Economic Rebalancing Should Be the Core of China’s Supply-Side Reform

Part of Chapter 2 | Macroeconomic Policy Coordination

By Wang Yuzhu
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As it enters a “New Normal,” China’s economy is undergoing fundamental changes in its comparative advantages and its driving forces. Meanwhile, the interrelations between the government and market is also reshaping. Under the background of supply-side reform, China should reconsider the policy focus thus to achieve a sustainable growth. Generally speaking, the root of China's loss of a comparative advantage in manufacturing mainly stems from the rise of land prices and the rental cost of real estate, rather than the cost of labor, and tax cutting that is seen as the core of the supply-side reform of limited spaces for the local government. The way for China to achieve its comparative advantage is to rebalance its economy between rural and the urban regions, and between the coastal and inland regions.

The Loss of China’s Manufacturing Comparative Advantage

Some people attribute the loss of China manufacturing’s cost advantage to the rapid rise of Chinese labor costs under the “Lewis turning point.” Actually, this is not true. For many enterprises, labor costs only account for around 5 percent on average of the total production cost, but the price of land and factory rental is much higher, accounting for nearly 20 percent, sometimes even higher. Due to the higher land rental price, these enterprises have to move away from the coastal, developed areas. Taking the company Huawei as an example as the most competitive company in China, it is also confronted with the land rental problem and wants to move out of Shenzhen. As China has put forward the Belt and Road Initiative, many companies are going out to seek a more competitive production base. According to one survey, as intelligent manufacturing develops labor costs can be largely substituted by robots. However, the land cost is always the first and the biggest concern for entrepreneurs in choosing their production bases. Many companies going out may pose a threat to China’s domestic economy in the long run, even though these going-out companies’ technical competitiveness is not very high, China’s manufacturing is still mainly at the mid-lower level at present. This large-scale “going out” is a big challenge for China's economy in the future, which may lead to the domestic “industrial hollowing” phenomenon of developed countries’ investment in foreign countries. Though high-level manufacturing only occupies a small proportion of the economy.

Limited Space for Tax Cutting in Promoting Economic Growth

China has had problems with the nominal tax rate and effective tax rate for a long time. Traditionally, tax evasion as an important means for small and medium-sized enterprises (SMEs) to maintain cost competitiveness has been a common problem in China. For example, several years ago, because of imperfect tax administration system, enterprises often used false invoices as the enterprise production expenditure, to offset the tax payment. In addition, business operators of SMEs also bring their individual expenditures like cars and some large consumer goods to bill them as production costs in the name of the enterprise. In this way, the actual tax paid by enterprises is small.

In response to this, China embarked on tax reform, which has achieved a positive result. For example, in the last few years, tax control machines have been widely installed even in small restaurants and stores. Thanks to the reform, China’s tax revenue has maintained double-digit growth despite the overall economic downturn since 2008. On May 1, 2016, China started replacing the business tax with a value-added tax. The value-added taxation system put almost all production and purchasing processes under the supervision of the tax system. As a result, few opportunities are left for enterprises to dodge taxes any more. For example, even though China put forward a series of tax reduction measures half a year later, due to stricter regulation measures China’s actual tax revenue still saw strong growth. Therefore, with the increasing and tightening measures of tax administration and regulations, currently China’s real effective tax rate is already extremely high for SMEs.

However, it is a paradox to further cut the tax rate, and there is limited space for local governments to cut taxes as a result of potential debt risks. At the moment, local governments are facing a serious situation for fiscal sustainability. Traditionally over the past decade, except for normal tax revenue, Chinese local governments’ fiscal balance mainly depend on income from selling land, which is also called land finance. The size of land finance is almost the same as the normal fiscal income. Land finance comes from land leasing fees, and has played a significant role in financing the local governments’ expansionary economic policies, and it also has been the main way to fill the local governments’ fiscal income gap for a long time.

However, land resources are always limited, and in most of the cities the local governments do not have more land to sell now. Meanwhile, after two decades of rapid industrialization in China, there is a trend toward declining land demand. Taking the growth of local debt risk into account, the central government has implemented a series of strict regulations on local governments debt growth and strengthened strict measures on fiscal revenues beyond taxes. Against this backdrop, local governments are facing a heavy burden in maintaining a balance between fiscal revenue and expenditures. Therefore, considering those factors mentioned above, China has limited space for tax cutting. If tax cuts continue, local governments will have difficulty with financial sustainability unless they sell state-owned enterprises. However, this will result in the further decline of the share of the state-owned economy in the overall economy, and that will post a challenge to the socialist system.

Regaining Comparative Advantages through Rebalancing Policies

Considering that the rise of land and real estate prices is irreversible, and that large-scale tax cutting is also not pragmatic, rebalancing policies are needed in both a geo-economical and social-economical way.

From the geo-economical perspective, one of the best ways to mitigate land rental and enterprise production costs is to transfer the production bases to mid-west areas with lower land prices. Today, it shows a great achievement in inland regions in manufacturing development. Rebalancing should be focused on more preferential policies to attract more capital and laborers into the central and western regions. Currently, as the industrialization process goes on, the central and westerns regions are confronted with many problems, such as a lack of labor, capital, technology, and other production factors. Several years ago, Foxconn had already started to use a large number of robots in its production base located in Henan Province. Therefore, policies are strongly recommended to facilitate those regions to give full play to Developed Advantages. Taking intelligent manufacturing as an example, in keeping pace with the coastal regions, the central government should promote intelligent manufacturing industry policies and related pilot measures in central and western regions as well.

On the other hand, rebalancing polices in the current dual economic system are also strongly needed, as China has nearly half of its population living in rural areas, and they are not equally treated in many ways. Actually, China’s internal consumption economy has large space to grow. Currently, the growth potential of China’s consumption economy is not dependent on creating extra economic growth, but it will become more and more dependent on China’s reforms in the fields of finance and income distribution, especially in the field of pensions in rural areas.

Nearly half of the population is still living in rural areas, and their income is only one-tenth of those people who work in cities. At present, it is roughly estimated that elderly people with rural household registration have only a $30 subsidy each month, but in a city like Shanghai elderly people with city household registrations have up to $300 per month. Thus, the consumption ability of those who live in rural areas is greatly restricted. In addition, there is a large part of the elderly population living in rural areas lacking in the ability to work. However, in Premier Wen Jiabao’s service term the overall coverage of pensions has been achieved. But till now, China’s pension system is still in a “dual track” system.

So, if we can narrow the gap between the rural areas and cities and solve the problem of the dual-track pension system, elderly people in rural areas will be a large consumption group. With the improvement from $30 to $300, the marginal consumption rate would be gradually increased. Currently, our policy is still gradually increasing the pensions of people in cities rather than immediately solving the dual-track dilemma. Actually, a lot of ways can be used to solve this problem, and it depends on how we are going to effectively design our pension policies. The Chinese central government is such a powerful government that it can do a lot of things in designing socially reasonable and economically sustainable policies.

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