Although our tax revenue may be higher than that of some countries, this does not mean that our tax base has no flaws or weaknesses.  Hong Kong's existing tax base is very narrow by international standards.  We have all along relied on limited types of tax and non-tax revenues to meet our public expenditure.  Since Hong Kong is an externally-oriented economy, income from these sources is very volatile and tends to go up and down with external economic conditions.  Moreover, our public expenditure pattern is rigid.  In such circumstances, a narrow tax base is likely to lead to budgetary imbalance, and it would be difficult for us to make long-term major investment and development plans.  In face of the global trend of lowering direct taxes, only with a broader tax base would we have room to cut our Salaries Tax and Profits Tax rates in order to maintain our competitiveness to attract investment and talent.  Furthermore, in light of our rapidly ageing population, we need a new source of secure and steady income from a broader tax base, so that our public finances would be better able to meet the major challenges ahead.

The advantages associated with our low tax rates are continually being undermined because many places around the world have reduced their reliance on direct taxes, such as Profits Tax and Salaries Tax, and lowered their tax rates in recent years so as to enhance their competitiveness.  Between 2000 and 2006, the European Union economies reduced their corporate profits tax rates by about 10 percentage points.  South Korea, Austria, Singapore, Iceland, Hungary, Ireland and other jurisdictions have also reduced their profits tax rates, with the maximum reduction being up to 12 percentage points.  As for Salaries Tax, the European Union economies and Singapore reduced the rates by about 7 percentage points.  On the contrary, Hong Kong raised its Profits Tax rate by 1.5 percentage points in the same period.   Our standard Salaries Tax rate was also increased by 1 percentage point while the top rate was increased from 17% to 19%.  This went against the international trend, and has greatly undermined our advantage in terms of tax rates.  We need to reform our tax system and broaden our tax base, so that we can have room to cut our Profits Tax and Salaries Tax rates to enhance our competitiveness as well as attractiveness to investment and talent.

More importantly, our tax revenue is very volatile and tends to fluctuate with economic conditions, while our expenditure is rigid.  This has greatly constrained our ability to manage and make plans for our public finances.  If we do not broaden our tax base, when we are faced with another economic downturn, we might need to raise taxes and adopt more stringent measures to meet our expenditure needs and cover deficits.

Hong Kong's economy is enjoying a full recovery, with strong economic growth, moderate inflation and a low unemployment rate.  It provides us with a respite and is therefore the right time to discuss tax reform to address the inherent flaws and weaknesses of our tax system, so that we could be better able to withstand future economic and social challenges.  This means that there is no need for us to raise additional tax revenue through tax reform.  As such, should a tax reform is implemented, the additional revenue raised can be returned to members of the community and businesses in the form of tax relief and other offset measures so as to enhance the competitiveness of our tax system and solve the problems arising from our narrow tax base.  The additional revenue raised may also be used to increase our public expenditure in areas such as education, health, social welfare, law and order or infrastructure with a view to enhancing our public services.

Moreover, undertaking tax reform in a revenue neutral manner can minimise its impact on the economy.  Australia has successfully adopted this model in introducing the Goods and Services Tax (GST).

Were we to do nothing, then in any future economic downturn we might need, as in the past, to increase taxes and cut expenditure on public services.  We would also be forced to draw down on our reserves or borrow money from the international market.  Possibly we would have to take all of these measures.  This might adversely affect our credit ratings.  Any short-term fiscal responses such as tax increases would undermine our competitiveness and might also have negative impacts on the livelihood of the community.

The current international trend, especially in the Asia-Pacific region, is towards lower income tax rates as a means of increasing economic competitiveness.  Hong Kong needs to respond to this challenge.  Only with a broader tax base we can stabilise our public finances by ensuring that they are not as susceptible to economic cycles as our existing tax base.  It can provide us with room to cut our Salaries Tax and Profits Tax rates and keep them at a low level sustainably, thus enhancing our attractiveness to internationally mobile talent and capital.

All along, the Government has strictly maintained the principle of managing our public finances prudently and keeping expenditure within revenue limits.  It is the Government's policy to control the proportion of public expenditure to 20% or below of GDP.  More importantly, in managing public finances, the Government must comply with Article 107 of the Basic Law which stipulates that "The HKSAR shall follow the principle of keeping expenditure within the limits of revenues 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."  Over the past few years, the Government has implemented a number of measures to strictly control public expenditure, including the civil service pay cut, reduction of the civil service establishment, re-prioritisation of public services, re-organisation of the structure of government departments and re-engineering procedures to optimize the use of limited resources.  We have limited scope for further reduction in expenditure.  As a large proportion of public spending goes to education, health, social welfare and law and order, which are generally rigid expenditure items, it is difficult to make corresponding adjustments according to changes in revenue.  Moreover, measures involving substantial cuts in public expenditure would hamper the quality of public services, and are not conducive to social harmony.

Since the launch of the tax reform consultation in mid July 2006, the Government conducted an interim review after a some five-month public consultation.  From the views collected, it is found that while the public generally agrees that there is a need to broaden the tax base, the majority does not consider that GST is an appropriate option to solve the problems of a narrow tax base.  As such, the Government has decided not to advocate GST for the remaining part of the consultation.  We hope that the public will continue to give their views on other viable options.  The Government will listen carefully and participate in the discussion.  When the consultation ends in March 2007, we will prepare a report on the views received for the Government of the next term to consider.

The Advisory Committee on New Broad-based Taxes chaired by Mr Moses Cheng submitted a report to the Government in 2002 with recommendations on how to broaden the tax base of Hong Kong.  The report studied more than ten options for broadening the tax base.  Based on the options in the report and other options suggested by the public during the consultation, we will continue the discussion with the public on how to broaden the tax base.

In addition, to assist the public in considering other options for broadening the tax base, we have prepared a brief listing out the major options that have been suggested and have provided a preliminary assessment on their applicability.  The brief has been uploaded to the tax reform website for the public's reference as from early February 2007.

Internationally, there is a set of widely accepted principles to evaluate the strengths and weaknesses of a tax system and these principles can be summarized into three major points-

(a) Fairness – a good tax system should comply with the 'capacity to pay' principle.  The design and the support measures of the tax system should ensure that people with greater financial capacity will bear heavier tax liability without widening the wealth gap;

(b) Provision of a stable and significant revenue – a good tax system should be able to provide a stable and significant revenue for the Government to respond to challenges and needs of the community and create social harmony.  A good tax system should work even when there is a change in economic conditions and demographic structure; and

(c) Maintaining international competitiveness – a good tax system should be clear and simple and be able to maintain Hong Kong's attractiveness to capital and talent.

The Government welcomes the public to continue to submit their views regarding the principles of broadening the tax base and on various options for broadening the tax base.