China’s latest tax reform plans, focused on raising income for local governments, as well as support from the central government, are long overdue. The property crisis triggered by the “three red lines” policy introduced in 2020 led to a wider economic downturn, but the deeper cause is the reliance of local governments on land-based financing.
This reliance is a product of China’s unbalanced fiscal architecture, where local governments shoulder a disproportionate share of the fiscal responsibility (over 80 per cent of spending last year) relative to their share of fiscal income (just over half). All this, while tasked with delivering unending economic growth, drove local governments to exploit the key resource at their disposal – land.
The rapid unravelling of the property sector might have surprised the central government but this unsustainable fiscal architecture was long due for a reckoning.
The lot was cast decades ago when mainland China adopted a local fiscal model inspired by Hong Kong’s reliance on land sales. It was an expedient choice which fuelled rapid, but ultimately unsustainable, economic growth. A rebalanced fiscal architecture is crucial to China’s next stage of sustainable growth.
In recent years, local government financing vehicles (LGFVs) have been central to this model, where infrastructure investments and rising land values created mutually reinforcing circles. This has come to an abrupt end. Now, such “off balance sheet” municipal financing, estimated at US$7-11 trillion, poses a significant financial risk to the economy.
Local governments, in chasing economic growth, have engaged in a vast range of business activities, habitually pursuing trendy sectors. This led to overinvestment and surplus production in sectors from solar panels to electric vehicles. While global consumers benefit from ever lower prices on these exportable goods, less fungible assets like ghost towns and failed tourism projects are stark reminders of the value destruction that can result.
08:36
A vanishing fairyland dream: how China Evergrande rose, then crashed
A vanishing fairyland dream: how China Evergrande rose, then crashed
Given the far-reaching economic impact of property woes, a coordinated rescue has been called for to rebuild buyers’ confidence and re-energise the economy. But the huge investment this entails would go to waste unless the government reforms its unbalanced fiscal architecture.
The decision taken at the third plenum to not just rebalance fiscal architecture but also strengthen social services and reorient housing policies means that regional and local governments should get a greater share of fiscal revenue while the central government assumes greater fiscal responsibility.
China’s model of state-driven development worked well in some regions for a time, as seen from the Greater Bay Area to Chengdu. But the costs are also in plain sight, with incomplete or abandoned projects from Guangxi to Guizhou.
Through differences in geography, history, human capital and economic networks, regions are not equally endowed for development. In starting China’s economic reforms, Deng Xiaoping leveraged such differences through special economic zones, which resulted in the rapid growth of coastal regions.
The state is right in many ways to broaden economic development. The same bold initiatives in Guizhou would clearly have a different chance of success in Guangxi. A more nuanced strategy that tailors resource allocation and development responsibilities to each region’s circumstances, while mitigating excessive risk-taking, would be more effective.
From healthcare to social housing, the central government should assume greater responsibility. While Beijing and Shanghai have world-class healthcare, too many rural regions have rudimentary services. Left on their own, it would take too long to narrow the disparity.
The central government has started to push for the creation of social housing through local governments buying up excess commercial housing inventory, but these governments lack the means and incentive to effectively implement this. Regional and local governments can be quite adaptive in shaping economic growth but they do not have enough motivation to provide more social welfare.
The era of the entrepreneurial local states may be drawing to a close for much of China. Where high levels of economic development have been reached, they may continue to thrive; where this is not the case, they may face further value destruction.
In this period of economic slowdown, amid an ageing population, there needs to be a transition to a greater focus on providing social welfare to ensure stability. Local governments can deliver on social services only when adequately funded by the central government.
Stability encourages consumption, so this may be the most effective way to stimulate economic growth. In the longer term, property tax should become foundational to municipal finance. However, this is not the time for a widespread roll-out, not until the property market recovers.
15:12
Chinese consumers are tightening their belts: What does that mean for the rest of the world?
Chinese consumers are tightening their belts: What does that mean for the rest of the world?
With the fiscal shortfall from dwindling land sales, many local governments have problems paying salaries. Some have resorted to collecting discretionary taxes or fees to make ends meet. Some entrepreneurial local states have started to degenerate into extractive ones. The latest announced reforms indicate that Beijing will not allow this to happen. The positive moves should go some way to restoring business confidence and maintaining social stability.
The central government has signalled that local governments are to be adequately funded. How may Beijing provide the fiscal resources? One is through deficit financing, by issuing long-term bonds. The other is through partially monetising state-owned enterprises – for the sake of people in a time of need.
Having largely completed their historical mission as entrepreneurial local states, China’s regional and local governments must now transition to providing essential social welfare services. Faced with fiscal challenges, there is a risk that some may become inward-focused and fail to serve the people effectively. At this juncture, the central government’s tax reforms are crucial to ensuring China’s long-term stability and prosperity.
Winston Mok, a private investor, was previously a private equity investor
