1. The Objective Necessity for China to Propose a Strategy for Domestic and Foreign Dual Economic Circulation Centered on a Large Domestic Circulation

Some observers say that China has decided to adopt a strategy centered on domestic economic circulation because of the U.S. containment of trade with China. While this view makes some sense, it doesn’t tell the whole story. From the time of China’s reform and opening-up in the 1980s to 2010, China had implemented a strategy centered on foreign economic circulation for around 30 years. China’s dependence on foreign trade reached 73.50% in 2007, and then declined in 2010 after the 2008 global financial crisis, but still stood at 48.95%. From 2006 to 2015, around one-third of all trade disputes in the WTO involved China. These disputes occurred because rapid increases in Chinese exports carved out dominant positions in other countries’ markets, triggering trade friction with China.

In 2019, China’s foreign trade dependence had decreased to less than 33%. The country’s export dependence had dropped to less than 18%. These decreases in China’s foreign trade dependence, particularly its export dependence, made it objectively necessary for China to pivot to a strategy centered on domestic economic circulation. China has an immense population, enormous markets, a complete industrial system and a strong agricultural production and supply capacity. The country possesses all of the conditions and capacities necessary to implement and realize a strategy for domestic economic circulation. At this time, China’s per capita GDP has reached US$10,000. According to McKinsey & Company’s China consumer report 2020, China’s consumer market will have surpassed the combined consumer markets of Europe and the U.S. by 2035. At that time, domestic economic circulation will have become standard in China, as it is today in developed countries such as European nations and the U.S. Looking at the trajectory of development in developed countries, per capita GDP of US$10,000 marks a turning point. From an objective perspective, economies that reach this turning point find that they must gradually transition from a development model centered on exports to one centered on internal circulation.

Of course, China’s current regional economic development is uneven and requires foreign circulation. However, the U.S. containment of trade with China and the strategic games between the U.S. and China have objectively accelerated China’s strategy centered on domestic circulation. As the Chinese proverb says, “Inscrutable are the ways of heaven.” In the long run, negative events can turn out to be blessings in disguise, and vice versa. This type of external pressure on China will likely raise the bar of the country’s science and technology, industry, and other industrial structures to a whole new level. While it is unclear whether this will be beneficial to the global economy, it will certainly have a profound global economic impact and could potentially alter the structure of the global economy.

2. Challenges Faced by China in Implementing a Domestic Circulation and How to Overcome Those Challenges

From 2010 onward, China has already put a foundation in place to implement a strategy centered on domestic economic circulation, and has begun shifting course to such a domestic circulation. However, in practice, there is still a long road ahead to realizing a domestic circulation, with many difficulties and constraints along the way. Also, in order to realize a true domestic circulation, the Chinese government will need to devote a lot of energy to certain matters, and will need to implement even more far-reaching internal reforms than before.

The greatest challenge facing the Chinese government, or the goal it must work to achieve, is to transform its current hourglass-shaped society into an olive-shaped society. Looking at China’s social structure, China’s social hierarchy has what can be described roughly as an hourglass shape. The upper bulb of the hourglass represents 400 million people who live primarily in first-line and second-line cities. They are part of China’s affluent and middle classes. These consumers own automobiles and homes, and have ample means to pay for goods and services. This tier consumes 60% of the world’s luxury items and 50% of the world’s automobiles. It purchases all of China’s mid-level and high-end homes. The neck in the middle of the hourglass represents around 100 million people who live primarily in second-line and third-line cities. Their income lies between the middle and lower classes. The lower bulb at the bottom of the hourglass is fairly wide, representing a population of 900 million people. These people live mainly in farming villages, and towns and small cities. Their income and spending power are not high, but they are able to live with a bare minimum standard of living under China’s system of socialism. Currently, China has a social structure that may appear simple at first, but is actually very complex. The incomes of the 400 million people in the upper class are on a par with incomes in developed countries, whereas the incomes of the bottom 900 million people are still at the level of developing countries. The Chinese government aims to solve the problem of the income and spending power of this enormous tier of people. Solving this problem will unlock massive growth potential for the domestic circulation of the Chinese economy. Listed below are six policy measures for realizing an olive-shaped society, in order to surmount the challenges facing China:

