Xi must end this silly 30-year-old tax treaty

Shuli Ren, Bloomberg

The system is ruining China’s public finance and is the root cause of the nation’s biggest economic problems.

So what if China levies taxes on private jets and golf clubs? Clawing money out of the very rich isn’t going to push the country off a fiscal cliff.

Expectations are rising that a tax reform is on the agenda at next week’s Third Plenum, a once-in-five-year conclave of top officials charting China’s economic future. A complete overhaul of consumption taxes — till now limited only to a handful of items such as tobacco, refined oil and alcohol — may be on the table. Municipalities might be allowed to impose levies on luxury services to broaden their income stream, according to local media reports.

A third year into a property slump, China’s municipal finance has become untenable. Land sales, which used to account for about one third of local governments’ total income, have fallen 42% from their 2021 peak.

Last year, borrowings from local government financing vehicles, essentially off-budget debt, reached 60 trillion yuan ($8.3 trillion), or 48% of China’s gross domestic product, according to estimates from the International Monetary Fund. That’s twice as big as the central government’s liabilities. Some provinces, such as Tianjin, Guizhou and Yunnan, are struggling to cover their interest payments, noted Moody’s Investors Service.

This dire fiscal dilemma has prompted some desperate behaviors from local officials, who are looking around all corners to find money and make ends meet. Some are addicted to traffic fines. Between 2020 and 2022, municipalities’ non-tax penalty revenue grew by 24%, data from the Ministry of Finance shows. Others are misappropriating social welfare funds, such as meal subsidies for poor rural students, to settle debt. And is there a statute of limitation in China? Some bureaucrats have asked companies to pay tax bills dating back to the 1990s.

While creative, these fundraising tactics are also detrimental to the mood on the street. Local bureaucrats are society’s first impression of the political apparatus. Drivers and street hawkers are angry with big fines, while people are easily spooked by online rumors of missing public pension money. Businesses are not willing to hire either, because of exorbitant social security contributions. Clearly aware of this issue, Beijing has repeatedly warned local officials not to use aggressive gimmicks.

But a thorough audit and harsh words from the State Council, China’s top governing body, did not resolve the core issue in the country’s fiscal system. A three-decade-old tax agreement, which former premier Zhu Rongji strong-armed out of reluctant local cadets, reclassified the types of levies municipalities could charge and redefined how central and local government share fiscal income.

In the early 1990s, as China’s economic miracle started to materialize, the power center in Beijing felt poorer as it watched coastal regions prosper. By 1993, the central government was getting only 22% of the total government revenue, from 40.5% a decade earlier.

The 1994 reform was essentially a power grab. That year, the central government’s revenue share soared to 56%, even as its spending remained largely unchanged. Since then, while Beijing still relies on local tax offices to collect dues, it’s been getting more than what it spends and gets to decide how and to whom it distributes money. Municipalities, meanwhile, are saddled with the lion’s share of public spending, forcing them to seek alternative non-tax income, such as fostering real estate development and selling land.

The possible luxury tax that Chinese media is talking about is a half-baked partial solution that complies with the archaic 1994 tax treaty. While the central government collects all existing consumption taxes, municipalities will be allowed to keep this new levy, according to Cailianshe, a Beijing-based financial media outlet. But how many cities have private jets circling in the air? This proposal is at best a populist move that yields few concrete yuan. It can’t pull impoverished provinces from the brink of default.

[Abridged]