This article first appeared in Forum, The Edge Malaysia Weekly on October 16, 2017 - October 22, 2017

October is the month when the federal government’s annual budget for the following year is first announced. And I am of the view that the Malaysian tax system has become more regressive over time.

Taxation in Malaysia has been regressive, at least since the late 1960s, as shown by studies by the late Professor Ismail Muhd Salleh, and more recently, by Professor Wee Chong Hui. Both showed that not only is income inequality more unequal after taxes, but this has also become worse, especially since the mid-1980s.

The introduction of the Goods and Services Tax (GST), a form of value added tax (VAT), has generally worsened post-tax inequality wherever it has been introduced, including Malaysia. Once the VAT system has been introduced, governments will be tempted to raise the VAT rate, as has happened in Europe and elsewhere.

Shifting tax burden

From the early 1980s, reducing tax rates and taxation was dignified by US President Ronald Reagan’s embrace of Professor Arthur Laffer’s curve, which promised higher savings, investments and more growth with less taxes.

With the election of US President Donald Trump, Laffer’s discredited claims have been resuscitated, although US National Bureau of Economic Research emeritus president Harvard Professor Martin Feldstein, once chair of Reagan’s Council of Economic Advisers, showed that the US experience provides no empirical support for Laffer’s claims.

With declining tax revenue, many governments have had to cut spending, often by neglecting and reducing public infrastructure and services. Once there was little political room left for further spending cuts, governments had to raise revenue, typically from greater indirect taxation, or from non-tax revenue, for example by raising customer charges or user fees, and by selling off state-owned enterprises, typically to private cronies.

Indirect taxation is mainly on consumption, as import tariffs or export duties have been discouraged in line with trade liberalisation commitments of recent decades. Many countries have been adopting VAT, promoted for decades by the International Monetary Fund and others as the superior mode of taxation.

Malaysian taxation more regressive

A progressive tax system would ensure that those with more means would pay proportionately more tax than those with less. Instead, tax systems in most emerging markets have become increasingly regressive, with the growing middle class, not the rich, bearing the main burden.

Consumption taxes, especially VAT, shift the tax burden to include the poor, making everyone taxpayers. Some VAT advocates claim that with everyone paying taxes, the public develops a broader and more inclusive appreciation of citizenship, involving rights (entitlements) and responsibilities (paying taxes).

Meanwhile, tax competition among countries has reduced direct tax rates, if not revenue. Thus, direct taxation became less progressive, as the rich pay proportionately less tax with all the tax evasion options available to them, both nationally and abroad (foreign tax havens).

As last year’s Panama Papers showed, legal and accountancy firms, as well as supportive politicians expanding tax loopholes, have expedited this process. Untaxed hidden wealth has thus increased both wealth and income inequality at both the national and international level.

Some financial outflows, motivated by tax evasion and avoidance, have put further pressure on Malaysia’s fiscal balance, as Table 1 shows. The official response in recent years has been to increase indirect taxation, making taxation’s overall impact even more regressive. Over 2013 to 2016, tax revenue from households rose 71%, with a sharp increase of RM21.3 billion during 2014 to 2016, with the introduction of GST.

Meanwhile, as Table 2 shows, subsidies and social assistance fell by 43% over three years, transforming net fiscal support for households into a burden. Of course, this has affected households differently, but the overall fiscal impact is now more regressive than before.

At the same time, following the collapse of primary commodity prices since late 2014, triggered by the Saudi decision to increase oil output and supply, and declining political confidence following revelations of 1MDB and other scandals involving government-linked companies, the Malaysian exchange rate has dropped from 3.2 to 4.2 against the US dollar, thus raising the costs of imports and travel to Malaysians.

Jomo KS is a Malaysian economic researcher. The views expressed here are entirely his own.

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