China - Revenue mobilization and tax policy (Vol. 1 of 2)

Report No. 7605-CHA China: Revenue Mobilization and Tax Policy Issues and Options (In Two Volumes) Volume 1: Main Report June 15, 1989 Country Operations Division China Department Asia Region FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed wvithout World Bank authorization.  CURRENCY EQUIVALENTS The Chinzse currency is called Renminbi (RMB'. It is denominated in Yuan (Y). Each Yuan is 1 Yuan = 10 jiao = 100 fen Calendar 1988 June 1989 US$1.00 = Y 3.72 US$1.00 = Y 3.72 Y 1.00 = US$0.27 Y 1.00 = US$0.27 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System LIST OF ACRONYMS MOF - Ministry of Finance GTB - General Taxation BureaL SRC - System Reform Commission PBC - People's Bank of China SAT - State Administration of Taxation SOE - State-owned Enterprise CMRS - Contract Management Responsibility System AMRS - Asset Management Responsibility System EMRS - Enterprise Management Responsibility System GFS - Government Finance Statistics VAT - Value Added Tax PIT - Personal Income Tax PIAT - Personal Income Adjustment Tax CICT - Consolidated Industrial and Commercial Tax ICIT - Industrial and Commercial Income Tax  FOR OMCIUL USE ONLY CHINA REVENUE MOBILIZATION AND TAX POLI.Y This report and its annexes are based on the findings of a mission which visited China in May-June 1988. In addition to interviews and discussions in Beijing, the mission visited Nanjing and Changzhou (Jiangsu Province), and Hefei (Anhui Province). The mission consisted of Christine Wallich (Mission Leader); Pradeep Mitra coordinated the work on Tax Policy with inputs ftom Anthony Pellechio (Direct Taxes) and Christopher Heady (Consultant, Indirect Taxes); Roy Bahl (Consultart) was responsible for Provincial and Local Government Finance; Mario Blejer (IMF) for Macroeconomic Policies; Peter Driscoll (IMF) for Tax Administration and Heidi Hennrich-Hanson for Expenditure Policy. The Mission was also accompanied in Beijing, and benefited from inputs from Gyorgy Szapary (IMF). The mission was conducted in collaboration with and accompanied in the field by a Chinese counterpart team from the Ministry of Finance's General Taxation Bureau and other agencies, sponsored by Mme Li Huizhong, Director, Budget Bureau, General Taxation Bureau, and led by Mr. Xu Shanda, Deputy Chief, Tax Research Division, General Taxation Bureau, Ministry of Finance. Members of the counterpart team included Gao Jian (MOF), Mme Gao Ying (MOF), Zhang Jungang (MOF); Xou Peiseng (SRC); Shi Yaobin (MOF); Shi Yajun (MOF); Mme Li Xiaojun (SAT). This document has a restricted distribution and may be used by recipients only in the performance of their ofTicial duties. Its contents may not otherwise be disclosed without World Bank authorization.  CHINA RESOURCE MOBILIZATION AND TAX POLICY ISSUES AND OPTIONS MAIN REPORT Table of Contents Page No. Sunmnary u-nd Connlusions .... i Preface ..... . ....................................................... xiv I. CHINA'S TAX SYSTEM AND MACROECONOMIC BALANCE .................. 1 A. The Progress of Tax Reforms to Date .. 1 B. Revenue and Expenditure Trends: China's Recent Budgetary Experience ......................................... 7 C. Revenue and Expenditure Issues: The Macroeconomic Perspective .............................................. 19 D. Conclusions ................................................ 25 II. REFORMING THE TAX STRUCTURE ................................... 27 A. Key Features of China's Present Tax System . . 27 The Tax System in 1988 .. 27 The Taxation of Individual Incomes . . 33 The Structure of Domestic Indirect Taxation . . 34 Other Indirect Taxation .. 36 Other Minor Taxes .. 37 Implicit Indirect Taxes .. 37 B. The Impact of the Current Fiscal Regime . . 38 Indirect Taxes ........................................... 38 Business Tax ............................................. 47 Enterprise Income Tax .. 47 Extrabudgetary Construction Tax and Wage Bonus Tax ....... 50 Resource Tax ............................................. 50 Agriculture Tax .......................................... 51 Personal Income Adjustment Tax .. 52 Taxes on External Trade .. 52 Taxes and Industrial Policy . . 53 C. Recommendations ............................................ 53 Indirect Taxes .... ..................................... 54 Implications of Recommended VAT Changes . . 58 Unifying the VAT Rate .................................... 62 Taxation of Enterprises .................................. 65 Resource Tax ............................................. 71 Other Taxes .............................................. 73 The Reform Package and its Revenue lmplications .......... 75 The Phasing of Tax Reform: A Summary . . 75  - ii - III. CENTRAL-LOCAL FISCAL RELATIONS AND REVENUE SHARING ........... . 80 A. Fiscal Decentralization and the Role of Local Government: Principles, Criteria and the International Practice .... 80 Fiscal Centralization vs Fiscal Decentralization ......... 80 What Revenue Raising Powers for Subnational Government? ............................................ 81 Intergovernmental Transfers .............................. 82 China in an International Context ........................ 84 B. The Present System of Subnational Finance in China ......... 88 Provincial Government Finance ............................ 88 Budgeting and Financial Planning ......................... 93 Tax Administration ....................................... 94 Provincial Revenues ...................................... 95 Intergovernmental Fiscal Relations ....................... 98 Tax Sharing Between Provinces and Their Local Governments ............................................ 102 C. Initial Assessment and Issues .............................. 103 Other Problems and Issues ................................ 111 D. Options for Reform ......................................... 114 Limited Tax Sharing ...................................... 114 Balanced Tax Sharing ..................................... 115 Base-Sharing Model ....................................... 116 Patching Up the Present System ........................... 119 IV. TAX ADMINISTRATION AND COLLECTION ............................. 123 A. An International Perspective on Principles of Administration 123 Efficiency in Administration ............................. 125 Machinery of Government .................................. 129 The Organization of the Tax Admiristration: Centralization vs Decentralization ..................... 129 B. Tax Administration and Collection in China ................. 130 The Institutional Background ............................ 130 Tax Collection Machinery and Practice in China ........... 135 C. Analysis and Issues ........................................ 136 How China's System Compares .............................. 136 Machinery of Government .................................. 137 Centralized vs Decentralized Administration .............. 137 Assessment ............................................... 140 D. Recommendations and Reform Options for the Present System.. 141 National Tax Service .................................. .. 141 Near-Term Steps to Strengthen the SAT .................... 142 Organization and Strengthening of Provincial and Lower-Level Offices .................................... 145 Near-Term Administrative Reforms: Micro-Level Administrative Measures ................................ 147 Transition: Some General Considerations ................ 149  - iii - TABLES IN TEXT Table 1.1: China Budgetary Revenues, 1980-1988 . . 3 Table 1.2: International Comparisons of Expenditure and Taxation... 6 Table 1.3: International Comparison of Revenue Structure . . 7 Table 1.4 China: Developments in Government Revenue, 1978-88 .. 9 Table 1.5: China: Structure of Government Expenditure, 1978-1988.. 17 Table 1.6: China: The Budget and Its Financing . . 19 Table 2.1: China: The Effects of Tax Cascading . . 46 Table 2.2: Marginal Effective Tax Rates in China . . 49 Table 2.3: Rate Structure of VAT: Selected Countries . . 57 Table 2.4: Effects of Value Added Tax on Sectoral Profitability .... 61 Table 2.5: Growth of VAT Revenue: Selected Countries . . 65 Table 2.6: Eliminating Principal Deductibility: Revenue and Profitability Effects .. 70 Table 2.7: Summary of Recommendations .. 78 Table 3.1: Importance of Local Government Revenue Share: Selected Countries .. 87 Table 3.2: Tax Collection and Expenditure of Central and Local Governments, 1980-86 . . 91 Table 3.3: China: Revenue-sharing System ................ 100 Table 3.4: Changing Fiscal Importance of Central and Subnational Government Sectors . .............. 104 Table 3.5: OLS Regression Results for Chinese Revenues and Expenditures ......................................... . 106 Table 3.6: Comparisons of Taxable Capacity and Tax Effort: By Province ........................ 108 Table 4.1: Taxpaying Entities by Type of Taxpayer - 1988 . ....... 131 BOXES Box 1.1: Recasting the Chinese Budget ........... . ............... 10 Box 1.2: The Tax Contracting System .............................. 14 Box 2.1: Measures of Profitability ............................... 41 Box 3.1: Formula Grants .......................................... 85 Box 3.2: Revenue Allocation and Tax Sharing ...................... 96 Box 3.3: Revenue Sharing and Tax Effort .......................... 109 Box 3.4: Profit and Sales Tax Sharing Under a Controlled Base-Sharing Model ................................... llR Box 4.1: Audit Programs .......................................... 1!7 Box 4.2: Tasks and Responsibilities of the SAT ................... 1's3 Box 4.3: The Steps in Turnover Tax Administration ................ 139 FIGURES Figure 2.1: Allocation )f Gross Income .. 29 Figure 2.2: Allocation of Net Income .. 31 Figure 3.1: Government Structure in China .. 90 Figure 4.1: The Hierarchy of Tax and Finance Bureaus . .......... 132 Figure 4.2: Tentative Organization Chart of the SAT . .......... 