China - The Taxman Cometh

Yesterday morning China slipped out the news that its respected finance minister Lou Jiwei is to be replaced by Xiao Jie. The same announcement named new ministers for state security and for civil affairs. The low-key way in which the news made its way to public view, and its unorthodox timing, raised all sorts of questions about the political manoeuvrings which may lie behind the move, as well as the policy implications. 

I think the crucial point is that in the new finance minister, China has a committed taxman. China’s policymakers recognize that at the heart of China’s debt and property market problems lies the inability of local governments to finance themselves adequately by taxes. And at the heart of that problem is the stark lack of an adequate system of personal taxation.  Very probably a fresh assault on this nexus of problems has forced its way to near the top of the policy agenda. 

In retrospect, it is possible to see that something was up. In my Shocks & Surprises global weekly summary, posted on Saturday, I wrote: 

“Perhaps the week’s most consequential release of data is also likely to have been among the least-regarded. The manufacturing and non-manufacturing PMIs compiled by the China Federation of Logistics and Purchasing are  establishing themselves as among the most broadly useful monthly check-ups on China’s economy. It is less the conclusions suggested by the headline indexes which are important (manufacturing rose 0.8pts to 51.2, non-manufacturing rose 0.3pts to 54), than the breakdown of orders,work backlogs, inventories and pricing which they describe. Where these can be cross-checked against other available data, they are providing an early lead to trends. 

“Of these subindexes, currently the most useful are the employment subindexes, since they provide a regular insight into China’s labour markets, which is of pre-eminent importance for China’s policy development, and  for which there is no obvious timely substitute. October’s employment subindexes rose 0.2pts to 48.8 for manufacturing – the mildest contraction since November 2013 – whilst the non-manufacturing subindex rose 0.3pts to 50, suggesting the contraction which started in February 2015 is finally abating. Weighting the two indexes by contribution to GDP results in the combined index rising 0.3pts to 49.2, suggesting the mildest squeeze on employment since March 2014. More, it extends what had been a tentative and debateable recovery into what begins to look like an established trend.

“If so, this marks an important development, since it provides scope for a shift in Chinese government policy priorities. Up to now, the need to support labour markets has been near the top of the government’s agenda (if not quite at the top), trumping in the short term the inescapable goal of restructuring China’s growth model.  

“If the deterioration of labour markets has been contained, as these PMIs suggest, then it allows the policy focus to shift back towards the knottier problems of overhauling China’s financial structure.  Consequently, it is probably not a coincidence that this was also a week in which the urgency of financial reform was stressed, with new policies: 
•    requiring swifter bankruptcies of China’s zombie companies, 
•    widening the scope of asset management company action, 
•    tightening the restrictions on bond issuance, 
•    launching China’s first CDS contracts (hardly a good sign, in my opinion), and
•    re-opening the debate about fiscal reform in a way which explicitly acknowledges the link with local government debt problems.  
The underlying message is that if the unemployment problem has lost some of its urgency, it’s time to take a firmer grasp on  financial issues. “

That last bullet point was one I wanted to elaborate on. It is always worth keeping an eye on the Global Times, a Party tabloid which runs a rosta of commentary pieces from which it is not difficult to distinguish interesting changes in tone and substance from ‘the usual fare’. Last week the new tone was unmistakeable: ‘New Strategy Needed to Get Fiscal Policy Right’.  To simplify what it said:

“Infrastructure-focused fiscal policies can no longer support sustainable growth as it may worsen government debt and hinder China’s economic transformation.’  This is absolutely true: the weakness of the local government revenue base is the core problem upon which virtually all China’s debt problems are based. But fortunately . . . . 

“Another fiscal tool is to cut taxes on corporations and individuals. At a Politburo meeting in late July, the top decision-making body highlighted the need to cut the “macro tax burden,” an expression that appeared for the first time in official parlance, fueling expectations of broader tax cuts. However, detailed measures have not been announced so far. The unfolding reforms to the tax system, which involve a move away from relying on corporate taxes and broadening the value-added tax (VAT) base, have been criticized by certain sectors for increasing their tax burden and hurting business. Although this negative impact on business may be temporary, it highlights the urgent need to fine-tune changes to tax policies.”

To these observations can be added another: the previous week, the Global Times also highlighted a recent State Council paper on China’s taxes on personal income, aimed at ‘reducing the tax burden on middle and lower-income classes and appropriately adjusting the tax rates on high-income earners’. Currently those with an annual income of Rmb 120,000 are classified as high earners and must file tax report. But that tax threshold was established back in 2005, and the Global Times was urging that if income taxes were going to rise, that threshold must rise too. 

This is the immediate background to the elevation of Xiao Jie, and it matters because Minister Xiao is, after all, a ministry of finance veteran who’ headed up the State Administration of Taxation between 2007 and 2013. Lou Jiwei was recently quoted as saying that he regretted the income and property tax systems were still only on the drawing board: ‘There are real barriers to income redistribution, but it must be carried out without hesitation’.  

Perhaps Minister Xiao has been put there precisely to get it done. 

And the situation is clearly now in need of an overhaul, and not only because of the direct link between inadequate tax collections and local government -related debt. First, the amount of revenues officially raised by the government has barely kept pace with GDP growth since 2011. As the chart below shows, total government revenues, including both tax and non-tax revenues, rose steadily as a proportion of GDP between 2000 and 2008, or arguably, taking into account the impacts of fiscal drag, to 2011.  At the beginning of 2000, those revenues were equivalent to 13% of GDP, and this rose to 20.4% by mid-2008 and 21.9% in mid-2011. However, since then, the proportion has flatlined, and in the 12m to 3Q16, revenues were equivalent to only 22.1% of GDP. 

Second, The monthly release claims to show central and local government revenues, including both tax and non-tax sources, and government spending, although it is highly doubtful that this is a comprehensive tally of either. Revenues tend to peak in January and to a lesser extent June, with tax representing about 82% of revenues. Of those taxes, the big revenue raisers are VAT (c28% of the total) and enterprise income tax (c24%) whilst personal income tax accounts for only about 7.5%.  VAT may be a relatively effective way of raising taxes but it is also inherently regressive, since its burden falls least heavily on the wealthy. 

Cometh the hour, cometh the taxman.