With its economy slowing, China will rely more on fiscal policies — including tax relief — to rebalance its economy to bolster private consumption and investment. However, tax relief, coupled with the overall slowdown, will result in tighter budgets for local and central governments, particularly in the central and western regions. Beijing will issue more local bonds, increase fiscal transfers and expand the local tax base with new property tax reforms in an effort to ease local governments' financial burden.
Spurred in part by its slowing economy, China is gathering steam in its efforts to rebalance its tax structure. During the country's annual legislative session this month, Chinese Premier Li Keqiang announced an expanded 2 trillion yuan ($298 billion) reduction — or 10 percent of China’s total government budget revenues last year — in taxes and fees for individual taxpayers and private business this year. Together with a smaller package last year, the measures could free 100 million individual taxpayers (mainly lower- and middle-class citizens) from income tax and lower the tax burden for private enterprises by as much as 20 percent. The tax package is designed to ease the growing financial stress on private businesses and kick-start flagging consumption amid the Chinese economy's struggles with high debt and the lack of impact from traditional government-led investments.
The Big Picture
In the decade since the global financial crisis, Beijing has relied on expanded credit to develop infrastructure and the property market to ameliorate economic pain amid a slow-moving economic transition. But as China faces multiple challenges, including an extended economic slowdown, the U.S. trade war and diminishing returns from its previous stimulation policies, Beijing is turning more toward different fiscal policies to address economic challenges.
Although the central government is on a relatively sound financial footing, growing imbalances (overall revenue sources are slowing — or even declining — while expenditures are growing) mean local governments will bear the brunt of the expected shortfall, since many are already wallowing in high debt. In response, Beijing will use various methods, including fiscal transfers, more bond issuances and the cultivation of new tax bases, to plug the gap; yet these measures have their drawbacks, ensuring that China's continued economic slowdown will limit just how far Beijing can go in righting the ship.
Providing Tax Relief
Beijing's resort to tax cuts speaks volumes about China's present reality. But following a decadelong credit boom, the majority of which flowed into government-led infrastructure projects and property investments, the costs of the expansion are now outweighing the benefits. Beyond high debts and excessive industrial capacity in state-owned sectors, as well as overspeculation in the property market, policies that funneled capital into state-owned enterprisesinstead of the private sector — the focus of most production and innovation — hurt the latter. At the same time, China is finding itself in a tight squeeze as it tries to incentivize domestic spending (a critical aspect of Beijing's attempts to rebalance) due in part to rising mortgage and overall household debt, which have grown the last three years. Essentially, now that quick-fix solutions are no longer as effective as before, China's leaders have no choice but to resort to less-palatable measures to put the country back on track to sustainable growth.
Still, tax cuts for corporations and households alone are unlikely to deliver the same effects as credit expansions or state-led investment spending. Although the relief will certainly help alleviate the burdens for companies and individuals, its net impact will be relatively light since the extended economic slowdown will deter consumption and private investments at a time when many small- to medium-sized private corporations are struggling to make ends meet. Last year, for example, overall industrial profits contracted for several key manufacturers in the information technology, automotive and other sectors, even though the government offered 1.3 trillion yuan in tax relief. Likewise, this year's tax package, which amounts to roughly 2 percent of gross domestic product, is only expected to generate 0.5 percent in GDP growth. In other words, if China's tax strategy is to succeed, Beijing must complement its supplementary policies with a more sustainable approach to support the real economy so consumers can spend and companies can expand their business scale and capital expenditures.
Tightening the Belt
Given the limited impact of the tax cut, the government will have to continue pumping money into infrastructure and investments and pursue other monetary policies to stimulate the economy. The challenge for China, however, is that it must do so against the backdrop of slowing, and perhaps even declining, overall revenue sources. Central government revenues have already slowed for two years straight, even dipping into the negative a few times in the final months of 2018 as a result of the decelerating economy and the tax cut.
Provincial and regional governments, meanwhile, are likely to come under greater stress. Significantly, land sales, which accounted for roughly half of local governments' total revenue sources in 2017, slowed sharply in 2018 because of continued restrictions on the property market. Partly as a result of these limitations, nearly half of China's provinces reported slower growth in local fiscal revenues last year. (Tianjin, meanwhile, even reported falling revenue.) And unless the government takes action to boost the real estate market in the coming months by loosening restrictions preventing homeowners from buying additional property or engaging in speculation, continued economic stress will likely further weaken provincial governments' fiscal position, just as tax cuts are taking effect and other expenditures are growing.
Ultimately, the growing fiscal stress has compelled both the central and local governments to tighten the belt this year. At present, China has forecast a budget deficit of 2.8 percent of GDP for 2019 — a figure that is far below that of many other major countries like the United States (3.9 percent) and Japan (3.7 percent) — but the final number is likely to be much higher. In the recent legislative session, nearly all provincial and regional governments reduced their projections for revenue growth this year, with several provincial governments, even those in wealthy coastal regions, looking to tighten bureaucratic expenditures by as much as 5 percent this year. In less prosperous regions, including Guizhou in the southwest or Inner Mongolia in the north, the target for cuts is as high as 10 percent. And with many provinces and regions already facing debt stress (especially those in the central and west with weaker financial abilities), fiscal constraints will add further challenges, undermining their ability to maintain economic and, by extension, social stability.
Coping With the Stress
To address the problem, Beijing has increased this year's local government bonds by 3.08 trillion yuan, a 41 percent rise year on year. Officially, local government debts remained at a healthy level of 18.4 trillion yuan, or 20 percent of GDP, at the end of 2018, but the true figure is estimated to be as much as 40 trillion yuan. In the end, with the fiscal stress unlikely to abate in the next two years, the local bonds essentially presage a greater local debt burden.
The current tax structure, which is based on a 1994 tax reform, has widened the fiscal imbalance between the central and local governments, privileging the former. But because local governments must foot the bill for the tax reduction and the growing fiscal burden, these jurisdictions will have greater cause to demand that Beijing increase fiscal transfers — even though such payments could erode the central government's financial strength in the long term. In 2017, 80 percent of the central government's revenue found its way to local governments, accounting for roughly 40 percent of local jurisdictions' total expenditures. Among the country's 31 provinces, just a handful of them — primarily eastern or coastal regions such as Beijing, Shanghai and Guangdong — are close to fiscal self-sufficiency, thereby allowing them to contribute to the central government's coffers. But as tax bases in these wealthy regions begin to evaporate, the growing outflow in financial transfers could also create disagreements between Beijing and these wealthy regions, as well as among local governments themselves.
Beijing, meanwhile, has been attempting to cultivate new tax bases by increasing dividends from state-owned companies, exercising tighter fiscal enforcement and finding new sources of tax, especially the long-discussed property tax. While the efforts to find new tax bases could raise the ire of the state-owned companies, the property tax could further hit the moribund property sector and, thus, the economy at large. With its economy facing strong headwinds, China will struggle to implement the necessary measures, leaving it on course for a more precarious position down the road.
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