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Budget 2007 – Changes necessary in our fiscal policy

Posted by theonlinecitizen on February 9, 2007

By Edmund

PM Lee announced in November 2006 two significant fiscal policy changes in the first parliament session after the election in May. First, the Goods and Services Tax (GST) will be increased to 7%, up from the present 5%. The GST hike by two percentage points will raise at least $1.5 billion of tax revenue per year.

Second, the definition of net investment income (NII) will be broadened to include realised capital gains. Currently, the NII recognises only interest income and dividends. The Constitution allows the government to spend, during its term, all the NII from current reserves and up to half of the NII from past reserves. The inclusion of realised capital gains could increase annual revenue by about $2 billion.

Since the announcement, the buzz has initially been focused on financing an enhanced social safety net to help the lower-income group and meet the rising social expenditure needs of an ageing population. The argument has since widen to improving Singapore’s competitiveness to foreign investors by reducing income tax for companies and the rich, and to fund infrastructural developments. In particular, SM Lee announced in January a corporate tax cut of at least 1 percentage point in the budget to be presented on Feb 15.


Rationale for the taxation changes

In this increasingly globalised world, human talent and capital are perceived to be more mobile across countries and hence have more bargaining power, while labour is seen to be less mobile. The government is shifting the taxation burden from capital and the more mobile higher-income to the middle and working classes, which cannot as easily move elsewhere.

The 1 percentage point cut in corporate tax rate at the upcoming Feb 15 budget is likely to be the first of more to come in the next few years. The previous increase in GST from 3% to 5% allowed a 4.5 percentage point cut in corporate tax rate and a 6 percentage point cut in top marginal personal income tax rate.

The impending GST hike could also be motivated by the constitutional bar against the current government spending surpluses built up by previous government. Hence the decision for the GST hike just months after the election to build up the buffer, while the corporate and personal income tax cuts phrase in the next few years. At the end of the term, part of the surpluses accumulated will be returned to the people as pre-election sweeteners. We have a government whose fiscal policy follows the electoral cycles more closely than economic cycles.


Impact of the GST hike

By itself, the GST hike is regressive because the poor spend a greater proportion of their income and hence GST as a portion of their income is higher than that for the rich. This is in constrast to the progressive income tax system where the rich pay more as a proportion of their income.

The net impact of the GST increase on income distribution depends on how the money raised is spent. If it is meant to fund increased social support for the more disadvantaged sections of our society, then the net effect may not be regressive.

Given the PAP’s taboo against welfarism and PM Lee recently calling welfare a ‘dirty’ word, it is unlikely that the government will spend much of the additional revenue on enhanced social safety support for the underprivileged. The increase in social spending is likely to be in the form of a permanent Workfare scheme, which was introduced in 2006 and paid out $150 million in its first year (10% of the revenue to be raised from the impending GST hike).

The lower and middle-income classes are expected to be the biggest losers as they have been in the previous tax reform changes. The PAP government claims that the poor will enjoy a relief package to offset against the impact of GST hike, but such measures are one-off. The relief packages implemented for the previous GST increases expired after two to three years, but those GST increases are permanent. So is the latest promise that all government fees will stay frozen and not be raised for one year after the GST hike.

The GST hike is also expected to stunt the domestic economy. SMEs will suffer as they have to incur greater GST costs. Private consumption has been weak in the current economic expansion, as the economic benefits are going to the rich and those who own capital. The impending GST hike is expected to dampen consumer spending further.


Is GST hike a necessary measure?

The justifications for the GST hike are touted as

  1. To finance the enhanced social safety net to help the lower income group,
  2. To improve Singapore’s tax competitiveness to foreign investors by reducing income tax for companies and the rich, and
  3. To fund infrastructural developments.

It has been emphasised that reducing corporate income tax rate is necessary to enhance our global competitiveness, and raising indirect taxes is the last resort. But is it the true picture?


Tax competitiveness

On the issue of tax competitiveness, Hong Kong is often held as a competitor to Singapore. Hong Kong’s top personal income tax rate of 16 percent and corporate tax rate of 17.5 percent are often cited as reasons why Singapore need to lower its headline income tax rates to remain attractive to foreign investors.

