How to understand the restoration of value-added tax on government bonds, etc

Event: On August 1, the Ministry of Finance and the State Administration of Taxation announced that starting from August 8, 2025, interest income from newly issued national bonds, local government bonds, and financial bonds issued on or after that date will be subject to value-added tax (VAT). Interest income from national bonds, local government bonds, and financial bonds issued before that date (including portions issued after August 8, 2025) will continue to be exempt from VAT until the bonds mature.

This regulation has a significant impact on the bond market, and our comments are as follows:

First, how did the exemption from VAT for national bonds come about?

According to relevant tax policies, previously, financial institutions holding national bonds, local government bonds, and financial bonds could enjoy VAT exemptions on interest income. The specific rules are as follows.

According to the "Notice of the Ministry of Finance and the State Administration of Taxation on the Comprehensive Launch of the Pilot Program for the Transformation of Business Tax to Value-Added Tax" (Cai Shui [2016] No. 36) Appendix 1, the interest income obtained by taxpayers holding bonds falls within the taxable scope of VAT (classified as "loan services," generally taxed at 6%), but there are three types of differentiated treatments:

• National bonds and local government bonds are exempt: Interest income is explicitly exempt from VAT (Cai Shui [2016] No. 36 Appendix 3);
• Financial bonds are exempt: The interest income from policy and non-policy financial bonds, if held by financial institutions, can be included in "interest income from financial interbank transactions" to enjoy tax exemption (Cai Shui [2016] No. 46, 70);
• Corporate bonds are taxed: Regardless of whether the holder is a financial institution or a non-financial institution, their interest income is subject to VAT.

Second, what is the background for the introduction of this regulation?

The core is to unify the tax system, strengthen bond market construction, optimize the curve formation mechanism, and activate the market. The tax exemption has largely fulfilled its historical mission of expanding institutional investors, and the current demand group in the bond market continues to grow. However, some "distortions" arising from this need to be corrected. For example, the central bank's monetary policy implementation report previously mentioned: "Currently, the pricing efficiency of China's bond market, the trading and risk management capabilities of institutional bond investments still need to be improved... From the perspective of the tax system, the design of the bond market tax system will also affect the price formation of the bond market and the benchmark role of national bond interest rates. For instance, the interest income from national bonds and other government bonds is tax-exempt, public funds and wealth management products have tax reduction advantages in trading price differences, and short-term trading willingness will also be stronger. Some non-tax-exempt corporate bonds may benchmark against the interest rates of tax-exempt national bonds, further increasing short-term fluctuations in bond market yields."

An article from Xinhua News Agency also quoted experts saying, "Overall, this policy adjustment is an optimization measure introduced based on the current development stage of the bond market, which can narrow the tax burden differences between different bonds, better play the pricing benchmark role of the national bond yield curve, and promote the sustained and healthy development of the bond market and financial market."

We believe that fiscal pressure may also be one of the considerations, but it should not be the main purpose. This year, fiscal revenue continues to be under pressure, with general budget revenue in the first half of the year down 0.3% year-on-year, still 0.4 percentage points lower than the annual target (0.1%) The restoration of value-added tax is expected to increase a portion of fiscal revenue, but the amount is not large. From August to December this year, the total issuance of national bonds, local bonds, and financial bonds is estimated to be around 17 trillion yuan. Assuming an average issuance interest rate of 1.8% and uniform monthly issuance, the value-added tax rate is calculated at 6% for self-operated accounts, and it is expected to only increase tax revenue by about 5 billion yuan this year. In subsequent years, it is expected to increase by an average of 24 billion yuan in tax revenue. However, if the interest rates of newly issued varieties rise as a result, it will have a significant offsetting effect, a considerable part of which will still be reflected in the issuance costs, of course, manifested in different accounts.

Third, what impact does this regulation have on the valuation of newly issued bonds?

According to the latest regulations, financial institutions holding national bonds, local government bonds, and financial bonds issued after August 8, 2025, will have their interest income subject to value-added tax again. Specifically, ordinary self-operated accounts will pay a tax rate of 6%, while asset management products will be taxed at 3%. This difference arises from the provisions of Document No. 56 [2017] issued by the Ministry of Finance and the State Administration of Taxation, which stipulates that the taxable activities of value-added tax occurring during the operation of asset management products should temporarily apply a simplified tax calculation method, with a tax rate of 3%.

