Economics
Chapter 7
Exchange rate
Currencies
Major currencies
 USA: US Dollar [Code: USD; Sign: $]
 British: Pound sterling [Code: GBP; Sign: £]
 Europe: Euro [Code: EUR; Sign:€]
 China: Renminbi [Code: RMB; Sign: ¥]
 Hong Kong Dollar [Code: HKD; Sign: $]
 Japanese yen [Code: JPY; Sign: ¥]
Exchange rate
Exchange rate

the price at which two currencies are exchange

the price of a foreign currency in terms of
the local currency, or vice versa

convertibility rate
Exchange rate
Expression (assume USD and HKD)
1.
The exchange rate of USD

US$ 1 can be converted into HK$ 7.8

HKD/USD = 7.8 / 1 = 7.8
Exchange rate
Expression (assume USD and HKD)
2.
The exchange rate of HKD

1
HK$ 1 can be converted into US$
7.8

1
USD/HKD =
7.8
Floating exchange rate



Exchange rate is
 Free-floating
 Depends on market demand and supply
Appreciation
 A rise in exchange rate
Depreciation
 A fall in exchange rate
Appreciation

USD Euro
Date
1 April 2011
1 May 2011


US$1 equals
€ 0.7
€ 0.8
The USD appreciates relative to the EUR
HKD JPY

Date
1 April 2011
HK$1 equals
¥10.40
1 May 2011
¥11.00
The HKD appreciates relative to the JPY
Depreciation

USD Euro


€1 equals
Date
1 April 2011
US$
1 May 2011
US$
1
=
0.7
1
=
0.8
US$1.43
US$1,25
The EUR depreciates relative to the USD
HKD JPY
Date
1 April 2011
1 May 2011

JP¥1 equals
1
HK$
= HK$0.096
10.40
1
HK$ = HK$0.091
11
The JPY depreciates relative to the HKD
Floating exchange rate
Appreciation:  exchange rate
Depreciation:  exchange rate
• There is only one exchange rate between two currencies.
• Appreciation of one currency = Depreciation of the other
Linked exchange rate system in HK
Since 1983

HKD linked with USD at a fixed exchange rate

Aim: To maintain stability of the exchange rate between
HKD and USD

Exchange rate: US$1:HK$7.75–7.85

Controlled by the HKSAR Gov’t (HKMA)
Brief history of linked exchange rates
system in HK:
History of Hong Kong's Exchange Rate System
•
Period
Exchange rate regime
1863–1935
Silver Standard
December 1935
Sterling exchange
–June 1972
July 1972
–November 1974
Fixed exchange rate
against the US dollar
November 1974
–October 1983
Free floating
1983–Present
Linked exchange rate
system
Features
Silver dollars as legal tender
•Standard exchange rate:£1:HK$16 (December 1935–
November 1967)
•£1:HK$14.55 (November 1967–June 1972)
•Exchange rate:US$1:HK$5.650 (June 1972–February 1973)
•US$1:HK$5.085 (February 1973–November 1974)
•Exchange rates on selected days:US$1:HK$4.965 (25
November 1974)
•US$1:HK$9.600 (24 September 1983)
•US$1:HK$7.80 (1983–1998)
(for issue and redemption of Certificates of Indebtedness)
•US$1:HK$7.75 (1998–2005)
(The HKMA undertakes to convert the HK dollars in licensed
banks’ clearing accounts maintained with the HKMA into US
dollars at the fixed exchange rate of HK$7.75 to US$1. The rate
has been moving to 7.80 by 1 pip each calendar day starting
from 1 April 1999 ending 12 August 2000.)
•US$1:HK$7.75–7.85 (May 2005 onwards)
HKMA set up upper and lower guaranteed limit since 18 May
2005
Source: http://en.wikipedia.org/wiki/Hong_Kong_dollar
Linked exchange rate system in HK
Revaluation

Originally, HKMA fixed the rate at US$1:HK$7.8

If HKMA set the rate at US$1:HK$6
(meaning that less HK dollar can be bought by US$1)
(value of HK dollar increases)

 the rate of HKD against USD rises

The government re-pegs exchange rate at a higher level
Linked exchange rate system in HK
Devaluation

