Pravin's pounding headache

When Finance Minister Pravin Gordhan stands up to deliver his 2014 budget speech on Wednesday, he will be in a difficult position.

He has to send an upbeat message to voters before the general election in May and at the same time reassure credit rating agencies that South Africa will stick to a policy of strict fiscal discipline.

Few experts believe Gordhan will raise taxes before the election, but he still has to find money to finance new government initiatives such as the Employment Tax Incentive, National Health Insurance and programmes to implement the National Development Plan, a blueprint for faster growth and job creation.

The rand's steep slide complicates matters. Not only does it make servicing South Africa's foreign debt more expensive, it also raises the cost of infrastructure spending plans that must be put into action to boost economic growth in a sustainable manner.

But the Treasury just cannot afford to increase its spending right now. Any slippage in its budget deficit targets over the next three years could trigger a credit rating downgrade, which would further raise the cost of government debt and discourage foreign investment.

"The budget is set to be one of Finance Minister Gordhan's most difficult, coming a few months before elections and against a backdrop of growing concerns about South Africa's economy and political stability," said Absa economist Peter Worthington.

"Although we do not expect the ANC to abandon all fiscal discipline in a last-ditch effort to shore up its flagging popularity, the budget will be an important part of the election campaign."

Gordhan will have to cut his growth forecasts for this year and next because of the economy's poor performance in the face of sluggish demand for its exports and weak household consumption, which has been curbed by rising inflation and a poor employment outlook.

In his medium-term budget policy statement last October, Gordhan predicted that the economy would grow 3% this year and accelerate to 3.2% next year. These estimates are likely to be cut to 2.5% and 3%, respectively, putting them more in line with market consensus.

Against the backdrop of slowing growth, rising inflation and higher interest rates, it will be difficult for Gordhan to justify raising taxes because this would dampen consumer spending and hurt job creation in the private sector.

It would also be premature to make any major changes ahead of the conclusion of the work of the Davis tax commission, tasked by President Jacob Zuma last year with reviewing tax structures. But some analysts believe that Gordhan could raise the top marginal tax rate of 40%, given that it would affect only a small number of the wealthiest voters.

"If the minister can manage to allocate budget to all necessary areas without increasing the budget deficit too much, he is a superhero," said Ettiene Retief, chairman of the national tax stakeholders committees at the South African Institute of Professional Accountants.

"Superheroes, however, exist only in fiction, and South Africans must face the harsh reality that taxes will sooner or later have to be increased, because the country can't borrow much more without further negative impact," he said.

Other tax options include introducing a multi-tiered system for VAT, which at 14% is low by international standards. The rate could be raised for luxury items while protecting low-income earners.

Corporate tax is likely to remain unchanged at 28%, but there will undoubtedly be inflation-linked increases in fuel levies and excise duties on alcohol and tobacco.

Markets will be watching closely to see if the trajectory of a narrowing budget deficit remains in place. In October, Gordhan forecast a shortfall of 4.1% of gross domestic product in fiscal 2014-15, shrinking to the key 3% level by 2016-17.

In fiscal 2013-14, the deficit ratio is likely to have amounted to just 4% of GDP instead of the 4.2% forecast earlier, owing to surprisingly strong revenue collection. But the shortfalls may be larger in the years ahead because of slower economic growth, which erodes tax revenues.

In each of the past two years, the Treasury has shifted the 3% budget deficit goal further into the future. I f this happens again, it will not go down well with rating agencies.

Moody's, Standard & Poor's and Fitch are all worried about South Africa's rising debt trajectory, with some justification. After all, gross debt as a percentage of GDP is expected to climb to 47.7% by 2016-17 from 36.8% in fiscal 2012-13.

Investec economist Annabel Bishop warned that rising interest rates would make government bond issuance more costly and inevitably widen the budget deficit, which could lead to more borrowing.