG in Figure 16.1.
16.1 Distinguish between the following indirect taxes:
• Single-stage and multi-stage sales taxes
• Excise tax and customs duty
• VAT and a personal consumption tax.
16.2 A uniform VAT rate is preferable to multiple rates. Discuss.
16.3 Identify the major tax reforms implemented globally.
ESSAY QUESTIONS
16.1 Explain why the government should levy indirect taxes.
16.2 ‘Indirect taxes are not transparent enough and inhibit informed choices by taxpayers. The direct tax
base should therefore be the major basis of government tax revenue.’ Discuss this statement.
16.3 What are the characteristics of value-added tax in South Africa? Why is it said that VAT is inequitable
and what can be done to correct the inequity?
16.4 In designing VAT and other indirect taxes, there is always a conflict between equity and efficiency.
Do you agree? Explain your answer.
16.5 Personal consumption is a better tax base than income. Discuss.
16.6 ‘Tax competition is preferable to tax harmonisation.’ Discuss critically.
16.7 Evaluate tax reform in South Africa since the late 1960s in light of the patterns and directions of
international tax reform.
1 For a comprehensive discussion of VAT, see Gillis, Shoup and Sicat (Eds) (1990: 3–16; 219–233) and Katz Commission (1994:
101–147).
2 See Cnossen (2003) in this regard and also for alternatives to the restricted-origin principle.
3 See the full report at
http://www.treasury.gov.za/comm_media/press/2018/2018081001%20VAT%20Panel%20Final%20Report.pdf.
4 C-efficiency refers to collection efficiencies (Cnossen, 2015: 1080).
5 Although relatively high compared to other countries, the IMF (2015: 13) revealed some fluctation in the ratio over this time
period, due to changes in compliance and the economy.
6 See Keen (2012) for more details on these indicators.
7 For empirical evidence on this finding, see Inchauste et al. (2016).
8 After the increase in the VAT rate (from 14% to 15%) in the 2018 SA Budget (see National Treasury (2018a)), the Minister of
Finance appointed a panel to review the zero-rating policy (see earlier comments on the panel recommendations and further
zero-rating in Section 16.3).
9 Tax earmarking of course creates problems of its own.
10 For a more comprehensive discussion of international tax reform, see Bernardi, Barreix, Marenzi and Profeta (2008), Norregaard
and Khan (2007), Tanzi and Zee (2000), Stotsky and WoldeMariam (2002), Boskin (1996), World Bank (1991), and
Khalilzadeh-Shirazi and Shah (1991).
11 The remarks made in this section are attributed to Tanzi (1996). For a more comprehensive discussion of the effects of
globalisation on tax policy, see Tanzi (1995).
12 In order to establish the nature and extent of so-called tax base erosion and profit shifting, the OECD initiated a major project in
2013 that has since involved more than 100 countries and which is aimed at collaboration on how to combat these phenomena
in the interest of all countries. For more information, the following website can be visited: http://www.oecd.org/tax/beps/.
13 For an excellent survey of theories of tax competition and formal models of tax competition, see Haufler (2001) as well as
Zodrow (2003) and Wilson (1999). The discussion here is a summary of these surveys.
14 See Keen (1989) for a detailed discussion.
15 Some argued that since dividends are paid out of after-tax income, they were previously double-taxed.
16 See the DTC website for full details on all reports released (https://www.taxcom.org.za/library.html).
Public debt and debt management
Estian Calitz and Ian Stuart1
The aim of this chapter is to study the essence of, and rationale for, public debt as well as its impact on the
economy. Public debt arises from the borrowings of government, as reflected primarily in the annual
budget. A systematic study of public debt and its management provides important insights into the
relationship between the various components of public finance as well as the interaction between fiscal and
monetary policy in their impact on the economy.
Our study begins with a discussion of the concept of public debt, followed by an overview of the size
and composition of public debt in South Africa. Next we discuss various theories on the rationale for public
debt, followed by an investigation of this question: Should government tax or borrow? Our final section
deals with public debt management.
define public debt
describe salient characteristics of the size, composition and nature of public debt in South Africa
explain and critically compare different theories of public debt
explain the rationale for borrowing versus taxation when funding government expenditure
define public debt management
identify and describe the different types of public debt cost
identify the goals of public debt management and discuss their pursuance, with special reference to South Africa.
17.1 The concept of public debt

Public debt may be defined as the sum of all the outstanding financial liabilities of the public sector in
respect of which there is a primary legal responsibility to repay the original amount borrowed (sometimes
called the principal of debt) and to pay interest (sometimes called debt servicing). Most of the time,
especially when considering the macroeconomic implications, the term ‘public debt’ is used to refer to the
debt of the national government only (see Figure 1.1, Chapter 1). We use this narrower definition in this
chapter. When we are referring to debt of other public sector entities, this will be specified.
Public debt arises primarily from the government’s annual budget deficits, which are one of the
consequences of fiscal policy, to be discussed in Chapter 18. The majority of public debt is incurred
through the sale of government bonds (also called stock) that have a maturity of more than three years.
Most of the time, these are fixed-interest bearing securities issued by the national government, that
represent a charge on the revenues and assets of the Republic. Government can also borrow in the short-
term in the form of treasury bills (debt normally issued for a 91-day period) or bank overdrafts for bridging
finance.
For many countries, the size and quality of the public debt is a politically charged issue. Debates focus
on whether government borrowing is counter- or pro-cyclical, being used effectively (e.g. financing
infrastructure or consumption spending) and, most importantly, whether it can be repaid without drastic
fiscal measures. Despite this, there is limited consensus on the macroeconomic effects of public debt, and
even the definition of debt sustainability.
Government’s public debt management can have implications for the wider economy. For example, the
interest rate on the R186 – a 10-year fixed-rate bond – is a benchmark on which the private sector and
state-owned companies base their own interest rates when issuing bonds. Treasury bills form part of the
liquid asset base of the private banking sector, which can influence the stock of money. This means that an
increase in treasury bills (that is, an increase in short-term government loans), immediately translates into
an increase in the supply of money, with inflationary implications. From a broader institutional perspective,
public debt management has been a major driving force behind the deepening and maturation of financial
markets in South Africa.
Other varieties of government bonds are variable-interest bonds (of which inflation-indexed bonds are
an example) and zero-coupon bonds. Zero-coupon bonds are bonds that do not pay interest during the
lifetime of the bonds. Instead, investors buy zero-coupon bonds at a deep discount from their face value,
which is the amount a bond will be worth when it ‘matures’ or becomes due. When a zero-coupon bond
matures, the investor will receive one lump sum equal to the initial investment plus interest that has
accrued. As financial markets develop and investor sophistication increases, the variety of bonds increases.
All government bonds, irrespective of their maturities, are regarded as liquid assets in the hands of banks.
Occasionally, debt is incurred outside the budget (off-budget debt) and is not reflected in the budget
deficit. For example, in the early 1990s, the government transferred bonds directly to the public employees’
pension funds to improve their funding levels, instead of budgeting for the expense in the normal fashion.
Details of the national government debt are published in the Quarterly Bulletin of the South African
Reserve Bank. This excludes the debt of extra-budgetary institutions (such as universities), provincial and
local governments, and the non-financial state-owned enterprises (such as Eskom and Transnet). Of course,
if the national government were to take over the debt of any of these institutions, the legal responsibility to
service and repay the debt would be transferred to the national government. From that moment, the debt
would be counted as part of the public (in other words, national government) debt. But this cannot happen
without a specific policy decision. The rising debt position and increasing financial predicament of Eskom,
South Africa’s energy utility, is a case in point: in his 2019 Budget Speech Finance Minister Mboweni
explicitly stated that Eskom’s debt will not be taken over by Government.
Our definition of public debt also excludes contingent liabilities (see Section 17.5.5), that is, the
outstanding financial liabilities of public entities (such as public enterprises) and private entities whose debt
carries an explicit guarantee by the national government. Only when a guarantee of this nature is called up
will the payment obligation be transferred to the national government (as guarantor) and the amount
involved will be added to the national debt. It is, of course, prudent to keep track of the government’s
contingent liabilities (inclusive of formal and implied guarantees) (see also Section 17.5.5) when
considering the total debt risk to which the government is potentially exposed. Implied guarantees arise
when an investor (for example, a bank) regards a loan to a public sector entity (for example, a local
government) as implicitly carrying a government guarantee on the assumption that the local government
will not be allowed to go bankrupt for political reputation reasons. We return to this possibility in Section
19.5 of Chapter 19 when explaining the occurrence of moral hazard in inter-governmental financial
relations.
We begin with a discussion of the concepts of public debt and debt sustainability, followed by an
overview of the size and composition of public debt in South Africa. Next we discuss various theories on
the rationale for public debt. Our final section deals with public debt management.
17.2 Public debt sustainability
In Chapter 18 we will discuss the issue of fiscal sustainability and consolidation in the context of fiscal
policy. As a precursor it is appropriate to say something about debt sustainability. This has been defined ‘as
a situation in which a borrower is expected to be able to continue servicing its debts without an
unrealistically large correction to the balance of income and expenditure’ (IMF, 2002: 4). When deciding
on the probability of fiscal distress or default, government bondholders and ratings agencies consider both
qualitative and quantitative information, including the economic growth outlook, and the institutional
strength of the fiscal authorities. A key measure of fiscal vulnerability is the public debt–GDP ratio.
Typically, countries with high debt–GDP ratios and large fiscal deficits are at higher risk of default. In
addition to debt repayments, the high debt ratio makes a country less resilient to fiscal shocks (e.g. a global
recession). At the same time, however, a country with a low debt–GDP ratio can find itself in difficulties on
account of the structure of its debt. For example, a high share of foreign-currency or short-term debt
exposes the sovereign to adverse exchange rate movements, and rollover risk. Furthermore, a country with
a moderate but rapidly increasing debt–GDP ratio may be more likely to have the sustainability of its fiscal
position called into question than a country with a high, but stable or declining debt level.
Ultimately a country’s debt position is no longer sustainable when markets deem it so. A debt stock can
quickly become unsustainable if global risk appetite and the availability of financing changes, especially if
accompanied by doubts about the government’s ability to push through contentious fiscal measures.
17.3 Size and composition of the public debt

On 31 December 2017 the total debt of the South African government (public debt for short) amounted to
R2 467 billion. This was 53% of the GDP, or roughly R43 600 per head of the population. This tells us that
if all of the public debt were to be repaid immediately, the government would on average have to impose a
once-off tax of R43 600 on each citizen, which amounts to a rather high 54% of the gross national income
per head of the population. Those citizens who are government bond holders as well will of course also be
on the receiving side when this debt is repaid. The impact of the international financial crisis of 2007–2009
and the subsequent recessionary conditions show how quickly the state of public finance can change in a
country (see Figure 17.1).
The average size of public debt as a percentage of GDP declined during the 1970s and 1980s, and then
rose substantially during the early 1990s until just after the political change of 1994. (See Figure 17.1 for
the period 1960–2017 and Table 17.1 for average data and highest and lowest debt–GDP ratios for
indicated times.) The surge led various economists to warn against the dangers of a debt trap, a term used
to signify the inability of a government to repay and service its debt. Part of this increased share was
because the government borrowed money to fund the government employees’ pension funds and took over
the debt of the independent homelands under the apartheid system. From the beginning of the next decade,
government debt as a percentage of GDP fell quite dramatically, averaging 35,3% in 2000–2007. The lower
debt–GDP ratio was mainly the result of the systematic reduction of the annual budget deficit as a
percentage of GDP and the use of privatisation income to reduce government debt. In 2008, the debt–GDP
percentage reached its lowest level (of 26,5%) during the 57 years covered by Table 17.1, more or less just
when the international financial crisis erupted. South Africa incurred a substantial Keynesian-type debt
increase during the next few years. The debt–GDP ratio subsequently reached levels of rising concern.
Together with political and economic uncertainties, this led to the downgrade of South Africa’s sovereign
debt in the international financial markets to sub-investment status. The ratio of 53% registered at the end
of 2017 was the highest in the period 1960–2017. In the 2019/20 Budget the ratio was expected to be
significantly higher and to only stabilise at 60,2% in 2023/24.
Since 2012 the debt–GDP ratio exceeded the average of 39% during the first twenty years since the
constitutional change in 1994. Macroeconomically, South Africa had more fiscal manoeuvrability before
the international financial crisis than many emerging market economies. However, at the end of 2013, the
country’s debt–GDP ratio was higher than that of peer countries such as Chile and Mexico, and was rising
faster after 2008 than that of Hungary, Brazil, Malaysia and Mexico.
The South African government has traditionally made relatively little use of foreign financing, so that
most of the issued public debt is domestic debt. During the period 1960 to 2000, foreign public debt as a
percentage of total public debt fluctuated between 10,9% (1976) and 1,6% (1992). During this period,
foreign debt never exceeded 4,3% of GDP. In 1985, 1986 and 1987, foreign loans were used to counter
private capital outflows, but access to the international financial markets subsequently became increasingly
difficult owing to international financial sanctions. Access to international financial markets was
normalised in 1994. Although this, together with the gradual phasing out of exchange control, has provided
the fiscal authorities with an increased array of foreign financing options, the rise in the share of issued
foreign debt in recent years has remained modest. A substantial jump occurred in, and was maintained after
2001, resulting in an average of 10,4% of total debt for 2001 to 2008. At the end of 2017 the ratio was
11,8%. It should be remembered that non-South Africans can buy rand-denominated debt in the South
African secondary market (in other words, the market in which bond issues are bought from the original or
subsequent owners). Between 2009 and 2013 foreign holdings of domestic (rand-denominated) government
bonds increased significantly from 12,8% to 36,4%, subsequently reported to have risen further to 41% at
the end of June 2018, the highest equivalent ratio among emerging market economies. This exposed the
government to the risk of a sudden outflow of capital in the form of the sudden sale of bonds by foreigners
who may be concerned about the relative attractiveness of their South African investments.
Figure 17.1 Public debt in South Africa, 1960–2018 (current prices as on 31 December, % of GDP)
Note: For the last two years, figures are preliminary.

Source: South African Reserve Bank. Various issues. Quarterly Bulletin. Pretoria: South African Reserve Bank.
Table 17.1 Public debt–GDP ratio in South Africa by sub-period, 1960–2017

Note: a For the last two years, figures are preliminary.
Source: South African Reserve Bank. Various issues. Quarterly Bulletin. Pretoria: South African Reserve Bank.
An analysis of the ownership distribution of public debt shows that the majority of public debt is in the
form of long-term bonds held by pension funds (including the Public Investment Corporation [PIC]) and
long-term insurers. At the end of 1992, the PIC alone owned about 37% of the long- and short-term
domestic marketable bonds of the national government. In line with the strategy of bigger investment
freedom, however, this ratio declined to the lowest recent figure of 16% at the end of 2012. At the end of
2017 the ratio was still at a low level of 16,6%.
The biggest investor in government bonds nonetheless remains the Government Employees’ Pension
Fund. This fund’s investment in government bonds, along with investable funds of other government
pension funds and other public bodies, is channelled via the PIC. Until 1989, insurance companies and
private pension funds were compelled by law to hold 53% of their untaxed liabilities and 33% of their tax
liabilities in fixed-interest-bearing public sector securities (Abedian & Biggs, 1998: 261). This provided the
government with a captive loans market. To the extent that the interest on these bonds was lower than
would have applied if government had to compete for these funds in a competitive market, these prescribed
investments constituted a hidden tax on the relevant institutions. For the government, the cost of debt was
therefore below the market rate. This implicit tax, which impacted negatively on savings, was criticised for
its unfairness and adverse influence on investment performance, and was abolished in 1989.
For some time, the PIC continued to be subject to strict investment requirements. However, this has also
changed and the PIC was increasingly allowed to make market-related investment decisions during the
1990s. This was owing to the fact that the PIC, as the investment arm of the government’s pension funds,
was responsible for the investment yield of these funds. Public employees contribute to a defined benefit
fund. It means that the weaker the investment performance of the PIC is, the higher the government’s future
obligation to ensure the solvency of these funds will be. For this reason, the government transferred bonds
to the pension funds at various occasions in the early 1990s; it reduced its contingent liability by increasing
its actual debt to ensure future solvency. When the PIC was transformed into a public corporation in 2004,
its investment freedom was formalised further, although this remains subject to political influences because
the organisation is wholly owned by the government on behalf of its employees. In recent times more
doubts were being expressed about the riskiness of PIC investments. At the time of writing the PIC was
under investigation by a Commission of Inquiry into allegations of impropriety, with possible financial risk
for the government.
An intriguing question, which we will address in Section 17.4, is whether, and on what basis, public
debt is justified. When attempting to understand the nature and causes of public debt, an important issue
that has to be considered revolves around the purpose for which debt is incurred. For example, are the
borrowed funds to be used to finance current or capital expenditure? Spending on goods and services that
are used up within a specified, usually short period is called current expenditure or consumption
expenditure (Bannock, Baxter & Rees, 1971: 82). In fiscal terms, these goods and services are normally
associated with tax rather than debt financing. Capital expenditure refers to expenditure on durable items
that yield services or revenue over a long period, such as roads, school buildings, hospitals, irrigation dams
and electricity networks. This kind of expenditure is normally financed through loans (public debt).
The inverse of the question about the justification for debt is whether public debt is something that
should be repaid. Most people would argue that a government is not like a business, the health of which is
determined by factors such as the value of its shares, its profit, its debt–equity ratio, and measures of
liquidity and solvency. These criteria are important determinants of whether a business is bankrupt or
thriving. If the business is to be sold, one needs to know its value or net worth to determine the price. Net
worth may be defined as the difference between the value of all assets and liabilities, that is, the
shareholders’ (or, in the case of government, the taxpayers’) ‘interest’. In the case of government, the
mirror image is the net indebtedness, which is the difference between the value of all liabilities and
assets.2 Many would argue that this kind of information is irrelevant when analysing the financial state of a
government because a government allegedly cannot become bankrupt or is unlikely to be put up for sale. In
fact, one type of government bond, known as a consul, is a perpetual bond, that is, a bond with an
indefinite maturity, never to be repaid. This is well-known in the UK, but no bond of this nature has been
issued in South Africa to date. The international financial crisis in Europe has shown the vulnerability of
countries with poor fiscal track records. Countries like Greece found their government stock trading at very
large premiums, to the extent that they could not finance their budget deficits without financial support
from the European Union, which came with rather strict fiscal conditions.
In recent times, the balance-sheet view of public finances has gained much more prominence. The
government is not only the supplier of public goods and services. It is also the custodian of public assets
owned collectively by the citizens (taxpayers) of the country. Informed and enquiring citizens have tended
to become interested in the way in which the government is managing their (public) assets and liabilities.
The net worth of government has become important, not as an indication of the potential selling price of the
government, but as a measure of the quality of fiscal management and of the impact on the next generation
(in other words, the inter-temporal burden and its implications for inter-generational equity). Attention to
the balance sheet of government has become a feature of public economics. Privatisation, for example, has
raised questions such as whether society is becoming poorer if public assets are sold and whether the
revenue from privatisation should be used to repay public debt or to acquire new assets. Of course, when
the government sells high-worth assets to pay off the debt of state-owned enterprises, the net worth of the
public sector is reduced.
Incidentally, the balance-sheet accounting implied above is also required to answer many of the
questions raised by public auditors who have over the past two to three decades advocated the importance
of value for money in a number of countries such as Canada and New Zealand. In South Africa, we focus
increasingly on commercially oriented questions such as the value of public assets, the (opportunity) cost of
non-earning or badly managed assets and the cost of excessive stockpiling (as was common in the defence
force in the past, for example).
17.4 Theory of public debt

Having now considered the concept of public debt and its size and composition in South Africa, we are in a
position to explore different theories of public debt.
17.4.1 Introduction
In Section 17.3, it was stated that loan finance (debt) is an acceptable method of financing capital
expenditure, while current expenditure may be a better candidate for tax finance. Is this necessarily true,
especially as the distinction between current and capital expenditure can be ambiguous? What is the
rationale for debt finance, and what are the criteria for choosing between tax and debt financing of
government expenditure? These are some of the oldest questions in economics and there are a number of
divergent views on the issue. The answer depends in part on who actually pays the public debt, which is a
question about the nature of the distribution or incidence of the public debt burden.
We begin our analysis of the rationale for debt finance by introducing the concept of the inter-temporal
burden. This refers to the shifting of the burden of the public debt from one generation to the next over
time. The burden of the debt refers to the responsibility for the actual payment of the principal and interest.
The American President Herbert Hoover once remarked, ‘Blessed are our children, for they shall inherit
the public debt.’ Is this necessarily true? There are different views on this topic,3 and before investigating
them, a few preliminary observations are necessary. When debt is incurred, benefits accrue to the present
generation since the proceeds of the loan are used to supply public goods and services. If capital goods such
as infrastructure are provided, the future generation also stands to benefit. The debt furthermore establishes
a responsibility to pay interest and to repay the loan or to refinance it. The requirement to repay or
refinance the loan means that a statutory burden is conferred on the next generation. The next generation
will pay interest to bond holders until the bonds expire. In the case of bonds that expire and are not replaced
by the issuance of new bonds (refinancing), the next generation will transfer income to bond holders. In the
case of the refinancing of maturing bonds – a common practice in public finance – the next generation will
pay interest to the new bond holders.
In our study of tax incidence (Section 11.5 of Chapter 11), we saw that there may be a marked
difference between statutory and effective (or economic) tax incidence. The same applies to public debt.
The chain of events set in motion by government borrowing may lead to an economic incidence that may
differ substantially from the statutory or legal incidence. The actual incidence depends on the assumptions
about economic behaviour and the concomitant relationships between economic agents. The answer
obviously also depends on the balance of the fiscal benefit and burden, that is, the net fiscal burden.
Two kinds of public debt have to be distinguished. Domestic or internal debt is the debt incurred by
government when borrowing from domestic residents or institutions, that is, when selling bonds in the
domestic primary capital market. The value of the debt is expressed in terms of the home currency. The
sale of the bond does not involve an inflow of foreign capital, and the repayment of principal and payment
of interest do not cause an outflow of funds from the country, provided the transaction is between two
residents. The balance of payments is therefore unaffected by the issuance of these bonds.4 Foreign or
external debt is the debt incurred by government when borrowing from foreign governments, residents or
institutions. The value of the debt is normally expressed in a foreign currency, but can also be denominated
in the home currency. The sale, repayment and servicing of the bond all affect the balance of payments.
There is an impact on the balance of payments in a number of cases as explained below.
• When bonds are sold to foreigners by the government (in the primary market) and bought by foreigners
from resident bond holders (in the secondary market), an inflow of foreign capital results (affecting the
financial account). In Figure 1.3 (Chapter 1), this will reflect as an increase in Sf .
• When foreigners sell the bonds to South Africans before the expiry date (in other words, before maturity).
This results in an outflow of capital (financial account). In Figure 1.3, this will reflect as a decrease in
Sf .
• When bonds are repaid in the hands of foreign investors, this also amounts to a capital outflow (financial
account). In Figure 1.3, this will again reflect as a decrease in Sf .
• When interest is paid to foreign bond holders, this is a payment for a foreign service that affects the
current account. In Figure 1.3, this will reflect as an increase in M (a factor service).
Since South Africa started to liberalise its financial markets, foreign investors increasingly started buying
government bonds in the secondary capital market (in other words, the Bond Exchange of South Africa on
which government bonds are traded after the date of issue), as was mentioned in Section 17.3. This means
that the bond may often change hands so that the debt associated with a bond may, during the ‘lifetime’ of
the bond, be counted as foreign or domestic debt at different times, depending on the nationality of the
registered bond holder at the time.
In financially integrated markets, the distinction between domestic and foreign debt becomes blurred,
since a foreigner can also purchase bonds issued domestically, just as a South African may buy foreign
issued bonds of the South African government. It is thus more appropriate to distinguish between bonds
issued in the domestic money and capital markets (domestically issued bonds), and bonds issued in foreign
money and capital markets. The distinction between domestic and foreign thus becomes one of source
rather than residence.
Internal versus external debt and the burden on future

17.4.2
generations
A view that characterised economic thinking in the 1940s and 1950s was that internal debt does not create a
burden for the future generation. This view is attributed, inter alia, to the American economist, Abba Lerner
(1903–1982). The argument is that certain members of the future generation will inherit a debt repayment
or debt-servicing obligation, but other members of the same generation will be the recipients of these
payments. In other words, members of the future generation owe the debt to themselves. On repayment of
the debt, income is transferred from one group of citizens (those who do not hold bonds) to another group
of citizens (the bond holders). As a whole, the future generation is therefore not in a worse position since it
is capable of the same aggregate level of consumption that would otherwise have been the case. The
repayment of the debt results in an intra-generational transfer or redistribution of resources (in other words,
a transfer within the same generation) rather than an inter-generational transfer (that is, a transfer between
two generations). In terms of this line of thinking, therefore, internal debt is neutral with regard to inter-
generational equity.
The situation is different when external debt is used. In this case, the distribution of the burden depends
on the way in which the funds are used, the fact that interest payments constitute a net transfer of funds to
the rest of the world and the fact that bond holders are now external to the economy. If the borrowed money
is used to finance current consumption expenditure, the future generation has to repay the loan without
enjoying the benefits. In fact, their income will be reduced by the amount of the loan and/or the accrued
interest that needs to be paid to the foreign lender. Aggregate consumption will be lower than in the case of
domestic debt repayment. Should the money be used to finance capital accumulation (for example, a
railway line), the project’s productivity is crucial. If it is a long-term asset with a real investment return in
excess of the marginal cost of funds obtained abroad (which, in a perfect market, will be the real interest
rate on the loan), the combination of the debt and the performing asset actually makes the next generation
better off. The opposite applies when the investment return is less than the marginal cost of funds.
Today it is realised that the incidence of the burden of public debt is a more complicated matter.
Generations overlap, and the inter-generational incidence of the debt burden may differ according to the
income distribution, tax burdens and inflation rates experienced by future generations, information that is
unknown at the time of the decision to borrow.
It should be noted that, apart from the equity considerations, external debt could alleviate pressures on
the domestic financial markets (in other words, on the domestic supply of saving) during an economic
upswing. Should the government decide to borrow abroad during these times, external debt may therefore
also fulfil a macroeconomic stabilisation role.
17.4.3 Inter-temporal burden

Lerner regarded a generation as consisting of everyone who is alive at a given time. However, if we define a
generation as everyone who was born at the same time, several generations exist at any particular point in
time and the burden of the debt may in fact be transferred across generations. An inter-temporal burden is
said to exist.
Suppose the government introduces a new programme that benefits everyone who is alive at a specific
point in time and debt financing is used. Suppose further that a special tax has to be instituted once the debt
repayment commences. It may well be that older citizens who benefited from the programme are no longer
alive. This implies that they escape the burden of the tax, which has to be carried by members of younger
generations.
The burden of the debt can thus be transferred to future generations. The distinction between external
and internal debt is of no relevance in this case. Even if the debt is completely internal, a burden is created
for the future generation. It is, of course, possible for the next generation to shift the burden forward once
again.
From the point of view of inter-generational income distribution, it is very difficult to anticipate whether
the next generation will be richer than the present generation. It is not inconceivable, of course, that if this
is to be known or suspected, the present generation may deliberately vote for an inter-generational
redistributive fiscal policy such as using debt finance, much the same as they may vote for intra-
generational redistribution from the wealthy to the poor. Of course, the wealth of the next generation cannot
be known, but it could be that the present generation’s actions add to the wealth of the future generation. If,
for example, there is a legacy of high-quality public infrastructure for the next generation, the present
generation may judge that the next generation will have a much better prospect of generating wealth than
they had. In the eyes of the present generation, debt financing would then be an appropriate policy
instrument of inter-generational redistribution.
The inter-generational debt burden is more complicated in a country experiencing a major change
(discontinuity) in its political dispensation, such as that experienced during the last quarter of the twentieth
century by countries converting to democracy in Eastern Europe, Asia, South America and Africa
(including South Africa during the 1990s). Often there are strong populist pressures on the new government
to renege on repayment of inherited debt or on foreign countries (or institutions) for debt exoneration. The
argument is that the present generation cannot be held ransom by creditors of the rejected previous regime.
However, the discontinuity in the political system does not imply a discontinuity in debt commitments,
which are legal obligations and represent investments in the hands of bond holders. Moreover, the new
generation cannot claim debt forgiveness while enjoying the benefits of the assets that were accumulated in
the process.
The inter-temporal fiscal burden reminds us that the distribution of fiscal benefits and burdens between
generations cannot be measured in terms of what happens in a particular fiscal year. A lifetime perspective
is required. In generational accounting, the present value of lifetime taxes to be paid by a representative
person of each generation is compared to the present value of lifetime benefits to be enjoyed from
government services. The difference is the net tax (at present value), or the net fiscal burden. A
comparison of the net tax of different generations provides a sense of how fiscal policy distributes income
or purchasing power across generations (Rosen & Gayer 2008: 468–470).
17.5 Should the government tax or borrow?

On the basis of the foregoing discussion of the rationale for public debt and our analysis of taxation, we
consider the following question: which is the best financing instrument for public expenditure: taxation or
loans (debt)? Remember that debt is nothing but postponed taxation; in a sense, our question is therefore
one of when to tax, rather than whether or not to tax. We explore the question by referring to the allocation
(efficiency) and distribution (equity) of resources, and by considering the implications for macroeconomic
stability.
17.5.1 Allocation (efficiency)

Is taxation more efficient than debt? The answer lies in its impact on allocative efficiency, that is, the
amount of excess burden created. Earlier we noted that the difference between tax and debt is one of
timing. In order to compare efficiency, therefore, we must inquire as to the impact of the time difference on
efficiency. Consider a particular project that is completed in one year and that may be financed through
either tax or debt. If tax finance is used, the full cost of the project is financed by levying a once-off tax. If
loan finance is chosen, the loan will have to be repaid over a number of years, for the purposes of which an
amount of tax will have to be levied every year. If lump-sum taxes are used in each case, there is no excess
burden, efficiency is ensured, and there is thus no difference between tax and debt on efficiency grounds.
Not all taxes are efficient, however. In Chapter 12 (Section 12.2.3), we saw that, in the case of an ad
valorem tax on a commodity, the amount of excess burden increases exponentially with increases in the tax
rate. This means that the excess burden of a single, relatively high tax is bigger than the sum total of the
excess burdens of a series of small taxes that generate the same revenue as the single tax. When a specific
tax is collected by levying a once-off, relatively high tax rate, it will therefore be less efficient than if the
same amount of tax is obtained by levying a succession of low tax rates. A succession of low tax rates
occurs in the case of debt financing. The debt-servicing cost is spread over a number of years and requires a
corresponding series of tax revenues. In this case, debt financing will be more efficient than a once-off tax
to finance the entire project up front. The choice between tax and debt on efficiency grounds, therefore,
depends on the type of tax used.
The efficiency issue has further implications, though. It also extends to the source of the funds.
Generally speaking, taxation reduces private consumption and savings. Debt finance – that is, if the debt is
not monetised – represents a direct use of savings, reducing the amount of savings available to finance
private investment. To the extent that debt finance represents a larger reduction in the country’s savings
than tax, it will be less efficient than tax from the point of view of investment decisions. This is the
crowding-out argument discussed in Chapter 18, Section 18.3.2.
Combined, it is impossible to know a priori which of the above efficiency effects will dominate, that is,
whether tax or debt finance is more efficient. The net effect can only be established empirically.
17.5.2 Distribution (equity)

Intuitively debt finance constitutes the one method whereby more than one generation could contribute to
the financing cost of activities that confer an inter-generational benefit, something that once-off tax finance
cannot effect. All debt imposes a burden on the future generation. The difficulty lies in knowing in advance
what the concomitant benefit to the future generation will be. If we were to know, for example, that the
future generation would be poorer than the present one, it would make sense to transfer income from the
present to the future generation, for example, by tax-financing an infrastructural project with long-term
benefits. The opposite would, of course, apply in the case of a more wealthy future generation.
Ricardian equivalence theory (see Chapter 18, Section 18.3.2) suggests that the government needs not
concern itself with inter-generational equity, since society will voluntarily effect this equity as is preferred.
By increasing their bequests in the face of debt finance, individuals will ensure that the impact of tax and
loan finance on the next generation is equated. From an inter-generational equity point of view, it is thus
immaterial whether tax or debt finance is used.
The final equity consideration is linked to the benefit approach to taxation (see Section 11.4.1 of
Chapter 11). According to this approach, it is fair (and efficient) for a particular group to pay for a
particular programme if members of that group benefit from it. There is no reason why the future
generation should not pay for programmes that benefit them. To the extent that a programme benefits a
future generation, they should carry part of the financing burden, that is, pay for the benefit that will accrue
to them. This could be achieved by means of debt finance.
17.5.3 Macroeconomic stability

From a macroeconomic perspective, the choice between tax and debt arises at the margin; in other words,
should additional expenditure be financed by taxes or by loans, thus incurring a deficit or increasing the
size of an existing deficit? No one has suggested that the full budget be loan-financed. Keynesian
economists argue that when unemployment is high, for example, debt-financed fiscal expansion is
warranted in order to stimulate aggregate demand until it equals aggregate supply at the full employment
level of income. A fiscal expansion of this nature may occur with or without a reduction in tax. Deficit
finance is a choice in favour of new debt rather than tax and may also entail substituting new debt for
existing tax. On the other hand, when unemployment is low in the Keynesian world, deficit financing may
be inflationary and tax increases (a lower budget deficit or a higher budget surplus) will be necessary to
constrain private spending.
The Keynesian consensus started to break down in the early 1970s, when periods of high unemployment
and high inflation were experienced and when it was no longer possible to increase employment in a non-
inflationary manner (see Chapter 18, Section 18.3.2.4). Lower budget deficits, preferably achieved by
keeping government expenditure in check, became the consensus view of Keynesians and monetarists
(Dornbusch et al., 1994: 397), albeit for quite different reasons. The monetarist argument revolves around
crowding out, explained in Chapter 18, Section 18.3.2. Debt finance has to be reduced to ‘crowd in’ private
investment. The positive impact of reduced budget deficits on investor confidence may outstrip the
depressing effect on income in the short term and may, on balance, be ‘good for growth’. In addition, lower
budget deficits reduce the risk of inflationary financing. The Keynesian argument is that a reduction in the
budget deficit should be effected by curtailing government expenditure in order to avoid the cost-push
effects of higher taxation; that is, to avoid the cost of using tax rather than debt. Of course, the international
financial crisis of 2007–2009 threw the debate about appropriate stabilisation policies wide open.
In the era of globalisation, the freedom of choice that countries have to change budget deficits
independently by large margins in order to pursue macroeconomic stability has been reduced substantially.
The strong drive for macroeconomic policy coordination subsequent to the financial crisis of 2007–2009 is
a case in point. The structural choice in industrial and developing countries has become one of how much
and how fast to reduce excessive public debt and budget deficits, rather than of how high the budget deficit
should be (in other words, how much debt instead of tax).
17.5.4 Summary of views on the impact of debt

We now summarise our findings, while also incorporating some of the macro issues contained in our
chapter on fiscal policy (see Chapter 18, Section 18.3). Table 17.2 consists of a matrix of the possibilities
associated with the various viewpoints discussed or to be discussed (the rows) and the basic economic
considerations of efficiency, equity and macroeconomic stability (the columns). Where possible, the name
of the major exponent or school of thought is also indicated.
Table 17.2 Summary of views on the impact of public debt

17.6 Public debt management
Having explored theories of public debt and considered the choice between tax and loan finance, we now
focus on the practical issue of public debt management.
17.6.1 Introduction
Thus far, our discussion has dealt with the economic justification (or not) of borrowing or incurring public
debt. Once a government has decided to use debt finance, another important set of questions arises: when to
borrow, for how long and at what cost, from whom to borrow, where to borrow, which debt instrument to
use and so on. These questions relate to debt management and, owing to their economic impact, are
important in their own right.
Given the existing debt and debt structure at any point in time, we define public debt management5 as
decisions regarding the timing of borrowing, the term structure of the existing debt, the desired future
maturity structure, the financial instruments, the cost of borrowing and the markets in which new debt is to
be issued. A somewhat more general definition is used by the International Monetary Fund and World
Bank (IMF and World Bank, 2001): sovereign debt management is the process of establishing and
executing a strategy for managing the government’s debt in order to raise the required amount of funding,
achieve its risk and cost objectives, and meet any other sovereign debt management goals that the
government may have set, such as developing and maintaining an efficient market for government
securities. The approach by the South African government closely resembles this definition.6
We discuss the questions raised above with reference to the following objectives of public debt
management (which may at times be in conflict):
• Minimisation of state debt cost
• Macroeconomic stability
• Development of domestic financial markets
• Financial credibility (ensuring access to financial markets, both domestic and foreign).
Before exploring debt management in terms of these objectives, we explain a few basic concepts and
operational issues.
17.6.2 Bonds and the cost of borrowing

You will recall that the price of a government security (P) is inversely related to its yield (i). If the coupon
(the fixed amount of earnings) on a consul (a perpetual bond) is denoted as E, we can write:
Assuming efficient markets so that the long-term interest rate is equal to the yield rate on all bonds, higher
interest rates imply lower bond prices (value) and vice versa. In the case of a security with a finite maturity,
the price is given by the following:
where i denotes the annual yield and n the number of years (periods) to maturity.7
Although the government cannot change the interest payments applicable to previously issued debt
when changing inflation rates affect the real value of the debt, the owner of this type of bond can be
protected against capital losses and realise capital gains if the bonds are sufficiently marketable. The
government, on the other hand, may, for example, be able to realise the benefits by buying back unexpired
bonds during periods of rising inflation or when these buy-backs would reduce debt service cost.8 The
government itself (National Treasury), the central bank (the South African Reserve Bank) or private
market-makers assume the responsibility of marketing government bonds. Government securities are an
important instrument of monetary policy to the central bank, as interest rates (and hence the money supply
control) are influenced by transactions in these bonds; these are so-called open market transactions.9 As
financial markets develop (and in order for these markets to develop), the liquidity of bonds in the
secondary capital market becomes more important. At some stage, private financial agencies are appointed
as so-called primary dealers or market makers; their functions are to quote (on behalf of the
government) two-way prices (selling and buying prices) for government bonds and to assume the
responsibility of always buying and selling securities in the secondary market.
When interest rates are volatile, the market value of bonds (and the net worth of government or net
indebtedness) changes accordingly. By valuing the government’s outstanding liabilities at current market
prices (so-called mark to market), a more accurate picture of the state of the fiscus is obtained. If the
financial assets and liabilities of government were to be managed by a profit-driven treasury, this valuation
would be done continuously in order to maximise profits and minimise losses as a going concern. However,
we will see later that when public debt management has macroeconomic stability as one of its objectives, it
is not solely driven by the profit-and-loss bottom line.
How much does it cost the government to borrow? The immediate response is that the answer depends
on the interest rate. If the interest rate rises, so will the interest bill, and vice versa. Note that owing to the
fact (or to the extent) that government stock is usually issued at a fixed rate of interest or coupon, a rising
interest rate affects only the interest cost pertaining to new debt or debt incurred to replace maturing debt,
unless existing bonds include variable interest bonds.
The interest cost is not the only cost. In modern capital markets, bonds are often issued at a discount,
which means that the government receives a smaller amount than that which will have to be repaid. The
reason for the discount on bonds is that the market rate of interest may be higher than the specified yield (or
coupon rate) on the bond when the bond is issued as a result of a number of market factors (such as changes
in economic conditions, monetary policy, demand, risk and so on). Instead of having to change the
announced coupon when a particular bond is issued, the amount of cash received is adjusted. The discount,
together with the coupon rate, therefore provides a better indication of the effective interest cost to the
issuer (or yield to the buyer). In fact, because it is assumed that all future coupon payments can be invested
at the current market rate during the remainder of the bond’s lifespan, this market interest rate is actually
known as the bond’s yield to maturity (YTM). The YTM changes on a daily basis as market conditions
change and, as a result, is beyond the control of the issuer.
Suppose that a bond of R100 (the nominal value) is issued at a discount of 5%. This means that the bond
will sell at a price of R100 – R(0,05 × 100) = R100 – R5 = R95. The investor thus pays R95 for an asset
with a nominal (book) value of R100. The amount received when a bond is issued at a discount (that is, the
discount price) differs from the nominal value. In this example, the government incurs an extra cost of R5
(in addition, that is, to the coupon or interest payment that is applicable to the bond). Suppose this bond has
to be repaid after five years. In addition to the coupon payments paid over the five-year period, the
government will have to repay R5 more in capital than the amount originally received, that is, the discount
price of R95 plus the R5 discount cost. The discount on a bond is thus defined as the difference between
the nominal value and the discount price of the bond.
The figures in our example may appear insignificant, but the amounts involved can be quite large. In
1998/99, for example, the discount on public debt in South Africa amounted to R6,4 billion, which
represented 12,8% of the total debt cost in that year.
The budget deficit, which is announced by the Minister of Finance in the annual budget speech, does not
account for discount on public debt on an accrual basis. If this were the case, it would result in a higher
budget deficit and state debt cost, and lower amounts of government debt in any particular financial year.
A bond may, of course, also be issued at a premium. If the market interest rate were to be below the
coupon rate on the day of issue, the bond would be sold at a premium as the effective interest rate would be
lower than the coupon rate. The premium will close this gap. For example, during March 2005, the R15310
(with 2010 as year of maturity) traded at a price constituting a significant premium of about 24%. This was
as a result of the fact that the 13% per annum (fixed) coupon rate on that bond exceeded its market yield
(YTM) of about 7,5% by a large margin. This means that for every R1 million in nominal value of the
R153 that the government issued in March 2005, it received R1,24 million from the buyer. However,
during fiscal year 2005/06, the government had to pay a coupon interest of R130 000 (13% × R1 000 000)
to the holder of every bond with a nominal value of R1 million. When an R153, bought in March 2005,
matured in 2010, the government only had to repay the holder R1 million.
There are various other costs associated with debt, such as conversion costs, which are incurred when
bonds are redeemed before maturity and converted into other bonds, and the cost of raising loans. These
costs are, however, relatively small.
17.6.3 Foreign borrowing
When foreign borrowing is undertaken, a foreign exchange cost may be incurred in the event of subsequent
exchange rate depreciation. Suppose that South Africa issues a one-year bond of €100 on 1 January. To
simplify the explanation, we assume an initial exchange rate of €1 = R10 on 1 January, a zero interest rate,
no discount on bonds and a 10% depreciation of the rand against the euro during the year. On 1 January,
the government receives R1 000 as the proceeds of the loan. On 31 December, the government has to repay
€100. In order to do this, rands have to be converted into euros. After the depreciation of the rand, the new
exchange rate is €1 = R11. The government will therefore require R1 100 to repay the loan. The
depreciation of the rand has caused an extra cost of R100. An exchange rate depreciation can therefore
increase the cost of foreign borrowing substantially. The opposite happens in the case of an appreciation of
the rand against the issue currency.
One must be careful, though, not to conclude that the cost associated with an exchange rate depreciation
rules out foreign loans altogether. Nominal interest rates are usually higher in a country with a depreciating
currency than in countries with stable or appreciating exchange rates. The latter type of country is normally
also the source of foreign financing. If, in this example, the bond rate was 2% in Euroland and 10% in
South Africa, the total cost of the foreign loan after one year (assuming interest is paid at the end of the
year) would be the exchange rate depreciation cost of R100 plus the interest cost, which, when converted to
rand, amounts to R22 (calculated as 0,02 × €100 = 11). The total cost equals R100 + 22 = R122. The cost
of a local bond of equal value (ignoring discount cost) would be 0,10 × R1 000 = R100. Had the South
African bond rate been 12,2% (in other words, had the margin between the domestic and foreign interest
rates been 10,2 percentage points), there would have been no difference between the cost of domestic
borrowing (which would be 0,122 × R1 000 = R122) and foreign borrowing. Owing to the changing value
of the South African rand against the currencies of countries in which foreign borrowing is undertaken, the
fiscal authorities recalculate (in rand terms) the value of maturing foreign loans in the year of repayment.
We now return to the objectives of public debt management, beginning with the minimisation of state
debt cost and macroeconomic stabilisation.
Public debt management objectives I and II: Minimisation of

