China Embracing Expansionary Fiscal Policy
Since the 1994 fiscal reform, China’s official budget has been conservative, with the deficit never reaching 3% of GDP. Recently, however, policy makers have called for a review of the implicit 3% limit. The 2016 budget proposal confirms the authorities’ readiness to adopt more expansionary fiscal policy to achieve the GDP growth target of above 6.5% under the 13th Five Year Plan (FYP, 2016-20).
The larger projected deficit is due mainly to stagnating revenues and tax cuts. Revenues missed the target in 2015 on slower growth and PPI deflation. In addition, the value-added tax ( VAT) will be expanded to the whole services industry (replacing the business tax) from May 1, effectively reducing the corporate tax burden. Some administrative fees imposed on enterprises will also be removed. Our estimates of the general public budget and the government funds budget show zero growth in revenues and about 2% growth in expenditure in 2016 relative to 2015.
Our estimate, based on widely accepted accounting methods, points to a wider budget deficit of 3.8% of GDP, versus the headline 3%. Our estimate amounts to CNY 2.776tn, CNY 596bn higher than the official number. We think the deficit will be financed by central government bonds (CNY 1.4tn), local government general bonds (CNY 780bn), local government special bonds (CNY 400bn, for local projects) and government deposits (CNY 196bn). We also expect the local governments to issue CNY 5tn of bonds to replace maturing loans.
Temporarily increasing the fiscal deficit
China looks set to adopt a more proactive fiscal stance and temporarily embrace a higher fiscal deficit in the coming years. First, the above- 6.5% GDP growth target for the next five years requires further policy support. We estimate China’s self- sustaining growth rate at 6% (at best); in our view, the government will need more policy stimulus to achieve this. Second, China still has fiscal room to support growth. The country’s public debt remains manageable relative to its peers. We estimate that total government debt was 60-70% of GDP (matched by a large amount of state assets) in 2015, including local governments’ contingent debt. Third, policy makers appear to favour fiscal policy over monetary policy as the main tool to boost the economy given concerns about the negative impact of China’s ultra-loose monetary policy and already-high private-sector leverage.
• CHINA’S 2016 BUDGET DEFICIT TARGET OF 3% OF GDP CONFIRMS EXPANSIONARY FISCAL STANCE; WE ESTIMATE 3.8%
• TAX CUTS, INSTEAD OF SPENDING STIMULUS, ARE THE MAJOR REASON FOR THE LARGER DEFICIT
• THE ENLARGED DEFICIT WILL BE FINANCED BY BOND ISSUANCE AND GOVERNMENT DEPOSITS
The 2016 budget Using broadly accepted accounting standards, China’s 2016 budget deficit will be as high as 3.8% of GDP, or CNY 2.776tn. This is CNY 596bn larger than the official deficit of CNY 2.18tn and the 2015 final deficit of CNY 2.36bn.
• General public budget. Unlike the official (and outdated, in our view) calculation of the budget, we treat withdrawals from fiscal stabilisation funds and the use of leftover funds from previous years as financing of the deficit, instead of revenue. Our deficit estimate under this category is therefore CNY 170.5bn higher than the official number.
• Governmentalso deficit,on the think which generalthe funds is official calculatedpublic budget. budget, budget basedWe does f iscal not conditionsfully ref for lect 2016, actualas the government funds budget is running a deficit this year rather than being in balance. Land-sale revenues, which account for more than 80% of the revenues of local government funds, are expected to contract 13.2% y/y in 2016. In addition to fiscal transfers from the central government (down 11.9%), we think special bond issuance of CNY 400bn and carryover funds (CNY 25bn) will be used to finance the gap between revenue and expenditure.
We expect broader fiscal policy to have a larger impact on the economy in 2016 for two reasons: 1. 2015 extrabudgetary activity contracted due to tighter controls on local government debt; we do not expect a further contraction in 2016; and 2. the 2015 actual fiscal deficit was much higher than budgeted as local governments started to use their accumulated fiscal deposits ( CNY 706bn) to finance additional expenditure. There is room to draw down those deposits further if necessary.
