How to Reverse the Economic Downturn? / Sheng Hong


How to Reverse the Economic Downturn?

Sheng Hong

It seems that there is no objection to whether the Chinese economy is seriously declining. What is the economic growth in 2018? There are still many judgments. For example, the National Bureau of Statistics says it is 6.5%, Xiang Songzuo said that the estimate of an institution is 1.67%.The “Keqiang index” I calculated (Note 1) is 3.6%; and after correcting the power generation of an important component of the “Keqiang Index” (Note 2), the “Keqiang Index” is about -1%. .The task now is to reverse the economic downturn. The policy for the right medicine should obviously be based on correct diagnosis. I have always stressed that because China’s urbanization process has not been completed, because China has a “major country effect” in international trade, we still have 15 to 20 years of rapid economic growth. These two advantages have always been the basis for our economic growth, bringing about an annual growth of 5 to 6%.Since there is such a growth base, why is China’s economy going down in 2018?

In my opinion, there are mainly four factors. The first is that the tax burden is too heavy, the second is the unfriendly to private enterprises, the third is the anti-urbanization policy (such as limiting the size of the city), and the fourth is the violation and restriction of the network economy. For the first point, I have discussed in detail in the article “The government share is expanding, the profit margin will be exhausted”. On the second point, I also discussed in the article “How to let private entrepreneurs believe in the government”; on the reverse urbanization policy, I also discussed in the article “The livelihood of the ordinary people, the foundation of big countries”; regarding the restrictions on the network economy, I discussed the positive impact of the new economy in the article “Two Kinds of Economy in China”. I will write an article devoted to the negative impact of limiting the new economy. In addition, there are two very important factors, one is the problem of state-owned enterprises, and the other is the issue of land system. The solution of these two problems will bring about a growth rate of more than one percentage point of GDP, but these two are long-term unresolved issues, not the main reason for the economic downturn in 2018.

It is clear what kind of policy should be adopted for these four major issues. In view of the problem of excessive tax burden, large-scale tax reduction is required. For the problem of private enterprises, it is necessary to improve the judicial system so that it can truly protect the legitimate rights of private enterprises. Regarding to anti-urbanization, it should stop restricting the size of the city, this is a policy that directly offsets the positive impact of the urbanization process; let the city open to all, and adopt other specific methods to solve the problem of insufficient single resources in the city. As to the limits to new economy, it should be realized that the property rights formed by the network economy are also property rights. It is also necessary for it to obtain protection as property rights do, and to protect the network market as well as protecting the physical market.

However, not all economists now agree with these four points, and the resulting policy recommendations are very different. There are two very different views on the excessive tax burden. One is to acknowledge that it is heavier than the Laffer Curve’s best tax rate, but it is not a big problem, not the main reason for the recession. The result of heavy tax burden is only to make the income of enterprises and residents less, which leads to weak consumption, but this can be compensated or replaced by expansionary macro policies. The other, my opinion, is that the tax burden is too heavy, not only above the optimal tax rate, but also to the point where companies can no longer survive. That is, companies have no profit margins. These two different views on tax burden have also led to different judgments on the nature of the economic downturn. The view that tax burden is not the main reason for the economic downturn argues that this economic downturn is similar to a cyclical recession, so it can be mitigated and hedged by counter-cyclical macroeconomic policy. The view that tax burden squeezes out profit margins argues that enterprises will shut down or evacuated in a short period of time, leading to an avalanche-type economic downturn, rather than a cyclical problem, so tax cuts must be taken. See the figure below for specific logic.

Figure 1 Schematic diagram of the tax rate affecting the economy


Description: This picture is only a schematic diagram. The horizontal axis represents time and the unit can be 1 year. Assume that over time, the tax rate is gradually increasing (measured by the right-hand coordinates). For a long time, although the government’s income is increasing, the income of enterprises and residents is decreasing, but it does not affect the total social income. But after a certain high tax rate (16% here), the company began to shut down or evacuate, and showed acceleration, while the total social income fell like an avalanche.

In the absence of profit margins, if only adopting an expansionary macro policy, adding a counter-cyclical demand increase based on the total demand determined by the market will only partially increase the company’s orders, but due to the high tax rate, there is still no profit margin. If an enterprise increases the output of one unit, it can only increase one unit of loss. The enterprise still has no incentive to expand production, and it cannot boost the economy from a macro level. Because the expansionary macro policy has not changed the distribution structure between the government and the corporate residents, the enterprise is still in a situation where there is no money to make. Others would say that the new demand from expansionary macroeconomic policies will reduce equipment idle rates and thus reduce average fix costs. In fact, since macroeconomic policy is only a countercyclical policy and is only adopted during a recession, the demand growth brought by this policy will not bring more demand than normal, and it will only reduce the equipment idle rate of the enterprise to normal status. The chart below shows the situation of the capital “deserved income” (no risk interest rate + reasonable risk premium) of private manufacturing listed companies. The chart shows that since 2012, the income of the capital of these enterprises has not cover the loss, and the length of time is close to a medium cycle. The loss that we see in the sense of capital “deserved income” is the loss under normal conditions, so expansionary macroeconomic policies cannot fundamentally change the company’s loss expectations.

