Hybrid tax could end GST-SST standoff

MALAYSIA’S proposed hybrid tax system may offer a way out of the long-running goods and services tax (GST) versus sales and service tax (SST) debate.

But getting the mix right will be far more important than what the new system is eventually called.

The government has said it is not ready to bring back a broad-based GST. Instead, it is looking at whether some GST features can be incorporated into the existing SST framework.

Tax experts say this can work, provided Putrajaya does not make the system unnecessarily complicated.

KPMG in Malaysia head of indirect tax Ng Sue Lynn tells StarBiz 7: “A proposed hybrid model would be interesting as it could combine the positive elements of both GST and SST.”

She sees merit in bringing one of GST’s main features – the input tax credit mechanism – into SST.

Businesses could offset tax paid on inputs against tax collected on their sales, reducing the tax-on-tax effect that can occur under a single-stage system.

It would also make the tax trail more transparent because businesses would have to account for the tax they collect and the credits they claim.

Marcus Tan, partner, tax services of Baker Tilly Malaysia, says the proposal could look like a de facto GST because of the way input tax credits would operate.

“The SST system, being a single- stage consumption tax, has a narrower tax base and cascading effect when tax is embedded in the cost of the supply chain.

“It lacks the input tax credit mechanism, which is a key feature in the broad-based GST system,” Tan points out.

“Combining certain elements of the GST into the existing SST and coming out with a hybrid SST system will need a balancing act,” he adds.

Conceptually, Tan says the hybrid system could allow businesses to claim eligible input tax against output tax and pay the difference to the government.

“In this instance, there is no cascading tax effect and the ultimate tax burden is borne by the end consumers,” he says.

Nadia Mazlan, economist at RAM Rating Services Bhd, says the intention appears to be to retain SST as the main framework while incorporating selected GST features to improve efficiency and revenue collection.

This could include broadening the tax base, refunds or credits for eligible business-to-business transactions, and full tax relief for exports. This is important because a hybrid system would not necessarily amount to GST by another name.

Nadia points out that the attraction of borrowing some GST mechanics is therefore more about addressing some of SST’s weaknesses, particularly tax cascading.

She says SST can create a “hidden compounding cost” as tax is passed through multiple stages before being embedded in the final price.

“A hybrid system could potentially combine SST’s more targeted scope with the revenue efficiency of GST as well as selected GST-style mechanisms that reduce tax cascading and leakages,” she says.

But this brings Malaysia to a problem it knows only too well: refunds. Businesses that had to wait for GST refunds in the past faced cash-flow pressures.

Ng suggests allowing a registered business not to charge SST when selling to another business with a valid SST registration number.

The tax would instead be collected from the final consumer, reducing the need for businesses to pay first and wait for refunds.

The arrangement could be linked to e-invoicing, with the SST registration number included in the e-invoice, creating a digital trail for tax authorities.

Learning from the past

Nadia says the 2015 to 2018 GST experience offers a clear warning that implementation matters as much as policy.

“The biggest takeaway from the GST experience from 2015 to 2018 is that implementation is just as important as the tax policy itself. One of the main grievances with GST was the delay in refunds.

“The delay created working capital challenges for businesses, particularly for firms operating on thin margins, which often resorted to raising prices due to uncertainty over the refunds.”

Tan says the government’s decision to engage stakeholders and conduct a full study is therefore a positive step, but the process should not be rushed.

The new system must provide certainty over refunds, he says.

“An automatic refund system within a certain timeframe could provide certainty to businesses in managing their cash flows,” Tan adds.

Keeping it simple

For Ray Choy, chief economist at MARC Ratings Bhd, the bigger issue is whether Malaysia can keep the resulting system simple.

“A combined system will inevitably introduce another layer of complexity.

“The real question is therefore not whether we call it GST or SST, but whether the system has a broad base and is easy to understand and comply with,” he adds.

That is perhaps the most important point in the debate.

Malaysia has already experienced what happens when a consumption tax becomes difficult to understand. Under the previous GST, businesses had to deal with refunds, exemptions and compliance requirements, while consumers grappled with its impact on prices.

Nadia says the GST experience also highlighted the need to minimise compliance costs, particularly for small and medium enterprises (SMEs).

“The reporting requirements should be simplified and filing systems should be user-friendly, such that compliance burdens are not heavy,” she says.

Tan says the implementation of e-invoicing, widely seen as a precursor to a GST or hybrid SST system, should not result in escalating compliance costs, particularly for SMEs.

“Administrative readiness and public trust are as important as the tax laws being introduced.

“A robust hybrid SST system should be fully studied and tested before it is introduced for implementation,” he argues.

The other difficult question is how to prevent the tax from hitting lower-income households hardest.

Consumption taxes are inherently regressive because lower-income households spend a larger proportion of their income on consumption.

Nadia says targeted assistance can help offset this.

“Cash transfers to low-income groups, such as the Rahmah cash contributions, are an efficient tool because they directly compensate more vulnerable households while also preserving the tax revenue-generating capacity,” she explains.

But cash assistance alone would not be enough.

“Cash transfers alone are insufficient and should be complemented with tax exemptions or a 0% tax rate on essential items such as food and public services, which can reduce the burden on lower-income groups,” Nadia adds.

