Headlines flashed last week as the U.S. Commerce Department finalized guardrails limiting expansion in China by companies receiving subsidies under the 2022 CHIPS and Science Act. Less widely covered, however, was China’s latest round of semiconductor incentives, upping the ante in its effort to reduce reliance on U.S.-controlled technology.
With China already boasting chip subsidies worth at least $150 billion in 2022, on September 19 China’s Ministry of Finance further upgraded the country’s tax credit for investments in semiconductor R&D by 20 percent. This new subsidy comes in the face of U.S. export controls, issued in October 2022 and rumored to be strengthened in late 2023. These restrictions have left Chinese policymakers scrambling for alternatives to advanced U.S.-controlled computer technology. These export controls, as well as the recently finalized guardrails prohibiting chipmakers receiving U.S. subsidies from expanding in China for 10 years, leave Beijing to plan for an economy receiving limited support from foreign chipmakers.
As Nicholas Mulder argued in his 2022 book “The Economic Weapon: The Rise of Sanctions as a Tool of Modern War,” countries facing sanctions often learn to adapt their economies, either by finding new trading partners or by “home-shoring” supply chains. Some industry leaders in China do not agree that it is advisable or even possible to develop an all-domestic chip ecosystem.
Nonetheless, some Chinese policymakers have been more aggressive about domesticating the chip supply chain, branding such policies as part of Chinese President and CCP General Secretary Xi Jinping’s “dual circulation” policy, which seeks reduced dependence on foreign markets. The September upgrade to China’s semiconductor R&D tax credit is the latest sign of a country adapting – and maybe even evolving – under U.S. pressure.
A Long Way to Self-Sufficiency
As U.S. Secretary of Commerce Gina Raimondo visited China in late August, Chinese smartphone maker Huawei released the Mate 60 Pro. To the surprise of U.S. officials, the new Huawei phone featured a chip capable of 5G communications that was allegedly designed and manufactured by China’s semiconductor champion, SMIC. Whether or not SMIC is capable of commercially producing such chips at 7-nanometer process technology, American officials (especially Republican members of Congress) are anxious that Beijing may be close to catching up technologically to the U.S.-led coalition of advanced semiconductor economies.
Rigorous analysis of the chip industry paints a much bleaker reality for China, however. Although China relies heavily on semiconductor imports, accounting for 24 percent of global chip demand, it only contributes 9 percent of the global value-add in developing and producing this technology. China’s General Administration of Customs highlighted that in the first three quarters of 2023, China imported more than $2 billion in chips but exported only $110 million worth of semiconductors, leaving it with a massive trade deficit in this critical technology. In fact, the only stage of the semiconductor supply chain where China commands the largest global share, chip assembly and packaging at 38 percent, is the industry’s lowest value-add step.
Chinese policymakers are increasingly anxious to close this technology gap by subsidizing chip R&D and manufacturing, but key Communist Party officials note that the country’s semiconductor subsidies are too unaligned to effectively face this national challenge. Some 66 percent of China’s semiconductor subsidies come from local governments and only 34 percent from the central government. These provincial and municipal semiconductor investment funds are primarily concerned with promoting economic activity, so many do not consider national supply chain needs when issuing incentives.
Recognizing this reality, a proposal made at this spring’s annual session of the Chinese People’s Political Consultative Conference urged national-level policymakers to align China’s various semiconductor development efforts into “one chessboard,” meaning a single national strategy.
Buying Freedom from Semiconductor Chokepoints
In response to growing economic pressure from the United States, Xi Jinping has stressed that mitigating chokepoints, technologies where China is reliant on foreign providers, should be a pillar of China’s national science policies. In September 2022, he announced the New Whole Nation System (新型举国体制), aimed at making China self-reliant in national security-critical technologies by way of large new central government incentives.
While local government subsidies still represent the lion’s share of Chinese chip subsidies, last week’s R&D tax credit bump is the latest in a series of tax policies that have increased Beijing policymakers’ weight in incentivizing chip companies. A 2020 State Council policy excuses corporate income tax for the initial five years of a semiconductor project and levies a reduced rate of 50 percent in the following years. More generally, in 1996, China first introduced a credit allowing companies to deduct 50 percent of their R&D spending from taxable income. China’s State Council raised this general R&D credit to 75 percent in 2016, then again to 100 percent in March 2023. The tax credit hike from March also created a massive new 200 percent credit bracket for R&D activities that result in patents.
