The "Local Surcharge Tax" reform is about to begin: How will the new trillion-yuan-level tax be established?

How can the reform of local surcharges avoid vicious competition among regions?

In order to address local financial difficulties, the central government plans to further develop the new local tax category—local surcharges.

The recently published “Report on the Implementation of the 2025 Central and Local Budgets and the Draft 2026 Central and Local Budgets” (hereinafter referred to as the “Budget Report”) emphasizes the need to improve the local tax system, expand local tax sources, and promote the reform of local surcharges as part of this year’s deepening fiscal and tax system reforms.

Currently, China does not have local surcharges; it is a new tax category still under research. The 20th Party Congress held in July 2024 first proposed studying the merger of the urban maintenance and construction tax, education surcharge, and local education surcharge (i.e., one tax and two fees) into a local surcharge, authorizing local authorities to determine specific applicable tax rates within a certain range.

Professor Liu Jindong, Vice Dean of the School of Finance and Taxation at Shandong University of Finance and Economics, is focused on the reform of local surcharges. He told Yicai that the clear requirement in the Budget Report to promote local surcharge reform signals the important initiation of this reform. While the reform of local surcharges appears simple—since “one tax and two fees” already exist—merging them directly is akin to “putting old wine in a new bottle.” In reality, local surcharges involve changes in the tax base, adjustments to tax rates, and coordination of other supporting measures, which is not a straightforward “merger,” and this reform will not happen overnight; it needs to be gradually advanced during the 14th Five-Year Plan period.

Numerous Challenges in Reform

Since the comprehensive implementation of the value-added tax replacing the business tax in 2016, the traditional main tax—business tax—has exited the stage of history. Although increasing the proportion of shared VAT revenue between central and local governments has maintained local fiscal stability, localities have lost their main tax base. Coupled with economic downturns, sluggish real estate prices, foreign trade shocks, and tax cuts and fee reductions, the contradictions in local fiscal revenue and expenditure have intensified.

To solve local fiscal difficulties, increase local fiscal autonomy, and expand local tax sources, the central government proposed the concept of local surcharges. The related statements in this year’s Budget Report indicate that the establishment of local surcharges is progressing steadily.

Professor Wang Yongjun from Central University of Finance and Economics told Yicai that compared to shared tax revenue and central transfer payments, local surcharges have unique advantages. They ensure that local governments can fairly and stably share large liquid tax bases (such as VAT) with the central government. They also grant local governments guaranteed, necessary, and critical autonomy in choosing tax rates, which is closely related to local expenditure autonomy and budget independence.

Luo Zhiheng, Chief Economist at Yuekai Securities, previously told Yicai that local surcharges can enhance local fiscal autonomy and motivate local enthusiasm. Additionally, converting the long-standing education surcharge collected as fees into a local surcharge simplifies the tax system, facilitates collection and management, improves taxpayer compliance, and helps stabilize local fiscal revenues.

The central decision to merge “one tax and two fees” into a local surcharge is related to their similarities. Currently, the urban maintenance and construction tax, education surcharge, and local education surcharge share the same taxable entities—units and individuals paying VAT and consumption tax—and the same tax bases, based on the actual VAT and consumption tax paid.

Of course, “one tax and two fees” also differ.

For example, the urban construction tax is a tax, whereas the education surcharge and local education surcharge are not taxes; they are government fees and belong to non-tax revenue. Merging these three involves transforming “two fees” into taxes. Moreover, the tax rates or fee rates of “one tax and two fees” are not uniform, and their collection purposes differ.

According to data from the Ministry of Finance, the urban maintenance and construction tax revenue in 2025 is projected to be 517 billion yuan, an increase of 2.9% over the previous year. Currently, the official scale of education surcharge and local education surcharge has not been disclosed. However, both “two fees” are based on VAT and consumption tax, taxed collectively at a rate of 5%. Data from the Ministry of Finance indicates that in 2025, domestic VAT and domestic consumption tax revenues are estimated to total 8.5804 trillion yuan; applying the 5% rate, the combined revenue of “two fees” is approximately 429 billion yuan. Theoretically, the revenue scale of “one tax and two fees” is close to 1 trillion yuan.

