What China Sees in Hong Kong

The current difficult situation and predicament in Hong Kong is not just about what is happening now or has been happening for the past decade in the territory, but also calls into question the future and overall political direction of China.

Protesters occupy Harcourt Road, Hong Kong on September 29, 2014, in front of Admiralty Centre and the Central Government Offices. (Image source: Wikimedia Commons)

Over the past 35 years of reforms, China proved to be very good at economic reform and long-term planning. However political reforms, which have nevertheless been going on in the country, have not proceeded at the same speed and with the same long-term planning as changes in the economy. This has many and complex causes; here without too much elaboration we can make a simple list: the structure of the party ruling the country; the ability of the liberalizing economy to convince all of the benefits of private enterprises by "corrupting" many of the concrete benefits of private enterprise in the market; the role of the World Bank and other international institutions in offering guidance and assistance to China in the process of opening up.

Yet perhaps one of the most important reasons for moving on economic reforms while slowing down the political agenda was the effective political exchange that took place after the 1989 Tiananmen protests. Then the party basically allowed entrepreneurial young people to develop their businesses in exchange for their non-interference in the political realm. That is, the state would not meddle (too much) in private business, for instance allowing de facto tax evasion, and in return private businessmen would not nose around in politics.

This exchange allowed private business to develop enormously (the success of Jack Ma, the chairman of Alibaba, comes from here) and granting central politics the freedom to proceed with its own agenda, deprived of interference from society and business, something supposedly "plaguing" Western politics.

The compromise is still working in China, where the central government is now committed to pushing back against large State-Owned Enterprises (SOEs) that gained undue power in the wake of the 2008 financial crisis by abusing the large financial stimulus package launched against a severe economic downturn. This push against SOEs should make room for more efficient and enterprising private companies, of which Jack Ma is the idol and the model. Mr. Ma hails from Zhejiang, the province where President Xi Jinping was party secretary until almost right before his promotion to Beijing.

A similar exchange of understandings apparently worked in Hong Kong, where common people seemed not too concerned with political rights as long as they could improve their lives and have a shot at becoming rich.

This arrangement seems to have stopped working in Hong Kong: the local tycoons have been monopolizing the resources and opportunities and are blocking the path for the rise of the middle class. Since the 1980s, the Hong Kong tycoons formed the pillar of Beijing's interests in the territory. Now they are a liability because many of the complaints of the demonstrators are actually also against them and the benefits they extract from Beijing for themselves but not for the territory.

In return for political support in Hong Kong, the tycoons received special opportunities in China in the 1990s. However, a decade later, after the smooth transition of Hong Kong to the Beijing rule, their role was no longer so important. A new class of Mainland entrepreneurs, both private and in the then just reformed SOEs, had started rising and the tycoons' opportunities in China grew smaller. For this reason, the Hong Kong businessmen started to diversify and not concentrate so much on China. Now, they do not provide stability in Hong Kong, and by monopolizing resources they are objectively part of the problem, not the solution.

The same pattern could possibly occur in the future in China (see Appendix below: "China's Inevitables: Death, taxes -- and democracy"). Everything should be clear about what to do then and about what to think, but possibly it is not. In China, leaders are not sure about the overall political direction of the world, and they have their reasons.

In Beijing, future global political trends are not so apparent. Before the 2008 financial crisis, China's political elite thought that economically, the American system was the role model to follow; about half of the political elite also thought that politically, China should follow America in its democratic system. The Central Party School and the China's Academy of Social Sciences (the two main think tanks of the country and the party) conducted many studies on democracy and democratic systems both in Asia and in the world. The elite had not developed a consensus on the future political direction of the country, but democratic evolution was being seriously considered. The financial crisis, however, proved that the American financial system had big flaws, and therefore could not readily be applied to China. If the financial system (which had almost fully convinced the Chinese) proved wrong, then the American political system and its democracy were even more suspect.