1. Reduce the personal income tax on low income earners. Currently, China levies a personal income tax based on progressive tax rates, with the highest rate set at 45%. This personal income tax was established in 1980, so it is already out of date. It features low deductions and low tax rates, but a high maximum tax rate. Personal income taxes in China account for only 7% of the country’s tax revenue. (China is one of the G20 countries. On average, personal income tax represents approximately 20% of tax revenue in the G20 countries. The percentages for India, Southeast Asian countries, Philippines, and Russia is around 15%.) China’s personal income tax has created a situation where the country’s personal income tax rate (45%) is higher than its corporate income tax rate (25%). As a consequence, corporate business leaders choose not to receive a high salary in order to avoid the 45% personal income tax, and pay only the 25% corporate income tax. Businesses also strive to implement tax mitigation strategies as much as possible. The wages of corporate executives and white collar workers are typically paid out from companies set up overseas or in Hong Kong, so that personnel can fulfill their tax obligations by paying only a 15% personal income tax. Ultimately, corporate business owners and white collar workers are able to save on taxes, while the main taxation target for personal income tax shifts to low income earners, who account for 70-80% of the taxpayer population. This results in a situation where personal income tax represents only 7% of national tax revenue. (In developed countries, the affluent class, which accounts for 15% of the population, pays 70-80% of personal income tax.) Accordingly, reducing the personal income tax rate in China will lead to growth in the taxpayer population, an increase in the tax paying ratio of the affluent class, and an increase in tax revenue. At the same time, it will prevent many service enterprises and trading companies from having to incorporate overseas, thereby helping to stem outflows of corporate income. If tax revenue increases, the government will be able to achieve its goal of social equity by effectively harnessing the income redistribution function of the personal income tax. Concurrently, the government will be able to foster groups in society that will have the spending capacity needed to support the growth of internal circulation in the economy.
2. Increase the incomes of the 900 million low income earners at the base of the hourglass, with a focus on increasing the property income of farmers. Surveys show that property income represents approximately 30-50% of the income of China’s urban population, but only 3% of the income of farmers. “We will safeguard the interests and property rights of farmers in rural homesteads. We will improve the rural homestead system through reform. We will select several pilot areas to steadily and prudently push forward the mortgage, guarantee, and transfer of farmers’ residential property rights, and expand the channels for farmers to increase their property income.” (From “Decision of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening the Reform” at the Third Plenary Session of the 18th Central Committee of the Communist Party of China). If the three rights of land tenure, land use, and land revenue are separated, and the possibilities for transfer, mortgage and high-value-added use of residential property emerge, this will pave the way for increasing the property income of farmers. At present, the detailed rules for these policies still remain at a pilot research stage.
3. Support the development of small and medium-sized enterprises (SMEs). SMEs in China account for 40% of social resources, generate 50% of tax revenue and 60% of GDP, and provide 70% of innovation in science and technology and 80% of employment. In practice, China introduced a preferential income tax policy for SMEs in 2018. The policy states that “income tax shall be calculated by applying an income tax rate of 10% to profit of 500,000 yuan and by applying an income tax rate of 20% to profit of 1 million yuan.” In other words, there was a time when the income tax rates for SMEs in China were set at the world’s lowest levels. Regrettably, however, these tax rates were only implemented over a short period through December 31, 2020. Some regions were not aware of the policy, while others were unable to implement the policy properly because the implementation period was so short. For this reason, according to Huang Qifan, some experts have proposed making this tax policy a basic national policy to support the development of SMEs. When that time comes, the domestic circulation and supply-demand capacity of the Chinese economy will likely advance to an even higher stage.
4. Reduce housing costs and increase the spending power of residents. In 2019, China’s average consumer spending was 23,000 yuan per person. Half of this spending was for housing, education and healthcare expenditures. If the government allocates large amounts of funds to public services such as housing, education and healthcare, and reduces the expenditures of the Chinese people in these areas, the government will be able to improve the spending power of the Chinese people and promote the domestic circulation of the Chinese economy.
5. Energize workplaces at the microeconomic level. Companies at the microeconomic level are the foundation of the business ecology of the entire country. In order to build a favorable business environment, the government must effectively reduce the tax burden of companies and solve problems associated with financing difficulties and high costs faced by private companies. It must build an environment of fair competition and strengthen intellectual property protections. The government must uphold integrity and be made free of corruption. It must support companies, and protect the personal and financial security of entrepreneurs. The government will need to align the business environment in China with international standards, and appropriately realize globalization, legislation, liberalization and market principles.
6. Create a competent government that encourages innovation and precise investment. At this time, China’s R&D investment in core technology, high-end technology and basic science accounts for only 2.1% of GDP and less than 5% of total R&D investment. In contrast, R&D investment in core technology, high-end technology and basic science in developed countries represents about 20% of total R&D investment. This is both a weakness for China and a key theme for investment growth in the country. At the same time, R&D investment is the cornerstone for China’s implementation of a domestic circulation strategy. Government investment should focus on the public services sector, in fields such as education, public health, culture, pensions, and healthcare, and should not take away profits from the private sector. The government’s industry advisory funds should encourage companies to invest intensively in new infrastructure such as 5G-based big data, cloud consulting, artificial intelligence, blockchain and IoT.

