CONSUMPTION TAX - THE TONGAN EXPERIENCE

Analysis

The following paper was presented by Tongan Minister of Finance Siosiua T.T. Utoikamanu at a conference held in New Zealand in November 2006.

The Hon. Siosiua T. T. "Utoikamanu Minister of Finance & Chief Commissioner of Revenue Kingdom of Tonga

Thank you Professor Krever for those kind words of introduction. And can I acknowledge the previous speaker, Professor Lee Burns, who has played such a valuable role in the development of the Kingdom of Tonga’s tax legislation; and an earlier speaker, Ian Dickson, who probably had an even greater role in the design and implementation of Tonga’s Consumption Tax than his role as manager of GST’s introduction twenty years ago. So I wish Ian and New Zealand a happy 20th Anniversary.

On April 1st last year the Kingdom became, we believe, the 137th nation to adopt the VAT/GST system of indirect taxation. With a resident population of 104,000 people, and a GDP of T$450 million – roughly NZ$350 million [US$220.5 million] - the Kingdom is one of the smallest, if not absolutely the smallest nation to have done so.

We are the "new boy" in the VAT/GST club, and a very small one at that! However I think our recent experience has some relevance to other nations, small and large, contemplating tax reform, and other fundamental policy direction changes.

In this respect, this conference is a very valuable opportunity for the "old VAT/GST" nations and the new and intending adopters to compare notes and learn what we can. I am particularly grateful that the organisers have seen fit to include this segment with a focus on the nations of the Asia-Pacific region, and to arrange a facilitated follow-up seminar next Monday, because I believe we have much to learn and gain from one another. Regional tax co-operation is a theme I will return to, because we in Tonga have benefited enormously from such co-operation with the New Zealand and Australia, and it has much to commend it.

The Tongan Context for Revenue Reform

First, I will outline the Tongan context for revenue reform.

Tonga is 54th in the UNDP rankings of countries in terms of human development. This is just outside the first group of most advanced countries, and one of the highest ranking of any Pacific islands nation. The level of human development in Tonga reflects income per head of about US$2,300 (2004/05 estimate), life expectancy at western levels, and a long-standing commitment to education, giving near-universal literacy.

The position of Tonga in the middle-income bracket of nations is partly a consequence of very high and sustained levels of remittances from Tongans working abroad. It is estimated that 40,000 Tongans work overseas (although the number living abroad may be as high as 100,000) mainly in the United States, Australia and New Zealand. The overseas Tongan labour force is probably of similar size or larger than the paid labour force in the Kingdom.

Worker remittances and a low level of net population growth are probably the most important factors in the development of the domestic Tongan economy in recent times. The level of human development is relatively high and Government health and education services meet social needs. To date, the economy has not needed to expand to provide for increased demands arising from population growth or an influx of tourists. Worker remittances sent home by overseas Tongans provide adequate incomes to supplement paid work and subsistence activities, without the need for rapid industrialisation or commercialisation of tourism. Import restrictions, rather than shortages of resources and labour, have also constrained the direction and pace of economic development.

Remittances from overseas have been increasing in recent years. In 2003/04 they were T$184.4 million (48.5 percent of GDP). Income from remittances may be not far short of double that earned in Tonga. Remittances from family members who are working overseas provide a stable source of supplementary income for many Tongans families and additions to the country’s foreign exchange reserves. A recent study by the World Bank indicates that approximately 90 percent of households in Tonga received cash remittances in 2004, averaging US$3,067 per household and US$753 per capita. The study concludes that remittances to Tonga improve income distribution; have a positive impact on poverty alleviation; induce higher savings, stimulate business activities, and result in larger investments in education.

These factors – low population growth and high overseas remittances – more than any other, explain the structure and recent performance of the economy. The orientation of the business sector towards meeting the consumption needs of the domestic resident population, more than serving any export markets is a consequence.

Addressing the implications of these issues in a sensible and consistent manner, while being mindful that as the nation we lack natural resources and live in a fragile environment, are the development challenges faced by the government, and providing a backdrop for the revenue reforms and other policy initiatives.

