SINGAPORE (Bloomberg) — There’s bound to be some disgruntlement with Singapore Prime Minister Lee Hsien Loong’s announcement this week that in next year’s budget he will raise the goods-and-services tax to seven percent from five percent.The source of displeasure is not hard to see.

The GST is a regressive tax: High earners would shrug off a S$200 ($129) increase in the price of a S$10,000 designer watch; the lowest-wage earners might not take so kindly to a S$2 increase in their S$100 electricity bill.

Yet if people don’t have jobs, electricity will be expensive at any price. With a resident population of about 4.5 million people and not much of a local market, Singapore can only create employment by retaining its place as a financial and high-value manufacturing hub in the global supply chain.

And that’s what the GST increase is all about.

If Lee goes ahead with it in the February budget, it will be Singapore’s third GST increase in five years. The last increment — from three percent to five percent — was administered in two equal installments spread over 2003 and 2004.

And even then, the decision upset retailers who had had little chance to recover from the 2001 recession before being hit by the spread of Severe Acute Respiratory Syndrome, or SARS. The Singapore economy in 2006 is a far cry from 2003.

With gross domestic product forecast to expand as much as 7.5 percent this year and the jobless rate down at 2.7 percent, this is a good time for Prime Minister Lee to raise the GST. Moreover, Lee’s government only recently won a five-year mandate. That’s long enough for people to adjust to the one-time inflationary effect that follows a sales-tax increase.

Moreover, to compensate for any absolute boost in the cost of living, Lee would, I suspect, announce an “offset package”, giving people cash to blunt the impact of the levy.

That’s what the city-state did when it introduced the GST in 1994, and then again from 2003 to 2005, when the government distributed the so-called Economic Restructuring Shares. Paid over three years, these entitlements put S$1,200 in the pockets of most Singaporeans 21 years of age or older.

The bigger question is: Is all this trouble worth it?

A value-added indirect tax such as the GST entails a lot of work. Companies have to collect the tax from their customers on behalf of the government and claim credit for the tax on inputs they buy.

Notwithstanding the apparent simplicity of the GST law in Singapore, businesses don’t exactly find it a breeze.

“Year after year, the tax and penalties collected from GST errors detected in tax audits have exceeded the amounts collected from income-tax audits,” says Koh Soo How, a tax partner at PricewaterhouseCoopers LLP in Singapore.

This is one of the reasons that businesses in Hong Kong, which has no sales tax at present, are opposing a government plan to impose a five percent GST.

Why can’t Singapore scrap the GST and simply raise its marginal income-tax rate of 20 percent?

Ditto for the corporate tax.

Although the stated levy is 20 percent, the city-state, in effect, appropriates a mere 12 percent of a company’s profits, compared with 27 percent in the US.

Why does Singapore pitch the corporate-tax rate so low and why did Prime Minister Lee stress the possibility of pulling it down even lower?

Singapore is not a natural home for companies. It doesn’t have deep consumer and labour markets or energy and mineral resources. It must compete based on the cost of doing business, a category in which the World Bank ranks it at the top of 175 economies. This advantage is not permanent.

Slovakia’s effective corporate-tax rate is 7.7 percent. Hong Kong’s top personal income-tax rate is 16 percent, four percentage points lower than Singapore.

To compete successfully for overseas corporate investors and wealthy foreigners, Singapore needs to cut its direct taxes before Hong Kong, armed with its own GST, is in a position to widen its income-tax advantage. Maintaining its world-class civic amenities while cutting income and corporate taxes necessitates an increase in the GST, which already accounts for 19 percent of the government’s tax revenue.

“The shift from direct taxes to a GST ensures that the country remains internationally competitive, with the GST providing a more stable source of tax revenues as it is less affected by economic cycles,” says PwC’s Koh.

There’s little else to tax. Singapore has no capital-gains charges, except on speculative transactions; apart from liquor, tobacco and cars, imports are largely duty-free. At seven percent, Singapore’s GST will still be low by Asian standards. The value- added tax rate in China is 17 percent, and in India it’s 12.5 percent.

How much further can Singapore go?

“A GST rate of ten percent is a possibility, but this would depend on how much the Singapore government is prepared to lower its income-tax rates to remain competitive and at the same time, require additional funds to compensate for the shortfall in tax revenues,” Koh says.

Singapore is preparing for a future in which national authorities have competed away their sovereign power to tax incomes. Such a world might be upon us sooner than we think.Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.