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MTBPS: End budget cuts, stop the bleeding – and crack down on illicit financial flows

MTBPS: End budget cuts, stop the bleeding – and crack down on illicit financial flows

Jaco Oelofsen and Dominic Brown |DailyMaverick | 28 October 2020

South Africa has one of the most corrupt private sectors in the world. This has a devastating impact on the tax base. The wealth lost to profit-shifting and illicit financial flows has been estimated as being up to 4% of South Africa’s GDP per year – nearly R200-billion in 2019 alone.

It is telling how quickly the nation’s focus has shifted from the government’s economic recovery plan to the upcoming Medium Term Budget Policy Statement (MTBPS), despite the fanfare accompanying the former’s launch last week. 

Everyone knows that having been given the carrot by President Cyril Ramaphosa, we now anxiously await the stick from Finance Minister Tito Mboweni.

To anyone who has been paying attention, it is obvious that the budgetary framework of this MTBPS will be punishing. 

In their mission to close “the hippopotamus’ mouth” – Mboweni’s term for the gap between the government’s revenue and its expenditure – Treasury is looking towards massive cuts to state spending. 

In July’s supplementary budget, these cuts were estimated at around R230-billion over the next two years, not including the plan to cut the public sector wage bill by R160-billion over the next three years.

In addition, Treasury is planning to institute a zero-based budgeting approach where all budget expenses will need to be justified from scratch. 

It will be hard for Treasury to dispute that the age of austerity has finally arrived.

Job cuts and hiring freezes in the public sector will add to the ticking time bomb of mass unemployment, while pay freezes and budget cuts will not only worsen the living conditions of many, but also further suppress economic demand on a massive scale. 

It is for this reason that the United Nations Conference on Trade and Development warned last month that austerity after Covid-19 could result in a “double-dip recession in 2021 or early 2022 followed by a lost decade of lower wages, higher unemployment and slower growth”. 

To ignore the urgency of South Africa’s economic situation is to court a crisis worse than Mboweni’s predicted fiscal crisis.

The Budget Justice Coalition has recently called for a human rights budget, arguing that austerity (fiscal consolidation) aimed at prioritising debt service costs invariably results in a growing debt-to-GDP ratio and therefore fails on its own terms – not to mention its disastrous human cost. 

Rather than reverting to austerity, many have argued that more government spending is an essential aspect of a post-Covid-19 recovery. 

While it has often been argued that South Africa’s tax base is too narrow to raise the revenues needed to achieve this, the fact is that the resources are there – they are just being very well hidden. 

Far from the halls of government, where the state locks horns with unions over their wages, vast amounts of wealth are leaving the country – unnoticed by most, but not by all.

In October 2019, the Association of Mineworkers and Construction Union (AMCU) filed court papers against the directors of the second-largest chrome mining company in the world – Samancor. AMCU, acting on the testimony of a whistle-blower as well as research conducted by the Alternative Information & Development Centre, has accused the directors of Samancor of systematically shifting around R7.5-billion in profits out of the country since 2006, to the detriment of more than 5,000 Samancor workers and members of the Ndizani Trust.

In an exclusive interview, the whistle-blower, Miadrog Kon, explains how, through the setting up of an independent but related company – Samchrome, located in the tax haven Malta – the directors of Samancor were able to shift profits from South Africa using a 9% sales commission fee. Samchrome had no employees and no telephone expenses – anomalous for a sales company, but not for a shell company set up as a means of tax evasion.

This is seemingly just one of the mechanisms Samancor directors employed to make sure their profits did not appear on the books in South Africa. 

Instead, they ensured that these profits were booked with shell companies falling under the same umbrella of ownership as Samancor itself. By means of these illicit financial flows (IFFs), Samancor avoided paying the 28% tax the South African Revenue Service would have levied on these missing profits, thus retaining a greater share for itself. Once these profits were off the books, they were also used to line the pockets of certain executives and directors within the company.

This is known as base erosion profit shifting (BEPS) and Samancor is far from the only player. Profit shifting is endemic, and part of the DNA of many of the multinationals dominating the South African economy.

In a 2018 report, SARS noted that it “has detected an evolution from businesses, especially transnational corporations, whereby they utilise domestic and international loopholes to evade tax and impermissibly avoid, take advantage of cross-border structuring and transfer pricing manipulations”.

