(This essay was published in Hong Kong Economic Journal on 15 March 2017.)
The last time I commented on the budget speech of the Financial Secretary was more than two decades ago. The principles governing the postwar Hong Kong budgetary framework have been highly predictable since the time of Cowperthwaite and Haddon-Cave so there is not much to say except to focus on minor blemishes and oversights. It is a fundamentally sound framework that respects liberty, fosters prosperity for the population, and need not be tempered with lightly out of ignorance or prejudice.
There is of course still room for some needed revisions to the budgetary framework. Since the 1980s, the world economy has become much more integrated and as a consequence, propertied asset values have increased significantly relative to income. Accordingly, the ratios used to govern fiscal revenues and expenditures and the balance between recurrent and capital accounts should be revisited.
The rise of asset prices relative to income, especially property prices in the major economic centers, was not, and probably could not have been, fully anticipated. As events have unfolded, there has been a belated recognition that economic inequality has widened in society.
In Hong Kong, the stewardship of the budget has come under increasing criticism for under-forecasting annual budget surpluses and under-spending on areas favored by the various interests. Large budget surpluses have long been an embarrassment for government, but they are a result of rapidly rising land sales and conversion values and the requirement of the Basic Law to balance budgets.
The assault leveled against the budget comes from both the right and left sides of the political spectrum. It comes from business associations, labor organizations, social activists, and all sorts of populist politicians and rent-seeking groups.
Some interests, for example, want government to help small- and medium-sized businesses to grow, and invest in education, technology and innovation. In these fields, government is called upon to lead the way to enable a new generation to meet the challenges of the 21st century and overcome sluggish economic growth. Other interests want government to redistribute income through tax reform, universal social pensions, and more public expenditures focused on the disadvantaged and less well off.
Moreover, the government’s ability to spend is sometimes also constrained by divisive politics in the legislature. Government budgetary initiatives are bogged down in partisan politics between the establishment and the opposition. Not all items of the budget can move forward even when they are in the common interest.
Underestimation of Land Revenues
One of the challenges in the government’s budgeting is estimating the surplus – something one can imagine other governments look upon with envy. John Tsang underestimated revenue compared to initial forecasts because of errors in forecasting land sales revenues. This year there is a surplus of HK$92.8 billion compared to an initial estimated surplus of HK$11 billion becausethe government collected over HK$60 billion more than it expected in land revenues.
Paul Chan has promised to more accurately project land revenues by basing the figure on the average proportion of land revenue to the city’s gross domestic product over the past 10 years – the resulting figure of 3.3 per cent of GDP is obviously a more aggressive forecast of future revenues compared to the assumption made by Tsang that was based on a lower average percentage derived from the average of the past 30 years.
But will the new updated formula for projecting future land revenues be more accurate?
If property prices were to continue to increase, then taking a 10-year average of the past would of course be more accurate than a 30-year average. But if prices were to peak and begin to decrease, then a 10-year average would appear more accurate around the turning point, but subsequently would increasingly over-predict land revenues. The problem is that we are making forecasts of what is ahead by looking at the rear mirror. This is a well-known phenomenon in forecasting.
There is no science for making accurate forecasts with quantitative easing in the background. Forecasting trends is easy, forecasting turning points more difficult. Tsang’s conservative approach would by the law of averages become more accurate as the end of the trend nears and starts to turn.
At the end of the day, every Financial Secretary has to decide whether he prefers to face the political cost of making positive errors or economic cost of committing negative ones. Tsang as a decision maker chose to err on the side of positive errors and is seen as a conservative. Chan has chosen to bet on forecasting lower positive errors. In the short run, it is a smart bet because it is not clear if he will serve beyond June 2017. If he does, then the chance of him forecasting negative errors will rise.
With hindsight, who would have confidently predicted property prices would continue to trend upwards after the 2008 financial crisis? And who would have confidently predicted property prices would refuse to turn even after the imposition of repeated punitive stamp duties by the current administration? With hindsight, we now know that quantitative easing, the wealth created by economic globalization, and technological progress have combined to propel the growth of property values in all major economic cities in the world.
Standard Logic of Conservative Budgeting
From 1945 to 2005, the world experienced growing prosperity and the triumph of free market ideas over government economic planning. In those sixty years, Hong Kong not only prospered economically but also became a shining beacon to the world of free market capitalism. It was the handmaiden that eased the entry of China into the global market economy.
No individual economic adviser of sound mind would counsel any Chief Executive to abandon lightly an economic policy and budgeting strategy that has worked for sixty years. But times have changed. Politics in Hong Kong is now more populist. Economic inequality in Hong Kong has increased due to rising property prices and growing relative wage inequality between skilled and unskilled workers. Ageing populations are putting increasing stress on health and social services. The voices of rent seekers demanding increasing government spending on housing, welfare, health, education, industry, environment and reviving agriculture are now louder than ever before.
