A Crisis of Legitimacy: Why Efforts to Reduce Chinese Industrial Subsidies are Doomed to Fail

USTR Robert Lighthizer (left) leads the US delegation in trade discussions with Chinese officials, led by Vice Premier Liu He (2019)

Credit: The White House / Wikimedia Commons

Chinese government subsidies to the country’s industry have been among the most aggravating and contentious points in the US-China relationship over the past 15 years. Recent estimates suggest that China spends around five percent of GDP on industrial subsidies, while a comparable estimate for US subsidies puts that figure at only about 0.4 percent of GDP. Heavily subsidized Chinese corporations often exploit these subsidies and dump their goods in other markets by undercutting existing prices, and then often go on to reap fabulous rewards for doing little more than accepting subsidies from their own government. It is therefore argued by the US and several European and Asian countries that China’s extensive use of subsidies not only violates its WTO commitments, but also very tangibly harms businesses across the world that do not receive similar subsidies and have to compete in markets defined by artificially cheap prices. Rational or otherwise, fears about market monopolization by Chinese companies are a defining feature of today’s global economy. It was in this context (although this was by no means the defining context) that “Tariff Man” was re-elected to the American presidency. 

There have been arguments that Donald Trump’s promise of ensuring “fair and reciprocal” international trade and his policy actions from behind the Resolute Desk are responses to perceived faults in the broader global trading system rather than responses to Chinese trading practices per se (we have seen Canada and Mexico face tariffs of 25 percent compared to the 20 percent cumulative tariffs on China). It is also, however, unquestionable that China was the first major trading partner to frustrate Trump. Thus, it is far from surprising that Trump now seeks to take action to minimize the US trade deficit with China. How could the US go about achieving this objective? There exist two major schools of thought that try to answer this question. 

The first school contends that tariffing Chinese-made goods will cause prices for US consumers to go up and thus the demand for Chinese-made goods to go down. Additionally, this school argues, the companies that manufacture these goods, hoping to protect their revenue, will choose to produce in the US instead, which will lead to increased US manufacturing and a lower trade deficit with China. This is the school that most officials in the second Trump administration seem to agree with. While the merits of this school’s arguments are scant for a variety of reasons (chief among them being the fact that the US no longer has a comparative advantage in low-cost manufacturing), even if one assumed that the US could somehow produce these goods efficiently, it would not necessarily lead to a decline in the US trade deficit with China. This is in part because the US would undoubtedly need to increase imports of intermediate goods in order to achieve any meaningful manufacturing growth, and because a significant number of those intermediate goods can only be sourced at scale from China.

Despite this, we have seen that the current Trump administration is resolved to pursue this policy approach quite vigorously. The administration has now twice imposed tariffs of 10 percent on all US imports from China, bringing cumulative tariff-rate increases on Chinese goods since Trump’s inauguration to at least 20 percent. It also suspended the de minimis exemption (which exempts imports worth less than $800 from American customs duties) for Chinese goods for about 30 hours, before abruptly walking back that suspension, albeit saying the exemption would face renewed suspension once Customs and Border Protection came up with better enforcement mechanisms. 

Unlike the earlier school, the second school of thought appreciates the status quo of the international trading system. The school holds that conventional tools like tariffs are unlikely to yield the results the Trump administration would like to see. It argues that rather than tariffing imports, the US should address existing weaknesses in its investment and taxation laws that provide the Chinese with material incentives to maximize their current-account surpluses. One of the most detailed discussions of this school’s arguments was made by Alex Raskolnikov and Benn Steil in a recent essay in Foreign Affairs entitled A Better Tool to Counter China’s Unfair Trade Practices: End the Tax Advantage for Chinese Investors in U.S. Markets. In their essay, Raskolnikov and Steil make two overarching arguments. First, they argue that although it is well-established that a smaller current-account deficit with China would lead to a smaller capital-account surplus, it is less well-established but no less true that a smaller capital-account surplus would result in a smaller current-account deficit. Second, they argue that the US should withdraw from the US-China tax treaty, and subsequently increase the withholding tax charged by the Internal Revenue Service (IRS) on dividend and interest income earned by Chinese entities holding American liabilities from the current 10 percent to the legal limit of 30 percent. There are also some in this school who stress that laws such as the Foreign Investment Risk Review Modernization Act, 2018 were insufficient to address structural shortcomings in institutions like the Committee on Foreign Investment in the United States, and that more needed to be done to create legal and institutional barriers to Chinese investment in the US. 

