This article appeared originally as a policy comment in the Centre for Policy Research and International Studies (CenPris), Universiti Sains Malaysia column in the New Sunday Times of 12 August 2018.
THE argument that the Goods and Services Tax (GST) was a major factor in price increases found receptive ears among Malaysians.
The promise to abolish GST was a powerful card played successfully by then opposition Pakatan Harapan to wrest power from Barisan Nasional. The question that begs to be answered is why GST proved to be so unpopular in Malaysia.
GST is a tax on the value added at each stage of the production distribution chain and is generically known worldwide as Value Added Tax (VAT). GST has been prescribed as a panacea for all economies facing revenue shortfalls by the World Bank and the International Monetary Fund (IMF). About 160 countries have adopted the GST or some variation of it.
As a revenue generator, GST’s performance is unrivalled because of its broad consumption base. Since consumption cannot be hidden, even people who evade or avoid taxes on income are forced to pay taxes when they consume. Furthermore, because the tax is collected at multiple points in the production distribution chain, revenue loss is minimised. And in theory, an invoice trail is created by the invoices that have to be obtained and produced in order to subtract the taxes paid on inputs from the taxes owed on outputs. This enables the tax authorities to check on the tax revenue collected and forwarded by businesses and their claims for credit on taxes paid on inputs and minimise the scope for cheating. This is why economists describe GST as being “efficient”. Since the customer knows exactly how much he is being taxed on each purchase, GST is “transparent” as well.
GST will protect revenues when we become an aging society and the revenue from income taxes decline as more people drop out of the workforce. Being a tax on consumption, and because even the aged must consume, revenue from GST will continue to flow into government coffers. These features make it attractive to governments, especially ones that are strapped for funds.
There are, of course, downsides to the GST that are largely ignored. And it is when these concerns are sidelined that a groundswell develops against it.
First and foremost, GST can turn out to be a major liability in the hands of fiscally irresponsible governments; the ease with which it generates revenue does not provide a strong incentive for governments to be frugal. Since virtually every individual is hit by the tax, there is greater interest on how the revenue is spent. Unless it is clearly seen to be spent for the welfare of the populace, discontent will build up.
Second, the GST is a complicated tax to administer and a considerable amount of preparation is necessary before it can be implemented smoothly. Although many developing countries have implemented variations of the GST, not many have done it efficiently and the complications and difficulties they faced or are still facing receive no publicity from international agencies that try to sell GST to cash-strapped governments. Sri Lanka and India are examples of countries struggling with poorly conceived and implemented GST regimes. There are many more.
Third, it is commonly held that businesses do not bear the burden of GST as they can pass the tax forward to consumers. However, businesses are in fact affected from two angles. On one side, passing the tax forward means raising prices and so long as goods have negatively sloped demand curves, this will reduce sales and revenues of businesses. On the other side, and this is frequently ignored by governments, is the compliance cost borne by businesses, with the compliance burden falling more on small rather than large businesses.
The compliance cost includes not only the expenditure necessary to prepare businesses to be GST compliant, but also the continuous cost of acting as a tax collector for the government without any compensation for the time and effort involved. Not surprisingly, many small establishments and family-run businesses ceased operations when the GST was introduced.
Fourth, GST burdens the consumer (taxpayer). However, because it is a broad-based tax, the burden is felt more under the GST than the Sales and Service Tax (SST) that it replaced because virtually no one escapes its effect. The impact on the consumer arises from two sources. One, the GST will raise prices and this lowers the purchasing power of consumers. Two, being a tax on consumption, it is likely to be regressive; that is, it will extract a large proportion of income by way of taxes from low-income groups compared with higher-income groups. If efforts are not made to ameliorate these effects, the GST will impose a heavy burden on consumers.
Finally, it is important to bear in mind that the GST evolved in a developed country context where income taxes are securely in place. The GST is a tax on consumption. If both taxes remained, the taxpayer would be hit both on the income and consumption sides. Therefore, when GST was introduced in developed countries, income tax rates were reduced to afford some relief on the income side. Since a large proportion of the working population pay income tax in developed countries, the reductions in tax rates to offset the effect of the GST on the consumption side benefited a large section of the working population, and this helped to mute protests against GST.
