On Jan. 1, China instituted a new value-based tax on coal production to be implemented nationwide at a variable rate of 2-10 percent per ton. The tax is one of several fiscal reforms Beijing has put forward to ease local governments' reliance on land sales for revenue generation. That reliance helped drive China's post-2008 housing construction boom, but now, as home prices and sales fall steadily, it threatens local governments across the country with financial insolvency. Along with pilot programs in municipal bonds and property taxes, value-based resource taxes are meant to give local governments new ways to raise capital while unwinding the political and economic incentive structures that generated the worst excesses of China's government investment- and construction-led growth model.
With the new coal production tax, provinces and regions are allowed — at least officially — to decide their own final rates. According to a Jan. 5 report from Reuters, most provinces opted, unsurprisingly, for a tax rate between 2 and 3 percent in an effort to relieve some of the pressure on local coal businesses already suffering from weak demand, high inventories at power generators and stiff competition from overseas suppliers. Notably, however, Inner Mongolia, Shanxi and Shaanxi, which collectively account for 65 percent of China's roughly 3.7 billion metric tons of annual output, set their rates much higher — at 8, 9 and 6.1 percent, respectively.
The decision to set tax rates in Inner Mongolia, Shanxi and Shaanxi so high is not entirely surprising. After all, given the overwhelming importance of coal to their economies, local governments in these regions stand to benefit from higher taxes on coal output than those in provinces like Sichuan or Henan, where coal is not a sufficiently significant source of government revenue to justify the impact that higher taxes might have on businesses and employment.
For Inner Mongolia, Shanxi and Shaanxi, shifting from the existing volume-based tax of 2-5 yuan ($0.32-$0.80) per ton of coal to a tax of 6-9 percent of the price per ton could lead to substantial increases in government revenue. Coal prices at mine mouth — the point of production — in China vary widely across provinces and individual producers. However, even if production costs are only a fraction of the benchmark price (526 yuan per ton in December) for coal delivered at China's most important coal port, Qinhuangdao, the receipts from a tax of 6-9 percent per ton could be anywhere from 3 to 20 times those from the existing volume-based tax. At a time of rapidly falling home prices and declining land sale revenues, those receipts represent a potentially crucial source of new funds for local governments, especially in the northern Chinese coal and steel boomtowns hit hardest by China's housing construction slowdown.
Other Reasons for the Core's Higher Rates
Two other factors likely helped push the tax rates in Inner Mongolia, Shanxi and Shaanxi higher than in most other provinces. First, the central government and provincial governments in these regions have been comparatively more aggressive in efforts to eliminate the various ad hoc and often extortionist local administrative fees. These fees have proliferated as local governments sought to capture a larger share of profits from the country's stimulus-driven coal boom than the meager volume-based coal tax could provide. In this context, higher tax rates could imply that Beijing is confident that local administrative fees in these regions have been sufficiently curbed so that the new tax will not overly burden coal producers or drive Chinese coal prices too high.
Second, and more important, Inner Mongolia, Shaanxi and (to a lesser extent) Shanxi have long been at the vanguard of central government efforts to consolidate the coal industry. As a result, coal production in these regions has — to a far greater extent than in other traditional mining hubs such as Hebei, Henan and Shandong — become concentrated under a relatively small number of large-scale state-owned producers. This fact applies in parts of western Inner Mongolia and Shaanxi, where state-owned conglomerates like Shenhua have their key production bases. It also increasingly applies to parts of Shanxi, where the myriad small-scale "township and village" mines that characterized China's coal sector in the 1980s and 1990s have gradually, albeit painfully and still only partially, given way to larger operations under pressure of central government edicts and, more recently, falling prices.
The net effect of industrial consolidation in these regions has been to lower production costs by creating economies of scale and integrating coal supply chains (Shenhua, which operates its own railways and power generators in addition to mines, is by far China's most cost-effective major coal producer). Moreover, this consolidation has made coal production much less labor-intensive, and the lower number of workers in the industry partially offsets concerns about the tax creating new unemployment. It also organizes the industry around large-scale state-owned conglomerates that are less vulnerable to local government extortion and better able to pay higher taxes (and also easier to tax) than their smaller counterparts. The new tax will reinforce consolidation efforts in parts of Inner Mongolia and Shaanxi that have already made tangible progress in this direction and will kick-start consolidation in places — especially in Shanxi — where those efforts have stalled.
