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Tax Choices for a Reluctant Hongkong

SCMP September 10

It may sound boring, but the Report of the Advisory Committee on New Broad-Based Taxes is one of the most important documents to have been presented to the Hongkong public since the handover. The taxation options that it examines go the heart of how Hongkong sees itself, and its cross-border relationship.

It is a concise and well written but controversial discussion document that deserves to generate plenty of debate. Although it does not say so in quite so many words, the Committee has confronted Hongkong with a choice between a broader, and perhaps higher, level of income tax, or a low but broad-based tax on consumption - a Goods and Services Tax (GST). On balance it clearly favours the latter, reflecting the predominant interests of the majority of its members, and the influence of the IMF, a well-known proponent of consumption taxes which has done its own study of GST options for Hongkong.

The tone of it is regressive and the philosophy summed up by the unsupported assertion that "overall lower tax burdens are less distorting to economic activity". There is the whiff of the country club in its attitudes. Unfortunately, the impact of the Committee's report is being diluted by delay in producing a parallel report - Task Force Review of Public Finances --into whether or not the government's operating budget deficit is cyclical or structural. This is not expected till the end of this year. There is the implication in this two-pronged approach by the government that if it is deemed that the deficit is primarily cyclical there may be no need to do more than tinker with the tax system. That would be a grievous error.

Quite regardless of the cyclical/structural debate, there is a desperate need to broaden the tax base away from that once sacred cow, property. The history of the budgets of the past decade, encompassing the careers as Financial Secretary of Donald Tsang and Hamish McLeod, has been one of persistent and irresponsible narrowing of the base even while officially proclaiming the need for a broader and more reliable revenue stream. Various increases in personal allowances have taken huge numbers out of the tax net, and so reduced effective rates that only very high income earners pay the standard rate of 15%.

The 1998/9 recession also saw sops to upper income earners through tax rebates and concessions to them and the property developers through tax allowances for mortgage interest. Add these politically inspired fiscal absurdities to needs for more educational spending and the health demands of an aging population and it is no wonder that Hongkong has an operating deficit. At best an overall deficit which is being disguised by asset sales such as the MTRC and the (diminishing) windfall from the 1998 stockmarket intervention. Perhaps the persistence of lower (but still high) property prices and the realisation that in future asset prices may rise no faster than the general price level will convince the government that whatever happens to the economy as a whole the revenue system has to change. Indeed, the government has been undermining its own future revenue from property sales by giving cosy deals to the MTRC which will enhance its profits from property development at the expense of public revenue!

Just how distorted Hongkong's revenue system had become is demonstrated by the fact that at the 1997/98 peak, if one added all property related revenue together - land sales, rates, stamp duty, property income, profits tax on developers etc - they came to around 60% of all revenue. The government used the boom in property prices to cut back other revenues - the exact opposite of what it should have done. As the Advisory Committee rightly notes, narrow tax systems are economically inefficient, inequitable, and unreliable.

Its report reasonably rejects several new tax options including capital gains tax, dividend tax, poll tax, taxation of foreign-sourced income and reinstatement of interest tax. Whatever their merits elsewhere they make little sense in an economy as open as Hongkong's and with such a low base rate for income tax. That leaves only three realistic options for raising significant amounts of revenue: a payroll tax, a GST or higher effective rates of income tax.

The payroll tax would, now that most of the mechanisms are in place because of the MPF, would be easy to collect. If imposed at 3% it would (at 1999-2000 income levels) raise HK$17.4 bn annually. The committee recognises its fairness and efficiency but says that by increasing employment costs it would reduce Hongkong's competitiveness. That is true but it is a small amount relative to the cost of the MPF and would be predictable. Nor is it likely to be so high as to deter employment. A city state with no minimum wage has no excuse for structural unemployment.

The income tax question has been divided by the Committee into three parts - whether to raise profits tax, salaries tax and whether to reduce allowances under salaries tax. This is unfortunate as it enables the committee to avoid the question of whether to raise the standard rate of all taxes on income. It notes that a 1% increase in profits tax would raise $2.8 bn and a 1% rise in salaries tax $2.2 bn.

It makes much of the assertion that rises in either go against international trends and would impact Hongkong's ability to attract investment and top people. However, given that effective rates are far lower than in almost every developed country - and Singapore, Taiwan etc -- this assertion is debatable. It is particularly dubious as any increase in direct tax would in effect be a substitute for the high but unpredictable taxation that in the past has been levied through the government's land price stranglehold.

The report makes much of the high proportion of direct tax already being accounted for by profits tax. What it fails to mention is that much of this derives not from local activities but from companies, multinational and mainland, routing profits through Hongkong because it has a low tax rate but is not deemed a tax haven. It is hard to imagine that a modest increase in the profits tax would drive away a business close to the hearts of the local accountancy profession.

Even more surprisingly, the committee does not seem very convinced by the argument that reducing salaries tax allowances would be desirable, even though it would hugely broaden the tax base and - assuming a 50% cut in allowances-raise $14 bn a year. The report argues that a "disproportionate amount of additional revenue would come from existing taxpayers". It is hard to see why that should be so heinous when a single person can earn almost $2 million before reaching the 15% rate and a married man with three children and dependent parents can earn $4.2 million before hitting this ceiling.

The committee also makes the rather curious argument that in the absence of a social security system personal allowances provide assistance to "taxpayers with increased levels of family responsibilities and low incomes". That is patent nonsense as the main beneficiaries of the allowances are the households - a mere 20% of the total -- with incomes over $400,000. Those are the ones least in need special consideration for social security provision.

Having tended to play down the merits of increased direct taxes, the committee has naturally had to take a very positive view of GST. A 3% tax on most goods and services would raise around $18 bn and, it asserts, be fair, neutral and efficient. It is hard to argue with the report's contention that such a tax would be an effective way of raising money and would have little impact on competitiveness. However it is so determined to press the case for it that it resorts to using the fact that all OECD countries have such a tax. So what? Most also have other taxes rejected by the report.

It also plays down the complexities of GST though reading Annex D and the summary of the IMF report on GST makes it clear that the administrative structure is not at all simple and itself involves difficult decisions on what to include, at what point to levy it, how to treat financial services, etc. The report also admits, in reference to passenger departure taxes, that a GST might necessitate a tax on cross border movements to protect Hongkong! "If a consumption tax were to be introduced… an expanded departure tax could help alleviate consumers' spending north of the border".

One could well argue that Hongkong labour and real estate costs are what make Shenzhen attractive to Hongkong consumers, and a 3% GST would make little difference to the cross border advantage. However, the committee does not make that case. Its position on the departure tax undermines its claim that GST is efficient. It also raises a significant political issue at a time when cross-border integration is supposed to be increasing.

Any discussion of the equity as well as efficacy of the tax system cannot be detached from other issues such as public housing and welfare policies. However, the tax system is a mess and need reform. The Advisory Committee report is too marked by its members' aversion to direct taxation to be acceptable. But at least the issue is now in the public domain. The Committee has invited comments on its report. Go to it. ends