Revenue growth in China has been impressive: by the end of 2005, revenue rep- resented 17.5 percent of GDP, up from about 10 percent of GDP in 1994.
Nevertheless, a number of reforms need to be implemented to streamline and rationalize the tax system and to increase its efficiency and transparency. In doing so, a number of sound principles for tax design will have to be respected: tax bases should be broadened; there should be a move toward taxes with revenue growth potential; and distortions, including administrative and compliance costs, should be minimized (Hussain and Stern 2006). This chapter focuses primarily on China’s three main taxes: the value added tax (VAT), the enterprise income tax, and the personal income tax. It outlines policy options on how these principles can be applied for each of these taxes.
Value Added Tax
The VAT has proved an effective tax revenue handle. Since its introduction in 1994, it has quickly grown to about 7 percent of GDP, or more than 40 percent of total tax revenue.6
China’s VAT is unique in two distinct ways. First, it is a production-type VAT—that is, credits are not given for VAT on capital goods. Second, it excludes most services, which are taxed under a separate turnover tax (the business tax, which is collected and retained by local governments). These two features repre- sent a major design limitation of China’s VAT. The first feature directly imposes a burden on investment and indirectly entails a significant degree of cascading. The second feature introduces significant distortions between goods and services, and it exacerbates cascading. Both features also distinguish China’s VAT regime from that of major comparator OECD and emerging market countries (table 4.1).7
Overcoming these limitations would bring the design of China’s VAT in line with best international practice. The shift from a production-based to a consumption-based
VAT is currently being piloted in the northeast. While the pilot results have been positive, nationwide extension has been put on hold because of concerns about encouraging further investment activities.8
In addition, the administration of VAT refunds is complex, for three main rea- sons. First, different refund rates apply to different categories of exports, partly to pro- mote or hold back certain types of exports and to clamp down on what the authorities consider abusive claims of refunds.9Second, VAT refunds are only partially granted to exporters, depending on what share of a company’s production is exported.10 Third, refunds are paid out of fixed budgetary allocations, which in the past did not keep pace with rapid export growth, leading to accumulation of arrears.11Best inter- national practice would call for fully zero-rating all categories of exports; relaxing the requirements for claiming refunds; centralizing responsibility for the payment of VAT refunds, which are shared between the central and provincial governments; and not binding refunds to fixed budgetary allocations. Guaranteeing that sufficient funds are centrally budgeted would facilitate VAT refunds and ensure that taxpayers are not denied legitimate VAT refunds because of budget constraints.
Modernizing the VAT system by shifting from a production-based to a consumption-based VAT and including services under it (thereby replacing the
Table 4.1 Value Added Tax Rates in Selected Countries
Country Tax rate (percent)a
OECD
Australia 10
Japan 5
Korea, Rep. of 10
New Zealand 12.5
Non–OECD
Brazil 20.5, 12.4, 9.9
Chinab 17, 13
Indonesia 10
Philippines 10
Russian Federation 20, 10
Singapore 3
Thailand 10
Source:Authors, based on information from various authorities’ Web sites and International Monetary Fund country files.
Note:Data are latest available information as of June 2006. In all countries in the table, VAT is imposed at the retail stage. In all countries except China, VAT is on consumption and imposed on both goods and services. China’s VAT is a production tax on goods only.
a. When multiple figures appear, the first figure represents the standard (most applied) rate.
b. Includes a very small number of services.
business tax) would have significant policy and administrative implications. It would produce large revenue losses (as more capital goods would become creditable).
It would also have implications for the treatment of small taxpayers and for VAT refunds in general (apart from those related to exports).12
Given these complexities, the proposed tax changes should be counterbalanced by additional measures. The revenue impact could be alleviated by a combination of the careful phasing in of the VAT credits on capital goods; raising the rate of consumption taxes (excises), which remain low by international standards; or both.
Additional compensatory revenue measures may be necessary for extending the VAT to services (because more capital goods would then become creditable). The conversion to a consumption-based VAT could be implemented first, followed by the extension of the VAT to services when the tax administration is in a posi- tion to handle an enlarged base of taxpayers, most notably after the completion of the ongoing modernization projects to improve audit and enforcement.
