Beyond LGFVs: three types of hidden debt unaccounted for in China's official stats
Former Deputy Director of the State Tax Administration unmasks VAT refunds, unpaid pension contributions, and farmers' implicit contributions, suggesting state-owned capital as compensation.
The debts accumulated by Local Government Financing Vehicles (LGFVs), often referred to as China's hidden debts due to their association with government liability, are widely known among observers of China's economy. However, in a recent speech and Q&A, Xu Shanda, Deputy Director of the State Tax Administration of China 2000-2006, brings forth a cautionary note regarding three additional categories of little-known hidden debts.
Unpaid VAT refunds for private enterprises: Particularly for private-owned high-tech companies, there is a significant amount of Value Added Tax (VAT) refunds owed to them since the 1990s. These refunds were promised but left unpaid due to fiscal constraints.
Unpaid pensions contributions: Before China’s establishment of socialized pension schemes, employees’ pensions were covered by the entities they had worked for. However, this became unfeasible as many state-owned enterprises (SOEs) faced bankruptcy during economic reforms. Neither the SOEs nor their employees had made contributions to the newly-created socialized pension funds to cope with bankrupted SOEs’ employees, so the de facto obligations had been rolled over - but will have to be met someday. On the other hand, China made an implicit political decision to use state-owned capital to bankroll part the socialized pension funds.
Historical debts to farmers who contributed compulsory labor and whose products were artificially discounted: Farmers in China have been making substantial contributions to the nation since the era of "socialist industrialization" (1949-1956), through compulsory labor and “price scissors” that deliberately kept low the prices of grains and raw materials. Present-day support policies for rural areas still fall short of compensating for the historical debts incurred during that period.
In all three scenarios, the sources of the implicit debt turned into Chinese state capital.
Xu Shanda worked extensively in China’s tax reforms and now serves as an expert at the SEEC Research Institute (SRI), a non-governmental think tank in China. The following is Xu Shanda’s speech and Q&A session at a seminar on China’s debt situations, organized by the New Economist thinktank. This transcript is also available at the SRI website.
I'd like to share my perspective on the current discussion regarding the scope of debt. What types of debt are currently in play? Let me begin by addressing three key aspects.
Value-Added Tax (VAT) refunds
When examining government debt, it's important to note that there are certain government debts not included in the official statistics. Let me delve into two of those. From the perspective of Chinese tax authorities, the most substantial component of government debt is VAT returns, which is linked to the tax collection methods of China. The amount involved is in the trillions (of yuan).
China introduced the VAT in 1994 — I won't go into the details, and the tax administrations adopted a VAT credit system. The standard VAT system should work like this: Companies balance their input and output on a monthly basis. If a company's output exceeds its input, the difference will be taxed; if the output is less than the input, the difference will be refunded.
However, as the then Minister of Finance Liu Zhongli said repeatedly, China’s fiscal circumstances in 1994 did not allow for full implementation of the policy. So an alternative approach was adopted — when a company's input exceeded its output, the tax authorities, instead of providing refunds, would put these funds on the government accounts as VAT credits. The companies' entitlement to these credits were acknowledged; once the companies generate more output than input, these credits will be utilized to offset their VAT obligations.
Essentially, these unpaid taxes of the government to businesses constitute a debt. This type of debt had minimal impact initially. But later, when China started trials that replace business taxes with VAT in 2012, the scope of refunding expanded to all businesses, resulting in a significant increase in VAT credits. This forms the first factor contributing to the substantial rise in VAT credits.
The second factor is linked to China’s support for high-tech, capital-intensive enterprises. The more high-tech and capital-intensive a company is, the longer its investment cycle, and the higher the amount of VAT credits. Consequently, this raises markedly both the cost of financing and the debt-to-asset ratios for these companies, casting a negative impact on the valuations of publicly listed companies.
In 2016, after China comprehensively rolled out replacement of business tax with VAT on the national scale, Yu Zhengsheng, then Chairman of the National Committee of the Chinese People’s Political Consultative Conference (CPPCC) organized an investigation into VAT credits, in which I also participated. The investigation report recommended transforming VAT credits into refunds and ceasing the practice of offsetting VAT credits with future VAT obligations.
The recommendation was approved by the National Committee of the CPPCC and the State Council, so the tax administrations started to refund VAT credits in cash starting in 2018. However, the accumulated amount over the years was so substantial that it could have costed more than a year’s fiscal revenue of the Chinese government; the government had no fiscal capacity for this.
Hence, from 2018 to 2021, the Ministry of Finance set a quota (of VAT refunds) to be distributed among local tax administrations, who then calculated the amount of VAT credits to be refunded, as well as the list of companies eligible for refunds. Not all amounts were refunded — there were criteria as to which credits qualify for refunds and the percentage of refunds to credits, as stipulated by the tax administrations. The tax administrations were only able to refund a portion of incremental VAT credits from 2018-2021, leaving the accumulated credits continuously on the rise. Neither the Ministry of Finance nor the State Taxation Administration disclosed the accumulated figure, but it was in the trillions of yuan.
