Chapter

9 Reform and the Market Economy and Tax in China

Editor(s):
Ehtisham Ahmad, Vito Tanzi, and Qiang Gao
Published Date:
September 1995
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Author(s)
Xu Shanda and Ma Lin* 

China started to reform its old tax system under the traditional planning economic mode in 1988. Since then, it has undergone a process of formulating reforms, putting them into operation, and making constant efforts to perfect them. A complex tax system is the result, with turnover taxes and income taxes as the main taxes, supplemented by other taxes. For the past dozen years or so, the system basically provided for needs of the development of the economy and the reform of the economic system. In 1992, however, the authorities decided that a socialist market economic system should be established. Accordingly, the tax system would also need further reform and adjustment in light of the requirements of the market economy.

Role of Taxation in a Socialist Market Economy

Under a socialist market economy, economic operations are organized via the market mechanism, and the market plays a basic role in resource distribution. Taxation is a means by which the state participates in the redistribution of income, raises public revenue, and forms a macroeconomic lever directly controlled by the state to regulate social production at all stages. No other administrative measures and economic tools can replace taxation. With the transition from a planned economy to a market one, the former heavy reliance on regulation, through administrative orders and mandatory production plans, will be reduced substantially, as will the role of administrative pricing tools. The state, however, will continue to play a role in the overall balance of the economy, industrial restructuring, the maintenance of an equitable competitive environment, and the alleviation of unequal social distribution. Thus, taxation will undoubtedly become one of the most important macroeconomic tools of the state in a socialist market economy, given its legal basis and regulation functions. Taxation, in this context, would guarantee the stabilization functions of the market economy, promote the formation and perfection of allocative market mechanisms, regulate social redistribution, and limit the negative externalities generated by the market.

The effective functioning of taxation in the market economy requires the following basic conditions:

  • All stages and the whole process of social reproduction, including production, distribution, exchange and consumption, and all economic activities, must be directly or indirectly placed within the market relationship. The market is the fundamental operational mechanism regulating the whole social economy, pushing the flow of productive elements and guiding the distribution of resources.

  • All enterprises must be given autonomy to run their own businesses, shoulder the obligations of paying taxes in accordance with law, and account for their own profits and losses. Separate producers and managers of commodities and financial transactions form the main body of the market.

  • The government must not directly interfere with the day-to-day affairs of production and management of enterprises, but rather regulate and standardize the operational activities of enterprises via financial, taxation, price, and banking policies.

  • All business operations must be conducted in accordance with the provisions of laws and regulations. The entire operation of the economy must be placed on a comprehensive legal basis.

The reform of China’s tax system must conform to the basic characteristics and rules of the market economy. The market is uniform, therefore the tax legislation must be unified; the market is open, therefore the tax structure and tax administration must be adaptable to the needs of opening up the economy and be aligned with the common international taxation norms; the market is competitive, therefore taxation policy must reflect the principle of equitable tax burden; the market operates in conformity to objective economic rules, therefore taxation should play a greater role in strengthening macroregulation and promoting microeconomic incentives.

It should be noted that, despite the outstanding achievements China has attained in restructuring its tax system over the past few years, the current system cannot entirely cater to the needs of the market mechanism, neither structurally nor functionally. A more fundamental tax reform is needed without delay.

Basic Principles Governing Tax Reform

Viewed from the practice of China, and the experiences of other countries, the construction and reform of a taxation system under the condition of a market economy must use the following basic principles.

Principle of Effectiveness

A scientific (or nonnegotiated) taxation system is the basis on which taxation can correctly and effectively play its intended role. The orientation of tax reform, therefore, must conform to the requirements of the development of a market economy and forge a tax system that can really help the effective operation of the economy; meanwhile, the tax administration system should also raise efficiency and reduce administrative cost.

Principle of Equity

Taxation should treat all taxpayers equally, in the sense of horizontal equity and vertical equity. The former implies that taxpayers with equal economic ability (ability to pay taxes) must pay the same amount of tax, that is, to treat people of similar conditions equally. The latter implies different economic capacities of taxpayers also be taken into account by the tax system.