Interestingly, in a feature article by the MOF for Budget 2006, Singapore was found to be most competitive based on a more comprehensive measure of the tax burden faced by companies. Singapore’s Marginal Effective Tax Rate (METR) is the lowest among the 36 countries surveyed, including Hong Kong and Ireland. The METR takes into account all the features of a country’s corporate tax regime, including rules on deductible expenses, capital allowances, treatment of foreign-sourced income as well as the definition of the tax base.


‘Under-reporting’ of government revenue

The overall budget position presented by the government is misleading, as two major items are not included in the income statement against international practice. Capital receipts, mainly from the sale of state land, are not included in the revenue. The sum could amount to S$4 billion a year, which is more than twice the tax revenue we are raising from the GST hike.

The second item is net investment income (NII). Only up to 50% of NII from the investment of accumulated reserves are available for use by the current government, though the definition of NII will be broadened to include realised capital gains, e.g. from equity investments.

By IMF standards, the overall surplus position in our last budget was understated to the tune of S$9.4 billion (or 4.5% of GDP). The budgeted revenue of $29.0 billion for FY2006 did not include the estimated capital receipts of $4.1 billion. The “investment and interest income’ was estimated at $7.7 billion, but only $2.4 billion was budgeted in the accounts.


Spending on military defence

A characteristic feature of the government’s expenditure pattern is the significant amount spent on defence. The government spends about one third of its total expenditure on defence, or $10.0 billion out of S$30.6 billion in the last budget. The spending on defence is more than what the government spends on education, health and community development combined. It is also about two thirds of what the other ASEAN countries spend on defence combined.

It is a huge burden to Singaporeans, as it is basically a matter of guns versus butter. While Singaporeans understand the importance of military defence to the country, many like myself who have served National Service knows that there is much room for improvements in productivity and efficiency in the SAF.


Changes necessary in our fiscal policy

In the following sections, I shall discuss the key long-term changes that I see is necessary in the fiscal system.


Insulating the poor from the regressive nature of GST

The approach for the government to insulate the lower income from the effects of GST increase is by giving utilities and housing rebates. As discussed above, such measures are one-off and temporary, but GST increases are permanent.

Another way of excluding the poor from GST is to have a tiered system in which GST on certain supplies are exempted or on a lower rate. If we were to restrict such exempted items to necessities, e.g. food products, utilities and public transportation, the GST exemption will help to address the regressive nature of the tax. Though the rich may consume more in absolute terms, the poor spend much more as a percentage of their income on necessities.

This approach has been adopted in many GST/value-added tax (VAT) systems. Essentially, it allows the targeting of subsidy to be self-contained within the system itself. Once such a system is institutionalised, it will minimise the erosion of the purchase power of the poor by further GST increases.

Enhancing fiscal tools for macro-economic management

With a more volatile economy, there is an increasing need to have more automatic stabilisers in our fiscal system for countercyclical demand management. The government announced two off-budget packages in 2001 and 2003 respectively in face of the sudden economic downturns. Unlike automatic stabilisers, discretionary measures are subject to recognition and decision lags. It is also difficult to calibrate optimal amount of rebates. The government should reconsider its position on the pay-as-earn (PAYE) income taxation system, which would provide stronger and more timely countercyclical effects than the preceding year basis of assessment that we have now.


Remove constraints on fiscal flexibility

As discussed earlier, fiscal policy in Singapore is constrained by the constitutional bar against the current government spending surpluses built up by previous government. Hence we have government’s fiscal policy following the electoral cycles instead of the economic cycles, and unfortunately, the two cycles do not coincide. This does not auger well if we were to pro-actively use fiscal policy for demand management.


Greater fiscal transparency

There should be greater fiscal transparency detailing the full extent of the financial resources of the government. Together with published studies on the long-term fiscal demands of an ageing population, e.g. health spending, it would provide justification and win people’s support for running hefty budget surpluses and the accumulation of reserves for our future needs.


