(This essay was published in Hong Kong Economic Journal on 12 March 2014)
The Financial Secretary has just presented his seventh Budget Speech to the Legislative Council. According to media reports, it is his least popular speech, presumably on account of the reduced amount of relief measures he has proposed this time around. Instead, he has chosen to alert the public to the structural fiscal deficit that the government could face as early as 2021/22 under the base case with historical enhancement.
Moreover, the accumulated fiscal reserves could be depleted as early as 2028/29 if nothing is done about the deficit under this same case. The Financial Secretary has urged the public to give their views on the way forward to address this challenge.
I believe that the Financial Secretary’s message that a structural fiscal deficit is coming is essentially correct. This deficit should be obvious to economists of any persuasion. His words are a refreshing voice in contrast to some of the populist, unthinking criticisms that have been leveled against this year’s Budget Speech and the Financial Secretary himself. Those are political sound bites that only make sense to the constituents that the critics hope to reach. They do not help us to understand the problems, but instead distract us from finding useful solutions to these problems. They are actually harmful to the economic and fiscal well-being of Hong Kong.
Emerging Structural Fiscal Deficits
Criticisms of the Financial Secretary fall into two broad categories. One is methodological. This argument alleges that his calculations are wrong and his forecasts of probable fiscal deficits in the last six budgets have all been wide off target, so his current forecasts of long term structural deficits cannot be trusted.
Another type of criticism is political in origin. When faced with fiscal deficits or structural fiscal deficits, there can still be different approaches as to how to tackle them. For instance, one could choose to (1) tighten fiscal expenditures, (2) increase fiscal revenues either by raising tax rates or widening the tax base, (3) grow the economy to increase tax revenues, (4) aim for a higher cost recovery rate on government provided services, (5) enter into deficit financing, (6) sell government assets, (7) manage government fiscal reserves to achieve a higher rate of return, or (8) some combination of the above. Note that deficit financing may require amending parts of the Basic Law that require the government to balance the fiscal budget.
These different approaches represent different views of what should be done and are necessarily political in nature because the benefits and costs of alternative approaches will be borne by different sectors of society. They are also economic in nature because they represent different views about the proper role of government in the economy. For example, should Hong Kong have a limited government or a bigger, more interventionist one for the good of the economy?
In the past two decades, criticisms of positive non-interventionism as the governing economic and budgetary philosophy of Hong Kong have increased considerably. Are these criticisms fair? The critiques claim that times and conditions have changed in Hong Kong and a government that sits back and does nothing is no longer adopting the appropriate policy for today.
Some people have argued that in the past three decades, income and wealth distribution have become more unequal so government must intervene to help the disadvantaged. Others believe that good economic opportunities are becoming less available for the typical young man and woman so the government must intervene to promote economic prosperity. What is at stake is whether Hong Kong should still remain essentially a free market economy. Without that, can we still have a free society?
A Tradition of Conservative Fiscal Budgeting
I shall address some of these issues in three essays. Since these questions are large and complex, I shall focus my comments on the long-term budgetary challenges of our government. My first essay this week shall describe the nature of the problem we are facing and why it is very massive and extremely long-lasting. My future essays will detail my quantitative projections of the scale of the problem ahead of us and a likely set of solutions if Hong Kong is to remain a free market economy and a free society.
First, the Financial Secretary has been accused of making repeated errors in forecasting the budget, in particular budget deficits that have persistently turned into surpluses. Is he so bad at making short-term annual forecasts? If so, how can he be trusted to make accurate long-term forecasts?
An economist knows that making accurate short-term forecasts are much more difficult than accurate long-term forecasts. And the reason is because fiscal revenues depend very much on macroeconomic activity. The latter is very volatile from year to year because of business cycle effects. Hong Kong is particularly sensitive to global macroeconomic business cycle conditions because it is a very open economy.
Long-term forecasts are much more accurate because the effects of business cycles tend to be averaged out in the long-run, therefore, we do not have to worry about short-term economic fluctuations. Long-term forecasts are driven primarily by two factors: (1) demographic factors, and (2) the economic productivity of the employed workforce. The trends in these factors are far less volatile and therefore easier to predict accurately compared to short-term macroeconomic business cycle fluctuations. For this reason, the long-term forecasts of the Working Group on Long-Term Fiscal Planning are far more reliable than the annual budget forecasts of the Financial Secretary.
It is interesting to note that since 1961 there have been altogether 53 realized budgets; of those a total of 40 have been surpluses and there have been only 13 deficits – all of them during severe business cycle downswings and 5 of them during the Asian Financial Crisis. Moreover 34 of these budgets were at first forecasted to have been deficits. What this track record tells us is that every Financial Secretary has been conservative in preparing their fiscal budgets, preferring to err on the side of forecasting deficits in order to exercise fiscal discipline to spend within the limits of resource availability.
