Re-orienting tax incentives could boost growth, jobs and support poverty alleviation

Re-orienting investment tax incentives towards sectors of the South Africa economy that have high productivity and a comparative advantage would stimulate growth, create additional jobs and support poverty alleviation, according to a World Bank report released today.

The ninth edition of the South Africa economic update, Private Investment for Jobs, analyzes the effectiveness and efficiency of investment tax incentives (ITIs) in various economic sectors. ITIs are one of several policy tools the government has used to accelerate industrial development in the past decade to promote additional investment and job creation against the shortcomings of a commodity-driven growth model, the report notes.

“We see from this report that most job creation, mainly from the service sector, took place during the commodity super cycle and its recent end calls for alternative sources of growth,” said Sebastien Dessus, World Bank program leader. “Our research suggests that re-aligning the ITIs into sectors of the economy that have high productivity and a comparative advantage is one way to help stimulate growth, create additional jobs and support poverty alleviation.”

The Update suggests that encouraging private investment is one area where policy can help to decisively turn around the South African economy and enhance growth.

Using firm level data, the report examines the effectiveness, cost, and impact of investment tax incentives (ITIs) granted to the various economic sectors for additional investment and job creation. It contends that if targeted well, ITIs can result in increased investment and job creation as intended and support poverty alleviation as each job created lifts about one person out of poverty.

However, the report reveals that the current set of ITIs, which the government of South Africa has deployed among other policy instruments that are aimed at promoting industrial development, have not yielded a significant reallocation of private capital toward industrial sectors, nor produced higher industrial employment as expected. Instead, private investment has in recent years increasingly gone to less productive sectors, generating negative total factor productivity growth. The report shows that in order to generate a post-tax return of 10 percent on investment, a pre-tax rate of return of 8.8 percent is needed in mining, against a pre-tax rate that is nearly three time higher in manufacturing which stands at 29.6 percent. This may be have resulted in investment moving away from productive sectors such as manufacturing.

“What we observe is a negative composition effect since 2012 in which capital went to sectors such as mining, electricity, transport and other services that recorded a decline in their capital productivity and away from sectors recording increases in capital productivity such as agriculture, manufacturing, construction, trade and finance, thus reducing average capital productivity,” says Dessus.

The report argues that re-orienting investment tax incentives to favor agriculture, manufacturing, construction, trade and other services sectors more would increase job creation at no additional fiscal cost as overall, tax incentives have generated additional private investment which exceeded foregone fiscal revenue. Furthermore, sectors which would benefit from re-oriented incentives are also those enjoying the largest employment multipliers, thus amplifying the impact of incentives on jobs creation. The positive impact of re-oriented tax incentives would be further magnified by the emergence of new comparative advantages in sectors such as manufacturing resulting from the recent evolution of South Africa’s terms of trade.

The update forecasts modest economic recovery in the next two years, with real gross domestic product (GDP) growth projected at 1.1% for 2017, and 1.8% for 2018. This increase will be driven by rising commodity prices, easing inflationary pressures and a pickup in credit stimulating household consumption demand, according to the report. However, the report warns, while growth will pick up, GDP will not rise sufficiently on a per capita basis to generate jobs on a large scale, and reduce poverty and inequality.

Private investment will be the determining factor in influencing the government’s current GDP trajectory, according to the report.

“Continued weak private investment would further undermine growth prospects, raise again the likelihood of a costly rating downgrade, and perpetuate a vicious circle of low growth-low investment,” said World Bank Senior Economist, Marek Hanusch.

“Accelerated private investment could benefit from a still weak stable rand, improving electricity capacity, and smoother labor relations, to boost exports and growth and stabilize the capital account.” Providing an enabling environment for private investment is a key priority for policy, the report notes.

Job creation is one of South Africa’s fundamental goals, with the country’s National Development Plan (NDP) targeting the creation of 11 million jobs to reduce the high unemployment rate to 6% by 2030, and to significantly reduce poverty and inequality. To meet this target, the report estimates that the economy would have to produce at least 600,000 new jobs on average, annually. However, the report reveals that the pace of job creation in the past decade has been too slow with about 310,000 jobs having been created on average every year; 265,000 by the private sector, and about 50,000 by the public sector between 2005-2015.

Unemployment, which reached its highest mark in 13 years in 2016, currently stands at 27.1% and poverty is expected to remain roughly constant between 2016 and 2018, when employing micro-simulations that model the impact of growth on household consumption, according to the report. 

“Accelerating the implementation of the NDP with strong coordination of implementing stakeholders, improving the execution of key public investment projects, strengthening cities as South African powerhouses and reducing political certainty are all areas that can raise gross fixed investment crucial to raising the growth potential of the South African economy and generating sustainable jobs,” says Hanusch.