After the issuance of the Consultation Document, "A Broader-based Tax System for Hong Kong?", public response has mainly been negative. Although not all of the criticisms are unreasonable, many are emotional reactions due to misunderstandings to the document. Since Hong Kong's tax system has become ill fitted to the transformed economic setting, in order to facilitate the reform of the tax system, replying rationally to the Consultation Document is deemed necessary.

Broad Consultation is not Inappropriate

It is certainly not a favourable moment to issue the Consultation Document at this stage. As global economic growth slows drastically, external momentum of the Hong Kong economy weakens significantly. Hong Kong's economic growth for the year is forecast to fall to around 2%. It is understandable that announcing the Consultation Document under such situation has induced criticisms. Nevertheless, since the document is only for consultation, it should not be considered inappropriate.

First, issuance of the Consultation Document is a routine procedure and is urgently needed. While submission of the report on the study of broadening Hong Kong's tax base has been scheduled at the end of 2001, it is necessary to conduct public consultation now, not to speak of the fact that the fiscal situation is also alarming: Investment return of the fiscal reserves and land sale revenue will fall short of the estimates widely.

Second, broad consultation will allow participation by the public. Reform of the tax system is a significant issue. Broad consultation can put into practice the spirit of relying on the people, widely listening to and absorbing public opinion.

Third, there is still a long time between consultation and actual implementation. According to an assessment by the IMF, due to the current limited custom and tax management of the Hong Kong SAR, it may take 3 years' time.

Reform may not necessarily mean to increase Tax

The sections on the suggestions on Increasing Revenue Productivity of Existing Taxes and Introduce New Taxes are the largest in the document. This may be misinterpreted as an intention to increase taxes, causing strong reactions. In fact, these suggestions are only for reference and comments, and not to be fully implemented.

Actually, according to the proposal by the consultant on Hong Kong's tax base, the main objective of broadening the tax base is not to increase tax revenue. The study considered that introducing general consumption tax is the most suitable for Hong Kong. The proposed tax rate is 3% and it is estimated to bring about annual revenue of 18 billion, which is equivalent to 1.5% of GDP. While introducing new taxes, other tax measures can be put forward according to three scenarios of Hong Kong's fiscal position. When additional revenue equivalent to 1-2% of GDP is required, revenue raised from the introduction of new taxes would be sufficient. When additional revenue equivalent to less than 1% of GDP is required, reduction of existing taxes would be made possible by the introduction of new taxes. When no additional revenue is required, possible reduction of taxes would even triple that in the second scenario.

Difficult to cut Spending

It cannot be denied that it is reasonable to ask the government to cut spending or simultaneously seek additional income sources. The reason is that rapid increase in public expenditure as well as the size of the public sector has been very notable. The fundamental driving force of such development, however, is that Hong Kong is moving towards a welfare society. Comparing 1999/00 with 1992/93, the share of broad social welfare expenditure (including social welfare, health care and housing) in total public expenditure increased substantially from 27.9% to 39%, and this does not include public housing construction and land price subsidies for the Home Ownership Scheme. Although critics have been warning against the rapid expansion of free lunch, with over-optimistic fiscal projections, public expenditure has already risen substantially beyond what is sufficient to care for people's basic needs. To cut expenditure, the most urgent and effective measure is to inhibit various free and low-priced services. Yet, as more and more people consider these their basic rights, together with vote-seeking politicians joining effort, more and more requests are coming up. Therefore, while it is reasonable to ask the government to cut expenditure and streamline, people should also stop raising unrealistic demands and impeding reforms.

No Way out without Reform

Amid Hong Kong's worsening fiscal situation, it is deemed necessary to reply to the consultation on broadening the tax base, which is a crucial step to restore Hong Kong's fiscal health.

1. Existing income sources do not match with the transforming economy

Economic activity is the basis of fiscal revenue. Since the 1990s, Hong Kong's economy has been supported by the real estate sector as well as the bubble created. Proceeds from land sale and property related revenue occupied over 60% of fiscal revenue at most. Currently, it is impossible as well as unadvisable for Hong Kong to follow the old track. Rather, Hong Kong has to foster economic transformation and develop high value-added industries. As the economy transforms, Hong Kong's revenue system has become out-dated. If it is to be maintained, with expenditure staying high, long-term deficit cannot be avoided.