We have profoundly changed the public sector. Last year nearly one quarter of the public service staff took early retirement or voluntary redundancy, and we are progressively rationalising public enterprises, a number of which have ceased trading and are being, or have been wound up. These changes have been given extra impetus by the settlement of the public service strike in 2005 that resulted in an average 70 percent increase in salaries, and contributed in no small part of the fiscal deficit of $22 million in 2005/06.

The External Context for Revenue Reform

These domestic factors themselves have to be seen in a wider context. The Kingdom needed reform of its tax system to better meet the challenges of a changing world.

1. In the first place, in order to encourage sustainable private sector-led growth, it needed to adjust to external changes such as:

The opportunities and threats from changes in the patterns and the rules of regional and global economic activity, including the impending free trade arrangements among the countries of the southwest Pacific – the PICTA and PACER, but also the WTO.

The pressing need to provide an environment for commercial investment that is recognisable and compatible with the tax systems of the main capital-providing countries, Fiji, New Zealand and Australia, and increasingly the United States. Years of ad hoc discretionary interventions had created a non-transparent, confusing and widely criticised set of tax policies in Tonga, while other governments were focussing on providing businesses with greater clarity, certainty and simplicity in tax matters.

Together these two factors created one impetus for revenue reform because of the necessity for Tonga to end its heavy reliance on taxes on international trade as a main source of government revenue. The era is at an end when heavy reliance could be placed on trade taxes to finance the burden of government spending. Such taxes would distort the pattern of trade and domestic commerce if used to support the level of government spending that is expected by the population in the Kingdom (and I will comment shortly on those expectations).

2. Secondly, in order to sustain social cohesion at home, a Kingdom which, as I noted, has such a high proportion of its people living overseas, had to accommodate:

International demonstration effects driving up many domestic Tongans" hopes and expectations for higher personal living standards – higher personal consumption, higher imports, etc.

Expectations of higher service levels from government agencies – especially the traditionally strong education sector which equips so many Tongans to work abroad.

3. Thirdly, in order to maintain macroeconomic stability, the Government of Tonga had to stabilise its fiscal position, after years of fluctuating fiscal fortunes:

We had to recognise that simply labelling increases in oil prices as "shocks" did not mean that there would automatically be other off-setting favourable external "surprises". We had to adjust to international economic events, but also reduce our future vulnerability by creating a fiscal buffer as best we could.

Similarly, we could not expect aid flows to be an adequate or sustainable fiscal solution.

Therefore, we had to overcome a chronic imbalance between expenditure and revenues.

Also, we had to smooth our revenue flows throughout the year to ease our recurring cash management problems, and help monetary and fiscal policy to work more effectively.

4. Fourthly – and against a backdrop of some fairly radical reformers in a certain country to our south west – the government had to create some credibility for itself as a reforming government:

We are well on the way to bringing the Kingdom’s taxes into conformity with international norms as well as current and future bilateral and multilateral obligations. Most immediate is the need to align the taxation system with what is permitted under the World Trade Organization requirements for membership. This alignment of domestic taxes and import duties must be in place by 1 January 2007.

Meeting the challenge of joining the global trading environment will help the business community in Tonga to become much more outward focused, productive, and resilient. Businesses in Tonga will become more competitive and rely less on tax preferences and subsidies, including because the tax burden on business inputs will fall significantly.

Political and Constitutional Context

Perhaps I should digress momentarily and explain a little about our system of Government, which is not much understood outside the Kingdom.

Tonga is a constitutional monarchy. The structure of the government is set out in the 1875 Constitution. Part II of the Constitution establishes the following aspects of the Government:

Tonga has a unicameral Parliament. Elections are held every three years. The Constitution provides that the Legislative Assembly be composed of:

The Privy Councillors and Cabinet Ministers who sit as Nobles (there are currently fifteen Cabinet Ministers).

Nine noble representatives elected by the 33 nobles.