Originally, HKMA fixed the rate at US$1:HK$7.8

If HKMA set the rate at US$1:HK$9
(meaning that more HK dollar can be bought by US$1)
(value of HK dollar decreases)

 the rate of HKD against USD falls

The government re-pegs exchange rate at a lower level
Difference:
Exchange rate system
Floating
Fixed
Exchange rate is determined by
Market
Government
Increase
Appreciation
Revaluation
Decrease
Depreciation
Devaluation
USA
China
Exchange rate of
local currency
against foreign
currency
Example countries
Linked exchange rate system in HK
Strong reserves support

A currency board system

HK monetary base is support by USD

Maintain the exchange rate when issuing banknotes
Linked exchange rate system in HK
Operation
 The bank is going to issue $7,800,000 banknotes
 It needs to pay USD of equivalent value (US$ 1 : HK$7.8) to
HKMA to buy Certificate of Indebtedness [CIs] (負責證明書)
 As a support for banknotes issued
 In this case, the bank pays US$1 million to HKMA
US$ 1: HK$7.8
Certificates
of
Indebtedness
HKMA
* In reverse, banks return HKD & CIs to the HKMA and get back the USD.
Linked exchange rate system in HK
Exchange rates change with the USD
 Under the linked exchange rate system, the exchange rates of the HKD
against other foreign currencies change with the USD.

Date
US$1 equals
(EUR/USD)
US$1 equals
(Linked exchange
rate system,
HKD/USD)
1 April 2011
€ 0.7
HK$ 7.8
HK$ 0.7 = HK$11.14
1 May 2011
€ 0.8
HK$ 7.8
HK$
USD appreciates
against EUR
Fixed
Euro 1 equals
(HKD/EUR)
7.8
7.8
0.8
= HK$9.75
EUR depreciates against HKD,
(i.e. HKD appreciates against EUR)
 Against other currencies


if USD appreciation  HKD appreciation (against other currencies)
if USD depreciation  HKD depreciation (against other currencies)
HK people suffer from RMB appreciation
Exchange rates change with the USD
 RMB appreciates against USD
since 1994
 Since 2006, exchange rose quickly
 USD depreciation is faster
 HKD is linked to USD,
so HKD follows USD and
depreciates against RMB sharply
 Meaning that HK people needs to
pay more HKD to buy products from
the mainland
 Before that, HK people went shopping
in the mainland
 Nowadays, mainland visitor come to HK
for shopping
RMB annual average middle exchange
rate from USD and HKD
(1 foreign currency unit to RMB)
year
US dollar
HK dollar
1996
8.3142
1.07510
1997
8.2898
1.07090
1998
8.2791
1.06880
1999
8.2783
1.06660
2000
8.2784
1.06180
2001
8.2770
1.06080
2002
8.2770
1.06070
2003
8.2770
1.06240
2004
8.2768
1.06230
2005
8.1917
1.05300
2006
7.9718
1.02620
2007
7.6040
0.97459
2008
6.9451
0.8919
2009
6.8310
0.8812
Source: http://en.wikipedia.org/wiki/List_of_Renminbi_exchange_rates
Balance of payment (BOP) account
Definition

The record of an economy’s receipts and payments arising from
external transactions
BOP account of HK


For a specific time period
Economic transactions between HK residents and non-residents
Balance of payment (BOP) account
Components of the BOP account:


Current account (經常帳)
Capital and finance account (資本及金融帳)
BOP account
Current account
All external transactions
not included in capital &
financial account
Capital and
financial account
International purchases or
sales of assets
Capital transfers
Balance of payment (BOP) account
Current account:
1.



Goods (visible trade)
Net receipt brought by merchandise trade (商品貿易)
Receipt: Exports of goods, e.g. garments, jewellery…
Payment: Imports of goods, e.g. rice, cars…
Balance of visible trade = Total exports of goods – Total imports of goods
Types of BOT:
Trade deficit (貿易赤字)
Exports < Imports
BOT < 0
Balance BOT (貿易平衡)
Exports = Imports
BOT = 0
Trade surplus (貿易盈餘)
Exports > Imports
BOT > 0
Balance of payment (BOP) account
Current account:
2.
Services (invisible trade)

Net receipt brought by services

Receipt: Exports of services, e.g. local airline…

Payment: Imports of services, e.g. World Cup broadcasting…
Balance of invisible trade = Total exports of services – Total imports of services
Balance of payment (BOP) account
Current account:
Factor income
Net income from abraod
All forms of investment income
3.