17.6.4
state debt cost versus macroeconomic stabilisation
At the end of the fiscal year 2017/18, that is on 31 March 2018, total national government debt in South
Africa amounted to R2 243,9 billion. During that fiscal year the interest of government debt was R162,2
billion, which was almost 3,5% of the GDP or 11,5% of the government expenditure budget. From the
perspective of cost effectiveness, no one will argue about the importance of debt cost minimisation. How is
this effected?
To answer this question, one must keep in mind that a bond is an investment to a bond holder. The
return on this investment has two components: the regular coupon yield E (interest earnings) and the capital
gain (the difference between the price at which it is sold and bought), both of which the investor would
want to be as high as possible. From a cost minimisation perspective, the government as borrower would
want the opposite: the lowest interest possible and the smallest capital loss. Note that in a liquid market, the
government can buy back bonds issued previously, even at a capital gain (which would amount to a capital
loss for the bond holder).
Debt cost minimisation is the result of three factors:
• Firstly, the size of the budget deficit and, consequently, the total amount of debt. The lower the annual
budget deficit is, the smaller the total debt and the lower the debt service cost will be, all other things
being equal.
• Secondly, the interest rate level, which is determined in the money market (short-term rates) and capital
market (long-term rates). In South Africa, the monetary authorities play a key role in determining short-
term interest rates through the repo-rate mechanism. As we shall see when we discuss macroeconomic
stabilisation, the monetary and fiscal authorities may not always desire the same interest level.
• Thirdly, there exists a maturity structure for any debt level that minimises debt cost, in other words, an
optimal maturity structure. The government dominates the primary bond market. In 2016, for example,
general government was responsible for 89% of new marketable public sector bonds issued. The
government cannot, therefore, passively take the market interest rate as a given (as a small market
participant would). Government policies (of which fiscal policy is an important component) and the
open-market transactions in government bonds have a major impact on interest rates and thus on the
borrowing cost. An optimal debt strategy therefore has to calculate the cost of debt, taking account of
the impact on interest rates of the very same debt strategy.
The key factor in debt cost minimisation is the difference between short- and long-term interest rates. The
yield curve (Figure 17.2) shows time-to-maturity of all bonds on the horizontal axis and bond yields to
maturity on the vertical axis. A yield curve can be constructed for any of a number of bonds. We focus on
government bonds, for which the curve is drawn relatively easily as a result of the homogeneous features of
these bonds. Points on the curve represent the relationship between yield and time-to-maturity of
government securities, of which there would typically be a substantial number. Owing to market volatility,
the yield-to-maturity varies often so that the yield curve may change frequently, sometimes even daily.
Figure 17.2 Yield curves of government securities
Generally, there are three types of yield curves:

• A horizontal or flat curve signifies no difference between short and long rates, so there would be no cost
advantage in changing the maturity structure of public debt.
• A negatively sloped or inverse yield curve is normally observed during periods of vigorous economic
expansion and close to the peak of the business cycle. Short-term yields (rates) are higher than long-
term yields (rates).
• When long-term yields (interest rates) are higher than short-term yields (rates), the yield curve has an
upward or a positive slope. Typically, this pattern is displayed during periods of economic recession
and moderate economic growth. In this case, higher long-term rates may reflect longer-term inflationary
expectations.
We will now discuss debt management with reference to the upward-sloping yield curve. (The reasoning in
respect of the inverse yield curve can easily be derived by inverting the arguments.)
In the case of a positive yield curve11, the forward-looking cost-minimising treasurer will sell (issue)
12
short-term securities (which are relatively expensive ) and buy back long-term securities (which are
relatively cheap). A relatively bigger portfolio of securities with short-term expiry dates provides the
treasurer with much greater manoeuvrability to buy (lock into) long bonds once long rates begin to decline
relative to short rates. The maturity or term structure of public debt will therefore shorten and the debt
service cost will be reduced.
The increased supply of shorter-term bonds, on the other hand, will decrease their prices and put upward
pressure on short-term interest rates. This may well be in conflict with macroeconomic stabilisation goals.
The monetary authorities may have no need for higher interest rates at that point in time; on the contrary,
low(er) interest rates may be viewed as compatible with the pursuance of higher economic growth. It is at
this point that the cost-minimising objective of the fiscal authorities and the macroeconomic stabilisation
objective of the monetary authorities may well be in conflict.
The question is whether debt management should be pursued actively as a macroeconomic stabilisation
instrument. There appears to be stronger support for debt management as an instrument of cost
minimisation than for pursuing macroeconomic stability. The argument is that the main contribution by the
fiscal authorities to macroeconomic stability concerns the size of the budget deficit, rather than the
financing thereof. The potential conflict between cost minimisation and macroeconomic stabilisation can
give such confusing signals to the financial markets that it would be more efficient if in debt management,
the fiscal authorities focused only on cost minimisation. The IMF and World Bank (2001) take this line.
They recommend that where the level of financial development allows, there should be a separation of debt
management and monetary policy objectives and accountabilities. In countries with well-developed
financial markets, borrowing programmes are based on the economic and fiscal projections contained in the
government budget, and monetary policy is carried out independently from debt management. This helps to
ensure that debt management decisions are not perceived to be influenced by inside information on interest
rate decisions and avoids perceptions of conflicts of interest in market operations. In some countries
(Sweden, for example), a separate debt office was established with the sole brief of minimising public debt
cost, given the size of the budget deficit and public debt.
The counter argument is that the fiscal and monetary authorities share the responsibility for
macroeconomic stability and that proper policy coordination, rather than separate or independent policy
entities, is the answer. The Keynesian world of integrated policy-making is more in line with this view. The
South African government appears to have moved in the direction of greater distance between public debt
management and macroeconomic policy-making, but remains aware of its coordinating role in relation to
the monetary authorities. No separate debt office has (yet) been established.13
One aspect of public debt that has been acknowledged as an important factor in stabilisation policy is
foreign debt management. In Section 17.4, we explored the theoretical views regarding the case for foreign
debt. Suffice to say that during an economic boom, when I > S, foreign loans by government add to the
supply of savings, relieving domestic demand pressures. Note, though, that cost minimisation may be in
conflict with the goals of exchange rate policy. A situation may arise where foreign borrowing may be in
the interest of the accumulation of reserves, at the same time that (or precisely because) the domestic
currency is under pressure. Although the fiscal authorities may find it too expensive to borrow abroad, the
monetary authorities may actually favour it. On the other hand, fiscal and exchange rate policy can also
complement each other. During 2010/11, for example, when there was concern about the strengthening of
the South African rand against major currencies, National Treasury contributed to a somewhat weaker
currency by borrowing in foreign rather than domestic capital markets.
Public debt management objective III: Development of

17.6.5
domestic financial markets
In South Africa, government bond issues have been a major factor in the development of the market for
loanable funds and the development of financial markets in general. From the point of view of enhanced
efficiency, in which greater liquidity and better information play an important role, various capital market
developments may be traced to aspects of debt management in South Africa. Marketing of government debt
through primary dealers, which was introduced in 1998, not only improved liquidity but also reduced the
refinancing risk of government. To improve liquidity, a debt consolidation programme consisting of
switches and buy-backs was introduced in 2002. Illiquid bonds were switched into benchmark bonds and/or
repurchased. As the majority of the illiquid bonds had high coupons, the debt consolidation through which
they were replaced resulted in savings on debt service cost.
The National Treasury has also diversified the funding instruments available from fixed income bonds
and treasury bills to inflation-linked bonds, variable-rate bonds and zero-coupon bonds. An innovation that
generated much interest is the fixed-interest retail bond that the government launched on 24 May 2004,
which was designed to offer an inexpensive and attractive saving opportunity to small savers.
17.6.6 Public debt management objectives IV: Financial credibility

Debt management is not only concerned with minimising cost. It is also concerned with the ability to
borrow (see footnote 13 regarding the policy framework of the National Treasury). Do prospective
investors regard the security as a good investment? Does the issuer of the bond (the government) have
financial credibility? South Africa’s re-entry into international financial markets, the acquisition of
international sovereign credit ratings in 1994 and the subsequent systematic improvement in the country’s
sovereign credit ratings tell the story of the long road to financial credibility and the hard work that this
required. Incidentally, a number of African countries have now acquired international credit ratings, albeit
at substantially different levels. Besides South Africa, countries as different as Botswana, Burkina Faso,
Cameroon, Egypt, Ghana, Madagascar, Mali, Morocco and Mozambique have subjected themselves to the
thorough investigation and scrutiny of international credit rating agencies. Credit rating agencies suffered
reputational damage when they did not detect the default risk underlying high-rated mortgage-backed
securities in the United States, a major cause of the international financial crisis of 2007–2009.
Nonetheless, a number of countries, including South Africa, were downgraded after the crisis and ratings
remain an important yardstick of financial creditworthiness.
These agencies basically ask two questions when assessing creditworthiness:
• Firstly, can the country service its debt? This question revolves around a country’s economic ability as
well as the likelihood that it will pay the interest and repay the principal (debt).
• Secondly, will the country service its debt? This is a question about the political will of the country to
repay the debt.
These questions are relevant irrespective of whether the government borrows domestically or
internationally. One of the asymmetries of economic life is that it is much easier for a government to impair
or destroy its financial credibility than it is to build it up. The greater the credibility is, the lower the debt
cost, and the better the chances of raising loans per se. We highlight a number of factors that are decisive in
determining financial credibility.
Market participants need to be convinced of fiscal sustainability. For example, during the first half of the
1990s, fiscal sustainability in South Africa became a matter of concern (Calitz & Siebrits, 2003: 58–59).
From a macroeconomic perspective, the fiscal situation deteriorated from 1990 until 1994, when the long
cyclical downswing depressed tax revenues and government expenditures were raised by several
extraordinary transfer payments as well as the expansion of social services. Government revenue and
expenditure trends in the first half of the 1990s resulted in the budget deficit peaking at 7,3% of GDP in
1992/93 and public debt rising to 49,5% at the end of fiscal year 1995/96, which gave rise to a debate about
whether or not a debt trap was looming.14 A debt trap is said to be looming when the government has to
borrow to pay interest on debt and runs the risk of default. It is now well-known that the South African
fiscal authorities, to their credit, not only averted the debt trap, but also succeeded in systematically
improving the government’s (and the country’s) financial credibility in the domestic and international
capital markets. This was achieved by a combination of measures: greatly improved tax administration and
compliance, expenditure restraint and the use of privatisation income to repay debt. Given the share of
government expenditure in the economy, the resultant reduction in the interest bill as a percentage of GDP
released resources for reallocation to higher priority expenditure areas, notably in the field of social
expenditure. An analysis by Calitz, Du Plessis and Siebrits (2011) has shown that the sharp increase in the
ratio of public debt to GDP during the middle of the 1990s was less steep if the funding of the government
employees’ pensions fund and the takeover of the debt of the homelands of the apartheid state were counted
as public debt when the obligations arose many years earlier (instead of when the national government took
over the debt during the first half of the 1990s). Retrospectively, the accusation of ‘weak aggregate fiscal
discipline’ in the early 1990s (see Ajam & Aron, 2007: 746) was excessive, more so because the improved
funding of the pension funds reduced, if not removed, a major liability that otherwise would have required
financing in the future.
Market participants also need to be convinced that the market rules of the game are upheld and
reinforced by government. It is quite conceivable that, owing to distortional interventions in the financial
markets, governments may encounter difficulties in raising loans in the domestic market or may only be
able to raise loans at high cost, even with relatively low budget deficits. We highlight three South African
examples that contributed to the financial credibility of government. The first is the abolition in 1989 of the
prescribed asset requirements in respect of insurance companies and private pension funds, referred to in
Section 17.3. In 2003, fourteen years later, the less intimidating and less distortional, albeit quite forceful,
technique of moral suasion was active in directing investment resources into targeted sectors of the
economy. The financial sector charter (Financial Sector Charter Council, 2008) was developed voluntarily
by the financial sector, naturally to avoid legislation of the kind aborted in 1989. Designed to underpin
black economic empowerment (BEE), the charter embodied targets (in total and for institutions) in respect
of BEE ownership, targeted investment in areas where gaps or backlogs in economic development and job
creation have not been adequately addressed by financial institutions, addressed investment in education
and so on.
The second example is the pre-1994 decision by the ANC to dispose of nationalisation as an economic
policy position. In February 1990, Nelson Mandela (who became President in 1994) stated that ‘the
nationalisation of the mines, banks and monopoly industry is the policy of the ANC and a change or
modification of our views in this regard is inconceivable’ (Nattrass, 1992: 624). Two years later, having
been confronted by the universal disapproval for nationalisation by world economic leaders at the World
Economic Forum in Davos, Switzerland, he told business people in Cape Town that he would try to
persuade the ANC to dispose of the policy, as it had become clear to him that South Africa would not be
able to attract foreign investment if investors felt that they had the ‘sword of Damocles’ of nationalisation
hanging over their heads. During 2010, a hefty debate about nationalisation of the mines was instigated by
the ANC Youth League. Despite government statements that nationalisation was not policy, support for this
continues to flare up from time to time.
The last example of a government that understands and upholds the rules of the (financial markets)
game is the decision by the ANC government not to renege on public debt that accrued in the apartheid era.
These examples illustrate actions that strengthened the development of a non-partisan style of
governance that values and pursues international best practices of good governance in a market-based
economy.
17.6.7 Contingent liabilities15

Finally, a word on contingent liabilities, which represent potential financial claims against the government.
When triggered, a definite financial obligation or liability will arise. Contingent liabilities may be explicit,
such as government guarantees on foreign exchange borrowings by certain domestic borrowers,
government insurance schemes with respect to crop failures or natural disasters and instruments such as put
options on government securities.
Contingent liabilities may also be implicit, where the government does not have a contractual obligation
to provide assistance, but (ex post) decides to do so because it believes that the cost of not intervening is
unacceptable. Examples include possible interventions in respect of the financial sector, state-owned
enterprises or sub-national governments.
According to the National Treasury, total contingent liabilities in South Africa at the end of the fiscal
year 2018/19 amounted to R879,6 billion (or 17,7% of estimated GDP for 2018) (National Treasury,
2019a: 217). Government guarantees have the effect of reducing the debt cost to the borrowing institution
and are therefore not free. In 2013/14, for example, Government received fees of R152 million on various
guarantees provided.
Unlike real government financial obligations, however, contingent liabilities have a degree of
uncertainty: they may only be exercised if certain events occur and the size of the fiscal payout depends on
the structure of the undertaking. Experience indicates that these contingent liabilities can be very large,
particularly when they involve recapitalisation of the banking system by the government (as was the case
with huge bailouts of financial institutions in various industrial countries during the international financial
crisis of 2007–2009), or government obligations that arise from poorly designed programmes for
privatisation of government assets, or the bailout of state-owned enterprises such as was the case at various
times with Eskom and the South African Airways. If structured without appropriate incentives or controls,
contingent liabilities are often associated with moral hazard for the government, since making allowances
ahead of time can result in risky behaviour and thus increase the probability of these liabilities being
realised. As a result, governments need to balance the benefits of disclosure with the moral hazard
consequences that may arise with respect to contingent liabilities. In Chapter 19 we discuss the issue of the
borrowing powers of sub-national governments in South Africa with reference, inter alia, to moral hazard.
Key concepts
• capital expenditure (page 375)
• consul (page 375)
• contingent liabilities (explicit, implicit) (page 391)
• crowding out (page 380)
• current expenditure (page 375)
• debt servicing (page 370)
• debt trap (page 372)
• discount on a bond (page 384)
• discount price (page 384)
• domestic or internal debt (page 377)
• foreign exchange cost (page 385)
• foreign or external debt (page 377)
• government bonds (page 370)
• inter-temporal burden (page 376)
• mark to market (page 384)
• maturity or term structure (page 387)
• net indebtedness (page 375)
• net tax or net fiscal burden (page 379)
• net worth (page 375)
• net worth of government (page 384)
• ownership distribution (of public debt) (page 374)
• primary dealers (market makers) in government bonds (page 384)
• principal of debt (page 370)
• public debt (page 370)
• public debt management (page 382)
• Ricardian equivalence (page 380)
• treasury bill (page 370)
• yield curve (horizontal or flat, inverse or negative, upward or positive) (page 387)
• zero-coupon bonds (page 370)
SUMMARY
• Public debt is the sum of all of the outstanding financial liabilities of the public sector in respect of which
there is a primary legal responsibility to repay the original amount borrowed (the principal of debt) and
to pay interest (debt servicing). Most of the time, the reference is to national government debt.
• Debt is predominantly incurred by the sale of government bonds (long-term securities) and treasury bills
(short-term paper) to finance the government’s budget deficit.
• The average size of South African public debt as a percentage of GDP declined during the 1970s and
1980s, and then rose substantially during the early 1990s, until just after the political change in 1994.
During and after the international financial crisis, South Africa incurred a substantial Keynesian-type
debt increase and concerns about fiscal sustainability were voiced in certain quarters. Although a
relatively low percentage of public debt has traditionally been sold in international financial markets,
foreign holdings of domestic (rand-denominated) government bonds increased significantly through
secondary market bond transactions, especially between 2009 and 2013. This exposed the government
to the risk of a sudden outflow of foreign capital.
• In recent times, the balance-sheet view of public finances has gained much more prominence. The
government is not only the supplier of public goods and services. It is also the custodian of public assets
owned collectively by the citizens (taxpayers) of the country. The net worth of government has become
important as a measure of the quality of fiscal management and the impact on the next generation.
Because government debt represents an investment by scores of bond holders (investors) and successive
generations benefit from loan-financed public infrastructure, timely repayment is crucial for fiscal
credibility even if major political changes occur.
• Various theories of public debt deal with the justification for public debt. A view that characterised
economic thinking in the 1940s and 1950s was that internal debt does not create a burden for the future
generation. On repayment of the debt by a future generation, income is transferred from one group of
citizens (those who do not hold bonds) to another group of citizens (the bond holders). When external
debt is used, however, the distribution of the burden depends on the way in which the funds are used,
the fact that interest payments constitute a net transfer of funds to the rest of the world and the fact that
bond holders are now external to the economy.
• Because generations overlap, even internal debt can cause an inter-temporal burden. It may well be that
older citizens who benefited from a loan-financed government programme are no longer alive. This
implies that they escape the burden of the tax, which has to be carried by members of younger
generations. The burden of the debt can thus be transferred to future generations.
• The inter-temporal fiscal burden reminds us that the distribution of fiscal benefits and burdens between
generations cannot be measured in terms of what happens in a particular fiscal year. A lifetime
perspective is required. In generational accounting, the present value of lifetime taxes to be paid by a
representative person of each generation is compared to the present value of lifetime benefits to be
enjoyed from government services. The difference is the ‘net tax’ (at present value), or the net fiscal
burden.
• Ricardian equivalence means that tax finance is equivalent to debt finance and activist fiscal policy (for
example, increasing the budget deficit to stimulate the economy) becomes ineffective. This happens
because rational citizens realise that a loan will have to be repaid from tax income at some future date
and will therefore increase their bequests by an amount equal to the increase in the tax burden of the
next generation. This constitutes a voluntary reduction in private spending, cancelling the impact on
domestic aggregate demand of the debt-financed government expenditure. Various criticisms to this
approach have been raised and empirical evidence of its existence is ambiguous.
• Table 17.2 presents a summary of the different views on whether the government should tax or borrow,
with reference to allocation (efficiency), distribution (equity) and stabilisation considerations. The
choice between tax and debt on efficiency grounds depends on the type of tax used. A succession of
low tax rates occurs in the case of debt financing and entails a lower total excess burden than a once-off
up-front tax payment. Debt finance arguably also serves inter- generational equity when used to finance
capital expenditure.
• Public debt management is defined as decisions regarding the timing of borrowing, the term structure of
the existing debt, the desired future maturity structure, the financial instruments, the cost of borrowing
and the markets in which new debt is to be issued.
• The price of a bond is inversely related to its yield. The cost (for the Treasury) of a government bond
depends on the rate of interest, which may require the issuance of a bond at par, at a premium or at a
discount, management costs, conversion costs and foreign exchange cost (if issued in foreign currency).
• Public debt management has various objectives, which can be conflicting. They are the minimisation of
state debt cost, macroeconomic stabilisation, development of domestic financial markets and financial
credibility.
• Debt cost minimisation is the result of three factors: the size of the budget deficit, the interest rate level
and the extent to which an optimal maturity structure can be achieved. A forward-looking, cost-
minimising treasurer will use the yield curve for government bonds to choose between short- and long-
term bonds. The yield curve shows time-to-maturity of all bonds on the horizontal axis and bond yields
to maturity on the vertical axis. It can assume three shapes, depending on the state of the business cycle:
horizontal, negatively sloped (an inverse yield curve) and upward sloped.
• In the case of a positive yield curve, for example, the treasurer will sell (issue) short-term securities (which
are relatively expensive) and buy back long-term securities (which are relatively cheap). A relatively
bigger portfolio of securities with short-term expiry dates provides the treasurer with much greater
manoeuvrability to buy (lock into) long bonds once long rates begin to decline relative to short rates.
The maturity or term structure of public debt will therefore shorten and the debt service cost will be
reduced.
• Because cost-minimisation actions may be in conflict with macroeconomic stabilisation goals, this could
give such confusing signals to the financial markets that it would be more efficient if the debt
management authorities focused only on cost minimisation. In some countries (Sweden, for example), a
separate debt office was established with the sole brief of minimising public debt cost, given the size of
the budget deficit and public debt.
• In South Africa, government bond issues have been a major factor in the development of the market for
loanable funds and the development of financial markets in general. Marketing of government debt
through primary dealers, which was introduced in 1998, not only improved liquidity, but also reduced
the refinancing risk of government. The National Treasury has also diversified the funding instruments
available from fixed income bonds and treasury bills to inflation-linked bonds, variable rate bonds and
zero-coupon bonds.
• South Africa’s re-entry into international financial markets, the acquisition of international sovereign
credit ratings in 1994 and the subsequent systematic improvement in the country’s ratings tell the story
of the long road to, and hard work in, successfully building financial credibility. International credit
rating agencies basically ask two questions when assessing creditworthiness: can the country service its
debt (a question about economic ability) and will the country repay its debt (a question about political
will)? Three examples are given of steps that enhanced the SA government’s credibility in the financial
markets. The credit status of a number of countries, including South Africa, was downgraded after the
international financial crisis. South Africa subsequently experienced further downgrading because of
rising public debt–GDP ratios, weak economic performance and political and economic uncertainties.
• Contingent liabilities represent potential financial claims against the government and only become public
debt once the borrowing entity defaults. Contingent liabilities may be explicit or implicit. Government
guarantees reduce the debt cost to the borrowing institution and are therefore not free. If structured
without appropriate incentives or controls, contingent liabilities are often associated with moral hazard
for the government, since making allowances ahead of time can increase the probability of these
liabilities being realised.
17.1 Which of the following statement(s) about public debt management is/are incorrect?
a. The price of a bond is proportional to the interest rate.
b. If the home currency is depreciating, it is always cheaper to issue bonds in foreign capital markets.
c. A positive yield curve suggests that long-term bonds should be sold.
d. A horizontal yield curve suggests that zero-bonds should be issued.
17.2 Choose the alternative(s) that will correctly complete the following statement: The South African
balance of payments is adversely affected if …
a. the South African government borrows abroad.
b. non-residents buy bonds in the South African secondary bond market.
c. South African residents buy bonds in the Yankee bond market.
d. interest is paid to foreigners owning South African bonds.
a. A zero-coupon bond is always cheaper than a variable interest bond.
b. Public debt management has only the minimisation of debt servicing cost as goal.
c. A primary bond dealer is obliged to quote two-way prices on government bonds.
d. Contingent liabilities are not government debt.
a. In Keynesian thinking, debt finance is always justified.
b. Ricardian equivalence means that it is immaterial whether short- or long-term bonds are issued to
finance infrastructure projects.
c. Net indebtedness of the government is unaffected when the budget is entirely tax-financed.
d. It is allocatively more efficient for the government to finance capital expenditure through loans than
a once-off tax increase.
17.5 Which of the following statements about equity is/are correct?
a. Public debt to finance the salaries of public servants promotes intra-generational equity.
b. Public debt to finance a new highway promotes inter-generational equity, ceteris paribus.
c. A benefit tax to finance a new highway promotes intra-generational equity.
d. It is impossible to know whether public debt to finance an infrastructural project will promote inter-
generational equity unless the inter-generational benefit is also known.
17.1 Suppose the South African government borrows $100 in the USA on 1 January. The exchange rate is
R8 to $1.
a. How much will have to be repaid in rand after two years if the rand appreciates by 10% per annum
against the US dollar over the period?
b. What will be the net result of the loan transaction for the South African government at the end of the
period if the US interest rate is 5% per year? (Assume that interest is calculated and paid in
arrears on the last day of each year.)
17.2 In what way does Ricardian equivalence serve equity considerations?
17.3 ‘If the home currency is depreciating, the home government should under no circumstances issue
foreign bonds.’ Discuss this statement.
17.4 What should the debt management strategy of a cost-minimising treasury official be when the yield
curve has a negative slope?
ESSAY QUESTIONS
17.1 Compare the different theories of public debt in terms of efficiency, equity and macroeconomic
stabilisation considerations.
17.2 ‘Tax finance is always superior to debt finance on both efficiency and equity grounds.’ Discuss this
statement.
17.3 Explain how debt management pursues its different objectives and point out potential conflicts with
monetary policy.
1 The authors thank Louis Fourie and Zichy Botha for their earlier critical comments and suggestions on sections of this chapter. The
usual disclaimer applies.
2 Sometimes ‘net indebtedness’ is only used in respect of the difference between the financial liabilities and assets of government.
3 The discussion of these views relies substantially on Rosen and Gayer (2008: 467–472).
4 Note that the balance of payments will be affected when transactions in the secondary market result in a transfer of ownership to
non-residents, as was mentioned in Section 18.2.
5 We follow, with slight amendments, the definition used by Abedian and Biggs (1998: 280–281). Substantial parts of the discussion
in this section rely on Abedian and Biggs (1998: 276–302).
6 The interested reader will notice this from National Treasury (2004a: Chapter 5).
7 This equation can be used to calculate the yield to maturity, which is the interest rate that makes the present value of the future
cash flow of a bond equal to the bond’s market price if the bond is held to maturity.
8 Buying back bonds is the same as repaying a loan before the due date.
9 For insight into these relationships, refer to the liquidity preference theory and the loanable funds theory; both are normally studied
in a monetary economics course.
10 The practice is to allocate a number such as this to a particular bond.
11 The slope of a normal yield curve is indeed upwards as the yield on longer-dated bonds must be higher than short-dated ones
owing to the so-called risk premium on the longer one.
12 This is as a result of the inverse relationship between the rate of interest and bond prices.
13 In 1996, the National Treasury (1996: 2) released a framework for debt, cash and risk management, stating that ‘… the Debt
Management Body has a direct management responsibility in ensuring the State’s continued orderly access to financial markets,
both domestic and foreign: and contributing to the absorptive capacity for State debt within these markets, through on-going
market development, product innovation and proper co-ordination of its activities with the monetary management operations of
the South African Reserve Bank.’
14 See, for example, Van der Merwe (1993). This debate clearly indicated the extent to which the private sector also had lost faith in
the potential of anti-cyclical fiscal policy. Retrospectively, if not by design, the rising deficit portrayed a strong anti-cyclical
policy stance. In financial circles, however, instead of being welcomed as an attempt to soften the impact of the cyclical
downturn, this caused alarm.
15 This section draws strongly on IMF and World Bank (2001: Section IV.5.2: 31–32).
Fiscal policy
Estian Calitz and Krige Siebrits
Fiscal policymaking and national budgeting are very complex tasks. Gerald Browne, Secretary of Finance in
South Africa from 1960 to 1977, aptly describes the experience of the fiscal policymaker as follows:
Those who have not personally taken part in such an exercise [of budgeting] may find it difficult to
appreciate the tremendous pressures for higher expenditure to which the Treasury is exposed –
pressures applied, for the most part, with the best of motives and for expenditure on services of
unquestioned merit. The Minister of Finance and his aides are condemned to fight a lonely and
thankless battle for a cause that is seldom adequately understood.
Source: Browne, G.W.G. 1983. Fifty years of public finance. South African Journal of Economics, 51(1) March, 64.
Copyright © 1999–2015 John Wiley & Sons, Inc. All rights reserved.
The aim of this chapter is to outline the nature of fiscal policy with reference to theories and empirical
observations, some of which have been discussed in earlier chapters. This chapter also discusses various
aspects of fiscal policy in South Africa and comments on aspects of the ongoing process of fiscal reform in
sub-Saharan Africa.
define fiscal policy, and describe fiscal goals and instruments at the macroeconomic, sectoral and microeconomic
levels
discuss the evolution of views on the macroeconomic role of fiscal policy, focusing on the distinction between the
Keynesian and the structural approaches, and the choice between discretionary and rules-based fiscal regimes
distinguish between the various definitions of budget balance and explain the economic significance of each
explain the importance of distinguishing between a cyclical and a structural budget deficit, and between active and
passive fiscal policy
explain the different types of fiscal frameworks
present the key features of the debate on fiscal rules versus fiscal discretion, also explaining which view you
support and why
describe salient features of fiscal policy in South Africa with reference to theory and fiscal frameworks, and against
the backdrop of international economic trends and aspects of the performance of the South African economy
describe some of the features of fiscal reform in sub-Saharan Africa in recent years.
18.1 Introduction
The decisions of government concerning the allocation and distribution of resources are embodied in its
fiscal policies and reflected in its budgets. The term ‘fiscal policy’ is normally used in relation to
macroeconomic policy and the contents of this chapter reflect that practice. Our discussion of the nature of
fiscal policy (Section 18.2) nonetheless recognises microeconomic goals and instruments of fiscal policy as
well. The reason why we do so is that fiscal policies aimed at achieving macroeconomic objectives are
seldom sustainable unless they consider or map out the implications for resource allocation at the sectoral
and micro levels as well. For example, if aggregate government expenditure has to be reduced to combat
inflation and all spending programmes are simply cut in equal measure, the efficiency and equity
consequences at the programme and project level of government can be profound. On the other hand, if the
government yields to pressures for more government expenditure at the programme and project level
without taking the consequences for the macro economy and the allocation of resources into account, it
could have serious implications for inflation, balance of payments stability and even long-term economic
growth (which might jeopardise the perceived sustainability of fiscal policy). Fiscal policymaking and
budgeting therefore constitute a juggling act of balancing ‘unlimited’ demands with limited resources. That,
after all, is what economics is all about.
In this chapter, we first explore the nature of fiscal policy, identifying in the process the fiscal
institutions in South Africa and typically found, in varied form, in the rest of Africa. We then discuss the
evolution of views on the macroeconomic role of fiscal policy, with special attention to the worldwide shift
during the last quarter of the previous century from active Keynesian anti-cyclical fiscal policies to what
may be described as the structural approach to fiscal policymaking. In addition, we consider the apparent
revival of Keynesian economics following the international financial crisis of 2007–2009 and the ensuing
Great Recession. This is followed by an overview of the nature of fiscal frameworks and a discussion of the
choice between rules-based and discretionary fiscal regimes. Thereafter, salient aspects of fiscal policy in
South Africa are outlined. The chapter ends with comments on the ongoing process of fiscal reform in sub-
Saharan Africa.
18.2 The nature of fiscal policy

This section defines fiscal policy and outlines its goals and most important policy instruments. It also
introduces the fiscal authorities in South Africa.
18.2.1 Definition
Fiscal policy may be defined as decisions by national government regarding the nature, level and
composition of government expenditure, taxation and borrowing aimed at pursuing particular goals. Like
all forms of economic policy, fiscal policy has both an active element (when a deliberate step is
implemented to do something, for example, to increase the budget deficit) and a passive element (when
there is a deliberate decision to do nothing or to refrain from doing something, for example, when no tax
increases are announced in a particular budget).
18.2.2 Fiscal policy and the budget constraint

At the very beginning of this book (Section 1.1 of Chapter 1) we were reminded that the scarcity of
resources and the associated budget constraint constitute the core of the economic problem. The need to
know and understand the budget constraint and resulting need for prioritisation, also underpins fiscal policy
choices. These choices dictate decisions at the macro level that affect the functioning of the entire
economy, as well as sectoral and microeconomic decisions that affect parts of the economy. Moreover, it
also sets rules of good financial housekeeping in government institutions, which need to abide by these
rules before they can expect the same of the economy as a whole.
Our point of departure is therefore that the government has to set an example of good governance, in the
sense of conducting fiscal policy according to precepts such as those set out in South Africa’s Public
Finance Management Act (see Section 18.6.2). This requires a good understanding of two sets of
causalities. The first is that the basis of the government’s scope for mobilising resources by means of
taxation is a credible view about the future generation of resources by the economy and how much of that
can be used to finance the functions that society entrusts to the government. The second is to know how the
use of these resources affects the welfare and behaviour of private economic agents – and in such a way
that the generation of new resources are optimised. These bidirectional causalities are also visible from the
flows illustrated in Figure 1.2 of Chapter 1.
As far as budgeting is concerned, this requires the setting of short- as well as medium-term revenue
constraints at the start of the budgeting process. This makes prioritisation essential from the outset and
ensures that budget requests do not become mere wish lists. It also ensures parliamentary assessment of the
executive’s proposed national budget as a comprehensive and integrated set of resource-constrained
expenditure programmes.
We will explain below that macroeconomic policy has developed over time to become an important
function of government. Fiscal policy is a vital element of this function. Macroeconomics developed
largely after the Great Depression of 1929–1933 and the government’s macroeconomic policy role
expanded along with the growing size of government on account of increases in the type and extent of
public services expected of government. The extent and pervasiveness of government’s associated resource
mobilisation enabled it to play a major role in the behaviour of economic agents.
18.2.3 Goals of fiscal policy

We distinguish the following macroeconomic goals of fiscal policy:
• Economic growth
• Job creation
• Price stability
• Balance of payments stability
• A socially acceptable distribution of income
• Poverty alleviation.
Note that this list contains none of the elements of the annual budget of the government, such as
government functions, programmes and taxes. The reason for this is that these elements are not goals; they
are the instruments that the government uses to pursue these goals. Note also that price stability, balance of
payments stability and cyclical economic growth are short-term goals; the others (including long-term
economic growth) are of a longer-term or structural nature.
The sectoral goals of fiscal policy include the following:
• The development of particular economic sectors, such as agriculture, tourism, mining, manufacturing or
the financial markets
• The pursuance of social goals pertaining to sectors such as housing, education, health and welfare (policies
of this nature are often referred to as social policies; see Chapters 8, 9 and 10).
It is also possible to specify microeconomic goals of fiscal policy. Goals of this nature relate to fiscal
action aimed at a single product, activity, economic participant, or group of participants. Normally they can
be seen as sub-divisions of sectoral goals. The following are examples of microeconomic goals:
• Improving efficiency by addressing negative externalities in respect of a particular product (for example,
tobacco) or activity (for example, toxic waste disposal by a chemical plant); see the discussion of
externalities in Chapter 3 and the discussion of indirect taxes in Chapter 16
• Combating poverty (the equity consideration) by intervening in the market for a particular product (for
example, a bread subsidy)
• Pursuing goals with regard to a particular geographical area (suburban or rural), for example, where
government-financed infrastructure and housing subsidies for low-income earners are incorporated in a
residential development project. Regional goals may even transcend national borders, as reflected in the
development of trans-border game parks or water supply facilities.
Fiscal policy is not the only tool for pursuing each of these sets of goals; in fact, it would be wrong to
expect of fiscal policy to be the panacea for all economic problems. Monetary policy, trade and industrial
policy, competition policy and labour policy are important allies in achieving these goals. It is quite often
necessary to prioritise the goals and also to recognise that they may be in conflict. For example, it may not
always be advisable to stimulate economic growth further, as doing so may fuel inflation. The government
must then decide whether economic growth or price stability should receive the highest priority. In these
circumstances, we say that there is a trade-off between economic growth and inflation (a related example is
the well-known Philips curve trade-off between inflation and unemployment). Fiscal policy differs
depending on whether the growth objective or price stability receives the highest priority.
Certain policies or policy instruments are more effective in pursuing some goals than others. An
increase in interest rates (a monetary policy measure) may, for example, achieve quicker results than a tax
increase (a fiscal policy measure) if private spending is to be reduced to combat inflation. The policy
authorities must therefore not only decide on the priority of policy goals, but also choose the most effective
policy instruments for the job at hand. We return to this point when we explain the different lags in fiscal
policymaking (Section 18.3.2).
What happened to efficiency and equity, you might ask? Are they not the ultimate goals of economic
policy? Have we not on numerous occasions emphasised these as the two pre-eminent considerations when
assessing any fiscal action? In earlier chapters, we have extensively studied various theories regarding
public goods, government expenditure and taxation. Efficiency and equity were recurrent themes in all of
these theories. We paid particular attention to the following:
• The conditions for Pareto efficiency in the allocation of resources between the supply of public and private
goods and the equity implications (Chapters 2, 3 and 5)
• The extent to which different voting rules produce efficient outcomes (Chapter 6)
• Identifying taxes that maximise efficiency (or minimise inefficiency) in the allocation of resources in the
private sector and assessing the equity implications of different taxes (Chapters 12 and 13)
• The trade-offs between efficiency and equity that have to be considered when dealing with the issues of
poverty and the distribution of income (Chapters 8, 9 and 10).
In Chapter 17, we paid attention to the choice between taxes and debt on the basis of efficiency criteria,
while considering the inter- and intra-generational distributional consequences of debt financing.
The reason why we did not mention efficiency and equity before in this section is that they do not
readily lend themselves to the specification of quantifiable targets for the economy as a whole. Instead of
equity, we therefore use more specific goals for which we can formulate quantitative criteria, such as
poverty alleviation or a socially acceptable distribution of income. The government may decide, for
instance, on a programme to reduce the Gini coefficient. The Gini coefficient was explained in Section 8.1
of Chapter 8. Under certain conditions, the promotion of economic growth and job creation will also serve
the equity goal. Efficiency goals can be developed at the level of government programmes and the tax
system can be designed with efficiency in mind, but it is not that easy at the macro level. In general terms,
higher economic growth may be seen as a reflection of greater efficiency, but this is by no means obvious.
Low inflation may also be a barometer of efficiency, just as high inflation might be indicative of a lack of
it. The ‘ultimate’ goals of efficiency and equity are thus included (or subsumed) in the list of
macroeconomic goals of fiscal policy.
18.2.4 Instruments of fiscal policy

