The Impact of Inflation Expectations and Public Debt on Taxation in South Africa

Abstract

The study investigates the impact of inflation expectations and public debt on taxation in South Africa, employing the autoregressive distributive lag model and Granger Causality techniques. The results indicate a long-run positive significant relationship between inflation expectations and taxation and a negative significant relationship between public debt and taxation. This reveals that when consumers and businesses expect the inflation rate to rise, taxable income will also increase. The public debt-taxation nexus can imply that the South African government finances its debts through borrowing than through taxation. Therefore, economic participants must have full knowledge of what can influence taxation.

1. Introduction

In South African economic history, the maintenance of price stability and debt stability has always been the major macroeconomic objective that South African policymakers must strive to achieve. In the world of globalization, the cross-border transmission of inflationary forces is undeniable and one of the dynamic macroeconomic issues confronting most economies around the world [1]. Therefore, the risks of inflation must be managed prudently and with caution. South Africa’s public debt has always remained a challenge for policymakers. For example, [2] states that policymakers still do not grasp what drives inflation expectations almost 10 years after the Great Recession of 2008–2009. In February 2000, the South African Reserve Bank (SARB) adopted the inflation target as a guideline, which describes an acceptable inflation rate in South Africa. However, inflation risks should be quantified into inflation expectations, and policymakers must consider them. Tax authorities when formulating tax systems, because if tax rates are not adjusted for inflation, this may lead to distortions in the economy [3]. Therefore, the primary aim of this research study is to give attention to how public debt and inflation expectations influence taxation.

Economic participants such as investors, financial analysts, workers, trade unions, and businesses all have opinions on the future rate of inflation, which are referred to as inflation expectations or expected inflation. As a result, people evaluate this rate when making judgments about various economic activities that they want to engage in shortly. In the world of central banking, inflation expectations serve at least two purposes. They provide a summary of statistics where inflation is expected to be because they are essential inputs into the price level. Secondly, they can be used to judge the central bank’s inflation target’s legitimacy. According to [4], the expected inflation for 2021 was estimated to be 4.6% in 2020 and 5.1% in 2021. Inflation expectations reversed course in the second quarter of the 2021–2022 financial year after declining by 0.3 percentage points relative to the fourth quarter in the previous survey, and on average inflation is expected to edge up from 4.2% in 2021 to 4.4% in 2022 and 4.5% in 2023 [5]. The trend analysis for the two conductors of the inflation expectations surveys depicts a stable price level in South Africa. Hence, on average inflation is expected to be within the official inflation target (3–6%). The rate of inflation expectation affects the behavior of various economic participants on how they should spend and invest, thus affecting taxable income [6].

The study on the effect of inflation expectations and public debt on taxation is important in South Africa. Researchers in South Africa have attempted to establish the link between public debt and taxation. For example, a study by [7] attempted to study the relationship between public debt, economic growth, and inflation based on data among BRICS countries. Based on the literature reviewed in this study, most studies around the world only focused on the relationship between inflation and public debt, which are the explanatory variables in this study [8, 9, 10]. From the literature review, it appears that there is a lack of studies about the effects of inflation expectations and public debt on taxation in South Africa. The studies reviewed do not link inflation expectation to public debt and taxation. Therefore, this study will make a significant contribution to the existing body of knowledge in South Africa, because of the unique selection of variables in the specified model. The study adopts the Autoregressive Distributive Lag (ARDL) estimation method for empirical analysis covering the period from 2000 to 2020, which includes the global financial crisis and two health crises.

As alluded to above, non-inflation-adjusted tax rates create distortions in the economy. However, taxation is also a distortion because there is no economic activity involved. Such small negligence in policy decision-making can be problematic, for example, by overestimating or underestimating the true value of the economic activity. Tax thresholds often do not increase in line with inflation [11]. If employees gain a salary increase to match inflation, then they are not better off in real terms. In addition, with a nominal salary increase, individuals may enter a higher tax bracket and therefore be worse off. This phenomenon is called bracket creep. In South Africa, a progressive personal income tax system is used to reduce inequality [12].

