The Importance of China's New VAT

Yesterday, China announced one of the most important tax reforms of the past twenty years. It is replacing a business tax on gross revenue for non-manufacturing companies with a VAT. Manufacturing companies have been subject to a VAT approach for a few years. The reform extends it from manufacturing and a few services in a pilot program to industry-wide application. It will now cover construction, real estate, finance and consumer services.

The shift to the VAT is expected to reduce the service sector's tax bill by CNY500 bln (~$77 bln) or 0.7% of GDP. A report indicated that businesses will pay 11% VAT compared with the previous 5.5% business tax. While the rate is higher, the base is considerably smaller. The break is consistent with the government's modest stimulative measures. It denies the government of revenue, but it was already built into this year's budget and incorporated in the deficit projection of 3% of GDP.

The shift to a VAT for services will help facilitate the economic transition from manufacturing to services as the economy matures. The manufacturing sector has benefited from the lower tax rate of the VAT and now services and small businesses will as well.

The VAT has other implications. While the introduction of a VAT for services seems fair as the manufacturing sector has benefited from what amounts to be a lower tax burden, and it acts as a small economic stimulus, it will exacerbate other imbalances in China.

The revenue of the older retail sales tax went completely to the coffers of local governments. It had accounted for about 40% of the revenue for local governments. The revenue generated from the VAT will be split, with the Ministry of Finance (central government) taking 75% and leaving the local government with 25%. As one can imagine, rich provinces, like Guangdong, does not like the new revenue sharing arrangement.

Here is the problem: Since the tax reform in the mid-1990s, the central government receives a little more than 45% of the tax revenues, but the local governments are responsible for more than 85% of the spending. This combination of low revenue and high spending obligations has created a perverse incentive structure of local governments. They have responded by relying on land sales, real estate development and off-balance sheet borrowings to square the circle.

Debt in China has accumulated on the corporate balance sheets and local governments. The revenue sharing of the new VAT may exacerbate the pressure on local governments. It does not seem sustainable, and the relationship between the local and central government will have to be restructured at some point.

The strengthening of the central government is consistent with the general thrust of President Xi's strategy. A range of actions has concentrated power in his hands. Within the Chinese Communist Party, there has been a balance between the so-called "princelings" and those from the Communist Youth League. President Xi is a princeling, and Premier Li is supported by the Communist Youth League. By tradition, the next government will have a person from the Communist Youth League as President while the Premier will be a princeling.

However, President Xi has so concentrated power and seems to shift responsibility for important things that have gone wrong, like the stock market slide and ham-fisted attempts last summer to stabilize to Premier Li and his supported. The risk seems to be growing that Xi's concentration of power is so great that the balance-of-power has been thrown out of kilter. Next year's 19th Party Congress is likely to see further consolidation of power by Xi.