Policy Statement & Submission

A SUBMISSION TO THE HONG KONG SAR FINANCIAL SECRETARY,
THE HON JOHN TSANG CHUN-WAH, ON THE GOVERNMENT'S BUDGET
FOR THE FISCAL YEAR 2008-09

(1 APRIL 2008 TO 31 MARCH 2009).

BUDGET SUBMISSION FOR THE 2008-09 FISCAL YEAR

“Acting to secure our future”

Our economy has grown nearly 7% per annum over the past four years, with a good balance of domestic and external drivers as well as consumption and investment. This pace is the fastest since 1987-90, and should not be expected to remain constant over the next four years. While it is gratifying that unemployment is just half of what it was at the trough of the depression and prices have stabilized, there is considerable uncertainty in the outlook for demand in the world's largest markets. In recent years, government revenues increased very strongly and, as we enter into a period of what is likely to be softer demand, it is time to return to the taxpayers the money we will need to see us through the next turn in the business cycle.

We dare not risk a return to large recurrent deficits, and so it will be necessary to significantly curtail operational spending. At the same time, our international tax competitiveness is barely staying ahead of Singapore and other jurisdictions. To square this fiscal circle, our submission for the 2008/09 budget envisages a two-pronged approach that reduces both spending and tax revenues, for the betterment of our society as a whole.

The recovery since 2004 has papered over a number of shortcomings, allowing greater spending without specific revenue measures. As a result, we have lost sight of the structural necessities, most particularly our narrow tax base and competitive positioning. Government appears to have stopped trying to control spending, despite the still overly large civil service. The trading funds remain in public hands, rather than being privatised. And, other business centres are more aggressively attacking our strategic position. As we move toward slower economic growth in 2008-12, we will face renewed pressure to deal with these issues before they get out of hand.

Our members tell us that they expect 2008 to be a more difficult year, and that they are less confident in Hong Kong's ability to remain confident. As the table below shows, early in the economic upswing members recognized improvements to our competitiveness. Last year, and again in our most recent survey, more believe competitiveness declined in the past year, and fewer believe it improved. We need to address this reality, right away.


Hong Kong's competitiveness over the past year
Surveys          Improved Declined Unchanged
2004 & 2005        28.3%        31.2%        39.9%
2006 & 2007        25.7%        35.1%        38.1%
May not equal 100% where some members did not answer the question.

And so, we take this opportunity to press for bold, strategic and competitiveness-enhancing steps toward securing our long term future prosperity:

- First, we ask for a commitment to reduce the Profits Tax rate to 15%.
- Second, we renew our long-standing call for immediate revisions to the Inland Revenue       Ordinance (IRO) to facilitate group loss relief and loss carry-back provisions.
- Third, we reiterate our belief that SMEs should be subject to a much simpler and lower tax       regime.
- Fourth, we look for a significant reversal of the rising cost of government.
- Fifth, we strongly urge that ways to broaden the tax base and secure future revenues continue       to be explored.

We recognize that not all measures included in this submission can be implemented in a single year, but we would ask that the most pressing – reducing the profits tax rate, implementing group loss relief and providing SMEs with a lower cost of compliance – be acted upon as soon as possible. For the steps to improve our competitiveness that cannot be implemented in 2008/09, we believe a firm commitment to act within a specific timeframe would go a long ways toward improving perceptions about our longer term competitiveness.

There are additional details in the appendix which, at the appropriate time should be considered for inclusion in the medium-term strategy. The five points mentioned in the previous paragraph, however, are the first steps to ensuring we have the wherewithal to remain the premier business and financial centre in the Asian half of the world.

The year 2007 is the fourth in a row of strong economic growth. The 6.1% real growth in the first three quarters is more due to consumption than is normal. While this has provided a comfortable cushion, the very volatile stock market, soaring property prices and prospects of a slow-down in external demand in the coming year combine to inject caution into our view of 2008. We are acutely aware that we have little control over the forces that determine if our economy grows well, grows slightly or fails to grow at all. Our only option is to pare back expenditure as far as possible, reduce public sector demands on the economy and give our businesses and our people the opportunity to weather the down-turns and capitalise on the upswings.

Financial Secretary, we need to reduce spending and broaden the tax base. And, we need to look to our international competitiveness as other countries in this region are so obviously doing. Extremely strong growth in the world economy has been very good to us in recent years, and we acknowledge our responsibility to the community. In inflationary times, lower income families are hit the hardest. We support government introducing one-off measures to provide a degree of relief. We also believe that the voice of the middle class should be thoroughly considered and balanced, in response to their significant contributions to Hong Kong's economic development. The Chief Executive has asked for business to respond to his call for greater corporate responsibility, and we are doing our part. However, we do need to see that government is also responding with measures that will ensure our immediate, and longer term competitiveness. Now is the time to act, before we are caught in the next turn of the business cycle.

Economic Outlook for the Coming Year

The Hong Kong General Chamber of Commerce forecasts slower growth in nominal GDP in the coming year, a modest rise in prices and modest improvements in employment and the unemployment rate. The specific figures are laid out in the table below.

