by Ken Davies
CHINA’s taxation system has developed rapidly in the past three and a half decades of transition from state-controlled to market economy, like the nation’s other economic institutions. But it remains a work in progress.
The government needs to raise more revenue to support higher social spending while simultaneously allowing more breathing room for private enterprise and consumers. The main item on its fiscal agenda is continuing reform of value-added tax (VAT), but several other changes are needed.
Taxes were unimportant during the period of centrally-planned economy from 1953 to 1978. The government owned industry and controlled collective agriculture. Factories remitted their earnings to the state, which requisitioned grain from farms.
The residue paid to workers and farmers was so small that there was no point in taxing it. Communist China had no individual income tax before 1980.
The current system was established in the next two decades. The corporatisation of state-owned industry, plus the return of family farming, removed regular sources of government income, necessitating the introduction of enterprise taxes. Increases in personal earnings made income tax feasible.
The authorities also needed to diversify their macroeconomic management tools. With financial markets not yet sophisticated enough to allow an effective monetary policy, the government remained dependent on crude central-planning implements.
Party leaders blue-pencilled infrastructure projects when hyperinflation threatened in the late 1980s. By 2008-2009, faced with a global crisis, they were able to unleash fiscal stimulus to support the bringing forward of major projects.
There was rough equality under Mao Zedong, who ruled from 1949 -1976: all were poor. Inequality has increased dramatically in recent years as the economy has grown rapidly.
Although this was foreseen, the regime now fears it may endanger ‘social stability’ ie Communist rule. Taxation can clearly play an important role in narrowing the income gap.
China’s tax system is now comparable to those in developed economies. Revenue, strictly defined, is approximately a fifth of GDP, slightly lower than in the United States and just over half the ratio in Denmark, with its developed welfare state.
Among the emerging economic nations of the BRICs group, China’s ratio is lower than Brazil’s and Russia’s, but higher than India’s. It is way above the ratios in Hong Kong, Singapore and Taiwan.
The ratio of total government revenue to GDP is lower than in the Mao period, at the end of which it stood at just under one-third. It fell during the first half of the reform period and has since risen markedly.
Tax revenues have grown as fast as, or much faster than, GDP every year since the mid-1990s. A major factor behind this surge has been high economic growth, coupled with fairly high inflation, which entails fiscal drag.
Industrialisation has shifted resources from low-tax agriculture to higher-tax sectors: manufacturing, construction and services.
Reforms have also increased the tax take. In addition, some revenue-generating activities such as property speculation and trade, that do not necessarily boost GDP, have flourished.
A major difference between China and other economies is the composition of taxes. According to the latest available figures, in the China Statistical Yearbook 2013, individual income tax comprised only 5.8 per cent of total tax revenue in 2012.
In the same year, federal income tax in the US was 56 per cent of federal revenue. Social security payments and payroll taxes are also rather lower in China.
Corporate income tax, though, provides a larger share of revenue there – 19.5 per cent in 2012 – than elsewhere. Direct taxes as a whole contribute less than 40 per cent of revenue, compared with more than 60 per cent in countries in the Organisation for Economic Cooperation and Development (OECD).
So more than half of the nation’s tax revenue is provided by direct taxes, mainly on goods and services and on property. In 2012, VAT accounted for 26.3 per cent of total taxation, domestic consumption tax for 7.8 per cent and import tariffs 2.8 per cent. Property taxes of various kinds bring in around seven per cent of the total.
China is a unitary state, even though several of its provinces are larger than the average country. Taxation is levied by the central government, albeit through local offices, and some of it is then disbursed to local governments.
The result is that Beijing disposes of more than half of total national tax revenue. The distribution of tax revenue matters, since inter-and intra-regional inequality is a major dimension of economic inequality.
China’s current structure of taxation is regressive, imposing similar levies on taxpayers through consumption tax and VAT, regardless of ability to pay. This is not wholly accidental.
The attractiveness of direct taxes is that they are more certain. Partly because income tax is a recent innovation, the habit of paying it has not yet become ingrained among wage and salary earners, or indeed among companies.
There are extra opportunities for tax evasion for individuals with enough money to travel or move their money abroad in other ways. China, like the US but unlike Hong Kong, levies tax on worldwide income, and those liable to such taxation have developed a range of transactions to conceal or minimise overseas earnings.
When individual income tax was first introduced, it had a disproportionately heavy impact on foreign employees, such as managers of foreign-invested companies, simply because they earned so much more than locals.
At that time, even fewer Chinese earned enough to pay tax than do so now. Officials enjoyed a relatively high standard of living, but mainly through benefits of office which made up for low salaries. The differential incidence of income tax between foreigners and locals has since narrowed as wages have risen.
In the 1980s Beijing introduced fiscal incentives to attract foreign direct investment (FDI). Overseas companies enjoyed an initial tax holiday and an enterprise income tax rate about half that paid by domestic enterprises. These incentives were abolished for new entrants at the beginning of 2008.