2. Literature review

This section is divided into two subsections, which are theoretical literature and empirical literature. The first subsection outlines theories associated with economic time series variables understudy. The second subsection presents empirical evidence related to the topic under review.

2.1 Theoretical literature

The study investigates the influence of inflation expectations and public debt on taxation, which may create distortions in the economy. The fiscal theory of the price level is proposed as a suitable theory that attempts to form and explain the nature of the relationship between inflation expectations and taxation in this study. This theory originates from the work of Woodford in 1994 [13]. This theory emphasizes the role of fiscal policy, including taxes (present and future taxes) and the debt level in determining inflation [14]. Traditionally, this role is tasked to the monetary policy as advocated in the Quantity Theory of money by Friedman in 1980. This theory opposes the monetarist view that states that the money supply is the primary determinant of the price level and inflation [13]. However, both theories share a common view on how an increase in government spending (through public debt) represents an injection in the economy and this increases the flow of money In the end, price levels are expected to increase because of the notion that too much money ceases few goods (ceteris paribus).

The fiscal theory of the price level suggests that in real terms, the government can inflate its debt away [14]. This means that high inflationary pressures caused by the fiscal policy will devalue government debt and the amount that must be repaid will be smaller in real terms. In terms of this theory, high price levels do not warrant the need for present and future tax increases. However, understanding that tax cuts and increases in government spending do not necessarily have to be paid by higher taxes later, may create room for too much government and unstable government debt. This theory will be tested against the Ricardian equivalence hypothesis, which will be reviewed in this subsection.

Ricardian equivalence hypothesis is proposed in this study, because of how it differs from the fiscal theory of the price level on taxation perspective when government increases spending. Ricardo in 1951 developed this theory, which was later elaborated upon by Barro in 1979 [15]. This theory assumes that economic participants are rational, and this allows them to anticipate an increase in taxes when government increases spending. According to this theory, all government purchases must be paid by taxes. Unlike the fiscal theory of the price level, this theory does not consider inflation expectations caused by an increase in government spending through borrowing [16]. Government debt must be repaid by increasing taxes. This theory for the interest of this study anticipates an increase in taxes when public debt increases. This theory suggests that a tax cut today is balanced by tax increases in the future.

This economic theory suggests that when a government tries to stimulate growth in the economy by increasing debt-financed government spending will lead to a tax increase in the future [14]. Therefore, an increase in debt-financed government spending has a positive relationship in the long run. Public debt and taxation are important instruments of fiscal policy [16]. This theory demonstrates the relationship between the two instruments in the economy. In addition, this theory advocates that those taxpayers should anticipate that they will have to pay higher taxes later.

2.2 Empirical literature

Some views in the literature indicate the effects of public debt on expected inflation. For instance, there is a study that investigated fiscal policy and expected inflation in households in the United States [17]. The study used a large-scale survey of US households to assess whether expected inflation reacts to the information provided. The study employed a Nielsen home scan panel, which included approximately 80,000 households to run the results. The findings revealed that most households do not perceive current high deficits or current debts as inflationary or as the indicator of significant changes in the fiscal outlook [17].

Although a considerable amount of research has been conducted on the issues of public debt and expected inflation, there is a research gap on the impact of inflation expectations and public debt on taxation especially in South Africa [17, 18, 19]. For instance, there is a South African study that employed the Autoregressive Distributive Lag (ARDL) to evaluate the nexus between inflation expectations and aggregated demand using secondary time series data [18]. The study revealed that when employing the Error Correction Model (ECM), a 1% increase in inflation expectations would lead to a 0.4% decrease in the level of gross domestic product, ceteris paribus. Since a shadow economy cannot be taxed, it destroys the tax base and reduces the tax revenues, forcing governments to resort to other ways to finance their expenditure [18]. In supporting this statement, another study measured the impact of the shadow economy on inflation and taxation using panel data of 162 countries from 1999 to 2007 [19]. The study observed that there is a positive relationship between the size of the shadow economy and inflation and that the size of the shadow economy and the tax burden are negatively related. From both relations, there have been causal effects running from the shadow economy and tax burden. The relationships are robust in controlling the debt ratio, estimating the two relations as a system, and using alternative estimates of the shadow economy [19].