146  - iv - APPENDIX TABLES I. State Budget Revenue 1978-1988 II. State Budget Revenue (Constant Prices) III. Summary of Tax System - 1988 IV. Collection and Expenditure Disparities Among Provinces - 1985 V. Recent Increase in Revenues and Expenditures. by Province VI. Changes in Ratio of Expenditures to Collections, by Province ANNEXES Annex 1: Reforming the Tax Structure in China Annex 2: Subnational Government Finances in China Annex 3: Tax Administration in China  - i - CHINA REVENUE MOBILIZATICN AND TAX POLICY Summaty and Conclusions i. In 1979 the Chinese goveinment set in motion a process of reform aimed at decentralizing production and investment decisions anu letting the market influence these decisions as a strategy to improve allocative efficiency and promote modernization and growth of the economy. Reforms concentrated first on the rural sector, leading to its remarkable growth in the post-reform period. ii. Beginning in 1984, reforms were initiated in the urban sector, with major changes in enterprise management and finance. A central element of the urban reforms was a reduction in the role of the government in the economy, both in determining the allocation of resources and their financing. Major emphasis was placed on a devolution of power to lower level entities, giving greate:r responsibilities to enterprises and provincial and local governments. These changing responsibilities have had a major impact on the role and size of the government budget, with the state's dominant role significantly reduced, as well as changed in nature and scope. iii. In June 1988, a World Bank mission visited China to analyze, in collaboration with a Chinese counterpart team from several government agencies, China's tax system and recommend improvements. This summary provides a brief overview of the mission's findings and recommendations, discussed in detail in the following main report. A companion volume of three Annexes provides further analysis of tax policy questions, subnational finances and tax administration, as well as a detailed description of China's tax system itself. China's Tax System in International Perspective iv. China's tax system differs significantly from other countries in its income group, both in terms of level and structure. Because of the major government role in the economy, China's tax to GDP ratio of 27Z in 1985 was almost twice that of other countries at its income level. Even now, with a tax ratio just under 20Z, the ratio remains higher than its comparator income group. China's tax structure is also unusual for a country with its per capita income, with direct taxes about 33Z of the total in 1988 and indirect taxes 46Z. In lower income countries, there is typically great reliance on taxes on international trade, while direct taxes are often lacking. In this respect, China resembles, not surprisingly, the socialist countries of Eastern Europe, where direct and indirect taxation of enterprises plays the major rcle. Moreover, China, like other socialist countries, levies almost no taxes on individual incomes.  - ii - Tax Reform and System Reform v. Tax reform is an essential element of the microeconomic efficiency enhancing reforms based on decentralized decision making. Price reform is also crucial to this process. If these efficiency-enhancing goals are to succeed in China and for resource allocatian to improve, prices must adjust to reflect economic scarcities. At the same time, price reform cannot be separa- ted from tax reform, because changes _n prices without changes in taxes would distort profitability. If price signals are to guide enterprise behavior, enterprises must also face a competitive environment. Specifically, enter- prises must face an environment in which chey can compete on an equal footing, a process to which China's current negotiated and personalized tax system does not contribute. The close relationship between taxes, prices and enterprise behavior implies that such system reform calls for coordinating progress in each of these areas. vi. Tax reform is therefore inevitably linked with both enterprise and price reform. With respect to the link between tax and enterprise reform, the main idea behind enterprise reform is to make enterprises responsible for their profits and losses and thus increase the incentives for efficiency. The allocation of resources will not be efficient, however, even if incentives and relative prices are rightly aligned, unless a "hard" budget constraint is imposed on enterprises. This is because the lack of a hard budget constraint limits the incentive effects of tax policy. At the same time, the current approach to tax policy--and the presence of discretionary and enterprise- specific taxea that are subject to bargaining--itself softens the budget constraint in a manner that distorts economic decisions. A general hardening of the budget constraint on enterprises via a harder tax constraint and less negotiation and personalized contracting would support the aims of enterprise reform, while enterprise reform would strengthen the incentive effects of tax policy. vii. Likewise, price and tax reform are also intimately linked. In the absence of price reform, there is an ongoing need to use the tax system to offset the producer preferences created by the current pricp regime's signals. Tax reform is thus partially constrained by the pace of price reform. By the same token price reform must be accompanied by tax reform, to prevent the tax rates designed for a "fix-price system" from creating new distortions. viii. The VAT rate structure, for example, cannot be unified, in the absence of price reform, because of the continuing need to use indirect taxes to equalize sectoral profitability differentials arising from price distor- tions. It follows that initiating price reform would imply greater scope for using VAT and that tax and price reforms must be coordinated with each other. As price liberalization proceeds, it would be possible to simplify the rate structure of VAT and move towards a unified VAT structure similar to that of other countries. Such a VAT would have the advantage of minimizing distor- tions of the market prices, while fulfilling the major tasks of revenue- raising, protecting the living standards of the poor and discouraging socially undesirable consumption.  - Iii - ix. In sum, the close relationship between taxes, prices and enterprise behavior implies that meaningful system reform will require simultaneous progress on all these fronts. At the micro level this means that many tax reforms cannot be imnlemented effectively prior to some progress in e.g., enterprise and price reform, while enterprise and price reform may be constrained in the absence of tax reforms. Coordinated Tax Policy, Administration, and Subnational Finance Reform x. In China, the close links between tax policy, tax administration, and the revenue sharing and collection system between central and local govern- ments also adds a "systemic" dimension to tax policy change. Although the followiiig sections treat Tax Design and Structure, Subnational Finance and Tax Administration separately and in turn, the fact of local government responsi- bility for revenue collection and upward sharing, creates strong links between all three areas. It can be argued that, unless tax reform addresses all three areas, it is unlikely to accomplish its objective. xi. A complex tax structure, as in any country, interferes with adminis- trative ease. The decentralized administration in China, whereby local governments collect the central government's taxes, implies that unless the center can be assured that local governments administer tax policy as designed by the center, tax policy objectives may be compromised. Management informa- ticn is crucial to ensuring this. Finally, the revenue sharing system itself creates incentives for tax system implementation at the local level, which may interfere with the achievement of thLe center's tax policy objectives. The package of tax policy reform, tax administration reform, and revenue sharing reform needs jointly to be considered, although for didactic purposes, each is treated separately in the Report. Reforming China's Tax System Improving the Efficiency of the Tax System: Tax Design and Structure xii. In China as elsewhere, taxes are designed to raise revenue and promote efficiency in production. But the extent to which taxation can succeed in its latter objective is caught in Lhe intricate web of relation- ships between the State and state-owned enterprises. The tax system which has emerged in China reflects the ad hoc and experimental approach which has characterized tax and other reforms to date, and the fact that i-. this period, tax reforms have been directed toward many objectives. There remains as a result, a significant commingling in the design (and objectives) of the tax system of the government's role as owner of state-owned enterprises and its role as tax collector. For that reason, tax reform and enterprise reform are seen as being closely related. In addition, there are two specifically Chinese institution'U characteristics that constrain tax reform: price controls and the abseace of valuation or pricing mechanisms for fixed assets in state-owned enterprises. xiii. Prior to reforms, most surpluses were generated by enterprises and transferred to the state via profit remittances. The move, in 1983, away from profit remittances to an enterprise income tax at 55Z led to the bulk of tax revenue being collected from the three principal indirect taxes (product tax,  - iv - VAT and business tax) and, to a significantly lower axtent, from the enter- prise income tax. Both direct and indirect taxes continue to tap the 'surpluses' in the enterprise sector which have accrued followirg the move from profit remittance. The reform of the enterprise income tax is seen as a way to improve incentives and raise productivity, a view that could explain the increasing popularity of the contracting system. Indirect taxes, on the other hand, fulfill a variety of roles. The existence of price controls affects sectoral pLofitability; product tax and VAT rates are therefore fine- tuned in an attempt to enssure equalization of such profitability across sectors (although concern for industrial policy may permit some differences in profitability). This fact accounts for the multiple rate structure. xiv. However, such equalization is necessarily confined to the sectoral level. Equal treatment of enterprises within a sector is accomplished by levying, for enterprises with access to natural resources, a resource tax to compensate for differential natural resource endowments; and for industrial enterprises, the income adjustment tax. Inasmucb as these differentials are due to differences in (virtually) free capital endowments from the state. justification is thought to be provided for tailoring the income adjustment tax to the circumstances of the individual enterprise. xv. The highly differentiated rate structures of the product tax, VAT and resource tax, together with the tailoring of the income adjustment tax on an enterprise-by-enterprise basis, introduce wide scope for discretion in the design, interpretation and implementation of tax policy. Such wide discretion runs counter to the spirit of system reform. In the area of direct taxes, tax remissions, by emphasizing discretion over rules, divert the attention of enterprises from lowering product cost and raising quality, and reinforce the symbiotic relationship between enterprises and their supervisory bureaus. Enterprise-specific variations in income and adjustment tax obligations, such as those characteristic of the contracting system, also make policy making difficult by removing "standard" contracts for purposes of evaluation. With regard to indirect taxes, in addition to the points made in the above para- graphs, administrative considerations argue against a complex VAT and product tax structure. xvi. This report's recommendations for reform of tax policy are to be seen as an integrated pac&age. They would restore to the tax system its primary role of raising revenue (and hence of aiding macroeconomic balance); reduce its scope for administrative discretion in favor of established rules; and, strengthen incentives for the more efficient use of fixed assets by state owned enterprises. Considerations behind this proposed policy package high- light the close relationship between taxes, prices and enterprise behavior, which implies that system reform requires simultaneous progress on all fronts. xvii. The recommendations also seek to build on the strengths of the existing tax system in China, focussing on refinements and amendments to the major taxes now in place (such as the VAT and the contracting and other elements of the enterprise income tax) rather than recommending radical change or a wholly new structure. The major recommendations and their justification are summarized below.  - v - xviii. Enterprise Taxation. With respect to enterprise taxation the report recommends: (a) that the present enterpris6 income tax continue to apply to the profits of all state enterprises at its current flat rate of 55Z. Consideration should not be given to lowering the enterprise income tax rate, and to unifying the tax treatment of different enterprise types, until after reform of the contractual responsibility system and its tax preferenices have been brought under control; (b) that no new contracts be initiated with respect to the payment of indirect taxes and the enterprise income tax; (c) that contracting between state-owned enterprises and their owners should be permitted only on payments to the government/owner out of after-tax profits; and (d) that repayment of loan principal should be disallowed as a deduction foL purposes of the enterprise income tax on all new loans with a view to the full elimination of principal deductibility over time. xix. Although consideration is being given to lowering the basic rate of enterprise income tax from its current level of 55X, there are two reasons why such a retiduction should be postponed until after the tax preferences prevalent under the contractual responsibility system have been fully eliminated. First, the incentive effects of the tax depend not just on the statutory tax rate but also on the treatment of depreciation, amortization and interest. This argues for simultaneous consideration of all provisions of the enterprise income tax and not simply its statutory rate. Second, decreases in tax rates unaccompanied by revenue-raising measures would risk losing significant amounts of revenue at a time when fiscal policy must play an important part in overall macroeconomic management. Finally, reassessing the tax rate only after the full budgetary impact of reforms (e.g. in housing, social security, etc.) is known will preclude the possible n-ed to make major upward revisions in tax rates as each reform proceeds. xx. Maintenance of the basic rate of enterprise income tax at its current 552 level, pending reform of the contractual responsibility system, implies that it will not be possible to unify the tax treatment of state-owned enter- prises with collectives and individual household enterprises. While unifica- tion may be a desirable longer-term goal, it is the report's view that taking control of the revenue base th-ough the taxation of state enterprises should receive higher priority than unifying tax treatment between different organi- zational units. Abalition of tax preferences in the contractual responsibi- lity system would offer the opportunity to implement a unified rate of enter- prise income taxation. That rate would be set by the authorities with reference to revenue requirements. Lack of information precludes the report from making a recommendation on what a more appropriate longer-term enterprise tax rate might eventually be. xxi. The report recognizes that incentives must be provided to State- owned enterprises to encourage efficient utilization of their fixed assets and return a dividend to the State. However, this should be done without eroding  - vi - the tax b,ase. Furthermore, the tax and contracting system should contribute to an important objective of enterprise reform, which is to distinguish between the roles of the State as tax authority and as owner of enterprises. It is therefore suggested that contracting occur out of after tax profits alone. This will mean discontinuing those aspects of the widely-used contracting forms that are conducive to tax remission. xxii. The rationale for the report's recommendation that the deductibility of amorti-;ation of bank loans be disallowed effective now, beginning with borrowing for new investment, lies in the positive effects this would have on government revenue and, by raising the cost of capital, its dampening effect on investment. It would also bring enterprise taxation somewhat closer to international practice on the income tax. Greater efficiency of new invest- ment would also be promoted, an objective which would also be su?ported by using more effective monetary and interest rate policies. xxiii. Other Direct Taxes. With respect to other forms of direct taxation of enterprises, the report recommends: (a) that the tax on extrabudgetary construction be phased out as and when interest rate and credit policy more effectively control investment; and (b) that the income adjustment tax on state-owned enterprises be phased out. xxiv. Such taxes on enterprises profits are common in socialist countries where t.,Aey are intended to discourage excessive investment and encourage more rational use of capital by explicitly raising the shadow cost of capital to the enterprise. The report recommends that these taxes be phased out as and when macroeconomic levers and policies--most importantly interest rate and credit policy--have become more effective and when the cost of capital itself is sufficient to rep-late investment decisions. The adjusunent tax would effectively be replaced by the payment by the enterprise of a dividend to the State. xxv. Resource Taxation. With respect to the Resource Tax and the taxation of resource-using enterprises, the report recommends that: (a) the present enterprise income tax continue to be applied to all resource using enterprises; (b) the resource tax be extended to all enterprises that have access to natural resources; and (c) the resource tax (or a land use tax or fee) be applied to urban uses of land. xxvi. The report recommends that the tax authorities charge for natural resources in much the same way as for fixed assets. The absence of a mecha- nism for valuing fixed assets in State enterprises is offered as an argument for the income adjustment tax which is levied on profits. Likewise, profits are used by the authorities as a surrogate for the value of resources, and the  - vii - lack of a market in resources causes the resource tax to be levied as an 'excess profits tax". Both types of tax, by failing to distinguish between sources of "excess profits", run the risk of penalizing more efficient enter- prises. Thus, higher taxes on profits could penalize enterprises who earn those profits as a result of lower marginal costs of resource extraction, or greater skills in using fixed assets on behalf of the State. xxvii. The arguments with respect to land taxes here are similar to those supporting the extension of the resource tax. It is important that the land use chargeslor fee be set at a level that reflects land's social value so that an enterprise's use of this resource (in the absence of a market for the resource) reflects its value and incentives for improving its efficiency in use are correspondingly enhanced. xxviii. Taxation of enterprise profits, together with-a contracting on after- tax profits in the form of a dividend, and taxes on enterprises' use of resources and land would ensure that the enterprise's use of the three major factor inputs--capital, land and resources--(in the absence of markets for the latter) more truly reflects their soc'.al value and that Incentives to improve efficiency in use are correspondingly enhanced. In the absence of such pricing of enterprise inputs, greater retention of earnings by enterprises is no guarantee of better resource allocation. xxix. Personal Income Taxation. Finally, with regard to direct taxation of individuals, the report recommends: (a) that the personal income adjustment tax be strengthened, with a view to the eventual elimination of the wage bonus tax. xxx. As wages increase towards the exemption level of the personal income adjustment tax, its strengthening would allow tax policy to limit excessive inequ&lity while continuing to serve the function of controlling macroeconom- ically unsustainable increases in consumption. Consideration should be given to including payments in kind in the base of the personal inccme adjustment tax. xxxi. Indirect Taxes: VAT and Product Tax. It is recommended that with respect to indirect taxes: (a) the VAT replace the product tax on those sectors still subject to it, and that the existing VAT and product tax be replaced by a value added tax of the consumption type as distinct from the "gross product" VAT currently in use; (b) that the VAT be implemented via the "invoice method", rather than relying on presumptive crediting as at present. (c) the proposed VAT would (i) apply to manufacturing and imports, (ii) exempt agriculture and services; and (iii) "zero rate' exports; and (d) the rate structure of the reformed VAT on manufacturing and imports be simplified significantly, especially for intermediate goods, and moved towards a single unified rate in line with price reforms.  - viii - xxxii. Replacing the product tax with the VAT has two advantages: First, by removing the divergences (due to cascading) between the statutory tax rate and the actual tax borne by each sector, it makes the actual tax burden and effects of taxation more transparent. Second, it ensures that exporters enjoy the full benefits of "zero rating", increasing the competitiveness of Chinese exports. xxxiii. A VAT of this kind recommended for China could be implemented even in the absence of price reform. Its implementation would be made easier with a more simplified rate structure; the adoption of such a rate structure depends among other things, on price reform. This is due to the use, in China, of the VAT to affect profitability of sectors producing goods subject to price controls. xxxiv. These recommendations for simplifying the rate ^. -uxcture of VAT reflect both the requirement for administrative efficiency and the report's view that differentiated indirect taxation is an inappropriate method of implementing industrial policy and that tax policy should not be used as a substitute for correcting price distortions. The basic rates of VAT would be influenced by public revenue requirements. With the implementation of price reforms it would be possible to introduce a single, uniform VAT rate. xxxv. The coverage of VAT would initially be confined to manufacturing and imports. It could eventually be extended to the retail level in the longer term, in line with the evolution of administrative capability. A consumption- type VAT would have the advantage of not discriminating against investment; control of investment is more efficiently achieved by interest rate policies, and on the fiscal side, by the measures recommended above for reform of principal deductibility under the enterprise tax. xxxvi. A standaru rate of VAT of 15Z, supplemented by selective excises, the report estimates, could raise as much revenue as the existing product tax, VAT and excises. A higher revenue requirement (e.g. to reestablish macroeconomic control prior to price reform) could be accomplished through a temporary, across-the-board levy on indirect taxes on top of the VAT structure. xxxvii. Excises and Other. With respect to the remaining indirect excise taxes the report recommends: (a) that capplementary excises be levied on items such as tobacco and alcohol whose consumption the government wishes to discourage; on gasoline and diesel to charge for road use; and on selected luxury items; and (d) that the business tax continue to be applied at the wholesale and retail level in the service sectors; xxxviii. The imposition of supplementary excises on luxury goods and perhaps others goods is consistent with international practice and poses no adminis- trative difficulties. Such excises will contribute to the revenue yield of indirect taxes (in such cases where the simplified VAT rates -uply a lower tax burden). They can also enhance the equity of the tax system if higher rates  - ix - are imposed on goods whose consumption is concentrated in better-off groups. The report's recommendation to maintain the present business tax has its roots in administrative considerations. Strengthening Subnational Government Finances xxxix. The overall reform process is changing the balance of revenues accruing to the zentral and local gover.merts. Current revenue sharing arrangements have shifted in favor of the provinces, which now retain a larger fraction of collected revenues. This is consistent with the spirit of reforms, specifically the decentralization of responsibility to lower levels of government. However, the central government's failure to achieve corres. ponding reductions in expenditures has led to budgetary pressures. This appears untenable in the long run, and mechanisms need to be developed--some combination of new local taxes, a reassignment of existing taxes or redivision of the tax base--to serve better both central and local interests. xxxx. The choice of a particular central-local fiscal relationship depends on how the government weighs the benefits of provincial responsibility for development versus lese central control. If the central authorities wish to strengthen the management of the revenue system as a whole they will need to reduce, if not eliminate, the local government's power to administer the tax system, to implement tax policy, and the discretion to give special tax concessions. If, on the other hand, they retain the present somewhat uncon- strained approach to decentralized implementation of tax policy, the central government will be less able to use tax policy to pursue macro stabilization and equalization goals. One cannot have it both ways. These issues are part of the more fundamental question of how far and in what manner to take govern- ment fiscal decentralization and this, ultimately, is what must be decided. In China, a difficult balance needs to be struck between centralizing the management and regulation of the tax system better to pursue macroeconomic objectives and increase the central government's equalizing capacity, and decentralizing to accommodate the diverse needs and preferences of the provinces. xxxxi. Rather than recommending any one alternative, the report considers several models of central-local relations, seeking to address the questions: (a) What is the "appropriate' share of revenues to allocate to the local government sector and what is the "appropriate" way to distribute this amodnt among local governments; (b) How much fiscal autonomy should be given to local governments and in what form should this autonomy be given; and (c) Is it possible to continue the present system of centralized tax policy responsibi- lity with local tax administration responsibility? xxxxii. At one extreme is a centralized tax sharing approach under which major taxes such as the enterprise income tax and the product, business and value-added taxes would become fixed central revenues. Local governments would be given the minor taxes. Most local government revenues would come from a regular formula grant program, with the formula chosen to reflect certain criteria such as population, size, per capita income, infrastructure requirements, tax effort, etc. The main advantages to this approach are: (a) it facilitates the exercise of the national government's responsibility to  - x - ensure an appropriate balance between widely varying needs and resources between regions and/or provinces; (b) it puts the central government in a better position to use the tax system for macrostabilization g3als; and (c) it makes possible the use of the tax system as a lever to achieve allocative goals. The biggest disadvantage is the reduced incentive for local government revenue mobilization. A more balanced version of this approach would give local governments relatively more revenue sources, and correspondingly fewer grants. This would give the center less flexibility than the centralized version of tax sharing. xxxxiii. A third model would be based on tax base sharing. This arrangement would have local and central governments share in the base of the enterprise income and product, business, and value-added taxes. The central government tax would be fixed by the central government at a rate that met its revenue needs, and local governments would be permitted to elect (within a range) a surtax rate on each base. Local revenue administration might be retained, but local governments could not engage in any tax relief policies that would effect the base or rate of the central government tax. xxxxiv. Finally, the report considered the possibility of reforming the present system to eliminate its most undesirable features while retaining its strengths: (a) the objective of giving the central government more control over the tax system better to pursue stabilization policy, would be served by eliminating or reducing local government discretion to give tax concessions or tax contracts to local enterprises, and reducing the retained shares of local governments; (b) the objective of equity among provinces would be served by replacing the present arrangements for distribution across provinces with more of a formula based on indicators of need and taxable capacity; and (c) the objective of separating the central and local taxing powers would be served by giving local governments some additional taxes. Tax Policy and Macroeconomic Balance xxxxv. China's consolidated budgetary revenue has grown at about 8Z p.a. since 1978 slightly less rapidly than expenditures. A deficit has emerged as reforms have led the government to yield control over pre-reform revenue sources (such as the enterprise profits and depreciation funds), without a corresponding degree of reduLtion in expenditures. A byproduct of this revenue shortfall has been pressures for a "claw-back" of enterprise profits through a variety of ad hoc tax increases and surcharges levied largely on enterprises, as well as the introduction of various off-budgetary financing arrangements and earmarked revenue sources to safeguard financing required for key central government projects. Hitherto, high levels of household savings, the rapid growth of GDP, and the low initial level of government debt in relation to GDP, have prevented the emergence of major macroeconomic or external imbalances and a modest deficit may well be sustdinable in the near term. However, a continuing downward trend in revenues without expenditure restraint would heighten concern about the fiscal deficit. xxxxvi. The macroeconomic problems in the post-reform Chinese economy high- light the need in the longer term, for a fiscal policy which supports domestic stabilization objectives. A strong fiscal policy tool should not be equated with a larger governmest role or share in the economy, but rather a tool which  - xi - effectively provides the necessary flexibility to meet changing expenditure and macroeconomic requirements as reforms proceed. xxxxvii. At the same time that a more effective fiscal policy instrument is needed, a number of developments over the reform period have reduced the central government's ability to use fiscal policy to achieve macroeconomic goals. On the revenue side, the major elements are: (a) the development of the "enterprise tax contracting" system; (b) the decentralization of fiscal powers through the "provincial contract responsibility" system for provincial governments; and (c) the shift of resources to off-budgetary categories of expenditures financed by borrowing. That this is occurring at the same time that other government policies are contributing to the emergence of inflation- ary pressures, makes the reduced control and flexibility of the central government to use tax policy as a stabilization instrument ill-timed indeed, and is particularly problematic in China where for a variety of reasons, mone- tary and interest rate policy have not been used as an effective tool for macroeconomic management. xxxxviii. Looking to the future, on the expenditure side of the budget, it is important that the reforms planned by the authorities in areas such as social security, housing and pension reform be designed from the outset with budge- tary custs in mind.l/ If such precautions are not taken, it will be necessary to raise additional funds via the tax system. xxxxix. To restore the fiscal lever as a stabilization tool, the report recommends that the inclusion of taxes in contracting be subject to serious scrutiny and that all new contracts exclude contracting for taxes. This will, as the old contracts phase out, eliminate the procyclical aggregate demand element which tax contracts introduce into tax policy, by leaving relatively more resources within enterprises, as production and profits grow to further fuel demand. 