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How China Restructures its Tax System

Photo: Wei Xiong

China is on the way to restructure its tax system. Wei Xiong, Professor of Law at Wuhan University, explains the main priorities for Chinese tax reforms, to what extent the reforms can help to level out inequalities and why courts play a small role when it comes to Chinese tax policy.

China’s fiscal policy faces many reforms nowadays. What are the goals of the new tax policy?

According to the Central Government the principle for tax reforms since 1994 is based on the following four points: broadening the tax base, reducing the tax rate, simplifying the tax system and strengthening the tax administration. We had a major tax reform in 1994 which completed only part of the initiatives compared with the extensive proposals released by the government then. The adjustments since 2008 are continuous efforts to pushing forward the planned reform.

China’s value-added tax contributes with a large percentage to China’s annual tax revenue. One of the most comprehensive reforms is the VAT reform, which has been initiated in January 2012 in Shanghai and expanded nationwide on August 1st of this year. What is this reform about?

In terms of indirect taxation first of all it has to be mentioned, that Chinese VAT was converted from a production-based tax into a consumption-based one. The production-based tax explicitly prohibited the deduction of the input VAT on fixed assets, which made the tax base broader than it otherwise would have been. This was a consequence of the decision-maker’s worrying about the over-decrease of revenue due to the VAT reform in 1994. The negative effects on the economy were ignored at that time.

Since the reform in 1994 we had a split system of turnover taxes. The coexistence of business tax and VAT forced taxpayers to pay VAT for their manufacture revenue and business tax for their service providing income. Since business tax does not provide credit for input tax and is imposed repeatedly for each transaction, it is accused of a cascading taxation and of bringing overburden to service industries. To create a level playing field for all economic sectors, and especially to promote the development of a modern service industry, the reform of combining VAT and business tax has been initiated. Nevertheless, it is still limited to selected industries. The most complex areas like finance, real estate, etc. were excluded so far. It is believed that all these industries will be covered before 2015. Till then, the business tax will be completely replaced by the VAT.

What is happening in terms of income tax? 

China enacted the Enterprise Income Tax Law in 2007 and as of January 1st 2008 applied it equally to both domestic and foreign investment corporations. Before, the two kinds of enterprises were imposed different sets of income tax rules, under which, the foreign investment companies could obviously enjoy more reductions and holidays than domestic companies. Now all enterprises are treated equally in regard of income tax, including tax preferential treatments, thus creating a fair competition environment and providing more opportunities for domestic enterprises.

So now it is rather about supporting domestic firms than about attracting foreign investment.

China’s foreign investment policy has been adjusted fundamentally. In the first 30 years after the opening-up policy had been adopted in 1978, China was eager to attract foreign capital in order to compensate the shortage of domestic investment, and tax reduction had been used as a tool or incentive. With the improvement of the infrastructures and the expanding consumption market, also along with the accumulation of domestic capital, it is thought to be the right time for China to change its approach to foreign investment.

What should the reform priorities be in your opinion?

The most important thing is to push forward the pilot reform of transforming business tax into VAT and to implement it nationwide for all industries. As a consequence, this will bring two related reforms in place which are also very critical to China’s tax reform. The first one is the re-allocation of tax revenues among various levels of government and the other one is the structural reorganization of the tax administration.

As the current tax-sharing system stipulates, VAT is a tax whose revenue is shared by central and local governments, 75 % by the Central Government and 25 % by the local ones, while the business tax is a pure local revenue subject to very limited exceptions. If in the near future all business taxes are substituted by VAT, this would inevitably bring changes to the intergovernmental fiscal distribution. The foreseeable end result would be that local governments will suffer losses from such changes; this had been proved by the pilot reforms in Shanghai.

What can be done to address this issue?

There are two possible approaches: The first one is to adjust the sharing ratio of the VAT revenue among central and local governments and thus to let local governments gain more weight in order to offset their losses from the reform. The other is to narrow the local governments’ spending scope and induce the Central Government to do more in respect of providing public service. From the recent news released by the departments of the Central Government, the second option is preferred.

