Taxation in Modern China

Donald J. S. Brean

• Publisher: Routledge
• Year: 2013
• Print ISBN: 9780415920179
• eBook ISBN: 9781136678929
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Taxation in Modern China is concerned with tax and public financial issues arising in China's economic transition. The contributors, among the leading authorities on public finance, transitional economics and policy reform in China, direct attention to the largest and most comprehensive fiscal reform program in modern history. The essays collected here cover the main institutional, intergovernmental and industrial issues and address the long-term challenges facing China as well as transitional changes.

1

FISCAL REFORM IN MODERN CHINA

AN OVERVIEW

Donald J. S. Brean

An Overview of the Chinese Economic Reform

For the past twenty years, China has been engaged in the most sweeping, most dramatic economic reform in the history of the modern world. In 1978, the government announced a series of reform initiatives that included the relaxation of direct central planning, the decentralization of industrial decision making, increased reliance on market forces to determine prices, the development of privately owned business firms, and the opening up of China to the outside world through international trade and foreign investment. Since then, adding to the simple superlative of its sheer size—1.2 billion people—China has enjoyed the highest sustained rate of economic growth in the world. The average annual growth of gross domestic product (GDP) for the entire period—8 percent—resulted in a quadrupling of GDP per capita. At least 450 million people have been lifted from abject poverty.

China’s economic revitalization began with an astonishing performance in domestic agricultural production—a direct response to liberalization in that sector—which then expanded to equally impressive progress in manufactured exports, residential and industrial construction, and infrastructural development. The rise of the Chinese economy was propelled by a remarkably high savings rate—in the range of 35 percent—which redirected income back into further investment and productive accumulation. These aggregate statistics are mere summary statements of a phenomenom that has translated into higher personal incomes, a newfound abundance of food supplies, and a substantially expanded variety of consumer goods.

The Chinese economic transition—from a command economy to a market economy—is built on four pillars of reform: price reform, industrial reform, banking and financial sector reform, and the reform of public finance. Within these major categories of transitional development, substantial change has also occurred or continues to evolve in international trade, social services, labor markets, enterprise governance, and a variety of other sectoral specific areas.

The focus of this volume is the role of taxation and public finance in China’s economic transition. Reform of taxation and the system of public finance has been as fundamental and as far-reaching as reforms in other dimensions. In many respects, however, the agenda for tax reform is determined by the progress on other fronts. To establish an appropriate political and institutional context for the issues in taxation addressed in this volume, it is useful to review briefly the recent history of economic reform in China—the motives, the process, and the results.

The path of Chinese industrial reforms was shaped by consensus decision making. Instead of sweeping out central planning in one bold stroke, elements of market competition were introduced gradually, often experimentally, always sensitive to potential intransigence of key ministries. This process can variously be described as deliberate, cautious, or cagey. Regardless, it is effective. It is moshitou guohe, “crossing the river by feeling for the stones.”¹

Even moshitou guohe tends to exaggerate the systematic component of China’s early reforms by suggesting a clear objective—the far bank of the river—where no such vision existed. China’s reforms typically involve what one might view as “enabling measures” rather than compulsory changes. Instead of eliminating price controls, for example, reform has gradually raised the share of sales transacted at market prices. Instead of wholesale privatization, there has been a growing range of firms issuing shares. Production planning does not vanish, but its span of control gradually shrinks. As Jefferson and Rawski (1996) depict the process:

This open-ended approach invites decentralised reactions that the centre can neither anticipate nor control. Governments at all levels become participants, sometimes even followers, as well as leaders of reform. Reform unfolds as a process replete with interactions among governments, enterprises, workers, and consumers rather than a sequence of events in which the state makes decisions to which businesses and individuals react.²

As we shall explore from various perspectives in this volume, the steep decline in the ratio of government revenue to gross national product (GNP) is an illustration of an unforeseen outcome that in turn shaped the form and pace of tax reform.

The merits of the gradual approach to economic transition, where it is possible, have been confirmed in China. Severe shocks are generally avoided,³ trials permit midcourse correction, institutional development can occur in line with the new systems, and economic agents can adjust slowly to the new conditions. China was thus able first to bypass and later dismantle its administrative controls at a pace appropriate to the emergence of the market-based alternatives and the competence of the remaining regulatory functions. Not only were severe and threatening dislocations avoided, but also China has enjoyed growth with reform—in marked contrast, to cite the obvious examples, with Eastern Europe and the former Soviet Union. Of course, much of China’s apparent good fortune in the transitional process has been due to the favorable initial conditions under which the reform was launched.

The Chinese economy at the inception of reform, unlike other centrally planned economies in transition, was not in a deep crisis of macroeconomic instability. In the lead-up to 1978, measured inflation was low, government and external balances were rarely large and, in terms of production of electric power, cement, and steel, the industrial base in the late 1970s was comparable to that of Japan or the Soviet Union in the 1960s.⁴ Income distribution and social indicators compared favorably with those of middle-income countries. Thus the question arises about the factors that prompted economic reform and the nature that it took.