Dividends
Interest from deposit
Net income from abroad
= Factor income from abroad – Factor income paid abroad
4.



Current transfers
Unilateral (單向) transfer of goods and capital
No economic value being received in return
For example: donations, remittances 匯款
Balance of payment (BOP) account
Current account balance:
Total balance of the 4 components:

Visible trade

Invisible trade

Factor income

Current transfer
Current account balance
= Balance of (Goods + Services + Factor income + Current transfer)
Balance of payment (BOP) account
Given the following table, calculate the current account balance of HK:
Components
Value ($ million)
Exports of goods
500
Imports of goods
200
Exports of services
350
Imports of services
100
Dividends from USA company
50
Compensation to employees in Europe
80
Donation to Japan
120
Current account balance
= ( $500 - $200 + $350 - $100 + $50 - $80 - $120 ) million
= $400 million
Think about:
In your own consideration:
Types of services/facilities
Frequently use Seldom use
Never use
1. Education
2. Housing
3. Medicine and health (including
hospital services)
4. Social welfare
5. Culture and entertainment (e.g.
libraries, sports facilities)
6. Transportation

Do you think the gov’t should increase subsidies in the above
items for you?
Public expenditure (公共開支)

Types of expenditure
Functions
: Examples
 Education
: 9-yr free education…
 Support
: wages of civil servants…
 Social welfare : C.S.S.A….
 Health
: medical services…
 Infrastructure : transportation, water supply…
 Security
: police, law affairs…
 Housing
: Public housing…
 Economic
: postal, airport…
 Environment and food: Environment protection
 Community and external affairs: culture, sports…
Government revenue

Types of revenue


Taxation

Direct tax

Indirect tax
Fee of selling of services

Medical services

Water supply

Application of ID card…

Fines / Penalties from punishment of illegality

Selling of land
Taxation

Adam Smith’s principles of taxation

Equity



Taxation should be fair.
Taxes are directly proportion to people’s income,
i.e. those who earn more income need to pay higher tax
Certainty




Clearly define the responsibilities to taxpayers
Clear tax calculation method
Clear tax payment deadline
Clear modes of payment
(in person / online / PPS / credit card…)
Taxation

Adam Smith’s principles of taxation

Convenience




Deadline & payment method: convenient to taxpayers
Allow enough time for payment
E.g. Salary tax in Hong Kong:
 May: Submission of Tax Return – Individual
 October: Notification of tax payment
 January: First installment
 April: Secondary installment
Economy


Cost of tax collection should be kept minimum.
Online / PPS tax payment   Cost of tax collection
Tax base (稅基)

The tax base of an economic territory means
 activities (e.g. buying car, taking flight overseas)
 revenue (e.g. salaries, profits)
 assets (e.g. properties, cars)
on which taxes are charged.

The government’s scope of taxation.

Broader the tax base
 more people need to pay tax
 more source of taxation
 more stable tax revenue
Classification of tax

By tax burden
 Direct tax
 Indirect tax

By tax rate
 Progressive tax
 Proportional tax
 Regressive tax
Classification by tax burden

Direct tax


The tax burden cannot be shifted to others by taxpayers.
Examples:

Salaries tax


Profits tax


Charges directly on the salary
Charges directly on profit-making firms
Property tax

Charges directly on rental income earned from land or properties.
Classification by tax burden

Indirect tax


The tax burden can be shifted to others by taxpayers
Examples:
 Duties (應課稅品)








Liquors (酒類)
Tobacco (煙草)
Hydrocarbon (燃油)
Methyl alcohol (甲醇)
Rates (差餉)
Betting duty (博彩稅)
Stamp duty (印花稅)
First registration tax (汽車首次登記稅)
Classification by tax burden

