Since the latest fad in Malaysia is the goods and services tax, I thought I should share my limited knowledge on the matter. I am not an tax expert but I know my microeconomics and welfare analysis sufficiently enough to have an informed opinion on the matter.
Those that have done basic microeconomics will appreciate the tools of preference curve and budget constraint. These two tools are easy to work with and are crucial in understanding the effect of income tax and GST on consumer welfare.
To make the contrast clear, we would have to make two assumptions in the spirit of comparative statics.
First, we would have to assume a situation where there is one tax and not the other. To have both at the same time and not mutually exclusive will necessarily make effort at observing the differences between the two harder than it should. Further, no other tax exists. In reality, of course, both could happen at the same time.
There is also the assumption that both taxes produce the same amount of revenue for the government. Again, in reality, that does not have to be. In fact, in reality, even if both types of tax theoretically produce the same amount of revenue for the tax man, issues like tax evasion are not accounted for. In this specific area, GST is better than income tax.
Before we begin, it is essential to note that any kind of taxation reduces welfare. But taxation exists for a variety of reasons that to go into it will necessarily veer off the topic we are interested in.
First off, the effect of income tax for consumer is reduced income. Say a consumer has a certain amount of income, a portion of it will be taxed. As a whole, the consumer could buy less quantity of an item — that is any item — the larger the tax size.
The effect of GST, which is a type of quantity tax (specifically, consumption tax but I prefer the term quantity tax because it is more general), is exactly the same as income tax if the GST is applied equally across all goods. By applied equally, I am referring to a situation where the opportunity cost of one item in terms of other items remain the same. An example involving a barter system is probably appropriate: y amount of butter could buy x amount of cheese, before and after tax. To put it in simpler terms but less precise, all items are taxed at the same rate.
The addendum is that the tax will only be paid if a purchase is made. The only way of not being taxed is by not spending. Whether that improves welfare depends on preference of consumer. If a consumer is really a large saver, he or she would probably be better off under GST than under income tax. However, for the majority of us, I would imagine not spending would make our welfare worse off.
If GST is not applied equally, it is possible for the consumer to be better off under GST scenario than under income tax scenario. Consumers could simply consume untaxed goods. With no income tax, quantity of untaxed goods consumers could purchase in terms of the taxed goods would likely increase. The consumers however would really have to love the untaxed goods for that to happen. If — still under unequal GST scenario — consumers prefer the taxed goods to untaxed goods, then consumers will be worse off under GST than under income tax. In microeconomics jargon, these refer to corner solutions.
Typical analysis offers this result however: income tax grants higher welfare to consumer compared to GST, in a situation when GST is applied unequally across goods. Reason is that income tax does not affect opportunity of goods purchased. Unequal GST does and that may force the consumer to move away from his or her optimum consumption under taxed scenario.