Why is zero tariff possible? / Sheng Hong

The escalation of the US-China tariff war is like two people trying to force each other to yield by self-mutilation. It seems that efforts should be made towards another direction. At the beginning of Sino-US trade disputes, Professor Steven Cheung suggested that China should adopt zero tariff, even unilateral zero tariff. But there are few respondents, and even many people think this is a strange theory. I think that’s because they don’t understand. Probably in most people’s minds, classical mercantilism still dominates. For example, if tariffs are abandoned, foreign products will be flooded in, domestic enterprises will lose their markets, workers will be unemployed, and ultimately suppress the development of their own economy. The second concern is that if there is a large trade deficit, gold and silver will flow out and the supply of domestic currency will decrease, resulting in deflation.

In fact, with the passage of time, neither of these two worries needs to be worried. Firstly, about currency. Since modern money is paper money, money supply can be adjusted artificially according to demand. When the trade deficit leads to money outflow, domestic monetary authorities can increase money supply by reducing the base interest rate or reserve ratio. The outflow of gold and silver and the insufficient supply of money that classical mercantilism feared no longer existed.

Then we will talk about the protection of the domestic market. Firstly, the way in which one country’s enterprises enter another country’s market is not only to export products to that country, but also to invest directly in that country. This is an alternative for profit-seeking enterprises. The difference is that export products use domestic labor and land, while direct investment uses the labor and land of the target country, which will bring about factor income and economic development of the country. This may have been difficult in the early days of industrialization. At that time, there were great differences in institutional cultures among different countries, and the infrastructure in the developing countries was not perfect. The cost of foreign direct investment will be high. But now it’s different. After more than two hundred years of contacts and integration in modern times, the understanding between different nations and nationalities has deepened, institutional culture has also influenced and blended with each other, and infrastructure has been completed a lot. Even if there are still many problems, in countries with lagging institutional structure and infrastructure, specific regions can be established, such as special zones, export processing zones, economic development zones, bonded zones, free trade zones, etc., to simulate a more suitable small environment for foreign investment. In this way, the cost of foreign investment can be greatly reduced.

This shows that governments have realized that the introduction of foreign capital can promote their own economic development better than mercantilist tariff protection policies. Foreign investment brings foreign advanced technology and management, not only creates local employment opportunities, but also buys local spare parts, bringing about local consumption demand. In the long run, foreign-funded enterprises often bring spillover effects of technology and management. That is, the transfer of technology from multinational parent companies to local subsidiaries; the new technology of foreign-funded enterprises causes competition in the local market and promotes research and development of local enterprises; the technological requirements of foreign-funded enterprises for affiliated enterprises bring about improvement; and more importantly, foreign-funded enterprises will cultivate local human capital, and the local personnel they employ are influenced in technology and management, starting a business by themselves after leaving office, and so on. Therefore, the means of competition among countries have changed from raising tariffs to protect domestic industries to attracting foreign investment. Since all countries have realized this, more than one hundred countries in the world have established more than 4000 free trade zones, so they are not simply attracting foreign investment, but competing with other countries for foreign investment.

Once foreign investment is to be competed for, the meaning of tariffs will be completely changed. Traditionally, tariffs are a means of forcing foreign firms to invest in their own countries, but this only assumes that a single product is subject to high tariffs. Considering that trade protection is comprehensive, the average high tariff level increases the cost of direct investment. Capital is to invest in places with good quality and low price. This means that in addition to a good institutional environment and infrastructure, tax rate is a dimension of competition. In China’s special zones and other areas, an important preferential policy is tax relief. For example, in China’s coastal economic and technological development zones established in the 1980s, the enterprise income tax is 15%, which is significantly lower than the enterprise income tax of 35% in the same period, and there are “three deductions and two exemptions”. Tariffs, in fact, are also indirect taxation of local and foreign-funded enterprises. Not only does the tariff on spare parts actually directly increase costs, but the tariff on final products also increases investment costs and labor costs. As a result, the level of tariffs also affects the competitiveness of a country or special zone relative to international capital. Therefore, reducing tariffs to zero is also attractive. For example, a bonded area is such a zero-tariff area, where enterprises invest without being negatively affected by the tariffs of that country.

