Is There an Industrial Land Discount in China? A Public Finance Perspective

Zhiguo He, Scott Nelson, Yang Su, Anthony Lee Zhang, Fudong Zhang
Jun 08, 2022
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Local governments, which serve as monopolistic land sellers in China, face a trade-off when deciding to supply residential land versus industrial land. This trade-off is determined by the different time profiles of revenues from industrial and residential land sales, local governments’ financial constraints, and the extent of local governments’ tax revenue sharing with other levels of government.

China’s land market, a key driver of the country’s extraordinary economic growth over the past 40 years, does not provide revenues to local governments via property taxes, unlike land markets in most developed economies. Rather, local governments serve as monopolistic sellers that control land supply and rely heavily on land sales for fiscal revenue (Liu, Fang, and Li 2014). Approximately one-third of local governments’ incomes from 2010 to 2012 arose from land sale revenues.

In light of the importance of land sale revenues for local governments, a puzzling fact of the Chinese land market is that land zoned for residential use sells for prices roughly ten times higher than land zoned for industrial use. We refer to this price gap as the “industrial land discount.” This begs the question of why local governments do not sell more residential land and less industrial land, until the marginal prices of the two kinds of land equalize.

The popular explanation for the industrial land discount is the non-pecuniary benefit (e.g., economic growth and employment) of supplying industrial land (Liu and Xiong 2020). We propose an alternative explanation for the industrial land discount, focusing on local public finance, namely, that local governments’ choice between industrial and residential land sales reflects an intertemporal revenue trade-off. Residential land sales generate higher upfront revenue. However, residential land is not taxed in China, so residential land sales do not generate future revenue flows. Industrial land sales generate substantially lower upfront revenues. However, industrial firms pay value-added taxes and income taxes in later years, so industrial land sales generate revenue in the future.

Are the tax revenues generated by industrial land sales large enough to make up for the difference in upfront sale revenues between industrial and residential land sales? To answer this question, we draw an analogy between local governments’ land sale decisions, and the classic theory of firm investment in corporate finance. The government’s decision to sell a parcel of land zoned as industrial, rather than residential, can be thought of as a project investment. The upfront cost of the investment is the industrial discount, and the future cash flows of the investment are the future tax revenues generated by industrial land sales. Given estimates of the industrial discount and the incremental tax revenues, we can define the government’s internal rate of return (IRR) on industrial land sales as the rate at which the government would need to discount cash flows to make the present value of cash flows from taxes exactly equal to the upfront costs.

We proceed to quantify these local government IRRs using comprehensive data on land sales in China from 2007 to 2019. We estimate industrial discounts by comparing prices of residential land parcels to industrial land parcels with similar characteristics, and vice versa. We estimate the incremental tax revenues generated by land sales using a differences-in-differences approach, comparing firms that purchased land to a set of control firms which did not. To address potential selection into which firms purchase land, we use control firms in the same industry and province and conduct propensity score matching based on previous sale growth and profit margin.

We find that from 2007 to 2010, the average industrial land discount is 1,176.4 RMB per square meter. Meanwhile, industrial land sales generate roughly 113.6 RMB per square meter in additional tax revenue in the first two years after the sale, and roughly 214.2 RMB per square meter in later years. This implies an IRR on industrial land sales of roughly 13.94%. This is a relatively high number; it is larger than most estimates of local governments’ costs of capital, which range from 3.5% to 7.5%.

Our findings thus suggest that revenue considerations alone can explain the large discount of industrial land, relative to residential land. In fact, our findings reverse the sign of the puzzle: if the returns from industrial land are much higher than local governments’ cost of capital, why don’t local governments sell more industrial land and less residential land?

Of course, land allocations in China are the outcome of a joint decision-making process between central and local governments, including quotas set by the Ministry of Housing and Urban-Rural Development; we discuss how this process is both top-down and bottom-up between different levels of government. In resolving the question of why more industrial land is not sold, we point to the unique incentives that affect local governments’ role in this allocation process. We build a simple model of the optimization problem facing a profit-maximizing local government deciding between industrial and residential land sales. We incorporate two realistic forces within the Chinese land market. First, local governments may have market power within land markets, so their marginal revenues from land sales may differ from prices, since their sales move overall prices. Second, local governments may not fully internalize the tax revenues from land sales, because approximately 75% of industrial tax revenues accrue directly to the central government, rather than to local governments (Wu and Zhou 2015). We find that tax sharing can plausibly explain why the IRR on land sales is so high, while market power—if anything—likely exacerbates the puzzle.

An important implication of our findings is that a local governments’ allocation decisions in the land market may be interlinked with those governments’ financial constraints, and with the tax sharing system between local and central governments. In fact, we show that these predictions hold empirically. Following a 2016 reform in the tax sharing system between local and central governments, cities that experienced a larger increase in tax share subsequently experienced greater increases in industrial discounts, suggesting that they respond by changing the relative amounts of industrial and residential land sold. Shocks to local governments’ bond yields are also associated with industrial discounts, in the direction predicted by our model.

Together, our results reverse the classic puzzle of relative prices in the Chinese land market. We find that industrial land sales in fact pay more, in present value terms, than residential land sales, when discounting tax revenues using local governments’ cost of capital. A plausible explanation for why local governments do not sell more industrial land is that they fail to internalize the entirety of the tax revenues generated by industrial land sales, a large share of which accrues to the central government. Our findings imply a novel inter-linkage between governments’ land sale decisions in China, tax sharing schemes, and local governments’ fiscal conditions, which are relevant for understanding how political economy and public finance interacts with allocative efficiency in the Chinese land market.


References

He, Zhiguo, Scott Nelson, Yang Su, Anthony Lee Zhang, and Fudong Zhang. 2022. “Is There an Industrial Land Discount in China? A Public Finance Perspective.” SSRN working paper. http://dx.doi.org/10.2139/ssrn.4030799.

Liu, Chang, and Wei Xiong. 2020. “China’s Real Estate Market.” In The Handbook of China’s Financial System, edited by Marlene Amstad, Guofeng Sun, and Wei Xiong, 183–207. Princeton, NJ: Princeton University Press.

Liu, Yansui, Fang Fang, and Yuheng Li. 2014. “Key Issues of Land Use in China and Implications for Policy Making,” Land Use Policy 40: 6–12. https://doi.org/10.1016/j.landusepol.2013.03.013.Liu, Yansui, Fang Fang, and Yuheng Li. 2014. “Key Issues of Land Use in China and Implications for Policy Making,” Land Use Policy 40: 6–12. https://doi.org/10.1016/j.landusepol.2013.03.013.

Wu, Min, and Li-An Zhou. 2015. “Tax Sharing Rates Among Sub-provincial Governments in China: Facts and Explanation.” Journal of Financial Research (in Chinese) 10: 64–80. https://caod.oriprobe.com/order.htm?id=47425286&ftext=base.


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