Given a level of fiscal deficit, the government can choose to cut taxes or increase expenditure. Spending more on infrastructure investment can quickly boost aggregate demand in the short term but also fuels debt expansion, and years of large-scale infrastructure investment faces declining marginal benefits. Considering the risks and benefits, tax cuts are now a better choice, not only stimulating private sector demand but also promoting deleveraging. Hitherto, tax-cutting measures have included replacing business tax with a value-added-tax and reducing the automobile purchase tax. Reforms on consumption tax and personal income tax are also expected.

The business tax to value-added-tax reform reduced the corporate sector’s tax burden. This reform was expanded to all industries on May 1, 2016, and is expected to save firms up to Rmb500bn in taxes according to the estimation by the Ministry of Finance. In April and May, business tax revenue surged due to the collection of unpaid tax and payments of tax in advance. Since June, business tax revenue plunged and the sum of business tax and VAT revenue declined YoY. The effect of tax cuts has begun to emerge. The reform reduces not only the tax burden of corporations but also that of consumers indirectly. More importantly, the B2V reform eases the double taxation on the service sector and is conducive to its division of labor and specialization.

Vehicle purchase tax reduction promotes car demand. The government halved the purchase tax for passenger cars with a displacement of 1.6L or below, effective October 1, 2015. Passenger cars with a displacement of 1.6L or below accounted for ~60% of domestic car sales. With vehicle purchase tax revenue amounting to Rmb279.3bn in 2015, we estimate the measure brought Rmb70bn in tax cuts a year. The tax incentive stimulated car demand. Since October 2015, the cumulative sales volume of passenger cars with a displacement of 1.6L or below grew 18.8% YoY, >10ppt faster than the growth over the previous 12 months. Vehicle purchase tax revenue fell 11.4% YoY YTD, but the expansion of automobile production generated more VAT revenue. As a result, total tax revenue from the automobile industry did not fall. The policy will expire at end-2016 but we think that an extension will help car demand grow steadily.

Consumption tax may be cut for some goods. Bloomberg reported that China is considering cutting the consumption tax on cosmetics and raising the taxes on tobacco and alcohol products. China levies consumption tax on 14 categories of goods, in which tobacco and cigarettes, alcohol, refined oil and automobiles contribute 99% of domestic consumption tax revenue. Cosmetics are subject to a 30% consumption tax which covers beauty cosmetics, high-end skin care cosmetics and cosmetic sets but does not cover cleaning and ordinary skin care cosmetics. In 2014, the cosmetics industry recorded sales of Rmb113.4bn and contributed Rmb1.4bn to domestic consumption tax revenue (Rmb2bn estimated in 2015). In addition, Rmb20bn of cosmetics were imported last year and may have paid several hundred million yuan of import consumption tax. Consumption tax cuts for cosmetics would benefit consumers, but consumption tax hikes for tobacco and alcohol products might push up total consumption tax revenue.

Personal income tax reform will help to improve income distribution. The government is pushing ahead the establishment of a dual system of both comprehensive and classified personal income taxes. The current personal income tax system is a classified one, levying on 11 categories of income, including wages, salaries and remuneration. While wages, salaries and operating income are subject to a progressive tax system, remuneration, royalties, property income and other income are subject to a unified tax rate of 20%, not fair to people of different income levels. The personal income tax reform may take into account more sources of income and levy a tax on total income, and also allow family burdens to be deducted, to promote tax fairness. In addition, the personal income tax exemption has been unchanged since it was raised to Rmb3,500 in 2011 and there is pressure to adjust it. Although personal income tax reform may not have much effect on overall tax burden, it will help to improve income distribution and promote consumption.