Home / Points of View & Perspectives / China strikes back at US with…. tax cuts

China strikes back at US with…. tax cuts

When US President Trump was heading across the Atlantic to the NATO top summit this week, he did not forget China, so he announced a further escalation of the trade war.

The president has asked his government to prepare a 10 pct. import duty on Chinese goods of another $200 billion. According to various reports, the preparations will be made during this month until August.

My assessment is that the trade war will continue to escalate, and both sides are prepared for this. I also expect that it is already more than prised in the financial markets. I agree with the market in the sense that I expect a further deepening of the crisis before real negotiations can be expected. I simply think that each party wants the trade war to hurt its counterpart as much as it can, before the trade war has actually enough effect to soften the opponent. My long-term assessment is however, that the two countries are on completely different tracks – particularly in terms of domestic developments of the economies.

It’s hard to see that President Trump has any long-term plan. Therefore, the tactical moves are so fierce, as he needs short-term results that can be presented at the mid-term elections in four months.

The battle about factory production lines took place in the 1990s and up to 15 years after that, but today, it is an almost outdated struggle. Globalisation has now reached the individual level, and the winning future economies become significantly more domestic-oriented. For the same reason, export of goods become less important in the future. Therefore, I cannot imagine that the Chinese government being opposed to lower the trade surplus towards the United States – perhaps the question is how to do it? This I will to leave to those who believe to know the solution.

My assessment is that Trump’s international actions strengthen the tendency for economies around the globe to become more domestic-oriented, especially in China where this trend will be intensified. The country is en route to become the world’s largest single market, and the government currently takes another great step in this direction via a significant tax reform. The total tax cuts in China per year amounts to approximately to one pct. of GDP, which also includes a lower corporate tax. A few days ago, details about the reform concerning personal taxation were released, and there are sizable tax cuts awaiting the Chinese consumer.

The lowest tax rate for ordinary personal income is 3 pct. in China, with the next step at 10 pct., then 20 pct., and further up to the highest rate at 45 pct. The tax-free income threshold is raised to 3,000 RMB ($ 450) per month. More important is that a significant number of taxpayers will only pay 20 pct. in income tax going forward – this becomes a typical tax rate for a middle-class income. The biggest effect materialises for annual incomes at around RMB 200,000 ($ 30,000), where the tax rate will be eight percent points lower. It is the government’s clear goal that the increasing disposable household income should be spent on consumption, thus strengthening the domestic economy.

The overall tax reform was decided in March, but the part covering personal taxes will finally be approved in October. It is the intention that the lowest paid workers will benefit the most from the tax cuts, but so will middle-class incomes, as mentioned, profit from the reforms. The government is very focused and outspoken on improving the disposable household income for the middle-class. The reason is that the middle-class is struggling to get wage increases, thus the government is trying to avoid the so-called “middle-class trap” to harm this growing part of the population.

The tax reform is not a direct function of the American trade war, but there is no doubt that Beijing is busy getting the tax cuts implemented. In short-term, the tax reforms have to compensate for a decline in exports that the trade war may cause.

The background for the tax reform is a longer history, as it originates from the lessons learned during the global financial crisis 10 years ago. It became apparent to the Chinese government that the country was too dependent on exports, and therefore, the domestic economy should be strengthened.

Source: OECD and National Bureau of Statistics of China

Graphic one shows the Gini coefficient expressing the economic inequality in societies, where in this case, it is the income distribution that is shown. China still has a very high inequality, but since the financial crisis, the government has worked quite focused on lowering the Gini coefficient. For example, by improving the economic conditions for the 300 million so-called “migrant workers”. In addition, the government has encouraged investments of different kinds for the past decade, but the imbalance is now a huge debt burden that needs to be reduced.

Source: OECD and Lundgreen’s Capital

One can therefore be tempted to believe that such heavy tax reductions will increase the public debt mountain as it happens in the United States during the coming years. Though graphic two is interesting, because it shows the total taxation of personal income as a share of GDP. It indicates that China could actually lower the personal income tax to zero in an extreme situation, without stressing the fiscal budget. It is hardly likely, but it illustrates which fiscal manoeuvre room China still has in order to ensure a high GDP growth to safeguard he road to becoming the world’s largest single market.

It’s natural for Asian and Western exporters to consider which products could be sold to the Chinese consumer now they will have more money to spend. Persons with annual incomes of around RMB 200,000.00 will explore the biggest effect (net RMB 16,000.00 a year). But even an income of RMB 500,000.00 will be taxed at 4 percent points less, so that there is room for buying more imported goods. However, my expectation is that the vast majority will go to consumption of Chinese goods and services. So in general, it does not change the fact that investors and companies have to move further into the Chinese market to profit from the improved purchasing power.

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