Some researchers found contradictions in the relationship between taxation, public debt, and the inflation rate using different methodologies. For example, one researcher used an ordinary least square (OLS) methodology to find the negative effects of taxation on macroeconomic aggregates, including inflation in Nigeria [20]. Others used autoregressive distributed lag (ARDL) and discovered that the impact of public debt on inflation is positive but statistically insignificant [9, 21, 22]. The positive association is in line with the study that investigated public debt and inflation nexus using a panel of 52 African countries [7]. Contrary to the findings, it was discovered that a negative relationship exists between the inflation rate and public debt [23].

There was an examination of public debt, budget deficit, and tax policy reforms for fiscal consolidation in Sri Lanka that employed the Vector Error Correction model (VECM) [10]. It was revealed that direct government tax revenue, indirect tax revenue, and consumer price index are negatively correlated with government debt to GDP ratio in the long run. In the short run, only direct tax revenue affects it significantly [10]. In addition, there was an examination of the effects of tax policy on inflation in Nigeria, employing Johansen cointegration test technique [24]. The results of the estimates revealed that the personal income tax rate harms inflation in the long run, while the company income tax rate has a significant positive relationship with inflation in the long run. However, some researchers found conflicting results that personal income tax and company income tax have no significant relationship with GDP [25].

Many scholars utilized Granger Causality tests to reveal the direction of causality in the relations between taxation, public debt, and expected inflation [10, 26, 27, 28, 29, 30]. It was revealed that a unidirectional causality relationship exists between tax revenue and public debt [10, 26]. However, few studies revealed that there is a unidirectional causality running from inflation to taxation [27, 28]. Others established a unidirectional relationship between inflation to domestic debt and external debt in Malaysia [29]. In Bangladesh, the results of a study indicated the presence of unidirectional causality running from budget deficit to inflation [30]. This budget deficit is a representation of public borrowing requirements.

In South Africa, a study investigated the relationship between oil prices, exchange rates, and inflation expectations in South Africa [31]. The study employed monthly time series data from July 2002 to March 2013, and the data were obtained from the South African Reserve Bank. The study employed a Vector Autoregression (VAR) model to run the results. The authors found out that oil prices and exchange rates have a positive relationship with inflation expectations in the long run. The food variable is inversely related to inflation expectations [31]. The study further indicated that oil, exchange rates, interest rates, and food costs are Granger causes of inflation expectations, both in the short run and long run. The study concluded that stable and low inflation together with well-anchored inflation expectations is important to monetary authorities as they help in achieving monetary policy objectives such as economic growth and financial stability.

This section laid down both the theoretical and empirical framework of the study. The first theory is the fiscal theory of the price level, which suggests that there is a need to understand that tax cuts and a rise in government spending do not necessarily have to be paid by higher taxes, and this may create too much unstable public debt [14]. Contrary to the first theory, the second theory is the Ricardian equivalence hypothesis, which does not consider the inflation expectations resulting from an increase in public debt [16]. The theory is based on the notion that a tax cut today is balanced by a rise in future taxes. In examining the empirical literature, more attention was given to taxation and inflation in most countries than the relationship between inflation expectations and taxation. Most studies reveal that there is a negative insignificant relationship between taxation and inflation. A relationship between public debt and taxation was found to be negative and that a stable relationship exists between public debt and inflation. Hence, this study will contribute by documenting new knowledge to the literature in addressing the impact of inflation expectations and public debt on taxation in South Africa.

