Investing in Our Competitiveness

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The inaugural column is a tour de force that delivers on environment, education, and real estate. In short: competitiveness. And then tax, tax and tax and our favourite rival Singapore – are they stealing a march on us?

Photo Credits: Chris Lusher

The Hong Kong economy is largely driven by external events over which we have little or no control. Interest rates, volumes of trade, tourism arrivals and stock market listings are largely decided elsewhere. Since we can’t control these factors, we should put our efforts into areas where our actions will have the desired impact.

Top of the list is the environment in which we live and operate. After years of excuses about cross-border air pollution, it is gratifying to see the Government directly dealing with our own emissions. We’re moving in the right direction here, so let’s move on to the next item on the list, which is labour.

Hong Kong is a small society compared to our competitors. We don’t have large pools of high quality labour, nor sufficiently well-paid work for those who do not, for one reason or another, obtain higher professional or academic qualifications. So, we need to be start-up friendly and to attract and retain the people we need. One of the areas where we haven’t done well enough is in ensuring that the children of nonlocal families are able to continue in an appropriate education structure. We’re now making more space available for international schools, which will eventually contribute to our competitive advantage.

Third on the list, and a challenge we share with New York and London, is the cost of doing business. There are several components involved, some of which we manage very well and others where we need to do better. Our regulatory environment, for example, is globally recognized as one of the most user-friendly. We regulate where we
should, and generally avoid pushing piles of paperwork on to the desks of busy leaders.

Still, we are an expensive place in which to operate. Our office, residential and retail space is limited and among the most costly in the world. The Chief Executive’s proposals to build additional housing, and longer term plans for creating one or more new core business districts will pay off over the next decade or more.

In the environment, education and real estate, we are putting in place the foundations that will enhance and improve our desire to be Asia’s global business and financial centre. We might have stepped up our efforts earlier, and now be enjoying the fruits of our investments, but there’s no use crying over spilled milk. The benefits will come, eventually.

In the meantime, we are losing the edge we once had. A decade or more ago, we were known for our astonishingly attractive tax rates, and our closest competitors had to sit up and take notice. Today, they are neck-and-neck with us. Moreover, they have also improved on their other competitive characteristics as mentioned above, and as a result we are beginning to look a bit long in the tooth. Fortunately, this is something we are well equipped to handle. All we need is the will power.

The IMF’s latest World Economic Outlook contains a wealth of data stretching back decades and covering most significant economies. It provides a useful benchmark of how well we’ve kept up with the competition over the years.

Throughout the 1990s and 2000s, Hong Kong’s tax policies extracted an average of 17% of GDP for the public purse. There were exceptions, notably in 2007 (22.2%), but the pattern was remarkably consistent. For Singapore, however, revenue extraction averaged 31.4% of GDP in 1990-2001, and 21.9% thereafter.

To put that in perspective, we here in Hong Kong went from taking half as much out of our economy as Singapore in the 1990s, to taking one-third less in the 2000s, and according to the IMF, an mere 6.6 percentage points less in this decade.

In other words, we’re rapidly losing ground. Part of the reason is that we have narrow and highly cyclical sources of revenue. But, by continuing to take large sums out of the economy, in good times and bad, and lock them away in our fiscal reserves and other funds, we have made a conscious decision not to invest in our competitiveness.

One reason Singapore was able to reduce the government’s share of the economy is that they strengthened the predictability of their revenue sources by broadening its tax base. This has allowed them to successfully challenge our status as Asia’s premier low-tax environment. It has given Singapore the means to reduce their profits tax rates without running the risk of incurring large fiscal deficits. And, it has given them the opportunity to charge a lower tax rate on the initial profits a company earns, so as to encourage and facilitate smaller enterprises.

For a myriad of reasons well known to HT readers, we have chosen not to expand our salaries tax network beyond 20% of the population. We have chosen not to apply a broad goods and services tax. We have chosen not to reduce our profits tax rates to competitive levels, and we have chosen to apply the same tax rate to the first dollar of profit as we do to the last.

On the corporate profits tax side, Singapore now charges a 17% profits tax, as compared to our own 16.5% rate. But, Singapore, which was already a serious competitor in the last century, has managed to reduce their rates by a full 10 percentage points while ours has been largely unchanged.

Further, Singapore found that inserting a couple of dozen words into the revenue ordinance boosted their ability to attract and keep corporate taxpayers. This was achieved by adopting the widely accepted practice of allowing group loss relief and loss carryback provisions. Group loss relief means that corporate groups openly declare and transfer a loss incurred in one company to another, profitmaking venture. Without such provisions, the same result would require shifting transactions around, and doing so with less transparency. Such provisions, and lower taxes on initial earnings are some of the main reasons the World Bank calculates Singapore’s profits tax rate at an effective 6% rate, and our own at 17.6%.

The second major innovation we’ve missed is loss carry-back. Companies that are able to carry the loss from one year back to previous tax years have lower effective tax rates than those who do not. Their cash flow improves, the cost of doing business comes down and they are encouraged to continue expanding where they are, rather than seek tax advantages elsewhere.

The third significant change we need is to charge a lower, say 10% tax rate on the first tranche of profits. This is not rocket science, and to maintain our “low and simple tax regime,” we need not differentiate between large and small companies. Taxing the first $2 million at a lower rate would provide a major cash flow boost to smaller companies and those in temporary difficulties. Singapore does it; we do not.

What matters to business is less about what government spends money on and more about where the money comes from, how sustainable the sources of revenue are, and how the cost of complying with the tax authorities’ demands compare to alternative locations. In his latest budget, the FS said he expects to take revenues from the economy at a faster pace over the next five years than the nominal economic growth. Considering that we hold sufficient reserves in various accounts for anywhere from two to five years worth of operating expenditure, we really don’t need the money. And, since we were able to increase the fiscal reserves (alone, excluding other funds) by half over the last five years, there is obviously plenty of money available to handle the worst economic crisis in many decades.

We need to pay closer attention to what our competitors are doing, and to the overall cost of doing business. Taking unnecessarily large amounts of money out of the economy, particularly during times of deep financial stress, makes little sense. Rather, we should modernise our tax regime, rethink what we tax and by how much, and invest some of our overly large reserves in our own competitiveness.