Moreover, the failures of U.S. support for democracy in Afghanistan, Iraq, Egypt, and Libya gave new food for thought to the opposition to democracy in the Chinese elite. Lastly, the political crisis in Thailand gave new ammunition to anti-democratic thinkers. Here, for its own considerations, the United States did not strongly oppose the anti-democratic coup d'état that overthrew a democratically elected government. The pragmatic Chinese leaders had plenty of evidence to conclude that the democratic system and cries for democracy were simple political tools to be used at convenient times against American enemies and for American interests. On the other hand, Russia—dominated by Vladimir Putin, a new autocrat who wants to stifle democracy in Russia—provided a new model for effectively challenging American ambitions and advancing national agendas.

These elements, however, may only partly apply to Hong Kong. Whereas in the short term, democracy has proven a system difficult to transplant and to foster, in the long term one can see clearly that there is a greater trend toward democracy around the world. Over a span of thirty years, a greater number of countries have adopted democratic systems. The whole of Eastern Europe and most of Latin America, formerly in the clutches of dictatorships, are now efficient democracies. Even Putin, though more authoritarian than the disastrous Yeltsin, is far more liberal than his Soviet predecessors.

This seems to indicate that while democracy cannot be parachuted into a country, there is a broader, long-term global trend toward democracy and that its growth depends on local conditions. Lastly in the Middle East and Central Asia, different political and cultural traditions are at play, hindering the full-fledged development of stable democratic institutions. But these political and cultural traditions are not working in east Asia, where South Korea or Taiwan have become efficient and steady democracies in the past 20 years, and, for instance, Indonesia and the Philippines are moving to a similar path.

In this sense, there is little doubt that Hong Kong is ready to become a mature democracy. However, full-fledged democracy in Hong Kong would have immediate massive implications for the political evolution of China. Yet large and substantive political reforms in China would have a gigantic impact on the world, possibly even greater than the already enormous impact of China's growth in recent decades on the global economy. Therefore, the failures of democracy in the Middle East should spur caution in wishing for full-fledged democracy in Hong Kong and in China.

That is not to say that China should not become democratic, or that the Chinese do not deserve to be free—quite on the contrary, it means that as economic development needed careful planning, political reforms need even greater planning. The question is: is China preparing for these political reforms? If it does not prepare, the pressure for democracy and freedom at some point could become huge and irresistible while the political system and elite are still unprepared for the change. The clash of pressures from below and lack of readiness from above, plus the eternal power struggle tormenting the party elite, could prove an explosive mix.

The present events in Hong Kong were fully foreseeable. Years ago, there were studies forecasting that Hong Kong could press for democratic reforms in the future Similarly, one can see that the demands for democratic reforms, quite tame now in China, could become very strong in a decade or two. These, just like rushing waters, could become positive energy for the growth of China and the world, if the country prepares for it; conversely, like water, long-term historic trends can be disruptive if not properly prepared and channeled.

Appendix

China's Inevitables: Death, Taxes—and Democracy

by Francesco Sisci
June 19, 2007
First Published in La Stampa, Italy

It is not an issue of ideology or of ideals, but of something much more practical and reasonable: How can one manage complex clashes of interests in complicated societies where many different groups have conflicting agendas?

Of course, from old 19th century social theories we know about the struggle between capitalists and the working class; we also know about a broader and vaguer clash between rich and poor. But since ancient times there has been the fight between interest groups. This latter continues today in an ever changing domestic and international environment, brought on by the growth of global capitalism.

The question then is how to reconcile all of these conflicts without recourse to violence, and in a manner transparent enough as to not create suspicion in rival or allied groups. One needs a peaceful environment, to prevent rebellions or internal wars, and one also needs a reasonable level of transparency to prevent the kinds of suspicion and fear that starts new wars.

The most dangerous conflicts are not the ones between rich and poor--people with differing access to wealth and weapons--but the ones among peers, with the same access to means of violence. In other words, if the miserable peasants rise up in a village, as they either do not possess weapons, or have very few and primitive ones, it is easy to crush them with a well-equipped police force. But it is a very different matter when rival interest groups compete within the government over political or economic agendas. If one side is dissatisfied with the results of the political negotiation it can take up violence against its competitors, and if they both have similar access to violence the conflict can spiral out of control. One can read the history of coup d'etat in different countries as the history of one group trying to prevail over another by force. To avoid such situations, one must create a space where confrontation can come out into the open, where rival factions feel they have equal opportunities to be heard and they share a long-term stake in the welfare of the state, which is above the particular interests of a single faction.

