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Contents of Mr. Eric LI’s Speech

Delivered at the Rotary Club of Kwun Tong on



I.     Public Revelation

The idea of introducing a sales tax was 'floated' by the Government on a number of occasions and if the intention had merely been to test public reactions, it succeeded.  The pragmatic public of Hong Kong had tended to reject this new and alien tax instinctively.  Critics of the sales tax lost no time to expose its various weaknesses and sounded warnings on its far reaching implications.  On the other hand, it would require deliberate efforts to properly explain the case for introducing the tax.

II.    The Need for Taxation

Justice Holmes called taxation 'the price of civilisation'.  Indeed, a component of public sector is required by all modern societies to undertake the task of fulfilling of collective obligations and social objectives.  These activities are not possible, otherwise, as a result of ordinary private activities.  Taxation is perhaps the dominant but not the only way to transfer private resources for public use.  It is, however, far from being a voluntary process.  Tax collections in the past made themselves quite unpopular by simply coerce people to pay.  Modern tax collectors may be a great deal more tactful, but when gentle persuasion do not yield the necessary dollars, they too must resort to commandeering the appropriate sums by legislation.

III.   The Proper Approach to Judge Whether A Tax is Desirable

If one simply raises an open-ended question to sound like 'who wants a sales tax?  A negative reply is almost inevitable.  The public will probably give the same reply to any other form of tax if the question is posed in more or less the same way.  As explained earlier, a conceived increase in taxation draws instinctive resentment.  Objective analysis cannot begin until the need for raising the tax has been accepted beyond question.

Another reality in life is that there exists no perfect tax structure.  Taxation is a distortion to the perfect economic system.  Individuals are also expected to arbitrarily adjust their economic behaviours so that they may avoid or shift the tax burden to others.  From a purist's view point, there can only be the bad tax and the worse tax.  Since a good tax cannot be made readily available, comparison of alternative tax structures are much more constructive than lob-sided fault findings.  To illustrate the principles involved, I shall attempt to compare the sales (indirect) tax with the traditional income (direct) taxes.

IV.    Important Characteristics of Direct/Indirect Tax

Direct Tax

e.g. profits, salaries

Indirect Tax

e.g. sales, value added

1.  Person actually pays is one intended to be burdened


1.  not placed directly on those intended to be burdened, greater tendency to shift tax to other bearers.


2.  Based on what people contribute to the economic system i.e. source of income.

2.  based on what people withdraw from   the economic system i.e. consumption or income less savings.  In theory, indirect taxes encourage saving and the tax payment are considered more  voluntary.


3.  Measures people's ability to pay at regular given intervals of time.


3.  measures people's ability to pay over their life time on permanent income basis e.g. consumption more stable with borrowings and savings while income fluctuate.

V.     Requirements of a Good Tax Structure

Successive Inland Revenue Reviews by our Legislative Council in 1954, 1967, 1976 and 1998 reaffirmed that the Hong Kong tax structure must be simple, efficient and maintained at low rates.  The less normative notions of stability and equity have also become increasingly prominent.  The list is not exhaustive but is, for the time being, taken as the appropriate requirements for Hong Kong.  The implications are analysed in turn below: -

A.  Simple and Efficient

A good tax structure ought to be capable of raising the required revenue without using too much resource (efficiency loss) in administration and compliance.  In isolation, both income and sale taxes are well capable of achieving this goal.  The tax authority of Hong Kong is highly experienced and well acclaimed for its efficiency.  There are numerous problems associated with the administration and compliance of the well tested sales tax but they will not be insuperable.  It is perhaps fair to say that the existing income tax structure is similarly plagued by just as many problems as the sales tax.  The size of hidden economy of Hong Kong with people evading tax by legal, illicit or illegal means is considered substantial.  If a sales tax is superimposed over the existing income tax, total avoidance will become much more difficult.

Nonetheless, despite the obvious advantage, there is no doubt that the administration of an additional tax structure will increase the complexity of the existing simple system and add further administration costs to the government and the wholesalers concerned.

B.  Low Rate of Tax

A good tax structure is one that is almost neutral to unwanted economic effects.  For example, income tax tends to dampen people desire to work and sales tax tends to shift consumer choice to inferior goods.  The extent of these distortions will vary according to the individual's preference of marginal income and elasticity of the goods supplied respectively.  However, a low rate of taxation is considered almost neutral in influencing economic behaviours and free market choices.

