China Plans 100% Tax on €11 Billion European Luxury Goods: China-Europe Trade War on the Verge of Eruption!

Few western business leaders have attracted as much attention in China as Bernard Arnault. The 75-year-old CEO of LVMH, who is worth $340 billion, frequently interacts with top government officials and became a hot topic on Chinese social media platforms during a whirlwind visit in June 2023. Still, the French luxury giant could be caught in the middle of ongoing tensions between China and the European Union.

The European Union has raised tensions with Beijing by proposing additional tariffs on Chinese-made electric cars, which it argues are too cheap due to state subsidies. Before the vote by EU member states, the EU's proposal to impose additional tariffs of up to 38 percent on Chinese-made electric vehicles would take effect over the next five years by November at the latest. Since the Commission first proposed new tariffs in June, the question has been how and whether China would respond.

Europe is a strategically important market for China in the face of a more hostile US. China has launched anti-dumping investigations into European brandy, pork and dairy products, but has not imposed any additional duties. In addition, in 2023, the total import value of new labels for these goods will be only 6 billion euros ($7 billion). By comparison, the European Union aims to export nearly 10 billion euros worth of battery-powered electric vehicles from China to the EU last year.

Europe's politicians may also cave. Spanish Prime Minister Pedro Sanchez reversed his stance this month and advocated lenient tariffs on Chinese-made electric cars.

His country had supported a tough approach until its 1.5 billion euro pork exports to China were under threat. If other governments, such as Italy, follow suit, tariffs could be reduced. However, the ball is firmly in Beijing's court, and some form of counterattack may already be brewing. European imports of luxury goods, including bags, perfumes, jewelry, shoes, suits and other clothing, were worth 11 billion euros in 2023. These goods fit China's requirements for retaliation for a number of reasons.

Unlike medicine, manufacturing and aircraft imports, luxury goods are far from essential to China's productivity. As with French cognac, overpriced status symbols don't carry as much cachet in China's current economic woes.

If their prices rise further, the number of angry buyers will be limited: the wealthiest 2% of customers typically account for about 40% of luxury sales, according to Bain & Co. The second factor is internal dynamics in Europe.

Unlike Germany, which still sees China as an important part of its auto market and trades with China for essential goods such as chemicals. France has been a vocal supporter of European tariffs on electric vehicles. France, along with Spain and Italy, is a major exporter of luxury goods, such as Christian Dior handbags, which can be worth up to $10,000. According to the European Union, a third of the $5 billion worth of leather and plastic handbags exported to China last year originated in France. LVMH as a French icon, according to a study by consulting firm aster, its 24 billion euros of fashion exports accounted for 4 percent of France's total exports in 2023, contributing to a new growth point for French exports.

The main challenge for the luxury sector is the complexity of its tariff policies. Since joining the World Trade Organization (WTO) in 2001, China has gradually reduced tariffs. According to Chinese customs brokers, handbags imported from the European Union are only subject to a 6 percent tariff when imported into China. However, anti-dumping investigations into high-end brands such as Balenciaga bags, and a possible surge in tariffs, could put China in breach of WTO rules. Still, only six of the 15 categories of "consumption tax" levied in China fall into the luxury category, including high-end watches, cosmetics, jewellery, yachts, golf equipment and sports cars. These goods are taxed at different rates on top of the standard VAT of 13%. For example, watches worth more than 10,000 yuan are subject to a 20 percent tax, while diamonds are subject to an additional 5 percent tax.

Extending the GST to LVMH's products, such as leather bags, would be relatively easy to implement. At present, these taxes are mainly collected by Chinese customs directly upon arrival of goods, but some are also collected at the point of sale. Either way, the logistical challenge of collecting taxes should be relatively small, as luxury goods are mostly sold in physical stores, while companies such as LVMH typically keep detailed customer records and receipts are often necessary to provide customer service. The idea is supported by local experts. Zhao Hongwei, a senior researcher at the Chongyang Institute for Financial Studies at Renmin University of China, suggested that China should impose a 100 percent luxury tax as a warning to the EU. Since it is not a tariff, such a targeted sales tax would not violate trade rules, and it is also in line with the Chinese government's broader trend of promoting domestic tax reform. Local governments urgently need new sources of revenue to pay off infrastructure debt, as the crisis in the property market has curtailed their ability to generate major revenue from land sales. In addition, Japan has introduced six consumption taxes to "promote wealth redistribution."

China's move could have a negative impact on luxury goods companies such as LVMH and Kering. Although neither company discloses its sales in China, the country accounts for most of their sales in Asia, excluding Japan, which will account for about a third of both companies' global revenues by 2023. While luxury groups want to pass on cost increases to Chinese consumers, it is harder to raise prices amid a prolonged economic downturn. Analysts at Bank of America predict that most luxury companies will have to choose to raise prices significantly.

One potential risk of the plan is that a luxury tax could prompt more Chinese consumers to choose to buy luxury goods overseas. In Japan, for example, a surge in the number of Chinese tourists and a weak yen led LVMH to increase sales by 57 percent in the three months to the end of June. Even then, however, things could still be worse than the status quo: Prices in Japan are on average 12% lower than in China, according to analysts at J.P. Morgan, while costs such as labor are higher in Japan.

Mr Arnault does not have to be a victim of a Sino-European trade war. This is more straightforward, both politically and practically, than some of the other possible responses.