Thursday, March 19, 2015

Economic Efficiency and GST

We’re less than two weeks away from GST going live, so it might be appropriate to look at the economic arguments in favour of it.

On the WCI blog, Frances Woolley reviews the textbook arguments (excerpt):

The case for taxing basic groceries

Economists frequently argue that taxing basic groceries is a good idea - for example, see these papers/posts making the case for taxing food in the US, Canada, and New Zealand.

The equity argument for taxing groceries is straightforward. Suppose everyone spends $500 a month on groceries. If groceries were taxed at 10 percent, everyone would pay about $50 in tax (or slightly less, if people cut back on their food expenditures when the tax is introduced). If part of the revenue raised by taxing groceries was used to give every low income individual a $60 tax credit, the tax on groceries would actually increase the well-being of the worst off members of society. Any additional revenues raised could be used either to decrease other taxes, leading to greater economic efficiency, or to provide needed social or infrastructure programs, further enhancing efficiency and/or equity.

This equity argument is the one emphasized in, for example, Michael Smart's recent paper. Yet it begs the question: why groceries? Why not increase the top rate of income tax instead, or raise capital gains taxes?

The heart of the economic argument for taxing basic groceries is that it increases economic efficiency.

There's a short version of the efficiency argument and a long version. The short version goes something like this: "If groceries aren't taxed, but other goods are, then people's choices will be distorted. They will substitute groceries for other goods, hence the economy will devote too many resources to producing food and too few to producing other goods. Economic efficiency will be compromised…."

It’s a long post, with lots of graphs and (gasp!) not a lot of math, so should be fairly easy to follow even without a microeconomics background. It’s essentially the same argument against energy subsidies, though in this case, it’s about differential taxation. The Canadian case is pertinent because Canada is one the very, very few examples of countries which have done what Malaysia is going to do – switching from a sales tax to a value-added tax.

The second argument is that, contrary to other forms of taxation, consumption taxes like GST actually boost growth (again from the WCI blog; excerpt):

Taxation and Economic Growth

I had a bit of an intellectual crisis this evening as I pondered the conventional wisdom in economics regarding the choice between reducing consumption taxes or income taxes. Briefly put, the simple conventional wisdom is that taxes on consumption are preferred to income taxes because they encourage saving and long-term capital formation and economic growth. Income taxes, on the other hand, distort the labour-leisure choice and can reduce labour supply and therefore reduce economic growth.

Yet, as I thought about the Canadian economy and how well it seems to have weathered the global economic downturn, one thing that stuck out in my mind is that the federal government reduced the GST rate just prior to the Great Recession....

...I’m afraid I don’t have an answer to that specific question for Canada. However, it should be possible to see if countries with greater reliance on consumption taxation have better growth rates than those that were less reliant. What I did do was quickly collect data from OECD Statistics for the 34 OECD countries on the annual average growth of per capita GDP in US PPP dollars over the period 2007 to 2009, the share of GDP accounted for by taxes on goods and services in 2008 and the share of GDP accounted for by taxes on income and profits in 2008. I then proceeded to plot the tax to GDP shares against the growth rates as shown in Figures 1 and 2 with a linear trend. The results show a positive correlation between growth in per capita GDP and the share of GDP accounted for by consumption taxation and a negative correlation between growth and the share of GDP accounted for by taxes on income and profits….

Two papers were also linked to in the comments (here and here).

Now, I can see the loopholes in this – higher growth doesn’t necessarily imply that this growth is inclusive. Lower marginal tax rates would increase the post-tax return for those at the top of the income distribution, and nothing is stopping individuals from incorporating themselves to take advantage of lower corporate taxes. Nevertheless, a bigger pie allows for bigger redistribution.

There’s a hierarchy of taxes in relation to growth – consumption and property/inheritance taxes are the most beneficial (actually, the least distortionary), while income taxes slow growth down. Of course, this depends on the level of taxation, and I think that income taxes in Malaysia (both personal and corporate) are low enough that raising them wouldn’t necessarily reduce growth. For the more technically inclined, I think we’re on the part of the Laffer curve where reducing income taxes just reduces government revenue without boosting savings, investment and growth.