2. Narrow tax base is odd against the international trend

Hong Kong's tax base is very narrow, as demonstrated in the consultancy report. The trend of Hong Kong's revenue composition also diverges from the international one. All OECD countries levy general consumption tax and treat it as a major source of revenue. Besides, they tend to stabilise the share of profits and income taxes, and lower that of property tax. Hong Kong, on the contrary, is the only jurisdiction that does not levy general consumption tax and raises the share of other taxes. A too narrow tax base would cause instability in fiscal revenue whereas divergence from the international trend would threaten Hong Kong's international competitiveness.

3. Debate on the appropriate level of reserves has reached a deadlock

Hong Kong is one of the few jurisdictions that maintain fiscal reserves. This ought to be admirable. Nevertheless, debate on the appropriate level of reserves has reached a deadlock in recent years. The government considers that the current level of reserves is appropriate and is particularly careful in the disposal of the reserves. Some critics, on the other hand, claim that the current level of reserves is too high and suggest to utilise them. Such debate has successively caused obstacles to the government. Should it persist, the government may have to trim construction expenditure and may not be able to restore fiscal balance throughout the medium range period.

The Best Option is to introduce General Consumption Tax

There should be no controversy about Hong Kong's need to broaden its tax base. Evaluating against the eight benchmarks of a good tax system and considering the urgency to broaden the tax base, introducing general consumption tax should be the best option among the various suggestions. In addition to broadening the tax base, introducing general consumption tax can tackle the aggravating unfair situation of utilising Hong Kong's facilities without falling into the tax net. Besides, it is a more stable source of revenue, less affected by economic cycles. Though it is regressive, the extent is minimal and can only marginally correct the current sole emphasis on vertical equity. Judging from the point of view that the resident has the obligation to pay tax or those obtaining benefits from Hong Kong should repay, it is necessary to make those originally out of the tax net pay some taxes. Moreover, being based on the amount of consumption, consumption tax is still equitable vertically. It will not threaten Hong Kong's competitiveness as zero tax rate will be applied to exports, tourists can apply for refund and Hong Kong's major competitors have already implemented consumption taxes. Furthermore, though it will push up prices, its impact will not be large as it will only be once and for all and inflation in the coming years would probably remain moderate.

When introducing general consumption tax in Hong Kong, the following characteristics and complementary measures should be incorporated.

Should general consumption tax be introduced simultaneously with reduction in income and property taxes, this reform would become part of the overall strategy to stimulate the economy. The essence behind the international trend of the above-mentioned tax system is to shift the tax base from income to consumption. Such development is an adaptation to the needs brought forth by globalisation. As globalisation increases the competition for capital and talents, tax burden becomes one of the major considerations for their domicile. For such reason, many countries have been reducing profits tax, income tax and property tax that directly affect investment, occupation and propensity to save, so as to stimulate investment, attract talents and boost initiative. Hong Kong's tax rate is still comparatively low, but is not particularly advantageous in attracting talents. Since Hong Kong does not grant tax credit to any sector, while all its neighbours provide such measures, it is difficult for Hong Kong to attract much high value-added new technology investment. With high income "penalised" by substantial tax burden, more and more people free from tax obligation and enjoying various welfare benefits, qualities such as perseverance, progressiveness and diligence have been repressed. Instead, people become more reliant on the government and often demand support from the society. The result is that labour quality deteriorates and talents become scarcer. These hamper the assembling of both capital and talents, and can be said to be the fundamental reason for Hong Kong's failure to make fast progress in economic transformation and running into difficulties amid deteriorating external environment. Under such circumstances, showing signs of shifting the tax base to consumption from income will make Hong Kong more attractive to capital and talents, and tackle the fundamental problem of the Hong Kong economy.

Introducing consumption tax may bring about short-term repercussions. Nevertheless, with proper administration and coordination, it will optimise Hong Kong's tax system and form a major part of the strategy to stimulate the economy, bringing forth good results beyond expectations. The most important is to treat the matter in a rational manner and seek the appropriate plan, so as to ensure a stable fiscal and tax system, favourable to long-term prosperity.