As in the case of goals, we also distinguish between macro and micro instruments of fiscal policy. The
macro instruments include total government expenditure, the economic categories of consumption and
capital expenditure (in other words, the composition of government expenditure), the total tax amount and
the budget deficit as well as the way in which the deficit is financed. The sectoral or micro instruments
include the various expenditure votes and programmes (for example, education, health and defence) and the
concomitant criteria for the mobilisation and allocation of public and private resources, the different types
of taxes and their rates1, and the different dimensions of the public debt (such as maturity, ownership
structure and so on).
18.2.5 The fiscal authorities in South Africa

The key figure in fiscal policymaking is the Minister of Finance, who is given certain statutory powers by
acts of parliament. He or she has the authority to levy taxes, allocate state income (tax and non-tax
revenue), and borrow funds domestically and internationally. No state guarantees can be given for the
borrowing of money without the approval of the Minister of Finance. He or she is also responsible for the
protection of the country’s gold and foreign exchange reserves. The Minister has the authority to take and
implement decisions on some matters immediately; these include changing the rates of value-added tax2,
excise duties or the fuel levy during the course of the government’s financial year, or providing guarantees
(at a cost) for foreign borrowing by parastatals (or state-owned enterprises or companies) such as Eskom
and Transnet. On other matters, such as changing income tax rates or implementing the appropriation of
state monies in the annual budget, parliamentary approval in the form of specific acts of parliament is
required before any changes can be made. The Minister of Finance does not take important decisions
without consulting and/or obtaining the approval of Cabinet. He or she is accountable to parliament for all
decisions made.
The Minister is responsible for the coordination of macroeconomic policy, and his or her statutory
powers cover all the fiscal policy instruments of government expenditure, taxation and borrowing. The
South African Constitution furthermore requires consultation between the Minister of Finance and the
South African Reserve Bank3 regarding the implementation of monetary policy, the Bank’s generic policy
function. In practice, therefore, the Finance Minister is responsible for macroeconomic policy formulation
and coordination, lays down the basic framework for monetary and exchange rate policy, and manages
fiscal policy.
The two key institutions that bear the responsibility for macroeconomic policymaking are the National
Treasury4 (macroeconomic and fiscal policy, expenditure allocation and control) and the South African
Reserve Bank (monetary and exchange rate policy). Another very important fiscal institution is the South
African Revenue Service (SARS). The responsibilities of SARS not only include tax collection and the
enforcement of tax law; SARS also plays an important supportive and advisory role in the determination of
tax policy. Close coordination between all of these institutions is essential for effective economic
policymaking.
There is an old saying that monetary policy begins in the Treasury. This signifies much more than the
fact that public debt is financed by the issuing of government bonds, which constitute the main instrument
of open-market policies by the central bank. It is a statement about the close links between fiscal and
monetary policy in the pursuit of macroeconomic goals. The economic impact of fiscal and monetary
policies is such that the fiscal and monetary authorities have to study and monitor the combined impact of
these measures on economic behaviour systematically and regularly. The fiscal policy menu that a
particular country selects has to be framed in the context of a coherent macroeconomic policy strategy that
includes monetary policy and a number of other policies (for example, trade and competition policy). The
implementation of a strategy of this nature requires regular consultation and active coordination among the
Minister of Finance, the Governor of the Reserve Bank and their respective staff. The issue of the
coordination between the fiscal and monetary authorities featured before in our discussion of public debt
management in Chapter 17.
Another important form of coordination pertains to the formulation of tax policy, where close
cooperation between the National Treasury and SARS is essential.
The fiscal approval of the annual budget occurs by way of an act of parliament, the watchdog of the
public purse, thus giving effect to an important statement of fiscal policy at macro, sectoral and micro level.
Traditionally, the South African parliament only had the power to approve or reject the national budget in
its entirety. Two recent reforms aimed at strengthening the oversight role of parliament were added. The
first was the Money Bills Amendment Procedure and Related Matters Act (Republic of South Africa,
2009), which creates a procedure through which changes to appropriations may be considered in
parliament. Secondly, a Parliamentary Budget Office was established in 2013 in terms of Section 15 of the
same Act to provide independent, objective and professional advice and analyses to parliament on matters
related to the budget and other money bills.
18.3 The macroeconomic role of fiscal policy

Mainstream views on the macroeconomic role of fiscal policy have changed significantly over time,
reflecting the interaction between continuously evolving theoretical ideas and new policy challenges. This
section first outlines the nature and shortcomings of the Keynesian approach to fiscal policy, which is also
known as fiscal activism or anti-cyclical fiscal policy. We also briefly contrast this with the Ricardian
equivalence view - an approach that pre-dated Keynesian thinking, but still has important proponents. This
is followed by a discussion of the structural view of fiscal policy that largely superseded the Keynesian
approach. The final part of the section points out that the cyclical effects of fiscal policy have recently
come under renewed scrutiny, in that elements of the Keynesian or activist approach complement a revised
structural approach to the macroeconomic role of fiscal policy.
18.3.1 The Keynesian approach

The Keynesian approach (also known as anti-cyclical fiscal policymaking) came to dominate fiscal
policymaking after 1945. In the three decades that followed, most governments saw it as part of their task
to manage aggregate demand actively with the aim of achieving equality between aggregate demand and
aggregate supply at the full employment level of income. Such manipulation of aggregate demand
constitutes the active policy dimension of Keynesian fiscal policy. Keynesian economists and policymakers
also believed that the structure of income taxes and unemployment benefits strengthens the demand-
stabilising effects of active fiscal policy. The argument was that income tax and unemployment benefits act
as automatic or built-in stabilisers because changes in income would automatically (or passively) trigger
changes in tax revenue and transfer payments that would stabilise aggregate demand, income and output.5
Given any set of statutory taxes and social security commitments, automatic stabilisers function much like
rules in the sense of being non-discretionary. In this section we explain the active and passive elements of
Keynesian fiscal policy and then outline the shortcomings that caused it to fall out of favour from the 1970s
onwards.
Figure 18.1 introduces an analytical apparatus that will feature again later in this chapter.6 The figure
depicts government revenue and government expenditure as functions of national income (Y). The
horizontal line G0 represents government spending. We assume that the government sets its outlays
annually; hence, public expenditure is not systematically related to the level of economic activity. (This
assumption is realistic in the context of most developing countries, including South Africa, where
unemployment benefit schemes are rudimentary or even non-existent. The governments of most industrial
countries, however, maintain extensive unemployment benefit schemes. The government expenditure line
of industrial countries would slope downwards because lower levels of income are associated with higher
unemployment and, consequently, higher levels of government spending on unemployment benefits.) The
government also sets tax rates, but the yields on the different taxes vary with the level of economic activity.
Hence, the tax revenue curve (T0) slopes upwards because individuals pay more tax when income increases
and vice versa. The positive relationship between income and tax revenues would be strengthened if some
taxes had progressive rate structures (a common example is the personal income tax system; see Section
13.3 in Chapter 13). Figure 18.1 also shows examples of the three possible budget outcomes. At income
level Y0, the budget is in balance at point A, where tax revenue (t0) equals government expenditure (g0).
Income level Y1 yields a budget deficit equal to the distance BC; here, government spending (g0) exceeds
tax revenue (t1). A budget surplus equal to distance DE occurs at income level Y2, where tax revenue (t2)
exceeds government spending (g0).
Figure 18.1 A framework for analysing Keynesian anti-cyclical fiscal policy
Figure 18.2 employs this framework to illustrate the distinction between active and passive fiscal policies.
Our point of departure is point A at income level Y0. The budget is in balance with tax revenue t0 and
government spending g0. Suppose the economy in question experiences an exogenous shock (say, a
decrease in export earnings) that reduces income to Y1. The fall in income reduces total tax revenue to t1
(point C on curve T0). The drop in tax revenue cushions the impact of the adverse shock because it
represents a reduction in the extent of leakage from the circular flow of income and expenditure in the
economy (see Section 1.5.3 in Chapter 1). The budget now exhibits a deficit (equal to g0 – t1 or the vertical
distance BC), which Keynesian economists traditionally regard as a stimulus to economic activity. Note
that the government took no active steps. The stabilising influence and/or counter-cyclical stimulus to
economic activity are the entirely spontaneous results of structural aspects of the tax system, hence the
name ‘automatic fiscal stabilisers’. The working of automatic fiscal stabilisers, or passive fiscal policies, is
depicted as movements along the tax revenue and government spending curves. To illustrate active fiscal
policy, we return to point A. The government now increases its outlays, shifting the government spending
line upward to G1. This step is a stimulus to economic activity that increases income and, with a lag, also
tax revenue. The extent of the stimulus and the time it takes to have its full effect on the economy depend
on the strength of the multiplier effect. One of the possible outcomes during this process of adjusting to the
higher level of public spending is point E, where the income level is Y2, government expenditure is g1 and
tax revenue is t2. A budget deficit equal to g1 – t2 (the vertical distance DE) has arisen. In contrast to the
deficit depicted by the distance BC, deficit DE resulted from active manipulation of a fiscal policy
instrument. Active fiscal policies are shown as shifts or rotations of the tax revenue and government
spending curves.
Figure 18.2 The distinction between automatic stabilisers and active fiscal policy
As indicated, most Keynesian economists were optimistic about the ability of the automatic fiscal
stabilisers to moderate cyclical fluctuations in economic activity. They agreed, however, that the stabilisers
can only reduce this instability; they are not able to counteract it fully. Therefore active measures were the
mainstay of the Keynesian approach to fiscal policy. In recessionary conditions, policymakers tried to
increase the budget deficit or change a budget surplus into a balanced budget or a budget deficit by
increasing government expenditure (shifting the G line upwards) or by reducing taxes (shifting the T curve
to the left or rotating the T curve in a northwesterly direction). They tried to do the opposite in situations
where economies became over-heated during an economic boom and experienced (rising) inflation: reduce
government expenditure (shift the G line downwards) or increase taxes (shift the T curve to the right or tilt
it downwards).
Box 18.1 Different budget balances
Three concepts of the budget balance can be defined, each of which has a different use. In all three cases, a negative
balance signifies a deficit and a positive balance signifies a surplus. Firstly, the conventional balance is equal to the
difference between total revenue and total expenditure. Total revenue consists of tax and non-tax current revenue
(the latter includes entrepreneurial and property income as well as administrative fees and charges), capital transfers
(which includes the sale of fixed capital assets) and other receipts (such as recoveries of loans and advances). This
balance is a measure of the total loan finance and other financing that the fiscal authorities require in a particular year
to balance the budget. Budget balances are calculated at current market prices and expressed in local currencies.
Hence, the amounts cannot be compared readily across countries or years. For this reason, it is customary to express
the budget balance as a ratio or percentage of nominal GDP (for example, 2% of GDP). One should keep the
following in mind when interpreting budget balances:
• In most countries (including South Africa), the budget balance is not a comprehensive reflection of the borrowing
requirement of the public sector as a whole because public enterprises and other extra-budgetary institutions are
responsible for a significant portion of public sector loan financing. Many countries therefore also calculate and
publish the net public sector borrowing requirement (PSBR) as a comprehensive measure. The net PSBR
consists of the net borrowing requirement of the general government, extra-budgetary institutions, social security
funds and non-financial public enterprises (in other words, the borrowing requirement of these government
entities after allowing for the refinancing of maturing debt). The non-financial public enterprises exclude
institutions such as the Development Bank of Southern Africa (DBSA). Because the DBSA lends to public
institutions, we would be counting some borrowing requirements twice if the DBSA’s requirements were also
included. Whilst the PSBR serves as an indicator of the impact of the entire public sector on private savings and
financial markets in general, it is rather difficult to manage changes in the PSBR in policymaking actively
because it is the outcome of a multitude of decentralised decisions by parties within and outside national
government departments.
• The state of the business cycle can significantly affect the size of budget balances. During an economic downswing,
government revenue (notably individual and company income tax) tends to be lower than the longer-term trend,
while government expenditure tends to rise above the trend (especially if the country has a well-developed social
security system). At the same time, nominal GDP (the denominator) is below the trend line. Hence the budget
deficit (in money terms and as a percentage of GDP) tends to be higher than its trend value. The opposite happens
during an economic upswing. Analysts sometimes take the impact of the business cycle into account by
calculating cyclically adjusted budget balances. We return to cyclically adjusted budget balances in Section
18.3.4.
Secondly, the current balance is the difference between total current revenue (tax and non-tax revenue) and total
current expenditure (including interest payments). Calculations of the current balance therefore ignore capital revenue
(for example, privatisation income from the sale of non-financial assets) and capital expenditure (for example, public
outlays on the construction of dams, roads, schools, hospitals and so on). The current balance is a measure of the
extent of saving by government. A current surplus (a situation when the government’s current revenue exceeds its
current expenditure) implies that the government saves some of its current revenue by using it to finance capital
expenditure. Conversely, a current deficit implies that the government dissaves: it has insufficient revenue to finance
all of its current spending, and has to borrow or sell assets to pay salaries and wages, interest on the public debt and
so on. This is an example of what is sometimes idiomatically described as ‘selling the family silver to buy groceries’.
As a rule, borrowing can be justified if it is used to finance capital expenditure, which should yield a return over a
number of years. From an intergenerational equity point of view, borrowing to finance current expenditure cannot be
justified as it means that future generations will have to pay for the consumption enjoyed by the current generation.
Moreover, government dissaving reduces the pool of savings that is available to finance capital formation in the
economy. In the national accounts, gross saving equals the amount of consumption of fixed capital (formerly known
as provision for depreciation), plus saving by households, corporations and government. If the government dissaves,
its contribution to gross saving is negative. The government sector then draws on the savings of the household and
corporate sectors to finance current outlays that usually do not contribute to economic growth.
Lastly, the primary balance is calculated as the difference between total revenue and total non-interest
expenditure. The primary balance should immediately be recognised as the conventional balance plus interest
expenditure. This is a measure of the government’s ability to service its debt (pay interest) through ordinary
revenue. It measures the impact of the budget on the government’s net indebtedness, that is, its liabilities net of
assets (see Section 17.3 of Chapter 17). If the primary balance is positive (in other words, there is a primary surplus)
and larger than the interest bill, government’s ordinary revenue (which is predominantly tax income) is sufficient to
pay all of the interest on public debt and redeem at least part of its debt or finance some of the public investment. Net
indebtedness is reduced. If the primary balance is positive (but smaller than the interest bill), a portion of the interest
bill is tax-financed. The rest is loan-financed (capitalised) and added to the public debt, thus increasing net
indebtedness. If the primary balance is negative (in other words, there is a primary deficit), all of the interest and
some of the current expenditure are loan-financed, thus adding to the public debt. In a situation of this nature,
government is borrowing to finance all its interest payments as well as some non-interest current expenditure. This
would also increase the net indebtedness of the government. A negative primary balance is normally regarded as an
unsound fiscal practice, particularly when it increases the risk of runaway public debt. A general rule of thumb is that
a negative primary balance can be maintained for some time without an increase in the government’s debt–GDP ratio,
provided the real rate of economic growth is higher than the real rate of interest in the economy. Another variation of
this is that if the primary balance is improving in the face of rising public debt–GDP ratios, the government is viewed
as being serious about fiscal sustainability.
The most widely used barometer of the extent of anti-cyclical fiscal policy is the budget deficit. Box 18.1
contains an overview of different budget balances.
Practical efforts to expand or contract an economy by means of fiscal policy are subject to various
limitations. These limitations can render fiscal policy largely ineffectual and even cause it to produce
perverse results by making fiscal policy pro-cyclical rather than counter-cyclical. In the next section, we
discuss the implications of these and other influences on the effectiveness of fiscal policy.
18.3.2 Shortcomings of anti-cyclical fiscal policy

As mentioned, the Keynesian approach to fiscal policy rose to prominence after World War II. Its heyday
was comparatively short, however: its support waned steadily from the mid-1970s onwards. Martin
Eichenbaum (1997: 236) summarised the opinions of mainstream macroeconomists at the end of the
twentieth century as follows:
In sharp contrast to the views that prevailed in the early 1960s, there is now widespread agreement that
counter-cyclical discretionary fiscal policy is neither desirable nor politically feasible. Practical
debates about stabilisation policy revolve almost exclusively around monetary policy.
Why did fiscal activism fall from favour so dramatically? The answer to this question lies in several
practical and theoretical developments in macroeconomics during the last third of the twentieth century and
the first few years of the current century.
At least three sets of considerations made experts doubt whether it is possible to conduct anti-cyclical
fiscal policy effectively. The first of these is that fiscal policymaking entails various stages, each with its
own delays or time lags. There are four lags:
• The recognition lag is the delay between changes in economic activity and the recognition that the
changes have occurred. It takes time to prepare and release economic data such as the national accounts
(which provide information on economic growth and the state of the economy in general). In South
Africa, this data is published every three months in the Quarterly Bulletin of the South African Reserve
Bank. When the annual budget of the South African government is presented in February every year,
the latest available GDP figures are estimates based on figures from the end of the third quarter of the
previous year. If, for example, the Minister of Finance wants to present a budget to stimulate economic
growth, a significant margin of error is possible, since official information about the performance of the
economy is lagging by six months – and then the estimates are still subject to changes.
• The decision lag refers to the time that elapses between the recognition of the problem and the decision on
how to react. Various factors play a role in this regard, such as the analysis of different options, the time
required for discussion between officials and ministers, and, eventually, the speed with which Cabinet
takes a decision. The South African Constitution places a high premium on consultation and various
consultative forums exist for this purpose, such as the National Economic Development and Labour
Council (Nedlac) and the statutory Budget Council and Budget Forum (bodies of consultation with
provinces and local government respectively). The forums and various consultative processes, such as
the public hearings of the parliamentary committees, may all contribute to the decision lag. These lags
are particularly evident when legislation is required. The national budget, for example, is presented in
February, but cannot be implemented before parliament has enacted it. In South Africa, this normally
happens more or less during June of each year (that is, about three months after the start of the fiscal
year). The government therefore has a standing legislative authority to spend funds provisionally until
the budget is approved by parliament. This includes provisions that enable the government to make
limited changes during the course of the year when urgent matters arise. Matters of this nature would
otherwise have to stand over until the next year.
• The implementation lag refers to the period after the decision has been taken, but before it is
implemented. This lag mostly arises from procedures of orderly and accountable government. An
example is the time that it takes for government departments to implement approved capital expenditure
programmes, such as is required by tender procedures. The time lag between the approval of a capital
project such as a national road and its opening for traffic is quite long. Administrative procedures in the
private sector also influence the implementation lag. Changing the VAT rate, for example, requires
adjustments to financial documentation, cash registers and other automated business machines in the
private sector. The fiscal authorities have to allow time for these adjustments before they can
implement rate changes. Internet trade, on the other hand, reduces the implementation lag in the sense
that transaction conditions and documentation can be adjusted and communicated much quicker.
• The impact lag refers to the time it takes before an implemented policy measure begins to affect economic
behaviour. An increase in income tax, for instance, can take quite some time to realise its full impact on
private expenditure. Taxpayers may not immediately behave as though their after-tax spending power
has dropped. They may reduce personal savings, for instance, in an attempt to maintain their living st
andard for some time. Another example of an impact lag arises when businesses delay price increases
because of higher taxes to reap some temporary competitive benefits. On the expenditure side of the
budget, certain programmes (for example, welfare benefits) have a much shorter impact lag than others.
The time lag may be quite long, for example, when transport or defence equipment with long delivery
lags is ordered.
These lags make it particularly difficult for fiscal policymakers to react to fluctuations in economic activity
in time.7 If the economy is overheating, for example, it could take so long to implement a tax increase that a
recession may already have superseded the upswing by the time that the intended dampening of demand
takes effect, by which time a stimulus would be more appropriate. Intended counter-cyclical fiscal policy
then becomes pro-cyclical in the sense that it deepens and prolongs (rather than smooths) cyclical
fluctuations in economic activity. Pro-cyclical fiscal outcomes were common in industrial and developing
countries during the era of fiscal activism. In South Africa, Strydom (1987), for example, found that the
structure of the public finances had a destabilising rather than a stabilising effect on the economy from
1960 to 1986. More recently, Du Plessis, Smit and Sturzenegger (2007) also found evidence of fiscal pro-
cyclicality in South Africa for the period 1994–2006, as did Thornton (2008) with regard to government
consumption expenditure in 37 low-income countries between 1960 and 2004. In general, the decision and
implementation lags are normally shorter in the case of monetary policy. This serves to increase monetary
policy’s ‘comparative advantage’ over fiscal policy as far as macroeconomic stabilisation is concerned. At
the time of the Great Recession, however, it was realised that monetary policy also has its limits when
nominal interest rates approach the lower bound of zero, a situation known as the liquidity trap.
Monetarists emphasise a second constraint to the effectiveness of anti-cyclical fiscal policy: the
possibility that an expansionary fiscal policy will push up interest rates and in this way crowd out private
expenditure. Suppose an initial equilibrium in the goods and money markets is disturbed by a budget deficit
incurred through an increase in government spending. What effect will it have on the economy? The
increase in government expenditure means that aggregate demand increases, which sets the multiplier
process in motion. The resultant increase in income leads to an increase in the demand for money. If the
supply of money remains constant in real terms, the excess demand for money causes interest rates to
increase. Higher interest rates dampen private investment and thus aggregate expenditure. This secondary
reduction in aggregate demand dampens the initial multiplier effect, resulting in a lower new equilibrium
level of income than would have applied if interest rates had remained unchanged. Given the negative
relationship between interest rates and investment, this type of financial policy therefore dampens the rate
of private capital formation (in other words, private investment) in the economy. This phenomenon is
called crowding out and may be defined as the dampening of private investment on account of increases in
interest rates associated with an increase in public expenditure, especially if the latter is debt-financed.
Crowding out can occur when government, through its borrowing, competes with the private sector for
funds. This line of argument is associated with the neoclassical school of thought.
This crowding out thus neutralises anti-cyclical fiscal policy measures by dampening the multiplier
effect of a fiscal policy stimulus. Monetarist analysis of fiscal policy also emphasises the effects of
different ways of financing budget deficits. Monetarists are particularly concerned about the extent to
which the government finances its spending by means of money creation, which fuels inflation. This was
also pointed out in Section 11.1 of Chapter 11.
Macroeconomists from the new classical school raise a third objection to Keynesian fiscal policies.
They argue that private agents would anticipate systematic counter-cyclical policies and respond to them in
ways that neutralise their intended effects. The Ricardian equivalence theorem, which states that it is
immaterial whether governments use tax or debt finance, is a well-known example of this thinking. In brief,
the argument goes as follows. Government loans to finance budget deficits must be repaid in future from
tax revenue. Rational economic actors realise that government borrowing now means a higher tax burden
for them (or for their children) in future. They would therefore respond to any increase in loan-financed
government spending by reducing their consumption spending and increasing their saving by equivalent
amounts, thus ensuring that they can meet their future tax obligations. This type of behaviour would mean
that tax financing has exactly the same effect on the level of aggregate demand as deficit financing. On
balance, this implies that the fiscal authorities cannot manipulate aggregate demand by varying the level of
the budget deficit. The empirical validity of the Ricardian equivalence theorem is still being debated, but
the possibility that countervailing behaviour by private agents has at times contributed to the disappointing
outcomes of attempted anti-cyclical fiscal policies cannot be dismissed summarily.
18.3.2.1 Political constraints on anti-cyclical fiscal policy

In addition to the sets of considerations that limit the practical effectiveness of anti-cyclical fiscal policy that
are listed above, a second reason why fiscal activism fell from favour was growing evidence that
governments tend to be unwilling to implement these policies consistently (quite apart from their ability to
do so). Considerations of political popularity make most governments far more inclined to adopt
expansionary policies (increases in public spending and, at times, tax cuts) during recessions than to
impose the short-term hardships associated with contractionary policies (tax increases and spending cuts)
in economies facing the danger of overheating. Economists from the public choice school emphasise that
this asymmetric approach to fiscal stabilisation contributed to the sharp growth in government spending in
the second half of the twentieth century. One time-series study (Tanzi & Schuknecht, 1997) found that
general government expenditure in the industrial countries increased from levels of 10% of GDP or less in
1870 to between 45 and 50% in 1994. More recently, South Africa showed a similar though less dramatic
trend, with the ratio of general government consumption and investment increasing from an average of
18,3% (1960–1969) to 23,4% (2008–2017) (see Table 1.1, Chapter 1).
It is worth considering the public choice view in more detail, because it has significant implications for
the discussion of the rules-versus-discretion debate in fiscal policy in Section 18.5.1.
18.3.2.2 Public choice view

In Chapter 6, we studied the properties of the various social choice rules as well as the extent to and the
conditions under which an optimal allocation of resources would be possible. Chapter 6 also presented the
public choice argument that democratic institutions exhibit inherent biases towards an overexpansion of the
public sector. According to this view, higher than optimal levels of government expenditure are the results
of the responses of politicians, bureaucrats, voters and special interest groups to incentives in the
democratic process.
Public choice economists argue that there are two causes of this bias. Firstly, it is attributed to the
alleged co-existence of concentrated benefits, and a diffused or widely spread distribution of the costs of
government expenditure programmes. Put differently, small groups tend to benefit from certain public
expenditure programmes, although the cost is spread over all (or a larger group) of taxpayers. A
programme or set of programmes with clearly defined benefits will have a better chance of being approved
if the advocating groups are well organised and the cost of financing is obscure or hidden.
A salary increase for highly unionised public officials is an example of this type of expenditure
programme. Debt finance, especially inflationary financing through money creation, is an example of a
very diffuse financing mechanism. In the case of loan finance, only a part of the burden of the cost is
incurred in the year in which the expenditure has to be voted. It may actually be a deliberate political
strategy to sell debt-financed programmes to voters because it enables politicians to be vague about the
cost, which is in any case to be shared by absent future generations. This form of strategic behaviour may
be particularly prevalent prior to an election that the incumbent political party is in danger of losing or at
the sub-national level when the particular tier of government is highly dependent on transfer income from a
higher tier of government (see Sections 19.5 and 19.6 of Chapter 19). It is so much more tempting (and
even easier) to sell expenditure programmes to voters if another politician is accountable to a different
constituency for the financing. Provincial politicians, for example, may use these tactics to force larger
transfer payments from the national government to the provinces, with the result that the tax or debt burden
at the national level is increased.8 These practices rest on the assumed existence of fiscal illusion among
the electorate, which may be defined as the belief that taxes are lower than they actually are, or will be.9
The second cause of the bias towards high levels of government expenditure is the separation of benefits
and costs in the budgetary process, a practice implied at the beginning of this chapter (see Section 18.2.2).
This separation actually reinforces the first cause. Expenditure and revenue budgets are designed and voted
on separately by parliaments. The one-year nature of budgeting is a further cause because annual budgeting
allows for the approval of expenditure programmes without information on the concomitant long-term
expenditure commitments and the long-term tax or debt implications of the total of all expenditure
programmes. The future gap between expenditure and revenue, which by definition amounts to future debt
financing, may increase without anyone being aware of it. This separation of revenue and expenditure
decisions is linked to the ability-to-pay approach to taxation, in other words, financing based on equity
rather than efficiency considerations. Public choice economists therefore tend to argue strongly for the
increased application of the benefit principle of taxation (instead of the ability-to-pay principle). An
additional method of correcting for these problems is to apply medium-term fiscal planning (see Section
18.6.1). Nowadays, many countries have medium-term fiscal frameworks in which the multiyear
implications of budgetary choices are revealed, thus allaying some of the concerns of public choice
economists.
Public choice economists also argue that the alleged bias towards overexpansion of the public sector has
been fed by the Keynesian legacy of budget deficits explained earlier in this chapter. In many countries, the
size of the public debt and the budget deficit reached such proportions that their concomitant fine-tuning
properties were lost.
The public choice view on how to improve efficiency in the allocation of public resources has important
implications for debt financing. Public choice economists argue that constitutional fiscal limits are required
to correct for the overexpansion bias, that is, they favour more rules and less discretion in fiscal policy. A
balanced budget – in other words, one without debt financing – is an extreme version of this prognosis. In
the United States, the idea of a balanced government budget enjoyed substantial popularity well into the
first decade of the twenty-first century. This can be attributed to the strong correspondence in this regard
between public choice and neoclassical thinking, which gained the upper hand in macroeconomic policy
thinking in the United States at the turn of the century. We discuss the debate on fiscal rules in Section
18.5.1. Notwithstanding strong support for balanced budgets, the United States has recorded federal budget
deficits in every year from 2002 to 2017. Clearly, the influence of this view waned a great deal at the time
of the international financial crisis of 2007–2009.
18.3.2.3 Summary of views on the impact of debt

A summary of the different views about the impact of public debt on the economy appears in Chapter 17,
Section 17.5.4.
18.3.2.4 Anti-cyclical fiscal policy and structural economic problems

The joint appearance of unemployment and inflation (in other words, stagflation) after the oil price shocks
of 1973 also sharply dented the popularity of Keynesian anti-cyclical fiscal policy. Economists soon
realised that the economic problems of the time were structural rather than cyclical in nature, and that
short-term demand management measures are ineffective for solving structural problems such as supply
shocks, structural unemployment and cost-push inflation.
18.3.3 The structural approach to fiscal policy
Taken together, the aforementioned considerations gave rise to a strong perception that active anti-cyclical
fiscal policy is ineffective at stabilising the economy, perhaps to the point of causing more instead of less
volatility. Supply-side economists, however, advocated a particular brand of fiscal policy as a cure for
stagflation. Members of this school of thought believe that the public sectors of most countries are too
large, and that the concomitant increases in tax burdens and tax rates are major disincentives to work effort,
saving, investment and economic growth. They therefore recommend a reduction in marginal tax rates (to
increase the incentive to work, save and invest and a concomitant reduction in government spending (to
create more scope for private sector activity). ‘Supply-side’ has now become a catch-all word for any
policy measure proposing to move the economy closer to its production possibility frontier or expanding
the frontier.
In a sense, the supply-siders reflected the mind shift that took place from the mid-1970s onwards. The
attention of fiscal policymakers shifted away from stabilisation policy – in the traditional Keynesian sense
of attempts to ‘fine-tune’ the level of economic activity – to structural measures aimed at increasing the
growth and job creation capacity of the economy as well as the redistributive impact of the budget. This
shift received further impetus from the development of unsustainable fiscal imbalances (excessive budget
deficits and public debt burdens) in many industrial and developing countries during the 1980s and early
1990s, and generally dominated fiscal policy thinking until the international financial crisis of 2007–2009.
For many policymakers, reducing these imbalances became a more pressing objective than using fiscal
policy for cyclical stabilisation purposes, although some scholars have pointed out that signs of active fiscal
policy could already be observed early on in the first decade of the twenty-first century. The United States
is an example.
Key aspects of what could be described as the structural approach to fiscal policy include the
following:
• Keeping the public debt (and the burden of servicing it) at a sustainable level by avoiding high budget
deficits or reducing it to acceptable levels (such as was required after the dramatic surge in deficits and
public debt levels as a result of the 2007–2009 international financial crisis)
• Keeping the overall tax burden at a level that does not seriously prejudice incentives to work, save and
invest
• Keeping government spending in check to avoid crowding out of private activity, inflationary financing,
and the cost-push and disincentive effects of an excessive tax burden.
One of the major outcomes of the widespread acceptance of the structural approach to fiscal policy has been
that more and more countries are adopting rules-based fiscal regimes in place of the discretionary regimes
that characterised the Keynesian era. We discuss this trend in more detail in Section 18.5. Another outcome
was that references to fiscal policy virtually disappeared from macroeconomic policy debates worldwide
for almost two decades (recall the statement of Martin Eichenbaum quoted earlier).
A good example of how the focus in fiscal policy analysis has changed is the contrasting reasons why
adherents of the Keynesian approach and the structural approach regard the extent of the budget balance as
important. During the heyday of Keynesian anti-cyclical fiscal policy, economists watched the budget
balance closely as an indication of whether the short-run impact of fiscal policy on aggregate demand is
expansionary or contractionary. The structural approach puts more emphasis on what the budget balance
suggests about the current and future sustainability of fiscal policy, and how the financing of budget
deficits is likely to influence the economy. This approach leaves room for passive anti-cyclical fiscal policy
to the extent that automatic stabilisers are effective.
There are several ways to finance a budget deficit. One option is to borrow from the central bank, which
amounts to the government using its overdraft facilities. This type of financing increases the money supply
and is potentially inflationary. Governments should therefore avoid it as far as possible. Another
undesirable option is to run down the country’s foreign reserves. Unless a country has an exceptionally
large stock of reserves, financing the budget deficit in this manner would soon deplete them and cause a
foreign exchange crisis. Most governments finance their deficits by borrowing from the domestic and
international capital markets. In countries with well-developed financial systems (such as South Africa),
governments borrow from the capital markets by issuing bonds (government stock) on which they have to
pay interest. This type of borrowing therefore increases the public debt, the sustainability of which has also
become an important criterion for judging the soundness of fiscal policy and macroeconomic management
in general. In practice, it is very difficult to determine the sustainability of the public debt: doing so
requires an assessment of whether or not it is and will remain at levels that the particular country can repay
and service (see Box 18.2). Economists often use a non-increasing (in other words, a decreasing or
constant) public debt–GDP ratio as a benchmark to distinguish between sustainable and unsustainable fiscal
policy (Chalk & Hemming, 2000: 3).
Apart from the possibility that it can become unsustainable (put differently, that the government would
have to default on its debt obligations), a large public debt also has other undesirable effects. For one thing,
government borrowing places a burden on future generations, who have to pay the interest and repay the
debt. As indicated in the discussion of the current budget balance, this type of inter-generational
redistribution is especially problematic when the government uses the borrowed funds to finance current
expenditure that only benefits the current generation. Another disadvantage of a large public debt is the
associated interest burden that, for a given level of public expenditure, leaves the government with less
money to use for productive purposes.
18.3.4 Renewed interest in active fiscal policy

Even before the international financial crisis of 2007–2009 and the ensuing Great Recession, there were
clear signs that policymakers were showing greater interest in the cyclical effects of fiscal policy than had
been the case only a few years earlier. This development should not be interpreted as a fully fledged return
to fiscal activism of the traditional Keynesian variety. At the time of writing, leading economists were still
grappling with a full understanding of the causes and consequences of the international financial crisis, and
the appropriate macroeconomic and regulatory response.
Gradually it became clear, however, that a number of important lessons had been learnt from the crisis.
Blanchard, Dell’Ariccia and Mauro (2010) mention three of these: low inflation limits the scope for using
monetary policy in deflationary recessions, countercyclical fiscal policy remains an important tool, and the
regulation of financial markets is not neutral in a macroeconomic sense. The latter acknowledges that the
regulation of financial institutions can be pro- or anticyclical. For example, if reserve requirements cause
banks to increase their deposits with the central bank during an economic recession, it reduces the
availability of credit at a time when an economic recovery would be facilitated by an increase in the supply
of credit.
Nonetheless, many economists still maintains that, except maybe in most extreme situations, monetary
policy is a better tool for stabilisation purposes than fiscal policy and that activist fiscal policies should
generally be avoided. Alan Blinder (2006: 54) puts it as follows:
Under normal circumstances, monetary policy is a far better candidate for the stabilisation job than
fiscal policy. It should therefore take first chair. That said, however, there will be occasional abnormal
circumstances in which monetary policy can use a little help, or maybe a lot, in stimulating the
economy – such as when recessions are extremely long and (or) extremely deep, when nominal interest
rates approach zero or when significant weakness in aggregate demand arises abruptly. To be
prepared for such contingencies, it makes sense to keep one or more fiscal policy vehicles tuned up and
parked in the garage, and perhaps even to adopt institutional structures that make it easier to pull them
out and take them for a spin when needed.
There are two reasons for the tentative comeback of fiscal policy in discussions of macroeconomic
stabilisation. First, automatic fiscal stabilisers often become destabilising when inflation is high. In many
countries, lower inflation rates have now rejuvenated the working of the automatic fiscal stabilisers, thus
restoring to fiscal policymakers a tool for influencing economic activity that is not subject to some of the
shortcomings of activist policies. Second, the decisions to bail out certain financial institutions when
financial markets in various countries were at perceived risk of systemic failure in 2007 and 2008, together
with the ineffectiveness of monetary policy to counter the severe recessionary effects when interest rates
approached the zero bound, seemingly left many governments with little choice but to fall back on fiscal
measures. During these times, monetary activism took on a new dimension, such as when the US Federal
Reserve Bank adopted a balance-sheet measure of quantitative easing (so-called QEs), whereby the supply
of money was increased.10 Because of the condition of countries’ public finances prior to the crisis (see
Tables 18.1 and 18.2), the scope for active fiscal policies varied and a measure such as quantitative easing
thus added to the arsenal of policy measures. On the whole, however, the approach to the macroeconomic
role of fiscal policy clearly shifted – at least temporarily – towards Keynesian anti-cyclical fiscal policy.
Appropriate indicators are needed to determine whether the fiscal policy stance complements or
undermines the actions of the monetary authorities. We introduced the cyclically adjusted budget deficit in
Box 18.1, and now discuss it in more detail with the aid of Figure 18.3 to show how countries have begun
to use cyclically adjusted (or structural) budget balances in assessing and designing fiscal policy.
The set-up of Figure 18.3 is similar to that of Figures 18.1 and 18.2: it also depicts government tax
revenue and government spending as functions of income (Y). As before, the total tax revenue curve (T)
slopes upwards and the government spending curve (G) has been drawn as a horizontal line. The economy
experiences full employment when income is YF. At this level of income, tax revenue and government
spending are t0 and g0 respectively. The associated budget deficit (distance AB) is not distorted by the
effects that any particular state of the business cycle may have on the levels of government revenue or
expenditure. As such, it represents the ‘underlying’ budget balance that results from the tax structure and
level of government spending at the full-employment, potential or trend-line level of income. The
benchmark level of the budget balance is variously known as the structural budget balance, the full-
employment income budget balance, the potential-income budget balance, the trend-line budget
balance or the cyclically adjusted budget balance.
The calculation of structural budget balances is easier said than done. Whereas the conventional budget
balance is usually expressed as a percentage of the estimated or actual gross domestic product, the
structural budget balance is expressed as a percentage of the potential output of the economy or the full-
employment level of income. Potential output and the full-employment level of income cannot be measured
accurately. They can only be estimated using techniques that remain controversial. This explains why Vito
Tanzi (2005: 9) once referred to cyclically adjusted budget balances as ‘counter-factual variables’ and
‘virtual variables’. Structural budget balances are nonetheless very useful indicators because they enable
policymakers to assess the extent and impact of observed budget balances in a dynamic manner and,
therefore, more accurately. Consider, for example, the situation at income level Y1 in Figure 18.3. The
economy is well below the full-employment level of income, and the levels of tax revenue t1 and g0 result
in a budget deficit depicted by the distance CE. Provided that they have a reasonably accurate estimate of
potential output, policymakers would be able to distinguish between the structural component of this deficit
(distance CD, which equals distance AB) and its cyclical component (distance DE). Given the assumption
in our example that government spending is not sensitive to the state of the business cycle, the cyclical
component of the deficit can be ascribed fully to a revenue effect. Tax revenue is lower than what it is
likely to be at the full-employment income level by the distance DE (= t1t0) because income is below the
full-employment level. This difference between potential (or full-employment) output and actual output is
referred to as the output gap.
Figure 18.3 Structural and cyclical budget balances

