New Consumption Taxes on Cars Unlikely to Change Purchasing Habits

China’s Ministry of Finance and National Tax Bureau has announced changes to the consumption tax on passenger vehicles. Effective September 1, the consumption tax on cars with engine displacements below 1.0 liter will be cut from 3.0 percent to 1.0 percent, and the tax on cars with 3.0 liter to 4.0 liter engines will be increased by 10 percentage points from 15 percent to 25 percent.

The consumption tax doubles from 20 percent to 40 percent for cars with engines above 4.0 liters. For passenger cars with engines having displacements from 1.0 liter to 3.0 liters, the consumption tax currently ranges from 3 percent to 12 percent and remains unchanged.

This latest government initiative is obviously an effort to discourage purchases of gas-guzzling 3.0 liter plus engines and spur demand for cars below 1.0 liter. As such, it is a step in the right direction. However, passenger car models which fall within the size ranges most heavily impacted by the new tax changes account for a relatively small part of car sales currently.

During the first half of 2008, approximately 3.0 million passenger cars were sold. Of this amount, only 139,000 cars (4.6 percent of the total market) with engines having engine displacements below 1.0 liter, and just under 21,000 passenger cars (0.7 percent of the total market) with engine displacements above 3.0 liters, were sold. In other words, cars with engine displacements between 1.0 and 3.0 liters account for 96 percent of sales, but are unaffected by the new tax changes.

As restructured, consumption taxes on autos now range from 1 percent to 40 percent in China, depending upon size of engine. Which companies can expect to benefit from this tax change? The most likely beneficiaries would seem to be the car makers that currently have products in the small car segment. As the China market for passenger cars broadens, and consumers with lower incomes join the population of car owners, this segment can theoretically be expected to grow. Of the 139,000 cars sold in the first half with engine displacements below 1.0 liter, the Xiali, QQ, Spark and the Alto account for over 95 percent. The Spark is made by SGM Wuling, a General Motors joint venture, and the Alto is made by ChangAn Suzuki. The Xiali and QQ are made by Tianjin Auto and Chery, respectively, both local car companies.

In actual practice, though, the market for small cars has not grown in China, despite the theoretical arguments as to why it should, and the new tax changes are unlikely to change this consumption pattern. It seems that Chinese consumers, once they reach an income level where they can afford a car, would prefer to pay more for a bigger car with more features that also provides more “face.” This is the same conclusion we came to when we analyzed the $2,000 Nano that Tata Motors of India has developed. The reason that Chinese car companies have not developed models at such a low price level is that Chinese consumers simply don’t want small cars with bare bones features.

The conclusion, unfortunately, is that the new consumption tax changes sound great on the surface, but are unlikely to have much impact. If the choice is between a small car with an engine below 1.0 liter and the consumption tax is 1.0 percent, and a bigger car with a 1.5 to 2.0 liter engine that has more features, but where the consumption tax is 5 percent, the difference in tax of four percentage points is unlikely to be large enough to change purchasing habits. For the consumer who has enough money to buy a large gas guzzler, an increase in tax of 15 to 20 percentage points is unlikely to make much of a difference. Moreover, even if the tax increases cause some of these consumers to switch to slightly smaller cars, there aren’t enough purchases in this category to make much of a difference.

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