Ideas for the Third Plenum

The forthcoming Plenum will be decisive for China's development for a decade to come.

The third plenum of the 20^th Central Committee (CC) of the Communist Party of China (CPC) has finally been scheduled for July15-18 2024. Previous 3^rd plenums, among which that of the 11^th (reform and opening up), the 14^th (socialist market economy) and the 18^th (decisive role of the market) spelled out comprehensive programs of policies and institutional reforms that defined China’s economic policies for decades to come. The question is whether the upcoming plenum will deliver the depth and breath of reforms that the 11^th, 14^th and 18^th 3^rd plenum delivered. Signs are that the forthcoming plenum could again deliver major reforms. Quite likely, the main theme of the plenum will be achieving “High Quality Development,” a term favored by CPC general secretary Xi Jinping.

A February 19 meeting of the Central Committee for Comprehensively Deepening Reform drew the comparison with the 3^rd plenum of the 18^th Central Committee in 2013, which suggests that the reform package sought could be ambitious. From the April politburo meeting readout it seems that the plenum will focus on China’s modernization and technology, as well as on the demand side and distribution of the economy. The Central Economic Work Conference of December 2023 had called for reforms in the fiscal system and household registration system. Xi Jinping’s meeting with private sector participants in Shandong province suggests that the role of the private sector in the new era will be on the agenda as well. A June 26 page 1 editorial in the People’s Daily,[1] authored by “Ren  Zhongping,” a pseudonym that stands for “important commentaries” of the People’s Daily, calls for a “high level socialist market economy” without defining the term, but echoing the “socialist market economy” theme of the 3rd Plenum of the 14th Central Committee in 1993.

The latest edition of Quishi[2] provides further indications of the type of reform initiatives that can be expected. It includes a compilation of excerpts from secretary general Xi Jinping’s speeches focused on the theme of High Quality Development. It also includes an article by Minister Han Wenxiu, deputy director of the Central Commission for Economics and Finance. Xi Jinping’s article spells out the conditions for high quality development: “High-quality development is development that can well meet the people's growing needs for a better life, development that embodies the new development concept, and development in which innovation becomes the first driving force, coordination becomes an endogenous feature, green becomes a universal form, openness becomes the only way, and sharing becomes the fundamental purpose.” Han Wenxiu’s article identifies several key areas of reform:

1.      Deepen the reform of the education, science and technology talent system and mechanism, promote innovation and development, and accelerate the construction of a modern industrial system.

2.      Deeply implement the main functional area system and comprehensive reform of agriculture and rural areas, promote coordinated development, and accelerate the formation of a new pattern of urban-rural integration and regional coordinated development

3.      Deepen the reform of the ecological civilization system, promote green development, and make green and low-carbon the basic background and future advantage of China's modernization.

4.      Improve the high-level opening-up system and mechanism, promote open development, and smooth the domestic circulation and domestic and international dual circulation.

5.      Deepen institutional reform in the field of people's livelihood, promote shared development, and continuously enhance the people's sense of gain, happiness, and security.

6.      Improve the system and mechanism for safe development, effectively coordinate development and security, and achieve a benign interaction between high-quality development and high-level security.

There is a wide recognition among China’s leadership that further reforms in the economic system are essential for achieving high quality growth. The third plenum is a key tool for comprehensive reforms, as it can forge the political agreements and compromises needed to get buy-in and rapid implementation of those reforms. The New Development Philosophy describes a path towards high quality growth, which is innovation and productivity driven, is coordinated, ecologically sustainable, open, and more equally shared among all Chinese. China has made progress on each of these counts in the past decade, but many challenges remain, including low domestic demand, lacklustre labour market performance, persistent inequalities in income, wealth and opportunity, and low total factor productivity growth. As Ren Zhongping’s People’s Daily Article puts it:

“The problems of imbalance, disharmony and unsustainability in development are still prominent, the development model is still extensive, the gap between urban and rural regional development and residents' income distribution is still large, social contradictions have increased significantly, and there are many problems related to the vital interests of the masses. Formalism, bureaucracy, hedonism and extravagance are prominent, and negative corruption is prone to occur frequently in some areas.”