It follows, therefore, given a fixed amount of taxation that needs to be raised, a combination of income and sales tax will enable the rates of taxes be kept at lower levels than a single tax.  There are important implications:

1.   low rate of taxation has been a major contributor to the development of Hong Kong as an important international financial centre.  This position is under constant challenge in a very competitive business environment.  It has become evident that other developed countries are shifting to indirect tax in order to lower their direct tax rates to stimulate investments.  It is crucial for Hong Kong not to stimulate investments.  It is crucial for Hong Kong not to loose this low tax advantage and the only way is to follow this trend and sustain a visible differential in tax rates.

2.  high rate of income tax may become punitive to our most productive citizens who are clever in selecting their occupation and skilful in their application.

3.    low rate of tax will not be burdensome in absolute terms and reduce the reward of avoidance.

It is worth noting that high rates of tax can also be applied positively to discourage undesirable social behaviours e.g. smoking and drinking and help to deflect private use on items needed for public consumption e.g. necessities during war efforts.

C.  Stability

In general, empirical studies of direct and indirect tax in their existing forms gave clear evidence that the latter is a more stable source of fiscal revenue over a long period of time.  However, this advantage of stability will diminish if the demand for the goods taxed are elastic to price.  Generally speaking, revenue derived from sales tax on luxury goods are more volatile than from basic necessities.  Since heavy reliance on tax derived from the sale of necessities are considered unfair and therefore socially undesirable, a trade off between stability and equity is clearly necessary.

D.  Equity

Every civic minded citizen would agree that he/she should contribute his/her 'fair share' of tax.  But what is 'fair share' remains, as always, the point of greatest controversy in the determination of tax policy.  Economists tended to judge the fairness of a tax structure on how close they come to satisfy two criteria:

(a)  Horizontal Equity: equal distribution of taxes among people considered equals.

(b)  Vertical Equity: an 'acceptable pattern' of tax payments by classes of people of different economic ability.

In general, people would support that the higher income group should pay proportionally more than the lower income group.  Many would even accept to pay progressively more $ out of every additional $10 they earn.  However, it can still be unfair to ask only few of our most productive citizens to make all the sacrifice.  There are two popular theories in measuring economic equality, they are:

(a)  Benefit theory - tax apportioned among people in relation to the benefits they receive from publicly provided goods and services.

(b)  Ability to pay theory - tax policy is considered independently of expenditure determination.  Income is generally regarded as the best measure of an individual's 'fiscal capacity'.

Notwithstanding serious drawbacks in applying these theories to practice, the principles provide most useful guidelines in the design of an equitable tax system.  A tax program will not be tolerated if people do not benefit from it or if people do not accept it as fair to them in relation to their relative fiscal capacities.  Some economists express a join relationship as net burdens and benefits for different income groups.  The following observations are pertinent when the theories are applied to a sales tax in Hong Kong:

1.   Sales tax is inequitable horizontally since it penalises large families.  It is also not vertically equitable since lower or fixed income groups need to devote a greater proportion of their current income in consumption.  However, it is incorrect to say that all income groups pay the same amount of tax since higher income groups are likely to consume more in absolute dollar terms.  Therefore, there is still a degree of vertical equity.

2.   Sales tax, like any other tool of collecting revenue, may be modified to remedy some of its undesirable effects e.g. subsidy, allowance, refund, exemption and differential tax rates.

3.   Sales tax is inflationary and ought to be avoided at time of rapid economic growth.  Judging from the experience of other countries, I expect the absolute inflationary effects will be mild with a low rate sales tax.  The inflationary effects will also be one-off with little after effects.

4.   When we debate on the equity of a tax structure, we cannot choose to ignore the benefit theory completely.  The tax base of Hong Kong is notoriously narrow while benefits e.g. public housing, education and medical services are enjoyed by many.  As the average income of Hong Kong rises steeply every year, it has approached a level as one of the highest in Asia and come close to levels of well developed European countries.  The general public is gradually demanding higher quality of public services which are in line with the rise of their own standard of living.  It has become hard to argue that some 80% of our working population still consider themselves as 'welfare class' who should be excused from the civic responsibility of paying tax.