Nine peoples’ representatives elected by popular vote.

As in New Zealand, the Legislative Assembly is the supreme law making body. As in most parliamentary democracies, Cabinet has historically had a significant influence on the Legislative outcomes. In more recent times, and consistent with an evolving and developing democratic institution, the legislature’s support for every Bill cannot be assumed.

Together, the King, the Cabinet, and the Privy Council compromise the executive branch of the Tongan Government. Until recently all members of the Cabinet were appointed by the King and thenceforth held office at the King’s discretion. However, following the March 2005 election, two members of the Cabinet are to be selected by the King from the elected peoples" representatives and two from the elected nobles. The current Prime Minister, the Honourable Feleti Sevele, is one of the peoples" representatives elected to the Legislative Assembly and appointed to Cabinet. The King, Cabinet, and the governors of the island groups of Ha’apai and Vava’u make up the Privy Council together with any others the King appoints. The Privy Council’s main role is to assist the King in the discharge of his functions.

Finally, the King has a formal role in constituting the Legislative Assembly. The King calls and dissolves the legislative assembly, and signs all acts of the Legislative Assembly into law.

The Tongan Judiciary comprises four levels of courts, namely: Court of Appeal; Supreme Court; Land Court; and Magistrates Court. Many of Tonga's lawyers and the judiciary studied law in New Zealand and Australia. The Court has a track record of independence from the government, including, from time to time, as it has, voiding legislation for being inconsistent with the Constitution.

In 2005 and 2006 that Kingdom has endured what many might regard as a disaster scenario for country and economy of our size and type, combining record high world oil prices and domestic fiscal challenges. On the domestic front there has been growing agitation for changes in the representativeness of the legislature and, as a society, we have coped with the death of the late King and the succession of King Siaosi Tupou V. The report of the National Committee on Political Reform that was presented to the late King before his death proposes, among other reforms, an increase in the number of peoples’ representatives from nine to 17.

All this has not lessened our determination to continue on with the reform program to build an economy that is a resilient and able to successfully participate in the new global trading environment. To stay on course we need realism about the nature of our challenges and the available solutions.

CT, in many respects had been the most tangible manifestation of the reform, up until the time we let go nearly one quarter of the public service employees. CT has been the lightning rod for complaint about government inaction or excess speed – depending on the critic’s viewpoint – but I would boldly assert that the net impact of CT implementation on local perceptions of government capability has been positive; that CT operation has improved the ability of government to give effect to its economic and budgetary policies – which is a very practical benchmark for good governance; and that the Kingdom’s economic foundations – and therefore social stability – have been strengthened as a result of CT’s design, and the improvements over the taxes it replaced.

Key Consumption Tax Policy Design Issues

Our tax, called Tukuhau Ngaue’aki - which literally translates from the Tongan to "Eating Tax", but is known universally as Consumption Tax or CT -- applies to imports and domestic supplies of goods and services at 15 percent. CT directly replaced four former taxes, which together raised T$35 million:

We abolished these taxes and introduced CT as part of a comprehensive tax reform programme which commenced in 2002:

In 2003 we introduced legislation to reform the administration of tax, including the Consumption Tax Act.

In 2005 we reformed indirect tax, absent Customs and excise.

In 2006, we are currently in the process of finalising new Customs legislation, including a WTO-compliant Customs Tariff Schedule and a new Excise Tax to apply to alcohol, tobacco, petroleum fuel and motor vehicles.

We have also in the past 12 months or so, completely overhauled the powers of Customs, the administration of Customs, and the staffing and management of the Customs service.

Finally in 2007 we will introduce a new Personal Income Tax, Business Income Tax and a yet-to-be developed system of Road User Charges to fund road maintenance.

We have the usual base-defining exemptions and zero rates -- financial services and export of goods and services. We also have a few concessions to social equity and political reality:

We also have an exemption for public passenger transport, which is starting to cause great difficulty, and is teaching us about the reasons why exemptions are generally a bad idea. The reasons why we chose to provide an exemption without credit for passenger transport, but not tourists which are fully taxable, is obscure, but the artificiality of it, and the exception to the generality, are now problem areas for us to manage.

