(Reprinted from HKCER Letters, Vol. 74 May-Aug 2003)
The Incredible 2003-04 Budget1
Hong Kong fiscal deficit is estimated to reach an unprecedented level at HK$70 billion for 2002-03.3 It will amount to 5.5% of GDP for 2002-03, a level significantly higher than those in the United States (US) and European Union (EU). US fiscal deficit is anticipated to be enormous, but is not expected to exceed 3% of its GDP, and EU requires its member states to contain their fiscal deficits within 3% of GDP. Indeed, 2002-03 is already the second fiscal year in a row that Hong Kong deficit has reached such a high order. The deficit was $63 billion for 2001-02. These two huge consecutive deficits manifest the severity of the problem.
Alas, Anthony Leung, the Financial Secretary, failed to anticipate the problem a year ago and did not adopt appropriate measures to prevent the problem from worsening. In the 2002-03 Budget, his maiden budget, he did not propose any concrete measures to raise revenues. Nor did he propose any thoughtful measures to control expenditures. For instance, he proposed a 4.75% pay cut in the civil service and the subventions, but the actual cut turned out to be substantially lower. Nonetheless, we should mention that he did set three targets for public finances in 2006-07 as follows:
• Restore balance in the Consolidation Account
• Attain a balanced Operating Account
• Reduce public expenditure to 20% of GDP or below
We agree that these are right targets. But setting the targets right is the first, and a very small, step in solving the budgetary problem. Leung did not start to address the problem until it became acute recently. He begins, in the 2003-04 Budget, to outline his plan of achieving the three targets in 2006-07. In this article, we review his plan and argue that it is not a credible proposal.
There is a company, which experienced a change in the management five years ago. The company had an excellent track record under the old management, but the performance of the company has inverted over the past five years under the new management. The loss for the last financial year was $63 million and has risen to $70 million for the current financial year. It is the worst of times for the company.
This company has a dispersed ownership structure, i.e. no single shareholder has a say to the management. When reporting the $70-million loss in the annual shareholder meeting, the CFO of the new management blames the old management for the inverted performance, because of the high operating costs left behind by them. Note this accusation makes no regard to the fact that the old management left five years ago. He reports that the new management has now successfully helped the shareholders bring the operating costs down to a reasonable level. He claims that it is the best of times for the company. It is ludicrous that a CFO does not use the bottom line to measure the performance of the company. What is the problem with the old management if they could deliver an excellent performance, measured by the bottom line, at high operating costs? Why do the shareholders care low operating costs if the company continues to suffer huge losses?
According to the CFO, the $63- and $70-million losses are a serious problem, because persistence losses will increase the company's costs of raising capital. This CFO commits the same mistake twice by focusing again on costs rather than the bottom line. He tells the shareholders that he has a plan to balance the book in four years. First, he projects that revenues per annum will be increased by $30 million in the fourth year as a result of natural economic recovery. He further proposes measures to cut costs gradually and expects that costs per annum will be reduced by $20 million in the fourth year. Last, the remaining $20-million gap is filled by some revenue-raising measures, but the measures he proposes are only expected to raise the revenues per annum by $14 million in the fourth year.
This plan has two faults. First, there is a $6-million gap in his revenue proposal. The gap is acknowledged, but not addressed by the CFO. Second, and more important, his whole plan relies critically on the $30-million revenues from natural economic recovery, which is completely out of his control. Due to this substantial uncertainty, it is unthinkable that the shareholders will be convinced that the CFO's plan will work. Had the ownership structure been less dispersed, the shareholders would have replaced the CFO and possibly the new management.
The three-pronged approach
The CFO's strategy to balance the book is the same as the one adopted by Leung and is termed a three-pronged approach. In the context of the 2003-04 Budget, the three-pronged approach to solve the HK$70-billion deficit problem consists of: natural recovering, cutting expenditures, and raising revenues.
