Economics

Chapter 7

Exchange rate

CurrenciesMajor currencies USA: US Dollar [Code: USD; Sign: $] British: Pound sterling [Code: GBP; Sign: £] Europe: Euro [Code: EUR; Sign:€] China: Renminbi [Code: RMB; Sign: ¥] Hong Kong Dollar [Code: HKD; Sign: $] Japanese yen [Code: JPY; Sign: ¥]

Exchange rate

Exchange rate

the price at which two currencies are exchange

the price of a foreign currency in terms of

the local currency, or vice versa

convertibility rate

Exchange rate

Expression (assume USD and HKD)

1. The exchange rate of USD

US$ 1 can be converted into HK$ 7.8

HKD/USD = 7.8 / 1 = 7.8

Exchange rate

Expression (assume USD and HKD)

2. The exchange rate of HKD

HK$ 1 can be converted into US$

USD/HKD =

Floating exchange rate Exchange rate is

Free-floating Depends on market demand and supply

Appreciation A rise in exchange rate

Depreciation A fall in exchange rate

Appreciation USD Euro

The USD appreciates relative to the EUR

HKD JPY

The HKD appreciates relative to the JPY

Date US$1 equals

1 April 2011 € 0.7

1 May 2011 € 0.8

Date HK$1 equals

1 April 2011 ¥10.40

1 May 2011 ¥11.00

Depreciation USD Euro

The EUR depreciates relative to the USD

HKD JPY

The JPY depreciates relative to the HKD

Date €1 equals

1 April 2011 US$ = US$1.43

1 May 2011 US$ = US$1,25

Date JP¥1 equals

1 April 2011 HK$ = HK$0.096

1 May 2011 HK$ = HK$0.091

Floating exchange rate

Depreciation: exchange rate

Appreciation: exchange rate

• There is only one exchange rate between two currencies.

• Appreciation of one currency = Depreciation of the other

Linked exchange rate system in HK

Since 1983

HKD linked with USD at a fixed exchange rate

Aim: To maintain stability of the exchange rate between

HKD and USD

Exchange rate: US$1:HK$7.75–7.85

Controlled by the HKSAR Gov’t (HKMA)

Brief history of linked exchange rates system in HK:

History of Hong Kong's Exchange Rate SystemPeriod Exchange rate regime Features

1863–1935 Silver Standard Silver dollars as legal tenderDecember 1935–June 1972

Sterling exchange •Standard exchange rate:£1:HK$16 (December 1935–November 1967)•£1:HK$14.55 (November 1967–June 1972)

July 1972–November 1974

Fixed exchange rate against the US dollar

•Exchange rate:US$1:HK$5.650 (June 1972–February 1973)•US$1:HK$5.085 (February 1973–November 1974)

November 1974–October 1983

Free floating •Exchange rates on selected days:US$1:HK$4.965 (25 November 1974)•US$1:HK$9.600 (24 September 1983)

1983–Present Linked exchange rate system

•US$1:HK$7.80 (1983–1998)(for issue and redemption of Certificates of Indebtedness)•US$1:HK$7.75 (1998–2005)(The HKMA undertakes to convert the HK dollars in licensed banks’ clearing accounts maintained with the HKMA into US dollars at the fixed exchange rate of HK$7.75 to US$1. The rate has been moving to 7.80 by 1 pip each calendar day starting from 1 April 1999 ending 12 August 2000.)•US$1:HK$7.75–7.85 (May 2005 onwards)HKMA set up upper and lower guaranteed limit since 18 May 2005

Source: http://en.wikipedia.org/wiki/Hong_Kong_dollar

Linked exchange rate system in HK

Revaluation

Originally, HKMA fixed the rate at US$1:HK$7.8

If HKMA set the rate at US$1:HK$6

(meaning that less HK dollar can be bought by US$1)