3. China’s Domestic and Foreign Economic Circulation Will Deliver Long-Term Benefits to China and the Rest of the World

First, domestic and foreign circulation are beneficial to the Chinese economy and the foreign economies that participate in China’s domestic circulation. In the early stage of the China’s reform and opening-up period, the Chinese economy was driven primarily by the “processing trade,” which is based on the “business of three imports and compensation trade” (the “three imports” refer to the processing of imported raw materials, manufacturing products according to imported samples, and assembling imported parts, while the “compensation trade” refers to the repayment of loans for imported equipment and technologies with products) and the principle of “imports and exports are both based overseas” (meaning both raw materials markets and selling markets are located in the international market). Of the production output of 100 billion, China’s real GDP is only 12% and 80% of components and raw materials come from overseas. Accordingly, China had only earned a processing fee of around 10%. If the raw materials are sourced domestically, China’s earnings will likely account for at least 30% to 33% of the production output in the domestic circulation. If Apple does not manufacture smartphones in China, it could possibly go out of business. Apple’s smartphone sales in China represent more than 30% of its overall sales. If foreign investors are told that China’s processing industry and its products account for around one-third of global market share, foreign capital will likely be unable to pull out from the Chinese economy. The reason capital flight will not be possible is that overseas, governments cannot dictate where capital flows. Outside of China, it is capital that directs governments. Foreign governments are unable to direct private companies or their capital. The question of who market share will belong to will be determined by who comes to China as an investor and invests in the market. Since capital seeks financial returns, as long as there is a market, there is no need to worry about capital not flowing into the country. For these reasons, in my personal view, no matter how much the U.S. government may interfere, as long as there is no change in the fundamental fact that capital seeks financial returns, it will be impossible to completely cut off the Chinese market from the rest of the world.

Next, once China fully develops the potential of a market centered on domestic circulation, imports will become even more crucial to the country. Massive imports would be an indicator of China’s level of globalization, the level of affluence of the Chinese people, and their ability to consume products from around the world. Meanwhile, massive imports will also help China to lay a foundation to become a global superpower. Among today’s developed countries, no country has become a developed country with only an export-oriented economy. Internal demand attracts and absorbs capital and relatively high-quality products from various countries like a magnet, and strengthens high-end industries and products. That process will help China to build up a foundation as a global superpower and strong nation. The U.S. is the world’s No. 1 importer. In 2019, U.S. GNP amounted to US$21.5 trillion, with exports representing only 19.5% of the whole. Over the past 10-plus years, the U.S. has continuously maintained this percentage of exports relative to GNP. In EU countries, exports and imports represent 60% of the economies of each country, when calculated independently. However, if you consider imports and exports within the EU to be part of the internal circulation of the economy, exports to countries outside the EU represent only 22% of the whole. In Japan, exports accounted for 50% of the economy in the 1950s. Subsequently, the country shifted course and exports have now settled down to a percentage of around 25% of the economy.

At this stage, the Chinese economy is still highly export-oriented. In the next 20 to 30 years, China will surely become a global economic superpower. The path for China to become a great power will not be realized by closing off the country to the world and relying only on a domestic circulation. Rather, China’s path to a global economic superpower will require the country to support efforts to open up to the world and promote globalization through the mutual interaction of dual circulations, with an open domestic circulation as the mainstay, augmented by a foreign circulation. Importing a massive amount of products from other countries will elevate China’s stature in international markets, reduce trade friction, and increase its influence on the world stage. China’s goal for globalization is to establish the renminbi as a global currency for settling transactions. This can be accomplished by obtaining the pricing power and negotiation leverage that comes with being the world’s largest buyer of goods and services. In this sense, the domestic circulation will serve as the foundation for the foreign circulation. The mutual interaction and fusion of these two circulations will guide China to its final goal of becoming a great power.

In closing, China will implement a strategy centered on domestic economic circulation, augmented by foreign circulation. The implementation of this strategy will enhance the independence and security of the Chinese economy, and remove the risk of the economy being controlled by external forces. It will also encourage companies to achieve technological advancement, paving the way for China to establish a dominant leadership position in R&D for core devices. China must capture the opportunities presented by the Fourth Industrial Revolution, develop new infrastructure, and strengthen science and technology, particularly R&D and product development in core industries, high-tech industries and basic sciences.