indistinguishable from equalization transfers. Shared revenue seldom qualifies as own-revenues in the sense described above, in that local governments cannot raise additional revenues, if needed, using this source, although revenue sharing is important in closing vertical imbalances.
At the other extreme, local governments may have full control over rates and bases. This is the case for property taxation in most countries, although the rates may be subject to upper and lower bounds to prevent a “race to the bottom.”
There is a considerable debate as to whether the share of the VAT should be considered as a subnational own-tax in the sense described above. Much of the discussion relates to ease of administration. In countries where the constitution permits them to do so, governments have chosen to centrally administer the VAT.
In Australia VAT revenue is redistributed by the Commonwealth Grants Commission through the equalization system; although it is treated as a state tax, it is thus de facto a central tax that finances an equalization transfer.
An alternative, discussed below, is one in which local surcharges are levied on central government bases, as in the United States. This provides a degree of control over revenues to the local government while minimizing administrative burdens and complexity. The critical issue is that local governments should have control over some tax rates at the margin. This does not have to be very extensive, as shown in the OECD examples in table 6.3.
In recent years, there has been a movement toward sharing the EIT above the 2001 levels, with 60 percent of the additional revenues going to the center.
Proposals have also suggested unifying the EIT on domestic and foreign compa- nies. It would also be sensible to consolidate the administration of the EIT and to divide all EIT revenues, not just the incremental elements, between the center and the local government.
Earmarking the incremental elements of the EIT accruing to the central government for transfers to the poorer provinces redistributes revenue, but it
Table 6.3 Taxing Powers of Subnational Governments in Selected OECD Countries, 1995
Subnational
government taxes Discretion Summary
as percentage of to set indicator of
Country Total taxes GDP taxesa taxing powerb
Sweden 32.6 15.5 100.0 15.5
Denmark 31.3 15.5 95.1 14.7
Switzerland 35.8 11.9 92.4 11.0
Finland 21.8 9.8 89.0 8.7
Belgium 27.9 12.4 57.9 7.2
Iceland 20.4 6.4 100.0 6.4
Japan 24.2 6.8 90.3 6.1
Spain 13.3 4.4 66.6 2.9
New Zealand 5.3 2.0 98.0 2.0
Germany 29.0 11.1 12.8 1.4
Poland 7.5 3.0 46.0 1.4
United Kingdom 3.9 1.4 100.0 1.4
Netherlands 2.7 1.1 100.0 1.1
Austria 20.9 8.7 9.5 0.8
Portugal 5.6 1.8 31.5 0.6
Czech Republic 12.9 5.2 10.0 0.5
Hungary 2.6 1.1 30.0 0.3
Norway 19.7 7.9 3.3 0.3
Mexico 3.3 0.6 11.2 0.1
Source: Ambrosanio and Bordignon 2006.
Note: Countries are ranked in descending order, based on the value of the summary indicator of tax- ing powers.
a. Figures show percentage of total taxes over which subnational governments hold full discretion over the tax rate, the tax base, or both. A value of 100 designates full discretion.
b. Indicator is the product of the ratio of subnational governments’ taxes to GDP and the degree of discretion to set taxes. It measures subnational government taxes with full discretion as a percentage of GDP.
introduces an element of rigidity and complexity into the fiscal system. It might therefore be preferable to overhaul the tax-transfer system.
Value Added Tax
The VAT played a major role in reversing the declining revenue trends since 1994.4 However, China’s VAT has the unusual feature that capital goods are included in the base, so that the VAT is a production-based (P-VAT) rather than a more traditional consumption-based VAT (C-VAT). A second feature of indi- rect taxation in China is that most services are subject to a turnover tax, known as the business tax, which is not creditable against the VAT. This tax accrues to local governments.
These features lead to several forms of cascading, distorting the choice of inputs for the production of both goods and services and leading to an arbitrary (and unknown) pattern of effective tax rates on different consumption items. On the grounds of economic efficiency, it would be desirable to eliminate these distortions.
Consumption-Based VAT
Moving to a C-VAT is a critical reform, but would imply an overall revenue loss, because the exclusion of capital goods reduces the tax base. Extension of the VAT to services would also imply a revenue loss for local governments, which could be offset by the revenue gain at the center. Ahmad, Lockwood, and Singh (2004) show that the magnitude of these revenue losses will vary across provinces. Thus, the reforms will not be easy to implement unless provinces are compensated for the compounded revenue shortfall they will face.
