Making sense of the GST hike

One effect will be to raise the general price level but GST need not be regressive if the government uses the money wisely

By VIKRAM KHANNA

ASSOCIATE EDITOR, Published January 24, 2007

ONE of the highlights of the upcoming budget on Feb 15 is likely to be an increase in the goods and services tax (GST), or the 'great Singapore tax', as it is known in the blogosphere.

That the GST will be hiked by two percentage points from the current level of 5 per cent has already been announced by Prime Minister Lee Hsien Loong last November - although whether this will happen in one step or two is not yet clear. But the impact of the GST hike on the economy and on consumers is still open to debate - and the answers will not be known, at least until after the budget is presented, and even then, not fully.

The original rationale for the GST when it was first introduced in 1994 - apart from conforming to the global trend of moving towards greater reliance on indirect taxes - was to prepare for the ageing of the population, which over time, would erode Singapore's tax base. It was noted, for instance, that over 1993-2020, the number of working people to support one aged person would drop from eight to three. This would imply an excessive tax burden on the working population. A GST would both help to spread the burden more evenly and obviate the need to raise direct taxes, which would affect competitiveness.

While this rationale remains, there are now others: on the revenue side, the government has indicated a willingness to cut direct taxes further; in 1993, a corporate tax rate below 25 per cent was thought unachievable because it would result in Singapore being classified as a tax haven, and consequently denied certain types of investments.

But that apprehension is no longer prevalent. Corporate taxes have been slashed worldwide, from an average of 38 per cent in 1993 to 27.1 per cent in 2006. Today, there are at least a dozen economies with corporate tax rates below 20 per cent, including most Eastern European countries (15-19 per cent), Hong Kong (17.5 per cent) and Ireland (12.5 per cent).

Raising the GST would give Singapore additional fiscal leeway to reduce its corporate tax rates. Over the weekend, Minister Mentor Lee Kuan Yew indicated that the rate would be cut, by at least one percentage point, which would take it to 19 per cent. There might also be cuts in personal income tax, in tandem.

On the expenditure side, the government has indicated that it wants to make its Workfare scheme to help low-wage workers a permanent, and perhaps automatic (as opposed to ad hoc) arrangement. This will require substantial resources. The government has also hinted at ambitious spending in the years ahead on health, education and infrastructure. Herein lies another stated rationale for raising GST.

Some economists argue that there are other alternatives. The government is said to be conservative in its budget accounting, omitting from its revenues inflows from land sales as well a significant part of investment income (though it has decided to include realised capital gains). If these additional revenues were factored in, the $2.9 billion deficit projected in the budget for 2006/7 last year would swing into surplus.

While it can be argued that adopting a less conservative approach to budgetary accounting would remove the need for GST increases, there are some unknowns. These include the coverage and structure of the Workfare scheme - both initially and in the future - and the scale and cost of infrastructure projects planned, as well as the size of future subsidies on health and education.

How much further down income and corporate taxes can potentially go in the medium term is another imponderable. Given the global tax environment, some would suggest that a target direct tax rate of 15 per cent should not be ruled out.

Raising GST can thus be said to be only prudent, and Singaporeans can take some comfort from the fact that the 7 per cent target level for the tax is below the global average VAT/GST rate of 16.4 per cent, and the Asia-Pacific average of 10.5 per cent.

What of the impact of a hike in GST?

One obvious effect of the tax will be to raise the general price level. But this is not expected to be significant: DBS Research estimates that a 2 percentage point GST hike will temporarily add about 1.1 percentage points to trend inflation, which would raise the overall inflation rate to about 1.8 per cent in 2007/08. But the impact would be one-off rather than ongoing.

Also, much would depend on when the GST increase takes effect, the extent to which it is absorbed by retailers and what offsetting reliefs and rebates are provided, as well as freezes in government rates and fees. The government's Committee Against Profiteering which is mandated to investigate unjustified price hikes that use GST as an excuse will also help limit the inflationary impact. In any event, any inflation beyond a level considered acceptable could be controlled by the Monetary Authority of Singapore (MAS) maintaining, or increasing, the Singapore dollar's appreciating bias.

With regard to the corporate sector, companies that have already registered for GST (which is mandatory only for companies with an annual turnover of $1 million - the highest threshold in the world) will not be much affected by even a 2 percentage point hike - except having to deal with tighter cash flow because of the time lag between having to pay higher GST on inputs and recovering GST on what they sell. On the other hand, they will enjoy lower corporate taxes.

For companies or businesses that have not yet registered for GST, the impact will be greater. They will have to pay GST on their inputs but not have the facility of recovering it. They could absorb the hike, as in the past, but this would be costly for them - especially if it is of the order of 2 percentage points. On the other hand, they can raise their prices, but many - especially in highly competitive, low-margin businesses such as small retailing - would be reluctant to do so.

Many of these businesses might thus be induced to go ahead and register for GST, which would entail some compliance costs.

The impact of higher (perhaps dramatically higher) numbers of GST registrations would mean a higher degree of GST pass-through to final prices - more so than the previous GST increase. A two-step increase in GST would ease the impact on small unregistered businesses, but might entail higher compliance costs. But a one-step increase from 5 to 7 per cent would probably induce more GST registrations.

Finally, what of the impact of the GST hike on society? In and of itself, any hike in an indirect tax like GST is regressive: it hurts the lower income groups harder because they typically spend a higher proportion of their incomes on consumption than their richer fellow citizens.

Before addressing this issue, it is worth noting that about 70 per cent of Singaporeans pay no income tax - a remarkable statistic for a country with a per capita income in excess of US$25,000 a year, which suggests that the direct tax regime at least, is highly progressive.

Moreover, anywhere in the world - and certainly in the case of Singapore - a hike in indirect taxes like the GST cannot be viewed in isolation, because it is typically accompanied by a host of other tax and policy changes; it is, in that sense, part of a package, and what must be assessed is the impact of the package as a whole, not just the GST component.

The other elements of the package, in Singapore's case, are expected to include a one percentage point hike in the employers' contribution to CPF, which is effectively a wage increase that can also lead to additional spending, to the extent that people use CPF to service their mortgages and higher CPF frees up more disposable income that would otherwise go towards mortgage payments.

The package is also expected to include offsets to help people (especially lower income groups) cope with the GST hike. In the past, GST offsets have been roughly equivalent to the amount of revenue collected from the increase in the tax in a single year.

The government has pledged to follow a similar approach this time. In addition, it has indicated it will freeze major government fees and rates (like HDB parking fees, conservancy charges and various license fees) for a year, as well as absorb GST on health care and education - all of which will help cushion some of the impact of the GST hike, not only for the poor but also for middle income earners.

The cushioning provided by these concessions will, however, be temporary, being intended more to ease the transition to a higher GST than to fully compensate for its longer-term effects. However, the longer term effects - especially the impact on the poor and the middle class - must be assessed in the context of how the government uses the additional resources that it collects from higher GST.

And here, the government needs to spell out, in as much detail as possible, its expenditure plans and their likely impact. How will Workfare work? How many stand to benefit and to what degree? What are the spending plans (including subsidies) on health and education? What infrastructure projects are planned and what will be their likely impact, on jobs and on growth?

The riddle of the impact of the GST hike will lie partly in the answers to these questions.