The authorities are therefore right to further pursue reforms across a broad range of areas. Further strengthening the modern industrial system, developing new quality productive forces and reforming the primary, secondary and tertiary distribution system are therefore likely to be at the core of the 3^rd Plenum Decisions document.

A CC plenum is a key tool for reconciling conflicting interests. Each individual reform could be opposed by blocking coalitions of interested parties. Taken as a package, though, would allow for a workable compromise, in which specific interest groups gain some and lose some, but on net they gain because the reforms make the pie larger. A plenum is also critical for better coordination among reforms different fields. Since “High Quality Growth” is such a broad concept, it is clear that individual policy measures often affect more than one aspect of high quality growth.  Science and technology policy, for instance, will be critical for innovation to drive growth, but fiscal, financial and human resource policies are important as well. Fiscal policies are critical for more shared growth, but hukou, education and health policies are as critical in building a society that offers equal chances for all (Table 1).

At this stage of China’s economic situation, there is a premium on specificity of measures to be included in the plenum’s decision document. Much has been said on high quality growth, Chinese modernization, new quality productive forces and other ideological breakthroughs of recent years. This is a time for delivering on the details. Detailed policies are necessary to rebuild the confidence of household s and the private sector, which has been waning in recent years, in light of the economic headwinds and perceived or actual policy changes. Details are also needed to provide guidance to ministries and local governments, as a centralization of decision making only works if it is clear who is to do what in the bureaucracy. 

The rest of this post suggests some concrete policy proposals that aim to increase the productivity of China’s economy, improve the distribution of resources, and to strengthen the role of fiscal policy as a tool for achieving government macroeconomic and distributional objectives. Together, they would support China’s move to the new development pattern.[3]

A. Enhancing productivity growth

1. Regulating subnational industrial policies. In recent decades, China has made impressive progress in industrial policy. At the same time, industrial policy has been marred by duplication, waste and overcapacity at the subnational levels and spill-overs in international markets. To further optimize industrial policy, central rules on what subnational governments are allowed to do in industrial policy and local government support are needed. A good example could be the rules that the European Union has in this area—which directs state support to truly innovative activities rather than support for non-viable companies. The government’s aspiration to join the CPTPP would also require reforms in the system of state support for enterprises to ensure competitive neutrality, domestically and internationally. Fully implementing the government’s own 2016 “fair competition review” would move in this direction.[4] Endorsement by the Central Committee will be critical for achieving orderly industrial policies.

2. Concentrating local SOEs on core functions.  State enterprises have been an essential part of China’s socialist market economy, and after the major reforms in the 1990s, they have become profitable and a key government tool for economic management. At the same time, their presence in many sectors is of little or no strategic interest for the government, has hampered the development of the private sector, and undermined efficiency and innovation.[5] To reinforce the “two unwavering” policy, government could consider focusing SOE activity on what it considers to be core interests of the state, including advanced technology and basic industries. Monetizing SOE assets outside of these core interest could also support local governments in resolving their current debt issues.[6] The government could set up teams at every level of government to identify and develop plans for monetization of subsidiaries or divisions of each SOE. Prevailing processes for sale of government assets could then be used to implement sales. Alternatively, these assets could be transferred to asset management companies with a mandate to monetize the assets and maximize returns on state capital.