1. The report also suggests that, to enhance macro control, the central government limit local governments' ad hoc implementation of the central government's unitary tax code, especially their granting of tax relief at the expense of revenue transfers to the center, and that consideration be given to redesigning the provincial centracting system for provincial revenue sharing. This aspect of fiscal decentralization has reduced the stabilization proper- ties of the tax system and reduced the central government's ability to use fiscal policy for stabilization purposes. As stated above, while the report makes no explicit recommendation on the appropriate balance of centralization vs decentralization it emphasizes that the government must weigh the benefits of decentralization against the costs of having less central capacity to manage and direct the system. li. Finally, to conduct macroeconomic policy effectively through the fiscal system, the authorities must have a true picture of the impact of the budget on the economy. The report suggests that greater transparency be given to the Government accounts, and that extrabudgetary accounts be aggregated 1/ Two World Bank studies are planned for FY89, which will examine reforms in social security and housing finance and make recommendations as to their scope and financing.  - xii - with the budgetary accounts. This would ensure that the budget better reflects the true resource transfer to government and the actual tax burden on enterprises. It would also clarify the present situation in which the overall revenue collection is declining as a percent of GNP at the same time that the effective burden of taxes and nontax charges on enterprises appears to be rising. Under present orders of magnitude, and assuming such fees are not. indeed user charges, the extrabudgetary revenues of government agencies are equivalent in tax terms to an increase in the enterprise income tax rate from its present level to more nearly 67Z. Formal taxation, with the certainty and transparency it implies, is preferable. lii. Further, and more importantly, the government should limit the intro- duction of additional off-budgetary financing or earmarking mechanisms for its expenditures. Such mechanisms erode the reliability of the budget as an indi- cator of the fiscal position and also make it more difficult to pursue stabilization using fiscal policy. Strengthening Tax Administration and Collection liii. In contrast to other countries, the central government in China has no tax collection mechanism of its own, relying rather on local governments (mostly at the city and county level) for the collection of taxes and their remittance to the central authorities. Provincial and local governments are not at all monitored and their staffs are inadequately trained and not equipped to handle the enormous number of taxpayers and rates. Thus, decen- tralization to this degree has left the central government critically short of information about the workings of the tax system and without the means for bringing about increased efficiency or greater standardization of treatment. This, together with the unavailability to SAT of legal enforcement powers considered standard in most other countries also severs the link between tax policy set at the central level and its actual implementation. Legal short- comings weakens tax policy in operations. The "tax levers" that the Central Government designs may be far different from the fiscal measures that are actually implemented. liv. The present rvstem which has been described as embodying the princi- ple of 'unified leadership, multilevel implementation', has considerable strengths from the point of view of the center, local governments and taxpay- ers alike and has served China's needs well in the pre-reform period. A local presence ensures local governments are responsive to local circumstances, and decentralization lessens the problems arising from the sheer size of the country. lv. But the system's inherent ambiguities also give rise to problems. For example, significant variations in practice apply in different provinces and regions. Local tax officials are also answerable to two masters--the Tax Bureau immediately superior to them and the local government of which they are part. Likewise, local governments themselves play a dual role in relation to 'their' enterprises--as owner and tax authority. The system also suffers from serious deficiencies as regards information flow and lack of uniformity and coordination. For the central government in particular this led to a general lack of control. At best, the effects of tax policy decisions might not be easily predictable. At worst, contradictions in tax policy occur.  - xiii - lvi. Because reforms to the overall tax system and the system of local finance remain in flux, the report outlines two broad approaches to tax administrationt (a) to introduce a "National Tax Service' run by the central government, along the lines of e.g., the Inland Revenue, or IRS and with Central Tax Bureaus at the local level; and (b) to standardize and strengthen the present administrative ,tructure and to adapt it to the demands of changed circumstances. lvii. A 'National Tax Service' and a more centralized system should, for work-effectiveness, integrate the administration of VAT, business tax, resource tax and enterprise, joint venture and personal income tax (and any other taxes on these bases). Other taxes could be left to local administra- tion. The report, however, sees this as a long-run option, in view of the enormous personnel shifts and staffing involved. lviii. In the near term, strengthening the administrative system is essen- tial. The report recommends creation of a specialized management unit within the State Administration ior Taxation and the introduction of an integrated management information system to assist management at all levels. Further steps would includes strengthening personnel and training functions, and the internal audit system; establishing a central "organization and methods" unit; establishing a central automatic data processing unit and arranging to stan- dardize administrative best practice. lix. The report also considered microlevel reforms within the existing tax administration and identifies improvements which could be implemented regardless of whether the overall system is subject to greater centralization. lx. The filing and payment s,stem should be strengthened by reducing the frequency with which taxpayers make tax returns, and streamlining administra- tion by requiring enterprises themselves to calculate and pay over income taxes. Such a change would need to be underpinned by more effective auditing and by credible penalties. At the same time it should be possible to simplify and rationalize the methods by which taxpayers actually pay their taxes. In the longer term, the introduction of a single tax account for each taxpayer bearing a unique taxpayer identification number would simplify the tax authorities' internal accounting system. lxi. The report recommends also standard invoices and return forms--essen- tial for the introduction of an invoice-method VAT. The personal income and personal income adjustment taxes would be more easily administered as an annual tax, with simplified withholding from employment income and annual returns in which taxpayers were responsible for calculating and paying correct tax liabilities. lxii. The audit and checking systems at present involve an exceptionally high ratio of staff to taxpayers in part because of a practice of tax officials esident in enterprises, which the report recommends phasing out. The report also recommends a more selective approach to examinations and that more selective efforts be put into audit and enforcement in view of the low level of the additional tax collected in relation to international standards. For best effectiveness, the audit effort should be based on stratified sampling and concentrated on vulnerable areas. The regular amnesties for defaulters should not be continued.  - xiv - CHINA REVENUE MOBILIZATION AND TAX POLICY Preface This report summarizes the findings and recommendations of a World Bank mission which visited China in June, 1988 to analyze, in collaboration with a Chinese counterpart team from the Ministry of Finance and other govern- ment agencies, the present status of China's fiscal system and, on the basis of this analysis, to make recommendations for further improvements. The mission benefitted from another, earlier, study of tax and expenditure developments, financial intermediation, and enterprise reforms, undertaken by another joint World Bank mission and counterpart team.21 A companion volume of annexes provides more in-depth analysis and a full description of China's present tax system. The focus of the Report is on China's tax system per se. Public sector pricing and user charges are not examined. Likewise, while the report is concerned with expenditure trends as an essential ingredient to formulating a sound tax structure and revenue adequacy, expenditure policy does not receive in-depth treatment. The report's main themes are the need for a more efficient set of tax instruments; the need for a more flexible revenue instru- ment, and the need to reform subnational tax, financial and administrative practices. The macroeconomic themes are discussed first in Chapter I which looks at China's tax policies and macroeconomic management issues relating to tax policy and the budget. Chapter II describes China's tax system at the present juncture, and discusses optiors for reforming the tax system in a way which promotes greater efficiency. Chapter III focuses on the present situa- tion for provincial and local finance, and Chapter IV offers recommendations for the strengthening of tax administration. 2/ World Bank: China - Finance and Investment, Report No. 6445-CHA, June 1987.  CHINA REVENUE MOBILIZATION AND TAX POLICY I. CHINA'S TAX SYSTEM AND MACROECONOMIC BALANCE Introduction 1.1 As a central element of its overall strategy to improve allocative efficiency and promote the modernization and growth of the economy, the Chinese government set in motion in 1979 a process of reform aimed at decen- tralizing production and investment decisions and subjecting them increasingly to market influences. Reforms in the rural sector contributed significantly to its remarkable growth in 1979-84. Beginning in 1984, reforms were initiated in the urban sector, with major changes in enterprise management and finance. The urban reforms reduced the role of thE government in the economy, in determining both the allocation of resources and financing. 