Waiting for 3rd Plenum - Is a historic fiscal reform package coming?
Waiting for 3rd Plenum - Is a historic fiscal reform package coming?
Two crucial strings of events have occurred over the last few weeks in China. On the one side, there has been a growing incidence of tax collection efforts over “unpaid taxes” going way back. On the other hand, some corners of media and official outlets have openly predicted that a big fiscal reform is going to be rolled out in the upcoming 3rd Plenum.
These two things are tightly connected and may be the single most important thing in China right now. In today’s post, my ambition, in the true spirit of this newsletter, is to help you piece together all of these and make sense of them.
The predicament
It’s no secret that China’s local government finances, once mainly buttressed by land sales, have recently met some serious troubles as the real estate market changed gears. The pains of a public finance crisis are being felt, in the form of downgraded public services and delayed salary payments to public sector employees in many places.
Against this backdrop, there has been a growing number of stories about tougher tax enforcement action. For example, many local governments have recently set up the horribly named “Joint Tax-Police Combat Command”, giving tax authorities more policing teeth. Nationwide, “non-tax revenue”, which includes fines and penalties, has been on the rise, just when tax revenues have declined.
Many listed companies in China have announced they have been punished for tax evasion. Even Sinovac, China’s star vaccine maker (against whom the Pentagon ran a now infamous disinformation campaign according to Reuters) received a penalty from tax authorities for a total tax payment plus fines of more than RMB 20 million.
And these are just the listed companies. They have the legal obligation to make public disclosures about such penalties, but you can imagine under the water how many more other enterprises and individuals may have been targeted.
To be sure, the government is not inventing any new rules here. Very likely what happens is that there has been indeed some non-compliance on the part of companies, but tax bureaus looked sideways in the past. One of the arts in China’s administration is to allow some flexibility in law enforcement, so authorities can flex their muscle when and where they find it convenient. And now is the time.
Also, there is a clear difference between central and local government’s attitudes in this. The central government is very quick to dispel rumors suggesting there is a national campaign to investigate tax infringement taking place up to 30 years ago. I believe they are being honest here. It is almost certain there is not such an idiotic campaign, not from them. But who is to stop local governments from opening case files against potential suspects? After all, if there is tax evasion, the government has all the powers to investigate and penalize.
Leaving aside the question of right or wrong, if we only look at the practical side, this type of enforcement action will only make the economic situation worse by dampening business confidence. Tougher enforcement over a dwindling tax base will only make that tax base even smaller, as businesses are too weary to do any real business. This is the proverbial killing of the goose that lays the eggs.
Then there is also this perennial problem that Chinese people only seem to know how to produce, not how to consume. All policies at “stimulating” the economy only seem to stimulate the production side, leading Chinese manufacturers to produce without end, lending credence to the so-called “over-capacity” narrative.
Our current problem can thus be very simply summarized as a lack of aggregate demand. Households are not spending as desired, but producers keep producing, leading to higher trade barriers so foreign buyers may only buy less. At normal times, the government should step in to spend more in order to stimulate demand. But in our case, (local) governments themselves are facing a financial problem, and thus have no resources to spend. (And even when they have the money to spend, they tend to spend on production, not consumption.) It is already tough just to maintain an adequate level of spending, and to achieve that it already involves tougher law enforcement action, which can only inhibit demand even more. A vicious cycle is thus formed.
It is clear that a major systemic reform is required to break this cycle.
[For the rest of this article, I will comment on why the rumored fiscal reform program may potentially solve the problems above. This section will be behind the paywall for 5 days. If you are already a paying subscriber of Baiguan, you are entitled to a year’s complimentary access and please DM me for the access.
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The solution
The solution to the problems above will need to achieve two goals at the same time. It will need to make local government “richer”, so they can spend again. It will also need to make local governments spend more on boosting consumption, so the Chinese people become more willing to spend more. Even better, the policy solution should make these two things happen at the same time.
And any policy response will need to factor in two important facts. First, despite the troubles at local governments, China’s central government is actually very well-funded, itself a result of the pivotal “1994 Tax-Sharing Reform” that effectively centralized fiscal resources to the top. (Arguably, it’s the same reform, coupled with an exploding real estate sector, that made China’s local governments hooked on land sale revenues for a clear 3 decades.)
Another important fact is that the Chinese people are very willing to buy things. This is something we at BigOne Lab / Baiguan know full well with all the data at our disposal. When you look at prices, yes, we seem to be in a deflationary spiral. But when you look at the volume, be it real estate transactions, e-commerce purchases, or parcel volume, the growth is still very strong. This means that in terms of material needs, people actually are buying more. But they are just paying less for each item. The problem is about the price, not the volume.
And of course, Chinese people are not getting “poorer”. We are actually getting “richer”, when valued by cash. Household deposits have hit new highs after new highs.
Also, when you look at things like tourism, Chinese people seem to have had a sudden change in our behaviors. We now value leisure activities much more than we used to. If you look at the crowds lining China’s touristy places, it is really difficult to square it with the suggestion we may actually be in the biggest economic downtime in a few decades. Honestly, in which major recession in any history did people travel more?