Stagnant revenue growth
Slow economic growth and tax cuts are the major culprits
We think China’s fiscal revenue is unlikely to achieve double-digit growth in the near future — an inevitable result of the economic slowdown. The high correlation between China’s nominal GDP growth and public revenue growth in the past two decades suggests that growth in public revenue will trend lower amid China’s economic transition and slowdown. The continuous decline in producer prices is aggravating the downward pressure on fiscal revenue.
Structural tax reduction and fee reduction
Structural ta x cuts and fee reductions, an important area of supplyside reforms, are an important reason behind stagnant revenue growth. Finance Minister Lou Jiwei has estimated a total of CNY 500bn (3% of public revenue) of tax and fee reductions in 2016, up from CNY 300bn in 2015. Tax reductions were initially introduced to reduce the tax burden on small and micro enterprises. Hightech and high-value-added companies, and even some individuals, could now benefit. Structural tax reform is another important aspect of structural tax reduction and will have a more farreaching impact on the fiscal regime, economic structure and growth outlook.
Using broadly accepted accounting standards, China’s 2016 budget deficit will be as high as 3.8% of GDP, or CNY 2.776tn.
Lou’s fiscal work report presented at the NPC this year listed the following as structural tax reform priorities for 2016: completing the transition from the business tax to VAT; individual income tax (IIT) reform; domestic consumption tax; and environmental tax reforms.
Transitioning from business tax to VAT: VAT is the biggest tax item, contributing 24.9% of tax revenue in 2015. The current standard manufacturing tax rate is 17%. The business tax, which accounts for 15.5% of total tax revenue, is mainly levied on services sectors; most sectors are subject to tax rates of 3% or 5%. The transition of the business tax to VAT, which started in 2011, has been achieved mainly by reducing VAT rates (to 11%, 6% and 3% from the standard 17%) and including more deductible assets (even property, starting this year) to avoid duplicate taxation, reduce the tax burden on corporates, and adjust the economic structure. Reforms have progressed in the past four years, but faced delays in 2015 amid sluggish domestic growth. 2016 will be the final year of this reform, with VAT coverage extending to the construction, realestate, financial and consumer services sectors — the final four, but most complex, services sectors.
Individual income tax reform: IIT accounts for only 7% of total tax revenue and has a limited role in income redistribution effects. The last time China reformed the IIT was to increase the monthly tax deduction to CNY 3,500 in 2011, from CNY 2,000. Lou indicated that IIT reform is not simply about increasing tax deductions, however. China’s IIT has wide tax brackets and is not household-based, in contrast to OECD countries. The reform approach now under discussion is to include a wider range of income as taxable income to strengthen redistribution effects; introduce various tax deductions or credits; and consider introducing joint tax filing for married couples. Given the complexity of the issue, this is likely to be a gradual process.
Domestic consumption tax: this tax differs from the common concept of consumption tax in other countries, which is equivalent to VAT. In China, this tax is levied on specific items, including luxury goods, alcohol and cigarettes. The future reform direction is to include refined oil and high- energy- consuming products to improve fiscal revenue and discourage consumption detrimental to health and the environment. The tax rate is also likely to be adjusted.
Environmental tax: this has been highlighted as a reform area for 2016, in coordination with the revision of the environmental protection law. Reforming the environmental tax and fees is aimed at promoting more environmentally friendly growth.
Property tax: introducing a property tax has been discussed for many years in China. While this is not listed as a reform priority in 2016, a legislative plan is under discussion.
China has numerous transaction-based taxes and fees on land and property, including the property tax, fees for using state land, an urban land use tax, a land appreciation tax, and a tax on deeds. Most are levied by local governments and they account for 16% of local tax revenue. However, a recurrent property tax is needed, as it has a more stable tax base. Pilot cities including Shanghai and Chongqing implemented a recurrent property tax in 2011. Nationwide, realestate registration rules took effect in March 2015. Expanding the recurrent property tax nationwide is likely to better align local governments’ revenue with their spending obligations, contain speculation, and facilitate urban development. The IMF estimates that the initial consolidation of current transaction-based taxes and fees on property into a recurrent property tax could be revenue neutral. Over time, economic growth and urbanisation could generate more local revenue, strengthen the fiscal position and optimise resource allocation.