On the other hand, with the development of transportation and communication technology, transportation and communication costs are getting lower and lower, which promotes the deepening of international division of labor, from product level to component level. According to Huang Qifan, in 2018, more than 70% of international trade is made of spare parts or raw materials. The cost of an end product depends on the cost of an intermediate product, which in turn is largely affected by tariffs. Therefore, reducing tariffs to zero is not to weaken the domestic industry, but to enhance the competitive advantage of the domestic industry. Of course, zero tariff also has the advantage of “zero formalities”. Professor Steven Cheung also emphasized it very much. Don’t underestimate the “formalities” issue, which is actually the transaction costs regulated by the government. Once there are formalities, there will be checkpoints, queues and waiting, there may be rent-seeking behavior, which is the cost. According to the experience of Shanghai Free Trade Zone, after the implementation of the system of “first entering the zone, then declaring”, goods need not be transported by customs supervised vehicles. The cost of goods per vehicle is saved by 200 yuan, which is about 10% of the logistics cost. (Wang Haimei, “The impact of Shanghai Free Trade Zone on surrounding cities and countermeasures”. Journal of Changzhou University, March 2014 ) Of course, this is only part of the cost of the procedure.

Of course, Hong Kong is the most successful example. The evidence of Professor Steven Cheung’s zero tariff is the success of Hong Kong. During the period of rule by Britain, Hong Kong had zero tariffs except for tobacco and alcohol. Other taxes are also significantly lower than in most other countries and regions. If the enterprise income tax is 15%~16.5%, the personal income tax will not be higher than 15%, and the property tax is about 12% of the rent payable. In the 1950s-1970s, with zero tariffs and low tax rates, combined with low labor costs, foreign capital flowed in and the local capital were activated, Hong Kong changed from an entrepot trading city to an industrial city in a short period of one to two decades, with the advantages of sufficient capital and low cost. The number of manufacturing workers increased from 92,000 in 1953 to 549,000 in 1970, with an average annual increase of 11.8%. From 1960 to 1970, the export of manufactured goods in Hong Kong increased by an average of 15.7% annually (Lu Shoucai et al., 2004, P. 210). From 1961 to 1979, Hong Kong’s GDP grew at an average annual rate of about 8.8% (the World Bank, the US dollar unchanged in 2010), which is a high-speed growth. This is the result of zero tariff and low tax rate.

Figure 1  Hong Kong Economic Growth Rate (1962-1979)                                 Unit.: %零关税.jpgData source: World Bank.

However, the tax burden is used to provide public goods. Whether the government can finance enough to assume the responsibility of providing adequate public services, if the zero tariff and other tax rates are too low? At this point, we should talk about the principle of tax and rent alternation. The so-called “rent” refers to the value brought about by the scarcity of resources, which is the remuneration of the owners of resources; the so-called “tax” refers to the price of public goods, which is the provider of public goods, often the cost of the government. The two are homologous and complementary. The reason why the resource owner can be remunerated is that his rights are protected, and the protection should be institutionalized and cost-consuming. It is the public authority who provides the service of protecting property rights, so the rights of resource owners can be protected. The reason why the public authority can get such remuneration as tax is that resources are scarce and it can bring scarce value. Land property rights and property rights protection are similar to a pair of complementary products. When the price of a product decreases, the price of complementary products will rise. Less tax, more rent.

In Hong Kong, we find this phenomenon of tax-rent substitution. When the tax rate in one place is significantly lower than that in other areas, businesses flock to it, but land prices (rents) rise at the same time. According to statistics, from 1959 to 1979, the price of industrial land in Hong Kong rose 132.5 times; the price of non-industrial land rose 41.5 times; and the price of residential land rose 86 times (Zheng Deliang, Modern Hong Kong Economy, China Finance and Economics Press, 1982, P. 173). If a taxpayer is a rent collector at the same time, he can attract enterprises to settle in by reducing the tax rate and get a bumper harvest of land rent or land price in a little later time. It is this role that the Hong Kong authorities play. With the soaring land prices in Hong Kong, the revenue from land sales by the Hong Kong government has also risen. From 1961 to 1980, the government’s land sales revenue increased 103 times, an average annual increase of 126%. The proportion of land sales revenue in fiscal revenue increased from 9.5% in 1970 to 47% in 1980 (Zheng Deliang, P. 256, P. 265). See the figure below. It should also be pointed out that the benefits of zero tariff and low tax rate will also be reflected in property tax and profit tax. Because the land price rises, the total amount of property tax at a certain tax rate will increase; because of the influx of enterprises, the total amount of profits will also increase.

Fig. 2  Financial revenue and land sales revenue (1970-1980) in Hong Kong  HK$1 million

Zero tariffData Source: Zheng Deliang, Modern Hong Kong Economy, China Finance and Economic Publishing House, 1982, P. 256, P. 265.