Although no crisis was apparent at the macroeconomic level, there was growing discontent with economic performance. Growth was due only to increasing amounts of capital and labor employed, with little or no growth in factor productivity. The rigidly controlled price structure led to inefficient resource allocation. Investment in heavy industry was at the expense of basic infrastructure. Agricultural production was stagnant, with shortages in non-grain products. Overall, economic management in China maintained a pervasive emphasis on quantity rather than on quality and variety, that led to slow growth in per capita consumption with acute shortages of many consumer goods and housing. Above all, any individual incentive to address any of these problems was seriously suppressed.

The early challenge of China’s economic reform was managing the political risk of the major redistributions of funds and power involved in the transition from central planning to a market economy. In this respect, the pragmatism of Deng Xiaoping was crucial. Political analysts describe the process adopted by Deng and his reformist lieutenants as pushing against the stone wall of Chinese bureaucracy. Where they found loose stones, they pushed them through; when stones would not move, they did not waste energy pushing, knowing that the whole structure would loosen sooner or later. “Not to engage in debates: this was an invention of mine,” declared Mr. Deng, “in order to get more things done.”

Radical agricultural decollectivization, for example, did not threaten the industrial ministries or the Ministry of Finance. Agricultural reform was introduced ahead of industrial reform, since the latter would diminish the control and resources of the central ministries. With a similar strategic motive in regard to price reform, a dual-track price system combined floating market prices with administratively set plan prices to avoid confronting the radical redistribution among raw materials and manufacturing sectors implied by comprehensive price liberalization. Lest a Western observer think that dual-track pricing only prompts black markets, side payments and queues, the fundamental point for effective economic transition is that indeed such “inefficiencies” are inevitable aspects of gradualism.

China did the easy things first. The reformers also experimented, and they continue to experiment.⁵ Moreover, using great political pragmatism, instead of attacking the perquisites and powers of central bureaucracies head-on, most reform initiatives circumvented the bureaucracies by creating new, closer-to-market forms of business exempt from normal state rules, such as private and collective firms and the Special Economic Zones designed to attract foreign investment. The dynamic growth of this nonstate sector put competitive pressure on state-owned firms and the government bureaucrats responsible for them; soon state managers and bureaucrats were demanding the same market freedoms for their state-owned firms.⁶

The gradualist, “stone-loosening” process applies as much to the reform of taxation as it does to the larger reform agenda in China. Some taxes, like some institutions, are amenable to early change, whereas others require more time to await indications of progress on other fronts.

Tax Reform in the Economic Transition in China

The transition from a command economy to a market economy requires fundamental change in the system of taxation and public finance. In China, the important challenges of tax reform stem from the need for government revenue, the need to adapt fiscal structures to the new decentralized economic order, and the need to address intergovernmental fiscal issues. These topics receive attention in the papers of this volume.

Revenue—Good Markets Start with Good Government

The guiding principle⁷ for public finance in transitional economies recognizes that good government requires sufficient resources. China is replacing the old command structure of government revenue with a market-based system of taxation. In contrast to the ad hoc, contractual, and confiscatory methods of the past, reform requires a revenue system based on appropriate measures of taxable flow—such as profit, income, sales, or value-added.⁸

More market does not demand less government. China has had too much government in some respects, too little in others. It has had too much in production and investment controls and too little in the rule of law, macroeconomic management, and the provision of public goods and services. There are direct implications for public finance: make the revenue side less interventionist and reshape the expenditure side to address functions that the market cannot serve effectively—education, health care, welfare, infrastructural development, research, environmental protection.

To make markets work better, China is enacting new laws that protect property rights, promote competition in product markets, and foster financial discipline. At the same time, China is developing the capacity to ensure macroeconomic and financial stability—even as potentially destabilizing reforms are being implemented.

Economic Decentralization—Making Room for Markets

Command economies fail the test of efficiency because they are generally rigid, slow to adjust, and suffer a dearth of information otherwise provided by flexible prices. Above all, central economic planning suppresses the market signals and incentives that, if unleashed, spur private capital formation and efficient allocation of risk. China’s tax system must be consistent with the broader structural change in the economic system that results in liberalized prices, less direct state involvement in production, more private enterprise, and a more commercially based financial system.

The most dramatic and effective action in this regard involves the dismantling of the state-owned enterprise sector together with its archaic methods of production planning, management, and governance. State-owned enterprises (SOEs) are an expensive burden for the government. As many lose money, they drain a huge volume of funds from the banking system. Their inefficiency hampers both job creation and economic growth.

China’s SOE reform strategy is twofold. One thousand large state firms have been selected to form the core of China’s modern enterprise system. These firms will institute a modern corporate structure and professional management practices, and will be opened to domestic and international competition and uniform banking practices. The remaining 304,000 SOEs will be extended the freedom to organise leases, mergers, or sales or, if necessary, to liquidate. An important element of SOE reform will be the transfer of pension, health, and education obligations from state enterprises to government authorities.

