More than 3.5 million South Africans are lifted out of poverty through fiscal policy, which taxes the richer in society and redirects resources to raise the income of the poor through social spending programs, according to a recently released World Bank Group (WBG) report.

The South Africa Economic Update: Focus on Fiscal Policy and Redistribution in an Unequal Society report explores whether fiscal policy reduces poverty and inequality. It offers an analysis which is based upon the innovative use of fiscal and household survey data to provide evidence on two main questions; how do taxes and spending in South Africa redistribute income between the rich and the poor, and what is the impact of taxes and spending on poverty and inequality? Against the backdrop of a high fiscal deficit and rising debt burden, it is essential that the government uses its existing resources effectively in the fight against poverty and inequality, according to the report.

Asad Alam, WBG country director for South Africa, said this report goes to the heart of the country’s most pressing challenges and speaks to how policies are working to support the National Development Plan’s (NDP) ambitious targets of eliminating extreme poverty and reducing inequality.

The report shows that the poorest in South Africa benefit from social spending programs. About 70% of outlays on social grants and 54% of spending on education and health go to the poorest half of the population in South Africa. Cash grants and free basic services lift the incomes of some 3.6 million individuals above $2.50 a day (PPP). The rate of extreme poverty, measured as the share of the population living on $1.25 per day or less, is cut by half from 34.4 to 16.5%. The child support grant and old age pension make the largest impact on poverty.

Fiscal policy is progressive and works to reduce inequality. By taxing the income of the rich proportionally more than the poor and using social spending to boost the incomes of the poorest more than 10-fold, fiscal policy narrows the income gap between the rich and poor. Before taxes and social spending the income of the richest 10% in South Africa is more than 1000 times bigger than the poorest 10%. After taxes and social spending, this gap falls so that the income of the riches 10% becomes 66 times bigger than the poorest 10%. This corresponds to a reduction in the Gini coefficient on income from 0.77, before taxes and social spending, to 0.59 after the impact of fiscal interventions.

The report also demonstrates that South Africa is having more success than other peer countries such as Brazil, Mexico, Argentina, Indonesia, and Ethiopia in using fiscal policy to tackle inequality and poverty. Despite the strides made by fiscal policy, because the income gap was so high to begin with, the level of inequality after fiscal policy is still much higher than it is in most other countries in the world.

Catriona Purfield, WBG lead economist for South Africa, said other polices are needed to complement fiscal policy so that the country can continue to reduce economic inequality.

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Executive Summary

Fiscal policy and redistribution in an unequal society

South Africa has made progress toward establishing a more equitable society. Since the end of apartheid, the government has used its tax resources to fund the gradual expansion of social assistance programs and scale up spending on education and health services. It thus was able to reduce poverty considerably. But progress in achieving greater income equality has proved elusive. Inequality of household consumption, measured by the Gini coefficient on disposable income, increased from about 0.67 in 1993 to around 0.69 in 2011, among the world’s highest.

With fiscal space becoming more constrained, this Update explores whether the government is making the best possible use of fiscal policy to reduce poverty and inequality. It provides an analysis based on the innovative use of fiscal and household survey data to answer two main questions:

1. How do taxes and spending in South Africa redistribute income between the rich and the poor?

2. What is the impact of taxes and spending on poverty and inequality?

This Update is the first study in South Africa to use the Commitment to Equity methodology developed by Tulane University, which allows the impact of fiscal policy on inequality and poverty in South Africa to be measured and then compared with that in 12 middle-income countries that have used the methodology.

In answer to the first question, this Update finds that the tax system is slightly progressive, and spending is highly progressive. In other words, the rich in South Africa bear the brunt of taxes, and the government effectively redirects these tax resources to the poorest in society to raise their incomes. On the tax side, fiscal policy relies on a mix of progressive direct taxes – such personal income taxes and slightly regressive indirect taxes – that when combined generate a slightly progressive tax system. Direct taxes (personal income and payroll taxes) are progressive, since the richer deciles pay a proportionally higher share of total direct tax collections than their share of market income. And because these taxes make up a fairly high share of GDP, they help narrow the gap in incomes between the rich and the poor. Indirect taxes are slightly regressive: the four poorest deciles contributed about 5.0 percent of total indirect tax collections, compared with their share of 4.8 percent in total disposable income. This regressivity at the lower end of the income distribution largely reflects the impact of excises, as value-added and fuel taxes are progressive.

South Africa uses its fiscal instruments very effectively, achieving the largest reductions in poverty and inequality of the 12 middle-income countries. As a result of South Africa’s fiscal system, some 3.6 million people are lifted out of poverty, measured as those living on less than $2.50 a day (in purchasing power parity dollars). The rate of extreme poverty is cut by half. The share of the population living on $1.25 a day or less falls from 34.4 percent to 16.5 percent, reflecting the impact of cash transfers and free basic services net of taxes. Inequality goes from a situation where the incomes of the richest decile are more than 1,000 times higher than the poorest to one where they are about 66 times higher. As a result, the Gini coefficient on income falls from 0.77, where it lies before various taxes and social spending programs are applied, to 0.59 after these fiscal interventions are incorporated. Still, the level of inequality remaining is higher than what all other countries in this sample start with before they apply fiscal policies.

In sum, fiscal policy already goes a long way toward redistribution. Even so, the level of inequality and poverty in South Africa after taxes and spending remains unacceptably high. But South Africa’s fiscal deficit and debt indicators show that the fiscal space to spend more to achieve even greater redistribution is extremely limited. Addressing the twin challenges of poverty and inequality going forward in a way consistent with fiscal sustainability will require better quality and more-efficient public services. It will also require faster and more-inclusive economic growth to address the need for jobs and higher incomes at the lower end of the income distribution – to narrow the gap in incomes between the rich and the poor and to reinforce the effectiveness of fiscal policy.