Pro-Poor Tax Policy Changes in South Africa: Potential and Limitations

Since 1994, the South African government has committed to increasing economic growth and reducing poverty and inequality. Tax policy has been the most important instrument at its disposal to meet these objectives. A dynamic computable general equilibrium model, with endogenous labour supply, is constructed and linked to a microsimulation model in order to assess the poverty and inequality implications of interventions associated with tax changes. Tax change scenarios are experimented with under a fiscally consolidated framework, i.e., full recovery of tax reductions and exemptions. Three main conclusions are reached. First, higher direct tax progression is unlikely, but there is room for changes in the tax mix towards indirect taxation to achieve greater efficiency, poverty and inequality reduction. Second, the implication for economic growth from tax policy changes is limited. Third, raising VAT and redistributing the proceeds back to poor and extremely poor households generates pro-poor outcomes. This latter finding has important implications for tax policy, as it addresses resistance to higher consumption taxes that is fuelled by arguments that VAT increases raise the tax incidence on the poor. This is completely reversed in the proposal by directly recycling the VAT revenues raised to poor households.