GST - Part 3: Getting Squeezed Tighter

The Goods and Services Tax to be implemented by 1 April 2015 has been the talk of the town, at least it had been until the unending swarm of rate hikes shifted our attention. Nonetheless, there is still a lot left under the carpet. The government has been airing various misleading advertisements about GST and word from social media has been equally misleading albeit spun in the opposite direction. To do my part to clear any confusion regarding GST and to capitalise on my prior research on GST, I shall write a series of articles on the subject.

Part 3 - What will GST do to us?

Foreword

Obviously, GST affects every individual and household in different ways, depending on income and consumption patterns. There is simply no way to account for all the variations therefore I will rely on statistics to prove whatever point I'm trying to prove. That being said, this is not a full-fledged research paper. For that, click here.

Is GST a progressive or regressive tax?

What is a progressive tax? A progressive tax is when the rich, in addition to paying a higher amount in taxes, pay a higher percentage of their income in taxes than the poor. 

For an example of progressive tax, look at an income tax system where the first RM1,000 earned is taxed at 10% and anything above is taxed at taxed at 20%. We have 2 people, A who earns RM1,000 and B who earns RM3,000.

A will pay RM100 in income taxes, effectively 10% of RM1,000. Simple. B, on the other hand, needs to pay RM100 for the first RM1,000 he earns and RM400 (20%) for the next RM2,000. B, in total pays RM500 in taxes for a RM3,000 income, effectively 16.67%. B, who earns more than A, pays more in taxes in proportion to income.

A regressive tax is the opposite, where the poor pays a large proportion in income as taxes as compared to the rich. This is never the case with income taxes, not in a single country in the world, as it is simply unconscionable to tax the poor more (in percentage) than the rich.

Back to the question, is GST a progressive or regressive tax?

In short, it is regressive. Why? Look at the graph below.

Income-expenditure relationship in Malaysia. Source: Penang Institute[1].

The graph shows the relationship between income and expenditure of Malaysians. As we can see, if you're earning RM1,000, you will most likely spend all or close to all of the money; if you're earning RM15,000, only about a third of your income is spent. So 6% of all your income is more than 6% of a third of your income, effectively 2%, in relation to income, zero-rated and exempt supplies notwithstanding.

Taking consumption patterns of standard-rated, zero-rated and exempt supplies into account, the effective GST on different income groups in Malaysia is shown in the graph below.

Effective GST (GSTI) of different income groups. Source: Penang Institute[2].

As we can see, GST is marginally progressive over the income range of RM500 to RM1,999. Afterwards, the decline in GSTI gets steeper as income increases. This is a sign of a regressive tax and worse, one that gets more regressive as income increases. Supposed RM5,000 is not the upper limit for this graph, say it were RM100,000, the GSTI would be far lower and the burden of GST is much larger on a poor person than it is on the rich. If you belong to the latter portion of the graph, put aside the benefits for you and ponder upon whether or not it is equitable that a poorer person is burdened more than you by a tax.

Will GST burden us more than the current tax system?

Yes. For a few simple reasons established in my previous article.

Firstly, GST now affects roughly ten times more businesses than the previous Sales Tax[3]. It can be assumed that ten times more businesses under GST would mean more products being taxed. More products being taxed means consumers are paying more taxes.

This is further reinforced by reason number two, the Royal Malaysian Customs is projecting an increment of RM5 - 6 billion in tax revenue due to the switch from the current Sales and Services Tax to GST[4]. Since GST is completely borne by the consumers, as established in part 1 of this series, the tax burden on consumers is sure to increase.

There is another side to the increase in burden - inflation. We can expect a one-time "blip" in the Consumer Price Index (CPI) once GST is implemented[5]. This is due to GST implementation costs as systems have to be set up to handle GST transactions[6]. However, CIMB analysts expect the inflation rate to just jump once and not accelerate further as GST is a refundable credit system (how does that figure?), there are exemptions e.g. exempt and zero-rated supplies, and last but not least, "strict market enforcement to monitor price changes"[7]. Pardon me for being cynical but 'strict enforcement', 'monitor'? Seriously?

But the government claims that prices will go down after GST is implemented.

Try not to be shocked when you read this: the government lied.

I know what the government tries to sell. Sales Tax is 10%, Services Tax is 6%, with GST, only one tax at 6%. Huge savings.