Finally, important transitional issues regarding tax-sharing arrangements or the entire system of tax assignments will emerge. Currently, VAT revenues are shared by the central government and provincial governments, revenues from the con- sumption tax are kept by the central government, and revenues from the business tax are kept by provincial governments. This implies that both the conversion to a consumption-based VAT and the extension of the VAT to services would have significant consequences not only for the division of revenue between the central and provincial governments but also for the distribution of revenue among provin- cial governments (Ahmad 2006).
Enterprise Income Tax
The enterprise income tax is an increasingly important source of revenue in China, as shown by its rapid growth in recent years, from just above 1 percent of GDP in 1998 to about 3 percent of GDP at the end of 2005. However, compared with performance in selected comparator countries, the enterprise income tax still has a limited yield (table 4.2). In particular, its productivity—that is, the revenue yield, as a percentage of GDP, from each percentage point of the standard corporate income tax rate—is low. A low level of productivity reflects both the lack of effi- ciency of a country’s tax administration and the extent to which tax incentives reduce the effective tax burden, through base erosion, a nominal rate reduction, or both. In China the large tax incentives provided to foreign-invested enterprises are likely to be the main cause of the low productivity of the enterprise income tax (see below), the rate of which appears to be in line with international standards.
Domestic and foreign-invested enterprises are subject to different tax-base def- initions, rate structures, and systems of investment tax incentives (table 4.3). In order to promote a level playing field for businesses, the government intends to unify these regimes; a proposal has been debated for some time, but so far this reform has been stalled. The current laws are based on the residence principle—
that is, profits earned by resident enterprises are taxed on a worldwide basis, but
profits earned by permanent establishments of nonresident enterprises are taxed on a territorial basis. It would be appropriate to continue to adhere to this approach once the enterprise income tax law is unified.
To strike a balance between meeting budgetary revenue needs and ensuring that the tax is adequately attractive for investment, the government could set the uni- fied rate at 20–25 percent. Unification should lead to the elimination of multiple enterprise income tax rates. This is a particularly severe problem when multiple rates are location and activity based as part of a tax incentive system, such as those applied to foreign-invested enterprises. Under these circumstances, enterprises fac- ing high tax rates may find it advantageous to transfer their profits to lower-taxed enterprises through a variety of transfer-pricing mechanisms. Even if the multiple rates are progressive based on profit levels—as rates on domestic enterprises are in China—problems may arise if such rates are not properly structured. The three enterprise income tax rates on domestic enterprises are average rates that vary with
Table 4.2 Corporate Income Tax Rates,Yields, and Productivity in Selected Economies, 2002
Top rate Yield Productivitya
Economy (percent) (percentage of GDP) (percentage of GDP)
OECD
Australia 30 5.3 0.18
Japan 30 3.1 0.10
Korea, Rep. of 27 3.1 0.12
New Zealand 33 4.2 0.13
Non–OECD
Brazil 15 2.5 0.17
China 30 2.6 0.09
Hong Kong (China) 16 3.1 0.19
Indiab 35 1.8 0.05
Indonesiab 30 1.9 0.06
Philippinesc 32 2.5 0.08
Russian Federation 24 1.6 0.07
Singaporeb 24.5 — —
Thailand 30 3.2 0.11
Source:Authors’ compilation based on data from IMF Government Finance Statistics 2006; International Financial Statistics2006; World Economic Outlook2006; IMF country documents; OECD Revenue statistics database; and the World Tax Database of the University of Michigan, available at www.bus.umich.edu/OTPR/otpr.
— Not available.
Note:Figures are for general government, unless otherwise specified.
a. Revenue yield for each percentage point of standard corporate income tax rate.
b. Central government.
c. Budgetary central government.
the level of taxable profits.13One possible solution would be to replace these average progressive rates with marginal progressive rates, so that higher tax rates are applied only on additional, not total, profits.14
The imposition of a ceiling on allowable wage deductions for domestic enter- prises—currently set at Y960 per month per employee—is largely the legacy of a time when the economy was centrally controlled and dominated by SOEs. A basic purpose of the ceiling was to limit the extent to which SOEs were able to transfer profits to workers as wage payments, as wages in excess of the ceiling would be subject to taxation at the applicable enterprise income tax rate.
