In implementing tax cuts to help businesses stay afloat, China has unwittingly made life harder for thousands of debt-ridden municipalities across the country. The impact on local government budgets may also have the unintended impact of reducing support for new infrastructure projects due to a lack of sufficient funding, analysts warned. As companies and individuals pay less tax to local government’s under 2 trillion yuan (US$298 billion) worth of tax cuts this year, it is the regions that will have to bear the brunt of squeezed budgets resulting from lower revenue unless Beijing reforms the tax-sharing arrangement between the central government and local authorities, analysts said. Regional woes are mounting in tandem with calls for additional funding support from the central government as the economy is growing at its slowest pace in nearly three decades. The depth of these concerns reverberated in discussions among local officials during March’s “two sessions” meeting of the country’s top legislative and political consulting bodies, including officials from some of the richest provinces. “It will be the tightest year for us fiscally. The central government should give more funding support for key local events and strategic projects,” said Wu Sufang, head of the Beijing municipal government’s fiscal bureau. Even before Premier Li Keqiang announced this year’s reductions in value-added and personal income taxes and a lowering of the social security contribution rate, China’s capital city of Beijing had cut its estimate for 2019 revenue growth to 4 per cent, down from the actual 6.5 per cent growth recorded last year. In fact, all 31 provinces and municipalities of mainland China except Jiangxi province and the Xinjiang autonomous region have lowered their revenue growth targets for 2019. Local governments have accumulated 19.1 trillion yuan (US$2.8 trillion) of debt as of the end of February, as well as an unknown quantity of “hidden debt”, largely a result of central government priority policies handed down to boost growth after the 2008 global financial crisis. It will be the tightest year for us fiscally. The central government should give more funding support for key local events and strategic projects. Wu Sufang With a majority of total government tax revenues going to the central government under the existing 1994 tax sharing arrangement, local authorities are forced to rely on transfer payments from Beijing or local land sales to finance their regular expenditure. This makes intense lobbying for additional central government funding the norm under the current fiscal framework. The tax cuts will hit China’s poor regions the most, according to a finance official from a county-level city in the prosperous eastern province of Zhejiang, who declined to be identified as he was not authorised to speak publicly. This was because poor governments operate using “feeding finance”, relying heavily on financial transfers from the central government to allow them to invest in upgrading industry as they have barely any additional funds from their own revenue sources beyond those needed to cover basic administrative functions. In contrast, the more affluent governments operate “development finance”, in which a portion of the budget is set aside annually to be spent in the future to ensure stable growth, the official said. The Beijing-mandated tax cuts are expected to reduce the government’s tax revenue by 800 million yuan (US$119 million) this year, with the resulting budget gap filled by last year’s budget savings and by shelving one or two infrastructure investments, the official added. “One big uncertainty though is the US-China trade war, which could have a bigger impact than the tax cuts” on the Chinese economic performance and therefore government revenues, he said. “We are still heavily reliant on exports. If the US increases tariffs on US$200 billion worth of goods from 10 per cent to 25 per cent, the impact will be huge, not just on us but also on the supply chain in the US.” Analysts, though, have forecast that the effect of the tax cuts could be less than the headline 2 trillion yuan figure promoted by Beijing. “The economic impact of tax cuts will likely be smaller. By our forecasts, tax cuts could amount to 1.5 trillion yuan in 2019,” said Standard & Poor’s analysts Yutong Zou and Kim Eng Tan. International rating agency Standard & Poor’s questioned in particular the net effect of the reduction in the social security contribution rate. “We do not expect the cut to cause a significant decline in net receipts because China has been implementing tougher enforcement [on collecting social taxes],” the analysts added. During the two sessions, Premier Li also said his cabinet would conduct due diligence on the sustainability of current public finances and predicted that 1 trillion yuan (US$149 billion) could be saved through spending cuts, larger remittances from state-owned firms and the recycling of underused government funds. “Local governments also need to do their homework and contribute,” Li said. “The [revenue] split between the central and local governments will be roughly 50:50. Our determination is to dig into existing interests [at all levels of government]. This will be like turning the blade of the knife on the government itself. It’s a key reform that requires exceptional courage and determination.” But mandatory spending cuts would be hard to achieve at the local level, cautioned Ding Shuang, chief Greater China economist at Standard Chartered Bank. If local governments are forced to cut their expenditures, they can either scale back construction projects or administrative expenses, both of which will be difficult given the backdrop of [priority of economic] stabilisation. Ding Shuang “If local governments are forced to cut their expenditures, they can either scale back construction projects or administrative expenses, both of which will be difficult given the backdrop of [priority of economic] stabilisation,” Ding said. The sustainability of local government finances will remain under pressure beyond 2020 because “you can’t find a trillion yuan of new funding each year”, he warned. Such pressures could push new funding abuses at the local government level, which were prevalent during Beijing’s massive fiscal stimulus programme in response to the global financial crisis a decade ago, warned Si Zefu, chairman of power generation equipment maker, Dongfang Electric Corporation. “It is tricky to let local governments find ‘workable means’ of raising funds, because they already have gained a lot of power [to do so],” Si said. Current measures to help ease local funding constraints, including a 10.9 per cent increase of a regional balance fund to help fiscally constrained authorities in the central and western regions and an increase of 800 billion yuan (US$119 billion) in the amount of special bonds local authorities can issue to fund infrastructure projects, may just scratch the surface of local government’s funding needs. Some deep-rooted issues remain unaddressed, including the division of responsibility between Beijing and local governments on central government-mandated policy priorities and the establishment of a tax system that guarantees local governments a stable source of revenue. With the establishment of a new property tax, seen as a future pillar of local fiscal revenue, still in the early stages of legislative review and limits on local government bond issuance set by the Finance Ministry, local government reliance on tax revenue handouts from the central government and local land sales will continue. Land sales reached 6.5 trillion yuan (US$967 billion) last year, equivalent to 35 per cent of national fiscal revenue. Revenue from land sales, according to the Zhejiang official, accounts for a much larger share of local government revenues than taxes. “The impact [on government revenues] from the tax cuts is not comparable to the impact from the property market,” he said. Additional reporting by Orange Wang