There are a few fallacies in that claim. One, Sales Tax is levied on manufacturers and is a one stage tax, as compared to GST, where the value added at every stage of the supply chain, is taxed and the taxable value is the final price of the goods or services. Think about it, 10% of the manufacturer's price is much likely to be lower than 6% of the final price after goods have passed through the hands of the manufacturers, wholesalers, retailers.

Two, there can be a marginal decrease in tax once GST is implemented, but it is most likely not going to happen. Say, if there are only 2 stages in the supply chain, manufacturer and service provider. Since under Sales Tax, the service provider will not be able to claim input tax deductions for the 10% paid to the manufacturer, the 10% will be priced into the service provider's price upon which another 6% will be levied. At the maximum, assuming the price of the manufacturer including Sales Tax (110%) is the same as the service provider's price, (now pause for a moment and think about how ludicrous that is, a business that has 0 gross margin,) add 6% service tax onto that (116.6%), effectively, it results in a tax saving of 63.86% from switching from the current system to GST (106%).

(16.6% - 6%)/16.6% = 63.86%

However, this situation is close to impossible in the real world. Supply chains are longer and there would be value added at every stage, which means the final service provider's price would be much higher than the manufacturer's price, cutting the tax savings to a point where they would be minimal. Also, businessmen in the real world are unlikely to pass on savings to consumers when consumers are already willing to pay the higher price, especially when it is not significant enough to increase demand. Don't forget about the implementation costs which would be priced into the goods and services if the government doesn't fully subsidise them.

As a result, prices are most likely increasing, as evidenced in the inflation rate projections by various think tanks and research houses.

Are there any measures in the budget to ease the burden?

There are in fact, two measures that the government has proposed to ease the burden of GST on the rakyat. First is an income tax rate cut; second is an increment in Bantuan Rakyat 1 Malaysia, more commonly known as its acronym, BR1M.

The proposed income tax rate cut is as follows:

Note that as opposed to the other graphs in this article which refer to monthly household income, the income here refers to annual individual income.

So how many people actually benefit from the income tax rate cut? According to PM Datuk Seri Najib Tun Razak, less than 10% of Malaysia's working population pay income taxes, which works out to be 5.6% of the entire population[8]. So, only 5.6% of Malaysians are benefiting from the cut.

BR1M is an annual handout of RM650 paid to heads of households with monthly household income of RM4,000 and below, senior citizens (aged 60 and above) living alone with monthly income of RM4,000 and below, and under 21s with monthly income of RM2,000 and below[9]. It is increased from RM500 for 2014 and beyond. For 2013, there were 6.8 million BR1M applicants[10].

Given that 44.7% of Malaysian households earn more than RM4,000, they are not eligible for BR1M[11]. Minus the 5.6% who benefit from income tax rate cuts, which is supposed to be a much smaller percentage once converted to household from individuals, that leaves about 40% of people who do not benefit from both measures and are to bear the brunt of higher living costs as a result of GST.

Net effect of income tax saving, BR1M and GST payments (household). Source: Penang Institute[12].

This, ladies and gentleman, is the middle class of Malaysia. This is always the group getting the short end of the stick.

Conclusion

As of now, it seems that GST implementation is a certainty. For the poor, the effects of GST will be mitigated; for the rich, the income tax rate cut will result in great savings; for the middle class of Malaysia, there is little that can be done but to brace for a tighter squeeze and pray and hope that this is the last squeeze. However, before GST hits, price and rate hikes are already wrapped and packed as 2014's New Year's gifts, and the effects are not limited to the middle class.

So, during this festive season, remember to be grateful and thank the government.

Chong Yu Cheng

Part 1 - What is GST and how does it work?
Part 2 - Is GST a good system and is the government ready for it?
Part 3 - What will GST do to us?
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[1]K H Lim & P Q Ooi, Implementing Goods and Services Tax in Malaysia [PDF document]. Retrieved from Penang Institute Site: http://penanginstitute.org/gst/GST&You_20131109.pdf

[2]Ibid.

[3]T Pua, The Tiger That Lost Its Roar: a Tale of Malaysia’s Political Economy, Democratic Action Party, 2010.

[4]Ibid.

[5] H G Lee, "Inflating Expectations of Subsidy Cuts and GST", Macro Pulse, CIMB, Jun 7, 2013.

