Emerging Markets: China Set To Roll Out National Tax On Oil and Gas

In a surprising and controversial move, China has confirmed that a new tax on sales of primary resources will be rolled out nationwide. The 5% tax is currently being tested in the western province of Xinjiang, with revenues going to the local government. The new tax reforms are part of a larger basket of policy changes designed to increase the fiscal income of the poor, but resource-rich western regions. The tax, which will be extended to coal sales, is being implemented to meet demands from local government for more fiscal autonomy, while enabling Beijing to meet is stated mandate for proactive economic and environmental leadership. While the creation of the tax is encouraging, one cannot help but question whether this reform is simply a superficial gesture masquerading a new form of environmental leadership, or a serious attempt at tax reform and national economic development? Will the resource tax increase revenues for the vast northwestern regions which have been consistently plagued by economic inequity? How quickly will the pilot tax be rolled out nationally? How will the tax impact foreign direct investment, economic growth, and financial risk? Will the tax efficiently spread wealth among all Chinese citizens, closing the gap between low, middle, and high income earners?  Or, will the tax increase the incidence of violent and non-violent protests which have paralyzed the region?

In recent news releases, the Chinese government has steadfastly maintained that the tax proceeds will be used to promote a process of industrial development and urbanization. On the face, it is hard not to agree, considering the many recent policy changes made over the last 6 months which address social and environmental inequity. From an investment perspective, a nationwide resources tax is likely to be welcomed by regional governments, particularly those which have seen their borrowing restricted by the central government in Beijing. Over the last 2 years, many Chinese local governments borrowed against state-owned land, despite the presence of a potential real-estate bubble that now seems ready to pop.  These governments also borrowed internationally, something that many Beijing authorities argued was immoral, as well as illegal. With the new resource tax, regional governments will see new streams of revenue that may help offset the need for external borrowing, while further offsetting the impact that changes to China's exchange rate policy will have on commodities markets. Many analysts continue to argue that this new "flexible" yuan policy will allow the Chinese currency to increase in value against the dollar over the coming months, making the cost of commodity and energy imports - on which the Chinese economy is heavily dependent - cheaper.

While the resource tax does have the potential to impact Chinese development, one cannot stop and consider the impact the tax will have on foreign direct investment. Won't this new tax squeeze excessive profits out of the country's resource producers? Invariably, the answer is yes. While the the new tax will promote the efficient extraction of natural resources over the long term, the economic impacts cannot be understated. With the benchmark rate set at 5 percent, the new tax policy will reduce the profitability of major resource producers such as PetroChina Co Ltd and China Petroleum and Chemical Corp (also known as Sinopec), resulting in higher tax costs. One estimate is that  PetroChina and Sinopec will see an increase in resource tax payments of 17.9 billion yuan ($2.64 billion) and 6.4 billion yuan respectively one the tax is rolled out nationally. This tax would directly impact Sinopec's earnings per share by 0.07 yuan and 0.06 yuan respectively. Additionally, the country's top coal miners, including China Shenhua Energy Co Ltd and China Coal Energy Co Ltd, will also be affected by the tax, but their impact will vary based on their exposure to the region. Almost all of Shenhua's upstream resources are located in the western region, mostly in Inner Mongolia autonomous region and Shaanxi province, while less than 5 percent of China Coal's mines are in the current pilot region.

Regardless of intention, the Chinese government must carefully monitor the impact of this tax to ensure it achieves its outcomes. A recent report from Beijing notes that the national policy makers may establish a lower tax rate for coal which serves as the country's mainstay fuel. This tax reduction will help appease concerns over inflation, while maintaining the profitability of downstream industries. For many environmentalists, this move continues to be interpreted negatively, particularly because coal is a significant contributor to air pollution across China. Despite this, sustainable development critics have a reason to be encouraged. Based on the initial plans, the tax reform will help reduce economic imbalances between the lesser-developed but resource-rich regions of western China and the nation's coastal centers. It will bolster local government finances, provide resources needed to support social and infrastructure development, and serve as part of a larger round of policy changes designed to boost sustainable economic growth in China. In the long term, it is arguable that this tax, along with the other similar policies, will help boost local economies, capital investment, as well as market confidence, assuming that the tax revenues are distributed downstream to the citizens and organizations that need them most.