Tan suggests a “soft landing” approach, including a lower SST rate alongside a broad-based GST input tax credit mechanism.

“A higher SST registration threshold for SMEs and a controlled list for specific exemption or zero-rated SST on necessities may further enhance the tax system and better protect the lower-income households,” he says.

Choy prefers a broad tax base with targeted transfers rather than a long list of exemptions.

Every exemption reduces the tax base and creates another rule for businesses and authorities to administer.

Nadia also warns against excessive exemptions.

“Excessive exemptions should be avoided as they can complicate the tax system, as different items face different tax rates, and can erode the tax base unnecessarily,” she says.

Fiscal consolidation

The government, therefore, faces a delicate balancing act: protecting vulnerable households without turning the tax code into a maze.

Then comes the question of revenue.

Choy estimates that a broader consumption tax could potentially generate an additional 1% to 2% of gross domestic product (GDP) in net revenue, depending on the eventual rate and coverage.

He notes that GST generated about 3% of GDP on a gross basis in 2017.

Nadia is more cautious about drawing conclusions from historical numbers.

She notes that SST revenue was RM27.67bil in 2019 after its reintroduction, compared with the GST revenue peak of RM44.29bil in 2017.

But she says the historical gap should not be treated as an indication of how much a new system could raise today.

“The potential revenue gains today may not be as large as this historical gap suggests, as the SST regime has since been broadened considerably.

“The potential revenue gains will ultimately depend on factors such as the breadth of the tax base and the tax rates imposed,” she says.

Nevertheless, Nadia believes a modified SST could strengthen the government’s fiscal position.

“While it is unlikely a standalone solution to fiscal consolidation, it could become an important measure to reduce the fiscal deficit towards the targeted 3% in the medium term and diversify revenue sources.”

Ng also cautions against assuming that input tax credits alone will bring in more money.

If the same basket of goods and services remains taxable at the same rates, introducing credits could actually reduce collections because tax would effectively be collected once at the final consumer level.

So if Putrajaya wants more revenue, it will have to look at the tax base, the rates or both.

Price impact likely to be limited

Then there is the issue that could determine whether the policy survives politically: prices.

Choy expects a one-off increase in the price level but not a prolonged inflation problem.

A 3% tax, for example, does not necessarily mean every price will rise by 3%, because some tax could already be embedded in the supply chain.

Nadia similarly expects some upward pressure during the transition, but not necessarily broad-based inflation.

“When implemented properly, a well designed GST-like system with a tax rate similar to the current SST should not lead to widespread price increases,” she says.

However, she reckons it could result in some upward pressure on prices during the transition period for goods and services that were previously not taxed under the SST regime.

“Thus, any price impact would likely be limited to these affected goods or sectors rather than causing broad-based inflation.

“Furthermore, these price adjustments should largely be a one-off adjustment rather than a persistent inflationary problem.”

Tan says a soft landing and targeted cash assistance could help minimise the impact.

“A strong political will and proper enforcement of the hybrid SST system are needed to mitigate any risk of reigniting inflation and raising the cost of living in Malaysia.

“As a best practice, clear awareness and public communication should precede the commencement of any new tax system,” he adds.

Nadia similarly stresses the importance of giving businesses sufficient lead time and monitoring prices to prevent opportunistic increases.

“The government should also strengthen monitoring and enforcement against unjustified price increases to help curb opportunistic price hikes,” she says.

This is where the government will have to learn from its previous experience.

A tax reform can be technically sound and still fail if businesses cannot manage the compliance burden, refunds are slow or consumers believe they are being overcharged.

Stronger digital infrastructure

The difference today is that Malaysia has a much stronger digital infrastructure.

Choy points to e-invoicing and digital transaction records as tools that can help authorities detect leakage, while Ng sees e-invoicing as part of the mechanism for validating business-to-business transactions.

Nadia also sees digitalisation as an opportunity to improve compliance.

“The government should accelerate the adoption of digitalisation across the tax system as it allows real-time reporting and can improve compliance,” she opines.

Tan believes the key design principles surrounding the hybrid SST system should contain the GST’s economic neutrality and audit trail with better refund governance.

“These could potentially lower the SME compliance costs and provide for a credible fiscal transparency in the tax system,” he adds.

There is, therefore, a case for a hybrid system. But it should not become an excuse to build another complicated tax regime.

The danger is that Putrajaya could start with a relatively simple objective – retain SST but introduce selected GST mechanisms – and gradually add exemptions, special treatments and administrative requirements until the system becomes difficult to understand.

Malaysia does not necessarily need another GST.

Nor does it need to preserve every weakness of SST.

It needs a consumption tax that raises more revenue without making life unnecessarily difficult for businesses and households.

The real test will therefore not be whether Putrajaya creates a system that looks like GST, SST or something in between.

It will be whether the government can build a system broad enough to raise meaningful revenue, simple enough for SMEs to comply with, transparent enough for consumers to understand and efficient enough to avoid the refund problems that undermined confidence in the past.

If Putrajaya can take the useful parts of GST, fix the weaknesses of SST and keep the system simple, a hybrid could work.

If it tries to satisfy every interest group with another exemption, exception or special rule, Malaysia may simply end up with the worst of both systems.