US embassy cable - 06HONGKONG687

TAX CUT PRESSURE AS NEW BUDGET LOOMS

Identifier: 06HONGKONG687
Wikileaks: View 06HONGKONG687 at Wikileaks.org
Origin: Consulate Hong Kong
Created: 2006-02-17 11:21:00
Classification: CONFIDENTIAL
Tags: PGOV ECON EFIN HK CH
Redacted: This cable was not redacted by Wikileaks.
VZCZCXRO0870
PP RUEHCN
DE RUEHHK #0687/01 0481121
ZNY CCCCC ZZH
P 171121Z FEB 06
FM AMCONSUL HONG KONG
TO RUEHC/SECSTATE WASHDC PRIORITY 4983
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
C O N F I D E N T I A L SECTION 01 OF 02 HONG KONG 000687 
 
SIPDIS 
 
SIPDIS 
 
STATE FOR EAP/CM AND EB 
MANILA PASS AMBASSADOR PAUL SPELTZ 
TREASURY FOR DAS DLOEVINGER, OASIA-GKOPEKE 
USDOC FOR 4420 
 
E.O. 12958: DECL: 02/17/2031 
TAGS: PGOV, ECON, EFIN, HK, CH 
SUBJECT: TAX CUT PRESSURE AS NEW BUDGET LOOMS 
 
 
Classified By: EP Section Chief Simon Schuchat; Reasons: 1.4 (b/d) 
 
 
SUMMARY AND COMMENT 
------------------- 
 
1. (C) With the next Chief Executive election planned for the 
first half of 2007, concerns about public acceptance of 
government revenue and spending policy are playing a 
heightened role in advance of the unveiling of the 2006-07 
budget, which will take place on February 22.  Hong Kong's 
economic performance is expected to be above trend for the 
third year in a row, and the small budget surplus that 
emerged last year looks set to be repeated.  Consequently, 
calls are growing among Hong Kong's population for a tax cut. 
 However, Hong Kong's reliance on accumulated surpluses to 
underpin its currency coupled with a volatile revenue base 
suggests that any significant revenue cuts offered now might 
have to be made up later, and in a more painful fashion, 
during what many believe will be an inevitable downturn -- 
both cyclical and structural -- in the HKG's fiscal 
condition.  END SUMMARY AND COMMENT 
 
BUDGET COMING NEXT WEEK 
----------------------- 
 
2. (SBU) Financial Secretary Henry Tang's February 22 budget 
speech will likely reveal a small revenue surplus for the 
second year in a row, thanks to recently strong economic 
performance -- 8.2 percent GDP growth in 2004 and an 
estimated 7 percent growth for 2005.  Amidst higher interest 
rates (i.e., higher mortgage payments), it is no surprise 
that many in the income tax-paying middle and upper classes 
have taken a look at current trends and decided they would 
like some money back in the form of a tax cut.  There is 
widespread speculation that Tang will at minimum deliver a 
one-time tax rebate, and that he may go even further than 
that. 
 
LONGER TERM STRUCTURAL CHALLENGES... 
------------------------------------ 
 
3. (SBU) While the budget may look flush at first blush, 
there are underlying structural weaknesses that make a tax 
cut problematic, given that revenue collections are highly 
dependent on the economic cycle.  The tax base remains narrow 
here.  Income taxes and various fees account for most 
government revenue, and yields from these sources move up and 
down with economic performance and property value swings. 
Further, around 20 percent of fiscal intake comes from highly 
volatile non-tax sources such as land sales and interest 
rate-sensitive returns on accumulated surpluses. 
 
4. (C) This unstable revenue environment funds a government 
that must meet the needs of a society with one of the world's 
lowest fertility rates, and the aging of the population 
promises increased health care and social welfare costs over 
time.  Consequently, behind the headlines and editorials 
calling for tax cuts, there is a quieter agreement among 
government officials and analysts that Hong Kong will in the 
longer run need to stabilize its revenue base with a 
consumption tax (now under consideration) and perhaps fund 
increasing health care costs with new contributions. 
 
... CANNOT BE IGNORED 
--------------------- 
 
5. (SBU) Surpluses were the norm in Hong Kong until the Asian 
Financial Crisis, global high-tech downturn, and SARS put 
government finances under severe pressure after 1997, peaking 
with a deficit of 6 percent of GDP in the 2001-02 budget. 
Chronic deficits are a special concern here because an 
erosion of accumulated fiscal reserves would threaten 
confidence in the peg of the Hong Kong dollar to the U.S. 
dollar, which is backed by those surpluses.  The necessity of 
bringing the budget back into balance forced Hong Kong to dig 
out of its recent deficits in part by reining in expenses, 
including making painful cuts over the years to civil service 
employment and compensation. 
 
A DIFFICULT CHOICE 
------------------ 
 
6. (C) Taking all this together, there is a strong case to be 
made that tampering with cyclical surpluses is a tradeoff 
between collecting revenue now, when times are good, or 
 
HONG KONG 00000687  002 OF 002 
 
 
making it up at a more painful juncture in the future, when a 
downward cycle might well raise the prospect of chronic 
deficits, forcing a tax hike at an economically painful and 
politically inopportune time.  Given that the HKG is already 
expected to be forced to strengthen its finances by 
introducing a consumption tax, any compounding of that 
sensitive move with a further tax hike or painful expenditure 
cuts would create significant political tension down the 
road. 
 
IMF WEIGHS IN 
------------- 
 
7. (C) The IMF cautioned against cutting taxes this week, and 
a contact there told us that he hoped coverage of a report 
released by his organization would help Tang avoid giving in 
to public pressure.  Citigroup Analyst Joe Lo shared with us 
his research note titled "Candy First, Bitter Pills Later," 
where he concluded that the HKG probably has some time amidst 
the strong economic cycle to make small tax cuts and modestly 
increase expenditures -- but painful fiscal reforms to 
address public health care and social welfare issues are 
inevitable. 
Cunningham 

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