Figure 2  The part of the private equity manufacturing listed company’s return on net assets minus the “deserved income” from 2009 to 2016

deserved income

Explanation: This picture is a picture I used in my article, “Government’s share expanding, profit margin will be exhausted”. This is the net return on equity of privately companies in manufacturing minus the risk-free rate, minus the reasonable risk premium. The implication is that when this number is negative, the return on net assets is already lower than the reasonable return of capital. It should be noted that this data have been negative for many years since 2012. If the economy declines severely in 2018, it may be a larger negative number. From 2012 to 2016, we should also regard it as “normal years”, so the expansionary macro policy can only pull the situation of the enterprise back to the “normal year” and cannot eliminate their losses.

A more detailed analysis is that the expansionary macro policy will increase the supplementary demand when the demand shrinks, and mitigate the impact of the recession, but only reduce the fixed cost allocation, but cannot fully offset the fixed cost (depreciation + capital cost + management fee) ) the apportionment. Because as mentioned above, capital has no reasonable return. At this time, although the company can regard the fixed cost already invested as the sunk cost, do not care, as long as the current price can make up for the variable expenses, it can continue production. But entrepreneurs will not make new investments because capital is unprofitable. This macroscopically shows that expansionary macroeconomic policies can stimulate short-term production growth, but cannot stimulate long-term production capacity increase, which cannot fundamentally solve the economic downturn. What’s more, according to the theory of rational expectations, macroeconomic policies can only be “unexpected” and only work if the enterprises and residents cannot foresee. If the government claims to adopt an expanded macro policy in advance, the enterprise will not be bewildered by additional demand, and rashly take the decision to increase production capacity and investment, but raise prices. As a result, the economy has not grown, and prices have gone up. This is stagflation.

Regarding the expansionary macro policy, when the economy is seriously declining, macro monetary policy will not actually have much effect. Because the money supply depends on the base currency and currency turnover rate. The central bank can only affect the issuance of the base currency, and the speed of currency turnover depends on the efficiency of the market system and people’s expectations. When people are generally pessimistic, the currency turnover rate will slow down, thus offsetting the effect of the central bank’s expansion policy. What’s more, when the market system is weakened, the currency turnover rate will also slowdown. In addition to this, it is the macro fiscal policy. We know that this is even more problematic. The first is that adopting an expansionary fiscal policy requires more financial resources, which greatly reduces the incentives for tax cuts. Second, as we saw in 2008, the expansionary fiscal policy only emphasizes Increase demand without paying attention to the investment of financial resources and related efficiency. On the one hand, financial resources will rely on the channels of state-owned enterprises, while the efficiency of state-owned enterprises is relatively low; on the other hand, in the context of government decision-making and emergency response, financial resources are more likely to invest in the wrong direction or industry, resulting in further distortion of production structure.

Some people will say that didn’t the “four trillion” expansionary fiscal policy in 2008 avoid China’s economic recession?Why can’t it be done now? If “four trillion” still has the right place, then the timing is right. .Because it is only based on general budgetary expenditures, China’s macro tax rate is 6.2 percentage points lower in 2008 than it is now.(In this paper, the “macro tax rate” includes general budgetary expenditures, government fund expenditures, state-owned enterprise opportunity income, and social security. Here, we assume that the proportion of latter three parts in GDP is not changed, and treat the changes in general fiscal budget expenditures as Changes in macro tax rates.) Going back 10 years, the macro tax rate from 1999 to 2006 is 5 to 7 percentage points lower than the macro tax rate from 2009 to 2016.See Figure 3.Therefore, at that time, the capital gains of manufacturing enterprises were still above the “deserved income”, capital was profitable, and enterprises were willing to expand production and investment.

Figure 3 General Budgetary Expenditure/GDP from 1999 to 2006 and 2009~2016


Note:Going back 10 years, the company has additional profit margin   which amounts to between the above two lines, about 5~7%.In this picture, I put the general budgetary expenditure/GDP from 1999 to 2006 in the same period as the general budgetary expenditure/GDP from 2009 to 2016. We can visually see the gap in the macro tax rate over the past 10 years.