5.   The case for the 'sandwich class' being unfairly treated in the present income tax structure is already well established.  Furthermore, the really low income group, say the lowest ten percentile, and people with special needs e.g. disabled and elderly, enjoy only similar benefits as one earning a median income.  The present income tax structure can easily be described as unfair to these groups.

E.  Summing up

The above four requirements are all important but no unique weighting of these factors can be applied in making an overall judgement of a tax system.  Each factor must be looked at individually as a necessary but not sufficient condition to justify a reasonable tax.  Trade offs are unavoidable as the requirements are sometimes conflicting. 

It ought to be recognised that sales tax is not claimed to be superior to income tax on the basis of an overall comparison.  If it is, sales tax would have completely replaced income tax in Hong Kong and other countries long ago.  The main disadvantage of a sales tax is, when compared to a progressive income tax, undeniable it's inferior quality in achieving vertical equity.

However, the point at issue in Hong Kong is not whether sales tax should replace income tax.  The argument is, should we follow the example of all other modern developed countries to accommodate a greater element of indirect tax so we can depend less on revenue derived from land and that the rates of both taxes can be kept as competitively low as possible and that the undesirable economic effects of each can compensate for one another.

VI.    Recommendations

1.  Establish the Need for Taxation

Economists have noted that during prosperous times, equity considerations become the primary concern of the general public.  In times of sluggish economy, huge Budget deficits like now, attention will shift and the efficiency aspects of the tax system become the greater concern.  It explains why most sales or similar consumption taxes found their way during post war depressions.  We are not as yet suffering a prolonged depression and the Hong Kong Government are bound to be required to establish firstly, that it has already exercised all reasonable constraints on expenditure and then lastly, that there are no other more desirable alternative avenues of finance i.e. accumulated reserves, public borrowings and increase fees/ charges.  Only after these arguments are put beyond reasonable doubt, will there be a case for introducing the sales tax.

2.  Limit the Scope of Goods and Services:

In 1987, the Government estimated that only about half of the goods and services are required to be included in the tax net to raise a meaningful level of revenue.  There seems to be plenty of room to leave out the necessities and to make a selection of those goods and services conforming more closely to the purchasing patterns of the higher income groups.

3.  Scope for Differential Rates:

Higher tax rates may apply to discourage unsocial behaviours and conspicuous consumptions e.g. tobacco, alcohol, adult films and publications, gambling, flashy nightclubs and restaurants, jewellery, high fashion goods etc.  In addition, pollution-levy ought to be considered.

4.  Increase Welfare Expenditure:

People with special needs, charitable organisations, pensioners and the lowest income group ought to be generously compensated through increased welfare expenditure for the adverse inflationary effects imposed upon them by a sales tax.

5.  Refund Sales Tax to Tourists and Exporters:

Although the primary consideration has got to be the preservation of Hong Kong's status as a major international financial centre, we must also look after our tourist industry which has a justifiable concern.  Hong Kong can follow the example of other developed countries which are operating refund systems of sales tax to tourists and exporters.

6.  Consider Corresponding Reforms of Salaries Tax:

It will also be opportune time to remove some of the existing unfairness of the 'sandwich class' under the present salaries tax structure.  Generous allowances should also be considered to compensate for the adverse effects of sales tax on large families.  Since sales tax affects individuals directly, salaries tax concessions are considered appropriate.

VII.   Conclusion

Despite the many correct criticisms of a sales tax, the existing income tax system by itself has not worked well during the recent depressions.  Our Government has been forced to cut back or delay worthy social programmes depriving the chance of better welfare for the most needy group of our society.  The quality of public services also suffered.  It also kept the rates of direct tax up in uncompetitive levels doubly penalised our most productive citizens at a time when their income were low.  It has depleted some of our much needed reserves which we depend on to maintain currency stability.  By rejecting the sales tax, these fundamental problems will not go away.  In effect, we are allowing the chance for this unsatisfactory scenario to repeat itself when the inevitable economic depression catches up with our economy time and again.  We must look at the way ahead.

No Government can find a tax beyond criticisms.  We must help them to make a well balanced choice from a long term point of view.  I have always been impressed by the fair-mindedness of the Hong Kong public.  I am sure that they will give the sales tax a 'fair' hearing if the matter is properly debated in the academic circle. 


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