Reforming Salaries Tax
24 February 2011
As usual, yesterday's budget was devoid of any structural reform to our public finances. In this article, we'll zoom in on the salaries tax regime and look at ways in which the Government, or the next one, might reform it to make it fairer and more efficient. A lot of media focused on the lack of "one-off" rebates (that's why they're called "one-off") or changes to the basic personal allowance, but this really misses the big picture.
Approach and current structure
The basic approach of salaries tax is to tax each earning person on their personal "profit", i.e. their earnings minus reasonable living expenses. That represents their share of economic output, or Gross Domestic Product. They provide their services to employers, but they have costs in doing so, namely the cost of living - housing, eating, transport and so on.
It is similar to the way we tax businesses, but it would be impractical for each person to file accounts, let alone audited accounts, documenting their expenses, so HK keeps this simple by giving workers personal allowances for such expenses, and tax them on any earnings after deducting those allowances. Thus, a single person gets a personal allowance of HK$108k (US$13.8k) per year, a married couple $216k, and if a person supports a sibling, parent, grandparent or minor child (or student up to 25 years old) then he gets an allowance for the cost of that too.
This is an eminently sensible approach. We should treat children as an allowable expense, because parents are creating the taxpayers of tomorrow. We even have a higher deduction in the year the child is born, because that is when healthcare costs for the mother and child are highest. There are other deductions, most of which make sense. For example, if you are taking an education course, that will probably improve your future earnings power and taxpaying ability, so you get a deduction for that, up to $60k p.a..
However, what happens to the remaining "chargeable income" is a mish-mash of history unique to HK. We have the following tax bands on chargeable income, after allowances and deductions:
*17% subject to a cap of 15% on income after deductions but before allowances.
What this means, for high-earning people, is that their marginal tax rate drops from 17% to 15% above a certain level. Because this "standard rate" of 15% is on income before allowances, the threshold above which your tax rate drops to 15% depends on whether you are supporting a spouse or children or other relatives. For a single person, it is $1.518m (or $126.5k/month), and for a married person with a non-working spouse and 2 children, the threshold will be $3.456m (based on yesterday's proposed increase in child allowance from $50k to $60k per child). Above that, you pay 15%.
Another inequity is that a married couple with only one working spouse gets a combined allowance of $216k (twice the $108k singleton allowance), but the earner only gets one block of $40k chargeable income at the 2%, 7% and 12% bands, so if the earner earns more than $256k then she pays more tax than if each spouse had half the combined income. For example, if she earns $456k, then she pays $28.8k in tax, whereas if they each earn $228k, then they only pay $16.8k in tax in total.
We don't have a breakdown of the actual assessable incomes of the 1.4m current salaries taxpayers, but we know from a study commissioned by the Government in 2001 that in 1999, 21% of salaries taxpayers paid 82% of the tax. More recently, in 2008 there was a LegCo Question which resulted in a table of salaries tax paid in ranges for the 2006-7 year. Taking the mid-point of each range multiplied by the number of payers, and knowing the actual salaries tax collected in 2006-7, we estimate that the 20% of taxpayers (8% of workers) who paid $20k or more in tax paid 90% of all salaries tax that year. For reference, the first $90k was taxed in 3 bands at 2%, 7% and 13%, then 19% thereafter with a standard rate of 16%.
A fair and flat salaries tax
It would be far simpler and more equitable to tax personal profit at a flat rate. To be politically acceptable, any reform should not involve workers paying more dollars in salaries tax than before, so here's how it can be done:
- There is little point in charging people 2% on the first $40k. It raises only $800, so even if all of the 1.4m salaries taxpayers were earning the full $40k (which they are not), this band only raises $1.12bn out of the budgeted $48.15bn of salaries tax, and the administrative cost of assessing and collecting it from those who don't have more than the $40k of chargeable income eliminates a lot of the tax raised. So one simple step would be to abolish the 2% band by raising personal allowances by $40k.
- The next $40k band of 7%, even if all 1.4m taxpayers are in it (which they are not), could only raise $3.92bn. Probably only half the workers are partially in that bracket. Let's assume half of our 1.4m taxpayers earn three quarters of that bracket, then they pay 700k x $2,100 = $1.47bn.
- Taken together, the first $120k of assessable income charges just $8,400 in tax, an average rate of 7%. So a taxpayer earning all of that would pay the same amount if we taxed half of it at 14%. So we propose increasing personal allowances by $60k and then tax all chargeable income at a flat 14%. No taxpayer would pay more, almost all would pay less, and some would fall out of the salaries tax net altogether.
- The "standard rate" of tax would be abolished as an anachronism. Even high-earning people should be entitled to the same allowance for basic expenses.
So here is how our 14% flat-tax would look, based on existing allowances for comparison purposes:
|Tax now||14% Flat tax||Tax reduction|
|$80k||$3,600||$20k x 14% = $2,800||$800|
|$100k||$6,000||$40k x 14% = $5,600||$400|
|$120k||$8,400||$60k x 14% = $8,400||$0|
This would of course reduce overall revenue from salaries tax, but the middle-income workers, who currently pay 17% on chargeable income over $120k (that is, above $10k of "profit" per month) would benefit more in percentage-of-income terms (a 3% tax cut) than the very high earners who currently only pay 15% on their income before allowances. They would only get a 1% tax cut, plus they would stop being taxed on their personal allowance.
