Chapter 1
Government Spending and Revenue
(1.1) Size of the Government
The size of the government is an important factor affecting the prosperity of
an economy. In the literature, government size is often defined as the ratio of
government spending to GDP. If a government is too small, there may not be
enough resources to protect property rights, safeguard the law and so forth. The
long-term economic growth rate would then be negatively affected. On the other
hand, a big government means that resources are concentrated in the hands of
politicians or government bureaucrats who have little incentive to manage other
people’s money efficiently. This could also lower the long-term economic growth
rate. Barro (1990) shows that theoretically there is an optimal size of the
government, which maximizes the growth rate of the economy. However,
empirically, one observes that, when other factors are held constant, there is a
negative relationship between the long-run economic growth rate and government
size. The implication of this result is that most governments in the world seem to
have exceeded their respective optimal sizes.
Efficiency of HK Gov expenditure !!! (eg. Affordable education, $2 transportation fee for elderly)
Since Hong Kong does not have to pay for national defense and pay-as-yougo social security, which constitute two important components of government
spending in many countries, we should expect the size of its government to be
relatively small. Indeed, if we look at government consumption as a share of GDP,
it is just 12.7 percent in 2020, a value which is rather low by world standard.
However, a better measure for government size in the context of Hong Kong is
public expenditures as a share of GDP, which is substantially higher. “Public”
expenditures, in the context of the fiscal system in Hong Kong, include not only
“government” expenditures, but also those of subvention organizations supported
by the government. The most important example is the Housing Authority, which
supplies almost half of the housing in Hong Kong. The Authority gets land from
the government. In the past, it derived funding by using part of the free land to
build and sell apartments. Public expenditures include consumption, investment,
and transfer payments by the government and by subvention organizations. Thus,
in general, public expenditures are larger than government expenditures. Table 1.1
and Figure 1.1 present data on public expenditures/GDP from 1984 to 2021.
Table 1.1: Changing Size of the Government: Public Expenditures as
Percentage of GDP
Year
PE/GDP
1984
15.5
1985
16.0
1986
15.2
1987
14.0
1988
14.2
1989
15.5
1990
16.3
1991
15.6
1992
15.3
1993
16.7
Year
PE/GDP
1994
15.8
1995
17.1
1996
17.2
1997
17.2
1998
20.6
1999
21.3
2000
20.3
2001
20.4
2002
20.6
2003
22.0
Year
PE/GDP
2004
20.0
2005
17.7
2006
16.3
2007
15.3
2008
19.4
2009
18.5
2010
18.0
2011
19.9
2012
19.6
2013
21.4
Year
PE/GDP
2014
18.8
2015
19.3
2016
19.9
2017
19.3
2018
20.2
2019
21.6
2020
22.6
2021
26.6
Sources: Budget Speeches of the Financial Secretary, Hong Kong
Government, various years.
Figure 1.1: Public Expenditures/GDP
30
25
20
15
10
5
0
1980
1985
1990
1995
2000
2005
2010
2015
2020
2025
As can be seen from Table 1.1, there had been substantial increase in the size
of the Hong Kong government from the mid-1980s to 2003. In 1987, public
expenditures/GDP was 14 percent, but in 2003, it was 22 percent. This represents a
57 percent increase in the size of the government. Since 2003, the government has
made major efforts to control expenditures. Partly because GDP has gone up
significantly, public expenditures as a share of GDP has declined to 15.3 percent in
2007, and was expected to stablize at that level for several years. However, the
unprecedented budget surplus for the 2007/08 fiscal year had induced the
government to spend more money. Moreover, the slightly counter-cyclical policy
subsequent to the financial crisis continued to maintain the level at the 19-to-21percent range. Has government size moved closer to or farther away from the
optimal level? The limited information available would not permit us to arrive at a
definite answer. However, the slower average GDP growth rate since the 1990s
does not lend support to the claim that increasing the government size would help
the economy.
(5.2) Expenditures Going Up Faster Than Revenues?
The Basic Law, or the mini constitution of Hong Kong, stipulates some
conditions of small government and fiscal prudence that the Government must
honor. Article 107 of the Basic Law says:
(a) follow the principle of keeping expenditure within the limit of
revenue in drawing up the budget;
(b) strive to achieve a fiscal balance, avoid deficits; and
(c) keep the budget commensurate with the growth rate of the GDP.
