China's central government is tightening tax policy on two fronts—pursuing businesses that have misused existing breaks while also eliminating some incentives entirely, as years of fiscal pressure push authorities toward more aggressive revenue collection.
Local government debt reached $18.9 trillion by late 2025, accumulated through decades of infrastructure spending and welfare obligations once offset by land-sale revenues. Those revenues collapsed when the real estate sector, which accounted for 20 to 30 percent of GDP and 27 percent of all bank loans, entered a prolonged downturn after property bubbles burst around 2020.
With land financing no longer reliable, local governments have pursued alternative measures to stay solvent. Some municipal governments sent local police across provincial lines to seize assets from entrepreneurs in wealthier provinces—a practice criticized as "deep-sea fishing." Others intensified enforcement of restaurant hygiene rules and parking violations to generate fines. More orthodox moves included converting high-interest, short-term debt held by local subsidiary entities into lower-rate, longer-term official bonds.
Tax enforcement has become a primary tool. China's tax authorities launched "precision tax inspections," targeting businesses for back-tax collection and administrative penalties. Online influencers and recipients of state-linked maternity payments were among those subjected to fresh scrutiny, reflecting the breadth of the campaign as conventional revenue sources dried up.
The removal of tax breaks marks a more direct step than enforcement alone. For years, local governments competed to attract manufacturers by offering subsidies, preferential loans and tax incentives. That competition drove what Chinese economists and officials call "involution"—race-to-the-bottom price cutting and razor-thin margins across electric vehicles, solar equipment, chemicals, real estate and platform delivery services. President Xi Jinping's central government has launched an explicit campaign to curb that dynamic.
The link between tax breaks and overcapacity is direct. Local governments, stripped of property revenues and under pressure to hit GDP and industrial output targets set by Beijing, poured resources into manufacturing expansion. Subsidies, cheap loans and tax exemptions allowed firms to produce at scale with negative margins, sustaining excess supply in sectors well past profitability. Removing those incentives aims to drain the subsidy floor that kept unviable capacity alive.
Private firms sit at the center of the adjustment. They generate most employment and economic activity and lead innovation in sectors Beijing considers strategically vital, including artificial intelligence, biotechnology and semiconductors. Whether the rollback of tax incentives falls proportionately on state-owned enterprises or private companies will shape how the campaign plays out across industries.
The real estate and electric vehicle sectors illustrate divergent trajectories. Both face declining profits, excess supply and high debt. But the property sector has limited expansion prospects and fewer policy tools, while the EV sector retains growth potential in export markets even as domestic margins compress. Beijing's regulatory choices in each sector reflect those distinctions.
For local governments, the removal of tax breaks creates a contradiction. Officials are being asked to stop using incentives to attract manufacturers while still facing GDP targets that reward industrial growth. Until the central government realigns those targets with new fiscal constraints, local officials have conflicting instructions: stop subsidizing overcapacity while continuing to report the output growth that depended on it.
