Bust a cap in your economic policy

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Click to read The New Growth Path pdf

Ebrahim Patel announced his New Growth Path policy document yesterday. At 36 pages, it’s more readable than many tome-like policy documents, but still no lightweight walk in the park. The good intentions are clear in the document, but unfortunately so are the many economic sink-holes created through inadequate input from people who actually understand economics.

Some of the coverage highlighted the proposal to cap pay and bonuses for those earning above R550,000 per year.  (Another was for 30,000 more engineers by 2014 – obviously Patel knows something different from the rest of us given that all the engineers graduating in 2014 are probably already enrolled in universities to start in 2 months time. Not a lot of wiggle room to improve education and encourage students to become engineers).

But let’s get back to that salary cap. What an impressively bad idea. And not bad in the “I don’t want to have my pay capped” flavour, but rather in the “you really, really didn’t think this through did you?” spicy sesame version. If any thinking was happening in was through the lens (moonlighting as a blackout curtain) of idealogical blindness.

Let’s first look at some of the obvious implications, but I really want to start painting a potential picture of the new economic reality under a genuine cap of R550,000 on total remuneration in a few paragraphs time. Fascinating stuff, but let’s start with the obvious.

The obvious flaws of the salary cap

  1. Remove the incentive to work hard and people won’t work hard. Underemployment of the scarce, skilled human resources we desperately need to promote economic growth will be a feature of the new economy. Underemployment does not represent the same economic hardship in the short term as unemployment does, but the long-term implications for economic growth are nothing but dire.
  2. Instant epinephrine straight into the Brain Drain. Catastrophic exodus  of skills in our economy. The best educated, most skilled citizens will up and off in time to have benefited from subsidised education, but before they pay it back to the country through production and taxes. Emigration will skyrocket and immigration of skills from other countries will drop to next to nothing.
  3. Our tax base is significantly (and rightly) skewed towards higher earners. No high earners, no high taxes. In fact, this proposal is so much worse even than 60% or 80% marginal tax rates on high earners since no tax revenue will be generated.
  4. With no incentive to work harder, bonuses and performance rewards can only be constituted as additional leave with total package remaining constant. The most productive employees are the most underemployed. Not great for any economy.

All in all a catastrophic idea. But wait, the really interesting ideas haven’t started yet.

Some further implications of capping salaries

There are a range of possible but bizarre outcomes I’ve touched on here. Make sure you read till the end because I’ve kept the most serious, and arguably most likely for last.

Incentives to cheat

Any time regulations become onerous, the incentive to cheat increases. Can you imagine the extent of activity all designed around avoiding the cap on salaries? All this energy and effort and application of bright minds giving no productive value to the economy. With such incredibly onerous regulations will come incredibly intense avoidance and evasion actions.

The New Nobility

Income inequality becomes person of leisure inequality. I can just imagine the social unrest when low-skilled workers work five or six days a week to earn their way, whereas the skilled elite work a day or two a week and spend the rest of the time at camps bay reading books and socialising. Not a way to impress the previously disadvantaged.

The Woodstock Revival

Parks and beaches, books and home movies – all forms in inexpensive entertainment will spike in popularity. With plenty of free time and little income, even stamp collecting may become fashionable.

With all this free time and limited financial resources, I can only imagine what will happen to our birth rate.

The End of Education

Invest in your own education? Delay working and spend money on Masters programmes? Definitely not. Only those who intend to leave the minute they have their skills will bother with advanced education.

The investment of time and money will never repay itself, and since the R550,000 cap is an annual cap, any year that is lost is lost for good. No advanced education, no research and development and technological progress. Nobody to teach the more basic education programmes either for that matter.

On the upside, we’ll have more artists and poets than accountants, engineers and doctors – you know the skills most valued and most in short supply currently.

Increase in costs of training

The costs of training staff will increase for skilled positions.  Jobs that required one fulltime person to perform previously could now be shared between 2 or 3 or more. Each of these people need to be trained. Decrease in productivity, decrease in the attractiveness of labour as an input.

