Hong Kong’s Two-Tier Profit Tax Misses its SME Mark

Hong Kong’s Two-Tier Profit Tax Misses its SME Mark
Credit: REUTERS/Damir Sagolj/達志影像

What you need to know

In her first Policy Address, new Hong Kong Chief Executive Carrie Lam proposed a new two-tier profit tax system designed to ease the burden on small-and-medium-sized enterprises (SMEs). But only a small proportion of Hong Kong's businesses actually pay profit tax, and the likelihood is that a higher proportion of them are big businesses.

In her first policy address, Hong Kong Chief Executive Carrie Lam (林鄭月娥) proposed to introduce a two-tier profit-tax regime which officially aims to “provide further tax relief to small and medium-sized enterprises (SMEs).”

The proposal has been hailed as the biggest reform to Hong Kong's tax system in years, but analysis suggests it might not be the boon for SMEs that the government claims.

In an address to attendees of the Summit on New Directions for Taxation two weeks ago, Lam boasted of her achievement in materializing her campaign manifesto by introducing this two-tier profit tax.

Under the scheme, the first HK$2 million (US$256,337) of taxable profit would be subject to a lower tax rate of 8.5 percent instead of 16.5 percent under the existing single-tier profit tax regime.

Lam said, “This scheme would mostly benefit SMEs. SMEs, accounting for over 90 percent of the total number of enterprises [in Hong Kong], are the pillars of domestic economy … I hope the two-tier profit tax [can] lighten the tax burden of enterprises, such that they would have more capital for re-investment, or even improve employees’ welfare.”

During the same event, Hong Kong Financial Secretary Paul Chan Mo-po (陳茂波), disclosed that there were around a hundred thousand companies paying profit tax in Hong Kong.

Not for SMEs?

While it appears to be reasonable that a profit tax cut would benefit SMEs, the devil is in the detail.

According to the Company Registry, which registers companies and obliges them to file their annual returns, there were about 1.38 million registered companies in Hong Kong as of September 2017. But the financial secretary disclosed that only around one hundred thousand firms are paying profit tax. This means that only about 10 percent of firms in Hong Kong are paying profit tax.

In economics, it is not uncommon to include an assumption that “all (firms/consumers) are the same” to simplify analysis. But in reality, firms are not the same. As the CE said, more than 90 percent of firms in Hong Kong are SMEs, the majority of which will not turn a taxable profit.

The questions is whether the roughly 10 percent of firms that pay profit tax are SMEs or big enterprises, and whether the proposed tax cut would indeed benefit SMEs. One extreme is that all of the tax-paying firms are big enterprises. If this is the case, then SMEs would not benefit at all. If this is so, the government is misleading the public.

Another extreme is that all the tax-paying firms are SMEs. If this is the case, then around a hundred thousand SMEs would benefit from the tax cut, or about 10 percent of the total SMEs. The reality is likely somewhere between the two, meaning that an even smaller portion of SMEs, perhaps 5 percent, stand to gain, while half of big enterprises could benefit. In this case, how can the CE justify her claim that the proposal would “mostly benefit SMEs”?

The need for transparency

It is obvious from the above elaboration that the proposed tax cut likely means that a bigger proportion of big enterprises in Hong Kong would benefit, instead of SMEs as claimed by the government. The government had full information on the composition of tax-paying firms and therefore the answer to the question of who would benefit should the proposed two-tier system be introduced. Did they knowingly conceal that information so as to create the impression that SMEs would be the main beneficiaries of the CE’s pet project?

Whether the government had done the proper policy analysis before announcing the proposed tax cut is confidential, but it is not unreasonable to assume that the CE should have some idea about which companies are actually paying profit tax. As a former Deputy Secretary for the Treasury, a post she filled in the 1990s, Lam should know the government’s tax income inside out.

Tax cuts are usually universally welcomed. However, a government should properly disclose details when tax cut policies are announced. Non-disclosure is bad enough. Misleading the public and lawmakers so that they approve of a policy is even worse. My hope is that Lam truly believes that her proposal would mostly benefit SMEs, and that she will now review its content.

No one likes to stand in the way of a proposed tax cut, and it is unlikely that the two-tier profit tax proposal will be scrutinized in detail when it comes before the Legislative Council, Hong Kong’s unicameral lawmaking body. As such, it is up to the government to disclose detailed data in relation to profit tax such that the general public and lawmakers can understand exactly how the proposal stands to benefit SMEs as the government has claimed.