Hence, structural budget balances enable policymakers to distinguish between the permanent and
transitory components of observed budget balances. This distinction can help policymakers to avoid errors,
a typical example of which is taking long-lasting decisions on taxes and expenditures based on transitory
movements in revenues. The situation at income level Y2 illustrates this possibility. Here tax revenue is t2
and government spending is g0, yielding a budget surplus equal to the distance FH. Many governments
(supported by interest groups) would interpret the emergence of a budget surplus as an indication that they
can and should increase public spending, for example, to help the poor or to expand the country’s physical
infrastructure. Increases in public spending, however, are seldom easily reversible: once appointed, public
servants cannot be retrenched at will, and newly created assets (such as schools and hospitals) have running
expenses and require maintenance. Policymakers should therefore ensure that sufficient financing will be
available on a sustained basis to cover recurring costs associated with public outlays before expanding
them. Here the observed budget surplus appears to be a temporary (cyclical) phenomenon: income is well
above the full-employment level (by the distance Y2YF) and this raised tax revenue from t0 to t2. What
Figure 18.3 tells us, is that income should eventually revert to the full-employment level YF, with a
concomitant fall in tax revenue to t0 and the re-emergence of the structural budget deficit. In fact, the
budget surplus may be the very deflating factor that moves the economy back to YF . If, however, the
government uses the windfall revenue to finance spending programmes of a long-term nature, the
horizontal line G0 would shift upwards to G1 to cut the T-function at F so that the structural deficit
increases from AB to (AB + FH). The distinction between the cyclical and the structural budget balances
could therefore help policymakers to avoid the ratchet effects that many economists blame for persistent
budget deficits and secular increases in government spending levels. These effects were an important
reason why Keynesian fiscal activism lost its appeal in the 1970s.
A brief reflection on the fiscal consequences of the
18.4
Great Recession
Even though governments resorted to some form of Keynesian fiscal activism during and after the
international financial crisis, much concern remains about countries’ fiscal scope to stimulate the economy.
The levels of debt and budget deficits signal warning lights at a time when governments are under pressure
to stimulate economic recovery and to restore fiscal sustainability. Tables 18.1 and 18.2 show the fiscal
predicament of some industrial as well as developing countries eight years after the crisis.
In retrospect the words by Spilimbergo, Symansky, Blanchard and Cottarelli (2008: 2) sound prophetic.
They concluded that the measures to be contained in an optimal fiscal package should be timely (because
the need for action was immediate), large (because the current and expected decrease in private demand
was exceptionally large), lasting (because the downturn would last for some time), diversified (because of
the unusual degree of uncertainty associated with any single measure), contingent (because the need to
reduce the perceived probability of another ‘Great Depression’ required a commitment to do more, if
needed), collective (since each country with fiscal space had to contribute) and sustainable (so as not to
have led to a debt explosion and adverse reactions of financial markets). They then argued that spending
increases as well as targeted tax cuts and transfers were likely to have the highest multipliers. General tax
cuts or subsidies, either for consumers or for firms, were likely to have lower multipliers.
In reality, different countries applied different fiscal measures. Countries such as India, Indonesia and
Mexico mainly used tax reductions. The United States, Australia, Korea, France and Russia made use of a
mix of tax and expenditure measures. The United Kingdom, Canada, Germany and Turkey mostly resorted
to expenditure measures. Countries such as Greece, Portugal and Ireland had no room for stimulatory
measures, and had to rely on bailout support from other countries and the International Monetary Fund, in
addition to harsh measures of fiscal restraint.
Table 18.1 The evolution of general government fiscal positions in South Africa and selected advanced economies (% of
GDP, selected years from 2006 to 2016)
Source: IMF World Economic Outlook, April 2018.
Table 18.2 The evolution of general government fiscal positions in South Africa and selected emerging markets and other
developing economies (% of GDP, selected years from 2006 to 2016)
Source: IMF World Economic Outlook, April 2018.
When we compare fiscal trends across groups of countries from 2006 (the year before the international
financial crisis) to 2016, IMF (2018) data show significant differences. The biggest increases in budget
deficits and public debt occurred in industrial countries. Yet, even after downgrading of their sovereign
debt, they retained much higher credit ratings than many emerging market economies. A country’s
creditworthiness obviously depends on other factors too, such as growth performance and potential,
political stability, the structure of financial markets, property rights, security of contracts and various other
risks to foreign investment.
After the financial crisis, South Africa’s fiscal position was much less disconcerting than that of some of
the advanced economies, but worse than some emerging market economies. One aspect of the fiscal debate
was about the speed with which economic recovery should be pursued with fiscal activism, in other words,
what the nature of fiscal consolidation should have been. Fiscal consolidation simply means the
combination of policies used by a government to reduce its deficits and accumulated stock of debt to
acceptable levels in a particular timeframe. At face value, this would suggest a more conservative fiscal
approach in high-debt countries, which would not have generated as speedy a recovery, but would have put
fiscal sustainability less at risk. As it turned out, the general government budget deficits were reduced
sharply in countries such as the UK and the USA, but debt ratios continued to increase, largely because of
low economic growth.11 Box 18.3 gives an overview of literature findings regarding fiscal consolidation
outcomes, including the rather controversial interpretation of such findings known as the ‘expansionary
fiscal contraction hypothesis’.
What added to misgivings about the effectiveness of active fiscal policies as growth stimuli, was that
consumers appeared to respond to some of the measures (for instance, in the United States) by replenishing
lost savings (or wealth) rather than increasing consumption. Such behaviour, which resembled Ricardian
equivalence, undermined the Keynesian increases in aggregate demand envisaged by policymakers.
Another complication was that a number of smaller countries (for example, Greece and Ireland) exhibited
fiscal unsustainability, and had to be bailed out by the International Monetary Fund and the European
Central Bank. The conditions accompanying the bailouts entailed major fiscal austerity measures, which
halted the period of active fiscal policies and dampened the strength of the economic recovery. One of the
major steps to reduce the structural deficits in European countries was the raising of the retirement age, that
is, the age at which people become entitled to pension benefits. Although the retirement benefits of the
welfare states of Europe varied, in general they had for a long time been regarded as increasingly
unaffordable and unsustainable, although very hard to change. The grim realities of the Great Recession as
well as the cost to taxpayers of the bailouts and the active fiscal measures seemed to have made it
politically feasible to increase the retirement age. This had the effect of reducing future fiscal commitments
and social security costs, which were socio-politically easier to digest than a future cut in benefits or an
increase in taxes.
Fiscal balances also matter for the assessment of fiscal sustainability. Some countries had budget
surpluses before the crisis, like Germany, Chile and South Africa. These countries, as well as low-deficit
countries not only encountered a less severe recession, but were also able to generate quicker economic
recoveries. This was also experienced by many developing countries that had been applying prudent fiscal
policies. Barring a few exceptions such as China and India, however, these countries apparently did not
achieve exceptional growth recoveries. It may well be that the structural approach to fiscal policy is needed
for most countries to increase their potential output, rather than to achieve mere cyclical upturns. Keynesian
policy then becomes a tool that is put to use only when a major shock leaves policymakers with no real
alternative – but then also just to address short-term demand deficiencies. Even so, there are limits to what
fiscal measures can do to achieve fiscal sustainability. It requires the harnessing of the full range of
structural economic policies to enhance the countries’ potential output, amongst which measures are
needed that increase countries’ international competitiveness.
Box 18.2 Fiscal sustainability
Fiscal sustainability refers to a government’s continued ability to service its debt (in other words, pay the interest on
its domestic and foreign debt timeously) and repay the loan amount (principal) when it becomes due. In more
technical terms, we distinguish between fiscal solvency and fiscal sustainability. A government is fiscally solvent if
the present value of the flow of all future revenues exceeds the value of outstanding debt plus the discounted value of
future government expenditure. This is a necessary though not a sufficient condition for fiscal sustainability. The
concept of fiscal sustainability adds the requirement of a track record regarding the generation of revenue and the
management of expenditure, together with a credible expectation that the track record will be repeated in future.
It is difficult to judge fiscal solvency and sustainability as described here in practice. The concept of fiscal
sustainability can be made operational by arguing that states maintain fiscal sustainability when the government is
regarded as solvent without the need for any changes to the present stance of fiscal policy. Attempts to judge the
sustainability of fiscal policy in individual countries often employ primary balance trends as a predictor of the intent
to restore a sustainable fiscal stance when rising fiscal conventional deficits threaten macroeconomic stability or
when the debt burden is rising to levels that generate concerns. A widely used rule of thumb states that primary
deficits are consistent with stable government debt–GDP ratios only if and for so long as the real rate of economic
growth exceeds the real rate of interest. Applications of this rule of thumb usually rely on the following equation for
calculating changes in the ratio of government debt to GDP:
Change in the ratio of debt to GDP = Bt/Yt – Bt–1/Yt–1 = (r – g) Bt–1/Tt–1 + (Gt – Tt)/Yt + (Mt – Mt–1)/Yt
where (r – g) = difference between real rates of interest and economic growth

Bt–1/Yt–1 = previous year’s debt–GDP ratio
(Gt – Tt)/Yt = primary balance as ratio of GDP
(Mt – Mt)/Yt = seigniorage (in other words, government revenue on account of an expansion of the money supply) as
ratio of GDP.
This equation, sometimes also referred to as reflective of the inter-temporal budget constraint, gives rise to another
diagnostic rule of thumb about fiscal prudence: if the primary balance is improving in the face of rising public debt–
GDP ratios, the government is viewed as being serious about maintaining or restoring fiscal sustainability.
During the past twenty to thirty years, much attention has been given to the nature and measurement of
fiscal sustainability, and to fiscal consolidation strategies to restore fiscal sustainability. Fiscal
sustainability remains a somewhat elusive concept because it depends on assumptions about future tax
compliance and government expenditure discipline, and the projected output gap, that is, the difference
between the actual and the potential GDP. Several scholars have investigated fiscal policy in South Africa
over the years. Most of them concluded that fiscal policy in South Africa has been sustainable (see, for
example, Burger, Stuart, Jooste & Cuevas, 2012). However, there has been growing concern about the
sustainability of fiscal policy because of the increase in South Africa’s public debt–GDP ratio in the
aftermath of the international financial crisis and the ensuing Great Recession (see Table 18.1). Ultimately,
South Africa’s international sovereign debt was downgraded to speculative (‘junk-bond’) status by two of
the three major credit ratings agencies during 2017. To address the growing fiscal dilemma, Burger, Calitz
and Siebrits (2016) mentioned an increase in public investment relative to government consumption
expenditure as a means of improving the asset side of the government’s balance sheet (or, as the accounting
profession would say, the statement of financial position). After President Ramaphosa replaced President
Zuma at the end of 2017, serious steps were taken with a view to rebuilding the economy and restoring
fiscal sustainability.
Box 18.3 Fiscal consolidation approaches and the ‘expansionary fiscal contraction hypothesis’12
Fiscal deficits (and, by implication, public debt burdens) can be reduced in three ways: by reducing government
expenditure, by increasing government revenue, and by a combination of the two. Several empirical studies compared
the effectiveness of these types of deficit-reduction strategies. Most studies of this nature began by formulating exact,
albeit arbitrary, criteria for judging the success of fiscal consolidation efforts.13 Next, the criteria were used to
distinguish those efforts that brought significant reductions in fiscal deficits from those that did not. A further
distinction was made between durable successful efforts and episodes in which reductions in budget deficits were
soon reversed. The researchers then identified features associated with the success and durability of consolidation
efforts. Some studies simply compared changes in the average values of fiscal aggregates in the groups of episodes,
while others used econometric techniques to identify the features of successful and durable fiscal consolidations.
Most analyses of attempted fiscal consolidations in OECD countries found that efforts based mainly on cuts in
transfer payment and the government wage bill were more likely to have achieved significant reductions in fiscal
deficits than those based mainly on tax increases. Another key result of the majority of these studies was that
episodes of deficit reduction based mainly on reductions in the same categories of government spending were more
durable than ones that relied mainly on revenue increases, in the sense of having been less likely to have been
reversed within a few years after satisfying the chosen criteria for a successful consolidation. Analyses of emerging
market and other developing economies also linked the success and persistence of fiscal consolidations to the extent
of cutbacks in current government spending. In such countries, however, revenue increases were seemingly also
important elements of durable reductions in fiscal deficits, especially in cases where revenue collection was weak.
Another important finding was that protecting or increasing the share of capital spending in total government
expenditure during consolidation episodes increased the probabilities of success and persistence.
On balance, these results suggested that a ‘one-size-fits-all’ approach to fiscal consolidation should be avoided. A
plausible interpretation of the differences in the findings for OECD and developing countries is that individual
countries should design consolidation plans consisting of mixtures of revenue increases and spending reductions
capable of correcting the specific causes of their fiscal imbalances. Excessive growth in spending on the remuneration
of government employees and social transfer payments were major causes of fiscal problems in most OECD
countries; hence, such items should have been targeted for reductions in attempts to reduce budget deficits. In many
developing countries, by contrast, weak revenue collection efforts often contributed markedly to fiscal imbalances.
Such countries usually had considerable scope for increasing tax revenues without raising tax rates, for example, by
improving the administration of the tax system and by curbing tax evasion. The finding that the success and durability
of fiscal consolidations in developing countries were linked to the share of capital outlays in total government
expenditure confirmed that deficits can be reduced in more or less appropriate ways. Some governments reduced
deficits by reducing asset formation (i.e. public investment) or by accumulating hidden liabilities (for example,
borrowing via off-budget agencies). Both strategies might put fiscal sustainability at risk: underinvestment in
infrastructure might harm the future growth performance of the economy, while off-budget borrowing ultimately
remains liabilities of the public sector. The implication of this interpretation of existing research is that the literature
on fiscal consolidation does not suggest a simple set of prescriptions for reducing the fiscal deficit and public debt.
Recommendations should be derived from a thorough analysis of the factors influencing the size of and trends in
these fiscal aggregates.
GDP growth facilitates attempts to reduce deficit–GDP and public debt–GDP ratios by boosting the denominator
of such ratios. Hence, the success and persistence of fiscal consolidation efforts are also linked to the effects of such
efforts on output growth. Simple Keynesian models imply that fiscal tightening dampens economic activity in the
short to medium run: Spending cutbacks and revenue increases reduce aggregate demand and income directly and via
multiplier effects. Recent studies of the output implications of deficit reduction have focused on the possibility and
likelihood of non-Keynesian effects. Drawing on case studies and cross-country empirical analyses, adherents of the
‘expansionary fiscal contraction hypothesis’ have claimed that fiscal consolidation can have positive effects on output
that sometimes outweigh the negative ones highlighted by Keynesian models. According to some authors fiscal
adjustment can stimulate growth via the demand side and the supply side of the economy. Credible consolidations
that change expectations about future fiscal policy can appease fears of more dramatic and disruptive future policy
changes. The resulting boost to the confidence of private agents and the reduced need for precautionary saving might
stimulate private consumption and investment. This boost to aggregate demand would be reinforced if the
consolidation contributes to lower interest rates by decreasing pressure on capital markets and risk premia for default
on the public debt. In addition, fiscal consolidations based mainly on cuts in the government’s wage bill can boost the
supply side of the economy if spillover effects result in downward pressure on unit labour costs. Reductions in unit
labour costs increase the competitiveness of private firms.
This possible supply-side effect suggests that the influence of fiscal consolidation on economic growth is also
linked to its composition (that is, the relative weights of revenue increases and expenditure reductions). The
distinction between spending-focused and revenue-focused consolidation efforts possibly matters for the demand-side
effects on economic growth as well. It has been pointed out that the positive credibility effects of decisive steps to
rein in spending on large and politically sensitive items, such as reductions in public employment and tightening of
the eligibility criteria for transfer payments in OECD countries, should eclipse those of tax hikes. This argument
suggests that expenditure-based consolidations should stimulate private investment and consumption more than
revenue-based consolidations would.
The notion that deficit reduction can be a painless or, for that matter, a growth-stimulating process appeals greatly
to politicians, many of whom fear backlashes against fiscal austerity. The ‘expansionary fiscal contraction
hypothesis’ remains controversial, though. Some empirical studies found no evidence of non-Keynesian effects in the
wake of attempts to reduce fiscal imbalances. There has also been criticism of the practice of using fiscal outcomes as
the basis for identifying episodes of fiscal contraction. Arguing that this practice often leads to unwarranted
inferences about the intentions of policymakers and inadequate attention to the effects of exogenous factors on fiscal
outcomes, some critics argued for a narrative approach that bases identification of fiscal consolidation episodes on
careful study of policymakers’ pronouncements and actions. The results of the application of narrative approaches
amounted to a rejection of the ‘expansionary fiscal contraction hypothesis’. Given the dearth of empirical research
on the validity of this hypothesis in emerging markets and other developing countries and the inconclusiveness of
results for advanced countries, it would be unwise to expect that fiscal consolidation would always or, for that matter,
usually stimulate economic growth.14 The possibility that it might not dampen economic growth significantly, if at
all, is intriguing, however, and should be kept in mind when reflecting on the design of fiscal consolidation
programmes.
18.5 Fiscal policymaking frameworks 15
Much attention is given nowadays to connections between fiscal policymaking frameworks and fiscal
outcomes. A country’s fiscal policymaking framework consists of all the institutions that structure fiscal
policymaking processes. The following are the best-known institutions of this nature.
• Numerical fiscal rules are quantitative restrictions on the absolute or relative levels of fiscal aggregates.
The most common categories of numerical fiscal rules are: limits on the extent of the public debt
(expressed as amounts or as ratios of the gross domestic product or GDP); limits on various definitions
of fiscal balances (expressed as ratios of the GDP); limits on the absolute levels, growth rates or GDP
shares of public spending aggregates; and upper or lower limits on government revenue (expressed as
ratios of GDP).
• Procedural fiscal rules are the details of budget processes, that is, the arrangements governing the
formulation of budget proposals by executive branches of governments, the approval of budget
proposals by legislatures and the implementation of budget laws. Such rules determine the distribution
of fiscal policymaking powers, for example, that between the Minister of Finance and the other cabinet
ministers and that between the executive and the legislative branches of government. Procedural fiscal
rules are also known as budget-process rules.
• Medium-term expenditure frameworks are rolling revenue and expenditure projections presented
against the backdrop of economic and fiscal goals and the prospects of the economy. The purposes of
such frameworks are to enhance the transparency of budget processes, strengthen links between policy
priorities and longer-term spending plans, and improve expenditure control. The medium-term
expenditure frameworks of countries are closely linked to their budget-process rules.
• Fiscal responsibility laws specify the medium-term paths of key fiscal aggregates, outline annual and
medium-term strategies for achieving policy objectives, and establish frameworks for regular reporting
on fiscal trends and auditing of fiscal information. The main aim of fiscal responsibility laws is to make
policymakers more accountable by increasing the transparency of fiscal processes.
The fiscal policymaking frameworks of a growing number of countries also contain fiscal councils, which
are non-partisan agencies consisting of independent fiscal policy experts. Such agencies have monitoring
and advisory tasks that range from costing of budgetary initiatives to advising policymakers on fiscal policy
options; monitoring compliance with numerical rules; analysing fiscal trends; and generating independent
economic and fiscal forecasts for policymaking purposes. Fiscal councils differ from the institutions listed
above in being organisations rather than rules. They are usually regarded as elements of fiscal frameworks,
however, because they influence aspects of fiscal policymaking processes in the same ways that those
institutions do.
The reason for the current interest in fiscal policymaking frameworks is the belief that appropriate
policymaking institutions can contribute to better fiscal outcomes. More specifically, a growing body of
theory and empirical evidence suggests that fiscal policy is more sustainable and more supportive of
macroeconomic stability when underpinned by well-designed fiscal policymaking frameworks. The
remainder of this section discusses this theory and evidence. It first comments on the long-running
discretion-versus-rules debate in fiscal policy, then discusses the influence of fiscal policymaking
frameworks on fiscal outcomes, and ends with a concluding comment.
18.5.1 Rules versus discretion in fiscal policy

Dornbusch, Fischer and Startz (2004: 198) formulated the choice between the rules-based and discretionary
fiscal policymaking regimes as follows: ‘Should … the fiscal authority conduct policy in accordance with
pre-announced rules that describe precisely how their policy variables will be determined in all future
situations, or should they be allowed to use their discretion in determining the values of the policy variables
at different times?’ Debates about the pros and cons of these two types of regimes have been features of
macroeconomics for a very long time. Such debates traditionally focused on the choice between discretion
and numerical fiscal rules, and this section maintains that perspective. However, the arguments also apply
to the other institutions or rules that make up fiscal policymaking frameworks (e.g. procedural fiscal rules
and fiscal responsibility laws) - as will become apparent in Section 18.5.2.
Policymakers operating in discretionary regimes have more flexibility (that is, more scope to adjust
policy instruments) than their counterparts in rules-based regimes do. There are two possible reasons why it
might make sense to limit fiscal policymakers’ flexibility by means of numerical rules.
• Rules may function as binding constraints that improve the effectiveness of fiscal policymaking by
making it very difficult (if not impossible) for the authorities to stray from sound policies. The
argument that rules are necessary to prevent policymakers from lapsing into unsustainable or
procyclical fiscal policies rests on the premise that policymakers cannot be trusted to manage the public
finances well all the time. Policymakers might not be competent enough to do so, for example, or might
exhibit utility-maximising behaviour that distorts policy choices (recall the discussion of government
failure in Chapter 6, Section 6.7).
• The adoption of and adherence to rules may be a mechanism for fiscal policymakers to make credible
commitments to sound policies. Such commitments may help to make policies more effective by
influencing the expectations and responses of private economic agents. Consider an example: To
encourage investment, governments would like to reassure prospective investors that they would not
resort to unsound fiscal practices that lead to high inflation and financial crises (for example, running
excessive budget deficits and financing them by borrowing from the central bank).16The argument is
that the adoption of rules that limit the size of budget deficits would be ideal mechanisms to signal
commitment to fiscal discipline, thus fostering investment and economic growth. Note that the premise
of this justification for rules differs from that of the binding constraints argument. The credible
commitment argument does not rest on the belief that governments should be constrained by rules
because they are inclined to stray from prudent fiscal policies. Instead, it holds that governments with
strong commitments to restoring or maintaining fiscal discipline should choose to constrain themselves
by means of rules to convince private actors of their resolve.
The popularity of discretionary and rules-based fiscal policymaking regimes has changed over time.
Keynesian macroeconomics emphasised the sluggishness of market adjustment to shocks and the
stabilising properties of active anti-cyclical fiscal policies. The dominant view during the heyday of
Keynesian macroeconomics was that rules-constrained policymakers cannot pursue activist policies
effectively. Fiscal discretion was therefore the norm in fiscal policymaking from the end of World War II
until the mid-1970s. Recall from Section 18.3.3, however, that numerical fiscal rules have grown in
popularity since the emergence of the structural approach to fiscal policy. Both sets of arguments outlined
above contributed to this development. For one thing, the shortcomings of activist fiscal policies identified
in Section 18.3.2 were interpreted widely as clear proof of the inadequacy of discretionary policy regimes.
A number of countries adopted rules in the belief that doing so would prevent the problems associated with
activist policies by making it very difficult (if not impossible) for the fiscal authorities to stray from sound
policies. The binding constraints justification for fiscal rules underpinned such reforms of fiscal
policymaking frameworks. The case for fiscal rules was bolstered further by the widespread adoption in
macroeconomics of the rational expectations hypothesis, which states that all agents make optimal use of
the information at their disposal by taking into consideration past, current and the expected future states of
their environment – including anticipated economic policies – when they make decisions. One of the
implications of this hypothesis is that announced policies only affect the behaviour of the agents in the
manner desired by policymakers if the policies are deemed credible, that is, if agents believe that
policymakers will implement them fully. As was suggested earlier, proponents of fiscal rules argue that the
adoption of numerical rules represents credible commitments to sound policies that should make fiscal
policies more effective at influencing the expectations and behaviour of private agents.
The empirical record of numerical fiscal rules is mixed. To be sure, a growing number of studies suggest
that fiscal outcomes tend to become more prudent and less destabilising after the adoption or strengthening
of such rules. Still, many governments find it easy to ignore, abandon, suspend or circumvent quantitative
limits on fiscal aggregates. Two well-known tactics to circumvent rules are to base budgets on unrealistic
GDP or government revenue forecasts and using ‘creative accounting’ to hide breaches of numerical limits.
The vulnerability of numerical rules was evident during the Great Recession, for example, when the
Stability and Growth Pact rules failed to prevent large increases in the budget deficits of all European
Union countries, a severe public debt crisis in Greece and near-crises in Portugal and Spain.17 This shows
that the binding constraints argument for fiscal rules has limited validity.
There are two main reasons why many rules-based fiscal regimes fail, however. The first reason is that
no individuals or agencies can force sovereign government to adhere to rules. The second is that
policymakers have limited control over fiscal outcomes. As indicated above, numerical fiscal rules
typically establish upper limits for the ratios of key fiscal aggregates to GDP (for example, budget balances
and the level of public debt). The values of these ratios are strongly affected by factors beyond the
immediate control of governments, including GDP shocks (which impact upon the denominator and the tax
revenue component of the numerator) and restrictions on the scope for changing the level of public
spending in the short run (for example, the contractual nature of major expenditure items such as
compensation of employees, interest on public debt, procurement programmes, and certain subsidies and
transfer payments).
On paper, the credible commitment justification is a powerful argument for fiscal rules. For example,
adopting numerical rules seems to be one of the few options available to a new government without a
record of fiscal prudence that wishes to signal its commitment to sound fiscal policies. Introducing rules
may yield credibility benefits in such circumstances. Ultimately, however, the durability of such benefits
will depend on the government’s ability to honour its commitment by adhering to those rules. To avoid
undermining their credibility by breaching rules, policymakers may have little choice but to respond
actively to small or transitory increases in budget deficits or public indebtedness caused by negative GDP
shocks, among other things. Yet such responses may not be effective given that policymakers cannot
control the values of key fiscal aggregates with precision. Moreover, the same policy lags that caused
problems for active fiscal policies aimed at stabilising the business cycle will also cause problems for
active fiscal policies aimed at complying with fiscal rules. Hence, rules may force policymakers to adopt
ultra-conservative forecasting and budgeting techniques that result in excessively contractionary fiscal
outcomes. Other common undesirable effects of attempts to comply with rules are inappropriate forms of
tax increases and expenditure cuts. Experience has shown that policymakers often respond to shocks that
threaten compliance with rules by using measures that are likely to provoke little political resistance,
instead of those that are most appropriate from an economic point of view. For example, they often reduce
growth-promoting capital spending programmes while maintaining subsidies to loss-making public
enterprises.
18.5.2 Fiscal policymaking frameworks and fiscal outcomes

Section 18.5.1 pointed out that there is a strong case for fiscal rules based on theoretical considerations and
evidence of the weaknesses of discretionary fiscal policymaking. Yet it also argued that rules-based fiscal
policymaking has a mixed record, in part because it faces formidable practical hurdles (such as the limited
controllability of important fiscal aggregates). These considerations raise two questions about the
relationship between fiscal policymaking frameworks and fiscal outcomes. First, are the other elements of
fiscal policymaking frameworks (procedural fiscal rules, medium-term expenditure frameworks, fiscal
responsibility laws and fiscal councils) more likely to contribute to good fiscal outcomes than numerical
fiscal rules have been? Second, can the effectiveness of numerical fiscal rules be enhanced by combining
them with these other elements of fiscal policymaking frameworks?
With regard to the first questions, theory and empirical evidence from advanced and developing
countries suggest that well-designed budget-process rules can contribute to good fiscal outcomes. The best-
known argument is that fiscal discipline is enhanced if the budget process curtails the influence of the
spending ministers and departments as well as the legislature, and assigns strong powers to the finance
minister and the treasury. The premise of this argument is that national budgeting is a common-pool
problem: most public spending programmes are financed from general tax revenues, but benefit specific
groups of voters (such as the inhabitants of particular geographical areas). This implies that the
beneficiaries of public spending programmes often pay for fractions of the benefits they receive. Hence, the
argument goes, politicians and voters overestimate the net marginal social benefits of these programmes
and demand excessive levels of public government spending. A plausible solution for the common-pool
problem is to concentrate decision-making authority in the hands of finance ministers and treasuries - the
parties who are most likely to acknowledge the overall budget constraint and to enforce it against the
demands of spending ministers, legislatures and interest groups. A key aspect of the argument is that the
budget process should be ‘top-down’, which means that finance ministers should determine aggregate
expenditure envelopes and budget balances before decisions are taken about allocations to spending
programmes.
The other three (medium-term expenditure frameworks, fiscal responsibility laws and fiscal councils)
are fairly new elements of fiscal policymaking frameworks, and it might be too soon to draw definitive
conclusions about their effectiveness. Yet the early indications are that these three elements can also
contribute to better fiscal outcomes, most notably by enhancing transparency and accountability in fiscal
policymaking. Fiscal transparency means being open to the public and to financial markets about the
structure and functions of government as well as fiscal projections, policy intentions and outcomes.
Advocates of transparency argue that it improves fiscal policymaking by making the fiscal authorities more
accountable. Some fiscal policy experts believe that transparency-enhancing reforms are more effective
mechanisms to make fiscal policies credible than adopting fiscal rules.18
The extent to which transparency-based frameworks constrain policymakers depends on their details.
On balance, however, transparency-based frameworks are more flexible than rules, but less flexible than
discretionary ones. The greater flexibility of transparency-based regimes gives them a major advantage
over rules-based regimes (especially to policymakers who are strongly committed to prudent fiscal policies
and who therefore do not need binding by rules). Another advantage of transparency-based regimes over
rules-based ones is their superior ability to strengthen the effectiveness of market discipline over fiscal
policymakers. ‘Market discipline’ refers to the phenomenon that the financial markets restrain the de facto
independence of fiscal policymakers: the markets quickly ‘punish’ fiscal laxness by suspending lending,
withdrawing capital and increasing risk premiums on borrowed funds. On the whole, the influence of
market discipline on fiscal policymaking is benign, but there is the danger that governments could become
excessively concerned with gaining or maintaining the confidence of markets and allow the short-term
oriented preferences of market participants to bias their macroeconomic policy decisions. Rules-based
regimes tend to emphasise a small number of summary indicators of fiscal policy and in this way foster the
tendency of market participants to judge fiscal policy on a too narrow basis. Transparency-based regimes,
on the other hand, can strengthen the effectiveness of market discipline by ensuring that the bigger picture
receives due emphasis.
Turning to the second question, it has become increasingly clear that complementary transparency-
enhancing elements can make rules-based fiscal regimes more effective. Recall that governments sometimes
attempt to circumvent rules intended as binding constraints by basing budgets on unrealistic forecasts or by
applying ‘creative accounting’ tricks. The detailed reporting requirements of medium-term expenditure
frameworks and fiscal responsibility laws as well as the monitoring and whistle-blowing activities of fiscal
councils can thwart such attempts to mislead voters and financial markets. In addition, transparency is
particularly helpful for policymakers using rules to signal commitments to sound fiscal policies. We
pointed out before the need to protect their own credibility and that of the rules-based regime might force
policymakers to respond whenever compliance is threatened, even if such reactions are costly in economic
terms. Transparency-focused policymaking frameworks include tools and structures for clear
communication with outside parties. These aspects of fiscal policymaking frameworks and objective
assessments of policy responses by fiscal councils can help policymakers to avoid knee-jerk reactions and
preserve their credibility even if fiscal shocks cause occasional breaches of numerical rules.
The ability of fiscal councils to strengthen the effectiveness of numerical rules depends on their degree
of independence from governments, the scope of their mandates and the quality of their outputs. The
importance of independence stems from the high likelihood of tension between governments and fiscal
councils. In discharging their functions, fiscal councils are likely to criticise governments from time to
time. Hence, legal and other safeguards are needed to protect such agencies against retaliation by offended
governments, whether in the form of public criticism, budget and staff cuts, or disbandment. Empirical
evidence confirms that governments’ fiscal forecasts and fiscal outcomes improve when they are monitored
by fiscal councils with high levels of operational or legal independence and strong media profiles.
18.5.3 Concluding comment

Appropriate fiscal policymaking frameworks can contribute to better fiscal outcomes, but their potential
should not be exaggerated. The ultimate determinant of a country’s fiscal outcomes is not the nature of is
policymaking framework, but the strength of its government’s commitment to fiscal discipline. A
policymaking framework cannot substitute for government commitment in the sense that the mere
existence of institutions cannot prevent irresponsible policies.
18.6 Fiscal policy in South Africa

This section highlights and briefly discusses key features of fiscal policy in South Africa. Section 18.6.1
discusses the evolution of the macroeconomic (stabilisation) role of fiscal policy in South Africa. We focus
mainly on the period since 1990, but refer to longer-term trends and developments where appropriate.
Section 18.6.2 comments on aspects of the fiscal policymaking framework in South Africa.
18.6.1 Macroeconomic aspects of fiscal policy in South Africa19

As was the case in most other countries, the South African fiscal authorities adopted Keynesian policies
after World War II. Fiscal policy in South Africa continued to reflect aspects of Keynesian thinking well
into the 1980s and even continued to achieve anti-cyclical effects from time to time thereafter. Towards the
end of the 1970s, however, there were indications that the authorities were beginning to abandon active
anti-cyclical stabilisation policy in favour of longer-term fiscal planning, a changing mindset that prepared
the way for formal medium-term expenditure planning some 20 years later. Taxation and government
expenditure were no longer used actively or deliberately to stimulate economic growth in times of
recession, nor to dampen demand during boom times. South Africa’s progressive income tax was no longer
capable of exerting strong automatic stabilizing effects owing to bracket creep, which was not compensated
for by indexing income tax brackets to inflation. Moreover, the Treasury was under so much pressure to
reduce government expenditure that it had lost the option of stimulating or cooling-off the economy by
changing the level of government expenditure.
The longer-term focus that gradually replaced the Keynesian approach emphasised fiscal discipline,
which the authorities regarded as a prerequisite for improving the longer-term growth and job creation
potential of the South African economy. The strong emphasis on the pursuit of price stability, based on the
view that lower inflation is a necessary condition for sustained economic growth, further confirmed the
longer-term and structural focus of fiscal policy. Statements in the annual budget speeches of successive
Ministers of Finance suggest that price stability was the most important macroeconomic objective of fiscal
policy from 1994 until 1997, and the second most important in 1990, 1993 and 1998. During the 1990s,
government budgets contained almost no measures aimed at deliberately stimulating economic growth in
the short term. When growth regained pride of place as an objective of fiscal policy in 1999, the fiscal
authorities emphasised their intention to promote growth by microeconomic reforms to boost the supply
side of the economy, instead of demand stimulation.20 The government’s decision to adopt medium-term
expenditure planning in 1998 further cemented the movement away from expenditure fine-tuning.
During the 1990s, the focus on fiscal discipline and other structural aspects of fiscal policy was closely
associated with the stabilisation or even the reduction of the public sector’s claim on resources, including
the total pool of savings. This development should be interpreted against the backdrop of longer-term
trends in the major fiscal aggregates.
Sections 1.5.2 of Chapter 1 and 7.2.1 of Chapter 7 showed that the total tax burden and government
expenditure increased, on balance, as percentages of GDP during the 1960s, 1970s and 1980s. The budget
of the national government was in deficit throughout the 1960s and the 1970s, and the loan debt of the
national government increased more than sevenfold in nominal terms from 1961 to 1981. For most of this
period, the economy grew even more rapidly, however, and the debt ratio (i.e. the national government debt
expressed as a percentage of GDP) therefore decreased significantly. On average, the national budget
deficit–GDP ratio was no higher during the 1980s than during the preceding two decades. Yet because of
sluggish economic growth, these deficits resulted in a faster growth of the public debt than the gross
domestic product. Hence the government debt ratio increased by about six percentage points of GDP during
the 1980s. This experience reminds us of the simple arithmetic reality that a strongly-growing economy can
accommodate higher budget deficits without or with manageable increases in the public debt–GDP ratio.
The period from 1989 to 1995 saw a marked deterioration in the overall fiscal situation: the long
recession from March 1989 to May 1993 depressed tax revenues, while several extraordinary transfer
payments and the expansion of social services sharply increased government expenditure. The budget
deficit ballooned from 1,4% of GDP in 1989/90 to 7,3% in 1992/93. The resulting sharp increase in
national government debt (from 36,4% on 31 March 1989 to 49,5% on 31 March 1996) caused widespread
concern about the sustainability of fiscal policy.21 Some South African economists even predicted that the
government was heading for a debt trap in which it would not be able to service its debt and might find it
increasingly difficult to raise loans in the capital market. These fears confirmed that the private sector had
lost faith in the potential of Keynesian anti-cyclical fiscal policy. The government did not deliberately
increase the budget deficit to stimulate the economy, but the rising deficit during a deep recession
nevertheless represented a strong anti-cyclical policy stance.22 In the heyday of Keynesian anti-cyclical
fiscal policy, the private sector would have welcomed this as an appropriate attempt to soften the cyclical
downturn. In the early 1990s, however, the relatively high deficits and rising public debt caused alarm in
financial circles.
It is important to keep in mind that the debt ratio never reached a particularly high level in international
terms. It remained, for example, well below the sixty-per-cent-of-GDP threshold that countries had to
achieve to qualify for membership of the European Economic and Monetary Union (EMU). Analysts of
fiscal policy were more worried about the growth of the public debt than about its level. The situation was
also the first test of the democratic government’s commitment to fiscal discipline. The first two Ministers
of Finance after the political transition in South Africa, Derek Keys and Chris Liebenberg, were
businesspersons whose perceived political neutrality gave them much credibility in local and international
financial circles. The appointment of ANC politician Trevor Manuel as Minister of Finance in 1996 raised
a crucial question: would the democratic government maintain fiscal discipline or would it pursue
unsustainable populist fiscal policies to achieve its well-publicised goals of fighting poverty and
redistributing income?
It was against this background that the South African government adopted the growth, employment and
redistribution (GEAR) strategy in June 1996. From a fiscal policy point of view, the two most important
goals of GEAR were to turn the deteriorating fiscal situation around and to quell fears about the democratic
government’s perceived lack of commitment to fiscal prudence. Hence the fiscal goals of the GEAR
strategy for the period 1996 to 2000 included a step-wise reduction in the budget deficit to 3% of GDP,
maintenance of the total tax burden at 25% of GDP, the reduction of general government consumption
expenditure as a percentage of GDP and the gradual elimination of general government dissaving. Apart
from making major progress towards effecting a socially more acceptable distribution of income, the
application of the strategy succeeded on both counts. From 1996 to 2001, a combination of buoyant
revenue growth, strict control over public spending and wise use of privatisation receipts reduced the
conventional budget deficit from 5,1% of GDP to 1,9%. Concern about a possible debt trap also evaporated
as the debt ratio dropped from a peak of 49,9% of GDP in 1999 to 43,9% in 2001.
The achievements of the first ten years after the political transition brought the authorities an enviable
reputation for sound fiscal policymaking23, as was evident from the consistent improvement in South
Africa’s international credit ratings since the first official ratings were issued in 1994. It has also drawn
warm praise from experts on fiscal policy. Tanzi (2004: 539), for example, recognised this in an article
about episodes of successful fiscal reform:
Outside of the Americas, South Africa merits a mention because … it has followed, in recent years, a
steady path towards fiscal adjustment, trying to use its public resources sparingly and efficiently and
creating an efficient tax system while resisting the temptation of magic solutions. The country has
managed to reduce its fiscal deficit by about five to six per cent of GDP over the past decade through a
careful reallocation of spending and tax reform …
The stated fiscal policy stance became more expansionary after 2001. A major aim of this stance has been to
raise the growth rate of the South African economy through investment in social services and the country’s
physical infrastructure. The data do not reflect the more expansionary fiscal stance fully, however, because
government revenue regularly exceeded budget forecasts and kept the budget deficit below 2,5% of GDP.
Assisted by relatively brisk economic growth, these modest budget deficits reduced the public debt ratio
further to 29,0% of GDP on 31 March 2007. The fiscal authorities also succeeded in eliminating
government dissaving: whereas general government current expenditure exceeded general government
current income by 7,3% of GDP in 1992 (the extent of dissaving, in other words), general government
saving amounted to 1,2% of GDP in 2006 and 2,4% of GDP in 2007. The longer-term perspective provided
by Table 1.1 (Chapter 1) further amplifies the significance of the fiscal consolidation between the middle of
the 1990s and the first half of the 2000s, during which time the share of public sector resource use and
public sector resource mobilisation in the economy decreased significantly from the average levels
recorded for the period 1990–1994. No wonder that, in an analysis of fiscal consolidation between 1990
and 2014, it was found that government expenditure and not revenue was the fiscal factor that adjusted to
restore fiscal sustainability during periods of rising debt (see Burger & Calitz, 2014). This curtailment of
the longer-term growth of government is remarkable in that it occurred after the country’s constitutional
change and its adoption of constitutional social rights in recognition of all human rights. This expenditure
pattern actually contradicts some theories of public sector growth, which predict that the share of public
spending in national income is likely to increase in countries with unequal income distributions if lower-
income groups receive voting rights.24 Section 18.3.4 discussed the recent world-wide revival of interest in
the cyclical effects of fiscal policy and Section 18.4 looked at the momentum gained by fiscal activism in
response to the international financial crisis of 2007–2009. South Africa has been no exception in this
regard: of late, several researchers have attempted to estimate the size of the automatic fiscal stabilisers and
to establish how fiscal policy has affected the stability of the macroeconomy since 1994. The automatic
stabilisers in South Africa appear to be of the order of 0,5% of GDP (Du Plessis & Boshoff, 2007: 10;
Swanepoel & Schoeman, 2003: 813). This suggests that these stabilisers exert a modest, but by no means
negligible, influence on fluctuations in economic activity. The findings of efforts to determine whether
fiscal policy has been pro-cyclical or anti-cyclical since 1994 have been sensitive to the empirical methods
employed, but a careful analysis of the evidence (Du Plessis, Smit & Sturzenegger, 2007) concluded that
fiscal policy had not significantly affected the stability of economic activity in South Africa since 1994.25
Up to the time of the international financial crisis of 2007–2009, the approach followed by the fiscal
authorities in South Africa was largely reminiscent of the view that regards monetary policy as a more
potent instrument for stabilisation policy than fiscal policy. Attempts to ‘fine tune’ the level of economic
activity by means of fiscal policy (in other words, active fiscal policy) was therefore generally avoided.
This did not mean, however, that the fiscal authorities were ignoring the cyclical state of the economy or
the need for mutually supportive fiscal and monetary policy stances when formulating the budget. A clear
example of this approach was the inclusion of estimates of the structural budget balance in the 2007
Medium-Term Budget Policy Statement (National Treasury, 2007d) and the 2008 Budget Review (National
Treasury, 2008a). The 2007 Medium-Term Budget Policy Statement (National Treasury, 2007d: 3)
commented as follows on these matters:
Fiscal policy over the past few years has increasingly taken account of the economic cycle. Government
revenue performance fluctuates in response to economic fortunes, influenced in turn by the economic
performance of our major trading partners, commodity prices, interest rate cycles, inflation trends and
business profitability. These are complex factors that affect the economy and tax revenue in ways that
cannot be fully modelled or predicted. In the face of potentially destabilising cyclical factors, it is
important to adopt a policy stance oriented towards stable long-term growth.
In this MTBPS, the National Treasury introduces the concept of a structural budget balance as a
contribution to more systematic and consistent adaptation of the fiscal stance to cyclical factors. Simply
put, when economic conditions are good, as they are now, we must invest and save in a manner that
allows us to maintain public spending and societal welfare when economic conditions turn less
favourable, as they inevitably will.
The 2008 Budget Review (National Treasury, 2008a: 42) contains a clear example of how the fiscal
authorities use estimates of the structural (or cyclically adjusted) budget balance to inform policy decisions:
The 2008 Budget takes account of a more unsettled global economic environment. While total revenue
growth is expected to moderate in line with economic activity, strong commodity prices are generating
robust tax revenues from the mining sector. As a result, the cyclical element of tax revenue remains
significant. Taking these factors into account, government is budgeting for a fiscal surplus, which keeps
the cyclically adjusted budget balance from deteriorating. By saving a share of the cyclical revenue, the
fiscus is protected from cyclical and external volatility, and ensures that the state does not contribute to
pressure on inflation and the current account deficit.
Some commentators criticised the authorities for budgeting for a surplus in the 2008/09 financial year,
arguing that it would have been better to increase government spending further to address various social
needs. The quoted statement, however, confirms that contemporary views of the macroeconomic role of
fiscal policy in South Africa and elsewhere attempt to balance short-term considerations and the ever-
present longer-term issue of the sustainability of the public finances.
The fiscal surplus turned out to be a blessing in disguise. As indicated earlier, at the start of the
international financial crisis South Africa was one of the developing countries that was able to utilise its
fiscal space to counter the ensuing recession with active fiscal policy measures, without running the same
fiscal sustainability risk experienced by some industrial countries. In 2010/11, however, the fiscal surplus
did turn into a deficit equivalent to 5,3% of GDP. This was the outcome of reduced revenue and the
maintenance of medium-term expenditure patterns on economic and social services, but was also reflective
of a structural budget deficit. At the same time, the government committed itself to a process of fiscal
consolidation. The 2011/12 budget envisaged a reduction of the deficit–GDP ratio to 3,8% in 2013/14. The
fiscal consolidation turned out to have been less successful than in comparable emerging market
economies: in fact, the reality that the debt–GDP ratio in South Africa had increased faster than in peer
emerging market countries had become a matter of concern.
A more comprehensive assessment of fiscal sustainability requires that trends in the government budget
deficit and public debt be considered together with public assets, that is, to take account of trends in the
balance sheet of government. In this regard Burger, Calitz & Siebrits (2016) concluded that one sensible
way to restore fiscal sustainability might be to stabilise the debt–GDP ratio at its post-crisis level but by
way of the substitution of much-needed infrastructure capital expenditure for current expenditure. This will
entail a reversal of the falling fixed capital–GDP ratio, which would be a positive impetus for economic
growth.
18.6.2 The fiscal policymaking framework in South Africa