As an alternative, even if we did not want to reduce the headline top rate, we could accomplish a flat tax of 15% by increasing the allowance by $64k and taxing everything above it at 15%. The next $56k at 15% would raise $8,400, which is what we get from the current $120k in 3 bands. Nobody would pay more than before. A 15% flat tax would look like this:
|Tax now||15% Flat tax||Tax reduction|
|$80k||$3,600||$16k x 15% = $2,400||$1,200|
|$100k||$6,000||$36k x 15% = $5,400||$600|
|$120k||$8,400||$56k x 15% = $8,400||$0|
Even if all the income above the first $120k is currently taxed at 17% (which it isn't), then dropping that to 14% would cut the revenue on that by 3/17 or 17.6%. That's the upper bound, but in reality, because of the standard tax rate, the revenue reduction on the over-$120k amount would be more like 14%, and perhaps 15% for salaries tax overall. So we estimate that our flat tax proposal would probably only reduce salaries tax revenue by about 15%, or $7.2bn in 2011-12. That is very affordable compared with the $24bn that the Government proposes to inject into MPF accounts, although the two are not mutually exclusive. A reminder that we have about $1,200bn in liquid reserves.
Yesterday's budget actually froze personal allowances for those who do not have children or dependent relatives, reducing the allowance in real terms after this year's expected 4.5% inflation. Our proposal would instead give everyone a $60k increase in personal allowance to $168k per year (or $14k per month), and a simple, understandable flat tax regime thereafter, with none of the current anomalies.
One other reform is needed to salaries tax, and that is to start taxing people on what they are paid rather than how they are paid. Currently there is a giant loophole in the tax law Section 9(2) of the Inland Revenue Ordinance, which says that if your employer reimburses your rent or provides you with a home, then you will not be taxed on the rental value of the home but it will be taxed as 10% of your cash income. For example, if your employer pays you $50k per month and provides you with a home worth $50k per month then you will be assessed on $55k, not $100k, even though that is the tax-deductible cost for the employer. Other benefits which cannot be converted into cash and do not settle the employee's liabilities are also exempt, except for school fees. So if your employer pays for life insurance, health insurance or utilities on a flat rented in the employer's name, then he can deduct that from taxable profits as an employment expense, but you do not pay tax on the value of that benefit.
This policy is unfair and should be abolished. All benefits should be part of assessable income in the hands of an employee, as they are tax deductions to an employer. In the case of quarters provided rent-free, the rateable value of the premises should be the deemed value of the benefit. We made this point 7 years ago, after the budget in 2004.
The additional revenue from properly taxing benefits, particularly housing benefits, would partially offset the reduction in revenue from a flat tax at 14% as proposed above. Consequently over time, we may be able to lower the flat tax rate further.
Home loan interest deduction
One deduction doesn't make sense: the home loan interest deduction of up to $100k for 10 years, because housing costs should be covered by the personal allowance, and there is no deduction for rental costs. So that should be scrapped as part of our proposed reforms, with a larger personal allowance instead. As then-Financial Secretary (now Chief Executive) Donald Tsang said in his budget of 1997:
"Some Members have again called for a tax allowance to cover spending on mortgage interest or even rental payments...it would be wrong in principle to create a general tax concession, regardless of the individual family's needs, to cover investment in housing"
Demonstrating his renowned ability to flip-flop his principles, he then introduced it in the following budget. Our proposed $60k increase in personal allowance ($120k per couple) is some compensation for removal of that distortion between renting and buying. With interest rates at record lows, now is the best window of opportunity to abolish the deduction.
A footnote on profits tax
An anonymous official briefing SCMP before the budget (as many did) said that profits tax could not be reduced because of the "current anti-business sentiment". This is a deplorable basis on which to decide tax policy. Not all businesses are giants in cartels - the vast majority by number are small and medium enterprises. If you are over-taxing, under-spending, and hoarding $1.2 trillion of reserves, then you should be cutting taxes across the board and not engaging in haphazard "one-off" handouts such as general rates waivers and electricity subsidies. The Government is still in denial that is has a structural surplus, despite repeatedly underestimating the outcome.
Profits tax currently raises about twice as much as salaries tax, because businesses make more profits than people do, and is budgeted at $96.9bn this year, compared with $48.15bn for salaries tax. Profits taxes and salaries taxes must be kept in sync, because otherwise people who own businesses will convert their profits into salaries (including bonuses) and declare no profit. Corporate profit becomes personal profit.
The general argument in favour of a slight differential between the rates of profits tax and salaries tax (which HK has) is that businesses tend to qualify for more tax deductions than workers do, and they can also carry forward their losses to offset future profits, which workers cannot. So if we introduce a headline salaries tax rate of 14%, down from 15%, then we should cut profits tax by the same 1%, from 16.5% to 15.5%. That would cut profits tax income by 1/16.5, or about $5.9bn, based on the budgeted figure.
We do not support the notion of a progressive tax (tiered) rate for businesses - that would just encourage large companies to divide their businesses into multiple subsidiaries, such as a separate company for each shop, to benefit from the lower rate. Indeed many do already, for other reasons. A flat tax rate is as simple and fair for business as it is for individuals.
So that's how to reform salaries tax.
- Raise the personal allowance from $108k to $168k, with a flat rate of tax at 14% thereafter, or to $172k with a flat rate of 15% tax thereafter. Abolish all the other rates and the standard rate. Nobody would pay more tax than at present from this change.
- Tax housing benefits at their real value, and tax other non-cash benefits, because we should tax workers on what they are paid, not how they are paid.
- Remove the home loan interest deduction, because the (enlarged) personal allowance should cover basic housing costs, whether interest or rental.
- If you cut the top rate of salaries tax from 15% to 14%, then cut profits tax from 16.5% to 15.5% to keep them synchronised and avoid arbitrage.
© Webb-site.com, 2011