Amid financial difficulties faced by local governments in China, there have been widespread rumors in recent days that the upcoming Third Plenum of the Communist Party of China (CPC) this month will expand the scope of high-end consumption taxation and gradually allocate the collected consumption tax to local governments. Experts believe that allocating half of the central consumption tax to local governments is merely a drop in the bucket when it comes to solving fiscal problems. The CPC, in its haste to address the current crisis, may risk social unrest by imposing excessive consumption taxes intended to boost consumption.
Starting on July 2nd this year, rumors about consumption tax reforms have once again spread rapidly across major investment groups. Rumors suggest that a trillion-yuan reform in consumption tax is imminent, with luxury goods and high-end services possibly being the first targets for experimentation.
Consumption tax is one of the top four tax categories in China, with a revenue of 1.6118 trillion yuan in 2023, accounting for 8.9% of China’s total tax revenue. It is currently one of the four major tax sources that are not shared between the central and local governments.
Since the end of 2023, authorities have hinted at initiating a so-called “new round of fiscal and tax system reform.” Throughout this year, mainland China’s official media and scholars have published articles discussing tax reforms, with a focus on consumption tax issues.
Shi Zhengwen, Director of the Tax Law Research Center at China University of Political Science and Law, recently pointed out in an interview with mainland media outlet Yicai that the shifting of the consumption tax collection focus could begin with mature products such as high-end watches.
Currently, China’s consumption tax mainly comes from tobacco (43.4%), petroleum fuels (33%), automobiles (7%), and alcohol (4.6%). The existing “Provisional Regulations on Consumption Tax” was last revised in 2008, with many luxury consumer goods and activities such as private jets, equestrianism, and upscale club leisure activities not included in the scope of consumption tax collection.
According to reports from securities firms and financial media such as China Securities and Finance, China Merchants Securities believes that the direction of consumption tax reform is already clear, focusing on expanding the tax collection scope, shifting the tax collection process, and gradually allocating it to local governments, accompanied by corresponding adjustments in tax rates.
Currently, China’s consumption tax is entirely retained by the central government as central tax revenue, collected at the production stage by tax authorities in the production areas. The proposed distribution of consumption tax, known as downward allocation, involves transferring a portion or specific tax items of the consumption tax from the central government to local governments.
Guotai Junan Securities estimated that if the consumption tax revenue from cigarettes, alcohol, and other categories were split equally between the central and local governments at 50%, with finished oil products giving 20% to local governments, and small cars giving 100% to local governments, based on the 2023 revenue base, local governments are expected to see an increase in tax revenue exceeding 700 billion yuan, boosting local fiscal revenue by around 6 percentage points.
However, reports also mention that market expectations for consumption have been gradually declining since last year, and income data shows a declining trend in personal income tax growth. With the backdrop of declining income and consumption expectations, the potential impact of consumption tax reform remains to be seen.
On January 8, 2023, the Chinese authorities ended over three years of a “zero tolerance” policy, yet the economy has struggled to recover since then. Topics such as “downgrading consumption,” “return to poverty for the middle class,” “youth unemployment rates,” “deflation,” and “sudden salary cuts” have frequently trended on the internet. According to the Ministry of Finance of the CPC, personal income tax revenue from January to May this year was 607.2 billion yuan, a 6% decrease year-on-year.
Chinese issues expert Wang He stated that one of the reasons for the CPC’s fiscal and taxation reforms is the escalating debt levels of local governments, particularly hidden debts that are on the brink of exposure. The second reason is the collapse of the real estate bubble, leading to fiscal turmoil in land finances. Coupled with the continuous decline in China’s economic growth rate, the central government is facing major challenges.
Official data from the CPC indicate that by the end of 2023, the total debt balance of Chinese local governments was approximately 40.74 trillion yuan. However, according to data from the International Monetary Fund in 2022, local government debt in China had already reached 9.2 trillion yuan, accounting for 76% of the GDP.
Wang He mentioned that the so-called new round of fiscal and tax system reform should consider increasing revenue, as well as how to share power and distribute interests between the central and local governments. The traditional fiscal and tax system has become increasingly inadequate, and readjusting interests between central and local authorities poses significant challenges.
Chinese-American economist Li Hengqing commented that the fiscal reform initiated by Zhu Rongji aimed to encourage local governments. However, since Xi Jinping came to power, there has been a trend towards centralization, with the central government forcibly transferring fiscal power and national social security funds to the central government. Local governments have been locked in a long-standing power struggle with the central government due to their mounting fiscal pressures.
“When Liu Kun was the Minister of Finance, he said to take back the financial child, whereas the current minister, Lian Weiqing, might introduce some adjustments because if you cannot handle the pressure, local finances will be crushed. After negotiation, the central government might transfer more than 60% of the value-added tax to local governments, but direct tax rights will not be given to local governments for independent use.”
Regarding the rumored introduction of consumption tax, Wang He expressed skepticism, stating that while consumption tax was originally solely under the central government’s domain, if half were to be given to local governments, it would be of little help in addressing the escalating debt issues faced by local governments.
He believes that fiscal reforms are not likely to significantly alleviate the governance crisis within the CPC. “Rebuilding the current tax revenue structure is extremely difficult. The interest alignments have been solidified. The fiscal transfers by the central government last year exceeded one trillion, indicating a lack of fiscal space now.”
Li Hengqing noted that current mainland Chinese economists are advocating for an increase in consumption tax and even proposing a nationwide real estate tax. However, given the weak tax base amid economic struggles, now may not be the right time for tax hikes. He stated that adjusting the consumption tax would have little impact on the wealthy but would significantly affect the working class.
“With everyone facing financial constraints, increasing consumption tax would only discourage spending. If you promote consumption but then add consumption tax, people would be less inclined to spend. The CPC, while aspiring to boost the economy and consumption, is simultaneously expanding tax collection. This rush to implement consumption tax or real estate tax during this time is definitely not ideal and could spark social unrest. The authorities are solely focused on resolving immediate crises, with no long-term considerations; it’s a day-by-day approach,” he remarked.