The realignment of fiscal revenue with spending obligations between the central and local governments is another focus area of tax reform. Reforms in this area have been slower than expected, according to Lou. Local governments’ spending responsibilities go beyond their budgets for historical reasons. Structura l ta x reform could also potentially reduce local governments’ revenue. Taking VAT reform as an example, tax revenue from VAT is currently shared between the central (75%) and local governments (25%). The business tax, however, is a local tax and is the biggest contributor to local governments’ tax revenue. During the transition period, VAT revenue collected from services sectors still goes entirely to local governments rather than being shared with the central government. However, if the reform is completed, tax revenue will be reallocated. According to Lou, guidance on how to realign spending obligations between the central and local governments will be announced this year, and a transitional plan on how to share VAT revenue between the central and local governments will be rolled out at some point in the future.
Optimising the fiscal spending structure
This year’s larger fiscal deficit harkens back to 2008-2009, when China rolled out a massive fiscal stimulus package, and has led investors to ask whether history might repeat itself. The 2016 budget suggests that spending growth will be modest, however.
General public budget spending (after adjustment) is set to grow 6.7% in 2016, much slower than nominal GDP growth. Government funds spending is budgeted to fall by 1.2%. Combined spending will grow only 1.8%, according to our calculation. The focus in 2016 will be on optimising the spending structure rather than aggressively increasing spending in specific sectors (as in 2008-2009).
Strict controls on spending on officials’ overseas travel, business cars and business receptions will remain in place, while spending on social welfare and necessary public services is secured. Education, technology, social security and health care have been highlighted as key sectors to receive fiscal support in 2016. This is different from the 20082009 fiscal stimulus, which focused heavily on investment in infrastructure and transport construction.
Financing the deficit
The government will also use a variety of channels to finance spending. The use of stabilisation funds is one traditional way to top up. Consolidating and utilising carryover and leftover funds is also an important way to fund spending. In 2015, a total of CNY 706bn of leftover funds (4.7% of local governments’ expenditure) were used to offset the gap between revenue (undershooting the budget) and spending (overshooting the budget). In addition, the government is exploring ways to make government spending and investment more efficient. Rather than being fully invested, fiscal money can be invested in industrial funds and equities; the government can also attract private capital in the form of PPP projects; fiscal subsidies are another indirect way to support investment. This is different from 2008-2009, when local governments’ extra-budgetary financing and the rapid expansion of local government financing vehicles ( LGFVS) were the main channels to finance government-backed investment projects.
Local government debt swap likely to expand in 2016
The local government debt ceiling is set at CNY 17.18tn for 2016, CNY 1.18tn higher than in 2015. 2015 was the first year of local government debt reform — according to the revised budget law, local government debt was placed under local budget management in 2015. Local governments’ financing can be done only through bond issuance in the future and is subject to a debt ceiling. The ceiling can be adjusted only upon approval from the standing committee of the People’s Congress.
The CNY 17.18tn ceiling includes CNY 10.7tn of general debt and CNY 6.48tn of special debt. For existing nonbond liabilities, the government will use the debt-to-bond swap programme to swap existing debt with bonds of longer maturity at lower cost. We expect about CNY 5tn of local debt to be swapped in 2016, up from CNY 3.2tn in 2015. This will leave about CNY 6-7tn of debt (direct liabilities) to swap in 2017. The swap programme will not increase the debt stock. We expect total local government debt to decline to 35% of GDP in 2016 from 36% in 2015, assuming local governments strictly follow the revised budget law and finance their debt only through bond issuance.
Education, technology, social security and health care have been highlighted as key sectors to receive fiscal support in 2016.
( Authors: economists from Standard Chartered Bank ( HK) Limited)