But I think the most important reason for backing GST is that its the one instrument that can raise enough revenue to properly fund the required social transfers to make a real dent in inequality (excerpt; emphasis added):

Revisiting Robin Hood's agenda: Be less concerned about taking from the rich and focus on giving to the poor

...As a matter of statistics, it's perfectly true that people who are in (say) the top 10% have received the lion's share of gains to national income. But people who are at the 90th or even the 95th percentile could fairly object to such a broad brush, because they - like the people at the median - haven't seen much in the way of increases in income either....

...I like the idea of a surtax on the top 1% or the top 0.5%, but I view it as a sort of a speed bump to slow a worrying trend; it's not likely to generate much in the way of revenues....

...And now we return to Ed Broadbent's question: how do places like Finland, Sweden and Denmark do it?...

...The remarkable thing about this graph is that the redistributive effects of the tax systems of all of these countries are approximately the same, and are pretty small at that. I've made this point before, and it's worth repeating: the countries that have been the most successful in reducing inequality don't have particularly progressive tax structures. The real gains in reducing inequality are achieved by means of well-designed transfers....

...successful social democracies have learned that the goal of the tax structure is to generate as much revenues as possible with the fewest distortions as possible….

…It's true that these tax instruments probably won't do much in the way of redistributing income, but as we've seen, that's not the point. They are an efficient way of generating tax revenues that can be in turn redistributed in the form of transfers.

Successful social democracies have learned to worry less about taking from rich and to focus on giving to the poor.

Higher marginal tax rates, capital gains taxes, inheritance/estate taxes all have their place – but their job is really to limit gains at the top. The Malaysian tax base is so narrow, that what they can’t and won’t do is really address the structure of inequality itself.

We can’t make achieve any meaningful reduction in Malaysia’s Gini coefficient without addressing the middle and the bottom of the distribution too. BR1M is a start, but its too poorly funded and too stretched thin to make a real impact. The post-BR1M reduction in Malaysia’s Gini number is almost lost in statistical noise. Multiply it by a factor of five (e.g. by earmarking all GST revenue for social spending and transfers), get it better targeted (I’ve seen estimates that a third of BR1M payments are “leakage”), and then we might get somewhere.


  1. Hmm... My thoughts on the implication of GST in Singapore in 1993 was that the government foresaw that with an ageing and shrinking workforce to come, there would be to small a base to support expenditure via direct taxes, so an indirect tax on consumption like GST was the solution. Also, I was of the opinion that indirect taxes like GST were regressive as the poor would spend a greater percentage of their income on it. Is there any divergence in the Singapore and Malaysia reasons (Is my take on the Singapore reasons correct in the first place, in your opinion)?

    1. @The Slug

      I really can't speak for Singapore's reasons to implement GST.

      However, I've seen the MOF simulations - GST is regressive, but only with respect to SST. Otherwise, it's pretty progressive with respect to income i.e. the effective tax rate gets higher as incomes go up.

      And this is before the expansion of the zero-rated and exempt list in last year's budget.

  2. No way poor spend more on gst. No way regressive. Just the opposite.

  3. too hypothetical....the fact remains that it is regressive in is said that the GST is meant to redistribute the income and mainly to help the rural poor/ development process. My question is, how is it going to be helpful if someone from low income group is 'robbed' RM 400 a month just to be given back the same amount or less later? Please enlighten me. In our case it can be worse. The money is used to pay off debts

    1. @Lawrence

      1. The compensating BR1M payments started in January i.e. in advance

      2. On a net basis, if you're paying RM400 more in GST than in SST, you're already in the upper-middle/higher income group.

    2. @lawrence & @hishamh

      I was wondering about the implementation of GST, is it true that the govt will be able to essentially collect the tax earlier which means it would be able to spend it on activities that would make the money grow? It was explained to me by my colleague that the GST is essentially leveraging on the concept of time value of money to collect taxes now as opposed to later.

      Please explain.