China faces big decisions as it reforms its taxes

CHINA’s taxation system has developed rapidly in the 35 years of transition from state-controlled to market economy. But it remains a work in progress, writes World Review guest expert Ken Davies. The government needs to raise more revenue to support higher social spending while allowing more breathing room for private enterprise and consumers. During the period of centrally-planned economy up to 1978, payments to workers and farmers were so small that there was no point in taxing them. 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. China’s tax system is now comparable with those in developed economies. Revenues have grown at least as fast as GDP every year since the mid-1990s. Industrialisation has shifted resources from low-tax agriculture to higher-tax sectors such as manufacturing, construction and services. A major difference between China and other economies is the composition of taxes. The China Statistical Yearbook 2013 shows that individual income tax comprised only 5.8 per cent of total tax revenue in 2012. Corporate income tax, though, provides a larger share of revenue in China – 19.5 per cent in 2012 – than elsewhere. More than half of the nation’s tax revenue is provided by direct taxes, mainly on goods and services and on property. Taxation is levied by the central government 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 attractiveness of direct taxes is that they are more certain, but paying it has not yet become ingrained among wage and salary earners, or indeed companies. There are extra opportunities for tax evasion for individuals with enough money to travel or move their money abroad. China, like the United States, but unlike Hong Kong, levies tax on worldwide income. In the 1980s Beijing introduced fiscal incentives to attract foreign direct investment (FDI). These were abolished for new entrants at the beginning of 2008. Sweeteners were originally offered to compensate foreign investors for poor infrastructure and the lack of an institutional framework for investment, which have gradually been remedied. China has also made strenuous efforts to reform its internal tax system in line with international practice. The most prominent example is VAT. When 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. In the past five years, there have been gradual moves towards transforming it into a consumption-type, destination-based tax applying to a wide variety of goods and services. 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. This would be a major change: currently, unlike 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. 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. It would fit in with the renewed FDI liberalisation heralded in 2013 with the establishment of the Shanghai Pilot Free Trade Zone. The authorities could increase tax compliance by compulsory deduction at source for wage and salary earners, and compulsory corporate disclosure, to make evasion by companies more transparent. China could make much more use of taxation to support its ambitious environmental strategy. As it opens several coal-fired power stations each month, it may have to deploy much higher taxes on fossil fuels to reduce carbon emissions. 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. On the other hand, tax benefits to encourage high-tech and ‘green’ investment may be increased in line with the country’s move towards technology-intensive industry and as a component of its environmental policies.

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