(value of HK dollar increases)

the rate of HKD against USD rises

The government re-pegs exchange rate at a higher level

Linked exchange rate system in HK

Devaluation

Originally, HKMA fixed the rate at US$1:HK$7.8

If HKMA set the rate at US$1:HK$9

(meaning that more HK dollar can be bought by US$1)

(value of HK dollar decreases)

the rate of HKD against USD falls

The government re-pegs exchange rate at a lower level

Difference:

Exchange rate system Floating Fixed

Exchange rate is determined by Market Government

Exchange rate of local currency against foreign

currency

Increase Appreciation Revaluation

Decrease Depreciation Devaluation

Example countries USA China

Linked exchange rate system in HK

Strong reserves support

A currency board system

HK monetary base is support by USD

Maintain the exchange rate when issuing banknotes

Linked exchange rate system in HK

Operation The bank is going to issue $7,800,000 banknotes It needs to pay USD of equivalent value (US$ 1 : HK$7.8) to

HKMA to buy Certificate of Indebtedness [CIs] (負責證明書 ) As a support for banknotes issued In this case, the bank pays US$1 million to HKMA

* In reverse, banks return HKD & CIs to the HKMA and get back the USD.

Certificatesof

Indebtedness

US$ 1: HK$7.8

HKMA

Linked exchange rate system in HKExchange rates change with the USD Under the linked exchange rate system, the exchange rates of the HKD

against other foreign currencies change with the USD.

Against other currencies if USD appreciation HKD appreciation (against other currencies) if USD depreciation HKD depreciation (against other currencies)

DateUS$1 equals(EUR/USD)

US$1 equals(Linked exchange

rate system, HKD/USD)

Euro 1 equals(HKD/EUR)

1 April 2011 € 0.7 HK$ 7.8 HK$HK$11.14

1 May 2011 € 0.8 HK$ 7.8 HK$HK$9.75

USD appreciatesagainst EUR

Fixed EUR depreciates against HKD, (i.e. HKD appreciates against EUR)

HK people suffer from RMB appreciationExchange rates change with the USD RMB appreciates against USD

since 1994 Since 2006, exchange rose quickly USD depreciation is faster HKD is linked to USD,

so HKD follows USD and depreciates against RMB sharply

Meaning that HK people needs to pay more HKD to buy products fromthe mainland

Before that, HK people went shopping in the mainland

Nowadays, mainland visitor come to HKfor shopping

RMB annual average middle exchange rate from USD and HKD

(1 foreign currency unit to RMB)

year US dollar HK dollar

1996 8.3142 1.07510

1997 8.2898 1.07090

1998 8.2791 1.06880

1999 8.2783 1.06660

2000 8.2784 1.06180

2001 8.2770 1.06080

2002 8.2770 1.06070

2003 8.2770 1.06240

2004 8.2768 1.06230

2005 8.1917 1.05300

2006 7.9718 1.02620

2007 7.6040 0.97459

2008 6.9451 0.8919

2009 6.8310 0.8812

Source: http://en.wikipedia.org/wiki/List_of_Renminbi_exchange_rates

Balance of payment (BOP) account

Definition The record of an economy’s receipts and payments arising from

external transactions

BOP account of HK For a specific time period Economic transactions between HK residents and non-residents

Balance of payment (BOP) account

Components of the BOP account: Current account (經常帳 ) Capital and finance account (資本及金融帳 )

International purchases or sales of

assetsCapital transfers

All external transactions not

included in capital & financial account

Capital and financial account

Current account

BOP account

Balance of payment (BOP) account

Current account:1. Goods (visible trade) Net receipt brought by merchandise trade (商品貿易 ) Receipt: Exports of goods, e.g. garments, jewellery… Payment: Imports of goods, e.g. rice, cars…

Types of BOT:

Balance of visible trade = Total exports of goods – Total imports of goods

Trade deficit (貿易赤字 ) Exports < Imports BOT < 0

Balance BOT (貿易平衡 ) Exports = Imports BOT = 0

Trade surplus (貿易盈餘 ) Exports > Imports BOT > 0

Balance of payment (BOP) account

Current account:

