CMC calls for ‘thriftiness’ as China sees spike in fiscal deficits; fiscal and tax reforms hinted at in media unlikely to resolve China’s problems

  1   CMC calls for ‘thriftiness’ as China sees spike in fiscal deficits

June 11
Xi Jinping signed an order to release the newly revised regulations on military auditing (軍隊審計條例). The regulations require that military auditing work be based on the positioning of economic supervision, as well as enhance its political nature and political functions.

The regulations, which consist of eight chapters and 75 articles, would take effect on July 1, 2024.

June 20
The General Office of the Central Military Commission issued measures on “upholding hard work and thriftiness to improve the quality and efficiency of military construction” (關於堅持努力勤儉建軍 提升軍隊建設品質效益的措施). The measures require the People’s Liberation Army “firmly establish the concept of living a frugal life, carefully calculate and budge [expenses], and handle all affairs with diligence and thriftiness.

  Big picture

1. Since the start of the year, an increasing number of Chinese companies have been required by the PRC authorities to pay retroactive taxes, with some asked to pay taxes stretching back as far as the 1990s. This has created financial difficulties for firms and has led to closures.

2. On June 24, the PRC finance ministry released China’s fiscal revenue date for the first five months of the year.

• The national general public budget revenue decreased by 2.8 percent from the previous year to 9.69 trillion yuan, with a “comparable growth” of 2 percent.
• The national general public budget expenditure increased by 3.4 percent from a year earlier to 10.83 trillion yuan.
• The deficit increased by 119.2 percent year-on-year to 1.14 trillion yuan.

  Our take

1. The CMC’s call for the PLA to “uphold hard work and thriftiness” is Beijing’s indirect way of getting the military to engage in belt-tightening measures to save costs. This is another sign that China’s economic downturn and fiscal shortages are quite severe and likely exceeded the CCP’s expectations.

Having the military engage in belt-tightening runs counter to the Xi leadership’s willingness to assign more funds to the PLA in recent years despite urging local governments to live frugally (過緊日子) due to rapid economic deterioration in China. Signs that Beijing has been generous in military spending include:

• From 2020 to 2024, the growth rates of the national defense budget were 6.6 percent, 6.8 percent, 7.1 percent, 7.2 percent, and 7.2 percent respectively. In 2024, defense spending reached 1.67 trillion yuan, marking the eighth consecutive year that China’s defense budget exceeded one trillion yuan.
• January 2021: The South China Morning Post reported that PLA troops would receive a pay increase of up to 40 percent. Commissioned and non-commissioned officers saw the biggest wage rise, particularly those stationed in border areas like Tibet, Xinjiang, the East China Sea, and the South China Sea. Military veterans also received a higher monthly pension based on their length of service.
• October 2021: The CMC issued interim regulations guaranteeing medical treatment for soldiers and military-related personnel that granted free medical treatment for military spouses and preferential medical treatment for the parents and spouses of officers and noncommissioned officers.
• April 2022: The Central Political and Legal Affairs Commission and CMC PLAC jointly issued an opinion on “protecting the national defense interests and the legitimate rights and interests of military personnel and their families in the new era” (關於新時代維護國防利益和軍人軍屬合法權益的意見).
• May 2022: The CMC General Office issued interim regulations on military retirement homes (軍隊干休所工作暫行規定) that called for improving services and guarantees for retired cadres, including medical care, living services, housing security, and humanistic care.
• November 2022: The CMC issued an opinion on “adjusting and standardizing policies related to the relocation and household registration of military families” (關於調整規范軍人家屬隨軍及落戶有關政策的意見).

Xi Jinping likely justified the greater allocation of funds to the military in considering the PLA’s importance to his power consolidation and maintenance (especially in the lead up to the 20th Party Congress), as well as the PRC’s increasing need to protect its global interests (Belt and Road Initiative, etc.) and gain parity with geopolitical rivals. Xi also likely calculated that the CCP regime could afford to sustain a high military budget during the COVID years because the economy was expected to bounce back after the “zero-COVID” policies were ended. However, China likely experienced negative growth rather than an economic recovery in 2023 and for the most part in the first half of 2024. The expansion of the fiscal deficit by 119.2 percent from a year ago in the first five months of 2024 points to China’s economic troubles.

2. Having the military engage in belt-tightening could potentially increase resentment towards Xi Jinping in the PLA and heighten political instability in the regime.