Under such a tax rate, the company’s capital “deserved income” is met. Most of the data in Figure 4 is the same as Figure 2, except that the tax rate 10 years ago was adopted .Therefore, the adoption of expansionary macroeconomic policies 10 years ago not only increased orders, but also increased profits, and also prompted enterprises to increase investment and production capacity, thus enabling China to avoid the economic recession in the context of the global economic crisis. However, today, when the macro tax rate is 5-7 percentage points higher than 10 years ago, the so-called “four trillion” policy will no longer have the original effect. We can also consider the data in Figures 2 and 4 as the basis for calculations when entrepreneurs make decisions, and they calculate the expected return on their investment by the average. The actual income is fluctuating around the expected value. When the expected value is lower than the capital “deserved income” (Figure 2), they will not invest.

Figure 4 The portion of the private manufacturing listed company’s return on net assets from 2009 to 2016 calculated according to the macro tax rate from 1999 to 2006 is higher than the “deserved income”

deserved income2

Note: All the data in this figure are the same as in Figure 2, except correcting them by the difference between the existing macro tax rate and the macro tax rate 10 years ago.

Of course, many people have pointed out that the “four trillion” policy still has many drawbacks. Most people regard expansionary policies as demand policies. There has never been an isolated demand side policy or a supply side policy. The expansionary fiscal policy is mainly achieved by increasing government expenditures, including public works expenditures, and increasing the investment of state-owned enterprises. Therefore, the first is the impact on supply. Focusing on the stimulus to demand, because of the classic metaphor of Keynes’s “pit-digging and filling”, people generally don’t care what the government or state-owned companies are spending. In the implementation of expansionary fiscal policy, the government and state-owned enterprises are less concerned about whether the investment projects are economically reasonable, and they do not care whether they make money, so it is obviously much less efficient than the market-determined investment, resulting in resource misplacement. .Once the direction and industry were misdirected, it was difficult for the government and state-owned enterprises to withdraw easily. This caused a serious imbalance in the supply structure and the so-called “overcapacity.” This is not only a domestic economic issue today, but even an international economic issue. Obviously, adopting an expansionary fiscal policy will not only cannot solve the supply structure problem, but will worsen it.

Another view is to reduce taxes while adopting an expansionary fiscal policy. The problem is that tax cuts require a reduction in fiscal revenues, while expansionary fiscal policies require increased government spending; this will increase the fiscal deficit. This in itself will contain the tax cuts, making the tax cuts less than they should be. Even if the deficit is increased and the large-scale tax cuts and expansionary fiscal policies are implemented at the same time, the large deficit itself will bring new problems, which will not only offset the benefits of the two measures, but also bring about other damages. For example, there are two ways to hedge a deficit. One is borrowing, and the other is issuing money. For the government to borrow, there is a “Ricardo equivalent” proof that borrowing is only a delayed tax, and its effect is equivalent to taxation. Buchanan admits that there is still a difference between “taxation” and “deferred taxation”. This is because modern people borrow money and let it is returned by future generations, which will give people a “financial illusion” and think that public goods are cheaper. But the result is that the government will be levied more taxes. What’s more, the government’s increase in borrowing has squeezed the resources of the money market, which has led to an increase in interest rates, which has led to an increase in the financial costs of enterprises. Therefore, borrowing debt to expand fiscal policy will eventually offset the benefits of tax cuts.

The so-called “increasing currency” is the issuance of the base currency above the reasonable rate of money growth, and the result is inflation. As mentioned earlier, in the early stages of the recession, due to widespread pessimism, the base currency issued could not effectively increase the money supply. This has been proved by the facts of our country in 2018.From 2018 to the present, the central bank has reduced the deposit reserve ratio four times. By the end of the year, the loan balance increased by 13.5% from the end of the previous year, an increase of 2.6 trillion yuan over the previous year, but the money supply (m1) increased only 0.005% by the end of November. On this basis, the continued issuance of currency will not have a significant effect in the short term. But these additional currencies will lurk, and jump out when the economy turns around and the currency turnover speeds up, bringing inflation. The depreciation of the currency brought about by inflation is equivalent to imposing an inflation tax on businesses and residents. Nominal income appears to have increased, but production costs and consumer goods prices have increased year-on-year and will be completely offset. Since there is a time lag between the issuance of money and inflation, since the issued currency flows from the government to the society through state-owned enterprises, the government and state-owned enterprises will eat most of the inflation tax, and the private enterprises will increase the tax burden. .So choosing an inflation policy does not make a company enjoy a lower tax burden.