2. Services (invisible trade)

Net receipt brought by services

Receipt: Exports of services, e.g. local airline…

Payment: Imports of services, e.g. World Cup broadcasting…

Balance of invisible trade = Total exports of services – Total imports of services

Balance of payment (BOP) account

Current account:3. Factor income Net income from abraod All forms of investment income

Dividends Interest from deposit

4. Current transfers Unilateral (單向 ) transfer of goods and capital No economic value being received in return For example: donations, remittances 匯款

Net income from abroad = Factor income from abroad – Factor income paid abroad

Balance of payment (BOP) account

Current account balance:Total balance of the 4 components: Visible trade Invisible trade Factor income Current transfer

Current account balance

= Balance of (Goods + Services + Factor income + Current

transfer)

Balance of payment (BOP) account

Given the following table, calculate the current account balance of HK:

Current account balance= ( $500 - $200 + $350 - $100 + $50 - $80 - $120 ) million= $400 million

Components Value ($ million)

Exports of goods 500

Imports of goods 200

Exports of services 350

Imports of services 100

Dividends from USA company 50

Compensation to employees in Europe 80

Donation to Japan 120

Think about:In your own consideration:

Do you think the gov’t should increase subsidies in the above items for you?

Types of services/facilities Frequently use Seldom use Never use

1. Education

2. Housing

3. Medicine and health (including hospital services)

4. Social welfare

5. Culture and entertainment (e.g. libraries, sports facilities)

6. Transportation

Public expenditure (公共開支 ) Types of expenditure

Functions : Examples Education : 9-yr free education… Support : wages of civil servants… Social welfare : C.S.S.A…. Health : medical services… Infrastructure: transportation, water supply… Security : police, law affairs… Housing : Public housing… Economic : postal, airport… Environment and food: Environment protection Community and external affairs: culture, sports…

Government revenue Types of revenue

Taxation

Direct tax

Indirect tax

Fee of selling of services

Medical services

Water supply

Application of ID card…

Fines / Penalties from punishment of illegality

Selling of land

Taxation Adam Smith’s principles of taxation

Equity Taxation should be fair. Taxes are directly proportion to people’s income,

i.e. those who earn more income need to pay higher tax

Certainty Clearly define the responsibilities to taxpayers Clear tax calculation method Clear tax payment deadline Clear modes of payment

(in person / online / PPS / credit card…)

Taxation Adam Smith’s principles of taxation

Convenience Deadline & payment method: convenient to taxpayers Allow enough time for payment E.g. Salary tax in Hong Kong:

May: Submission of Tax Return – Individual October: Notification of tax payment January: First installment April: Secondary installment

Economy Cost of tax collection should be kept minimum. Online / PPS tax payment Cost of tax collection

Tax base (稅基 ) The tax base of an economic territory means

activities (e.g. buying car, taking flight overseas) revenue (e.g. salaries, profits) assets (e.g. properties, cars)

on which taxes are charged.

The government’s scope of taxation.

Broader the tax base more people need to pay tax more source of taxation more stable tax revenue

Classification of tax

By tax burden Direct tax Indirect tax

By tax rate Progressive tax Proportional tax Regressive tax

Classification by tax burden

Direct tax The tax burden cannot be shifted to others by taxpayers. Examples:

Salaries tax Charges directly on the salary

Profits tax Charges directly on profit-making firms

Property tax Charges directly on rental income earned from land or properties.

