Making China's tax cuts fiscally sustainable

China is about to slash the employer contribution rate to the social-security fund from 18-20 per cent (with some variation across regions) to 16 per cent, and cut the value-added tax (VAT) rate from 16 per cent to 13 per cent (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 of some CN¥2 trillion, or about 2.1 per cent of GDP, this year alone. The policy package would likely raise the central government’s fiscal deficit from 2.8 per cent of GDP to about 5 per cent, and increase central-government debt from about 47 per cent of GDP to perhaps 70 per cent 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 per cent of GDP in a few years.

International experience from developing countries shows that 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 three additional reforms.

First, the authorities 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 government debt; it would actually boost growth more powerfully than a permanent cut of the same magnitude, because households and firms would have an incentive to spend and invest sooner.

Second, China should replace administrative restrictions on greenhouse-gas emissions and other pollution with new taxes. The scope for doing so is large, given that 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 demand for environmentally friendly policies is growing stronger.

While China has a modest tradable-permit programme for certain pollutants, most of the control takes the form of administrative restrictions targeting certain activities by certain firms. While such restrictions reduce emissions by raising the costs 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 emissions — and broaden the coverage to other offending activities not currently restricted. This includes ramping up the tradable-permit programme by lowering the threshold beyond which firms have to pay, and eliminating exemptions from permits for firms or industries. Such actions would not only boost fiscal sustainability — the additional revenues could total 2 per cent of GDP — but also improve the efficiency of overall resource allocation.

Finally, 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, by contrast, has retained the same six-layer administrative structure — starting with the central government, and moving down through provinces, prefectures, counties, townships, and villages — 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 fall under 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 technologies, the country could eliminate one or two layers of its administrative apparatus. This would reduce overall government spending, while improving the delivery of government services. It would also help reduce 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 could be encouraged by modest inducements to subsidise job searches. In this manner, the government could be made 15-20 per cent smaller — and considerably more efficient — within, say, eight years.

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 by a few complementary actions — making the VAT rate cut temporary, broadening taxes on greenhouse-gas emissions and other pollution, and downsizing the government. These reforms would make China more efficient and prosperous. 

The writer, a former chief economist of the Asian Development Bank, is professor of Chinese business and economy and professor of finance and economics at Columbia University. ©2019 Project syndicate