Monday, Apr 24, 2017, 11:06 PM CST – China

Editorial

The impact of China’s tax reform will go beyond economics

China’s tax code has become a major contributor to the hot-button issues of rocketing housing prices and industrial overcapacity.

During the annual National People’s Congress session held in March, Chinese Premier Li Keqiang announced that, as of May 1, China’s value-added tax (VAT) reform program will be expanded to the construction, real estate, financial and consumer services sectors. If fully implemented, the impact of this reform will be both economic and political.

Firstly, extending VAT to include the affected industries would bring all industries under the same tax code, which could lower their overall tax burden. In the past, as these industries were eligible for business tax while other industries paid VAT, they would find themselves effectively subject to double taxation, paying both the VAT on purchases made from up-chain industries and the business tax payable on their products and services. Once the proposed reforms are introduced, businesses in these industries will be able to offset VAT paid on purchases from other industries against the VAT applied to their products, while business tax is eliminated entirely. It is estimated that the overall tax burden of China’s service industries will decrease from 5 percent to 3 percent, injecting vitality into key economic sectors and boosting the prospects of economic growth, an ongoing concern for decision makers. 

Secondly, by applying VAT to the construction and real estate sectors, it is hoped that officials can accelerate much-desired economic restructuring. In the past, business tax and VAT have respectively been the top two sources of revenue for local governments. With business tax applied to construction and real estate, and VAT applied to heavy industry, local governments consequently adopted policies to maximize their potential tax take. For example, as higher land and housing prices bumped up business tax revenue, local governments resorted to various means, such as limiting the amount of land allocated to the sector and liberalizing financial policies, in order to inflate housing prices.

 For heavy and often polluting industries, which yield a bigger VAT windfall than others, local governments have resorted to lowering the price of industrial land and loosening environmental protection regulations to appeal to businesses.

As a result, China’s tax code has become a major contributor to the hot-button issues of rocketing housing prices and industrial overcapacity.

According to the government’s policy agenda, the implementation of tax reform will be followed by the restructuring of the revenue sharing policies of central and local governments. Currently, all business tax and 25 percent of VAT revenue goes to local governments, while 75 percent of VAT goes directly to the central government. With the scrapping of business tax, reform of tax revenue distribution becomes essential, providing a rare opportunity to address problems rooted in the current system, such as local authorities’ excessive dependence on real estate sales.

VAT reform will inevitably lead to an overhaul of China’s income tax system. Currently, income tax only accounts for 6 percent of total tax revenue. That ratio is 35 percent in the US, and 20 percent in many emerging economies. As China’s income tax is essentially a salary tax, the wealthy and those with significant gray incomes are largely exempted. By scrapping business tax, the government has apparently adopted a “direct taxation” approach. With a fairer and more comprehensive income tax code, China can achieve multiple goals, including reducing the overall tax rate for business, securing a stable source of revenue and addressing the problem of the ever-widening income gap.

The successful implementation of the reform program will be a major factor that helps determine whether China can achieve its overall dual policy goals of economic sustainability and political stability. 

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