Property taxes are considered a silver bullet for improving local government finances and cooling down China’s property market. This is only partially true. China does not need more property taxes it mostly needs to change the nature of existing property taxes. The task is difficult but could have some momentum in 2014.
Property tax revenues are strong
China’s existing property tax levels are in fact relatively high by international standards. In 2013, Chinese property tax revenue as a share of GDP was higher than the average high income economy including Japan and Korea.
At current levels property taxes are already a dominant source of revenue for local governments. In 2013, property tax revenue was the second largest source of tax revenue after business taxes on the service sector. If business tax revenue received from real estate developers was included as a part of property taxes this would make property taxes the leading source of tax revenue and nearly one-fourth of total tax revenue.
Tax on transaction or tax on possession
The problem in China is the nature of property taxes not the level. Most local governments in high income economies and emerging markets derive more revenue from recurring annual taxes on the value of property holdings. For example, Japan levies a 1.4 to 2.1 percent tax on the value of land or building above a certain threshold. Korea also levies a 0.15 to 0.5 percent tax on property owners depending on the location and value of the property.
In contrast China’s local governments derive most of their property tax revenue from transactions rather than recurring property taxes. The largest source of property tax revenue is a 3 percent tax paid on the value of property by the buyer for transferring property rights (契税). Meanwhile, China’s current recurring property taxes are levied only against commercial property owners not households.
A transition away from property taxes on transactions is important for China. First, Chinese local governments are already highly exposed to property cycles due to heavy reliance on land transfer fees – a fee paid by the property developer on the value of land sold for development – to finance infrastructure investment. Recurring property tax on home owners tends to be counter-cyclical in nature, thus reduce the exposure of Chinese local government revenues to downturns in the real estate sector.
Second, property has become a speculative asset class in China. According to a household survey by the Southwestern University of Finance and Economics, nearly one-fifth of urban households owned more than one home in 2011. Recurring property taxes would help dampen speculation in the real estate market by discouraging households to buy and hold vacant properties.
Reform is coming?
Property tax reform is now one of the top three fiscal reform priorities outlined by the Ministry of Finance following the third plenum. At that time, Finance Minister Lou Jiwei promised a gradual transition away from transaction tax on property toward recurring taxes on property owners.
Simple geographic expansion will not be enough. In current form Shanghai and Chongqing pilots apply to a limited subset of home owners and remain a rounding error for local government revenue. For example, Shanghai currently levies an annual 0.4-0.6 percent tax based on the purchase cost of homes. The tax only applies to a subset of new buyers – non-residents or those purchasing a second home or more. Currently less than one percent of homes are covered by this tax.
At a minimum if such a plan had any hope of reducing the revenue from property taxes on transactions down to the average for middle income countries it would require at least an average 0.77 percent tax on the value of all urban housing in 2011 (close to the average property tax rate in the United States of 1 percent). In order for recurring property tax revenue to reach the middle income country average in terms of 35.5 percent of all local government revenue, the tax rate would need to be as high as 2.92 percent on the value of all urban housing.
Ironically, local governments may be among the groups lobbying the most against this transition. Land transfer fees in 2013 were at least three times higher than property taxes. Local governments fear that any dampening housing (and thus land prices) caused by widespread adoption of recurring property taxes could impair infrastructure investment.
The Ministry of Finance may finally have some luck in overriding these interests. Last year was a particularly frothy year for China’s property market with the highest average annual increase in prices since property market controls were put in place at the end of 2010. Some banks now appear to be responding by cutting back on real estate loans. This could finally open the door for the Ministry of Finance to push through an expansion of recurring property taxes this year.