Classification by tax burden

Indirect tax The tax burden can be shifted to others by taxpayers Examples:

Duties (應課稅品 ) Liquors (酒類 ) Tobacco (煙草 ) Hydrocarbon (燃油 ) Methyl alcohol (甲醇 )

Rates (差餉 ) Betting duty (博彩稅 ) Stamp duty (印花稅 ) First registration tax (汽車首次登記稅 )

Classification by tax burden

Indirect tax How is the tax burden shifted? Examples:

Duties: Tobacco Gov’t charges tax on tobacco traders

Tobacco traders raise the price of cigarettes Consumers need to pay more for the cigarettes

i.e. The tax burden is shifted to consumers through increase in price

all kinds of sales taxes are indirect tax

Tax base: Direct tax vs. Indirect tax

Direct tax Levied on companies and salaried workers Only tax on profit or income earning Number of taxpayers is limited Even worse if no profit or salary Tax base is narrow

Indirect tax Imposed on taxable goods and services Tax on anyone who made consumption Number of taxpayers is large Tax base is broader

Tax base (稅基 )

Which of the following can broaden (擴闊 ) the tax base of Hong Kong?

(1) Greatly decrease the basic tax allowance of the salaries tax.

(2) Impose a general sales tax.(3) Increase the current indirect tax rate.

A. (2) onlyB. (1) and (2) onlyC. (2) and (3) onlyD. (1), (2) and (3)

Answer: B

Stable tax revenue: Direct tax vs. Indirect tax

Gov’t revenue fluctuates with economic cycles (經濟週期 ) Direct tax

During economic recession (經濟衰退 ) Companies: Low profit Workers: Low salaries Therefore, gov’t has less profit and salaries taxes

During the time of economic boom (經濟繁榮 ) Greatly increase in tax revenue

Tax revenue is not stable

Indirect tax No matter what the time is, people need to consume Tax revenue is relatively more stable

Tax rate and tax revenue:Why is there smuggling (走私 )?

Suppose the gov’t wants to raise tax revenue Way to achieve: tax rate (e.g. duty on tobacco) Traders shift the tax burden to consumer People needs to pay more To avoid higher price, consumers buy smuggled cigarettes incentive of smuggling market Finally, lower tax revenue gained

Conclusion Higher tax rate

illegal activities: smuggling and tax evasion (逃稅 ) tax revenue cost to fight crime

Tax rate and tax revenue Laffer Curve (textbook p.189)

Two extremes (e.g. salaries tax): 0% tax rate No tax revenue 100% tax rate All income paid for tax (i.e. no personal income)

No one will work No tax revenue

Optimum level (t*) If current tax rate < t*,

tax rate tax revenue If current tax rate > t*, tax rate tax revenue

To tax revenue Increase tax rate if tax rate < t* Decrease tax rate if tax rate > t*

Tax revenue ($)

0Tax rate (%)100t*

Classification by tax rate

Basic terms Taxable income Tax rate Tax payment

Basic calculation Tax rate =

Taxable income = Total income – Tax allowance – Tax deduction

e.g. parent, children…

e.g. donation, study fee…

Classification by tax rate

Calculate the tax rates on each person at different scheme. Tax scheme

Mr. Lee Mr. Chan Miss Wong

Income ($)

Tax payment ($)

Income ($)

Tax payment($)

Income ($)

Tax payment ($)

A 10,000 1,000 100,000 2,200 1,000,000 12,000

B 10,000 1,000 100,000 10,000 1,000,000 100,000

C 10,000 1,000 100,000 15,000 1,000,000 200,000

Tax scheme Mr. Lee Mr. Chan Miss Wong Types

A 10% 2.2% 1.2% Regressive

B 10% 10% 10% Proportional

C 10% 15% 20% Progressive

Classification by tax rate

Progressive tax (累進稅 ) Higher the taxable income, higher the tax rate. When taxable income increases, the tax rate increases.

Taxable income ($)

Tax payment ($) Tax rate (%)

Mr. A 100,000 5,000 5

Mr. B 200,000 20,000 10

Mr. C 300,000 45,000 15

Classification by tax rate Progressive tax

Relationship between Taxable income Tax rate

Tax rate (%)

0Taxable income ($)

100,000 200,000

5

10

15

300,000

Classification by tax rate Progressive tax

Relationship between Taxable income Tax payment

Tax payment ($)

0Taxable income ($)

100,000 200,000

5,000

20,000

45,000

300,000

Classification by tax rate

Proportional tax (比例稅 ) No matter the taxable income is, the same tax rate. When taxable income increases or decreases,

the tax rate remains unchanged.