Principle of Standardization

The nature of taxation calls for standardization of the tax system. At the same time, standardization is an important condition for the enforcement of tax laws and the realization of equal tax burdens. The design of the overall tax system, the determination of various tax elements, and the methods of tax collection and administration, therefore, must all be considered from this starting point. The proposed tax system will be unified and integrated, thus avoiding arbitrariness, and will respect international norms, as well as China’s specific characteristics. The features must, finally, be reflected in the respective tax legislation.

Principle of Stabilizing the Economy

Taxation is a lever used by the government to regulate the economy, specifically to maintain full employment and stable relative prices. When the economy is approaching full employment and is experiencing inflation, tax rates can be raised to reduce demand and alleviate the pressure of inflation; when the growth of economy is slowing down and the unemployment rate is rising, the tax rates can be lowered to curb the trend of economic depression.

Principle of Neutrality

Under market economic conditions, profits will guide investment and the market will play a leading role in resource allocation. Therefore, taxation should be as economically neutral as possible; that is, it should not interfere with or distort the effective operation of market mechanisms.

Main Problems of Existing Chinese Tax System

Although outstanding achievements have been reached, the prevailing Chinese tax system leaves much room for improvement in view of keeping abreast of the development of the market economy. It is necessary and urgent to further the reform of China’s tax system.

The main manifestations of disharmony between China’s present tax system and the market economy are as follows:

  • Through the gradual evolution of economic structural reform, constrained by historical conditions and policy choices, China has established an enterprise income tax system, whereby enterprises of different types apply different categories of taxes with different tax rates and preferential treatments, resulting in unequal tax burdens. This pattern is detrimental to enterprise restructuring and fair competition.

  • There are high nominal tax rates but low actual tax burdens. In the state-owned enterprise, the nominal tax rate is 55 percent. The actual tax burden, however, is far less than this figure, because of the treatment of the repayment of loans as a before-tax charge (Chapter 12). Moreover, the management contract responsibility reduces the effective tax burden. Similarly, with turnover taxes and other taxes, the tax bases are incomplete and various kinds of tax preferential treatments exist. Thus, there is a much lower actual tax burden than the rate structure would imply.

  • There is irregular and indeterminate distribution of functions between the state and the state-owned enterprises. The state’s functions in distribution, as the manager of the society and the owner of the state’s properties, are not duly reflected in the tax system.

  • The scope and depth of regulation by taxation are not in line with the requirement that all productive elements should enter into the market. The regulating functions played by taxation are very weak in such areas as land values, individual incomes, and capital market gains. The structure of tax revenues should reflect changes in the sources of income as the market economy expands.

  • A complete local tax system is yet to be established. Revenues raised by local taxes are very limited. The division of tax administrative power is not very rational, which impedes the smooth transition to a system whereby the central government and the local governments raise their own revenue through different taxes.

  • The current turnover tax features too many rates and steep rate brackets. This is because the turnover tax is designed to alleviate the sharp differences in profit margins of enterprises, resulting from the controlled price system. Presently, however, most commodity prices have been freed. Thus, a neutral indirect tax system should be established in accordance with the requirement of the market mechanism.

  • The fact that domestic enterprises and foreign-funded enterprises are under the jurisdiction of two separate tax legislations causes a contradiction that is becoming more and more acute.

Proposed Reform of Tax System

The decision to establish a socialist market economy has brought forth a series of issues to be solved. It is our view that the guiding principles for designing the tax reform should be as follows: unify tax laws; balance the tax burden; simplify the tax system; rationalize the division of tax jurisdictions; standardize the pattern of allocation; and put allocational relationships in order. The principles of enlarging tax bases, rationalizing tax burdens, reducing tax incentives, and enhancing penalties should also be followed.

