For China, tax cuts may work where its 4 trillion yuan stimulus failed – by boosting the economy without creating more debt
- Hao Zhou says with Beijing still struggling to control the debt that swelled as a result of its 2008 rescue package, it has no appetite for more debt-fuelled stimulus. One way to increase domestic demand is to reduce the tax burden
China’s economic momentum has slowed noticeably, as suggested by headline growth figures, sentiment indicators and activity data. Since the beginning of 2018, the People’s Bank of China has lowered the reserve requirement ratio for the major commercial banks by 250 basis points in total, clearly suggesting that an easing cycle has been initiated.
However, China intends to shore up growth without falling back on debt-fuelled stimulus in this easing cycle, as a massive package to boost growth would trigger a déjà vu of the debt/disinflation cycle that has repeatedly happened in the past decade.
Indeed, since the Lehman collapse, while China has succeeded several times in preventing a dramatic economic slowdown with aggressive easing policies, the rapid credit/debt expansion – with deteriorating profitability of the corporate sector – suggests that the growth model is unsustainable.
Let’s begin with a brief review. Against the backdrop of a global financial crisis following Lehman’s collapse, the 4 trillion yuan (US$582 billion at exchange rates today) stimulus package was announced in November 2008.
The economic plan was seen as a success, and while China's economic growth dipped sharply to almost 6 per cent during the fourth quarter of 2008 and the first quarter of 2009, it recovered to about 8 per cent in the second quarter of 2009 and over 9 per cent in the third.
However, the side effect of the large stimulus package was a steep rise in local government debt and non-financial corporate debt.
As a result, non-financial corporate debt, which includes credit to local government financial vehicles, jumped by more than 40 percentage points as a share of GDP from 2008 to 2010, the sharpest rise since records began in 2006, This has posed a risk to financial stability since then.
Unfortunately, China fell into the same trap when the economy slowed again, in early 2014. At the beginning of 2014, the government started to roll out targeted stimulus policies.
However, the monetary easing didn’t achieve the desired effect as growth rates fell below the target for two consecutive years, in 2014 and 2015, with a property inventory overhang posing further risk to the economy.
To head off the risks in the property sector, the government launched a property destocking campaign in late 2015, encouraging commercial banks to increase mortgage lending to absorb the stock of unsold property.
As a result, unsold housing inventories fell significantly in 2016 and 2017, which stabilised the economy somewhat.
The flip side of this drop in unsold housing stock is that household debt has risen, driven by a rapid increase in mortgages. By the end of the first quarter of 2018, China’s household debt was 49.3 per cent of GDP, exceeding the average of 40.6 per cent for emerging economies.
Facing mounting debt pressure, Beijing initiated a financial deleveraging campaign in 2017, with the intention of curbing the financial excesses, which resulted in an economic slowdown, as expected.
While the central bank has shifted its monetary policy to an accommodative stance since the third quarter, growth momentum still looks weak. In addition, the escalating trade tensions with the US continue to weigh on growth prospects, putting pressure on the authorities to prop up the economy further.
But it seems that China does not want to swallow the bitter pill again. To avoid a debt-fuelled stimulus, the government is likely to roll out a sizeable tax cut to increase domestic demand and boost confidence, especially among private firms.
Chinese companies have complained for years about the growing tax burden. Indeed, they now contribute, via value-added tax and corporate income tax, more than 60 per cent of China’s total tax revenue, indicating there is room to lower their tax burden.
Furthermore, with corporate profits falling in many sectors, troubled companies need help to cut costs.
Moreover, according to a report jointly issued by the World Bank and PwC, China is among the countries with the highest burden of tax and mandatory social contributions.
In particular, China’s employer-side payroll taxes for social insurance – including pensions, medical insurance, unemployment insurance and workers’ compensation – are high by international standards.
According to investment bank Guotai Juanan Securities, the average rate in China was 29 per cent of the payroll in 2015, compared with 8 per cent in the US and 20 per cent in Germany. As such, a reduction of mandatory social contributions is also one of the most widely discussed policy options at this junction.
All this suggests China has a lot of room to lower costs for the corporate sector. Some measures to reduce personal income tax have been announced.
In addition, the market expects a comprehensive tax relief package to be unveiled when the National People’s Congress meets in March. According to media reports, the overall tax reduction is likely to reach 1 per cent of GDP in 2019, which will probably prevent a sharp economic deceleration.
However, while a tax cut makes sense, the fundamental issue remains: China’s economy is likely to slow again in the near future unless a more sustainable growth model can be found, as the positive impact of any stimulus package (either outright fiscal spending or a big tax cut) will fade after a short period of enthusiasm.
Hao Zhou is senior emerging markets economist at Commerzbank