[6]Ibid.

[7]Ibid.

[8]http://www.theedgemalaysia.com/commentary/221121-pre-budget-2012-caught-in-the-middle.html

[9]https://ebr1m.hasil.gov.my/

[10]http://www.nst.com.my/nation/general/govt-may-up-income-eligibility-for-br1m-1.311470

[11]http://www.epu.gov.my/documents/10124/c9352eab-28fe-4b0f-9fc1-8a70c18b0cd9

[12]Ibid. 1.

GST - Part 2: Generally Superior, Theoretically

The Goods and Services Tax to be implemented by 1 April 2015 has been the talk of the town, at least it had been until the unending swarm of rate hikes shifted our attention. Nonetheless, there is still a lot left under the carpet. The government has been airing various misleading advertisements about GST and word from social media has been equally misleading albeit spun in the opposite direction. To do my part to clear any confusion regarding GST and to capitalise on my prior research on GST, I shall write a series of articles on the subject.

Part 2 - Is GST a good tax system and is the government ready for it?

Is GST a good tax system?

At any point where you have no idea what the hell I'm talking about because you're unsure how GST works, scroll up and click here.

GST is an excellent tax system. If otherwise, it would not be implemented in 160 countries around the world. It is without a shred of doubt better than the current system in Malaysia whereby there are two taxes - Sales Tax and Services Tax in terms of efficiency.

Before any comparison can be done, we need some explanation on how the taxes work.

Sales Tax is levied upon any person (individual or company) who engages in the manufacturing of taxable goods in the course of business[1]. Manufacturers with an annual turnover of less than RM100,000 of taxable goods can apply to be exempt from Sales Tax[2]. As it is only charged to manufacturers, it is a one stage tax, as compared to GST, which is a multistage tax levied on every business in the supply chain. Sales Tax rate is generally 10% but is 5% for basic products, 20% for others while fuels have specific tax rates[3].

The inefficiency of the Sales Tax lies in the fact that it is a one stage tax. Manufacturers which are required to pay Sales Tax can easily set up companies to sell their products to at rock bottom prices. As a result, they are taxed less and the companies which bought the products are free to sell at market prices, without paying Sales Tax. With GST, there is no escape from the taxman as goods and services are taxed at every stage. The companies set up by the manufacturers would be taxed anyway when they sell their products, eliminating this trick from the book. This is why GST is more efficient, as it is more difficult to avoid taxation.

Services Tax is 6% which is the same rate as GST so no changes there other than the turnover threshold which is up to RM500,000 for GST from a range of RM150,000 to RM500,000 for Services Tax[4]. Taken at face value there should be no gain in efficiency in the switch. That being said, the gain in efficiency lies in the fact that there will be one tax system - GST as compared to the current two - Sales and Services Tax.

All in all, GST is a more efficient tax as it is harder to avoid and eliminates the need for two tax systems.

Is the government ready for it?

It is pretty much established that it in theory, GST is superior tax system as compared to the current system. It is also excellent for our government in terms of revenue as it affects more businesses than before and is projected by the Royal Malaysian Customs to rake in an additional RM5 – 6 billion per annum[5]. However, is the government ready for it?

I don’t think so. We know that a system is only as good as its execution. Any system, no matter how theoretically sound it is, means nothing if it’s poorly executed. That is the concern I have for the implementation of GST in Malaysia. GST, as much as it is efficient, is more complex than the previous tax systems. The complexities are not only present in the administration of the tax but also in its legal side. Bear with me and let me explain how.

Administration

The first issue I have with the administration of GST is the workload. Let us look at it using simple mathematics. Currently, there are about 20,000 manufacturers with Sales Tax licences, meaning they have to pay the taxes. Once GST is implemented, the number of businesses affected will be north of 200,000, tenfold of what it was before[6].

It doesn’t end there. Sales Tax involves little to no refunds, except in the cases of erroneous refunds, overcharging, or with approval from the Finance Minister or the Director General of Customs and Excise[7]. We can assume that most taxes go one way, from manufacturer to customs, with the few exceptions. If it goes the other way, it would mean that our customs is doing a poor job to begin with. With GST, taxes go both ways in the form of input and output taxes as shown in my previous article. 