Leung forecast that economic recovery in Hong Kong will increase Government's revenues by HK$30 billion in 2006-07. This forecast is based on the following assumptions:
Over the period 2003-07,
• 3% growth in real GDP per annum
• 0% inflation rate per annum
• 3% growth in nominal GDP per annum
We believe that these assumptions are too optimistic. First, according to his own forecast, in 2003, real GDP will grow at 3%, deflation at 2% (measured by GDP deflator), and nominal GDP will grow at 1%. There is a significant gap between the 2% deflation in 2003 and 0% inflation over the period 2003-07. Indeed, deflation has become a threat to the global economy. We do not see how Hong Kong, as a small and open economy, can be immune to the global deflationary threat. Consequently, underestimation of deflation overestimates growth in nominal GDP, which is more important than growth in real GDP in bringing up revenues. Hence, the underestimation of the deflation over 2003-07 overestimates the additional HK$30 billion revenue in 2006-07.
Second, his forecasts were made before the outbreak of Severe Acute Respiratory Syndrome (Sars) in Hong Kong and other parts of the world and the war in Iraq. The outbreak of Sars has severe acute impacts on domestic consumption and tourism in Hong Kong. In 2002, real GDP grew at 2.3%, deflation at 2.7% (in terms of GDP deflator), and nominal GDP fell by 0.6%. It is unlikely that 2003 will be a better year than 2002. Leung should revise his 2003 forecasts downward to reflect the reality. In addition, the government is offering relief measures amounting to HK$11.7 billion to the society at large and the most-hit industries in particular. It is almost certain that the outbreak of Sars will push the deficit for 2003-04 to another record high, which is originally forecast at HK$67.9 billion.
The war in Iraq will have a negative medium-term impact on global economic recovery. The US "unilateral" action of by-passing the UN will disturb the global political relationship, which is not conducive to global economic recovery. The war in Iraq has ended sooner than expected. The conventional wisdom will regard it to be positive to US economic recovery. We are more conservative, however, since the end of the war exposes the uncertainties the US has to face in trying to reorient the Middle East. US economic recovery will certainly affect global economic recovery (as the largest economy in the world) and more significantly to economic recovery in Hong Kong (as the largest exports market of Hong Kong). Leung's 2003-07 medium-term forecasts are clearly too optimistic from this perspective.
We believe that the medium-term economic recovery in Hong Kong will be slower than what Leung has assumed and, hence, will increase revenues substantially less than HK$30 billion in 2006-07.
While we are not convinced that the first prong will work, we believe that the second and third prongs are in the right direction. The second prong comprises of reducing the establishment, cutting the salary of civil servants, improving the pay adjustment mechanism, and adjusting social security payments downward.
In his 2003 Policy Address, the Chief Executive, Tung Chee Hwa, set a new target to reduce the establishment of the civil service to 160,000 posts by 2006-07. (We proposed to cut the establishment a year ago, Ching 2002.) According to Leung, this target is to be achieved via a voluntary retirement scheme. We do not think a voluntary retirement scheme can effectively achieve the target. Ipso facto, this is the second-round voluntary retirement scheme, which is less generous than the first-round scheme, and the job market now is much worst than before. In our opinion, Leung should convince Tung to retract his promise of not laying-off civil servants. Otherwise, Leung will not have the leverage to meet Tung's target. Our analysis will show that Leung will need to cut the establishment further in order to achieve his three own targets for public finance in 2006-07.
The salary of civil servants will be cut to the level in cash terms as at June 30, 1997 in two phases. The pay adjustment mechanism will also be reviewed. We doubt the usefulness of reviewing the pay adjustment alone, since there is no room to cut the salary of civil servants further, which is protected by Article 100 of the Basic Law. We propose to take the pay adjustment review further to overhaul the existing civil service pay policy and system. Our specific recommendation is to convert all non-cash benefits to cash at a discount. The advantage is that it will cut personnel-related expenses and save resources from administering the associated tedious procedures, without compromising the well-being of civil servants (Ching 2002).