3. Research methodology

3.1 The estimated model

The model used in this study is an econometric model, which runs multiple regression analyses between taxation as a dependent variable and the independent variables that affect taxation such as inflation expectations and public debt. Inflation (CPI) is a control variable in the model. The general model is specified as follows:

$$\mathit{TAX}=\mathit{f}\left(\mathit{INFE},\mathit{PD},\mathit{CPI}\right)$$E1

Eq. (1) describes the relationship between the dependent variable (taxation) and the independent variables (inflation expectations, public debt, and inflation rate). Where TAX is Taxation, INFE is Inflation expectations, PD is public debt, and CPI is Inflation.

3.2 Data

The study used quarterly secondary time series data obtained from the South African Reserve Bank. Due to the availability of data, especially for inflation expectations, the study covered the period from 2000 to 2020.

3.3 Estimation techniques

An ARDL-based ECM is employed in this study to analyze the short-run effects of inflation expectations and public debt on taxation. After testing for stationarity, if variables portray different orders of integration like at first level [I (0)] or at first differencing [I (1)], the ARDL can be employed [18, 32, 33]. The ARDL approach simultaneously captures the cointegration between a set of variables, the long-run and short-run estimates including the speed of adjustment. The ARDL cointegration test is also called the bounds test [33] and indicates if the long-run relationship exists in the series. It is advantageous due to its ability to incorporate small sample size data and yet generate valid results [32]. The ARDL bounds test gives the lower bound critical value and the upper bound critical value. If the computed F-statistics lie above the upper critical bounds test, we reject the null hypothesis of no cointegration, indicating that cointegration exists. In the case where the computed F-statistic lies in between the two bounds test, the cointegration becomes inconclusive [33]. When the F-statistics is below the lower bound, then there is no cointegration.

To determine the long-run estimates, the short-run dynamics, and ECM, Eq. (1) can be transformed into Eq. (2):

$$∆{\mathit{TAX}}_t=\begin{array}{l}\alpha +\sum _{i=1}^k{\beta }_1∆{\mathit{TAX}}_{t-1}+\sum _{i=1}^k{\beta }_2∆{\mathit{\text{INFE}}}_{t-1}+\sum _{i=1}^k{\beta }_3∆{\mathit{PD}}_{t-1}\\ +\sum _{i=1}^k{\beta }_4∆L{\mathit{CPI}}_{t-1}+{\delta }_1{\mathit{TAX}}_{t-1}+{\delta }_2{\mathit{\text{INFE}}}_{t-1}+{\delta }_3{\mathit{PD}}_{t-1}+{\delta }_4{\mathit{CPI}}_{t-1}\\ +\phi {\mathit{ECM}}_{t-1}+{\epsilon }_t\end{array}$$E2

Where ∆ denotes the first difference operator in the model, α represents the constant, and ε represents the error term also known as the white noise disturbance. The long-run relationship in the model is represented$\mathrm{by}{\delta }_1-{\delta }_4$ coefficients. The short-run relationship in the model is represented by ${\beta }_1-{\beta }_4$ coefficients, $\mathit{phi}$denotes the speed of adjustments, and ECM denotes the residual obtained from estimated cointegration in the equation. As Engle and Granger in 1987 put it, error-correcting or simply ECM allows long-run components of variables to obey equilibrium constraints while short-run components have a flexible dynamic specification [9, 18, 21]. After confirming the long-run equilibrium among the variables with the bounds test, the short-run, long-run and ECM coefficients (α, β’s, δ, φ) are estimated using ARDL [21].

The study employs the Granger causality test to determine the nature of the relationship among the variables in the study. This study requires an assessment of whether these variables Granger cause each other and the nature of Granger causality if it is bidirectional (that is, the variables have an impact on each other) or unidirectional (only one variable has an impact on the other) or independent (they have no impact on each other) (Gujarati and Porter, 2003). The first variable is said to Granger cause the second if the forecast of the second variable improves when lagged values of the first variable are considered [28, 30].