In its inaugural year, CT collected T$53 million. This exceeded our expectations for first year revenue by T$7 million, although the composition of border and inland collections, and information on arrears, both indicate that another T$2-3 million is available. Border collection from imports amounted to nearly three-is quarters of the total, which is too high, even in relation to our relatively shallow domestic economic base. Even still, at around 12 percent of GDP and 42 percent of tax revenue, the total collected was a pleasing first year result, and a great relief to a Minister of Finance presiding over such a momentous change at a time of great fiscal inconvenience.

We are a moderate tax country. Total taxation amounts to 28 percent of estimated GDP, and government spending -- the true measure of the taxation burden -- was 33 percent in the fiscal year just finished in June.

We estimate that CT applies to around sixty percent of household consumption spending (cash and non-cash expenditure). The major exceptions are:

In the monetised sector, electricity and water which together make up about around 5 percent.

In the social services sector, health care and education, which are mostly free, but make up about 2 percent.

In the non-monetised sector, the value of self supplied or bartered subsistence goods and services, or the value added in the produce of exempt businesses, mostly food stuffs, 32 percent.

Key CT Tax Administration Issues

Businesses with an annual turnover that does not exceed T$ 100,000, about NZ$75,000, are not required to register for CT. All others and all government licensing authorities must register, charge and return tax monthly. As a result, the vast majority of the approximately 2,500 businesses in the Kingdom are not obliged to register and we have, at last count, 468 registered taxpayers.

The numbers registered continues to increase, and I am confident we will shortly break though 500. At the time of introduction 320 had pre-registered. The increase is attributable to three factors:

General awareness-raising through TV advertising of the registration requirement, most recently in Chinese languages as well as in Tongan and English. (I will talk more about communication shortly.)

Specific enforcement actions aimed at certain industries where compliance has been found to be low. Some of these, such as in the construction sector, are on-going.

New business formation.

The high registration threshold was a deliberate measure to limit the numbers of smaller, perhaps properly described as micro-businesses that are often part-time or part-year occupations from the necessity of administering CT. Although beneficial in minimising the administrative and compliance burden, this is not without its own problems. Two kinds of problems have surfaced:

We have been unable to resist pressure to relieve some below-threshold businesses from the impact of exemption, resulting in a zero-rate being applied to a wide range of agricultural inputs. Pressure continues to extend this concession to other private sector inputs that pose greater problems from a control perspective.

Annual turnover is a poorly understood indicator of business size, and we have had some success in breaking the requirement into daily, weekly and monthly equivalents in public communications.

So far, restructuring to fragment business operating units to below-threshold sizes has not been a noticeable problem.

The Role of the Revenue Information Office

We broke new ground in the Kingdom for the way communications with taxpayers and the public were handed, for the integration with communication and training for staff involved in tax administration, and for the breadth and sheer volume of that communication.

The Revenue Information Office (RIO - now expanded into the Reform Information Office) has played a major role in ensuring the public and key stakeholders are educated and informed about the revenue reform programme. Consultation is vital to ensuring policies are implemented successfully because it allows the public and key stakeholders to make submissions and provide input into the decision-making process.

Since the introduction of CT, the RIO Unit has been at the forefront in providing regular information on tax matters as well as advice on compliance and legal requirements for all taxpayers. RIO has developed a large range of media tools designed to reach all sectors of the community. These tools include websites such as Tonga-Now [http://www.tonga-now.to] which attracts around 100,000 hits per night from around the world, TV programmes, radio talk back shows, media statements, brochures and special events such as the sponsored secondary school debating competition about CT (with the finals carried on TV).