Under this financial structure, Hong Kong not only has sufficient financial resources to provide adequate infrastructure, but also maintains a rare fiscal surplus. From 1949 to 1979, only four years were deficit (Deng Shuxiong, Public Finance History of Hong Kong (1949/1950-1979/1980)). This shows that the financial structure of zero tariff, low tax rate and land sales income is not a barely substitute for the traditional financial structure, but has advantages.

Some people will say, since rent and tax are substituted for each other, what is the benefit to the enterprise? In fact, the rise in land prices caused by zero tariffs and low tax rates is a process. Initially, companies saw signs of zero tariffs and low tax rates, and land prices were rather low before the influx of enterprises. Only when a large number of enterprises enter, the land price rises gradually. But at this time, the advanced enterprises not only enjoy the benefits of zero tariff, low tax rate and low land price, but also enjoy the benefits of market expansion or land value added brought by the continuous influx of enterprises. For this reason, zero tariff and low tax rate also have a time incentive mechanism, that is, the first entrants will gain greater benefits, thus attracting enterprises to rush ahead. Only after a long time, the per capita income of the local people has reached the top of the world, and the competitive advantage has been reduced by the higher labor cost, will the structure of zero tariff, low tax rate and high land price be close to equilibrium. However, twenty or thirty years have passed, and the economy has grown at a high speed in this stage.

There will also be doubts as to whether this Hong Kong model can only be applied to Hong Kong, a small place, and whether it will not work if it is placed in the vast Chinese mainland. In fact, one of the most important measures of China’s reform and opening up is to learn from Hong Kong. This is the system of special zones or development zones. The development zone not only has relatively perfect infrastructure and relatively mature market economy system, but also has only 15% enterprise income tax rate, and zero tariff on imported raw materials, spare parts and equipment. This is basically similar to Hong Kong. Since the establishment of fifteen coastal economic and technological development zones in the early 1980s, it has increased to 2543 by 2018. Of these, 219 national economic and technological development zones account for 11.3% of GDP and 17.7% of the added value of secondary industry in the whole country (Office of Development Zone, Foreign Investment Department, Ministry of Commerce, “Main Economic Indicators of National Economic and Technological Development Zones 2018”, June 4, 2019). Today, China has become the second largest foreign capital inflow country in the world. It should be said that the Economic and Technological Development Zone is an important driving force for the reform and opening up and even the miracle of China. This also shows that the Hong Kong model has in fact been partially promoted in mainland China.

On the other hand, the development zone also brings good financial situation to the local government. Many cities with development zones have a considerable amount of revenue from land, which is called “land public finance”. Its scale and extent are far beyond Hong Kong’s level. See table below. On average, from 2016 to 2018, Hangzhou was the highest, and its income from land was 143% of the general fiscal revenue. In this group of cities, Shenzhen, the earliest open city, was the lowest, only 22.9%. Among these factors, the local government used the government to forcibly seize land from farmers around the city for sale at a low price. This is obviously wrong, which is a violation of farmers’ land rights. So the excessive dependence on land finance is problematic. However, this does not deny that the high land price in this area is due to the substitution of rents and taxes caused by the preferential policies of development zones, that is, the high land price caused by zero tariffs and low tax rates. This is the result of the Hong Kong model. If the local government respects the land property rights of farmers, the revenue of land finance will still be considerable, though less than the current situation.

Table 1  Urban Land Fiscal Dependence Rank (2016-2018)       Unit.: 100 million yuan


Urban land sales revenue in 2018 fiscal dependence on land in 2018 fiscal dependence on land in 2016 Fiscal Dependence on land in 2017 Average
Hangzhou 2442.9 134% 155% 140% 143.0%
Foshan 894 127% 100% 141% 122.7%
Nanjing 956.9 65% 155% 136% 118.7%
Jinan 722.3 96% 106% 129% 110.3%
Wuhan 1380.8 90% 84% 111% 95.1%
Zhengzhou 1063.6 84% 69% 78% 77.0%
Guangzhou 1475.9 90% 52% 80% 74.1%
Kunming 575.6 97% 36% 80% 70.9%
Shijiazhuang 454.8 89% 75% 39% 67.7%
Chengdu 849.3 60% 34% 99% 64.5%
Xián 680.6 99% 38% 53% 63.5%
Changzhou 465.9 83% 45% 55% 61.1%
Suzhou 875.5 41% 85% 49% 58.4%
Ningbo 547.5 47% 62% 41% 50.0%
Tianjin 1059.2 50% 48% 43% 47.1%
Chongqing 868.9 38% 35% 56% 43.1%
Beijing 1682.9 29% 17% 51% 32.4%
Qingdao 574.5 47% 20% 30% 32.2%
Shanghai 1908.8 27% 26% 22% 25.0%
Shenzhen 449.6 13% 32% 24% 22.9%