3. Unifying the hukou system. To create a mobile and versatile labour force with equal access to a common standard of public services, reforms in the household registration system are needed. China has been urbanizing rapidly and urban residents now make up more that 65 percent of the population, but only half of the population has been granted urban hukou status. The hukou system has outlived its original status of controlled urbanization, and has become a major barrier to labour mobility, a source of inequality in opportunity, and a cause of low consumption. Equalizing hukou among all Chinese will improve the allocation of labour and will also be a major boost to domestic demand, as current migrants would be able to settle, buy a house, and consume requires a central government policy. This requires a national policy, as individual localities have local, not national objectives in relaxing their hukou policies, often put undue conditions on changing hukou status, and avoiding the costs of doing so. A good example for future policies could be the EU, [7] which allows full mobility of labour and grants any EU citizen access to all social services and protection. Subsidiary reforms in land rights management and the fiscal system will be needed.[8]Setting a clear timeline for unification of hukou would urge local governments to adjust.

4. Sharing of VAT based on actual consumption. VAT, at almost 7 percent of GDP in revenues is by far the most important revenue source for central and local governments. Although VAT is meant to be a tax on consumption, the current system of sharing revenues of VAT creates distortions. The VAT is shared on a derivation basis (where taxes are collected) which provides local governments a bias towards production rather than consumption and towards urban areas rather than rural areas. Sharing VAT according to where consumption actually takes place instead of collection points would remedy this bias, which in the end leads to wasteful investment and government spending. China’s subnational national accounts now produce reliable consumption numbers, which could therefore be used as a basis for central-local sharing. Japan shares the VAT with prefectures based on retail sales. Germany simply shares the VAT with the Laender on a per capita basis—which is strongly equalizing and would therefore support the government’s objective in providing minimum levels of public service across the country.

5. Equalizing the VAT rates for goods and services. Most of services are currently taxed at the lower 6 percent rates rather than the standard 13 percent. This incentivizes local governments to pursue industry rather than service sector, which leads to  sub-optimal allocation of government resources and low employment growth. The central government could provide stronger incentives for services sector development by equalizing the VAT rate for services with that for goods. In particular, the government could start with high level services so as to encourage development of the most productive services. Over time, all VAT rates could be equalized at the previous standard rate of 17 percent to ensure a strong revenue base for government to meet the expenditure pressures of a modernizing, middle class and increasingly aged society

B. Improving Functional and Personal Distribution of Income.

6. Increasing SOE Dividends. Dividends of state enterprises (SOEs) are a promising source of non-tax revenues. SOEs contribute about 1/3 of total tax revenues to the budget through VAT and EIT, but they would have done so also if they would have been private enterprises. Dividends are a payment to owners, not tax authorities. SOEs are now quite profitable: in the past 5 years for which data are available, profits from non-financial SOEs and State Commercial Banks add up to some 5.5 percent of GDP.[9] Revenues in the State Capital Management Budget (SCMB) are fall less than that—less than 0.5 percent of GDP. And the transfer from the SCMB to the general budget has been less than 0.2 percent of GDP in recent years. OECD practice is to transfer 30-50 percent of profits to the government coffers through dividends. If applied to China, an additional 1-2.5 percent of GDP could be raised in revenues. For this to benefit the general budget, it should not be used for spending in the State Capital Management Budget, but should go straight into the general budget, or the National Social Security Trust Fund.[10]  Government could also encourage private enterprises to distribute more of their profits to shareholders, which would mean a reduction in the domestic savings rate, as retained earnings are accounted as corporate savings in the national account.

7. Broadening application of the personal income tax. Though China’s personal income tax rate structure is progressive, and its highest marginal tax rate at 45 percent is relatively high, there are few that actually pay it. The current personal exemption of RMB 60,000 leaves out some 85 percent of taxpayers (Sina.com, 2019), which is at about the average wage income, as compared to half of average wage income in OECD countries. even for the highest income decile, the personal income tax paid is less than 3 percent of pre-tax income. Important income categories for the better off, such as dividends and interest, are lightly taxed at 20 percent, whereas capital gains are not taxed. The government could gradually phase in more income taxes by maintaining the current tax brackets in real terms. With real incomes growing at some 4-5 percent, people would gradually pay more taxes over their additional income. Furthermore, a gradual application of capital gains taxes could also broaden the income tax base. A medium-term goal of 3 percent of GDP in revenues (the Asia Pacific average) and in the longer term 5-6 percent of GDP (Korea’s revenues) from personal income tax seems aligned with the government’s goals.