Revival of the Barter Economy

You mow my law, I’ll do your books. You fix my car, I’ll invite you and a few hundred of my other “friends” to a musical performance I’m arranging.  Can you imagine the legislation trying to prevent this? All this energy is entirely wasted and the inefficiencies of a barter system (we use money as a medium of exchange for good reason) reduce economic capacity.

Further, none of these good and services will attract VAT since they are part of the enormous grey economy, yet again reducing revenue available for economic development.

Personal services will be more affected here. I’m not sure how easy it will be to manufacture a car on a production line in exchange for clothing design, but I am confident an entire industry will be created to solve this very problem.

The Agricultural Revolution

Division of labour and specialisation will take a back seat to self-sufficiency. Every good that must be purchased requires the generation of income. Given the limited supply of income, individuals, families, neighbourhoods and book-clubs will co-operatively grow vegetables and raise sheep, bake bricks and build houses, make furniture and babysit the huge number of babies.

Making computers this way is harder, so there will be much less of that in the economy.

Division of labour is one of the single biggest reasons for economic growth in the industrialised era. Comparative advantage (of people, not countries) means that everyone is collectively better off when each of us specialises.

Massive Recession, Deflation and the end of the Vuvuzela

Finally, seriously, and most importantly of all, this suggestion will drive the economy into recession.  Has Patel forgotten that in an economy we collectively earn what we collectively spend, less what we collectively save? And savings are available for investment, allowing development over time.

If we decrease incomes, we obviously decrease consumption, savings or both. With all this decreased consumption and decreased savings (thus decreased investment) how exactly will this be positive for the economy? Removing productive capacity from the economy does not help the economy.

Decreased consumption will drive the economy into recession.  With plenty of fixed investment and sunk costs, enterprises will slash prices in order to increase the utilisation of their factories. Slashed prices gives rise to deflation, further discouraging current consumption and forcing the economy further down.  Ultimately, this will increase the real value of the salary cap until such point as it becomes irrelevant. At that point, after a lost decade to make Japan’s Lost Decade look like an extended Seven Years of Plenty, it will be up to the politicians not to reduce the caps in line with deflation or we’ll keep on spiralling.

What have I missed?  Enjoy the post – don’t pay me, I’ll trade you for a comment.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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  1. Book clubs co-operatively growing vegetables and raising sheep? Time for parks, beaches, books and baby making? When you put it like that, Patel’s plan holds a certain appeal 🙂 Good points though, going to be interesting to see how he defends the obvious flaws of the salary cap.

    1. Thanks Linda. Fixed the gremlins.

      @Anonymous – Nothing really stopping any of us from doing that at the moment, but I agree it’s very attractive.

      @Zing – exactly!

  2. Awesome stuff Dave, thanks!

    It looks like your last sentence in the “Incentive to cheat” paragraph got cut off though?

  3. Nicely said.

    Of course Mr Patel has thought this through. When he gets to earn his R550k limit, so will Mrs Patel, and Mr Patel Junior, and the Patel residence gardener, with whom they will have an exclusive contract.
    That makes up for the R2m that he is earning atm. And he’ll still be able to afford the R800k luxury sedan, and the R5m mansion, and thereby contribute healthily to the 5% growth of the economy . . .

    Oh, wait – you’ve already covered that under cheating. . .

    I won’t be doing any of that of course!

  4. Some potentially interesting figures (from memory from a Business Day article, so please forgive any minor errors, but these are materially correct):

    The top tax bracket (40% marginal) starts at R552,000. +-227,000 people declare incomes that cause them to hit this bracket.

    These +-227,000 (around 0.5% of SA’s population) people pay **46.4%** of the total personal income taxes paid in SA. (Note that “personal” income taxes, i.e. not corporate nor VAT/etc.)

    1. Thanks Andrew. Useful numbers, and I’m really happy you highlighted that this is just personal income tax. Some guys get slightly carried away and forget that VAT is actually a regressive tax and casts a wide net etc.

      I’m still hearing people say “maybe we should keep an open mind” to the NGP and salary caps specifically. It’s not that I don’t like them, it’s that they are absolutely flawed and won’t work. More, it’s that Patel showed his lack of ability to consider the economy as something more than an idealogy. He lost all credibility.

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