The microfiscal matter of industrial incentives—establishing proper incentives—is a reason for enterprise tax reform in the first place. In a practical if not ideological sense, the fiscal quid pro quo for the state to give up mandatory remittances is the prospect of an even richer flow of tax revenue from more efficient industry.

Intergovernmental Fiscal Issues—Beijing and the Provinces

The transition from central economic command to a decentralized market system inevitably and profoundly changes the fiscal relations between the center and the lower levels of government. Over the centuries, China had developed a sophisticated system of local government to raise revenues and to attend to local public needs. The tradition of local government in fact became stronger under communist rule. Indeed, marshaling lower-level power was crucial to Mao Zhedong during the Revolution, while thirty years later Deng Xiaoping adopted similar political strategies to solidify support for economic reform. Today, with the main features of the economic transition well advanced, China must move with great resolve to establish a workable system of revenue sharing and expenditure assignment that fairly distributes the economic benefits of the reforms—stemming the divisive pressures toward regional and social inequality.

Reconstructing public finance on a national scale in view of social as well as economic priorities entails spending in areas such as health care, the environment, education, and the social safety net to meet the needs of a modern market economy. This demands proper alignment of revenue and expenditure responsibilities among levels of government—the nation, the provinces, and municipalities—to foster greater accountability and efficiency of public expenditure. China needs a rules-based system of transfers to ensure that the benefits of growth are spread evenly across the country.

In summary, tax reform in modern China is framed in three major dimensions: mobilizing revenue, making room for markets, and restructuring intergovernmental fiscal relations. The revenue imperative is a macroeconomic matter, market development is microeconomics, and intergovernmental issues are part of China’s political mosaic. The rest of this overview paper addresses each of these issues with reference to—and summaries of—the papers in the volume as they explore structural considerations and policy in these respective areas in greater detail.

The Great Evaporation of Revenue

The challenge of fiscal reform in transitional economies is to replace, speedily, the old command-type revenue sources with explicit, market-based tax systems that ensure adequate revenue within a new tax environment that is conducive to markets and efficient decentralized allocation. In China, the “adequate revenue” requirement has been especially elusive. In fact the most significant fiscal feature of the Chinese economic transition has been the steep and steady decline of government revenue relative to GDP (table 1.1) with a corresponding rise in the fiscal deficit.

Atinc and Hofman analyze the history of the fiscal deficit from 1985 to date, the period of the most rapid decline of the revenue-to-GDP ratio and also the time through which substantial structural change occurred in relations between industry and the government. Atinc and Hofman deal exclusively with the macroeconomic figures; more detailed explanations of the phenomenon will be discussed in other papers. They carefully develop alternative definitions of the deficit—definitions that differ in the extent to which they account for the comprehensiveness of central command of resources.

The government deficit, especially its definition and measurement, reflects interrelations between fiscal and financial systems that differ fundamentally in a command economy as opposed to a market economy. As China moves from one to the other, the fiscal deficit is the devil in the detail of transition. Prior to the reforms, there was no meaningful distinction between the government accounts and the accounts of the state-owned industrial system. Since SOE net cashflow was subject to remittance, SOE net cashflow was essentially government revenue. The banking system was the government’s cashier, the conduit for credit to industry. With reforms, enterprise and government accounts have become progressively separated and, as a result, the GDP’s share of budgetary revenues has declined sharply.

The “budget deficit,” with adjustments for a variety of Chinese idiosyncratic public accounting techniques, can be viewed as a reasonable approx...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Contents
• ABBREVIATIONS
• ACKNOWLEDGMENTS
• 1 FISCAL REFORM IN MODERN CHINA
• 2 CHINA’S FISCAL DEFICITS, 1986–1995
• 3 ENTERPRISE TAXATION AND TRANSITION TO A MARKET ECONOMY
• 4 MARGINAL EFFECTIVE TAX RATES IN THE REFORMED TAX SYSTEM
• 5 CAN SEIGNIORAGE REVENUE KEEP CHINA’S FINANCIAL SYSTEM AFLOAT?
• 6 CENTRAL-PROVINCIAL-LOCAL FISCAL RELATIONS
• 7 INTERGOVERNMENTAL FISCAL RELATIONS IN CHINA IN INTERNATIONAL PERSPECTIVE
• 8 FISCAL DUALISM IN CHINA
• 9 MARKET-ORIENTED ECONOMIC REFORM AND THE GROWTH OF OFF-BUDGET LOCAL PUBLIC FINANCE
• 10 THE REFORM OF THE FISCAL TRANSFER SYSTEM
• 11 THE FUTURE OF MARKET SOCIALISM IN CHINA
• 12 ACCOUNTING IN CHINA
• ABOUT THE CONTRIBUTORS
• INDEX