Last week, Financial Secretary Paul Chan delivered the last Budget speech of his term at the height of the pandemic. In his expansionary budget, he announced counter-cyclical fiscal measures to the tune of $170bn, much higher than last year’s $120bn and one of the largest in Hong Kong’s history. If we include infrastructure and other spending, the whole package is expected to bolster the Covid-stricken economy by approximately 3 percentage points. The Financial Secretary projects Hong Kong GDP to grow by 2.0-3.5% for this financial year, while annual headline CPI inflation is expected to come in at 2.1%. For medium term growth, he expects GDP to grow by 3.0% annually between 2023-2026, the figure is higher than the previous trend growth assumption because it takes into account the anticipated catch-up growth post pandemic.
Looking at the budget for FY 2022-23, the government estimates total government revenue and expenditure to come in at $715.9bn and $807.3bn, respectively, resulting in a fiscal deficit of $91.4bn, equivalent to 3.1% of GDP. This fiscal gap or the borrowing requirement will likely be financed by issuance of Green Bonds and depletion of the fiscal reserves. Consequently, reserves are expected to fall to $890.3bn by the end of Mar-23, or 13 months of government expenditure from 16 months in the year before.
As usual, the budget comes with a revised estimates of figures for FY 2021-22. Revenue was revised sharply upwards (+15%), mainly due to higher than expected land premium and profit tax, while expenditure was revised lower (-4%) because of lower than expected operating expenditure during Covid. The result is that the anticipated fiscal deficit (excluding bond proceeds) was revised down precipitously from $136.7bn to just $16.2bn, a forecast error that had raised some eyebrows (no less than the cost of Nord Stream 2).
So far, the media has focused largely on the “sweeteners” i.e. the consumption vouchers and tax relief, but we think there are other underlying issues that need to be addressed in this Budget.
Concerns over forecasting errors
We think the forecast issues witnessed over the past few years were likely due to outdated forecasting infrastructure and philosophy at the FSO. For instance, the Office for Budget Responsibility (OBR) in the UK is transparent about their budget forecast methods, using the so-called Treasury model. The forecast for a variable like corporate tax was subdivided into three types of receipts and each has its own economic determinants and forecast judgements being applied upon the final econometric outcome, with manual adjustments going as detailed as companies’ behaviour on how they carry-forward losses. Looking at the Hong Kong Budget reveals the simplicity of how some of these projections are made1. Some may argue that this is the result of Hong Kong’s simple tax system and revenues and expenditures are volatile anyway, but we think it is important for the government to invest in good forecasting capability, particularly when Hong Kong is not an insignificant economy, the resources it mobilises to redistribute across economic sectors and social hierarchy are immense. With so much at stake, a misallocation because of inaccuracy of the forecast will have long term socio-economic implications. If the government wants to modernise its processes and economy as set out in this Budget, fixing this persistent forecast error may be something of a priority.
It is interesting to note that the Budget tends to overstate government expenditure and understate government revenue in its fiscal estimates. As a result, there is a positive bias to the fiscal balance estimates, as much as 5% of GDP at one point. In other words, the government is likely to have made a habit of underestimating surpluses and overestimating deficits.
Rapid rise in recurrent expenditure growth
There have been concerns over the rapid rise in recurrent expenditure in recent years. Indeed, recurrent spending has increased from just 12.3% of GDP a decade ago to an estimated 18.8% in FY 2022-23, rising at an annual rate of 7.2%, well above nominal GDP growth. At the same, government revenue only increased at an annual rate of c.4.5%. This is reflected in an accumulated operating deficit over the last ten years (FY 13-14 to FY 22-23) as opposed to an operating surplus in the period before (FY 03-04 to FY 12-13). It looks like that we are deviating from the Golden Rule set out in the Basic Law which says the budget should be commensurate with growth in the economy.
Taking a closer look reveals that most of the spending increase was seen in education, social welfare and health services, which now accounts for 60.6% of recurrent spending or 11.4% of GDP in FY 2022-23. This is unsurprising given rapidly aging population with more medical needs, higher welfare spending to bridge the ever-growing wealth gap and lastly, more investment in education adapting its workforce to the digital economy and to reduce inequality in the long run. With the underlying trend unlikely to change, its share in recurrent spending can only rise from here.