Historically, then, Hong Kong has resisted the temptation to allow fiscal expenditures to rise over time, which has avoided the necessity of raising more taxes to pay for larger expenditures and obviated the need for budget deficits. Behind this budget philosophy is an economic philosophy that the economic pie will become larger for society if government is limited and markets are big and take the lead. Government is necessary but prone to making decisions out of political considerations rather than economic ones, and it is unavoidably wasteful and inefficient. People therefore benefit more from keeping governments limited and small. At the very least, they are able to spend more freely the income they have earned.
Four Major Rising Expenditures
A good way to understand our government’s fiscal budget is to think of its expenditure side as being composed of five major parts: housing, education, health, social welfare and other spending. Figure 1 presents the percentage shares of housing, education, health and social welfare in government or public expenditure in the period 1971-2015. It includes both recurrent and capital spending.
Figure 1: Percentage Shares of Housing, Education, Health and Social Welfare in Government or Public Expenditure, 1971/72-2014/15
Source : Hong Kong Yearbooks, Hong Kong Annual Digest of Statistics & The 2014/15 Budget
During this period, the total share of government spending on housing, education, health and social welfare has risen from 38.3% in the starting year of 1971/72 to 49.8% in the ending year of 2014/15 and is expected to continue to do so. Government spending on housing has not changed very much over this period from 6.1% to 5.8%. Education spending has fallen very modestly from 20.0% to 17.1%. Health care spending has risen considerably modestly from 10.4% to 12.9%. The most rapid increase is in social welfare expenditure rising from 1.9% to 14.1%.
A closer examination over the years shows that the increases have not always happened in a straight line or been maintained. The share of housing expenditure has experienced the greatest change over the years. It first rose from 6.1% in 1971/72 to a peak spending of 16.8% in 1999/2000 and then fell to a projected spending of 5.8% in 2014/15. I believe the decline in government spending on housing since 1999/2000 has reflected (1) a fear on the part of government that housing demand would be lethargic in the aftermath of the Asian Financial Crisis and the Financial Tsunami, and (2) the failure to foresee a new source of demographic-driven rapid growth in the demand for public housing due to family formation resulting from high and rising divorce and remarriage rates, especially among low-income families.
Housing expenditure will obviously be reversing its recent downward path in the future because of renewed effort by government to build more public sector housing units. Public concern that this will further add to rising government expenditure has surfaced recently. How public sector housing units should be financed is a matter that has to be addressed, otherwise it will obviously add to long-term fiscal deficits.
Education expenditure takes up the largest share of government spending, but in the past decade it has not grown at all, largely because of the decline in the population aged 0-24 (see Figure 2). This pattern will probably be reversed after 2020, according to demographic projections conducted by the Census and Statistics Department for the years up to 2041 and the United Nations up to 2100. The reversal is more apparent in the UN projected numbers. Furthermore, if we begin to enhance the standard of provision, the expenditure will rise further. For example, subsidized school spaces could be provided for (1) all pre-primary students and on a full-day basis, (2) all secondary school students up to completion of senior secondary level, and (3) associate degree places.
Figure 2: Actual and Projected Numbers and Average Annual Percentage Change of Young (aged 0-24) and Elderly Persons (aged 65+) in 1970-2100.
Source: UN Population Projection
The share of health expenditure has risen considerably and will rise even faster in future because of the rapid ageing of our population. The number of elderly above the age of 64 (see Figure 2) will increase rapidly in the coming decades, a pattern confirmed in both the Census and Statistics Department’s projections up to 2041 and the United Nation’s projections up to 2100.
The cost of health care is likely to rise further if government policy to train medical and health care professionals is not stepped up and the Hong Kong Medical Council continues its present practice of serving as a formidable barrier to the recruitment of foreign-trained doctors, including those who are Hong Kong residents.
Social welfare as a share of government expenditures has risen the most over time, in part because of growing demand from those with such needs – the disabled, the elderly without means, troubled teenagers, divorced individuals, drug addicts and so on. In addition, the politicization of society has increased the voice of organized advocacy groups to seek social welfare handouts from government as a means to gain political support. New policy initiatives currently in the works to help the working poor, coupled with the highly politicized demands for old age social pensions, all threaten to increase government expenditures even further.
In conclusion, housing, education, health and social welfare expenditures as a whole have risen from taking up one-third of government expenditures in 1971/72 to one-half today. Every single component of these expenditures can be safely predicted to rise further into the long-term future due to demographic and political forces. Will our economy be able to finance them without radical changes in how we raise revenues and fund these activities? And if we make radical changes, what will happen to our society? Will there be political consensus on the way forward? I shall begin to address these issues next week.
Report of the Working Group on Long-Term Fiscal Planning, Hong Kong SAR Government, March 2014
Twelfth essay in the series on Rekindling Hong Kong’s Magic