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Fading Hope for Fiscal Responsibility

The HKSAR Government is facing its sixth straight -- and largest -- budget deficit, writes DAVID O'REAR

The government's formula for rebalancing the budget is a three-legged stool: increase revenue, help the economy and cut spending. In recent months, however, there seems to be an increased emphasis on economic growth as the main pillar of support, followed by increased revenues. The largely unspoken assumption is that this is now a two-legged stool -- that spending cuts are ill-advised at this time -- and that is dangerous.

Certainly, given enough growth and only a very mild glance at expenditures, the budget would eventually balance. However, the pattern of the recent past suggests that the assumed 3.5 percent per year economic growth will be insufficient to bring revenues up to the level of expenditures.

The first graph shows that even double-digit economic growth (in nominal terms) failed to increase fiscal revenues. Moreover, it also illustrates how spending continued to grow as revenues shrank. Comments from the Chief Executive and Financial Secretary suggest that there is little likelihood of any significant action to rebalance the budget this year, and perhaps not next year either.

The revenue side is just about tapped out. The extremely narrow tax base cannot sustain further tax increases without losing taxpayers to other business centers. As shown in the second graph, the salaries tax base -- the number of people actually paying tax -- has been narrowing for some time, declining 9.2 percent in the 2002-03 fiscal year. In 1997-98, some 20.5 percent of the population paid some salaries tax; last year, it was just 16.2 percent. Moreover, the average tax paid has increased, by 9.5 percent in 2001-02 and a further 10.8 percent in 2002-03.

When times are good, revenue collection rises. Companies earn higher profits and employees get raises and bonuses. Over the past several years, of course, the reverse has been true, and so in 2002-03 the combined profits and salaries tax revenue dropped 8.5 percent. Add the suspension of land sales and generally poor equities market, and total income has come down sharply. Three years ago, revenues averaged HK$14.4 billion a month, but in the first eight months of the last two (2002-03 and 2003-04) fiscal years, monthly revenues averaged just HK$10.8 billion.

In the two years after the handover, the government's huge fiscal reserves provided earnings of nearly HK$40 billion a year, money that went straight into the operating revenues. Today, with extremely low interest rates we'd be lucky to get one-quarter of that amount, and the further the reserves fall, the less we'll earn. On this basis -- reduced profits and sales tax revenue, unreliable income from property and the stock market and sharply lower earnings on the dwindling fiscal reserves, a back-of-the-envelope calculation points to insufficient revenues for as far as the eye can see.

Does it really matter? After all, the economy is still very weak and trying to rebalance the budget too quickly runs the risk of pushing us back into recession. In fact, economic theory says that governments should run budget deficits when the economy is weak, and surpluses when it is strong.

We certainly ran large surpluses back in the 1990s, when nominal growth was near double digits. However, what we didn't do was to cut spending, which in that decade rose four percentage points faster than economic expansion.

Today, our past largess is rapidly becoming a severe problem. In October, the Financial Secretary told Legco he anticipated operating expenditure in 2003-04 to be about HK$218 billion, or more than 8 percent higher than in the previous year. Revenues, however, would be nearly 15 percent higher, at HK$155 billion.

The gap is still HK$5 billion a month, or close enough for the FS' rough calculations. Extrapolating from his targeted HK$200 billion in both spending and revenues in 2008-09, reserves would fall to only about 10-11 months worth of spending in the second half of the decade. These assumptions put us in a dangerous position, and not only because past forecasts have been erring on the side of too rosy revenues and too conservative spending.

Several years ago, the level of reserves deemed adequate was defined as an amount equal to about two year's worth of government spending. This was broken down into funds needed to cover seasonal cash flow (three months' spending), money saved for a rainy day (nine months' worth) and an amount held in the Exchange Fund, to help ensure the stability of the peg (about one year's spending at the time). That last amount was said to be equal to the level of the M-1 money supply, plus or minus 25 percent.

Unless the formula for gauging the level needed has changed, the latest figures show that our reserves are inadequate. We have enough to either cover cash flow and contingencies, or to maintain sufficient deposits with the Exchange Fund, but not both.

What is most worrying is that past projections of the level of fiscal reserves have been poor, as shown in the last graph. While that may not have been a big problem when reserves were more than adequate, we now have very little room for error.

David O'Rear is the Chamber's Chief Economist. He can be reached at david@chamber.org.hk