Using my previous example, with 3 businesses in the supply chain, under the Sales Tax only the manufacturer would be taxed. That is it. Under GST the same supply chain would have tax collected from 3 businesses taxed and 2 businesses getting deductions. Bear in mind that this is possibly the simplest supply chain. In the real world, manufacturers would be procuring raw material from other manufacturers. There could also be more than one wholesaler. Most goods actually go through multiple distributors in a supply chain. Every time goods change hands, two tax transactions occur. As such, the administrative workload would be multiplied by factors way beyond ten.

As far as I know, Customs has no plans on mass recruitment for the implementation of GST. It would seem that it is relying more on systems than personnel for the smooth running of GST. However, even the best systems need to be monitored. With the much larger number of transactions once GST is implemented, one would think that they would need a larger workforce. This is one reason I doubt the government’s readiness for GST.

If in any case that the system fails to live up to its promise and Customs rushes GST deductions and refunds due to increased workload, many fraudulent claims would pass through the net, causing losses for the government[8].

Legal

The issue regarding the legal side of GST is a bit less intuitive than the previous point. Still, it is no less important.

GST is governed by a piece of legislation, the GST act. In the GST act, a very important section is the list of taxable and exempt supplies. Now, it may seem strange that there would be complications arising from such clear cut distinctions of what is taxable and what is not. I assure you that this is, in fact, true. The best way of demonstrating this is to study a real legal case.

Proctor & Gamble (P&G), manufacturer the potato crisps (or chips, if you’re American), Pringles, won a case in the UK High Court for their product to be exempt from VAT (same as GST), because the judge ruled that the product is in fact, not a crisp[8]. In the UK, crisps are taxable supplies whereas most foodstuffs are not[9]. P&G argued that Pringles, due to their ‘melt mouth’ taste, ‘uniform colour’, ‘regular shape’ which is ‘not found in nature’ and they contained non-potato flour unlike other crisps[10]. It was also argued that the tube packaging unique to Pringles distinguishes it from crisps[11]. The judged ruled that Pringles were found to fall outside the definition of crisps as the products, in all their flavours contain less than 50% potato[12]. The judge also agreed with most of P&G's arguments[13].

However, the Court of Appeal then overturned the decision on the basis that Pringles contained 42% potato which is sufficient to be reasonably viewed as to be made from potato, therefore are in fact, crisps and liable for VAT[14]. The tax amount in question was £100 million plus £20 million per year in the future. 

The above example shows that determining whether or not a supply is taxable is not as simple as it sounds and the amount of money in contention could be extremely sizeable.

If I remember correctly from one of my Tax Law lectures, there is also another case in Australia where the argument was on whether Italian shortbread is bread or biscuit, whereby bread is GST exempt whereas biscuit is not. In Australia, between 2011 and 2013, there are on average 3 GST-related cases every month[15].

Is our judiciary ready for this type of workload? One could argue that with Sales Tax, these cases would already have existed. However, it is important to go back to the point where many more businesses are affected by GST as compared to Sales Tax.

Conclusion

GST, taken on its merits as a system, is a beautiful piece of work. However, it entails much more work than our existing system. Given the track record of our government and civil servants, there is much room for doubt on the smooth running of a complex tax system. Don’t get me wrong, I am not outright accusing them of being too incompetent to do it. What I am saying is the level of assurance required for me to believe that it will be well run is pretty damn high.

If the government does it wrong, the tax revenue could fall short of expectations, requiring either the system and/or personnel to be revamped or raising the GST rate. I think we know very well which is the easier option.

Chong Yu Cheng

Part 1 - What is GST and how does it work?

Part 2 - Is GST a good system and is the government ready for it?

Part 3 - What will GST do to us?

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[1] http://www.agc.gov.my/Akta/Vol.%202/Act%2064.pdf
[2] Ibid.
[3] http://malaysiantax.com/attachments/Malaysian-tax-PUA-355-Sales-Tax-2.pdf
[4] http://www.nbc.com.my/service-tax-in-malaysia.html
[5] http://www.freemalaysiatoday.com/category/business/2013/11/22/rmc-gst-at-6-to-raise-rm22b-revenue/
[6] T Pua, The Tiger That Lost Its Roar: a Tale of Malaysia’s Political Economy, Democratic Action Party, 2010.
[7] http://www.agc.gov.my/Akta/Vol.%202/Act%2064.pdf
[8] Ibid. 6.
[9] http://www.bakeryandsnacks.com/Markets/Pringles-are-not-crisps-rules-UK-court-in-VAT-case
[10] Ibid.
[11] http://news.bbc.co.uk/2/hi/8060204.stm
[12] Ibid. 9.
[13] Ibid. 9.
[14] Ibid. 9.
[15] Ibid. 11.
[16] http://chrissievers.com/gst-case-summaries-2/

GST - Part 1: Goodness! So Technical!

