For a fairer tax system, how about scrapping the profit tax?

Hong Kong property baron may have a point in calling for switch to a dividend tax that would place burden on shareholders

PUBLISHED : Tuesday, 27 August, 2013, 12:00am
UPDATED : Tuesday, 27 August, 2013, 4:35am

The chairman of one prominent Hong Kong property company likes to argue that the city's tax on corporate profits is inefficient and unfair. He believes it should be scrapped.

At this point I can almost hear you choking on your morning coffee.

"Well, duh!" I can imagine you spluttering. "Of course the head of a big property company would say that. He just wants to line his own pockets at the expense of the rest of us."

That was my first response too. But on closer examination, it seems our property baron may have a point.

In international surveys, Hong Kong usually wins praise for its low tax rates. Its profit tax of 16.5 per cent is seen as an especially attractive inducement for companies to set up businesses in the city.

At that rate, Hong Kong charges the lowest corporate taxes in East Asia, and few economies outside the oil-rich states of the Gulf, former Soviet clients or a handful of tax havens impose a lower burden on companies (see the first chart).

But it is not the rate of taxation our property boss is complaining about, it is the whole idea of a corporate profit tax, which he believes is fundamentally flawed.

Politicians like corporate taxes because they want to be seen to be shifting the burden of taxation away from ordinary people and onto big business.

As a result, profit taxes make up just over a quarter of the Hong Kong government's revenues, by far the biggest contributor to the city's coffers (see the second chart).

The problem is that when it comes to tax, companies are just a convenient legal fiction. They don't really exist, and they don't really pay taxes. Ultimately only people pay taxes.

That's fine, you are probably thinking. The people who end up shouldering the burden of corporate taxes are their shareholders. And the richer they are, the more shares they own, so the more tax they pay. That seems fair enough.

Unfortunately, things don't quite work out like that.

To see why, imagine the Hong Kong government were suddenly to double the profit tax from 16.5 per cent to 33 per cent. Company bosses would face a choice. They could accept a lower post-tax profit, meaning that shareholders would pay the extra, either in the shape of reduced dividends or in the form of lower retained earnings, which would erode the scope for future investment and eat into the value of the company.

Alternatively, they could try to boost pre-tax profits in order to keep their net income steady. That would entail either boosting revenues, which would mean putting up prices, or cutting costs, which would mean slashing wage bills. Either their customers or their employees would foot the bill.

It's not hard to guess who would get lumped with the cost. In Hong Kong, capital is highly mobile. If shareholders don't like the prospect of reduced dividends, they go elsewhere.

In contrast, customers and employees move less easily, and face costs and risks when they switch companies.

As a result, it is not shareholders, but customers and workers who end up shouldering most of the burden of the profits tax.

The solution, believe tax reformers like our property company chairman, is not to tax companies on the profits they make, but rather on the income they distribute to their shareholders.

In effect this would mean scrapping the profits tax and replacing it with a dividend tax, to be collected at source and remitted to the government by the company itself.

This, argue supporters, would shift the tax burden away from customers and employees and onto shareholders, while simplifying the tax system, encouraging corporate investment and reducing the opportunities for tax avoidance.

They might well have a valid point. But it would take a bold government indeed to implement their proposal.