Xi likely rocked a lot of boats in the upper echelons of the CCP in consolidating his control over the Party’s “gun” by ordering significant military reforms and anti-corruption efforts that reduced the Jiang faction’s influence over the PLA as a byproduct, as well as promoting a large number of relatively inexperienced senior officers to higher rank and key positions. The Party’s political and military elites tolerated and even approved some of Xi’s actions early on to restrain the Jiang faction (certain powerful elites like the clan of Marshal Ye Jianying were opposed to Jiang Zemin) and in recognizing the PLA’s need for reform and modernization to stay relevant, safeguard regime security, and boost the regime’s capability to fight and win wars.

The Party’s elite, however, likely grew wary of Xi as he increasingly centralized power and tightened his control over them and all aspects of the regime. Meanwhile, Xi’s purging of senior military officers whom he vouched for and elevated like former defense minister Li Shangfu and the PLA Rocket Force leadership demonstrated Xi’s poor judgment and weakened his “quan wei” (authority and prestige). Xi’s move to rein in military spending is likely to engender greater resentment towards his leadership and heighten his political risks. Xi is almost certainly aware of his growing “quan wei” problem and thus sought to strengthen his control over the military through stepping up political indoctrination and anti-corruption efforts as laid out in the CMC political work conference in Yan’an.

The call for the PLA to “uphold hard work and thriftiness” is unlikely to curb wastefulness and corruption in the military. Instead, the move could exacerbate existing problems or encourage “countermeasures” by senior military leaders, including the reduction of benefits for those in lower ranks, the issuing of substandard or inadequate military supplies, and the staging of substandard drills to cut costs. This would affect the PLA’s combat effectiveness and ability to aid the CCP regime in “stability maintenance,” as well as increase dissatisfaction toward the Xi leadership among the lower ranks.

  2   Fiscal and tax reforms hinted at in media unlikely to resolve China’s problems

  China’s fiscal deficit widens in the January-May 2024 period

June 24
The PRC Ministry of Finance released China’s fiscal revenue data for the first five months of 2024.

National general public budget revenue and expenditure situation

• The national general public budget revenue decreased by 2.8 percent year-on-year to 9.69 trillion yuan, with a “comparable growth” of around 2 percent.
  • The national tax revenue decreased by 5.1 percent year-on-year to 8.04 trillion yuan, with a “comparable growth” of around 0.5 percent. Non-tax revenue increased by 10.3 percent year-on-year to 1.6 trillion yuan.
    • Domestic value-added tax decreased by 6.1 percent year-on-year to 3.01 trillion yuan.
    • Domestic consumption tax increased by 7.2 percent year-on-year to 760.7 billion yuan.
    • Corporate income tax decreased by 1.7 percent year-on-year to 2.24 trillion yuan.
    • Individual income tax decreased by 6 percent year-on-year to 607.2 billion yuan.
    • Stamp duty on securities transactions decreased by 50.8 percent year-on-year to 43.9 billion yuan.

National government fund budget revenue and expenditure situation

• The national government fund budget revenue increased by 3.4 percent year-on-year to 10.8 trillion yuan.
  • Interest expenditure on debt increased by 7.3 percent year-on-year to 506.1 billion yuan.
  • Revenue from the transfer of state-owned land use rights decreased by 14 percent year-on-year to 1.28 trillion yuan. Expenditure related to the transfer of state-owned land use rights decreased by 7.3 percent year-on-year to 1.78 trillion yuan. The deficit was 495.1 billion yuan.

  Caixin hints at new round of fiscal & tax reforms

June 24
Mainland media Caixin published a cover story on the “importance and challenges” of a new round of fiscal and tax reforms in China.

Caixin said China’s economic situation faces issues such as local fiscal difficulties, excessive local debt pressure, an aging population, and economic downturns. Therefore, Beijing needs to enhance China’s fiscal sustainability, adjust the economic structure, stimulate market vitality, mobilize local enthusiasm, and promote the development of a unified national market.

Caixin added that the PRC authorities’ reforms have “entered deep water territory,” and quoted former finance minister Lou Jiwei as saying that financial reform involves adjustments to both “finance” (財) and “governance” (政).

