Recently, amidst the controversy over tax audits in various parts of China, there is a buzz in the Chinese media about the “reform” of new taxation, but it is also seen with pessimism. Experts are focusing on the economic crisis behind the new actions of the Chinese Communist Party (CCP), believing that issues including central transfer payments, local debts, etc. are difficult to resolve. The CCP authorities’ attempt to stimulate local enthusiasm through “reform” is seen as simply expanding arbitrary taxation, and the current auditing of tax payments from the past 30 years is already damaging the economy.
In 2023, the CCP Central Economic Work Conference and the Fourth Meeting of the Central Comprehensive Reform Committee began to mention the so-called “new round of fiscal and tax system reform.” This point was also brought up in the Government Work Report during this year’s “Two Sessions.”
Regarding the new round of fiscal and tax reform, reports from January 12 by Yicai Network and June 24 by Caixin, both compared it with the background of the 1994 tax system reform and the 2014 fiscal and tax system reform, pointing out the significant differences in the current economic situation. The CCP is facing financial shortages and serious issues such as local debts.
On June 24, Qin Peng, a political and economic observer in the United States, told Dajiyuan that the environments and goals of the previous two fiscal and tax reforms differ from the current one. The 1994 tax reform primarily focused on the tax-sharing system, establishing a system of returning tax revenues from central to local governments, leaving administrative power to local authorities and financial power to the central government. The rapid economic growth in China during the first 20 years, where fiscal growth rates even exceeded GDP growth rates, along with the central government allowing local governments to sell land to boost revenue, especially in 2008 when the CCP injected 4 trillion yuan to rescue the economy, led to a rapid expansion of local fiscal revenue through land finance. Today, local governments are burdened with high debts, which is a legacy of the tax-sharing system.
He pointed out that the fiscal and tax reform after 2014 was supposed to happen much earlier but was delayed until the past few years. The central authorities further centralized power, leading to the acceleration of manufacturing relocation, wealthy individuals emigrating abroad, and a continued slowdown in economic growth.
“It is well known that under the Party’s leadership in everything, the various disturbances by the CCP in the past decade have had a greater impact on enterprises and private individuals, leading to the exhaustion of the high-speed development of real estate economy and land finance. Now, these sectors have reached a dead end.”
Qin Peng believes that in the current background, the so-called fiscal and tax reform that has been initiated is mainly aimed at the crucial issue of addressing the government’s lack of revenue sources to ensure stable income for the regime.
“There are three major crises looming in China’s economy – local government debt crisis, real estate crisis, and the financial crisis of small and medium-sized banks. Obviously, preventing and resolving the risks of local government debt is also a significant goal of the new round of fiscal and tax reform.”
Caixin’s report also indicated that in recent years, economic growth has continued to slow down, with the growth rate of general public budget revenues consistently lower than economic growth, leading to tighter local finances.
Official figures show that in 2023, the national fiscal revenue was 21.7 trillion yuan; however, the income from land transfer fees dropped to 5.8 trillion yuan that year, a significant decrease of nearly 3 trillion yuan compared to the historical peak of 8.7 trillion yuan in 2021, marking a consecutive two-year decline. Various events such as bus suspensions, salary arrears to civil servants and institutions were seen in many places.
On June 24, American economist David Huang told Dajiyuan that local Chinese governments have been competing with the central government for tax and fiscal revenue share. Each reform has been an act of centralizing power.
He mentioned that in the tax reforms under Zhu Rongji in 1994, most of the tax revenues were managed centrally, with some revenues collected from areas with unbalanced development and redistributed through transfer payments. In the 2014 reform which aimed to refine the tax-sharing system, the power and scope of local tax administration were further reduced with most tax collection centralized under the central government, followed by central redistribution.
According to official CCP data, in 2023, central government’s transfer payments to local governments exceeded 10 trillion yuan.
Yang Zhiyong, a researcher at the Chinese Academy of Social Sciences Institute of Financial Strategy, told Caixin that excessive reliance of local finances on transfer payments could lead to phenomena such as waiting, relying, and demanding, but he believes the authorities may not solve these problems in the short term.