Last week’s announcement builds on the 100 percent and 200 percent general R&D credits by adding a special sweetener for the semiconductor industry. Research expenses in chip technology that do not result in patents qualify for an additional deduction of 120 percent of their taxable income. (This equation of the 100 percent general deduction plus 120 percent semiconductor deduction results in a 220 percent deduction for non-patent producing chip R&D.) Research expenses in chip technology that do result in patents qualify for a deduction of 220 percent of their taxable income. However, the announcement did not specify whether this deduction is on top of the existing 200 percent bracket or not (to make 420 percent), and the authoritative ministerial document on which the announcement is based is not readily available.
Notably, the new semiconductor tax credits do not totally exclude outsourced foreign research from the deduction. So long as outsourced research does not exceed two-thirds of the total cost of research, companies can claim 80 percent of their foreign research expenses in the new deduction. This inclusion suggests that China’s policymakers are focused on increasing the long-term technological capabilities of Chinese companies, regardless of where that know-how originates. It reflects a mature industrial policy, devoid of short-term protection.
Who Will Carry the Subsidy Torch?
China’s R&D tax credits have long served to catalyze its overall innovation ecosystem. At the behest of Xi Jinping’s call to mitigate key technological chokepoints, however, policymakers are increasingly concentrating their efforts on semiconductors and other key industries. Tools like this semiconductor R&D tax credit will increase the pressure on domestic champions to usher in China’s bid to catch up with the West.
Two chipmakers will likely claim large deductions from the program. Huahong Semiconductor is China’s leading chipmaker focused on mature nodes (semiconductors with production process between 1 micron and 28 nanometers). A pure-play foundry, Huahong is key to China’s “digitization through greenification” efforts by producing chips for electric vehicles, smart grids, and the Internet of Things.
Closer to the cutting-edge, Semiconductor Manufacturing International Corporation (SMIC) is China’s advanced chipmaking champion, as well as the subject of intrigue amidst Huawei’s Mate 60 announcement. SMIC manufactures chips for applications ranging from telecommunications to advanced logic, and its production process ranges from 28 nanometers to nodes theoretically as advanced as 7 nanometers. SMIC is key to developing China’s domestic advanced chip capacity as U.S. restrictions increasingly cut China off from leading American and allied chipmakers.
Semiconductor toolmakers are also key to the sustainability of China’s increasingly decoupled chipmaking industry, and U.S. trade restrictions are spurring a repeat of the industrial realignments recounted in Mulder’s “The Economic Weapon.” Naura Technology Group, Advanced Micro-Fabrication Equipment, and U.S.-sanctioned Shanghai Micro Electronics Equipment were among the over 300 companies attending Wuxi’s 2023 China Semiconductor Equipment Annual Conference. At the event, one industry official quipped that U.S. export controls have made downstream Chinese electronics makers more willing to buy tools from domestic equipment companies, as well as to offer them venture funding.
Beijing is eager to further encourage these toolmakers’ investments in R&D because China is particularly reliant on foreign advanced manufacturing technology, with only 10 percent of “high-end machine tools” being domestically developed. As the United States has convinced the Dutch and Japanese governments to limit semiconductor manufacturing equipment exports to China, Beijing hopes to develop domestic alternatives to the likes of ASML and Tokyo Electron Limited.
Not Just What is Possible, But What Beijing Thinks is Possible
China is nowhere near its “Made in China 2025” goal of fulfilling 70 percent of its own semiconductor demand. The country not only still has a massive chip trade deficit, but its leading chip equipment makers are also at least four years behind their foreign counterparts.
Regardless, Beijing is investing billions of dollars into developing domestic alternatives to foreign semiconductors and manufacturing equipment. For policymakers in Washington in particular, it is perhaps less important to ask whether China’s semiconductor industry will ultimately succeed in catching up with the West’s and more important to ask whether Beijing thinks it can catch up. Each additional piece of semiconductor technology the U.S. subjects to export controls is an additional technology Beijing will attempt to make at home, pitting U.S. export controls and “fences” against Chinese subsidies and tax credits.