8. Creating a nationally administered minimum pension system. China has made great progress in expanding access to social protection and security in recent decades, including by creating the Urban and Rural Resident System (URRS) alongside the Urban Worker System (UWS). China is now one of countries with the highest pension coverage in the world. In 2020, China had a total participation of almost a billion people (contributors and pensioners) in its pension system. But benefit levels differ widely across pension systems, and across different localities. Central government could consider making the URRS a national system, with minimum pension benefits guaranteed by central government, and the same across China, corrected for cost of living. The central government can use the National Social Security Trust Fund to finance this, and add revenues to this trust fund from SOE dividends and general budget allocations. The central guarantee for a minimum pension would prevent elderly from slipping into poverty, increase consumption, and increase labour mobility across China. A basic pension of RMB400 per month for the current 129 million eligible elderly would cost RMB 787 billion, about 0.6 percent of GDP, or roughly double what is currently spent. In the medium term more reforms are needed to gradually align UWS and URRS and to retain financial sustainability of a pension system that provides for the eldely.

C. Strengthening Fiscal Policy Tools.

9. Introducing a property tax on new property. Property taxes are a good revenue source for local government, as they are stable and align well with the benefits that people derive from local government services.  At the same time, there is considerable resistance to the tax from existing owners who fear property value declines, and the property sector is currently in turmoil. Government could consider applying a property tax to new property only. Such a tax would not affect existing property, and lower the price of new property, as future taxes are discounted in the current property price. Over time, as existing land leases fall due, the property tax could also be gradually applied as condition for renewal of the lease. However, even if the Chinese authorities introduce a real estate tax, expectation on revenues should be modest. On average, OECD countries raise 0.6 percent of GDP in revenues from real estate taxes on households. In the US, revenues are 1.1 percent of GDP, and in the UK, revenues are 1.8 percent of GDP, the highest share in the OECD. Thus, local governments would need additional revenue sources to restore their revenue base.

10. Introducing a local surcharge on the personal income tax. A good complement to a property tax is a local surcharge in the personal income tax. Such a tax serves similar purposes as the property tax, notably a payment for local services, and would also contribute to better income distribution as more people pay more. A surcharge would still be administered by the national tax administration, but local governments could determine the rate within centrally set limits. As such this can increase local government fiscal accountability, and provide a stronger base for funding local government services. How much such a surcharge could raise depends on the surcharge, and to what extent China would want the personal income tax to play a larger role in society.

11. Removing the 3 percent deficit limit. The division of the government budget into regular account, funds account, State Capital Management Account and Social Security Account has outlived its purpose. The prevailing budget presentation obscures the government’s fiscal policy stance and risks a loss of state assets and resources. To reflect a more active role of fiscal policy in economic management, the informal rule of presenting a budget deficit that does not exceed 3 percent of GDP could best be abolished. China’s actual fiscal deficit is currently in the order of 8 percent of GDP (rather than the reported 3 percent of GDP) which is more aligned with the current needs of the economy. Making this transparent is important for government to signal its policy intent to other sectors in the economy, and better perform its core function in macroeconomic stabilization.

12. Creating a central-local capital transfer mechanism.  Even with additional revenue sources, local government finances will take time to recover from the major correction in real estate and the local government financing vehicle crisis.  Many local governments will not be able or willing to borrow for quite some time to com. Meanwhile, investments are needed in local and regional infrastructure to improve services, and realize China’s green transition. Meanwhile, central government, with less than 25 percent of GDP in debt, remains highly creditworthy.  Rather than granting local governments the right to borrow, for financially weak local governments the central government can borrow, and transfer proceeds to local governments by means of a capital transfer. Such a capital transfer would allow fiscally weak local governments to continue to invest, whereas richer local governments can continue to borrow. Central government can set conditions for the use of the transfers, to ensure proper use of the money and alignment with national as well as local priorities.  The size of the capital transfer mechanism can be determined as part of the annual budget process, and be determined in light of the needs of economic stability.