This experiment could not be replicated in Malaysia. With the bulk of the population spending a higher proportion of their income on consumption and only 15 per cent of the 14.6 million workers paying income tax (in 2016), a GST accompanied by a reduction in personal income tax hit poorer consumers with a “double whammy”. They paid more taxes via consumption (thanks to the broader base of the GST relative to the limited base of the then prevailing SST), but enjoyed no benefits from the lowered income taxation since they were outside the income tax net to begin with.
On the other hand, richer consumers probably enjoyed a “double dividend” — lower consumption taxes as a proportion of total income (since consumption expenditure as a proportion of income typically falls as income increases) and greater relief from income taxes.
One of the issues with the GST is its effect on the general price level. While there is no reason to believe that the introduction of the GST will trigger inflation per se, there is evidence to indicate that it could result in a one-time increase in the general price level. Or stated differently, if all other factors remain unchanged, it could lead to a one-time fall in the purchasing power of consumers. The GST was only found to trigger inflation when it was introduced in economies that were already predisposed to inflation due to factors like constraints on the supply of goods and services, or because an easy money policy was being pursued.
Countries that tried to minimise the impact of GST on the price level followed several strategies. First, they ensured that the GST was revenue neutral when it was first introduced. In other words, the GST was structured in such a way as to ensure that it generated about the same revenue as the tax it replaced. Thus, if the GST was designed to replace a sales tax, it should have been designed to initially bring in the same revenue that would be lost by abolishing the sales tax. Second, the timing of the GST is important and should be introduced when the economy was not facing inflationary pressures from other sources or causes. Third, auxiliary measures need to be put in place to check that general prices do not rise unjustifiably immediately after GST’s introduction.
A widely-cited study on the price effects of the VAT or GST by Alan Tait of the IMF covered 36 countries, 21 of which were developing economies.
In the developing countries sample, the tax was found to impact only negligibly on the consumer price index (CPI) in 14 countries (or 66.7 per cent of the sample) but these countries had adopted measures to minimise the impact on the price level. In another four cases (19 per cent), the tax triggered a clear, one-time (permanent) increase in the price level. In three cases (14.3 per cent), expansionary wage and credit policies were already in place and so the tax was suspected of accelerating inflation. This would suggest that in an economy not already facing inflationary pressures, the GST will probably not trigger inflation but could result in a one-time increase in the general price level.
A more detailed look at the experiences of 10 countries that put in place measures to minimise the price effects of the GST is revealing. Unfortunately, it focused entirely on European countries with the exception of South Korea, which was one of the few Asian countries to adopt the GST at the time of the study. Nevertheless, the study suggests that the outcomes were surprisingly similar for the European economies and South Korea.
In countries like New Zealand, South Korea, West Germany, the United Kingdom and Ireland where the effects of GST on prices were small or negligible, their tax regimes had either been consciously designed to be revenue neutral and/or had put in place auxiliary measures to minimise price effects, such as price and wage freeze, education campaigns, penalties for unjustified price increases and price-monitoring mechanisms.
Consumer groups were active in moderating unjustified price increases. In other words, complementary strategies were required in the wake of GST to keep its impact on prices minimal. Where adequate attention was not given to auxiliary measures (as in the case of Denmark, for instance) prices did rise beyond expectations.
More importantly, the lesson that emerges from the study is that even if measures to control the impact on the general price level are successfully implemented to negate major increases in the CPI, it can often hide substantial price changes across commodity groups within the CPI basket of goods, which could adversely affect the consumption of lower-income households.
Now, let us look at the Malaysian context. The first point to note is that the GST was not revenue neutral and it was never intended to be. The purpose of the exercise was to generate much-needed revenue. It covered 60 per cent of all the goods and services in the basket of goods used to compute the CPI. Thus, while the abolition of the SST resulted in an estimated loss of revenue of RM17.1 billion (in 2014), the GST brought in revenue of RM27 billion in the first nine months of its implementation in April 2015. In 2016, the GST generated RM38.5 billion, and RM44 billion last year. This implies consumers forked out RM27 billion more for goods and services last year than they did in 2014. Thus, it is not hard to see that the GST did impact the general price level.