1.2 These reforms changed the government's expenditure responsibilities, its needs for revenue and the means for raising it. Taxation became a new element in the government's relation with enterprises, households, and provinces. Tax reform continues to be an imnortant factor in the success of China's reform effort. Hitherto, the st-ps for addressing the balance of revenue and expenditure and the fiscal balance between central and local government have been largely experimental. Examples include the introduction of experimental enterprise taxation in 1979 and the introduction of contracting in 1986. 1.3 This chapter briefly reviews China's tax system and provides a preli- minary assessment of key issues facing China as it develops its tax system as a fiscal instrument. Section A briefly reviews China's progress in tax reform to date, together with an international perspective. In Section B, recent developments in China's budget are discussed, including trends in revenue and expenditure, the deficit and its financing. Section C outlines the key macro- economic features of China's tax system, including the implications of con- tracting, provincial finaace and the reforms. The section concludes with an assessment of China's tax system in light of these macroeconomic considera- tions, while Section D previews other issues discussed in Chapters II through IV of the report. A. The Progress of Tax Reforms to Date 1.4 The reform process taking place in China since 1979 emphasizes a devolution of power to lower level entities, giving greater decision-making responsibility to enterprises and provincial governments. These changing -esponsibilities affect the role and size of the government budget. With ;reater autonomy given to enterprises and local governments, the central government's effectiveness in mobilizing resources and its role in financing investment and other expenditures has diminisraed, as well as changed in nature and scope. This shift is reflected in the trends in tax and nontax revenues mobilized by all levels of government in China, which have fallen from some  S. *f ~ 2- 342 of GDP in 1978 to just under 20X in 1988 (as shown in Table 1.1).1/ This decline reflects a reclassification of revenues from the budget to the enter- prise sector and parallels the decline in budgetary expenditures which has come about as a result of the devolution of expenditure responsibilities to enterprises. It also reflects structural inelasticities in revenue generation. 1.5 Shift in the Pattern of Revenue Generation. China's revenue system has undergone significant change since the reforms. Before 1979, government derived revenues by tapping sectoral surpluses through nontax means. Agri- cultural surpluses were tapped through price ceilings and procurement policies; wage policy reduced surpluses in the urban household sector; and enterprise surpluses were remitted to the budget. Indeed, until 1983, the bulk of government revenue, approximately 60?, was generated from the remit- tance of profits (that is cost-price margins) by state-owned enterprises to the government budget. In the early 1980s, this system began to be replaced, on an experimental basis, with taxation of enterprise profits in an attempt to provide state-owned enterprises with greater incentives for increasing efficiency. This experimental system featured, broadly, a statutory 55? enterprise tax rate (there was a separate tax for collectives and small scale enterprises, and for enterprises involved in natural resource extraction) and an "adjustment tax" which was intended to tax awav "excess" profits (defined as profits as a return on sales) accruing to an enterprise as a result of factors external to the enterprise, such as the structure of administered prices in relation to input costs, in particular, raw materials costs and capital with which enterprises had been costlessly endowed by the State. 1.6 Commodity taxes were also restructured at the same time, with the previous "consolidated industrial and commercial tax" (CICT) divided into three separate indirect taxes: the VAT, the business tax (levied on enter- prises in the services sector) and the product tax (levied on industrial sector enterprises). Commodity taxes were also designed to equalize profits. In the absence of a flexible price system, unequal profit margins caused by plan price distortions were thought to create artificial producer preferences, which could be inconsistent with those the authorities wish to signal. One objective of this indirect tax-cum-price mix was to ensure equalization of profits across sectors. Indirect taxes in China are therefore much more like 1/ All revenue and expenditure figures reported in this study have been adjusted to conform with conventional presentation of budgetary accounts as outlined in the IMF's "Government Finance Statistics GFS) Manual." See Chapter I, Box 1.1 for an elaboration of the differences between Chinese and GFS presentations.  direct taxes than indirect taxes.21 However, with tax rates set by commodity, only equalization across sectors can be achieved. The adjustment tax was a refinement to equalize profits of enterprises within a sector as well as to increase revenue to the government which had fallen following the switch from profit remittance to tax. As illustrated in Chapter II, a major shortcoming is that the measure of profitability forming the basis for tax policy--an enterprise's return on sales--bears little relationship with profitability of investment. Thus heavy taxation of industries with 'high profits" can reduce funds for expansion or for wage bonuses, which now come from retained earnings r^.ther than government grants as in the past (see Box 2.1 on "Alternative Measures of Profitability"). Table 1.I.: C4HDA: SAMDlARY REVSJES, 1980-88 (1a1 fCP) 1978 1979 1980 1981 1982 1983 1984 1983 1Q88 1987 1988 1988 (eudget) (Actual) I. Direct taxes a 20.4 18.8 17.8 18.8f 14.3 13.3 11.9 8.4 8.7 7.4 6.2 n.r,. of which: remittances (18.9) (17.5) (16.4) (15.6) (18.3) (11.8) (10.1) (O.S) (0.4) (0.4) (0.4) II. Indirect taxes Lk 12.0 11.7 11.3 11.4 11.7 10.7 10.6 12.1 11.7 10.6 8.8 n.s. III. Taxes on %rade 0.8 0.7 0.8 1.2 0.9 1.0 1.5 2.5 1.6 1.3 1.0 n.a. IV. Other tax and nontax LS 0.8 0.7 0.8 1.2 1.1 3.4 3.2 3.6 4.0 4.2 2.9 r.. V. Total Revenue 34.0 32.1 P0.4 29.9 28.0 28.8 27.1 27.5 26.0 28.4 19.0 19.8 VI. Memo iteam: Total expenditures 8S.8 37.3 33.7 31.2 29.4 80.0 28.7 28.0 28.2 25.7 21.2 22.0 Deficit +0.2 -5.2 -3.3 -1.8 -1.4 -1.7 -1.6 -0.5 -2.2 -2.6 -2.2 -2.4 LS Includes taxeo on state enterprises, the adjuustment tax. all profit remittances from atate enterprises up to 1984, profita tax on collective (CICr). and tax on extrabudgetery funds, construction tax, and other udirecta taxes. / Product tax, VAT, business tax. Residual: includes depreciation funds and other taxes. Source: Ministry of Finance and IMP. 2/ In China, reference is often made to "pure" indirect taxes, and "impure" indirect taxes, the former being those which are levied in market economies and designed to be taxes on consumption, ana the latter, fal'ing, in a fix-price environment, on profits. The distinction between direct taxes and indirect taxes is blurred in China due to the use of indirect taxes as tools for equalizing profitability. This discussion and the accompanying tables, follow the convention that direct taxes are those formally levied on profits and indirect taxes (such as the VAT) are on commodities. However, the reader should be aware that in China's fix-price environment, indirect taxes are designed to be levies on profits.  - 4 - 1.7 The results of experiments in direct and indirect taxation were closely watched and in 1984 China introduced a general tax reform. Broadly. the reform was fixed in outline by 1985 and comprised: (a) a series of corpo- rate income taxes applied to all state enterprises and collectives, levied on net income, plus a "profits adjustment tax" to compensate for excess profits earned by some enterprises due to ongoing price distortions and the different capital endowments of enterprises; (b) the transformation of the commodity tax into separate retail and wholesale taxes on intermediate and final goods, and the introdt'ction of a partial VAT to selected sectors of the economy; (c) various low-yielding 'pre-refo."ml taxes--salt tax, slaughter tax, market tax. agriculture tax, etc.--which accrued to local governments, were left in placet and (d) a series of ad hoc taxes on extrabudgetary "construction", wage bonuses, and extrabudgetary funds were introduced to control enterprise expenditures in "unproductive" areas, in the absence of appropriate price signals and traditional tools of macroeconomic control such as interest rate and credit policies, and other demand management instruments. 1.8 Since 1986, tax reforms have focused on a more general application of a system of enterprise incentives known as the "contract system." Inaugurated selectively and experimentally from the late 1970's to the mid 1980's, it now applies to over 802 of enterprises. This system aims to develop enterprise performance responsibility by establishing clear criteria for profitability and accountability. While contracts differ in their details (four major types are described in Box. 1.2 on "The Tax Contracting System"), all establish a contract between government and enterprise determining profits or taxes to be remitted by the enterprise to the government.3/ The contract system has shes uniform taxation of enterprises. 1.9 In the area of indirect taxation, the coverage of the VAT has been broadened since the initial reforms and now covers all but three industrial subsectors. A number of low-yielding taxes have also recently been intro- duced, such as a "vehicle and ship usage tax", stamp tax, a banquet tax and housing, and land taxes in urban areas. A tax on "households engaged in enterprise" and a "personal income adjustment tax" have both been applied to individuals for the first time in 1988 in China. Some of these minor taxes have been assigned to local government in an attempt to increase their revenue sources. The housing and land taxes, although yielding little revenue now, 3/ A full description of the Chinese tax system, up to 1986, is to be found in Finance and Investment, (CHA 16445) Annex III. A full description of reforms under the contract system is to be found in "Symposium on Enterprise Reforms in China," Diaoyutai Guest House, Beijing China, October 4-10, 1987; and Kochav, David; "China: Enterprise Management Report: Issues and Options;" October 18, 1988, AS3, IBRD, CHA-__, 1988.  represent an attempt by the government to begin to tap the growing surpluses arising in the household sector as a result of wage reforms and the responsibility system and establish direction for future reform. 