What China can learn from Trump, the Soviets, and Kublai Khan

Donald Trump

AP Photo/Evan Vucci

If there is a number coming out of Donald Trump’s White House that should get Beijing worried, it is not the 10 per cent growth in the military budget. It is the promised 20 per cent corporate tax cut.

The US president signalled two weeks ago that he intended to propose a “historic increase” in military spending to US$603 billion – up 10 per cent from a year ago. The eye-watering number immediately grabbed headlines around the world. In China, which was about to release its own defence budget the following week, the news attracted even more attention.

Some in the Chinese military argued that Beijing should respond with a double-digit defence budget expansion. Although Trump never explicitly mentioned China as the reason for the hike, Beijing is the elephant in the room. Some experts worried that the US would step up its military deployment in Asia, increase missions in the South China Sea and widen the already-significant technological gaps between the two sides.

When Beijing announced its defence budget earlier this week at the annual parliamentary sessions (“Two Sessions”), it was a moderate 7 per cent growth – one of the lowest in years. Accepting that the actual amount could be bigger, the figure is still a disappointment to many hot-blooded nationalists in China. This is maybe why the Ministry of Finance chose not to include the figure in its annual budget report – the first time in decades. It was considered “too sensitive”.

It is the right call.

Trump’s defence budget proposal – even if approved – poses no immediate challenge to China’s security. Despite tough language from both sides over Taiwan and the South China Sea, the chance of a direct military conflict is slim. The Chinese leadership is mindful of the lesson of the Soviet Union. They do not want to be drawn into an arms race with the US. Most historians blame the Soviet empire’s demise on excessive spending on its military. In 1960, Soviet military spending was US$36 billion. That figure reached US$70 billion by 1970 – about 90 per cent of the US defence spending at the time. Given that the Soviet economy was significantly smaller, the burden was devastating.

Things got worse in 1983 when Ronald Reagan, then president, announced the Strategic Defence Initiative (SDI), better known as the Star Wars programme, a missile-defence system aimed to render the vast Soviet nuclear arsenal obsolete. A worried Moscow decided to drastically increase its military investment and enter an arms race with the US. At its peak, various estimates put Soviet military spending at a shocking 35 per cent of gross domestic product (GDP). The excessive military spending stunted its growth and collapsed its economy.

China is fully aware of that history. For the past 17 years, it kept its military spending between 1.9 per cent and 2.1 per cent of its GDP, according to estimates from the Stockholm International Peace Research Institute. By comparison, America’s is between 3.3 per cent to 4.7 per cent. China could be more aggressive, but it is taking the long view. It believes that as long as its economy maintains a relatively high pace of growth, China will eventually catch up. Beijing wants to reform its military and put it on par with the best in the world, but it wants to do so at its own pace.

china military

Reuters

The real challenge to China is Trump’s repeated pledge to reduce the corporate tax rate from 35 per cent to 15 per cent. However, the number was curiously absent in the tax plan he recently submitted to Congress. With an almost US$20 trillion national debt and US$200 trillion in unfunded entitlement obligations, it would seem there are limits to how much Trump can cut taxes. But so far, he has proven to be a man who does what he says – no matter how controversial or difficult it is.

If Trump really cut corporate taxes significantly and if Beijing does not come up with an effective response, China could face a far bigger problem than a powerful US military in the South China Sea.

Beijing should take a lesson from Kublai Khan, the first non-Han Chinese ruler who established a dynasty in China. The Great Khan did not conquer China by sheer military force, but also through clever tax and trade policies, and a deft political touch.

The war between the Song dynasty and the Mongols lasted 44 years (1234 to 1279) – the longest in the history of the Mongolian conquest. While Song had no effective cavalry force, it boasted the world’s most powerful navy. The dominance of its fleets over the vast waterways in Southern China enabled Song to withstand wave after wave of Mongolian invaders.

Kublai Khan changed this when he came to power in 1260, after his brother Mongke, the conqueror of Iraq and Syria, died in an unsuccessful China campaign.

China's President Xi Jinping arrives for the third plenary session of the National People's Congress (NPC) at the Great Hall of the People in Beijing, China, March 12, 2017. REUTERS/Tyrone Siu

Thomson Reuters

He drastically cut the tax rate for merchant ships that used a Mongolian-controlled port as their home base. The Great Khan also aggressively reduced duties and simplified trade terms. Historical records indicate that duties on exports passing through his ports were only about 3 per cent to 5 per cent of the total value of the goods, compared with 10 per cent to 30 per cent elsewhere. At the same time, the Song court made the unfortunate decision to raise the duties on exports and force merchants to rotate ships through government services. Many Chinese merchants defected to the Mongol empire, bringing with them all their fleets.

Within a few years, the nomad empire had a navy bigger than anyone else. Kublai Khan’s conquest of China started with a series of naval victories over the Song. “There would have been no further progress in Kublai’s war with Song without a powerful Chinese navy being at his disposal,” historian James Waterson wrote.

Many fear that Trump’s tax cut could have a similar effect. The two biggest problems facing China’s economy today is capital flight and lack of private investment. Last year, private-sector investment experienced the slowest growth since China began publishing such data in 2012, decelerating to around 3 per cent.

Meanwhile, the authorities are desperately trying to stem capital flight from the country. Capital outflows surged last year to a record US$725 billion.

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US Navy Photo

Chinese business leaders are now openly complaining about a deteriorating business environment, excessive government restrictions and monopolies. Beijing has pledged to reduce the tax burdens, but so far the results are not convincing.

At this year’s parliamentary sessions, Premier Li Keqiang (李克強) promised in his work report that corporate taxes would go down by US$50 billion and administrative fees by US$28.9 billion. He claimed that China cut taxes by US$82 billion in 2016. But this is not a broad tax-rate cut and is subject to many terms and conditions. Also China’s tax cuts cannot be verified independently. Last year, the combined business tax and value-added-tax revenue reached US$754 billion, against US$728 billion in 2015, showing no obvious effect of cuts.

Many business-sector delegates were not convinced, though they did not openly criticise the report. Zhong Qinghou, an outspoken tycoon, told the South China Morning Post that “China still has room for further tax cuts” after Li’s speech.

Beijing needs to act fast. As Kublai Khan showed 800 years ago, taxes are sometimes more powerful than swords.

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