Qin Peng told Dajiyuan that a while back, Guizhou wanted to pass on the burden of debts to the central government, but the central government insisted, “Everyone should take care of their own problems.” Wealthy provinces and cities are unwilling to bear the burden for the whole nation and are passive in their resistance. With the backdrop of a highly centralized and authoritarian central government not providing funds, local governments are becoming increasingly inactive, waiting for directives and deployments from the central authorities, essentially turning it into a farce.
David Huang noted that one reason for the financial crunch in local governments is their rapid investments and spending during the past years of fast economic growth. Now they are unable to stop spending, and many infrastructure projects have entered a phase of requiring extensive maintenance and repairs. The other reason is that new officials in local governments only know how to increase revenue but are not skilled in reducing expenditure. Each new official wants to launch large infrastructure projects to boost GDP quickly, leading to extravagance, waste, and a continuous increase in debts.
Signs indicate that some local governments are exploring various sources of revenue.
According to Caixin, a significant reason for the financial difficulties faced by local governments is the sharp decline in revenue from land transfers. Some regions are already seeking alternative sources of income, such as revitalizing state-owned assets. Resource-based provinces are accelerating the revitalization of mining rights, among other initiatives. Recent discussions have also proposed using equity finance and data finance to replace land finance. However, the report believes that these alternative sources are not optimistic, with limited income increments.
A senior fiscal and tax researcher told Caixin that in the short and medium term, the CCP may have to increase the scale of government debt financing.
In the current debt structures of the CCP government, local government debt exceeds national debt levels. According to CCP Ministry of Finance data, by the end of 2023, China’s national debt balance was 30.03 trillion yuan, while the balance of local government debt was 40.74 trillion yuan.
Caixin pointed out that even without considering the hidden debts of local governments, the aforementioned debt structure is quite rare among major economies, as government debts internationally are generally dominated by central government debt to facilitate macroeconomic regulation.
Yicai Network mentioned that in the new round of fiscal and tax system reform, reshaping the fiscal relations between governments is crucial to stimulate local enthusiasm and address local financial difficulties and debts.
Based on Caixin’s reporting, former CCP Finance Minister Lou Jiwei suggested that China should manage affairs like a conventional major power where the central government takes charge of what should be managed centrally. The corresponding need for an increased number of central government officials could be met by transferring some from local governments. The proportion of central fiscal expenditure will increase accordingly, with significant reductions in special transfer payments and substantial reductions in interference in local affairs.
Other interviewees also told Caixin that the new round of fiscal and tax reform might focus on mobilizing and harnessing local enthusiasm.
However, Qin Peng told Dajiyuan that most provinces and cities are already running deficits under the previous central-local tax-sharing system. In the past few years, just a few provinces and cities have been supporting the entire nation financially, all shifting money around in the same basket. Therefore, the current tax-sharing reform is actually an illusion, as it cannot solve the national fiscal shortfall issue without expanding the total tax revenue. The latest data shows that almost only Shanghai has a fiscal surplus nationwide and can redistribute funds to other provinces and cities. So, the purpose of this tax-sharing reform is to stimulate local initiative, expand arbitrary taxation, not to relax the situation.
Recently, tax authorities in many regions of China have been investigating some companies’ tax payments dating back 30 years, causing social panic. This tax investigation wave coincided with the CCP’s hint of a new round of fiscal and tax reform, leading to speculation.
Qin Peng stated that the current wave of tax investigations in various regions mainly stems from the fact that local governments are indeed financially strained. The real economic growth in China is not as promoted officially, and is likely closer to -5% based on their calculations. This significant decline leads to a substantial drop in tax revenues from businesses and individuals.
He mentioned that local governments are now resorting to aggressive tax investigations to squeeze profits from private enterprises as their only option.
David Huang mentioned that before 2018, local governments were aggressively attracting investments, competing with each other, often offering ultra-low land prices and engaging in subsidies that violated tax regulations. The current investigations might be a result of their past violations, albeit without documented agreements, leading to enterprises being held responsible for tax evasion. Additionally, the rent-seeking behavior of tax departments has always existed, and is another reason why local authorities are now conducting tax investigations.
Huang added that another reason for the investigations is that the CCP has been sustaining government operations by continuously increasing currency issuance and debt. Now it wants to transition into a healthier operation model focusing on tax revenue. However, the timing for this transition is not appropriate as the economy is already slowing down. This investigation wave could cause significant damage to the economy.