The related point is that the economy was already facing pressure on the price level when the GST was introduced. The major upward pressure on the price level was caused by the almost simultaneous move to cut subsidies on basic goods, such as cooking oil, flour and sugar. While subsidies needed to be rolled back, it was unwise to do it when the GST was being brought in. Besides, there were other pressures on the general price level that were left unchecked.
Electricity tariffs were increased by 15 per cent in the peninsula and by about 17 per cent in Sabah and Labuan in January 2014 preceding the introduction of the GST. Water rates were increased in Johor in August 2015 after the GST came into effect, and Penang followed suit by announcing an increase in its water “surcharge” this year.
There were also supply-side constraints on imported basic food items (like onions, chillies, potatoes and so on) that raised their prices. Delays in refunding claims to businesses further aggravated the situation with affected businesses attempting to pass the costs forward by way of price increases. Finally, the weakening ringgit made imports of everything, including foodstuff more expensive. If not for a softening of oil prices, Malaysian consumers would have been hit even harder.
Thus, whatever role the GST had in raising the price level was aggravated by other factors that put an upward pressure on prices. However, protests regarding rising prices were dismissed by trumpeting the fact that the CPI increases were small after the introduction of the GST. This was despite the fact that important players in the retail sector had complained of severe decline in sales.
I am not aware of any systematic attempt by the authorities to track the increase in the components of the CPI that affected the daily lives of ordinary consumers either. I am, of course, ignoring the valid argument that the basket of goods used to measure the CPI is badly in need of revision to accurately capture the changes in the price level.
For me, the GST experiment in Malaysia failed because it was implemented hastily as a fire-fighting measure without adequate thought or preparation. When the GST is designed to increase revenue (as in the case of Malaysia) and implemented in an environment already predisposed to rising prices (due to reductions in subsidies of key commodities like petroleum, flour, sugar and cooking oil, etc) it is to be expected that it will result in price increases than otherwise would be the case.
It was perilous to ignore the consequent impact on low-income consumers. While BR1M (1Malaysia People’s Aid) payments helped, the purchasing power of these payments was eroded by rising prices. Besides, leakages in implementation resulted in some payments being diverted to those not needing the assistance. Actually, attention was necessary on two fronts: rising prices in general and the differential impact of the increase in the general price level on different commodity groups within the CPI. Both were sadly lacking.
It must be added that there were enough examples of countries that rescinded the GST soon after introducing it to learn and understand where they went wrong. At least four countries abolished the GST — Malta, Grenada, Ghana and Belize (British Honduras). Malta introduced it in January 1995. Initially, revenues rose substantially but the high-compliance cost faced by medium-sized enterprises and the complications from extensive zero-rating saw the tax being abolished by the new government that took over in December 1996.
Hong Kong is an example of an economy that decided against implementing the GST, after nine months of debate from July 2006 to December 2006. There is some evidence to suggest that even China may be contemplating replacing the GST with a Retail Sales Tax.
The advantage of the GST as a stable, efficient, transparent and effective revenue source cannot be ignored. Malaysia may have to return to the GST sometime in the future. It is instructive to add that nearly all of the countries that abolished the GST either reverted to it at a later date, or are considering a reversion. The important point to note is their commitment to avoid the mistakes made during the first attempt at GST.
Similarly, if Malaysia plans to follow suit in the future, the following points might be noted. It must introduce a revenue-neutral GST initially, with base broadening rather than revenue generation being the major objective over the first few years. Also, it is important to set the sales threshold for registration for GST high enough so that small businesses will not be affected. An annual sales turnover of RM1 million (or more) would be more appropriate than the RM500,000 level that was in effect in 2015. Furthermore, it must be borne in mind that the GST is appropriate when the bulk of the population earns incomes high enough to be taxed via income tax. Only then will concessions on the income tax side reduce the bite of the tax on the consumption side.
Finally, all the other measures discussed earlier to minimise the impact on the price level must be firmly put in place.
The writer is a professor at the School of Social Sciences, Universiti Sains Malaysia, Penang.