Hong Kong's economy has turned the corner. The government is expecting 7.5 per cent GDP growth in real terms for the whole of 2004.

We saw a quick rebound in the property market. The number of property transactions in the first half of 2004 increased by 22 per cent over the second half of 2003. The average property price went up by 30-40 per cent last year.

The number of tourists arriving in Hong Kong from the mainland and also from other parts of the world increased substantially. The number of tourists arriving in Hong Kong in June 2004 exceeded the pre-SARS level. In July 2004, the number of tourists reached almost two million.

Private consumption on the average grew by 7 per cent in real terms in the first three quarters of 2004. The total retail sales volume also increased by 6.8 per cent in December 2004, reflecting a strong rebound in the consumption market.

All these improving economic situations have a positive impact on government revenue. For tax revenue, direct taxes - including salaries tax and profits tax - will increase. We saw an increase in turnover in the stock market and in the property market, which will lead to a rise in indirect tax.

For non-recurrent revenue, the government has also been doing very well, thanks to the recovery in the property market. The government's revenue from the land premium amounts to HK$27.7 billion, HK$15.7 billion higher than expected. Another important component of the non-recurrent revenue is the investment return. Although there were uncertainties in the global economy, such as surging oil prices and an increase in US interest rates in 2004, the government is expected to achieve a good investment return. All these figures explain why a surplus of HK$25.2 billion was recorded in January 2005 and a cumulative surplus of HK$22.4 billion was achieved during the first ten months of 2004/05.

At the moment it is the peak period for tax-collection. If we take the bond issues of HK$26 billion away from the total revenue, the government will still be likely to end up with a surplus, though small, for 2004/05. This is quite different from what Financial Secretary Henry Tang predicted in his last budget speech. He predicted an operating deficit of HK$46.6 billion and a consolidated deficit (before bond issuance) of HK$62.1 billion for 2004/05.

There are demands from the community for tax cuts. In my view, we are not ready for any tax cuts.

First, although the Hong Kong economy has recovered, not everybody can benefit from the improving economic situation. Hong Kong still has a high unemployment rate of 6.4 per cent. The unemployment rate has already been declining from the peak level of 2003. The evidence shows that the overall job market is improving and that employment has been increasing. However, the unemployment rate is declining at a slow pace because of the increasing number of people looking for jobs. Hong Kong has a mismatching problem in the job market in that there are jobs that cannot find the right people and people that cannot find the right jobs. When we examine the profiles of the jobless people, we find that most of them are uneducated and unskilled. It is evident that they may not be able to benefit from the economic recovery, at least not at this stage. There will be demand (may not be increasing but not decreasing) for social welfare. Of course, there is also a need to take a closer look at our social welfare system.

Second, Hong Kong used to maintain reserves of more than HK$400 billion in the late 1990s and we were discussing at that time how the Hong Kong government should make good use of the reserves. The level of reserves dropped to a bit more than HK$200 billion in 2003 and has been further dropping. However, economic recovery will help stabilize the level of reserves. This demonstrates that the fiscal reserves can decrease very quickly in times of economic downturn. This also shows us the importance of having an adequate level of reserves to prepare for the economic downturn, and, more importantly, for crisis situations. Therefore, I think we should save for the rainy days before we go for any tax cuts.

Third, this surplus situation is attributed to the contribution from the non-current revenue, including land premiums. The decline in property prices during past years makes us realize that the land premium, though an important kind of revenue, may not be a reliable source of revenue.

There is a need to stabilize government revenue. At the moment, it relies heavily on direct taxes, including salaries tax and profits tax. They account for 60 per cent of the total tax revenue. We have to understand that direct taxes are easily affected by the economy. When the economy is good, people and companies generate more income and pay more direct taxes. When the economy is down, they pay less tax. In addition, only 40 per cent of the working population pay salaries tax. Among those who do not pay tax, either they do not earn enough to pay the salary tax or the government has no way to include them in the tax system. This may be due to the fact that the government was too generous in increasing the tax allowances during the past few years and the lack of determination in adjusting the tax allowances during the deflation period. The remaining question is how to increase the proportion of indirect tax revenue which is relatively more stable.

There has been discussion on the introduction of a goods and service tax. This is going to be a major change in Hong Kong's tax system, which will require another two to three years of preparation and discussion. There is a need for a consensus from different sectors on tax reform. At present, Hong Kong's tax base is too narrow, unstable, while there is an increasing demand on public expenditure. We also have to be aware that the government may have the tendency to spend more with the new tax revenue. Therefore there is a need for a proper mechanism to monitor the growth of public expenditure.

The fundamental problem of our deficit is simply that the recurrent revenue cannot match recurrent expenditure. In my view, the deficit problem is the result of the rapid expansion in public expenditure during the past couple of years. This expansion is due to deflation and the inflexibility of the public sector. The government should continue its efforts in reducing public expenditure.

I suggest the government should try to cut its expenditure and keep the public expenditure/GDP ratio under 20 per cent. This is in line with the slogan of "small government and large market". At present, we see our government is getting bigger. We have to bear in mind that the deficit problem has not been solved yet. It is likely that economic growth in 2005/06 may slow down as predicted by the market. The government could incur a budget deficit in 2005/06. Without any major reform in the tax system to stabilize government revenue and reduce expenditure, the deficit problem will stay with us for a long time.