Ahmad, Lockwood, and Singh estimate central government losses from the movement to a C-VAT, adopting various assumptions about collection efficiency.
Their calculations are based on the impact of allowing VAT credits on machinery and equipment. As construction is a service subject to the business tax, it is treated as exempt for VAT purposes; the VAT on materials embedded in buildings would therefore not be creditable.
The estimations show that the distribution of C-VAT losses across provinces has an inverted-U shape. Poorer provinces, in which manufacturing is relatively unimportant, and the richest provinces, including Beijing and Shanghai, which rely more heavily on service sectors, tend to have smaller losses than middle- income provinces, where collection efficiency is at 50 percent. Outlying provinces are responsible for the inverted-U shape. If these provinces are excluded, richer provinces lose more than poorer ones (figure 6.2).5
The first step is to calculate the increase in the VAT share required to achieve this objective (table 6.4). One way of compensating provinces for their revenue shortfall would be to increase their share of VAT revenue. In the base-case scenario, the share of VAT revenue to the provinces increases from the current level of 25 percent to the point where aggregate provincial VAT revenues rise to their ini- tial level (that is, revenue neutrality is maintained for provinces only).
The increase in the provincial VAT sharing rate needed for overall revenue neutrality depends on the efficiency of VAT collection.6However, the difference does not seem to be large. At the lower bound of 50 percent efficiency, the sharing rate would need to rise to 29.6 percent from the current 25 percent, while at the upper bound of 100 percent efficiency, the rate would need to rise to 36.3 percent.
However, the budgetary consequences of this option for the central government are quite severe, because it must share a larger proportion of a smaller pool of VAT revenue with provincial governments. For both levels of collection efficiency considered, the central government would lose about one-third of its current VAT revenue if it fully compensated the provinces for the reform.
An alternative would be to compensate provinces by raising the standard rate of VAT from 17 percent to make the reform revenue neutral (that is, to leave
0 5 10 15 20 25 30
0
Provincial per capita GDP (yuan)
Percentage of VAT revenue lost
5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
Figure 6.2 Provincial Revenue Losses from C-VAT Reform, Base-Case Scenario
Table 6.4 Effect of Revising VAT Revenue-Sharing Rules
Revenue-neutral Revenue loss of
VAT share for Revenue loss of central government as Collection provinces central government percentage of 2001
efficiency (percent) (yuan, billion) VAT revenue
Low (50 percent) 29.6 114.2 28.4
High (100 percent) 36.3 142.7 35.5
Source:Ahmad, Lockwood, and Singh 2004.
Source:Ahmad, Lockwood, and Singh 2004; National Bureau of Statistics 2002.
aggregate VAT revenue unchanged). If the rate increase is revenue neutral for the provinces in aggregate, it would also be revenue neutral for the central government.
However, large increases in the standard rate would be needed. This could have undesirable macroeconomic and incentive effects on the economy (raising prices, for example). The calculations by Ahmad, Lockwood, and Singh do not take into account any second-round effects.
Extension of VAT to Services
The extension of the VAT to services other than finance and insurance is an important complement to the tax reforms and should largely offset losses associ- ated with the move to a C-VAT.7However, since services are already subject to the business tax, the business tax would be replaced as part of the reforms.
Transactions in the financial sector are hard to tax under a VAT, because it is dif- ficult to determine the share of value added by the borrower and the lender (Ebrill and others 2001). The difficulty is that the business tax accrues entirely to local governments, whereas the VAT would presumably be shared.
Ahmad, Lockwood, and Singh (2004) estimate the magnitude of the distrib- utional effects of replacing the business tax with the VAT while continuing to apply the current business tax to the finance and insurance sector.8The relative size of this sector differs widely across regions. In 2001 it provided about 15 percent of provincial GDP in Beijing but only about 0.9 percent of GDP in Heilongjiang.
To calculate how much each province would lose from abolishing the business tax except on this sector, Ahmad, Lockwood, and Singh assume that the province retains a share of its business tax revenue, ai, where aiis proportional to the share of finance and insurance in regional GDP and the 28 percent of business tax revenue is retained. The amount presumed to be lost is given by (1 – ai) times the actual business tax revenue in province i.9The overall gain from this reform is the increase in VAT revenue (calculated at 100 percent or 50 percent efficiency) minus the loss of revenue from the business tax.