Tax Structure

China is a developing country with low productivity and relatively low personal incomes. Thus, direct taxes are unlikely to be the main revenue source in the foreseeable future. Based on the actual conditions in China, the selection of the main tax instruments must satisfy the dual requirements of state finance and economic regulation. In the social reproduction process, production and circulation are two stages whereby the national income is created and realized, respectively. Extensive and easy-to-control tax sources are concentrated there. Taxes levied on these stages can guarantee the steady growth of tax revenue and, effectively, play the function of regulating production, circulation, distribution, and consumption. Furthermore, the stage of allocation of national income mainly relates to enterprise net income, that is, the enterprises’ profits. The tax source is thus relatively concentrated. Taxes levied at this stage can also play a certain regulatory function, particularly with regard to allocation. Therefore, starting from China’s status quo, it is appropriate to rely on indirect taxes on the sales of commodities, at the production and distribution stages, and the enterprise income tax as the main taxes of the country’s tax system. In addition, some supplementary taxes will also be enacted, so that the function of taxation will exist in all sectors.

Currently, the revenue from indirect taxes (value-added tax, product tax, business tax, and the consolidated industrial and commercial tax) exceeds two thirds of the total tax revenue (excluding customs duty). Such a big proportion presents some difficulty for tax reform. The short-term tax reform should first of all consider the adjustment of the revenue structure. Given the particular development level of China’s national economy, and the specific conditions of its economic system, however, indirect tax revenue will continue to make up the better part of the total tax revenue for a relatively long period of time. Indirect taxes and enterprises’ income tax will be the main taxes complemented by other smaller taxes.

Reform of Enterprise Income Tax

The immediate target of the enterprise income tax reform is to unify the domestic enterprise income tax. The separate domestic enterprise income tax and the income tax of enterprises with foreign investment (joint ventures) and foreign enterprise will be unified to form a uniform “Enterprise Income Tax Law of the People’s Republic of China” applicable to all enterprises. The establishment of a unified and standardized domestic enterprise income tax system will not only eliminate an obvious obstacle to the transformation of enterprises’ operating mechanisms, so as to help push the enterprises to the market and create a fair competition environment, but also may set right the allocational relationship between the state and the enterprises.

The main ideas on unifying the domestic enterprise income tax are as follows:

  • Unify the current State-Owned Enterprise Income Tax, the Collective Enterprise Income Tax, and the Private Enterprise Income Tax. Phase out the Adjustment Tax for State-Owned Enterprises.

  • Reduce the income tax rates for enterprises to apply a uniform 33 percent flat rate. Appropriate measures will be adopted within a certain period of time to take care of small enterprises (see Chapter 12). Unify and standardize the items deductible and the corresponding limit. To avoid erosion of the tax base, deduction before tax must follow the stipulations of the tax law.

  • As a supporting measure to the unification of domestic enterprise income taxes, the present practice of the repayment of loans as tax deductible items will be changed to conform with international practice, whereby loans have to be repaid from after-tax resources. With the introduction of this system, the key energy and communication construction fund and the budgetary regulating fund appropriated after tax should also be eliminated.

  • The state, as the owner of the state-owned enterprises, has the right to share the after-tax profit of the enterprises. Considering the actual conditions of the enterprises, however, most enterprises, except a very few, will be allowed to keep all their after-tax profits for a certain number of years.

Unifying the domestic enterprise income tax is of great significance to the deepening of the economic structural reform. It will touch upon a series of reforms in relation to the enterprise system, including the depreciation system, the investment system, the financial and accounting system, the wage and bonus system, and the employee’s social security system. The reform of the enterprise income tax system and these reforms are constraints, but also influence and promote each other. With the aforesaid reform measures being gradually put into place, the transformation of operating mechanisms of enterprises will be assured.