South Africa has adopted two institutional innovations in monetary policy after 1994: constitutional
protection of the independence of the central bank (1996) and inflation targeting (2000). The South African
fiscal authorities have implemented multiyear expenditure planning, but have not committed themselves to
numerical fiscal rules enshrined in legislation (yet). As indicated in Section 18.5, however, rules are
growing in popularity in other countries and it is therefore likely that they will remain under consideration
in South Africa.
South Africa has not used formal numerical fiscal rules since 1976, when the dual-budget system that
had been in use since 1910 was abolished. Under this system, the authorities had to finance current
spending from tax and other current revenues via the Revenue Account and capital spending from loans via
the Loan Account. Its purpose was to maintain current balance, that is, equality between the current
revenues and current expenditures of government (the principle of current balance is sometimes called the
‘golden rule of fiscal policy’). We pointed out earlier that the South African authorities have adopted
annual or medium-term fiscal targets from time to time in recent years to give effect to the more structural
approach to fiscal policy. These targets, however, never achieved the status of formal numerical rules.
From 1985 until the mid-1990s, fiscal policy in South Africa was guided by a 3% deficit guideline. This
guideline had no theoretical basis and proved to be ineffective when the budget deficit rose sharply during
the early 1990s. In 1995, the post-apartheid government embarked on the very successful fiscal adjustment
effort that was discussed in Section 18.6.1. This effort was guided by the goals of the GEAR strategy. The
GEAR goals were pursued in a flexible manner, as became apparent when the timeframe for reaching the
3% deficit goal was extended by one year when the Asian crisis of 1997/98 precipitated an economic
downswing. With the exception of a central bank borrowing rule and constitutional restrictions in the inter-
governmental fiscal system, there were no permanent restrictions on fiscal policymaking during the
adjustment.26 More recently, the fiscal authorities introduced nominal expenditure ceilings in the 2014/15
budget. The ceilings are not fully fledged numerical rules, however, because they lack a legal basis and
enforcement mechanisms.
From 1998 onwards, the South African government adopted various measures to make fiscal
policymaking more transparent. The overarching framework for this endeavour is the Public Finance
Management Act (PFMA) of 1999. The Act does not put limits on the absolute or relative values of fiscal
aggregates, that is, it does not prescribe numerical fiscal rules. Instead, it aims to address the accountability
dimension of fiscal transparency by emphasising regular financial reporting, sound internal expenditure
controls, independent audit and supervision of control systems, improved accounting standards and training
of financial managers, and greater emphasis on outputs and performance monitoring. The Act also compels
the South African fiscal authorities to disclose their longer-term objectives and views about future trends in
fiscal policy annually. The introduction of the Medium-Term expenditure Framework (MTEF) in 1998/99
gave effect to Article 28 of the PFMA. Hence, South Africa’s current fiscal policymaking framework is
very similar to the transparency-based ones discussed in Section 18.5.2.
Both regimes that have been used since 1994 (target-guided discretion from 1994 to 1998 and
transparency-based discretion since then) have worked well. The successful completion of the fiscal
adjustment effort in 2001 and the maintenance of fiscal discipline thereafter were made possible primarily
by the fiscal authorities’ strong commitment to fiscal prudence. However, the flexibility of these regimes
proved useful in a turbulent milieu marked by, inter alia, political democratisation, strong popular pressure
for more expansionary policies and three currency crises (1996, 1997/98 and 2001). Their discretionary
nature was not a drawback from a credibility point of view. The authorities have earned considerable
credibility for themselves and the regime, having established an enviable reputation for maintaining fiscal
discipline. In fact, Frankel, Smit and Sturzenegger (2006: 71) suggested that the degree of credibility
enjoyed by the South African fiscal authorities at the time made fiscal rules unnecessary:
South African authorities have worked hard to earn credibility which has the benefit of allowing some
margin of discretion. What would then be the logic of constraining themselves with fiscal rules which
are just bound to be violated when shocks require the use of discretion?
The excellent reputation of the fiscal authorities until the international financial crisis was also evident from
South Africa’s relatively good international credit ratings, which improved consistently since the first
official ratings were conducted in 1994. These considerations suggest that there was no compelling reason
why South Africa should have adopted numerical fiscal rules. Rules were unlikely to have added credibility
benefits over and above those already enjoyed by policymakers and the transparency-based regime,
especially if it is taken into account that rules as such could not have constrained future generations of
policymakers. Moreover, the adoption of numerical rules would have denied policymakers the valuable
flexibility that they have used wisely – until recently at least. However, the high fiscal cost of social
security benefits such as the proposed national health insurance system will, if implemented, be a far
greater challenge to fiscal discretion and might well strengthen the case for fiscal rules in future. This is one
of the reasons why fiscal sustainability has become a matter of concern in the aftermath of the international
financial crisis and the ensuing Great Recession. Counter-cyclical fiscal policy resulted in the ratio of
public debt to GDP rising rapidly from 26,5% in 2007/08 to 43,9% in 2013/14. The ratio subsequently
increased further to 55,6% in 2018/19 (National Treasury, 2019a: 215). South Africa’s international
sovereign credit was downgraded in 2012 by both Moody’s and Standard and Poor’s, the most prominent
rating agencies, but the country did retain its investment-grade rating (National Treasury, 2014a: 66).27
Subsequently matters deteriorated further, however, as was reported earlier with reference to the country’s
downgrading to below investment grade.
As mentioned earlier, the fiscal authorities’ increasing concerns caused National Treasury to already
introduce rolling cash ceilings for nominal main budget expenditure in 2012. The ceilings are ‘soft rules’
that lack a legal basis and enforcement mechanisms. The rules have worked well from an accounting point
of view: Main budget spending has remained below the ceiling in every year from 2012/13 onwards
(National Treasury, 2015a: 117; National Treasury, 2016: 32). Yet this achievement did not prevent the
upward trend in the government expenditure–GDP ratio, relatively large budget deficits and persistent
growth in the public debt–GDP ratio. With the benefit of hindsight, it is clear that the ceilings were too high
to compensate for the effects of the anaemic rate of GDP growth on government revenue as well as the
government spending–GDP ratio.
18.7 Fiscal reforms in sub-Saharan Africa 28
Many of the fiscal issues with which South Africa has been grappling also feature on the fiscal agendas of
other countries in sub-Saharan Africa. The public finances of most sub-Saharan African countries are
inherently fragile as they have narrow revenue bases and government spending is under great pressure.
During the 1970s and 1980s, policy mistakes and global economic developments rapidly destabilised the
vulnerable fiscal systems of many sub-Saharan African countries. Since then, efforts to correct these
imbalances and to prevent them from re-emerging have dominated fiscal policymaking in the region. When
assessing fiscal trends in sub-Saharan Africa, one should keep in mind that this part of Africa consists of 48
countries whose fiscal situations and structures differ in many respects. Generalisation is always risky.
Several broad shifts are nonetheless taking place. We highlight a few positive developments.
• Budget balances have improved in many countries, especially from the mid-1990s onwards. It appears as
if the trend toward lower budget deficits in sub-Saharan Africa mainly reflects expenditure cutbacks
rather than revenue increases. Even in 2009, during the Great Recession, national government budget
balances in 27 (about half) of the African countries were better than –3% of GDP. By 2013, this ratio
had worsened slightly, with the average budget balance for all African countries amounting to a
comparatively modest –3,3% of GDP (African Development Bank, 2016). A considerable number of
sub-Saharan African countries have reduced their dependence on taxes on international trade, partly
because these taxes distort prices and partly to comply with World Trade Organization agreements. A
number of countries recouped the lost revenue by introducing value-added tax. Countries in all parts of
sub-Saharan Africa now use this high-yielding and relatively non-distorting tax. Reductions in income
tax rates have been common and many countries have successfully broadened their tax bases and/or
improved tax collection. Of the thirteen countries for which data was available for the period 1987 to
2002, eleven countries reduced their highest marginal income tax rates on individuals and twelve
countries reduced their highest rate on corporations. More recently (in 2006), Egypt and Mauritius
reduced their highest marginal income tax rates, from 34% to 20% and from 30% to 15% respectively
(Global Finance, 2019). Reductions in corporate tax rates continued to occur: in 2008/09, rates were
reduced in Benin (from 38% to 30%), Cape Verde (from 30% to 25%), Sudan (from 30% to 15%) and
Togo (from 37% to 30%) (World Bank & PriceWaterhouseCoopers, 2010). The impact of the Great
Recession subsequently put a damper on corporate tax reductions. The only country registering a major
tax reduction was Zimbabwe, whose highest marginal corporate tax rate was reduced from about 31%
to about 26% between 2010 and 2012 (Global Finance, 2014).
• Factors such as faster economic growth, accelerated debt relief and smaller fiscal deficits have reduced the
debt burdens of a number of sub-Saharan African countries. The resulting reduction in the interest
burdens of these countries has released budgetary resources for more productive ends. In contrast to the
1980s, the norm during the 1990s was no longer to reduce public investment sharply when fiscal
problems occur. This, together with indications that government spending on education and healthcare
generally did not fall nearly as much during reform periods as is often claimed by critics of structural
adjustment, suggests that government-spending priorities have improved in many sub-Saharan African
countries. Before the international financial crisis, public finances in a number of countries (for
example, Mozambique, South Africa, Tanzania and Uganda) were on a much sounder footing than a
decade earlier, and they were in a better position to promote growth, efficient resource allocation, and
the reduction of poverty and inequality. Empirical evidence indicates, however, that fiscal policy
instruments are often pro-cyclical (and practically never counter-cyclical [Carmignani, 2010]). The
average fiscal balance for African countries during 1986–1990 amounted to –7,5%, which improved to
2,6% during 2004–2008. The subsequent weakening of the economies together with stimulus packages
caused fiscal balances in Africa to deteriorate on average by around 6,5 percentage points of GDP, that
is, from a surplus of 2,2% of GDP in 2008 to a deficit of 4,4% of GDP in 2009, thus mitigating the
downturn of aggregate demand.29
The fiscal challenges nonetheless remain formidable. Narrow tax bases and underdeveloped financial
markets still make many African countries highly dependent on grants and foreign borrowing as sources of
financing for government spending. Spending pressures and susceptibility to external shocks remain high,
and the gains of the recent past are therefore fragile. Moreover, governance and service delivery challenges
remain acute, as was affirmed by the findings of a survey commissioned by the United Nations Economic
Commission for Africa (2004). The international financial crisis of 2007 and beyond has revealed that
policymakers’ room to manoeuvre in fragile countries in sub-Saharan Africa is limited in periods of crisis
because of low fiscal space and limited institutional capacity (Allen & Giovannetti, 2011). In African
countries, successful fiscal consolidations were achieved using discretionary fiscal regimes (for example, in
South Africa) or regimes bound by conditionalities of the Bretton Woods institutions.
Key concepts
• active or passive fiscal policies (page 405)
• automatic or built-in stabiliser (page 403)
• budget-process rules (page 426)
• common-pool problem (page 430)
• contractionary (fiscal) policy (page 411)
• conventional balance (page 406)
• crowding out (page 410)
• current balance (page 437)
• cyclically adjusted budget balance (page 416)
• decision lag (page 408)
• discretionary policy (page 428)
• dissaving (page 407)
• expansionary (fiscal) policy (page 411)
• fiscal activism or anti-cyclical fiscal policy (page 403)
• fiscal consolidation (page 421)
• fiscal councils (page 426)
• fiscal discretion (page 428)
• fiscal illusion (page 412)
• fiscal policy (page 398)
• fiscal policymaking framework (page 426)
• fiscal responsibility laws (page 426)
• fiscal solvency (page 422)
• fiscal sustainability (page 422)
• fiscal transparency (page 430)
• full-employment income budget balance (page 416)
• impact lag (page 409)
• implementation lag (page 409)
• Keynesian approach (page 403)
• macroeconomic goals of fiscal policy (page 399)
• macro instruments (page 401)
• market discipline (with reference to fiscal policymaking) (page 430)
• medium-term expenditure frameworks (page 426)
• microeconomic goals of fiscal policy (page 400)
• multiplier (page 405)
• National Treasury (page 402)
• net borrowing requirement (page 406)
• net indebtedness (page 407)
• numerical fiscal rules (page 426)
• ordinary revenue (page 407)
• output gap (page 417)
• potential-income budget balance (page 416)
• primary balance (page 407)
• primary deficit (page 407)
• primary surplus (page 407)
• procedural fiscal rules (page 426)
• Public Finance Management Act (page 399)
• public sector borrowing requirement (page 406)
• rational expectations hypothesis (page 428)
• recognition lag (page 408)
• Ricardian equivalence (page 403)
• sectoral goals of fiscal policy (page 399)
• sectoral or micro instruments (page 401)
• stagflation (page 413)
• structural approach to fiscal policy (page 414)
• structural budget balance (page 416)
• supply-side economists (page 413)
• total revenue (of government) (page 406)
• transparency-enhancing reforms (page 430)
• trend-line budget balance (page 416)
SUMMARY
• Fiscal policy are decisions by national government regarding the nature, level and composition of
government expenditure, taxation and borrowing, aimed at pursuing particular goals. It has an active
and a passive element.
• Fiscal policy has macro, sectoral and micro goals and instruments. Fiscal policy is not a panacea for all
economic problems. Monetary policy, trade and industrial policy, competition policy and labour policy
are important allies, and some are more effective than others in pursuing particular goals.
• The Minister of Finance is the key figure in fiscal policy and is given certain statutory powers by acts of
parliament. Various supporting institutions exist, notably the National Treasury, whose policymaking
role is undertaken in close coordination and cooperation with the South African Reserve Bank.
• The final approval of the annual budget occurs by way of a law of parliament, the watchdog of the public
purse. Two recent reforms have strengthened the oversight role of parliament.
• Mainstream views on the macroeconomic role of fiscal policy have changed significantly over time. The
Keynesian approach dominated thinking for three decades after World War II, following which new
classical and structural views gained supremacy. Keynesian thinking regained some credibility during
and after the international financial crisis of 2007/08. The passive (automatic stabilisers) and active
dimensions are explained in Figures 18.1 and 18.2.
• Different budget balances are used in the planning, implementation and assessment of fiscal policy,
namely the conventional, current and primary balance. These and other related concepts are explained
in Box 18.1. Sometimes cyclically adjusted balances are calculated to analyse the underlying or
structural balance, which is important for long-term fiscal sustainability.
• There are three reasons why anti-cyclical fiscal policy is deemed ineffective. Firstly, it entails various
stages, each with its own delays or time lags, namely the recognition, decision, implementation and
impact lag. Secondly, there is the possibility that an expansionary fiscal policy will push up interest
rates and in this way crowd out private investment. This dampens the multiplier effect of a fiscal policy
stimulus. Thirdly, new classical macroeconomists argue that private agents would anticipate systematic
counter-cyclical policies and respond to them in ways that neutralise their intended effects. The
tendency of governments to apply popular expansionary measures eagerly during economic recessions,
but not to reverse these measures symmetrically during upswings, revealed a further operational
shortcoming, as pointed out by public choice economists. This tendency contributes to increases in the
share of government in the economy and to rising public debt ratios.
• Supply-side economists and proponents of the structural approach to fiscal policy have voiced opposition
to fiscal policy activism. The latter puts more emphasis on the current and future sustainability of fiscal
policy, and how the financing of budget deficits is likely to influence the economy. This approach
leaves room for passive anti-cyclical fiscal policy to the extent that automatic stabilisers are effective.
• The international financial crisis kindled a renewed interest in Keynesian activism, but many economists
still maintain that, except perhaps in most extreme situations, monetary policy is a better tool for
stabilisation purposes. There are two reasons for the tentative comeback of fiscal policy: owing to lower
inflation, automatic fiscal stabilisers became more effective and monetary policy lost its effectiveness
once interest rates approached the zero bound. This, in turn, was countered by quantitative easing.
• The importance of distinguishing between cyclical and structural budget balances is explained with
reference to Figure 18.3. The distinction can help policymakers to avoid errors, a typical example of
which is taking long-lasting decisions on taxes and expenditures based on transitory movements in
revenues.
• The fiscal consequences of the international financial crisis are explained with reference to Tables 18.1
and 18.2. It illustrates the difference between countries with structural deficits and surpluses, and the
countries’ big differences in the ratio to GDP of primary balances and public debt. What made the
choice of fiscal measures so problematic was the uncertainty about the nature and depth of the crisis,
the likely duration of the economic downswing, the reaction time to and strength of different
stimulatory measures, and the difficult trade-off between short-term fiscal stimulation (with the
associated higher deficit and debt levels) and longer-term fiscal sustainability (associated with lower
deficits and debt levels). One set of authors concluded that an optimal fiscal policy package should be
timely, lasting, diversified, contingent, collective and sustainable. They then argued that spending
increases as well as targeted tax cuts and transfers were likely to have the largest multipliers.
• Fiscal sustainability, as explained in Box 18.2, refers to a government’s continued ability to service its
debt (in other words, pay the interest on its domestic and foreign debt timeously) and repay the loan
amount (principal) when it becomes due. It should be distinguished from fiscal solvency. Fiscal
sustainability remains a somewhat elusive concept because it depends on assumptions about future tax
compliance and government expenditure discipline, and the projected output gap, that is, the difference
between the actual and potential GDP.
• The mixed track record of discretionary fiscal policy has resulted in the adoption by industrial and
developing countries of fiscal rules, which are permanent restraints on fiscal policy, typically defined in
terms of indicators of overall fiscal performance such as expenditure, current balances, overall balances
or public debt. Fiscal rules are discussed as one of four elements of fiscal frameworks. Fiscal rules
essentially have a negative purpose, namely to prevent policymakers (who allegedly cannot be trusted
to do the right thing) from lapsing into fiscal profligacy.
• Proponents of fiscal rules argue that the adoption of these rules represents a credible commitment to sound
policies that should lessen or solve the credibility problem in a rational expectations world. This needs
to be distinguished from binding constraints on fiscal policy. There are, however, two main reasons
why governments find it relatively easy to circumvent, ignore, suspend or abandon fiscal rules: all rules
are subject to sovereign political authority and policymakers have only limited control over fiscal
outcomes. It is therefore argued that the rational economic agents postulated by modern
macroeconomic theory would recognise the fragility of rules and not regard rules-based commitments
as credible.
• Two other criticisms of rules have been raised. Firstly, rules may force governments to adopt ultra-
conservative forecasting and budgeting techniques that result in excessively contractionary fiscal
outcomes or to undertake undesirable forms of tax increases and expenditure cuts. Secondly, neither
economic theory nor experience provides a basis for adopting rules that transcend business cycles and
structural economic changes for long periods.
• Some fiscal policy experts believe that transparency-enhancing reforms are more effective than fiscal rules
to make fiscal policies credible. Their greater flexibility gives them a major advantage over rules-based
regimes (especially to policymakers who are strongly committed to prudent fiscal policies and who
therefore do not need binding by rules). Another advantage is their superior ability to strengthen the
effectiveness of market discipline over fiscal policymakers. This refers to the speed with which the
markets punish fiscal laxness by suspending lending, withdrawing capital and increasing risk premiums
on borrowed funds.
• Adopting rules may well be useful when a new government without a record of accomplishment wishes to
signal its commitment to sound fiscal policies.
• There is a sense in which rules and discretion meet each other. Discretion with increased transparency and
accountability (and the underlying institutional reforms to correct for destabilising incentives on the
side of policymakers) amounts to constrained flexibility. Rules with escape clauses or rules specifying
medium-term boundaries or constraints to be met over the course of the business cycle amount to
flexible constraints.
• A fairly recent institutional development complementing rules and adding to transparency has been the
establishment of fiscal councils. A fiscal council typically consists of a group of independent experts
with designated responsibilities to analyse and comment publicly on fiscal policy. Three types are
distinguished. Their ability to strengthen the effectiveness of numerical rules depends on their degree of
independence, their remits and the status of their forecasts.
• Medium-term fiscal or expenditure planning is essential in industrial and developing countries from a
macro, sectoral and microeconomic point of view. South Africa’s medium-term budget policy
statement (MTBPS) (published annually since November 1997) is an example of this type of planning.
• Fiscal policy in South Africa continued to reflect aspects of Keynesian thinking well into the 1980s,
although there were earlier signs of abandoning it in favour of longer-term fiscal planning. The longer-
term focus emphasised fiscal discipline, which the authorities regarded as a prerequisite for improving
the longer-term growth and job creation potential of the South African economy. During the 1990s, the
focus on fiscal discipline and other structural aspects of fiscal policy was closely associated with the
stabilisation or even the reduction of the public sector’s claim on resources, including the total pool of
savings.
• The period from 1989 to 1995 saw a marked deterioration in the overall fiscal situation: a sharply rising
budget deficit and public debt, with fears of a debt trap. Analysts were more worried about the growth
in the public debt than about its level. The situation was also the first test of the democratic
government’s commitment to fiscal discipline. From a fiscal policy point of view, the two most
important goals of GEAR were to turn the deteriorating fiscal situation around and to quell fears about
the democratic government’s perceived lack of commitment to fiscal prudence. The post-apartheid
government succeeded with both and was credited for achieving fiscal sustainability in a transparency-
based discretionary manner (in other words, without numerical fiscal rules). The Public Finance
Management Act of 1999 played an important role in this regard.
• However, fiscal sustainability in South Africa has become a matter of concern for various reasons in the
aftermath of the international financial crisis and the ensuing Great Recession.
• The public finances of most sub-Saharan African countries are inherently fragile as they have narrow
revenue bases and government spending is under great pressure. During the 1970s and 1980s, policy
mistakes and global economic developments rapidly destabilised the vulnerable fiscal systems of many
sub-Saharan African countries. Since then, efforts to correct these imbalances and to prevent them from
re-emerging have dominated fiscal policymaking in the region. A few positive developments are
highlighted.
• The international financial crisis has revealed that policymakers’ room for manoeuvring in fragile
countries in sub-Saharan Africa is limited in periods of crisis because of low fiscal space and limited
institutional capacity. In African countries, successful fiscal consolidations were achieved using
discretionary fiscal regimes (for example, in South Africa) or regimes bound by conditionalities of the
Bretton Woods institutions.
18.1 Which of the following is a macroeconomic instrument of fiscal policy?
a. The bank rate
b. The excise tax rate on tobacco products
c. A government subsidy on white bread
d. The primary budget balance
e. All of the above options are correct.
18.2 The primary budget balance is equal to …
a. total government revenue minus total government expenditure.
b. the conventional budget balance plus interest expenditure.
c. the conventional budget balance minus interest expenditure
d. the conventional budget balance plus capital expenditure.
18.3 The following statement best describes Keynesian thinking on fiscal policy:
a. In total, the conventional budget balances should be equal to zero over the course of the business
cycle.
b. The structural deficit should equal government dissaving.
c. The cyclically adjusted conventional budget balance should always be zero.
d. Automatic stabilisers are an important instrument of active fiscal policy.
18.4 Empirical research indicates that the best way to restore fiscal sustainability is by …
a. increasing the personal income tax rates.
b. reducing public investment.
c. issuing new government bonds.
d. reducing the government wage bill.
18.1 ‘The conventional budget deficit is superior to other definitions of budget deficit as a measure of the
stance of fiscal policy.’ Do you agree? Explain your answer.
18.2 ‘Owing to lags, fiscal policy is irrelevant.’ Do you agree with this statement? Substantiate your answer.
18.3 Use a diagram to explain the distinction between automatic fiscal stabilisers and active fiscal policies.
18.4 How would you know that a government was serious about ensuring fiscal sustainability?
18.5 Discuss the structural approach to fiscal policymaking.
18.6 Discuss the advantages and disadvantages of numerical fiscal rules. Is fiscal policy in South Africa
driven by rules or discretion? Substantiate your answer.
ESSAY QUESTIONS
18.1 Discuss the principles of Keynesian anti-cyclical fiscal policy and the reasons for its fall from favour
since the mid-1970s.
18.2 Use a diagram to explain the distinction between automatic fiscal stabilisers and active fiscal policies.
18.3 Why did the Keynesian approach to fiscal policy lose its appeal during the 1970s, and then regain some
attractiveness during and after the Great Recession?
18.4 Use a diagram to explain the distinction between the structural and the cyclical components of budget
balances, and discuss the practical significance of this distinction.
18.5 Discuss the difference between binding constraints and commitment devices in fiscal policy. Which of
them will best serve credible fiscal policymaking and why?
1 The economic impact of some of these taxes is largely limited to a particular sector or a limited number of sectors in the economy
(for example, the excise tax on tobacco, the levy on plastic bags or the mining tax). Others such as value added tax, the fuel tax
and income tax on individuals and companies, exert their influence throughout the economy. Changes in these taxes may
therefore affect the macroeconomic performance of the country.
2 Section 77 of the Value Added Tax Act (Act 89 of 1991) authorises the Minister to make such adjustments, with the proviso that
Parliament has to legislate this within six months after notification.
3 For more information, visit the following website: http://www.resbank.co.za.
4 For more information, visit the following website: http://www.treasury.gov.za.
5 Section 12.4 in Chapter 12 introduced the notion of automatic stabilisers.
6 This framework was adapted from El-Khouri (2002: 213–215).
7 An analysis of the difference between actual and budgeted figures in South Africa for the period 2000/01–2010/11 found that the
margin of forecast error in respect of each of revenue, expenditure and GDP had been quite big at times (Calitz, Siebrits &
Stuart, 2013). The authors pointed out that fiscal credibility would be severely tested if such errors were to coincide in any
particular year.
8 Incidentally, taxation through inflation as a result of bracket creep, which was discussed in Chapter 13 (Section 13.4.4), falls in the
same category.
9 In 1903, the Italian fiscal economist, Amilcare Puviani, recognised that the existence of fiscal illusion or the potential for its
establishment would enable or ensure the continued tax financing of growing demands for public goods.
10 Quantitative easing (QE) is an unconventional monetary policy whereby central banks stimulate the economy when standard
monetary policies (notably interest rate measures) have become ineffective. It entails buying specified amounts of financial
assets from commercial banks and other private institutions, thus increasing the monetary base and lowering the yield on those
financial assets. This is distinguished from the more usual open-market policy of buying or selling government bonds in order
to keep inter-bank interest rates at a specified target value. Three rounds of QE took place in the US: in 2008, 2009 and 2011.
11 The United States and the United Kingdom implemented large fiscal stimulus packages. Blinder and Zandi (2010) reported that
the United States was to spend close to $1 trillion (roughly 7% of GDP) on fiscal stimulus. Note from Table 18.1 that both the
UK and the US had substantially higher debt–GDP ratios in 2009 than in 2006 and that both countries experienced further
increases since then. By comparison, the South African ratio was still falling by 2007 and had increased to only 30,1% in 2009.
12 The contents of this box comes from Calitz and Siebrits (2018: 1–4).
13 Even though earlier in this chapter a definition of successful fiscal consolidation was offered, definitions differ from author to
author. A consensus view has not emerged.
14 According to Sundaram and Chowdhury (2016), the historical experiences of Eurozone and other economies suggested that the
probability of successful fiscal consolidation is low. Factors that affected the probability of success included global business
cycles, monetary policy, exchange rate policy and structural reforms.
15 This section draws on parts of Siebrits and Calitz (2004b) and Siebrits (2018). These writings contain references to many
important publications on fiscal policymaking frameworks.
16 Various spillover and other effects provide a rationale for the adoption of fiscal rules in a regional bloc (such as the European
Union). It could also be argued, however, that rules are credibility-enhancing devices that reflect the commitment of the
member states to economic integration.
17 Fiscal rules did however seem to retain their value as points of fiscal responsibility to which countries should return by
implementing medium-term fiscal consolidation measures, albeit within time frames varying greatly across countries.
18 Australia, New Zealand and the United Kingdom pioneered the adoption of transparency-enhancing measures aimed at making
fiscal policy-makers more accountable. The fiscal frameworks of these countries do not prescribe specified numerical targets,
but require the fiscal authorities to disclose their fiscal objectives regularly. The objectives may or may not take the form of
quantitative targets. Section 18.6.2 shows that South Africa’s current fiscal policymaking framework also focuses on the
notions of transparency and accountability.
19 This section draws on Calitz and Siebrits (2003), Siebrits and Calitz (2004b) and Burger, Calitz and Siebrits (2016).
20 The shift to supply-side factors is in line with the thrust of new growth theory, which argues that growth-promoting capital
formation is not limited to investments in privately owned physical capital (for example, factories and machinery). New growth
theory indicates that additions to any of the following components of the capital stock may yield increasing returns by creating
externalities that benefit a range of sectors and industries: the existing physical infrastructure (for example, roads and electricity
networks), accumulated human capital acquired through education, training and healthcare, and technical expertise acquired
through learning-by-doing and research and development (see Section 7.6 of Chapter 7). These kinds of measures obviously are
important ingredients of any attempt to improve a country’s international competitiveness.
21 Some of this high debt reflected the consolidation of subnational regional debt, which, together with the new Provincial
Government Borrowing Act, laid the basis for much more prudent subsequent borrowing. Also the proper (full actuarial)
funding of the government employees’ pension funds (GEPF) removed a potential future contingent liability. (During 2018,
however, it became apparent from the actuary’s report on the GEPF that the fully funded status has come under threat.) The
funding status nevertheless needs to be taken into account when comparing South Africa’s debt–GDP ratio to that of countries
with underfunded, pay-as-you-go pension funds. The debt–GDP ratios of such countries would be higher if the actual pension
liabilities are taken into account as well. For more on this, see Calitz, Du Plessis and Siebrits (2011).
22 This impression of counter-cyclical fiscal policy is not borne out by econometric analysis of the pattern over longer periods.
Various studies have found fiscal policy to be pro- rather than counter-cyclical. Swanepoel and Schoeman (2003) found that
fiscal policy was strongly pro-cyclical between 1986 and 2000. Burger and Jimmy (2006) also found that fiscal policy was pro-
cyclical between 1975 and 2004.
23 For an assessment of fiscal policies post South Africa’s political transition, see Ajam and Aron (2007).
24 This is the main line of argument developed by Meltzer and Richard (1981); see Section 7.4.2 of Chapter 7.
25 Nonetheless, Du Plessis, Smit and Sturzenegger (2007) found that fiscal policy itself was pro-cyclical between 2002 and 2006.
26 Section 13(f) of the South African Reserve Bank Act of 1989 (as amended) prohibits lending to the South African government.
27 One of the reasons for the downgrades was the ‘(s)hrinking headroom for counter-cyclical policy actions, given the deterioration
in the government’s debt metrics since 2008, the uncertain revenue prospects and the already low level of interest rates’
(Moody’s Investors Service, 2012).
28 This section draws on Calitz and Siebrits (2007).
29 For this and other information on the past trends and economic outlook of African economies, see African Economic Outlook
(African Development Bank, 2014).
Fiscal federalism
Tania Ajam
The aim of this chapter is to study the rationale for fiscal federalism and the nature of inter-governmental
fiscal relations from an efficiency and equity perective, with particular reference to the South African
context.
We start by examining the economic rationale for fiscal decentralisation as opposed to the arguments for
fiscal centralisation. This is followed by an explanation of the considerations on which the assignment of
tax powers and expenditure functions to sub-national governments are based. Next we discuss tax
competition and tax harmonisation as well as borrowing powers and debt management at sub-national
level, before proceeding with an analysis of different kinds of inter-governmental grants. The chapter
concludes with an overview of inter-governmental fiscal issues within the spheres of provincial and local
government in South Africa.
explain why sub-national governments exist at all, and compare the merits of fiscal decentralisation and
centralisation
describe the Tiebout model
describe the assignment of expenditure functions and revenue sources (tax powers) to the national, provincial and
local spheres of government in South Africa
distinguish between tax competition and tax harmonisation
explain the reasons for, and the nature of, inter-governmental grants
list the types of inter-governmental grants
explain the issues that surround borrowing powers and debt management at sub-national level
review the role of the South African Financial and Fiscal Commission (FFC) in sharing revenue across the three
spheres of government
explain how economies of agglomeration contribute to the existence and growth of cities
discuss trends and issues in provincial and local government financing in South Africa.
19.1 The economic rationale for fiscal decentralisation

In Chapter 1, we introduced the concept of general government (Figure 1.1). This concept signifies that
governments typically consist of more than one level. That is, there may be provincial or local tiers of
government in addition to national government.
The term ‘sub-national government’ (in other words, provincial and local government) refers to those
levels of government that have smaller geographic jurisdictions compared to the national government.
National government’s jurisdiction would, of course, extend to the whole country, whereas the jurisdiction
of a municipality, for instance, would only be within the borders of that particular municipality. In some
countries, provincial governments are called state or regional governments, and the national government is
called the central or federal government. The local tier of government typically consists of several
municipalities.
Budgetary decisions are generally made at different levels of government. The greater the discretion that
sub-national governments are authorised to exercise (for example, decisions about spending, taxation and
borrowing), the more decentralised the fiscal system is. In a state with more than one level of government,
inter-governmental fiscal relations, also called ‘fiscal federalism’, is concerned with the structure of
public finances: how taxing, spending, borrowing and regulatory functions are allocated among the
different tiers of government as well as the nature of transfers between national, provincial and local
governments. In contrast to approaches followed in political science and constitutional law, the generic
meaning of the term ‘federalism’ in economics implies decentralisation, and fiscal federalism deals with the
fiscal implications of a decentralised system of multilevel government.
The justification for a decentralised system embodying sub-national decision-making powers stems
partly from our earlier analyses presented in Part 1 of the book. Firstly (and as discussed in Chapter 2), it
may improve allocative efficiency or the ability of the public sector to produce the level and mix of public
services that citizens demand and that correspond with their preferences. However, this depends on the
nature of the specific public (and merit) goods produced and delivered by government, which differs from
country to country. Some public goods are national in scope (for example, defence) or indeed global (as
discussed in Section 3.9 of Chapter 3). Local public goods, however, confer benefits that are confined to a
limited geographical area. For instance, the transmission of a regional or local radio programme would
benefit only those people within the broadcasting range of the transmitter, and public playgrounds would
generally serve the recreational needs of children living close to them. Local public goods are therefore
specific to a particular location. By electing to locate in a particular geographic jurisdiction, consumers can
therefore choose the quantity and type of local public goods they receive. This theme is explored in greater
detail in Section 19.1.1, where we discuss the Tiebout model and the allocative role of government.
Local and provincial governments therefore exist as a result of the fact that the spatial incidence of
public goods differs. In practice, however, the boundaries of sub-national governments are often
historically or politically determined. Therefore these may not coincide exactly with the benefit areas of the
public goods that sub-national governments produce. As a result, spatial externalities may exist, that is,
spillovers of costs and benefits at the boundaries between sub-national government jurisdictions.
A second rationale for decentralisation is provided by public choice theory generally, and the limitations
of a centralised majority-based democratic system in particular, as discussed in Chapter 6 and briefly
elaborated on in Section 19.1.2 below.
19.1.1 The Tiebout model

