China’s Fiscal Challenges and the Path to Reform
For years, local budgets in China have relied heavily on land sales and value-added tax (VAT) income. However, both of these revenue sources are now declining, forcing Beijing to make difficult decisions about its fiscal strategy.
As China drafts its 15th five-year plan, a series of expansive blueprints that have shaped the country’s development for over seven decades, it is crucial to understand how these documents influence and reflect high-level policy priorities. The next iteration of the plan will likely address pressing issues such as local-level financial woes.
In late March, an announcement from Hubei province sent shockwaves through wealthy individuals across China: a local resident was forced to pay 1.41 million yuan (US$200,000) in back taxes and late fees on undeclared overseas income. Within days, three other local tax departments announced similar cases, with some payments reaching as high as 1.26 million yuan. These actions marked a broader crackdown by Chinese authorities on tax violations, which had previously been tolerated.
The shift in enforcement comes as China’s government finances face immense pressure. Tax revenues have declined amid an economic slowdown and a prolonged property crisis. Local authorities are struggling to fill budget gaps, leading to stricter enforcement of tax laws, including those related to undeclared foreign earnings.
However, these measures are unlikely to resolve long-term fiscal challenges. The root of the problem lies in an unbalanced tax system that has long needed reform. During the property boom, local governments were able to generate significant revenue from land sales, allowing them to balance their budgets despite transferring most tax revenue to the central government. Now, with land sales plummeting since 2021 and developers still burdened with unsold properties, replacing this income is proving difficult.
Li Lixing, director of Peking University’s China Centre for Public Finance, noted that “when economic growth slows and the real estate market decelerates, fiscal and tax-related difficulties become increasingly apparent.” This issue has become a focal point as the government begins drafting its next five-year plan, which will shape policy for the rest of the decade.
Some experts are calling for bold tax reforms to address deep-seated imbalances in China’s economy. These reforms could not only boost government revenues but also tackle major issues such as industrial overcapacity, weak consumption, and a widening wealth gap. However, implementing changes will be challenging, especially given the current economic climate and rising trade barriers.
Despite the awareness of these challenges, progress on tax reform has been slow. Li pointed out that “our approach to [tax] reform has developed substantial inertia and strong path dependency, making a turnaround very difficult.”
The deterioration in local government finances is already affecting public services. Bus services in many cities have been cut, medical insurance coverage has been reduced in some areas, and civil servants are facing pay cuts and delayed salaries. These issues highlight the urgency of addressing fiscal imbalances.
During last year’s third plenum, officials outlined goals to revise the tax system and adjust the fiscal relationship between central and local governments. This signals that “deeper structural changes” will be required over the next five years.
Official data shows the scale of the challenge. In 2024, China’s tax revenue fell 3.4 per cent year-on-year to 17.5 trillion yuan. While overall fiscal revenue rose 1.3 per cent to 21.97 trillion yuan, this increase was largely driven by a 25.4 per cent jump in non-tax revenue, such as administrative fees and government fines.
China’s tax take remains low by international standards. Last year, tax revenue accounted for just 13 per cent of GDP, compared to nearly 34 per cent for OECD countries. The decline in tax revenue was mainly due to a drop in VAT income, which accounts for nearly 40 per cent of total tax revenue.
Lou Jiwei, former finance minister, argued that increasing VAT rates would be the simplest way to boost tax revenues. He noted that China’s standard VAT rate of 13 per cent, along with preferential rates of 9 and 6 per cent, is “indeed too low.”
While VAT is easier to collect than other major taxes, its current distribution system has faced criticism. The allocation of tax revenue based on where a product or service is produced rather than consumed creates incentives for local governments to prioritize production over consumption. This exacerbates structural imbalances in the economy.
Some economists suggest revamping the allocation system to direct more VAT revenue to locations where consumption occurs. However, Lu Bingyang, a professor at Renmin University of China, warned that this could create new issues unless a reliable system for calculating retail sales is in place.
Another area of focus is the consumption tax system. China’s leaders have pledged to shift the collection of consumption tax to the retail stage and allocate funds to local governments. However, this change could lead to unintended consequences, as it may encourage local governments to stimulate the production or consumption of certain goods, contrary to the original intent of the tax.
Reforms to VAT and consumption tax alone may not be sufficient to address local government financial challenges. A lasting solution would require increases in direct taxes, such as personal income tax, which provide the bulk of local government revenues in most major economies.
Beijing has long recognized the need for such reforms. The 2021 five-year plan included the goal of “moderately raising the share of direct taxes” in government revenues. At the third plenum, leaders reiterated their commitment to strengthening the direct tax system.
However, progress has been limited. Compared to developed economies, China’s personal income tax has a narrower taxpayer base and lower compliance rates. It also imposes a heavy tax burden on labor income while placing a lighter one on capital income. As a result, high-net-worth individuals often avoid personal income taxation by deriving wealth from non-salary sources.
Zhuang Bo, a global macro strategist at Loomis Sayles Investment Asia, noted that China’s individual income tax accounts for a “much lower” share of total tax revenue than in most other countries. Increasing revenue from direct taxes would provide local governments with a more diversified and stable income stream, helping them cope with collapsing land sales and fluctuations in indirect tax revenue.
Pivoting from indirect to direct taxes would also help reduce inequality and boost consumption, Zhuang added. Local governments should also receive a higher proportion of personal income tax revenue, as the central government currently keeps 60 per cent of the funds.
Another measure long advocated by economists is the introduction of a property tax, which would provide local governments with a large and stable revenue stream. However, Beijing appears unlikely to implement the tax while the real estate sector remains in a deep downturn, despite some cities having run pilot schemes.
Given the domestic and external economic challenges facing China, and the fragile state of market confidence, any further expansion of property tax pilot programmes seems unlikely for now. Analysts believe the policy may have been quietly shelved.
In response to a question from the Post, Liao Min, vice-minister of finance, stated that the ministry has developed plans for tax system reform in line with arrangements made during the third plenum. “Moving forward, we will roll out reforms one by one as conditions mature and in light of evolving circumstances,” Liao said at a press conference in early September.
