A simpler, fairer tax system
30 January 2019
Once again there are calls from politicians and accountants to allow individuals to deduct home rental expenses from their earned income before salaries tax. The latest was from the HKICPA on Monday (28-Jan-2019), proposing a maximum HK$100k annual deduction. This amount was chosen because it mirrors the existing maximum HK$100k annual deduction for home loan interest (limited to 20 years). At an interest rate of say 2.5% on a mortgage loan, that covers a HK$4m loan, or 5% on a $2m loan if rates rise.
However, both of these deductions miss the point. Rather than having behaviour-modifying deductions that can only be used if a certain behaviour is adopted (borrowing to buy a home, or renting), and rather than incurring all of the administrative overhead that involves, it would be simpler to scrap the interest deduction and increase personal allowances (the amount of permitted non-taxable earnings), leaving it entirely up to employees how they spend their earnings. Whether they take out a mortgage loan, rent a flat, or continue living with their Mum and spend the money on holidays, or save it, should be no concern to Government. We note that in the UK, mortgage interest deduction was abolished in 2000 because it was seen to have played a role in driving up home prices by increasing demand.
The existing rental deduction - the housing loophole
In fact, unmentioned by the HKICPA, there is already a way to exempt the bulk of your rent, without limit, from salaries tax. You simply use the housing loophole, explained in our article Tax Benefits (10-Mar-2004). Under the archaic Section 9(2) of the Inland Revenue Ordinance, if an employer pays or reimburses your rent or provides you with housing as part of your remuneration, then the rent is deemed to be worth only 10% of your cash earnings. For example, if your employer pays a monthly salary of $60k and a rent reimbursement of $40k, then you are deemed to earn $66k, not $100k, so hey presto, you effectively get a $34k per month rental deduction from your taxable income, or $408k per year, far more than the HKICPA proposes.
Of course, the housing loophole does require the co-operation of your employer, but any respectable employer (particularly for higher-earners) would do so since it provides value to the employee without costing the employer anything except a bit of paperwork to check the lease and fill in the relevant section of the Employer's Tax Return. The loophole is a bit of colonial madness and should be abolished, because it is unfair to those who cannot benefit from such an arrangement, for example because they own their own home or are living in someone else's. The Housing Loophole taxes people on how they are paid rather than how much they are paid.
At the same time as abolishing the interest deduction, personal allowances could be raised by $100k so that nobody is worse off than now. Given the vast surpluses that the Government hoards (over $1 trillion since 1997), a revenue cut is needed, just to comply with the Basic Law obligation (Article 107) to "strive to achieve a fiscal balance", or balance the budget. The personal allowance is basically an estimate of the cost of a reasonable standard of living that a person and their dependents should be able to enjoy as expenses, before paying tax on the "personal profit" in excess of the expenses. That is why there are additional allowances for supporting children, dependent siblings and elderly parents.
A flat tax
As we've said before (Reforming Salaries Tax, 24-Feb-2011), the Government should also abolish the tiered rates of tax, and adopt a flat rate, while ensuring that nobody pays more as a consequence. Currently there are bands of 2%, 6%, 10% and 14% on $50k each of chargeable income, with 17% on the excess, but bizarrely, subject to an overall cap of 15% on net total income (before allowances), so above some point, the marginal tax rate drops from 17% to 15%.
The first 2 bands, 2% ($1k on $50k) and 6% ($3k on $50k), totalling just $4k, are not worth collecting, given the efforts the Government goes to with its cash hand-outs of $4k each in the opposite direction. So they could easily raise the personal allowance by $100k and abolish those bands, or if they really want to collect $4k, then raise the allowance by $60k and tax the next $40k at 10%.
A simple, flat 10% rate on chargeable income (after personal allowances), leaving more cash in consumers' pockets, would do wonders to stimulate the economy and return part of the hoarded surpluses to society. There's nothing magical about 10% though. If it was determined that a flat tax of 10% isn't enough, then we currently collect an average 12% on the next $100k, so another way to do it would be a flat rate of 12% on all chargeable income and abolish the 2 lower bands.
The rates of salaries tax and profits tax must be kept in line to avoid tax arbitrage. Othewise, if the profits tax rate is higher than the salaries tax rate, then business owners will pay themselves a director's bonus and pay salaries tax on that rather than let the money be taxed as a corporate profit. Conversely, if the profits tax rate is lower, then they will let the company pay the profits tax and receive a divdend instead.
So when we flatten out salaries tax rates at 10% (or whatever is deemed right), the profits tax rate should be the same.
Instead, Carrie Lam's government has introduced a gimmicky half-rate of profits tax on the first HK$2m, and business owners are now planning their affairs so that the first $2m of profits is taxed that way and paid as a divdend rather than paid to them as a director's bonus which would incur tax at the standard rate of 15%. That gives them an extra $135k of after-tax income (6.75% on $2m), equivalent to an extra $900k of personal allowance!
And when we say "business owner", that includes a person who owns a company which does nothing but own an apartment and rent it out.
Carrie Lam's other big gimmick is a 300% super-deduction for "research and development" (200% above the first $2m) which is just a huge headache for a newly-hired army of assessors in the Inland Revenue Department to enforce, because there will be endless arguments as companies seek to reclassify their expenditure as R&D, as we explained in our article of 24-Oct-2017. That should be abolished too.
The bottom line: keep it simple, make it fair, set a lower, flat rate of tax and stop hoarding public money.
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