While still found in some transition economies, such a practice is out of place in China’s economy today. It artificially raises the labor cost of a domestic enter- prise requiring a skilled workforce, putting it at a significant disadvantage relative to a foreign-invested enterprise in the same line of business that is not subject to the ceiling. In the prospective unified enterprise income tax law, the wage deduc- tion ceiling should be removed.
The current depreciation system applicable to foreign-invested enterprises consists of only three asset groups, with reasonable depreciation rates. For domestic
Table 4.3 Main Differences between Enterprise Income Tax Laws on Domestic and Foreign-Invested Enterprises
Item Domestic enterprises Foreign-invested enterprises
Taxation principle Worldwide Worldwide if head office is in China, territorial if head office is not located in China
Tax ratesa <Y30,000: 18% 10%, 15%, 24%, 30% + 3%
Y30,000–Y100,000: (provincial) 27% >Y100,000: 33%
Deductions for Subject to ceilings Actual expense wages and welfare
payments
Deductions for Subject to ceilings Actual expense donations to charity
Depreciation ratesb
Houses and buildings 1.8%–12% 5%
Machinery and
equipment 2.9%–20% 10%
Cars, computers,
and tools 2.9%–20% 20%
Source:“Provisional Regulations of China on Enterprise Income Tax” and its detailed rules of imple- mentation; “Income Tax Law of China on Enterprises with Foreign Investment and Foreign Enterprises” and its detailed rules of implementation.
a. Excludes tax rates that are time bound.
b. Depreciation rates are on a straight-line basis. For domestic enterprises, rates are industry specific.
enterprises, however, there are six groups of depreciable assets, and applicable depreciation rates depend on the estimated physical life spans of the assets, differentiated by 13 industries. Such a system is not only administratively complex, it also penalizes domestic enterprises relative to foreign-invested enterprises. In the prospective unified enterprise income tax law, the current depreciation system for foreign-invested enterprises should be adopted for all enterprises.
Finally, incentives are still provided predominantly in the form of enterprise income tax holidays and reduced enterprise income tax rates, concentrated largely in the eastern coastal regions and heavily targeting foreign-invested enterprises.15 Tax incentives should be rationalized by replacing enterprise income tax holidays (at the margin) with accelerated depreciation and a longer loss carry-forward period. In order to promote the transparency of China’s tax incentive system and enhance its cost-effectiveness, the tax expenditures entailed by such incentives should be estimated and either formally integrated into the budget process as expenditure items or at least explicitly reported as part of the budget documents.16 Unification of the enterprise income tax regimes would need to be carefully phased in, to avoid perpetuating some of the distortions and regressivity of the current system of tax sharing. The current system favors richer provinces: local tax revenues derive mainly from the VAT, the enterprise income tax, and busi- ness taxes, whose bases typically cover manufacturing and service sectors.17 Provinces in which the shares of the secondary and tertiary sectors in GDP are relatively high fare above average in terms of revenue collections. In contrast, the central and western provinces, which are predominantly agriculture based, fare poorly. Absent reforms to tax assignments and the transfer system, the inequities of the current system may be exacerbated.
Personal Income Tax
The personal income tax has a complex structure, mainly reflecting the fact that this tax is an amalgamation of three different personal income taxes (applied separately to residents, nonresidents, and the self-employed) introduced in the 1980s. Its yield, while rising in recent years, amounted to only 1.1 percent of GDP (7 percent of total tax revenue) at the end of 2005, quite low by international standards (table 4.4). The relatively low average monthly wage still prevailing in China is likely the main rea- son why the yield from the personal income tax is low; as incomes rise, the personal income tax therefore holds important revenue potential.
The major shortcoming of the current personal income tax system is that differ- ent rate schedules—some with a relatively high degree of marginal progressivity—
are applied on different income categories. There is a need to consolidate the 11 separate categories of taxable income into fewer categories, in a manner that is both conceptually sound and administratively feasible. One possible solution would include consolidating the 11 categories of taxable income into two categories, labor income and capital income. Labor income (including income from self-employment) would be taxed under one unified progressive rate schedule, while capital income
would continue to be taxed through final withholding at a flat rate. This consolidation is in line with practice in many developing and developed countries, and its imple- mentation is well within the capacity of China’s tax administration.
