Potential Impact of Consumption Tax Reform

The State Council[1] on October 9 issued a document on reforming revenue allocation mechanism between central and local governments amid larger-scale tax & fee cuts. The plan proposes to 1) continue allocating half of value-added tax (VAT) revenue each to central government and local government, 2) improve sharing mechanism for refunding un-deducted input tax, and 3) shift consumption tax collection to wholesale or retail side and transfer consumption tax revenue to local government. The reforms on VAT represent continuation of previous initiatives, and the market pays more attention to the consumption tax reform.

The consumption tax reform aims to shift consumption tax collection from the points of production (and import) to wholesale or retail, and transfer consumption tax revenue from central government to local government to expand local government’s source of revenue. In principle, incremental consumption tax revenue should be allocated to local government.

The initial step of reform only covers limited product categories. The plan proposes to reform consumption tax on high-end watches, precious jewelries, gems and jades initially. China is collecting consumption tax from 15 product categories, i.e. cigarettes, refined oil, cars, liquor, precious jewelries & gems, motorcycles, high-end watches, golf balls & equipment, yachts, high-end cosmetics, disposable wooden chopsticks, solid wood floors, firecrackers & fireworks, batteries, and coating materials. Notably, cigarettes, refined oil, cars and liquor contribute around 99% of domestic consumption tax revenue, and they are not covered by the initial step.

Consumption tax is the fourth largest tax revenue source in China, and transferring incremental consumption tax revenue to local governments will expand their source of revenue. Domestic consumption tax revenue reached Rmb1.06trn in 2018, accounting for 7% of total tax revenue and making it the fourth largest tax revenue source in China after value-added tax, corporate income tax and individual income tax. In addition, China also collects consumption tax on imported goods. In 2018, consumption tax and VAT on imported goods totaled Rmb1.68trn, of which we estimate consumption tax accounted for a small part as it is not collected on all imported goods. At present, consumption tax revenue is all allocated to central government. Transferring incremental consumption tax revenue to local governments will expand their future revenue source.

We estimate that shifting consumption tax collection to wholesale or retail may increase overall consumption tax, provided that tax rate and tax calculation method remain unchanged. Sales price of a product increases from producers to distributors and retailers. If tax rate and tax calculation method remain unchanged, shifting consumption tax collection to wholesale or retail will increase consumption tax. While producers may benefit in the near term thanks lower direct tax burden, rising consumption tax may weigh on consumption and producers’ sales. Apart from contributing tax revenue, consumption tax also has the functionalities of mitigating externalities and improving income distribution. Consumption tax is mainly collected on products with negative externalities and goods consumed by the rich. Boosting consumption may not be a primary target of the consumption tax reform.

The scope of consumption tax reform may gradually expand. As downstream wholesalers and retailers significantly outnumber producers, shifting tax collection from production side to wholesale or retail side could increase tax collection cost. According to the plan, the collection of consumption tax will be gradually shifted from the production (and import) side to wholesale or retail side for some products, provided that tax collection and management is controllable. The product categories covered by the consumption tax reform would be steadily expanded after elaborate discussion and approved case by case. Together with consumption tax legislation, reform pilot will be carried out on other product categories when conditions are appropriate. We think consumption tax reform will steadily and gradually advance.

Legislation on consumption tax still under way. The interim regulation on consumption tax and the implementation rules for the interim regulation on consumption tax, both released in 2008, regulate consumption tax in China. In 2019, the Ministry of Finance[2] plans to draft laws for value-added tax, consumption tax, stamp duty, city maintenance & construction tax, land appreciation tax and custom tariff and regulations for lottery management, and submit them to the State Council. The latest progress of consumption tax legislation is yet to be announced.

Note:
[1]http://www.gov.cn/zhengce/content/2019-10/09/content_5437544.htm
[2]http://www.mof.gov.cn/mofhome/tfs/zhengwuxinxi/caizhengfazhidongtai/201903/t20190320_3199939.html