Changing the possibility of loan repayment before tax into an after-tax charge is a key point of unifying the domestic enterprise income tax. Simply put, loan repayments before tax were associated with the old system, whereby all profits were remitted to the state, and all expenditures of the enterprises were allocated by the state. The main manifestation areas follow. First, investment loans borrowed by enterprises are mainly guaranteed by the state’s tax revenue. Enterprises and banks both take quite small risks. This kind of no-risk investment mechanism is likely to result in an unreasonable and inefficient investment structure. Second, inappropriate investment signals can lead to excessive overall outlays, detrimental to the macroeconomic control of the state. Third, the income tax base of enterprises is seriously eroded, resulting in a gap between the nominal tax rate and the actual tax paid. The reforms will support the steady growth of the state’s revenues. By the introduction of repayment of loans after tax, a risk-taking mechanism will be built up in the investment system of enterprises. This is conducive to improvements in investment efficiency, and in the economic performance of the state-owned enterprises. It is also helpful from the view of enterprises building up the mechanisms of self-constraint and self-development. This is a crucial link to encourage enterprises to change their operating mechanisms. Without making enterprises responsible for investment risks, the transformation of enterprises’ operating mechanisms would not be feasible.

Reform of Indirect Taxes

The reform of the turnover tax is targeted at establishing a system whereby the value-added tax (VAT), the product tax, and the excise tax co-exist and a two-tiered regulatory function is formed. Specifically, the VAT will be used in the production and circulation sectors of commodity for general regulatory purposes, while the product tax will be used for special regulatory purposes, applicable only to a few selected consumption goods such as cigarettes, alcohol, gasoline, and cars. In addition, a business tax will be imposed on the tertiary industries, except commercial wholesale and retail businesses.

When China was beginning to introduce the VAT, there was a view that it could be levied on only the manufacturing stage with the purpose of eliminating cascading effects of taxation. Trial experimentation of the tax over the past dozen years, however, has shown that there has been a superficial introduction of the computation methods of the value-added tax, while the requirements of a wide base and simple rates, which are needed by the nature of the tax, have been overlooked. This negligence plus a controlled price system have combined to cause the problem of complicated computational processes and distorted deductions.

The future reform will follow the common international practices, determine a standardized principle, and make the value-added tax cover all stages of production and distribution of commodities, while at the same time simplifying the rate structure. Only in this way can the full function of this tax be brought into play. This is because first, only when the tax is extended to all stages of production and distribution can the system of deducting VAT, based on the tax stated on invoices, be established. The current problem of deducting the tax based on purchasing cost does not reflect the true tax element, and usually results in tax leakages. Thus, a check-and-balance mechanism among taxpayers themselves will be established. Second, the computation methods will be greatly simplified, so that tax compliance and tax administration will become more convenient. Third, the chronic problem of distinguishing wholesale and retail businesses will be tackled by setting the standard rate of VAT at a higher level than the tax burden on the retail stage.

Specific ideas on turnover tax reform are as follows:

  • Extend the coverage of VAT. As the first step, VAT will be imposed on all manufacturing sectors, and then, during the second step, the tax will extend to the retail stage.

  • Simplify the VAT tax rates. The rate structure will be one standard rate and another reduced rate.

  • Simplify the computation and collection methods of VAT. Input VAT will be credited against output VAT, and the balance will be paid by the taxpayer by means of invoices on which the tax amount is separately listed.

  • Calculate VAT on the basis of the sales prices, excluding VAT.

  • Enact the excise tax, which will play a special regulatory role. After the merging of VAT tax rates, a considerable number of products will experience a drop in the tax burden. In order to maintain the overall scale of fiscal revenue, the excise tax can be levied on a few selected consumption goods after subjecting them to a general levy of the valued-added tax. The coverage of the excise tax could include some high grade and luxury consumption goods.

  • Adjust tax rates in accordance with the industrial policy of China and the actual condition of the development of the tertiary industry. The business tax mainly plays its function in the tertiary industry sector.

On the premises of improving the indirect tax system, and the unification of the domestic and foreign-funded enterprise income tax, some taxpayers may experience an increased tax burden. Some transitory preferential methods will be conferred within a prescribed period of time.

Reform of Individual Income Tax

Equitable allocation of income is one of the important social targets a socialist country seeks to attain. The market, however, is not able by itself to realize this objective. Therefore, appropriate income and tax policies are devised by the state to maintain the impartiality of allocation and distribution.

