In his address to the Legislative Council in March, Financial Secretary Henry Tang said there should be no tax increases so that Hong Kong's recovery could gain ground. More important, he emphasized that the underlying principle guiding future development should be that the "market leads and government facilitates." Now that the recovery is well underway, the secretary's attention has turned to closing the fiscal deficit by introducing new taxes and holding government spending to no more than 20 percent of GDP. And he still wants the market to lead the way. But will it?
If a new goods and services tax is enacted, along with proposed taxes on capital gains and on income earned by Hong Kong residents overseas, the budget gap may be closed, but Hong Kong would no longer be the most free-market economy in the world.
The secretary's goal of limiting spending to no more than one-fifth of GDP may sound good to someone looking at European welfare states, but it certainly is not what Sir John Cowperthwaite (financial secretary from 1961-71) and the founders of Hong Kong's laissez-faire system had in mind. Total government spending for 2004-05 is expected to be HK$258.7 billion, about 20 percent of GDP, with 26.4 percent of the budget going for social welfare and health.
Social welfare spending has risen by 236 percent over the past decade. If that growth is not stemmed, Hong Kong will lose its comparative institutional advantage. Instead of creating wealth, Hong Kong will increasingly redistribute and lose wealth.
Mr. Tang told the Legco in March that he hoped the budget could be in balance by 2008-09, and that he would strive to cut the size of government to 16.9 percent of GDP. However, if his tax proposals were to be enacted, the government's tax base would widen. There is no doubt that tax rates would rise as the government sought to maximize its revenue, just as happened in the United States after the Reagan tax reforms of the 1980s.
Under Reagan's initiative, Congress lowered marginal tax rates from 70 to 28 percent but widened the base. Once Reagan left office, politicians on both sides of the aisle took advantage of the broader base to raise rates and gain revenue. Today the top marginal tax rate is 35 percent, government has grown, not shrunk, and the deficit is larger than ever.
To effectively constrain the growth of government, there must be an ethos of economic liberty. Hong Kong's greatest asset has been economic freedom. It would be a tragedy to lose that freedom by inadvertently broadening the tax base and later finding that the "grabbing hand" of government supplanted the "invisible hand" of the market.
In 1844, Robert Montgomery Martin, the British colonial treasurer in Hong Kong, predicted, "There does not appear the slightest probability that, under any circumstances, Hong Kong will ever become a place of trade." Today Hong Kong is one of the wealthiest places in the world -- not because of the abundance of natural resources, but because of economic freedom. Entrepreneurs flock to Hong Kong precisely because of its openness and low taxes. Hong Kong has been able to make the transition to a service economy because of its flexible labor and capital markets and its transparent legal system that protects private property rights and freedom of contract. Introducing a GST and a capital gains tax would deny Hong Kong its uniqueness and impede its competitiveness.
More than 250 years ago, the great Scottish economist Adam Smith observed, "Little else is required to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice." His observation is still valid today. In a study of OECD economies and 60 nations around the world, James Gwartney, Randall Holcombe, and Robert Lawson found that "the growth-maximizing level of government expenditures is no more than 15 percent of GDP" -- and "when the scope of government expands beyond this level, there is a negative impact on the wealth of nations."
Whether Hong Kong continues to thrive will depend largely on how well it safeguards its legacy of laissez-faire. Instituting new taxes to stabilize government revenues and close the deficit should be secondary to limiting the size and scope of government and preserving economic freedom.