This might be a little hard to swallow for those accustomed to the myth that South Africa has a corrupt public sector but a clean and efficient private sector. 

The reality is that South Africa has one of the most corrupt private sectors in the world, according to the latest PwC report on economic crime. It notes that “South African companies have seen a notable upsurge (from 15% in 2016 to 34% in 2020) in instances of senior management perpetrating fraud”.

This has a devastating impact on the tax base. 

The amount of wealth lost to profit shifting and illicit financial flows has been estimated as amounting to up to 4% of South Africa’s GDP per year; nearly R200-billion in 2019 alone. 

In March, the commissioner of SARS stated that more than R100-billion in tax revenue had been lost in the past year due to tax avoidance/evasion. These findings are corroborated by the Financial Intelligence Centre (FIC), who estimate that South Africa continues to lose between $10-billion and $25-billion annually as a result of illicit financial flows, even though regulations have been strengthened.

Over and above the erosion of the tax base, the Samancor case, as well as the Lonmin example, illustrate that illicit financial flows, base erosion and profit shifting further directly impacts on the small shareholders – in the Samancor case it was the losses in dividends to the Ndizani Trust; the wages lost to workers demanding improved wages at the collective bargaining table; and the unfulfillment of social labour plan obligations. 

In this regard, as we have previously shown, wage evasion is often the blind spot in the discussion on illicit financial flows and BEPS.

It cannot be said that the state has ignored this issue: the fact that the government officially recognises the threat that illicit financial flows and BEPS poses is a small step forward. However, there are a number of severe limitations in its attempts to address the problem. 

Here it must be pointed out it has thus far relied mostly on the international efforts taken to address the issue of IFFs and BEPS. The Organisation for Economic Cooperation and Development’s (OECD) BEPS action plan – a 14-point set of policy recommendations to tackle profit shifting – has guided some of the measures taken by SARS, including the adoption of an automatic system of financial data reporting by South African financial institutions, as well as a common reporting standard.

While these measures are welcome, they are also insufficient. 

The OECD BEPS initiative is still in the process of being put together; a process that has been fraught with problems, including accusations of bias towards wealthy countries. 

For example, the exclusion of known tax havens including the US, Netherlands and Switzerland from the list of non-cooperative jurisdictions, as well as a lack of agreement on the basic principles behind the process. The measures put forward have also been criticised for not challenging the architecture behind the international tax system, which is a core enabler for profit shifting and wage evasion among transnationals.

However, the key issue is the fact that the South African government has continually created an environment in which profit shifting and capital flight flourishes.

Since the mid-1990s, revenues from corporate income tax continued to fall in comparison to revenues raised from indirect taxes (including the increases in value-added tax in 1993 from 10% to 14%, and in 2018 from 14% to 15%) which disproportionately impacted on poorer households.

South Africa is no exception to the massive outflow of capital from developing countries, especially in the form of interest and dividends paid to non-resident bondholders. This phenomenon arose as South Africa deregulated financial markets through the phasing out and liberalisation of capital and exchange controls. 

In addition to this, South Africa also reduced its corporate income tax rate, from 50% in 1990 to 40% in 1994, dropping even further to 28% in 2009, in line with the global corporate tax race to the bottom. 

The deregulation of financial markets and the reduction in the corporate income tax rates were meant to make South Africa more attractive for foreign direct and portfolio investment. This objective was achieved as capital inflows into the South African economy rose steadily from the early 2000s.

However, the byproduct of this has been the growing level of payments in the form of dividends and interests to non-resident bondholders (which continues to put pressure on the country’s current account of the balance of payments) as well as the declining progressivity of the South African tax framework. 

Since the mid-1990s, revenues from corporate income tax continued to fall in comparison to revenues raised from indirect taxes (including the increases in value-added tax in 1993 from 10% to 14%, and in 2018 from 14% to 15%) which disproportionately impacted on poorer households.

Moving toward the reimplementation of stricter capital controls is an essential policy reform. 

Another fault in the government’s attempts to address the problem of profit shifting and wage evasion is that it has recently indicated its intent to further reduce corporate income tax rates. 

Most states used capital controls until the International Monetary Fund forced them to “liberalise” as part of structural adjustment in the 1980s. But since the 2008/09 global financial crisis, there has been a resurgence in the legitimacy of capital controls following many countries successfully reimposing these policy reforms. 

