Ever wondered why tax rates differ or why you can claim certain expenses, and not others, as deductions? Personal Finance Cameron looks at the factors the government must juggle when setting tax policy.
You may not think so, but the government performs a number of delicate balancing acts when it decides where and how much to tax you. It is not simply a matter of the government deciding that it wants X billion rand and then telling you how much tax you must pay.
Professor Keith Engel, the chief director of legal tax design at the National Treasury who is intimately involved in this balancing act, says that it is not an easy task to decide on the different taxes and the level at which they must be paid. Tax experts (such as Engel) at the National Treasury's offices in downtown Pretoria and at the South African Revenue Service across the Jukskei River in Brooklyn spend days, months and years trying to get the balance right.
The first balancing act involves ensuring that taxpayers feel they are taxed fairly. Tax unfairly and there is resistance to paying tax, and this can unsettle the country's economic stability.
The next issue is the redistributive nature of tax. Almost everywhere in the world, tax is used to address the imbalance between rich and poor. But if a government taxes the rich too excessively, it kills the incentive to earn more, or the rich simply move to a more friendly tax jurisdiction, taking their skills and assets with them.
Engel told a recent meeting of the Association for Savings & Investment SA about the difficulties of getting the tax balance right, and how the financial services industry can upset the balance.
For example, just when the government thinks it may have the balance right, along come products that comply with sharia law, which prohibits the payment of interest, and create different types of returns, or new financial vehicles are created that change the nature of the "profits" (returns made by investors) to enable investors to pay less tax or, worse for the taxman, no tax at all.
Getting the tax balance right even affects the way you may or may not save.
It is in the government's best interest that individuals save. The reasons are both macro-economic - the economy has more resources on which to draw so that it can grow - and micro-economic - if you save for the long term, you are less likely to become dependent on the state, particularly if you are in ill-health or have retired. So the government attempts to use the tax system to encourage you to save - not always successfully, considering the very low rates of individual saving in South Africa.
In designing a saver-friendly tax regime, Engel says the government needs to take into account that you will save only if your income exceeds your consumption. The weapons used by the government are:
- Reducing the tax on your pay cheque, hopefully so that something is left over for you to save. The government has decreased the income tax rates, particularly at the middle- and low-income levels, while raising the threshold at which you start to pay tax.
- Increasing indirect taxes, such as VAT and ad valorem tax (including "sin taxes" on alcohol and tobacco), to discourage spending on luxuries.
- Providing direct incentives to save. Here are two examples: there is an annual tax exemption of R22 300 (if you are under the age of 60) or R32 000 (65 and older) on the interest and foreign dividends you earn on your investments. Second, within limits, you can deduct from your taxable income the contributions you make to a retirement fund. The retirement contribution incentive defers the tax until you withdraw your savings, which in the meantime earn tax-free returns. So the longer you defer spending your savings, the better off you will be.
- Administrative action. For example, making it compulsory to belong to a retirement fund and banning pre-retirement withdrawals from your fund.
Currently, we have semi-compulsory retirement fund membership: you are obliged, in terms of the Income Tax Act, to belong to a retirement fund only if you work for an employer that has a fund.
Early withdrawals are permitted from an occupation retirement fund only when you leave your employer, because the legal obligation to belong to the employer's fund will fall away. But if you leave an employer and do not transfer your retirement savings into another retirement-savings vehicle, the taxman will come looking for his share.
With a retirement annuity, you are not permitted to withdraw anything before the age of 55.
Not always an incentive to save
Engel says that tax incentives do not necessarily encourage long-term saving.
"If you make a profit of any kind, to be fair it should be subject to tax. But we do not want to tax savings too much with the result that we discourage saving," he says.
"In the United States there are tons of incentives to encourage saving, but everyone lives on credit card debt. In Mauritius there are no tax incentives for saving, but there is a very good savings ratio.
"Tax incentives can only play a very small role. Culture is the biggest determinant of savings."
Often, tax incentives result only in people who already save shifting from one savings product to another to take advantage of the tax breaks. They would have saved with or without the incentives.
Engel says forced saving, such as compulsory membership of an occupational retirement fund, is often the better method to encourage saving.
"If you do not see the money because it is taken off before you receive your pay cheque, you don't spend it, but the danger still exists that people simply borrow more than they save."
He says that if a system of compulsory saving is introduced, there must be absolute trust that at retirement you will receive a pension based on what you have contributed plus the investment returns.
