In considering how best to rebalance the budget, the debate in recent months has shifted from cutting expenditure to devising new ways to extract revenue from the economy. Income has indeed fallen, and structural changes support arguments that Hong Kong needs to revamp its sources of income. The large and persistent fiscal deficit simply complicates matters.

Most taxes fall into one of three categories: direct, indirect and excise. Direct taxation is that which affects incomes, profits or wealth, while indirect taxes apply to goods, services or trade. Another way of thinking about it is that direct taxes are paid directly to the Inland Revenue, while indirect taxes are paid to someone who then pays the government. Excise taxes, which we will not mention further, are the group to which import duties and similar levies belong.

One of the key differences between direct and indirect taxation is in the choices they offer taxpayers. Direct taxes may be avoided by reducing income, profits or wealth (generally not attractive options), whereas indirect taxes may be avoided by deciding to purchase fewer products subject to tax, or none at all. Alcohol, tobacco and fuel are indirectly taxed in Hong Kong and those wishing to avoid paying the levy may simply chose not to use these products. Some taxed products are more difficult to avoid than others, but the general rule holds true.

Is one type of tax inherently better, or less damaging than another? It is commonly argued that indirect taxes are more regressive than direct taxes, which is to say that the higher one's income, the smaller portion of that income goes to pay the tax, and vice versa. This is true to a degree, as in the case of a tax on rice or water: regardless of level of income, everyone will buy such products, and the poorer one is, the greater the tax burden as a share of income. However, a tax on motor vehicles is less regressive as one must already be in a certain (fairly high) income bracket before being subjected to the tax.

The two also differ in how they modify behaviour. Direct taxes apply to personal income or corporate profit, and if they are too high, may discourage people from working harder or recording more profits inside the tax jurisdiction. In extreme cases, where the tax rate rises sharply, it may actually be disadvantageous to earn more money. For example, if someone earning up to $1 million is taxed 25 percent, and those earning over $1 million are taxed 40 percent, then any raise between $1 million and $1.25 million would result in a net loss of take-home pay.

Indirect taxes, on the other hand, discourage consumption (or, encourage savings). The more one consumes, the more tax one has to pay. Certainly, everyone must consume a certain minimum amount to keep body and soul together, and so it is argued that because richer people need to spend a smaller share for their daily needs, indirect taxes are unfair. However, the richer family still pays more tax than their poorer relations. If a family spends $1,000 on food, and is taxed 5 percent on that purchase, the tax is $50, while those who spend $5,000 on food would pay $250 in taxes.

Further, indirect taxes are often used to urge consumers to alter their behaviour in ways that are thought to be good for society. Hence, alcohol and tobacco are frequently taxed at a higher rate than fruit and vegetables. However, such systems add complexity to retailers' accounting and costs to revenue collectors in the form of more complicated audits.

Most economies tax both directly and indirectly, although the two are typically much more balanced than in Hong Kong. Income and profits taxes are usually progressive in nature, that is, the first bite the taxman takes is smaller than subsequent bites on higher income and profits. The argument in favour of progressive taxation -- that those who earn more should pay more - is fundamentally about income redistribution. Everyone benefits from fire services, but under a progressive tax regime it is the wealthier people who pay for, or pay more for everyone's safety.

Finally, there is the cost of tax collection. Direct taxes require that detailed records be kept by each potential taxpayer, to prove how much tax (if any) should be paid. Indirect taxes require that such records are kept by businesses. In both cases, each layer of complexity adds to the cost of collection and, ultimately, reduces the amount available to the government.

As we consider the pros and cons of a goods and services tax (GST), we should think about ways to reduce the impact on the poorest members of society while limiting the accounting costs to business. One way to help the neediest among us would be to increase the Comprehensive Social Security Allowance (CSSA) by the same amount as the GST, say 5 percent. That would be a very low-cost way of ensuring that the tax does not hurt those who can afford it the least.

The alternative approach is to exclude a shopping list of items from taxation. The exemptions might include rice, vegetables and so forth. However, there are two undesirable side effects to this method. First, rich people would benefit from tax-free rice and vegetables as well, and so the exemption itself would be regressive. Second, merchants would have to calculate the tax on each separate item, rather than on the total grocery bill, which would add to their costs. As the Financial Secretary ponders such issues, it would be wise to remember the KISS principle: Keep It Simple, Sir.