Balancing act - increasing tax revenue and pursuing sustainable growth

Strengthening the nation’s tax system is not just about raising revenue, it is also about having one that promotes sustainable growth, builds inclusiveness, encourages good governance, and provides better outcomes for society.

In brief

• Tax revenue is key in supporting a nation’s developmental needs and delivering public services.
  
• One way to improve tax compliance is to simplify the rules by making them transparent and easy to adopt.
• Striking a careful balance between introducing higher or new taxes and achieving inclusive, sustainable economic growth is key.

Tax revenue is key in supporting a nation’s developmental needs and delivering public services. A tax system design should fit the domestic requirements of the country, encourage economic growth, support its people and be responsive to international developments. Strengthening the nation’s tax system is not just about raising revenue, it is also about having one that promotes sustainable growth, builds inclusiveness, encourages good governance; and provides better outcomes for society.

Spurring economic activity

Higher economic activity can generate growth in tax revenue, which in turn, engenders income and wealth creation. To illustrate, policies to encourage growth in certain economic sectors that are key to the country’s development, will create more employment opportunities and build a skilled labor force, resulting in higher incomes and consequently, a growth in the nation’s tax revenue.

Targeted fiscal incentives are also key to boosting economic activity. Offering attractive tax reliefs and incentive packages to bring in foreign investments and support industry sectors such as advanced technologies will help promote the growth of the entire industry ecosystem. When tailoring incentive packages, Malaysia must also consider the preferences and needs of the relevant investor, especially since large multinational groups may be subject to a global minimum tax rate of 15% from 2023, pursuant to an initiative by the Organisation for Economic Co-operation and Development (“OECD”) and the G20. Reducing marginal tax rates on business income may further encourage Malaysian companies to invest domestically instead of looking abroad; especially in the current competitive landscape where countries in the region are leveraging fiscal policy tools to attract foreign investments.

Similarly, tax breaks for research and development (R&D) activities will encourage innovation and the creation of new ideas, that will help boost the knowledge and skills of Malaysians and catalyze economic growth. As announced in the 12th Malaysia Plan, there is expected to be an increase in R&D spending from one percent of the GDP (in 2020) to 2.5% of the GDP in 2025. This signals a greater emphasis towards innovation-led growth and building the nation’s capability and talent towards this objective.

It is equally important to measure outcomes and track the growth of businesses, that have been granted the incentives.

Building trust in tax administration

Taxpayers and the general public want to know how the country’s tax collections are being used, and if the funds are being directed to the right areas. They want transparency on government spending and visibility on the use of tax revenue for infrastructure projects, healthcare, education and other public services. Good public service delivery will enhance the people’s trust, and this can result in the reduction of tax evasion, an increase in compliance and the prevention of tax leakages. The cost for the Government to ensure tax compliance will also subsequently reduce, which will enable them to channel their focus and resources towards developing more effective policies to support socio-economic growth.

Taxation as a form of influencing behavior to drive sector growth

Reasonable tax rates encourage the development of the private sector and the formalization of businesses. A reasonable tax rate is especially important for small and medium enterprises (SMEs). Whilst SMEs may not add significantly to the country’s tax revenue, these enterprises provide significant employment and contribute to economic growth in various other ways. In Malaysia, SMEs contribute 38% to the GDP and employ 60% of the national workforce. A higher tax on smaller businesses may be counterproductive as it may not necessarily add much to government tax revenue but may instead, cause these businesses to stop re-investing and innovating and may lead to reduced compliance with tax compliance and payment obligations. Some SMEs may even cease operations.

Ensuring compliance with the tax rules and regulations is important and one way to achieve this is to simplify the rules by making them transparent and easy to adopt. A good tax system is able to influence business activity that generates positive economic growth. A study by the World Bank on 118 economies over six years found that a 10% reduction in tax administrative burdens (based on the number of tax payments per year and the time required to pay taxes), led to a 3% increase in annual business entry rates. Other countries in the region have also committed to simplifying their tax regimes or maintaining the simplified nature of existing regimes.

Finding new sources of revenue

Introducing new taxes will influence business decision-making, incentivize behavioral changes, and stimulate or discourage investments by companies. Hence, there should be careful and holistic evaluation when considering new taxes, so that the intended outcome for the nation can be achieved.

To sum up, there needs to be careful consideration and balance between increasing tax revenue through higher taxes or new taxes and achieving sustainable economic growth that prioritizes the welfare of the rakyat and that drives the right behavior. Tax cuts, on the other hand, may increase budget deficit. Taxation can be an effective tool, not just for revenue collection by the Government, but also to influence the desired growth for the economy by incentivizing businesses, encouraging people to invest, work and develop their skills, promoting innovation, attracting domestic and foreign direct investments and creating the much-needed spill-over sector growth, without driving up deficits in the long-run.