The integration of communication with staff training meant, for instance, that staff on taxpayer visit training were briefed on the draft CT information material and involved in assessing how well it answered taxpayer questions. It is important to note that RIO was not just outward-focused. Firstly, the team worked hard to make sure that we aligned the messages to the public with the capability being created in tax administration - not just asking the hard questions about the level of staff understanding, but even taking part in delivering some of the staff training. Secondly, they were collecting, analysing and helping respond to the messages coming in from all the various stakeholders. In some ways, through this linking role, they were the de facto programme office connecting various projects.

Lessons from Our Experience with CT Implementation

I have described the CT introduction as "having gone as well as might be expected".

I would be being less than frank if I did not confess that there were a few "bumps" along the road, and not a few "tears before bedtime". Because we are still in the middle year of a three-year reform programme, it is interesting to understand the combination of factors behind this evaluation. I will mention four.

Firstly, quite a number of merchants changed their systems but did not re-price their stock, thus incurring the anger of their customers in the weeks following the introduction. Partly, this simply saved them a lot of work, but also it reflected a doubt that the tax would come into force on the announced date. This can be interpreted as a widespread doubting of reform credibility - after all this was the first visible and tangible sign on what up to then had just been announcements. It was an important issue to address and overcome.

The second issue worthy of mention is preparedness. No matter how much we advertised, communicated directly with prospective taxpayers, visited their place of business, and even sparked public protest, there were some who simply were not aware. Perhaps this is a natural manifestation of human nature to put off the things that are not immediate. Perhaps a history of announcing policies that then evaporated or retreated at the first sign of public opposition had robbed our announcements of all credibility for some people. Could we have done more? We could have started even earlier than we did, but I do not believe our efforts were wrong or misdirected, human nature being what it is!

Resources are the third issue. Both among taxpayers and in the revenue authorities we struggle with recruiting, retaining and training suitably qualified individuals to undertake the necessary work. The key skill gap is standard business practice and specialist tax knowledge. These are hard skills to find in the Islands. I will comment more on this aspect in a different context shortly. Around 10 percent of the taxpayers have at one time filed late. Subsequent investigations have showed that in a majority of cases resource issues were to blame - and mostly very human issues such a personal or family illness -highlighting the vulnerability of even larger businesses to key-person risk. The two-month return period we stared with contributed to confusion at month end and we switched to a one-month return period in October to compensate.

Finally the fourth matter is business customary practices. There are still many areas where standard commercial documentation is not the norm. Businesses do not as a rule generate invoices, let alone tax invoices, and it has been a struggle to inculcate the habit. Bank cards are near universal but we remain primarily an economy driven by cash. A related problem we have encountered is exemplified by the misunderstanding that it is exporters rather than exports that are zero-rated, and merchants who believe that all their sales are free of CT if they make some export sales.

The Impact of Issues like International Trade in Services and Financial Services

I would just comment briefly that being small and a developing country, and not sharing a common land border with other tax jurisdictions does not absolve us from many or most of the same problems facing the administration of VAT/GST taxes in other countries.

We face the same difficult issues with the definition of time and place of supply of services – especially financial services, which looms large in a small place where, for example, 100 percent of bank back office services are outsourced overseas. Agents in Tonga handle transactions between principals in third countries – even our Post Office is involved in this way handling mail for third parties. In terms of solutions to these problems, I think it would be prudent for Tonga to plan on being a follower of international best practice rather than a trail-blazer!

The Scope for Regional Cooperation and Integration in Tax Matters

Being small, and a developing economy, also does not mean an absence of the sophistication that characterises the more developed nations, including sophistication on the part of individuals and groups intent on subverting the law and the revenue.

To date, we have not detected any episodes that would point to missing trader fraud, or any other of the schemes that bedevil larger countries, but we are equally as exposed to the Achilles heel of the VAT/GST system. We have instituted some safeguards, such as requiring a two-period carry forward of excess credits, an application for refund, and rigorous checking before releasing a refund.

The key difference is that we do not have available to us directly the specialist legal, accounting and audit resources necessary to address such issues when they arise. It is my expectation that we will face such issues at some time: the incentives to cheat are the same as anywhere else and our ability to respond is limited.

