A year ago, I argued that Hong Kong had enjoyed the best tax system in the world for nearly 60 years. The Hong Kong economy routinely grew by 7 percent a year (as it did last year), with no recession between 1975 and 1997. Since real gross domestic product (GDP) doubled every decade, real tax revenue could likewise double every decade without increasing as a percentage of GDP.
After the regional setback in 1998, Hong Kong suffered another unusual budget crunch because of SARS. But the government just reported a $14 billion surplus, which leaves a rainy day fund of nearly $311 billion. The report worries that "in any future economic downturn we might . . . be forced to draw down on our reserves." Yet the point of reserves is to meet emergencies.
The International Monetary Fund spent five years trying to persuade the Hong Kong government to convince its citizens to accept a new Goods and Services Tax (GST) -- a value-added tax on consumer spending. Hong Kong's brilliant and charming Financial Secretary Henry Tang eventually relented and released a report proposing a new 5 percent GST. The government welcomes comments (email@example.com).
The "tax reform package would not need to generate additional revenue . . . for the first five years." After that, it is quite another story. Mr. Tang promised the new tax "would secure . . . our capacity to meet public expenditure needs." That doesn't sound "revenue neutral," does it? Even during those five years, the report suggests that "as an alternative to using some, or all, of the available funds for tax relief, we could increase public expenditure . . . on education, health, social welfare, law and order or infrastructure." Hong Kong's subsidies to higher education, hospitals and housing are already lavish, even by Scandinavian standards.
The temptation of enormous revenues from a GST or value-added tax (VAT) always proves disappointing soon after such taxes are introduced, which is one reason the initial tax rate is usually increased. Any such tax on sales will, of course, reduce sales. In a country like Hong Kong, a tax on retail shopping will also shrink tourism, because tourists go there to shop. They know from experience that GST or VAT rebates are difficult and limited (my family stopped shopping in Canada). The end result of a new GST is much less income tax revenue from shopkeepers' profits -- and much less income tax from people who would otherwise have been employed in those shops or producing merchandise for them. Whether or not the increased tax on sales compensates for the lost tax on profits and jobs is something that should be contemplated but never is.
In 1947, Hong Kong had a flat tax of 10 percent on salaries and profits. There is still a flat tax on profits and rent, but the tax on salaries has become increasingly progressive. Hong Kong's lowest tax rate was reduced from 5 percent to 2 percent years ago. The top tax rate of 19 percent is 10 times as high as the lowest rate. Nearly two-thirds of workers pay no income tax, leaving the top 2 percent shouldering more than 40 percent of the burden.
The report says, "Hong Kong's existing tax base is very narrow by international standards. We rely on only a very limited range of taxes." Yet the breadth of tax base is best measured by how many people pay taxes, not by how many taxes are paid. To say that Hong Kong's salary tax is "narrowly based" is a euphemism. It means the tax is too progressive -- overly dependent on a small number of rich people whose incomes fluctuate with the stock and real estate markets (the U.S. is making the same mistake).
Hong Kong's lowest 2 percent rate is a huge revenue loser with no beneficial impact on incentives. Every taxpayer, including the richest, pays only 2 percent on the first $3,800 (in U.S. dollars) of taxable income, then 7 percent on the next $3,800, 13 percent on the next $3,800, and 19 percent on the rest (or 16 percent without personal allowances at high incomes).
The report claims the only viable option to a GST is "a drastic reduction in personal allowances," so that "nearly all wage and salary earners would be brought within the salaries tax net." On the contrary, a much safer and simpler option than the GST would be to raise the 2 percent tax rate to 4 or 5 percent. Yet the report actually contemplates reducing the 2 percent rate to 1 percent for five years. It worries that raising tax rates "would go against the international trend of lowering income taxes and risk losing mobile labor and capital to more competitive jurisdictions." But tax competition is about lowering high tax rates, not the lowest ones. A Hong Kong worker facing only a 4 percent tax on a small portion of earnings could not find a more competitive tax anywhere.
If doubling the lowest tax rate has been ruled out only because it would be politically unpopular, consider the experience of two countries that added a GST.
In the summer of 1989, Sosuke Uno was prime minister of Japan for only 69 days because he introduced a 3 percent GST. The GST was increased to 5 percent in April 1997, promptly followed by recession. For many reasons (including additional new taxes on capital gains and land), Japan's economy and tax receipts remained stagnant until very recently.
In 1993, Canadian Prime Minister Brian Mulroney pushed through a 7 percent GST, instantly becoming the most unpopular PM in Canadian history. His Progressive Conservative Party lost so many seats that it ceased to be a major party.
The new Hong Kong report claims such international experience proves a new GST or VAT is only temporarily harmful to economic growth. But that depends on whether it was something new (as in Japan and Canada), or whether it replaced an equally onerous retail sales tax (India) or was accompanied by cutting the highest income tax rates in half (New Zealand). There is no such thing as a harmless tax, whether imposed on what we earn or on what we buy.
Hong Kong, like every country that followed its example, has prospered for decades by sticking to just two simple rules: Keep marginal tax rates as low as possible. Don't let government spending grow any faster than the economy that supports it. As Japan should have taught us, a new GST is no alternative to Hong Kong's older wisdom.