A little more than a year ago, following a months-long slump in auto sales in China, the Chinese government slashed the vehicle purchase tax from 10% to 5% for cars with small engines of 1.6 liters or less. This measure was extremely effective, instantly snapping China's auto market out of its funk. Through the first 11 months of 2016, industry sales have surged 16% year over year.

GM has capitalized on a temporary tax cut for small vehicles in China. Image source: General Motors.

However, the tax cut was scheduled to expire at the end of 2016. This situation has led to a lot of investor angst, as the expiration of the tax cut could cause Chinese auto sales to swoon again in 2017.

It looks as if that worrisome scenario won't come to pass. China has set the tax on small cars at 7.5% for 2017, as first reported by Bloomberg, rather than letting the rate snap all the way back to 10%. That's relatively good news for General Motors (NYSE:GM), which sells more vehicles in China than in any other market.

The Chinese market is getting tougher

China has been a key earnings driver for General Motors in recent years. Equity income from its joint ventures there has risen fairly steadily, from $1.2 billion in 2010 to $2.1 billion last year.

However, pricing pressure has become a major profit headwind in China. Automakers have added lots of production capacity in recent years to take advantage of China's economic growth and rising middle class. As auto demand has slowed, automakers (and dealers) have had to cut prices to keep sales growing.

GM has certainly felt this pressure. The company expects its China joint-venture income to decline slightly this year to around $2 billion, even though GM's retail deliveries in China increased 8.5% through the first 11 months of the year. But profitability in China would have been even worse this year without the temporary tax reduction.

How GM aims to keep profits steady

The coming increase in the small-vehicle purchase tax to 7.5% in 2017 may cause another slowdown in auto sales growth in China, as well as incremental pricing pressure. (Of course, there would have been far more damage if the tax rate had been allowed to rise to 10%, as originally planned.)

However, General Motors has several levers to offset sales and pricing pressure in China. First, it is working hard to reduce costs. Second, the General is benefiting from the growing popularity of SUVs, which are more profitable than sedans at all price points.

But third -- and most importantly -- GM's Cadillac luxury brand is gaining traction in China. Cadillac sales have grown at least 50% year over year for five consecutive months.

Cadillac sales in China have surged recently. Image source: General Motors.

A big tipping point was the opening of the first dedicated Cadillac plant in China back in January. This facility is allowing GM to avoid steep import taxes on the new CT6 and XT5 models, which are both produced there. By 2018, GM plans to build 95% of the Cadillacs sold in China locally.

Cadillac is also in the midst of an aggressive vehicle-launch cycle, which started with the CT6 and XT5 models. By building products that are on par with the luxury industry leaders, Cadillac should be able to earn similarly high margins, thus offsetting the pricing pressure GM faces for mass-market vehicles.

Politics is a wild card

Between rising demand for higher-margin Cadillacs and SUVs and the partial extension of the tax break for smaller vehicles, General Motors is well positioned to maintain its China equity income stream at around $2 billion in 2017. However, a U.S.-China trade war or a major diplomatic dispute could upend that calculus.

President-elect Donald Trump has promised to crack down on what he sees as unfair trade practices by China. He also offended many people in China recently by showing favor to Taiwan's president.

Both of these actions could contribute to a severe backlash against U.S. companies in China. A few years ago, a territorial dispute between Japan and China caused Japanese automakers' sales in China to plunge by about 40%. A similar backlash against GM and other U.S. automakers would decimate their profitability in China.

GM's business in China looks solid for now. But if U.S.-China relations continue to deteriorate, the outlook could become a lot worse in a hurry.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.