The impact of this regulation on the valuation of newly issued bonds and the spread between new and old bonds can be preliminarily assessed through static calculations. Taking a 10-year national bond as an example, if the coupon rate is 1.7%, self-operated accounts need to pay value-added tax at 6% (outside price tax), and the calculated impact is about 10 basis points (1.7%×6%/(1+6%)); for asset management products calculated at a 3% tax rate, the impact is about 5 basis points (1.7%×3%/(1+3%)). It is expected that the fluctuation range of the spread between new and old bonds will be 5-10 basis points. The specific impact on other maturities and bond types is detailed in the table below. It should be noted that if the coupon rate of bonds adjusts with market changes in the future, the calculation results of the spread between new and old bonds also need to be updated accordingly.

Fourth, what impact does this have on public funds?

The current core disagreement in the market focuses on two points: first, whether the tax exemption policy for public funds will also be adjusted; second, if taxation is imposed, whether the applicable tax rate will be 3% or 6%. From the policy basis, public funds previously enjoyed value-added tax exemption on interest income from national bonds, local bonds, and financial bonds, which is consistent with the legal basis for other asset management products and self-operated accounts, all stemming from Document No. 36 [2016], Document No. 46 [2016], and Document No. 70 [2016]. Therefore, the latest regulations have the same binding force on public funds as on other financial institutions, which means that the interest income from relevant bonds held by public funds will no longer enjoy tax exemption benefits. At the same time, since public funds fall under the category of "asset management products," they should be subject to a value-added tax rate of 3%.

It is worth noting that this move may further widen the tax gap between public funds (including other asset management products) and self-operated accounts in bond investments, with public funds (including other asset management products) benefiting relatively. Previously, the tax difference between the two mainly reflected in the income tax stage: self-operated accounts were required to pay income tax at a rate of 25% (covering interest income and capital gains), while public funds were exempt. Now, in the value-added tax stage for holding period interest income, self-operated accounts are subject to a tax rate of 6%, while public funds and other asset management products are subject to a tax rate of 3% The relative tax advantages of public funds are further highlighted.

Subsequent attention should be paid to whether there are adjustments to the tax regulations on bond income; if changes occur, the impact on the market may be more significant. The monetary policy report also pointed out that "public funds and wealth management products have a tax exemption advantage in trading price spreads," focusing on the adjustment of medium-term income tax.

Fifth, what impact does this have on the bond market?

First, there will be a 5-10bp interest rate spread between new and old government bonds. After August 8, the interest income from newly issued bonds will be subject to value-added tax, while previously issued old bonds will continue to enjoy tax exemption until maturity, which will directly push up the interest rate spread between new and old bonds (calculations show that the new bond - old bond spread may rise by 5-10BP). However, this spread change does not mean that the impact is "shared" equally between new and old bonds—i.e., the yield of new bonds rises by 5BP while the yield of old bonds falls by 5BP; rather, the yield of new bonds is expected to rise more than the yield of old bonds falls. The reason is that the new regulations impose a substantial cost increase on new bonds, leading to a decrease in their attractiveness, and the upward pressure on yields should be stronger, while the yield decline of old bonds is more due to price comparison effects and institutional behavior (such as proprietary funds subscribing to public bond funds).

The bond market's reaction to this news has been very dramatic. First, interest rates rose as the market worried that the tax increase would lead to higher compensation through interest rates; second, interest rates fell as the market began to interpret the advantages of old bonds and the expansion effect of public bond funds; third, market sentiment began to stabilize. In fact, the actual impact of this policy on old bonds is minimal, and the large fluctuations are an overreaction.

Second, the credit spread of ordinary credit bonds has narrowed. The income tax on credit bond interest remains unchanged, while other bond types have increased; newly issued credit bonds will benefit relatively, leading to a compression of spreads of about 5-10BP compared to other bond types.

Third, the market's enthusiasm for "bond swapping" has diminished. Considering that newly issued government bonds and financial bonds after August 8 will be subject to a 3% value-added tax, market trading enthusiasm for new bonds may experience a temporary decline, which may affect the pace of bond swapping.

Fourth, for government bond futures, there will be a rebound after the market opens next Monday. However, as newly issued government bonds become the cheapest-to-deliver (CTD) bonds for government bond futures, considering that the yields of new bonds are significantly higher than those of old bonds, this may lead to a decline in government bond futures prices, especially for longer-dated contracts.

Fifth, under the assumptions of new classical theory, if the government decides to impose a tax on a certain commodity, the tax burden is essentially borne by both buyers and sellers, with the party that is less elastic bearing a larger share of the tax burden. From the perspective of major asset classes, the current level of bond yields is already relatively low, and an increase in taxes will further reduce the relative cost-effectiveness of assets, which is relatively favorable for the stock market from an opportunity cost perspective, especially for dividend stocks and similar bond-like stocks, although the extent is limited.

Authors of this article: Zhang Jiqiang, Qiu Wenzhu, Wu Yuhang, Source: HTSC, Original title: "How to Understand the Restoration of Value-Added Tax on Government Bonds and Others"

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