The State Council then decided to intensify efforts in advancing VAT refunds so as to support high-tech, capital-intensive enterprises. These enterprises have longer investment cycles and larger investment scales. If the VAT credits weren’t resolved, the incentives for them wouldn’t work. Thus, the State Council decided to refund both the stock as well as the increments of the VAT credits, but how could they? At that juncture, the fiscal revenue was insufficient even to cover the newly generated credits, let alone the accumulated ones.
So, what did the government do with all the VAT credits owed to businesses (which should have gone back to companies in cash)? The government used them for investments and expenditures. Investments can be seen as the formation of state-owned assets, that is, an increase to the state-owned capital. A report by the SRI, where I work as a researcher, suggests channeling state-owned capital to paying the VAT credits.
At the end of 2021, the State Council decided to allocate 1 trillion RMB from financial institutions, including the People’s Bank of China (PBoC) and the State Administration of Foreign Exchange (SAFE), to the Ministry of Finance, and thereafter to the State Taxation Administration and to tax authorities at the provincial, municipal, and county levels. The VAT stock credits, as calculated by separate regions, were 1 trillion RMB in total. Due to fluctuations in exchange rates, the PBoC's assets were allocated in batches. In the end, approximately 1.08 trillion RMB was refunded, according to the Ministry of Finance.
However, the accumulated VAT credits have yet been completely refunded, and the exact amount has not been disclosed. It is still in the trillions (of yuan). Although VAT credits have a different repayment mechanism from that of typical debts such as commercial bank loans or government bonds, they should also be considered as government debt — only not as visible as government bonds or corporate bonds. This is something that needs more consideration in government debt discussions.
The growth of high-tech, capital-intensive enterprises is crucial for achieving high-quality development and will be a major investment area in the future. Therefore, the VAT credits/refunds, which is the first item of hidden debt I want to talk about, must be addressed promptly.
The Income-Expenditure Gap in Enterprise Employee Social Security
The Chinese government has formally acknowledged another item of implicit debt. Retirees in China used to collect their pensions directly from the companies they had served. However, following the state-owned enterprise (SOE) reform led by the then Premier Zhu Rongji, numerous companies found themselves at a high risk of bankruptcy. Consequently, retired employees would have lost their pensions (because the companies cease to exist).
It was then decided that a socialized pension system was to be established. Ideally, pensions should have been managed nationally, but China’s central finances were not yet robust enough. Not many years had past since the introduction of the central-local tax-sharing system in 1994, and pension reforms only came into play in 1998 and 1999. Consequently, China opted for a province-based system where a certain percentage of individual wages in addition to enterprises must contribute to employee pensions. These changes were implemented post-reform, but what about those who retired before the reform? Also, in cases where an individual retired shortly after the reforms and had not made substantial contributions, questions arose about how they should receive pension benefits.
In response, the Chinese government made a significant decision, essentially interpreting the absence of pension contributions from both enterprises and employees before the reforms as a strategy aimed at reducing enterprises' operating costs, boosting their profits, and subsequently reinvesting these profits to establish new enterprises and expand state-owned capital. In 2017, another pivotal decision was taken to transfer state-owned capital to form the National Council for Social Security Fund. This transfer wasn't just about redistributing SOE shares; it signified the government's acknowledgement that state-owned capital bore an implicit liability towards employees. Initially, the redistributed SOE shares mainly came from publicly listed SOEs, but it later encompassed all state-owned capital, regardless of their listing status.
In simple terms, China recognizes a certain portion of state-owned capital as a social security debt to employees, which should now be repaid using state-owned capital. I believe it is another hidden debt that isn’t reflected on bonds and bills.
Farmers' Implicit Contributions to the Government
There's another unaccounted item of hidden debt: the implicit contributions made by farmers.
In 2006, the State Council decided to abolish the Agricultural Tax [A hefty tax on any individual/entity engaged in agricultural activities. It has been in place since 1958, but similar taxes date back around 2,600 years in China.] and the "three deductions and five charges". ["three deductions" refer to public reserve funds, public welfare funds and management fees; "five charges" refer to charges for rural education, family planning, militia training, rural road construction and subsidies to entitled groups. These are additional taxation on farmers besides the Agricultural Tax, which oftentimes exceeded the Agricultural Tax.]
The rationale behind the 2006 decision was that in the early years of industrialization, farmers supported urban workers and rural areas supported cities. Basically, wealth created in agriculture and by farmers was drawn to industrialization without compensation. The agricultural tax and the "three deductions and five charges" were the explicit contributions of farmers to the government.
