Prophets

What a China Response to U.S. Tax Cuts Means for the Yuan

Whatever happens, expect a a drag on the Asian's nation's current-account balance and a subdued exchange rate.

The U.S.-China economic relationship is getting perilous.

Photographer: Pool

China has an Achilles’ heel in the capital outflows that it has tried so hard to control. Although a weaker U.S. dollar aided China’s efforts to stem the flow of cash leaving the country in 2017 and gave a boost to the yuan, things may be about to change.

The Trump administration looks like it’s moving closer to labeling China a “strategic competitor,” and a trade war is becoming a real possibility. In addition, further interest-rate hikes by the Federal Reserve, when combined with tax cuts, may cause the dollar to strengthen -- and the yuan to weaken -- as capital flows into the U.S.  

There are several ways that China could respond to these three events, but none are likely to result in further upward pressure on the yuan.  

In a global economy, a country’s tax policy is essentially the cost of doing business and a key indicator of competitiveness. The cut in the U.S. corporate tax rate to 21 percent from 35 percent generated a strong response from Japan, home to the world’s third-largest economy, which approved a corporate tax cut with incentives tied to wage increases. Will China, home to the second-largest economy, join the race to cut?

Even though China’s headline corporate income tax is as low as 25 percent, it becomes the highest among major economies once employers contribute to a pension fund, medical insurance, unemployment insurance, job-related handicap insurance, birth insurance and a housing provident fund. World Bank data put China’s total tax rate at 67.3 percent, much higher than the U.S.’s 43.8 percent and the global average of 40.5 percent.

Nonetheless, high tax rates didn’t seem to impede China’s competitiveness, as global companies are attracted by the nation’s large pool of skilled, low-cost labor and huge market potential. Therefore, the U.S. tax cut should have a limited impact on capital outflows and a loss of competitiveness in China.

Total Tax Rate (% of Commercial Profit)

Source: World Bank Doing Business project

Hence, China is under no pressure to immediately make huge tax cuts. However, it has room to improve its tax structure. Since Premier Li Keqiang announced in March that the government planned to reduce taxes and charges by about 1 trillion yuan ($154 billion) in 2017, China has taken various measures to simplify value-added taxes, reduce government charges on companies, and allow small/macro and high-tech companies to enjoy a lower tax rate of 10 percent to 15 percent.

China is also working to attract and retain foreign capital:

  1. It has been more accommodating to foreign investors as part of its aim to achieve high-quality growth in areas such as finance, high-end manufacturing, green industry and services. Foreign firms might be skeptical about China’s claim to provide a level playing field due to policies that have been perceived as protectionist, but the government’s emphasis on boosting foreign direct investment in selected areas seems to have made progress. FDI rose by 9.8 percent to 803.62 billion yuan in the first 11 months of 2017 from the same period of 2016.
  1. The “go-go” days of "irrational” outward bound investments, or ODI, are numbered, as Chinese authorities have tightened policies in this area with the goal of stemming capital outflows. In particular, illogical and illegal investment activities in gambling, property, entertainment and sports have been curbed. Meanwhile, ODI in high-quality and productive foreign assets and to countries involved in the so-called Belt and Road Initiative are still encouraged. At the same time, Chinese firms seeking to expand abroad through acquisitions have seen their efforts increasingly blocked by the U.S. and European countries.

    China’s FDI and ODI
  1. Other measures to enhance competitiveness and attract capital include a further opening of China’s bond and equity markets to foreign investors, encouraging innovation and lowering tariffs to lure technology imports.

China’s policies for encouraging FDI and rationalizing ODI will have long-term implications for investors. Countries and companies will need to reorient their investment and trade portfolio structures toward China’s new focus areas. The drive to encourage innovation and respect intellectual property is a move in the right direction, and tech-related companies should benefit. On the flip side, China’s service trade deficit will continue to expand due to the government’s drive to attract foreign capital in services industry, acting as a drag on the current-account balance and putting downward pressure on its currency.

    To contact the author of this story:
    Tracy Chen at tchen59@bloomberg.net

    To contact the editor responsible for this story:
    Robert Burgess at bburgess@bloomberg.net

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