Source: Leju Finance and Economics, “The list of 20 cities in China, most dependent on land public finance!” January 15, 2019. (https://baijiahao.baidu.com/s?Id=1622717925819983737 & wfr=spider&for=pc)

Some people will ask whether the huge size of China’s mainland will lead all regions of China to compete for less capital. In fact, more than 2,000 economic development zones in our country have covered most of the regions and cities with superior geographical position, and opening all areas will only give more choice space for capital, so as to better allocate capital in space. This will slow down excessive land prices in individual areas and increase capital in other similar areas. On the other hand, the current situation is clearly overcapitalization. Japan’s central bank’s base interest rate lasted only 0.1% for 10 years, while the deposit rate has remained below 1% since 1995. Since 2016, short-term interest rates in the EU have been negative, reaching – 2.345% in June 2019 (CEIC, European Union Short Term Interest Rate). In fact, investment opportunities and regions are more scarce than capital. At this time, zero tariff is an important means to compete for capital. On the contrary, raising tariffs, even as a means of trade warfare, is not conducive to domestic enterprises’ competing for capital.

Back to the feasibility of zero tariff as a strategy of Sino-US trade war. The United States is clearly China’s largest national market. In the face of setbacks in Sino-US trade relations, China clearly wants to expand its relations with other trading partners. Professor Steven Cheung’s proposal that a bilateral zero-tariff agreement with Britain should be signed first is a good suggestion. Britain is a country with mature trade system and has an international exemplary role. It can be extended from Britain to the European Union. If China achieves zero tariff parity with the EU and the UK, it will increase trade by at least 6 percentage points. Even in the face of the US tax increase, Professor Steven Cheung’s proposal that unilateral zero tariffs should also be considered. If China reduces tariffs to zero, that is to say, it is reducing the cost of enterprises. Those enterprises that increase the cost in the US market because of the US tax increase will offset part of the cost by China’s zero tariffs. Moreover, zero tariffs are also the goal of trade negotiations in the United States. China’s proposal of zero tariff is more likely to be echoed by the United States. If China, the United States, European Union and the United Kingdom can achieve reciprocal zero tariff, it will open a new era of world free trade. As one of the important promoters, China’s contribution will never be forgotten.

In fact, as early as 2002, China and ASEAN countries established a free trade area to reduce tariff rates year by year. In 2010, tariff rates dropped to zero with the six old ASEAN countries and zero tariff with the new ASEAN countries in 2015. According to some studies, for every percentage point of tariff reduction, trade volume will increase by 0.8 percentage points (Wang Yueshuo, Evaluation of Tariff Concessions in China-ASEAN Free Trade Area, 2018). From 2005 to 2016, China’s direct investment in ASEAN countries increased 64-fold, with an average annual growth of 41.4% (calculated according to China’s Statistical Bulletin of Foreign Direct Investment). This shows that the reduction of tariffs to zero promotes foreign direct investment, which also promotes the economic development of the countries. The experience of these free trade zones is enough to support the full realization of the choice of reciprocal zero tariff. On the other hand, since the establishment of Shanghai Free Trade Test Zone in 2013, China has established 11 Free Trade Test Zones. According to the Ministry of Commerce’s China Free Trade Pilot Area Development Report (2019), by the end of 2018, the FTA accounted for 2% of the territory, attracted 12% of foreign investment and created 12% of imports and exports. At the same time, the government consciously summarizes the experience of simplifying and facilitating trade, and replicates and promotes it throughout the country. This proves the effectiveness of zero tax rate, but also accumulated experience of zero procedures. Total zero tariff is only one step away.

The greatest tragedy of mankind is to insist on doing something harmful to oneself, but still think it is beneficial. Keynes once said, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” This situation may reappear today when we face the zero tariff problem. Many people are still slaves of classical mercantilism. They play games against each other to hurt themselves. Although the practice of Hong Kong and mainland China has proved the validity of the new model, except for Professor Steven Cheung’s hypothesis of new theory, the economic circles are still lagging behind, and no mature new theory has emerged, so that people seem to be “slaves of some defunct economists”. However, the vivid facts should have a stronger impact on people than the theory, and influence people’s decision-making better, so that they will not insist on the negotiating conditions that are unfavorable to themselves in the Sino-US trade war. In that case, what we have to do is not to calculate under the theory of the late economist, but to get rid of that “slave” status.


At Fivewoods Study, Aug. 20, 2019

Published firstly in FT Chinese on August 27

Author: flourishflood

Economist, Confucianist

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