The most important issue of the expansionary macro policy is that it is only a countercyclical policy. What we are facing now is not a cyclical recession, that is, the adjustment caused by some investment mistakes brought about by the economic upswing, but a big problem that most companies have no profit margins. Therefore, our current task is not to counter-cyclical, but to curb the economic collapse. If we can’t prescribe the right medicine, we can’t stop the economy from continuing to decline. And as mentioned above, it may bring stagflation, further worsen the macroeconomic situation, and then when we want to go back and implement tax cuts, it has delayed the timing and will have to pay a higher price if it is to be corrected. Because it is followed by a crisis in the financial market due to problems in the real economy, leading to the break of the creditor’s debt chain, and the rapid contraction of the money supply, which in turn will hurt the real economy, and the real estate market will also have a crisis, leading to a rapid economic contraction. Finally, it is the employment problem. In the past, China has to provide 10 million new jobs every year. If the economy is seriously declining, the employment problem is a very serious problem. And these problems have begun to appear now. Therefore, policy choices should not allow to be wrong.

Therefore, only large-scale tax cuts can really reverse the economic downturn. The so-called large-scale, I have proposed that the value-added tax should be reduced by more than 3 percentage points, and the corporate income tax should be reduced by more than 5 percentage points; overall, the macro tax rate should be reduced by more than 4 percentage points. This is equivalent to 4 trillion yuan. It can’t be called “mass tax cuts” if it is reduced by several hundred billion yuan. The core role of large-scale tax cuts is to give enterprises and residents a clear profit margin by giving a strong signal, so that they have incentive to invest. This is an action to expand long-term effective production capacity. Tax cuts themselves will increase the current income of enterprises and residents by changing the distribution ratio, thereby increasing the current total demand, but the greater demand brought by tax cuts is actually the investment demand brought by the optimistic expectations of such enterprises, and the recovery from the market transactions and the increase in revenue generated from the market. This kind of income is the healthiest, most mainstream, largest, and most market-dependent income, because it shows that the company’s products are marketable products that meet the real needs of the market. It is a reward for making the right decisions about production and investment.

As mentioned earlier, tax cuts, although referred to as “supply policies”, actually bring about an increase in the total health demand. Say said that “supply itself brings demand”, and Steven Cheung goes further and says “people supply for their demand” , this relies on an effective and mature market. Only when the transaction is voluntary, the price signals formed by many transactions are not distorted, enterprises and residents make production and consumption decisions based on price signals, and supply will directly become income, and income will directly become demand. Therefore, as a supply policy, tax reduction requires simultaneous market-oriented reforms and reduced government intervention. Another self-evident consequence of tax cuts is the need to streamline government institutions. The main reason why China is currently weakening the market system, distorting the price signal, and intervening in the behavior of market entities is that the government departments are too large. If we streamline 90% of the administrative permissions, streamline those government departments that have a negative effect on the market, and streamline the overly bloated administrative agencies, we can greatly reduce intervention to market, and threats to and violations of corporate property rights. At the same time, solve the problem of being unfriendly to private enterprises.

Tax cuts will not bring about fiscal deficits caused by expansionary policies, inflation, and crowding out money resources, so it is a policy with little side effects, health and cleanliness. It will also significantly speed up the economy, so the tax cut is lower than the tax-rate cut (ie, lower than the aforementioned 4 trillion yuan).It has only one weakness, that is, the government administration may not like it. Because tax cuts are a reduction in the amount of resources that government administrations may control, this is at least intuitively detrimental to these sectors. The expansionary fiscal policy requires increasing the resources that the government’s administrative departments must control, and at the same time increasing their power and interests. As a result, expansionary fiscal policy is more likely to be a substitute for tax cuts for macro decision makers. But the hope that the expansionary macro policy works will only be a desire. What is actually going to happen is likely to be as described in this article, which will quickly lead to a deterioration of the situation. Only those who have a vision beyond the immediate interests of the executive branch, and who have the mind and foresight, can take drastic tax cuts. At the end of last year, the Politburo of the Communist Party of China proposed to “reducing taxes and reducing fees on a larger scale.” We will see what “larger scale” means.


Note 1: The three components of the “Keqiang Index” in this paper are: by November 2018, the growth rate of cargo turnover (3.4%, weight 25%), the growth rate of money supply (m1) (0.005%, Weight 35%), power generation growth rate (6.9%, weight 40%).

Note 2: This is a correction based on data provided by my authoritative friend. The corrected power generation growth rate is -4.7%.


January 5, 2019 in Fivewoods house

Published on January 22, 2019 firstly in FT Chinese and China-review Weekly

Author: flourishflood

Economist, Confucianist

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