Why must the tax administration be restructured?

Since 1994 we have a dual system of tax administration and tax collection in China. The State Administration of Taxation (SAT) and its’ local offices are responsible for the collection of VAT and some other taxes attributable to the Central Government. Local governments have their own institutions responsible for collecting their own revenues, mainly business tax. Once the business tax has been completely replaced by the VAT, the local tax authorities will lose most part of their functions and therefore the justification for their existence would be affected.

As a matter of fact, the dual system of tax administration gives rise to huge inefficiency both to the government and to the taxpayers. The collection costs could reach 10 % on average, which is very high compared to 0.5 % in the USA. Apart from fiscal losses related to public spending, taxpayers will have to face two sets of authorities at the same time, which means repetitiveness and waste of time in terms of tax registration, filing returns, tax investigation, etc.
At the same time, the SAT and its local offices also face the pressure of reorganisation in that they are not able to fit with the new development of tax administration. In western countries like the USA, taxpayers are treated as clients which means an equal relationship between government and taxpayers. This has become the guiding principle underlying the restructuring of the tax administration in China. What the tax authorities should do is to provide improved services according to the taxpayer’s needs in order to advance tax compliance.

The property tax reform as well is supposed to re-balance the intergovernmental fiscal relationship in China. Can you tell us something about this reform?

The property tax reform aims to increase the fiscal revenue of local governments. Confronted with the revenue shortage of the local governments, China had introduced a natural resource tax reform in June 2010 first in Xinjiang, the extreme west area in China which is an autonomous region of minority ethnics,  and in November 2011 it was  implemented also in other regions. The core idea of this effort was to raise the tax burden of specific natural resources and to keep the incremental revenue with the local governments. For the places not rich of natural resources, China has been thinking about reforming the property tax regime by making the owners pay more for their properties. Initially, the authority was trying to enact a brand new real estate tax in place of the existing property tax. Obviously there was no consensus reached not even after almost ten years of research and discussions. The most important hurdle it has to cross is that, based on the current progress in principle of legality, any new tax has to be imposed by the legislature, not by the executive department. Maybe in order to circumvent this hardship, the government finally decided to introduce a pilot program in Chongqing and Shanghai effectively as of January 1st 2012, without fundamental changes to the existent property tax system. There is an exemption clause for household properties in the property tax regulation, which was issued by the Central Government in 1986 under the authorisation of the top legislature, the National People’s Congress in 1985. This exemption is not applicable in the pilot areas, the relevant local governments being authorized to design their own rules to tax the household properties.

Tax lawyers and tax law professors have continuously been doubting the legitimacy of the pilot reform. I myself had once requested the Standing Committee of the National People’ Congress to review the Central Government’s delegation decision and the rules issued by Chongqing and Shanghai. The critical questioning for the reform is that the Central Government’s re-delegation runs counter to the requirements of the Legislation Law of China, which was enacted by the Congress; this provides that the State Council’s legislating power delegated by the National People’s Congress shall not be re-delegated to anybody else. It is expected that the pilot reform will most likely not be expanded to other municipalities. However, the principle of legality for the reform proposal is still a problem which needs to be resolved by the policy-makers.

There is another striking phenomenon in Chinese tax system: courts seem to play a very small role. What do you think are the reasons?

In China, the judiciary is traditionally regarded as a branch of administration to govern the citizens, not to function as an independent third party to solve disputes fairly. Also traditionally, people are ashamed of being involved in lawsuits, both as plaintiff or as respondent. They are more accustomed to resorting to negotiations or mediations. However, since the kicking off of the economic reform, things change gradually but dramatically. Nowadays in China the courts at various levels are overburdened by civil and commercial cases. By contrast, there are still very limited tax cases heard before the courts, which, partly estimated, do not exceed 1000 a year nationwide. Since there are around 3000 courts in China, each court could hear a tax case every three years. Given this situation, it is impossible for the courts to develop high expertise to deal with tax disputes. Most cases only revolve around the procedural issues for these very limited tax cases. As far as substantive issues are concerned, there is almost no way for courts to hear and adjudicate. So the adjudications have not much institutional significance for future disputes.

