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Goods & Services Tax Made Simple

Most governments rely on a goods and services tax to generate a steady flow of revenue. The Chamber's Chief Economist DAVID O'REAR explains how the system works

The Chamber and other organizations have been calling for a broadening of the tax base for some time. One of the most common means of achieving this goal is through some sort of broad-based sales tax. Hong Kong is one of only a very small number of economies without such a tax, and as our other revenues decline -- but spending does not -- we need to think this one through. It will take a combination of sharp reductions in recurrent expenditure, more reliable sources of revenue and good economic growth to rebalance the budget within the decade. While the Chamber believes that spending cuts need to be the top priority, an important second consideration is the current, extremely narrow tax base.

Typically, a Goods and Services Tax (GST) takes three to five years to implement, and so concerns that "the time is not right" should be set aside right from the beginning. However, it is vital that we get it right, and so consultation on the form of a GST appropriate for Hong Kong should begin as soon as possible. Below, we explain the key features of a GST.

Taxing once

A GST is typically designed to avoid a "cascading effect," in which something is taxed more than once. To achieve this result, a GST is applied each time an item changes hands (or, the service is provided). When a product is sold, the seller collects a tax from the buyer. At the end of the month, the seller then offsets what tax he collected from buyers against what tax he paid to his suppliers. The balance is then remitted to the government, or in the case of a negative balance may be claimed back.

For example, a company making wooden chairs would pay GST on wood bought from a lumbar yard. If the wood cost $100, and the tax is 3 percent, the furniture maker pays the lumber yard $103. When the company later sells the chair for $250, the buyer pays an extra $7.5 (3 percent) in GST. The difference in the two taxes, $4.5 ($7.5 collected minus $3 paid), is remitted to the government.

In addition to the chair maker getting a full refund (directly from the buyer) on the wood it purchased, it also has the use of the extra $4.5 between the time of the sale and when it remits the money to the Inland Revenue.

Exemptions and zero rates

Where a specific economic activity is deemed desirable for social or other reasons (such as allowing people to buy cheap rice), there are two ways to bypass the GST. One is to declare the end transaction exempt from tax, and the other is to impose the GST at zero (rather than 3) percent.

A company, product or service that is exempt from collecting tax from the end consumer, still has to pay tax. For example, a rice seller needs to buy a scale to weigh his products and pays the GST on that purchase. However, because he cannot collect tax on the rice that he sells, he has no way to offset the tax that he has paid.

If the rice is zero taxed, rather than exempt, the store will be entitled to offset the 3 percent paid for the scale against the zero tax received on the sale of rice. While that may appear to be the same on the face of it, in reality the store would have a negative tax liability (having paid but not collected tax), and be entitled to a refund. Exports and tourism are economic activities governments like to encourage, and so exports are usually taxed at a zero rate, and tourists receive a refund when they leave.

The tax rate

A GST is logically applied at a single rate, to simplify record keeping and reporting requirements for vendors, and to reduce fraud through improper categorization. A low tax rate has the advantage of being too much trouble to evade, as well as being more politically acceptable (not to mention in line with the Basic Law provision that Hong Kong shall be a low tax environment).

There seems to be a general consensus that a rate of about 3 percent is the minimum rate worth imposing after taking into account the cost of collection to government. The GST is relatively inexpensive to administer. The cost of collecting $100 is typically in the order of $1-2, or about the same as the cost of collecting salaries taxes. Although some of the cost of collection is borne by the private sector, this cost is offset significantly by the ability to collect the tax but not pay it to government until the end of the collection period, which may be anywhere from one to three months. Medium-sized businesses in particular will appreciate the free addition to their cash flow.

Services: getting the 'S' right

From an administrative point of view there should be no exemptions, to reduce the cost of collection and the potential for avoidance. This principle needs to be tempered by the practical problems of how to assess tax in some special cases. One of the most complex and difficult areas is financial services. The problem is that for many financial services the price is built into the interest rate spreads, such that the cost of the service cannot easily be calculated on a transaction by transaction basis.

Another difficult area, and one which is particularly sensitive in Hong Kong, is the GST treatment of real estate. In many jurisdictions, residential real estate rentals are not taxed, so as not to cause distortions between owner occupied and rental real estate. In contrast, commercial real estate rentals tend to be taxed, with companies having the ability to recoup the tax from its tax receipts. In relation to the purchase of new residential and commercial buildings, many countries tax both.

GST thresholds

In most GST jurisdictions, small companies are not required to register to collect GST, due to their limited ability to absorb the administrative costs of collection. However, the threshold, as defined by annual turnover, at which companies are obliged to collect GST, varies markedly among countries. For example, in Singapore the annual turnover threshold is S$1 million (about HK$4.5 million) while in Australia it is A$50,000 (about HK$300,000).

In principle, higher thresholds reduce the administrative cost to government and spread the cost to business across a higher value of transaction. However, if the threshold is set too high, customers may shift their purchases to smaller businesses. In any case, any business, regardless of turnover should be able to opt into the system, thereby off-setting its own tax payments.

All the above points are issues that need to be carefully studied through a thorough consultation process. This, of course, will take considerable time to ensure we get it right, after which the government will then have to set up the system and educate businesses. In a nutshell, even if the government starts studying a GST for Hong Kong tomorrow, it will take at least three years before it can be implemented. This first step in the long process of considering a GST will give the government a concrete option of broadening the tax base when the time is right.