Internal dialogue and compromise can be a very difficult, because divides between interests shift rapidly as contexts change. Therefore, the state political structure must be flexible enough to adapt in a timely fashion.

The way in which many countries found a way to make this work is a system cursorily called "democracy". So bluntly described, the system loses much of the charm and appeal it possesses when romantically depicted with symbols of ultimate liberty. But these symbols are ideals, laden with ideology, and ideology, whether of the left or the right, north or south, often shades into religious issues and has left deep scars on the world and caused millions of deaths. In the last century, the world was plunged into ideological/quasi-religious wars that were waged for or against fascism, for or against communism or liberal democracy.

Conversely, if we look at democracy simply as a mode of government, then we see that it provides a nimble and solid structure with which to achieve change and retain state and international stability; to find a common ground between different interest groups.

Presently the Chinese press is printing reams of articles on the necessity to build "socialist democracy". Premier Wen Jiabao called for political reforms in his press conference at the end of the March 2007 plenary session of the NPC (National People's Congress, China's parliament). We are not very clear about what reforms they are speaking of, but it seems that they are trying to adapt and find ways to have greater transparency and open discussions about different political and economic directions. In a way, this is a move towards the practical democracy we were speaking of.

In a sense, the recent rush of party members and rich people to get a seat at the NPC or the CPCC (China Political Consultative body, a kind of lower house of Parliament) goes in this direction. Both at national and local levels, rich people want to curry favor with the government and push their agendas, while the government wants to keep channels open with some of the most active members of the business community. From this it may be that the whole "paraphernalia" of modern democracy--voting and a free press--could develop.

These trends are bolstered by another distinctive tendency typical of modern democracy. Both in England and France, parliaments developed as a method to control the king's expenditures, i.e. the state expenditures, after the common people had paid their taxes. In a way, the essence of modern democracy is encoded in the phrase, "no taxation without representation". The taxpayers wanted oversight on how their money was spent.

Of course, no one likes to pay taxes. When one grudgingly does so, he will most likely demand to receive the services he was promised in return. In other words, he will demand some degree of representation for his taxes. Around the unpleasant necessity of paying taxes, government and society must build a consensus. Taxation without this consensus--without return of services or information on the allocation of funds– will in the long run only lead to tax evasion on a grand scale or open rebellion. Nor is it possible to imagine a state sustaining itself without taxes; even the most minimalist government is expected to provide some services which can be only paid by taxes. Like death, there is no escape from taxes.

In China we see a dramatic shift in tax contribution over the past few years:

Table 1, Percentage of total tax paid, without car taxes

Sources: China Statistical Book

As the table shows, state-owned enterprises' (SOEs) contributions to the overall China tax pool went down from 52.3% in the 9th 5-year plan to 28.3% in the next one. And in the following years it came down even further. SOE taxes is just the state paying itself; it is an internal loop. SOEs and the state tax bureau are part of the same family: The central government appoints the head of the tax bureau just as it appoints the heads of the SOEs. In such cases the tax-payer does not "suffer" from his contribution; he is merely a bureaucrat handling money that doesn't belong to him.

But it is a different story when the taxpayer is giving his own money to the state. Will he just meekly obey or will he try to pay less or will he wish to know exactly how the money is spent? We see that most taxes even in 2005 are paid by SOEs or "transformed" SOEs. Most stock-listed enterprises are in fact SOEs that have partly changed their ownership structure, accepting investment from the non-state sector. But still, they remain state controlled. Furthermore, "collective enterprises" are a confused cover for many different things: Among other grey areas, there are private companies which gave out part of the ownership rights to a powerful state entity to gain political protection; there are villages running their local economy under the muscular leadership of the village chief. In this light, we can see that in 2005 over 50% of China's tax contributions still came from the state sector.

Table 2

Sources Naughton (2006), China Statistical Book. (Courtesy of Bert Hoffman, the World Bank in Beijing).