3.4 Diagnostic and stability tests

The study conducted diagnostic tests for heteroskedasticity, serial correlation, and normality [7]. For heteroskedasticity, the study employed the Breusch-Pagan Godfrey test, for serial correlation the Breusch-Godfrey LM test, and Kurtosis for normality. The study utilized the cumulative sum of recursive residuals (CUSUM) and CUSUM-square to check the stability of the model [11].

4. Findings and discussions

The unit-roots results indicated that the variables are integrated at different orders, which are I (0) and I (1), hence the study is employing the ARDL bounds test. Table 1 presents the results of the ARDL bounds test approach. The estimates were found using E-views 12, which automatically chose the optimal lag length for the model.

Test statistics	Value	Significance	Lower bound	Upper bound
F-statistics	8.51
		10%	2.2	3.09
		5%	2.65	3.49
		1%	3.29	4.37

Table 1.

ARDL bounds test computed from E-views 12.

Table 1 shows significant levels for the lower bound and upper bound at 1%, 5%, and 10%. The number of independent variables understudy is 3, hence k = 3. The results show an F-statistic value of 8.51, which is greater than the lower bound I (0) and upper bound at all levels of significance (1%, 5%, 10%) respectively. The lower bound and the upper bound critical values are obtained from [33]. The information about F-statistics means that there is cointegration. The existence of cointegration in the model provides evidence of a long-run relationship between all the independent variables on taxation through the ARDL bounds test approach.

The cointegration results are consistent with prior expectations and other studies’ findings that examined public debt, budget deficit, and tax policy reforms for fiscal consolidation in Sri Lanka [10]. In their study [10], they found a positive and statistically significant relationship between public debt and taxation. Additionally, other studies analyzed the relationship between taxation and inflation in Nigeria [9]. The study revealed that cointegration exists between the variables. It is therefore necessary to estimate the long-run and short-run coefficients and speed of adjustment, and Table 2 indicates the results of ARDL estimates.

Variable	Coefficients	Probability
Dependent Variable: Taxation
Long-run results
Inflation expectations	0.8386	0.0007
Public debt	−7.8686	0.0039
Inflation	0.0832	0.5076
Short-run results
Speed of adjustment	−0.8267	0.0000
D (Inflation expectations)	0.0618	0.8943
D (Public debt)	1.5133	0.8272
D (Inflation)	−0.1796	0.0250
Constant	90.3247	0.0000

Table 2.

ARDL results computed from E-views 12.

The results in Table 2 show that there is a significant positive relationship between inflation expectations and taxation in South Africa. A unit change in inflation expectations will result in a 0.84 unit change in taxation (ceteris paribus) in the South African context. This relationship is statistically significant at a 1% level of significance. This is in line with economic theory, and the fiscal theory of price level because when consumers, as well as businesses, expect the inflation rate to rise in the future, this will increase their income tax, capital gains tax, and profits [14]. However, these findings differ from some studies that found a negative relationship though that study was between inflation expectation and aggregate demand [18].

The results further indicate that there is a negative significant relationship between public debt and taxation in South Africa as indicated in Table 2. The results show that when public debt increases by 1 unit, taxation will decline by 7.86 units (ceteris paribus). Therefore, there is an inverse relationship between public debt and taxation. This relationship is statistically significant at a 1% level of significance. This inverse relationship can mean that when public debt increases, the government does not immediately finance its debt through taxation. They might borrow money from banking institutions or International Monetary Fund (IMF). The Ricardian equivalence theory confirms that when public debt increases, we should estimate that taxation will increase, but this does not occur immediately when public debt rises [15, 16]. Hence, in South Africa, the government does not finance its debt through taxation immediately when there is an increment in public debt. The results are in line with studies that found a negative significant relationship between public debt and taxation in the long run [10, 24]. Inflation as one of the control variables indicates a positive insignificant relationship between taxation.

