1 Task Force on Review of Public Finances

2 Introduction Alert sign for Hong Kong fiscal system Hong Kong fiscal system undergoing structural changes Trust that Members and the community understand the importance of prudent fiscal management to the long term prosperity and stability of Hong Kong

3 Alert sign for Hong Kong fiscal system Operating deficits and consolidated deficits will persist for each of the next five years if the current revenue and expenditure policies are to continue and the economy is assumed to grow at a steady (i.e. medium growth) rate. Position as follows:

4 Alert sign for Hong Kong fiscal system

5 Projected Fiscal Balance and Fiscal Reserves to Current Policies Scenario (Medium Growth)

6 Alert sign for Hong Kong fiscal system Projected operating and consolidated deficits to persist in the next 20 years

7 Projected Fiscal Balance and Fiscal Reserves to Current Policies Scenario (Medium Growth)

8 Causes for the alert Changes in the economy Changes in government revenue Changes in government expenditure

9 Changes in the economy: Upsurge of the asset markets Average real GDP growth 5.2% per annum Inflation ： –average GDP deflator 6.9% per annum –average CCPI 8.5% per annum

10 Changes in the economy: Asian financial crisis Global economic downturn Average real GDP growth 1.9% per annum Deflation: –average GDP deflator –3.0% per annum –average CCPI –1.6% per annum

11 Year-on-Year GDP Growth Rates in Real and Nominal Terms

12 GDP Deflator and Composite CPI

13 Changes in government revenue (1) A fundamental change has occurred in the property market since 1998/99

14 Changes in government revenue (1) A fundamental change has occurred in the property market since 1998/99

15 Changes in government revenue (1) A fundamental change has occurred in the property market since 1998/99

16 Changes in government revenue (2) Since , investment income from the fiscal reserves became a key operating revenue item. Its importance has been increasing.

17 Changes in government revenue (2) Since , investment income from the fiscal reserves became a key operating revenue item. Its importance has been increasing.

18 Changes in government revenue (2) To finance increasing annual operating expenditure by investment income at a constant proportion, annual investment income will have to increase accordingly. To achieve the above objective, there are theoretically two means – –rate of investment return will have to increase year after year; but this is not quite possible with the global trend towards low inflation –alternatively, there needs to be fiscal surplus year after year to increase the fiscal reserves and in turn the investment income

19 Changes in government revenue (2) However, with the recent consecutive years of deficits, the level of fiscal reserves has been falling. From $430 bn on 1 April 2001, the reserves are projected to decrease to $369 bn by the end of the current fiscal year.

20 Changes in government revenue (3) Outreach of the Hong Kong economy to the Mainland and elsewhere, plus acceleration of economic globalisation may conceivably adversely affect direct tax revenue, particularly profits tax and salaries tax This is due to the territorial source-based tax system practised in Hong Kong With available data, the magnitude of the effect cannot be quantified at this stage

21 Changes in government expenditure (1) Higher differential price movements in government expenditure than that of the economy; government prices slower to adjust Partly due to the heavy weighting of the salaries and personnel-related component (eg pension) in government operating expenditure The effect will worsen in a deflationary environment because government wages have not adjusted downwards in line with prices in the economy in general

22 Changes in the GCE Deflator and GDP Deflator

23 Changes in government expenditure (2) Ageing population, dependency ratio to increase substantially in 2010s

24 Changes in government expenditure (3) Since 1998, Government has maintained growth of expenditure higher than growth of the economy in order not to exacerbate the economic downturn As a result, growth in government expenditure has far exceeded growth of the economy in money (or nominal) terms – one of the reasons for the strain on the fiscal system

25 Cumulative Growth Rate in Government Expenditure, Government Revenue and GDP in Nominal Terms

26 Government Revenue, Government Expenditure and Public Sector Expenditure as a Percentage of GDP

27 Budget Model Economic parameters Demographic parameters Revenue and expenditure parameters

28 Budget Model Economic parameters Calender Year % % % Real GDP Growth Rate GDP Deflator Nominal GDP Growth Rate

29 Budget Model Revenue and expenditure parameters Revenue –each major revenue item aligned with an economic driver –eg. In the longer term, profit tax yield = 9.3% of gross operating surplus of previous year salaries tax yield = 5.0% of compensation of employees of previous year

30 Budget Model Revenue and expenditure parameters Expenditure –current expenditure control guideline, growth of government expenditure aligned to trend real growth of economy –addition of 80 basis points on top of GDP deflator to reflect government expenditure price rigidity –social consequences of ageing population

31 Budget Model Projections To achieve consolidated balance in five years' time, revenue increase and/or expenditure cut measures averaging $35 billion per annum, about 12.3% of annual government expenditure, will be required from to under medium growth assumptions Beyond , revenue increase and/or expenditure cut measures will need to increase to: $89 billion in , being 21.9% of government expenditure* $141 billion in , being 26.0% of government expenditure* $215 billion in , being 29.7% of government expenditure* * Revenue increase and/or expenditure cut has already taken into account amount of measure in previous period.

32 Budget Model Projections Assuming that the level of fiscal reserves should be maintained at 18 months of government expenditure starting in and thereafter, the revenue increase and/or expenditure cut measures will be: $127 billion in , being 31.3% of government expenditure* $186 billion in , being 34.3% of government expenditure* $236 billion in , being 32.6% of government expenditure* * Revenue increase and/or expenditure cut has already taken into account amount of measure in previous period.

33 Budget Model Projections Assuming that the level of fiscal reserves should be maintained at 12 months of government expenditure and thereafter, the revenue increase and/or expenditure cut measures will be: $107 billion in , being 26.4% of government expenditure* $159 billion in , being 29.3% of government expenditure* $235 billion in , being 32.4% of government expenditure* * Revenue increase and/or expenditure cut has already taken into account amount of measure in previous period.

34 Annual Revenue and/or Expenditure Measures Required under Different Scenarios (Medium Growth) * Revenue increase and/or expenditure cut has already taken into account amount of measure in previous period.

35 Fiscal Reserves Levels under Different Scenarios (Medium Growth) * Revenue increase and/or expenditure cut has already taken into account amount of measure in previous period.

36 Conclusion Change fiscal “lifestyle” Expenditure: reinforce existing guideline by having regard to trend GDP growth in money (or nominal) terms in addition to GDP growth in real terms Revenue: consider views of Advisory Committee on New Broad-based Taxes and others