Finally, in all areas of reform, getting the balance right between party, central government, local government, SOEs, and the non-state sector will be critical. China achieved its high growth era through decentralization of decisions, creating space for the private sector and opening up to foreign investment and trade.  In the past decade, China has increasingly centralized political decision making, and more so within the party. This has increased coordination, and reduced waste and local protectionism, but also dampened initiatives from local government and reduced private sector innovation. China needs both to succeed.

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[1] Ren Zhongping, Taking comprehensive and in-depth reform as the fundamental driving force for promoting Chinese-style modernization, http://paper.people.com.cn/rmrb/html/2024-06/26/nw.D110000renmrb_20240626_7-01.htm?utm_source=substack&utm_medium=email

[2] Xi Jinping: Create a new situation of high-quality development in my country (开创我国高质量发展新局面), Qiushi 2024/12, http://www.qstheory.cn/dukan/qs/2024-06/16/c_1130162921.htm?utm_source=substack&utm_medium=email accessed 16-06-2024.

Han Wenxiu, Promoting high-quality development through deepening reform (以深化改革促进高质量发展), Qiushi 2024/12, http://www.qstheory.cn/dukan/qs/2024-06/16/c_1130162921.htm?utm_source=substack&utm_medium=email accessed 16-06-2024.

[3] I would like to acknowledge the inpurts of many colleagues and friends inside and outside China, which inspired several of the proposals.

[4] “State Council Opinion on Establishing Fair Competition Review Mechanism in Building Market System.” Retrieved from http://www.gov.cn/zhengce/content/2016-06/14/content_5082066.htm and National Development and Reform Commission and four other ministries. 2017. “Tentative Implementation Plan for the Fair Competition Review Mechanism.” Retrieved from http://www.ndrc.gov.cn/gzdt/201710/W020171026610334156557.pdf

[5] See, among others, World Bank and Development Resource Center, 2019, Innovative China: New Drviers of Growth.

[6] For instance, in Guizhou, total government debt at the end of 2022 was RMB 1.2 trillion. At the same time, the government also owns 60 percent of Moutai, a liquor company, currently valued at RMB 2.1 Trillion. Therefore, monetizing this drinks company would solve the province’s debt issue.

[7] Within the European Union (EU), a “right to reside” in another EU country beyond three months is linked to one’s employment status. Workers and self-employed persons have the right to reside without any conditions but must have the proper documentation to prove their status, such as a certificate of employment or proof of self-employment. In the case of students or “economically inactive” persons (unemployed or retired, for example), the right to reside involves proving that they have comprehensive health insurance as well as “sufficient resources” to not become a burden on the host EU country’s social assistance system during their residency. The “right to permanent residence” requires five years of continuous legal residence in the host EU country and, once acquired, is not subject to the conditions mentioned above. Some categories, notably workers or self-employed persons, receive more favourable treatment in this regard and may acquire this right before five years, under certain conditions. One can lose the right to permanent residency only through an absence of more than two consecutive years, although there are certain stipulated reasons for which such an absence is acceptable.

[8] Among others, portability of construction land rights for those that permanently move to urban areas. On the fiscal system, basing central government grants on actual population numbers is an important incentives for local government to absorb migrants and deliver services.

[9] This does not include all SOEs. Among others, data for the profits of the central bank are not disclosed.

[10] OECD/World Bank (2024) provides an overview of SOE dividend practices in OECD countries and other emerging economies. While actual policies vary, among others by sector, desired capital structure and other performance criteria, for those countries that set a minimum dividend rate, Brazil (25%), India (30 percent) and a number of former transition countries such as Bulgaria, Croatia, Latvia, Rumania, Serbia and Uzbekistan put the minimum at 50 percent of profits.