At present, the three taxes charged on natural persons, namely, the individual income tax, the individual income regulatory tax, and the income tax on individual businessmen exist in parallel. This practice lacks legality, and there is an absence of standardization of legislation and policy integrity. Thus, it causes some contradictions. With a view to implementing effective macrocontrol, by means of taxation, in the field of allocation, a new individual income tax system will be established in the near term. This will suit the allocation pattern of distribution according to work, acknowledging reasonable differences in individual income, but also to perform needed income redistribution functions. The specific ideas are as follows:

  • A unified “Individual Income Tax Law of the People’s Republic of China” is to be formed to consolidate the current individual income tax, individual income regulatory tax, and income tax on individual businessmen of cities and towns.

  • With reference to the common international practices, expand the scope of levy of the individual income tax. The individual’s income from business operation will be subject to this tax.

  • The individual income tax will use progressive tax rates. Experiences of foreign countries will be assimilated in connection with the actual conditions of our country when setting up an appropriate level tax burden.

  • The individual income tax will adopt different allowable deductions with respect to Chinese citizens and foreigners.

Reform of Local Taxes

With the furtherance of the economic structural reform, the shortcomings of the current contracted financial system started to surface. The relationship between the central government and the local government needs urgent adjustment. The direction of reform is to implement a separate tax jurisdiction system. Proposed tax reforms must suit the implementation of this system.

Establish Local Tax System

Those taxes that have less significant macroregulation functions but are closely linked with the development of the local economy and are also convenient for the local government to administer will be assigned to the local government as their fixed revenue basis. Tentatively, in addition to the present local taxes, the business tax will be basically within the jurisdiction of the local government. Second, the scope of the resource tax will be for local government revenue. Third, taxes levied on property and land will be local taxes.

Expand Scale of Local Tax Revenue

It is important to raise considerably the proportion of local tax revenue in relation to the total tax revenue so that the local governments can cover most of their expenditures through their own resources.

Macrocontrol

On the premise of concentrating necessary macrocontrol with the central government, tax administration responsibilities must be clearly defined. The present chaos of the tax administration must be changed. Tax jurisdiction powers over taxes that have been assigned as fixed local government revenue should be mostly delegated to the local government.

Legislation

Tax legislation power over local taxes can be appropriately delegated to the legislative organs of the province, autonomous regions, and municipalities directly under the State Council, except those that require unified implementation across the country.

Reform Local Tax Structure

At present, China has a complicated, compound tax system with overlapping responsibilities, and local tax assignments are not very reasonable. Some local taxes should be merged or abolished; some should be restructured and perfected; and a few new taxes should be enacted. Specifically, the market trade tax, the livestock transaction tax, the bonus tax, the wages and salaries adjustment tax, and the oil consumption special tax will be abolished; the salt tax will be merged into the resource tax, and the special consumption tax into the excise tax. In addition, it should be possible to replace the urban land and house tax, and the vehicle and vessel license tax, with a unified house property tax and vehicle and vessel use tax; introduce at an appropriate time the land gains tax, the security transaction tax and the inheritance tax; delegate the feast tax and the slaughter tax to local governments; and reform and adjust the urban maintenance and construction tax, and the city and township land use tax.

Measures Supporting Reform of Tax System

A number of measures are needed to initiate the tax reforms discussed above. These are briefly summarized as follows:

Reform of Tax Administration System

The current tax administration system of China was formulated in 1977. Constrained by the then-planned economy, this system focused on the division of administrative powers. Since then, China’s tax system has undergone large adjustments. Furthermore, great changes have also taken place with respect to the state’s economic structure and situation. Under such conditions, the present tax administrative system must be reformed in parallel. The general principle for such reform is to tie together tax jurisdictional power and responsibility of tax revenue. Taxes that are central government revenues, or shared revenues between the central and the local governments, should be under the jurisdiction of the central government. Taxes that will go to local coffers should be under the jurisdiction of local governments.