Indirect tax


How is the tax burden shifted?
Examples:
Duties: Tobacco
 Gov’t charges tax on tobacco traders
Tobacco traders raise the price of cigarettes
 Consumers need to pay more for the cigarettes
 i.e. The tax burden is shifted to consumers through increase
in price


 all kinds of sales taxes are indirect tax
Tax base: Direct tax vs. Indirect tax

Direct tax






Levied on companies and salaried workers
Only tax on profit or income earning
Number of taxpayers is limited
Even worse if no profit or salary
 Tax base is narrow
Indirect tax




Imposed on taxable goods and services
Tax on anyone who made consumption
Number of taxpayers is large
 Tax base is broader
Tax base (稅基)
Which of the following can broaden (擴闊) the tax
base of Hong Kong?
(1)
(2)
(3)
A.
B.
C.
D.
Greatly decrease the basic tax allowance of the salaries
tax.
Impose a general sales tax.
Increase the current indirect tax rate.
(2) only
(1) and (2) only
(2) and (3) only
(1), (2) and (3)
Answer: B
Stable tax revenue: Direct tax vs. Indirect tax
Gov’t revenue fluctuates with economic cycles (經濟週期)
 Direct tax

During economic recession (經濟衰退)




During the time of economic boom (經濟繁榮)



Companies: Low profit
Workers: Low salaries
Therefore, gov’t has less profit and salaries taxes
Greatly increase in tax revenue
 Tax revenue is not stable
Indirect tax


No matter what the time is, people need to consume
 Tax revenue is relatively more stable
Tax rate and tax revenue:
Why is there smuggling (走私)?

Suppose the gov’t wants to raise tax revenue







Way to achieve:  tax rate (e.g. duty on tobacco)
Traders shift the tax burden to consumer
People needs to pay more
To avoid higher price, consumers buy smuggled cigarettes
 incentive of smuggling market
Finally, lower tax revenue gained
Conclusion

Higher tax rate
 illegal activities: smuggling and tax evasion (逃稅)
  tax revenue
  cost to fight crime
Tax rate and tax revenue

Laffer Curve (textbook p.189)

Two extremes (e.g. salaries tax):



Optimum level (t*)



0% tax rate  No tax revenue
100% tax rate  All income paid for tax (i.e. no personal income)
 No one will work  No tax revenue
If current tax rate < t*,
 tax rate   tax revenue
If current tax rate > t*,
 tax rate   tax revenue
Tax revenue ($)
To  tax revenue


Increase tax rate if tax rate < t*
Decrease tax rate if tax rate > t*
0
t*
Tax
100 rate (%)
Classification by tax rate

Basic terms




Taxable income
Tax rate
Tax payment
Basic calculation
𝑇𝑎𝑥 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝑖𝑛𝑐𝑜𝑚𝑒
𝑥 100%

Tax rate =

Taxable income = Total income – Tax allowance – Tax deduction
e.g. parent,
children…
e.g. donation,
study fee…
Classification by tax rate

Calculate the tax rates on each person at different scheme.
Mr. Lee
Mr. Chan
Miss Wong
Tax scheme
Income
($)
Tax payment
($)
Income
($)
Tax payment
($)
Income
($)
Tax payment
($)
A
10,000
1,000
100,000
2,200
1,000,000
12,000
B
10,000
1,000
100,000
10,000
1,000,000
100,000
C
10,000
1,000
100,000
15,000
1,000,000
200,000
Tax scheme
Mr. Lee
Mr. Chan
Miss Wong
Types
A
10%
2.2%
1.2%
Regressive
B
10%
10%
10%
Proportional
C
10%
15%
20%
Progressive
Classification by tax rate

Progressive tax (累進稅)


Higher the taxable income, higher the tax rate.
When taxable income increases, the tax rate increases.
Taxable
income ($)
Tax payment ($)
Tax rate (%)
Mr. A
100,000
5,000
5
Mr. B
200,000
20,000
10
Mr. C
300,000
45,000
15
Classification by tax rate
 Progressive tax

Relationship between


Taxable income
Tax rate
Tax rate (%)
15
10
5
Taxable income ($)
0
100,000
200,000
300,000
Classification by tax rate
 Progressive tax

Relationship between


Taxable income
Tax payment
Tax payment ($)
45,000
20,000
5,000
Taxable income ($)
0
100,000
200,000
300,000
Classification by tax rate