While the implementation of stricter capital controls is not a panacea, it provides the government with the stick it needs to discipline domestic capital and harness the domestic resources available. 

There are a number of key benefits to this, including providing more mechanisms to clamp down on the deleterious practices of transnational corporations, as well as slow the level of capital outflows from the current account. 

Coincidentally, such an approach would also lead to a more sustainable way of managing the country’s public debt, through the creation of the space required to further reduce the interest rate as well as through the alleviation of pressures on the current account of the balance of payments – meaning that we will require less external borrowing in the future in order to offset the current account deficit.

Another fault in the government’s attempts to address the problem of profit shifting and wage evasion is that it has recently indicated its intent to further reduce corporate income tax rates. 

It intends to do this in order to reduce incentives for corporations to shift profits and to “encourage businesses to invest and expand production”. This is a part of the exact set of policies and the rationale behind them that has created an enabling environment for the increased levels of illicit financial flows and BEPS, as well as contributing the global corporate income tax race to the bottom. 

These actions have resulted in the declining progressivity of the tax framework and have also been a key facet of the country’s growing gross external debt levels.

The logic by which the government’s drive to create an “attractive investment environment” results in fostering illicit financial flows and BEPS is also evident in the mining sector. 

Although mining has fallen in significance since its apartheid-era heyday, the state has continued in its efforts to court foreign investment by mining transnationals – often riding roughshod over the wishes of mining-affected communities in the process. 

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As a result, mining is still a key driver of the South African economy, accounting for 38% of the country’s total export value in 2018, and 7.3% of total GDP.

The environmentally and socially destructive nature of mining is often justified in terms of its overall economic benefit, but the mining transnationals courted by the state are among the worst and most consistent practitioners of profit shifting

As mining is an export-focused industry, the majority of profit shifting here happens through trade misinvoicing, whereby export goods are sold to subsidiaries or partners of the same transnational at well above or below market price to either avoid export taxes, or to claim export tax incentives. 

According to Global Financial Integrity, up to 11% of South Africa’s total trade value is lost to trade misinvoicing every year – the vast majority of this in mining. Mining is an inherent hotbed of profit shifting, and the sooner its economic centrality is displaced the better.

As for legal reform, the government’s current General Anti-Avoidance Rule – the set of laws which define and prohibit tax-avoidance – is vague and ineffective, complicating any attempt at prosecuting companies involved in profit shifting. There is a clear need to replace this with a purpose-built legal framework – a General Anti-Tax Avoidance Act – that leaves no loopholes and enables swift prosecution for companies involved in IFFs.

Further, as the law does not require transnationals to disclose much detail about their financial operations or internal structure, it is also extraordinarily difficult to acquire the kind of information that would be needed to take action against companies involved in profit shifting. 

Greater transparency requirements are a crucial tool for both identifying and tackling profit shifting, and thus any progressive tax reform must build on these.

Finally, the potential cuts to SARS to be announced in the MTBPS will further inhibit SARS’ capacity to investigate and to combat the deleterious practices of these corporations. 

Instead of waiting for international initiatives and perpetuating the corporate income tax race to the bottom, the state must look at what it can do here and now to stop the bleeding of the tax base and end growing income inequality.

During the State Capture years, SARS lost more than 2,000 employees. The appointment of the new SARS commissioner seems to be a step in the right direction in terms of being able to restore SARS’ integrity and the public’s trust in the organisation. However, SARS is underfunded and is thus unable to fill the vacancies within the organisation, of which 600 to 800 positions are critical. 

Any potential budget cuts to SARS would further impede the organisation from being able to fulfil its mandate effectively.

In the current context, where it is expected that tax revenues will be more than R300-billion lower than expected in February 2020, the need to clamp down on profit shifting and wage evasion is more necessary than ever to raise the revenues required to address the multiple crises exacerbated since the outbreak of the pandemic.

To regain these lost revenues, the South African government will need to enact a paradigm shift in its approach to IFFs and BEPS. 

Instead of waiting for international initiatives and perpetuating the corporate income tax race to the bottom, the state must look at what it can do here and now to stop the bleeding of the tax base and end growing income inequality.

The delivery of the MTBPS on 28 October will see unions and groups like the Assembly of the Unemployed take to the streets to demand an end to austerity in favour of a radical progressive economic shift. 

Will Tito Mboweni be listening?

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