The impact of the new tax will likely be muted in the first few months of 2015 as Chinese authorities struggle with enforcement and troubleshooting. Even when fully in place, the tax is unlikely to alter core conditions for coal mining companies and local governments in most regions. The 2-3 percent taxes in place in the majority of coal producing provinces could add 4-12 yuan per ton, and for producers selling coal on annual supply contracts to power generators (which have lobbied aggressively for prices well below their 570 yuan per ton contracts for 2014), this could cut into earnings. But for the most part, the tax will not boost costs substantially above present levels and, for instance, force producers to sell at a loss to power generators, which account for more than half of the final coal demand in China. The tax also will not render Chinese coal uncompetitive with comparable Australian supplies.
The consequences of higher tax rates in Inner Mongolia, Shanxi and Shaanxi are potentially further reaching, but even so the effects of the new tax will vary substantially between and within regions. Large and inexpensive producers such as Shenhua will remain competitive with all but the cheapest overseas suppliers, with average mine mouth prices at its major fields in Inner Mongolia and Shanxi not likely to exceed 150 yuan per ton even after a 10 percent tax. But for smaller producers with average production costs closer to 400-450 yuan per ton, a tax of 6-9 percent could boost the price anywhere from 24 yuan to 40 yuan per ton. Even with a tariff of 3-6 percent on coal imports, that is easily enough to make coals from inland Shanxi or Shaanxi uncompetitive with supplies from Australia in markets such as Guangdong or the Yangtze River Delta.
The trouble for regions like Inner Mongolia, Shanxi and Shaanxi is that even with the headway made toward industrial consolidation in recent years, coal largely remains a highly fragmented and labor-intensive industry. As a result, it is inefficient, costly, and yet critical to maintaining the high employment rates that for decades have underpinned social and political stability in these regions. These pressures are less acute in Inner Mongolia, where coal sector consolidation is most advanced, and in Shaanxi, which has a far more diversified economy with robust and growing services and electronics manufacturing industries around the capital city, Xian.
However, the pressures are particularly acute in Shanxi, where society, economy and politics are inextricable from coal. Of China's three largest producers, Shanxi — which alone mines roughly 1 billion metric tons per year, comparable to the entire United States — has the most fragmented coal industry and the highest average production costs. This fragmentation makes it the most vulnerable, socially and politically, to shifts in coal prices. Effective enforcement of the new tax, combined with a return of coal spot prices to their August-September 2014 lows of around 480 yuan per ton, would almost certainly result in mine closures and corporate debt defaults throughout much of the province. With long-planned rail transport expansions due to be completed in 2015 and the Chinese economy set to slow further, such a decline appears likely.
Across China, 2015 will test local governments' ability to cope with the social and political effects of slowing economic growth. Perhaps nowhere will those effects be felt more intensely than in the extractive industry powerhouses of northern China, especially Shanxi. Given these circumstances, it is notable that in recent months Shanxi has emerged as the latest major target of the central government's anti-corruption campaign. Since June, at least 11 and as many as several dozen Shanxi-based or connected officials have come under investigation for alleged disciplinary infractions, including the brother of Ling Jihua, a former top aid to former President Hu Jintao and leader of the so-called "Secretary Gang," as well as several executives from provincial coal businesses.
It is as yet unclear whether and how the nascent crackdown on Shanxi provincial officials intersects with economic and policy developments there, including the coal tax. The province's dire economic straits — in the second quarter of 2014, annual growth plummeted to just 1.7 percent, and has likely fallen further — have clearly exposed deep-seated problems in local governance. Beijing's established goal of restructuring and streamlining coal production and coal supply chains suggests there may be a more pointed policy or political aim to the crackdown, one whose realization the sector's natural slowdown has made more viable. Likewise, the link between at least one Shanxi official and Ling indicates that the campaign in Shanxi has a political edge. But beyond this, it is difficult to ascertain to what extent the crackdown is a response to the province's economic decline or is driven by specific policy or political goals.