1.10 As a result of these changes. China now has a significantly more formalized system of taxation than before, consisting in the main of corporate income and profits taxes (budgeted in 1988 to generate some 331 of total revenue); domestic indirect and commodity taxes (contributing 46?); and customs duties (62). Agricultural sector taxation and personal income taxa- tion together contributed an insignificant share (about 1.5?) of total revenue, while miscellaneous other low-yielding taxes contributed some 71 and nontax revenue contributed the remaining 6?. Table 1.1 showed how these revenue trends have evolved over time, and reflects both the striking declin- ing share of revenues in GNP as well as the shift in reliance from direct to indirect taxes. 1.11 Changes in Revenue Sharing. Major changes have also taken place in the area of local government finance. China's fiscal system is a unitary one. In principle this means central government directs expenditure policy and determines all aspects of tax policy. All taxes, with few exceptions, are national-level central taxes formally accruing to the central government, which then shares them with provincial, lower level governments. Subnational governments have few revenue sources of their own. However, because taxes are collected at the local level, by local governments on behalf of the center, the central government's revenues in fact accrue in the first instance, to lower level governments. 1.12 In this regard, therefore, China differs from many other countries in that the central government collects very few of its own taxes. Rather, local government, typically municipal and county-level government, collects most revenues other than customs duties and selected excises. This reliance on local government for tax collection complicates analysis of the system because local governments have substantial effective control over the revenues they collect. From the perspective of tax collection, China is strikingly decentralized.4/ 1.13 This revenue-sharing system is an outgrowth of earlier experiments beginning in 1980 that moved from the 'big pot" system in which all revenue and expenditure authority was centralized, to revenue sharing based on the principle of "eating out of separate kitchens." These reforms attempted to devolve greater revenues as well as expenditure responsibility to provincial governments to establish better incentives for local revenue mobilization and expenditure control. The new system assigned some taxes to the central government or local governments exclusively, and other taxes were shared between levels of government along with a system of grants. One purpose was to develop a local government tax base. Refinement of the revenue sharing formula was to enable the provinces, in principle, to plan and budget over a multiyear period. 4/ Only in Brazil, Colombia and Nigeria, among developing countries, do subnational governments contribute significantly (25-35z). In most others, the subnational share of the total is in the 15-20? range, and in many it is 52 or less (See Chapter III for detailed table).  - 6 - 1.14 This initial reform program has undergone several changes since 1979. TUnler present arrangements, the central government has negotiated multiyear "revenue' contractsm with many of the provinces, under which the provinces will remit a guaranteed level of revenues to the MOF. Some targets are fixed in nominal terms, others incorporate some revenue growth. 1.15 International Comparisons. China's tax system differs significantly from other countries in its income group both in level and structure. Becausc of the major government role in the economy, the level of revenues as a share of GNP has been relatively high, as shown in Table 1.2, almost twice that of other countries at its income level. China's tax structure is also unusual for a country with its per capita income, with direct taxes (see Table 1.3) making up about one-third of the total in 1988, compared with some 17Z for other countries with similar per capita income. China shares this feature with the socialist countries of Eastern Europe, where a large fraction of total revenues come from the socialized enterprise sector. China collects a far higher proportion of its total revenue in indirect taxes than its compara- tors. Of total revenue, 46? comes from commodity taxes, more than any other country group. China is also unusual regarding trade taxes on which most low income countries rely heavily. In 1988, trade taxes contributed about 6Z of total revenues in China and almost 30Z of total revenues in other low-income economies. Table 1.2 INTERNATIONAL COMPARISONS OF EXPENDITURE AND TAXATION Country Group Per Capita Expenditurel Revenue/ Deficit/ Income ($) GNP (Z) GNP (Z) GNP (Z) China (1978) 230 34.0 34.0 +0.2 China (1988) 320 22.0 19.8 -2.2 Low income countries 270 20.8 15.4 -5.1 Middle income countries 1,510 27.5 24.0 -5.8 Industrial countries 10,760 28.6 24.1 -5.1 Other Socialist countries 2,000 65 62 -3.0 Source: World Development Report, 1980, and 1988, Tables 23, and 24 (sample of 90 countries) and P.T. Wanless; Taxation in Centrally Planned Economies; Croon Helm Publishers, Beckenham, T'K, 1985. Note: For all country groups listed, data refer to central government revenue and expenditure only; for China: consolidated central and provincial revenue and expenditure on a GFS basis. Figures for socialist countries are unweighted averages and not strictly comparable. 1.16 A striking difference between China and other developing countries is also the near total absence of any personal income taxation, although to some extent in China and other socialist countries, wage and subsidy policies are  -7- akin to personal taxes. In most market countries, direct taxes ar3 imposed on both personal and corporate incomes; on average, about 40? of direct tax revenues derive from the former and 60? from the latter. In China, the entire explicit burden of direct taxation is on the 3nterprise. Table 1.3: INTERNATIONAL COMPARISON OF REVENUE STRUCTURE (2 of Total Revenues) Income Other tax Country group and social Profits Commodity Trade and nontax security taxes taxes taxes revenues China (1978) -0- 62.3 32.9 2.3 2.3 China (1988) -0- 33.0 46.0 6.0 15.0 Low income countries n.a. 16.8 32.2 28.1 19.8 Middle income countries n.a. 25.7 25.5 8.3 22.5 Industrial countries 16 24.0 17.3 1.2 9.0 Other socialist countries 10 50-70 20-30 n.a. 1.0 Sources: World Development Report. 1988: Table 23, and P.T. Wanless; Taxation Centrally Planned Economies; Croon Helm Publishers, Beckenham, UK; 1985. Vito Tanzi; Quantitative Characteristics of Tax Systems in Developing Countries", in D. Newbery and N. Stern; eds. Modern Tax Theory for Developing Countries; Oxford University Press, for IBRD; 1986. Data for all countries are for 1985. Note: Central government revenues only for country groups; consolidated central and local revenues for China on a GFS basis. B. Revenue and Expenditure Trends: China's Recent Budgetary Experience 1.17 Fiscal policy is a central instrument of macroeconomic management and stabilization policy. The design and implementation of tax policy is thus a crucial element in determining China's ability to carry out the macroeconomic policies and stabilization programs required to underpin the structural adjustments which China's economy is seeking to attain. In the pre-reform system, tax policy did not play a major role and government expenditure was the primary instrument of fiscal policy. Revenues were determined by profit remittances from enterprises and channeled back to enterprises through Plan investments, working capital allocations, and subsidies. During periods of overheating, administrative cutbacks in government expenditures--usually investment expenditures--were made to contain inflationary pressure. In the new economic system, the emphasis has moved towards the use of 'indirect levers" and tax policy to regulate the behavior of increasingly autonomous economic agents.  1.18 China's budgetary revenues have grown at 8.32 since 1978, slightly less rapidly than expenditures. A modest deficit has emerged as reforms have led central government to surrender control over pre-reform revenue sources (such as the enterprise profits and depreciation funds) without a correspon- ding degree of reduction in expenditures.5/ Table 1.4 shows these recent budgetary trends, according to the standard presentation of fiscal accounts. Box 1.1 outlines differences between Chinese presentation of budgetary accounts and thos- more commonly used in other countries. 1.19 Trends in Revenue. A salient feature of the evolution of government revenue since the onset of the reform is that consolidated government revenue as a ratio of GNP has been falling continuously, from 34Z in 1978 to just under 20Z budgeted for 1988 (Table 1.4).6/ The primary cause of this trend is the steady decline in direct tax revenue from the enterprise sector, which has grown nominally at less than 22 annually over the 10 year period, and declined from about 202 of GNP (602 of total revenues in L978 when all enterprise profits were still remitted to the budget) to an estimated 6.5Z of GDP in 1988 (322 of budgetted revenue). Enterprise income taxation with its emphasis on contracting has reduced the importance of profit remittances and taxes as sources of government revenue (see Box 1. 2 on 'the Tax Contracting System"). Less than 1.6Z of total revenue now derives from profit remittances, compared to 56Z in 1978. 5/ All revenue and expenditure figures reported in this report have been adjusted to conform with conventional presentation of budget data as defined in the IMF's Government Finance Statistics Manual. See Box 1.1 for a discussion of the differences between Chinese budget statistics and GFS format. 6/ This reflects buoyancy of about 0.7. Buoyancy refers to the revenue yield of the tax system as a whole including the effects of discretionary modifications of the tax system. Algebraically, buoyancy can be calculated as: Tn - To * Yn - Yo; where To Yo To = tax collections in the first year of the period being measured. Tn = tax collection in the final year of the period, and Yo and Yn are GDP in the first and last years, respectively. Buoyancy can also be calculated as the coefficient of a log-linear regression equation regressing on the GDP (or some measure of the tax base) tax yield and a constant. Elasticity, by contrast, reflects only the revenue yield from tax(es) in the absence of any discretionary change in the tax (system). Given the major changes that the system has undergone in 1978-88, the buoyancy estimates are presented in Table 1.4 reflect important discretionary tax changes in addition to the underlying dynamics (or elasticity) of the tax system.  