Tiebout (1956) asserted that if there were a large enough number of local government jurisdictions and each
of these local governments offered a different mix of local public goods and taxes, individuals would reveal
their true preferences for local public goods by choosing a particular local government jurisdiction in which
to live. In this model, citizens (who have different tastes) are mobile and choose to settle in the local
government jurisdictions that produce the mix of tax and public good outputs that correspond most closely
to their preferences. Their choice of location thus reveals their preferences for public goods in the same
way that their choice of private goods purchased in the market reveals their preferences for private goods.
Just as the consumer may be visualised as walking to a private market place to buy his or her goods, we
place him or her in the position of walking to a community where the prices (taxes) of community
services are set. Both trips take the consumer to market. There is no way in which the consumer can
avoid revealing his or her preferences in a spatial economy.
Tiebout, 1956: 422
The greater the number of communities and the greater the variation in taxes and public services offered, the
closer consumers will be to satisfying their preferences. Under these conditions, local public goods can be
decentralised in a way that is immune to the free-rider problem. Tiebout’s notion of ‘voting with one’s feet’
permits the revelation of preferences by allowing people to sort themselves into groups with similar tastes.
Furthermore, the equilibrium that will be achieved by voting with one’s feet will be Pareto efficient. The
Tiebout model thus describes a theoretical solution for the problem of preference revelation, a
phenomenon that inhibits the achievement of allocative efficiency (see Chapters 2, 3 and 6).
It must be noted that the Tiebout model is based on the following restrictive assumptions:
• All citizens are fully mobile.
• Individuals have full information about the local public goods offered by each jurisdiction.
• There is a large number of jurisdictions to choose from, spanning the full range of public good
combinations desired by citizens.
• There are no geographic employment restrictions: people receive income from capital only and are not tied
to a particular location through job or family ties.
• There are no spillovers across jurisdictions.
• There are no economies of scale in the production of public goods.
If there are economies of scale in the production of public goods and hence declining average cost (for
example, the cost of an additional listener to a local radio programme or of an additional road user may be
zero), then a local public goods equilibrium may not exist at all. Preference revelation once again becomes
a problem.
If there is only a limited number of communities, they may compete with each other to attract outsiders.
While this behaviour (analogous to a monopolistically competitive firm) may provide an incentive towards
an efficient production of public services, the mix and level of public services provided may not be Pareto
efficient. If there are fewer communities than types of individuals, a person might not be able to find a
jurisdiction where people’s tastes match his or her own.
Finally, there are issues concerning redistribution. As there is an element of redistribution involved in
the provision of local public goods (for example, health and education services), the wealthy may attempt
to avoid this redistribution by segregating themselves from the poor (Atkinson & Stiglitz, 1980).
Although the Tiebout model is based on a number of stringent assumptions, it does clearly demonstrate
that a decentralised fiscal system – which can accommodate a diversity of preferences for public goods –
can be welfare-increasing in relation to a centralised system that imposes a standardised public good-tax
mix on people, no matter what their tastes (see Box 19.1). Fiscal decentralisation can in principle contribute
to a more efficient provision of local public goods by aligning expenditures more closely with local
priorities.
Box 19.1 The Tiebout model extended
Since its debut in 1956, the Tiebout model has become the cornerstone of fiscal federalism and new local government
finance literature, inspiring literally hundreds of journal articles and books, which later extended the very simple,
highly abstract initial model. The original model and its subsequent refinements have captured the attention of
economists as well as political scientists, geographers and other social scientists (Fischel, 2006).
One type of extension to the Tiebout Model under which its efficiency conditions continued to hold was the
addition of a political collective choice mechanism, most often through imposing a median voter mechanism. This
rendered the model more descriptively realistic, since in practice, residents do not only have the option of relocating
to other communities in order to change their public good consumption patterns (that is, ‘voting with their feet’,
referred to above), but they can also influence the mix of public goods offered at local level by voting in elections.
Other researchers have added a focus on the role of municipal managers in service provision (Fischel, 2006).
Other significant extensions to the model include expanding the role of property taxation (in practice, this is a
major revenue source for many municipalities), land use regulation and the impact of zoning restrictions, the
relationship with housing markets and residential sorting (in other words, whether communities consist of
homogenous communities of a single income class or heterogeneous communities with a mix of income classes). In
the original Tiebout model, taxes are regarded as merely the ‘price’ of a basket of local public goods, and the model
made no attempt to explain the form and nature of these taxes or local government budget processes. Extensions to
the Tiebout model that incorporated property taxes, however, evinced an incentive for citizens to free-ride. Citizens
could purchase a house with a value substantially below the value of the neighbouring houses, thereby paying less
property tax than other homeowners in the community, but still consuming the same basket of local public goods
(Oates, 2006). Hamilton (1975) resolved this dilemma of partial free-riding by adding a zoning rule that enforced a
minimum threshold in housing consumption (through zoning by-laws, for instance). Zoning is the practice of
regulating land use (for example, specifying the minimum size of a house or the density of construction) to limit the
growth in a particular community, to achieve optimal size for public service provision and to avoid ‘free riders’ who
would consume more in public services than they would pay in property taxes. Since all the households in the
community would have more or less the same property value (as a result of zoning), homeowners in a particular
community would have similar property tax burdens for consuming the same bundle of local public goods, which
would be equal to the costs of service provision.
The Tiebout model focused exclusively on the efficiency of public service provision and ignored the distributional
impacts completely. However, the distributional consequences of homogenous Tiebout communities caused concern
since there would be an incentive for rich or white communities to segregate themselves in wealthy enclaves,
excluding poor individuals or possibly even those of a different race or religion:
‘Arguably, the reason that the debate about the micro-foundations of the Tiebout model has enjoyed such a long
life and generated such strong feelings is the possibility that sorting has less to do with preferences about service-and-
tax bundles and more to do with the preferences of well-healed citizens, especially White people, to sort themselves
into racially and economically homogenous enclaves’ (Bickers et al., 2006: 59).
Zoning requirements in many countries explicitly may not exclude potential residents on the basis of race, religion
and so on, but political scientists have expressed concerns that the application of zoning by-laws or resident income
thresholds could indirectly have an exclusionary impact in practice.
Furthermore, the stratification of communities on the basis of income would limit local cross-subsidisation and
redistribution, so that efficiency in local public provision could be achieved, but at the cost of conflicting with other
social values, such as inclusivity and diversity (Oates, 2006).
The Tiebout model was never intended solely as a theoretical mechanism for the revelation of local public good
preferences. It also aimed to explain the actual behaviours observed in local government (particular urban
metropolitan municipalities). The Tiebout model experienced an academic resurgence when Oates first attempted to
test an important implication of the model empirically in 1969. If citizens were willing and able to ‘shop around’
across local government jurisdictions for the mix of local public goods and associated taxes that most closely
matched their preferences, as the Tiebout model would postulate, then both the quality of local public goods and
services and local property tax liabilities should be reflected in local property values. In other words, fiscal
differentials should be ‘capitalized’ into the prices of houses across different municipal jurisdictions. Since Oates’
seminal application in 1969, a myriad of empirical studies (primarily in developed countries) have exhibited
significant capitalisation among homes in the same housing market. Some debate remains, however, about the degree
of capitalisation that occurred (Oates, 2006).
After Oates, a vast empirical literature emerged, testing either whether the assumptions on which the Tiebout
model is based prevail in practice or the implications of the model, which are empirically testable. Empirical testing
has focused mainly on the developed world, particularly the United States, the United Kingdom and Canada. The
evidence has been mixed over the last 50 years, with certain patterns and trends consistent with the model and others
conflicting (Baiker et al., 2010). Dowding et al. (1994) surveyed over 200 journal articles and books on the Tiebout
model. Their findings in relation to some of the testable implications of the extended Tiebout model include the
following:
• The larger the number of local jurisdictions is, the greater the satisfaction levels of citizens. Mixed but marginal
evidence was found for this proposition.
• The larger the number of jurisdictions in the same metropolitan area is, the greater the competition among them to
attract residents. This was difficult to test rigorously and hardly any credible evidence in support of this hypothesis
was found.
• The larger the number of competing local jurisdictions is, the more homogenous each will be. Only weak evidence
was available to support this proposition.
• The rich may band together to avoid paying higher taxes to cross-subsidise local public service delivery to the poor.
There is empirical evidence in the developed world to suggest that rich households do relocate to avoid
redistributive local taxation.
• The higher the quality of local services offered, the higher the property values in a local jurisdiction (as indicated by
house prices, for example), and the higher the property tax level , the lower the value of properties. There is
evidence that the locational decisions of households are influenced by both taxes and services, and to a lesser
extent that there is a relationship between local taxes and services and property values.
• The decisions of households to relocate are affected by the different taxes levied, and baskets of services offered, by
different local jurisdictions. Migration patterns can be explained by differences in tax and service packages and
welfare benefits (in other words, fiscally induced migration). Differences in tax and service packages do seem to
affect migration decisions, but the evidence is also open to other interpretations.
While the empirical jury is in many respects still out on the practical application of the Tiebout model, its
theoretical contribution remains enormously influential. Instead of viewing public good provision in
municipalities and provinces as a collective choice exercised by static communities, the Tiebout model
highlighted the rational decisions and dynamic responses of mobile individuals who move to match their
preferences. This not only introduced a more defined spatial focus, but also focused attention on the role of
migration and mobility. The Tiebout model remains a fertile area for further research, especially within the
developing world as urbanisation proceeds rapidly.
19.1.2 Public choice perspective on fiscal federalism

From a public good perspective, we have already discussed (in Chapter 6) Arrow’s impossibility theorem
and the maximising behaviour of politicians, bureaucrats and special interest groups within a centralised
democratic system. Both explicit and implicit logrolling1 on the part of political parties and individual
politicians as well as the empire-building motives of bureaucrats, coupled with rational ignorance among
the broad electorate, can give rise to an oversupply of public goods in the economy. To the extent that they
do, the net effect is clearly sub-optimal, with goods and services not being allocated in accordance with the
relative preferences of the community as a whole.
This Leviathan hypothesis, first proposed by Brennan and Buchanan (1980), views government as a
revenue-maximising monopolist that seeks to exploit its citizens systematically by maximising the tax
revenue that it extracts from the economy. According to this perspective, fiscal decentralisation would
place a powerful restraint on the government’s Leviathan tendencies. Devolution of taxing and spending
powers to sub-national governments would act as a disciplinary force on the size of government by forging
a closer link between raising funds and spending funds. For instance, any additional expenditure by a sub-
national jurisdiction may have to be funded by increased sub-national taxation. Centralised fiscal systems
break this link, encouraging the growth of government. In centralised fiscal systems, local residents have
more opportunities to lobby for spending programmes that are financed out of nationally collected revenues
or national loans.
19.1.3 Other reasons for fiscal decentralisation

Competition among sub-national jurisdictions may enhance innovation. Successful provincial and local
government experiments may be replicated elsewhere and the failures discarded. This argument will be
examined in greater detail later (see the discussion on dynamic efficiency in Section 19.3.3).
Furthermore, there may be a high cost associated with decision-making if it is completely centralised.
Owing to the smaller groups involved, the devolution of spending and taxing powers may reduce the cost
of decision-making. Decision-making by smaller groups would most probably result in different levels of
optimal majority at local level than if the same issue were to be decided nationally (see Section 6.6, Figure
6.2). Fiscal decentralisation could also encourage public participation in decision-making since local and
provincial governments may be closer to the communities they serve and may foster fiscal accountability.
19.2 Reasons for fiscal centralisation
Although there are advantages associated with fiscal federalism, there are also factors that favour
centralisation.
Firstly, spatial externalities may arise when the benefit or costs of a public service spill over to residents
of another jurisdiction. Goods with external benefits are likely to be underproduced, since each sub-
national government is concerned primarily with the welfare of its own residents. Similarly, public goods
with significant external costs may be overproduced since the residents of a jurisdiction do not bear the full
social cost. Under these circumstances, it may be preferable to have a centralised provision to ‘internalise’
these costs and benefits.
Secondly, centralised provision of public services may be justified by economies of scale; that is, certain
services (such as transport systems and water) may require areas larger than a single sub-national
jurisdiction for cost-effective provision.
Thirdly, centralised provision may lead to lower administration and compliance costs in the financing of
public services. For example, using one computer system for the whole country or one revenue collection
system serving national and provincial governments may prevent the cost of duplication.
In practice, no country has a completely decentralised or completely centralised system. While the
provision of certain goods is preferable at national level, others are best provided at sub-national level. The
crucial question is therefore the following: what is the optimal degree of fiscal decentralisation? This brings
us to the assignment problem.
19.3Taxing and spending at sub-national level: The

assignment issue
The assignment problem is concerned with how spending and taxation responsibilities should be
distributed among national and sub-national governments when taking considerations of macroeconomic
stabilisation, distribution (equity) and allocative efficiency into account. Fiscal federalism literature
provides broad guidelines on this fundamental issue.

There is general consensus that macroeconomic policy should be assigned to central government. Sub-
national governments cannot and should not conduct monetary policy. If the power to create money were
decentralised to regional entities, there would be strong incentives for sub-national governments to print
money to finance public service provision, rather than raising sub-national taxes or imposing user charges.
This type of behaviour would clearly lead to inflationary pressures, thus adversely affecting the national
economy and compromising national government policies for which the particular sub-national government
bears no responsibility.
The conventional wisdom in the fiscal federalism literature is that a fiscal stabilisation policy would be
ineffective at the sub-national level. Provincial and local economies tend to be ‘open’ (in other words, they
‘import’ and ‘export’ from other provinces or local jurisdictions large shares of what they produce or
consume). If a single sub-national government were to pursue an expansionary fiscal policy, for example,
much of the increase in demand would be lost to outside jurisdictions owing to the openness of such
economies. If, for example, a provincial government were to cut taxes substantially in order to stimulate the
provincial economy, most of the newly generated spending would flow out of the provincial economy in
payment for goods and services produced elsewhere. The ultimate impact on employment levels in the
province would be very small. Fiscal policy by sub-national governments is thus likely to prove impotent
since the extent of import leakages would substantially reduce any multiplier effects. Taxes suitable for
macroeconomic stabilisation, such as personal and corporate income tax, should therefore be centralised
(Musgrave, 1983).
19.3.2 Distribution function
In the fiscal federalism literature, it is generally argued that only a centralised redistribution policy by
central government is likely to be effective. The argument is that any effort to redistribute income by a
single sub-national government (for example, by increasing taxes on high-income earners and firms, and
spending the proceeds on the poor) would ultimately be self-defeating. There would be an influx of poor
migrants into the jurisdiction, attracted by the fiscal benefits (transfer payments such as social grants, or
increased access or quality of public services). This would be accompanied by an exodus of high-income
earners and businesses from that jurisdiction. It then becomes more difficult for the jurisdiction to attain its
distributional goals, given the dwindling tax base. Sub-national governments may therefore end up in a
worse distributional position, which may in fact clash with the redistributive objectives of the national
government.
19.3.3 Allocation function

Probably the most compelling economic case for fiscal decentralisation is its potential to secure efficiency
gains. The static arguments linking fiscal decentralisation with improved efficiency include the following:
• Uniform centralised policy forces every region to consume the same mix of taxes and public spending,
even though tastes and attitudes may vary widely across regions in a large country with many cultural
and ethnic groups. Each decentralised jurisdiction could tailor its service and tax package more closely
to the preferences of its citizenry. For instance, the residents of particular provinces might want
education in particular languages. Education provision, and its associated expenditure, may therefore be
allocated to provincial governments rather than the national government. Politically, decentralisation,
which accommodates diversity, may be necessary to induce various regions to remain part of the
federation (for example, Quebec in Canada).
• Different public goods have different spatial characteristics. Some benefit the entire country (for example,
defence) whereas others benefit only a province (for example, forestry services) or a locality (for
example, street lighting). The defence expenditure responsibility could therefore be assigned to national
government, forestry services to provincial governments and street lighting to municipalities. Public
services are provided most efficiently by a jurisdiction that has control over the minimum geographic
area that would internalise the benefits and costs of this provision.
• Lower-tier governments may have more information about the needs and priorities of their citizens as well
as region-specific conditions and prices than national governments, which could improve programme
design and service delivery.
• Diseconomies of scale and increasing bureaucratic inefficiency arise when spending programmes become
too large, that is, when they serve too large a geographical area.
The dynamic efficiency arguments point out that fiscal decentralisation can stimulate innovation.
Contestability in the public sector arena may have similar beneficial effects to competition in private
markets. Centralisation of functions may mean that national governments may be prone to inertia. With
little experimentation, practices within government may become rigid and perpetuate themselves, even
when the underlying logic for their introduction no longer holds true. Variety in policy design and
application at sub-national level is seen as desirable as it diversifies the country’s exposure to disastrous
policy experiments. Successful policy experiments at sub-national level can be replicated by other tiers of
government as best practice and the failures can be discarded.
Improved allocative efficiency in a decentralised system depends heavily on the political and
institutional mechanisms through which sub-national governments can be made aware of their electorates’
preferences and are held accountable for their actions. However, in many developing countries, these
democratic structures are not in place or if they are nominally in place, de facto do not function.
Furthermore, sub-national governments may lack capacity and may be prone to corruption. Thus, while
efficiency gains owing to fiscal decentralisation are attainable in principle, the way in which fiscal
decentralisation is implemented determines whether these are in fact realised. In a sense, while fiscal
decentralisation can attenuate one form of government failure, it may introduce other forms. The above
discussion also shows clearly that while a decentralised system may promote efficiency, it may prove
detrimental to the equity goal (in other words, redistributive goals) and may even compromise stabilisation
objectives.
19.3.4 Tax assignment

Expenditure assignment refers to the allocation of functions and associated spending responsibilities to the
various levels of government. In the same vein, tax assignment refers to the assignment of tax sources to
different tiers of government.
It is intuitive that tax assignment should complement expenditure assignment. In principle, the greater
the spending responsibilities assigned to a particular level of government are, the greater the tax revenue
sources that should be assigned to it. As the difference between expenditure and tax assignments increases,
so sub-national governments become more dependent on grants from national government in order to meet
their spending obligations. As a result, sub-national governments may become more responsive to the
preferences of national government rather than their citizenry, and the ability of the electorate to enforce
fiscal accountability decreases.
In determining the most appropriate tax assignment, important factors for consideration are equity
(ensuring vertical and horizontal equity among individual taxpayers as well as across regions) and
administrative and allocative efficiency (minimising the cost of collection and compliance as well as
minimising any market distortions). In the light of the issues of equity and efficiency, Musgrave (1983)
proposes the following assignment guidelines:
• Progressive redistributive taxes should be assigned to the national government (for example, personal and
corporate income taxes).
• Taxes appropriate for macroeconomic stabilisation should likewise be centralised (for example, value-
added tax and personal income tax). As its corollary, taxes assigned to the sub-national governments
should be less sensitive to economic and business fluctuations, that is, they should be cyclically stable
(for example, motor vehicle taxes).
• Unequal tax bases among jurisdictions should be assigned to the national government (for example,
mining tax).
• Taxes on mobile factors of production should be centralised (for example, corporate income tax or value-
added tax where companies are able to shift the accounting base of the tax to lower-tax jurisdictions).
• Residence-based taxes such as excise taxes should be assigned to the provinces.
• The local authorities should levy taxes on immobile factors of production, for example, property taxes.
• All levels of government may charge user charges and benefit taxes.
In practice, assignment of expenditure responsibilities and taxation and borrowing powers are often the
result of constitution negotiating processes or other political and legislative processes with several
stakeholders with multiple (often conflicting) objectives. In the pursuant compromises, the negotiated
consensus may produce expenditure, taxation and borrowing powers which are not congruent. In this case,
intergovernmental grants may be introduced to mitigate the resultant fiscal imbalances (discuss below in
Section 19.6) or formal or informal intergovernmental fiscal institutions may evolve to mitigate some of the
resultant tensions.
19.4 Tax competition versus tax harmonisation

When different sub-national governments impose different tax rates, citizens and businesses may react by
moving to jurisdictions with lower tax rates. Tax competition occurs when sub-national governments
adjust (lower) their tax rates to attract mobile factors of production (notably capital) from other
jurisdictions. Tax harmonisation occurs when sub-national governments coordinate their tax policies (for
instance, by limiting the degree of variation in tax rates levied or by defining the tax bases in a uniform
way). Note that this distinction corresponds to our earlier discussion of the same concepts introduced in
Chapter 17, Section 17.5.4.
Tax competition was initially regarded as distortionary, non-neutral and leading to sub-optimal
outcomes, and it was thought that it could be rectified by means of tax harmonisation. The rationale was
that if one province decides to pursue a competitive tax strategy, the other provinces would respond
likewise. This ‘beggar-thy-neighbour’ downward spiral caused by provinces attempting to undercut each
other could eventually lead to identical but sub-optimally low tax rates on mobile production factors. In
addition, the distribution of mobile factors (particularly capital) would be distorted. Uncoordinated tax
policies could therefore lead to market distortions with regards to mobile factors of production as well as
tradable goods and services.
More recent thinking sees tax competition as a positive influence and efficiency-enhancing.
Decentralised tax powers could promote innovation, as sub-national governments would be able to
experiment with various fiscal packages. In the public sector analogue of private market competition and
discipline, policy successes could be emulated elsewhere and failures abandoned. It could also permit sub-
national governments to tailor tax mixes to their citizens’ preferences and encourage accountability. If
governments are providing services that individuals and firms want and are willing to pay for, the adverse
effects of tax competition may be limited. If government overspends and tries to place the tax burden on
those who do not derive any benefit from the service, tax competition may be construed as a positive spur
to increased government responsiveness. One reason for the about-face is the intensifying global
competition. Owing to international mobility of capital, investment that is merely displaced to another
region at least remains within the country instead of migrating across national borders.
19.5Borrowing powers and debt management at sub-

national level
Sub-national governments generally have more limited capacity than central government in issuing debt
obligations. In the interest of coordinated macroeconomic policy and the achievement of overall
macroeconomic objectives, there must be a central government supervision of the debt operations of sub-
national governments. Because the national economy is larger and more diverse, central government can
absorb the shocks that a single region would find too great to deal with.
Another related aspect of sub-national debt is fiscal exposure, which refers to the total amount of the
direct liabilities of government (for example, bonds) and the contingent liabilities (for example,
government guarantees). Sub-national borrowing requires an active market in government securities
assisted by bond-rating agencies. Fiscally irresponsible behaviour of sub-national governments is then
penalised with increased interest rates. The discipline of the market may, however, be undermined by
contagion effects and negative pecuniary externalities. Financial contagion refers to a situation where a
financial crisis in one government or in respect of one particular type of financial instrument triggers a loss
of confidence in investors, which precipitates similar crises in other similar governments or similar classes
of financial instruments. In this context, one province’s inability to service debt could cause a loss of
investor confidence in other provinces. Provincial tax bases are narrower and more elastic than national tax
bases as a result of factor mobility. An adverse shock may render a province unable to service its debt,
precipitating a financial panic. The perception that the financial panic is contagious might impose a
negative externality on the other provinces. Alternatively, the higher interest rates in response to increased
perceived risk will affect all of the provinces.
Effective market discipline on the borrowing activities of provinces assumes, however, that private
agents have sufficient information to assess provincial risk profiles accurately. For instance, if sub-national
governments do not have their own substantial tax revenue sources, potential lenders and bond-rating
agencies will set their interest rates based on their perceptions of the terms under which revenue sharing or
inter-governmental grants are likely to be made. In some developing countries, payments to sub-national
governments are often suspended when central governments run into financial problems. In practice,
information asymmetries are rife, creating the conditions for ‘moral hazard’ behaviour.
Moral hazard occurs in a situation where the actions of one party with respect to a contract cannot be
monitored by the other party or parties to the contract. This permits opportunistic behaviour on the part of
the party whose actions are ‘hidden’, to the detriment of the other less informed parties. A classic example
of moral hazard can be found in the insurance industry, where drivers (whose driving style and ability
cannot be observed by the insurance company) start to drive more recklessly once fully insured. Moral
hazard behaviour and sub-national debt are described below.
In the instance of sub-national debt, moral hazard entails that one party (the lending institution) may
behave in fiscally imprudent or risky ways, such as by extending risky loans to provincial governments of
dubious creditworthiness, knowing that the debt will be either explicitly or implicitly guaranteed by the
other party (the national government). To complicate the problem, provincial governments know that the
national government is explicitly or implicitly underwriting their debt and therefore also have an incentive
to act fiscally imprudently. There is thus moral hazard between the lender and the provincial government as
well as between the provincial governments and the national government.
Even if a government explicitly refuses to bail out a sub-national government, this may have very little
credibility with markets. Although it would be best for a government to say in advance that it will not bail
out sub-national governments in such an eventuality, it has every incentive to renege on its undertaking. In
other words, no matter how emphatically national government refuses to aid bankrupt provinces, there will
always be a strong incentive for the government to assist sub-national governments should they find
themselves in financial trouble. The long-term costs of impassively standing by while a sub-national
government fails may be so great that national governments invariably act as the government of last resort.
Anticipating this behaviour, markets would react as if the national government had implicitly
underwritten sub-national government lending. The implicit guarantee by central government (which
generally has a better credit rating than sub-national governments) will mean that sub-national governments
will be able to borrow on more favourable terms than would have applied otherwise, thereby encouraging
increased debt.
In addition, under these circumstances, moral hazard behaviour by creditors could exacerbate the
situation. The closer a sub-national government is to financial crisis and the more liabilities it accumulates,
the more likely it is that the national government will have to step in and bail it out. Banks and financial
institutions, anticipating this, may lend more rather than less to the sub-national government. This may
result in even more unsustainable sub-national debt, which could have a destabilising effect on the macro
economy.
As political circumstances render it untenable in most cases for a central government to allow a sub-
national government to go bankrupt2, national government may ultimately find itself liable for any default
on public debt, no matter which tier of government does the borrowing. This would apply even if the actual
letter of the debt contract exempts the national government from any liability. There is thus a need for
national government regulation in order to allow sub-national borrowing, but under conditions that
minimise national government risk. In an international setting, irresponsible behaviour by or on behalf of a
sub-national government could harm the country’s credibility and credit rating, and thus impose a negative
externality on other spheres of government.
19.6 Inter-governmental grants

Inter-governmental grants are transfer payments from one sphere of government (for example, national
government) to another sphere of government (for example, a provincial or local government). As
discussed in Section 19.6.5, they may be introduced, for example, to correct a vertical fiscal imbalance
where the own revenue sources of sub-national governments fall short of the expenditure responsibilities
assigned to them. Inter-governmental grants may be unconditional or conditional. Unconditional grants
may be spent by recipient governments as they see fit. Conditional grants must be spent on the specific
service stipulated by the grantor (in other words, the sphere of government that is making the grant).
Grants may also be matching or non-matching. In a matching grant, the grantor government will match
a certain percentage of each rand of spending by the sub-national government on the same activity. A non-
matching grant is just a lump-sum allocation that does not depend on the level of sub-national expenditure.
19.6.1 Unconditional non-matching grants
An unconditional non-matching grant is a lump-sum transfer to sub-national government on which no
constraints are placed as to how it is to be spent. The national government could recommend that the grant
be spent on certain public goods – referred to below as ‘grant-aided public goods’ – but the choice
ultimately lies with the recipient government. The recipient government may spend it on any public good or
service, or provide tax relief to its citizens. This grant acts to increase the income of the recipient
government, but does not alter the relative price of any particular public good. A non-matching grant is in
effect an income supplement. A block grant in the South African context refers to a type of unconditional
non-matching grant where a global lump sum is transferred to a sub-national government to be spent at its
discretion. This is also referred to as revenue sharing.
The effect of introducing a grant of this nature is illustrated in Figure 19.1. We measure spending on the
grant-aided public good in rand, on the horizontal axis. Spending on all other public goods is measured on
the vertical axis. The line AB shows the government’s budget constraint before receiving a grant. The line
CD shows the government’s new budget constraint after receiving the grant. I0 and I1 are the indifference
curves of the median voter, indicating society’s relative preferences.
Point E0 shows the initial equilibrium, which could be thought of as reflecting the median voter’s
preferences (in other words, preferred combination of grant-aided and other public goods). An
unconditional grant (of BD rand) shifts the recipient government’s budget constraint from AB to CD. The
new equilibrium is at E1, signifying a higher level of social welfare. There is an increase in grant-aided
public good expenditure by the sub-national government (GH). This increase is, however, less than the
amount of the grant (BD). Because unconditional grants may be spent on any public good or to finance tax
breaks, they have the least stimulatory impact on the recipient government’s consumption of the grant-
aided public good.
Figure 19.1 Unconditional non-matching grant

19.6.2 Conditional non-matching grants
Conditional non-matching grants provide recipient governments with a given amount of funds (without sub-
national matching), with the condition that these funds be used for a particular purpose. For example, a
conditional grant might be for spending on healthcare only. As shown in Figure 19.2, the sub-national
government’s budget line will therefore shift outwards by the amount of the grant (AF) from the original
budget line AB to the post-grant budget line AFD.
From the sub-national government’s perspective, OJ (equal to AF) of the grant-aided good is ‘free’.
Therefore at the new equilibrium E1, at least OJ of the grant-aided public good will be produced and
consumed. Note that this particular community can still reduce its own spending on the grant-aided good as
long as the full grant (in other words, AF = 0J) is spent as prescribed. At E1, therefore, the extra spending
on the subsidised good (GM) is less than the grant (OJ), as part of the initial spending on the subsidised
good by the sub-national government was diverted to the other goods (LK). Grants of this type are most
appropriate to subsidise activities that are considered low priority by sub-national governments, but
considered to be high-priority activities by national government.
19.6.3 Conditional matching grants (open-ended)

Matching conditional grants, which are cost-sharing arrangements, may be open-ended or closed-ended. In
the case of open-ended matching grants, the national government pays some proportion of the cost of
providing a particular public good or service. The sub-national government provides the rest of the funds
needed. It therefore, in effect, reduces the price of that particular public service (say healthcare) for the
recipient government. Since the grant is open-ended, the sub-national government can use as much of the
grant at the new price as it wishes, as long as it matches the national government’s contribution by the
stated percentage.
Figure 19.2 Conditional non-matching grant
As shown in Figure 19.3, a 33⅓% subsidy on healthcare provision or expenditure (in other words, R2 of
sub-national government funds for each R1 of grant) would rotate the budget line outwards from AB to AD.
(If the slope of the original budget line were 1, then the slope of the budget constraint after the grant would
be flatter at ⅔, reflecting the change in the relative price of the two goods. The public good subsidised by
the grant becomes relatively cheaper.) Owing to this cost-sharing arrangement, the sub-national
government can afford 50% more healthcare services at any level of other goods and services. As in the
case of a selective tax on income (see Section 13.4.1 of Chapter 13), a grant that changes the relative price
of public goods has an income and a substitution effect. In this case, the income effect means that the
public (as represented by the sub-national government) is better off, and can thus consume more of both the
grant-aided goods and the other public goods. The substitution effect involves the substitution of the grant-
aided good for other public goods. The net effect determines the position of E1, the new equilibrium. As
long as E1 lies to the right of E0, more of the subsidised public good is purchased. Both the income and
substitution effects would prompt the sub-national government to increase expenditure on the public good.
Figure 19.3 Conditional matching grant (open-ended)

If relative preferences were such that E1 lay to the left of E0, the income effect would dominate the
substitution effect to such an extent that less of the subsidised good will be purchased than before the grant
(in other words, the subsidised good or service is an inferior or Giffen good or service).
In general, open-ended matching grants are regarded as most appropriate for correcting inefficiencies in
public good production that result from positive externalities (Shah, 1995). Positive externalities, or benefit
spillovers, occur when the provision of goods and services by one sub-national government benefits other
sub-national governments, which do not, however, bear the cost of provision. In this case, there would be
an incentive for the sub-national government to underprovide that public good or service unless it was
subsidised. Note that open-ended matching grants may benefit richer sub-national governments more than
poorer ones, who might not be able to match national government expenditure. It can be shown
geometrically that if E1 were to lie directly above E0, the cost to the sub-national government of the new
bundle of public goods would be the same as the pre-grant combination. The response of a poor community
to a conditional grant may well be to seek a combination of goods that does not increase or even decrease
the total cost in respect of all public goods; that is, E1 will be directly above or even to the left of E0.
19.6.4 Conditional matching grants (closed-ended)

There are also closed-ended matching grants, where the national government pays some proportion of the
cost of providing a particular public good or service up to a certain limit. The effect of a closed-ended
matching grant is illustrated in Figure 19.4.
Figure 19.4 Conditional matching grant (closed-ended)

When there is a 33⅓% subsidy on, for instance, healthcare up to a limit, the budget line will move from AB
to ACD. Costs of healthcare provision will be shared along AC until the subsidy limit (at spending level OJ)
is reached. Beyond the subsidy limit, healthcare is unsubsidised and the sub-national government faces the
full price of provision; hence the steeper slope of the section CD of the new budget line (the slope of CD is
the same as that of AB). At the new equilibrium, E1, more healthcare will be provided than would have been
the case without the grant.
Grantor governments generally prefer closed-ended matching transfers as these allow them to retain
control over their budgets.
19.6.5 The rationale for inter-governmental grants

The main arguments for inter-governmental transfers are summarised below. The design of the grant should
be appropriate to the objective it seeks to attain.
• Fiscal imbalances between expenditure needs and revenue generation capacities of sub-national
government can be addressed. Under circumstances where it is not feasible to devolve increased tax
powers to sub-national government, unconditional non-matching grants (in other words, block grants)
should be considered. Sometimes revenue is collected at national level, and then transferred to sub-
national governments as block grants to address fiscal imbalances. This is known as revenue sharing.
Where national government devolves an additional expenditure responsibility to sub-national
governments without the assignment of sufficient additional own revenue sources or a concomitant
increase in inter-governmental grants, this may lead to an unfunded mandate for sub-national
governments. Unfunded mandates undermine the effective and equitable delivery of services by sub-
national governments.
• Conditional non-matching grants are appropriate to ensure minimum standards in the provision of public
goods and services across the nation.
• Conditional matching transfers (open-ended) are suitable to compensate for benefit spillovers. The rate of
subsidisation should reflect the degree of benefit spillover.
A conditional matching grant (closed-ended) may be considered to assist sub-national governments

financially while promoting expenditures on an activity considered by the national government to be of a
high priority, but at the same time affording the national government better control over its own budget (see
Box 19.2).
Box 19.2 Conditional grants in 2019/20
Conditional grants are made from national government departments to provincial governments and to municipalities.
These grants are appropriated (that is, budgeted for) in the annual Division of Revenue Act (DoRA) passed by
Parliament at the same time as the Budget. To a much lesser extent, provincial governments may also occasionally
give conditional grants to municipalities. Conditional grants are earmarked allocations that are ring-fenced for a
specific purpose by national government, and provinces and municipalities can only use these grants for the purpose
for which they were appropriated. But, as we have seen in Section 19.6.2, nothing prevents a sub-national
government from spending less of its own funds on the grant-aided good or service than before the grant was
announced.
The amount budgeted for each conditional grant as well as indicative allocations for the next two fiscal years are
listed in the DoRA. Each conditional grant has its own grant framework, which spells out in detail the conditions
attached to that particular grant, the service delivery outputs or outcomes expected from that grant, the criteria used to
divide each grant among provinces or municipalities, a summary of the audited actual spending on that grant in the
previous year, a grant payment schedule, and how and by whom the grant’s performance will be monitored. Grant
recipients report quarterly on their spending of the grant and on their delivery performance. Should provincial
departments or municipalities receiving a grant not adhere to its conditions, the DoRA empowers the National
Treasury to stop or withhold payments and to relocate grant payments to other recipients.
In 2019/20, there were 26 provincial conditional grants, collectively amounting to R106,7 billion. Examples of
provincial conditional grants include the following:
• A Comprehensive Agricultural Support Grant for emerging farmers from the national Department of Agriculture,
Forestry and Fishing to the nine provincial Departments of Agriculture
• The National School Nutrition Programme Grant from the national Department of Basic Education to provincial
Departments of Education
• A Comprehensive HIV/AIDS and TB Grant, a health facility revitalisation grant and a National Tertiary Services
grant for specialised health services from the national Department of Health to provincial counterparts
• The Human Settlements Development Grant for housing and related infrastructure from the national Department of
Human Settlements to the provincial Departments of Housing.
Most of these grants were direct conditional grants disbursed directly to, and to be spent by, recipient provincial
governments. There were, however, indirect grants, in other words, grants that are spent by a national government
department on behalf of a provincial government that does not have the capacity to spend the grant effectively. One
example is the school infrastructure backlogs grant, where the national Department of Basic Education builds schools
in provinces lacking the requisite capacity.
As can be seen in Table 19.3, R44,8 billion of direct conditional grants was budgeted to be paid directly to
municipalities in 2018/19, of which R15,3 billion was for municipal infrastructure, R11,3 billion was for urban
settlements development and R6,3 billion was for public transport. In addition, R7,9 billion was budgeted for as
indirect conditional grants in 2018/19, mainly for national integrated electrification programme (R3,3 billion), but
also regional bulk water and sanitation infrastructure (R2,9 billion). In the case of indirect grants, which are grants-in-
kind, national government spends the allocation on behalf of municipalities that lack the capacity to roll out
infrastructure themselves.
Examples of local government conditional grants include the following:
• The Municipality Infrastructure Grant is paid by the Department of Cooperative Government and Traditional Affairs
to individual municipalities for the provision of basic services such as water and sanitation, roads and social
infrastructure to poor households in non-metropolitan municipalities.
• The Public Transport Network Grant, administered by the national Department of Transport, funds the public
infrastructure and operations of integrated public transport networks in 13 cities.
• The National Electrification Programme funds municipalities and Eskom to sustain progress in connecting poor
households to electricity.
• The Municipal Systems Improvement Grant assists municipalities in building capacity for management, planning
and technical skills.
19.7 Inter-governmental issues in South Africa

The section below uses the fiscal federalism theoretical framework to analyse the structure and performance
of the South African inter-governmental system. It covers the constitutional assignment of revenue and
expenditure responsibilities to provincial and local government in South Africa as well as revenue-sharing
processes, formulae and institutions. The section concludes by focusing on specific provincial and
municipal financing challenges.
19.7.1 Constitutional issues

Constitutional issues first focus on expenditure assignment, and then on revenue and borrowing matters.
19.7.1.1 Expenditure assignment

The South African constitution establishes a state with three spheres of government: national, provincial and
local. It assigns to each of these three spheres of government certain powers or functions. These
competencies may be concurrent (shared responsibility of national and provincial governments) or
exclusive (sole responsibility and discretion of the province or sole responsibility of national government).
Functional areas of concurrent legislative competencies are listed in Schedule 4 of the Constitution and
exclusive provincial responsibilities are detailed in Schedule 5.
Schedule 5 of the Constitution specifies that certain expenditure responsibilities be devolved completely
to the provincial sphere (for example, provincial roads and abattoirs). Others (as described in Schedule 4)
are administered jointly as concurrent competencies (for example, primary and secondary education and
health). Some functions remain at national level (for example, foreign affairs and defence).
Provincial legislation in respect of these Schedule 5 functions takes precedence over national legislation,
except when national legislation is necessary to establish national norms and standards, to maintain
economic unity, to protect the common market in respect of the mobility of goods, services, capital and
labour or to promote economic activities across provincial borders. Provinces therefore have a limited
degree of fiscal (and political) autonomy, although this is weighed against the national interest.
Local government competencies are detailed in Part B of Schedule 4 and Schedule 5. Examples of
concurrent functions of local government include water, sanitation, air pollution, electricity and gas
reticulation, municipal health services and so on. Exclusive local government competencies include
beaches and amusement facilities, cleansing, dog licensing, local amenities, sport facilities and municipal
roads.
19.7.1.2 Revenue assignment and borrowing powers