To address such issues we have become focused on field audit as providing a primary control mechanism. We have been greatly assisted by NZ’s IRD and NZAID with secondments of a succession of capable individuals who have helped us to make useful progress. It must be remembered that before 2005, no such function existed in our revenue agencies. We are starting from scratch in building capability that is essential to a tax system built on voluntary compliance.

I mentioned earlier the benefits to the Kingdom from regional cooperation provided by NZ’s IRD, the Australian Tax Office and their respective funding agencies. This has been of immense help to us as we have sought to build permanent capacity to administer our new taxes with the required levels of skill, impartiality and independence.

It is apparent to me that we have much to gain mutually from cooperation with our near neighbours in the South-Western Pacific:

We host capital providers to one-another, a trend that will increase in coming years.

PICTA and PACER will bring our economies closer together through the commodity markets.

Rising skill levels, professional qualifications and increasing opportunities will see our respective citizens living and working in other PIC"S not just emulating the old trend to NZ, Australia and the western seaboard of the United States.

We each have limited administrative resources, and no current formal means to pool them in matters of mutual interest.

We want to avoid, at all cost, getting into situations where unhealthy tax competition may develop. To varying degrees our main industries compete, especially when location, sunshine and scenery are the main attractions. It is always a temptation when developers are seeking tax concessions and promising economic development benefits, but if we are just being gamed there would be value in a mutual approach.

The seminar on Monday is an opportunity to test this proposition for its merits, relevance and its practicality.

Specific Issues for Pacific island Counties

I hope my remarks have given you a little insight on our recent experiences. Before closing, I must add that the fact of reform and the nature of our CT reform was also influenced by three specific issues which are likely to be shared with other Pacific island Countries.

The first issue relates to tax administration: the feasibility of scaling down and simplifying what we could observe had been happening in larger and more developed countries as new tax administrative possibilities had been opened up through new technologies. We took some comfort from the example of these other countries" new tax procedures that leverage these new technologies directly – and also indirectly, as the plummeting price of information technology places digital data management and the internet within reach of smaller businesses. But we had to test and prove that these factors would apply to Tonga.

What we confirmed in practice is that it is indeed possible to scale down and simplify indirect tax administration for a smaller and less-sophisticated economy, but still get the benefits of new technologies and processes.

Secondly, there is the issue of implementation. Our experience has also demonstrated that the technology, training and communication techniques that had been developed in our neighbours – especially New Zealand – could be successfully adapted and adopted by us.

Thirdly, and most importantly, there is the issue of tax policy design, which underpins the other two issues. Unless exceptions had been kept to an absolute minimum, and discretion virtually eliminated, there is no way that we could have gone as far as we did in simplifying tax administration both for taxpayers and revenue officers; and our ability to communicate clearly and gain stakeholder acceptance of CT’s fairness and workability would have been severely compromised. I suggest that, for small countries with limited resources, the lessons from experience that I offered earlier show that the trade-offs are not simple linear relationships: small increases in tax complexity add greatly to tax administration difficulties and greatly reduce the likelihood of a relatively smooth implementation.

I suggest that these three issues would apply to other Pacific Island countries following after us.

Indeed, I am aware that other Pacific Island countries, such as the Solomon Islands, are contemplating the introduction of their own form of consumption tax. I extend to them the offer to visit and observe what we have done, and I commend to them the excellent support that we have received – and continue to receive – in terms of funding and agency-level collaboration from the New Zealand and Australian governments, and the professional inputs of a number of the experts here today.

Can I conclude by commending this conference as a very valuable opportunity for the new adopters to learn what we can from each other and the old hands of the Asia-Pacific region GST club.

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[1] The civil disturbances of 16 November 2006 meant that the legislation associated with these changes was not able to be passed before the end of the 2006 parliamentary session

[2] Electricity, being wholly sourced from diesel fuel, is very expensive to generate at 60 seniti a unit (about 45 NZ cents per kWh), and indeed is currently subsidized for domestic use because of high world fuel prices.

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