Furthermore, Article 108 states:
“…..The Hong Kong Special Administrative Region shall, taking the low tax
policy previously pursued in Hong Kong as reference, enact laws on its own
concerning types of taxes, tax rates, tax reductions, allowances and exemptions,
and other matters of taxation.” 1
Government expenditures and revenues are often driven by political forces
with no regard to the Basic Law. It is therefore healthy for the Government to
regularly review whether it has deviated from what the Basic Law requires. In
2013, the Financial Secretary appointed some government officials and lay
members to form a “Working Group on Long-Term Fiscal Planning” to study this
problem. The Working Group issued the first report in March 2014. It shows that
up to 2013, expenditures have been going up much faster than revenues and GDP.
It further warns that large fiscal deficits and debts will likely appear in the future if
the Government does not address the problem as soon as possible.
Sources: Data from 1997 to 2012 are from HKSAR Government, Report of the Working Group
on Long-term Fiscal Planning, March 2014. Data since 2013 are updated from the Annual Digest
of Statistics 2021 and from the 2021 Budget Speech of the Financial Secretary.
The phrase “taking the low tax policy previously pursued in Hong Kong as reference” is the
official translation of “參照原在香港實行的低稅政策” in the original Chinese version. An
alternative translation that seems to better capture the original intention is “following the model
of the low tax policy previously pursued in Hong Kong”.
1
Figure 1.2 (and the Table attached to it) plots the cumulative growth rates of
total government expenditure, total government revenue and nominal GDP from
the fiscal year of 1997-98 to 2020-21. As we can see, during this period,
government expenditure had gone up by a total of 319.9%, but nominal GDP had
only increased by 95.8%. This means that government expenditure had gone up
much faster than nominal GDP. The cumulative growth of revenue is 107.5%,
which is roughly in line with GDP growth.
One may argue that this comparison is not entirely fair because the result
may be affected by when the starting year is. There is some truth in this criticism,
but it must be examined carefully. Table 1.2 presents the cumulative growth rates
of these variables starting from 1993-94, 1998-99, and 2008-09, respectively, with
ending period in 2017-18.
Table 1.2: Cumulative Growth Rates from Different Years to 2017-18
Nominal GDP
growth
1993-94 to 2017-18
1998-99 to 2017-18
2008-09 to 2017-18
107.0%
117.3%
66.5%
Government
Revenue growth
Government
Expenditure
growth
120.4%
142.3%
186.8%
96.7%
95.8%
49.4%
Source: Based on data from Annual Digest of Statistics, various issues.
The results from Table 1.2 show that cumulative government expenditure
growth can indeed be lower than the corresponding growth rate in nominal GDP. It
can also be lower than the growth rate in government revenue. If we accept these
conclusions, then the problems implied by Figure 1.2 may be misguided. However,
we must ask the question on why the start year seems to matter.
In Figure 1.3, we compare the growth rates of government expenditure and
GDP. We can see that the former does not always exceed the latter. During the
sample period from the early 1990s to 2017, there were three episodes (1993-94,
2008-09, and 2008-09) when government expenditure growth far exceeded GDP
growth. During the other years, average growth rates of the two variables are not
significantly different. The analogy is that of two competing runners. They run at
similar speed most of the time, but one of them can run much faster in some short
periods. This would be sufficient for this runner to be well ahead of the other at the
very end. If we inadvertently ignore these short episodes and start measuring the
speeds only after the fast growth periods of government expenditure, then we
would miss the point.
(1.3) Effects of Population Aging on Fiscal Planning
Chapter 2 shows that Hong Kong has a serious problem of population aging.
One can reasonably assume that when the proportion of retired people in society
has become large, the government will have to spend much more on such items as
health care, social welfare, or housing. The more optimistic people may believe
that this is not a problem because the Government has large amount of fiscal
reserves and has fiscal surpluses in most of the years.
Indeed, as Figure 1.4 indicates, the Hong Kong Government possesses large
amounts of fiscal reserves. There was a big jump in fiscal reserves in 1997 because
the massive amount of land fund was incorporated into fiscal reserves in that year.
However, the several bad economic years due to the Asian Financial Crisis (199798), the bursting of the dotcom bubble and SARS had significantly depleted the
fiscal reserves. The Global Financial Crisis of 2008-09 did not do too much to the
fiscal situation. At the end of the 2017-18 fiscal year, total reserves amounted to
roughly HK$ 1,087.6 billion. It is hard to claim that in that year the fiscal health of
Hong Kong was in jeopardy.