Moving to a VAT on services would cause a loss of revenue stemming from the removal of cascading. The pattern of gains and losses across provinces is complex, as several factors are at work. First, other things equal, provinces in which the service sector is large but finance and insurance are relatively unimportant would tend to lose most, because they would lose all their revenue from the business tax on these activities. By the same token, provinces in which finance and insurance are important would tend to lose less or gain, because their business tax revenue from these activities would not be lost.
No clear pattern emerges between provincial gains and losses and provincial per capita GDP (figure 6.3). Ignoring the outliers of Beijing and Shanghai, which do well because the revenue from the business tax on finance and insurance is pro- tected, the reform seems to be mildly equalizing as middle-income provinces do a little worse on average than lower-income ones. However, on its own, this is not a reform that would win much support among provinces.
In order to compensate the provinces for the loss of the business tax revenues, their VAT share would have to increase to 30 percent if 100 percent were collected or to 37 percent if efficiency was 50 percent. It is not clear that the benefits or losses fall predominantly on poorer or richer provinces and an increase in the general shar- ing rule would not appropriately target the provinces facing a revenue shortfall. With the replacement of the business tax by the VAT, it would be easier to compensate needy provinces through the transfer system than changing the VAT sharing rate.
The Revenue-Returned System
The revenue-returned formula returns an additional portion of VAT and con- sumption tax revenues to provinces. According to this mechanism, 30 percent of the increase in VAT and consumption tax collection over their 1994 base levels is returned to the originating province. Both measures are regressive, as they tend to benefit richer provinces.
Ahmad, Lockwood, and Singh (2004) show that the revenue-returned formula does not operate uniformly across provinces. To see why this is the case, suppose that both province A and province B receive an additional Y1 million in VAT or consumption tax revenue. The amount passed back to province A would generally differ from that passed back to province B based on the revenue-returned formula.
This would not be a problem if this feature had been designed into the formula in a rational way, with the clear objective of helping poorer provinces, or those with the
Figure 6.3 Provincial Revenue Losses from Extension of VAT to Services
0 5 10 15 20 25 30 35 40 45 50
0
Provincial per capita GDP (yuan)
Loss as percentage of VAT and BT revenue
5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
Source:Ahmad, Lockwood, and Singh 2004; National Bureau of Statistics 2002.
Note:Figure assumes 50 percent collection efficiency. BT = business tax.
greatest gap between expenditure needs and revenue capacity. However, this is not the case; the differences in treatment of the provinces seem largely arbitrary.
The revenue-returned formula states that
(6.1)
where RRi,t revenue returned to province iat year t;VATi,t VAT revenue collected in province i at year t; and CTi,tconsumption tax revenue collected in province iat year t. That is, this year’s revenue returned is equal to last year’s return times 0.3 the growth rate of the sum of VAT and consumption tax rev- enues for that province. This formulation tracks actual revenue returned quite well over the past decade (table 6.5).
From equation (6.1), an increment Δin either VAT or consumption tax rev- enue in year twill lead to the following change in revenue-returned to province i in that year:
(6.2) From equation (6.2), it is clear that the share of any increase in VAT or con- sumption tax revenue in the current year, t, returned to the province by the revenue returned formula is simply
(6.3)
which Ahmad, Lockwood, and Singh (2004) call the incremental tax share.10 From equation (6.3), it is clear that this incremental tax share may differ across provinces. In particular, a province’s share will be higher the higher the previous year’s revenue returned and the lower the previous year’s VAT and consumption taxes collected.
A major disadvantage of the revenue-returned formula relative to simple shar- ing is that it is not transparent. In particular, differences across regions are driven by history and not necessarily by the current needs or revenue capacities of provinces.
In fact, the sharing rates are mildly equalizing, in that some richer regions tend to receive smaller shares, although this tendency is not uniform (figure 6.4).
The revenue-returned formula does have a potentially significant advantage over a sharing rule. Viewed as a transfer, a simple sharing rule is permanently disequalizing, in that richer provinces, which generate more tax revenues, will always receive more revenue returned than poor provinces. In contrast, the revenue-returned formula is only temporarily disequalizing. In the long run, the revenue returned as a proportion of tax revenue will tend to zero. This is clear
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from equation (6.1), because revenue returned grows only a third as fast as VAT and consumption tax revenue.