Tourism is a very interesting case in point. It’s a consensus that we have entered a golden era of tourism, especially domestic tourism. But it doesn’t seem local governments are super hyped about it. One recent conversation I had with a local official of a low-tier city was quite telling. That city, although small, was moderately famous for its beautiful natural scenery, bucolic lifestyle, and relative proximity to metropolitan areas, so tourists and digital nomads really like to visit there. I asked the local official, who is in charge of attracting more manufacturing businesses to relocate there, why they did not focus on developing tourism instead. He said, well, tourism looks nice, but we (the government) have no revenues from it. In fact, with more congested traffic and higher security concerns, it’s only about expenditures.
It’s easy to see a huge mismatch reflected in these words. On the one hand, we all know that tourism is a rising sector in China. But the tourism dollar will not go into healthcare, education and other basic social infrastructures, nor will it go into paying the salaries of public employees. Two important trends - a rising consumerist society and a financially embattled local government - happen in a parallel universe.
It just doesn’t feel right, does it?
So here we are. We have a central government that is rich. Our people are also “rich” in cash but cautious about spending. The only missing link here is the “poor” local government. If we can’t solve local governments’ fiscal situation, the one systemic defect will threaten to make the whole economy ground to a halt. But if we do solve this one thing, all the right elements may fall into their right places, money go to where it should be going, and we will get moving again.
That’s why a huge fiscal reform has been rumored to be on the table of the 3rd Plenum, and also why within this possible fiscal reform package, “consumption tax” has been talked about the most.
Consumption tax is often an overlooked part of China’s tax system. At RMB 1.6 trillion, it’s only 8.9% of overall tax revenues, way behind value-added tax (VAT) and income taxes. At present, it’s only charged for a select group of consumer categories, such as luxury products, cigarettes, and booze.
Looking at how we levy our consumption tax, you will instantly understand why this particular issue suddenly becomes so relevant. There are 2 interesting things about this tax. First of all, it’s highly centralized. All consumption tax revenues go directly to the central government, unlike VAT (local governments have 50%) or income taxes (40%). Secondly, although it’s called a “consumption tax”, it’s charged to the producer, not to the consumer/retailer side! So maybe its more proper name should be “production tax for certain consumer categories”.
Putting yourself in the shoes of China’s local government. When you have a public finance crisis, what will be your first instinct? You will try your best to motivate more production because only when factories keep producing, you will have VAT and income tax revenue. You will never care about consumption, because A, only production can earn you consumption tax, and B, all of those taxes go to the central government anyway.
Here lies the key to understanding the logic of that local government official, understanding why governments in China and the consumer market seem to exist in a parallel universe, and understanding why despite persistent urgings from both outside and inside advising the Chinese government to boost domestic demand, our government still hasn’t committed to anything significant.
With the current fiscal setup, even if the central government launches any demand-boosting program, it will end up nowhere because the local governments, who are really in charge of the day-to-day affairs, will not have the incentive to carry out those programs.
This is also the key to solving the problem.
Prominent among the voices is the idea of shifting consumption tax to local governments. It’s also suggested that consumption tax may be charged “downstream”, meaning the retail side, turning it into a “real” consumption tax. It’s also likely that consumption tax may be expanded to more consumer categories. The hope is that, after this re-configuration of taxing mechanisms, local governments will now have a clear incentive to boost consumption, either by direct consumer subsidies or by indirect investments into public services such as healthcare and education.
recently had an article about David Daokui Li, a key policy advisor:he wasn’t citing any inside sources in his elaboration, but the former member of the Monetary Policy Committee of China’s central bank insists that after years of emphasizing the domestic investment part of domestic demand, Beijing has finally come around to the conclusion that domestic consumption is the key to stimulate domestic demand.
Now, if you think the 1994 China fiscal reform, the associated land-backed public finance, the real estate boom, and the rapid urbanization represented the most important trend over the last 3 decades in China, then clearly this 3rd Plenum is likely to be another watershed moment. I don’t know why media such as FT keep suggesting this is going to be a non-event.
So, is this big pivot really likely to happen? Has the leadership signaled any messages about this before?
This April, only a few days before the 3rd Plenum was announced to be held in July, Xi paid a visit to Chongqing and used this new phrase “民生为大 people’s wellbeing is of utmost importance”:
中国式现代化，民生为大，中国共产党要做的事情就是让老百姓过上更加幸福的生活。
In modernization with Chinese characteristics, people’s wellbeing is of utmost importance. The Communist Party of China’s job is to help the people to live a better life.
Was he trying to signal something?
A note to readers
Thanks for reading! Since I started this newsletter, I have stuck with the schedule of writing at least once a week. It’s almost an experiment about how much time and energy a full-time CEO of a company can dedicate to writing long-form essays. At this moment, I feel the results of this experiment are mixed. During busier times, I often feel I can’t keep up with the schedule.
In order to keep the fun and to avoid it from turning into a psychological strain, I decide not to stick with a fixed schedule. I will still try to write once a week, and I will definitely write something when really big events happen, but when and if there is a week when I don’t publish anything, I will not give advance notice.
If you are a paid subscriber but believe me writing at least once a week is part of the deal, I apologize and please come to me for a pro-rated refund.