Hong Kong Adapts to the
Brave New World
by GaveKal
September 2, 2006

One of our favorite anecdotes about Hong Kong dates back to 2003, when the S.A.R. was mired in doom and gloom (property prices were down –70% from their highs, people were hysterical about SARS…). That year, taxi drivers went on a strike to ask for… lower cab fares! The logic was that, at a lower price, more people would ride taxis (the government refused on the premise that the cabs would then start competing with the buses, tramways & MTR). If nothing else, this story illustrates HK’s amazing power of adaptation and “can do” attitude.

In recent days, we have been reminded of Hong Kong’s power of adaptation as the territory starts a debate on whether to lower income tax rates, and introduce instead a goods sales tax (GST). Unsurprisingly, as the debate shapes up, precious few commentators fail to mention that, should Hong Kong adopt such reforms, it would be adopting a new tax regime of “tax breaks for the rich” and “new taxes for the poor”.

Advertisement

But of course, this misses the more important point, namely that the HK government is adapting to the new economic realities.

In Our Brave New World, we wrote that one of the implications of the platform company model is that industrial jobs in the creative world disappear, only to reappear in Mexico, China, etc... Over time, the job market in developed economies moves to a minority of very creative individuals who work for themselves, and a majority of fellows who work in the service industry for the creative minds and/or the tourists coming in from the industrial world (this, of course, is a left wing politicians’ worst nightmare, if for no other reason that their political parties all rely heavily on trade unions and organized labor for their funding, and to bring out the votes on election day).

And this is where it gets interesting: once the switch to the platform company model is made, companies usually realize that they should domicile their research and marketing activities in countries with low marginal tax rates.

Take the financial industry as an example: on any given day, the biggest foreign net buyer or seller of US Treasuries is the Caribbean Islands. Now needless to say, the Caribbean islanders are not amongst the world’s largest investors; but the hedge funds domiciled there most definitely are. So the ‘efficiency capital’ of the world which used to be domiciled in big investment banks, in the world’s financial centers (whether London, New York, Frankfurt, Tokyo…) has now re-domiciled itself in hedge funds whose legal structures are in the Caymans, Bermuda, the British Virgin Islands, etc…

The tax revenue on the ‘efficiency capital’ is now lost for the US, the UK…; and there is little they can do to gain it back.

As an increasing number of companies move to the ‘platform-company’ model, or as people leave the big companies to work for themselves or smaller entities, it is likely that the top talent will want to work (or at least be taxed!), in low tax environments.

This economic reality should lead to a structural decline in tax receipts in the countries which do not adjust to this new model. In the new world towards which we are rapidly moving, income taxes will becoming increasingly voluntary and governments will have to get their pound of flesh through property and consumption taxes instead. This is good news. Over time, it should lead to more efficient (i.e., downsized) governments all over the Western World. The platform company business model should end up killing off the Welfare State.

In the ‘first wave’ world, governments provided subjects a modicum of Regalian functions (police, army, judges). With the second wave, governments started to branch out and provided citizens with income redistribution, education, pensions, healthcare, unemployment insurance, etc…But in the ‘third wave’ world, will governments still be able to provide “prosumers” with all of the above services? How will they pay for them?

In the ‘third wave’ world in which platform companies operate, taxes will increasingly become voluntary. Governments will thus have to compete with each other to provide the best services at the lowest possible costs to attract the world’s best platform companies, and their workers. Over time, this should mean that governments which provide the most efficient Regalian functions, and at the lowest costs (Hong Kong? Singapore? ...) stand to survive in their current structures. Hong Kong is adapting to this economic reality. And that is great news for the local economy.

We remain bullish on Hong Kong assets.

Good investing,

GaveKal

- Excerpt taken from GaveKal Five Corners semi-monthly investment strategy, July 2006.

Editor’s Note: GaveKal is a full-service independent research firm based in Hong Kong, launched by Charles Gave, Louis-Vincent Gave and Anatole Kaletsky in 1999.