Social insurance scheme for unemployment

There is a need to enhance the social safety net – more than making Workfare a permanent scheme. The Workfare scheme would encourage the lower-paid workers to return to the labour force and symbolically address the increasing income disparity through income support for those left behind.

It is likely that we will continue to see a lot of economic volatility and employment transition. In the absence of a sufficient social safety net, e.g. unemployment insurance, a disproportionate share of burden of adjustment falls on the workers. Having an effective safety net would ease the pain on the people and speed up the adjustment to economic restructuring.

Finally, direct transfers to the underprivileged segments of the population should be automatic and criteria-based, so that they target at the truly needy. The key is to build a social safety net targeted at those most in need so that it does not affect the incentive to work.

References:

“My Say: Tax Restructuring, Chapter 2?” Sim Moh Siong and Chua Hak Bin, The Edge Singapore, 30 Nov 2006

Budget Highlights – Financial Year 2006/2007, MOF, 17 Feb 2006

IPS-ESS Workshop – Fiscal Policy in Singapore, IPS, May 2004

Time Limit for Prime Minister’s Speech (Suspension of Standing Orders), Hansard, Parliament no 11, Session no 1, Volume no 82, Sitting no 5, Sitting date 2006-11-13

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Read also CNA’s report on the budget: “This year’s Budget expected to be progressive one”

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3 Responses to “Budget 2007 – Changes necessary in our fiscal policy”

  1. Sarek said

    SM Lee announced in January a corporate tax cut of at least 1 percentage point in the budget to be presented on Feb 15.

    It should be MM Lee.

    Mr Steve Chia made similar observation of “‘Under-reporting’ of government revenue” in his 2006 Budget speech:

    Given that only 50% of Net Investment Income (as required by constitution) amounting to S$3.7 billion cannot be touched and must go into the national reserves, the government will still expect to have an operating surplus of S$5.1 billion. This S$5.1 billion comprises S$4.1 billion of capital receipts (mainly from land sales and other capital receipts) and an additional S$1 billion of investment income, allowed but also not reflected in this budget. Apparently, the government decides to use only 33% of projected NII returns for this term of government. Why did it not use up all the 50% allowed – to show a smaller budget deficit of $1.86 billion is something beyond my understanding! Can the Prime Minister explain?

    http://www.nsp.sg/speech_transcript.php?more=29

    As we can see from the following reply, state land is part of the reserved and the capital receipts from the sale of state land is locked up and cannot be drawn without permission from the president:

    Dr John Chen Seow Phun (Hong Kah): Mr Deputy Speaker, Sir, Mr Steve Chia earlier accused the Government for concealing the truth by not including in the Budget proceeds from Government land sales, thereby showing a deficit budget. I think either Mr Chia does not understand what constitutes reserves and the protection of it, or he is, indeed, deceiving the people himself. Proceeds from Government land sales obviously is part of reserves, otherwise a rogue government, with the election promise to give away money, can come in easily and start to sell land and give the money to the people. That is why we have the Presidential Election Act to protect the reserves, and land sales is part of the reserves.

    PARLIAMENTARY DEBATES – Tuesday, 28th February, 2006

    The changes to the net investment income (NII) seems to be addressing the two points raised by Mr Chia. Allowing the government to use up 100% of Net Investment Income is a rational move. However, the move to include realised capital gains is something we need to watch carefully. We need a transparent mechanism to monitor and track the realised capital gains. Otherwise a rogue government, can have a GLC set the value of a piece of asset $X above its actual market value and have another GLC buys it at the overvalued price. The government will then receive $X as realised capital gains. Worse, since the GLC is paying the asset with government reserves entrusted to it, it means the rogue government is drawing on the reserves and bypassing the constitutional protections.

  2. Edmund said

    Correction: Would like to change the last sentence in the first paragraph under the section Spending on military defence from
    “It is also more than what the other ASEAN countries spend on defence combined.”
    to “It is also about two thirds of what the other ASEAN countries spend on defence combined.”

  3. HI Edmund,

    I’ve made the changes.

    Thanks.. 🙂

    Regards,
    theonlinecitizen

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