But the contribution to the GDP is a different story. In the first 25 years of reform, the private contribution to industrial production went up from nil to 72 percent, while at the same time the state contribution to industrial production went down from 100 percent to little more than 20 (the meaning of "collective" ownership also changed in this 25 years: In 1978 it was a de facto form of state ownership; in 2003 it was something vaguer). Arguably, the contribution of the non-state industrial sector to the overall GDP could be even larger, as the industrial sector is more heavily controlled by the state.

The comparison of the two tables must be done with extreme caution, as the data are not consistent and to my knowledge there is no research openly available that evaluates contribution to GDP and tax contribution—perhaps for good reasons, as we shall see.

The official Xinhua news agency reported that "The number of Chinese officially described as 'middle class' has risen by almost 15 million people in the last two years to 80 million in total. About 6.15 percent of the population were middle class, and the number was still rising, Hou Yunchun, director of the Research Office of the State Council, told a conference on wealth management, the Shanghai Securities News… Hou's estimate was based on the criterion of the National Bureau of Statistics (NBS), which defined middle-income households as having an annual income between 60,000 and 500,000 yuan (7,792 and 65,790 U.S. dollars)."[1]

The official percentage of taxes is as follows:

1. individual income tax

(China statistical bureau).

According to present tax criteria, these people ought to pay some 20% of their income in taxes. 80 million making an average of only 80,000 yuan a year and paying an average of 20% per cent of taxes to the country should contribute some 1.3 trillions of yuan of taxes. The calculations are very rough, but can still give a sense of the magnitude involved.

The total paid according official data is the following:

Total individual income tax:

2003 141.8 billion Yuan (6.93% of the total, 2045 billion Yuan)

2004 173.7 billion Yuan (6.75% of the total: 2571.8 billion Yuan)

2005 209.4 billion Yuan (6.78% of the total: 3086.6 billion Yuan)

2006 245.2 billion Yuan (6.52% of the total: 3763.6 billion Yuan)

The numbers of the amount to be paid can only be a vague indication, but there is a dismal difference between our rough calculations based on official figures of income and the amount of individual income taxes paid, that include amounts from lower income people. The calculations are, again very rough, but they suggest that the middle class pays only less than 10 per cent of its taxes. Moreover, personal income taxes are just a fraction of the total tax collection.

However, even a cursory look at the figures reveals that while the non-state sector contributes to the GDP for some 75 percent, its contribution to the overall taxes is not so great, being less than 50 percent. In other words, the private sector is evading taxes in a big way. Moreover, we can believe that this tax evasion is also concentrated in certain sectors. Foreign enterprises, for a number of reasons, tend to pay all their dues; charges of tax evasion in China could jeopardize the overall company global image, and it is not worth their while. But for small, aggressive, Chinese startup companies it is a different matter; often tax evasion is the means to survival.

Tax evasion from the Chinese private sector can be seen as a form of self-financing: The money saved from the taxman pays for the company's development. Chinese private companies do not share the access to banking that is provided to SOEs. Over 70 percent of total outstanding loans are granted to state companies, producing some 30 percent of the total GDP, whereas the non-state sector, producing some 70 percent of GDP has to make do with some 30 percent of the total loans. This means that the Chinese private sector is very efficient in its utilization of funds. It means that if banks were to loan to the private sector, they would immediately improve the quality of their loans and decrease the overall quantity of non-performing loans. In other words, China could grow faster with less money in circulation and also create more new jobs.

Yet, private companies have been reluctant to approach state banks for their loans, and would rather pay high interests rates--over 30 percent to small illegal "qian zhuang", moneylenders--or risk the dreadful wrath of the taxman by evading taxes. They do so because they do not feel protected when going to the bank and telling the bank manager their entire company history. Many private companies have a history of tax evasion, and perhaps sourced their seed money in shady ways. Banks, being state-owned, are SOEs, part of the same system as the tax bureau. So if a company tells its secrets to the bank it feels it is just one step away from telling them to the tax bureau or the police. Thus, the high interest rates of the money-lender, or the tax evasion, seem safer.