Is it then a matter of culture and of historical development?

It is hard for me to give a black or white answer. Actually, it is not only true that the courts do not play a vital role in tax disputes but also in almost all administrative cases. When further looking into the administrative cases brought to the courts, we may interestingly find that most cases are not initiated by enterprises, but by individuals. For those initiated by enterprises, another interesting phenomenon is that, in most of the cases, the defendants are not the agencies who could govern the enterprises in all the stages of business - like tax authorities -, but those who may deal with the enterprises occasionally for very limited business. These facts give us full space for imagination about the reasons why tax cases are rarely to be lodged to the courts. There must be something deterring for taxpayers to go to court.

Now we may tentatively come to the answer for the courts’ passive role in tax cases. Since there is no tradition and practice of rule of law, the courts and judges have never gained independence from the governments and the ruling party. Though not stipulated so by the constitution or any law, the court is still just acting as a branch of the government or a tool for the ruling party’s dictatorship. If the courts do not function as a fair judge but as an honest servant for power, how can the taxpayers believe that their disputes with the government will be resolved without partiality or prejudice? On the other hand, we further find out that the discretion of tax authorities is huge enough to revenge taxpayers legally at any time if any they dare to bring disputes to the courts and affects the review for their achievements negatively. From the perspective of taxpayers, they don’t want to win the case once but they face harassment and even revenges for ever. So the clever thing for them is to consult tax authorities patiently and to try to resolve all disputes within the possibilities of administrative remedies.

Do you think the current tax reforms in China can also help to level out inequalities?

Yes, more or less, the reforms mentioned above could help to level out inequalities from different perspectives. The reform of the VAT to replace the business tax will help to alleviate the inequalities among manufacturing and service industries; the equal application of income tax law to domestic and foreign investment enterprises will stimulate fair competition among enterprises. Even the very limited individual income tax reform will to some extent also add consumption capacity to poor people.

However, the corner stone of these tax reforms is economic efficiency, not social equality. Since the beginning of the economic reform, China has been showing utmost desire on stimulating and protecting the enthusiasm for investment and most of the efforts are revolving around how to create a level playing field for business competition. The authorities may be afraid that any substantial or significant reform targeted at distributional inequality would possibly have negative affect on investment. Though I don’t think tax that the policy can play a most vital role in improving social equality in contrast to economic development or public expenditure, some taxes, for example the individual income tax and the inheritance tax, could be used as important means to enlarge social fairness and justice.

China has adopted a most investor-favoured tax policy in view of the relevant attitude to wage-earners. In the rate structure of individual income tax, the marginal rate for wages and salaries is the highest one, 45 %, while the nominal rate for investment income, like dividends, interest, capital gains, is only 20 %. If taking tax reduction into consideration, the effective rate for investors is much lower than that for the working class. There is another element needed to be noted. Due to the withholding system, the efficiency for the collection of income tax derived from salary-earners is very high and there is little way for these taxpayers to conceal any income or to design any scheme to avoid the taxes. As a contrast, the ways to avoid or evade taxes for investment income are plentiful. It is a huge challenge for the Chinese tax authorities to gather enough information in administration to catch the rich. This is the reason why in China statistics always show that most of the individual income taxes are born by the working classes and not by the wealthy people, which definitely has widened the gap between the haves and the haves-not and worsened social inequality accordingly.

As for inheritance tax, although it was already on the agenda of the 1994 tax reform, till now it is still a skeleton on paper without details. The rich always have more influence on the decision-making. In China, a very peculiar phenomenon is, the way for most of the rich to get richer is not by honest business, but by the coalition with public power. These people not only own huge wealth but they also possess great political influence and they should be the biggest opposition force to the adoption of the inheritance tax. I think this tax is an indicator of whether China will really want to promote social equality and I don’t see any light in the near future.

Oktober, 2013