ISE01/14-15

• The Government has previously published the findings of the commissioned study on "Future Development of Retirement Protection in Hong Kong" conducted by The University of Hong Kong. In its research report, it suggests introducing a payroll old age tax as one of the capital sources to fund the proposed cash grant for all Hong Kong permanent residents aged 65 and above. Payroll tax is commonly seen in overseas places such as the United States and Sweden where payroll tax is used to support social insurance programmes. In this respect, payroll tax can be considered as a type of earmarked tax.

What is earmarked tax?

• In general terms, earmarked tax means that all or a fixed portion of revenues from a particular tax or levy^{1Legend symbol denoting According to the international guidelines published by the International Monetary Fund and the Organisation for Economic Co-operation and Development, a levy (or a fee) may be considered as a tax when the government is not providing a specific service in return for the levy, and the levy payer is not the receiver of the benefit. Alternatively, if the benefits received by levy payers are not in proportion to the payments made by them, the levy may still be considered as a tax.} are kept separate from general revenue and used exclusively for a specific government expenditure programme or specific activity. Usually, there is some degree of association between the tax revenue source and the programme or activity being funded. For instance, in some European countries, there are environmental/green taxes earmarked for financing environmental protection activities; in the United States, there is gasoline tax for highway construction and maintenance; and in New South Wales of Australia, there is parking space levy for financing public transport related projects.^{2Legend symbol denoting For these examples, the earmarked revenue is deposited into a separate account or fund.} There are also cases where the tax revenue source and the programme being funded have weaker association, e.g. in Thailand, a fixed portion of tobacco and alcohol tax is used to fund public broadcasting service. This practice is contrasted with the funding of government expenditures from general revenue.
• Hong Kong primarily relies on general revenue to finance the government expenditures. The General Revenue Account is the main account for revenue collection and day-to-day departmental expenditures. Under the General Revenue Account, revenue receipts are credited to the relevant revenue heads and expenditures are drawn from the relevant expenditure heads. Unlike tax earmarking, revenue under the General Revenue Account is used to fund government expenditures and allocation of funds to different programmes is made based on the expenditure needs.

What are the merits of tax earmarking?

• The benefits principle is often used to justify tax earmarking. The principle lies in the proposition that those who receive the greatest benefits should pay the most taxes. It is essentially a "user pays" approach to taxation, which shifts the burden of paying for the service to users rather than the average taxpayers. Some suggest that it is conducive to more efficient resources allocation. Hence, the stronger the benefits principle, the better the case for tax earmarking.
• Tax earmarking to a particular government programme aims to establish a connection between the tax paid and the benefits received. Thus, taxpayers can be informed of the true cost of the programme funded by the tax. These attributes make it easier for the government to gain public acceptance of the new tax (or to build public support for tax increases). Compared with general revenue, the revenue derived from an earmarked tax for an expenditure programme is believed to be more predictable. Since the expenditure programme has a priority claim on the tax revenue, it can insulate itself from competing with other programmes for funding in a budgetary process.

Is tax earmarking a good idea?

• Tax earmarking finds its strongest support in programmes which demonstrate a close connection between the tax paid and the benefits received. Building on this notion, there exists a case for earmarking when the tax acts like a user charge paid by the beneficiaries of a government programme. It should however be recognized that in reality, the benefits principle is not always applicable or relevant. For example, if a government expenditure programme is for social welfare purpose, it is by no means logical to ask the beneficiaries of the programme to pay.
• There are also constraints from the government budgeting perspective. The earmarking practice may deprive policymakers of the flexibility to effectively allocate funds among different expenditure programmes based on the prevalent needs. The government may simply take the earmark as the appropriate level of spending for the programme and need not compare it against other competing claims. Assessing all competing claims to determine which of them will provide the most public benefits for the money spent is generally considered to be good budgeting practice. However, for earmarking, the government may simply adopt the earmarked level of spending. Hence, there are critics that earmarking introduces rigidities, making budgetary planning and control difficult while incurring additional administrative costs arising from separate tracking and accounting.
• Having said that, earmarking seeks to achieve a steady and reliable funding source for a particular programme. In order to achieve efficient allocation of resources and fund sustainability, the earmarked tax must be set at a level able to cover all its commitments. However, ensuring sufficient revenue to cover the expected expenditure of a programme over the long term may be a challenge. If the earmarked tax is only used to partially fund a programme, with the general revenue to cover the shortfall, this will likely undermine the connection between tax collection and expenditure, and make the argument for future increases in the earmarked tax less convincing.

Prepared by Tiffany NG
Research Office
Information Services Division
Legislative Council Secretariat
9 January 2015