Taxable income ($)

Tax payment ($) Tax rate (%)

Mr. A 100,000 5,000 5

Mr. B 200,000 10,000 5

Mr. C 300,000 20,000 5

Classification by tax rate Proportional tax

Relationship between Taxable income Tax rate

Tax rate (%)

0Taxable income ($)

100,000 200,000

5

300,000

Classification by tax rate Proportional tax

Relationship between Taxable income Tax payment

Tax payment ($)

0Taxable income ($)

100,000 200,000

5000

10,000

15,000

300,000

Classification by tax rate

Regressive tax (累退稅 ) Higher the taxable income, lower the tax rate. When taxable income increases, the tax rate decreases.

Taxable income ($)

Tax payment ($) Tax rate (%)

Mr. A 100,000 12,000 12

Mr. B 200,000 20,000 10

Mr. C 300,000 24,000 8

Classification by tax rate Progressive tax

Relationship between Taxable income Tax rate

Tax rate (%)

0Taxable income ($)

100,000 200,000

12

10

8

300,000

Classification by tax rate Progressive tax

Relationship between Taxable income Tax payment

Tax payment ($)

0Taxable income ($)

100,000 200,000

12,000

20,000

24,000

300,000

Indirect taxes are regressive taxes Duty on tobacco ($1.706 per cigarettes)

Suppose 3 persons consume 1000 cigarettes per year. Their income and tax payment on cigarettes are list below. To simplify calculation, assume tax on each cigarette = $2

Mr. A, with the least taxable income, pays the highest tax rate. Mr. C, with the most taxable income, pays the lowest tax rate.

It is a regressive tax.

Taxable income ($)

Tax payment ($) Tax rate (%)

Mr. A 60,000 2,000 3.33

Mr. B 180,000 2,000 1.11

Mr. C 1,000,000 2,000 0.2

Hong Kong tax system

Types Classification by tax rate

Items Description

Direct taxes

Progressive Salaries taxOrdinary salary earners pay a progressive tax

Proportional

1. Profit tax2. Property tax3. Salaries tax

(standard rate)

Profit tax rate - limited companies: 16.5%- other companies: 15%Property tax rate: 15% of balance after deduction of 20% rental incomeStandard tax rate of the salary tax: 15%

Indirect taxes

Regressive Duties

Taxes imposed on goods:- Hydrocarbon oil- Alcoholic beverage- Methyl alcohol- Tobacco

Calculation of salaries taxMr. A’s monthly salary in fiscal year 2010/11 = $40,000 Annual salary = $40,000 x 12 = $480,000 Personal allowance = $108,000 Assume no other deductions Then, taxable income = $480,000 - $108,000 = $372,000

  Net Chargeable Income ($) Rate Tax Remaining

  372,000  

On the First 40,000 2% 800 332,000

On the Next 40,000 7% 2,800 292,000

Sub-total 80,000   3,600

On the Next 40,000 12% 4,800 252,000

 Sub-total 120,000   8,400

Remainder 252,000 17% 42,840

Total 51,240

Calculation of salaries taxMr. B’s monthly salary in fiscal year 2010/11 = $20,000 Annual salary = $20,000 x 12 = $240000 Personal allowance = $108,000 Assume no other deductions Then, taxable income = $240,000 - $108,000 = $132,000

  Net Chargeable Income ($) Rate Tax Remaining

  132,000  

On the First 40,000 2% 800 92,000

On the Next 40,000 7% 2,800 52,000

Sub-total 80,000   3,600

On the Next 40,000 12% 4,800 12,000

 Sub-total 120,000   8,400

Remainder 12,000 17% 2,040

Total 10,440

Calculation of salaries taxMr. C’s monthly salary in fiscal year 2010/11 = $12,000 Annual salary = $12,000 x 12 = $144,000 Personal allowance = $108,000 Assume no other deductions Then, taxable income = $144,000 - $108,000 = $36,000

  Net Chargeable Income ($) Rate Tax Remaining

  36,000  

On the First 36,000 2% 720 0

On the Next 0 7% 0 0

Sub-total   720

On the Next 0 12% 0 0

 Sub-total 0   720

Remainder 0 17% 0

Total 720

Calculation of salaries tax

Mr. A: Higher the salary Higher the tax rate Mr. C: Lower the salary Lower the tax rate Salaries tax is a progressive tax.