The Constitution permits a province to impose taxes, levies and duties other than income tax, value-added
tax, general sales tax and rates on property or customs duties. Most productive taxes are reserved for
national government.
A province may also levy flat-rate surcharges on the tax bases of any tax (including individual income
tax), levy or duty imposed by national legislation except corporate income tax, value-added tax, rates on
property and customs duties.
Provinces may levy these taxes provided that they do not prejudice national economic policies,
economic activities across provincial boundaries, and national goods and services or factor mobility.
Additional own revenue3 raised by provinces or municipalities may not be deducted from their share of
revenue raised nationally or from other allocations made out of national government revenue. This is to
provide an incentive for provinces to increase their tax effort.
To supplement own revenues and fiscal transfers from national government through the revenue-sharing
formula (see Section 19.7.2), provinces are also empowered to raise loans. The Borrowing Powers of
Provincial Governments Act of 1996 and the Public Finance Management Act of 1999 set out the
conditions under which provinces may borrow. Loans may only be raised to finance capital expenditure
(for example, bridges and other infrastructure) and not for current expenditure (for example, wages). The
only exception to the ban on borrowing in order to finance current expenditure is for bridging finance, in
which case the loans must be redeemed within the same fiscal year. No national government guarantee is
available in respect of provincial borrowing.
Local governments are entitled by the Constitution to impose rates on property and surcharges on fees
for services provided by or on behalf of the municipality (for example, for electricity or sewerage). In the
past, municipalities were able to raise Regional Services Council (RSC) levies as a source of revenue.
These were, however, abolished since they were unconstitutional. Until a new alternative revenue source is
made available to municipalities, they will receive a temporary grant to replace lost RSC levy income. With
the proposed restructuring of the electricity distribution industry, municipalities could also lose their
electricity user charge income, which could further compromise local fiscal capacity. Municipalities are
also allowed to borrow, subject to the same restrictions as those described above for the provinces. The
Municipal Finance Management Act (2003) describes the framework for municipal borrowing.
Inter-governmental transfers and the Financial and Fiscal

19.7.2
Commission (FFC)
In South Africa, most taxes are raised at national level because collection is easier to administer and it
avoids the administrative duplication and higher compliance costs for taxpayers associated with a more
decentralised system. However, the Constitution assigns provinces with certain responsibilities regarding
the delivery of goods and services, either individually or jointly with national government. There is an
imbalance between the expenditure mandate of sub-national levels of government and the financial
resources that they can raise on their own account. This mismatch is referred to as vertical fiscal
imbalance and arises as a result of the limited capacity of the provinces to raise revenue for themselves
independently of national government. For most provinces, income raised within the province as ‘own
revenue’ (mainly from car licences and hospital fees) amounts to less than 5% of the provincial budget (see
FFC, 1996), a percentage that has subsequently declined even further in some provinces. In terms of tax
assignment criteria and the constitutional mandate of provinces, the scope to expand the provincial revenue
base is thus limited.
The Constitution states that provinces are entitled to an equitable share of the revenue collected
nationally, in line with their new expenditure responsibilities and functions. The process by which
government incomes are pooled and subsequently divided among national and sub-national governments is
referred to as revenue sharing.
The Financial and Fiscal Commission (FFC) is an independent body established in terms of the
Constitution to make impartial recommendations to the national parliament and the nine provincial
legislatures on financial and fiscal matters such as the following: equitable allocations to the three tiers of
government from the national revenue pool, intentions of provincial governments to levy taxes and
surcharges, raising of loans by lower tier governments and the criteria to be used for these purposes. We
now focus on the process of making equitable allocations to national, provincial and local government from
nationally collected revenues.
19.7.2.1 The vertical division of revenue

The allocation of funds from nationally collected revenue entails a vertical division of such revenue
between the national, provincial and local spheres of government. The vertical division of revenue for the
fiscal years 2015/16–2021/22 is shown in Table 19.1. First a ‘top slice’, which consists mainly of funds to
service the debt and provision for a contingency reserve, is subtracted from the nationally collected revenue
pool. The remainder is then split vertically among the national, provincial and local spheres. Note that the
national share includes the budgets for national departments, but excludes conditional grants to provinces
and local government. The contingency reserve is an unallocated pool of funds set aside for new priorities
in future years or to deal with unforeseeable events that are difficult to budget for precisely (such as natural
disasters, or foreign and domestic economic shocks).
From Table 19.1, it is evident that in 2018/19, after the ‘top slice’ (for state debt service costs and the
contingency reserve) was subtracted, R1 327,6 billion remained for division among the three spheres.
National government’s share of this amounted to 48,1% in 2019/20, and was expected to decrease
marginally to 47,8% over the next two years. In 2019/20, provincial governments received 43,0% of total
revenue after the top slice was subtracted (consisting of their ‘equitable share’, which is an unconditional
grant, as well as various conditional grants from national government). It was envisaged that the provincial
share would increase marginally to 43,1% between 2019/20 and 2021/22. Local government received only
8,9% after the top slice was subtracted in 2019/20. The relatively small local government share has raised
concerns about adequacy in the light of provision of free basic services, service backlogs in poorer
municipalities, migration from neighbouring states and the developmental mandate of municipalities.
Table 19.1 Vertical division of revenue in billions of rands in South Africa, 2015/16–2021/22
Source: National Treasury. 2019a. Budget Review 2019.
While the FFC formulae and recommendations are regarded as important inputs in the calculation of
these vertical divisions, the Commission’s recommendations are apparently not decisive. The government
regards the vertical division of funds between the different spheres of government as a political policy
judgement that reflects the relative priority of functions assigned to each sphere of government and not
something that can be captured in a formula (Ministry of Finance, 1999: 59).
19.7.2.2 The horizontal division of revenue of the provincial pool

The vertical division of revenue is followed by a horizontal division of the provincial and local pools of
resources available among the nine provinces and the 278 municipalities respectively. To ensure that each
provincial government receives an equitable allocation in order to meet its constitutional expenditure
obligations, the FFC (1996) proposed a revenue-sharing formula over a three- to five-year period for the
horizontal division of resources among the nine provinces. The FFC asserted that formula funding is more
objective and less prone to manipulation by politicians and civil servants. In addition, it would enable
provinces to predict the revenues that would accrue to them over the period in which the formula was in
force with greater certainty. The original FFC formula was mainly population-driven, with the population
in a province being an indicator of the fiscal need of the province, given explicit minimum standards of
service such as learner–educator ratios or average number of primary health care clinic visits. It was also
weighted in favour of rural people as a proxy for backlogs and for poverty.4 The formula aimed to equalise
rural weighted spending per capita across the provinces. As such, it addressed the horizontal fiscal
imbalances among provinces that arise from differences in revenue (tax) capacity in relation to their
expenditure responsibilities.
However, the FFC is only an advisory body and its recommendations are not binding on the Budget
Council, which actually does the division of revenues. The Budget Council consists of the Minister of
Finance and the nine provincial MECs for Finance, with the FFC as observers. The actual formula used by
the Budget Council to determine each province’s equitable share is based on the provinces’ demographic
and economic profiles (which are an indication of the relative need for public services across provinces),
given implicit service standards. The formula used in the 2019/20 division of revenue consisted of the
following:
• An education share (48%), based on the size of the school-age population (ages five to seventeen) and the
number of learners (Grade R–12) enrolled in public ordinary schools
• A health share (27%) based on a combination of the health risk profile of each province and its health
system case load (for example, women of child-bearing age and older persons consume more health
services than the population average; therefore a province with a greater share of women of child-
bearing age and of older persons would have a greater health risk profile, which is taken into account in
the formula).
• A basic component (16%) derived from each province’s share of the national population
• An institutional grant (5%) divided equally among the provinces, which recognizes that some costs of
running a provincial government are not related to the size of a province’s population or factors
included in other formula components.
• A poverty component (3%) based on the province’s share of poor households (in other words, people
falling in the lowest 40% of household incomes in the 2010/11 Income and Expenditure Survey
[StatsSA 2012]), reinforcing redistribution in the formula.
• An economic output share (1%) based on the Gross Domestic Product by Region (GDP-R) data (GDP-R,
published by Statistics South Africa, measures the gross domestic product produced in each province).
The formula determines the equitable share that is given to the provinces as an unconditional block grant. In
order to determine the total allocation for each province, the conditional grants that each province receives
from national government must be added to the equitable share. Table 19.2 shows the budgeted allocations
to the provinces for 2019/20.
Table 19.2 Budgeted provincial allocations in billions of rands for 2019/20

Because the provincial formula is largely population driven, provinces with large populations such as
Gauteng and KwaZulu Natal tend to receive larger allocations than provinces with smaller populations such
as the Northern Cape.
Since 1996, the formula has been revised several times at five-year intervals to respond to new census
data and new policy objectives. New census results typically reveal that as a result of migration between
provinces, the populations of certain provinces have increased and others have declined, with an equivalent
impact on the demand for public services. As the demographic data in the formula are updated to reflect
these changes, the share received by each province is adjusted upwards or downwards accordingly. The
new shares are not effective immediately, but are phased in over three years to enable provinces receiving
lower shares of nationally collected revenue to scale back their operations and provinces that are the
recipients of additional resources to put in place the capacity to spend their increased allocations
effectively.
19.7.2.3 The horizontal division of revenue of the local government pool

Table 19.1 shows that in 2018/19, local government received R117,3 billion or 8,8% of nationally collected
revenues available for sharing, after top-slicing debt servicing costs and the contingency reserve. This
amount comprises both unconditional transfers such as the local government equitable share and
conditional grants to municipalities, as illustrated in Table 19.3 below.
In 2018/19, municipalities received 75,2 billion through the local government equitable share and other
related unconditional grants. The eight metropolitan municipalities (in large cities) also received an
additional R12,5 billion in unconditional transfers in 2018/19 as a share of the General Fuel Levy.
A further R44,8 billion was paid to municipalities in 2018/19 as direct conditional grants to be spent
mainly on municipal infrastructure. Finally, the national government spent R7,9 billion as indirect
conditional grants (in other words, grants in kind) on behalf of low capacity municipalities that could not
spend effectively themselves.
Table 19.3 Transfers to local government, 2018/19–2021/22

As will be illustrated later, local governments are (in aggregate) not as reliant as provinces on transfers
from other spheres of government. There is, however, substantial variation among municipalities. Some
poorer municipalities rely on grants for up to 92% of their income (for example, the Bohlabela
municipality), while some urban municipalities raise up to 97% of their own income (National Treasury,
2005a: 30). Transfers to the local sphere include unconditional equitable share grants, direct conditional
grants and indirect conditional grants in kind (for example, the Water Services Infrastructure grant).
Conditional grants are generally for municipal infrastructure and other capital expenditure, capacity
building or in support of restructuring.
The individual municipality’s claim to nationally collected revenue depends not only on the total size of
the vertical division, but also on the nature of the horizontal division among municipalities. The FFC
formula for the division of the local government resource pool, which is the basis of the method used by the
Department of Cooperative Governance and Traditional Affairs and the National Treasury to distribute the
equitable share, bases the claim for a share on the relative needs of jurisdictions, after taking the tax
capacity into account. The purpose of the formula is to provide financial assistance to those municipalities
that cannot provide basic services to the poor from their own tax base.
Essentially, the latest version of the local government equitable share formula consists of five
components:
• A basic services component for water, refuse removal, sanitation, environmental healthcare services and
electricity reticulation to poor households earning less than R2 300 per month; for each of the
subsidised services, there are two levels of support: a full subsidy for those households that actually
receive services and a partial subsidy for unserviced households set at one-third of the subsidy to
serviced households
• An institutional support component to support the basic administrative and governance capacity in local
governments; it consists of a base allocation that will go to every municipality regardless of size, and a
variable allocation depending on the population in the municipality and number of councillors
• A community services component that funds services that benefit communities as a whole rather than
individual households (which are provided for in the basic services component) such as municipal
health services, fire services, municipal roads, cemeteries, planning, storm water management, street
lighting and parks
• A revenue-raising capacity correction component to take into account the estimated revenue capacity of
each municipality; it is applied to the institutional and community services components of the formula
to ensure that these funds are targeted at poorer municipalities that are least likely to be able to fund
these functions from their own revenues
• A correction and stabilising factor to ensure that municipalities are given at least 90% of what they had
been promised in the previous MTEF round of allocations in the current formula, and to ensure that
allocations would not be negative owing to the revenue raising correction (National Treasury, 2018a).
Like the provincial equitable share formula, the structure of the local government equitable share formula
itself is reviewed every five years to factor in new policy priorities. In addition, the demographic
information and other data used by the formula are updated regularly, for instance, when a new census is
conducted that shows that as a result of urbanisation, populations of rural and small towns may have
declined and that populations of larger cities have increased. These changes mean that some municipalities
may experience big drops in their equitable share allocations and other municipalities may receive
substantial gains. These allocation changes are phased in gradually over five years in order to smooth out
the impact of the changes and to allow municipalities’ spending patterns to adjust to their changed
allocation.
The introduction of free basic services at municipal level in 2003/04 placed increasing pressure on the
local governments’ equitable share as well as on their capital budgets. It became necessary for them to roll
out services to previously underserved communities characterised by high levels of poverty and
unemployment, and with little ability to pay cost-reflective municipal tariffs for basic services. While
backlogs in the provision of water, sanitation and other municipal services persist, requiring new
infrastructure, municipalities also battle to fund the maintenance and upgrade of existing municipal
infrastructure. It is a struggle to find people with the necessary technical engineering skills to do so. These
pressures have been exacerbated by cuts to, or slow growth in, key conditional grants to local government
in 2019/20 due to fiscal consolidation and deficit reduction imperatives implemented by National Treasury.
As reflected in Table 19.3, for instance, the Municipal Infrastructure Grant declined to R14,8 billion in
2019/20 from R15,3 billion the previous year; though the Urban Settlements Development grant increased
to R12,0 billion in 2019/20 from R11,3 billion the previous year; and the National Integrated Electricity
Grant was reduced to R1,86 billion in 2019/20 from R1,9 billion the previous year. This decline in
conditional grant funding may further undermine municipal financial sustainability and basic service
backlog reduction, as the number of indigent consumers qualifying for free basic services has increased in
the aftermath of the Great Recession of 2008/09. Given the need to conserve electricity and water, and to
finance significant infrastructure maintenance backlogs, the prices of bulk water and electricity have
increased markedly, putting upward pressure on municipal rates and on the tariffs that municipalities
charge for these services.
19.7.3 Provincial financing issues

Until 1996, provinces were only spending agencies for the national government, disbursing funds according
to the policies and priorities determined at national level. In the past, provinces were treated in much the
same way as national departments in the budget process, rather than distinct spheres of government. They
were mainly concerned with the implementation of national policy. They could not set their own priorities,
nor did they have much accountability. Problems could always be blamed on national government.
Estimating and evaluating expenditures across functions and provinces were done by government officials
in Pretoria, with little regard for provincial priorities. Under the provisions of the Constitution of 1996, the
provincial governments have much more latitude to determine their own spending patterns, given their own
revenue resources and the equitable share of nationally collected revenue which they receive as
unconditional transfers.
Provincial budgets should therefore increasingly embody the provincial governments’ responses to
regional challenges and opportunities for development within the nine provinces. Under these
circumstances, coordination between the spheres of government in setting expenditure priorities becomes
crucial, so that differing needs can be provided for without jeopardising national goals.
However, the nine provinces have vastly differing capacities for financial management and expenditure
control. Accountability and efficiency thus depend on the strengthening of managerial and administrative
capacity in all provinces, especially the weaker ones. Given South Africa’s history of government
overspending, sound financial management is particularly important so that provinces can perform the
spending functions devolved to them without the risk of provincial overspending. Provincial overspending
would, of course, jeopardise national deficit targets and other stabilisation objectives.
It is also important that the share of national revenue received by the province be adequate to fulfil
provincial spending obligations and that unfunded mandates are avoided. If financing is not commensurate
with the new distribution of responsibilities across spheres of government, this could also lead to persistent
pressures that encourage provincial overspending.
Probably one of the most pressing challenges facing provincial governments is the need to diversify
their tax bases and reduce dependence on national government. Provinces in South Africa have very little
own revenue capacity compared to sub-national governments in other countries and thus are fiscally highly
dependent on central government. Provincial own revenues currently represent less than 5% of provincial
expenditure on average. These revenues are mainly derived from motor vehicle licences, hospital fees and
gambling proceeds.
There are concerns that the overreliance on funding from central government could undermine
provincial fiscal autonomy. Furthermore, there is a weak link between the revenue-raising responsibility,
which is mainly at the national level, and the responsibility for spending decisions, which is provincial.
This could dilute fiscal accountability in the sense that provincial executives are not called upon to justify
expenditure patterns to provincial electorates as taxpayers. This could also induce perverse incentives such
as inefficient increases in expenditure, since costs are de facto being shifted onto national government, as
well as deviation from provincial electorate preferences. Fiscal federalism’s supposed benefit of allocative
efficiency is thus weaker. Tax legislation has recently been passed that should allow provinces limited
leeway to extend their tax bases.
The FFC has proposed that provinces be allowed to ‘piggy-back’ a provincial surcharge on the national
personal income tax, in line with constitutional provisions. For a number of technical reasons, it is unlikely
that provincial governments will be able to implement a surcharge on the personal income tax in the near
future, although they may elect to levy smaller taxes in terms of the Provincial Taxation Regulation Process
Act of 2001. If provinces were empowered to tax, it would probably only benefit the better-off provinces,
which have viable tax bases (for example, Gauteng, the Western Cape and possibly KwaZulu-Natal). In
2005, the Western Cape Provincial Government proposed a provincial fuel levy surcharge of between 10
and 50 cents as a new own revenue source, which was approved by the then Minister of Finance, Trevor
Manual, but was never implemented.
The other major challenge for provincial governments is to ensure allocative efficiency in employing
public funds in order to achieve desired basic education, health and other developmental outcomes. While
national government sets overall policy as well as national norms and standards for concurrent functions
such as health and education, actual delivery of services by schools and hospitals is implemented and
budgeted for by provincial governments. While South Africa spends much more per capita than other
African and developing countries, our basic education and health outcomes are much poorer, and continue
to be characterised by stark inequalities (Ajam & Aron, 2007).
19.7.4 Urban economics

Cities around the world, with their high concentrations of economic activities and dense populations,
provide significant opportunities for stimulating economic growth and development, but also introduce
considerable challenges in relation to pollution, traffic congestion, public transport and crime as well as the
efficient and equitable provision and financing of services such as water, sanitation and electricity. South
African cities also have to contend with the racially skewed spatial distribution of economic activity and
land use as a result of apartheid segregation, where high concentrations of poverty and backlogs in housing
and infrastructure co-exist with wealth and first-world living standards.
Urban economics is a field of study that uses the analytical tools of economics to explain the spatial
and economic organisation of cities and metropolitan areas to analyse their special economic problems and
explore solutions. Urban economics considers land use, human settlement patterns and densities, transport
costs and geographic location factors in production and consumption decisions. Unlike other economic
disciplines, which virtually ignore geography, urban economics focuses on these spatial relationships to
explain the economic motivations underlying why and how cities are formed, function and develop over
time. Policies designed to change the distribution of populations and economic activity within cities,
between cities, and between urban and rural areas also fall within the domain of urban economics (Heilbrun
& McGuire, 1987; Henderson, 1988).
A vast array of context-specific geographic, historical, political, cultural and sociological factors has
given rise to the growth of cities. Economic analysis of why cities exist goes back to Alfred Marshall’s
Principles of Economics in 1890 and has largely centred on the concept of agglomeration economies.
Agglomeration economies are economies of scale external to the firm, which could lead spatially
concentrated economies to have higher productivity and growth rates.
Internal economies of scale (also called increasing returns to scale) relate to a production technology
within a firm where the cost of producing an additional unit of output (that is, the marginal cost of a
product) reduces as the volume of output (in other words, the scale of production) increases. External
economies of scale (or agglomeration economies, as they are also called) refer to cost reductions that firms
realise when locating near each other, which increases productivity of individual firms and/or clusters of
firms in general. Unlike internal economies of scale, agglomeration economies result from the collective
presence and actions of a group of other firms in the vicinity and falls outside the control of any individual
firm. Agglomeration economies refer to cost savings to the individual firm that depend on the existence of
the scale of the industry to which the firm belongs or other complementary industries (Parr, 2002).
Agglomeration economies may arise as a result of a number of causal factors such as the following
(Ciccone & Hall, 1996; Glaeser & Gottlieb, 2009):
• Transport cost savings: The more concentrated labour, capital and other factors of production are (in other
words, the greater their spatial density), the lower the transport costs incurred. If, for example,
production of the various intermediate components that comprise a manufactured good exhibits
constant returns to scale, but transport increases with distance, then the production of all goods within
the geographical area would have increasing returns to scale. In other words, the ratio of outputs to
inputs will increase with greater density. Customers located near production facilities would also reduce
costs.
• Labour market efficiencies: Concentrations of labour may make it easier for workers to match up with a
firm’s skill requirements and vice versa. Concentration (or pooling) of labour markets may reduce
employment risk for workers and allow them to move from less productive to more productive firms
(which may be in a position to pay higher wages). In event of retrenchment, their likelihood of finding
another job in industrial concentration is greater. Furthermore, the depth of the labour market in terms
of specialist skills is likely to be greater in spatially dense urban areas.
• Sharing of inputs and infrastructure: Agglomeration economies may result from sharing, for example,
rental and specialised equipment as well as electricity generation and reticulation infrastructure.
• Information sharing, learning and innovation: Physical proximity may stimulate low-cost sharing of
information, the spread of ideas and hence increased productivity through innovation. The greater
competition borne of physical proximity may also encourage innovation. On the other hand, the age of
information and communication technology (ITC) has reduced the importance of physical proximity in
cost saving in many sectors.
• Greater consumption possibilities: Cities may offer an array of services not available elsewhere, for
example, opera houses or universities. Their density may make certain public services more sustainable,
for example, light rail public transport, large sport stadia and specialised schools.
A number of studies have attempted to establish the existence of agglomeration economies in different
countries and time periods, and to quantify them using different specifications of agglomeration economies.
While there has been widespread empirical support for the existence of agglomeration economies, precise
measurement of this phenomenon and isolation of its underlying causes proved to be far more elusive
(Glaeser & Gottlieb, 2009; Melo, Graham & Noland, 2009). This lack of understanding of the extent,
nature and causes of agglomeration economies is problematic from a public policy perspective, since it is
not clear whether existing fast growing and productive urban concentrations could, or indeed should, be
replicated. Many urban and regional development strategies based on clustering economic activity are
based on the potential to achieve agglomeration economies (Parr, 2002).
With increase in urban density and hence economics of agglomeration come increasing diseconomies of
agglomeration, including congestion, overcrowding and pollution. Using a cross-country data set of 105
countries between 1960 and 2000, Brülhart and Sbergami (2009) found evidence that agglomeration
promotes GDP growth at the initial phases of an economy’s development (when transport and
communication infrastructure and skills are scarce, and the access to capital markets is limited). Once
countries attain a certain level of GDP per capita, however, agglomeration may have no impact on growth
or even a negative impact on growth.
A policy implication of this is that there may be a trade-off between national growth and inter-regional
equity. Realising increased agglomeration economies through greater urbanisation might stimulate
aggregate growth of the national economy. It could also, however, exacerbate inter-regional or urban rural
inequality (Brülhart & Sbergami, 2009). This tension has also surfaced in South Africa, where the
increased focus on cities as dynamic centres of growth and employment may raise concerns that rural areas
are being neglected (see Box 19.3). The challenge is to ensure that linkages between urban and rural areas
are mutually beneficial and growth-enhancing.
Box 19.3 South African urban development opportunities and challenges
In African and Asian nations, there has been a trend towards ever larger proportions of the population being resident
in urban areas, ranging from small towns of 15 000–20 000 people to large cities with millions of inhabitants. It is
estimated that 60% of their populations will be urbanised by 2050, creating huge opportunities for economic growth
and combatting poverty, but also many developmental challenges (growth of informal settlements, access to basic
services such as water, sanitation and electricity, congestion, pollution, increased carbon footprint and so on
[Department of Cooperative Government and Traditional Affairs, 2013]).
In South Africa, the percentage of the population living in urban areas was 63% in 2013. This is expected to
increase to 80% in 2050 (Department of Cooperative Government and Traditional Affairs, 2013). Cities and large
towns are the economic powerhouses of South Africa, comprising 80% of the country’s gross value added (GVA). It
is therefore not surprising that they attract rural migrants in search of job opportunities and access to better public
services. The built footprint of South African cities is estimated to grow at between 3 and 5% per annum. Not only
has South Africa to deal with the challenges of urbanisation, it also has to contend with persisting spatial, economic
and social segregation on racial lines despite the demise of apartheid two decades ago. South African cities tend to be
sprawling and have fragmented spatial forms with some of the lowest densities in the world, which makes provision
of certain public goods (such as public transport and other urban infrastructure networks) less financially viable
(Department of Cooperative Government and Traditional Affairs, 2013).
19.7.5 Local government financing issues