The extent of the effect of population aging on fiscal sustainability should
not be based only on how big the initial reserve is. It depends critically on the
projected government expenditures and revenues of the future. The Working
Group had studied the financial implications of aging on education, social welfare,
healthcare, infra-structure (which includes such items as construction of new
hospitals, facilities for old people and environmental protection), pension of civil
servants, and other minor items. After making some assumptions on the future
growth of the macro-economy, it further considers 4 scenarios. Here we shall
discuss only two extreme cases.
The first scenario assumes that the service provided by the Government
would remain at the current level, i.e., there would be no improvement in the future
at all. Any increases in expenditures would be due to population aging and
inflation. Average inflation from 2015 to 2041 is taken to be 3.1%. The second
scenario assumes that there would be service enhancement. The speed of quality
improvement would follow the historical trend of the period from 1997 to 2014.
Thus, expenditure increases are due to population aging, inflation and the
additional costs for improving service quality.
Table 1.3: Structural Deficit and Complete Depletion of Reserves
No enhancement of
government services
Service enhancement follows
historical trend of 1997-2014
Initial year when
Structural Deficit
Occurs
2029-30
Initial year of Complete
Depletion of Fiscal
Reserves
2041-42
2021-22
2028-29
Source: Report of the Working Group on Long-term Fiscal Planning
In the two scenarios depicted in Table 1.3, sustained fiscal deficit will
inevitably occur just as a matter of time. Before deficits appear, the Government
will continue to accumulate reserves. After that, the fiscal reserves will gradually
be depleted. If the Government simply follows what it had been doing from 1997
to 2014, all the reserves will be gone by the fiscal year of 2028-29. In case the
Government can control the expenditures rigorously, complete depletion will occur
as late as 2041-42. After the complete depletion year, the Government will be in
debt.
Table 1.4: Comparing the Outcomes of Two Scenarios in 2041-42
No enhancement of
government services
Service enhancement
follows historical
trend of 1997-2014
Government
expenditure
as share of
GDP (%)
23.9
Government
expenditure
(in billion
HKD)
1,700
Government
revenue as
share of
GDP (%)
19.8
Government
revenue (in
billion
HKD)
1,407
Government
debt (in
billion
HKD)
271
41.5
2,949
19.8
1,407
10,965
Table 1.4 shows that under the second scenario, government debt will
accumulate to close to 11 trillion HKD in current value by the end period of 204142. This is an astronomically high value and must be avoided. Also note that
government revenue is constrained at 19.8% of GDP. This assumption is consistent
with the requirements of the Basic Law. The two scenarios above represent two
opposite but extreme situations. It is of course possible to have immediate
scenarios between these two.
The results discussed above indicate that the financial implications of an
aging society are very serious. Since the proportion of old people will inevitably go
up, we cannot reduce cost through this route. The alternative is to use government
resources more efficiently. Since there are a number of years before the reserves
are used up, the Government has the option of investing part of these in high-return
high-risk assets with longer terms of maturity. This is what the Working Group’s
second report has recommended.
(1.4) Composition of Expenditures and Revenues
The Hong Kong Government regularly classifies public expenditures into 10
policy areas. Table 1.5 depicts the shares of these policy areas. Although their
relative sizes change over time, education has usually been the largest. During the
fiscal year of 2017-18, it was 17.4% of total public expenditures. It was followed
by expenditures in infrastructure, which occupied 17.0% of the total. Welfare had
the fastest growth, increasing from 5.8% in 1991-92 to 13.8% in 2017-18. Figure
1.5 also shows that welfare has the steepest increase over time, while housing, and
community and external affairs have the largest declines.
Table 1.5: Public Expeditures by Policy Functions
199192 (%)
199798 (%)
200708 (%)
Education
18.0
20.0
21.5
12.6
108011
Support
13.6
12.9
12.5
23.4
201682
Health
10.0
11.9
13.1
11.4
98308
Welfare
5.8
9.3
13.6
11.6
100066
Housing
11.6
10.5
5.9
4.2
36005
Security
13.5
10.1
11.0
7.5
64609
Infrastructure
13.3
9.1
9.0
9.0
77575
Economic
5.4
7.6
5.5
13.5
116002
Environment & Food
2.5
3.0
4.7
4.1
35129
Community & External Affairs
6.3
5.6
3.2
2.6
22749
100.0
100.0
100.0
100.0
860136
Total
202021 (%)
2020-21
(million)
Sources: Annual Digest of Statistics, various years, and 2021 Budget Speech of the Financial
Secretary.
Figure 1.5: Shares of Public Expenditures by Policy Functions
Civil servants, volunteers for administrative work/vaccination
Another outstanding problem of government revenue is that the tax base is
generally regarded as narrow. Table 1.6 shows the composition of the officially
estimated revenues for 2020-21. Profits and salaries taxes together constitute a
large fraction of total revenues.