The Goods and Services Tax to be implemented by 1 April 2015 has been the talk of the town, at least it had been until the unending swarm of rate hikes shifted our attention. Nonetheless, there is still a lot left under the carpet. The government has been airing various misleading advertisements about GST and word from social media has been equally misleading albeit spun in the opposite direction. To do my part to clear any confusion regarding GST and to capitalise on my prior research on GST, I shall write a series of articles on the subject.

Part 1 – What is GST and how does it work?

What is GST?

Goods and Services Tax or GST is a consumption tax. It is collected at every stage of the supply chain but is ultimately borne by the consumer. It is designed to tax the value added at every stage of the supply chain. As such, it is called Value Added Tax or VAT in many countries.

For Malaysia, the GST will be replacing two tax systems, Sales Tax (10%) and Services Tax (6%) at a starting rate of 6% effective 1 April 2015.

How does it work?

First, we must explore the concept of supply chain. A supply chain is a system of organisations, people, activities, information, and resources involved in moving a product or service from supplier to customer. For my example, the supply chain consists of a manufacturer, a wholesaler, a retailer and finally a consumer.

This is what a supply chain looks like without GST:

Without GST, the manufacturer sells goods to the wholesaler for RM1.00, the wholesaler sells to the retailer for RM2.00 and the retailer sells to the consumer for RM4.00. No rocket science there.

Now, let us throw GST into the mix:

With GST, 6% is collected from every stage of the supply chain based on the price at each stage. So the manufacturer sells goods to the wholesaler for RM1.06 now, of which 6 sen (6%) goes to the government. The manufacturer still receives RM1.00. Same goes for wholesaler to retailer at RM2.12 - 12 sen to the government and retailer to consumer at RM4.24 - 24 sen to the government. These are called output tax.

Now, 6 + 12 + 24 = 42 sen, which is effectively 10.5%. So are we taxed more than 6%?

No, the GST component paid for by a business to the previous business in the supply chain, or input tax, is deductible. Look at the diagram below:

For the wholesaler, the 6 sen paid to the manufacturer is deductible. It is offset against the output tax of 12 sen when the it sold goods to the retailer. In the end, the GST payable to the government is 6 sen. The same goes for the retailer, 12 sen paid to the wholesaler is deductible, which is offset against output tax of 24 sen and the GST payable is 12 sen. Add up all the GST payable across the supply chain: 6 + 6 + 12 = 24 sen, which is 6% of RM4.00, the final sale price of the goods.

So, all in all, the manufacturer receives RM1.00, the wholesaler RM2.00, the retailer RM4.00, as it is without GST. The government receives 6% on the final sale price, 24 sen, which is collected from all stages of the supply chain other than the consumer. However, the consumer pays RM4.24 for the goods, and the 24 sen GST is borne by the consumer.

What about standard-rated supplies, zero-rated supplies and exempt supplies?

Standard-rated supplies are goods and services which are charged the standard 6% rate as explained above.

Zero-rated supplies are goods and services which are charged GST at a rate of 0%, which means it is GST-free. Businesses do not charge GST for zero-rated supplies but if any input tax that is paid by the businesses can be claimed. However, this does not mean that prices of these goods and services will not increase after GST is implemented as the costs in manufacturing, transporting, selling, marketing the products might carry GST. Although these costs are deductible, businesses are unlikely to pass on the full savings from the deductions to the consumers. As such, prices of goods and services will still rise despite being zero-rated.

Exempt supplies are charged GST at every stage of the supply chain except where it goes from final provider to consumer. The government tells us that consumers will not bear the GST in this case, which is true, but the GST borne by businesses will most definitely be passed on to the consumers and prices will still increase.

Chong Yu Cheng

Part 1 - What is GST and how does it work?
Part 2 - Is GST a good system and is the government ready for it?
Part 3 - What will GST do to us?