The extent of this advantage depends on how fast tax revenues grow. If all tax revenues grow at 10 percent a year (a not unreasonable assumption for China), it would take more than a decade for revenue returned to become half as important for tax revenue as it was in 2001. More generally, if all taxes are growing at some common rate, the “half-life” of the formula can be calculated (table 6.6). Thus, it
0 10 20 30 40 50 60
0
Percentage sharingrate
5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 Provincial per capita GDP (yuan)
Figure 6.4 Incremental VAT Shares, by Province
Source:Ahmad, Lockwood, and Singh 2004.
Note:See equation (6.3). Includes 25 percent VAT share.
Table 6.5 Collected and Returned Revenue, 1996–2001
Item 1996 1997 1998 1999 2000 2001
Collected revenue (yuan, billion)
Excise taxes 62.0 67.4 81.5 82.0 85.7 92.9
VAT 296.3 327.9 362.8 387.8 455.3 535.6
Total collection 358.3 395.3 444.3 469.9 541.0 628.6
Returned revenue (yuan, billion)
Actual 194.9 201.2 208.3 216.73 228.2 234.0
Formula n.a. 200.9 208.7 211.9 226.6 239.3
Actual as percentage
of total collection n.a. 50.9 46.9 46.1 42.2 37.2
Formula as percentage
of total collection n.a. 50.8 47.0 45.1 41.9 38.1
Source:Ministry of Finance various years; Ahmad, Lockwood, and Singh 2004.
n.a. Not applicable.
would take decades for returned revenues to fall by half should revenue growth slow. The advantage of the revenue-returned formula as declining over time should therefore not be oversold.
The earlier discussion of the C-VAT ignored the effects of the inclusion of the revenue returned in the C-VAT reform. But Ahmad, Lockwood, and Singh show that with revenue returned, there is a more pronounced inverted-U share between the percentage losses and the per capita income of provinces (figure 6.5). In order to make the full-VAT reform a viable option, the system of transfers will thus need to be simultaneously reformed (Ahmad, Singh, and Fortuna 2004).
Personal Income Tax
China’s personal income tax, introduced in 1980, has not been a major revenue earner so far, amounting to 1.2 percent of GDP in 2002, or about 7 percent of total tax revenues. It does represent one of the most rapidly growing revenue bases in the country, however. Furthermore, given the perceived inequalities in income, this tax has a major role to play in meeting the distributional objectives of the Xiaokangsociety.
Despite reforms to the personal income tax, as described in Zee and Hameed (2006), the personal income tax remains schedular:
• Wages and salaries are subjected to a multiple-band progressive marginal rate structure that ranges from 5 percent to 45 percent in five incremental brackets.
• Business incomes of individual commercial and business enterprises, income from contracted or leased operations, and income from personal and professional services are subject to separate progressive schedules.
• Remuneration of authors is subject to a flat tax of 15 percent.
• Other sources of income—including royalties, interest, dividends, distributed profits, and rental income—are subject to a flat rate of tax (20 percent; the tax on rents from personal residential properties is 10 percent).
Until recently, the basic monthly allowance for wages and salaries was Y800.
Zee and Hameed (2006) contend that eliminating the 5 percent bracket and raising the basic monthly allowance to Y1,300 (bringing the allowance back to its 1987 level in constant terms) would remove almost 60 percent of personal income tax
Table 6.6 “Half-Life” of Revenue-Returned Formula
Number of years for revenue returned as a Growth rate of tax revenues (percent) proportion of tax revenue to fall by half
5 20.5
10 10.5
15 7.2
Source:Ahmad, Lockwood, and Singh 2004.
taxpayers from the tax net, considerably simplifying administration and improving the equity of the system. The revenue loss of the reform could be made up with marginal adjustments to higher rates (the authorities increased the basic monthly allowance to Y1,600, effective January 1, 2006).
In the 1994 reforms, revenues from the personal income tax were assigned to local governments. In 1999 the revenue from deposit interest was assigned to the central government. In 2002 an additional change in the revenue-sharing arrangement stipulated that increases in personal income tax revenues above the 2001 level would be shared equally by the central government and local gov- ernments, with the central government’s share of this increment increased to 60 percent in 2003. Thus, while personal income tax revenues continue to accrue largely to local governments, the center now receives a growing percentage of a growing revenue base. This is achieved at the cost of considerable complexity and lack of clarity on the incentives for local governments. There is much scope for consolidating the personal income tax, rationalizing the rate structure, and aligning the top marginal rate with the EIT. In addition, there is scope for making the personal income tax a better source for own-source revenues for local governments.