The social welfare payment will be adjusted downward to restore their original intended purchasing power. The adjustment is based on the movements of the Social Security Assistance Index of Prices. This adjustment is commendable, since the social welfare payment should not be used to distort incentives of seeking jobs.
Leung also mentions the "3R1M" approach as a general measure to controlling expenditures. The 3R1M approach refers to Reprioritize the provision of services, Reorganize the structure of government departments, Reengineer procedures and Make full use of the market. The 3R1M approach certainly sounds more sophisticated than the "1P" approach (i.e. Privatization) we proposed two years ago (Ching 2001). However, we believe that the 3R1M approach is not as effective as the 1P approach in addressing the fundamental inefficiency of bureaucracy.
Salaries tax, profits tax, property tax, motor vehicles first registration tax, air passenger departure tax, betting duty will be increased under the revenue proposal. The proposal also introduces two new taxes: soccer ball betting duty and boundary facilities improvement tax. Leung acknowledges that this proposal is estimated to generate an additional revenue of HK$14 billion and he has yet to come up with other measures to bring in the remaining HK$6 billion.
In essence, the salaries tax will be reverted to the 1997-98 level. This is very close to the recommendation we made two years ago (Ching 2001): to revert the salaries tax to the 1996-97 level. Furthermore, Leung proposes to increase the standard rate from 15% to 16%, while we recommended no change to the standard rate. We think that Leung's proposal of increasing the standard rate is unjustified. According to his forecast, the salaries tax proposal will generate an additional HK$6.8 billion revenue, while the profits tax proposal will generate an additional HK$3.5 billion revenue.
We do not see how Leung can justify that the increased tax burden on salaries taxpayers is double of that on profits taxpayers. According to him, the main problem of the fiscal deficit is that it may lead to an outflow of capital, thus pushing up interest rates. A higher interest rate has at worst a neutral impact on salaries taxpayers, since they have interest-bearing assets as well as interest-paying liabilities. Their overall net asset position is generally positive. However, a higher interest rate will have an adverse impact on profits taxpayers, since it increases their costs of doing business. Why should salaries taxpayers take up a bigger responsibility than profits taxpayers of solving a problem affecting profits taxpayers? Therefore, the unjustified 16% standard rate should be brought back to 15%. Similarly, the profits tax rate for unincorporated business and the property tax rate should be kept at 15%.
It should be made clear that we are not arguing for a profits rate higher than the one proposed by Leung. He proposes to increase the profits rate from 16% to 17.5%. Two years ago, we recommended the profits rate be reverted from 16% to the 1996-97 level of 16.5%. Our position is that Hong Kong should preserve its simple tax regime with low tax rates. We certainly do not want to see the profits rate to exceed 17.5%. The implication is that Leung has limited room to raise revenues via higher tax rates.
Leung also proposes to increase the motor vehicle first registration tax.4 In principle, we object having a motor vehicle first registration tax. A motor vehicle first registration tax is a tax on ownership. An ownership tax, per se, is not justified. Otherwise, what prevents the government from taxing owners of luxurious watches, jewelries, and other pricey assets. The fundamental reason that motors vehicles are taxed, but not watches and jewelries, is that motors vehicles can cause traffic congestion which imposes a negative externality on other road users. Taxing ownership is an indirect, and hence ineffective, measure to address this negative externality problem. The direct solution to the problem is electronic road pricing. It should be pointed out that privacy is no longer an issue under the current technology. We believe that an innovative and creative government should embrace the latest technology of electronic road pricing to solve the traffic congestion problem, not to mention that it helps the government raise revenues.
Leung introduces a soccer betting duty. This is the same as the recommendation we proposed a year ago (Ching 2002). Leung estimates that the soccer betting duty will increase Government's revenue by $1.5 billion. Another new tax proposed by Leung is a boundary facilities improvement tax. The problem with this tax is that it contradicts the general government policy of promoting integration between Hong Kong with the Pearl River Delta Area.