Despite the fact that the latter school’s proposals make more sense than the former’s, it still requires the US to forego Chinese capital, the benefits of which are entirely abstract and, as Raskolnikov and Steil themselves concede, rather ambiguous. Furthermore, the arguments utterly fail to deal with the fact that since the pandemic, Chinese companies are investing less and less in the US anyway, and that the overall stock of Chinese foreign direct investment in the US is actually shrinking. 

Despite all their strengths and all their flaws, both of these schools of thought and all of their efforts to reduce Chinese government subsidies and minimize its impact on the US are doomed to fail. The reason for this inevitable failure has nothing to do with the economic soundness or the popularity of either particular policy proposal per se. Rather, its failure is assured because such an attempt would fundamentally challenge the ability of the Chinese Communist Party (CCP) to maintain its claim to legitimacy. 

Three and a half decades ago, in the aftermath of the Tiananmen massacre, the Chinese people agreed to become party to a new social contract, a social contract under which the CCP would backtrack on changes from the previous decade and reassert its role as a Hobbesian Leviathan. The Chinese people agreed that so long as the country experienced economic development and the lives of ordinary people improved, they would relinquish any claims to political rights. In other words, the people agreed that the Party’s monopoly on political power would be legitimated by popular belief so long as the Party could improve its citizens’ wellbeing.  

And improve citizen wellbeing the Party did. In the period between 1989 and 2021, there were 17 years when China’s annual GDP growth rate exceeded nine percent—10 of those times it achieved double-digit growth rates. China’s GDP per capita went from $310.90 in 1989 to $12,617.50 in 2021. The Chinese economy was truly experiencing “miracle” growth in every sense of the word. 

This growth was not, however, uniform or without changes to its principal drivers, and what can perhaps be described as its most important change occurred between 2008 and 2009. In late 2008, as economies all over the world were reeling from the global financial crisis and a severe liquidity crunch, demand for Chinese exports became incredibly sluggish. In response, in an all-out effort to maintain economic growth, the Chinese State Council on November 9, 2008, unveiled a stimulus package of an estimated $586 billion, with most of it being spent on infrastructure development. Thus began the era of the supremacy of gross fixed capital formation (GFCF). Every single year after 2008, the contribution of GFCF to China’s economy as a percentage of GDP has always exceeded 40 percent (in comparison, GFCF accounts for just 21 percent of US GDP). 

However, time brings change, and around the start of the COVID-19 pandemic, the CCP realized that China was facing increasingly diminishing returns on capital investments. Major real estate companies were overleveraged and had built vast quantities of housing despite knowing there were few prospective customers. The loss of revenue from land sales to real estate developers in turn caused local government revenues to plummet and forced local governments themselves to resort to increased borrowing. Perhaps most significantly, China’s GDP growth rate has been abysmally low since 2019, averaging just 4.36 percent annually between 2019 and 2024. As a result, the CCP has come to the conclusion that its claim to legitimacy is weakening and that it needs to rapidly pursue corrective action. 

Consequently, the Party placed renewed emphasis on reducing fixed capital formation and on exporting the country’s industrial overcapacity. Since 2019, GFCF as a percentage of China’s GDP has been on a downward trend. At the same time, despite it looking like Chinese exports have stabilized, the fact is that the ever-increasing volume of Chinese exports is being offset by the ever-decreasing prices of Chinese goods. Because the CCP needs to artificially generate employment and economic growth to uphold its legitimacy even among its own ranks, the Party will concede little ground on vital and effective levers of economic control like subsidies merely to appease demands from the US, a country which has thus far, even during the Trump presidencies, refused to take actions that might cause serious damage to the Chinese economy. Furthermore, even if the US decided to inflict such damage by actually imposing the 60 percent tariffs that President Trump continually threatens, the fact remains that America’s share in Chinese overall trade has been going down for a long time. 

The Chinese Communist Party has always valued its strategic independence, and it will be terribly loath to let the US undermine the Party’s efforts over the past 75 years to strengthen its legitimacy and consolidate its power. If America wants to see real change, it should think long and hard about alternative policies that will elicit more than just frustration from the other party.