Conservative budgeting is a strategy to hold down spending and to save for a rainy day. It is obviously more difficult to practice now. The intellectual high ground held by free markets and limited government that once existed has been partly tarnished by the onset of the world financial crisis of 2008.
The only defense the Financial Secretary now has is the constitutional constraint of the Basic Law requirement that budgets be balanced. His task has been rendered more difficult by the rapid appreciation of land values that has provided government with accelerating revenues from land sales and conversions. The underestimation of revenues has worsened.
Land values, however, reflect perceived future supply and demand conditions. There is a legitimate concern not to squander capital revenues on recurrent expenditures in case perceptions about the future were to rapidly change. The government would then be vulnerable to permanently increased recurrent expenditures but without a stable source of recurrent revenues (which would consequently breach the Basic Law).
Many have urged the government to broaden the tax base. But this is a cure that could be worse than the disease. First, it goes against the canons of small government and low taxes. Second, introducing new taxes was difficult even before the political system opened up. It is downright political suicide to do so now.
Economically a broad tax base is less distortionary because it can raise a fixed amount of tax revenues at a lower tax rate than with a narrow tax base. It is therefore more desirable on economic grounds. From a political economy point of view, a narrow tax base makes it more difficult to raise taxes as it generates more resistance from all taxed constituencies. A narrow tax base therefore fits the objective of a limited government keen on holding down public spending.
The difficulties with and hesitations about broadening the tax base have led the government to become increasingly dependent on less predictable land sales revenues on the capital account to fund expenditure growth. Rising land revenues on the capital account has made it easier for government to pour money into capital projects rather than to increase recurrent spending because. Not surprisingly, government receives a lot of flak for being biased towards white elephant projects from pressure groups that fail to be well funded.
The public is less familiar with the logic of budget reasoning. The government has not sought to defend itself in public. This has contributed to the wide perception that government uses a high land price policy to milk the public while dignifying its policy as a commitment to limited government. This is unfortunate and will continue to erode support for what is still a sound budgetary framework.
What to Review
The new Financial Secretary Paul Chan has proposed to set up a tax policy unit to review the revenue base. It may look at ways to create new taxes on top of the current major sources – profits and salaries taxes, stamp duty, and land sale revenue. This is a bold goal. Judging from the outcomes of past reviews, I am not optimistic that the current tax review exercise will get very far.
A more meaningful step would be to change how prices on new land sales and conversions are settled. At present, the full value has to be paid up at the outset. All paid-up land values are entered into the capital account. These land values are the capitalized values (or present values) of the future rentals from the property. At present, there is no property tax except for assessed rates based on the rental value of the property after completion (and a land tax for properties in the New Territories and other areas).
If government were to introduce a new “additional rates” assessed on the future rental values, then the paid-up value for new land would be lower. These new “additional rates” would only be applicable to those land sales and conversions that take place after it has been introduced. The government would receive less capital revenue currently and more recurrent revenue over the future. By deferring income received from land sales and conversions, the government would not only reduce its annual surplus, but also produce a more stable recurrent revenue stream to fund recurrent expenditure in a more transparent way.
The proposed arrangement does not introduce new taxes but merely changes the way in which revenues are collected. Instead of big lump sums today, it would produce steady flows in the future. It is conceivable that these new additional rates could be applicable for only a fixed period (say of 30 or 50 years). Rates can be easily collected using existing methods and it would also broaden the tax base.
Such a shift may lessen the political pressure to spend huge budget surpluses on capital projects. And it would indirectly precipitate more careful monitoring of project performance without overstretching the capacities of managers and overseers. It would also lead to more effective allocation of recurrent spending as budget transparency is enhanced. There would be less pressure to hide surpluses within all sorts of opaque development funds, future funds, and the rest.
The proposed arrangement to transform capital revenues into recurrent revenues would reduce the immediate values used to settle new land sales and conversions, but would not reduce their true prices since it merely defers part of the payment. This would be beneficial to end-users as it would improve and reduce the amount of initial down payment used for purchasing housing.
For government, it would improve the budgetary planning and management process without altering the deep budgetary framework. I am not the first person to propose this arrangement. But it is time that it be taken seriously for otherwise the sound budgetary framework of the past sixty years may be seriously at risk in today’s populist political environment. Still, any attempt to radically alter a deep budgetary framework will require political consensus to forestall political divisiveness. Tax reforms, after all, have toppled many bold governments when they least expect it.