Local government or municipal finance (or urban public finance, as it is sometimes called) is an important
component of urban economics that considers how cities raise revenues (through user charges, property
rates and inter-governmental grants) in order to deliver services and promote economic growth and
development.
Unlike the provinces, local government in South Africa has a more substantial tax base in aggregate and
the 278 municipalities that make up the local government sphere generate more than 90% of their aggregate
budget as own revenues. Government transfers are therefore a much smaller percentage of local
government revenue than at the provincial level (see Box 20.4).
Box 19.4 Local government finances in 2018/19
In the 2018/19 local government financial year, aggregate municipal operating expenditure amounted to R336,3
billion in total. In addition, municipalities collectively spent R55,4 billion on their capital budgets for that year. The
combined operating and capital spend of all municipalities amounted to a total of R391,7 billion in 2018/19.
The eight metropolitan municipalities5 alone made up 57,9% of the combined operating and capital budget of all
municipalities in 2017/18 (R235,5 billion) which reflects the concentration of economic activity and revenue bases in
urban areas (National Treasury, 2019c).
Local government capital expenditures on the construction and rehabilitation of municipal infrastructure of R55,4
billion in 2018/19 were financed through the following means:
• Transfers and subsidies (including conditional grants from national government) of R33,3 billion (60,1%)
• External loans of R8,0 billion (14,4%)
• Historical operating surpluses and other internal contributions of R13,1 billion (23,6%)
• Public contributions and donations, totalling R1,0 billion (1,8%).
This indicates that the local government sphere as a whole is very dependent on national government for infrastructure
funding on capital budgets. This is particularly true for rural and poor municipalities that have limited revenue bases.
Operating revenue for all municipalities amounted in aggregate to R342,5 billion in 2017/18 and was derived from
the following sources:
• Service charges for water, electricity and sanitation of R172,1 billion (49,3%)
• Operational transfers R78,2 billion (22,4%)
• Property rates of 67,4 billion (19,3%)
• Revenue from investments R4,7 billion (1,3%)
• Other own revenues of R27,0 billion (National Treasury, 2019c).
The aggregate municipal operating expenditure of R336,3 billion in 21018/19 consisted of the following:
• Personnel expenditure (30,1%)
• Bulk purchases such as electricity bought from Eskom and retailed to residents, and bulk purchases in connection
with water and sewage service provision (33,2%)
• Finance charges such as interest and redemption on loans (2,5%)
• Depreciation and asset impairment (7,3%)
• Remuneration of councillors (1,2%)
• Other expenditure such as general overheads and administration of the council (24,7%).
In the Western Cape and Gauteng, municipalities in aggregate are less reliant on inter-governmental grants and have
greater access to own revenue sources. In these provinces, municipal own revenues amounted to 83,6% and 85,9% of
total operating revenue respectively in 2017/18. Direct infrastructure conditional grants constituted 73,8% and 49,7%
of capital funding in the Western Cape and Gauteng respectively. This suggests that the municipalities in provinces
with greater levels of economic activity and residents with higher income levels tend to be more self-financing, more
sustainable and less dependent on inter-governmental grants.
This is in contrast to municipalities in the Eastern Cape, Mpumalanga and Limpopo, where municipal fiscal bases
are constrained by high levels of unemployment and poverty, and own revenues (raised by the municipalities
themselves) constitute a significantly lower proportion of total operating revenue. Municipal own revenues in the
Eastern Cape, Mpumalanga and Limpopo comprised 71,9%, 71,1% and 59,2% of operating revenue in 2017/18
respectively. Direct infrastructure grants from national government funded a higher proportion of aggregate
municipal capital budgets in these provinces (In 2017/18 78,4%, 85,6% and 83,9% respectively). Municipalities in
poorer provinces tend to be more dependent on grants from national and provincial governments, and less self-
financing.
Outstanding consumer accounts for municipal services amounted to R165,5 billion as at 30 June 2019, of which
R4,2 billion was deemed irrecoverable and written off as bad debt (up from R143,2 the previous financial year).
These increases in debts owed by consumers to municipalities indicate their weak ability to recover the revenue that
is due to them. Revenue management remains one of the weaknesses of local government.
In 2018/19, 125 of the 257 municipalities found themselves in financial distress. The symptoms of financial
distress included insufficient cash reserves to fund their operations, overspending on operating budgets but
underspending on capital budgets, increases in consumer debt owed to municipalities, high levels of water and
electricity losses, inadequate repairs and maintenance spending and deteriorating audit outcomes.
The Constitution distinguishes three main categories of municipalities: metropolitan councils (category A),
local councils (category B) and district municipalities (category C). There is considerable variation both
within and across these categories in terms of revenue and expenditure patterns. Metropolitan councils
occur in the big cities, for example, Johannesburg, Tshwane, Cape Town and Ethekwini. Outside of the
metropolitan councils, groups of adjacent local councils comprise a municipal district, which has its own
district council. South Africa therefore has a two-tiered local government system outside of the urban
metropolitan areas.
The key issue confronting local governments is sustainability. Muni-cipalities are under extreme
pressure (as evidenced by service delivery protests) to improve access to services as well as the quality of
the services they deliver (for example, eradication of the bucket system and provision of effective
sanitation, safe drinking water and electricity). Rural municipalities, in particular, are also faced with
infrastructure backlogs that must be eliminated as well as existing infrastructure that must be maintained.
Urban municipalities are under pressure to invest in economic infrastructure such as public transport, which
is required to underpin economic growth. All of these create spending pressures on municipal budgets, but
their revenue sources are also severely constrained. A culture of non-payment for municipal services has
led to the accumulation of arrears and pressured the revenue side of municipal budgets. Many
municipalities have experienced great difficulties in recovering the user charges owed to them by
households for services rendered.
One of the challenges of local government is to improve financial management to ensure that budgets
are adhered to. This would include the introduction of uniform accounting standards and compliance with
GAMAP (Generally Accepted Municipal Accounting Practices). Financial reporting systems also tended to
be weak at municipal level, precluding early warning systems and effective monitoring as well as
evaluation of financial and service-delivery performance. While improved credit control, debt collection
and other forms of financial management can certainly contribute to the sustainability of poor
municipalities, their financial condition will remain vulnerable unless the underlying structural conditions
of unemployment, poverty and the skewed spatial distribution of economic activity are also addressed.
Since 1994, local governments have been undergoing a fundamental transformation that culminated in
the redemarcation of municipalities in December 2000. The number of municipalities was reduced from
843 to 278 in 2014. Other important changes include the reassignment of functions between district and
local municipalities, the impact of the restructuring of the electricity industry, the devolution of health and
certain public transport functions, the funding of free basic services and the introduction of a new property
rates system. It is important to assess the impact of all these factors cumulatively on local government
finance. At present, however, there are too many transformational processes that are still either under way
or newly completed for the true financial position of individual municipalities to be determined. The
Municipal Finance Management Act of 2003 and the Property Rates Act of 2004 introduced a uniform
valuation system that should go some way to providing a legal framework for enhancing the financial
viability of municipalities. The challenge which remains is to fully implement these acts, and to identify
sustainable, new revenue streams for municipalities.
As service delivery protests at municipal level intensify, there is an urgent need for poorer and rural
municipalities to develop the managerial and technical capacity to deliver services effectively to their
residents. In addition, they must eliminate the waste, mismanagement and outright corruption that are
brought to light so often by the Auditor General. Finally, the poor performance of many public entities such
as Eskom, PRASA and some of the water boards seriously undermine the ability of municipalities to
delivery basic services, create inclusive cities and towns conducive to job creation, harness the emerging
technologies of the Fourth Industrial Revolution, deal with water scarcity and food security, and develop
resilience to climate change. Better national government oversight and effective, independent regulation of
state owned enterprises to combat corruption and inefficiency will be crucial to support municipalities in
confronting the many challenges facing them.
Key concepts
• assignment problem (page 456)
• agglomeration economies (page 478)
• block grant (page 462)
• closed-ended matching grants (page 465)
• conditional grants (page 461)
• expenditure assignment (page 458)
• financial contagion (page 460)
• fiscal federalism (page 450)
• horizontal fiscal imbalances (page 472)
• inter-governmental fiscal relations (page 450)
• inter-governmental grants (page 461)
• matching grant (page 461)
• moral hazard (page 460)
• non-matching grant (page 461)
• open-ended matching grants (page 463)
• revenue sharing (page 466)
• spatial externalities (page 450)
• sub-national government (page 450)
• tax assignment (page 458)
• tax competition (page 459)
• tax harmonisation (page 459)
• Tiebout model (page 483)
• unconditional grants (page 461)
• unfunded mandate (page 466)
• urban economics (page 478)
• vertical fiscal imbalance (page 461)
SUMMARY
• Most governments around the world have different sub-national levels or tiers. These include
provincial/state or regional governments and/or local governments or municipalities.
• Fiscal federalism (also known as inter-governmental fiscal relations) is a body of economic theory that
tries to explain why these different levels or tiers of government exist and which functions are best
centralised (that is, performed at national level) or decentralised (that is, performed by provincial and/or
local governments).
• The Tiebout model demonstrates that a decentralised fiscal system – which can accommodate a diversity
of preferences for public goods – can be welfare-increasing in relation to a centralised system that
imposes a standardised public good-tax mix on people, no matter what their tastes. Tiebout’s notion of
‘voting with one’s feet’ permits the revelation of preferences by allowing people to sort themselves into
groups with similar tastes
• Fiscal federalism theory also explains which revenue instruments (such as taxes and user charges), which
expenditure responsibilities and which borrowing powers are best assigned to each sphere of
government.
• Fiscal federalism also looks at the design of inter-governmental grants that are allocated by national
government to sub-national governments, either unconditionally (discretionary) or conditionally (in
other words, earmarked for a specific purpose only).
• Urban economics focuses on the economic rationale for the existence of cities based on agglomeration
economies and their growth and development (for example, as a result of increasing urbanisation and
rural-urban migration).
• Local government finance is a specialised sub-discipline of economics looking at how cities raise funds
(through taxes such as property rates as well as user charges for water and electricity) and how they
spend these funds in order to deliver services (for example, the rollout of municipal water and
electricity infrastructure).
• South Africa has three spheres of government: national government, nine provincial governments and 278
municipalities, each with their own expenditure functions and revenue sources, as determined by the
Constitution.
• Most of the buoyant revenue sources are collected at national government level by the South African
Revenue Services. Provincial governments as well as certain poor and rural municipalities have limited
own revenue sources, but significant expenditure responsibilities.
• As a result of this vertical fiscal gap, the South African Constitution outlined a process whereby nationally
collected revenues are divided equitably across the three spheres of government (vertical division of
revenue) and within each sphere to each provincial government and municipality (horizontal division of
revenue).
19.1 Which of the following statements are correct? The delivery of public goods with the following
characteristics are better decentralised to sub-national governments:
i. There are limited economies of scale involved in their production.
ii. They generate spatial externalities.
iii. Citizen preferences and tastes for these public goods vary substantially across jurisdictions within a
country.
a. All of the above
b. i and ii only
c. i and iii only
d. ii and iii only
19.2 Which of the following statements are correct? The following types of taxes are best centralised in
national government:
i. Property taxes
ii. Value-added tax (VAT)
iii. Corporate income tax
a. All of the above
b. i and ii only
c. i and iii only
d. ii and iii only
19.3 Which of the following is not an assumption of the Tiebout model?
a. Citizens have full information on the public goods offered by each jurisdiction.
b. There are a large number of jurisdictions for citizens to choose from.
c. All factors of production are fully mobile.
d. There are no spillovers across jurisdictions.
19.4 Certain provinces, such as the Western Cape and Gauteng, have academic hospitals that offer
specialised health services such as heart transplants, while other provinces have no academic hospitals,
but refer patients to those provinces that do offer specialised services. If provinces had to finance
specialised services in academic hospitals from their own revenue sources, they would underprovide.
What type of inter-governmental grant from national government does fiscal federalism theory suggest
is most suitable for ensuring minimum standards of access to these services?
a. Unconditional non-matching grants
b. Conditional non-matching grants
c. Conditional matching grants
d. None of the above
19.1 Explain what a local public good is and provide an example.
19.2 In a decentralised fiscal system with different municipalities or provinces, negative and positive spatial
externalities may exist. Explain what a spatial externality is and give an example of each.
ESSAY QUESTIONS
19.1 The fiscal federalism literature contends that stabilisation and distribution functions are best performed
at national level, whereas allocative functions are best performed at sub-national level. Can you
explain why?
19.2 Explain the assumptions and main arguments of the Tiebout model.
19.3 ‘A fiscally decentralised system is always more efficient and more equitable than a fiscally centralised
system.’ Discuss.
19.4 Which type of inter-governmental grant would be most suitable to ensure minimum educational
standards across all provinces? Why? Illustrate your answer by means of a diagram.
19.5 ‘Tax competition by sub-national governments always has negative effects.’ Do you agree?
19.6 Should provincial debt be formally guaranteed by the national government? Why (not)?
19.7 How does South African expenditure and revenue assignment compare with the guidelines of fiscal
federalism theory?
19.8 What are the key issues and trends in provincial and local government finances in South Africa?
1 Logrolliing refers to the reciprocal exchange of support or favours among political parties or politicians whereby one will vote for
the other’s proposed project or legislation in exchange for similar support.
2 The United States is an exception. Cities have been allowed to declare bankruptcy, most famous of which is New York City (1975)
and Detroit (2013).
3 Own revenue is taken to refer to revenue raised within the province or on behalf of the province. These include provincial taxes,
user charges, licence fees and so on.
4 Although the original 1996 FFC formula did suggest costed minimum service norms and standards, their formula was never used.
The provincial formula actually used by National Treasury and approved by the Budget Council only has implicit service
standards.
5 Johannesburg, Cape Town, eThekwini, Ekurhuleni, Tshwane, Mangaung, Buffalo City and Nelson Mandela.
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Answers to multiple-choice questions
The solutions to all of the end-of-chapter multiple-choice questions are provided here.
Chapter 1
1.1 a, b, c and d
1.2 a, b, c and d
1.3 d
1.4 b
1.5 c
Chapter 2
2.1 d
2.2 a and b
2.3 c
Chapter 3
3.1 a and b
3.2 a and c
3.3 a and c
3.4 d
Chapter 4
4.1 a, b and c
4.2 b
4.3 a and c
Chapter 5
5.1 b
5.2 a, b and c
5.3 d
5.4 a, c and d
Chapter 6
6.1 c and d
6.2 b and c
6.3 b and c
6.4 d
Chapter 7
7.1 d
7.2 b
7.3 a
7.4 d
7.5 d
Chapter 8
8.1 a, b and d
8.2 a and b
8.3 b and c
8.4 a, b and c
Chapter 9
9.1 a and d
9.2 b, c and d
9.3 a, b, c and d
9.4 b and d
Chapter 10
10.1 b and d
10.2 b, c and d
10.3 a and b
10.4 b and c
Chapter 11
11.1 d
11.2 b
11.3 c
11.4 b, c, d and e
Chapter 12
12.1 c
12.2 b
12.3 a
12.4 b, c and d
Chapter 13
13.1 c
13.2 e
13.3 b
13.4 e
Chapter 14
14.1 b
14.2 a and c
14.3 c
Chapter 15
15.1 d
15.2 b and c
15.3 c
15.4 a
Chapter 16
16.1 d
16.2 c and d
16.3 e
16.4 b and c
Chapter 17
17.1 a
17.2 c and d
17.3 c and d
17.4 b, c and d
17.5 b and d
Chapter 18
18.1 d
18.2 b
18.3 a
18.4 d
Chapter 19
19.1 c
19.2 d
19.3 c
19.4 b
Index
This is a subject index arranged alphabetically in word-by-word order, so that ‘allocation’ is filed before ‘allocative
efficiency’. See and see also references guide the reader to the preferred or alternative access terms used. Figures are
expressed in bold italic font and non-English words in italics.
A
ability-to-pay principle 227, 229–230, 244, 268, 290, 321, 322, 349, 412
active fiscal policy 415–418
active fiscal policies 405, 416, 429
as growth stimuli 421
and passive fiscal policies 404
actuarially fair premium 162–163, 164
additive welfare function 89, 105
administrative efficiency 247–264
and tax revenue 286–287
administrative fees 12, 222, 243, 406
ad valorem tax 221, 225–226, 232, 244, 257, 380
incidence 234–235
adverse selection 163, 164, 188, 195, 196
problems 164, 165
agenda manipulation 105
agglomeration economies 478–479, 484
concept 478
in different countries 479
allocation (efficiency) 65–82, 379–380
allocative efficiency 22–27, 36, 39, 65–82, 250, 343, 451
increase 193
promotion 200
for provincial governments 477
and taxation 379, 458
allocative function of government 31–32
alternative markets 56–57
altruism 87, 88
Arrow theorem 102
impossibility theorem 102–105
assignment problem 456
asymmetric information 28, 163
adverse selection 163–164
moral hazard 164–165
automatic stabiliser 263, 287
B
balanced budget incidence approach 231
base broadening 354
philosophy 361
policy debate 354
basic education
resources and outputs 203–204
service delivery issues 207–208
basic tax on companies 317
Baumol’s unbalanced productivity growth 133–134
benchmark model of economy 20–37
and allocative efficiency 22
Condition 1 22–23
Condition 2 23–25
Condition 3 25–27, 25
basic assumptions 20, 21–22, 35
efficiency
in consumption 22, 26
and economic growth 27–28, 27
in exchange 23
in production 24
benefit
principle 227–229, 244, 293, 328
and indirect taxation 339
shortcomings 229
of taxation 328–329, 335, 412
ratio 152
Bergson criterion 84, 88–92, 94
block grant 462, 472
bonds
and cost of borrowing 383–385
bracket creep 285, 287–288, 313
effects 288
and fiscal drag 288
Brown and Jackson’s microeconomic model 134–135
budget
balance 18
imbalance 15, 16
redistribution 145–146
poverty alleviation 145–146
budget-process rules 426, 429
bureaucratic
failure 110–111, 110
models 70
inefficiency 111
bureaucrats 135–136
C
cap-and-trade programmes 56
capital expenditure 128, 139, 295, 310, 375, 436, 475
allowance 312
and borrowing 222
and government expenditure 401, 407
incentives 306, 307
and loans 469
programmes 409
on R & D 307
capital gains 226, 267
on shares 316
and personal income tax 269
tax 267, 292, 308–311
capital transfer taxes 320, 321, 333–337, 361
economic effects 333–335
administrative issues 333–334
efficiency issues 333
equity issues 333
taxation in South Africa 334–335
capital value system 326
capitalised value 328
cash transfer programmes 189
conditional cash transfer schemes 189
catastrophic health expenditures 213
central government 11, 126, 223, 456, 459, 461, 477
child support grant 187–188
classical system or partnership approach 296
closed-ended matching grants 465
club goods 47
Coase theorem 57, 58, 59
command-and-control regulation 55, 56
commodity markets 36
common pool
problem 430
resources 47
communities
and public choice 97
company tax 292, 293–294
base 294–296, 317
capital gains tax 308–311, 318
economic efficiency 301
fairness 308, 318
tax burden on shareholders, workers and consumers 308
income tax reform 292, 311–312
dual income tax 313–317
flat rate income tax 312–313
and investment 301–308
decision to invest 302–303
non-tax matters 303–304
tax incentives 304–308
small and medium-sized enterprises 297–301, 317
structure 294–301
company income tax base 294–296
small and medium sized enterprises 297–301, 299, 300
types of company tax 296–297
competitive
markets 39
restructuring 65, 73–74, 77
effectiveness 81
of state-owned-monopolies 81
compliance costs 151, 227, 258, 261, 299
composite rating or differential rating 325
comprehensive income tax base 267
conditional cash transfer 148, 189
programmes 148, 169–172, 189
conditional grants 461, 473, 481
2019/2020 466
direct 467, 474, 474, 475
indirect 467, 474, 475
infrastructure 481
key 476
matching 461
to municipalities 473
to provinces 472
conditional matching grants (closed-ended) 465–466
conditional matching grants (open-ended) 463–465
conditional non-matching grants 463
congestion tax see emission fee
consolidated national government 11, 18
consul 375, 383
Constitution 4, 119, 139
and public goods 120
constitutional
Court 121
entitlements 120–121
failure 109
framework 120
reform 109–110
consumer
preferences 39
surplus 66, 69, 81, 199
approach 247, 248, 252–253, 264
loss 112
consumption
activities 49
smoothing 162, 165, 166, 169, 188, 189
tax regime 364
VAT 342
contingent liabilities 371, 391–392, 395, 459
in South Africa 391
contractionary fiscal
outcomes 429, 443
policies 411
conventional balance 406, 407, 419, 420
co-payments 197
Corlett-Hague rule 280
corruption 73, 202, 259, 457, 483
in developing countries 113
prevalence 6
and rent-seeking 111–114, 113
serious issue 120
and state capture 126, 129, 133
in Zuma administration 126
coverage 178
South African income security system components 178
childhood 178
old age 180
working age 178–179
crowding out 381, 414
argument 380
definition 410
effect 70, 138
of private investment 382
current balance 407, 437, 443
principle 437
current-balance rules see fiscal rules
current expenditure 17, 139, 206, 375, 376, 407, 434
and current revenues 437
financing 415, 469
customs duties 339, 469
cyclically adjusted budget balance(s) 407, 416, 436
cycling 105
D
deadweight loss 66, 113, 200, 257, 264, 285
of a tax 248
debt management 369–396, 449
and public debt 369, 371, 372–376, 382–383, 386–391
at sub-national level 459
debt servicing 370, 392
cost 380, 473
obligation 378
debt trap 373, 433, 434, 444
looming 390
decision lag 408–409
decision-making costs 106, 107, 108, 115
demand 4
for pure public goods 38
and supply curves 49
deregulation 17, 68
destination principle 342, 343, 364
developmental state 10, 18, 76
model 9
differential tax incidence 231
diminishing marginal utility 162
direct democracy 100, 114
direct government intervention
versus indirect government intervention 34
direct regulation 55–56
direct tax 153, 248
direct versus indirect government intervention 34
discount on a bond 384
discount price 384
discretionary policy 428
displacement effect 127, 131
of Peacock and Wiseman 131–132
disposable incomes 153, 153, 154, 154
dissaving 283, 349, 407, 434
distribution (equity) 380–381
distribution
final 83
of income 30, 83, 84
of primary income 146
of secondary income 146–147
of wealth 36, 83
distributive function of government 32–33
dividend tax 297, 317
on shareholders 363
domestic or internal debt 377
donations tax 333, 334, 335, 361
dual income tax 292, 312, 313–314, 315, 316, 317, 318, 356
dynamic efficiency 166, 455
arguments 457
definition 27
E
earmarked tax 229
economic classification of government expenditure 123
economic development 128
economic globalisation 354, 355–356
definition 355
economic growth 17, 129
and service delivery 129
economic incidence 231, 376
of a tax 233, 244, 329
economic performance 4
economic regulation 76–77, 82
see also regulation
economic rent 112
education 126, 139, 202–208
government expenditure on basic education 204
resources and outputs 203–204, 207
service delivery 202–203, 207–208
undue influence of labour unions 207
wasted learning time 208
weakness in provincial education departments 207
weaknesses of teachers 207
educational outcomes 205, 207
in South Africa 205–207
efficiency 39
considerations 92–93
and economic growth 27–28
efficiency-loss ratio 257
elasticity of taxable income 285
electricity tariffs in South Africa 80
emission fee (congestion tax) 53
employment opportunities 306, 307
endogenous or new growth theory 136, 140
entitlement theory see Nozick’s entitlement theory
equilibrium
price 40
of a private good 40
of a pure public good 42
equity and social welfare 83–95
errors of inclusion
type 1 150
type 2 150
Eskom 12, 70–73
electricity tariffs 80
estate duty 320, 333, 335, 361, 362
abatement 334
insignificant source of tax revenue 334
relevance 360
excess burden 70, 199, 215, 251, 257, 264, 275, 279
magnitude 252–254, 253, 256
measurement 247
and selective tax 252
of a subsidy 199, 199, 200
of taxation 248, 250, 264
excise duties 225, 226, 242, 339, 347, 363, 401
reforms 355
excludability 39, 47
see also non-excludability
exemption 269, 310, 312, 318
of basic consumer goods 341
from estate duties 334
from VAT 346
exhaustive expenditure 12, 18
expansionary fiscal policy 410, 442, 456
expenditure assignment 458, 468
and tax assignment 458
external costs 48, 51, 56
and benefits 21, 29, 38, 61, 62, 97
and decision-making costs 106, 107–108, 115
of pollution 49
of public goods 455
externalities 10, 22, 32, 48–49, 51–52, 53, 54, 58
alcohol 51, 52
negative or positive 32, 48, 49, 60, 62
negative production externality 49–50
policy options 69–73
pollution 51, 63
positive consumption externality 50–51
and public goods 38–64
solutions to externality problem 52, 62
creation of regulated markets 56
direct regulation 55–56
legal solution: property rights 57–58
Pigouvian taxes and subsidies 52–55
support of alternative markets 56–57
theory 84
externality argument for redistribution 87
extra-budgetary institutions 11, 18, 121, 370, 406
F
final incomes 153, 154, 155
financial contagion 7, 460
fiscal activism 7, 127, 382, 403, 411, 421, 435
era 410
fiscal centralisation 455–456
fiscal challenges 5–8
fiscal consolidation 212, 421, 434
approaches 423
and economic growth 425
measures 323, 428
outcomes 421
strategies 423
success 424, 425, 440
fiscal contraction 425
hypothesis 421, 423, 425
fiscal councils 426, 429, 430, 443
whistle-blowing activities 431
fiscal decentralisation 450, 455
economic rationale 450
fiscal discretion 428, 438
fiscal drag 288
fiscal federalism 357, 449–484, 484
borrowing powers and debt management at sub-national level 459–461
collected revenues 484
conditional matching grants 463–465, 464, 465, 465–466
conditional non-matching grants 463, 463
inter-governmental grants 461, 484
rationale 466–468
inter-governmental issues in South Africa 468–476
constitutional issues 468, 484
provincial financing issues 476–478
urban economics 478–480
literature 456
local government financing issues 480–483, 484
public choice perspective 454–455
rationale for fiscal decentralisation 450–451
Tiebout model 451–454, 484
reasons for fiscal centralisation 455–456
tax competition versus tax harmonisation 459
taxing and spending at sub-national level 456–458
allocation function 457–458
distribution function 456–457
stabilisation function 456
tax assignment 458
theoretical framework 468, 484
unconditional non-matching grants 461–462, 462
fiscal illusion 109, 412
advantage 339
fiscal incidence 152–157
analysis 152, 153, 154, 154, 156, 157
fiscal incomes 153
fiscal measures 17
fiscal policy 397–444
active fiscal policy 405, 405, 415–418, 442
activism 442
anti-cyclical fiscal policy 408–411
impact of debt 413
political constraints 411
public choice view 411–413
shortcomings 408–411
and structural economic problems 413–415
fiscal authorities in South Africa 401–403
fiscal consequences of the Great Recession 418–425
goals 399–401
instruments 401
macroeconomic role 403, 441
Keynesian approach 403–408, 404, 405, 444
nature 398–403
and budget constraint 398–399
definition 398
and oversight role of parliament 441
passive fiscal policies 405
rules versus discretion 427–429
in South Africa 431, 444
macroeconomic aspects 432–436
fiscal policymaking frameworks 426–427
comment 431
and fiscal outcomes 429–431
fiscal reforms
in sub-Saharan Africa 439–440, 444
fiscal responsibility laws 426–427, 429, 430, 431
fiscal rules 313, 413, 427–429, 430, 443
numerical 426, 427, 428, 429, 437, 438
procedural 426, 427
fiscal solvency 422, 442
fiscal sustainability 7, 360, 371, 408, 418, 421, 422, 423, 435, 441, 442
risk 436
in South Africa 390, 392, 423, 444
fiscal transparency 430, 437, 443
flat rate income tax 312–313, 318
flat rating 325
forced carrying 227
foreign
borrowing 385–386
exchange cost 385, 394
or external debt 377
free-riding 44, 45, 227, 453
behaviour 283
extent 45, 46
problem 58
friction and lags in adjustments 29
full-employment income 416, 417
budget balance 416
full insurance 164–165, 166
full integration system 296
functional classification of government expenditure 125
functional composition
of government expenditure 125, 128, 139, 192n1
of total outlays 127
G
general equilibrium
analysis 244
framework 230, 232, 240, 328, 330
theory 20
general government 7, 11, 12, 18, 124, 386
consumption 128
expenditure 14, 121, 122, 122, 123, 124, 125, 127, 133, 138, 182
on basic education 203, 204
growth 139
on health 211, 211, 212
output 15
resource use 122
revenue 156
sector 5, 122, 123, 139
spending 123, 125, 126
general tax or broad-based tax 225
Gini coefficients 143, 145, 154, 157
global
institutions 60
or regional public and merit goods 58–61
tax reform 364
warming 59
globalisation
and tax reform 355–356
‘good’ tax
properties 226–227, 244
government 14
and the economy 136–138
expenditure 5, 119, 157, 215–216
failure 9, 34–35, 70, 108, 114, 358, 458
growth 129–130
individualistic view 9
intervention 36, 193
direct or indirect 36
in education 193–195
in healthcare 195–198
regulatory role 55
spending 138
tax or borrow 379
government bonds 316, 321, 374, 383, 387, 394
issue 402
sale 370, 392
trading 377
government intervention 34, 142–157
benefits and limits of targeting 149–151
costs of targeting 151
in education 193–195, 194
effectiveness of targeting 152
in healthcare 193, 195–198, 197
to reduce inequality and poverty 142–143
in SADC countries 143–145, 144
targeting spending programmes 148–149
Great Recession
fiscal consequences 418–425
greenhouse
emissions 63
gases 60–61
growth of government 129, 136–138, 139
macro models 129–130, 139
Meltzer-Richard hypothesis 132–133
micro models of expenditure growth 133–136
Peacock and Wiseman’s displacement effect 131–132
role of politicians, bureaucrats and interest groups 135–136
Wagner’s stages-of-development model 130–131
H
health services 213–215
access and quality 213–215
affordability 213
physical proximity 213
pro-poor access 213
utilisation 213
health system see healthcare
healthcare 195–198
composition of government spending 211–213, 214
expenditure insurance 197
service delivery 208–217
South African health system 209–211
government spending 211, 211–213
and universal health coverage 209–210
horizontal equity 261, 308, 310, 313, 317, 353, 458
and vertical equity 229
and wealth 322
horizontal fiscal imbalances 472
human capital 59–60, 128, 137, 193, 195
accumulation 137, 169, 172, 189, 194
of children 148, 170
development 142
formation 27
investment 316
theory 193
I
impact of debt 381–382
impact lag 409, 442
impersonal (in rem) tax 324
implementation lag 409, 410
implicit logrolling 108, 109, 109, 454
impossibility theorem 102–105, 115, 454
income effect 249, 257, 277, 278, 282, 283, 286, 333, 464
income protection systems 172–176, 189
incentive effects 172–176
income security system(s)
components 161
in South Africa 176–177, 189
coverage 178–180
scope and adequacy 180–184
income-splitting rules 316
income tax reform 292
incomplete markets 29
increasing returns to scale 68, 478, 479
independent
Auditor-General 4
central bank 4
judiciary 4
indicator targeting 148–149, 152, 157
indifference curve approach 248, 252
indirect government intervention 34
indirect taxes 34, 155, 226, 339, 363
advantages 363
critical assessment 339–342
types 339–342
individualistic view of government 9
see also mechanistic view of government
inequality and poverty 142–148
policies 147–148
in SADC countries 143–145
inflation tax 222, 243
informal income security systems 176, 188
infrastructure investment 138
inheritance tax 311, 324, 334
administration 333
advantage 333
done-based 333
and estate duty 334
in-kind subsidies 192, 198–201, 215
excess burden of a subsidy 199
subsidisation of tuberculosis treatment 201
input tax 344, 348
credit 348
institutional framework 98, 108, 114
instruments of fiscal policy 8, 398, 401
macro instruments 401
micro instruments 401
insurance
-based income protection systems 188
motive 87
intellectual property rights 321
see also property rights
interest groups 135–136
inter-governmental
fiscal relations 447, 449, 450, 484
grants 449, 461–468, 481, 484
rationale 466–468
issues 468
Constitutional issues 468
expenditure assignment 468
revenue assignment and borrowing 469
local government financing issues 480–483
provincial financing issues 476–478
transfers and Financial and Fiscal Commission 469–470
horizontal division of revenue 471–473
local government 473–476
provincial 471–473
vertical division of revenue 470–471
international financial crisis 17–18
International Monetary Fund 30, 60, 192
bailout support 418
definition of public debt 383
VAT tax gap for South Africa 258
international tax competition
and tax harmonisation 356–360
international taxation of income 267–269
residence vs source principle 267–269
inter-temporal burden 375, 376, 378–379, 382, 393
inverse elasticity rule 237, 240, 250, 252, 263, 264, 345
application 342
J
job losses 5
justice in acquisition 85, 94
K
Katz Commission 298, 303, 306, 324, 334
Keynesian approach 403–408, 432, 441
adherents 414
to fiscal policy 403, 405, 408
to stabilisation 33
L
labour income 85, 86, 184, 289, 311, 312, 314
and selective tax 275–280, 283
tax rates 314, 315, 316, 317, 318
lack of information 28–29
Laffer curve 286, 287, 312
legacy of the past 5
lifetime budget constraint 282
lifetime income 280, 281
livelihood
promotion effects 166, 169, 170, 188
protection effects 166, 188
local authorities 11, 121, 126, 260, 328, 458
and property taxes 324, 335
logrolling 100, 105–106
lump-sum tax or poll tax 225, 231, 244, 249–250, 252, 279
M
macroeconomic goals of fiscal policy 399–401
macro instruments 401
macro models of government expenditure growth 130, 133
macroeconomic
instability 29–30
stability 381
majority rule 98, 100, 102
and criticism 102
voting rule 98, 115
majority voting
and the median voter 100–102
and preference intensities 105–106
rule 102, 105, 106, 108, 115
mandatory social insurance programmes 165
marginal effective tax rate 302
marginal private and social costs 57
marginal tax rates 261, 264, 273, 280, 284, 288, 314
changes 273–274, 285
decrease 261
and the rich 284
and the substitution effect 278
mark to market 384
market
for public goods 42–44
market discipline 430, 443
effectiveness 431, 460
market failure(s) 9, 31, 35, 38, 47, 65, 81, 83, 130, 193
categories
capital markets 195, 215
and competitive markets 32, 33
concept 20
distribution of income 30, 142
effects 31
efficiency-related 162, 165, 179, 188, 189
friction and lags in adjustments 29
further notes 30–31
incomplete markets 29
instances 28
lack of information 28–29, 163, 164, 198
macroeconomic instability 29–30, 33
non-competitive markets 29
overview 28–31
range 97
sources 38, 48, 61
market incomes 153, 153, 154, 155, 159
market performance 38
market system 4
market value
of assets 310
of bonds 384
method 327
of property 325, 326, 327, 328, 335
matching grants 461, 465, 465, 466
maturity or term structure
of public debt 387, 394
means testing 148–149, 151, 152, 168, 170, 175
mechanistic view of government 9
median voter
model 101
theorem 100, 101, 132
medical tax deductions 363
medium-term expenditure frameworks 121, 426, 429, 430
reporting requirements 431
Meltzer-Richard hypothesis 132–133
model 132
merit goods 46–48, 58, 120, 135, 165, 228, 450
education and healthcare 48
microeconomic goals of fiscal policy 400
micro models of government expenditure growth 130, 133, 140
minimum tax threshold 272, 286
mixed goods 32, 40, 46–48, 62
classes 46–47
education and healthcare 47
and merit goods 46–48
public provision 47–48
and services 47, 193
and technology 47
monetary and exchange rate policies 36
monopoly 67
moral hazard 148, 164, 188
problems 148, 151, 165
multiple rates 343, 347, 348
multiplier(s) 136, 442
effect 405, 410, 424, 442, 456
process 410
multi-stage commodity tax 339
municipalities 4
N
National Treasury 286, 300, 348, 360, 389, 391, 394, 402, 438, 441, 475
natural monopolies 29, 65, 68–73, 81
characteristics and effects 68–69
competitive restructuring 73–74
and government 69, 81
policy options 69–73
natural monopoly industries 81
needs 4
negative externalities 48, 49, 51, 54, 56, 460, 461
negative production externality 49–50
net borrowing requirement 406
net indebtedness 375, 384, 407–408
net market incomes 153, 153, 154, 155, 185
net tax or net fiscal burden 379, 393
net wealth tax 320, 321, 323, 324, 335
revenue 323
net worth 267, 375
net worth of government 375, 384, 393
net worth tax see net wealth tax
new growth theory 136–137
new model for the governance of decreasing-cost industries 73, 76, 81
and risks 81
nominal income 288
non-excludable
mixed goods 47
public goods 40, 41, 44, 59, 61, 229
non-excludability 41, 43, 44, 47
non-exhaustive government expenditure 12
non-governmental organisations (NGOs) 10
and donors 10
non-matching grants 462, 462, 463, 463, 466
non-private goods 40
non-profit-making 8, 10
sector 10, 18
non-rivalry in consumption 41, 48
Nozick’s entitlement theory 84, 85–87, 94
principles of justice 94
third principle 85
numerical fiscal rules 426, 427, 428, 429, 437, 444
see also fiscal rules
O
occupational insurance 161, 162, 165, 166, 182
contributions 180
programmes 177, 177
schemes 183, 188, 189
system 181
open-ended matching grants 463, 465
optimal majority 115
and cost of democratic decision-making 107
point 107
optimal taxation 251, 252, 255
theory 355
optimal voting rules 98, 106–108, 115
ordinary revenue 407
outcomes
fiscal 427, 428, 429–431, 443
health 171, 189, 195, 211, 239
learning 213
market 34, 146, 168
social 201, 202, 215
output gap 417, 423, 443
output tax 344, 348
outputs
ownership distribution of public debt 374
P
Pareto
criteria 84, 85, 87–88, 89, 92, 94
optimal top-level equilibrium 26
optimality
in consumption 22, 249
in production 23
partial equilibrium framework 232, 244, 252, 328, 329, 335
Peacock and Wiseman’s displacement effect 131–132
pecuniary externalities 48
perfect
competition 66, 81
price discrimination 62
perfectly competitive market system 115
personal capital income 314
personal consumption tax 338, 339, 348–351, 364
disadvantages 350–351
rationale 349–350
personal income tax 266–290
base 269–270
calculating liability 270, 289
deductions 271
exclusions 270–271
exemptions 271
rate structure 272–275
progressiveness 272–275
rebates 271–272
burden of a proportional tax 279
distorts relative prices 289
equity 283–285, 290
flexibility 287–289
general tax on income 275
selective tax on interest income 280–283
selective tax on labour income 275–280, 276
taxing the rich 284–285
effect on savings 281, 289
rates in South Africa 274
Laffer curve 287
personal property 324
Pigouvian
subsidy 51, 53
taxes 50, 52–53, 54–55, 56, 57, 62
policies
design and assessment 147–148
policy
intervention by the state 114
options 69–73
of redistribution 95
political system 4
politicians 108–110, 115, 135–136
poll tax 223
pollution 56
problems 56, 62–63
positive externalities 32, 48
positive consumption externality 50–51
positive and negative non-neutral effect 251
post-fiscal incomes 154, 154, 155, 159
potential-income budget balance 416
poverty 36, 94, 142–158
alleviation 145–146
and inequality 157
rates in South Africa 155
reduction 94, 154
in SADC countries 144
preference intensities
and voting 105–106
presumptive taxation 286
advantages 299
price-cap regulation 77, 78–79, 82
formula 78
prices 227, 231, 342
charged 78, 79
to consumers 308
current 13
different 29, 32, 43, 45, 62
distorted 164, 168, 248, 275, 439
equilibrium 22
of houses 48, 453
individual 43, 44
lower 54, 56, 63, 70
market 48, 112, 373, 406
regulated 1
relative 10, 187, 225, 247, 248, 251, 264, 275, 279, 280, 289
of water and electricity 476
primary balance 407, 408, 419, 420, 441
calculation 407
and public debt 442
trends 422
primary dealers or market makers in government bonds 384, 389, 394
primary deficit 407, 422
primary income 145–146, 153, 156, 312
distribution 146, 157
primary surplus 407
principal of debt 370, 392
principal-agent problem 28, 31, 111
private goods 43, 47, 48
and benchmark model 39–40
characteristics 40, 41, 42, 43, 44
and public goods 46, 61, 62, 102, 400, 451
private markets 44
and consumption 44
privatisation 15, 46, 74–76, 81
BOOT model 75
effects 76
and investors 303
in South Africa 10
of state-owned monopolies 75, 76
procedural fiscal rules 426, 427, 429
profit regulation 77
see also rate-of-return regulation
progressive tax 166, 224, 278, 315
on income 230, 278
on labour income 314
property rights 39, 44, 52, 57–58, 63, 303, 421
definition 57–58, 59
enforcement 58
and public goods 41
property taxation 324
assessment 326–328
efficiency effects 332
equity effects 328
benefit principle of taxation 328–329
incidence of a property tax 329–331
real property tax base 324–325
tax rates 325–326
unpopularity 332–333
proportional tax 277, 279, 282, 297, 315
analysis 278
provincial governments 11, 456, 460, 471, 484
grants 467
and property tax 324
running costs 472
public choice theory 97–116
public corporations 10, 12, 13, 18
public debt 369–395
bonds and cost of borrowing 383–385, 392, 394
concept 370–371
contingent liabilities 391–392, 395
foreign borrowing 385–386
and government 379, 393
allocation 379–380
distribution (equity) 380–381
macroeconomic stability 381
securities 387
impact of public debt 381–382, 382
inter-temporal burden 378–379
internal versus external debt 377–378
management 382–383, 386–389, 394
contingent liabilities 391–392
objectives 386–389, 389–391
size and composition 372–376
sustainability 371–372
theory 376–377, 393
public employment 5
public economics 4, 11, 35, 62, 88, 376
study field 8–10, 17, 18
theory 3
public enterprises 10, 11, 12, 76
financial liabilities 371
and loan financing 406
losses 429
or state-owned companies 10
public expenditure and growth 119–141
comparison with other countries 127–129
Constitution and public goods 120
constitutional entitlements 120–121
constitutional framework 120
economic composition 123–125, 124, 125
functional shifts 125–127
size and growth 121–123
size, growth and composition of public expenditure 121–123, 122
Public Finance Management Act of 1999 399, 437, 444, 469
public goods 61, 110
characteristics 44
and externalities 38–64
global dimensions 38
market 42–44
and private goods 44
supply 44–46
public infrastructure 15, 379, 393, 468
investments 138
public interest 9, 34, 79, 111, 112, 114
groups 100, 101
public issues 98
public-private partnerships 10, 15, 75
public sector 3, 4, 11, 31
borrowing requirement 406
and the economy 18
general approaches 31
allocative function 31–32
distributive function 32–33
stabilisation function 33–34
and private sector 14–16
restructuring 6, 17
size 12, 13, 18
composition 11, 11
public services 121
pure public goods 32, 38, 40–42, 61, 120, 135
consumers 43
definition 40, 41
market 42
R
Ramsay rule 264
rate-of-return regulation 77–78, 82
pricing 77
and sliding-scale regulation 79
rational expectations hypothesis 428
Rawlsian
experiment 98–100
theory of justice 97, 98, 114
welfare function 99
real income 288, 321
and nominal income 288
real property tax base 324
recognition lag 408
rectification of injustice
redistribution 7, 8, 17, 48, 85, 93, 145, 154–155, 242, 472
GEAR strategy 434
impact 243
of income 83, 87, 88, 91, 94, 99, 132, 166, 177, 188
issues 452
policy 93, 95, 354, 456
of resources 60, 378
of wealth 85, 94
regressive tax 224–225
regulated markets 56
regulation 7, 8, 29, 34, 76–77
in developing countries 79–81
regulatory
capture 79
function of government 34
measures 4, 5, 17, 55–56
rent-seekers
and bribes 113
corrupt behaviour 115
rent-seeking and corruption 76, 111–114, 113, 115
activities 6, 17, 113
behaviour 112
consequences 112
theory 112
representative democracy 98, 100, 110, 223
and voting 115
residence principle 267, 268, 304
application 269
or worldwide basis principle 268
resource(s) 4
allocation 4, 109
mobilisation 12, 13, 13, 18, 121, 122, 139, 399, 434
use 4, 12, 13, 17, 18, 121
by government 34, 122, 122, 139
restricted-origin principle 339
revenue sharing 357, 460, 462, 466
formula 469, 472
processes 468
Ricardian equivalence 382, 393, 403, 410, 411
theory 380
rivalry in consumption 39, 47
role of government 5
in the economy 18, 35
S
secondary income 145–146, 154
distribution 146–147, 157
secondary tax on companies 297, 361, 362
sectoral goals of fiscal policy 399, 400
sectoral or micro instruments 401
selective tax or narrow-based tax 225, 250–251
on capital 331
on commodities 240
on wealth 332
self-targeting 149, 157
mechanisms 168
service environment 135
sin taxes see sumptuary taxes
single-stage commodity tax 339
site value
rating 325
system
assesses value of land 326
sliding-scale regulation 77, 79, 82
social assistance 160–191, 166–167
cash and in-kind transfers 167, 167–169
cash transfer programmes 169–172
Tanzania 171–172
livelihood protection effects 166
programmes 160, 161, 165, 166, 167, 176–177, 182, 183
effectiveness 184–188, 189
social grants 181, 183, 189–190
and child support grants 187
and fertility 187–188
labour market effects 186–187
and welfare of poor households 184–186
social indifference curves 90
social insurance 160–191, 162
income protection
incentive effects 172–176
role 162
programmes 160, 161, 165, 166, 176, 188
rationale 162–166
social security 129
benefits 438
contributions 352, 353, 362
costs 421
definition 160
and education 120, 139
expenditure 130, 180
funds 406
needs 183, 189
network 271, 315
services 121
systems 128, 160, 161, 176, 177, 180, 182, 163, 188, 189
taxes 161, 229
social service(s) 192–216
delivery 201–202
outputs and outcomes 202
process 215
social welfare function 88, 94, 99
sources of finance 222
see also taxation
administrative fees 222
benefit taxes 222
source of income principle 268
South African
Constitution 4, 484
democratic state 4
economy 3, 5, 119
income security system 176–177
coverage 178–180
scope and adequacy 180–184
Revenue Services 226, 231, 260, 286, 300, 348, 362, 402, 484
social assistance programmes 184–188
effectiveness 184–188
spatial externalities 450, 455
special interest groups 115
specific tax 225, 353, 380
analysis 266
examples 225
stabilisation function of government 33–34
stages-of-development model 130–131
stagflation 413
state-owned enterprises 11, 15, 18, 371
bailout 392
debt 376
foreign borrowing 401
statutory incidence 231
statutory monopolies
definition 65
social costs 66–68
structural approach to fiscal policy 413–415
structural budget balance 416–417, 418, 435, 442
sub-national governments 357, 449, 450, 455, 459, 463, 464, 465
borrowing powers 392, 459–461
and corruption 457
and revenue sharing 470
taxing and spending 456
and unfunded mandates 466
substitution effect(s) 54, 92, 174, 249, 275, 276, 277, 279, 286
and income 280, 284, 289, 333, 464
and marginal tax rates 278
and price change 282
sumptuary taxes 339, 341
sun-national governments
borrowing powers 459–461
debt management 459–461
supplier-induced demand 198
supply and demand 4
supply-side economists 413, 442
sustainable economic growth 138
T
targeting 157
benefits and limits 149–151, 150
costs 151, 152, 168
administrative 151
incentive 151
stigma 151
effectiveness 149, 152
errors 151
government spending programmes 148–149
mechanisms 142, 147, 148, 149, 150, 152, 157, 176
tax
assignment 458, 470
avoidance 258, 264, 294, 323, 360
activities 334
by individuals 293, 355
base 221, 223, 225
burdens 244
compliance 247
rates 223–224
tax competition 354, 356, 357, 358, 359, 449
adverse effects 358, 459
theory 357
versus tax harmonisation 449, 459
tax deductions 225, 271, 310, 314
for children 272
for workers 308
tax efficiency 247–265, 359
excess burden of taxation 250, 252, 255
consumer surplus approach 248, 252
flexibility 263
indifference curve analysis 248–249
lump-sum taxes and general taxes 249–250
magnitude 252–254, 253
price elasticities 254–256
selective taxes 250–251
tax neutrality 251–252
tax rate 256, 256–257
tax exclusions 270–271, 315
tax exemptions 271, 294
tax expenditures 270, 289, 293, 298, 306
associated with VAT 345
category 271
removal 354
scrapping 361
tax evasion 258, 260, 261, 262–263, 264
indicator 259
measurement 258
prevalence 258
tax flexibility 247–263
tax gap 258, 259
in South Africa 258
tax harmonisation 356–360, 359, 449, 459
tax holidays 298, 302, 303
advantage 305
in developing countries 317
popularity 305
and tax incentives 304
tax incentives 283, 301, 311
for companies 293, 298, 302
in developing countries 304, 305
for employment 146
and foreign investment 317
ineffectiveness 303
for investment 302, 305, 306, 307
for retirement saving 180, 280
for small business 307
in South Africa 306
and uneven tax burden 305
tax incidence 230
of an ad valorem tax 234–235
concepts of incidence 230–232
general equilibrium analysis 240
general tax on commodities 241
selective tax on commodities 240–241
partial equilibrium analysis 232–234
incidence of an ad valorem tax 234–235
incidence of a unit tax 232–234, 234
and price elasticities of demand and supply 236–240, 237, 238
and pure monopoly 235, 235–236
and tax equity revisited 241–243
of a unit tax 232–234
tax morality 227, 261, 262
level 259
standards 261
tax neutrality 251–252, 268, 293
tax payments 46
tax rate structure
and personal income 272–275, 363
for small business 298, 299
and tax base 224
tax rebates 270, 271–272, 273, 284, 290, 302
lowered 286
tax reform 338–363,
in South Africa 360–363, 364
international experience 351
globalisation 355–356
industrialised and developing countries 351–353
international tax reform 353–355
international tax competition and harmonisation 356–357
tax revenue by type 352
tax wedge 70, 234
taxation 221–244
rates 223–225
and tax equity 221–227
ability-to-pay principle 229–230
benefit principle 227–229
fairness 227
taxation of wealth 320–335
capital transfer taxes 333, 335
administrative issues 333–334
economic effects 333
efficiency issues 333
equity issues 333
efficiency effects 331
equity effects 328
benefit principle of taxation 328–329
incidence of a property tax 329–331
property taxation 324, 329, 331, 335
tax base 324–325
tax rates 325–326
assessment 326–328
types of wealth taxes 321
unpopularity of property taxation 332–333
why tax wealth 321, 335
efficiency considerations 323
equity considerations 321–323
revenue and administrative considerations 323–324
taxes
broad-based 225
definition and classification 222–223
direct and indirect 226
general and selective 225
narrow-based 225
specific and ad valorem 225–226
taxes on goods and services 338–364, 340
personal consumption tax 348–349
disadvantages 350–351
rationale 349–350
types of indirect taxes 339
critical assessment 339–342
value-added tax 342–345
see also value-added tax
taxing and spending at sub-national level 456
allocation function 457–458
assignment issue 456
distribution function 456–457
stabilisation function 456
technical efficiency see X-efficiency
technological externalities 48
Telkom 12
theory
of second best 252
of general equilibrium 35
third-party payment problem 196, 197, 198
Tiebout model 451–454
tiers of government 4
executive 4
local government 4
provincial governments 4
total revenue 231, 236, 406
in company tax 317
formula 233
growth 436
and zero rating 347
transaction costs 57–58, 63, 309
definition 57
transfer payments 12, 13, 14, 18, 32, 128, 390, 403, 433, 461
Transnet 12
transparency-enhancing reforms 430, 443
treasury bill 370, 389, 392, 394
trend-line budget balance 416
Truth and Reconciliation Commission 85, 94
types of indirect taxes 339
U
unanimity rule 98, 102, 106, 108, 114, 115
objection 100
and Rawlsian experiment 98–100, 114
shortcomings 99
unbalanced productivity growth 133, 134
model 133
unconditional grants 461–462
unemployment 165
unfunded mandate 466, 477
uniform rate 317, 329, 345
unit tax 232, 236
and ad valorem tax 225, 234, 244, 339
on consumption 225, 233, 233,
incidence 232–234, 235
on output 235
unit of taxation 272
family 273
individual 273, 361
universal health coverage 210
systems 209
universal income grant 172–173
programme 174
urban economics 478–480
use value
determination 327
methods 327
for property 327
as a valuation base 327
user charges or benefit taxes 222, 228, 243, 329, 458, 482
examples 222
user cost of capital 302, 317
V
value-added tax 8, 154, 339, 342–345, 344, 356, 363–364
calculation 342
economic effects 340, 345–348
administration 348
efficiency and tax rate 345–346
equity 346–348
revenue 345, 363
gap 258
general tax on consumption 225, 354
rate 100
vertical equity 229, 230, 242, 259, 271, 312, 316
and bracket creep 288
effect 316
and horizontal equity 229, 230, 259, 317
objectives 308
vertical fiscal imbalance 461
vote trading 100, 105–106
see also logrolling
voter preference
size of health budget 101
voting
community homogeneity 107
outcomes 115
paradox 105
rule 115
W
Wagner’s stages-of-development model 130–131
war veterans grants 180
wealth 6, 8, 148, 223, 243, 249, 310, 322, 335
distribution 36, 83, 142, 228, 320, 322, 333
and economic opportunities 322
inequalities 320, 322, 333, 334
redistribution 85, 94
status 226
taxes 248, 311, 321, 322, 323, 324, 327, 335
and saving 323
tax base 243, 267, 320
taxation 320–337
transfer 112, 333
types of wealth taxes 321
why tax wealth 321–324
welfare effects of public policy 94
willingness to work 92, 95
worldwide basis principle 268
see also residence principle
X
X-efficiency 22, 27, 68
X-inefficiency 27, 27, 48, 67, 68, 70, 81
Y
yield curve 386, 394
types 387, 387
Z
zero-coupon bonds 370, 389, 394
zero-rating 343, 346, 360
of consumption goods 341
on foodstuffs 347
policy 348
revenue loss 347
shortcoming 347

Public Economics Seventh Edition

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Public Economics Seventh Edition

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Oxford University Press is a department of the University of Oxford.

It furthers the University’s objective of excellence in research, scholarship

PART 1 Perspectives on the role of government in the economy

The public sector in the economy

Benchmark model of the economy: Positive and normative approaches

Public goods and externalities

Allocative efficiency, imperfect competition and regulation

Equity and social welfare

Public choice theory

PART 2 Public expenditure

Public expenditure and growth

Government intervention to reduce inequality and poverty

Social insurance and social assistance

Introduction to taxation and tax equity

Tax efficiency, administrative efficiency and flexibility

Personal income taxation

14.1 Why company taxation?

16.1 Types of indirect taxes

PART 4 Fiscal policy

Public debt and debt management

PART 5 Inter-governmental fiscal relations

Part 4 covers fiscal policy and public debt.

Plan and outline of the book

The book is divided into five main parts.

How to use this book

1.2 Legacy of the past

1.3 Fiscal challenges

1.4 The study field of public economics

1.5.1 Composition of the public sector

Figure 1.1 The composition of the public sector

1.5.2 Size of the public sector

Philip Black and Ada Jansen

Box 2.1 Assumptions of the two-sector model

2.2 The benchmark model and allocative efficiency

Figure 2.1 Efficiency in exchange

Figure 2.2 Efficiency in production

Figure 2.4 Consumption and overall equilibria

Figure 2.5 X-inefficiency and economic growth

2.4 Market failure: An overview

2.4.1 Lack of information

2.4.2 Friction and lags in adjustments

2.4.3 Incomplete markets

2.4.4 Non-competitive markets

2.4.5 Macroeconomic instability

2.4.6 Distribution of income

2.4.7 Further notes on market failures

Box 2.2 Market failure: Alternative view

2.5 Enter the public sector: General approaches

2.5.1 Allocative function

2.5.2 Distributive function

2.6 Direct versus indirect government intervention

2.7 Note on government failure

Philip Black and Krige Siebrits

3.1 Private goods and the benchmark model

Figure 3.1 Equilibrium of a private good

3.2 Pure public goods: Definition

3.3 The market for public goods

Figure 3.2 Equilibrium of a pure public good

Table 3.1 A comparison of key characteristics of public and private goods

Public goods Private goods

Property rights Non-excludable Excludable

Consumption Non-rival Rival

The sum of marginal