China has recently slashed the employer contribution rate to the social-security fund from 16-20% (with some variations across regions) to 16%, and cut the value-added tax (VAT) rate from 16% to 13% (for most enterprises). This is on top of a previously announced reduction in the corporate income-tax charged on the first CN¥3 million ($447,000) of taxable income. These policy moves are timely and useful in combating the downward pressure on economic growth, but they also raise the risk of a future debt crisis.
The loss of government revenue will not be entirely proportional to these rate reductions as the government can also tighten enforcement to reduce tax evasion. Still, the government expects the tax reform package to lead to a substantial reduction in revenue by some CN¥2 trillion, or about 2.1% of GDP, this year alone. The policy package would likely raise the central government’s fiscal deficit from 2.8% of GDP to about 5%, and increase central-government debt from about 47% of GDP to perhaps 70% over the medium term. Add to that the liabilities implicit in closing the funding gap in the social security system, as well as massive local-government debts, and overall public debt could grow much larger, potentially exceeding 150% of GDP in a few years.
International experience from developing countries shows that a large and growing government debt is unsustainable and often leads to a major economic crisis down the road. To avoid such an outcome, China can consider five additional reforms.
First, they should make the VAT reduction temporary, announcing that the 2018 rate will be restored in 2021 (with a possible extension, if the economy is still not meeting its growth potential). A temporary cut would not only put less pressure on the long-run value of the government debt; it would actually give a more powerful boost to growth than a permanent cut of the same percentage because households and firms would have incentive to spend and invest sooner.
It should be pointed out that the reduction in the employer contribution rate to the social-security fund can be made permanent, and the contribution rate may even be further reduced to 15%. There is no reason to return to the level in 2018. China’s social security tax rate in 2018 was higher than not only most developing countries, but also most developed countries. By seriously undermining the international competitiveness of enterprises, it has a negative impact on job opportunities. It is important to note that the nature of a country’s social security system is a compulsory saving scheme, which is very important for countries with low savings rates, such as the United States and the Philippines. It is less crucial to impose a compulsory saving scheme in countries such as China when the households’ voluntary savings rate is already high. Because a reduction in the social security contribution rate will affect both the government’s future expenditures on pension payout and revenues, it will not have a significant impact on the government’s total debt in the long run.
Second, China should replace administrative restrictions on greenhouse gas emissions and other pollution with new taxes. The scope for doing so is big as China is the world’s largest polluter and CO2 emitter, on an annual basis. (In cumulative emissions, the United States remains in the lead.) And public demands for environmentally friendly policies are growing stronger.
While China has a modest tradable-permit program for certain pollutants, most of the control in practice takes the form of administrative restrictions targeting certain activities by certain firms. While such restrictions reduce emissions by raising costs of emission for firms, as a tax would, they generate no revenue for the government. They can also undermine efficiency, by creating disparities in marginal production costs among producers in similar industries.
A better approach would replace most or all administrative restrictions with taxes on emissions and pollution – the two are not the same as some pollution does not involve greenhouse gas emission – and broaden the coverage to other offending activities not currently restricted. This includes ramping up the tradable-permit program by lowering the threshold beyond which firms have to pay and eliminate exemptions from permits by firms or industries. Such actions would not only boost fiscal sustainability – the additional revenues could total 2-3% of GDP – but also improve the efficiency of overall resource allocation.
Third, some parent companies of state-owned enterprise groups have accumulated a large sum of dividends and undistributed profits, while they may not have much profitable investment opportunity. Since the State is the owner of these SOE conglomerates, it can demand to transfer these undistributed profits and dividends to the state coffer. This will not only help to reduce the government debt but also potentially improve the overall investment efficiency of the economy. To implement this policy, it is important not to adopt a one-size-fits-all approach. Instead, it is useful to distinguish between SOE groups that have high-return investment projects and others that have low efficiency and low returns. Furthermore, for low-efficiency SOEs in competitive sectors, it may be worthwhile to sell off these firms to the more efficient and more innovative firms in the private sector and generate more revenue for the State.
Fourth, China can lower government spending (in the medium term) by streamlining its vast administrative hierarchy. In recent decades, many of the largest global companies have taken advantage of new technologies to reduce the number of employee layers, from top executives to factory workers, thereby reducing costs and boosting efficiency. China’s government, in comparison, has retained the same five-layer administrative structure – starting with the central government, and moving down through provinces, prefectures, counties, districts or cities – since the founding of the People’s Republic 70 years ago. This vast administrative apparatus employs over 14 million civil servants, and millions more who work for government agencies but do not use that classification.
China is already a global leader in e-commerce and digital payment; it has all the physical infrastructure to become a leader in e-governance. Using digital technology and other Information and management technologies, China could eliminate one or two layers of its administrative apparatus. This would massively and permanently reduce overall government spending, while improving the delivery of government services. It will also help with reducing corruption.
One concern may be that downsizing government employment would exacerbate the effects of slowing economic growth. But the cuts need not be abrupt. A longer-term attrition plan could be put in place that takes advantage of retirement and normal resignations to reduce the overall size of the government over time. Additional voluntary separations can be induced by modest inducements to subside job searches. In this manner, the government could be made 15-20% smaller – and considerably more efficient – within, say, eight years.
Fifth, it is time to make a real estate tax and land use tax a part of the tax system. To reduce distortions and minimize corruption, such taxes should be simple, uniform, and with no exemptions. This can become a significant part of local government revenue and can help housing prices to transition to a level more compatible with economic fundamentals.
China’s latest tax cuts serve an important purpose: to combat downward pressure on economic growth. The risk of a future debt crisis should be addressed with a few complementary actions – making the VAT rate cut temporary, broadening taxes on greenhouse gas emissions and other pollutants, converting undistributed profits and dividends from those low-efficiency SOEs to government revenue, implementing a real estate tax, as well as streamlining the government. These reforms will contribute to more efficiency, greater fiscal sustainability, and longer lasting prosperity.