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The HKD22.4bn consolidated surplus is the first for the same period since theHand-over. When compared with the HKD45.2bn deficit recorded last year, the turnaround totals HKD67.6bn. This is mainly due to the performance of January that managed to reverse the tide. The Government produced a surplus of HKD25.2bn for the month by taking in HKD46.4bn in revenue and paying out HKD21.2bn in expenditure. Historically, January is known as a month with strong revenue because the majority of salaries tax and profits tax are collected during the month, with no exception even in those years with large deficits. Surplus has never been less than HKD10.0bn since the Hand-over. And amounts exceeding HKD20.0bn are the norm. In fact, the foundation had already been set before January for the fiscal turnaround.

Based on this latest information, we are revising our full year estimates. With a surplus of HKD22.4bn under the belt for the first ten months, the fiscal performance of February and March will be critical. Yet historical patterns for those two months yield little clue because large volatilities were recorded. Usually, a quarter of the remaining salaries tax can be paid during the two months. The stamp duty from stock and property transactions will also impact revenues. In the year 2000, there was a surplus of HKD31.7bn for the two months due to strong performances of both the stock and property markets. But in 2002, they fared miserably, resulting in a deficit of HKD22.8bn. Therefore it is believed that asset markets fluctuations contributed to the marked divergence in the past.

Thus, the implication for this year is that the Government could record consolidated surplus for February and March combined just as in the previous year. The average daily turnover of the stock market was HKD16.9bn in February. And the end of the Chinese New Year Holidays should result in even higher turnover in March. In the property market, the transaction value amounted to HKD29.0bn in February, and possibly breaking above the HKD30.0bn mark in March, boosting the stamp duty receipts accordingly. With land sale reaping an extra HKD1.8bn in February, it could push for a small surplus for those two months. Consequently, the full year consolidated surplus could reach HKD26.0bn. Even after deducting the HKD25.8bn proceeds form bond issuance, the Government could still be in the black, marking a turning point for the public finance.

What's Behind the Fiscal Turnaround?

Under such favorable circumstances, the Finance Secretary was reportedly saying that the surplus did not make writing the new Budget an easy task. Many factors are believed to contribute to such a dilemma. Firstly, the surplus is a great achievement given the HKD42.6bn deficit originally budgeted for the year, showcasing the favorable and sizable surprise resulted from the vibrant economic recovery. The IMF recently suggested moving the deadline of balancing the budget from 2008-09 back to the original 2006-07. But it is the growth prospects for the next several years that the Government has to ponder when assessing this option. Secondly, with a surplus, there are natural demands for the Government to "distribute sweets" and/or suspend or even rescind the previous tax increase decisions. To continue to implement its expenditure reduction plan requires greater resolve. Thirdly, challenges originating from policies aimed at helping the poor and needy, dealing with an aging population, reforming the retirement and medical insurance systems are not yet reflected in the current budget. And lastly, tax reform with a surplus at sight is likely to come under greater pressure.

Rigorous fiscal discipline mandates that the benchmark to fiscal health should lie in a Government's operating account. It is in this regard that the SAR Government still has its works cut out for it because it probably still registers an operating deficit even under a consolidated surplus. The Government's land related revenues include land premium, rates, property tax, and stamp duty, etc. The most important source of income is land premium, which is counted as capital or non-operating revenue. Against the HKD12.0bn originally budgeted, land sales alone this fiscal year has fetched HKD20.4bn. Even when using the conservative assumption of HKD6.7bn for premium from modification of existing leases, exchanges and extensions, total land premium could easily double the original estimates. Of course, special factors such as the resumption of land auctions after years of suspension contributed to such developments. And the HKD891mn land premium recorded in 2003-04 was not normal either. But whether receipts of more than HKD20.0bn from land premium can be fetched every year is controversial. Therefore, a neutral estimate of annual land premium should be around HKD16.0bn, suggesting that at least HKD10.0bn of this year's income is attributable to non-recurring circumstances, excluding which the operating account should still show a deficit of roughly the same amount. This argues that there is still room for improvement.

Furthermore, other asset markets besides the property market also contribute to the revenue's volatility. In the original Budget, investment income from the fiscal reverses was estimated at HKD10.0bn. According to the HKMA's information regarding the year 2004's investment performance, the actual amount could come in well above this estimate, assuming continuous weakness in the US dollar and strength in Hong Kong stocks. And stamp duty receipts from the stock market transaction could also rise in sync. This indicates that a great proportion of both the operating and capital revenues hinges upon the asset markets' performances, which could be volatile considering the stock market has rallied strongly two years in a row and the property market also surged by close to 30% on average last year. The botched attempt of the Link's listing adds great uncertainty to the Government's asset sales plan, possibly offsetting the above extra revenues. And the legal battle over the civil services' salary cuts may derail the original cost cutting plan. As a result, many challenges still lie ahead.