Proportional tax (比例稅)


No matter the taxable income is, the same tax rate.
When taxable income increases or decreases,
the tax rate remains unchanged.
Taxable
income ($)
Tax payment ($)
Tax rate (%)
Mr. A
100,000
5,000
5
Mr. B
200,000
10,000
5
Mr. C
300,000
20,000
5
Classification by tax rate
 Proportional tax

Relationship between
Taxable income
Tax rate


Tax rate (%)
5
Taxable income ($)
0
100,000
200,000
300,000
Classification by tax rate
 Proportional tax

Relationship between


Taxable income
Tax payment
Tax payment ($)
15,000
10,000
5000
Taxable income ($)
0
100,000
200,000
300,000
Classification by tax rate

Regressive tax (累退稅)


Higher the taxable income, lower the tax rate.
When taxable income increases, the tax rate decreases.
Taxable
income ($)
Tax payment ($)
Tax rate (%)
Mr. A
100,000
12,000
12
Mr. B
200,000
20,000
10
Mr. C
300,000
24,000
8
Classification by tax rate
 Progressive tax

Relationship between


Taxable income
Tax rate
Tax rate (%)
12
10
8
Taxable income ($)
0
100,000
200,000
300,000
Classification by tax rate
 Progressive tax

Relationship between


Taxable income
Tax payment
Tax payment ($)
24,000
20,000
12,000
Taxable income ($)
0
100,000
200,000
300,000
Indirect taxes are regressive taxes


Duty on tobacco ($1.706 per cigarettes)
Suppose 3 persons consume 1000 cigarettes per year.





Their income and tax payment on cigarettes are list below.
To simplify calculation, assume tax on each cigarette = $2
Taxable
income ($)
Tax payment ($)
Tax rate (%)
Mr. A
60,000
2,000
3.33
Mr. B
180,000
2,000
1.11
Mr. C
1,000,000
2,000
0.2
Mr. A, with the least taxable income, pays the highest tax rate.
Mr. C, with the most taxable income, pays the lowest tax rate.
 It is a regressive tax.
Hong Kong tax system
Types
Direct
taxes
Indirect
taxes
Classification
by tax rate
Items
Description
Progressive
Salaries tax
Ordinary salary earners pay a
progressive tax
Proportional
1. Profit tax
2. Property tax
3. Salaries tax
(standard
rate)
Profit tax rate
- limited companies: 16.5%
- other companies: 15%
Property tax rate: 15% of balance after
deduction of 20% rental income
Standard tax rate of the salary tax: 15%
Duties
Taxes imposed on goods:
- Hydrocarbon oil
- Alcoholic beverage
- Methyl alcohol
- Tobacco
Regressive
Calculation of salaries tax
Mr. A’s monthly salary in fiscal year 2010/11 = $40,000
 Annual salary = $40,000 x 12 = $480,000
 Personal allowance = $108,000
 Assume no other deductions
 Then, taxable income = $480,000 - $108,000 = $372,000
Net Chargeable
Income ($)
Rate
Tax
Remaining
372,000
On the First
40,000
2%
800
332,000
On the Next
40,000
7%
2,800
292,000
Sub-total
On the Next
80,000
40,000
Sub-total
Remainder
12%
120,000
252,000
Total
3,600
4,800
8,400
17%
42,840
51,240
252,000
Calculation of salaries tax
Mr. B’s monthly salary in fiscal year 2010/11 = $20,000
 Annual salary = $20,000 x 12 = $240000
 Personal allowance = $108,000
 Assume no other deductions
 Then, taxable income = $240,000 - $108,000 = $132,000
Net Chargeable
Income ($)
Rate
Tax
Remaining
132,000
On the First
40,000
2%
800
92,000
On the Next
40,000
7%
2,800
52,000
Sub-total
On the Next
80,000
40,000
Sub-total
Remainder
12%
120,000
12,000
Total
3,600
4,800
8,400
17%
2,040
10,440
12,000
Calculation of salaries tax
Mr. C’s monthly salary in fiscal year 2010/11 = $12,000
 Annual salary = $12,000 x 12 = $144,000
 Personal allowance = $108,000
 Assume no other deductions
 Then, taxable income = $144,000 - $108,000 = $36,000
Net Chargeable
Income ($)
Rate
Tax
Remaining
36,000
On the First
36,000
2%
720
0
On the Next
0
7%
0
0
Sub-total
On the Next
720
0
Sub-total
Remainder
0
0
Total
12%
0
720
17%
0
720
0
Calculation of salaries tax



