Hong Kong review vital to overcome problems with narrow tax base

There were few surprises in Paul Chan Mo-po’s first budget speech, but this was understandable given the impending change in government leadership.

Nonetheless, this should not be viewed as a budget handed down without due consideration. Indeed, the financial secretary took the opportunity to provide a detailed review of the measures and initiatives introduced by the outgoing administration, together with their achievements. In doing so, he provided a stock take of recent government activity which should help the new administration formulate an agenda for the coming years.

One announcement likely to help set the agenda of the new government was the establishment of a tax policy unit in the Financial Services and Treasury Bureau to comprehensively examine the international competitiveness of Hong Kong’s tax regime and address the long recognised problem of its narrow tax base.

The review of international competitiveness, together with Chan’s observations about the widespread adoption of tax concessions by a broad range of countries, hints at a further move away from the Hong Kong government’s long-held view that tax concessions were not generally necessary given the low-tax rate and simple tax system.

Targeted concessions aimed at attracting particular types of industries are common features of tax systems all over the world. They are something which Hong Kong should explore further as part of its overall economic policies and goals.

Careful consideration is, however, required in the current international tax environment. In particular, an important element of the G20 and Organisation for Economic Cooperation and Development (OECD)’s project on Base Erosion and Profit Shifting (BEPS), to which the financial secretary referred and which Hong Kong has embraced, is the countering of harmful tax practices.

The application of this aspect of the BEPS project to many types of concessions remains unclear. Moreover, many observers believe that the OECD’s work in this area will continue to evolve in pursuit of an unwritten agenda of generally reducing tax competition. Accordingly, for concessions to be successful, they will not only need to comply with the BEPS recommendations, but also be accepted by potential investors as likely to survive the continuing evolution of those rules. Investments may not go ahead if a regime, although within current rules, is likely to attract continuing international scrutiny and criticism.

The commitment to examine the problem of Hong Kong’s narrow tax base, on the other hand, is not new. More than 15 years ago, the government undertook two major studies, which concluded that there was a structural problem as a result of the narrow tax base and that the only feasible solution was the introduction of a value-added tax (VAT) or a goods and services tax (GST). This led, in 2006, to the government consulting on the proposed introduction of a VAT/GST.

Ultimately, due to widespread opposition, this proposal was dropped. But, as recently as two years ago, the former financial secretary reiterated the problem of the tax base and the need to explore ways to address it in his budget Speech.

So the problem of the narrow tax base is well understood, but the same conclusions as to the action necessary and the political difficulties this will entail will probably be reached again. Nonetheless, the government is correct to face up to this issue now as it is likely to become more urgent.

Demographic changes alone are certain to put further pressures on government expenditure. The financial secretary correctly focused on the need to support the elderly and disadvantaged, but this has caused social welfare expenditure to increase by 71 per cent in five years.

In the coming year it will represent 20 per cent of the government’s recurrent expenditure. This will only increase in future years and cannot be reduced in slower economic times, so will likely only exacerbate the effect of the structural problem arising from a narrow tax base.

So notwithstanding the absence of any major new initiatives, the financial secretary should be commended on the budget, which demonstrates insight and a willingness to consider difficult issues.

David Smith is senior tax adviser of PwC Hong Kong