Beijing’s Dilemma: Cut Spending or Raise Taxes to Deal with Local Debt?

One of the key challenges facing the Chinese government today is rehabilitating the financial health of local governments. It is a tall order that requires trade-offs in an environment of fiscal constraints, which will shape local governments’ choices of where to cut spending and where to raise revenue (taxes). While here we focus only on the spending side, future commentary will look at the potential for raising revenue.

When it comes to spending cuts, entitlements is a good candidate to be on the chopping block because that mainly comes from local provincial budgets. But provincial budgets are facing the dual pressures of declining revenue and meeting debt obligations. Moreover, Beijing’s spending priorities on industrial policy and economic security will likely crowd out entitlement spending in an already shrinking revenue pie.

In four charts we show why local governments will likely target entitlement spending cuts and the potential implications on consumption.

Figure 1. No Land Sales, No Revenue (% y-o-y growth)Source: Wind.

Figure 1 shows that China’s property sector bust has led to a significant contraction in land sales, which are highly correlated with local government revenue (on average, local governments depend on land sales for 40% of their revenue). Since the property market isn’t likely to ever return to its halcyon days of the 2000-2010s, local governments simply cannot depend on land sales revenue like they used to.

With no significant land sales rebound in sight and debt obligations mounting, local governments need to find savings somewhere. Entitlement spending, which on average accounts for ~20% of local fiscal expenditure, appears to be where they’re looking.

Even the central government seems to have encouraged localities to target entitlement cuts. For instance, the central government capped the 2023 increase in pension benefits at 3.8%, significantly lower than both fiscal revenue and wage growth, while mandating local governments to cap their spending at an even lower level. Moreover, Beijing has also instructed local governments to aggressively cut healthcare benefits, which has triggered large-scale protests in multiple cities.

But it’s a peculiar time to be cutting entitlements, when Beijing should be accommodating the hundreds of millions of expected retirees over the next decade. Figure 2 shows that Chinese retirees—those 65-years or older—are expected to almost double from 195 million to roughly 360 million in 18 years. It’s as if all of America became retirees. As Chinese retirees balloon, cutting entitlement spending means per capita benefits will be reduced.

Figure 2. From Youth Bulge to Geriatric Bulge in a Single Generation (>65 years old)Source: United Nations.

Knowing they might get short-changed on entitlement benefits, soon-to-retire Chinese households will need to save more today to maintain their post-retirement living standards. Figure 3 shows that historically, smashing of the “iron rice bowl” in the late 1990s—the dismantling of the social contract with state workers—led to rising household savings rates for a decade.

Figure 3. Chinese Household Savings Rate Increased for a DecadeSource: Wind.

And if China is entering another cycle of increased household savings, which seems likely at the moment, that will have implications for both the trade surplus and the debt/GDP ratio. Figure 4 shows China’s trade surplus is at its highest level since 2010, which suggests weak domestic demand is already knocking the rebalancing process off balance.

Figure 4. China’s Trade Surplus Trending Higher (% of GDP)Source: Wind.

Local government budgets may get some reprieve from savings on entitlement spending, but it’ll be temporary at best. For one, Beijing will likely have to reverse course in 5-6 years because the army of new retirees will force more spending, not less, on entitlements, which means tolerating higher fiscal deficits. In an environment of slower growth structurally and higher spending needs, it will be very difficult to move the needle on the debt/GDP ratio by cutting entitlements.