In addition to a credible cost-cutting programme which was suspended this year because of Covid, the government has already started looking for ways to make its processes more efficient by introducing I&T at all levels, and to explore new economic growth engines which can be revenue generating. They also reviewed the revenue side, raising the stamp duty on stock trading and introducing a progressive rating system for domestic properties which has a positive financial impact. However, this probably is not enough to avert a weakening of our public finances in the medium term. Moreover, the future income expected from the “top-up” tax levied on MNEs in association with the OECD global minimum tax reform is far from certain. With further financial commitments to the mega infrastructure projects (Artificial Island off Lantau & the Northern Metropolis) and the worsening demographics, a structural deficit in the future is not inconceivable if nothing more is done, not to forget the sizable statutory pension liability (c.$1 trillion) and green bonds issuance which is currently unfunded. In fact, bond repayments will start kicking in FY 2024-25 according to the medium term forecast in the budget.
There are a couple of suggestions. On the revenue side, we suggest the government to explore what it takes to widen Hong Kong’s tax base, it is far too narrow at the moment. Widening it can wean the city off revenues generated from land premiums and stamp duties, partly solving the intertwined housing problem, killing two birds in one stone. Consumption tax was examined years ago, but the discussion was dropped because of poor economic timing. The progressive tax has low administrative and economic costs, we think it can be tabled for discussion again when the time is ripe. Second, with the government recent experience with personal income tax relief2 the government could make personal income tax more progressive, the current tax brackets for high income earners are low vis-a-vis other financial centres.
Imbalanced economic development
Finding new growth engines can increase fiscal revenue. The report had its focus on developing the “new economy”, such as innovative and technology industries (I&T), including biotechnology where our strength lies, and of course, the financial industry.
The Financial Secretary spent a few paragraphs discussing the imbalanced development of the economy, raising financial industry as an example, suggesting that economic success is not being felt so broadly in the society. He also talked about the wages of younger generation with tertiary education, which are significantly lower because there are simply not enough high quality jobs for them. In fact, we have been reflecting a similar message to the government through different channels before, but we think the younger generation with lower education attainment is more of an issue.
We are a tad disappointed that the rest of the report goes straight to discussing the niche industries of I&T and financial services without addressing timely enough on these deep-rooted issues. Details of government initiatives about the new economy can be found in the section 3 below under the “Four main themes”.
On the surface, it seems the plan is to develop another growth engine that only few people would benefit from it. Re-industrialisation is considered as relatively more labour intensive, but it will take a long time to bear fruits. We believe the current continuing education scheme and other retraining initiatives such as the ERB are not sufficient (or too restrictive to enrol) to build a brighter future for the young and the unemployed. Moreover, the current education curriculum for primary, secondary and tertiary education has not prepared today’s student well for their future challenges. For instance, the range of courses on offer is a mismatch to the future economic structure proposed in this budget. This weakness in the education system is also reflected in the slower rate of increase in government expenditure over the past decade compared to health and social services.
As for the financial industry, the government may want to adopt policy to maximise local citizens’ opportunity to share economic success as said in the Budget. Many major financial centres, namely Singapore and Dubai, already have various immigration policies protecting local employment in finance. A company may need to hire a minimum number of local residents before hiring expatriates, and when they hire them, they need to prove that they cannot find talents locally. This will go a long way to ensure more high quality jobs for the younger generation.
What to do with the Brain-Drain?
In recent years, many expatriates, and locals had left Hong Kong because of social unrest and the adopted pandemic measures, with the trend was reportedly intensifying in recent months. The Budget did set out various talent or labour market measures, but none of the policies are designed to retain talents, this comes as a surprise because retaining talents is easier than attracting new ones, particularly in the current environment. Brain-drain is occurring in many key industries, including health services, finance, professional services etc… and its impact on the society is substantial, from student intakes for local and international schools to falling rents in prime areas. We believe the government can allocate more resources implementing talent retainment measures to stem the exodus.
Permanent housing for cage home residents
As Covid rages across the city, this Budget allocated $12bn for the construction of isolation camps dotted around the territory. At the time of writing, a combined capacity of 50,000 units will be ready in a matter of weeks. We believe it makes sense for the government to keep some of these facilities after the pandemic for poverty alleviation purposes, such as a permanent home for existing cage home (bedspace apartments) residents. Currently there are 5,000 individuals living in illegal cage housing in Hong Kong, licensed cage homers are in their thousands. Although this is one of the deeply ingrained problems that the government would like to eradicate by 2049, the obstacle remains that most of the land used were destined for other purposes or they were simply borrowed from the private sector.
Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.