We commend that the government commits not to introduce a Goods and Services Tax for the near future, but we are not convinced that it is necessary to introduce such a tax in the long term. The reason is that the benefits of a Goods and Services Tax could easily be outweighed by the costs. For instance, one often mentioned benefit of a Goods and Services Tax is that it is broad based, which provides a stable source of revenues to the government. However, it is not only a stable, but also a convenient, source of revenues to the government. The availability of easy money undermines government's discipline in controlling expenditures. The higher expenditures are financed by higher taxes. A vicious cycle can easily develop. This explains why a Goods and Services Tax is additive. The consequence is that we probably will end up with a big government and a small market, contrary to the "big market, small government" principle laid down by Leung.
Gary Becker made a comment on keeping the currency board, a fixed exchange rate system, in Hong Kong at the end of last year.5 His general comment is that a flexible exchange rate is better if you trust the government; but if you don't, a fixed rate is superior. He then continued to say that Hong Kong should keep the currency board unchanged. We extend Becker's comment to a Goods and Services Tax. A Goods and Services tax should be introduced if you trust the government; but shouldn't if you don't. We think that a Goods and Services Tax should not be introduced in Hong Kong, unless the government can credibly commit not to abuse such a tax. It is necessary for the government to demonstrate that it can make such a credible commitment first.
Our analysis shows that Leung's 2003-04 Budget is an incredible proposal. We are not convinced that he can achieve the three targets for public finances in 2006-07. First, he is too optimistic about the medium-term economic recovery, especially deflation is underestimated and, consequently, the additional HK$30 billion revenue in 2006-07 via economic recovery is overestimated.
Second, his current revenue proposal is estimated to generate an additional HK$14 billion revenue in 2006-07, but he admits that the additional revenue he needs in 2006-07 is HK$20 billion. More important, we find it unjustified to ask salaries taxpayers to shoulder a higher burden than profits taxpayers for a problem primarily affecting the profits taxpayers. As a result, the standard rate should be kept at 15%. However, we are not arguing for a profits tax rate higher than 17.5% as proposed by Leung. Our point is that he has a difficult time to raise the additional HK$20 billion revenue in 2006-07.
The preceding analysis shows that the only way Leung can balance the book is to cut expenditures substantially more than $20 billion. However, he has too many constraints in cutting expenditures. He has already plan to push the civil service pay to the cash level at June 30, 1997, which is the limit allowed by the Basic Law. He has no choice but to cut the establishment of civil service to below 160,000 posts. However, he does not yet have the leverage due to Tung's no lay-off promise. In our opinion, he should convince Tung to retract the no lay-off promise. Otherwise, we do not see how he can achieve the three fiscal targets in 2006-07.
Ching, Stephen (2001), "Has the Budget Addressed the Deficit Problem?", Asia-Pacific Journal of Taxation, 5(1), pp.71-75.
¡X (2002), "The 2002-03 Budget: A Critical Review", Asia-Pacific Journal of Taxation, 6(1), pp.69-73.
Financial Secretary (2002), The 2002-03 Budget.
¡X (2003), The 2003-04 Budget.
1 This article was originally published in Asia-Pacific Journal of Taxation Vol. 7 No. 1 - Spring 2003, pp. 67-73. Permission to reprint the article in the HKCER Letters is gratefully acknowledged.
2 School of Economics & Finance and HIEBS, The University of Hong Kong, Pokfulam Road, Hong Kong; Tel: (852) 2859 2192, Fax: (852) 2548 1152, Email: firstname.lastname@example.org.
3 The 2002-03 deficit was revised to HK$61.7 billion at the end of April, but it has no material impact on our original argument.
4 This article will not discuss Leung's (lack of) integrity of not declaring the purchase of a Lexus LS430 prior to announcing the higher motor vehicle first registration tax.
5 The comment was made in a public lecture held at The University of Hong Kong on December 20, 2002.