Options to diversify tax base limited, nation needs funds to turbocharge development
The goods and services tax (GST) was first introduced in 2015 and repealed in 2018. At the time, we predicted that a similar consumption tax of its type would eventually return. Fast forward five years, three different governments and a pandemic later: the GST is back on the national agenda.
This is a much-needed move. Over the past few decades, Malaysia’s spending needs have surged tremendously. As the country continues its path towards breaching high-income status, there have been ever-greater demands for better infrastructure, more inclusive social protection, and greater spending on healthcare and education.
At the same time, there is a growing realisation that we need to invest to secure Malaysia’s strategic future in terms of investing in local innovation, increasing global competitiveness, and fostering greater human development – all of which suggests that meeting future spending needs will necessitate greater fiscal firepower.
But government revenues have not risen to meet this need – on the contrary, they have been steadily falling for more than five decades. Total public revenue to GDP is now at its lowest point since the 1970s. This leaves us with among the lowest government revenue-to-GDP ratios in the region – certainly lower than expected for a country at the cusp of reaching the World Bank’s high-income threshold.
This narrow tax base, combined with limited capital taxation, means that large swathes of the economy continue to evade the reach of tax authorities and failing to contribute to Malaysia’s development.
Oil price vagaries
To bridge this fiscal gap, a few options are available. We could go back to relying on oil-related revenues, raise personal and/or corporate tax rates, increase government borrowing, or widen the tax base with a broad-based consumption tax like the GST. But only the last option presents a viable long-term solution.
First, we have long known that petroleum-related revenues are volatile – something that became clear during oil price slumps in 2015 and 2020. As such, going back to a dependence on petroleum-related revenues means once again exposing public finances to the vagaries of global energy prices. Although petroleum revenues can be a crucial fiscal bulwark in times of crisis, they are unreliable as a long-term solution for our developmental needs.
Second, raising personal income and/or corporate tax is also not a sustainable solution in and of itself. For one, the direct tax base is tiny. Only about 4% of all Malaysians (about 16.5% of all formal sector workers) are subject to any kind of personal income tax. Worse still, as a larger proportion of the population continues to age out of the labour force, this already small tax base will only continue to shrink.
Likewise, Malaysia already has some of the highest headline corporate income tax rates in the region – and since corporate tax revenues are tied to the business cycle, they are vulnerable during economic downturns. While raising top tax rates for personal and corporate taxes is important to ensure more are paying their fair share of taxes, this needs to be part of a comprehensive approach to enlarge the tax base and build sustainable long-term revenue streams.
Third expanding government borrowing, either through issuing more government debt securities or by expanding the money supply, is politically fraught. The government has already expressed resolve to reduce gradually the nation’s debt and improve macroeconomic stability – a stance that precludes increasing borrowing, particularly amid the rise in government bond yields over the past year, and as debt service costs continue to mount.
Broader tax base
This leads us to the most viable option – broadening the tax base. To meet our growing development spending needs and strengthen fiscal resilience, we need a sustainable and predictable source of revenue. To this end, a broad-based value-added consumption tax like the GST, is an attractive option.
This type of value-added tax offers a transparent, efficient and stable long-term revenue stream. Cross-country evidence suggests that a GST-style tax can help to mobilise revenues as well as improve tax compliance and reduce evasion. Indeed, similar value-added taxes are popular across the world – some 90% of countries have some type of GST.
Of course, bringing theory to practice is rarely straightforward. For all its purported benefits, shifting to GST-style taxation requires important considerations for policymaking. Ensuring that the new GST lasts longer than a few years requires deliberate policy design, rigorous implementation and a serious amount of political resolve to tackle the accompanying challenges of this shift.
One potential challenge commonly cited by critics is that consumption taxes like the GST are regressive. This is true. Because lower-income individuals spend a larger share of their income on consumption while wealthier individuals are more likely to save and invest, increases in consumption taxes hit lower-income families harder. Or in more technical terms: the effective tax rate decreases as income goes up.
But what is often forgotten is that all consumption taxes are regressive and that includes the current SST. Furthermore, the regressive nature of a GST or any consumption tax can be offset by the design of the broader tax-and-transfer system. This could involve exemptions for basic necessities while using the higher GST tax revenues to increase spending on public services like education and healthcare. It could also involve increasing redistribution to low-income families, such as through the Sumbangan Tunai Rahmah (STR) cash transfers.
Implementation key to success
Going deeper, a more critical challenge to the GST lies in its implementation. A value-added tax like the GST requires more concerted and careful implementation, particularly due to higher compliance burdens for smaller and more inexperienced businesses – a struggle that became apparent during the rollout of the first GST in 2015.
The transition to a new GST should be phased and gradual. This needs to involve substantial capacity building efforts for smaller businesses to help them overcome technical and technological barriers. This, along with enacting tax-registration exemptions for microenterprises and entrepreneurs will ease the transition process.
Similarly, the rate at which the new GST is introduced is also crucial. Learning from implementation challenges of the first GST, policymakers should introduce the new GST at a lower rate, allowing time for businesses and consumers to adjust before gradually raising the rate to a level optimal to meet longer-term spending needs.
This may mean introducing the new GST at a revenue-neutral rate, meaning a rate that generates the same amount of revenue as the current SST. Back-of-the-envelope estimates suggest that this introductory rate is probably closer to 3.5%-4%, much lower than the 6% when it was first implemented in 2015.
Ultimately, the success of a new GST will be tested by public opinion. Public perception surrounding the introduction of the first GST in 2015 was that it added to the cost of living, while the additional revenue did not lead to significant benefits for the people.
Now, as discussions about the reintroduction of GST are gaining momentum, the government needs to confront these perceptions head-on and build public trust through better fiscal management.
Policymakers should take this opportunity to credibly demonstrate to the nation that a new GST can indeed fuel the public spending needed to propel Malaysia’s progress – rather than as a cash grab to patch over fiscal mistakes of the past. After all, a GST will not be the cure-all for all the nation’s developmental woes but could provide the fiscal fuel we need to confront them with.