Like all taxes, the future establishment of local surcharges depends on defining core factors such as the purpose of taxation, taxable entities, tax bases, tax rates, preferential policies, and tax administration. This requires considering multiple factors, including controllability of tax collection, tax burden capacity, stability of local fiscal revenue, and optimization of fiscal relations between central and local governments.

Liu Jindong stated that in the future, allowing local governments to determine specific applicable tax rates for local surcharges within a certain range could lead to complex impacts. For example, local governments might engage in traditional “bottom competition” to attract investment by lowering surcharge rates, which could cause a Matthew effect—where economically developed regions become richer and less developed regions fall further behind—since only economically advanced areas can bear lower surcharge rates.

He explained that local surcharges are a type of benefit tax; wealthier regions with high economic agglomeration benefit more, with higher objective tax capacity and subjective willingness to pay, forming a “tax rent” effect. Conversely, less developed regions cannot sustain high tax burdens, and local governments cannot afford many tax incentives, making them appear strained compared to wealthier areas.

Additionally, Liu Jindong pointed out that establishing local surcharges is just one part of the overall tax system reform. It must be coordinated with other reforms, such as the reform of consumption tax. Moving certain consumption tax items to the wholesale and retail stages will expand the tax base for local surcharges, and the VAT deduction chain will be continuously adjusted and optimized, which will also lead to changes in the surcharge tax base.

“Therefore, after the simple ‘three-in-one’ merger of local surcharges, ongoing optimization and adjustments are expected. The goal is to expand the surcharge scale to fulfill its role as a supplementary fiscal resource, while also regulating and tightening potential negative effects,” Liu Jindong said.

Tax Rate Setting is Critical

Because “one tax and two fees” share the same taxable entities and tax bases, some experts believe that the future local surcharge will likely continue to use the previous scope and bases for taxation. However, how to set the tax rates reasonably remains a key issue.

Liu Jindong and other scholars estimated in the journal “Tax Research” that if local surcharges are based on the total domestic VAT and consumption tax revenues, calculating with tax rates of 10%, 12%, 15%, 17%, and 20%, they found that when the rate reaches 20%, the scale of local surcharges in 2023 and 2024 could exceed 1.65 trillion yuan. This would surpass the local share of corporate income tax revenue during the same period and be second only to the local VAT share, indicating that the reform of local surcharges could play a crucial role in reshaping local fiscal power.

Liu Jindong suggested that in the future, the central government should set a range for local surcharge rates, within which local governments can determine specific rates and submit them for approval by the local people’s congress. Meanwhile, the central government should establish a comprehensive evaluation system based on local fiscal gaps, future expenditure plans, and the level of economic agglomeration, to guide local rate-setting more accurately.

“Such measures can prevent local governments with small fiscal gaps, low public expenditure needs, and low economic agglomeration from setting excessively high rates that lead to over-taxation; they can also prevent highly agglomerated regions from setting too low rates, which would cause revenue loss and regional ‘involution’ competition for investment, thus maintaining healthy and orderly macroeconomic operation,” Liu Jindong said.

Implementing local surcharges is a current measure to increase local fiscal autonomy and alleviate local financial difficulties. Besides, reforms such as allocating some consumption tax revenues to local governments, optimizing the sharing ratio of shared taxes, and increasing general transfer payments are also important steps to enhance local fiscal capacity.

Liu Jindong believes that while the introduction of local surcharges will directly increase local fiscal revenue, it is not sufficient to be the main source of local finances. Its primary role is to strengthen scientific fiscal management, ensuring healthier fiscal operations in the future.

He also pointed out that, given that enterprises are the main taxpayers in China’s tax system, local surcharges should mainly be limited to productive uses benefiting enterprises, such as urban infrastructure construction, employee training subsidies, and digital vocational skills training. This approach can improve taxpayer compliance, create a virtuous cycle of fiscal revenues and expenditures, and ensure the sustainability of local fiscal resources. In the future, it may be appropriate to moderately expand the surcharge scale while continuously reducing unreasonable enterprise-related fees, thereby creating a fairer, more transparent, and predictable business environment.

(This article is from Yicai)