Tax Reform: Learning from Hong Kong, China’s Reform Challenges

Hong Kong, China has long had a tax-friendly system for businesses. Photo: Simon Zhu
Hong Kong, China has long had a tax-friendly system for businesses. Photo: Simon Zhu

By Matteo Lanzafame, Michael Timbang

Hong Kong, China’s tax system and prudent approach to fiscal policy are two pillars of its success. Despite this, aging and climate change will require tax reforms to ensure fiscal sustainability and competitiveness.

Hong Kong, China has one of the most competitive tax systems in the world. It provides solid foundations to its economic success by attracting international capital and business. Low tax rates and simple tax rules are coupled with a straightforward and prudent approach to public finance. Public expenditure is allowed to increase only proportionally to fiscal revenue, aiming to maintain a balanced budget and substantial financial reserves. 

This strategy paid dividends during the pandemic, as ample fiscal space allowed the government to provide significant support to the economy. Still, with output contracting by 6.5% under the weight of the pandemic, Hong Kong, China’s fiscal deficit widened to 9.4% of GDP in 2020, from 0.6% in the previous fiscal year.  Owing to its narrow tax base, Hong Kong, China’s fiscal revenue can be volatile and fall substantially in downturns.

To a large extent, therefore, fiscal prudence is a necessary complement to Hong Kong, China’s low-tax environment. However, two structural factors will increasingly require greater public spending in the medium- to long-term, making it harder to balance fiscal budgets without raising taxes.

The first factor is population aging. Demographic projections indicate that the share of working-age population will drop from 69% in 2022 to 64% in 2030, and 59% in 2050. Meanwhile, the share of people aged 70 and older will increase from 14% in 2022 to 19% in 2023, and 27% in 2050. An older population will require higher spending on pensions, healthcare, and other social services in the coming years.

The second factor is climate change, which affects a coastal city such as Hong Kong, China in various ways. According to the Hong Kong Observatory, under an intermediate scenario for greenhouse gas emissions, the annual mean sea level in 2100 will rise by 0.37–0.82 meters relative to the 1995–2014 average, and by 0.57–1.08 meters in case of very high emissions. Average annual temperatures increased by 0.31℃ per decade during 1992–2021 and extreme precipitation has become more frequent. Hong Kong, China recently experienced two powerful storms in consecutive years: Super Typhoon Hato in 2017 and Super Typhoon Mangkhut in 2018. 

Typhoons are a regular occurrence, so infrastructure is designed to cope with them, but Super Typhoon Mangkhut—the strongest since 1983—still caused direct economic losses estimated at about HK$4.6 billion. While the green transition may create investment opportunities and have potential benefits for fiscal balances, there is little doubt that climate-change mitigation and adaptation will require increased spending.

These challenges and, more broadly the need for tax reforms are common to other economies in Asia. One example is Mongolia, which has significantly reformed its key tax legislation over the last few years. While the policy question is the same—how to mobilize tax revenue to meet growing social and other needs—the appropriate solutions will vary. 

An older population will require higher spending on pensions, healthcare, and other social services in the coming years.

In many economies, increasing the efficiency of domestic resource mobilization is key.  Fair and efficient tax systems are critical to addressing poverty; reducing income, gender, and other inequalities; and tackling climate change in the region. As outlined in Asian Development Outlook 2022, this will often require a multipronged approach to optimize the tax structure. Options include raising tax progressivity where it is generally low, reducing informal work, and boosting domestic and international tax compliance. 

 Reforms that streamline the use of digital technology in tax administration can also contribute to strengthening public finance management, governance, and institutional capacity. Improvements in these areas offer opportunities to boost fiscal revenue by increasing the number of taxpayers as opposed to tax rates, thus reducing the negative impact on work and investment incentives and, ultimately, economic activity.

As such, broadening the tax base is also a crucial ingredient of tax reform in Hong Kong, China. The recent announcement of a progressive rating system for domestic properties expected to come into force in fiscal year 2024-25—whereby higher-rated properties pay higher taxes—is a positive step to structurally increase tax revenue. 

The adoption of the global minimum corporate tax rate advocated by the Organisation for Economic Co‑operation and Development (OECD) should also produce benefits, by raising revenue from profit taxes in the medium term. Other alternatives include introducing a value-added tax, raising excise taxes, increasing personal income tax rates for the top brackets, and taxing capital gains and dividends. 

The design and implementation of comprehensive tax reforms should follow the principles of efficiency, equity, and simplicity to ensure fairness, fiscal sustainability, and competitiveness. In practice, however, these objectives are difficult to satisfy simultaneously. 

An efficient tax system achieves its goals with low marginal tax rates and broad tax bases, while equitable taxes typically require higher rates on a relatively narrower base of richer taxpayers. Ultimately, tax reforms should consider both policy objectives and constraints through the lens of revenue needs, institutional capacity, and political and administrative feasibility. 

Policymakers in Hong Kong, China, as well as elsewhere in the region, will need to strike the right balance among tax reform objectives, constraints, and feasible measures—in itself a significant challenge.