Hong Kong's Fiscal Policy -- Look beyond the good times, by Jahangir Aziz, Division Chief, Asia and Pacific Department, and Paul Gruenwald, Resident Representative, Hong Kong Office, IMF

February 22, 2006

A Commentary
by Jahangir Aziz, Division Chief, Asia and Pacific Department
and Paul Gruenwald, Resident Representative, Hong Kong Office
International Monetary Fund
South China Morning Post
February 22, 2006

Hong Kong's budget will be unveiled today against the backdrop of strong growth and a vastly improved fiscal position. We are likely to see a surplus for the first time since 2000. This is a far cry from only a few years back, when many commentators were drafting the city's economic obituary.

Given this sharp turnaround, including the restoration of a balanced budget three years ahead of schedule, how should one now think about fiscal policy? There are many options—and many temptations—but the International Monetary Fund believes this is a good time to focus on Hong Kong's longer-term fiscal challenges, to position the economy for continued prosperity.

The city's fortunes have turned around remarkably since the depths of the Sars crisis in mid-2003. Gross domestic product growth reached 8.25 per cent in 2004 and more than 7 per cent last year, helped by a robust global expansion and strengthening integration with the mainland, including deeper financial co-operation and a surge in tourist arrivals. As a result of this rapid growth—together with commendable spending restraint by the government—fiscal performance has improved sharply. A deficit equal to 5 per cent of GDP in 2001-2002 and 2002-2003 was reduced to only 0.25 per cent of GDP in the 2004-2005 financial year.

The good news does not stop there. An improvement in public finances also provides additional confidence in the sustainability of the currency board system—which locks the value of the Hong Kong dollar to that of the US dollar—and assures markets of the predictability of Hong Kong's low-tax environment. Moreover, the growth outlook appears bright, and thus fiscal performance is likely to continue to improve. Is it therefore time to declare victory and loosen the purse strings? Before we can answer that question, we need to determine whether there are any looming fiscal challenges that could potentially cloud the current picture. In fact, there are.

Hong Kong's population will age quickly, and this has substantial fiscal consequences. First, IMF estimates indicate that by 2030, households' health-care costs could rise by 7 percentage points of GDP. Most of those costs will need to be met by higher public spending, under current policies. While 2030 appears quite far off, the pressures on the budget could start as early as 2015. Won't other expenditure need to be cut? Remember the Basic Law: the government must keep expenditure growth within GDP growth, and generally live within its means.

Second, population ageing will shrink the size of the workforce, and thus reduce the income tax base. It is estimated that by 2030 the proportion of the non-working population to the working population will double from its current level of 16 per cent and exceed those of other Asian countries.

Third, Hong Kong's revenue base is narrow and depends rather heavily on volatile government investment income and land sales (which provide roughly one-quarter of total revenue). There is a need to broaden the tax base and reduce reliance on such unstable income. Several options are proposed, including the introduction of a consumption tax.

This would make sense given that the population will be ageing and consumption, rather than income, is likely to provide greater stability as a tax base. While there is growing public pressure to reduce taxes, a cut without broadening the base would raise reliance on those volatile revenue sources.

Public policy would be much better served by fully and openly debating these matters in the context of formulating a longer-term budget strategy rather than speculating over how much taxes can be cut this year.

The temptation is to assume that the boom times will last forever and the task of preparing for longer-term challenges can be put off for another day. This assumption, more often than not, turns out to be wrong. Hong Kong should seize the opportunity provided by the good times. This year's budget is a good place to start.

Jahangir Aziz is the chief of the IMF's China division. Paul Gruenwald is the IMF's resident representative in Hong Kong.


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