Tuesday, March 06, 2007

China's Signal: No More Foreign Capital, Please?

A BNA Daily Tax Report update issued late today indicates that China’s National People’s Congress may be heading toward a program of tax “unification” for overseas and domestic firms. According to the article, overseas firms obtain a variety of tax breaks to incentivize investment, resulting in an average tax rate of 15 percent, whereas domestic firms are taxed at 25 percent. Unification would eliminate those breaks for the overseas firms, bringing all firms to the same, higher tax rate.

Rumblings of tax changes always have disruptive effects on the marketplace. Last Friday, the BNA Daily Tax Report included a story that the Chinese government had disavowed plans to impose a capital gains tax on investors, moving that rate from zero to 20 percent. If investors anticipate an increase in those rates, then the price of stocks are likely to decline. Some commentators have suggested that this may have had some impact on the swift decline in Chinese stocks last week. I’m not so sure this is the cause of the dramatic selloff in Chinese stocks last week, but it is not a crazy idea either.

One must remember: every trade involves a buyer and seller. The buyer is typically betting on a couple of things being true: (1) Over time, the net present value of future cash flows associated with this investment will yield a positive and favorable rate of return; (2) One of those cash flows will be the value of the exit right – i.e., the amount that someone else will pay you for the privilege of taking over those future cash flows. If a buyer purchases stock, chances are he believes these factors are a little rosier than the seller does, assuming willing buyer/seller conditions. (If you have to sell to pay medical bills or to raise bail, that’s another story.)

If there is a potentially large increase in capital gain taxes on the horizon, it stands to reason that sellers will be more anxious to sell to take advantage of the lower rates. Buyers have no built-in gains and tax concerns in the near term, but keep in mind that the value of those cash flows must take into account the take of your government partner. Thus, your after-tax earnings will decline if tax rates increase. Thus, values fall for either party to the exchange.

Of course, before you think "those Crazy Chinese, what are they doing!?!" you should remember that we are in just this posture: by 2010, capital gains rates will go from 15-20 percent and ordinary income rates, including the rates on dividends, will also increase. Though we pushed this back two years from the original sunset of 2008, 2010 is not that far off. We are likely living under the shadow of this change.

With regard to the situation in China, the People's Congress may be sending a message: no more foreign capital, please. Or at least, not so much. A 25 percent tax rate is pretty good, in comparison to other opportunities, but it does send a signal. They may believe that they have enough capital being invested in US Treasury securities, which are financing current government spending in the US. A change in tax rates on foreign capital thus may portend a willingness to shift those investments to the domestic sphere in China. It only makes sense: why finance US spending growth at the expense of your own people? (My colleage Ernie has written on this in past blogs, and I'm interested in his views on this point.)

The implications are potentially significant: By raising taxes, China may slow its growth rate to a more sustainable level from its blistering, double-digit pace. But it may offset this to some extent by increasing government spending. Citizen clamor for this may increase as they seek to catch up with Western standards.

As for us, with the supply of capital infusions to fund government borrowing decreasing, we may experience a hike in interest rates. However, with constraints in spending growth and healthy tax collections, we might ameliorate some of the pressure from this coming capital shift in government financing. Stay tuned. This could be big.

EAM

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