Annual income ($)

Tax payment ($) Tax rate (%)

Mr. A 480,000 51,240 10.68

Mr. B 240,000 10,440 4.35

Mr. C 144,000 720 0.5

Calculation of salaries tax (high income)Mr. D’s monthly salary in fiscal year 2010/11 = $80,000 Annual salary = $80,000 x 12 = $960,000 Personal allowance = $108,000 Assume no other deductions Then, taxable income = $960,000 - $108,000 = $852,000

  Net Chargeable Income ($) Rate Tax Remaining

  852,000  

On the First 40,000 2% 800 92,000

On the Next 40,000 7% 2,800 52,000

Sub-total 80,000   3,600

On the Next 40,000 12% 4,800 12,000

 Sub-total 120,000   8,400

Remainder 732,000 17% 124,440

Total 208,440

Calculation of salaries tax (high income)

Mr. D’s annual salary in fiscal year 2010/11 = $960,000

By usual calculation, tax payment = $208,440

Tax rate = = 21.71%

Since tax rate > standard tax rate (15%)

Standard tax rate will be charged

Actual tax payment = $960,000 x 15% = $144,000

Calculation of salaries tax (low income)

Mr. E’s monthly salary in fiscal year 2010/11 = $6,000

Annual salary = $6,000 x 12 = $72,000

Personal allowance = $108,000

Assume no other deductions

Then, taxable income = $0,

because annual income < personal allowance

No need to pay salaries tax

The structure of salaries tax in HKTax rate (%)

0Income ($)

A

Tax allowance

Standard tax rate

B

Progressivetax

Proportionaltax

The effects of tax on income redistribution

1. Narrow the gap between the rich and the poor The government’s revenue and expenditure

Tax revenue from the taxpayers who earn taxable salaries the companies which gain profit

Expenditure provide inexpensive or free services for the poor or low income earners subsidies for the unemployed or low income groups

Progress income tax Higher income earners pay higher a tax rate. Lower income earners pay lower a tax rate.

The effects of tax on income redistribution

2. Salaries tax be adjusted A more equal income distribution

A. Increase the basic tax allowance

Personal allowance

Dependent children

Dependent parents/grandparents maintained by you

More low income earners can be excluded from paying tax

The effects of tax on income redistribution

2. Salaries tax be adjusted A more equal income distribution

b. Decrease the tax rates of all tax bands

That is, tax rate of the first three bands of $40,000 taxable

income

Lower tax burden of the middle class

More low and middle classes pay less tax burden.

The effects of tax on income redistribution

2. Salaries tax be adjusted A more equal income distribution

c. Increase the standard tax rate

Very higher income earners pay a standard tax rate

Increase in standard tax rate will affect high income groups only

More tax revenue can be collected from the high income groups

The effects of tax on income redistribution

3. Goods and Services Tax (GST)

Suppose 20% GST is charged on buying a book ($100).

Therefore, $20 is the tax payment.

To a low income (income = $200) buyer,

tax rate = = 10%

To a high income (income = $40,000) buyer

tax rate = = 0.05%

GST is a regressive tax, more uneven income distribution.

Argument of imposing GST in HK

For Broaden the tax base Many examples from foreign countries, e.g. Japan, U.S.A. Reasonable to “buy more goods, pay more tax” Fair tax system. All people need to pay GST.

Against Increase tax burden Worry of increase in tax rate High cost of tax calculation High cost of tax collection P Qd , lower consumption lower GDP Destroy the simple tax system of HK Income disparity