Caixin then cited the views of several experts and scholars who believe that the problems in China’s economy require fiscal and tax system reforms and outlined the directions and challenges of those reforms. Key points of concern raised include:

• China’s economy is still in the post-pandemic recovery process, market entities lack vitality, economic growth continues to slow, and the growth rate of the general public budget revenue continues to be lower than the rate of economic growth due to the effects of tax cuts, fee reductions, and low prices.
• Since 2021, deep adjustments in the real estate sector have impacted the land market and tightened local finances. This has led to incidents such as the suspension of public transportation and wage arrears for civil servants and employees of public institutions in some regions.
• The new round of fiscal and tax system reforms must address:
• The continuous decline in macro tax burdens, fiscal tightness, rising local debt risks, and the future of land finance in the short term.
• Systemic and mechanism reforms are needed to resolve the problem of fiscal sustainability and avoid a fiscal crisis over the middle term.
• Over the long term, fiscal and tax system reforms should be aligned with national governance and strategy, focusing on promoting common prosperity, high-quality development, building a unified national market, coordinating development and security, and constructing a new fiscal and tax system.
• The sustainability of China’s future finances will also face challenges from an aging population:
• Social security spending is increasing, with annual fiscal subsidies to the social security fund exceeding 2 trillion yuan.
• The tax base is shifting. As the working population shrinks, the tax base derived from labor income may contract, while the consumption tax base may increase as the population ages.
• The new round of fiscal and tax system reforms should effectively reduce the tax burden on enterprises and fundamentally regulate the financial distribution relationship between the government and enterprises.
• The current tax-sharing reform previously resolved the incentive issues of local governments, but also led to excessive competition among local governments and market fragmentation to some extent. To attract investment, local governments have been competing on policies, returning a large portion of fiscal revenue to enterprises through various rebate measures and resulting in increasingly limited actual available financial resources for local governments. From the perspective of building a unified national market, it is necessary to eliminate various tax incentives and regulate local investment attraction practices.
• The main theme of China’s tax reform in recent years has been structural tax cuts and fee reductions. Former financial minister Liu Kun previously revealed that China’s macro tax burden level, when calculated on an internationally comparable basis, fell from 28.1 percent in 2016 to 25.4 percent in 2021, which is relatively low by global standards. However, many enterprises and taxpayers do not feel from their experiences that their tax burden is relatively low. On the one hand, tax collection and management have become increasingly strict after the full implementation of the value-added tax (VAT) pilot program. On the other hand, the profitability of enterprises under economic pressure has not been good and they are more sensitive to tax burdens.
• China’s VAT is the largest of its 18 tax categories, reaching 6.93 trillion yuan in 2023 and accounting for 38.3 percent of total tax revenue. Corporate income tax is the second-largest category and reached 4.11 trillion yuan in 2023. Domestic consumption tax and personal income tax also reached trillion-yuan levels at 1.61 trillion yuan and 1.48 trillion yuan respectively. For local governments, the distribution of VAT revenue is crucial.
• With the development of the digital economy, the concentration of the platform economy has led to a clear separation between the tax source location, production location, and actual consumption location, amplifying the deficiencies of the existing tax-sharing model based on production locations. This has resulted in significant disparities in fiscal revenue among regions.
• Recently, some enterprises have received notices for the collection of back taxes or tax risk warnings, with some retroactive taxes stretching back three decades ago. Such tax collection measures are no longer isolated incidents amid local fiscal tensions. Enterprises are concerned that this practice may become more commonplace, and the move would inevitably put more pressure on an economy in a slowdown.
• With land transfer revenue declining and no short-term alternative financial resources in sight, the government may have to increase debt financing in the short and medium term. Currently, the scale of local government debt exceeds that of the national debt in China. By the end of 2023, China’s national debt balance would be 30.03 trillion yuan while the local government debt balance would be 40.74 trillion yuan. Even without considering the issue of hidden local government debt, this debt structure is already quite rare among the major economies.
• A large proportion of China’s fiscal expenditure was previously used for economic construction. This structure has gradually improved in recent years, with a higher proportion of expenditure going towards people’s livelihood and directed towards the provision of public services and products. Currently, the scale of China’s social security funds is too low and the distribution structure has further issues.
• To address the current financial difficulties and lack of enthusiasm among local governments, it is necessary to adjust the fiscal relationships between different levels of government, especially between the central and local governments:
• The central government’s fiscal revenue share has remained at approximately 45 to 46 percent over the past decade since the tax-sharing reform. Meanwhile, local fiscal expenditure has consistently exceeded 80 percent due to local governments bearing a disproportionate amount of expenditure and with local fiscal revenue accounting for just over half of the fiscal revenue share. The gap between revenue and expenditure is mainly filled by transfer payments from the central government to local governments. In 2023, the central government’s transfer payments to local governments exceeded 10 trillion yuan for the first time and accounted for 36.1 percent of local financial resources, the highest level since data became available in 2010.
• In 2019, the average financial self-sufficiency rate at the county level was 40 percent, with the remaining 60 percent made up through transfer payments. Some local grassroots entities have become heavily dependent on transfer payments and have adopted a “lying flat” attitude. Although the system’s design is intended to generate incentive effects, this dependency may diminish the overall effectiveness of transfer payments.
• Fiscal and tax system reforms need to adapt to the construction of a unified national market. It is necessary to explore minor adjustments to the tax-sharing method, and consider a shift from the current “production-based principle” to a combination of “consumption-based principle” and “production-based principle.” For example, the current 50-50 central-local government split of the VAT revenue can be maintained, but of the 50 percent allocated to local governments, 25 percent would be distributed based on each area’s permanent population and the previous year’s consumption statistics while the remaining 25 percent would be distributed based on the location where the tax was paid.