All this could slowly change, as last March the Chinese parliament approved a new law protecting private property. Yet, this must still be "legally acquired". But in past decades, in the historic passage from planned to market economy, there have been many grey areas. It was often very difficult to say what was legal and what was not legal. Perhaps nobody in China who made any money was strictly law-abiding. Thus, anybody could be picked out for his past wrongdoings. To drastically change the present picture and convince all private entrepreneurs to move from high-interest moneylenders to low-interest state banks, and from high-risk tax evasion to low-risk tax compliance, one would need some kind of amnesty for past "economic crimes".

This is very difficult on several fronts. It is ideologically delicate, as it would confer blessings and benefits on people who, in the past, broke the law and are now rich over and against those who were law-abiding and are still poor. It would hurt the interests of powerful princelings who can carry on with the ongoing transfer of state assets into their own pockets as long as the gray areas are still in place. Of course, the princelings pocketing the money would take up the cudgel against the private sector, competing with them, in favor of the law-abiding people not doing business and not reaping the windfall of the economic reforms.

There is also a technical issue on how to enact this kind of amnesty. The state may want to pardon tax evasion but not drug trafficking. It is no easy thing to track the origins of a fortune.

The fast growing middle class has reason to want greater legal protection, but they also have an interest in not pushing it too far or too fast. They do not feel serious pressure from the tax bureau. For all intents and purposes, they are allowed to evade taxes. It is a way of financing themselves but most importantly it is a political pact: The government allows tax evasion in return for political obedience. In effect, the government says: "You don't pay taxes but also do not bother too much about what the state does. As you contribute minimally to state expenditures you have no rights to check how it spends tax money: No taxation, no representation." China tolerates large-scale tax evasion from the private sector, and in return for the money so earned, it does not demand representation in politics.

But if the state now wants citizens to pay more taxes, they might want to ask for more say in politics. The pact works quite well for the new middle class who would rather pay no taxes and not vote rather than buy their right to elect their government by paying much more taxes.

The government feels growing pressure from its middle class, exposed to a largely democratic international environment, and it responds to it. It has introduced some kind of democratic reforms at all levels of the state bureaucracy. There are village elections and now even elections at some district and city levels, and there are elections of appointed officials. This is a critical point. In all the world's bureaucracies, promotion within the ranks is done by selection or exams, or both. Representative democracy is limited to the top levels of the political system, while the middle officials are appointed or selected through the ranks. In China, the selection process is becoming most complicated.

To move for instance, from the post of director (chuzhang) to director general (sizhang), one must be recommended by superiors, and maybe also have the blessing of some senior retired minister (who is out of the political fray and whose opinions are considered thus more objective), but often he must also be voted into position by the personnel in his office, and receive the votes of at least two thirds of his people. This is done in order to help establish the consensus considered necessary to run an office and create a favorable atmosphere. However, this creates a very cumbersome mechanism. The ambitious official will have to try to get support from everybody, high and low, and will have little time to carry out his duties. It creates spaces of corruption and "election campaigns", as the competing aspiring officials will have to pay homage to bosses and peers, carrying gifts, offering and receiving favors. In other words, over time a system that brings "democracy" to the middle and lower level but rules out representative democracy makes the state body inefficient and corrupt. This only grows, as all involved, the corruptors and the corrupted, have no interest in transparency.

Representative democracy, with the huge flows of election money, creates great opportunities for the corruption of leaders. But this could be checked with strict rules about transparency, accountability, and by imposing strict meritocracy, and no democracy of any kind, at lower and middle levels of the bureaucracy. In other words, in an efficient representative democracy, the senior politicians might be corrupt but the policemen in the street have fewer opportunities to be so. And at the end of the day it might be more efficient to have a few potentially corrupt than many potentially corrupt.

In China, overall, it seems to be the opposite. The central leaders, with little or no access to "election money" are rarely corrupt, whereas at a lower level corruption is rife. But for the common people it is less important that the president is clean when the local policeman wants a bribe for anything. The common person might be happier with the opposite, no bribes to the local policeman and a moderately corrupt president.

