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Hong Kong has been relying on its simple and low tax system for several years to attract talent and capital in order to maintain competitiveness. Are there any flaws in our tax regime? In order to investigate the strength and weakness of our taxation system, we have explored seven key criteria of a good taxation system. The purpose is to identify critical issues confronting Hong Kong economy which is related to the weakness of our taxation system so as to investigate possible measures to improve current situations. Narrow tax base and wealth inequality are the two concerns that have been identified, we are going to look into these two problems and discuss how to improve these situations.
Good Taxation System
There are 7 characteristics of good taxation system:
- A good taxation system should achieve both horizontal and vertical equity. Horizontal equity is preserved when individuals and businesses with the same ability-to-pay are taxed equally. Vertical equity is preserved by taxing in proportion to taxpayers’ ability to pay. Vertical equity is concerned with redistribution of income by adoption of progressive taxes to achieve a more equitable distribution of wealth in society.
- An effective taxation system must be revenue-productive to yield sufficient revenue to finance public services and development. It should be stable, sustainable and less sensitive to economic cycles and thus enhance overall fiscal system to achieve stabilization of economy.
- Good taxation system should have high transparency. It should be clear who are being taxed, how much are being taxed and how the money is used.
- A good taxation system must be operationally efficient to minimize compliance costs for taxpayers and administration costs for government.
- An effective taxation system should be simple and intelligible. The rules are clear, simple to understand and easy for calculation.
- In a good taxation system, certainty regarding the time and amount to be paid to government is important.
- A good taxation system should be flexible and capable of adapting to technological changes, commercial developments and other changes of the economy.
Before we go into Hong Kong taxation system, we need to understand the importance of fairness to a society in order to justify whether we have a fair tax regime. According to the ‘Second Principle’ of John Rawls in his book ‘Justice as Fairness’ concerning about social and economic inequalities, all people should have equality of opportunity which indicates people with the same talents and willingness should be offered same educational and economic opportunities regardless of whether they were born rich or poor. Furthermore, any inequalities such as wealth and income are only allowed when it is good for all, especially for those who are advantaged least. A fair taxation system is important because it ensures all people share the equality of opportunity and regulates inequalities of wealth and income to achieve social harmony.
Two Sides of the Hong Kong Taxation System
Hong Kong is famous at its simple, low and competitive tax system. Only three direct taxes are imposed: profits tax (16.5%), salaries tax (15%), property tax (15%). As Hong Kong depends heavily upon overseas investment for its continued economic growth, such a simple and efficient tax system helps maintain an attractive investment environment for Hong Kong. Furthermore, Carrie Lam, the Chief Executive of Hong Kong, announced in her ‘2017 Policy Address’ the two-tiered profits tax rates which has been implemented on April 1, 2018. The profits tax rate is lowered to 8.25% for the first two million of corporation profits. This will reduce the tax burden on enterprises, especially SMEs and startup companies. Besides, Hong Kong is a free port and levying no tariffs on imports while the tax regime remains high transparency, certainly, flexibility and efficiency. All these advantages come to a favorable business environment and economic growth, enhance the competitiveness for Hong Kong as an international city.
Although current tax regime contributes to fiscal balance for Hong Kong for years, it hides uncertainties that may affect the future economic growth and prosperity. One of the issues confronting Hong Kong economy is the narrow tax base which is regarded as being inconsistent with equity because the overall tax burden is born by relatively few taxpayers. According to 2018-2019 Budget Consultation, profits tax is our largest operating revenue, however, about 86% of our profits tax is contributed by the top 5% taxpaying corporations (i.e., about 5 200 corporations) in the year of assessment 2015-16, around 1 072 000 registered companies (about 91% of the total registered corporations) do not pay any profits tax. For salaries tax, it has been our second or third largest operating revenue. Of the 3.77 million working population, about 1.92 million or 51% of the working population need not pay any salaries tax. Of the 1.85 million who paid salaries tax, the top 5% taxpayers (i.e., about 93 000 taxpayers) contributed 63% of the revenue from salaries tax. The 2018-2019 Budget Consultation also showed that profits tax and salaries tax contribute almost 40% of the total government revenue. It is unhealthy that around 40% of total government revenue is mainly taxed from few percentages of taxpayers. Hong Kong as a small and open economy relies upon only a narrow range of taxes that is sensitive to economic fluctuations, has been limited the ability to manage public finances, especially in times of downturns in economic cycles and adversity such as finances crisis in 1997 and SARS in 2003.