Engel says that another challenge to fostering a culture of saving is that many people are too poor to save. A way to give low-income earners an incentive to save is to put more money in their pockets at the end of every month by taxing them less. He points out that South Africans have enjoyed significant income tax relief in recent years, and this has put more money into the hands of low-income earners so they can improve their lot.
Engel says the tax authorities also have to ensure that, when applying tax, they do not favour one type of investment vehicle over another. This is not, however, a simple matter of taxing all investment vehicles equally. The government also has to match the profit (investment returns) with the potential risk.
And the lives of tax experts such as Engel are made even more difficult by savings product intermediaries, such as unit trust and life assurance companies. The structure of these companies and the nature of their products mean that taxes have to be paid at different rates and in different ways from different sources.
Life assurance companies pay tax in four different ways, known as the four fund approach.
For example, the life company pays one rate of tax on its profits (28 percent) but a different rate on the "profits" it makes on your behalf, and these rates differ depending on whether you are saving through an endowment policy (30 percent) or a tax-incentivised retirement-savings vehicle (zero percent).
When you save through a life assurance company, the life company pays any tax due on your behalf.
If you save through a unit trust management company, you pay income tax on the "profits" every year on part of the interest and foreign dividend "profits", whether you retain those "profits" in your savings or withdraw and spend them.
All investors pay the same tax on every rand of "profit" with a life assurance investment. The problem is that this system is not necessarily fair.
Life assurance tax is not fair on low-income earners, because the taxman taxes the investment port-folios at the same rate of income tax: 30 percent. This favours taxpayers whose marginal tax rate is above 30 percent. It definitely does not favour people on a marginal tax rate of less than 30 percent, particularly if they fall below the earnings threshold at which tax is paid. And no one can take advantage of the tax exemptions on interest earnings.
The reason for this unfair tax structure is that when you save through a life assurance company you do not "own" the money (or assets). Instead, you are given a promise that at a certain date in the future you will receive an amount (the maturity value) based on something. That something may be related to a stock market, a unit trust fund or a combination of asset classes.
The life company does not have to invest the money in the something on which it says it will base your maturity value. The life company can invest your money in anything, and in the case of what are called fully or partially guaranteed index-linked pro-ducts, it does exactly that. The ability to "promise" an outcome means that life assurance companies can provide you with guarantees that you cannot obtain from a unit trust management company.
When you save with a unit trust company, the money is always yours. Your savings are held by custodians on your behalf. The custodians know on a daily basis exactly how much is due to you in terms of the value of your invested capital plus the returns. So it is easy for the unit trust company to pass, by way of what is called the conduit principle, the exact "profits" on to you, to be taxed in your hands.
It is difficult for a life company to allocate returns to a particular investor, and that is why it pays tax on your behalf, at the same rate for everyone.
Another thing that worries Engel is that the life companies may take advantage of the four different tax structures to transfer assets into the most favourable structure.
But Engel says there may also be an unfair advantage for unit trust investors. For example, the unit trust companies collect "profits" on your behalf, but before they pass the "profits" on to you, they deduct management fees. So if, for example, your investment returns in one year are R1 000 and the management fees are R250, you receive "profits" for tax purposes of R750 instead of the real taxable returns of R1 000.
And then there are those creative products that challenge Engel and his colleagues. Take, for example, the massive growth of dividend income funds, which, through a number of "magical" structures, convert taxable interest into non-taxable (at the moment) dividends. One of the reasons they can do this is because no tax is payable in the hands of the product manufacturers. The conversion of taxable interest into non-taxable dividends is allowing many people on the top marginal rate to escape paying tax, adding to the tax burden of others.
Engel says the basic building blocks for savings are debt (which earns interest), shares in listed and unlisted companies (capital gains and dividends), real estate (rentals and capital gains), derivatives (mainly capital gains), commodities (capital gains) and exotics, such as art and films (capital gains). Savings intermediaries - such as banks, collective investment schemes, life assurance companies, private equity companies, occupational retirement funds and even the government, with its high-end bonds and lower-end SA Retail Bonds - use these building blocks to provide products for savers.
Engel says that in developing tax policy, the government has a direct role to play in matching "profits" with potential risk, dealing with the substance rather than the form of the "profits" that it taxes, and balancing tax and inflation so that your real rate of tax does not decline because of inflation (fiscal drag).
When it comes to savings intermediaries, the government has to attempt to achieve tax neutrality so that one intermediary is not given an advantage over another. This includes avoiding taxing one intermediary at a different rate on the same product, while taking account of tax incentives to save.