Tax Legislation Work

At present, of all the tax legislation in China, only the following are promulgated by the National People’s Congress and enjoy the status of law: “Income Tax Law for the Enterprises with Foreign Investment and Foreign Enterprises”, “Individual Income Tax Law,” and the procedure law “Tax Collection and Administration Law.” Most other taxes have yet to be formally legislated. Some have only the status of provisional rules, of which some even do not have implementation regulations; still others have been implemented in the form of draft regulations for quite a number of years. To establish a modern market economy, it is not only necessary that the legislative work must be carried out in parallel with tax reform but also that tax legislation must become a guarantee to tax reform. Therefore, tax legislation work must be strengthened. At every step of the tax reform, tax legislation work must also be fulfilled in accordance with legal procedures, to realize the target of placing taxation on a legal and standard basis in the market economy environment.

Reinforcing Tax Administration

In parallel with the tax system reform, the reform of tax administration should also be furthered and deepened. Thus, the present backward tax administrative system should be thoroughly overhauled and a scientifically based, rigorous, and highly effective tax administration system be established.

The strategy for tax administration reform is as follows. First, popularize the self-assessment and self-filing system. It must be made clear to taxpayers that filing their tax returns is the primary link for fulfilling their tax-paying obligations. Establishing the taxpayer self-filing system is conducive to the formation of a check-and-balance mechanism among taxpayers themselves and helpful in strengthening their consciousness of tax compliance. It is foundation-laying work for the effective management of the tax administration. Once the system is established, those who do not file their tax returns within the prescribed time limit will be subject to economic penalties. Those who make false declarations will be treated as tax evaders and severely punished in accordance with law.

Second, actively introduce the tax agent system. International practice should be followed so that nongovernmental agencies, such as accounting firms, law firms, and tax consultancy firms, can be trusted with the task of helping taxpayers perform tax-paying procedures. Tax agent services will be an indispensable and important link in the entire tax administration system, forming a three-part, check-and-balance mechanism between taxpayers, tax agents, and tax authorities.

Third, expedite the process of tax administration computerization. International experience has proved that computerization is the surest way to establish a scientific, rigorous, and effective tax administration system that is also less costly. Because China has many sparsely populated areas, small-scale taxpayers, and the foundation of computerization is relatively weak, it might be wise to start with the cities, and first computerize the administration of the major taxes, and then gradually form a nationwide, criss-crossing tax administration computer network.

Fourth, establish a rigorous tax inspection system. After the establishment of a general taxpayer self-filing system and a full-fledged tax agent service sector in place, the tax administration can shift its main resources into day-to-day, priority tax inspection, forming a three-part tax administrative pattern of tax declaration, tax agenda, and tax audit. This system will be enforced by heavy punishment for tax evasion and tax leakage.

With the above measures, China will have a tax administration system whereby tax legislation, tax administration, tax audit, lawsuit and administrative reconsideration will co-function, and form a check-and-balance pattern. The system will better serve the development of a socialist market economy.

Tax collection and administration is, in essence, a process of law enforcement. Therefore, to establish a tax system that meets the needs of the development of a market economy, tax administration work must be strengthened. To strengthen tax administration, the principle of rule by law and its strict enforcement must be adhered to. The priority of the tax administration should be to discover and punish acts of tax evasion and tax leakage. The principle of severe punishment should also be reflected to enhance the deterrent effect of tax law. Through strict enforcement, the market transaction activities can be disciplined and the market order straightened up, all abnormal competition and action in violation of the market order will be checked, so that tax laws and tax policies can be implemented smoothly.

Striving to set right the allocational relationship of tax revenue and perfect the tax system in the next few years is of great significance to the development of the market economy. Tax reform is a key tool of macroeconomic policy and entails a series of reallocations and readjustments that will be of economic benefit to various sectors. Therefore, strong leadership is necessary, as well as popular support for the reform of the macro control system. In designing the reform scheme, extensive investigation must be carried out, meticulous forecasting and verification must be conducted, opinions of different departments and economic sectors need to be elicited, and international experiences will be conscientiously studied and assimilated. Through the aforesaid reforms, the tax system of China will be more streamlined, rational, and efficient.

State Administration of Taxation, China.

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