Will China's Tax Policy Throw Property into the Deep Freeze?
China's leaders appear once again to want to bludgeon their property market into submission. Their 20 January announcement that they would enforce a capital gains tax on property development that would cut developers' margins to 20 percent shows that their grasp on market mechanisms remains remarkably slippery.
But blunt instruments don't always work. Besides the question of how developers will react when they can get higher margins on their money elsewhere, there is the question of whether China's red-hot property market has peaked and if the action could cause more damage than it would cure. The announcement sent property stocks reeling in mid January, with shares descending by 20 percent in Hong Kong, Shenzhen and Shanghai.
The goal seems laudable – making housing more affordable and avoiding a disastrous bubble. But restricting supply through tax policy – in this case a measure that has been around, unused, for thirteen years — may not be the way to go.
But while the markets haven’t liked it, some are arguing that the new tax policy is a good thing. Shenzhen-based Niu Dao, touted as "China's most influential real estate commentator", is a noisy critic of developers' profiteering. He is one of the rare publicly declared supporters of the government's intention to enforce the appreciation tax collection.
"This tax measure will deal a harsh blow to stratospheric house prices. On an objective level, it will cause developers to reduce their land banks and to expedite the development process," he said. "An industry that loses the support of the general public cannot have much room for growth. Today, the public has virtually lost all trust in the real estate industry."
Qingyi, the blog name for an academic with the China Center for Economic Research at Beijing University, on the other hand believes that against a backdrop of tightening housing supply and rising demand, the government's housing policy should aim at boosting supply rather than restricting it. He thinks that unlike Japan, where land is privately owned and a land tax can and did serve to boost supply and bring down property prices in the 1990s, China, owing to land being monopolized by government, cannot expect a land tax to have the same outcome.
In the past, officials have tried various measures to attempt to halt speculation including raising interest rates, property sales taxes and banks' reserve ratios (to curb their capacity to lend). None has been effective.
The market has been on a tear, with investment in property development topping 1.9 trillion yuan in 2006. The sector soared upwards by 21.8 percent in 2006 following 20.9 percent growth in 2005 and now accounts for 9.3 percent of the nation's GDP.
The State Administration of Taxation announced that starting Feb. 1 it intends to collect unpaid but due land appreciation taxes from developers. The tax was actually introduced in 1994, but neither the tax bureau nor local governments, which usually have snug relationships with developers and turn a blind eye to unpaid tax balances, have ever bothered to collect it.. Developers were mostly required to pay only 0.5 to 2 percent of estimated sales revenue as a tax prepayment at the start of pre-sales, with the remaining tax balance hanging in mid-air.
With the central government appearing newly resolute in correcting excesses in the real estate market and corralling local government corruption, the announcement his property stocks hard. The 20 percent profit margin is far below what most property developers believe is reasonable. Although figures are hard to come by in China, at one point before the Asian financial crisis shattered Hong Kong's property boom in 1997, some developers were running 400 percent margins. By one estimate, the land appreciation tax would cut
developers' margins by 30 to 60 percent.
Most people are skeptical, believing that developers will ultimately force consumers to eat the increase, but the law is designed to preclude that. Ren Zhi Qiang, chairman of Beijing Huayuan Property Co. is a popular ‑ and unusually frank – blogger on real estate matters. He has pointed out that the appreciation tax is not part of developers' costs. It applies only to profits over and above a certain threshold, Ren wrote, saying that removes a reasonable excuse to raise prices.
If the development profit does not reach that threshold, no appreciation tax is payable. In other words, the tax does not affect the developer's profit and loss relationship. Rather, it affects his level of profitability.
According to the State Administration of Taxation website, the tax applies progressively to the difference between sales revenue and "total deductions", which are defined as "total development cost plus 20 percent." This is the threshold that Ren refers to. Where the difference is below 50 percent of total deductions, the tax rate is 30 percent; where the difference is over 50 percent but under 100 percent, the tax rate is 40 percent; where the difference is over 100 percent but under 200 percent, the tax rate is 50 percent; and where the difference is over 200 percent, the tax rate is 60 percent.
Thus a 20 percent return on cost is already built into the deduction items. From an investment viewpoint, a 20 percent return cannot be said to be meager in any business. Thus, the tax is targeted at the "excessive" portion of profit and as such is hardly unfair.
Nanfang Daily columnist Xue Cong points out that the return rate of an individual entity's economic actions should be close to that of the whole society. If the former exceeds the latter by a wide margin, it means that the society is overpaying the individual or entity. When this happens, hatred for the wealthy will surface. While market forces should be allowed to solve housing shortage problems for the low- to middle-income class, a government should attempt to maintain an orderly market via tax policies, Xue adds.
Fair though it may be, the question is whether it will cool the market, freeze it outright, or have any effect at all. Pan Shi Yi, chairman and co-CEO of Soho China, a real estate group that has helped transform Beijing's skyline, warns that the impending tax collection will indirectly worsen the supply-demand situation by hurting and eliminating financially weak developers or forcing them to turn from selling to renting properties.
"In the past two years, owing to various austerity measures being put in place, especially those related to banking policy, a lot of developer companies have been facing liquidity problems," Pan says. "Some of these companies may well go under because of this tax payment clearing requirement. And this in turn will definitely cause a tightening of housing supply. The possibility of small developers turning for-sale properties into rental properties will increase, thus reducing the market supply." Pan says.
On the tax's negative effect on housing supply, Ren and Pan share the same opinion. Ren even insists that the tax move will not benefit consumers by way of lower prices as long as the supply is tight.
Indeed, in a survey conducted by the National Bureau of Statistics, nearly 100 leading economists believe that 2007 will see property prices continuing on an uptrend.
It is not farfetched to conclude that most nay-sayers are vested interests and their accomplices who do not want to see prices drop. But to pass a death sentence on a measure that has yet to take effect seems a bit impatient to say the least. Ordinary folks remain suspicious of whether this particular move is going to work, but wish it would.
Even Ren Zhi Qiang acknowledges that there is an upside. "One positive effect of the LAT is for government to take one more bite out of the developers' pie and boost its fiscal balance sheet. The tax works to redistribute excessive development profit and is instrumental in evening out wealth distribution. But it may be an impediment in a competitive market system and in implementing macro austerity measures," he said.
In the face of rampant speculation, the government does not want to sit idle. But, as so often with governments, there is a big gap between aspiration and execution. In Hong Kong, it was half-hearted efforts to rein in rapacious developers and speculators in 1994 that led to the subsequent bubble and its ultimate explosive deflation.
With Hong Kong as a precedent, China's leaders will likely be a little more persistent in carrying out anti-speculative policies for the sake of social and economic order. At a deeper level, however, there is a bigger question: can a free market system be effectively applied to the real estate industry while land is a resource monopolized by government?