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Making China’s Tax Cuts Fiscally Sustainable

Following its latest tax reform, China's government expects the total tax revenue it collects to drop substantially – by some CN¥2 trillion this year alone. While this is music to the ears of Chinese business owners, it raises questions about whether the country is moving onto a fiscally unsustainable path.

NEW YORK – China is about to slash the employer contribution rate to the social-security fund from 18-20% (with some variation across regions) to 16%, and cut the value-added tax (VAT) rate from 16% to 13% (for most enterprises). This is on top of a previously announced reduction in the corporate income tax charged on the first CN¥3 million ($447,000) of taxable income. These policy moves are timely and useful in combating the downward pressure on economic growth, but they also raise the risk of a future debt crisis.

The loss of government revenue will not be entirely proportional to these rate reductions, as the government can also tighten enforcement to reduce tax evasion. Still, the government expects the tax reform package to lead to a substantial reduction in revenue of some CN¥2 trillion, or about 2.1% of GDP, this year alone. The policy package would likely raise the central government’s fiscal deficit from 2.8% of GDP to about 5%, and increase central-government debt from about 47% of GDP to perhaps 70% over the medium term. Add to that the liabilities implicit in closing the funding gap in the social security system, as well as massive local-government debts, and overall public debt could grow much larger, potentially exceeding 150% of GDP in a few years.

International experience from developing countries shows that large and growing government debt is unsustainable and often leads to a major economic crisis down the road. To avoid such an outcome, China can consider three additional reforms.

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