In the short run, inflation is the only significant variable at 5% (see Table 2). The coefficient of the speed of adjustment is −0.83 implying that deviation from long-run inflation expectations and public debt in taxation is corrected by 83% of the following period. This means the system can adjust by fluctuating, and this fluctuation will decrease in each period and return to equilibrium. The speed of adjustment confirms the existence of a stable long-run relationship [23, 24]. Table 3 displays the results of Granger causality to determine the direction the relationship that the series takes.

Null hypothesis	Probability
Inflation expectation does not Granger cause taxation; Taxation does not Granger cause inflation expectation	0.0048; 0.7055
Public debt does not Granger cause taxation; Taxation does not Granger cause public debt	0.2698; 0.0011
Inflation does not Granger cause taxation; Taxation does not Granger cause inflation	0.0016; 0.7524
Public debt does not Granger cause inflation expectation; Inflation expectation does not Granger cause public debt	0.2656; 0.0236
Inflation does not Granger cause inflation expectation; Inflation expectation does not Granger cause inflation	6.E-06; 0.3986
Inflation does not Granger cause public debt; Public debt does not Granger cause inflation	0.0125; 0.1001

Table 3.

Granger causality computed from E-views 12.

In Table 3, there is unidirectional causality between inflation expectations and taxation. Inflation expectations have a positive impact on taxation at a 1% level of significance. This leads to the rejection of the null hypothesis since a unidirectional relationship exists between inflation expectations and taxation. The results are like findings in the study by [27]. There is also a unidirectional relationship between taxation and public debt. Taxation Granger causes public debt at a 1% level of significance. This concedes with the findings of [28], who revealed that a unidirectional relationship exists between taxation and public debt in South Africa. The results further indicate that inflation Granger causes taxation; hence, there is a unidirectional relationship between inflation and taxation in South Africa. This coincides with the findings by [28].

The series was subjected to diagnostic and stability tests. All variables were free of heteroskedasticity and correlation as the probability of the variables was insignificant. The Kurtosis of 3.5 indicates that the series follows a normal distribution [18]. In addition, the CUSUM, as well as the CUSUM of squares, shows that the model is stable as illustrated in Figures 1 and 2 by the blue line inside the red lines.

Figure 1.

CUSUM computed from E-views 12.

Figure 2.

CUSUM of squares computed from E-views 12.

5. Conclusion and recommendations

The study investigated the relationship between inflation expectations and public debt on taxation, a proxy of personal income tax, capital gains tax, and profits in South Africa from 2000 quarter 3 to 2020 quarter 4. To achieve the objectives that are stated in Section 1, the study used secondary time series data gathered from the South African Reserve Bank. The ARDL and Granger causality methods have been employed in the analysis. To scrutinize the order of integration among the variables, the study used the Augmented Dickey-Fuller (ADF) test and Phillips Perron (PP).

The results revealed that there are different orders of integration since taxation, inflation expectations, and public debt are integrated at I (1) for both methods while inflation is integrated at I (0). Hence, the study adopted the ARDL techniques. The study found out that inflation expectations and public debts are the two main macroeconomic variables that have an impact on taxation in South Africa, in the long run. The results revealed that there is a positive significant relationship between inflation expectations and taxation in the long run. However, the study found a negative correlation between public debt and taxation in the long run, but positively related in the short run. The pairwise Granger causality tests found that inflation expectations Granger cause taxation. There is a unidirectional relationship between inflation expectations and taxation. A causal relationship also existed from taxation to public debt.

Policymakers have long understood the importance of communication strategies and the importance of managing economic expectations; therefore, they must always communicate or inform economic participants (households and firms) about the changes in inflation expectations that might occur in the future. Using monetary policy tools can help policymakers to strive to anchor inflation expectations at roughly 3–6%, which is the inflation target rate in South Africa. This is to help inflation expectations to remain stable. There must be a balance between financing public debt through borrowing and taxation. An increase in taxation may place slow pressure on inflation, which will, in turn, enable the Reserve Bank to keep up with high-interest rates. Hence, there is a need for coordination between fiscal and monetary policies to achieve stability in the economy.

Conflict of interest

The authors declare no conflict of interest.