  Backdrop

Starting on June 21, the Shanghai Composite Index fell below the key psychological level of 3,000 points for three consecutive trading days and hit 2933.33 points at the lowest.

  Our take

1. China’s fiscal situation in the first five months of the year is measurably worse than last year.

Some brief observations:
i) China’s fiscal deficit reached 1.14 trillion during the January to May 2024 period, an increase of 119.2 percent when compared to the same period in 2023. Also, while tax revenue fell by 5.1 percent, the non-tax revenue increased by 10.3 percent.

ii) The growth in domestic consumption tax amid the decline in the major tax categories could be related to the increased collection of retroactive taxes by the tax authorities this year.

iii) The over 50 percent decrease in stamp duty collected on securities transactions is likely related to the recent regulatory restrictions on quantitative trading by securities companies, which have led to a sluggish stock market and reduced trading. Meanwhile, the Shanghai index falling below 3,000 points reflects the limited ability of the “national team” to support the market and weakening market confidence.

iv) The drop in fiscal revenue is another economic indicator that affirms our earlier observations that the Chinese economy is not growing but is actually in decline.

2. The Caixin report on a new round of fiscal and tax reforms suggests that the economic downturn and real estate woes have created significant financial shortages for the CCP regime, and the urgency for reform is evident.

Some brief observations:
i) The Caixin comment about the PRC authorities’ reforms “entering deep water territory” and how financial reforms will involve adjustments to the government (i.e. political reform) suggests, as we have pointed out on numerous occasions, that the Xi leadership plans to more fully wrestle control over the PRC financial system and sector from the remnant Jiang faction and other Party elites through the anti-corruption campaign and other measures.

Xi Jinping likely believes that the only way to fix the mess left by his predecessors is to implement political and economic reform to consolidate more power and pursue “self-rectification.”

ii) The Caixin report highlights the impact of the real estate crisis on the finances of local governments and grassroots operations, in particular by calling attention to the “suspension of public transportation and wage arrears for civil servants and employees of public institutions in some regions.”

iii) The Caixin report also acknowledges the fiscal impact of China’s growing demographic problem. In particular, an aging population results in increased social security expenditure but reduced income tax revenue from a shrinking population.

The challenges posed by China’s various economic troubles will only intensify as the population ages and China’s growth loses momentum.

iv) Caixin points out the problems of Chinese enterprises facing a high tax burden and local protectionism stemming from the tax incentives previously offered by local governments to attract investments. We believe that some of the recent efforts by local tax authorities to collect retroactive taxes are related to local officials opting not to recognize the irregular tax incentives that their predecessors offered to businesses.

v) Caixin’s discussion of the imbalance between fiscal authority and expenditure responsibility in the central-local tax-sharing system exposes another drawback of the CCP authoritarian system.

Xi Jinping has been strengthening the central authorities’ control over the economy ever since he took power, resulting in local governments relying on transfer payments to sustain their operations. This reliance has caused local officials to either become passive and inactive in pursuing growth, or engage in bad practices like forcibly seizing land and demolishing properties, as well as squeezing enterprises for revenue and leaving the risks to the central government.

vi) In theory, Caixin’s call for shifting the current tax-sharing method from the current “production-based principle” to a combination of “consumption-based principle” and “production-based principle” would encourage local governments to stimulate consumption and abandon local protectionism, and would benefit China’s economy. However, the PRC authorities would struggle to find alternative tax sources and overcome the financial shortages caused by the real estate crisis and other deep-seated fiscal issues.

vii) We believe that while the Xi leadership will introduce fiscal and tax system reforms at the Third Plenum in July, those reforms will be “too little, too late” to resolve over the short term the current crises plaguing the CCP regime. Instead, attempts by Beijing to address ongoing problems while adhering to ideology (“socialism with Chinese characteristics,” “Xi Jinping Thought,” “Sinicized Marxism,” etc.) will only further damage China’s business environment, exacerbate existing problems, worsen the crisis of confidence in the CCP, and push the regime into a death spiral.