Another issue confronting Hong Kong is the uneven distribution of wealth which does not obey the equity of a good taxation system. The extent of wealth inequality is reflected by Gini coefficient showing how evenly income is distributed on a scale from zero to one. Gini coefficient above 0.5 indicates large income disparity. According to the Hong Kong Inequality Reported released by Oxfam in Sep 25, 2018 examining data from the Census and Statistics Department’s 2001-2016 Population Census, Hong Kong’s Gini coefficient (based on original monthly household income) is 0.539 which is the highest in 45 years. Although the Gini coefficient based on post-tax post-social transfer monthly household income was 0.473 in 2016, the wealth gap is still one of the most extreme among developed economies, including the Canada – 0.318, United Kingdom – 0.351, United States – 0.391, Singapore – 0.356 and Australia – 0.337. Wealth inequality imposes a negative effect on economic growth. According to the OECD report ‘Focus on Inequality and Growth’ in 2014, a long-term trend increase in income inequality has curbed economic growth significantly by hindering human capital accumulation because it undermines education opportunities for disadvantaged individuals, lowering social mobility and hampering skills development.
Improvements
There are two possible ways to improve the narrow tax base situation. The first method is to introduce new tax on current narrow tax base. Goods and services tax (GST) has been a long argument in society, however in short term it looks like the most appropriate treatment for narrow tax base. In fact, most of the developed countries have implemented GST such as Singapore, Australia and Canada. GST is an indirect tax which provides a stable and predictable income because private consumption is relatively stable in economic fluctuations. It contributes a considerable income even at low rate because tax base is very broad that all people who produce or purchase goods and services are taxed. This also minimizes tax evasion and avoidance problem. It is a fair tax because people who consume more would need to pay more tax. With the adoption of sales tax, Hong Kong can keep its low and simple tax system as usual to attract foreign investors and manpower to maintain our competitiveness. New tax income provides more resources on treating critical issues such as aging population and poverty issue. However, there are obstacles for GST implementation in Hong Kong. Sales tax is a recessive tax because lower income people must spend a larger share of their income than higher income people for buying the same product. Thus, implementation of GST should come along with tax refund or other compensation to low-income people and welfare policies to offset the negative effect of GST on poverty problem. The second one is to dilute concentrated income sources by new industries. Currently tax revenue is heavily relying on a few key industries. ‘Distribution’, ‘Property, Investment and Finance’ and ‘Banking’ that account for over 65% of profits tax, most of the top 5% taxpayers are in these key industries and majority of them belong to service sector. In long term, it is necessary to well develop emerging industries such as ‘cultural and creative industries’ and ‘innovation and technology’. Among the ‘Four Asian Tigers’, the GDP percentage occupied by industry sector in 2017 for South Korean – 39.3, Taiwan – 35.5, Singapore – 24.8, Hong Kong is 7.6 while service industry shared 92% of GDP by economic activities. It implies that government has to allocate more resources on other industries in order to diverse the industries so as to broaden income source.
The extreme high Gini coefficient reflects that current tax regime does not help improve wealth disparity efficiently. There are two possible ways to shorten the wealth gap. Raising 1 to 2 % on profits tax rate is a quick and direct method to obtain more tax from high profit-generating corporations. It will help achieve a fairer society as current wealth inequality is not good for everyone’s advantage, especially for the poverty groups. New profits tax raised the flexibility for government to transfer more resources from the rich to the poor. This helps improve their education, health care, livelihood issues so as to increase social mobility, cultivate talents, promote social harmony. Some people concern about increasing profits tax will decrease Hong Kong’s competitiveness. According to ‘The Global Competitiveness Report 2018’ conducted by World Economic Forum (WEF), Germany and Japan ranked the third and fifth of global competitiveness respectively while Germany has a total tax rate of 48.9% and that of Japan is 47.4%. Hong Kong ranked the seventh of global competitiveness. This indicates tax rate is not the only criteria to maintain one’s competitiveness. The small tax increase will not affect SMEs a lot because of the two-tiered profits tax. To precisely allocate resources to decrease the wealth gap, we need to identify who are in the poverty group. The Oxfam report found out there are six groups of people affected by poverty are residents of subdivided flats, low-income workers, women, children, the elderly and ethnic minorities. Government should wisely allocate resources to decrease the poverty population. For example, resources can be allocated to provide labor protection and flexible job types for household women that encourage them to work and increase income, more financial support for children to ensure they have equal opportunity for education.
Conclusion
We have accessed the effectiveness of Hong Kong taxation system by comparing it with standard hallmarks of an effective taxation system. Hong Kong maintains a simple and low taxation system to attract talents and capital to increase global competitiveness. However, we have identified two critical issues confronting Hong Kong economy which are related to weakness of our taxation system. First, Hong Kong has a narrow tax base which is sensitive to economic fluctuations, the situation can be improved by broadening current tax base through adding GST as new tax. In long term, developing new industries provides more income sources for government and thus diluting current concentrated income sources from only few industries. Second, the wealth disparity is extreme large in Hong Kong due to uneven distribution of wealth, the situation can be improved by increasing profits tax in 1 to 2% together with two-tiered profits tax. It is a direct way to withdraw more resource from the rich to the poor while not imposing much influence on SMEs. In order to reduce wealth gap, government resources should be precisely and wisely allocated to identified poverty groups.
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