Again, the level of grass root corruption can be sustainable within certain limits, when it does not make life impossible for many and when many feel they can benefit, though marginally. For instance, if strict law means I cannot build two extra stories in my house I am happy to venture to bribe the local officer. But if building permits from local bureau are safer and cheaper than the bribe, then there is no competition.

All this hinges on taxes. If the state increases its tax revenues, it can afford higher pays for officials who in turn must be more responsive to the central government and less inclined to kickbacks. If officials are paid peanuts, this creates a malaise throughout the bureaucracy and breeds tolerance for a high level of corruption in the ranks.

Therefore, the efficiency of the Chinese state demands it. The pact (no tax no representation) cannot last forever; and unfortunately for the authoritarian state and the almost tax-free middle class, more taxes from the private sector will be demanded by the state. In the past couple of years the government has made clear that it wants to move from the export-oriented economy to economic growth generated by the domestic market. To facilitate this passage the state will spend more money on social welfare and contribute to basic education and a basic healthcare system. In other words, it will spend more public money, and it will need this money from higher tax contributions. Presently total taxes are about 23 percent of the GDP--a very low percentage. For a welfare system that could sustain domestic demand, the total tax inflow should move up a few points.

From this we can surmise a very rough time-table of political change in China.

Over a period of about five to ten years, the basis of a welfare system could be established. Economic growth would be mainly driven by domestic demand. The renminbi would become fully convertible, and then the stock exchange would be open to flows of money in and out. The percentage of total taxes over GDP could be well over 25 percent, possibly as high as 30 percent. The contribution of SOEs to GDP could be around 10-15 percent and the contribution of the state sector to tax revenues could be around 30 percent or below. The total private sector could contribute for 30 percent or more of the overall tax revenues, and the rest would be covered by the "mixed economy".

Then, the crack between taxes and representation will be wider but, as large margins of tax evasions will be still tolerated, it might not be wide open. The pace of change would be subject to one main variable: The efficiency of economic performance. If more money comes from abroad, pushing the economy up, the government has less need to call on the more efficient private companies to pay higher taxes and lower bank interest rates. If capital inflows from abroad decrease, or if the economy slows down then the state will need more taxes from the private sector and must provide it with lower bank interest rates.

Even then there is no direct and immediate link between democracy and taxation. A rebellious society may want more democracy before it pays more taxes; a timid one may prefer to pay more taxes rather than demand political change. Plus, the Party has shown its ability in recruiting entrepreneurs into the NPC and CPCC at various levels, and this trend might well continue. But it is very hard to think that in 15-20 years, when the middle class could be asked to actually pay about 40 percent of its income in taxes, and both the society and the world at large has only become more open, this middle class will remain content to stay out of politics.

By then, most of the Chinese population will be urbanized, and the peasants that have migrated to the cities might have lost their fields and houses in the countryside, which provided a security net in times of unemployment in the cities. These people will need a sounder welfare system for possible unemployment or economic downturns in the cities. It will be necessary to set up political buffers that could channel their grievances without challenging the overall political stability and do not turn into a social and political revolution. In other words, one may say that the government must open a political But at the same time, the contribution of state companies to tax revenues is decreasing. Therefore, the private sector will be called upon more and more to foot the bill. This, in turn, will create a more efficient economic system and build seeds of resentment among the middle class. The political pact of "no taxation and no representation" will be cracked, although not entirely broken.

dialogue with potentially destabilizing social forces, giving them ways to express their sufferings in a peaceful, orderly manner, without recurring to violence, at least not in a way that turns protests into civil war.

All this is to say that the third decade of the century, starting at the latest around 2020, should be one of dramatic political changes in China. This is very far away but it is also a clear horizon: If only death and taxes are certain, then so perhaps, is also some form of democracy in China.

In the short term, however, large-scale and largely tolerated tax evasion is the most practical tool to forestall dramatic democratization. Democracy might be unavoidable, yet one can try to put it off for as long as possible.

[1] See Xinhua June 18, 2007 "China Has 80 Million Middle Class Members: Official"

[2] I want to thank Nolan Sharkey who corrected this table suggesting rightly that these figures are only monthly income and thus all following calculations have to be revised.