Tax and spend

What does Beijing’s first major fiscal change since 1994 signal?

Apartment buildings are seen in a residential area at Pudong district in Shanghai

Time for a property tax to help out local government finances?

When central governments make changes to local taxes the effects can be far-reaching. For instance, when Lord North, the British prime minister, passed the 1773 Tea Act his American subjects objected, citing the now famed mantra “No taxation, without representation”. The War of Independence followed and the United States was born.

Changes in tax policy are rarely as dramatic as that, but a shift in how tax is collected in China this month is being viewed as significant. In fact, it’s the biggest revamp of the fiscal relationship between the central and local governments since 1994.

On May 1 the State Council formally got rid of business tax – a source of income appreciated by local governments because they kept all of it – and replaced it with VAT (value-added tax). Manufacturers had previously paid VAT, but what changed this month was that the services economy was included for the first time – i.e. sectors like construction and finance.

Under the changes, the levy moves from a ‘percentage of revenue’ to the ‘value added at each step from producer to consumer’. Local governments are distinctly less keen on VAT than business tax, because they keep less of the proceeds. Instead the bulk of the revenue flows into the central government’s coffers in Beijing.

“In the long run, the tax change is the right move for the economy,” points out The Economist. “It replaces a business tax based on gross revenues. Under the value-added system, companies may deduct many of their input costs… the deductions should end up saving them money.”

Indeed, Xinhua quotes a senior figure with the State Administration of Taxation as claiming that the switch to VAT will save companies around Rmb500 billion ($76.72 billion). Looked at this way, it is a timely stimulus for an economy suffering from a slowing growth rate (the sectors affected by the new tax account for 30% of China’s GDP).

The same tax authorities reckon the change could add 0.3% to growth, boost private consumption by 1% and lead to the creation of 700,000 new jobs, reports Time Weekly

The changes should also create greater transparency – companies will have to produce a comprehensive paper trail of receipts in order to claim back the maximum deductions. This should shrink the black economy over time.

But the elimination of the business tax marks a blow to local tax bureaus, whose staff did the collecting. A lot of these officers will now be surplus to requirements as the VAT will be captured by the State Administration of Taxation in Beijing. It thus marks another round in the tug of war between central and local tax authorities, that has been ongoing since the People’s Republic was founded in 1949.

A new paper by the ADB Institute – co-authored by Fan Ziying, a professor at the Shanghai University of Finance and Economics and the ADB’s Wan Guanghua – looks at this relationship and why 1994 proved a watershed year. The authors note that as Deng Xiaoping’s economic reforms picked up pace in the 1980s, local governments captured most of the fiscal benefits while “a weak central tax system” deprived the central authorities in Beijing of revenues (and, by extension, control). The 1994 reform reversed this, recentralising tax policy and channelling the majority of revenues to Beijing to disburse as it pleased.

The authors say this had positive and negative outcomes. The central government still transferred most of the revenues back to the local governments (for example, in 2012 central revenue was Rmb5.6 trillion, of which Rmb4.5 trillion was sent back to the localities). However, Beijing was able to stipulate that a proportion of the funds was spent on projects that it had identified as priorities, especially infrastructure projects. This spending had a multiplier effect. The ADB paper found that for every 1% rise in earmarked transfers for infrastructure there was an associated 5% increase in local spending. The outcome: the Chinese economy modernised rapidly over that period, helped by all those new roads, ports and railways.

The downside to the tax deal was that local governments were still saddled with costly bills for education, healthcare and other public services. Some of the fiscal transfer from the centre covered these expenses but the authors calculate that as much as 42% of funds was earmarked in any given year to infrastructure, and thus unavailable.

This put enormous stress on local budgets, with business taxes (the ones that have just been abolished) not sufficient to cover the shortfall. The local governments found two main ways to raise the extra funds they required: selling land to developers (which the authors of the ADBI report say could make up over half of local revenues in any given year) and borrowing money (often incurred off-balance sheet by local government financing platforms).

Fan and Wan’s paper – entitled The Fiscal Risk of Local Government Revenue in the People’s Republic of China – argues that neither source was sustainable.

Which brings us back to the current round of tax reform. Local governments had feared that the new measures would worsen their financial situation as they expected to be rebated 25% of the VAT take. Instead they are to be given a more generous 50% and they have received a promise from the finance ministry that further payments will ensure that no locality is worse off.

While most analysts have been positive on the VAT change, there are those that argue that it only reinforces the centralising principle established in 1994 – and that it won’t solve local governments’ difficulties in balancing their books. Nor, says the ADBI report, can land sales be counted on to make up the shortfall forever – aside from being a volatile source of income there is a finite amount of attractive land that can be sold.

(In one of their more interesting findings Fan and Wan also argue the current fiscal arrangements can lead to regional favouritism. They looked at the birthplaces of 29 ministers of the State Council and found that “on average, if the minister came from a certain city, then earmarked transfer funds received by the city would increase 10.4%”.)

Their conclusion is that the next round of major tax changes should favour local governments by boosting their tax-take locally. The authors say the only way forward is a US-style property tax, which levies an annual rate on the value of local real estate. This scheme has been piloted in Shanghai and Chongqing, although the receipts are said to have been very low “due to the low efficiency of collection and lenient tax terms in the two cities”. However, by the authors’ assessment, should Shanghai levy a more aggressive 1.2% rate on the city’s real estate owners the take would reach Rmb97 billion – more than the land sale revenue of Rmb87.5 billion the city obtained in 2011.

In other words, a property tax could replace the need to sell land to developers, they believe.

As a more sustainable way of replenishing local government budgets, what is stopping the nationwide introduction of such a property tax? Well, government officials at central and local level worry it could have a toxic effect on the all-important real estate sector. And given that property and construction are key drivers for the wider economy, now is not felt to be the time to weaken sentiment.

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