GST 5- 7 percent - what's really at stake

VERY LONG POST> WARNING

Please turn back if you can't stand long economic, theoretical essays. Ciaos



On Monday, the Singapore PM dropped what many people saw as a bombshell. The goods and services tax, a consumption tax in Singapore, is moving up from 5% to 7%.

His reasoning: Globalisation has caused the income gap to grow. And with the expected increase spending as the population ages, there will be a need to find more money. He says the government wants to help these people, especially those at the bottom of the wage gap. For example, he wants to put, as a more regular feature, the Workfare bonus, a financial incentive to get people to work, by giving money to those who can hold unto a job.

But there needs to be additional sources of revenue, if the government is to avoid dipping into its reserves. So raise the GST from 5 to 7% so more money can be collected. Also, change the definition of the Net Investment Income, so that the government can take out more from the money earned from investing its reserves. (This is managed by the Singapore government's investment companies, Temasek and Government Investment Corporation)

Naturally, this created a huge uproar. His argument seems to be: We want to help the poor. Raise taxes so we can get more money. Redistribute this money so that the poor gets more help. Sorta like Robinhood.

Of course, this is entirely counter-intuitive. Shouldn't you lower taxes to help the poor?

First, consumption tax is regressive as compared to income tax, which is, in most cases, progressive.

A progressive tax system is one in which the richer pay a proportionally higher rate of taxes than the poorer. For example, in Singapore, the rich pay xx% of their wages, which is higher than xx% of someone who earns xx dollars.

In the case of regressive taxes, or in this case, the consumption tax, the poor guy pays a higher proportion of his salary to taxes than compared to the rich guy.

This is different from paying a larger absolute amount of tax, which the rich does in the case of the consumption tax.

For example, everyone needs to eat. The richer may eat a more expensive meal than the poor, but all will have to eat. In the case of Singapore, most Singaporean families buy rice for food to eat at home. So let's assume that there is only one type of rice in Singapore, and it costs $10.

If GST increases by 2% to 7%, then all families will have to pay that extra 20 cents more. For a poor family, if the household income is say $1,000, 20 cents is a higher proportion in the poorer familiy, than it would be in a household which earns $10,000.

But of course, we know that the rich people buy more expensive rice. There is of course the fragrant rice version, the organic version or the cheapest gunny sack version. The prices differ and depending on the income level, families would spend differently. But since rice is such a basic necessity for most families, we can assume, not without being too extreme, that there is not that much of a difference in price of rice. So even if the price of the most expensive rice is say, double that of the cheapest, the rich would still be paying a significantly less proportion of their salaries in buying rice.

In other words, the poor will almost always spend more of their money on consumption than the rich do because their salaries are just much smaller than the rich, even though the rich will probably end up paying more taxes by virtue of them spending more.

If this is the case, how can a rise in GST help the poor, many people complain. Will this not make the poor poorer and the rich poorer too?

On this question, there is significant debate at the intellectual level. But economic theory posits that indirect taxes (GST) is a better system than direct taxes (income tax).

Why? It is more efficient as it leaves the individual in charge of his own spending patterns.

A person would usually base his spending, saving and investing patterns on just how much he has in the bank, economic theory says.

So in the case of a direct tax, like income tax, the person will have a certain percentage of his money taxed and he can only decide what to do with the money after taxes has been deducted.

But if the system moves from a direct tax system to a more indirect tax system, there is more money for the person to play around with. So it gives him control of his own finances.

At the same time, a consumption tax would mean that it is more expensive to buy things. As such, the incentive to save and invest grows.

But that does not mean that consumption will go down, because a person's decision to cosume varies from person to person. It does mean that there will probably be more people attracted to saving and investment. In fact, you can avoid taxes by just deciding not to consume that much in the first place.

Another effect of lowering income taxes is that in a globalised world, people are mobile. So one major consideration for top talent and CEOs is how much of the money they earn actually goes into their pocket.

And in this knowledge economy, talent is the greatest contributor to value. So the country which can attract the most talent will most likely thrive. Those which cannot, will probably fall by the wayside.

Similarly, for companies, a major consideration for them when they consider where to invest in is how much a country taxes their profits. So they would invest in a certain country which has lower taxes than one which taxes them more.

Like individuals, companies which are taxed less on their profits has an option to invest the increased amounts of returns into capital or research and development.

Of course, this does not solve the problem of the regressive nature of consumption tax. But it does mean that the economy becomes more competitive.

This is then where it gets tricky, no pun intended.

If the economy gets bigger, as the saying goes, the pie grows larger as well, which means that everyone has more to eat.

If more investments and talent flood into a country, the economy booms and more jobs are created. Incomes at the top will increase exponentially.

This will create the trickle-down effect, so that the poorer people also get better paid jobs. This is what economists claim the market economy will do for the entire economy. Let the market decide and everyone will be better off than they were if the market was mangled with.

Well, I try to put this into persepective in my next post on Singapore's experience.