So next time you fill in your income tax return, spare a thought for the difficult task that faced the people who drew up the rules.
Higher-income earners set to shoulder a greater burden
All taxpayers, to some degree or another, have enjoyed real tax relief over the past decade, but bad news may be on the way for middle- and high-income earners, Kyle Mandy, the head of national tax technical at PricewaterhouseCoopers SA, says.
Mandy says there were significant reductions in the average rates of tax in the 2002/3, 2003/4 and 2006/7 tax years. But real tax relief has been notably more muted since the 2007 Budget, with no real tax relief granted to middle- and high-income earners in the 2008, 2009 or 2010 Budgets.
The 2010 Budget was one of the most challenging for the government in light of the economic downturn, constrained consumer spending and shortfalls in the collection of tax revenue. Apparently, high-income earners came within a whisker of seeing an increase in their personal income taxes.
He says that each year the National Treasury emphasises the income tax that is "given back" to taxpayers, particularly low-income earners. This comes mainly in the form of an adjustment to the income tax tables and an increase in the tax rebates, which compensate for wage inflation, or fiscal drag.
Taking hypothetical taxpayers and structured inflation-adjusted salary packages across the three income groups since the 2001/2 tax year as examples, Mandy says that tax relief is evident in all three groups.
"However, the low-income groups have been the most obvious beneficiaries."
For a specific low-income earner who currently earns about R178 000, the average effective tax rate has nearly halved, from 16.4 percent for the 2001/2 tax year to 8.7 percent for the 2010/11 tax year. "The tax burden in this case has fallen dramatically," Mandy says.
Lower-income earners are paying less tax in monetary terms in the 2010/11 tax year than in the 2001/2 tax year, even though pay packages have increased by 78 percent over that period. "Low-income earners can definitely be satisfied with the tax relief received over the past several years," Mandy says.
For middle-income earners (people who currently receive a total annual package of about R710 000), real tax relief between the 2001/2 and 2010/11 tax years has been far more muted, he says.
"While low-income earners have seen the average tax rate almost halved, the average tax rate for middle-income earners has declined by only 20 percent from the 2001/2 tax year, going from 30.7 percent to 24.7 percent over the period," Mandy says.
No real tax relief has been granted to middle-income taxpayers since the 2007/8 tax year, he says, and "in fact there has even been a small element of fiscal drag".
High-income earners (about R1.2 million a year in 2010/11 terms) have enjoyed even less real tax relief. The average effective tax rate of high-income earners has moved from 33.7 percent in 2001/2 to 29.5 percent in 2010/11 - a reduction of only 12.5 percent, he says.
Mandy says he is concerned by the trend of real tax relief to low-income earners coming at the expense of middle- and high-income earners. "While tax relief for low-income earners is an admirable policy, South Africa's tax regime is already massively redistributive. Making it even more so could impede us attracting and retaining critical skills required for growth," he says.
The shifting of the tax burden has come about in part by eliminating or significantly reducing the employee tax benefits that are commonly used by middle- and high-income earners. This has included:
- The elimination of deductions for entertainment expenditure (in the 2002/3 tax year);
- The capping of tax-free contributions to medical schemes (2006/7);
- The increase in deemed private mileage for travel allowances (2005/6 and 2006/7);
- The capping of vehicle costs and the inclusion of finance lease agreement residual values for travel allowances (2005/6); and
- The failure annually to adjust the deemed travel expenditure table.
Mandy says more adjustments are in the pipeline that will further burden higher-income earners.
He says the proposal to change the medical scheme contribution deduction to a tax credit system in the 2012/13 tax year will benefit taxpayers whose current taxable income is R221 000 or less and who are currently taxed at a marginal rate of up to 25 percent.
For middle-income earners, the change will raise their average tax rate by 0.3 percent for the 2010/11 tax year.
The already promulgated scrapping of the deemed business kilometre regime for travel allowances will hit hard, he says.
For a hypothetical middle-income earner who does limited business travel, the new regime could increase the average tax rate by over three percent if it were applied in the 2009/10 tax year, Mandy says. In such a situation, the average tax rate of the hypothetical middle-income earner will rise to above that in 2002/3 and reverse any real tax relief enjoyed since then. However, the higher the actual business travel relative to the deemed business travel, the more muted will be the effect of the change, he says.
This article was first published in Personal Finance magazine, 3rd Quarter 2010. See what's in our latest issue