By Joseph Yam –
Those with an interest, from whichever perspective, in the public finance of Hong Kong post-1997 may be familiar with Article 107 of the Basic Law, which requires that:
“The Hong Kong Special Administrative Region shall follow the principle of keeping expenditure within the limits of revenue in drawing up its budget, and strive to achieve a fiscal balance, avoid deficits and keep the budget commensurate with the growth rate of its gross domestic product.”
Reading through Article 107 quickly, the overall message on the need to be prudent in the management of public finance in Hong Kong, which everybody supports, seems to be very clear. The specific requirements therein, such as “follow the principle of keeping expenditure within the limits of revenue”, or the need to “avoid deficits”, have also not been subject matters of controversy or even of significant interest in the community or in academia, important though they may be. The general sentiment seems to be that, as long as Hong Kong is not running fiscal deficits, then the HKSARG, in the management of public finance in Hong Kong, is dutifully observing Article 107. The fact that in the past decade Hong Kong has been continuously running substantial fiscal surpluses, notwithstanding the requirement in Article 107 to “strive to achieve a fiscal balance”, has not been a matter of public concern, other than the mild criticism directed at the Financial Secretary in being a miser.
But Article 107 justifies much more attention in the community. There is the obvious question of compliance by the HKSARG. Another question is whether the HKSARG is prudently making full use of the framework defined in Article 107 to promote the public interest. Indeed, with Hong Kong experiencing historically slow economic growth rates in the past decade and a strong desire of everybody in Hong Kong to invest in the future of Hong Kong and build a more dynamic economy, the contractionary fiscal stance on the economy of a decade of fiscal surpluses seems inappropriate, if not irresponsible. The problem of fiscal drag on the economy is, of course, a complex one that is not totally within the control of the fiscal authorities. But at least budgeting should appropriately allow for, on the revenue side, progressivity in the tax structure interacting with expected inflation to boost receipts, and on the expenditure side, the restraining effect of budget allocations being in cash terms and, regrettably, worsening Hong Kong style filibustering. A deeper and wider understanding by all concerned of Article 107 will help to take Hong Kong confidently forward.
Deeper understanding of Article 107
Let me first deal with the easier and non-controversial aspect concerning the time dimension. It was never the intention that there should be balanced budgets with no deficits year after year. Sensibly, we should be talking about achieving a balance over an economic cycle. But, given the externally-oriented nature of the Hong Kong economy and the frequent external economic and financial shocks that we are exposed to, it will be difficult to be definite about the duration of an economic cycle. And so there is a need to be pragmatic and flexible in terms of the time frame for striving to achieve fiscal balance, and to exercise best judgement in the preparation of the budgets for individual years, while being transparent about the theoretical foundation for arriving at that judgement.
The second point concerns the distinction between the budget (ex ante) and the outcome (ex post). With all the good intentions in the world, things never quite turn out exactly the way they were planned. Article 107 refers to the budget and not the outcome, understandably allowing for the many unexpected developments that affect the public finance during a financial year. Thus, judging compliance should be in respect of the former and not the latter, but obviously the difference between the two, inevitable as it may be, is a reflection of the robustness of the budgetary process that the authorities need to reflect on and improvements, if identified, introduced.
The third point is that Article 107 is conceptual in nature and not prescriptive. It uses, for example, words such as “follow the principle” (of keeping expenditure within the limits of revenue), “strive” (to achieve a fiscal balance) and “avoid” (deficits). Yes we simply should not live beyond our means. But Article 107 does not prohibit counter-cyclical budget deficits that mirror budget surpluses over an economic cycle. It also does not prohibit budget deficits arising from, for example, the HKSARG making productivity-enhancing investments in the future of Hong Kong, which will boost future economic growth and government revenue, and can be seen as a necessary effort now to strive to achieve fiscal balance in the future in the light of the enlarging fiscal burden arising from an aging population.
The fourth point is most important and, regrettably, much neglected as well as misunderstood. This concerns the requirement for the HKSAR to “keep the budget commensurate with the growth rate of its gross domestic product”. This has been interpreted as either a requirement for government expenditure (and revenue) to grow at the same rate as GDP or a requirement for government expenditure to be limited at a fixed percentage of GDP, for example, 20%. I do not think that these interpretations are correct. If there were such requirements intended, Article 107 could have simply said so.
It is important to appreciate that in this part of Article 107, we are talking about the budget as a quantitative measurement in terms of dollars and cents on the one hand and the growth rate of GDP as a measurement of speed on the other hand. A requirement for the quantity of something to be commensurate with the speed of something else is, of course, predicated on there being an interactive relationship between the two. The use of the words “commensurate with” (instead of, for example, “at the same pace”), is most interesting in that it recognizes the need for the use of fiscal policy in macroeconomic management. Readers will more readily appreciate the wisdom behind all this by considering the example of driving a car: you inject a greater quantity of gasoline when the speed of the car is too slow and less when the speed of the car is too fast! In other words, the budgets should be characterized by more spending and less tax to the extent of running deficits when the growth rate of the economy is too slow and the opposite when the growth rate of the economy is too fast.
Let me hasten to add, as I am sure some will want to point out, that with a highly externally-oriented economy, the scope for active macroeconomic management in Hong Kong is perhaps more limited than in other less externally-oriented economies. Indeed, large leakages into imports means a low multiplier effect for public expenditure. But let me quote from The New Palgrave Dictionary of Economics. In the entry on “fiscal stance”, it says: “there is usually a general tendency for public expenditure to involve a lower import content than private spending, at least at the first round, and a measure of fiscal stance not adjusted for this might therefore misrepresent the scale of long-term demand effects if policy is heavily concentrated on, say, expanding public expenditure or reducing taxes”. Furthermore, in crafting an expansionary budget to speed up the economy, whether as a counter-cyclical measure or as a measure to address the structural problem of a sub-par growth trend, priority can be given to those items with higher multiplier and productivity-enhancing effects. And if the danger of growth in recurrent expenditure becoming excessive is a concern, then priority can also be given to those with relatively low recurrent implications.
I have been encouraged by the honourable desire of the new term government of HKSAR to “Seize the Opportunity to Invest for the Future” in its “New Fiscal Philosophy”. I thus offer these viewpoints on Article 107 for consideration. But I am acutely aware of the fact that I am not a lawyer. I was, however, involved as a member of the inner team assisting successive financial secretaries in preparing the annual budget and in helping to draft their budget speeches for about 20 years from the mid-70s. And I did have an opportunity to express my views when Article 107 itself was being drafted.
Joseph Yam is an Executive Council member and former chief executive of the Hong Kong Monetary Authority. This article was first published in his personal blog, http://www.josephyam.com.
The headline was written by VOHK. It original headline was Viewpoints on Public Finance in Hong Kong.
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