OUR VIEW OF 2008

Calendar Year (% change)       2006    2007 (e)    2008 (f)
Nominal GDP growth                  +6.6     +8.0         +8.0
GDP Deflator                             -0.1      +2.0         +3.5
Real GDP growth                       +6.8     +6.5         +5.0
(e) estimate (f) HKGCC forecast

As the most globalized economy on earth, Hong Kong is highly vulnerable to the winds of change. The current global economic boom has lasted longer than anticipated, which suggests that when the down-turn comes, it may be deeper than expected. Already, there are signs of significantly slower growth in the US in 2008. Europe and the Mainland of China face strong currencies and high energy costs. As economies slow, and the US political season matures, we will see very rapidly increasing signs of protectionism, mainly focused on the strength of the renminbi. This has the potential to increase costs in Hong Kong, and so we must be prepared to do what we can to minimise the disruptions to our own economy.

It is clear that the renminbi will continue to appreciate against the US dollar for some time to come. As our own currency does not adjust, our prices must do so, easily and quickly. The deflationary era showed us the importance of being able to reduce the cost of doing business during hard times, and now as we enter a more inflationary period, we will need to increase our efficiency even more. October's seasonally adjusted inflation rate matched the fastest rise in prices in more than 11 years, and few observers believe the trend will not continue. Our members tell us that the two most pressing challenges they face are rising wages and rising rents, Continued economic growth in the OECD in recent years, despite very high oil prices, has shown oil producers that there is no need to reduce prices to the $20-30 per barrel rates that held sway for so long. Energy, it seems, will be expensive for many years to come.

For the sake of Hong Kong's competitiveness, we must act, now, to reduce the cost of doing business. We cannot delay, lest we lose our valuable edge just at the time when opportunities – and, yes, some threats – are at their greatest. We have postponed taking the necessary steps to reduce excess recurrent spending, guarantee revenues and improve our competitiveness. Now, we are in a situation where those same decisions are all the more urgent, yet the economic conditions under which we will have to act are less favourable.

Expenditure Matters

Our economy has grown 30-35% during the upswing in the current business cycle. This year, operating expenditure is forecast to rise more than 9%, to $214.2 billion, and under the former Financial Secretary's 2007/08 budget, spending would soar by more than $31 billion in the next four years. Clearly, this has to be reversed. Our narrow tax base gives us excess revenues during good times, and demands that we return the money to the taxpayers when times are hard. If we do not, our taxpayers are free to leave.

The famous 20% of GDP expenditure target masks the actual rise in spending as a share of the economy by including lumpy capital goods monies. Under closer scrutiny, we see that salaries and profits taxes combined paid for about 56% of operating expenditure in the 1990s, but in more recent years larger expenditures reduced that figure to as low as 35%. To return to the more sustainable level would require reducing spending by some 12-13%, assuming that the economy remains robust. A recession, as so many fear, would require even further reductions.

While the moderation in some years has been a welcome relief, the likely $100 billion surplus is far out of proportion to even the most prudent considerations. We can no longer depend on good luck to cover our excesses. Rather, we need to get our spending under control. Now, as the economy slows, that share of GDP figure will inevitably rise, perhaps sharply.

OPERATING EXPENDITURE

Fiscal Year                           2002/03   2003/04   2004/05   2005/06   2006/07*   2007/08*
Operating Expenditure $ bn       200.3       203.2     196.9        192.5      195.7        214.2
% change                               +0.8%     +1.5%     –3.1%       –2.3%    +1.7%      +9.4%
Nominal GDP % change #        –1.7%     –3.3%     +4.6%      +7.1%     +6.6%      +8.0%
Operating Expenditure / GDP    16.0%     16.7%     15.4%      13.9%     13.3%      13.5%
Change in fiscal reserves $ bn    -57.8       -57.0       -40.1       +20.6      +14.7       +58.6
* HKSAR Government forecasts # calendar year

We recall previous financial secretaries suggesting that even fiscal reserves covering just 12 months of operating expenditure might be sufficient, and others aiming for double that. While there may be no magic formula there is a need to ensure that we are not taking surplus from the economy at a time when doing so harms our longer term interests. Last year, we added more than $58 billion to the reserves and there is little prospect of less excessive income in the current fiscal year. While we favour strong reserves, taking more than $100 billion – perhaps much more – out of the economy in a two-year period is unwise.

The current strategy is to continue accumulating reserves in good times and spending the money when our overly narrow tax base again proves insufficient to generate the revenues needed on an annual basis. Absent unexpected shocks – such as the Asian Financial Crisis, SARS, depression, Avian Flu, external credit market shocks or wild swings in the equities markets – there is nothing inherently wrong with such a strategy. But, we do run into these shocks more often than not, which calls into question the basic assumptions.

It would be far safer, we believe, to broaden the tax base. We understand the political difficulties, and so at least temporarily we need to fall back on the second-best option: cutting operational expenses. The alternative, as we have noted, is to continue the steady deterioration of our competitive position vis--vis better structured alternative business centres. That, we find unacceptable.

Revenue Matters

Hong Kong's tax base will shrink next year, as it so regularly does when the economy slows. The Inland Revenue's latest annual report cites 1.24 million salaries taxpayers in 2004-05 (the latest data available), little more than 18% of the population and by far the smallest taxpayer-to-population ratio in the developed world

Those companies that choose to record profits here (and, we fully believe it is, to a large extent, a choice) compare us with alternative locations. They acknowledge that our headline rate is low, but not that low. They also are aware that the definition of what is taxable actually increases the overall burden beyond what they might pay elsewhere. This cannot be ignored.

As noted at the onset, we also have a number of suggestions for ensuring IRD consistency, increasing taxpayer certainty, enhancing compliance and reducing complexity. Together with some recommended concessions that will contribute to our international competitiveness, these are spelled out in detail in the Appendix.