At the same time, the number of rate schedules should be reduced, and the number and progressivity of rates within a schedule should be streamlined (the system currently has nine different rates, reaching as high as 45 percent). Two con- siderations should drive the choice of rates. First, the top marginal personal income tax rate should be closely aligned with the enterprise income tax rate, in order to reduce taxpayers’ incentives to artificially organize themselves as enterprises for tax advantage. Second, the basic allowance should be chosen to impart a proper degree of progressivity to the rate schedule, even if the schedule includes only a few rates. On this basis, the number of positive marginal rates should be limited to two or three. In line with these principles, the government doubled the personal income tax monthly allowance, from Y800 to Y1,600, effective January 1, 2006.
Table 4.4 Personal Income Tax Rates,Yields, and Productivity in Selected Economies, 2002
Yield Productivitya
Top rate (percentage of (percentage of
Economy (percent) GDP) GDP)
OECD
Australia 47 12.1 0.26
Japan 37 4.7 0.13
Korea, Rep. of 36 3.1 0.09
New Zealand 39 14.8 0.38
Non–OECD
Brazil 27.5 3.9 0.14
China 45 1.1 0.02
Hong Kong (China) 17 2.6 0.16
Indiab 30 1.5 0.05
Indonesiab 35 1.5 0.04
Philippinesc 32 2.2 0.07
Russian Federation 35 0.0 0.00
Singaporeb 22 … …
Thailand 37 1.9 0.05
Source:Authors’ compilation based on data from IMF Government Finance Statistics 2006; International Financial Statistics 2006;World Economic Outlook 2006;IMF country documents; OECD Revenue statistics database; and the World Tax Database of the University of Michigan, available at www.bus.umich.edu/OTPR/otpr.
Note:Figures are for general government unless otherwise specified.
a. Revenue yield for each percentage point of standard personal income tax rate.
b. Central government. Data for Singapore are not available.
c. Budgetary central government.
This is a welcome measure, as it helps protect the incomes of the lower-income segments of the population. Consideration might be given to adjusting it in line with inflation in order to prevent its erosion in real terms over time.
Finally, reform of the personal income tax could have important intergovern- mental implications, not so much because it is a shared tax (as its yield currently remains limited) but because limited tax policy powers on personal income tax could be devolved to the provinces.18In particular, provinces could be allowed to provide a supplemental basic monthly allowance tied to certain objectives and transparent provincial economic indicators; they could also impose provincial personal income taxes that piggyback on the national rate structure. The central government could prescribe limits on either measure. As provinces would be expected to bear the revenue consequences of their own discretionary policy actions, these changes should carry no implications for the way in which the revenue from personal income is divided between the central government and provincial governments.
Other Taxes
There is scope for introducing new taxes and rationalizing existing ones. As China’s economy grows, environmental considerations should be built into the design of its tax system. China’s current level of excise taxes on vehicles and petroleum products, which are low by international standards, should be reassessed.19Real estate taxes should also be rationalized, on the basis of a unified conceptual and valuation frame- work; along with the possible piggybacking on the personal income tax mentioned above, these taxes could prove valuable tax handles for local governments (Ahmad 2006). More generally, the appropriate design of local taxes, including bounded local control over rates, should be high on the reform agenda.
These reforms would help make the tax system more transparent and efficient.
They would also contribute to ensuring an appropriate level of resources for the government to fulfill its development and redistribution objectives. In this con- nection, it has also been increasingly advocated that SOEs, which currently do not pay dividends to the government, start doing so.20In addition to reducing the pro- cyclicality of investment financed by retained earnings, dividends paid to the budget could help fund a stronger social safety net, particularly for rural households.
Such a measure could reduce the incentive for households to save, thereby boost- ing consumption—objectives that are in line with the government’s new growth strategy. More generally, it would contribute to offsetting possible revenue losses associated with some of the reform options identified above.