But there are also implicit contributions. To illustrate this with a simple example, during the Second Plenary Session of the Eighth Central Committee of the Communist Party of China (CPC) in 1956, Chen Yun, the then Vice Chair of the Central Committee, proposed 50 billion units of compulsory labour for farmers in the Second Five-Year Plan (1958-1962). Just think about the capital that could be generated from 50 billion units of labour, especially at that period of time! Some of you may still remember the history: rural labor force were required to labor for the government for a certain number of days every year; the government didn't provide food, clothing, or wages. For instance, if a production team [the basic unit of China’s rural collective under the people's commune 人民公社, a multipurpose local organization which assumed both productive and administrative authority during 1958-1984] of 100 laborers was assigned 1,000 units of labor, either 10 people worked for 100 days or 100 people worked for 10 days to meet the 1,000 units of labor. So, compulsory labor served as a channel for the accumulation of capital nationally.
That’s still not the whole picture of the implicit contributions. The price scissors, meaning the price disparity between agricultural and industrial products, were implemented under the direction of Chairman Mao (Zedong) to “prioritize capital accumulation over substantial improvements in people's living conditions." (较少改善民生，较多提取积累)
With agricultural product prices deliberately kept low while industrial product prices were raised to generate accumulation, resources drawn from people's welfare were transformed into state-owned capital. Therefore, China’s state-owned capital also carries an implicit debt towards farmers.
Since the abolition of the Agricultural Tax and the "three deductions and five charges," China has reversed its national strategy to what is now “supporting agriculture with industry, and rural areas with urban development” (城市反哺农村，工业支援农业). This has not, however, entirely resolved the accumulated debt issues — somewhat akin to what I mentioned earlier about the accumulated VAT credits.
Many experts have discussed various forms of government debt, but all of them are explicit and can be accounted for in official records. I believe it is crucial to also consider the implicit debts in studying China’s overall financial situation. So I'm proposing this broader perspective for a more comprehensive review of the substantial impact on China’s economy.
Q&A 1: How does the government repay these hidden debts, especially amid voices calling for tax cuts?
I believe the strategy of “prioritizing capital accumulation over substantial improvements in people's living conditions” led to a faster development of China’s industrial system than many had anticipated at the time.
A prime example is comparison with India which, like China, had a large population and a similar per capita GDP level during the 1980s before China’s reform and opening up. In 1980 or so when the planned economy and the above-mentioned strategy were still in place, China's per capita GDP had exceeded $3000, while India's remained at just over $1000. The progress was tremendous because when the People’s Republic of China was founded in 1949, the per capita GDP of both countries was only around $300.
[China’s per capita GDP reached $3,468 in 2008, while that of India was only $994. The per capita GDP of both countries in 1990 stand at around $300. So Xu saying China’s GDP per capita exceeded $3,000 in 1980 could be a slip of the tongue, or the original Chinese transcript is wrong.]
This accumulation of wealth also constituted the foundation for the significant progress of China after reform and opening up. Of course, the cost was substantial, with little improvement in people's living standards and abnormally high mortality rates.
At first, China borrowed from the Soviet Union, and in the 1970s, turned to the United States and Japan. While external capital was utilized for industrialization, it had to be repaid using domestic assets, as foreign ownership of assets in China was not allowed. So foreign lending to China didn’t result in their ownership of assets in China, but China’s debt to them.
It wasn't until 1979 that China opened its doors to foreign ownership, an achievement of the reform and opening up. Foreign-owned capital received reimbursements through dividends based on value-added, eliminating the necessity for China to extract domestic accumulations for repayment of debt owed to the outside. This institutional change effectively tackled the capital shortage issue in China and shifted the repayment method to a new cycle of investment, appreciation, and returns.
Coming back to the hidden debts discussed earlier, while a significant portion of these funds was allocated to administrative expenses and military development, a considerable share were converted into state-owned capital. Looking through the lens of a balance sheet, I believe state-owned assets and the hidden debts are on the two ends of the equation, and that their connection can be studied and calculated. Indeed, China has a substantial amount of debt, including hidden debt, but it has also witnessed significant growth in its assets in spite of high costs. There's no such thing as perfection in the world; China has its share of mistakes and errors. Nevertheless, I believe it's crucial to conduct an objective assessment to discern the right decisions from the wrong ones.
Q&A 2: So the enhancement of the efficiency in state-owned asset operation and tax cuts can complement each other?
Absolutely, as both are resources under government control. The government has the authority to generate fiscal revenues from the market annually, and the appreciation of state-owned capital also belongs to the government. Therefore, it's crucial to analyze the equilibrium between total assets and total liabilities.
While it is appropriate to study China's debt, Western media have completely distorted its significance. China has the lowest debt burden and the highest asset : debt ratio of any nation.
Beijing is holding at least $9 trillion in reserves, and explosive GDP growth ($1.5 trillion this year) would quickly erase the debt in any case.
90% of its debt is productive, backed by assets and paying dividends. The 'white elephant' 40,000km HSR system has an 8% ROI, and the Three Gorges has a 300% ROI.