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Fiscal Structure Needs Review

The announcement by Hong Kong's Financial Secretary, Donald Tsang, to expect a significant budget deficit has fallen on deaf ears. Many feel he is 'crying wolf' after two similar warnings in the past which have both proven to be false. The prediction of an impending deficit is difficult to believe as the economy has come under pressure during the past three years, but it has consistently produced budget surpluses. In previous issues, I wrote that these deficits were prevented by the non-recurrent windfall surpluses from the government's Hong Kong share portfolio.

Now, the situation is changing and an impending deficit could be a reality, especially as some of our revenue sources are depleting. For instance, I surmised that the level of investment income would drop significantly this year from the levels attained in 1998/99 at HK$36 billion and 1999/00 at HK$44 billion.

Moreover, the HKMA recently announced that the audited figures for the period 2000/01 are only at HK$22 billion, some HK$9 billion short of the original budgeted figure. This is compounded by the fact that the original budgeted figure of HK$15 billion from the MTRC public share offer will be short by about HK$5 billion, due to the lower than expected offer price.

If we consider other sources of recurrent income, the situation does not improve. Land sales will be lower than those forecast. We cannot expect windfalls from sources based on a narrow tax net - the Financial Secretary correctly pointed out that Hong Kong is experiencing a 'mismatch' between economic growth and direct tax income such as profits and salaries tax. So even though the economy is growing, we are not immediately seeing higher tax revenues to reflect it.

Aside from reduced revenue sources which will fuel a budget deficit this year, another important area to examine is Hong Kong's fiscal structure.

In a LegCo Motion Debate on 14 February, I urged the Financial Secretary and my LegCo colleagues not to tinker with minor tax adjustments and to brush aside the more fundamental problems that now exist in relation to how we manage the public purse.

Instead, I asked them to look carefully at Article 107 of the Basic Law and examine its validity since the handover. Article 107 seeks to preserve Hong Kong's well-tried principles of prudently managing our public funds. However, it is flawed as it does not consider three major changes that have taken place.

Firstly, the Hong Kong Government has amassed huge reserves in the past few years. Hundreds of billions of dollars have been derived mainly from lucrative land sales and from trading in Hong Kong shares. Article 107 insists on 'fiscal balance, avoid deficits', and to 'keep expenditure within the limits of revenues'. However, it provides no mechanism to utilise our fiscal reserves which are being conveniently hoarded to generate additional recurrent revenue.

Secondly, we must not consider the GDP figure as our only economic measurement. Article 107 assumes that both government revenue and expenditure will rise and fall at the same time as the market experiences economic growth. This assumption is false due to:

  • A sustained period of 'negative' GDP growth. Whilst income contracts quickly, public expenditure will not. In particular, the rapid change in the political environment has rendered it almost impossible to downsize the civil services quickly or to reduce their salaries. Cutting expenditure on major public works is also difficult due to binding legal contracts.

  • Article 107 unwittingly embodies a deliberate policy of high land prices. This article is ill-equipped to deal with sudden and significant adjustments in land prices seen in recent years. The revised policy of placing government land for sale on a reserve list will further destabilise this source of revenue. Even though land sales and related stamp duties probably respond faster in sympathy with our GDP cycle, the new policy will create a time lag. And unless we revert to the old policy of allowing property prices to rise at least as quickly as our GDP growth, government revenue is going to lag behind its expenditure which is now tied to the GDP growth rate.

Thirdly, our traditional profits tax net is becoming outmoded; Hong Kong's industrialists, traders, retailers and professional service providers are moving en-masse across the border and our big corporations are starting to make larger investments overseas. This will affects the territorial source-based principle. The exclusion of capital income such as dividends will soon prove to be a handicap.

The problem will be further aggravated by the growth of e-commerce which will increase GDP but not our tax catchment. It is only a matter of time, until the GDP is no longer an accurate measure of Hong Kong's true wealth and hence, capacity to pay tax. The 'mismatch' between our GDP growth and our profit tax yield is likely to lead to more serious implications in the long run than simple timing differences.

I urged the government to study these structural issues carefully before making any rash moves to hike up our narrow profits and salaries tax base. In particular, I think the government should wait for the results of the comprehensive tax review - it should revisit the grounds for keeping such high reserve levels, and to examine ways to deploy these reserves prudently.

The Financial Secretary may also wish to take advantage of Article 106 of the Basic Law which allows Hong Kong to be independent in managing its public finances; and perhaps adjust some of the outdated principles of Article 107 after analysis and public consultation. Otherwise, I fear a structural deficit will persist unless we make it a priority to return to an era of high land prices, widen our existing tax net and make painful efforts to downsize our civil service.

Eric Li is the Accountancy Functional Constituency Representative on the LegCo. His website can be found at http://www.ericli.org

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