Incentives were originally offered to compensate foreign investors for poor infrastructure and the lack of an institutional framework for investment. This rationale lost validity as China remedied these deficiencies.
By the 2000s, FDI had come to be no longer regarded as good for development, more as part of the curse of over-investment. Successful domestic enterprises complained of tax discrimination in favour of foreign investors, whom they accused also of monopolising whole sectors, crowding out domestic firms.
As well as abolishing FDI tax incentives, China has made strenuous efforts to reform its internal tax system in line with international practice.
The most prominent example is VAT. When this was introduced in 1984, it was a production-based tax, designed on the basis of central planning, and applied solely to goods and a few services. Its effect has been more like that of an indiscriminate turnover tax, with few deductions available.
In the past five years, there have been gradual moves towards transforming VAT into a consumption-type, destination-based tax applying to a wide variety of goods and services, with a greater availability of deductions and refunds for inputs.
This reform is, however, still far from complete. And there are more strategic choices to be made.
China could upgrade to a developed-country personal income tax aimed at spreading the tax burden and redistributing income. Brackets would have to be set low enough to bring in most workers – at present, most do not earn enough to pay tax.
If effective, this would be a major change: currently, in sharp contrast to most other countries, personal income tax has an almost zero redistributive effect in China.
Alternatively, Beijing might prefer to follow the Hong Kong/Singapore model, in which most people pay no income tax and those who do contribute only a small proportion, typically 15 per cent, of total income.
A similar choice is available with regard to business taxation. A Hong Kong/Singapore rate of enterprise income tax ie around 17 per cent would initially bring in less revenue, but might encourage fuller disclosure and therefore more regular payment.
This could be coupled with increased offsets to fixed investment, provided it was not felt to countermand the policy of reorienting the economy from investment-to consumption-driven. Such a policy would fit in with the renewed FDI liberalisation heralded in 2013 with the establishment of the Shanghai Pilot Free Trade Zone, as it would reduce the corporate tax burden without restoring discriminatory fiscal incentives.
The authorities could increase tax compliance by compulsory deduction at source for wage and salary earners, and compulsory corporate disclosure, to make tax evasion by companies more transparent.
The division of revenue between central and local government may not be appropriate now that some provinces have GDPs commensurate with those of medium-sized developed country economies, and in which local tax revenues are bound to sink as reforms bite.
One solution would be to grant tax-and-spend powers to the provinces similar to those available to states in a federal system such as the United States. If the nation’s rulers do not trust provincial governments, though, it might instead make sense to establish a stronger central revenue distribution mechanism.
China could make much more use of taxation to support its ambitious environmental strategy. As it opens several coal-fired power stations and builds millions of new cars each month, it may have to deploy much higher taxes on fossil fuels to reduce carbon emissions.
At present, the rates are much lower than in other countries. Total environmentally-related taxes amount to less than 1.5 per cent of GDP as compared, for example, with nearly three per cent in South Korea and nearly four per cent in Turkey.
There may be changes in the pattern of stimulus for investment. Although fiscal incentives to attract foreign investment were abandoned in 2008, a complex system of incentives remains to support China’s industry and regional development policies.
These benefit both Chinese and foreign companies and many are large enough to have a significant impact on after-tax rates of return, so companies currently eligible for them must take account of the incentive-loss risk over the medium term.
Corporate income tax is reduced to 15 per cent – half the normal rate – for investments in the Western Region until the end of 2020. Whether this is extended will depend on how successful the central government is in promoting economic take-off in these inland provinces.
A thriving West will eventually become a fertile source of tax revenue instead of a region receiving development assistance. When this happens depends on both national and local economic factors.
Sectoral incentives may also change. Tax holidays for infrastructure investment may be at risk in the medium term as the authorities strive to restructure the economy away from fixed investment and towards consumption.
If it slows further, however, they may be retained, even ramped up, as a means of renewed stimulus to maintain employment. On the other hand, tax benefits to encourage high-tech and ‘green’ investment, for example, in energy-saving enterprises, may be increased and their scope expanded in line with the country’s move towards technology-intensive rather than labour-intensive industry and as a component of its environmental policies.
There has recently been a spate of legal actions against foreign-invested enterprises in China, including prosecutions for corruption and anti-trust judgments.
Some business people see these as part of a coordinated effort to attack overseas companies. Given that the cases are evidence-based, this charge may be unfair or irrelevant, but there is no doubt that the government no longer needs to do foreign investors any favours: China is suffering from over, not under-investment.
Foreign companies present high-profile targets for tax inspections and need to be doubly diligent in ensuring tax compliance.
At the moment, the Chinese Communist Party is cracking down on corruption and extravagant spending by officials. If it switches to a concerted campaign against tax avoidance and evasion, expect foreign businesses to be in the crosshairs, even more than at present.
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