Annual
income ($)
Tax payment ($)
Tax rate (%)
Mr. A
480,000
51,240
10.68
Mr. B
240,000
10,440
4.35
Mr. C
144,000
720
0.5
Mr. A: Higher the salary  Higher the tax rate
Mr. C: Lower the salary  Lower the tax rate
 Salaries tax is a progressive tax.
Calculation of salaries tax (high income)
Mr. D’s monthly salary in fiscal year 2010/11 = $80,000
 Annual salary = $80,000 x 12 = $960,000
 Personal allowance = $108,000
 Assume no other deductions
 Then, taxable income = $960,000 - $108,000 = $852,000
Net Chargeable
Income ($)
Rate
Tax
Remaining
852,000
On the First
40,000
2%
800
92,000
On the Next
40,000
7%
2,800
52,000
Sub-total
On the Next
80,000
40,000
Sub-total
Remainder
12%
120,000
732,000
Total
3,600
4,800
8,400
17%
124,440
208,440
12,000
Calculation of salaries tax (high income)
Mr. D’s annual salary in fiscal year 2010/11 = $960,000

By usual calculation, tax payment = $208,440

Tax rate =

Since tax rate > standard tax rate (15%)

Standard tax rate will be charged

Actual tax payment = $960,000 x 15% = $144,000
$208,440
𝑥100%
$960,000
= 21.71%
Calculation of salaries tax (low income)
Mr. E’s monthly salary in fiscal year 2010/11 = $6,000

Annual salary = $6,000 x 12 = $72,000

Personal allowance = $108,000

Assume no other deductions

Then, taxable income = $0,
because annual income < personal allowance

No need to pay salaries tax
The structure of salaries tax in HK
Tax rate (%)
Progressive
tax
Proportional
tax
Standard
tax rate
A
0
Tax
allowance
B
Income ($)
The effects of tax on income redistribution
1. Narrow the gap between the rich and the poor
 The government’s revenue and expenditure

Tax revenue from



Expenditure



the taxpayers who earn taxable salaries
the companies which gain profit
provide inexpensive or free services for the poor or low income earners
subsidies for the unemployed or low income groups
Progress income tax


Higher income earners pay higher a tax rate.
Lower income earners pay lower a tax rate.
The effects of tax on income redistribution
2. Salaries tax be adjusted  A more equal income distribution
Increase the basic tax allowance
A.


Personal allowance

Dependent children

Dependent parents/grandparents maintained by you
More low income earners can be excluded from paying tax
The effects of tax on income redistribution
2. Salaries tax be adjusted  A more equal income distribution
Decrease the tax rates of all tax bands
b.

That is,  tax rate of the first three bands of $40,000 taxable
income


Lower tax burden of the middle class
More low and middle classes pay less tax burden.
The effects of tax on income redistribution
2. Salaries tax be adjusted  A more equal income distribution
Increase the standard tax rate
c.


Very higher income earners pay a standard tax rate

Increase in standard tax rate will affect high income groups only
More tax revenue can be collected from the high income groups
The effects of tax on income redistribution
3. Goods and Services Tax (GST)

Suppose 20% GST is charged on buying a book ($100).

Therefore, $20 is the tax payment.

To a low income (income = $200) buyer,
tax rate =

= 10%
To a high income (income = $40,000) buyer
tax rate =

$20
𝑥100%
$200
$20
𝑥100%
$40,000
= 0.05%
 GST is a regressive tax, more uneven income distribution.
Argument of imposing GST in HK
For
Broaden the tax base
 Many examples from foreign countries, e.g. Japan, U.S.A.
 Reasonable to “buy more goods, pay more tax”
 Fair tax system. All people need to pay GST.
Against








Increase tax burden
Worry of increase in tax rate
High cost of tax calculation
High cost of tax collection
P   Qd , lower consumption lower GDP
Destroy the simple tax system of HK
Income disparity