Nevertheless, the Government's efforts to curb expenditure should be praised. For the first ten months, total expenditure was down 1.5% YoY, the first decrease in four years. Against the backdrop of rapid economic growth, this significant achievement proves the resolve of the Government.

A Comprehensive Approach To the Budget

After taking into account all these aspects, expectations to the new Budget should be centered on striking a balance among the needs to deploy additional sources, implement the original expenditure reduction plan, study new ways to increase revenue, and take on the responsibility of and build a foundation for the long-term fiscal health. As current revenue sources are vulnerable to asset markets and investment income fluctuations, any measures to return wealth to the public have to be balanced against potential new spending such as helping the poor and providing incentives for child birth, etc. If the Budget can sustain economic prosperity, forestall the return of deflation, and facilitate nominal growth, then Hong Kong people will generally be better off than simply receiving "sweets" from the Budget.

Notwithstanding the difficulties, the Finance Secretary has consistently emphasized two principles of public finance: that operating expenditure should be covered by operating revenue, and that measures to reduce expenditure should precede those to increase revenue. The first principle is the benchmark for a truly healthy public finance that will remain the focal point of the market and rating agencies' attention, as well as a major determinant of Hong Kong's risk premium. As the operating account before investment income is likely to remain in deficit for the seventh year in a row, it is premature to declare victory.

Regarding spending cuts, the Government has delivered its promise to rein in total expenditure. The civil service force has been fine-tuned close to the targeted 160,000. The two-phase salary cuts, if fully implemented, can save up to HKD7.0bn each year. However, recent lawsuit over the salary cuts threatens the plan's execution. In the worst case scenario when the action has to be aborted or even rescinded, previous efforts could go in vain, resulting in a reversal of up to HKS14.0bn. And it could set a precedent, drawing more resistance against efforts to reform the social welfare and education systems. Supports for measures to increase revenue would also dwindle.

In the Finance Secretary's consultations on the Budget, concrete proposals are mainly on the revenue front including goods and services tax, estate duty, capital gains tax, worldwide tax, duty on alcoholic beverages, etc. This suggests that no major spending cuts are to be introduced. Regarding the new tax proposals, Hong Kong society has engaged in spirited debates. Any measures to increase revenue should take into consideration of the needs to broaden the tax base, stabilize revenue source, balance direct and indirect taxes, and reduce revenue's dependence on asset markets. The proposals all have their advantages and disadvantages. Making the hard choice will test the Government's wisdom.

As a timely reference, the Chairman of the US Federal Reserve Alan Greenspan's latest remarks to President Bush's tax reform commission is worth noticing. He basically states that taxing consumption instead of income would help promote economic growth because it could encourage savings and promote investments. As the transition would be challenging, a mixed system is the likely outcome. During the last fiscal year, Hong Kong's salaries tax and profits tax combined reached HKD74.5bn, accounting for more than half of the operating revenue. As Hong Kong does not tax capital gains, dividends and interest incomes, these two sources make up for the majority of the operating revenue. Under the global trend of gradual migration from direct tax to indirect tax, the Government's consideration of a goods and services tax has its own merits.

Last month, Singapore's Prime Minister and Finance Minister Lee Hsien Loong announced that he would lower the top personal income tax rate to 20% within two years, as he did to the company income tax rate before. The objective is to attract international investment as well as talents. The decision was made against the backdrop of public finance returning to balance one year ahead of schedule due to rising tax revenue from the fastest growth in four years. The Government's efforts to curb spending also helped make the cuts possible. Hong Kong was generally shocked by the news, even though its tax rates are still more competitive. For example, salaries tax rate is 16% and profits tax rate is 17.5% in Hong Kong, while they are 20% respectively in Singapore. However, few mentioned the role of Singapore's goods and services tax played in this decision. Singapore first introduced the GST on April 1, 1994 at 3%. At the beginning of 2003, the Singaporean Government planned to hike it up two percentage points to 5%. But due to the struggling economy at that time, the hike was implemented in two phases, namely at the beginning of 2003 and 2004 respectively. In Singapore, most goods except alcohol, tobacco and cars are imported tariff free, similar to Hong Kong. And the hike of the GST proves successful. In other words, the Government pays for the income tax cuts with the GST hikes. Otherwise, one still can’t cook a meal without rice. Therefore, the implication of Singapore's tax cuts to Hong Kong is not that we are losing our advantages in the tax regime, rather, even a revenue neutral transition from a system of direct tax to indirect tax can still help achieve the triple goals of facilitating economic growth, balancing the budget and increasing competitiveness.