Table 1.6: Composition of Estimated Government Revenues 2020-21
Profits Tax
Salaries Tax
Stamp Duties
Land Premium
Investment Income
Other Income
Total
$130.9B
$59.9B
$75.0B
$118.0B
$57.0B
$131.7B
$572.5B
22.9%
10.5%
13.1%
20.6%
9.9%
23.0%
100%
Source: Budget Speech of the Financial Secretary 2021, Hong Kong
From Table 1.7, we can see that in 2015-16, 66.9% of the profits tax come
from the top 1,000 companies (1.0% of the total number of registered companies).
This problem is also prominent in salaries tax. In Table 1.8, it can be inferred that
in 2015-16, 5% of the working population paid for more than 60% of the entire
salaries tax. Out of the 3.77 million people in the working population, only 1.85
million (49.1%) were paying. The fact that so many people do not have to pay
salaries tax may have political implications. Economic theory of moral hazard tells
us that those not paying may favor further expansion in government spending since
the resulting financial burden would only be borne by others.
Table 1.7: Distribution of Profits-Tax Payers 2015-16
Assessable profits
>100M
No. of corporations
% of total profits tax yield
1,000 (1.0%)
66..9%
$50M to 100M
800 (0.8%)
7.6%
$30M to $50M
1,100 (1.1%)
5.2%
$20M to $30M
1,200 (1.2%)
3.8%
$10M to $20M
3,000 (2.9%)
5.4%
$7.5M to $10M
1,700 (1.6%)
1.8%
$5M to $7.5M
3,000 (2.9%)
2.3%
$3M to $5M
4,800 (4.6%)
2.3%
$2M to $3M
4,700 (4.5%)
1.4%
$1M to $2M
10,500 (10.1%)
1.7%
$0.5M to $1M
12,500 (12.0%)
1.0%
$1 to 0.5M
59,500 (57.3%)
0.6%
Table 1.8: Distribution of Salaries Taxpayers 2015-16
Tax-Paying Population = 1,852,000 = 49.1% of Working Population of 3,774,000.
Annual Income ($)
>2,000,000
1,000,001 to 2,000,000
700,001 to 1,000,000
500,001 to 700,000
400,001 to 500,000
300,001 to 400,000
200,001 to 300,000
108,001 to 200,000
Number of Taxpayers % of total salaries tax yield
44,000 (2.4%)
46.9%
107,000 (5.7%)
25.8%
138,000 (7.5%)
13.0%
228,000 (12.3%)
8.3%
206,000 (11.1%)
3.0%
300,000 (16.2%)
1.8%
427,000 (23.1%)
1.0%
402,000 (21.7%)
0.2%
Source for Table 1.7 and Table 1.8: Information Pack for the Budget Speech of the Financial
Secretary, January 2018, Hong Kong SAR Government.
The moral hazard problem caused by the narrow tax base may be partly
mitigated by broadening the latter. If a major new tax, such as the sales tax,
(officially called the goods and services tax), were introduced, the proceeds could
be substantial enough to eliminate possible budget deficits in the short run.
However, since the government would then have a new source of revenue, lobby
groups in society might find it convenient to pressure the government to spend
even more. Eventually, budget deficit might emerge again.
The government may deal with this criticism by making the sales tax
“revenue-neutral,” in the sense that the rates for other taxes can be reduced so as to
compensate for the new burden due to the sales tax. Can such a policy work?
Introducing a major new tax like that of the sales tax is politically difficult.
However, gradually increasing the rates of some taxes is much easier. Even though
the sales tax may indeed be “revenue-neutral” in the beginning, there is no
guarantee that the rates of other taxes will not be raised back to the old levels later.
Whether this would happen or not depends on how politically powerful the lobby
groups are.
There is another category of assets controlled by the Financial Secretary that
is often over-looked. Throughout the years, the Exchange Fund has made profits
from its investments. The accumulation of these profits builds up the fund equity
on the balance sheet of the Exchange Fund. In December 2021, this amount was
HK$ 0.7889 trillion. The Financial Secretary has full authority to make use of this
money if he wants to. Thus, when needed, the Financial Secretary has the legal
power to spend the sum of fiscal reserves and the fund equity, which, at the end of
2021, amounted to HK$ 1.7668 trillion.
Existence of sales tax increases implicit cost
—> Incentive to cheat: not reporting income/profits honestly to authorities