China’s new export tax rebate policy: a two-edged sword

China’s highly pro-industry tax rebate policy made its debut in 1985 and has been further elaborated over the past 20 years. Its aim is to lower the tax levy on export goods through a subsidy mechanism so that they could be marketed overseas at more competitive prices. Such preferential practice for boosting up export trade has been very common in most developing countries. In recent years, the system has been blamed for an immense trade surplus for China against a couple of bumper China-goods importing countries, in particular, the US.

China’s Ministry of Finance has started a new round of reduction or removal of tax rebates for 2,831 items accounting for 37 per cent of China’s export portfolio since 1 st July, 2007 in a bid to reduce the huge trade surplus, hammer out some trade conflicts and change the industry structure.

The magnitude of this latest round tax alteration on export products is unprecedented. No grace period was given. The change can be divided into three levels.

The first level covers 553 export products with their production related to pollution and resources exhausting processes. All previous tax rebate for them are to be abolished. These goods include cement, fertilisers, dyes, leather, and others related to endangered species of flora and fauna and so forth.

The second level applies to a wide spectrum of 2,268 light-industry consumer products which are deemed to easily cause trade conflicts with other countries. The list includes toys, textiles and clothing, paper, shoes, ceramics, steel and furniture. The new tax rebates are tuned down to a range between 5 and 11 per cent for these affected products.

For the third level, there are 10 export items which become tax exempted. They are peanuts, nuts, sculpture boards, stamps, oil paints, revenue stamps, etc.

Surging trade surplus and conflicts

Spates of goods that are advantageously sold to many developed countries like the US and those in Europe are literally made in China thanks to the latter’s unrivalled low price afforded by cheap land rent and other low cost factors. The total value of tax rebates enjoyed by the Chinese manufacturers amounted to US$337.2 billion and US$428.5 billion respectively in 2005 and 2006. China’s export is escalating at an extremely fast rate year on year. In comparison, China is much less dependent on imported goods from developed countries, leading to a huge imbalance and a staggering trade surplus for China against the importing countries. It was reported that China had a US$73.9 billion trade surplus with the US in the first half of this year, an 18.6% increase over last year. The severe imbalance has triggered increasing episodes of trade frictions.

Mr. Wang Yuan-hong, an economist at the State Information Centre in Beijing, has stated that the trade surplus for China is now not merely an economic issue, but also carries a political overtone. Governments and trade bureaus of the developed countries have long been dissatisfied with the widening trade gap and the flooding loads of cheap Chinese goods imported into their markets. They have employed such protectionist strategies as anti-dumping measures to iron out the problem. Obviously, the decade-long tax rebate policy has provided an absolutely competitive edge to the Chinese manufacturers, partly contributing to the trade surplus. The Chinese government has been under more and more pressure to reduce or abolish the tax rebate subsidy in a bid to counter the ever-expanding trade surplus.

An expected move

Echoing the similar view is Mr. Frank Gong, JP Morgan’s chief China economist. He believed that slashing or reducing the tax rebate would help alleviate the trade conflicts. “People will regard it as the right decision because China’s major trading partners, including the US and Europe, have been complaining China’s heavy tax rebate program is kind of a subsidy for its exporters. So, by reducing the subsidy, definitely, I think it will help cool off some of the critics of China’s widening trade surplus,” says Mr. Gong.

The July round of China’s new tax amendment was the third attempt in 2007 to curb the spiralling trade surplus. Many industry veterans and market watchers have somehow expected the Chinese authority’s looming act. “I think the move is pretty much expected and Beijing will continue to reduce export incentives. Small exporters may suffer in the short run, but the move would be healthy for the whole industry in the long run,” said Mr. Billy Wong, an analyst at BNP Parbas Securities.

There are opinions that the trade surplus could be reduced because of this new round of rebate cut, but probably not in a very large extent. And the new policy would rather pose a threat to the survival of many Chinese export-oriented manufacturers. From an online poll by Webtextiles, China’s first textile portal, gauging the effect of a reduced tax rebate implemented in early 2007, over 65 per cent of the 2,200 people polled said the tax rebate cut would have a noticeable impact on their companies. The third rebate reduction this time has fuelled the similar worries and concern.

Tough time ahead

Particularly for the thin-margin companies, the impact of the altered tax rebate can be devastating. The textile industry has been reportedly struggling hard to deal with the blow. Mr. Liang Qun, senior manager of the China Artex Taizhou Import and Export Co., Limited in Zhejiang Province, predicts that one fifth of the textile companies in Wenling, China will close in the wake of the series of tax rebate cut in 2007. “The new tax rebate policy will force more textile companies to go bankrupt,” Mr. Liang said.

The toy industry is another sector expected to receive the hard hit. Though its tax rebate is reduced by a lesser extent of 2 per cent from 13 to 11 per cent, this ‘slight’ deduction still affects thousands of toy manufacturers tremendously. The 2 per cent cut in tax rebate is tough enough for them. Already stricken with the rising cost of raw materials, labour and land rent, the survival of many toy manufacturing companies is threatened and becoming even more difficult to operate than before. The small-sized enterprises might not be able to cope with the increase in cost and be forced to shut down in the end.

Tax rebate has been important to the development and business operation of the country’s manufacturing industries. With drastic reduction in the rebate, many factories are destined to wither and close down. A huge number of workers will lose their jobs since most industries concerned are labour-intensive in nature.

Coping with the new rules

Following the policy change after 1 st July, 2007, the majority of China’s manufacturers have to shoulder increased business risk, as the deduction or elimination of tax rebate leads to higher cost and hurts their cash flow.

Nevertheless, a number of manufacturers with foresight have already got prepared and adopted ways to lower cost before the onset of the new policy. Some have started relocating their production plants to areas where the costs of labour, transport, raw materials and land rent are comparatively lower. Others are taking steps to shift to more high-end production, for example, the making of more hi-tech electronics.

The revised tax rebate policy is bringing both suppression and encouragement effect, depending on the nature of the industries. Suppression is imposed on industries and companies that involve pollution-prone, resources-exhausting processes, and those liable to cause trade conflicts. The other proclaimed goal of the new tax rebate system is to encourage an up-move in the industry structure towards high value-added and hi-tech production.

The vast majority of current manufacturing industries in China are labour-intensive in nature, and much of which are concentrating on the production of resources-intensive consumer goods. The newly-imposed disincentives are to discourage the development of these industries. Faced with increased competition from regional production rivals and advancement in technology, China’s manufacturers need to turn to higher value-added products. Only by shifting to the technology-oriented and knowledge-based mode can the Chinese manufacturing be sustainable and benefit the Chinese labour population in the long run.

For those with sufficient ‘preparation’ and real strength, they can eventually survive and continue to thrive in the new regime a proper transformation. But for the smaller-scale companies with limited resources, they might find themselves unable to accommodate the cost burden and go bust. The extent of the new policy’s impact will remain a hot subject to be closely assessed and addressed in the months to come.