1.20 Receipts from the personal income tax are negligible because the vast majority of individuals are exempted, since their income is below the rela- tively high minimum taxable level of Y 400 per month. TIable 1.4.: OCI: DVEL P lrS IN COVMIY REVUJE - CON68LMATED GOV13N 1078-d8 LS (In S of GNP) 1978 1979 1980 1981 1982 1983 1984 1988 1986 1987 1988 Ncminal Buoyancy 1f Budget Oroeth * 1978-d8 Total revenue 34.0 82.1 80.40 29.C 28.0 28.S 27.1 27.4 28.9 28.2 19.0A 8.3S 0.71 Direct TaxeLa 20.4 18.8 17.5 16.8 14.8 18.8 11.9 8.4 8.7 7.4 6.2 2.1S 0.11 Profit tox (1.8) (1.1) (1.0) (1.0) (0.9) (1.1) (1.4) (8.4) (8.8) (7.4) (6.2) (1.65) (0.10) Profit Remittance (18.9) (17.8) (16.4) (15.8) (13.3) (11.8) (10.1) -- - - - Indirect Taxes 12.0 11.7 11.8 11.4 11.7 10.7 10.5 12.1 11.7 10.5 8.8 11.15 0.95 Product tax - - - - -- -- - (7.2) (5.8) (4.9) (3.8) (-2.75) (-0.18) VAT - - - - -- -- -- (1.8) (2.5) (2.8) (2.3) (81.75) (1.81) Business tax - -- -- __ _ __ __ (2.5) (2.8) (2.8) (2.5) (19.89) (1.23) Agricultural tax (0.6) (0.7) (0.6) (0.6) (0.6) (0.6) (0.5) (0.5) (0.5) (0.5) (O.8) (5.55) (0.52) Taxes on int. trade 0.8 0.7 0.8 1.2 0.9 1.0 1.5 2.5 1.6 1.8 1.0 17.95 1.68 Other taxes Lk - -- -- 0.8 2.8 2.0 8.4 1.9 1.9 1.8 14.15 8.95 Nontax revenueaj 0.8 0.9 0.8 0.7 0.8 1.1 1.2 1.1 2.1 2.8 1.6 28.85 1.89 Howo item: Extrabud. receipts: - of government -- -- -- -- 0.8 0.9 0.8 0.6 0.5 0.3 - -- n.u. - of public agencies La - -- -- -- 2. 2.9 2.9 8.3 8.1 3.6 -- - n.a. Profit remittances (18.9) (17.5) (16.4) (15.6) (13.8) (11.8) (10.1) (0.5) (0.4) (0.4) (0.4) - n.s. La Consolidated central. provincial and local governente. Data on di;aggregated basis for 1988 actual revenues asg not available. 1988 total revonue (actuals) wes V 281.4 billion, or 19.85 of GFiP. Lk Includes taxes on *xtrebudgetary receipts, on extrabudgetary construction. and wea Wi binus txa. La Excludes enterprise retained earnings nd dnpreciation funda. . Includes profit remittance 1978-84. /n. Includes profit remittances 1985-88. Jf Buoyancy calculated as the log linear fore of: T - mY8 * a. All coefficients significant at 955 or above. Note: Alternative epeclfications of goes of the buoyancy coefficients aore tested: (I) Seseg tax ma function of retail gIlees (0.8). (ii) Indirect taxes ao function retails saes (0.8). (iii) Trade taxes as a function of (xz*) = (1.1). (iv) Agriculture tax as a function of CVAO a (0.4). (v) Enterprie- profits as a function of OVIO: (0.6) and not significant. Source: Ministry of Finance. (Note: Adjustad according to WFS format, which differs from Chinese budget).  - 10 - Box 1.1: RECASTING THE CHINESE BUDGET The Chinese State Budget consolidates the budgets of the central and local governments. Local government refers to all governments below the national level. Thus, provinces, municipalities, counties and townships are included. The state budget excludes the financial operations of state enter- prises, as well as the so-called extrabudgetary funds. The presentation of budgetary accounts in China differs from that found in most other countries.l/ Among the major differences are that: (i) revenue in the Chinese definition includes all proceeds from domestic tarrowing (treasury bill issues and domestic bank financing) as well as foreign loan proceeds, whereas these are more typically classified as domestic and foreign financing; (ii) similarly, principal repayments on these borrow- ings are included as a form of expenditure rather than as a negative financing item; (iii) operating losses of state industrial enterprises are netted out of gross profits, (as were, until 1987, operating losses of commercial enter- prises arising from the various subsidies for daily living necessities and agriculture inputs) thus including subsidies to state enterprises in revenue (as a negative revenue) rather than as an expenditure item; (iv) the failure to include some 3Z of government (extrabudgetary) expenditures in the budget; and finally; (v) balances unspent in previous years (surpluses) may be spent, and are included in expenditures, but their drawdown is not shown under (increases in) financing. Cash from the sale of state assets (about which no information is available) is included in "revenues." The table below provides a smm-ary of the steps required to move from the national presentation of the State Budget in China to a definition closer to that found in the other countries. The exercise is instructive because it shows that, for the 1987 budget, China's deficit, shown in official statistics as being in the order of Y 8 billion, is in fact closer to Y 32 billion, or more nearly 2.7Z of GNP than 0.7Z of GNP. There are five principal adjustments required: (i) First, it is necessary to recognize subsidies explicitly (whether to cover the price differential between the procurement price of grain and its retail price (this has been done in the Chinese budget since 1987), or the operating losses of indus- trial enterprises) as expenditure. Since in the Chinese defini- tion of revenues, such subsidies have been netted out from gross profit remittances, to include them explicitly as expenditure, these subsidies must be added both to revenue and expenditure. (ii) Second, domestic and foreign borrowing must be subtracted from the Chinese measure of revenue and placed 'below the line" as a financing item. 1/ IMF, A Manual on Government Finance Statistics, (Washington, D.C., June 1974).  - 11 - (iii) Third, foreign and domestic loan repayments (amortization) must be subtracted from the Chinese definition of expenditure, and placed "below the line", as a reduction in financing. (iv) Finally, to present a complete picture of the magnitude of public sector financial operations, the official budgetary tables should be adjusted for extrabudgetary transactions. WhA4.e it is difficult to estimate either the precise magnitude of extrabudgetary expenditure, the overall financial balance on extrabudgetary accounts, or even the characteristics of the sources and uses of such funds, at the very least, the off- budget funds of local governments should be included. These are thought to constitute almost 32 of consolidated "unadjusted" budgetary expenditure. Therefore, budgetary expenditure accounts (and financing items) have been adjusted by an esti- mated Y 8 billion in 1988 of known extrabudgetary expenditure. The financing by "key construction bonds" is also included below the line as financing items. (v) The drawdown of past surpluses, which in the budget is included as an expenditure item, should also be shown as an "addition to financing.n The item is shown, but no data is provided. In addition, and looking beyond the budget and extrabudgetary funds, there is the hidden "quasi-fiscal" deficit in the form of bad loans in the portfolios of state-owned banks and of subsidies to enterprises in the form of low interest rate loans. This is a very important point in assessng the stance of fiscal policies in a broader context. While precise quantitative estimates are difficult, it seems clear that the banking system is partly used as a fiscal agent, and that fiscal expenditures are underestimated in the published budget to the extent that loans are extended to support ailing enterprises. Estimates suggest that this "quasi-fiscal deficit* could be of the same order of magnitude as the deficit itself, and that together they amount to some 5-62 of GNP.2/ 2/ See Bosworth, Barry, "Notes on Visit to Beijing", October, 1988.  - 12 - Box Table : CHINA: REDEFINITION OF CHINESE STATE BUDGETARY OPERATIONS (in billions of yuan) 1988 (Budget) Total revenue: Chinese definition 255.5 Less: - foreign loan receipts 12.8 - domestic loan receipts - Treasury bond receipts 9.0 - cash from sale of state assets Plus: - subsidies for living necessities and ag. inputs - - operating losses of state-owned industrial enterprises 40.7 Equals: Total revenue: recast format 274.4 Total expenditure: Chinese definition 263.5 Less: - foreign loan repayments 4.5 - domestic loan repayments - treasury bond repayments 2.7 Plus: - subsidies for peoples' living necessities and ag. inputs -- - operating losses of state-owned industrial enterprises 40.7 - extrabudgetary capital construction 8.0 - Opast surpluses" a/ Equals: Total expenditure: recast format 305.0 Overall deficit (-): Chinese definition -8.0 Less: - foreign loans received 12.8 - Treasury bonds 9.0 - "key construction bonds' issued 8.0 - draw down of past surpluses a/ - receipts from sale of state assets a/ Plus - loan repayments (foreign) 4.5 - loan repayments (domestic) - loan repayments (treasury bond) 2.7 Adjusted overall deficit (-): recast format -30.1 /a No data available.  - 13 - 1.21 Since the mid-1980s, indirect taxes have been by far the most impor- tant revenue source, accounting for about half of total government revenue. However, while revenue growth from indirect taxes has been 12? over the ten year period, revenue as a percentage of GNP has decreased from just over 11t in 1978 to 9.0? budgetted in 1988. The policy of phasing out the product tax and replacing it with VAT is reflected in the respective growth rates of product tax (-2.7X) and VAT (31.7Z). Revenue from the agricultural tax is low and has grown slowly, at about 5? p.a., and has declined as a percentage of GNP since the late 19709. Behind this lies a political decision to maintain a minimal tax burden on agriculture with low tax rates intended to stimulate agricultural output. Poor tax administration has also played a part.71 1.22 Trade taxes on imports and exports have exhibited the highest growth, at over 14? p.a. However, despite the rapid expansion of foreign trade and the greater openness of the economy, revenue from international trade taxes (essentially on imports) has been falling as a share of GNP since the mid- 1980s. This has largely been the result of a shift in the composition of imports from higher-taxed consumer goods to lower-taxed raw materials and intermediate goods and a tendency to provide tax relief on customs duties in some contracts. Nontax revenues (which included until recently profit remit- tances from financial institutions) account for some 6-8? of total revenue. 1.23 In addition to tax rind nontax budgetary revenues, the government receives so-called lextrabudgetary revenues" consisting of receipts of local governments and government institutions. Local surcharges on the general sales tax and other taxes and fees provide the bulk of extrabudgetary revenue for local governments. Other sources include rental income from public housing and charges for the use of parks and public health facilities. Taken together, these extrabudgetary revenues of government have not grown and have fallen from 0.9? of GNP in 1982 to 0.3? in 1987. Government agencies also collect revenues not reflected in the budget. Their "extrabudgetary revenues" account for about 3.52 of GNP.8/ 1.24 Trends in Expenditures. The economic reforms had a profound impact on total budgetary expenditures, which as a ratio of GNP have declined from 34Z in 1978 to an estimated 22? in the 1988 budget. Overall, expenditures have grown 9.6? per annum over the post-reform period from 1979 to 1988 and government revenues have grown 8.3?, making the decline in the expenditure/GDP ratio much less rapid than the decline in the revenue/GDP ratio. Table 1.4 outlines these trends. A major