Hong Kong Chief Executive Tung Chee hwa's (董建華) finance team indicated its intention to raise taxes. Justifying an increase in levies in the March budget, Financial Secretary Antony Leung (梁錦松) pointed out that the fiscal deficit is approaching a critical level. Three of the previous five budgets have been in deficit, and the next one is expected to exceed HK$70 billion (US$9 billion), 5 percent higher than the territory's GDP.
These persistent deficits are due in part to a rise in government spending to 23 percent of GDP. In previous years, spending equaled 20 percent of GDP. At the same time, declining assets and deflation caused reductions in these sources of tax revenues.
Most observers mistakenly believe there is ample room to raise taxes in Hong Kong. They support their argument by stating that business and individual income tax rates are set at 16 percent and 15 percent respectively. Yet most tax revenues are derived from levies on properties with inflated rent. Taking this into consideration, the effective rate of taxes is quite high.
Since global capital can move freely, especially towards the Pearl River Delta, this approach is very likely to backfire. Indeed, raising taxes might be the worst possible solution for balancing government books.
It turns out that the territory's government faces several constraints:
On the one hand, the Basic Law compels the government to attain fiscal balance.
On the other hand, Hong Kong's government is reluctant to finance its structural deficit problem with borrowing lest such borrowing should result in a rating downgrade, thus making it more difficult to attract foreign investors, which could lead to a rating downgrade on local businesses as a well, forcing them to pay higher interest rates for international loans.
Of course, a politically expedient approach would be to raise taxes on foreign companies operating in Hong Kong. Singapore could give Hong Kong a run for its money by reducing the overall tax burden to attract more foreign investors.
Most of the proponents of raising taxes ignore the availability of simpler alternatives that are easier to implement and that will yield quicker results. For example, the quickest method to generate more revenue is to privatize. More land and many of the large physical infrastructure projects, including the airport, could be put on the auction block.
Another money raiser would be civil service cutbacks. There are 180,000 civil servants, and an additional 170,000 employees work in government-funded agencies.
Meanwhile, most of the territory's income-tax revenue comes from less than 100,000 taxpayers. With pay to civil servants accounting for 70 percent of government spending, their salaries are higher than those of most people in the private sector.
Leung suggested that middle-class savers and salary earners should shoulder the burden of tax increases since their purchasing power is higher after four years of deflation. But that same logic suggests that civil servants should have their salaries reduced. In all the above cases, the tax base will be compromised and cause overall revenues to tumble.
So it appears that attempting to use higher taxes to reduce deficits is based upon faulty economic logic.
A better approach would be to stimulate entrepreneurship. Higher economic growth brought about by lower taxes will bring in more revenues even at lower tax rates. Meanwhile, lower marginal rates decrease the incentive to evade or avoid taxes.
As businesses expand, overall tax revenues would rise so that the budget deficit would be reduced. Calculations by Tim Condon of ING indicate that a 25 percent cut in profits and salaries tax would generate sufficient additional growth to pay for itself within five to 10 years.
Restoring Hong Kong's economy to a high-growth trajectory requires an implementation of policies that provide private entrepreneurs with incentives to take risks. A higher tax burden will reduce the number of job opportunities since it punishes success in private-sector actions and allows them to keep less of what they earn.
Instead, the territory's government should set a high priority on finding ways to reduce spending while raising revenues without increasing the overall tax burden. Otherwise there will be an accelerated exodus of capital from the territory.
Christopher Linge is professor of economics at Universidad Francisco Marroquin in Guatemala.
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